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STOCK OPTIONS AND ALIEN LUCK

March 20, 2006

Napoleon supposedly said that the best generals are lucky generals. If that works for executives, The Wall Street Journal has identified some titans. In a report in their weekend edition($ link), they found some executives who had just amazing good fortune in having their stock options priced on the days when the stock price happened to be unusually low - in hindsight.

Stock options are designed to give executives an incentive to boost the value of the company stock. The executive normally can buy the stock for an extended period at the stock's price on the date the option is issued. If the stock price goes up, the executive profits. That's why it's lucky to have your options issued on a day when the price is depressed.

The CEO of Affiliated Computer Services, the wonderfully-named Jeffrey Rich, had an amazing run of luck:

His annual grant of stock options was dated that day, entitling him to buy stock at that price for years. Had they been dated a week later, when the stock was 27% higher, they'd have been far less rewarding. It was the same through much of Mr. Rich's tenure: In a striking pattern, all six of his stock-option grants from 1995 to 2002 were dated just before a rise in the stock price, often at the bottom of a steep drop.

Just lucky? A Wall Street Journal analysis suggests the odds of this happening by chance are extraordinarily remote -- around one in 300 billion. The odds of winning the multistate Powerball lottery with a $1 ticket are one in 146 million.

The implication, of course, is that the credit goes not to luck, but to 20-20 hindsight and artful backdating. The Journal reports that the SEC is investigating some of these "lucky" executives.

INCENTIVE STOCK OPTIONS

This brings to mind the tax law rules on "Incentive Stock Options." While most stock options generate ordinary income when they are exercised, ISOs generate no income for regular tax purposes on exercise (but they do generate potentially ruinous alternative minimum tax). If the options are held for a year after exercise and two years after grant, the gain is taxed as capital gains, typically at a much lower rate.

The tax law requires the exercise price of ISOs to be no lower than the stock price on their issue date. This is the issue that cost IRS whistleblower Remy Welling her job when she tried to enforce this rule on Micrel, Inc. Micrel beat the problem through a process that looks a lot like old-boy cronyism.

I don't know whether any of the options cited in the Journal article are ISOs, but if they are, the IRS may come snooping, and the companies involved may make a discreet call to Micrel to see if they know any good string-pullers.

FURTHER READING

The Taxprof has more on the Wall Street Journal story, with links and discussion of why the option dates look too good to be true and an explanation of the securities law issues.

 • Backdated Options       Bookmark: del.icio.us • Digg • reddit