Options Backdating

[Guy Berger]

In case you've been following the various scandals involving corporate executives but don't exactly understand what is going on, wikipedia has a nice article on options backdating:

Options backdating is the potentially illegal (depending on the country) practice of the grant of restricted Employee stock options at an exercise price equal to the value on the date that the grant is apparently made. However, the date chosen for the grant date is cherry picked to select an earlier date, one when the price of the underlying stock was lower. This results in a value of the option most favorable to the employee receiving it. This practice reduces the risk of share price going down for the year.

Backdating of stock options is not necessarily illegal. If the grantor of the stock options properly discloses the backdating at the actual time of grant, no fraud has taken place. It would only mean that it would not qualify for the favorable tax statutes carved out to encourage employee stock options like SARs or Stock Appreciation Right or incentive stock options. Also since the Enron scandal, Congress enacted Section 409A of the Internal Revenue Code to deal with such non-qualified deferred compensation.

Most of the legal issues arising from backdating are a result of the grantor falsifying documents submitted to investors and regulators in an effort to conceal the backdating. This practice is a hot-button issue with investors all over the world and is currently being investigated/debated by the United States Securities and Exchange Commission.

[Guy Berger]

Can anybody here explain what "favorable tax statutes carved out to encourage employee stock options like SARs or Stock Appreciation Right or incentive stock options" means?

Guy

[Scott Dolan]

Isn't this what they're trying to go aftre Jobs for?

[Guy Berger]

Isn't this what they're trying to go aftre Jobs for?

Yup. The guy is a crook -- he should have been canned or at least reprimanded.

Guy

[Scott Dolan]

Yeah, but the dude only makes a fucking dollar per year in salary. I'm not sure he'd be all that worried about losing his job.

[Guy Berger]

Yeah, but the dude only makes a fucking dollar per year in salary.

That's for tax reasons. The guy is handsomely compensated through stock and executive gifts (including a $46M jet).

I'm not sure he'd be all that worried about losing his job.

But he might be worried about going to court...

Guy

Edited January 18, 2007 by Guy

[Scott Dolan]

Very true.....

[Eric]

Backdating of stock options is not necessarily illegal. If the grantor of the stock options properly discloses the backdating at the actual time of grant, no fraud has taken place. It would only mean that it would not qualify for the favorable tax statutes carved out to encourage employee stock options like SARs or Stock Appreciation Right or incentive stock options. Also since the Enron scandal, Congress enacted Section 409A of the Internal Revenue Code to deal with such non-qualified deferred compensation.

This is the interesting point. Backdating is not illegal per se. In theory, a Board of Directors could choose this as a legitimate compensation tool. But failure to disclose (and account) for backdated options is a no-no and that is what all these companies are getting nailed with. Did they learn nothing from Nixon?

Edited January 18, 2007 by Eric

[Guy Berger]

Backdating of stock options is not necessarily illegal. If the grantor of the stock options properly discloses the backdating at the actual time of grant, no fraud has taken place. It would only mean that it would not qualify for the favorable tax statutes carved out to encourage employee stock options like SARs or Stock Appreciation Right or incentive stock options. Also since the Enron scandal, Congress enacted Section 409A of the Internal Revenue Code to deal with such non-qualified deferred compensation.

This is the interesting point. Backdating is not illegal per se. But failure to disclose (and account) is and that is what all these companies are getting nailed on.

Yup. I don't think there's anything inherently wrong in backdating -- all you're doing is forking over more dough to the options recipient(s). Whether that's right or wrong is for the shareholders to decide. But lying to the shareholders...

Guy

[Scott Dolan]

Which makes me wonder just how "legal" it is. Not the practice, but how they go about it. Is there no disclosure because the shareholders would likely shitcan it? If so, that, in and of itself, doesn't sound legal.

[Eric]

Backdating of stock options is not necessarily illegal. If the grantor of the stock options properly discloses the backdating at the actual time of grant, no fraud has taken place. It would only mean that it would not qualify for the favorable tax statutes carved out to encourage employee stock options like SARs or Stock Appreciation Right or incentive stock options. Also since the Enron scandal, Congress enacted Section 409A of the Internal Revenue Code to deal with such non-qualified deferred compensation.

This is the interesting point. Backdating is not illegal per se. But failure to disclose (and account) is and that is what all these companies are getting nailed on.

Yup. I don't think there's anything inherently wrong in backdating -- all you're doing is forking over more dough to the options recipient(s). Whether that's right or wrong is for the shareholders to decide. But lying to the shareholders...

Guy

Exactly. The extent to which this was going on is rather stunning.

[Eric]

Which makes me wonder just how "legal" it is. Not the practice, but how they go about it. Is there no disclosure because the shareholders would likely shitcan it? If so, that, in and of itself, doesn't sound legal.

Shareholders have to approve the general terms of a stock option plan. It seems that "backdating" would be the kind of term that needs approval, i.e. it is a pretty significant feature of the plan. So, in addition to not disclosing and not accounting, they were overstepping the terms of a plan previously approved by the shareholders. Bad stuff all around.

[Scott Dolan]

Right. So if it's not disclosed to the shareholders for approval, doesn't it then become illegal practice?

[Guy Berger]

Can anybody here explain what "favorable tax statutes carved out to encourage employee stock options like SARs or Stock Appreciation Right or incentive stock options" means?

Guy

More research on wikipedia:

Stock Appreciation Right (SAR) is a kind of compensation to employee with ESO (Employee Stock Option).

Upon exercise of ESO (that is, exercise the option/right to buy some stock at a certain price), Stock Appreciation Right requires the company to pay cash for the difference between the grant price and the market price of the company stock on the exercise date.

For example, if the [stock] grant price is $10 per share and the market price is $15, the company will give the employee a bonus of $5 per share in order to compensate for option holder's not realizing $15 as cash because they can not sell the granted stock until a certain/agreed time.

So if I understand this correctly, unlike a regular option (that allows you to purchase a stock and then sell it), this is an option which allows you to purchase a stock, prohibits you from selling that stock, and then compensates you for the difference between the strike price and the market price. What are the advantages/disadvantages? (It seems to me that it grants the recipient privileges since they can effectively profit from the stock twice.)

Incentive stock options (ISO's), are a type of employee stock option that can be granted only to employees and confer a U.S. tax benefit.

The tax benefit is not having to pay ordinary income tax on exercise on the difference between the exercise price and the fair market value of the shares issued (however, the holder may have to pay U.S. alternative minimum tax instead). Instead, if the shares are held for 1 year from the date of exercise and 2 years from the date of grant, then the profit (if any) made on sale of the shares is taxed as long-term capital gain. Long-term capital gain is taxed in the U.S. at lower rates than ordinary income.

Although ISOs have more favorable tax treatment than non-ISOs (aka NSO or NQSO), they also require the holder to take on more risk by having to hold onto the stock for a longer period of time in order to receive the better tax treatment.

Additionally, there are several other restrictions which have to be met (by the employer or employee) in order to qualify the compensatory stock option as an ISO.

Why don't backdated options qualify for these?

Guy

Edited January 18, 2007 by Guy

[kh1958]

Can anybody here explain what "favorable tax statutes carved out to encourage employee stock options like SARs or Stock Appreciation Right or incentive stock options" means?

Guy

You asked for it!

Options are generally not taxed on the date of grant. However, if the option is granted with too deep a discount (for example, the stock is worth $1 but the option exercise price is 1 cent), then the option is regarded as the underlying stock and is taxable to the extent of its value on the date of grant.

An incentive stock option is a special type of option that is required under the Internal Revenue Code to be granted with an exercise price equal to the fair market value of the stock subject to the option on the date of grant. The benefit of an ISO is that upon exercise of the option, the holder has no taxable income, even though the stock acquired is worth more than the exercise price on the date of exercise.

A non-statutory option is not required to have an exercise price equal to value on the date of grant. However, they usually are granted with a fair market value exercise price. The point is to reward executives for increasing the stock value, not grant an immediate bonus (which is what a discounted option is). When a non-statutory option is exercised, the executive has taxable income equal to the excess of the value of the stock over the exercise price.

So, if an ISO were backdated to achieve a lower exercise price, it would not be an ISO and hence would be taxable on exercise, rather than non-taxable.

Stock appreciation rights are forms of deferred compensation--it is an unsecured promise to pay the executive cash equal to the appreciation in the value of the stock after the date of grant. SARs are generally not taxed until the cash is paid to the executive.

Client requests to backdate documents arise from time to time. Bebe Rebozo, Richard Nixon's lawyer, was disbarred for helping President Nixon backdate a charitable donation into a prior year. Keeping that in mind, the response of an ethical attorney is that a document cannot be backdated prior to the date it is executed. It is possible to have a prior oral agreement, so a document might be prepared in appropriate cases that sets forth that it was executed on the date signed, but was effective on the prior date of the partie's oral agreement.

[Guy Berger]

kh1958, you rock!

It'll take me some time to digest what you've written but I know I'll be smarter after I read it.

Guy

[kh1958]

kh1958, you rock!

It'll take me some time to digest what you've written but I know I'll be smarter after I read it.

Guy

I was expecting a string of jokes in reference to my comment about the "ethical attorney"!

[Tom Storer]

all you're doing is forking over more dough to the options recipient(s).

Forking over more potential dough to the option recipients. You never know when the stock price is going to dive. At the company where I work, people typically get some options when hired. There was a period when the stock was way low, and people hired when the stock option plan reflected that low price are in a very good position; others were hired when the stock was much higher than it now is, and their options are currently worthless. Stock options are always a risk.