Heightened regulatory scrutiny of improperly backdating stock option grants shows no signs of abating. That’s amid reports of ongoing Securities and Exchange Commission investigations at several companies, and news of a tentative settlement by Analog Devices.

Cagney

As reported by Compliance Week in July, a number of companies—including software company Mercury Interactive Corp.—have been under SEC investigation for their alleged timing of option grants (see related coverage at right). “As a result of what happened at Enron and other cases, there’s an incredible amount of pressure from the SEC [on companies] to make sure the financial accounting is done correctly,” notes Lawrence Cagney, partner and chair of the executive compensation and employee benefits group at Debevoise & Plimpton in New York.

Last week, Analog Devices, the $2.6 billion maker of analog and digital integrated circuits, announced the tentative settlement of an investigation into its stock option pricing practices. That proposed settlement deals with the company’s disclosure of options to employees and directors before the Internet stock market bubble burst, and the grant dates for options granted to employees and officers starting in 1998.

According to the company, the settlement will say that ADI should have made disclosures in its proxy filings to the effect that it priced option grants made in Nov. 1999 and in Nov. 2000 prior to releasing favorable financial results. It will also say that the company should have used a grant date of Sept. 8, 1998, for options granted on Sept. 4—one trading day later than the date used to price the options—and will acknowledge that the company should have used different grant dates for option grants made on two other occasions.

Under the terms of the settlement, which is subject to approval by the SEC, the company—without admitting or denying the SEC’s findings—would pay a $3 million civil penalty to settle an investigation into stock-option pricing practices and would reprice options granted to its chief executive, Jerald Fishman, and other directors in certain years. In addition, Fishman would pay a $1 million civil penalty and make an unspecified disgorgement payment with respect to options granted in certain years. In a Nov.15 statement announcing the proposed settlement, Analog Devices also retracted statements made earlier this month by a company spokesperson to the Wall Street Journal which it said “were not intended to deny the SEC's contemplated findings.”

The company and Fishman, “agreed it is in the best interests of ADI's shareholders to put this behind us and settle this case on the proposed terms rather than face a protracted dispute with the SEC,” said Analog Devices’ chairman and c-founder Ray Stata. ADI, which said it granted options to between 2,000 and 3,500 employees in each of the years under investigation, said no restatements would be necessary due to the proposed settlement.

“This indicates the SEC takes this fraud seriously,” says Bruce J. Shnider, tax partner in the Minneapolis office of Dorsey & Whitney and co-chair of the firm's executive compensation practice group. “It really undermines all credibility regarding executive comp. public disclosures.”

A Thing Of The Past

Koblenz

“The SEC is looking very carefully at what public companies are doing these days,” agrees Michael Koblenz, a partner at Mound Cotton Wollan & Greengrass. “Before [companies] get creative with accounting or backdating options,” advises Koblenz, they should “go to the SEC and request a no-action letter.”

While it remains to be seen whether the probes currently underway will uncover widespread abuses involving backdating, securities experts who spoke with Compliance Week say they doubt that backdating is a prevalent practice, and that regulatory changes in recent years make it unlikely that companies would try to manipulate grant dates today.

Sher

“I would be surprised if it turned out to be a really widespread practice given the fact that the SEC has brought enforcement actions in prior years,” says Barry Sher, litigation department chair in the New York office of Paul Hastings Janofsky & Walker. “It is less likely that people have been able to manipulate the exercise date now, since insiders have to report trades to the SEC within two days.”

Carleen

Donald Carleen, a partner in the New York office of Fried, Frank, Harris, Shriver & Jacobson, agrees that backdating of options is not prevalent today. “I strongly believe that this issue is a thing of the past,” he says, “Few companies would able to do it today for a number of reasons, including the heightened scrutiny on executive compensation, increasing board attention on executive compensation matters and accelerated reporting of equity grants.”

Becker

“I don’t believe it [the practice of backdating] is currently widespread,” agrees Irv Becker, director of the executive compensation practice at consulting firm Hay Group. “Ten or 15 years ago, companies had more flexibility in locking in a grant date because in a lot of cases, the compensation committee would delegate the authority to make option grants to a stock committee and that committee might not have met on a set schedule the way compensation committees meet today.” According to Becker, the practice of authorizing option grants is more rigid than it used to be. “Companies typically have regularly scheduled comp. committee meetings each quarter, either right before or right after board meetings,” he adds. “Any grants authorized by the compensation committee are priced and effective that day.”

“There’s potential for a lot of legal and accounting violations, so I can’t believe that this is broad problem,” agrees Ken Raskin, head of the executive compensation practice at White & Case, who notes that backdating could lead to potential securities laws violations for public companies, as well as potential violations of tax, accounting and deferred compensation rules.

Options On A Napkin Over Lunch

But some experts say that the problem isn’t necessarily the improper dating of options, but the inadequate disclosure. “In and of itself, I don’t know that it’s illegal,” says Sher. “The problem companies can run into is that if they’re backdating [option grants], they don’t make the proper disclosures, they don’t account for it properly, and they don’t pay taxes on the option grants properly, because the taxes are calculated off of incorrect prices and dates,” he says. “Those are real issues.”

According to experts, many public companies have run into problems when the CEO grants an option award without the proper authority to do, or when an employee is promised an option grant at hire but the paperwork isn’t completed until weeks or months later.

Raskin

“I think what’s going on many times is that companies have a hiring situation where they promise an executive a stock option award upon hire, but the award isn’t granted at that time,” says Raskin at White & Case. “Then the company goes back to put the paperwork in order and they use the date of hire, but the board or comp. committee hadn’t taken action at the time of hire” he adds. “But the company feels they owe it to the executive to give them the price on the date of hire, so they backdate the award.”

TENTATIVE SETTLEMENT

The excerpt below is from the Analog Devices press release, "Analog Devices Announces Tentative Settlement Of The SEC's Previously Announced Stock Option Investigation," issued Nov. 15, 2005:

The Board of Directors for Analog Devices, Inc. (NYSE: ADI) today announced a tentative settlement of the U.S. Securities and Exchange Commission’s (SEC) stock option investigation of ADI, first disclosed in the company’s 10-K filing dated November 30, 2004.

...ADI and its President and CEO, Mr. Jerald G. Fishman, have made an offer of settlement to the Staff of the SEC, which is subject to agreement regarding the specific language of the SEC’s administrative order and other settlement documents. The SEC Staff has decided to recommend the offer of settlement to the Commission. A final settlement is subject to review and approval by the Commission.

...The contemplated settlement addresses two separate issues. The first issue concerns ADI’s disclosure regarding grants of options to employees and directors prior to the release of favorable financial results. Specifically, the issue relates to options granted to employees (including officers) of ADI on November 30, 1999 and to employees (including officers) and directors of ADI on November 10, 2000. The SEC settlement would conclude that ADI should have made disclosures in its proxy filings to the effect that ADI priced these stock options prior to releasing favorable financial results.

The second issue addressed by the tentative settlement concerns the grant dates for options granted to employees (including officers) in 1998 and 1999, and the grant date for options granted to employees (including officers) and directors in 2001. Specifically, the settlement would conclude that the appropriate grant date for the September 4, 1998 options should have been September 8th (which is one trading day later than the date that was used to price the options); the appropriate grant date for the November 30, 1999 options should have been November 29th (which is one trading day earlier than the date that was used); and the appropriate grant date for the July 18, 2001 options should have been July 26th (which is five trading days after the original date).

In connection with the contemplated settlement, ADI would consent to a cease-and-desist order under Section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder, would pay a civil money penalty of $3 million, and would reprice options granted to Mr. Fishman and other directors in certain years. Options granted to all other employees would be excluded from the repricing. Mr. Fishman would consent to a cease-and-desist order under Sections 17(a)(2) and (3) of the Securities Act, would pay a civil money penalty of $1 million, and would make a disgorgement payment with respect to options granted in certain years. With the exception of options granted in 1998, Mr. Fishman has not exercised or sold any of the options identified in this matter. The Company and Mr. Fishman would settle this matter without admitting or denying the Commission’s findings. This press release retracts statements by an ADI spokesperson reported in The Wall Street Journal on November 11, 2005, which were not intended to deny the Commission’s contemplated findings in this matter.

Analog Devices has determined that no restatement of its historical financial results would be necessary due to the proposed settlement, because the effects of using revised measurement dates for options granted in 1998, 1999 and 2001 are not material to any of the fiscal years 1998 through 2005, based on the materiality guidelines contained in SAB 99. If a stock-based compensation charge had been taken as a result of the revised measurement dates for option grants to all employees (including officers) and directors, the net income of Analog Devices for fiscal years 1998 through 2005 would have been reduced by $21.8 million in total. During this period, ADI earned cumulative net income of over $2.5 billion. There would be no impact on revenue, cash flow from operations, or stockholders equity as a result of using the revised measurement dates...

ADI’s option program has been designed for the long-term retention of its employees and as such ADI grants options to a broad base of its employee population each year. ADI granted options to between 2,000 and 3,500 employees in each of the years under investigation. ADI’s option program differs from customary industry practices in that most options do not begin to vest until three years after the grant date.

Source:

"Analog Devices Announces Tentative Settlement Of The SEC's Previously Announced Stock Option Investigation" (Nov. 15, 2005)

Raskin says his firm has gotten calls from companies wanting to award options at a price in the past because they had promised to make a grant when they were hiring someone, but the company forgot to formalize the award at time of hire. But companies can’t do that, “unless the award was approved by the board at the time and communicated to the recipient reasonably promptly,” says Raskin, who says that rather than backdating the grant, companies should award more options to make up for the difference in value.

“The more common problem we run into is a situation where the CEO grants options on a napkin over lunch to a new VP and wants the grant treated as if it were made on the date he wrote it on the napkin, despite the fact that he had no authority to make an option grant,” says Shnider of Dorsey & Whitney. “What we typically have to tell people in that situation is that we can’t use the price on the napkin, but they may be able to start vesting on that date,” he says. “They have to use the stock price on the day the compensation committee acts.”

Hidden Deals = Bad

Shnider

To avoid such an issue, says Shnider, “In some cases, the company can set up an option program where the comp. committee could grant authority to the CEO to grant options to certain non-insiders within certain parameters.”

“The real issue for companies is not to have any hidden deals,” says Sher at Paul Hastings. “When you have hidden deals, it looks bad. Companies have to recognize how it will look if two years from now, someone goes back and tries to figure out what was done.” Sher advises that companies need to be “squeaky clean” on the dates and prices for the grants and exercises of options. That includes accounting for it accurately, disclosing it completely, and paying withholding taxes appropriately.

Experts say the recent SEC investigations also serve as a reminder that companies need to make sure their documentation related to option grants is in order. “Companies need to properly document the grant and award of options by the board and communicate the grant to the optionee,” says Raskin at White & Case.

“Companies should have their documentation set up so that the stock option grants are in fact filled out and distributed that day or the next,” says Dorsey & Whitney’s Shnider. “I’ve never understood the situation where it takes people months to get an option agreement out the door.” Shnider adds that companies may want to establish procedures that can be monitored and reviewed to be sure that option grants and prices are accurate.

In addition, Becker of Hay Group says companies should approve grants on a regular schedule to mitigate problems. “Most companies we see have a set schedule of making grants either once a year, once a quarter or once a month,” says Becker. “Some companies are granting annual grants over the year (quarterly) to get a ‘dollar cost averaging’ advantage, rather than granting everything on one day,” he adds.

Paul Hastings’ Sher notes that companies that think they might have a problem related to the timing of option grants need to investigate it. “If they have a real problem, they should self report,” he says. “Like any other SEC violation, they will get credit if they act proactively to deal with an issue they uncover.”

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