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Corporate Quick Hit: Pre-2002 Retroactive Stock Option Strike Prices Attracting Regulatory Enforcement Attention
June 2006
Authors: Irwin A. Kishner

Pre-2002 Retroactive Stock Option Strike Prices Attracting Regulatory Enforcement Attention

The issue. Prior to the enactment of the Sarbanes-Oxley Act in 2002, corporations offering stock options as part of their compensation packages may occasionally have looked back at stock performance and retroactively set option strike prices at a low point which was followed by a sharp run upward in the price of the stock. While there is nothing illegal on its face with retroactive strike price determinations if allowed by the compensation plan and properly disclosed in public filings, the practice is attracting the attention of enforcement bodies and the press is vilifying it as the latest example of post-Enron greed run amok.

Why it may be a problem for you. Stock option compensation gives a powerful and legitimate incentive to corporate employees and officers to work hard to make the company a success and increase the value of the company stock. There is absolutely nothing wrong with having a low strike or exercise price on stock options and seeing hard work translate into an increase in the stock price. However, a company with an otherwise legal stock option program may run into trouble complying with the very technical and specific requirements of proper treatment and disclosure of stock option compensation. Enforcement bodies are seizing on these errors with potentially catastrophic consequences for violators.

The United States Attorneys for the Southern and Eastern Districts of New York, the District of Massachusetts and the Central District of California have all issued subpoenas to some 43 companies for stock option backdating materials. The Securities and Exchange Commission has opened multiple investigations into this form of executive compensation. The Internal Revenue Service is investigating the tax consequences of improper option compensation income reporting. Federal prosecutors have at their disposal criminal charges which include mail and wire fraud, bank fraud, securities fraud, money laundering, and tax evasion. Potentially, these charges carry very long prison sentences for individuals and crippling fines for institutions. The SEC could seek disgorgement, restitution and industry bans. The IRS could seek back tax payment, interest and penalties. Companies are vulnerable to investor class action suits as well, alleging violations of proper corporate governance procedures and breach of fiduciary duty as evidenced by a recent filing in the Southern District of New York. A number of corporate executives have been fired in connection with option backdating.

What to do. Any company that has an executive compensation plan which includes stock option grants should educate itself about—and keep abreast of—the current regulatory climate. You may wish to consider authorizing an internal audit of option compensation practices. If there are no problems, it is money well spent for peace of mind. If the audit identifies potential issues, internal controls can be suggested, considered and implemented. Change can be instituted before criminal prosecutors issue subpoenas and regulators begin an adversarial audit. This internal audit can be privileged and, to be truly independent, should be authorized by the Board of Directors or the Audit Committee. Often, these matters are so technical that only a dedicated audit can accurately determine whether a problem exists. Prosecutorial and regulatory enforcement decisions will turn on very specific factual determinations.

Individuals who have received significant option compensation also need to be concerned for their personal position, which may not always be directly aligned with that of the company. Executives and other employees may wish to consider an initial consultation to fully understand the issues and the potentially drastic consequences.

Issues to consider. Below, we have provided you with a quick list of issues that might be investigated in an audit. We can also provide a Navigant brochure on the subject and a representative sampling of press coverage if you want further written information.

Representative Audit Issues

  • Was the stock option plan properly approved of by the shareholders?
  • Did individual executives have any ability to influence the size and timing of grants?
  • Does the plan clearly specify how the grant date will be determined, or is it vague?
  • Are options awarded at specified or unspecified times?
  • Are there differences between the promise date, the grant date, and the setting of the strike price?
  • Is there a frequent pattern of profit reflected by a low stock price, the strike price set and a subsequent increase in price of the stock or is option profitability a more hit or miss proposition?
  • How were option grants disclosed to external auditors, in public filings and in corporate tax filings?

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

Irwin Kishner at 212.592.1435 or email

Copyright © 2006 Herrick, Feinstein LLP. The Lending and Restructuring 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.