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SEC, PCAOB Chairmen Testify About Stock Options Backdating

Testifying before the Senate Banking Committee, SEC Chairman Christopher Cox and PCAOB Chairman Mark Olson discussed issues surrounding the backdating of stock option grants by management. The two chairmen responded to inquiries by senators about the agencies' resources for investigating backdating, whether the term "backdating" needs to be legislatively defined, the improvements that the Sarbanes-Oxley Act made to the accounting for options and how the new executive compensation disclosure rules will affect the reporting of options as compensation in the future.

Cox told the committee that the SEC is currently investigating more than 100 public companies for possible wrongdoing with regard to option grants and would continue to bring enforcement actions against the most serious violators. Several senators questioned whether the SEC has adequate resources and tools to handle such a sweeping task. Cox said that information gathered by the staff of the SEC's Divisions of Enforcement and Corporation Finance, as well as internal data from the Office of Economic Policy and external data from scholars in academia, was voluminous but that the SEC has the tools to investigate possible wrongdoing.

Cox drew attention to two tools in particular. The Sarbanes-Oxley Act mandated that the options disclosure period be reduced to two days. This requirement, combined with the use of interactive data, makes it much easier to find out when options are being granted, Cox said, as well as giving the SEC earlier notice. He stressed that the SEC would not focus on "the capillaries, but on the jugular," when deciding which cases to pursue, acknowledging that some companies make inadvertent errors and would not be the proper target of an enforcement action.

Some senators inquired whether the term "backdating" should be specifically defined in order to facilitate investigation and enforcement. Cox said that while he would not necessarily be opposed to a specific definition, he felt that it would be "aesthetic." Although it might "feel better" to have a definition, for now the SEC can easily prove elements of misrepresentation and so a strict definition of backdating is not needed, in his view.

In addition to the executive compensation rules recently approved by the SEC, Cox said that the SEC's Office of the Chief Accountant would issue more public guidance on the backdating issue. He emphasized that the SEC's role in regulating companies' salary decisions is primarily focused on disclosure. While backdating is not itself illegal, companies must accurately report the procedures used to fix the option price. Cox noted that "spring loading," where a company grants options just before the announcement of good news that drives up the price of the stock, is "bound up with the concept of insider trading." He stressed, however, that the SEC should "dichotomize" those insider trading cases from "the mere fact that options are being granted at a time when management possesses inside information" because management is usually in possession of inside information. The SEC should instead look to the integrity of process under which the options were granted, Cox said.

PCAOB Chairman Olson also addressed the spring loading issue by pointing to the PCAOB's recent Audit Practice Alert regarding option grants backdating. Senator Paul Sarbanes (D-MD) noted that in the PCAOB's alert, the Board made reference to the issue in a footnote. Olson responded that the nature of the release was to alert firms to the situations that might result in a liability or lead to reputational risks for the firm.

Olson also said that the two-day reporting requirement for stock option grants, combined with FAS 123R requiring the expensing of options, has eliminated many abuses by reducing the opportunity for manipulation. Because of these measures, a "same day" disclosure period advocated by some observers is unnecessary and, if imposed, could create problems for U.S. companies doing business overseas in different time zones, in his view.