Investigating Potential Allegations of Backdating Option Grants

Transcription

1 EXECUTIVE COMPENSATION LIBRARY JOURNAL REPORTS: LAW AND POLICY 2006 Investigating Ptential Allegatins f Backdating Optin Grants By William F. Sweetnam, Jr., Grm Law Grup, Chartered Washingtn, D.C. September 2006 The press recently has reprted abut several high prfile cmpanies that, either intentinally r unintentinally, treated ptins as granted at an earlier time than they actually were granted, resulting in greater prfit ptential fr executives. Several academics have prduced studies that the authrs say demnstrate that backdating is prevalent in many cmpanies.1 Plaintiffs' attrneys have instituted suit against cmpanies fr apparent backdating prblems and gvernment attrneys have filed criminal charges against crprate fficers due t ptin backdating.2 Clearly, ptin backdating is smething that crprate cunsel shuld be aware f. What is Optin Backdating? Optins prvide the ptin hlder with the ability t acquire stck at a certain price at sme time in the future. Essentially it gives the ptin hlder the ability t wn the stck in the future withut having the financial risk f the decline in the value f the stck during the time perid befre the ptin exercise. Typically the ptin hlder will recgnize gain when the ptin is exercised in the amunt that the fair market value f the stck when exercised is greater than the ptin exercise price. 3 Cmpanies frequently use stck ptins as incentive devices fr their executives as well as the rank and file emplyees. When an ptin is granted and the ptin exercise price is at the fair market value f the stck at the date f grant, then the executive will be rewarded if he r she exercises the ptin when the stck price increases after the grant. Such an incentive cmpensatin tl wrks well fr the cmpany and its sharehlders: executives are rewarded when the stck price rises and the value f the sharehlders hldings is increased by the increase in share price. Cmpanies award executives this frm f incentive cmpensatin because it rewards the executive nly if verall sharehlder value increases. Optins are typically granted t executives with exercise prices equal t the fair market value at date f grant. There are mre favrable accunting and tax cnsequences that ccur when the ptin exercise price is at least equal t the fair market value f the underlying stck at date f grant. Optin backdating ccurs when, either intentinally r unintentinally, the grant f an ptin is deemed t have been made in the past at an ptin exercise price that, while equal t the fair market value f the stck at the earlier date, is lwer than the fair market value n the actual grant date. When the backdating f stck ptin grants ccurs, it remves that linkage between the value delivered t the Cpyright 2006, The Bureau f Natinal Affairs, Inc. Reprductin r redistributin, in whle r in part, and in any frm, withut express written permissin is prhibited except as permitted by the BNA Cpyright Plicy. 1

2 executive and the value the sharehlders receive fr increase in the stck's market value after the date f the grant, since the executive has already been given a leg-up n the stck's future appreciatin.4 Causes f Backdating Backdating can be inadvertent. It may happen because all f the apprvals and authrizatins that are necessary t grant an ptin have nt been met s that when the ptin becmes legally binding, a perid f time has elapsed between the date that the ptin exercise price was determined and the date the ptin was legally granted. Fr example, assume that the cmpensatin cmmittee f the bard f directrs apprves the grant f a fair market value ptin n the date f a meeting held via a cnference call but that the apprval is nt legally binding until all the cmpensatin cmmittee members execute the unanimus written cnsent f the cmmittee. If that unanimus cnsent is nt executed by all the members f the cmpensatin cmmittee until the fllwing mnth, but the ptin exercise price remains based n the fair market value as f the date f the cnference call, that ptin culd be said t be backdated. Backdating can be deliberate. This ccurs with executives r directrs wh knw the adverse tax and accunting cnsequences f using an ptin with an exercise price that is lwer than the fair market value at date f grant. Nevertheless they deem the ptin t be granted at an earlier date when the fair market value is less and treat the ptin as if granted with an exercise price equal t the fair market value. Such actins may be taken in rder t lck in sme prtin f gain r eliminate sme element f risk t the ptin hlder. Backdating the ptin may be dne t hide that the ptin exercise was belw fair market value s as nt t trigger the adverse tax and accunting cnsequences f a belw fair market value ptin grant. In additin, many stck ptin plans require that nly stck ptins with an exercise price that is at least equal t the stck's fair market value at date f grant can be granted, s backdating may be used as effrt t avid that restrictin. Cnsequences f Belw Market Value Optins There is nthing illegal with granting ptins with exercise prices belw fair market value at the date f grant. There are reasns fr such a cmpensatin strategy and there is nthing under the tax and securities laws r under the accunting rules that makes belw market value ptin grants illegal r impermissible. Hwever, pursuing that cmpensatin strategy has certain financial reprting and tax ramificatins, which backdating attempts t circumvent. Under the ld accunting rules fr cmpensatry stck ptins,5 stck ptin grants were treated as an expense t the extent that the fair market value f the ptin was greater than the ptin exercise price at the date f grant.6 Since ptins granted at fair market value wuld nt be charged against earnings, there was an incentive t make sure that the ptin exercise price equaled the fair market value f the stck at date f grant. There are a number f tax cnsideratins with an ptin granted with an exercise price belw fair market value. First, the favrable tax treatment accrded t an incentive stck ptin ( ISO ) f n taxatin upn ptin exercise is nly available if, amng ther things, the ptin has an exercise price equal t the fair market value f the stck at date f grant.7 Withut that, the ptin will nt be cnsidered an ISO and upn the exercise f the ptin the emplyee will be taxed at the difference between the ptin exercise price and the fair market value f the stck at the time f exercise. Cpyright 2006, The Bureau f Natinal Affairs, Inc. Reprductin r redistributin, in whle r in part, and in any frm, withut express written permissin is prhibited except as permitted by the BNA Cpyright Plicy. 2

3 Anther tax cnsideratin is whether the crpratin receives a deductin at the time f ptin exercise. Under general tax rules, the crpratin that grants the ptin (ther than an ISO) will be entitled t a cmpensatin deductin equal t the amunt the emplyee includes as incme upn the ptin exercise.8 Hwever, publicly traded cmpanies are limited t a $1 millin annual deductin fr the amunt f cmpensatin paid t certain executives.9 This deductin cap nly applies t the chief executive fficer and the next tp fur executives in terms f cmpensatin.10 As an exceptin t this $1 millin cmpensatin cap, payment f any perfrmance-based cmpensatin can be deducted by the cmpany.11 Included in the definitin f perfrmance-based cmpensatin are stck ptins granted with an exercise price n less than the fair market value f the stck at date f grant. Optins granted with exercise prices belw fair market value at date f grant cannt be cnsidered perfrmance-based cmpensatin, and therefre, the cmpany culd lse deductin they wuld therwise be entitled t upn exercise f the ptin.12 Finally, ptins are nt cnsidered nnqualified deferred cmpensatin under the new rules under 409A f the Internal Revenue Cde ( 409A ) as lng as, amng ther things, the ptin exercise price is n less than the fair market value f the stck at the time the ptin is granted.13 Optins grant ed with exercise price less than fair market value f the stck at the grant date will be cnsidered deferred cmpensatin and will be subject t strict rules n when the prceeds f the ptin grant can be realized by the ptin hlder. Generally this means that the ptin hlder cannt freely exercise his r her ptins withut vilating the rules under 409A. Vilatin f thse rules because f backdating r therwise will mean that the ptin hlder is taxed n the value f the ptin (mst likely calculated as the ptin spread) at the time the ptin becmes fully vested and subject t an additinal 20 percent tax as well as imputed interest.14 Unlike the rules dealing with the deductin lss n cmpensatin in excess f $1 millin that apply nly t the tp five fficers f a publicly traded cmpany, the 409A rules apply t all emplyees f all types f cmpanies. Clearly, cmpanies and the executives d nt want t be subject t the 409A rules with regard t their ptins. What t D Nw The backdating f ptin grants may be less f an issue nw than it was previusly. Under the Sarbanes-Oxley Act f 2002 ( SOX ), the grants f ptins t tp executives must be disclsed within tw business days. The shrt time frame between grant date and the filing deadline des nt give much rm t backdate the ptin grant. Cmpare the new filing deadline under SOX with the pre-sox filing deadline f within 45 days f the end f the crpratin's fiscal year and yu can see that there is less rm fr intentinal backdating f ptin grants. Hwever, fr crpratins that are nt publicly traded and subject t these federal securities law disclsure requirements, there still may be the incentive and ability t backdate ptins. The bard r the cmpensatin cmmittee may want t examine the cmpany's grants f ptins t make sure that there are n backdating issues. Internal cunsel may want t start such an investigatin, but, if evidence f backdating is uncvered, it might be best fr an independent utside cunsel t be engaged by the bard. The first thing that shuld be examined is the cmpany's internal prcedures with regard t ptin grants. The fllwing utlines what shuld be examined: Cpyright 2006, The Bureau f Natinal Affairs, Inc. Reprductin r redistributin, in whle r in part, and in any frm, withut express written permissin is prhibited except as permitted by the BNA Cpyright Plicy. 3

4 Plan Dcumentatin. Cnfirm that the actual administratin f the plan fllws the terms f the underlying dcument. Des the ptin grant dcumentatin cnfrm t the underlying dcument? Even if there is n evidence f ptin backdating, it is always imprtant t have legal dcumentatin and the administrative practices cnfrm. Apprval f ptin grant. Bard f Directrs r Cmpensatin Cmmittee What level f invlvement des the Bard r Cmpensatin Cmmittee have with regard t wh is granted ptins, hw many ptins are granted, and the timing f the ptin grant? If there is little direct invlvement by the Bard r the Cmpensatin Cmmittee, especially with regard t large ptin grants made at nnrecurring times, a higher level f scrutiny f the timing f the grant is warranted. Subcmmittee f the Cmpensatin Cmmittee T avid having the Bard r the Cmpensatin Cmmittee get invlved in numerus ptin grants made at nnrecurring times, sme cmpanies have delegated the ptin granting authrity t a smaller grup r t a cmmittee f ne, where the actin f just ne individual will result in ptins being granted. 15 In these circumstances, a higher degree f scrutiny wuld be warranted since it wuld be easy fr the prper dcumentatin nt t ccur r fr smene t try t manipulate the ptin grant date. Timing f ptin grant. Are the ptins granted n a regular basis at a regularly scheduled time? If regularly scheduled ptin grants, determine whether any grants have ccurred utside that time; these ptin grants may be mre susceptible t manipulatin f the grant date. Are ptin grants usually part f cmpensatin agreements fr new emplyees? If s, then the ptin exercise price must be examined clsely. Many times, the intent f the grant f ptins at the cmmencement f emplyment is t make up fr stck ptin value at a previus emplyer and the terms f an ptin grant (number f ptins, exercise price) may be set befre the emplyment actually cmmences and the emplyment cntract is effective. That may result in ptins being granted with an exercise price less than the fair market value f the stck n the date when the new emplyee has a legally binding right t thse ptins. Dcumentatin f the ptin grant. Terms and Cnditins Are all the terms and cnditins (number f ptins granted, ptin hlder, grant price, date f grant) f the ptin addressed in the dcumentatin r can they be determined by reference t ther dcuments? The clearer the dcumentatin f the ptin grant the less chance there will be f inadvertent backdating. Emplyee Cmmunicatin What is the dcumentatin given t the emplyee f his r her ptin grant? Des it clearly reflect the ptin exercise price and the term f the ptin? Is the Cpyright 2006, The Bureau f Natinal Affairs, Inc. Reprductin r redistributin, in whle r in part, and in any frm, withut express written permissin is prhibited except as permitted by the BNA Cpyright Plicy. 4

5 dcumentatin given t the emplyee is a timely manner after the ptin is granted? The mre infrmatin given the emplyee in a timely fashin the less likelihd that the ptin grant date was manipulated. Chain f cntrl f dcuments identifying the terms and cnditins f the ptin. Wh is in charge f ptin administratin and d they understand the legal significance f what they d? Often ptin administratin falls between the crprate secretary's ffice and the human resurce department, with little thught given t the legal significance f what an ptin is. This culd result in inadvertent ptin backdating since the administratr may nt knw the prper terms f the ptin r it culd facilitate deliberate backdating since the administratr may nt understand when and hw the ptin grant shuld be made in a crrect manner. If ptin administratin is utsurced, is the ptin administratr getting infrmatin frm the cmpany in a timely basis? While it may turn ut that a cmpany des nt have an ptin backdating prblem, peridic review f these imprtant prcesses is a gd thing t d. This is especially true in this time f increased scrutiny f ptin grants by the gvernment, sharehlders, plaintiff's attrneys, and the press. Ftntes 1 Eric Lie f the University f Iwa and Randall Hern f Indiana University have published a few papers dealing with the timing f stck ptin awards and pssible backdating. 2 Brcade Cmmunicatins Systems has recently settled a sharehlder lawsuit regarding backdated ptins and criminal charges have been filed against Brcade's frmer chief executive fficer and frmer vice president f human resurces. 3 I.R.C. 83(a). Hwever, if the ptin is an incentive stck ptin and it is exercised and the stck received is nt sld within the time perids prescribed, then the ptin hlder will nt be taxed upn grant but rather when the stck is subsequently sld. I.R.C It is imprtant t nte, hwever, that the backdated ptin has n value t the ptinee unless the stck price exceeds the exercise price upn vesting which typically ccurs at least ne year after the grant date. 5 Accunting Principles Bard Opinin (ABP) N Under current accunting rules, the fair value f the ptin is reprted as a change t earnings regardless f whether the ptin was granted with an exercise price equal t fair market value at grant r nt. Statement f Financial Accunting Standard N. 123 (revised 2004). 7 I.R.C I.R.C. 83(h). 9 I.R.C. 162(m)(1). Cpyright 2006, The Bureau f Natinal Affairs, Inc. Reprductin r redistributin, in whle r in part, and in any frm, withut express written permissin is prhibited except as permitted by the BNA Cpyright Plicy. 5

6 10 I.R.C. 162(m)(3). This will likely be revised t reflect the change in executives cvered by the SEC's revised prxy rules. 11 I.R.C. 162(m)(4)(C). 12 Treas. Reg (c)(2)(vi) (1995). 13 Prp. Treas. Reg A-1(b)(5)(A) (2005). 14 I.R.C. 409A(a)(1). 15 Such delegatin nrmally des nt apply t grants t fficers f public cmpanies. Cpyright 2006, The Bureau f Natinal Affairs, Inc. Reprductin r redistributin, in whle r in part, and in any frm, withut express written permissin is prhibited except as permitted by the BNA Cpyright Plicy. 6