Home » News & Events » Publications » White Collar Crime Articles » MA Lawyers Weekly, Opinion, August 21, 2006

Backdating Stock Options: Cost of "Scandal" Promises To Be High

By Michael A. Collora and William J. Lovett
Published: Opinion, Massachusetts Lawyers Weekly, August 21, 2006

Virtually daily since March, the business sections of financial newspapers have revealed yet another company under investigation for possibly backdating stock options granted to its corporate officers.

Of the more than 80 companies with problems in this area, at least seven publicly traded Massachusetts companies have recently received Securities & Exchange Commission or federal grand jury subpoenas for records relating to their granting of stock options to top executives.

The focus of these SEC and Department of Justice investigations, as well as class-action lawsuits filed on behalf of investors, is the apparent practice of backdating the grant date on stock options issued to top executives to obtain a low strike price.

Backdating essentially provides management with stock options that are "in the money" when the options are issued, resulting in an immediate gain to the recipient. This practice has been described by commentators as betting on a horse race the day after it was run or purchasing a lottery ticket after the winning number is announced. See Marcy Gordon, "Stock backdating irritates investors and bothers SEC," Associated Press (June 18, 2006); Gordon, "Latest stock option cases have new twists," Associated Press (June 12, 2006).

Hi-tech companies in Massachusetts, such as Brooks Automation in Chelmsford and Analog Devices, Inc., in Norwood, were initially the focus of the government's investigatory efforts. Recently, however, the probes have spread into other sectors.

Sepracor, a Marlborough pharmaceutical company, and American Tower Corp., a Boston-based wireless and broadcast communications company, have both reported receiving inquiries from the SEC.

Brooks Automation has been named in multiple civil suits alleging breach of fiduciary duty and various securities law violations. See e.g., Gedell v. Brooks Automation, Civil No. 2006-01808 (Middlesex County). Brooks recently disclosed that its former CEO and two directors signed a false document allowing the CEO to exercise stock options after the expiration date.

As the list of companies under investigation and named in lawsuits grows daily, companies here and elsewhere will be forced to deal with the legal fallout, including potential federal criminal charges in egregious cases.

Background

A stock option gives the recipient the right to buy company stock at some predetermined point in the future at a price normally set at the time the option is granted (exercise or strike price).

The use of stock options in executive compensation strives to give the recipient an incentive that is tied to the company's stock price. If the stock price increases, the value of the option rises accordingly. For tax purposes and in an effort to tie the option to long-term performance, the right to purchase the stock traditionally vests over a period of time and is dependent on an increase in the employer's stock price.

Beginning in at least November 2005, the SEC began an investigation of certain registered companies that utilized stock option plans for their executives focused on management's method for choosing the exercise price for options.

The investigation was triggered, in part, by a 2005 study by Erik Lie, a University of Iowa professor who reviewed publicly filed documents by companies with stock option plans and found that numerous executives received stock options at prices at or near the low price for the quarter. His study suggested that the option exercise prices were being rewritten to capture immediate profits. Lie, "On the Timing of CEO Stock Option Awards," 51 Management Science 802 (May 2005).

Although the backdating of stock options grants is not per se prohibited if properly disclosed, undisclosed backdating may expose corporations and executives to both civil and criminal liability in the area of tax law and securities law.

For tax and financial reporting purposes, historically companies have granted stock options to executives "at the money" where the exercise price is equal to the fair market value of the stock at the time of the grant. See Heron & Lie, "Does Backdating Explain the Stock Price Pattern Around Executive Stock Option Grants," publication pending, Journal of Financial Economics.

Historically, there were no financial implications to the company or the recipient at the time the options were granted; rather, companies were only required to recognize an expense in the future in an amount equal to the difference between the exercise price and the fair market value at the time the option was exercised. Moreover, option-related expenses were fully deductible for tax purposes because such expenses were performance-based.

However, if a company issues options that are "in the money," where the exercise price is less than the current stock price, the difference should be recognized as a compensation expense. A problem obviously arises when options are backdated to make it appear as if the option was issued "at the money." The company may have failed to properly recognize appropriate compensation expense, overstated its income and improperly deducted certain non-performance-based compensation expenses for tax purposes.

Civil and Criminal Charges

The first criminal and civil charges related to the stock options scandal were recently filed in federal District Court in the Northern District of California and the Eastern District of New York against executives of Brocoade Communications Systems, a San Jose computer networking company, and Comverse Technology, Inc., a New York-based software provider.

In the Brocade case, the civil complaint filed by the SEC and the criminal indictment returned by the grand jury allege that Brocade executives concealed millions of dollars in expenses from investors and significantly overstated income by backdating stock options and falsifying corporate records to conceal the scheme. See Securities and Exchange Commission v. Reyes, et al., Case No. CR-06-4435 (N.D. CA, July 20, 2006); United States v. Reyes, et al., Case No. CR-06-0556 (N.D. CA, Aug. 10, 2006).

The SEC suit further alleges that the executives violated various securities laws, including: Section 17(a) of the Securities Act; Section 10(b) and Rule 10b-5 of the Exchange Act; Section 13(b)(5) and Rule 13b2-1 of the Exchange Act; Section 13(a) and Rules 12b-20, 13a-1 and 13a-13 of the Exchange Act; and Rule 13a-14 under the Exchange Act, as well as aiding and abetting violations of Section 13(b)(2)(A) and 13(b)(2)(A) of the Exchange Act. The criminal indictment charges the same executives with similar criminal securities law violations as well as conspiracy and mail fraud.

In the Comverse Technology case, the government filed civil and criminal complaints in the Eastern District of New York alleging that Comverse's CEO, CFO and general counsel committed numerous securities law violations and conspired to commit violations of Rule 10b-5, mail fraud and wire fraud. See Securities and Exchange Commission v. Alexander, et al., Case No. CV-063844 (E.D. N.Y. Aug. 9, 2006); United States v. Alexander, et al., Case No. M-06-817 (E.D. N.Y.).

According to the complaints, Comverse executives systematically backdated options from 1998 through 2001. They allegedly concealed the scheme by issuing options to non-existent employees that were placed in a slush fund for later distribution, rewarding new employees with options that were backdated to a date prior to the employee's hire date, altering corporate records, and making false and misleading statements in Comverse's public filings and to its institutional investors.

The complaint also alleges that after the scheme was uncovered, the executives approved false statements made to the Wall Street Journal on Comverse's behalf, and lied to Comverse's in-house counsel and its auditor in an effort to offer an explanation for their unlawful conduct.

The fallout for these companies under investigation from both a legal and business perspective is significant. As companies disclose the existence of investigations, they are faced with restating prior financial statements, falling stock prices and the potential loss of high-ranking executives.

Defenses

If the misstated options were granted and exercised more than five years ago, the criminal prosecutors may face a five-year criminal statute of limitations (18 U.S.C. Sect. 3282) or six years for a tax violation (26 U.S.C. Sect. 6531).

However, if an option were granted in 1997 (and the strike price misdated) but not exercised until 2002, prosecutors could argue that the crime constituted a continuing offense and only ended when the money was realized, and the statute of limitation had not yet tolled. Civilly, an injunction and disgorgement could still be brought.

Because scienter must be established in a criminal case, a company's and individuals' exposure will depend on the flagrancy of the backdating, its frequency, the knowledge or approval by the board, the amount of money involved and the position of the recipient.

Good lawyering may reduce the penalty or avoid a criminal reference, but much is unknown at this point.

Conclusion

As companies struggle to deal with the fallout of the backdating scandal, they will be faced with potential civil and criminal liability, restatement of financial results, tax liability, loss of management and declining stock prices. The cost will likely be significant in terms of both money and personnel.

Michael A. Collora is a partner at Dwyer & Collora in Boston. William J. Lovett, a former federal prosecutor with the Department of Justice, Tax Division, is an associate at the firm.

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