Backdating Investigations

As federal investigators examine the stock option programs of more than 160 companies, innumerable other companies launch internal investigations. As top executives resign, shareholders file dizzying numbers of derivative class action suits. Finally, as the Securities Exchange Commission and Department of Justice bring enforcement actions and criminal charges, the media is vilifying the so-called stock option backdating scandal as the biggest example of corporate abuse since Enron. The option backdating media frenzy focuses upon investigations by federal prosecutors and other regulatory agencies into public companies that have employed stock option compensation plans for corporate executives and employees.

Investigators allege companies may have backdated stock options by taking a 'look back' to a date when stock prices were low to retroactively set a strike or exercise price. Usually, a strong upward run in the stock price followed the low price period, allowing holders of the stock options to reap no-risk profits. The alleged evil and potential crime is not in the backdating itself but in the accounting and public disclosure of the options award. The main issue revolves around whether companies appropriately booked option grants as compensation or as true incentive grants which need not be treated as compensation. Moreover, these regulatory actions and criminal cases are being touted as easy to prove, a cinch for a lay juror to understand, and a virtual 'slam-dunk' conviction for government prosecutors and regulators. Suffice it to say, an option backdating investigation can wreak havoc upon a company's bottom line, stock price and morale.

Such multi-front investigations, which can in turn spawn complex litigation across several jurisdictions, can be challenging for corporate or general counsel to handle. The purpose of the this article is to briefly explore the issues generally presented in an option backdating investigation, to suggest possible methods of approach for counsel to effectively respond to an investigation and to predict where the option compensation issue will move in the future.

The Backdating Investigation

The current investigations center on the suspicion that companies set the strike price for option awards by looking back to a point at which the company stock was low and then experienced a dramatic rise. One source has characterized this practice as betting on a horse after you know who won the race. While few proclaim that this suspected practice of option backdating exemplifies model corporate governance, it is another question altogether as to whether it constitutes criminal conduct. With only a few notable, high profile exceptions, indictments of individuals have been rare and no company has yet to be criminally charged as a result of the investigations.

Indeed, the Sarbanes-Oxley Act ('SOX') mandated that as of August 2002 any company issuing stock options as compensation must notify the Securities and Exchange Commission ('SEC') within two days of the award. Along with this notification, a company must also disclose the date of the grant and the exercise price. The rationale behind this provision is that it virtually insures there will be no room for backdating in the future. Thus, the time period under scrutiny is the mythic bull market of the 1990's, fueled as it was by so many so-called 'dot com' start-ups, instant initial public offerings, and the making of overnight fortunes. Competition among new frontier tech companies was fierce for knowledgeable employees and stock prices soared daily. Many companies offered option compensation as a way to attract qualified executives and employees. As a result, many of the companies that received subpoenas from federal law enforcement officials are technology based service or product providers. However, no company seems immune from scrutiny with Home Depot, Cablevision and Apple joining the ranks of corporations that have received subpoenas and are under investigation.

Accounting Issues and APB-25

At the heart of any option grant investigation is how the accounting was done. Prior to December 15, 2005 companies accounted for stock option grants under Accounting Principles Board Opinion No. 25 ('APB-25') and later under Financial Accounting Standards Board Statement No.123 ('FASB123'). Through these are two distinct regulations, the later-enacted FASB 123 allowed companies to continue to use the APB 25 method as long as companies footnoted the fair-based compensation value of the stock options in their financial statements.

Thus, under either rule, if the strike price was set on the day of the grant, then it was granted as a true incentive based option and no compensation expense was recorded. However, if the exercise price was lower than the fair market value of the stock on the date of grant, or granted immediately 'in the money,' the option had an instantaneous value and the company was required to record an executive or employee compensation expense equal to the difference between the strike price and the fair market value of a share of stock on the date of award.

The issue in any option backdating investigation will be: 1) whether or not options were true incentive based awards or were granted with an immediate value; and 2) were they accounted for and disclosed properly in public filings. If a company actively awarded option compensation during the years in question, unraveling how such awards were authorized, approved, recorded, awarded and accounted for can be a massive, complex and daunting process. If regulatory attorneys from the SEC or prosecutors from DOJ conduct the investigation, the process can become intensely stressful with the fate and future of the company hanging in the balance.

What to Do When the Subpoena Comes

General or corporate counsel who receives a subpoena directed to the company from the SEC or from a United States Attorney's Office requesting information regarding option awards should immediately retain outside counsel to handle the subpoena on behalf of the company. The particular outside counsel selected should be truly independent and not a firm the company has used to handle normal litigation needs or to assist in commercial or corporate matters. Truly independent, outside counsel will impress regulators and prosecutors that the company is serious about conducting a focused, conflict free investigation and is committed to a through house cleaning if necessary. General counsel should consider whether outside counsel should be retained separately for the company and in addition, separately on behalf of the audit committee or board of directors. Provisions of SOX suggest that an audit committee or board of directors may need independent counsel.

Once selected, outside counsel will bring investigative teams to the table which will include former law enforcement agents, forensic accountants and tax specialists. Indeed, if general counsel was personally involved in the option compensation process, they may be witnesses themselves or worse yet, targets of a criminal investigation. In a few high-profile examples, general counsels have entered pleas of guilty in connection with crimes alleged by prosecutors investigating option compensation awards. General counsel should seek separate, individual representation immediately if they were involved in any process leading to option compensation awards. Even if they did nothing wrong, the area is so technical that the advice of personal counsel is crucial.

Indeed, whether individual company executives should immediately have personal counsel and whether the company should pay the legal fees for a given individual's lawyer is a consideration of prime importance and is a cutting edge legal issue. Sometimes, the interests of the company and the interests of individual executives and corporate employees may be in conflict. If top executives were intentionally involved in misleading investors by knowingly hiding massive compensation grants from public disclosure through a surreptitious scheme to backdate option awards and then improperly account for them, the company has an important interest in self-reporting the problem and turning in the executives in question in order to avoid being prosecuted itself. On the one hand, the executive may have provided years of loyal service to the business, delegated decisions regarding option awards to a compensation committee, never heard of APB-25 and received the advice of outside counsel who at the time believed everything was fine. Should general counsel orchestrate an internal investigation bent upon getting all the details to ultimately be shared with regulators and prosecutors through a waiver of attorney client privilege and work product privilege at the potential expense of individuals? On the other hand, will too much deference to executives turn regulators and prosecutors against the company itself and limit the information available to bring out what actually happened?

The Attorney Client Privilege; the McNulty Memo And United States v. Stein

In the aftermath of the Enron failure and other high profile corporate accounting frauds, the issue of whether and under what circumstances companies will be required to waive the attorney client privilege and report their investigative findings to prosecutors and regulators has been hotly debated. To what extent a company cooperates with investigating authorities is crucial to whether a company will face regulatory or criminal charges. The position of the Department of Justice on whether a decision to charge a corporation will be tied to a waiver by the company of its own attorney client privilege has been addressed in a series of memoranda authored by various Deputy Attorney's General. The 'McNulty Memorandum' supersedes the more aggressive 'Holder Memorandum' and 'Thompson Memorandum,' and requires supervisory approval prior to a waiver request, however it does not remove waiver from the calculus of whether a company has cooperated sufficiently to avoid criminal charges.

The four factors to be considered before a demand for waiver made by a prosecutor is approved by senior DOJ officials are: 1) the benefit to the government; 2) whether the information sought can be obtained in a timely manner from another source; 3) the completeness of the disclosure already provided; and 4) the collateral consequences of waiver to the corporation. These amorphous, catchall categories provide little direction to corporations and employees who need to rely on a dependable privilege: as the U.S. Supreme Court noted in the case of Upjohn Co. v. United States, 449 U.S. 383, 393 (1981), an 'uncertain privilege'is little better than no privilege at all.'

However, the McNulty Memo removes from consideration the payment or reimbursement of legal fees by the corporation for employees as a factor to be weighed against the company in determining the completeness of its cooperation. Thus, general counsel should press the company to pay the legal fees of executives and employees, subject to directors and officers insurance considerations and company practice concerns. The payment of legal fees should be without regard to whether or not executives and employees decide to cooperate with investigations or fight the allegations being investigated.

Indeed, in United States v. Stein, Judge Lewis Kaplan ruled that it was unconstitutional for KPMG to pay the legal fees of cooperating employees but refuse payment to those who wished to contest the charges. Read in tandem, the McNulty Memo and Stein strongly support the view that a company should pay for the legal fees its officers and employees.

The Future Course of Investigations

Thus far, with a handful of high profile exceptions, prosecutors have refrained from bringing criminal charges against individuals in connection with option backdating investigations and no company has been charged with a crime. It remains to be seen whether all but the most egregious examples of blatant accounting fraud will be dealt with by way of a indictment or whether criminal charges will become more common. It appears likely that many more criminal cases will be threatened or brought before this initiative ends.

One of the potentially thorny problems for general counsel may involve the interplay between regulatory and criminal investigations on the one hand and shareholder law suits on the other. In order to avoid criminal prosecution and regulatory action, executives may well legitimately be able to claim a lack of knowledge or understanding of the details of the option compensation and public accounting process.

However, as more and more stockholders bring derivative actions against the companies that very same successful defense to criminal and regulatory allegations may cause fiduciary liability problems. In Ryan v. Gifford & Maxim Integrated Products the Delaware Court of Chancery has allowed a consolidated shareholder's derivative action to proceed on a theory that executives, directors and the board of compensation of Maxim breached a fiduciary duty of care in permitting backdated option grants to be awarded but not to be properly accounted for and disclosed, notwithstanding an argument by the company that the business judgment rule protected it from such claims. Moreover, the very same court in In Re Tyson Foods, stated that '[a]t their heart, all backdated options involve a fundamental, incontrovertible lie: directors who approve an option dissemble as to the date on which the grant was actually made.' The court went on to state that backdating options always involves a factual misrepresentation to shareholders. Thus, by avoiding the dangerous Scylla of the SEC and the Department of Justice, general counsel may be faced with the Charybdis of a crippling shareholders derivative action.

Conclusion

An investigation into stock option compensation practices presents complex challenges for general and corporate counsel in managing a multi-front legal process. Obtaining experienced outside counsel for the company, the board of directors and key individuals is crucial and should be paid for, where possible, by the company itself. Absent particularly egregious circumstances it appears that restatements, proper disclosure and payment may be an accepted route to avoid formal regulatory and criminal charges. However, care must be taken not to rush to admissions in settlement statements or deferred prosecution agreements that make it simple for plaintiff's derivative actions to automatically prevail.

Charles A. Ross is the principal of Charles A. Ross and Associates, and focuses his practice on white-collar criminal defense. The firm represents clients in complex criminal matters in cases involving public corruption, the RICO Act, bank fraud, bribery, government procurement fraud, antitrust, healthcare fraud, and tax and securities fraud. Ross may be reached at [email protected].

As federal investigators examine the stock option programs of more than 160 companies, innumerable other companies launch internal investigations. As top executives resign, shareholders file dizzying numbers of derivative class action suits. Finally, as the Securities Exchange Commission and Department of Justice bring enforcement actions and criminal charges, the media is vilifying the so-called stock option backdating scandal as the biggest example of corporate abuse since Enron. The option backdating media frenzy focuses upon investigations by federal prosecutors and other regulatory agencies into public companies that have employed stock option compensation plans for corporate executives and employees.

Investigators allege companies may have backdated stock options by taking a 'look back' to a date when stock prices were low to retroactively set a strike or exercise price. Usually, a strong upward run in the stock price followed the low price period, allowing holders of the stock options to reap no-risk profits. The alleged evil and potential crime is not in the backdating itself but in the accounting and public disclosure of the options award. The main issue revolves around whether companies appropriately booked option grants as compensation or as true incentive grants which need not be treated as compensation. Moreover, these regulatory actions and criminal cases are being touted as easy to prove, a cinch for a lay juror to understand, and a virtual 'slam-dunk' conviction for government prosecutors and regulators. Suffice it to say, an option backdating investigation can wreak havoc upon a company's bottom line, stock price and morale.

Such multi-front investigations, which can in turn spawn complex litigation across several jurisdictions, can be challenging for corporate or general counsel to handle. The purpose of the this article is to briefly explore the issues generally presented in an option backdating investigation, to suggest possible methods of approach for counsel to effectively respond to an investigation and to predict where the option compensation issue will move in the future.

The Backdating Investigation

The current investigations center on the suspicion that companies set the strike price for option awards by looking back to a point at which the company stock was low and then experienced a dramatic rise. One source has characterized this practice as betting on a horse after you know who won the race. While few proclaim that this suspected practice of option backdating exemplifies model corporate governance, it is another question altogether as to whether it constitutes criminal conduct. With only a few notable, high profile exceptions, indictments of individuals have been rare and no company has yet to be criminally charged as a result of the investigations.

Indeed, the Sarbanes-Oxley Act ('SOX') mandated that as of August 2002 any company issuing stock options as compensation must notify the Securities and Exchange Commission ('SEC') within two days of the award. Along with this notification, a company must also disclose the date of the grant and the exercise price. The rationale behind this provision is that it virtually insures there will be no room for backdating in the future. Thus, the time period under scrutiny is the mythic bull market of the 1990's, fueled as it was by so many so-called 'dot com' start-ups, instant initial public offerings, and the making of overnight fortunes. Competition among new frontier tech companies was fierce for knowledgeable employees and stock prices soared daily. Many companies offered option compensation as a way to attract qualified executives and employees. As a result, many of the companies that received subpoenas from federal law enforcement officials are technology based service or product providers. However, no company seems immune from scrutiny with Home Depot, Cablevision and Apple joining the ranks of corporations that have received subpoenas and are under investigation.

Accounting Issues and APB-25

At the heart of any option grant investigation is how the accounting was done. Prior to December 15, 2005 companies accounted for stock option grants under Accounting Principles Board Opinion No. 25 ('APB-25') and later under Financial Accounting Standards Board Statement No.123 ('FASB123'). Through these are two distinct regulations, the later-enacted FASB 123 allowed companies to continue to use the APB 25 method as long as companies footnoted the fair-based compensation value of the stock options in their financial statements.

Thus, under either rule, if the strike price was set on the day of the grant, then it was granted as a true incentive based option and no compensation expense was recorded. However, if the exercise price was lower than the fair market value of the stock on the date of grant, or granted immediately 'in the money,' the option had an instantaneous value and the company was required to record an executive or employee compensation expense equal to the difference between the strike price and the fair market value of a share of stock on the date of award.

The issue in any option backdating investigation will be: 1) whether or not options were true incentive based awards or were granted with an immediate value; and 2) were they accounted for and disclosed properly in public filings. If a company actively awarded option compensation during the years in question, unraveling how such awards were authorized, approved, recorded, awarded and accounted for can be a massive, complex and daunting process. If regulatory attorneys from the SEC or prosecutors from DOJ conduct the investigation, the process can become intensely stressful with the fate and future of the company hanging in the balance.

What to Do When the Subpoena Comes

General or corporate counsel who receives a subpoena directed to the company from the SEC or from a United States Attorney's Office requesting information regarding option awards should immediately retain outside counsel to handle the subpoena on behalf of the company. The particular outside counsel selected should be truly independent and not a firm the company has used to handle normal litigation needs or to assist in commercial or corporate matters. Truly independent, outside counsel will impress regulators and prosecutors that the company is serious about conducting a focused, conflict free investigation and is committed to a through house cleaning if necessary. General counsel should consider whether outside counsel should be retained separately for the company and in addition, separately on behalf of the audit committee or board of directors. Provisions of SOX suggest that an audit committee or board of directors may need independent counsel.

Once selected, outside counsel will bring investigative teams to the table which will include former law enforcement agents, forensic accountants and tax specialists. Indeed, if general counsel was personally involved in the option compensation process, they may be witnesses themselves or worse yet, targets of a criminal investigation. In a few high-profile examples, general counsels have entered pleas of guilty in connection with crimes alleged by prosecutors investigating option compensation awards. General counsel should seek separate, individual representation immediately if they were involved in any process leading to option compensation awards. Even if they did nothing wrong, the area is so technical that the advice of personal counsel is crucial.

Indeed, whether individual company executives should immediately have personal counsel and whether the company should pay the legal fees for a given individual's lawyer is a consideration of prime importance and is a cutting edge legal issue. Sometimes, the interests of the company and the interests of individual executives and corporate employees may be in conflict. If top executives were intentionally involved in misleading investors by knowingly hiding massive compensation grants from public disclosure through a surreptitious scheme to backdate option awards and then improperly account for them, the company has an important interest in self-reporting the problem and turning in the executives in question in order to avoid being prosecuted itself. On the one hand, the executive may have provided years of loyal service to the business, delegated decisions regarding option awards to a compensation committee, never heard of APB-25 and received the advice of outside counsel who at the time believed everything was fine. Should general counsel orchestrate an internal investigation bent upon getting all the details to ultimately be shared with regulators and prosecutors through a waiver of attorney client privilege and work product privilege at the potential expense of individuals? On the other hand, will too much deference to executives turn regulators and prosecutors against the company itself and limit the information available to bring out what actually happened?

The Attorney Client Privilege; the McNulty Memo And United States v. Stein

In the aftermath of the Enron failure and other high profile corporate accounting frauds, the issue of whether and under what circumstances companies will be required to waive the attorney client privilege and report their investigative findings to prosecutors and regulators has been hotly debated. To what extent a company cooperates with investigating authorities is crucial to whether a company will face regulatory or criminal charges. The position of the Department of Justice on whether a decision to charge a corporation will be tied to a waiver by the company of its own attorney client privilege has been addressed in a series of memoranda authored by various Deputy Attorney's General. The 'McNulty Memorandum' supersedes the more aggressive 'Holder Memorandum' and 'Thompson Memorandum,' and requires supervisory approval prior to a waiver request, however it does not remove waiver from the calculus of whether a company has cooperated sufficiently to avoid criminal charges.

The four factors to be considered before a demand for waiver made by a prosecutor is approved by senior DOJ officials are: 1) the benefit to the government; 2) whether the information sought can be obtained in a timely manner from another source; 3) the completeness of the disclosure already provided; and 4) the collateral consequences of waiver to the corporation. These amorphous, catchall categories provide little direction to corporations and employees who need to rely on a dependable privilege: as the U.S. Supreme Court noted in the case of Upjohn Co. v. United States, 449 U.S. 383, 393 (1981), an 'uncertain privilege'is little better than no privilege at all.'

However, the McNulty Memo removes from consideration the payment or reimbursement of legal fees by the corporation for employees as a factor to be weighed against the company in determining the completeness of its cooperation. Thus, general counsel should press the company to pay the legal fees of executives and employees, subject to directors and officers insurance considerations and company practice concerns. The payment of legal fees should be without regard to whether or not executives and employees decide to cooperate with investigations or fight the allegations being investigated.

Indeed, in United States v. Stein, Judge Lewis Kaplan ruled that it was unconstitutional for KPMG to pay the legal fees of cooperating employees but refuse payment to those who wished to contest the charges. Read in tandem, the McNulty Memo and Stein strongly support the view that a company should pay for the legal fees its officers and employees.

The Future Course of Investigations

Thus far, with a handful of high profile exceptions, prosecutors have refrained from bringing criminal charges against individuals in connection with option backdating investigations and no company has been charged with a crime. It remains to be seen whether all but the most egregious examples of blatant accounting fraud will be dealt with by way of a indictment or whether criminal charges will become more common. It appears likely that many more criminal cases will be threatened or brought before this initiative ends.

One of the potentially thorny problems for general counsel may involve the interplay between regulatory and criminal investigations on the one hand and shareholder law suits on the other. In order to avoid criminal prosecution and regulatory action, executives may well legitimately be able to claim a lack of knowledge or understanding of the details of the option compensation and public accounting process.

However, as more and more stockholders bring derivative actions against the companies that very same successful defense to criminal and regulatory allegations may cause fiduciary liability problems. In Ryan v. Gifford & Maxim Integrated Products the Delaware Court of Chancery has allowed a consolidated shareholder's derivative action to proceed on a theory that executives, directors and the board of compensation of Maxim breached a fiduciary duty of care in permitting backdated option grants to be awarded but not to be properly accounted for and disclosed, notwithstanding an argument by the company that the business judgment rule protected it from such claims. Moreover, the very same court in In Re Tyson Foods, stated that '[a]t their heart, all backdated options involve a fundamental, incontrovertible lie: directors who approve an option dissemble as to the date on which the grant was actually made.' The court went on to state that backdating options always involves a factual misrepresentation to shareholders. Thus, by avoiding the dangerous Scylla of the SEC and the Department of Justice, general counsel may be faced with the Charybdis of a crippling shareholders derivative action.

Conclusion

An investigation into stock option compensation practices presents complex challenges for general and corporate counsel in managing a multi-front legal process. Obtaining experienced outside counsel for the company, the board of directors and key individuals is crucial and should be paid for, where possible, by the company itself. Absent particularly egregious circumstances it appears that restatements, proper disclosure and payment may be an accepted route to avoid formal regulatory and criminal charges. However, care must be taken not to rush to admissions in settlement statements or deferred prosecution agreements that make it simple for plaintiff's derivative actions to automatically prevail.

Charles A. Ross is the principal of Charles A. Ross and Associates, and focuses his practice on white-collar criminal defense. The firm represents clients in complex criminal matters in cases involving public corruption, the RICO Act, bank fraud, bribery, government procurement fraud, antitrust, healthcare fraud, and tax and securities fraud. Ross may be reached at [email protected].