From Fraud to Greed to Oops: Inadvertent Stock Option Backdating

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By Gary Levine - One of our speakers at a recent webinar on Compliance, Craig Newfield, General Counsel at Gomez, Inc., aptly used the phrase “from fraud to greed” to explain the transition from the Enron period scandals that brought us the Sarbanes-Oxley Act of 2002 to the executive compensation and option backdating scandals that have brought us CEO resignations and new SEC executive compensation disclosure requirements in 2006. I’ve always thought the unique connection between these two scandals was that almost all of the intentional option backdating ended in 2002 as a result of the expedited Section 16 filing requirements of Sarbanes-Oxley.

However, as a result of Sec. 409A, FAS 123R, and increased scrutiny of equity compensation reporting, we may now have entered a new period where the risks and penalties associated with “inadvertent” stock option backdating, rather than primarily intentional backdating, will become the next “gotcha” for financial executives at both public and privately-held companies with deferred compensation plans, including the most basic forms of stock option plans.

Recently, John Hancock, a corporate partner at the Boston law firm of Foley Hoag LLC, highlighted for an audience of financial executives at a Two Step Software webinar the connection between the end of the transitional rules period for Sec. 409A and on-going stock option backdating scrutiny. The overriding principle is to offer the greatest clarity as possible as to when an option grant occurred by providing written evidence that all steps were taken with respect to an option grant on a specific date.

If there is any uncertainty with respect to the number of shares, the vesting period or the list of recipients, this will increase the likelihood that the option could be considered to be granted on a later date when potentially the fair market value of the stock could be higher, resulting in an option being granted below fair market value. This could convert a qualified option to a non-qualified option, change the financial and tax implications to the employee and the company, and potentially trigger the severe penalties under Sec. 409A that apply to discounted stock options.

As far as practice tips for new stock option grants, his recommendations included:

  1. Avoid actions by written consent.
  2. Promptly create minutes reflecting board actions and file in minute books.
  3. Avoid subsequent changes to the authorization by the Board.
  4. Avoid authorizations that suggest there will be future decisions to be made.

Following the SEC Chief Accountant’s September 2006 letter that addressed option granting practices, the IRS making option backdating a Tier 1 issue in June 2007, and the new SEC executive compensation disclosure rules, it is clear that auditors will be giving greater scrutiny to equity compensation reporting and the related back up legal documentation.

With that in mind, every company, public or private, should work on standardizing their stock option granting and administration practices to reduce the risk of option backdating and improve their equity compensation reporting. In addition, companies should adopt appropriate internal controls to insure their policies and procedures are actually being followed. This type of work at the front end will pay big dividends at your next audit, your next financing transaction, or when the company goes public.

Gary D. Levine, President and CEO
Two Step Software, Inc.
www.CapitalizationMatters.com

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