Page 454 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

440 The Complete Guide to Executive Compensation

optionee, who then decides whether to keep all, sell all, or sell enough to pay the taxes
(assuming a nonstatutory option).
Companies can use the stock option exercise proceeds (plus the cash flow from any tax
deductions) to buy back a portion of the shares issued with the exercise of the option. The
greater the difference between market value at time of exercise and grant cost, the smaller the
percentage that may be bought back. For example, if 4,000 shares of an option priced at $100
a share are exercised when the fair market value is $200 a share, the company has received
$400,000 from the optionee and could buy 2,000 shares. However, if the company has a tax
deduction on the $100 spread (and the corporate tax rate is 35 percent), then it has an addi-
tional $140,000 to buy back an additional 700 shares. As a net result, shares outstanding are
increased by 1,300 shares, not the 4,000 exercised. However, if the fair market value were
$400, then (using the same methodology) the company would be able to buy back only 2,050
shares, resulting in an increase in number of shares outstanding of 1,950 shares.
Should the company decide to give the executive a loan to exercise a stock option, it is
important to determine whether it will be recourse or nonrecourse. It should be remembered
that the Sarbanes-Oxley Act prohibits such loans for company insiders. An interest-free loan
may not be used to exercise a statutory option. A recourse loan will carry with it the right for
the lender to not only recapture the stock exercised but also lay claim to other assets of the
borrower until the full value of the outstanding loan is satisfied. A nonrecourse loan entitles
the borrower only to recapture the stock received from exercising the stock option.
According to the Emerging Issues Task Force (EITF Issue 95-16), fixed-date accounting
is permitted for both recourse and nonrecourse loans if the interest rate is not variable and
the loan is not prepayable. Under fixed-date accounting, the grant price at time of purchase
and the interest cost for the period of the loan are subtracted from the fair market value of
the stock on the date of exercise. This amount is expensed over the period of the loan. If
variable accounting is required, the loan amount plus the interest paid will be subtracted from
the fair market value of the stock purchased on the date the loan is paid. If fixed accounting
is permitted, the income charge is determined on the date the loan is given (not when paid).
For a brief period several companies permitted cancel-and-forgive exercises, also called
rescissions, before the regulatory agencies made it very unattractive to the company. This
policy permitted the executive to undo an exercised stock option if the market value subse-
quently dropped significantly below the grant price. In essence the company would give the
executive back the exercise dollars and reinstate the stock option under its original terms. It
also canceled a loan if one was granted to exercise the stock option. Some also called this the
disappearing stock option exercise.

Tendering Company Stock. Rather than sell company stock and have to pay taxes, it is more
advantageous to tender (i.e., turn over to the company shares of company stock owned) or
attest (i.e., confirm in writing the number or shares owned whose value without reduction for
taxes is sufficient to exercise the stock option). This is called a stock-for-stock exchange, or stock
swap, enabling the optionee to defer tax on the value of shares tendered until they are actu-
ally sold. This form of payment may also be used to exercise a statutory option; however, both
the shares tendered and new shares must meet the one-year and two-year requirements of
statutory options to avoid a disqualifying disposition.
A stock-for-stock exchange allows a company to help the executive avoid financing
problems. Specifically, it permits the optionee to use stock already owned to meet a
portion of the exercise cost. This is illustrated in Table 8-25. Assume the executive owns