Corporate Law Alert: Backdating Stock Options

The practice of “backdating” stock option grants has recently captured the attention of regulators, prosecutors, the plaintiffs’ bar, shareholders and the media. The SEC’s Enforcement Division and the offices of the United States Attorney are investigating the option granting practices of dozens of companies and actions taken by their executives. Several companies have expressed their intent to restate financial statements due to option timing issues, and opportunistic attorneys have already filed derivative and class action lawsuits. The author of the academic study who is credited with focusing regulators on this issue estimates that at least 10% of “at-the-money” grants of options to CEOs between 1996 and 2002—before Sarbanes-Oxley shortened the reporting period for option grants—were backdated. SEC Chairman Christopher Cox recently stated that the proposed SEC rules on disclosure of executive compensation will “almost certainly address options backdating explicitly.”

I. What Are Backdated Options?
Companies have considerable discretion in determining the timing of stock option awards. Most employee stock options are, or purport to be, granted “at-the-money,” meaning that the exercise price of the option equals the market price of the underlying stock on the date of the grant. The stock plans of many public companies prohibit the granting of below-market options; other companies disclose in their SEC reports that stock options are granted at market and prepare their financial statements on that basis. The term “backdating” refers to a number of option granting practices in which the reported grant date is different from the date on which the option is actually awarded, resulting in an option that is already “in-the-money” at the time of the grant.

Misdating Option Grants.
In its most basic form, backdating can range from the blatant falsification of a document to take advantage of a lower stock price to allowing executives to select a grant date during a specified period, for example during the 30 days after the grant is approved by the board or committee. Although these practices involve different types of conduct, both create problems because the date when the exercise price is set is not the same as the date on which the option is awarded.

Allocation of Option Shares.
Another scenario involves the allocation of grants to employees from an authorized pool. If the exercise price is set when the pool is authorized by the board or committee but the allocation and actual grants occur later (when the stock price has increased), backdating issues may arise.

Grants to New Hires.
Option grants to new employees have their own set of backdating issues. A company may want to give a new employee the benefit of any increase in the stock price from the date of acceptance of the employment offer. Grants to new employees based on inaccurate employment commencement dates are troublesome. Options granted as of the commencement of employment based on the market price as of the date of acceptance may be problematic if the plan does not permit below-market grants or the grant is not treated as a discounted option for accounting and tax purposes. Options granted as of the date of employment acceptance are also troublesome if the plan does not permit grants to non-employees or if the additional tax and accounting issues relating to grants to non-employees are not adequately addressed.

Delays in Corporate Approval Processes.
A company may decide to grant options on a specific date but the corporate formalities may not be completed until a later date. This problem occurs most often when boards or committees act by unanimous written consent but there is a delay in the receipt of all of the signed consents. Even though no documents are backdated and there may be no intent to select a lower exercise price, backdating issues may arise if the stock price increases before the corporate formalities have been completed. State law and bylaw provisions as to the time of effectiveness of unanimous consents may be helpful in evaluating these issues. The practice of granting options in advance of the disclosure of positive news does not involve option backdating, but it is often discussed in the context of backdating and is also under scrutiny.

II. What Are the Potential Consequences of Backdating?
It is important to note that most of these practices are not inherently illegal. If no documents are forged, and if practices are properly approved and disclosed, appropriately accounted for, properly treated for tax purposes and in accordance with the terms of the option plan, most option granting practices should fall safely within the law. But if these conditions are not met, a number of negative consequences can result, depending on the individual circumstances of the practice at issue.

Accounting Issues – Restatements, Delays in Filings and Internal Controls.
Options that are granted at less than fair market value result in higher levels of compensation expense. Before FAS 123R, generally only options granted below fair market value resulted in any compensation expense. After 123R, the “fair value” of discounted options will be greater than the “fair value” of comparable undiscounted options, resulting in higher compensation expenses. If the compensation expense is not properly reflected in earnings, the company’s financial statements will be inaccurate and restatement of the financials may be required. The discovery of past backdating practices may raise issues as to the adequacy of the company’s internal controls and disclosure controls and procedures. It could also lead to delays in filing financial statements while the magnitude of the problem is determined.

Disclosure Issues.
Option backdating may result in inaccurate compensation disclosures in proxy statements and other SEC filings by the company and in Section 16 reports by executives.

Tax Consequences.
Adverse tax consequences may result from option backdating practices. An option granted at less than fair market value will not qualify as an incentive stock option and therefore generally will be subject to income tax and withholding requirements upon exercise of the option. An option granted at less than fair market value will also not qualify as “performance based compensation” and thus must count toward the $1 million executive compensation deduction cap under Section 162(m) of the Internal Revenue Code. Finally, an option granted at less than fair market value that either vests in whole or in part after December 31, 2004 or granted or modified after October 3, 2004 raises issues under the new deferred compensation rules set forth in Section 409A of the Code. Under Section 409A, the recipient could be subject to acceleration of taxable income and additional taxes and penalties, and the company could be subject to special tax withholding and reporting requirements.

Violation of Plan Provisions and Stock Exchange Rules.
Options granted at less than fair market value or without proper board or committee approvals may violate the terms of the applicable option plan, with the result that options could be invalid. Exceeding the authority set forth in a shareholder-approved plan may also run afoul of stock exchange rules requiring shareholder approval of equity-based compensation.

Regulatory Enforcement.
Civil and criminal authorities are investigating the option granting practices of many companies. Companies and individuals could face monetary penalties, restitution and disgorgement under the securities laws and the Internal Revenue Code. Officers and directors could face criminal liability if they have intentionally falsified documents.

Civil Liability.
Plaintiffs’ attorneys have filed lawsuits based on backdating allegations, claiming breach of fiduciary duty, unjust enrichment, self-dealing, corporate waste and violations of securities laws.

III. What Steps Should Companies Take Now?

Companies need to understand their historical option granting practices, address any potential problems and review their option granting procedures going forward.

Review Past Practices and Inform Board.
The first step is to review historical practices with counsel to identify areas of potential concern. The board should be updated on the company’s practices, both current and historical, and the audit committee should be promptly informed of any potential issues that have been identified.

Prepare Response to Inquiries.
The company should be prepared to respond to inquiries from auditors, regulators, shareholders, analysts, D&O insurers and others. Companies should be careful in responding to inquiries and not simply give a negative response without a full understanding of whether any type of arguably improper backdating practices may have occurred. In responding to inquiries, companies also need to consider Regulation FD and avoid making selective disclosure of material information.

Detailed Investigation; Correct Any Deficiency.
If issues are identified, we recommend conferring with counsel to develop a more detailed investigation plan to identify all issues and risks and to deal with the potential results of the investigation, including communicating with auditors and correcting any past deficiencies.

Regulatory Inquiries and Litigation.
If civil litigation or regulatory enforcement is on the horizon, we recommend conferring with counsel to discuss strategies for navigating the many issues that could arise. The company may need to take affirmative steps to ensure that all necessary documents are saved, including the suspension of existing document retention policies. Defenses that should be explored include statutes of limitations, materiality and scienter defenses and the business judgment rule. If the company is served with a subpoena or is contacted informally by regulatory or other officials, it should immediately contact counsel.

Review Option Practices Going Forward.
The company should revisit its option granting procedures going forward, review best practices developing in the area and tighten up the company’s procedures as appropriate. While best practices are emerging in this area, companies have different needs, and practices can be expected to vary to some extent from company to company and with respect to different kinds of grants (annual grants, new hire grants and promotion grants).