The Guest Blog

Fich: Do Unscheduled Options to CEOs During Merger Talks Create Perverse Incentives?

Eliezer Fich, Associate Prof., Drexel University

Today’s front page article in the Wall Street Journalreports that many firms grant unscheduled option grants to their CEO’s while negotiating their own acquisition. The article, which refers to my research paper titled: Stock Option Grants to Target CEOs during Private Merger Negotiations (co-authored with Jie Cai and Anh Tran), cites recent examples in which CEOs of target firms have ripped millions from this practice.

Consider for example the case of Omniture , an acquisition target of Adobe Systems . Merger talks between these firms began on March 31, 2009. On June 15, 2009 Omniture re-priced old options its CEO held. But the CEO had already received scheduled option on 2/27, so the timing of the June award is puzzling. Moreover, since the merger offer price was $21.50 and the old exercise price (for the re-priced options) was $18.23, the CEO could have made $3.27 per share (or about $2 million on the original award) if the award was never re-priced. Instead, re-pricing the options to $12.99 more than doubled these profits to well over $5 million.

In another case involving Hewlett-Packard and EDS, a proxy filed by Hewlett-Packard detailing its acquisition of EDS reads:

“On November 5, 2007, Mr. Rittenmeyer and another member of our senior management met with Mark Hurd, the chairman, chief executive officer and president of HP, and other members of HP management to discuss, among other things, our purchase and use of HP’s hardware and software products. At this meeting, in addition to discussing these matters, Messrs. Rittenmeyer and Hurd discussed consolidation in the IT services industry. Specifically, Mr. Rittenmeyer expressed an interest in possibly pursuing a transaction in which we would acquire the IT services business of HP. Based on this preliminary discussion, Messrs. Rittenmeyer and Hurd agreed that further consideration of such a transaction was warranted. On November 13, 2007, Mr. Rittenmeyer communicated with the chairpersons of each of the three standing committees of our board of directors regarding his meeting with Mr. Hurd.”

On February 13, 2008, Mr. Rittenmeyer received an unscheduled option award for 2 million shares from EDS with an exercise price of $18.30. A merger between the two companies was announced on May 13, 2008 with an offer price from HP of $25.00 per EDS share. Mr. Rittenmeyer’s profit: over $13 million. It should be noted that the size of the February award significantly exceeds Mr. Rittenmeyer’s two previous annual awards. Please see table and graph below.

The issue is whether the unscheduled options align the incentives of target CEOs and target shareholders or whether these awards create perverse incentives.

On the one hand, CEOs expected to remain in office for several years if their firms were not sold might oppose a deal. Consequently, the awards might induce these executives to sell their firms. This might benefit target shareholders, particularly those in hard-to-sell firms. Our paper shows that the expected present value of lost compensation experienced by target CEOs (if their firms were sold) correlates with the likelihood that these executives get pre-merger unscheduled options.

On the other hand, because change-in-control agreements (common to many executive compensation contracts) are only triggered if the firm is sold, CEOs might hurry to sale their firms. In the latter case, such scuttle might cause lower than expected takeover bids and harm the wealth of target shareholders.

In our paper, we document that when CEOs receive unscheduled options during merger negotiations their firms receive lower than expected takeover bids. To put this result in context, we find that target firm value drops about $54 for every unscheduled option dollar their CEO gets. This finding suggests that unscheduled options to target CEOs while merger negotiations are underway can have perverse incentives.

Is this activity legal?

As mentioned in my previous article for, option grants are neither a sale nor a purchase of securities as defined in the 1934 Securities Act. Consequently, granting unscheduled option awards while merger talks are underway may escape legal liability under current insider trading laws. Specifically, (Sections 16(b) and 10(b)) of the 1934 Securities Act proscribe the purchasing or selling of a security by any person while in possession of material, nonpublic information.

There is also the issue of equal shareholder treatment during a merger. Rule 14d-10 of the 1934 Securities Act proscribes “bidders from making a tender offer unless the consideration paid to any security holder pursuant to the tender offer is the highest consideration paid to any other security holder during such tender offer.” While this rule appears to be simple in concept, courts have wrestled on how to interpret it in the context of a variety of compensation arrangements of top executives of target companies, since CEOs and other top managers are often shareholders as well. Put simply, because of the last minute options CEOs are doing better than other target shareholders. Amazingly, on October 18, 2006, the SEC adopted amendments to Rule 14d-10(a)(2) which provide a safe harbor enabling the compensation committee of a target's board of directors to provide employment compensation, severance or other employee benefit arrangements (including options) for its executives during a tender offer negotiation. Given this amendment, it is unlikely that the targets we identify in our paper and in this article violate Rule 14d-10 of the 1934 Act.

In sum, our research exposes non-trivial weaknesses in some securities laws that appear to encourage shareholder expropriation during acquisitions. It is our hope that these findings result in improved regulation aimed at increasing disclosure requirements during mergers with the goal of discouraging shareholder expropriation.

Eliezer Fich is Associate Professor of Finance at Drexel University, Le Bow College of Business