Hedging ESOs by writing calls compared with early exercise of ESOs

 
This article is meant to make grantees aware of the method of managing the granted  ESOs to maximize the value to themselves.

The 4 paragraphs below assume the specific terms of examples of NQESOs (Non-Qualified Employee Stock Options) that we analyze.

A. Non Qualified ESOs to buy 10,000 shares are granted which have an exercise price of $20.00 with an expiration day of 7 years (2555 days) later. The ESOs vest in 2 years.

B. The assumed interest rate is 3.30%, and the volatility is .35, with no dividend payable. The theoretical value of the granted ESOs is approximately $8.50 per share, making the total value of the grant $85,000.

C. Assume that the NQESOs are held for 3 years and the stock
is now trading at $40.00 with the volatility and interest rate remaining the same with no dividend.

D. Assume the theoretical value of exchange traded calls with 3 years to expiration with an exercise price of $40.00 is approximately $11.00.
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Below is a Comparison of methods of managing the position after a 100% increase in the stock:

Method 1 : Assume the grantee exercises the NQESOs when the stock is trading for $40.00 after 3 years from the grant day. Assume the grantee then sells 50% of the stock to pay the tax in California and other charges and the grantee sells other shares to pay the exercise price to the issuer.

The value of the stock is $400,000 when the NQESOs are exercised, the exercise price is $200,000 making the grantee's profit $200,000.

The tax is approximately $100,000.00 in California and the grantee nets $100,000 cash if the stock is immediately sold for $40.00 per share. There is no alignment with the issuer after the exercise, unless the grantee holds onto the 2500 remaining shares.

The theoretical "time value" above the "intrinsic value" upon exercise is equal to about $22,000 which is forfeited to the issuer upon the early exercise three years after the grant.
                                                        

Method 2 : Assume the grantee after 3 years, instead of exercising early, writes (sells) 100 calls expiring in 3 years with the strike price of $40.00 when the stock trading at $40.00. The grantee would receive $110,000 cash that is not taxable when written, but would be taxable as short term capital gain if the calls are out-of-the-money at the expiration of the calls. The tax is payable in the year following the  expiration of the written calls .

The "delta" (the equivalent stock position) of the combined long ESOs and the short calls is approximately +3500 after the calls are written. So the alignment of the grantee is +3500 , given the two positions added together.

So after the call writes, the grantee receives $110,000 and has a an substantial alignment with the company that is greater than the alignment he would have if he exercised early, paid the tax and the exercise price with shares sold and held the 2500 shares of stock and received no cash.

Method 3 : Assume the stock advances to $55.00, 3 years after the call write with the calls expiring and the NQESOs with one year left to expiration. The calls with the $40.00 exercise price would be worth each $15.00 giving a short term capital loss of $40,000.

But if the ESOs were exercised, the stock value would be equal to $550,000, making the net gain $350,000 on the ESOs with a net gain after tax, if exercised, of approximately $175,000. The short term capital loss of the $40,000 is deductible the following year, with a tax credit of perhaps $16,000, thereby reducing the after tax profit of $175,000 to $151,000.

Method 4 : If the ESOs were exercised after the first three years and the shares were held after for 3 more years  having paid the exercise price and taxes with shares, the 2500 shares would be worth 2500 x $55 = $137,000 with a capital gain tax due on the $15 gain per share on the 2500 shares if sold. This would make the net profit about $129,000.                                            

 Method 5 : If the written calls were out-of-the money when written instead of at-the-money, the profit overall would be somewhat less if the stock was unchanged or decreased over time. But the results would in total be better if the stock advanced after the out-of-the-money call write, thereby maintaining the alignment with the company much longer than would be the case if the exercise was made after 3 years.

Method 6 : If the stock decreased from $40.00 to $30.00 three years after writing the calls when the stock was $40.00, the gains from the call writes  and holding the ESOs far out-weigh the gains from early exercise and sales or early exercise and holding the stock. And the alignment with the issuer is greater for holding the ESOs and writing the calls than early exercise pay taxes and hold or early exercise pay the tax and sell stock.

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In summary, it is almost always better after vesting with the stock having increased 100% in 3 years for the grantee to write calls rather than exercise early. It generates immediate cash and no immediate taxes. And doing so extends the alignment with the company longer and reduces the risk to the grantee.

So why do the issuers often prohibit writing calls by employees and executives? The answer is that the designers of the plans know that early exercises of NQESOs allow the issuer to recoup the remaining time value of the ESOs, thereby reducing the costs to the issuer, notwithstanding that early exercises result in less alignment as the owners of the ESOs upon exercise generally sell all or most of the net stock position.

Below is an SEC Release illustrating that holders of vested Employee Stock Options can efficiently write calls to reduce risk without advancing cash for margin.

SECURITIES AND EXCHANGE COMMISSION
(Release No. 34-60127; File No. SR-ISE-2007-121)
June 17, 2009 Self-Regulatory Organizations; International Securities Exchange, LLC; Order Granting Approval to a Proposed Rule Change, as Modified by Amendment No. 1, Relating to Margin Requirements

I. Introduction:

On December 24, 2007, pursuant to Section 19(b)(1) of the Securities Exchange Act of1934 (the "Act"),1 and Rule 19b-4 thereunder,2 the International Securities Exchange, LLC (the Exchange" or "ISE") filed with the Securities and Exchange Commission (the "Commission") a proposed rule change to modify its margin requirements to facilitate, under certain circumstances, the ability of account holders to use vested and currently exercisable compensatory employee stock options ("Vested Employee Options") issued by publicly traded companies as collateral for writing call options that have the same underlying security as the Vested Employee Options. On April 29, 2009, ISE filed Amendment

No. 1. The proposed rule change was published for comment in the Federal Register on May 13, 2009.3 The Commission received no comments on the proposed rule change.

II. Description

 
The Exchange proposes to amend its margin requirements to facilitate, under certain circumstances, the ability of account holders to use Vested Employee Options issued by publicly traded companies ("Issuers") as collateral for writing call options that have the same underlying security as the Vested Employee Options.

Specifically, the proposal would allow accountholders to sell, as a hedge, listed equity call options on the same underlying security as the account holder's Vested Employee Options without the requirement of margin (the "Transactions"). The proposal would permit account holders to engage in the Transactions using their Vested Employee Options as collateral. Currently, such Transactions would be deemed "naked" for purposes of margin rules and subject to a deposit of cash margin, effectively making the strategies cost prohibitive and impractical.

The Exchange believes that enabling employees who hold Vested Employee Options to generate income and liquidity on their otherwise illiquid asset through the listed options markets will benefit investors by providing greater transparency and liquidity.

Under Section 220.12(f)(1) of Regulation T,4 the Exchange, as a registered national securities exchange, is permitted to recognize the type of transactions described below as eligible for margin treatment subject to the approval of the Commission.

The proposal would permit account holders to sell listed call options on the same security that underlies their Vested Employee Options without the requirement of margin. Given the un-certificated nature of employee stock options, in order to secure the account holder's obligations under the Transactions, the proposal would require:

 
1. The account holder to (A) pledge the Vested Employee Options to the broker-dealer and (B) provide the broker-dealer with an irrevocable power-of-attorney authorizing the broker-dealer to exercise the Vested Employee Options on the account holder's behalf if the listed call options are assigned or if the broker-dealer determines it is necessary. The irrevocable power-of-attorney may also be used in the event the account holder wishes to close the listed option position prior to its expiration and instructs the broker-dealer to exercise that number of Vested Employee Options necessary to cover the cost of the closing purchase (the account holder will also have the option of depositing additional cash in the account holder's account to cover the cost of the closing purchase).

2. In the event the Vested Employee Options are exercised between the date of the Transaction in the listed call options (the "Commencement Date") and the date the Transaction is closed (the "Closing Date"), the shares issued upon exercise will be pledged to the broker-dealer (thereby replacing the Vested Employee Options that had been pledged prior to exercise). For example, during the time a Transaction is pending, the account holder may resign from the account holder's employment with the Issuer and may be required to exercise the Vested Employee Options within a certain timeframe following the account holder's departure. In such a scenario, the account holder would ask the broker dealer to exercise the Vested Employee Options and the stock issued pursuant to the exercise would be pledged to the broker-dealer.

3. The Issuer will promptly deliver the stock upon payment or receipt of the exercise notice from the broker-dealer.The Issuer will also agree prior to the Commencement Date to waive any forfeiture conditions that otherwise might apply to the Vested Employee Options (e.g., upon a termination of the account holder's employment with the Issuer) as well as any transfer restrictions that would preclude pledge of the Vested Employee Options to the broker-dealer. In addition, the Issuer will represent that the Vested Employee Options are covered by an effective registration statement on Form S-8. If the registration statement becomes ineffective the Issuer will notify the broker-dealer immediately.

The Exchange will proscribe a set delivery period, which is expected to be no later than three business days following assignment of the listed options.

4. Because it is essential that the account holder, broker-dealer and Issuer cooperate and are each fully informed, agree to and acknowledge their own and each other's responsibilities, all Transactions will be governed by an agreement (the "Agreement") entered into by the account holder, broker-dealer and Issuer prior to the Commencement Date of the first transaction. The Agreement would generally set forth each party's obligations, representations and acknowledgements and the terms and conditions governing the Transactions and must be ina form acceptable to the Exchange.

 
5. Such other terms and conditions prescribed by the Exchange in accordance with such form, formats and procedures as may be established by the Exchange from time to time would also apply. In this regard, upon approval of the proposed rule change and for a period of one year, the Exchange will require that, prior to the Commencement Date, a legal opinion with respect to the account holder's and Issuer's legal right to enter into the Transactions under the terms of the Issuer's employee stock option plan and related documents (the "Legal Opinion") be obtained in a form acceptable to the Exchange. During the one-year time period, the Exchange may determine that such Legal Opinion is no longer necessary and will revise its established forms, formats and procedures accordingly.

 
III. Discussion and Commission's Findings

 
After careful review of the proposed rule change and ISE's response, the Commission finds that the proposed rule change is consistent with the requirements of the Act and the rules and regulations thereunder applicable to a national securities association. 
6 In this regard, the Exchange currently intends to recognize the Master Vested Stock Option Monetization Agreement, created by iOptions Group, LLC, as one acceptable agreement.
7 In approving this proposal, the Commission has considered the proposed rule's impact on efficiency, competition, and capital formation. See 15 U.S.C. 78c(f).

In particular, the Commission finds that the proposed rule change is consistent with Section 6(b)(5),8 in that the proposed rule change is designed to prevent fraudulent and manipulative acts and practices, promote just and equitable principles of trade, remove impediments to and perfect the mechanisms of a free and open market and a national market system, and, in general, to protect investors and the public interest. The proposed rule change will offer market participants new trading opportunities and will enhance the Exchange's competitive position.
The Commission believes that the proposed rule change to amend the Exchange's margin rule should be allowed. However, the Commission does have significant concerns with the amount of control each broker-dealer has over the Vested Employee Options. One purpose of the margin rules is to protect broker-dealers in the event of market turmoil. The broker-dealer must have enough control over the cash or securities it is holding as margin on behalf of investors to be able to act unilaterally to protect itself. With Vested Employee Options, the broker-dealer cannot act unilaterally to use the margin deposited by the customer (i.e., the Vested Employee Options); instead, the broker-dealer must rely on another person (i.e., the issuer) to promptly deliver the required shares. For example, if an issuer notifies the broker-dealer that there is an ineffective registration statement, it could prevent the broker-dealer from exercising the options and receiving publicly tradable shares, a prospect that could cause financial harm to the broker-dealer.
The Commission raised these concerns in the Notice by noting in a footnote that absent relief from the Commission, broker-dealers would need to take a capital charge for any unsecured margin debt and by asking questions about how the broker-dealer's legal authority to exercise the Vested Employee Options could be enhanced and how to limit the liquidity and operational risks arising from the Transactions. The Commission received no comments on this
15 U.S.C. 78f(b)(5). footnote or these questions. Thus, for purposes of determining whether an account is unsecured or partly secured pursuant to the net capital rule, including an account containing a Transaction, a broker-dealer may not include the value of a Vested Employee Option.

IV. Conclusion

 
IT IS THEREFORE ORDERED, pursuant to Section 19(b)(2) of the Act,10 that the proposed rule change (SR-ISE-2007-121), as modified by Amendment No. 1, be, and hereby is, approved.

 
For the Commission, by the Division of Trading and Markets, pursuant to delegated authority.

 
Florence E. Harmon
Deputy Secretary

In conclusion, write calls to reduce risks of holding vested in-the- money NQESOs, unless prohibited by the issuer.