The backdating of stock option grants by public companies continues to be a focus of news stories and law enforcement investigations. What initially appeared to be an issue associated with some technology companies may in fact be more widespread, possibly extending to hundreds of companies.
The consequences are potentially significant. It has been reported that several dozen companies have received inquiries from the SEC or grand jury subpoenas from the United States Attorney’s Offices in Manhattan, Brooklyn and San Francisco. Shareholders have filed over 60 civil lawsuits alleging breach of fiduciary duty and other improprieties and a number of executives have resigned or have been terminated following internal investigations of option grant practices. It is widely believed that this is just the beginning of a tidal wave of regulatory scrutiny and litigation.
At issue is whether companies backdated or otherwise manipulated option grants to enable executives to utilize a lower than current market price to realize an immediate monetary benefit or maximize future gains. An academic study conducted in 2005 reported a pattern of option grants that coincided with low points in the issuer’s stock price and suggested that this phenomenon was likely the result of the official grant date having been set retroactively. A March 18, 2006 report by the Wall Street Journal suggests that "backdating was widespread."
Option backdating raises a number of issues of potential concern to public companies and option grant recipients.
- One issue is whether a company’s option grant practices are consistent with its public reporting and disclosure to shareholders. Already a number of companies face securities fraud class actions or derivative actions raising this issue, or related issues about internal controls, corporate governance or fiduciary obligations.
- A second issue is whether backdated grants made at below fair market value received proper accounting treatment. If a grant was made at below fair market value, there is a question of whether the company recorded a compensation expense equal to the difference between the exercise price and market price on the date of the grant. Failure to follow applicable accounting rules may require the company to amend and restate its financial statements. In a recent statement, SEC Chairman Christopher Cox warned that backdating must be fully disclosed and accounted for properly.
- A third issue is the tax treatment of options. Backdating may result in adverse tax consequences both to the company and the option recipient and put in jeopardy certain favorable tax treatment that might otherwise be available.
Every company should review whether there is any basis for concern regarding its prior practices (such as the use of "as-of" grant dates). Whether backdating was intentional or inadvertent, it is important to consider whether there are any disclosure, accounting or tax implications that need to be addressed. Beyond this, companies should consider whether they have adequate policies, procedures and controls in place to help ensure that future grants are documented and recorded accurately and that options are issued in a manner that is consistent with option plan documents filed with the SEC and other company disclosures.
Pillsbury, which already represents a number of companies in these matters, has a legal team that can assist public companies in addressing all of the relevant issues. The team includes executive compensation attorneys with experience relating to option plans, including tax and accounting issues; corporate and securities attorneys with experience relating to SEC disclosure issues; former SEC enforcement attorneys and Assistant United States Attorneys with experience in assisting Audit Committees, Special Committees and Boards of Directors in conducting internal investigations and handling regulatory and law enforcement inquiries; and securities litigators experienced in defending class actions and derivative actions.
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