Canada: The U.S. Option Backdating Scandal: What It Means for Canadian Issuers and Their Executives

Last Updated: July 19 2006

Canadian stock exchanges and securities regulators are likely to scrutinize option grants as a result of the latest governance scandal in the United States—backdating option grants to give executives a windfall. More than 50 U.S. companies are being investigated by the Securities and Exchange Commission (SEC) and the U.S. Department of Justice, and several senior executives have been terminated or forced to resign.1 The challenged practice is to falsely date option grants to a date before a stock price run-up by using a grant date that precedes the date on which the board approved the grant; using a grant date that is "effective as of" a date before the actual grant; using a grant date that precedes the date on which all signatures on a written resolution were obtained; and changing the date of board resolutions approving the option grant.

As the investigation broadens, allegations are also being made that companies are "springloading" options—that is, manipulating the timing of the release of material information to benefit insiders who receive options.

The consequences of these practices are dire (on both sides of the U.S.–Canada border) and may include criminal, regulatory or civil actions for fraud, illegal insider trading, misrepresentations in disclosure documents, filing false certifications and tax evasion; the loss of tax benefits; the need to restate financial statements; and questions about the adequacy of internal controls. Shareholder class actions have been commenced in the United States against companies suspected of these abuses.

TSX rules provide that listed issuers may not set option exercise prices on the basis of market prices that do not reflect material information that management is aware of but that has not been publicly disclosed. For instance, the TSX will not permit option grants if the issuer is considering or negotiating strategic alternatives. If this rule is breached, the TSX may require that options be cancelled, forfeited or repriced or, in egregious cases, the issuer be delisted. The TSX has previously stated that when undisclosed material information exists, it is not appropriate for an issuer to grant options under a compensation arrangement even if the recipient of the option is unaware of the undisclosed material information. An exception is made when the recipient of the option is neither an employee nor an insider and the options are granted at a price that was set when material information was undisclosed if the grant relates to the undisclosed event (such as an acquisition by the listed issuer of another company).

The TSX rules also provide that the exercise price established for any stock option must not be lower than the market price of the relevant securities at the time the options are granted. This is also important for tax purposes because if the exercise price is set below the market price at the date of grant, the benefit of effective capital gains tax treatment will be lost.

For the purposes described above, it is important to determine the grant date of an option. Generally, options are granted on the date that the board of directors has passed a resolution approving the grant of the options. If that approval has been delegated to management, the grant date will usually be the date on which management has exercised the delegated authority. (Note that many corporate statutes do not allow the board to delegate the authority to issue securities.) The key principle is that an option is granted when the legal steps necessary to authorize the issue of the options have been completed.

The TSX is also very leery of options that are granted during blackout periods or outside trading windows. A recent TSX staff notice cautions listed issuers about granting options during a blackout period, whether or not there is material undisclosed information during that period. Blackout periods differ among companies and represent a period of risk during which a company may be likely to possess undisclosed material information. If the company is satisfied that no material undisclosed information in fact exists and the appropriate internal approvals are obtained, the mere existence of a blackout period should not be an absolute bar to issuing options or establishing the exercise price during a blackout period.

In view of the intense scrutiny that option-granting practices are receiving in the United States, Canadian issuers should expect their practices to be scrutinized by Canadian regulators and shareholders. Prudence suggests that you carry out an internal review of your option-granting practices to ensure that they are beyond reproach. You should consider, for instance, establishing regular, predetermined dates for option grants. And you should also appreciate that while most of the problems in the United States represent intentional manipulation of option grants, some of the allegations relate simply to sloppy grant procedures.


1. Most of these abuses are alleged to have occurred before the enactment of the Sarbanes-Oxley Act of 2002, which requires accelerated reporting of option grants within two days of the date of grant. As a result of that requirement and the increased focus on internal controls, it is likely that most of these alleged practices have already stopped in the United States.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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