Outside directors are suppose to be the watchdogs of shareholders by bringing an objective and detached view to the board room and providing a check on management.  Yet, a new study in what seems to be an ever-expanding series on option backdating now questions the role of such directors. 


Yesterday, the NYT discussed a study sponsored by the Harvard Law School Program on Corporate Governance that suggests stock option manipulation extends not only to executives, but also to outside directors. See Eric Dash, “Study Finds Outside Directors Also Got Backdated Options,” 12/18/06.  The study alleges that upwards of 1,400 outside directors may have received manipulated options and is the first study to measure the extent of outside directors who directly benefited from the practice. 


The study analyzes roughly 30,000 directors who were granted stock options from 1995 to 2005 and compares the percentage of grants made at monthly low prices with the portion they expected had they been randomly assigned.  The study concludes that out of all director grant events, 9% were lucky grant events, i.e., falling on days with a stock price equal to a monthly low.  Surprisingly, contrary to common belief that outside director options were typically awarded around the time of a company’s annual meeting, the study offers that about 29% of the time companies granted stock options to directors on the same date as those given to executives.  Further, the study suggests that 3.8% of all grant events were super-lucky – defined as taking place at the lowest price of the calendar.


In this light, the study raises concerns about the role of outside directors as gate keepers in a company’s corporate governance structure.  As discussed by one of the study’s authors, Lucian A. Bebchuk, a Harvard Law School professor, this revelation has “large governance significance.”  To date the option scandal has focused on the agency problems between executives and the board of directors, while this study focuses on the agency problems between the outside directors and the company’s shareholders.  The concern becomes whether those expected and trusted to be gatekeepers have failed in their duties.  Perhaps its time to reevaluate these so-called watchdogs and carefully look at just who is watching the watchdogs.

See Bebchuk, Lucian Arye, Grinstein, Yaniv and Peyer, Urs C., “Lucky Directors” (12/2006). Available at SSRN: http://ssrn.com/abstract=952239

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Recently, Deputy Attorney General McNulty issued a memo revising the Thompson Memo.  Mr. McNulty’s revision of the standards for prosecuting organizations, which focuses largely on the question of cooperation, common interest agreements, and the payment of legal fees by organizations, is, as noted here yesterday, a significant step.  Unfortunately, the Memo fails to address the key problem under Thompson – the lack of standards defining cooperation.  This oversight, coupled with the coercive atmosphere in which charging decisions are made, makes it extremely difficult for organizations to make independent decisions on whether or not and to what extent to cooperate with law enforcement.  It is the vagueness of cooperation standards and the potentially devastating impact of an indictment which causes corporations to take virtually any step that might possibly help them be viewed as cooperative.  Often this “cooperation” is dictated by today’s coercive environment and not by what prosecutors may actually demand. 

The SEC’s standards of cooperation, defined in its Seaboard Release and standard practices, are no better.  The standards are vague and open-ended, leaving organizations in the difficult position of deciding whether or not to self-report.  Unlike the Antitrust Division’s program, which grants amnesty to the first self-reporting company under certain circumstances, the SEC has no established terms defining what constitutes cooperation or what action the SEC may take after learning of misconduct.  Like with the vague DOJ standards, organizations are forced to guess at what might help them be viewed as cooperative and avoid the additional injury inflicted by an enforcement action. 

While the McNulty Memo is a significant step – and more than the SEC has done – it is time to go further.  Now, as corporate scandals such as Enron and others wind down, it is the time for the SEC to step forward and establish a bright-line standard for cooperation to end the coercive charging environment and to foster a climate that encourages cooperation with law enforcement.  Such a standard would be beneficial for the SEC because it would encourage self-reporting, provide factual information, and facilitate prosecution of the individuals involved.  At the same time, the standard would benefit organizations because it would end the current coercive environment and provide certainty that cooperation prevents further injury.  Thus, an established standard should help foster a better relationship between law enforcement and corporations.  

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