What Is Bullet Dodging?
The term bullet dodging refers to an employee stock options practice that delays the release of the options until such time that a really bad piece of news involving the company is made public, thus causing the stock's price to fall. Bullet dodging is considered a shady practice. Because an option's exercise price is linked to the underlying stock's price when it is issued, waiting for the stock price to drop allows option holders to benefit from a lower exercise price.
- Bullet dodging is a shady employee stock options practice where the options release is delayed until bad news comes out, causing the stock's price to drop.
- This process enables employees to benefit from a lower exercise price which increases their chances of making a profit.
- Options holders end up benefiting from potentially market-moving information not available to the public.
How Bullet Dodging Works
Employee stock options are a popular perk that some employers provide for their employees as part of their benefits packages. They are just another form of compensation that employees—executives and other employees—may receive along with their annual or hourly salaries. Although they are very popular, they can be, very troublesome, as is the case with instances of bullet dodging.
Bullet dodging is often very controversial and is considered by some to be a form of insider trading. That's because companies generally hold off on granting the options until bad news comes out or an undesirable situation is made public which pushes the stock price down.
This process enables employees to benefit from a lower exercise price—the price where the underlying security can be bought or sold when put options or calls may be traded—which increases their chances of making a profit. This defeats the purpose of options-based compensation, which is meant to reward employees for helping to increase shareholder value. The option holder, who is usually a member of the company's management, ends up benefiting from potentially market-moving information that is not available to the public.
Bullet dodging may be unethical, but it is legal—as long as the board members who sign off on the options grant are informed in advance.
Bullet dodging isn't the only form of unethical, shady practice companies have at their disposal when they grant stock options. In fact, there are several others that companies use. Spring loading is another similar controversial practice. It occurs when options are granted just before the company reports really good news—the opposite of bullet dodging. It allows employees to reap the benefits and profits from any good news that comes from a company. Just like bullet dodging, spring loading is also legal, albeit unethical.
Another legal practice companies use when granting stock options is to time the releases of bad news to precede regularly scheduled option grants. Numerous studies show that the stock prices of companies granting options tend to underperform the market in the days leading up to grants and dramatically outperform afterward.
A fraudulent practice known as options backdating, where options are granted with a date prior to the actual issuances of the option, so the exercise price can be set at a lower price than that of the company's stock at the granting date - has become much more difficult after the Sarbanes-Oxley Act of 2002, made it a legal requirement for companies to report the granting of options to the Securities and Exchange Commission (SEC) within two business days.
Example of Bullet Dodging
Let's take a hypothetical example to show how bullet dodging works. Suppose that XYZ Corporation planned to grant stock options for its chief executive officer (CEO) on May 7, 2007. And suppose the company will fail to live up to its earnings forecasts when they are published on May 14, and the share prices will likely fall as a result. Moving the options-granting date to May 15 is likely to lead to a lower exercise price than would be the case if the option were granted on May 7.