Stock option "springloading": an examination of loaded justifications and new SEC disclosure rules.

• Author: Hughes, William

1. INTRODUCTION II. BACKGROUND A. Role of Stock Options and Growth as a Component of Executive-Compensation Packages 1. The Agency Problem 2. Pay-for-Performance Compensation B. Manipulative Timing of Stock Options 1. Option Backdating 2. Option Springloading 3. Exposure of Option Practices C. Insider Trading Laws 1. Development of Insider Trading Rules 2. Economic Rationales for Insider Trading Prohibitions D. Debate over the Legality of Springloading III. ANALYSIS OF SPRINGLOADING JUSTIFICATIONS A. No Counterparty Harmed by the Option Grant 1. Options Do Represent a Cost 2. Benefit to Shareholders is Lacking B. Business Judgment Rule Protects Springloading Decision IV. RECOMMENDATION A. Penalizing Springloading Fulfills the Policies of Insider Trading Laws B. New SEC Rules Provide an Alternative to Rule 10b-5 V. CONCLUSION I. INTRODUCTION

   Since 2006, corporations have come under fire for using what has been dubbed "stock-options fraud" (1) as part of their executive compensation packages. The practices of option "backdating" (2) and "springloading" (3) have received widespread attention from government regulators: Congress has heard testimony about these matters, (4) and some senators have made statements about possible legislative action to address public concerns. (5) Recently, the U.S. Securities and Exchange Commission (SEC) enacted new reporting rules requiring public corporations to disclose, in detail, the role that options play as part of executive compensation packages in an effort to improve transparency in the use of options. (6)

   Notwithstanding the SEC's new rules, questions of the legality of backdating and springloading continue to float. While both backdating and springloading strike many as fraudulent, or at least unethical, neither is per se illegal. (7) Indeed, even officials at the SEC have expressed contradictory views in the options debate. (8) This Note focuses on the legality of stock option springloading as a compensation technique.

   Part II of this Note provides information about the reasons for the growth of stock options as a part of executive compensation and the purposes stock options serve. Part II then discusses the current debate surrounding option timing practices, both backdating and springloading. Finally, Part II looks at the development of and policy reasons for insider trading prohibitions for use in comparing that practice to springloading.

   Part III examines statements made by SEC Commissioner Paul Atkins in defense of springloading's legality, first looking at whether springloading in fact causes harm to shareholders, and then examining the practice in the context of the business judgment rule. Part IV offers the recommendation that while springloading does not fit squarely within the elements of a traditional insider trading action, springloading should not be permitted without consequence in order to fulfill the policy goals of insider trading prohibitions. Although not a typical insider trading regulation, the new SEC disclosure requirements provide legal repercussions against a corporation that fails to provide shareholders with information about option timing practices, thus serving to enforce the policy considerations of insider trading. (9)

2. BACKGROUND

   1. Role of Stock Options and Growth as a Component of Executive-Compensation Packages

      The role of stock options as a portion of executive compensation grew considerably during the 1990s. (10) This increase was largely due to a new theoretical view of the role of executive compensation: a company's performance should determine the level of management's compensation. (11) Because the value of stock options corresponds to the underlying market price of the company's stock, stock options became a powerful compensation device, used to link executive payoffs to corporate performance (as measured through the stock price). (12)

      1. The Agency Problem

         Underlying this discussion of compensation and managerial incentives is the theory of agency. (13) An agency problem exists anytime the objectives of the principal and the agent conflict and the principal must incur costs to monitor the agent. (14) The principal/agent division leads to conflict when an agent has a different risk tolerance than the principal and, therefore, pursues a course of action that the principal himself would not take. (15)

         Agency problem is entwined with the corporation: (16) separation of ownership and control is a fundamental element of a publicly traded corporation. (17) Shareholders compose the ownership interest in the firm (the principal). (18) But the managers (the agents) (19) are the decision makers in charge of the operations of the corporation, affecting the interests of the shareholders. (20) Agency problem manifests itself when managers use their control of the firm's assets to benefit themselves (21) rather than to optimize the value of the firm. (22)

      2. Pay-for-Performance Compensation

         The remedy to the corporate agency problem was the pay-for-performance compensation scheme. (23) By tying a large portion of management's compensation to the success of the corporation (measured through stock price), shareholders benefit from management's drive to increase its own pay. (24) This scheme aligns the interests of both shareholders and management by setting a common goal for everyone's financial interests: maximizing stock value. (25)

         Jensen and Murphy advocated this position in an article revealing data showing that executive compensation was largely unconnected to stock performance. (26) Jensen and Murphy argued that management should directly own stock in its corporation. (27) Stock ownership ties manager wealth to the market performance of the corporation's stock. (28)

         One result of this new movement was a change in the tax code that capped the deductibility of non-performance-based executive compensation. (29) Congress added Internal Revenue Code [section] 162(m), (30) which limits deductible employee remuneration to one million dollars, (31) in 1993 (32) in an effort to reign in exorbitant salary packages for corporate management. (33) However, [section] 162(m) defines "applicable employee remuneration" so as not to include performance-based compensation. (34) To qualify as performance-based pay, [section] 162 requires: (1) a compensation committee of outside directors set performance goals, (2) disclosure of performance goals and the terms of the compensation to shareholders and then approval by shareholders by a majority vote, and (3) the compensation committee must certify that the employee satisfied the specified performance goals. (35) Without a cap on performance-based pay, the effect of this amendment was to limit salaried compensation to one million dollars and place greater emphasis on performance-based pay as a means of attracting talent to managerial positions. (36)

         Stock options are the definitive example of performance-based compensation. (37) Issuers of stock options include an exercise price, which is typically the market price of the stock on the date of granting the option. (38) Stock options permit the owner to purchase a specified number of shares of the stock at the option's fixed exercise price rather than at the market price. (39) The value of the option therefore depends upon the market price of the corporation's stock. (40) As the market price rises, an option holder may exercise the option and purchase shares at the much lower exercise price, thereby realizing a profit. (41) When the current market price of the stock exceeds the exercise price of the option, this is known as an "in-the-money" option. (42) Conversely, as the market price of the stock falls, the value of the option also falls, since exercising the option either will result in smaller profits or will ultimately be unprofitable if the exercise price is higher than the open-market purchase price. (43)

         Empirically, the impact of both the new pay-for-performance approach to compensation and the amended tax code was a surge in the use of stock options as part of executive compensation packages. (44) Perry and Zenner analyzed data for Chief Executive Officer (CEO) compensation trends in the 1990s and found an upward trend in the overall compensation levels between 1992 and 1998. (45) Median compensation for CEOs of firms listed on the S&P 500 stock market index grew from $1,984,000 in 1992 to $5,141,000 in 1998. (46) The use of options, however, was the primary driver of this trend. (47) As a percentage of total compensation, options increased from 21.80% of total compensation in 1992 to 37.65% in 1998. (48) Conversely, salary as a component of total compensation declined from 35.53% to 20.89% over the same period. (49) Perry and Zenner suggested that this trend was largely in response to the passage of [section] 162(m) in 1993. (50)

   2. Manipulative Timing of Stock Options

      The increased use of stock options in the 1990s brought attention to what many perceive as apparent abuses: option backdating and springloading. (51) This latest corporate "scandal" has led to a wave of investigations into corporate accounting practices. (52) Congress has also held hearings regarding these new issues. (53)

      1. Option Backdating

         Companies engage in "backdating" when they retroactively determine the grant date for options issued to management so that it appears that the company made the award on an earlier date. (54) Because the exercise price of the options is also typically the stock's market price on the date of the grant, (55) this retroactive decision permits executives to choose a date when the market value of the stock was at a low point, or at least at a lower price than the current stock value. (56) Because the exercise price of the option is below the current market price, the corporation is effectively issuing an in-the-money option since the option is profitable if the holder exercises it immediately. (57) However, because the corporation backdated...