Page 457 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 8. Long-Term Incentives 443

borrows the needed monies from a broker to exercise the options and then has the
broker sell those shares. If the company covers the cost of the loan, it would seem to be
barred by Sarbanes-Oxley for officers and directors. Merely arranging for the loan might
also be a violation.
Cashless exercises became possible in late 1987 when the Federal Reserve Board amended
Regulation T, permitting brokers to loan money using unexercised stock options as collateral.
Prior to this change, the broker could use as collateral only stock or other assets already owned
by the buyer.
If the executive chooses not to borrow money from the broker to exercise the option
but merely receives the appreciation (less tax withholding) in cash or shares of stock, the
transaction is sometimes called an immaculate exercise (perhaps because it is so clean). If it is
presumed the gain will be in shares of stock, then fair-value grant-date fixed accounting
will apply under FAS 123R. If it is likely to be settled in cash, then variable accounting
is required.
In 1991, the Securities and Exchange Commission significantly reduced the requirements
and restraints of the “short swing” insider trading rules under Section 16 of the Securities
Exchange Act of 1934. This section applies to insiders, defined as officers, directors, and those
owning 10 percent of more of publicly traded companies. It defined the purchase date of a
stock option as the date on which it was granted, not the date on which it was exercised, there-
by making it possible to exercise and sell the option on the same date without violating six-
month short-swing rules. The action steps and their sequence are described in Figure 8-3. In
many cases, steps 7 and 8 are electronic rather than paper transactions.

Optionee I Company

2
6 3 7

Broker

4 58

Market

1. Optionee notifies company to excercise the option and send stock to broker.
2. Optionee borrows money from broker to cover exercise cost and tells broker
to sell the shares being exercised, paying company the option price.
3. Broker sends check to company (for option price and withholding).
4. Broker sells stock.
5. Proceeds of sale sent to broker.
6. Broker sends check to optionee for balance (less commission and loan interest).
7. Company sends stock certificate to broker.
8. Broker sends stock certificate to buyer.
Figure 8-3. Cashless exercise