Client Alert

Stock Options Back-Dating Investigations


In the past week, more than twenty-five companies have been targeted by regulators in a fast-spreading investigation of stock option back-dating.  Each day more companies announce internal investigations or the receipt of subpoenas from regulators.  Several senior executives have already been terminated or forced to resign.

The revelations are being fueled by press and stock analyst reports of unusual correlations between option grant dates and low points in a company's stock price.  These correlations appear, in some cases, simply too good to be true, leading observers to speculate that option grants were back-dated or otherwise manipulated to capture the lowest possible strike prices.

The Securities and Exchange Commission reportedly has established a centralized enforcement team in Washington D.C. to coordinate a wide-ranging investigation of options practices, and many of the companies publicly identified as having options back-dating exposure have acknowledged receiving subpoenas from the SEC.  At the same time, the United States Attorney in Manhattan has been quick to serve criminal subpoenas on many of the same targeted companies, and some reports indicate the Internal Revenue Service is also serving subpoenas on the companies and their executives. 

What Is Being Investigated? 

The investigations seem to be focused on various forms of alleged back-dating.  The challenged practices apparently include:  (1) Using a grant date earlier than the date of the compensation committee meeting at which the options were awarded; (2) Using an "effective as of" or "look back" grant date; and (3) Changing or altering the recorded date of a board resolution, board meeting, award notification, or option agreement.

Many of these alleged practices may also raise issues regarding the procedures used by directors and option plan administrators to fix option grant dates and the amount of discretion given to executives or administrators in the implementation of option awards. 

What Other Practices Might Be Challenged?

So far, press reports and research analysts have looked for evidence of back-dating.  This has meant, for the most part, looking for patterns of option grant dates occurring at or near the lowest stock price for the period.  But some of the analysis has begun to focus on other potential abuses, including:

Option Grants Made with Inside Information?  Press reports and research analysts have started looking at option grants made shortly before large run-ups in a company's stock price.  Analysts have already begun to argue that these produce "excess returns" to executives when compared to those received by long-term investors.  Regulators may argue these grants indicate abuse of inside information regarding a company's future prospects and may constitute undisclosed compensation to executives.

Option Grant Dates for New Hires?  Many times, an employee's biggest option award is received at hiring.  The employee's hire date, of course, is negotiated along with the new employee's salary, title, responsibilities, and stock options award.  Did the company and its new employee agree on a hire date that is days or weeks earlier in order to capture a lower stock price for options award purposes? 

Special Treatment for Senior Executives?  Some of the more serious accusations have involved option awards to senior executives that were issued separately, and in a different manner, from the awards made to rank-and-file employees.  Evidence of favorable treatment given to senior executives, but not rank-of-file employees, should be expected to cause heightened scrutiny by regulators and the press.

Special Vesting Agreements Upon Extended Leave or Termination?  Employees sometimes seek extended vesting privileges upon termination or a lengthy leave of absence.  These types of accommodations may violate a company's option plan and constitute additional compensation to the employee.

What Are the Consequences to My Company?

The risks faced by companies and their executives cut across the financial, accounting, taxation, and legal arenas. 

Accounting and Tax Issues.  Under rules in effect until recently, option grants made at the stock's then-current market price did not produce any immediate compensation expense.  An award of "in-the-money" options, on the other hand, constituted immediate compensation to the employee.  Thus, options back-dating to take advantage of a lower stock price can be argued to comprise current income to the employee and a current compensation expense to the company.  From the company's perspective, a finding that options were back-dated may require a restatement of prior years' compensation expense and income tax deductions, as well as an adjustment to retained earnings.  From the employee's perspective, a finding of options back-dating may trigger additional income tax liability.

Disclosure Issues.  Options back-dating also raises financial disclosure issues.  Stock option plans are described in a company's SEC filings.  Often the compensation committee will also articulate, in the company's filings, its compensation policy and objectives.  These descriptions might be found to be false or misleading if they don't disclose the practice of back-dating options awards.  Similar problems arise if the company files a registration statement, and individuals face exposure for inaccuracies in their Form 4 filings.

Stock Option Plan Issues.  Options back-dating could be argued to violate the terms of a company's master stock option plan which, in turn, could lead to invalidation of the plan.

Internal Controls Issues.  Sarbanes-Oxley imposed a series of internal controls standards (and related public certifications regarding internal controls) on companies and their independent auditors.  Systematic options back-dating could raise questions about the adequacy of a company's internal controls, the accuracy of its Sarbanes-Oxley certifications, and the thoroughness of auditors' audits and quarterly reviews.

Legal and Regulatory Risks.  The Securities and Exchange Commission, Department of Justice, and Internal Revenue Service have, at their disposal, a full panoply of remedial actions and penalties to punish proven acts of options back-dating.  These may include:  disgorgement of gains and civil penalties, injunctions, officer and director bars, and, in the worst case, criminal prosecution for fraud or for income tax evasion.  Private investors will also certainly commence class and derivative actions seeking to recover profits from executives and damages from the responsible directors.

What Steps Should I Take?

The tidal wave shows no signs of cresting.  Researchers and reporters are scrambling to look at option grant dates and stock prices in efforts to ferret out new examples of alleged abuse.  And because all the information is publicly available, there is every reason to expect that more examples of suspected abuse will be found.

We recommend that companies immediately review past options grant practices.  The audit committee should immediately be informed of any suspicious practices.  We also recommend that companies review the processes by which options are awarded.  The safest practice is to award options on the same date each period and to document the process carefully.

Morrison & Foerster is a national leader in defending companies and their executives in securities litigation matters.  We have broad experience representing companies, board committees, and individuals in matters involving allegations of stock option backdating, timing, and other improper compensation practices.




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