A Sequel to the Options Scandal?

The SEC takes a harder look at executives who may have misreported the exercise date of stock options to cut their tax bills

by Jane Sasseen

For a few years in the late 1990s, former E*Trade Group (ETFC) Chief Executive Christos M. Cotsakos epitomized a new breed of fast-moving entrepreneur who propelled the dot-com boom. Combining brash tactics with great business timing, his aggressive "Boot your broker" ad campaign not only made online trading hip but also established E*Trade as a major player.

Turns out that's not the only way Cotsakos demonstrated good timing. On six separate occasions between 1998 and 2002, Cotsakos exercised stock options when E*Trade hit a monthly low, and he held on to the shares. At first glance, that hardly seems lucky: Executives usually try to exercise options near stock highs to pocket the biggest profits. But going for low exercise prices and holding the stock for a while could have enabled Cotsakos to slash the tax bill owed when he sold the shares.

Now questions loom as to whether such impeccable timing reflects mere good luck or something more. The Securities & Exchange Commission has intensified a probe begun last fall into allegations that executives may have taken advantage of loose reporting rules in place before the Sarbanes-Oxley Act of 2002 to fudge the dates on which they exercised options. By doing so, executives may have changed stock-sale proceeds on which they owed ordinary income taxes into capital gains, which were taxed at roughly half the rate. SEC enforcement head Linda C. Thomsen has called the practice, known as exercise backdating, "fraudulent," though in the one case that has come to court, the jury could not reach a verdict.

Tax Evasion?

Amid the broader scandal over options grants, exercise backdating has gotten relatively little attention. But signs are mounting that it may have been prevalent during the boom. A recent SEC study found strong statistical evidence of exercise backdating over those years, while an examination by equity researchers Gradient Analytics found more than 500 companies—including PC maker Dell (DELL) and satellite-TV provider EchoStar Communications (DISH)—at which executives exercised options on favorable dates. "It's not a random pattern we're seeing," says Gradient co-founder and finance professor Carr Bettis.

The lure was the difference between the tax rates on ordinary income and on capital gains. When executives exercise options, they usually sell the shares right away to lock in the gain between the option price and the current value; any such gains realized are subject to ordinary income taxes. For top-bracket individuals, that meant Uncle Sam took a 39.6% cut each year between 1997 and 2000 and 39.1% in 2001. Those taxes are triggered when the options are exercised, regardless of whether the person sells the shares. But if someone exercised options and held the shares for at least a year, the gains realized after the exercise date would be taxed at the much lower capital-gains rate—just 20% between 1997 and 2002. Backdating accomplishes two things: It lowers the amount of taxes paid at the outset, and it potentially converts some of the highly taxed income into more lightly taxed capital gains.

Exercise backdating could come back to bite companies suddenly forced to deal with correcting tax filings or restating their financial results. And for individuals, there's at least the possibility of criminal tax evasion and securities fraud charges if backdating is proven.

Opportune Delay

Before Sarbanes-Oxley took effect in August, 2002, executives didn't have to report their options exercises until the 10th day of the month following the transaction, so up to 40 days could pass between the reported exercise date and the SEC filing. Executives may have been able to look back and choose an opportune date—when the stock traded lower—to report they had exercised options.