Tuesday, July 11, 2006


Personally, I think my headline is more on target than the one that actually ran in the weekend Wall Street Journal, above a story regarding the latest stock-option scam:

Can Companies Issue Options, Then Good News?

As reported, the story itself is straightforward:

New controversy is brewing over the way companies dole out stock options, this time over the practice of granting them just days before announcing good news -- an effort to give executives a quick profit on paper.

Known as "spring loading," such options grants have generated heat in recent days. While spring loading is different from "backdating," another type of options timing, corporate critics blast it as a form of insider trading. Defenders call it a legitimate form of compensation -- and their ranks include a commissioner of the Securities and Exchange Commission.

That last sentence is what gets me.

The fact that Boards of Directors are allowed, under the current rules, to help their pals in management get to G5 status faster by granting them options in front of good news is not nearly so alarming as the fact that an SEC commissioner sees nothing wrong with it.

The Journal duly reports that SEC commish's logic as follows:

In a speech Thursday before the International Corporate Governance Network, Republican SEC Commissioner Paul Atkins gave a spirited defense of spring loading, calling it a legitimate and low-cost way for boards to efficiently compensate executives. He rejected claims that such awards amount to trading on inside information.

"Boards, in the exercise of their business judgment, should use all the information that they have at hand to make option-grant decisions," Mr. Atkins said. "An insider-trading theory falls flat in this context, where there is no counterparty who could be harmed by an options grant. The counterparty here is the corporation -- and thus the shareholders."

I don’t know much about Mr. Atkins except he is a lawyer, and that may be everything you need to know. By focusing on “theory” instead of reality, Mr. Atkins has allowed himself to miss the point: this is insider trading, plain and simple.

But before we get into cases, let’s stop calling them “spring-loaded” option grants, because that makes it sound as if the economic payoff for the insiders is simply a bit more leveraged to a rise in the stock price than the payoff for other shareholders when the company announces the expected good news.

No, what has happened is the insiders have given themselves a larger slice of the shareholder's pie when they know the value of that pie is about to increase. So let’s call them “front-running” option grants, because that is exactly what they are.

On its face, the ability of management to grant themselves front-running options violates the very SEC regulations Mr. Atkins has been sworn to enforce.

After all, Reg FD requires an even playing field for investors: no tips to Wall Street’s Finest; no wink-wink, nudge-nudge to Fido; no nothing to the big hedge funds prior to disclosure of market-moving news, good or bad. So why should management be able to front-run their own news flow?

Using Mr. Atkins’ lawyerly legalese, ipso facto, the thing stinks.

Furthermore, lawyer though he may be, Mr. Atkins’ defense of front-running option grants (that Boards “should use all the information that they have at hand to make option-grant decisions”) is flawed logic.

After all, if Boards are allowed to game option grants based on future news flow, they will give their friends in management option grants in front of good news and only good news. No way will they grant options in front of bad news if they can help it.

So you’ll have companies diluting any windfall accruing to their existing shareholders by granting options prior to all the good news, while forcing existing shareholders bear the full economic loss from whatever bad news comes down the pike.

Res ipsa loquitor, the thing stinks.

A Board of Directors that really wants to do its job and protect the economic interests of all shareholders should allow option grants on a specific date, same time every year, to all employees, no exceptions.

And if that same Board wants to take advantage of good news for the benefit of all, as Mr. Atkins would have us believe it is doing by granting front-running options, there is a much better way to accomplish this that appears to have escaped Mr. Atkin's lawyerly logic: the company can buy back stock for the corporate treasury ahead of good news.

That's good for the company, good for shareholders, and good for all the employees who hold options in the equity value of the company.

Anything less, and it becomes lex non distinguitur awop-bop-a-loo-mop alop bam boom.

Jeff Matthews
I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.


Its_strange said...

And what if that good news turns out to be hype or misleading or just plain wrong and the bigshot exercises and than sells on that yet to be announced correction or restatement ? It looks to me Cox should do some reading...Start with SEC vs. TTWO

cadamyale said...

Dead on. Thanks, Jeff.

Aaron Koral said...

Jeff - Here's another idea: why not change the tax treatment on Non-Qualified Stock Option Plans (NSO's), where instead of the employee paying the tax on the difference between the current stock price and the exercise price of the option on its expiration date, have the company pay the tax instead and eliminate the deduction it takes? The change in tax law would stop the "front-running" of option grants "cold in its tracks", I would think (but I could be mistaken).

bubbles said...

It stinks so bad it makes me sick. What blows me away is the fact the defenders see nothing wrong with this. Don’t these people have any morals?

Gone to the blogs said...

This statement made my jaw drop...

"An insider-trading theory falls flat in this context, where there is no counterparty who could be harmed by an options grant. The counterparty here is the corporation -- and thus the shareholders."

Excuse me, but how is the shareholder not a harmed counterparty when an ownership interest is essentially granted at a below-market price?

schinvst said...

The Board/firm should simply pay the CEO, CFO, CIO, COO and all the rest what is needed, period. Simple, above board and done with. If absolutely required it is just as well, as Jeff suggests, that options are granted on a particular day in the year.

Ideapush said...

Graff Crystal over on Bloomberg News just joined your camp:

Keep telling it like it is

the management said...

This is a very curious interpretation of "insider dealing theory". As far as I'm aware, under the standard economic theory of insider dealing, the counterparty is not the victim of an insider deal, because they were a willing party to the original trade. Insider dealing is a crime against the market as a whole, because it reduces liquidity as spreads have to be wider to compensate for the risk of dealing with an insider. Since front-running option grants are certainly a risk that would need to be priced into the spread, I can't see how they don't fall into the normal category of insider dealing theory.

SiamTwin said...


Honorable Justice Jorge P. Smythe said...

Robert Reich got to this too.

I liked this quote:

"I’ve heard a lot of arguments over the years to justify almost anything. But let me tell you, this is a doozie. It’s a little like arguing that home insurers benefit if people back-date their home insurance policies to take effect before their houses burn down because then they’ll have the money to renew their policies."

whydibuy said...

I thought that vesting eliminated the possibility of flipping. Most option grants I see don't vest and become exercisable untill at least 12 months and then only a portion with the remainder vesting in increments over a multi year span.