Stock Options Backdating: Legal or Illegal?
By Ghillaine A. Reid, Esq.[1]
Over the past two years, the business and financial news media has been flooded with reports regarding “stock options backdating” practices which result in lucrative compensation packages for corporate executives. Federal regulators and other government authorities have undertaken hundreds of investigations into executive compensation practices, several of which have resulted in civil and criminal litigation proceedings. Recently, several large company executives (including officers of corporate behemoths like Apple, Inc. and Comverse Technology, Inc.) have pleaded guilty to and agreed to settle securities fraud charges related to options backdating practices. In many instances, general counsels have been implicated in backdating schemes.
In the wake of government interest in options backdating, a multitude of public companies have conducted costly and lengthy internal reviews of their options grant practices. Despite the media frenzy and government scrutiny, however, not all backdating of options is illegal. This article addresses the following key questions — What is options backdating? When is it illegal and why? What can companies do to avoid civil and criminal liability?
What is Backdating?
Stock options have long been a customary component of executive compensation packages. An option is a derivative security which confers on the grantee the right to purchase a specific stock at a specific price (which is commonly known as the “strike” price) for a specific time period. The strike price is customarily determined based on the value of the stock at the time the options are granted. A profit is made, or a loss incurred, when the option is exercised; that is, when the underlying stock is purchased at the strike price. Thus, the amount of the profit (or loss) is governed by the difference between the strike price and the stock price when the options are exercised. Accordingly, the grantee can make a substantial profit if the exercise price is far below the market stock price. Options backdating practices can magnify the difference between the exercise and market price and, thereby, increase the profit potential for the grantee.Specifically, backdating tends to occur when the options grantor (usually the company’s compensation or other similar committee) arranges the options grant at a time when the strike price is lower than the market price. For example, the company may set the options strike price on a date before the company’s approval of the options grant in an effort to secure a lower strike price and, thereby, “backdate” the options. Backdating, therefore, centers on timing - usually the timing of the approval of the grant. The goal is to ensure that the strike price is set at a time when it will be measurably lower than the market price of the stock when the options grant is approved or otherwise made. In essence, backdating occurs when the strike price is determined after the grant is approved. Although it may appear to be nefarious, the practice of backdating options is not illegal. The manner in which a company handles backdating, however, can transform an otherwise legitimate grant of stock options into a fraudulent practice.
When Is Backdating Illegal?
Options grant practices implicate several areas of corporate management including tax, accounting, governance and legal matters. The recent government investigations and proceedings involving backdating, however, focus more on the proper disclosure of options backdating, than on the backdating itself. These cases often involve allegations that the defendants failed to accurately report backdating practices in violation of the antifraud provisions of the federal securities laws — Section 17(a) of the Securities Act of 1933 (15 U.S.C. § 77q et seq.) and Section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C. § 78j(b)).These provisions prohibit fraud in connection with the purchase or sale of securities. More specifically, Section 10(b) proscribes the use of any “manipulative or deceptive device” relating to any securities trading, and Section 17(a) prohibits any “scheme to defraud” through an “untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made . . . not misleading.” In their periodic reports and financial statements, companies must fully and accurately disclose their options backdating practices. Failure to do so may result in violations of the antifraud provisions referenced above, as well as violations of Section 302 of the Sarbanes-Oxley Act, which requires a public company’s senior-most executive and financial officers to certify the accuracy of the information contained in periodic filings with the SEC. Sarbanes-Oxley Act, Pub. L. No. 107-204, 116 Stat. 745, 777, § 302 (codified at 15 U.S.C. § 7201 et seq.).
In short, companies may engage in backdating practices, but they cannot hide it or lie about it. The consequences of hiding and lying about backdating practices can be severe, and these issues have been at the heart of recent backdating cases, as the following two examples demonstrate.
Take-Two Interactive Software, Inc.
In February of this year, the former CEO of Take-Two Interactive Software, Inc. (“Take-Two”), a video and computer distributor, pleaded guilty to charges that he falsified business records to backdate stock options grants, making him the first CEO to be convicted in a backdating scheme. The New York County District Attorney’s Office and the SEC filed civil and criminal actions against the former Take-Two CEO, alleging that he granted options to himself at historically low annual and quarterly stock prices without the knowledge or approval of the company. SEC v. Brant, 1:07-Civ-1075 (S.D.N.Y. Feb. 14, 2007); see also SEC Litigation Release No. 20003 (Feb. 14, 2007). These clandestine options grants, which violated Take-Two executive compensation policies, were effected through falsified company records. Because the grants were undisclosed to the company, its periodic filings with the SEC contained misleading information, and the company failed to disclose and account for compensation expenses relating to the grants. See Complaint in SEC v. Brant, 1:07-Civ-1075, 1-3. In addition to pleading guilty, the former CEO settled with the SEC, agreeing, among other things, to forfeit more than $6 million in ill-gotten gains and be permanently barred from serving as an officer or director of a public company.Comverse Technology, Inc.
In 2006, the U.S. Attorney’s Office for the Eastern District of New York and the SEC charged the CEO, CFO and General Counsel of Comverse Technology, Inc. (“Comverse”) with securities fraud, and a wide range of other violations, in connection with an alleged scheme to enrich themselves through undisclosed options grants. See U.S. v. Alexander, et al., M-06-817 (E.D.N.Y. July 31, 2006); SEC v. Alexander, et al., 06 Civ. 3844 (E.D.N.Y. Aug. 9, 2006). In connection with the criminal cases, the former General Counsel has been sentenced to a year in prison and, among other things, was ordered to pay $51 million in restitution; the former CFO is awaiting sentencing; and the former CEO is awaiting extradition proceedings in Namibia (where he fled after he was charged in the backdating scheme).In its complaint against the Comverse executives, the SEC alleges that the defendants granted to themselves and others “undisclosed” stock options that were backdated to “coincide with historically low closing prices for the [c]ompany’s stock.” See Complaint in SEC v. Alexander, et al., 06 Civ. 3844, 1. The complaint— which includes allegations of securities fraud, falsification of accounting records, false and misleading proxy disclosures, fraudulent stock sales and other charges —focuses on the non-disclosure and misrepresentation of critical facts relating to options grants. Specifically, the principal facts underlying the complaint are that the Comverse defendants did not disclose compensation expenses related to the options grants, overstated the company’s net income and earnings per share, falsified company records related to the date on which the grants were made, and misrepresented in periodic filings and proxy statements that the strike prices of the granted options were equal to the market value of the company stock on the date of the grant. Id. at 1-5.
The criminal case against the Comverse executives similarly focused on misrepresentation and non-disclosure of key facts regarding the backdating. In that case, the government alleged that the executives concealed the fact that they selected favorable grant dates, lied in response to inquiries by the company’s compensation committee and auditors regarding the backdating, and used fictitious names to create options grants which they awarded to themselves and favored employees. See Criminal Complaint in U.S. v. Alexander, et al., M-06-817, 21, 25-29, 32-41.
How Can Companies Avoid Liability from Backdating?
The Take-Two and Comverse cases, like most backdating cases and investigations, focus on options grants that were made in the mid to late 1990s. The Sarbanes Oxley Act of 2002, and other recent rules changes, have tightened disclosure requirements relating to stock options grants which, hopefully, will reduce incidents of hiding and lying about options backdating. Before Sarbanes-Oxley was enacted, a public company was not required to report options grants until forty-five (45) days after the close of the fiscal year in which the options were granted. Today, however, Sarbanes-Oxley requires companies to file notification of options grants within two business days of the date on which the options are granted. See Sarbanes-Oxley Act, Pub. L. No. 107-204, 116 Stat. 745, 777, § 403 (codified at 15 U.S.C. § 78p). This time limitation inevitably requires companies to focus more carefully on their backdating activity and related disclosure obligations. In addition, in July 2006, the SEC approved changes to rules requiring the disclosure of executive compensation.
Among other things, the proposed rules will require companies to disclose (i) the options grant date; (ii) the market price of the stock on the grant date, if it is greater than the strike price of the award; (iii) the date that the company approved the grant (if it is different from the grant date); and (iv) the method by which the strike price was determined if, it differs from the closing market price on the grant date. See 17 C.F.R. § 229.402 (eff. Dec. 29, 2006); see also SEC Press Release entitled “SEC Votes to Adopt Changes to Disclosure Requirements Concerning Executive Compensation and Related Matters” available at http://www.sec.gov/news/press/2006/2006-123.htm (July 26, 2006).
In addition, the company must disclose the entire compensation package, including options, for its top-five executives. See id. The government’s recent interest in options backdating has more to do with disclosure than with backdating itself. Accordingly, companies may engage in options backdating as part of its executive compensation protocol (and avoid liability) as long as the backdating practices, and their implications, are fully and accurately reported in periodic filings with the SEC, financial statements, accounting and other corporate records.
To that end, public companies and their executives should ensure that for each options grant the details relating to the grant are (1) fully disclosed in periodic filings and financial statements; (2) properly reflected in earnings, taxes and otherwise accurately accounted for; (3) in compliance with the company’s executive compensation policies and applicable rules and regulations; and (4) properly memorialized in the company’s books and records.
References
[1] Ghillaine A. Reid, Esq. is a Director of Gibbons P.C. in its Business & Commercial Litigation department. Amy J. Metzger, an associate at Gibbons, contributed to this article. 
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