Options backdating, tax shelters, and corporate culture.

Backdating. Backdating camouflaged an in-the-money cushion and gave options some intrinsic value. For example, suppose Amanda, a new employee of Acme High-Tech Corporation, verbally accepts her new job on June 1, 1999, when Acme's stock price is $35. By the time she starts work and signs an employment agreement on July 1, 1999, the stock price is $40. If she is then awarded at-the-money options dated "as of" June 1, 1999, when Acme's stock price was $35, Amanda has a cushion of $5 of intrinsic value per share. The options are "in-the-money": if the options vested immediately, she would be able to buy the stock at the exercise price of $35, sell the stock at the market price of $40, and pocket $5 per share as profit. Most employee stock options do not vest immediately, however, making this intrinsic-value cushion less valuable than it might appear at first glance.

Front-running or spring-loading. Companies occasionally time option grants to immediately precede positive news announcements. For this brief moment in time between the grant date and the announcement of the news, the true value of the stock (based on private information) is greater than the market value of the stock. A stock option with a strike price equal to the market value of the stock is, nonetheless, constructively in the money. This practice is also sometimes called "spring-loading."

Bullet-dodging. Companies may announce bad news immediately before the granting of options, which is intended to decrease the market price below the true market value. Unless the market systematically overreacts to bad news, however, it would be difficult to consistently increase the value of options with a bullet-dodging strategy.

Engineered backdating. Some companies granted options with a strike price set at the lowest point within a thirty-day window. In almost all cases, then, the strike price of the option will be below the market price on the day on which the contractual right was established.

"As of" dating. Some backdating was unintentional. Suppose an executive reaches agreement with the company as to the broad terms of employment (Day T - 15). A compensation committee considers the details of the compensation package, including the number of options to be offered, and makes a recommendation to the board. The board approves the offer and gives written consent to the CEO delegating the authority to price the options (Day T). The company relays the details of the offer to the executive, who formally accepts the offer (Day T + 15). The human resources department of the company completes the paperwork on the options (Day T + 45). If the compensation committee approved at-the-money options, which date should be used to price the options?

The grant date is normally considered the date on which the board takes action (Day T), even if the employee is not informed of this fact until a later date (Day T + 15). (16) Companies priced the options on a variety of dates, including before and after Day T. In many cases there was no clear record of when each event occurred, nor were internal controls in place so compliance officers could guard against gamesmanship. There is substantial empirical evidence that the dates chosen were often advantageous for the employee; there is also evidence that some chosen dates were disadvantageous. (17) Absent a fairly rigorous system of internal controls, some degree of backdating is inevitable. A significant portion was the innocuous sort of "as of" dating that lawyers engage in every day as a matter of practical necessity.

The muddle of backdating was accidentally assuaged even before academics or the media focused on it. Section 403 of the Sarbanes-Oxley Act of 2002 (SOX) (18) requires that companies report grants to executives before the end of the second business day following the grant, narrowing the window in which backdating may occur. (19)

The academic investigation of why backdating occurred at some firms but not at others is now underway. Many of the companies that backdated options had a volatile stock price. This volatility cuts both ways. On the one hand, as University of Iowa economists Erik Lie and Randall Heron argue, technology companies had more opportunity to backdate effectively: the high volatility of technology stock prices created larger gaps between the stock price and the strike price, increasing the size of the intrinsic-value cushion. (20) On the other hand, that same volatility makes the cushion less important over the long haul.

Boston University law professor David Walker has noted that this high volatility among backdating firms made the typical backdating cushion worth mere pennies on the dollar. (21) In the example above, Amanda's five dollar intrinsic-value cushion was, in terms of option value, worth less than fifty cents on an option worth more than thirty dollars. (22) Given the large option value associated with volatile stocks, picking up a few nickels of intrinsic value was senseless, and reckless.

B. Tax Consequences

The tax consequences of options backdating depend on whether the option was intended to be an incentive stock option (ISO) or a nonqualified stock option. ISOs cannot be in-the-money when issued. (23) Even if the options are not intended to be ISOs, section 162(m) prohibits the deduction of compensation in excess of $1 million that is not paid "solely on account of the attainment of one or more performance goals." (24) The relevant regulations clarify that in-the-money options do not qualify as performance-based compensation. (25) In-the-money options may give rise to employment tax liability and, for options issued after January 1, 2005, may trigger liability under section 409A.

1. Section 162(m)

It is useful to begin with a very brief recapitulation of the basic rules of the transfer of property in exchange for services.

Section 83. The transfer of property in exchange for services normally gives rise to ordinary income. There are exceptions, however, for property subject to vesting requirements (like restricted stock), and there is a special rule for the transfer of options without a readily ascertainable fair market value (most employee stock options). Most executives receive nonqualified stock options. Because vesting requirements make many options difficult to value accurately, the Code takes a wait-and-see approach towards most employee stock options. (26) Both the employee's inclusion into income and the employer's deduction are deferred until the options are exercised. (27) When the options are exercised, the difference between the market value of the stock and the strike price is ordinary income to the employee, and employers may take the corresponding ordinary deduction. (28) These rules apply to nonqualified stock options regardless of whether they are in-the-money, at-the-money, or out-of-the-money. (29) Section 83, then, does not pose a problem for most nonqualified stock options, even if they were backdated.

Section 162(m). For the CEO and the four other highest-paid executives of public companies, the rules are more complicated. Section 162(m) limits the deduction that corporations may take for these covered employees to $1 million unless the pay is performance-based. (30)

The Code itself does not specify the meaning of performance-based compensation beyond the language "payable solely on account of the attainment of one or more performance goals." (31) Conceptually, an in-the-money option might still be considered performance-based because its value depends on maintaining the stock price above a certain number. The regulations, however, are explicit. They specify that only options granted with an exercise price at least equal to the fair market value on the date of grant may qualify. (32)

If such pay does not qualify under section 162(m), then when the options were exercised (triggering ordinary income to the employee and, in the case of qualified performance-based pay, an ordinary deduction to the employer), employers should not have taken a deduction on any amount above $1 million per employee. (33) In many cases, the deduction at issue amounts to tens of millions of dollars. Numerous corporations are restating financial statements to account for the newly-discovered tax liability. (34)

2. Sections 421 and 422 (ISOs)

Many rank-and-file employees receive ISOs. Most options offered to executives are nonqualified stock options, meaning that when the options are exercised, the employee realizes ordinary income on the fair market value of the option. ISOs, by contrast, allow employees to defer recognition of income until they actually sell the underlying stock, and they recognize that income at lower long-term capital gains rates. (35)

Section 422 sets out the requirements to qualify as an ISO. To qualify, an option must, among other things, have a strike price "not less than the fair market value of the stock at the time such option is granted," and ISO treatment is limited to options on stock worth $100,000 per year per employee, measured at the time of grant. (36)