Knowing Your Stock Options

The burgeoning scandal over the timing of stock option awards will, as a matter of course, prompt companies to review their directors and officers (D&O) liability coverage. Reuters wrote in May that executives will be exposed to “…a wave of fresh shareholder anger as the list of companies under government scrutiny grows.” But just what is being scrutinized and by whom?

BACKGROUND

Stock options were once the darling of economists and compensation experts alike. During the ’80s, the rallying cry was for the alignment of corporate leadership interests with the interests of shareholders, in an effort to discourage the pursuit of executive personal enrichment to the detriment of the corporation.

To achieve this, executive compensation structures tied officers’ rewards directly to the appreciation of their companies’ share price. The presumption underlying this compensation scheme was share prices could only increase if corporate chieftains behaved themselves – i.e. if they pursued strategies to build shareholder value and executed those strategies successfully. Having done so, presumably investors would recognize the firm’s growing value, driving up demand for shares to the benefit of existing shareholders. Stock options were therefore intended to motivate company management to increase shareholder value and support good governance.

In practice, however, the use of options as a form of compensation has provided incentive for some to artificially inflate their company’s financial strength. The company’s resultant increase in stock price would thereby generate windfall gains for the executives upon exercise of the options. Others discovered the potential to backdate option grants to qualify them as “in the money” immediately without much, if any, risk to the officer.

BACKDATING OPTIONS

Typically, company-issued stock options give executives the right to buy shares in the future at a “strike price” equal to the closing price of the stock on the date the options were granted. If share prices subsequently rise and the options have vested (i.e., can then be exercised), the executive may purchase the optioned shares at the strike price and sell the shares at the higher current price, to realize the gain of the option. “Backdating” involves manipulating the date – and strike price – of the options in a way that creates a larger windfall for those executives who hold the options.

Torys LLP, which has offices in Toronto and New York, among others, has noted Canadian stock exchanges and securities regulators may adopt the current scrutiny of option issuance practices in the United States. The consequences of backdating are significant in both Canada and the U.S., and the prescribed rules and allowances for backdating options may differ from jurisdiction to jurisdiction.

Broadly speaking, there are a number of issues – from corporate governance to financial accounting perspectives – surrounding the so-called option backdating scandal. For Canada and the U.S., there are some issues of particular note.

BACKDATING AS A PROHIBITED PRACTICE

Currently in the U.S., companies may report in their proxy statements that strike prices for options are always equal to the market value on the date of a grant. The grant date generally coincides with the date on which the board of directors votes on the award. Revising the date thereafter could constitute a securities-fraud violation for a misstatement of material fact in a company’s disclosure. Indeed, the practice of backdating is not prohibited under SEC regulation if properly disclosed.

In Canada, the Toronto Stock Exchange (TSX) rules require the exercise price for stock options cannot be lower than the market price of the stock at the time the option is granted. This obligation appears, at the very least, to severely restrict the ability to backdate stock options. However, the process by which options are granted – typically done when a board of directors passes an approving resolution on the date they are granted – may still be subject to scrutiny, particularly if it is not stringently followed. Neverthe-less, as recently noted by a TSX spokesperson, if one is determined to manipulate exercise prices and timing issues, it would be difficult to detect.

INVOLVEMENT OF REGULATORS AND STOCK EXCHANGES

In what some are calling the biggest change governing executive compensation disclosure in almost 15 years, the SEC in the U.S. has recently proposed a plan whereby companies would be required, among several other things, to furnish tables in their annual filings that clearly show values of options on the date of the grant, and the closing market price on that day, if it is greater than the exercise price. The table would be designed to reveal any attempts by companies to give executives options priced below the value on the date they were granted; any discrepancies would have to be explained. Most parts of the new rule were expected and had been proposed in early January. But the sheer enormity and rapidly growing scope of the option backdating situation appears to have forced the SEC to act more quickly than anticipated, and to set clear guidelines for companies and stakeholder alike. On July 28, 2006, the U.S.-based Public Company Accounting Oversight Board issued its first ever “audit practice alert,” warning auditors to be watchful of problems relating to the timing and accounting treatment of stock option grants.

In Canada, interestingly, the TSX issued in October 2005 a staff notice to applicants, listed issuers, securities lawyers and participating organizations, reminding them of certain provisions in the TSX Company Manual relating to the granting of options under security based compensation arrangements. The notice states: “Staff has become aware that listed issuers may not be adhering to the requirements of Section 613(j) of the Manual, particularly in the context of ongoing consideration or negotiation of strategic alternatives of the listed issuer.” The notice emphasizes the requirement: issuers may not set option exercise prices on the basis of market prices that do not reflect material information of which management is aware, but which has not been disclosed to the public. The message of concern regarding stock option manipulation and the associated serious consequences is very clear.

UNDER THE MICROSCOPE

To date, the SEC, Department of Justice, U.S. Attorneys in New York and California, and the Internal Revenue Service all, in one form or another, have taken action based on the emerging backdating scandals. In June 2006, Integro Insurance Brokers reported to its clients that approximately 50 companies were either under investigation or embroiled in regulatory and legal scrutiny. As of August, the number increased to almost 80. In fact, the number of companies under SEC investigation or inquiry has nearly quadrupled from May 2006 to July 2006. According to Christopher Cox, SEC Chairman: “With more than 20,000 comments and counting, it is now official that no issue in 72 years of the commission’s history has generated such interest.”

INSURANCE IMPLICATIONS

Given the momentum of this issue, from an insurance perspective it is critical to know whether your company’s D&O insurance policy would respond if your firm becomes embroiled in these issues. The following elements of a D&O policy contract are worth reviewing and considering:

* Are investigative costs covered? Many companies caught up in the backdating scandal have publicly stated they have initiated ongoing investigations. These are usually undertaken by a special committee of the board of directors and supplemented by outside counsel; in some circumstances, accounting specialists are involved. Costs associated with these activities may or may not be covered. A review of the definition of “claim” and “loss” should be undertaken.

* Do policy proceeds pay for disgorgement? In some circumstances, policy proceeds might not pay for disgorgement. The possibility that options-related windfalls may be deemed ill-gotten gains should be examined and may determine efficacy of coverage.

* Is backdating excluded? A policy’s so-called conduct exclusions may bar coverage.

* Will these claims affect the indemnifiable or non-indemnifiable insuring clause of the D&O contract, or both? Will the limits of the total D&O program be sufficient in the event of multi-pronged litigation involving both criminal and civil allegations? Only exposure-based benchmarking of the D&O program can reasonably answer these questions.

* If there is a restatement of the financials of the company as a result of the backdating issue, will the carrier rescind coverage? Is there any non-rescindable coverage available to the directors and officers within the program?

CONCLUSION

The backdating issue, while still unfolding, is gaining steam within the regulatory and government communities, as well as the plaintiffs’ bar. Insurers and insureds alike will no doubt continue to monitor the evolution of the matter as it relates to management liability insurance. Taking the insured’s perspective, it will be critical to understand whether your company is properly covered in the event that it is investigated and/or sued. Also, the insured should determine what steps can be taken to maximize the responsiveness of the current D&O program and improve upon the program for the future.

The author gratefully acknowledges the contributions from his colleagues RJ Coar and Louise Pennington, who work in the New York office of Integro Insurance Brokers