Introduction to Stock Options
Stock options are defined as contracts that grant the holder the right, but not an obligation, to buy or sell an underlying asset (e.g. stock) at a predetermined price (referred to as the “strike price”) on or before a specified date (the “expiration date”). Here is a key breakdown of the elements key concepts f stock options:
Types of Stock Options:
- Call Options: Grants the holder the right to buy the underlying asset at the strike price.
- Put Options: Grants the holder the right to sell the underlying asset at the strike price.
Key Elements of a Stock Option:
- Underlying Asset: The specific stock or other asset that the option contract is based on.
- Strike Price (Exercise Price): The predetermined price at which the holder can buy or sell the underlying asset.
- Expiration Date: The date when the option contract expires and becomes worthless if not exercised.
- Premium: The price paid by the option buyer to the option seller for the rights granted by the contract.
Intrinsic Value and Time Value:
- Intrinsic Value: The difference between the underlying asset’s current market price and the option’s strike price, representing the immediate profit potential if the option were exercised.
- Time Value: The additional value of an option above its intrinsic value, reflecting the potential for future price movements to make the option more profitable before expiration.
Stock Options in Investing:
- Speculation: Options can be used to leverage investment positions and potentially generate high returns (but also carry significant risk).
- Hedging: Options can be used to protect existing stock holdings against potential losses.
- Income Generation: Strategies like selling covered calls can generate income from option premiums.
Employee Stock Options:
- Compensation: Companies often grant stock options to employees as part of their compensation packages.
- Incentive and Non-qualified Stock Options: These have different tax implications and may have vesting schedules.
Risks and Benefits of Trading Stock Options
Benefits:
- Leverage: Control a large number of shares with a relatively small upfront investment.
- Flexibility: Implement various trading strategies based on market outlook.
- Potential for high returns: If the underlying asset moves favorably.
Risks:
- Limited lifespan: Options expire, and if not exercised, the premum is lost.
- Potential for total loss: If the underlying asset does not move in the desired direction.
- Complex strategies: Options trading can be complex, and some strategies carry significant risks.
Understanding Options Pricing:
- Current price of the underlying asset: Higher prices generally increase the value of call options and decrease the value of put options.
- Strike price: The relationship between the strike price and the current market price determines an option’s “moneyness” (whether it’s in-the-money, at-the-money, or out-of-the-money), which impacts its value.
- Time to expiration: Generally, options with longer times to expiration have higher premiums due to the increased probability of the underlying asset moving favorably.
- Implied volatility: Higher implied volatility (market expectation of future price fluctuations) typically leads to higher option premiums.
- Interest rates: Higher interest rates generally increase the value of call options and decrease the value of put options.
- Dividends: Expected dividends can affect option prices, as they reduce the stock price and potentially the value of call options.
Understanding these factors is essential for informed options trading.
How Stock Options Can Incentivize Greed
Stock options, while intended to align employee interests with company performance, can inadvertently incentivize greed and unethical behavior in several key ways:
Backdating Scandal:
The practice of repricing stock options (lowering the exercise price after a stock price decline) or backdating them (assigning an earlier, more favorable grant date) can undermine the intended incentive structure and create a sense of unfairness for shareholders who do not have the same privileges.
To say this unethical practice was prevalent in the late 1990s and early 2000s would be a monumental understatement. The backdating scandal affected more than 100 companies across nearly every industry. The backdating scandal resulted in many executive resignations, company restatements, and an estimated $10 billion in investor losses.
Additionally, the backdating scandal manipulated accouting rules and tax laws allowing companys to avoid correctly reporting executive compensation.
One study estimated that 29 percent of 7,774 companies surveyed backdated option grants to executives between 1996 and 2002, which is nearly 2,300 companies. Companies could observe the stock price fluctuations within the two-month reporting period. They would then grant the option and backdate it to a point within that period where the stock price was at its lowest. Then, the backdated grant date would be the official reported date to the U.S. Securites and Exchange Commission (SEC).
- Investigations and Enforcement: The SEC investigated more than 80 companies concerning their stock option practices. The Federal Bureau of Investigation (FBI) reported having 52 companies under criminal investigation. As of November 17, 2006, backdating was identified at more than 130 companies, leading to the resignation or firing of over 50 top executives and directors.
- Did executives give back all the money they made from the backdating scandal? Of course not. While numerous enforecement actions and shareholder derivative actions were filed, and while some executives were forced to return some of the ill-gotten gains from backdated stock options, it was not a universal requirement or outcome by a long-shot. It should be noted hat quantifying the exact amount of “ill-gotten gains” from the backdating scandal was extremely complex, and settlements often involve various other factors beyond simply returning all the money made from the options such as enhancements to corporate governance.
- Disgorgement and fines: In cases where executives were found to have engaged in backdating, settlements or judgments often included disgorgement (returning the improper gains) and civil penalties. For example, the former CEO of UnitedHealth Group, William McGuire, settled a backdating case by paying a record $468 million in civil penalties and restitution. Apple’s former General Counsel, Nancy Heinen, also agreed to pay $2.2 million in disgorgement, interest, and penalties without admitting or denying guilt..
In conclusion, while some executives involved in the stock option backdating scandal were forced to return a portion of their profits through settlements and judgments, it was not a blanket requirement that all money was given back, and it was not even close. the Sarbanes-Oxley Act, enacted in 2002, significantly curtailed the unethical practice of options backdating by requiring timely reporting of option grants.
Short-Term Focus and Risk-Taking:
The potential for large financial gains from stock options, especially if the stock price rises significantly, can encourage executives to prioritize short-term results over long-term sustainability and ethical practices. This can lead to decisions that boost the stock price temporarily, even if they ultimately harm the company or its stakeholders, a blatent breach of the duty of loyalty.
A breach of the duty of loyalty occurs when a corporate director or officer places their personal interests ahead of the interests of the corporation and its shareholders. This fiduciary duty is a cornerstone of corporate governance, designed to ensure that those in positions of power act for the collective benefit of the company and its investors.
Other examples of a breach of the duty of loyalty include:
- Self-dealing: Engaging in transactions where a director or officer benefits personally at the expense of the company. For instance, awarding contracts to a business they personally own without proper disclosure and approval. This is a breach of the duty of loyalty.
- Usurping corporate opportunities: Taking advantage of a business opportunity that rightfully belongs to the corporation for personal gain. For example, if a director learns about a lucrative opportunity and pursues it for themselves instead of presenting it to the board.
- Misappropriating corporate assets or funds: Using company resources or funds for personal use. This could include embezzlement or fraud.
- Engaging in a competing business venture: Acting on behalf of a competitor or diverting business opportunities away from the corporation to a competing entity in which the director or officer has a personal interest.
- Insider trading: Using confidential company information for personal financial benefit by trading the company’s stock. This would include selling or shorting stock based on non-public negative information, or buying stock based on non-public positive news
To prevent a breach of the duty of loyalty, it is iperativefor directors and officers to:
- Disclose any potential conflicts of interest to the board of directors and, in some cases, to shareholders.
- Recuse themselves from decisions where they have a conflict of interest.
- Present any corporate opportunities to the board for evaluation before pursuing them personally.
By understanding and upholding the duty of loyalty, corporate leaders can ensure they are acting in the best interests of the company and its shareholders, fostering trust and promoting strong corporate governance.
Earnings Manipulation:
Stock options can create an incentive for executives to commit violations of the federal securites laws by manipulate financial statements or engage in other forms of unethical behavior to artificially inflate the company’s reported earnings and, consequently, the stock price. This can result in misleading information for investors and a distorted view of the company’s true performance. When the truth finally emerges through a collective disclosure, the stock price plummets, and sharehoders suffer portfolio decimation. More more on the subject look up “Enron” or “Worldcom” scandals.
High CEO Vega:
A high CEO “vega,” meaning their wealth is highly sensitive to stock price volatility, can encourage riskier decision-making, including those that may have negative ethical implications within the workplace. This can manifest as cost-cutting measures that compromise employee safety or increased workloads, leading to a decline in workplace integrity.
Reducing Safety-Related Spending:
In an effort to cut costs and improve short-term profitability, executives might reduce spending on safety protocols or equipment, potentially endangering employees, and violating numerous laws including a breach of the duty of loyalty, the highest duty imposed under the law.
Increasing Employee Workloads:
To maximize productivity and drive up earnings, executives might impose unrealistic workloads on employees, potentially leading to stress, burnout, and unethical behavior.
Key Takeaways
- The backdating scandal involved executives falsifying stock option grant dates to increase their compensation illegally.
- The practice exploited accounting rules and tax code loopholes, allowing companies to avoid properly reporting executive compensation.
- Academic studies and investigative journalism ultimately exposed the backdating scandal..
- The scandal resulted in many executive resignations, company restatements, and an estimated $10 billion in investor losses.
- New regulations were put in place requiring prompt reporting of option grants and proper expense accounting to prevent future abuses.
Conclusion
In conclusion, it should be noted that, while stock options can incentivize greed, they are also can be a valuable tool for motivating employees and aligning their interests with the long-term success of the company when used appropriately. Additionally, robust governance and oversight practices, along with strong ethical leadership, can mitigate the risks associated with stock options and ensure they are used to promote responsible and sustainable corporate behavior
Contact Timothy L. Miles Today for a Free Case Evaluation
If you believe you suffered losses as a shareholder by corporate misconduct, or just have general questions about you rights as a shareholder, please contact attorney Timothy L. Miles of the Law Offices of Timothy L. Miles, at no cost, by calling 855/846-6529 or via e-mail at [email protected]. (24/7/365).
Timothy L. Miles, Esq.
Law Offices of Timothy L. Miles
Tapestry at Brentwood Town Center
300 Centerview Dr. #247
Mailbox #1091
Brentwood,TN 37027
Phone: (855) Tim-MLaw (855-846-6529)
Email: [email protected]
Website: www.classactionlawyertn.com
