Opinion ID: 799861
Heading Depth: 2
Heading Rank: 1

Heading: .Background on Options Backdating

Text: The gravamen of the SEC's complaint in this case is the allegation that Jasper engaged in a scheme to illegally back-date stock options granted to Maxim employees and directors, concealing millions of dollars in expenses from investors and significantly overstating the Company's income. Thus, before turning to the facts and history of this case, we briefly explain the practice known as stock options backdating. A stock option grants the recipient the opportunity to purchase a certain number of shares of company stock at a given price [called the `exercise price'] on or after a predetermined date. N.M. State Inv. Council v. Ernst & Young LLP, 641 F.3d 1089, 1093 (9th Cir.2011). The recipient may exercise the option by purchasing stock from the company at the exercise price, and he is then free to sell the same stock at its current market price. If the option is issued at an exercise price equal to the current market price, the option is referred to as having been issued at the money. Conversely, an in the money option is issued at an exercise price that is lower than the current market price. This latter type of option is in the money because it is immediately profitable: the price at which the stock may be bought is lower than the price at which it may be sold. Last, an out of the money option is issued at an exercise price that is higher than the current market price. Perhaps needless to say, none of the options at issue during trial were either at the money or out of the money. During the time period relevant to this case, at the money and in the money options were treated differently for accounting purposes pursuant to generally accepted accounting principles (GAAP). For in the money options, accounting principles require the company to record an expense for the [option recipient's] `profit,' i.e., the difference between the exercise price and the market price of an in the money option is treated as compensation to the option recipient over the vesting period. Id. This is because the company could have sold its treasury stock at the market price, rather than grant an option on such stock to another. If the company does grant an option at a price below market, it is transferring a potential company profit to the option recipient. The difference between exercise price and market price must be added to the firm's costs, usually as employee compensation, since the option recipients are usually employees. Backdating of options occurs when the company official responsible for administering a company's stock option plan monitors the price of the company stock and awards an at the money stock option grant as of a certain date in the past when the share price was lowest. Id. This lock[s] in the largest possible gain for the option recipient but also does not require the company to recognize as an expense the difference between the backdated exercise price and the market price of the stock as of the legitimate date of the option's award. Id. This practice is therefore akin to betting on a horse race after the horse has already crossed the finish line. Id. Backdating options is not in and of itself improper under the law or accounting principles, but it often leads to violations of the securities laws because [i]f the company does not properly record the back-dated options, then the company's reported net income is overstated for each of the years the options vest, potentially deceiving the market and investors. Id. That is what the jury found occurred here.