In response to pressure from investors, proxy advisory firms, and the public to curb excessive executive pay practices, many companies added new pay policies and rules. Now they have the added task of ensuring that everyone abides by them.
That means more focus on internal investigations related to pay, when claims arise that executives may have broken the rules on compensation practices. The most common problem areas, according to lawyers at law firm Gibson Dunn & Crutcher, are improper reporting or authorization of perks and benefits, unreported or improper benefits from third-party transactions, and reimbursement of executive expenses.
Steven Hall, managing director of executive compensation consulting firm Steven Hall & Partners, says companies regularly conduct reviews on all compensation areas to make sure they fully comply with the policies and procedures they have put in place. Further investigations are only conducted when evidence of wrongdoing is found. “They can be issues on insider trading, wrongdoing in exercise of stock options and restricted stock, and compensation issues including compensation committee adviser independence,” he says.
Hall adds that companies are still finding evidence of improperly backdated stock options, despite the well-publicized difficulties at companies such as Apple, Brocade, Broadcom, and Comverse.
The most recent backdating option lawsuit was filed last year by the Securities and Exchange Commission against integrated circuits provider Trident Microsystems. The founder and former CEO of the company, Frank Lin, and the former chief accounting officer, Peter Jen, were charged on allegations of stock option backdating from 1993 to 2006.
According to the SEC complaint, Lin had ordered others to select stock option grants dates that coincided with the dates of low closing prices of a company's stock. The documentation was then backdated to make it appear as if the options had been granted on earlier dates. Their backdating practices include backdated offer letters to newly hired employees and keeping low-priced options under the names of certain employees which were later allocated to others in subsequent months when the company's stock price increased. The complaint alleged that Jen was aware of some of the backdating practices and that he approved backdated grants to certain employees.
The most common area that can lead to an executive compensation investigation is how executives use and report benefits and perquisites, says Kevin Petrasic, a partner at law firm Paul Hastings. “If you have certain management officials who get perks not covered by the company's pay program, or the program is applied to non-covered executives, that will warrant further investigations,” he says.
As early as January this year, the SEC filed a lawsuit against government Website manager NIC and its former and current CEOs and CFOs for failure to disclose more than $1.18 million in perks paid to former CEO Jeffrey Fraser in the 2000s. The perks given to Fraser including vacations, computers, living expenses, and daily work commute by private aircraft from his residence in a Wyoming ski lodge to the company's Kansas office.
“If you have certain management officials who get perks not covered by the company's pay program, or the program is applied to non-covered executives, that will warrant further investigations.”
—Kevin Petrasic,
Partner,
Paul Hastings
The company and the other executives were charged for falsely misrepresenting to investors that Fraser worked for free from 2002 to 2005, and continued to understate the perks Fraser received in 2006 and 2007.
According to Petrasic, the board of directors, especially the compensation committee, needs to be on the lookout for abuse of perks. “If you have executives by virtue of the business who do a lot of international travel but the reimbursements of the executive expenses do not match the activities, then it will warrant further investigation,” he says.
”There are still people who cut corners and companies may want to take it upon themselves to review issues if there is a sense that something has run afoul,” says Keith Watanabe, member of the Watanabe Law Firm. As a rule of thumb, he says companies should check on compensation items as addressed by both the Dodd-Frank Act and the Sarbanes-Oxley Act to detect or clear any presence of potential violations.
Handling Investigations and Findings
Depending on the severity of the alleged violations, companies may either choose to have its internal auditors investigate the allegations or seek external expertise, Watanabe says. Circumstances will dictate whether companies should appoint internal employees to conduct these investigations or seek outside expertise.
TRIDENT CASE FACTS
Below is an excerpt from the SEC's press release regarding the Trident Microsystems case.
The Securities and Exchange Commission today filed a civil action against Trident Microsystems, Inc., a Santa Clara, California-based provider of integrated circuits, Trident's founder and former chief executive officer, Frank C. Lin, and Trident's former chief accounting officer, Peter Jen, alleging violations related to stock option backdating.
The Commission's complaint, filed in the United States District Court for the District of Columbia, alleges that from at least 1993 to May 2006, Trident, through the conduct of Lin and Jen, engaged in a fraudulent and deceptive scheme to provide undisclosed compensation to executives and other employees, concealing millions of dollars in expenses from the company's shareholders. According to the complaint, Lin used, and directed others to use, hindsight to select for stock option grants dates that coincided with the dates of low closing prices for the company's stock. Lin backdated stock option documentation to make it appear as if options had been granted on earlier dates, resulting in disguised “in-the-money” option grants to company employees, officers, and on at least one occasion to directors. Among the alleged backdating practices, Trident backdated offer letters to newly hired employees and “parked” low-priced options under the names of certain employees which were later allocated to different employees in subsequent months when Trident's stock price increased. The complaint alleges that Jen was aware of some of the backdating practices during at least 1998 to 2006 and that he approved backdated grants to certain employees.
The complaint alleges that Lin and Jen signed and/or approved of the filing of annual and quarterly reports with the Commission that they knew, or were reckless in not knowing, failed to include compensation expenses associated with the “in-the-money” portions of the backdated grants. The reports falsely stated that Trident complied with stock option accounting rules and, in certain cases, stated that Trident granted options at the fair market value of the company's stock on the date of grant. Lin and Jen also signed registration statements filed with the Commission that incorporated by reference these false and misleading periodic reports. The complaint also alleges that Lin and Jen reviewed and/or prepared proxy statements provided to shareholders that falsely reported stock option grant dates for executives and falsely stated that those stock options were granted at the market value of the company's stock on the date of grant. Lin and Jen also filed beneficial ownership forms (Forms 4) with the Commission misrepresenting the purported grant dates of backdated stock options that they each received.
According to the complaint, in August 2007, Trident filed a restatement to record approximately $37 million of compensation expenses that the company had failed to record over a thirteen-year period. As a result of Trident's failure to properly account for its stock option grants, Trident materially overstated its pre-tax income or understated its pre-tax losses, by as much as 113 percent, in each of the company's fiscal years from 1993 through 2005, and through the third quarter of its 2006 fiscal year, according to the complaint.
Trident, Lin, and Jen agreed to settle the matter without admitting or denying the allegations of the Commission's complaint.
Source: SEC.
“The higher up the food chain, the more difficult it will be for internal employees to conduct the investigation for fear of retaliation. The result of the investigation may also be influenced by the fact,” he says. The best practice when dealing with investigations involving senior members of a company is to seek independent outside expertise.
An advantage of getting internal employees to conduct these investigations is accessibility to information, Petrasic says. “If there are concerns that information is being hidden by wrongdoers, get the internal auditors to perform the investigations. They will have more access to a company's information,” he says.
At companies that wish to conduct the investigation internally, the board of directors should seek qualified employees to investigate the issues and begin a review process. “Make sure that the investigation is independent and will not be influenced by senior management or those who are involved,” Petrasic says. Upon the release of findings, directors should review the evidence and recommendations accordingly and consider appropriate remedial actions to address these issues.
Watanabe adds depending on the outcome of the investigations, the board members should have procedures in place on the appropriate actions to take. “It is not necessary that all investigations will lead to evidence pointing at outright fraudulent activities. In some instances, certain allegations of wrongdoing can be the result of technical flaws in the processes,” he says.
For minor offenses, he says, board members can review the by-laws, take corrective action, and make full disclosure on the amendment if required. “However, if it is outright fraud, boards should consider retaining outside counsel to advise them on the proper actions to take,” he says. If the finding of the investigation points to fraud, it will usually lead to termination of those involved.
If there are issues found in executive compensation packages, boards can work with executives to restructure their compensation in line with the company's policy. “In those circumstances, they will amend the package and work with the executive from there,” says Petrasic.
Watanabe says the best method to deal with issues in executive compensation is to practice good internal controls that can make it harder for violations to occur in the first place. “Take it upon yourself to practice good internal controls and implement remedial actions as soon as an issue is identified,” he says.
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