Last week, Erik R. Sirri, SEC Director of Division of Market Regulation, gave a speech offering suggestions and discussion points for a cooperative approach to enable foreign exchanges and foreign broker-dealers to conduct business within U.S. boarders. Mr. Sirri set the stage for discussing the issue, which the SEC originally raised 17 years ago, by highlighting the economic realities of the financial services industry and its continued growth, pointing to the recent alliances and mergers among exchanges; the advancements in technology in leveling the global playing field; and the evolution of regulatory oversight in foreign jurisdictions. He outlined the US securities structure and its three major components, corporate issuers, securities exchanges, and broker-dealers focusing on the SEC’s mandate to protect investors. The tension, of course, is how to satiate US investors’ growing appetite for foreign securities, which they can already obtain, and adhere to the SEC’s mandate. Mr. Sirri suggested that it is time for the SEC to consider a cooperative approach that would “reduce costs and frictions of obtaining foreign securities in the US, without jeopardizing investor protection for US investors. In fact, we may be able to work cooperatively with foreign regulators to raise standards for investors in all of our markets.”

The proposed approach relies on the SEC’s authority to provide exemptions to the securities laws. As Mr. Sirri explained, in 1996, Congress gave the SEC exemption authority from “any of the provisions of the Exchange Act and impose appropriate conditions on their operation.” The SEC could, therefore, determine whether in the public interest and consistent with its investor protection mandate, certain foreign exchanges and broker-dealers should be exempt. Mr. Sirri set forth several suggestions for conditions that should apply to any exemption: recognized jurisdiction; notice to investors; foreign securities only; US membership limited to broker-dealers; fair access; coordinated oversight; and recordkeeping, reporting and disclosure. Mr. Sirri’s comments are further detailed in a paper authored by Ethiopis Tafara, SEC Director of the Office of International Affairs, and Robert J. Peterson, Senior Counsel for the Office of International Affairs. Ethiopis Tafara and Robert J. Peterson, “A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework,” 48 HARV. INT’L L.J. 31 (2007) (forthcoming, Winter 2007) available at

In essence, it is not difficult to imagine that any resulting rules for such exemptions will require successful applicants to submit to or already be governed by some system designed to ensure investor protection.

Print Friendly, PDF & Email

SEC Enforcement Trends – Stock Option Backdating 

Stock option backdating is a primary area of interest for both the SEC and the Department of Justice.  Since articles first began appearing in the Wall Street Journal in the fall of 2005 and March of 2006, the questions concerning stock option backdating have received substantial media attention while being the focus of ever-expanding investigations by the SEC and DOJ.  Although those investigations began slowly as they often do, the number has continued to increase and the SEC staff has acknowledged that it is investigating about 140 companies for the practice.  Likewise, while the pace at which the SEC and the DOJ brought enforcement cases was initially rather slow, recently it has picked up substantially. 

Backdating options typically involves selecting a date prior to the grant date when the stock price was lower; thus making the options “in the money,” rather than “at market” if priced on the grant date.  This practice is not illegal in and of itself.  When the practice is not properly disclosed, however, or the accounting is not done correctly the practice can result in violations of the securities and tax laws and accounting rules.  A related practice is “spring-loading” (i.e., choosing an option’s grant date and exercise price at a time shortly before the release of positive corporate news or in the case of negative news, “bullet-dodging”).  Neither practice is really backdating but rather is a form of insider trading (see blog post of 1/30/07).  The SEC has not taken a position on the controversial question of whether spring-loading and bullet-dodging are contrary to the insider trading laws.   

For those caught up in the backdating scandal the SEC Chief Accountant has issued guidance on the proper accounting (see blog post of 1/18/07).  The Division of Corporation Finance has also simplified the restatement process and the IRS has announced an amnesty program for those who inadvertently find themselves with backdated options (see blog post of 1/18/07).  

The SEC and the DOJ have significantly increased the pace of filing enforcement cases in recent weeks.  The first cases were filed with significant fanfare in July and August of last year.  The first, involving options of Brocade Communications, were brought in the Northern District of California by the SEC on the civil side and the U.S. Attorney’s Office on the criminal side and are captioned, respectively, SEC v. Reyes et al. and U.S. v. Reyes et al.  Both cases allege a fraudulent scheme involving the former CEO Gregory Reyes and others to backdate options for themselves and others, while hiding their activities with false documents (see blog post of 7/20/06).  The following month cases were filed in the Eastern District of New York involving the options of Comverse Technology, captioned SEC v. Alexander, et al. and U.S. v. Alexander, et al.  Again the allegations in the civil and criminal cases claimed option backdating involving the CEO, CFO, General Counsel and others along with a cover up involving false documents (see blog post of 8/10/06).  On January 10, 2007, General Counsel Sorin plead guilty and settled with the SEC (see blog post of 1/11/07).  

Six months later, the government brought several cases in rapid succession.  First, only the SEC has brought cases involving the options of Engineering Support Systems SEC v. Landmann and SEC v. Gerhardt, both in the Eastern District of Missouri (see blog post 2/7/07).  Mr. Gerhardt consented to an injunction, an officer/director bar, and to pay almost $900,000 in disgorgement, prejudgment interest, and penalties.  A week later the SEC brought settled charges in New York, one involving the options of Take Two Interaction Software, SEC v. Brant, (S.D.N.Y. Feb. 14, 2007) and a second involving options at Monster Worldwide, SEC v. Olesnyckyj, (S.D.N.Y. Feb. 15, 2007).  Mr. Brant consented to an injunction and over $6.2 million in disgorgement, prejudgment interest, and penalties, and an officer/director bar.  Messrs. Brant and Olesnyckyj pled guilty to securities fraud in the New York State Supreme Court and Southern District of New York, respectively, the same day the SEC cases were filed.  Mr. Brant agreed to pay $1 million related to the criminal charges.  

Likewise, just last week the SEC charged Kent H. Roberts, the former GC and Corporate Secretary of McAfee, Inc., with securities fraud for wrongfully re-pricing McAfee stock option grants awarded to him and others, SEC v. Kent H. Roberts, (D.D.C. February 28, 2007).  The US Attorney for the Northern District of California also charged Roberts criminally. 

While frequently the class action bar files actions based on SEC and DOJ enforcement actions, relatively few damage actions have been brought to date.  This may stem from the difficulty of calculating damages.  A number of shareholder derivative cases have been brought.  Those cases received a substantial boost when the Delaware Chancery Court denied a motion to dismiss a derivative action based backdating and spring-loading claims in Ryan, et al. v. Maxim Integrated Products, Inc., et al., (Del. Chan. Feb. 6, 2007). 

In the weeks and months to come the SEC and the DOJ will continue to expand their investigations, adding to the number of companies under inquiry.  At the same time, both the SEC and the DOJ will bring more cases resulting in more settlements and consent decrees containing statutory injunctions, disgorgement, penalties and officer director bars for SEC cases and similar remedies and guilty pleas perhaps resulting in jail time and fines in DOJ cases. 

Yet it is difficult to project the scope of liability in these cases.  The cases brought to date have been based on clear allegations of fraud with falsified documents, fictitious grantees and cover ups.  The defendants have been the corporate officials directly involved in the claimed fraudulent conduct.  These cases and claims are typical of initial government enforcement cases in a relatively new area such as options backdating – cases based on blatant intentional conduct which, if proven, clearly violates the law. 

As the options backdating scandal continues to unfold it is doubtful, however, that the claims in the currently filed cases will delimit the parameters of liability.  Rather, as the government develops more cases the claims will, in probability, move past the kind of blatant fraud allegations in the current cases to more subtle forms of securities fraud.  At the same time the scope of liability may well increase.  Each of the current court cases is part of an on-going investigation.  As those investigations and others move forward there is no doubt that the SEC and the DOJ will be looking closely at the role of others involved in the option process.  Close attention will be given to the roles not only of executives and the general counsel but also to directors on the board committee which grants options, other members of the board, internal auditors, external auditors, outside counsel and outside consultants involved with executive compensation.  This scrutiny holds the potential to greatly expand the parameters of liability in both civil and criminal actions. 

Some indication of the reach of these cases may emerge from the Brocade cases later this year.  Presently U.S. v. Reyes is scheduled to go to trial in June.  If that schedule holds it will be the first options backdating case to go to trial.  Mr. Reyes has vowed with his legal team to fight this case to the end.  While details of the defense are not known at this time, evidence that has emerged suggests a dramatically different picture from that painted by the government in its charging papers.  That evidence suggests that the dates for options were selected by a clerk pursuant to a standard company practice with forms subsequently forwarded to Mr. Reyes for signature as a matter of course.   The picture painted by this evidence stands in sharp contrast with the claims of stark charges of fraud leveled by the government.  The ability of the government to develop sufficient evidence to prove its fraud claims and prevail at trial may well impact the scope of future prosecutions and the willingness of the DOJ and the SEC (who is having problems with its parallel civil case, see blog post of 2/20/07) in the future.  Regardless of the result, however, the options backdating scandal will continue to unfold throughout the year and ensnare may more companies and individuals. 

Print Friendly, PDF & Email