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Pepper Hamilton, L.L.P.

Gay Parks Rainville of Pepper Hamilton Elected to SeniorLAW Center's Board of Directors
Gay Parks Rainville, a partner with Pepper Hamilton LLP, has been appointed to the board of directors of the SeniorLAW Center, a nonprofit organization that serves the legal needs of Philadelphia’s elderly. Her appointment is for four years.

Ms. Rainville, resident in Pepper’s Philadelphia office, concentrates her practice in complex commercial litigation, including securities, corporate governance, breach of contract, commercial tort and antitrust matters.

SeniorLAW Center (www.seniorlawcenter.org)otects the legal rights and interests of seniors in need. The Center provides legal services, community education, outreach and advocacy to thousands of seniors each year, including victims of elder abuse and financial exploitation, elders facing housing crises and homelessness, and grandparents raising grandchildren. SeniorLAW Center also acts as a link in the complex network of services available to senior citizens.

Pepper Hamilton LLP is a multi-practice law firm with 400 lawyers in six states and the District of Columbia. The firm provides corporate, litigation and regulatory legal services to leading businesses, governmental entities, nonprofit organizations and individuals throughout the nation and the world. The firm was founded in 1890.

08-09-2006

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Michael Best & Friedrich, LLP

OIG Issues Advisory Opinion Regarding Emergency Ambulance Services
In a recently published advisory opinion, the Office of Inspector General of the U.S. Department of Health and Human Services ("OIG") considered a proposed exclusive arrangement for emergency ambulance services. Although the OIG found that the proposed arrangement implicated the Federal Anti-Kickback Statute ("AKS"), the OIG decided that it would not impose sanctions on the parties requesting the advisory opinion for the reasons discussed below.

08-09-2006

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Akin Gump Strauss Hauer & Feld, L.L.P.

SEC Publishes Final Guidance on Use of "Soft Dollars"
On July 18, 2006, the Securities Exchange Commission (the Commission) published final interpretative guidance regarding the use of "soft dollars" (the Release). The Release clarifies the circumstances under which money managers may use client commissions to pay for brokerage and research services under the soft dollars safe harbor in Section 28(e) of the Securities Exchange Act of 1934 (the Safe Harbor) and specifically addresses four issues: (1) when do "brokerage or research services" fall within the Safe Harbor, (2) what constitutes "eligible research," (3) what constitutes "eligible brokerage services" and (4) what is the appropriate treatment for "mixed-use" items.

08-09-2006

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Pillsbury Winthrop Shaw Pittman LLP

Beyond Backdating: Stock Option Grant Self-Assessment Guide
In recent weeks, corporate stock option practices have come under extreme regulatory and media scrutiny. The U.S. Securities and Exchange Commission initiated investigations of more than 80 companies for potential accounting and disclosure problems relating to the dating of their stock option grants. Companies and individuals have been targeted with grand jury subpoenas, and federal indictments in this area have made front-page news. The plaintiffs' bar has filed dozens of derivative and class action lawsuits against executives and directors, challenging option grants. Options granted as far back as the 1990s are being closely examined, and companies face severe consequences if their historical practices failed to meet the then-current accounting and taxation requirements.

08-09-2006

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Vinson & Elkins L.L.P.

Options Backdating Update
On July 26, 2006, the SEC announced new rules on executive compensation that will include new disclosure requirements about the timing and pricing of options. These rules follow on the heels of the options backdating controversy, which has developed into a growth industry for securities law enforcement agencies and plaintiffs’ lawyers. On July 20, three government agencies jointly announced the filing of criminal and civil securities fraud charges against the former CEO and former Vice President of Human Resources of Brocade Communications Systems, Inc., “alleging that the two routinely backdated stock option grants to give employees favorably priced options without recording necessary compensation expenses.” In the press conference announcing that action, the Director of the SEC’s Division of Enforcement noted that the agency has 80 ongoing investigations in this area. The U.S. Attorney’s Office for the Northern District of California (which was partly responsible for this action) has formed a task force to pursue options backdating cases, and other U.S. Attorney’s Offices have launched investigations into particular companies.

How many of these investigations will result in enforcement actions is anyone’s guess, but the effect on public companies is already profound: more than 80 companies have disclosed that they are conducting internal investigations, are the subject of investor lawsuits, or are under government investigation for their backdating practices. And this could be just the tip of the iceberg. A recent academic study concluded that over 2,000 companies may have engaged in options backdating between 1996 and 2005 and that 13.6% of options granted to executives during this period were manipulated through backdating or similar techniques. Obviously, this issue is not going away anytime soon. In a time of unparalleled oversight over the governance of corporate affairs and an aggressive enforcement environment, backdated options will provide yet another basis for government scrutiny of public companies and their compensation practices and, inevitably, will result in civil and criminal enforcement actions.

Backdating Explained
A stock option allows the holder to buy shares of company stock at a fixed price (the “strike” or “exercise” price) for a fixed period of time (the option period). Options are typically used to give employees incentives to work harder to increase the value of the company’s stock and to create an incentive for company employees to stay with the company—typically through time-based vesting provisions. For small companies strapped for cash, options also provide a way to hire the best talent without depleting their operating funds on salaries and bonuses.

Backdated options, which are sometimes called “look-back options,” are created when a company claims to have granted an option at fair market value as of a date earlier than the actual date of grant, generally in order to give the option recipient a lower exercise price for the option than the market value of the company’s stock on the true date of the grant. As a result, the option is “in the money” on the day the option is really granted. As an example of how backdating works, suppose that on June 30, Company wants to grant nonqualified stock options to Executive. The stock is trading at $20 per share. On June 10, the stock was trading at $15 per share, so Company dates the options as of June 10, with a strike price of $15. Option backdating is not necessarily illegal, as long as it is properly accounted for, properly reported for tax purposes, properly disclosed to the public, and otherwise within the company’s power under state law, its charter, and the governing stock plan documents. Nevertheless, in many cases it appears that companies may have treated the “as of” grant date as though it were the true grant date for all purposes, giving rise to a variety of possible problems.

Related Issues
Other issues relating to the timing of option grants have caught the attention of the press and regulators. “Spring loading” involves the awarding of options shortly before and in anticipation of a company’s announcing good news that will increase the market price of the stock, thus setting the option exercise price lower than the value that a fully informed market would establish. “Bullet dodging” is the practice by which a company intentionally postpones an option grant until after bad news is disclosed so that employees receive lower-priced options.

Some commentators have complained that spring loading and bullet dodging are forms of illegal insider trading because the company has acted on information not available to the general public at the time of the option grant (in the case of spring loading) or at the time of postponement of the grant (in the case of bullet dodging). Some also argue that these practices over-compensate company insiders, reduce incentives for insiders to seek good stock performance, or result in the under-disclosure of compensation amounts because of the short-term pricing benefit inherent in the practices. Finally, some have argued that spring loading sets the exercise price lower than what the fair market value of the stock truly is (that is, lower than the price the market would have set had it known the good news that the company had not yet disclosed) and therefore is not a fair market value option entitled to favorable accounting or tax treatment.

Others have rejected these views. This group rejects the insider trading argument principally because the body making the awards (typically the board of directors, a committee of the board, or a senior executive) is fully informed about the future positive or negative information that will affect price and therefore is not defrauded in setting the price or postponing the award. That the public is not fully informed on that date is irrelevant under this view, because the public is not party to the transaction in which the option is granted. In the end, the timing of the award is simply the result of a decision about how best to structure compensation. The short-term compensation argument is rejected principally because employee stock options typically vest over three to five years, reducing or eliminating the ability of an employee to take advantage of a short-term difference between exercise price and market price, and also because the argument focuses unduly on compensation as a function of exercise price alone without looking at other matters, such as the number of shares subject to the options, that may have been considered in establishing the awards. Finally, this group argues that fair market value, under plan documents and relevant accounting, tax and securities law standards, simply refers to the actual market price on the date of grant or at the close of business on the previous day.

Effects of Sarbanes-Oxley
The Sarbanes-Oxley Act of 2002 (“SOX”), enacted July 30, 2002, curtailed the opportunities for backdating by requiring that stock option recipients report their grants to the SEC on Form 4 before the end of the second business day following the date of grant. This information becomes publicly available by the day after the report is filed. Before SOX, stock option grants had to be reported in two ways: (1) to the SEC within 45 days after the company’s fiscal year-end (or 10 days following the month of grant, depending on the circumstances) and (2) to stockholders in the proxy statement for the following year’s annual stockholders’ meeting. Thus, backdating was much easier in the pre-SOX world.

SOX has not eliminated the ability to manipulate option grants. In one high profile case, a company’s internal investigation revealed that even after SOX took effect in 2002, certain top executives acted to “deliberately override certain controls” on stock options through March 2005. A recent academic study suggested that 21% of option grants may not have been reported within the required two business days, which may raise concerns about backdating. In addition, according to one recent academic report, even after SOX 10% of option grants made outside of regularly scheduled grant dates give indications of backdating—the option grants were all priced at a stock’s 52-week low on a consistent basis over time. SOX should have little effect on the practice of spring loading because a company can time a grant to precede good news or postpone a grant until after bad news, and still report the true date of grant within the two-day window. In sum, while SOX has caused a marked decrease in the instances of suspected options backdating, it has not eliminated causes for concern.

Serious Potential Consequences
The options backdating issue involves an unusually complex convergence of accounting, tax and securities regulation as well as state corporate law and carries the potential for serious civil and criminal consequences.

First, backdated options may not have been recorded and accounted for correctly. In very general terms, before the adoption of FAS 123(R), a company had to take a compensation charge for an option unless the option was granted with an exercise price equal to or greater than fair market value on the date of grant. If options were backdated to establish an exercise price lower than the fair market value on the actual date of grant, the company should have recognized the difference in exercise price and grant date market price as an expense. In reference to the backdating example involving Company previously discussed in “Backdating Explained,” if the person granting the options represented to Company accountants that the actual date of grant was the “as of” date (June 10) and that the exercise price therefore was at the fair market value on the date of grant, Company’s accountants would likely record the “as of” date as the grant date and fail to recognize compensation expense related to the options. This could understate compensation expense, overstate net income, overstate retained earnings, and overstate earnings per share. If the error is discovered and is material, Company may be required to restate its financial statements, as some companies have done already. Whether or not a restatement must be made, the identification of the error could also lead Company’s management and auditors to conclude that there was a material weakness in Company’s internal control over financial reporting, with attendant public disclosure in Company’s 10-Q or 10-K, and may prompt a report to the audit committee about possible fraud.

Second, the tax implications that may flow from options backdating include the possibility that the company could lose tax deductions for performance-based compensation under Section 162(m) of the Internal Revenue Code because the options were not in fact granted at fair market value. This could cause a company to amend its tax returns and be subject to penalties and interest. The recipient of incentive stock options under Section 422 of the Internal Revenue Code receives favorable tax treatment, but could lose that treatment if the option exercise price was not at fair market value. Loss of that treatment also would create administrative challenges for the company in its tax reporting for those options.

Third, options backdating may give rise to liability for securities law violations. The Enforcement Division of the SEC and the U.S. Attorney’s Office have alleged that Brocade’s former CEO and former VP of Human Resources caused Brocade to improperly record options and related expenses, thereby violating the “books and records” clause of the Securities Exchange Act of 1934, and that they and the former CFO violated Section 18 of the Exchange Act by filing false and misleading financial statements, false statements that stock options were accounted for in compliance with generally accepted accounting principles, and false certifications of periodic reports and internal control over financial reporting. Private litigants and the SEC may also assert that incorrect disclosures in proxy statements or other reports about the value of option grants, about whether the exercise prices were granted at fair market value, and about whether a company’s option grants to executive officers would qualify for favorable tax treatment under Section 162(m) constitute misstatements of material facts and therefore violate the reporting and anti-fraud provisions of the securities laws.

Fourth, backdated options may fail to comply with the terms of a company’s board-approved option plan and may violate a director’s or officer’s fiduciary duties. Some option plans contain specific provisions establishing the date of grant or the determination of what constitutes fair market value, and some also prohibit grants below fair market value. Option grants that are determined to violate such provisions might be challenged as possibly lacking corporate authority. Directors or executive officers who knowingly engaged in backdating may be found to have lacked good faith or to have acted without sufficient care necessary to satisfy that person’s fiduciary duties to stockholders under state law.

Finally, investigations, litigation and criminal proceedings involving any of these areas can have expensive consequences for management and the company, regardless of whether management or the company ultimately prevails in its defense. In addition to the potentially irreparable harm to management’s and the board’s reputations based simply on allegations of impropriety, there is the specter of government investigation and prosecution. The SEC and the Department of Justice have filed their first enforcement and criminal actions in this area. Many others are expected to follow. State attorneys general and the Internal Revenue Service are likely to engage this issue aggressively.

Companies have also begun to feel the sting of the seemingly inevitable investor class action and derivative lawsuits. Plaintiffs’ lawyers have already filed hundreds of lawsuits complaining of backdated options alleging that certain officers and directors manipulated the prices of stock option grants through backdating. They have alleged that these practices violate federal and state securities laws and the company’s stock option plan and over-compensate the option grantees to the company’s expense. How the courts will treat these cases remains to be seen.

Mercury Interactive, a California software company, was one of the first companies that the SEC investigated for options backdating. It provides some insight into the potential scope of the problem. After the SEC first raised questions about Mercury’s options granting practices, the company launched an internal investigation that resulted in auditors wading through over two million internal documents. After expending nearly $70 million on legal and accounting fees, the company is restating its financial statements, reversing $567 million in previously reported pre-tax profits from 1992 through 2004 to account for backdating and other misbehavior related to stock options. Although Mercury ultimately concluded that it had problems beyond simple backdating, its experience shows the potential consequences of the backdating issue.

Emerging Legal Standards
Despite the flurry of investigative activity, there is very little guidance on the legality or illegality of options backdating, spring loading or bullet dodging. Even at the SEC’s highest levels, there is disagreement over how to view the backdating issues. Former Commissioner Cynthia Glassman stated last month that she believed that certain backdated options were “clearly illegal.” At almost the same time in another forum, Commissioner Paul Atkins stated that “the mere fact that options were backdated does not mean that the securities laws were violated.” It is apparent that both the SEC and the Department of Justice will scrutinize and potentially challenge cases in which options are priced as of a date prior to the actual grant date to capitalize on dips in the issuer’s share price. Whether the practice is challenged in a particular case, will depend in part on the company’s disclosure concerning its options granting practices and whether the company expensed the granting of “in the money” options. Whether spring loading and bullet dodging situations will lead to enforcement actions is uncertain. It is also unclear whether simple failures to complete paperwork for grants by the pricing date, in cases in which there is no indication of any intention to affect the value of the options, will be deemed worthy of law enforcement actions.

As Chairman Cox promised last month, the SEC’s new executive compensation rules address options backdating explicitly. Under the new rules, companies will be required to disclose certain details on executives’ total compensation, including:

Detailed information on how the company determines when executives receive option grants and how and why the company backdates options, if the company does so.

The dates of options grants.

When the exercise price is less than the stock’s market price on the date of the grant, the market price on that date.

Whether the company plans to time, or has it timed, its release of significant information for the purpose of affecting the value of executives’ stock options.

Commissioner Atkins has stated that companies may have previously lacked clear guidelines to understand their disclosure obligations in this area. The new regulations should provide the necessary guidance going forward but, of course, will not resolve issues of past conduct.

Taking Action
In light of the risks surrounding options grant manipulation, management and members of the board of directors should consider the following actions:

Understand the legal and accounting issues involved in the granting of stock options and review their company’s option-granting practices.

Respond immediately and thoroughly to any indication of improper practices by involving inside and outside auditors in determining the extent of the problem, and making all necessary adjustments to the company’s financial statements and correcting revealed internal control deficiencies.

Include option issues in the company’s periodic review of its internal controls.

Consult with counsel as necessary to address potential legal issues.

08-09-2006

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Thelen, Reid, Brown, Raysman & Steiner, LLP

Failure to Click "Submit" Button Dooms Online Low Bid
A contractor’s failure to actually click ""submit"" caused its bid to be rejected, even though the information actually had been received by the public agency.

Glasgow, Inc., the contractor, submitted a bid of $10,335,645.80 to the Pennsylvania Department of Transportation to perform a road construction project. The bid was submitted in accordance with the department’s bidding instructions via the department’s Internet bidding system, known as the Electronics Contract Management System (ECMS).

The department’s specification for the project included a provision entitled ""Disadvantaged Business Enterprise Requirements."" It provided that when the goal established by the department was met or exceeded, the apparent low bidder was required to electronically submit evidence of compliance within seven calendar days after the bid opening. The specifications also provided that when the required DBE documentation was not provided by the apparent low bidder within the time specified, the bid would be rejected.

On July 17, 2003, Glasgow received an e-mail from the department advising it that it was the low bidder for the project. The e-mail further advised Glasgow to submit its DBE participation information via ECMS by July 24, 2003.

On July 23, 2003, Glasgow placed all relevant DBE information on the department’s Web site. The information indicated that DBE participation in Glasgow’s bid was 7.1 percent, which exceeded the 7 percent goal required by the department for the project. However, Glasgow’s estimator neglected to take the next step and press the ""submit"" button on the screen.

Taking this failure to hit the ""submit"" button as a failure to submit the information, the department rejected Glasgow’s bid because the information had not been ""submitted"" by the required time. Even though the department had received all of Glasgow’s DBE information on its Web site, the department found that until Glasgow hit the submit button, no information actually had been provided; there were just ""screens"" that were filled, with no formal commitment to the DBE goals. The contract was awarded to the next lowest bidder, whose bid was $432,626 higher than Glasgow’s.

The Secretary of Transportation denied Glasgow’s bid protest, Glasgow petitioned for relief on grounds that the secretary abused his discretion and the Pennsylvania Commonwealth Court affirmed. Glasgow, Inc. v. Pennsylvania Department of Transportation, 851 A.2d 1014 (Pa. Commw. Ct. 2004).

The secretary noted the department’s longstanding practice, before implementation of ECMS, of rejecting bids when a bidder forget to fax or attach information regarding DBE participation. The secretary determined that a bidder’s failure to hit the submit button is no different than a bidder’s failure, under prior procedure, to timely mail or fax the information.

The court held:

While a governmental body has the discretion to waive non-material bid defects where the non-compliance (1) does not deprive the agency of the assurance that the contract will be entered into and performed and (2) does not confer a competitive advantage on the bidder…, the failure to submit the information in this case is not a waivable defect. Where specifications set forth in a bidding document are mandatory, they must be strictly followed for the bid to be valid, and a violation of those mandatory bidding instructions constitutes a legally disqualifying error for which a public agency may reject a bid.

By specifically providing in the bid instructions that the bid would be rejected if the information was not provided within the time specified, the court held that the department removed any discretion it had to waive the time to submit information. However, even if the failure to submit the information were a waivable defect, the court held the department did not abuse its discretion in rejecting Glasgow’s bid. When governmental entities are at the beginning stages of implementing electronic bidding, determining the requisites for a proper bid should be left to the discretion of the agency, especially at the early stages, the court concluded. The court analogized the ""submit"" requirement to similar requirements when making online purchases and charges.

08-09-2006

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Stroock & Stroock & Lavan, LLP

Pension Protection Act of 2006: Congress Makes it Easier to Satisfy the ERISA Plan Assets Regulation 25% Limit and Provides Much Needed Relief From Certain of the Prohibited Transaction Rules Under ERISA and the Code
On August 3, 2006, the Senate passed H.R. 4, the Pension Protection Act of 2006 (the "Act")1, which provides significant relief from certain of the plan asset and prohibited transaction rules under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), and the corresponding rules under the Internal Revenue Code of 1986, as amended (the "Code"). The Senate passed H.R. 4 without amendment by a vote of 93-5, after the House had passed H.R. 4 by a vote of 279-131 on July 28, 2006. President Bush must now sign the bill in order for it to become law.

08-09-2006

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