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Managing
the Risks Associated with Stock Options Backdating
By Brian
Cleary
APRIL 2007 -
Stock options backdating does not inherently violate any federal
mandates. But for companies that lack visibility into option issuance
processes, options backdating can create real business risks because
of SEC disclosure and IRS tax accounting requirements. Failure to
comply with these rules can and does result in stiff penalties,
adverse publicity, loss of employee morale, and damage to investor
confidence—any of which can cause a company’s market
valuation to be reduced.
A company can avoid these
occurrences with a robust governance solution that enables transparent
oversight of the stock-option issuance process and that empowers
the company to incrementally establish a risk-and-control framework
that delivers a single point of management over other financial,
privacy, and industry-specific governance issues.
A
Symptomatic Governance Issue
More than
100 companies are under investigation for options backdating.
Although this practice is not illegal, regulators may view the
practice as an indicator of potentially greater wrongdoing. The
SEC could consider requiring external auditors to inspect options
backdating under the Sarbanes-Oxley Act (SOX) because of issues
associated with expensing options and the volatility that can
result from inaccurately reporting earnings. If options backdating
problems are found at more companies, Congress may be driven to
act. Last year the Senate Finance Committee (New York Times,
September 5, 2006) indicated its intention to discuss the scandals
associated with options backdating.
The risks
associated with backdating options do not exist in a vacuum; they
are simply part of a growing litany of governance challenges.
Even though companies may have documented their processes and
policies associated with issuing stock options in three-ring binders,
this manual approach fails to provide the visibility and automated
control tracking capabilities required to fully manage the risks
associated with regulatory scrutiny of options backdating. Meeting
this challenge head-on requires a holistic, enterprise-wide approach
to governance that delivers the following:
- A control-monitoring
mechanism that flags option grants that meet the defined criteria
which qualify them as being backdated;
- An automated
and auditable process that can ensure all required disclosures,
earnings restatements, and tax-reporting actions are completed
within allotted intervals; and
- A way
to ensure that any impacts of these remediation actions on the
organization’s overall risk-management and governance
positions are visible, understood, and proactively managed.
Solution
Requirements
To establish
a framework that will enable implementation of the policies, processes,
and visibility required to support these three requirements, companies
should look for a governance solution that can automate the process
of inspection for instances of options backdating on any scheduled
interval. These intervals vary by organization, but generally
should occur after meetings of the organization’s compensation
committee, because these meetings are where options grants are
most often made.
For existing
staff, instances of options backdating can be identified with
a technology solution that captures and stores the dates employees
were granted their options, the number of options granted, and
the strike price. The solution should provide a centralized repository
where documents related to the compensation committee’s
issues of stock options can be inspected and locked down, so that
the actual strike price at the market close on the date the grants
were made, and the strike price of those options as issued, can
be compared. In addition, the solution must ensure that the option
grant date, the option strike price, and the number of options
granted all match the compensation committee’s specifications.
Version control of the content in the repository will ensure that
original documents cannot be changed or tampered with.
If these
parameters do not match, then the technology solution should be
able to automatically notify the option issuance process owner
of the situation to determine if any wrongdoing has occurred,
and then trigger a remediation workflow to the appropriate departments
that will need to respond to the situation (e.g., finance, tax,
treasury). An audit trail of these actions should be maintained
in the central repository. Issuances need to be similarly treated
in cases where new hires receive option grants before receiving
their first payroll check. And, if remediation actions for either
existing staff or new hires are required with a frequency that
exceeds acceptable limits, the solution should launch a workflow
that notifies the appropriate executives or compliance officers
and offers suggested policy changes.
Finally,
the solution should be able to determine if remediation actions
affect other operational areas in the company, and how these actions
may affect overall risk management and governance requirements.
For example, if earnings need to be restated as a result of an
options-backdating occurrence, any impacts on SOX compliance or
on tax-filing reporting obligations need to be determined, and
the appropriate workflows need to be launched. Stock-option risk
dashboards, which provide rapid detection of potential problems,
and trend-analysis reporting enable executives and audit committees
to see patterns in option grant pricing that might cause regulators
and financial markets to question their corporate ethics.
Time
for Action
The short
version of the options-backdating story is that organizations
that retroactively date options must notify the SEC, expense the
costs of the options against earnings in the appropriate quarter,
and ensure that appropriate tax deductions are taken. Unfortunately,
the story has become more complex because the difficulty of meeting
these mandates has, all too often, translated into inactivity.
As a result, many organizations face enormous risks as various
government agencies start cracking down on options-backdating
practices.
Why has
this become such a focus of the government? According to a working
paper by researchers at the University of Michigan (Eric Dash,
“Report Estimates the Cost of a Stock Options Scandal,”
New York Times, September 6, 2006), backdating options
boosted surveyed executives’ compensation by an average
of $600,000, but resultant investigations caused a $500 million
decrease in shareholder value for their companies. Furthermore,
according to research done by the Indiana University Business
School, 19% of all option grants between 1996 and 2005 may have
been backdated, so the potential losses to shareholders may be
nothing short of startling. It comes down to this: The companies
currently under investigation may represent only the tip of the
iceberg, and regulatory pressures are almost certain to mount.
Against
this backdrop it is clear that the time to control options-backdating
risks is now—and the way for companies to do so is with
a holistic governance solution that provides the process, policy,
risk, and control framework that meets today’s enterprise-wide
mandates while positioning the company for tomorrow’s regulatory
challenges.
Brian
Cleary is vice president of marketing and product management
for OpenPages (www.openpages.com),
a provider of business governance risk, and compliance technology
solutions. |
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