Another Dodgy Way To Dole Out Options

Grants intentionally timed to good news are becoming the focus of greater scrutiny

When it comes to questionable stock options practices, so-called backdating -- awarding options retroactively to ensure bigger payoffs to execs -- may be the tip of the iceberg.

Even more companies may have engaged in "spring-loading" by intentionally issuing rafts of options just ahead of positive news, or after bad news has beaten a stock down. Since The Wall Street Journal first reported on the issue of backdating in March, investigators, analysts, and investors have been poring over corporate filings in search of misbehavior. That could bring headaches for a much larger swath of companies -- and their shareholders. "The timing questions are potentially a much bigger issue than backdating," says Patrick McGurn, executive vice-president of Institutional Shareholder Services Inc., the investor advisory firm. "A lot of people are worried." The worst-case scenario: Federal prosecutors could bring felony fraud charges.

Already, one spring-loading scandal has sprung. On June 12 medical device maker Cyberonics Inc. disclosed a Securities & Exchange Commission inquiry into its options practices. The probe came after analyst Amit Hazan of SunTrust Robinson Humphrey raised questions about grants made on June 15, 2004, to Cyberonics Chairman, CEO and President Robert P. Cummins and two others just hours after a Food & Drug Administration panel recommended approval of a Cyberonics device to treat depression.

Trading was halted on June 15 pending the news announcement. But the grants were priced at $19.58, the closing price on June 14. When shares opened at $31.70 on June 16, a 62% rise, Cummins was holding an instant paper profit of $1.8 million. Although the stock has since fallen, Cummins' options, which haven't been exercised, are still up roughly 10%, while investors who bought on June 16 are down 30% or more. In an SEC filing, CFO Pamela B. Westbrook said the options were "properly approved, priced, and granted at fair market value." The company declined further comment.

Cyberonics is among the first companies to be targeted for issuing new options ahead of good news rather than for backdating -- but others will likely follow. Since March, some 40 companies have been ensnared in inquiries by the SEC and the Justice Dept. Pay experts say that with the explosion of options in the mid-'90s, spring-loading became common, especially among tech companies. At conferences for the staffers who manage stock-option plans for companies, McGurn says, "people talked openly about timing options to get the biggest bang for the buck."


But grants that are actively pegged to news may violate civil and criminal law. "If a company knows the quarter is going to be good, and it comes out with a huge slug of options, are they in possession of material inside knowledge? Absolutely," says Todd M. Fernandez, a senior research analyst at investor advisory firm Glass Lewis & Co.

Still, proving the company knew the information would juice the stock price could be difficult. "That's a much grayer area," says Fernandez. The key question: Was it a one-time grant that appears out of sync with earlier awards? If so, it's suspicious; a grant that comes just ahead of the release or regulatory approval of a much anticipated product, for example, will raise more questions than a regular award in advance of scheduled earnings. In cases where timing appears particularly egregious, says Jacob S. Frenkel, a former SEC enforcement lawyer and federal prosecutor, charges could range from civil disclosure violations to criminal securities, mail, and wire fraud.

Much depends on the role of the board. If a board signs off on a grant in advance of good news, then both directors and executives could be vulnerable to insider trading charges. And if the board didn't know about the upcoming event -- or it delegated the timing of grants to top managers who then issued options before the news broke -- then legally, the transaction may not be much different from an executive buying up shares ahead of the announcement. And that could spell trouble.

By Jane Sasseen

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