Early Exercise, Sell and Diversify Deception Analysed


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This paper goes further in exposing a sophisticated fraud that is being carried out upon employees and managers holding employee stock options of most major companies.
Ten of billions are transferred annually from the employees to the company and the wealth advisers.

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Early Exercise, Sell and Diversify Deception Analysed

  1. 1. .
  2. 2. An analysis of the Craig McCann, Kaye Thomas paper "Optimal Exercise of Employee Stock Options and Securities Arbitrations" 2005 ---------------------------------------------------------------------------------------------------------- This is an analysis of the paper "Optimal Exercise of Employee Stock Options and Securities Arbitrations" 2005 by Craig McCann and Kaye Thomas. Those writers focus on the idea that employee stock options should be exercised early because “diversifying” the employeeʼs assets has substantial merit as a risk reduction method. The McCann Thomas paper consists of discussions about the management of concentrated positions held by employees in employer stock options and employer stock. They promote the idea that those concentrated positions should be reduced or eliminated by sales of stock owned or by early exercising employee stock options and then selling stock.     
  3. 3. They claim that employees then should “diversify” the net proceeds as there are alleged advantages of a “diversified” portfolio. They also mention certain legal liabilities that advisers may have who give advice counter to their ideas. My criticism of the paper deals with concentrated positions in employee stock options. My criticism does not focus on concentrated positions in stock, other than the fact that the equity compensation plans are designed to create concentrated positions in company stock which the advice in the McCann and Thomas paper attempts to defeat. My conclusion is that the article is deliberately misleading with regard to holdings in employee stock options and it promotes a strategy for the benefit of the company and the wealth managers and to the detriment of the uninformed ESO holders.
  4. 4. It is clear to me that the strategy they promote, if accepted by holders of concentrated employee stock options positions will cause damages to those options holders and perhaps cause the advisers to the holders to be sued for failure to advise proper risk reduction and for recommending a strategy of inappropriate trading as well as violation of SEC Rule 10b-5.   -------------------------------------------------------------------------------------------------------------  The Title of their Paper refers to the Optimal Exercise of Employee Stock Options. That Optimal Point, they claim, is at the price where their "investment value"* crosses the "intrinsic value" in a graph that they have created.That graph is on page 7 of their paper. They define their "Optimal Exercise" and "Investment Value" below.
  5. 5. Optimal Exercise Optimal exercise balances the benefits of diversification against the destruction in remaining option value. The tradeoff is pictured in Figure 2. The line labeled “Investment Value” is the Black-Scholes value of the option reduced by a penalty for the lack of diversification. The option’s Investment Value is its value to the employee as a continuing investment. If the Investment Value is less than the Intrinsic Value the option should be exercised. If the Investment Value is greater than the Intrinsic Value (i.e. the net proceeds which can be realized from exercising the option) the option should be held unexercised. Page 7 .
  6. 6. What they are saying is that "diversification" has substantial value that overcomes the forfeiture of the remaining "time value" in the options, and the early payment of compensation income taxes, and the costs associated with “diversifying”. They do not define specifically what “diversifying” means and certainly make no explanation of the value of its alleged advantages. They know that by understating the penalties of the forfeiture of remaining "time value" and the costs of the early tax payment and the costs of “diversifying”, and exaggerating the merits of "diversifying" they have a better chance to prove their case. And that is what they do.
  7. 7. They claim that the optimal point to exercise is when the intrinsic value equals the "investment value" and if the "intrinsic value" is equal to or above the "investment value”, the options should be exercised, the taxes paid and the residual amounts “diversified”. If the investment value is above the intrinsic value, then the ESOs should be held un-exercised according to MCCann and Thomas. However, in fact, the “investment value” can never be less than the intrinsic value as the options can be exercised at any time and sell the stock and make the intrinsic value. They do not discuss how the “investment value” is calculated because they are just pulling that value out of thin air and minimizing it as a result of exaggerating the advantages of “diversifying”.
  8. 8. Option Values The McCann and Thomas graph shows the” investment value” crossing the “intrinsic value” at about 110% above the exercise prices (about when the stock is $42). There is no mention of the volatility of the stock, the interest rate, or the expected time to expiration or the expected dividend or the probability of the stock being $42 or higher having started when the stock was $20. In parts of the paper, they refer to "deep-in-the-money" ESOs and ESOs that vest in 3-4 years. They also claim that it is not rare to find "deep-in-the-money"( defined by them as having little “time value remaining) ESOs after just a small fraction of the 10 years time to expiration. The paper was written in 2004-2005 when risk free interests were 5%, the volatilities of stocks with substantial ESOs outstanding ranged from 30 to 70 and expected time to expiration was in the range of 6 to 6.5 years with very little dividends if any paid.
  9. 9. The two graphs below illustrate the values of ESOs that have assumptions that were accurate during the time the paper was written. The phrase “time value” and “time premium” mean exactly the same thing.  
  10. 12.   These two graphs illustrate that if there are options giving the right to purchase 1000 shares at $20 and the stock increases to $40 with 4.5 expected years to expiration, the “time value” is $4526 (.30 volatility), or $6460 (.60 volatility) which is forfeited upon exercise. Nowhere in their paper is there any mention of how “diversification” will overcome the forfeiture of the $4526 or $6460. If an early exercise is made, there is also a penalty to the early exerciser in the form of an early tax of perhaps 40% of the intrinsic value of the options. Nowhere is there an explanation of how that penalty will be recovered by “diversification”, as if “diversification” is some kind of magic bullet.
  11. 13. But they do say that: “ By exercising the option and selling the stock, the employee can eliminate the uncompensated risk associated with the concentrated position, often at a cost that is smaller than the cost of hedging that loss for a single year (e.g. the purchase price of put options for that period)”Page 6 They however, do not say what put is purchased and what price they could have paid for it and what the chances are of the amount paid being lost. Effectively the statement is just words and gives no information. If they would have chosen the sale of a call rather than the purchase of the put, which is more appropriate when hedging employee stock options, would they then say that the proceeds from the sale of the call is a gain from not exercising and selling and diversifying?
  12. 14. They also say: “ The cost of diversification is the abandonment of the option’s remaining “time value”.If the employee stock option is deep in the money, the cost of abandoning the remaining time value of the option is relatively small, even if the option will not expire for several more years”.Page 7 The two graphs above show the forfeited “time value” (time premuim) when the stock is 100% above the exercise price (and very close to their Optimal Exercise point) and 4.5 years to expiration is $4526 with a .30 volatility and $6460 when the stock has a .60 volatility.  
  13. 15. They also say: “ Early exercise of stock options has an additional cost because the employee must pay the income tax associated with the exercise and this payment could have been deferred by delaying the exercise.” Page 8. That is a true statement. But, then they say the following: “ The benefit is much smaller though than commonly believed, and far too small to justify exposure to extraordinarily high levels of risk.” Page 8 Now what support do they have for that statement that holding ESOs when the stock is 110% above the exercise price is “exposure to extraordinarily high levels of risk.”, which will somehow be relieved by exercising, selling and diversifying. 
  14. 16. Lets see if they find some. They say: “Tax deferral is often described as a benefit equivalent to receiving an interest-free loan. Yet careful analysis of the tax consequences faced by an option holder reveals that deferral in this situation is not equivalent to an interest-free loan. We can illustrate this point with a simplified example where the option is so deep in the money that the exercise price is effectively equal to zero.” Page 8. So they are going to try to show that tax deferral is not equivalent to an interest free loan by using an example of options with a strike price of near zero, rather than using an option with an exercise price of $20 and a market price of $42, which is the case here, and then assume the stock doubled. 
  15. 17. They also dismiss the tax that would be payable on the gain from the “diversifying” the residual amounts after exercise if those amounts increased 100%. Its getting comical now, because they suggest on page 6 that investment grade bonds should be bought which will never double in price and pay interest that is taxable at ordinary rates. But if we used 1000 ESOs with the exercise price of $20 and a market stock price of $42 and we then assumed that the stock doubled from $42 and the tax rate was 30% on the earnings after exercise and paying the tax, we get the following. 
  16. 18.   A. For the premature exerciser. 60% x $22,000 = $13,200 equals the net after tax received upon the early exercise. $13,200 x 200% = $26,400 minus (30% x $13,200 = $3960) = $22,440 net after tax. B. For the non-exerciser: $42,000 x 200% = $84,000 $84,000 - $20,000 = $64,000 x 60% = $38,400. So $38,400 is more than $22,440 by $15,960 which is the after tax difference between the two strategies if the stock doubled from $42 . Yet McCann and Thomas say the tax difference is “0”.  ----------------------------------------------------------------------------------------
  17. 19. Although the difference of $15,960 is not entirely from delaying the tax and the gain from holding more shares, a large part is. The early tax penalty is expected to be approximately 5-7% annually of the taxes that would be paid upon an early exercise. So early exercises have large penalties from the forfeited “time value” and the payment of an early tax, which will seldom be overcome by any advantages there are from “diversification”. In fact those penalties reduce the possible risk reduction of premature exercise, sell and “diversify” down to incidental if any at all. In fact, the penalties are generally never overcome.  
  18. 20. If the employee wanted to efficiently reduce risk in a manner which has very few if any penalties, he/she could sell exchange traded calls and he/she does not have to wait for the stock to go up 110%. The chance is about 1 in 11 that the stock will be equal to or more than 110% above the exercise price after three years from the grant. He/she could sell calls and partially hedge when the stock is near 50% over the exercise price, which is far more likely than for the stock trading for near 110% over the exercise price. So early exercises sell and diversify is irrelevant 91% of the time after three years from grant day with stock having a .30 volatility. 
  19. 21. And the risk of a large percentage loss from holding ESOs with the stock 50% or 60% above the exercise price is much greater than if the stock is 110% greater than the exercise price. Since that is the case, the risk averse employee should look to reduce risk partially far sooner than waiting for the stock to go up 110% over the exercise price if it ever does. And his/her advisers have a legal obligation to make the employee aware of the risks, the penalties and available strategies to reduce risk and maximize gains and minimize taxes sooner. 
  20. 22. In summary, there are essentially three strategies to manage ESO holdings: 1. Hold the ESOs to near expiration without premature exercises or sales of calls. This strategy offers the most potential gain with highest risk.   2. Make premature exercises, sell, and “diversify” is by far the worse strategy, which is what McCann and Thomas and their followers recommend. 3. Reduce risks by selling calls and/or buying puts. This is the best strategy if the employee wants risk reduction. In fact, its the only efficient strategy to reduce risk. 
  21. 23. Exhibits This Exhibit shows the total penalties (red) for the employee making early exercises.  Exer... Market....Vol...Expected....TimeValue..Ear.Tax...Total....Net After Tax Price.....Price.............Time.Ex.......Forfeited...Penalty. Penalty.....Proceeds 20...........30........30.....5.5 yrs......... $6114......$1200 ..... $7314 ........$6000 20...........40........30.....4.5 yrs......... $4528......$1918 ..... $6446 .......$12,000 20...........50........30 ....3.5 yrs......... $3368......$2100 .... .$5468 .......$18,000 20...........60........30.....2.5 yrs......... $2372......$2000 ..... $4372 .......$24,000 1000 ESOs exercised .30 Vol, 5% risk free Interest rate, "0" dividend   20..........30.........60.....5.3 yrs......... $9300......$1200...$10,500 .......$6000 20..........40.........60.....4.3 yrs......... $6460......$1918.....$8378 .......$12,000 20..........50.........60.....3.3 yrs......... $4740......$2100.....$6840 .......$18,000 20..........60.........60.....2.3 yrs......... $2870......$2000.....$4870 .......$24,000 1000 ESOs exercised .60 vol, 3% risk free interest rate, "0" dividend  
  22. 24. This chart below shows the benefits to the company of early exercises. Exer.....Market..Vol...Expected...Time Value.....Cash flow.............Benefit of Price    price............Time to. Ex...Returned.. .Fr Ex,. Fr Tax... Receipt of early tax credit 20...........30.......30......5.5 yrs........ $6114........$20K......$4K ..........$1200 20...........40.......30......4.5 yrs........ $4528....... $20K......$8K .......... $1918 20...........50.......30......3.5 yrs........ $3368........$20K....$12K ...........$2100 20...........60.......30......2.5 yrs........ $2372........$20K....$16K ...........$2000 1000 ESOs exercised. 30 Vol, 5% risk free Interest rate, "0" dividend   20..........30.......60.......5.3 yrs......... $9300........$20K......$4K ...........$1200 20..........40.......60.......4.3 yrs......... $6460........$20K......$8K ...........$1918 20..........50.......60.......3.3 yrs......... $4740........$20K.....$12K ..........$2100 20..........60.......60.......2.3 yrs......... $2870........$20K.....$16K ..........$2000 1000 ESOs exercised .60 vol, 3% risk free interest rate, "0" dividend   The above two exhibits make very clear who benefits from early exercises and who pays for those benefits.
  23. 25. Finally the question arises. If diversifying is such an improvement over holding un-exercised executive stock options why do executives like James Dimon, John Chambers, Larry Ellison, Steve Jobs, Paul Ortellini and 135 top executives at Goldman Sachs choose to hold the granted ESOs to near expiration?    See below Steve Jobs exercised.................. 120,000 on 8/12/07, ESOs expired 8/13/07 Apple's Ron Johnson exercised ...200,000 on 12/1/ 09 ESOs expired 12/14/09 Paul Otellini of Intel exercised .... 800,000 on 11/9/07, ESOs expired 11/12/07 Larry Ellison of Oracle exercised. 10,000,000 on 4/3/09, ESOs expired 6/4/9 John Chambers exercised ...........2,000,000 on 2/8/10, ESOs expiring 5/14/10 John Chambers exercised........... 1,350,000 on 2/13/07, ESOs expiring 5/1/07  James Dimon exercised ----------   1,261,000 on 7/17/09, ESOs expiring 8/15/09    None made early exercises, sales and “diversified”. No “time value” was forfeited. Why?    
  24. 26. The answer is these executives and the top 135 executives from Goldman Sachs know the penalties of early exercise and understand the merits of hedging risks. They also may know the small advantages of “diversification”. See the link below to an article of February 11, 2011 in the New York Times from which I quote. http://dealbook.nytimes.com/2011/02/05/stock-hedging-lets-bankers-skirt-efforts-to-overhaul-pay/ More than a quarter of Goldman Sachs’s partners, a highly influential group of around 475 top executives, used these hedging strategies from July 2007 through November 2010, according to a New York Times analysis of regulatory filings. The arrangements were intended to protect their personal portfolios when the firm’s stock was highly volatile, especially at the height of the crisis.  
  25. 27. Graphic: A Hedge That Worked "In some cases, executives saved millions of dollars by using these tactics. One prominent Goldman investment banker avoided more than $7 million in losses over a four-month period." “ For Goldman partners, the most popular hedging strategy was covered calls. Take Christopher Cole, chairman of Goldman’s investment bank and a member of the management committee. From 2007 to 2009, he made at least 11 such transactions, earning more than $675,000, according to the filings.” And with regard to the famous CEOs mentioned above, they surely are getting the best advice from true experts and no true expert advises premature exercise, sell and “diversify” if the interest of the employee/grantee is the primary concern. If diversifying has an advantage, these CEOs would have taken it. Billions of dollars are transferred from employees to the shareholders and the wealth managers yearly partly as a consequence of papers like this one.  But what do you expect from a tax lawyer and a investment teacher who have no experience in trading options or options risk management but call themselves experts. 
  26. 28.   Finally, this paper is part of a very large scam to extract the wealth from the employees and transfer it to the company while the wealth managers and top executives get paid very well for doing so. John Olagues  [email_address] 504-428-9912 www.optionsforemployees.com/articles  http://www.amazon.com/John-Olagues/e/B00314DLEY