Backdating Scandal Continues to Spread; Employee Suits Expected

Over 100 companies are now reported to be under investigation, internally or by the SEC, for backdating their stock options (recording the grant date as being a prior date when the stock price was low) or "spring-loading" their options (issuing options just before issuing good news). The story continues to make daily appearances in the press. One issue that has not gotten a lot of attention (but will next year, we suspect) is employees suing companies over tax problems that backdating creates. Alisa Baker, coauthor of the NCEO's forthcoming book The Law of Equity Compensation, says that these lawsuits could be one of the biggest backdating headaches companies will face. She notes that many employees will be facing large new tax bills for a variety of possible reasons. Some employees, for instance, may end up with taxes under the new Section 409A deferred compensation rules. Unless plans are amended by the end of the year, any unexercised options granted at less than fair market value will not be exempt from the rule, requiring substantial additional taxation. Other employees will find the IRS asking them to pay back taxes, penalties, and interest because they reported their option grants as incentive options but, because the awards were granted with a discount, must now be treated as nonqualified options. If these employees also paid the Alternative Minimum Tax, they likely will only be able to regain that payment slowly, if at all. Employees who face these bills will no doubt sue their employers if the amounts are substantial enough.

Many of the problems with options can be avoided if companies grant them on a regular, pre-set schedule, and give smaller awards more frequently. By doing his, some of the volatility that can make options a very imprecise incentive can be averaged out over time.