United States: Focus On Backdating Of Stock Option Grants Intensifies

Since our June 2006 Alert, public scrutiny about the backdating of stock option grants has intensified on several fronts. The SEC, criminal prosecutors and the plaintiffs’ bar continue their broad sweep to catch companies and individuals who may have intentionally backdated stock option grants to award additional and undisclosed compensation via "in the money" stock options.

According to an SEC Commissioner, the SEC enforcement staff is presently sorting through the companies identified to date to differentiate cases of intentional wrongdoing from cases involving "dating issues arising from ministerial, logistical delays," and SEC accountants are working with accounting firms to avoid "a mass stampede of restatements because of misplaced, excessive zeal."¹ Recent academic research suggests that as many as 29% of companies may find that they have backdating problems.²

In this uncertain environment, public companies should take the initiative to determine whether there are any backdating problems with their stock option grants. Public companies can expect their auditors to ask questions about past practices regarding the timing of stock option grants, particularly in light of recent guidance to the auditing community from the PCAOB.³

The SEC has announced that it is currently investigating over 80 companies concerning possible backdating of stock option grants. United States Attorneys’ offices in San Francisco, New York, Boston and elsewhere have been conducting parallel criminal investigations involving certain of the same companies. On July 21, 2006, the U.S. Attorney in San Francisco -- who has formed a special task force to prosecute backdating cases -- filed criminal charges against Brocade Communications Systems, Inc.’s former CEO Gregory Reyes and another executive, while the SEC filed a related civil case against the same defendants plus a former CFO. The government alleges that Reyes repeatedly granted "in the money" options to nonofficer employees by falsifying option documentation to make it appear that the grants had been made on dates when the stock price was lower, that Reyes included himself in certain backdated grants, and that he also used the backdating scheme to attract key employees to the company. There is little doubt that a large number of additional companies will be investigated and may face civil charges from the SEC. In a smaller number of situations certain individuals (most likely not companies) will also face criminal charges. In addition, the IRS Commissioner has announced that the IRS is consulting with the SEC to identify companies and individuals for scrutiny regarding potential tax obligations triggered by backdated stock options.⁴

The plaintiffs’ bar has filed numerous shareholder derivative lawsuits accusing certain executives and/or board members of having manipulated stock options grants for their own benefit and thus "wasting" corporate assets. The actions are not confined to technology companies but instead target companies in a range of industries. Plaintiffs have also begun to file class action lawsuits alleging violations of the securities laws, and more suits can be anticipated where companies have a significant stock price drop following the announcement of a restatement of financial results.

The focus has thus far been on stock option grants pre-dating August 29, 2002, when the SEC first required under the Sarbanes-Oxley Act that stock option grants be disclosed within two days of the grant. This rule has been thought to have made it much more difficult to manipulate the timing of stock option grants, but work by a pair of academics from the University of Michigan published earlier this year found that nearly one-quarter of stock option grants are reported late and that Sarbanes-Oxley may not have completely stopped manipulation of the timing of stock option grants.⁵

On July 26, 2006 the SEC voted to adopt changes to the rules regarding disclosure of executive and director compensation. These new rules will change the landscape for company disclosures about their stock option programs. The SEC has not yet released the actual text of the new rules, but it has indicated that companies will be required to disclose details about their stock options grants in a table and will likewise have to include a narrative description with regard to the timing of grants of stock options.

The focus continues to be on stock option grants that pre-date August 29, 2002. However, public companies should also consider their later stock option grants, particularly if problems were uncovered with earlier grants or there have been instances of late reporting of stock options grants. Going forward, companies will need to address the new disclosure requirements mandated by the SEC.

Bingham McCutchen has been retained in a number of matters related to stock options grant timing. We are representing companies and executives facing government investigations or litigation about the timing of stock option grants.

Our partners have experience in the disciplines relevant to the issues surrounding the timing of stock option grants. These Bingham partners -- who focus on internal investigations, securities litigation, SEC enforcement defense, corporate governance, tax, employee benefits and executive compensation, and white collar criminal defense -- work together seamlessly and efficiently. They have the skills and experience either to develop and implement a plan to investigate on behalf of an independent board committee or to defend a company or executives accused of improper actions with regard to the timing of stock option grants, providing a coordinated response in multiple jurisdictions, in parallel proceedings before all levels of regulatory authority or in civil or criminal matters. They also have experience with the design and implementation of stock option plans and can provide guidance about strategies for reducing legal risks from a company’s stock option plan.

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