Just when you thought it was safe to write a check for stock investing, the options backdating scandal hits. Our problem as money managers is that much of the information that has been disseminated about options back dating, and stock investing is just pure WRONG. The purpose of this article is to clear the air, and inform you as some one in need of stock market information just what you need to know about this scandal.

Let’s begin. CEO’s and senior management at any company whether it’s Steve Jobs at Apple, or over 100 other companies in question receive their executive compensation in two forms. The first form is an outright salary grant. Let’s say $5 million per year. No one is challenging that there have been any games with this part of the compensation package.

The second form of payment is stock options of which there are many types. We are going to use the most common form of stock options which is a straight options grant. Let’s create an example. Let’s say John Smith is CEO of ABC Computer and he was given options on 1,000,000 shares of ABC Computer this afternoon which is January 22, 2007 at $10 per share which is the selling price of the stock on the open market.

Now let’s say back on December 15, 2006 the stock was trading at $5 per share. The compensation committee at the corporation in question wants to do the CEO John Smith a favor. They BACKDATE the options agreement to December 15, 2006, when the stock was selling at $5 per share. The date of the options agreement is called the GRANT DATE. You need to remember this term.

Under the IRS Code, an executive must hold the option for 2 years. It is now 2 years and one day later. Let’s make it December 16, 2008, and the stock is selling for $15 per share. John Smith the executive exercises his options and sells 1,000,000 shares at $15 per share on the open market. Because of options backdating, he is showing a grant price of $5 per share, on December 15, 2006. His profit is $10,000,000.

You get the profit by selling one million shares at $15 per share, with a cost price of $5 per share. It’s a $10 per share profit on one million shares, or $10 million profit. If the company had used the correct date of January 22, 2007, the grant price would have been $10 per share, and the selling price would have remained the same at $15 per share. The profit would have been $5 million dollars or half the profit that was made by BACKDATING.

Of course, John Smith CEO would have had to wait until it was two years past the real grant date of January 22, 2007 to sell his stock in order to meet the IRS requirements. We now see that because of options backdating, this CEO executive John Smith made $10 million exercising his options as opposed to $5 million. There are several more things you need to know in order to understand what’s at work here.

* What is the nature of the compensation when the options are being exercised? Is it ordinary income, or capital gain? The answer is that the sale of the options after two years from the grant date is ordinary income. Mr. Smith in this case has $10 million in ordinary income on top of what he is paid in compensation by ABC Corporation.