July 24, 2006

First Criminal Action Brought on Option Backdating

The media has been eating up Thursday’s announcement from the DOJ and the SEC regarding their first criminal action brought against a company for option backdating (here are remarks from SEC Chair Cox). As noted in this press release (and litigation release and complaint), the former CEO and head of Human Resources for Brocade Communications are in the crosshairs. Here are some thoughts in the wake of this action:

– We’re going to see a quick succession of cases, the SEC said it has over 80 in its Enforcement pipeline

– Officers don’t necessarily have to financially benefit personally to be a target of the DOJ and SEC

– Doctoring minutes and other corporate documents can lead to regulatory action (and regulators will pursue those doctoring documents, not just the officers who may have directed their subordinates)

See the White Collar Crime Prof Blog and the D&O Diary Blog for some more observations about the Brocade complaint. As the LA Times noted in this article, the US Attorney’s office now has a task force to investigate improper option grants – which includes an unspecified number of FBI agents!

Disclosure of Your Option Granting Process

With the SEC’s upcoming executive compensation rules likely to require disclosure about how companies make their grants, the first companies are voluntarily describing their granting processes in SEC filings. For example, Broadcom described a few details in this recent Form 8-K. I haven’t seen similar disclosures in Form 10-Qs or 10-Ks yet, but most companies haven’t been required to file those documents since backdating issues were thrust under the microscope. I would expect to see more of these disclosures when companies begin to file their Form 10-Qs for the quarter ended June 30th in the next week or so. We have about five dozen Form 8-Ks listed in our “Timing of Stock Option Grants” Practice Area on

By the way, the Council of Institutional Investors just started posting responses to their letter which asked companies if they had backdating issues – and these responses are available to the general public! In the past, they made responses to other letters they had sent to companies only available to CII members…

Creating an Stock Option Grant Policy

After boards review the allegations in the Brocade complaint, one reaction by the corporate community may be the disappearance of the fairly common practice of delegating authority to make option grants. State laws, such as Section 157(c) of the the DGCL, permit the board to delegate the authority to make option grants to one or more officers (who don’t have to be directors) – and it hasn’t been uncommon for boards to exercise their authority to delegate so that executive officers are the ones that make grants to employees below the executive level.

As I mentioned in our Q&A Forum on Friday, some companies appear to be considering adopting policies that would formalize their option grant processes, including implementing the concept of an open window period (eg. grants can be made only during a specified period of time each year, except for new hires) – similar to the use of such periods in insider trading policies which dictate when directors and officers are allowed to make trades in company stock.

For those companies with broad-based option plans, it probably is unrealistic that a compensation committee would get together to make decisions and sign resolutions for each of the many grants that would be need to be made during course of a year. So either delegation for lower level employee grants will continue to be delegated to executive officers – or perhaps practice will change and instead of new hires getting grants on their hire date, there will be a meeting held each quarter when the compensation committee makes grants to all employees hired during that quarter.

We will be exploring this developing area in the next issue of The Corporate Counsel as well as on this site. In addition, ISS’s recommendations on page 7 of this Option Backdating White Paper might serve as a good starting point when looking for ideas when drafting such a policy. Let me know if you have already done so as I am researching what the trends are here…

30% of Companies Have Backdating Issues? The Witch Hunt Continues?

As I have blogged before, it seems like there is a lot of questionable thinking about stock options these days. The latest academic study – from Professors Erik Lie and Randall Heron – assert that over 2,000 companies have engaged in option backdating. My gut tells me there is something fishy about this one.

First, I deal with a lot of people that either administrate these plans – or advise those that do – and I did not become aware of such abuses until last year’s Mercury revelation. And my experience jibes with anyone else that I talk to “on the inside.” So many good people can’t be lying.

And just look at the results from this recent NASPP survey. Among other questions, it was asked “In light of the controversy over grant dates, are you undertaking an internal investigation of your grant dating procedures? There were over 600 respondents who indicated:

– Yes, already completed it – 17.0%
– Yes, in progress now – 18.5%
– Planning to do so but haven’t started it yet – 2.7%
– Still deciding whether this is necessary – 7.0%
– No, we already know we’re okay – 53.6%
– Not unless we’re forced to by investors or regulatory authorities – 1.2%

Just glancing at the articles written about the study, I have some questions for Professors Lie and Heron. For example, can it possibly be correct to assume, as the they do, that the baseline for stock growth or decline following any given option grant is that “half should be positive and half should be negative?” In the context of steadily rising markets, don’t stocks go up more often than they go down?

I suppose I should read the study before launching a critique – but based on what I have read so far and from my own experience, I remain skeptical that illegal backdating problems are so universal. Those Section 16 reports can be tricky to interpret and may account for the discrepancy between my gut and the Professor’s 30% level. Thanks to Rick Wood of Kirkpatrick Lockhart for his thoughts!