What Would Michael Corleone Say?

Mr. Cummins said in a telephone interview that all the options had been legally priced, properly reported and approved by the company’s auditors and lawyers.

—New York Times And so it is that the CEO and Chairman of the Board of Cyberonics, a medical device maker, defends the granting of options on 150,000 shares of Cyberonics stock at a special board meeting hours after an FDA panel had approved the company’s device for treatment of chronic depression, in February 2005.

The options were priced based on the company’s stock price earlier that day—$19.58 a share. Of course, given the great news from the FDA, the stock was fifteen bucks higher the next day. Hey, it is a wonderful life.

The issue of Mr. Cummins’ wonderful option grant was raised—surprisingly, perhaps, to those of us accustomed to the ‘see no evil’ qualities of fee-hungry Wall Street types—not by a disgruntled shareholder or an investigative reporter (the Wall Street Journal has led all media in breaking the issue of back-dating option abuse), but by a medical device analyst for a mainstream brokerage firm.

The analyst in question, Amit Hazan, may not have done himself any favors by saying something less than fawning about the CEO of one of the very companies on which his career depends, but at least we can say this: one of Wall Street’s Finest is calling it as he sees it.

Now, in case you’re asking yourself “Why did it take so long for an analyst to raise this issue?” let me provide a cynical answer: Wall Street’s Finest routinely practice the same sort of artificial pricing of which Mr. Cummins is accused.

The way it works is this: when a major event occurs overnight that substantially increases the expected value of a stock—such as Cyberonics’ FDA event—the analysts covering that stock are allowed to upgrade the stock before the market opens, and the price at which they are deemed to have upgraded the stock is, just like Mr. Cummins’ option grant, the price at which the stock previously closed. Even if the stock is going to open up, like Cyberonics, fifteen bucks when trading resumes.

In other words, they do exactly what Mr. Cummins is accused of doing.

And it wouldn’t surprise me if more than one analyst upgraded shares of Cyberonics itself the morning following the FDA’s action, at a price of $19.58 a share instead of the price everybody would have to pay when the stock would open for trading a few short hours later.

Now, analysts upgrading (or downgrading, in the case of a company with bad after-hours news) a stock in this way do not make money when the stock goes up or down once trading is resumed, as in the case of a CEO who gets a favorable stock option grant. But they look a heck of a lot better than they would if their upgrade (or downgrade) was priced at the same price the public would be able to buy (or sell) the stock.

In response to the analyst’s report, Mr. Cummins—as quoted above from today’s account of the dust-up in the New York Times—has resorted to what looks and sounds a lot like the defense used (unsuccessfully) by former Enron COO Jeff Skilling in his recent trial on fraud and insider trading charges.

In essence, Skilling said that since everything at Enron had been vetted by the lawyers and the auditors, not to mention the Board of Directors, there had been no crime.

As we know, it didn’t work.

Now, I have no idea how far the Cyberonics controversy will go, nor am I going to sound off here on what Mr. Cummins may or may not have done, rightly or wrongly, when it comes to his wonderful option grant.

But I’d bet dollars to donuts that one reason Wall Street’s Finest have been slow to document the systemic abuse of the options gravy train is that Wall Street’s Finest frequently resort to precisely the same type of behavior highlighted by one of their own.

As Michael Corleone said, “We’re both part of the same hypocrisy, Senator.”

Jeff Matthews I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.