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Employee stock options are contracts giving employees the right to buy the company’s common stock at a specified exercise price, at a specified time or during a specified period, and after a specified vesting period.

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The intrinsic value of the option is the market value of the stock less the exercise price, which is only relevant if the stock option is issued in the money.

The time value of the option when granted lies in the prospect that the market price of the company’s stock will increase by the time the option is exercised (used to purchase stock); that is, its potential appreciation value.

This report will be updated as issues develop or new legislation is introduced. 11 Key Legislative and Regulatory Developments.............................................................................11 American Jobs Creation Act of 2004 (Section 409A)..............................................................11 FASB Rule for Expensing Stock Options................................................................................11 Sarbanes-Oxley Act: Stock Option Disclosure Reforms.........................................................12 SEC’s 2003 Requirement of Approval of Compensation Plans..............................................12 SEC’s 2006 Executive Compensation Disclosure Rules.........................................................12 Gateke eper s .................................................................................................................... 14 Corporate Boards and Compensation Committees.................................................................14 Outside Auditors......................................................................................................................16 Securities and Exchange Commission....................................................................................18 Late Filings.......................................................................................................................19 The Question of the SEC’s Alertness to Misconduct........................................................20 Potential Policy Options................................................................................................................20 Improve Enforcement of Timely Filing of Option Awards.....................................................21 Require Same Day Filing of Option Grants............................................................................21 Require Scheduling of Grants of Executive Stock Options....................................................21 Ban Equity-based Pay for Top Attorneys and Board Members...............................................22 Increase Shareholder Roles in the Election of Board Members..............................................22 Eliminate the Cap on Deduction for Executive Pay................................................................23 Appendix A.

Introduc tion ..................................................................................................................................... 1 Illustration of Undisclosed Backdating...........................................................................................3 Types of Stock Options....................................................................................................................4 Nonqualified Stock Options......................................................................................................4 Qualified Stock Options............................................................................................................4 Growth of Stock Options in the 1990s............................................................................................5 The Omnibus Budget Reconciliation Act of 1993....................................................................5 Higher Marginal Individual Income Tax Rates...................................................................5 “Excessive Remuneration”—Section 162(m).....................................................................5 The Stock Market Boom of the 1990s......................................................................................7 Cost Accounting Rules for Certain Stock Options....................................................................7 The Extent of Timing Manipulation of Options..............................................................................7 The Potential Costs of Backdating..................................................................................................8 Costs to Shareholders................................................................................................................8 Costs from Earnings Hits....................................................................................................8 Costs of Reduced Executive Performance..........................................................................8 Costs from Delistings..........................................................................................................9 Costs from the Actions of Bondholders..............................................................................9 Costs of Additional Taxes...................................................................................................9 Costs of Probes, Fines, and Lawsuits................................................................................10 Employees ...................................................................................................................... 10 Bondholde rs ............................................................................................................................ 10 Ta xpaye rs ...................................................................................................................... Other Forms of Timing Manipulation......................................................................24 Appendix B.

Policy options to further reduce backdating and other timing manipulation include changes in SEC regulations and a change in the tax law.

The SEC, various state prosecutorial, and Department of Justice (DOJ) probes into backdating abuses are ongoing.

Setting a lower exercise price increases the value of the option.

At the grant date for the options, rather than selecting an exercise or strike price based on the current market price for the stock, officials at some companies have selected a prior date with a lower market price; that is, they backdated stock options to an earlier date.

Undisclosed backdating of stock options violates regulations of the Securities and Exchange Commission (SEC), accounting rules, and tax laws.

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