Backdating comes to the fore

UK finance directors have never been offered the lucrative mega-million stock option packages that American CFOs regularly rake in, but as a result they’ve been shielded from the latest pay scandal. The US stock options backdating furore hasn’t spiked the interest of UK regulators because stringent governance standards here prevent any serious fiddling with grant dates.

“The disclosure rules around stock option grants prevent this sort of thing,” says Financial Services Authority spokesman Joseph Eyre. In the UK, companies have a 42-day period following results announcements to grant option packages, leaving little room to meddle with grant dates or time options to coincide with company announcements. The requirement for better disclosure of stock option packages and exercise conditions for UK issuers also prevent this sort of manipulation.

Around the time US management teams and boards were conspiring to inflate share options for top executives in the late 1990s, performance conditions were applied to stock options for top executives in the UK. “The Cadbury Report took a very close look at remuneration and it was very unlikely for somebody to manipulate option grant dates at that time,” says Paul Hodgson at The Corporate Library. “You could backdate options in the UK, but you still had to meet certain performance targets to get your options.”

Highly diluted

The amount of options set aside for senior executives at UK companies is tiny compared to what is awarded to US executives. “It’s not uncommon for options in the UK to be 6% or 7% of potential dilution, but in the US we have seen this go up to 40%,” says Gavin Anderson, CEO of GovernanceMetrics.

In 2002, California-based Siebel Systems made history with option grants reaching 80% of dilution. The state of Louisiana sued the software maker, accusing it of giving CEO Tom Siebel and board members discounted options. Siebel returned 26 million of the options he received as compensation that year.

There has also been stronger shareholder resistance to large option payouts this side of the Atlantic. Shareholders in the UK will engage with management more frequently than in the US when dissatisfied with remuneration packages for the top ranks. “In the UK, shareholders would consider anything above 10% potential dilution to be worrisome, whereas in the US, it is not unusual to see companies with 20% dilution,” says Anderson.

As a result of performance targets and stricter disclosure rules for options grant dates and exercises, there has never been a case in the UK where executives have received millions of options in one year. But this became standard practice in the US in the late 1990s, particularly among tech companies.

The median gain for top CFOs who exercised options in 2000 was $964,000 (£512,500), according to Mercer Consulting. That year Tyco’s CFO Mark Swartz took home $14m in option gains.

Large slice of the pie

Lavish options grants were reined in among US corporates after the tech bust in 2001, but they are still the largest slice of the pie for senior FDs. Last year, $10.8bn in value was realised from options granted to senior executives at the 1,800 US companies included in Standard & Poor’s ExecuComp database.

Tipped off by an academic study, which showed that more than 2,000 companies may have backdated options between 1996 and 2005, the US Securities and Exchange Commission (SEC) began investigating options backdating in earnest last spring. The study came from Erik Lie of the University of Iowa and has now become required reading for those interested in executive compensation. Dr Lie doesn’t name any companies, but suggests that the practice of backdating grant dates to boost senior executives’ bank accounts is widespread among US issuers.

The SEC has now named 105 companies it’s carefully scrutinising for backdating and dubious stock option practices. The companies on its hit list include big names like Apple, Gap, Home Depot and BEA Systems. Apple’s share price took a hit after it announced it might have to restate its financials going back to 2002 after discovering problems related to option grants.

A number of companies under investigation have similarly announced internal investigations of regulatory filings dating back almost a decade. Other US issuers have volunteered to trawl through past regulatory filings to double-check the timing of grant dates. As a result, there has been a surge in late filings with 48 US companies delaying their most recent quarterly statements because of option grant investigations.

The SEC appears to be out for blood, having charged former top executives at San Jose-based Brocade Communications and Converse Technology with fraud. Among those facing charges is Converse’s former finance chief David Kreinberg.

“People have been forging documents and lying,” says Hodgson at The Corporate Library. “They are bringing criminal charges, so they4 need hard evidence like forged documents, or they may ask for compensation committee meeting documents.”

Fiddling with option grant dates is not illegal, per se, in the US, but fudging the books to cover option manipulation is obviously fraudulent. The SEC is rushing to come up with new rules on executive compensation disclosure, but is stopping short at preventing the backdating or fortuitous timing of options packages. “The SEC is saying, if you do this, you have to disclose it,” says Hodgson.

The implementation of the Sarbanes-Oxley rules appears to have curbed option manipulation, since many of the most egregious backdating cases predate the bill’s passage in 2002. “Under Sarbanes-Oxley, companies now have to disclose options granted within two days of their award,” says Anderson. “Nobody is looking into options awards subsequent to the passage of Sarbanes-Oxley because it doesn’t provide any leeway.”

Solid governance

One of the conclusions emerging from this latest pay controversy is the link between solid corporate governance and above board management. GovernanceMetrics rates companies’ governance practices and has looked into the ratings of 73 of the 105 companies now under investigation by the SEC.

It looked specifically at the ratings these companies were given around the time the backdating allegedly occurred and found that, of the 73, only four companies received above average governance scores. “This suggests that companies which have good governance practices are not generally going to be caught up in this type of activity,” says Anderson.

A second conclusion is that a small pool of board members and senior executives instigated backdating for management’s benefit. Hodgson, at The Corporate Library, has looked at the boards of 50 of the US companies implicated in the SEC investigation and found that 11 directors sat on more than one board within that group.

He is now expanding his study to include all the companies implicated and, so far, that number has more than doubled. “We are suspicious that this practice has spread by word of mouth through directors or executives on these boards,” he says.

The danger, of course, is that the SEC’s current obsession with historical compensation packages is drawing their attention away from dubious practices going on today.

Either way, this latest attack on executive remuneration has revealed the mixed blessing of stringent governance rules for UK FDs. On the one side, they prevent FDs from reaping the riches of their US peers, but they also appear to have protected management from the temptation of toying with options.