The SEC’s opinions regarding backdating and fraud were primarily due to the various tax rules that apply when issuing “in the money” stock options vs.the much different – and more financially beneficial – tax rules that apply when issuing “at the money” or "out of the money" stock options.
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In 2008, the long-term capital gain rate for individuals in the lowest two tax brackets (currently 5% and 15%) was further reduced to zero.
The controversy continued and in 2005, at the insistence of the SEC, the FASB modified the FAS123 rule to provide a rule that the options should be expensed as of the grant date.
Early exercises also have substantial penalties to the exercising employee.
From the supply side, the question is what motivates a firm to grant a backdated option, and from the demand side, what motivates an executive to demand (or, at the very least, accept) a backdated option?
Cases of backdating employee stock options have drawn public and media attention.
According to a study by Erik Lie, a finance professor at the University of Iowa, more than 2,000 companies used options backdating in some form to reward their senior executives between 19.
Second, we find that CEO compensation is curbed before union contract negotiations, especially when the compensation is discretionary and the unions have a strong bargaining position.
Third, we report that curbing CEO compensation mitigates the chance of a labor strike, thus providing a rationale for firms to pay CEOs less when facing strong unions.
Healy, “The effect of bonus schemes on accounting decisions,” Journal of Accounting and Economics 7, 85-107 (1985).
Those penalties are a) part of the "fair value" of the options, called "time value" is forfeited back to the company and b) an early tax liability occurs.
The SEC’s opinions regarding backdating and fraud were primarily due to the various tax rules that apply when issuing “in the money” stock options much different – and more financially beneficial – tax rules that apply when issuing “at the money” or "out of the money" stock options.