Stock blot

Stock options are turning out to be the new area of corporate controversy in the US, with manipulation verging on the illegal becoming rife. Michael Feldberg reports

When a Texas jury convicted Enron’s top executives Ken Lay and Ray Skilling on 25 May, it seemed a fitting end to an era of corporate corruption that spawned litigation of an unprecedented magnitude, even by US standards.

But more trouble was around the corner. Manipulation of stock option grants through backdating, spring-loading and other techniques has become the latest scandal threatening to engulf corporate US in regulatory investigations, private lawsuits and criminal prosecutions.

In the US, as in the UK, granting stock options is a popular ‘carrot’ for motivating executives to serve a company’s interests. Despite the legitimacy of their ostensible purpose, options have proved vulnerable to manipulation.


Options grant employees a right to purchase their company’s stock at a future date based on a preset price known as the ‘exercise’ or ‘strike’ price. Usually an option’s exercise price is set at the market price of the stock on the day the option is granted. In such circumstances the option has no intrinsic value at the outset and is described as ‘at the money’.

Backdating, as the name suggests, involves setting the exercise price lower than the stock’s current market price by choosing an earlier date when the stock price was lower. Because these options have intrinsic value immediately, they are described as ‘in the money’.

One criticism of backdating is that it provides an instant paper profit that undermines the incentive to improve stock value. However, options typically have a vesting period of a year or more, so executives cannot immediately realise any paper profit, and whatever profit they may realise later will depend on subsequent improvement in stock price. Therefore it is not surprising that there is nothing inherently illegal about backdating under US law.

What is illegal, however, is a failure to account for backdated options properly. Prior to 15 June 2005, generally accepted accounting principles (GAAP) in the US did not require options to be expensed unless the exercise price was lower than the market price when granted. Thus, in-the-money options were supposed to be expensed. However, it appears that numerous companies failed to expense in-the-money backdated options. This improper accounting seems to have been widespread at Silicone Valley companies, which relied heavily on options to attract talent during the late 1990s.


Another controversial practice is ‘spring-loading’, which occurs when a company grants options immediately prior to the announcement of positive news, knowing that the stock price will go up. Alternatively, a company issues options following a negative announcement, knowing that the stock price will rebound after a short decline.

Critics regard spring-loading as insider trading, but it has some notable defenders. Paul Atkins, a commissioner of the Securities and Exchange Commission (SEC), gave a speech defending spring-loading, saying that it is a legitimate, efficient form of compensation. By contrast, the Public Companies Accounting Oversight Board (PCAOB), which regulates accounting firms, has stated that spring-loading may “create legal or reputational risks and raises concerns about the issuer’s control environment”.

Government investigations and actions

Often a company’s difficulties begin with notice that a regulator is undertaking an informal investigation. The SEC has targeted more than 80 companies in its investigation into options timing, but we may have only seen the tip of the iceberg. University of Iowa associate professor Erik Lie, widely credited with revealing backdating as a concern last year, recently completed a study which found that more than 2,000 companies may have illegally backdated options over 10 years. Some well-respected companies such as Apple and Microsoft have commenced internal investigations into back-dating. Apple recently announced that its mishandling of options would require “significant” revisions to its most recent quarterly results.

While the SEC has not reached a consensus on spring-loading, it appears that there are circumstances in which the SEC and criminal prosecutors will scrutinise the practice. For example, the SEC and federal prosecutors are investigating a grant of options by Cyberonics on the same day that the Food and Drug Administration recommended approval of one their products, resulting in a 78 per cent increase in stock value the following day. Similarly, Analog Devices reached a tentative settlement with the SEC concerning allegations of both spring-loading and backdating, and subsequently received a document subpoena from federal prosecutors.

When the SEC is involved, officers and directors must attempt to avoid regulatory action against themselves, as well their corporation. For instance, the SEC has given three directors of Mercury Interactive Corporation ‘Wells notices’, warning that it may bring civil enforcement actions against them based on their knowledge of stock option manipulation by the former chief executive officer (CEO).

Companies must also be prepared to respond to the Internal Revenue Service, which is working with the SEC to address taxation issues arising from options manipulation.

The most dreaded fate is criminal prosecution. On 20 July a special taskforce of federal prosecutors investigating backdating announced securities fraud charges against the former CEO of Brocade Communications Systems and its former vice-president of HR. Interestingly, the CEO is not accused of manipulating the value of his own options. Prosecutors point to incriminating evidence of backdated records, including minutes of compensation committee meetings and employment offer letters. The SEC has filed a civil enforcement action against the two criminal defendants and a third Brocade executive.

SEC enforcement actions and criminal charges in other cases are expected. As this article goes to print three more executives have been charged with options manipulation: the former chief executive officer, chief financial officer and general counsel of software company Comverse Technology have been indicted for allegedly orchestrating a backdating scheme that generated millions of dollars in profit for them.

Private suits

Because there is no ‘loser pays’ principle in US litigation, US plaintiffs’ attorneys tend to sue first and ask questions later. Therefore, shareholder suits are likely to follow any public disclosure of the possibility that option grants were manipulated. For instance, Apple was slapped with several suits within days of announcing its internal investigation into options pricing.

A shareholder may launch a derivative action on behalf of the company against officers and directors alleging breaches of fiduciary duties. Alternatively, a shareholder may commence a class action, seeking to represent all shareholders bringing securities fraud claims against the company and its directors, officers and possibly auditors. Plaintiffs often prefer class actions because they result in higher damages, but in backdating cases it may be difficult to establish necessary elements, which include loss causation.

Health insurance giant United Health Group faces both types of suits – a securities fraud class action based on a drop in stock value following media reports of backdating and derivative litigation seeking disgorgement of profits by its executives.

Despite the trend towards greater transparency, there is still plenty of room for disagreement about options, as the debate about spring-loading illustrates. n
Michael Feldberg is US head of litigation at Allen & Overy