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A Primer on the Option-Grant Scandal

From Standard & Poor's RatingsDirect

In the past several months, stock-option granting practices have come under significant scrutiny as questions have arisen regarding the propriety of the timing of those grants and the manner in which their strike price was set.

The issues came to light because of a study commissioned by The Wall Street Journal, which identified highly unusual timing of executive stock-options grants occurring shortly before a significant increase in share prices or coinciding with what appears to be abnormally low share-price levels. The study indicated the probability of these observations occurring on a random basis, for the companies identified, is extremely low, ranging from 1 in 800,000 to 1 in 100 million.

The issue has gained momentum in the past few weeks as the Securities and Exchange Commission, the Justice Dept., and the Internal Revenue Service have initiated investigations into stock-option granting practices while the Journal also expanded its study, resulting in identification of several more companies.

Here, Standard & Poor's Ratings Services attempts to answer investors' questions about the option-grant controversy and its potential impact on rated companies:

What are the issues?

It is alleged that several companies have made awards of stock options to senior executives with exercise prices set at artificially low levels by permitting the backdating of the grant to points when the company's shares traded at lower levels -- in some cases, at lows for the year. Backdated grants can seemingly guarantee large payouts to executives and misalign, rather than align, their interests with those of the company's shareholders and other stakeholders.

Although the SEC has been looking at stock-option granting practices for some time, the recent studies commissioned by the media and several ensuing studies performed by other researchers have publicly identified more companies with likely backdating issues -- underscoring the potential for this issue to be much more prevalent and pervasive, and to extend well beyond the handful of companies identified initially. Generally, companies named in these studies soon thereafter became subject to inquiries and informal investigations by regulators. Several have embarked on their own internal investigations, and some have already resulted in the departure of top-ranking executives.

Is backdating illegal?

Backdating is not illegal per se -- but if a company backdates an option for financial gain and fails to disclose it, the company could face allegations that it acted fraudulently and may have to restate its financial statements to rectify the disclosure omission. In addition, backdating raises issues related to prudent governance, alignment of stakeholder interests, and adequacy of internal controls.

Furthermore, for many companies, backdating may be explicitly prohibited by the plan's charter or the company's bylaws and could result in a loss of valuable tax deductions. The purportedly questionable ethics involved do not go unnoticed by Standard & Poor's analysts, and are closely evaluated and considered in conjunction with our evaluation of management, the culture of companies, the integrity of their executives, and the board's oversight posture, which are evaluated as part of the analysis of the issuer's credit quality in general.

What are the disclosure requirements?

The Sarbanes-Oxley Act of 2002 (SarbOx) brought a change to the disclosure requirements with regard to the timing of granting and exercising of stock options. Under Section 403 of SarbOx, both option grants and option exercises must be reported on Form 4 by the end of the second business day following the day on which the transaction was executed. This change was effective Aug. 29, 2002. The two-day reporting requirement effectively eliminates the backdating issue from this date on. The recent inquiries, however, predominantly involve grants made before the effective date of SarbOx, when grants were reportable within 45 days after the close of the company's fiscal year and exercises were reportable on Form 4 by the 10th day of the month following the exercise.

It is expected that shareholder lawsuits may be filed, and SEC actions be taken, on the grounds of inadequate and misleading disclosures under securities law, as the grants in question may have been priced at dates earlier than those disclosed in the SEC filings.

The wave of recent inquiries also raises the prospects of deficient internal controls over financial statements and disclosures -- raising the possibility of material weaknesses being identified in the company's SarbOx Section 404 opinions. It also fuels further discussion on whether executive interests are truly aligned with shareholder interests and whether executive compensation has been excessive in many instances.

What are the financial-statement and income-tax implications?

The most immediate implication could be companies having to restate prior-year financial statements. Generally speaking, accounting guidelines established when the majority of the options that are the subject of these questionable practices were granted (before the issuance of FAS 123R, Share-Based Payment) allowed companies to not record compensation expense for grants with fixed terms where the strike price of the option met or exceeded the current fair value of the underlying shares at the grant date. Under FAS 123R and its predecessor FAS 123, if this option were selected, the company was required to provide financial-statement disclosure indicating what the income-statement impact would have been had it used the fair-value-based method.

For most companies, the guidance issued by the Financial Accounting Standards Board under FAS 123R explicitly requires companies to expense the fair value of options granted commencing on Jan. 1, 2006 (even those granted at-the-money or at below current price levels). Before that day, this was an alternative that was not extensively used before the financial debacles of the decade, but which was gradually embraced by many companies as a sign of "good citizenship" during the past two years.

Are there alternative plausible explanations for what the Journal study observed?

A compensation committee that granted options immediately following negative news or immediately before positive news could appear to be backdating if the news had a material effect on the company's share value. Grants before positive news raise the possibility that the board acted in possession of material nonpublic information, which raises other concerns. Inadvertent backdating could in theory also represent control weaknesses in record-keeping as well as delinquent approval practices.

In certain cases, boards may have deliberately granted in-the-money options, which might represent an appropriate and prudent decision under certain circumstances. These grants would have been required to be appropriately disclosed and compensation expense recorded in the financial statements. In other cases, scrutiny may have been leveled at executives simply because of the value of the options held, rather than owing to concerns regarding backdating.

Executives might have been granted options over a multiyear period as part of a comprehensive compensation program and the shares might have appreciated in value over that time period. As a result, the executive may now be holding options valued at significant amounts. In these circumstances, one can see the granting program has apparently resulted in doing what was intended, that being for the executive to increase shareholder value over a longer time period.

Standard & Poor's does not believe that the issue of backdating options will have a significant ratings impact given how we take stock-based equity into account in our credit analyses. However, our ratings could yet change as a result of corporate-governance concerns arising from these troubling discoveries or as a consequence of the ensuing investigations, litigation, restatements, or adverse capital-market reactions.

Standard & Poor's Rated Companies Contacted By U.S. Attorney or SEC

(as of May 26, 2006)

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