How to Ensure Your Grant Procedures Are Scrutiny-Proof

October 26, 2020

Imagine a company grants stock options and then its stock increases by 1000% on the day following the grant. Suspicious? Or just a nice deal if you can get it?

Kodak’s Conveniently Timed Option Grants

This is exactly what happened at Kodak. On July 27, Kodak granted stock options to top executives, including options to purchase 1.75 million shares to its CEO, some of which were immediately vested.  The following day (yep, just one day later), Kodak announced that it would receive a loan of $765 million from the federal government to produce components to make pharmaceuticals. The Hill noted that the loan “amounts to 54 percent of [Kodak’s] total assets, 78 percent of its annual revenue and is 64 times larger than its annual operating cash flows, according to its most recent 10-K filing.”

After the loan announcement, Kodak’s stock price surged from $2.62 to as high as $60, settling around $24 per share. By the day after the grant date, the CEO’s options had increased in value to $50 million (the options were granted at four different exercise prices, ranging from $3.03 to $12 per share).

One day after the loan announcement, the Forms 4 reporting the executive grants were filed with the SEC. This scenario is a great example of why the SEC requires most transactions to be reported on Form 4 and why the Form 4 filing deadline is two business days after the transaction occurs. Back before the Sarbanes-Oxley Act in 2002, Kodak would have had until August 10 to report the grants. The two-day deadline ensures that investors and the market receive timely notice of insider transactions.

The Fallout

Granting equity awards in advance of an announcement of good news is referred as “spring loading.” It isn’t clear that spring loading is prohibited under US insider trading regulations, but that doesn’t mean it is without consequences. In Kodak’s case, the first and most significant consequence is that the loan is on hold while the government organization that issued the loan investigates. The SEC is also investigating (at the urging of Sen. Elizabeth Warren), two House committee chairs launched their own investigations, and shareholders may bring lawsuits against the company.

The Internal Investigation and Report

Another consequence of the grants is that Kodak hired law firm Akin Gump to conduct an internal investigation. Personally, I am skeptical of investigations in which the investigator is hired, paid, and can be fired by the subject of the investigation. But for what it’s worth, Akin Gump did not find any wrongdoing, summarizing their findings as follows:

[W]hile granting options to company management ahead of positive news can be controversial, it is not prohibited by SEC regulations and can only give rise to state law breach of fiduciary duty claims under certain circumstances not present here. However, we did identify several flaws in the process that Kodak’s General Counsel followed with respect to the grants. As a result, Kodak’s Board and the [Compensation, Nominating and Governance Committee] were not warned that the timing of the grants could give rise to concerns about so-called options ‘spring loading,’ regardless of whether these particular options grants were ultimately determined to be legal.

Scrutiny-Proof Grant Procedures

In the aftermath of the option backdating scandal that broke in 2005, grant practices received a significant amount of scrutiny. Regulators investigated, financials were restated, fines were levied, options were amended, and some executives even went to jail. As a result, best practices were defined, companies adopted policies designed to prevent future improprieties, and the SEC added a disclosure on grant timing policies to the CD&A.

Although Kodak’s grant irregularities did not involve backdating, Akin Gump found that they failed to comply with their own grant policy. I suspect they aren’t the only company where procedures have gotten a little lax. A decade after the backdating scandal, I’m now occasionally asked if it would be okay to grant equity awards retroactively (usually in the context of an employee who was inadvertently omitted from the grant recommendation submitted to the compensation committee). (To be clear, the answer is no, that is most definitely not okay.)

It feels like a good time for a refresher. Below are key recommendations for grant policies:

Have a written policy: Document when grants are issued, how they are priced, how the number of shares granted is determined, how the grant date is established, who has authority to approve grants, and any limitations on that authority. If grants are approved by unanimous written consent, define when the approval is considered effective. Verify that your written policy aligns with the grant timing policy disclosure in the company’s CD&A.

Implement appropriate controls: Implement appropriate audit procedures to ensure that grant recommendations are accurate and complete and that the grants entered into the recordkeeping system align with approval records.

Document grant decisions: Keep clear documentation of which grants were approved, when the approval is effective, the FMV on the date of approval, and who approved them. If grants are approved at board or compensation committee meetings, the approval should be noted in the meeting minutes. The records should include specific details as to who received each grant, the size of each grant, and other key terms. If the decision or approval process deviated from the standard process, this should also be documented.

Define a corrections process: Mistakes will happen; make sure the written policy addresses how they will be handled. Some errors to address include omitting an employee from the grant recommendation, including an employee who should not have received a grant, and approving a grant for an incorrect number of shares (too many or too few).

Be consistent: Issue grants according to a consistent schedule. In the event that a particular grant is questioned, being able to demonstrate that it is part of an established pattern can be helpful. Consider timing grants so that they occur only during open window periods.

Know your policy: Familiarize yourself with your company’s grant policy so that you can help your company ensure that it is followed. Bring deviations from the policy to the attention of your general counsel or other appropriate individual. 

  • Barbara Baksa
    By Barbara Baksa

    Executive Director