Option Lies May Be Costly for Directors

For companies that played games with employee stock options, the possible penalties are growing. New rulings in Delaware indicate that directors would be personally liable if options were wrongly issued.

And the Internal Revenue Service has decided that employees who innocently cashed in backdated options in 2006 face a soaring tax bill. The agency has given companies two weeks to decide whether to pick up the tax for the workers.

That means directors must decide whether to spend corporate assets on bailing out workers, possibly angering shareholders, or leave the workers to shoulder huge tax bills.

In two rulings issued this month, Chancellor William B. Chandler III of the Delaware Chancery Court made it clear that the backdating of options was illegal. That was no surprise, but he went on to say that the same applied to “spring loading,” the practice of issuing options just before the release of good news.

“It is difficult to conceive of an instance, consistent with the concept of loyalty and good faith, in which a fiduciary may declare that an option is granted at ‘market rate’ and simultaneously withhold that both the fiduciary and the recipient knew at the time that those options would quickly be worth much more,” Chancellor Chandler wrote.

That decision creates the possibility of significant liability for directors, particularly those on compensation committees. Issuing options is an area over which they had specific authority.

And since the decisions came in suits filed by shareholders of Tyson Foods and Maxim Integrated Products, they open the way to similar suits by owners of other companies.

Chancellor Chandler’s opinions go well beyond anything that the Securities and Exchange Commission has said. The S.E.C. has denounced backdating, the practice of saying an option was issued earlier than it was, when the share price was lower. It has forced companies to restate financial results and pay penalties.

But on spring loading, the only official comments from the commission have come from its chief accountant, who said there was no need to revise accounting, and from one commissioner, Paul S. Atkins, who suggested that the practice was just fine with him.

“Isn’t the grant a product of the exercise of business judgment by the board?” he asked in a speech last year. “For example, a board may approve an options grant for senior management ahead of what is expected to be a positive quarterly earnings report. In approving the grant, the directors may determine that they can grant fewer options to get the same economic effect because they anticipate that the share price will rise. Who are we to second-guess that decision? Why isn’t that decision in the best interests of the shareholders?”

Chancellor Chandler, without mentioning Mr. Atkins, had an answer for him. It is possible that a decision to issue spring-loaded options “would be within the rational exercise of business judgment,” he wrote. But, he added, that could be true only if the decision were “made honestly and disclosed in good faith.” No such disclosures were made by spring-loading companies.

Chancellor Chandler’s opinion counts because Delaware is where most major companies are incorporated. He cleared the way for a suit against Tyson directors who approved options that appear to have been spring loaded, although that has not been proved.

He also ruled that companies could not use the statute of limitations to avoid such suits. Even if the options were issued years ago, the fact that the directors hid the practice means that they can be sued now, when the facts have come out.

The tax issue stems from a law that took effect in 2005 regarding deferred compensation. It was not aimed at backdated options, but the I.R.S. says it applies to them if they were vested — that is, if the employee got the right to exercise them — after the end of 2004. Options can vest up to five years after they are issued, so some old option grants are partly covered.

If a taxpayer exercised such an option in 2006, the effective tax rate rises from 35 percent of the profits to 55 percent, and interest penalties could make the figure even higher.

The I.R.S. gave companies until Feb. 28 to notify it if the company would pay the excess taxes for employees who exercised such options last year, and said the employees must be notified by March 15.

Directors of companies that issued backdated or spring-loaded options may now try to shift the blame. One can imagine directors contending they were deceived by executives or by corporate counsel, and that they, not the directors, should pay.

Personal liability, in other words, can concentrate a director’s mind.