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The U.S. Securities and Exchange Commission (SEC) has recently increased its scrutiny of the timing of option grants by publicly traded companies. Motivating the SEC’s interest is longstanding academic research showing an overall pattern of stock prices dropping just before the reported dates of option grants and rising immediately thereafter. See, e.g., Donal Byard & Ying Li, “Guest Column, What Influences the Timing of Option Grants,” The Friday Report, Dec. 17, 2004, at www.institutionalinvestor.com/ . The SEC appears to have initially focused on whether companies were timing grants in order to benefit from positive corporate news. Recently, however, the agency appears to have shifted its focus to corporate backdating of options. Five of the reportedly dozen companies whose practices are under review have publicly disclosed the existence of the SEC inquiries. This article summarizes one of the SEC’s investigations and provides recommendations designed to help a public company prevent the manipulation of option-grant dates. A recent SEC inquiry and its potential consequences In November 2005, Analog Devices Inc., a multibillion-dollar semiconductor company, reached a tentative settlement with the SEC concerning its stock-option recordkeeping and accounting. According to the company’s press release, the settlement order will allege that the company recorded incorrect grant dates for three option awards in 1998, 1999 and 2001 and improperly excluded from its proxy-statement disclosure the fact that two option grants (on Nov. 30, 1999, and Nov. 10, 2000) were made just before the company released favorable financial results. See “Analog Devices Announces Tentative Settlement of the SEC’s Previously Announced Stock Option Investigation,” at www.analog.com. According to its press release, without admitting or denying the SEC’s allegations, Analog will pay a $3 million civil money penalty and reprice some of the options granted to its officers and directors. In addition, its chief executive officer will pay a $1 million civil money penalty and make an option-related disgorgement payment. Despite the fact that the SEC’s interest appears to be limited to the option-grant practices of technology companies, its focus could broaden to other industries in the future. Although the backdating of options is not necessarily illegal, the ramifications stemming from such practices could be. Backdating of options may result in inaccurate disclosures in public filings with the SEC as well as accounting errors. First, companies often state in their proxy statements filed with the SEC that the strike prices for options are equal to the market value on the date of a grant. Such a statement would be clearly erroneous and potentially misleading if the company had backdated its options. Next, under the option accounting rules set forth in Financial Accounting Standards Board Staff Position 123(R), www.fasb.org/fasb_staff_positions/fsp_fas123r-1.pdf, which became effective for nonsmall business issuers beginning with the first interim or annual reporting period of the issuer’s first fiscal year beginning on or after June 15, 2005, stock options with exercise prices less than fair market value on the date of grant will result in a greater compensation charge than options with exercise prices equal to or greater than fair market value on the date of grant. In addition, such options also may be treated differently for tax purposes. In an extreme case, it is possible that the inaccurate reporting of stock option information could result in a restatement of a company’s financial results or could cause certain executive officer certifications required by Sarbanes-Oxley to be filed with the SEC to be incorrect. There are tax implications for backdated options Furthermore, backdated options may be subject to early income inclusion, penalties and interest under � 409A of the Internal Revenue Code. In general, � 409A establishes rules applicable to deferred compensation arrangements. While stock options granted at fair market value are not generally subject to � 409A, those granted below fair market value are subject to � 409A. A variance in the actual grant date may result in the Internal Revenue Service deeming the option to be granted below fair market value, and thus subject to � 409A’s rigorous requirements, including limitations on exercise. Options subject to � 409A that do not meet its strict requirements may be subjected to taxation upon vesting, a 20% penalty tax and interest charges. Recommended actions in light of the SEC inquiries The recent events described above indicate that it is in the best interests of public companies to establish procedures to ensure that option grants are accurately recorded. The following are recommendations to assist companies in achieving that goal: Review and test internal controls. Internal controls over financial reporting have been a primary focus of publicly traded companies since the passage of Sarbanes-Oxley in 2002. Public companies should have already designed and implemented internal controls to eliminate the ability to manipulate option grant and exercise dates. If so, those internal controls should be tested periodically. If not in place, such controls should be established immediately. Specifically, compensation committee members should oversee the drafting of option grant documentation and the accounting for such grants and carefully scrutinize management’s determinations. One approach may be to have one or more members of the compensation committee review option grant documentation to ensure that the date of grant in the option grant letter corresponds to the date of the meeting of the compensation committee during which the option grant was authorized. The company’s internal auditors or an independent third party should periodically review the option grant documentation and the minutes of the meetings of the compensation committee to confirm that the dates correspond and that the internal control system is functioning properly. Internal auditors or an independent third party also should review the amounts received by the company upon the exercise of the options to ensure the appropriate exercise price was paid. In addition, it may be prudent for public companies to request in-house or outside counsel to participate in compensation committee meetings to assist in the option grant process and, following such meetings at which grants are authorized, ensure that timely filings are made, pursuant to � 16 of the Securities Exchange Act of 1934, by the company’s principal stockholders, officers and/or directors receiving such grants. Issuing grants on a regular basis has several benefits Regularly schedule grants. Companies should implement a regular schedule of grants to avoid the appearance of manipulation. For example, many companies grant options once a year, once a quarter or once a month. An added benefit of such a practice is that optionees may benefit from dollar-cost average pricing, rather than fixed pricing tied to a single grant date. Don’t backdate option grants to hiring dates. A company should not promise new employees option grants effective as of their dates of hire unless the board of directors or the compensation committee has authorized the grant as of that date. Some companies have mistakenly backdated grants to an employee’s date of hire in an attempt to honor the terms of an agreement. Rather than backdating option grant letters, companies might consider granting more options to the new employee to make up for any potential loss in value resulting from an option grant authorization occurring subsequent to the date of hire. In the event that a review of past option grant activity indicates that there have been material errors with respect to option grant dates, and consequently exercise prices, a company should consider self-reporting its findings to the SEC. The SEC generally appreciates (usually in the form of reduced sanctions) companies that act proactively and self-report potential violations of the federal securities laws. In fact, in its 2001 Seaboard report, Release No. 34-44969 (Oct. 23, 2001), the SEC set forth four broad criteria that it will consider in evaluating whether to charge a company with violations of the federal securities laws, including whether the company conducted a “thorough review of the nature, extent, origins, and consequences of the misconduct” and whether the review was conducted by “independent persons such as outside directors and legal counsel.” These factors should guide corporate counsel in investigating suspicious option-related activity. Derek M. Meisner ([email protected]) is of counsel to the Boston office of Kirkpatrick & Lockhart Nicholson Graham. His practice focuses on representing clients in enforcement investigations, conducting corporate internal investigations and advising clients on related corporate governance and compliance issues. Timothy R. Bowers ([email protected]) is a corporate associate at the firm with a practice focused on M&A and corporate securities. Michael A. Hickey ([email protected]), a partner at the firm, provided invaluable assistance in the preparation of this article.

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