Backdated Options

On Feb. 8, 2007, the Internal Revenue Service ('IRS') made an usual offer to employers: on very short notice ' by Feb. 28, 2007, employers could inform the IRS of their intent to pay the back taxes and penalties owed by (non-insider) employees who exercised stock options with 'an exercise price of less than fair market value of the underlying stock on the date of grant in 2006.' See IRS Announcement 2007-18 ('Corporate Resolution Program For Employees Other Than Insiders For Additional 2006 Taxes Arising Under '409A due to the Exercise of Stock Options') ('Announcement 2007-18' or 'Program'). Under this Program, companies with backdated options programs were 'allowed' to calculate and pay, by June 30, 2007, on behalf of their employees who exercised such options, a 20% penalty tax, and an additional 1% interest on underpayments, owed by such employees under ' 409A of the Internal Revenue Code ('IRC').

If your company is taking the IRS up on the offer, you will have the satisfaction of knowing that you can pay taxes that your employees, not the company, really owe. The amounts you pay on your employees' behalf will be included in the employees' gross incomes for 2007, as they would have been if the IRS Announcement 2007-18 had not been issued. And you will have openly alerted the IRS, and possibly the Securities and Exchange Commission, to the fact that your stock options program has historically included (if it does not still include) backdated or 'in the money' options. And certainly you will have saved the IRS a lot of paperwork by calculating what is owed by each employee who exercised such options last year. I hope for your sake that this does not result in a time-consuming and troublesome audit or other investigation of the entire company's backdating practices.

But it is doubtful that many ofthe readers of this article signed up for the Program provided for in Announcement 2007-18. Even though the Feb. 28, 2007, 'deadline' set in the Program has passed, you can still pay such taxes for your employees, or pay them a 'gross-up' bonus or other compensation in an amount equal to the what they owe for such taxes, as you could have before the Program was announced. So the IRS wasn't really giving you a break ' in substance the 'Program' was a bogus inducement to get you to do what you could have done anyway, and still can do.

Should Backdated Options Taxes Be Paid to Corporate Insiders?

Assuming that your company did not take advantage of the opportunity presented in Announcement 2007-18, if your company has made grants of backdated options, and you have not paid the taxes of your employees who have exercised such options, then you still have the problem addressed by the IRS Program, i.e., your employees will face tax liabilities that may be both unexpected and financially burdensome. Is the company going to step in to help by paying these taxes for their employees, or by 'grossing-up' up their compensation to help them meet these obligations? And if so, should the company do so for all employees who have exercised backdated options, or just selected groups of such employees, as suggested in the IRS Program?

In Announcement 2007-18, a distinction is made between those who are 'corporate insiders,' whom the IRS said were not eligible for the Program, and those who are 'not subject to the disclosure requirements of the Securities Exchange Act of 1934,' who were said to be eligible. As the IRS said in a Press Release (IR-2007-30), the Program was 'aimed at providing relief for rank-and-file employees' and was intended to assist such employees 'who might be unaware that they held backdated options.' According to the same Press Release, however, the Program was not to be made available to 'most corporate executives or other insiders.' Oddly, although the Announcement suggests that it would be improper to pay the ' 409A taxes for such 'corporate insiders,' no law or regulation prohibiting such action is cited. Considering this, is there any reason to believe that paying such taxes for 'corporate insiders' is unlawful, or even ill-advised, from the standpoint of public relations or the financial health of the company?

The answers to these questions may well depend on: 1) who made the decision to implement the company's stock option plan; 2) who devised the plan so that stock options could be backdated; and 3) who will be deciding whether the company pays the taxes of corporate insiders. Did these decision makers receive options that were backdated? Do they have personal conflicts of interest versus the interests of the shareholders? And, from a public relations standpoint, how will it look to shareholders and potential investors when it becomes known that the company will be paying or has paid the backdated options taxes of such insiders?

An Environment Hostile to Backdated Options

Certainly, a company can have defensible reasons for wanting to help rank and file employees who in selling their stock may not have been aware that they would be subject to a 20% penalty tax on top of other taxes and interest. Such unexpected liability could be demoralizing if not financially debilitating. But public perception is another matter, especially if the company's payment of such taxes primarily benefits corporate insiders.

No one who reads the business or financial pages of today's mainstream press can be unaware of the attention given to options backdating issues. In many news articles and bylines, there is an implicit suggestion that backdating of options is inherently immoral and perhaps illegal per se. While that is certainly not an accurate picture of the legal landscape, and it may be lost on some that fully disclosed options compensation programs that utilize backdating can be entirely proper and lawful, the current climate is one in which such compensation plans are given extremely close scrutiny, to say the least. And, for better or worse, the public perception of such plans is extremely negative. Careers have been ruined, and the stock prices of otherwise financially sound companies have plummeted, based on mere suspicion that all was not above board with respect to backdating programs. Indeed, boards of directors of well known companies have come under direct public challenges from shareholder groups (including in some cases, organized campaigns to oust directors from office) who are concerned about what is perceived to be inappropriate compensation of senior executives.

Moreover, some courts have not been kind to corporations that have employed backdating practices. On Feb. 6, 2007, two days before the IRS issued Announcement 2007-18, Chancellor Chandler of the highly influential Delaware Chancery Court decided the case of Ryan v. Gifford. In Ryan, members of the board of directors of Maxim Integrated Products, Inc. were accused of breaching their fiduciary duties to shareholders by approving backdating programs alleged to be in contravention of previously approved stock option plans. In denying the defendants' motion to dismiss these claims, the court merely allowed the case to go forward to an evidentiary stage. Nevertheless, the language used by the court in its opinion to describe its assumptions about backdated options should give pause to any employer considering the use of such options as part of an executive compensation plan: 'Backdating options qualifies as one of those rare cases [in which] a transaction may be so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability exists.'

The Better Part of Valor

It is easy to make light of Announcement 2007-18. Perhaps it was only a 'politically correct' pronouncement by a government agency that did not wish to appear to approve of backdated options. And it may well be that a company can lawfully pay the backdating options taxes of its corporate insiders, even if such key executives would benefit significantly more from such a decision than the rank and file employees who exercise such options. In some companies, the same key management insiders who already have benefited most from backdated options plans may also be urging, if not insisting, on implementation of a tax payment plan from which they would benefit most.

But is it worth the risk? Win, lose, or draw, shareholder derivative suits such as the Ryan case can be enormously expensive for companies and, rightly or wrongly, for their shareholders. And, to use the language of the court in Ryan, at what point does a backdating 'scheme' (as it likely will be called) become so 'egregious' that there is an issue of fact for a jury as to whether approval of the plan by the board of directors or other insiders is a breach of fiduciary duty? And if such a case gets to a jury, what is the likelihood of a favorable outcome for the company in today's political atmosphere?

Many otherwise knowledgeable people either do not understand, or will not accept, the idea that the backdating of stock options can possibly be legitimate. Even the courts appear to be buying into such thinking, or at least such rhetoric, e.g., in the Tyson Foods Inc. (also decided Feb. 6, 2007) derivative shareholder litigation, the Delaware Chancery Court expressed the view that '[a]t their heart, all backdated options involve a fundamental, incontrovertible lie: directors who approve an option dissemble as to the date on which the grant was actually made.' (Emphasis added.)

Perhaps your company can arrange matters so that the backdated options taxes of your key insiders can be lawfully paid. But who will make the decision? Will the decision be made by insiders who will not personally benefit? And if so, can it be done in such a way that it will not further incense shareholders who are already suspicious of backdated options programs? Can such a tax payment program be crafted so that it will be defensible in the courts and to the investing public as a legitimate exercise of business judgment? Will key officers and directors put themselves, or let themselves be put by others, in positions which ultimately require them to step down, if only for reasons of shareholder relations?

Some companies may decide that the better part of valor is to leave matters as they stand, and let employees, especially insiders, pay their own taxes. Others may decide to go even further, devising compensation plans for the future that are more transparent and less likely to arouse suspicion or resentment. For the future, they may even eliminate backdated options altogether.

John B. Gamble, Jr., is a partner in the Atlanta office of Fisher & Phillips LLP, a management-side labor and employment law firm.

On Feb. 8, 2007, the Internal Revenue Service ('IRS') made an usual offer to employers: on very short notice ' by Feb. 28, 2007, employers could inform the IRS of their intent to pay the back taxes and penalties owed by (non-insider) employees who exercised stock options with 'an exercise price of less than fair market value of the underlying stock on the date of grant in 2006.' See IRS Announcement 2007-18 ('Corporate Resolution Program For Employees Other Than Insiders For Additional 2006 Taxes Arising Under '409A due to the Exercise of Stock Options') ('Announcement 2007-18' or 'Program'). Under this Program, companies with backdated options programs were 'allowed' to calculate and pay, by June 30, 2007, on behalf of their employees who exercised such options, a 20% penalty tax, and an additional 1% interest on underpayments, owed by such employees under ' 409A of the Internal Revenue Code ('IRC').

If your company is taking the IRS up on the offer, you will have the satisfaction of knowing that you can pay taxes that your employees, not the company, really owe. The amounts you pay on your employees' behalf will be included in the employees' gross incomes for 2007, as they would have been if the IRS Announcement 2007-18 had not been issued. And you will have openly alerted the IRS, and possibly the Securities and Exchange Commission, to the fact that your stock options program has historically included (if it does not still include) backdated or 'in the money' options. And certainly you will have saved the IRS a lot of paperwork by calculating what is owed by each employee who exercised such options last year. I hope for your sake that this does not result in a time-consuming and troublesome audit or other investigation of the entire company's backdating practices.

But it is doubtful that many ofthe readers of this article signed up for the Program provided for in Announcement 2007-18. Even though the Feb. 28, 2007, 'deadline' set in the Program has passed, you can still pay such taxes for your employees, or pay them a 'gross-up' bonus or other compensation in an amount equal to the what they owe for such taxes, as you could have before the Program was announced. So the IRS wasn't really giving you a break ' in substance the 'Program' was a bogus inducement to get you to do what you could have done anyway, and still can do.

Should Backdated Options Taxes Be Paid to Corporate Insiders?

Assuming that your company did not take advantage of the opportunity presented in Announcement 2007-18, if your company has made grants of backdated options, and you have not paid the taxes of your employees who have exercised such options, then you still have the problem addressed by the IRS Program, i.e., your employees will face tax liabilities that may be both unexpected and financially burdensome. Is the company going to step in to help by paying these taxes for their employees, or by 'grossing-up' up their compensation to help them meet these obligations? And if so, should the company do so for all employees who have exercised backdated options, or just selected groups of such employees, as suggested in the IRS Program?

In Announcement 2007-18, a distinction is made between those who are 'corporate insiders,' whom the IRS said were not eligible for the Program, and those who are 'not subject to the disclosure requirements of the Securities Exchange Act of 1934,' who were said to be eligible. As the IRS said in a Press Release (IR-2007-30), the Program was 'aimed at providing relief for rank-and-file employees' and was intended to assist such employees 'who might be unaware that they held backdated options.' According to the same Press Release, however, the Program was not to be made available to 'most corporate executives or other insiders.' Oddly, although the Announcement suggests that it would be improper to pay the ' 409A taxes for such 'corporate insiders,' no law or regulation prohibiting such action is cited. Considering this, is there any reason to believe that paying such taxes for 'corporate insiders' is unlawful, or even ill-advised, from the standpoint of public relations or the financial health of the company?

The answers to these questions may well depend on: 1) who made the decision to implement the company's stock option plan; 2) who devised the plan so that stock options could be backdated; and 3) who will be deciding whether the company pays the taxes of corporate insiders. Did these decision makers receive options that were backdated? Do they have personal conflicts of interest versus the interests of the shareholders? And, from a public relations standpoint, how will it look to shareholders and potential investors when it becomes known that the company will be paying or has paid the backdated options taxes of such insiders?

An Environment Hostile to Backdated Options

Certainly, a company can have defensible reasons for wanting to help rank and file employees who in selling their stock may not have been aware that they would be subject to a 20% penalty tax on top of other taxes and interest. Such unexpected liability could be demoralizing if not financially debilitating. But public perception is another matter, especially if the company's payment of such taxes primarily benefits corporate insiders.

No one who reads the business or financial pages of today's mainstream press can be unaware of the attention given to options backdating issues. In many news articles and bylines, there is an implicit suggestion that backdating of options is inherently immoral and perhaps illegal per se. While that is certainly not an accurate picture of the legal landscape, and it may be lost on some that fully disclosed options compensation programs that utilize backdating can be entirely proper and lawful, the current climate is one in which such compensation plans are given extremely close scrutiny, to say the least. And, for better or worse, the public perception of such plans is extremely negative. Careers have been ruined, and the stock prices of otherwise financially sound companies have plummeted, based on mere suspicion that all was not above board with respect to backdating programs. Indeed, boards of directors of well known companies have come under direct public challenges from shareholder groups (including in some cases, organized campaigns to oust directors from office) who are concerned about what is perceived to be inappropriate compensation of senior executives.

Moreover, some courts have not been kind to corporations that have employed backdating practices. On Feb. 6, 2007, two days before the IRS issued Announcement 2007-18, Chancellor Chandler of the highly influential Delaware Chancery Court decided the case of Ryan v. Gifford. In Ryan, members of the board of directors of Maxim Integrated Products, Inc. were accused of breaching their fiduciary duties to shareholders by approving backdating programs alleged to be in contravention of previously approved stock option plans. In denying the defendants' motion to dismiss these claims, the court merely allowed the case to go forward to an evidentiary stage. Nevertheless, the language used by the court in its opinion to describe its assumptions about backdated options should give pause to any employer considering the use of such options as part of an executive compensation plan: 'Backdating options qualifies as one of those rare cases [in which] a transaction may be so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability exists.'

The Better Part of Valor

It is easy to make light of Announcement 2007-18. Perhaps it was only a 'politically correct' pronouncement by a government agency that did not wish to appear to approve of backdated options. And it may well be that a company can lawfully pay the backdating options taxes of its corporate insiders, even if such key executives would benefit significantly more from such a decision than the rank and file employees who exercise such options. In some companies, the same key management insiders who already have benefited most from backdated options plans may also be urging, if not insisting, on implementation of a tax payment plan from which they would benefit most.

But is it worth the risk? Win, lose, or draw, shareholder derivative suits such as the Ryan case can be enormously expensive for companies and, rightly or wrongly, for their shareholders. And, to use the language of the court in Ryan, at what point does a backdating 'scheme' (as it likely will be called) become so 'egregious' that there is an issue of fact for a jury as to whether approval of the plan by the board of directors or other insiders is a breach of fiduciary duty? And if such a case gets to a jury, what is the likelihood of a favorable outcome for the company in today's political atmosphere?

Many otherwise knowledgeable people either do not understand, or will not accept, the idea that the backdating of stock options can possibly be legitimate. Even the courts appear to be buying into such thinking, or at least such rhetoric, e.g., in the Tyson Foods Inc. (also decided Feb. 6, 2007) derivative shareholder litigation, the Delaware Chancery Court expressed the view that '[a]t their heart, all backdated options involve a fundamental, incontrovertible lie: directors who approve an option dissemble as to the date on which the grant was actually made.' (Emphasis added.)

Perhaps your company can arrange matters so that the backdated options taxes of your key insiders can be lawfully paid. But who will make the decision? Will the decision be made by insiders who will not personally benefit? And if so, can it be done in such a way that it will not further incense shareholders who are already suspicious of backdated options programs? Can such a tax payment program be crafted so that it will be defensible in the courts and to the investing public as a legitimate exercise of business judgment? Will key officers and directors put themselves, or let themselves be put by others, in positions which ultimately require them to step down, if only for reasons of shareholder relations?

Some companies may decide that the better part of valor is to leave matters as they stand, and let employees, especially insiders, pay their own taxes. Others may decide to go even further, devising compensation plans for the future that are more transparent and less likely to arouse suspicion or resentment. For the future, they may even eliminate backdated options altogether.

John B. Gamble, Jr., is a partner in the Atlanta office of Fisher & Phillips LLP, a management-side labor and employment law firm.