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Feature Looking for problems is almost a guarantee that you will find some. However, the consequences are likely to be less onerous if the company is proactive rather than reactive. By Paul R. Berger, Lawrence K. Cagney, W. Neil Eggleston, David P. Mason, Elizabeth Pagel Serebransky and Colby A. Smith The spate of companies identified in the popular press as having problems with regard to the timing and pricing of option grants continues to grow. A recent study suggests that, at least with respect to the period from 1999 to 2000, this issue is prevalent at a large percentage of growth companies where options represent a significant portion of total compensation. The problems run the gamut from apparently deliberate backdating for the enrichment of corporate insiders to inadvertent errors arising from less than disciplined governance practices. The consequences of these problems can be far-reaching, ranging from: • failing to reflect appropriate financial accounting charges associated with essentially discounted stock options; • deficiencies in the company’s disclosure in its proxy statements and periodic reports; • adverse tax consequences for the company to the extent the option is exercised by an officer who is a covered employee under Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”); • adverse tax consequences for the optionee by reason of Section 409A of the Code, if the option had not vested by December 31, 2004; • questions regarding the authority to grant the options to the extent the plan under which the options were granted did not permit the grant of “discounted options,” particularly if the company’s state of incorporation requires shareholder approval for the issuance of stock options and similar rights; • possible investigations by the U.S. Attorney (particularly in New York and San Francisco) or the Securities and Exchange Commission; and • shareholder derivative litigation alleging, among other things, breach of fiduciary duty. This broad array of potentially significant issues may prompt directors of public companies to ask if their company has any option pricing “issues.” Management may want to anticipate this inquiry and undertake a review of the company’s past option practices to ascertain whether and, if so, to what extent the company has these issues. Indeed, SEC Chairman Christopher Cox has stated that it is “certainly… best practice” for corporations to conduct their own internal investigation into their past stock options grants and process, and that compensation committees and boards of directors are now on notice that stock option backdating is an area in which they need to be involved. Most large American companies have gone through this process already. If yours is not one of those companies, there is good reason to investigate this issue: The SEC looks more favorably on companies that ferret out and disclose problems before the SEC finds them. Moreover, the Public Company Accounting Oversight Board (PCAOB) recently has notified auditing firms that in future audits they “should assess the nature and potential magnitude of risks associated with the granting of stock options and perform procedures to appropriately address those risks.” As a result, public companies will be better off reviewing any potential stock option accounting issues before the next audit season is upon them. Based on our involvement in these inquiries, there are some basic questions that may help in conducting your review: 1. How does the timing of option grants over the past several years line up with a chart of the company’s stock prices over that period? This is a relatively easy, but important, question to ask, since the central criticism of backdating is that the grant dates for employee stock options were manipulated so that the options appeared to have been granted shortly before a run up in share price or were actually granted after an increase had occurred. Simply plotting the date of option grants against a chart of the company’s stock price will often give a first indication of whether there is a potential problem. 2. Has the board or compensation committee used unanimous written consents or other procedures to approve option grants that might create technical timing issues? Apart from deliberate backdating scenarios, technical foot faults can also give rise to vexing option pricing questions. The crucial question of “When was the option actually granted?” will often turn on when the grant was legally effective. If board approval of a particular grant is at the heart of this particular question, then approval by means of unanimous consent might be problematic, given that action by unanimous written consent will likely be effective no earlier than when the last consent is given — which could occur several days after the date intended to be the grant date, and after an increase in the value of the underlying stock. Pre-employment pricing for new hires may also give rise to similar issues. The question of when an option grant became legally effective is particularly important because guidance recently issued by the SEC’s Office of Chief Accountant (OCA) clarifies that the proper accounting for stock option grants depends on the difference, if any, between “the exercise price and the market price of the underlying stock at the measurement date.” The “measurement date,” for accounting purposes, is the date on which “the terms and recipients of those stock options were determined with finality.” Where unanimous written consent procedures have been used to make option grants, the OCA’s guidance suggests that a review of the underlying facts and circumstances normally will be needed. Any conclusion that a delay in the completion of relevant paperwork--such as the signing of unanimous written consents after a board or board committee has given oral consent to a grant --“must be considered carefully.” The concern is that the option may not be “final” or “known” prior to all of the procedural steps being completed. This is especially true if, for example, a corporation has, on previous occasions, issued options deemed “final,” but then changed the options’ terms prior to the completion of all of the required granting steps. An internal review of stock option grant practices should reveal this relevant information and any other potential issues associated with option granting procedures. 3. If there is a question regarding past practices, is the issue minor or material? Obviously, questions of magnitude are important in determining what corrective action, if any, should be taken. If the prior practices could have had a substantial impact on the company’s financial statements, due to large discounts not recorded as discounts, the company will have to evaluate whether a restatement is in order. If the problem relates to less than perfect documentation of an off-cycle grant or two, such an administrative error is not likely to be material. It may lead to corrective action such as adjusting the grant price to avoid tax problems or having the appropriate board committee ratify a grant that was not consistent with best practices. But such action may not need to be disclosed in any periodic report, or trigger other significant public disclosures. The conundrum is that the only way to be certain that there is not a material issue is to conduct a review and come to a considered judgment. 4. What is the benefit of self-evaluating, and self-correcting, rather than waiting for the issue to be raised by a third party, such as shareholders or the SEC? This may be the most difficult question to answer. Looking for problems is almost a guarantee that you will find some. However, if there are material problems, our experience is that the SEC is receptive to companies that self-identify and that the consequences will likely be less onerous if the company is proactive rather than reactive (especially if it is reacting to a subpoena or shareholder litigation). Finally, finding technical problems may force the company to confront problems that might otherwise never have surfaced, but there may be an opportunity to address some of the concerns (and, where a Section 409A issue is present, the available “fixes” may only be available in 2006). And in view of PCAOB’s recent guidance, audit firms undoubtedly will scrutinize past option practices in future audits, so that being proactive now could avoid having issues arise when trying to complete and file an annual report. 5. What procedures does the company have in place to minimize these issues going forward? To avoid inadvertent mishaps, a compensation committee (or board) should have clear procedures in place that record when any requisite approval is given and that directly tie the option exercise price to the effective date of that approval (or a later date clearly specified as part of such approval). In addition, to avoid even the appearance of improper option timing, boards should give careful thought to adopting policies (if not already in place) that provide for a consistent pattern for annual grants (e.g., always at the February or March meeting of the compensation committee) or permit option grants only in appropriate windows (such as following earnings announcements, etc.). In addition, many companies give the chief executive officer authority to grant options to permit quick action, at least for persons below the executive officer ranks. Where an option grant is made below the board level to someone who is or later becomes an executive officer, that may raise issues under Section 16(b) of the Securities Exchange Act of 1934, as amended, or Section 162(m) of the Code. 6. What should be done if the company uncovers material concerns about option pricing practices? Addressing material issues in this area will often be a task that will or should require outside assistance. Thoroughly addressing these issues will require expertise in internal investigations, securities laws, corporate governance, and executive compensation. In addition to the fact that internal legal departments may not have this depth of experience, the board and the company will likely benefit from an independent review of these matters, especially if the members of management who would be involved in the review process prove to be recipients of the options at issue. Thus, if any potentially troubling issues surface, it would be advisable for the board to commission an outside law firm with the required expertise to assess the concerns in a formal investigation, and assist the board in drafting the appropriate course of any corrective conduct required. |
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R. Berger, W. Neil Eggleston and Colby A. Smith are partners in the
Washington, D.C., office, and Lawrence K. Cagney, David P. Mason and
Elizabeth Pagel Serebransky are partners in the New York office of
Debevoise & Plimpton LLP, http://www.debevoise.com. Copyright © 2006 Directors & Boards, P.O. Box 41966 Philadelphia, PA 19101-1966. All rights reserved. Contact the webmaster. < Privacy Notice > |
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