The Criminal Implications Of Backdating Stock Options

Wednesday, November 1, 2006 - 01:00

More than one hundred companies have been implicated in the recent federal inquiry into stock options backdating.1In July and August 2006, criminal charges were filed against executives from Comverse Technology, Inc. and Brocade Communications Systems, Inc.2With more criminal charges in the pipeline, companies and executives need to understand the potential scope of criminal liability.

There are three major areas of potential criminal liability for former executives involved in stock options backdating: securities fraud, tax fraud, and mail or wire fraud. Backdating is not illegal per se . Backdating only becomes illegal when executives fail to disclose the practice in financial reports, and fail to properly account for backdated options according to Generally Accepted Accounting Principles (GAAP) and the relevant tax laws. Whether executives will be criminally liable depends on whether they were consciously trying to cover up the practice of backdating.

Securities Fraud

The primary source of criminal liability for backdating are the federal securities acts, which regulate the sale of securities by publicly traded companies. See Securities Act of 1933, 15 U.S.C. 77A et seq. ('Securities Act'); Securities Exchange Act of 1934, 15 U.S.C. 78 et seq . ('Exchange Act'). Any person who willfully violates ' any provision' of the Securities Act or the Exchange Act and ' any rule or regulation thereunder' commits a criminal offense, and could be subject to substantial fines as well as imprisonment. See Securities Act of 193324, 15 U.S.C.77x; Exchange Act32, 15 U.S.C.78ff. Criminal charges for backdating could include alleged violations of Section 17(a), 15 U.S.C.77q, which prohibits fraudulent interstate transactions, and Section 10(b), 15 U.S.C.78j(b), and Rule 10b-5, 17 C.F.R.240.10b-5, which prohibit the use of manipulative and deceptive devices in connection with the purchase or sale of securities. The basic violation under these statutes is the same: an intent to defraud another by means of an untrue statement of material fact or an omission of a material fact necessary in order to make a statement not misleading. This means a company must properly disclose and account for any backdating practices in its financial statements. Failure to do so may render financial statements 'false or misleading with respect tomaterial fact,' and create potential criminal liability under the securities acts. See 15 U.S.C.77x, 78ff.

Regardless of which acceptable GAAP approach a company used in valuing options,3a statement in a company's financials stating that the strike price was equal to the fair market value ('FMV') on the grant date would be false or inaccurate if the company backdated options. Furthermore, the failure to record an expense for discounted options granted to employees might result in understated financials, which could in turn make other financial reports inaccurate, particularly net revenues. Filing an inaccurate report with the SEC might subject the company and its executives to a multitude of securities fraud violations for disclosures that are 'false or misleading with respect tomaterial fact.'

Criminal liability for securities fraud will depend squarely on the disclosure and accounting made in a defendant's financial reports. To avoid criminal liability, the company must have disclosed the fact that it was backdating and explained particularly how the option strike prices had been determined. In addition, regardless of the GAAP accounting method the company used, the company must have recorded some sort of compensation expense for the discounted options.

A. Additional Liabilities Under Sarbanes-Oxley

When Congress and the SEC approved the Sarbanes-Oxley Act to amend the Exchange Act, they created additional financial regulations for publicly-owned corporations. Two of these new regulations may give rise to liability, but only for backdating that occurred after August 29, 2002, the effective date of the amendments. Sarbanes-Oxley Act of 2002,403(b), 116 Stat. 745, 789.

Section 403 significantly shortened the time companies are permitted to wait before disclosing transactions involving management or principal stockholders, including option grants. 116 Stat. at 788. Previously, companies were allowed to wait until the end of their fiscal year before reporting these transactions. See 17 CFR240.16a-3(g), 16b-3. Now option grants must be reported to the SEC within two business days of the grant date. This shortened time frame essentially removes the significant benefits of backdating because the limited volatility most stocks experience over the course of two days narrows the potential discount margin between the market price on the grant date and the strike price.

Section 302 requires the principal executive and financial officers of publicly-traded corporations to certify each annual or quarterly report filed with the SEC. 116 Stat. at 777. This certification represents that the officers reviewed the company's financial data, and that it presents the financial condition of the company in all material respects. The officers also certify that they are responsible for establishing and maintaining internal corporate controls to ensure the proper disclosure of all material information. If an executive who participated in backdating certified the company's financial reports, and those reports did not disclose and account for backdating, then he would be liable for making a fraudulent certification. In addition, any inadequate internal controls that led to the inaccurate reporting would constitute a separate violation.

B. Intent Requirement For Securities Fraud

Under the securities acts, a defendant must act 'willfully' or 'willfully and knowingly.' See 15 U.S.C.77x, 78ff. Though federal courts have inconsistently construed these terms,4the most widely accepted interpretation requires a defendant to have intentionally committed a securities violation knowing the conduct was wrongful, but not necessarily knowing it was unlawful.5Where the statute requires the person acted 'willfully and knowingly,' however, some courts require the government to show not only that the defendant knew that backdating was wrongful (willfully), but also that it was unlawful (knowingly).6This intent requirement is important in options backdating cases to determine whether executives may face criminal, rather than merely civil, penalties.

Tax Fraud

Executives who used backdating practices may also face criminal prosecution for federal tax fraud. Three possible violations of the Internal Revenue Code ('Code') could create criminal liability for backdating: (1) exceeding the compensation deduction limits of Section 162(m), (2) failing to qualify options under the rules that govern incentive stock options in Section 422, and (3) violating the provisions of Section 409A regulating deferred compensation. Like securities fraud, the criminal tax fraud statutes require an intent element. See I.R.C.7201-07. Therefore, to be criminally liable under the Code's criminal statutes, a person must 'willfully attempt[]to evade or defeat any tax imposed by [the federal government].' I.R.C.7201.

A. Internal Revenue Code Section 162(m)

Section 162(m) caps the annual deduction for compensation paid to top executives at one million dollars. See I.R.C.162(m). Certain 'performance-based' compensation payments are not counted toward the cap, including stock options that are granted with an exercise price equal to or greater than the FMV of the companies' shares on the date of the grant. See I.R.C.162(m)(4)(B)-(C). Because backdated options have an exercise price lower than FMV as of the grant date, they are not excepted and must be included when calculating whether an executive's compensation has exceeded the cap. See I.R.C.162(m)(4)(C). Aside from interest and penalties that might accrue if a company amends its income tax returns, executives who implemented backdating practices may also be criminally liable for willfully failing to pay taxes, see , e.g., I.R.C.7202, or providing fraudulent and false statements in a tax return, see , e.g., I.R.C.7207.

B. Internal Revenue Code Section 422

Section 422 permits public companies to grant employees 'incentive stock options' (ISOs), allowing them to purchase the company's stock at a discount rate and free from taxes, unless and until the employee later sells any purchased shares. See I.R.C.421(a)(1), 422. To qualify as an ISO, an option must have an 'option price [] not less than the fair market value of the stock at the time such option is granted.' I.R.C.422(b)(4). Consequently, options granted at a discount would not qualify, and are subject to income tax and Federal Insurance Contributions Act (FICA) withholding. I.R.C.83, 422(b)(4). The company would be liable for any taxes it failed to withhold, as well as interest and other penalties, and executives' concomitant personal liability would depend on whether they committed these acts 'willfully' and in violation of the Code's criminal provisions. See I.R.C.7201-07.

C. Internal Revenue Code Section 409A

Section 409A requires companies that grant discounted stock options to treat them as a form of 'non-qualified deferred compensation' for taxation purposes. I.R.C.409A(d)(1). In addition, discounted options that do not have a fixed exercise date are subject to an additional twenty percent penalty tax. I.R.C.409A(a)(1)(B)(i)(I-II), 409A(a)(2). Therefore, any executive who failed to account for backdated options under 409A and/or failed to pay the penalty tax for options lacking a fixed exercise date could be criminally liable for willfully failing to pay taxes, see, e.g., I.R.C.7202, or providing fraudulent and false statements in a tax return, see, e.g. , I.R.C.7207. Section 409A would apply only to options granted since its enactment in 2004.

Wire And/Or Mail Fraud

Finally, improper backdating practices could also subject an executive to criminal liability for violations of the federal mail and wire fraud statutes, which prohibit the use of mail or wire communication in furtherance of a 'scheme or artifice to defraud' or to 'obtain[] money or property by means of false or fraudulent pretenses, representations, or promises.' 18 U.S.C.1341, 1343. Under either statute, the penalties are the same and a conviction can result in substantial fines plus up to 20 years imprisonment.


1 Richard Hill, Cox: SEC Probing Over 100 Cases Involving Reporting; New Rules Halt Slide, 38 Securities Regulation & Law (BNA) 37, (Sept. 18, 2006) at 1567.
2 Complaint, U.S. v. Reyes, (N.D. Cal. July 20, 2006) (No. 3 06 70450); Affidavit in Supp. of Arrest Warrants, U.S. v. Alexander et al., (E.D.N.Y. Aug. 10, 2006) (No. 06-817).
3 Two GAAP approaches, Accounting for Stock Issued to Employees , Accounting Principles Bd. Opinion No. 25, (Fed. Accounting Standards Bd. 1972) and Accounting for Stock-Based Compensation , Statement of Fin. Accounting Standards No. 123, 123R (Fin. Accounting Standards Bd. 1995) were available to companies between 1995 and mid-2005.
4 See, e.g., U.S. v. Tarallo, 380 F.3d 1174 (9th Cir. 2004); U.S. v. Charney, 537 F.2d 341 (9th Cir. 1976); U.S. v. Dixon , 536 F.2d 1388 (2d Cir. 1976); U.S. v Peltz, 433 F.2d 48 (2d Cir. 1970).
5Harold S. Bloomenthal , Securities Law Handbook 36:2.30 (2006 ed.).
6U.S. v. Tarallo, supra . n. 4, at 1174.

Martha Boersch , a Partner in Jones Day's San Francisco office, is a trial lawyer who practices corporate criminal defense and complex civil litigation. Rene Beltranena Bea is a trial Associate in Jones Day's New York office. This article is excerpted from a Jones Day Commentary, which is available on request from the authors.

Please email the authors at mboersch@jonesday.com or rbeltranena@jonesday.com with questions about this article.