A major scandal involving stock options has come to light in recent weeks that is causing great nervousness in corporate boardrooms and executive suites. The careers of many CEOs and other corporate chiefs are in potential jeopardy. A few may even go to jail.
In an Aug. 15 article, The Independent summed up the scandal this way: “In what amounts to systematic corruption, dozens of American companies stand accused of manipulating share options to inflate executive pay artificially, and then lying to shareholders about it.”
My wife Sue, a CPA and forensic accountant, gives an example. A conpany’s stock is $100 a share today. The company issues backdated options for an insider to buy 100,000 shares. The option price is based on a previous date when the stock price was $50 and is higher than that price. Bingo, an instant $50 a share profit times 100,000 or $5,000,000. “This is all sorts of felonies,” says Sue, both for the company and the insider, including income tax evasion.
The company issues the backdated options and makes the exercise price higher than the stock price (the stock was $50, the exercise price, $60). This cuts down the amount of taxes payable by the employee. Plus, the company can then avoid recognizing any compensation expense. Thus, they can report phony profits which keeps the stock price artifically high – as well as heaping on even more felonies.
Execs caught in this web of apparent greed and corruption could include Steve Jobs of Apple, and many others as well. Jobs got options to purchase 10 million shares at the stock’s low price of 7.44 in Jan. 2001. Do the math. If he made $10 a share, that’s 100 million. Like, he needed the money? He co-founded Apple, and as of March 6 owned 5,426,451 shares. The current price is $68.75. Thus, just for stock he currently owns, he’s worth 373 million (that’s not counting any options he has exercised.)
We have a lunatic economic system based on greed, and exploitation. All those millions plundered by executives at a multitude of companies using phony stock options was money made for them by the workers, who of course never saw a dime of it. Apple is now delinquent in their regulatory filings and could be delisted. Expect a “re-statement” of Apple profits for the years involved.
PS Al Gore is a member of the Apple board, serves on the compensation committee as well, and could get caught up in this too.
Update and clarification from Sue.Here’s how it works: as long as stock options are issued at a strike price higher on the date of issuance than the actual market price, there is no compensation to the employee — because the employee has received nothing of value — and no compensation expense to the company — because the company has given nothing of value. The theory is that the employee will work hard for the company, the stock price will rise, and at some point be higher than the strike price of the option. At some point the employee will exercise the option, buying the shares from the company at the strike price. If the employee then sells the shares, the gain is a short- or long-term capital gain, depending on how long the shares are held. The tax rate is the lower capital gains tax rate, not the higher ordinary income rate. The benefit to the company is “incentivizing” the employee to work harder and stay employed at the company, without incurring more expense and lower the profits, hence the stock price.
But the company and the employee decide to cheat. They backdate the share agreement to a date three years ago and pick a strike price higher than the then market price, but much lower than today’s market price. If done legally, the employee would recognize ordinary income and the company compensation expense.