Detecting Employee Stock Option Fraud

Even though it may seem like a good idea at the time backdating stock options for employee retention issues is not so bright. It may start out just find but in the end the attempt to maintain and recruit strong employees ends up being illegal due to recent court decisions. Many companies may not find themselves in legal troubles as the government cracks down.

Ground Breaking Case:

Consider the case of Gregory Reyes, a former human resource executive at Brocade Communications Systems. Mr. Reyes never backdated any of his personal stock options but he did for other employees that he was trying to either retain or recruit. Mr. Reyes was convicted of 10 counts which included fraud, falsified accounting, conspiracy and filling false statements.

The conviction could mean that up to 140 other companies, including Apple, could be in line for government prosecution. Thus, 70 executives have either been fired or resigned after internal corporate investigations. These executives were either fired or resigned to thwart off prosecution.

"To get a conviction with these facts, which weren't all that strong will encourage the government to continue prosecuting backdating cases" says Phillip Stern a former enforcement officer with the Securities and Exchange Commission (Stecklow & Waldman, 2007).

How Backdating Works:

A stock option gives an executive the right to buy shares of the company at a future date for a fixed price. These prices are usually at a much cheaper amount than what the stock is currently going for. By backdating the stock options it gives the executive a cheaper purchase rate which allows for instant money when sold.

Even though backdating stock options is a questionable practice it becomes doubly so when it is not reported in the companies accounts as a compensation expense. To cover for this type of fraud annual reports, meeting minutes and the compensation manager's records have to be doctored in order to conjure previous non-existent discussions.

How Companies can Protect Themselves from Backdating Fraud:

Backdating fraud requires many altered documents and participation from both the employees receiving the benefit as well as the compensation manager. Therefore a lot of hands are involved in the process which makes detection much easier. Companies can implement within their policies and employee handbook that any type of fraud must be reported to the labor relations department or other acting official. Failure to disclose potential fraud an lead to immediate termination and prosecution.

In addition it is beneficial to conduct annual or semi-quarterly audits of compensation records. Most fraud is uncovered when independent parties investigate discrepancies in the paper work. In many cases the schemes become more elaborate and more likely of detection as time goes on. An audit is considered one of the most common fraud prevention tools.