Option Backdating: A New Study Dictates a Proactive Approach

A new study by finance professors suggests that the backdating of stock options may be a much more wide-spread practice than once thought.  Initially, many believed that stock option backdating might have been concentrated in the high tech area.  Later, many thought that the practice occurred predominately during the period before the passage of the Sarbanes-Oxley Act in 2001.  Now, however, a new study by Professor John Bizjak of Portland State University and Michael Lemmon and Ryan Whitby of the University of Utah entitled “Option Backdating and Board Interlocks” suggests that as many as fifty percent of the companies that issued options during the 1990’s engaged in backdating.  This conclusion would clearly make the practice much more wide-spread than anyone had initially thought. 
 

The study also suggests that the practice may have proliferated as a result of directors who held positions on more than one board.  Overlapping board memberships may have facilitated the transmission of the practice from one company to another through the small and exclusive club of corporate directors.  This suggestion is also contrary to the current wisdom that the practice was management driven – at least that is the inference from the two cases the SEC and DOJ have filed.  This finding also undermines the theory that outside directors will serve as a watchdog on improper management practices.  If correct, it means the watchdog is the source of what may –backdating is not illegal in and of itself – be an improper practice. 
 

The study should clearly cause everyone to rethink the issues surrounding option backdating.  It also significantly changes the stakes for corporate boards and officers.  Previously, companies understandably could have thought that questions about backdating were limited to a handful of companies and, thus, no action was required.  Now the stakes are different.  The new study suggests that the problem is so prolific that it cannot be ignored, particularly in view of the stakes. 
 

If a company discovers a problem it has the opportunity to take control of the situation and expeditiously resolve it.  If, however, the SEC, another regulator, or even a whistleblower discovers a problem the company will loose the opportunity to control the situation and guide it to a chosen resolution.  Prudence dictates that companies take a proactive approach, conducting an internal investigation into its past option granting practices followed by taking any necessary corrective steps.  The alternative is to gamble that the company is in the fifty percent of companies that did not backdate any option grants.  In view of the high stakes and the impact of being wrong, that would be a bad gamble.
 

Bizjak , John M., Lemmon, Michael L. and Whitby, Ryan J., “Option Backdating and Board Interlocks” (November 2006). Available at SSRN: http://ssrn.com/abstract=946787.  A discussion of the report is contained in the New York Times, January 21, 2007 at BU-5.

Stock Option Scandal – Now On To The Accounting

While the daily headlines are focused on the conduct that has resulted in the recent stock option scandal and the scandal’s effect on corporate leaders, CFOs, controllers, and others in the finance trenches must be concerned about how to properly report previously issued financials that contain accounting errors. The errors are bad enough, but now introduce the overwhelming task and expense of restating prior financials for what could be several years on end, and the possibility of getting the restatement accounting wrong, which may lead to multiple restatements.

To aid registrants in this dilemma, this week Carol A. Stacey, Chief Accountant Division of Corporation Finance, supplemented the staff’s prior guidance on the accounting for such errors issued September 19, 2006 and posted a sample letter to CFOs providing guidance to companies on disclosing and filing such errors. Available at http://www.sec.gov/info/accountants/staffletters/fei_aicpa091906.htm (9/19/06 guidance); http://www.sec.gov/divisions/corpfin/guidance/oilgasltr012007.htm (1/16/07 guidance, mislabeled by the Commission as a oil/gas letter).

The letter offers that the staff will not require amendment of prior filings if the “company amends its most recent Form 10-K and includes in that amendment [a] comprehensive disclosure” that follows 10 requirements and subparts, explicitly detailed in the letter. None of the requirements are surprising and they do more to provide acceptable uniformity. The requirements follow known rules of restatement and accounting, i.e., requiring compliance with Items 301, 302 and 303 of Regulation S-K; FASB Statement 123 (Accounting for Stock-Based Compensation); and APB Opinion 25, Accounting for Stock Issued to Employees.

Not surprisingly, the staff reserves the right to review and comment on all filings and, specifically, states that adhering to the guidance does not “foreclose any action recommended by the Division of Enforcement under Section 304 of the Sarbanes-Oxley Act, Forfeiture of Certain Bonuses and Profits, with respect to the periods that the company’s financial statements require restatement, irrespective of whether the company amended the filings to include the restated financial statements.”