Stock Investing – The REAL DEAL on Options Back Dating and what it means for Stock Investing

Just when you thought it was safe to write a check for stock investing, the options backdating scandal hits. Our problem as money managers is that much of the information that has been disseminated about options back dating, and stock investing is just pure WRONG. The purpose of this article is to clear the air, and inform you as some one in need of stock market information just what you need to know about this scandal.

Let’s begin. CEO’s and senior management at any company whether it’s Steve Jobs at Apple, or over 100 other companies in question receive their executive compensation in two forms. The first form is an outright salary grant. Let’s say $5 million per year. No one is challenging that there have been any games with this part of the compensation package.

The second form of payment is stock options of which there are many types. We are going to use the most common form of stock options which is a straight options grant. Let’s create an example. Let’s say John Smith is CEO of ABC Computer and he was given options on 1,000,000 shares of ABC Computer this afternoon which is January 22, 2007 at $10 per share which is the selling price of the stock on the open market.

Now let’s say back on December 15, 2006 the stock was trading at $5 per share. The compensation committee at the corporation in question wants to do the CEO John Smith a favor. They BACKDATE the options agreement to December 15, 2006, when the stock was selling at $5 per share. The date of the options agreement is called the GRANT DATE. You need to remember this term.

Under the IRS Code, an executive must hold the option for 2 years. It is now 2 years and one day later. Let’s make it December 16, 2008, and the stock is selling for $15 per share. John Smith the executive exercises his options and sells 1,000,000 shares at $15 per share on the open market. Because of options backdating, he is showing a grant price of $5 per share, on December 15, 2006. His profit is $10,000,000.

You get the profit by selling one million shares at $15 per share, with a cost price of $5 per share. It’s a $10 per share profit on one million shares, or $10 million profit. If the company had used the correct date of January 22, 2007, the grant price would have been $10 per share, and the selling price would have remained the same at $15 per share. The profit would have been $5 million dollars or half the profit that was made by BACKDATING.

Of course, John Smith CEO would have had to wait until it was two years past the real grant date of January 22, 2007 to sell his stock in order to meet the IRS requirements. We now see that because of options backdating, this CEO executive John Smith made $10 million exercising his options as opposed to $5 million. There are several more things you need to know in order to understand what’s at work here.

• What is the nature of the compensation when the options are being exercised? Is it ordinary income, or capital gain?
The answer is that the sale of the options after two years from the grant date is ordinary income. Mr. Smith in this case has $10 million in ordinary income on top of what he is paid in compensation by ABC Corporation.

• Is the IRS being defrauded by options backdating?
The answer is no, the $10 million is being declared as income and is includible in income. The IRS is not being defrauded by OPTIONS BACKDATING, although the media would have you believe this is the case. If anything, the IRS is getting more taxes than it is entitled to because the compensation declared is $10 million. If the correct grant date were used the compensation would have been $5 million as we talked about above.

• Is anybody getting defrauded?
You bet, the shareholders of the company are being defrauded by whoever is granting the options, and the recipient of the options if he or she DIRECTLY knew about the backdating. In this case, the fraud amounts to $5 million of excess compensation paid because of the backdating. You get that number by figuring out what the compensation would have been if the correct GRANT DATE were used, as opposed to an erroneous earlier date, or backdating.

• Is there any way that an executive can make his gain a CAPITAL GAIN and pay the Capital Gains rate on the transaction?
Yes, but it involves the executive in question declaring the value of the option on the grant date, and paying ordinary income taxes on the grant date to the government. This is a section 83b election under the IRS code. The executive then can convert his gain to a capital gain on the date of sale 2 years later. This basically only happens if the stock is very cheap, pennies per share on the grant date. During the Internet go-go years, executives who elected this option got huge tax bills that they could not pay because stocks went from pennies a share to hundreds of dollars per share, and then collapsed before they could sell them, leaving the executive with a huge tax liability.

Another thing an executive can do is exercise his option on the exercise date 2 years later and then NOT SELL, but hold on. He will begin a capital gain holding period on the exercise date 2 years later. Keep in mind that this means the executive is now at risk.

Conclusion

The options backdating scandal has resulted in the shareholders of the companies in question being defrauded by the amount of excess compensation that was earned by the executive granted the option. The IRS was never defrauded by the company. In fact the IRS benefited in the excess compensation paid the executive by receiving additional taxes from the executive.

Options backdating should not be tolerated by any Board of Directors of a company, and certainly not by the shareholder base. To the extent that it is, the Directors are violating the rules of corporate governance that they have a fiduciary responsibility to uphold.

Bill Gates of Microsoft has said publicly the most useful skill he ever learned was a working knowledge of the tax code. Now having said that, where do we sign up to get some of these stock options?

Goodbye and Good Luck

Richard Stoyeck
Value Investing at StocksAtBottom.com

Richard Stoyeck’s background includes being a limited partner at Bear Stearns, Senior VP at Lehman Brothers, Kuhn Loeb, Arthur Andersen, and KPMG. Educated at Pace University, NYU, and Harvard University, today he runs Rockefeller Capital Partners and StocksAtBottom.com

Value Investing at StocksAtBottom.com