Thursday, July 20, 2006

Backdating Scandals: What's REALLY Going On?

Media coverage of backdating scandals, newly-released research indicating widespread backdating practices in corporations, and hush-hush hints of allegations pending and charges soon to be filed, dominated the business news pages of the Wall Street Journal, Financial Times, and the legal media for the last few days. What's really going on here?

My conversations with CLOs on this issue indicate that while "true" backdating is a heinous practice, many of the current allegations levied by the governance ratings organizations, the SEC, and the media have swept into that category a whole bunch of practices that:

a.) aren't illegal (and indeed were tacitly condoned by auditors and the SEC)
b.) have been common practice in companies that have always prided themselves on the integrity in their compensation processes,
c.) have been openly disclosed (so there's no concern over super-secret executive shenanigans) and
d.) have CLOS and the business leaders they advise furious about being categorized as engaging in corrupt practices that inappropriately enriched company executives.

Companies that as a common practice choose a prospective or current date to grant options and then get that grant authorized by the Board's compensation committee members for approval (say, by passing a date of July 6 through telephonic approval on or before July 6), but who did not complete the paperwork to make the transaction complete for accounting purposes until later (say, July 19) are not appropriately swept into the same category as folks who decide on July 19 that they'd like to grant options dated July 6. To my (admittedly-non-securities-expert) mind, these two activities are entirely different things, and evidence entirely different mind-sets. But I'm talking to lots of people whose companies are being investigated for the former practice, as if they've engaged in some kind of secret criminal conspiracy to unjustly enrich business team members.

Clearly, one of the benchmarks emerging for companies that may have chosen dates ad hoc in the past is to consider setting dates that options will be granted for a regular schedule in the future (so that no one can claim that backdating to choose more advantageous dates was practiced).

But in the meantime, practitioner groups are forming to push back on what is being perceived as yet another attempt to criminalize non-criminal behavior, while at the same time that the SEC, investor groups, and even a special task force in San Francisco (will the State AGs be far behind?) are forming ranks to pursue possible charges against companies and execs that include a whole bunch of folks who never had a clue that their above-board and board-condoned options grant practices were going to be future classified as shady dealings. Certainly the SEC and auditors, which knew about many of the practices they now sweep into a general category of inappropriate backdating, never before suggested they had any problems with the practices. Just to cover the bases, the
SEC has supposedly asked the PCAOB to delay an examination and proposals regarding this issue for the moment. Kind of hard to know what to advise when only hindsight is 20/20, eh?

Of course there are egregious practices in the backdating scandals currently under scrutiny, but there seem to be a whole lot more folks who may be implicated (and essentially blackmailed into either expense defensive tactics or settlements) whose practices were above-board, non-criminal, and -- frankly -- widely considered just good business sense and common practice by regulators, in-house counsel, and so-called governance experts. What's your take?

Susan Hackett
Senior Vice President and General Counsel


Mukund Mohan said...

Susan, Nicole,
Option backdating is not ethical. Whether its illegal or not is an interesting but only useful for lawyers.

I do think a lot of these practices were not correctly spelled out which is why a lot of companies inaderverntly did the wrong thing and others (like Sycamore etc.) did the absolutely wrong thing.

Of the 63+ companies, there are possibly less than 5 (currently) that did the wrong thing in my opinion. We at Vangal have worked with a few companies and have seen unintentional mistakes.

One part of the hoopla is created by the media, but the other part is equally agressive ambulance-chasing lawyers who are "blackmailing" boards and companies to conduct internal review "just to be sure". We have seen this in 2 cases.


Susan Hackett said...

Mukund and I are in agreement on the important issues, I'd suggest.

In terms of some of the semantics, however, I do want to respond. While I appreciate that the practical result of this waive of allegations and scrutiny is that companies will think more carefully about how they structure options grants in the future (even if their current practices were not violating the spirit of the rules) so as to avoid any questions of backdating, Mukund's comment about illegality being interesting but only useful for lawyers is counter to the frustration I'm reading in the in-house bar and in C-suites and board rooms across the country .... lawyers are hired by clients to help them avoid what is illegal, and many lawyers feel that they may face discharge or even liability if they counselled a client about options grants processes based on what auditors and the SEC deemed allowable and customary practices in the marketplace, and then find their company under investigation for these same practices. Spotting and avoiding illegalities and insuring proper management behaviors is exactly what corporate lawyers do, so a question about something that previously wasn't illegal now becoming the basis for possible criminal indictment is more than a salon-like theoretical debate amongst lawyers. It's a reality that could threaten the future viability of the entity or land executives in jail.

No one suggests that the kind of practices alleged in the Brocade matter in the news today are appropriate, or the stuff of what lawyers should advise their clients. But a lot of people are being questioned about "backdating" issues that have nothing to do with a lack of open disclosure, nor about dating practices that were designed to allow management to go shopping for options dates with the benefit of hindsight understanding of the company's stock performance.

We probably agree on the larger issues here based on your company's experience that a lot of those under scrutiny probably didn't do anything wrong or untoward, and certainly very few did anything illegal. My point is that the research out of the University of Iowa that purportedly started this debate probably sweeps a lot of practices into a too-broad definition of backdating, and subjects a lot of companies with nothing to be sorry for to the scrutiny better reserved for those with criminal intent on their minds.

Susan Hackett
General Counsel, ACC