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.