Canada: Stock Option Backdating: What Every Director Should Now Know

The number of U.S. cases grows and media attention heightens:

  • UnitedHealth – Financial restatement of between $400 and $600 million
  • Comverse – Top executives found guilty of criminal charges, while paying roughly $3 million to settle civil accusations of fraud – top lawyer sentenced to a year and one day for his role in the backdating scheme
  • Maxim – Delaware judge opens the floodgates for shareholder derivative suits in backdating cases

American courts have brought the practice of stock option backdating to the forefront. Described by the Wall Street Journal as "the perfect payday"1, some company executives and directors are now beginning to suffer the consequences of a practice that saw several of them draw undue profits after issuing stock options on dates hand-selected to coincide with favourable exercise prices.

The American Perspective

The number of cases involving options backdating continues to rise in the United States. There have already been nearly 150 shareholder derivative lawsuits filed, as well as over 100 public inquiries launched by both the SEC (Securities and Exchange Commission) and DOJ (Department of Justice). Nearly 40 directors and officers have resigned as a result of these investigations. Just how high these numbers will climb is not yet certain; according to a study conducted by Professor Lie of the University of Iowa, an estimated 30%, or 2 300, American corporations have engaged in the backdating of stock options.2

Recent court decisions have given way to a variety of actions against both company executives and directors. Of late, Delaware's Court of Chancery has agreed to hear a shareholder derivative suit that is aimed at both the directors and the recipients of backdated stock options; the former for a breach of their fiduciary duty, and the latter for unjust enrichment.3 The case of former Comverse CFO, David Kreinberg, highlights the reality that repercussions may extend beyond civil liability. Having been the first to plead guilty to charges of fraud and conspiracy in relation to backdating, Mr. Kreinberg was also forced to pay $2.4 million in order to settle civil fraud charges. The situation is similar for Comverse's former general counsel as well as former CEO, Jacob Alexander.

With Canadian corporate culture generally considered akin to that of the United States, the question of whether or not options backdating will reach scandalous proportions North of the border inevitably presents itself. In anticipation of this possibility, there is certain information that all company directors should now be aware of.

Backdating Defined

At its root, backdating allows for the use of hindsight when determining the grant date for stock options and therefore the price. By drafting or modifying the grant document to reflect a past date associated with a favourable exercise price, one may create the illusion that the decision to grant options was, in fact, made on the indicated date. While, according to the grant document, it appears that options are offered "at the money", meaning at a price equal to the share price at the time of the grant, the options are, in reality, offered "in the money". As opposed to an "at the money" option, an "in the money" option holds an intrinsic value; there is already a built-in profit at the time of the grant.

Options backdating contravenes the very nature and purpose of stock option grants. Originally conceived as a tremendous tool allowing companies to attract talent and reward employees without affecting cash flow, stock options also serve to align the interests of company executives with those of shareholders. The granting of an "in the money" option clearly negates such an alignment.

Backdating Techniques

Modifying the Supporting Document

In its most traditional form, backdating is accomplished by the intentional modification of the minutes of the meeting in which an option grant is authorized. Such situations make it possible to modify not only the date of a grant but also the number of options in question and the identities of the grantees. As highlighted by Delaware courts, it is the intent with which these actions are taken that causes them to be in bad faith, thus opening the doors to director liability.4 This element of intent is also present when other backdating techniques are employed. Certain practices are more likely to raise red flags than others; grants by unanimous written consent and large grants with long lists of grantees are among such practices. Open-ended clauses reading "effective as of", as well as long, ambiguous lists attached to more complex grant documents, are particularly likely to raise suspicions of misconduct.

Spring-loading

Beyond practices involving the modification of grant documents, the value of options may also be inflated by timing a grant in relation to the release of information that is likely to affect stock price. For example, "spring-loading" takes place when a grant is authorized prior to the publication of positive information that is likely to cause a rise in stock price. In this case, the result is not only a more favourable exercise price but the likely contravention of Canadian securities legislation as well.

The Canadian Perspective – CSA Staff Notice 51-320

response to potential concerns over the situation in the U.S., the Canadian Securities Administrators (CSA) released a staff notice5, which provides directors with certain guidelines intended to reduce the risk of non-compliance with securities legislation. These guidelines include, among other points, (i) the establishment of a compensation committee; and (ii) the adopting of policies regarding corporate disclosure, insiders and "black-out" periods around earning announcements. The notice concludes with a warning that enforcement action may be taken if the CSA is made aware of any non-compliance with securities legislation.

While the CSA indicates that options backdating is not as rampant in Canada as it is in the U.S., the preliminary results of a study reported in the Chicago Tribune appear to suggest that the practice is nevertheless present in this country.6 Although only a preliminary report has been compiled to date, the study notes that, following the examination of 66 of Canada's largest corporations, exchange practices in line with those of backdating were found. While conclusive evidence has yet to be reported, the study highlights the fact that the opportunity was present.

Rommendations When Faced With Inquiries, Derivative Suits or Class Actions

Inquiries

Following the significant amount of press surrounding backdating cases, some companies are starting to conduct internal inquiries into their own option granting practices. Be it internal or not, the primary goal of an inquiry is to determine whether, in fact, backdating has occurred.

Depending on both the factual situation and the budget, the early stages of an inquiry may involve the employment of forensic accountants, as well as the production of a statistical analysis outlining the more suspect grants. In certain cases, statistics may constitute overwhelming evidence; the WSJ determined that the odds of systematically authorizing grants on ideal dates are around 1 in 300 billion.7 At the very root of the process, it is crucial to identify all individuals implicated in the granting of options and to gather all relevant documents.

A rather wide range of documents could be potentially significant. To begin, a company's stock option plan, as well as any other written policies and procedures may provide a preliminary understanding of grant practices. Meeting minutes are often the most significant evidence if the grant was authorized in an actual meeting. Furthermore, Minute books may also contain any grants by unanimous written consent. Often the most damning evidence of backdating, as witnessed in the Comverse case, comes from internal communications such as e-mails, memos and meeting notices, which may help establish the reality behind a given situation.

Derivative Suits

With shareholder derivative suits clearly established as the most frequently used judicial recourse for backdating cases in the U.S., they may be brought against both directors for a breach of their fiduciary duty, as well as against any grantee of backdated stock options for unjust enrichment. Claims are also possible when a director or officer of a corporation fails to implement any form of control over the granting of stock options or, chooses to neglect the methods of control already established.

Class Actions

Resulting from the fact that stock prices have remained relatively stable in the majority of backdating cases, there has not been an overwhelming number of class action suits filed in the U.S. This does not, however, negate the possibility of future class action lawsuits in relation to the timing of options.

Outlook

While it remains to be seen whether or not stock option backdating will ever erupt into a scandal North of the border, it has become clear that Canadian securities authorities have prepared themselves for the possibility. As a result, it is only prudent that company directors do the same; self-awareness of one's option granting practices is key at this point.

On a different front, options backdating has caused many American insurers to re-examine their Director and Officer policies. In many cases, these policies contain exclusions related to the conduct of the director and officer. Generally, a policy will not insure against intentionally fraudulent conduct, an issue that highlights the importance of differentiating intentional backdating from errors in accounting.

Gowlings can provide assistance and guidance to review your Directors and Officers policies and your option granting practices, as well as any other compensation plan.

Footnotes

1. Wall Street Journal (18 March 2006).

2. Lie, E., 2005, On the timing of CEO stock option awards, Management Science 51, 802-812.

3. Ryan v. Gifford , WL 416162, (Del.Ch. 2007).

4. Ashby Jones and Mark Maremont, "Maxim Ruling Opens Door For Backdating Cases" Wall Street Journal (8 February, 2007), online:
Advisen FPN

5. CSA Staff Notice 51-320

6. Stuart Weinberg and Mark Heinzl, "Backdated options in Canada?" [Chicago] Tribune (3 December 2006, this article is now an archived document)

7. Wall Street Journal, supra note 1.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions