SEC Springs Warning on Option Grants

The Securities and Exchange Commission is warning companies to do better at estimating and reporting the value of “spring-loaded” stock option grants they give to executives, possibly as a prelude to future enforcement actions against companies that continue to ignore the tricky accounting challenges involved here. 

Spring-loaded stock option grants are equity awards that companies give to employees while the company is sitting on material, nonpublic information that’s likely to goose up the share price. (Say, a favorable earnings report due to hit the wires the following week.) Such grants are permissible under federal securities law, but companies need to report the fair market value of the options grant — which requires the company to estimate the volatility of the share price across the term of the option grant.

Those calculations are explained in Accounting Standards Codification 718, Share-Based Payment. Apparently the SEC believes that corporate filers haven’t been applying that standard correctly enough, because the agency just issued Staff Accounting Bulletin 120 to clarify how SEC staff wants to see things done. 

The principal issue involved here is how a company estimates the value of its stock options. The company can use any of various valuation techniques, so long as the technique it chooses meets several criteria spelled out in ASC 718. Those three criteria are:

• The model is applied in a manner consistent with fair-value measurement objectives;
• The model is based on established principles of financial economic theory and generally applied in that business; and
• The model reflects all substantive characteristics of the instrument (that is, the options grant). 

It’s that third point that seems to have captured the SEC’s attention. Spring-loaded grants implicitly carry some extra value beyond other, more routine option grants, thanks to that material, nonpublic information likely to boost the share price. So companies awarding the grant must keep that fact in mind as they estimate the value of the grant and report it to shareholders. 

“Companies should not grant spring-loaded awards under any mistaken belief that they do not have to reflect any of the additional value conveyed to the recipients from the anticipated announcement of material information when recognizing compensation cost for the awards,” the SEC said in a statement accompanying the Staff Accounting Bulletin.

Stock Option Scandals Through Time

If any of this sounds familiar, that’s because the SEC went through an enforcement wave in the mid-2000s over the much more offensive practice of stock option backdating. That’s where companies deliberately altered the grant date of option grants, usually to some prior date where the share price was lower, so the value of the options on the date an employee exercised them would be higher — giving the employee more money. 

Back in the day, scores of companies were caught in the options backdating scandal, including huge names such as Steve Jobs and Apple, and Michael Dell and Dell Corp. No charges were filed against the iGenius or Apple, although charges were brought against Apple’s then-CFO and general counsel. 

Today stock option backdating has gone the way of the dodo bird, mostly because the Sarbanes-Oxley Act requires that options given to senior management must be reported to the SEC within two days of the grant date; so there’s essentially no opportunity to backdate. The enforcement wave that happened in the mid-2000s related to backdating that happened pre-SOX, and those days are over.

By issuing this guidance, the SEC is warning everyone that enforcement against abuses over spring-loaded options is possible. Such enforcement would probably result in monetary fines for the company and disgorgement of ill-gotten gains for the errant executive; and that person might face tax consequences from the IRS too. 

Will any such enforcement actually happen? I don’t know, but the SEC staff don’t issue accounting bulletins just to hear themselves type. We may hear more from the agency next week at the AICPA’s annual conference on SEC and PCAOB developments, which usually brings out a phalanx of SEC functionaries to explain issues exactly like this. Yours truly will be on scene and report back as warranted. 

Spring-Loading Details

We should also consider which companies might be most vulnerable to this spring-loaded reporting risk. A few come to mind.

First are private companies that have filed a registration statement with the SEC so they can go public. Those companies have extra questions to consider, since ASC 718 allows private companies to value stock options based on intrinsic value, but that’s not a method available to public companies. Transitioning from private to public status is an intricate dance, with plenty of disclosures the company will need to make in its SEC filings.

Second are companies that have seen a big run-up in share price over the last year — which would be lots, considering the Dow Jones average is up nearly 20 percent for this year and up 85 percent from the lockdown lows of March 2020. That’s a lot of positive upside, and a lot of volatility to incorporate into your valuation calculations. 

Third are companies either recently acquired by SPACs or are in the middle of a SPAC acquisition. As we noted just yesterday, SPACs have flooded Wall Street over the last year, and many are now at least halfway through their 18- to 24-month window to acquire a private company. The closer a SPAC is to that deadline, the more pressure sponsors feel to close any deal they can find. That’s when the loosey-goosey accounting stuff happens and people make poor judgments, and spring-loaded options are tailor-made for those types of mistakes.

We also can’t ignore that audit season is coming up, and audit firms will take their cues from SAB 120 about how to look at option grants. So companies will need to test and document their valuation models, including the validity of whatever data you might use to justify your valuation decisions. You’ll also need to assure that your disclosure controls are working, to capture and disclose details such as significant assumptions in your valuation methods or changes you make to your models.

I also wonder how these questions might intersect with the 10(b)5-1 plans companies use to manage stock sales by corporate insiders. Recall that in 2020, the SEC warned companies that those programs need controls over insider information to prevent executives from trading shares while the company is sitting on such intel, “even if an individual officer or director did not personally have knowledge of the information.” How would that standard of internal control apply in this context, if at all? That’s a question worth pondering.

The Staff Accounting Bulletin walks through all those issues in much more detail than we can provide here; so if you’re responsible for internal control, equity compensation reporting, or related duties at your company I’d recommend reading it closely. If we hear more from SEC staff at next week’s AICPA conference, I’ll post an update. 

Meanwhile, that’s one more blip of concern on your internal control and compliance radar screen.