|
|
 |
|
. |
|
|
Stock Option Compliance
.
|
|
|
I. Backdating of Stock Options
Is backdating of stock options illegal?
The answer is no; however, it becomes illegal if:
- the backdating of stock options is withheld from investors
- financial filings do not reflect the backdating of stock options
- internal documents have been changed to evidence a previous date of issuance from the original agreed grant date
- tax authorities are not accurately notified
Backdating of stock options is retroactively choosing an option grant date earlier than the date on which the compensation committee, corporate officials or board actually approved the grant of options in order to use a lower stock price in effect on the earlier date as the option exercise price. If the company did backdate options for employees or use it as a tool to hire employees, they must 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.
Companies may also face tax audits and lose valuable tax deductions with respect to stock option compensation. The SEC can claim that the company’s financial statements, i.e., securities law filings and proxy statements were incorrect or misleading. A potential SEC investigation into alleged financial misreporting or other disclosure issues is the most immediate risk a company faces regarding this new circumstance. The SEC has the authority to seek civil or administrative penalties. They can also share their work with federal and/or state regulators and prosecutors.
Accounting and Disclosure Issues – if the backdating of stock options was completed, and the disclosures regarding its stock option plans, policies and/or its accounting and tax treatment of stock option are reported incorrectly, the company may have incurred unreported or under-reported compensation expenses and a restatement of financial statements is necessary.
Tax Implications – companies may also have to revise prior tax returns and may be ineligible for deductions in connection with future executive option gains. It may also constitute “nonqualified deferred compensation” that could expose the individual who received the options to additional tax liabilities and/or penalties.
Corporate Governance and Internal Control
Inconsistencies and irregularities in a company’s stock option granting procedure and its record keeping will signal a deficiency in internal controls. These will also expose weaknesses in audit controls in place. This will probably create a scenario where corporate governance and internal controls will require change.
Companies will have to restate previously filed financial statements and a restatement of financial filings with regulators will lead to investor uncertainty. Company stock price will certainly become more volatile when the restatement news reaches the financial press.
As a result of the aforementioned, many companies now face private securities class action and shareholder derivative lawsuits. This activity is expected to increase dramatically in the near future and there is concern that this will blossom into the next big financial scandal.
II. “Spring Loading” of Options
Spring loading of stock options is also being investigated by the SEC. This is the practice of issuing options to an executive/employee prior to positive news being released that causes the share price to increase. The positive news immediately puts the receiver of the options “in the money.” The SEC has been concerned that insider information is being used to time the granting of options.
III. Litigation
US Attorney’s Office and SEC Separately Charge Former Brocade CEO and Vice President in Stock Options Backdating Scheme
The United States Attorney’s Office for the Northern District of California, the Securities and Exchange Commission, and the Federal Bureau of Investigation announced the filing of criminal and civil securities fraud charges against Gregory L. Reyes, the former CEO, President, and Chairman of Brocade Communications Systems, Inc., and Stephanie Jensen, its former Vice President of Human Resources, alleging that the two routinely backdated stock option grants to give employees favorably priced options without recording necessary compensation expenses. The actions, which are among the first cases involving manipulation of stock option grants in violation of the federal securities laws and other criminal statutes, are the result of 18-month investigations by the Commission and the FBI.
According to the criminal complaint and the Commission’s civil complaint, Reyes, 43, of Saratoga, California, and Jensen, 48, of Los Altos, California, regularly caused Brocade to grant “in-the-money” options (i.e., the exercise price is below the stock’s market price on the day of grant, giving the recipient an immediate paper gain) to both new and current employees between 2000 and 2004, but backdated documents to make it appear that the options were “at-the-money” (i.e., the exercise price is the same as the stock’s market price on the day of the grant) when granted, thus concealing millions of dollars in expenses from investors. Under well-settled accounting principles applicable at the time, options granted “at-the-money” did not need to be recorded as a compensation expense. In contrast, options granted “in-the-money” needed to be recorded as a compensation expense.
The separate criminal and civil complaints allege that Reyes repeatedly used hindsight to select a date with a lower stock price from the recent past as the supposed option grant date. To facilitate the scheme, Jensen created, or directed others to create, paperwork making it appear that the options had been granted on the earlier date. In some instances, employment offer letters and compensation committee minutes were falsified and purported to document option grants to employees before they had even been hired by the company. As a result of this practice, Brocade was able to give employees “in-the-money” stock options without having to recognize compensation expenses as required by accounting rules. When these stock option abuses surfaced, Brocade was required to restate and revise its financial statements for fiscal years 1999 through 2004.
IV. Insurance
Directors and Officers insurance providers are very concerned that they may be brought into this latest scandal. D&O policies protect company executives and members of the board from liability in the event of a lawsuit claiming wrongdoing that will affect the company’s business. The coverage usually pays the defense costs and also a part of the settlement.
Insurance websites have suggested that many companies have put insurance carriers on notice of potential loss due to the impending lawsuits regarding the backdating of stock options. Insurance companies are gearing up to handle an increased number of potential claims.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
