New option for employee options (covered call options) - 9 Aug 2009

By Robert N. Gordon



August 9, 2009

Until now, if the holder of employee options sold exchange traded
calls on the underlying stock, those call options were considered to be
written naked. Naked calls need a lot of collateral as margin, and if
the stock price increases, they require more margin. If the options are
considered to be covered-call options, as the recent rulings state,
then only the unexercised options are necessary as collateral.

Kudos to the folks at iOptions Group LLC in Chicago, who have been working on this for 10 years.

The
change potentially could clear the way for employees to sell covered
calls in the market and lock in some of the unrealized gains in their
unexercised employee options. Employees holding stock options can now
more easily capture the income available through the sale of call
options. The time premium associated with options is normally not
available to employees and is automatically lost upon early exercise of
the employee option. Note that the Securities and Exchange Commission
will allow this structure only if the employee options are vested.

I foresee two potential stumbling blocks to implementation.

First,
given the uncertificated nature of employee stock options, employees
will need the assistance of their employers to complete transactions.
Before the unexercised employee options can act as collateral, the
employer must sign an agreement that contracts the company to deliver
shares (if the employee exercises the option) only to the
broker-dealer, not to the employee. This agreement will also stop the
unexercised options from being pledged more than once.

The
employer also agrees to waive any forfeiture conditions that otherwise
might apply to the em-ployee options, as well as any transfer
restrictions that would preclude pledging of the employee options. In
addition, the employer will represent that the em-ployee options are
covered by an effective registration statement on Form S-8. If the
registration statement becomes ineffective, the em-ployer agrees that
it will notify the broker-dealer immediately. Until this process
becomes standard operating procedure, many employers are likely to balk
at these obligations.

The second stumbling block is tax.

The
majority of value in em-ployee options is in non-qualified stock
options that give rise to ordinary income when exercised. The potential
problem is a whipsaw if the underlying shares increase after the call
options are sold. As the stock increases, more ordinary income will be
generated upon exercise of the employee options. The economic trade-off
is a corresponding loss in the listed-call options — a capital loss.
The combination of large amounts of capital losses and a like amount of
taxable ordinary income can be deadly to those without capital gains.

We've
written before on the possibility of an individual's utilizing Internal
Revenue Code Section 1221, which was enacted so that corporations
hedging business risks in the normal course of their business aren't
saddled with capital losses when a business hedge goes against them.
The question is whether an individual can make a 1221 election when
placing a hedge.

It is rumored that a bank
re-quested a private ruling on this question but withdrew that request
upon learning that it was likely to be denied.

Some
comfort has been taken from a private-letter ruling that provided
guidance about the application of Section 1221 when a derivative is
used to hedge in the context of employee compensation. This ruling
involved an employer that offered employees deferred compensation based
on the performance of certain mutual funds. The employer identified the
corresponding investment as hedging transactions under Section 1221.
The ruling held that the deferred-compensation obligation was an
“ordinary obligation” and that the investment contracts qualified as
hedging transactions for purposes of Section 1221.

The
ruling also stated that the employer's deferred-compensation liability
is an “ordinary obligation” under Section 1221. Although em-ployee
options are an asset, not a liability, in the hands of an employee, the
same analysis could arguably apply.

Robert N.
Gordon is chief executive of Twenty-First Securities Corp. of New York
and an adjunct professor at New York University's Leonard N. Stern
School of Business. He can be reached at bob@twenty-first.com.

http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20090809/REG/308099986/1034/TAXES