"The Key To Any Securities Investigation Is Materiality"

Tuesday, May 1, 2007 - 01:00
Jonathan E. Rich

Editor: Mr. Rich, would you tell our readers something about your professional experience?

Rich: I have been in practice for over 25 years. I represent a wide range of clients in complex commercial litigation and white collar criminal defense matters. I have defended companies and individuals in SEC enforcement actions, securities fraud class actions, federal and state criminal prosecutions, regulatory investigations and internal investigations. Many of those cases include claims of securities fraud. I have also represented clients in a broad range of commercial disputes, including breach of contract, copyright and trademark infringement, licensing, trade secrets, unfair competition, product liability, royalty conflicts and wrongful termination. The industry sectors from which these matters arise are equally varied and include telecommunications, entertainment, pharmaceuticals and health and wellness products.

Editor: How did you come to Proskauer Rose? What were the things that attracted you to the firm?

Rich: I came to Proskauer in 2000. I was attracted to Proskauer's reputation for excellence in all aspects of practice. Proskauer's Los Angeles office particularly appealed to me because it offers the resources of a world-class law firm with the intimacy of a growing, dynamic office.

Editor: Please tell us about your practice. How has it evolved over the course of your career?

Rich: I began at Hughes Hubbard & Reed in New York. I then joined the Legal Aid Society of New York, where I was a public defender in Manhattan Criminal Court. From there I returned to private practice in a suburban firm outside Philadelphia. I moved to Los Angeles in 1997 for professional and personal reasons. My practice at Proskauer is a synthesis of the past 25 years in criminal defense and commercial litigation.

Editor: Please give us an overview of the current key issue in corporate compliance - the backdating of stock option grants. For starters, what is the practice of backdating?

Rich: The stock option exercise price is supposed to be the market price of the stock at the grant date. Because the option value is higher and the exercise price is lower, executives prefer to be granted options when the stock price is at the lowest. Backdating, in general, as it relates to Justice Department investigations and SEC enforcement actions, is the practice of picking grant dates for the company's executive stock options that coincide with dates of low closing prices without complying with the company's written stock option plan. As alleged by the government in these cases, this practice has been accompanied by the preparation of documents that falsely indicate that the options grants were made on an earlier date.

Backdating, as alleged by the government in these cases, allows executives to choose a date when the market price was low, thereby inflating the value of the options. The SEC and the Justice Department consider backdating in these circumstances to be fraudulent and to violate securities laws.

Editor: I gather that more than just "backdating" is under review. What appears to be under scrutiny is the whole concept of the timing of options.

Rich: The SEC has apparently been reviewing "spring loading' and "bullet dodging" practices. These terms reflect the timing of option grants before expected good news or after expected bad news. We have seen conflicting accounts of the SEC's position on these practices. Some sources suggest that the SEC considers these practices to constitute insider trading.

Editor: These activities have gone on for some time. Why have they only come to light recently?

Rich: SEC Chairman Christopher Cox has said that the SEC's scrutiny of the practice is part of its focus on the quality of disclosure of executive compensation.

Editor: Is there a particular focus on the part of government investigations today?

Rich: I understand that there are currently anywhere from 120 to 170 cases that are being investigated by the SEC. The SEC has itemized some of the characteristics that it looks for when examining these cases. These include the duration of misconduct, the quantitative materiality of any unreported compensation, the quality of the evidence and scienter. The SEC will also review whether there is evidence of concealment or obstruction. Given the publicity of recent investigations, we expect to see more high profile actions.

Editor: What are the consequences to a company that, innocently or otherwise, has one date for the granting of options and another date for determining the exercise price?

Rich: Materiality to the company's financial statements is important to any securities investigation. If it is material, backdating may have serious repercussions to the company. The company's accounting of stock options may be affected by backdating, including any failure of options granted to the top five executives to qualify as performance compensation under the Internal Revenue Code. The company's financial statements may fail to disclose an accounting charge during the required period. The company may be required to include a charge against earnings in prior periods to account for the option discount during the vesting period of the option.

A failure to accurately reflect options grants in a company's records may rise to a books and records violation under Section 13 of the Exchange Act. A failure to have adequate systems in place for documenting and recording the options may also be seen as a deficiency in the company's disclosures and its internal controls and procedures.

As to the shareholders - who are paying the inflated compensation - backdating may invite civil lawsuits, very probably class actions for securities fraud and breach of fiduciary duty.

Editor: What about the consequences to the company in terms of investor confidence and the perception of the general public?

Rich: These cases highlight the need for public companies to ensure that their internal controls and oversight structures adequately prevent stock options from being granted in ways that are contrary to shareholder approved plans. In the event such backdating is discovered, companies must demonstrate to regulatory agencies and to the general public that they are addressing the problem.

Editor: Our publication is directed to corporate counsel. What steps should be taken by general counsel of a company perceived to have an options timing problem?Rich: Under Sarbanes-Oxley, attorneys who learn of a securities violation must report that information to the company's chief legal officer. If there is reason to believe that the chief legal officer is not responding appropriately, they must report the violation to the company's audit committee or such other committee as may be charged with independent oversight.

To the extent that there is credible evidence of a violation of law or breach of fiduciary duty, it seems likely that the SEC will deem that violation to be material if it involves backdating of options. The SEC and the Justice Department will want to know that the company is a good corporate citizen and that it is not complicit in any unlawful conduct that may have occurred. It is therefore incumbent on general counsel to consider retaining independent outside counsel to work directly with the audit committee and independent directors in order to ensure the independence of the company's internal investigation.

Editor: Suppose general counsel is himself a beneficiary of stock option grants?

Rich: General counsel should project credibility and good faith at all times during the internal investigation. This may require the general counsel to step aside and defer to the company's outside law firm. The selection of outside counsel is very important. Though it is possible for an outside firm with preexisting ties to the company to be independent, the credibility of general counsel and the company will be enhanced if they work with outside counsel that has no such ties.

Editor: SEC Commissioner Atkins recently gave a speech in which there seems to be a suggestion that we may have gone too far with this scrutiny of stock option grants and the timing question. Do you have any thoughts on whether the pendulum will swing back?

Rich: It would be imprudent for any corporate counsel to think that these investigations are going to go away any time soon. Though it is essential for corporate counsel to be sensitive to the ways in which the regulatory agencies view these issues, they should assume that the SEC will continue to view these transactions with some level of scrutiny. Also, no matter what the regulatory climate may bring, corporate counsel should always be sensitive to questionable practices and be prepared to diligently investigate, report and correct unlawful conduct.

Please email the interviewee at jrich@proskauer.com with questions about this interview.