More than 50 publicly traded companies have announced over the past several weeks that the U.S. Department of Justice and/or the U.S. Securities and Exchange Commission are investigating how these companies dated stock option grants. A few of these companies have announced that they will need to restate previously published financial statements as a result of issues relating to option grant dates, several executives (and in some cases) directors of these companies have resigned or otherwise left their companies, and many of these companies now face a wave of private securities class action and shareholder derivative lawsuits.
The current regulatory focus on options dating practices is a reaction to a number of high-profile articles that appeared in The Wall Street Journal and elsewhere highlighting studies of public company stock option grants conducted by a private financial research organization and by Professor Eric Lie of the University of Iowa. One of these studies grouped the companies studied into "higher risk" and "moderate risk" of having backdated options. In that analysis, a company that had granted stock options to executives three or more times during the period 1997-2002 at exercise prices that matched exactly or were close to the company’s lowest stock price within 40 days of the grant date was deemed to be at a "significant" or "higher" risk of backdating. As described by the government, "backdating" means retroactively picking an option grant date earlier than the date on which the board, compensation committee, or other corporate official actually approved the grant in order to use a lower stock price in effect on the earlier date as the option exercise price. In the government’s view, backdating an option allows a company to issue a below-market value option that carries with it a potentially higher gain upon ultimate exercise of the option and sale of the corresponding option shares in the public markets.
Apart from the potential for corporate and individual liability and the risk of securities class action/shareholder suits alleging inappropriate option dating practices, companies that – inadvertently or otherwise – did not use the correct date when setting the exercise prices of granted options potentially face numerous legal issues. For example, a company may need to consider whether a financial restatement is required. Under APB 25 formerly in effect, a public company that granted a below-fair-market-value option was required to record a charge to earnings equal to the difference between the fair market value of the stock on the actual date of grant and the option exercise price (sometimes referred to as a "comp charge"). Likewise, grants could be voided if the affected company’s option plan required grants to be made at fair market value. Below-market option grants also may not qualify as performance-based grants under Section 162(m) of the Internal Revenue Code, and companies could potentially face tax audits and lose valuable tax deductions with respect to option compensation. If option backdating actually occurred at a public company, the SEC may argue that company’s proxy statements and other securities law filings were incorrect or misleading, and that SEC filings reflecting option grants may have been untimely. Recipients of discounted (i.e., below market value) stock options also could become subject to the 20% tax imposed by Section 409A of the Internal Revenue Code.
It is important for public companies to keep in mind that the specific facts relating to their option grants are extremely important when assessing whether options were granted using incorrect grant dates (and therefore exercise prices). Whether the exercise price used in granting options was appropriate will depend on the specifics of each grant. To the extent that options were granted using incorrect dates, it may ultimately be proved that this was the result of a deliberate decision to price the options involved on dates other than the dates they actually were granted, or it might also have been the result of inadvertence, unintentional administrative delay, lessthan- ideal recordkeeping or a good faith belief that the date used was entirely appropriate. Likewise, in the event an incorrect date is found to have been used, whether restatement of prior period financial statements will be required will depend, in part, on the materiality of any misstatement. Materiality (or immateriality) cannot be assumed in advance.
Since the options backdating furor began, the SEC has announced that its focus goes beyond backdating, and that it is concerned as well with what SEC Chairman Cox recently called "springloading" of option grants. "Springloading" refers to the timing of stock option grants shortly before a company’s public announcement of positive news or shortly after the announcement of negative news. In both cases, the SEC says that it is concerned about the potential misuse of non-public corporate information. On July 6, 2006, however, Paul Atkins, one of the SEC’s five commissioners, stated publicly that he does not believe that the grant of stock options immediately prior to the announcement of positive corporate news violates the federal securities laws. Rather, Commissioner Atkins stated that "[b]oards, in the exercise of their business judgment, should use all the information that they have at hand to make option-grant decisions." In Commissioner Atkin’s view, a company that grants options just before it issues material non-public information which causes its share price to rise is not engaging in prohibited insider trading because "there is no counterparty who could be harmed by [such] an options grant." Commissioner Atkins also stated that, in his view, improper backdating has not occurred where directors approve the grant of options on a certain date and the written consent memorializing that action is not signed by each of the directors involved until a later date.
The SEC also has said that it intends to issue new rules requiring enhanced disclosure concerning option dating practices. Anticipating these new rules, the SEC recently asked the Public Company Accounting Oversight Board (the entity that oversees public accounting firms) to hold off issuing guidance regarding what option grant issues accounting firms should examine as part of their audits.
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