Backdating Update; Pay Rule Fallout; More

Securities and Exchange Commission Chairman Christopher Cox told lawmakers last week that his agency is now investigating more than 100 companies for possibly fraudulent reporting of stock option grants, and said more guidance on backdating issues is forthcoming.

Cox made his comments as Capitol Hill’s scrutiny of stock option backdating and executive pay abuses rolled along at full tilt, with two Senate committees holding hearings on the issue.

In testimony before the Senate Banking Committee, Cox noted that while media reports often associate Silicon Valley companies with backdating—given the technology industry’s heavy use of stock option grants to lure employees in the 1990s—the SEC’s Division of Enforcement is investigating companies throughout the country, across all industries, and from Fortune 500 mammoths down to small-cap issuers.

Cox

While not all of the investigations will result in enforcement proceedings, Cox said, he repeated a warning sounded by others at the agency recently: “We have to expect other enforcement actions will be forthcoming in the future.” So far the SEC has filed charges against two companies, Brocade Communications Systems and Comverse Technology.

The enforcement staff is sharing information related to its investigations with other law enforcement and regulatory authorities, including the Department of Justice, the President’s Corporate Fraud Task Force, U.S. attorneys’ offices around the country, the Federal Bureau of Investigation, and the Internal Revenue Service.

Cox also said the Office of the Chief Accountant will issue further public guidance on the accounting issues surrounding backdating.

Cox partly blamed the backdating scandal on a tax law change that capped the corporate deduction for executive compensation at $1 million per executive—which spurred companies to award equity compensation such as stock options rather than cash. While the stated purpose of the cap was to control the rate of growth in CEO pay, Cox said, “With complete hindsight, we can now all agree that this purpose was not achieved. Indeed, this tax law change deserves pride of place in the Museum of Unintended Consequences.”

The Senate Finance Committee also held hearings last week, and Chairman Sen. Chuck Grassley, R-Iowa, said modifying the deduction for performance-based pay or “at least tightening up the eligibility are possibilities I think members of the Finance Committee will want to consider.”

Grassley

Grassley said he fears “a new set of problems behind this backdating: all the individuals who supported this illegal activity,” including board members, attorneys, accountants and outside consultants who all “either blessed or looked the other way when it comes to backdating.” Grassley said he plans to contact several major corporations that have been involved in the backdating of stock options to request board minutes regarding the decision to backdate and “any and all material from advisers”—including attorneys, accountants and compensation consultants who assisted in these efforts.

Statements by SEC Chairman Cox and Sen. Grassley, as well as related coverage on backdating, can be found in the box above, right.

Few Companies Plan Pay Changes In Response To Rule

Most corporate personnel and compensation executives believe the SEC’s new rules on executive pay disclosure will have little effect on pay levels, and only a handful of companies plan to change their corporate compensation programs, according to a new poll by compensation consulting firm Watson Wyatt.

The SEC rules, which mark the most sweeping rewrite of executive compensation disclosures in nearly 15 years, were adopted in July and will take effect with the 2007 proxy filings.

Only 28 percent of the nearly 200 compensation and human resource executives at large, publicly traded companies polled by Watson Wyatt say the rules will decrease executive pay levels, while 54 percent say the new rules will have no effect at all. Only 3 percent think the rules will lead to higher pay levels, and the remaining 15 percent are unsure.

Still, companies aren’t planning immediate changes to their compensation programs in response to the rules. Only 5 percent of those polled plan to change their programs, while 49 percent aren’t planning changes, and 45 percent haven’t yet decided.

Kay

Ira Kay, director of compensation consulting at Watson Wyatt, says he is not surprised that companies say they plan to make no changes, but adds that “I believe many companies are mistaken about that.”

“Companies have made many changes in their compensation programs over the last few years, yet it appears institutional investors still are not satisfied,” Kay says. “We believe the enhanced disclosures will allow investors to continue to put pressure on companies to further change their programs.”

While Kay says he doesn’t expect overall direct pay (salary, bonus and stock incentives) to decline much, if at all, he adds, “It won’t go up either.” Instead, he says, the new rules will add pressure on companies to increase their reliance on performance-based compensation and to decrease the value of supplemental retirement plans, severance packages and perks.

“Severance, supplemental pensions and perquisites will be under significant downward pressure due to the new disclosures, and companies will need to respond to that,” he says. “They’ve already started. In many cases companies have reduced or limited executives’ personal use of corporate jets, and there have been some cut backs in severances.”

Most of those polled (73 percent) say the new rules won’t improve corporate performance, compared with 11 percent who believe they will.

Details on the study, as well as related coverage, can be found in the box above, right.

SEC, DoJ Defend Constitutionality Of Accounting Overseer

The SEC has joined the Department of Justice in defending the Public Company Accounting Oversight Board, the oversight body created by Congress in 2002 under the Sarbanes-Oxley Act, in connection with a lawsuit challenging the Board’s constitutionality.

The Free Enterprise Fund and Nevada accounting firm Beckstead & Watts filed a lawsuit in February claiming that the PCAOB is unconstitutional. Their complaint claims that the process of appointing PCAOB members violates separation-of-powers principles, because the Board performs an executive function but the president does not appoint or remove board members. (PCAOB members are appointed by the SEC.) The plaintiffs say even if it is proper for the appointments to be delegated, the SEC doesn’t have appointment power.

In a brief filed in the U.S. District Court for the District of Columbia, the government argued that “at bottom, plaintiffs’ argument offers little more than thinly disguised attacks on the constitutionality of independent administrative agencies per se.”

The government argues that the statutory method for appointing the members of the PCAOB “is consistent with the Appointments Clause [of the Constitution] because the members of the PCAOB are inferior officers who may be appointed by heads of departments, including the SEC.”