Exploring Corporate Governance Around the World

By Allison Garrett, Senior Vice President for Academic Affairs at Oklahoma Christian University

Saturday, July 22, 2006

Options Backdating, Springloading and Repricing

Now that the SEC and the U.S. Attorney in San Francisco have filed both civil and criminal charges against two officers of Brocade, I thought I would speculate about what else might be uncovered as the SEC and criminal investigators start turning over rocks.

There's been a tremendous amount of press about backdating and quite a bit about springloading. I think it's also possible that as all of these investigations continue, another scandal involving option repricing (reissuing the options at a lower strike price as the company's stock price tumbles) could be uncovered at a few unscrupulous companies. It wouldn't surprise me greatly to learn that at some companies, all of the paperwork for early option grants was destroyed and new options were issued at a lower strike price. This would allow companies to grant

Companies are reluctant to simply reprice options at a lower strike price because of the consequences. Institutional investors often have policies requiring them to vote against management's nominees for director if the company engages in options repricing. In fact, many institutional holders will vote against a company's proposed stock option plan unless it specifically prohibits option repricing.

The other consequence of options repricing is messy disclosure. Companies must include in their proxy statement a table showing options repricing. Naturally, companies don't want to include this type of table because it shows that executives could potentially still profit even though the stock price recently fell. If I'm an investor, I don't have the option to tell my broker, "I paid too much last month. I'd like to rescind that transaction and buy ABC Co. stock again at the new, lower price."

The rules regarding back dating and springloading are a little murky and experts disagree on the legal consequences. Regarding repricing, though, the SEC's rules are very clear. It will be interesting to learn whether, as the SEC takes investigative testimony, some companies are actually engaging in repricing without characterizing it as such and without complying with the SEC's rules.


Mukund Mohan said...

In the Mercury case if you remember, they were other embarassing things uncovered:
1. Unapproved loans to the CEO
2. Consistent purposeful "override" of internal controls - indicating board has no oversight
3. Side agreements.

I think you are right about repricing. What about grant restatements?

Mukund Mohan

Allison Garrett at Faulkner University said...

Regarding option repricing, as noted in the original posting, I expect that as the SEC's 80+ investigations continue, there will be several examples of companies that "terminated" options and then issued new options at a lower strike price. Whatever you call it, this is nothing more than a repricing.

The SEC's rules require that companies make disclosure all along regarding whether an exercise price might be lowered (Reg S-K, instruction 5 to Item 402(c)). When I talk about repricing, I am not discussing dilutive events that require repricing. For example, if an executive had 50 options at a $100 strike price and the company did a 2-for-1 stock split, then the executive would have 100 options at $50 each.

If the company engages in repricing, then Item 402(i) requires the report on options repricing in which the repricing and the "basis for each such reprixing" must be explained "in reasonable detail."

Not only does the SEC regulate repricing through the stick of disclosure, but many options plans specifically prohibit it. Plans that have been adopted in the last decade generally contain such a prohibition because institutional holders will often vote against a plan that does not contain a prohibition against repricing.

With regard to alternatives to repricing, I believe that we will see examples of all types of other approaches such as restatements; granting of new, additional options at a lower strike price; granting restricted stock to make up for the fact that options which are underwater don't have a "golden handcuff" effect; and changing the option terms other than the strike price, such as accelerating or extending the term of the grant.