Stock Options Scandal Gathers Steam
By: MATTHEW T. BOOS
Several recently-reported investigations point to an intensifying climate around stock option backdating – i.e., the practice of altering a stock option grant date to an earlier time when a company’s stock price was relatively low. This, of course, increases the option holder's potential for profit. Problems arise when companies backdate stock options without notifying shareholders.
Backdating stock options, if done with the intent to deceive shareholders, will likely mean trouble for the offending companies, executives and/or board members. As the professor of securities law at Columbia University, John C. Coffee, put it: "It's cheating the corporation in order to give the CEO more money than was authorized [by the board]."
But is backdating illegal? Not necessarily, if it is:
- Clearly communicated to the company shareholders.
- Properly reflected in earnings. For example, because backdating is used to choose a grant date with a lower price than the price on the actual decision date, the options are effectively in-the-money on the decision date, and the reported earnings should be reduced for the fiscal year of the grant. Because backdating is typically not reflected properly in earnings, some companies may have to restate earnings for past years.
- Properly reflected in tax calculations. For tax reasons that are beyond the scope of this article, an artificially low exercise price might alter tax payments for the company and the option recipient.
Unfortunately, these conditions are not always met, making backdating illegal in many cases.
In addition to provoking shareholder unrest and raising tax issues, backdating may also violate the 2002 Sarbanes-Oxley Financial-Accountability Act. Backdating for the top five employees is banned under this Act, which requires companies to report the issuance of stock option grants for those employees within two days. But even if backdating is more difficult or less common now, the fact that stock options historically have been a key part of certain executives' compensation – particularly in the technology area – has fueled speculation that other companies could be dragged into the controversy.
Companies that have failed properly to disclose the practice of backdating may face SEC investigations, restatements of quarterly financial statements, falling stock prices, and shareholder lawsuits. They may face civil claims such as securities fraud under Section 10b-5 of the Securities Exchange Act of 1934, breach of fiduciary duty, aiding and abetting a breach of fiduciary duty, unjust enrichment, or rescission.
Government and corporate investigations of stock option practices have accelerated as companies continue to report regulatory and internal investigations. Indeed, directors and executives from at least 40 public companies are now reported to be under investigation by federal or state officials for backdating stock options.
Federal prosecutors have launched separate criminal inquiries into over a dozen companies. The United States Attorney for the Eastern District of New York has issued grand jury subpoenas to, among others, Comverse, American Tower, Brooks Automation, and Juniper Networks. The United States Attorney for the Southern District of New York has subpoenaed Affiliated Computer Services, Caremark, Nyfix, Safenet, United Health Group, Vitesse Semiconductor and, most recently, Monster Worldwide, Inc., the nation’s largest recruiting website. Sycamore Networks, Inc. has received a subpoena from federal prosecutors in Massachusetts. At least 10 senior executives or directors at affected companies have resigned, including the CEO at Vitesse Semiconductor. Antivirus software maker McAfee Inc. has fired its general counsel for misconduct involving company stock options. At this point, it is unclear whether federal prosecutors will bring criminal charges against any of the companies or individuals under investigation.
Another sign of concern over the stock option backdating issue is a report from the California Public Employees’ Retirement System (CalPERS), a pension fund with more than $200 billion in assets that it is seeking explanations from 25 companies identified in the media for questionable options practices. CalPERS is concerned that the backdating allegations raise questions about a lack of board oversight, weak internal controls, faulty internal and external audit practices, and poor accounting—as well as the possibility of civil and criminal penalties against the companies involved.
At the very least, companies should familiarize themselves with their past practices in terms of stock option grants. If problems are identified proactively, companies may be able to avoid being surprised by a government inquiry.