Thursday, August 24, 2006

Proxies, Shareholder Consent, and Options Backdating Litigation

The D & O Diary’s list of options backdating litigation (here) has been updated to include the action (here) filed on August 23, 2006 against Zoran Corporation and ten of its past or present directors and officers. The Zoran complaint presents an interesting variation in the options backdating litigation, because it focuses on allegedly improper or misleading solicitation of shareholder proxies and consent. The complaint alleges that between July 1998 and September 2001, senior Zoran executives were granted unlawfully backdated stock options at the expense of Zoran shareholders, in violation of GAAP and the Internal Revenue Code. The complaint alleges that the defendants’ grant of the backdated options and subsequent solicitation of shareholder proxies, consent or authorization violated the Exchange Act.

The complaint is filed on behalf of a purported class of shareholders who received Zoran proxy statements between April 30, 1999 and May 1, 2006. The class period covers this longer period even though the allegedly improper grants took place between 1998 and 2001 because each of the allegedly improper grants were for a term of ten years, so the first date at which the grants expire has not yet occurred, while the Company has continued to issue proxy statements allegedly containing misleading information about the grants.

Under Section 14 of the Securities Exchange Act of 1934 and its corresponding rules, whenever shareholders must approve a compensation plan, the issuer must accurately disclose the material elements of the proposed plan. With respect to stock options, the compensation disclosure must include the grant date, the exercise price, and grant and exercise tax consequences for the issuer and the recipient. If the issue is soliciting proxies in connection with the grant of stock options having a below-market exercise price, the issuer must disclose the option exercise price and the market price on the grant date, as well as the value of the options at the market price on the grant date.

If the company does not apply the proper tax treatment for below market options grants, the proxy disclosures may inaccurately reflect the tax consequences for grant and exercise. Because the difference between the grant and market prices for backdated options represents income to the recipient, the recipient must pay tax and withholding on the difference. The issuer could be liable for income and FICA tax it failed to withhold upon exercise, as well as interest and penalties. In addition, because the difference between the exercise price and the market price represents compensation, it counts toward the $1 million maximum for each executive’s compensation deductibility under Internal Revenue Code Section 162(m). If the issuer did not allow for this compensation in connection with deduction for the executive’s compensation, the issuer could owe additional taxes, interest and penalties.

Even if we assume that the plaintiffs' allegations are true, the value of the remedies the Zoran plaintiffs’ seek is uncertain. The complaint seeks to void the election of directors based on the allegedly improper proxies, which seems like a perhaps principled but not very financially valuable remedy at this late date (unless you assume for the sake of discussion that shareholders are better off without any of the current directors involved with Zoran in any way). The complaint also seeks unspecified damages. Whether the plaintiffs can demonstrate damages that are not simply speculative or fraught with causation questions seems debatable, at best.

Bruce Vanyo and Michael Weisman of the Katten Muchin Rosenman firm have written an interesting paper entitled “Backdating Stock Options: An Overview” (here) that examines these proxy solicitation and income tax issues, as well as other legal issues surrounding option backdating, in much greater depth.

Special thanks to Adam Savett of the Lies, Damned Lies blog for the link to the Vanyo paper.

The Securities Litigation Watch blog is also maintaining a list of securities class action lawsuits relating to options backdating, which may be found here.

The Fugitive: Kobi Alexander, Photobucket - Video and Image Hosting the former CEO of Comverse Technology and a fugitive from criminal allegations filed against him in connection with the options backdating investigation at the company, has been found in Sri Lanka, according to news reports. An intersting legal commentary on the prospects for Alexander's extradition from Sri Lanka can be found on the White Collar Crime prof blog, here. A more entertaining discussion of Alexander's choice of Sri Lanka as his hideout appears on the DealBreaker.com blog, here. The DealBreaker.com also had an earlier, amusing discussion (here) of the issues a fugitive faces in attempting to flee overseas.

Now This: While many astronomers (and bloggers) still hope for signs of intelligent life on planet Earth, signs of another sort abound (here). Caution: Viewer discretion advised, may not be appropriate for all audiences.

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