Client Alert

In the past week, the Securities and Exchange Commission has taken decisive action on two fronts to address the snowballing option backdating issue. First, on July 20, 2006, the SEC, the United States Attorney’s Office and the FBI jointly filed criminal and civil securities fraud charges against two former Brocade Communications Systems, Inc. executives, alleging that the executives routinely backdated option grants to give employees lower priced options without recording compensation expense. Second, in connection with its adoption of new executive compensation disclosure rules yesterday (press release available at http://www.sec.gov/news/press/2006/2006-123.htm), the SEC adopted new rules that will require additional specific disclosure of a company’s practices regarding the timing and pricing of its option grants. These recent SEC actions, coupled with mounting regulatory, media and investor furor over allegedly illegal or suspicious option grant practices at dozens of companies, have catapulted the issue to the forefront of hot topics in corporate governance. Consequently, it is more important than ever that companies undertake a thorough review of their grant practices to ensure that they comply with applicable laws and best practices. (Our November 29, 2005 client alert regarding option grant and exercise practices can be accessed here: http://www.wcsr.com/resources/pdfs/cs112905.pdf).

Recent SEC Actions 

• Brocade action. The Brocade charges are noteworthy because they reflect the first SEC and DOJ civil and criminal actions regarding option backdating, following 18 months of investigations. The complaints allege that the former CEO and a former human resources vice president caused in-the-money options to be granted to employees through the backdating of option grant documents and falsification of offer letters and compensation committee minutes. These alleged actions made it appear that the discount options were granted at fair market value and led Brocade not to record compensation expense for the discount options. As a result of the backdating scheme, Brocade was forced to restate its financial statements, resulting in a reduction in net income of hundreds of millions of dollars. If convicted of securities fraud, the executives could face a maximum prison term of 20 years and a $5 million fine, plus restitution. The SEC is currently investigating option grant practices at over 80 companies, so the Brocade litigation is likely to be the first of several cases that the government will bring regarding possible fraudulent reporting of option grants. 
• Disclosure of Grant Practices. In adopting new executive compensation disclosure rules, the SEC stressed that it takes no position on the advisability of granting discount options and that companies can approach these issues as they see fit, so long as equity compensation practices are adequately disclosed and appropriately accounted for. To that end, the SEC voted yesterday to adopt new rules that will require both tabular and narrative disclosure of practices relating to the timing and pricing of option grants. New tabular disclosure will be required in two instances: (1) if an option’s exercise price is different from the underlying stock’s fair market value on the FAS 123(R) grant date, this price must be disclosed in a separate column and accompanied by a description of the methodology used to determine the price; and (2) if the date that action is taken to award an option is different from the FAS 123(R) grant date, the additional date must be disclosed in a separate column. In addition, under the new rules, the Compensation Discussion & Analysis (CD&A) report will be required to include specific discussion regarding option grant practices. The SEC’s final rules (which are expected to be publicly available in the near future, and which we will address in a future client alert) will contain additional guidance regarding the required scope of CD&A discussion as it relates to option timing and pricing issues.

Grant Practices Under Scrutiny

In response to public outcry regarding executive compensation practices and the perceived wealth of the "optioned gentry" in particular, the SEC and other regulators, investors, academics and the media continue to put option grant practices under the microscope. Potentially suspect option grant practices include the following: 

• Option backdating, which involves changing the grant date of a stock option to an earlier date than the date the board, compensation committee or other plan administrator granted the option. Typically, the fair market value of the company’s common stock on the earlier date is less than the fair market value of the common stock on the date the option was actually granted, which results in the option having a built-in value for participants based on the difference in the fair market value between the two dates, a practice criticized by many as unfair. 
• Option "springloading," which refers to the grant of an option in advance of disclosure of material nonpublic favorable information about the company, thus effectively enabling participants to receive options at a lower price. 
• Option "bullet-dodging," which refers to the delay of an option grant until after material negative news has been released, thereby potentially allowing participants to benefit from lower option prices due to a dip in the market price of the stock. 
• Manipulation of option exercise dates, which some executives have been alleged to have done in order to minimize the tax consequences upon exercise. 
• Restricted stock grants, which, although not subject to the intense scrutiny that option grants have been, may involve some of the same issues that apply to options (e.g., backdating the grant date to minimize the fair value accounting consequence). 
• Improper record-keeping, which may involve less egregious but still potentially actionable practices such as failure to maintain proper records (compensation committee minutes, signed consents, award agreements, etc.) reflecting option grants. These actions may result in, among other things, invalid awards or inadvertent backdating.

In addition to heightened SEC and DOJ scrutiny of grant practices, a number of investor groups, such as Institutional Shareholder Services, Glass Lewis & Co., the Council of Institutional Investors and CalPERS, have increased their focus on this issue, as has an advisory group of the Public Company Accounting Oversight Board. Many commentators expect the Internal Revenue Service to jump on the bandwagon, and given that the IRS recently expanded its executive compensation audit program, such heightened IRS scrutiny seems likely. Lawsuits have already been filed by shareholders of some companies under fire, and more can be expected to follow.

Implications of Improper Grant Practices

It is important to keep in mind that, as noted by SEC Commissioner Paul S. Atkins in a speech (available at http://www.sec.gov/news/speech/2006/spch070606psa.htm) earlier this month, many grant practices currently under scrutiny are not per se illegal. However, as noted below, engaging in option backdating or other suspect grant practices may subject companies, directors and executives to civil and/or criminal liability and/or penalties if these practices occur under circumstances that do not comply with applicable state corporate laws, or are not reported properly under applicable securities laws, tax laws and accounting principles.

These grant practices implicate a number of legal and accounting issues, such as the following: 

• Tax issues: Improper grant practices raise a host of potential tax issues, which may result in improperly claimed deductions, failures to comply with withholding and/or reporting requirements, amendments to corporate and individual tax returns and potential taxes, interest and penalties for both the company and the participant.
  
  ISO status. Options designated as incentive stock options (ISOs) may lose their favorable tax status if the option price is found to be less than the market value on the grant date, since ISOs must have an option price at least equal to the fair market value of the stock on the grant date.
  Code Section 162(m) issues. Options and stock appreciation rights (SARs) with an option or base price below the market price of the stock on the grant date are not eligible for the Internal Revenue Code Section 162(m) $1 million performance-based compensation deduction exception.
  Code Section 409A issues. Under the new Code Section 409A deferred compensation taxation regime, discount options subject participants to immediate taxation upon vesting, interest on such tax and a 20% tax penalty unless the award complies with the onerous provisions of Section 409A (including fixed exercise date(s)) or is grandfathered under narrow IRS rules.
• Accounting issues: Discounted options result in a compensation expense under former APB No. 25, and increase the amount of compensation expense under current FAS 123(R). As noted in the Brocade allegations, improper grant practices could force companies to restate their financial statements to reflect the true accounting cost of equity awards. Even if a restatement does not result in criminal or civil charges, it may result in adverse publicity and/or market reaction. 
• Securities laws concerns: Option grant practices also raise a number of potential federal securities laws issues. These include:
  
  Disclosure issues: The failure to properly disclose grants of equity awards to directors and executive officers in the company’s proxy statement or in other periodic reports may constitute securities law disclosure violations.
  Certification issues: CEOs and CFOs may face liability for certifying periodic reports that contain materially inaccurate financial statements or other disclosures.
  Reporting issues: Improper grant practices may result in Form 3, Form 4 and Form 5 reporting delinquencies and related proxy statement disclosures.
  Insider trading issues: Although not entirely clear, certain questionable option grant practices (such as option springloading) may give rise to claims of insider trading violations.
  Controls and procedures: The failure to accurately document the grant of equity awards may implicate deficiencies in a company’s disclosure controls and procedures and/or internal control over financial reporting. These deficiencies may prevent a company’s auditors from signing off on the company’s financial statements and delay the filing of the company’s SEC reports. This delay could in turn result in a default under the company’s material debt instruments, as Mercury Interactive experienced earlier this year as a result of irregularities in its stock option grants.
• Corporate law and corporate governance issues: Directors who have not properly overseen option grant practices or who failed to exercise judgment that was independent of management may find themselves subject to fiduciary duty claims involving alleged breaches of the duties of loyalty, care and good faith and/or corporate waste claims. In addition, technical deficiencies in grant practices, such as the failure to state the effective date of grants or the failure to have consents signed by all directors, may result in invalid awards. Both compensation committee and stock plan administration procedures may need to be revised to reflect corporate governance best practices.
• Plan document issues: Grants that are not made in accordance with governing plan documents may be considered invalid grants. For instance, if a stock plan requires that the option price be no less than the market value on the grant date, and an option is found to be a discount option based on the date the grant was finalized, the option may be considered invalid since it is not permitted under the terms of the plan. If an award is invalid based on the terms of the stock plan, the shares issuable under the award may not be covered by the Form S-8 registration statement registering plan shares. In order to avoid having the award invalidated, companies may be forced to seek shareholder approval of such awards under the applicable shareholder approval rules of the NYSE or NASDAQ. 

What To Do Now

The option grant controversy can be expected to get worse before it gets better. Every company that has not already done so should take steps now to assess whether its equity award grant practices are in compliance with applicable laws and whether its equity grants have been properly reported, taxed and accounted for. For most companies, it is likely that inadequacies in grant practices are unintentional and not manipulative. Even those companies, however, would benefit from improved grant policies and procedures. Companies that identify irregularities in grant practices based on an initial review should promptly consult with their legal counsel to help determine an appropriate response, including contacting the company’s auditors and communication with the company’s board of directors or audit committee. Where appropriate, a company’s audit committee or an independent special committee of the board should oversee the investigation. In some cases, it may be appropriate for the board, individual directors or members of management to retain independent outside counsel or advisors.

In addition, companies should evaluate their equity award procedures to determine whether they need to be tightened up to avoid manipulation or abuse. For example:

•  Companies should consider granting awards at specified intervals (annually, quarterly, etc.) or during established window periods (e.g., following earnings releases). 
• Companies should consider granting awards only at compensation committee meetings (where the grant date usually is clear), as opposed to via written consents. If used, consents should be carefully drafted and procedures should be put in place to be sure all members timely execute the consent. 
• Companies should reevaluate the advisability of delegating authority to the CEO or other officers to make grants. Any such delegation must be in compliance with state law requirements and steps should be taken to ensure that the grants follow proper procedures.