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SEC Law: Basics

My company backdated more stock options than just those of the senior executives. How does this affect employees like me and the taxation of my stock grants?

At a minimum, do not expect any new stock option grants with an exercise price lower than the market price on the grant date unless these are explicitly allowed by your stock plan and have been approved by the board of directors (see the FAQ on how exercise prices are set). Some of the companies involved in the controversial backdating of stock options restricted employees from exercising outstanding options or buying stock through ESPPs (as explained by the San Francisco Chronicle). At the end of the options blackout period, companies such as McAfee extended the post-termination exercise period and made cash payments for options that had expired.

A company may impose a stock plan blackout because the S-8 registration statement the company filed with the SEC for the shares issued under the stock plan is no longer current. The financial statements it references need to be restated for the backdating. Most stock plans have a provision that allows a company to stop issuing stock or options if it cannot do so, and some companies interpret the invalidation of the S-8 registration statement as grounds for triggering this provision. For any shares you own, the problem will escalate if trading in your company's stock is suspended until the restatement, the shares are de-listed, or the stock price drops. For this situation, consultants recommend that companies consider an automatic-extension provision for new and outstanding grants.

Tax consequences. The tax issues depend on the type of grant you received, on whether you have exercised options already, and on future IRS guidance. One of the requirements for incentive stock options (ISOs) is that they cannot be granted at a discounted price. Therefore, any ISOs among your grants may have been disqualified. If you have held the shares long enough after exercise to receive the special ISO tax treatment, any capital gains tax you paid for the ISO stock sale may be converted in part back to ordinary income. Plus, taxes should have been paid at exercise, as these are now really nonqualified stock options (NQSO), including withholding for Social Security and Medicare.

For backdated options granted as NQSOs, your spread at exercise was larger than it otherwise might have been because you had a lower exercise price than the market price on the grant date. With this bigger spread, you paid more taxes at ordinary income rates, but then again your gains were larger. Options that have vested since January 1, 2005, face additional problems under Section 409A of the Internal Revenue Code. They are discounted options, which are considered nonqualified deferred compensation and are subject to additional taxes.

Alert: In 2007, the IRS released an Internal Industry Directive on backdated stock options. This showed the importance that the IRS, in its tax audits, initially placed on backdated options, especially for ISOs that are really NQSOs and for discounted stock options that trigger penalties under Section 409A of the tax code. As the law firm Fenwick & West pointed out in a memo, "the directive also signals the IRS's intention to pursue the issue against individuals who received such options."

In 2008, the IRS issued a directive that redesignated the status of backdated stock options from Tier I to Tier II, indicating a less intensive focus on the issue by the IRS.

In 2007, IRS let companies pay penalty tax for employees. Employees and former employees who exercise backdated stock options owe an additional 20% tax plus any interest under Section 409A of the tax code. In Announcement 2007-18, the IRS confirmed this and let companies step forward in 2007 to pay this tax for rank-and-file employees (not for executives) who exercised in 2006. The IRS stipulated the following for what it called the Compliance Resolution Program.

  1. Companies had to notify the IRS by February 28 of their intent to participate in the program.
  2. Affected employees had to be told within 15 days of notifying the IRS (i.e., no later than March 15). By the same deadline, companies were required to notify the IRS again about the number of affected employees who had been contacted.
  3. The owed tax had to be paid to the IRS by June 30. Additional interest is owed on payments received after April 17 (the normal deadline for individual tax returns in 2007).
  4. Companies had to confirm this payment to affected employees by July 15.

If your company fully complied with the IRS requirements, you were not responsible for reporting or paying this additional tax, though you might have had additional compensation for 2007 because your company paid the tax for you. Your company could have also increased your income to cover taxes on this additional compensation. If your company did not participate in this IRS program, you were responsible for the 20% tax and the interest (your company may reimburse you for this amount), as you would be for exercising backdated (i.e., discounted) stock options at any time. Whether or not you knew about the backdating did not matter. These same rules applied to any backdated stock appreciation rights. (For more on this move by the IRS, see a memorandum from the law firm WilmerHale.) In testimony (page 6) before the Senate, Kevin Brown, the former acting IRS commissioner, revealed that 80 employers with over 13,500 employees participated in this program.

Exchanges for backdated options at some companies. After an SEC investigation into backdating at Brocade Communications Systems, the company made a tender offer to its employees (see the Schedule TO, filed with SEC) that let them exchange backdated options either for cash equal to the Black-Scholes value or for options repriced to the fair market value on the grant date plus cash equal to the eliminated discount. At some companies, senior executives and directors agreed to reprice their improperly priced unvested options without any additional cash payment for the "discount." They also repaid their companies for any gains received from exercising backdated options, and the companies reimbursed them for any 409A tax penalties. (For example, see the 8-K that Barnes & Noble filed with the SEC.) In the settlements of shareholder derivative suits related to backdating, executives relinquished unexercised stock options (see the settlement in the case of Family Dollar). Other companies with unvested backdated options took similar approaches.

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