Mercury interactive backdating
Backdating allows executives to choose a past date when the market price was particularly low, thereby inflating the value of the options.
An example illustrates the potential benefit of backdating to the recipient.
Unless corporate insiders can predict short-term movements in the stock market, my results provided further evidence in support of the backdating explanation.
In a second study forthcoming in the Journal of Financial Economics (available at Randy Heron of Indiana University and I examined the stock price pattern around ESO grants before and after a new SEC requirement in August of 2002 that option grants must be reported within two business days.
In particular, he found that stock prices tend to increase shortly after the grants.
He attributed most of this pattern to grant timing, whereby executives would be granted options before predicted price increases.
For several years, Micrel allowed its employees to choose the lowest price for the stock within 30 days of receiving the options.
In a 2004 CNBC interview, Remy Welling said that "this particular -- well, it's called a 30-day look-back plan, is even widespread in Silicon Valley and maybe throughout the country."The terms "spring loading" and "bullet dodging" refer to the practices of timing option grants to take place before expected good news or after expected bad news, respectively. This is what Professor Yermack hypothesized in his article discussed above, though he never used these terms.
Most shareholder approved option plans prohibit in-the-money option grants (and thus, backdating to create in-the-money grants) by requiring that option exercise prices must be no less than the fair market value of the stock on the date when the grant decision is made. For example, because backdating is used to choose a grant date with a lower price than on the actual decision date, the options are effectively in-the-money on the decision date, and the reported earnings should be reduced for the fiscal year of the grant.
(Under APB 25, the accounting rule that was in effect until 2005, firms did not have to expense options at all unless they were in-the-money.
Furthermore, the pre-and post-grant price pattern has intensified over time (see graph below).
By the end of the 1990s, the aggregate price pattern had become so pronounced that I thought there was more to the story than just grants being timed before corporate insiders predicted stock prices to increase.