Backdating Probes Cause Boom In Late Filings

Companies are late filing quarterly reports in record numbers this summer, largely thanks to the first major accounting scandal after Sarbanes-Oxley: options backdating.

From Aug. 4 through Aug. 11 alone, nearly 140 companies with market capitalizations above $75 million notified the Securities and Exchange Commission they would be late filing their quarterly reports—up 52 percent from the same period one year earlier, according to proxy advisory firm Glass, Lewis & Co. Glass Lewis also reports more late filings in second-quarter 2006 than any other quarter since it began tracking such delinquencies at the start of 2004.

Investigations into options backdating seem to be the prime culprit. “This issue is causing an outsized number of delinquent filings,” says Todd Fernandez, a senior research analyst at Glass Lewis. “If you pull out those companies who were late because of options probes, the number of late filings is consistent with the number during the second quarter of 2005.”

Among the 138 late filers in the second quarter, 48 attributed the delays to reviews of stock option grants. (A complete list of the group is below.) Of those 48, 19 have already said they’ll need to restate past financial statements.

In total, more than 120 companies have now disclosed some sort of investigation into their option grants, whether the probes be internal or from government regulators. That number has climbed steadily all year and shows no signs of stopping.

Lee

“The growing number of companies delaying filings creates substantial amount of anxiety in the marketplace,” says Jason Lee, co-chair of the securities litigation practice at Shartsis Friese. “It’s a huge deal, because this is the first major accounting scandal post-SOX. A delay is an indication that there may be problems.”

Still, Fernandez cautions that for some companies “this is a more significant problem than others.” Those companies that have not yet given a preliminary indication of the financial numbers they might need to restate, nor whether any backdating was due to administrative error or deliberate fraud, are most worrisome, he says.

“Our opinion is that the majority aren’t due to manipulation or fraud, but are likely due to administrative and control issues,” Fernandez says. “The reason for the delays in many cases is that companies have to go well back in time and locate documentation and piece together information to recreate the past. That can take a lot of time.”

Lee also expects to see “a lot of companies who’ve delayed filings come to the conclusion that a lot of these issues occurred because of poor administration, but nothing rising to level of fraud.”

Lots Of Work Ahead

Experts note that even companies with issues that resulted from poor record-keeping rather than fraud have much to straighten out. Investigations can take months (or longer) to complete, depending on how far back the company must look and how many employees received option grants.

Keough

These investigations “aren’t something that can be done in a week’s time,” says Kevin Keogh, a partner at the law firm White & Case. “They usually take several weeks’ time. They longer they go on, the more likely it is that the company has problems that may reach back to a number of prior years’ financial statements.”

Such investigations often involve outside counsel and forensic accounting firms, not to mention years’ worth of paper and electronic documents, says Daniel Tyukody, a securities litigation partner at Orrick, Herrington & Sutcliffe. “Even in cases with non-intentional conduct, companies have to make tricky determinations of materiality.”

Compounding the problem, most of the grants in question occurred prior to the adoption of Sarbanes-Oxley in 2002, which imposed tight new reporting requirements that have curbed most option-related abuses.

Raskin

If a company does find that it backdated options, then effectively it granted discount options resulting in a compensation expense that should have been recorded on its books, says Ken Raskin, another partner at White & Case. “Depending on the degree of backdating, that can have potentially significant effect on the financial statement numbers.”

“There’s a lot at stake in these examinations,” says Jack Ciesielski, owner of investment research and portfolio management firm R.G. Associates. “Companies are going to be skewered in the courts and the public markets, so they want to be sure they’re right, so they’re ‘hurry up’ and ‘go slow’ in their nature.”

Keogh also notes that companies with numerous acquisitions under their belts may also face tangled documentation. “It was not uncommon, particularly in the ’90s, for companies that were consolidators to offer the employees of newly acquired companies stock options,” he says. “The administration of options plans amid a fast-moving acquisition program probably wasn’t as good as you’d see in regular plan administration. So there may be more to be examined there.”

Looking Bad Versus Being Late

Seth Rodner, a former federal prosecutor and now lawyer at Fowler White Boggs Banker, says companies’ fear of the market consequences resulting from a late filing may have given way to their concerns about making sure their reports are accurate post-SOX.

Rodner

“I think issuers are erring on the side of caution, and where there’s concern about the accuracy of items in the financial statements, companies will err on side of getting it right, even if it takes more time,” he says. “While there’s a risk that a delay can occasion an adverse market reaction, issuers are sensitive to the fact that the negative repercussions flowing from filing an inaccurate report can be far, far greater.”

Others expect the trend of late filings to continue. “I think we’ll see a wave of late filings in the next quarter as well,” Tyukody says. “It seems likely that more companies have these issues.”

More delisting notices are likely to follow, too—particularly for Nasdaq-listed companies, Keogh says, since Nasdaq measures compliance with timely reporting based on the filing of quarterly reports. Late filers on Nasdaq have a short grace period before they get a preliminary de-listing notice and must make a written submission to apply for a hearing to appeal, while the New York Stock Exchange has a longer “cure period” to fix delisting offenses. “So, it’s likely that any companies listed on NYSE—particularly if they’re calendar-year companies—will be able to fix any problems before they get a de-listing notice,” he says.

Lee, meanwhile, says the SEC could move to “calm some of the nervousness that’s out there.”

“The SEC has remained largely silent, other than the announcement of charges, as to what constitutes the level of misconduct that they’re going to go after,” Lee says. “The Commission has an opportunity to signal the market, investors and issuers, and bring a level of clarity that isn’t there right now.”

He says the SEC could give companies and investors some guidance—and comfort—as it has in the past, through the public remarks of commissioners and other top officials such as the director of the Enforcement Division or the chief accountant.

Lee also notes that companies looking into options backdating would be wise to get in touch with regulators before the regulators get in touch with them.

“If a company is conducting an internal probe, and the SEC and Justice Department aren’t already involved, the company should let the SEC know of the probe before a late filing,” Lee says. “Doing so allows them to capitalize on that first token of cooperation.”