Examining Your Options: Backdating and Other Stock Option Timing Issues Karen Hirschman Gillian...

Examining Your Options: Backdating and Other Stock Option Timing Issues

Examining Your Options: Backdating and Other Stock Option Timing Issues

Karen Hirschman

Gillian Hobson

October 2007

Karen Hirschman

Gillian Hobson

October 2007

Overview - Stock Option Timing IssuesOverview - Stock Option Timing Issues

• Demystifying the Issues

• Regulatory Changes

• Other Issues and Developments

• Evaluating Risks

Demystifying the IssuesDemystifying the Issues

Demystifying: “Backdating”Demystifying: “Backdating”

• Company “papers” an option grant using 20/20 hindsight to make it appear to be granted on a different date (i.e., the Company’s option records and the grant documents reflect a date different than the date the option was issued)

• Typically, the date chosen as the “grant date” is one where the stock price is lower than the current price. This means the stock option carries a lower exercise price, making it “in the money” for the executive when granted

• Nothing illegal about “in-the-money” options if properly granted, accounted for, and disclosed

• When not properly accounted for, “in-the-money” options typically understate the compensation expense for the Company

Demystifying: Key Accounting TermsDemystifying: Key Accounting Terms

Grant Date• APB No. 25 never defined “grant date.” Typically, considered to be the

same as the measurement date.• Typically the date on which the actions required to effect the grant are

completed under a company’s corporate governance provisions, stock option plans and applicable laws (SEC’s Chief Accountant Guidance Letter, 9/19/06)

• The date on which an employer and employee have a mutual understanding of the terms of a stock-based compensation award. FAS 123(R)

Measurement Date• The first date when both (1) the number of shares the employee is

entitled to receive and (2) the exercise price are known. This is when the accounting event occurs. APB No. 25, paragraph 10(b)

Quoted Market Price• The quoted market price at the measurement date. Not further defined.

Demystifying: Accounting Concepts(Example No. 1)Demystifying: Accounting Concepts(Example No. 1)

• APB 25: Intrinsic value method (quoted market price = exercise price)– Intrinsic value is the amount by which the quoted market price of the

underlying stock on the measurement date exceeds the exercise price of an option

– On 1/1/00, Company A grants stock options to purchase 100,000 shares of common stock at an exercise price of $10 per share. On the same date, Company A common stock closes at a market price of $10 per share. The options vest 25% per year on 12/31 for the next four years.• Market price of stock at date of grant $10• Exercise price of stock option $10• Intrinsic value at the date of grant $ 0

– Compensation Expense to be recorded = $0 per share

Demystifying: Accounting Concepts(Example No. 2)Demystifying: Accounting Concepts(Example No. 2)

• APB 25: Intrinsic value method (quoted market price > exercise price)– On 1/1/00, Company B grants stock options to purchase 100,000

shares of common stock at an exercise price of $5 per share. On 1/1/00, Company B common stock closes at a market price of $10 per share.1 The options vest 25% per year on 12/31 for the next four years.• Market price of stock at date of grant $10• Exercise price of stock option $ 5• Intrinsic value at the date of grant $ 5 per share

– Compensation expense to be recorded = $125,000/year ($500,000 intrinsic value on grant date divided by 4 years of vesting)

1 For illustrative purposes only. This example is not intended to illustrate accounting treatment when the opening market price or an intraday trading price is $5.00.

Demystifying: Potential Accounting Impact of BackdatingDemystifying: Potential Accounting Impact of Backdating

• Inadequate recognition of compensation expense – If options backdated to earlier grant date and lower stock price,

additional compensation expense should be recognized to avoid overstating pre-tax income

– Example No. 1 (market price = exercise price): • No compensation expense

– Example No. 2 (market price > exercise price):• If compensation expense of $125,000 per year for four years not

recognized, financial may be misstated• If “in-the-money” grants made to multiple employees over many years,

compensation expense may be significantly understated

• Inadequate disclosures– Public companies and individuals may run afoul of disclosure

requirements if they fail to adequately disclose practice of backdating option grants to date other than actual grant date (e.g., Forms 10-K and 10-Q, Proxy Statements, and Forms 4 & 5)

Demystifying: Potential Accounting Impact of BackdatingDemystifying: Potential Accounting Impact of Backdating

• Internal control issues– The practice of backdating, regardless of quantitative effect, may

raise qualitative questions about adequacy of company’s internal controls (“tone at the top”)

– The ability of a single individual to make grants may implicate internal controls over assets

• Violating option plan terms– Some plans require all options to be granted at fair market price on

grant date

– Some plans restrict grant-making authority to Board or a committee

– Concern that grants in violation of plan requirements may have a different measurement date (after shareholder or board approval) or accounting treatment like cash-settled SARs

Demystifying: Accounting GuidanceDemystifying: Accounting Guidance

• APB 25 “Accounting for Stock Issued to Employees” (effective for grants 12/31/72)

• SFAS 123 “Accounting for Stock-Based Compensation” (effective for fiscal years after 12/15/95)– Important note: Companies could adopt disclosure provisions of

SFAS 123 but continue to account for options under APB 25’s intrinsic value method (most chose APB 25 accounting to avoid negative impact on net income)

• FIN 44 “Accounting for Certain Transactions involving Stock Compensation” (effective 7/1/00)

• SFAS 123R “Accounting for Share-Based Payments” (effective 6/15/05; after 12/15/05 for Small Business Filers)

• SEC’s Chief Accountant Guidance Letter ― Discussing existing accounting guidance related to stock option grants (issued 09/19/06)

Demystifying: Potential Tax EffectDemystifying: Potential Tax Effect

• IRC § 422– Exercise price of an incentive stock option must be equal to the fair

market value of the Company’s stock on the date of grant. If an ISO is granted at a discount, then • employees lose ability to get capital gains tax treatment and

would be liable for additional tax in the year of exercise along with interest and penalties

• The Company may be liable for withholding and FICA taxes, and associated interest and penalties

• IRC § 162(m) (effective 1993) – Tax deduction for compensation to top executives limited to $1 million

unless performance-based such as fair market value options• Company may be liable for underpayment of withholding and

FICA taxes, plus interest and penalties• IRC § 409A (applicable to options granted or vesting after 2004)

– May subject “in-the-money” options to 20% excise tax– Company may need to withhold taxes unless options are repriced at

fair market value

Demystifying: Other Option PracticesDemystifying: Other Option Practices

• Intentional Backdating– using earlier grant date to obtain favorable historic price

• Failure to Observe Formalities/Incomplete Recordkeeping– unintentional backdating resulting from failure to observe formalities

(e.g., unanimous consents signed after grant made)

• Forward dating– If options are approved, but before the employee is notified and the

documents are finalized, the price drops, this can be viewed as repricing with accounting and disclosure consequences


• Issuing before employment– If grants issued to employees before they actually start work, this can

be viewed as backdating

– Some companies improperly used block grants to new employees then transferred them to senior executives

• Bullet-dodging– Delaying grants until unfavorable information has been released

• Extended Vesting– Granting extended vesting for retiring or absent employees may

violate company’s stock option plan or create a new measurement date


• Springloading– Granting options before disclosure of material nonpublic information

likely to have favorable impact on stock price

– SEC Chief Accountant says no accounting effect: “[C]ompensation cost must be computed on the measurement date by reference to the unadjusted market price of a share of stock of the same class that trades freely in an established market.”

– But SEC Enforcement Staff claims there may still be legal or regulatory issues (possibly insider trading or manipulation claims, especially if options granted during a closed window period)

• Market Timing– Granting options during temporary decline in price (e.g., 9/11) that

does not involve material nonpublic information

Regulatory ChangesRegulatory Changes

Regulatory ChangesRegulatory Changes

• SEC Chairman Cox testified September 6, 2006 regarding laws and regulations:– Sarbanes-Oxley “has closed the disclosure loophole that

permitted months and sometimes more than a year to elapse before option grants had to be reported”

– FAS 123R “has eliminated the accounting benefit of granting at-the-money options”

– “The SEC’s brand new executive compensation rules now require a complete quantitative and narrative disclosure of a company’s executive compensation plans and goals” and

– Additional accounting guidance will be forthcoming.

New Executive Compensation RulesNew Executive Compensation Rules

• New rules issued on August 11, 2006

• Expanded option grant disclosure requirements:

– Timing of option grants

– Company granting practices

• Effective dates

– After November 7, 2006 – triggering events must be reported on Form 8–K

– After December 15, 2006 – for other SEC filings

Compensation Discussion and AnalysisCompensation Discussion and Analysis

• Any program, plan or practice to time option grants to its executives in coordination with the release of material non-public information;

• How any program, plan or practice to time option grants to executives fits in the context of the registrant’s program, plan or practice with regard to option grants to employees generally, if any;

• Whether the registrant sets the grant date of its stock option grants to new executives in coordination with the release of material non-public information; and

• Whether the registrant plans to time, or has timed, its release of material non-public information for the purposes of affecting the value of executive compensation.

• Disclose any program, plan or practice of awarding options and setting the exercise price based on the stock’s price on a date other than the date of grant and any provisions in option plans or other practices for determining the exercise price based on formulas or other considerations.

Other Required DisclosureOther Required Disclosure

• Summary Compensation Table

• Grants of Plan-Based Awards Table

• Outstanding Equity Awards at Fiscal-Year End Table

• Option Exercises and Stock Vested Table

• Supplemental Narrative Disclosure

• Director Compensation Table

Other Issues and DevelopmentsOther Issues and Developments

Issues and Developments: Internal InvestigationsIssues and Developments: Internal Investigations

Some potential questions from clients:• Should client undertake internal investigation?

– What are risks/benefits of conducting an internal investigation?– What are risks/benefits of not investigating?

• If client decides to conduct internal investigation:– Independence concerns

• Who should be in charge of the investigation?• Who should conduct the investigation?

– In-house counsel?– Internal audit?– Regular outside counsel versus independent outside counsel?

– Substantive concerns• What type of investigation should be conducted?• What materials should be reviewed?• How far back should the investigation go?

Issues and Developments: Internal Reviewof Historic Option PracticesIssues and Developments: Internal Reviewof Historic Option Practices

• Companies that have made significant use of stock options in the past, whether or not they have been identified as potentially having a problem, should consider doing an initial internal review to confirm the adequacy of past practices

• Review coordinated by (independent):

– In-house legal

– In-house auditor

– External forensic accountant

– External law firm

– Independent committee with independent counsel

• The review could examine the company’s historic practices, including whether grants were made on fixed or variable dates, whether management exercised grant authority and whether grants were made in blocks. It could chart the option prices against the company’s stock prices to see if there are abnormal patterns that raise suspicion. The readily available documentation, including relevant minutes and board and committee books, should be reviewed.


• How far back to review?

– At least for the prior three years (Stanley Keller)

– Open ended (ABA)

– Natural cutoff (due to merger, IPO, etc.)

– 1991 (Comverse)

– Statute of Limitations (?)

• If a material potential problem or fraud is identified, a thorough internal investigation should be conducted by an independent committee of the board

• Consider expense advancement, joint defense agreements and other information sharing


• Self remediation

– Personnel changes

– Policy and procedure changes

• Develop a plan for responding to inquiries from third parties. This plan should be Regulation FD compliant.

• Consider the need and desirability of early public disclosure

• Consider self-reporting

• Preserve attorney-client privilege

Issues and Developments: Suggested Future ProtocolsIssues and Developments: Suggested Future Protocols

• Clearly define grant approval process

– Observe corporate formalities (charter, bylaws, resolutions and plan documents)

• Clearly define the approval process for outside-of-guideline grants

• Minimize outside-of-guideline grants

• All grant approvals should be in writing

– Unanimous consents

– Minutes

• Reconcile stock plan database to written approvals

Issues and Developments: Suggested Future ProtocolsIssues and Developments: Suggested Future Protocols

• Know the limits on each approver’s authority and make sure grants comply

– Two people required to approve grants for internal controls

• Establish a set schedule for approving grant recommendations

– Open vs. closed window periods

• Ensure receipt of advance notice of any grant recommendations for Section 16 officers

• Complete grant paperwork and notification to recipients in a timely manner

• Audit, audit, audit!

A Shot Across the BowA Shot Across the Bow

Remarks by Stephen M. CutlerDirector, Division of Enforcement, SECSeptember 20, 2004• Importance of gatekeeper: auditors, attorneys and directors• SEC requires attorneys with evidence of material violations of

federal securities laws or breaches of fiduciary duty to “report up the ladder” to senior management and the board of directors.

• Charges against general counsel for false certifications• Investigative focus on in-house and outside counsel:

– Assisting registrants in covering up fraud– Signing off on misleading disclosures– Conducting investigations so as to hide ongoing fraud – Obstructing internal investigations

• Enforcement actions against non-management directors for ignoring signs of improper accounting practices.

SEC Is True To It’s WordSEC Is True To It’s Word

• In stock option arena alone:– Six General Counsel have been charged with

violations of the securities laws• Lisa Berry, KLA and Juniper Networks• Susan Skauer, Mercury Interactive • Nancy R. Heinen, Apple• Kent H. Roberts, McAfee• Myron F. Olesnyckyj, Monster Worldwide, Inc.• William F. Sorin, Comverse Technology, Inc.

The Accounting Rules Were Far From ClearThe Accounting Rules Were Far From Clear

• Office of Chief Accountant of Commission issued guidance on September 19, 2006 in light of numerous questions raised about application of APB 25– Is oral authorization sufficient? – Can option granting authority be

delegated? • Yet, some of the facts are egregious

Common FactsCommon Facts

• Public filings contained representations that option grants were made at fair market value– Amounts are usually material

• Grants were approved by unanimous written consents – Thus contemporaneous approval of the terms on

the grant date could not be established• No compensation expense was recorded for stock

option grants • Remedies sought: injunctive relief, disgorgement,

money penalties, and order barring officer from serving as an officer or director of a public company

Corporate “Cooperation”Corporate “Cooperation”

• Sharing results of internal investigation with the Commission

• Waiving privilege

• Implementing controls designed to prevent recurrence

• Throwing executives “under the bus”

KLA/Juniper NetworksKLA/Juniper Networks

• “The Commission's action today confirms that attorneys are no less bound by the securities laws than other public company executives," said Linda Chatman Thomsen, the SEC's Director of Enforcement. "At both KLA and Juniper, Ms. Berry was in a unique position to insure that the companies accurately disclosed their stock option expenses; instead, she facilitated their fraud on investors."


• KLA – 46% overstatement of net income in one year• Juniper - $895 million in compensation expense over 7 years• KLA/Juniper signed consent judgment but paid no fine• “The Commission declined to charge the company with fraud or

seek a monetary penalty, based in part on the company's swift, extensive, and extraordinary cooperation in the Commission's investigation, as well as its far-reaching remedial measures. KLA-Tencor's cooperation included an independent internal investigation and the sharing of the results of that investigation with the government. The company also took significant remedial actions in response to the findings of its internal investigation, including the implementation of new controls designed to prevent the recurrence of fraudulent conduct, removal of certain senior executives and board members, and the re-pricing and cancellation of retroactively-priced options held by several individuals.”


• Lisa Berry, in-house corporate attorney, charged with:– Causing companies to report false financial information– Working with other senior executives to establish procedures

that disguised in-the-money grants as at-the-money grants– She and Compensation Committee were responsible for

establishing procedures– Used same process at KLA and Juniper Networks– She selected the exercise prices using historical information – Received backdated options– Created false minutes for Committee meetings that never

occurred– Majored in accounting and obtained a masters of law in

taxation after graduating from law school.

Mercury Interactive, Inc. Mercury Interactive, Inc.

• “The $28 million corporate penalty in this case, together with a permanent injunction, should send a clear signal that fraudulent stock option backdating and other financial fraud will be severely punished," said SEC Chairman Christopher Cox. "The Commission's Enforcement Division will reinforce that principle by vigorously pursuing the charges against the individuals who were responsible. In this case as well as those that will follow, the SEC will do everything within our power to see to it that illegal options backdating is stamped out."

Mercury InteractiveMercury Interactive

• 45 grants over 6 year period– Each grant was backdated

• $258 million in compensation expense• Some of the grants were backdated by as much as 4

months• Shareholders had rejected proposed changes to plan that

would permit non-qualified options to be granted at less than fair market value

• CEO and 2 CFO’s were also charged • Mercury agreed to settle for payment of $28 million in civil

penalties and permanent injunctive relief, without admitting liability

Mercury InteractiveMercury Interactive

• Susan Skauer, General Counsel, charged with:– Preparing false unanimous written consents memorializing

dates selected with hindsight by the CEO and CFO• UWC’s and Minutes prepared with “as of” dates

– Backdated exercise dates for senior executives– Fraudulent loans for stock option exercises by overseas

employees to conceal accounting consequences– Received backdated options– Understood accounting issues

• Evidence: attendance at Board meeting where there was discussion of compensation charge for in-the-money options

• Skauer had explained accounting issue to others in connection with merger transactions

AppleApple

• "Marc J. Fagel, Associate Regional Director of the SEC's San Francisco Regional Office, stated, "Apple's shareholders relied on Heinen and Anderson, as respected legal and accounting professionals, to ensure the accurate reporting of the company's executive compensation. Instead, they failed in their duties as gatekeepers and caused Apple to conceal millions of dollars in stock option expenses."

AppleApple

• “The Commission also announced today that it would not bring any enforcement action against Apple based in part on its swift, extensive, and extraordinary cooperation in the Commission's investigation. Apple's cooperation consisted of, among other things, prompt self-reporting, an independent internal investigation, the sharing of the results of that investigation with the government, and the implementation of new controls designed to prevent the recurrence of fraudulent conduct.”

AppleApple

• $105 million in pre-tax compensation expense over 4 year period

• CFO also charged

– Settled without admitting liability for $3.5 mm in disgorgement and penalties

AppleApple

• General Counsel Nancy R. Heinen, charged with:– Backdating two large option grants to senior executives

• 4.8 million grant to executive team, including herself• 7.5 million grant to CEO Steve Jobs• Provided list of share prices to Jobs and suggested he use

earlier date– But email indicated desire to select date after “Macworld”

announcement– Altering company records to conceal the fraud

• Prepared UWC’s with “as of” dates• Prepared minutes of special meeting of board that never

occurred– Compensation Committee call took place that day– Heinen backdated her attestation of the minutes as

Corporate Secretary

McAfee, Inc.McAfee, Inc.

• Linda Chatman Thomsen, Director of the Commission's Division of Enforcement, said, "Roberts flouted his duties as McAfee's general counsel by subverting the very systems that he was charged with safeguarding to improperly benefit himself and others. This action further demonstrates the Commission's resolve to stem fraudulent conduct by legal officers of public companies.“


• Two grants, neither very material

– $197,500 for Roberts’ own option

– $739,200 for CEO’s option


• General Counsel Kent H. Roberts charged with:– Secretly accessing computer database and

changing option date for his grant• Confessed he had done so due to

disappointment with performance of stock price that made his grant worthless

– Falsely representing that the Board had approved changes to CEO grant

– Falsifying Compensation Committee minutes by changing the date to the next day, following $2 stock price drop

Monster Worldwide, Inc.Monster Worldwide, Inc.

• Linda Thomsen, Director of the Commission's Division of Enforcement, said, "By backdating the vast majority of the stock options it granted, Monster, one of the premier Internet companies of the last decade, used the lure of instant 'paper profits' to attract and retain its employees without booking the appropriate employee compensation charges. This scheme defrauded Monster's investors. The SEC will continue to work tirelessly to uncover and to stop such conduct.“

• Mark Schonfeld, Director of the Commission's Northeast Regional Office, said, "Olesnyckyj knew that backdating was wrong but nonetheless went along with the scheme. Any lawyer who works at a public company should do everything possible to thwart fraud — not participate in it."


• $340 mm in compensation expense over 9 years


• General Counsel Myron F. Olesnyckyj charged with:– Preparing false documentation

• UWC’s with “as of” dates before the dates the attached schedules were prepared

– Concealing the scheme• Discarded schedules prepared after the grant date

– Smoking gun email:• “No written document should ever state lowest price over next 30

days! The auditor will view that as backdating options and we’ll have a charge to earning in the amount of the difference between price on day 30 and any lower price which is used.”

– Entering into settlement agreement• Permanent injunction• Public officer/director bar• No financial penalties

Comverse Technology, Inc.Comverse Technology, Inc.

• CEO “Kobi” Alexander and CFO hand-picked dates

• Six of seven company-wide grants were made at or near the lowest price for the fiscal quarter or year

• Created “slush fund” of options used for recruiting– Names of fictitious employees

• Plan permitted in-the-money non-qualified options


• General Counsel William F. Sorin, charged with:– Creating company records that falsely indicated that a committee

had approved the option grant on dates “cherry-picked” by the CEO• Prepared UWC’s with “as of” dates

– Making misrepresentations to the auditors• That grants were approved “as of” the dates in the UWC’s• After WSJ report, falsely claimed oral approvals had been

given on those dates– Receiving $14 mm in gains from options

• But only $1 mm due to hindsight selection of grant date– Failing to file required Form 3’s and 4’s reporting option activity– Serving on the Compensation Committee of a subsidiary of

Comverse


• General Counsel William F. Sorin– Settled with SEC for $3 mm in civil penalties and

disgorgement, permanent injunction, permanent officer-director bar, and suspension from practicing before the Commission• $1 mm “in-the-money” benefit• $817,000 in pre-judgment interest• $600,000 civil penalty

– Linda Chatman Thomsen, Director of the SEC's Enforcement Division, said, "Today's settlement signals that the Commission will vigorously pursue those responsible for backdating schemes wherever the investigation may lead, even, as appropriate, into the offices of corporate counsel."


• General Counsel William F. Sorin

– Also indicted by US Attorney’s Office for the Eastern District of New York for conspiracy to violate the antifraud provisions of the federal securities laws, wire fraud, and mail fraud

– Pleaded guilty to one count of conspiracy

Examining Your Options: Backdating and Other Stock Option Timing Issues Karen Hirschman Gillian...

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