*Why* Are Directors Awarding Spring-Loaded Options?

Elizabeth Nowicki —  12 July 2006

Of late, my colleagues on the internet have been blogging about stock options – notably discussing backdating and “spring-loading.�  My colleagues have done a fine job with debating whether or not the latter is illegal (and/or reprehensible) and discussing the status of play with the former.

My contribution to the discussion is to ask “what are boards of directors *thinking* when they sign-off on spring-loaded options�?  Why are directors willing to risk a firestorm?

As to backdating, it is possible that directors are often unaware of the backdating (the Wall Street Journal had an article today discussing a fellow who was fired for refusing to change employees’ employment dates (to result in revalued options), and the article indicated that the backdating endeavors at issue were covert).  As to awarding “spring-loadedâ€? options, however, I have a hard time thinking of an instance where a CEO (CFO, COO, etc.) could get these options without approval first from the directors (or arguably just the compensation committee of the board).  Therefore, the directors clearly know or should know about the granting of these options, and I have to wonder why directors of the corporations at issue sign-off on the awards.

Here is why I am raising the point:  I can see no other reason for granting spring-loaded options than to allow a CEO to get a monetary award from an about-to-be-announced item of material good news.  Yet the timing of this sort of award at least raises securities fraud issues, as others have noted.  Even if ultimately it is determined that the award of spring-loaded options on as-yet undisclosed material news is not securities fraud, it clearly smells bad.  Why would a thoughtful director go down that road?

Moreover, as best I can tell, these options are intended to be a reward to the grantee presumably for a job well done (as opposed to a motivator for future success).  Given the “smells bad� concern, why would thoughtful directors not insist on rewarding executives in a more innocuous way, such as with cash?  The tax hit is moderate (relatively speaking), the cost to the corporation is relatively small, the disclosure is limited (e.g. I am not sure that the cash would need to be more specifically broken down on the year-end report than any other bonus), and the potential for ugly media is minimal.  Someone on these boards of directors should have been saying “Isn’t it going to. . . look bad to give options to an executive dated/priced the day before we announce big, positive, stock-price-moving news?  Aren’t our stockholders going to be . . . miffed?�

From the director liability standpoint, surely one cannot argue that the failure to raise the issue within the board of directors is an act of good faith.  (Remember that the “good faithâ€? language has recently been the language du jure regarding director liability.)  If directors are signing-off on the spring-loaded options, *and* the directors know that the corporation is soon to announce big news, there is no credible argument that the directors were justifiably unaware of the “spring-loading smells badâ€? issue.  Failure to discuss at length the “smells bad” issue (or the “potential illegality” issue) before awarding the options cannot be an act in good faith, if the directors know that (a) spring-loaded options at least *raise* the securities fraud issue, (b) public disclosure of the options will likely not enhance corporate goodwill and reputation, (c) the option grants might well undermine investor trust (to the extent that they at least smell a bit like insider trading), and (d) there are other, more conservative, less controversial ways to reward executives on the eve of good news.Â

Let me take a moment to plug an article written by organizational behavior maven Dr. Margaret Nowicki (the smarter, funnier, nicer Professor Nowicki) and her colleagues Drs. Lippitt and Lewis on symmetrically re-loading stock options. Directors might consider whether the re-loading feature these professors suggest is worth using to avoid the heat that spring-loading draws.  I think it is.

P.S.  Hopefully it is not a violation of blogging norms to post a topic related to a very recent post by Professor Wright.  If so, I apologize.  I do not want to be fired after only one day as a associate visiting guest or visiting associate guest or associate guest visitor or whatever.

3 responses to *Why* Are Directors Awarding Spring-Loaded Options?

    Steven Donegal 12 July 2006 at 11:13 am

    Allow me to suggest the most plausible reason (at least to me): at the time, no one thought it was a big deal. You are applying today’s governance standards (which have changed radically since Enron) to past practices. In the time frame we are talking about, generally pre-2003, executive compensation was not the boogeyman that it is today. Options had no accounting cost. Most securities lawyers did not (and still do not) believe that springloading was illegal, or in most cases, immoral or unethical. Accordingly, boards were advised that it was not a problem if they granted options at a meeting prior to release of a positive earnings announcement. Second, prior to the effectiveness of FAS 123R, most directors (and I think it is fair to say, most analysts and investors) did not think that mildly discounted options had much cost to market value of the shares, so there was not an ethical concern about grants in advance of good news. Management was much more concerned that key employees had a substantial number of unvested, in-the-money options.

    I think what many people do not focus on is that grants are typically made to all eligible employees at the same time, so that when the CEO gets a grant, so typically do middle managers and engineers and others. For the latter group, a key element in equity grants is the retention value of those grants. It is good for morale and retention for option grants to be in the money. For that reason, even if not technically springloading, companies often chose to grant options at times that management and the board thought the stock was undervalued.

    In today’s climate, behavior has changed. Companies are moving away from options to restricted stock grants (Query whether that is really better for stockholders?) and to grant dates specified well in advance that typically occur during open window periods. It will be interesting to see where grant practice settles out after the current hysteria dies away and whether five years from now there has been any noticeable effect on corporate performance.

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