Institutional Investors Voice Backdating Ire

Institutional investors are turning up the heat on companies to determine whether their past compensation practices skidded into the murky waters of backdating stock options, even as regulators vow their own scrutiny and still more executives find themselves either under investigation or on the unemployment line.

Earlier this month, CalPERS, the largest U.S. public pension fund with more than $200 billion in total assets, sent a letter to 25 companies under investigation by the Securities and Exchange Commission. The letter listed seven recommendations for directors, including that they conduct independent investigations into backdating allegations, publicly disclose all findings from both internal and external probes, and develop and disclose in their financial and proxy statements a new board policy for the determination of all option grant dates (see box at right for the letter).

Likewise, the Council of Institutional Investors, an organization of more than 140 public, corporate and union pension funds with more than $3 trillion in investments, sent a letter to board chairmen at 1,500 companies inquiring about how they determine the timing of option grants, whether the boards are reviewing option granting practices, and whether those practices are under investigation by any federal law enforcement agency.

“Council members are interested in knowing your company’s policy for setting the timing of stock option grants, including whether the board allows executives to have any role in choosing the grant date.”

— The Council of Institutional Investors' letter to 1,500 companies.

“The Council believes that except in extraordinary circumstances, long-term incentive awards of options should be granted at the same time each year,” the June 12 letter said. “Council members are interested in knowing your company’s policy for setting the timing of stock option grants, including whether the board allows executives to have any role in choosing the grant date.”

At press time, CII Deputy Chairman Amy Borrus said the Council had not yet received any responses to the letter. She said CII plans to send a letter to the SEC asking the agency to address the issue in its rulemaking.

The SEC appears happy to oblige. The Commission has promised to address backdating concerns in forthcoming rules on executive compensation disclosure, which are expected later this summer. As Compliance Week previously reported, SEC Chairman Christopher Cox said the proposed rule “will provide better and more useful disclosure of the backdating of options” and would require that a company “clearly identify the portion of compensation that results from ‘in-the-money’ option awards resulting from backdating.”

The proposed rule will also require the disclosure of the full value of an option based on the date the award was actually made, so the added value from an option’s being in-the-money at the time of grant would be clearly disclosed. The rule would also require that the exercise price of an option be compared to the market price on the day the option is granted whenever the exercise price is below market value, so investors can see the additional compensation conferred by the options given, Cox said.

Cox

Cox said the Division of Corporation Finance staff will make a recommendation to the Commission at an open meeting “soon” about the precise language of the rule. “We want this matter settled in time for next year’s proxy season, and I have every reason to expect that it will be,” Cox said.

CalPERS, for one, cheers the SEC’s moves. “The problems related to stock option backdating is a job that the SEC needs to address and we are encouraged by Chairman Cox’s remarks,” spokesman Brad Pacheco says. “Stock option backdating potentially threatens the performance of companies and will erode shareowner value.”

More Casualties

Dunne

The latest victim in the widening backdating scandals is Thomas Dunne, founder, chairman and former chief executive officer of SteelCloud. Dunne resigned from the IT services company’s board last week following an internal investigation into the company’s option practices.

According to a SteelCloud statement, Dunne’s resignation was in response to the results of an investigation by the audit committee “relating to matters associated with the attempted exercise of certain employee stock options owned by Mr. Dunne.” SteelCloud said the matter was discovered through operation of its internal controls and procedures, and resulted in no direct financial loss nor had any direct effect on its financial statements. Dunne has denied any wrongdoing.

EXCERPT

Below is an excerpt from AFL-CIO Secretary-Treasurer Richard Trumka's letter to Countrywide Financial, urging its compensation committee to investigate possible options backdating.

Like backdating, the timing of stock option grants based on inside information is unfair to shareholders. Union-sponsored pension funds hold approximately $400 billion in assets, and are significant shareholders of Countrywide. I urge the Compensation Committee to review Countrywide’s stock option grant procedures and controls and to disclose to shareholders if any stock option grants were improperly timed.

Countrywide should also adopt new stock option safeguards to protect shareholders. For example, stock options should only be granted on a predetermined schedule, and no less than 30 days from earnings announcements. The Compensation Committee should set stock option grant dates independently of company executives, and directors should not receive option grants at the same time as company executives.

Lastly, I urge you to consider using other forms of executive compensation that are less subject to improper manipulation. For example, many companies have replaced executive stock options with shares of stock that require the achievement of performance goals as a prerequisite to vesting. These performance shares combine the goals of pay-for-performance with increasing executives’ direct share ownership. Compared to stock options, the value of performance shares is also less dependent on grant date timing.

Source

AFL-CIO (June 13, 2006)

Also, the AFL-CIO sent a letter to the chairman of the compensation committee at Countrywide Financial expressing concern over the timing of stock option grants to Countrywide executives. Richard Trumka, secretary-treasurer of the powerful labor group, cited a report by The Corporate Library that showed that Countrywide Chief Executive Officer Angelo Mozilo received option grants within 30 days of the issuance of a press release that was relevant to the company’s share price.

Trumka

Trumka urged the compensation committee to review Countrywide’s option grant procedures and controls and to disclose to shareholders if any stock option grants were improperly timed. In addition, the letter recommended that Countrywide grant options only on a predetermined schedule and no less than 30 days from earnings announcements, that grant dates be set by the compensation committee independently of company executives, and that directors not receive option grants at the same time as company executives.

Trumka also urged the company to consider using other forms of executive compensation “that are less subject to improper manipulation,” such as shares of stock that require the achievement of performance goals as a prerequisite to vesting.

Dozens of other companies are now under investigation by the Justice Department, the SEC, the IRS or local U.S. attorneys for possible backdating. Numerous companies have pre-emptively announced their own probes; just last month IT security giant McAfee fired its general counsel for “improper” options practices in 2000 that turned up after an internal probe.

While much of the focus has been on whether companies backdated grants to periods when their companies’ stock prices were lower to provide profits for executives, the SEC is also looking into possible instances of so-called spring-loading—the practice of purposely scheduling a grant ahead of expected good news or after the disclosure of business setbacks that are likely to send shares lower, to increase value for recipients.

The Los Angeles Times quoted Cox as saying the Commission will be “very interested in both kinds of spring-loading.”

Grassley

Lawmakers have also called on the Justice Department to prosecute executives found to have manipulated stock option grants. During a June 13 hearing on corporate tax issues, Senate Finance Committee Chairman Chuck Grassley (R-Iowa) said he hopes the Justice Department and the SEC “are taking a hard look” at the practice of backdating.

“I’ve asked the Justice Department to let me know whether the tax laws on the books are adequate to rein in and prosecute stock option backdating,” Grassley said. “If the tax laws are inadequate, I want to beef them up.”

Grassley said he was “glad” Justice officials made it clear that executives can face possible prison time for backdating stock options and said he expects the Justice Department to “fully enforce the law in all of these areas.”

Related resources and coverage can be found in the box above, right.