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A Hot Date with the SEC
A probe by the U.S. Securities & Exchange Commission has dragged several electronics companies onto the carpet for allegedly backdating stock-option grants. So far, only a handful of companies are involved publicly, but some accounting experts believe that the probe could eventually involve scores of high-tech companies.
Although the SEC does not discuss ongoing investigations, the probe appears to be targeting several issues. Options grants typically require approval by a corporation's board of directors or compensation committee. The grant date is supposed to be the date of that approval, and the price is normally based on the closing price of the previous trading day, says Paul Dorf, managing director of consultancy Compensation Resources. But companies allegedly had retroactively dated some grants—that is, reported that the grants were approved earlier than they actually had been—to benefit from a rise in the stock price that predated the approval. The SEC also appears to be examining companies' practice of timing grants to take advantage of pending good company news that they expect will raise the share price. Although this practice may not be illegal, the agency is examining whether companies are properly disclosing it.
The probe came to light in late 2004, when Analog Devices reported that the SEC was investigating its options-granting practices. Then a trickle of announcements from other companies throughout 2005 indicated that the investigation continues and may be heating up:
- In May, Brocade Communications Systems announced that it would restate financial results for the last three years to account for stock-based compensation, higher than previously reported, resulting from incorrect grant dates. The company also said that the Department of Justice and the SEC were jointly investigating its stock option granting practices.
- In early November, Mercury Interactive announced that its CEO, CFO and general counsel had resigned in light of the findings of a special committee the company had formed in response to an SEC inquiry about backdating of option grants. The committee found 49 instances of grant date manipulations between 1995 and the present. The company is restating its financial results.
In mid-November, Analog Devices announced a tentative settlement with the SEC regarding the company's option grant practices. Under the proposal, the company would pay a civil penalty of $3 million and would reprice options granted to CEO Gerald Fishman and other directors in certain years. In addition, Fishman would personally pay a $1 million civil penalty and would make a disgorgement payment. Disgorgement typically means to pay back to the company any ill-gotten profits. Maria Tagliaferro, Analog Devices' director of corporate communications, would not provide any further details on any disgorgement, noting that final details were still to be determined. Under the proposed settlement, Analog would neither admit to nor deny the SEC's findings.
Most of the backdating seems to have taken place at the height of the tech boom, from the mid-1990s through 2001. Until the Sarbanes-Oxley Act, companies were allowed weeks or even months before they were required to report options grants. But the new law, which took effect in 2002, reduced the time between the granting of options and the reporting of those grants to the SEC to two days, dramatically reducing the potential for companies to manipulate grant dates. What's unknown, however, is how many companies may have participated in this practice during the height of the tech boom and how many the SEC is going after. Erik Lie, an associate professor at the University of Iowa whose research helped prompt the SEC probe (see the sidebar, "Academic Research Shines Light on Grant Backdating"), says he's heard that 30 to 40 high-tech companies are under investigation.
Experts say that companies are getting nabbed not for the backdating itself but rather for reporting inaccurate dates and numbers in SEC filings. (Lie likens it to the Martha Stewart case: Stewart didn't get convicted of insider trading but, rather, of lying about it afterward.) First, there is the SEC's 10b5 rule, which says a company can't file false documents, according to David Yermack, associate professor at New York University's Stern School of Business. Including incorrect grant dates in company filings would violate this rule. What's more, if the options are in the money, that would affect the expense a company must deduct from its earnings in financial reports. With backdating, "you've effectively granted a discounted option," says Alan Dye, a securities attorney and a partner at law firm Hogan & Hartson. That's why both Brocade and Mercury are restating their financials. (Analog Devices said in its press release that it would not restate financial results, because the changes caused by the revised dates were not material.)
 A probe by the U.S. Securities & Exchange Commission has dragged several electronics companies onto the carpet for allegedly backdating stock-option grants. So far, only a handful of companies are involved publicly, but some accounting experts believe that the probe could eventually involve scores of high-tech companies.
Although the SEC does not discuss ongoing investigations, the probe appears to be targeting several issues. Options grants typically require approval by a corporation's board of directors or compensation committee. The grant date is supposed to be the date of that approval, and the price is normally based on the closing price of the previous trading day, says Paul Dorf, managing director of consultancy Compensation Resources. But companies allegedly had retroactively dated some grants—that is, reported that the grants were approved earlier than they actually had been—to benefit from a rise in the stock price that predated the approval. The SEC also appears to be examining companies' practice of timing grants to take advantage of pending good company news that they expect will raise the share price. Although this practice may not be illegal, the agency is examining whether companies are properly disclosing it.
The probe came to light in late 2004, when Analog Devices reported that the SEC was investigating its options-granting practices. Then a trickle of announcements from other companies throughout 2005 indicated that the investigation continues and may be heating up:
- In May, Brocade Communications Systems announced that it would restate financial results for the last three years to account for stock-based compensation, higher than previously reported, resulting from incorrect grant dates. The company also said that the Department of Justice and the SEC were jointly investigating its stock option granting practices.
- In early November, Mercury Interactive announced that its CEO, CFO and general counsel had resigned in light of the findings of a special committee the company had formed in response to an SEC inquiry about backdating of option grants. The committee found 49 instances of grant date manipulations between 1995 and the present. The company is restating its financial results.
In mid-November, Analog Devices announced a tentative settlement with the SEC regarding the company's option grant practices. Under the proposal, the company would pay a civil penalty of $3 million and would reprice options granted to CEO Gerald Fishman and other directors in certain years. In addition, Fishman would personally pay a $1 million civil penalty and would make a disgorgement payment. Disgorgement typically means to pay back to the company any ill-gotten profits. Maria Tagliaferro, Analog Devices' director of corporate communications, would not provide any further details on any disgorgement, noting that final details were still to be determined. Under the proposed settlement, Analog would neither admit to nor deny the SEC's findings.
Most of the backdating seems to have taken place at the height of the tech boom, from the mid-1990s through 2001. Until the Sarbanes-Oxley Act, companies were allowed weeks or even months before they were required to report options grants. But the new law, which took effect in 2002, reduced the time between the granting of options and the reporting of those grants to the SEC to two days, dramatically reducing the potential for companies to manipulate grant dates. What's unknown, however, is how many companies may have participated in this practice during the height of the tech boom and how many the SEC is going after. Erik Lie, an associate professor at the University of Iowa whose research helped prompt the SEC probe (see the sidebar, "Academic Research Shines Light on Grant Backdating"), says he's heard that 30 to 40 high-tech companies are under investigation.
Experts say that companies are getting nabbed not for the backdating itself but rather for reporting inaccurate dates and numbers in SEC filings. (Lie likens it to the Martha Stewart case: Stewart didn't get convicted of insider trading but, rather, of lying about it afterward.) First, there is the SEC's 10b5 rule, which says a company can't file false documents, according to David Yermack, associate professor at New York University's Stern School of Business. Including incorrect grant dates in company filings would violate this rule. What's more, if the options are in the money, that would affect the expense a company must deduct from its earnings in financial reports. With backdating, "you've effectively granted a discounted option," says Alan Dye, a securities attorney and a partner at law firm Hogan & Hartson. That's why both Brocade and Mercury are restating their financials. (Analog Devices said in its press release that it would not restate financial results, because the changes caused by the revised dates were not material.)
But a potentially bigger issue is that executives may not have paid personal income taxes on the profits they collected as a result of the backdating, says Yermack. "If I were one of these people, I'd be worried about the tax issues," he says. There may also be tax problems for the companies themselves, says Lie. Neither the companies nor the regulators have said anything publicly about taxes.
The SEC is also looking at the practice of timing grants to benefit from positive corporate news. Such a practice is not necessarily illegal, says Dye. "If there is material news and the company grants the options before that news is released, is that a violation? Most lawyers say it isn't," says Dye, calling it just another way of giving executives a bonus. The executives would not be trading on insider information, because both parties—the executives and the compensation committee—are aware of the same information.
Where companies can get into trouble with the practice, however, is in disclosure. "If your practice is to target dates when good news is pending, that should be disclosed, because that's essentially a compensation program," says Dye. That is one of the issues in the Analog Devices case. According to the company, the proposed settlement would conclude that Analog Devices should have made disclosures in its proxy filings, explaining that it had priced certain options prior to releasing favorable financial results.
In light of the probe, companies should review both their options-granting practices and their disclosure practices with their corporate counsel. But experts differ on whether companies should bring any irregularities to the attention of the SEC. The SEC may just be seeking to make an example of a few companies, so companies might just "let sleeping dogs lie," says Dorf. But Yermack believes that companies would be better off admitting to the practice. If they do, he says, "I would expect a lot of voluntary restatements when companies start coming out with their annual reports in the first quarter of this year."
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