ISS, the Institutional Investors Service, has put together a wonderful overview of the options backdating scandal. What I find very egregious is the way some of the companies have exploited investors – particularly technology companies – by fattening the wallets of executives at the expensive of individual investors. I will discuss

• what is options back dating, providing examples of high tech companies that back date options.
• how options back dating may be the reason why high tech stocks are so volatile
• why high tech executives purposely create volatility in their stock so that they can backdate their options.

What is Options Back Dating?

An option is the right to buy a stock at a given price. As ISS explains,

Almost all U.S. companies grant options to their top executives “at the money,” i.e., by setting the options’ exercise price (purchase price) equal to the stock price on the grant date. That exercise price often is set at the closing share price on the grant date, or at the average of that day’s high and low. Under Section 162(m) of the Internal Revenue Code, at-the-money options are generally considered performance-based compensation that is deductible from corporate tax returns, even if an executive earns more than $1 million a year.

Many people believe high tech stocks are volatile because technology is hard to understand or predict. I disagree. They are volatility because executives want cheap options. Executives of high tech companies are incentivized to create volatility in their stock prices so that they can take advantage of options back dating. The process is simple. Release bad news, make the stock go down, grant yourself options. Release good news, make the stock go up, exercise your options. Think about it. This is free money. If you were awarding yourself options, why not create volatility? If Microsoft stock stayed at the same price all the time, then how would a Microsoft executive make money?

http://mrwavetheory.blogspot.com/2006/09/high-tech-executives-create-volatility.html