WSJ: Perfect Timing: Stock Option Grants at 52-Week Lows

The Weekend Wall Street Journal has a fascinating article, The Perfect Payday:  Some CEOs Reap Millions by Landing Stock Options When They Are Most Valuable.  Luck -- Or Something Else?, by Charles Forelle & James Bandler.  The article tracks numerous examples of lucrative stock options that are granted to corporate executives when the stock is at or near a 52-week low, thus guaranteeing the executives the maximum possible profit. The article notes that pure luck cannot explain the remarkable timing:

Just lucky? A Wall Street Journal analysis suggests the odds of this happening by chance are extraordinarily remote -- around one in 300 billion. The odds of winning the multistate Powerball lottery with a $1 ticket are one in 146 million. Suspecting such patterns aren't due to chance, the Securities and Exchange Commission is examining whether some option grants carry favorable grant dates for a different reason: They were backdated. The SEC is understood to be looking at about a dozen companies' option grants with this in mind.

The Journal's analysis of grant dates and stock movements suggests the problem may be broader. It identified several companies with wildly improbable option-grant patterns. While this doesn't prove chicanery, it shows something very odd: Year after year, some companies' top executives received options on unusually propitious dates.

The Journal chronicles many examples, including this one:

On a summer day in 2002, shares of Affiliated Computer Services Inc. sank to their lowest level in a year. Oddly, that was good news for Chief Executive Jeffrey Rich. His annual grant of stock options was dated that day, entitling him to buy stock at that price for years. Had they been dated a week later, when the stock was 27% higher, they'd have been far less rewarding. It was the same through much of Mr. Rich's tenure: In a striking pattern, all six of his stock-option grants from 1995 to 2002 were dated just before a rise in the stock price, often at the bottom of a steep drop.

Mr. Rich called his repeated favorable option-grant dates at ACS "blind luck." He said there was no backdating, a practice he termed "absolutely wrong." A spokeswoman for ACS, Lesley Pool, disputed the Journal's analysis of the likelihood of Mr. Rich's grants all falling on such favorable dates. But Ms. Pool added that the timing wasn't purely happenstance: "We did grant options when there was a natural dip in the stock price," she said. On March 6, ACS said that the SEC is examining its option grants.

The Journal worked with Erik Lie, Associate Professor and Henry B. Tippie Research Fellow at the Henry B. Tippie College of Business, University of Iowa:

The analysis bolsters recent academic work suggesting that backdating was widespread, particularly from the start of the tech-stock boom in the 1990s through the Sarbanes-Oxley corporate reform act of 2002. If so, it was another way some executives enriched themselves during the boom at shareholders' expense. And because options grants are long-lived, some executives holding backdated grants from the late 1990s could still profit from them today....

The Wall Street Journal asked Erik Lie, an associate professor of finance at the University of Iowa who has studied backdating, to generate a list of companies that made stock-option grants that were followed by large gains in the stock price. The Journal examined a number of the companies, looking at all of their option grants to their top executive from roughly 1995 through mid-2002. Securities-law changes in 2002 curtailed the potential for backdating a grant. Executives typically receive option grants annually. Mr. Lie and other academics say a pattern of sharp stock appreciation after grant dates is an indication of backdating; by chance alone, grants ought to be followed by a mixed bag of stock performance -- some rises, some declines.

Professor Lie's paper on the subject is On the Timing of CEO Stock Option Awards, 51 Management Science 802 (May 2005).  Here is the abstract:

This study documents that the abnormal stock returns are negative before unscheduled executive option awards and positive afterward. The return pattern has intensified over time, suggesting that executives have gradually become more effective at timing awards to their advantage, and possibly explaining why the results in this study differ from those in past studies. Moreover, I document that the predicted returns are abnormally low before the awards and abnormally high afterward. Unless executives possess an extraordinary ability to forecast the future marketwide movements that drive these predicted returns, the results suggest that at least some of the awards are timed retroactively.

The Journal observes:

Companies have a right to give executives lavish compensation if they choose to, but they can't mislead shareholders about it. Granting an option at a price below the current market value, while not illegal in itself, could result in false disclosure. That's because companies grant their options under a shareholder-approved "option plan" on file with the SEC. The plans typically say options will carry the stock price of the day the company awards them or the day before. If it turns out they carry some other price, the company could be in violation of its options plan, and potentially vulnerable to an allegation of securities fraud.

It could even face accounting issues. Options priced below the stock's fair market value when they're awarded bring the recipient an instant paper gain. Under accounting rules, that's equivalent to extra pay and thus is a cost to the company. A company that failed to include such a cost in its books may have overstated its profits, and might need to restate past financial results.

Steve Bainbridge (UCLA) agrees:

There's nothing inherently illegal about either paying large compensation or even backdating an option contract, so long as proper corporate procedures were followed and the grant does not amount to a waste of corporate assets. Where public corporations are concerned, however, failure to disclose the backdating likely would constitute securities fraud. In particular, failure to do so probably would constitute a material omission with respect to the executive compensation disclosures required in the proxy statement for the corporation's annual meeting.

The Journal also explains that "[a]nother possible explanation for big rises in stock prices following grants is that executives knew favorable company news was coming and timed the grants just before it." Indeed, Iman Anabtawi (UCLA) made this point in Secret Compensation, 82 N.C. L. Rev. 835 (2004). But the Journal contends that "academics think timing for company news is a less likely explanation for the patterns, given the consistency of the stock climbs after grant dates. Also, for many of the companies the Journal examined, no obvious company news followed closely upon the option grants."

Update:  Geoffrey Manne has more here.