the options scandal sec and private enforcement trends 2139

7/30/2019 The Options Scandal Sec and Private Enforcement Trends 2139

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Background

Between 140 and 170 companies have been investigated over thelast year for options backdating.

Estimates are that the scandal is costing public companies over $5billion in market capitalization.

Now, with technology available for the first time, the SEC and theprivate plaintiffs bar are looking at spring loading options.

Learn from one of the attorneys who has been close to the issueswhat is happening, and where enforcement is going.

Will the plaintiffs bar jump into the spring loading cases too?


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Definitions

Options backdating is the practice of granting anemployee stock option that is dated prior to the date thatthe company actually granted the option.Bullet dodging - delaying an options grant until just afterbad newsSpring-loading - timing an options grant to precede goodnewsSymmetric spring-loading - where members of the boardwho approve the grant are aware of the forthcominggood news

Asymmetric spring-loading - where members of theboard who approve the grant are unaware of theforthcoming good news


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Nefarious But Legal?

Granting in-the-money options is not illegal, solong as:

you account for it properly,

it is allowed under the stock option plan, you disclose it, and

pay your taxes.

Backdating is to pretend that youre not granting

in-the-money options when in fact you are.


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Violate SOPs

Almost always be violating the terms of the SOPapproved by shareholders.

SOPs almost always require that the options be granted

at fair market value on the date of the grant.

If not in SOP would have to make disclosures like:

Please note that when we grant options, we sometimes pretendthat we grant them on certain dates when in fact we grant themweeks later. Not to worry, though. We just do this to amuseourselves, because we account for them properly using the realdates. Roger Parloff ,Senior Editor (Legal Affairs) FORTUNE


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Bad Apple

GC Nancy Heinen emailed CEO Steve Jobs aspreadsheet on January 30, 2001.

Noted that it was a bad idea to choose a grantdateeven though that was the day the stockhad been at its lowestif they wanted:

to avoid any perception that the Board was acting inappropriately [sic] for insiders prior to Macworldannouncements.

Instead they chose the next lowest afterMacworld.


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History

David Yermack, a New York University finance professor, in 1995 studieddata that companies were obligated to publish, under a 1992 SEC decree,the exact dates of options grants in proxy statements.

Previously, dates were disclosed within often ignored filings. He found apattern that the stock prices often declined in value just prior to the options

grant and rose afterwards.

He theorized these were timed to precede good news and follow bad news.

In 1997, his findings were published in the Journal of Finance.

Finance professors David Aboody of UCLA and Ron Kasznik of Stanfordfollowed with a study of companies that grant options at the same timeevery year and found a similar pattern, indicating timing of news.


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Eric Lie

Finance professor Erik Lie of the University of Iowa in 2004 notedthat many options grants were timed to exploit marketwide pricedepressions that nobody, including insiders, could predict leading tothe conclusion that at least some of the grants must have beenretroactive.

His mid-2005 research first suggested that hundreds of companiesmay have routinely manipulated stock- option accounting rules tosweeten top executives' paydays. A later study done with hisresearch partner, Indiana University associate professor RandallHeron, puts the number at 2,000, or 29% of all public corporations.

Lie helped make sure the scandal exploded, notifying the Securities& Exchange Commission of his work and showing The Wall StreetJournal how to interpret a particular company's options records,although he insists he never I.D.'d companies himself.


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SEC Begins Looking

Suspecting such patterns aren't due to chance, the Securities andExchange Commission began examining whether some optiongrants carry favorable grant dates for a different reason: They werebackdated.

Before the Sarbanes-Oxley Act of 2002, companies did not have toreport option grants until 45 days after the end of the fiscal year inwhich they were granted, which provided firms a significant windowof time to retroactively match grant dates with share lows.

Companies now are required to file Form 4 reports on option grantswithin two business days of the grant date, which limits opportunitiesfor backdating.

Cant hide any longer.


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Mercury Interactive

The SEC started looking at Mercury Interactive Corp., aMountain View, Calif., software maker.

CEO and two others resigned late 2005.

Internal probe found 49 cases where the reported date ofoptions grants differed from the date when the optionsappeared to have been awarded.

The company said it would have to restate financialresults.


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Analog Devices

Analog Devices Inc. admits reached a tentativesettlement with the SEC late 2005.

It neither admitted nor denied that it had misdated

options or had made grants just before releasing goodnews that would tend to push up the stock.

Agreed to pay a $3 million civil penalty and re-price

some options.

CEO Jerald Fishman tentatively agreed to pay a $1million penalty and disgorge some profits.


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Perfect Payday

Wall Street Journal reporters Charles Forelle and James Bandler,along with Journal reporters Mark Maremont and SteveStecklow,write The Perfect Payday--Some CEOs reap millionsby landing stock options when they are most valuable. Luck --or something else".

The first article was published in the WSJournal in March 2006.

Exposed widespread practice of secretly backdating stock optionsgrants to benefit corporate insiders

Based on material provided to the Journal by Lie.

Honored by the Pulitzer committee with Pulitzer Prize top honor forpublic service reporting in April 2007.


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The Perfect Payday Buy Low

William McGuire

UnitedHealth Group, chairman and chief executive

Total grants: 12

Odds: At least 1 in 200 million


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The Perfect PaydayBuy Low

Robert TherrienBrooks Automation, former chief executive

Total grants*: 7Odds: About 1 in 9 million


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Timothy Main*

Jabil Circuit, president and chief executiveTotal grants: 6

Odds: About 1 in 1 million


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The Perfect Payday Buy Low

Jeffrey Rich

Affiliated Computer Services, former chief executive

Total grants: 6

Odds: About 1 in 300 billion


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Kobi Alexander

Comverse Technology, chairman and chief executive

Total grants: 8

Odds: About 1 in 6 billion


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WSJ Keeps Story Alive

The Perfect Payday: CEOs Reap Millions by Landing Stock Options WhenThey Are Most Valuable--March 18

How the Journal Analyzed Stock-Options Grants--March 18

Five More Companies Show Questionable Options Pattern--May 22

At HealthSouth, an Options Issue--May 31

Monster Worldwide Gave Officials Options Ahead of Share Run-Ups--June12

During 1990s, Microsoft Practiced Variation of Options Backdating--June 16

Executive Pay: The 9/11 Factor--July 15

Setting the Date: How One Tech Company Played With Timingof Stock Options--July 20


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WSJ Flags 26May 24, 20061. Affiliated Computer Services

2. Altera

3. Boston Communications Group

4. Brooks Automation

5. Caremark Rx.

6. CNET Networks

7. Comverse Technology

8. F5 Networks

9. Jabil Circuit

10. Juniper Networks

11. KLA-Tencor

12. Meade Instruments

13. Medarex

1. Mercury Interactive

2. Openwave Systems

3. Nyfix

4. Power Integrations

5. Sycamore Networks

6. Quest Software

7. Renal Care Group

8. RSA Security

9. SafeNet

10. Semtech

11. Trident Microsystems

12. UnitedHealth

13. Vitesse Semiconductor


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WSJ Options Score Card

About 126companies thathave disclosedgovernment probes,misdated options,

restatements and/orexecutivedepartures.

http://online.wsj.co

m/public/resources/documents/info-optionsscore06-full.html


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200 Companies HaveAnnounced Internal

Investigations


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SEC and DOJ Action

Division of Enforcement is investigating over 140-170 mattersrelating to potential abuses of employee stock options.

The investigations are being conducted by SEC offices throughoutthe country and are being centrally coordinated and tracked inWashington.

Substantial criminal interest in options matters from United StatesAttorneys' Offices nationwide.

SEC has brought several enforcement actions one relating to

Brocade and another involving Comverse. With respect to both,there are pending parallel criminal actions as well. Most recently theSEC filed an action against Apple.

.


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New Comp Disclosure (1)

SEC unanimously adopted final rules July 26 on the disclosure of executive anddirector compensation--including on stock option grants.

Specifically, the rule would require disclosure of the timing of option grants incoordination with the release of material nonpublic information (spring-loading), andthe selection of exercise prices that differ from the underlying stocks price on thegrant date.

Some of the required disclosure will include clear tabular presentations of optiongrants including: the fair value on the grant date, as spelled out by Financial

Accounting Standards Statement 123R; the closing market price on the grant date if itis greater than the exercise price of the award; and the date the compensationcommittee or full board took action on the award if that date is different than the grantdate.

Further, if the exercise price of an option grant is not the closing market price on thegrant date, the rules will require a description of the methodology for determining theexercise price. The MD&A section also will require enhanced narrative disclosure ofgrants to executives.


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New Comp Disclosure (2)With regard to the timing of option grants, companies will have to answer questions,such as:

Does a company have any program, plan, or practice to time option grants to itsexecutives in coordination with the release of material non-public information?

How does any program, plan, or practice to time option grants fit in the context of thecompanys program, plan or practice, if any, with regard to option grants toemployees more generally?

What was the role of the compensation committee in approving and administeringsuch a program, plan, or practice? How did the board or compensation committeetake such information into account when determining whether and in what amount tomake those grants? Did the compensation committee delegate any aspect of theactual administration of a program, plan, or practice to any other persons?

What was the role of executive officers in the companys program, plan, or practice ofoption timing?

Does the company set the grant date of its stock option grants to new executives incoordination with the release of material non-public information?

Does a company plan to time, or has it timed, its release of material non-publicinformation to affect the value of executive compensation?


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Trends in Enforcement--SECSEC currently has about 140-170 investigations into stock option backdating.

Many more companies have derivative actions filed against them for optionsbackdating issues.

Some of these investigations have since been closed with no enforcement action, butmany are still open.

The Commission has filed five to ten options backdating cases thus far.

In determining whether to recommend such an enforcement action, the SEC staffconsiders the degree of scienter of the individuals involved, the amount of harm, andthe personal benefit to those who were directing the activity.

The Commission is likely to continue bringing options backdating cases where either

conduct was egregious or criminal, or the case involves unique facts that may conveyan important message.

Some cases are more attractive to criminal prosecutors than others.

Some companys options backdating problems do not rise to the level of fraud.

They may the result of sloppy administration or record-keeping. While there might beaccounting consequences, this is not fraud.


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DOJ Actions

The Justice Department filed criminalcharges in summer of 2006 against formerexecutives at

Comverse Technology Inc.

Brocade Communications Systems Inc.


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Apple Enforcement Action

Key question: What standard prosecutors will use when exercisingtheir broad discretion to charge?

On April 25, 2007, SEC gave some indication of where that linemight fall. It brought a long awaited action based on its investigationinto the backdating practices at Apple. Named as defendants in anenforcement action were Apples former GC of nine years, NancyHeinen, and its former CFO and director, Fred Anderson. SEC v.Nancy R. Heinen and Fred D. Anderson, Case No. 07-2214-HRL(Lloyd) (N.D. Cal. filed April 24, 2007)http://sec.gov/litigation/litreleases/2007/lr20086.htm

These are the two persons identified by internal investigators ashaving engaged in possible misconduct.


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Apple Enforcement Action

The SECs complaint follows what is becoming a familiar formula. Italleges:

instances of backdating and preparation of false documents and targetsthose persons who specifically participated in granting the options.

two option grants, the first in January 2001 of 4.8 million options toApples Executive Team and the second in October 2001 of 7.5 millionoptions to Apples CEO Steve Jobs.

in both instances Ms. Heinen caused Apple to backdate the options and

directed her staff to prepare documents to reflect the new date. Ms. Heinen signed fictitious board minutes for a special meeting that didnot occur.

Mr. Anderson should have realized the implications of Ms. Heinensactions, failed to disclose key information to Apples auditors andneglected to ensure that the financial statements were accurate.


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Settlements-ComverseWSJonline-5/9/2007

Comverse-The maker of telecom software said May 4 that it received a subpoenafrom the U.S. attorney's office for the Eastern District of New York, indicating acriminal investigation of stock-option-granting practices.CEO Kobi Alexander, as well as the company's CFO and senior general counsel,resigned just days earlier.In April, the company said some option-grant dates used in its accounting "differed"from the actual grant dates, and that it would restate more than five years of financial

results.On Aug. 9, the former CEO, CFO and general counsel were charged with criminalfraud.On Sept. 27, Alexander, who failed to show up in court and was declared a fugitive bythe FBI, was found in Namibia, and was set to be extradited to the U.S.On Oct. 24, ex-CFO Kreinberg pleaded guilty to securities-fraud charges in federalcourt, making him the first person to plead guilty in the backdating scandal.On Nov. 2, 2006 former general counsel William F. Sorin pleaded guilty to aconspiracy charge. On Jan, 10, 2007, it was announced that Sorin will pay $3 millionto settle an SEC lawsuit over stock-option grants.

http://online.wsj.com/public/resources/documents/info-optionsscore06-full.html


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Settlements-Take TwoWSJonline-5/9/2007

Take Two-The New York entertainment software company disclosed onJuly 10, 2006 that the SEC opened an informal investigation into stock-option grants dating back to January 1997.Take-Two said it plans to fully cooperate and also is conducting its owninvestigation. The company said on Aug. 31 that it has received additionalgrand-jury subpoenas requesting documents regarding stock options,

compensation and expenses.On Dec. 11, the company said an independent investigation foundimproprieties in the process, and it will need to restate its historical financialresults to record charges for compensation expense related to optiongrants.On Jan. 21, 2007, the company accused former Chairman and ChiefExecutive Ryan Brant of backdating stock options spanning a six-year

period.On Feb. 14, 2007, Mr. Brant pleaded guilty to a false filing charge, agreeingto pay $7.3 million in disgorgement, interest and penalties in connectionwith the New York criminal case and a SEC civil probe. Brant agreed tosettle the SEC probe without admitting or denying wrongdoing.http://online.wsj.com/public/resources/documents/info-optionsscore06-full.html


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Settlements-ESSIWSJonline-5/9/2007

ESSI-Parsippany, N.J., military contractor DRS announced on June 12 thatit has been advised by the SEC and the U.S. Attorneys office that each isinvestigating possible backdating of option grants at recently acquired ESSI,prior to DRS's acquisition of the company, a supplier of logistics andmaintenance support.DRS said the U.S. Attorneys office has advised DRS that it considers DRS

to be a witness, not a subject or target of its investigation.On Feb. 6, 2007, the SEC filed civil charges against two former executivesESSI, accusing them of participating in a six-year options backdatingscheme in which they granted in-the-money options to themselves andother executives.Steven Landmann, the former controller, agreed to settle the charges bypaying $886,557 and accepting a bar on serving as an officer or director of

a public company and a ban on practicing before the SEC as anaccountant. Ex-CFO Gary Gerhardt hasn't settled with the SEC.

http://online.wsj.com/public/resources/documents/info-optionsscore06-full.html


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Winding Down?

On April 25, 2007, Reuters reported that SEC ChairmanChristopher Cox expects to wrap up many of its stock options datingcases within weeks.

We are working on procedures to move many of the cases veryquickly, Cox said, adding their resolution would be within weeks.

Rueters reported that Mr. Cox gave no indication of whether theoptions cases would be resolved through settlements, lawsuits or acombination of both.

Mr. Cox added that the SEC would like to put the option backdatingscandal behind them, noting that such conduct will not likelycontinue in todays environment.

Mr. Cox did not elaborate on what process the SEC is likely to use.


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Securities Fraud Class Actions

29 Securities ClassActions as of April2007

1. American Tower Corp.05/26/2006USDC - D.2. Mass.Amkor Technology11/21/2006USDC - E.D. Pa.3. Apollo Group11/02/2006USDC - D. Ariz4. Apple Computer, Inc.08/25/2006USDC - N.D. Ca5. Aspen Technology09/08/2006USDC - D. Mass6. Broadcom Corp.08/13/2006USDC - C.D. Cal7. Brocade Communications Systems, Inc.05/19/2005USDC -

N.D. Cal.8. Brooks Automation, Inc.06/19/2006USDC - D. Mass.9. Comverse Technology, Inc.04/19/2006USDC - E.D.N.Y.10. Hansen Natural Corporation11/29/2006USDC - C.D. Cal.11. HCC Insurance Holdings, Inc.03/08/2007USDC - S.D. Tex.12. Jabil Circuit, Inc.09/19/2006USDC - M.D. Fla.13. Juniper Networks, Inc.07/17/2006USDC - N.D. Cal14. .KLA-Tencor Corp.06/29/2006USDC - N.D. Cal15. .Marvell Technology Group10/06/2006USDC - N.D. Cal.16. Meade Instruments, Inc.09/27/2006USDC - C.D. Cal17. .Mercury Interactive Corp.08/19/2005USDC - N.D. Cal.18. Michaels Stores, Inc.09/06/2006USDC - N.D.19. Tex.Monster Worldwide, Inc.03/15/2007USDC - S.D.N.Y.20. Openwave Systems Inc.02/21/2007USDC - S.D.N.Y

21. .Quest Software10/27/2006USDC - C.D. Cal.22. Rambus, Inc.07/17/2006USDC - N.D. Cal.23. Safenet, Inc.08/01/2006USDC - S.D.N.Y.24. Sunrise Senior Living01/16/2007USDC - D.D.C25. .UnitedHealth Group, Inc.05/05/2006USDC - D. Minn26. .Vitesse Semiconductor Corp.05/02/2006USDC - C.D. Cal27. .Witness Systems, Inc.08/15/2006USDC - N.D. Ga.28. Wireless Facilities, Inc.03/19/2007USDC - S.D. Cal29. .Zoran Corp.08/10/2006USDC - N.D. Cal.


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ERISA Actions

5 ERISA or 401(k) Cases

1. United Health Group

2. Affiliated Computer Services

3. Analog Devices

4. KB Homes

5. The Home Depot


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Its Not Over

18.9% of unscheduled, at-the-money option grants to top executives during theperiod 1996-2005 were backdated or otherwise manipulated.

23.0% before the new two-day filing requirement took effect on August 29, 2002.

10.0% afterward.

19.9% for grants not filed within the required two-day window.

Higher frequency of backdating among tech firms, small firms, and firms with highstock price volatility.

Firms that use smaller (non-big-five) auditing firms are more likely to file their grantslate.

29.2% of firms manipulated grants to top executives at some point between 1996 and2005.

What fraction of stock option grants to top executives have been backdated or manipulated?, Randall A. Heron and Erik Lie, July 14, 2006


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Its Not Over

Call for more information.Reed R. Kathrein

PartnerHagens Berman Sobol Shapiro LLP

San Francisco, CATelephone: (415) 896-6300

Fax: (415) 896-6301Email: [email protected]
mailto:[email protected]:[email protected]

the options scandal sec and private enforcement trends 2139

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