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SEC Enforcement Director Reports On Options Backdating and Advocates Defined Process

The SEC's Division of Enforcement is moving vigorously against the abusive backdating of stock options, noted Director Linda Chatman Thomsen, with over one hundred matters under investigation. The investigations are being conducted by SEC offices throughout the country and are being centrally coordinated and tracked in Washington. In addition, there is substantial criminal interest in options matters from U.S. Attorneys' Offices nationwide.

The SEC does not expect to bring 100 enforcement cases regarding stock options, she noted, but is focusing on the worst conduct. That said, she indicated that more enforcement actions can be expected in addition to the four that have already been brought. The SEC has recently brought two enforcement actions, one relating to Brocade and the other involving Comverse. With respect to both, there are also pending parallel criminal actions.

Thomsen observed that Comverse's former CFO became the first top level executive to settle actions brought by the SEC and the U.S. Attorneys' Office since options backdating came into the media spotlight. In settling with the SEC, the former CFO consented to, among other sanctions, a permanent bar against serving as a corporate officer or director and payment of $2.4 million in disgorgement and pre-judgment interest. At the same time, in a related criminal action brought by the U.S. Attorney, he pled guilty to securities fraud and conspiracy to commit securities fraud, mail fraud and wire fraud, and faces up to 15 years in jail, mandatory restitution and a possible criminal fine.

In addition to the enforcement efforts, the Commission has taken two other major steps to address the issue of backdating. First, recently adopted executive compensation disclosure rules specifically address options. These rules, in combination with the provisions of Sarbanes-Oxley requiring timely reporting of stock option grants, will, in her view, go a very long way toward preventing the current problems with backdating from occurring in the future. Second, the SEC's Chief Accountant issued guidance for companies trying to cope with the financial reporting ramifications of their various historical options practices from a reporting perspective.

According to Thomsen, the collective efforts by the SEC are a model way of addressing the issue and coming up with practical and wide-ranging solutions. She emphasized that the death knell on backdating has tolled because the motivation and opportunity to backdate has been substantially eliminated due to a combination of new accounting rules requiring the expensing of all options, and the Sarbanes-Oxley two-business-day reporting requirement for grants that became effective in 2002.

Through backdating, stock option grants were used by some companies as a means of providing compensation that was entirely independent of performance. One reason that stock options grants became a monster, she said, is that companies either abandoned or compromised their processes in granting options. Once released from a process designed to ensure legal compliance and fairness, she noted, stock option grants were allowed to "run amok." Also, many companies failed to comprehend that a stock option can be granted either in the money or at the money, but not both. You can take your pick, she emphasized, but you have to accept the consequences of your choice.

It is evident that a defined and consistent process in granting stock options is critical, Thomsen said. If a company devises a specific lawful process for granting employee stock options and always follows it, she advised, there should be no problem explaining how, when and at what price any particular options were granted.

Moreover, the existence of a process and a company's adherence to it tends to ensure that the matter has been given careful consideration and is in the company's best interests. By following a standard options grant process, a company gets fair and transparent results, and there should be no random anomalies to explain. Further, in her opinion, the cost associated with creating a standard process for the award of stock options pales when compared with the costs of backdating to companies involved.

Finally, and more broadly, tone at the top is as important in this area as it is in other areas of corporate governance, Thomsen said. What the SEC has learned from stock options backdating, she noted, is that corporate character matters and that employees take their cues from senior management. If a CEO is known for his or her integrity, integrity becomes the corporate norm. If, on the other hand, a company's senior executives are more interested in personal enrichment at the expense of the shareholders, she concluded, SEC backdating investigations demonstrate yet again that other employees will follow suit.