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Plain Talk About Stock Options: An Outline Of A New Model (Part II)

Joseph W. Bartlett, Founder of VC Experts.com


4. An Old Sad Story

Let me close this phase of the monograph with a caveat. I am not commenting on the result in any given case. The gravaman of the civil and criminal actions I have seen reported in the press apparently focus on the deliberate publication of misleading disclosures to the marketplace, the company stating unequivocally that options were granted with an exercise price calculated at the trading price of the stock in the market on the date of grant, which was an untrue statement and those responsible for the statement knew it was untrue. By so doing, the issuer inflated earnings (or minimized losses) by avoiding a charge to earnings in the amount of the spread between fair value as of the date of grant and the strike price. If those allegations are accurate and ultimately proven, it looks like yet another instance of the sad but eternal verity . it's not the initial act that is the crime, it's the cover up.

In this connection, as pointed out in a recent perceptive piece: [22]

An immediate risk facing some companies under investigation is the potential restatement of historical financial statements resulting from the failure to record compensation expense with any backdated options. Under the long-standing APB 25 accounting standards (which have been superseded by FASB 123R), compensation expense for option grants needed to be recorded only if the exercise price was less than the fair market value of the underlying stock at the date of the option grant - so-called discount option. Therefore, if an option was backdated, a company may have improperly failed to record compensation expense, which may require it to restate historical financial statements. A number of companies under investigation have already announced that they will be restating historical financial statements. Accounting errors of this type may also give rise to a finding of a material weakness in a company's internal controls, as well as possible forfeitures of option profits under Section 304 of Sarbanes-Oxley. At least one company has already disclosed a "significant deficiency" in its internal controls as a result of its backdating practices. As noted below, the failure to record income tax expense properly can also trigger a restatement. Because improper accounting and disclosure regarding a company's option grant practices can have a material impact on the accuracy of its financial statements, claims under multiple federal and state statutory provisions, as well as common law, are likely if disclosure of improper practices becomes required.

In other words, a culpable fraud or deliberate manipulation can trigger a chain reaction. As reported in the WSJ, Monday, August 14th:

An investigation and restatement can require sifting through thousands, even millions, of documents, applying arcane accounting rules .

According to the CEO of a board member of a company under siege,

. 'There were so many groups of lawyers and regulators and others, and there were so many agendas. There were a huge number of forces trying to slow the process down.'

And, plaintiff counsel are likely to have a field day. A survey of the landscape in the latest edition of Insights [23] gives a laundry list of some of the opportunities, in the form of statutory and common law violations, open to ever hungry and hugely creative plaintiffs' counsel plus ambitious and pro-active "sheriffs" . the SEC, the Justice Department, et al. Potential causes of action, enforcement actions and/or indictments can be based on, e.g.

  • Issuance of financial statements misstating compensation expense or containing false statements concerning the company's practice in accounting for stock options in proxy statements and in registration statements on SEC Form S-8. Such actions may violate Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1, 13a-13, 13a-14 of the Act, See 15 U.S.C. õ 78m(a) (2005); see also 17 C.F.R õõ 240.12b-20, 240.13a-1, 240.13a-13, and 240.13a-14 (2005).
  • Filing false tax returns if a company has erroneously claimed that compensation to an executive is "performance based" under Internal Revenue Code Section 162(m).
  • Failure properly to withhold under the Internal Revenue Code and FICA
  • Issuing financial statements that misstate the company's tax expense, if, for example, the company did not properly account and include tax expense, assuming the option grant did not qualify under Section 162(m).
  • Misleading the auditors by providing an inaccurate management letter, which in turn may be a violation of the `34 Act Rule 13(b)2-2.
  • Failing to maintain accurate books and records, which may in turn, may be a violation of Section 13(b)(2)(A) of the `34 Act.
  • Suffering material weaknesses in the company's internal controls with respect to the option grants, which in turn, may violate Section 13(b)(5) of the `34 Act.
  • Violation of New York Stock Exchange or NASDAQ rules requiring approval of stock option plans.
  • The ever popular 'breach of fiduciary duty' and other state law claims against the directors [24]

The short of the matter is that, once the investigations start, it is generally true that the Pandora's Box effect will inexorably set in. The new accountants and lawyers will find a number of deficiencies, many of them unrelated to the triggering event, and the process, including civil litigation, can go on for years . and involve multi-millions in expense, plus diminution in stock price all out of proportion to the alleged accounting misstatement, diversion of management's attention . in other words, bad news for the company and its shareholders. [25]

This unhappy state of affairs is not, however, the primary subject of this memorandum. The cases sub judice will be decided on facts specific to the situation and allegedly well recognized principles of law concerning the accuracy and completeness of disclosures by public companies in the United States. Nothing in this piece should be construed as commentary on the rules, regulations and principles pertaining to company disclosures; there is an ample supply of analysis and commentary on that subject and I am not attempting to "go there." [26] Rather, the primary purpose of this piece is to clear up misinformation and misunderstanding about option practice (particularly as it existed before õ409A) as a perfectly legitimate, and indeed socially desirable method of compensating and motivating executive talent.

Finally, the current wave of contentiousness raises the question whether what was, and indeed still is, legal in the stock option arena constitutes "best practice." Given the usefulness of stock options, the question is whether the current regimes are as good as we can devise. Or, is there an alternative model which: avoids so much of the underlying criticisms not only of sharp practices but of undeserved rewards; gives the boards and compensation committees adequate controls; insures the employees are adequately and sufficiently motivated . but not overly favored, like a lottery winner; and precisely aligns the regime with the results desired, which is to motivate management to improve company performance long term and reward the shareholders, the employees and the U.S. economy.

5. THE NEW MODEL

I would be remiss if I did not suggest there is an alternative to the current regime which, in my view, accomplishes the core objective but in a much more nuanced and sophisticated . and therefore, effective . way. The new deal, if you like, of equity-flavored compensation is set out in the paper I published while an adjunct on the faculty of NYU Law School and which formed the subject of an interview with Broc Romanec of The Corporate Counsel. [27]

Please note that the model outlined below does not mean a retreat to fainthearted CEO compensation; the working assumption is that the essence of the '80s analogy should be preserved . but radically improved. While the cascading criticism of options is so intense and pervasive that a search for a replacement solution is in order, nonetheless, we do not want to throw the baby out with the bath water, I submit; we need to offer extraordinary compensation to extraordinary CEOs, and not revert to, say, a statist formula. i.e., "No one makes more than 10 times the pay of the guy on the factory floor." In the right circumstances, the opportunity for venture capital type rewards is what generates an aptitude for constructive risk on management's part and, in the process, helps create great companies.

Rather than escrowing, in effect, some 20 (+/-) percent of the company's outstanding stock into a stock option pool, the "fix" I am suggesting contemplates issuing outright, say, 20 percent of the outstanding stock into a vehicle organized as a limited liability company (LLC). The question of accounting for dilution is, as of the date of issuance of the shares, settled. The shares are currently outstanding; they have been issued to an LLC (taxed as a partnership) of which the company is initially the sole member, with an opening capital account equivalent to the then fair market value of the shares so deposited. If compensation expense is required to be booked, then I would make it simple: capitalize the value of shares deposited and amortize the expense over a sensible period . say, ten years. To honor the KISS imperative (Keep It Simple, Stupid), assume for this purpose (whether or not the fact) that the entire value of the deposited stock is compensation expense . this simplifies "apples to apples" comparisons with competing firms, which pay managers in cash.

The managers of the LLC are the Compensation Committee of the Company's board. The non-voting members (other than the Company) are the executives who otherwise would have participated in the stock option pool. They are issued, selectively, profits interests that can be adjusted annually or periodically by the Committee without the imposition of tax (as long as capital accounts are not shifted). New executives join the pool, others withdraw, and the assets are "booked up" periodically so as to start all newcomers on a level playing field, so to speak, with the existing employee members.

Each member has a special profits interest, representing an interest in a fixed number of shares; unallocated shares belong to the Company and are treated as treasury stock. Once a liquidation event occurs, in accordance with the executive's contract and/or in the discretion of the Committee, the LLC sells the shares into the stock market and distributes the profit, minus any contractual givebacks.if the CEO is fired for cause or quits and joins a competitor, for example. The shares, or the proceeds there from, may be distributed (tax free) earlier than scheduled, in whole or in part, on petition of the executive and agreement of the Committee (death, disability, discharge other than for cause, pressing need), and presumptively will be distributed upon a change of control. A critical safeguard; in the event, which will be the norm at the option of the Compensation Committee, the LLC (vs. the executive) sells shares upon the executive's request, the sale is for the executive's account but subject to 'adult supervision.' That is, sales will be timed only, for example, during window periods or pursuant to Rule 10B5-1. The LLC managers can impose hold backs if too much stock is being sold and can compel an underwritten registration on Form S-3 if the same is deemed in the best interests of all the shareholders.

The Company's profits interest is, in effect, the reservoir; as awards are made and/or lapse each year, the Company's interest is enlarged or diminished. The shares in the account may be subject to a buy/sell arrangement if the parties so agree and, in any event, a right of first refusal in the Company will be a typical limitation.

Another highly critical point: Distributions of stock or cash to the executives are subject to an escrow of, say, 50 percent of the distribution to satisfy a clawback requirement . the same clawback which governs the outcome of an LBO fund partner, meaning a true up to insure equity to both capital and labor over an extended period. Thus, until the expiration of a prescribed, say, 10-year period, the executive leaves in her capital account escrowed profits in the form of stock or cash, the capital account standing as collateral for the clawback at the end of the period. When the true-up occurs, the departing executive either pays up or not, depending on the fortunes of the Company over the entire period. Thus, the long term interests of the executive and her employer are aligned.

Repricing is not an issue. If the manager is granted a profit interest in stock valued at $10 a share and, through no fault of hers, the stock goes to $2, the profits interest can be modified to cover a carefully calibrated number of $2 shares. The executive need not be long the stock, out of her personal resources, for an entire year to obtain capital gain treatment and gains taxable to the executives do not create AMT. Gross ups are not required to alleviate the tax burdens typical of restricted stock awards. Absent the tax issue, the profits interests can be distributed democratically; vide "Microsoft Millionaires"

To illustrate how this system can operate, herewith a hypothetical (not yet, obviously, complete) example:

Newco, Inc., a company planning an IPO, elects to introduce a program for aligning the interests of senior executives with those of the shareholders. A compensation committee, comprised entirely of independent board members, picks among three alternatives:

(a) A conventional stock option program;

(b) Restricted stock; or

(c) The LLC proposal outlined above (the "LLC Plan").

The LLC Plan is picked, and implemented as follows:

1. The shareholders are asked to vote on the LLC Plan.

2. 20% (15%) of Newco's expected post-IPO shares outstanding are issued to a newly organized LLC (the "Comp. LLC") The issuance covered by Reg. D and the subsequent sales by an evergreen registration statement under Rule 415. No-action letter to allow Rule 144k treatment for all hands, including controlling persons (since they do not control).

3. Newco's Compensation Committee members are 100% of the Managers of Comp. LLC. As allowed by the Delaware Act, the LLC Agreement negates the Managers' "fiduciary duties" to the members, Newco stockholders and/or other potential litigants, the residual duty being good faith and fair dealing.

4. Newco's charter is amended to require all claims by Newco shareholders involving alleged wrongdoing by the LLC Comp. Committee be confined to compulsory arbitration. [28]

5. The Plan establishes the method of establishing the "fair market value" ("FMV") of Newco shares on deposit in the Comp LLC, as follows: of the date of any award of a profits interest, FMV will be established by the average trading price of the shares during a six month period . the three months prior to, and the three months post the notional date of the award. This means slip ups in the precise date are likely to be inconsequential, even as and if viewed through the 20/20 prism of hindsight. An averaging technique inhibits gaming the system and the resultant FMV is more likely, in the view of the Comp Committee's consultants, to reflect genuine values. This method is validated by an IRS Private Letter Ruling ("PLR") . FMV established, as the Code requires, "in good faith.".

6. Awards are made by the Comp Committee, and only on, (i) the date Newco has established for each grantee's performance review, but no earlier than January 2nd and no later than January 31st of each year; (ii) on the first business day following June 30th of each year; and/or (iii) the date the grantee, if a new hire, first reports for work at Newco.

7. For tax purposes, the profits interests of each grantee is confined to gains from a specified number of Newco shares, identified separately from the general pool; when shares are sold, the hurdle is that Newco recovers its basis in the shares sold (cash to Newco . no need for cashless exercise) being the fair market value (calculated as indicated above) of the shares as and when the award was made. The PLR will be handy in this regard.

8. All awards dilute Newco's residual profits interests until (unlikely) 100% of the interests have been awarded; if so, all new awards dilute existing holders pro rata. Awards are subject to vesting; a õ83(b) election is filed as a precaution.

9. Under current law, it should be possible to structure awards as tax-free on the date of grant (see e.g. Rev. Proc. 93-27 and authorities in the Section 409A area discussing grants of pure profits interests).

10. The carrying value of the shares in the LLC are "booked up" each time awards are made, for purposes of measuring, and then allocating, future profits to the capital account of each new grantee.

11. Grantees may petition the Managers to distribute profits, vetted through their capital accounts, by selling some or all of the Newco shares allocated to the grantee upon four separate occasions each year, meaning the date each quarter with respect to which Newco's counsel opines to the Managers a window period exists. Absent special circumstances (death, disability, termination), sales will be in accordance with schedules filed by the grantee under Rule 10b5-(c)(3)of the `34 Act. All sales will be supervised by the Managers, with authority to freeze, suspend or delay any trades if deemed necessary to avoid even the appearance of improper use of inside information.

12. Assuming the lapse of the relevant holding period, and assuming the holders are "true partners," gain on sale of shares should be taxed to the grantee at capital gains rates.

13. The Managers will determine the appropriate amount of the gain (after distributions at least sufficient to cover the liabilities) to each grantee to be escrowed to secure Newco's clawback right.

14. Each grantee agrees to a negotiated clawback which sets the length of the clawback period and the target which, if not met over time, will result in the grantee forfeiting a percentage of his or her gain, from the escrow account.

15. The accounting charge to compensation expense, subject to guidance from the SEC, is simplified . the fair market value of the shares withdrawn, in effect, from the Company's residual ownership in the Comp LLC, that number to be amortized ratably, net of basis recovery as shares are sold, over the period during which shares are subject to vesting or the clawback, whichever is longer. There will be no tax deduction to Newco since the grantee pays no tax.

16. Cash compensation expense will be reduced because (i) the gain to the grantee's . his or her piece of the upside . is taxed at capital gains rates; (ii) no tax is due on the award date as opposed to restricted stock grants; (iii) no requirement that the grantee risk a one year holding period post option exercise in order to avoid ordinary income tax; (iv) sufficient gain distributed to the grantee to enable payment of federal, state and, if any, taxes.

17. If a grantee is dismissed for Cause, the capital account will be forfeited.

To get this structure in place, I suggest the details be blessed by an IRS Private Letter Ruling and an SEC no-action letter. The time to act on that suggestion is, in my opinion, right now. The last thing our dicey economy needs is another flood of strike suits, diverting managers, penalizing shareholders . and rewarding lawyers. For companies to survive in today's global economy, the fundamental imperative is "innovate or die." This necessarily requires a management which is, in very important respects, the opposite of risk averse, which entertains a healthy appetite for taking calculated risks in order to keep the growth curve in line with society's expectations. And, you cannot ask a manager to take risks if she is paid according to a formula that is essentially static; the two notions are mutually exclusive. Accordingly, pay tied to performance, and generous pay for generous performance, are axioms which we accept as self-proven in our economy, a necessary cornerstone of modern prosperity in the United States


[22] Drapkin, "Stock Option Timing: The Scrutiny Intensifies." Mondaq Business Briefing, July 31, 2006.

[23] Winer, Gray & Johnston, "Options Backdating," 20 Insights 2 (Sept. 2006).

[24] Cathy Reese, Fish & Richardson P.C., advises that:

While federal court litigation will predominate, the fact is that, from May through August 2006, a dozen shareholder derivative suits were brought in Delaware against corporate directors challenging the backdating of stock options . The corporate claims included the old standbys: breach of fiduciary duties, of loyalty, care, reasonable inquiry, oversight, good faith, and disclosure or candor; as well as gross mismanagement and waste of corporate assets.

Reese, "State Corporate Law Implication for Backdating of Stock Options," Fish & Richardson Webinar, Oct. 17, 2006.

[25] See Cash, "Report Estimates Cost of a Stock Options Scandal," N.Y.Times C4 (Sep. 6, 2006):

Three researchers at the University of Michigan estimated that backdating stock options between 2000 and 2004 helped sweeten the average executive's pay by more than 1.25 percent, or about $600,000. But the fallout from the recent options investigations has caused those executives' companies to fall in market value by an average of 8 percent, or $500 million each. As an economic analysis, the study assumed that investors' calculations of those risks [e.g. class action lawsuits], not irrational panic, was responsible for the substantial stock market declines.

[26] If an investigation reveals material errors related to option grants, liability may arise under the financial reporting, books and records, and internal control provisions of the Securities Exchange Act of 1934 (Exchange Act Sections 13(a) and 13(b) and the SEC rules promulgated thereunder). Such misconduct could also expose a company and the officers and directors involved to further violations of the anti-fraud provisions of the Securities Act of 1933 and the Exchange Act (Securities Act Section 17(a), Exchange Act Section 10(b), and Rule10b-5). Criminal proceedings for violations of the conspiracy and mail and wire fraud statutes are also possible. Improper disclosures or accounting for options could render statements in a company's proxy materials false or misleading. Inaccurate reporting in an individual officer's or director's Form 3 or 4 flings, reflecting personal securities transactions, could also give rise to potential liability under Exchange Act Section 16 and related SEC rules. In addition, federal tax liability provisions may be implicated. At the state level, multiple derivative lawsuits have followed recent disclosures about improper accounting for options, alleging that the officers and directors involved breached their fiduciary duties to the corporation under state corporate law.

Drapkin, n. 19 supra.

[27] Innovation Review, "To Expense or Not To Expense? Looking for a third option in the great stock option debt," The Berkley Center for Entrepreneurial Studies, Fall 2002. Inside Track with Broc: "Joe Bartlett on Getting Creative with Executive Compensation" (6/23/04), The Corporate Counsel, Broc Romanec. The idea is not exclusively mine. See "United States: Ten Thoughts About Equity Compensation for Investors and Entrepreneurs" (28 July 2005), an article by Scott A. Webster, John R. LeClaire and F. George Davitt of Goodwin Procter.

[28] See Bartlett, Tort Reform In The Securities Sector, Buzz of the Week, www.vcexperts.com. (________, 2006).