Lessons From the Stock Options Scandals

A Q&A with White & Case’s Owen C. Pell and Kenneth A. Raskin

November 1, 2006

More than 220 companies are currently targets of SEC, IRS, US Department of Justice and internal investigations into whether they backdated or in other ways manipulated stock option awards illegally. More than 130 companies have said that they must restate financial results, with the revelations triggering more than $12.2 billion in restatements, revisions and charges. In addition, they have prompted the dismissal of more than 90 corporate executives and directors. More federal and state investigations, and criminal prosecution and shareholders’ lawsuits, may ensue.

In late July, federal prosecutors filed the first criminal charges based on back-dating, charging securities fraud against executives at Brocade Communications for possible manipulation of options, and the SEC filed a civil complaint. The scores of companies facing probes range widely across industries and in size, from giants such as Barnes & Noble and UnitedHealth to smaller companies such as Altera.

Owen Pell, a corporate defense partner in White & Case’s New York office and Kenneth A. Raskin, global head of White & Case’s Executive Compensation, Benefits and Employment Law practice, both key members of the stock options task force, recently discussed some of the top concerns for clients.

Q: What exactly is backdating of options and why has the practice become controversial?

Raskin: Stock options basically allow the holder the option to buy a certain number of company shares at a certain price for a set period of time. The price is usually the price the stock traded at on the date the option was granted. If the stock price rises above the price at the option’s grant-date, the option becomes in the money—in other words, the holder of the option can buy the shares at the grant-date price—less than market price.

Backdating of options occurs when an earlier date is selected as the official grant-date for an executive or employee receiving the options. Generally, companies that are currently being investigated by authorities had chosen grant dates when their options were below market value.

Pell: What the SEC is focusing on is whether the backdating grants have been disclosed properly and if accounting rules have been stretched to the point of falsifying information. If employees have been granted stocks at a lower price, they are getting bigger payoffs than they are entitled to, and thus diluting the value of shares for the other stockholders.

Q: Can you elaborate on how the backdating was done improperly?

Raskin: While backdating itself is not per se illegal, it can be, if not undertaken properly. That means the backdating must be done with proper authorization, proper disclosure, proper accounting and with the proper tax treatment. But apparently, in the cases under investigation, the backdating may have been done without proper accounting and without proper disclosure, which violates securities laws. In the Brocade case, for example, authorities are basically charging that executives were engaged in securities fraud because they changed stock option dates and concealed the fact. From the tax perspective, a company that doesn’t properly report grants of in the money options might not be paying all the taxes it should.

Q: Why do companies offer stock options?

Raskin: For years, many US companies have provided executives and employees with stock options as an incentive. In the late ’90s, technology companies began utilizing the practice in record numbers to attract better job candidates to start-ups and high-tech firms, and then backdating the options to maximize the package they could offer. Options are essentially awarded as a way to help motivate executives to boost the company’s stock price—if the stock rises in value, their options will become more valuable as well, of course. Options are also offered as a way to attract talented executives to companies while conserving the company’s cash, which is why so many technology start-ups offered options and why they are now the primary targets for investigation.

Q: What prompted the current furor over backdating?

Pell: The practice of backdating goes back many years, but only came to widespread attention with an academic report written a couple of years ago by a researcher at the University of Iowa, Erik Lie. He studied the movements of thousands of companies’ stock prices after the award of stock options between 1992 and 2002, and concluded that there had to have been illegal backdating. This captured the attention of the SEC and the Department of Justice, which, in the wake of the Enron and Worldcom scandals, have become even more vigilant about accounting irregularities and improper disclosure that may occur with backdating. This in turn fed the interest of the press. Since then, the issue has exploded.

Q: If a company is targeted for investigation, what should it do?

Pell: Companies should immediately examine their stock option policies and launch a complete and thorough internal investigation, including with respect to accounting issues. If they do uncover any irregularities, they should immediately consult with experienced regulatory and corporate defense counsel to determine the best way the company should position itself with the SEC or the DOJ. If companies opt not to disclose irregularities to regulatory agencies, the end result will likely be a much harsher punishment and significantly higher penalties than if they cooperated in the first place.

Q: Are there any insurance issues with investigations into timing of stock option grants?

Pell: Definitely. Companies need to carefully analyze their D&O insurance policies as to the extent of coverage and as to claim reporting requirements. Individual officers and directors covered by those policies need to know what exclusions may apply, and whether the insurer can rescind their insurance if the company’s financial statements, which the insurer considered in deciding whether to underwrite the insurance, will have to be restated.

Q: Where will the current investigations lead?

Raskin: It’s likely that the investigations will continue, at least for some time to come. It’s also likely that backdating is in fact a practice that has dwindled by now. That’s because Sarbanes-Oxley, in 2002, required that option grants be reported within two days, which made concealing information more difficult. Before that, although the SEC had required that option grants be carefully reported, starting way back in 1992, the reporting could be delayed quite awhile, which meant that records could be easily manipulated.

The SEC has since taken action, recently voting for a major change to its disclosure requirements for executive compensation. The new rules are intended to ensure that compensation arrangements are disclosed more clearly and completely to investors.

Pell: Backdating may also become a basis for shareholder and derivative class action suits, which heightens the need for experienced outside litigation counsel to be involved in a company’s internal examination practices.

Owen Pell is a partner in White & Case’s Corporate Commercial Litigation Group. Mr. Pell’s areas of practice include complex commercial litigation, securities litigation, bankruptcy litigation, litigation involving foreign sovereigns and their state-owned entities, and litigation involving issues of public international law. Mr. Pell represented Deutsche Bank in class and other securities actions relating to the collapse of Enron. In addition, Mr. Pell has advised companies and conducted investigations relating to relating to fraud, lender liability,Sarbanes-Oxley and the Foreign Corrupt Practices Act compliance.

Kenneth A. Raskin is head of White & Case’s Executive Compensation, Benefits and Employment Law Practice Group. He provides counsel on the entire spectrum of employee benefit concerns. Mr. Raskin advises both corporate and individual clients on executive compensation issues. He provides counsel in the design and negotiation of executive employment contracts, incentive compensation arrangements, stock option plans, non-compete agreements, severance arrangements and parachute plans. A Certified Public Accountant as well as an attorney, Mr. Raskin has represented clients before federal, state and city tax agencies. He provides ongoing advice to clients on the implications of new legislation and regulations and specific actions concerning compensation and benefit plans.

“Talking” features White & Case lawyers answering questions about emerging legal and business issues. For more information about White & Case’s Stock Options Task Force or to schedule a lawyer interview, please contact Roger Cohen at .

Any information contained in this interview is for educational purposes only. It should not be construed as legal advice.