December 5, 2004

In the Timing of Options, Many, Um, Coincidences

EVER notice how huge stock option awards are often given to executives just ahead of bullish company news? The Securities and Exchange Commission apparently has.

Last Tuesday, Analog Devices, a maker of integrated circuits, disclosed that the S.E.C. had requested information about the timing of option grants given to company executives and directors during the last five years. In its disclosure, the company noted that its grants in some years "occurred shortly before our issuance of favorable annual financial results." The company added that it believed other companies had received similar inquiries from the regulator.

The S.E.C., as is its custom, declined to comment on the inquiry.

As executives have binged on stock options in recent years, academic studies have detailed the opportunities for fatter pay that well-timed option grants represent. By analyzing stock price behavior after option awards, these studies concluded that corporate managers systematically receive options at prices that do not reflect favorable nonpublic information.

Options typically carry a strike price - the level at which they can be converted into common shares - equal to the prevailing market price of the underlying stock on the day of the grant. Any increase in the underlying stock, therefore, means a potential gain for the option holder. Because stock options are typically exercisable for 10 years, they are extremely valuable.

Many companies dispense options at preset times during the year, limiting the opportunity for timing mischief. But 40 percent of grants were issued whenever a board chose to do so, according to an academic study published in 2000. Directors on a company's compensation committee typically approve option grants, but chief executives wield significant power among directors in these matters.

Even though most grants can be exercised only in fractional increments over time, academics have also found that gains in share prices immediately after a grant usually hold up over the long haul.

In an article in the North Carolina Law Review last March, Iman Anabtawi, acting professor at the School of Law at the University of California, Los Angeles, called favorably timed option grants "secret compensation." Grant timing is hard to detect and rarely analyzed, she said, so shareholders are not aware of the consequences.

"Allowing a company to time option grants around inside information," Ms. Anabtawi said, "is substantively equivalent to allowing a company to engage in insider trading in the open market and then secretly pay its executives with the profits."

KENNETH F. BROAD, a portfolio manager at Transamerica Investment Management, says he is distressed by these practices because they put the interests of executives squarely against those of their stockholders. He, like Ms. Anabtawi, likens the practice to insider trading.

"Even if technically it's not illegal, shareholders who own stock in a company that does this should think long and hard about the management they are dealing with," Mr. Broad said. "Every dollar lower on the strike price is at the shareholders' expense."

Analog Devices is a heavy user of options. A recent analysis by Adam Parker, an analyst at Sanford Bernstein noted that in each of the last five years, the company has handed out options representing about 3.5 percent of the company's shares outstanding.

One option grant that the S.E.C. may be scrutinizing occurred on Nov. 10, 2000, and covered 920,000 shares given to the company's top five executives. The strike price was $44.50 a share, just $2.25 above the stock's low for all of 2000.

Three days later, Analog Devices reported that Siemens A.G., the German electronics maker, had decided to use two of the chip maker's products in its new wireless phones and devices; the stock rose 8.3 percent on the news. The next day, the company announced that its fourth-quarter profit had more than doubled. The shares jumped to $55.50.

Within a week of the grant, shares of Analog Devices had risen, up 34.3 percent.

Maria C. Tagliaferro, a spokeswoman for Analog Devices, said the company was considering how to grant options without creating the perception of executive opportunism. She said the options from 2000 could start being exercised only last year and that at recent prices - $38.66 as of Friday's close - the options were now underwater.

Still, from October 2003 to July 2004, Analog Devices' shares were above the options' strike price, meaning that they could have been cashed in at a profit.

Another example of a spectacularly timed options grant is the one received last year by Erik C. Blachford, a founder and former chief executive of Expedia, the online travel retailer. Mr. Blachford had been named Expedia's chief executive in February 2003, when the company was partially owned by USA Interactive, the online conglomerate overseen by Barry Diller that is now called InterActiveCorp.

On March 17, 2003, Mr. Blachford received options to buy 253,000 shares of Expedia at $39.38 each. Two days later, USA Interactive announced that it would acquire in a stock-for-stock deal the Expedia shares it did not already own. The offer, at a premium of more than 34 percent to the prevailing market price, resulted in an immediate increase in the value of Mr. Blachford's option grant.

Deborah Roth, an InterActiveCorp spokeswoman, said Mr. Blachford had received the options as "a bonus incentive for accepting his new position as president and C.E.O. of Expedia, a standard practice we employ with many employees in connection with their promotions." She declined to comment when asked why the company did not wait to give Mr. Blachford his options until its offer to buy all of Expedia's shares was made public.

Alan G. Spoon, a partner at Polaris Venture Partners in Waltham, Mass., is chairman of InterActiveCorp's compensation committee of the board. He did not return a phone call seeking comment about the grant's timing.

In August 2003, when InterActiveCorp completed the Expedia buyout, Mr. Blachford's 253,000 options became 490,503 InterActiveCorp options with a strike price of $20.31 a share. InterActiveCorp shares now trade at $25.01. Last month, Mr. Blachford retired from the company. Ms. Roth said that he was on vacation and not available for comment.

RECENT option grants at Cypress Semiconductor have also generated quick value on positive news. On April 11, 2003, for example, the company granted options on 540,000 shares to four of its top executives at a strike price of $7.56.

Less than three weeks later, Cypress said its revenue in that quarter would be higher than analysts had been expecting. On May 2, 2003, the stock closed at $10.60.

As of Friday, Cypress's shares were at $10.29; the options granted in April 2003 have been in the money since they were awarded. They started vesting immediately in monthly increments of about 1.7 percent of the grant.

Joseph McCarthy, Cypress's spokesman, said, "There is no incentive for opportunistic behavior" relating to the grant because the gains did not represent a windfall.

Managers in corporate America may argue that handing out options that almost immediately rise in value generates goodwill among employees, especially those holding options dispensed during the mania of the late 1990's that are now underwater. But most options still go to top managers, so well-timed grants only make the obscenely rich even richer.

Making option grants subject to blackout periods around the dissemination of market-moving news, as some pay experts have suggested, would reduce the opportunities for executive enrichment associated with the grants.

In any case, because options handed out just before good news are essentially given at a discount, the extra value attached to them should be disclosed to investors as compensation. Sunlight is needed here.

And if the S.E.C. finds that well-timed option grants are deplorably common in corporate America, shareholders should revolt. They should vote against compensation committee members who approve such awards or sell their shares outright.

Corporate insiders, alas, can be expected to put their own interests first these days. But shame on the shareholders who let them get away with it.