Just when you thought you could sit back and enjoy a financial scandal-free summer, options backdating kept rearing its ugly head. But whether or not the most recent corporate outrage du jour is deserving of the attention it’s received is open to debate.
A few egregious examples have already cost some executives their jobs, and the SEC has hastily issued new disclosure rules for options, adding them to an already fasttracked overhaul of executive compensation disclosure. The backdating issue has cast a long shadow over any company that uses stock options. Many have received requests for information from the SEC, while others have decided to go back and review their options granting practices proactively to make sure there aren’t any skeletons in their own closets.
Technology companies are grabbing the most headlines when it comes to backdating – this is unsurprising, given their heavier reliance on options as compensation – but the issue hasn’t spared any specific industry.
‘Any high-tech company using options has gone ahead and done an internal investigation in the last few months. I think Apple was the one that really brought the issue to mainstream companies and got more people checking into it,’ says Mukund Mohan, CEO of Vangal, a consulting firm specializing in options grants and insider trading forensics.
Delayed filings
One trend that has been exacerbated by options backdating is late filing, which is already on the rise and hit record levels this year. According to proxy research firm Glass Lewis & Co, a record 138 companies with a market cap of at least $75 mn were late filing financial reports with the SEC in the second quarter. That’s up from 120 companies that filed late Q1 reports. A total of 48 companies said they delayed their recent quarterly reports because they were investigating historical options grants.
Take Affymetrix as an example. The California-based biotech firm filed a late 10Q due to the company restating its financials following an internal review into its options granting practices. ‘Given some of the high-profile stories on the backdating of options, our audit committee requested that we go back and conduct a review of the prior ten years of grants,’ says Doug Farrell, VP of investor relations. ‘This review found some minor issues with documentation, particularly around a single grant made in 1999. So there was no contact from the SEC and no accusations of wrongdoing that prompted us to conduct the review. We restated primarily for tax impact purposes.’
Obviously, any filing delay can cause alarm these days – not to mention the threat of delisting. As Affymetrix anticipated, it received a Nasdaq ‘staff determination’ letter indicating that the company was not in compliance with the filing requirements for continued listing. The firm returned to compliance once it filed its current quarter a few weeks later.
Some companies have made unusual choices when faced with a delay. Software giant Computer Associates (CA) was all ready to file its 10K for the fiscal year ending March 31 but found it needed to investigate issues surrounding the timing of options grants and revenue recognition. The solution: CA filed the vast majority of its 10K as an 8K. Investors seemed to react well to CA’s efforts to present as much financial information as possible as soon as possible.
The IR challenge
This is an era of heightened activism and increased scrutiny of corporate governance practices. And let’s face it, the investment community has a heightened sensitivity to any whiff of corporate malfeasance. The backdating issue represents just one more challenge from an IR standpoint.
Each company faces a unique set of circumstances in dealing with backdating and related investigations, however. That’s led to a disparity in opinion on how best to handle the issue when it comes to IR. Basically it’s a question of what to tell investors – and when.
Dell, for example, revealed in August 2006 that the SEC had launched an informal investigation into some of its accounting practices in August 2005. Dell said that in the course of responding to SEC queries it had uncovered some issues that warranted an additional internal audit – issues it declined to discuss. There was some criticism of Dell’s decision not to disclose the SEC’s informal inquiry and its own discoveries when it was first made aware of them.
Some experts caution against going overboard with your disclosure, however, especially with regard to backdating. ‘You don’t want to panic and make too big a deal about it before you know the impact. There’s a fine line between disclosing too much and too little,’ says Mohan. ‘Some companies do not disclose an informal investigation from the SEC, for example, but they do disclose an internal investigation. Typically the disclosure is through a press release or 8K. You want to make sure investors who have a right to know, know.’
Given that Dell is an S&P 500 company and subject to annual review by the SEC because of its size, it’s no surprise that management chose not to disclose the inquiry earlier. But Todd Fernandez, senior research analyst at Glass Lewis, doesn’t necessarily agree the decision was the right one.
‘We are fully in favor of full and upright disclosure. We think companies, while not wanting to set off alarms, open themselves up to further criticism when they do not disclose quickly because it raises the question of whether they were trying to hide something. It is a judgment call, but I would think in Dell’s case, the situation warranted immediate disclosure,’ says Fernandez.
Glass Lewis has a set of questions for clients to pose to companies to gauge the extent of their problems. But as Fernandez notes, with the SEC and Department of Justice now investigating, companies are far less inclined to respond: ‘Investors should be closely scrutinizing these disclosures and focusing on those where there was flagrant abuse, if not fraud.’
Early responder
In contrast to Dell, Redback Networks disclosed everything as it happened when it faced difficulties earlier this year, in a conference call, a press release and a subsequent 10Q. It issued a press release on June 30 announcing an informal request from the SEC for information on its historical options granting practices. It also disclosed that it had received a subpoena from the US attorney for the northern district of California requesting options grant documents. Through its press release, Redback announced that its audit committee had commenced an internal review.
‘The audit committee and some outside counsel and auditors looked at every executive stock option grant and option exercise,’ explains Redback spokesman Doug Wills. ‘We did a comprehensive and exhaustive review, looking at millions of e-mails. After a month or so, we took a conservative approach and published the 10Q with the results of that review. We disclosed that we studied the entire ten-year history of the company. All that was found were a couple of incidents where the paperwork was incomplete – missing signatures, for example.
‘Part of the reason we took the 10Q disclosure route was that the government scrutiny is ongoing,’ Wills adds. ‘But prior to that, management did provide an update in our quarterly conference call and said we expected to complete the review before our
10Q was due. The 10Q was filed a few days late because we wanted to include this information. All along we made an effort to be as transparent and proactive as we could, and we gave that information to investors. We didn’t hide from it. It is very important for us to remove market uncertainty on this issue.’
Repercussions from the initial shock over abuses of options backdating continue, including news that the IRS will look at the tax implications for certain companies – and of course, there are a number of shareholder lawsuits. But nearly all of the problems are historical; between Sox and the new SEC executive compensation disclosure rules, it is now quite hard to abuse the system.
‘For executive officers, it’s really very difficult given the new Section 16 filings and their two-day deadlines. The only real room for abuse is nonexecutive officer grants,’ says Thomas Kellerman, a partner at law firm Morgan Lewis.
As for the companies uncovering problems themselves, the media attention has been unwelcome. But for many, the reaction from investors has not been as negative as they feared. ‘Most of the companies have not had a major issue,’ says Mohan. ‘Looking at those companies that have had problems, the reaction from investors has generally been muted. These companies were open and proactive, and that helped them. Most investors have been fairly savvy in discerning whether the issues involved were fundamental or superficial in each instance.’
The confidence factor
How companies that find significant backdating problems ultimately fare may boil down to one key factor: the investment community’s confidence in management. As Farrell notes, no investor is happy with revelations about delayed SEC filings, but fear is often an overreaction from investors.
‘I think the biggest issue for investors is the credibility of management and intent with regard to backdating,’ he says. ‘We did an exhaustive analysis at the request of our audit committee and identified certain documentation lapses, but did not find any pattern or practice of inappropriately identifying grant dates with hindsight in order to provide ‘discounted’ or ‘in-the-money’ grants.’
Farrell points out that Affymetrix’s options issues were isolated and had to do with mere documentation lapses. ‘This is very different to some of the headline cases in which management actively manipulated stock grants for personal gain and in doing so demonstrated a fundamental lack of integrity,’ he says. ‘The bottom line is that the story on backdating of options needs to be looked at on a case-by-case basis, as the facts of each case can be quite different.’
‘It comes down to how much you trust the management team,’ agrees one sell-side analyst who follows several companies with backdating problems. ‘Some companies have fared worse than others because management was already on shaky ground with investors, but you have to be careful how you disclose things. You have to time it right. I had a company that did a call to discuss backdating, and it was just a disaster; it was held hastily, and management was too aggressive in estimating the impact. In the end, management overreacted to the situation. So you have to be balanced when you deal with investors. It’s a hard thing to do because we all act emotionally.’
