Attorney and Auditor Potential Liability for Options Backdating
August 11, 2006
The initial wave of lawsuits arising out of stock options backdating, filed by the U.S. Securities and Exchange Commission (SEC), the U.S. Department of Justice (DOJ) and private plaintiffs in the form of class and derivative actions, are washing over the legal landscape like a tsunami. The focus thus far has been on the public companies sponsoring and issuing the allegedly offending options and on the executives who benefited from receipt of them.
Another wave of backdating lawsuits may be coming: suits against the attorneys and auditors who were consulted on the mechanics and disclosure of the offending options program. This may prove fertile territory because the practice of backdating options may not be wrongful in many instances. It is the failure adequately to disclose, properly account for, and pay taxes as a result of such programs that can transform a permissible method of compensation into a violation of law. Faulty advice on this subject can place the professional advisors in the sights of the issuing companies and their executives under attack, shareholders seeking additional sources of recovery, and regulators attempting to assess blame and create reform.
These circumstances suggest that it is prudent for law firms and auditors to take proactive steps to determine whether they have, and if they do to protect against, meaningful exposure. In addition, the professional advisor needs to assess the actual and potential conflicts it may face both in addressing its own exposure and in defending clients who relied on the firm’s advice in the creation or disclosure of the offending backdating program.
Potential Claims Against Attorneys
If history follows form, both the plaintiffs’ bar and issuing companies and their executives under attack will seek additional targets on which to assess, or lay off, liability. It will not be surprising for a company and/or its executives to defend themselves by explaining that their intent was to provide a lawful compensation mechanism to reward and incentivize their managers for superior performance in the best interests of the company and its shareholders. The implementation and disclosure of the program was left to the outside lawyers, accountants and auditors. Is that not why, the refrain will go, companies hire professionals, i.e., to structure complicated programs properly and to advise concerning their obligations under those programs? Private litigants’ claims against the professionals may be for negligence or intentionally wrongful conduct. Moreover, the SEC and DOJ will be only be too happy to attribute blame to professionals for allowing backdating abuses to take place. And, this is not simply a matter of civil liability, though that exposure can be painful enough. DOJ already has filed criminal charges in backdating cases with more sure to come.
A tally of the many legal disciplines involved in stock options programs provides insight into how vulnerable law firms may be. Constructing and implementing a stock options program requires detailed analysis of corporate legal structure, securities law considerations, employee benefits concerns, executive compensation issues, complex tax rules and disclosure obligations. For example, options granted below market value provide the recipient with a financial gain. A company issuing such options must disclose this amount as an additional cost on its financial statements. Failure to do so will result in overstated earnings. Did the lawyers who assisted the company in creating the options plan advise the company that the program will create additional expense and reduce earnings, and that those facts must be timely recognized and disclosed? When attorneys reviewed the company’s stock options plans in connection with their opinion letters for plan registration filings with the SEC, did they advise the clients of the required disclosures on this subject?
Corporate and employee benefits lawyers may have been asked to lead clients through complex stock option rules that impose varying requirements depending on the myriad circumstances in which the options are granted. For example, a board of directors may approve an options grant on one day, the corporation may issue the options on another day, and the effective date may be selected as one of those two dates, or a date between or preceding those dates. Each of these circumstances comes with different economic, and legal, results.
Still further, attorneys who review quarterly and annual filings typically analyze a host of documents to be sure requisite disclosures are made. The law firm performing the Form-10Q and Form-10K reviews may or may not be the firm that advised on the option plan. In either case, the reviewing law firm is exposed if the disclosure is not accurate.
Executives who receive backdated options have a reciprocal obligation in connection with their income taxes. Backdating options may create substantial personal income that must be reported on the individual’s personal tax returns. Subsequent to the effective date of Internal Revenue Code (IRC) Section 409-A, the fair market value of an option is taxable to the employee when its vests, even if the option is not exercised. In some circumstances, the recipient may be subject to an additional 20 percent tax. IRC Section 422 sets forth rules that must be complied with in order to qualify for incentive stock option treatment. Did the company’s lawyer have any responsibility to the executives who received the options to provide advice on these issues?
Potential Claims Against Auditors
Auditing firms are faced with a similar dilemma. Often, it is the auditing firms that provide advice concerning issuance of stock options and related tax ramifications. Moreover, auditors review and opine on the financial statements of public companies quarterly and annually. Did the auditors miss any of these issues, give incorrect advice or otherwise permit the wrongful backdating activity to occur? These questions inevitably will be posed.
Prophylactic Measures Should Be Undertaken: Review by Independent Counsel
In light of the claims that undoubtedly are coming, law firms and auditors should undertake a detailed examination of the stock options advice they have provided to their clients over the last several years. Such an analysis will allow the firm to determine if it has a problem and to take appropriate measures to minimize the exposure. Retaining independent counsel for this task is advisable, as self-examination will not have the credibility and reliability that comes with an objective review. Moreover, the confidential and privileged nature of the review may be enhanced. The investigation needs to consider all of the various disciplines upon which the options-related advice touched, including corporate, tax, executive compensation, employee benefits and disclosure issues.
Watch Out for Conflicts of Interest
Two separate sets of conflict of interest concerns come into play for law firms. In the first instance described above, the firm may need an independent analysis by a law firm with expertise in the various substantive areas impacted by the options backdating issues in order to obtain a meaningful and objective understanding of whether the legal advice given was accurate and complete. After all, the firm’s own lawyers’ conduct is being examined in this process. Accordingly, a review by independent counsel may be the firm’s best chance to protect itself.
A separate set of conflict-related considerations comes into play for a law firm that provided the advice on a stock option plan under attack. If the client asks that same firm to defend it against the backdating allegations, the law firm may be required to defend its own work in the process of defending its client. What if the law firm’s original advice concerning the options program was off the mark? Should the firm fall on its sword and explain that it was not the company’s fault? Such a defense will point the liability finger at the law firm itself. This conflict may be impossible to negotiate.
Moreover, a law firm that gave the stock options advice and then tries to defend its client in a lawsuit over the options program may need to put on the witness stand its own partners in order to defend the work. In many states, the "lawyer as witness" rules make such representations difficult to undertake. If the litigation takes a turn south and the law firm becomes a defendant, the firm’s litigation representation undoubtedly must come to an end in midstream, with wreckage all around.
Auditing firms have similar concerns. To the extent the firm is asked to analyze or assist in the defense of a stock options program concerning which it provided advice, the conflicts may be insurmountable.
In all events, professional firms will be well served to analyze their exposure, ready themselves to deal with tough questions, and be watchful for conflicts so they do not take on a representation that will increase their risk.
