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Corporate Alert: Registered Audit Firm Independence and Audit Committee Communication; Stock Option Grants Scrutinized; Retroactive S Corporation Elections; Wide Latitude in Parallel SEC and DOJ Proceedings
May 2008
Authors: Edward B. Stevenson, Irwin A. Kishner

PCAOB Adopts Rule Regarding Registered Audit Firm Independence and Audit Committee Communication

The Public Company Accounting Oversight Board adopted Rule 3526 on April 22, 2008 to "enhance communication between audit committees and registered audit firms regarding the firm's independence" and to "reflect the critical role of the audit committee under the Sarbanes-Oxley Act." Under the Rule, a registered audit firm must inform the public issuer's audit committee in writing of all relationships between the audit firm and its affiliates and the issuer or any person employed by the issuer having a financial reporting oversight role before it accepts any initial engagement under PCAOB standards, as these relationships may bear on the audit firm's independence. If any such relationships do exist, the audit firm must discuss the implications of any engagement by the issuer with the audit committee. Such disclosure and discussion is required annually to address any new relationships or changes in existing relationships.

If the SEC approves Rule 3526, it will supersede the Independence Standards Board's Standard No. 1, Independence Discussions with Audit Committees, and take effect on the latter of September 30, 2008 or 30 days after SEC approval.

Stock Option Grants Scrutinized by SEC and Delaware Court of Chancery

Recent SEC enforcement actions and stockholder litigation in the Delaware Court of Chancery stress the importance for corporate officers and boards of directors to seek the advice of legal counsel when granting stock options. 

For example, the SEC recently charged two former executives of Monster Worldwide, Inc. for allegedly backdating stock options granted to thousands of Monster officers, directors and employees, in violation of the antifraud provisions of the federal securities laws. The SEC is seeking permanent injunctive relief, disgorgement of profits, and financial penalties from each defendant, in addition to other penalties (see SEC v. James J. Treacy and Anthony Bonica, SEC Litigation Release No. 20544, April 30, 2008). 

The SEC also filed a civil fraud action against Broadcom Corporation for falsifying its reported income by backdating stock option grants from 1998 to 2003, resulting in a restatement of its financial statements in January 2007 to report more than $2 billion in additional compensation expenses. Without admitting or denying the SEC's allegations, Broadcom agreed to settle the charges by paying a $12 million civil penalty and agreeing to a permanent injunction against certain further securities law violations (see SEC v. Broadcom Corp., SEC Litigation Release No. 20532, April 22, 2008).

In Weiss v. Swanson, the Delaware Court of Chancery recently denied a motion to dismiss plaintiff-stockholder's derivative action claims that alleged that certain officers and  directors  improperly  granted "spring-loaded" and "bullet dodging"  options  (grants  timed  to  precede  positive  and  follow  negative company news) in violation of stockholder-approved option plans and in breach of defendants' fiduciary duties. The motion to dismiss centered on the plaintiff's failure to adequately plead an excusal of the demand requirement and failure to state a claim. Generally, under Delaware law, a stockholder must formally demand that the board of directors pursue a claim prior to filing the derivative action unless such demand would be futile. Here, the court found there was reasonable doubt that the option grants were valid exercises of business judgment, that company officers and directors withheld material information from stockholders regarding the timing of the option grants, and that each director received some of the improper option grants. Given these and other findings, the court held that the demand was adequately excused and it rejected the defendants' motion to dismiss.

New Jersey Allows Retroactive S Corporation Elections

The New Jersey Division of Taxation has issued regulations to permit certain corporations to file a retroactive election if they failed to timely file a New Jersey S corporation election. 

Currently, corporations in New Jersey that elect to be treated as an S corporation must file a form CBT-2553 within one calendar month of when a Federal S corporation election is required. Specifically, it must be filed before the 16th day of the fourth month of the first tax year that the election is to take effect. The new regulations provide retroactive relief for corporations that inadvertently failed to make the election on time. 

The election is available only if (i) the applicant is authorized to do business in New Jersey and registered with the Division of Taxation; (ii) all appropriate Corporation Business Tax returns have been timely filed and taxes timely paid as if the S corporation election request was previously approved; (iii) the retroactive request is received prior to a final assessment for a year covered by the request becoming final; (iv) the Division of Taxation has issued no notice denying a previously late filed New Jersey S election request, and the applicant has not protested the denial within 90 days; and (v) all of the applicant's shareholders have filed appropriate tax returns and paid the tax in full when due, as if the S corporation election was previously approved and the taxpayers have reported the appropriate S corporation income on such tax returns.

Corporations wishing to file the retroactive election must file a form CBT-2553-R and pay a $100.00 administrative user fee. (The form CBT-2553-R is available online at: 

Ninth Circuit Approves Wide Latitude in Parallel SEC and DOJ Proceedings

Securities law violations are often investigated through parallel proceedings, coupling investigations by civil authorities and federal prosecutors when they relate to the same facts and circumstances. In the past, targets of such parallel proceedings have argued that the government's practice of obtaining information in civil investigations to eventually be used in criminal proceedings was deceptive.

Recently, in U.S. v. Stringer (9th Cir., April 4, 2008), the Ninth Circuit Court of Appeals vacated an Oregon federal district court's finding that government agents engaged in deceitful conduct—in violation of the defendants' due process rights—by covertly funneling evidence obtained in a civil investigation to a prosecutor. Overturning the district court's ruling, the Court of Appeals found that no deceit had occurred, as the government fully disclosed to the defendants the possibility that information received in the course of the SEC's civil investigation could be used for criminal proceedings. The court found nothing in the government's conduct amounting to deceit or an affirmative misrepresentation. Additionally, the Court of Appeals concluded that the SEC's conduct was permissible given its explicit Congressional authority to share information with the Department of Justice to facilitate the investigation and prosecution of crimes.

The Stringer decision reinforces the SEC's wide latitude to share information obtained in civil investigations with federal prosecutors conducting parallel criminal proceedings.

For more information on these issues or other corporate matters, please contact:

Irwin Kishner at 212.592.1435 or
Edward Stevenson at 973.274.2025 or

Copyright © 2008 Herrick, Feinstein LLP. Corporate Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.