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The Employee Ownership Update

Corey Rosen

August 14, 2006

(Corey Rosen)

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.

The New Pension Law and ESOPs

The new pension bill has only a limited impact on ESOPs. For the vast majority of ESOPs, the only significant impact is the new vesting rules. For contributions after 2006 (except for stock acquired by leveraged ESOPs with loans in place on September 26, 2005, where the old rules still apply for any plan year beginning before the earlier of the date the loan is fully repaid or the date on which the loan was scheduled to be repaid as of September 26, 2005), vesting must be completed after three years (for cliff vesting) or six years (for graded vesting). ESOP companies really should not lose any sleep over this change. Very few companies of any kind, but especially companies with already low turnover, have more than a tiny percentage of the workforce leaving in years four or five (for cliff vesting) or year seven. Employees who work for three years generally work for many more. The impact is so small, in fact, that most companies will want to apply the new rules to all contributions.

ESOP Participants More Engaged at Work

In a study of over 5,000 participants in nine ESOP companies, Robert Buchele, Douglas Kruse, and Joseph Blasi found that employees in ESOP companies appear to be more engaged than employees in general. The data come from a large survey of employees created by the National Bureau of Economic Research Shared Capitalism Project. Results are compared to data from a 2002 General Social Survey of employees.

The study found that 67.9% of employees in ESOP companies said they work mostly as part of a team, compared to 60.9% in the general survey. On a four-point scale, with 4 being strongly agree, employees in ESOP companies averaged 3.26 when asked how much direct influence they had in deciding how they do their jobs, compared to 2.88 for the general survey. One-third of the workers said they were involved in a work team (there was no comparable question from the general survey).

While the number of participants in the survey is large, the sample is small and may not be representative of the ESOP universe. The results were presented at the 18th annual meeting of the Society for the Advancement of Socio-Economics.

Author biography and other columns in this series

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