Lawyer Article

In recent months, the SEC has stepped up its scrutiny of stock option grant and/or exercise practices at certain companies, with companies such as Mercury Interactive Corporation, Analog Devices Inc., Brocade Communications Systems Inc., Nyfix Inc., Siebel Systems Inc. and Symbol Technologies Inc. reporting that they have been the subject of SEC inquiry. Earlier this month, both Mercury Interactive and Analog Devices announced that they had taken certain actions designed to address allegedly improper option grant and/or exercise practices. These recent events suggest that companies should "take stock" of their option grant and exercise practices to confirm that they are in compliance not only with plan terms and company grant practices but also applicable legal considerations.

First, on November 15, 2005, Analog Devices announced a tentative settlement with the SEC Staff (which is subject to approval by the SEC) regarding the SEC's investigation of ADI's stock option grant practices. According to ADI, the proposed settlement would address ADI's disclosure regarding certain option grants made in 1999 and 2000 prior to the release of favorable financial information. The SEC settlement is expected to conclude that ADI should have disclosed in its proxy filings that ADI priced the options prior to releasing favorable financial results. The settlement also is expected to address alleged improper practices regarding manipulation of the timing of certain stock option grants made in 1998, 1999 and 2001. As part of the settlement, options granted to ADI's president and CEO and certain other directors would be repriced, and ADI would be subject to a $3,000,000 civil penalty. Significantly, ADI's president and CEO would also be required to pay a $1,000,000 civil penalty and to disgorge certain options under the terms of the proposed settlement.

Second, on November 2, 2005, Mercury Interactive took the unusual step of announcing the involuntary resignations of three top executives as a result of a special board committee's investigation into Mercury's grant practices. The special committee recently identified 49 instances of misdating and manipulating employee option grants between 1995 and 2005. The misdating typically occurred when either the grant date was picked retroactively or the grant date was selected on one date but finalized (and sometimes changed) at a later date. In most instances, the price of Mercury’s stock on the actual grant date was higher than the price on the stated grant date. In the case of several option grants to Mercury’s now-resigned chief executive officer, misdating reduced the officer’s taxable income and exposed Mercury to possible penalties for failure to pay withholding taxes.

As a result, Mercury has delayed the filing of its quarterly report on Form 10-Q for the quarter ended September 30, 2005, and is restating its historical financial statements due to the unreliability of financial statements for fiscal years 2002, 2003 and 2004. In addition, the company may face delisting by NASDAQ if it does not complete the restatements of its financial statements and make the appropriate filings with the SEC. Certain Mercury investors earlier this month filed a lawsuit in the Delaware Chancery Court against the company’s board of directors and former executives.

As noted by the ADI proposed settlement, the SEC appears to be focusing on the timing of option grants from both disclosure and antifraud perspectives. In particular, the SEC appears to be concerned about option grants made shortly before positive news is released about a company, which can result in the option having immediate value to the employee and a lower accounting expense. The SEC also appears to be focusing on the timing of option exercises. For instance, in June 2004, Symbol Technologies Inc. settled charges brought by the SEC regarding manipulation of option exercise dates. In that case, certain executives were allegedly permitted to select an exercise date from a 30-day "lookback" period prior to the executives' actual exercises, a practice which allegedly reduced the cost of exercise to the executives.

Companies should keep in mind that a number of other considerations in addition to those discussed above may impact option grant and exercise practices. For instance:

• Earlier this year, the Financial Accounting Standards Board ("FASB") modified an earlier informal position and stated that companies may treat as the grant date for FAS 123(R) equity award expensing purposes the date awards are approved by the company's board of directors (or management with appropriate authority), as long as (i) the awards are unilateral and employees do not have the ability to negotiate their terms, and (ii) the key terms of the awards are expected to be communicated to employees within a "relatively short" period of time. If these conditions are not met, a delay in communicating the grant of awards may impact the calculation of an award's "fair value" accounting expense under FAS 123(R).
• Incentive tax option regulations state that an ISO will not be considered to have been granted until the company completes the corporate action necessary to make an offer for sale to the individual under the terms and conditions stated in the option, and an unreasonable delay in communicating a grant may indicate that the grant was not in fact made at that time, thus potentially impacting the status of an option intended to qualify as an ISO.
• Under new Section 409A of the Internal Revenue Code of 1986, as amended, discount options and discount stock appreciation rights are subject to immediate taxation and a 20% tax penalty if the award does not comply with certain onerous requirements imposed by Section 409A. However, options and SARs with an option price or base price that can never be less than the fair market value of the underlying stock on the grant date are outside the reach of Section 409A. Similarly, a modification to the option or base price of an option or SAR that was initially exempt from Section 409A may result in the modified award being subject to Section 409A. Companies should exercise care not to manipulate the grant date since doing so could affect whether an option or SAR was deemed to be a "fair market value" award and thus could impact whether an option or SAR is exempt from Section 409A's reach.  

Companies with equity compensation plans should take care to ensure appropriate internal controls are in place in order to avoid issues related to the timing of option grants or exercises. To minimize the impact of these and other concerns, for many companies, as a matter of corporate practice (and as often required by plan terms), an equity award is deemed to have been granted on the date the compensation committee or board takes action (unless the resolutions of the board or committee specifically provide otherwise, for instance, in the case of new hires). In addition, many companies have adopted a practice of granting equity awards only at fixed intervals, such as annually, semi-annually or quarterly. Finally, although certainly not prevalent, insiders may consider adopting a Rule 10b5-1 plan for their option exercises.