Employee Stock Options and Warrants

One of the most common investment mistakes people make is investing too much of their asset value in one company’s stock. This can be particularly dangerous when that one company is the company that employs the investor.

 Employees of corporations sometimes are given stock options or warrants as part of their compensation package. Stock options and warrants give an employee the right to buy company stock at a specified price by no later than a specified date. As long as the stock’s market value is greater than the price at which the options or warrants can be exercised, the employee can choose to buy the stock at the lower price and sell it for a profit.

But employees who choose to exercise and buy their company’s stock do not have to immediately sell that stock. They can hold on to it. When this happens, the employee’s entire financial well-being can become dependent on the employer’s success. Why? Because both the employee’s livelihood and the value of his or her stock becomes tied to the employer’s performance. If there is a downturn in business, the employee may lose the job and the investment.

Some stockbrokers have wreaked havoc in the lives of employees like these by persuading them to follow what is called an “exercise and hold” strategy. The broker might explain it like this:

“Listen, I can help you keep more of your money with a simple approach. Now you could exercise and sell your shares immediately, but if you do, you’ll pay tax on the profit at ordinary income tax rates. But if you exercise, buy the shares, and hold them for at least one year, your tax at the time of sale will be calculated at the much lower rate applicable to long term capital gains. Now obviously, holding that much stock in one company is risky, so we’ll lend you money to exercise the options and buy the shares, then use the shares as collateral to lend you more money and use that money to buy shares in lots of other companies so you can have a safe, diversified portfolio.”

What’s wrong with this picture? Nearly everything. A proper analysis can be extremely complicated, but let’s grossly simplify. For instance, assume the stock options were non-qualified stock options, the most common variety.

When non-qualified stock options are exercised, the difference between the value of the shares acquired and the exercise cost is taxed as ordinary income, and the tax basis for the acquired shares is set to their value at the time of acquisition. As a result, the employee can sell the shares immediately without incurring any additional tax cost. Having sold the shares, he can and should use the proceeds to diversify his position unless that position is small relative to all of his other holdings.It is irrational to exercise and hold a concentrated position in the shares in order to obtain the capital gains rate.

But the broker ignores all that. He instead has the employee borrow, exercise the options, and hold the shares. The broker-dealer can provide credit because it has the employee open a margin account. The employee will incur margin interest on the borrowed funds. This will be a lucrative source of revenue to the brokerage firm, which might even share some of it with the broker. The broker will use even more margin credit in buying other stocks to “diversify” the account, thereby earning sales commissions. Meanwhile, use of margin subjects the employee to a high degree of risk and magnifies the potential for loss. The value of the securities held in the margin account, which will fluctuate, must be kept above a certain level or the employee will receive a margin call requiring him or her to deposit additional securities and/or cash in the account. If the employee cannot satisfy the margin call, the brokerage firm may sell securities in the account. The employee can be wiped out overnight in the case of a serious downturn.

If something like this has happened to you, please contact an investment misconduct lawyer at Hermann, Cahn & Schneider in Cleveland, Ohio today. We may be able to help you get compensation through the securities arbitration process.