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Penn West Energy shareholder David Lester launched a lawsuit against the firm in 2013 and wants it to sue six former employees.Todd Korol/Reuters

Penn West Petroleum Ltd. manipulated stock options in its early days as an income trust, and its compensation and record-keeping practices before that era may have been deficient, according to a secret internal investigation by the company.

The Canadian oil-and-gas company, as a result, entered into settlement negotiations with at least three former long-time directors, according to court documents, including a report on the investigation. Those negotiations are on hold as the company and an investor spar in court over the allegations.

Penn West in 2011 formed a three-person special committee to investigate a shareholder's allegations that the company illegally issued stock options. The committee delivered its conclusions to its board colleagues in a report on Nov. 4, 2013. Penn West filed that report in court last October in connection with a lawsuit that David Lester, the shareholder, launched against the firm in 2013.

Stock options are a form of compensation for company officials, an incentive to run companies well. Options are generally issued at the closing stock price of the day before they are granted. They can be converted years later into stock at the fixed purchase price, which provides a financial benefit if the price has gone up. But some companies have been caught manipulating stock options using a tactic known as backdating. That means they use hindsight to pick dates on which the share prices were low, making the options more valuable.

Penn West's special committee determined the company backdated options between June, 2005, and August, 2006 – its first year as an income trust.

"We have concluded that grant dates were selected with the use of hindsight with price being the determining factor in date selection," the special committee's 38-page report says. Before 2005, the report concludes "it is open to question whether hindsight may have been employed in the selection of a limited number of grant dates."

Murray Edwards, a major player in Alberta's energy industry, co-founded Penn West in 1992 and left in 2005. He is among the six people Mr. Lester wants Penn West to sue for illegally issuing options, court documents say. Mr. Edwards also founded Ensign Energy Services Inc. and was part of a multimillion-dollar settlement a judge approved last year in connection with almost identical allegations. In Calgary, two more energy firms have publicly faced allegations of manipulating options: Savanna Energy Services Corp. and Trican Well Service Ltd. Both admitted mistakes and settled the disputes.

The hundreds of pages of court documents filed in the backdating lawsuit against Penn West provide a rare glimpse of how the firm ran its compensation program for nearly 20 years. Penn West's accusers say the battle is about illegally enriching executives and directors, and that statistics and governance practices back up their allegations. Penn West argues that any mistakes related to issuing options between 2005 and 2006 happened because the firm was small, directors were too trusting of management and it was trying to do the best for employees.

Penn West director James Allard, who was on the board of the Alberta Securities Commission between 1999 and 2007, served as the special committee's chairman. He said he had "never seen" Mr. Lester's 11-page lawsuit before the special committee issued its conclusions to the company's board, according to court documents. A backdating expert filed a 12-page statistical analysis in court supporting Mr. Lester's claim. In 15 of 27 grant dates the expert analyzed between 1993 and 2010, the average five-day stock price immediately before the grant date is lower than any of the average five-day prices over the next 20 trading days. The expert calculates the odds of picking favourable prices for the options so often by chance are one in 5,000, and he says it is consistent with backdating.

The special committee recommended against suing Penn West's former executives and directors. The board, chaired by former Suncor Energy Inc. chief executive Rick George, unanimously accepted the committee's recommendations, court documents say. Mr. Allard filed a document last October disputing Mr. Lester's claims and dismissing the statistical analysis – even though he had still not read the investor's lawsuit, court filings show.

The oil-and-gas company declined to comment because the issue is before the courts. Mr. Allard did not respond to a request made through the company for comment. None of the allegations have been proven in court.

Canadian regulators have not pursued backdating allegations with the same vigour as their U.S. counterparts. Regulators in the United States investigated more than 100 companies and collected hundreds of millions of dollars in fines from executives for backdating after the schemes were uncovered around 2006. Few Canadian companies faced the same scrutiny in court or from regulators. However, the Ontario Securities Commission settled in 2009 with Research In Motion Ltd. (now BlackBerry Inc.) executives over allegations of backdating. Co-founders Jim Balsillie and Mike Lazaridis, along with other senior officers, agreed to pay $77-million in fines and restitution.

Backdating fell out of favour after the U.S. crackdown. But as the Penn West allegations show, backdating in Canada may have extended beyond 2006, and heated disputes over the practice continue to surface north of the border years after the same happened in the United States.

The law firms representing Mr. Lester – Siskinds LLP in London, Ont., and Calgary's Jensen Shawa Solomon Duguid Hawkes LLP – have become mainstays in options cases. The firms came out on top against Ensign, Savanna and Trican. Some believe they work in the best interest of shareholders and want justice for financial misdeeds; others argue they are vultures, using puppet investors to launch cases against companies and wealthy people that end up paying the law firms' legal fees as part of settlement agreements.

In addition to Mr. Edwards, the investor is demanding Penn West sue former directors Bill Andrew, who was involved in Penn West when it was founded, Nabih Faris, Thomas Phillips, Murray Nunns and John Brussa.

Mr. Edwards told the The Globe and Mail he is not involved in the court case between Penn West and Mr. Lester. He said he has not seen the special committee report. The others declined to comment or did not respond to messages seeking comment. Court documents show Mr. Andrew, Mr. Brussa and Mr. Phillips launched settlement discussions with the company. Their lawyer, Steven Leitl at Norton Rose Fulbright LLP, said the talks are on hold as the trio "confidently" awaits the outcome of the court case.

Penn West's special committee hired Deloitte, an international auditing company, and law firm Osler, Hoskin & Harcourt LLP, to assist with the investigation. Deloitte collected 1.6 million documents as part of its review, the special committee report says.

Deloitte calculated the "hypothetical impact of foregone capital" from potentially mispriced options may be about $7-million between Penn West's founding and 2005, court documents say. The auditing firm estimated the "hypothetical" reduction in Penn West's capital to be about $5.8-million between 2005 and 2006. Penn West, by May, 2012, had spent more than $2.2-million on legal fees and Deloitte's fees, court documents show.

Penn West, the report concludes, lacked "continuity" after Mr. Edwards left in 2005, creating conditions ripe for manipulating options after the company became a trust. The trust's directors, including those who were there before it converted, were too trusting of management and staff, the report says.

Penn West's corporate governance style plays a key role in the special committee's findings regarding the years before 2005.

"The Special Committee found that Penn West's practices during this period may have been deficient, that record keeping relating to option grants during this period was poor and there was a lack of objective data to assist in understanding how stock option grant decisions were made," Mr. Allard, who held options that were allegedly backdated, said in his October affidavit.

Between Penn West's inception and May, 2005, the board granted options "almost exclusively" using so-called unanimous written consent resolutions using dates on which they become effective, the special committee's report says.

Written unanimous consent resolutions, also known as round-robin resolutions, allow directors to pass motions without formal in-person board meetings. Instead, each director receives, signs and returns documents containing proposed resolutions. Support must be unanimous and the resolutions are valid only after the final signed document is returned to the corporation. While written unanimous consent resolutions with effective dates are considered approved when all directors return the paperwork, the motion is applied relative to the effective date, which can be before directors sign and return the documents. In short, effective dates could allow directors to make decisions retroactively.

The special committee found a lack of physical evidence and fading memories when it researched Penn West's options practices before 2005, according to court documents. The investigators could not find "objective evidence of a systemic approach" to backdating over this stretch, the report says. The committee report says the review found "no evidence to suggest" the effective date of stock option grants issued through unanimous consent resolutions differed from the date the board decided to issue the options. Mr. Lester's lawyers argue a lack of physical evidence proves backdating may have occurred. Robert Hawkes, one of Mr. Lester's lawyers at Jensen, said in an interview with The Globe that the statistics overwhelmingly support their case.

Penn West hired its own expert to pick apart the statistical analysis on which Mr. Lester's case depends. The company's expert argues in a 15-page report filed in court that the findings of Mr. Lester's expert are unsound.

"Wet clothes are consistent with having been out in the rain without an umbrella, but they do not justify the conclusion that one has been out in the rain without an umbrella; any number of other explanations might actually have been the cause of wet clothes," Penn West's expert says in his 15-page report. "A proper logical interference that results were caused by antecedents requires consideration of alternative causes. As a matter of logic, since [Mr. Lester's expert] does not consider possible alternative causes, his conclusion does not follow."

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