Foley & Lardner LLP co-hosted with InsideCounsel a national web-cast for corporate counsel discussing the recent stock option backdating controversy as resulting recommended stock option granting best practices and majority voting. The July 11 presentation, "Boardroom Best Practices — Stock Option Granting Best Practices and Majority Voting Update," of The Web Conference Series for Corporate Counsel was lead by InsideCounsel Publisher Nat Slavin. Mr. Slavin was joined by Foley Business Law Partners Steven R. Barth and Patrick G. Quick as well as Deloitte Financial Advisory Services Principal Chyhe Becker. The article, "Stock Option Granting Best Practices," published in the Corporate Secretary Magazine written by Foley partner, Steven R. Barth, and Foley summer associate, Charles V. Walker, also addressed similar issues. Between both the presentation and article, the issues presented include: ongoing fallout from options backdating allegations, recommended option granting best practices, and the latest developments surrounding majority voting initiatives.

Addressing Trends

The backdating of stock option grants has become a hot button issue for many U.S. companies. The practice involves changing a stock option grant date from the day it was truly granted to a prior date, usually one on which the company’s stock was trading at a lower price. As a result, an option is created that is already "in the money," or "discounted."

Additionally, certain investors increasingly are calling on companies to adopt majority voting — a process by which a director nominee is elected only if he or she receives a majority of votes cast. However, many companies are resistant to the change and continue to favor plurality voting.

These issues are anticipated to continue to gain more attention and will almost certainly impact the upcoming proxy year.

Sharing Solutions

Stock Option Grant Backdating and Other Alleged Problematic Option Practices

The controversy over stock option backdating erupted after publication of a study conducted by Dr. Erik Lie — Associate Professor and Research Fellow at the University of Iowa’s Henry B. Tippie College of Business. The study suggests that backdating may be the root cause for the abnormal rise in the value of options granted to many company executives. Professor Lie estimates that 10 percent of all option grants made prior to 2002 may have been backdated. Others have estimated that over 2,000 companies may have backdated options.

Currently, more than 80 companies are subject to investigation because of allegations of potential stock option grant backdating or other forms of alleged problematic option practices. A number of large, recognizable companies have been under investigation, including Microsoft, Home Depot, Apple Computers, Michaels Stores, and Monster Worldwide. As this issue becomes subject to more self-analysis by companies, the number of companies facing additional scrutiny is expected to increase.

In addition to backdating, companies are being investigated on allegations of other types of potentially questionable stock option grant practices, including:

  • Front running/spring loading: Granting options in advance of public disclosure of material favorable good news about the company
  • Forward dating: Granting options on a date in the future when the company’s stock is at its low point for a given period
  • Hire date timing: Artificially timing the "official" hire date of a new executive to a date that corresponds to a stock price dip, effectively making the option "in the money"
  • Phony optionees: Granting options to phony employees to create a compensation slush fund
  • Post facto favorable changes to vesting and exercise provisions making it easier after the fact for executives to exercise more of their options

The Effect of SOX on Backdating

Prior to the passage of the Sarbanes-Oxley Act (SOX) in August 2002, executives were required to report publicly their option grants once a year, on their annual Form 5 filing with the Securities and Exchange Commission (SEC). The form was due to the SEC 45 days after the company’s fiscal year end. As a result, companies considering backdating were given quite a bit of time to look back over the company’s stock price performance for the prior year to determine the stock’s low point and designate that date as the retroactive stock option grant date.

In the wake of SOX, executives are now required to complete a Form 4 filing with the SEC within two business days after their stock option grant. While this makes backdating more difficult, it still has occurred. The panel noted that nearly 20 percent of executives are filing their Form 4s up to two to four weeks late. This still gives companies enough time to review the two to four week time period and retroactively date their options.

Additionally, Financial Accounting Standards (FAS) 123R now establishes the grant date of options for accounting purposes as the date on which a company’s board or compensation committee approves the option grant.

Why Backdating Is Potentially "Wrong"

There are those who feel that option backdating may be an acceptable practice. Those who do not object to option backdating point to the need for incentives such as discounted stock options to retain and recruit valuable employees in a competitive environment, especially at high-technology companies. Additionally, they argue that issuing discounted options is just a compensation decision and does not involve the actual payment of company cash or a guarantee that the option will be "in the money" upon ultimate vesting.

However, a litany of reasons that plaintiffs have argued against the practice of option backdating include the potential:

Violation of the Company’s Stock Option Plan and Shareholder Approval Requirement

Most stock option plans do not allow the exercise price of an option to be less than 100 percent of its fair market value on its grant date. Additionally, backdating may violate NYSE/NASDAQ stock option plan shareholder approval requirements. If shareholders voted on a plan that did not allow for discounted options, it could be argued the company violated the applicable shareholder approval requirements.

Improperly Stated Financial Statements

This is the area of most plaintiffs’ focus and allegations. Backdating may cause the improper statement or underreporting of compensation expense, triggering a restatement of the company’s financials going back to the date of the mis-dated option grants. This may also result in a "claw-back" of executive bonuses paid based on misstated financial results.

Violation of Federal Securities Law Disclosure Rules

Backdating may cause a company to run afoul of federal securities law disclosure rules. For example, a company’s proxy statements may have been misstated from either an executive compensation disclosure or an option plan approval standpoint. The company may have inaccurate Form S-8 registration statements, or it may have securities offering registration statements, that misstate the nature of its option grants. Finally, companies may find themselves embroiled in litigation alleging fraud on the market, based on misstated financial statements containing understated compensation expense and overstated earnings.

False SOX Certifications

Many lawsuits allege false SOX 302 and 906 certifications by the CEO or CFO.

Failure or Weakness in Internal and Disclosure Controls

The backdating of options may lead to the identification of a material failure or weakness in the internal controls or the disclosure controls of a company.

Income Tax Ramifications

Backdating may lead to Internal Revenue Code (IRC) 409A tax problems, where there is an immediate taxation of the option spread on the option vesting date, rather than the option exercise date. Additionally, individuals benefiting from backdated options may encounter income tax avoidance issues or be accused of filing false income tax returns.

Claims of Fundamental Unfairness or Unjust Enrichment

Many plaintiff’s suits make claims of fundamental unfairness or unjust enrichment — claims that executives are realizing significant monetary gains through the potential breach of the backdater’s fiduciary duty of loyalty because the interests of the company’s executives were placed before those of the company’s shareholders. Politicians and political pundits are seizing on this aspect to justify further investigation of alleged backdating.

Loss of IRC § 162(m) Tax Deduction

Discounted options are not eligible for the performance-based compensation exclusion under IRC § 162(m).

Violation of Corporate Governance Principles or Code of Conduct

Companies using backdating may find themselves faced with allegations that they and their board did not adhere to the companies’ principles of corporate governance or code of conduct.

SEC "Books and Records" Charges

The SEC may claim that a company has a "books and records" problem or that the company’s executives lied to the auditors in connection with the company’s audit. If the SEC succeeds in pressing forward on its allegations of misconduct, it may insist on a director or officer bar, which will impact individuals serving on the company’s boards or management teams as well as on those of other publicly held companies.

Problems With Reelecting Compensation Committee Members and Obtaining Future Shareholder Approval of New or Amended Stock Option Plans

Companies may encounter difficulties with the reelection of compensation committee members who have been deemed responsible for the issues resulting from backdating of options. Additionally, companies may encounter significant problems when attempting to secure shareholder approval of new or amended equity plans. This may become significant for the 2007 proxy session.

Directors and Officers (D&O) Insurance Policy Issues

Companies engaged in backdating activity may face the possibility of problems with their D&O insurance carrier. The panel indicated the escalating number of backdating lawsuits may lead to a rise in D&O claims that also may impact overall D&O pricing and terms of coverage.

Does Your Company Have Potential Backdating Issues?

Companies are highly encouraged to perform their own self-initiated review of their historical stock option granting policies and procedures to determine whether they have potential stock option backdating issues. A number of steps a company should take when performing this review include:

Evaluate the Company’s Historical Option Granting Practice

Does the company have fixed annual or quarterly granting dates, or does it have variable and unscheduled grant dates? Companies using variable and unscheduled grant dates should question and understand the rationale for why the company engaged in this practice.

Perform a Statistical Analysis of Historical Option Grants

Perform an analysis to determine if the company’s option granting practices have resulted in abnormal economic gains to optionees. This is especially important for companies that have had variable option grant dates.

Evaluate Grant Authority

A company should evaluate its option plan to determine what it provides about the company’s grant procedures. For example, is there delegated granting authority to the company’s management?

Evaluate Communication of Option Grants

Determine how the company historically has communicated option grants through evaluation of:

  • Company correspondence with optionees and compensation committee
  • Proxy statement disclosures
  • Financial statement footnote disclosures, including auditors’ workpapers
  • Form S-8 filings
  • Securities offering registration statements and prospectuses
  • Human resource records

Next Steps, Should a Potential Issue Surface

Your company should consider this three-step approach in the event an issue is uncovered as a result of your self-review:

  • Question. Who approved the backdating of the options? Was it the company’s board of directors? The compensation committee? Management? Additionally, who benefited from the backdated options? Was it management or the general employees?
  • Confirm. If your internal review indicates there may be a problem, then immediately initiate an independent investigation into the situation, calling upon the experience of third-party counsel and/or independent forensic accountants to confirm whether an issue exists.
  • Communicate. If a potential problem is uncovered either through the internal self-review or independent investigation, report the findings to your company’s management, chair of the compensation and audit committee, the board, auditor, D&O insurance carrier, and internal relations/public relations. If an actual problem is confirmed, then report the findings to the SEC and NYSE, or NASDAQ. Prepare mea culpa public disclosures as soon as possible.

Self-Imposed Remedies

The remedies a company can take on its own are largely dependent upon who authorized the backdating of the options, who benefited from the transaction, and how widespread the behavior was. For example, allegations that a member of management backdated options for his own benefit are likely to be more serious than allegations that the board or compensation committee backdated options for the benefit of the general employee base.

However, as a short-term "fix," the panel suggested the company may need to consider voiding existing backdated options, disgorging profits on backdated options, redating option agreements to the actual grant date in order to bring options to a higher strike price, terminating offenders, and/or denying indemnification. A restatement of financial statements may also be required.

Option Granting Best Practices Going Forward

In light of the current controversy, there are several recommended best practice guidelines that companies should follow in granting options in the future:

  • Limiting the granting authority to the company board or compensation committee (having more than one member)
  • Avoiding delegated grant date authority
  • Establishing fixed and prescheduled stock option grant dates during an annual or quarterly "window period"
  • Establishing a fixed date on which the options of new hires are automatically granted (i.e., first day of the following month)
  • Disclosing publicly the granting procedures and rationale in the company’s proxy statement or Web site
  • Filing stock option grant Form 4s on time

Majority Voting Update: What Options Does a Company Have?

The panel discussed the various options available to a company facing the prospect of a shareholder effort to adopt majority voting at the company, including:

  • Adopting nothing at the present; waiting for a shareholder proposal and attempting to fight it at that time.
  • Adopting a policy under which the company’s board retains some discretion in all areas.
  • Adopting a binding bylaw amendment under which the company’s board has no discretion or limited discretion. In some circumstances, the board can take this action by itself; however, state law might not allow that action or may require shareholder approval of the action.

Latest Developments

With the 2006 proxy season over, several trends related to majority voting have been revealed, including:

Growing Support for Majority Voting Proposals

Support for majority voting proposals continues to grow among shareholders. More institutional investors are supporting the idea of majority voting, so the trend will continue.

Having a majority voting policy in place can offer a company some insulation and help defeat a majority voting proposal. However, having a self-initiated policy in place can sometimes actually encourage shareholders to submit a proposal for a stronger form of policy. Companies with policies in place often still receive shareholder proposals for a stronger form of majority voting policy; those proposals often receive shareholder support exceeding 40 percent; and in some cases those proposals have passed.

Delaware Amendments Passed

The State of Delaware has amended its corporate statute this summer relating to majority voting. Under the amendments, the board cannot override a stockholder-approved majority bylaw. The amendments also clarify the certainty and enforceability of director resignations.

However, the plurality standard — in which a nominee for an open director’s position is elected to the position upon receiving the highest number of votes — remains the default standard. A change from the plurality standard will require board or shareholder action by each company. Additionally, the Delaware state statute does not provide a mandate for majority voting, nor does it resolve "holdover" issues.

American Bar Association (ABA) Model Act Revisions

Proposed revisions to the ABA Model Act were released in June 2006. They include the opportunity for a bylaw amendment that shareholders could adopt. This change would essentially retain the plurality standard as the starting point but allow shareholders to force mandatory majority voting by the passage of a bylaw amendment. This Model Act change must be enacted on a state-by-state basis for it to be effective.

California Legislation Progress

The State of California has been pursuing its own legislation on the subject of majority voting. While that statute as initially proposed would have made majority voting mandatory, through amendments, the legislation was headed toward the ABA approach.

NYSE Proxy Working Group Recommendations Regarding Broker Voting

The NYSE Proxy Working Group has recommended that director elections should no longer be considered "routine." Should the group’s recommendations be adopted, brokers will not be able to vote on directors without directions from beneficial owners. Right now, this is only a proposal; however, final action is possible in soon, with an eye to effectiveness for the 2007 proxy season. This change would make it harder for director candidates to receive favorable majority votes.

Reasons Why Companies Should Avoid Majority Voting

Reasons companies may want to stave off shareholder majority voting as long as possible, include:

  • Majority voting has a significant impact on board decisions and may turn board actions into shareholder referendums
  • The potential for the loss of broker voting for directors and for availability of proxy materials via the Internet makes majority voting more significant
  • Open questions remain; more is learned with each new policy and passing development
  • Shareholders may not fully understand the impact of withholding votes
  • Withholding votes may further some misplaced agendas; more often, the concern is that a shareholder is not voting against a director’s performance or qualifications, but on a single, unrelated issue
  • Candidates see reduced incentives to serve on the board
  • The company may incur significant increased costs in terms of both management time and expense to obtain votes
  • Adopting a policy actually may trigger a previously unconsidered shareholder proposal

Although the majority of companies have not adopted policies regarding majority voting, a study conducted by Neil Gerber & Eisenberg indicated that nearly 25 percent have taken actions to put a policy or majority voting in place. Additionally, the study indicated that a healthy majority of those who have acted have adopted a policy that preserves the board’s discretion.

Reasons Why Companies Should Enact Majority Voting

Why should a company adopt majority voting in some manner? According to the panel during the July 11 presentation, it is a matter of perception. Majority voting is seen as inevitable, so why should a company risk being perceived as "behind the curve" or recalcitrant on an issue that is unavoidable?

Ultimately, the panel suggested companies should be proactive, delving into the issue in detail and formulating a plan to have available once the inevitable shareholder proposal is presented. Once the plan is developed, the company should take a "wait and see" approach until it is forced to act, unless it feels compelled to act earlier for other reasons.

Summary

Companies are encouraged to remain informed regarding the latest developments on each of these issues.

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.