Life After Enron and Worldcom: Preparing for the New Regulatory Environment

Orange County Business Journal, Apr 23-Apr 29, 2007 by Piazza, Mike

With the number of shareholder class action lawsuit filings continuing to decline, and in the absence of mega-cases concerning alleged corporate fraud (the likes of Enron and Worldcom) in the headlines these days, one would think that officers and directors of public companies could breathe easier. Yet regulatory scrutiny by the United Stales Securities and Exchange Commission, state Attorney General offices, and the Department of Justice continue to make headlines. While many of these inquiries focus on the regulatory bread and butter type of cases involving revenue recognition and other accounting issues, increasingly the government is looking at new twists on old crimes. For example, there is a concerted effort to uncover insider trading in connection with private investments in public equity (PIPEs). Similarly, the government is focused on trading in options ahead of merger and acquisition announcements. And, of course as we learned last year, the SEC has not forgotten how to bring a Foreign Corrupt Practices Act case and in fact has brought several in the past twelve months.

Stock option backdating

Of course, no discussion of regulatory and prosecutorial trends in securities enforcement would be complete without some discussion of stock option backdating. Remember last May, just as the Enron criminal trials were ending? At the time some pundits predicted the trials marked the end of large scale corporate fraud in America. Yet already gaining traction at that moment was a new word appearing in the daily business reports-backdating.

The genesis of the so-called "backdating scandal" reveals how vulnerable officers and directors are to the ever-quickening news cycles and the always present desire of politicians, prosecutors and pundits to maximize their press coverage and increase their public persona. Keep in mind that the entire backdating saga began inauspiciously enough in an academic paper researched and authored by an Iowa college professor. Serendipitously, that research paper was picked up by The Wall Street Journal. Within just a few months of the Journal's first backdating article, none other than Chairman Christopher Cox and Chief of Enforcement Linda Thomsen were standing at a podium in northern California, having flown to San Francisco to announce the filing of the Brocade stock option backdating case. Moreover, and more ominously, that press conference was held jointly with the Department of Justice which similarly announced its first criminal prosecution relating to backdating, also in the Brocade case. At that time, Chairman Cox vowed swift justice to all involved and not just at Brocade. Yet today, nearly a year later, although nearly 150 companies have been under scrutiny for their option granting practices, and still more have conducted their own internal investigations to uncover any irregularities in option grants, the SEC has brought fewer than 10 backdating-related cases. The DOJ has brought even fewer. So much for swift justice. Or, perhaps, the initial rush to convict by headline and press conference was overdone. Regardless, companies and individuals have already had to pay millions of dollars in professional fees to conduct investigations, to defend themselves from government probes and, in some cases, to mount a defense in court actions. All as a result of one college professor's research paper.

"Safe harbor" trading plans

Now Chief of Enforcement Thomsen again is rattling the SEC's sword, this time focusing on 10b5-1 trading plans. As many people know, a 10b5-1 trading plan is an SEC-created safe harbor to allow executives to conduct trading in their company stock holdings at regular, pre-determined intervals without fear of insider trading allegations. The SEC, apparently, now is concerned that executives that are participants in these safe harbor trading plans may actually be gaming the system by timing their company's release of good or bad news to coincide with their planned trading dates. And guess who the source is of this latest SEC initiative? That's right, yet another academic who wrote a research paper that came to the SEC's attention.

Creating an ethical corporate culture

So in this environment of enforcement driven by news stories and research articles, how can corporate officers and directors best prepare themselves and their companies to withstand regulatory or shareholder scrutiny concerning whatever the scandal of the day may happen to be? At the risk of trotting out an old sports cliché, sometimes the best defense is a good offense. That is certainly true in this circumstance.

Building and maintaining strong internal controls and consistently and effectively communicating a corporate philosophy of ethical behavior and support for compliance efforts are good starting points. The SEC staff like to say that the "tone from the top" is a critical element in promoting an ethical corporate culture. Chairman Cox also is fond of saying that sunshine is a great disinfectant. Put simply, by instituting strong, ethical corporate leadership and robust compliance programs, officers, directors and their companies will go a long way toward preventing scandals, and in the event that something does go awry, it will have a strong defense in the event of any subsequent government or shareholder actions. With CEO and CFO civil and criminal certifications now mandatory for companies that are subject to Sarbanes-Oxley requirements, it is hard to understand why any public company C-level executive would demand anything less from his or her employees than is expected of him or herself.