Options Backdating

I've been out of the office for the past two weeks and have not had the opportunity to update my blog. During that time, I've watched additional press coverage of the options backdating scandal, and I wanted to take a few minutes today to pull thoughts together from various postings that I've done in the past few weeks on the issue.

1. The options process: At most public companies, employee stock options are awarded only to executive officers or other senior corporate officers. The company's compensation committee makes the award and sets the grant date and strike price. The compensation committee typically makes the award because awards by that committee -- if comprised of independent directors -- qualify the options for an exemption from the short swing profit rule, which requires company officers to turn over their profits made when they both buy and sell the stock within a 6-month period of time. Most executives exercise and sell within a period of a few days, using the sales proceeds to cover the option exercise price.

No law requires that the strike -- or exercise -- price be the fair market value on the date of grant, but there are sound reasons to set the strike price at FMV. These include:

• A need to disclose the practice of backdating. The company must make extensive compensation disclosures in its proxy statement each year and failure to make necessary disclosures may make the company's proxy statement false and misleading and subject it to liability under the federal securities laws. There are specific rules about disclosing options repricing, but until now, the SEC did not believe it was necessary to specifically address backdating.
• Tax and financial statement reasons. If the company is granting "in the money" options, then the company incurs a company incurs a compensation expense on the date of grant. Similarly, the employee may have a taxable event on the grant date.

2. Why is options backdating bad? If you disclosed the practice of backdating so that your company's shareholders purchased shares whose price already took into account the practice and whose financials already booked the appropriate expense, then there would be nothing illegal about the practice. But searching back in time for a point where the stock price was depressed and using that as the strike price puts executives on an unequal footing with normal investors. I don't get to call my broker and say, "Buy Cisco, but give me last week's price."

Many of the regulations passed in the last few years by the SEC have been geared toward placing small investors on an equal footing with other market participants. For example, Reg FD requires companies to make disclosure to the market as a whole, rather than to analysts or institutional holders in sidebar conversations. And many of the changes since the Enron scandal regarding earlier filings of 8-Ks, 10-Qs, Forms 4 and the like give individual investors earlier information.

3. What should companies do? I've noted previously that the safest approach is to come up with a specific date and use that date every year to calculate the strike price for that year's grant (assuming the company grants options only once per year). Compensation committees can still pick a date, but need to assure that they do so contemporaneously with the meeting (or the date the unanimous consent is circulated if the committee is not meeting).

Watch for spring loading, as well. If the compensation committee is asked to grant options on a certain date, alert committee members should ask, "Is there any good news that the company plans to disclose in the next couple of weeks?" In other words, are the options being granted at a price that is guaranteed to go up in the immediate future?

Disclosure is the cheapest form of D&O insurance available. For companies that may have engaged in the backdating practice, they need to review carefully their disclosure. Many securities fraud class actions could have been prevented (or dismissed) by earlier disclosure.

4. Should options be granted at all? Years ago, most compensation was in the form of base compensation. Then the trend became performance-based compensation in the forms of options and bonuses. Options have been criticized because they are not entirely performance-based. The high tide floats all the boats. A company might actually be performing poorly relative to its peers, but because of a bull market, even that company's stock price rises and the executives is therefore rewarded for underperforming peer companies.