Software Nerd

Friday, July 21, 2006

Option Backdating

The government has filed charges against Brocade for "back-dating" options. If the charges are true, the company clearly violated IRS rules. If tax-evasion was the primary basis of prosecution, I would not be writing about it. However, the government isn't stressing tax evasion, but "fraud".

What they did: Here's a simplified example of what happened at Brocade.

Suppose the share price was $10 on June 30th, but rose to $20 on December 31st. Now, on Dec 31st, the CEO says to an executive Mr. X: "As compensation, the company will give you the option to buy 100 shares for $10 a year from now." Since the shares are already selling at $20 on Dec 31st, that's a nicer deal (for the employee) than giving him an option to buy the shares for $20.

If that was all to it, no prosecution would have resulted. Managers are free to make such offers. They can even compensate with shares for 1 cent, or for "free". On Dec 31st, a manager may give an employee an option to buy the shares at the price they were selling for on June 30th. Where the managers do fall afoul of tax law is when they pretend that they made the offer on June 30th. That is the totality of their "wrong-doing".

If the company admits that they gave Mr. X options priced at $10 on a date when the shares were already selling for $20, then the government may end up getting more tax (from the company and/or the employee) under today's rules which give a tax-break to certain specific types of options. So, lying evades tax.

However, the SEC's case is not about lying to the government. It is accusing the company of fraud for misleading the shareholders and the general investing public. There's no doubt that such a statement is a lie. However, it is not a material lie to any intelligent investor. The date on which the offer was made makes no difference to the shareholder. (The difference to someone reading the annual statement is that some of the cost is shown in a footnote rather than being shown in the body of the income-statement.) The only underlying fact that really matters is the price of the option.

Take an analogous example. From time to time the government gives tax-breaks for certain types of spending during a specified period. Now, suppose a company gets a tax-break if they buy a machine in one year. Suppose they actually buy the machine in the first week of the next year and change their documents to show that it was bought in the previous year. They are obviously lying to the IRS and evading tax. However, the analogous case would be if the SEC (rather than the IRS) went after the company for lying to its shareholders, because its books reflected this lie (which is immaterial to all but the IRS), which was designed to earn more money (albeit via tax-evasion) for its shareholders.

Yes, managements can sometimes do such things to fool shareholders. When they do so, the shareholders be the one to sue. (If a majority of shareholders think they've been wronged, they can also fire the managers.) Prove harm and get recompense... that's how it should work.

The SEC is leading this fight, supposedly protecting small investors from evil managers. When Christopher Cox was appointed to head the SEC, some called him a fan of Capitalism and even an Ayn Rand admirer. Instead the ARI's fears about Cox turned out to be right.

The SEC recently tried to increase their control of hedge-funds; fortunately this was just struck down by a court. Congress passed the ridiculous Sarbanes-Oxley bill. There have been other new "crimes" invented all the time, often applying retroactively! As with Sarbanes-Oxley, as with restrictions on IRA accounts, as with restrictions on consensual adult sex, the government is trying to play big-daddy, protecting the "little guy" against his own possible lack of rationality; as if we'd all be lost without Big Brother!

It's unfortunate that a large number of people share Cox's view of Capitalism as a system where the rich guys fleece the poor guys, with generally good results as long as the government keeps a leash on the rich guys. As a result, not only do they not understand the morality of issues related to the SEC, they also do not understand how the U.S. government's steady erosion of America's primary competitive advantage hurts them in the long run.

Prognosis: In the case of Brocade, the CEO did not backdate options to himself. He gave these to employees. The jury won't see a man trying to enrich himself. However, it's my guess that government chose this case because they have ample evidence to back up the fact that a lie was published. I wonder if a jury can get past that and say: "sorry, come back with an IRS case, if you want us to vote guilty". (Not that I'd cheer the IRS on, but it's what I would expect and what Brocade ought to have anticipated.)

Cut down on rules: What the SEC ought to do to say that a company need not specify when an option was granted. The company can give that information to the IRS, but need not give it to the public. The SEC should make a long list of things that a company is not required to publish, and then leave it up to the marketplace to figure out what to ask of companies before investing. Consider this, some shareholders may sell a company's shares if they learn that the CEO is gay. This should not be about prosecuting companies that lie about their CEOs being straight, it is about not forcing companies to state whether their CEO is gay -- let the market decide if that information is relevant. Those who think that the market cannot solve this without government help do not understand Capitalism.

Shady managers: Some commentators have sneered at those who complain about the government's case, asking: would you buy stocks in a company that does this? The truthful answer is that I would not buy shares in a company that engages in stupid tax-evasion tricks like this. Not because I want to pay more taxes, but because I think I'll end up paying more in the long run. If the IRS did not have their stupid rule in place, this would never have happened in the first place; the managers would have little reason to lie about the date.


  • Well thought out post, good work.

    Here are the three issues that still need some thinking and debate before your recommendations I think.

    1. Based on our experience 15% (roughly) of the cases are due to companies trying to leverage the tax deduction from options. This is easily fixable but there are various ways to implement this. Which would be the most effective and least cost to implement? The suggestions range from per employee deduction to flat number.

    2. How can spring loading be really prevented? If a standard date is fixed for option grants, then there is a possibility for executives to wait for good news to be published "later" than grant date. Tihs can solve another 10-15% of the cases.

    3. The biggest issue to still solve with no new rules required is to have a fixed date (recurring) of options grants. This will solve more than 50% of the problems, but has to be managed with the spring loading issue.

    Mukund Mohan

    By Anonymous Mukund Mohan, at 9:15 PM  

  • In principle, other than the "IRS issue" I see no other "problem" for the government to address. [Not that I'm an IRS fan; just that the legitimacy of income-taxes is a separate discussion.]

    Limiting my suggestions to what would be politically viable (which is a massive limitation), I'd suggest an IRS rule along the following lines:

    Any option grant of more than x% of its existing stock in any month must be reported within Y days of the month-end, aggregated across employees. E.g. "N options were issued during the month at a strike price of $D". The rules should consider it to be acceptable, from a tax perspective, for a company to choose a tax-advantaged "grant date" within that month.

    If a company gives less that x% of its existing stock as options, it should be allowed to declare the amounts at the end of the year.

    If employee-by-employee reporting is not expensive even for a small company, then the IRS could ask for reporting at that level.

    If shareholders of individual firms want to place certain restrictions on what their firms can do, let them do so. The market will evolve a system it wants -- which might be "no system". I would favor public announcements for everything above a certain percentage, on similar lines to the IRS-type rules I mentioned above.

    It's probably too much to expect the SEC to keep its nose out of this. If it absolutely has to have a rule, it should ask for the same aggregated information that is reported to the IRS.

    By Blogger softwareNerd, at 5:15 AM  

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