INTRODUCTION II. STOCK OPTIONS: POTENTIAL FOR ABUSE A. Options Backdating B. Manipulation of Exercise Date C. Spring-Loading and Bullet-Dodging D. Manipulation of Information Release III. CURRENT STATE OF OPTIONS MANIPULATION: THE EMPIRICAL EVIDENCE IV. FEDERAL SECURITIES LAWS IMPLICATED IN STOCK OPTION MANIPULATIONS A. Options Backdating and Forward-Dating B. Spring-Loading 1. Disclosure requirements 2. Insufficiency of Disclosure 3. Legislative Intent 4. Nature of the Harm 5. Role of Incentives C. Bullet-Dodging V. CORPORATE GOVERNANCE IMPLICATIONS: FIDUCIARY DUTIES A. Overview of Fiduciary Duties 1. Duty of Care 2. Duty of Loyalty 3. Acting in Good Faith 4. Duty of Disclosure B. Standard of Review C. Fiduciary Duty Implications of Options Manipulation 1. Backdating 2. Spring-Loading and Bullet-Dodging VI. PROPOSAL FOR REFORM VII. CONCLUSION I. INTRODUCTION
It has been nearly ten years since the scandals broke regarding the backdating of executive stock option grants in 2006. (1) Stock option packages in executive compensation, once heralded as a simple device to solve the agency problem inherent in the separation of ownership and control to align the interests of management with those of the shareholders, (2) were found to be too tempting to leave to chance. Executives found ways to manipulate the size of their compensation by fraudulently changing the date of a grant, i.e., backdating or forward-dating, so that options that were meant to be granted "at-the-money" as of the grant date were "in-the-money" instead. This provided top executives and directors with an immediate unearned bonus. (3) Researchers have documented that the backdating of options granted between 2000 and 2004 resulted in an average loss of about 7% to shareholders, or about $400 million per firm. (4) This meant that, on average, executives gained over $500,000 per firm each year. (5)
The Sarbanes-Oxley Act of 2002 (SOX), (6) which was meant to bring transparency and honesty to financial statements, (7) was passed in reaction to massive corporate frauds such as Worldcom, (8) Tyco, (9) and Enron. (10) Regarding stopping options backdating however, we find that the practice continues. Executives have simply ignored SOX's two-day reporting requirements and fraudulently manipulated their compensation. (11) In addition, SOX has failed to prevent other forms of stock option value manipulation, i.e., spring-loading and bullet-dodging.
In this study, we show that, despite the effect of SOX and all the reforms in response to the backdating scandal of 2006, (12) manipulation of options is still too tempting and continues to this day. Our evidence shows that executives employ a variety of manipulative devices to increase their compensation, including backdating, bullet-dodging, and spring-loading. Although each of these practices in isolation may have a marginal impact on their compensation, together these manipulative devices unfairly tilt the balance in executives' favor in a meaningful way. Overall, we find that, as a result of these manipulative devices, executives are able to increase their compensation by about 6%. Further regulation is thus needed to ensure honesty and transparency in corporate financial statements and promote market fairness.
This Article proceeds as follows. Part II provides an overview of the various ways executives have been found to manipulate option grants to increase their compensation, including backdating, forward-dating, spring-loading, and bullet-dodging. Part III details our empirical study demonstrating that these schemes exist and continue today. In Part IV, we analyze these manipulative behaviors and argue that they should be considered violations of Sections 10(b) (13) and 10(b)(5) (14) of the 1934 Securities Exchange Act. Part V discusses why these behaviors also violate the fiduciary duties of officers and directors under state laws. Proposals for reform are presented in Part VI, followed by our concluding remarks in Part VII.
STOCK OPTIONS: POTENTIAL FOR ABUSE
Including stock options as part of the executive compensation package can have important advantages. For instance, it can lead to an alignment of interests between managers and shareholders. (15) It may also allow firms to conserve resources and yet remain attractive to the best talent. (16) Startups in particular find stock options useful because they often have growth potential but shallow pockets initially. (17) Yet, in executive compensation plans, stock options can be, and have often been, abused.
Professor David Yermack first found irregularities in stock price returns around executive stock option grants in 1997. (18) He argued that the executives accelerated the date of the grants when the corporation was getting ready to release good news. (19) In the early 2000s, researchers provided evidence that managers have manipulated the release of information around option grant dates to maximize the value of those grants. (20)
As the use of stock options increased, so did the interest of the government in restricting the potential for abuse. SOX requires "real-time disclosure of option grants." (21) Section 302 of SOX demands that CEOs and CFOs of public corporations state that they have reviewed the company's quarterly and annual reports and explicitly confirm that "(1) the financial statements and information is materially accurate, (2) disclosure controls and procedures are effective and (3) they have disclosed to the company's auditors and audit committee any control deficiencies." (22) False statements made under SOX could subject the individual to enforcement by the Securities and Exchange Commission (SEC), Department of Justice (DOJ) prosecution, or civil litigation instituted by shareholders. (23)
Backdating was discovered simultaneously by Professors Lie, Heron, Narayanan, and Seyhun and reported in the financial press as early as February 2005. (24) Researchers showed that managers falsified grant dates to receive options with lower strike prices. (25) The stock price of the company would decline right before the exercise of the grant and increase thereafter. (26) In 2008 and 2009, research further suggested that managers are likely to make accounting changes beneficial to the CEO prior to option grant dates. (27)
There are several possible forms of option timing manipulation observed in the empirical literature. First, as described above, options may be backdated. (28) Second, executives may alter the exercise date of an option, rather than its grant date. (29) Third, executives may manipulate the timing of information release, announcing positive information about the company immediately before the grant date (i.e., spring-loading) or negative information about the company immediately after the grant date (i.e., bullet-dodging). (30) Alternatively, executives may manipulate the timing of stock option awards to occur shortly before an already scheduled release of positive information about the company (again spring-loading) or shortly after the release of negative information about the company (again bullet-dodging). (31) These manipulative practices are described further below.
A. Options Backdating
Options backdating is a practice whereby the date of the option grant is changed to a date prior to when the option was in fact granted. This practice was possible and easy when the SEC rules did not require reporting of the issuance of stock options until months after the grant date. (32) This reporting delay allowed companies to wait until the company's stock price rebounded from a drop before submitting their disclosure forms. (33) The option would then be backdated at its lowest point or near that point so that this lower exercise price could be reported to the SEC. (34) Backdating of stock options thus allows the individual to benefit from larger gains. (35)
Shortly after SOX was signed into law, the SEC changed its disclosure rules to also require disclosure of option grants within two days of the grant, (36) thereby effectively closing the loophole giving rise to backdating. This information must be disclosed electronically, allowing shareholders access to the information almost instantly. (37) Furthermore, the SEC approved changes to the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotations system (NASDAQ) Stock Market listing standards, which mandate that nearly all equity compensation plans be presented to shareholders for a vote. (38) The terms of the plan must be disclosed, as well as whether the plan allows for the exercise price to be less than the fair market value at the time of the grant. (39) Nevertheless, based on the discoveries of the backdating studies, it appears that executives have simply ignored these requirements and continued backdating. (40)
In December 2004, the Financial Accounting Standards Board (FASB) issued the Statement of Financial Accounting Standards (FAS) 123R, which essentially eradicated the accounting benefit of stock options issued at-the-money. (41) The Standards state that all stock options granted to any employee must be documented as an expense on the financial statements regardless of whether the exercise price is at fair market value. (42) In 2006, the SEC began to require all public companies to also report information including: "the grant date fair value under FAS 123R (which is aggregated in the total compensation amount that is shown for each named executive officer); [t]he FAS 123 grant date; [t]he closing market price on the grant date if it is greater than the exercise price of the option; and [t]he date of the compensation committee or full board of directors took action to grant the option, if that date is different than the grant date." (43) Companies are also required to explain the goals and policies behind the executive compensation plans. (44) Reports to investors must discuss whether the company has backdated...
Ending executive manipulations of incentive compensation.
|Author:||Avci, S. Burcu|
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