Full Disclosure

By Thomas Brom
     
      Bad Timing
      Where do corporate scandals come from?" to paraphrase Chairman Mao. "Do they drop from the skies? No. Are they innate in the minds of executives? No. They come from social practice."
      In the case of backdated stock options, they apparently come from lots of practice. The discovery by academic researchers of routine backdating has grown to include some 100 SEC inquiries, 40 Department of Justice investigations, and indictments of company executives on both coasts. Stock option backdating is the first great scandal of the postSarbanes-Oxley period--much of it based on compensation practices that weren't illegal at the time and have been made less likely by recent SEC regulations. So why this scandal, and why now?
      Sometimes bad stuff just rolls downhill. In a recent guide for its investor clients, Institutional Shareholder Services (ISS) of Rockville, Maryland, reviewed the genesis of the scandals, beginning with academic research in 1997 showing that some executives engaged in "opportunistic timing" of their option grants. Timed at a low point in the trading price, these "in-the-money" grants provided an instant paper profit, which could be realized at a specified date. Though obviously generous and dilutive of the stock's value for other shareholders, the practice is legal if a company maintains accurate grant records, treats the options as discounted, and accounts for the grants in its earning reports and tax filings. That's a big "if."
      In May 2005 Professor Erik Lie of the University of Iowa published a paper that took the matter to the next level. (Management Science 51, 802812.) Lie reviewed almost 6,000 CEO stock option awards from 1992 through 2002, finding abnormally low stock returns before grant dates and unusually high returns afterward. "Unless executives possess an extraordinary ability to forecast the future market-wide movements that drive these predicted returns, the results suggest that at least some of the awards were timed retroactively," Lie wrote. The practice of backdating option grants seemed widespread.
      "There are a lot of concentric circles, but we don't know yet when the rock hit the water," says Patrick McGurn, executive vice president and special counsel at ISS. "To put it in viral terms, we don't know the alpha. But it defies logic that all companies began doing this on their own. We may never find the alpha, but we can take it back to the first generation--to certain companies, venture capitalists, and advisors."
      Using the Lie study as background, the Wall Street Journal published a front-page investigation, "The Perfect Payday," on March 18, 2006. The article featured graphs of stock prices for a half-dozen companies, with option grant dates highlighted, each made at or about the lowest trading day of the companies' shares for the period. The odds of that happening randomly varied from about one in a million at one company to one in 300 billion at another.
      "The Journal article gave the issue a momentum it did not have before," says a Silicon Valley attorney. "Since then the press has used a loaded term, 'backdating,' to lump together a wide range of behavior, some of which may involve intentional wrongdoing."
      Lie had looked only at the period prior to 2002--the year of Sarbanes-Oxley; the mandated expensing of stock options; and a new, two-day reporting rule for option grants. So in July 2006 he and colleague Randall A. Heron of the Kelley School of Business at Indiana University published a follow-up study, which found that the new rules had slowed but not stopped the practice of backdating. "We estimate that 29.2 percent of firms manipulated grants to top executives at some point between 1996 and 2005," the study concluded.
      Not to be outdone, the Journal published a feature on July 15 showing graphs of option grants at ten major corporations that were timed at the market low immediately following the terrorist attacks on 9/11. Now that's tacky.
      The attorney in Silicon Valley contends that the press has blown the backdating scandal out of proportion, that "there's a lot more smoke than fire." Plaintiffs attorneys, not surprisingly, feel otherwise. "There will be huge exposure before this can be fixed," says Bruce L. Simon, a partner in the Burlingame office of Cotchett, Pitre, Simon & McCarthy. "I'm scared for the financial markets."
      Because many of the scandals involve small companies that used option grants extensively to attract talent while keeping cash expenditures low, much of the cleanup work is in the high-tech sector. Northern California law firms that aren't conflicted out by their existing clients are doing a booming business in internal investigations.
      "The most serious problem involves the falsification or manipulation of records," says Clifford C. Hyatt, a partner in the Los Angeles office of Pillsbury Winthrop Shaw Pittman. But client alerts sent out by Pillsbury and other firms invariably include a long list of concerns, including accounting, disclosure, and tax issues; SEC and DOJ inquiries; and civil litigation.
      The Silicon Valley attorney says the financial-reporting issues are the most urgent, because improper accounting may involve material misstatements that would require either a delay in quarterly SEC filings or financial restatements. "Failure to file a timely 10-Q can trigger all kinds of consequences," he says, "including the delisting process at Nasdaq and possible default in connection with public-debt covenants."
      So far civil litigation isn't a major concern--ISS lists about twelve securities class actions filed since April. Jeffrey W. Lawrence, a partner in the San Francisco office of Lerach Coughlin Stoia Geller Rudman Robbins, says his firm has filed mostly derivative actions that allege a breach of fiduciary duty to shareholders. The suits require board approval and, if successful, yield attorneys fees based on a percentage of damages.
      Simon of Cotchett Pitre, however, believes plaintiffs attorneys can expand the liability net to include advisors and consultants who presumably participated in the first generation of backdating. "The federal courts of appeal have recognized in a number of cases that auditors and attorneys have a special responsibility to their clients," Simon says. In June, Simon's firm won a Ninth Circuit ruling in an unrelated case that permitted plaintiffs to allege liability against third-party defendants as primary violators in a scheme to overstate revenue. (Simpson v. AOL Time Warner Inc., 452 F.3d 1040.)
      McGurn at ISS also has concerns about suspected backdating enablers--compensation committee directors, auditors, and attorneys. "The advisors, including counsel, had to endorse backdating, or at least look the other way," he says. "Ultimately, they may have to answer for that behavior."
      Todd Fernandez, a senior research analyst at Glass Lewis & Co., a proxy research firm based in San Francisco, adds, "We knew that companies did this, but we were only looking at current option grants. We didn't think anyone cared about past behavior. We were wrong."
     

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