[Senate Hearing 109-1072]
[From the U.S. Government Publishing Office]
S. Hrg. 109-1072
STOCK OPTIONS BACKDATING
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
ON
THE PRACTICE OF RETROACTIVELY CHANGING GRANT DATES IN ORDER FOR
EXECUTIVES TO BENEFIT FROM A LOWER EXERCISE PRICE.
__________
WEDNESDAY, SEPTEMBER 6, 2006
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Justin Daly, Counsel
Dean V. Shahinian, Democratic Counsel
Alex M. Sternhell, Democratic Professional Staff
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
C O N T E N T S
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WEDNESDAY, SEPTEMBER 6, 2006
Page
Opening statement of Chairman Shelby............................. 1
Opening statements, comments, or prepared statements of:
Senator Sarbanes............................................. 2
Senator Bunning.............................................. 4
Senator Menendez............................................. 4
Senator Allard............................................... 6
Senator Crapo................................................ 6
Senator Bennett.............................................. 7
WITNESSES
Christopher Cox, Chairman, Securities and Exchange Commission.... 8
Prepared Statement........................................... 39
Response to written questions of:
Senator Shelby........................................... 87
Senator Bunning.......................................... 88
Mark Olson, Chairman, Public Company Accounting Oversight Board.. 12
Prepared Statement........................................... 43
Response to written questions of:
Senator Bunning.......................................... 88
Lynn Turner, Managing Director of Research, Glass Lewis & Co.,
LLC............................................................ 25
Prepared Statement........................................... 50
Erik Lie, Associate Professor of Finance, University of Iowa..... 28
Prepared Statement........................................... 78
Response to written questions of:
Senator Bunning.......................................... 90
Kurt Schacht, Managing Director, CFA Centre for Financial Market
Integrity...................................................... 31
Prepared Statement........................................... 82
Russell Read, Chief Investment Officer, California Public
Employees' Retirement System................................... 33
Prepared Statement........................................... 85
Additional Material Supplied for the Record
Letter from the Council of Institutional Investors............... 91
STOCK OPTIONS BACKDATING
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WEDNESDAY, SEPTEMBER 6, 2006
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:10 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Richard Shelby, Chairman of the
Committee, presiding.
OPENING STATEMENT OF CHAIRMAN SHELBY
Chairman Shelby. Good morning. The Committee will come to
order.
This morning the Committee revisits the issue of employee
stock options. In the last Congress the Financial Accounting
Standards Board proposal requiring that companies recognize
options as a compensation expense in financial reports
generated much controversy. Indeed, there was an intense
lobbying campaign to thwart FASB's efforts.
But I believed then, as I do now, that the Board's
independence to establish generally accepted accounting
principles without political interference must be preserved.
That is the only way to ensure that the preeminent goal of
financial reporting is accuracy rather than politically
expedience.
As a result of FASB's project, the fair value of all stock
options as of the grant date must now be shown on corporate
income statements. Investors will benefit from this enhanced
transparency.
We are not here today to re-examine the expensing issue.
Rather we meet to consider the practice known as stock options
backdating. Almost 10 years ago an academic study noted
favorable stock patterns following option grants. The study's
author concluded that the rises in stock prices occurred
because executives knew favorable company news was coming and
timed the grants just before it.
Groundbreaking research published last year by Professor
Erik Lie, who is going to be one of our witnesses this morning,
indicated that something else led to the post-grant stock
gains. The grant dates were almost certainly retroactively
changed in order for executives to benefit from a lower
exercise price.
In his testimony later today, he will cite an unpublished
study he conducted with another professor. There Dr. Lie
concluded that 29 percent of firms that granted options to top
executives between the years 1996 and 2005 manipulated one or
more option grants in some fashion.
These findings raise some serious questions about the
accuracy of financial reporting during the period, even
assuming that they are only remotely accurate.
In March the Wall Street Journal published a widely
discussed statistical analysis revealing highly improbable
timing of option grants at several companies. For example, all
six of the option grants awarded to the chief executive of
Affiliated Computer Services were dated just before a rise in
the stock price, often at the bottom of a steep drop. The odds
of this happening by chance were around one in 300 billion.
At another company, UnitedHealth Group Inc., the chief
executive received option grants in 1997, 1999 and 2000 that
were dated the same day the company's stock hit its low for
those years. The Journal estimated the odds of such a favorable
pattern occurring by chance would be at least one in 200
million.
Intentional and undisclosed manipulations of grant dates
appears to be a black-and-white example of securities fraud.
Corporate officers and directors engaging in this practice are
cheating the owners of the company, who are the stockholders,
and should be held accountable to the fullest extent possible.
I am confident that this will happen.
I understand that the Securities and Exchange Commission is
currently investigating at least 100 companies for potential
backdating abuses. It has been suggested that it would have
been much more difficult, if not nearly impossible, to backdate
option grants had the accounting rules required expensing in
the 1990's. Accountants would have been more vigilant in
reviewing option grants if their expense were required to be
shown on the income statement.
Today we have assembled, I believe, an excellent lineup to
discuss these issues. Testifying on the first panel will be the
Honorable Christopher Cox, Chairman, Securities and Exchange
Commission and the Honorable Mark W. Olson, Chairman, Public
Company Accounting Oversight Board.
On the second panel we will hear from Dr. Erik Lie,
Associate Professor of Finance, University of Iowa; Mr. Lynn
Turner, Managing Director of Research, Glass Lewis & Company,
LLC and former SEC Chief Accountant; Mr. Kurt Schacht, Managing
Director, CFA Centre for Financial Market Integrity; and Mr.
Russell Read, Chief Investment Officer, California Public
Employees' Retirement System.
We will welcome all of you for your appearance and your
testimony here today.
Senator Sarbanes.
STATEMENT OF SENATOR SARBANES
Senator Sarbanes. Thank you very much, Chairman Shelby. And
I want to thank you for holding today's hearings on a subject
matter of serious concern to investors, and that is the
practice of improperly backdating stock options.
Federal securities laws are predicated, in large part, on
public companies making full and fair disclosure. Investors
rely on companies' disclosures in their investment decisions
and obviously they expect honest representations. If the
company makes misleading or fraudulent statements, investors
will lose confidence in the company's accounting, internal
controls and management. And regrettably, if enough companies
engage in this conduct, investors will begin to question the
integrity of the U.S. capital markets. In fact, their
reputation for integrity, I think, has been an important
economic asset for the nation.
In May 2005, Professor Erik Lie, the Chairman has already
referred to this study, published research that found that
returns on unscheduled stock option grants by a large number of
companies were abnormally high. He concluded, and I quote him
``Unless executives possess an extraordinary ability to
forecast the future marketwide movements that drive these
predicted returns, the results suggest that at least some of
the awards are timed retroactively.''
Regulators are now investigating a large number of
companies that may have awarded options retroactively, contrary
to their stated policies. Glass Lewis reports that over 120
companies have announced that they are under regulatory
investigation or are investigating themselves to determine
whether they have improperly backdated stock options.
This issue has attracted broad public attention and
concern. In an article ``At the Options Buffet Some Got a
Bigger Helping,'' in the New York Times in July of this year,
it was noted ``Investors are getting a clearer view of what
these executives were doing with their beloved options. It's
not pretty.''
The San Francisco Chronicle, in an article in July, opined
that ``The real story is how stock options, once a universally
cherished benefit in Silicon Valley, have led to executive
abuse and erosion of the public trust.''
And USA Today observed that it serves ``As yet another
troubling example of how shareholders are being fleeced. It
would also show how a benefit designed to attract, reward and
retain talented employees has been perverted.''
Unfortunately, it appears that improper backdating has been
widespread and gone unregulated for many years. Even after the
enactment of Sarbanes-Oxley and its 2-day reporting
requirement, which curtailed the problem, backdating reportedly
has continued where option reports were filed late. In other
words, did not comply with the statutory requirements.
The SEC and others have broad enforcement actions against
former officers of companies. The SEC also, on August of this
year, just a month ago, almost a month ago, published final
rules that require more disclosure about option grants,
particularly backdated options, and about spring-loading.
Notably, the Commission received a record 23,244 public
comments on this rule, showing a strong investor interest in
the disclosure of executive compensation.
The PCAOB has published a staff practice alert touching on
this issue.
I look forward to hearing about the scope of this
significant problem, what the regulators are doing to address
it, and what more should be done to prevent future problems. I
am particularly interested in whether the SEC needs more
resources for enforcement staff or otherwise or more authority
in order to address this issue.
Mr. Chairman, I join with you in welcoming our
distinguished witnesses. We are pleased to have Chairman Cox
back before the Committee, have Chairman Olson here as Chairman
of the Public Company Accounting Oversight Board. He has been
before us on other occasions in other capacities. This is the
first time as Chairman of the PCAOB.
And of course, the second panel includes a number of
distinguished witnesses, including Lynn Turner, former Chief
Accountant of the SEC; University of Iowa Professor Erik Lie,
whose who study we both referenced; Kurt Schacht of the CFA
Institute; and Russell Read of CalPERS.
Once again thank you, Mr. Chairman, for your leadership
first on the issue of expensing stock options, which we had to
address in an earlier time, and now for conducting this
important oversight hearing on the backdating and spring-
loading of stock options.
Thank you very much.
Chairman Shelby. Senator Bunning.
STATEMENT OF SENATOR BUNNING
Senator Bunning. Thank you, Mr. Chairman.
I am glad we are taking the time to look at the backdating
of stock options and any improper or criminal action that may
have happened. It is an issue that not only affects companies
and auditors, but also investors' confidence.
I commend Professor Lie for his work in bringing this issue
to everyone's attention. His work and the ongoing SEC
investigation show that our disclosure rules provide investors
and regulators with valuable information about what public
companies are doing.
The SEC is also working on new executive compensation
disclosure rules that would provide us with even more
information on option grants.
With the passage of Sarbanes-Oxley in 2002, Congress
reduced the time that directors, officers and principal stock
holders have in reporting stock options grants from 45 days to
2 days. That effectively ended the backdating that occurred in
the 1990's and the early 2000's. In other words, backdating
appears to be a problem of the past.
I am interested to hear from our witnesses today about
their findings on the current options granting practices.
We can all agree that those who willfully mislead and
defraud shareholders should be published. Anyone who broke the
law should be published. And any accounting problem should be
fixed. So far it appears that the SEC and other Government
agencies have the power they need to punish wrongdoers, so I
think we should be careful not to overreact by further
regulating how companies compensate their employees.
I look forward to hearing from our witnesses. Thank you
very much, Mr. Chairman.
Chairman Shelby. Thank you. Senator Menendez.
STATEMENT OF SENATOR MENENDEZ
Senator Menendez. Thank you, Mr. Chairman.
Let me thank you and the ranking member for holding a very
important and timely hearing on the backdating of stock
options.
It seems to me that to protect New Jersey families,
families across this nation, and their retirement security, we
have to have financial markets that are transparent, accurate
and full of integrity.
As we know, backdating is the practice of moving the date
for stock option grants to ensure an exercise price below the
fair market value of the stock on the date of the grant, and
thus, a bigger payday for the receiver of the option.
Perhaps even more widespread than option backdating is the
practice of timing a grant of options to take advantage of
anticipated market reactions to a forthcoming public
announcement by the company. This practice, which has been
referred to and commonly known as the option spring-loading,
has also come under scrutiny in the last several months.
I believe we have to get to the bottom of the true size of
this stock option problem. We know that there are over 100
companies that have come under scrutiny for past stock option
grants, and this includes companies that have disclosed
Government investigations, misdated options, or have made
restatements. However, some researchers believe the actual
number of companies that may be affected is up to 10 times that
figure.
In addition, these practices occurred over several years.
One or two entities have already been delisted on a market
because they could not file financials. Others have had
enforcement actions taken against them. And still others have
fired executives and members of their boards.
Imagine the potential impacts this situation could have,
not only for investors across this country but for the
financial markets themselves.
And this is not a victimless crime. Could this be the Enron
of 2006?
When this hearing was announced, I thought about the
various implications that the backdating of stock options
without disclosure could have. Under securities law, a company
and its CEO and CFO may be liable under the Securities Exchange
Act of 1934 for filing false and misleading financial
statements that did not properly account for the grant of
discounted options and may also be liable for other public
disclosure of executive compensation that did not describe such
discounted options. So the company would be in violation of its
option plan on file with the SEC and open to investigation for
potential securities fraud.
A company could also face accounting issues. Under rules
used in accounting, a company that has backdated stock options
would have to amend financial statements to reflect the
compensation expense resulting from the difference between the
lower exercise price and the higher stock option on the actual
grant date.
And finally, the Internal Revenue Service has announced
investigations of more than 40 companies to determine whether
they owe taxes related to option backdating. From the
company's, prospective discounted options do not qualify as
``performance-based compensation'' that is otherwise exempt
from the $1 million limit on the deduction of compensation paid
to company's top officers. A company that has improperly
treated certain options as having been granted at fair market
value may have overstated its profits and would have to restate
earnings to account for the lost deduction.
Several shareholder derivative suits have already been
filed against companies accused of option backdating. In
addition, such actions could potentially cause a company's
stock to fall, which would impact those that have invested in
the company.
So what I hope to find out today is whether we have a
better idea of the size of this backdating problem and whether
the rules on the books are both enough to stop this practice
from occurring anymore, while also allowing for effective
prosecution. Our responsibility is to ensure the objectivity
and independence of such investigations so that there is
greater public confidence in stock option grants and in our
financial markets while we protect the retirement security of
American families.
Mr. Chairman, I look forward to the testimony.
Chairman Shelby. Thank you. Senator Allard.
STATEMENT OF SENATOR ALLARD
Senator Allard. Mr. Chairman, I want to thank you for the
hearing.
And as a former small-business owner, I know a difficult
and challenging it can be to attract and retain top quality
staff, especially for positions that require a lot of education
and experience. Startup companies obviously have found stock
options one way to meet that challenge. We understand that.
I also understand that companies have used stock options to
motivate their employees, because they get to share in the
profits of the company at the time that those are issued and
collected on.
While stock options provide both benefits to employees and
the owners themselves, the companies, obviously there are rules
that must be followed when granting stock options. And these
rules help ensure the integrity of information reported to
shareholders and the marketplace.
Unfortunately, I understand not all companies have followed
the rules, and I commend the SEC for investigating possible
instances of backdating stock options and I will be eager to
hear the results of the investigation thus far.
I also commend the SEC, IRS and PCAOB and others for taking
steps to correct any financial misstatements that may have
occurred as a result of stock option backdating. Fair and
efficient markets rely upon the accuracy of financial
information.
While it appears that Sarbanes-Oxley and FASB action have
helped stem the occurrence of backdating, I will be eager to
hear from our witnesses regarding whether they believe any
further safeguards are necessary.
I would like to thank all of our witnesses for taking the
time to be here today. I look forward to your testimony.
Chairman Shelby. Thank you. Senator Crapo.
STATEMENT OF SENATOR CRAPO
Senator Crapo. Thank you very much, Mr. Chairman.
I think that historically we have seen that stock options
have been a very effective tool for companies to be able to
attract the talent and the people that they need to be
competitive and to help our economy to remain on the
competitive edge.
Recent events have also shown us that this tool can be
abused. It seems to me that we've got an extremely well-
qualified panel, a couple of panels, of witnesses here today
who can help us to find the right line in terms of where the
regulatory balance should be in managing and operating the use
of stock options while still allowing them to be a viable tool
for those companies that can utilize them in the proper way to
be a strong part of our economy and to help our nation continue
to be the leading economy in the world.
So I am interested in the testimony of the witnesses today
and appreciate the fact that you have brought this hearing
forward.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Bennett.
STATEMENT OF SENATOR BENNETT
Senator Bennett. Thank you very much, Mr. Chairman.
I am looking forward to the witnesses here. I have had the
experience of being granted stock options as inducement to come
to work as the president of a company. The number of options
was quite generous, and the stock never ever got back to the
level that it was when I joined the company. As a consequence,
I never converted any of the options and never got any of the
benefit.
I am sure that had nothing to do with my talent as the
president of the company, but was as a result of circumstances.
[Laughter.]
I recall here in the Congress, when we raised taxes in
1993, that we added to the tax code a provision that chief
executive compensation in excess of $1 million a year could not
be deducted. In other words, there would be no tax advantage to
a company that paid an executive $2 million a year. There would
be a tax penalty. Instead of being able to deduct the entire $2
million as a legitimate business expense, they can only deduct
$1 million as a legitimate business expense. The idea was to
discourage companies from paying their CEOs too much.
I will not go so far as to suggest that that was
responsible for the manipulation that occurred at Enron or the
temptation to backdate option grants. But certainly in the
rhetoric that surrounded that particular decision on the part
of the Congress, there was a great deal of talk about how
valuable it would be if CEO compensation was taken away from
straight cash and turned toward some kind of performance
incentive like stock options.
Well, we are now here talking about companies that have
manipulated stock options in order to maximize executive
compensation and perhaps get around the unintended consequence
that I think has occurred from what the Congress did.
I think we should remove the limit on the amount of
deductibility for cash paid to a chief executive and say if a
company wanted to pay its CEO $10 million in cash, it should be
able to do so and deduct the entire $10 million as a legitimate
business expense.
I know some CEOs who would say I would rather have the
cash. The stock option thing is--I will take less if I can get
it in cash, which I know is certain, rather than the
uncertainty of a stock option.
So we may, in the Congress, have created an unintended
incentive to cheat. That does not excuse the people who do
cheat. And I commend the SEC for their vigilance in following
up on people who may have decided that a clever way to deal
with this issue of compensation is to backdate options and be
able to pick, after the fact, the most advantageous time at
which the option becomes exercisable.
So I look forward to the hearing, Mr. Chairman, and I
appreciate your vigilance in calling the hearing and bringing
these witnesses before us. But I think if there needs to be
congressional change in the law in response to what is going
on, it might be in the jurisdiction of the Finance Committee to
deal with this aspect of the tax law that was put in place over
a decade ago and that, in my opinion, has not produced anything
of value to the markets or to the economy as a whole.
Chairman Shelby. Just for the record, I voted against that
tax bill.
Senator Bennett. So did I, Mr. Chairman.
Chairman Shelby. Chairman Cox, Chairman Olson, we welcome
you to the Committee. Your written testimony will be made part
of the record in its entirety. Chairman Cox, we will start with
you. You proceed as you wish.
STATEMENT OF CHRISTOPHER COX, CHAIRMAN,
SECURITIES AND EXCHANGE COMMISSION
Mr. Cox. Thank you very much, Chairman Shelby, ranking
member Sarbanes, and members of the Committee, for inviting me
today to testify about stock options backdating.
I think the reason that this issue is one of such intense
public interest is that it strikes at the heart of the
relationship among a public company's management, its directors
and its shareholders. I appreciate the opportunity to explain
the Commission's initiatives to deal with abuses involving
backdating of options.
I am especially pleased to be testifying this morning with
Chairman Mark Olson of the Public Company Accounting Oversight
Board. I will let Chairman Olson speak to the steps that the
PCAOB is taking to address these issues from the auditing
regulators' perspective, but I would like to assure the
Committee and the public that the Commission is working closely
with the PCAOB in this area.
There are many variations of the options backdating theme.
It comes in many flavors. But here is a typical example of what
some companies did. They granted an in-the-money option, that
is an option with an exercise price lower than that day's
market price. And they did this by misrepresenting the date of
the option grant to make it appear that the grant was made on
an earlier date when the market value was lower. That, of
course, is what is meant by abusive backdating, in today's
parlance.
The purpose of disguising an in-the-money option through
backdating is to allow the person who gets the option to
realize larger potential gains without the company having to
show it as compensation on its financial statements.
Rather obviously, this fact pattern results in a violation
of the SEC's disclosure rules. It also results in a violation
of accounting rules and the tax laws. The SEC has been after
this problem of abusive stock options backdating for several
years.
As a preliminary step in explaining the Commission's
response to this problem of abusive options backdating, it
might be useful to put the whole topic of executive
compensation into some perspective. As you know, during this
last year the Commission has been intensely focused on the
quality of disclosure of executive compensation. Very recently
we enacted new rules that will require, beginning with the next
proxy season, that there be full disclosure of all aspects of
the top executives' compensation.
Under the new SEC rules governing executive comp, the total
that a manager makes will be summed into one number so that it
can be compared easily from person to person, company to
company, and industry to industry. The new rules will, in
particular, require more detailed disclosure about stock
options. And this new disclosure will make it clearer to
investors if a company has backdated options and why.
The purpose of our new executive compensation rules is to
make the CEO's pay understandable to the shareholders who own
the company. Of course, no new SEC rules would be necessary to
make executive pay transparent if executives were all paid in
the form of salary. But, beyond the obvious fact that the
income tax code discriminates in favor of non-salary
compensation that can be taxed as capital gains, one of the
most significant reasons that non-salary forms of compensation
have ballooned since the early 1990s is the $1 million
legislative cap on salaries for top public companies that was
added to the Internal Revenue Code in 1993.
As a Member of Congress at the time, I well remember that
the stated purpose was to control the rate of growth in CEO
pay. I think we can now all agree, with perfect hindsight, that
that purpose was not achieved. In fact, this tax law change
deserves pride of place in the museum of the unintended
consequences.
There are other accounting and tax reasons as well that
stock options over the years were increasingly included in
compensation packages of executives and non-executives.
Beginning in 1972, the accounting rule was that employee stock
options would not have to be shown as an expense on the income
statement so long as the terms were fixed when the option was
granted, and so long as the exercise price was equal to the
market price on that day.
In addition to this favorable accounting treatment, and
beyond the favorable tax treatment afforded to capital gains as
opposed to ordinary income, there was a further tax benefit.
The $1 million cap on the tax deductibility of executive
compensation, which I just mentioned, does not apply to options
granted at fair market value. So, for companies that wanted or
needed to pay an executive more than $1 million, the tax code
outlawed the companies deducting it if it was paid in a
straightforward way through a salary, but permitted a deduction
to the company if the compensation was paid through at-the-
money options.
Of course, there were other reasons, many of them good
reasons with solid economic rationales, behind the use of
options as a form of compensation. For example, a properly
structured option plan can be useful in more closely aligning
the incentives of shareholders and managers. And, for growth
companies, the use of stock options as compensation offers a
way to conserve resources while attracting top-flight talent in
highly competitive job markets.
All of these factors have contributed to the now widespread
use of stock options as compensation. But just as option
compensation has increased, so did the potential for abuse. And
Congress deserves credit for taking preemptive action that we
now know was critical to stopping the spread of the backdating
contagion.
Four years ago, in 2002, the Sarbanes-Oxley Act very
presciently tightened up on the reporting of stock option
grants. Before Sarbanes-Oxley, officers and directors did not
have to disclose their receipt of stock option grants until
after the end of the fiscal year in which the transaction took
place. So a grant in January might not have to be disclosed
until more than a year later. Sarbanes-Oxley changed that, by
requiring real-time disclosure of stock options grants.
In August 2002, shortly after that law was signed, the
Securities and Exchange Commission issued rules requiring that
officers and directors disclose any option grants within two
business days.
Not only must option grants be reported now within two
business days, but this information was among the first that is
now required to be reported to the SEC using interactive data.
Thanks to this new data-tagging approach, economists,
researchers, law-enforcement and the investing public now have
almost instant access to information about stock option grants
in a form that they can immediately download into spreadsheets,
analyze and compare.
In 2003 the SEC took another important step that has helped
increase the transparency of public company option plans. The
Commission approved changes to the listing standards of the New
York Stock Exchange and the NASDAQ stock market. Those, for the
first time, required shareholder approval of equity
compensation plans. Since then, companies have had to disclose
publicly the material terms of their stock option plans in
order to obtain shareholder approval.
Very importantly, the required disclosure includes the
terms on which options will be granted, and companies must tell
their shareholders whether the plan permits options to be
granted with an exercise price that is less than the market
value on the date of grant. If backdating as a means of
granting in-the-money options is permitted by the plan, the
disclosure has to make that fact clear.
In December 2004, the Financial Accounting Standards Board
issued Statement of Financial Accounting Standard 123R, which
effectively eliminated the accounting advantage that had
previously been given to stock options issued at-the-money.
Since this new accounting rule took affect, all stock options
granted to employees have to be recorded as an expense in the
financial statements, whether or not the exercise price is at
fair market value. This rule is now almost fully phased in.
And most recently, in July of this year, the Securities and
Exchange Commission adopted new rules requiring that public
companies more thoroughly disclose their awards of in-the-money
options to top executives. The rules also require that
companies disclose the fair value of the option on the grant
date as determined under the new accounting rules. And, because
the dates and the numbers often do not tell the whole story,
companies will also be required to discuss the policies and
goals of their executive compensation plan and their stock
option practices in plain English.
The reports to investors will describe whether and, if so,
how a company has engaged in backdating or any of the many
variations on that theme concerning the timing and pricing of
options. The Commission will continue to avail itself of every
opportunity to clarify the rules and procedures for options
issuance going forward.
To that end, you can expect that the SEC's Office of the
Chief Accountant will soon issue further public guidance on the
accounting issues surrounding backdating.
Each of these steps that I have described has made an
important contribution to preventing backdating abuse and its
further spread. In combination, they have effectively slammed
the door shut on the easy opportunities to get away with
secretive options grants. That is why almost all of the stock
option abuses that our enforcement division has uncovered
started in the period prior to these reforms.
But, while these accounting and disclosure rule changes
have made it easier to detect and punish the backdating of
stock options going forward, uncovering the problems from prior
years has been quite a challenge.
A few years ago the SEC began working with academics to
decipher market data that provided the first clues that
something fishy was going on. One of the academics with whom
the SEC worked was Erik Lie with the University of Iowa who,
Mr. Chairman, as you noted, is here with us today. He
subsequently published a paper in 2005 that showed compelling
circumstantial evidence of backdating.
Specifically the data showed that before 2003 a surprising
number of companies seemed to have had an uncanny ability to
choose grant dates that coincided with low stock prices. With a
fair amount of detective work and with the aid of economic
research conducted by the SEC's Office of Economic Analysis,
the Commission succeeded in turning what had begun as mere
evidentiary threads into solid leads. Eventually some of the
evidence we began turning up was so compelling that several
U.S. attorneys took a criminal interest.
Over the past several years, our inventory of backdating
and related investigations has grown substantially. Beginning 3
years ago, the SEC has brought several enforcement actions
against companies and individuals for fraudulent option
practices. For example, in 2003 the Commission charged
Peregrine Systems Incorporated with financial fraud for failing
to record an expense for compensation when it issued in-the-
money options using a look-back scheme that took the lowest
price of the stock during a quarter. As a result, the company
understated its expenses by approximately $90 million.
The following year, in 2004, the SEC brought a case
alleging that Symbol Technologies Incorporated and its former
general counsel manipulated option exercise dates so that
senior executives could profit unfairly at the company's
expense. The SEC charged that the company's general counsel
instructed his staff to backdate the relevant documents and to
substitute phony exercise dates on the forms the executives
used to report their option exercises to the SEC and to the
public. When the company restated its accounting for this
improper backdating, it had to increase its reported expenses
for options by $229 million.
Most recently, in July of this year, the SEC filed a civil
fraud action against former executives of Brocade Communication
Systems, alleging that the former CEO and former vice president
of human resources backdated documents to make it appear that
the options they granted were at-the-money, in the process
concealing millions of dollars in expenses from the investing
public.
In fact, the SEC's complaint alleges that the scheme
resulted in the inflation of the company's net income by as
much as $1 billion in a single year.
And in another recent case, the SEC charged that three
former executives of Comverse Technology Incorporated engaged
in a decade-long fraudulent scheme to grant undisclosed in-the-
money options to themselves and to others by backdating stock
options grants to coincide with low closing prices of Comverse
stock.
In addition, the complaint alleges that the former CEO and
CFO created a slush fund of backdated options by granting them
to fictitious employees.
Both of these recent cases have resulted in criminal as
well as civil charges.
The SEC's Division of Enforcement is currently
investigating over 100 other companies for the possible
fraudulent reporting of stock option grants. The companies are
located throughout the country and include Fortune 500
companies as well as smaller cap issuers. They span multiple
industry sectors.
Of course, not all of these investigations will result in
enforcement actions by the SEC. At the same time, we have to
expect that other enforcement actions will be forthcoming.
To summarize, Mr. Chairman, the SEC has been and will
remain vigilant in the battle against fraudulent options
backdating. In our rulemaking, in our provision of accounting
and financial regulatory guidance, and in our enforcement
program we are determined to deal aggressively with past abuses
and to provide ample guidance going forward to stamp out
abusive backdating once and for all.
The Agency is grateful for the opportunity to provide you
with this update on an important subject. Of course, I will be
happy to take your questions.
Chairman Shelby. Chairman Olson.
STATEMENT OF MARK OLSON, CHAIRMAN,
PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD
Mr. Olson. Thank you very much, Chairman Shelby, ranking
member Sarbanes, members of the Committee. Thank you for the
invite. I am also pleased to be here today with Chairman Cox.
From the perspective of the PCAOB, as the Committee knows,
the PCAOB does not regulate accounting or disclosure. PCAOB's
role is to oversee auditors of public companies in order to
protect the interest of the investing public in order to
improve the quality and reliability of public company audits.
I support the observation that a number of you have made
that well managed stock options are useful and an appropriate
tool to attract and retain employees. But questions have arisen
about the pattern and of the timing of those options grants.
And studies suggest that there may have been some retroactively
assigned grant dates.
As all of you have referred to, and as we will be hearing
more from Erik Lie, Professor Lie, in the second panel, the
circumstances surrounding the options dating I think have been
very thoroughly aired to this point. But let me just remind the
Committee of a sequence of events that have, as Senator Bunning
has suggested, and others have suggested, significantly
narrowed the opportunity.
The first, as Chairman Cox pointed out, with the passage of
Sarbanes-Oxley, 403, and the rules implementing 403, that
requires a 2-day reporting for employee stock options grant has
significantly reduced the opportunity for manipulation of the
grant date.
Second, the sequence of accounting changes, from APB 25 to
FAS-123 to 123R, that now require the accounting at fair value,
also have significantly brought about a change.
Nonetheless, the PCAOB in July of this year did issue, as
Senator Sarbanes suggested, the audit practice alert that
summarized some of the existing literature. It summarized some
of the research that had been done by us and by others
regarding the timing of options and what auditors should be
looking for. That was issued at the advice of our advisory
council, some of the members of that council are participating
on your second panel.
There continue to be certain audit issues that do arise as
a result of the past practices and we are continuing our dialog
with the accounting profession to assure that not only are they
looking at those issues but they are establishing a risk-based
focus on auditing issues that would not only uncover this but
prospective issues as they would come up in the future.
I look forward to answering any questions.
Chairman Shelby. Thank you.
Chairman Cox, can you discuss here the forensic
capabilities of the SEC so we may better understand the means
and the methods that the Commission has to detect and prosecute
similar instances of fraud in the future?
Mr. Cox. Certainly, Mr. Chairman.
In both the Division of Corporation Finance and the
Division of Enforcement, we have teams assigned to monitoring
the delinquent filing of Form 4s, also of other periodic
reports, 10-Ks, 10-Qs, and so on.
We are also, in the Office of the Chief Economist, using
both the internal data that is generated from regulatory
filings and other academic analysis produced in the outside
world. For example, the collaboration with Dr. Lie is one of
the things that we mentioned, to drill down into these
problems.
I mentioned in my testimony that the filings on Form 4 of
the options grants were among the first that were required to
be filed in interactive data format. What that means is that,
instead of an electronic filing cabinet where the Form 4
appears like the other documents on EDGAR and you can print it
out or rekeyboard it into some other more useful form, you can
actually identify individual pieces of data on the Form 4.
So for example, the date of the options grant is
extractable automatically because it is in interactive data
form. So is the date that the form was filed. And, by comparing
those dates, you get an early read on where you should be
focused. That is just one of many tools that can be used.
Because of the academic interest in this subject, our own
economist's focus in this area, and the teams that we have
working in both Corporation Finance and Enforcement, the
analysis right now is getting pretty sophisticated.
Chairman Shelby. Do you believe you have got the tools to
do the job here?
Mr. Cox. I think there is no question the analytical tools
are there.
Chairman Shelby. That is good.
Chairman Cox, as you noted in your testimony, the SEC is
currently investigating approximately 100 companies for
possible violations of the securities laws associated with the
rewarding of stock options. What led to the decision to pursue
these particular investigations? Beyond the cases in current
active investigation, do you think there were other instances
of backdating that occurred?
In other words, do we have 100 cases? Or is there a bottom
line here with the number of companies involved? Or we just do
not know yet?
Mr. Cox. I think to answer that question it is worth asking
what is the touchstone for SEC interest? We are interested in
serious abuses. We are going to go after fraud. We are going to
go after cases, for example, that might also interest the
criminal authorities, as you have seen.
Chairman Shelby. You are working with the Justice
Department on a number of these cases, are you not?
Mr. Cox. That is exactly right. We are not going to focus
on the capillary. We are going to focus on the jugular. We are
going to have an instinct, we hope, for the jugular here.
There are probably a lot of companies that have paperwork
issues and inadvertent errors. The SEC is not going to use the
force of its Enforcement Division to play gotcha in such
instances. But we are very deeply and seriously concerned about
serious intentional abuses. Those are the kinds of cases that
we are going after.
So it has been that approach that has resulted in the
selection of the cases that we are investigating thus far. If a
company is under investigation, and then, it is established
that the errors are inadvertent and that this is not a proper
area for enforcement action, we will terminate our
investigation, drop it, and move on.
Chairman Shelby. Given the magnitude of the problem, would
it be advisable at all for the Commission to urge all public
companies to conduct an internal investigation? In other words,
look inward, examining the timing and pricing of the options
awarded in the past say 10 years or so?
In other words, to clean up their own act. I know it would
be something the SEC would advocate.
Mr. Cox. That is certainly good advice and is certainly
best practice. Compensation committees and boards of directors,
I am absolutely certain, are now on notice, and this hearing
will help in that respect as well, that this is an area where
they need to be involved.
Chairman Shelby. But if they do not do this, we are going
to probably see a small drip, here are some this week and next
week and so forth, whereas a lot of public companies could
probably help clean up the problem, could they not?
Mr. Cox. There is no question. Our Division of Corporation
Finance informs us that most large public companies, at least
in America, have already gone through this process as a result
of the attention that has recently been paid this issue.
Chairman Shelby. Chairman Olson, I have a question for you,
if I could. It has been suggested that auditors likely would
have been more vigilant in their review of the timing and the
pricing of stock option grants in the 1990's had the Financial
Accounting Standards Board, FASB, expensing rule been adopted
in the 1990's. Companies were then required to show the
compensation cost of options on the income statement.
Do you have a view on that? I know it is reaching back.
Mr. Olson. There is no question but what the issue of stock
options dating was not considered a high priority risk
exposure----
Chairman Shelby. But it should have been.
Mr. Olson [continuing]. At that time. And there are a
number of other combinations of circumstances that perhaps
would have brought it more into focus, and that may well have
been one of them, if they would have been expensed as opposed
to not had to be expensed under APB 25.
Chairman Shelby. Senator Sarbanes.
Senator Sarbanes. Thank you very much, Mr. Chairman.
Chairman Cox, I want to refer back to Chairman Shelby's
opening question to you about the failure on the part of a
number of companies apparently to comply with the 2-day
reporting requirement that was put in by Sarbanes-Oxley.
Professors Heron and Lie, in a recent study, noted that the
incidence of backdating was very substantially reduced as a
result of the 2-day filing requirement, but that it remains
significant for grants that are filed late.
Now as I understand your answer, you are now monitoring
that situation; is that correct?
Mr. Cox. That is exactly right.
Senator Sarbanes. Do you have adequate staff to do that?
Mr. Cox. As I mentioned, we have teams in two divisions
working on this, as well as the assistance of the Office of the
Chief Economist. And so we are, I think, all over this problem.
At the same time, I am quite certain that any additional
resources that Congress provided would be put to good use.
[Laughter.]
Senator Sarbanes. I hope you make that pitch to your
appropriations committee. We will try to be helpful in that
regard.
Chairman Shelby. We are going to meet later today. I guess
it will be about that, right, Mr. Chairman?
Senator Sarbanes. I want to ask about spring-loading. The
Los Angeles Times referred to two variations of a practice
called spring-loading which I think has raised substantial
public concern. It said, and I am now quoting them, ``In this
practice a company purposely schedules an option grant ahead of
expected good news or delays it until after it discloses
business setbacks that are likely to send the shares slower.''
So they can play it both ways.
The Commission actually has similar categories in its
preamble to its new final rules on executive compensation.
Chairman Cox, you were quoted in the L.A. Times as saying
``Going forward we will be very interested in both kinds of
spring-loading.''
Now Chairman Olson, the PCAOB, in its Audit Practice Alert
No. 1, in your footnote there you suggest that a grant of
options, and I am now quoting you, ``Immediately before the
release of information that the issuer believed would be
favorable to its share price, may create legal or reputational
risks and raise concerns about the issuer's control
environment.''
Seems to me that you are raising a very important red flag
here. What can be done about this practice?
I put the question to both of you.
Mr. Olson. Senator, from an audit perspective, the reason
to send the alert is that we would call attention to that
exposure the same way that we would for any other contingent
liability that a firm might have. It is intentionally in there
to direct the attention to potential legal issues, but also
reputational issues.
I think that the example that you just cited may, in fact,
be as significant a reputational risk as a legal risk. But
there are also income recognition, expense issues and tax
issues that may result from the practice. And that was what we
would expect the auditors to be looking for in instances where
there is a timing question regarding the issuance of the
options.
Senator Sarbanes. Chairman Cox.
Mr. Cox. As you note Senator, because spring-loading, as it
is not legally but in parlance defined, refers to timing option
grants to occur just before expected good news, it is bound up
with concepts of insider trading. Whenever insiders in a
company are conducting transactions in the company's securities
while in possession of material nonpublic information, these
insider trading issues exist. And the category of cases that
the Commission is going to be interested in are those in which
insider trading can be established and has occurred.
But I think that we can dichotomize that category of cases,
on the one hand, from the mere fact that options are being
granted at a time that management processes inside information.
Because management virtually at all times possesses inside
information. So one has to look at the integrity of the options
plans and the procedures by which the options are granted.
Senator Sarbanes. Mr. Chairman, I see my time is up. Thank
you very much.
Chairman Shelby. Senator Bunning.
Senator Bunning. Thank you Mr. Chairman.
Chairman Cox, this is just off the topic but I wanted to
follow up on a question I asked you at a prior hearing. I asked
about the status of the New York Stock Exchange's application
to expand their automated bond trading system. At that time,
you said the Commission would be acting soon.
But nothing has happened yet. Can you give me an update on
the status of its approval?
Mr. Cox. I can. I would be pleased to do so. The Commission
published the New York Stock Exchange exemptive request and a
proposed exemptive order for public comment.
We have received comment letters in response. We are now
going through that process of analyzing the comment letters and
dealing with the New York Stock Exchange on these issues.
I do not see any philosophical questions. We are just
working through the comments.
Senator Bunning. Thank you very much. Let us go back to the
current topic.
Should backdating be prohibited completely?
Mr. Cox. That is entirely dependent on whether Congress has
first defined what it means by backdating, since, at least
under present circumstances, not only is backdating in some
cases legal, but what we all think we agree on when we talk
about backdating is ill-defined. It is not really defined in
the law.
Senator Bunning. That is the question. Should we define it?
Mr. Cox. But if first we agreed on what it was we were
talking about, and second we agreed that it was unethical,
injurious to shareholders, violated our norms of disclosure and
so on, then I think a statutory prohibition--although it might
be belt and suspenders--would be completely in order. Because I
think there is a universe of things we could all agree we mean
to prohibit. And that is what these cases are all about.
But I hasten to add that these cases that we are bringing
are brought on the basis of existing law. So there is law there
to go after this.
Senator Bunning. This gets a lot to the point better I
guess, this question. What do you think is the appropriate role
for Government in regulating how companies compensate
employees? Should Government's role be limited to requiring
disclosure so the market can determine what compensation is
appropriate? Or should we be doing more and regulate how
business can and cannot compensate their employees?
Mr. Cox. Provided that there is no lying, cheating or
stealing going on, then, certainly from the standpoint of the
SEC's traditional role and authorities, disclosure is by far
the preferred course. Where companies are operating in a market
environment, certainly there is a competitive market for
talent. And so the executive compensation arena as a market,
like anything else, should be free to conduct themselves as
market actors without Government anticipatorily or preemptively
micromanaging that process.
But, as we discuss options backdating here today, it is
also possible that the normal task of a company paying someone
who works for them can be perverted or manipulated into a
device or a scheme to rip off the shareholders. And I think we
have to be on our guard against that.
Senator Bunning. In Mr. Lie's testimony today he advocates
reporting options grants on the same day they are granted. This
is for both of you.
Would it be feasible for companies to file with the SEC on
the same day that options are granted?
Mr. Cox. That is a very important question and I do not
know the answer. I do not know the answer despite the fact that
I have asked that question myself. It is something that we are
trying to look at and understand.
With companies that have operations around the world, the
time change becomes an issue. You have to be able to, if you
are in Europe, call somebody in the United States if the
transaction takes place in that way. There are just a lot of
aspects of this that may make it a little more difficult than
it seems to reduce the period from 2 days to one. The 2-day
period is already causing some people some problems.
Senator Bunning. Go ahead.
Mr. Olson. Senator, I would tend to support the comments of
Chairman Cox. I think the important thing is that where
previously it had been 45 days after the close of the fiscal
year, that allowed for a lot of opportunity for mischief where
the 2-day window narrows it down very significantly. And when
you combine the combination of down to 2 days with now the full
implementation of FAS123R, I think you have significantly
eliminated a lot of the abuses.
Senator Bunning. Thank you, Mr. Chairman.
Chairman Shelby. Senator Menendez.
Senator Menendez. Thank you, Mr. Chairman.
Senator Sarbanes. Senator Menendez, would you yield me 10
seconds just to make a comment?
Senator Menendez. I would be happy to.
Senator Sarbanes. It follows right in.
The one problem I see with this full disclosure as serving
the remedial requirement is it presupposes the shareholder
access to the Board of Directors in order to make them
accountable that does not exist in many instances.
Now the Commission has taken up that issue in the past. I
think you have now put it off. But I just wanted to make that
observation.
In other words, you can get the information. Then what are
they in a position to do with it? Other than if you do not like
it, sell your stock and go off in another direction.
But in terms of correcting the corporate practices, it is
very much related to what the shareholders can do in terms of
changing the corporate governance, either the directors or the
management. That is a different issue but I just wanted to make
that observation.
Mr. Cox. But I think it is a very important issue. The fact
is we do not yet have experience with a combination of the
Sarbanes-Oxley disclosure requirements that, as Chairman Olson
just mentioned, foreshortened the period from sometimes over a
year that you had to report these grants down to 2 days, and
what the SEC is now putting in place, much more detailed
disclosure about not only when grants are made and the terms of
those grants, but the policy of the company.
Do you use timing as an element in determining how you
grant options? And so on.
Because none of this disclosure has ever been made before,
perforce it is difficult to know how the market will react to
that kind of information and whether it will be an effective
tool. But I certainly expect it will help. And the question is
will it be the entirety of the solution or not?
Senator Menendez. Mr. Chairman, we have had an antiseptic
discussion about this topic. I would like to try to have you
characterize it for us.
I read your whole statement, in addition to listening to
your oral testimony. What do you believe is the--how would you
characterize this issue? A serious one? A major one?
Mr. Cox. There is no question that it is serious. There is
no question that it is major. And it is certainly major for the
companies involved and for their shareholders.
Our intention going forward is to cabin off this problem,
to ensure that it is an historical anomaly and that it does not
persist. So we are giving registrants every opportunity to
understand going forward how to avoid these problems. And we
are coming down hard on the most serious abuses that have taken
place.
Senator Menendez. Because it is not only the number of
investigations, I heard the figure 120, but it is what the
dollars that may be affected in that process.
I am referring to this Wall Street Journal article that had
a listing of all of these different companies. And just to take
two that had dollar figures attached to it, in one case there
was an acknowledgment that, in fact, they may have to reduce
the past 3 years net earnings by $286 million.
In another case the company said that it expects to record
additional non-cash stock-based compensation expenses of more
than $750 million as it corrects accounting for past stock
option grants. That is a total, just for those two companies,
that's $1 billion in restatement.
And so it seems to me that there is potentially a very fair
amount of money that is involved as it relates to shareholders
at the end of the day. So I appreciate hearing that you believe
it is both major and serious.
You said you had the analytical tools, in response to the
Chairman's question. Are there any other tools that you need
that you do not have to vigorously pursue the investigation of
these companies?
Mr. Cox. I do not believe so, although there are always
opportunity costs. We have chosen to focus resources on this
area. So, to the extent that a focus in one area creates an
opportunity cost elsewhere, we are probably paying such an
opportunity cost.
Senator Menendez. Sometimes board of director members get
stock options, as well; is that not correct?
Mr. Cox. Yes, of course.
Senator Menendez. In the process of doing that, are you not
concerned with the potential conflicts of interest and
overlapping relationships that could exist on the special
committees that many companies have, as part of their internal
investigation into the backdating of stock options?
Mr. Cox. Yes, of course, conflicts of interest have to be a
concern, not only of the SEC but of all regulators and
certainly of investors. The SEC, for its part, mandates very
full disclosure. And, as I described, we mandate much more in
this respect now than we have ever had before, effective with
the next proxy season.
Senator Menendez. Mr. Chairman, my last question.
Restatement, that simply does not absolve you if you had an
intentional effort to violate the law, I would assume? Because
it would be the equivalent of going ahead, robbing the bank,
somebody finding out that you robbed it, and then returning the
money.
Mr. Cox. That is correct. And in many cases we see both
fraud convictions in a criminal sense and fraud judgments in a
civil sense accompanied by restatements, which are necessary to
clean up after the damage is done.
Senator Menendez. Thank you, Mr. Chairman.
Chairman Shelby. Senator Allard.
Senator Allard. I am gathering from your testimony so far
that you think you pretty much have the tools, it is just
pretty much enforcement is the challenge you have. You need to
have the resources for that enforcement. Is that correct?
Mr. Cox. I think that is right. There are two aspects to
this problem. One is looking back at what went on. I think we
have all discussed here some of the historical reasons that
these problems could exist. There was perhaps a perfect storm
of circumstances that enabled these opportunities for fraud and
manipulation.
So we have got the historical problem on the one hand and
enforcement is going after these cases.
Then we have the question of what happens now? And what
happens in the future? The SEC is using its regulatory powers
to issue both rules and guidance in this area so that hopefully
for all but the most nefarious of wrongdoers there will be
every opportunity to avoid these problems in the future.
Senator Allard. That kind of brings me up into my next
question. Have you done some analysis on what the motives are
of the companies? Part of it was maybe driven by the tax code?
Was it ignorance of the law, not realizing that they could not
do that procedure? Maybe it is a company that had just become
public and they did not have to worry about that when they were
a closely held corporation?
Or was it some--maybe they were purposefully trying to
instigate some fraud? What was driving the motives? It would be
nice if we had a list of what motivated companies to do this.
Mr. Cox. Of course. I mentioned in my formal testimony that
you should expect reasonably soon additional guidance from the
Office of the Chief Accountant at the SEC on the accounting
issues connected to abusive backdating. One of the reasons that
we did not rush out with guidance--although issuing it as
quickly as we can--is that the SEC, and the Chief Accountant,
wanted to make sure that we had our arms around all of the
different fact patterns. And I think while there are perhaps
endless variations on these themes, we are reasonably
comfortable now that we have seen the major variations and that
we understand the different fact patterns.
In some cases people have black hearts. In other cases,
they are pure as the driven snow and they made mistakes and it
was all an accident. And then there is everything in between.
The fundamental economic motive for backdating, of course, is
that you get the opportunity to take money from the
shareholders and give it to someone else without anyone
knowing. And you do not pay taxes on it. And you do not
disclose it as an expense in your financial statements. Those
are all illegitimate objectives, but they are also the payback
from violating the law.
Senator Allard. On some of these cases where----
Mr. Cox. If you get away with it, I should say, which we
intend for people not to do.
Senator Allard. Were some of these, in cases of fraud, were
they pretty elaborate schemes and difficult to pick up? Or were
they pretty straightforward from an accounting perspective?
Maybe Chairman Olson would be the best one to answer that
question.
Mr. Cox. I can only describe, of course, the cases that we
have publicly brought, but I think that they serve as a good
example. I have described there in my formal testimony, which
is abridged in my oral statement; it is much longer in the
written form. But I have described the facts of those cases.
And I think you will see that these are not casual acts. These
are very elaborate schemes carried out quite knowingly, the SEC
alleges, by the people whom we have charged.
Senator Allard. Chairman Olson, do you want to comment?
Mr. Olson. Senator, there is a process by which an illegal
act, when an auditor encountered it, would either be referred
up through the chain of management to the board, to senior
management, or ultimately even possibly to the SEC.
But our focus from an audit perspective has been instead to
look at the environment that would tend to create these kinds
of risk exposures.
For example, if you have a company that is an aggressive
issuer of options, in an industry where there is a great deal
of volatility of that stock, and they continued to use the
accounting treatment, APB 25 accounting treatment, up to the
last possible minute, that would be evidence to an auditor that
they might want to look much more carefully at whether or not
there were timing issues with respect to the audit.
So, rather than try to look at it from the legal
perspective, we look at it from where the accounting risk
exposures are.
Senator Allard. You mentioned that we have not really
defined the backdated option. I think you mentioned that.
What is the problem of defining the backdated option?
Mr. Cox. I do not think it is intractable. I think we can
define it if we chose to do so. It would just be a necessary
first step if there were going to be any specific rulemaking or
legislation on this topic.
And so, in answer to Senator Bunning's question, I just
wanted to make sure that we all understood that backdating thus
far is not defined in the law but we are able to use pre-
existing legal concepts without difficulty in these cases.
Senator Allard. So it has been done through court case
pretty much? You do not think--you have not defined it in
regulatory--or if you do decide to do it in regulatory--do you
need law to be able to----
Mr. Cox. I think this is really esthetics. The question is
whether or not you would feel better if the term backdating had
a legal definition. But all of the elements of backdating that
make it abusive and illegal backdating are clearly defined in
the law right now. So I do not think we have any trouble
bringing these cases.
Senator Allard. Thank you. Thank you, Mr. Chairman.
Chairman Shelby. Senator Carper.
Senator Carper. Gentlemen, welcome. I just walked in. I
missed your testimony.
Let me just start off, if I could, asking a question of
you, Chairman Cox.
You have a reputation being plainspoken so I will just ask
you to use that reputation in responding.
What do we need to be doing in this regard to address some
of the behavior that we have become aware of? What do we need
to do in this Committee and in the Congress, if anything?
Mr. Cox. First, this oversight hearing is helpful because
we have two problems. One is an historical problem, the things
that already have happened and gone by the boards. The other is
what happens today and going forward.
I believe that the attention that is being paid in the
regulated community to this backdating problem is, in major
respect, a function of the attention that has been paid to it
by the Congress and by the Agency. So first, keep a focus on
it.
Second, I think the approach that I have inferred the
Committee taking today is the right one, which is keep a
weather eye to the question of whether our existing laws work.
So far our experience at the Agency is that they do, and that
they are adequate to this task. So we are not here today asking
for new legislation. But watch it like a hawk to make sure that
we do not miss an opportunity if one arises.
Senator Carper. I think you have been asked if you have the
tools that you need. Is that correct? And you said you do?
Mr. Cox. We do. We have chosen to apply the Agency's
resources particularly in this area. I mentioned that because
we are an agency with finite resources that implies an
opportunity cost. And that to the extent--within reason, to the
extent Congress chose to provide the SEC more resources, I
think we would put them to good use. But we have the resources
and are applying them to deal with this problem right now.
Senator Carper. Good, thanks.
Mr. Chairman, Chairman Olson, the same two questions. What
ought we to be doing now here in this Committee and in the
Senate? And do you have the resources that you need?
Mr. Olson. Senator, as we had discussed earlier, there is
an extent to which this is an issue that the opportunity for
abuse is significantly behind us. But nonetheless, there are
still audit issues.
As we think of the issue prospectively, we would expect
that accounting firms would have, or the auditors would have, a
risk measurement or some sort of a risk focus that would help
them identify what the future issues will be. Options dating is
the issue du jour but there will be others, as you know.
So what we are interested in doing is seeing that the
accounting profession is aware and is alert to those and has
the tools to deal with those. And so I think that is the case.
Regarding resources, we are getting there. We are a
startup, as you know. You gave us a big challenge, the Congress
did, when it was started. I think that my predecessors, who I
am very proud of, have done a very good job of getting us
significantly up to speed, but we are getting there.
Senator Carper. Good. Thank you.
My other question relates to investor confidence. The
economy is, we are in a point where we are seeing a leveling
off in home sales, home prices, some concerns about what is
going to happen to interest rates and inflation. And the last
thing we need is for investors to be spooked. We want them to
continue to have strong confidence in our markets.
As this issue of backdating of stock options gains some
public profile, any sense for how it might be affecting
investor confidence?
Mr. Cox. I suppose the good news here is that virtually at
the same time that the public learned about the problem of
options backdating, they could see their Government in action
going after these problems. They can also see that there are
already rules in place and now effective that will make much
more elaborate the disclosure in this area. They also can see
that the opportunities for backdating that existed have been
foreclosed. So that now it will require truly aggressive
cheating and stealing in order to carry this out. The easy
opportunities are gone.
I would hope, therefore, that this would not be an issue of
investor confidence for that reason. Or indeed that investors
would have confidence that the system is working the way it
should in terms of law enforcement. Certainly the SEC, as the
investor's advocate, sees our main mission to protect America's
savings and investment. And so we want to be sure that people
see their government working.
Senator Carper. Thanks. Thanks.
Mr. Chairman, Chairman Olson, do you want to add or take
away anything from that?
Mr. Olson. Only to this extent. For reasons that we have
discussed earlier, you readily identify the type of company
that were involved in the most aggressive use of stock options.
And I think it will be interesting to see the extent to which
the market responds in some ways, either those companies or
that group of companies. I think it is the disclosure of some
of these practices that will help bring about a better
awareness, to separate the people that disclose in a way so
that they do not obfuscate the substance of the transactions
but clearly state them.
The market, in a perfect world, would reward those
companies relative to the others.
Senator Carper. Thank you both.
I would ask you both to continue being vigilant in going
after the perpetrators of these schemes. Thanks.
Chairman Shelby. Senator Crapo.
Senator Crapo. Thank you very much, Mr. Chairman.
Chairman Cox, as you know, another Senate Committee, the
Finance Committee, at this very same time, is holding a hearing
on executive compensation as well to look at the issue from the
perspective of the tax code. Both in your oral testimony and
your written testimony you have raised issues in that context.
In your written testimony, you state ``Beyond the obvious
fact that the income tax code discriminates in favor of non-
salary compensation that can be taxed as capital gains, one of
the most significant reason that non-salary forms of
compensation have ballooned since the early 1990's is the $1
million legislative cap on salaries for certain top public
company executives that was added to the Internal Revenue Code
in 1993.'' And then you went on in both places to say this law
change deserves a place in the museum of unintended
consequences.
Could you comment for a minute about whether you believe
that Congress should act now with regard to that $1 million
cap? And also, could you address generally the question of the
fact that the compensation on stock options is taxed at a
capital gains tax rate, though it is not a normal investment
decision that is being made, but it is a tool utilizing stock
as an executive compensation tool. Should we look at the
question of the level of taxation or the type of taxation or
tax treatment as we address this issue?
Mr. Cox. I am sorely tempted to tell you what I think the
tax laws ought to look like, because I got paid to----
Senator Crapo. That is the invitation here.
Mr. Cox [continuing]. Engage in those debates for many
years. But I think you probably want me to give you the SEC's
perspective on it, and you invited me here as the Chairman of
the SEC for that reason, and not as a former member. So let me
restrict myself to the SEC's interest in this question, which
is that we have an abiding interest and we are very, very
determined to succeed in this area, in making executive
compensation understandable to the shareholders. We are in the
business of transparency and clarity.
So, to the extent that the tax code causes companies to do
something that otherwise they would not do, that is more
complicated in the area of executive compensation than what the
market would produce. That is, one would hope, an unintended
consequences, and it makes our mission more difficult.
To simplify what we have in, I believe it is Section
162(m), we have a million-dollar price control that has proven
unworkable. It is an unworkable price control and its repeal
would actually encourage companies to subject more of the CEO's
compensation to taxation at ordinary income rates.
Senator Crapo. Thank you.
Chairman Olson, do you have an opinion on this issue?
Mr. Olson. Just to remind everybody of a fundamental
truism, I guess, that any tax penalties or tax incentives have
consequences. They tend to work. And while there was an
unintended consequence to this tax provision perhaps what
should have been clear is that there would have been a response
to it in one way or another. What was unpredictable was the
manner in which the response would play out.
The fact that there was a response should have been
predictable.
Senator Crapo. Thank you.
Chairman Cox, I will reserve to our private conversations
your personal opinions about the tax code, but I would like to
know what they are.
Mr. Cox. They are voluminous, just as is the tax code
itself.
[Laughter.]
Senator Crapo. Thank you, very much.
Chairman Shelby. Thank you, Senator Crapo.
Chairman Cox, Chairman Olson, we appreciate your appearance
and I am sure you will be back. Thank you very much.
But more than that, I appreciate your diligence in
following this issue.
Senator Sarbanes. Mr. Chairman, as our witnesses depart, I
just want to bring to Chairman Olson's attention an article
that was in the Wall Street Journal back in June, entitled
``Backdating woes beg the question of auditors' role.'' The
article began where were the auditors?
So I would commend that article to you.
Mr. Olson. I am quite familiar with the article and we
continue to ask that question of the profession and of
ourselves. Thank you.
Senator Sarbanes. Thank you.
Chairman Shelby. Thank you both very much.
We will call up our second panel, Mr. Lynn Turner, Managing
Director of Research, Glass Lewis and Company, and former SEC
Chief Accountant; Dr. Erik Lie, Associate Professor of Finance,
University of Iowa; Mr. Kurt Schacht, Managing Director, CFA
Centre for Financial Market Integrity; and Mr. Russell Read,
Chief Investment Officer, California Public Employees'
Retirement System.
Gentlemen, we appreciate your appearance today.
As I said earlier, your written testimony will be made part
of this hearing record in its entirety.
Mr. Turner, we will start with you. As I said earlier, all
of your written testimony will be made part of the hearing
record.
We are going to have a vote in about 30 minutes, we think.
So we would like for you to get to your points. I think all of
you have got something to say here today and we appreciate
that.
STATEMENT OF LYNN TURNER, MANAGING DIRECTOR OF RESEARCH, GLASS
LEWIS & CO., LLC.
Mr. Turner. Thank you, Chairman Shelby, ranking member
Sarbanes.
This is an important issue and I congratulate and commend
you both on holding this important hearing. It is also worth
noting, I think though, Chairman Shelby, I remember in the last
couple of years we went through quite a battle over options and
the expensing of options. At the time I was spending a fair
amount of time in the tech community.
Chairman Shelby. We all have a little shrapnel in us, but
we are still standing.
Mr. Turner. Yes, indeed. And we would not be standing,
though, without your leadership.
Chairman Shelby. Thank you. Senator Sarbanes was also
standing with me on that issue.
Mr. Turner. I think you both took bullets. You look better
for the wear and tear.
But moving on, I would like to focus my remarks to start
with just on spring-loading. I know some people have said
spring-loading is not illegal. The notion of, as Chairman Cox
said, granting the options and then right thereafter disclosing
the good news, realizing that the options were discounted
because of that.
I could not disagree more with those who have said that
that is not a problem and is not illegal. As we have gone
through filings, we have yet to see a filing that has properly
made those disclosures. We often heard well, it is not illegal
if. But we have never seen the if. The disclosures have been
grossly false and misleading, saying that they were granted at
the market price when they were not; they are properly valued
when they were not; the financial reporting was in compliance
with GAAP, which it was not. And they failed to note the
negative tax consequences, which the other Senate Committee is
holding their hearing on today.
So in summary, I think the investors were misled and the
executives failed to tell the truth, the whole truth and
nothing but the truth, which is a violation of the securities
laws. So I think those are definitely a problem.
The question was actually brought up earlier, too, about
the benefits of SOX and how SOX, in a number of areas has
certainly helped here, the timely filings, the internal control
provisions, the executive certifications. But if you look at
the written testimony that I submitted, you will see in there
the Forms 4 in just this last year.
So current people were asking is this still going on? And
the answer is yes it is, as Professor Lie's paper noted. But if
you look at the Form 4s that are included in the testimony for
Children's Place, you will see examples, actually several
examples, of a situation where well after the 2-day requirement
the forms were filed, well after the transaction date. And
right after the transaction date the company came out with a
positive announcement and the stock price jumped over 26
percent.
So this is in 2005. This is not 2002, 2001. It is still
going on. The late filings of these forms continue. We have
noted a number in the written testimony that we see and we have
actually seen some others on top of that that is not disclosed
in the testimony.
The result of this is the list that is in the testimony, we
started with a list of 121 companies when I first was asked to
testify. It is now up to 128 and the drip, drip, drip Chinese
torture that you mentioned that investors are facing continues.
I have no doubt that we have not yet gotten to the bottom
of it. I was heartened to hear Christopher Cox, Chairman Cox,
say that in fact the SEC would commend companies to go out and
do self-investigation and self-reporting on this. I do not
think the SEC, in any way, has the resources to get to the
bottom of it.
Certainly, it is my understanding the SEC----
Chairman Shelby. They do have the resources to set some
examples, do they not?
Mr. Turner. Yes. Yes. They really do need to bring some
great cases. They have brought a couple. But keep in mind you
have 128 under investigation now. You have got two cases filed
so far.
There can be a couple of lessons. One, a lesson if you
really do make a good case. But if at the end of the day there
is only two out of 128, that also sends a very strong message
too, that most are not going to have to worry about it. So that
is a concern, especially given the number of companies that, as
a result of this thing, are restating, have turned up with
internal control weaknesses, have had to provide late
disclosures.
The question was asked earlier also about where were the
gatekeepers? And I think there are some legitimate questions
with respect to the auditors. But I think the lead gatekeeper
here is the legal counsel. I have sat on ports. I have granted
options. I have received options. I have used them in small and
big businesses. And the one person, the one gatekeeper that is
always there is the legal counsel.
And so I think we are going to find, as in one of the cases
we have already seen, the legal counsel is the gatekeeper who
is most problematic here. And certainly I hope the SEC will do
something with that.
I think the No. 1 thing that does need to be done here is
stricter enforcement by both the SEC and the PCAOB. The SEC
staff need to get an electronic tool that automatically allows
them to go into the filings. You can see the filing right
there. They should have an electronic tool that, without adding
staffing, automatically kicks out for them those findings that
are late and outside the 2 days, such that they could
automatically send a dunner notice, something like that.
Chairman Shelby. Do they have the software today to do
that, in your judgment? Do you know?
Mr. Turner. No. No, they do not. I have spent some time
with the staff on a number of their electronic tools. The SEC,
certainly when I was there, was in the dinosaur age. I think
they have come a fair amount of distance since then. If you
look at their most recent annual report, they say they are
pilot testing a lot of tools. The reason they are pilot testing
is they do not have the resources to buy them.
Congress has got to give them the resources to buy tools
and to do the type of electronic monitoring that I just
described. You cannot go through all of these filings. There is
thousand upon thousands upon thousands of filings coming
through on it. They do not have the staff to go through each of
those manually. You could do it fairly quickly automatically,
electronically. They deserve to have those tools if you want
them to do the job that they have been asked to turn around.
Chairman Shelby. Do you have any judgment as to the kind of
money you are talking about? I think the results would be good.
Mr. Turner. I do not think the type of money that you are
talking about is a whole lot of money. In fact, we are putting
in a similar system for ourselves. You can tee it off. But you
are not talking hundreds of millions of dollars here.
On the other hand, you see corporations, quite frankly,
invest $10 million or $15 million a year in technology, and it
is not happening and it needs to happen.
I would also note that----
Chairman Shelby. I was asking that question because in
another committee I chair that Appropriations Committee and I
am going to talk to Chairman Cox this afternoon about that.
Senator Sarbanes asked him do you need more resources. I have
asked him that, too, because I agree with you. And you know, as
the former Chief Accountant, we have the obligation, I believe,
to furnish the resources to the SEC to do their job. If they
need more technical resources in today's world to help them do
this, that is our obligation.
Mr. Turner. I could not agree more with you, Chairman
Shelby.
Let me, just a couple of things to close off here so we can
move along.
You were brilliant in your defense of the FASB and the
independent private standard setting. That will only work
though if that standard is appropriately implemented. I am
concerned about whether that is going to occur. There has
already been some research that indicates that people are
playing games with that number. That number is a key anchor
part of the new FCC disclosures that Chairman Cox talked about,
the value of these options.
If people are allowed to play games with that----
Chairman Shelby. Elaborate what you mean by that, for the
record. This is important.
Mr. Turner. There are some key points of data that go into
these models that calculate the value of these options,
primarily the volatility rate, how the stock is moving up and
down over time, as well as the expected life of those options.
And by decreasing the volatility and decreasing the expected
life of the option, you can have a fairly dramatic impact on
the value of the option and the compensation expense that is
being recorded.
We have seen instances where companies will change
volatility say from a 70 percent down to a 30 percent level
without seemingly a change in the actual volatility of the
stock in support for that. Likewise with the lives.
If that goes on and that becomes the practice, then we will
have lost a significant benefit from that standard that people
went through such a battle over. And so I would certainly hope
that the Committee would encourage the SEC to ensure that they
watch that, we get good implementation of that standard.
On the board level, I would just say boards do need to get
much more actively involved, which they do in the U.K. It is
feasible to file on the same days you do the grant. They do it
in the U.K. I have a tough time believing our English
counterparts can do it and are better at it than we are, so I
think we could get it done in a day here, as well.
I would also urge the SEC, Chairman Cox, though to go out
and urge all companies to self-report and self-investigate. The
Council for Institutional Investors has written 1,500 letters
to 1,500 of the larger corporations in the United States asking
them about their backdating, where they had practice, where
they have done it, what their policy is. To date they have only
received 200 letters back. There are 1,300 unanswered letters
out there which, without a doubt, means there is still a
serious question out there.
So I think with that, let me close it off and just say I do
think it is an issue. I commend the Committee for having the
hearing. I think the hearing will do a lot to bring attention
to this matter in the boardroom and elsewhere. So thank you.
Chairman Shelby. Dr. Lie, we appreciate the work you have
done over the years and we want you to keep it up. And we
appreciate your appearance here today. You can sum up what you
want to tell us.
STATEMENT OF ERIK LIE, ASSOCIATE PROFESSOR OF FINANCE,
UNIVERSITY OF IOWA
Mr. Lie. Thank you, Chairman Shelby, ranking member
Sarbanes, and members of the Committee. Thank you for inviting
me to testify today about stock option backdating.
We have been talking quite a bit about stock options and
stock option grants already, but let me provide some key
aspects about this process.
Stock options are granted to executives at various
intervals. It is common to grant options once a year, though it
is also possible for executives not to be granted options in a
year or to be granted options numerous times in a year.
In most cases, there is no fix schedule to these grants,
meaning that they do not occur on the same date in consecutive
years.
The new 2-day filing requirement which we talked about
earlier dramatically reduced a lag between the grant date and
the filing date. You will see in my written report a graph of
this. Importantly, though, about 22 percent of grants since
August 29, 2002 were filed late and almost 10 percent were
filed at least 1 month late.
Most executive stock options are granted at-the-money, that
is the exercise price is set to equal stock price on the day of
the grant. In a sample of about 40,000 grants from 1996 to
2005, the exercise price matches the closing price on the grant
date in 50 percent of the cases. And interestingly, it matches
the closing price on the day before the grant date in 12
percent of the cases.
The practice of granting options at-the-money provides
incentive to time the grant to occur on a day when the stock
price is particularly low or to manipulate the information flow
around the grant date. Note that these incentives would be
present for in-the-money and out-of-the-money grants also,
provided that the exercise price is a function of the stock
price.
In my 2005 study entitled ``On the timing of CEO stock
options awards'' I documented negative abnormal stock returns
before and positive returns after CEO option grants between
1992 and 2002. These trends intensified over time. I further
reported that the portion of the stock returns that is
predicted by the overall market factors exhibits a similar
pattern, prompting my conclusion that, unless executives have
an informational advantage that allows them to develop superior
forecasts regarding the future stock market movements that
drive these predicted returns, the results suggest that the
official grant date must have been set retroactively.
In a soon-to-be-published study entitled ``Does backdating
explain the stock price pattern around executive stock option
grants?'' that I coauthored with Randy Heron of Indiana
University, we found further evidence in support of my earlier
backdating argument. As noted earlier, a provision in the
Sarbanes-Oxley Act reduces the SEC filing requirement for
option grants to 2 days. To the extent that companies comply
with this new requirement, backdating should be greatly curbed.
Thus, if backdating explains the stock price pattern around
the option grants, the price pattern should diminish following
the new requirements. Indeed, we found that the stock price
pattern is much weaker since the new reporting requirements
took effect.
Any remaining pattern is concentrated on a couple of days
between the reported grant date and the filing date, and for
longer periods for the minority of grants that violate the 2-
day reporting requirements. We interpret this as strong
evidence in support of backdating.
In an unpublished study entitled ``What fraction of stock
option grants to top executives have been backdated or
manipulated?'' also coauthored with Randy Heron, we used a
sample of almost 40,000 grants to top executives across about
8,000 companies between 1996 and 2005 and we estimate the
following: 14 percent of all grants to top executives dated
between 1996 and 2005 were backdated or otherwise manipulated.
Twenty-three percent of unscheduled at-the-money grants to
top executives dated between 1996 and August 2002 were
backdated or otherwise manipulated. This fraction was cut to
less than half, to about 10 percent, as a result of the new 2-
day reporting requirement that took effect in August 2002.
Among the minority of unscheduled at-the-money grants after
August 2002 that were filed late, 20 percent were backdated or
otherwise manipulated.
Among the majority of unscheduled at-the-money grants after
August 2002 that were filed on time 7 percent were backdated or
otherwise manipulated.
Backdating was also found to be more common among tech
firms, small and medium firms, and firms with a high stock
price volatility.
The auditing firm is only modestly associated with the
incidence of backdating.
And finally, 29 percent of firms that granted options to
top executives between 1996 and 2005 manipulated one or more of
these grants in some fashion.
So clearly, backdating of option grants was a pervasive
practice among publicly traded corporations in the U.S. in the
late 1990's and the beginning of this century. My own research
suggests that spring-loading, bullet-dodging, and manipulation
of the information flow was either significantly less prevalent
or less successful in the aggregate in producing immediate
gains for the option recipients during the same period.
The problem of backdating can be eliminated by requiring
grants to be filed electronically with the SEC on the same day
that they are granted. Of course, this requirement has to be
strictly enforced with appropriate penalties for any violation
such that the frequency of late filings that is evident for the
last few years is greatly reduced.
As the problem of backdating is eliminated, the problems of
spring-loading, bullet-dodging and manipulation of the
information flow might become more prominent. Thus, it is
critical to clarify whether these alternative strategies are
legal. And if so, restrictions to minimize their occurrence
should be developed. In particular, options should not be
granted near major corporate announcements. And further, there
should be timely and complete disclosure of these grants.
Finally, to eliminate timing relative to recent stock
prices, the benchmark stock price should be the price on the
grant date. For example, if the options are granted at-the-
money, the exercise price should be set equal to the stock
price on the same date, on the grant date, and not the stock
price on the prior date, which is fairly common practice, as I
indicated earlier. This eliminates the possibility that options
are granted on a day when the price has increased significantly
but the prior day's lower price is used for contracting
purposes.
Thank you.
Chairman Shelby. Mr. Schacht.
STATEMENT OF KURT SCHACHT, MANAGING DIRECTOR,
CFA CENTRE FOR FINANCIAL MARKET INTEGRITY
Mr. Schacht. Good morning, or good afternoon at this point.
Thank you very much for inviting us to be here. I am Kurt
Schacht from the CFA Centre for Financial Market Integrity,
which is the advocacy arm of the CFI Institute, and we are the
credentialing organization for the Chartered Financial Analyst
designation.
Thank you, Senator Sarbanes and Senator Shelby, for
inviting us, and also for holding the line on 123R. I know a
lot of investors very much appreciate that, as we do.
So again, thank you for the opportunity to be here.
We were asked to provide some perspective of our
organization on options backdating and some of the accounting
and auditing issues associated with that. And we come to this
topic primarily as an investor advocate and, as we have
mentioned here before, with a focus on protecting shareholder
interests and ensuring accurate and transparent financial
reporting.
We were one of the early voices to the SEC to amend the
newly released executive compensation disclosures to include a
more direct focus on the issues of backdating and the companion
practice of spring-loading. Chairman Cox and the SEC have done
a very fine job, in our view, with those new rules.
Our perspective is this: historically, the rationale for
granting stock options was alignment of shareholder interests
and providing a performance incentive. There are a number of
commentators out there today that are suggesting that
backdating and spring-loading were really not manipulation,
intentional manipulation of information or of the option price,
that backdating does not necessarily pervert the incentive
purpose of options, that backdated options continue to have
those attributes of alignment and incentive, and that if
backdating is a misdeed or it is a crime, that it is a
victimless one.
We think, obviously, that those views are quite misguided.
Options reward performance. They should not reward the
manipulation of the grant process.
We do very shortly agree with Senator Allard and others who
have talked about the benefits of options. We agreed that
discounted options and stock are an entirely permissible
executive compensation tool. But to achieve the discount
through sleight of hand and then, in the case of backdating, to
conceal that activity by inaccurate financial reporting and tax
filings is clearly not in alignment with shareholders'
interests and it does place the company itself at substantial
risk of manager removal and uncertainty, huge investigative and
regulatory costs, and that is hardly a victimless infraction,
in our view.
We remain very concerned about the ultimate scope of the
backdating cleanup problem. Backdating itself is a thing of the
past, no pun intended. It has been done in by a number of the
things that Chairman Cox has mentioned here this morning. But
the degree of the necessary cleanup due to the vast numbers of
companies that have engaged in option granting practices, as
well as the size of some of these grants in that time period
from 1990 through 2002, is still an unknown aspect of this
controversy. And I think we need to get our hands around that.
As Senator Menendez remarked, this should not become a sequel
to the financial reporting crisis in confidence that we
experienced earlier in this decade.
Now with respect to auditing and accounting practice, very
quickly the auditing standard relating to stock option expenses
that existed for many years before the current day, 123R, was
very clear on this. APB opinion 25 required that in-the-money
option grants require the reporting of the relative
compensation expense unless it is immaterial. The entire
premise, the entire premise of backdating was to get an in-the-
money grant. So nearly every company that has been identified
as having backdating problems has failed to properly record the
compensation expense and, as a result, has failed to file
financial statements that comply with generally accepted
accounting principles. The rules on backdating were clear and
they were not subject to interpretation.
Viewing the backdating issue from the internal auditor
perspective still concerns us very greatly. How was this
practice repeatedly missed or even, in some cases, possibly
sanctioned? In some cases, it may have been sloppiness or
incompetence. It may have been a matter of an intentional act
of concealment by the company's management.
Either way the internal papering of the option transaction
appeared as though no compensation expense needed to be
reported. The auditors felt that that was a very low-risk
noncash area for review. They relied on the company records and
they did not verify what had actually happened.
It is one thing to be lied to by your client. It is quite
another to be complicit in the deceit. And we remain concerned
whether certain auditors were actually complicit, turning a
blind eye to this practice, given the client pressures that
were so evident back in the days of option megagrants and
because it seemed like everyone was doing this in certain
sectors of corporate America.
No matter which it is, we now would expect that proper
audit procedures would demand a very close look and a
verification of these option restricted stock practices.
A couple of real quick lingering concerns, the gaming of
grants of both options and restricted stock around the release
of material nonpublic information, or spring-loading, needs to
have another look. The SEC, as Chairman Cox mentioned, requires
now that there be a full review and report of issues by the
compensation committee. But it does not prohibit spring-
loading. I think we need to ask the question should the
officers and directors who are in control of the material
nonpublic information, and also in control of the option
granting process, whether they should be barred from
participating in any spring-loaded grants, just as they would
be prohibited from trading in any of the company's securities
while in possession of that information.
Finally, one facilitator of backdating was accounting rules
that failed to result in fair value expensing of the cost of
all options. 123R has now resolved much of that. But
historically auditors apparently failed to consider such off-
balance sheet items of sufficient high risk to warrant a full
audit or a full review.
There are many more items, several of considerable size,
relative to most company's balance sheets that remain off
balance sheet and that remain unexpensed. If they are reported
at all, they are reported in the company's footnotes. I think
the lessons of Enron and now the lesson of backdating are
pretty clear, that auditors should tighten their procedures to
make certain that these off-balance sheet items receive similar
attention.
I would conclude by saying that backdating may be
effectively stopped at this point, but to keep the pressure on
companies to come clean so that this does not become a Chinese
water torture situation, and that we sanction past infractions
appropriately. We should consider whether and who should be
engaged in the process of spring-loading. We should confirm
whether any of these manipulative practices have carried over
to the restricted stock area. And finally, we should encourage
audit procedures that guard against this misreporting of
similar off-balance sheet items.
Thank you very much.
Chairman Shelby. Thank you, sir. Mr. Read.
STATEMENT OF RUSSELL READ, CHIEF INVESTMENT
OFFICER, CALIFORNIA PUBLIC EMPLOYEES' RETIREMENT SYSTEM
Mr. Read. Thank you, Chairman Shelby, Senator Sarbanes, and
other members of the Committee.
I am pleased to be here today to provide an institutional
investors' perspective on option backdating and spring-loading.
I am Russell Read, Chief Investment Officer for the California
Public Employees' Retirement System or CalPERS. As you know,
CalPERS is the nation's largest public pension system with more
than $209 billion in assets.
We have been long a voice for good corporate governance. We
are committed to executive compensation reform, full disclosure
and transparency of pertinent financial information and
director accountability. The recent allegations around secret
and even fraudulent backdating of options are disturbing. We
appreciate your leadership, Mr. Chairman, in calling for this
hearing and for your personal commitment and the commitment of
the Committee toward addressing this problem.
CalPERS believes that as part of a good executive
compensation policy, stock options are appropriate.
As referred to by Mr. Schacht earlier, the core alignment
of interest principle for responsible use of options can be
framed as a question. Namely, do the options align employee
interests with that of share owners? Moreover, do boards and
compensation committees fully accept the alignment of interest
principle with respect to option grants?
The widespread prevalence of backdating potentially
indicates that boards and compensation committees have not
fully accepted the alignment of interest principle with respect
to option grants. And when critical features of the options are
hidden from view, and when the options awards themselves did
not tie to performance, it can create a serious problem.
As you know, CalPERS's size does not lend itself to selling
our stocks in troubled companies. In effect, we are a source of
long-term, indeed permanent investment, in the U.S. capital
markets. When an executive takes stealth payments that we
cannot trace, when companies make false statements and omit
material facts concerning backdating of option grants, billions
of dollars can be inappropriately shifted from share owners to
key employees. And once the truth of such option grant
practices are made, it can cause company stocks to fall
precipitously. This directly hurts the retirement security of
ordinary Americans.
In CalPERS's case, we are talking about clerks, custodians,
school bus drivers, firefighters and highway repair people. for
example.
Since this issue has come to light, an unprecedented number
of late filings with the SEC have occurred which, of course,
delays disclosure to share owners.
Second, these late filings are often considered to be
technical violations of the conditions of borrowing, and that
is costing companies, too. Last month, the Wall Street Journal
reported that some bond holders are calling in their loans or
demanding payment or large fees in exchange for an extension of
their default deadlines. As many as two dozen companies were
reported to have faced this dilemma over the past 18 months,
and some had to pay multimillion dollar fines--fees, sorry
fees.
Even more astonishing, as the Wall Street Journal has
reported, we are now learning that as stocks sank after the
terrorist attacks of September 11th, scores of companies rushed
to issue options on top-tier executives' compensation when the
stock market reached its post-attack low on September 21st,
2001.
Now comes a cascade of class-action and share owner
derivative lawsuits. Once again, this scandal has brought back
a number of fundamental corporate governance questions such as
one, are boards condoning this behavior? Two, if not, and the
boards themselves are surprised to learn of questionable
backdating, then the question is where was their oversight?
Three, raising questions about adequate internal and external
auditor controls. Are the auditors being vigorous enough in
their examination of a company's option granting practices? And
last, four, investors want to know if illegalities are
occurring, will the wrongdoers be swiftly and aggressively
prosecuted? And will they be held accountable with civil and
criminal penalties where appropriate?
Mr. Chairman, you hit the nail on the head when you said
that if the public is to maintain full confidence in our public
markets, the appropriate action needs to occur.
Over the past 2 months, we have approached 42 portfolio
companies under investigation by the SEC. We have asked that
companies perform independent investigation and that they
publicly disclose all findings resulting from such
investigations, regardless of the outcome. We have urged
company boards of directors to develop policies that disclose
how stock option grant dates are established and then publicly
disclose those policies in company financial and proxy
statements. We want company boards and compensation committees
to conduct an audit of their executive compensation plan
administrator to be sure they are acting in full compliance
with their directives. And we strongly believe that something
needs to be done to ensure that corporate resources are not
used to satisfy the tax and legal liability of executives
implicated for this kind of wrongdoing. Such an inappropriate
use of corporate assets hurts share owners twice, once by the
offense of such backdating and the other by the defense when
they area allowed to use company assets to defend their
actions.
We urge the Committee to call on the SEC to continue to
investigate and to aggressively prosecute wrongdoing.
We believe the SEC does have the authority it needs to
solve this problem. The SEC has asked an extraordinary impact
in regard to preventing problems when they are explicit in what
constitutes good practice.
An explicit statement of policy toward option granting
practices would go a long way. It would make the corporate
community sit up and take notice. In essence, an ounce of
prevention would make up for a lot of pounds of cure. So an
explicit statement would by the SEC would grant a lot of
ethical and moral authority to the alignment of interests
principle.
In addition, they need to be more aggressive in enforcing
the rules for the filings of Forms 3, 4 and 5. SEC rules
require company stock sales to be reported on SEC forms within
2 days of execution. As we have heard earlier, we think this
can be effective, but needs to be also accompanied with an
alignment of interest principle statement.
We welcome the PCAOB's help by providing greater oversight
of auditing practices pertaining to option grants. Their July
28th practice alert is very beneficial and we welcome their
continued oversight.
I would like to close by giving our view on the issue of
spring-loading of options. We believe the SEC's requirement
that an issuer disclose its option grant policy will have a
positive effect. It should mitigate the activity of spring-
loading options in the future. However, should this not prove
to be the case, we recommend that the SEC take additional steps
to ensure that option grant practices are carried out in a
systematic fashion, unaffected by the timing and release of
material nonpublic information.
To sum up, we are going to do our part as active
shareowners to demonstrate and to hold board of directors and
compensation committees accountable. We will work with the SEC
and the PCAOB in whatever way they deem helpful. And of course,
we stand ready to assist this Committee by providing any
additional information.
Finally, on behalf of the 1.4 million public servants we
represent, I want to thank you once again, Mr. Chairman and
Senator Sarbanes, for all the help that you are doing to
restore the public trust in these financial markets.
Chairman Shelby. We are again backed up because we have a
vote on the floor and we have fewer than 10 minutes to get
there.
I am going to ask some questions to all of you. You can
answer them fast or you can do it for the record, because I
think they are important.
I will start with you, Mr. Turner. There are corporate
governance implications of backdating. Unfortunately, that
appears to be the latest example, to me, of corporate boards
failing to protect shareholders.
What can policyholders do, if anything, to improve the
performance of directors? Also, what about other gatekeepers,
you mentioned it earlier, such as legal counsels and auditors?
Where do they fit in?
I know time will not permit you to give a complete answer
here, but you can elaborate for the record.
Mr. Turner. Senator, I would be more than happy to answer
any questions in writing. If you want to submit any questions,
I would be more than happy.
The compensation committees have failed here. There is no
question about that. The legal counsel involvement, I know, is
there. That has failed----
Chairman Shelby. You mentioned that. It is crucial, is it
not?
Mr. Turner. Yes. And the SEC has capabilities under Rule
102(e), which I actually worked on when I was at the
Commission, to take action there.
Chairman Shelby. Would you elaborate on this for the
record?
Mr. Turner. Yes. In writing or now?
Chairman Shelby. In writing.
Mr. Turner. I would be more than happy to, Senator. I
understand the vote.
Chairman Shelby. Dr. Lie, I cannot resist this. In your
statement, you cite again your research indicating that 14
percent of all grants to top executives dated between 1996 and
2005 were backdated or otherwise manipulated, and 29 percent of
firms that granted options to top executives during the same
period manipulated one or more of these grants in some fashion.
If this is true, this suggests a staggering problem associated
with stock options.
If you want to elaborate on that for the record, I would
appreciate that. I am going to give Senator Sarbanes a little
time here. Will you do that?
Mr. Lie. Yes, I will certainly comment for the record.
Chairman Shelby. Mr. Read and Mr. Schacht, corporate boards
have the responsibility to keep a careful watch over executive
compensation, I believe. In the wake of the backdating scandal,
what specific recommendations would you two make to boards to
ensure they are meeting their responsibilities? You can answer
that for the record because this is a hearing record here
today.
And last, Mr. Turner, spring-loading, timing option grants
ahead of information that may increase the company's stock
price will, I hope, be deemed illegal, or at least should be
illegal, even if disclosed in options plans.
Dr. Lie, you assert that options should not be granted near
major corporate announcements. And for the record, would you
elaborate on that later?
Mr. Lie. Certainly.
Chairman Shelby. Senator Sarbanes.
Senator Sarbanes. Mr. Chairman, I will be very brief
because there is a vote and we have to get over to the floor. I
apologize to the panel.
Chairman Shelby. I apologize to the panel. This is a great
panel.
Senator Sarbanes. But we have no control over that, as you
understand.
I do want to say, first of all, this has been an extremely
helpful panel. I have had a chance to look at your written
statements and they are enormously helpful and the supplemental
will also be important.
Mr. Chairman, I want to take just a moment to comment on
the people at the table and to thank them for their
contributions they have been making to this effort to develop
transparency and honesty and integrity in the workings of the
U.S. capital markets.
Mr. Turner, of course, has had a stellar career, including
his service as Chief Accountant at the SEC, where he twice was
selected as receiving the Chairman's Award for Excellence. He
has worked now in the private sector at Glass Lewis, is
teaching out in Colorado. And we appreciate all of the
contributions he has made throughout what is a long process. We
are still working at it. We think we are moving it forward.
Mr. Lie, if anyone ever says to you that academics are
removed from having an impact on public policy, I think you
need only cite your studies and the impact they are having. You
have provided important factual material and now the rigorous
analysis to go with it to really have, I think, a measured
impact on developments here. And it is, of course, reflected by
the comments of the Chairman of the SEC today citing your work
as they move forward. So we thank you very much for that.
Mr. Schacht, I want to commend the CFA and your work with
them, and particularly as the Director of the Centre for
Financial Market Integrity. This is what we need, is we need
the professionals to take this kind of interest in sustaining
high standards. You all have been committed to that. You,
yourself, have I think played an important and leading role. We
have turned to you for counsel and advice over the years and I
want to thank you publicly here today.
Mr. Read, I note that you are a Chartered Financial
Analyst, so you come under Mr. Schacht's umbrella. I simply
want to say--CalPERS, of course, has a tremendous impact. They
are obviously enormously significant, as some argue, as the
major institutional investor. We are glad to see you move into
the public sector and assume this important role as the chief
investment officer of the California Public Employees'
Retirement System. You are in a position, of course, there to
exercise a marked influence on all of this.
So I really want to thank all of the members of the panel
for the contributions you have made, that you are making now,
and the contributions I anticipate you will continue to make.
Thank you.
Mr. Turner. Chairman Shelby, I hope you are around for a
long time. But I know ranking member Sarbanes will soon be
leaving this fine institution. And that let me just say over
the last 8 years it has been a privilege and a tremendous honor
working with you. And investors and consumers and the like owe
you a tremendous debt of gratitude for your fine work.
Senator Sarbanes. Thank you very much.
Chairman Shelby. Thank you all. We hate to break the panel
up, but as Senator Sarbanes said, we have no choice.
The Committee is adjourned.
[Whereupon, at 12:16 p.m., the Committee was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF CHRISTOPHER COX
Chairman, Securities and Exchange Commission
September 6, 2006
Chairman Shelby, Ranking Member Sarbanes, and Members of the
Committee:
Thank you for inviting me to testify today about options
backdating. This issue is one of intense public interest because it
strikes at the heart of the relationship among a public company's
management, its directors, and its shareholders. I appreciate the
opportunity to explain the Commission's initiatives to deal with abuses
involving the backdating of options.
I am especially pleased to testify together with Chairman Mark
Olson of the Public Company Accounting Oversight Board. I will let
Chairman Olson speak to the steps the PCAOB is taking to address these
issues from the auditing regulator's perspective, but I'd like to
assure the Committee, and the public, that the Commission is working in
close cooperation with the PCAOB in this important area.
There are many variations on the backdating theme. But here is a
typical example of what some companies did: They granted an ``in-the-
money'' option--that is, an option with an exercise price lower than
that day's market price. They did this by misrepresenting the date of
the option grant, to make it appear that the grant was made on an
earlier date when the market value was lower. That, of course, is what
is meant by abusive ``backdating'' in today's parlance.
The purpose of disguising an in-the-money option through backdating
is to allow the person who gets the option grant to realize larger
potential gains--without the company having to show it as compensation
on the financial statements.
Rather obviously, this fact pattern results in a violation of the
SEC's disclosure rules, a violation of accounting rules, and also a
violation of the tax laws.
The SEC has been after the problem of abusive options backdating
for several years. As a preliminary step in explaining the Commission's
response to the problem of fraudulent options backdating, it would be
useful to put the whole topic of options compensation into some
perspective.
As you know, during the last year the Commission has been intensely
focused on the quality of disclosure of executive compensation. Very
recently, we enacted new rules that will require, beginning with the
next proxy season, the full disclosure of all aspects of executive and
director pay and benefits. A key component of that disclosure will be
compensation in the form of stock options, which has been a fast
growing portion of executive pay since the early 1990s.
Under the new SEC rules, all of an executive's compensation will
now be totaled into one number, so that it can be compared easily from
person to person, company to company, and industry to industry. The new
rules also require detailed disclosure of compensation in the form of
stock options, which will show whether a company has backdated options,
and if so, why. The purpose of the new executive compensation rules is
to make the CEO's pay understandable to the shareholders who own the
company.
Of course, no new SEC rules would be necessary to make executive
pay transparent, if executives were all paid in the form of salary. But
beyond the obvious fact that the income tax code discriminates in favor
of non-salary compensation that can be taxed as capital gains, one of
the most significant reasons that non-salary forms of compensation have
ballooned since the early 1990s is the $1 million legislative cap on
salaries for certain top public company executives that was added to
the Internal Revenue Code in 1993.
As a Member of Congress at the time, I well remember that the
stated purpose was to control the rate of growth in CEO pay. With
complete hindsight, we can now all agree that this purpose was not
achieved. Indeed, this tax law change deserves pride of place in the
Museum of Unintended Consequences.
There are other accounting and tax reasons, as well, that stock
options over the years were increasingly included in the compensation
packages of executives and non-executives.
Beginning in 1972, the accounting rule was that employee stock
options wouldn't have to be shown as an expense on the income
statement--so long as the terms were fixed when the option was granted,
and so long as the exercise price was equal to the market price on that
day. Indeed, no expense would ever need to be recorded in the financial
statements for fixed options that weren't granted in-the-money.
In addition to this favorable accounting treatment, there was a tax
benefit. The million-dollar cap on the tax deductibility of executive
compensation, which I mentioned earlier, doesn't apply to options
granted at fair market value. So for companies that wanted or needed to
pay compensation in excess of $1 million per year, the tax code
outlawed deducting it if it was paid in a straightforward way through
salary, but permitted a deduction if the compensation was paid through
at-the-money options.
And of course there were other reasons, many of them good ones with
solid economic rationales, that companies wanted to use options as a
form of compensation. For example, a properly-structured option plan
can be useful in more closely aligning the incentives of shareholders
and managers. And for growth companies, the use of stock options as
compensation offers a way to conserve resources while attracting top-
flight talent in highly competitive markets.
All of these factors have contributed to the now-widespread use of
stock options as compensation. But just as option compensation
increased, so did the potential for abuse. And Congress deserves credit
for taking preemptive action that we now know was critical to stopping
the spread of the backdating contagion.
Four years ago, in 2002, the Sarbanes-Oxley Act very presciently
tightened up on the reporting of stock option grants. Before Sarbanes-
Oxley, officers and directors didn't have to disclose their receipt of
stock option grants until after the end of the fiscal year in which the
transaction took place. So a grant in January might not have to be
disclosed until more than a year later. SOX changed that, by requiring
real-time disclosure of option grants. And in August 2002, shortly
after the law was signed, the SEC issued rules requiring that officers
and directors disclose any option grants within two business days.
Not only must option grants now be reported within two business
days, but this information was among the first required to be filed
electronically using interactive data. Thanks to this new data-tagging
technology, the public now has almost instant access to information
about stock option grants.
The following year, in 2003, the SEC took another important step
that has helped increase the transparency of public company options
plans. The Commission approved changes to the listing standards of the
New York Stock Exchange and the Nasdaq Stock Market that for the first
time required shareholder approval of almost all equity compensation
plans. Companies have to publicly disclose the material terms of their
stock option plans in order to obtain shareholder approval.
Very importantly, the required disclosures include the terms on
which options will be granted. And companies must tell their
shareholders whether the plan permits options to be granted with an
exercise price that's less than the market value on the date of grant.
Then, in December 2004, the FASB issued Statement of Financial
Accounting Standard 123R, which effectively eliminated the accounting
advantage that had previously been given to stock options issued at-
the-money. Since this new accounting rule took effect, all stock
options granted to employees have to be recorded as an expense in the
financial statements, whether or not the exercise price is at fair
market value. This rule is nearly fully phased in.
Most recently, in January of this year, the SEC proposed that
public companies be required to more thoroughly disclose their awards
of in-the-money options to certain executives. The Commission also
proposed that companies be required to disclose the fair value of the
option on the grant date, as determined under the new accounting rules.
The Commission adopted final rules on these subjects on July 26, 2006.
As a result, in the next proxy season beginning in the spring, all
public companies will now report this information in clear, easy to
understand tabular presentations.
The tables will include:
The grant date fair value under FAS 123R (which is aggregated in
the total compensation amount that is shown for each named executive
officer);
The FAS 123R grant date;
The closing market price on the grant date if it is
greater than the exercise price of the option; and
The date the compensation committee or full board of
directors took action to grant the option, if that date is different
than the grant date.
Because the dates and numbers often don't tell the whole story,
companies will also be required to discuss the policies and goals of
their compensation programs--in plain English. The reports to investors
will describe whether, and if so how, a company has engaged (or might
engage in the future) in backdating or any of the many variations on
that theme concerning the timing and pricing of options. For example,
if a company has a plan to issue option grants in coordination with the
release of material non-public information, that will now be clearly
described.
So, to recap, here is what has been done by way of prophylactic
rules to eliminate the opportunities for abusive backdating. First,
Sarbanes-Oxley has closed the disclosure loophole that permitted months
and sometimes more than a year to elapse before option grants had to be
reported. Second, a new accounting rule--FAS 123R--has eliminated the
accounting benefit of granting at-the-money options. And third, the
SEC's brand new executive compensation rules now require a complete
quantitative and narrative disclosure of a company's executive
compensation plans and goals. That enhanced disclosure will make it
clear whenever options are being backdated, and it will require an
explanation of the reasons.
Each of these steps by itself is an important contribution to
preventing backdating abuse. In combination, they have effectively
slammed the door shut on the easy opportunities to get away with
secretive options grants. That's why almost all of the stock option
abuses our Enforcement Division has uncovered started in periods prior
to these reforms.
But while these accounting and disclosure rules changes have made
it easier to detect and punish backdating abuses going forward,
uncovering the problems from prior years has been quite a challenge.
A few years ago, the SEC began working with academics to decipher
market data that provided the first clues something fishy was going on.
One of the academics with whom the SEC worked was Erik Lie of the
University of Iowa, who subsequently published a paper in 2005 that
showed compelling circumstantial evidence of backdating.
Dr. Lie's data showed that before 2003, a surprising number of
companies seemed to have had an uncanny ability to choose grant dates
that coincided with low stock prices.
(In a follow-up paper this year, co-authored with Dr. Randall Heron
of Indiana University, Dr. Lie demonstrated that this problem has
greatly diminished since 2002, when the Sarbanes-Oxley Act shortened
the time for reporting option grants to two business days.)
With a fair amount of detective work, and with the aid of economic
research conducted by the SEC's Office of Economic Analysis, the
Commission succeeded in turning what had begun as mere evidentiary
threads into solid leads. Eventually, some of the evidence we began
turning up was so compelling that several U.S. Attorneys took a
criminal interest. Over the past several years, our inventory of
backdating and related investigations has grown substantially. And
beginning three years ago, the SEC has brought several enforcement
actions against companies and individuals for fraudulent option
practices.
For example, in 2003, the Commission charged Peregrine Systems,
Inc. with financial fraud for failing to record any expense for
compensation when it issued incentive stock options. The SEC's
complaint alleged that at each quarterly board meeting, the company's
directors would approve a total number of options for employees. The
company would then allocate the options to the employees during the
quarter. But the options wouldn't be priced until the day after the
next quarterly Board meeting. On that day, the company looked back at
the market price of its stock between the two quarterly Board meetings,
and picked the lowest price. That turned the options into in-the-money
grants. But even though accounting rules required that they then be
recorded as compensation expense, the company didn't do that. As a
result, Peregrine understated its expenses by approximately $90
million.
The following year, in 2004, the SEC brought a case involving the
manipulation not of option grants, but of exercise dates. Our complaint
charged that Symbol Technologies, Inc. and its former general counsel
fudged option exercise dates so that senior executives could profit
unfairly at the company's expense. Rather than use the actual exercise
date as defined by the company's option plans, the general counsel
picked the most advantageous date from a 30-day ``look-back'' period in
order to come up with a lower exercise price. This was done without
board approval or public disclosure. The SEC charged that to create the
false appearance that these exercises had actually occurred on the
chosen dates, the company's general counsel had instructed his staff to
backdate the relevant documents, and to substitute phony exercise dates
on the forms the executives used to report their option exercises to
the SEC and the public. The result, according to the complaint, was a
serious misstatement of the company's stock option expenses.
When the company subsequently restated its improper accounting, the
cumulative net increase in reported stock option expenses was $229
million. The amount would undoubtedly have been higher had it not been
for the passage of the Sarbanes-Oxley Act. Thanks to the Act's new two-
day deadline for reporting options transactions by officers and its
prohibition on company loans to officers and directors, the company and
its general counsel had put a halt to the ``look-backs'' because the
law had rendered the practice unfeasible.
While the alleged manipulations of option grants and exercises in
these two cases were part of larger accounting fraud charges, two more
recent cases have focused solely on option practices. These are the
Brocade and Comverse actions that the SEC filed in July and August of
this year. The executives charged in these cases are contesting the
SEC's allegations.
In July, the SEC filed a civil fraud action against three former
executives of Brocade Communications Systems, alleging that the former
CEO and the former Vice President of Human Resources routinely
backdated stock option grants to give employees favorably priced
options without recording the necessary compensation expenses.
Specifically, the SEC's complaint alleges that the CEO caused Brocade
to grant in-the-money options to both new and current employees between
2000 and 2004, and then backdated documents to make it appear that the
options were at-the-money when granted. This had the effect of
concealing millions of dollars in expenses from investors.
The complaint alleges that the CEO repeatedly used hindsight to
select a date with a lower stock price from the recent past as the
purported option grant date, and that, to facilitate the scheme, the
Human Resources executive created, or directed others to create, false
paperwork making it appear that the options had been granted on the
earlier date. The complaint alleged that, in some instances, employment
offer letters and compensation committee minutes were falsified to
suggest that options had been granted to employees before they had even
been hired by the company.
The SEC's complaint also charged Brocade's former CFO, alleging
that he learned of the backdating after joining the company but took no
action to correct or halt the practice and instead signed Brocade's SEC
filings. When these stock option practices surfaced, Brocade was
required to restate and revise its financial statements for six fiscal
years, from 1999 through 2004. The scheme resulted in the inflation of
Brocade's net income by as much as $1 billion in the year 2000 alone.
Simultaneously with the filing of the SEC's complaint, the U.S.
Attorney's Office for the Northern District of California separately
filed criminal charges against the former CEO and the former Vice
President of Human Resources for the same misconduct.
In the second recent case, the Commission filed a civil fraud
complaint last month against three former senior executives of Comverse
Technology, Inc., 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 Comverse common stock.
The complaint alleges that from 1991 to 2002, Comverse's founder
and former Chairman and CEO repeatedly used hindsight to select a date
when the closing price of Comverse's common stock was at or near a
quarterly or annual low. According to the complaint, the CEO then
communicated this date and closing price to Comverse's former general
counsel who, with the CEO's knowledge, created company records that
falsely indicated that a committee of Comverse's board of directors had
actually approved the option grant on the date the CEO had picked.
The complaint also alleges that Comverse's former CFO joined the
scheme no later than 1998, and assisted in selecting backdated grant
dates. It is alleged that each of the three defendants realized actual
illicit gains from the backdating when they sold stock they acquired
from exercises of backdated options, including at least $6 million by
the CEO alone. In addition, the complaint alleges that the former CEO
and CFO created a slush fund of backdated options between 1999 and 2002
by causing options to be granted to fictitious employees and, later,
used these options to recruit and retain key personnel.
Comverse has publicly announced that it expects to restate
historical financial results for multiple years in order to record
material charges for option-related compensation expenses.
Simultaneously with the filing of the SEC's complaint, the U.S.
Attorney's Office for the Eastern District of New York unsealed a
criminal complaint charging these three executives with conspiracy to
violate the antifraud provisions of the federal securities laws, wire
fraud, and mail fraud by engaging in the same scheme.
These cases demonstrate some of the variations on the basic theme
of fraudulent backdating that the Commission has uncovered. They
involve backdated option grants that are more profitable to recipients;
backdated option exercises that reduce recipients' taxes at the expense
of shareholders; options granted to top executives; and options granted
to rank and file employees. They involve actual personal gain to
wrongdoers, and real harm to companies that failed to properly account
for the options practices.
Unfortunately, these cases that I've used as illustrations are not
the only matters the SEC has under investigation. The SEC's Division of
Enforcement is currently investigating over 100 companies concerning
possible fraudulent reporting of stock option grants. The companies are
located throughout the country, and include Fortune 500 companies as
well as smaller cap issuers. They span multiple industry sectors.
You should not expect that all of these investigations will result
in enforcement proceedings. At the same time, we have to expect other
enforcement actions will be forthcoming in the future.
The SEC's Enforcement staff is sharing information related to its
investigations with other law enforcement and regulatory authorities as
warranted and appropriate, including the Department of Justice, the
President's Corporate Fraud Task Force, U.S. Attorney's offices around
the country, the Federal Bureau of Investigation, and the Internal
Revenue Service.
In our rulemaking, our provision of accounting and final regulatory
guidance, and our enforcement programs, the SEC has been and will
remain vigilant in the battle against fraudulent options backdating.
The agency is grateful for the opportunity to provide you with this
update on a very important subject. I am happy to take any questions
you may have.
______
PREPARED STATEMENT OF MARK OLSON
Chairman, Public Company Accounting Oversight Board
September 6, 2006
Chairman Shelby, Ranking Member Sarbanes, and Members of the
Committee:
I am pleased to appear today on behalf of the Public Company
Accounting Oversight Board to discuss the PCAOB's response to concerns
relating to certain stock option granting practices.
The PCAOB oversees the auditors of public companies, in order to
protect the interests of the investing public in the preparation of
informative, accurate and independent audit reports on public company
financial statements. The PCAOB does not regulate accounting or
disclosures by public companies; rather, the PCAOB's role is to enhance
the quality of the audits of such financial statements. Simply put, the
PCAOB's job is to improve the quality and reliability of public company
audits, so that investors can have more confidence in audited financial
statements.
The Board has a variety of tools with which to promote improved
audit quality. While those tools include meaningful enforcement and
disciplinary authority--important authority backing up all of our other
authority--the Board has focused on implementing a supervisory model of
regulation intended to focus firms on the need for high quality
auditing, by helping them see where they are falling short and
providing feedback and guidance that facilitates their efforts to
improve. The PCAOB's approach to the audit issues that arise in
connection with companies' stock option granting practices is an
example of the PCAOB's emphasis on real-time improvements in audit
quality.
I. Stock Option Granting Practices Have Raised Concerns About
Companies' Accounting for and Disclosure of Compensation Costs
Before describing the PCAOB's response to concerns about some
companies stock option granting practices, I will briefly describe the
history of these concerns and certain regulatory changes that appear to
have reduced the opportunity and incentive for some of the practices at
issue.
A. Employee Stock Options Can Be a Useful Tool, but
Concerns Have Arisen Whether Companies Have
Properly Disclosed Their True Costs
As we all know, many companies issue stock options as a form of
compensation and to give employees vested interests in improving their
companies' performance and share prices. Such options usually give
employees the right to buy shares in the future, at the price of the
stock on the date of the grant. The higher the share price rises
relative to the exercise price, the more valuable the options are. Well
managed, stock options can be a useful and appropriate tool to attract
and retain employees.
Companies' financial statements, of course, must account for and
disclose options consistent with applicable accounting and regulatory
requirements, and recently concerns have arisen that some may not have
done so. More than 120 companies have announced they are involved in
civil or criminal investigations, or internal reviews, of possible
problems in the way they have granted, accounted for and disclosed
stock option compensation to senior executives and other employees.
Academic studies have long noted suspiciously favorable patterns
related to the timing of option grants. Those patterns were largely
attributed to companies planning option grants in advance of
significant releases of information, until a 2005 study by University
of Iowa researcher Erik Lie, who I understand will discuss his work in
the second panel of this hearing.\1\ That study suggested that the
favorable granting patterns could be attributable to companies having
retroactively assigned option grant dates on dates their stocks hit
relative lows, when the options were in fact granted weeks or months
later.
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\1\ See Lie, E., ``On the Timing of CEO Stock Option Awards,''
Management Science (May 2005), at 802, available at http://
www.biz.uiowa.edu/faculty/elie/Grants-MS.pdf.
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B. Changes in Regulatory Requirements Appear to Have
Reduced the Incidence of Suspiciously-timed Option
Grants
While the extent of the problems arising from backdating and other
stock option granting practices is not yet clear, two significant
changes in the disclosure and accounting for stock option grants in
recent years--the first initiated by, and the second supported by, this
Committee--seem to have significantly reduced companies' opportunity
and incentive to backdate grants.
First, the Sarbanes-Oxley Act appears to have significantly reduced
the incidence of backdated option grants. Specifically, the SEC's rules
implementing Section 403 of the Act now require public company officers
and directors to report their receipt of stock options within two days
of the grant.\2\ Previously, such persons were generally not required
to report option grants until 45 days after the fiscal year in which
they were received.\3\ Given the new filing requirement, the ability to
backdate option grants to coincide with low stock prices is greatly
curtailed. Indeed, subsequent research has shown that, following the
change, when company insiders reported options within the new deadline,
there was little to no pattern of abnormal share price increases soon
afterward.\4\
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\2\ See SEC Release No. 34-46421, Ownership Reports and Trading by
Officers, Directors and Principal Security Holders (August 27, 2002),
available at http://www.sec.gov/rules/final/34-46421.htm. Section 403
of the Sarbanes-Oxley Act required certain company insiders to file
reports of certain transactions in the securities of their companies
within two days of the transaction. In addition, it required such
reports to be filed electronically and available on a public, SEC Web
site as well as on the company's Web site if it maintains one.
\3\ Under Section 16 of the Securities Exchange Act of 1934, and
the SEC's implementing rules, directors, officers and certain others
are required to report transactions and holdings involving their
companies' securities, including the receipt of employee stock options.
Until August 29, 2002, stock options awarded under most employee stock
purchase and other benefit plans were required to be reported (on the
SEC's Form 5) within 45 days after the end of the fiscal year in which
they were granted. In its rule implementing Section 403 of the
Sarbanes-Oxley Act, the SEC required certain transactions that were
formerly reportable annually on Form 5, such as option grants, to be
reported, like other insider transactions, on Form 4 within Section
403's new two-day deadline.
\4\ That research also shows that the previously identified pattern
of stock prices rising shortly after grant dates has continued for
those companies whose insiders have not complied with the two-day
requirement. See Heron, R. and Lie, E., ``Does Backdating Explain the
Stock Price Pattern Around Executive Stock Option Grants?'' forthcoming
in Journal of Financial Economics, available at http://
www.biz.uiowa.edu/faculty/elie/Grants-JFE.pdf.
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Second, accounting standards for employee stock options have also
gone through several changes over the last few years. Historically, the
applicable accounting standard--found in Accounting Principles Board
Opinion No. 25--required companies to record, as compensation cost, the
amount, if any, by which the price of an employee stock option exceeded
the market price on the date of the grant.\5\ Compensation expenses
associated with such ``in-the-money'' stock options was required to be
reported as incurred in the period or periods in which the employee
performed services for the option, which could extend for years after
the option grant.\6\ As a result, failure to account properly for in-
the-money options could affect several financial periods.
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\5\ See Accounting Principles Board Opinion No. 25. Accounting
Principles Board Opinions were promulgated by the American Institute of
Certified Public Accountants until 1973, when the Financial Accounting
Standards Board was established. At that time, the FASB adopted
outstanding APB Opinions, as amended, and over time has superseded
them.
\6\ APB Opinion No. 25, para. 12.
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APB Opinion No. 25 permitted companies not to record any cost,
however, when employee stock options were granted at a price equal to
or greater than the market price on the date of the grant. APB Opinion
No. 25 thus discouraged companies from granting options at less than
the prevailing market price, although such discounted options could be
more lucrative for recipients. Some companies may have attempted to
have it both ways, though, by granting options at prices below market
on the date of the grant but treating them for accounting and tax
purposes as if they were granted on a date when market prices were
lower.
In 1994, the Financial Accounting Standards Board adopted Statement
of Financial Accounting Standards No. 123, which encouraged companies
to report the cost of stock option grants to employees at their fair
value, but permitted them to continue to rely on APB Opinion No. 25, so
long as they disclosed what the compensation cost would have been had
they recorded such options at their fair value.\7\ Finally, in 2004,
the FASB eliminated APB Opinion No. 25 and, beginning with financial
statements for annual periods starting after June 15, 2005, required
companies to account for employee stock options at their fair value,
regardless of any difference between an option's exercise price and the
market price at the time of grant.\8\
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\7\ See Statement of Financial Accounting Standards No. 123, Share-
Based Payment, available at http://www.fasb.org/pdf/fas123.pdf.
\8\ See Statement of Financial Accounting Standards No. 123
(revised 2004), Share-Based Payments, available at http://www.fasb.org/
pdf/fas123r.pdf; see also SEC Release No. 33-8568 (April 15, 2005).
Certain small business issuers have until annual periods starting after
December 15, 2005 to comply with FAS 123(R). Id.
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II. The PCAOB Has Alerted Auditors to Use Judgment in Considering
Issues Relating to Stock Option Granting Practices in Their
Audits
Although much of the conduct currently under review appears to
predate the Sarbanes-Oxley Act, errors related to such conduct may
affect current period financial statements if employee performance
related to past option grants continues into the present. That is, if
an employee is still earning an option through performance (e.g., the
option has not vested yet) then any compensation cost associated with
the option may be allocable to the current financial period. In
addition, new revelations of such conduct may trigger current auditor
obligations with respect to past financial periods.
As the prevalence of problems in dating of stock option grants
became clear, the PCAOB considered the implications of such problems
for audits, and developed a strategy to draw those issues to auditors'
attention so that they can address them in this year's audits.
Specifically, the PCAOB reviewed patterns in option granting practices
identified in available research, accounting firms' existing guidance
to their auditors related to option granting practices, and auditing,
accounting and regulatory requirements that have a bearing on audits of
stock option grants. In addition, the Board discussed issues related to
the timing of stock option grants at the June 2006 public meeting of
its Standing Advisory Group.\9\ With the encouragement of members of
this advisory group, these efforts led to an Audit Practice Alert
publicly issued by the Board's staff on July 28, and disseminated
electronically to the more than 1,600 public accounting firms
registered with the PCAOB. This tool allowed the PCAOB to provide real-
time guidance as auditors begin a new audit season, without adding to
the volume or complexity of the body of existing standards.
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\9\ The Board convened its Standing Advisory Group pursuant to
Section 103(a)(4) of the Sarbanes-Oxley Act. The Group consists of a
select group of experts in auditing and financial reporting, including
representatives of investors, accountants, and public companies and
meets three times a year to advise the Board on its standards-setting
responsibilities.
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I have attached a copy of this Alert as Exhibit A. The Alert
focuses auditors on several considerations related to evaluating and
addressing in their audits the risk that stock option granting
practices may have led to material misstatement of financial
statements. In doing so, the Alert identifies existing standards that
could bear on their work and applies them to the issues that have been
raised regarding companies' stock option granting practices; the Alert
does not establish new requirements.
Specifically, the Alert tells auditors that, in audits currently
underway or to be performed in the future, they should use certain
information that existing standards direct them to acquire, in order to
assess the nature and potential magnitude of risks associated with
their audit clients' stock option granting practices. The Alert also
emphasizes that auditors must use professional judgment in making this
assessment and in determining appropriate procedures to address any
identified risks. In addition, the Alert reminds auditors of several
procedural considerations, such as how they should approach requests
for consents to use past audit opinions, including situations in which
they are no longer the auditor of record. The Alert also describes
circumstances in which existing standards require auditors to
reconsider past audit opinions.
As the Alert points out, in assessing the risk of material
misstatement of financial statements, an auditor should consider
whether the company accounted for options that are still outstanding
under APB Opinion No. 25. If so, and if a company granted options at a
price that was lower than the market price on the true grant date, then
the auditor should consider whether compensation costs were materially
understated (and whether additional disclosures should have been made)
in the periods of the recipient employee's performance, including the
current period. The Alert also instructs the auditor to consider the
effect of any errors in measuring compensation on the effectiveness of
the company's internal control over financial reporting. Finally, the
Alert reminds auditors that errors in reported option compensation may
have material tax implications for companies \10\ and may result in
material contingent obligations, including those due to pending legal
and regulatory matters.
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\10\ The Internal Revenue Code limits the deduction public
companies may take for compensation paid to certain executive officers
to $1 million, but it excludes from this limit compensation that is
performance-based. See Internal Revenue Code Section 162(m). Stock
option compensation may be treated as performance-based when the
exercise price is equal to or more than the grant date's market price.
If, on the other hand, the option provides for a discounted exercise
price, it counts toward, and is subject to tax if it exceeds, the
deduction limit. Companies that may have granted stock options at an
exercise price that differs from the market price on the grant date,
may have a tax liability, and potentially penalties, for past taxes
due. If material, auditors should confirm that these items are recorded
and reported in the financial statements.
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In closing, the Board appreciates the opportunity to describe how
it has approached concerns about companies' accounting for employee
stock options. Alerting auditors to practices and trends that may be
relevant to their ongoing audits is a critical part of the PCAOB's
approach to oversight. The Board's goal is to help auditors identify
and address problems in financial reporting in order to protect
investors' interests in high-quality and reliable audits. The PCAOB's
work in the area of auditing employee stock option grants is an
important step toward this goal.
I would be pleased to answer any questions.
Staff Audit Practice Alert No. 1--Matters Related to Timing and
Accounting for Option Grants--July 28, 2006
Audit Practice Alerts highlight new, emerging, or otherwise
noteworthy circumstances that may affect how auditors conduct audits
under the existing requirements of PCAOB standards and relevant laws.
Auditors should determine whether and how to respond to these
circumstances based on the specific facts presented. The statements
contained in Audit Practice Alerts are not rules of the Board and do
not reflect any Board determination or judgment about the conduct of
any particular firm, auditor, or any other person.
Recent reports and disclosures about issuer practices related to
the granting of stock options, including the ``backdating'' of such
grants, indicate that some issuers' actual practices in granting
options might not have been consistent with the manner in which these
transactions were initially recorded and disclosed. Some issuers have
announced restatements of previously issued financial statements as a
result of these practices. In addition, some of these practices could
result in legal and other contingencies that may require recognition of
additional expense or disclosure in financial statements.
This practice alert advises auditors that these practices may have
implications for audits of financial statements or of internal control
over financial reporting (``ICFR'') and discusses factors that may be
relevant in assessing the risks related to these matters.
Background
The recorded value of a stock option depends, in part, on the
market price of the underlying stock on the date that the option is
granted and the exercise price specified in the option. Some issuers
may have granted options with exercise prices that are less than the
market price of the underlying stock on the date of grant. These
options are sometimes referred to as ``discounted'' or ``in-the-money''
options. Where discounted options were granted and an issuer failed to
properly consider this condition in its original accounting for the
option, errors in recording compensation cost, among other effects, may
have resulted. These errors may cause an issuer's financial statements,
including related disclosures, to be materially misstated.\1\
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\1\ In addition, academic research has suggested the possibility
that some issuers may have purposefully granted options immediately
before the release of information that the issuer believed would be
favorable to its share price. While these practices may not result in
the granting of discounted options, they may create legal or
reputational risks and raise concerns about the issuer's control
environment.
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While this alert does not attempt to describe all of the variations
in circumstances that may result in the issuance of discounted options,
a range of practices appears to be involved, including----
The application of provisions in option plans that allow
for:
the selection of exercise prices based on market prices
on dates earlier than the grant date, or
the award of options that allow the option holder to
obtain an exercise price equal to the lower of the market price of the
stock at the grant date or during a specified period of time subsequent
to the grant date.
Preparation, or subsequent modification, of option
documentation for purposes of indicating a lower exercise price than
the market price at the actual grant date.
Treating a date as the grant date when, in fact, all of
the prerequisites to a grant had not yet occurred.
Available information suggests that the incidence of these and
similar practices may have substantially decreased after the
implementation of the shortened filing deadline for reports of option
grants specified by Section 403 of the Sarbanes-Oxley Act of 2002. In
August 2002, the Securities and Exchange Commission (``SEC'')
implemented this requirement by requiring the reporting of an option
grant on Form 4 within two days of the date of grant. However, periods
subsequent to the grant of an option may also be affected by improper
accounting for a grant because option cost is generally expensed over
the period during which the issuer receives the related services, most
commonly its vesting period.
Matters for auditor consideration
Auditors planning or performing an audit should be alert to the
risk that the issuer may not have properly accounted for stock option
grants and, as a result, may have materially misstated its financial
statements or may have deficiencies in its ICFR. For audits currently
underway or to be performed in the future, the auditor should acquire
sufficient information to allow him or her to assess the nature and
potential magnitude of these risks. An auditor must use professional
judgment in making these assessments and in determining whether to
apply additional procedures in response.
In making these judgments, auditors should be mindful of the
following--
Applicable financial accounting standards. Financial Accounting
Standards Board Statement of Financial Accounting Standards (``SFAS'')
No. 123 R (revised 2004), Share-Based Payment, applies to issuer
reporting periods beginning after June 15, 2005 (December 15, 2005 for
small business issuers). Accounting for options was, however,
previously governed by other accounting standards and related
interpretations, specifically Accounting Principles Board Opinion No.
25, Accounting for Stock Issued to Employees (APB 25), and SFAS No.
123, Accounting for Stock-Based Compensation. If an auditor determines
that it is necessary to consider the accounting for option grants and
related disclosures in financial statements of a prior period, the
auditor should take care to determine the applicable generally accepted
accounting principles in effect in those periods and to consider the
specific risks associated with these principles.
Accounting for discounted options. For periods in
which an issuer used the provisions of APB 25 to determine
compensation cost related to stock options, the issuer may have
been required to record additional compensation cost equal to
the difference in the exercise price and the market price at
the measurement date (as defined in APB 25). In periods in
which the issuer has recorded option compensation cost using
the fair value method as allowed by SFAS No. 123, or as
required by SFAS No. 123 R (revised 2004), the impact on the
calculated fair value of options of using an incorrect date as
the grant date would depend on the nature and magnitude of
changes in conditions that affect option valuation between the
incorrect date used and the actual grant date. In all cases,
the compensation cost of options should be recognized over the
period benefited by the services of the option holder.
Accounting for variable plans. For periods in which
an issuer used the provisions of APB 25 to determine
compensation cost related to stock options, an option with
terms allowing a modification of the exercise price, or whose
exercise price was modified subsequent to the grant date may
require variable plan accounting. Variable option accounting
requires that compensation cost be recorded from period to
period based on the variation in current market prices. In
periods in which the issuer records option compensation cost
using the fair value method as allowed by SFAS No. 123, or as
required by SFAS No. 123 R, the right to a lower exercise price
may constitute an additional component of value of the option
that should be considered at the grant date. In all cases, the
cost of options should be recognized over the period benefited
by the services of the option holder.
Accounting for contingencies. If the consequences
of the issuer's practices for stock option grants or its
accounting for, and disclosure of, option grants result in
legal or other contingencies, the application of SFAS No. 5,
Accounting for Contingencies, may require that the issuer
record additional cost or make additional disclosures in
financial statements.
Accounting for tax effects. The grant of discounted
stock options may affect the issuer's ability to deduct
expenses related to these options for income tax purposes,
thereby affecting the issuer's cash flows and the accuracy of
the related accounting for the tax effects of options.
Consideration of materiality. In evaluating materiality, auditors
should remember that paragraph .11 of AU sec. 312, Audit Risk and
Materiality-in Conducting an Audit, and SEC Staff Accounting Bulletin:
No. 99--Materiality emphasize that both quantitative and qualitative
considerations must be assessed. Quantitatively small misstatements may
be material when they relate to unlawful acts or to actions by an
issuer that could lead to a material contingent liability. In all
cases, auditors should evaluate the adequacy of related issuer
disclosures.
Possible illegal acts. Auditors who become aware that an illegal
act may have occurred must comply with the applicable requirements of
AU section (``AU sec.'') 317, Illegal Acts, and Section 10A of the
Securities Exchange Act of 1934. Section 10A, among other things,
requires a registered public accounting firm to take certain actions if
it ``detects or otherwise becomes aware of information indicating that
an illegal act (whether or not perceived to have a material effect on
the financial statements of the issuer) has or may have occurred....''
If it is likely that an illegal act has occurred, the registered public
accounting firm must ``determine and consider the possible effect of
the illegal act on the financial statements of the issuer, including
any contingent monetary effects, such as fines, penalties, and
damages.'' The registered public accounting firm must also inform the
appropriate level of management and assure that the audit committee is
adequately informed ``unless the illegal act is clearly
inconsequential.'' The auditor may, depending on the circumstances,
also need to take additional steps required under Section 10A if the
issuer does not take timely and appropriate remedial actions with
respect to the illegal act.
A. Effects of options-related matters on planned or ongoing audits
In planning and performing an audit of financial statements and
ICFR, the auditor should assess the nature and potential magnitude of
risks associated with the granting of stock options and perform
procedures to appropriately address those risks. The following factors
are relevant to accomplishing these objectives--
Assessment of the potential magnitude of risks of
misstatement of financial statements and deficiencies in ICFR related
to option granting practices. This assessment should include
consideration of possible indicators of risk related to option grants,
including, where appropriate:
The status and results of any investigations relating
to the timing of options grants conducted by the issuer or by
regulatory or legal authorities.
The results of direct inquiries of members of the
issuer's management and its board of directors that should have
knowledge of matters related to the granting and accounting for stock
options.
Public information related to the timing of options
grants by the issuer.
The terms and conditions of plans or policies under
which options are granted; in particular, terms that allow exercise
prices that are not equal to the market price on the date of grant or
that delegate authority for option grants to management. In these
situations, auditors should also consider whether issuers have other
policies that adequately control the related risks.
Patterns of transactions or conditions that may
indicate higher levels of inherent risk in the period under audit. Such
patterns or conditions may include levels of option grants that are
very high in relation to shares outstanding, situations in which
option-based compensation is a large component of executive
compensation, highly variable grant dates, patterns of significant
increases in stock prices following option grants, or high levels of
stock-price volatility.
In planning and performing audits, auditors should
appropriately address the assessed level of risk, if any, related to
option granting practices. Specifically:
In addition to the general planning considerations for
financial statement audits identified in AU sec. 311, Planning and
Supervision, the auditor should consider:
The implications of any identified or indicated
fraudulent or illegal acts related to option grants to assessed risks
of fraud (AU sec. 312.07 and AU sec. 316, Consideration of Fraud in a
Financial Statement Audit); the potential for illegal acts (AU sec.
317, Illegal Acts by Clients); or the assessment of an issuer's
internal controls (AU sec. 319, Internal Control in a Financial
Statement Audit).
The scope of procedures applied to assess the
potential for fraud (AU sec. 316) and illegal acts (AU sec. 317).
The nature, timing, and extent of audit procedures
applied to elements of the financial statements affected by the
issuance of options. In particular, this assessment should include
consideration of:
The need for specific management
representations related to these matters (AU sec. 333,
Management Representations) and the nature of matters
included in inquiries of lawyers (AU sec. 337, Inquiry
of a Client's Lawyer).
Where applicable, the result of tests of
internal controls over the granting, recording, and
reporting of option grants.
The need, based on the auditor's risk
assessment, for additional specific auditing procedures
related to the granting of stock options.
For integrated audits performed as described in PCAOB Auditing
Standard No. 2, An Audit of Internal Control Over Financial Reporting
Performed in Conjunction with An Audit of Financial Statements (``AS
No. 2''), the auditor should consider the implications of identified or
potential accounting and legal risks related to options in planning,
performing, and reporting on audits of ICFR. In addition, as discussed
in paragraphs 145-158 of AS No. 2, the results of the audit of ICFR
should be considered in connection with the related financial statement
audit.
B. Auditor involvement in registration statements
In cases where an auditor is requested to consent to the inclusion
of his or her report, including a report on ICFR, in a registration
statement under the Securities Act of 1933, AU sec. 711, Filings Under
Federal Securities Statutes, provides that the auditor should perform
certain procedures prior to issuing such a consent.\2\
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\2\ Under Paragraph 198 of AS 2, the auditor should apply AU sec.
711 when the auditor's report on management's assessment of ICFR is
included in filings under federal securities statutes.
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Paragraph .10 of AU sec. 711 provides that an auditor
should perform certain procedures with respect to events subsequent to
the date of the audit opinion up to the effective date of the
registration statement (or as close thereto as is reasonable and
practical under the circumstances). These procedures include inquiry of
responsible officials and employees of the issuer and obtaining written
representations from them about whether events have occurred subsequent
to the date of the auditor's report that have a material effect on the
financial statements or that should be disclosed in order to keep the
financial statements from being misleading. The auditor should consider
performing inquiries and obtaining representations specifically related
to the granting and recording of option grants.
Paragraph .11 of AU sec. 711 provides that a predecessor
auditor that has been requested to consent to the inclusion of his or
her report on prior-period financial statements in a registration
statement should obtain written representations from the successor
auditor regarding whether the successor auditor's audit and procedures
with respect to subsequent events revealed any matters that might have
a material effect on the financial statements reported on by the
predecessor auditor or that would require disclosure in the notes to
those financial statements. If the successor auditor becomes aware of
information that leads him or her to believe that financial statements
reported on by the predecessor auditor may require revision, the
successor auditor should apply paragraphs .21 and .22 of AU sec.
315.\3\
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\3\ In cases in which a predecessor auditor reissues his or her
report on financial statements included in a filing under the
Securities Exchange Act of 1934, the predecessor auditor should follow
the directives in paragraphs .71 through .73 of AU sec. 508.
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If either the successor or predecessor auditor discovers
subsequent events that require adjustment or disclosure in the
financial statements or becomes aware of facts that may have existed at
the date of his or her report and might have affected the report had he
or she been aware of them, the auditor should take the actions
described in paragraph .12 of AU sec. 711. In addition, where the
auditor concludes that unaudited financial statements or unaudited
interim financial information presented, or incorporated by reference,
in a registration statement are not in conformity with generally
accepted accounting principles, he or she should take the actions
described in paragraph .13 of AU sec. 711.
C. Effects of option-related matters on previously issued opinions
If an auditor becomes aware of information that relates to
financial statements previously reported on by the auditor, but which
was not known to him or her at the date of the report, and which is of
such a nature and from such a source that he or she would have
investigated it had it come to his or her attention during the course
of the audit, he or she should take the actions described in AU sec.
561, Subsequent Discovery of Facts Existing at the Date of the
Auditor's Report.
Contact information
Inquiries concerning this Practice Alert may be directed to--
Phil D. Wedemeyer, Director, Office of Research and Analysis, 202-
207-9204, [email protected].
Thomas Ray, Chief Auditor and Director of Professional Standards,
202-207-9112, [email protected].
______
PREPARED STATEMENT OF LYNN TURNER
Managing Director of Research, Glass Lewis & Co., LLC.
September 6, 2006
Chairman Shelby, Ranking Member Sarbanes, thank you for the
opportunity to testify before the Senate Banking Committee regarding
the growing stock-option scandal. As noted in Appendix A, the number of
companies presently caught up in this scandal has mushroomed and now
totals in excess of 120. It grows and multiplies each week. Professors
Lie and Heron have noted that 18.9% of the unscheduled, at-the-money
option grants to top executives during the period 1996-2005 were
backdated. This includes a 10% rate subsequent to changes in
regulations in 2002, requiring more timely reporting of these
transactions. At the same time, investor groups such as the Council of
Institutional Investors, the CFA Institute, and leading institutional
investors from Australia, Canada, England, the Netherlands, New York,
Connecticut, Florida, California, Illinois and elsewhere have written
the Securities and Exchange Commission (SEC) expressing ``great
concern'' regarding the backdating of options. Also, I would note the
Council of Institutional Investors has written letters to approximately
1,500 companies inquiring of their policies with respect to backdating.
To date, approximately 200 of those companies have responded, leaving a
big question mark with respect to the other 1,300.
But before I begin, I think it is worth noting that, as Business
Week recently reported, the option scandal had its beginnings, in part,
in Congress in 1994. That is when the Senate passed a resolution
opposing the efforts of the Financial Accounting Standards Board (FASB)
to create greater transparency for options. As a direct result of this
overreaching interference, during the ensuing 11 years, companies in
the Standard & Poor's 500-stock index alone excluded $246 billion in
options compensation from net income figures, overstating earnings by
7%.\1\
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\1\ Business Week, August 31, 2006 in citing statistics from The
Analyst's Accounting Observer.
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Fortunately, when efforts to increase transparency of options arose
once again in the aftermath of Enron, investors had a new champion.
Chairman Shelby, your courage, your leadership, and your vision of the
necessity of honest accounting and full and fair disclosure for the
capital markets almost single-handedly prevented Congress from
repeating its mistakes of the past. Your support of the FASB's efforts
to reflect the economic reality of options in financial statements
ensured greatly enhanced transparency for the 90 million Americans
investing in the capital markets. That effort, despite an onslaught of
opposition, including by companies now caught up in the option scandal,
has helped to mitigate the scandal's future potential impact.
Let me also say that, as a business executive, I have been both a
giver and a receiver of stock options. In the past I have not opposed
their use in a thoughtful manner. However, the focus of their use must
be on what Franklin Roosevelt called the ``. . . thrill of achievement,
in the thrill of creative effort.'' \2\ Not the self serving, single-
minded pursuit of evanescent profits. Not abuses of investor interests
through the repricings, early accelerations, or early vesting of
options that have become all too common.
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\2\ Franklin Delano Roosevelt, First Inaugural Address, Washington,
D.C., March 4, 1933.
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I firmly believe that what one manages is what one measures. As a
result, requiring the measurement and expensing of the value of options
granted as compensation will increase the focus and attention they duly
deserve and will help eliminate abuses.
Capital Markets Depend on Integrity and Transparency
As many learned during the early years of this decade--when the
markets lost trillions in value, with stockholders actually withdrawing
cash--the ability of the U.S. capital markets to attract capital
depends on investors having confidence in the integrity and
transparency of the markets. Confidence is earned over time through
honest and fair markets that provide investors with the material
information they need to make informed decisions.
But that confidence can quickly erode if investors believe the
markets have become ``rigged,'' and one party is given an unfair
advantage over others. Unfortunately, that is what occurs when an
executive who has a fiduciary relationship of trust with shareholders
engages in either ``backdating'' or ``spring-loading'' of options. The
executive uses confidential information, available as a result of his
or her position in the company, for self-serving gains. Such is the
beginning of what is referred to as a manipulative or deceptive device.
Sam Raybum, a legend in this town, once said ``men charged with the
administration of other people's money must not use inside information
for their own advantage.''\3\ Indeed, the Securities and Exchange Act
of 1934, passed with the help of Rayburn's leadership, includes a
provision that makes it unlawful for people to use'' . . . any
manipulative or deceptive device. . .'' in connection with the purchase
or sale of a security. Likewise, in the '34 Act and related rules,
Congress and the SEC have made it unlawful for the votes of investors
to be solicited in a proxy that contains false or misleading statements
with respect to material facts. In particular, Rule 14a-9 specifically
addresses false and. misleading statements in a proxy provided to
investors, including omission of material facts.
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\3\ H.R. Rep. No. 1383, 73d Cong., 2d Sess. 13. Cited by the U.S.
Supreme Court in Blau vs. Lehman, et al., 368 U.S. 403 (1962).
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With that as background, I would first like to focus my remarks on
``spring-loading'' of options.
Spring-loading
Let's say a government contractor receives notice from the
government that it has been awarded a profitable contract. The
company's stock is trading at $15 before news of the new contract is
disclosed to investors. Three days later, upon the announcement and
disclosure of the contract, the company's stock price increases to $20.
But before the disclosure is made, while the stock is still trading at
$15, a grant of options to the top executives is made with an exercise
price of $15. In essence, the options have been ``spring-loaded'' to
the tune of $5.
There are a few key points I want to highlight with respect to this
spring-loading example. First, the options were not granted at the fair
value of the underlying stock. It is clear if the market had the
information on the date of the grant with respect to the new contract,
the stock would have traded higher. Second, if properly valued using
all the available information at the time of the option grant, the
grant would have resulted in a benefit to the recipient, as it was
granted in-the-money, not at the market price. And finally, generally
accepted accounting principles (GAAP) would require the value of such
in-the-money options to be expensed under the old accounting rule,
Accounting Principles Board Opinion No. 25, or the new accounting rule,
FASB statement No. 123R.
Now, some would lead you to believe that granting such ``in the
money'' options, or spring-loading, is not a bad thing, not illegal. I
beg to differ.
First of all, research has shown that companies include in their
annual reports, disclosures such as:
``The Company accounts for those plans using the intrinsic value
method prescribed by APB Opinion No. 25, Accounting for Stock Issued to
Employees. No stock-based compensation cost is reflected in the
statements of operations, as all options granted under those plans had
an exercise price equal to the market value of the underlying common
stock on the date of grant.''
Or:
``As permitted by Statement 123, the Company currently accounts for
share-based payments to employees using Opinion 25's intrinsic value
method and, as such, generally recognizes no compensation cost for
employee stock options.''
In addition, I have seen proxy disclosures that indicate options
are being granted at the fair value of the underlying stock, and that
no gain is available to the executive without further stock
appreciation. In cases involving potential spring-loading, they fail to
properly disclose the options were granted in the money. In one
instance, the disclosure noted the grant of options was designed to
align the executive's interests with those of the stockholders, without
noting the spring-loading. Likewise, the proxy disclosures fail to note
that, when options have been spring-loaded and granted ``in the money''
to the executives, there may be significant negative tax consequences.
If a company has engaged in spring-loading, disclosures such as
those above would be misleading to investors and other users of
financial statements. First, since the option had an embedded value on
the date of grant, the company was wrong in saying they were granted at
the market value. Second, given spring-loaded options are ``in the
money'' at the date of grant, the company should have reported
compensation expense under the intrinsic value method required by APB
25. Likewise, any proxy disclosures noting options were granted at fair
value, when they in fact were not, would be misleading. So would
statements that the options were granted pursuant to plans requiring
the options be granted at fair value. The failure to disclose the
significant tax implications of not granting the options at the money
also would be misleading.
Unfortunately, I have not seen disclosures of the nature the SEC
has recently adopted with respect to a company that has a ``. . . plan
or practice to select option grant dates . . . in coordination with the
release of material non-public information that is likely to result in
an increase in its stock price, such as immediately prior to a
significant positive earnings . . . announcement.'' I could not agree
more with the SEC when it said ``the Commission believes that in many
circumstances the existence of a . . . plan . . . to time the grant of
stock options to executives in coordination with material non-public
information would be material to investors . . .'' \4\ The failure of
companies with spring-loading plans to disclose that information is an
omission of a material item of interest to investors.
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\4\ Securities and Exchange Commission, Executive Compensation and
Related Person Disclosure. Release Nos. 33-8732;34-54302; File No. S7-
03-06.
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Accordingly, I believe that disclosures made in the past regarding
spring-loaded option grants will be found in all too many instances to
have been false and misleading, violating the securities laws and
regulations.
Integrity of Management
Equally important, I believe information regarding the integrity of
management is always vitally important and material to investors. After
all, what investors want to give management their money when the
integrity of that management team is in question?
Yet executives who are found to have spring-loaded or backdated
their options will find their integrity challenged as a result of
representations they have made to their companies' auditors, as well as
certifications they have made to their companies' shareholders. When
the CEO and CFO complete the financial statements for a company, they
must provide the auditors with a representation letter that indicates
they have prepared the financial statements in accordance with
generally accepted accounting principles. This would include the proper
accounting for stock options, including recognizing expense for spring-
loaded or backdated options that were granted ``in the money.'' At the
same time, the CEO and CFO must certify to investors that the company
has properly prepared its financial statements and has effective
internal controls, including over the accounting for options. However,
if these executives have engaged in spring-loading (or backdating)
options, failed to properly account for these options, and failed to
note this in their representations to auditors and certifications to
investors, consistent with the types of misleading disclosures I
discussed earlier, the executives would have once again violated
securities laws and regulations.
Accordingly, given that spring-loading certainly can and probably
has resulted in improper financial reporting and misleading
disclosures, raising serious questions about the integrity of
management, I would challenge those who have argued its acceptability
to take a closer look at the filings of companies who have engaged in
this behavior. I think they will find them most troublesome from the
perspective of an investor, as well as a securities regulator.
Late Filings
Now I would like to turn my attention to another issue of concern.
That is the issue of late filings. In particular, late filings of the
forms the SEC requires to be filed within two days by certain
executives or corporate board members, namely Form 4's.
A sample of actual Form 4's for the company, Children's Place
Retail Stores, is included as Appendix B. These forms are required to
be filed on a timely basis so investors have insights into transactions
key insiders are entering into with respect to the stock of the
company. In fact, Enron and other corporate scandals highlighted just
how late this information was being filed at times, much to the
detriment of investors. And, in response to this concern, Congress
adopted Section 403 of the Sarbanes-Oxley Act of 2002 to ensure
investors received the information within two business days.
However, we continue to see late filings, or, quite frankly, Form
4's that are not filed at all. For example, if you look closely at one
of the Children's Place Form 4 filings, you will see it was filed on
May 20, 2005. At the same time, the company states that the transaction
date was on April 29, 2005, well outside the two-day requirement of
SOX. Of interest in this instance is that Children's Place's stock
price increased $9.58, or 26%, to $46.79 between the filing date of the
Form 4 and the disclosed transaction date. On May 5, 2005, the company
issued a press release raising fiscal-year earnings guidance to $2.15-
$2.25 a share from $2.10-$2.20 a share. Children's Place does not have
an established pattern of granting executive options at this time each
year. And while one might well be hesitant to draw conclusions as to
why the Form 4 was filed late, the April 29th date did provide an
unusually low exercise price for the options.
If the Form 4's had been filed on time, investors would not have to
wonder about the integrity of the grant date. That is why it is
important the SEC begin to enforce the provisions of SOX that require
timely filing. And while I have used Children's Place merely as an
example, it is not alone. Companies such as Novatel Wireless, P.F.
Chang's, Activision, Sigma Designs and SafeNet are all on a growing
list. In fact, if you look at SafeNet's proxy disclosures, which I have
included as Appendix C, you will see the filings themselves show the
company repeatedly abused the rules. And despite this constant pattern
of late filings, I am not aware of any formal SEC sanctions being
handed in a timely fashion to ensure the company and its insiders
commence complying with the law. To its credit, SafeNet has disclosed
this shortcoming to investors, something that cannot be said for other
late filers.
Restatements and Internal Control Weaknesses
Another topic worth noting is the 48 companies that have recently
reported they will be delaying providing their investors and the SEC
with their financial statements until they are able to complete their
own investigations of the matter. Of these companies, 19 have announced
they will be restating their financial statements, and certainly a good
portion of the remaining 29 could join that group. Another 22 companies
that were not late filers this quarter have also announced
restatements.
In addition, 18 of the companies listed in Appendix A also reported
they had material weaknesses related to their accounting for stock
options. As you are well aware, Congress since 1977 has required
companies to maintain adequate internal controls that will provide
reasonable assurance their financial statements have been properly
prepared. Yet we are finding, no doubt due to Section 404 of SOX, that
companies have not maintained those necessary controls. Nor in prior
years have the executives reported these weaknesses to investors as
required by Section 302 of SOX. Both Sections 404 and 302 of SOX--tools
that were not available when this scandal initially began in the Enron
era--should help aid the law enforcement agencies in cracking down on
violators.
Where Were The Gatekeepers?
In what has become a recurring theme in recent years, investors are
asking once again: Where were the gatekeepers, including legal counsel
and independent auditors?
As both a business executive and corporate board member, my
experience has been that legal counsel--general counsel, if the
position exists--often takes the lead along with the CEO, CFO and vice
president in charge of human resources in making the determinations as
to option grants, including grant dates. Based on that experience, I
would expect legal counsel to have been aware of backdating of options
if it occurred. Obviously, one would hope that any legal counsel
involved would have had sufficient common sense to have objected to
backdating or spring-loading. However, that appears not to have been
the case for at least some of the companies.
With respect to independent auditors, I suspect they failed to be
skeptical enough with respect to options, despite their known effect on
how at least some executives behave. All too often, it appears they did
not pay sufficient attention to the disclosures the company made with
respect to option plans and grants. All too often, I have seen auditors
pay way too little attention to disclosures in footnotes, merely
treating them almost as an afterthought towards the end of an audit. In
at least one circumstance now involved in litigation, it has been
argued the auditors even gave their blessing to backdating.
However, as a former auditor, I certainly believe that, in some
instances, executives at a company could have intentionally withheld
critical information on option grants and company performance from the
auditors that the auditors otherwise would not have learned of.
Accordingly, the auditors would not have detected the misstated
financial statements.
Steps to Remediate and Prevent a Recurrence of The Option Scandal
One will naturally ask why a professor, living among the cornfields
of Iowa, and two Wall Street Journal reporters were able to bring this
scandal to light well before the current rise in the number of law-
enforcement investigations. In addition, the question of who thought up
the concept of backdating remains unanswered. Hopefully it will be
answered through the investigations underway. I will leave those
questions for the committee to pursue.
Yet I do think it is important to focus not just on what has
transpired, but also on what steps should be taken to ensure it is not
repeated.
Benefits of SOX
Certainly, the passage of SOX has helped and will help mitigate the
potential for abuse. Its requirements mandate more timely reporting of
transactions to investors. They mandate that executives establish their
accountability for the company's financial statements and internal
controls. They mandate independent examinations of those controls. And
they make it unlawful to mislead independent auditors. I also believe
the newly adopted disclosure requirements of the SEC will facilitate
greater transparency, as well. I suspect the media attention this
matter has received has also sharpened the focus of corporate boards on
the issue of grant dates, backdating and spring-loading as well.
But, as we have seen in the past, the allure and upside to options
are great, and they at times seemingly have a drug-like effect on
rational people's thinking. As a result, I don't believe that only the
changes made to date will prevent a recurrence of the problem.
Need for Stricter Enforcement and Adequate Resources
I think the changes made to date must be followed up with stricter
enforcement of the new rules, which it appears to me has not yet
occurred. The SEC needs to send a clear message through its enforcement
actions that investors must be provided information on these
transactions through timely filed Form 4's, coupled with honest and
transparent disclosures in financial statements, annual reports and
proxies. Companies that have solicited the votes of investors based on
misleading disclosures need to be held accountable. While the SEC has
announced some 80 ongoing investigations, I am worried that when we
look back on this episode in five years or so, we will find these
investigations will not have resulted in holding the responsible
individuals accountable. This includes gatekeepers who are found to
have been actively involved with problematic option grants. Certainly
the SEC's actions will have fallen short if executives, board members
or gatekeepers are found to have backdated and/or spring-loaded options
in violation of laws, and are not required to disgorge themselves of
these ill-gotten gains.
One reason for that concern is the decreasing level of resources
being dedicated to the enforcement activities of the SEC staff,
including the reviews of filings. For example, in its fiscal 2007
congressional budget request, the SEC includes a request for 1,187
full-time equivalents for the enforcement division and 463 FTE's for
the division of corporation finance, which reviews the filings. Both of
these numbers represent declines from the 1,216 budgeted and 1,232
actual FTE's for the enforcement division in 2006 and 2005,
respectively. They also reflect a comparable decline from 478 budgeted
and 495 actual FTE's, respectively, for corporation finance. And while
spending is projected to be up slightly in 2007, it appears that
increases in salaries are coming at the expense of available staff. I
would hope Congress would rethink the wisdom of such cuts to an agency
so critical to the capital markets and investors.
At the same time, the SEC's budget request stated the staff were
piloting a number of technology tools to assist them with enforcement
and monitoring of filings. Congress should ensure these pilot programs
turn into reality. For example, the SEC staff should have the
technology available to them that would automatically match up
transaction and filing dates from all Form 4's and generate exception
lists whenever a filing is outside the two-day requirement. This should
not have to be a manual procedure. At the same time, technology is
available whereby option-grant dates can be compared to stock values.
Certainly the SEC staff should have these tools available to them to
permit quicker identification of these issues.
I would encourage the SEC to step up its enforcement of Section 403
of SOX. As part of each triennial review of a company's filings
mandated by SOX, I believe the SEC staff should review the company's
compliance with the law. And where there are repeat offenses, such as
occurred with Safe Net, the SEC should hand out appropriate sanctions
AND fines to those late with their filings.
I certainly do support the new SEC disclosure requirements, which
are a positive step forward. However, once again, how good they turn
out to be will depend on whether they are enforced.
One of the new requirements includes disclosure of the value of
option grants calculated in accordance with the new FASB accounting
standard. That means these disclosures and the values reported as
compensation expense will be only as good as the implementation of that
rule. In its comment letter to the SEC, the Council of Institutional
Investors stated:
``. . . the Council believes that the backdating controversy
illustrates that the financial accounting and reporting for
employee stock option grants is an area in which there is a
high risk of intentional misapplication of the accounting
requirements. The Council notes that those companies involved
in the backdating controversy appear to have failed to comply
with the rules-based exception contained in the Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees (``Opinion25'')
. . . The council, however, is concerned that some preliminary
evidence surrounding the adoption of Statement 123R appears to
indicate that some companies may be intentionally understating
certain inputs required by the standard in an effort to
continue the Opinion 25 practice of understating compensation
costs and inflating reported earnings. [Footnote omitted] The
Council believes that the benefits of Statement 123R will not
be fully realized by investors unless and until the SEC closely
monitors and rigorously enforces a high quality implementation
of the standard's requirements.''
I share the council's concern and believe it is a valid one. Again,
this is an issue of enforcement. If the SEC chooses to go ``soft'' on
the enforcement of the new accounting standard, then it should not be
surprised when investors begin to question its commitment to investor
protection and the integrity of financial statements.
Changes for Corporate Boards to Consider
Corporate boards, I believe, must also change from being passively
involved to one of active involvement with option grants. Corporate
boards should be setting the grant dates. I believe it would certainly
be a best practice if they chose a set time frame, such as at the
annual stockholders meeting, to award option grants.\5\ At a minimum,
grants should not be permitted during the typical ``blackout periods,''
when the possibility exists there is material information available
that has not yet been disclosed to investors.
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\5\ New grants for new employee hires may need to be tied to the
timing of their hiring.
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In the United Kingdom, I understand that a company is required to
notify the stock exchange on the date an option grant is made.
Certainly that is a very good practice that should be considered here.
Finally the treasurer of the state of Connecticut has stated that
compensation consultants may be conflicted as a result of services they
provide to the executive team. The treasurer has recommended that the
SEC require disclosure of such services as an initial step, a
recommendation I concur with.
Bringing Closure to The Scandal
Finally, let me close by noting that investors have now suffered
through a growing list of companies disclosing they have been caught up
in the backdating scandal. In the mid 1970s, the SEC faced a similar
scandal involving illegal payment of corporate bribes. After initially
involving a dozen or so companies, more than 400 companies were found
to have engaged in improper payments and behavior, along with lax
accounting in their books and records. Given the magnitude of the issue
confronting the agency, and realizing its enforcement resources were
going to be insufficient to deal with the breadth of the scandal, then-
SEC Chairman Roderick M. Hills announced a program urging companies to
self-investigate and, when problems were found, provide independent
reports to the SEC along with full disclosure to investors. In turn,
the SEC stated that, with adequate disclosure, it would not pursue
enforcement remedies unless fraudulent behavior was found, in which
case the SEC reserved its legal rights.
Today, I believe the SEC faces a similarly daunting task. With a
reported 80 investigations already underway, I see no way the SEC
staff, with current resources, can or will adequately investigate all
of these cases. As we also continue to find dubious cases of option
granting in our own research, I believe we will find many more--perhaps
hundreds of companies--that have yet to report inappropriate disclosure
and accounting of stock-option grants. Certainly, Prof. Lie's research
makes that a possibility.
Accordingly, I would hope this committee would urge the SEC to
undertake a program, as it has in the past, to more quickly bring this
issue to the forefront and to conclusion, while allowing companies to
get on with their business. Investors should no longer have to suffer
this Chinese water torture, as news of another company backdating
continues to drip out.
In Closing
Let me close by noting that I have devoted little time to
backdating of options. This is a practice akin to winning the lottery
or betting on a race, after the race is over. For that reason, there
has been universal agreement that backdating of options is unlawful and
should be punished with the full force of the laws, especially when it
is done through backdating of documents or involves the misleading of
auditors or corporate boards. As such, I have left that topic to be
addressed by others today.
However, I do believe spring-loading of options cannot be justified
anymore than backdating. It once again provides the insider with an
advantage other corporate shareholders do not receive, and I have yet
to see it done with full and fair disclosure and appropriate treatment
in the financial statements. Once that is forced to occur, and sunlight
is focused on this affliction, I suspect this practice will cease to
exist. Indeed, it is this lack of transparency that has permitted some
unscrupulous executives to engage in doing what they will not do when
fully exposed.
______
PREPARED STATEMENT OF ERIK LIE
Associate Professor of Finance, University of Iowa
September 6, 2006
Chairman Shelby, Ranking Member Sarbanes and Members of the
Committee:
Thank you for inviting me to testify today about stock options
backdating. In theory, stock options can be used to motivate executives
and other employees to create value for shareholders. However, they
have also been used to (i) conceal true compensation expenses, (ii)
cheat on corporate taxes, and (iii) siphon money away from shareholders
to option recipients. I will take this opportunity to offer some
background on stock options and stock option grants, describe the
practice of backdating, and make some recommendations for the future.
Background on Stock Options and Stock Option Grants
Let me first provide some background on and mention some key
aspects of executive stock options and option grants.
A stock option gives its owner the right to buy the stock
of the company in the future.
Stock options are granted to executives at various
intervals. It is common to grant options once a year, though it is also
possible for executives not to be granted options in a year or to be
granted options numerous times in a year. In most cases, there is no
fixed schedule to these grants, meaning that they do not occur on the
same date (e.g., on July 1) in consecutive years.
Before August 29, 2002, executive option grants had to be
filed anywhere from 10 business days to more than a year after the
grant, depending on (i) when a grant occurred within a calendar month
and fiscal year and (ii) whether a Form 4 or Form 5 was used when
filing the grants with the SEC. Under the current regulations that took
effect on August 29, 2002 as part of the Sarbanes-Oxley Act, option
grants to executives have to be filed with the Securities and Exchange
Commission (SEC) within two business days. Distributions of the number
of days between the official grant date and the filing date based on a
sample of about 40,000 grants to top executives between 1996 and 2005
are given in the graph below. The new filing requirement dramatically
reduced the lag between the grant date and the filing date.
Importantly, about 22% of grants since August 29, 2002 were filed late,
and almost 10% were filed at least one month late.
Most options granted to executives expire after exactly
10 years.
The price at which the stock can be bought is determined
at the time of the grant and generally does not change. It is called
the ``exercise price'' or the ``strike price.''
Most executive stock options are granted ``at-the-
money,'' i.e., the exercise price is set to equal the stock price on
the day of the grant. (``In-the-money'' means that the exercise price
is below the stock price, and ``out-of-the-money'' means that the
exercise price is above the stock price.)
In a sample of 40,000 grants from 1996 to 2005, the
exercise price matches the closing price on the grant day in 50% of the
cases and the closing price on the day before the grant day in 12% of
the cases.
There are several reasons why options are granted at-the-
money:
Accounting Principles Board (APB) Opinion No. 25,
which was phased out in 2005, allowed companies to expense
options according to the intrinsic value method, whereby the
expense equals the difference between the fair value of the
underlying stock and the exercise price of the option. Under
this rule, at-the-money options did not have to be charged
against reported earnings. (Under FAS 123R, which replaced APB
25, companies have to expense the fair market value of the
options at the time of the grant.)
Unlike in-the-money grants, at-the-money grants
qualify as performance-based compensation. As such, at-the-
money grants receive favorable tax treatment under Section
162(m) of the Internal Revenue Code, which limits the
deductibility of nonperformance-based compensation for tax
purposes to one million dollars per executive.
Incentive stock options (ISOs), which are often a
part of broad-based option plans that could qualify for more
favorable tax treatment than non-qualified options at the
individual level, cannot be granted in-the-money. Note,
however, that most options granted to executives are non-
qualified options (NQOs), and not ISOs, as ISOs are limited to
a value of $100,000 per employee per calendar year and also
count as income in the determination of the Alternative Minimum
Tax (AMT).
At-the-money grants might be perceived as a better
incentive mechanism than in-the-money options, because
executives are only rewarded if the stock price increases.
The practice of granting options at-the-money provides
the incentives to time the grant to occur on a day when the stock price
was particularly low and/or to manipulate the information flow around
the grant date. (Note that these incentives would be present for in-
the-money and out-of-the money grants also, provided that the exercise
price is a function of the stock price, e.g., 90% or 110% of the stock
price.)
Some potential strategies that might be used to inflate
the value of option grants include the following:
Spring-loading/Bullet-dodging: The terms ``spring-
loading'' and ``bullet-dodging'' refer to the practices of
timing option grants to take place before expected good news or
after expected bad news, respectively. They have also been
referred to as ``forward dating.''
Manipulation of the information flow: This refers to
the practice of timing corporate announcements relative to
known future option grant dates. For example, if a firm will
soon announce a share repurchase plan that is expected to raise
the stock price, this announcement might be postponed until
after the option grant.
Backdating: This refers to the practice of cherry-
picking a date from the past when the stock price was
relatively low to be the official grant date.
Research on Option Grant Timing
In a 1997 study entitled ``Good timing: CEO stock option awards and
company news announcements,'' David Yermack of New York University
reported that the average abnormal stock return during the months after
option grants to CEOs between 1992 and 1994 exceeds 2%, which he
interpreted as evidence that the grants are timed to occur before
anticipated stock price increases (i.e., spring-loading).
In a 2000 study entitled ``CEO stock option awards and the timing
of corporate voluntary disclosures,'' David Aboody of UCLA and Ron
Kasznik of Stanford University reported that the average abnormal stock
return is positive even for a subsample of grants between 1992 and 1996
that appear to be scheduled. They interpreted this as evidence that the
information flow around grants is manipulated.
In my 2005 study entitled ``On the timing of CEO stock option
awards,'' I documented negative abnormal stock returns before and
positive returns after CEO option grants between 1992 and 2002, and
these trends intensified over time. I further reported that the portion
of the stock returns that is predicted by overall market factors
exhibits a similar pattern, prompting my conclusion that ``unless
executives have an informational advantage that allows them to develop
superior forecasts regarding the future market movements that drive
these predicted returns, the results suggest that the official grant
date must have been set retroactively'' (p. 811).
In a soon-to-be-published study entitled ``Does backdating explain
the stock price pattern around executive stock option grants?'' that I
coauthored with Randy Heron of Indiana University, we found further
evidence in support of my earlier backdating argument. As noted
earlier, a provision in Sarbanes-Oxley reduces the SEC filing
requirement for new option grants to two days from the earlier
requirements that allowed executives to report grants up to several
months after the grant date. To the extent that companies comply with
this new requirement, backdating should be greatly curbed. Thus, if
backdating explains the stock price pattern around option grants, the
price pattern should diminish following the new requirements. Indeed,
we found that the stock price pattern is much weaker since the new
reporting requirements took effect. Any remaining pattern is
concentrated on the couple of days between the reported grant date and
the filing date (when backdating still might work), and for longer
periods for the minority of grants that violate the two-day reporting
requirements. I replicated these results in the figure below using a
sample of about 40,000 grants to top executives during the period 1996-
2005. We interpreted the findings as strong evidence that backdating
explains most of the abnormal price pattern around option grants.
In an unpublished study entitled ``What fraction of stock option
grants to top executives have been backdated or manipulated?'' Randy
Heron and I used a sample of 39,888 grants to top executives across
7,774 companies between 1996 and 2005 to estimate the following:
14% of all grants to top executives dated between 1996
and 2005 were backdated or otherwise manipulated.
23% of unscheduled, at-the-money grants to top executives
dated between 1996 and August 2002 were backdated or otherwise
manipulated.
This fraction was more than halved to 10% as a result of
the new two-day reporting requirement that took effect in August 2002.
Among the minority of unscheduled, at-the-money
grants after August 2002 that were filed late (i.e., more than
two business days after the purported grant dates), 20% were
backdated or otherwise manipulated.
Among the majority of unscheduled, at-the-money
grants after August 2002 that were filed on time, 7% were
backdated or otherwise manipulated. (The benefit of backdating
is naturally greatly reduced in such cases.)
The prevalence of backdating differs across firm
characteristics; backdating is more common among--
tech firms,
small and medium firms (i.e., those with a market
capitalization less than $1 billion), and
firms with high stock price volatility.
The auditing firm is only modestly associated with the
incidence of backdating.
PricewaterhouseCoopers is associated with a slightly
lower fraction of backdated grants after controlling for other
factors.
Non-big-five auditing firms are associated with a
higher fraction of both late filings and unscheduled grants,
which appear to result in more backdating.
29% of firms that granted options to top executives
between 1996 and 2005 manipulated one or more of these grants in some
fashion.
Is Option Grant Timing Illegal?
There is an ongoing debate regarding whether spring-loading and
bullet-dodging are illegal. These practices have been compared to
insider trading of stock. The debate hinges on the definition of the
``harmed party.'' In regular insider trading cases, one party in the
transaction possesses inside information that the other party (the
harmed party) does not possess. In cases of option grants, some have
argued that both parties, i.e., the option recipient and the Board of
Directors of the firm that grants the options, have access to the same
inside information, so it is not the case that the option recipient
exploits an informational advantage. The other point of view is that
insiders, with the consent of the Board of Directors, are using their
informational advantage to extract additional compensation from the
firm's owners (shareholders). Under this viewpoint, the harmed party
would be the firm's existing shareholders, who do not possess the same
information, and whose ownership value is reduced to a greater degree
than would otherwise be the case.
Backdating is less ambiguous. If options purported to be at-the-
money on the backdated grant date were in-the-money on the actual grant
date (which should be the measurement date for financial and tax
reporting purposes) and not properly accounted for, then
the firm's reported earnings were too high according to
the accounting regulations (under both APB 25 and FAS 123R),
the firm's taxes might have been too low (due to IRC
Sec. 162(m), and because the deductible spread between the exercise
price and the stock price at the time of the actual option exercises is
artificially inflated),
if the options are ISOs, one of their requirements for
their favored tax-status has been violated, and
any requirement in the option plan that the options
should be granted at the fair market value is violated.
In addition, to implement the backdating strategy, documents might
have been forged, which is a federal offense.
Conclusion
Backdating of option grants was a pervasive practice among publicly
traded corporations in the U.S. in the late 1990s and the beginning of
this century. My own research suggests that spring-loading, bullet-
dodging, and manipulation of the information flow was either
significantly less prevalent or less successful in the aggregate in
producing immediate gains for the option recipients during the same
period.
The problem of backdating can be eliminated by requiring grants to
be filed electronically with the SEC on the same day that they are
granted. Given that (i) the form for filing this information is very
simple and (ii) the forms can be filed online, this is a reasonable
requirement, and, in fact, some grants are already filed on the grant
date. Of course, this requirement has to be strictly enforced with
appropriate penalties for any violation, such that the frequency of
late filing that is evident for the last few years is greatly reduced.
As the problem of backdating is eliminated, the problems of spring-
loading, bullet-dodging and manipulation of the information flow might
become more prominent. Thus, it is critical to clarify whether these
alternative strategies are legal. If so, restrictions to minimize their
occurrence should be developed. In particular, options should not be
granted near major corporate announcements. Further, there should be
timely and complete disclosure of grants.
Finally, to eliminate timing relative to recent stock prices, the
benchmark stock price should be the price on the grant date. For
example, if the options are granted at-the-money, the exercise price
should be set to equal the stock price on the grant day rather than the
stock price on the prior day, which is a fairly common practice (see
earlier statistics). This eliminates the possibility that options are
granted on a day when the price has increased significantly but the
prior day's lower price is used for contracting purposes.
------
PREPARED STATEMENT OF KURT SCHACHT
Managing Director, CFA Centre for Financial Market Integrity
September 6, 2006
Introduction
I am Kurt Schacht, the Executive Director of the CFA Centre for
Financial Market Integrity, the advocacy arm of CFA Institute. I would
like to thank Senator Shelby, Senator Sarbanes and other members of
this committee for the opportunity to speak to you today on the topic
of stock option practices, in particular backdating of option grants.
This issue raises important shareholder concerns and we are supportive
of your committee taking a closer look, as well as the work of Chairman
Cox and the Securities and Exchange Commission (SEC) to investigate
alleged abuses.
First, some background about CFA Centre and its parent
organization, CFA Institute. CFA Institute is a non-profit professional
membership organization with over 84,000 members in 128 countries. Its
mission is to lead the investment profession globally by setting the
highest standards of ethics, education, and professional excellence.
CFA Institute is most widely recognized as the organization that
administers the CFA examination and awards the CFA designation, a
designation that I share with nearly 68,000 investment professionals
worldwide. I direct the advocacy efforts of CFA Institute through the
newly created CFA Centre for Financial Market Integrity, which develops
research, education projects and promotes ethical standards within the
investment industry.
The CFA Centre Perspective: Options Backdating
Our organization approaches this topic primarily as an investor
advocate with a focus on protecting shareholder interests and ensuring
accurate and transparent financial reporting. We were an early voice
for the SEC to amend its newly released executive compensation
disclosures to deal with the practice of option backdating and its
companion practice of ``spring-loading.'' Both have been prevalent for
years and have generally gone unnoticed. In some cases, these practices
have been purposefully hidden from shareholder view. The recent focus
by various academic studies and the resulting regulatory investigations
into the backdating practices have confirmed what is at best, the
latest executive compensation controversy and at worst, a growing
financial reporting scandal.
Historically, the rationale for granting stock options to
executives and other employees was to align their interests with
shareowners, and to provide an incentive for them to enhance
shareholder value. Several commentators have suggested that even
backdated options continue to have such attributes and that the
backdating controversy is overblown with politics and rhetoric. They
would have us believe it is a ``victimless'' infraction. In our view,
the practices of backdating and spring-loading are unethical
manipulations of the option granting process designed to increase
employees' compensation to the detriment of shareowners. These
practices have been secretive and have placed numerous companies at
significant financial and leadership risk. As with most company
scandals resulting in significant cost and uncertainty, it is the
public shareowners that fall victim.
We remain concerned about the ultimate scope of the backdating
problem. Specifically, is this activity limited to the 100-plus firms
under formal investigation or does it extend to a much larger group?
For a variety of reasons, including the recent public outrage, the
requirements of FASB Statement 123R and APB Opinion 25, the Sarbanes-
Oxley requirement to file accelerated Form 4's and the new SEC
compensation disclosure rules, backdating itself may be yesterday's
problem. However, the degree of necessary ``clean-up'' due to the vast
number of companies and the size of stock options incentives in 1990-
2002, seems to be unknown. It represents an overhang for individual
companies for sure, but more problematic, it must not become a sequel
to the lost confidence in financial reporting experienced earlier in
this decade.
One mitigating factor may be that in recent months, the use of
stock options has fallen out of favor due partly to the new option
expensing rules. Whether we consider long term effects or short term
effects of backdating and spring-loading, options use has become more
rationalized. What this may signal however, is a need for further
examination of the ``replacement'' for options, the practice of
granting restricted stock. We should be certain that the gaming of
grant dates or material information has not become part of the calculus
for this now more favored type of stock incentive.
One final point of perspective relates to the ethical implications
of backdating. This controversy comes at a time when executive
compensation practices in general, are under intense scrutiny. These
latest revelations concerning backdating and spring-loading certainly
appear to be yet more practices intentionally conducted under the
radar, for obvious reasons. It leaves many wondering about the
respective standards and duties of officers and directors who approved
of and even participated in some of these option granting
irregularities. This is all the more troubling given that the practice
appears to have continued after Sarbanes Oxley was passed in 2002 and
suggests that at least some compensation and audit committee members
may have been less than diligent in their duties.
Accounting and Auditing Practice--What Happened?
The accounting standard relating to stock option expenses that
existed for many years before FASB Statement 123R was clear. APB
Opinion 25 allowed companies to avoid a compensation expense only if
certain criteria were met. Such criteria clearly included a requirement
that the underlying stock price on the date of the grant must be equal
to the exercise price of the options. Stated differently, the grant
date price and the exercise price must match, in order to avoid the
attendant compensation expense.
It is difficult to fashion an argument as to how this might ever
happen in the context of backdating an option grant. Therefore, in
nearly every case where an option grant date was backdated, a
compensation expense was required to be recognized and reported in the
company's income statement, unless it was deemed immaterial. As a
result, nearly every company identified in the press as having
backdating problems failed to properly record compensation expense for
options and thereby filed financial statements that did not comply with
the U.S. Generally Accepted Accounting Principles (GAAP) (again, unless
the amount of expense was ``immaterial'').
Viewing this in the context of external auditor responsibilities,
it remains unclear how this practice was repeatedly missed or worse,
sanctioned. In some cases it may have been sloppiness, incompetence or
both. In other cases it may have been an intentional act of concealment
by the responsible managers. A number of the accounting firms have
suggested that the client company's option documentation was typically
taken at face value. Such documentation would generally indicate that
the company had granted at-the-money, fixed-plan, employee options,
when in fact they had not. This ``papering'' of the option transactions
therefore appeared as though no compensation cost needed to be
reported.
Generally, auditors thought that option practice was a low-risk
(non cash) area and relied on the client company's records without
attempting to verify if such records reflected what actually occurred.
We think a clear lesson has now been established. However, we remain
concerned whether auditors were actually complicit, turning a blind eye
because of client pressures or because it seemed like ``every one was
doing it'' (backdating). We have little doubt that auditors today will
acknowledge that backdating typically failed to meet the criteria of
APB Opinion 25, that is, recognition of zero expense only for at-the-
money options.
It is now the case in over 100 countries around the world that
follow either U.S. GAAP or International Accounting Standards rules,
that backdating, without expensing of the full fair value of the
options, would constitute a violation of accounting standards. Whether
because of these new option expensing rules, Sarbanes Oxley, the public
furor over backdating or some combination thereof, we must now expect
that proper audit procedures would demand a closer look and
verification of these options and restricted stock practices. We expect
this will be facilitated by the SEC's new executive compensation
disclosure requirements.
Lingering Concerns
As we noted above, the companion practice of spring-loading options
grants should be further scrutinized. This involves the gaming of
grants around the release of material non-public information. Studies
suggest this has been rampant for many years and it happens regardless
of whether grant dates are fixed annually or at the discretion of
management or directors. The protections offered by the Sarbanes Oxley
accelerated Form 4 filing, does not address this. While the latest
executive compensation disclosure requirements of the SEC do require a
full review and report by the compensation committee on any spring-
loading activities, it does not prohibit them. We would encourage a
closer look at whether officers and directors in control of the option
granting process should be barred from participating in any spring-
loaded grants, just as they would be prohibited from trading in any
other company securities while in the possession of inside information.
We have one additional concern. We believe that one facilitator of
backdating was accounting rules that failed to result in fair value
expensing of the cost of the options. As we have said, auditors
apparently failed to consider such off-balance-sheet (OBS) items of
sufficiently high risk to warrant full scrutiny and thorough audits of
the option grants. Many more items, several of considerable size
relative to most companies' balance sheets, remain off-balance-sheet
and unexpensed, and reported if at all, in the notes. We would hope
that auditors would learn from the lessons of the 2001-2002 corporate
collapses involving large OBS transactions and the backdating/spring-
loading problems currently receiving scrutiny and tighten their
procedures to make certain that these receive the same attention as
items required to be expensed.
Conclusion
We commend the members of the Committee for your continued
attention and leadership on this unethical industry practice. In
summary, we encourage three further steps.
1. Consideration of a possible ban on spring loading for named
executives and directors.
2. A closer look by auditors and regulators for any irregularities
in the granting process used for restricted stock.
3. A bolstering of audit procedures to include a closer review of
any other off balance sheet items posing similar risks of being
misreported.
Our markets can ill afford further lapses in the ethics relating to
executive compensation or the integrity of financial reporting. We have
been down that market-paralyzing road before.
______
PREPARED STATEMENT OF RUSSELL READ
Chief Investment Officer, California Public Employees' Retirement
System
September 6, 2006
Chairman Shelby, Senator Sarbanes and members of the Senate Banking
Committee, I am pleased to be here today to provide an institutional
investor's perspective on the important topic of stock option
backdating and spring loading.
I am Russell Read, Chief Investment Officer with the California
Public Employees' Retirement System (CalPERS). As you know, CalPERS is
the nation's largest public pension system with more than $209 billion
in assets. We have long been a voice for corporate governance. We are
committed to executive compensation reform, to full disclosure and
transparency of financial information, and to director accountability.
The recent allegations around secret and even fraudulent backdating
of options are disturbing. We appreciate your leadership, Mr. Chairman,
in calling for this hearing and for your personal commitment and the
commitment of the Senate Banking Committee toward addressing this
problem.
CalPERS believes that as part of a good executive compensation
policy, stock options are appropriate. They align employees' interest
with that of the shareowners. But when options are hidden from view,
and when the option awards themselves do not tie to performance, it
creates a serious problem.
As you know, CalPERS size does not lend itself to selling our
stocks in troubled companies. As a large institutional investor, we
don't have the luxury of not showing up for the ballgame. Baseball fans
can choose to stay home, but as the steward for so many public servants
who depend on us for their retirement security, we cannot.
If we are out of the ball game, we can't produce the investment
returns that cover $3 of every $4 of our people's retirement benefits.
When an executive takes stealth payments that we can't trace, when
companies make false statements and omit material facts concerning
backdating of option grants, billions of dollars can be inappropriately
given and once the truth of such option grant practices are made, it
can cause the company's stock to fall precipitously. This directly
hurts the retirement security of ordinary Americans. In CalPERS case,
we're talking about clerks, custodians, school bus drivers,
firefighters, and highway repair people, for example.
Since this issue has come to light, an unprecedented number of late
filings with the SEC have occurred, which of course, delays disclosure
to shareowners.
Secondly, these late filings are often considered to be technical
violations of the conditions of borrowing, and that is costing
companies too.
Last month, the Wall Street Journal reported that some bondholders
are calling in their loans or demanding payment or large fees in
exchange for an extension of their default deadlines. As many as two
dozen companies were reported to have faced this dilemma over the past
18 months, and some had to pay multi-million dollar fees.
Even more astonishing, as the Wall Street Journal also reported, we
are now learning that as stocks sank after the terrorist attacks of
September 11, scores of companies rushed to issue options to top tier
executives when the stock market had reached its post-attack low on
September 21, 2001.
Now comes a cascade of class action and shareowner derivative
lawsuits.
Once again, this scandal has brought back a number of fundamental
corporate governance questions, such as:
1. Are Boards condoning this behavior?
2. If not--and the Boards are themselves surprised to learn of
questionable backdating--then the question is where was their
oversight?
3. It raises questions about adequate internal and external
auditor controls. Are the auditors being vigorous enough in their
examination of a company's option granting practices?
4. And finally, investors want to know if illegalities are
occurring, will the wrongdoers be swiftly and aggressively prosecuted,
and will they be held accountable with civil and criminal penalties
where appropriate?
Mr. Chairman, you hit the nail on the head when you said that if
the public is to maintain full confidence in our public markets, the
appropriate action needs to occur.
Over the last two months, we have approached 42 portfolio companies
under investigation by the SEC. We have asked that companies perform
independent investigations and that they publicly disclose all findings
resulting from such investigations, regardless of the outcome.
We have urged company boards of directors to develop policies that
disclose how stock option grant dates are established and then publicly
disclose those policies in company financial and proxy statements.
We want Company Boards and Compensation Committees to conduct an
audit of their executive compensation plan administrator to be sure
they are acting in full compliance with their directives.
And we strongly believe something needs to be done to be sure that
company resources are not used to satisfy the tax and legal liability
of executives implicated for this kind of wrongdoing. Such an
inappropriate use of corporate assets hurts shareowners twice--once by
the fruits of such backdating, and the other when they are allowed to
use company assets to defend their actions.
We urge the Committee to call on the SEC to continue to
investigate, and to aggressively prosecute wrongdoing.
We believe the SEC has the authority it needs to solve this
problem. But we think they need to be more aggressive in enforcing
rules for the filing of Forms 3, 4 and 5. SEC rules require company
stock sales to be reported on SEC Forms within two days of the date of
execution. SEC rules also require two-day reporting of certain
transactions between employee benefit plans by officers and directors
and that transactions involving stock options such as grants, awards,
cancellations and re-pricing be reported in the same time frame.
We welcome the Public Accounting Standards Board's help by
providing greater oversight of auditing practices pertaining to option
grants. Their July 28th practice alert is very beneficial, and we
welcome their continued oversight.
I would like to close by giving our view of the issue of spring
loading of options.
We believe the SEC's requirement that an issuer disclose its option
grants policy will have a positive effect. It should mitigate the
activity of spring loading options in the future. However, should this
not prove to be the case, we recommend that the SEC take additional
steps to ensure that option grant practices are carried out in a
systematic fashion, unaffected by the timing and release of material
non-public information.
To sum up, we are going to do our part as active shareowners to
hold Boards of Directors and Compensation Committees accountable. We
will work with the SEC and the PCAOB in whatever way they deem helpful,
and of course, we stand ready to assist this Committee by providing
additional information. Finally, on behalf of the 1.4 million public
servants we represent, I want to thank you once again, Mr. Chairman for
all that you and this Committee are doing to restore the public trust
in our financial markets.
I would be pleased to answer any questions.
______
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM CHRISTOPHER COX
Q.1. In your testimony you discuss the new disclosures mandated
by the recently adopted SEC executive compensation rules and
say that ``if a company has a plan to issue option grants in
coordination with the release of material non-public
information, that will now be clearly described'' in proxy
statements approved by shareholders. Chairman Cox, if a company
were to time an options grant before announcing unexpectedly
high quarterly earnings, and this was fully consistent with the
material terms of the options plan and the executive
compensation rules, would there be any violation of SEC rules
or the securities laws?
A.1. If a company times option grants in coordination with the
release of material non-public corporate information and that
practice is consistent with the material terms of its options
plan and is fully disclosed pursuant to the Commission's
executive compensation rules, the fact that a grant coincided
with the announcement of unexpectedly high earnings would not,
in and of itself, suggest a violation of the federal securities
laws. Other circumstances surrounding a fortuitously timed
option grant, however, could implicate potential securities law
violations. Each case would have to be evaluated on its own
facts and circumstances.
Q.2. The Sarbanes-Oxley provision shortening the time for
reporting option grants to two business days, along with the
Financial Accounting Standards Board expensing rule, helped to
significantly reduce fraudulent backdating activity. I would
make the observation that in order for the SOX provision to
serve as an effective deterrent, however, there must be
sanctions for failing to meet the two day requirement under
Form 4. What is the percentage of Form 4 filings that are
submitted outside the two day window and what are the sanctions
for such late filings, particularly for repeat offenders?
A.2. Our staff has been working to better understand the extent
to which filers are not meeting their reporting obligations for
stock option grants, focusing on Forms 4 filed through our
EDGAR system from July 2005 to June 2006. In general, the staff
concluded that grants to executives at large corporations,
defined for these purposes as those with market capitalizations
of $750 million or more, are by and large timely reported. Over
93% of filings by these companies met the two business day
reporting deadline, and over 96% were filed within five days of
option grant. The staff did, however, find higher rates of late
filing among smaller issuers, with about 83% of the forms
associated with these companies being filed on time and over
88% filed within five days of option grant. We note that in
some cases, a Form 4 may appear to have been filed late, but
because of discrepancies in the manner in which the filer
completes the form, it may actually have been filed on time.
As with all violations of our rules, the remedies depend
upon the individual facts and circumstances in each case. In
particular, Enforcement actions involving late Section 16
filings also may involve other securities law violations.
Depending upon the specific facts, violators may be ordered to
cease and desist, be enjoined, or be assessed civil monetary
penalties.
------
RESPONSE TO WRITTEN QUESTION OF SENATOR BUNNING FROM
CHRISTOPHER COX
Q.1. Some concerns have been raised about IRS cooperation with
the SEC in efforts to focus on the tax returns of companies
that have admitted to backdating. To what degree is the SEC
coordinating with the IRS on this issue?
A.1. The Commission has granted the IRS access to our
investigative files in a number of our options backdating
investigations. In addition, Commission staff have met with IRS
staff to determine how best to communicate and share
appropriate additional information.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM MARK
OLSON
You have asked us to respond to two questions from Senator
Bunning for the record of the Committee on Banking, Housing,
and Urban Affairs' September 6th hearing on Stock Options
Backdating. Our responses to the questions appear below.At the
outset, we should note that, under the Sarbanes-Oxley Act of
2002, the PCAOB's mission is to oversee the auditors of public
companies. Since 1973, the Financial Accounting Standards Board
(``FASB'') has been the designated organization in the private-
sector for establishing financial accounting standards.
Accordingly, the answers below reflect our understanding of
FASB's (and its predecessor's) reasons for their decisions.
Q.1. Because options have vesting periods and there is no
ability to cash out immediately for profit, I am curious why
the FASB ever made the decision to treat ``at the money'' and
``in the money'' options differently; that is, to treat one as
valuable and one as value-less when it comes to expensing. To
what degree do you think that decision contributed to the
practice of back-dating?
A.1. This question requires insight into the deliberations of
the accounting standard setters in their work to establish
standards of financial accounting and reporting which govern
the preparation of financial reports. The Accounting Principles
Board (APB) of the American Institute of Certified Public
Accountants (AICPA) issued pronouncements on accounting
principles until 1973. The APB was replaced by the FASB.
Accounting Principles Board Opinion No. 25 (1972) (``APB No.
25'') required companies to use the ``intrinsic value'' method
for determining the compensation cost of an employee stock
option. According to this method, as described in APB No. 25,
``compensation cost is measured by the difference between the
quoted market price of the stock at the date of grant or award
and the price, if any, to be paid by an employee.'' When it
issued APB No. 25, the Accounting Principles Board noted that
the value of an option is also affected by, among other
factors, restrictions on transferability and the differentrisk
profiles of an option and the stock underlying it. It decided,
however, that, the effects of these factors were difficult to
measure, and that the intrinsic value method was therefore a
more practical approach. In 1995, FASB adopted Statement of
Financial Accounting Standards No. 123, Share-Based Payments
(``FAS 123''), which encouraged companies to use the ``fair
value'' method to account for employee stock options. According
to that method, the fair value of an option is estimated using
an option-pricing model, such as the Black-Scholes model. FASB
noted when it adopted FAS 123 that since 1972, when APB No. 25
was issued, options trading had increased significantly and
mathematical models had been developed to estimate their fair
value. According to FAS 123, these option-pricing models allow
the fair value of an option to be determined with sufficient
reliability to justify recognition in financial statements.
Under FAS 123R, which FASB issued in 2004, companies are
required to use the fair value method.Senator Bunning also asks
whether the different accounting treatment of ``at the money''
and ``in the money'' employee stock options contributed to the
practice of backdating. As noted in the PCAOB's written
testimony for the hearing, by permitting companies not to
record any cost when employee stock options were granted at a
price equal to or greater than the market price on the date of
the grant, APB No. 25 discouraged companies from granting
options at less than the prevailing market price, although such
discounted options could be more lucrative for recipients. Some
companies may have granted options atprices below market on the
grant date but treated them, in contravention of accounting
principles, for accounting and tax purposes as if they were
granted on a date when market prices were lower. The adoption
of FAS 123R seems to have significantly reduced companies'
incentive to backdate employee share option grants.
Q.2. Last week, a Wall Street Journal article highlighted a
statement by Milton Friedman and many others advocating the end
of the expensing of options, stating that expensing is bad
accounting. Their argument is that expensing misstates the
nature of the transaction, which is a transfer outside the
business from the owners to the employees, rather than through
the business. I am interested to hear your thoughts on this
idea.
A.2. The FASB considered this argument during the development
of FAS 123 and again with FAS 123R. After following its due
process procedures, which include an opportunity for public
comment, FASB concluded that a company's receipt of an
employee's services in exchange for an equity instrument
(employee share options) was an event that gave rise to
compensation cost. One basis for this conclusion was that
determining whether to record a compensation cost should depend
on whether the employee performed services for the company in
exchange for compensation and not on the nature of the
consideration that was paid to the employee.With respect to the
specific argument that the award of employee share options is a
transfer outside the business from the owners to the employees,
FASB noted -Some who do not consider [expensing] to be
appropriate contend that the issuance of an employee share
option is a transaction directly between the recipient and the
preexisting shareholders. The Board disagrees. Employees
provide services to the entity-not directly to individual
shareholders-as consideration for their options. Carried to its
logical conclusion, that view would imply that the issuance of
virtually any equity instrument for goods or services, rather
than for cash or other financial instruments, should not affect
the issuer's financial statements. For example, no asset or
related cost would be reported if shares of stock were issued
to acquire legal or consulting services, tangible assets, or an
entire business in a business combination. To omit such assets
and the related costs would give a misleading picture of the
entity's financial position and financial performance. FAS
123R, Paragraph B20.
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RESPONSE TO WRITTEN QUESTION OF SENATOR BUNNING FROM ERIK LIE
Q.1. Last week, a Wall Street Journal article highlighted a
statement by Milton Friedman and many others advocating the end
of the expensing of options, stating that expensing is bad
accounting. Their argument is that expensing misstates the
nature of the transaction, which is a transfer outside the
business from the owners to the employees, rather than through
the business. I am interested to hear your thoughts on this
idea.
A.1. I believe that options should be expensed. I understand
the arguments put forth by Milton Friendman and others, and I
think it is quite reasonable. However, I do not think it should
matter for accounting reasons whether the compensation comes
via cash or options. One could argue that unlike cash
compensation, option compensation is a form of gain-sharing
instrument that does not represent a direct cost to the
company. But in either case, the shareholders, as the owners of
the company, bear the cost of the compensation, and this should
be explicitly recognized.
ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD
Council of Institutional Investors
Washington, D.C., September 8, 2006
The Honorable Richard C. Shelby
Committee on Banking, Housing, and Urban Affairs
United States Senate
SD-534 Dirksen Senate Office Building
Washington, D.C. 20510-6075
Re: September 6, 2006, Hearing of the Committee on Banking, Housing,
and Urban Affairs on Stock Options Backdating
Dear Mr. Chairman:
I am writing on behalf of the Council of Institutional Investors
("Council"), an association of more than 130 public, corporate and
union pension funds with combined assets of over $3 trillion. We
applaud your decision to have held the above referenced hearing on a
very important and timely issue of great interest to our members in
their role as institutional investors. We respectfully request that
this letter be made a part of the official hearing record.
The Council believes that executive compensation is a critical and
visible aspect of a company's governance. Pay decisions are one of the
most direct ways for shareowners to assess the performance of the
board. And they have a bottom line effect, not just in terms of dollar
amounts, but also by formalizing performance goals for employees,
signaling the market and affecting employee morale.
Well designed executive stock compensation programs can lead to
superior performance when structured to achieve appropriate long-term
objectives and align executives' interests with those of the
shareowners. Those programs, however, as evidenced by stock options
backdating, can also be abused, undermining the purpose and potential
benefits of stock compensation.
We share your view that that stock options backdating ``hurts the
capital markets . . . [and] destroys confidence in our system.'' \1\ We
also appreciate and support your interest in ensuring that the
Securities and Exchange Commission (``SEC'') has the necessary
resources and authority to address the issues raised by stock options
backdating and other potential executive compensation abuses that may
arise in the future.
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\1\ Vineeta Anand and Jesse Westbrook, ``Congress Wants to Ensure
SEC Has Funds to Police Option Awards,'' Bloomberg.com (September 6,
2006).
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Many of the parties that participated in stock options backdating
activities appear to have been motivated by the desire to provide extra
compensation to certain executives without: (1) requiring any
performance from the executives in return for the extra compensation;
(2) requesting approval or even informing existing or potential
shareowners that the extra compensation was being granted; and (3)
reporting the extra compensation as a cost or expense, and thereby
overstating the company's earnings to market participants.
In addition to violating the federal securities laws that were
designed to protect investors, stock options backdating activities also
appear to have violated a number of the Council's recommended
"Corporate Governance Policies," including the following:
Performance options: Stock option prices should be . . . based on
the attainment of challenging quantitative goals.
Stock option expensing: Since stock options have a cost, companies
should include these costs as an expense on their reported
income statements and disclose valuation assumptions.
Grant timing: Except in extraordinary circumstances, such as a
permanent change in performance cycles, long-term incentive
awards [including stock compensation] should be granted at the
same time each year.
Award specifics: Compensation committees should disclose the . . .
performance criteria and grant timing of . . . [stock
compensation] granted . . . and how each component contributes
to long-term performance objectives of a company.
For your information, given our members' significant interest in
stock options backdating, in June 2006 the Council sent letters to the
1,500 largest U.S. companies by market capitalization asking those
companies to explain: (1) how they granted equity awards; (2) whether
they were conducting an internal review of past stock option practices;
and (3) whether they were under investigation by the SEC or any other
law enforcement agency for stock option-related practices. To-date we
have received over 220 responses. The responses are available on the
Council's website at www.cii.org. We would welcome the opportunity to
share our analysis of the responses with the Committee upon request.
We again want to thank you for holding a hearing on stock options
backdating and appreciate the opportunity to provide the Committee with
our views on the issue. We look forward to continuing to work with you,
Ranking Member Sarbanes, other Members of the Committee, the SEC, and
the Public Company Accounting Oversight Board on issues relating to
stock option backdating and other issues of importance to our nation's
investors.
Sincerely,
Jeff Mahoney
General Counsel
cc: The Honorable Paul S. Sarbanes, Ranking Member, Committee on
Banking, Housing, and Urban Affairs
The Honorable Christopher Cox, Chairman, United States Securities
and Exchange Commission
The Honorable Mark W. Olson, Chairman, Public Company Accounting
Oversight Board