Canada: Stock Options: ´Backdating and Springloading´ - Are Your Records in Order?

By Eric C. Belli-Bivar and Liana L. Turrin

Just when you might have thought that the dust had settled on the series of scandals that have rocked corporate America, the latest chapter in this continuing saga - involving stock options - is just being written. Currently, the practices of ‘backdating’ and ‘springloading’ are the focus of investigation by US securities regulatory authorities and US federal prosecutors, as well as being the subject of several class-action lawsuits by shareholders.

The recent announcement by the Chief Criminal Investigator of the FBI, Mr. Chip Burrus, that it is probing the conduct of executives and officials at 52 companies, and that more cases are underway, underscores just how seriously the practices of backdating and springloading are being dealt with south of the border. Mr. Burrus notes that where his agency becomes involved "there are allegations of criminal misconduct".

The list of casualties in this ever-widening scandal seems to grow day by day. For example, at McAfee, the general counsel left after the company’s investigation into options timing. At Comverse Technology, the CEO and 2 other executives quit in May 2006 after the company found that grants had been backdated. Broadcom Corp. has announced that it expects a restatement of financial results to increase expenses by more than US $1.5 billion. Broadcom’s CFO also recently ‘accelerated’ his retirement following the internal investigation.

Perhaps the most egregious case that has come to light to date was announced by Cablevision Systems Corp. which, in a company filing, reported that options had been awarded to the company’s vice-chairman after his 1999 death but backdated to make it appear as though the options were granted while he was alive. The company had previously delayed releasing its second quarter results and said that it would likely restate earnings because of an internal probe into option grants. In addition, 2 directors of Cablevision have stepped down from the compensation and audit committees in the wake of several shareholder lawsuits naming them, among others, as defendants.

Evidence that companies in Canada are not immune from this latest corporate scandal came in the form of an announcement on September 28, 2006 by RIM - the maker of the iconic wireless email Blackberry devices - that it is reviewing its stock option grant practices as a consequence of the "heightened public awareness and concern regarding stock option grant practices by publicly traded companies".

RIM reported that its audit committee has already made a preliminary determination that "accounting errors" have been made in connection with stock options granted as far back as 1998, as a result of which RIM delayed reporting full 2nd quarter results. A company spokesman noted that the options review may require the company to reduce the amount of previously reported earnings by between US $25 and US $45 million dollars, and restate past results. RIM declined to provide any details as to the nature of the "accounting errors" giving rise to the restatements.

The current controversy over options backdating was sparked by the research of an unlikely champion of corporate governance, a Norwegian academic by the name of Erik Lie, who is an assistant professor of finance at the University of Iowa.

In his ground-breaking research, Professor Lie examined the proxy statements of more than 2000 large S&P companies to determine whether there was any empirical evidence to support his hypothesis that the dates of option grants were deliberately selected to coincide with a date on which the stock price was particularly low. His research found abnormally low stock returns before grant dates, and unusually high returns after those grant dates. This observation led him to conclude that "unless executives possess an extraordinary ability to forecast the future market-wide movements that drive these predicted returns, the results suggest that at least some of the awards were timed retroactively".

The conclusion reached in Professor Lie’s paper was that the abnormally high stock returns following stated option grant dates were consistent with his hypothesis that the official grant date must have been retroactively selected, and that the actual timing of option grants were not being properly recorded.

Options are frequently granted by public companies as a form of future compensation to motivate or incentivize employees (especially senior executives to whom the bulk of options have typically been awarded) and to align their interests with those of shareholders. The theory is that executives to whom grants are made will be motivated to increase the value of the company’s stock, and therefore the value of the awarded options. Investors expect options to be awarded ‘at the money’, that is, the exercise price of the options is equal to the price of the stock on the grant date. In fact, for TSX listed issuers, options must be issued at the then prevailing stock price of the underlying security.¹

Backdating can occur in at least a couple of ways. The first is to declare a stock option at a board (or committee) meeting without setting the exercise price at the time. At a subsequent meeting, having the benefit of hindsight as to how the stock has performed in the intervening period, a lower price during that period is selected as the exercise price. A second - and potentially fraudulent - variation occurs where there is a substitution of the actual date of the grant with a different date when the stock price is lower. In this case, the original grant date is simply erased, and the actual date is substituted with a more favourable one.

Another questionable practice concerning the timing of stock option grants has been referred to as ‘springloading’. This involves making a grant of options (whether scheduled or unscheduled) and delaying or deferring the release of positive corporate information until a time following the date of the grant. The expectation being that following the release of the information, the stock price will rise.

As a consequence of Professor Lie’s research, the SEC had, at last count, launched investigations against more than 100 companies for civil fraud, and the US Justice Department has laid criminal charges against several companies and executives. Expectations are that the number of companies and executives under investigation could significantly increase.

The practice of backdating has drawn the ire of lawmakers, regulators and shareholder groups because it involves some or all of the following:

• Board and committee minutes, resolutions and ancillary documents are backdated to misrepresent the actual dates of the related meetings and the associated option grants. It should be obvious to anyone who files disclosure documents with securities regulatory authorities that the falsification of documents carries with it very serious consequences.
• Where stock options are issued at a discount, applicable accounting rules require that an associated expense be reflected in the financial statements. On the other hand, during most of the period of time under scrutiny by regulators (generally, pre-2002), accounting rules did not require any expense to be recorded for stock option grants made "at the money", i.e. without a discount. Rectifying improperly dated option grants may, therefore, entail the following:

• company financial statements may be required to be restated to reflect the additional compensation costs of granting ‘in the money’ options
• expenses related to compensation are increased (and in some case may be disallowed for tax purposes)
• stated profits are reduced
• tax returns may need to be re-filed, and additional taxes paid, by the company, thereby further reducing the company’s stated profit

• The applicable securities laws and the rules of any stock exchange on which the company’s securities are traded may have been breached and, in the case of springloading, allegations of insider trading on the basis of undisclosed material information are raised.
• The stated purpose to align executives’ interests with those of shareholders is subverted insofar as the executives are awarded an instant benefit, as opposed to a potential reward based on their, and the company’s performance. Option backdating allows executives to realize significant wealth without building long term shareholder value. These practices also call into question the oversight of directors and compensation committees who, some argue, failed to protect the interests of shareholders.
• Cash compensation expenses are increased where stock delivered under the option is purchased by the company in the open market. When options are exercised, the company must either (a) issue stock from treasury, and thereby dilute the float, or (b) purchase the shares in the open market. In purchasing the shares in the market, the company must pay the difference between the exercise price and the market price which, naturally, is greater where the exercise price has been artificially depressed.

While there are many similarities to the US legal and securities regulatory regime, there are distinct differences in the current and historical Canadian rules governing the grant of options. As regards the current Canadian regulatory environment, the Canadian Securities Administrators (the "CSA") recently issued a Staff Notice (CSA Staff Notice 51-320 Options Backdating, the "Staff Notice") intended to communicate the CSA’s understanding of the backdating issue in the Canadian context. The Staff Notice identifies a number of requirements of the Canadian legal regime which it suggests may reduce the opportunity for Canadian companies to backdate or time option grants. Those factors include the TSX Exchange requirements that the exercise price of options must not be less than the market price of the stock at the time of the grant, and that the exercise price must not be based on market prices that do not reflect undisclosed material information.

The CSA Staff Notice also observes that the TSX rule which requires that all option grants must be reported to the TSX within ten days of the end of the month in which the grant was made may reduce the opportunity for Canadian companies to backdate or time option grants.² This reporting requirement is considerably longer, however, than the applicable reporting obligations established under the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act") in the US where option grants since the coming into force of that Act in 2002 are required to be disclosed within 2 days of the date of the grant. Prior to the enactment of the Sarbanes-Oxley Act, the disclosure obligations under applicable securities legislation were generally the same in the US as they currently exist in Canada. Interestingly, it is the accelerated disclosure obligations which were established under the Sarbanes-Oxley Act that some US commentators credit with largely eliminating the opportunity for companies to backdate options. Indeed, a follow-up study co-authored by Professor Lie suggests that the incidence of abnormal price increases following option grants have been reduced by some 80% (as compared with the pre-2002 data) as a consequence of the accelerated disclosure obligations mandated by the Sarbanes-Oxley Act.³

Whether Canadian legal obligations make it more or less likely to identify and capture questionable practices concerning the timing of option grants is certainly a question of debate. It would seem, however, that the prevailing corporate cultures north and south of the border are sufficiently similar to warrant an investigation into whether the practices of Canadian companies as regards the timing of option grants are in full compliance with all then applicable and currently prevailing legal requirements.

Many legal commentators consider that it is incumbent on all companies to undergo their own study before one is required ‘from the outside’. It is also reasonable to assume that option award practices will be the subject of question by auditors as the traditional audit season begins in the new year. While many companies have voluntarily initiated a review of audit of option award practices, Harvey Pitt, the former SEC chairman states that "many companies are sitting back and waiting for the government to tell them if there is anything wrong. You’ve got a mindset that says ‘don’t go looking for problems’," he says, noting that small companies are reluctant to conduct such audits because of the expense involved - even though those companies are the most likely to have used stock options for recruiting purposes in the pre-Sarbanes-Oxley Act era.

In light of developments in the US, a prudent course of action for all public companies in Canada - particularly those which are also publicly listed in the US - is to conduct a comprehensive review of past option practices and documentation, and as well to establish a policy regarding future option grants and the timing thereof. On this point, the CSA Staff Notice recommends that all issuers assess their current policies, procedures and controls for option grants and equity-based awards to ensure that they comply with relevant stock exchange rules and securities legislation.

Proactive action on the part of companies which use stock options in their compensation mix will not only enhance existing stock option grant practices, but will also demonstrate your company’s commitment in upholding the highest ethical standards in the conduct of its business. Indeed, as is noted in the CSA Staff Notice, in considering what course of action to take in the event that a breach of the applicable rules is discovered, "CSA staff may take into account what steps, if any, [such] issuers took to ensure their policies and controls complied with regulatory requirements". Proactive remedial action is also the recommended course of action in the US, the FBI’s chief criminal investigator noting that "if we linger around these things, then it’s not good for them, it’s not good for us".

We would be pleased to assist you or your company in performing an appropriate review, and appreciate your comments and observations.

Footnotes

^{1 Note, however, that the TSX Venture Exchange permits options on the stock of companies whose shares are traded on that exchange to be issued at discounts ranging from 15-25%.}

2 The filing deadline for “insiders” however is within 10 days of the date of the grant.

3 See Heron and Lie, “Does backdating explain the stock price pattern around executive stock option grants?” Forthcoming (2006) J. of Financial Economics

Eric Belli-Bivar has a broadly based corporate-commercial law practice, with a focus on corporate finance transactions. Eric is also a member of the Firm's Corporate Counselling and Governance groups, and regularly provides advice to public companies concerning their compensation and equity-incentive programs for senior executives, officers and directors.

Liana Turrin is a partner at Fasken Martineau. She is a corporate commercial lawyer with a broad range of experience in acquisitions and dispositions, commercial real estate, financing transactions and restructurings. Liana has acted for public and private companies in a variety of industries such as manufacturing, real estate, high tech, financial and retail, as well as financial institutions and governmental bodies.

© 2006 Fasken Martineau DuMoulin LLP

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.