Friday, May 19, 2006

If You Give a Moose a Stock Option…

Fred Whittlesey
Compensation Venture Group, Inc.

Publisher’s Weekly used the phrase “…the complexities that can follow a simple act of kindness” regarding the book If You Give a Moose a Muffin. For those who’ve read that story, or others from that series by Laura J. Numeroff, the complexities are never envisioned from the simple act of giving a moose a muffin.

Companies that recently have been accused of backdating or suspiciously timing the grants of options to executives and employees are about to follow a similar path and see an uncanny similarity to that bedtime story they’ve been reading to their children all these years. While these actions have attracted media attention, investigations by the SEC, and continued public furor over executive pay shenanigans, the story really is just beginning. On top of any ethical and criminal implications, the complex rules surrounding equity-based compensation make this fascinating (for an equity-based compensation geek like me).

If you give a moose a stock option and it turns out that the option was granted at a price lower than the fair market value at the date of grant you in fact gave the moose a discounted nonqualifed stock option. A company that didn’t think it gave the moose a discounted option didn’t recognize an expense under APB25 for that option and didn’t appropriately calculate the Black-Scholes value for FAS123 reporting of the discounted option. Now, under FAS123R the amount of the expense on the income statement is incorrect (although ironically it is lower under FAS123R than it was under APB25 due to the quirks of option pricing models). As a result, all financial statements issued since the date of grant misrepresent the company’s financial condition, perhaps by a material amount. In the world of Sarbanes-Oxley, the Chief Executive Moose (CEM) and Chief Financial Moose (CFM) who knowingly signed off on those financial statements might now go to Moose Jail for reasons in addition to basic fraud and securities laws violations.

Of course, if bonuses were paid based on the incorrectly reported financial results those bonuses may need to be refunded to the company to the extent the bonus amount was inflated by the absence of expense for the discounted options.

If the moose thought he had an Incentive Stock Option, instead of a nonqualified option, he probably didn’t report ordinary income at the date of exercise but included that amount of the gain as income for purposes of the Alternative Minimum Tax. Poor Moose. It turns out he owed ordinary income tax in the year of exercise and is delinquent, owing taxes, interest and penalties. That’s one for the CPAs to sort out, especially if Moose exercised unvested options with an 83(b) election.

Adding to Moose’s tax woes, any options that vested after 2004, per Section 409A, were taxable at the date of vesting even if they are not yet exercised so Moose owes taxes, excise taxes, interest, and penalties on those paper gains too. And the company is liable for not withholding the required taxes on that taxable event, and thus further misreported its financial transactions. Hopefully the CEM and CFM can serve concurrent sentences.

Of course, gains from discounted options are not a tax-deductible compensation amount under Section 162(m) – the million dollar cap rule - for the CEO and four highest paid officers, so the company’s tax returns and financial statements are further incorrect.

Shareholders, Exchanges, and Regulators
If the company’s stock option plan, approved by shareholders, expressly prohibits the granting of discounted options, it seems those options in fact couldn’t have been granted from the plan but the securities lawyers can chime in on that. For SEC insiders I think this means the option grant was not an exempt transaction under Section 16(b)-3. Poor Executive Moose has problems with the SEC because he didn’t file the appropriate paperwork at the time of grant and may be guilty of insider trading. But the company has even bigger problems if they advised the executive on those filings and are liable for those incorrect filings.

And those shareholders might be angry that they approved a plan on the basis that no discounted options by the company would be granted at all and the company tricked them into voting in favor of the plan. Stock exchanges requiring shareholder approval of any grant except for certain “inducement” grants (which would have had to have been identified and disclosed at the time) means these grants would then be in violation of exchange rules. If the company’s proxy statement issued each year since the grant of the option said those options had been issued from the plan, but they now were not, those disclosures were all incorrect in addition to the failure to disclose the proper grant price. There are other potential legal issues but I’m not a lawyer so I’ll stop there.

Muffins and Jam
If you give a moose a muffin he’ll want some jam to go with it. If you give a moose an option, sometimes apparently there isn’t enough earning potential in those and he wants a discounted price to go with it. Maybe he’ll want to be reimbursed for the liabilities created from that option. And if you reimburse the moose he might want a tax gross-up to go with it because when he's eaten all your muffins, he'll want to go to the store to get some more muffin mix. Maybe that’s what drove these companies to take such huge risks to deliver additional pay through backdated or suspiciously-timed option grants.

These mooses are definitely in a jam.

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