D & O insurers, concerned about lawsuits that have already have been filed and troubled by the possibility of an unknown number of lawsuits yet to come, have begun to respond to the options backdating investigation. On June 20, 2006, the Wall Street Journal (subscription required) carried an article entitled "Options Timing Raises Concern Among Insurers" discussing the response of the D & O insurance marketplace to the options backdating investigations. The D & O Diary’s author’s views on the topic of options backdating and D & O insurance may be found here, in an article entitled "The Options Backdating Scandal and the D & O Insurance Marketplace." This article provides background on options backdating, and discusses the kinds of problems that companies involved in the investigations are facing. The article also examines the ways that the D & O marketplace is responding to the investigations and suggests practical steps for companies to take in connection with their purchase of D & O insurance under the circumstances.
Erik Lie’s website: As anyone who has followed the options backdating story knows, the existence of options backdating was first established by University of Iowa business school professor Erik Lie. Those interested in a deeper understanding of options backdating will want to visit Professor Lie’s website, which is remarkably readable and informative.
Options Springloading: As described in the June 11, 2006 post on The D & O Diary, "options springloading" refers to the practice of timing option grants to take place before expected good news. (Professor Lie’s website has a detailed discussion of options springloading). The June 20, 2006 issue of the Los Angeles Times (registration required) carried an interesting article quoting SEC Chairman Christopher Cox as saying that the SEC is "very interested" in options springloading and stating that the forthcoming SEC executive compensation rules will contain provisions designed to address options springloading.
Cost of Being Public: The cost of being public declined slightly in 2005, according to one law firm’s annual report of the costs associated with corporate governance reform. But while overall costs are declining, audit costs are continuing to climb, especially for the smallest companies. Foley & Lardner released its fourth annual study report on June 15, 2006. The firm prepared the study using a statistical analysis of proxy statement data and survey responses from 114 public companies.
The study found that the overall costs to a compnay of being public (including, among other things, legal fees, audit fees, D & O insurance, and board compensation) declined 16% for companies with under $1 billion in annual revenue and 6% for companies with revenues over $1 billion. But according to the firm’s analysis of 850 public companies’ proxy statements, audit fees increased 22% for S & P small cap companies, 6% for mid-cap companies, and 4% for S & P 500 companies. These data are somewhat inconsistent with some published reports suggesting that audit fees declined in 2005.
The study includes a number of other interesting findings, including the finding that the average cost of compliance for companies with under $ 1 billion in annual revenue has increased from approximately $1.1 million in 2001, the year prior to Sarbanes Oxley’s enactment, to approximately $2.9 million in 2005, an increase of 174%. Not too surprisingly, one in five survey respondents (21%) is considering going private as a result of corporate governance and public disclosure requirements.
While the law firm’s 2005 study report is interesting, and while the study is on solid ground where it relies on the statistical analysis of proxy statements of a large group of public companies, the study’s reliance on a limited set of survey data undermines some of its other conclusions. For example, of the 114 public company survey responses, only 33 came from companies with annual revenues of over $1 billion. These 33 companies reported an average D & O insurance premium that was 35% greater than the average D & O insurance premium reported in the 2004 study with respect to companies with revenues over $1 billion. This of course does not mean that premiums went up 35% between 2004 and 2005 for companies in that category. It does not even mean that the 33 companies in that category that responded to the 2005 survey saw their D & O insurance premium rise 35% between 2004 and 2005. It simply means that the companies in that category that responded to the 2005 survey reported premiums that averaged 35% higher than the different companies in that category that responded to the 2004 survey.
That is the problem with attempting to draw conclusions by comparing two small but different sets of data. Small differences can produce results that appear significant but that may be misleading, due to the different composition of the two sets of data. The study’s authors may be faulted for not doing a reality check before issuing their report – any D & O insurance professional could have told them that D & O insurance premiums did not increase 35% between 2004 and 2005 for any category of companies.
But this shortcoming notwithstanding, the study report still merits attention, at least with respect to the portion of the report pertaining to statistical analysis of proxy data.