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The Stock Option Grant Issue

By Michael S. Sirkin and Andrea S. Rattner
August 31, 2006

Just as everyone involved with executive compensation matters was settling in to address the impact of the new accounting rules under FAS 123R, the requirements of the stock exchanges, the deferred compensation rules under Internal Revenue Code (IRC) section 409A, the new Securities Exchange Commission's (SEC) proxy rules and the proper balance between adequate executive compensation and good governance, a new jolt came into play in the executive compensation arena. Studies emerged indicating that many companies consistently issued stock options at the lowest price during a period of time. This immediately propelled the government and the media to review and question many companies' stock option granting practices and prompted many companies to review such procedures. The result to date has been a surprising ” and disappointing ” revelation of intentional backdating in certain instances, a recognition that grant procedures have been sloppy in even more instances and that timing of option grants is an issue that, especially from the governance aspect, needs greater consideration.

Timing and Pricing of Options

Granting of stock options is subject to a number of rules, many keyed to whether or not stock options are granted at less than fair market value at the time of grant. Most of the grant issues pre-date the Sarbanes-Oxley Act of 2002 and the change to filing Form 4s with the SEC within 2 business days of grant (which forced public companies to put in better procedures and made backdating very difficult), although sloppiness issues still continue. Up until recently with the release of FAS 123-R, APB 25 controlled. It required an earnings charge for options issued with an exercise price of less than the fair market value of the underlying stock on the date of grant. Granting at less than fair market value, if not prohibited by the plan, was allowed, but the discount was treated as a charge to earnings over the vesting period.

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