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The Truth Behind the Backdating Brouhaha

Approximately 100 companies have come under fire for the backdating of stock option grants. The resulting investigations, in turn, have led to the resignation of 30 officers- many of them CEOs, CFOs and general counsels. Notable casualties include Altera and UnitedHealth Group, as well as SafeNet, KLA-Tencor and Sapient-with more announced daily.So, what exactly is …

Approximately 100 companies have come under fire for the backdating of stock option grants. The resulting investigations, in turn, have led to the resignation of 30 officers- many of them CEOs, CFOs and general counsels. Notable casualties include Altera and UnitedHealth Group, as well as SafeNet, KLA-Tencor and Sapient-with more announced daily.

So, what exactly is backdating? Options-or the right to buy a set number of shares at a fixed price- are usually granted under a plan approved by shareholders. The idea is to reward executives for increasing the price of the stock. Option plans typically call for granting options at their fair market value on the date of grant. The backdating of options, on the other hand, involves selecting a previous date when the stock price was lower so that the options granted are immediately in the black. In short, backdating gives the option grantees an unfair head start. However, discounting options through backdating is legal if disclosed and accounted for properly and if intended by the compensation committee to be additional compensation. The backdating situations under investigation purported to be options that were not discount options but options at fair market value.

UnitedHealth: Double Dipping?

UnitedHealth’s option program won attention because its stock performed so well. The case involved Dr. William McGuire, a pulmonologist who negotiated a contract with William G. Spears, chairman of the compensation committee. The resulting options were backdated to the time of the year when the stock price was at its lowest. In essence, McGuire got a $12 million head start.

Another wrinkle for McGuire emerged in an October 15, 2006, report from the law firm of Wilmer- Hale concerning double options. In 1999, the options offered in the prior five years were “under water,” meaning the exercise price greatly exceeded the fair market value, rendering the options worthless. The company addressed this by “suspending” the 2 million options already held by McGuire and granting an equal number at a lower price. Unfortunately, at the time, the repricing of options was subject to variable accounting-as the market went up, earnings would be reduced by the increase. While not strictly a repricing, this suspension and regrant should have been treated as such because that was the effect.

But the greed did not end there. As the stock soared in value, the suspended options gained substantial value. The suspension was then lifted so that McGuire got a double option. It is not clear whether the board knew about this; if they were deceived, then the lifting of the suspension would be an additional problem for McGuire and possibly for the chairman of the compensation committee.

Many-and Varied-Risks 

There are many risks in backdating. In previous years, when the options currently under investigation were granted, options awarded at fair market value did not require an accounting charge. However, discounted options involved additional compensation and did require a charge. Accordingly, the backdating of options requires restating earnings for many years to reflect the charges for options-an expensive proposition. For example, Mercury Interactive, a Silicon Valley software company involved in a backdating scandal, reported spending $70 million just to clean up and restate earnings.

Not reporting discounted options is a violation of SEC disclosure rules and can lead to civil penalties and charges. If done with intent, those involved can face criminal charges and jail time. Comverse Technology’s CFO pled guilty to securities fraud relating to backdating. In the first such criminal guilty plea, he eventually settled civil charges of $51 million for $2.4 million. However, he may also serve up to 10 years.

The risk of class actions seeking damages is significant. And there are tax concerns for top executives, such as the deductibility of the options when granted at a discount.

Finally, at least on the NASDAQ, a company’s stock can be delisted and relegated to the pink sheets, which could affect the price of the stock as well as its liquidity. Nyfix and Mercury Interactive have been delisted. In addition, four other companies may be delisted-Apple Computer, Altera, Bea Systems and Comverse. Under the new tax act, discounted options are immediately taxable to the executive. However, previously granted, unvested and discounted options can be replaced on or before December 31, 2007, without any negative tax effect. Backdated options are not subject to this release; IRS Notice 2006-79 makes this quite clear.

Defense Moves

The maneuvers at United- Health are examples of the uproar that ensues when independent directors, CEO, general counsel and compensation committee members consider their individual liability and reputations. When backdating prompts an investigation, directors who knew nothing about the suspect actions and were simply deceived by the CEO and general counsel are in the best possible position.

As chairman of the compensation committee at UnitedHealth, Spears was deeply involved and was asked to resign. The independent members of the board, including the other members of the compensation committee, have stated that they did not know about the backdating. Basically, UnitedHealth’s general counsel, CEO and one director are potentially subject to civil and possibly criminal charges. The other directors will have to rely on the defense that they were deceived.

Now the board will be faced with the question of what to do about the CEO’s severance package when he is terminated without cause. (Cause does not apply since in this case it requires conviction of a felony-not merely a charge.) Misconduct could qualify as cause, but the contract `requires a warning and then time for correction, which was not possible in McGuire’s case. The money at stake is a package estimated in excess of $500 million. What’s more, all options that have not vested in McGuire’s hands will vest immediately and be exercisable for six years rather than 90 days, making them even more valuable. In addition, there is a pension of $5 million a year and a lump sum of $6.4 million.

There is also the question of coverage for McGuire under the indemnification and directors and officers insurance. Until the matter is resolved, however, his legal fees and defense charges will have to be covered.

The Spears Conflict

Spears has serious problems due to his actions as chairman of the compensation committee. He was listed as an independent director, but the SEC investigation ascertained close ties that had not been disclosed. Spears was chosen to serve as a paid trustee for the two trusts that benefit McGuire’s children, and he was an investment adviser for approximately $55 million of McGuire’s billions. McGuire also invested $500,000 to help Spears buy back his money management firm from a financial conglomerate that had acquired it.

Disclosure of “some conflict” had reportedly been made to the full board, but the board denies any such knowledge. Two directors stated that they would have remembered this had they been told. The other board members insist that they learned of the conflicts only when investigators uncovered the matter.

It will be interesting to see whether the general counsels involved in these situations implicate outside accounting firms or outside counsel as part of their own defense. It has been suggested that all of these actions occurred prior to the change in culture and the change in law involved in the passage of Sarbanes- Oxley. This hardly seems like a defense. The board and chairman of the compensation committee clearly have fiduciary duties.

Likewise, the allegation that this was common practice does not hold water. A study by economist Erik Lie, a professor at Iowa University, estimated that 2,200 companies backdated options.

The Board: A Plan of Action

  • The board should retain independent counsel as well as independent accountants to determine whether backdating existed in their company going back at least three years; others have suggested 10 years.
  • The board should review and approve minutes of all meetings to ensure the accuracy of entries regarding the approval of backdating options without disclosures.
  • The directors will not hesitate to point to others in establishing that they were not involved and were deceived the same way as other shareholders.
  • All conflicts are required to be disclosed. The board should take action so that the alleged nondisclosures by Spears or McGuire and their intricate relationship, which involved the clearest conflict of interest, are disclosed.

The CEO’s Defense

The CEO will not hesitate to say that the backdating of options was legal because discounted options were legal, and such discount was approved by the board or the compensation committee. The board must be prepared to disprove this allegation.

The CEO should obtain his own counsel as promptly as possible and should be aware that he may need to require separate counsel to negotiate the severance package. Also, a criminal lawyer may be needed to defend against criminal charges and the plaintiff’s class action lawsuits that will inherently follow.

Spears will need separate counsel because of his alleged direct involvement in backdating and his conflict of interest, which was not disclosed.

Backdating is a serious problem coming as it does at a time when executive compensation is under intense criticism by unions, compensation experts and corporate governance experts. The Grasso decision may influence the committee’s decision as to whether to pay. The court has already held that former NYSE CEO Dick Grasso was overpaid by the nonprofit corporation for which he worked.

Backdating problems will not disappear; in many cases, they are just starting. Determining who is responsible in addition to the CEO, and possibly inside counsel, will be litigated. Criminal charges are hard to prove but reportedly, some are about to be filed. In addition, the plaintiffs bar has a new cause of action against board members and CEOs that they will not hesitate to litigate. There are damages-and they can be substantial. The damages involve not only the discount but the charges required to clean up the mess and to restore the good reputation of a company.


Arthur H. Kroll is CEO of Hartsdale, N.Y.-based KST Consulting Group, and author of Compensating Executives.

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