Your company is about to report spectacularly good news. You get a big grant of options just before the announcement. Is that a crime?
It depends, I learned Monday at a conference put on in Washington by Stanford Law School’s Rock Center for Corporate Governance. If you’re the CEO, you know about the pending announcement, and you fail to inform the board members who sign off on the options grant, you’re in big trouble. This is what Rock Center faculty director and Stanford Law professor Joseph Grundfest calls “asymmetric springloading,” and a federal appeals court ruled 38 years ago (for those of you with access to Westlaw: SEC v. Texas Gulf Sulphur Co., 401 F.2d 833) that it amounts to fraud–even if the board, after the fact, declares that it didn’t really mind.
But what of “symmetric springloading,” where the board members making the grant are fully aware of the news that is about to send the stock price leaping? Or “bullet dodging,” where a grant is delayed until after the announcement of some really bad news? Or timing releases of bad news to precede a regularly scheduled options grant–a practice for which there is apparently no nickname?
These are all a bit icky, and certainly give insiders an advantage unavailable to outside shareholders. But are they illegal? The consensus of the legal experts on hand Monday was that they would be very difficult cases for prosecutors to win. “What I’d tell a client is, ‘You have a very serious fraud problem, but I can help you,’ ” said David Becker, a former SEC general counsel who is now a partner at Cleary Gottlieb, when Grundfest questioned him on the legality of bullet dodging.
Forging documents to make it seem that options were granted before they really were–backdating–turns out to be just the most obviously illegal tip of an iceberg of dodgy corporate behavior regarding options grants. These practices were discovered by accounting and finance professors looking at the interesting behavior of stock prices before and after options grants. Study after study has found that the stock price of a company granting options tends to underperform the market in the days leading up to the grant, and dramatically outperform it afterwards.
The first paper revealing this empirical result, by NYU’s David Yermack, was published in the Journal of Finance way back in 1997 (it’s not available free online, but an abstract is). Yermack speculated that companies timed their options grants to take advantage of pending news. This unleashed a torrent of similar research, Stanford accounting professor Ron Kasznik said at the conference Monday, including a 2000 paper by Kasznik and UCLA’s David Aboody (summary here) that found a similar stock price pattern around regularly scheduled options grants. Aboody and Kasznik theorized that companies timed their news releases to maximize the value of their options.
It was only in 2004, though, that Erik Lie of the University of Iowa proposed that some companies might actually be rewriting history and pretending that options were granted well before they actually were. That’s what set off the current frenzy of investigations into options backdating that has so far cost the companies involved hundreds of millions of dollars and claimed the jobs of 40 high-level executives.
What about the less-obviously illegal practices of timing options grants and news releases to maximize gains? Such actions amount to, in more or less innocent form, insider trading. There is a school of thought, most vigorously represented through the years by Henry Manne, which holds that insider trading is an good thing, because it facilitates the rapid transfer of information–through the mechanism of stock prices–from insiders to the market at large.
But Manne has never been able to convince Congress or the SEC or most of the securities bar of the rightness of his views. So we’re left with the question: Are springloading and bullet dodging and messing with the timing of news releases–all of which appear to be far more widespread in corporate America than options backdating–things we ought to be up in arms about?
UPDATE: For those of you who can’t get enough of this stuff, Jack Cieselski has already put up a couple of posts about the conference on his Analyst’s Accounting Observer Weblog, with more likely to come.
UPDATE 2: My Fortune colleague and fellow blogger Roger Parloff has posted his own take on the backdating mess.