Former Regulators Discuss Backdating Stock Options

Editor: Why did the firm decide to create a Securities Litigation and Enforcement Practice Group?

Stewart: Winstead sought to pull together the practices it had and expand the services offered to clients. Although the firm had historically represented financial industry clients in securities litigation, it was determined to expand the scope of its representation to include enforcement and regulatory matters.

Editor: What contributions will you be able to make to this new practice group?

Taylor: With more than 25 years of practice in the area, I hopefully add regulatory and enforcement depth to the firm. I started my career at the SEC in Washington and later headed its Houston office. I have represented issuers and financial services firms in securities litigation and in enforcement and regulatory matters brought by the SEC, NASD, New York Stock Exchange, and other regulatory bodies.

Stewart: I spent 20 years as an enforcement lawyer with the SEC. In the mid 1970s, I was appointed Assistant General Counsel to the SEC. I was involved in hundreds of SEC investigations and related criminal prosecutions brought by the Department of Justice.

Thereafter, I joined Merrill Lynch as an Assistant General Counsel which gave me further insights into Wall Street, the inner workings of the brokerage business and experience in dealing with the SEC.

Editor: Would you comment on the current stock option backdating scandal?

Taylor: There are always highly topical issues that are pursued nationally and this is one of them. The stock option backdating controversy concerns financial reporting and disclosure (transparency, if you will) with respect to a company's earnings.

You have to look at it on two planes. First, there is the self dealing aspect of giving officers instant profits where stock options are actually intended to provide incentives for future performance. A more critical issue is the impact of options manipulation on the issuer's reported earnings. Options can be lawfully backdated if disclosed and properly accounted for. However, if you create "in the money" options but backdate them to make them appear to be "at the money," you are not properly recognizing compensation costs. If you do not expense those costs, the company's earnings are overstated.

Editor: Why do you feel that companies got themselves into this mess? I would have assumed that many of the companies involved had competent counsel.

Taylor: One of the problems is that although the oversight of stock option plans and compensation generally is a board function, to some extent the nuts and bolts of options issuance have been delegated downstream to operating officers who potentially have conflicts of interest.

Editor: What kinds of governance issues would be raised where backdating of stock options has occurred?

Taylor: The board of directors and its audit committee are directly responsible for accurate financial reporting. Sarbanes-Oxley imposes specific procedural burdens upon the audit committee for oversight of the financial statements and internal controls. Where options problems are detected, the audit committee likely will find it necessary to initiate an internal investigation. The audit committee typically will hire outside counsel to conduct an independent review. The auditors will be involved and informed. The findings will be reported to the board of directors and - if there is a serious problem - reported to the SEC.

Editor: If there has been backdating of stock options in the past, unless there is a restatement of the financial statements, the distortions in expense and income figures will carry forward into the present period.

Taylor: The stock option plan and specific grants of options may span several financial reporting periods. The independent auditors are not likely to go forward with auditing current financial statements if they perceive a problem with prior periods that may have to be restated.

Editor: Yet the auditors under Section 404 at great expense to companies failed to pick this up.

Taylor: Some recent accounting literature mandates heightened scrutiny of backdating of stock options and other potential options dating practices such as "spring-loading" or granting options immediately prior to the announcement of "good news." Those things were not always so squarely on the radar screen.

Going forward you can be sure that independent auditors will be testing to see how options programs have been executed, whether there has been manipulation of the dates and possible manipulation of the earnings of the company.

Editor: Do you anticipate that derivative litigation is being launched as a result of this scandal?

Stewart: A number of class action lawsuits already have been filed. Litigation could take the form of derivative suits as well. The class actions tend to track the government's cases. Brocade Communications is a classic example. The class action law firms will have the benefit of piggy-backing SEC investigations and "self reporting" by issuers. Where companies self-report, the report and documents provided to regulators generally will not be privileged.

Editor: Do you see problems arising with respect to D&O insurance claims?

Taylor: As always corporate indemnification and D&O insurance is available to officers and directors who have been faithful to the corporation's interests. Ultimately, however, there can be no indemnification where the officer or director is held to have breached a fiduciary duty to the company.

Editor: The sources from where litigation might come include shareholders, mutual funds, parties to acquisitions or mergers

Taylor: Theoretically, anyone who is entitled to rely on the company's financial statements is a potential plaintiff to the extent that there was backdating of stock options to conceal compensation expense and overstate earnings.

Editor: What do you think is going on at the SEC in terms of reaction to this problem?

Stewart: There is no question that the SEC will pursue companies that it identifies as having manipulated earnings by backdating stock options. The SEC's staff will obtain information from a variety of sources, including voluntary disclosures, periodic filings, disaffected employees and investigative newspaper reporters.

Taylor: The SEC is also aided by Sarbanes-Oxley because any alert audit committee of a public company will initiate an internal review that may lead to self-reporting.

Editor: How big a factor is intent in determining the severity of the sanctions that the SEC will impose on a company that engaged in stock option backdating practices?

Taylor: Scienter is a concept that is fundamental to the application of the anti-fraud provisions of the federal securities laws. These violations involve deliberate manipulation of documentation for the purpose of misstating earnings. To the extent that boards misstate the company's minutes, manipulate employment offer letters and the like, scienter will be established.

Stewart: If backdating was the result of knowing misconduct, the SEC will impose stringent sanctions on those involved. Moreover, if the backdating was intentionally concealed and took place secretly in an effort to manipulate earnings by concealing compensation, there may be criminal implications.

Editor: Do you have any indication of how active the Justice Department will be in pursuing these issues criminally?

Taylor: In recent years, the SEC and the U.S. Attorney's Offices have increasingly worked in tandem. Given the rapid fire filings that we have seen in these high profile cases, it would appear that the SEC is cooperating with criminal prosecutors early on.

Editor: What messages do the backdating scandals send to senior management?

Taylor: In recent years, the regulators have made "earnings management" issues a top priority. This is really a continuation of that. "Earnings management" in the form of options manipulation will be dealt with accordingly. The over-all focus on the integrity of financial statements is ongoing.

Editor: Should general counsel be more involved in looking at these financial transactions?

Taylor: In-house counsel will likely focus on the issue of internal controls. I would assume that there will be a focus on tighter internal controls rather than an expectation that in-house counsel will scrutinize every grant of options.

Editor: Many of these situations occurred before 2002. Should the board scrutinize transactions even if there is no reason for the board to believe that there is a problem?

Taylor: Most audit committees (and auditors) are reading about this recognizing that there is at least a potential problem with financial statements for prior periods. Some level of inquiry clearly would be prudent.

Editor: Should an internal investigation be conducted by outside counsel?

Taylor: The audit committee will first look at the facts. If they perceive problems they almost certainly will engage outside counsel (assisted by forensic experts). The audit committee will not have the resources to conduct the internal investigation itself and any investigation done by operating officers may lack credibility.

Editor: If the facts uncovered indicate a serious violation which may involve fraud on the part of high level executives or directors, should the company make a self disclosure?

Stewart: I would generally recommend going to the SEC and laying the facts on the table, but only after taking appropriate remedial action. When you self-report, you must advise the SEC of the corrective actions that you have taken. This might include terminating or otherwise penalizing employees involved and putting in place procedures that will prevent future misconduct. Although some clients may resist self-reporting, failure to disclose a known problem - particularly one affecting the integrity of financial statements - often involves much greater risk and expense.

Editor: What about the likelihood of the SEC uncovering the problem?

Taylor: Where the auditors have determined that a re-statement is necessary, the odds are that the SEC's staff will focus upon it. Periodic and other reports filed with the SEC are routinely monitored for potential enforcement issues and problematic disclosures are often referred to the Division of Enforcement.

Editor: Your firm's team includes experts from other practice groups who have experience with the stock option backdating issue.

Stewart: In any SEC enforcement matter you will coordinate with and involve lawyers on the transactional side. Although internal investigations are a litigation and enforcement function, the work is informed by corporate and tax expertise on financial reporting and disclosure issues. We have a team of professionals working on backdating matters, which includes not only our practice group, but also includes lawyers from other practice areas throughout the firm such as tax, corporate, and labor and employment.

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