Sunday, June 11, 2006

First Options Backdating; Now Options Springloading?

In the last couple of months, there has been widespread media coverage (including several prior posts on The D & O Diary) discussing the growing investigation into options backdating. New allegations have surfaced that may evidence options “springloading.”

Options backdating involves retroactively dating the grant and exercise price of an options issue to a time preceding a rally in the price of the underlying shares, which maximizes the profits for the grant recipients. Options springloading, according to this June 7, 2006 Reuters article, involves looking forward to set the grant date and exercise price ahead of the release of positive news expected to raise share values, also boosting option profits.

Analog Devices Inc.'s November 15, 2005 tentative settlement with the SEC regarding the company's stock option practices involve allegations of practices that, although not using the term "options springloading," present the circumstances that phrase describes. The company's announcement stated that the settlement addressed

ADI's disclosure regarding grants of options to employees and directors prior to the release of favorable financial results....The SEC settlement would conclude that ADI should have made disclosures in its proxy filings to the effect that ADI priced these stock options prior to releasing favorable financial results.

Under the settlement Analog Devices agreed to pay a civil money penalty of $3 million, and certain of the grants to officers and directors were repriced.

Options springloading may be involved in the circumstances described in a June 9, 2006 New York Times article about options practices at Cyberonics. According to the article, the company’s Board approved stock option grants for top executives one evening in June 2004, a few hours after the company received positive news about the regulatory prospects for a promising product. When trading began the next day, Cyberonics share price soared, along with the value of the options. The option grant gave the Company’s chairman and CEO instant paper profits of $2.3 million, and lesser amounts of paper profits for the other two executives who received options in the grant. The company has publicly challenged the notion that there was anything wrong with the grant, saying that the options grant was immediately reported, and noting that none of the grant recipients has yet exercised any of options. The securities analyst whose recent report first questioned the Cyberonics option grant noted that while the grant did not involve options backdating, “the effect is exactly the same.” The analyst also noted that options are supposed to align executives’ financial interests with those of investors, but because these options were granted before investors were able to trade on the good news, the grant operated as a reward rather than an incentive. He also contends that because the options were priced below the market value fully loaded for the good news that was known to the company when the grant was made, the grant should have been counted as compensation in the quarter in which the grant was made.

The Reuters article cited above also contained a report that the SEC is looking at whether auditors have culpability in connection with the options backdating investigation. According to the article, the SEC is looking into whether auditors knew about the questionable practices and whether the auditors may have signed off on improper options backdating and springloading.

Article Plug: The D & O Diary recommends the recent law review article by Sean Fitzpatrick appearing in the Fordham Law Review. This article, entitled “The Small Laws: Eliot Spitzer and the Way to Insurance Market Reform,” argues that while Eliot Spitzer’s campaign against contingent commissions purportedly sought to eliminate anticompetitive behavior in the insurance brokerage industry, the ironic effect of Spitzer’s efforts is that smaller brokers may be harmed, as a result of which there may be further consolidation in the insurance broker industry, resulting in less rather than more competition. The article's author recommends simpler, less draconian solutions for reform. The article may be found here.

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