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May 31, 2006 11:52 pm

Stock options under scrutiny

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Every day this week as the Enron headlines have receded, corporate America has watched a steady drip-drip of news coming from another enfolding scandal: stock options backdating.

The issue has now spread beyond the executive suite after McAfee, a software antivirus specialist, on Tuesday fired its general counsel after finding an “improper episode” as part of an internal review of prior stock options policies.

This is a sign that, even as at least 20 companies face scrutiny from regulators and the US attorney and as about a dozen directors and executives have been fired, companies’ professional advisers are getting caught up in the scandal.

For investors, Wall Street analysts, corporate governance specialists and companies themselves, the question is how far this could spread. Covington & Burling, a law firm, says: “The number of companies, officers and directors facing scrutiny for these issues is likely to increase significantly as journalists and investigators goad investigators to cast a wider net.”

Erik Lie, associate professor of finance at the University of Iowa, believes that up to 10 per cent of US corporate stock options were backdated.

His research was a leading factor in sparking a series of company probes by the US attorney and the Securities and Exchange Commission.

At issue is the behaviour of a host of technology companies in the period 1997-2002, before Sarbanes-Oxley legislation came into force tightening options granting disclosure requirements.

Studies by Mr Lie and the Wall Street Journal showed that companies awarded their executives stock options at dates that immediately preceded a rise in the share price.

That led to suspicion that the options may have been backdated to take advantage of a low price in the company’s stock.

Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware, says: “It’s basically betting on a horse race after the race is over with. It’s unfair.”

In the period in question, backdating itself was not necessarily illegal. Under laws in place at the time, companies had a window of about three months in which to report the granting of stock options and the price at which they were awarded.

The suspicion is that some companies used that window to backdate but, crucially, did not properly disclose and expense such action.

Class-action lawsuits have emerged from shareholders claiming that companies’ directors abdicated their fiduciary responsibilities by not properly expensing stock options.

For the SEC, the issue could not have been more delicately timed. In January it tabled proposals that would amend disclosure requirements for executive and director compensation. In a sign of intense public interest in the subject, the SEC received about 20,000 comments on its proposals.

One focus of investigation is likely to be the use by company boards of “unanimous consents” for options grants, where a board does not formally have to meet to approve a grant.

Covington & Burling last week advised its clients to cease using unanimous consents for option grants.

That leaves, among others, the question of what general counsel knew, and when.

Cheryl Moore, a securities litigation lawyer at Patton Boggs, asks: “Was there other counsel that looked at this? Who drafted the documents? These will be issues.”

David Martin, head of the securities practice at Covington & Burling, says: “It is slippery, because 10 years ago when people were throwing around stock options like baseball cards they weren’t thinking about it carefully enough.

“There will be a little bit of rough justice here because the standards have changed.”

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