These stock options deserve the SEC’s scrutiny

In principle, corporate directors and executives, who naturally have privileged information about their companies, aren’t supposed to use it to enrich themselves at the investing public’s expense. Yet there remain many ways in which they can nonetheless do so.

In seemingly obscure accounting guidance, the Securities and Exchange Commission has moved to shut down a significant one. It’s a good decision, signaling a tougher approach to insider trading more broadly.

At issue is the timing of stock-option grants, a form of compensation that allows executives to purchase shares at a predetermined price. They’re typically intended as an incentive to focus on shareholder value: If the share price goes to $10, an option to buy at $1 becomes worth a lot. Sometimes, though, the grants occur suspiciously close to the announcement of positive news that causes a company’s stock to jump, providing executives with an immediate windfall — arguably at the expense of regular investors who couldn’t have known the news was coming.

Pool/Photographer: Evelyn Hockstein-P

Such “spring-loaded” options have long been a legal gray area. In 2002, officials cracked down on the more egregious practice of backdating, in which companies effectively guaranteed executives’ gains by granting options at a lower, historical exercise price. Criminal prosecutions, together with a new pre-existing statutory requirement that options grants be disclosed within two days, made it abundantly clear that backdating was illegal. But since no similar action was taken on spring-loading, companies got the message that it might be OK.

Eastman Kodak offers a notable example. In mid-2020, just before the company’s stock price jumped as high as $60 on news of a big loan from the Trump Administration to produce pharmaceuticals, it granted hundreds of thousands of options to CEO Jim Continenza at exercise prices ranging from $3.03 to $12. Although an internal investigation eventually cleared the company and CEO of wrongdoing, the New York State Attorney General is still investigating Continenza’s separate purchase of almost 50,000 shares about a month before the loan announcement. (The loan deal later fell through.)

Kodak is far from alone. Back in 2009, I wrote about the serendipitous timing of 750,000 options given to Marvel CEO Isaac Perlmutter: They had an exercise price of $25, and were granted about a month after the company began negotiations that eventually resulted in the sale of the company to Walt Disney Co. for $50 a share. Earlier this year, a Roku Inc. shareholder sued the company’s founder and its board over spring-loaded options.

There have been dozens of other publicly reported examples over the years, and they’re probably just the tip of the iceberg. Companies don’t flag options granted near important news events, so finding them all would be a monumental and quixotic undertaking. There’s also room for interpretation: Sudden, one-off grants, for example, should raise more questions than regularly scheduled ones.

It’s thus encouraging that the SEC under new Chair Gary Gensler is subjecting the practice to greater scrutiny. In its guidance, the first of its kind in two years, the agency clarifies that companies must take any material non-public information into account when setting the exercise price and determining the value of options grants — and in their public disclosure of such grants. The guidance doesn’t change the rules, but it puts companies on notice that the SEC will no longer turn a blind eye to spring-loaded grants, as it has done for a long time.

This, in turn, suggests that the SEC is getting serious about closing gaps in its insider-trading enforcement, and might soon make examples of some companies that have pushed the limits, thinking that officials weren’t paying attention. If so, the tougher approach is welcome and long overdue.