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Saturday, November 12, 2005

SEC Investigates Back-Dated Option Grants

According to Friday's Wall Street Journal, it seems that the SEC is investigating some companies for playing games with their option grants.

In a call option, the holder has the right (but not the obligation) to purchase the stock at a set price during a given time frame. As a result, we call an option a "derivative" security, since its value is derived from the value of some other asset (or security). If the value stock price increases, so does the value of the option. This means that an employee who holds a call option on their company's stock has an incentive to take actions that increase the firm's stock price.

Here's an example that might make this point clearer: A March 1, 2006 call option with an exercise price of $40 would give the holder the right to purchase a share of stock at $40 up until March 1. As long as the stock price is greater than the exercise price, the option is said to be "in the money". In this case, if the stock was currently selling at $45 a share, the holder of the option could exercise it, buy the stock at $40, and harvest a $5 profit.

Most executive options are issued "at the money" with a term of around three years. In other words, they are issued with an exercise price (also commonly called the "strike" price) that's equal to the current stock price, and the opion can be exercised after three years' time. So, if the stock price goes up, so does the value of their options.

Here's what apparently has the SEC concerned - it sems that some companies are "back-dating" their options. Let's take an example where the company's stock price was $40 on October 1 and $50 on November 1. Then, assume that the company granted options to their executives on November 1, but back dated the options to October 1. Since the options are issued "at the money", they would therefore have an exercise price of $40, giving the option holders an immediate profit of $10.

To read the Friday's Wall Street Journal article on this, click here. If you don't have a subscription, you can also read this one in CFO magazine.

This issue is interesting for a couple of reasons. It's a classic example of an agency problem where managers take advantage of shareholders. Second, they involve some disclosure issues - for obvious reasons, the companies involved don't give the "proper" date of these option grants. So, I wouldn't be surprised to see lawsuits in the ner future. Finally, they explain one of the more interesting patterns that academics have already observed - that stock prices often drop before option grants, and rise following them. This pattern makes a lot more sense if management can game the system by back-dating the options to the optimal date.

The WSJ and CFO Magazine articles mention the work of two academics who've studied stock price reactions around option grants - David Yermack and Erik Lie. You can find working paper versions of Yermack's work here and Lie's here.

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