July 11, 2006

Dissecting the Options Spring-Loading Controversy

The media - and others - are expending quite a bit of effort commenting on SEC Commissioner Paul Atkins's speech before the International Corporate Governance Network last week (eg. Saturday's WSJ article). This is notable in itself just for the fact that a SEC Commissioner - not the SEC Chairman - has made a speech that has garnered so much attention.

In his speech, Commissioner Atkins states that he believes that the practice of "spring-loading" stock options (ie. setting the grant date and exercise price of an option at a time shortly before the release of positive corporate news) should not be considered insider trading, as he questions whether there was any "legitimate legal rationale" for pursuing any theory of insider trading in connection with option grants.

This is not a new issue. As well covered in past issues of The Corporate Counsel and The Corporate Executive, the underlying “offense” has sparked considerable debate ever since then-SEC Enforcement Director Stephen Cutler first commented on the practice at the 2004 Northwestern Law School Securities Regulation Institute in January 2004. Here is an excerpt from the November/December 2004 issue of The Corporate Counsel:

"Some see it as a legitimate, time-honored way to get the best price for optionees (choosing to ignore that, as with most equity compensation grants, top executives receive most of the benefit). The same skeptics also question whether, or how, Rule 10b-5 would be implicated, since (i) the grantor/issuer (obviously) is aware of the undisclosed information, and (ii) the grantee either knows or the information, being favorable to the grantee, isn’t material to the grantee in this context.

Others (e.g., investors) see evils here, e.g., the dilution/waste caused by committing to sell stock below market value, violation of the option plan requirement to price options at (or above) FMV, non-disclosure of the practice, an accounting problem (a higher fair value charge; even under APB No. 25, there is an earnings charge for discounted stock options), and just plain bad governance. Our purpose here is not to resolve the debate, but to point out that Enforcement does not appear to be stopping to argue."

I don't begrudge - or even disagree with - Commissioner Atkin's opinion on whether spring-loading constitutes insider trading. However, I was miffed that he spoke out on this practice as constituting a "cheap" way to compensate officers. Putting aside the disclosure, accounting, etc. issues that would clearly need to be addressed, I just don't see how springloading fits into a properly designed pay package, where pay is supposed to facilitate better corporate performance - what amounts to discounted options really doesn't seem to do the trick.

At the end of the day, however, the springloading debate just doesn't get me very excited since there aren't many instances of positive news that continue to impact stock prices over the entire length of an option's vesting period. The biggest issue for me is the perception that this practice holds for investors. Given today's media and investor fascination with option granting practices, "perception" is critical and should be sufficient incentive for companies to simply avoid the controversy and use other pay design techniques.

SEC Commissioner Atkins on Option Backdating

On the other hand, I wholeheartedly agree with Commissioner Atkins' thoughts on the witch hunting aspect of the option backdating scandal. He is the voice of reason when he says:

"But it is worth taking a step back before we plunge headlong into wholesale condemnation of all options practices. We need to distinguish scenarios that are black-and-white fraud from legitimate practices that are being attacked with attenuated theories of liability. With respect to the former, there have been many reported stories of clear-cut doctoring of documents done knowingly by executives and/or directors. I will not quibble with the vigorous pursuit of the knowing perpetrators of this kind of activity: a fraud is a fraud. Attempts to evade legal obligations through intentional alteration of documents or deliberate flouting of internal controls cannot be tolerated, because they strike at the core of our system of corporate governance.

Backdating of options sounds bad, but the mere fact that options were backdated does not mean that the securities laws were violated. Purposefully backdated options that are properly accounted for and do not run afoul of the company’s public disclosure are legal. Similarly, there is no securities law issue if backdating results from an administrative, paperwork delay. A board, for example, might approve an options grant over the telephone, but the board members’ signatures may take a few days to trickle in. One could argue that the grant date is the date on which the last director signed, but this argument does not necessarily reflect standard corporate practice or the logistical practicalities of getting many geographically dispersed and busy, part-time people to sign a document. It also ignores that these actions reflect a true meeting of the minds of the directors, memorialized by executing a unanimous written consent."

In some cases, I think companies now caught up in the option backdating scandal were probably just trying to be fair way back when those options were granted in the '90s. Newly public companies really struggle with the idea that option price differs by grant date, so an employee hired this month could end up with a totally different price than an employee hired last month. Particularly if you have a highly volatile stock, the randomness of option prices can seem very unfair.

These companies were used to the way it was when they were private, where everybody hired during the year had the same price. So they came up with some bizarre pricing procedures in an attempt to be fair. Then, unless someone questions them early on, those procedures get formalized - and here we are ten years later with a scandal on our hands...

Director Liability and Responsibilities: After Disney

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The Role of Investment Bankers

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