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The stock option backdating scandal continues to mushroom. According to Glass Lewis & Co., the proxy advisor firm, 121 companies have disclosed restatements, internal investigations or governmental investigations; even more companies are late in filing their current Securities and Exchange Commission (SEC) quarterly reports, apparently in many cases because they are reviewing prior option grants. A study by two financial economists estimates that 29.2% of firms manipulated option grants to top executives at some point between 1996 and 2005. See Randall Heron and Erik Lie, “What fraction of stock option grants to top executives have been backdated or manipulated?” (July 14, 2006), www.biz.uiowa.edu/faculty/elie/grants%207-14-2006.pdf. Yet, however broad the past scandal, backdating is a practice that was coming to a screeching halt even before the first criminal prosecutions were brought. The reason was that the Sarbanes-Oxley Act contained the serendipitous answer to a problem that had not even been recognized at the time of its passage in 2002. That act amended � 16 of the Securities Exchange Act to require directors and officers to report any change in ownership (including option grants) to the SEC on Form 4 within two business days. As a result, executives who received backdated options are compelled to make a late filing, and in today’s environment late filings are a virtual roadmap for the SEC to the doorsteps of the guilty. Method, rather than practice, will likely change But this does not mean that option manipulation will fade away. To the contrary, the incentives are too strong, especially in the case of companies with volatile stock prices. Rather, the modus operandi will likely change. Assume that a chief executive officer possesses two items of material information, one positive and one negative. The temptation today and for the future is to delay disclosure of both until stock options are about to be awarded, then release the negative information a day or two before the option grant, and the positive information a week after. The result will leave a telltale “V” in the corporation’s stock price chart, with options being awarded at the base of the vortex. Already, the pattern is strong enough that a new term- “springloading”-has been coined to describe the release of positive information immediately after option grants. Some hedge funds are reportedly buying stocks on the announcement of option grants based on the statistical evidence that favorable, market-moving news will shortly follow. Of course, such behavior will be viewed by the SEC as manipulative. But manipulation is tough to prove. The clever CEO might even encourage the firm’s counsel to advise the firm that the negative information was material and should be disclosed, while the positive information was not quite yet “ripe” for disclosure. Depending on how the CEO structures the conversation, counsel will find it easy, and possibly even necessary, to give such advice. Similarly, so long as the board committee also knows the positive information, “springloading” is not equivalent to insider trading. Against this backdrop, what are the weapons that federal prosecutors and the SEC possess? In the simple backdating case, if the board was not advised that “in-the-money” options were being granted, prosecutors will likely use their favorite weapon, the federal mail and wire fraud statutes, and allege a “scheme to defraud” the corporation. Use of these charges spares the prosecutor any need to prove that the misrepresentation or omission was material to investors. But even this theory has its limits. Suppose, as is alleged to be the case in the Brocade Communications Systems prosecution, that the senior executives did not personally profit, but rather used backdated, “in-the-money” options to hire “star” executives away from other firms. Now, who was the victim? To be sure, the practice still has some “badges of fraud” in the falsified books and records, but it arguably benefited the firm. In U.S. v. Brown, 2006 U.S. App. Lexis 19397 (5th Cir. Aug. 1, 2006), the 5th U.S. Circuit Court of Appeals reversed on precisely this logic the convictions of the Merrill Lynch & Co. Inc. bankers who had helped Enron structure its Nigerian barge transactions in order to enable Enron to meet its forecasted earnings. In Brown, the prosecutors relied in part on an “honest services” theory of mail fraud under 18 U.S.C. 1346. Following the 2d Circuit’s decision in U.S. v. Rybicki, 354 F. 3d 124, 139-144 (2d Cir. 2003), the 5th Circuit held that an “honest services” prosecution against a private official must prove a “scheme…to enable an officer or employee of a private entity purporting to act for and in the interests of his or her employer secretly to act in his or her or the defendant’s own interests instead.” Id. at *27. Brown and Rybicki may then represent major potential barriers in cases where self-dealing is not present. But defendants face an additional problem because another special factor has characterized virtually all backdating cases: The issuing corporation failed to take the charge to earnings that generally accepted accounting principles then required when an in-the-money option was granted. As a result, a restatement of the issuer’s financial statements becomes necessary, and this may well represent an alternative “detriment” to the corporation that satisfies the necessary element in an “honest services” prosecution that there be an actual injury. In any event, more promising theories of liability may be available to the government. Section 13(b)(5) of the Securities Exchange Act provides that “[n]o person shall knowingly circumvent or knowingly fail to implement a system of internal accounting controls or knowingly falsify any book, record, or account described in [� 13(b)(2)].” Backdating inherently involves the falsification of corporate books and records, at least to the extent that the minutes of the compensation committee meeting are backdated. Does such a backdating of the grant date violate � 13(b)(5) with its specific reference to � 13(b)(2)? The leading case on this point is SEC v. World-Wide Coin Investments Ltd, 567 F. Supp. 724, 748-49 (N.D. Ga. 1983), which found that for purposes of � 13(b), “virtually any tangible embodiment of information made or kept by an issuer is within the scope of � 13(b)(2)(A) of the [Foreign Corrupt Practices Act], such as tape recordings, computer print-outs, and similar representations.” Similarly, Sarbanes-Oxley makes it a federal felony to “mislead” the outside auditor or for the CEO or chief financial officer to falsely certify that the corporation’s financial statements “fairly present” its results of operations. Of course, in any criminal prosecution for a violation of the Securities Exchange Act, � 32(a) requires that the prosecution prove that the violation was committed “willfully.” See U.S. v. Cassesse, 428 F.3d 92, 98 (2d Cir. 2005); U.S. v. Peltz, 433 F.2d 48, 55 (2d Cir. 1970) (willfulness means “a realization on the defendant’s part that he was doing a wrongful act” under the securities laws). But more than the typical market timing or accounting case, backdating involves inherently suspicious behavior that resembles a classic “badge of fraud.” Revealingly, a whistleblower at Sycamore Networks Inc., has released to the press an internal memo in which the human resources personnel at that company painstakingly calculated the odds on whether the auditors would be able to detect their backdating of option grants across a range of cases. Better evidence of scienter seldom exists. Selective release of positive and negative information All of this suggests that corporate executives in the future will shrink from the use of a tactic as vulnerable and flagrant as backdating. Instead, the selective release of positive and negative information in order to whipsaw the corporation’s stock price appears a more promising tactic that leaves far fewer footprints. Moreover, to the extent that the SEC has been successful in prosecuting market manipulation cases, these have generally involved fictitious transactions (e.g., “wash sales” or “wooden tickets”) or massive purchases by individuals acting in concert. See Markowski v. SEC, 274 F.3d 525, 528-29 (D.C. Cir. 2001). Criminal prosecutions for manipulation have met greater judicial resistance based on the courts’ fear that they depend too much on an uncertain inference about whether a purchase was “effected for an investment purpose.” See U.S. v. Mulheren, 938 F.2d 364, 368 (2d Cir. 1991). How then should this fraud be deterred? The most practical step would be to induce issuers to move from “unscheduled” option grants to “scheduled” ones. Financial economists have found the rate of manipulation and backdating to be much higher (nearly 10 to 1) in the case of unscheduled grants (see Heron and Lie, supra, at Table 4). When executives have discretion as to timing, they can better exploit market conditions and nonpublic information. If the SEC, or a truly independent board, compelled management to use the same grant date each year (at least for option grants to insiders), discretion would be better constrained. If, year after year, the corporation’s stock price still revealed the same “V” pattern on the same grant date, this pattern would become unmistakable and embarrassing. Informed traders would begin to anticipate these movements, selling short in advance and going long on the grant date, thereby making the practice even more visible. Ultimately, unscheduled grants enable management to hide the ball. Scheduled grants restore a measure of accountability. The best reform then is “blinddating”-to disable management from being able to use asymmetric information by announcing an unvarying grant date. Of course, that a practical remedy exists does not mean that it will be used. As always, that requires pressure from investors and independent directors. John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia Law School and director of its Center on Corporate Governance.

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