The Do-It-Yourself Backdating Probe

If executives know anything about options timing—now that the Securities and Exchange Commission is insisting on more disclosure and the Justice Department is filing criminal charges—they know that the issue is here to stay.

Scores of companies are under investigation by the SEC and federal prosecutors. Investor advocates like the Council of Institutional Investors and the AFL-CIO are confronting companies directly about possible backdating. Plaintiff lawyers are salivating, lawsuits at the ready.

In that case, legal experts say, you might as well roll up your sleeves and get on with the chore of investigating yourself.

Barth

Not all of Corporate America has reached that conclusion yet. In a recent webcast hosted by the law firm Foley & Lardner to discuss the mushrooming scandal, only 56 percent of participants said they had begun internal reviews to confirm whether or not they had a backdating problem. “That’s a very low percentage,” says Steven Barth, a partner at Foley & Lardner who participated in the webcast. “If companies aren’t asking, their auditors will be asking in the near future. Institutional investors are already on the bandwagon, and it will come up in earnings calls.”

Some people speculate that companies may still be in denial that backdating is improper—or even previously considered the practice a smart idea. “They may have even believed they were acting in the corporation’s interests because they saw it as a way to deliver value to executives in a way that didn’t create an expense for the company,” says Edward Bright, a partner with Thacher Proffitt & Wood. “But really, they were just hiding information from their shareholders. Looked at in a simplistic light, they could rationalize it as a good thing for companies.”

Jack Dolmat-Connell, president of executive compensation consulting firm DolmatConnell & Partners, agrees. “They saw it as a convenient way of winning the war for talent,” he says. “But it didn’t pass the sniff test. People just weren’t paying attention to what they were doing.”

Doing The Cleanup Job

Now that the SEC and institutional investors have companies’ attention, executives should be conducting their own internal investigations, reviewing option-granting policies, and disclosing and correcting any problems, experts advise.

First comes the internal review, where companies should determine whether they have an historical backdating problem. Companies with annual or fixed grant dates have a lower risk than companies with variable or unscheduled grant dates, because annual or fixed grants don’t necessarily correlate to low points in stock value.

Companies that do have variable or unscheduled grant dates should compare board or compensation committee meeting minutes with consent paperwork related to option grants, including SEC filings. Where option grant dates differ from meeting or consent dates, problems may arise.

Barth recommends that companies next do a statistical analysis to determine whether grants typically correspond with low points in the stock price. (He calls it a “mini-Professor Lie analysis,” after Erik Lie at the University of Iowa, who first suggested backdating may be a widespread practice.)

Wirtshafter

John Wirtshafter, a partner with McDonald Hopkins, says his firm tells its clients that if an internal review raises any hint of concern, the best move is to hire an independent firm to investigate. “If there’s any possibility they may have a problem, you hire an outside law firm so it remains confidential,” he says.

What the fallout might be will depend on the severity of the backdating problem, Wirtshafter says. Companies may have to take back benefits that had been granted, disclose concerns to investors and regulators, and possibly even restate financial results.

Finding The Right Path

With the "look back" complete, the next step is to examine option granting policies and procedures to assure problems won’t return in the future. Compensation experts say companies would be wise to end random grants and instead grant options at predetermined fixed points, such as annually, quarterly, or upon hire.

Bright at Thacher Proffitt & Wood goes even further, suggesting that companies set fixed points during their trading windows when it’s presumed that all important information about the company is in the market, typically three days to 10 days after an earnings release.

Bright

“It assures the price you’re using is a price that’s market,” he explains. “By doing it regularly at the same time each quarter, you establish a routine, so when you grant options you’re not playing games with the timing.”

Compensation experts say companies would be wise to end random grants and instead grant options at predetermined fixed points, such as annually, quarterly, or upon hire.

Institutional Shareholder Services encourages blackout periods, similar to those for stock purchases and sales by insiders, when options cannot be granted. The blackouts would cover periods when company executives have material information in hand that is not available to the public.

Experts differ on how companies should handle new hires. Some say companies should retain the flexibility to grant options on the date of hire; others say it’s a bad idea, pointing to current revelations that companies have manipulated new-hire paperwork to mask the true value of in-the-money option grants.

Barth says even new hires should be granted options only in conjunction with board or compensation committee grants. His firm recommends companies set option grants for new employees on a fixed date following the hiring date, such as the first business day of the following month.

Orsagh

Companies also must make timely Form 4 filings to advise the SEC of when options have been granted. “Companies are supposed to report in two days, but hasn’t always been the case,” says Matthew Orsagh, a senior policy analyst with CFA Institute.

Before Sarbanes-Oxley, companies could take as many as 45 days following their year-end close to advise the SEC of option grants, providing plenty of opportunity for selecting grant dates with full market hindsight. Post-SOX, companies are expected to file within two days of granting an option, a requirement that most experts say is routinely overlooked.

Orsagh pointed out that most of the current investigations into backdating are examining options granted when companies had a longer window of time to file. He and others expect regulators will clamp down on timely filing requirements in light of recent developments.