Self-Deal? CEOs? Nahhh ...

Backdating may be just the beginning: A lot of other suspicious stuff tends to happen when companies grant options.

By Justin Fox

(Fortune Magazine) -- It is never really a shock to find executives enriching themselves at shareholders' expense. It can sometimes be surprising, though, just how clear the evidence is, and how long it takes us to notice.

Take the options-backdating scandal that has claimed such CEO scalps as that of Comverse's (Charts) Kobi Alexander (currently fighting extradition from Namibia), UnitedHealth's (Charts) William McGuire (ousted after 14 years of spectacular success) or KB Home's (Charts) Bruce Karatz (who voluntarily stepped down and agreed to pay the difference for incorrectly priced grants).

Kobi Alexander, former CEO of Comverse, fled to Namibia to avoid prosecution.

The scandal has its roots in a 1992 SEC decree that companies list in their annual proxy statements the exact dates that they gave stock options to top executives. The dates had been disclosed before, but only in mailed-in filings that no one ever looked at.

To corporate America, the new rule was a minor hassle; to a first-year New York University finance professor named David Yermack, it was a new source of interesting data. Yermack began examining stock prices before and after options grants, and found the eerily consistent pattern displayed (in updated form) in the chart on this page: The average company's stock price dropped in the days before its CEO was given a bushel of options, and rose afterward.

Executive options are usually granted "at the money" - i.e., if the stock is at $10, the CEO gets options to buy it for $10 a share - so getting options on a bad day for the stock is good news for the recipient.

Yermack figured that this wasn't just luck, and theorized that companies were timing their grants to precede good-news announcements and follow negative ones. His findings began making the rounds in 1995, sparked a flurry of interest among finance and accounting scholars, and were published in The Journal of Finance in 1997.

Accounting professors David Aboody of UCLA and Ron Kasznik of Stanford followed up with an examination of companies that made options grants on more or less the same day every year, and found a similar stock price pattern. Their theory: Companies time releases of bad and good news to depress prices before the grants and boost them afterward.

And then, suddenly, absolutely nothing happened. Nobody off campus paid any attention - until 2004, when finance professor Erik Lie of the University of Iowa noted that many options grants were timed to exploit marketwide price movements that no CEO could predict. "At least some of the official grant dates must have been set retroactively," Lie suggested in a paper.

Fiddling with options grant dates retroactively and lying about it in corporate financial reports is clearly illegal. So Lie sent a copy of his paper to the SEC and the agency began sniffing around.

The resulting backdating scandal has so far led to criminal charges at two companies and a paroxysm of what Stanford law professor and former SEC commissioner Joseph Grundfest calls "Maoist-style self-criticism" at many others, with more than 40 high-level executives losing their jobs.

The first lesson to be learned from this brief history is that we should pay more attention to number-crunching B-school professors, who now have played a key role in uncovering two major business scandals. After-hours trading in mutual funds, remember, was brought to light by Stanford economist Eric Zitzewitz and other scholars.

Beyond backdating

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Then there's the realization that, even before Lie's backdating bombshell, scholars suspected that executives were using insider information for financial gain in timing options grants and news releases.

Does that make backdating just the most obviously illegal tip of an iceberg of dodgy corporate behavior? And is anyone going to get in trouble for the other stuff?

Those are questions currently of great interest to securities lawyers, I learned at a late-October conference at Washington's Union Station. "Lucky Strikes" was the title of the event - organized by Stanford's Rock Center for Corporate Governance, of which Grundfest is faculty director - and much of the jargon was along similarly flip lines.

"Bullet dodging," for example, is the term for delaying options grants until just after the release of bad news (or moving up the release of bad news to precede an already scheduled grant). Because the grant comes after the news is out in the open, such behavior is nearly impossible to prosecute on insider-trading grounds.

More problematic is "spring-loading" - timing an options grant to precede the announcement of good news (or delaying the happy announcement to follow an already scheduled grant).

At Union Station, Grundfest divided this into "symmetric spring-loading," where the members of the board of directors who approve the grant are fully aware of the good news to come, and "asymmetric spring-loading," where they are not. Asymmetric spring-loading itself comes in two flavors: "with ratification," when the board says after the fact that it's okay, and without.

As Grundfest reeled off these terms, I and the reporter sitting next to me giggled, mainly because they sounded so much like something from a diving meet. ("She's going to attempt a reverse double asymmetric spring-loader and ... she nailed it!") But the distinctions may make all the difference, legally speaking.

Current law on spring-loading dates to the case of Texas Gulf Sulphur, a company that in 1963 made a spectacular mineral find on property it owned in Canada. Executives wanted to keep the discovery quiet while the company bought up land around the site, and were afraid outside board members would leak the news.

In the meantime, these executives accepted options grants from the board. In a 1968 ruling that became a key building block of insider-trading law, a federal appeals court agreed with the SEC that this spring-loading was fraud, even though the board members said afterward that they didn't mind.

Would that be the verdict now? Much has changed since 1968, most crucially the entry of economic reasoning into the legal mainstream. One of the leading lights of this "law and economics" movement, former George Mason University Law School dean Henry Manne, famously argued that insider trading is a good thing because it facilitates the movement of information from inside corporations out to the stock market.

Grundfest contends that this argument has landed "in the dustbin of intellectual history" because inside corporate information amounts to a "trade secret that's owned by the company, not the managers of the company." That means it's up to the board and not individual managers to decide what use can be made of such information. (Manne disputes the "dustbin" characterization but agrees that board approval is key.)

By this reasoning, symmetric spring-loading is entirely legal. Asymmetric spring-loading with ratification might be okay (opinions were mixed at the conference), and asymmetric spring-loading without ratification is fraud.

But no one can know for sure about this until the courts rule. The SEC has yet to aggressively pursue any spring-loading cases, and while a few shareholder lawsuits are in the works against purported spring-loaders, none is near a decision. "Everybody's sitting and waiting," says Grundfest.

In the meantime, Grundfest has been advising companies to schedule their options grants three trading days after a quarterly earnings announcement. This minimizes the amount of inside information that executives could possibly take advantage of. It also has the interesting side effect of giving them an incentive to miss the quarterly earnings target set by Wall Street analysts (because that might depress the strike price of their options). Now that would be a shocking development.


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