United States: Stock Options Grant Timing: Is Your Company at Risk?

Last Updated: June 16 2006
Article by   Orrick and Melinda Haag

The Securities and Exchange Commission, and United States Attorney's Offices in New York, California and Massachusetts currently are investigating if the abnormal return patterns associated with certain stock option grants are attributable to improper backdating of such grants. Government regulators and prosecutors have noted recent statistical studies in academic journals and the popular press (particularly the Wall Street Journal) that indicate a pattern where stock returns are abnormally negative before the date stock options are granted and abnormally positive afterward, and where the grant is often dated at the share price's monthly or quarterly low. Indeed, some companies have granted options to executives at exercise prices and dates that matched exactly or were close to a 40-day low in the company's stock price. According to some of these studies, the probability of hitting the low on recurring grant dates is extremely low, ranging from 1 in 800,000 to 1 in 100 million. It is these odds that have so peaked the prosecutors' interests, and so concerned the directors, executives and regular legal counsel who planned and executed these stock options grants.

Determining the Grant Date

Stock options give the grantee the right to buy shares at a fixed price, known as the exercise price or strike price. Stock options for executives typically are granted by a board of directors or compensation committee thereof where the exercise price is equal to the fair market value of the underlying stock on the date the options are granted. Stock option grants with the expense price equal to the fair market value of the underlying stock is required for favorable tax, accounting and securities purposes. If the stock later rises, the grantee can cash in the option for a profit, as long as he or she has held them long enough to vest. The lower the exercise price, the greater the gain for the grantee.

There is no securities rule or regulation prohibiting the use of alternative dates for pricing purposes. However, if the effective date of a grant is anything other than the date of approval, the company's finance and tax departments should be informed and involved in those decisions. If a practice of selecting alternative grant dates is not consistent with the company's stock option plan, and the details of that plan are disclosed in the company's financial statements, there may be an issue with false or misleading statements to the public regarding the company's stock option practice, as discussed below. According to the regulators and commentators, few if any companies involved in selecting alternative grant dates disclosed that fact to their finance and tax personnel, or to the public. Regulators therefore consider it impermissible "backdating" if a company looks back in time to select an effective grant date. Several commentators have also noted that the practice undermines the incentive purpose of options.

Companies at Risk

According to the Center for Financial Research and Analysis (CFRA), companies have a significant risk of improper backdating options when the company has, on three or more occasions, granted options to executives at exercise prices and dates that matched exactly or were close to a 40-day low in the company's stock price. Under CFRA's risk assessment criteria, the likelihood of options backdating is greatest when the price on the grant date is within 105% of the 10 or 40 day period stock price low, and the stock price range (highest stock price-lowest stock price) is greater than 10% of the lowest stock price. According to CFRA, nearly one-third of the top 100 corporate grantors of options are at high or moderate risk of options backdating. Other studies, including those by analysts at Bear Stearns and Merrill Lynch, have used different formulas but have reached similar conclusions.

Two-Day Section 16 Reporting

Most commentators believe that option backdating occurred from the 1990s through August 29, 2002, when the Sarbanes-Oxley Act tightened disclosure requirements. After 2002, the deadline for reporting exempt grants changed from 45 days after the end of the fiscal year to two business days after the grant, effectively eliminating any ability to make grants effective more than two days before the decision to make the grant is made. However, while most option grants being scrutinized by the SEC appear to pre-date the adoption of two-business day reporting, the regulators may believe some issuers are still backdating options and simply filing "late" Forms 4. The SEC will undoubtedly look into this possibility.

Perils of Options Backdating

Companies found to have engaged in impermissible options backdating face several risks, including:

  • SEC Investigation and Federal Criminal Prosecution Risk
  • Accounting Restatement Risk and Reduced Net Profits
  • Potential Civil Lawsuits
  • Regulatory Risk and Tax Implications
  • Management Credibility Risk

SEC Investigation and Federal Criminal Prosecution Risk

If the practice was inconsistent with the company's stock option plan, or if the accounting and tax treatment was not correct, companies and individuals can face securities fraud claims by the SEC. If there was criminal intent, securities fraud, wire fraud and other criminal charges could be considered by U.S. Attorney's Offices. Possible theories of liability involving federal securities law violations include inaccurate books and records (1934 Exhange Act, Section 13(b)(2)), false financial statements (Section 13(a), 15(d), Rule 10b-5), and misleading proxy statement disclosures (Section 14(a), Rule 14a-9, 10b-5). If Forms 4 reflect inaccurate grant dates, grantees may be liable for violation of Section 16(a).

By the second quarter of 2006, approximately 30 companies have received inquiries from the SEC, and approximately 20 companies have been served with federal grand jury subpoenas for documents and testimony relating to backdating options, and more subpoenas appear likely. The U.S. Attorney's Offices for the Southern and Eastern Districts of New York have shown the greatest interest to date in this issue, with the U.S. Attorney's Offices for the Northern District of California and the District of Massachusetts not far behind. The scope of the investigation, involving the most experienced securities fraud prosecutors, indicates that this is the "next big thing," and, at least one commentator has suggested the creation of a backdating stock options task force, akin to the Enron Task Force.

Accounting Restatement Risk and Reduced Net Profits

Companies with backdated options may be forced to restate their financial statements depending on the materiality of the impact on the balance sheet and income statement. Backdating stock option to capture a low price hides the discount from fair market value on the appropriate date of grant, which should be treated as a cost (compensation) that could result in a material overstatement of earnings when corrected.

Potential Civil Lawsuits

Companies facing backdating issues potentially face two types of private civil suits. The first is the traditional securities class action based upon Section 10(b) and Rule 10b-5 of the 1934 Exchange Act, and potentially Sections 11 and 12(a)(2) of the 1933 Act if an initial or secondary offering is involved. These could be based on a material misstatement of earnings or in other allegedly false and misleading statements regarding executive compensation.

The second category involves shareholder derivative suits alleging that the directors breached their duties of loyalty and/or care by deliberately or negligently "allowing" these backdating practices.

Regulatory Risk and Tax Implications

Most stock plans require that the exercise price of an option may not be less than the fair market value of the underlying stock, determined as of the date of grant. Under such plans, dating an option to make it appear that it was granted on a date other than the actual grant date, when the market price of the underlying stock was lower, creates a discounted option that violates the option plan and constitutes a plan amendment that violates New York Stock Exchange and NASDAQ rules, which require shareholder approval of equity compensation plans and material plan amendments. However, discounted options are prohibited in most plans due to shareholder resistance and tax issues (IRC Sections 162(m) and 409(A)), as discussed below.

Compensation disclosures are required by Regulation S-K Item 402, which is violated if options are backdated, and the option grant table requires particularized disclosure where the exercise price of an option is less than the market price on the grant date. Section 16 requires the grant date reported on Form 4, which determines the filing deadline. Mis-reporting the actual grant date violates Section 16(a)'s reporting requirements and can create a reporting delinquency disclosable in the proxy statement.

Backdating options can force companies to restate tax positions, which can result in an obligation to lose tax deductions and pay back taxes, penalties and interest. For tax purposes, corporations can generally deduct executive compensation. However, IRC Section 162(m) limits this deduction for public companies to $1 million per year per executive for compensation paid to the top five most highly compensated executive officers for proxy reporting purposes. Under Section 162(m), the amount of stock option gains will not be included within the $1 million deduction cap as long as the options are granted under a plan that has a per person per period limit on the number of options that can be granted each year, the options are not in the money when granted, an independent compensation committee grants them, and there is shareholder approval of the plan. If options are in the money when granted (which is the essence of some of the backdating allegations), then the compensation realized by the grantee upon exercise will count towards the $1 million IRS deduction cap. Thus the discounted options are ineligible as performance-based compensation under Section 162(m). Furthermore, discounted options would be treated as "non-qualified defined compensation" under Section 409A, resulting in taxation (and excise taxes) at the time of vesting, rather than exercise. Finally, for incentive stock option to qualify for favorable tax treatment, they must be granted at 100% of the underlying stock fair market value on the date of grant.

Management Credibility Risk

The reputation of management and the related stock premium for superior management could falter if a management team is found to have wrongfully engaged in backdating options. Several companies under investigation for backdating have experienced stock decreases after the announcement of the investigation or after the resignation of one of their directors or officers. Many boards have set up special committees to investigate past practices and in several cases the result has been the resignations of CEOs, CFOs and GCs who allegedly benefited or were complicit on such practices, all of whom face potential individual exposure.

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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