Corporate Governance - Equity Incentive Bulletin
October 2006
Fasken Martineau DuMoulin LLP
Stock Options: 'Backdating and Springloading'
Are Your Records in Order?
Eric C. Belli-Bivar and Liana L. Turrin, Toronto
Just when you might have thought that the
dust had settled on the series of scandals
that have rocked corporate America, the
latest chapter in this continuing saga involving stock options - is just being
written. Currently, the practices of
‘backdating’ and ‘springloading’ are the
focus of investigation by US securities
regulatory authorities and US federal
prosecutors, as well as being the subject
of several class-action lawsuits by
shareholders.
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The recent announcement by the Chief
Criminal Investigator of the FBI, Mr.
Chip Burrus, that it is probing the conduct
of executives and officials at 52
companies, and that more cases are
underway, underscores just how seriously
the practices of backdating and
springloading are being dealt with south
of the border. Mr. Burrus notes that where
his agency becomes involved “there are
allegations of criminal misconduct”.
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The list of casualties in this ever-widening
scandal seems to grow day by day. For
example, at McAfee, the general counsel
left after the company’s investigation into
options timing. At Comverse Technology,
the CEO and 2 other executives quit in
May 2006 after the company found that
grants had been backdated. Broadcom
Corp. has announced that it expects a
restatement of financial results to increase
expenses by more than US $1.5 billion.
Broadcom’s
CFO
also
recently
‘accelerated’ his retirement following the
internal investigation.
Perhaps the most egregious case that has
come to light to date was announced by
Cablevision Systems Corp. which, in a
company filing, reported that options had
been awarded to the company’s vicechairman after his 1999 death but
backdated to make it appear as though the
options were granted while he was alive.
The company had previously delayed
releasing its second quarter results and
said that it would likely restate earnings
because of an internal probe into option
grants. In addition, 2 directors of
Cablevision have stepped down from the
compensation and audit committees in the
wake of several shareholder lawsuits
naming them, among others, as
defendants.
Evidence that companies in Canada are
not immune from this latest corporate
scandal came in the form of an
announcement on September 28, 2006 by
RIM - the maker of the iconic wireless
email Blackberry devices - that it is
reviewing its stock option grant
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practices as a consequence of the “heightened public
awareness and concern regarding stock option grant
practices by publicly traded companies”.
RIM reported that its audit committee has already
made a preliminary determination that “accounting
errors” have been made in connection with stock
options granted as far back as 1998, as a result of
which RIM delayed reporting full 2nd quarter
results. A company spokesman noted that the
options review may require the company to reduce
the amount of previously reported earnings by
between US $25 and US $45 million dollars, and
restate past results. RIM declined to provide any
details as to the nature of the “accounting errors”
giving rise to the restatements.
Where It All Started
The current controversy over options backdating was
sparked by the research of an unlikely champion of
corporate governance, a Norwegian academic by the
name of Erik Lie, who is an assistant professor of
finance at the University of Iowa.
In his ground-breaking research, Professor Lie
examined the proxy statements of more than 2000
large S&P companies to determine whether there
was any empirical evidence to support his
hypothesis that the dates of option grants were
deliberately selected to coincide with a date on
which the stock price was particularly low. His
research found abnormally low stock returns before
grant dates, and unusually high returns after those
grant dates. This observation led him to conclude
that “unless executives possess an extraordinary
ability to forecast the future market-wide movements
that drive these predicted returns, the results suggest
that at least some of the awards were timed
retroactively”.
The conclusion reached in Professor Lie’s paper was
that the abnormally high stock returns following
stated option grant dates were consistent with his
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hypothesis that the official grant date must have
been retroactively selected, and that the actual
timing of option grants were not being properly
recorded.
How Does Backdating Occur?
Options are frequently granted by public companies
as a form of future compensation to motivate or
incentivize employees (especially senior executives
to whom the bulk of options have typically been
awarded) and to align their interests with those of
shareholders. The theory is that executives to whom
grants are made will be motivated to increase the
value of the company’s stock, and therefore the
value of the awarded options. Investors expect
options to be awarded ‘at the money’, that is, the
exercise price of the options is equal to the price of
the stock on the grant date. In fact, for TSX listed
issuers, options must be issued at the then prevailing
stock price of the underlying security.1
Backdating can occur in at least a couple of ways.
The first is to declare a stock option at a board (or
committee) meeting without setting the exercise
price at the time. At a subsequent meeting, having
the benefit of hindsight as to how the stock has
performed in the intervening period, a lower price
during that period is selected as the exercise price.
A second - and potentially fraudulent - variation
occurs where there is a substitution of the actual date
of the grant with a different date when the stock
price is lower. In this case, the original grant date is
simply erased, and the actual date is substituted with
a more favourable one.
Another questionable practice concerning the timing
of stock option grants has been referred to as
1
Note, however, that the TSX Venture Exchange permits
options on the stock of companies whose shares are
traded on that exchange to be issued at discounts
ranging from 15-25%.
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•
company financial statements may be
required to be restated to reflect the
additional compensation costs of granting
‘in the money’ options
•
expenses related to compensation are
increased (and in some case may be
disallowed for tax purposes)
Why does Backdating Matter?
•
stated profits are reduced
As a consequence of Professor Lie’s research, the
SEC had, at last count, launched investigations
against more than 100 companies for civil fraud, and
the US Justice Department has laid criminal charges
against several companies and executives.
Expectations are that the number of companies and
executives under investigation could significantly
increase.
•
tax returns may need to be re-filed, and
additional taxes paid, by the company,
thereby further reducing the company’s
stated profit
‘springloading’. This involves making a grant of
options (whether scheduled or unscheduled) and
delaying or deferring the release of positive
corporate information until a time following the date
of the grant. The expectation being that following
the release of the information, the stock price will
rise.
•
The applicable securities laws and the rules of
any stock exchange on which the company’s
securities are traded may have been breached
and, in the case of springloading, allegations of
insider trading on the basis of undisclosed
material information are raised.
•
The stated purpose to align executives’ interests
with those of shareholders is subverted insofar
as the executives are awarded an instant benefit,
as opposed to a potential reward based on their,
and the company’s performance. Option
backdating allows executives to realize
significant wealth without building long term
shareholder value. These practices also call into
question the oversight of directors and
compensation committees who, some argue,
failed to protect the interests of shareholders.
•
Cash compensation expenses are increased
where stock delivered under the option is
purchased by the company in the open market.
When options are exercised, the company must
either (a) issue stock from treasury, and thereby
dilute the float, or (b) purchase the shares in the
open market. In purchasing the shares in the
market, the company must pay the difference
between the exercise price and the market price
The practice of backdating has drawn the ire of
lawmakers, regulators and shareholder groups
because it involves some or all of the following:
•
Board and committee minutes, resolutions and
ancillary documents are backdated to
misrepresent the actual dates of the related
meetings and the associated option grants. It
should be obvious to anyone who files
disclosure documents with securities regulatory
authorities that the falsification of documents
carries with it very serious consequences.
•
Where stock options are issued at a discount,
applicable accounting rules require that an
associated expense be reflected in the financial
statements. On the other hand, during most of
the period of time under scrutiny by regulators
(generally, pre-2002), accounting rules did not
require any expense to be recorded for stock
option grants made “at the money”, i.e. without
a discount. Rectifying improperly dated option
grants may, therefore, entail the following:
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which, naturally, is greater where the exercise
price has been artificially depressed.
The Canadian Context
While there are many similarities to the US legal and
securities regulatory regime, there are distinct
differences in the current and historical Canadian
rules governing the grant of options. As regards the
current Canadian regulatory environment, the
Canadian Securities Administrators (the “CSA”)
recently issued a Staff Notice (CSA Staff Notice 51320 Options Backdating, the “Staff Notice”)
intended to communicate the CSA’s understanding
of the backdating issue in the Canadian context. The
Staff Notice identifies a number of requirements of
the Canadian legal regime which it suggests may
reduce the opportunity for Canadian companies to
backdate or time option grants. Those factors include
the TSX Exchange requirements that the exercise
price of options must not be less than the market
price of the stock at the time of the grant, and that
the exercise price must not be based on market
prices that do not reflect undisclosed material
information.
The CSA Staff Notice also observes that the TSX
rule which requires that all option grants must be
reported to the TSX within ten days of the end of the
month in which the grant was made may reduce the
opportunity for Canadian companies to backdate or
time option grants.2 This reporting requirement is
considerably longer, however, than the applicable
reporting obligations established under the
Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley
Act”) in the US where option grants since the
coming into force of that Act in 2002 are required to
be disclosed within 2 days of the date of the grant.
Prior to the enactment of the Sarbanes-Oxley Act,
the disclosure obligations under applicable securities
Corporate Governance Bulletin
legislation were generally the same in the US as they
currently exist in Canada. Interestingly, it is the
accelerated disclosure obligations which were
established under the Sarbanes-Oxley Act that some
US commentators credit with largely eliminating the
opportunity for companies to backdate options.
Indeed, a follow-up study co-authored by Professor
Lie suggests that the incidence of abnormal price
increases following option grants have been reduced
by some 80% (as compared with the pre-2002 data)
as a consequence of the accelerated disclosure
obligations mandated by the Sarbanes-Oxley Act.3
Practice Recommendations
Whether Canadian legal obligations make it more or
less likely to identify and capture questionable
practices concerning the timing of option grants is
certainly a question of debate. It would seem,
however, that the prevailing corporate cultures north
and south of the border are sufficiently similar to
warrant an investigation into whether the practices
of Canadian companies as regards the timing of
option grants are in full compliance with all then
applicable
and
currently
prevailing
legal
requirements.
Many legal commentators consider that it is
incumbent on all companies to undergo their own
study before one is required ‘from the outside’. It is
also reasonable to assume that option award
practices will be the subject of question by auditors
as the traditional audit season begins in the new
year. While many companies have voluntarily
initiated a review of audit of option award practices,
Harvey Pitt, the former SEC chairman states that
“many companies are sitting back and waiting for
the government to tell them if there is anything
wrong. You’ve got a mindset that says ‘don’t go
3
2
The filing deadline for “insiders” however is within 10
days of the date of the grant.
4
See Heron and Lie, “Does backdating explain the stock
price pattern around executive stock option grants?”
Forthcoming (2006) J. of Financial Economics
Fasken Martineau DuMoulin LLP
looking for problems’,” he says, noting that small
companies are reluctant to conduct such audits
because of the expense involved - even though those
companies are the most likely to have used stock
options for recruiting purposes in the pre-SarbanesOxley Act era.
In light of developments in the US, a prudent course
of action for all public companies in Canada particularly those which are also publicly listed in
the US - is to conduct a comprehensive review of
past option practices and documentation, and as well
to establish a policy regarding future option grants
and the timing thereof. On this point, the CSA Staff
Notice recommends that all issuers assess their
current policies, procedures and controls for option
grants and equity-based awards to ensure that they
comply with relevant stock exchange rules and
securities legislation.
Proactive action on the part of companies which use
stock options in their compensation mix will not
only enhance existing stock option grant practices,
but will also demonstrate your company’s
commitment in upholding the highest ethical
standards in the conduct of its business. Indeed, as is
noted in the CSA Staff Notice, in considering what
course of action to take in the event that a breach of
the applicable rules is discovered, “CSA staff may
take into account what steps, if any, [such] issuers
took to ensure their policies and controls complied
with regulatory requirements”. Proactive remedial
action is also the recommended course of action in
the US, the FBI’s chief criminal investigator noting
that “if we linger around these things, then it’s not
good for them, it’s not good for us”.
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5
We would be pleased to assist you or your company
in performing an appropriate review, and appreciate
your comments and observations.
Eric C. Belli-Bivar
416 865 4353
[email protected]
Eric Belli-Bivar has a broadly based corporatecommercial law practice, with a focus on corporate
finance transactions. Eric is also a member of the
Firm's Corporate Counselling and Governance
groups, and regularly provides advice to public
companies concerning their compensation and
equity-incentive programs for senior executives,
officers and directors.
Liana L. Turrin
416 868 3401
[email protected]
Liana Turrin is a partner at Fasken Martineau. She
is a corporate commercial lawyer with a broad
range of experience in acquisitions and dispositions,
commercial real estate, financing transactions and
restructurings. Liana has acted for public and
private companies in a variety of industries such as
manufacturing, real estate, high tech, financial and
retail, as well as financial institutions and
governmental bodies.
Fasken Martineau DuMoulin LLP
Corporate Governance Bulletin
This publication is intended to provide information to clients on recent developments in provincial, national and international law. Articles in this bulletin
are not legal opinions and readers should not act on the basis of these articles without first consulting a lawyer who will provide analysis and advice on a
specific matter. Fasken Martineau DuMoulin LLP is a limited liability partnership and includes law corporations.
© 2006 Fasken Martineau DuMoulin LLP
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