The Backdating Bite At This Year’s Meeting

Sneaking improperly dated stock option grants into the financial statements may now be a thing of the past, but such abuses are still top of mind—particularly for proxy-advisory firms and institutional investors—as the 2007 proxy season approaches.

Backdated options are just one item on a long list of compensation-related issues proxy firms and institutional investors are watching this proxy season. While the scandal may have exploded in 2006, it still wears on company and investor alike today in a steady stream of news about internal investigations, criminal and regulatory probes, restatements, and executive departures. The most egregious cases of options-related abuses have also cast doubt on corporate boards, as institutional investors raise questions about those who failed to prevent the problem.

While companies “are beginning to address the issue,” says Dan Pedrotty, director of the AFL-CIO Office of Investment, “The other shoe hasn’t dropped yet. More remains to be seen on this issue from a lot of companies.”

The Securities and Exchange Commission is examining the option grant practices of more than 130 companies. In addition, the Department of Justice is said to be probing at least 50 companies, and the number of companies quietly conducting internal investigations is anyone’s guess.

“We’re unnerved by the continuing drip of revelations about options abuses,” says Amy Borrus, deputy director at the Council of Institutional Investors, an organization of more than 140 public, corporate, and union pension funds with more than $3 trillion in investments. “It seems like every time you turn around, some new options abuse comes to light.”

As companies work to resolve their backdating issues, proxy-advisory firms and large institutional investors are paying close attention to how corporate boards are responding. At least two proxy-advisory firms, Egan-Jones Proxy Services and Institutional Shareholder Services, have updated their policies and voting guidelines this year to take a tougher stance toward directors at companies that have disclosed backdating problems.

Egan-Jones, for example, will examine companies on a case-by-case basis and recommend “withhold” votes for directors or the chief executive officer when it deems necessary. The advisory firm will consider factors such as the intent, scope and timing of the practice, the significance of any restatement required, and any corrective action taken.

“We’ll have a watch list of companies identified as having a problem, and we’ll look at them case-by-case to see what they’ve have done,” managing director Kent Hughes tells Compliance Week. “It’s disturbing to see how widespread a practice it’s apparently been.”

Still, Hughes is optimistic that most companies will have addressed their problems by the time the annual meeting season starts later this spring. “By the time their meetings come around, I think—and I hope—a lot of companies will have taken actions that we can comment on favorably,” he says.

Among other changes, Egan-Jones will generally favor “responsible proposals” calling for more use of performance-based equity in compensation plans. That won’t include conventional stock options, but will include such tools as indexed options, restricted stock, performance-contingent options, and premium-priced options.

ISS Updates Position On Backdating

ISS also has updated its policy position on options backdating for 2007. Like Egan-Jones, it has adopted a case-by-case approach; where backdating occurred, ISS may recommend withholding votes from the compensation committee, depending on the severity of the practices and remedial actions by the board.

In recommending withhold votes from committee members who oversaw questionable grant practices or from current committee members who fail to respond proactively, ISS says it will consider several factors, including the reason and motive for backdating; the length of time; the size of any restatement; corrective actions by the board or compensation committee; and the adoption of a policy that prohibits backdating and creation of a fixed grant schedule or window period for equity grants going forward.

Meanwhile, institutional investors continue to press companies for information—and action—on options-timing issues.

Gozan

Amalgamated Bank Longview Funds, which filed shareholder proposals last September seeking to reform option grant practices at six companies where backdating was alleged, has since filed the proposal at a seventh company and plans to add an eighth to the list, says Julie Gozan, vice president and director of corporate governance.

“We’re in active negotiations with half of those companies,” Gozan says. Amalgamated, which recently filed the proposal at Semtech and plans to file it this month at McAfee, may also consider further filings, says Gozan.

The proposals, first filed at Analog Devices, Apple Computer, Brooks Automation, Macrovision, Progress Software, and Sanmina-SCI, ask the companies to adopt a fixed date or dates for making option awards that will be announced before a fiscal year begins, with an exception for awards to executives recruited from the outside, provided that the strike price isn’t linked to the release of material, nonpublic information that could affect the stock price.

“We’re unnerved by the continuing drip of revelations about options abuses … It seems like every time you turn around new abuses come to light.”

— Amy Borrus, Deputy Director, Council Of Institutional Investors

CII, which had a policy opposing backdating, added new language to its corporate governance policies that specifies that “stock options should never be backdated” and approved a policy change on grant-timing at its September 2006 member meeting, Borrus says.

Last June, CII sent a letter to board chairmen at 1,500 companies inquiring about how they determine the timing of option grants, whether boards are reviewing option grant practices, and whether those practices are under investigation by any federal law enforcement agency. To date, the Council has received 225 responses, says analyst Cambria Allen.

“We’re very gratified by the volume of responses,” Borrus says. “It does seem that most companies have reasonable option granting policies and seem to grant options at the same time every year.”

Cambria says 77 companies recently have begun, or are in the process of, reviewing their option granting practices. Most either conduct reviews of their grant practices at regular intervals or conducted a review in light of the recent press coverage. Another 23 companies don’t currently grant options as part of executive compensation.

Among those responding to CII’s letter, 148 companies grant options annually, three grant options semiannually, and three others time grants annually on pre-scheduled intervals following an earnings release. Twelve companies allow their boards or compensation committees to choose the dates on which options are granted, while six grant options at regularly scheduled meetings of the compensation committee.

AFL-CIO Looks To Auditors Concerning Options Timing

Meanwhile, the AFL-CIO, which has had discussions with some companies it contacted last year about options timing issues, has also turned its attention to their auditors. The AFL-CIO sent out several options-related letters in 2006, including one that went to eight companies identified by The Corporate Library, a governance watchdog group, as having opportunistic timing of CEO option awards. Three companies responded.

The labor group also called on the compensation committee chairs of six companies to explain questionable post-9/11 option grants. Pedrotty says the AFL-CIO had a discussion with one company in that group, Teradyne. Only Merrill Lynch has responded in writing.

Last September, the AFL-CIO sent a letter sent to the Big 4 audit firms asking what role they may have played in backdating, what steps they’re taking to determine their involvement in backdating where it occurred, and what steps they’re taking to help clients implement guidance from regulators to clear up murky financial statements now. Pedrotty said his group has met with PricewaterhouseCoopers and Ernst & Young and will meet with KPMG next month.

Another institutional investor keeping an eye on backdating is CalPERS, the nation’s largest pension fund, which sent a letter to 69 equity portfolio companies identified as under investigation by the SEC. As of Dec. 18, 2006, CalPERS received 40 responses, according to a report by its corporate governance staff to the CalPERS board’s investment committee. The letter included several recommendations for directors, including that they conduct independent investigations into backdating allegations, publicly disclose all findings from 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. CalPERS says it expects to contact additional companies on the issue.