This article is reprinted with permission from the
August 25, 1997
edition of
New York Law Journal.
1997 NLP IP Company.

 


Stock Option Development

By Joseph E. Bachelder.

 

THIS COLUMN EXAMINES a recent decision by an accounting body, the Emerging Issues Task Force (EITF), on accounting for stock options that permit the deferral of gains on exercise. 1 The column also discusses a holding, reached earlier in 1997, by the Delaware Chancery Court that stock options granted for past services did not constitute corporate waste.

In the May 30 issue of the New York Law Journal, we discussed the development among public corporations of programs permitting the deferral of gains on the exercise of stock options. As explained then, such a program allows the option holder to elect to defer the gain on exercise of the stock option. The result is that the executive is not taxed until the proceeds attributable to the option are paid out at a later date (and, consequently, the employer must defer its deduction for tax purposes until the later date when the employee is taxed).

As also noted in that column, to accomplish deferral it is generally necessary for the executive to exercise the option by turning in stock owned by him or her rather than by paying cash. For this purpose, stock used to exercise the option must have been held for at least six months. 2

A significant open issue, as noted in May, has been the accounting issue. Can the option be exercised and the gain deferred by the executive without the employer losing the non-expense feature of the stock option? At the May 22 meeting of the EITF, the issue was reviewed but left open for further discussion. 3

Deferral in Form of Stock Units

At its meeting on July 23 the EITF concluded that deferral of gain on exercise of a stock option does not take away the charge-free status of the option, but it added one major proviso. Deferral must be in the form of stock units (a unit representing a share of stock of the employer) or the equivalent. Payout at the end of the deferral period must be in the form of shares of stock, not cash. If an employer defers in the form of stock units and pays out in stock, not only will the stock option remain a non-expense item but any growth in value from the date of exercise of the option to the date the stock is paid out will also avoid a charge against earnings.

If deferral is permitted in the form of a diversified portfolio or even as deferred cash with interest, the deferral will be treated as a right to cash out (as in the case of a stock appreciation right [SAR]). As a consequence the accounting treatment will be the same as that for an SAR or other form of "variable plan" award and will result in a charge against earnings reflecting the growth in value of the stock over the period based on a "mark to market" valuation each year until the option is exercised. 4

This result will disappoint executives who wanted both (a) to defer their gains for tax purposes and (b) to diversify the investment of the deferred proceeds, since most employers now will be unwilling to allow diversification because it would result in a charge against earnings.

On the other hand, there still will be an interest on the part of many executives in deferring gain in the form of stock units. Among the reasons for doing so:

(1) The executive may wish, prior to the expiration of the option period, to shift from an investment mode pursuant to which all gain would be lost if the stock price falls to or below the exercise price (normally the market price of the stock on the date the option was granted). Of course, many executives will prefer to keep the leverage of the option (the upside opportunity on a greater number of shares) throughout the exercise period notwithstanding the risk just noted.

(2) Exercise of an option (even on a defer-the-gain basis) presumably will be counted toward meeting a stock-to-salary-ratio requirement that many corporations have adopted for their top officers.

While accomplishing either or both of (1) and (2), the executive will, of course, continue to be able to defer the tax to a later date, as noted in the preceding paragraph, thus continuing the pretax build-up of the gains. 5

The Taxpayer Relief Act of 1997, just signed by the President, 6 will reduce the maximum federal long-term capital gains rate to 20 percent from 28 percent (if property is held for more than 18 months). This reduces somewhat the disparity between (i) the executive's after-tax position with ordinary income on the deferred amounts at the later date of payout versus (ii) the executive's taking the proceeds and paying tax now at ordinary rates but obtaining long-term capital gains on the resulting investment later. Even so, deferral (assuming ordinary income rates remain at today's level) continues to be an attractive alternative to taking the proceeds and paying tax today.

Following is a comparison of exercising an option and taking the proceeds (and paying the tax) today versus exercising the option but deferring the gain. Assume an executive has a spread in an option of $100,000 and a combined effective federal, state and local ordinary income tax rate of 45 percent. The new long-term federal capital gains rate will be assumed to apply at 20 percent. Assume, further, that the choice is between (x) taking the gain and paying the tax today and (y) deferring the gain. Whichever choice is made (i.e., the proceeds are left in the company or taken out and invested in an alternative form of investment), it is assumed the pretax return is 12.5 percent per year. Two periods of deferral are considered: five years and 10 years.

Exercise Option Today But Defer Gains (and Tax)

1. Gains on exercise: $100,000

2. After-tax gain on exercise: 0

3. After-tax value (Assumes $100,000 deferred in form of stock units of employer with pretax return of 12.5 percent and ordinary income tax on distribution of stock at end of period.)

5 years later: $99,112

10 years later: $178,603

Alternative Two: Exercise Option, Pay Tax Today and Invest in Other Form(s) of Investment

1. Gain on exercise: $100,000

2. After-tax gain on exercise: $55,000

3. After-tax gain on investment (Assumes $55,000 is invested with pre-tax return of 12.5 percent and long-term capital gains tax on increase in value of investment at end of period.)

5 years later: $87,422

10 years later: $145,848

Finally, the staff of the Financial Accounting Standards Board reportedly has indicated that the conclusions reached by the EITF on July 23 apply only to options granted or option modifications made after that date. This raises a number of questions, including what was the rule as in effect on or before that date (see May 30 NYLJ column).

Corporate Waste

Earlier this year, the Delaware Chancery Court held that stock options granted for past services could not be set aside on grounds of corporate waste (granting defendant's motion to dismiss). Zupnick v. Goizueta, No. 14874 (Del. Ch. Jan. 21, 1997).

In this case, the Coca-Cola Co. granted its chairman and chief executive officer, Roberto C. Goizueta, an option to purchase 1 million shares of the corporation's stock. Under the Coca-Cola stock option plan options were to vest over three years unless the optionee's employment terminated sooner by reason of death, disability or retirement, in which event the options would vest and become exercisable immediately. (This also would occur in the event of a change in control of Coca-Cola).

Since Mr. Goizueta was eligible to retire, the plaintiff argued that Mr. Goizueta could exercise immediately (by retiring), and therefore the option grant was for past, not future, services.

The plaintiff quoted from the Coca-Cola proxy statement to support its argument that the option was granted for past services only. That statement noted that since Mr. Goizueta became CEO there had been a "remarkable increase in market value of the Company during this period (nearly $69 billion)." 7 Since the executive already had been compensated for past services, the plaintiff argued the option grant constituted corporate waste.

The consideration of the case by the Chancery Court, based on a motion to dismiss, was framed by the complaint. As stated by the court:

The plaintiff does not claim that the board failed to act in good faith, or that it had a disqualifying self-interest or lacked independence. Rather, he claims that the option grant itself was wasteful and not protected by the business judgment rule. 8

The court began its analysis by citing Delaware Corporation Law 157, which provides that, absent fraud, "the judgment of the directors as to the consideration for the issuance of . . . options and the sufficiency thereof shall be conclusive." 9

The plaintiff's position was that there was lack of any valid consideration. The Delaware court stated that there are exceptions to the plaintiff's position that "retroactive compensation" does not constitute valid consideration. One of those exceptions, noted by the court, exists "[where] the amount awarded is not unreasonable in view of the services rendered." 10

The court turned back at the plaintiff the above-quoted excerpt from the Coca-Cola proxy statement (as contained in the complaint) that since Mr. Goizueta became CEO there had been a "remarkable increase in market value of the Company."

Fair Exchange

The court went on to state that "this Court cannot conclude that a person of ordinary, sound business judgment would be unable to find that the consideration received by the corporation was a fair exchange for the options granted." 11

The court quoted from Steiner v. Meyerson, No. 13139 (Del. Ch. July 18, 1995), another case dealing with the grant of stock options. In that case, the Chancery Court stated that (absent factors such as fraud, self-dealing or negligence) the rule is that "if under the circumstances any reasonable person might conclude that the deal made sense, then the judicial inquiry ends." 12 The court in Steiner v. Meyerson went on to say:

"the waste theory represents a theoretical exception to the statement very rarely encountered in the world of real transactions. There surely are cases of fraud; of unfair self-dealing and, much more rarely negligence. But rarest of all -- and indeed, like Nessie, possibly non-existent -- would be the case of disinterested business people making non-fraudulent deals (non-negligently) that meet the legal standard of waste!" 13

Based on Steiner v. Meyerson and Zupnick v. Goizueta, a board of directors that approves a grant of stock options in consideration for past services and follows reasonable corporate governance procedures in doing so cannot be challenged successfully on grounds of corporate waste under Delaware law. For this purpose, good corporate governance includes approval by a vote of disinterested directors who, generally speaking, should have obtained expert advice and had the opportunity to reflect on that advice.


FOOTNOTES:

1 The author wishes to express his appreciation to Paula Todd of Towers Perrin for her helpful comments regarding the May 22 and July 23 meetings of the EITF that addressed this issue.

2 Under a 1984 EITF ruling, shares used to exercise an option must have been held for at least six months (so-called "mature shares") in order to avoid treatment of the option as a "variable plan" option, which would result in a charge against earnings under the "pyramiding" rule. EITF Issue No. 84-18, "Stock Option Pyramidings." Upon satisfactory evidence that the executive exercising the option holds sufficient "mature" shares to exercise the option, some corporations will permit exercise without actual certificates being exchanged. This should not affect the tax or accounting treatment.

3 EITF Issue No. 97-5, Issue Summary No. 1.

4 EITF July 23-24, 1997 Meeting Minutes, p.7.

5 In the case of a Named Executive Officer, the employer may want the executive to defer option gains until after he or she ceases to be a Named Executive Officer. If the stock option does not qualify for an exemption under 162(m) of the Internal Revenue Code, which imposes a $1 million cap on the annual deductions for certain compensation paid to such officers, the employer may lose a deduction unless the option gains are deferred until after the executive ceases to be a Named Executive Officer. See Treas. Reg. 1.162-27(e)(2)(vi) for requirements applicable to stock options in order to qualify for the exemption.

6 HR 2014; 105th Congress, 1st Session.

7 Zupnick v. Goizueta, Mem. Op. at 3.

8 Id. at 7.

9 In contrast to the Delaware statute, the New York Business Corporation Law requires shareholder approval of the issuance of options to officers. NYBCL, 505(d). Under the New York statute, in the absence of fraud, the judgment of the board of directors is "conclusive as to the adequacy of the consideration . . . received" for options. Id., 505(h). This assumes, of course, that if the shareholders set the standard for consideration the Board complies with that standard.

10 Zupnick v. Goizueta, Mem. Op. at 12.

11 Id. at 13.

12 Steiner v. Meyerson, Mem. Op. at 2.

13 Id. at 13-14.