Option backdating awards options based on a past date when the value was lower than the current share price. It is not illegal but has ethical implications. It allows investors to realize an immediate return. It is commonly used in assigning shares to employees. The effective date is associated with the price used in the transaction. Advocates see it as an incentive, while opponents argue it reduces the incentive to work harder. Some countries require reporting of backdating and impose time limits.
Option backdating is a strategy in which options are awarded to an investor based on a date when the value of those options was less than the current share price. While this type of activity is not considered illegal in most countries, there is some doubt in some quarters about its ethical implications. In actual practice, backdating options allows investors who are granted shares to immediately realize a return, since the previous share price has already been replaced by the most recent and higher price per share.
One of the most common situations in which option backdating occurs is the assignment of shares of the company’s stock to employees. In the context of employee stock options, the company identifies a specific date in the recent past that serves as a reference point for pricing the value of the stock granted. For example, Company XYZ may decide to give an executive one thousand shares of preferred stock on December 31, when the stock trades at a rate of $50 US dollars (USD) per share. Instead of using the current trading value, the company could decide to use the price at which the shares traded on December 1, which was $40 USD per share. This means that the executive immediately generates a return of $10 per share on each of those thousands of shares.
In terms of organizing paperwork, the issuer will use the effective date associated with the price used in the transaction. This means that even if the shares were granted on December 31, the options backdating process requires that the documentation be dated December 1, effectively justifying the price used in the deal. As a result, the effective grant date associated with the shares does not coincide with the grant date reported in the documentation.
There is some difference of opinion as to how effective this process is in terms of promoting greater efficiency among managers. Advocates see the immediate reward gained from using backdating options as an incentive that encourages the recipient to be more committed to the employer. Opponents note that once this immediate reward is granted, the executive has little incentive to work harder and encourage business growth, an action that would likely result in an increase in stock value.
In some countries, any instances of option backdating must be reported to the national regulatory agency which oversees trading and investment activities within that particular country. Time limits are often imposed which prevent the backdating process from using a price that applies to a date outside a defined range. For example, the agency may permit a company to issue the stock to corporate executives at a price that applied to any date in the two calendar months prior to the stock grant date, but would not allow the use of a price that it was three months old.
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