| In April of 1998 Cendant disclosed a restatement of | | | | interests of shareholders - but rather in what I'd call |
| 1997 results, including a reduction in net income of $ 100 | | | | 'boardroom atmosphere.' Board membership requests |
| million due to various accounting irregularities. Then on | | | | are being declined in record numbers due to the |
| July 14, 1998 Cendant announced a further | | | | perception of risk of being a director in this |
| restatement of financial results for 1995, 1996 and 1997, | | | | environment. However, corporate governance |
| including all quarters due to recognition of fictitious | | | | provisions are being taken much more seriously and |
| revenues and cookie cutter reserve mismanagement. | | | | since Sarbanes-Oxley mandates them, these recent |
| At the end of August Cendant filed an SEC report | | | | revelations almost guarantee its place in history. |
| indicating a reduction in operating income of $ 500 | | | | BACKDATING STOCK OPTIONS: CORPORATE |
| million; a reduction in net income before taxes of $ 297 | | | | REMEDIATION |
| million and the effect on earnings per share. As a | | | | As of August 17th the Wall Street Journal posted a |
| result, the market price of the stock decreased from a | | | | study of 87 companies that have initiated probes, |
| high of $35. in April to $11. per share in August. Normally | | | | announced restatements, had executive resignations |
| a 10% drop in stock price following an adverse | | | | or Department of Justice inquiries into their stock |
| announcement is enough to trigger a class action suit | | | | options practices. The SEC has filed civil charges |
| within 72 hours. Here the drop was precipitous: 69%. | | | | against executives of public companies, alleging that |
| Fifty lawsuits were filed in the U.S. District Court which | | | | they engaged in a decade-long fraudulent scheme to |
| were consolidated by the judge with several | | | | grant undisclosed, in-the-money options to themselves |
| institutional investors as the Lead Plaintiffs. Hundreds of | | | | and to others by backdating stock option grants to |
| thousands of documents were produced by Cendant, | | | | coincide with historically low closing prices of their |
| Ernst & Young and the various defendants. An | | | | stock. These complaints have alleged that former |
| investment banking firm and a forensic team were | | | | executives collectively realized millions of dollars of |
| retained as expert witnesses. Cendant settled for $2.8 | | | | ill-gotten compensation through the exercise of illegally |
| Billion. Ernst & Young settled for $ 335 Million. This | | | | backdated option grants and the subsequent sale of |
| settlement was followed by even larger valuations in | | | | related common stock. |
| the cases of WorldCom ($ 6.2 Billion) and Enron ($ 7.1 | | | | In a separate matter, U.S. Attorney's Offices have |
| Billion, pending final court approvals). | | | | unsealed criminal complaints charging executives with |
| Enron directors agreed to settle class action against | | | | conspiracy to violate the antifraud provisions of the |
| them for $ 168 million as their proportionate share of | | | | federal securities laws, wire fraud and mail fraud. It has |
| the settlement. Insurance covered most of the cost, | | | | been alleged that backdated option grants and secret |
| but left them with terms that required the directors to | | | | option slush funds were "deceits of the highest order" |
| personally pay $ 13 Million. WorldCom directors had a | | | | upon shareholders. Executives, according to the SEC, |
| settlement requiring them to pay their proportionate | | | | have repeatedly used hindsight to select dates when |
| share, $ 54 Million, leaving them $ 18 million owed on a | | | | the closing price of their common stock was at or |
| personal liability basis. The directors in the settlement | | | | near a quarterly or annual low. The complaints further |
| admitted no wrongdoing. | | | | allege that under well-settled accounting principles, in |
| Backdating Stock Options | | | | effect at the time, companies that granted |
| The backdating scandal we are currently reading | | | | in-the-money options were required to record a |
| about in the Wall Street Journal may, according to | | | | corresponding compensation expense and disclose |
| academics, affect up to 3,000 publicly-held companies. | | | | such amounts in filings with the Commission. The |
| Defense attorneys, plaintiff attorneys and expert | | | | executives have also been charged with violations of |
| witness are beginning to mobilize. This potentially | | | | the Sarbanes-Oxley officer certification provisions of |
| massive arena of litigation and expert testimony has | | | | the federal securities laws. Injunctive relief, civil |
| occurred because of the practice in the last ten years | | | | penalties, disgorgement, with prejudgment interest, and |
| of publicly-held companies granting stock options to | | | | officer and director bars against each of the |
| key executives which were in-the-money but not | | | | defendants has been requested. |
| properly recorded as compensation expense, thus | | | | HOW THE BACKDATING OCCURRED |
| violating GAAP, and misstating tax liabilities as well | | | | It is helpful to review how the practices originated in |
| over every quarter since the practice began. In other | | | | order that remediation of one's own internal control |
| words, dates were assigned to the options using | | | | policies can effectively take place. The executives |
| hindsight that were earlier dates than the actual grant | | | | directed and controlled the option grant process and |
| date. The SEC has just begun an investigation into | | | | initiated the backdating schemes. Among other things, |
| approximately eighty companies, and the list is | | | | they specifically selected the backdated grant dates |
| expanding daily. The DOJ and U.S. Attorney offices | | | | by interfacing with the Compensation Committee. |
| are making logistic decisions as to how to allocate | | | | Grant documents with false grant dates were |
| predicted case load. Several criminal charges have | | | | approved by the Compensation Committee. |
| been filed. At a minimum, companies that are involved | | | | Unscheduled grants were the modus operandi. A |
| will face civil charges by the SEC, massive | | | | spreadsheet contained lists of proposed grantees. At |
| restatements and therefore the virtual guarantee of | | | | some point, the executives "cherry-picked" the grant |
| class action and derivative suits. The suits have as | | | | date by looking back at their historical stock prices and, |
| their basis that the companies in question and their top | | | | with the benefit of hindsight, chose a grant date that |
| executives as well as boards of directors have | | | | corresponded to a date on which the common stock |
| engaged in breaches of fiduciary duty, gross | | | | was trading at a relative low. The master list was then |
| mismanagement, unjust enrichment and violations of | | | | submitted to the Compensation Committee for |
| the SEC Act of 1934. Back-dated options have | | | | approval. |
| allowed the defendants to reap millions of dollars in | | | | Unanimous written consent forms pertaining to the |
| unlawful windfall profits at the expense of the | | | | proposed grant were sent to Compensation |
| company. One law firm alone recently filed 34 | | | | Committee members for signature. It was known |
| derivative suits. It's the largest area of civil litigation in | | | | among the executives that these dates were the |
| history that is beginning to unfold before our very eyes. | | | | "low-ball" look-back dates they had previously chosen. |
| Shareholder Derivative Suits | | | | Compensation Committee members were generally |
| Shareholder derivative suits are increasingly filed in | | | | not aware of an impending grant prior to receiving the |
| connection with class action suits. A primary concern is | | | | master list. The Committee members then signed, but |
| that directors and officers will find themselves without | | | | did not date their copies of the consents and returned |
| coverage for defense costs, awards for plaintiff's | | | | them. Based upon their involvement in the option grant |
| attorneys fees and a monetary settlement. Director | | | | process, each of the defendants knew, or were |
| & Officer insurance policies sometimes exclude | | | | reckless in not knowing, that the unanimous written |
| payments for non-civil litigation, as where certain types | | | | consents were false because the "as of" dates that |
| of fraud which involve scienter exist. Even if it does, | | | | were inserted into the consents and reflected in the |
| usually the coverage does not begin until an indictment | | | | company's books and records did not represent the |
| is brought. Another area that contains elements of peril | | | | true grant dates. |
| is that often payments are made on a first-come, | | | | The executives knew that no corporate action to |
| first-serve basis. In other words, in the order that claims | | | | approve the options grants had actually occurred on |
| are filed. This can often lead to a shortage in the case | | | | the "as of" date. They knew this because they were |
| of a settlement. | | | | the ones who had picked the grant dates by use of |
| There is an upward trend in filings of derivative suits, | | | | the look-back tables, with the benefit of hindsight. They |
| which are filed primarily in state courts, as opposed to | | | | had examined historical trading prices and selected a |
| class action suits, filed in federal district courts. State | | | | date with a low trading price. Options with backdated |
| courts often permit plaintiffs to recover on | | | | dates in effect also accelerated the vesting schedule |
| non-unanimous verdicts (required in the federal | | | | because the Company used the backdated date for |
| system) and some state laws permit lower standards | | | | vesting purposes, not the date of the actual |
| of findings for recovery purposes. These stand-alone | | | | Compensation Committee approval. A large number of |
| derivative suits are normally for breach of fiduciary | | | | grants were grants at or near the lowest price for the |
| duty, proxy violations, excessive compensation and | | | | fiscal quarter or year. In an article published by the Wall |
| breach of the duty of care or duty of loyalty. | | | | Street Journal, the patterns of stock options grants |
| The Business Judgment Rule supports active decisions | | | | were analyzed and astronomically high odds, some |
| of the Board of Directors, but it does not cover these | | | | approaching one is six billion, were determined to exist |
| breaches. For example, breach of the duty of care | | | | that such grants would have fallen on dates just |
| does not cover unintelligent decisions, ill-advised actions, | | | | ahead of sharp gains in the related corporate stock |
| or illegal breach of federal laws. Failure to question | | | | price by chance. |
| management representations is another example of | | | | The secret backdating schemes allowed the |
| this type of breach. | | | | defendants to disguise the fact that the Company |
| One solution to adequate D & O coverage is a | | | | was paying higher compensation to executives and |
| Side A-only policy, which can protect directors and | | | | employees by awarding them in-the-money options, |
| officers from losses not normally indemnified. These | | | | and to avoid having to expense the in-the-money |
| policies typically provide coverage even under adverse | | | | options as compensation expense, thus avoiding |
| conditions, including corporate bankruptcy, when the | | | | reductions to the company's net income and EPS. In |
| limits of the traditional policy have been exhausted and | | | | addition, certain large institutional investors have long |
| under cases where the normal policy excludes | | | | been opposed to stock option plans that allowed |
| payments. Some states do not permit corporate | | | | grants of options at below the fair market value of the |
| indemnification of unsuccessful defense against | | | | underlying stock at the time of the grant. This is the |
| derivative suits and in these cases as well a Side | | | | basis for the tens of billions of dollars of derivative suits |
| A-only policy will provide coverage. | | | | filed in recent weeks against related corporations by |
| The Private Securities Litigation Reform Act of 1995 | | | | law firms on behalf of large institutional investors. |
| provided modifications and a safe harbor for | | | | The California Public Employees' Retirement System |
| corporations in one aspect of derivative suits - the | | | | (CalPERS) is the largest U.S. public pension fund, with |
| forward-looking statement. Tenuous inferences are not | | | | over $ 200 Billion in total assets. They have recently |
| permitted in plaintiff pleadings. Allegations must include | | | | written an open letter to the Chairs of the |
| specificity as to falseness or why the statements | | | | Compensation Committees of a number of portfolio |
| made by the company were misleading. Under the | | | | companies related to inquiries on employee stock |
| safe harbor provisions of the Reform Act, a company | | | | option backdating practices. Their letter contains |
| is not liable for projections which are inaccurate if such | | | | implications of allegations, including lack of oversight by |
| statements are properly identified and accompanied | | | | the Board of Directors, weak internal controls, weak |
| by a cautionary statement which indicates that actual | | | | internal and external audit practices, poor accounting, |
| results could differ from projected results, and liability | | | | significant income tax consequences for persons |
| also does not exist if the plaintiff does not prove the | | | | implicated for backdating options, and problems with |
| forward-looking statement was made with knowledge | | | | the Executive Compensation Plan Administrator. |
| that it was misleading. Forward-looking statements are | | | | Senator Chuck Grassley of Iowa, Chairman of the U.S. |
| often made verbally at analyst conferences, so this | | | | Senate Committee on Finance, has publicly stated: "It's |
| provides some measure of assurance to the | | | | one thing for an executive to make big profits |
| corporate public relations department. However, as | | | | because he's improved his company, but it's a whole |
| regards the option backdating practice, there is no | | | | different thing to make big profits because he's playing |
| safe harbor. | | | | fast and loose with the dating of stock options. Outside |
| Trading Models | | | | the corporate suite, Americans don't get to pick and |
| The economic basis of these settlements is an area | | | | choose their dream stock price. The market dictates |
| of adversarial tests. In a monograph in the early 1990s, | | | | the price." |
| several authors criticized the use of trading models to | | | | The CFA Institute recently published an open letter to |
| estimate aggregate damages in class action suits, | | | | the SEC stating "In the case of Post-Dating, senior |
| claiming that the results were not reliable and often | | | | executives (and possibly directors) used inside |
| overstated damages by as much as 74%. Daubert | | | | information or post-closing market prices to determine |
| grounds have been challenged on a variety of | | | | when to retroactively set the effective date of |
| proposed models. In Daubert the Supreme Court | | | | share-based awards in order to enhance the return of |
| directed federal courts to consider four factors in | | | | such awards. This practice also appears to have |
| evaluating expert testimony under Federal Rule of | | | | involved falsified accounting, may circumvent financial |
| Evidence 702: (1) the general acceptance of the | | | | reporting requirements for 'variable' option grants, may |
| economic model; (2) potential rate of precision error; (3) | | | | conflict with governance requirements related to the |
| peer review or publication; (4) whether the theory has | | | | pricing of stock options, and may ultimately lead to |
| been tested. In finding that various proposed trading | | | | criminal and tax penalties against companies engaged |
| models do not meet these standards, the court is | | | | in these activities, thereby harming shareowner value |
| concerned about whether the model has been tested | | | | even more." |
| and whether the model has been accepted by | | | | REMEDIATION |
| professional economists. | | | | In the real world, the best stance is one of pro-active |
| The Journal of Legal Economics is a good starting | | | | remediation before any investigation by third parties |
| point for obtaining solid valuation models. It is a double | | | | begins. Materiality thresholds need to be considered |
| blind refereed journal. Each manuscript is reviewed by | | | | according to SEC Bulletin No. 99 and Sarbanes-Oxley |
| at least three qualified individuals, in addition to the | | | | thresholds. If the materiality threshold is not breached, |
| Editor. It was conceived as a forum for contributing | | | | then no restatements will occur. If a restatement |
| authors, both from the profession of lawyers as well | | | | occurs, it almost guarantees an SEC investigation and |
| as the quantitative professions of accounting, | | | | also a finding of a "Material Weakness" by one's |
| economics and finance, to offer constructive insights | | | | third-party auditors. Material Weakness findings can |
| to colleagues. It is designed to be a useful research | | | | cause the loss of significant blocks of market |
| tool for application as well as theory. | | | | capitalization upon disclosure. |
| In theory, the "out-of-pocket" loss is the measure of | | | | The problems are not restricted to Information |
| damages in open-market class suits. Therefore a | | | | Technology companies. Their excess returns in the |
| defrauded buyer can recover his share of class | | | | studies performed by the academics at the University |
| member's damages, less applicable attorney fees, | | | | of Iowa and others were what caught initial attention |
| which can range from 15-30%. However, since this | | | | to the issue, but the scope is beyond IT companies. It is |
| actual trading data is buried in repositories, models | | | | estimated that close to 3,000 companies are involved. |
| have been chosen to produce tangible results. The | | | | In many of these cases undoubtedly management has |
| Private Securities Litigation Reform Act of 1995 leaves | | | | retained its integrity, and the element of scienter does |
| it open for the court to select the most reliable method | | | | not exist. The rest of the public companies need to |
| of damages proof that is available. Two-trader models | | | | study and research adequate Sarbanes procedures to |
| also exist, which assume, probably correctly, that there | | | | assure they are not affected in the future. The initial |
| are passive investors and there are traders. Traders | | | | studies of proxy statements for statistics on options |
| of course have a higher probability of acquiring and | | | | before the implementation of Sarbanes Oxley |
| selling shares, and thus this model utilizes parameters | | | | changed the reporting requirements to 2 trading days |
| for damage estimates with the damages estimated | | | | following August of 2002 indicated the problem existed |
| using depository record data. One-trader models often | | | | as early as 1996 with the majority of companies. Grant |
| significantly overstate damages by 90-98%. | | | | patterns on excess return post-option pricing began |
| Assumptions can therefore lead to bias. Three-trader | | | | largely in the mid-1990s. One company alone has close |
| models also exist which involve high-activity investors, | | | | to two million documents that need to be examined to |
| low-activity investors and intraday-traders (who do not | | | | determine the extent of the backdating issues. I |
| utilize overnight positions). Often these traders can | | | | understand investigative, forensic and related |
| account for up to one-third of all trading activity. | | | | professional costs in this one case alone are targeted |
| Recommendations | | | | and budgeted for $70 Million dollars. This does not |
| One strategy that is sometimes effective is the | | | | include defense or settlement costs for related |
| formation of a special litigation committee (SLC) that | | | | class-action and derivative lawsuits. |
| has the substance and form of independence. The | | | | Without going into specific detail what is referred to as |
| committee has the responsibility of retaining forensic | | | | the Tone at the Top must be re-established at |
| teams to review thousands of pages of documents | | | | Compensation Committees throughout the world |
| and interview hundreds of witnesses. One corporation | | | | today. Directors and particularly Audit Committee and |
| alone has 2 million documents to review and expects | | | | Compensation Committee members need to be |
| to pay $ 70 Million just to receive a Findings Report. | | | | re-educated as to governance requirements that |
| The purpose of the committee is to provide the Court | | | | comply with both the spirit and letter of the law. |
| with the "business judgment rule" confidence to dismiss | | | | Compensation programs should not be driven by |
| the derivative action. However, this procedure is not as | | | | competitive surveys but by superior performance over |
| simple and straightforward as it sounds. | | | | the long-term. Full disclosure is necessary in proxy |
| Delaware and other states permit the board of | | | | statements. Independent directors are a major |
| directors to respond to suits by appointing an SLC | | | | necessity. Experts have to be added to Compensation |
| comprised of independent directors. As long as the | | | | Committees. If they are not there, then third parties |
| SLC is in process, the derivative suit is stayed. | | | | must be hired who are expert consultants. Issues of |
| However, in the adversarial process that is underway | | | | Incentive Compensation, Dilution, Performance Options |
| continues, motions are often filed that question the true | | | | and Structures, Repricing, and a variety of tax and |
| objectivity of the SLC. Delaware courts often slam the | | | | governance issues have to be addressed. Steps have |
| door to the SLC by ruling against them and letting the | | | | to be taken to ensure that Board and Committee |
| suit proceed. If the SLC members have significant | | | | evaluations of compensation are equitable and it would |
| social ties to the defendants in terms of past or future | | | | be advised to refrain from using company resources |
| relationships that is one disqualification. Another is a | | | | to satisfy legal and tax liabilities for executives who |
| public statement by the head of an SLC at any time | | | | are implicated in wrongdoing. This could lead to further |
| prior to the issuance of the report that illustrates bias. It | | | | derivative suits. Independent detailed investigations on a |
| is hard to believe this would occur but in specific cases | | | | case-by-case basis with strong Board of Director |
| it has and it has destroyed the company's defenses | | | | backing need to be undertaken. The implications of |
| from the beginning. | | | | Sarbanes need to be fully understood and addressed. |
| Directors often share institutional and social | | | | Lying to auditors is now a federal offense. Insider |
| connections based on board service. This makes it | | | | manipulation is now not being tolerated by the market, |
| particularly difficult to find objective third parties. | | | | nor by enforcement authorities who have oversight. |
| Warren Buffet explained it this way: "Why have | | | | Justice officials have made it clear that executives can |
| intelligent and decent directors failed so miserably? The | | | | face possible prison time for backdating stock options. |
| answer lies not in inadequate laws - it's always been | | | | Serious change and corporate governance must now |
| clear that directors are obligated to represent the | | | | follow. |