Brocade backdating options

In connection with announcing the charges, SEC chairman Christopher Cox stated that “options backdating strikes at the heart of investor confidence in our capital markets [and] . An immediate risk facing some companies under investigation is the potential restatement of historical financial statements resulting from the failure to record compensation expense with any backdated options.Under the long-standing APB 25 accounting standards (which have been superseded by FAS 123R), compensation expense for option grants needed to be recorded only if the exercise price was less than the fair market value of the underlying stock at the date of the option grant – so-called discount options.

Accounting errors of this type may also give rise to a finding of a material weakness in a company’s internal controls, as well as possible forfeitures of option profits under Section 304 of Sarbanes-Oxley.

At least one company has already disclosed a “significant deficiency” in its internal controls as a result of its backdating practices.

However, prior to reviewing the litany of potential legal issues, we think it is important to draw a line (similar to that drawn in GAAP between “errors” and “irregularities”) between circumstances involving serious legal/governance issues and technical noncompliance issues that many, if not most, companies will confront when reviewing their historical option grant practices.

From our perspective, the key question (and distinguishing characteristic) between technical errors and more serious issues is whether the board of directors or the compensation committee knowingly approved the terms of stock option grants and the prices at which the options were exercisable.

Therefore, if an option was backdated, a company may have improperly failed to record compensation expense, which may require it to restate historical financial statements.

A number of companies under investigation have already announced that they will be restating historical financial statements.

Although many of the alleged abuses under investigation took place prior to the Sarbanes-Oxley requirement that option grants be reported within two business days after grant and prior to the implementation of FAS No.

123R, Share-Based Payment (requiring companies to expense the grant-date fair value of all stock options rather than just those granted below fair market value), we believe the procedures outlined in this Commentary continue to provide relevant guidance to public companies today.

Finally, discount options cannot qualify for the favorable tax treatment provided for incentive stock options.

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