Archives For option timing scandal

Today’s W$J has an article describing some of the option granting practices at Brocade (see here). Among them was the creation of a one member compensation committee consisting of Brocade’s CEO, Greg Reyes. The article gives the following as the reasoning:

The process of granting stock options was cumbersome because the compensation committee met only every three months. Mr. Reyes said he wanted to speed it up so he could recruit better in those hectic days in Silicon Valley. The board gave him authority to approve options by himself, including their exercise prices.

He said the idea was supported by Larry W. Sonsini, one of the most prominent attorneys in Silicon Valley, who was then a Brocade director. A spokeswoman for his law firm, Wilson, Sonsini,Goodrich & Rosati in Palo Alto, said that one-person stock-option committees are legal under the laws of Delaware. That’s where Brocade is incorporated. “One-person stock-option committees were adopted during a time of intense competition for hiring and retaining employees and the ability to act quickly was critical,” said the spokeswoman for the law firm.

Wilson, Sonsini is of course correct. DGCL Sec. 141(c)(1) provides: “The board of directors may, by resolution passed by a majority of the whole board, designate 1 or more committees, each committee to consist of 1 or more of the directors of the corporation.” (emphasis added). The MBCA has a similar provision. While it may not represent best corporate practice to have single member committees, given the statutory language it is certainly within the board’s business judgment as to whether it is appropriate in a particular case.

With respect to compensation committees, however, NYSE and Nasdaq listing standards adopted in 2003 make it clear that the CEO cannot be on the committee–it has to be composed entirely of independent directors. Note that the standards do not specify whether a compensation committee can consist of a single independent director, but they use the plural “directors” in a way that implies the answer is no.

Although listing standards may make the question moot for most public companies, if you were a director, would you sign-off on a single member compensation committee? My inclination is “no.” Even during “a time of intense competition for hiring and retaining employees,” it seems to me that at least three directors could make themselves readily available to approve option grants through written consent. Executive compensation is just too riddled with temptation for abuse to leave to one person.

Story here. The SEC will hold a Webcast press conference at 5pm E.D.T. (click here).

ISS on Option Timing

Bill Sjostrom —  18 July 2006

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.”

Today’s WSJ has a great article by Holman Jenkins on reporting on the backdating “scandal.”  Larry is, of course, on the case.  I would also — modestly — point out that much of what Jenkins says in his article today, I said in this space about four months ago, when the news was first breaking.  The key elements:

  1. The notion that backdating gives executives an incentive-defeating “paper profit right from the start” is asinine.
  2. “Backdating” may make perfect sense as a means of compensation, especially given certain regulatory quirks.
  3. If the practice amounts to corporate shenanigans, they sure didn’t bother to hide it very well.
  4. Non disclosure of the practice, if disclosure was required, may, of course, be illegal.
  5. To quote Larry, “second-guessing executive compensation is a tricky business, even when the problems seem clear.”

On the somewhat-related matter of spring-loaded options (the raising of which was not at all inappropriate, Elizabeth), I find myself in complete agreement with Larry.  Strange, I know.  But it ain’t misappropriation if the board knows what’s going on.  Once again, perhaps some disclosure is required, but it’s hard to see how non-disclosure of the compensation scheme could transform informed executive compensation into a section 10(b) violation.

In both cases, I’m pretty sure there’s no “there” there, but I’m equally sure we’ll be reading (and litigating) about them for quite some time to come.

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.

Over at Professor Bainbridge’s place, Iman Anabtawi has some thoughts on the granting of “spring-loaded” options, an option granted at a market price that does not incorporate some favorable non-public information, and insider trading laws. The practice is analytically similar to granting a discount option (one with an exercise price below the market price) and is related to backdating (issued retroactively after the information is released). Check it out.

UPDATE: Ribstein responds.

A letter to the editor in today’s W$J (see here) asserts the following regarding option backdating:

[B]y backdating options at the lowest price of the past period, say, three months, a company is not providing any more incentives to CEOs to work harder on behalf of shareholders. If anything, since the options are already in the money on the grant day, CEOs are getting money right now, even though they have not done a thing to benefit shareholders. It defeats the very purpose of granting stock options, namely to align future efforts of CEOs to the best interest of shareholders in the future.

This is a criticism appearing in various forms in various articles I’ve read regarding option backdating, and it makes little sense to me. The incentive provided by stock options comes not from the strike price but from the fact that the option increases in value essentially dollar for dollar as the company’s stock price rises. If setting a strike price below market price is in and of itself problematic in terms of incentives, people should have been in an uproar when Microsoft and other companies changed from stock options to restricted stock. The grant of restricted stock is essentially the same as granting an option with an exercise price of zero. I do not recall any uproar, nor should there have been one.

Further, CEOs do not “get money right now” from backdated options. They do have an immediate paper gain, but the gain is typically subject to vesting, and locking in the gain is greatly complicated by Section 16 of the Exchange Act. If the stock tanks before the option can be exercised or the gain locked, the CEO never gets the money. Hence, options, even if backdated, certainly provide CEOs with incentives to increase share value.

An article in yesterday’s NYT describes the genesis of option backdating at Micrel Inc., a silicon valley semiconductor company:

Throughout the 1990’s, Silicon Valley companies were locked in an intense battle to recruit employees, and stock options were their primary tool.

* * *
So when new hires began complaining that the [Micrel’s] volatile share price meant that colleagues who had arrived just days earlier were receiving stock options worth thousands of dollars more, Micrel executives moved to satisfy the troops. They raised with their auditor, Deloitte & Touche, the idea of adopting a new options pricing strategy similar to one that other tech companies, including Microsoft, used at the time.

Instead of granting options at the market price on a new employee’s hire date, Micrel proposed setting the price at the lowest point in the 30 days from when the grant was approved.

It seemed like an ideal solution. The 30-day window could help Micrel attract and reward new hires on a more equal footing, while helping to retain existing employees. And if it were extended up the corporate ladder, the prospect of built-in gains and tax breaks, worth millions of dollars, could enrich senior executives.

Deloitte allegedly approved the strategy but five years later reversed course. By then, however, the practice had become the norm in Silicon Valley and perhaps ultimately led to the option backdating scandal we’re now in the midst of.

As I’m sure you’ve heard by now, the Delaware Supreme Court finally issued its opinion in Disney. See this post at the glom for commentary by Gordon Smith and a collection of links to discussion on other blogs. As for option backdating, I think directors on compensation committees of companies embroiled in the backdating scandal (or perhaps more accurately, D&O insurers) can breathe a sigh of relief following Disney, at least with respect to personal liability under state corporate law. The reason I say this is I suspect there is a strong argument that many of these directors breached the duty of care by failing to be properly informed when approving the issuance of backdated options. Specifically, my guess is that there is evidence out there that directors signed-off on written consents with grant dates left blank, approved minutes with altered grant dates, or ratified grants with no inquiry as to whether the grant dates were accurate. I’m not saying the directors knew of the backdating but that they were not properly informed/grossly negligent in approving the grants (it’s a different story if they knew). Prior to Disney there may have been concern that this sort of gross negligence arguably constituted a failure to act in good faith allowing a plaintiff to get around a 102(b)(7) exculpation provision. Disney, however, equates failure to act in good faith with bad faith and makes it clear that gross negligence does not constitute bad faith (see here).

For those following the option backdating scandal, the W$J has a regularly updated scorecard here listing the embroiled companies, etc.  (HT:  Lattman).

As I noted in this post, there are a variety of federal securities law claims that could be alleged with respect to option backdating. The case filed against UniteHealth, however, is a derivative suit which indicates it is based on state law claims. I was curious as to what exactly the claims are so I tracked down a copy of the complaint (see here). The complaint specifies the following five counts:

Count 1: Breach of fiduciary duty (care, loyalty, reasonable inquiry, oversight, good faith and supervision).
Count 2: Gross mismanagement.
Count 3: Waste of corporate assets.
Count 4: Unjust enrichment.
Count 5: Breach of contract.

I was surprised not to see a specific reference to a breach of the duty of disclosure/candor ala Malone v. Brincat. UnitedHealth, however, is a Minnesota corporation, and perhaps Minnesota does not recognize the duty. Also, counts 2 and 3 seem redundant to me in that they constitute breach of duty of care claims.

It will be interesting to see if the case goes anywhere in light of the business judgment rule and the exculpation provision which I assume UnitedHealth has in its articles of incorporation.  However, I could see the plaintiffs arguing that the backdating resulted in an intentional misstatement of material fact in the UnitedHealth proxy statement which constitutes a knowing violation of law thereby rebutting the business judgment rule and piercing the exculpation provision.

Following up on this post, a new paper entitled “The Dating Game: Do Managers Designate Option Grant Dates to Increase Their Compensation?� was recently posted on SSRN (click here). The paper was co-authored by two U. of Michigan Finance professors, M.P. Narayanan and Hasan Nejat Seyhan. Here’s the abstract:

We provide evidence of a dating game that entails picking a grant date ex-post, i.e., after the board’s compensation decision is made. We suggest two variants of the dating game. Back-dating (picking a date in the past with a lower stock price compared to board decision date) if the stock price has been rising prior to the board date, and forward-dating (waiting after the board decision date to observe the stock price behavior) if the stock price has been falling prior to the board date. Using a database of 638, 757, option grant filings by insiders between August 29, 2002, and December 31, 2004 we find evidence consistent with both types of dating games. Specifically, we find stock price behavior around the grant date to be positively related to reporting lag, consistent with back-dating. In the promptly reported sample, we find stock return behavior around the grant date and the pattern of reporting lags consistent with forward-dating. Our calculations show that managers can obtain economically significant benefits by playing the dating game.