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 CompensationStandards.com.
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!
In this podcast, John Kocoras, Managing Director and Regional Counsel in the Business Intelligence & Investigations division at Kroll, provides some insight into white-collar prosecution developments, including:
– What trends do you see in white-collar prosecutions?
– What effects do you see these trends having on companies?
– What investigative tips can you give in-house counsel when they are advised of potential wrongdoing by high-level employees?
Forward-Looking Information Safe Harbor: Incorporation By Reference Case
From “The 10b-5 Daily Blog“:The PSLRA’s Safe Harbor for forward-looking statements is designed to encourage companies to provide investors with information about future plans and prospects by limiting their potential liability for these statements. Under the first prong of the Safe Harbor, a defendant is not liable with respect to any forward-looking statement if it is identified as forward-looking and is accompanied by “meaningful cautionary statements” that alert investors to the factors that could cause actual results to differ.
In the case of oral forward-looking statements, the PSLRA specifically provides that the meaningful cautionary statements can be incorporated by reference in a readily available written document. The statute is silent, however, about whether this is also true for written forward-looking statements. A surprisingly small number of courts have addressed this issue, but the trend appears to be in favor of finding that a company’s incorporation by reference is sufficient.
In Yellen v. Hake, 2006 WL 1881205 (S.D. Iowa July 7, 2006), the court addressed a securities class action brought against Maytag Corp. The court found that “[w]hile the Safe Harbor provision does not explicitly provide for incorporation by reference for written forward-looking statements” it is implicit in Congress’ direction that courts consider “all information and documents relevant to a determination of whether a defendant has given adequate warnings.” Accordingly, the court agreed to consider warnings contained in Maytag’s 2004 Annual Report that were incorporated by reference in the press release and investor presentations that allegedly contained false or misleading forward-looking statements.
Michael Eisner: He Ain’t No Larry King
More summer fun…flipping around a few nights ago and came across former Disney CEO Michael Eisner’s new cable talk show: “Conversations With Michael Eisner.” From this article, it doesn’t seem like the show has “legs.”
It was painful to watch. Eisner clearly is not a natural at drawing others out; not surprising for a guy used to having his way for decades. I’m sure I was projecting onto him, but I half-expected him to reach out and grab Goldie Hawn by the throat – even though they seemed to be friends. Here are some pretty funny Eisner anecdotes from DealBreaker.com.
Yesterday, the SEC announced that it will hold an open Commission meeting next Wednesday – July 26th – to consider adopting the executive compensation rules. My guess it will then take the Commission at least a week to issue an adopting release.
Today’s WSJ includes an article that provides some predictions of changes to the SEC’s proposals – none of them shocking – such as scrapping the “Katie Couric” proposal that would include non-executives in the Summary Compensation Table, keeping the stock performance graph and requiring details of option granting practices. This will be Commissioner Casey’s first open Commission meeting fyi…
New Conference Dates – And Now Live in Washington DC!
Now that we know the new executive compensation disclosure rules will be adopted soon, we are meeting the overwhelming number of requests from members – who apparently couldn’t bear the thought of watching a two-day conference from their computer – so that our Conference (“Implementing the SEC’s New Executive Compensation Disclosures: What You Need to Do Now!“) will be held live in Washington DC at the Marriott Wardman Park (please wait a day to call the Marriott to get special room rates – we are still working on those arrangements). The Conference will still be video webcast live as well.
The Conference dates have been pushed up slightly – it will now be held on September 11-12, instead of September 13-14. These new dates were the only ones available at a hotel large enough to accommodate the Conference.
If you come to Washington DC to take in the conference, you still will get access to the video archive of the Conference, which will be important when you actually sit down to draft – and review – disclosures during the proxy season.
An incredible number of members have already registered for the video conference – if you would rather attend live in DC, check out these FAQs to figure out the best way to change the nature of your registration.
If you haven’t yet, check out this detailed conference agenda to understand the types of challenges you should expect to face from the new rules.
Audit Committees in Action: The Latest Developments
We have posted a copy of the transcript from the webcast: “Audit Committees in Action: The Latest Developments.”
Avoiding a Potential FAS 123(R) Trap: Anti-Dilution Provisions in Equity Plans
The Big 4 apparently are at it again with yet another restrictive interpretation of FAS 123R. This one would require an earnings charge in the event of an equity restructuring (e.g., stock split) or business combination if an equity plan has a permissive rather than mandatory adjustment provision. I have received dozens of e-mails over the past few weeks about this issue and am glad that the first batch of memos on the topic are now out.
Here is a brief snap shot of the issue from Dorsey & Whitney:
“Some major accounting firms are advising clients that the typical anti-dilution provisions of existing equity compensation plans may need to be amended in order to avoid potentially significant increases in compensation expense associated with adjustments to equity awards in connection with stock splits, stock dividends or other changes in the issuer’s capitalization.
The issue turns on whether the anti-dilution adjustment applied to awards under equity plans is determined to be mandatory or permissive. If the adjustment is determined to be permissive, then the award is deemed to be modified upon adjustment under FAS 123R, resulting in a re-calculation of the fair value of the award and a possible increase in the compensation expense for the company.
Many plans are written flexibly, allowing compensation committees to determine whether the corporate event is one triggering an appropriate anti-dilution adjustment. Companies should review the terms of their equity compensation plans and arrangements and consult with their external auditors concerning this issue well in advance of any change in capitalization requiring an adjustment of awards under their equity plans.”
And here is the take from Cleary Gottlieb: “We understand that the Big Four accounting firms recently reached a consensus concerning the application of FAS 123R in circumstances in which employee stock options and other equity awards are revised to reflect changes in the capitalization of the employer. It appears that the precise wording of a stock plan’s “antidilution” provision (or the absence of an antidilution provision) can make a world of difference in the accounting charges that might need to be taken in connection with a stock split, stock dividend, recapitalization, spin-off or other equity restructuring.
In sum, if a plan contains no antidilution provision or the antidilution provision provides for discretion on the part of the employer to adjust equity awards in connection with a change in capitalization (e.g., “the Committee may adjust awards as it deems necessary or appropriate to prevent enlargement or dilution of rights”), then such adjustment will be deemed to be a modification of the award, resulting in an adverse accounting consequence: any incremental fair value of the award after its modification compared to the fair value of the award prior to modification will need to be recognized as compensation expense. If, however, there is an antidilution provision and it does not permit any such discretion, (e.g., “the Committee shall adjust awards as it deems necessary or appropriate to prevent enlargement or dilution of rights”), then such adjustment will not be deemed to be a modification and no compensation expense would need to be recognized.
For purposes of determining any incremental fair value, the award’s fair value immediately prior to the modification is determined assuming that the equity restructuring will occur and no antidilution adjustments will be made. The award’s fair value immediately after the modification is determined by taking into account the adjustments made. For example, assume that an employer decides to effect a 2-for-1 stock split at a time when its stock is worth $50 per share. The employer determines, pursuant to the exercise of its discretion and not pursuant to a contractual obligation, to adjust outstanding options equitably to reflect the split.
As a result of the adjustment, a stock option for 10 shares with a strike price of $15 becomes a stock option for 20 shares with a strike price of $7.50. Assume that the value of a share of stock immediately after the split is $25. Under FAS 123R, we understand that the option would have to be valued both immediately before and after the split, in each case using the $25 per share value of the stock after the split. Using assumptions for a hypothetical company, based on a black-scholes valuation model, the compensation that would be required to be recognized for such option would be on the order of magnitude of $1,000.
We urge you to review your stock incentive plan antidilution provisions, to consult with your auditors concerning the matters described above and to consider adding or amending plans to provide for automatic and non-discretionary adjustments to be made in connection with certain equity restructurings. However, you need to carefully consider the consequences of making such changes. First, such changes may not avoid an accounting charge if made in anticipation of a capital change or restructuring. Second, any such change would give participants legal rights that they did not previously have. Third, it is not clear what effect a revision of an antidilution provision would have on outstanding stock options or other equity awards for purposes of Section 409A or, for incentive stock options, Section 422 of the Internal Revenue Code.”
The Early Bird expires tommorrow, July 20th – so take advantage of the huge savings while you can. For example, the Early Bird member rate for a single attendee is only $495, after July 20th – it goes up to $750 (which is still reasonable, but 50% more than the Early Bird rate).
Practical Guide to Tax Accounting Under FAS 123(R)
– How to account for excess tax deductions and shortfalls under FAS 123(R)
– Special procedures necessary to account for disqualifying dispositions of ISOs and ESPPs
– How to account for tax benefits (or lack thereof) of grants to overseas employees
– Administrative considerations, including practice pointers and internal controls for period-end reporting
– The FASB’s alternative approach for calculating your FAS 123(R) paid-in-capital starting balance
The Trending of Stock Option Grants
The Sunday NY Times included this article that confused me because it described a new academic study that indicates that stock option grants to executives continue to trend up – the study even claims that grants are now at the highest level since the end of the Internet boom in 2000. Since this is contrary to loads of anecdotal commentary I have heard about how option grants are down, I decided to poll some of the compensation consultants on the CompensationStandards.com Task Force. [By the way, the study is unpublished.]
The universal response was that the consultants were also confused by the article, as they noted that the surveys and studies they have seen (as well as their daily experience) show that option grants are down significantly and that restricted stock grants are up by roughly the same amount. They noted that long-term incentive (LTI) values overall have been fairly level – and that there has been a pronounced shift away from time-vested restricted stock to performance-vested restricted stock.
Many of the consultants expressed a view that a major problem with the study is that it focused on the number of shares awarded, not the value – and that it is unclear how anyone could conclude options are expanding if they only looked at the number of shares. For example, if a company splits its stock and grants twice as many shares to provide the same value, the Professor would have concluded the company doubled the amount of an executive’s awards.
Here are some more specific thoughts from the Task Force:
Jim Reda of James Reda & Associates says: “This is definitely flawed data. He is using number of shares. Most companies award to value. If stock price goes up, number of shares go down. Moreover, a lot of companies are phasing in LTI strategy. You will not see effect until 2006. The study looked at 2005 data. In fact, most companies’ fiscal year did not begin until 1/1/06. The strategy was to award stock options, vest them immediately or front load to avoid future expense.
Our experience shows a dramatic drop in LTI value from 2002 to 2005, depending on the industry. Some industries experinced 50% drop in LTI multiple and others 30% drop. Combined with stock price increases, this can translate into substantial drop in shares of stock options. But, as stated, companies were taking advantage of last days of expense free option awards.”
Robbi Fox of Hewitt states: “I obviously would have to look at his study in more depth, but I believe his conclusions are flawed. I don’t know how he calculates “value” – that may not be done correctly. One can’t really look at the number of options granted to determine change in stock option granting practices because if the stock price is declining you would expect a company to issue more options in order to have the same economic value. We know for a fact there has been a large shift of option value to full value shares as well such as restricted stock and performance shares. Also, just looking at SEC filings is misleading because most of the takeaway has been at the lower levels. Lastly, many companies are moving to a portfolio approach so options still make up some piece of the long-term pie so prevalence of companies granting options should not change much.”
And Myrna Hellerman of Sibson Consulting notes: “My clients have been trying to wean themselves from purely stock option grants but have encountered some obstacles including: (a) plan documents that allow for only stock options or they are bumping up against available quota of full-value shares and they don’t want to go back for more authorization because they fear they might not meet ISS tests, and/or (b) a culture within the company (especially those in the growth mode) that options are the way to go. Companies seem very cognoscente of the expense associated with option grants and are concerned that they are not getting sufficient “value” for that expense.(especially true in companies whose stock has high volatility thus causing a high Black-Scholes value for FAS 123R purposes).
Another consideration about what’s happening with stock option grants is that while the size may be the same (or bigger) we’re also seeing more conditions attached to the grant [e.g. premium pricing, more rigorous vesting (performance vesting rather than time, vesting over a longer period of time -for instance 0% first two years 20% next two years, 60% last year), holding requirements, etc.].
Admittedly not all grants are done as thoughtfully as suggested above, but I have found that at least with the Compensation Committees I serve, there has been an increased focused on the ‘what, why, how, how much, how often’ of equity grants.”
On the question of which free writing prospectuses is the most interesting, we had a clear-cut winner with 75% of the vote: Chipotle’s IPO road show with all those catchy songs!
New Survey on Executive Sessions
Now it’s time to participate in our new Quick Survey, this one is an Executive Session Survey. Please answer four quick questions on the frequency of board’s executive sessions; frequency of audit committee executive sessions; who’s in the room during an audit committee executive session, and who meets with the audit committee in executive session.
Japan’s Proposed Corporate Governance Reform
Recently, Japan’s regulator – the Financial Services Agency – has proposed steps that would improve the infrastructure involving their capital markets and likely make them more competitive. This has included steps to strengthen the quality of their audits, as described in this WSJ article and this Financial Times article.
In these significant FSA proposals, Japan proposes to enhance protection for investors through such steps as:
– Broading the definitions of investment schemes including financial instruments
– Enhancing disclosures through quarterly reporting, reporting on internal controls by management and auditors, and reviewing regulations on tender offers
Warning! Only three days left until the Early Bird Discount expires for the important conference: “Implementing the SEC’s New Executive Compensation Disclosures: What You Need to Do Now!” Check out this detailed conference agenda to understand the types of challenges you should expect to face from the new rules (which many expect to be adopted next week by the SEC!).
The Early Bird expires this Thursday, July 20th – so take advantage of the huge savings while you can. For example, the Early Bird member rate for a single attendee is only $495, after July 20th – it goes up to $750 (which is still reasonable but 50% more than the Early Bird rate).
How to Develop a Whistleblower Compliance Program Today
Don’t forget tomorrow’s webcast – “How to Develop a Whistleblower Compliance Program Today” – featuring Dixie Johnson of Fried Frank; Mark Schreiber of Edwards Angell Palmer & Dodge; Carrie Wofford of WilmerHale; Jim Brashear of Sabre Holdings; and Kathy Combs of Exelon. This is our third webcast in a series dealing with audit committees and their advisors.
Selling the Venture-Backed Company
The fourth installment of DealLawyers.com’s M&A Boot Camp is now available: “Selling the Venture-Backed Company.” Join Phil Torrence and David Parsigian of Miller Canfield as they teach us about “everything you need to know” to understand the basics of the issues typically present in a sale of a venture backed company with multiple class of stock and varying liquidation preferences.
If you are not a DealLawyers.com member, try a no-risk trial as we just launched our half-price “Rest of 2006” rate – believe it or not, a license for a single user is only $100 and there are similar reduced rates for offices with more than one user!
1. Prior to SOX 404, quality of financial reporting processes in many companies was inadequate. For example, we now know that nearly 1 in 6 large companies had material weaknesses in internal controls over financial reporting.
2. Solid evidence suggests that smaller companies have even weaker financial reporting processes than larger companies. Historically:
– They have twice the risk of restating their financial statements
– They are more likely to have material weaknesses in internal controls
– They are more likely to be the subject of fraud
3. SOX 404, where applied, has helped to significantly improve the quality of financial reporting information
– By Year 2 (through early May 2006), only 1 in 15 large companies had material weaknesses in their internal controls
– Smaller companies will realize similar improvement
4. SOX 404 implementation costs have been high because the requirement was new; the application guidance has been continuously evolving; and because of a generally high level of deferred maintenance on corporate internal controls—but cost is coming down.
5. Exempting certain companies from SOX 404 (or allowing compliance to be voluntary) will result in four negative consequences:
– Non-compliant companies will continue to produce financial reporting information that is increasingly inferior to compliant companies;
– Over time (once investors experience the reality of the above disparity) the market will adjust the cost of capital to reflect this differential;
– In the meantime, investors in smaller companies will lose money, and litigation will increase for non-compliant companies, their management, boards and auditors;
– Insurance costs, litigation costs and audit costs will increase for the non compliant companies to offset the increased level of risk.
6. We can improve the efficiency of implementing SOX 404—and improve the quality of financial reporting—without eliminating the requirement to evaluate and audit internal controls.
In this podcast, John Williamson of Morris, Manning & Martin analyzes issues raised by a recent 10th Circuit opinion – In re Qwest Communications International Inc. – where the court rejected the so-called “selective waiver” doctrine (i.e., the doctrine that companies may turn over privileged materials, such as interview memoranda and reports to the Board in internal investigations, to the SEC and the DOJ, but still withhold them from private litigants), including:
– What are the facts behind the Qwest Communications opinion?
– What is the significance of the Qwest Communications opinion?
– What do you recommend that in-house counsel do now?
I previously blogged that Delaware was considering an amendment to the Delaware General Corporation Law that would modify director voting rules. This amendment has now been adopted – and will be effective August 1st – and primarily addresses two items with respect to director elections:
– It amends Section 141(b) to provide that a director resignation can be made effective upon the happening of a future event, coupled with the authority to make such a resignation irrevocable if the director fails to achieve a specified vote for re-election. This amendment allows Delaware corporations to voluntarily switch to a voting standard that is different from a plurality one.
– It amends Section 216(b) to provide that a by-law adopted by shareholders that prescribes the vote required for director elections may not be further amended or repealed by a Board of Directors.
We continue to post law firm memos regarding this development in the “Majority Vote Movement” Practice Area.
FASB and IASB Publish First Draft Chapters of Joint Conceptual Framework
Last week, the FASB and IASB published the first installments of their joint conceptual framework – globalization is here! Here is the related press release and the draft chapters.
SEC Issues NYSE’s Proposal to Eliminate Annual Report Delivery
A few weeks ago, the SEC issued a NYSE proposal (which had just been amended since it was first submitted to the SEC last September) in an effort to eliminate the current NYSE requirement that a listed company “physically” distribute an annual report to shareholders. Note that this proposal would have the biggest impact on foreign private issuers, who aren’t subject to the SEC’s proxy rules – US companies would still be required by Rule 14a-3(b) to deliver proxy statements that are accompanied or preceded by annual reports meeting the requirements of Rule 14a-3 (at least until the SEC’s e-Proxy proposal is adopted).
The NYSE’s proposal would allow a company to satisfy the annual financial statement distribution requirement by making its annual report available on its corporate website, with a prominent undertaking to deliver a paper copy, free of charge, to any shareholder who requests it – listed companies would also be required to issue a press release stating that its annual report has been filed with the SEC and that shareholders have the ability to receive a hard copy of the company’s complete audited financial statements free of charge upon request. The NYSE’s proposal would also specifically require listed companies to maintain websites.
Yesterday, the SEC issued this concept release, as earlier promised under the SEC’s Four-Point Plan. The SEC seeks input on 35 questions related to assessing risks, identifying controls, evaluating effectiveness of internal controls and documenting the basis for the assessment. Comments are due in 60 days – doesn’t it feel like folks have commented on internal controls at least a dozen times?
The SEC still intends to announce an additional postponement of the deadline for compliance by non-accelerated filers, including foreign private issuers that are non-accelerated filers. The current deadline for non-accelerated filers is their first fiscal year ending on or after July 15, 2007.
COSO Issues Internal Controls Guidance for Smaller Companies
Yesterday, COSO announced the release of its guidance for small public companies (including an archive of a webcast held yesterday about the guidance). Here is a perfunctory statement from the SEC.
Although the guidance should prove helpful, I wouldn’t be surprised to hear complaints from small issuers that it doesn’t go far enough to reduce their burdens. For instance, I have heard some small issuers say that some of the controls are undocumented and that it would be expensive if they had to start anew to document those controls. One suggestion was that maybe the auditor could rely on extra levels of management review to compensate for fewer documented controls. On yesterday’s COSO webcast, one of the panelists said that – although the documentation could in some instances be less extensive for smaller companies – there still needs to be some level of documentation so that the auditors would be able to review and test the controls. Thanks to Bob Dow of Arnall Golden Gregory for the heads up and his thoughts!
The Evolution of Law Review Articles?
I’m not a big fan of law review articles generally – and not because I was the ultimate slacker on my own law review squad – as I often find they don’t provide much in the way of practical guidance. So I was surprised to see this paper (warning: don’t click if you are offended by profanity) which I am told will be published soon as a law review article. Ah, the changing nature of scholarship…
The media – and others – are expending quite a bit of effort commenting on SEC Commissioner Paul Atkins’s speech before the International Corporate Governance Network last week (eg. Saturday’s WSJ article). This is notable in itself just for the fact that a SEC Commissioner – not the SEC Chairman – has made a speech that has garnered so much attention.
In his speech, Commissioner Atkins states that he believes that the practice of “spring-loading” stock options (ie. setting the grant date and exercise price of an option at a time shortly before the release of positive corporate news) should not be considered insider trading, as he questions whether there was any “legitimate legal rationale” for pursuing any theory of insider trading in connection with option grants.
This is not a new issue. As well covered in past issues of The Corporate Counsel and The Corporate Executive, the underlying “offense” has sparked considerable debate ever since then-SEC Enforcement Director Stephen Cutler first commented on the practice at the 2004 Northwestern Law School Securities Regulation Institute in January 2004. Here is an excerpt from the November/December 2004 issue of The Corporate Counsel:
“Some see it as a legitimate, time-honored way to get the best price for optionees (choosing to ignore that, as with most equity compensation grants, top executives receive most of the benefit). The same skeptics also question whether, or how, Rule 10b-5 would be implicated, since (i) the grantor/issuer (obviously) is aware of the undisclosed information, and (ii) the grantee either knows or the information, being favorable to the grantee, isn’t material to the grantee in this context.
Others (e.g., investors) see evils here, e.g., the dilution/waste caused by committing to sell stock below market value, violation of the option plan requirement to price options at (or above) FMV, non-disclosure of the practice, an accounting problem (a higher fair value charge; even under APB No. 25, there is an earnings charge for discounted stock options), and just plain bad governance. Our purpose here is not to resolve the debate, but to point out that Enforcement does not appear to be stopping to argue.”
I don’t begrudge – or even disagree with – Commissioner Atkin’s opinion on whether spring-loading constitutes insider trading. However, I was miffed that he spoke out on this practice as constituting a “cheap” way to compensate officers. Putting aside the disclosure, accounting, etc. issues that would clearly need to be addressed, I just don’t see how springloading fits into a properly designed pay package, where pay is supposed to facilitate better corporate performance – what amounts to discounted options really doesn’t seem to do the trick.
At the end of the day, however, the springloading debate just doesn’t get me very excited since there aren’t many instances of positive news that continue to impact stock prices over the entire length of an option’s vesting period. The biggest issue for me is the perception that this practice holds for investors. Given today’s media and investor fascination with option granting practices, “perception” is critical and should be sufficient incentive for companies to simply avoid the controversy and use other pay design techniques.
SEC Commissioner Atkins on Option Backdating
On the other hand, I wholeheartedly agree with Commissioner Atkins’ thoughts on the witch hunting aspect of the option backdating scandal. He is the voice of reason when he says:
“But it is worth taking a step back before we plunge headlong into wholesale condemnation of all options practices. We need to distinguish scenarios that are black-and-white fraud from legitimate practices that are being attacked with attenuated theories of liability. With respect to the former, there have been many reported stories of clear-cut doctoring of documents done knowingly by executives and/or directors. I will not quibble with the vigorous pursuit of the knowing perpetrators of this kind of activity: a fraud is a fraud. Attempts to evade legal obligations through intentional alteration of documents or deliberate flouting of internal controls cannot be tolerated, because they strike at the core of our system of corporate governance.
Backdating of options sounds bad, but the mere fact that options were backdated does not mean that the securities laws were violated. Purposefully backdated options that are properly accounted for and do not run afoul of the company’s public disclosure are legal. Similarly, there is no securities law issue if backdating results from an administrative, paperwork delay. A board, for example, might approve an options grant over the telephone, but the board members’ signatures may take a few days to trickle in. One could argue that the grant date is the date on which the last director signed, but this argument does not necessarily reflect standard corporate practice or the logistical practicalities of getting many geographically dispersed and busy, part-time people to sign a document. It also ignores that these actions reflect a true meeting of the minds of the directors, memorialized by executing a unanimous written consent.”
In some cases, I think companies now caught up in the option backdating scandal were probably just trying to be fair way back when those options were granted in the ’90s. Newly public companies really struggle with the idea that option price differs by grant date, so an employee hired this month could end up with a totally different price than an employee hired last month. Particularly if you have a highly volatile stock, the randomness of option prices can seem very unfair.
These companies were used to the way it was when they were private, where everybody hired during the year had the same price. So they came up with some bizarre pricing procedures in an attempt to be fair. Then, unless someone questions them early on, those procedures get formalized – and here we are ten years later with a scandal on our hands…
Director Liability and Responsibilities: After Disney
Warning! Less than 10 days left until the Early Bird Discount expires for the important conference: “Implementing the SEC’s New Executive Compensation Disclosures: What You Need to Do Now!” The Early Bird expires on July 20th – so take advantage of the huge savings while you can. For example, the Early Bird member rate for a single attendee is only $495, after July 20th – it goes up to $750 (which is still reasonable but 50% more than the Early Bird rate).
The Role of Investment Bankers
The third installment of DealLawyers.com’s M&A Boot Camp is now available: “The Role of Investment Bankers.” Join Kevin Miller of Alston & Bird, who is a former in-house lawyer for an i-bank, for an entertaining session that teaches the basics of what you need to know about what investment bankers do – and the top issues that bankers face today.
If you are not a DealLawyers.com member, try a no-risk trial as we just launched our half-price “Rest of 2006” rate – believe it or not, a license for a single user is only $100 and there are similar reduced rates for offices with more than one user!
