What You Should Do About Options Backdating
from
September/October 2006
by Julie Connelly
Is your company exposed to an options-backdating scandal? If so, you’re in a crowded field. More than 2,000 companies have used backdating to reward executives in recent years, according to a study by the University of Iowa’s business school, and a bunch of big-name outfits, including Microsoft, have admitted they might face legal problems over the way they’ve dated options.
Backdating per se won’t necessarily land you in trouble. “It is not illegal to give an employee in-the-money options,” says attorney Kenneth M. Breen, who runs the New York white-collar crime and government investigations group at the law firm Fulbright & Jaworski, speaking of options with a strike price lower than what the stock traded for on the day they were granted. “But the company has to disclose that, and treat the grant properly with regard to tax and accounting rules.”
Board members should get out in front on this issue. “If your company is engaging in an active options-grant compensation program, look into it now,” Breen says. “Don’t wait for the reporter or, worse, the prosecutor to call.” Such calls are frequently followed up by subpoenas. Regulators take a far more benign view of companies that voluntarily investigate their own practices and step forward if anything material surfaces—as some have done since the scandal first surfaced in March at UnitedHealth Group—than they do of outfits where they’ve had to ferret out wrongdoing.
You’re in strong shape if you have a good paper trail establishing that grants are awarded on the same dates every year and that no one has an unusual amount of discretion in doling them out. For some boards, a phone call or two with the company’s outside counsel may be all that’s needed as a review.
But if there isn’t a trail or if papers are missing, that’s a wildly flapping red flag all by itself. There should be documents relating to the options plan, options agreements, minutes from compensation-committee and board meetings that establish when grants were approved and at what price, correspondence among consultants and employees involved in administering the options plan, regulatory disclosure forms, and charts that trace the historical trading patterns of the stock.
“The information is readily available without digging deeply,” says Robert Hayward, who specializes in corporate and securities transactions at the Kirkland & Ellis law firm in Chicago. “If you know when the grants were made and the historical share prices, you can pretty quickly see if you need to dig deeper.”
If you do have to tunnel down, the board should form a special committee—or delegate the job to the audit committee—to hire an outside law firm for an investigation. Don’t use the firm you already have on retainer, or one that is connected in any way with a board member. The firm’s investigation will consist of three parts: gathering and preserving the documents relevant to the backdating; interviewing the people involved in the options program and others who have pertinent information; and making a report to the committee, either in writing or orally. The report should describe what the investigation turned up and recommend how to handle the findings and prevent the problem in the future. Says Joseph Serino, a litigation partner at Kirkland & Ellis: “Among other things, the report should suggest whether disclosures should be made or updated, whether the financials should be restated or amended, whether options policies should be changed, whether people should be terminated with legal action taken against them, and whether the company should report itself to the regulatory agencies.” After all the directors have discussed the report and voted on what to do about the recommendations, there may be one more step you need to take: Dust off your management-succession plans.
