With the filing of civil and criminal complaints against executives of Brocade Communications Systems, Inc., the other widely-reported SEC and Department of Justice investigations ("DOJ"), and the SEC's adoption of new executive compensation disclosure rules, it is clear that the federal government is committed to exposing and eliminating fraud and criminal misconduct associated with the timing of stock option grants. Although many of the alleged abuses took place prior to the Sarbanes-Oxley requirement that option grants be reported within two business days after grant and prior to the implementation of FAS No. 123R, Share-Based Payment (requiring companies to expense the grant-date fair value of all stock options rather than just those granted below fair market value), the procedures outlined in this article continue to provide relevant guidance to public companies today.
The practices called into question can be grouped into three general categories:
"Backdating," or using a grant date earlier than the date on which the options were granted.
Failure to follow board procedures by misdating, changing, or altering the recorded date of a board/compensation committee resolution, or meeting, grant notification or option agreement.
"Spring-loading," or granting stock options before the public release of favorable information, and "bullet-dodging," or waiting for unfavorable information to depress the market price before making a grant.
Options backdating in and of itself is generally not illegal under U.S. law, but the failure to disclose or account for backdated options properly can have significant implications. However, it is important to draw a line between circumstances involving serious legal/governance issues and technical noncompliance issues. The distinguishing characteristic between technical errors and more serious issues is whether the board of directors or the compensation committee knowingly approved the terms of stock option grants. While technical issues may exist that could require changes in option-granting procedures, absent evidence of fraud or manipulation, these technical issues should not, in many instances, be treated as a legal or governance crisis mandating special committee investigations, up-the-ladder reporting and disclosure, or similar extraordinary actions.
With these baseline considerations in mind, a list of possible implications of option-granting errors or irregularities follows.
SEC, DOJ and IRS Investigations/Proceedings. One of the most immediate issues facing many companies is the possibility of civil and/or criminal investigations initiated by the SEC, the DOJ, and/or the IRS. More than 80 companies are currently the subject of one or more federal investigations. Some state attorneys general have also begun investigations.
As noted above, on July 20, 2006, the U.S. Attorney's Office for the Northern District of California, the SEC, and the FBI announced the filing of civil and/or criminal securities fraud charges against former executives of Brocade Communications Systems, Inc., a company that had been under investigation prior to the current spate of inquiries. The charges allege that the company routinely backdated stock option grants without recording necessary compensation expenses. When announcing the charges, the SEC indicated that additional charges may be forthcoming against other companies.
Restatements. An immediate risk facing some companies under investigation is the potential restatement of historical financial statements resulting from the failure to record compensation expense associated with any backdated options. Under the long-standing APB 25 accounting standards (which have been superseded by FAS 123R), compensation expense for option grants needed to be recorded only if the exercise price was less than the fair market value of the underlying stock on the grant date. Therefore, if an option was backdated, a company may have improperly failed to record compensation expense. A number of companies under investigation have already announced that they will be restating historical financial statements. Accounting errors of this type may also give rise to a finding of a material weakness in a company's internal controls.
Tax Implications. Stock options granted at a discount, whether due to backdating or otherwise, may result in tax issues. Discount options are not exempt from the $1 million cap on certain executive pay. Therefore, all or part of the spread when the option is exercised may not be deductible, depending on the circumstances. Discount options will also fail to be exempt from the newly enacted, highly punitive legislation governing so-called nonqualified deferred compensation. In some cases, the options may be grandfathered from the new rules or may be eligible for special transition relief before January 1, 2007. Otherwise, the options must be substantially amended prior to January 1, 2007, in order to comply with the new law, or significant tax penalties could be imposed on the optionees. Finally, discount options cannot qualify for the favorable tax treatment provided for incentive stock options.
Theories for Potential Civil and Criminal Liability. If an investigation reveals material errors related to option grants, liability may arise under the financial reporting, books and records, and internal control provisions of the Securities Exchange Act of 1934 (Exchange Act Sections 13(a) and 13(b) and the SEC rules promulgated thereunder). Such misconduct could also expose a company and the officers and directors involved to further violations of the anti-fraud provisions of the Securities Act of 1933 and the Exchange Act (Securities Act Section 17(a), Exchange Act Section 10(b), and Rule 10b-5). Criminal proceedings for violations of the conspiracy and mail and wire fraud statutes are also possible. Improper disclosures or accounting for options could render statements in a company's proxy materials false or misleading. Inaccurate reporting in an individual officer's or director's Form 3 or 4 filings, reflecting personal securities transactions, could also give rise to potential liability under Exchange Act Section 16 and related SEC rules. At the state level, multiple derivative lawsuits have been filed, alleging that the officers and directors involved breached their fiduciary duties to the corporation under state corporate law.
Auditor Reviews/SEC Filing Delays. As a result of the investigations and media scrutiny, independent accounting firms have been requiring companies to represent affirmatively that they do not have any backdated options during the years covered by audit reports and to provide documentary evidence going back for substantial periods. This may delay some companies from timely filing reports with the SEC.
Possible Delisting. As a result of the inability of many companies to file quarterly and annual reports in a timely manner, many companies under investigation have been notified by NASDAQ or the NYSE that they may be delisted if timely compliance with SEC reporting requirements cannot be achieved. If a company faces a potential delisting, a Form 8-K must be filed.
SEC Reporting/Disclosure Issues. Companies that are unable to file timely annual or quarterly reports are required to file a Rule 12b-25 notification. Similarly, companies that are required to restate historical financial statements may be required to file a Form 8-K under Item 4.02 as to nonreliance on historical financial statements. Many companies under investigation have also filed a Form 8-K disclosing the investigation(s) and any resulting events, such as a derivative shareholder lawsuit. Additionally, on July 26, 2006, the SEC voted to adopt new rules that will require companies to explain their option grant practices and, in particular, whether option grants are specifically timed to the public release of company information and the circumstances involving grants where the exercise price does not match the market value of the stock on the date of grant.
Corporate Governance Issues. Backdating and other irregular option grant practices may give rise to a finding of deficiencies in a company's corporate governance functions, as well as its internal controls and audit functions. Deficient option grant procedures, to the extent they constitute material noncompliance with the option plan, can also lead to invalidation of option grants or Securities Act registration requirements and violations of stock exchange rules and regulations.
Recommended Option Grant Practices
In view of these potential ramifications, companies should consider adopting specific procedures relating to option plan administration. The recommended practices set forth below should be treated as "best practices" and not necessarily required by law.
Regular Grant Cycle. Option grants should normally be made in accordance with a regular grant cycle, which provides for option grants to be made in the same general time frame from year to year. Exceptions would be made for new hires, for which individualized option grants would be necessary. Companies ought to batch authorization of new-hire option grants with regularly scheduled grants to avoid the appearance of special treatment.
Grants Following Release of Material Information. As a legal matter, "spring-loading" (when options are granted prior to the release of positive news) is not illegal so long as the board of directors or committee granting the options has access to the material facts at the time of the grant. This consideration has the effect that option grant dates would not be set during a period preceding an event that is likely to affect the company's stock price. Granting options during normal trading windows might be considered.
Record Keeping. Grant agreements should comply with the terms of the company's stock option plans. In addition, resolutions authorizing a grant should explicitly set the exercise price exactly as provided for in the relevant option plan ( e.g. , a trading price or the closing price immediately preceding or on the grant date).
No Changes to Specified List of Optionees. Additional optionees or grants should not be added at a later date to a board or compensation committee schedule listing the names of optionees and the number of shares subject to the grant. Otherwise, the additional grant could be deemed to have been made at a price less than fair market value.
Eliminate or Closely Monitor Officer of single Director Grants. Section 157 of the Delaware General Corporation Law permits a board of directors to delegate authority to an officer(s) to select option recipients and the number of options granted if certain parameters are established. Companies should specifically evaluate the extent, if any, to which option-granting authority should be delegated. Companies generally should not delegate authority for senior executives, but could delegate option-granting authority (within director-approved parameters) for lower-level employees.
Use of Unanimous Consents. Companies should be aware that, under state law, actions taken by a board or committee by unanimous consent may not be deemed effective until the last director has signed the consent and other procedural requirements (i.e. filing the consent with the minutes of the board or committee) have been satisfied. The potential timing implications associated with the use of written consents to authorize option grants should be considered carefully.
Notification of Grant. Companies should promptly communicate option grants to optionee(s). Failure to do so may give rise to tax consequences and affect accounting treatment, which assumes that prompt notice will be given to grant recipients. Companies may consequently find that a delayed notification date will be treated as the grant date.
Review of Internal Controls. Compensation committees should exercise general oversight option grants (as required by most equity plans). Public companies should review and test their procedures and controls to confirm they are effective. As noted above, companies that have not yet reviewed their option grant practices may face a request from their auditors requiring such a review as part of the quarterly and/or annual report certification process.
There is no "one size fits all" approach for every company, but in the current environment, companies should review their option grant programs with these considerations in mind.
Lyle G. Ganske, a Partner in Jones Day's Cleveland office, is co-chair of the firm's global mergers & acquisitions practice and advises large companies on corporate governance and executive compensation issues. Meredith L. Deutsch, an Associate in the New York office, practices in the areas of securities and general corporate laws and advises clients with corporate governance, disclosure and fiduciary issues. This article is excerpted from a Jones Day Commentary, which is available from the authors.