As executive officers return from their summer vacations, many may be suffering from the “Compensation Blues.” No, this isn’t a new “love-gone-bad” heartache captured by Billy Holiday in a ballad you somehow missed. This is a real-life corporate heartache, as painful as any about which Lady Day sang, arising from the ever-widening stock option backdating scandal, and related developments.
The story of backdating stock option grant dates started out badly, but keeps getting even worse. What began as an academic observation about the statistically improbable “luck” of many senior executive officers when it came to stock option grant dates has become the latest “fraud du jour” for regulators, upwardly aspiring state attorneys general and plaintiffs’ lawyers. Approximately 100 companies are said to be facing SEC civil investigations, with many also facing companion criminal investigations.
At last count, 26 public companies have taken, or announced they expect to take, charges against earnings, with many restating—or signaling an intent to restate—past financial results. A surprising number of CEOs, CFOs, GCs and even directors have departed from their companies in the past few months (by no means voluntarily) as a result of the mishandling of options at their companies. Entire forests have been felled as plaintiffs’ lawyers seemingly file new state and federal lawsuits every day.
And, as baseball fans like to say, the hits just keep on coming. In early August, Apple Computer announced it would delay filing its quarterly financial statement and likely will restate financial results for at least four years, as an internal probe uncovered “irregularities” in prior years’ stock option grants. The very next day, $3.7 billion specialty retailer Michaels Stores disclosed its receipt of a grand jury subpoena for documents related to stock options granted since 1990.
The first civil and criminal fraud charges were filed in July against the former CEO and vice president of human resources at Brocade Communications Systems over documents falsified in connection with the grant of what now appear to have been “in the money” stock options, but were treated as “at the money” stock options when they were granted. This action was followed in August by criminal and civil charges against Comverse’s former CEO, CFO and general counsel, who were charged with conspiracy to commit securities fraud, mail fraud and wire fraud. These developments have some senior executives wondering whether they’ll be singing “Jail House Rock” in addition to “The Compensation Blues.” At the least, C-level executives anticipate being consumed by endless conversations with their directors, auditors, and shareholders over compensation issues as they return to their offices.
In the midst of this unfolding scandal, the SEC approved the first dramatic overhaul of existing compensation rules in nearly 15 years. From a disclosure perspective, the new rules require simplified tables that allow easy comparisons across companies, and discussions in plain English on the process, philosophy and approach to executive compensation, as well as disclosure requirements—added at the 11th hour—for greater detail about option granting practices. These requirements give companies a unique opportunity to take compensation out of the hands of consultants and lawyers who’ve developed incomprehensible boilerplate discussions decipherable only by their authors. The proposed Compensation Discussion & Analysis section of the SEC’s new requirements encourages companies to break from the obfuscating practices of the past and disclose the philosophies underlying compensation decisions and the procedures used to implement those philosophies.
Other regulatory bodies are active as well. The PCAOB issued its first-ever Staff Audit Practice Alert on Matters Related to Timing and Accounting for Option Grants in late July, cautioning outside auditors to be alert for improperly accounted stock option grants in the financial statements of their audit clients. On the same day, the IRS advised that its staff is consulting with the SEC’s staff to determine whether dubious stock option award practices at some companies violated various tax laws.
Questions about option granting practices continue. In addition to backdating, there are concerns over the practice of timing option grants to precede favorable news or earnings releases (known as “springloading”), or timing them to avoid unfavorable news events or earnings releases (“bullet dodging”). Unfortunately, determinations concerning these actions will be made ex post facto unless companies were remarkably prescient when selecting their option grant dates and consistently accurate and reliable about documenting their options policies and procedures. Unfortunately, many of the disclosures about option grants have revealed problems ranging from inept record-keeping to outright fraud. As the options backdating fiasco continues and auditors descend en masse—spurred on by the recent PCAOB Staff Audit Practice Alert—it’s imperative for companies to explore their compensation and disclosure practices and to reach their own conclusions before others step in and do it for them.
Although there are valid reasons for concern, and responding to these issues and regulatory pronouncements is daunting, this environment offers a tremendous opportunity for companies to distinguish themselves from those unfortunately enmeshed in this morass. By following a simple plan centered on discovery, disclosure and proactivity, companies can achieve desirable results: carefully considered and well-executed compensation plans that employees, shareholders and regulators can understand and endorse. With sensible compensation policies, increased corporate transparency, and better investor relations, companies will be able to respond successfully to the concerns of their shareholders, not to mention the concerns of the SEC, the Department of Justice and state attorneys general.
The following rules of thumb are designed to address the major issues arising from the stock option grant scandal and requirements contained in the SEC’s new compensation disclosure rules.
The starting point is a careful re-evaluation of every aspect of a company’s compensation philosophy. In far too many companies, compensation is a rote exercise: Their “comparables” are identified, and they then agree to pay their senior executives at least 75 percent of the range of compensation paid by their comparables. But that process, spurred on by compensation consultants and compensation counsel, is responsible for so many of the problems now being addressed by various regulatory agencies. Indeed, even without the SEC’s new compensation requirements, and even in the absence of the current backdating option scandal, companies should have been approaching the process dramatically differently.
To re-evaluate its compensation philosophy effectively, a company first needs a compensation philosophy. Those who view the SEC’s new requirements as merely disclosure rules miss their true significance. The SEC is concerned that companies develop a philosophy for compensating senior executives, create a well-defined process for making appropriate compensation determinations, and finally, disclose both the philosophy and the process. The failure to develop and articulate a serious philosophy will create major problems for companies when it comes time to satisfy the SEC’s new CD&A requirements.
Once a compensation philosophy has been developed, companies should identify the various components of each senior job, the measures for determining successful performance of those components, a method for ascertaining whether compensation has in fact been earned, and the consequences of failure to meet stated job requirements. It should not have taken a corporate compensation scandal, or SEC revision of decades-old rules, to encourage companies to look at compensation for what it really is: a reward for good performance. Shareholders should be told not simply what their officers are being paid, but why, and how.
Companies need to gather all relevant compensation philosophy and procedures information. This includes employment contracts, performance reviews and annual business plans, consulting studies as well as compensation committee meeting presentations and minutes. These documents and policies will be needed to make relevant disclosures, such as change in control provisions. They will also form a basis for the CD&A. Companies will want to avoid drafting a CD&A that contradicts or omits significant provisions of employment contracts.
Companies should create a matrix of the critical data involving their Form 4 disclosures for the past seven years. The matrix should include the beneficiary of the option grant, the number of options, the maturity date, the date of the grant, the exercise price, the stock price close on the date of the grant, and the stock price one week and one month after the grant. Using this information will assist companies in creating a timeline of option grant dates, press announcements and stock prices. Having created such a matrix, it should be examined for any option grants where the strike price is different from the closing stock price on the date of grant, or where there have been significant increases in the stock price after the grant of the options. To the extent anomalies are discovered, all supporting documentation—such as board resolutions or compensation committee minutes—should be reviewed by the board.
Companies need to determine their standards for director independence and then survey independent directors for their compliance with these standards. There are two kinds of independence is this modern era: “regulatory independence” and “independence-in-fact.” The former standard will get companies through various regulatory and statutory hurdles. The latter standard, however, is critical to provide senior management and companies with the protections that come only from having truly independent directors on board. This effort should entail the construction of a list of affiliated companies and companies with enough interrelation to raise concerns.
The procedures and control manual for disclosures surrounding compensation and option grants should be reviewed and updated. Because the CD&A must be included in a company’s 10-K, it is subject to Sarbanes-Oxley Section 302 certification by the CEO and CFO, as well as SOX 404 review of the adequacy of a company’s material internal controls. Company auditors will want to ensure that the process is up to current standards.
An outside expert should review compensation tables and Form 4 matrices for accuracy and completeness. As decisions start to be made, seemingly innocuous and inadvertent mistakes can become catastrophic. Many outsiders, including auditors and regulatory bodies, will be interested in the accuracy of this disclosure. Once questions are raised, it is difficult for a company to distinguish inadvertent oversights from willful misstatements.
The compensation committee and the board each should review drafts of the compensation table, the options grant matrix, the timeline, and the CD&A. This is a company’s opportunity to explain how it manages its most valuable and expensive resource: senior management. While competitive factors play a significant role in compensation decisions, it’s critical to establish a meaningful link between company performance and executive compensation. These drafts should be read as if by an outside investor, the SEC’s enforcement division or, worse yet, a state attorney general.
If internal reviews surface uncomfortable or questionable issues, the board should commission an independent investigation to examine the issues. Appropriate disclosures should be made to keep investors and regulatory bodies abreast of developments.
If the compensation committee or board is uncomfortable with proposed disclosure drafts, appropriate changes in compensation policy should be instituted. Although regrettable, everyone understands that mistakes or oversights occur; compensation may have been determined using a philosophy and procedures with which the board becomes unhappy. If so, rather than ignoring the discomfort, the opportunity should be seized to adopt methods for determining compensation that are more appropriate. Investor confidence will improve if procedures are put in place to prevent similar mistakes or misjudgments from happening in the future.
Improving compensation policies and disclosure now—no matter how labor and time intensive—will help companies and their senior executives, in the long run, avoid having to sing their own off-key rendition of the Compensation Blues.
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