Investments Analyst Criticizes 'Spring-Loading' of Options

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

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.

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 Rayburn, 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.

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.

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 4s 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 29^th 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 priors 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 fill 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:

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.

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 1970's, 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.

² Franklin Delano Roosevelt, First Inaugural Address, Washington D.C., March 4, 1933.

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).

⁴ Securities and Exchange Commission, Executive Compensation and Related Person Disclosure. Release Nos. 33-8732;34-54302; File No. S7-03-06.

⁵ New grants for new employee hires may need to be tied to the timing of their hiring.

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