In November 2005, a publicly-traded company announced the resignation of three of its top executive officers following an SEC investigation into the backdating of stock option grants. Since then, more than 20 companies have announced the formation of independent committees to investigate option granting practices or the existence of a government investigation into their option grants.
Recently, the Wall Street Journal and several investment banking and research firms analyzed a number of companies’ stock option grants, and found multiple instances in which grant dates corresponded to a company’s lowest trading price. The suggestion has been made that these occurrences could not have been coincidental. As a result, the issue of option “backdating” has become front-page news.
What is backdating?
Stock options are typically granted “at the money”—that is, with an exercise price that equals the current price of the stock at the time of grant. Particularly where a company’s stock price is volatile, the date of the grant may have a material effect on its value to the recipient. “Backdating” refers to the intentional setting of a grant date that precedes the actual date of the corporate action that effected the grant, in order to achieve a lower option exercise price and hence a higher value to the recipient. Backdating results in an option already being “in the money” at the time of the grant.
Backdating could be accomplished either at the time of the grant, by arbitrarily selecting an earlier date when the stock’s price was lower, or after the grant has been made, by retroactively changing the grant date. Published reports have highlighted some instances in which a company’s stock price increased substantially shortly after the reported grant date, suggesting that backdating may have occurred.
A number of commentators have suggested that there may be other circumstances under which option grant dates may be open to question, including grants made by use of unanimous written consents. These circumstances do not appear to be the focus of the recent articles and research reports, and their possible consequences are currently subject to considerable debate. As discussed below, however, it is advisable for all public companies to consult with outside counsel in order to discuss the issues outlined here and to formulate a plan of action going forward.
What is the government investigating?
Thus far, recent government investigations appear to have centered around backdating of grants to executive officers. These inquiries have presumably focused on executives because information relating to executive grants is publicly disclosed in proxy statements, and can easily be compared to stock price history to determine the existence of suspicious patterns. Most of the investigations appear to center around stock option grants made prior to August 29, 2002, because after that date, executive officers were required to file forms with the SEC disclosing stock option grants within two business days.
A separate issue that is currently overshadowed by the focus on backdating involves options granted shortly prior to the announcement of positive news. Several years ago, the SEC announced that it was investigating certain companies that had granted options to executives immediately prior to announcing positive news—thereby quickly rendering these options “in the money”—without making proper disclosure of the real value of the options. The SEC maintains that where grants are made immediately prior to a positive announcement, a failure to discuss the timing and value of the grant in SEC filings is a disclosure violation.
What are the potential ramifications?
The primary issues facing companies are:
Accounting Issues. Until very recently, most companies accounted for stock option grants under APB 25. Under this method of accounting, if a stock option was granted “at the money,” then no compensation expense was recorded. However, if the exercise price was lower than the fair market value of the stock on the date of grant, then the company was required to record compensation expense equal to the difference between the exercise price and the fair market value at the date of grant. As a result, the improper dating of options may require a company to restate its financial statements for prior years to reflect additional compensation expense. Because compensation expense is recorded over the vesting period of the option (generally four years), a single occurrence of improper dating could result in the restatement of several years of financial statements. In addition, irregularities in option grant practices could reflect material weaknesses in internal controls.
Disclosure Issues. Publicly-traded companies are required to disclose executive officers’ compensation in their proxy statements. If a company disclosed that stock options were granted “at the money,” but in fact the options were granted on a date when the fair market value of the underlying stock would have resulted in the options being “in the money,” the disclosure may have been inaccurate.
Tax Issues. Under a relatively recent addition to the Internal Revenue Code, Section 409A, stock options that are treated as deferred compensation arrangements that do not comply with Section 409A can result in regular plus an additional 20% income tax to the option recipient on the date(s) of option vesting, rather than on the date(s) of option exercise or sale of the underlying stock, plus interest on any such tax that should have been paid. The grant of an “in the money” stock option that is exercisable at any time following vesting may be treated as a non-compliant deferred compensation arrangement under this section of the IRC with these unfavorable tax consequences for the recipient. Such a grant also could create withholding obligations for the company and possible liability for failure to withhold. In addition, if the stock option was intended to be an “incentive stock option,” improper dating could disqualify the option from the favorable tax treatment ordinarily accorded that type of option.
Section 16 Reporting. Under Section 16 of the Securities Exchange Act of 1934, executive officers are required to report the grants of stock options on forms they file with the SEC. Inaccurate reporting of a stock option grant date could be alleged to be a violation of the securities laws.
Stock Option Plan Issues. Many stock option plans require that stock options be granted with an exercise price no lower than fair market value or a specified percentage thereof (generally 85%) on the date of grant. If an improperly dated option grant results in an exercise price lower than that permitted by the plan, the grant might violate the terms of the plan unless it were characterized as a grant outside of the plan or as a de facto amendment of the plan, either of which could violate the rules of the stock exchange upon which the stock is listed.
Regulatory and Criminal Investigations. Where the possibility of irregularities is suggested, federal and state authorities and the stock exchanges can be expected to vigorously investigate. These agencies have a broad array of enforcement powers and resources to punish unlawful actions. In several cases to date, investigations by the SEC or the Department of Justice are reported to have led to resignations or firings of senior management.
Civil Litigation. Companies facing suspicions about their option grant practices can expect shareholder lawsuits, most likely in the form of derivative claims and/or class actions under the federal securities laws.
What should companies do about past grants?
Because every company has a different history and set of corporate practices, no one series of actions is necessarily appropriate for all. We recommend that you contact your outside legal counsel promptly to discuss the issues outlined here and to formulate a plan of action for your company. Here are the most immediate issues that you should discuss with counsel:
Preliminary Review of Stock Option Practices. We recommend, as a preliminary matter, that each company have a conversation with counsel to assess the general propriety of its option grant practices. You may be able to ascertain at that point the likelihood of potential irregularities. If your company has been publicly identified as one with a risk of backdating problems, you should consider carefully reviewing the grants identified as suspect to determine if there is any merit to the suspicions.
Determine the Appropriate Response to Investor Inquiries. Your investor relations department may be receiving calls from investors asking if you have a backdating problem. There may be a natural tendency to respond, possibly without having done any investigation, that the company has no problems or is not aware of any problems. In the absence of at least a preliminary review, however, such a statement may turn out to be incorrect. You should work with counsel to prepare an appropriate response to potential questions, taking into account the stage of your review and whether any actual or potential problems have been identified. A prepared response may be especially important if your company has been publicly identified on one or more “at risk” lists. If you receive an inquiry letter or subpoena from the SEC or a prosecutor, you should promptly decide whether to issue a press release disclosing that event.
More Detailed Investigation of Stock Option Practices. You should determine, together with your legal counsel, whether and to what extent you may need to conduct a more thorough investigation of your company’s past practices. For many companies, a preliminary review may be sufficient. However, for some companies there may be irregularities that cannot be uncovered without a comprehensive review of pertinent records. One course of action that outside counsel may suggest is that you analyze stock options granted to executive officers to determine whether any were made on dates that, in hindsight, were especially favorable, i.e., dates on which the stock price was at or near a low for the period. Keep in mind that your independent auditors may require that you conduct this type of investigation in connection with their evaluation of your internal controls. You are usually better served by discovering any issues and reporting them to your auditors than by having them discover the issues themselves. A review done at the direction of internal or external counsel may afford the company the opportunity to protect any analysis under the attorney-client privilege or the attorney work product doctrine.
Formulate a Comprehensive Plan of Action. Contact your outside legal counsel promptly to discuss these issues and formulate a plan of action for your company, so that the company is proactive rather than reactive. Whatever course of action is adopted, keep your Board of Directors and Audit Committee informed.
What should companies do about future grants?
In the midst of the flurry of announcements and government investigations, it is difficult to predict all of the ramifications of these issues for future practices. As with other perceived abuses, there is a risk that Congress or the SEC will mandate adoption of specific option grant and/or disclosure practices under pain of loss of tax deductions or other penalty. In our view, a better result would be for public companies to voluntarily adopt option grant practices that help restore public faith in the process. A few of our suggestions of possible “best practices” are below:
Executive Officer Grants. To provide assurance of the proper measurement date of stock option grants to executive officers, we believe compensation committees are likely to approve grants at meetings and minimize the use of actions by written consent. For regular performance-based grants to executive officers, we expect that leading companies may establish, and perhaps announce in their proxy statements, practices specifying that all such grants will be made each year at a specified time or times. To avoid granting options at stock price lows that might occur prior to an earnings announcement, we would also recommend that companies establish these dates to coincide with “open window” periods occurring immediately after earnings announcements, when all material information is likely to have been disclosed. New executive hires will be the great challenge to this approach, given the desire to grant options to the executive promptly after hiring.
Non-Executive Officer New Hire Grants. Many companies have already established a process under which all option grants for new hires or promotions are made on a regular schedule, such as the first day of each month. While many companies have delegated the authority to make such grants to a Board committee composed solely of the Chief Executive Officer, recent changes in Delaware law allow approval of non-executive officer stock option grants to be delegated to a committee composed of non-board members. Note however, that Delaware law does not clearly permit delegation to non-directors of authority to make grants of restricted stock. We would recommend the establishment of committees composed of multiple executive officers in order to ensure that at least one executive officer is available to execute the necessary documentation on the pre-established monthly grant date. Using this approach, each designated executive officer would be given the sole authority to grant stock options in accordance with pre-approved grant ranges or other guidelines approved by the compensation committee. By following this type of non-discretionary procedure for determining the grant date of stock options for non-executive officer new hires, we believe that companies can enhance their internal controls over stock administration and also establish a routine designed to permit their stock administration personnel to timely prepare, record and deliver stock options to individuals to ensure compliance with SFAS No. 123R.
Annual “Performance” or “Focal” Grants. For many companies, annual “performance” or “focal” grants generally occur once per year and involve the grant of additional stock options to a large number of current employees based on their performance. As with executives, we believe companies will establish in advance an annual time period during which annual reviews will occur and a date on which management will present a final list of proposed stock option grants to the board of directors or compensation committee for approval. A board of directors or compensation committee could then elect to make these grants immediately upon presentation and approval of the final list, or it may choose a grant date in the future. In either case, as the grant date is discretionary, we recommend that this date also occur during an “open window” period.
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.
