Boxing his family pictures, award plaques and all the mementos of an otherwise sterling 39-year career at the company, the CEO thought how could it all have come to such an ignominious end. These may have been the thoughts of Andrew McKelvey, who resigned the helm of Monster Worldwide Inc. last October amidst an options backdating probe targeting his company. Enforcement investigations relating to backdating are wreaking havoc upon scores of public companies and their top executives.

Stock options are typically granted “at the money” where the options exercise price equals the current price of the stock at the time of the grant. Backdating refers to the setting of an options-grant date that precedes the corporate action date that gave rise to the grant in order to establish a lower exercise price that benefits the options holder. Backdating is the latest target of major focus by securities prosecutors that will end with large numbers of executives being fired, sued and sanctioned.

Not only will reputations of executives and their public companies be sullied, the companies will collectively spend hundreds of millions in investigating, defending and paying penalties and civil liabilities associated with backdating. The ultimate losers will be public shareholders of these companies who will collectively experience billions of dollars of losses in the value of their effected company stocks.

This article explores how some longstanding and ubiquitous commercial practices such as backdating become cause celebre securities enforcement cases. In the end, have SEC and other government prosecutors overreacted? Should there be objective guidelines to evaluate the severity of a particular offense in the spectrum of offenses so as to correctly calibrate the prosecutorial reaction? Were there other regulatory approaches that could have been used to address backdating?

The Finance Professor’s Study

The SEC’s enforcement focus on backdating was triggered in large measure by a study by professor Eric Lie of the University of Iowa. Lie “document[ed] that the predicted [stock] returns are abnormally low before the [options] awards and abnormally high afterward. Unless executives possess an extraordinary ability to forecast the future marketplace movements that drive these predicted returns, the results suggest that at least some of the awards are timed retroactively.”

The Lie study reviewed almost 6,000 CEO options awards from 1992 to 2002, and its sweeping conclusions spawned numerous investigative articles by the financial press on the subject. Surprised by the Lie study and impelled by sensational press articles, the SEC and criminal prosecutors shifted into high gear to take significant enforcement action against those perceived having been engaged in backdating.

A decade earlier, a study by two finance professors rocked the world of Nasdaq trading. William Christie of Ohio State University and Paul Schultz of Vanderbilt University studied Nasdaq stock quotations. The study observed that Nasdaq permitted stocks to be quoted in one-eighth-point (12.5 cents) increments, but found that Nasdaq market makers typically posted quotations in one-quarter-point (25 cents) increments and never in odd eighths. The Christie-Schultz study hypothesized that in a competitive market eighth-point quotations should more frequently be displayed. In the absence of such markets, the study concluded that collusion existed among the market makers to maintain artificially wide spreads between the best bid and offer quotations, which generated greater trading profits for market makers as a group.

Like the Lie study on backdating, the Christie-Schultz study surprised the SEC and the Justice Department even though the absence of eighth-point markets in Nasdaq was obvious, well-known and not questioned by regulators and market participants for years prior to the study. Fueling enforcement flames, the financial press wrote incendiary stories about the “scandal.”

The Christie-Schultz study triggered a massive government investigation and subsequent enforcement action against the National Association of Security Dealers (NASD) and many market making firms of all sizes. In the wake of these investigations, many executives of these firms lost their jobs and reputations. Civil law suits seeking reparations from market makers were quick to follow. The Christie-Schultz study also was the catalyst for the SEC to completely restructure the NASD, the self-regulatory organization overseeing the Nasdaq marketplace.

There will be a healthy debate over whether the government’s massive enforcement inquiry into backdating and odd eighths is and was properly measured and appropriate. The fact is that enormous industry resources are and were spent by both the government and the targets of the probes. Should the SEC wield a sledgehammer to address these types of issues or would a tack hammer approach be better? To answer this, we should evaluate why the SEC reached for its sledgehammer.

In both backdating and odd eighths, the respective academic studies presented massive statistical data that inferred the existence of widespread and prolonged practices that the SEC itself should have uncovered and dealt with much earlier. In both cases, the press, particularly the print media, tenaciously followed with further articles of their own which sensationalized the matters as the uncovering of major wrongdoing. In this crucible, the SEC frequently reaches for its biggest hammer.

The backdating investigations have disclosed a considerable amount of leeway in how public companies have historically awarded options compensation. By the time of the publication of the Lie study, however, such leeway had been significantly reigned. In testimony before Congress, the SEC chairman recapped the “prophylactic rules to eliminate the opportunities for abusive backdating.” The SEC chairman advised that: “[f]irst, Sarbanes-Oxley has closed the disclosure loophole that permitted months and sometimes more than a year to elapse before option grants had to be reported. Second, a new accounting rule FAS 123R has eliminated the accounting benefit of granting at-the-money options. And third, the SEC’s brand new executive compensation rules now require a complete quantitative and narrative disclosure of a company’s executive compensation plans and goals. That enhanced disclosure will make it clear whenever options are being backdated, and it will require an explanation of the reasons. These new rules will soon be complemented by additional accounting guidance on these subjects.”

The SEC chairman summarized that “[e]ach of these steps by itself is an important contribution to preventing backdating abuse. In combination, they have effectively slammed the door shut on the easy opportunities to get away with secretive options grants. That is why almost all of the stock option abuses our enforcement division has uncovered started in periods prior to these reforms.” In light of the success of current corrective measures, could the SEC have taken an approach other that formal enforcement action against companies and individuals to address historic backdating? The answer is yes.

Even in circumstances where corrective measures have not been introduced, the SEC has simply issued a warning notice to identify bad practices and demand an immediate stop to such practices. For example, without taking enforcement action, the SEC provided this form of warning to broker-dealers and customers who were engaged in probable short-sale rule violations through “married put” transactions.

A married put is the purchase of an option to sell stock at a particular price and time, bought contemporaneously with the same underlying stock. The SEC often viewed these transactions as shams used to create the appearance of stock ownership to evade SEC short-sale regulations. In this regard, the sale of bona fide owned stock is not subject to such regulations. Discovering that these sham transactions were widespread and had occurred over a prolonged period of time, the SEC determined to fire a warning shot across traders’ bows to stop these violative transactions.

The married-put release stopped the abusive practices cold. Of more relevant note, no enforcement actions have been taken against the many firms and individuals who had been engaged in married put transactions. Respecting married puts, there was no academic study or intense and continuous media coverage of the practices, and the SEC had uncovered the practices through their own regulatory channels.

The SEC and other government prosecutors need to establish new internal guidelines as to when to use the enforcement sledgehammer. If a practice they deem violative has been widespread and has occurred for ages, there needs to be recognition that the rules governing the area may need to be supported by bright-line rules or at least a no-nonsense warning by the government that certain practices will not be tolerated.

In the case of backdating, we should presume that the likes of Steve Jobs, chief executive of Apple, McKelvey, and most of the many other titans of their corporations currently mired in Backdating investigations are reasonably ethical and law-abiding folks who never believed that serious laws and regulations were being broken. Where rules appear to be gray to so many, would not a married-put release-type warning have been a better-suited governmental response? Moreover, shouldn’t the government forecast the consequences of swinging its sledgehammer that may inevitably knock out so many industry leaders who have and should be permitted to continue generating products, jobs and great wealth for their companies and shareholders?

The SEC clearly recognizes these costs, but does not tie such costs to its aggressive enforcement activities. In a speech last fall, the SEC director of enforcement defended the massive SEC backdating-enforcement movement and conceded that “[m]any companies have lost an entire generation of seasoned executives who have resigned or been fired as a result of the options scandal – undoubtedly causing enormous disruptions and upheavals at the effected companies.”

Once the government launches a formal investigation against a public company and or its executives, particularly one that ends in enforcement action being brought, very bad things are in store for those companies and individuals. Mandatory disclosures of such investigations by the companies drop share prices. Internal investigations by “disinterested” committees may become witch-hunts to “clean house” before the government sledgehammer is swung. Careers and reputations are ruined without normal due process protections. Companies become obsessed with ferreting out possible ancient wrongdoing resulting in less focus on current business operations and strategies. Once the government targets companies for enforcement action, civil, including class action suits are certain to follow.

Each time the government swings its massive enforcement sledgehammer at a targeted practice, it will not be able to swing such hammer at other and arguable more serious abuses such as money-laundering and insider trading because government enforcement resources are scarce and constrained.

With so many unintended consequences resulting from backdating, the SEC and other government prosecutors should place their enforcement sledgehammers under lock and key before they pick up and read the next finance professor’s study.

William W. Uchimoto is a partner and co-chairman of the securities industry practice group at Saul Ewing. Uchimoto appreciates research assistance on this article from Mu’min Islam, who will be a summer associate in the firm’s 2007 Summer Expedition. Uchimoto can be contacted at 215-972-1888.