The key question about the stock option backdating scandal is not if more cases will be brought, but rather what standard prosecutors will use when exercising their broad discretion to charge.   To date there are at least 200 companies which have announced internal investigations into their option issuance practices.  About 140 of those are under investigation by the SEC and some are the subject of criminal inquiries by various U.S. Attorney’s offices.  The conduct engaged in by persons at these companies probably ranges from the bumbling to actual fraud.  In-between there are varying shades of gray.  Those companies, along with their directors and officers are holding their collective breath, wondering where in those shades of gray the line will fall between those charged and those not charged.

Today, the SEC gave some indication of where that line might fall.  It brought a long awaited action based on its investigation into the backdating practices at Apple.  Named as defendants in an enforcement action were Apple’s former GC of nine years, Nancy Heinen, and its former CFO and director, Fred Anderson.  SEC v. Nancy R. Heinen and Fred D. Anderson, Case No. 07-2214-HRL (Lloyd) (N.D. Cal. filed April 24, 2007)   These are the two persons identified by internal investigators as having engaged in possible misconduct.

The SEC’s complaint follows what is becoming a familiar formula.  It alleges instances of backdating and preparation of false documents and targets those persons who specifically participated in granting the options.  The complaint focuses on two option grants, the first in January 2001 of 4.8 million options to Apple’s Executive Team and the second in October 2001 of 7.5 million options to Apple’s CEO Steve Jobs.  According to the complaint, in both instances Ms. Heinen caused Apple to backdate the options and directed her staff to prepare documents to reflect the new date.  For the October options, the SEC alleges that Ms. Heinen signed fictitious board minutes for a special meeting that did not occur.  The complaint alleges that Mr. Anderson should have realized the implications of Ms. Heinen’s actions, failed to disclose key information to Apple’s auditors and neglected to ensure that the financial statements were accurate.  While Ms. Heinen has vowed to fight, Mr. Anderson settled with the SEC without admitting or denying the allegations and will pay over $3 million in disgorgement, prejudgment interest, and fines.  Anderson avoided an officer and director bar and disqualification from practicing before the Commission. Citing the company’s full cooperation, the SEC is not pursuing an action against the company.  The SEC release does not state that its investigation is continuing as is typical, perhaps suggesting that its inquiry is at an end.  The San Jose Mercury News reported earlier this week that Apple CEO and high tech rock star Steve Jobs who many think is Apple would not be charged criminally. 

Putting this case together with the handful of earlier SEC actions in this area suggests the parameters of liability being used by the agency.  In Apple, as in earlier cases, there are allegations of false documents and a cover-up – the kind of acts that support scienter.  In Apple, as in earlier cases, the named defendants are alleged to have been directly involved in the issuance of the backdated options.  In Apple, as in earlier cases, the company was not named nor were those outside the options issuance process. 

Perhaps the only deviation from earlier cases is the negligence based allegations against Mr. Anderson claiming that he “should have known” the implications of what was going on.  Not an unreasonable charge against a CFO but it is interesting that the SEC chose not to allege fraud.  Equally interesting is the fact that the SEC did not seek an officer/director bar against Mr. Anderson as has become its customary practice, although he has retired.  A press release issued by Mr. Anderson suggests that the SEC will also forgo its usual Rule 102(e) action to bar him from practicing before the agency which, given the consent decree he executed, is virtually automatic.  Nevertheless, Mr. Anderson was the CFO of the company at the time, was involved in the transactions according to the complaint, and was identified by internal investors as possibly a culpable person.  Thus, this case seems to fit within the pattern of earlier cases suggesting that in the future the SEC will focus on those directly involved in bringing options backdating cases where it finds clear evidence of scienter such as falsified documents and cover ups.

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Enforcement Chief Linda Thomsen, in an April address before the Mutual fund Directors Forum, called for a spirit of cooperation between independent directors at mutual funds and the SEC, citing a speech by the First Chairman of the SEC, Joseph Kennedy.  Specifically, Ms. Thomsen noted that, in her view, good corporate citizenship should be viewed from a cooperative prospective.  To amplify her thoughts she revisited the SEC’s 2001 Seaboard Report, which discusses cooperation standards.  Under that Report, according to Ms. Thomsen, the four key points considered in determining whether a sanction should be imposed on a company and if so to what extent are:  1) self-policing, 2) self-reporting, 3) remediation, and 4) cooperation with law enforcement.  Ms. Thomsen chose two specific examples to illustrate her point.  The first was an action involving Putnam Fiduciary Trust Co., where the SEC elected not to bring an enforcement action against the company, but only against the individuals.  The Commission’s decision was based on Putnam’s conduct, including that it self-reported, conducted an independent internal investigation, shared the results of that inquiry with the government, terminated and otherwise disciplined those employees involved, made full restitution and implemented new controls.  An enforcement action was brought, however, against the individuals involved.  SEC v. Karnig H. Durgarian, Jr. et al, Litigation Release No. 19517 (Jan. 3, 2006),    

In her second example, the SEC decided that the facts and circumstances warranted bringing an action against the firm.  In that case, however, the SEC elected not to seek disgorgement against OppenheimerFunds, Inc., prejudgment interest or a penalty in view of the company’s cooperation.  There the cooperation included an independent investigation of the company’s revenue sharing practices, reporting on those practices to the fund boards, and the company determining that payment should be made to the funds, and voluntary reimbursement to the funds in an amount that exceeded the actual benefit the company received from the fraudulent practices.  Yet, unlike the first example, the cooperation did not include sharing privilege information with the Commission.  In re OppenheimerFunds, Inc and OppenheimerFunds Distributor, Inc., Investment Company Act Release No. 27065 (Sept. 14, 2005.), 

Ms. Thomsen’s call for cooperation between the SEC and the companies it regulates is reminiscent of the tone evoked in the McNulty Memo, which is DOJ’s revision of the highly criticized cooperation standards in the predecessor Thompson Memo.   Unfortunately Ms. Thomsen did not offer any specific clarification of the Seaboard Report and its factors, which suffers from many of the same flaws as the Thompson Memo.  

At the same time however, careful analysis of  Ms. Thomsen’s remarks in the context of the cases she cited are a cause for real concern by any issuer considering cooperating with the SEC.  Previously, the Seaboard Report has been heavily criticized for contributing to the so-called “culture of waiver,” referring to the fact that under DOJ and SEC cooperation standards most companies and their counsel concluded that they must waive fundamental rights in order to have any opportunity to be viewed as cooperative.   Ms. Thomsen and the SEC staff have repeatedly denied that waiver is a requirement of cooperation.   

In a January 2007 letter to the SEC, however, the ABA requested reform of the Seaboard Report.  The SEC has been silent on the ABA’s request and others to reform Seaboard – seemingly until Ms. Thomsen’s speech.  Analysis of the examples cited by Ms. Thomsen in her speech suggests that the critics are correct – cooperation equals waiver, at least if the company is seeking non-prosecution.  In the Putnam case, one of the cooperation factors cited by the SEC in its Litigation Release is the waiver of privilege.  SEC v. Karnig H. Durgarian, Jr. et al, Litigation Release No. 19517 (Jan. 3, 2006),  In contrast, in the Oppenhemier case there is no reference to waiver.  In the Putnam case, the company was not prosecuted, according to Ms. Thomsen, because of its cooperation, although she failed to mention the privilege waiver.  In the Oppenheimer case, the company did not waive privilege, a fact also not mentioned by Ms. Thomsen.   

The Seaboard Report is consistent with the examples cited by Ms. Thomsen.  At the beginning of the Seaboard Report the SEC gives an example of cooperation from the underlying case.  In the example, the company, like Putnam, was not prosecuted and waived privilege.  In contrast Oppenheimer’s cooperation saved the company from having to pay a penalty (likely because it already paid restitution, disgorgement by the SEC would seem inappropriate) but without the privilege waivers the company was not spared prosecution.  While the Commission refuses to properly define what each of the Seaboard factors requires, after considering Ms. Thomsen’s speech the true price of cooperation could not be clearer:  Cooperation may not, as the staff frequently says, require waiver – unless the company is seeking non-prosecution.  

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