Page 433 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 8. Long-Term Incentives 419

• Financial statements are likely to have to be restated thereby resulting in misstated
filings with the SEC because FAS 123R establishes the grant date as the date it is
approved by the company, not the effective date of the grant.
• Form 4 requirements that a stock option action must be filed within two days of the
grant date would require an adjusted filing.
• The optionee has a tax liability for the amount of discount under Section 409A of the
Internal Revenue Code in addition to a 20 percent tax penalty. Some companies that
have restated the effective date of the grant as the date the action was taken then paid
a “bonus” to the optionee for amount of the discount. The stated logic is that the
optionee was not part of the decision process and therefore should not be penalized.
Overlooked in the argument is that the higher option price may never be realized.
The action probably also saved the optionee a 20 percent tax penalty.
• A restated effective date will also affect the tax deduction taken be the company since
the optionee’s income will be lowered by the extent of the lost discount, as well as the
immediate taxation on the option price spread.

In addition to the above problems, backdating stock options is inconsistent with good
corporate governance.
Future Date. This is when the effective date of the grant is in the future. A typical example
would be a grant made subject to shareholder approval. For accounting and tax purposes, the
effective would be the date approved by shareholders. It is more likely that the effective day
is the day following the grant, thereby permitting communication of the grant price (such as
closing price of the day of action). However, some engage in the questionable practice of
stating the option will be granted when the stock price declines by a stated percentage or
dollar amount. Even though it may be legal, is it consistent with good corporate governance
or with executive greed?

Exercise Period
Waiting Period. The stock option grant specifies a beginning date (typically the date of the
grant) and an end date (when the right to purchase the shares expires). Within this period
(typically 10 years), there is a date when first eligible to purchase (typically called the waiting
period) before any shares may be exercised. The grant will also specify the maximum number
of shares that may be exercised on or after that date.
While most plans have a fixed exercise period (e.g., 10 years), some use a failure to meet
stated financial targets or stock prices at prescribed dates during the exercise period to
automatically cancel the option. This is one way to minimize, if not completely avoid, under-
water stock options (i.e., the option price is above the market price). Some refer to this as a
truncated stock option for its shortened period of exercisability.
Vesting. Many plans have a one-year waiting period, after which all shares granted might be
exercised. Others have additional eligibility requirements (typically called a vesting period). One
form is the cliff vest, which sets a waiting period before which no shares are exercisable, and after
which all shares are exercisable. A typical example would be 5 years on a 10-year option.
Another version is the installment vest. A typical approach would be to vest 20 percent of the
shares after one year, 40 percent after two years, 60 percent after three years, 80 percent after
four years, and 100 percent after five years. Such vesting schedules are designed to penalize
optionees who leave shortly after receiving a stock option since they will have to forfeit the