There is no statute that explicitly outlaws backdating stock-option grants, but it seems virtually impossible to backdate options and achieve the ultimate goal of putting grants “in the money” without first deliberately falsifying documents and then covering up the sham. At least that seems to be the conclusion reached by the Department of Justice and the Securities and Exchange Commission regarding their first case against executives charged with fraud related to backdating.
Last week the DoJ brought criminal charges against two Brocade Communications Systems executives, while the SEC filed a civil suit against the same two and the CFO. As expected, the charges focused on backdating stock options by doctoring employment documents, neglecting to record the stock-option expense on the company’s books, and misleading investors.
The cascading litany of alleged charges is not likely to stop with the Brocade case. Indeed, with more than 80 companies being reviewed by the SEC for potential illegal backdating practices, and one academic study claiming that more than 2,000 companies have engaged in the practice, civil and criminal charges will probably mushroom in the next few months.
A quick examination of the cases against Brocade clearly identifies why backdating is synonymous with fraud, even though no U.S. law bars the practice.
The purpose of backdating is straightforward: it gives options holders an immediate paper gain, and a real gain once the option is exercised. The practice involves using hindsight to assign a stock-option contract an earlier date than its actual grant date. By pushing the date into the past, to a time when the underlying stock traded at a lower price than it did the day the grant was issued, the option holder is, in effect, being given the promise of cash. That promise is considered to be an in-the-money options grant.
In-the-money options are different from performance-based compensation in the eyes of the Internal Revenue Service and the Financial Accounting Standards Board. For example, the IRS disallows certain corporate tax deductions for in-the-money options, but it allows them for performance-based pay. Furthermore, since 1995, when FASB issued FAS 123, Accounting for Stock-Based Compensation, companies have been required to record in-the-money grants as a compensation expense. (In 2004, FAS 123 was revised to require that all stock-option grants be expensed.)
Brocade’s crime, charges the DoJ, is that between 2000 and 2004, company executives “routinely backdated stock option grants to give employees favorably priced options without recording necessary compensation expenses.” Ultimately, the alleged criminal fraud is a disclosure and accounting issue that violates Section 10 (Manipulative and Deceptive Devices) of the Securities Exchange Act of 1934. The DoJ claims that by not properly accounting for the options expenses, the company’s financial condition was misrepresented to investors.
What’s more, the DoJ asserts that to facilitate the alleged scheme, the Brocade executives falsified documents — including employment offer letters and compensation-committee minutes — to make it appear that the paperwork supported the earlier options-grant dates.
The civil suit filed by the SEC also charges securities fraud, citing specific securities-law provisions, including those having to do with books and records, internal controls, misrepresentation to auditors, and Section 302 of the Sarbanes-Oxley Act, which requires CEOs and CFOs to certify the accuracy of financial statements.
The tax issue is narrower, but still looms. Under the U.S. Tax Code, a company can take up to a $1 million deduction for performance-based compensation awarded to “covered” executives. Those executives usually wind up being the top five executives.
Recall that in-the-money options are not considered performance-based compensation by the IRS. That means that if an option is in the money as a result of backdating, the company forfeits its tax deduction for the covered employees, explains Lehman Brothers tax expert Robert Willens. If the court finds that Brocade knowingly took a deduction it was not entitled to have, the company or executives involved could be guilty of tax fraud, as well.
In the end, if the DoJ proves that the Brocade executives deliberately orchestrated a scheme to mislead investors and regulators by falsifying documents and forging financial statements, it could amount to criminal securities fraud, contends Kenneth Lee, a securities litigator in the New York office of Thacher Proffitt and Wood. But the prosecutors would have to show that the backdating process was a deliberate attempt to mislead investors, rather than neglect on the part of the executives to properly understand and implement backdating.
Indeed, if the practice was properly documented and disclosed in the financial statements, and given the appropriate tax treatment, there is an argument to be made that no law was violated, contends Lee.