| Through dozens of shareholder derivative actions filed across the country, Schiffrin Barroway Topaz & Kessler, LLP has initiated an extensive campaign against options backdating, seeking not only to hold the directors and officers responsible for their past misconduct, but also to ensure that proper corporate governance reform is instituted so that these practices are finally eliminated. The firm has been appointed as lead or co-lead counsel by courts across the country in some of the most prominent backdating cases. A representative list of the firm’s more high-profile options backdating cases can be found to the left. For more information about these specific cases please contact either Eric L. Zagar, Esquire or Lee D. Rudy, Esquire who co-chair the firm’s Derivative Litigation department.
How do options work?
Stock options are intended to tie the pay of CEOs and other relatively senior level employees to a company’s performance: the value of the options depends on whether the company’s share price rises from the time the option is received by the employee. Stock options give recipients a right to buy company stock at a set price, called the exercise price or strike price. The option usually does not vest for a year or more, and then does not expire for several years after that. The more the stock rises, the more valuable each option becomes.
For example, if an executive is granted a stock option with a strike price of $10 per share, the value of the option one year from now will be the difference between the stock price at that time and $10. If the stock price one year from now is $19 per share, each option will be worth $9 per share. However, if the stock price one year from now is $9 per share, the option will be essentially worthless.
Options are typically granted to executives pursuant to a stock option plan, approved by shareholders, which sets out the total number of shares that may be granted pursuant to the plan, who is eligible to receive options, and how the options are to be awarded. Once the stock option plan is approved by shareholders, the plan is administered by the compensation committee of the board of directors, which approves the individual option grants.
In addition to purportedly aligning managements’ incentives, options also receive favorable tax treatment under § 162(m) of the Internal Revenue Code. Amended in 1993, § 162(m) sought to curb “excessive employee remuneration” by capping corporations’ tax deduction for compensation of the five most highly compensated executives at $1 million per employee. The limit on excessive compensation, however, had one primary exception: performance-based compensation. If the executives’ compensation qualified as “performance-based,” the cost of the entire compensation package could be deducted from the company’s earnings, significantly lowering the corporation’s taxable income.
What is backdating?
Broadly speaking, option backdating is the manipulation of stock option grants so that they are granted at an exercise price that is below the stock’s fair market value on the date of grant. Typically, instead of setting the exercise of the option at the market price on the date of grant, the responsible (or perhaps more aptly named “irresponsible”) party would look back at the stock price over the prior few weeks, months or years, then select a date on which the stock price was particularly low and backdate the option to make it appear as though it was granted on that more favorable date. All things being equal, every dollar gained by the recipient of the option from exercise of the option at a price lower than it should have been, through this manipulative process known as backdating, is a dollar taken from shareholders’ pockets.
What is the problem with backdating?
Of course, options which are granted at an exercise price already lower than the current trading price for the stock hardly serve as “incentive” compensation. Rather, this money clearly qualifies as “excessive” compensation and as corporate “waste.” Directors, such as those sitting on a company’s compensation committee, cannot have adequately discharged their fiduciary duties by agreeing to such a scheme.
More specifically, companies that took part in backdating options likely committed no less than three violations relevant to shareholders. The first such violation involves the false disclosures in the company’s proxy statements that represent that options were granted at fair market value on the date of the grant. A backdated option is not granted at fair market value, but instead at a lower price.
Second, backdating options also underreports the company’s compensation expense, thereby artificially inflating company earnings. Until 2004, the Financial Accounting Standards Board (“FASB”) applied the APB 25 rules to stock options. The APB 25 rules required compensation expense to be reported only if the exercise price of the option grant was less than the stock price at date of grant. Thus, until 2004, as long as the options were granted at fair market value on the date of the grant, a company could grant millions of dollars of options to executives without reducing income by a single cent. However, backdated options, which are granted at less than fair market value, required the company to record a compensation expense for the value of the entire option grant, significantly eroding the company’s net income. Thus, companies that secretly backdated options in the past without recording a compensation expense must now restate their earnings for each year they backdated options to account for the increased compensation expense they never recorded. The company itself, along with members of the company’s audit committee who are charged with overseeing the company’s financial reporting, face liability for failing to ensure an accurate accounting of the company’s compensation expenses.
Third, by backdating options, a company violates the tax laws by improperly deducting the value of the backdated options from its taxable income. Unlike the above-referenced disclosure and accounting violations related to backdating, the improper deduction taken for backdated options will likely lead to an actual cash charge when the company is required to pay back taxes to the Internal Revenue Service (“IRS”). Although the IRS has yet to take a position on the issue of backdated options, it is also possible that companies that backdated their option grants will face fines for failing to pay their taxes on time.
Shareholder litigation is required to root out these improper compensation schemes
Private enforcement of shareholder rights is often the most effective means of seeking redress for corporate malfeasance. This is particularly applicable to the breaches of fiduciary duty implicated in the backdating of stock options.
Each of these harms caused by options backdating constitutes a “derivative” claim by shareholders, which means that such a scheme directly harms the corporation, and thereby indirectly harms the company’s shareholders. Of course, if such conduct leads to a drop in the company’s stock price, these companies may also face liability under the federal securities laws.
More Information
For more information about the work we are doing on behalf of investors in these and other cases please contact Darren J. Check, Esquire at (610) 822-2235 or via e-mail at dcheck@sbtklaw.com. |
