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Should CEOs' Buyout Options Be a Securities Violation?

The revelation that Marvel Entertainment CEO Isaac Perlmutter received option grants for more than a million shares while the merger of his company to Walt Disney was underway is a recent example of how CEOs of target firms have used this practice for personal gain.

Indeed, in my research paper titled: “Stock Option Grants to Target CEOs during Private Merger Negotiations,” which is co-authored with Jie Cai and Anh Tran, we document that the Marvel situation is just another example of a target CEO benefiting from the private knowledge of the impending acquisition his firm.

In the paper, we examine whether the granting of unscheduled options to target CEOs while merger talks are underway violates securities laws, particularly those aimed at preventing insider trading. After all, during our data collection stage we uncovered many instances in which target CEOs received substantial unscheduled options when their firms were privately been sold.

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These awards would end up netting these target CEOs millions.

My co-authors and I were baffled to discover that target CEOs, such as Marvel’s Perlmutter, are not technically in violation of Sections 10(b) and/or 16(b) of the 1934 Securities Act which penalize insider trading. Specifically, these laws state that “any person purchasing or selling a security while in possession of material, nonpublic information shall be liable in an action in any court of competent jurisdiction…”

However, well-timed option awards (such as those received by Perlmutter) are not actionable as insider trading violations. This occurs because an option award is technically not a “purchase” of securities for the purpose of the 1934 Act.

Despite the fact that granting unscheduled options to target CEOs might not violate insider trading laws, according to our research, such practice might be costly to target shareholders. This occurs because after receiving the options target CEOs can only cash in the options if deals go through. This might prompt these executives to accept lower takeover bids. In the firms we analyze our estimates indicate that, on average, shareholders in these targets lose about 307 million dollars when their firms are sold.

To put this result into context, for the average target firm in our sample, target value is reduced by 54 dollars for every dollar the target CEO receives from unscheduled options granted during private merger negotiations.

An example of this appears in the figure below (adapted from my paper) which illustrates the stock price of Scientific Atlanta (SA) around its acquisition of Cisco systems. According to our estimations, SA’s should have commanded an offer of approximately 44.36 per share. It was sold for $43 per share. As a result, shareholders probably lost close to 209 million dollars when SA was acquired. However, unscheduled options SA’s CEO Mr. James F. McDonald received during merger negotiations were valued at over $2 million.

Finally, we also find (as the Marvel example illustrates) that reporting regulations related to executive compensation promulgated under the Sarbanes-Oxley Act and other laws, have done little to eradicate the practice of granting CEOs unscheduled stock options during private merger negotiations.

The Marvel case along with our findings illustrate potential loopholes in existing securities laws aimed at deterring insider trading and weaknesses in the way executive compensation is reported by public firms. Moreover, we suspect that if regulators go over data related to merges in the recent past, the issue of unscheduled stock options to target CEOs during merger negotiations might reach a status similar to the recent option backdating scandal.

Stock Prices for Scientific-Atlanta. This figure graphs daily closing prices for Scientific-Atlanta from 5/18/2005 until 2/24/2006. These dates coincide with the initiation of merger talks between Scientific-Atlanta and Cisco and the date in which the deal between the two parties is completed, respectively.

Stock Prices for Scientific-Atlanta
Stock Prices for Scientific-Atlanta
Stock Prices for Scientific-Atlanta

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