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DC Bar Panelists Discuss Options Backdating

The D.C. Bar last week hosted the first in a two-part program on stock option backdating. The first program focused on enforcement. The second, scheduled for February 1, will focus on corporate governance matters. Thomas Newkirk, a former associate director in the SEC's Division of Enforcement, now a partner with Jenner & Block LLP, addressed the legal issue of whether the practices known as springloading and bullet dodging constitute insider trading.

Newkirk noted that SEC Commissioner Paul Atkins, "seemingly the nemesis of the enforcement staff," has questioned whether springloading constitutes a securities law violation. Springloading refers to the intentional scheduling of an option grant ahead of good news. Atkins said that one must consider the business purposes behind the timing of option grants, and suggested there was no better way than springloading to maximize the value to the option recipient.

Newkirk also noted that the Office of the Chief Accountant has suggested that springloading and bullet dodging are disclosure issues rather than an accounting issue. He has heard that OCA's view is controversial inside the SEC.

Newkirk reviewed the SEC's insider trading charges against a chief financial officer who engaged in a series of stock and option transactions in advance of bad news in SEC v. Willey. Willey, the CFO of Capital One Financial Corporation, learned that the Federal Reserve Board of Governors planned to downgrade Capital One's supervisory assessment. Without informing the other members of senior management or the board of directors, Willey engaged in the series of transactions and obtained substantial profits. When the other officials were informed and the supervisory action was disclosed, Capital One's stock price dropped 40%. Newkirk noted that the case was eventually settled for less than half of what the SEC originally sought, he said, which raises the question of whether the SEC was concerned about its insider trading theory.

Antonia Chion, an associate director in the Division of Enforcement, said she was not familiar with the Willey case but suggested a scenario in which directors granted stock options to themselves based on knowledge only they have. Newkirk said it is debatable as to whether that would constitute a rule 10b-5 case, but he assumes that issue may be among the Division's 130 open options backdating investigations.

Some analysts have estimated the scope of the options backdating problem to be in the range of 500 to 2,000 companies. Backdating can present an accounting nightmare when a company must correct and restate past financial statements. Companies may also face potential delisting from Nasdaq or the NYSE for failure to timely file required reports.

Newkirk said that options backdating is not the "scandal of the Century," given that investors do not seem to care much. In general, he said that stock prices recover pretty quickly after the announcement of the discovery of options backdating. There have been few class actions, he added, which may be based on the lack of damages. Chapter two of the scandal may be the backdated exercises of stock options, he said, which raises a tax and SEC filing problem for the exerciser, and a books and records violation for the company. The company may also be subject to charges of aiding a tax violation, he said.

Chion said the majority of cases under investigation involve grant dates. She reviewed a number of recent cases involving backdating. Chion said investors care if the disclosure is wrong, the accounting is wrong, the executive compensation is wrong and executives are involved in the conduct. To be optimistic, Chion said backdating may be a problem of the past. Backdating may not be the scandal of the Century, she added, but to the extent the conduct is intentional and constitutes fraud, it raises the question of whether there are other problems as well.

Newkirk asked whether auditing firms had been complicit in the cases the SEC is investigating. Chion said it is pretty much a given that, where there is fraud, the staff will look at the gatekeepers.

Jacquelyn Lumb