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Feature

Robert L. Messineo
Partner
Weil, Gotshal & Manges

Avoiding Risks in Option Grants

If you want to sidestep ‘spring-loading’ or ‘bullet-dodging’ problems, the following recommendations may head off trouble.

By Robert L. Messineo

The practices used by companies in making option and other equity awards to their executives, employees, and directors have been subject to intense attention in the past year. Options investigations by the SEC and internal company reviews now involving over 100 companies have introduced a new vocabulary to the discussion of options — “backdating,” “spring-loading,” and “bullet-dodging,” although at this point no precise legal definitions of the terms have emerged. Recent court decisions have also raised issues regarding the fiduciary duties of directors regarding such practices.

Backdating has been the subject of the most scrutiny, almost on a daily basis. The following analysis focuses on the less addressed spring-loading and bullet-dodging practices, and offers guidance regarding grant practices that boards of directors and senior management should consider adopting.

Spring-loading generally refers to the practice of granting options in anticipation of the disclosure of material information that is expected to produce an increase in the market price of the shares to be acquired pursuant to the option — i.e., under circumstances where it is intended that the options will in fact have intrinsic value.

The Market’s Reaction
The corollary practice of bullet-dodging involves the intentional setting of an option grant date after the approval date so that material information that is expected to cause a decrease in the market value of the related shares can first be disclosed, or the intentional timing of option grants so as to follow the release of material information of such nature, in either case with the result that the exercise price will reflect the market’s reaction to the information and be lower than it otherwise would be.

Some argue that both spring-loading and bullet-dodging are inconsistent with explicit or implicit representations that only “at-the-market” options will be issued. However, issuing options with an exercise price less than the market price of the shares on the date of grant is not inherently improper as long as the issuance complies with the terms of the stock option plan approved by the shareholders (including representations about pricing “at the market,” if any) and the issuance is properly approved, disclosed, and accounted for, and the appropriate income tax treatment for such “discount options” is applied.

Nevertheless, the customary practice in issuing options to officers, other employees, and directors has long been to set the exercise price for the shares to be purchased pursuant to the option at the market value of the shares at the time the option is granted — i.e., to issue only at-the- market options.

Risk-Avoidance Measures
To minimize or eliminate the risk of spring-loading and bullet-dodging, which may be regarded as contrary to such option plan undertakings, consider the following recommendations:

• Grant dates should be set in advance on a regular schedule. Consider granting options (and, possibly, all equity grants) only at pre-established times of the year after the company has filed its periodic SEC reports or issued an earnings release. These may be the same as the “window periods” during which trading by officers and directors in company stock is permitted under the company’s insider trading policy. For example, if the company makes grants on an annual basis, such grants would be made only during a short period following the release of the company’s year-end earnings or the filing of its annual report on Form 10-K. (However, adopting such a policy may require a change in the company’s schedule for making personnel evaluations and paying bonuses or making other incentive awards, so that option and other equity grants can be made at the same time.)

• Alternatively, if grants are made on quarterly basis, such grants would be made only during a short period following the release of the company’s quarterly earnings results or the filing of its reports on Form 10-Q, as well as the release of year-end earnings or the filing of its Form 10-K. Grants made in connection with promotions or new hires may be treated differently but should be made only on a pre-established day of the month, such as the last trading day of the month employment starts or a promotion is effective.

• No changes should be made to the lists of grantees after the grant date, other than to withdraw a grant to an individual in its entirety because of a change in circumstances between approval of the grant and issuance of the award to the recipient; any other change (including to correct errors) should be considered a new grant subject to the company’s normal grant-making process. For example, adjustments in award amounts in the course of giving to employees their performance reviews would not be permitted.

• Pursuant to standard procedures to be established by executive management and approved by the compensation committee, all grants should be communicated to grantees “within a relatively short time period after the grant date” (in compliance with FAS 123R-2).

• If option grants are to be made to directors, the options should be issued insofar as practicable on an automatic basis or, if grants to directors are to involve the exercise of discretion by the board or a board committee, the grants should be made only on a date set well in advance of the actual date of issuance pursuant to an established policy. For example, a director compensation plan may provide that directors should receive options only for a pre-established number of shares on the last trading day of the year or the last trading day of the month of election or re-election to the board and at the market price on such date.

• Equity grants should be subject on a regular schedule to appropriate internal audit procedures to confirm the due approval and documentation of grants and the correct accounting.

• Explanation of the company’s enhanced option grant processes and procedures and documentation (including record-maintenance) requirements should be distributed to all involved personnel and updates should be distributed on a regular basis. Training and education programs should be established designed to ensure that all relevant personnel involved in the administration of stock option grants understand the terms of all of the company’s equity incentive plans, company policies, the relevant accounting requirements under generally accepted accounting principles for stock options and other share-based payments and other applicable disclosure requirements.

Auditor Focus
In light of the emerging concern over options-related financial statement errors, in July 2006 the Public Company Accounting Oversight Board issued guidance requiring auditors to review more carefully company option grant practices. Thus, as part of their audits, companies should expect that their auditors will focus on grant practices and controls and may require more detailed representations from management regarding grant practices.

Robert L. Messineo is a partner in the Public Company Advisory Group of Weil, Gotshal & Manges LLP, resident in its New York office. He is a member of the American Bar Association’s Committee on Federal Regulation of Securities and writes and lectures frequently on corporate governance and securities law compliance matters. He can be contacted at robert.messineo@weil.com.

A more comprehensive analysis by the author of the issues involved in option issuance is available at http://www.weil.com under "Resources/Public Company Materials/February 2007."