THE OPTIONS SCANDAL: SEC AND PRIVATE ENFORCEMENT TRENDS

REED R. KATHREIN, Partner HAGENS BERMAN SOBOL SHAPIRO LLP

EEIs ANNUAL SEC ENFORCEMENT INSTITUTE Effective Compliance Strategies in an Era of Stepped-Up Enforcement! May 22-23, 2007 New York June 27-28, 2007 Chicago

Reed R. Kathrein
11 years defended corporations 19 years sued corporations for securities fraud 1994 2004 Partner and founder of San Francisco office of Milberg Weiss 2004 2006 Partner in Lerach Coughlin 2007 Partner and founder of San Francisco Office of Hagens Berman

Background
Between 140 and 170 companies have been investigated over the last year for options backdating. Estimates are that the scandal is costing public companies over $5 billion in market capitalization. Now, with technology available for the first time, the SEC and the private plaintiffs bar are looking at spring loading options. Learn from one of the attorneys who has been close to the issues what is happening, and where enforcement is going.

Will the plaintiffs bar jump into the spring loading cases too?

Definitions
Options backdating is the practice of granting an employee stock option that is dated prior to the date that the company actually granted the option. Bullet dodging - delaying an options grant until just after bad news Spring-loading - timing an options grant to precede good news Symmetric spring-loading - where members of the board who approve the grant are aware of the forthcoming good news Asymmetric spring-loading - where members of the board who approve the grant are unaware of the forthcoming good news

Nefarious But Legal?

Granting in-the-money options is not illegal, so long as:
you account for it properly, it is allowed under the stock option plan, you disclose it, and pay your taxes.

Backdating is to pretend that youre not granting in-the-money options when in fact you are.

Violate SOPs
Almost always be violating the terms of the SOP approved by shareholders. SOPs almost always require that the options be granted at fair market value on the date of the grant. If not in SOP would have to make disclosures like:
Please note that when we grant options, we sometimes pretend that we grant them on certain dates when in fact we grant them weeks later. Not to worry, though. We just do this to amuse ourselves, because we account for them properly using the real dates. Roger Parloff ,Senior Editor (Legal Affairs) FORTUNE

Bad Apple
GC Nancy Heinen emailed CEO Steve Jobs a spreadsheet on January 30, 2001. Noted that it was a bad idea to choose a grant dateeven though that was the day the stock had been at its lowestif they wanted:
to avoid any perception that the Board was acting in appropriately [sic] for insiders prior to Macworld announcements.

Instead they chose the next lowest after Macworld.

History
David Yermack, a New York University finance professor, in 1995 studied data that companies were obligated to publish, under a 1992 SEC decree, the exact dates of options grants in proxy statements. Previously, dates were disclosed within often ignored filings. He found a pattern that the stock prices often declined in value just prior to the options grant and rose afterwards.

He theorized these were timed to precede good news and follow bad news.
In 1997, his findings were published in the Journal of Finance. Finance professors David Aboody of UCLA and Ron Kasznik of Stanford followed with a study of companies that grant options at the same time every year and found a similar pattern, indicating timing of news.

Eric Lie
Finance professor Erik Lie of the University of Iowa in 2004 noted that many options grants were timed to exploit marketwide price depressions that nobody, including insiders, could predict leading to the conclusion that at least some of the grants must have been retroactive. His mid-2005 research first suggested that hundreds of companies may have routinely manipulated stock- option accounting rules to sweeten top executives' paydays. A later study done with his research partner, Indiana University associate professor Randall Heron, puts the number at 2,000, or 29% of all public corporations. Lie helped make sure the scandal exploded, notifying the Securities & Exchange Commission of his work and showing The Wall Street Journal how to interpret a particular company's options records, although he insists he never I.D.'d companies himself.

SEC Begins Looking

Suspecting such patterns aren't due to chance, the Securities and Exchange Commission began examining whether some option grants carry favorable grant dates for a different reason: They were backdated. Before the Sarbanes-Oxley Act of 2002, companies did not have to report option grants until 45 days after the end of the fiscal year in which they were granted, which provided firms a significant window of time to retroactively match grant dates with share lows. Companies now are required to file Form 4 reports on option grants within two business days of the grant date, which limits opportunities for backdating. Cant hide any longer.

Mercury Interactive
The SEC started looking at Mercury Interactive Corp., a Mountain View, Calif., software maker. CEO and two others resigned late 2005.

Internal probe found 49 cases where the reported date of options grants differed from the date when the options appeared to have been awarded. The company said it would have to restate financial results.

Analog Devices
Analog Devices Inc. admits reached a tentative settlement with the SEC late 2005. It neither admitted nor denied that it had misdated options or had made grants just before releasing good news that would tend to push up the stock. Agreed to pay a $3 million civil penalty and re-price some options. CEO Jerald Fishman tentatively agreed to pay a $1 million penalty and disgorge some profits.

Perfect Payday
Wall Street Journal reporters Charles Forelle and James Bandler, along with Journal reporters Mark Maremont and Steve Stecklow,write The Perfect Payday--Some CEOs reap millions by landing stock options when they are most valuable. Luck -or something else". The first article was published in the WSJournal in March 2006. Exposed widespread practice of secretly backdating stock options grants to benefit corporate insiders Based on material provided to the Journal by Lie. Honored by the Pulitzer committee with Pulitzer Prize top honor for public service reporting in April 2007.

The Perfect Payday Buy Low

William McGuire UnitedHealth Group, chairman and chief executive Total grants: 12 Odds: At least 1 in 200 million

The Perfect PaydayBuy Low

Robert Therrien Brooks Automation, former chief executive Total grants*: 7 Odds: About 1 in 9 million

The Perfect PaydayBuy Low

Timothy Main* Jabil Circuit, president and chief executive Total grants: 6 Odds: About 1 in 1 million

The Perfect Payday Buy Low

Jeffrey Rich Affiliated Computer Services, former chief executive Total grants: 6 Odds: About 1 in 300 billion

The Perfect PaydayBuy Low

Louis Tomasetta Vitesse Semiconductor, president and chief executive Total grants: 9 Odds: About 1 in 26 billion

The Perfect PaydayBuy Low

Kobi Alexander Comverse Technology, chairman and chief executive Total grants: 8 Odds: About 1 in 6 billion

WSJ Keeps Story Alive

The Perfect Payday: CEOs Reap Millions by Landing Stock Options When They Are Most Valuable--March 18 How the Journal Analyzed Stock-Options Grants--March 18 Five More Companies Show Questionable Options Pattern--May 22

At HealthSouth, an Options Issue--May 31

Monster Worldwide Gave Officials Options Ahead of Share Run-Ups--June 12 During 1990s, Microsoft Practiced Variation of Options Backdating--June 16 Executive Pay: The 9/11 Factor--July 15 Setting the Date: How One Tech Company Played With Timing of Stock Options--July 20

WSJ Flags 26 May 24, 2006

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

Affiliated Computer Services Altera Boston Communications Group Brooks Automation Caremark Rx. CNET Networks Comverse Technology F5 Networks Jabil Circuit Juniper Networks KLA-Tencor

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

Mercury Interactive Openwave Systems Nyfix Power Integrations Sycamore Networks Quest Software Renal Care Group RSA Security SafeNet Semtech Trident Microsystems

12.
13.

Meade Instruments
Medarex

12.
13.

UnitedHealth
Vitesse Semiconductor

WSJ Options Score Card

About 126 companies that have disclosed government probes, misdated options, restatements and/or executive departures. http://online.wsj.co m/public/resources/ documents/infooptionsscore06full.html

200 Companies Have Announced Internal Investigations

SEC and DOJ Action

Division of Enforcement is investigating over 140-170 matters relating to potential abuses of employee stock options. The investigations are being conducted by SEC offices throughout the country and are being centrally coordinated and tracked in Washington.

Substantial criminal interest in options matters from United States Attorneys' Offices nationwide.
SEC has brought several enforcement actions one relating to Brocade and another involving Comverse. With respect to both, there are pending parallel criminal actions as well. Most recently the SEC filed an action against Apple. .

Non-Enforcement Efforts
SEC adopted rules relating to executive compensation disclosure which specifically address options. These rules, in combination with the Sarbanes-Oxley requiring timely reporting of stock option grants, will go a very long way toward preventing. In September 2006 the Office of the Chief Accountant issued guidance for companies trying to cope with the financial reporting ramifications of their various historical options practices from a reporting perspective.

New Comp Disclosure (1)

SEC unanimously adopted final rules July 26 on the disclosure of executive and director compensation--including on stock option grants. Specifically, the rule would require disclosure of the timing of option grants in coordination with the release of material nonpublic information (spring-loading), and the selection of exercise prices that differ from the underlying stocks price on the grant date. Some of the required disclosure will include clear tabular presentations of option grants including: the fair value on the grant date, as spelled out by Financial Accounting Standards Statement 123R; the closing market price on the grant date if it is greater than the exercise price of the award; and the date the compensation committee or full board took action on the award if that date is different than the grant date. Further, if the exercise price of an option grant is not the closing market price on the grant date, the rules will require a description of the methodology for determining the exercise price. The MD&A section also will require enhanced narrative disclosure of grants to executives.

New Comp Disclosure (2)

With regard to the timing of option grants, companies will have to answer questions, such as:
Does a company have any program, plan, or practice to time option grants to its executives in coordination with the release of material non-public information? How does any program, plan, or practice to time option grants fit in the context of the companys program, plan or practice, if any, with regard to option grants to employees more generally? What was the role of the compensation committee in approving and administering such a program, plan, or practice? How did the board or compensation committee take such information into account when determining whether and in what amount to make those grants? Did the compensation committee delegate any aspect of the actual administration of a program, plan, or practice to any other persons? What was the role of executive officers in the companys program, plan, or practice of option timing?

Does the company set the grant date of its stock option grants to new executives in coordination with the release of material non-public information?
Does a company plan to time, or has it timed, its release of material non-public information to affect the value of executive compensation?

Trends in Enforcement--SEC
SEC currently has about 140-170 investigations into stock option backdating. Many more companies have derivative actions filed against them for options backdating issues. Some of these investigations have since been closed with no enforcement action, but many are still open. The Commission has filed five to ten options backdating cases thus far.

In determining whether to recommend such an enforcement action, the SEC staff considers the degree of scienter of the individuals involved, the amount of harm, and the personal benefit to those who were directing the activity.
The Commission is likely to continue bringing options backdating cases where either conduct was egregious or criminal, or the case involves unique facts that may convey an important message. Some cases are more attractive to criminal prosecutors than others. Some companys options backdating problems do not rise to the level of fraud. They may the result of sloppy administration or record-keeping. While there might be accounting consequences, this is not fraud.

Trends in Enforcement--DOJ
U.S. Attorneys are interested where:
Bottom of the V in-the-money options were granted;

Magnitude of the fraud is large.

Managers remain; No steps to prevent it from recurring.

DOJ Actions
The Justice Department filed criminal charges in summer of 2006 against former executives at
Comverse Technology Inc. Brocade Communications Systems Inc.

Apple Enforcement Action

Key question: What standard prosecutors will use when exercising their broad discretion to charge? On April 25, 2007, 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 Apples 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) http://sec.gov/litigation/litreleases/2007/lr20086.htm

These are the two persons identified by internal investigators as having engaged in possible misconduct.

Apple Enforcement Action

The SECs 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.

two option grants, the first in January 2001 of 4.8 million options to Apples Executive Team and the second in October 2001 of 7.5 million options to Apples CEO Steve Jobs.
in both instances Ms. Heinen caused Apple to backdate the options and directed her staff to prepare documents to reflect the new date. Ms. Heinen signed fictitious board minutes for a special meeting that did not occur. Mr. Anderson should have realized the implications of Ms. Heinens actions, failed to disclose key information to Apples auditors and neglected to ensure that the financial statements were accurate.

Settlements-Comverse
WSJonline-5/9/2007
Comverse-The maker of telecom software said May 4 that it received a subpoena from the U.S. attorney's office for the Eastern District of New York, indicating a criminal investigation of stock-option-granting practices. CEO Kobi Alexander, as well as the company's CFO and senior general counsel, resigned just days earlier. In April, the company said some option-grant dates used in its accounting "differed" from the actual grant dates, and that it would restate more than five years of financial results. On Aug. 9, the former CEO, CFO and general counsel were charged with criminal fraud. On Sept. 27, Alexander, who failed to show up in court and was declared a fugitive by the FBI, was found in Namibia, and was set to be extradited to the U.S. On Oct. 24, ex-CFO Kreinberg pleaded guilty to securities-fraud charges in federal court, making him the first person to plead guilty in the backdating scandal. On Nov. 2, 2006 former general counsel William F. Sorin pleaded guilty to a conspiracy charge. On Jan, 10, 2007, it was announced that Sorin will pay $3 million to settle an SEC lawsuit over stock-option grants.
http://online.wsj.com/public/resources/documents/info-optionsscore06-full.html

Settlements-Take Two
WSJonline-5/9/2007 Take Two-The New York entertainment software company disclosed on July 10, 2006 that the SEC opened an informal investigation into stockoption grants dating back to January 1997. Take-Two said it plans to fully cooperate and also is conducting its own investigation. The company said on Aug. 31 that it has received additional grand-jury subpoenas requesting documents regarding stock options, compensation and expenses. On Dec. 11, the company said an independent investigation found improprieties in the process, and it will need to restate its historical financial results to record charges for compensation expense related to option grants. On Jan. 21, 2007, the company accused former Chairman and Chief Executive Ryan Brant of backdating stock options spanning a six-year period. On Feb. 14, 2007, Mr. Brant pleaded guilty to a false filing charge, agreeing to pay $7.3 million in disgorgement, interest and penalties in connection with the New York criminal case and a SEC civil probe. Brant agreed to settle the SEC probe without admitting or denying wrongdoing.
http://online.wsj.com/public/resources/documents/info-optionsscore06-full.html

Settlements-ESSI
WSJonline-5/9/2007

ESSI-Parsippany, N.J., military contractor DRS announced on June 12 that it has been advised by the SEC and the U.S. Attorneys office that each is investigating possible backdating of option grants at recently acquired ESSI, prior to DRS's acquisition of the company, a supplier of logistics and maintenance support. DRS said the U.S. Attorneys office has advised DRS that it considers DRS to be a witness, not a subject or target of its investigation. On Feb. 6, 2007, the SEC filed civil charges against two former executives ESSI, accusing them of participating in a six-year options backdating scheme in which they granted in-the-money options to themselves and other executives. Steven Landmann, the former controller, agreed to settle the charges by paying $886,557 and accepting a bar on serving as an officer or director of a public company and a ban on practicing before the SEC as an accountant. Ex-CFO Gary Gerhardt hasn't settled with the SEC.
http://online.wsj.com/public/resources/documents/info-optionsscore06-full.html

Settlements-Apple
WSJonline-5/9/2007 Apple-On Aug. 3, 2006, the Cupertino, Calif., computer maker said it will delay filing quarterly results and will likely restate past results after discovering more "irregularities" as part of an internal probe of stock-option grants going as far back to 1997. In June, Apple said "one of the grants in question" was made to CEO Steve Jobs. On Oct. 4, the company said its internal investigation had found Jobs was aware of options backdating but didn't benefit from the practice. Director Fred Anderson, who served as the company's chief financial officer from 1996 until 2004, resigned from its board of directors. Apple said Dec. 29, 2006 that CEO Jobs had recommended the selection of some favorable stock-option grant dates, but didn't personally benefit. It also said it will restate financial data going back to 2002 and take an $84 million charge. On April 24, 2007, the SEC filed civil charges against Apple's former general counsel, Nancy Heinen, and former CFO Fred Anderson for their alleged involvement in backdating of stock options at Apple. Mr. Anderson settled the charge with the SEC without admitting wrongdoing.
http://online.wsj.com/public/resources/documents/info-optionsscore06-full.html

Winding Down?
On April 25, 2007, Reuters reported that SEC Chairman Christopher Cox expects to wrap up many of its stock options dating cases within weeks. We are working on procedures to move many of the cases very quickly, Cox said, adding their resolution would be within weeks.

Rueters reported that Mr. Cox gave no indication of whether the options cases would be resolved through settlements, lawsuits or a combination of both.
Mr. Cox added that the SEC would like to put the option backdating scandal behind them, noting that such conduct will not likely continue in todays environment. Mr. Cox did not elaborate on what process the SEC is likely to use.

Securities Fraud Class Actions

29 Securities Class Actions as of April 2007
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29.

American Tower Corp.05/26/2006USDC - D. Mass.Amkor Technology11/21/2006USDC - E.D. Pa. Apollo Group11/02/2006USDC - D. Ariz Apple Computer, Inc.08/25/2006USDC - N.D. Ca Aspen Technology09/08/2006USDC - D. Mass Broadcom Corp.08/13/2006USDC - C.D. Cal Brocade Communications Systems, Inc.05/19/2005USDC N.D. Cal. Brooks Automation, Inc.06/19/2006USDC - D. Mass. Comverse Technology, Inc.04/19/2006USDC - E.D.N.Y. Hansen Natural Corporation11/29/2006USDC - C.D. Cal. HCC Insurance Holdings, Inc.03/08/2007USDC - S.D. Tex. Jabil Circuit, Inc.09/19/2006USDC - M.D. Fla. Juniper Networks, Inc.07/17/2006USDC - N.D. Cal .KLA-Tencor Corp.06/29/2006USDC - N.D. Cal .Marvell Technology Group10/06/2006USDC - N.D. Cal. Meade Instruments, Inc.09/27/2006USDC - C.D. Cal .Mercury Interactive Corp.08/19/2005USDC - N.D. Cal. Michaels Stores, Inc.09/06/2006USDC - N.D. Tex.Monster Worldwide, Inc.03/15/2007USDC - S.D.N.Y. Openwave Systems Inc.02/21/2007USDC - S.D.N.Y .Quest Software10/27/2006USDC - C.D. Cal. Rambus, Inc.07/17/2006USDC - N.D. Cal. Safenet, Inc.08/01/2006USDC - S.D.N.Y. Sunrise Senior Living01/16/2007USDC - D.D.C .UnitedHealth Group, Inc.05/05/2006USDC - D. Minn .Vitesse Semiconductor Corp.05/02/2006USDC - C.D. Cal .Witness Systems, Inc.08/15/2006USDC - N.D. Ga. Wireless Facilities, Inc.03/19/2007USDC - S.D. Cal .Zoran Corp.08/10/2006USDC - N.D. Cal.

Shareholder Derivative Actions

157 Shareholder Derivative Actions filed.
1. Actel 2. Activision 3. Adobe Systems 4. Affiliated Computer Service 5. Affymetrix 6. Agile Software 7. Alkermes 8. Altera 9. American Tower 10. Amkor 11. Analog Devices 12. Apollo Group 13. Apple 14. Applied Micro Circuits 15. Arthrocare 16. Aspen Technology 17. Asyst 18. Atmel 19. Autodesk 20. Barnes and Noble 21. BEA Systems 22. Bed Bath and Beyond 23. Biomet 24. Black Box 25. Blue Coat 26. Boston Communications Group 27. Broadcom 28. Brocade Communications 29. Brooks Automation 30. CA, Inc. 31. Cable Vision Systems 32. Cardinal Health 33. Caremark Rx 34. Ceradyne 35. Cheesecake Factory 36. Children's Place Retail Stores 37. Chordiant Software 38. Cirrus Logic 39. Cisco Systems 40. Clorox 41. CNET Networks 42. Coherent 43. Computer Sciences Corp.

Claim directors and officers breached their fiduciary obligations by backdating options or otherwise manipulating grant dates to maximize executive pay.

ERISA Actions
5 ERISA or 401(k) Cases
1. United Health Group 2. Affiliated Computer Services 3. Analog Devices 4. KB Homes 5. The Home Depot

Its Not Over

18.9% of unscheduled, at-the-money option grants to top executives during the period 1996-2005 were backdated or otherwise manipulated. 23.0% before the new two-day filing requirement took effect on August 29, 2002. 10.0% afterward. 19.9% for grants not filed within the required two-day window. Higher frequency of backdating among tech firms, small firms, and firms with high stock price volatility. Firms that use smaller (non-big-five) auditing firms are more likely to file their grants late. 29.2% of firms manipulated grants to top executives at some point between 1996 and 2005.
What fraction of stock option grants to top executives have been backdated or manipulated?, Randall A. Heron and Erik Lie, July 14, 2006

Its Not Over

First Options Backdating; Now Options Springloading? Springloading is when a company purposely:
schedules an option grant ahead of expected good news or delays it until after it discloses business setbacks likely to send shares lower.

Its Not Over

Call for more information. Reed R. Kathrein Partner Hagens Berman Sobol Shapiro LLP San Francisco, CA Telephone: (415) 896-6300 Fax: (415) 896-6301 Email: reed@hbsslaw.com