Editor: Mr. Profusek, would you tell our readers something about your professional experience?
Profusek: I have spent my entire career with Jones Day, and like other so-called corporate lawyers in the late 1970s and early 1980s, transformed into a more specialized M&A and corporate governance practitioner with the advent of hostile takeovers and proxy fights. I have spent much of my career in the board room, and today I head Jones Day's global M&A practice.
Editor: How has your practice evolved over the course of your career?
Profusek: The focus of M&A has shifted, dramatically so, from a fixation on documenting the transaction to a focus on due diligence, regulatory considerations, social issues and board room dynamics. Directors do not want to know so much about the contract today, but they do want to know about synergies, the rationale behind the merger and the risks presented. Practitioners are required to marshal a great deal more information than in the past, and they are required to address questions of risk that were seldom raised in the past. Corporate governance is obviously very different today from what it was in the past, and one of the differentiators is the degree to which directors today can be expected to cut through the form of a transaction to zero in on its substance.
Editor: Would you give us an overview of the current hot issue in the area of corporate compliance - the backdating of stock option grants? For starters, what is the practice of backdating?
Profusek: Backdating is something of an unfortunate term. I believe that there are very few instances where the board of directors itself knowingly approves the grant of an option on a date that is not authorized by the underlying plan. Most often there is no perception of wrongdoing. An executive may have a contractual right to pick an option date after board action. In my mind there is a huge difference between doing something and knowing it is wrong, and doing something that may be inconsistent with board direction and not appreciating that fact at the time. There are also cases where something turns out to be wrong in hindsight, but the cause was a loose or informal approval process, not anything nefarious. The media has a tendency to lump all of these things together. One of the consequences of such a climate is that even the most innocent - and correctable - mistake triggers an internal investigation process, even governmental involvement.
Recently Commissioner Atkins of the SEC indicated that we may have gone too far in attempting to address this issue. The SEC has also put out the word that not every option measurement date circumstance should require calling in the fraud squad. I think that some of the reactions we have seen are out of all proportion to the underlying issue, and I do not believe new laws are necessary to deal with situations which, for the most part, are errors rather than what the accountants would call irregularities and regulators would perceive to involve fraud.
Editor: These activities have gone on for some time. Why have they only come to light recently?
Profusek: That is a good question and, of course, part of the answer has to do with the current environment in which intense scrutiny is directed at corporate governance. Last summer several academics, and then some of the major brokerage firms, released statistical analyses indicating many stock option grants occurred when the stock price was at its lowest point. Where that lowest point took place before the actual date of the grant, you have "backdating." The reverse situation, "spring loading," occurs where you have good news in the wings, and the options are granted prior to publication of that news.
Editor: Is there a particular focus on the part of government investigations today?
Profusek: The SEC has a dual mission: that of protecting the investing public, and that of helping to make the U.S. capital markets accessible to business enterprises. I think the governmental investigations are going to reflect the current concern about getting things into the proper balance. That translates into the situation where, if the investigation concludes that a mistake has been made, the government will make the company fix the problem and move on. If they determine that the case is truly a rip-off, of course, they will move to prosecute. I think what is important here is the recognition on the part of the government that it is essential to separate the one type of case from the other. The failure to do so might make American capital markets rather unattractive globally, and the government certainly does not want that.
Editor: Please tell us about Maxim Integrated Products, Inc. v. Gifford. What is the background of the case?
Profusek: The complaint was predicated upon a Merrill Lynch analysis that questioned the statistical likelihood that the options granted would have the values as given, compared to what a random selection would have shown, and went on to allege that backdating must have occurred. What is remarkable about the case is that the Delaware Chancery Court - an incredibly sophisticated state court - found that such allegations were sufficient to justify a law suit.
I personally do not believe that a newspaper article or some speculation about statistical modeling should be a sufficient foundation for a legal action. However, this is essentially what Chancellor Chandler said in permitting this case to go forward.
Editor: What about the fact that the plaintiff didn't ask the board of directors to remedy the situation?
Profusek: Whether the plaintiff must make a demand on the board is a complex one legally. The Chancellor determined the case before him to be a "demand excused" case: he noted that the compensation committee that approved the awards was comprised of three directors, and that since the full board consisted of only six members, the plaintiff was excused from making a demand on the board. I do not think that is a good result. If there are any truly disinterested directors, in my view they are supposed to have a say in whether the case is to go forward. The Chancellor did not accept this reasoning but determined that since directors other than the ones on the compensation committee served on the audit committee - and, after all, these backdating issues were accounting matters - a majority of the board was interested in one way or the other. This was a small board, and that may be a basis on which this case will be distinguished later on.
Editor: Would you explain the connection - or lack of connection, actually - between actions of Maxim's compensation committee and the business judgment rule?
Profusek: Compensation decisions, like all decisions in which directors do not have a direct interest, are subject to business judgment rule protection. That means the plaintiff is compelled to advance some concrete evidence of a breach of the duty of good faith or of loyalty to the corporation; otherwise the directors' decision stands. If the board or board committee makes a decision that turns out to be wrong or misguided, then, in the absence of evidence that it was deliberately dishonest, made frivolously, without due deliberation or investigation, or is tantamount to gross negligence, the directors are not liable for their actions.
Here the allegation was that the business judgment rule did not apply because the directors knew that the grants they were awarding were in violation of a shareholder-approved stock option plan, and they knew that the disclosures regarding their purported compliance with that plan were incorrect.
One factor that I think is important here is that there is no allegation that the directors themselves got anything out of the stock options they awarded. Going forward, I think it is premature to conclude that the directors are going to be actually held personally liable. In the Disney case, for example, after a lengthy trial and an enormous amount of media interest - where everyone assumed that the Disney directors were going to be found personally liable, the end result was that their conduct did not involve an actual breach of fiduciary duty.
I confess the Maxim case makes no sense to me. It has occurred to me that the Delaware Chancellors in the now highly charged executive compensation area may be trying to head off the federal government from enacting legislation that would be in no one's interests. Perhaps they are saying that they are on top of this issue and that there is no need for federal intervention.
Editor: What happens next? How do you see this case being finally determined?
Profusek: From the defendant's standpoint, the problem with losing a motion to dismiss is that it gives the plaintiff leverage in settlement negotiations. The presumption has been that if you lost the motion to dismiss, you need to settle due to the cost and disruption of defense and the ever-present possibility of losing even if you didn't do anything wrong. Winning the case at trial is a distinct possibility - maybe even a probability in some instances - but it is enormously expensive. The cost of electronic discovery alone is astronomical. And, if the directors are being charged with misconduct individually, the cost in terms of stress can be very high and can have an adverse impact on the company's operations. Indeed, indemnification may not be available, and the company's D&O coverage may not be available either. Thus, it can be a very tough situation.
One of the other disturbing things about this case is the underlying implication that the directors were responsible for statements made in the company proxy statement. In point of fact, the directors do not write the proxy statement. They primarily rely on management and outside experts to do this correctly, and any implication that they have personal responsibility for the statements that it contains is going to have a chilling effect on recruiting for the board room.
Editor: And the implications of the ruling for corporate compensation practices and for an enhanced culture of corporate compliance?
Profusek: I think many companies are going to look at this case and try to improve the ways in which this process is handled. Certainly the directors are going to focus more on disclosure because it appears they have some sort of presumptive responsibility here. A variety of pricing mechanisms are under consideration at the moment. What makes the discussion a little bizarre is the fact that, under the old accounting rules there were no charges for option expenses, as there are today. Companies are digging through old files trying to determine whether they did things correctly, while we now operate under a system where this would not be relevant at all. I think this is indicative of the rather astonishing hypersensitivity in today's corporate governance climate.
Editor: Is there anything you wish to add?
Profusek: I suggest people read Commissioner Atkins' January 22nd speech and attempt to see the balance that he is trying to promote in this hypersensitive environment. Unless a little rationality is injected into the process, I think we run the risk that people will not be raising money in New York in the future, but that Europe and Asia will be the destinations of choice for capital formation. That would not be a good thing for America.