(cont. from section 1)
So what is backdating? Why is it a problem? Where is the illegal conduct?
Let’s start at the bottom again. The most common conduct alleged in backdating options involves companies or individuals setting the date (and therefore the exercise price) of an option grant at some arbitrary point in the past when the company’s shares were trading at a discount. Backdating is essentially cherry-picking the price the option recipient will pay in order to maximize his or her profit when the options are exercised.
So - practically - how does one ‘backdate’ an option grant? There are a number of ways, and this is where the backdating scandal starts to get messy. Dubious conduct could be something as bad as criminal fraud, or it could be something as benign as lazy record keeping. The most obvious way to backdate a grant, which also happens to constitute fraud, is modifying a company document (agreement, resolution, notification letter, etc.) to establish a desired grant date. This does not happen very often, but there have been examples of individuals literally scratching out the grant date and substituting a new date at a lower exercise price. On the other end of the scale are companies like Microsoft, which for most of the 1990s followed a policy which set the grant date for employee stock options at the lowest closing price for its stock during the previous month. This is technically backdating, but seems fair in the sense that employees are treated equally under a policy approved by the board of directors. Most companies with questionable stock option practices are investigating conduct that falls somewhere in the middle.
To understand the problems companies have had in this area, one must understand how an option grant usually works.Again, starting at the bottom: corporations are only empowered to do certain things, and those things are set out in the articles of incorporation. If a corporation is empowered to issue stock options to its employees, it may adopt a stock option plan duly approved by the shareholders and the board of directors. All employee stock options must be issued under the plan and will be subject to its procedures and limitations.
Once it is established that a corporation may issue stock options, who decides how many options are issued and who receives them? The answer is usually the corporation’s board of directors, a smaller committee of its members, or a committee of the corporation’s executive leadership. No matter what committee approves the grants, the issuance must be recorded, preferably contemporaneously in a Unanimous Written Consent resolution signed by all members.
This brings us to a larger problem that many corporations have, despite the reforms of Sarbanes-Oxley: sloppy corporate governance. Most corporate executives and directors are extremely busy people. The balance of their day is spent on the business of the corporation, like sales, marketing and product development issues. As a shareholder this is fine with me because I want the executives of the corporation to spend their time maximizing profits and driving growth.
However, this attitude leads many executives to view corporate governance as ‘paperwork’. The result is often board and committee resolutions drafted many weeks or months after the date of the meeting. In the case of options, this may mean that the grant date (and exercise price) have been established and communicated to the employee before any of the official corporate documents have been created. This leaves the door open to abuse if executives, directors and employees do not remain vigilant.
This will make more sense in the context of an example. Let’s say the CEO and CFO of a major corporation get together and decide to award a bonus in the form of 10,000 stock options to the Vice President of Sales for a record performance in the first quarter. They notify the Vice President in a congratulatory phone call on April 30. On the same phone call, they ask corporate counsel to draft a stock option agreement. Counsel replies that this is fine; however, the Stock Option Plan requires that grants of over 5,000 options must be approved by the Compensation Committee of the Board of Directors. Counsel also notes that the Board is scheduled for a full meeting June 1, during which the Compensation Committee will also meet. The CEO decides to have counsel draft the agreement with an effective date of April 30 (the day they promised the VP his bonus) and save it for approval at the June 1 Board meeting. Assume the stock price rises from April 30 to June 1.
What result? Well, the scenario above is plausible. It is also textbook backdating. Note that there is absolutely no paper trail that the grant was dated April 30. Therefore, when the Board approves the grant on June 1, what the Board is actually doing is issuing an option grant at a price less than the closing price on the day of the grant. In this situation, the company would be forced to recognize as a compensation expense the difference in price between 10,000 options at the April 30 closing price, and 10,000 options at the June 1 closing price.
The CEO and the CFO were acting in good faith. Assume management does not always act in good faith, however, and there are many ways to manipulate the exercise price to benefit themselves and their employees.
The most common cases of backdating involve going back in time to select a grant date, but there are many other ways to manipulate the exercise price to benefit employees. One common method is to manipulate the effective date of the event underlying the option grant. In other words, if someone is awarded stock options as a bonus for a promotion, one could easily change the effective date of the promotion to achieve a lower exercise price. This comes up often with new hire grants. Many companies use stock options to lure key employees away from competitors. If an employee decides to accept an offer, there is often pressure to make those stock options as lucrative as possible. One way to do this would be to pick a hire date based on stock price, no matter what date the employee actually started working for the company.
In the next section, we will discuss ways to prevent backdating problems and the role of counsel in ensuring good corporate governance.
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