>> SEC Is Divided on Practice Known as 'Spring Loading;' Critics See 'Insider Trading'
By KARA SCANNELL, CHARLES FORELLE and JAMES BANDLER July 8, 2006
New controversy is brewing over the way companies dole out stock options, this time over the practice of granting them just days before announcing good news -- an effort to give executives a quick profit on paper.
Known as "spring loading," such options grants have generated heat in recent days. While spring loading is different from "backdating," another type of options timing, corporate critics blast it as a form of insider trading. Defenders call it a legitimate form of compensation -- and their ranks include a commissioner of the Securities and Exchange Commission.
Options give recipients the right to buy a share of stock at a set price, typically the closing share price on the date a grant is made. Companies that backdate are setting the grant date retroactively to align with a stock's low point, creating an instant paper gain.
By contrast, spring-loaded options usually are priced the same day they are granted. The catch: Companies are aiming to build a quick, expected gain into a grant, by assuming that good news -- like an upbeat earnings forecast -- will push the stock price up in coming days.
The SEC is investigating at least 50 companies for the timing of their options, and while there is wide agreement that backdating is wrong in most cases, there appears to be division over spring-loading. The divisions underscore a broader debate over the myriad ways companies grant options and whether or not some practices are, or should be, banned.
In a speech Thursday before the International Corporate Governance Network, Republican SEC Commissioner Paul Atkins gave a spirited defense of spring loading, calling it a legitimate and low-cost way for boards to efficiently compensate executives. He rejected claims that such awards amount to trading on inside information.
"Boards, in the exercise of their business judgment, should use all the information that they have at hand to make option-grant decisions," Mr. Atkins said. "An insider-trading theory falls flat in this context, where there is no counterparty who could be harmed by an options grant. The counterparty here is the corporation -- and thus the shareholders."[I disagree with this simplistic view because there *is* a harmed counterparty: shareholders at large who suffer assured dilution from the fact that these option grants become immediately in-the-money.]
Crying Foul
Quickly, some investor groups cried foul. "Let's step back and take it out of the legal domain. This is just not fair," said Ann Yerger, executive director of the Council of Institutional Investors. "I don't think any rational individual or director or executive could argue it is fair. The whole point is to motivate and incentivize. To do this and set up an award so they're already in the money is so unfair. I think it's a mark of poor integrity."
Mr. Atkins's speech came just a few weeks before commissioners are to vote on a rule overhauling rules for how executive compensation is disclosed. The agency is working to include guidance on options-timing, SEC Chairman Christopher Cox has said.
Corporate lawyers and some SEC commissioners have said the pending disclosure rule tackles some of the concerns over backdating. Others already have been addressed by other rules, such as one shortening the amount of time in which executives must file beneficial-ownership forms, and the new accounting rule requiring all options to be expensed.
The question is whether other practices are, or should be, on the agenda. Mr. Atkins has "laid out a marker," says David B.H. Martin, a former SEC official who is now a partner at Covington & Burling. "He's not going to be swayed by public opinion. He wants to analyze things openly."
In an interview Friday, Mr. Atkins defended his position on spring loading, pointing out that options are designed to give executives a long-term incentive to boost performance. "You might have a temporary transfer of wealth from the shareholder to the employees in a case where there's a pop in the price, but again, these are options," he said. "If they are properly constructed and are meant to try to retain people for the long term, they're going to have to survive for 20 quarters, or 40 quarters or 200 quarters."
The debate illuminates some of the challenges facing the SEC as it wades into the options-timing issue. The agency sees backdated options as at least problematic -- especially if not disclosed -- since they carry a strike price -- the price at which they can be redeemed -- lower than the market price on the date they really were granted.
Accounting rules demand that such "discount options" be expensed on the company's books. The tax code disqualifies them from certain corporate deductions and exemptions. And companies that didn't disclose the backdating -- or implied in their filings that they didn't backdate -- can face serious securities violations.
Options timed to news may not be as problematic, since their strike price is the market value on the date of grant. But no consensus has yet emerged from the SEC.
Consequently, the agency, which is looking at several different spring-loading cases, could do nothing, or take any of several tacks in arguing that spring-loaded options aren't kosher.
Misleading Investors
The simplest case is to argue that companies that engaged in spring-loading mislead investors by not disclosing that options are awarded with foreknowledge of the impending good news. That's how the SEC has approached the case of Analog Devices Inc., a Norwood, Mass., technology concern that is also being investigated for backdating.
A tentative settlement that Analog reached with the SEC states that it failed to adequately disclose that it priced stock options before the release of favorable financial results. In one of those instances involving options grants in November 2000, directors as well as officers were the recipient of the grants, according to the terms of the proposed settlement. The Analog case has not yet been brought before the full commission for a vote.
Cyberonics Inc., a Houston medical-device maker, drew questions for a June 2004 grant made to several executives on the day a Food and Drug Administration advisory panel recommended approval of a Cyberonics device. Trading in Cyberonics was halted that day. Grants carried as their exercise price the closing price of the prior day. After trading began again, shares leapt 78%.[Although technically spring-loading, the singular details of the CYBX case make it more akin to a backdating violation, IMO.]
An analyst at SunTrust Robinson Humphrey questioned the grant in a research report last month. The SEC is conducting an informal inquiry of Cyberonics, and federal prosecutors in Manhattan have subpoenaed the company. Cyberonics has called the analyst report "misleading" and said it properly accounted for the options.
Insider-Trading Rules
Another approach for the SEC could be to argue that spring-loaded grants violate insider-trading rules, particularly if directors with knowledge of the news give options to themselves, or if executives conceal good news from directors in urging them to grant options. In a famous insider-trading case that the SEC brought against mining concern Texas Gulf Sulphur Co. in the 1960s, a court found that executives who received grants before the company announced a big mining discovery violated federal securities laws. In that case, the compensation committee was unaware of the pending news at the time of the grants.
As for taxes, the implications of spring-loading are "not as clear as with options backdating," says S. James DiBernardo, a partner at Morgan, Lewis & Bockius LLP who specializes in compensation tax issues.
Mr. DiBernardo says he "wouldn't be surprised" if the IRS tries to make the argument that spring-loaded options are also discount options, and thus come with the same tax "parade of horrors" that follows backdated options. But, he says, such an argument would be "much, much more difficult" for the IRS to win. Among other things, the IRS would have to establish what was the "true" market value on the day the spring-loaded options were granted, and it isn't clear how that could be done, he says.
>> By CHARLES FORELLE and JAMES BANDLER October 20, 2006
Investors and the public heaped scorn on William McGuire this week for his role in apparent stock-options backdating at UnitedHealth Group Inc. But his thorniest legal problems could stem from a 1999 transaction in which backdating played only a minor role.
In the transaction, according to a report prepared by outside lawyers commissioned by UnitedHealth directors, Dr. McGuire and other employees were able to effectively get the same options twice, at favorable prices, while skirting disclosure requirements and potentially violating accounting rules. For Dr. McGuire alone, the extra options are now valued at $250 million. Just as troublesome for Dr. McGuire, the report concluded that it's unclear whether directors ever intended to give Dr. McGuire such a generous deal.
Dr. McGuire's role in implementing the transaction is amply documented. The lawyers probing UnitedHealth found a 1999 memo from Dr. McGuire to directors in which he initiated the arrangement. He also told the investigators that it was structured as it was in part to avoid having to reprice the options, which would have unpleasant accounting consequences, according to a person familiar with the matter. That would cause a drag on earnings.
But UnitedHealth's outside lawyers believe that the accounting treatment was nonetheless improper. That will likely require UnitedHealth to take substantial charges, and it may expose Dr. McGuire or others to allegations of accounting misdeeds.
Dr. McGuire, the longtime chief executive of UnitedHealth, stepped down as chairman of the giant Minnetonka, Minn.-based insurer Sunday, and he will leave his post as chief executive by Dec. 1. The moves follow an internal investigation by the law firm of Wilmer Cutler Pickering Hale & Dorr, released in a report on Sunday, that found rampant backdating of stock options at the company, and attributed a substantial portion of the blame to Dr. McGuire.
"If I were at the SEC, I think I would have plenty from the WilmerHale report that would motivate me to look very hard at Dr. McGuire's conduct," said Donald C. Langevoort, a law professor at the Georgetown University Law Center. The 1999 options-swap transaction, he added, "is a perfect example of a major compensation decision not being presented clearly and plainly to the investing public until well after the fact."
Dr. McGuire's lawyer, David M. Brodsky, said, "Dr. McGuire is an expert in health care but not the legal and accounting issues concerning options. For that, he sought advice from others and relied on their advice." He said he doesn't know who gave Dr. McGuire the guidance.
In late 1999, according to the WilmerHale report, Dr. McGuire was concerned that some stock options issued in the prior five years were "underwater" -- that is, carrying exercise prices above the stock's current market value. Because options give recipients the ability to buy stock at a fixed exercise price, that meant the options couldn't immediately be cashed in for a profit.
On Oct. 22, 1999, Dr. McGuire wrote a memo to the board's compensation committee proposing an unusual maneuver. He suggested that more than two million options held by him and others be "suspended," and that new ones be issued in their place with a lower exercise price. The motivation for such a swap appears to be avoiding the deleterious accounting consequences of a straight "repricing" -- whereby options are simply given a new exercise price.
Accounting rules adopted in 1998 required repriced options to be recorded on a company's books under so-called variable accounting, a punishing method that requires assessing an option every quarter between vesting and expiration to determine if it gained in value, and recording any gain as an expense. By contrast, the usual method of accounting for options that were issued at market value at the time of grant involved no expense whatsoever.
In any event, directors approved the swap, giving Dr. McGuire and others roughly the same number of new options at substantially lower exercise prices. As it happens, the WilmerHale report concluded the new options likely were backdated to Oct. 13, 1999, the low point that year for UnitedHealth's stock, giving the recipients a running start to make a profit on their replacement options.
Dr. McGuire's actions were likely in vain, though. The WilmerHale report said the 1999 replacement grant "was effectively a repricing for accounting purposes." Though UnitedHealth itself hasn't come to a conclusion about how to account for the grant, it is likely the company will conclude that its past financial statements didn't record adequate compensation expenses -- meaning the company's earnings looked better to investors than they should have.
Charles Mulford, an accounting professor at Georgia Institute of Technology, said, "I would argue, in substance, this was a repricing and should have been accounted for as such."
In August 2000, the suspended options were reactivated. That meant that Dr. McGuire and other employees got the best of both worlds-owning both the original options, which were now "in the money" because the stock price had surpassed the exercise price, and the purported replacements.
The WilmerHale report said Dr. McGuire's 750,000 options were reactivated with an average strike price of $47.21, at a time when shares were changing hands at $81.81 -- an instant gain of $26 million for Dr. McGuire alone.
Though the reactivation was apparently approved by directors, the WilmerHale report suggested they may not have fully understood what they were doing. The report cited missing or nonexistent documents, and said that minutes from the August 2000 board meeting don't even mention the reactivation.
Two directors "recalled that there was a discussion of the reactivation at [the August 2000] meeting," the report said. But "no member of the Compensation Committee in 2000 specifically recalled that Dr. McGuire was the intended recipient of such a large grant of options."
Legal experts said the Securities and Exchange Commission will want to determine whether directors were, in effect, bamboozled. "To the extent that the commission decides that Dr. McGuire or anyone else in senior management was not candid with the board and let them operate in the dark, I think the commission could turn that into the basis for an enforcement action," Prof. Langevoort said.
A person close to Dr. McGuire said the August 2000 reactivation was not a surreptitious pay grab. Indeed, this person said, it was decided at a compensation-committee meeting and at a full board meeting. This person added that employees with suspended options were sent a memo shortly after the meeting noting that the suspension had been lifted, and that such lifting didn't affect the 1999 supplemental grant.
In any case, the WilmerHale lawyers determined, the August 2000 reactivation should have been treated as a new grant altogether, requiring UnitedHealth to take a substantial charge against its earnings.
Dr. McGuire and UnitedHealth are negotiating the financial terms of his departure. The question of whether he should be allowed to keep the now-disputed reactivated grant is likely to be a key element in those discussions. <<
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