Sunday, May 7, 2006

Options Timing Probe Turns Criminal, So Will the Privilege Waivers Start Flowing?

The probe into whether corporate executives backdated documents to permit stock options grants to have a lower exercise (or strike) price, thus increasing the value of the options for them, has now turned criminal with the disclosure by Comverse Technology, Inc. that it has received a federal grand jury subpoena.  The company's CEO, CFO, and Executive VP all resigned over the issue, and near the very end of an 8-K (here) it rather blandly notes, "On May 2, 2006 the Company received a subpoena from the United States Attorney's Office for the Eastern District of New York in connection with the issuance of stock option grants between 1995 and the present. The Company intends to fully cooperate with the United States Attorney in responding to this subpoena."  It's not clear why the Brooklyn U.S. Attorney's Office has started an investigation rather than the Southern District, but that is likely a turf battle we won't learn much about.

Another company also disclosed that two of its senior executive resigned over backdating documents related to options grants.  Power Integrations Inc. announced (here) that its chairman (and former CEO) and CFO resigned after an internal investigation revealed the following:

The special committee has reached a preliminary conclusion that the actual dates of measurement for certain past stock option grants differed from the recorded grant dates for such awards. As a result, the company expects to record additional non-cash charges for stock-based compensation expenses in prior periods. Based on the special committee's preliminary conclusion, the company expects that such non-cash charges will be material and that the company may need to restate its historical financial statements for each of the fiscal years 1999 through 2004, and for the first three quarters of the fiscal year ended December 31, 2005.

A significant topic in the white collar crime world lately has been the issue of waiver of the attorney-client privilege and work product protection related to a corporation's internal investigation.  Comverse Technology asserts that it will cooperate fully, and it is likely that federal prosecutors will seek (or demand?) a waiver of the confidentiality protections during the course of the investigation.  The question will be how soon the request comes, if it hasn't been made already.  The Thompson Memo remains an important consideration in any corporate investigation, and with all indications that the options timing situation is now a criminal probe, the waivers may start flowing shortly.  It will be interesting to see if any company refuses because it has determined that there was no wrongdoing and therefore no need to cooperate in the investigation beyond responding to grand jury subpoenas.

Regarding the substance of the investigation, the interesting issue will be whether the conduct itself is a violation of the antifraud provisions of the federal securities laws.  While backdating documents is likely a violation of the recordkeeping requirements, it may be a stretch to say that timing an options grant to make them more valuable is a scheme to defraud when the grant itself is authorized by the company and the effect of the conduct is to lower the tax deduction the corporation can claim.  The timing issue likely will require companies to restate their financial statements, but the amounts are likely to be relatively small so that an argument could be made that it is immaterial.  It is surely more than a little unseemly for well-compensated executives to play a timing game to increase their compensation through stock options, and likely a breach of their state law fiduciary duty, but whether it is a securities fraud remains to be seen.  (ph)

Fraud, Investigations | Permalink

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What a bias you display by wondering why not the SDNY! With the company located in Massachusetts, the better question is why not that district? The EDNY has a long history of doing corporate and securities fraud prosecutions, many of which you yourself have written about.

Posted by: Anonymous | May 7, 2006 12:48:18 PM

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