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July 10, 2006
"Spring Loaded" Compensatory Stock Options
The SEC investigation of back-dated options has uncovered a related, but different, practice -- "spring loaded" executive options. In back-dated options, the company sets an exercise price equal to the lowest stock price in the past several months and claims that the options were granted on that date. It is lying. With spring loaded options, on the other hand, a company waits for announcements of good news that it knows will bump up market price and then grants options to executives on the day before the announcement. The value of the options is "spring loaded" because a day or two after they are granted there is a high likelihood that the options will be "in the money" -- the exercise price will be below market price, affected by the new announcement of good news. Is this or should this be illegal?
The answer is complex. The practice is illegal if the company delays news that it should disclose so as to grant the options but is not illegal otherwise as long as the option grants and the news are disclosed within SEC mandated deadlines. It is similar to making stock grants to executives before good news is announced. It is not "insider trading," it is a form of compensation that is an alternative to a cash grant. Whether the executives deserve the value depends , first, on whether they are performing well in their positions and, second, on proper procedure (whether an independent board of directors has made the decision). The only argument is with the timing of the disclosure -- the SEC could force companies to disclose the practice before the grant of options or stock rather than a few days after (current practice).
The real problem comes with the tax consequences. Compensatory options issued "at the market" are tax favored and spring loaded options are technically at the market. The issue is in the lap of the IRS that has the power to ignore technical compliance when the spirit of the tax rules is compromised. The IRS could choose to re-characterize the options to be "in the money" and lose their favored tax status. I am not a fan of the IRS rules on give favored tax treatment to some forms of compensatory options but if the IRS wants to continue the practice they will have to protect it with new definitional rules.
July 10, 2006 in Corporate Governance | Permalink
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Comments
It is not illegal (nor even a violation of any known SEC regulation). My understanding from my colleagues who are working on option enforcement cases is that the SEC has largely given up on this theory because they couldn't find a coherent violation of securities law.
I also don't think it should be illegal. Let's not forget that most options vest over a several year period and most will have at least a one year cliff. The purpose of options from the company's point of view is generally one of employee retention. Options that are in the money and unvested are "good" from the company's point of view because they have real retention value. The point of spingloading is not necessarily to get the lowest price, but to avoid the higher price, and thus make it more likely that the options will be in the money and remain in the money. Now that the accounting rules have done away with the favorable treatment of options, many companies are moving to restricted stock grants instead of options for this very reason--they have an excellent retention feature. No matter what the stock price does prior to vesting, the employee knows they will get some element of compensation if they stay with the company through the vesting period.
Posted by: Steven Donegal | Jul 10, 2006 6:46:40 PM
I am not an attorney...however I find it hard to believe that springloading options does not violate insiders' fiduciary duty to disclose non-public information or abstain from trade. If these grants are considered to be "trades", how is it that insiders who anticipate the grants do not have the duty to disclose the material non-public positive news that they anticipate will follow the grants (the scenario, by definition, with springloading)?
Posted by: Alan Jagolinzer | Jul 12, 2006 12:23:23 PM
Spring loading is illegal. It is tax fraud by the recipient of the options as the recipient does not report the expected in the money value of the ESOs when granted.
It is fraud by the Compensation Committee and the recipient as the conspire to understate options expense.
If there are sales of equity securities within 6 months at a profit, they must return the profit to the company. But the executives are all promoting the joint interests of each other and will not expose their joint fraud. So they keep it quite.
The designers of the plans are complicit because they do not want to seem incompetent. So they keep quite hoping it blows over.
The result is that the executives get richer, the planners have more work and the stock holders get the results of the criminal managers.
Posted by: John Olagues | Aug 1, 2006 9:55:58 AM
