Whether executives will be criminally liable depends on whether they were consciously trying to cover up the practice of backdating. Like securities fraud, the criminal tax fraud statutes require an intent element. Securities Fraud The primary source of criminal liability for backdating are the federal securities acts, which regulate the sale of securities by publicly traded companies. To qualify as an ISO, an option must have an 'option price  not less than the fair market value of the stock at the time such option is granted.' I. Any person who willfully violates ' any provision' of the Securities Act or the Exchange Act and ' any rule or regulation thereunder' commits a criminal offense, and could be subject to substantial fines as well as imprisonment. Two of these new regulations may give rise to liability, but only for backdating that occurred after August 29, 2002, the effective date of the amendments. Section 302 requires the principal executive and financial officers of publicly-traded corporations to certify each annual or quarterly report filed with the SEC. The officers also certify that they are responsible for establishing and maintaining internal corporate controls to ensure the proper disclosure of all material information.
Criminal charges for backdating could include alleged violations of Section 17(a), 15 U. C.77q, which prohibits fraudulent interstate transactions, and Section 10(b), 15 U. This means a company must properly disclose and account for any backdating practices in its financial statements. Furthermore, the failure to record an expense for discounted options granted to employees might result in understated financials, which could in turn make other financial reports inaccurate, particularly net revenues. The basic violation under these statutes is the same: an intent to defraud another by means of an untrue statement of material fact or an omission of a material fact necessary in order to make a statement not misleading. Regardless of which acceptable GAAP approach a company used in valuing options,a statement in a company's financials stating that the strike price was equal to the fair market value ('FMV') on the grant date would be false or inaccurate if the company backdated options. Aside from interest and penalties that might accrue if a company amends its income tax returns, executives who implemented backdating practices may also be criminally liable for willfully failing to pay taxes, see , e.g., I. C.7202, or providing fraudulent and false statements in a tax return, see , e.g., I. With more criminal charges in the pipeline, companies and executives need to understand the potential scope of criminal liability. ('Securities Act'); Securities Exchange Act of 1934, 15 U. Tax Fraud Executives who used backdating practices may also face criminal prosecution for federal tax fraud. Therefore, to be criminally liable under the Code's criminal statutes, a person must 'willfully attemptto evade or defeat any tax imposed by [the federal government].' I. There are three major areas of potential criminal liability for former executives involved in stock options backdating: securities fraud, tax fraud, and mail or wire fraud. Backdating only becomes illegal when executives fail to disclose the practice in financial reports, and fail to properly account for backdated options according to Generally Accepted Accounting Principles (GAAP) and the relevant tax laws. Three possible violations of the Internal Revenue Code ('Code') could create criminal liability for backdating: (1) exceeding the compensation deduction limits of Section 162(m), (2) failing to qualify options under the rules that govern incentive stock options in Section 422, and (3) violating the provisions of Section 409A regulating deferred compensation.
To avoid criminal liability, the company must have disclosed the fact that it was backdating and explained particularly how the option strike prices had been determined. Previously, companies were allowed to wait until the end of their fiscal year before reporting these transactions. Now option grants must be reported to the SEC within two business days of the grant date.
Failure to do so may render financial statements 'false or misleading with respect tomaterial fact,' and create potential criminal liability under the securities acts. Filing an inaccurate report with the SEC might subject the company and its executives to a multitude of securities fraud violations for disclosures that are 'false or misleading with respect tomaterial fact.' Criminal liability for securities fraud will depend squarely on the disclosure and accounting made in a defendant's financial reports. Because backdated options have an exercise price lower than FMV as of the grant date, they are not excepted and must be included when calculating whether an executive's compensation has exceeded the cap.