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May 19, 2006

Maybe when luck has a little too much help (WSJ $link):

In a dramatic widening of the investigations into potential stock-option abuses, federal prosecutors in Manhattan have launched criminal probes of at least five U.S. companies.

Caremark Rx Inc., SafeNet Inc., Affiliated Computer Services Inc. and Vitesse Semiconductor Corp. said Thursday that they had received subpoenas from the U.S. attorney for the Southern District of New York. Late Wednesday night, giant health insurer UnitedHealth Group Inc. said it also had received a subpoena from the same prosecutor, along with a document request from the Internal Revenue Service.

The tax issue arises because if stock options are backdated so that the cost to exercise them is lower than the stock price on the real option issue date, special limits apply to disallow executive compensation deductions. Usually a company can deduct the amount that its stock price exceeds the exercise price when the executive finally exercises the option; this is the same amount the executive is taxed on. If the option is backdated, the deduction (but not the executive's taxable income) is capped at $1 million.

If a company doesn't get caught, backdating the option date to the lowest point of a market trough saves the executive a lot of money when he pays the exercise price. You can't always count being so lucky that the compensation committee issues options only at the month's market low.

A WSJ illustration shows this better than I can explain it:


The Wall Street Journal ($link) discusses why this may be more serious than just owing the IRS some millions:

Backdating itself isn't necessarily illegal. But if options' strike price and grant dates are deliberately and improperly changed, that may constitute fraud.

Backdating "is not illegal per se but you've got to look at all the circumstances," says S. James DiBernardo, a partner at Morgan Lewis & Bockius, who works in the firm's compensation practice, which designs and implements executive compensation plans. "It's not black and white." It is in disclosure and financial reporting where companies can get into hot water. It's not because of the options themselves, rather it's the way the companies treat backdated options for financial and tax purposes and regulatory disclosure that is drawing scrutiny.

All of this activity on backdated options must be bitter vindication to IRS whistleblower Remy Welling, who lost her job when she went to Congress for help after the agency refused to assess a taxpayer in a similar case.

Other Coverage:

New York Times


White Collar Crime Prof Blog

Prior Tax Update Coverage:




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