Stock Option Backdating

The problem appears to be widespread. In June 2006, Merrill Lynch reported from studies it had conducted: 'On average, a stock in the S&P 500 derived 2% excess return in the 20-trading day period following options pricing events between January 1999 and December 2002 ' this would equate to an annualized 36% excess return.' The cost to companies and shareholders have been enormous. The New York Times recently reported that 'at least 46 executives and directors have been ousted from their positions,' and that Glass Lewis & Company, a research firm that advises large investors, found that 'companies have taken charges totaling $5.3 billion to account for the impact of improper grants.' Dash E: Dodging Taxes Is a New Stock Options Scheme, NY Times (Oct. 30, 2006).

The Cost to Companies

Not too surprisingly, many companies have been incurring large legal fees to conduct internal investigations and defend against criminal probes, shareholders' suits, and regulatory actions by the SEC and the IRS, while also having to worry about potential delisting actions by NYSE and Nasdaq, since option backdating may violate their shareholder approval requirements. Two types of shareholders suits are being filed ' derivative claims and securities actions. Meanwhile, the IRS is investigating tax under-reporting related to backdated options, and the SEC is probing 80 companies for how they reported their options grants. Among the regulatory actions so far is a civil injunctive action filed against Comverse Technology's former Chairman/CEO, CFO, General Counsel, and a former director ' alleging that they engaged in a protracted scheme to grant undisclosed, in-the-money, stock options to themselves and others by backdating the option grants to coincide with historically low closing prices of Comverse's common stock. SEC v. Alexander, Kreinberg and Sorin, Litig. Rel. 19796,a No. 06-CV-3844 (GJ) (E.D.N.Y. Aug. 9, 2006).

How could so many boards have approved backdated options? Like many issues that attract regulatory scrutiny, the answers are not quite as simple or nefarious as some critics suggest. Clearly some blame rests with Congress and with Generally Accepted Accounting Principles (GAAP) for arbitrarily penalizing in-the-money options. As U.S. Comptroller General David M. Walker recently noted: 'A combination of at best arbitrary and arguably irrational tax and accounting rules all but dictate that options not be granted in the money, ie, with an exercise price less than the market price of the stock on the date of the grant.' Walker DI: Some Observations on the Stock Options Backdating Scandal of 2006, http://ssrn.com/abstract=929702.

Stock Option Basics

The holder of a stock option has the right to exercise it to buy a specified number of shares at a set price (the strike price) from the company granting the option during a specific time (the exercise period) after the option has vested. See generally Anabtawi I: Secret Compensation. 82 N.C.L. Rev. 835, 836 (March 2004). Because stock options are worthless at the end of the exercise period unless the strike price is below the market price ('in the money'), employees who receive options as part of their compensation ordinarily assume some risk in the company's performance.

Shared risk is one just one of many attributes of stock options that make them an attractive component of the compensation package of highly compensated employees. Stock options also help to align the loyalty of key employees and make them stay longer, since commonly the vesting of options is staggered over a period of years. Another attractive feature is that options are not reported as expenses against earnings because they do not have a fixed value, yet they can be deducted from income for tax purposes if they meet certain standards under the Internal Revenue Code (IRC). See Brodie MT: Aligning Incentives with Equity: Employee Stock Options and Rule 10b-5. 88 Iowa L. Rev. 539, 548 (2003).

Tax and Accounting Treatment of Stock Options

Since 1993, federal tax laws have allowed companies to add stock options to compensation packages without suffering tax consequences even though they are prevented from expensing annual salaries in excess of $1 million. IRC ' 162(m) ('Certain excessive employee remuneration'). As a result, most large, publicly traded companies have been using stock options to attract and retain executives. Executives also get tax benefits because their profit from options will probably be taxed as long-term capital gains instead of ordinary income.

The core rules governing the tax treatment of stock options appear in IRC ' 422 (entitled 'Incentive Stock Options') and in ' 421 (entitled 'General rules'). Under IRC ' 422(b)(1) and (4), companies are entitled to favorable tax treatment if the options are granted under an approved plan within 12 months before or after the plan is adopted and are priced at the fair market value of the stock at the time of the award. IRC ' 421 sets rules for when there will be no tax recognition from the award or receipt of the options and, among other things, requires that there can be '(a) (1) no disposition of such share ' within 2 years from the date of the granting of the option nor within 1 year after the transfer of such share ' '

Backdating options to make them appear to have been at a lower cost to the company than they actually were violates the Internal Revenue Code and eliminates most of the risk to the employee associated with the grant of such options. This triggers serious tax consequences for both the company and the option recipient.

Backdating also was an attempt to circumvent GAAP reporting rules, since prior to 2005 options whose strike price was the same or above the market price on the date of the grant did not need to be charged against earnings.

Stock Fraud Issues

Because listed companies are re-quired to report material information at periodic intervals, companies that didn't report their options accurately face serious consequences under the federal securities laws. At a minimum, they have a duty to correct or update information that is alive in the marketplace and that was not accurate when made or became inaccurate thereafter.

For example, the indictment charging former executives of Brocade Communications with securities fraud, mail fraud and conspiracy, United States v. Reyes and Jensen, Cr. No. 06-0556 (N.D.Cal., Aug. 10, 2006), alleges, among other things, that the defendants backdated committee minutes of Brocade's board so that it appeared the committee had met, granted stock options, and priced them at the market value of Brocade's stock on dates when it was relatively low ' meetings that allegedly never occurred on those dates; backdated various personnel records to make it falsely appear that stock option recipients had been employed on the grant dates; caused fraudulent entries to be made in the company's books and records; caused materially false statements and omissions to be made to the company's outside auditors; and caused materially false and misleading financial statements to be filed with the SEC.

The SOX 'Fix' to Stock Option Fraud

As troublesome as the stock option backdating problems have become, the problems are largely confined to the period before the enactment of the Sarbanes-Oxley Act in 2002. This is because before the Act officers and directors didn't have to disclose their receipt of stock options until the end of the fiscal year in which the options were granted. But SOX limited the time in which stock option grants could be manipulated by requiring real-time disclosure. In addition, shortly after the Act, the SEC issued rules mandating that officers and directors receiving grants report them within two business days. Moreover, in late 2004, the Financial Accounting Standards Board issued 'Statement of Financial Accounting Standard 123R' under which all stock options issued to employees must be recorded as an expense in a company's financial statements, even when the exercise price is the fair market value on the date of issue.

Conclusion

In this era of heightened awareness about good corporate governance and enhanced responsibilities on outside auditors, corporate executives and board members, the revelation of this new form of corporate misconduct is especially troublesome. Under the Caremark doctrine, board members, to limit their potential personal liability, should have implemented necessary controls. See In re Caremark Int'l, Inc., 698 A.2d 959 (Del. 2000) (discussing a board's duty to monitor). But as Enron revealed, good corporate governance requires more than just adopting codes of conduct and compliance plans. Publicly traded companies must instill cultures of compliance if they are to avoid the types of problems exemplified by the stock option fraud investigations and cases.

Michael E. Clark ([email protected]), a member of this newsletter's Board of Editors, is a former federal prosecutor, Chair of the White Collar Crimes Committee of the ABA Business Law Section, Co-Chair of the South Texas Region of the White Collar Crimes Committee of the ABA Criminal Justice Section, and Chair of the Publications Committee of the ABA Health Law Section.

'Where were these professionals when these clearly improper transactions were being consummated? Why didn't any of them speak up or disassociate themselves from the transactions?' Lincoln Sav. & Loan Ass'n v. Wall, 743 F. Supp. 901, 920 (D.D.C. 1990) (Sporkin, J.).

Just as the business community began making headway with Congress to reduce Sarbanes-Oxley (SOX) obligations, a new type of corporate wrongdoing has been revealed ' backdated stock options used by the executives at many companies and some directors to convert their options at the most opportune times and at the expense of other shareholders and investors. What is troubling is how the boards of directors at so many companies could have approved the backdating or not known about it after SOX and the recent wave of high-profile corporate fraud investigations and prosecutions.

Criminal charges have already been lodged against some high-ranking corporate executives. See DOJ Press Release, 'Former Executives of Comverse Technology Inc. Charged with Backdating Millions of Stock Options and Creating a Secret Stock Options Slush Fund' (Aug. 9, 2006), www.usdoj.gov/opa/pr/2006/August/06_odag_517.html; and 'Brocade Executives Indicted' (Aug. 12, 2006), lawprofessors.typepad.com/whitecollarcrime_blog/2006/08/brocade_executi.html. Public companies have been forced to restate their earnings and witness their stock values tumble following the negative publicity from acknowledging that they had incorrectly accounted for and reported stock option grants in prior years.

The problem appears to be widespread. In June 2006, Merrill Lynch reported from studies it had conducted: 'On average, a stock in the S&P 500 derived 2% excess return in the 20-trading day period following options pricing events between January 1999 and December 2002 ' this would equate to an annualized 36% excess return.' The cost to companies and shareholders have been enormous. The New York Times recently reported that 'at least 46 executives and directors have been ousted from their positions,' and that Glass Lewis & Company, a research firm that advises large investors, found that 'companies have taken charges totaling $5.3 billion to account for the impact of improper grants.' Dash E: Dodging Taxes Is a New Stock Options Scheme, NY Times (Oct. 30, 2006).

The Cost to Companies

Not too surprisingly, many companies have been incurring large legal fees to conduct internal investigations and defend against criminal probes, shareholders' suits, and regulatory actions by the SEC and the IRS, while also having to worry about potential delisting actions by NYSE and Nasdaq, since option backdating may violate their shareholder approval requirements. Two types of shareholders suits are being filed ' derivative claims and securities actions. Meanwhile, the IRS is investigating tax under-reporting related to backdated options, and the SEC is probing 80 companies for how they reported their options grants. Among the regulatory actions so far is a civil injunctive action filed against Comverse Technology's former Chairman/CEO, CFO, General Counsel, and a former director ' alleging that they engaged in a protracted scheme to grant undisclosed, in-the-money, stock options to themselves and others by backdating the option grants to coincide with historically low closing prices of Comverse's common stock. SEC v. Alexander, Kreinberg and Sorin, Litig. Rel. 19796,a No. 06-CV-3844 (GJ) (E.D.N.Y. Aug. 9, 2006).

How could so many boards have approved backdated options? Like many issues that attract regulatory scrutiny, the answers are not quite as simple or nefarious as some critics suggest. Clearly some blame rests with Congress and with Generally Accepted Accounting Principles (GAAP) for arbitrarily penalizing in-the-money options. As U.S. Comptroller General David M. Walker recently noted: 'A combination of at best arbitrary and arguably irrational tax and accounting rules all but dictate that options not be granted in the money, ie, with an exercise price less than the market price of the stock on the date of the grant.' Walker DI: Some Observations on the Stock Options Backdating Scandal of 2006, http://ssrn.com/abstract=929702.

Stock Option Basics

The holder of a stock option has the right to exercise it to buy a specified number of shares at a set price (the strike price) from the company granting the option during a specific time (the exercise period) after the option has vested. See generally Anabtawi I: Secret Compensation. 82 N.C.L. Rev. 835, 836 (March 2004). Because stock options are worthless at the end of the exercise period unless the strike price is below the market price ('in the money'), employees who receive options as part of their compensation ordinarily assume some risk in the company's performance.

Shared risk is one just one of many attributes of stock options that make them an attractive component of the compensation package of highly compensated employees. Stock options also help to align the loyalty of key employees and make them stay longer, since commonly the vesting of options is staggered over a period of years. Another attractive feature is that options are not reported as expenses against earnings because they do not have a fixed value, yet they can be deducted from income for tax purposes if they meet certain standards under the Internal Revenue Code (IRC). See Brodie MT: Aligning Incentives with Equity: Employee Stock Options and Rule 10b-5. 88 Iowa L. Rev. 539, 548 (2003).

Tax and Accounting Treatment of Stock Options

Since 1993, federal tax laws have allowed companies to add stock options to compensation packages without suffering tax consequences even though they are prevented from expensing annual salaries in excess of $1 million. IRC ' 162(m) ('Certain excessive employee remuneration'). As a result, most large, publicly traded companies have been using stock options to attract and retain executives. Executives also get tax benefits because their profit from options will probably be taxed as long-term capital gains instead of ordinary income.

The core rules governing the tax treatment of stock options appear in IRC ' 422 (entitled 'Incentive Stock Options') and in ' 421 (entitled 'General rules'). Under IRC ' 422(b)(1) and (4), companies are entitled to favorable tax treatment if the options are granted under an approved plan within 12 months before or after the plan is adopted and are priced at the fair market value of the stock at the time of the award. IRC ' 421 sets rules for when there will be no tax recognition from the award or receipt of the options and, among other things, requires that there can be '(a) (1) no disposition of such share ' within 2 years from the date of the granting of the option nor within 1 year after the transfer of such share ' '

Backdating options to make them appear to have been at a lower cost to the company than they actually were violates the Internal Revenue Code and eliminates most of the risk to the employee associated with the grant of such options. This triggers serious tax consequences for both the company and the option recipient.

Backdating also was an attempt to circumvent GAAP reporting rules, since prior to 2005 options whose strike price was the same or above the market price on the date of the grant did not need to be charged against earnings.

Stock Fraud Issues

Because listed companies are re-quired to report material information at periodic intervals, companies that didn't report their options accurately face serious consequences under the federal securities laws. At a minimum, they have a duty to correct or update information that is alive in the marketplace and that was not accurate when made or became inaccurate thereafter.

For example, the indictment charging former executives of Brocade Communications with securities fraud, mail fraud and conspiracy, United States v. Reyes and Jensen, Cr. No. 06-0556 (N.D.Cal., Aug. 10, 2006), alleges, among other things, that the defendants backdated committee minutes of Brocade's board so that it appeared the committee had met, granted stock options, and priced them at the market value of Brocade's stock on dates when it was relatively low ' meetings that allegedly never occurred on those dates; backdated various personnel records to make it falsely appear that stock option recipients had been employed on the grant dates; caused fraudulent entries to be made in the company's books and records; caused materially false statements and omissions to be made to the company's outside auditors; and caused materially false and misleading financial statements to be filed with the SEC.

The SOX 'Fix' to Stock Option Fraud

As troublesome as the stock option backdating problems have become, the problems are largely confined to the period before the enactment of the Sarbanes-Oxley Act in 2002. This is because before the Act officers and directors didn't have to disclose their receipt of stock options until the end of the fiscal year in which the options were granted. But SOX limited the time in which stock option grants could be manipulated by requiring real-time disclosure. In addition, shortly after the Act, the SEC issued rules mandating that officers and directors receiving grants report them within two business days. Moreover, in late 2004, the Financial Accounting Standards Board issued 'Statement of Financial Accounting Standard 123R' under which all stock options issued to employees must be recorded as an expense in a company's financial statements, even when the exercise price is the fair market value on the date of issue.

Conclusion

In this era of heightened awareness about good corporate governance and enhanced responsibilities on outside auditors, corporate executives and board members, the revelation of this new form of corporate misconduct is especially troublesome. Under the Caremark doctrine, board members, to limit their potential personal liability, should have implemented necessary controls. See In re Caremark Int'l, Inc., 698 A.2d 959 (Del. 2000) (discussing a board's duty to monitor). But as Enron revealed, good corporate governance requires more than just adopting codes of conduct and compliance plans. Publicly traded companies must instill cultures of compliance if they are to avoid the types of problems exemplified by the stock option fraud investigations and cases.

Michael E. Clark ([email protected]), a member of this newsletter's Board of Editors, is a former federal prosecutor, Chair of the White Collar Crimes Committee of the ABA Business Law Section, Co-Chair of the South Texas Region of the White Collar Crimes Committee of the ABA Criminal Justice Section, and Chair of the Publications Committee of the ABA Health Law Section.