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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Options Backdating: The Enforcement Perspective


Linda Chatman Thomsen

Director, Division of Enforcement
U.S. Securities and Exchange Commission

Washington, D.C.
October 30, 2006

Good afternoon. Thank you so much for spending time today on this important topic. I thought I'd talk a little about where we are from an Enforcement perspective. Looking backward, I'll ruminate a little about how we got here, and finally, at the risk of appearing to be or worse, actually being the secular equivalent of a sanctimonious twit, offer some thoughts looking forward on lessons we might take away from all of this. I should begin of course where I always do — with a disclaimer. My views are my own and do not necessarily reflect the views of the Commission or any other member of the staff. That's the official disclaimer. I have an additional, more personal disclaimer. My views are affected by my view. I have reached the point in life where I view the world through ridiculously expensive progressive lenses, but I guarantee you these lenses are not rose-colored.

So where are we? To recap much of what you may already have read or heard, the Division of Enforcement is investigating over 100 matters relating to potential abuses of employee stock options. The investigations are being conducted by SEC offices throughout the country and are being centrally coordinated and tracked here in Washington. In addition to our investigations, there is substantial criminal interest in options matters from United States Attorneys' Offices nationwide. In recent months, the SEC has brought two enforcement actions — one relating to Brocade and another involving Comverse. With respect to both, there are pending parallel criminal actions as well.

As most of you know, the Comverse criminal case has had a certain amount of drama surrounding former CEO Kobi Alexander, who was first a fugitive from justice, and later was located after he took up residence in Namibia, where he is presently fighting extradition to the United States. Taking a very different tack, Comverse's former CFO, David Kreinberg, last week became the first top level executive to settle actions brought by the SEC and the US Attorneys' Office since options backdating came into the media spotlight last Spring. In settling with the SEC, the former Comverse CFO consented to, among other sanctions, a permanent injunction against violation of the securities laws, a permanent bar against serving as a corporate officer or director, and payment of $2.4 million in disgorgement and pre-judgment interest. At the same time, in a related criminal action brought by the US Attorney, Kreinberg pled guilty to securities fraud and conspiracy to commit securities fraud, mail fraud and wire fraud, and he now faces up to 15 years in jail, mandatory restitution and a possible criminal fine.

Despite all the recent media attention, Brocade and Comverse are not the SEC's first stock options cases. In the past few years, we brought two other cases involving option issues in the context of allegations relating to broader financial frauds — one in 2003 involving Peregrine and one in 2004 involving Symbol Technologies. We do not expect to bring 100 enforcement cases regarding stock options — we are focusing on the worst conduct. But we do expect to bring more cases.

To be a little less enforcement-centric, I would also like to talk about where the Commission as a whole is on stock option matters. In addition to the enforcement efforts, others at the Commission have taken two other major steps to address this issue. First, there are the recently adopted rules relating to executive compensation disclosure which specifically address options. These rules, in combination with the prescient provisions of Sarbanes-Oxley requiring timely reporting of stock option grants, will go a very long way toward preventing the kinds of problems we are seeing today from occurring to the same degree in the future. Second, in September the Office of the Chief Accountant issued guidance for companies trying to cope with the financial reporting ramifications of their various historical options practices from a reporting perspective. From my perspective, the collective efforts by the SEC are a model way of addressing an issue — proceeding from various perspectives to come up with practical and wide-ranging solutions.

How did we get here? I'd like to address this on two fronts — first, I'll discuss how we got to our efforts at the Commission and then I'd like to step even further back and talk about some of my impressions on how we ended up with the option issues we are confronting. First, on the SEC front, our investigations are born of a conscious effort to proactively think about where problems might be, to methodically inquire whether there actually are problems, and then to pursue the best ways to address any problems that exist. In this regard, we identified stock options grants as a potential trouble spot several years ago — well ahead of the curve. We examined the academic literature that quantified the potential issues. Our Office of Economic Analysis then analyzed data and refined the areas of concern. And in the Enforcement Division, we gathered information and data regarding specific cases to bring the issues into focus, culminating in our enforcement actions over the last several years.

On a broader plane, how did we get here? I am old enough to remember employee stock options as an anti-takeover device. At that time, in the eighties and nineties, stock options, often in the money, were granted to employees in the hope that a highly-motivated employee pool would put the company in a better position to resist in hostile takeover battles. Over time, shareholders objected to the fact that the options were granted in the money and eventually many companies developed stock option plans in which grants could only be made at the money — that is, at the closing price of the stock on the day of the grant.

Meanwhile other legal and regulatory developments occurred that created distinctions between in the money and at the money options. These developments also tended to favor at the money grants. For example, at the money options received more favorable accounting treatment — they did not need to be expensed. They also generally received more favorable tax treatment. At the money options and other forms of performance-based compensation became even more attractive when the $1 million salary deductibility cap was enacted. So, from the shareholder, accounting and tax perspectives, at the money options had certain distinct advantages.

On the other hand, companies could make in the money grants. While they offended corporate shareholders, had to be expensed by the corporation, and had less favorable tax consequences, they had other advantages. In the money grants offered instant paper gains and the prospect of future wealth that was obviously attractive to employees, some of whom were themselves entrusted to decide precisely when options would be granted. In the late 1990s, companies were facing intense competition to hire and retain the best and brightest employees. At the same time, there was sharp rise in the overall level of executive compensation (some would say astronomical), despite the million-dollar salary deductibility cap. In this environment, cash-strapped companies found stock options an attractive way to provide competitive compensation without further tapping their limited cash flows.

Corporations faced pressures in two different directions — they wanted to attract and retain employees with attractive stock ownership opportunities offered by in the money grants, but they also wanted all the corporate advantages of making at the money option grants.

What did companies do? The right thing to do was to pick one or the other. A company could legitimately choose to make highly attractive in the money grants, so long it convinced its shareholders that such grants were necessary and desirable and also complied with all of the proper accounting and tax rules. Or it could choose to make at the money grants, and take full advantage of their accounting and tax advantages.

A word about the process of making stock option grants is in order here. Stock options grants usually require approval by a sub-committee of the Board of Directors. This usually happens in one of two ways — either the company convenes an actual meeting of the sub-committee at which they approve the grants, or the company circulates "uniform written consents" to each member of the sub-committee and solicits their approval of the options grants in writing. Either way, the process is time-consuming. But with the stock market frothing as it was in the late 1990s — those days of irrational exuberance — time was money. A day or two difference in the stock option grant date could have a tremendous impact on the value of the grants.

A company could focus on process — adhering to their ordinary processes for approving stock options regardless of the resulting grant date and strike price — or try to change their process to be more agile. Or a company could focus on timing, trying to capitalize on the ever-changing value of the stock options by manipulating their processes achieve a particular grant date. The trouble with the timing approach is it's nearly impossible to know in advance which day will be the most advantageous grant date. Nonetheless, companies tried to be more nimble, often delegating the authority to approve option grants to a single corporate officer — which, as we have seen — was a near-perfect opportunity for abuse.

In the face of all these competing interests and pressures, what happened? Far too many companies seem to have succumbed to the temptation to make in the money grants that appeared — for all corporate intents and purposes — to be at the money grants. How did they achieve this sleight of hand? Backdating — in all of its myriad forms. Putting false dates on corporate grant documents — as alleged in Brocade — was by far the simplest fraudulent scheme, but the variations seem to be limited only by the perpetrators' imaginations. In Comverse, for example, the company's top officers — the former CEO, CFO and General Counsel — are alleged to have routinely backdated stock option grants, giving themselves and other employees the benefit of 20-20 hindsight. According to the SEC's complaint, they went so far as to create a secret slush fund by making backdated options grants to fictitious employees, and later used those options to recruit and retain key personnel. To hide the backdating scheme, they also allegedly altered corporate records and lied to the company's auditors. Unfortunately, in the course of our investigations, we are finding that schemes like the one alleged in Comverse were not so unusual. Given the extremes that many company's top-level executives were willing to go to, backdating must have appeared to offer the best of both worlds — employees enjoyed the dazzling paper profits and stock ownership opportunities of in the money grants, while the corporation enjoyed all the advantages of at the money grants.

But stepping back for a moment — you have to ask yourself, what were they thinking? Falsified documents? Forgeries? Secret slush funds? Fictitious employees? Lying to the auditors? There's something very wrong here. The matters we are pursuing involve blatant and intentional conduct — not to mention the accounting and tax consequences to the corporation in eventually unwinding the scheme. And the scope of the unwinding consequences alone is enormous. The Associated Press reported last week that the companies that have publicly disclosed backdating problems to date will collectively incur costs of more than $10.3 billion in lost share price and additional compensation expenses.1 The AP also reported 41 senior executives have left 20 companies involved in the backdating scandal,2 and the total rises every week. Many 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 disruption and upheavals at the affected companies. Aside from the prospect of an SEC enforcement investigation and possible criminal liability, options backdating in all its various forms has left the companies involved in an accounting, tax and human resources quagmire. The good news is that the death knell on backdating has tolled because the motivation and opportunity to backdate has been substantially (though not entirely) eliminated due to a combination of new accounting rules that went into effect in 2005 requiring the expensing of all options, and the two-business-day reporting requirement for grants that became effective in 2002. Of course, we have been looking for more recent violations as well.

What lessons can we draw from all of this? I've given it some thought, and I think most of the lessons to be learned are consistent with what we all recognize as basic common sense.

First, beware the morphing monster — and its unintended consequences. Tools devised for one purpose can have dramatic unintended consequences when employed for different purposes in a different legal and tax environment. We've seen this happen over and over again. One example is the "Special Purpose Entity" or "SPE," which was designed as a special form of off-balance sheet accounting originally used in the aircraft industry. But SPEs migrated into other industries and morphed into a monster that was used extensively by the likes of Enron in perpetrating financial frauds. Another example is financial research — once a quiet backwater in financial services firms. When used as a tool by investment bankers, however, research reports morphed into a monster that clinched banking deals and drove IPO prices sky high — often regardless of the merits of the company, the true opinions of the analysts or the financial consequences to shareholders. Similarly, stock options were initially developed in the 1980s as an anti-takeover device, but because of unrelated changes in the tax and accounting rules, they morphed into a means of providing non-salary performance-based compensation, which was not their original purpose. And as we have seen, to the extent that stock option grants were viewed in the 1990s as a means of better aligning the interests of management and corporate shareholders by linking executive compensation to performance, they had yet another set of unintended consequences. Through backdating, stock options grants were used by some companies as a means of providing compensation that was entirely independent of performance. How did stock option grants become a monster? While most companies would ordinarily grant stock options through a specific and defined process that ensured legal compliance and fairness, many companies appear to have abandoned or compromised their processes in granting stock options. Once released from the restraints of process, stock option grants were allowed to run amok.

Second, your mother was right — just because your best friend jumps off a bridge doesn't mean you should too. Clearly, a lot of companies were involved in options backdating, but that doesn't excuse the fundamentally fraudulent nature of the scheme. If the only reason that can be offered as a justification for backdating is that "everyone else was doing it," that's a poor excuse for what amounts to unjust enrichment of a few employees at the expense of corporate shareholders.

Third, the simplest and most obvious lesson, you can't have your cake and eat it too. A stock option can be granted either in the money or at the money, but not both. You can take your pick, but you have to accept the consequences of your choice.

Fourth, process can be your friend. This is a variant of the "sunscreen and dental floss" rule. You see, both sunscreen and dental floss can have tremendous benefits, but only if you use them every single day. In the same way, if a company devises a specific lawful process for granting employee stock options and always follows it, there should be no problem explaining how, when and at what price any particular options were granted. The problems we are seeing with stock option abuses often seem to occur when a company abandons its regular process and starts to award stock options on an ad hoc basis. Like a hiker who strays off the path and into the wilderness, without the familiar signposts it's easy to get lost. If a particular grant process isn't working, then it should be changed. But the existence of a process and a company's adherence to it tends to ensure that the matter has been given careful consideration and is in the company's best interests. From a compliance perspective, creating and following a consistent process for awarding stock options seems to me to be something of a "no-brainer." Executive compensation is obviously an area where effective internal controls are critical. Like related party transactions, executive compensation is an important issue for boards of directors. Compared to other internal control measures, creating a standard process and a fixed schedule for the award of stock option compensation is relatively easy and inexpensive, especially when you consider the reported costs of backdating to companies involved. By following a standard options grant process, a company gets fair and transparent results, and there should be no random anomalies to explain. This brings me to another lesson.

The fifth lesson: If you are ever in doubt about whether any particular practice is right, imagine explaining it to your family, especially your children. This "explain-it-to-your-family" exercise has two advantages. To start with, you have to simplify and distill whatever it is you're contemplating down to its essence. The very process of simplifying the concept to its essence will usually enable you to see its true strengths and weaknesses. The other advantage is that you're pitching your plan to a supportive audience, but one that will give you their real opinions. If you want a really objective view of what you're doing, try asking a teenage boy. Teenage boys will tell you, in detail, all the flaws in your plan, and, for that matter, everything else you're doing. If you want more support, you might try your spouse — well, that depends. But if you can't imagine explaining to your children or other family members why what you're contemplating is the right thing to do, then you shouldn't do it. If you think about it, family members (except certain teenage boys) are the most sympathetic audience you're ever likely to face, so if you can't explain why it's right to them, it probably isn't right. In my prior career as a federal criminal prosecutor, whenever we won a guilty verdict from a jury, and fortunately we usually did, one of the hardest things was to watch the front row of the gallery — where the spouses and children sit — when a defendant stood up for sentencing.

Finally, what we have learned from stock options backdating — and from every other scandal in the financial markets in recent years — is that character matters. Corporate character matters — and employees take their cues from the top. In our experience, the character of the CEO and other top officers is generally reflected in the character of the entire company. If a CEO is known for his integrity, integrity becomes the corporate norm. If, on the other hand, a company's top executives are more interested in personal enrichment at the expense of the shareholders, our backdating investigations demonstrate yet again that other employees will follow suit.

In this regard, I am gratified to see that we have learned something from Enron and all that followed, particularly the enactment of the Sarbanes-Oxley Act, insofar as it has highlighted the critical importance of corporate governance. I spoke a few moments ago about the importance of process. Corporate governance is itself a process, which, when given due regard, ensures the integrity of the corporation and its conduct. I want to congratulate the Rock Center for all of the work it has done since its foundation earlier this year to address corporate governance issues, and to thank you all for your kind attention.



Modified: 11/06/2006