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This article provides a brief summary of the issues implicated by the options backdating controversy. Then it identifies some specific steps that issuers should consider taking in response to the controversy.
In recent months, the business press has been dominated by a substantial controversy regarding the timing of option grants. (1) Over 80 companies have announced either that they plan to restate their financial statements or that they are the subject of Securities and Exchange Commission (SEC) or Office of the US Attorney inquiries. These include some of the biggest names in corporate America. (2)
The SEC's Home Office and several regional and district offices are conducting inquiries regarding the timing of option grants. Criminal prosecutors at a number of US Attorney's Offices are conducting investigations with the assistance of postal inspectors and of investigators from the Federal Bureau of Investigation (FBI) and Internal Revenue Service (IRS). In July and August 2006, the SEC and the criminal prosecutors filed the first civil and criminal complaints, alleging that certain executives violated federal securities laws by backdating their options grant.
Scope and Nature of the Controversy
There is a widespread public perception that all of the companies implicated in this controversy fall within the following scenario, which widely has been condemned as fraud:
* The companies backdated stock option grants by looking back over the prior weeks and months, and with the benefit of hindsight, selected as the disclosed grant date a date when the company's stock price was at a low point.
* The companies retroactively made that date the option grant and pricing date, thereby creating a stock option that was already "in the money" (i.e., on the date when the company authorized the options, the exercise price was below the related current stock market price of the shares underlying the option).
* The companies then disclosed as the actual date of the grant the purported grant date, rather than the date on which the options were granted.
* The company then accounted for the options as if the options had been granted on the purported date of the grant (i.e., as if the options were not in the money when granted).
For quarters ended on or before June 15, 2005, many companies followed Accounting Principles Board (APB) Opinion No. 25 in accounting for compensatory stock options. (3) APB 25 provided that, "[c]ompensation for services that a corporation receives as consideration for stock issued through employee stock option, purchase, and award plans should be measured by the quoted market price of the stock at the measurement date less the amount, if any, that the employee is required to pay." (4) APB 25 further provided that, "[t]he measurement date for determining compensation cost in stock option, purchase, and award plans is the first date on which are known both (1) the number of shares that an individual employee is entitled to receive and (2) the option or purchase price, if any." (5) APB 25 also stated that, "for purposes of this Opinion, the unadjusted quoted market price of a share of stock of the same class that trades freely in an established market should be used in measuring compensation. ... If a quoted market price is unavailable, the best estimate of the market value of the stock should be used to measure compensation." (6)
In addition to this "look back" backdating of options, the press has swept a number of other timing issues under the rubric, "backdating." These issues include:
* Granting options in anticipation of the company's public disclosure of material information that is likely to increase the company's stock price. This practice is sometimes referred to as "front running" or "spring loading." Although some critics argue that this practice constitutes insider trading, (7) a strong argument can be made that the practice is perfectly lawful, especially if the person approving the option grant is aware of the information and is not participating in the option grant. (8) In addition, stock option plans, including the Compensation Committee's compensation policy and objectives, are described in a company's SEC filings, and some critics argue that this practice poses a potential disclosure issue unless the description included specific disclosure of this practice. A strong argument can be made, however, that specific disclosure is unnecessary, especially if the company disclosed retention of employees as an objective of its option program.
* Issuing negative information before the grant date. This practice also is sometimes referred to as "spring loading." (9) Some critics argue that this practice also poses a potential disclosure issue unless it was specifically disclosed. Again, a strong argument can be made that specific disclosure was unnecessary, especially if the company disclosed retention of employees as an objective of its option program.
* Using the wrong measurement date in connection with mass grants to employees. Some companies used the wrong measurement date in connection with the mass grant of options for employees. For example, at some companies, the Compensation Committee approved a grant of options to non-executive employees and authorized top management to allocate the options. Top management then allocated the options among the non-executive employees. The company might have misstated its compensation expense if the company measured the value of the options based on the date that the Compensation Committee approved the options, rather than on the date that they were allocated. This appears to be at least part of what happened to Broadcom Corp., which announced on July 14, 2006, that it expected that problems with its measurement date would result in a restatement of non-cash stock based compensation expense in "excess of $750 million." (10)
* Setting the official hire date of a new employee for a date other than the actual start date. (11) Some companies have a policy of setting the official stock start date as the date at which the stock was at is lowest price during a …