Options backdating: plenty to worry about; More than 80 companies are being probed for alleged abuse of backdating. Two attorneys review what's been happening and offer tips on what CFOs should do if they think company is at risk.

Many CFOs and other top finance executives have been treading water over the past four years as they negotiated the sea of Sarbanes-Oxley regulations. But just as they've started to make some headway, questions regarding the backdating of stock options threaten to immerse them and their companies anew in a wash of investigations by the Securities and Exchange Commission (SEC), federal prosecutors, the Internal Revenue Service (IRS) and shareholder-related class-action derivative suits.

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Ongoing news stories have turned backdating into a growing nationwide scandal. As of early August, more than 80 companies, particularly in the technology sector, had been targeted by federal and state authorities or had launched internal investigations into backdating practices. As a result, they are scrambling to institute damage control and are re-examining their own compensation and reporting policies to determine whether they backdated or otherwise manipulated the timing of stock options illegally.

Apple Computer made headlines earlier this summer when it announced it would be late in its quarterly filings to the SEC to give it time to restate earnings to take into account backdated options. Two executives from Brocade Communications have been indicted on criminal charges for securities fraud for possible manipulation of stock options, and the SEC has filed a civil complaint against the company.

Federal prosecutors have also filed charges against former executives (the former CEO, CFO and general counsel) of Comverse Technology, a New York-based communications software company, claiming the executives made misleading statements to the board and its auditors.

As is widely known, stock options allow the holder of the option to buy a certain number of company shares at a certain exercise price for a set period of time. The price is usually the price the stock traded at on the date the option was granted. If the stock price rises above the price at the option's grant date, the option becomes "in the money," and the holder of the option can buy the shares at the grant-date price, which is less than current market price.

Backdating of options occurs when a date earlier than the formal grant date is selected as the grant date for purposes of setting the exercise price of options. Backdating in itself is not illegal, as long as options are authorized and issued following correct corporate procedures, are adequately disclosed, accounted for properly and appropriate taxes have been paid, including withholding taxes for employees.

What's raising the hackles at the SEC is when the backdated grants have not been disclosed properly and when accounting rules have been "stretched" to the point of falsifying information. If employees have been granted options lower than authorized, they are getting bigger payoffs than they are entitled to, thus diluting the value of shares for the other stockholders.

Federal prosecutors are also getting into the game. In July, Kevin Ryan, the United States Attorney for the Northern District of California, the top federal prosecutor in San Francisco, formed a task force with the FBI to investigate whether Bay Area companies and executives fraudulently backdated stock option grants. Moreover, the IRS has announced that it will examine stock option awards to executives at some companies for possible tax law violations and consult with the SEC to determine which companies might merit investigation.

So what does this mean for finance executives? Corporate board members, including compensation and audit committee members, who themselves could be subject to investigation into backdating, may look to CFOs and senior finance executives to organize internal audits of stock option award policies and review accounting methodology.

Below are seven steps that CFOs should consider to determine if their company is at risk:

* Look closely at all written stock option plan documents and board policies regarding options. Review the language that specifically speaks to the granting of awards and setting of prices. Does the policy stipulate that all options are to be awarded at fair market value on the day the award is granted? What specific authority, if any, has the board delegated to the CEO or other officers? Is it clearly stipulated what actions can be taken by the board, the compensation committee and the CEO in authorizing grants?

* Immediately initiate an internal review of stock options practices. The internal audit should go back at least 10 years, because many of the option grants currently under investigation took place before the Sarbanes-Oxley Act began requiring publicly traded companies to file Form 4 reports, pursuant to Section 16 of the Securities Exchange Act of 1934, within two days following the date on which the options were granted.

Investigators will need to review a broad range of corporate documents, since backdating can result from deliberate malfeasance (fraud, falsification of records and intentional deviation from generally accepted accounting principles) to accounting mistakes, bookkeeping errors or inadvertent lack of attention to the details of corporate recordkeeping.

Companies may want to consider hiring outside counsel and/or forensic accountants to conduct an internal independent investigation. This will likely be more costly than doing it internally, but it will also demonstrate to shareholders that the issue is being taken seriously. An independent investigation might also be viewed more favorably by regulators should any irregularities be identified.

* If any irregularities are found, CFOs should immediately inform their board, compensation and audit committees. The company should also consult with experienced regulatory and corporate defense counsel to discuss not only how to resolve the irregularities, but the process by which findings should be presented to regulators. Taking a wait-and-see approach will likely work against companies and their executives, as regulators tend to be more lenient with those companies that voluntarily disclose problems, instead of waiting for federal authorities to uncover them.

Bear in mind that if any irregularities are present, the company will need its own counsel, while board members might need their own independent legal representation. If any executives are subject to investigation, they, too, may require individual white-collar counsel.

* In consultation with your outside auditors, determine if a restatement of financial statements and revised public disclosures are needed. Company disclosures in SEC filings may have included misstatements that need to be corrected.

* Calculate the tax impact of the backdating and whether any tax penalties are owed. An award of in-the-money stock options may result in taxable income to the option holder and create an obligation for the company to withhold taxes. Fair-value options are considered performance-based compensation, so the resulting compensation can be deducted for tax purposes even if the option holder is paid more than $1 million. However, if options are in the money on the grant date, they will not qualify for such tax deductions.

Additionally, incentive stock options must be granted at an exercise price at or above the market price on the date of grant; an option that has been backdated would not be eligible for favorable incentive stock option treatment. Also, a backdated option, whether incentive or non-qualified, could subject the option holder to an additional 20 percent tax.

* Contact insurers. Directors and officers' (D & O) liability coverage needs to be analyzed in terms of potential exclusions and possible attempts by insurers to rescind for misstatements. Coverage under any fiduciary liability policies should also be assessed.

Derivatives suits and class actions concerning allegedly improper option grants will also implicate a company's directors and officers' insurance policies, and management and the board need to understand the effects on coverage at an early stage--particularly if any financial statements provided to insurers in the underwriting process will require restatement.

* Finally, the company should review option grants on an annual basis to ensure that all terms are met, and that the option granting process is correct going forward. Boards are responsible for monitoring that all options are granted in accordance with board policies. If those companies currently under investigation had done this, most of their problems likely would have been caught earlier.

Clearly, the SEC will continue to be vigilant about accounting irregularities and improper disclosure that may occur with backdating. However, in a July 6 speech before the International Corporate Governance Network's 11th annual conference, SEC Commissioner Paul S. Atkins said of backdating, "It is worth taking a step back before we plunge headlong into wholesale condemnation of all options practices. We need to distinguish scenarios that are black-and-white fraud from legitimate practices that are being attacked with attenuated theories of liability....

"The mere fact that options were backdated does not mean that the securities laws were violated. Purposefully backdated options that are properly accounted for and do not run afoul of the company's public disclosure are legal. Similarly, there is no securities law issue if backdating results from an administrative, paperwork delay."

Savvy CFOs who don't want to find themselves suddenly cast adrift in rough waters, however, should act now to review their current stock option policies and ensure that past behaviors haven't put their companies at risk.

Joseph P. Armao is a partner in White & Case's Corporate Defense and Special Litigation Group in New York; he can be reached at 212.819.8279. Kenneth A. Raskin is head of White & Case's Executive Compensation, Benefits and Employment Law Practice Group. He can be reached at 212.819.8508. Both are members of White & Case's Stock Options Task Force.

RELATED ARTICLE: takeaways

* As of early August, more than 80 companies, particularly in the technology sector, had been targeted by federal and state authorities or have launched internal investigations into backdating practices.

* Backdating in itself is not illegal, as long as options are authorized and issued following correct corporate procedures, are adequately disclosed, accounted for properly and appropriate taxes have been paid. But clearly, these procedures were abused in some cases.

* If they think their company may be at risk, CFOs should take a series of actions, including assessing a need for restatements of financial results.