On an almost daily basis, corporations are announcing their involvement in investigations concerning the timing of stock option grants made to senior executives. These investigations—which are being separately pursued by the U.S. Securities and Exchange Commission (SEC) and by the U.S. Department of Justice (DOJ)—have prompted restatements by some corporations, and in some instances have led to the resignations of senior corporate officials.
The issue catalyzing these investigations is whether corporations used stock option grants to improperly enrich their senior executives. These investigations focus on two main issues:
- Whether options were “backdated,” or retroactively granted on a date when the stock price was low in order to build in a profit for the executives
- Whether the options were “spring-loaded,” or granted immediately before corporate announcements that were likely to increase the price of the shares
Concerns and Consequences of Investigations
The options backdating investigations raise both civil and criminal issues for corporations and their executives. The SEC is investigating whether companies backdated options to provide undisclosed compensation to senior executives and whether the failure to disclose this practice constituted securities fraud. Thus, these recent investigations focus on how companies report and disclose backdated options for financial and tax reporting purposes.
Similarly, the DOJ is also looking at these cases from a criminal standpoint, i.e., was there fraud? Were documents altered or misdated as a part of the fraud? Finally, were shareholders told the truth about the option grants and the compensation of corporate officials? The corporations and executives involved in improperly backdating options may face securities, mail and wire fraud as well as tax charges. Private civil litigation involving these same issues also has been filed against some companies.
Because of the potential civil and criminal liability that companies and their officers may face, corporations suspecting they may have problems relating to the backdating of options need to evaluate a number of possible compliance issues and should consult counsel. In some instances, corporations acting through special committees of the board of directors may want to seek independent counsel to investigate such problems.
Financial and Accounting Problems
Even companies that are not currently facing investigations or litigation as a result of backdating must evaluate financial and accounting issues that may result from the practice. For instance, options granted below the market value provide the recipient with an automatic financial gain and may be considered equivalent to extra pay under accounting rules. A company’s failure to disclose this extra cost on its books may overstate its net earnings. Depending on the materiality of the amounts involved, this may necessitate a restatement of the company’s financial statements in order to rectify any irregularities.
There also may be significant tax and insurance consequences stemming from violations or irregularities due to inaccurate or incomplete tax return filing. Backdated options may create serious issues under Internal Revenue Code Section 409A, Section 162(m) and Section 422. If an option was issued after the effective date of Section 409A, the following adverse consequences will result for the employee to whom it was granted:
- The fair market value of the option will be taxable to the employee when it vests without any relief if the option is never exercised
- The employee will be subject to an additional 20 percent tax
Finally, in order to qualify for the favorable treatment afforded to “incentive stock options” under Section 422, the exercise price of an incentive stock option cannot be less than the fair market value of the underlying stock at the time of actual grant. Any discount in the exercise price will disqualify the options from incentive stock option treatment.
Companies and individuals likely will turn to directors and officers (D&O) liability insurance to fund costs incurred due to governmental investigations and related shareholder lawsuits. These costs may include legal fees, settlements and judgments. To better determine and understand the insurance issues that may arise, including proper submission of claims, insurers’ defense obligations, the scope of coverage afforded by D&O insurance for options backdating claims, and the placement of future coverage, both companies and individuals should consult counsel.
Options Backdating: Some Remarks
According to a June 23, 2006 article in the Wall Street Journal (“Backdating Woes Beg the Question of Auditors’ Role”), SEC representatives have recognized that a danger exists if various issues relating to stock options are lumped together. The SEC representative stated that backdating options so that an executive can receive a larger paycheck is “an intentional lie”; however, there may not be an intent to backdate in other instances where there is a difference of a day or two in the date when a board approved a grant.
It is vital to note that options backdating can occur without any intentional wrongdoing merely due to failures in corporate procedures. Albeit such inadvertent errors are uncommon, the consequences can be serious.