Stock options that made Microsofties rich are now their undoing
DAN RICHMAN
SEATTLE P-I REPORTER
Oct. 20 - The same Microsoft stock options that made thousands of employees rich are now driving some of them into debt.
THE CAUSE: UNPRECEDENTED declines in the stock’s price, plus unwise decisions by some employees on how to exercise their options.
Dorothy, the wife of a Microsoft programmer, said every time Microsoft shares drop by $5 and stay at the lower price for more than three days, the phone rings.
It’s the couple’s broker, Salomon Smith Barney, making yet another margin call. Such calls warn shareholders that the broker is about to sell some of their stock to maintain its collateral in loans to the shareholders.
“They say they’re going to sell more of our shares,” said Dorothy, 41. “All we can do is hang on. Those options are deadly.”
No one is suggesting Microsoft or any brokerage did wrong. In fact, some experts blame the shareholders themselves for their dilemma.
“Stock options made them rich. Poor business judgment made them poor,” said Mark Nebergall, president of the Software Finance Software Finance and Tax Executives’ Council in Washington, D.C.
Options are the right to buy a stock at a given price, usually lower than the current market value. Employees who can’t afford the price can borrow it from their brokers. That’s what Dorothy and her husband, David, did.
About half the time, they let Salomon Smith Barney buy the shares and pay the taxes, assuming the rising value of their Microsoft shares would easily cover those loans.
Then they went a step further – borrowing hundreds of thousands of dollars against their shares to buy a house, take vacations and even make mortgage payments.
On paper, the couple’s shares were worth $1.8 million at one time. On Wednesday, when the stock closed at $51.75, they were broke, Dorothy said, with debts of $900,000 outweighing the $828,000 value of the stock. But the stock market is fickle. It rallied yesterday, and their Microsoft stock was worth $990,000 by the end of the day.
In issuing four margin calls since mid-May, Salomon Smith Barney has sold about 17,000 of the couple’s Microsoft shares. They owe the Internal Revenue Service $50,000 and Salomon Smith Barney $850,000.
David earns about $70,000 a year, and Dorothy does not work. The couple lives in a $320,000 house in Redmond. Both were interviewed on the condition that their real names not be used.
The couple’s predicament is exacerbated because they have borrowed so heavily against their Microsoft stock. But Dorothy and David aren’t alone.
Larry Feinstein, a bankruptcy lawyer in Seattle, said he has six Microsoft employees going through Chapter 13, which establishes a payment plan for tax and other debts to forestall bankruptcy. The six all incurred their debt through option-related financial missteps, he said.
“I have clients who owe the Internal Revenue Service $40,000, $50,000 or $80,000 in taxes that they have no ability to pay,” Feinstein said.
Some shareholders underestimate how much income tax they owe on the exercised options. On April 15 of the next year, the IRS demands the difference.
Spokesmen for two brokerages said they’ve been making increasing numbers of margin calls as Microsoft shares decline.
“I’ve spent all morning making margin calls” to Microsoft employees, said a Seattle customer-service representative at one brokerage that exercises Microsoft options. She said “a moderate number” of Microsoft employees use margined accounts.
“We have been making a lot of margin calls,” said Rhonda Baker, a customer service representative with Charles Schwab & Co.
Margin calls to Dorothy and David began in mid-May. They have continued until this week.
‘These are demand loans, provided as a service to both the employee and the employer. Regardless of how low the share prices drop, we're still owed the amount loaned.’
—Dan Flaherty
spokesman for Boston's Fidelity Investments Employees have historically flocked to Microsoft for its much-vaunted stock options. The company’s stock has made an estimated 10,000 people millionaires in the Puget Sound area alone. Options also saved Microsoft money, because until August 1999 the company paid smaller salaries and made up the difference in stock options. David has worked there since 1994.
The stock climbed more or less steadily since Microsoft went public in March 1986, reaching its all-time high of $119.94 on Dec. 30, 1999.
Given the company’s stellar performance and market domination, it’s easy to see why investors assumed that the curve would continue ever upward.
“In good times, what they did is probably OK,” said Feinstein. Then it makes sense to borrow against shares, because the interest rate paid to the brokerage is less than the gain on the shares, he said. But “in bad times, it’s stupid.”
Matt Pilla, a spokesman for Microsoft, said of the situation, “The company is proud to offer a strong and comprehensive compensation plan, and it’s unfortunate that some people have made financial decisions that have put them at risk.”
In retrospect, it’s easy to see how shareholders stumbled into debt.
Stock options, unlike stock grants, aren’t free. Given as incentives or bonuses, they allow the recipient to buy shares, usually at a lower price than where the stock is trading.
But many workers can’t pony up the cash to buy even those low-priced shares, especially in the large blocks – up to 10,000 shares – that Microsoft employees may exercise. And if the options aren’t exercised within a certain time, they expire.
So employees take a loan from their broker for the purchase price.
Part of that loan covers the income tax due on the difference between the price at which the options are offered and the shares’ fair market value. When options are non-qualified (an IRS designation) – as are most of those granted by Microsoft – the gain is taxable as ordinary income immediately upon the exercise of the option.
At the time of exercise, the employee is asked to estimate which tax bracket – between 28 percent and 39.6 percent, commonly – is appropriate for determining the tax rate on the transaction. Underestimates are common. Shortfalls result in tax liabilities.
This technique of option exercise is known as “purchase and hold” or “exercise and hold,” depending on the brokerage. Brokers are willing to make purchase-and-hold loans because they generate interest. Schwab charges 10.25 percent annually. Salomon Smith Barney charges Microsoft employees between 8 5/8 percent and 9 7/8 percent.
But like all loans, these must be supported by collateral. When the collateral – in these cases, Microsoft shares – falls below a certain percentage of the loan, the brokers first contact clients to solicit additional collateral. If none is provided, they start selling shares to protect their loans. The lower the stock goes, the more shares are sold.
Brokers are no more willing to forgive debts than any other lender.
“These are demand loans, provided as a service to both the employee and the employer,” said Dan Flaherty, a spokesman for Boston’s Fidelity Investments, which exercises Microsoft options for some employees. “Regardless of how low the share prices drop, we’re still owed the amount loaned.”
A federal regulation, called Regulation T, sets some of the margins. The Federal Reserve Bank, and brokerages, supply the rest.
Regulation T says no shareholder’s account can fall below 25 percent equity.
At Salomon Smith Barney, an amount up to 50 percent of a shareholders’ account can be loaned. Margin calls there begin when the shares decline in value to the point where the shareholder’s equity falls below 30 percent. In other words, the collateral must be 30 percent greater than the loan, or margin calls begin.
At Fidelity Investments, margins can vary daily, depending on the diversity of the borrower’s stock portfolio and on the volatility of the shares held and the sector to which they belong, said Flaherty.
No customers go on margin unaware of the possible consequences, the brokerages said. At Salomon Smith Barney, if customers decide to exercise options on margin, or to take a loan against their shares, “the customer-service representative has a lengthy discussion with the customer, explaining the implications,” said one source.
The purchase-and-hold method of option exercise is by no means the only alternative available to those who can’t afford to buy them outright.
Other possibilities are straight sell, when the employee exercises the options and sells the shares immediately; and sell to cover, when the employee exercises the options, then sells enough shares to cover the cost of their purchase and the income tax.
Straight selling makes sense if you assume the stock won’t appreciate more than some other investment, said financial adviser Donald Safstrom of Safstrom & Co. in Seattle. Selling to cover is a middle-of-the-road approach, appropriate when you believe the stock is a good investment but aren’t comfortable enough to be leveraged against it, he said.
Dorothy said she and David just didn’t realize the consequences of their decisions.
“Whenever I needed a check, I just called Salomon Smith Barney and they came up with the money,” Dorothy said. “When the stock’s going up, we just didn’t realize it could snowball down.”
P-I reporter Dan Richman can be reached at 206-448-8032 or danrichman@seattle-pi.com |
