UK: Backdating? Not An Option!

Last Updated: 4 January 2007
Article by Francis Kean and Roderic McLauchlan

Originally published in BLG’s Directors’ and Officers’ Liability Review, Winter 2006

In this article we explain what lies behind the ongoing SEC investigations and related US litigation in respect of allegations that certain directors of well known companies wrongly backdated stock options for their own benefit. We look at the nature of the liabilities to which these allegations may give rise and consider whether and to what extent directors of English companies may face similar problems. We also look briefly at the D&O coverage implications.

Since the Spring of 2006, US criminal and regulatory authorities have been investigating the backdating of stock options. They have been seeking to determine if executives wrongfully backdated stock option grants between the late 1990s and August 2002. In this article we explain the problem and see to what extent it may have an impact on the UK market.

What are executive stock options?

A stock option is a contractual right granted to executives to purchase a stock in the future at a fixed price: the "exercise" or "strike" price. In the US, the right will often not vest for at least a year. If the current market price is higher than the date of the option grant, then the option holder captures that profit. The crux of the matter is that the grant dates can be chosen retrospectively. The grant date would typically be at a low point in the stock price, in order to increase the profit gained when the stock is sold at market price.

However, this practice allegedly runs foul of disclosure rules in the US concerning executive remuneration, as well as corporate accounting rules and tax laws. Although some companies did disclose the practice, others did not reveal to shareholders this aspect of executive remuneration. Furthermore, according to US accounting rules, backdating an option grant is deemed to be the payment of additional compensation to the recipient and must be accounted for as an expense, which it appears that certain companies failed to do. By backdating, they caused the overstatement of earnings and the underbooking of compensation expenses. Finally, both the company and the executives may have broken tax laws if the option "exercise" dates and the resulting profits are not accurately recorded. Further investigations are ongoing on the backdating of "exercise" dates to reduce tax burdens.

By the end of October 2006, the SEC was investigating 105 companies, including such well known companies as Apple, Gap, Home Depot and BEA Systems. Some companies have announced that they would consider adjustments to their financial statements for non-cash charges for stock-based compensation over several years, in some cases as far back as 1998.

The investigations have been swift and SEC civil actions have led to substantial settlements. Other companies have voluntarily carried out internal investigations, and if backdating has been discovered, restatements of financials have followed. By one estimate, charges totalling $5.3 billion have been taken to account for the improper grants. It should be noted that the most serious allegations arise from the "telecom bubble" of the late 1990s to 2002. It may be that the provisions of Sarbanes-Oxley have discouraged most companies from continuing the practice in recent times.

Unsurprisingly, the SEC investigations have generated numerous civil law suits, both investor class actions and derivative actions. The investor class actions allege that there have been misrepresentations in the financial statements, and contend that damages were caused by the improper dilution of the value of the investor stocks because executives received millions of dollars in stock options at lower option prices than they were entitled to. That said, because few of the target companies in fact suffered a decline in their stock prices once the information was revealed, proof of damage to shareholders will be a difficult evidentiary threshold to overcome.

For this reason, many of the civil claims are derivative actions against the executives involved, brought by shareholders on behalf of and in the name of the company, on the basis that the executives of the company were in breach of their fiduciary duties to the company. These actions seek rescission of the options, compensatory and punitive damages, corporate governance changes and legal fees. Indeed, numerous US states allow claimants’ lawyers to be indemnified by the company for costs incurred in prosecuting derivative actions. This is a significant incentive for the claimants’ bar.

Could this problem affect UK companies?

In the UK, although stock options are commonly part of remuneration packages, they are neither as prevalent nor of the same magnitude. Further, comparatively stringent governance standards - in particular the Directors Remuneration Regulations 2002 - have dampened the risk of any serious manipulations. Under the Disclosure Rules of the 2002 Regulations, companies have only a 42-day period to grant options and allow them to be exercised. This reduces the window for any price fluctuation. More importantly, during the period from 1997 to 2002, many of the stock option plans also imposed performance conditions, which would significantly narrow any opportunity for backdating. The level of options granted was much smaller as well. Finally, there has been stronger shareholder resistance to large option packages in the UK.

Whilst civil litigation is less likely, a real prospect of regulatory investigation exists. The FSA’s newsletter of September 2006 specifically addressed backdating of options. The FSA warned market-listed companies that they should recall that they face fines and sanctions if they try to manipulate stock options. They warned both against "springloading" (bringing forward the timing of option grants to allow executives to benefit from a rise in share price, caused by the release of positive news) and "bulletdodging" (delaying grants until share prices fall after negative news). Because the granting, buying and exercising of options falls within the meaning of "dealing" with securities, they would potentially be subject to "market abuse" sanctions and penalties, if such dealing is done on the basis of inside information by executives. Whether the warning is necessary and whether investigations will result is a matter to be watched.

Insurance implications

Directors and officers, and the risk managers for their companies, may wish to consider to what extent they would have insurance cover if either a regulatory investigation or a civil action were commenced. Indeed, there have already been reports of insurers specifically excluding "option" related losses. Certainly, insurers will be scrutinising their insureds’ compensation plans to assess the potential for any claims being asserted. Among the issues insurers may need to consider is the threshold question as to whether a claim seeking a return of profits made by executives is covered under a D&O policy at all. Arguably, depriving an individual of something to which he was not legally entitled in the first place does not result in an indemnifiable loss. Questions may also arise as to the potential application of the so-called "personal conduct exclusions".

However, even if some of these issues arise, many policies will provide indemnity for defence costs until there has been a final adjudication on the claim. As always, policy response will require a close analysis of the specific policy language against the allegations and causes of action in each claim.

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.

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