Options and insider trading

Suppose a company awards stock options as of a date in the past that they know is a low price? This is backdating, and is not a problem if the practice is properly disclosed and accounted for.

Now suppose that the stock options are awarded as of today, the day before the company knows it will be announcing good news. Any problem? Not if the practice is properly disclosed and accounted for.

However, there seems to be some belief to the contrary, triggered by an article about the practice in Saturday's WSJ. This deserves some discussion.

Now, if the board didn't know the info when it granted the options, the famous Texas Gulf Sulphur case says this might be insider trading. But if the board had the info, and has otherwise performed its duty under state law granting the compensation, no problem. Though the executive trades with uninformed shareholders, any "unfairness" is not in itself illegal.  As I discuss in Federalism and Insider Trading, 6 Supreme Court Economic Review, 123 (1998), since the owner of the information, through its board, is authorizing the trade, there is no "misappropriation" of information, and therefore no violation of federal law.  (Indeed, one might argue that the board might generally authorize the executive to trade on inside information, but that's a little trickier under current law.)

Now comes Iman Anabtawi, through Professor Bainbridge, to offer her own theory:

Under federal insider trading law, corporate insiders must disclose all material nonpublic information known to them before trading or abstain from trading. Does knowledge of the inside information and approval by a disinterested board or board committee cleanse the transaction of deception?

Commissioner Atkins has espoused the view that board knowledge of inside information eliminates any deception in an intra-corporate securities transaction.

Another view, however, is to focus on the purposes underlying Section 10(b) of the Securities Exchange Act of 1934, under which the SEC has promulgated the insider trading rules. These purposes involve ensuring that those charged with the administration of other people’s money must not use inside information for their own advantage. While it is true that using discount options may be efficient compensation policy, doing so without adequate disclosure to shareholders involves making materially misleading statements in connection with a securities transaction − in other words insider trading.

As explained above, it is simply not the rule that corporate insiders “must disclose all material nonpublic information known to them before trading or abstain from trading.” In the scenario Anabtawi describes – the trading is approved by a disinterested board – there is apparently no misappropriation, and therefore so no duty not to trade without disclosure.

It is important not to perpetuate the popular misconception that trading on nonpublic information is illegal. It is not, and cannot reasonably be, because the ability to trade on unequal information is the incentive engine that drives market efficiency. There may be reasonable questions about where to draw the line, but it’s crucial to get this basic idea straight.

To be sure, there may be a federal duty to disclose backdating and related compensation schemes to the shareholders even if the granting board was disinterested under state law. But it is far from clear that any breach of this duty would convert the executive's board-approved options to misappropriation.  Anyway, such a rule would be a far cry from the broad duty Anabtawi asserts to refrain from trading on material nonpublic information.

In any event, this is not exactly one of the great problems facing America today.  Even if Ben Stein prefers to liken it to drug dealing (HT Law Blog). If we're looking for big problems, how about the fact that we have trouble in this country distinguishing executive compensation from drug dealing?

Comments

[Robert Schwartz]

Imam's reading was arguably correct in the early 1970s (when I wrote my law review note on the subject), but SCOTUS sank that idea in Santa Fe and Buffalo Forge (and, no, my note was ignored, as it should have been).

IIRC, rule 10b-5 was promulgated to give the SEC a statutory basis for protecting sellers, as 33 Act Section 17 only protected buyers, not as an all purpose Federal law of fiduciary duty.

[Iman Anabtawi]

I believe that we can agree that the classical theory of insider trading liability (not the distinct misappropriation theory) requires a breach of a state-law fiduciary duty and conduct that is manipulative or deceptive. In the context of springloaded options, let me suggest two possibilities for satisfying these elements. First, in cases in which directors are receiving a direct or indirect benefit from the issuance of the springloaded options (in other words, the directors are not disinterested), their actions implicate the state-law duty of loyalty to shareholders. Second, under Malone v. Brincat, 722 A.2d 5 (Del. 1998), directors have a fiduciary duty to communicate honestly with shareholders when they communicate with them about corporate matters (such as compensation policy), id. at 10. The central question in the springloading/insider trading debate, as I view it, is not whether the practice of granting in-the-money options is good compensation policy, as some seem to see it. Rather, it is whether and what kind of disclosure to shareholders is required in connection with doing so.

[Larry Ribstein]

Iman

I'm not persuaded.

First, the Supreme Court has made clear in O'Hagan and Dirks that the only current theory of federal insider trading liability (not the "classical" theory) is based on misappropriation.

Second, although an action by an interested board may trigger the duty, my post explicitly referred to a disinterested board.

Third, Malone is not an insider trading case. Are you arguing that breach of the Malone duty would trigger insider trading liability? If so, what's your support? Certainly not VC Strine's opinion in Oracle!

Finally, there may be a federal disclosure duty here -- you don't have to resort to a state law theory. But as I said in my post, I doubt that converts this to insider trading.

[William Wang]

I agree with Larry’s conclusions, but would apply both the misappropriation doctrine and the classical relationship theory. The courts apply both theories of Rule 10b-5 insider trading liability.

With an option grant by a fully-informed disinterested board, I agree with Larry that no Rule 10b-5 misappropriation exists.

What about the classical relationship theory? Under that theory, the insider owes a duty to the party on the other side of the trade. (For this reason, the corporation cannot permit its executives to trade company stock on material nonpublic information. See William K.S.. Wang & Marc I. Steinberg, Insider Trading, sections 5:4.1[B] & nn. 614-22, 5:4.10 (PLI 2d ed. 2005)).

With the option grant, the party on the other side of the “insider trade” is the corporation. The fully-informed disinterested board made the decision on behalf of the company. The insider deceives neither the board nor the corporation. Because of this absence of deceit, the classical relationship theory would not apply.

To analogize, suppose in a face to face trade one executive of a public company sells corporate stock to another executive. Both executives possess the same material nonpublic information. Because of the absence of deceit, no Rule 10b-5 liability would result.

Nevertheless, I think that Larry and Iman are not that far apart. Larry acknowledges: “[T]here may be a federal duty to disclose backdating and related compensation schemes to the shareholders . . . .” under some theory other than insider trading.

In other words, even if the INSIDER is not guilty of deceit of the company (the party on the other side of the trade), the COMPANY might owe a duty to disclose to the shareholders.

Assume arguendo that Chiarella/Dirks does not apply to debt instruments, even junk bonds and convertible bonds. (For discussion of this issue, see “Insider Trading” section 5:2.6[C] (PLI 2d ed. 2005)). Suppose a fully-informed disinterested board issues either junk bonds or convertible bonds to an executive at a below-market price that does not reflect material nonpublic bullish information known to both the board and the executive. No insider trading liability would result, but the COMPANY might owe a duty to disclose to the shareholders under the federal securities laws.

Below is an excerpt from Insider Trading, section 5:2.1 at notes 36-37 (long footnotes omitted):

START OF EXCERPT
Although Chiarella's conviction and Dirks' censure both were reversed, the Court stated for the first time in Chiarella and restated in Dirks that rule 10b-5 prohibits insider trading on an impersonal stock market if a [classical] special relationship exists between the contracting parties. Chiarella seemed to extrapolate from face-to-face transactions to impersonal stock market trading. Justice Powell apparently felt that if the president of a closely held corporation cannot purchase stock from a shareholder based on material nonpublic information, the president of a publicly traded corporation cannot do so for the same reason. In both instances, the gravamen of the offense is the nondisclosure, and the president has a fiduciary duty to disclose to the shareholder. Thus, Justice Powell's Chiarella decision indicates that, in stock market insider trades as well as face-to-face transactions, the duty to disclose (based on a classical "special relationship") is owed to the party in privity with the insider trader. In exonerating Chiarella, Justice Powell repeatedly emphasized that Chiarella had no [classical] special relationship with those who sold to him.
END OF EXCERPT

[Iman Anabtawi]

Perhaps it is because I view the Chiarella/Dirks formulation to be ill-suited to analyzing an intra-corporate transaction that I consider the deception question (at least as it applies to the Board's fiduciary duties to shareholders) to be more interesting than does Bill.

[John Olagues]

I have a related question.

SEC Rule 16b requires that executives return to the company any profits made as a result of buys and sales made within 6 months.

The grant of employee options is considered a buy. However, the grant is exempt if the Compensation Committee are qualified and other facts are in place.

Assume an executive receives a grant when he posses very positive non public material information and sells stock after the announced positive information after the stock increses 30%.

Is the grant exempt under 16b 3 thereby making the grant and sale within two months not a violation of 16b? Or is the grant not exempt because the object was to in fact violate the spirit of the law and use the exemption to carry out legalized insider trading?

[Late arrival]

Today, I came across a case citing, at some length, some of Professors Ribstein and Anabtawi thoughts on the issue of "springloading." See In re Tyson Foods, 2007 WL 416132, at *18 n.77 (Del. Ch. Feb. 6, 2007). (I've since read Prof. Ribstein's posting (including readers' comments) and Prof. Anabtawi's article in my alma mater's law review). I think you've both overlooked certain critical issues which undermine the force of your arguments -- and have succeeded in confusing at least one court.

First, in context of Section 10(b), where's the "purchase or sale" of a security (an element both private plaintiffs and the SEC must satisfy)? I don't believe the execution of an option agreement satisfies it. The first qualifying transaction -- unless the option holder sells his or her option, which is unlikely -- will be the option holder exercising the option and purchasing the underlying securities. And it's only then that those securities can be sold to the investing public. This is an important fact which is too often overlooked. It is one of the factors that distinguishes so-called "springloading" from any form of insider trading.

Second, where's the scienter? If you look at most of the companies under investigation, the vast majority of option holders are usually employees who have no role in deciding whether to grant options. When one of those employees exercises an option, he might as well have purchased it in the open market on the grant date. He has no more insider information than the outsider with whom he later trades.

Third, even assuming the option contains some information discount and the insider was aware of that discount, by the time those securities are sold that information will have long since reached the market because most options vest over several years. (But even if the option vested immediately, there would still be no securities fraud. The entire premise of springloading is that the relevant information must reach the market to boost the stock price; thus, putting buyer and seller on equal footing.) This is simply not the type of harm Section 10(b) seeks to redress. It seeks to prevent harm to investors by prohibiting insiders from trading on material inside information, so that the investor with whom the insider trades will not subsequently suffer a loss when the market corrects for newly disclosed information. This rationale is inapplicable in the context of springloading. At the point in time of the transaction with the public, the disclosure arguably causing the discount is no longer material and there is no asymmetry of information between buyer and seller. What's being complained about here is not the harm to the investor due to the insider's superior and undisclosed knowledge (whether procured through a breach of fiduciary duty or otherwise), but the discount or benefit the insider obtained from the earlier transaction with his company.

Fourth, no shareholders or potential shareholders are harmed by the transaction between the company and its employees. I don't think I've even seen anyone argue that shareholders are harmed simply because an option was granted prior to the announcement of news that moves a company's stock price. (Most of the argument's Prof. Anabtawi makes in his article deal more with harm to the corporation as opposed to harm to "investors," which I discussed below.) There is no deceptive or manipulative act involving investors. And, unlike backdating, which understates expenses and overstates income, there is no misstatement or omission of material fact disseminated to investors at the time of the grant. (The disclosers under FAS 123 or APB 25 are often calculated using the Black-Scholes model, which, as I understand it, values the actual option and doesn't factor grant or measurement dates nor exercise prices.) According to the SEC's chief accountant, springloading is not an accounting issue.

Finally, in the context of insiders' fiduciary duties, there is no appreciable harm to the corporation or its shareholders. Prof. Anabtawi argues to the contrary in his article:

Take the example given earlier in which a CEO is granted options to purchase 400,000 shares at an exercise price of $50 per share. In that example, the options vested immediately and the announcement that the FDA approved the company’s new drug for commercial sale raised the
stock price to $70. If the option is exercised, timing the grant before the release of the good corporate news results in the CEO’s purchasing the shares underlying the option for $50, which is $20 less than the CEO would have paid had the options been granted after the news release. The direct pre-tax cost to shareholders of this benefit is $ 8 million.

The cost to shareholders is $8 million? As discussed above, Prof. Anabtawi's example does not evidence any direct harm to shareholders -- the $8 million was paid by investors with full knowledge of the material facts. If there is any harm, it must be indirect and as the result of a harm to the company. But such harm is illusory.

It is true that, had the corporation done what Prof. Anabtawi advocates and granted the option on the day of the disclosure (i.e., at $70), the "company" would receive an additional $8 million when the CEO exercised the option. At bottom, this argument boils down to a theory of corporate waste. The corporate "deciders" decided to compensate an employee with something they reasonably suspected would appreciate in value -- at least short-term. But how can that be improper when no one, including the SEC, seriously contends that a company cannot grant an employee an option that is actually "in-the-money," so long it's disclosed (keeping in mind that this is simply an accounting disclosure; the corporation need not include in its MD&A conspicuous language saying it gave an in-the-money option and, as stated above, a "springloaded" option has no accounting implications).

[Alex]

I think Late arrival's first point is particularly interesting--where is the securities transaction? If the company actually hands an executive a bunch of options, then, since options are defined as securities under the '34 Act, that's a security. But my understanding is that this isn't normally the way these options plans work: instead, they have certain vesting periods before which the options don't really belong to the grantee at all. The unvested options isn't necessarily a synthetic--it's not dependant on the efforts of others to the extent that the executive's individual actions (such as leaving the company) can destroy the unvested interest.

I think this turns on the definition of a security (I'm thinking it would fall under "investment contract") but my recollection of 33 Act class was a bit hazy. HOWEVER, assuming that an unvested options is not a security, it may also turn on the breadth of the "in connection with" requirement under 10(b). A grant of an unvested option may still be "in connection with the purchase or sale of a security" to the extent that the sole purpose is to later allow the executive to purchase a security. Of course, the "stock options" plan may be entirely synthetic, i.e. the corp just pays out a cash settlement, in which case I guess we'd go back to the investment contract analysis.

[JMTaylor]

In my view, the "no transaction" theory is pretty much a red herring (probably why I didn't see any further reply). First, an option is defined in the statute as a security under both the '33 Act and the '34 Act. (In fact, the sale of an immediately exercisable option constitutes the sale of sale of the underlying security as well under Securities Act § 2(a)(3)). If the option is not immediately exercisable, it doesn't matter either, because you still have the option which is a security, which gives you § 10(b) nexus. And I think it has been well decided by now that an option granted by a company in the employment context is still a sale (even though the optionee typically does not pay value for it) because the continued employment is deemed consideration for the sale. (The Ralston Purina and Texas Gulf Sulphur cases involved employee options if I'm not mistaken.) And even if this authority is not on point, if a grant of a compensatory option was not a sale, there would be no need for Securites Act Rule 701 which provides an exemption for registration for non-reporting companies issuing compensatory options and other securities. To put the final nail in the coffin, remember that the definition of "sale" under the '34 Act is broader than under the '33 Act because it does not require that the disposition be "for value."