White & Case LLP - Publications - Stock Option Backdating

Stock Option Backdating — Crossing the Line

February 2007
California Litigation Report, February 2007

Fernando L. Aenlle-Rocha

Throughout the country, companies suspected of stock option backdating (setting a stock option's exercise price on a date prior to the board meeting in which it was awarded) now face a series of legal challenges that threaten their profitability if not outright economic livelihood. These challenges include civil enforcement actions by the Securities and Exchange Commission (SEC), shareholder derivative lawsuits, tax assessments, delayed SEC filings, a freeze on the trading of shares, financial restatements, and the specter of criminal prosecution.

From May 2006 to the present, more than 100 companies disclosed potential discrepancies in their stock option practices. In July 2006, only two months after the initial wave of corporate self-disclosures, the United States Attorney's Office for the Northern District of California, in conjunction with the Federal Bureau of Investigation, launched a stock option backdating task force, requiring the production of documents related to suspected backdating practices at multiple California-based companies. Similarly, the United States Attorney's Offices for the Eastern and Southern Districts of New York initiated investigations into the activities of numerous corporations, including Barnes & Noble, Inc. and The Home Depot, Inc. To date, over 80 companies have announced that they are under investigation by the United States Department of Justice (DOJ) and/or the SEC.

Are these events merely aberrational or do they reveal an engrained practice at companies that has only just begun to come to light? A July 14, 2006 statistical analysis by two academics — including Erik Lie, whose 2005 study on backdating originally attracted regulators' attention to the practice — would tend to point toward the latter. In that study, Lie and his colleague estimated that at least 29% of the companies they studied engaged in backdating or otherwise manipulated stock option grants between 1996 and 2005.

In light of these numbers, directors need to understand how and why prosecutors choose to target certain companies — and what directors can do to exercise due care and protect their companies from criminal and civil liability.

Two Recent Criminal Actions
Through its United States Attorneys, the DOJ has brought criminal charges against five executives at two companies in California and New York alleging illegal stock options backdating.

In August 2006, a federal grand jury sitting in the Northern District of California indicted Gregory Reyes and Stephanie Jensen, respectively the former Chief Executive Officer and Chairman of the Board, and former Vice-President of Human Resources, of Brocade Communications Systems, Inc. on multiple criminal counts, including securities fraud, mail fraud, false SEC filings, and false books and records. According to the indictment, the executives backdated board of directors' minutes, altered employment offer letters and personnel records to make it appear that employees had been hired on earlier dates, caused fraudulent information to be entered into Brocade's financial books and records,¹ and made materially false and misleading statements to outside auditors and the SEC. Brocade's board allegedly had granted Reyes sole authority to determine stock options for employees other than certain officers and directors — in effect, making him a compensation "committee of one" for purposes of granting options to employees.

Similarly, in September 2006, Jacob Alexander, the former CEO and Chairman of the Board of Comverse Technology Inc. (who is now a fugitive living abroad), along with the company's former General Counsel, Corporate Secretary and Board member, and its former CFO were indicted for securities fraud, mail fraud, false SEC filings, and other financial crimes. According to the indictment, the former executives had backdated stock options for themselves and employees to dates when the company's stock traded at periodic low points. The executives also allegedly inserted fictitious names in option grant lists to generate backdated options, "parked [the options] in a secret slush fund designed to evade the requirements of [the company's] stock option plans," and falsified documents to hide the slush fund from the board of directors and outside auditors. The indictment further alleges that the charged executives caused some of these options to become immediately exercisable, in violation of shareholder-approved stock option plans, resulting in immediate cash gains of several million dollars.

When Prosecutors Choose To Intervene
As these cases make clear, criminal prosecutors will act when they conclude that there is compelling and pervasive evidence of fraud, including the intentional falsification of company books and records, the concealment of material information from outside auditors, the filing of misleading reports with regulatory agencies, and the dissemination of fraudulent information to the investing public.

As with other recent examples of corporate fraud, the federal prosecutors responsible for handling stock option backdating investigations will likely look to the severity of the conduct and the relevant parties' intent when determining whether to pursue criminal charges. The US Attorney for the Northern District of California has stated that his team will "investigate whether individuals and companies may have deliberately backdated stock options with the intent to defraud. " [Emphasis added]. In recent testimony before Congress, US Deputy Attorney General Paul McNulty explained that the DOJ's "theories of [backdating] prosecution are concerned with the accuracy and adequacy of disclosure of material information and, in that respect, they are similar to many other DOJ prosecutions for corporate fraud." [Emphasis added].

With both Brocade and Comverse, federal prosecutors apparently chose to bring criminal charges because they believed the relevant executives acted knowingly, willfully, and with the intent to perpetrate a fraud — a state of mind that, in the government's view, crossed the line into corporate criminal behavior.

Steps to Protect Your Company
To help stave off potential criminal prosecution, all directors should initiate an internal review of their corporate stock option practices. It is best practice to engage independent outside counsel who have no prior involvement with the conduct at issue to handle the investigation. Given the accounting issues at play and the possibility that corrective action may include a restatement of financial statements, forensic accountants can also be useful in assisting outside counsel in conducting the internal review. Thought should also be given to creating a special committee of independent directors that will be tasked with reviewing and monitoring the investigation.

If the investigation uncovers any irregularities, consult with experienced corporate defense counsel to discuss how to resolve them and how to present your findings to regulators. Our experience has shown that federal prosecutors are more likely to decline to prosecute or settle for less severe monetary and other penalties if a company demonstrates a good faith effort to cooperate with prosecutors, corrects its regulatory filings, and implements revised corporate governance safeguards. Taking a wait and see approach will likely work against companies and their boards, since prosecutors tend to be more lenient with those companies that voluntarily disclose problems instead of waiting for federal authorities to uncover them on their own or through a company insider.

In addition:

Bear in mind that if any backdating irregularities are uncovered, the company, board members, and officers may each need to hire independent counsel to represent their separate legal interests.
Work with your company's outside auditors to determine whether any financial statements will require revisions. The failure to properly account for options under generally accepted accounting principles may require your company to restate its financial statements, especially if it results in a material adjustment to its financial results.
If prior disclosures in SEC filings included material misstatements, work with regulatory counsel to correct those filings promptly and to maintain stock exchange listings.
Calculate the tax impact, if any, of backdating with your CFO and auditors, and develop a financial plan for tax payments.
Analyze D&O, fiduciary liability, and other insurance policies to determine the extent of coverage and any potential exclusions. Some policies require companies to provide prompt notice of circumstances that could give rise to a covered claim. In some cases, insurers can rescind coverage if the company's financial statements require restatement.
Determine the appropriate treatment for individuals implicated in illegal backdating. Depending on the severity of their conduct, this may include allowing the company to recoup profits from option exercises, re-pricing options, and terminating employment or board memberships.
Finally, the board's compensation committee should regularly review all of the company's option grants going forward, since boards are responsible for monitoring all options to ensure that they are granted in accordance with corporate policies.

In short, directors should not wait until federal prosecutors and agents come knocking. As part of their responsibility to protect their companies, they should take active steps to uncover any irregularities relating to options practices. In the event such practices are discovered, directors can require companies to self-report to the relevant authorities and make any necessary changes to established corporate practices and culture. In this manner, directors can minimize the risk that a potential backdating problem will become a nightmare of criminal proportions for the company, its employees, and its shareholders.

Reprinted from the December, 2006 issue of Directors Monthly, a newsletter of the National Association of Corporate Directors, Washington, DC (nacdonline.org).

¹ Although not charged in the criminal complaint, Brocade's former Chief Financial Officer ("CFO") was named in a civil complaint brought by the SEC alleging false filings with the Commission and the creation of false records intended to avoid detection by Brocade’s auditors. Although not directly involved in manipulating stock option grant dates according to the SEC complaint, the former CFO allegedly was aware of facts that cast doubt on the veracity of Brocade's financial statements as a result of the company's stock option grant practices. Further, the Commission alleged that the former CFO facilitated the misconduct of others at the company by failing to investigate the issue further or informing the board's audit committee, as well as by ensuring that certain company documents containing option grant dates were internally consistent.

This newsletter may include links to websites other than the White & Case website. White & Case LLP has no responsibility for any websites other than its own, and does not endorse the information, content, presentation or accuracy, or make any warranty, express or implied, regarding any other website.

This newsletter is protected by copyright. Material appearing herein may be reproduced or translated with appropriate credit.