Tuesday, December 12, 2006

Another sleazy twist to the stock option scandal

Front paged at Booman Tribune and ePluribus Media. Recommended at Daily Kos

A few months back, I wrote about a corporate scandal involving the backdating of stock options, titled, The biggest corporate scandal you never heard of... (this was also diaried nicely by both PsiFighter37 and bonddad). While that diary focused on a way that executives were able to increase their income by backdating a stock option to a time when the value of the option was lower, this one will focus on a different angle that hasn’t gotten as much press but is just as sleazy, if not worse.

That would be the backdating of the exercise date in order for executives to cheat on their taxes. Don’t worry if your eyes are glazing over already – I will make this readable (I promise). Today’s Wall Street Journal has not one but two articles about stock option backdating (although the second is a bit more dry than the first, and deals with a different tax issue that I don’t think you want to hear about here).

Although I gave background in my prior diary, it is still applicable here, so I will reproduce that part below:


Just a bit of information on stock options, since it isn't the sexiest of areas (unless you are getting them). When you receive a stock option, it is essentially an "option" to purchase stock at a specified price. That price is (or should be) determined as of the date the option is granted. For example, if you are granted a stock option today, it should be based on TODAY's stock price.

When you receive the stock option, there is no income that you would report or derive, since you haven't yet bought the stock, and the stock price may ultimately fall below the price you have the option to buy it for. Additionally, there is generally a specified period that you must hold the option for before "exercising" it.

When you "exercise" the option, there is income to the individual who exercises the option. This income is also subject to payroll taxes and income tax withholding. This income is based on the difference between the price of the option when it was granted and the price the stock is on the day you exercise it. You don't have to sell the stock to have the income, although many people do exercise and sell the stock at the same time.

Example: You receive a stock option in January when the price of the stock is $5. You exercise it in October when the stock price is $15. You have income of $10 on that stock option, regardless of when you sell it.

If you sell the stock at a later date, then the income you have from the "exercise date" to the "sell date" is only subject to the capital gains tax, and we all know how Bush and Congress just reduced that tax rate. Following the example above, if you sell the stock in December when the price is $20, then there is the original $10 subject to income tax (at a higher rate) and the $5 (from the $15 to the $20) is income which is taxed at a LOWER capital gains rate.

In my prior diary, we were concerned with the first part of this – the artificial “deflating” of the initial grant price to get more income. Here, we are talking about the artificial “deflating” of the EXERCISE price when the stock is sold at a later date, which would then be taxed at a lower capital gains tax rate (the bolded portion of the blockquote).

What does backdating the exercise date mean then?

Since the links may be behind a WSJ subscriber firewall, I will give some info from the article. But first, why is this an issue (or a different issue)? Well, the cheating-on-the-tax part deals with the time period between the exercise of the option and the sale of the stock. When the option is exercised and sold at the same time, there is no issue here.

But as noted above, when the option is exercised, it would be subject to income tax withholding (federal at 25% up to $1,000,000 in income with a mandatory 35% rate on all amounts above $1,000,000, as well as state withholding tax), as well as Medicare tax (1.45% for both the employee and employer). I will assume that all executives that this applies to make over the maximum amount subject to social security tax (which is around $94,000 in 2006).

However, if the stock is held after exercise and the price goes up more before the individual sells the stock, that difference is only taxed at the capital gains tax rate (which are usually substantially lower than the income tax rates).


Let’s use the example above. Under normal circumstances, the $10 gain upon exercise could be taxed at a total rate of close to 50% (once all taxes are taken into account), while the $5 gain from exercise to sell would be taxed generally at a 15% tax rate (federal, with additional state tax). This is close to a 30% or so difference between the tax rates.

Now, let’s say that the employee went and retroactively changed the exercise date so that it was exercised when the stock price was $10 and not $15 even though it was really exercised at $15. This would result in tax at the 50% or so rate on ONLY $5, with a total tax rate of approximately 15-20% on $10. Obviously, this results in an overall reduction in the tax due. Since many executives are granted thousands of stock options, the tax cheating can be huge dollars (as I wrote about in early August in my diary, Ultra-wealthy cheat IRS out of $70 billion per year)

What, if anything is being done about this?

This is a bit tougher to catch than the backdating of the options that bonddad, PsiFighter37 and I wrote about. The reason is that much of this documentation for stock option exercises is internal, and there were lax rules until around 2004 with respect to the dates when such transactions needed to be reported. So, this isn’t as common a practice anymore as it was back from 1998 – 2003. However, there are ways to study the timing of such transactions for patterns, and a study was recently released in this area:

Academics have looked before at the issue of option-exercise timing, but studies were largely inconclusive. However, new research by SEC economist David Cicero suggests that some executives may have cut their income-tax burden by pretending their options were exercised on a prior day, when the company's stock was trading at a lower price. That would likely be a fraud under federal tax laws.

"The Cicero paper appears to be very well done," said David Yermack, a finance professor at New York University's Stern School of Business who has studied options issues. "It's strong evidence that executives were manipulating their exercise dates, similar to the way they were manipulating their award dates."

Mr. Cicero, who is also a doctoral candidate at the University of Georgia, examined more than 40,000 transactions between 1996 and 2005, and zeroed in on the subset of exercises in which the executive exercised and held on to the resulting shares.

The patterns he found in that subset are stark: Before the tightening of reporting requirements in 2002, shares on average fell 1.3% in the 20 trading days prior to the reported exercise date. In the next 20 days, they rose 4.8%. In other words, on average, executives were exercising options during a noticeable trough in the market price. After Sarbanes-Oxley, the phenomenon vanished.

Mr. Cicero wrote that the "striking stock price pattern" is "highly suggestive" of some type of timing, and said "backdating is difficult to rule out." Mr. Cicero didn't name any individual executives or companies.

A number of companies have been caught up in this scandal – for starters, Symbol Technologies and Mercury Interactive have been in the news with respect to this practice. Additionally, EPIX Pharmaceuticals, Comverse Technologies, Maxim Integrated Products and Royal Gold Inc. were all mentioned in the WSJ article as potentially or definitively being involved in this practice.

As mentioned above, new rules make this practice much tougher to do, however, there are most likely huge sums of money that the IRS has been cheated out of in this area over the past 6 - 8 years. However, it is pretty safe to say that much of this money will never be recouped, and one can only imagine what a few billion dollars could do for millions of Americans if it was used for something other than the neocon war machine.

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