Share Options and Corporate Fraud

by

SALLY RAMAGE [[1]]

The backdating of share option grants by public companies may possibly have occurred in thousands of companies in the USA, UK and elsewhere. In the United States,  several dozen companies have received inquiries from the SEC or they may have received grand jury subpoenas from the United States Attorney’s Offices. Shareholders in the US have filed over 60 civil lawsuits alleging breach of fiduciary duty following internal investigations of option grant practices.[[2]]

Whether companies backdated or manipulated option grants to enable executives to utilize a lower than current market price is the issue. ‘Backdating’ involves the use of a grant date for a share option that comes before the date when the decision was made to award the option. This allowed the option to be back-dated to when the awarding company’s share price was lower, increasing the potential profit for the executives when the option is exercised. To investigate for option backdating, the investigator looks into whether options were deliberately backdated to periods when a company’s share price was at or near a record low and whether this was properly disclosed and accounted for. Option backdating raises a number of issues of potential concern to public companies and option grant recipients. Whether a company’s option grant practices are consistent with its public reporting is one issue. Some US companies face securities fraud class actions and derivative actions raising this issue, or related issues about internal controls, corporate governance and fiduciary obligations.

Whether backdated grants made at below fair market value received proper accounting treatment is another issue and failure to follow  accounting rules may require such a  company to amend and restate its financial statements, depending on jurisdiction. A third issue is the tax treatment of options. Companies must consider whether they have adequate policies, procedures and controls in place.

In the US,  SEC enforcement staff are  investigating those companies identified to date, in order to differentiate cases of ‘intentional wrongdoing’ from cases involving ‘dating issues arising from logistical delays’ and Securities Exchange Commission accountants are working with accounting firms to resolve this issue. The SEC is currently investigating over 80  US registered companies concerning possible backdating of share option grants and  Brocade Communications Systems Inc is one such company. Two pension funds have sued  a second such company, namely, United-Health Group Inc for allegedly breaching its duty to shareholders by allowing its Chief Executive Officer to secretly manipulate its share option plans. The United-Health case exposes an abuse of executive compensation, in which a single individual was given full permission to use share options as his personal fund. United-Health came under intense scrutiny for its treatment of share options after the Wall Street Journal published an article recently about the CEO’s share option grants. These share options were  fortuitously timed before a share price increase. The CEO’s action defied  statistical probability. The authority to pick the option grant dates had been  formalized in United- Health’s CEO’s 1999 employment contract, but not disclosed to shareholders. The complaint was filed to the SEC as a proposed class action and derivative suit by the Ohio Public Employees Retirement System and the State Teachers Retirement System of Ohio, alleging breach of fiduciary duty and violation of the Securities Exchange Act by way of

*  mis-statements and omissions in United-Health's proxy statements

* and  unjust enrichment against United Health ‘s CEO.[[3]]

Back-dating of options was something that used to take place even before [[4]] the Enron fiasco which catapulted the US government to enact Sarbanes-Oxley Act[[5]] which states that share option grants must be disclosed within two days of the grant. 

A University of Michigan  study published earlier this year[[6]] found that nearly one-quarter of share option grants are reported late and that the  Sarbanes-Oxley Act 2002 may not have completely stopped manipulation of the timing of share option grants. Thereafter, in July 2006, the  SEC voted to adopt changes to the rules regarding disclosure of executive and director compensation and companies will be required to disclose details about their share options grants in a table, together with a  narrative description of the timing of grants of share options. The US’s  Public Company Accounting Oversight Board (PCAOB) has been requested by investors and audit experts to notify auditors on how to find and prevent any future abuses.

There have been at least  three  cases  recently decided in U.S. district courts which deal with  certifications in securities fraud class actions pleadings, namely the Watchguard Securities Inc case, the Invision Technologies Inc case and the Lattice Semiconductors Corporation case. In each of these cases, the shareholder plaintiffs alleged that the company’s SEC reports contained material mis-statements. In Watchguard Securities  case, the plaintiffs argued that the CEO and CFO knew that the company’s financial results contained accounting errors. Those same officers had certified that they had designed and evaluated the company’s internal control over financial reporting. But  it was held  that the certifications were insufficient by themselves to prove that the officers knew about the errors. A similar decision was reached in the Invision Technologies Inc. case Officers’ certifications were insufficient to infer knowledge. The Lattice Semiconductor Corporation  also relied on the fact that certifications were evidence of knowledge and the decision was for the plaintiffs because these certifications  were not the only evidence of knowledge. There were several other compelling facts suggesting that the defendants knew that the company’s disclosure was misleading.

A fourth case is MCI Inc  when such share options were revealed. MCI Inc settled some $35 billion in outstanding debt. MCI Inc also had to  restate its  financial results for the years 2000, 2001 and 2002. The fraud was discovered in 2003. New corporate-governance policies were adopted  by MCI Inc and  internal controls were reinforced. This particular share option fraud involved some 50 employees and $11 billion of fraud  was discovered in the book-keeping. Billing systems were re-examined  and revenue was re-calculated in order to provide a proper baseline. The income statements had to be reconstructed. Former CEO Ebbers’ $70 billion worth of acquisitions were re-assessed in this process and overvalued by a total of $5.8 billion, resulting in $5 billion in company debt.

 

US Companies are being reminded by their accountants [[7]] that  FAS 123(R ) [[8]] applies in the context of equity restructurings such as share splits and share dividends. The discretionary adjustment of equity compensation under plans and arrangements that do not provide for automatic adjustments upon an equity restructuring may result in an additional compensation expense. Under FAS 123(R), companies that modify share awards are required to recognize as an additional compensation cost the excess of the fair value of a modified award over the fair value of the original award immediately prior to the modification (the "Incremental Cost"). In an equity restructuring, outstanding share awards  are adjusted to reflect the event. For example, a company will adjust its outstanding share awards to reflect a share dividend by increasing the numbers of shares subject to the share awards and reducing their ‘exercise’ prices. If the share  award contains an automatic anti-dilution provision, there is  no incremental cost associated with the adjustment to the share award. However, if the share award does not contain an anti-dilution provision, then the adjustment of the share award to reflect the equity restructuring may result in a significant incremental cost. FAS 123(R) also provides that if a share award is modified to add an anti-dilution provision and that modification is not made in contemplation of an equity restructuring, then a measurement of the incremental cost is not required.

Often a plan’s anti-dilution provision[[9]] will require that share awards be adjusted in the event of an equity restructuring, but leave the company or its board to determine whether a particular event is an equity restructuring and, if so, what adjustment is appropriate. Such a provision should be treated as automatic and non-discretionary.  An equity compensation plan containing discretionary anti-dilution provisions should be treated as not having an anti-dilution provision at all and the adjustment of share awards to reflect an equity restructuring could result in a significant incremental cost. If the plan does not contain an anti-dilution provision and no equity restructuring is currently contemplated , companies must amend their equity compensation plans to add an automatic, non-discretionary anti-dilution provision and consider the tax impact of any such modifications. Should such an amendment  impair the rights of the holder of a share award, the underlying plan may prohibit such an amendment without the holder’s consent.

Share options may be part of an employee’s contract of employment and thereby used as an incentive to keep employees. Such share option plans impose a condition requiring the employee’s continued employment with the company on the exercise date.

An example of  such a case was decided in the year 2001, it being Pommier v Bureau Veritas. Other cases are X v Ethicon in 2004 in which the case decision was that such a clause was enforceable and the case Jamy v Generale des Eaux Vivendi.

To avoid accusations of lack of share option transparency, a company can take example from Coco-Cola which decided in 2002 to  voluntarily expense share options, by accounting for share options on its Profit and Loss Accounts. A study of the impact that share options have on the value of a share revealed that, for instance, eBay’s share option plan yielded an estimated dilution of share price by nearly 30%. The company eBay had issued 19.55 million options in the year 2001.

A table of examples of the dilution that options cause on company value  is as follows:

Company

2001 options

[millions]

dilute shares

[millions]

percentage

%

Yahoo!

59.9

569.7

10.58

Cisco

297.9

71`96.0

4.18

Microsoft

223.0

5574.0

4.0

Krispy Kreme

2.2

58.4

3.8

Starbucks

9.6

394.3

2.4

Coco-Cola

45.0

2487.0

1.8

GE

60.8

9932.2

0.6


There is a huge difference in valuation which results when the level of dilution of a company is taken into account. and even though share options are not illegal in themselves especially when used as an employment tool, they do affect the value of shares, especially when they are not transparent.

 

 

The share option concern has not bypassed the United Kingdom where it is widely known that share options are used, to such an extent that there are precedent forms for share option plans. An example of a United Kingdom share option plan precedent is as follows:-

Company share option scheme (CSOP) rules1

Rules of the

(insert name of company)

 

Share Option Scheme

adopted by the Company on (insert date)

and approved by HM Revenue and Customs

under the CSOP Code

under reference no X.....2

on (date)

1 Definitions and interpretation

1.1  In this Scheme, the following words and expressions shall, where the context so permits, have the following meanings:

1.1.1  'Acquiring Company' -- a company that has obtained Control of the Company, or has become bound or entitled to acquire shares in the Company within any of the sets of circumstances specified in paragraph 26(2) of Schedule 4;

1.1.2  'Acquisition Price' -- the price at which each Share subject to an Option may be acquired on the exercise of that Option, being (subject to Rule 11) not less than:

1.1.2.1  the Market Value of a Share on the business day immediately preceding the Date of Grant; or

1.1.2.2  if greater, and Shares are to be subscribed, the nominal value of a Share;

1.1.3  'the Act' – the Income Tax (Earnings and Pensions) Act 2003

1.1.4  'AIM Rules' -- the AIM Rules of the London Stock Exchange;

1.1.5  'Associated Company' -- One company is an 'associated company' of another at any time if, at that time or within one year previously, one has control of the other, or both are under the control of the same person or persons (control being determined according to Sections 416(2)-(6)Income and Corporation Taxes Act 1988);

1.1.6  'Auditors' -- the auditors for the time being of the Company;

1.1.7  'Certified Provision' -- provision for  option holders which the Auditors have reported to the Directors to be, in their opinion, fair and reasonable;

1.1.8  'the Company' --(insert name)plc registered in England under No(insert number);

1.1.9  'Control' -- as defined by the Income and Corporation Taxes Act 1988 section 840;

1.1.10  'Constituent Company' -- the Company and:

…

1.1.10.2  any company ('the jointly owned company') of which 50% of the issued share capital is owned by the Company and 50% is owned by another person and which is controlled by both the Company and the other person taken together; or

…

1.1.11  'CSOP Code' – the Income Tax (Earnings and Pensions) Act 2003 sections 521-552andSchedule 4, and the Taxation of Chargeable Gains Act 1992 Schedule D Part 3;

..

1.1.13  'Demerger' -- a transfer by the Company to either:

1.1.13.1  all or any of its shareholders of shares in one or more of its Subsidiaries; or

1.1.13.2  another company (the 'transferee company') of substantially the whole of its interest in a trade (or substantially the whole of its shares in one or more of its Subsidiaries) in return for the issue of shares in the transferee company to the Company's shareholders;

1.1.17  'Grant Period'-- once the Scheme has commenced under Rule 14.1, if any shares in the Company are officially listed on the London Stock Exchange or traded on the Alternative Investment Market of the London Stock Exchange, a period of 42 days commencing on the day following the occurrence of any of the following events:

1.1.17.1  the approval of this Scheme (or any amendment to it) by HM Revenue and Customs under the CSOP Code; or

1.1.17.2  an announcement by the Company of its results for any year, half-year or other period, or the issue by the Company of any prospectus, listing particulars or other document containing equivalent information relating to Shares; or

1.1.17.3  a day on which an announcement is made of amendments to be made to the Act, or the Income and Corporation Taxes Act 1988,or a day on which any such amendments come into force;

1.1.19  'Market Value' -- on any day:

1.1.19.1  (in relation to Shares which are not listed on the London Stock Exchange) the market value as determined by the Auditors in accordance with Part 8 of the Taxation of Chargeable Gains Act 1992,and agreed in advance for the relevant purpose with HM Revenue and Customs Shares Valuation Division; or

1.1.19.2  (in relation to Shares which are listed on the London Stock Exchange) the middle market quotation of a Share as derived from the Daily Official List of the London Stock Exchange;

1.1.23  'Relevant Share Option' -- a share option scheme (other than a savings-related share option scheme) established by the Company (or any Associated Company) and approved under the CSOP Code, and any share option complying with the EMI Code in Chapter 9 of and Schedule 5 to the Act, and the Taxation of Chargeable Gains Act 1992 Schedule 7DPart 4;

1.1.27  'Subsisting Option' -- an Option which has neither lapsed nor been exercised.

3.1  In relation to any Option which the Relevant Grantor grants to an Eligible Employee, the Relevant Grantor shall:

3.1.1  execute an Option certificate (in the form of a Deed) on the Date of Grant, and

3.2.1  the Date of Grant of the Option,

3.2.2  the number and class of Shares subject to the Option,

3.2.3  the Acquisition Price payable for each Share under the Option,

3.2.4  any date or dates (as determined by the Relevant Grantor in accordance with Rule 4.2) upon which the Option is first exercisable in whole or in part, or when the Option ceases to be exercisable, and (where only part of the Option is exercisable on any date) the number of Shares in respect of which such partial exercise may be made,

3.2.5  the last day by which a notice exercising the Option can be given, and

3.2.6  any performance condition or other condition to be satisfied as a condition of exercise of the Option in accordance with Rule 4.1.

4 Conditions of Exercise

4.1  The exercise of an Option may be conditional upon the satisfaction of an objective performance condition or any other objective condition to be set by the Relevant Grantor at the Date of Grant[but which must be acceptable to and approved in advance by HM Revenue and Customs.] [The performance condition shall be measured over any consecutive 3 financial years commencing no earlier than the Financial Year during which the Option is granted, and should demonstrate the achievement of demanding and stretching financial performance over the period ripe for opportunity.]

4.2  When granting an Option, the Relevant Grantor may (if it in its absolute discretion thinks fit) determine any date or dates, or period, at any time from the Date of Grant to the day before the tenth anniversary of its Date of Grant, during which the Option is exercisable in whole or in part, and (where only part is exercisable on any date) the number of Shares in respect of which such partial exercise may be made.

4.3  If, after the Relevant Grantor has determined any objective condition to be satisfied pursuant to Rule 4.1, events occur which cause the Relevant Grantor to consider that any of the existing targets or conditions have become unfair or impractical, it may, in its discretion (provided such discretion is exercised fairly and reasonably)[with the prior approval of the shareholders of the Company in general meeting]amend or relax[(or waive)]such targets or conditions to the intent that any targets or conditions which are amended or relaxed will be no more and no less difficult to satisfy than when they were originally imposed, or last amended or relaxed. The Relevant Grantor shall notify all relevant Option holders in writing of any amendment, relaxation or waiver of existing targets or conditions made in accordance with this Rule 4.3.

4.4  The Relevant Grantor shall notify each Option holder in writing when any target or condition to which the exercise of his Option is subject (as amended or relaxed[(or waived)]pursuant to Rule 4.3) has been satisfied, or has become incapable of being satisfied.

5 Individual Limits

5.1  No Option shall be granted to an Eligible Employee if, or to the extent that, it would cause the aggregate Market Value of the Shares issued or transferred to that Eligible Employee on the exercise in full of all unexercised options then held by him under this Scheme or any other approved CSOP Scheme, to exceed £ 30,000 or such other limit as shall be specified from time to time in paragraph 6 of Schedule 4.

5.2  For the purposes of Rule 5.1, the Market Value of Shares shall be calculated as at the Date of Grant of the Options in relation to those Shares, or such earlier time as may have been agreed in writing with HM Revenue and Customs.

7.7  Where an Option holder ceases to be a director or employee of a Constituent Company,[a proportion of]any Option which is not exercisable by virtue of Rule 7.1 or Rule 7.2 (or both) at the date of cessation may become exercisable[(that proportion, if any, being determined by the extent to which any performance conditions set out in accordance with Rule 4.1 have been proportionately satisfied at that date, as adjusted on a pro rata basis to reflect the amount of the performance period completed)] and may be exercised (together with any Option which is already exercisable at that date) within the period of 6 months beginning with the date of cessation, provided that the cessation was on account of:

7.7.1  injury, ill-health or disability (evidenced to the satisfaction of the Relevant Grantor), or

7.7.2  redundancy (within the meaning of the Employment Rights Act 1996), or

7.7.3  retirement at the age of[60], for both men and women, or

7.7.4  the transfer of the undertaking or part-undertaking in which the Option holder is employed to a person other than a Constituent Company, or

7.7.5  the Company by which the Option holder is employed ceasing to be under the Control of the Company, or

9.2  If, under the Companies Act 1985 section 425, the Court sanctions a compromise or arrangement proposed for the purposes of, or in connection with, a scheme for the reconstruction of the Company or its amalgamation with any other company or companies,[a proportion of]any Option which is not exercisable by virtue of Rule 7.1 or Rule 7.2 (or both) at the date the Court sanctions such a compromise or arrangement may become exercisable[(that proportion, if any, being determined by the extent to which any performance conditions set out in accordance with Rule 4.1 have been proportionately satisfied at that date, as adjusted on a pro rata basis to reflect the amount of the performance period completed)], and may be exercised (together with any Option which is already exercisable at that date) immediately prior to, and conditional upon, the Court sanctioning that compromise or arrangement, unless the compromise or arrangement makes Certified Provision for the adjustment of Options or their replacement.

9.3  If any person becomes bound, or entitled, to acquire shares in the Company under the Companies Act 1985 sections 428-430F,[a proportion of]any Option which is not exercisable by virtue of Rule 7.1 or Rule 7.2 (or both) at the date that person becomes so bound or entitled may become exercisable[(that proportion, if any, being determined by the extent to which any performance conditions set out in accordance with Rule 4.1 have been proportionately satisfied at that date, as adjusted on a pro rata basis to reflect the amount of the performance period completed)], and may be exercised (together with any Option which is already exercisable at that date)at any time during which that person remains so bound or entitled.

9.4  If the Company passes a resolution for voluntary winding up, any Subsisting Option may be exercised within 6 months of the passing of the resolution, unless the winding up is for the purposes of a reorganisation or reconstruction which makes Certified Provision for the compensation of Option holders or the grant of new options to them.

10 Exchange of Options on a Takeover

10.1  Notwithstanding the provisions of Rule 9, any Option holder may at any time within the periods specified in Schedule 4 paragraph 26(3), by agreement with the Acquiring Company, release his Option ('the Old Option') in consideration of the grant to him of a new option ('the New Option') which is equivalent to the Old Option (by virtue of satisfying the requirements of Schedule 4 paragraph 27) but relates to shares in a different company (whether the Acquiring Company itself or some other company which, on the assumption that the Acquiring Company were the grantor, would be a company falling within Schedule 4 Paragraph 16 sub-paragraph (b) or (c)).

10.2  Where any New Options are granted pursuant to Rule 10.1:

10.2.1  the New Options shall be regarded for the purposes of the subsequent application of the provisions of this Scheme as having been granted at the time when the corresponding Old Options were granted, and

10.2.2  with effect from the date on which the New Options are granted, Rules 7, 8, 9, 10, 11, 14.2, 14.5 and 14.6 (and, in relation to expressions used in those Rules, Rule 1) of this Scheme shall be construed in relation to the New Options as if references to the Company and to the Shares were references to the Acquiring Company and to shares in the Acquiring Company (or, as the case may be, to the other company to whose shares the New Options relate and to the shares in that other company), but references to the Company in the definition of Constituent Company shall continue to be construed as references to(insert name of original company)plc.

10.3  As soon as practicable after having granted the New Option in accordance with the provisions of Rule 10.1, the new Acquiring Company shall issue an Option certificate in respect of that Option (or shall procure that an Option certificate is issued).

10.4  Subject to the above provisions of Rule 10, the Option certificate shall (subject as aforesaid) be issued in such form and manner as the Directors may from time to time prescribe and shall state:

10.4.1  the date on which the Old Option (which has been released in consideration of the grant of the New Option) was granted,

10.4.2  the number and class of Shares subject to the New Option,

10.4.3  the Acquisition Price payable for each Share under the New Option, and

10.4.4  the last date on which a notice exercising the New Option can be given.

11 Variation of Share Capital

11.1  In the event of any capitalisation, consolidation, sub-division or reduction of the share capital of the Company (and in respect of any discount element in any rights issue or any other variation in the share capital of the Company):

11.1.1  the number of Shares comprised in an Option,

11.1.2  their Acquisition Price, and,

11.1.3  where an Option has been exercised but no Shares have been allotted or transferred in satisfaction of such exercise, the number of Shares to be so allotted or transferred and their Acquisition Price,

etcetera.

ENDS

 

 

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[1] Sally Ramage, a member of numerous scholarly organisations. She is an established author of law books and articles . Her most recent book is  “A comparative analysis of corporate fraud”, ISBN-0-595-40198-8.

[2]  Other companies with share option troubles are Apple Computer, McFee, Mercury Interactive, Cnet Networks,  Brocade Communications Systems and Nvidia GeForce.

[3] see Public Employees Retirement System of Ohio v. McGuire et al., No. 06-2094, complaint filed, 22nd May 2006).  See also Securities Litigation & Regulation Reporter, Volume 12, Issue 03, 14th June 2006.

 

[4] Since the year  1993, it was proposed that US companies record share options on their balance sheets in order to close this accounting loophole. The accounting industry resisted this change and in 1994, Sen. Joseph Lieberman, California, led a successful effort in Congress to condemn the proposal, resulting in a 88-to-9 vote.

 

[5] The US  Sarbanes-Oxley Act of 2002 requires Chief Executive Officers and Chief Finance Officers to certify that their companies’ financial statements are accurate and that they have designed and evaluated internal control for financial reporting

[6] M.P. Narayanan & H. Nejat Seyhun, “The Dating Game: Do Managers Designate Option Grant Dates to Increase Their Compensation”, (June 2006).

 

[7] It brings to light another fear that the Big Four accounting firms misinterpreted accounting rules, overlooked any warning signs or approved the accounting practices, allowing manipulation as companies issued options at discounted prices, not necessarily illegal, without disclosing these grants to the Internal Revenue Service (IRS), investors or regulators. Another issue seems to be that companies repeatedly backdated options to dates more advantageous to the grantees, which saw paper profits sooner than others. This is a benefit in kind and must be treated as such.

 

[8] This accountancy standard means that a company cannot hide the true value of a share option by fixing the option terms on a date other than the true grant date.

[9] An anti-dilution provision is "a provision designed to equalize an award’s value before and after an equity restructuring." See FAS 123(R), paragraph A156.