A Sequel to the Options Scandal?

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The maximum gains that could be transformed from ordinary income to capital gains by the maneuver would be the difference between the value of the shares on the day the options were reportedly exercised and the date the transaction was filed with the SEC.

Bettis cautions that it's impossible to tell through public records alone precisely what happened with any individual trade. But in many cases, he believes, the trading patterns ought to raise serious questions. Consider E*Trade's Cotsakos. He reported exercising options for 1.75 million split-adjusted shares on May 24, 2000; that day, the stock closed at 13.94 after plunging 32% in a week. By the time he filed with the SEC on June 5, shares had recovered 29%, to 17.94. According to Gradient, the stock's sharp rise during the timing lag could potentially have allowed Cotsakos to convert up to $7 million in stock proceeds from ordinary income into capital gains. And that was hardly his only lucky moment: On five other dates, Cotsakos picked the lowest day of the reporting month to exercise options on a total of 2.6 million more shares. E*Trade says numerous documents support the reported exercise dates of the transactions. A spokesperson for Cotsakos, who left the company in 2003, denies any wrongdoing and says contemporaneous documents reviewed show no evidence of any "looking back" to a prior date.

Such cases were far more common before Sarbanes-Oxley took effect. SEC economist David C. Cicero recently analyzed exercises by 8,141 executives at more than 3,000 companies between 1996 and 2005. Before SarbOx, some 29% of executives held on to shares after exercising options, and those who did tended to exercise at clear troughs in the stock price. In the 10 days before an exercise, their shares fell an average of 1.93%; in the 20 days after exercise, their shares rose an average of 4.72%.

Red Flags

That contrasts sharply with executives who sold shares right away; they tended to exercise near stock highs. And according to the study, the trough disappeared after SarbOx as executives had to start reporting stock transactions within two business days. Roughly 12% of such options exercises took place at the lowest price of the month pre-SarbOx; after Sarb­Ox, that figure dropped to 6.9%.

Another red flag in the study: Returns tended to be higher when more than one executive exercised options without selling shares on the same day, a pattern Gradient also found. Two Dell executives, for example, appear to have made well-timed exercises on June 1, 1998: Then-Chief Financial Officer Thomas J. Meredith exercised options for 320,000 split-adjusted shares, while Vice-Chairman Morton L. Topfer exercised 2.24 million options on a day when Dell shares hit 19.58 after a two-week slide. By the time the pair filed with the SEC on July 10, the stock had jumped above 25. For Topfer, the difference meant up to $12.6 million in gains may have become eligible for capital-gains treatment, while for Meredith, gains of up to $1.8 million might have gained the more beneficial rate. He exercised another 320,000 options on June 1, 1999, as shares hit an annual low of 33.06. By the time he reported it, on July 9, shares were up 29%. The potential benefit: up to $3.1 million in proceeds shifted to capital gains. Topfer has since left Dell and declined to comment. Meredith, who became acting CFO of Motorola (MOT) on Apr. 1, was unavailable for comment. Dell says it's confident the transactions occurred on the dates reported.

Charles W. Ergen, the founder and CEO of EchoStar, has benefited from well-timed trades, too. He reported exercising options for 428,704 split-adjusted shares on May 5, 1999, after shares fell 22% to bottom out at 11.06. By the time the SEC report was filed on June 10, shares had soared more than 50%. According to Gradient, up to $2.4 million may have been considered capital gains instead of ordinary income. Meanwhile, EchoStar's general counsel, David K. Moskowitz, reported exercising a combined 447,490 options on Dec. 1, 1999, and Jan. 6, 2000; both dates fell on the stock's monthly low. By the time they were reported, roughly five weeks later, the potential benefit was as much as $1.98 million in income transformed into capital gains. Neither Ergen nor Moskowitz were made available for comment. Robert F. Rehg, EchoStar senior vice-president, says some options were about to expire and had to be exercised, and adds that the company's records show all transactions were executed properly.

Sasseen is Washington bureau chief for BusinessWeek.