Pre-Merger Option Grants

Today's WSJ reports that:

Numerous companies have awarded stock options to their top executives while engaged in negotiations to be acquired, according to academic research and a Wall Street Journal review of company filings.

The practice, which experts say appears to be legal under federal law, typically results in the target firm's executives receiving a bigger payout when the takeover is later announced.

On Deal Journal, the same reporter notes that:

David Yermack, a finance professor at New York University’s business school, says doling out new stock options to target company CEOs in the midst of merger talks is like a “bribe” to get them to go along with the deal.

But that may not be such a bad thing, he says.

Yermack was reacting to this page one article in Monday’s Wall Street Journal that focuses on cases in which target companies award unusual stock-option grants to their executives during merger talks. The executives often pocket millions of extra dollars from the new options when a deal later is announced and closes.

Yermack, who is credited for first uncovering the practice of stock-options timing by companies more than a decade ago, says handing out pre-deal grants isn’t much different from golden parachutes or special deal-related bonuses. Such goodies tend to smooth the way for CEOs to agree to sell their businesses, he says, rather than fight to hang on to their well-paid jobs.

“You have to ask the question, would the CEO have advanced the deal if he hadn’t gotten a payoff?” Yermack says. “This may resemble what’s been done with the tacit agreement of shareholders for a long time.”

When I read this story this am, my first reaction was: Huh. Firms have found a way to end run non-deductibility of golden parachute payments and the 20% excise tax imposed on their recipients. Assuming the options are structured so as to avoid being treated as "parachute payments" as defined by the IRS, what we're dealing with here is a tax dodge, not insider trading or securities fraud.)

Larry  Ribstein also noticed the golden parachute parallel:

Assuming the grants were timed to beat public disclosure of the merger, they amount to informal golden parachutes. As with parachutes generally, there’s a question whether the grants enable managers to appropriate some of the gain for themselves, skew their incentives regarding acceptance of the bid, or help shareholders by encouraging managers to accept bids they would otherwise reject.

The authors of the above study note this function of parachutes, but nevertheless suggest that shareholders are being hurt:

[A]bsent any ethical or legal issues, issuing target CEOs unscheduled options during merger talks might be consistent with the incentive alignment hypothesis if such awards induce target CEOs to negotiate higher offers, or, at the very least, offers that reflect their firms’ fair value. However, this last possibility seems unlikely, given that targets that issue unscheduled options to their CEOs during merger talks earn premiums significantly lower than those expected. The failure to earn premiums close to those predicted generates adverse wealth effects for shareholders in those targets. We estimate that in deals involving these firms, shareholders lose about 307 million dollars. To put this result in perspective, the average target loses 54 dollars for every dollar their CEO gets from unscheduled options granted during private merger negotiations.

The problem with this reasoning is that it assumes the takeovers would have happened even without the “parachute.” However, this isn’t clear: Diversified shareholders might get a bigger share of mergers that happen, but might lose across their portfolios because fewer value-increasing takeovers occur because powerful managers have incentives to reject them.

The basic problem with these ad hoc parachutes is that the arguably the shareholders ought to decide rather than letting the executives use a backdoor through the option program. But this ought to be a matter for state fiduciary duties and not federal law. Under state law firms could decide whether to allow their managers to reap some of the gains from impending mergers, rather than being forced by a federal disclosure or other rule to share these gains with the shareholders.

I think that's right as a matter of corporate and securities law, although the IRS may have something to say about the tax dodge aspect.

John Carney also thinks this is much ado about little, noting that the options have the same incentive effect as golden parachutes:

Another options grant story is trumpeted on the front page of the The Wall Street Journal. Those of us who remember how the backdating scandal started out with a bang and ended with a whimper should be asking whether this is another media-manufactured nonscandal.

Before we get to our doubts about the latest options grant scandal, let's run through the mechanics.

• Once again, the Wall Street Journal has picked up the trail of a largely unknown options grant practice that was first uncovered in an academic paper.
• This time around, the practice involves awarding stock options to top executives during negotiations for acquisitions.
• These options grants mean that the executives get bigger paydays when the merger is announced and the stock shoots up.
• In those deals where CEOs got the well-timed, unscheduled options grant, shareholders got a lower takeover premium than shareholders in companies that didn't give these 'spring loaded' grants.

The paper's authors, Eliezer Fich, Jie Cai, and Anh L. Tra, and WSJ reporter Mark Maremont, one of the reporters who won the Pulitzer Prize for reporting on backdating, clearly think they've uncovered a major scandal. While Maremont notes that the practice is probably legal, they clearly imply that shareholders are getting cheated while executives are enriched.

"We estimate that in deals involving these firms, shareholders lose about 307 million dollars," the academics write. "To put this result in perspective, the average target loses 54 dollars for every dollar their CEO gets from unscheduled options granted during private merger negotiations."

Is this what's really happening? We're not so sure. The evidence could actually cut the other way. The crucial finding that the academics think is truly damning is that shareholders in these deals received lower takeover premiums than average. If that is because executives didn't negotiate good deals because they were getting the spring loaded options grants--as the academics believe--then clearly shareholders are being hurt.

But that's not necessarily the case. It could be that the lower takeover premium reflected the maximum price the buyer was willing to pay but that price was too low to entice the target's executives to sell. In that case, the options grants to executives may have prompted a sale where none would have otherwise occurred. 

It's possible that if not for the spring loading, shareholders would not have received any takeover premium at all because the deal would never have been closed. In other words, spring loading may be allowing the shareholders of the targets to get premiums that would have otherwise been unavailable. This is at least as consistent with the correlation of lower premiums and spring loading as the scandalizing conclusion drawn by the academics.

The core problem with the paper and the WSJ piece is that both seem to assume that the acquisitions would have gone forward without the spring loaded options. It isn't obvious why we should accept that assumption.

Excellent stuff.

As for the tax dodge aspect, if I'm right that that's what is happening here (at least in part), I would recall to your attention Judge Learned hand's famous dictum that: "Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands."

Comments

[Greg]

For purposes of the 280G golden parachute rules, an option agreement entered into within one year before the change of control is presumed to be contingent on the change of control (and therefore does not avoid the excise tax/deductibility issue) unless the taxpayer can establish by clear and convincing evidence that the option agreement is not contingent on the change of control. One of the factors in determining whether the taxpayer can meet its burden is the degree of likelihood that a change in control would occur, determined at the time the option agreement is entered into. Treas. Reg. 1.280G-1, Q&A 25&26. Most tax practioners who perform a 280G analysis would not typically exclude options granted during the negotiation phase of a deal unless (i) it was clear that they were simply granted in the ordinary course of business, or (ii) the deal closed more than a year after the option grant.