The U.S. Court of Appeals for the Ninth Circuit agreed with a district court on Tuesday that the former CFO of semiconductor concern Maxim Integrated Products, Carl Jasper, would be on the hook for backdating stock options without expensing them.
The case is notable for two reasons: it has been one of the few times that an options-backdating case actually went to trial, and it shows that CFOs and chief executives have no way to hide from improper expensing, even years later.
The Securities and Exchange Commission prevailed in its jury trial against Jasper in April 2010, but it has taken until now for the case to wind through the U.S. Appeals Court. Jasper appealed the case on trial errors he claims violated his rights, but did not dispute his knowledge of or involvement in the backdating scheme. He was ordered to repay Sunnyvale, California-based Maxim $1.8 million, as well as pay a civil penalty of $360,000.
The practice of backdating stock options as a way of retaining valued employees is legal, as long as the true expense of the backdated options is recorded as a company expense for employee compensation. In theory, it’s fine to offer an employee a backdated stock option — such as one for $20 when a firm’s stock is currently at $30 — as long as it’s accounted for correctly.
Ninth Circuit Judge Carlos Bea noted in his opinion on the SEC v. Jasper appeals case yesterday that for “in the money” options, in which an option’s strike price is typically lower than a firm’s share price, accounting principles require the company to record an expense for the profit to the options recipient, since the company could have sold its stock at the market price rather than grant an option.
The onus to maintain accurate financial statements is the responsibility of both CFOs and CEOs. “It falls on them because the statements were materially false at a time they were representing those statements were accurate,” says Mark Fickes, partner at BraunHagey & Borden and former lead trial counsel for the SEC in the Maxim/Jasper trial. Jasper signed all of Maxim’s filings with the SEC at that time.
Liability was found in the Maxim case partly because backdating and a failure to expense the practice were proven, Fickes notes. But it was also found because the CFO and CEO were aware of the backdating, understood the accounting consequences, and still allowed the company to issue its financial statements, he said.
Although Maxim’s backdating omissions date from 2000 to 2005, it reported in 2006 that it had to restate earnings dating back to 1997. The company eventually revealed in its 2006 10-K that it had an $838.3 million reduction in pretax income stemming from the backdating and an extra $515 million of pretax expenses from the improper handling of the options.
Silicon Valley, in particular, had been a hotbed for the practice of backdating options to retain key employees. “There were numerous individuals and companies that were prosecuted for backdating as a result [of inaccurate expensing]. We saw a greater concentration of it in Silicon Valley to retain key employees,” says Fickes.
But companies are currently less likely to run into the same problem that Maxim did, according to Koji Fukumura, a partner in the litigation department at Cooley. “The policies and procedures now in place in most public companies for owning options have been strengthened in light of the events of 2005 [when the SEC released stock-based compensation audit guides]. Most companies have very strict and detailed policies on the granting of stock options,” he says.
Companywide stock-option grants, for one, are typically initiated well in advance and involve generating a list of who can receive them. But as Fukumura notes, “Companies didn’t want to have sloppy processes; they just didn’t know all the variations that occur when lists are created. The vast majority of companies, to the extent that mistakes were made, [made] innocent mistakes, which we now view as insufficient policies and procedures.”
Jasper’s attorney, J. Scott Ballenger, could not be reached for comment at press time.