United States: Stock Options Backdating Controversy Raises Issues

One of the dominant stories of late in the equity compensation area is the revelation by numerous companies that they are being investigated, by the government or in internal investigations, in the fast-spreading controversy generally referred to as "stock option backdating." Every day, it seems, additional companies announce the receipt of subpoenas or the commencement of internal investigations regarding their stock option grant practices. Moreover, several senior executives have already been terminated or forced to resign for their role in such practices. The government investigations are being separately pursued by the U.S. Securities and Exchange Commission (SEC) and the U.S. Department of Justice and it appears likely more companies will be targeted.

In addition to the governmental investigations, numerous civil suits have been filed against companies and their officers and directors, alleging breach of fiduciary duty, and several senior executives have already been terminated or forced to resign due to their roles in option grant practices. The Internal Revenue Service has also indicated that, due to the significant tax effects that option backdating can have, it likely will also investigate these situations.

The investigations, and companies' disclosures that their practices were being scrutinized, were initially fueled by numerous stories in the press exposing unusual correlations between option grant dates at certain companies and the date on which the companies' stock reached relatively low trading prices. The question to be answered by these investigations is whether corporations used stock option grants to improperly enrich their senior executives. These investigations focus on two main issues: (1) whether options were "backdated," or granted retroactively as of a date when the stock price was low, creating a built-in profit, and (2) whether options were granted immediately before corporate announcements that were likely to increase the price of the shares.

Consequences of Investigations

The issues raised by these numerous investigations include tax, accounting, securities law disclosure, corporate governance and insurance issues. Key implications include:

Accounting Issues: Prior to certain recently adopted rules, if an option was granted with an exercise price at or above the market price at the date of grant, the company was not required to recognize that grant as an expense. Thus, by backdating an option, a company could preserve this ability to avoid a compensation expense. Even under the new rules, backdating an option could substantially lower the expense the company must recognize. The failure to have properly accounted for this expense could require a company to restate its financial statements.

Securities Law Disclosure Issues: Failure to have disclosed backdating conduct in a company's SEC filings could mean that the company's disclosures concerning its executive compensation were inadequate or contained misstatements, potentially leading to liability for securities violations.

Corporate Governance: Backdating conduct may raise a question as to the authority to grant the options, particularly if the plan under which the options were granted does not permit the grant of "discounted options." This question becomes more pertinent if shareholder approval for the issuance of such stock options is required by the company's state of incorporation.

Employee and Company Tax Issues: An award of an in-the-money stock option may create unfavorable tax consequences for the employee and could create a withholding obligation and corresponding liability for the company. It could also result in the company losing a deduction for the compensation expense when the option is exercised. Further, at-the-money options are considered performance-based compensation and can therefore be deducted for tax purposes even if executives are paid in excess of $1 million. However, if the options were effectively in-the-money on the decision date, they might not qualify for such tax deductions. Additionally, incentive stock options must be granted at an exercise price at or above the market price at date of grant; an option which has been backdated to try to meet this requirement would not be eligible for favorable incentive stock option treatment. Also, a backdated option, whether incentive or non-qualified, could be subject to rigid exercise rules or an additional 20 percent excise tax.

Insurance Coverage: Companies may need to notify their directors and officers (D&O) liability insurance carriers of potential backdating issues, to preserve claims under the policy for costs incurred due to an investigation or shareholder action.

Because of the potential liability involved (both civil and criminal), companies that suspect backdating conduct may have occurred need to evaluate the numerous compliance issues and may want to consider promptly consulting counsel. Boards of directors may want to seek independent counsel to discuss potential issues involved.

If a company determines that backdating conduct has occurred and material problems are present, it may want to initiate a plan for self-correcting. The SEC tends to be receptive to companies that self-identify and any consequences that may be forthcoming would likely be less burdensome if a company is proactive rather than reactive, especially in a situation where it is faced with a subpoena or shareholder lawsuit.

Any company that issues stock options may want to undertake a complete review of its compensation practices and procedures, including the award of stock option grants. This review should include all of the issues addressed above.

About Duane Morris

In response to the stock option backdating controversy, Duane Morris LLP has formed a multidisciplinary team of lawyers with experience in the following areas to assist companies that either are involved in an investigation or would like to perform an internal review of their practices: corporate compliance, securities law compliance, employee benefits and executive compensation, internal investigations, white-collar criminal defense and securities litigation.

Our multidisciplinary team assists clients with respect to (1) internal audits of stock option pricing and grant practices, (2) employee benefits and executive compensation practices, (3) SEC enforcement defense, (4) securities litigation defense, (5) insurance recovery, (6) white-collar criminal defense and (7) tax matters.

This article is for general information and does not include full legal analysis of the matters presented. It should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances. The description of the results of any specific case or transaction contained herein does not mean or suggest that similar results can or could be obtained in any other matter. Each legal matter should be considered to be unique and subject to varying results. The invitation to contact the authors or attorneys in our firm is not a solicitation to provide professional services and should not be construed as a statement as to any availability to perform legal services in any jurisdiction in which such attorney is not permitted to practice.

Duane Morris LLP, among the 100 largest law firms in the United States, is a full-service firm of more than 600 lawyers. In addition to legal services, Duane Morris has independent affiliates employing approximately 100 professionals engaged in other disciplines. With offices in major markets, and as part of an international network of independent law firms, Duane Morris represents clients across the nation and around the world.