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.  

December 12, a WSJ article focused on another manipulation technique relating to the stock option backdating scandal:  avoiding paying income taxes.  See How Backdating Helped Executives Cut Their Taxes, Evidence Suggests Recipients Of Some Stock-Option Grants Manipulated Exercise Dates, By Mark Maremont and Charles Forelle.  The article suggests that an SEC economist, David Cicero, believes that there is “strong statistical evidence” that companies not only backdated stock options, but also manipulated the options’ exercise dates to avoid paying certain income taxes.  Generally under IRS rules, executives pay ordinary income tax [up to 35%], as well as payroll taxes, on any profit made when they exercise options and sell the resulting shares, i.e., the difference between the stock’s value as exercised and its strike price, the fixed purchase price set when the option was issued.  However, if the executives holds the shares, meaning they exercised their options but do not sell the shares for at least a year, they will pay only capital-gains tax [15%] on any profit. 

The WSJ article gives the following example:  Consider an executive who holds options on 100,000 shares with a strike price of $10. If he exercises and sells when the price is $20, he realizes $1 million in income and must pay $350,000 in income taxes.  If he instead can claim an exercise price of $16, he lowers his income tax to $210,000. If he then sells a year later and the stock is at the same price of $20, he pays $60,000 in capital-gains levies, for a total tax bite of $270,000. In other words, he has the same $1 million gain but saves $80,000 in taxes. The problem arises if the executive misrepresents when the exercise occurred to claim a lower exercise price. 

The article does acknowledge that without access to individual income tax returns it is difficult to assess which executives may have engaged in this conduct.  Also, the article does not assume that the practice was as wide-spread as option backdating.  Regardless of these limitations, however, the possibility that such conduct occurred should give executives and companies pause and provide yet another avenue to review when considering past practices.