United States: What's Wrong with Stock Option Backdating?

What's wrong with stock option backdating? The short answer is that there is nothing wrong with backdating stock options if appropriate procedures are followed and the transactions are properly accounted for and disclosed. Backdating is a practice of locking in financial gains by retroactively pricing stock option grants on days when a company's stock price is low, thereby increasing the value of the options. This practice is legal when properly recorded as a non-cash corporate expense. Then why have more than 170 companies been investigated since 2007 by the Securities and Exchange Commission (SEC) and other federal authorities for potential fraud in connection with stock option backdating (SOB) practices?

At its peak, about 125 companies were under investigation for alleged accounting violations and improper disclosure related to the backdating and pricing of stock options awarded to attract and incentivize corporate executives. More than 100 companies have restated their earnings to account for backdating, and the SEC has filed civil cases related to several dozen of those situations. To date, the Justice Department has also brought criminal charges against several companies or their executives with respect to alleged improper backdating schemes and cover-ups.

Over the past couple of years, many press reports have talked about a federal criminal lawsuit against Broadcom Corporation and its senior executives for alleged fraud. In December 2009, a federal judge threw out the fraud charges and essentially terminated one of the last SOB cases brought by federal prosecutors. U.S. District Judge Carrey dismissed the Broadcom case before jurors began their deliberations because he found that prosecutors had improperly intimidated witnesses and "distorted the truth-finding process." The judge also expressed doubts about whether the supervising executives at Broadcom had intended to commit any crimes.

The same U.S. attorney for the Central District of California brought another criminal case last year against the former chief executive officer of KB Homes Inc. for fraud in connection with SOB practices over a number of years, beginning in 1999. In 2007, KB restated its earnings to reflect more than $36 million in compensation expenses for SOB practices from 1999 through 2005. The CEO's defense in the KB case is the same as the one used by the two Broadcom executives – that he believed he was acting legally and that the company's SOB practices were above board and not covered up in any way. Last month, the federal judge declined to investigate claims of alleged prosecutorial misconduct in the SOB criminal case of KB's CEO and, if convicted, he faces up to 415 years in federal prison.

A former executive for human resources (Ray) of KB has testified against the CEO in the criminal case, claiming that the company changed its policy for awarding stock options in 1999 after Ray and the CEO were unable to convince the compensation committee chair to support a separate plan. In May of 2009, Ray agreed to pay $550,000 to settle civil charges brought by the SEC stemming from the SOB scheme at issue in the fraud case against the CEO. Although he did not admit or deny the allegations in his settlement of the SEC's civil complaint, earlier – in December 2008 – Ray had pleaded guilty to conspiring in 2006 with the CEO to obstruct an investigation of SOB practices at KB. Ray faces up to five years in prison in that criminal case.

The SEC's civil complaint against Ray, filed in U.S. District Court for the Central District of California on May 14, 2009, is instructive with respect to the SEC's enforcement approach regarding SOB violations. The complaint alleges that Ray used "hindsight" to pick advantageous grant dates for KB's annual stock option grants in order to enrich himself and others. On several occasions, the grant dates coincided with dates of the lowest monthly closing prices for KB's common stock. Even after the passage of the Sarbanes-Oxley Act of 2002 (SOX), which changed the reporting rules for officers and directors who change their stock ownership (including receiving stock options), Ray and the CEO continued to use a "wait and see" strategy to pick grant dates that would maximize the value of stock option grants.

In mid-2006, when KB's unusually advantageous option grant dates came under media scrutiny, Ray and the CEO allegedly fabricated an innocent explanation for the SOB scheme for KB's audit committee. Furthermore, Ray allegedly lied in interviews with KB's chief legal officer when he said that the stock options process was not manipulated in any way, and that hindsight had not been used to select annual option grant dates.

On the basis of the aforementioned recital of facts in the SEC's complaint, the Commission lodged the following allegations against Ray. First, by engaging in the SOB scheme, Ray committed fraud in connection with the purchase or sale of securities in violation of Section 10(b) of the Securities Exchange Act of 1934, as amended (Exchange Act), and Rule 10b-5 thereunder. Second, Ray falsified the books and records of KB and circumvented internal accounting controls by perpetrating the SOB scheme. Third, Ray violated the "insider" reporting requirements under Section 16(a) of the Exchange Act and Rule 16a-3 thereunder, which require the filing of statements of changes in beneficial ownership of common stock (and stock options) for officers and directors at the end of each calendar month in which there is a change. Fourth, Ray, directly or indirectly, falsified or caused to be falsified KB's books, records and accounts in violation of Rule 13b2-1 under the Exchange Act. Fifth, Ray aided and abetted KB in filing materially false and misleading periodic reports and proxy statements, committing record-keeping violations, and violating internal accounting controls and procedures under Sections 13 and 14(a) of the Exchange Act and Rules 12b-20, 13a-13 and 14a-9 thereunder. With respect to each aiding and abetting violation, Ray allegedly provided substantial assistance to KB either in failing to make or keep books, records and accounts in reasonable detail that fairly and accurately reflected transactions and disposition of the company's assets or in filing and issuing false reports and proxy statements.

The types of relief that the SEC requested in its civil case against Ray are typical of other similar actions involving alleged SOB or other fraud violations. In addition to requesting the court to find that Ray had committed the alleged securities law violations, the SEC asked that Ray be permanently enjoined from violating the antifraud and other provisions of the Exchange Act recited in the allegations. Further, the SEC asked the court to order Ray to pay civil penalties under Section 21(d)(3) of the Exchange Act. As is common in any civil action brought by the SEC for insider trading or other fraud-related violations of the federal securities laws, the SEC also requested that the court enter an order prohibiting Ray from serving as an officer or director of any company with registered securities under Section 12 of the Exchange Act. Ray agreed to a court order settling the SEC's charges without admitting or denying the allegations, which is typical in these cases, requiring him to disgorge his gains with interest and to pay a civil penalty as well as barring him from serving as an officer or a director of a public company for five years.

At the center of the Ray and other SOB civil and criminal complaints are allegations of manipulation and fraud by the corporate executives who are responsible for overseeing their companies' compliance with the federal securities laws. Although these cases are difficult, time consuming and expensive to investigate and prosecute, federal authorities have proved their willingness over the past few years to expend significant resources to uncover and prosecute SOB schemes that enrich corporate insiders at the expense of shareholders. In addition to existing record keeping, internal audit and reporting requirements under the Exchange Act, SOX stresses the role of audit committees in the oversight of internal controls over financial reporting. The NYSE listing standards also provide that the audit committee should oversee the steps that management takes to monitor and control the company's major financial risk exposure. Under federal sentencing guidelines governing the imposition of criminal penalties against a corporation, one of the mitigation factors taken into consideration is the extent to which a company's board is involved in overseeing areas of risk and promoting a culture of ethics and compliance with law. Stock option award and backdating practices should therefore be approved by the board's compensation committee and reviewed by the audit committee on a regular basis. Any discrepancies should be reported to the full board and appropriate corrective measures should be taken promptly.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.