Springloading Options Stumps The Experts

Backdating stock option grants is a no-no—that message from the Securities and Exchange Commission, companies have heard loud and clear. But what’s the harm in a little “springloading” to goose an option’s value without the mischief of fabricating any grant dates?

That’s the question companies may now be weighing as they decide if and how to modify their option granting practices going forward.

Backdating—which typically involves falsification of stock option documentation so that the excercise price of the grant is lower than the fair market value of the stock price on the grant date—has emerged as a clear invitation for trouble. Springloading is different: It is a properly executed and documented option grant, but timed so that it coincides with news that has not yet been announced. It might immediately precede good news likely to drive a stock price up, or immediately follow bad news that has pushed prices down.

If that sounds a little like insider trading, that’s because it’s the same concept—except that no one is buying stock.

Kaiser

“There’s nothing illegal about springloading,” says Gordon Kaiser, an attorney with Squire, Sanders & Dempsey. “It’s OK to do it as long as you’re pretty scrupulous about how you do it. If the general process is appropriate—meaning it’s handled by an independent board committee with knowledge of the circumstances—I don’t see that this is a bad practice, and certainly not an illegal one. It has a bad odor to it because it sounds like abuse of insider information.”

Even one SEC commissioner, Paul Atkins, also an attorney, has publicly said springloading doesn’t violate any securities law and isn’t necessarily a bad idea. In a speech to the International Corporate Governance Network in July, Atkins argued that boards of directors need some flexibility to exercise their own judgment about when to grant options.

“A board, by issuing options at an opportune time, maximizes the effect of those options,” Atkins said. “In other words, it takes fewer well-timed options to make the employee happy, and the company does not need to burn cash.”

Atkins challenged the advice many compensation consultants and attorneys are giving their clients today, to adopt predetermined grant dates and avoid any appearance of impropriety. “From the shareholders’ point of view and from the point of view of the board member who is representing the shareholders’ interests, there is good reason why options grants would not be made according to a rigid, pre-set schedule,” he said.

Flunking The Smell Test

Atkins is the only SEC member known to advocate for allowing boards some leeway to time grants around market-moving news. His views don’t sit well with some shareholder advocates.

“It’s extremely problematic when you have insiders benefiting from nonpublic information,” says Daniel Pedrotty, counsel in the Office of Investment for the AFL-CIO, a powerful voice in the institutional investor community. “I don’t see how this falls outside the realm of what constitutes insider trading.”

A recent client alert from the law firm of Proskauer Rose seemed to take a similar view:

This practice, referred to by certain commentators as

“springloaded” options, generally raises fewer technical legal issues than those raised by backdated options but, again, the scope and nature of any potential problem depends upon the applicable facts surrounding the option grants. For

example, while certain corporate governance and disclosure

issues may arise in connection with certain forms of

springloading, if the compensation committee or other

entity making the option grant is fully informed regarding

all facts that may affect the stock price at the time of the

grant, it is likely that no insider trading occurred.

But Kurt Schacht, managing director for the CFA Centre for Financial Market Integrity, said the market doesn’t like the way springloading sounds, even if it is technically legal. “The general sense of shareholders is that it’s at least unethical and probably self-dealing, depending on who’s actually the beneficiary of the option grant,” he says.

“This is negatively perceived in the marketplace, like backdating of options, and that will cause companies to really look at this and make some decisions for themselves.”

— Jack Dolmat-Connell, DolmatConnell & Partners

Schacht said he understands the corporate position that aggressive option granting helps attract and retain skilled labor in a competitive market, “but whether it’s an honest, good compensation practice in the interest of investors is another question.”

Dolmat-Connell

Jack Dolmat-Connell, president of executive compensation consultancy DolmatConnell & Partners, says the question of whether companies can or should springload option grants is proving to be a line in the sand. “Do you see ethics and morals as gray area or a hard-and-fast line?” he asks. “Companies that would do this see it as a gray area.”

Dolmat-Connell doesn’t believe companies are acting deceitfully if they choose to springload—but a negative perception of springloading still exists, he says, making it a dangerous practice. “This is negatively perceived in the marketplace, like backdating of options, and that will cause companies to really look at this and make some decisions for themselves.”

Then there are the purists such as Boyce Watkins, a finance professor who focuses on investments and behavioral finance at Syracuse University; he sees no gray area at all. “It’s just flat-out wrong,” he says. “It’s deceptive because you haven’t told shareholders what you’re doing.”

Tamar Frankel, a law professor at Boston University, is equally convinced. “You don’t allow the person who is faced with temptation to also control it,” she contends. “It’s insider trading. It’s unfair to shareholders because they don’t know it’s happening. I don’t see any basic difference between springloading and insider trading.”

Can Springloading Survive?

While ethicists and companies sort out how they plan to proceed with option grants, some note that the decision may soon be made even easier now that the SEC has published new rules on disclosure of executive compensation. Ultimately, the new rules will require companies to provide more straightforward explanation of their thinking behind such decisions, according to Dolmat-Connell—and that will cause companies to take a more conservative approach.

“Companies are going to have to say how and why they chose the dates they did,” he says. “Most companies are just going to get into a practice of having a fixed grant date.”

Lie

Erik Lie, the University of Iowa professor whose research alerted the market to the practice of backdating in the first place, says his studies don’t necessarily support an assumption that springloading is very effective in greasing the compensation wheel for executives, nor that it’s even a common practice. “Our results show that either springloading is not widespread or it fails to generate large gains for the option recipients,” he says.

Lie’s Web site says the “collective evidence” suggests springloading plays only a minor role in explaining the aggregate stock return around grants. If springloading were important, people would observe “pronounced price decreases before grants and increases after grants, irrespective of whether they are filed on time, but we don’t,” he wrote.

Paula Todd, managing principal with Towers Perrin, said her firm’s economic analysis shows executives don’t necessarily gain a great deal in the long run when option grants are timed around market-moving news.

Using a Black-Scholes valuation model, an accepted but still-criticized method of valuing stock options, Towers Perrin calculated the ultimate value for a hypothetical option granted at a value 10 percent below the trading price for the day. It assumed 50 percent volatility and a risk-free rate of 5 percent.

The calculation shows that when exercised, the ultimate value of the option was only 2.68 percent greater than if it had been granted without the discount. The firm surmises its 50 percent volatility assumption is probably conservative, so the real gain for executives is probably even smaller.

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