Will the SEC Bring a Spring-loaded Options Case?

Well, it depends.  In December, we noted that the SEC had “not made a decision” concerning such cases, according to senior members of the enforcement staff.  This is not surprising, given the difficult nature of the issue.  For example, in July 2006, SEC Commissioner Paul Atkins commented in a speech before the International Corporate Governance Network, that spring-loading stock options (i.e., choosing an option’s grant date and exercise price at a time shortly before the release of positive corporate news; or in the case of negative news, “bullet-dodging”) does not fall within the parameters of insider trading.  “Boards, in the exercise of their business judgment, should use all the information that they have at hand to make option-grant decisions,” Mr. Atkins said. “An insider-trading theory falls flat in this context, where there is no counterparty who could be harmed by an options grant. The counterparty here is the corporation — and thus the shareholders.”  Mr. Atkins even went so far to comment that spring-loading options is an efficient low-cost way to compensate executives.  The SEC’s Office of the Chief Accountant recently noted that spring-loading is not an accounting issue, but is a disclosure issue.  While in some senses this may not seem fair, insider trading is not based on fairness or parity of information.  Rather, it is based on an abuse of position in the form of a breach of duty or a misappropriation, it would seem difficult, at best, to sustain a claim of insider trading where the company approves the option grant to take advantage of a news event.  As Mr. Floyd Norris noted in his October 6, 2006, NYT article “They Deceived Shareholders. Who Cares?,” various professors and former SEC staff believe that the SEC will have a tough time bringing such a case.  

Supporters of an insider trading theory, however, point to cases where executives were granted or exercised options when the board was unaware of the pending positive or negative corporate news.  More than 40 years ago, executives at Texas Gulf Sulphur, aware of a significant mineral discovery, bought stock and options and accepted company options while they, and not the authorizing board, were aware of the discovery.  The Second Circuit held that the executives’ conduct was illegal. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968).  Recently, the SEC settled a two-year old case where an executive, David Willey, who was the only person in the corporation who knew the Federal Review Board was going to downgrade the company, used the information to trade stock and exercise his options.  http://www.sec.gov/litigation/litreleases/2006/lr19918.htm

These cases are distinguishable from those where the Boards of Directors knew about the company information or ratified the option grants thereafter.  Where is the misappropriation or breach of fiduciary duty when both sides of the stock transaction, the Board and the executive, have the same material information?  While the SEC may be investigating instances of spring-loading or bullet-dodging, it will be interesting to see what type of cases it elects to bring.  It could elect to litigate the issue by bringing a case where the entire board was aware of the information.  On the other hand, it may elect to seek a case where there are other more clear cut securities law violations and add in the spring-loading/bullet-dodging theory.  Based on past history, the latter seems more probable.