A recent study of stock option disclosures and stock prices suggests that some companies may have committed instances of backdating into the current fiscal year, contradicting the widespread belief that backdating largely ended in 2002 with the passage of Sarbanes-Oxley Act.
A handful of companies included in the recent study, conducted by proxy research firm Glass, Lewis & Co., have disclosed that they are cooperating with the Securities and Exchange Commission and conducting their own investigations to determine whether their tardy Form 4 filings and corresponding spikes in stock prices would suggest backdating has occurred.
Form 4 is the “statement of changes in beneficial ownership” filing required by the SEC anytime a director or officer buys or sells stock in his own company and is the same form used to disclose awards of stock or options. Until Sarbanes-Oxley, companies had weeks after an option grant to submit any Form 4 filings, but SOX reforms cut the filing deadline to just two days following a reportable event.
Glass Lewis studied thousands of late Form 4 filings from 2004 through mid-2006 and issued a report asserting that it had identified “hundreds” of instances where late filings corresponded with surges in stock prices. “In our view, such fact patterns raise questions about whether the grants may have been backdated,” senior research analyst Todd Ferenandez wrote.
“It’s not definitive that companies with late filings that show an increase in stock prices have backdated, but it creates the possibility for that,” Ferenandez told Compliance Week after the study was published.
Fernandez says Glass Lewis studied about 6,000 filings that were at least two weeks overdue and found that the stock prices related to those companies increased an average of 6 percent from the reported grant date to the actual filing date.
Fernandez acknowledges that the late filings and the increasing stock price aren’t direct evidence of backdating. Still, he says, the research process included another important step that raises the bar of suspicion: The study drew a distinction between officers and directors, and found that for option grants made to officers—whom Fernandez contends have more opportunity to manipulate paperwork—the corresponding increase in stock price was greater than the overall average. If director grants are excluded, the average increase in stock price jumps from 6 to 7.2 percent, he explains.
“That indicates that if this was something random or all tied to administrative errors, you would expect those numbers to be fairly close together,” he says.
Difficulty In Deadlines
The Glass Lewis report identified nine companies where it viewed the strongest pattern of tardy filings related to officer grants and a corresponding increase in stock price. The report emphasizes that drawing definitive conclusions that backdating has occurred at these companies is impossible without access to the companies’ internal records.
The nine companies include Children’s Place Retail Stores, Hansen Natural Corp., and Silicon Image—all of which have disclosed SEC inquiries into their stock option granting practices and have begun internal reviews as well. A Children’s Place spokesman told Compliance Week: “The Children’s Place is committed to resolving these issues as quickly as possible and will update the market as appropriate.”
OPINION
Excerpts from the SEC Chief Accountant Conrad Hewitt’s letter discussing accounting issues related to options grant practices follow.
This letter expresses only the views of the Office of the Chief Accountant on accounting issues related to Opinion 25, and its limited application should not be extended by analogy or relied upon in any other circumstances. Certain option granting practices might raise legal or regulatory issues. It should be noted that the views presented herein are limited to the ramifications of these questions to the financial statements (including the footnotes thereto), and that this letter does not address how these questions might affect disclosures outside of the financial statements or the circumstances under which any of these practices could violate laws or regulations. Of course, any analysis will be heavily dependent on the particular facts and circumstances of each company, and evidence of fraudulent or manipulative conduct would require different or additional analysis.
As can be seen from the views expressed in this letter, the staff believes that many of the issues that have been raised in public disclosures or uncovered in reviews of option granting practices resulted in the grant of in-the-money options and accordingly do have an accounting consequence under Opinion 25. On the other hand, there may also be situations where an at-the-money grant was actually decided with finality, but there were unimportant delays in the completion of administrative procedures to document the grant that did not involve misrepresentation of the option granting actions. In those situations, if compensation cost would not have otherwise been recorded pursuant to Opinion 25, short delays in completing the administrative procedures to finalize the grant would not result in an accounting consequence.
The staff’s views are presented in several sections. In the discussion regarding each issue, we briefly describe the issue and the application of the applicable accounting guidance. For ease of discussion, each section of the letter addresses a particular question or issue on its own, and implicitly assumes no other issues exist. That is, we have not attempted to provide specific discussion on all possible combinations of issues that might arise.
H. Timing of Option Grants
Some companies appear to have engaged in techniques to select their award dates in coordination with the disclosure of information to the public. For example, a company may have granted stock options while it knew of material non-public information that was likely to result in an increase to the stock price. Alternatively, a company may have delayed the grant of options until after material information that was expected to result in a decrease to the stock price was issued. To the extent such practices were used, questions have been raised as to whether an adjustment would be necessary to the market price of the stock at the measurement date for the purpose of measuring compensation cost. Pursuant to paragraph 10(a) of Opinion 25, the staff believes that compensation cost must be computed on the measurement date by reference to the unadjusted market price of a share of stock of the same class that trades freely in an established market.
I. Changes to Option Grants Due to the Release of New Information
The staff is aware that some companies may have changed the terms of previously granted awards due to the release of new information to the public. For example, a company may have granted options to employees at one date, subsequently released information to the public that caused the stock price to decline, and lowered the exercise price of the previously granted options to the market price immediately following the release of the unfavorable news. In that circumstance, the staff believes a repricing of the award has occurred. Variable accounting should therefore be applied to the option from the date of modification to the date the award is exercised, is forfeited, or expires unexercised.
Source
Securities & Exchange Commission’s Office Of The Chief Accountant’s Letter (Sept. 19, 2006)
Websense, another company targeted in the research report, says the company’s audit committee and management have reviewed its grants with outside attorneys and outside auditors and have concluded they are compliant with Generally Accepted Accounting Principles.
“Although we did file Form 4s late for two sets of officer grants, we disclosed our error as soon as we realized it,” Websense spokesman Cas Purdy says. “We have full documentation, including signed compensation committee meeting minutes, support the grant dates, and the grants were appropriately included in our share counts and earnings per share calculations.”
Edward Bright, a partner with the law firm of Thacher Proffitt & Wood, says clear conclusions are difficult to make from the research. “With the new filing requirements there is a high volume of Form 4 filings that are done quickly. Mistakes are made and forms are filed late,” he cautions. “The SEC pays attention to them and takes enforcement action against chronic and egregious late filings, but you can’t rely on the SEC to assure every form gets filed on time.”
Dow
The challenge for many companies is simply getting the paperwork done and filed on time, says Robert Dow, a partner with the law firm Arnall, Golden & Gregory. “It raises questions about companies’ disclosure controls and whether they have systems in place to make sure the filings get done on time,” he says.
Bright and Dow both say a disconnect often exists between the people who manage or oversee reportable events (such as a compensation committee granting stock options) and the people who are responsible for reporting those events (the company’s accounting or financial reporting staff).
“The only thing companies can do is have someone physically present when reportable decisions are made who’s responsible for getting the information reported,” Bright says. In the case of option grants, for many companies that means having outside advisers attend compensation committee meetings.
Bright
“And there’s a cost to that,” Bright notes. “Companies have to decide where the cost-benefit breakpoint [is] in terms of spending more money on compliance to get a little better at it. A lot of companies are concluding that spending to become perfect on compliance may be cost prohibitive.”
Still, Bright and Dow agree the Glass Lewis findings are worth a closer look by regulators.
“A fair argument can be made in the case of occasional late filings that they are the result of inadvertence or something falling through the cracks,” Bright says. “But if a company is chronically late with respect to options and not other transactions, it raises a legitimate question.”
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