SEC Fraud

If you’ve been reading the news, you may have seen that on March 12th, the SEC charged Quest Software and three current and former officers for stock option backdating. What is stock option backdating and why is it illegal?

To begin, stock options are used as compensation in many tech startups because they potentially cost the company nothing. An option is the right to buy stock at a predefined price, known as the strike price. If the current price of the stock is $10, giving you stock options today at the strike price of $10 means you can buy the stock for $10. If the price goes down, your options are worthless because it makes no sense to buy them at $10 when you can buy them on the open market for less. If the price goes up, you win because you can buy at $10 and sell on the open market for more.

Why is stock option backdating illegal? It actually isn’t illegal, but what happens is that shareholders aren’t told about it. If I were to offer you stock options and date them in the past, but made all the proper regulatory filings with the SEC, then everything would be fine. The problem is that many of these companies involved in the options backdating scandal didn’t file the proper regulatory papers.

Companies are required to disclose executive pay, including stock options, and when they fail to do that, they run afoul of the regulations. Only then is backdating illegal.