More than 200 public companies are now embroiled in Securities and Exchange Commission and company-initiated investigations, as well as private litigation. Aside from the accounting impact, what impact will Sarbanes-Oxley and litigation have on past option violations and future option practice?
Before that question can be assessed, a brief review of the stock options background is in order.
The option landscape in recent years was rich in suspicious scenarios. Options were backdated due to administrative incompetence, with the granting process stretching for weeks, particularly in overworked emerging technology companies. Lack of integration between HR and legal resulted in sloppiness in options to new hires.
Options were granted in violation of option plans (certain plans prohibited grants “in-the-money”). Options were spring-loaded (granted just before good news) or bullet-dodged (granted just after bad news).
Lists of grantees were amended. Option amounts and exercise prices were changed to compensate for unexpected marketplace news. Fraudulent backdating (to a date with lower share price) occurred.
Initial government activity focused on accounting. The PCAOB issued its staff audit practice alert on July 28, 2006. The director of the SEC’s Division of Enforcement testified before Congress in September 2006 relative to the accounting and tax impacts of backdating. The only official SEC guidance on backdating was issued in September 2006 (www.SEC.gov/ news/press/2006-156.htm), and dealt exclusively with accounting issues.
Historically, accounting for stock options was controlled by APB Opinion No. 25 of the Financial Accounting Standards Board (FASB). Incentive stock options were not taxed at grant. At exercise, the employee incurred no tax. The company recognized compensation expense equal to the excess of then fair market value over strike price.
In 1995, FAS No. 123 of the FASB recommended that the fair value of each option (calculated using valuation formulae) be recognized at grant and amortized over the life of the option. Companies could elect to continue to report under APB 25, provided they footnoted the impact of FAS 123.
FAS No. 123(R), enacted in 2004, required companies to use fair value-based accounting beginning in 2006.
The SEC’s accounting release in 2006 seemed designed to calm fears that backdated options were void, or to eliminate egregious proposed remedies. The release focused on determining the “measurement date.”
At that date, when amount and price of the option is known, an incentive option cannot be in the money. Putting aside purposefully fraudulent conduct, the SEC lobbed softballs toward companies struggling with improper option procedure:
An explosion of company investigations followed the Sac’s release. Typically, special committees are designated, and they hire counsel and undertake forensic accounting. Although these investigations are almost universally not filed with the SEC, the results manifest themselves in various ways: restatement of financial statements; delay in filing periodic reports under the ’34 Act; and punitive action taken against management.
Company corrective action must be coordinated with CPAs. The accountants must be satisfied that remediation complies with auditing requirements of Section 10A of the ’34 Act. Executives, directors and counsel invoking Fifth Amendment rights are relieved of their duties. Failure to do so might cause CPAs to place a scope limitation on their financial opinion by reason of 10A non-compliance.
Delaware judicial guidance
Two decisions of the Delaware Chancery Court on Feb. 6 have set the table for future litigation. Each decision (Ryan v. Gifford and In re Tyson Foods, Inc. Consolidated Shareholder Litigation) involves motions by defendant directors to dismiss shareholder derivative actions claiming breach of fiduciary duty by directors. In both cases, the court signaled severe punishment under state corporate law.
Each case involves option grants issued pursuant to a shareholder-approved plan that prohibited options at less than fair market value. (It is unclear if the court would have been swayed by a plan allowing in-the-money options). The theme of each case is lying and deception by the board.
Ryan is the most egregious case. The compensation committee knowingly approved backdating options. The defendant directors were denied the benefit of the business judgment rule, which meant no demand for remedy upon the board was required prior to suit, and the statute of limitations defense was tolled because the evils were hidden by the company’s incomplete disclosure of option practices.
The court denied the defendants the protections afforded by Section 102(b)(7) of the Delaware Business Code (director indemnification) because it condemned blatant backdating by a board as a “lie” to the shareholders and a breach of the duty of loyalty.
In Tyson Foods, the plaintiffs alleged spring-loaded options were granted “days before Tyson would issue press releases that were very likely to drive stock prices higher.”
The court concluded that intentional spring loading breaches the duty of loyalty. All backdated options involve fundamental and incontrovertible lies, while spring-loaded options “clearly” constitute indirect deception, according to the court. The key breach is the use by directors of the option plan in a manner that undermines shareholder objectives. If a director “knows those shares were actually worth more than the exercise price” he or she has breached the duty.
The role of SOX
The corrective provisions of SOX have reduced the egregious actions that formed the basis for most SEC investigations and private litigations. Most questionable actions occurred prior to the effective date of SOX, because under SOX officers and directors now report option awards within two days of grant.
Statistical impact is stark: Prior to SOX, option grants tended significantly to outperform the market, while not so after SOX.
We should not be surprised to see certain other aspects of SOX arise in the future. Section 304 requires CEOs and CFOs to surrender performance-based compensation, including cash and profits from stock options, where restatement of financial results was caused by “misconduct.”
Although clearly no one was watching prior to SOX, the language of Sections 302 and 906 certifications (filed by the CEO and CFO with each ’34 Act filing containing financial statements) appears literally to certify reporting and financial controls with respect to option grants.
Since option reporting has been accelerated, boards and their committees have nothing to worry about in the further grant of options, right? Wrong.
For companies that have investigated or are in the process of investigating option practices, Ryan and Tyson suggest a more careful re-screening for spring loading and bullet dodging (granting of options following bad news). These rulings indicate the duty of care and loyalty is breached when a director (even in compliance with the literal terms of an option plan) subverts the purposes of the plan (compensating for future performance) by failing to properly reflect the true value of the underlying shares.
In view of recent developments, some “best practices” have emerged:
Stephen M. Honig is a member of Duane Morris’ corporate department in the firm’s Boston office. You can reach him at smhonig@ duanemorris.com.