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| 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.
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