______________________ 10 th Annual Advanced Course Study/Video Webcast EXECUTIVE COMPENSATION Strategy, Design, Implementation Scott Spector Fenwick &

______________________

10th Annual Advanced Course Study/Video Webcast

EXECUTIVE COMPENSATIONStrategy, Design, Implementation

Scott Spector

Fenwick & West LLPJay Pomerantz

Fenwick & West LLP

June 20, 2007

Option Backdating and Ethics: Who is Responsible, and Who

Could Have Prevented It?

2

The Current Scope of the Problem

■ More than 150 companies under SEC/DOJ investigation

■ Over 80 planned restatements or financial charges announced

■ Criminal and SEC civil charges in several cases

■ Derivative and class actions filed

■ Termination/resignation/indictment of executives involved in option pricing situations

■ IRS document requests (IDR) and tax audits

■ Section 409A Schedule TOs filed

3

Stock option grant practices

■ “Front-Dating” (aka repricing)

Grant date selected on Day 1

Price then declines

A new grant date selected on Day 2

Or, new hire grant is supposed to be issued on date of hire, but is granted at a date after hire date at a lower price

■ “Pool approval”

Comp Committee approves pool of shares on Day 1

Stock not allocated to individuals until weeks or months after Day 1

4


■ Deferral/Bullet-Dodging Management has inside knowledge of bad news and delays

granting options until after announcement of bad news to the market, at a lower price

Or, management elects to “hold” or “defer” large option grants (e.g. to avoid including in dilution calculations)

■ Extended Vesting / Extended Exercise Time Employee option vesting normally terminates on day of

employee termination

Employee typically has three months to exercise vested options after employee termination

Company alters termination date or puts employee on unpaid leave to enable continued vesting or exercise

5


■ Re-loading Granting an employee a certain number of options, and

then giving them an additional grant after the price falls

■ Wait and See Practice is for company to grant options on certain date,

depending on CEO, CFO or Compensation Committee’s availability

Approving entity is unavailable when stock price is high

Options priced on subsequent date when stock price is lower

6


■ “Flexercising” Options related practice concerns cash exercises conducted

directly with the Company

Issue: absent broker facilitation, there is no independent record of when the exercise request was made

Auditor concern: potentially allows for a look back period in which to minimize/manipulate the delta between the option grant price and the exercise price (and thus, the immediate tax consequences).

7


■ Repricings Arising From Acquisitions

Company plans to issue options to employees acquired through the acquisition in order to “true up” the new employees’ compensation to acquirer's standards.

The Company hopes to have employment agreements with each of the newly acquired employees by the close of the acquisition.

Initial grant date is planned to be the date of the acquisition’s close.

The hiring-transition process does not proceed as smoothly as planned. Some acquired employees agree to join the acquirer’s company before the

acquisition’s close, and their grants are set in motion to be effective as of the date of the acquisition’s close.

Other acquired employees delay their decision to join the acquirer's company until the close of the acquisition.

To ensure comity, all new employees, those that agreed to employment both before and those that agreed after the close of the acquisition, receive the same grant date.

The revised grant date must be after the close of the acquisition as it can only be after each employee agreed to join the acquirer's Company.

The Company must rescind the grants of the employees who received a grant as of the close of the acquisition and reprice the grant to the revised grant date.

8


■ A Window Into the Future

Company’s Board or Compensation Committee delegates to management the discretion to select a grant date within a pre-scheduled window.

Board Meeting on Day 1

Board grants discretion to management to select a grant date between Days 2-10.

Common triggers for the window: Board or Compensation Committee Meeting

Close of Acquisition

Date of new hire

Date of earnings release

What was the intent of the Board’s delegation? To allow management to select any day within the window, even with

hindsight, i.e. selection occurs after the window has closed?

To allow management to only contemporaneously select a day within the window?

9


■ Deception of Compensation Committee

Management submits a list of option grants to the Compensation Committee for approval at Q1 meeting, duly approved

Before Q2 meeting, management changes the list of optionees and number of shares

Management presents the revised list at the Q2 meeting as part of the minutes of the Q1 meeting to be adopted and actively decides not to draw the Committee’s attention to the differences

Compensation Committee approves the list attached to the minutes assuming that it is what was presented at the Q1 meeting, not knowing that the list has been altered from what the CC actually approved

10


■ Now You See Me, Now You Don’t

An employee is hired, receives a grant on his or her hire date but, for some reason (often a pre-planned vacation) does not actually work for the Company until after the hire date.

Such a grantee does not fit the common law definition of an “employee” and is thus not entitled to an option grant.

■ Belt and Suspenders

Person or Body issues a grant. Higher authority “ratifies” the grant, typically out of a belief that the original grantor did not have authority to issue the grant.

■ Fluctuating Employee Lists

A list of employee grants is approved on the purported record date. Certain employee grant totals are re-allocated after the record date. Under FIN 44 this can be deemed a repricing and would require variable accounting.

11


■ Minutes for Comp Committee and BOD meetings

Is there evidence that the minutes do not accurately reflect what occurred at the meeting regarding stock option grants?

Is there evidence that the meeting did not occur on the date set out in the minutes, or that the meeting did not occur at all?

Is there evidence that the actual approval for the grant did not occur on the date set out in the minutes?

■ Unanimous Written Consents

Same or similar issues as with meeting minutes, i.e., is there evidence that the UWCs do not accurately reflect the actual approval process, including the dates when actual approval occurred?

12

Issues for Companies

■ Whether and how to investigate Internal Personnel? Special Committee with outside counsel? Interactions with SEC?

■ Complete investigation before next SEC filing – the need for speed

■ Suspension of Form S-8s Immediately? Equity Grant Plan? Section 423 Plan? After financial information goes stale? Reinstatement of S-8? Scope of the investigations?

■ Will restatement be required?

■ Insurance company inquiries?

■ Will executives be tainted/have to be terminated?

■ Are grants valid and are shares received “fully paid and nonassessable”?

■ Will options have to be repriced or restitution made?

■ Will there be Section 409A tax gross-ups?

■ Will a Schedule TO be filed for Section 409A purposes?

■ What is the impact on merger transactions?

■ Will SOX 304 be applicable?

13

Issues for Individuals

■ Indemnification and separate legal counsel

■ Section 409A Liability

■ Termination of Employment

■ SEC and DOJ Charges

14

Emerging Best Practices

■ Consider avoidance of unanimous written consents

■ Consider limited use or avoidance of delegation process

■ Consider adoption of equity grant policy requiring grants to be made at specified times during fiscal year or during open window periods

■ Consider limitations on grant dates

For new hires

Restrict grant dates for executives

■ Plans to specify that grants should be at closing price on date of grant

15

New Executive Compensation Disclosure Rules

■ New disclosure rules substantially modify executive compensation disclosure under Item 402 of Regulation S-K

■ New section entitled “Compensation Discussion and Analysis” requires the issuer to analyze and discuss in depth its executive compensation programs and philosophies

Must answer six questions about the issuer’s compensation program

Must specifically include a discussion of stock option grant programs, plans and practices

16

CD&A: Stock Option Timing Disclosure

■ Enhanced disclosure regarding stock option timing Does the company have any program, plan or practice to time option grants

to executives in connection with the release of material nonpublic information?

Applies to all forms of equity compensation (See § 402(b)(2)(iv))

How does any program, plan or practice to time option grants to executives fit in the context of the company’s program, plan or practice (if any) with respect to option grants to employees more generally?

Indicates that even though CD&A is generally with respect to executive officers, must address option timing policies for all employees

Applies to directors as well as employees (See Release footnote 64.) What role does the compensation committee play in administering the

program, plan or practice regarding option grants? How did the board of directors or the compensation committee take such

information into account when determining whether and in what amount to make option grants?

Did the compensation committee delegate any aspect of the actual administration of a program, plan or practice to any other person?

What role did the company’s executive officers play in the 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 the company plan to time, or has it timed, its release of material nonpublic information for the purpose of affecting the value of executive compensation?

17

409A Option Issues for Exercised Options

■ For affected options that vested after 2004 and that were exercised in 2006 These awards cannot be fixed because the exercise has

already occurred. Therefore, employees are subject to unpaid income taxes, an additional 20% tax and interest upon exercise on the option spread. California has a similar 20% tax.

IRS has introduced a settlement initiative for non-officer employees whereby the company can pay the additional 20% tax and interest charge on behalf of the employees. This payment must be reported as taxable wages in W-2s for 2007. IRS Notice 2006-100.

California has instituted a similar program

18

409A Option Issues for Exercised Options (con’t)

■ For affected options that vested after 2004 and that are outstanding: It is possible to make a Tender Offer to employees to allow

them to increase the exercise price to eliminate the grant date discount and in return receive a payment equal to either the intrinsic value on those affected options where the grant price is in-the-money or the fair value based upon a Black-Scholes model for those options where the grant price is out-of-the money.

Certain Section 16 officers were required to agree to increase the exercise price prior to the end of 2006.

19

Schedule TO “Tender Offer” Issues

■ If a company has outstanding options that may have been granted at a discount, to avoid application of Section 409A, “fixing” them may require TO filing (because an investment decision is being made)

■ Schedule TO required:

Raise exercise price

Optionee given choice to pick 409A compliant exercise schedule (short term deferral or fixed)

Examples include: Adobe Systems, Apple Computer and KLA-Tencor (filed Schedule TOs, raise exercise price and receive cash “true-up” payment). Nvidia Corporation (filed TO, amend option agreements to provide for fixed exercise schedules).

■ Employers may compensate the employee for the loss in value by making a compensatory payment to them via a tender offer.

■ IRS rules require any payment made by the employer to reimburse for the adjustment of the option price cannot be made in the year of the tender offer. Accordingly, the compensatory payment on a 2007 tender offer can not be made before 1/1/08.

■ SEC rules require prompt payment in a tender offer. The SEC is permitting companies to delay payment but are not permitting former employees to participate.

■ The tender offer cannot be closed until the employer is current on SEC filings and must be outstanding for at least 20 business days.

20

■ Decisions Granting Motions to Dismiss

In re Linear Technology Corp. Deriv. Litig. (N.D. Cal.)

In re Novellus Systems, Inc. Deriv. Litig. (N.D. Cal.)

In re Computer Sciences Corp. Deriv. Litig. (N.D. Cal.)

In re CNET Networks, Inc. S’holder Deriv. Litig. (N.D. Cal.)

Stovall v. Marshall (Cal. Sup. Ct.)

In re Openwave Systems Inc. S’holder Deriv. Litig. (N.D. Cal.)

Desimone v. Barrows (Del. Ch.)

■ Decisions Denying Motions to Dismiss

Ryan v. Gifford (Del. Ch.)

In re Tyson Foods, Inc. Consol. S’holder Litig. (Del. Ch.)

In re Zoran Corp. Deriv. Litig. (N.D. Cal.)

Option Backdating Derivative Actions

21

■ In re Linear Technology Corp. Deriv. Litig. (N.D. Cal.)

Court concluded that “no ‘pattern,’ let alone a ‘striking’ pattern is apparent” because, although plaintiffs alleged that stock options were dated “just after a sharp drop” on seven occasions over a period of seven years, they did not allege “how often and at what times” defendants granted options in the past

Court held that plaintiffs failed to show that conduct violated the business judgment rule because they did not plead specific “backdating” facts

■ In re Novellus Systems, Inc. Deriv. Litig. (N.D. Cal.)

Court held that plaintiffs made “no specific showing of backdating”, and lacked standing because they did not own stock throughout the class period

■ In re Computer Sciences Corp. Deriv. Litig. (N.D. Cal.)

Court held that CEO was not “disinterested” in the decision about whether to pursue litigation because he received backdated option grants

However, court held that allegations about the audit committee’s accounting of backdated grants, nominating and corporate governance committee’s decision to keep CEO as a director, and board’s oversight responsibilities were not specific enough to implicate one-half or more of the board

Court gave no weight to the Ryan and Tyson Foods decisions because applying those holdings to cases where “the core allegations of backdating are comparatively weak and lack particularity” would be inappropriate

Decisions Granting Motions to Dismiss inOption Backdating Derivative Actions

22

■ In re CNET Networks, Inc. S’holder Deriv. Litig. (N.D. Cal.)

Court found that, although Plaintiffs’ “backdating” claims were allegedly based on statistical improbabilities, an inference of fraud was “difficult to support” without “sound analytical methods”

As in Computer Sciences, court held that CEO was not “disinterested” because he received backdated option grants

However, court concluded that allegations that directors “ratified” backdated options did not show that directors were “interested” because such allegations failed to specify what the directors did to “ratify” the grants

Court held that membership on a committee with the duty to administer an options plan is not enough to show members are “interested” unless they chose the date of the backdated grant or knew the grant’s true date

Decisions Granting Motions to Dismiss inOption Backdating Derivative Actions (con’t)

23

■ Stovall v. Marshall (Cal. Sup. Ct.)

Court sustained Sunrise Telecom, Inc.’s demurrer because plaintiff failed to allege his stock ownership with enough particularity to show he had standing

Citing Ryan, Computer Sciences, and CNET, court held that plaintiff failed to allege demand futility with sufficient particularity

■ In re Openwave Systems Inc. S’holder Deriv. Litig. (N.D. Cal.)

The identification of 21 grants “does not, alone, indicate backdating” if the challenged grants are less than five percent of the total number of grants

The probability that 10 of 40 grants fell on the lowest price is “as consistent with a random selection of [dates] . . . as with a pattern of backdating”

Court concluded that plaintiffs should not be permitted to conduct discovery until and unless they demonstrate that demand is excused


24

■ Desimone v. Barrows (Del. Ch.)

Court held that plaintiff lacked standing to challenge all of the option grants that were awarded before he became a shareholder

Plaintiff claimed he had standing to challenge grants made before he owned stock under “continuing wrong doctrine”, but there was no “continuing” wrong because grants are “completed the moment the options are granted”

Regarding employee grants, plaintiff failed to plead specific facts showing that: (1) any director was “involved in the details” of the grants “in any way”; (2) compensation committee members were involved in backdating, even if they had a duty to administer the options plan; (3) CEO was involved in backdating, despite former employee’s conjecture that CEO was involved; and (4) backdating occurred as a result of an alleged lack of oversight

Regarding officer grants, plaintiff failed to plead specific facts showing that: (1) the board knowingly backdated options; (2) each “spring-loaded” grant was “sufficient in itself” to state a claim of disloyalty; and (3) directors had positive information that would render them liable for “bullet-dodging” grants

Regarding director grants, plaintiff properly alleged that directors were not “disinterested” because (as in Computer Sciences and CNET) they received challenged grants, but court held that plaintiff failed to state a claim because the claim that grants were backdated was contradicted by the fact that grants were made “automatically each year on the date of [the] annual stockholders meeting, which was scheduled far in advance”


25

Decisions Denying Motions to Dismiss inOption Backdating Derivative Actions

■ Ryan v. Gifford (Del. Ch.)

Court held that plaintiff’s claims were sufficient to go to trial

Court’s decision was based on statistical improbability that the grants were apparently timed (i.e., grant prices were “too fortuitous to be coincidence”)

Court found that “backdating” options might qualify as an act “so egregious on its face that board approval cannot meet the test of business judgment”

■ In re Tyson Foods, Inc. Consol. S’holder Litig. (Del. Ch.)

Plaintiffs alleged that the board breached its fiduciary duties by granting “spring-loaded” stock options to insiders

Court concluded that plaintiffs had adequately alleged that board approved grants while in possession of material non-public information

Court found that such alleged conduct was not permitted by the business judgment rule

26

Decisions Denying Motions to Dismiss inOption Backdating Derivative Actions (con’t)

■ In re Zoran Corp. Deriv. Litig. (N.D. Cal.)

As in Computer Sciences, CNET, and Desimone, court held that directors were not “disinterested” because they received backdated option grants

Court held that plaintiff lacked standing to assert claims regarding events that occurred before he became a shareholder

Court denied motion to dismiss for failure to state a claim under Sections 10(b) and 20(a) against two individual defendants, and under Section 14(a) against audit committee and compensation committee members

27

Special Issues in Stock Option Investigations and Civil Actions

■ Has the bar been lowered for the criminalization of securities and breach of duty violations?

Some argue DOJ overly aggressive in pursuing indictments in the stock option arena

Applying consistent standards or just making an example of an unlucky few?

■ Are Individual Directors and Officers Being Thrown Under the Proverbial Bus?

Have Special Committees, Audit Committees and SLCs unfairly targeted a few individuals to placate government attorneys in the name of:

Cooperation Toughness Investigative Legitimacy

28

Special Issues in Stock Option Investigations and Civil Actions

■ Impact of the Threat of Government Action: Settlement Dynamics in Derivative Actions

The Pressure is On: A Related Development

Threat of government action being used by companies to strongly urge Ds and Os to settle stock option derivative claims

Large financial payments back to company for mis-priced options

Problem: settling to avoid publicity that might catch the attention of the DOJ and SEC

In the months to come, look for public announcements of companies settling alleged derivative claims against Ds and Os based on return of “benefit from mis-priced options”

29

Special D&O Insurance Issues in Stock Option Investigations and Civil Actions

■ “Informal investigation” does not meet definition of “Claim” for purposes of D&O coverage

Voluntary company investigation Long running; largely in conjunction with auditors

(forensic/company) No D&O “Claim” yet (as defined by the policy)

SEC “informal” investigation also not a D&O “Claim,” even though SEC has principally proceeded in this manner

■ If Company concludes there are valid derivative claims against Ds and Os, no D&O coverage? Insured vs. insured exclusion not invoked if derivative

action pursued without assistance from company If company believes valid claims against Ds and Os, it’s

likely that the carrier will invoke this exclusion

Documents

______________________ 10 th Annual Advanced Course Study/Video Webcast EXECUTIVE COMPENSATION Strategy, Design, Implementation Scott Spector Fenwick &