SOFT DOLLARS QUESTIONABLY TIMED OPTION GRANTS

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1 VOLUME 2, ISSUE #2 APRIL 1, 2006 JUNE 30, 2006 The Securities and Exchange Commission (SEC) has intensified its regulatory activities over the last several years, and its efforts throughout this quarter were no exception. During this reporting period, the SEC published interpretive guidance for soft dollar practices at money management firms, began an examination of alleged stock option backdating practices of 80 corporations, and solicited public comments on mutual fund governance rules originally adopted in This issue of the Corporate Governance Quarterly Review briefly discusses all of these topics. SOFT DOLLARS he SEC has released T interpretive guidance on soft dollars to define what legitimately qualifies as brokerage and research services and ultimately help reduce soft dollar abuses. Soft dollars are defined as the industry-wide practice of external money managers paying brokerage firms higher trading commissions or giving them increased business in exchange for brokerage and research services as defined under Section 28(e), 1 the safe harbor provision of the Securities Exchange Act of 1934 (Exchange Act). This new SEC directive narrows the scope of brokerage and research products that are covered by the safe harbor provisions. The following continued on pg. 2 1 Section 28(e) of the Exchange Act established a safe harbor that allows an investment manager to use client funds (such as LACERA s brokerage commissions) to purchase specified brokerage and research services for clients without breaching its fiduciary duty. QUESTIONABLY TIMED OPTION GRANTS H eadlines across the nation have revealed a growing number of U.S. corporations accused of alleged misconduct related to the timing of stock option grants. Much of the concern is focused on whether questionably timed option grants may have been backdated by corporate executives to secure lower exercise prices and subsequently increase the value of the option payout. Backdating, briefly stated, is when a company sets the strike price of stock options retroactively to a date when the shares were trading at lower price. Stock options enable executives to buy company stock at a predetermined strike price. Options with a lower strike price are more valuable (more financially favorable to the person receiving the proceeds) because they are less expensive to exercise and the profits are greater when they are sold. For additional information about this topic, please review the attached informational memo recently submitted to the Board of Investments by LACERA s Legal Office. Corporate Governance Committee Lisa Mazzocco, Chair Marsha Richter David Muir Stuart Mesnik, Staff

2 MUTUAL FUND GOVERNANCE C hairman Christopher Cox s predecessor at the SEC William Donaldson eloquently discussed the aftermath of mutual fund improprieties in the following excerpt from an SEC Open Commission Meeting in July 2004: Beginning in 2003, a series of scandals were uncovered in the mutual fund industry involving truly egregious, illegal and unethical behavior on the part of fund advisers. Advisers in a host of different fund complexes knowingly endorsed, among other abuses, late trading, market timing (including some advisers timing their own funds), directed brokerage, and selective disclosure to favored investors. The scandals resulted in enormous losses for investors, and revealed systemic breakdowns in compliance systems, weaknesses in fund governance structures and a significant betrayal of investors' trust. In the wake of these market timing and late trading scandals, the SEC adopted mutual fund governance rules in January In April 2006, however, the SEC was forced to re-evaluate these rules after a federal appeals court invalidated certain key amendments. The key amendments imposed two conditions on mutual fund companies to help mitigate conflicts of interest. First, mutual fund boards would have to be comprised of at least 75 percent independent directors. Second, the boards would have to be chaired by an independent director. These conditions were designed to enhance the independence and effectiveness of mutual fund boards and to improve their ability to protect the interests of mutual funds and the fund shareholders they serve. 2 As a result of pressure from the U.S. Chamber of Commerce in support of mutual fund companies, both of the 2 Source: SEC Release No. IC27305, Investment Company Governance, June 13, 2006 SOFT DOLLARS continued from pg. 1 research services are eligible under Section 28(e)(3)(A) or (B) of the Exchange Act: Research reports analyzing the performance of a particular company or stock. Quantitative analytical software and software that provides analyses of securities portfolios. Discussions with research analysts relating to the advisability of investing in securities. Meetings with corporate executives to obtain oral reports on the performance of a company. Seminars or conferences that provide substantive content relating to a permissible subject matter, such as issuers, industries and securities. Financial newsletters and trade journals that are not mass-marketed. Certain market research and market data may be also be eligible. The following brokerage services 2

3 STOCK OPTIONS BACKDATING; THE NEXT CORPORATE SCANDAL? A s you may have already heard or read over the past several weeks, stock options backdating has the potential to become the next large-scale corporate scandal. In what may be the first significant development at the federal level, the Los Angeles Times reported on July 21st that federal prosecutors filed the first criminal complaint against company executives in an ongoing investigation into the possible manipulation of stock options. According to the Los Angeles Times, the U.S. Attorneys Office in San Francisco charged former Brocade Communications, Inc. executives Gregory Reyes (CEO) and Stephanie Jensen (VP, Human Resources) with one count each of securities fraud. The criminal complaint alleges that the former executives doctored the minutes of board meetings, job-offer letters and other documents to make it appear that employees were granted stock options at an earlier date, when the share price of Brocade was lower. Separately, the SEC announced that it has filed a civil complaint against Brocade s former chief financial officer, Antonio Canova, and two other former executives. But the recent charges against Brocade s executives appear to be just the tip of the iceberg. As early as November 2005, The Wall Street Journal reported that federal regulators and academics were scrutinizing a broad pattern of well-timed stock-option grants at publicly traded companies and examining the extent to which companies improperly backdated grants to provide insiders an extra pay windfall. 1 Since then, the story has grown into a scandal potentially impacting as many as 2,000 companies. 2 Currently, the SEC is examining the alleged backdating practices of at least 80 companies. SEC Chairman, Christopher Cox, has called the practice poisonous and said the S.E.C. is committed to bringing it to an end nationwide. In addition, federal prosecutors in San Francisco, Manhattan and Brooklyn are currently looking at more than 33 stock options backdating cases for potential accounting problems or fraud. 3 So what s the big deal? Granting stock options is intended to align the incentives of executives with those of shareholders. With a significant option package, an executive has a great incentive to raise the company s share price, which increases both the value of his or her options and shareholder returns. To this end, stock options are generally granted at-themoney by setting the strike price (the options purchase or exercise price) equal to the stock price on date the option is granted. The strike price often is set at the closing share price on the grant date, or at the average of that day s high and low, and the recipient may have to wait at least a year before exercising all or a portion of their options. 4 1 Mark Maremont, Authorities Probe Improper Backdating of Options - Practice Allows Executives To Bolster Their Stock Gains; A Highly Beneficial Pattern, The Wall Street Journal (November 11, 2005). 2 Randall A. Heron and Erik Lie, What Fraction Of Stock Option Grants To Top Executives Have Been Backdated Or Manipulated?, Kelly Sch. Of Bus., Indiana University (July 14, 2006). 3 The SEC and federal prosecutors are also scrutinizing a related practice referred to as spring loading, which involves dating option grants to immediately precede positive company news. 4 See Institutional Guide to the Stock Options Timing Scandal, Institutional Shareholder Services (July 2006), available at 3

4 SOFT DOLLARS continued from pg. 2 are eligible under Section 28(e)(3)(C) of the Exchange Act: Trading software used to route orders to market centers. Software that provides algorithmic trading strategies. Software used to transmit orders to direct market access systems. Communication services related to the execution, clearing and settlement of securities transactions. While soft dollar practices are deeply entrenched and remain controversial, the SEC s new guidance if prudently implemented by investment managers should help mitigate the perception that soft dollars are being used for the wrong purposes. MUTUAL FUND GOVERNANCE continued from pg. 2 independent director 3 conditions were challenged in the U.S. Court of Appeals. The Court then invalidated the amendments on a procedural technicality and issued an opinion that the SEC violated the Administrative Procedure Act by not seeking public comment on the data used to estimate the costs of implementing the two conditions. Subsequently, on June 13, 2006, the SEC announced that it would solicit comments until August 21, 2006 regarding these costs, as well as any issue related to the underlying purpose of the board independence requirements. After reviewing all public comments, the SEC will, once again, release the mutual fund governance rules. 3 Independent outside directors can bring objectivity and a new perspective to the numerous issues facing a corporation. They also bring new contacts and specialized skills to a board of directors. When developing internal controls, formulating executive compensation policies, and responding to takeover offers, the inherent conflict of interest problem is much less severe for outsiders than it is for executive officers. Source: LACERA Proxy Voting Guidelines, April 27, STOCK OPTIONS BACKDATING; THE NEXT CORPORATE SCANDAL? continued from pg. 3 Backdating, on the other hand, occurs when a company sets the exercise price for a stock option to an earlier date. If the stock was trading at a lower price on that earlier date, then the option may already be in-the-money when the executive receives the grant. Backdating the strike price of an option is not per se illegal. 5 However, for publically-traded companies, failure to properly disclose and report it can lead to series problems and/or potential securities laws violations. For example, improper dating of options may require a company to restate its financial statements for prior years to reflect additional compensation expense. Because compensation expense is recorded over the vesting period continued on pg. 5 5 Prior to 2002, companies were not required to report option grants until months later. This changed when Congress passed the Sarbanes-Oxley Act in 2002 requiring companies to report grants within two days. 4

5 STOCK OPTIONS BACKDATING; THE NEXT CORPORATE SCANDAL? continued from pg. 3 of the option (generally four years), a single occurrence of improper dating could result in the restatement of several years of financial statements. In addition, irregularities in option grant practices could reflect material weaknesses in internal controls. Also, publicly-traded companies are required to disclose executive officers compensation in their proxy statements. If a company disclosed that stock options were granted at-the-money, but in fact the options were granted on a date when the fair market value of the underlying stock would have resulted in the options being inthe-money, the disclosure may have been inaccurate. Further, the exercise price affects the basis that is used for estimating both the company's compensation expense for tax purposes and any capital gain for the option recipient. Thus, an artificially low exercise price might alter the tax payments for both the company and the option recipient. Also, under Section 16 of the Securities Exchange Act of 1934, executive officers are required to report the grants of stock options on forms they file with the SEC. Inaccurate reporting of a stock option grant date could therefore be alleged to be a violation of state and/or federal securities laws. Not surprising, investors have entered the fray and initiated shareholder lawsuits against several companies stemming from their options backdating practices. 6 Most of these cases consist of derivative claims where investors have brought suits on behalf of the company. However, several recent securities class actions have been brought on behalf of shareholders seeking to recover individual losses. For example, CalPERS recently joined other investors in bringing suit against the country s second largest health issuer, Unitedhealth Group, alleging that the fund lost more than $20 million because of the company s improper stockoptions grants practices. The Legal Office has been actively monitoring and evaluating these cases over the past several months to determine whether the fund has an interest or should consider taking an active role. We recently issued a request for proposals in a case that appears particularly strong and where LACERA may have a significant financial interest. (We are currently preparing a memo for your Board, which we will provide under separate cover.) In the meantime, we will continue to monitor and evaluate these cases and keep you apprised of our efforts in this regard. 6 To date, investors have brought state and/or federal securities actions against several companies, including GMH Communities Trust, Fairfax Financial Holdings Limited, Unitedhealth Group, Comverse Technology, Discovery Laboratories, Vitesse Semiconductor, Escala Group, American Tower, Juniper Networks, KLA-Tenor Corp., Brooks Automation, Quest Software and Rambus. More are expected to follow. 5