In April of 1998 Cendant disclosed a restatement of 1997 results, including a reduction in net income of $ 100 million due to various accounting irregularities. Then on July 14, 1998 Cendant announced a further restatement of financial results for 1995, 1996 and 1997, including all quarters due to recognition of fictitious revenues and cookie cutter reserve mismanagement. At the end of August Cendant filed an SEC report indicating a reduction in operating income of $ 500 million; a reduction in net income before taxes of $ 297 million and the effect on earnings per share. As a result, the market price of the stock decreased from a high of $35. in April to $11. per share in August. Normally a 10% drop in stock price following an adverse announcement is enough to trigger a class action suit within 72 hours. Here the drop was precipitous: 69%.
Fifty lawsuits were filed in the U.S. District Court which were consolidated by the judge with several institutional investors as the Lead Plaintiffs. Hundreds of thousands of documents were produced by Cendant, Ernst & Young and the various defendants. An investment banking firm and a forensic team were retained as expert witnesses. Cendant settled for $2.8 Billion. Ernst & Young settled for $ 335 Million. This settlement was followed by even larger valuations in the cases of WorldCom ($ 6.2 Billion) and Enron ($ 7.1 Billion, pending final court approvals).
Enron directors agreed to settle class action against them for $ 168 million as their proportionate share of the settlement. Insurance covered most of the cost, but left them with terms that required the directors to personally pay $ 13 Million. WorldCom directors had a settlement requiring them to pay their proportionate share, $ 54 Million, leaving them $ 18 million owed on a personal liability basis. The directors in the settlement admitted no wrongdoing.
Backdating Stock Options
The backdating scandal we are currently reading about in the Wall Street Journal may, according to academics, affect up to 3,000 publicly-held companies. Defense attorneys, plaintiff attorneys and expert witness are beginning to mobilize. This potentially massive arena of litigation and expert testimony has occurred because of the practice in the last ten years of publicly-held companies granting stock options to key executives which were in-the-money but not properly recorded as compensation expense, thus violating GAAP, and misstating tax liabilities as well over every quarter since the practice began. In other words, dates were assigned to the options using hindsight that were earlier dates than the actual grant date. The SEC has just begun an investigation into approximately eighty companies, and the list is expanding daily. The DOJ and U.S. Attorney offices are making logistic decisions as to how to allocate predicted case load. Several criminal charges have been filed. At a minimum, companies that are involved will face civil charges by the SEC, massive restatements and therefore the virtual guarantee of class action and derivative suits. The suits have as their basis that the companies in question and their top executives as well as boards of directors have engaged in breaches of fiduciary duty, gross mismanagement, unjust enrichment and violations of the SEC Act of 1934. Back-dated options have allowed the defendants to reap millions of dollars in unlawful windfall profits at the expense of the company. One law firm alone recently filed 34 derivative suits. Its the largest area of civil litigation in history that is beginning to unfold before our very eyes.
Shareholder Derivative Suits
Shareholder derivative suits are increasingly filed in connection with class action suits. A primary concern is that directors and officers will find themselves without coverage for defense costs, awards for plaintiffs attorneys fees and a monetary settlement. Director & Officer insurance policies sometimes exclude payments for non-civil litigation, as where certain types of fraud which involve scienter exist. Even if it does, usually the coverage does not begin until an indictment is brought. Another area that contains elements of peril is that often payments are made on a first-come, first-serve basis. In other words, in the order that claims are filed. This can often lead to a shortage in the case of a settlement.
There is an upward trend in filings of derivative suits, which are filed primarily in state courts, as opposed to class action suits, filed in federal district courts. State courts often permit plaintiffs to recover on non-unanimous verdicts (required in the federal system) and some state laws permit lower standards of findings for recovery purposes. These stand-alone derivative suits are normally for breach of fiduciary duty, proxy violations, excessive compensation and breach of the duty of care or duty of loyalty.
The Business Judgment Rule supports active decisions of the Board of Directors, but it does not cover these breaches. For example, breach of the duty of care does not cover unintelligent decisions, ill-advised actions, or illegal breach of federal laws. Failure to question management representations is another example of this type of breach.
One solution to adequate D & O coverage is a Side A-only policy, which can protect directors and officers from losses not normally indemnified. These policies typically provide coverage even under adverse conditions, including corporate bankruptcy, when the limits of the traditional policy have been exhausted and under cases where the normal policy excludes payments. Some states do not permit corporate indemnification of unsuccessful defense against derivative suits and in these cases as well a Side A-only policy will provide coverage.
The Private Securities Litigation Reform Act of 1995 provided modifications and a safe harbor for corporations in one aspect of derivative suits the forward-looking statement. Tenuous inferences are not permitted in plaintiff pleadings. Allegations must include specificity as to falseness or why the statements made by the company were misleading. Under the safe harbor provisions of the Reform Act, a company is not liable for projections which are inaccurate if such statements are properly identified and accompanied by a cautionary statement which indicates that actual results could differ from projected results, and liability also does not exist if the plaintiff does not prove the forward-looking statement was made with knowledge that it was misleading. Forward-looking statements are often made verbally at analyst conferences, so this provides some measure of assurance to the corporate public relations department. However, as regards the option backdating practice, there is no safe harbor.
Trading Models
The economic basis of these settlements is an area of adversarial tests. In a monograph in the early 1990s, several authors criticized the use of trading models to estimate aggregate damages in class action suits, claiming that the results were not reliable and often overstated damages by as much as 74%. Daubert grounds have been challenged on a variety of proposed models. In Daubert the Supreme Court directed federal courts to consider four factors in evaluating expert testimony under Federal Rule of Evidence 702: (1) the general acceptance of the economic model; (2) potential rate of precision error; (3) peer review or publication; (4) whether the theory has been tested. In finding that various proposed trading models do not meet these standards, the court is concerned about whether the model has been tested and whether the model has been accepted by professional economists.
The Journal of Legal Economics is a good starting point for obtaining solid valuation models. It is a double blind refereed journal. Each manuscript is reviewed by at least three qualified individuals, in addition to the Editor. It was conceived as a forum for contributing authors, both from the profession of lawyers as well as the quantitative professions of accounting, economics and finance, to offer constructive insights to colleagues. It is designed to be a useful research tool for application as well as theory.
In theory, the out-of-pocket loss is the measure of damages in open-market class suits. Therefore a defrauded buyer can recover his share of class members damages, less applicable attorney fees, which can range from 15-30%. However, since this actual trading data is buried in repositories, models have been chosen to produce tangible results. The Private Securities Litigation Reform Act of 1995 leaves it open for the court to select the most reliable method of damages proof that is available. Two-trader models also exist, which assume, probably correctly, that there are passive investors and there are traders. Traders of course have a higher probability of acquiring and selling shares, and thus this model utilizes parameters for damage estimates with the damages estimated using depository record data. One-trader models often significantly overstate damages by 90-98%. Assumptions can therefore lead to bias. Three-trader models also exist which involve high-activity investors, low-activity investors and intraday-traders (who do not utilize overnight positions). Often these traders can account for up to one-third of all trading activity.
Recommendations
One strategy that is sometimes effective is the formation of a special litigation committee (SLC) that has the substance and form of independence. The committee has the responsibility of retaining forensic teams to review thousands of pages of documents and interview hundreds of witnesses. One corporation alone has 2 million documents to review and expects to pay $ 70 Million just to receive a Findings Report. The purpose of the committee is to provide the Court with the business judgment rule confidence to dismiss the derivative action. However, this procedure is not as simple and straightforward as it sounds.
Delaware and other states permit the board of directors to respond to suits by appointing an SLC comprised of independent directors. As long as the SLC is in process, the derivative suit is stayed. However, in the adversarial process that is underway continues, motions are often filed that question the true objectivity of the SLC. Delaware courts often slam the door to the SLC by ruling against them and letting the suit proceed. If the SLC members have significant social ties to the defendants in terms of past or future relationships that is one disqualification. Another is a public statement by the head of an SLC at any time prior to the issuance of the report that illustrates bias. It is hard to believe this would occur but in specific cases it has and it has destroyed the companys defenses from the beginning.
Directors often share institutional and social connections based on board service. This makes it particularly difficult to find objective third parties. Warren Buffet explained it this way: Why have intelligent and decent directors failed so miserably? The answer lies not in inadequate laws its always been clear that directors are obligated to represent the interests of shareholders but rather in what Id call boardroom atmosphere. Board membership requests are being declined in record numbers due to the perception of risk of being a director in this environment. However, corporate governance provisions are being taken much more seriously and since Sarbanes-Oxley mandates them, these recent revelations almost guarantee its place in history.
BACKDATING STOCK OPTIONS: CORPORATE REMEDIATION
As of August 17th the Wall Street Journal posted a study of 87 companies that have initiated probes, announced restatements, had executive resignations or Department of Justice inquiries into their stock options practices. The SEC has filed civil charges against executives of public companies, alleging that they engaged in a decade-long fraudulent scheme to grant undisclosed, in-the-money options to themselves and to others by backdating stock option grants to coincide with historically low closing prices of their stock. These complaints have alleged that former executives collectively realized millions of dollars of ill-gotten compensation through the exercise of illegally backdated option grants and the subsequent sale of related common stock.
In a separate matter, U.S. Attorneys Offices have unsealed criminal complaints charging executives with conspiracy to violate the antifraud provisions of the federal securities laws, wire fraud and mail fraud. It has been alleged that backdated option grants and secret option slush funds were deceits of the highest order upon shareholders. Executives, according to the SEC, have repeatedly used hindsight to select dates when the closing price of their common stock was at or near a quarterly or annual low. The complaints further allege that under well-settled accounting principles, in effect at the time, companies that granted in-the-money options were required to record a corresponding compensation expense and disclose such amounts in filings with the Commission. The executives have also been charged with violations of the Sarbanes-Oxley officer certification provisions of the federal securities laws. Injunctive relief, civil penalties, disgorgement, with prejudgment interest, and officer and director bars against each of the defendants has been requested.
HOW THE BACKDATING OCCURRED
It is helpful to review how the practices originated in order that remediation of ones own internal control policies can effectively take place. The executives directed and controlled the option grant process and initiated the backdating schemes. Among other things, they specifically selected the backdated grant dates by interfacing with the Compensation Committee. Grant documents with false grant dates were approved by the Compensation Committee. Unscheduled grants were the modus operandi. A spreadsheet contained lists of proposed grantees. At some point, the executives cherry-picked the grant date by looking back at their historical stock prices and, with the benefit of hindsight, chose a grant date that corresponded to a date on which the common stock was trading at a relative low. The master list was then submitted to the Compensation Committee for approval.
Unanimous written consent forms pertaining to the proposed grant were sent to Compensation Committee members for signature. It was known among the executives that these dates were the low-ball look-back dates they had previously chosen. Compensation Committee members were generally not aware of an impending grant prior to receiving the master list. The Committee members then signed, but did not date their copies of the consents and returned them. Based upon their involvement in the option grant process, each of the defendants knew, or were reckless in not knowing, that the unanimous written consents were false because the as of dates that were inserted into the consents and reflected in the companys books and records did not represent the true grant dates.
The executives knew that no corporate action to approve the options grants had actually occurred on the as of date. They knew this because they were the ones who had picked the grant dates by use of the look-back tables, with the benefit of hindsight. They had examined historical trading prices and selected a date with a low trading price. Options with backdated dates in effect also accelerated the vesting schedule because the Company used the backdated date for vesting purposes, not the date of the actual Compensation Committee approval. A large number of grants were grants at or near the lowest price for the fiscal quarter or year. In an article published by the Wall Street Journal, the patterns of stock options grants were analyzed and astronomically high odds, some approaching one is six billion, were determined to exist that such grants would have fallen on dates just ahead of sharp gains in the related corporate stock price by chance.
The secret backdating schemes allowed the defendants to disguise the fact that the Company was paying higher compensation to executives and employees by awarding them in-the-money options, and to avoid having to expense the in-the-money options as compensation expense, thus avoiding reductions to the companys net income and EPS. In addition, certain large institutional investors have long been opposed to stock option plans that allowed grants of options at below the fair market value of the underlying stock at the time of the grant. This is the basis for the tens of billions of dollars of derivative suits filed in recent weeks against related corporations by law firms on behalf of large institutional investors.
The California Public Employees Retirement System (CalPERS) is the largest U.S. public pension fund, with over $ 200 Billion in total assets. They have recently written an open letter to the Chairs of the Compensation Committees of a number of portfolio companies related to inquiries on employee stock option backdating practices. Their letter contains implications of allegations, including lack of oversight by the Board of Directors, weak internal controls, weak internal and external audit practices, poor accounting, significant income tax consequences for persons implicated for backdating options, and problems with the Executive Compensation Plan Administrator.
Senator Chuck Grassley of Iowa, Chairman of the U.S. Senate Committee on Finance, has publicly stated: Its one thing for an executive to make big profits because hes improved his company, but its a whole different thing to make big profits because hes playing fast and loose with the dating of stock options. Outside the corporate suite, Americans dont get to pick and choose their dream stock price. The market dictates the price.
The CFA Institute recently published an open letter to the SEC stating In the case of Post-Dating, senior executives (and possibly directors) used inside information or post-closing market prices to determine when to retroactively set the effective date of share-based awards in order to enhance the return of such awards. This practice also appears to have involved falsified accounting, may circumvent financial reporting requirements for variable option grants, may conflict with governance requirements related to the pricing of stock options, and may ultimately lead to criminal and tax penalties against companies engaged in these activities, thereby harming shareowner value even more.
REMEDIATION
In the real world, the best stance is one of pro-active remediation before any investigation by third parties begins. Materiality thresholds need to be considered according to SEC Bulletin No. 99 and Sarbanes-Oxley thresholds. If the materiality threshold is not breached, then no restatements will occur. If a restatement occurs, it almost guarantees an SEC investigation and also a finding of a Material Weakness by ones third-party auditors. Material Weakness findings can cause the loss of significant blocks of market capitalization upon disclosure.
The problems are not restricted to Information Technology companies. Their excess returns in the studies performed by the academics at the University of Iowa and others were what caught initial attention to the issue, but the scope is beyond IT companies. It is estimated that close to 3,000 companies are involved. In many of these cases undoubtedly management has retained its integrity, and the element of scienter does not exist. The rest of the public companies need to study and research adequate Sarbanes procedures to assure they are not affected in the future. The initial studies of proxy statements for statistics on options before the implementation of Sarbanes Oxley changed the reporting requirements to 2 trading days following August of 2002 indicated the problem existed as early as 1996 with the majority of companies. Grant patterns on excess return post-option pricing began largely in the mid-1990s. One company alone has close to two million documents that need to be examined to determine the extent of the backdating issues. I understand investigative, forensic and related professional costs in this one case alone are targeted and budgeted for $70 Million dollars. This does not include defense or settlement costs for related class-action and derivative lawsuits.
Without going into specific detail what is referred to as the Tone at the Top must be re-established at Compensation Committees throughout the world today. Directors and particularly Audit Committee and Compensation Committee members need to be re-educated as to governance requirements that comply with both the spirit and letter of the law. Compensation programs should not be driven by competitive surveys but by superior performance over the long-term. Full disclosure is necessary in proxy statements. Independent directors are a major necessity. Experts have to be added to Compensation Committees. If they are not there, then third parties must be hired who are expert consultants. Issues of Incentive Compensation, Dilution, Performance Options and Structures, Repricing, and a variety of tax and governance issues have to be addressed. Steps have to be taken to ensure that Board and Committee evaluations of compensation are equitable and it would be advised to refrain from using company resources to satisfy legal and tax liabilities for executives who are implicated in wrongdoing. This could lead to further derivative suits. Independent detailed investigations on a case-by-case basis with strong Board of Director backing need to be undertaken. The implications of Sarbanes need to be fully understood and addressed. Lying to auditors is now a federal offense. Insider manipulation is now not being tolerated by the market, nor by enforcement authorities who have oversight. Justice officials have made it clear that executives can face possible prison time for backdating stock options. Serious change and corporate governance must now follow.
The author maintains a web page with information about an eBook he has written entitled Streamlining the Sarbanes-Oxley Process: Research & Procedures. It is designed for senior management, board members and university use, and contains one of the most extensive analyses of the Enron case available.
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