Thursday, September 07, 2006

Capitol Hill Looks at Options Backdating

The unfolding options backdating story may have hit its high water mark (or its low point, depending on your perspective) on September 6, 2006, when the Senate Committee on Banking, Housing and Urban Affairs and the Senate Finance Committee both held hearings concerning options backdating. The hearings involved the testimony of numerous regulators, academics and other pundits, and included the testimony of SEC Chariman Christopher Cox (testimony here), which was noteworthy for its identification of Internal Revenue Code Section 162(m) as the culprit in the scandal. Among other things, Cox said:

…one of the most significant reasons that non-salary forms of compensation have ballooned since the early 1990s is the $1 million legislative caps on salaries for certain top public company executives that was added to the Internal Revenue Code in 1993. As a Member of Congress at the time, I well remember that the stated purpose was to control the rate of growth of CEO pay. With complete hindsight, we can all agree that this purpose was not achieved. Indeed this tax law change deserves pride of place in the Museum of Unintended Consequences…The million-dollar cap on tax deductibility of executive compensation…doesn’t apply to options granted at fair market value. So for companies that wanted or needed to pay compensation in excess of $1 million per year, the tax code outlawed deducting it if it was paid in a straightforward way through salary, but permitted a deduction if the compensation was paid through at-the-money options.

So the tax law encouraged at-the-money options, which in turn encouraged creative actions to maximize the return under the options.

Linda Thomsen, Director of the SEC Enforcement Division, also testified (here) about the tax incentives that provide context for options backdating.

Cox’s and Thomsen’s testimony also make interesting reading for the history they provide about the SEC’s enforcement activity in connection with the options timing investigations, and in particular the enforcement activity that preceded the media attention that was drawn to the issue earlier this year. Cox’s testimony reviews the 2003 enforcement proceedings the SEC brought against Peregrine Systems, and the 2004 action against Symbol Technologies. (Thomsen’s testimony also discusses the Symbol Technologies action in detail.) Peregrine Systems was charged with financial fraud for failing to record any expense for compensation when it issued incentive stock options. The Symbol Technologies case involved manipulation not of options grant dates but of exercise dates, to ensure that the exercise date was the most advantageous to the grant recipient during a 30-day lookback period. The Symbol Technolgies complaint, which alleged numerous allegely misleading activites, was settled with a payment of $37 million.

Cox’s stated that the SEC’s Enforcement Division is “currently investigating over 100 companies concerning possible fraudulent reporting of stock option grants.” Cox added that while not all of these investigations will result in enforcement proceedings, “we have to expect that other enforcement proceedings will be forthcoming in the future.”

The written testimony of all of the witnesses who appeared before the Senate Banking Committee can be found here. The written testimony of all the witnesses who appeared before the Senate Finance Committee can be found here. The Wall Street Journal’s September 7, 2006 article describing the hearings can be found here (subscription required).

Options Timing Hot Seats Multiply: Senate Finance Committee Chair Charles Grassley (R. Iowa), in his closing remarks at the hearing (which can be found here) declared his intentions to target “all the actors” involved in the options backdating scandals. That includes accountants, lawyers, and compensation consultants who advised executives to backdate options, and board members who “blessed it or looked the other way.” Sen. Grassley apparently is going to lead a campaign to request materials from companies involved in the backdating investigation, including board minutes regarding the decision to backdate “as well as any and all materials from advisors…who assisted in these efforts.” Grassley also said that he is considering legislation to address the tax issues that Cox and other identified.

More about Options Springloading: The testimony on Capitol Hill reflected the continuing debate surrounding options springloading (granting options now in anticipation of good news later that it is anticipated will increase the company’s share price). As The D & O Diary has previously noted (here), options springloading seems categorically different from options backdating, among other reasons the value of the options at the time of the grant cannot be locked in as with options backdating, since there is no way to be sure how the market will react to the impending news. In addition, some commentators, including SEC Commissioner Paul Atkins (remarks here), have publicly stated that they see nothing wrong with springloading. But in his testimony before the Senate Banking Committee (testimony here) Lynn Turner, the former chief accountant at the SEC, came down in strong disagreement “with those who say it’s not illegal or a problem.” Turner clearly equates springloading with trading on inside information, and therefore unlawful. He also cites numerous ways in which the failure to disclose springloading would make proxies and other disclosures misleading. He concludes his thoughts about springloading by saying "I believe that disclosures made in the past regarding springloaded options grants will be found in all too many instances to have been false and misleading, violating the securities laws and regulations." Turner also asks rhetorically with respect the options practices that have come to light"Where were the gatekeepers, including legal counsel and independent auditors?"

The Cost of Backdating: Three University of Michigan professors have written an article entitled “The Economic Impact of Backdating of Executive Options,” (here) which attempts to determine the financial impact of options timing. The authors analyzed thousands of stock option grants between 2000 and 2004 at 48 companies who had announced prior to July 1, 2006 that they were under investigation in connection with stock options practices. The authors measured the maximum possible gains for executives if they backdated every option grant during that period. The authors also measured the drop in market capitalization of the 48 companies by comparing the companies’ share prices in the ten days before and the ten days after the news of the backdating inquiry was released. The authors found that while the average executive’s pay would have been increased about 1.25 percent, the average decline in market value per company when the news of the options investigation was announced was an average of eight percent.

The D & O Diary notes that while the cost of options backdating to the companies and their shareholders clearly is greater than the benefit to the executives, the eight percent market cap decline that the authors’ determined is consistent with The D & O Diary’s ongoing theory on why this scandal has not produced more securities fraud litigation. (According to the D & O Diary’s tally, here, there have only been 15 companies sued in securities class action lawsuits so far.) A stock price drop of that magnitude is just not sufficient to attract the attention of the plaintiffs’ lawyers. Indeed, in a September 5, 2006 New York Times article (here, registration required), Melvin Weiss of the Milberg Weiss firm is quoted as saying in explanation for why there is not more securities fraud litigation in connection with the options timing scandal, "A lot of these companies aren't reacting with big drops in price, or, if they dropped initially, they come back over a short period of time."

The D & O Diary also has an observation about the authors’ presentation of their research. While their paper is now available on line, it states on its face that it will appear in the June 2007 issue of the Michigan Law Review. The article is timely and topical now, but by next summer it is going to be completely out of date. Almost all of the footnotes will have been superseded by intervening events, and many of the legal issues that the authors conjecture about will have been addressed in actual proceedings. The lag time almost guarantees that the article, while relevant today, will be completely irrelevant by the time it appears in a traditional publication form. All of this is by way of observation that the Internet may be making traditional forms of legal scholarship obsolete. Perhaps Internet weblogs are the rightful successors to more traditional law journals in an Internet age.

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