| Options
Timing: Lucky Strikes or 20/20 Hindsight?
OCTOBER 2007
- The Mega Millions Jackpot reached $350 million recently, and
I’m embarrassed to admit that I bought a few tickets. When
I revealed the evidence of my human frailty to my family, they
had a good laugh but then talked about how wonderful it would
be to have a window into the future, and thereby know what lottery
numbers to play. While they discussed how far in advance each
would wish to see with their crystal ball, I began to spend—er,
invest—this imaginary windfall.
What if you
could see into the future and know the winning lottery numbers,
or trade in the stock market using 20/20 hindsight? Unfortunately,
such fantasy is just that. Or is it?
The
Name of the Game
Although
most investors don’t come out ahead when they try to time
the market, some corporate executives have had better success,
albeit with the benefit of hindsight, in the guise of backdating
stock options, the subject of several excellent articles in this
month’s issue. When it comes to predicting the future, not
all shareholders are created equal.
Backdating
occurs when the grant date of a stock option precedes the authorization
date and the stock price has increased in the interim. These options
are said to be “in the money.” But backdating is only
the tip of the options-timing iceberg.
“Bullet
dodging” is when a corporation delays an option’s
grant date until after it releases unfavorable news or expedites
the announcement of bad news to precede an already scheduled grant.
A mirror image of this method is “springloading,”
where the grant date is set prior to the announcement of good
news (or the corporation delays good news until after an already-scheduled
grant).
Both techniques
are option-timing games used by some executives to benefit personally
by trading on material, nonpublic information about their company.
To prevent violations of insider trading rules, corporate insiders
are required to report trades involving their own securities to
the SEC. The purpose of this disclosure requirement is to alert
investors about companies with investment potential or warn about
a company that may be headed for the rails (at least in the view
of corporate insiders).
Prior to
the Sarbanes-Oxley Act (SOX), companies had 45 days after the
end of the fiscal year to report options granted during that year.
SOX section 403(a)(2) now requires that a company report to the
SEC its officers’ or directors’ trades of company
shares “before the end of the second business day following
the day that the subject transaction has been executed.”
Unfortunately, this requirement has not been enforced: According
to a report by the research firm Glass Lewis (www.glasslewis.com),
many companies have not complied, allowing them an opportunity
to change the actual option grant date to one when the stock was
trading at a lower price.
Legal
or Illegal?
The legality
of options timing has been argued in and out of the courtroom.
This argument, however, misses the point. Violation of law, as
it pertains to these issues, generally can be prevented with adequate
disclosure and proper accounting and tax recognition. But what
about a corporation’s duty to treat shareholders equitably
and properly disclose compensation costs? Timing options so that
executive shareholders benefit at the expense of others, or so
that executive compensation costs are hidden, can fall short of
a legal violation while constituting poor business practice.
Ironically,
a 1993 tax law that limited the deductibility of executive non–performance-based
cash compensation has been fingered as the culprit for the creative
accounting associated with options timing. (A colleague of mine
would call that “barking, and blaming it on the dog.”)
Compliance with the letter of the law has led to distortions and
violations of the spirit of the law. Stock options are a legitimate
form of performance-based compensation; however, some have defended
the practice of backdating options as a board’s prerogative
to exercise its business judgment. Anything that raises questions
about the integrity of a public company, including the manipulation
of stock option grants, undermines investor confidence in the
fairness of our economic system.
Research
has documented that stock prices tend to be abnormally negative
prior to executive option grants, and abnormally positive afterward.
Not surprisingly, this pattern essentially disappeared after the
implementation of the SOX disclosure provisions, but companies
that still show this pattern also tend to have reporting delays.
Today’s technology makes same-day electronic disclosure
of executive stock transactions possible. Isn’t it time
to require companies to use it?
For those
of you who are still dreaming about how to pick the winning numbers
for that lottery ticket—If you want a sure bet, simply backdate
an option.
As always,
I welcome your comments.
Mary-Jo
Kranacher, MBA, CPA, CFE
Editor-in-Chief
mkranacher@nysscpa.org
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