Option Backdating, Negligent Conduct And Spring Loaded Options

Last Friday, the SEC filed a settled civil action and a related administrative proceeding based on option backdating claims. The defendants are Analog Devices, Inc. of Massachusetts and its CEO Jerald Fishman. SEC v. Analog Devices, Inc., Civil Action No. 1:08-cv-00920 (D.D.C. May 30, 2008); In the Matter of Analog Devices, Inc., Adm. Proc. File No. 3-13050 (May 30, 2008).

The allegations of the civil action and the administrative proceeding differ little from other option backdating cases. According to the complaint, from 1998 through 2001 Mr. Fishman caused the company to backdate stock option grants, pricing them below the market price of the stock on the date they were actually approved. The in-the-money grants given to company officers and employees resulted in $30.7 million in compensation costs that the company did not properly record or disclose. The Commission’s papers do not state that a restatement of Analog Devices’ financial statements was necessary.

Two aspects of this matter are significant. First, although the charging documents state that Mr. Fishman is responsible for the option backdating, the claims against him are based on negligence. In the civil complaint, Mr. Fishman is charged in Count II with violating Sections 17(a)(2) & (3). In contrast, Count I against the company is based on a claimed violation of Section 10(b). That complaint was resolved with a consent by Mr. Fishman to pay disgorgement and prejudgment interest and a civil penalty equal to about the total of those two items. The company consented to the entry of an order requiring the payment of a $3 million civil penalty (three times that of Mr. Fishman).

To resolve the administrative proceeding, Mr. Fishman consented to the entry of a cease and desist order based on Sections 17(a)(2)&(3), again negligence. The company consented to a similar order, but based on Section 10(b). Both defendants entered into certain undertakings with regard to re-pricing unexercised options.

Analog is only the second option backdating case based on negligence. The first, filed against the former CEO of Maxim Integrated Products in SEC v. Maxim Integrated Products, Inc., filed in late December, is discussed here. Together, these actions may suggest that, as the Commission works through its inventory of option backdating cases, the prosecution standards will continue to shift from the initial focus on intentional fraudulent conduct to negligence.

The second aspect of Analog Devices of interest is what was not part of the complaint. A footnote in both the complaint and the Order for Proceedings states in part: “At some point during these earlier years, certain management and non-management Directors had obtained advice from Analog’s outside counsel that it was not inappropriate in the context of the company’s insider trading policies for the company to grant options on the basis of and prior to the release of favorable nonpublic financial information.” The company apparently issued “spring loaded” options, although the Commission’s papers make it clear that they are not the predicate for the charges here. Yet, the Commission does not state the reason this material is included in the complaint.

The use of spring loaded options (or the variant, bullet dodging options) is controversial. Some have argued that this conduct is insider trading. Others have claimed that since the company is the ultimate insider it cannot be insider trading. While the SEC has been aggressive in insider trading cases, based on Analog Devices it appears that the Commission will not will not prosecute spring loaded or bullet dodging options – at least where that conduct is based on a legal opinion.

Conclusion: SEC Enforcement Trends And Priorities, 2008

The SEC’s enforcement program has long been known as having at least two key facets. On the one hand is a “cop on the beat,” essential to maintaining the integrity of the nation’s capital markets. On the other, it has engaged in “regulation through litigation,” often pushing the edges of, and in some instances redefining, the law.

Both of the program’s historic characteristics are evident in the cases brought last year. At the same time, a review of the SEC’s enforcement program over the last year leaves more questions than it answers as to its direction and overall vitality.

The increased number of cases suggests that the program is more robust. At the same time, a number of those cases involve the delisting of largely micro-cap companies for failing to file periodic reports. This alone raises questions about that statistic, suggesting, at a minimum, that they do not tell the entire story.

More questions are raised by the significant drop in the amount of court-ordered disgorgement and penalties. While some reduction can be explained by the lack of huge cases such as Worldcom, the 50% drop in these numbers last year raises clear questions and concern. Those questions are amplified by the recent efforts of the Chairman to defend the enforcement program results before Congress by claiming that this year penalty and disgorgement orders are at record levels. That might be true if the $600 million figure from the settlement of Dr. McGuire is included. Trouble is, most of that sum is from the private actions the SEC combined with its settlement. Reportedly, the Commission made little if any contribution to the private case settlements.

A review of key policies and procedures not only raises questions, but suggests an entrenched program that may be unwilling to consider improvements. To date, the impact of Chairman Cox’s new corporate penalties program is debatable, at best. At the same time, it does raise significant concerns about the vitality of the settlement procedures. Those concerns are not ameliorated by the fact that the agency seems to have ignored the suggestions for reform by Congress and others calling for new procedures and that cooperation policies. This apparent unwillingness to improve the program may ultimately undermine its goals. This may be particularly true if conduct such as that approved in Stringer – where SEC attorneys acted as stalking horses for DOJ prosecutors under the guise of Form 1662 – is permitted to continue. Such tactics cannot be expected to yield cooperation.

These questions are amplified by matters such as the botched Pequot investigation, SEC v. PacketPort.com, which was dismissed for want of prosecution and SEC v. Jones, where much of the relief sought by the Commission was denied as time barred. Equally troubling are the hedge fund/PIPES cases, where the courts have raised questions not only about the legal theory being argued by the SEC, but its candor in presenting the case.

At the same time, the Commission has continued to focus in its traditional enforcement areas with success. While the number of insider trading cases may not have significantly increased last year, there should be little doubt that the agency has placed a renewed emphasis on the area and in many instances is taking an aggressive posture. This is clearly evident in actions such as the Barclays Bank case and the repeated warnings about the misuse of Rule 10b5-1 plans.

The enforcement program also has a renewed emphasis on the FCPA. While this has long been a traditional enforcement area, the re-emphasis last year will clearly continue into this year. That focus will be keyed to bringing actions against individuals. It can also be expected to continue to take an expansive approach to interpreting the statutes.

In other traditional areas such as financial fraud, the Commission will no doubt continue to bring cases. Earnings management, the misuse of reserves, premature earnings recognition and similar improper conduct will continue to be probed. At the same time, many of the cases brought in this area reflect long past conduct. These often ancient actions raise significant questions regarding the necessity for the traditional SEC injunction and whether such relief is really to prevent future violations or punish past transgressions.

Overall, there is no doubt that the enforcement program continues to be “cop on the beat,” and, in some instances, to push the edges of the law. Cases are being brought in traditional areas such as insider trading, FCPA and financial fraud. Yet, repeatedly ignoring calls for reform or improvement, as well as criticisms by the courts and others, presents significant concerns about the vitality of the program.

The key to the enforcement program has always been strong direction and leadership from the top. As the Commission likes to say “tone at the top” is critical. So too, for the enforcement program. Tone at the top, and strong leadership from the top, is a necessity. The current program seems in search of these qualities.