Institutional Shareholder Services (ISS) has posted an eight-page white
paper entitled An Investor Guide to the Stock Option Timing Scandal. The paper provides a good overview of the recent option backdating and spring-loading revelations.
There has been a number of posts in the blawgosphere debating the legality of backdating and spring-loading. While these practices are not necessarily illegal, as the paper points out:
The option-timing scandal . . . calls into question the oversight provided by boards and compensation committee members at these companies. . . . [I]nvestors may fear that other accounting problems exist but have yet to come to light. The disclosure of backdating sends a ‘signal that management is willing to fudge numbers for their own benefit and they might be willing to play other accounting tricks.’
ISS recommends the following as best practices for option grants:
- Adopt “blackout” periods to preclude stock grants when company executives have material, non-public information in hand.
- Adopt fixed grant date schedules that provide for grants on a periodic basis (monthly, quarterly, or annually), along with rules for the establishment of option exercise prices on such grant dates.
- Refrain from making grants on these fixed dates when executives have market-moving news.
- Disclose the rationale for grants on a certain date, explaining why the compensation committee chose that date over other possible dates.
- File Form 4 reports on option grants promptly with the SEC.
While these practices would certainly go a long way towards eliminating backdating and spring-loading, as Geoff pointed out essentially on day one of the scandal (see here), option timing can be an efficient form of compensation. SEC Commissioner Atkins recently expressed a similar view regarding spring-loading in a speech before the International Corporate Governance Network (see here). This view, however, has not been particularly well received (see, e.g., here), perhaps in part for the reasons Tom discusses here.
It will be interesting to see how many companies adopt the measures recommended by ISS. For companies embroiled in the scandal, the lost flexibility in designing a compensation package would likely be outweighed by the potential restoration of investor confidence. For companies outside the fray, perhaps the scandal will simply result in a couple of lines of added disclosure along the lines of “The compensation committee may, in the exercise of its business judgment, from time to time approve grants of options shortly before the public disclosure of favorable company developments.”
Bill — 162(m) has been interpreted in a way that equates performance-based with a rise in stock price. In-the-money options are not treated as performance based because they would have value even if the stock price declined a bit. Backdated options are the functional equivalent of in the money options. Spring-loaded options are at best a closer case.
Mind you, I’m not defending the way that the tax code draws a silly line between in the money and at the money options. It should all be deductible.
And yes, only companies with a positive marginal tax rate will care. Some tech companies don’t; I wonder if this helps explain the pattern of backdating.
I’m not aware of any authority either way on spring-loaded options. Why do you think it seems like an aggressive stance (it may very well be, but since you are the tax expert I was hoping you could elaborate)?
Also, wouldn’t the full brunt of the 35% penalty generally only apply to companies that have sufficient taxable income in the year of grant to take advantage of the deduction?
Bill — Just as a side note, the efficiency argument falls apart if you lose the tax deduction under 162(m), and possibly run afoul of 409A. Is there authority out there saying that spring-loaded options are still performance-based for purposes of 162(m)? It seems like an aggressive stance.
I certainly agree that tying a comp committee’s hands could appear to be inefficient for companies that don’t have an investor confidence issue. But if the tax code has already imposed a 35% penalty on in-the-money and effectively in-the-money options, then the ISS proposals do seem sensible.
I’m surprised ISS didn’t announce its preferred position that all options be granted at the high stock price in the year of grant. I heard they were considering recommending pricing at the high price during the vesting period, but thought that might not provide the proper incentives.