SEC Raises Questions About Timing Of Executive Option Grants

12/14/04
By: Ann C. Logue, Complianceweek.com

When chipmaker Analog Devices filed its 10-K report on Nov. 30, it announced that the SEC is conducting an inquiry into how the company has granted executive stock options. “We weren’t under any obligation to make the statement,” says Maria Tagliaferro, the company’s director of corporate communications. The company’s legal counsel believes that there may be other companies included in the same inquiry, but they are not yet known.

“We’ve identified the timing of options grants as a matter of interest to us,” says John Heine at the SEC’s Office of Public Affairs.

If executives are given options immediately before positive news is released, they are potentially benefiting from material non-public information; the options would be granted at the lower, pre-announcement price, thereby allowing a company to record a smaller compensation expense.

Back in 1999, Ron Kasznik at the Stanford University Graduate School of Business, and David Aboody of the UCLA Anderson Graduate School of Management, released a paper showing that CEOs who received large stock option awards tended to schedule announcements of good news just after their options award dates and announcements of bad news just before. This strategy maximizes the difference between the option price and stock price.

The practice “could be construed as being wrong or unethical,” says Paul Dorf, managing director at Compensation Resources, an executive compensation consulting firm based in Upper Saddle River, N.J.

Is It Insider Trading?

Richard Painter, a professor at the University of Illinois College of Law who specializes in securities issues, says that the timing of options grants probably doesn’t fall under Section 10(b) of the Securities Exchange Act of 1934.

That doesn’t mean that awarding options in advance of good news is a good idea. Painter says that it’s a corporate governance issue falling under state law. “It is a breach of fiduciary duty for the company executives to be giving themselves options when they are in possession of material non-public information,” he says.

So how can companies avoid such an issue?

“Documentation is key to show a consistent pattern,” says Andrew Oelbaum, president of ExecPay, an executive compensation consulting firm in Port Washington, N.Y.

According to Oelbaum, consistency is critical to defensible positions. “The executive programs should follow other programs,” he says. “If the executive grants are at crazy times but the employee grants are always April 15, that stands out.”

Oelbaum notes that it may be all right to issue options the day before earnings are announced, as long as the grant occurs whether earnings are good or bad.

Dorf at Compensation Resources says that one solution, using an average price for a 30-day prior to the option award date rather than the price on the award date, solves ethical issues but creates accounting headaches. A better solution, he says, is to pick an award date and stick to it. “Most organizations try to peg it to the board meeting that takes place at the end of the fiscal year,” He says. Another is to select such other forms of long-term compensation as restricted stock and stock appreciation rights.

As a matter of good governance, U. of I. Professor Painter notes that the entity granting the award can be just as important as the timing of the award. Rather than executives having any say in the issue, the grants should be made by the board’s independent compensation committee, says Painter, assuming that it is truly independent.