Out-Law / Your Daily Need-To-Know

Why the stock options backdating scandal won't hit the UK

Out-Law Analysis | 24 Jan 2008 | 6:38 pm | 2 min. read

OPINION: The former CEO of a US tech giant will have 21 long months in which to rue the day he ever heard of stock option backdating. Brocade Communications' Gregory Reyes has been sent to prison for 21 months and fined $15 million for backdating options.

This is a practice that was once viewed as little more than financial sharp practice but in 2006 exploded into major scandal for some of Silicon Valley's biggest names. It is a phenomenon that will never rock the UK markets as it has the US ones.

US technology employees may live on their salaries, but whether they get truly rich or not depends on their share of the company. While lucky early employees might get actual shares, most workers will depend on stock options to cash in on the tech boom.

A stock option granted, for example, on the day you join the company allows you the right to buy that share at that day's price, but not until a fixed period – say a year – has elapsed. If the price has risen in that time you can buy the share at the option price, sell it and pocket the profit. If the price has fallen, you simply don't buy the share.

Backdating is the practice of rewriting the agreement so that the option appears to have been granted at an earlier time when the share was even cheaper. That way you make even more money when you sell the share at today's prices.

The practice is not actually illegal in US law, as long as you tell the shareholders it is going on. Also, the backdating of options brings with it accounting obligations: the backdating has to be recognised as a compensation expense.

Academics had long recognised an odd phenomenon of share prices appearing to rocket on the day after senior executives were given stock options. One explanation was that options were being backdated to before major rises.

That idea broke from academia into the business mainstream in 2006, and backdating scandals swept like wildfire in 2006, involving companies as famous as Apple, Dell and Broadcom.

Reyes is the first executive to go on trial, though others have settled cases with US financial regulator the Securities and Exchange Commission and paid not only fines, but millions of dollars of 'ill gotten gains' in some cases.

So why have we not seen such scandals in the UK? The simple answer is that the practice has not taken hold because of the quality of UK regulation.

It is simply not an option for publicly listed companies to pretend that an option was granted days or even weeks ago. Publicly traded companies must disclose any grants of options to directors as soon as possible. In fully listed companies that includes people discharging managerial responsibility.

This disclosure must come no later than the end of the following trading day, effectively preventing any back-dating of option grants.

Companies also have to have their own share dealing codes. When they don't they simply adopt the stock exchange's own rules. These rules say that options can't be granted when executives have access to unpublished price-sensitive information.

Backdating option grants to, for example, just before an announcement that had a positive share price effect would be equivalent to granting the option in a prohibited period. Directors are rightly highly sensitive about share dealing because they can be censured by the stock exchange; prosecuted for abusing the market by the Financial Services Authority; or even summarily dismissed by the company itself.

Protections don't just apply to big listed firms, though. Even for privately held companies the scope to backdate an option grant is very limited indeed. Many privately held companies rely on an HM Revenue and Customs-agreed valuation to fix a market value option price, typically for Enterprise Management Incentive ("EMI") option. These HMRC agreed valuations usually remain valid for 30 days only.

So the scandal and court intrigue in the US is unlikely to be repeated here because tight regulation has ensured that a backdating culture simply never developed in the first place.

By Rory Cray, a partner of Pinsent Masons, the law firm behind OUT-LAW.COM. Rory has a decade's worth of experience in the area of executive incentives and employee share plans. Contact: [email protected]