Monthly Archives: August 2007

Greed, Not Firms’ Well-Being, Was Motive for Backdating

Editor’s Note: This post is from Jesse Fried of Harvard Law School.

The San Jose Mercury News recently published my op-ed piece on the recent criminal conviction of Greg Reyes, the former CEO of Brocade, for securities fraud in connection with options backdating.  The op-ed runs as follows:

Greed, Not Firms’ Well-Being, Was Motive for Backdating

In a recent high-profile trial, former Brocade CEO Greg Reyes was found guilty of criminal securities fraud arising from options backdating.  Many pundits have questioned whether criminal charges were appropriate.  They argue that Reyes, like other CEOs caught in similar scandals, did not personally benefit from backdated options.  According to The Economist, for example, Reyes “made no financial gain from backdating.”  Rather, Reyes–like other backdating CEOs–manipulated option grant dates just to attract talented employees.  But the view that options were backdated solely to benefit the firm, and not to enrich executives, is absurd.

A stock option gives an employee the right to buy the firm’s stock at some point in the future by paying the option’s “exercise” price.  The lower the exercise price, the more likely it is that the option can be exercised profitably and the larger the profit will be.  In almost all employee options, the exercise price is set to the market price on the grant date of the option.  The main reason: Until recently, such options did not have to be recorded as an expense against the firm’s reported earnings.  In contrast, options with a lower exercise price–one below the grant-date price–had to be expensed, just like cash salary or bonus.

Option backdating enabled Brocade and other firms to offer lower-priced options disguised as non-expensed options.  Reyes, with the benefit of hindsight, picked a day when the stock price was much lower than on the actual grant date.  He then pretended that the options were granted on that hindsight-chosen date, and set the option price to that date’s low price.  So Brocade awarded options whose exercise price was below the market price on the true grant date, while accounting for the options as if they had been issued at the grant-date price.  The result: The options were not expensed, boosting Brocade’s reported earnings.  The Reyes jury concluded that this deception constituted securities fraud.

Were Brocade and other companies forced to engage in secret option backdating to recruit top-tier workers?  No.  Had firms wished to openly award lower-price options to their employees, they were free to do so.  To be sure, these options, like the workers’ cash salaries, would have had to be expensed, but that would not have prevented firms from attracting high-quality workers.  Employees care about how much they are paid, not how their compensation affects reported revenues.  No worker has ever turned down a cash bonus because it has to be expensed.

So why, then, did Reyes and other CEOs engage in option backdating?  Because it enabled them to directly and indirectly boost their own pay.  Over a million of Brocade’s backdated options ended up in Reyes’ own hands.  True, the criminal charges against Reyes focused on his backdating of other employees’ options.  But the government’s civil complaint against Reyes shows he also personally received backdated options, including an October 2001 mega-grant of 1.2 million options.  The backdating appears to have lowered the exercise price on the mega-grant by about 50 percent.  This manipulation boosted the value of Reyes’ compensation in 2001 by millions of dollars, none of which was reported to shareholders.

While boosting his actual pay, the backdating of the 2001 mega-grant also enabled Reyes to hide a large amount of his compensation that year.  Brocade disclosed this grant to investors in its 2002 proxy statement, indicating that the exercise price was set to the grant-date market price.  Using this information and a standard formula for calculating option value, analysts tabulating Reyes’ 2001 compensation valued the option grant at $13.2 million.  Had Brocade provided accurate information, the option grant would have been valued at $28 million.  By camouflaging around $15 million of his compensation, Reyes reduced the likelihood that shareholders would find his pay excessive and pressure the board to reduce it.

Even if Reyes had not received backdated options himself, Reyes gained indirectly by backdating other employees’ options.  Much of CEOs’ bonus pay is tied to reported earnings.  So is the price at which executives can unload their stock.  The firm-wide backdating of options jacked up earnings, and the amounts involved were not trivial.  Backdating firms have so far acknowledged over-stating earnings by an aggregate of more than $12 billion.  These inflated earnings, in turn, enabled CEOs like Reyes to fatten their bonuses and increase their profits from selling shares.

The fact that backdating CEOs lined their pockets does not mean that criminal prosecution against them is necessarily warranted; civil liability may be more appropriate.  But one cannot determine the right legal remedy for backdating without a clear understanding of why it occurred: CEOs backdated options to directly and indirectly inflate their own pay, not to benefit their firms.

Editor’s Note: The Reyes case is just one example of the implications of option backdating for firms, regulators, directors, and CEOs.  Lucian Bebchuk, Yaniv Grinstein, and Urs Peyer have described the broader backdating trends in Lucky CEOs and Lucky Directors, which examine the likelihood that CEOs and directors of about 6,000 firms backdated options over a recent 10-year period.  The authors summarized their findings in a December 2006 Financial Times op-ed urging that backdating “deserves all the attention it has been getting and more.”

Leverage and Pricing in Buyouts: An Empirical Analysis

This post is from Michael S. Weisbach of The Ohio State University.

Ulf Axelson, Tim Jenkinson, Per Stromberg, and I have released Leverage and Pricing in Buyouts: An Empirical Analysis, a study of the financings of 153 large buyouts.  The Article gathers a sample of large recent buyouts and considers the impact of a number of factors on their pricing and structure.  The paper presents our findings with respect to the factors that drive buyout dynamics.

We find, for example, that the availability of leverage seems to be an important determinant of prices in buyouts.  In other words, as financial markets have become more lax, historical prices of buyouts have gone up, potentially leading to the boom in buyouts of the last 2 or 3 years.  This finding suggests that, given the crash in the bond market last month, there would be fewer buyouts–and those that do occur will be at lower prices than before.  All of those predictions are consistent with what we are seeing in financial markets now.

Another finding of interest is that “club” deals occur, if anything, at higher prices than otherwise-similar deals that are sponsored by a single private-equity house.  This finding is in contrast to allegations that a reason for “club” deals is to collude on prices.

The full Article is available for download here.

Special Negotiating Committees: If, When, Who, and How

This post is from Charles M. Nathan of Latham & Watkins LLP,.

My colleagues Mark D. Gerstein and Bradley C. Faris of Latham & Watkins have released this Memorandum analyzing whether and when a company should consider empanelling a special negotiating committee when assessing a merger proposal that raises a conflict of interest.  The Memorandum begins by providing critical background for in-house counsel facing the difficult decision whether to convene a special committee to consider the terms of a particular transaction.

The authors then explain why Sarbanes-Oxley, as well as some recent Delaware decisions scrutinizing board processes in connection with going-private deals, should have the general counsel of any corporation thinking seriously about how to manage conflicts of interest in acquisitions–including whether a special committee is needed.  Mark and Bradley conclude:

A board that fails to adequately address conflicts of interest, including in appropriate circumstances by forming a special negotiating committee, risks litigation and personal liability.  An effective special negotiating committee process requires nuanced analysis, strategic planning and careful execution, all things in which, in our experience, general counsels excel.  The general counsel’s participation and support is an essential element to effectively manage the legal and business risks associated with conflict of interest transactions and establish processes that will result in the maximum deference allowed by law from a reviewing court.

The full Memorandum is available here.

Delaying a Merger Vote Under Delaware Law: A New Standard of Review?

This post is from Theodore Mirvis of Wachtell, Lipton, Rosen & Katz.

Someone very famous once said that the common law grinds slowly but exceedingly fine (or something like that).  Someone else once said that when it comes to the stockholder franchise, the grinding can get bumpy.  Yet a third person is reported to have commented that, when you throw in the fact of life that stockholder activists now seem to have the power to affect the outcome of merger votes by holding out for a final bump–and no one can really tell if the activists even own shares in any economic sense–well, that is why God created directors.

But none of that matters.  What matters is what the Delaware courts say about directors’ postponing stockholder votes on mergers, and that subject received some close scrutiny and a thorough–if not intermediate–review in Vice Chancellor Strine‘s recent opinion in Mercier v. Inter-Tel.  The opinion, described briefly in this Memorandum, grapples with what came before on the subject and is certain to be the touchtone for what comes after, as the common law continues to grind–even in August.

SEC Proposes Two Alternatives on Shareholder Access for Director Nominations in the Company’s Proxy

This post is from Theodore Mirvis of Wachtell, Lipton, Rosen & Katz.

Marty Lipton, Andrew Brownstein, Steven Rosenblum, Adam Emmerich, and David Katz have released this Memorandum on the SEC’s recent 3-to-2 vote to issue two alternative proposals on shareholder access to the company proxy for director nominations.  The first proposal would codify the Commission’s view that proposals on proxy-statement access for board nominations are excludable under Rule 14a-8–a position the Second Circuit called into question last year in AFSCME v. AIG–and the second would allow shareholders owning 5% or more of the company’s shares to include in the proxy a proposal to amend the bylaws to allow shareholders to nominate director candidates.

The Memorandum describes in detail the continuing debate over this long-running controversy, and concludes:

Well advised companies are generally very receptive and sensitive to shareholder views and concerns.  These avenues of communication tend to be more constructive than an election contest, and are almost always less disruptive.  Changes in the SEC’s rules that would facilitate more election contests at this time are both unwise and unnecessary, and indeed might only serve to channel the evolving dialogue between companies and their shareholders into a less cooperative and productive framework.

We intend to express our views again to the SEC by providing comments on the SEC’s two alternative rules proposals well in advance of the October 2 deadline.  We encourage others to do the same.

The full Memorandum is available here.

Hands-Off Options

Editor’s Note: This post is from Jesse Fried of Harvard Law School.

Stock options have been at the heart of many of the corporate governance scandals over the last decade.  For example, managers’ ability to choose when to unwind their equity incentives encouraged them to manipulate earnings.  And executive influence over the timing of option grants led to backdating and springloading.  The problem is that executives have had too much control over when stock options are granted and when they are cashed out.

As I discuss in a recent Marketplace Radio commentary, one could substantially reduce managers’ influence over their options through the use of what I call “hands-off” options.  The text and audio of my commentary can be found here.

Since I am writing about “hands-off” options for a symposium piece on executive compensation, any comments would be most welcome.  You can reach me at jfried [at]

Strine Theory

Editor’s Note: This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

The National Law Journal recently published Strine Theory, a detailed profile of Vice Chancellor Leo Strine.  The article, which details both the Vice Chancellor’s courtroom style (including an apparent affinity for the lyrical musings of Elvis Costello) and his contributions to academia (including his time visiting here at Harvard, also covered here and here), is a must-read–especially for those paying close attention to the Vice Chancellor’s recent work in private-equity acquisition cases.  (Those opinions are covered in separate posts here and here.) 

Strine Theory begins:

In a recent hearing about whether a plaintiff’s lawyer could have access to a company’s books and records for his shareholder client, Delaware Court of Chancery Vice Chancellor Leo E. Strine Jr. used song lyrics by Elvis Costello to explain Delaware corporate case law.

The defendant company had formed a special litigation committee to explore another shareholder’s demand for litigation in light of the company’s accounting problems.  Strine referred to the state law standard (Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981)) when he stayed the plaintiffs’ document request until the committee issued its report.

“There’s that Elvis Costello song [lyric], ‘Yesterday’s news is [tomorrow’s] fish and chip paper,'” Strine said.  “There’s a question under Zapata whether special committee recommendations are due deference.”

The hearing illustrated Strine’s sharp-witted courtroom style that melds popular-culture references with a multilayered analysis of corporate law issues.  Strine’s style has attracted attention and admiration from lawyers, but the substance of his recent bench decisions calling for more company disclosure in proposed mergers and acquisitions before a shareholder vote and addressing the subtle points of Delaware corporate law have altered dealmaking.

The full profile is available here.

Corporate Governance Litigation: 2006 Review

This post comes to us from John L. Reed of Edwards Angell Palmer & Dodge.  John has previously posted here.

Directors & Boards magazine recently launched the inaugural edition of its annual report, The Year in GovernanceThe 2007 report provides a comprehensive timeline of key developments and includes articles on a range of subjects, including a report card assessing the SEC’s regulatory activities, a summary of the 2007 proxy season, a “heads up” on the “next big blowup” in securities litigation, a summary of several critical legal rulings in 2006, and a preview of what we can expect in 2007.

My article in the report, Corporate Governance Litigation: 2006 Review, discusses cases clarifying the duty of good faith, the applicability of business-judgment protection for certain controlling-stockholder transactions, the (un)availability of direct claims brought by creditors, and whether a company can turn its back on paying for the defense of its officers and directors to demonstrate cooperation with an ongoing investigation.  In a brief introduction to key developments in 2007, the article also notes that several stock-option backdating cases have survived early motions to dismiss.  The article begins:

Although not a year of Enrons or WorldComs, 2006 was an extremely active year on the securities and corporate governance fronts, and directors of publicly traded corporations faced a variety of significant challenges.  Highlighted by the wide-ranging stock option backdating scandal and a host of legal, accounting, and tax issues, an unprecedented number of companies found themselves in the unwelcome spotlight of the national media, government enforcers–both civil and criminal–and an energized plaintiffs’ bar purporting to represent stockholders.

The full article is available here.

GAO Report on Proxy Advisors: No Smoking Guns

This post is from Broc Romanek of

I know a lot of people have been waiting a long time for the Government Accountability Office’s report on the state of the proxy advisory industry.  The GAO report–which had been requested by two members of Congress–was finally released to the public on Monday.

I guess the big surprise from the report is that there really was not much in the way of surprise.  It appears that the primary purpose of the report was to hone in on Institutional Shareholder Services’s potential conflicts of interest (i.e., taking on both investors and issuers as clients).  But since ISS fully discloses those arrangements–and investors told GAO that they were comfortable with ISS’s practices in this area–ISS’s conflicts of interest proved to not be much of an issue for the report.

Here are some of the “notable” findings in the GAO’s report:

(1) There are over 28,000 public companies worldwide that send out proxy statements–with over 250,000 separate issues. Nice stats to know.

(2) Most institutional investors indicate that they conduct their own due diligence to obtain reasonable assurance that ISS is independent and free from conflicts.  But in many cases, the investors’ diligence consists only of reviewing ISS’s conflict policy.

(3) Proxy advisors may also be conflicted where their owners do other business with issuers and investors (and where the owners of advisory firms serve on boards of other companies).  In my view, this is the real conflict risk that exists in the industry.

(4) A helpful chart on page 13 shows how dominant ISS is within the industry, with more clients than the other 4 proxy advisory firms combined.  I have to admit that I had not heard of Marco Consulting Group before–and it has been around for nearly 20 years.

(5) Many of the investors that GAO contacted said that they do not vote their proxies; they hire asset managers to do that for them.

So what did the GAO miss in its review of the proxy advisory industry?