Editor: Ms. Standish, would you tell our readers something about your background and professional experience?
Standish: The law is a second career for me. I studied engineering at MIT and went on to the Air Force, where I worked on F-16 flight test programs. I then went to graduate school to work on space shuttle life sciences experiments. This technical background has oriented me toward a practice in patent and other IP litigation, and I am a registered patent attorney. I have also been engaged in a considerable volume of securities litigation, and the combination - the IP work, which involves building and protecting a company's portfolio, and the securities litigation work, which requires a knowledge of the company's core business and broader goals - provides a wonderful platform from which to serve clients.
Editor: How did you come to Winston & Strawn? What were the things that attracted you to the firm?
Standish: Following a stint in the U.S. Attorney's Office, which gave me a great deal of trial experience, and then at another large law firm, where I handled securities cases, I concluded that I needed another type of firm if I wanted to pursue both my securities work and build an IP litigation practice. Winston is a litigation powerhouse, and its IP and securities capabilities are formidable. I was also attracted to the firm because its West Coast presence was recent, and it was bringing in a great deal of strong, young talent. It was, and continues to be, a great opportunity.
Editor: You have spoken and written about the current hot issue in corporate compliance - the backdating of stock option grants. For starters, what have public companies been doing?
Standish: It is more a question of what some companies have not been doing - proper reporting and, in some cases, following their own corporate by-laws and executive compensation plans.
The backdating issue derives from the situation where the company actually grants a stock option on a certain date and selects another date - an earlier date when the underlying stock had a lower trading price - as the "grant date" for purposes of setting the exercise or "strike" price of the option. Options granted this way are immediately "in the money." In other words, they have value because the recipient - usually a corporate executive - could theoretically exercise the option at the lower strike price and then sell at the higher market price. If the option date and the date of the strike price are the same, there is a wash - and any value to the option must be earned in the future. Prior to the implementation of certain Sarbanes-Oxley reporting requirements in 2002, companies had a year within which to report on their stock option grants. This gave them a long window of time to look back and select a grant date that coincided with a dip in stock price, while still reporting in a timely fashion so as not to get caught manipulating the dates. Today, the company has a two-day reporting window, and if that report indicates that the grant was made six months earlier, there is an obvious reporting requirement violation, at the least.
The practice came to light when an academic named Erik Lie did a statistical analysis and determined that a great many stock option grants occurred when the stock price was at its lowest over a given period. He went on to do further work with another academic, Randy Heron, which indicates that 2270 companies, out of 7774 that were included in their study, may have stock option backdating issues, intentional or otherwise.
Backdating is what seems to have caught the attention of the media and the public, but in fact what is under scrutiny is the timing of options, and that entails more than backdating. "Spring loading," for instance, involves the situation where the company, knowing that positive news is going to be released to the public on a certain date, grants the options before going public with the information. The stock price goes up, and the option immediately increases in value. While this sounds nefarious, there is an argument that the grant recipients have contributed to the positive news and deserve the compensation that the options represent, like a form of bonus compensation. "Bullet dodging" is just the opposite practice, and occurs when a company waits until after the issuance of bad news to grant options at a time when the stock price is depressed.
Editor: What is the current focus of government investigations?
Standish: The investigations are very broad, and the debate within governmental agencies as to whether certain timing issues constitute bad conduct or not continues. So far, the actions that have been brought by the SEC and the Department of Justice have been against individuals, not companies, but companies have to deal with indemnification agreements, and still face potential liability as well as possible accounting and tax consequences.
Editor: Would you take us through the possible consequences to the company that, innocently or otherwise, has one date for the granting of options and another date for determining the exercise price?
Standish: Companies may have to restate their financials. In-the-money options have to be expensed in the year they are granted, reducing company earnings. In most cases this is not going to entail large restatements because the dollar amount of the additional value awarded to the executives is usually small relative to the company's total revenue. A similar problem arises with respect to the tax treatment accorded the grant on the company's books. Companies may have to file amended tax returns and pay penalties.
The really significant consequences have to do with disclosure - to the SEC and to the shareholders. If the company is forced to make what is only going to be perceived as a bad news disclosure, that may affect the stock price, and that may lead to shareholder suits. Suppose the disclosure reveals that the options were granted or priced in violation of company policy? That is certainly going to invite unpleasant attention.
At present, the civil lawsuits have taken the form of either securities fraud cases or derivative suits alleging breach of fiduciary duty. Shareholder plaintiffs file securities fraud cases where there was a significant drop in price when the market learns that the company has a problem. It will be very interesting, if any of these cases go beyond the settlement stage, to see how the plaintiffs' bar proves damages, because the drop in stock price is probably way out of line with the actual inflation in stock that can reasonably be linked to the failure to disclose the backdating practice. What has actually harmed the shareholder? The failure to disclose backdating, or the market's general loss of confidence in management?
The easier of the two types of cases to make in terms of liability is the derivative case alleging breach of fiduciary duty, particularly where self-dealing is present. Determining how the company was damaged may still be difficult to measure. For example, just because someone has received in-the-money options does not mean that those options will be exercised, if they are exercised at all, before the stock price drops. Often, executives are prevented from exercising their options for a certain period, which may be years. In any event, there is the issue of loss of goodwill - although also hard to quantify - in addition to costs of financial restatement and possible tax penalties to consider.
Editor: And the consequences to the company in terms of investor confidence and the perception of the general public?
Standish: These can be very serious indeed. The company may never be indicted, but the fact that it is under scrutiny for this particular practice may trigger a serious drop in stock price. The investing public may conclude - in this post-Enron environment - that a timing of options issue is a reflection of a culture of deception on the part of the company. To the investing public the obvious question is, if the company is doing this, what else is it doing? The company needs to be proactive here. It needs to show that it is a good corporate citizen. That is why so many companies are self-investigating, even when they are relatively certain they do not have a problem.
Editor: Please share with us your thoughts on the steps to be taken by general counsel of an enterprise perceived to have an options timing problem?
Standish: The first thing is to review all of the company's policies and procedures, including by-laws and stock option plans to determine what guidelines must be followed. Then, investigate historical practices by comparing option grants during the relevant period to market prices over the same period, and by examining documents such as minutes of the board of directors and the compensation committee. It is important to bring in a forensic accountant to conduct an analysis to determine whether the company's public documents indicate anything suspicious. As we've been discussing, do the stock option grants coincide with dips in the stock price?
If this process results in anything untoward, general counsel is usually well advised to bring outside counsel into the picture. Indeed, outside counsel should be involved in the retention of any forensic accountant in order to fully protect the attorney-client and work product privileges.
Editor: And the situation where general counsel is also a beneficiary of the stock option grants?
Standish: In any conflict of interest situation - where general counsel is himself a beneficiary or where general counsel has had too much discretion, perceived or otherwise - the advice of outside counsel is of crucial importance. Indeed, the company's usual outside counsel may be compromised if they had passed on the options program in the first place, and an independent outside counsel may be the way to go in these circumstances. The important thing here is to determine to go down the appropriate road early rather than late in the process.
Editor: And the role of outside counsel in this process?
Standish: A few firms, Winston & Strawn among them, have established options timing task forces. This combines the strengths of several different practice areas, and brings an extraordinary grouping of talent to bear on the issue. We handle a considerable volume of governmental investigation work and corporate investigation work, particularly in this and related securities areas. If the problem is serious, it is essential to have serious help, and this extends to a variety of arenas, including the forensic investigation and a host of electronic discovery issues.
An outside firm with access to a full inventory of legal disciplines and practice groups will be able to address the employee benefits and tax implications of the company's programs. Whether the company turns out to have a problem or not, it is important to have an assessment of the potential risk areas and to invoke best practices for the programs that are to be retained going forward. Outside counsel is probably in the best position to determine whether self-interested directors and executives are being utilized to determine the timing of options, and, more importantly, how to bring the curtain down on this practice.
With respect to Justice and SEC investigations, outside counsel is in a position to utilize the attorney-client and work product privileges to the maximum extent available in a climate that is changing very rapidly. While, under pressure from the American Bar Association and others, the United States Sentencing Commission has dropped its policy of encouraging enforcement officials to coerce corporations to waive these privileges in return for cooperation credit, it is important to note that at the present time the Department of Justice has not followed suit. Helping protect these privileges to the maximum extent possible while still cooperating with authorities is one of the principal contributions that outside counsel can make in this process.
Published September 1, 2006.