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The Employee Ownership Update

Corey Rosen

May 26, 2006

(Corey Rosen)

Option Backdating Becomes Major Concern

Dozens of companies are under investigation by the Securities and Exchange Commission for backdating stock options. The Manhattan U.S. District Attorney's Office has also issued several subpoenas in launching a criminal probe. National concern about the practice has been spurred by a series of articles in the Wall Street Journal. An analysis of 1,000 companies by M.P. Narayanan and H. Nejat Seyhun of the University of Michigan for the newspaper showed that that option granting practices between 2002 and 2004 often failed to comply with the Sarbanes-Oxley requirement that grants of awards to executives be reported within two days of board approval ("The Dating Game: Do Managers Designate Option Grant Dates to Increase Their Compensation?", working paper, April 2006). Prior research at Erik Lie at the University of Iowa found a pattern of probable option backdating in a number of companies before 2002.

Stock options are usually granted at the then-current market price of the stock. When the option holder exercises the option (i.e., purchases the stock pursuant to the option), the option holder buys the stock at the grant date's price (the "exercise price") instead of the current market price. For example, say that on July 1, 2005, an option is granted at $25, the current market price. On July 1, 2006, it is exercised when the market price is $30. The option holder pays $25 per share and thus has an immediate gain of $5 per share ($30 market price minus $25 exercise price). Suppose that the company's stock had fallen to $5 per share on January 1, 2005. In a typical backdating situation, the company might grant the option on July 1, 2005, but backdate it (change the date on the grant) to January 1; the option now would be granted at $5 per share; and the option holder would now exercise at $5 per share and thus has an immediate gain of $25 per share ($30 market price on July 1, 2006, minus $5 exercise price). Multiply this by the thousands of shares a top executive may receive in a single option grant, and you have some real money.

In the situations that have given rise to controversy, the typical practice was to record a felicitously timed prior date as the grant date, such as the point when the stock had been at its lowest in recent months, instead of the date when the award was actually granted. Companies found to have practiced this could be forced to restate their earnings. Alternatively, a company could hit a low without actually backdating its options by granting awards just before a major (positive) earnings announcement--a move that is likely to be unpopular with shareholders, but that doesn't necessarily cause securities law problems. A more extreme and more clearly illegal practice was to say that an award was exercised on a date other than its actual exercise date. Recording the exercise as having occurred on an earlier date when the stock price was lower would minimize the executive's income tax liability, but constitutes tax fraud.

The research suggests that a lot of companies showed patterns of grants whose timing was just too good to be true. On the other hand, some of the companies that get entangled in this may have been making honest mistakes, recording dates that were off by a few days because of inadequate administrative procedures. (The administrative problem could be resolved if more companies would hire people with the right skills for stock plan administration, such as those with certification from the Certified Equity Professional Institute at Santa Clara University.)

Backdating is not per se illegal, but, under the Sarbanes-Oxley Act, top executives must report grants made to them within two days of the grant (before Sarbanes-Oxley, it was 45 days). For its part, the company must report failure to comply on its annual proxy statement. But aside from Sarbanes-Oxley, whose effective date was after most of these practices were alleged to occur, there is a raft of potential other problems:

1. Shareholders: start your attorneys! Backdating will be a field day for securities lawyers, for a number of reasons. First, if a company said it was issuing options at fair market value, but really didn't, shareholders could sue because they never approved such a plan. The New York Stock Exchange and NASDAQ listing standards, which were tightened in 2003, require shareholder approval of new and modified equity compensation plans. Furthermore, IRS rules make shareholder approval a condition for tax-qualified incentive stock option plans. Second, shareholders could sue for fraud. After all, the company did not really properly disclose its plan or its costs, so investors were making decisions based on misleading information that may have amounted to millions of dollars. Third, the shareholders could sue for a wasting of corporate assets, claiming that the executive didn't really need all that extra money to be motivated to do the job.

2. The SEC will be very, very busy: Lawyers still haven't quite sorted out all the violations that could be involved with backdating. If an executive got options timed just before the release of data that would affect the stock price, that's potentially insider trading. If the options were granted in a way not in accordance with the plan, that could mean that proper disclosures from the executive to the SEC had not been made. If the two-day rule for reporting grants was effectively violated (because the grant date was pushed back more than two days over what the company actually claimed it was), then the securities laws are violated again.

3. The government's deficit may be lowered: It's not entirely clear how the new rules on the taxation of deferred compensation will apply to backdated options issued before the effective date of the new "409A" rules under the Internal Revenue Code. That Code section says that certain kinds of deferred compensation will be heavily taxed unless the recipient specified well in advance when the award would be paid. Options generally do not require such an advance election (you can exercise whenever you like once they are vested until they expire; that's why they are so appealing). Option grants at fair market value are not covered by this section of the tax code, but discounted options are. If the options were exercised before the effective date, that should not be a problem, but if they had not been, then the law seems to say that the plan would need to be modified by the end of this year to avoid punitive taxation on below-market grants of options. That modification, in turn, would mean the executive would either have to pay the company the difference so that the grant was at fair market value or pay the punitive taxes.

More clear is that if the options were incentive stock options-a kind of option that qualified the holder for capital gains treatment on the sale as opposed to ordinary income on the exercise of an option-then the backdating would disqualify the option as an incentive option, and the executive would owe big-time back taxes on the exercised award, even if the stock had not yet been sold.

If the exercise date is bogus, that means the company has underwithheld taxes on the exercise. And that means it owes the government, with penalties and interest.

4. Accountants will be recalculating; investors won't be buying: Rules for recording the impact of options expenses have changed, but under both the old rules and the new rules, pretending the awards were granted at a price they were not requires companies to go back and restate earnings. Investors never like restating earnings.

5. Your stock exchange may not be happy to have you any more: Stock exchange rules for shareholder approval of options plans don't include provisions saying that it's OK to have shareholders approve awards made at the grant date fair market value when in fact you issue discounted options. So trading in your company's shares may be suspended until the problem is fixed. This also is not an investor favorite.

Here Come the Lawsuits

As this was written in late May 2006, the many lawsuits that inevitably will be filed against companies accused of backdating had just started. The first have been against the poster company for these allegations, United Health Group in Minnesota. The company's stock had performed very well, although in 2006, after the allegations surfaced, it announced that it would be restating earnings. A particular concern was CEO William McGuire, who held an estimated $1.6 billion in options awards. An analysis of the likelihood that McGuire's options could have been as felicitously times as they were showed that the odds were millions to one against it.

On April 19, 2006, Minnesota Attorney General Mike Hatch asked to intervene in a shareholder lawsuit against United Health Group (Brandin v. McGuire, No. 06-CV-1216, D. Minn., motion filed Apr. 19, 2006). The motion said that office has an interest in protecting the rights of interests of citizens of Minnesotans. The state, however, has not taken a position on the merits of the claims. Hatch said that the importance of the company to the state's health care system meant that if there were substantial and unjustified costs, Minnesotans could be harmed. The legal theory involved here could open the door for other interventions in potentially abusive executive compensation issues. Soon thereafter, two public pension funds in Ohio indicated they will be suing United as well, followed by a retirement fund for Pirelli Armstrong Tire.

Enough Seems Never to Be Enough

Excessive executive compensation seems to be an issue that just won't go away-because excessive executive compensation won't go away. The theory seems to be that a good CEO is worth any price a company will pay, no matter that the compensation might literally exceed the GNP of some countries or be enough to hire hundreds of talented employees. Any gain a company makes is assumed to be the sole result of the extraordinary wisdom of this one very special person, not the collective efforts of hundreds or thousands of employees. It's demonstrably bunk, but then the people setting executive pay operate in a parallel universe. Despite all the editorials, all the accounting rule changes, all the new laws, nothing much seems to change except the particular manner in which so many executives get overpaid. Chances are this particular practice will now go away, but another one will surface all too soon.

Refocusing on Who, Not Just How Much

As important as the issue of executive equity compensation is, it should not blind us to a more important concern. Research has definitely shown that broadly-granted equity awards improve corporate performance; concentrated grants force it down (the details are in our article "Broadly Granted Stock Options Improve Corporate Performance"). Yet in all the many discussions about this scandal, and others that have preceded it, the issue of who should get awards is almost never raised. And that may explain why the problem of executive compensation has not been effectively addressed. No matter how much particular practices may be decried, the consensus seems to remain that corporate success is attributable to a very few people at the top, with everyone else pretty much replaceable parts. That theory is just plain wrong.

Author biography and other columns in this series

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