PLANS/TECH/POLICY: WSJ finds a slight flaw in options awards

A while back there was a boring argument interesting exchange in THCB on whether the options awards to a certain health plan CEO were really part of compensation or costs to the company (and hence to its shareholders and customers). I suggested that option grants that were “in the money” certainly were. Of course if you really want to play the option and stock trading game really well, you’re better off if you are transported back in a time machine and you could then place bets on a game of which you already knew the result. OK, if you haven’t mastered time-travel, you could just be allowed to backdate the timing of your option grants (and hence the strike price) to the lowest closing price of the year. And the WSJ has a rather interesting article showing that apparently both the certain health plan CEO and the CEO of the largest Medicaid technology outsourcing company did just that. Nice work if you can get it. But of course none of this is costing us —the suckers paying premiums and the taxpayer paying the tab for Medicaid—any money, is it?

Below the jump are the graphs about UnitedHealth’s McGuire and ACS’ Rich:

The Journal’s analysis raises questions about one of the most
lucrative stock-option grants ever. On Oct. 13, 1999, William W.
McGuire, CEO of giant insurer UnitedHealth Group Inc., got an enormous
grant in three parts that — after adjustment for later stock splits —
came to 14.6 million options. So far, he has exercised about 5% of
them, for a profit of about $39 million. As of late February he had
13.87 million unexercised options left from the October 1999 tranche.
His profit on those, if he exercised them today, would be about $717
million more.The 1999 grant was dated the very day UnitedHealth
stock hit its low for the year. Grants to Dr. McGuire in 1997 and 2000
were also dated on the day with those years’ single lowest closing
price. A grant in 2001 came near the bottom of a sharp stock dip. In
all, the odds of such a favorable pattern occurring by chance would be
one in 200 million or greater. Odds such as those are "astronomical,"
said David Yermack, an associate professor of finance at New York
University, who reviewed the Journal’s methodology and has studied
options-timing issues. Options grants are made by directors,
with details often handled by a compensation committee. Many companies
make their grants at the same time each year, a policy that limits the
potential for date fudging. But no law requires this. Until last year,
UnitedHealth had a very unusual policy: It let Dr. McGuire choose the
day of his own option grants. According to his 1999 employment
agreement, he is supposed to choose dates by giving "oral notification"
to the chairman of the company’s compensation committee. The agreement
says the exercise price shall be the stock’s closing price on the date
the grants are issued.Arthur Meyers, an executive-compensation
attorney with Seyfarth Shaw LLP in Boston, said a contract such as that
sounded "like a thinly disguised attempt to pick the lowest grant price
possible." Mr. Meyers said such a pact could pose several legal issues,
possibly violating Internal Revenue Service and stock-exchange listing
rules that require directors to set a CEO’s compensation. "If he picks
the date of his grant, he has arguably set a portion of his pay. It’s
just not good corporate governance."UnitedHealth called the
process by which its grants were awarded "appropriate." It declined to
answer specific questions about grant dates but noted that on all but
two of them, grants were made to a broad group of employees. William
Spears, a member of UnitedHealth’s compensation committee, said the
October 1999 grant wasn’t backdated but was awarded concurrently with
the signing of Dr. McGuire’s employment contract. Mr. Spears said a
depressed stock price spurred directors to wrap up negotiations and get
options to management. The board revised terms of the employment
contract last year and will start making stock-option grants at a
regular time each year, Mr. Spears added.

And the lead about ACS’ rather approporiately named (now former) CEO Jeffrey Rich

On a summer day in 2002, shares of Affiliated
Computer Services Inc. sank to their lowest level in a year. Oddly,
that was good news for Chief Executive Jeffrey Rich.

His annual grant of stock options was dated that
day, entitling him to buy stock at that price for years. Had they been
dated a week later, when the stock was 27% higher, they’d have been far
less rewarding. It was the same through much of Mr. Rich’s tenure: In a
striking pattern, all six of his stock-option grants from 1995 to 2002
were dated just before a rise in the stock price, often at the bottom
of a steep drop.

Just lucky? A Wall Street Journal analysis suggests
the odds of this happening by chance are extraordinarily remote —
around one in 300 billion. The odds of winning the multistate Powerball
lottery with a $1 ticket are one in 146 million.


At ACS in Dallas, Mr. Rich helped turn a small
technology firm into one with more than $4.4 billion in annual revenue
and about 55,000 employees. ACS handles paperwork, accounting and data
for businesses and government agencies. It is a major outsourcer,
relying on global labor. "It is a pretty boring business," Mr. Rich
told the University of Michigan business school in 2004, "but there is
a lot of money in boring."

While most of Mr. Rich’s stock-option gains were
due to rises in ACS stock, the exceptional timing of grants enhanced
his take. If his grants from 1995 through 2002 had come at each year’s
average share price, rather than the favorable dates, he’d have made
about 15% less.

An especially well-timed grant, in which Mr. Rich
received 500,000 options at $11.53, adjusted for stock splits, was
dated Oct. 8, 1998. This happened to be the bottom of a steep plunge in
the price. The shares fell 28% in the 20 trading days prior to Oct. 8,
and rose 60% in the succeeding 20 trading days.

ACS’s Ms. Pool said the grant was for Mr. Rich’s
promotion to CEO. He wasn’t promoted until February 1999. Ms. Pool said
there was a "six-month transition plan," and the Oct. 8 option grant
was "in anticipation" of his promotion.

Mr. Rich would have fared far worse had his grant
come on the day ACS announced his promotion. The stock by then was more
than twice as high. The grant wasn’t reported to the SEC until 10
months after the stated grant date. Ms. Pool said that was proper under
regulations in place at the time.

A special board committee oversaw Mr. Rich’s
grants. Most years, its sole members were directors Frank Rossi and
Joseph O’Neill. Mr. Rossi declined to comment. Mr. O’Neill said, "We
had ups and downs in our stock price like any publicly traded stock. If
there were perceived low points, would we grant options at that point?

Mr. Rich said grants were made on the day the
compensation committee authorized them, or within a day or so of that.
He said he or Chairman Darwin Deason made recommendations to the
special board committee about option dates.

Mr. Rich, who is 45 years old, resigned abruptly as
ACS’s chief executive on a Thursday in September to "pursue other
business interests." Again, his timing was advantageous. In an unusual
separation agreement, the company agreed to make a special payment of
$18.4 million, which was equal to the difference between the exercise
price of 610,000 of his outstanding stock options and the closing ACS
stock price on the day of his resignation.

But the company didn’t announce the resignation
that day. On the news the next Monday that its CEO was departing
suddenly, the stock fell 6%. Mr. Rich netted an extra $2 million by
cashing in the options before the announcement, rather than on the day
of it.

Mr. Rich said ACS signed his separation agreement
on Friday, using Thursday’s price for the options payout. He said it
waited till Monday to release the news because it didn’t want to seem
"evasive" by putting the news out late Friday.

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2 replies »

  1. Yes, I saw this article.
    Being somehow permitted doesn’t make backdating right. Note that this is not the same as an up-front agreement to base the grant based on some historical price.
    The stockholders at the time who paid for the grants. Not the “public”. The shareholders elect the boards, and if they elect a bad one they will be ripped off. If they are convinced of super-powers on the part of the executives, maybe they will pay too much, but be happy about it nevertheless — they were not ripped off.
    But since this is all so boring and its so much more fun to be jealous simply and tsk-tsk whilst feeling put-upon and self-righteous, I will close.

  2. Well, Matt, of course if companies don’t play by the rules the situation is different, and the arguments change. Interestingly, the article you reference points out that back-dating of options was permitted in the past, but Sarbanes-Oxley slammed the door on that practice. Even when permitted, I think back-dating of options was an abuse, because there was definitely a cost to the company when it issued back-dated options. I’ve worked in several companies, all but one of which did not backdate. The other one (which BTW was acquired) did. Again perhaps coincidentally, the company that was acquired is Oxford Health – acquired by United Health – whose CEO is McGuire. Small world.
    Still it’s nice you decided to contribute to the boring conversation. As someone must have said “there’s a lot of money in boring” and of course many truly interesting things are uncovered following the money.