How Backdating Helped Executives Cut Their Taxes [WSJ]
Evidence Suggests Recipients Of Some Stock-Option Grants Manipulated Exercise Dates
By MARK MAREMONT and CHARLES FORELLE
December 12, 2006; Page A1
New evidence suggests that corporate executives may have found another way to manipulate their stock options, this time to cheat on their income taxes.
In a paper that began circulating in recent days, a Securities and Exchange Commission economist concludes there is strong statistical evidence that executives manipulated the exercise dates of their options as part of a tax dodge. And a review of corporate filings turns up some companies with startling options-exercise patterns.
The new information could open another front in the options-backdating scandal. Backdating already has sparked the broadest corporate-fraud probe in decades, with more than 130 companies under investigation by federal authorities. So far, attention has focused on the practice of retroactively selecting favorable dates to grant options. The new wrinkle involves rigging the dates on which options are exercised, sometimes years after they're granted.
The tax dodge related to options, however, almost certainly involves fewer executives than are caught up in the furor over the backdating of grants. (See related article.)
The reason it can be tempting to backdate the exercise of options lies in the way the Internal Revenue Service treats different types of income for tax purposes. Options, a common part of executive pay packages, give the recipient the right to buy a company's stock at a fixed price in the future. That price, known as the strike price, is usually the stock's market price on the day the options were granted.
About three-quarters of the time, executives immediately sell the shares they buy when they exercise options. Under IRS rules that typically apply, those executives must pay ordinary income tax, as well as payroll taxes, on the difference between the stock's value on the date the option was exercised and the option's strike price. The highest federal marginal income tax rate is 35%.
But for a variety of reasons, including corporate rules that require top managers to own a certain amount of stock, some executives don't sell immediately. Those who hold the shares for at least a year pay a much lower capital-gains tax -- currently 15% -- on any profit between the time they exercise and when they eventually dispose of the shares. That lower rate gives the executive an incentive to exercise the options at a relative low point for the stock: The move reduces the amount of money that would be owed at the ordinary income tax rate, and shifts the difference so it is potentially taxed at the much-lower capital gains rate.
Consider an executive who holds options on 100,000 shares with a strike price of $10. If he exercises and sells when the price is $20, he realizes $1 million in income and must pay $350,000 in income taxes.
If he instead can claim an exercise price of $16, he lowers his income tax to $210,000. If he then sells a year later and the stock is at the same price of $20, he pays $60,000 in capital-gains levies, for a total tax bite of $270,000. In other words, he has the same $1 million gain but saves $80,000 in taxes. The problem arises if the executive misrepresents when the exercise occurred to claim a lower exercise price.
Determining which executives or companies might be involved is difficult, and it's impossible to know what information they may have included in their tax returns. But some executives have exhibited unusual timing in their options exercises.
At Maxim Integrated Products Inc., a Sunnyvale, Calif., chip maker, chief executive John F. Gifford exercised options and held shares seven times between 1997 and 2002, according to regulatory filings and insider-trading data from Thomson Financial. In all but one case, Mr. Gifford's reported exercise date was the very day the stock reached its lowest closing price of the month. After the Sarbanes-Oxley corporate-reform law took effect in 2002, drastically reducing the opportunity to backdate by tightening reporting requirements, his fortunate timing vanished.
Maxim is facing investigations by the SEC and federal prosecutors in California over its option-granting practices. A special committee of directors is also probing the matter.
Chuck Rigg, a Maxim vice president, said the company is "looking into" questions about Mr. Gifford's options exercises, but said initial data don't indicate any problems. Mr. Rigg added that the company used an outside broker to handle options exercises. "There's not a way you can backdate that," he said. Mr. Gifford didn't respond to requests for comment.
At Royal Gold Inc., a Denver-based mining concern, Chairman Stanley Dempsey exercised options and held shares 12 times between 1997 and 2001, according to regulatory filings and Thomson data. Ten of those trades ostensibly came on a day when the stock was equal to its monthly low. The stock was thinly traded, and in some cases, there were several days each month when the stock closed at the same low price.
Karen Gross, Royal Gold's corporate secretary, said the company had informed the board of The Wall Street Journal's inquiry about the exercises, and has "begun looking into the matter." Mr. Dempsey didn't return a phone call seeking comment.
Academics have looked before at the issue of option-exercise timing, but studies were largely inconclusive. However, new research by SEC economist David Cicero suggests that some executives may have cut their income-tax burden by pretending their options were exercised on a prior day, when the company's stock was trading at a lower price. That would likely be a fraud under federal tax laws.
"The Cicero paper appears to be very well done," said David Yermack, a finance professor at New York University's Stern School of Business who has studied options issues. "It's strong evidence that executives were manipulating their exercise dates, similar to the way they were manipulating their award dates."
Mr. Cicero, who is also a doctoral candidate at the University of Georgia, examined more than 40,000 transactions between 1996 and 2005, and zeroed in on the subset of exercises in which the executive exercised and held on to the resulting shares.
The patterns he found in that subset are stark: Before the tightening of reporting requirements in 2002, shares on average fell 1.3% in the 20 trading days prior to the reported exercise date. In the next 20 days, they rose 4.8%. In other words, on average, executives were exercising options during a noticeable trough in the market price. After Sarbanes-Oxley, the phenomenon vanished.
Mr. Cicero wrote that the "striking stock price pattern" is "highly suggestive" of some type of timing, and said "backdating is difficult to rule out." Mr. Cicero didn't name any individual executives or companies.
He stressed in the paper, which is in draft form, that the views were his own, not those of the SEC.
An SEC spokesman, John Heine, declined to comment on the Cicero study. But he noted that the agency's enforcement director, Linda Thomsen, testified in a U.S. Senate hearing in September that the SEC is investigating exercise backdating as well as backdating of option grants.
Mr. Yermack said he also has been studying the issue, along with Erik Lie of the University of Iowa and Randall Heron, of the University of Indiana. Messrs. Lie and Heron are widely credited with the first academic research that suggested backdating of option grants could be widespread.
Although preliminary, their new research found that 13% of the exercises by CEOs who followed an "exercise-and-hold" strategy and didn't immediately report the actions to the SEC came at their stock's lowest price of the month. That percentage is nearly three times as great as would be expected if CEOs were exercising on random dates, Mr. Yermack said, and is highly suggestive that some were backdating exercises to avoid taxes.
The team of three professors also found that the phenomenon greatly diminished after Sarbanes-Oxley, which required executives to report option exercises to the SEC within two days. Before that, they had until the 10th day of the next month to report, which critics say provided a wide enough window to allow backdating to occur. The findings of a potential new options-fraud maneuver come even as Sarbanes-Oxley is coming under attack as being too harsh.
The phenomenon of option-exercise manipulation isn't new. An executive of Symbol Technologies Inc. pleaded guilty to tax-fraud charges in 2004 in connection with the practice, and Mercury Interactive Corp. has said former executives engaged in it. But it has largely remained under the radar as the scandal over option-grant backdating has snared headlines.
Alan L. Dye, a securities attorney at Hogan & Hartson LLP in Washington, said there are scant external checks to prevent backdating if an executive exercises an option and doesn't immediately sell the stock in the open market. "All the documentation is internal paperwork," he said. "Like any internal paperwork, unless good controls are in place, they can be misdated."
Michael D. Webb, the former CEO of EPIX Pharmaceuticals Inc., exercised options and held shares on 11 occasions between 1997 and 2002, according to filings and Thomson data. On six of those occasions -- including the last five in a row -- his reported exercise date corresponded to the lowest closing price of the month. The other five dates were also relatively favorable: Two on the second-lowest closing price of the month, and none any worse than the seventh-lowest.
Mr. Webb left EPIX, which is based in Cambridge, Mass., last year. In an interview, he said he wouldn't be able to answer any questions about his options timing without consulting transaction records, which he said he didn't have available. He declined to discuss how EPIX handled option exercises. A spokeswoman for EPIX declined to comment, citing "significant changes in management" that made it difficult to research past events.
Last week, a person familiar with the matter said a special committee of Comverse Technology Inc. directors began looking into whether the company's former CEO, Kobi Alexander, may have improperly altered exercise dates for his options. Mr. Alexander is in the African nation of Namibia fighting extradition to the U.S., where he faces criminal fraud charges related to the backdating of his option grants.
The unusual timing of a 1998 option exercise by Mr. Alexander was noted in a Nov. 27 report by Gradient Analytics Inc., a Scottsdale, Ariz., research firm. The report was distributed to clients including hedge funds and mutual-fund money managers. The full Gradient report, which the firm hasn't released publicly, also raises questions about option exercises at other companies.
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