New England Biz Law Update
With new Securities and Exchange Commission enforcement proceedings and shareholder suits over stock option backdating cropping up more and more, attorneys should be urging public companies to complete internal investigations of their options practices.
The SEC is investigating more than 80 companies for stock option backdating failures. In the wake of the widening scandal, the Commission has released new rules for reporting executive compensation practices.
.
The FBI and the Department of Justice are also stepping up their involvement in the investigations.
Experts say this is only the beginning.
“The storm hasn’t even hit yet,” predicted John Sten, a former SEC attorney now with Greenberg Traurig in Boston.
For in-house counsel the issue is more than just the need to give good advice – some company attorneys may have been personally involved in rubber-stamping any stock option backdating that occurred.
“What’s a little different about this round of corporate issues, as distinguished from Enron and WorldCom, is those lawyers had no role. It was accounting executives cooking the books,” noted Jahan P. Raissi of San Francisco, a former SEC enforcement attorney who represents executives and directors in stock-related matters. “With options, more lawyers were involved, and the government will be more likely to look at the conduct of in-house attorneys.”
Elizabeth Nowicki, a former SEC attorney who is a visiting professor teaching securities regulation at Cornell Law School, agreed.
“Lawyers are going to start to get nervous,” she said.
In fact, earlier this year the SEC filed securities fraud charges against the in-house lawyer for Comverse Technology for his alleged involvement in illegal backdating. The company fired him and other executives charged in the case days later.
From the standpoint of companies, they should take matters into their own hands, said Julie Allen, a corporate governance attorney with Proskauer Rose in New York City.
“Don’t wait until the issue comes to find you,” Allen cautioned. “Do an investigation to the level required by the size and practices of your firm.”
After months of work, the SEC filed its first securities fraud charges July 20 against former executives of Brocade Communication Systems, Inc. Company executives have already agreed to settle the shareholder suit that followed.
Apple Computer has been in the spotlight also, hit with a shareholder class action claiming its chief executive and other directors illegally changed the grant dates of stock options and then failed to appropriately account for the changes on financial statements.
Companies charged with illegal backdating will almost always “has a shareholder suit on their hands,” noted Sten.
What’s illegal?
“Backdating” is a practice in which stock option grant dates are adjusted to an earlier time when the stock was trading at a lower price. This allows recipients of the options to receive greater profits when they sell their shares at higher market prices.
The practice is legal as long as it’s properly disclosed to shareholders, approved by the company’s board and taken into account on company earnings statements.
“You can do it until the cows come home, but it has implications you have to account for,” said Raissi. “If you do it, and the day you granted the stock the price is actually higher, the company has to take a charge for that.”
Backdating is governed by federal securities laws, including the Securities Exchange Act of 1934, as well as some more recent disclosure requirements mandated by Sarbanes-Oxley.
Of the companies under investigation, Raissi said it’s still unclear what behavior will rise to the level of securities fraud.
“An awful lot of conduct falls into the unintentional, unknowing, sloppy category, and no one knows yet what the government is going to say about whether certain companies need to restate their financials,” said Raissi, who practices with Shartsis Friese.
For example, a company may have granted options but its board didn’t meet to approve it for two weeks.
“Technically they may have backdated those options, but is that wrong?” asks Raissi.
But Nowicki said SEC investigations are usually based on real misconduct, not sloppiness.
The agency “doesn’t have enough resources to waste it’s time looking into companies who they don’t really think have done anything wrong,” she said.
In-house lawyers’ involvement
In-house counsel play a major role in creating procedures related to options grants, often including authorizing backdating.
Under a 2003 rule issued pursuant to Sarbanes-Oxley, the SEC can bring disciplinary sanctions against a lawyer who fails to meet “minimum standards of professional conduct for attorneys appearing and practicing before the Commission,” which might include failing to report material violations of securities laws.
Raissi predicted such claims are coming – even against lawyers who didn’t participate directly in illegal backdating but simply failed to prevent it.
Nowick said a lawyer who reviewed a stock option grant could also get into trouble for authorizing an award of options that “conflicted with internal governing documents” of the company.
In-house counsel could be stuck in a tough spot because they will be asked to help with internal investigations while they themselves may have been involved in a questionable stock option grant process.
In addition, said Nowicki, outside lawyers who played a role in a company’s backdating plan could be implicated, although it would be more difficult to hold them accountable than in-house counsel.
Raissi recommended that in-house attorneys – and company executives – hire their own counsel.
This will help lawyers make sure “they don’t inadvertently say something that compromises their own position,” he advised. “I tell clients, ‘We have to remember this may be playing out on the front page of the New York Times.’”
Sten agreed.
“Hire outside independent attorneys to go back and look at all the records,” he suggested.
However, just because the SEC or shareholders take action against in-house counsel doesn’t necessarily mean they will be on the hook. Going forward, proving executives or lawyers acted with fraudulent intent when they improperly backdated options will be a big challenge, said Nowicki.
“The government and the stockholders are going to have a tough time proving intent,” she said. “Judges have been very conservative in what they are willing to infer.”
Investigating internally
All public companies that grant options need to start an internal investigation, if they haven’t already done so.
“Companies should not wait until their next audit cycle,” said Allen, noting the Public Company Accounting Oversight Board has already announced it will require specific documentation on options grants “at a more focused level than it has in the past.”
The extent of the investigation really depends on the size of the company, its internal compliance and legal staff, and its past stock option grant practices. The audit committee or company board will likely play a key role in the inquiry.
“Clients need to be clear on the terms of the company stock option plan, the price of the options at the time of the grant and how it was accounted for,” said Sten. “You definitely need human resources, finance professionals and attorneys to help evaluate this.”
A company that finds it has backdating irregularities must go back and account for those mistakes when it finds them, including changing financial statements and informing shareholders, said Allen.
Raissi said taxes might also have to be recalculated, because options grants generally allow companies certain deductions, which may have been improperly taken if they failed to account for backdating.
Questions or comments can be directed to the writer at: [email protected]
