Pension Risk Matters : Pension Risk News & Analysis : Investment Governance, Inc. : Pension Risk & Investment

In "Backdating Fine May Set Model - Brocade Is the First to Pay Penalty in Options Probe (June 1, 2007)," Wall Street Journal reporter Kara Scannell describes a $7 million settlement with the SEC over option backdating. Law.com reporter Jessie Seyfer describes a judge's refusal to dismiss the case, with significant focus surrounding the issue of material economic harm to shareholders. (Is there harm or not?) Click here to read the May 14, 2007 article.

In the wake of several stories about 401(k) stock drop litigation, one connects the backdating - company stock dots by asking: "How much extra homework should pension fiduciaries undertake before recommending company stock (if at all) when the terms of prevailing option awards are misunderstood, questionable or insufficiently transparent?" Should pension fiduciaries ask to meet with the compensation committee and more thoroughly vet company stock risk factors related to option awards for those at the top of the management ladder? Click here to read "Will Executive Option Issues Drive the Next Wave of Pension Litigation?" by Susan M. Mangiero (Journal of Compensation and Benefits, March/April 2007). 

Not addressed in the article but an interesting point to ponder relates to possible conflicts of interest. When the compensation committee and the pension investment committee are one in the same, will individuals who approve the granting of executive options be able to support an arm's length assessment of company stock as a viable defined contribution plan choice? The answer is not necessarily "no" but it does pose some added complexities.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Alleging questionable stock option practices at technology giant Apple Inc, the New York City Employees' Retirement System ("NYCERS") will serve as lead plaintiff in a lawsuit filed a few months ago. Citing the Private Securities Litigation Reform Act of 1995 ("PSLRA"), NYCERS claims the largest financial interest in the lawsuit. (Click here to read the original filing and here to read "Recent Developments Under the PSLRA.")

According to Reuters (January 22, 2007), the NY fund's ownership stake is roughly one million shares or about $87 million in current value terms. Its 2006 Comprehensive Annual Financial Report shows $46.34177 billion as plan net assets as of June 30, 2006. While NYCERS equity exposure to Apple is large in absolute terms, it is small compared to the equity interests held by institutional investors such as Fidelity Management & Research (60,316,011 shares as of September 30, 2006) or AllianceBernstein L.P. (48,637,731 shares in second place). Click here to review ownership statistics, courtesy of Thomson Financial (and reprinted by the Wall Street Journal.)

The intent of this post is not to single out any one company nor to imply that the filing of a complaint supports any or all of the allegations. That's for the trier of fact to determine. What is important is to understand that executive compensation practices can (and often do) impact shareholder value. If the market interprets a particular practice as far removed from economic reality and/or regulators start sniffing around, defined benefit and defined contribution participants stand to lose a bundle. In order to reduce the likelihood of an adverse outcome due to investing in company stock, pension fiduciaries must carefully consider relevant risk factors. That includes the percentage of company stock already part of a particular plan (whether self-directed or not). See "Options, Pensions and the SEC" for additional comments about backdating and pension fiduciary duty.

With more than 120 companies being asked questions about their respective option practices, there is surely much more to say on this topic!

• Email This
• Print
• Comments
• Trackbacks
• Share Link

It's hard to pick up a newspaper these days without reading some story about stock options - when they are granted, how often they are repriced, what portion of an executive's total compensation they represent and so on. What has authorities particularly busy is a fast-expanding review of practices such as option backdating and spring loading. As of December 31, 2006, the Wall Street Journal counts 120 companies on their option backdate list. Click here to view the options scorecard and learn about executive departures and various regulatory agency investigations.

The Free Dictionary defines backdating as "dating any document by a date earlier than the one on which the document was originally drawn up." Spring loading can mean either that "a company purposely schedules an option grant ahead of expected good news or delays it until after it discloses business setbacks likely to send shares lower." See "SEC eyes 'springloading'" as published by the New York State Society of Certified Public Accountants. In both cases, the idea is to inflate the value of the executive's stock option. (Experts remind that neither backdating nor spring loading is necessarily illegal per se, a conclusion that is best left to attorneys and regulators.)

These and other practices are important to pension fiduciaries and plan participants alike. Defined benefit plans sometimes invest in company stock. Defined contribution plan participants are often given a similar choice. Any problems with option grants, especially when they result in tax and/or accounting penalties, not to mention regulatory enforcement levies or litigation payouts, can do serious harm to an employee's retirement plan. From a fiduciary perspective, real questions could arise about the ex-ante assessment of company stock as a viable investment vehicle for a sponsored plan(s). Did an adequate due diligence review of risk factors that influence company stock price occur? Did pension fiduciaries sufficiently understand existing practices regarding executive compensation, including option awards? How often did pension fiduciaries assess option grant practices and/or inquire about industry norms, internal controls and likely impact on "shareholder" retirement plan participants?

For interested readers, the D&O Diary, authored by attorney Kevin LaCroix, has an excellent collection of articles about option backdating.

Option valuation is another topic with considerable import. Relatively new accounting rules in the form of FAS 123R set the stage for a vigorous debate about how to value employee and executive stock options (ESO's). Unlike shorter-term options that actively trade in ready markets, ESO's are more challenging to value for a host of reasons. Though a bit outdated with respect to regulations, readers may nevertheless find my article about option valuation of interest because it highlights the importance of having good inputs and an appropriate model. (Click here to read "Model Risk and Valuation," Valuation Strategies, March/April 2003.)

In a recent decision, the SEC notified Zions Bancorporation that its Employee Stock Option Appreciation Rights Securities (ESOARS) is "sufficiently designed to be used as a market-based approach for valuing employee stock option grants for accounting purposes under Financial Accounting Standards (FAS) No. 123R." According to Zion's press release, it is their intent to assist other public companies in valuing ESOs. I took a quick look at their site and plan to read more. Certainly a mechanism that facilitates marketability is a step in the right direction. After all, the coming together of willing buyers and sellers, under ideal circumstances, permits a flow of information that should result in the "right" price.

Editor's Note:
I am currently writing an article about option backdating as it relates to pension fiduciaries.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Executive stock options continue to grab headlines. In late 2004, after a parade of protests, the Financial Accounting Standards Board issued the "Summary of Statement No. 123 (revised 2004): Share-Based Payment". Intending to promote transparency, FASB's rule requires public companies "to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award" and to recognize the cost "over the period during which an employee is required to provide service in exchange for the award-the requisite service period (usually the vesting period)."

Following suit, on July 26, 2006, the U.S. Securities and Exchange Commission announced news about additional (and arguably more comprehensive) disclosure rules for all sorts of executive compensation vehicles, including stock options. The SEC plans to provide "additional guidance regarding disclosure of company programs, plans and practices relating to the granting of options, including in particular the timing of option grants in coordination with the release of material nonpublic information and the selection of exercise prices that differ from the underlying stock's price on the grant date."

(Click here and here for recent posts on this topic.)

Now, backdating takes a bow. The Corporate Library describes this practice as "awarding stock options on one date, and then backdating the grant or award date to a time when the stock price was lower."

Experts say that backdating per se is not illegal. So why the hullabaloo? Several reasons account for the recent news flurry. For one thing, there may be tax consequences. CNNMoney.com reports that "companies and individuals could face hundreds of millions of dollars from civil penalties, unpaid taxes and interest payments if widespread wrongdoing is found." One law firm, McDermott Will & Emery writes that "failure to disclose this practice could possibly constitute securities fraud" and give rise to accounting misrepresentation as well.

Concerned about alleged misdeeds and an adverse impact on stock price, pension funds are lining up to bring suit. Institutional Shareholder Services writes that "an international group of 14 institutional investors led by the U.K.'s Universities Superannuation Scheme and the Australian Reward Investment Alliance asked the SEC to increase disclosure requirements for option grants. The group includes five U.S. state pension funds and institutions from Canada, Norway, and the Netherlands."

To be clear, it is impossible to tackle the merits of any one situation without sufficient information to evaluate a problem, if one exists, and assess economic damages to anyone found to have been harmed by backdating.

However, even in the absence of case-specific information, a discussion about the valuation of executive stock options is nevertheless worthwhile. Saying that this topic is broad is like saying that Lake Michigan is a little body of water. That's why this topic will show up again in subsequent posts to www.pensionriskmatters.com and why it will continue to resurface as the topic du jour in court, regulatory proceedings, auditors' roundtables and board meetings everywhere.

To begin, pricing model choice and determination of inputs are integral to option valuation. While myriad factors contribute to a final assessment, one variable, volatility, is often described as dominant.

What exactly is volatility and how is it measured? Given different types of volatility, which one makes sense to use? Historical volatility is frequently measured as the standard deviation of returns for the underlying asset and can serve as a proxy for uncertain future asset price movement. This technique assumes that past price behavior is a bellwether for the future. Sometimes this is not an appropriate conclusion. An industry and its constituent members may have undergone radical change in the form of deregulation or technological innovation, completely changing the profitability landscape thereafter. In contrast, implied volatility is derived by examining market prices of an option (characterized by time to maturity, exercise price and other relevant factors) and backing into an estimate of investors' beliefs.

As demonstrated in "Model Risk and Valuation" by this blog's author, Dr. Susan M. Mangiero, the volatility number can have a dramatic impact on the computed value of an option. Moreover, the relationship between volatility and option value is not proportional. Consider that an increase of ten percent in volatility does not necessarily translate into a ten percent rise in the value of the option. (This is a simplistic statement since option value does not depend on volatility alone.)

Business Week reporters Jane Sasseen and Greg Hafkin correctly make the point that "options for volatile stocks carry higher expenses". Citing a report by Credit Suisse Group analyst David Zion, they describe a precipitous drop in the value of options granted by S&P 500 member companies, from "$104 billion in 2000 to $30 billion in 2005", adding that "implied numbers have been lower than the historical ones" but that "volatilities are heading up."

One thing is certain. Estimating volatility should amount to more than a mere number crunching exercise. The process should reflect an assessment of economic performance going forward. A mistake in volatility choice can be costly and lead to a slew of unwelcome events.

There is a lot (!) more to say on this topic.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

The San Jose Mercury News reports a litigation backlash against thirteen Silicon Valley firms in connection with questions about their stock option programs. While arguably newsworthy, what is perhaps more telling is the role played by U.S. and foreign pensions.

Since the Private Securities Litigation Reform Act became federal law in 1995, the clout of these moneyed giants has not gone unnoticed. (There is even a blog by the name of The PSLRA Nugget.)

Several studies have tried to reconcile the intent of the law (i.e. to cede more clout to the investor tied to the largest financial stake) with outcomes in terms of fees, settlements, cases filed and so on.*

In their 2005 paper, Stephen J. Choi and colleagues write: "We find no systematic evidence that private institutional lead plaintiffs are associated with larger class recoveries. Public pension funds, on the other hand, are correlated with higher class recoveries as a fraction of the potential damage award in the post-PSLRA period. Our results are, however, consistent with the possibility that public pensions 'cherry pick' the actions in which they seek to become lead plaintiff, selecting only the cases with the largest potential damages and the strongest evidence of fraud. Further analysis is necessary to evaluate this possibility." (See "Institutions Matter The Impact of the Lead Plaintiff Provision of the Private Securities Litigation Reform Act" by Choi, Stephen J., Fisch, Jill E. and Pritchard, Adam C. April 15, 2005, NYU, Law and Economics Research Paper No. 04-08.)

According to the New York Stock Exchange Fact Book, U.S. pension funds now own about twenty-two cents of every dollar of issued corporate equity. Institutional investors (including pensions) own roughly fifty cents or one-half.

What does this mean?

Here's my humble take. As stated several times before, pension fiduciaries are in the spotlight as never before. Any investment-related loss is likely to trigger some type of response. Will it be surprising if it takes the form of litigation to recoup losses? Not really. Will it be a bad thing? Maybe. Maybe not. This is a complex question, one that cannot possibly be answered here.

More to come...


* To prevent a flood of cases migrating from federal to state courts as a result of the PSLRA, the Securities Litigation Uniform Standards Act of 1998 barred certain lawsuits from being filed in state courts. (Please be reminded that the author is not an attorney and urges readers to always seek counsel with respect to any legal question.)

• Email This
• Print
• Comments
• Trackbacks
• Share Link