The Origins and Consequences of the Stock-Option Backdating Scandal
By Michael F. Perlis and Richard R. Johnson
I.
INTRODUCTION
Corporate scandals and resultant calls for better corporate governance are nothing new.
From well before the Foreign Payments scandals that led to the enactment of the Foreign
Corrupt Practices Act in 1977, through the wave of accounting scandals that crested in
20021 and prompted the enactment of the Sarbanes-Oxley Act, to the current StockOption Backdating scandal and the new, resultant SEC regulations regarding the
disclosure of executive compensation, the regulatory regime has evolved and expanded in
a series of familiar cycles commencing with the revelation of yet another ingenious (or
just audacious) fraudulent scheme – the possible varieties of which are apparently as
limitless as the human imagination itself – and culminating in yet another attempt by
regulators and investors to catch up with the crooks by enacting new rules that will
themselves invariably entail unforeseen consequences, good or ill, and perhaps ultimately
point the clever and unscrupulous to even newer forms of abuse.2 It appears that the SubPrime Lending problems might well emerge as the next scandal in this series.
The Stock-Option Backdating scandal, like the other scandals before it, has its own
unique set of accounting, tax, litigation, enforcement, insurance, business and other
consequences, many of which are addressed below.
II.
BACKGROUND AND BASIC PRINCIPLES
The Stock-Option Backdating scandal, which was characterized by the Financial Times
as “one of the biggest scandals since the dotcom collapse,” involves the recent discovery,
by Professor Erik Lie of the University of Iowa, the Wall Street Journal, and various
regulatory agencies and prosecutors, including the Securities and Exchange Commission
(“SEC”), the Department of Justice (“DOJ”), and the Internal Revenue Service (“IRS”),
of the previously undisclosed but apparently widespread practice by public companies
between 1996 and 2002 of misrepresenting the dates on which they granted certain stock
options to their employees. While Professor Lie has predicted that only a minority of the
companies that engaged in backdating will be caught, the scandal has already affected
over 150 public companies, and spawned a multitude of accounting restatements, internal
investigations, executive resignations, SEC, DOJ and IRS investigations and enforcement
1
While fairly significant accounting scandals occurred throughout the 1980s and 1990s, 2002 witnessed an
unprecedented series of restatements and other disclosures of major accounting problems by public
companies, including, among others, AOL, Adelphia, Bristol-Myers Squibb, CMS Energy, Computer
Associates, Duke Energy, Dynegy, El Paso Corporation, Enron, Freddie Mac, Global Crossing,
Halliburton, Harken, Energy, Homestore.com, ImClone Systems, Kmart, Liberate Technologies, Lucent
Technologies, Merck & Co., Merrill Lynch, Mirant, Nicor Energy LLC, Peregrine Systems, Qwest
Communications, Reliant Energy, Sunbeam, Tyco International, Waste Management and WorldCom.
2
On the subject of unintended consequences, for good or ill, of government regulation, it is worth noting
that the Stock-Option Backdating problem apparently emerged as an unintended consequence of optionfriendly IRS regulations enacted in 1993 ostensibly for the sake of enabling current employees to resist
hostile takeover bids and creating a closer correlation between executive pay and corporate performance,
and then quietly petered out in 2002 as a result of the Sarbanes-Oxley Act’s options expensing and grant
reporting requirements, which were imposed for reasons having nothing to do with backdating.
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actions, criminal prosecutions, federal securities class action lawsuits, ERISA lawsuits
and state and federal shareholder derivative lawsuits.
What Is Stock-Option Backdating?
Backdating, or the misrepresentation of a stock option as having been granted at a date
earlier than the date on which it was actually granted, is only one, albeit apparently the
most popular, of many different methods of manipulating (fraudulently or otherwise) the
value of stock options. Other methods of option price manipulation, which are discussed
in more detail below, include spring-loading, bullet-dodging and manipulation of the
information flow. Intentional backdating should also be distinguished from “misdating,”
an unintentional error with many of the same consequences, which is also addressed more
fully below.
To understand the nature and significance of backdating, it is necessary to understand
certain basic principles and terminology applicable to stock options. A “stock option” is
a security that entitles the option holder to purchase a share of the stock of the issuer for a
specified price, known as the “exercise price” or “strike price,” irrespective of the market
price of the underlying stock at the time of exercise.3 An option which bears an exercise
price equal to the market price of the underlying stock on the “grant date” (the date on
which the option is granted to the recipient) is said to be granted “at the money,” whereas
an option with an exercise price which is less than the market price of the underlying
stock on the grant date is described as “in the money” (and an option with an exercise
price greater than the market price of the underlying security is described as “out of the
money”).
In short, the “backdating” of option grants means the assignment to a stock option of a
false grant date (a date on which the market price of the underlying stock was particularly
low and which was selected retrospectively with the benefit of hindsight) that precedes
the actual date on which the option was granted (on which date the market price of the
underlying stock higher than the exercise price assigned to the option), with the purpose
and effect of misrepresenting an effectively in-the-money option as having been granted
at the money.
For various tax, accounting, governance and business reasons discussed below, many
public companies use stock options to compensate their directors, officers and
employees. Companies typically grant their executives and other employees, at regular
or irregular intervals, a number of unvested stock options, 20% of which vest (become
exercisable) at each of the first five anniversaries of the grant date, and which expire (are
no longer exercisable) on the tenth anniversary of the grant date. Companies usually (at
least purport to) grant stock options to their executives and other employees “at the
money.” While there is no general prohibition on the grant of in-the-money options,
3
The types of stock options at issue in the backdating scandal, viz., those that permit the option holder to
purchase the issuer’s stock for a fixed exercise price, are known as “call options.” “Put options,” which, by
contrast, entitle the option holder to sell the issuer’s stock for a fixed price, are not at issue here.
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many companies’ shareholder-approved stock option plans require that options be
granted at the money, i.e., at 100% of the market price (or sometimes even out of the
money, e.g., at 110% of the market price, for recipients who already own large blocks of
stock). Moreover, even if the plan does not require it, there are significant accounting
reasons and tax incentives for granting options at the money.
The principal accounting reason for granting options at the money was that, prior to
January 1, 2005, companies did not need to recognize any compensation expense for such
options. Pursuant to Accounting Principles Board (“APB”) Opinion No. 25
(“Accounting for Stock Issued to Employees”), the standard that governed the accounting
treatment of employee stock options under GAAP prior to January 1, 2005, options
granted at the money did not create any compensation expense for the issuing company.
This is because APB Opinion No. 25 allowed companies to value options using the
“intrinsic value” method, which measures the value of an option as the difference
between the option’s exercise price and the market price of the underlying stock on the
grant date. Under the intrinsic value method, an at-the-money option (i.e., one that is
granted with an exercise price equal to the market price on the date of the grant) has an
intrinsic value of zero. Therefore, a company that grants at-the-money options need not
record any compensation expense in association with the grant of such options.
Accordingly, the grant of at-the-money options was, prior to January 1, 2005, a means by
which companies could increase the compensation of their employees and executives
without taking any charge against earnings in their publicly-filed audited financial
statements.4
A significant tax reason for granting options at the money was that Internal Revenue
Code (“IRC”) Section 162(m), which was enacted in 1993 to limit to $1 million for each
of the company’s top five most highly compensated executives the amount of
compensation expense for which a company could take a tax deduction, excluded from
the $1 million limit performance-based compensation such as at-the-money options. As
discussed more fully below, whether an option is granted at the money or in the money
also affects other aspects of a company’s tax liability, including its obligation to withhold
income taxes and other payroll taxes.
Another rationale for granting options at the money as opposed to in the money is the
theory that option-based compensation, so long as its value depends entirely upon the
performance of the stock subsequent to the grant of the options in question, should better
align the interests of management with those of shareholders, by giving management a
4
In October of 1995, the Financial Accounting Standards Board (“FASB”) issued FASB Statement 123
(“Accounting for Stock-Based Compensation”), which proposed an alternative “fair value” method of
evaluating options, using pricing models, such as the Black-Scholes model, to assign values even to at the
money options. Pursuant to FAS 123, companies could continue to use the intrinsic value method to value
options, as long as they included, in the footnotes to their financial statements, pro forma calculations
showing what the compensation expense would have been under the fair value method. Most companies
continued to use the intrinsic value method over the next decade. However, in December of 2004, FASB
issued Statement 123 Revised (FAS 123R), which provided that issuers could no longer use the intrinsic
value method to value options in fiscal years beginning after June 15, 2005.
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financial incentive to take actions that have the effect of raising the market price of the
company’s stock. While at-the-money options should effectively provide such an
incentive inasmuch as such options will have value only to the extent that the market
price of the underlying stock increases subsequent to the option grant date, in-the-money
options would presumably provide less incentive for raising the future stock price, since
they are already exercisable for a profit as soon as they are granted. For this reason,
many companies’ shareholder-approved Stock Option Plans require that employee stock
options be granted at the money.
Backdating itself, as opposed to other forms of options manipulation discussed below,
can take many forms. The sine qua non is that the purported grant date assigned to the
option be selected by hindsight. For example, while it might not be obvious at first
glance, one particularly widespread practice that qualifies as backdating is the “ThirtyDay Pricing Methodology,” a practice pursuant to which the exercise price of options is
left open for a thirty-day window after the date on which the company decides to grant
options, so that, in the event that the stock price were to drop significantly within that
window, the date on which the stock price is lowest can be selected as the purported
grant date of the options. This practice appears to have been adopted by a number of
companies in order to avoid one of two undesirable scenarios: (1) that options granted at
fair market value on the grant date become almost immediately out-of-the money or
“underwater,” and thus effectively worthless, as a result of a stock price drop shortly after
the grant date; and (2) that options granted at fair market value to different employees
hired only a few days apart bear radically divergent exercise prices because of some
intervening stock price movement (something that understandably generated a number of
complaints by those employees whose exercise prices were significantly higher than their
peers’). In order to avoid such unattractive possibilities, several companies agreed to
adjust the exercise price of their options to the lowest price available within the thirty day
window following the grant decision by assigning to the options, as their putative grant
date, the date within the window on which the market price of the stock was the lowest.
The reason why this practice usually qualifies as backdating is that the exercise prices of
the options, and thus the essential terms of the grant, are not determined until the end of
the thirty-day window. Thus, unless the last day of the thirty-day window is selected as
the putative grant date (in which case there would be no backdating problem), the
purported grant date assigned to the options at the end of the thirty-day window will have
been selected by hindsight and will not correspond to the measurement date for purposes
of GAAP.
One company, Micrel Semiconductor (“Micrel”) alleged, in a complaint it filed against
its former auditor, Deloitte & Touche LLP (“D&T”), that D&T caused Micrel to incur
expenses in excess of $52 million by advising the company from 1996 through 2001 that
the Thirty-Day Pricing Methodology was appropriate. See, Complaint filed on April 21,
2003, in the matter captioned, Micrel, Inc. v. Deloitte & Touche, LLP, et al., Cal. Super.
Ct. Case No. CV816477 (Santa Clara County) (attached). D&T recently settled that case
for $15.5 million. (See, Micrel’s March 22, 2007 Form 10-K, p. 70.) It has also been
reported that Microsoft Corporation received the same advice from D&T.
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What Backdating Is Not.
Backdating should not be confused with other forms of arguably-improper optionsgranting practices, e.g., spring-loading, bullet-dodging, manipulation of the information
flow, and simple misdating.
“Spring-loading” refers to the practice of intentionally timing the grant of stock options
to precede the company’s announcement of good news that is expected to increase
market price of the company’s stock. “Bullet-dodging” refers to the practice of
intentionally timing the grant of stock options to follow the company’s announcement of
bad news that is expected to decrease the market price of the company’s stock. Such
practices (like backdating itself) are feasible only when a company’s stock plan allows
options to be granted at any time. “Manipulation of the information flow,” on the other
hand, refers to the timing of the company’s announcements of good or bad news so that
they follow or precede, respectively, regularly-scheduled grants of stock-options. If
option grant dates are already scheduled, as they are at some companies, the timing of
company announcements is the only way to manipulate the price at which options are
granted.
While there is some disagreement as to whether spring-loading, bullet-dodging and
manipulation of the information flow constitute illegal insider trading, the SEC and many
commentators, including Professor Lie, take the position that they do. However, SEC
Commissioner Paul S. Atkins, in a much-quoted speech to the International Corporate
Governance Network 11th Annual Conference (July 6, 2006), arguing that spring-loading
does not constitute insider trading, stated:
Many of the hypothetical fact patterns being bandied about seem to be
rooted in a questionable reading of the law. A scenario that has drawn
much attention is the colorfully named “springloading,” which has been
defined as the practice by which a company purposefully schedules an
option grant ahead of good news, or purposefully postpones an option
grant until after bad news. I am not sure where the term springloading
came from, but it certainly has an ominous ring to it.
Not only are there difficult factual issues that need to be proven, such as
the nexus between the grant decision and the subsequent news event, but
there are also substantive legal issues that need to be addressed.
Specifically, we need to ask ourselves whether there has been a securities
law violation even if a nexus can be identified between the grant and the
news event. Isn’t the grant a product of the exercise of business judgment
by the board? For example, a board may approve an options grant for
senior management ahead of what is expected to be a positive quarterly
earnings report. In approving the grant, the directors may determine that
they can grant fewer options to get the same economic effect because they
anticipate that the share price will rise. Who are we to second-guess that
decision? Why isn’t that decision in the best interests of the shareholders?
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We also need to remember that predicting the stock price effect of an
upcoming event is difficult, let alone predicting the trajectory of the stock
price over the next twenty quarters until the options vest.
Also swirling about are accusations of insider trading by corporate boards
in connection with options grants. Again, one has to ask whether there is a
legitimate legal rationale for pursuing any theory of insider trading in
connection with option grants. Boards, in the exercise of their business
judgment, should use all the information that they have at hand to make
option grant decisions. An insider trading theory falls flat in this context
where there is no counterparty who could be harmed by an options grant.
The counterparty here is the corporation — and thus the shareholders!
They are intended to benefit from the decision.
Practically speaking, because corporate boards are almost always in
possession of material nonpublic information, it would be difficult (if not
impossible) to require them to refrain from making options grants when
they are in possession of such information. Along those lines, would we
call it insider trading if a board chose not to grant options because it knew
of impending bad news?
(http://www.sec.gov/news/speech/2006/spch070606psa.htm)
Backdating should also be distinguished from simple misdating, which could conceivably
occur in the absence of any positive wrongdoing, as, for example, when a company
erroneously determined a measurement date that is incorrect because all of the required
granting actions had not yet been completed, or unverifiable because the required
paperwork is missing or incomplete. With respect to such misdating, Commissioner
Atkins opined:
Similarly, there is no securities law issue if backdating results from an
administrative, paperwork delay. A board, for example, might approve an
options grant over the telephone, but the board members’ signatures may
take a few days to trickle in. One could argue that the grant date is the date
on which the last director signed, but this argument does not necessarily
reflect standard corporate practice or the logistical practicalities of getting
many geographically dispersed and busy, part-time people to sign a
document. It also ignores that these actions reflect a true meeting of the
minds of the directors, memorialized by executing a unanimous written
consent.
(Id.)
Commissioner Roel C. Campos, in his Remarks Before the 2007 Summit on Executive
Compensation (Jan. 23, 2007), stated, presumably with respect to such administrative
misdating that is unaccompanied by falsification of documents:
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. . . we recognize that not every case in which stock option paperwork is
less than 100% correct presents grounds for an Enforcement action.
(http://www.sec.gov/news/speech/2007/spch012307rccc.htm.)
However, it should be noted that such process and paperwork problems seem to point to
deficiencies in internal controls that make intentional backdating and other forms of
abuse more likely to occur.
Why Did Widespread Stock-Option Backdating Occur?
One rationale offered for stock option backdating is that companies considered the
practice to be essential to their efforts to attract and maintain executive talent. It is true
that the competition for executive talent is, and during the affected period was, intense,
and that stock-based compensation, particularly options, constituted a significant portion
of the typical executive pay package at many companies, especially start-up technology
companies with little cash on hand. This explains why many companies considered it
necessary to make their options as attractive as possible, including by granting options
with in-the-money exercise prices that made it more likely (barring some precipitous
stock price drop before such options vested) that the recipients would be able to exercise
them for a significant profit. However, the competition for executive talent does not, by
itself, explain why so many companies resorted to backdating to disguise such in-themoney options as at-the-money options, rather than openly granting the options in the
money, a practice that (in contrast to backdating) would have been entirely legal.
In view of the various reasons for (at least purportedly) granting options at the money, the
purpose of disguising in-the-money options as at-the-money options by means of
backdating is clear: to maximize the true value of option-based compensation without
facing any of the following consequences: (1) recognizing any compensation expense,
which would negatively impact the company’s attractiveness to investors by reducing
publicly disclosed earnings and profit figures; (2) incurring the less favorable tax
treatment that is afforded to options that are not at the money; or (3) appearing to violate
the terms of shareholder-approved Stock Option Plans, which typically require that
options be granted at the money.
Professor Lie, in his testimony before the U.S. Senate Committee on Banking, Housing
and Urban Affairs on September 6, 2006, summarized the pernicious effect of backdating
as follows:
In theory, stock options can be used to motivate executives and other employees
to create value for shareholders. However, they have also been used to (i) conceal
true compensation expenses, (ii) cheat on corporate taxes, and (iii) siphon money
away from shareholders to option recipients
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(Erik Lie, September 6, 2006 Testimony Before the U.S. Senate Committee on Banking,
Housing, and Urban Affairs, p. 5 of 6.)
Similarly, SEC Chairman Christopher Cox, in his testimony on the same day before the
same committee, was clear about fraudulent purpose of stock-option backdating:
There are many variations on the backdating theme. But here is a typical example
of what some companies did: They granted an “in-the-money” option – that is, an
option with an exercise price lower than that day’s market price. They did this by
misrepresenting the date of the option grant, to make it appear that the grant was
made on an earlier date when the market value was lower. That, of course, is
what is meant by abusive “backdating” in today’s parlance.
The purpose of disguising an in-the-money option through backdating is to allow
the person who gets the option grant to realize larger potential gains – without the
company having to show it as compensation on the financial statements.
Rather obviously, this fact pattern results in a violation of the SEC’s disclosure
rules, a violation of accounting rules, and also a violation of the tax laws.
(Christopher Cox, September 6, 2006 Testimony Before the U.S. Senate Committee on
Banking, Housing, and Urban Affairs, p. 1 of 8.)
It should be noted that backdating is a largely, but not entirely, a pre-Sarbanes-Oxley Act
phenomenon. Prior to the August 29, 2002 effective date of the Sarbanes-Oxley Act,
executives who received stock option reported the grants to the SEC on Forms 5, which
were not required to be filed until 45 days after the end of the fiscal year in which the
grant occurred. This provided a broad time window within which those who were so
inclined could, with the benefit of hindsight, retrospectively select dates on which the
stock price was particularly low, and pretend that the company had in fact granted at-themoney options on such dates, when in fact the options in question were not granted until
some later point after the stock price had risen significantly.
Pursuant to changes mandated by the Sarbanes-Oxley Act, executives are now required to
report their option grants to the SEC on Forms 4, which must be filed within two business
days of the grant date. Professor Lie has demonstrated that the incidence and magnitude
of backdating have declined precipitously since the enactment of the Sarbanes-Oxley Act.
However, his study has also revealed that some backdating does still occur, both within
the smaller two-day window left open by the Act, and, to a more significant degree,
among those companies that fail to comply with the Act.5
5
See, Randall A. Heron and Erik Lie, Does Backdating Explain the Stock Price Pattern Around Executive
Stock Option Grants?, 83 Journal of Financial Economics, pp. 271-295 (February 2007).
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Who Is To Blame?
There appears to be plenty of blame to go around, both within and without the affected
companies. In many cases, particularly those in which officers or other employees forged
or falsified books or records, and/or otherwise concealed the true nature of the backdated
grants from the board and/or the relevant committees thereof, the knowing conspirators
themselves are the obvious culprits.
However, there are issues as well with respect to boards of directors that knowingly
countenanced backdating, which, as mentioned above, appears to have had no purpose
other than to disguise in-the-money options (which are subject to unique accounting and
tax treatment) as at-the-money options (which are subject to substantially different
accounting and tax treatment).
Potentially responsible parties outside the affected companies would include experts,
such as attorneys, accountants/auditors, and/or compensation consultants, on whose
expert advice boards of directors typically rely. The vast number of companies that
appear to have engaged in backdating would suggest that someone on whose advice a
board might typically be justified in relying must have been saying that the practice was
permissible.
Among other anecdotal indications that this was the case are recent news reports
concerning the involvement of a number of highly-regarded law firms with companies
caught up in the backdating scandal, and the recent settlement by Deloitte & Touche for
$15.5 million of a lawsuit (mentioned above) in which Micrel Semiconductors alleged
that its auditors had advised that a form of backdating was permissible.
Companies should consider the possible assertion of claims, for contribution, professional
negligence, or otherwise, against potentially responsible third parties such as attorneys,
accountants and compensation consultants whose advice might have contributed to their
backdating problems. On the other hand, companies may have significant reasons not to
press such claims, including valuable ongoing relationships with such professionals,
especially outside auditors, which, in the event that they were to become adverse to the
company in such litigation, could be expected to resign – a prospect that could give rise
to substantial transition costs and/or even cause the companies’ public filings to be
delayed (which in turn could lead to, among other consequences, exchange delisting and
default on loan or bond covenants). In any event, companies are often required, under the
terms of their D&O liability insurance policies, to preserve such claims against
potentially responsible third parties (e.g., by executing tolling agreements) on behalf of
their D&O insurers, which, in the event of a payment under the policy, would be entitled
to pursue such claims themselves in subrogation.
How Was The Backdating Scandal Discovered?
The use of option-based executive and employee compensation has been a common
practice of public companies since the enactment of IRC Section 162(m) in 1993. Since
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shortly thereafter, keen observers have noted with suspicion the fact that executives and
other employees very often received at-the-money options at times when the market price
of the underlying stock was relatively low. See, e.g., David Yermack, Good Timing:
CEO Stock Option Awards and Company News Announcements, Journal of Finance, Vol.
52, No. 2 (June 1997), pp. 449-476.
Professor Yermack, and other commentators who examined the issue, initially attributed
the suspicious timing of option awards to other, more complicated forms of manipulation,
such as spring-loading, bullet-dodging, and/or manipulation of the information flow. In
light of these suspicions, the SEC commenced investigations of option timing at several
companies as early as 2003.
Then, in the summer of 2005, Erik Lie, a Norwegian-born professor at the University of
Iowa Business School, discovered that the apparent cause of the suspicious timing was a
much simpler, more straightforward, and obviously fraudulent practice, viz., backdating.
Professor Lie examined a sample of 5,977 option grants from 1992 through 2002 (which
was limited to companies in which option grants were not scheduled for the same date
every year) and discovered a striking pattern in which stock prices tended to decrease
before the grant dates, at which point the stock price was abnormally low, and then
tended to increase sharply right after the grant date, a trend that intensified over the
course of the decade. On Dr. Lie’s graph of cumulative abnormal stock return relative to
option grant dates, the stock price movement surrounding the grant date looks essentially
like a “V” with the grant date in the middle at the point where the stock price is the
lowest. (In contrast, a similar graph relative to post-Sarbanes Oxley option grants that
were reported within one day shows no discernible stock price movement surrounding the
grant date.) Professor Lie further determined that this suspicious pattern occurred even
when the movement in the underlying stock price was attributable solely to movements
of the stock market as a whole. See, Erik Lie, On the Timing of CEO Stock Option
Awards, Management Science, Vol. 51, No. 5 (May 2005), p. 802-812.
Based upon this pattern, Professor Lie concluded that “unless executives have an
informational advantage that allows them to develop superior forecasts regarding the
future market movements that drive these predicted returns, the results suggest that the
official grant date must have been set retroactively.” Id., at p. 811.
In response to Professor Lie’s findings, Professor Yermack stated, “I didn’t believe it at
first. . . . The whole idea was so sinister.” Steve Stecklow, Options Study Becomes
Required Reading, Wall Street Journal (May 30, 2006). However, Dr. Yermack has since
acknowledged that Dr. Lie’s backdating hypothesis provides the best explanation for the
suspicious patterns he had earlier discovered: “I found the problem and he’s the guy who
came up with the explanation of the puzzle. . . . To be perfectly blunt about it, I didn’t
have as much imagination as Erik did to think about backdating.” Id.
While Professor Lie deserves the lion’s share of credit for discovering the widespread
backdating phenomenon, the scandal did not become a focus of general public attention
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until March 18, 2006, when the Wall Street Journal printed a front page story by Charles
Forelle and James Bandler entitled, “The Perfect Payday: Some CEO’s reap millions by
landing stock options when they are most valuable. Luck – or something else?”
In its Pulitzer Prize-winning Perfect Payday article, the Wall Street Journal analyzed the
fortunate timing of option grants issued by Affiliated Computer Service, Inc. (“ACS”),
UnitedHealth Group Inc., Mercury Interactive Corp., Analog Devices Inc., Brooks
Automation Inc., Comverse Technology Inc., and Vitesse Semiconductor Corp., and
determined that the odds against such timing having occurred by chance were
astronomical. In reference to the fact that all six of the stock-option grants received by
ACS CEO Jeffrey Rich “from 1995 to 2002 were dated just before a rise in the stock
price, often at the bottom of a steep decline[,]: the paper reported:
Just Lucky? A Wall Street Journal analysis suggests the odds of this
happening by chance are extraordinarily remote – around one in 300
billion. The odds of winning the multistate Powerball lottery with a $1
ticket are one in $146 million.[6]
In the twelve months since this article was published, some 100 public companies have
announced that the SEC is investigating their options practices, at least 53 have
announced that they are being investigated by the DOJ, at least 33 have announced
option-inquiry-related resignations or terminations of directors or officers, and at least 81
have announced restatements or other charges to previously-reported earnings
attributable to the backdating or misdating of options. See, Wall Street Journal Online
Options Scorecard, http://online.wsj.com/public/resources/documents/infooptionsscore06-full.html.
Some scorekeepers tally that plaintiffs have also filed: (1) at least 29 securities class
action lawsuits against public companies alleging that they have been defrauded by the
companies’ option-related misstatements of earnings; (2) at least 155 shareholder
derivative suits against directors and officers for alleged breaches of fiduciary duty and
unjust enrichment in connection with options practices, and (3) at least 5 ERISA lawsuits
for breaches of ERISA fiduciaries’ duties to covered plans in connection with options
practices. (See, The D&O Diary, http://dandodiary.blogspot.com/2006/07/countingoptions-backdating-lawsuits.html.)
6
While NERA Economic Consulting (www.near.com) has published an article entitled Options
Backdating: The Statistics of Luck, in which some of its consultants purport to cast doubt on the Wall Street
Journal’s statements regarding these odds, which they characterize as “misleading,” by pointing out that
some companies, as a matter of random chance, will be lucky with their timing of option grants (and that
others will be unlucky), their argument simply does not appear to address the basis of Professor Lie’s
conclusion of widespread backdating, viz., that such large numbers of companies were so lucky so often.
Moreover, the observations offered in the NERA paper would seem to be somewhat beside the point, given
the fact that many executives, including at some of the companies mentioned in the Wall Street Journal
Article, have either admitted, pled guilty, fled the county, or been determined by special committees
appointed by their respective corporations to have committed intentional backdating.
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Some companies involved in backdating—and their shareholders—have suffered
immediate financial consequences as a result of the options backdating scandal.
Research by San Francisco-based shareholder consultancy Glass Lewis, published at the
end of October 2006, suggests that the companies named in the scandal had effectively
been handed a $10.3 billion bill for the alleged wrongdoing. Of this total, $5.2 billion has
been incurred in otherwise unexpected compensation expenses. These costs, as well as
additional auditing costs and lawyers’ fees, are expected to rise steeply in the coming
months. In addition, the study showed that companies implicated in the scandal have
suffered a collective $5.1 billion fall in their share prices since they admitted backdating
practices. Alternative research concludes that almost $8 billion has been lost from the
value of implicated companies when the underperformance of the companies compared
to their peers and/or the S&P 500 index is included.
On the other hand, many companies that have announced the discovery of backdating or
other options-related problems have not seen any (or any significant) negative stock price
movement following such announcements. While over 150 public companies have
disclosed options-related problems, only 29 have thus far been subjected to federal
securities class action lawsuits. Plaintiffs’ firms appear to be concentrating on alternative
strategies, including shareholder derivative suits (at least 155 of which have been filed so
far) and proxy-fraud suits under section 14 of the Securities Exchange Act of 1934 (and
Rule 14 promulgated thereunder) to void shareholder-approved stock option plans and all
options granted pursuant thereto. See, e.g., Section 14 Complaint filed on March 28,
2007 in the matter captioned, Calamore v. Juniper Networks, Inc., et al., Case No. 07CV-01772-MJJ (N. D. Cal.) (in which plaintiff seeks to void the shareholder-approved
2006 stock option plan and options granted pursuant thereto because prior backdating
was not disclosed to shareholders in the proxy statement) (attached).
While derivative suits could potentially produce positive results (such as, for example,
the institution of corporate therapeutic measures [including the strengthening of internal
controls] and/or the disgorgement of profits received by officers or directors who were
unjustly enriched by backdated options), it is difficult to see what Section 14 plaintiffs
hope to accomplish (apart from gaining an award of attorneys’ fees and costs) by voiding
post-backdating stock option plans and non-backdated options granted pursuant thereto
merely on the ground that such plans were approved by shareholders to whom past
backdating problems under a prior plan had not been disclosed in the proxy statement.
Is Stock-Option Backdating Illegal?
While some commentators have stated that backdating is not necessarily illegal in itself,
they seem to be referring not to backdating, but rather to the grant of in-the-money
options, which is legal, as long as it is permitted by the relevant stock-option plan,
properly disclosed in public filings, and subjected to the proper accounting and tax
treatment. The practice of backdating (as opposed to the grant of in-the-money options),
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however, has no apparent rational purpose other than to misrepresent the value,
taxability, and other material characteristics of stock-option-based compensation.7
After all, since there is no general prohibition on the grant of in-the-money options
(where permitted by the relevant plan), the grant of such options does not, in itself,
necessitate any manipulation of grant dates. Thus, any company that wished to grant inthe-money options could and should have done so openly without falsifying the purported
grant date.
However, as set forth more fully below, such in-the-money options would not confer on
the issuer and the recipients any of the significant accounting and tax advantages
attendant to at-the-money option grants. Moreover, the variable accounting treatment
required with respect to in-the-money options is reportedly very difficult and complex.
In addition, many companies’ shareholder-approved Stock-Option Plans also expressly
forbid the issuance of in-the-money options.
Accordingly, the mere desire to grant an option with a particular strike price does not, in
itself, necessitate or explain the resort to backdating. Therefore, the only discernible
reason for falsifying the grant date of an option is to disguise a more lucrative, discounted
in-the-money option grant as an at-the-money option grant subject to all of the favorable
accounting and tax treatment attendant to such grants.
Moreover, as shown below, backdating almost invariably entails, among other things, the
falsification of books and records (which is a violation of the Foreign Corrupt Practices
Act, as codified at section 13 of the Securities Exchange Act of 1934 [15 U.S.C.
78m(b)(5)] and Rule 13b2-1 promulgated thereunder), the dissemination to the public in
proxy statements and periodic SEC filings of materially false and misleading information,
and the violation of tax laws, securities reporting regulations and Generally Accepted
Accounting Principles (“GAAP”), and often violates the terms of companies’ stock
option plans.
In contrasting backdating with other, less obviously illegal forms of option-timing
manipulation, Professor Lie offered the following observation with respect to the
illegality of backdating:
Backdating is less ambiguous. If options purported to be at-the-money on the
backdated grant date were in-the-money on the actual grant date (which should be
the measurement date for financial and tax reporting purposes) and not properly
accounted for, then
7
Professor Lie, while opining that stock-option grant backdating “is not necessarily illegal” as long as it is
clearly disclosed to company’s shareholders, properly reflected in earnings reports and accorded the correct
tax treatment, and long as no documents have been forged, noted that “these conditions are rarely met,
making the backdating of grants illegal in most cases.” See, Erik Lie, Backdating of Executive Stock
Option (ESO) Grants, http://www.biz.uiowa.edu/faculty/elie/backdating.htm. Dr. Lie further points out
that, “it can be argued that if these conditions hold, there is little reason to backdate options, because the
firm can simply grant in-the-money options instead.” Id.
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•
the firm’s reported earnings were too high according to the accounting
regulations (under both APB 25 and FAS 123R),
•
the firms taxes might have been too low (due to IRC § 162(m), and because
the deductible spread between the exercise price and the stock price at the
time of the actual option exercises is artificially inflated),
•
if the options are ISOs [Incentive Stock Options], one of their requirements
for their favored tax-status have [sic] been violated, and
•
any requirement in the option plan that the options should be granted at the
fair market value is violated.
•
In addition, to implement the backdating strategy, documents might have been
forged, which is a federal offense.
(Erik Lie, September 6, 2006 Testimony Before the U.S. Senate Committee on Banking,
Housing, and Urban Affairs, p. 6 of 6.)
What Can A Company Expect When It Discovers that Backdating Has Occurred?
When stock-option backdating is discovered, the consequences for the company can be
enormous. Perhaps most significantly, the discovery that the company has previously
failed to recognize compensation expenses attributable to in-the-money options that had
been disguised as at-the-money options will, if the amounts at issue are material (as they
often are), necessitate the restatement of the company’s publicly-filed audited financial
statements for the affected periods. Recognition of compensation expense attributable to
backdated options can materially reduce a company’s reported earnings and profits.
The restatement of previously-filed financial statements can itself lead to serious
consequences, including (in addition to the substantial cost of preparing the restatement):
(1) delays in the filing of periodic reports with the SEC, which can lead to the delisting of
the company from NASDAQ or other stock exchanges and which can also constitute an
event of default under typical bond or loan covenants; (2) possible increased liability for
income tax and payroll taxes, along with associated interest and penalties for previous
nonpayment; (3) the possible rescission of Directors & Officers (“D&O”) liability
insurance policies on the basis material misrepresentations in the application, which
typically includes a company’s SEC filings and audited financial statements, and/or the
limitation of coverage available to various Insureds thereunder; (4) the disgorgement by
the Chief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”) of any
incentive-based compensation earned during the twelve months following the disclosure
that had to be restated, pursuant to Section 304 of the Sarbanes-Oxley Act; (5) the
triggering of SEC and DOJ investigations; (6) the filing of securities class action lawsuits
seeking damages incurred in connection with the purchase of securities in actual or
presumed reliance on financial statements and associated public disclosures which the
company, by restating, has admitted to have been materially misstated; and (7) the
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possibility that recipients of backdated options could see those options rescinded or repriced, or be forced to disgorge any profits received as a result of their exercise thereof.
Other consequences that can be expected to flow from the discovery of backdating,
irrespective of whether the company is ultimately compelled to restate its financial
statements, include: (1) the costs of conducting an internal investigation to determine the
cause and extent of the backdating problems, including the fees charged by outside
counsel and forensic accountants for their services in connection with such investigation;
(2) the risk that such an investigation will be deemed by regulatory officials to have
resulted in a waiver of the protections of the attorney-client privilege and the workproduct doctrine with respect to the findings of the investigation; (3) the termination or
resignation of executives and other employees discovered to have been involved in the
backdating; (4) possible criminal prosecutions of those persons determined to have
engaged in the forgery or falsification of documents in connection with such backdating;
(5) the costs of responding to any resultant SEC, DOJ and/or other investigations or
prosecutions, including the considerable expenses associated with the review, analysis
and production of company documents subpoenaed or otherwise requested in connection
therewith; (6) the costs and distractions attributable to the media fallout that inevitably
accompanies the disclosure of backdating problems; and (7) the costs of defending and/or
resolving shareholder derivative lawsuits for alleged breaches of fiduciary duty and
unjust enrichment in connection with such backdating.
III.
A.
LEGAL AND OTHER ISSUES RELATIVE TO BACKDATING
ACCOUNTING CONSEQUENCES OF BACKDATING UNDER GAAP
The only apparent reason to backdate stock options (as opposed to issuing stock options
that are openly in the money) was to grant effectively in-the-money options while
simultaneously affording those options the more favorable accounting treatment reserved
for at-the-money options. Pursuant to the “intrinsic value” method prescribed by APB
No. 25, at-the-money were treated as having no intrinsic value, whereas in-the-money
options had be expensed using the difference between the strike price and the market
price as the intrinsic value. Since both in-the-money and at-the-money options must now
be expensed using the “fair value” method pursuant to FAS 123R, there is no longer any
significant accounting incentive for backdating. This, together with the tightened
reporting requirements imposed by Sarbanes-Oxley, suggests that backdating is largely a
phenomenon of the past.
One could argue that the widespread use of backdating was merely a reaction to the
economic unreality of the “intrinsic value” method. An unvested (and hence unexercisable) option granted with a strike price of $19 on a date on which the market price
of the underlying stock is $20 is not really worth $1 more than an unvested (and hence
un-exercisable) option granted on the same date with a strike price of $20, even though
the “intrinsic value” method would hold that the former is worth $1 and the latter is worth
$0. After all, both options are essentially useless until they are exercisable and, if the
market price of the underlying stock is less than $19 by the time the options become
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exercisable, then both options will be equally worthless at that time. Using the “fair
value” method now imposed by FAS 123R, which takes into account the vesting
schedule, the volatility of the stock price, and other factors, the difference between
unvested in-the-money and at-the-money options is only a few cents for every dollar of
difference in the exercise price.
Yet, under APB No. 25, the $19 in-the-money option was supposed to be valued at $1
(even though it was really only worth a fraction of that if anything), whereas the $20 atthe-money option was supposed to be valued at $0 (even though it was really worth only
a few cents less than the in-the-money option). Moreover, in-the-money options, unlike
at-the-money options, were subject to variable accounting, a labyrinthine and purportedly
difficult process whereby the value of the option had to be recalculated periodically on
the basis of, among other things, the movement of the underlying stock price.
In light of the small difference in actual value between in-the-money and at-the-money
options, and the speculative nature of the ultimate value of either type of option, given
that they could end up being worthless by the time they were exercisable, it seems
unlikely that the motive of backdating was to disguise the true amount of executive
compensation, let alone to perpetrate a theft from the company. Rather, it would appear,
as many have suggested, that the usual motive behind backdating was a desire to simplify
the compensation process by picking an option exercise price that would be attractive to
the recipients, irrespective of the market price on the actual grant date, without going
through the allegedly difficult motions of affording such effectively in-the-money options
the variable accounting treatment required under GAAP. (On the other hand, while it
may not have been done primarily for tax purposes, the mischaracterization of in-themoney options as at-the-money options does seem to have operated as a tax fraud to the
extent that it resulted in the underpayment and under-withholding of taxes.)
Nevertheless, the mischaracterization and treatment of in-the-money options as at-themoney options did violate GAAP. Therefore, to the extent that the amounts of
compensation expense the company failed to recognize as required by GAAP, net of the
corresponding tax deductions to which the company would have been entitled on the
basis of such compensation expenses, are material, companies could be required to restate
their previously-filed financial statements. Such a restatement is an admission by the
company that its publicly-filed financial statements and other representations based
thereon were materially false and misleading. Moreover, relevant SEC regulations
provide that “[f]inancial statements filed with the Commission which are not prepared in
accordance with generally accepted accounting principles will be presumed to be
misleading or inaccurate, despite footnotes or other disclosures, unless the Commission
has otherwise provided.” 17 C.F.R. § 210.4-01(a)(1) (2006).
The accounting guidance applicable to most of the grants in question was APB No. 25,
which required that options be valued on the basis of the difference between the exercise
price and the market price of the underlying stock on the “measurement date,” which it
defined as “the first date on which are known both (1) the number of shares that an
individual employee is entitled to receive and (2) the option or purchase price, if any.”
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Thus, the valuation of options under APB No. 25 requires a determination of the correct
measurement date. Since the determination of the correct date has been rendered
somewhat difficult by various of the recently disclosed options-related practices, the SEC
Chief Accountant, Conrad Hewitt, issued an open letter, on September 19, 2006, to
provide reporting companies and audit firms with some guidance as to the determination
of the correct measurement date in the following circumstances:
•
Option Grants that Were Backdated – Backdating cannot change the
correct measurement date, which “cannot occur until the date the terms of the
award and its recipient are actually determined.”
•
Option Grants With Administrative Delays – The measurement date
occurs when all “required granting actions” (i.e., all procedures required by
the applicable corporate governance provisions, the terms of the stock option
[plans, or applicable law) are complete. Mere administrative delays may not
affect the measurement date as long as the terms and recipients had already
been determined and the company does not customarily operate as if the terms
of its awards are not final until the completion of all required granting actions.
However, any evidence that documentation was prepared in a manner
calculated to disguise the true nature of option granting actions would
preclude a company from concluding that a measurement date occurred prior
to the completion of all required granting actions.
•
Option Grants of Uncertain Validity – In cases in which the option grants
violated terms of the shareholder-approved stock option plans, “the
substantive arrangement that is mutually understood by both the company and
its employees represents the underlying economic substance of the past option
grants, and should serve as the basis for the company’s accounting[,]” where:
“(a) the company has, as applicable, been honoring the awards and settling in
stock; (b) the company intends to honor outstanding unexercised awards and
has a reasonable basis to conclude that the most likely outcome is that the
awards will be honored, and (c) the company intends to settle the outstanding
unexercised awards in stock and has a reasonable basis to concluded that it
will be able to do so (even if such settlement is not entirely within the
company’s control).”
•
Option Grants as to which the Recipients Had Not Ben Determined – If
the aggregate number of options to be granted has been approved, but the
particular recipients and the amounts received thereby have yet to be
determined, then: (a) the measurement date may have already occurred if the
manner in which the options will be allocated among particular recipients will
be based on objective, non-discretionary factors (e.g., seniority or position of
the employee); but (b) the measurement date will not occur until the allocation
is completed if such allocation is based upon subjective, discretionary
determinations by management.
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•
Options With Exercise Prices Set By Reference To Future Market Prices
– In cases in which the company, using the Thirty-Day Pricing Methodology
discussed above, leaves the exercise price open for a thirty-day window,
variable accounting is required until the contingency is resolved at the end of
the thirty-day window. On the other hand, in cases in which an option is
granted with a definite exercise price and is subsequently re-priced at the end
of a thirty-day window, variable accounting will be required until the option is
exercised.
•
Options Grants Prior to the Commencement of Employment – In cases in
which a company sets the terms and conditions of an option award for an
employee prior to that employee’s commencement of employment, the
appropriate accounting treatment depends on whether the employee provided
the company with any services prior to the commencement of employment. If
so, the option should be accounted for pursuant to FASB Statement No. 123
and EITF Issue No. 96-18 (“Accounting for Equity Instruments That Are
Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services”). If, on the other hand, the employee provided no
services prior to employment, the measurement date cannot occur prior to the
date on which the employment commences.
•
Option Grants for Which Documentation Is Incomplete or Missing – In
such instances, the company “must use all available relevant information to
form a reasonable conclusion as to the most likely option granting actions that
occurred and the dates on which such actions occurred in determining what to
account for. The existence of a pattern of past stock option grants with an
exercise price equal to or near the lowest price of the entity’s stock during the
time period surrounding those grants could indicate that the terms of those
grants were determined with hindsight. Further, in some cases, the absence of
documentation, in combination with other relevant factors, may provide
evidence of fraudulent conduct.”
•
Option Grants That Were Spring-Loaded – While some have suggested
that the value of spring-loaded options should be adjusted in consideration of
the company’s possession of inside information on the grant date, the SEC
believes that spring-loading does not change the accounting treatment
accorded to options, the intrinsic value of which should be computed,
pursuant to paragraph 10(a) of Opinion 25, using the market price of the
underlying stock on the measurement date.
•
Options With Terms That Changed After Non-Public Information Was
Released – In such instances, the options have been re-priced, and must
therefore be accounted for using variable accounting.
•
Option-Related Income Tax Benefits – The SEC understands that the use of
incorrect exercise dates as some companies has resulted in a reduction of the
amount of income taxes owed by recipients and a corresponding reduction in
the income tax benefit received by the company. The SEC believes that the
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company should record the excess tax benefit it otherwise would have been
entitled to receive on the actual exercise date as an addition to paid-in capital.
Any amount of such benefit foregone by the company due to a misstated
exercise date, and any other tax obligations of the employee paid by the
company, should be recorded as compensation cost to the employee.
B.
FEDERAL INCOME TAX CONSEQUENCES OF BACKDATING
Companies issue two basic types of stock options to their executives and other
employees, qualified or incentive stock options (“ISO’s”) and non-qualified or nonstatutory options (“NSO’s”), each of which is subject to significantly different tax
treatment.
Incentive Stock Options: ISO’s, which are usually used to compensate lower level
employees because the total value of a grant is limited to $100,000, are not recognized as
taxable ordinary income at the time of grant or at the time of exercise. Instead, as long as
the recipient satisfies the relevant holding-period requirements (two years from grant and
one year from exercise), he or she is taxed for the difference between the exercise price
and the sale price, at the lower long-term capital gains tax rate, at the time he or she sells
the underlying stock. The employer does not receive a tax deduction for compensation
expense with respect to grant or exercise of the options, and does not pay any FICA
withholding upon the sale of the underlying stock.
On the other hand, if the recipient makes a disqualifying disposition (i.e., sells the stock
within one year after exercising the options), then the gain (i.e., difference between the
exercise price and the sale price) is treated as ordinary income, taxable at the higher rate,
and the company is entitled to a deduction for compensation expense in the same amount.
To qualify as an ISO, an option must: (1) be granted pursuant to a shareholder-approved
plan; and (2) bear an exercise price at least equal to the market price of the underlying
stock on the date of the grant. See, IRC § 422(b). In light of these two requirements,
options that are found to have backdated or otherwise granted in the money (e.g.,
misdated) do not qualify as ISO’s and must, instead, be treated as NSO’s.
Non-Statutory Options: NSO’s, which are the type of options most often granted to
executives, are taxable when the option is exercised and subject the recipient to FICA
withholding. The difference between the strike price and the market price of the
underlying stock on the date of exercise is treated as ordinary wage income, while the
difference between the market price of the stock on the exercise date and the sale price of
the stock on the date of final disposition is treated as a long term capital gain taxable
upon the sale of the stock. The company is entitled to a deduction for compensation
expense in the amount difference between the strike price and the market price of the
underlying stock on the date of exercise and must pay its share of FICA withholding.
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Unlike ISO’s, NSO’s are not required by statute to be granted at-the-money. However,
many companies’ shareholder-approved plans require that all options be granted at-themoney. Moreover, pursuant to IRC Section 162(m), which limits to $1 million the
deduction a company may take for non-performance-based compensation of its top five
most highly compensated employees, NSO’s will be considered deductible performancebased compensation only if they are granted at the money.
Impact of Backdating: The tax consequences to a company upon discovery of backdating
are mixed. On the one hand, the company will be liable for any income tax and FICA
that it failed to withhold and pay upon the exercise of options that were considered at the
time to have been ISO’s but which should have been treated as NSO’s because they were
really in the money. Moreover, the company will no longer be entitled to any Section
162(m) deduction it may have taken for backdated options that should not have been
treated performance-based compensation since they were really in the money. Both the
non-withholding and the improper deductions will subject the company to interest and
potential penalties. On the other hand, a company’s tax deduction could increase upon
the discovery of backdating, since NSO’s entitle a company to compensation-expense
deductions unavailable for ISO’s, and the compensation expense attributable to in-themoney options will be higher than the compensation expense, if any, attributable to atthe-money options. Because the tax effects of backdating can thus cut both ways, is not
possible to predict, without actually going through the calculations, whether a company
has paid too little or too much in taxes as a result of backdating.
However, the tax consequences for individuals are more clear. Backdating almost
invariably results in an underpayment of income taxes and FICA by the recipients (as
well as under-withholding of employee taxes and underpayment of FICA contributions
by the company). Nonpayment and non-withholding of individual income taxes and
FICA will render the individual and the company liable for interest and potential
penalties.
The holders of backdated options might also be subject to additional taxes, interest and a
twenty percent penalty under IRC Section 409A, pursuant to which discounted stock
options are treated as non-qualified deferred compensation that must have fixed exercise
date. Section 409A is applicable only to: (1) options granted after October 3, 2004, or (2)
options granted before October 3, 2004 but still unvested after December 31, 2004.
While the IRS permitted taxpayers to avoid the adverse tax consequences by raising the
exercise price of the unvested options to the market price of the underlying stock on the
true date of the grant or by imposing a fixed exercise date for the unvested options, such
measures had to have been adopted prior to the end of 2006.
C.
SECURITIES AND DERIVATIVE LITIGATION RE: BACKDATING
As noted above, shareholders have filed some 155 shareholder derivative lawsuits and 29
securities class action lawsuits that are based at least in part upon option-related practices.
A factor limiting the number of securities class actions filed is that the announcement of
the discovery of options-related problems has not in all cases been followed by a
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significant drop in the stock price, such that the potential for significant damages is often
doubtful. In fact, it is difficult to discern any harm that has resulted to the corporation
and its shareholders from backdating. While the purchase of stock at discounted prices
could arguably have a dilutive effect on existing shareholders, such harm is extremely
speculative, especially where the options have not been exercised or even vested.
Therefore, most of plaintiffs’ efforts to date have been focused on shareholder derivative
actions.
1.
Securities Claims Potentially Available In Backdating Cases:
Federal securities law claims potentially available in backdating cases include claims
under sections 11, 12 and 15 of the Securities Act of 1933, sections 10(b), 14, 16, 18,
20(a) and 20A of the Securities Exchange Act of 1934 (and the relevant rules
promulgated thereunder). The Securities Act claims would only be available to the extent
that any option-related misstatements were included in a prospectus or registration
statement issued in connection with an initial or secondary public offering of securities.
a.
Section 10(b) Claims:
Section 10(b) of the Exchange Act makes it unlawful “for any person, directly or
indirectly, ··· [t]o use or employ, in connection with the purchase or sale of any security ···
any manipulative or deceptive device or contrivance in contravention of such rules and
regulations as the Commission may prescribe.” 15 U.S.C. §§ 78j, 78j(b). The elements of
a claim for violations of Rule 10b-5 thereunder are: (1) a misrepresentation or omission
of a material fact; (2) scienter; (3) causation; (4) reliance; and (5) damages. Livid
Holdings Ltd. v. Salomon Smith Barney, Inc., 416 F. 3d 940, 946 (9th Cir. 2005).
Aside from the damages issue, there are other potential hurdles to the prosecution of a
successful securities fraud claim in connection with options backdating, including the
following:
•
Scienter: Except in those cases in which there are guilty pleas to conspiracy
to commit securities fraud or evidence of intentional forgery or falsification of
books and records, it may be difficult to prove that defendants acted with
scienter.8
•
Materiality: Except in those cases in which the company restates its
previously-filed financial statements, it may be difficult to establish that the
company’s misstatements regarding the nature and amount of option-related
compensation expense were material.
8
A securities fraud claim under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5
promulgated thereunder requires proof that the defendant acted with scienter, which “refers to a mental
state embracing intent to deceive, manipulate, or defraud.” Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194
n. 12, 96 S. Ct. 1375, 1381 n. 12 (1976).
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b.
Section 14 Claims:
The perceived difficulty of pleading and proving a viable securities fraud claim, let alone
one for significant damages, has prompted some plaintiffs to pursue proxy misstatement
claims pursuant to Section 14 of the Securities Exchange Act, which does not require
proof of scienter. See, e.g. Lichtenberg v. Besicorp Group Inc., 43 F. Supp. 2d 376, 38485 (S.D.N.Y. 1999) (“To establish a violation of Section 14(a) of the Act and Rule 14a-9,
plaintiffs need only show that the Proxy contained a material misrepresentation, either in
the form of an affirmative statement or an omission.”) (citation omitted).
For example, in a securities complaint filed on March 28, 2007 in the matter captioned,
Calamore v. Juniper Networks, Inc., et al., Case No. 07-CV-01772-MJJ (N. D. Cal.),
plaintiff asserts only claims under section 14 and Rule 14 promulgated thereunder
seeking to void the shareholder-approved 2006 stock option plan and options granted
pursuant thereto because prior backdating was not disclosed to shareholders in the proxy
statement.
While section 14 claims do have a materiality requirement, a disclosure regarding the
nature of executive compensation that relates directly to the matter being voted upon by
proxy could arguably be material for purposes of a proxy fraud claim even if it was not
material for purposes of a claim for fraud in connection with the purchase or sale of
securities. However, since plaintiffs are not likely to have suffered any measurable
damages as a result of such proxy fraud, the only appropriate remedy might be the
rescission of any options [whether or not backdated] that were granted under a plan
approved by shareholders pursuant to a misleading proxy statement, as sought in the
Juniper Networks complaint mentioned above. It is not immediately clear either how that
result would benefit the shareholders or what affect, if any, it might have upon the
company’s ability to retain well-qualified employees.
c.
Section 16(b) Claims:
Another arguable basis for securities litigation is section 16(b), which requires officers
and directors to disgorge short swing profits. See, Gwozdzinsky v. Zell/Chilmark Fund,
L.P., 156 F. 3d 305, 308 (2d Cir. 1998) (“liability under § 16(b) does not attach unless the
plaintiff proves that there was (1) a purchase and (2) a sale of securities (3) by an officer
or director of the issuer or by a shareholder who owns more than 10% of any one class of
the issuer's securities (4) within a six month period”).
However, at least one district court has rejected such a claim:
Simply put, backdating is irrelevant to Section 16(b). SEC regulations
exempt any issuer-to-insider transfers of company stock “whether or not
intended for a compensatory or other purpose” as long as one of three
conditions is met: (1) the transaction is approved by the board of directors,
(2) the transaction is approved by the shareholders, or (3) the recipient of
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the grant holds the stock for at least six months. 17 C.F.R. § 240.16b-3(d).
In this Court's view, this exemption applies exactly when it says it does,
regardless of whether the grants are backdated. The statute says nothing of
backdating, and this Court declines to impose an additional gate-keeping
requirement for issuer-to-insider transactions where the SEC has not.
. . .
According to the SEC, transfers of stock from a company to an insider “do
not appear to present the same opportunities for insider profit on the basis
of non-public information as do market transactions by officers and
directors.” Ownership Reports and Trading by Officers, Directors and
Principal Security Holders, 61 Fed. Reg. 30,376, 30,377 (June 14, 1996).
As the SEC explained in enacting the rule, “where the issuer, rather than
trading markets, is on the other side of an officer or director's transaction
in the issuer's equity securities, any profit obtained is not at the expense of
uninformed shareholders and other market participants of the type
contemplated by the statute.” Id.
Roth v. Reyes, No. C 06-02786 CRB, 2007 WL 518621, at *4-*5 (N.D. Cal. Feb. 13,
2007).
2.
Shareholder Derivative Claims:
While there are a large number of state law claims that can potentially be asserted in the
context of a shareholder derivative lawsuit based upon allegations of backdating, such
claims fall into two basic categories, breach of fiduciary duty and unjust enrichment. In
the options-backdating context, derivative plaintiffs typically sue the directors and officer
who received backdated options for unjust enrichment, and the directors and officers who
permitted or failed to prevent such backdating for breach of fiduciary duty. Two recent
Delaware opinions shed some light on the viability of such claims in the face of typical
defenses such as demand futility and the business judgment rule.
In re Tyson Foods Inc., No. CIV. A. 1106-N, 2007 WL 416132 (Del. Ch. Feb 6, 2007)
(denying in part in motion to dismiss shareholder derivative suit containing allegations of
options spring-loading).
In Tyson, plaintiffs alleged that days before Tyson would issue favorable press releases
which were likely to drive its share price higher, the Compensation Committee of the
board of directors would award options to key employees, including Tyson officers and
directors. Id. at *5. The plaintiffs identified four instances where such “spring-loading”
occurred. Id. at *5-*6.9
Addressing the standards for pleading demand futility, the court stated:
9
The complaint also alleged that Tyson engaged in $163 million in related party transactions that were
unfair to the corporation and served to enrich corporate insiders without complete disclosure and failed to
properly disclose certain perquisites given to certain officers and directors. Id., at *6-*8.
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As famously explained in Aronson v. Lewis, plaintiffs may establish that
demand was futile by showing that there is a reason to doubt either (a)
the disinterestedness and independence of a majority of the board upon
whom demand would be made, or (b) the possibility that the transaction
could have been an exercise of business judgment.
There are two ways that a plaintiff can show that a director is unable to
act objectively with respect to a pre-suit demand. Most obviously, a
plaintiff can assert facts that demonstrate that a given director is
personally interested in the outcome of litigation, in that the director will
personally benefit or suffer as a result of the lawsuit in a manner that
differs from shareholders generally. A plaintiff may also challenge a
director's independence by alleging facts illustrating that a given director
is dominated through a “close personal or familial relationship or
through force of will,” or is so beholden to an interested director that his
or her “discretion would be sterilized.” Plaintiffs must show that the
beholden director receives a benefit “upon which the director is so
dependent or is of such subjective material importance that its threatened
loss might create a reason to question whether the director is able to
consider the corporate merits of the challenged transaction objectively.”
Id., at *10 (citations omitted).
While the Court did not specifically address how the spring-loading allegations raised an
inference of disinterestedness, it held that “[e]very derivative count implicates either a
member of the Tyson family or Tollett or Bond and, hence, plaintiffs raise a reason to
doubt the disinterestedness and independence of the board, justifying excusal of demand
with regard to the entire consolidated complaint.” Id., at *12.
Next, in addressing the sufficiency of plaintiff’s spring-loading allegations, the court first
noted that plaintiffs argued that “the entire board may be challenged because the
[Compensation] Committee was required to consider the recommendations of the
Chairman and Chief Executive Officer, each of whom were recipients of options
themselves.” Id., at *17.
Rejecting this assertion, the court reasoned that this requirement was irrelevant; the
Compensation Committee retained the authority to approve or modify whatever
recommendation it received. Id., at *18. Accordingly, the court held that the plaintiffs
could only properly target members of the Compensation Committee, even in the absence
of allegations that they personally benefited from spring-loaded option grants, and
dismissed allegations that the remaining defendants breached fiduciary duties by granting
spring-loaded options. Id., at *17 and n.72.
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While the court stated that allegations regarding spring-loading were insufficient to
suggest a lack of independence by the Compensation Committee members, id. at *18, it
emphasized that spring-loading options does breach the duty of good faith/loyalty:
Granting spring-loaded options, without explicit authorization from
shareholders, clearly involves an indirect deception. A director's duty of
loyalty includes the duty to deal fairly and honestly with the shareholders
for whom he is a fiduciary. [FN76] It is inconsistent with such a duty for
a board of directors to ask for shareholder approval of an incentive stock
option plan and then later to distribute shares to managers in such a way as
to undermine the very objectives approved by shareholders. This remains
true even if the board complies with the strict letter of a shareholderapproved plan as it relates to strike prices or issue dates.
FN76. In re Walt Disney S'holder Derivative Litig., 907 A. 2d 693, 755
(Del. Ch. 2005) (“To act in good faith, a director must act at all times with
an honesty of purpose and in the best interests and welfare of the
corporation.” (emphasis added)).
The question before the Court is not, as plaintiffs suggest, whether springloading constitutes a form of insider trading as it would be understood
under federal securities law. [FN77] The relevant issue is whether a
director acts in bad faith by authorizing options with a market-value strike
price, as he is required to do by a shareholder-approved incentive option
plan, at a time when he knows those shares are actually worth more than
the exercise price. A director who intentionally uses inside knowledge not
available to shareholders in order to enrich employees while avoiding
shareholder-imposed requirements cannot, in my opinion, be said to be
acting loyally and in good faith as a fiduciary.
Id., at *18.
Ryan v. Gifford (In re Maxim), No. CIV.A. 2213-N, 2007 WL 416162 (Del. Ch. Feb 6,
2007) (denying motion to dismiss shareholder derivative complaint containing allegations
of options back-dating).
In Ryan, the plaintiffs alleged that Maxim issued backdated stock options based on a
report by Merrill Lynch which indicated that Maxim stock returned annualized returns of
“243%, or almost ten times higher than the 29% annualized market returns in the same
period.” Id., at *2.
In addressing the issue of demand futility, the Court first compared the standards for
futility under Aronson and Rales. Under Aronson:
Failure to make demand may be excused if a plaintiff can raise a reason to
doubt that: (1) a majority of the board is disinterested or independent or
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(2) the challenged acts were the product of the board's valid exercise of
business judgment.
Id., at *7; quoting, Aronson v. Lewis, 473 A. 2d 805, 812 (Del. 1984).
Under Rales:
where the challenged transaction was not a decision of the board upon
which plaintiff must seek demand, plaintiff must “create a reasonable
doubt that, as of the time the complaint is filed, the board of directors
could have properly exercised its independent and disinterested business
judgment in responding to a demand.”
Id.; quoting, Rales v. Blasband, 634 A. 2d 927, 933-34 (Del. 1993).
In the case of Maxim, the court determined that Aronson applied:
At first glance, it appears that because this decision was not a board
decision, plaintiff must comply with Rales, alleging facts that raise a
reason to doubt that the board members could have properly exercised
their independent and disinterested business judgment in responding to a
demand. The unique facts here, however, present a different situation.
Maxim's board consisted of six members at all relevant times. The
compensation committee, at all relevant times, consisted solely of three
members, Bergman, Wazzan, and Hagopian. Thus, one half of the current
board members approved each challenged transaction. Where at least one
half or more of the board in place at the time the complaint was filed
approved the underlying challenged transactions, which approval may be
imputed to the entire board for purposes of proving demand futility, the
Aronson test applies.
Id., at *8.
Under the second prong of Aronson, the court found that plaintiff’s allegations of
backdating sufficiently alleged that the challenged grants were not a product of business
judgment:
Because the compensation committee attacked by plaintiff constitutes a
majority of the board, the business judgment analysis under the second
prong of Aronson may be readily applied. Plaintiffs may prove demand
futility by raising a reason to doubt whether the challenged transactions
were a valid exercise of business judgment.
Plaintiff alleges that the challenged transactions raise a reason to doubt
whether the option grants were a valid exercise of business judgment.
Specifically, plaintiff states that the terms of the stock option plans
required that “[t]he exercise price of each option shall be not less than one
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hundred percent (100%) of the fair market value of the stock subject to the
option on the date the option is granted.” [] The board had no discretion to
contravene the terms of the stock option plans. Altering the actual date of
the grant so as to affect the exercise price contravenes the plan. Thus,
knowing and intentional violations of the stock option plans, according to
the plaintiff, cannot be an exercise of business judgment. I conclude that
the unusual facts alleged raise a reason to doubt that the challenged
transactions resulted from a valid exercise of business judgment.
Id.
The court also found that demand would be futile even if Rales did apply:
A director who approves the backdating of options faces at the very least a
substantial likelihood of liability, if only because it is difficult to conceive
of a context in which a director may simultaneously lie to his shareholders
(regarding his violations of a shareholder-approved plan, no less) and yet
satisfy his duty of loyalty. Backdating options qualifies as one of those
“rare cases [in which] a transaction may be so egregious on its face that
board approval cannot meet the test of business judgment, and a
substantial likelihood of director liability therefore exists.” [FN37]
Plaintiff alleges that three members of a board approved backdated
options, and another board member accepted them. These are sufficient
allegations to raise a reason to doubt the disinterestedness of the current
board and to suggest that they are incapable of impartially considering
demand. [FN38]
FN37. Aronson, 473 A. 2d at 815.
FN38. Nor do defendant directors' concerns necessarily end with
consideration of the duty of loyalty. Were the board to pursue a derivative
suit, it might unearth facts that would subject directors to further civil and
criminal liability. Four board members, Gifford, Bergman, Wazzan, and
Hagopian were familiar with Maxim's stock option plans. In 1999, they
recommended the most recent options plan and submitted it for
shareholder approval accompanied by their own directorial stamps of
approval. In 2000 and 2001 proxy statements filed pursuant to section
14(a) of the Securities Exchange Act of 1934, Bergman, Wazzan, and
Hagopian, representing half of the board, verified that they bore direct
responsibility for granting options and that they granted all options
according to the options plan. . . . .
Id., at *10.10
10
The court relied on this same analysis in rejecting defendants’ argument that the complaint failed to state
a claim upon which relief could be granted. See, id. (“where plaintiff alleges particularized facts sufficient
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Another important point is the court’s treatment of the fact that plaintiff’s allegations
were largely based on the highly abnormal returns following option grants rather than on
hard evidence of backdating:
Defendants argue repeatedly that plaintiff's allegations ultimately rest
upon nothing more than statistical abstractions. Nevertheless, this Court is
required to draw reasonable inferences and need not be blind to
probability. True, the Merrill Lynch report does not state conclusively that
Gifford's options were actually backdated. Rather, it emphatically suggests
that either defendant directors knowingly manipulated the dates on which
options were granted, or their timing was extraordinarily lucky. Given the
choice between improbable good fortune and knowing manipulation of
option grants, the Court may reasonably infer the latter, even when
applying the heightened pleading standards of Rule 23.1.
Id. at *9 n.34.
The court also denied defendants’ motions to dismiss a claim for unjust enrichment on
the ground the one defendant was not alleged to have exercised the backdated options he
received:
Gifford does retain something of value, the alleged backdated options, at
the expense of the corporation and shareholders. Further, defendants make
no allegations that Gifford is precluded from exercising these options or
that the options have expired. Thus, one can imagine a situation where
Gifford exercises the options and benefits from the low exercise price.
Even if Gifford fails to exercise a single option during the course of this
litigation, that fact would not justify dismissal of the unjust enrichment
claim. Whether or not the options are exercised, the Court will be able to
fashion a remedy. For example, this Court might rely on expert testimony
to determine the true value of the option grants or simply rescind them.
Either way, Gifford's alleged failure to exercise the options up to this point
does not undermine a claim for unjust enrichment. Thus, I deny the motion
to dismiss the unjust enrichment claim.
Id., at *14.
to prove demand futility under the second prong of Aronson, that plaintiff a fortiori rebuts the business
judgment rule for the purpose of surviving a motion to dismiss pursuant to Rule 12(b)(6).”).
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D.
INTERNAL INVESTIGATIONS AND REGULATORY ENFORCEMENT
1.
Government Investigations:
As the noted above, the SEJ, the DOJ, and the IRS are actively investigating options
backdating and similar options-related problems at a multitude of public companies.
DOJ efforts have already resulted in the filing of criminal charges, as in the case of
Comverse Technology’s former CEO, Kobi Alexander, as well as a number of guilty
pleas, including those by Comverse’s former CFO, David Kreinberg, and former General
Counsel, William Sorin, for example.
While the SEC has also filed a number of civil complaints, issued several formal orders
of investigation and entered into a few settlements, it remains to be seen what types of
penalties the Commission will impose on corporations with backdating problems (outside
the context of voluntary settlements, some of which have already been reached, but none
of which has yet been formally approved) and in what circumstances it will impose such
penalties. The SEC has, however, provided some formal guidance as to the factors
(albeit discretionary) that should be considered by the commission determining what, if
any penalties, to assess in a particular case. In its January 4, 2006 Statement of the
Securities and Exchange Commission Concerning Financial Penalties, Release No.
2006-4, the Commission announced that its “view of the appropriateness of a penalty on
the corporation in a particular case, as distinct from the individuals who commit a
securities law violation, turns principally on two considerations”:
The presence or absence of a direct benefit to the corporation as a result
of the violation. The fact that a corporation itself has received a direct and
material benefit from the offense, for example through reduced expenses
or increased revenues, weighs in support of the imposition of a corporate
penalty. If the corporation is in any other way unjustly enriched, this
similarly weighs in support of the imposition of a corporate penalty.
Within this parameter, the strongest case for the imposition of a corporate
penalty is one in which the shareholders of the corporation have received
an improper benefit as a result of the violation; the weakest case is one in
which the current shareholders of the corporation are the principal victims
of the securities law violation.
The degree to which the penalty will recompense or further harm the
injured shareholders. Because the protection of innocent investors is a
principal objective of the securities laws, the imposition of a penalty on
the corporation itself carries with it the risk that shareholders who are
innocent of the violation will nonetheless bear the burden of the penalty.
In some cases, however, the penalty itself may be used as a source of
funds to recompense the injury suffered by victims of the securities law
violations. The presence of an opportunity to use the penalty as a
meaningful source of compensation to injured shareholders is a factor in
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support of its imposition. The likelihood a corporate penalty will unfairly
injure investors, the corporation, or third parties weighs against its use as a
sanction.
The Commission further enumerated “several additional factors that are properly
considered in determining whether to impose a penalty on the corporation”:
The need to deter the particular type of offense. The likelihood that a
corporate penalty will serve as a strong deterrent to others similarly
situated weighs in favor of the imposition of a corporate penalty.
Conversely, the prevalence of unique circumstances that render the
particular offense unlikely to be repeated in other contexts is a factor
weighing against the need for a penalty on the corporation rather than on
the responsible individuals.
The extent of the injury to innocent parties. The egregiousness of the harm
done, the number of investors injured, and the extent of societal harm if
the corporation’s infliction of such injury on innocent parties goes
unpunished, are significant determinants of the propriety of a corporate
penalty.
Whether complicity in the violation is widespread throughout the
corporation. The more pervasive the participation in the offense by
responsible persons within the corporation, the more appropriate is the use
of a corporate penalty. Conversely, within this parameter, isolated conduct
by only a few individuals would tend not to support the imposition of a
corporate penalty. Whether the corporation has replaced those persons
responsible for the violation will also be considered in weighing this
factor.
The level of intent on the part of the perpetrators. Within this parameter,
the imposition of a corporate penalty is most appropriate in egregious
circumstances, where the culpability and fraudulent intent of the
perpetrators are manifest. A corporate penalty is less likely to be imposed
if the violation is not the result of deliberate, intentionally fraudulent
conduct.
The degree of difficulty in detecting the particular type of offense. Because
offenses that are particularly difficult to detect call for an especially high
level of deterrence, this factor weighs in support of the imposition of a
corporate penalty.
Presence or lack of remedial steps by the corporation. Because the aim of
the securities laws is to protect investors, the prevention of future harm, as
well as the punishment of past offenses, is a high priority. The
Commission’s decisions in particular cases are intended to encourage the
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management of corporations accused of securities law violations to do
everything within their power to take remedial steps, from the first
moment that the violation is brought to their attention. Exemplary conduct
by management in this respect weighs against the use of a corporate
penalty; failure of management to take remedial steps is a factor
supporting the imposition of a corporate penalty.
Extent of cooperation with Commission and other law enforcement.
Effective compliance with the securities laws depends upon vigilant
supervision, monitoring, and reporting of violations. When securities law
violations are discovered, it is incumbent upon management to report them
to the Commission and to other appropriate law enforcement authorities.
The degree to which a corporation has self reported an offense, or
otherwise cooperated with the investigation and remediation of the
offense, is a factor that the Commission will consider in determining the
propriety of a corporate penalty.
2.
Internal Investigations:
Whether or not to conduct an internal investigation can be a complex question. For
example, while on the one hand the SEC has indicated that it will consider, when
deciding whether to impose monetary penalties against a corporation, the extent to which
the corporation itself took the type of remedial measures that might result from such an
investigation, on the other hand there is a concern that DOJ prosecutors would likely
pressure corporations to waive the attorney-client privilege with respect to any matters
learned in the course of the investigation in exchange for “cooperation” points.
Likewise, while the appointment of a special litigation committee could provide a strong
basis for countering plaintiffs’ “demand futility” arguments on a motion to dismiss a
shareholder derivative complaint for failure to make a demand, any report on the findings
of such a committee is likely to become Exhibit A in any subsequent litigation on the
issue. Moreover, to the extent that the special litigation committee recommends that
derivative litigation proceed, such assistance might jeopardize the corporation’s
entitlement to coverage under potentially applicable directors’ and officers (“D&O”)
liability and indemnification insurance policies. Another factor that might be considered
is the possibility that the SEC and other regulators could be so preoccupied and/or
understaffed that they might not take any adverse action against the company or its
executives with respect to options-related problems if the company does not, in effect, do
the investigation for them. In addition to these concerns, internal investigations can be
expensive, distracting, and potentially harmful to employee morale.
Ultimately the decision whether or not to commence an internal investigation, or, once an
investigation has commence, whether or not to terminate employees found to have some
knowledge of or involvement in the options-related conduct at issue, will depend largely
upon two factors: (a) whether the company has discovered any evidence of intentional
wrongdoing; and (b) whether the company is satisfied with its current management.
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The discovery of affirmative evidence of intentional wrongdoing should render the
commencement of an internal investigation, followed by terminations and other remedial
measures as warranted by the findings, a no-brainer. In such circumstances, the best
thing the board can do (assuming it is not in on the scheme) is to distance itself from the
wrongdoing, discover the parties responsible for it, and put a stop to it.
When there is no clear indication of wrongdoing, however, such decisions are more a
matter of business strategy, risk management and investor relations. If consumers and
investors are happy with current management, there may be less incentive to point the
finger in the absence of an unavoidable reason to do so. On the other hand, where
management has not been perceived to be performing well, or has recently been replaced
by new management, an internal investigation might present the board with a uniquely
valuable opportunity to do some housekeeping and set a new tone within the
organization.
E.
IMPACT ON D&O LIABILITY INSURANCE COVERAGE
Options backdating can potentially impact a company’s D&O insurance coverage in a
variety of ways, including with respect to: (1) rescission of the policy on the basis of
material misrepresentations in the application; (2) declination of coverage on the basis of
applicable policy exclusions and/or limitations on coverage imposed by positive law; and
(3) allocation between covered and non-covered loss.
1.
Rescission:
Stock-option backdating usually renders materially false and misleading many of the
public statements of the affected company, including the audited financial statements and
SEC filings that are typically required to be included in the company’s application for
D&O insurance. Representations typically rendered false by backdating include, among
others: (1) audited financial statements, which, by omitting compensation expense
attributable to in-the-money options, inflate net earnings and profit figures, thereby
necessitating a restatement if the amounts at issue are material; (2) associated
Management Discussion and Analysis that accompanies the financial statements in
Annual Reports filed on Form 10-K with the SEC; (3) proxy statements, which contain
(a) descriptions of the terms of the company’s stock option plans, which typically include
prohibitions on the issuance of in-the-money options that are inconsistent with
backdating, and (b) descriptions of executive compensation that are usually rendered
false by undisclosed backdating.11
11
Schedule 14A to Regulation 14A (17 CFR 240.14a-1, et seq.), promulgated under the Securities
Exchange Act of 1934, provides that a proxy statement must “[f]urnish the information required by Item
402 of Regulation S-K if action is to be taken with regard to: (a) the election of directors; (b) any bonus,
profit sharing or other compensation plan, contract, or arrangement in which any director, nominee for
election as a director, or executive officer of a registrant will participate, (c) any pension or retirement plan
in which any such person will participate, or (d) the granting or extension to any such person of any
options, warrants, or rights to purchase any securities, other than warrants or rights issued to security
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A company’s restatement of the audited financial statements that are included in the
typical D&O insurance policy application, or its public acknowledgment that option
grants have been backdated in contravention of the terms of plans described in the SEC
filings that are also included within the application, is tantamount to an admission by the
company that its insurance application contained material misstatements.
Relevant state statutes generally permit an insurer to rescind (i.e., to void) an insurance
policy that was procured by means of an application that contained material
misrepresentations or omitted to state material facts.12 For example, the California
Insurance Code provides that an insurer may rescind an insurance contract on the grounds
of material misrepresentation and concealment, whether intentional or unintentional. See,
Ins. Code §§ 331, 359.
Thus, a company’s announcement of previously-undisclosed backdating problems may
well jeopardize its ability to utilize the D&O insurance policy it would otherwise use to
defend or settle the litigation that is often triggered by such an announcement. While this
may be surprising to some, it is hardly unfair. A policy of insurance is, first and
foremost, a contract. In deciding whether to enter into a contract, each party is entitled to
rely upon the representations of other party (and, in some cases, his or her silence) with
respect to facts material to the subject matter of the contract. Just like any other party to
a contract, an insurer is entitled to receive accurate information from the other party, i.e.,
the insured, when weighing the benefits and detriments of the contemplated contract.
As the California Court of Appeals has explained, “[a]n insurance company is entitled to
determine for itself what risks it will accept, and therefore to know all the facts relative to
the [risk insured]. It has the unquestioned right to select those whom it will insure and to
rely upon him who would be insured for such information as it desires as a basis for its
determination . . .” Imperial Casualty & Indemnity Co. v. Sogomonian, 198 Cal. App. 3d
169, 180-181 (1988) (citations omitted).
Accordingly, when an insurer discovers that an insured has made a false statement (or
failed to disclose something that was required to be disclosed) in the application for
insurance, it is entitled to rescind the policy it issued on the basis of that application, as
long as the misrepresentation or omission at issue is material to the contemplated
insurance.
holders as such, on a pro rata basis.” Item 402 of Regulation S-K in turn requires, among other things:
(1) a “Summary Compensation Table,” which must include options within long term compensation; and
(2) an “Option/SAR Grants Table,” which must include, among other things, the numbers, exercise prices,
expiration dates, and either the potential realizable value or the present value, of any options granted.
Item 402(c) further provides that, “[i]f such exercise or base price[of the options] is less than the market
price of the underlying security on the date of the grant, a separate column shall be added showing market
price on the date of grant[.]
12
The elements of a claim for rescission vary from state to state. For example, while Texas law requires
proof that the misrepresentation at issue was made with the intent to deceive, California does not require
such a showing, and, to the contrary, permits rescission even on the basis of entirely innocent
misstatements, so long as they are material.
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While D&O insurance rescission actions typically involve a number of issues, two of the
most significant issues that the Court must invariably resolve in deciding such cases are
“materiality” (i.e., whether the misrepresentation is significant enough to justify
rescission) and “severability” (i.e., whether the insurer is entitled to rescind the policy as
to all insureds, or only as to those who had knowledge of the misrepresentation).
a.
Materiality:
To justify rescission of an insurance policy, a misrepresentation or omission must be
material: “a simple incorrect answer on an insurance application will not give rise to a
defense of fraud, where the true facts, if known, would not have made the contract less
desirable to the insurer.” Merced County Mut. Fire Ins. Co. v. State of Calif., 233 Cal.
App. 3d 765, 772-73 (1991).
A misrepresentation is considered material if affects either: (a) the nature of the hazard
assumed by the insurer (i.e., if the matter misrepresented renders the contingency insured
against more likely or even certain to occur), or (b) the insurer’s acceptance of risk.(i.e.,
if the accurate disclosure of the misrepresented or omitted facts would have caused the
insurer to reject the application for insurance, or to accept it only on different terms, such
as for a higher premium or with a specific exclusion barring coverage for certain known
risks).
The Merced court teaches that: “materiality is to be determined solely by the probable
and reasonable effect which truthful answers would have had upon the insurer (Ins. Code
§ 334); i.e., was the insurer misled into accepting a risk, fixing the premium of insurance,
estimating the disadvantages of the proposed contract or making his inquiries.” Id.
While materiality is sometimes characterized as a question of fact, in many cases it can
be determined as a matter of law. For example, “[t]he fact that the insurer has demanded
answers to specific questions in an application for insurance is in itself usually sufficient
to establish materiality as a matter of law.” Id., citing, Imperial, supra.
Some courts have held that false financial statements are material as a matter of law. See,
e.g., Jaunich v. National Union Fire Ins. Co., 647 F. Supp. 209, 211 (N.D. Cal. 1986);
Shapiro v. American Home Assurance Co., 584 F. Supp. 1245, 1249-50 (D. Mass. 1984)
(Shapiro I). Other courts have found financial statements to be material as a matter of
fact, based on the uncontradicted testimony of the insurer’s underwriter that he relied on
them in deciding whether, or on what terms (including premium charged and limit of
liability offered), to issue the policy. See, e.g., National Union Fire Ins. Co. v. Sahlen,
999 F. 2d 1532, 1536 (11th Cir. 1993).
It is important to recognize that what is material to the D&O insurer about an insured’s
false financial statements is not the actual financial results. Rather, it is the very fact that
the numbers reported to the public were false. While an insurer might agree to insure a
company and its D&Os against securities fraud liability even if the company’s earnings
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figures were not particularly impressive, it clearly would not do so if it knew that the
prospective insureds had already released materially false earnings figures to the
investing public. See, e.g., John D. Hughes, Restatements and Securities Litigation: a
Matched Set, http://www.hutch.com/whatsnew/set.htm (April 2002).
Thus, when a D&O insurance application contains financial statements that are ultimately
restated, materiality is practically a foregone conclusion.
b.
Severability:
Insurance Code Section 650 provides that “rescission shall apply to all insureds under the
contract, including additional insureds, unless the contract provides otherwise.” Thus,
absent contract language to the contrary, a policy procured on the basis of material
misrepresentations or omissions will be void, even as to those insureds who had no
knowledge of the misrepresentations.
While this result may seem harsh when viewed from the perspective of the so-called
“innocent” insured, it is nevertheless entirely fair, when one considers the fact that a
director is in a much better position to determine the financial condition of his or her
company than is the defrauded insurer, who is also “innocent.” As the court in one oftcited rescission case explains:
“While we sympathize with [the insureds’] position, and recognize that innocent officers
and directors are likely to suffer if the entire policy is voidable because of one man's
fraudulent response, it must be recognized that plaintiff insurers are likewise innocent
parties. [The director who filled out the application] was not [the insurers’] agent. [The
Insureds] do not deny that he was their agent in completing the application by which the
policy was obtained. . . . ‘Where the agent of the insured, in effecting an insurance,
makes a false and unauthorized representation, the policy is void. Where one of two
innocent persons must suffer by the fraud or negligence of a third, whichever of the two
has accredited him, ought to bear the loss [citation]. That the fraud of the agent in
inducing a contract is binding on an innocent principal is a well established doctrine of
agency law in other jurisdictions as well.’ ”
Bird v. Penn. Central Co., on reh’g, 341 F. Supp. 291, 294 (E. D. Pa. 1972); followed by,
Shapiro I, 584 F. Supp., at 1253.
The apparent harshness of the rule is also mitigated by the fact that the insured is free to
bargain for, and to purchase, a policy that provides additional protection for “innocent”
insureds in the event of rescission. Many D&O insurance contracts do limit the scope of
rescission by including a “severability” clause that operates to protect “innocent”
insureds in certain cases. Such a provision, which is typically available for a higher
premium, will enable an innocent insured to pass along to his or her insurer the risk that
his or her company or colleagues made misrepresentations in connection with the policy
application. However, not all severability provisions are the same.
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An example of the broadest, most protective form of severability clause provides that:
“this Insurance shall be construed as a separate contract with each Insured[.]” Shapiro v.
American Home Assurance Co., 616 F. Supp. 900 (D. Mass, 1984) (Shapiro II).
Provisions thus worded permit the insurer to rescind the policy only as to those insureds
that were aware of the challenged misrepresentation or omission.
An increasingly common, but slightly less protective (and therefore less expensive) type
of severability clause protects “innocent” insureds from rescission on the basis of
misrepresentations by other insureds in most circumstances, but provides that the “Policy
in its entirety [i.e., as to any and all insureds] shall be void and of no effect whatsoever if
such misrepresentation were known to be untrue on the inception date of the Policy by
one or more of the individuals who signed the Application.” See, Genesis Ins. Co. v.
Homestore, Inc., Case No. 02-CV-7738 ER (C.D. Cal. 2002), aff’d, Case No. 03-55995
(9th Cir. 2003). Since most D&O insurers require that the application for insurance be
signed by the insured’s Chief Financial Officer (who is usually the officer most likely to
know if the attached financial statements are materially false), this type of partial
severability clause is unlikely to protect “innocent” insureds from rescission in the event
of a restatement.
In addition, some policy applications contain language that expressly excludes from
coverage any claims based upon or arising out of omitted facts which were required to be
disclosed in the application. Such exclusionary language may operate to bar coverage for
“innocent” insured for lawsuits based upon false financial statements included in the
policy application, even when the policy itself contains a severability provision.
2.
Exclusions and Public Policy Limitations:
D&O policies usually contain various exclusions from the coverage otherwise provided.
Three common policy exclusions that are often triggered in options backdating cases are:
(1) the deliberate fraud or willful violation of statute exclusion; (2) the improper personal
profit, remuneration or advantage exclusion; and (3) the Insured vs. Insured exclusion.
a.
Deliberate Fraud/Willful Violation Exclusion:
The deliberate fraud or willful violation of statute exclusion typically comes into play in
those cases in which the backdating appears to have been part of a deliberately fraudulent
scheme involving a conspiracy to violate the securities laws and/or the intentional forgery
or falsification of documents (which, as noted above, is a federal crime).
Deliberate fraud or willful violation of statute exclusions may contain an adjudication
requirement, pursuant to which a carrier cannot invoke the exclusion in the absence of a
judgment or other judicial finding that such deliberate fraud or willful violation of statute
actually occurred. It is usually the case, and sometimes expressly provided in the policy,
that an adjudication requirement is satisfied by a plea of guilty or nolo contendere.
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The fact that an exclusion bars coverage for a claim as to one insured does not necessarily
mean that coverage for that claim is excluded as to every insured. Policies often contain
severability of exclusion clauses, which customarily provide that knowledge or facts
pertaining to one insured person are not imputed to other insured persons for purposes of
the application of policy exclusions.
However, many polices also contain imputation clauses that provide that knowledge or
facts pertaining to certain categories of insured persons (such as, for example, CEOs
CFOs, Chief Operating Officers, Presidents, Chairmen of the Board, or General
Counsels) will be imputed, sometimes to all insureds, but more commonly to the insured
organization.
b.
Improper Personal Profit/Remuneration/Advantage Exclusion:
The exclusion for claims involving improper personal profit, remuneration or advantage
is the one that comes into play in an options backdating or misdating, and typically
applies irrespective of whether the options problems resulted from a deliberate scheme.13
The improper personal profit, remuneration or advantage exclusion may not require any
adjudication. Rather, it may apply when an insured “in fact” received such improper
personal profit, remuneration or advantage. This “in fact” standard is satisfied by an
insured organization’s restatement of financial statements and/or other public admissions
contained in SEC filings.
The insurer may properly invoke an “in fact” profit exclusion to deny coverage (even for
defense) as to a claim alleging the insured’s receipt of a profit or other advantage to
which it was not entitled, where: (i) there is some evidence (especially in the form of an
admission) that the insured received the alleged profit or advantage alleged by the
underlying plaintiff, and (ii) the underlying plaintiff alleges the ground on which the
alleged profit or advantage is unlawful and there is no apparent ground on which the
insured could successfully argue that it was legally entitled to receive or retain the alleged
profit or advantage.14
13
While some cases have addressed disputes regarding what constitutes “profit” or “advantage” (see, e.g.,
Jarvis Christian Coll. v. Nat'l Union Fire Ins. Co. of Pittsburgh, 197 F. 3d 742, 748 (5th Cir. 1999)) that
issue is not likely to be significant to any case involving the grant of backdated stock options, since it
cannot reasonably be disputed that the grant of stock options in the money constitutes at the very least an
advantage (see, id.), and, to the extent that the grants are exercised, a profit and remuneration.
14
See, e.g., Brown & LaCounte LLP v. Westport Ins. Co., 307 F. 3d 660 (7th Cir. 2002) (mere allegations
trigger “in fact” exclusion); St. Paul Mercury Ins. Co. v. Foster, 268 F. Supp. 2d 1035 (C.D. Ill. 2003) (an
adjudication is required only “where the dispute concerned the illegality of the actions taken or profits
received”); In re Donald Sheldon & Co., 186 B.R. 364 (S.D.N.Y. 1995), aff'd, 182 F. 3d 899 (2d Cir. 1999)
(holding that an “in fact” exclusion did not require an “adjudication” in the underlying action”); PMI
Mortgage Ins. Co. v. Amer. Int’l Spec. Lines Ins. Co., 2006 WL 825266, *4 (March 29, 2006 N.D. Cal.)
(holding, apparently as a matter of first impression in the Ninth Circuit, “that the term ‘in fact’ within the
context of the exclusion here should be read to require either a final adjudication, including a judicial
adjudication, or at a minimum, at least some evidentiary proof that the insured reaped an illegal profit or
gain”).
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In the typical backdating case, directors and officers who received misdated, in-themoney option grants, in fact gained the following advantages to which they were not
legally entitled, including: (1) options with an exercise price below fair market value of
the underlying securities on the grant date, in contravention of the typical Stock Incentive
Plan; (2) non-withholding of federal income tax and payroll taxes which should have
been withheld had the options been expressly granted in-the-money; and (3) possibly
excessive incentive-based compensation calculated using inflated income and profit
figures.15
Legal authorities pursuant to which insured persons might be held not to be legally
entitled to the receipt of backdated option grants or retention of the benefits thereof
would include, inter alia:
1.
The terms of the Organization’s stock option plan;
2.
Applicable provisions of the Internal Revenue Code (“IRC”) and IRS
regulations promulgated thereunder;
3.
Section 16(b) of the Securities Exchange Act of 1934;
4.
Section 304 of the Sarbanes-Oxley Act; and
5.
State laws imposing a fiduciary duty of loyalty to the Organization.
The company at which backdating has occurred itself also gains in fact advantages to
which it is not legally entitled, including: (1) the initial accounting advantage created by
not recognizing the non-cash compensation expense embodied in the in-the-money
options; (2) tax deductions for purportedly performance-based executive compensation in
excess of $1 million under IRC Section 162(m); and (3) the non-payment of payroll taxes
that would have been owed on options expressly granted in the money.
c.
Insured Versus Insured Exclusion:
The Insured versus Insured exclusion can come into play in an options backdating case,
particularly when an company’s board of directors has appointed a special committee to
investigate allegations of backdating, and that company recommends that derivative
litigation proceed against the officers or directors found to have been involved in a
backdating scheme.
15
All Insured Persons who received misdated options gained the above advantages, whether or not they
ever actually exercised the options. All vested but unexercised options were real assets, the value of which
is measured by the difference between the exercise price and the market price of the underlying stock. As
such, the options could, for example, be used as collateral to secure financing. The Insureds could also,
through a broker, collar the options, using puts and calls, to lock in the value measured by the difference
between market price and exercise price.
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Insured versus Insured exclusions typically contain a carve-out clause providing that the
exclusion does not apply to derivative litigation, in which insured officers and directors
are sued by shareholders in the name of the nominal defendant corporation. However,
many policies provide that the derivative litigation carve-out does not apply unless the
derivative litigation is instigated and continued totally independent of, and totally
without the solicitation of, or assistance of, or active participation of, or intervention of,
any executive of an organization or any organization.
d.
Public Policy Limitations on Coverage:
Positive law also provides various public policy defenses to coverage, which apply
irrespective of the express terms of the policy, and which may well be implicated in the
typical options backdating case.
For example, California Insurance Code Section 533, which provides that an “insurer is
not liable for a loss caused by the wilful act of the insured,” bars indemnity coverage, as a
matter of law, for intentional wrongdoing that is either committed in order to cause harm
or is so “inherently harmful” in itself that the intent to cause harm is presumed. See, e.g.,
J.C. Penney Casualty Ins. Co. v. M.K., 52 Cal. 3d 1009, 1019-1020 (1991) (insurance not
available for conduct, such as child molestation, which is ‘inherently harmful’);
California Amplifier, Inc. v. RLI Insurance Co., 94 Cal. App. 4th 102 (Dec. 3, 2001)
(liability for violation of California securities laws is uninsurable, because such violations
must be ‘willful’); Downey Venture v. LMI Ins. Co., 66 Cal. App. 4th 478, 502 (1998)
(malicious prosecution uninsurable inherently harmful).
Section 533 would likely operate to preclude indemnity coverage for the settlement of a
backdating claim, irrespective of the deliberate fraud exclusion’s adjudication
requirement, to the extent that the underlying conduct included the deliberate falsification
of documents and/or an intentional conspiracy to violate the securities laws.
Another public policy defense that is likely to be implicated in a backdating case is the
“ill-gotten gains” doctrine, i.e., the general prohibition on the indemnification of
restitution or disgorgement. See, e.g., Bank of the West v. Superior Court, 2 Cal. 4th
1254, 1266, 10 Cal. Rptr. 2d 538, 833 P. 2d 545 (1992) (holding that it “is well established
that one may not insure against the risk of being ordered to return money or property that has
been wrongfully acquired”); Level 3 Communications, Inc. v. Federal Ins. Co., 272 F. 3d
908, 910 (7th Cir. 2001) (affirming the principle that “a ‘loss’ within the meaning of an
insurance contract does not include the restoration of an illgotten gain”); Conseco Inc. v.
National Union Fire Ins. Co., No. 49D130202CP000348, 2002 WL 31961447 (Ind. Cir.
December 31, 2002) (holding that damages for violation of Section 11 of the Securities
Act of 1933 did not constitute “Loss” covered under a policy, because such “damages”
actually represent the defendant corporation’s “liability to return funds it wrongfully took
from the investing public when the securities were sold during the class period”).
To the extent that the recipients of backdated options are compelled to pay for the fair
value, or to surrender the proceeds attributable to their exercise, of options to which they
were not legally entitled under the terms of their employer’s stock option plans or the
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provisions of applicable tax or securities laws, then any such payment can fairly be
characterized as the disgorgement of ill-gotten gains, and will likely be held to be
uninsurable as a matter of law.
One other public policy defense to coverage that might come into play in options
backdating cases is the “known loss” or “loss in progress” rule, codified in Sections 22
and 250 of the California Insurance Code and Section 1101 of the New York Insurance
Law, and discussed in such cases as Montrose Chemical Corp. v. Admiral Ins. Co., 10
Cal. 4th 645 (1995), Rohm & Haas Co. v. Continental Cas. Co., 566 Pa. 464, 781 A. 2d
1172 (2001), and National Union Fire Ins. Co. v. The Stroh Cos., 265 F. 3d 97 (2d Cir.
2001).
California Insurance Code Section 22 provides that: “Insurance is a contract whereby one
undertakes to indemnify another against loss, damage, or liability arising from a
contingent or unknown event.” Cal. Ins. Code § 22.
California Insurance Code Section 250 similarly requires a contingent or unknown event:
“Except as provided in this article, any contingent or unknown event, whether past or
future, which may damnify a person having an insurable interest, or create a liability
against him, may be insured against, subject to the provisions of this code.” Cal. Ins.
Code § 250.
Hence, when a loss is "known or apparent" before a policy of insurance is issued, there is
no coverage. Prudential-LMI Com. Insurance v. Superior Court, 51 Cal. 3d 674, 695 &
n. 7 (1990).
While this doctrine should, on its face defeat coverage for a company whose management
knew or should have known, at the time they purchased insurance, that the company’s
earnings were materially exaggerated as a result of options backdating while the public
was trading in the company’s securities, since any reasonable director or officer should
understand that ensuing private securities litigation would thus be inevitable, case law
interpreting the “known loss” doctrine has narrowed its application in various contexts,
such that it may not, by itself, at least in New York and California, be sufficient to bar
coverage.
Backdating claims may well be precluded by the “fortuity” or “known loss” doctrine as
interpreted by the courts of other states, including Texas, whose formulation of the
doctrine is one of the most expansive. See, Franklin v. Fugro-McClelland (Southwest),
Inc., 16 F. Supp. 2d 732, 736-37 (S.D. Tex. 1997) (holding that, under Texas’ known loss
doctrine, “[t]he relevant inquiry is whether [insureds] knew at the time they entered into
the insurance policy that they were engaging in activities for which they could possibly
be found liable”); Two Pesos, Inc. v. Gulf Ins. Co., 901 S.W. 2d 495, 501 (Tex. App.
1995) (“insurance coverage is precluded where the insured is, or should be, aware of an
ongoing progressive loss or known loss at the time the policy is purchased”).
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3.
Allocation Between Covered Loss and Non-Covered loss:
Given that the insurer’s rights to rescind the policy and/or to invoke policy exclusions to
deny coverage for a claim are typically subject to severability provisions that limit the
effect of such actions to only certain insureds, a situation often arises in which a claim is
being defended and/or settled both by insureds as to whom coverage potentially applies
and other insureds as to whom the policy has been rescinded or coverage thereunder has
been denied.
In such circumstances, the D&O policy may provide that defense costs, settlement sums
and judgments involving both covered and non-covered matters or persons be allocated
between covered and non-covered loss according to the relative exposure of the insureds
and non-insureds to covered and non-covered matters.
In backdating cases, the parties that presumably face the most exposure are: (a) those
directors, officers and employees, if any, that falsified documents or otherwise
participated in the fraudulent scheme, such that they are likely to be subject to the fraud
exclusion; (b) those directors, officers and employees who received backdated option
grants, such that they are likely to be subject to the profit/advantage exclusion; and (c) the
company itself, as to which the policy is likely to have been rescinded on the basis of
material misrepresentations in contained in the SEC filings and audited financial
statements included in its D&O insurance application.
Accordingly, since the parties that face the most exposure are also the parties who are
least likely to be entitled to coverage under the D&O policy, the lion’s share of any
defense costs or indemnity payments are likely to be allocated to non-covered loss under
the relative exposure method. Innocent directors and officer might be able to avoid such
an allocation, however, at least as to defense costs, by retaining separate counsel.
IV.
CONCLUSION
While the issues discussed above are among those most likely to be encountered in a
stock-option backdating case, it is impossible to address here all of the potential
consequences of, and issues implicated by, stock-option backdating.
Companies that discover or suspect the existence of backdating or other options-related
problems would be well advised to seek the advice of experienced legal counsel.
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