08.08.2006
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Updates
Public company executives and directors are in the crosshairs again, this time over stock option "backdating" and related issues. According to media reports, more than 80 companies have announced investigations into or deficiencies with their option granting practices, and at least 19 public company executives have been fired or have resigned as a result of option granting issues. In addition, the Securities and Exchange Commission and the United States Department of Justice are reportedly conducting numerous investigations into such matters. Recent developments demonstrate that these problems continue to escalate and foreshadow a "second wave" of option-related problems for companies beyond those currently under scrutiny.
- Apple Computer announced last week that its investigation of irregularities in its stock option accounting had widened to the point that investors should not rely on its reported earnings dating back to September 2002, and that it will probably delay filing its quarterly report and restate its earnings.
- The SEC and the Department of Justice recently filed criminal and civil securities fraud charges against the former CEO of Brocade Communications, Gregory Reyes, as well as Brocade's former Vice-President of Human Resources. The SEC also asserted civil charges against Brocade's former Chief Financial Officer, who allegedly did not learn of the backdating until after joining Brocade, but is alleged to have improperly signed Brocade's financial statements and SEC filings.
For virtually any public company that has used stock options as a significant part of its incentive and compensation programs over the last decade, even if not yet involved in an investigation, the increasing media coverage is prompting inquiries from analysts, investors, board members, auditors, and government agencies. The stakes are very high as deficient or improper stock option practices can cascade into restatements, tax liability, SEC enforcement and securities class actions, as well as possible criminal exposure. In addition, under the new compensation disclosure rules that will be effective for 2006 disclosure, public companies will generally have to explain their option granting practices.
This Update provides a brief explanation of stock option practices issues and offers practical advice for public company executives and directors.
Urgent Issue: Potential Accounting Problems Could Mandate Delaying Upcoming SEC Reports
The most immediate procedural question for public company executives — and especially for the CEO and CFO who certify the company's SEC filings — is confirming that the financial information to be included in the upcoming quarterly report on Form 10-Q is accurate in all material respects. Even if executives are confident that there are no issues with stock options granted during the current quarter, problems with earlier grants that would trigger restatement of prior period financial statements could also affect the current quarter's financial statements. Companies under investigation for stock option practices issues, or who are conducting an internal evaluation (like Apple Computer), may conclude that they have problems significant enough to mandate delaying filing their upcoming SEC reports until they can correct the financial statements to be included in them, or until they can assure the CEO and CFO that no material changes are needed. Companies who have not yet completed their internal evaluation of stock option practices should contact outside counsel regarding evaluation and whether they should consider delaying filing their upcoming SEC reports.
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Practical Tip Consider Modifying Sub-Certification to CEO and CFO Certification for Upcoming SEC Reports. Companies who have not completed their internal investigations or otherwise have not yet finished addressing stock option practices issues should consider modifying the sub-certification forms that support the CEO and CFO certifications filed with the SEC to cover stock option practices issues. For example, companies could add to sub-certification forms language like the following: "To my knowledge, there have not been any irregularities in the company's stock option practices, and (a) all stock options were granted on the dates indicated in the stock option documentation; (b) no stock option grants were backdated or misdated; and (c) no stock option grants were timed to take advantage of pending announcements, either favorable or unfavorable." |
What Types of Stock Option Practices Trigger Problems?
While some of the most glaring cases under investigation involved clear wrongdoing — like actual fraudulent stock option backdating and falsifying documents — many involve practices that were widely considered acceptable and may not be illegal, but that are now coming under increased scrutiny.
Stock Option Practices Under Scrutiny. The following chart outlines practices under scrutiny.
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Practice |
What Is It? |
How to Evaluate |
| Backdating | Deliberately selecting a grant date earlier than the date the stock option grant was actually approved for the purpose of using the lower stock price on that earlier date for the stock option exercise price. |
Run an analysis that compares stock option grant dates to historical stock prices. If grant dates generally occur at historically low stock prices, this may indicate a backdating issue. This is the method used in a May 2005 paper for Management Science by Professor Erik Lie of the University of Iowa cited in The Wall Street Journal's March 18, 2006 article, "The Perfect Payday." Companies should assume that plaintiffs' lawyers and others looking at these issues, like the SEC, analysts and institutional investors, will do this analysis. |
| Misdating | Documenting stock options with grant dates that are different than the date the stock options were actually approved, but inadvertently, rather than intentionally, likely through poor administrative procedures and practices. | Compare: (1) grant dates contained in actual stock option agreements; (2) grant dates shown in the company's stock option records; and (3) evidence demonstrating the date on which the stock option grants were actually approved (which could include board or committee meeting minutes or contemporaneous email or fax records for written consents or officer approval under delegated authority). |
| Spring-loading | Intentionally granting stock options before announcing good news to take advantage of the relatively lower stock price before the expected stock price increase when the good news is announced. | Review the dates for historical stock option grants, including "mass grants" (grants to many employees on a single date) or grants involving a large number of shares to one or a small number of executives, especially those that occurred on different days year-to-year. Also perform analysis suggested above for "backdating" and compare the stock prices on grant dates to prices shortly after these dates. If stock prices typically increase following grant dates, review announcements made shortly after grant dates and any documents that shed light on how and why timing occurred. |
| Bullet-dodging | Intentionally delaying granting stock options until after the announcement of bad news to take advantage of the relatively lower stock price after the expected stock price decrease when the bad news is announced. | Perform same review and analysis suggested above for "spring-loading." If stock prices typically decline before grant dates, review announcements made shortly before grant dates and documentation of how and why timing occurred. |
Even Identifying Potential Issues May Prove Challenging. Practical challenges to getting to the bottom of any potential issues include:
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for clearly illegal practices, the people who were involved are not likely to come forward with evidence that implicates them and, if those people are no longer employees, current staff may not even be aware of the prior illegal acts;
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for other practices under scrutiny, people may not be aware that the practice occurred or that such practice may present an issue today; and
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documentation may be poor and may not reflect information now considered critical, such as the dates when actions were taken.
Performing the analyses outlined in the chart above can help identify apparent problems related to timing issues — or suggest that no issues exist.
Other Practices to Look For . . . and Avoid. In the current environment, some of the practices that were not traditionally viewed as problematic are now coming under scrutiny. While the SEC and/or auditors may ultimately agree that these practices were okay, companies should review and document both their historical and current stock option granting practices now. The following practices are common, but potentially problematic.
- Approving Grants by Written Consent. Stock option grants approved by written consent, where the written consent was signed by one or more of the directors on a date other than the grant date.
- Inconsistent or Manipulative New Hire or Promotion Grant Practices. Stock options granted to new hires, or in connection with promotions, with a grant date that differs from the date on which the new hire commenced employment, or the promotion became effective — especially where the stock price on the "grant date" is lower, or where the company's practices for new hire and/or promotion stock option grants are not consistent.
- Approving Grants of Unallocated Shares. "Mass" or "block" grants where, for example, a board or committee approved stock option grants for a total "bulk" number of shares, but did not approve the specific allocation to individual employees, and then the CEO or other executive officer allocated the shares among individual employees on a different date or dates, but used the date of the board or committee approval as the "grant date."
- Modifying Outstanding Options. Outstanding stock options amended, for example to change the vesting schedule or extend the post-termination exercise period, where the modification is not treated appropriately, or where required approval is not obtained and/or documented.
If a company's internal investigation uncovers any of these practices, the next step is to quantify the potential magnitude of any issues by analyzing the numbers of shares involved and the potential accounting charge involved with the grants or modifications.
Additional Information
Further highlighting accounting and institutional shareholder interest in these issues, the Public Company Accounting Oversight Board recently issued an Audit Practice Alert regarding "Matters Related to Timing and Accounting for Option Grants," and Institutional Shareholder Services published "An Investor Guide to the Stock Option Timing Scandal."
Perkins Coie will also soon distribute and post on our website a follow-on Update that will cover in more detail the key issues involved for companies addressing stock option practices issues, and offer additional practical advice.
You can find discussion of other recent developments, cases, laws, regulations and rule proposals of interest to public companies on our website.
