Backdating of Options Might Spur New Rules

By Staff Report

Jun. 13, 2006

Regulators may not yet be finished with the string of rules affecting how companies determine and disclose executive compensation, thanks to the recent scandal involving companies that have allegedly backdated their stock option grants to executives.

This year, the Securities and Exchange Commission released a proposal requiring companies to disclose more clearly every aspect of executive compensation. The backdating of options wasn’t addressed then, but it surely will be now, compensation experts say.

Employers give stock options to top executives as part of their incentive pay. Usually, the exercise price of these options, or the price at which the executives can purchase the options, is determined by the fair market value of the company stock on the date the options are granted.

According to the allegations, grants at several firms, including UnitedHealth Group, occurred right before drastic jumps in the stock price. That pattern led the SEC and the U.S. Justice Department, as well as the U.S. attorney for the Southern District of New York, to investigate whether these companies set the date of the exercise price back to a date when the options were priced at their lowest. By backdating the options to a day before a stock run-up, companies could give their executives higher returns from the options.

If firms didn’t disclose that the options were backdated, and thus granted the options at a discount, they will have to pay huge accounting and tax charges. The companies also may have violated securities laws if they did not disclose the practice to shareholders.

The incidents highlight a need for more governance in this area, says Patrick McGurn, executive vice president at Institutional Shareholder Services, a Rockville, Maryland, company that advises institutional investors on how to vote on proxies.

Some analysts predict that the SEC might mandate that the exercise price of stock option grants be equal to the fair market value of the company’s stock on the day they are granted. Whether the agency takes this action or not, companies should be doing this as a best practice, says compensation consultant Jack Dolmat-Connell. Very few employers backdate options, but several choose dates in the future, he says.

“This is usually because if a company is dealing with a large grant, they have a lot of administrative (work) and communications to do before they actually make the grant,” he says. Dolmat-Connell says that the options-award contracts for executives shouldn’t be sent to the board “until you are ready to grant the options.”

But Russell Miller, a senior client partner in the New York office of Korn/ Ferry, doesn’t think the SEC will go as far as mandating grant dates. “The SEC has generally stated that it doesn’t want to get involved in managing companies,” he says.

At a minimum, the investigations into backdating will affect how the SEC’s final rule on executive compensation disclosure turns out, analysts say.

One of the controversial provisions in the proposal, which is expected to become a rule by year’s end, would require companies to add a new “Compensation Discussion and Analysis” section to their filings with the SEC.

These documents would explain the metrics companies use to determine compensation. As part of that, firms will have to explain how they determine the exercise price of their stock option grants to executives.

Many executives have written letters to the SEC complaining about putting that kind of analysis into a filed document. They feel that including such details in their SEC filings makes them liable for every minute piece of informa- tion, some of which they might not normally oversee.

“That argument is going to look pretty weak now,” McGurn says. “The SEC will want to put everyone on the hook.”

—Jessica Marquez

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