Backdating stock options, as any of more than 100 companies now under scrutiny can now attest, is a bad idea. But what about spring-loading, the forward-looking cousin of backdating?
In testimony before a Senate Committee on Banking, Housing, and Urban Affairs on Wednesday, regulators, an academic, and private sector representatives roundly condemned backdating, the practice of adjusting stock option grant dates to an earlier time than they were actually granted in order to provide a windfall to the new option holder. But spring-loading, which was also discussed during the hearing, received more mixed comments, underscoring general disagreement among regulators and in the marketplace over whether the practice is, in fact, illegal — or even unethical.
Spring-loading is the practice of scheduling an option grant before the release of positive corporate news, a move that anticipates a rise in the stock price and attempts to give a maximum boost to the value of the stock option. (Another practice, called bullet-dodging, is the practice of delaying a grant until after negative news has been released and a company’s stock price has declined.)
Unlike backdating, spring-loading can be difficult to prove. Guilty or not, companies accused of backdating clearly would have known what would be a favorable option grant date. But a company suspected of spring-loading cannot be said to have that advantage, and executives can argue, truthfully, that there is no way to know for certain how the market will react to impending news.
As a result, there is no consensus on whether spring-loading is a legitimate, albeit calculating, business judgment or an unethical or illegal corporate action that poses reputational and legal risks.
Christopher Cox, chairman of the Securities and Exchange Commission, mentioned spring-loading briefly during the Senate hearing and characterized it as a practice that is “bound up with concepts of insider trading.” Cox emphasized that the SEC focuses on cases in which insider trading has occurred and can be established — a comment that seemed to suggest spring-loading is even more difficult to prove.
A much stronger view came from Lynn Turner, managing director of research at Glass Lewis, an investment research and proxy advisory firm. Turner, a former chief accountant at the SEC, strongly denounced spring-loading. “I couldn’t disagree more with those who say it’s not illegal or a problem,” said Turner. In the filings of companies accused of spring-loading, the disclosures of stock option grants “have been grossly misleading and false,” he said. “Investors were misled and executives failed to tell the truth, which is a violation of securities laws.”
Another witness suggested banning spring-loading for named executives and directors. Speaking on behalf of the Chartered Financial Analyst Institute, Kurt Schacht, a managing director, said directors and officers that manage the option granting process should be prohibited from spring-loading, “just as they would be prohibited from trading in any other company securities while in the possession of inside information,” he said.
Russell Read, the chief investment officer at the $209-billion California Public Employees’ Retirement System (CalPERS), recommended that if the current disclosure requirements for executive compensation does not diminish spring-loading, the SEC should take additional steps to ensure that grants occur at specific times. “A specific statement by the SEC would create ethical authority with regard to granting stock options,” said Read.
The debate over timing options with an eye toward market reaction to corporate news is not new. In July, SEC Commissioner Paul Atkins argued that there was nothing wrong with spring-loading.
Speaking before a conference sponsored by the International Corporate Governance Network, Atkins asked, “Isn’t the grant a product of the exercise of business judgment by the board?” He explained that in deciding to grant options before positive news, the directors may determine that they can grant fewer options and the recipient could get the same economic effect when the stock price rises.
“Who are we to second-guess that decision? Why isn’t that decision in the best interests of the shareholders?” asked Atkins, who added that it is difficult to predict the stock price change of an upcoming event and the future direction of that stock over multiple years until the options recipient is vested in those options.
Fred Lipman, a partner at the law firm Blank Rome, believes that spring-loading is legal as long as the compensation committee awarding the options knows the same information as the recipient and the company discloses to shareholders that it does not withhold granting options when undisclosed, positive company information is pending.
However, said Lipman, “if both sides [don't have] equal knowledge, I think it can be a violation of insider trading rules.” For example, if a chief executive officer knows positive, undisclosed information will be released, but the compensation committee does not, that could be a violation.
Given the confusion and uncertainty around this practice, it’s easy to see why the SEC is targeting backdating cases first, notes Todd Fernandez, a senior research analyst at Glass Lewis who spoke with CFO.com before today’s hearing. Spring-loading cases would be much more difficult to prosecute, explains Fernandez. The onus of trying to justify that inside information was material enough that the company or the options recipient should have known the stock would react positively is difficult. “It’s not an open-and-shut case,” he said.