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Backdating comes to the fore

Strict governance rules mean UK finance directors are not reaping the riches like their US peers. On the positive side, they are being shielded from the latest remuneration controversy

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.

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