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The Backdating Option

When corporate executives decide to secretly backdate stock options, they could be setting up their HR leader to take the fall -- a risk HR would be wise to brace for.

Saturday, June 2, 2007
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When it comes to the complex and, at times, sensitive matter of stock-option grants for top executives, HR can ill afford to trust that everything will be just fine if they let others worry about the details. With the mushrooming of federal probes into questionable options grants -- as well as a few high-profile allegations of direct HR involvement in fraudulent cases of options-grants backdating -- it's time to jump in with both feet.

That, at least, is the suggestion being made by some attorneys and governance experts. For starters, they point out that stock options are a key component of executive compensation, and this is the natural domain of HR.

And, as a practical matter, they add, HR executives probably cannot avoid getting caught in the legal cross fire -- if not taking a bullet directly -- should things go awry, even if they weren't intimately involved: Their superiors will probably blame them, and subordinates will disavow them.

CEOs will claim their duty was to steer the ship, not wallow in procedural minutia. And lower-level managers will claim they were just following orders, regardless of the circumstances.

Meanwhile, the scope of investigations into the potential abuse of stock-options grants is expanding from the garden-variety undisclosed backdating, to "spring-loading" grants -- timing them to precede upcoming corporate "good news" presently known only to insiders to maximize their value.

A recent high-profile spring-loading case involving Tyson Foods Inc. resulted in a Delaware court judge criticizing a company director's behavior as not "acting loyally and in good faith as a fiduciary."

And a corollary practice, "bullet-dodging" -- delaying an options grant until just after the announcement of corporate bad news -- has also come under scrutiny, though no prominent legal cases involving it have yet arisen.

"There is no doubt in my mind that 'timed options' represent the next big wave in corporate-governance reform," Jay Eisenhofer, an attorney with Grant & Eisenhofer, a Wilmington, Del.-based law firm representing institutional investors, told the Reuters news agency recently. And the murkier realm of spring-loading grants could pose more headaches -- and legal hazards -- for HR because it is so much more ambiguous than backdating.

It all adds up to a loud wake-up call for HR executives, alerting them to the necessity not only of knowing when to sense a legal hazard, but to act proactively to prevent their organizations and executives from being wiped out by the next big wave, or even the last old one. The good news is that a set of relatively straightforward actions outlined below can be the "ounce of prevention" far outweighing the "pound of cure" after problems have started.

Probing the Problem

Estimates cited by the Wall Street Journal and other financial publications suggest more than 200 probes into options backdating are under way by the Securities and Exchange Commission, the Federal Bureau of Investigation and other regulatory and investigative units -- and that number is expected to grow. Backdating an option grant, of course, involves fixing the date of the option grant to an earlier point in time when the company's stock was lower, thereby creating an instant, or greater, spread between the "exercise" or "strike" price and the stock's market price.

The economic value of the option itself, when it is vested and the grantee can exercise it, is the difference between the exercise price and the market price of the stock when the option is exercised. If the market price falls below the exercise price, the option has no value. Indeed, one motivation for backdating options has been to artificially create a lower exercise price to create value in an option contract when the market price of the stock has gone south or has simply languished, instead of rising.

Attorneys are quick to point out that backdating options is not inherently illegal, if properly documented and promptly disclosed to shareholders. Then again, even if handled "properly," few companies would want the burden of justifying backdating to shareholders in their financial-disclosure statements, hence the preference for attempting to keep such actions under wraps.

In some cases, HR leaders have been alleged to be right in the thick of it. Perhaps the most widely reported one involves Gary A. Ray, the head of human resources at KB Home -- formerly Kaufman & Broad, the giant Los Angeles-based home builder.

In this case, CEO Bruce Karatz agreed to leave the company last November after an internal investigation revealed he had backdated his own stock-option grants. He will forfeit $13 million in gains from the backdating as part of an agreement with the company. Ray was terminated after reports alleged he had picked the dates for the options along with Karatz.

KB Home didn't disclose precisely how the backdated options were handled, though the company did tell the media that Ray and Karatz selected the dates without the blessings of the company's board of directors.

In another high-profile case now unfolding, Gregory L. Reyes, the founder and CEO of San Jose, Calif.-based Brocade Communications Systems Inc., a maker of storage-area network switches, and Stephanie Jensen, the company's former vice president of human resources, have pleaded not guilty to fraud charges filed by the U.S. Department of Justice and the SEC.

Jensen is seeking to separate her case from that of Reyes so he can provide exculpatory testimony at her trial, according to a filing in the U.S. District Court in San Francisco.

Federal prosecutors allege that Reyes and Jensen regularly backdated minutes of Brocade's board meetings so it would appear the board committee in charge of stock options granted them earlier than it had, on dates at which the company's stock price was lower than it had been on the true date of the board committee's action.

Further, Reyes and Jensen are accused of backdating job-offer letters so certain employees, whose option grants were based upon the date they received a job offer, would wind up with more valuable options than would otherwise have been the case.

An attorney for Jensen, however, has asserted that Reyes, if called to testify on this issue, can disprove the allegation that Jensen "knowingly and intentionally caused Brocade's financial statements to be materially false or misleading."

Jensen and Reyes face up to 25 years in prison and millions of dollars in fines if convicted.

Alleged backdating aside, with the federal entities and shareholder groups focusing intensely on stock-option programs, "HR executives are going to have to be much more attentive to risks," says Jonathan M. Cohen, partner at the Washington law firm of Gilbert Randolph. "It does highlight for HR executives that there are a number of pitfalls they need to be aware of in hiring and compensation practices."

Follow the Paper Trail

When an HR executive knows or suspects that backdating of options has occurred, he or she "should begin taking a careful look at the paper trail," says Michael R. Rosenthal, a Philadelphia employment attorney specializing in executive compensation. "If the backdating had been vetted by the compensation committee and then disclosed through various public filings, there would be no [legal] issue with it."

"But if the CEO or CFO are saying, 'We really didn't know the details of this; these options just appeared in our package and we went forward,' and the guys below the HR executive are saying, 'Well, we just implemented the directives of the HR executive,' at that point, the HR executive has already been thrown under the bus," Rosenthal says.

And the real peril of being run over by that bus arises when there were no disclosures or, worse still, documents were forged or history was rewritten with the purpose of deception. At the slightest hint of trouble, Rosenthal says, "get yourself an attorney."

To avoid finding themselves in that situation in the first place, HR executives should establish clear, firm roles for auditors and the securities firms handling the administration of the options programs, says Rick Wolf, founder and managing partner of Lexakos LLC, a West Orange, N.J.-based corporate governance, compliance and record-keeping consulting firm.

"You should establish a system such that, upon approval by the compensation committee, the information as approved should then go right into the hands of the outside auditors, or at least under the supervision of the outside auditors, to the financial-services firm that manages the stock-options account," says Wolf. "Then, it's out of the hands of those who may be tempted [to alter documents] after the options have been granted."

That, in effect, will protect the HR practitioners because they've done their job -- "They're really just the [party] moving information from Point A to Point B. They're not making decisions; they're just facilitating a process," Wolf says.

HR executives also need to tend to a little personal professional risk management.

Ideally, they will have secured D&O (directors & officers) or E&O (errors & omissions) coverage. While not bulletproof, the protection can help, says Cohen.

If covered by such a policy, Cohen says, the HR executive needs to decide whether and when to notify an insurer of possible problems, and whether to obtain the insurer's consent in retaining defense counsel, and the extent to which the insurer should be involved in the defense.

"These early decisions may implicate critical policy terms and sometimes could affect whether, and how much, coverage is available," Cohen says. "As a result, policyholders often must balance their need for insurance coverage with their strategies for defending themselves against backdating allegations."

Beyond looking out for No. 1, what can HR do for the home team?

Practical Pointers

Kent Mansfield, president and COO and a co-founder of Carrolltown, Texas-based Boardroom Software Inc., offers the following basic tips on administering an options program:

* Adopt a formal, written policy governing all facets of the program, including the grant approval process and procedures for policy changes.

* Be clear about process. Spell out your definitions of process exactly and mechanically -- perhaps with a flow chart -- around how each transaction will work. If you have a broker involved in verifying that the employee has accepted the transaction, involve the broker on the sale of optioned stock as well as its purchase.

* Keep printed copies of all key documents and agreements. Electronic versions may save trees and filing space, but printed documents with original signatures are essential.

* Produce and distribute regular reports listing grants and transactions to everyone who should be aware of what's happening in this arena.

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* Lastly, thoroughly train staff members who have any role in administering stock-options programs until you are confident they understand all of the policies and procedures.

Echoing Mansfield's last pointer, Harry Graham, a compensation and benefits consultant with Smart Business Advisory and Consulting in Tysons Corner, Va., says HR executives must step to the center of the ring by "coaching executives so they become familiar with the processes and procedures they should be following."

Advice on the proper design and management of options programs is also freely offered by Institutional Shareholders' Services, a Rockville, Md.-based advocacy organization representing big-ticket corporate investors. ISS' perspective may not always align with a CEO's or other top corporate executives' desires for maximum flexibility in granting options, but may offer a reasonable prescription for staying out of trouble.

High on ISS' list of suggestions is that companies adopt fixed grant-date schedules that provide for grants on a periodic basis (monthly, quarterly or annually), along with rules for the establishment of option-exercise prices on such grant dates. In addition, ISS urges companies to disclose their rationale for issuing grants on a particular date, as opposed to any other.

And, in light of growing attention to "spring-loaded" options grants, ISS advises companies to adopt "blackout" periods to preclude stock grants when company executives have material, non-public information in hand. (Similar rules have long applied to stock purchases and sales by insiders.)

Finally, ISS reminds companies to file required SEC disclosure documents promptly, noting that many fail to do so.

Such advice is already being heeded by many companies, says Robert Messineo, a New York-based partner at the Weil, Gotshal & Manges law firm. "I think that as a result of the issues that have come up with backdating and spring-loading, people are [establishing] much more formalized processes and more formal delegations," he says.

Many also are "centralizing somewhat not only who ultimately approves options grants [and] the circumstances under which authority is delegated," he adds, "[but] what limits and what processes are to be followed."

The Long View

In other words, companies, with varying levels of involvement from HR, are tightening up -- but not disbanding -- stock-options programs in the wake of the backdating furor. Charles G. Tharp, professor of human resource management at Rutgers University and president of the National Academy of Human Resources, puts matters in perspective with a basic reminder of the original underlying appeal of stock options that ultimately led to today's environment.

First, options promised a way of aligning the interests of the organization and its shareholders. If the company's stock price showed healthy improvement, all ships rose -- both those of employees who received stock options and those of shareholders.

Second, options were highly sought after by the kind of executive talent that companies were looking to hire.

And third, prior to a change in the public accounting industry's recommended standard for their tax treatment as expressed in the Financial Accounting Standards Board's "FAS 123" rule, stock options were highly tax-efficient.

"There was a nice sort of arbitrage that you could realize compensation, and the company did not have to expense it," says Tharp.

Then came the rapid run-up in the stock market in the late 1990s prior to the bursting of the "Internet bubble."

"Stock options became super-charged," recalls Tharp. And that environment, in the eyes of most experts interviewed for this story, led to the abuse that has brought about today's probes and litigation.

However, HR leaders and others involved in formulating compensation policy should not overreact and throw the baby out with the bathwater, says Jack Mollen, executive vice president at EMC Corp., a Hopkintown, Mass.-based information infrastructure solutions company.

"America has two great attributes going for it to be a global, competitive country, and they are innovation and inclusion," says Mollen. And stock options can play a key role in sustaining those positive forces, "especially in the high-tech world," he adds, because options offer better, quicker rewards for hard work and ingenuity.

From a public-policy standpoint, Mollen says, corporate America should take a fresh look at making options a more viable business tool to drive innovation, rather than let them languish due to the new tax and legal climate. "It's harder now for the [business] start-up to be able to go out and offer big stock-option packages, so people won't be as enticed to [go there]," he says.

To keep the motivational power of options alive at EMC, formerly "a pure stock-option company for many, many years," the company today blends stock options with restricted stock grants, along with any other vehicles for wealth creation and retirement-replacement income that make sense, Mollen says.

"A single [form of compensation] going forward probably is too big a risk for your employees," Mollen says. "It has to be a blended answer."

And no matter what the compensation tool, employees and executives need to understand it to appreciate it, which requires diligent education and communication. "People really have to start to better understand the vehicles you're putting in place and the performance that you're trying to drive."

Of course, HR executives themselves must understand the tools inside and out. Given the environment today, this is especially true in the case of stock-option grants, where HR must be fully confident that options are being issued, administered and disclosed in a manner that will withstand regulatory and legal scrutiny -- even if financial or other executives are directing the basic operations of the program.

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