By John Stuart and Kenneth Moore, Reitner, Stuart & Moore            

“Backdating” of stock options is the latest buzz in audit and compensation committee meetings and has also become the new hot issue for M&A due diligence. Backdating generally involves a difference between the date a company treats as the grant date for an option and the actual grant date for accounting purposes.

Several companies have recently restated their financial statements and many others have announced that they are looking into past practices and hiring independent counsel and experts to conduct an impartial review. Smaller companies are starting to be pushed into such re-examinations as a result of SOX empowered accountants or prospective buyers.

In a Sept. 19, 2006 letter, the SEC’s Office of Chief Accountant issued a discussion of the emerging issues that clearly demonstrates the problem need not involve nefarious, under the table fraudulent conduct but simple carelessness may be enough to run afoul of these rules.  

The SEC letter guidance involved old Accounting Principles Board Opinion No. 25 and the issue of what constitutes the “measurement date” for purposes of such Opinion. Measurement date means the first date on which the number of shares that an optionee is to receive and the exercise price are both finally determined. If an option award is made at a lower price than the market price on the measurement date, unexpected accounting treatment results. In addition to accounting disasters, there may also be unpleasant legal issues for the board to face, including whether the options are even lawful or tax qualified.

At first blush, it seems relatively unlikely that a company could have an award date prior to the actual measurement date of the option. However, all companies have various corporate governance, stock option plan and applicable legal provisions which specify the actions required to effect the grant of an option - what the SEC calls “required granting actions.” Problems could arise when there are administrative delays between the dates on which the option is granted and when required granting actions are actually taken. For instance, oral authorization from the board for the grant of an option on Feb. 1 which is not formally approved until the board meeting on Feb. 28, or the grant of an option by a committee member based on delegated authority on March 1 which is not formally approved until the board meeting on March 28, could both present difficult issues. In some instances, a company’s facts, circumstances and patterns of conduct may evidence that the option terms and recipient were determined on the earlier date. But, as the SEC argues, there may be facts, circumstances, and patterns of conduct which suggest that the terms were not finalized on such earlier date. A clear example of a problematic pattern of conduct cited by the SEC is when a company lowers the exercise price of some of its options where  the stock price has actually dropped from the earlier “grant” date to the date of formal action on those options.

In addition to the administrative delays in required granting actions, the Chief Accountant’s letter also discusses other practices that may be problematic, including:

• Uncertainty as to individual award recipients - for example, a board approving an aggregate number of options to be granted prior to the preparation of a final list of individuals;

• Exercise price set by reference to a future market price - for example, an option priced at the lower of market (i) on the date of grant or (ii) on the date 30 days after grant;

• Grants prior to commencement of employment - for example, setting the exercise price as of the date that an offer of employment is made;

• Documentation is incomplete or cannot be located - a very good reason to keep your board and committee minutes accurate and recorded when legally significant actions are taken;

• Changes to options grants due to the release of new information - for example, the lowering of the exercise price of an option after the release of negative information has driven down the price of the stock; and

• Income tax benefits related to options - for example, documentation of the exercise of an option before it actually was exercised.

If any of this sounds familiar, you can obtain the SEC’s letter from its website. Unfortunately, the guidance is far better at suggesting problems than solving any of them and has no apparent application to new options^[1]. If you think you have a problem, discuss it with the chairperson of your audit committee so that he or she can get accountants and counsel involved.  

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