Backdating of options: what's coming next?

Back on August 28, Restoration Hardware reported its second-quarter earnings--and announced that a review of its stock-options practices showed that it had misdated the accounting of certain previously granted options, mostly in 2002 to 2004.

It then added that the cumulative impact of the errors had created additional non-cash compensation of $600,000--which it deemed not material to the results of previously reported periods or the current fiscal year.

The California-based decorating chain's announcement is likely to be echoed in upcoming quarters as companies comb back through their options programs in an effort to decide whether or not they need to consider restating any earnings. That's the backwash from the ongoing options-backdating scandal that has been playing out in the business headlines for months, ensnaring well over 80 companies and raising the specter of criminal charges at some.

Restoration Hardware's tactic of releasing the information in conjunction with a normal quarterly filing could be part of a common pattern, says Frank Edelblut, CEO of Control Solutions, a New York-based consulting and software firm in the compliance area. Edelblut said in an interview that companies that do have backdating issues may consider doing "stealth restatements," in which they release information in footnotes to a conventional quarterly or annual filing and not as a separate 8-K filing for a material event. However, the Securities and Exchange Commission (SEC) has been telling companies lately through comment letters and speeches that they can't simply "bury" the information in a regular filing, but must file required documents--presumably an 8-K.

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Edelblut warns companies that to understand the dimensions of a possible backdating problem, "a management review may not be effective, and independent accountants may have to report a restatement on a financial statement that they issued an opinion on, and they may then be open to civil litigation." Better that a probe be done by an internal audit function or legal counsel, he says.

The SEC "seems to have a strategy--they realize they don't have the horsepower to investigate all the potential cases [of backdating]," Edelblut says. So they have issued so-called "Wells notices," warning that the agency may bring civil securities charges against a potential defendant.

"If a company gets a Wells letter in this day and age, they will react," says Paul Zikmund, a partner in Control Solutions' forensic and fraud services practice. But, he adds, "A lot of those [options transactions] will pass the sniff test. Not all will be [the result of] manipulation and fraud. Properly employed, options have frequently been used as a means to retain top talent."