Key to avoiding compensation suits governance.

• Author: Labaton, Edward
• Position: SHAREHOLDER LITIGATION

Abuses of executive compensation-provide no end to work for plaintiffs' lawyers pursuing class-action litigation against, and derivative suits on behalf of, companies that--in issuing options or stock to senior executives--expose themselves to the risk that these grants will be misused though backdating and insider trading.

While there is some skepticism about whether recent regulatory efforts at corporate governance reform have been effective in dealing with these problems, Prof. Jesse Fried of the University of California at Berkeley offers two new, practical approaches companies can adopt to help prevent insider trading and options backdating litigation.

Those are well worth reviewing. In 2007, the U.S. Securities and Exchange Commission (SEC) brought more insider trading cases than it had in the entire decade of the 1990s. And according to SEC Enforcement Director Linda Chatman Thomsen, this pace will increase in the near future.

Consider that in January 2008, current and former top officers of UnitedHealth Group agreed to pay a record $887 million to settle stock-option backdating charges brought by government agencies and by shareholders bringing private actions. This agreement exceeded a previous backdating class-action settlement record set barely three months earlier, in a case involving Mercury Interactive Corp. and alleged backdating covering the years 1997-2005.

Compensation Abuses And Board Independence

Recent scholarship has drawn striking conclusions about the relationship between director independence and the incidence of option manipulation. In a November 2006 study called "Lucky CEOs," Profs. Lucian Bebchuk, Yaniv Grinstein and Urs Peyer of Harvard University concluded that stock option manipulation was strongly associated with CEO influence on company pay-setting and governance processes.

After reviewing more than 40,000 grants of stock options, the authors concluded that manipulation was significantly more likely in companies that did not have a majority of independent directors and in companies whose CEOs had long tenure.

However, regulatory efforts to ensure board independence have been met with mixed reviews. While the Sarbanes-Oxley Act and listing rules at the major U.S. securities markets set out requirements for the formal financial independence of board members, lively debate exists as to whether such measures alone are sufficient.

Some commentators have suggested that a focus on the absence of any formal...