Tax Update Blog: Backdated Options Archives

ECFFSOA?

October 01, 2007

Congresscritters have a bad habit of giving their tax bills grotesque names that produce a lame acronym. Who can forget the "National Employee Savings and Trust Equity Guarantee Act" - "NESTEG"?

So what's with the "Ending Corporate Favors for Stock Options Act"? ECFFSOA? That sounds like something a Senator would say with his mouth full at a lobbyists hor's d'ourvres counter. If you don't even get a pronouncable acronym, why go with a tortured name?

This awkwardly-named bill would place more restrictions on deductions for executive compensation - in this case, just for stock options. The current $1 million deduction limit for cash compensation is arguably a major factor in the 1990s stock option frenzy and the resulting option backdating scandal. Daniel Shaviro analyses the proposal:

Even if you like the $1 million limit, and few people do, this is just silly. All one needs to do to avoid it is have a virtual stock option instead of a literal one. E.g., you have performance-based compensation that pays you off based on the stock price, but it isn't called a stock option despite having identical economics.

Read the whole thing.

Tags: stock options.tax policy.

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IRS SAYS BACKDATED OPTIONS ARE A 'TIER 1' EXAM ISSUE

July 12, 2007

The TaxProf reports:

The IRS yesterday made public a directive sent to agents in the field targeting transactions involving backdated stock options for the highest level of specialized enforcement within the Large and Mid-Size Business Division.

This can't be good news for the dozens of companies that appear to have backdated stock options to lower the exercise price and maximize income to executives.

DEDUCTION ISSUE

The directive focuses on three issues, but the issue likely to cause the most headaches is the likelihood of the loss of millions of dollars of executive comp deductions.

The tax law exempts stock options from the $1 million limit on executive compensation deductions. That allows the corporation can deduct the amount that the stock has appreciated from the time the stock option was awarded to the executive to the time the option is exercised and coverted into shares. For example, if an option is issued at $1 per share and the executive exercises it when the stock is trading at $10, he has $9 income and the corporation has a $9 deduction.

The exemption from the $1 million deduction lid only applies for option income resulting "solely" from appreciation from the grant date. If the options are backdated, it's hard to say that the option income is "solely" attributable to subsequent appreciation.

It seems unlikely that the government will consider all stock option backdating to be a securities law crime, and they may not succeed if they try.

The real breach of trust, it seems to me, is the willingness of executives to risk the loss of their companies' compensation deductions to squeeze a bit more out of their stock option programs. The $1 million compensation limit is bad tax policy, but that doesn't excuse executives who cause it to apply by backdating their own options

Now that the IRS is making backdating a priority, maybe they can engage Remy Welling as a consultant. Ms. Welling was fired for blowing the whistle when the IRS ignored option backdating on a corporate exam.

Link: Complete Tax Update coverage of backdating.

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IRS APPLIES DEFERRED COMP RULES FOR 2006 BACKDATED OPTIONS

February 09, 2007

The IRS yesterday set down a plan dealing with small fry in the options backdating scandal. The program "allows" companies to pay the 20% penalty tax for backdated options exercised in 2006 by employees who are not "insiders" for SEC disclosure purposes. The employees have to include the company payment in income.

The 20% penalty tax under the recently-enacted Section 409A applies to non-compliant deferred compensation plans. In this announcement the IRS lays down a marker: it says that 409A applies to backdated options.

There doesn't appear to be much of a concession here on the part of the IRS. It seems that the company always has the option to pay the employee's Section 409A penalty, as long as the payment is included in employee income. Tax Analysts reports ($link) that tax advisors for holders of backdated options aren't happy:

The IRS program departs significantly from the practitioners' recommendations and was quickly criticized. The group had suggested that employers be allowed to make a payment equal to 20 percent of the option discount at the time it was granted to remedy any backdated options, whether or not exercised. Instead, the IRS would force employers to make the 20 percent payment, plus interest, and then count the payments on behalf of their employees as compensation.

One practitioner, who asked to remain anonymous to protect IRS relationships, said the initiative offers no carrots for either companies or taxpayers. Companies are not currently liable for the tax and would be acting only to save thousands of potential taxpayers from having to fix the problem individually -- thus saving the IRS from the trouble of pursuing thousands of cases.

"I will not recommend that any of my clients take this offer," the practitioner said.

Unfortunately for this practitioner's clients, the IRS already has them over a barrel. The only thing that can keep the IRS from catching up with them not assigning enough agents assigned to the option backdating project. If I were an employee, I'd rather have my employer pay my 20% penalty, even if it increases my taxes, if I would otherwise have to pay the whole penalty myself. If I were the employer, though, I'd have another view entirely.

Link: Complete Tax Update backdated option coverage.

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TOO BAD YOU CAN'T BACKDATE YOUR SENTENCE

October 24, 2006

The stock option backdating scandal has netted its first guilty plea. From the Wall Street Journal online ($link):

The former chief financial officer of Comverse Technology Inc., David Kreinberg, pleaded guilty to securities-fraud charges in federal court today, after agreeing to cooperate in the investigation of a scheme to make millions of dollars by manipulating stock options.

Mr. Kreinberg is the first person to plead guilty in the stock-options backdating scandal that has roiled executive suites across the country. More than 100 companies are under federal investigation, and a number of executives have lost their jobs.

While the indictment mentions tax issues, the charges in the plea deal are securities violations.

The indictment is here.

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BACKDATING AND BOARD MEMBER GOSSIP

October 23, 2006

A new study seems to imply that the practice of backdating options spread like a flea-borne disease from company to company on the backs of corporate directors. Many of the companies also use the same law firm. Footnoted.org picks up the story:

Of the 120 [companies tied to option backdating] so far, the study found that over 40% have at least one director who sat on a board at two companies involved in options backdating. Six directors sat on the boards of three of the implicated companies. The bottom line is that options backdating seems to have spread via word-of-mouth from one director to the other.

The study also found that at the center of that circle — the monkey in the middle — seems to have been Silicon Valley power lawyer Larry Sonsini and other principals and partners at the law firm of Wilson Sonsini Goodrich & Rosati (WSGR). Though the report notes that there’s no evidence to suggest that WSGR invented options backdating or that WSGR attorneys did anything illegal, it does point to a number of odd coincidences.

Interesting. I figured some sort of country-club gossip grapevine helped spread the backdating craze, but it never would have occured to me to try to connect the dots this way.

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SEC AND BACKDATING

September 27, 2006

BenefitsBlog reports that the SEC has issued guidance on stock option backdating issues. It appears to have been well-received.

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WHITHER THE $1 MILLION COMP CAP?

September 08, 2006

Lawer-blogger Stuart Levine weighs in on this weeks hearings on possible changes to Section 162(m), the $1 million cap on executive pay deductions for public companies:

The hearings were directed toward the supposed cause and effect relationship between the $1 Million cap on executive compensation imposed by IRC Section 162(m) and the stock option backdating scandal. The argument in favor of the repeal of Section 162(m) goes like this: Section 162(m) imposes a penalty tax on executive compensation in excess of $1 Million a year, except compensation that is "performance-based." This has caused a growth in such performance-based compensation mechanisms as stock options which, in turn, have lead to such abuses as backdating of the options.

While I have some doubt as to the wisdom of Section 162(m), the option backdating scandal hardly provides a basis for repeal of the section any more than Bonnie and Clyde provided a justification for outlawing banks. (Although, I suppose that argument would have been a good excuse for a catchy slogan: "Unless banks are outlawed, only outlaws will have banks.")

I can only wish Mr. Levine were right in thinking that there is any intention of repealing 162(m), which is a clumsy and ineffectual attempt by Congress to tell the nation's public company compensation committees how to do their jobs. Alas... I see nothing that indicates Congress would do anything so sensible. Far more likely that they will add some new parts to a law that already doesn't work well.

Mr. Levine's analogy on repealing 162(m) in the wake of the option backdating scandals is interesting - like outlawing banks in response to Bonnie and Clyde. A better analogy is to repealing prohibition in response to Al Capone. That actually worked out all right.

Link: IT'S NOT WORKING? HIT IT AGAIN, HARDER.

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IT'S NOT WORKING? HIT IT AGAIN, HARDER.

September 07, 2006

The Senate Finance Committee got together yesterday to look at stock option backdating. The result is likely to be more vindication of the saying "when all you have is a hammer, everything looks like a nail." The Finance Committee's hammer is the tax law.

Dozens, perhaps hundreds, of public corporations apparently backdated their stock option grant dates to make exercising options cheaper for their executives. This will usually cost the company deductions they would otherwise get for executive pay. Failure to disclose the options could mean criminal problems. What do you do when the taxpayers ignore the tax laws you've already passed? If you're Senator Grassley, you ponder passing more tax laws:

Companies have found it easy to get around the law. It has more holes than Swiss cheese. And it seems to have encouraged the options industry. These sophisticated folks are working with Swiss watch-like devices to game this Swiss cheese-like rule.

I want to know what went wrong and consider whether it makes sense to make changes. Modifying the deduction for performance-based pay or at least tightening up the eligibility are possibilities I think members of the Finance Committee will want to consider based on comments made at this hearing. Today's hearing is helpful in sorting through the pros and cons of changing the deduction and possible alternatives. It's challenging for Congress to stay one step ahead of some companies that try to exploit tax loopholes faster than we can close them.

CONGRESS AND THE OPTION PROBLEM

In one of its periodic spasms of self-righteousness, Congress passed a law in the 1990s (Code Section 162(m)) limiting deductible compensation of public company executives to $1 million annually. It then carved out loopholes for "incentive based compensation," including stock options (Backdated options fall outside the exclusion because the compensation is not "solely" from appreciation after the grant date). This deduction limit discouraged straight cash pay and made options a better after-tax compensation vehicle. The absurd accounting rules that allowed companies to not expense option compensation on their financial statements - rules largely resulting from Congressional interference - also favored options over cash compansation.

There are philosophical disagreements about how much executive compensation should be in cash, how much should be in options, and whether straight stock bonuses are more appropriate than options (with stock bonuses, the executives are at risk for stock declines, too; with options, its all upside and no downside). In any case, it's impossible to see why Congress should make these calls in place of the compensation committees of public company boards.

WHY DID THEY BACKDATE?

Companies backdated options because of the natural tendency of public company executives to carve for themselves. Economists call this the "agency problem." By backdating the options to a lower price, the executives could pay less for the options and make more. This violates the justification for options - motivating the executives to increase share price - because share price is built in. From the viewpoint of the executive, though, the response is, "So?".

There are several reasons they thought they could get away with it. The securities rules used to allow a lag between the granting of options and the reporting of the options. This gave the companies time to cherry-pick the grant dates. I suspect that country club banter helped the idea get around among executives. Corporate culture probably tended to favor backdating ("Who do you think you are, complaining about backdating options? The IRS? Or the SEC?"). And they never thought they'd get caught; it didn't occur to them that statistical modeling could identify habitual backdating as clearly as a dirty face identifies a little boy who's been sneaking chocolate chip cookies:

(Source: Wall Street Journal)

Once the securities rules were tightened to require disclosure of options within 2 days, backdating opportunities pretty much disappeared (though there may be residual problems with late filings). Problem solved - no tax legislation required.

THEN WHY NEW TAX LEGISLATION?

It's what legislators do. The smart thing would be for Congress to admit that it has no role in deciding the compensation of public company executives by repealing Section 162(m). Highly unlikely; rather than leaving the grown-ups on corporate boards to do their jobs, Congress is likely to "close loopholes" in Section 162(m). This will mean more billable time for CPAs and attorneys while doing nothing for corporate governance or, for that matter, to make American companies competitive. But they have a hammer, so...

Links:

Senate Finance Committee Hearing member and witness statements

Real-player feed of hearings

Complete Tax Update coverage of option backdating

Wall Street Journal option backdating scorecard

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OPTION BACKDATING GRANDSTANDING HEARINGS TODAY

September 06, 2006

The Senate Finance Committee has its hearing on stock option backdating today. This will give Congress a chance to draft baroque and incomprehensible legislation to crack down on activities that are already illegal, while displaying mock outrage at accounting violations ("How dare you cook the books? That's our job!")

Yet some good comes out of the process: an excellent TaxProf Blog post full of links to scholarly and not-so-scholarly discussion of tax and legal issues around the backdating scandal. You can read my jaded take on the hearings here.

UPDATE: The Wall Street Journal ($link) says today that Congress may consider eliminating the stock option exception to the $1 million limitation on executive pay - even though the exception aready doesn't apply to backdated options.

In an interview, Sen. Grassley, whose committee opens hearings on options and executive compensation today , said doing away with the deduction for performance-based pay entirely is a "possibility," as is "at least tightening it up." Though he said he couldn't give a precise head count of support in Congress, he said "a lot of members are interested" in possibly scaling back executive-pay deductions.

Far better to just eliminate the $1 million cap. I guess it's too dangerous to allow consenting adults to engage in compensation without micromanagement from the 535 economic geniuses in Congress.

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GRASSLEY TO HOLD EXECUTIVE COMP HEARINGS

August 29, 2006

Senate Finance Committee Chairman Grassley will hold a hearing September 6 to look at stock option backdating and executive compensation tax issues. The press release says:

Chairman Grassley is exploring the extent of abuse of executive compensation tax restrictions with an eye toward possible legislation.

It's hard to say any tax law changes are needed here. The backdating of stock options already violates tax rules and has led to some securities law indictments.

The last time Congress tackled executive compensation issues, the result was the awful "Section 409A" rules on deferred compensation. Passed in the Enron political preening frenzy, these rules apply to every business with non-qualified deferred compensation, even if just a simple retirement bonus plan. They are so complicated and poorly written that after nearly two years the IRS still hasn't been able to come up with workable regulations. The situation is so bad that the AICPA threw up its hands earlier this month and called for either drastic revisions or outright repeal.

It's probably too much to hope that Senator Grassley will decide that they should undo the damage done already, rather than add yet more complexity to the already baroque tax code.

Link: BenefitsBlog Section 409A link collection.

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THE SKEDADDLE OPTION

August 16, 2006

The Wall Street Journal law blog reports that the option backdating scandal has created its first fugitive:

Comverse Technology’s former CEO, Kobi Alexander, is regarded as a fugitive by the U.S. government, which last week charged him with conspiracy related to backdated stock options, his attorney said. Here’s the WSJ story.

Robert Morvillo of Morvillo, Abramowitz, Grand, Iason, Anello & Bohrer said he last spoke to Alexander about two weeks ago, when Alexander was in Israel as part of a regular summer trip to his native country (and where Comverse has operations). But now Morvillo says he has no idea of his whereabouts.

With 90+ companies enmeshed in the backdating fiasco, those countries without extradition treaties may experience boom times.

In other backdating news, the Wall Street Journal reports ($link) that some of the companies with backdated option problems were fervent opponents of requirements to expense stock options. Well, if you are willing to cheat your shareholders, why wouldn't you also want to pull the wool over their eyes?

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A BLOG FOR EVERYTHING: OPTION BACKDATING

August 11, 2006

A Technorati search led me to Vangal, a blog devoted to stock option backdating. I don't care for their blog page format -- you only see headlines and you have to click on the story to read anything else -- but it's updated frequently and appears to be very much on top of the expanding backdating scandal.

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MORE STOCK-OPTION BACKDATING INDICTMENTS

August 10, 2006

The Stock-option backdating scandal has generated more indictments. Two executives at Comverse Technology Inc. were charged with securities fraud yesterday. The Wall Street Journal law blog has a chronology of life at the Comverse executive suite once a reporter inquired about the option grant dates; the Journal computes the odds that they would have picked such happy option grant dates by coincidence at one in 6 billion.

The Wall Street Journal is keeping a scorecard; there are over 90 firms implicated, all of which face big tax bills when the IRS gets around to these companies. Maybe the IRS should hire back Remy Welling, who was fired for trying to blow the whistle on a similar scheme two years before the nationwide scandal broke. Or at least they could apologize.

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BACKDATED OPTIONS: A GOOD THING?

June 22, 2006

The Wall Street Journal law blog calls my attention to a piece by WSJ columnist Holman Jenkins ($link) criticizing the coverage of the option backdating scandal. The blog entry says:

Jenkins writes that anyone “who waded through the literature on CEO compensation has long been aware of studies showing that executives reap non-random gains on their stock options.” He continues: “No surprise here: Options are meant to motivate executives to produce non-random gains, and the whole theory of corporate governance is that executives are self-interested and possess inside information, so you’d expect them to negotiate pay deals for themselves from which they’d benefit.”

Mr. Jenkins goes on:

Yet there is nothing categorically corrupt or improper about backdating to justify a conclusion that the boards here weren’t doing just that.

The scandal element, instead, arises because ever-shifting accounting, regulatory and tax standards were, by some readings, punitive during the years in question toward choosing a past date to make an options package effective.

That's cool: "by some readings" tax standards were "punitive." In fact, by any but the most willfully obtuse reading, backdated stock options are disqualified from the the exemption options otherwise enjoy from the $1 million tax deduction limit on executive compensation. By backdating options the executives have cost their companies, and their shareholders, millions of dollars in additional taxes. That by itself is a scandal. Even if you don't think that tax law is good policy - and I don't - that doesn't excuse executives who transfer millions of dollars of shareholder money to the IRS by flouting it.

UPDATE: In the comments IRS whistleblower Remy Welling notes the no-backdating rule for incentive stock options; that is independent of the $1 million compensation cap.

ANOTHER UPDATE: A more sympathetic view of the Jenkins piece from the barren icy wastes of southern Canada.

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MICREL, AUDITOR DUKE OUT OPTION PRICE DISPUTE

June 21, 2006

The New York Times has an article up this week about Micrel's lawsuit against its former auditor over stock option repricing. The Micrel practice of repricing its stock options is back in the news now that other companies are under suspicion for backdating executive stock options.

From the story:

Instead of granting options at the market price on a new employee's hire date, Micrel proposed setting the price at the lowest point in the 30 days from when the grant was approved.

It seemed like an ideal solution. The 30-day window could help Micrel attract and reward new hires on a more equal footing, while helping to retain existing employees. And if it were extended up the corporate ladder, the prospect of built-in gains and tax breaks, worth millions of dollars, could enrich senior executives.

But the 30-day pricing method, which Micrel adopted in mid-1996, was an aggressive move legally and financially. In hindsight, it was also a major misstep.

Nearly five years later, Deloitte reversed its opinion and urged Micrel to restate its financial reports. The Internal Revenue Service came banging on its door. And today, Micrel and Deloitte are passing blame back and forth in court.

Of course, the IRS banged on the door, came in and looked around, and walked out empty-handed. I doubt it will be so gentle on the current crop of option backdaters.

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BACKDATED OPTIONS: IT'S LOOKING LIKE A NAIL

June 14, 2006

The old saying holds that when all you have is a hammer, everything looks like a nail. If your a lawmaker, your hammer is legislation. Case in point:

U.S. Senate Finance Committee Chairman Charles Grassley said executives who manipulated stock- option grants should be prosecuted, and he's willing push for changes in tax laws to make it happen.

"I've asked the Justice Department to let me know whether the tax laws on the books are adequate to rein in and prosecute stock-option backdating," Grassley, an Iowa Republican, said in a statement today. "I've asked the Justice Department to let me know. If the tax laws are inadequate, I want to beef them up."

But a new law isn't the answer to every bad thing. Backdating stock options already carries pretty serious tax consequences. With U.S. Attorneys investigating a raft of companies with backdated options, it's likely that the practice can constitute securities fraud or tax fraud. The Sarbanes-Oxley securities law probably put an end to the practice by requiring the reporting of options within two days of their grant.

Of course, you can pass all of the laws you want, but they don't work very well if they aren't enforced.

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SEC CHAIR ON OPTION BACKDATING

June 13, 2006

In a recent speech SEC Chairman Christopher Cox talked about option backdating:

While I can't comment on the SEC's ongoing investigations of specific companies, I can tell you what the Commission's position is. Back-dating must be fully disclosed. And the granting of back-dated options must be properly accounted for.

As one means of dealing with this problem, our proposed executive compensation rule will provide better and more useful disclosure of the backdating of options. It would require that a company clearly identify the portion of compensation that results from "in-the-money" option awards resulting from backdating.

Via BenefitsBlog.

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MICREL BACK IN THE PAPERS

June 01, 2006

The Wall Street Journal today notes ($link) that Micrel is suing its former auditors over the option backdating issue that led to the firing of IRS whistleblower Remy Welling. From the article:

In a lawsuit filed in 2003, Micrel Inc. alleges [Deloitte & Touche], its former auditor, signed off on an arrangement in which the company would set the strike price for employee stock options at the stock's lowest price during the 30 days after the grant of options was approved. Micrel disclosed the lawsuit when it was first filed but provided detail about the options-related nature of the legal action in regulatory filings made in the past few months.

Deloitte denies the allegations in the lawsuit.

A number of public companies are in trouble for backdating stock options to enable their executives to buy stock at bargain prices. IRS examiner Welling challenged the Micrel's tax deductions on the options and went public after her supervisors refused to support her.

Links:

Reuters article on WSJ Micrel story

Tax Update coverage of option backdating.

Tax Update coverage of Micrel:

FAVORITISM FOR IRS ALUM ON EXAM?

MICREL DENIES ASSERTIONS OF NY TIMES STORY

A MESSAGE FROM REMY WELLING, IRS WHISTLEBLOWER

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BACKDATE UPDATE

May 30, 2006

The AccountingWeb has posted a nice roundup of the executive stock option backdating story.

AFTERNOON UPDATE: The Wall Street Journal continues its coverage with a profile ($link) of Norwegian U of Iowa prof Erik Lie. An excerpt:

He examined options that weren't granted the same date every year and found a striking pattern in which prices fell before the grant date, and rose soon afterward. He also discovered that the stock market as a whole also often rose following option grants at certain companies. "I said, 'look, it's uncanny how good these executives must be at predicting what will happen with future stock prices," he says. He began to wonder "that maybe it wasn't so uncanny."

Calling his hypothesis "novel," he wrote a paper entitled "On the Timing of CEO Stock Option Awards" that suggested that "at least some of the awards are timed retroactively."

"The results are provocative and might cause some investors to cry foul," he wrote. The paper was published a year ago in a journal called "Management Science." He and another researcher, Randall A. Heron, have since completed a forthcoming, follow-up study that looked at a 2002 change in regulatory law that now requires companies to report option grants within 48 hours. The study found that when companies reported options the same day they were granted, there was no pattern of share prices quickly rising. But the pattern continued when companies delayed reporting option grants.

Hmmmm.... So if there was a delay between the option grant and the announcement, prices went up after the grant date; otherwise, no. Funny how much foresight needed hindsight to work.

The WSJ also has coverage ($) of the firing of the general counsel of anti-virus software company McAfee for option-related causes.

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HOW IOWA PROF ENDED LUCKY RUN FOR EXECUTIVE STOCK OPTIONS

May 25, 2006

The Des Moines Register has a piece today on Erik Lie, the University of Iowa finance professor who helped expose the backdating of stock options by corporate executives:

Lie, a University of Iowa associate professor of finance, said he never set out to uncover what's being called the next big scandal to shake corporate America. In 2003, he began hunting for a correlation between option grant dates and price movements of the underlying shares.

Instead, his findings suggest some companies were manipulating the timing of the stock options they granted to top executives. The result pumped up the executives' pay.

Because the tax law puts caps on deductions for backdated options, some companies could end up owing millions in back taxes.

Working with data from Lie and other academics who have studied options, the Wall Street Journal reported in March on six companies that granted options whose dates repeatedly coincided with share price low points. The newspaper estimated that all six option grants made to Jeffrey Rich, the former chief executive officer of Affiliated Computer Services Inc., came just before sharp runups in the price of the Dallas company's share price. The odds of that occurring were one in 300 billion. The odds of winning the Powerball lottery with a $1 ticket are estimated at one in 146 million.

Rich denied to the paper that any backdating occurred, and said the timing was a result of "blind luck."

If I had that kind of blind luck, Angelina Jolie would accidentally call me at work and ask to buy me dinner and Lexus would accidentally deliver new cars to my house twice a year.

Link: Prior coverage of backdated options

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MORE OPTION LUCK UNRAVELS

May 23, 2006

The Wall Street Journal continued to advance the story of backdated executive stock options ($link). The WSJ fingered 15 more companies whose executives managed in an absolutely uncanny way to have their options priced the Wal-Mart way: always the lowest price.

If the executives were just that lucky, they had an honorable way of saving millions of dollars in stock exercise costs. Of course, the suspicion is quite strong that it wasn't just luck, and that options were in fact backdated. If that's the case, their employers stand to lose millions of dollars in deductions.

The WSJ shows a number of examples of this amazing luck, and the odds of such low option prices happening purely by chance. A sample of their charts:

(Source: Wall Street Journal)

Take these guys with you next time you go to Prairie Meadows to play the ponies.

Prior Tax Update coverage starts here.

UPDATE: The WSJ Law Blog has a subpoena scorecard.

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SINCE WHEN IS IT A CRIME TO BE LUCKY?

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

CNN

White Collar Crime Prof Blog

Prior Tax Update Coverage:

OPTION 'LUCK' WIDESPREAD?

BACKDATING OPTIONS? THAT'S RICH...

STOCK OPTIONS AND ALIEN LUCK

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OPTION 'LUCK' WIDESPREAD?

May 18, 2006

The Wall Street Journal today has another article ($link) on the apparent popularity of backdated options:

Federal prosecutors in Manhattan began a criminal probe of options-granting practices at UnitedHealth Group Inc., and Vitesse Semiconductor Corp. fired three top managers, including its chief executive officer, in the latest developments from a stock-options scandal that is roiling corporate suites.

UnitedHealth also said the Internal Revenue Service had made a request for documents, suggesting that the agency may be looking at the tax implications of possibly misdated stock options at the giant health insurer. UnitedHealth previously said that because of a "significant deficiency" in its options administration and accounting, it may need to restate at least three years of financial results and lose tax deductions.

The tax law caps executive compensation deductions if the "strike price" of stock options is lower than the stock's value on the date the option is issued. It appears that a number of companies backdated options so their price would be lower, saving the executives money at exercise time. This could cost companies millions of dollars in executive salary deductions.

Link: Prior Tax Update Coverage.

Additional Coverage:

Forbes

Twin Cities Business Journal

New York Times

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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.

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