Best Practices For Stock Option Grants

November 2006

As we have been reminded recently, it is important that companies with stock option and other equity based compensation plans implement and adhere to grant procedures. This is a good time to review your option grant procedures and controls.

Below are our recommendations with respect to oversight of stock option grant and other equity compensation programs.

Why the attention now?

Recently, media and regulatory attention has been directed at two types of potential problems with respect to option grant practices. The first involves the actual timing of option grants and the second involves the procedures for pricing stock options.

The Securities and Exchange Commission and the Department of Justice have initiated several investigations into situations where significant option grants were made and priced at times when the stock's fair market value (and, so, the exercise price of the options) was low relative to the stock's value at other times during the period during which the grants were made. One example of the targets of these investigations is where a company grants stock options immediately prior to the issuance of a positive earnings report or other public notice of good news about the company, where the earnings report or other news is expected to result in an increase in the value of the company's stock (referred to as "spring loading"). A variation on this practice is to intentionally delay a stock option grant until after the public disclosure of bad news about the company in order to provide the option holder with the benefit of a lower stock price (referred to as "bullet dodging"). Another example involves situations where the company may have retroactively granted stock options (referred to as "backdating") so that, instead of the option exercise price being fair market value on the date the grant actually occurred, the option exercise price reflects the lower fair market value on an earlier date. Backdating can occur in a variety of forms, from the intentional backdating of legal documents to inadvertent backdating resulting from undisciplined corporate governance practices.

What are the implications of these option grant practices?

Although backdating is not an illegal practice in and of itself, the grant of backdated options can create a host of unintended consequences. For starters, the backdating of options can have significant accounting implications (regardless of whether the options were accounted for before the company became subject to FAS 123R and regardless of whether the backdating was intentional). A company found to have engaged in option backdating may be required to restate its financial statements if the accounting consequences are material. Because of the nature of the accounting rules for equity-based compensation, these restatements can affect recent years' financial statements even though the grants themselves may have occurred several years earlier.

Other adverse consequences that could result from option backdating include:

§ The SEC may challenge a company's public disclosures regarding its stock options, which could result in a potential securities disclosure violation.

§ Shareholders could initiate suits against the company on the basis of its option grant practices, alleging self-dealing, waste and other breaches of fiduciary or contractual duties.

§ Senior management may face personal liability for their involvement in problematic option grant practices. As part of a consent decree or judgment, the government may impose financial and other penalties on individual officers and directors, including barring them from serving as public company officers or directors. Chief executive officers and chief financial officers, who are required to certify company financial statements, may face particular exposure. If an investigation leads to a financial restatement, there also is the possibility that certain officers will have to disgorge bonuses (including equity compensation awards) paid to them with respect to the affected company fiscal years. If the Department of Justice is involved in an investigation, criminal penalties may apply.

§ A required financial restatement could cause a company to breach its debt covenants resulting in the acceleration of an obligation.

§ With respect to possible tax implications, if option grants are backdated, the company may lose any ability to take a tax deduction for compensation paid.

§ Employee recipients of stock options may face greater individual tax liability with respect to their options, including if the options granted to them failed to qualify as incentive stock options or if the options are deemed to be "deferred compensation" under new Internal Revenue Code Section 409A (which may result in tax penalties for individuals holding discounted stock options). This greater individual tax liability also could cause the company to have failed to comply with applicable tax withholding rules.

§ If the option plan does not permit below market grants, then the option grants could be considered ultra vires in which case the options would be void. Alternatively, the grants may be deemed to be de facto plan amendments, in which case the company could be in violation of applicable stock exchange rules that require shareholder approval of certain plan amendments.

§ Recipients of stock options may have violated their reporting obligations under Section 16 of the Securities Exchange Act of 1934.

§ It is likely that insurance carriers of director and officer insurance policies will require representations about a company's option grant practices in connection with policy renewals.

§ Backdating issues could be raised by outside auditors, resulting in delays in filing audited financial statements and possible internal control deficiencies.

§ Backdating issues will be explored in any merger or acquisition due diligence process, which could hinder the sale of the company.

What are considered the best practices for option grant procedures?

Although these practices are not mandated by law, we believe that the following will assist officers and directors with reviewing the company's option grant procedures:

§ Consider designating one or two officers or high level employees to serve as option grant gatekeepers with responsibility for overseeing the entire compensation process, with those persons reporting to the board of directors.

§ Identify the duties and responsibilities of all of the various people or groups involved with the equity compensation program, and their roles in the option grant process. This would include the board of directors, any compensation committee of the board, any other committee delegated authority over option grants (such as a "stock option committee"), company personnel (including legal, human resources, and finance), third-party service providers (including any stock plan administrators), and the company's outside auditors and legal counsel.

§ Incorporate any existing or developed procedures into the company's general disclosure controls and procedures, and get approval of the procedures from the company's auditors.

§ Develop procedures that provide for consistency in determining the fair market value of options.

§ Develop appropriate procedures for obtaining consents of the compensation committee and/or any stock option committee. Oftentimes under state law, written committee consents are not effective until signed by all members of the committee. This has resulted in a number of inadvertent cases of backdating where the grant was inadvertently made before the written consent was executed by all committee members. Do not use "as of" dating for option grants.

§ Develop appropriate procedures for communicating material terms of option grants to recipients. When a committee approves an option award at the price established by the plan, even if a formal option agreement has not been executed, accounting rules provide that the option will be deemed to have been granted on the date of the committee approval as long as the key terms and conditions are not negotiable and are communicated to the recipient shortly after the grant has been approved by the committee.

§ Consider how the timing of awards relates to company announcements of earnings or other significant corporate events.

§ Keep the company's accountants involved, because most compensation actions have financial statement implications.

§ Consider adopting pre-scheduled grant dates-for example, by making option grants for new hires on one particular day each month, and making annual option grants at the same time each year for all affected employees.

§ Pay particular attention to, and consider having a higher level of review for, "offcycle" or special award grants.

§ Become familiar with and follow the provisions of the company's stock plans, board and committee charters, employment agreements, procedural manuals and contracts with third-party service providers, and ensure consistency between these documents and communications made to shareholders about equity compensation plans and practices.

§ Pay particular attention to the terms of any authority delegated to the compensation committee or to a lower-level administrative committee (often comprised of company personnel); authority delegated to a lower-level administrative committee should typically establish specific share and other limitations. The measurement of fair market value of the company stock should be made as of the actual grant date by the lower-level administrative committee and not by the date the compensation committee delegates authority.

§ Pay particular attention to share-number limitations specified in stock plans (e.g., the number of shares available for issuance under a plan or the maximum numbers of shares that may be granted to individual employees during certain periods).

§ Review disclosures in the company's SEC filings or other public statements for completeness and accuracy. Effective for proxy statements filed on or after December 15, 2006, companies will have to provide extensive disclosure about option grant practices, including practices relating to spring loading and bullet dodging grants.

§ Keep current on the technical requirements applicable to equity compensation, including the accounting, tax, disclosure, exchange and other applicable regulatory rules.

§ Await final regulations under the new deferred compensation rules under Code Section 409A later this year, and consider actions that must be taken to comply with these rules before the end of the applicable transition period (currently, December 31, 2007).

The Sherman & Howard Business Department is ready to assist clients with stock option grant practice issues or other related matters. Please visit our website at http://www.shermanhoward.com for more information.

	Contact Us Services Attorneys News and Events Publications About the Firm Inclusiveness Careers Blog In the Media Events and Registration Press Releases Speaking Engagements Articles Client Advisories Subscriptions History Offices Pro Bono Interlaw Contact Us Culture Legal Opportunities Support Staff Publications Client Advisories Home > Publications > Client Advisories > View Best Practices For Stock Option Grants November 2006 As we have been reminded recently, it is important that companies with stock option and other equity based compensation plans implement and adhere to grant procedures. This is a good time to review your option grant procedures and controls. Below are our recommendations with respect to oversight of stock option grant and other equity compensation programs. Why the attention now? Recently, media and regulatory attention has been directed at two types of potential problems with respect to option grant practices. The first involves the actual timing of option grants and the second involves the procedures for pricing stock options. The Securities and Exchange Commission and the Department of Justice have initiated several investigations into situations where significant option grants were made and priced at times when the stock's fair market value (and, so, the exercise price of the options) was low relative to the stock's value at other times during the period during which the grants were made. One example of the targets of these investigations is where a company grants stock options immediately prior to the issuance of a positive earnings report or other public notice of good news about the company, where the earnings report or other news is expected to result in an increase in the value of the company's stock (referred to as "spring loading"). A variation on this practice is to intentionally delay a stock option grant until after the public disclosure of bad news about the company in order to provide the option holder with the benefit of a lower stock price (referred to as "bullet dodging"). Another example involves situations where the company may have retroactively granted stock options (referred to as "backdating") so that, instead of the option exercise price being fair market value on the date the grant actually occurred, the option exercise price reflects the lower fair market value on an earlier date. Backdating can occur in a variety of forms, from the intentional backdating of legal documents to inadvertent backdating resulting from undisciplined corporate governance practices. What are the implications of these option grant practices? Although backdating is not an illegal practice in and of itself, the grant of backdated options can create a host of unintended consequences. For starters, the backdating of options can have significant accounting implications (regardless of whether the options were accounted for before the company became subject to FAS 123R and regardless of whether the backdating was intentional). A company found to have engaged in option backdating may be required to restate its financial statements if the accounting consequences are material. Because of the nature of the accounting rules for equity-based compensation, these restatements can affect recent years' financial statements even though the grants themselves may have occurred several years earlier. Other adverse consequences that could result from option backdating include: § The SEC may challenge a company's public disclosures regarding its stock options, which could result in a potential securities disclosure violation. § Shareholders could initiate suits against the company on the basis of its option grant practices, alleging self-dealing, waste and other breaches of fiduciary or contractual duties. § Senior management may face personal liability for their involvement in problematic option grant practices. As part of a consent decree or judgment, the government may impose financial and other penalties on individual officers and directors, including barring them from serving as public company officers or directors. Chief executive officers and chief financial officers, who are required to certify company financial statements, may face particular exposure. If an investigation leads to a financial restatement, there also is the possibility that certain officers will have to disgorge bonuses (including equity compensation awards) paid to them with respect to the affected company fiscal years. If the Department of Justice is involved in an investigation, criminal penalties may apply. § A required financial restatement could cause a company to breach its debt covenants resulting in the acceleration of an obligation. § With respect to possible tax implications, if option grants are backdated, the company may lose any ability to take a tax deduction for compensation paid. § Employee recipients of stock options may face greater individual tax liability with respect to their options, including if the options granted to them failed to qualify as incentive stock options or if the options are deemed to be "deferred compensation" under new Internal Revenue Code Section 409A (which may result in tax penalties for individuals holding discounted stock options). This greater individual tax liability also could cause the company to have failed to comply with applicable tax withholding rules. § If the option plan does not permit below market grants, then the option grants could be considered ultra vires in which case the options would be void. Alternatively, the grants may be deemed to be de facto plan amendments, in which case the company could be in violation of applicable stock exchange rules that require shareholder approval of certain plan amendments. § Recipients of stock options may have violated their reporting obligations under Section 16 of the Securities Exchange Act of 1934. § It is likely that insurance carriers of director and officer insurance policies will require representations about a company's option grant practices in connection with policy renewals. § Backdating issues could be raised by outside auditors, resulting in delays in filing audited financial statements and possible internal control deficiencies. § Backdating issues will be explored in any merger or acquisition due diligence process, which could hinder the sale of the company. What are considered the best practices for option grant procedures? Although these practices are not mandated by law, we believe that the following will assist officers and directors with reviewing the company's option grant procedures: § Consider designating one or two officers or high level employees to serve as option grant gatekeepers with responsibility for overseeing the entire compensation process, with those persons reporting to the board of directors. § Identify the duties and responsibilities of all of the various people or groups involved with the equity compensation program, and their roles in the option grant process. This would include the board of directors, any compensation committee of the board, any other committee delegated authority over option grants (such as a "stock option committee"), company personnel (including legal, human resources, and finance), third-party service providers (including any stock plan administrators), and the company's outside auditors and legal counsel. § Incorporate any existing or developed procedures into the company's general disclosure controls and procedures, and get approval of the procedures from the company's auditors. § Develop procedures that provide for consistency in determining the fair market value of options. § Develop appropriate procedures for obtaining consents of the compensation committee and/or any stock option committee. Oftentimes under state law, written committee consents are not effective until signed by *all* members of the committee. This has resulted in a number of inadvertent cases of backdating where the grant was inadvertently made before the written consent was executed by all committee members. Do not use "as of" dating for option grants. § Develop appropriate procedures for communicating material terms of option grants to recipients. When a committee approves an option award at the price established by the plan, even if a formal option agreement has not been executed, accounting rules provide that the option will be deemed to have been granted on the date of the committee approval as long as the key terms and conditions are not negotiable and are communicated to the recipient shortly after the grant has been approved by the committee. § Consider how the timing of awards relates to company announcements of earnings or other significant corporate events. § Keep the company's accountants involved, because most compensation actions have financial statement implications. § Consider adopting pre-scheduled grant dates-for example, by making option grants for new hires on one particular day each month, and making annual option grants at the same time each year for all affected employees. § Pay particular attention to, and consider having a higher level of review for, "offcycle" or special award grants. § Become familiar with and follow the provisions of the company's stock plans, board and committee charters, employment agreements, procedural manuals and contracts with third-party service providers, and ensure consistency between these documents and communications made to shareholders about equity compensation plans and practices. § Pay particular attention to the terms of any authority delegated to the compensation committee or to a lower-level administrative committee (often comprised of company personnel); authority delegated to a lower-level administrative committee should typically establish specific share and other limitations. The measurement of fair market value of the company stock should be made as of the actual grant date by the lower-level administrative committee and not by the date the compensation committee delegates authority. § Pay particular attention to share-number limitations specified in stock plans (e.g., the number of shares available for issuance under a plan or the maximum numbers of shares that may be granted to individual employees during certain periods). § Review disclosures in the company's SEC filings or other public statements for completeness and accuracy. Effective for proxy statements filed on or after December 15, 2006, companies will have to provide extensive disclosure about option grant practices, including practices relating to spring loading and bullet dodging grants. § Keep current on the technical requirements applicable to equity compensation, including the accounting, tax, disclosure, exchange and other applicable regulatory rules. § Await final regulations under the new deferred compensation rules under Code Section 409A later this year, and consider actions that must be taken to comply with these rules before the end of the applicable transition period (currently, December 31, 2007). The Sherman & Howard Business Department is ready to assist clients with stock option grant practice issues or other related matters. Please visit our website at http://www.shermanhoward.com for more information. Copyright 2000-2013 Sherman & Howard L.L.C. All rights reserved. Privacy Policy \| Terms of Use