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It has been difficult to pick up a newspaper or listen to broadcast business reporting recently without hearing of yet another company caught in the expanding web of investigations and inquiries into the timing and alleged manipulation of stock option grants. Companies that appear to have repeatedly issued options to top executives just prior to a run-up in the stock price or at the very bottom of a steep dip are coming under increasing government scrutiny. The concern is that companies have either back-dated stock options to benefit executives or have otherwise manipulated corporate decision making to benefit executives over shareholder interests.

There are currently more than 50 major companies in a range of industries under some sort of scrutiny for their options practices. Some of them have explicitly acknowledged significant accounting issues, others have responded by making personnel changes, and others are still trying to evaluate their situations. Many of the companies currently under investigation appear to have a statistically significant history of granting options at times particularly advantageous to the option holders, such as repeatedly granting options at or near the bottom of an annual low in the stock price. Regulators are looking for unusual patterns of options being granted just before a sharp rise in price or near the bottom of a steep dip.  

What’s the Crime?: Potential Legal Theories

It remains unclear whether back-dating option grants is illegal per se. And given the fact that the Securities and Exchange Commission and Department of Justice are just beginning to focus on this issue, those authorities have not yet articulated the legal theories on which they intend to proceed against companies and individuals alleged to have been involved in the manipulation of option grants. There are several different theories of potential liability that could have significant financial and legal repercussions for a company, its executives and even lower ranking individual employees.   

To date, government investigations appear to be focused on grants of stock options to executives where the date of grant precedes the date on which the grant is properly approved by the company’s board of directors. This practice results in option grants that have exercise prices that are lower than the fair market value of the underlying stock on the date of board approval and, therefore, are of greater value to the option recipients. Among the practices that might constitute stock option back-dating are the following:

• selecting an effective date that is earlier than the date the grant is made;
• retroactively changing the date of grant to a later date; or
• altering the date of a resolution of the board or the award agreement.

In addition to back-dating, other stock option practices that are facing increased scrutiny include:

• option grants to newly hired executives that are timed in order to secure a low exercise price; and
• option grants made immediately prior to the public release of positive information that permit executives to capture the increase in stock value.

Back-dating of stock options raises a number of accounting, tax and legal issues, including the following: 

Accounting Issues. Until recently, companies were not required to record any compensation expense with respect to option grants made at fair market value. Options granted with an exercise price lower than fair market value on the date of grant resulted in compensation expense to the company. As a result, companies that discover that options have been back-dated may be required to restate financial statements in order to reflect additional compensation expense and reduced earnings.

Tax Liability. Option back-dating may result in increased personal tax liability as well as the loss of tax deductions on the part of the company. If the exercise price of an option is less than the fair market value on the date of grant, holders of options that were not vested as of January 1, 2005 or were materially modified after October 3, 2004 could be subject to a 20% tax (in addition to ordinary taxes) and other penalties under the federal tax code’s new rules on non-qualified deferred compensation. Back-dating stock options that are intended to be incentive stock options (ISOs) to a date with a lower exercise price would cause the favorable capital gains tax treatment of such options to be lost. In addition, the corporate tax deduction permitted to companies upon the exercise of a back-dated option may be reduced or eliminated with respect to options granted to senior management of publicly-traded companies. As an example, HealthSouth has reported $346 million in realized option gains for its five top-paid executives from 2003-2005 that may not be deductible by HealthSouth. It also acknowledges another $2.4 billion in unrealized, exercisable option gains that may also not be deductible. Assuming a federal corporate tax rate of approximately 35% over the last three years, the tax savings to HealthSouth on the exercised options, if deductible, could have been as much as $120 million for the tax years 2003-2005, with another potential $800 million expected on as-yet unexercised options.

False or Misleading Disclosures. The reporting company and its compensation committee make disclosure in the company’s SEC filings regarding the company’s stock option grants and compensation policies and practices. If a company discloses that stock option grants have been made at fair market value or describes a compensation policy of granting stock options at fair market value when, in fact, options have been back-dated to have an exercise price that is lower than fair market value, the company’s SEC filings may be found to be false or misleading in violation of the federal securities laws.

Insider Trading. If company executives know of information that is likely to cause an increase in the company’s stock price and take steps to cause options to be granted to the executives prior to the public announcement of the information, the executives may be accused of profiting from inside information. It is at least possible that prosecutors would argue that exercising an option that was granted as of a date other than the actual grant date based upon non-public information would constitute the purchase or sale of a security on the basis of material non-public information, which is a violation of the insider trading laws.

What Actions Should Companies Take Concerning Stock Option Practices?

Executives and boards of directors are well advised to understand clearly and thoroughly the potential legal consequences of past stock option practices and to review and update their stock option policies accordingly. The government’s legal theories of wrongdoing are only beginning to emerge, and there are subtleties and assumptions that may have serious consequences for a company.

Companies should review their stock option policies and practices with legal counsel to determine whether current practices raise concerns.

If there are concerns regarding a company’s past stock option practices, it should contact its legal counsel to discuss these issues and to determine whether a more formal investigation should be initiated.  Investigations into executive compensation matters, including stock option grants, often involve conflicts of interest between the company and its management. Consequently, management should consult legal counsel about whether a special committee of the board of directors should be formed to oversee any internal investigation. In all cases, the company’s audit committee should be informed of any practices that may result in liability to the company or its management.

This advisory was prepared by the firm's Government Investigations and White Collar Defense practice group.  For more information please call your attorney contact at Nutter, at (617) 439-2000.

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances.  Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.