[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

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs




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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

                              ----------                              

                      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

                              ----------                              


                      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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
      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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
      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\
---------------------------------------------------------------------------
    \1\ Business Week, August 31, 2006 in citing statistics from The 
Analyst's Accounting Observer.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \2\ Franklin Delano Roosevelt, First Inaugural Address, Washington, 
D.C., March 4, 1933.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \4\ Securities and Exchange Commission, Executive Compensation and 
Related Person Disclosure. Release Nos. 33-8732;34-54302; File No. S7-
03-06.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \5\ New grants for new employee hires may need to be tied to the 
timing of their hiring.
---------------------------------------------------------------------------
    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.
                                ------                                


 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.
---------------------------------------------------------------------------
    \1\ Vineeta Anand and Jesse Westbrook, ``Congress Wants to Ensure 
SEC Has Funds to Police Option Awards,'' Bloomberg.com (September 6, 
2006).
---------------------------------------------------------------------------
    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
