New backdating scheme rips off stockholders

A novel twist in the options scandal makes bad execs look even worse, says Fortune's Geoff Colvin.

By Geoff Colvin, Fortune senior editor at large

(Fortune Magazine) -- It's tempting to roll your eyes at the latest options backdating news - more evidence that in certain ways American executives are still the world's most creative.

But in fact it's worth a closer look, because this type of conniving, which involves backdating exercise dates rather than grant dates, is different and in some ways worse.

More on options...
An assistant director says FBI is vigorously investigating 55 corporations. (more)
Plaintiff attorneys, rather than the government, may prove to be a bigger headache for corporations embroiled in the stock backdating scandal. (more)
Amidst backdating options scandals, American Tower uses another legal tactic for hiding executive compensation - backdoor options filtered through a subsidiary. (more)
How companies handle the investigation into backdating can have a big impact on their business - and investors. (more)

Bizarrely, while this book-cooking appears to be a tax scam, it may actually leave the U.S. Treasury better off than if the executives had been honest. What it reveals most strongly is some executives' utter contempt for their shareholders.

Evidence of this new twist on backdating arose in a study by an economist at the Securities and Exchange Commission, first reported in the Wall Street Journal. Thus far the backdating scandal, which has already involved well over 100 companies, has centered on firms manipulating the dates on which options were granted to executives. Stock prices were lower on the bogus dates, so executives' potential gain would be greater.

But in the more recently discovered scam, executives allegedly fudged the date on which they chose to exercise options, citing some earlier date when the stock price was lower, thus reducing their own gain.

Why would anyone want to do that? Most people wouldn't, because most option holders sell their shares the same day they buy them. But some executives plan on holding their shares for a while before cashing them in. Their "gain on exercise" - the difference between what they pay for the shares and the shares' market price that day - is taxed as ordinary income, at a top rate of 35 percent.

But any gain after that is taxed as a long-term capital gain, at 15 percent, assuming the executive holds the shares more than a year. By moving the exercise date back to when the market price was lower, this new backdating is simply a tax dodge that transforms some highly taxed gain on exercise into lower-taxed capital gain.

Any executive who did this - and we can expect a new wave of investigation announcements from companies in the coming weeks - is playing a far more dangerous game than in the old type of grant-date backdating. There, no money changed hands; some old documents just had incorrect dates in them. But this new exercise backdating "involves a real transaction," observes Dennis Beresford, former chairman of the Financial Accounting Standards Board and now a professor at the University of Georgia.

"The executive has to deliver cash or shares to the company" in order to buy the shares under option. That transaction can presumably be tracked down and the stock's market price on that date checked. If the numbers don't match, somebody's in deep trouble.