The myStockOptions Blog

SCOTUS Decision On Stock Options At Railroad Companies: Do The Justices Understand Stock Compensation?

Some interesting summer reading came our way in a recent Supreme Court decision that features stock options: Wisconsin Central Ltd. v. United States. The decision is an easy read that provides some insights into what the justices in our highest court know about equity compensation. While initially it appears that the application of the decision is narrow and applies only to employee stock options (also perhaps RSUs and other types of stock compensation) at railroad companies, the implications are broader.

In short, by a 5–4 margin, the Supreme Court ruled that options are not taxable compensation under the Railroad Retirement Tax Act (RRTA) because they are not "money remuneration" as meant by the term in the statute, which was written in 1937. Significantly, when Congress adopted the RRTA it also enacted the Federal Insurance Contributions Act (FICA), which taxes "all remuneration," including benefits "paid in any medium other than cash." Therefore, according to Justice Neil Gorsuch, who wrote the majority opinion, "the Congress that enacted both of these pension schemes knew well the difference between 'money' and 'all' forms of remuneration and its choice to use the narrower term in the context of railroad pensions alone requires respect, not disregard."

The RRTA, which few stock comp professionals are familiar with, provides funding for pension-like benefits to railroad employees instead of Social Security retirement benefits. The spread at exercise would still be subject to the standard income tax rules, as the NASPP recently confirmed in its blog. For railroad companies, a commentary from PwC provides some guidance on the decision. Of course, for those not working on the railroads, the spread at the exercise of nonqualified stock options (NQSOs) remains subject to Social Security and Medicare taxes.

Does The Supreme Court Understand Stock Options?

The vote on the court followed the conservative-versus-liberal pattern of many 5–4 decisions. Therefore, in our view, the majority opinion and the dissenting opinion (by Justice Breyer, joined by Ginsberg, Sotomayor, and Kagan), represent an argument over two points:

• the approach the Supreme Court should take in interpreting statutory language
• the ability of government agencies, such as the Treasury Department and the IRS, to issue regulations when terms of a statute are ambiguous

Like any well-written Supreme Court decision, this case can be analyzed on many different levels. At myStockOptions.com we were interested to see how well the Supreme Court justices understand and explain stock options and equity compensation. They seem to know how stock options work, they recognize the differences in the taxation of ISOs and NQSOs, and they comprehend the underlying purpose of equity compensation for employers. Justice Gorsuch succinctly states that the goal of options is "to encourage employee performance and align employee and corporate goals" and describes in his own way the various exercise methods. In his dissent, Justice Breyer discusses how companies use stock options to compensate employees—in part, "hoping that by doing so they will provide an incentive for their employees to work harder to increase the value of the company."

For Justice Gorsuch, the author of the majority opinion, it didn't seem to matter as much that stock options can be easily exercised and the shares sold for money. Yet in the minority opinion, Justice Breyer elucidates in detail the procedure for cashless exercises and provides data on how a large percentage of employees at railroad companies use this exercise method. He also notes that many of the country's "top executives are compensated in both cash and stock or stock options," with stock-based compensation often exceeding cash salary. The strongest argument in his dissenting opinion is that cashless exercise makes options almost identical to money remuneration. After reading a summary of the justices' questions during the oral argument and the lawyers' replies, we do wonder if the decision hinged on whether the justices who supported the majority opinion fully understood how cashless exercises really work. For stock plan professionals who lived through the intense debates as to whether stock options should be expensed on the income statement (they have been since 2006), it is odd that the decision does not mention the accounting rules, even in its discussion of whether options have a "readily discernible value."

More Lawsuits Involving Stock Compensation

Back in January, this blog looked at some recent lawsuits of interest involving stock compensation. In recent months, a few additional court decisions involving equity comp have caught our attention.

Online Grant Acceptance

Electronic distribution and acceptance have become common procedures for stock grants. Occasionally lawsuits challenge these, often when the agreement has a provision that restricts an employee who later contends that he or she did not see it or agree to it (e.g. a covenant not to compete). That's what happened in ADP v. Lynch, in which the US Court of Appeals for the Third Circuit upheld a lower court's decision enforcing restrictive covenants in electronically delivered grant agreements. In the company's online procedure, employees needed to check boxes confirming that they had reviewed the documents, which included the plan, the award agreement, and the noncompete. The first page of the grant agreement also specifically told employees that acceptance of the award depended on their agreeing to the noncompete. The court found that by checking the box affirming their reading of these documents, employees agreed to the provisions. It rejected as irrelevant the contention that the employee did not recall doing so and was not adequately informed about the consequences of accepting the grants.

This case is a clear warning that you need to read and understand the provisions in your grants agreement and stock plan. Plus, don't assume that the provisions in new grants you receive are identical to the provisions of prior grants. For more on restrictive covenants in stock grants, including this case and others, see the myStockOptions article Watch For Noncompetes And Other Restrictive Covenants In Stock Grant Agreements.

Divorce

Like other assets and forms of compensation, stock comp sometimes gets dragged into divorce property settlements and alimony payments, though the issues can be more complex. In the case Ludwig v. Lamee-Ludwig, the Massachusetts Court of Appeals looked at the question of whether unvested shares are considered assets for the property settlement and/or income for child care/alimony. The court confirmed a lower court's decision that the calculation of an employee spouse's alimony obligation may include income received from unvested employee stock options that were not subject to equitable division as assets, under application of the "time rule" in Baccanti v. Morton (434 Mass. 787, 2001), for dividing unvested grants. This would not constitute "double counting" if the income were included in determining the husband's alimony or child support. At his blog, divorce attorney Jason Owens discusses the importance of this case, which in his view offers "precision" for treating unvested options not divided under the property settlement (Treating Stock Options And RSUs As Assets Vs. Income In A Divorce).

For more details on the treatment of restricted stock and stock options in an divorces, see the articles and FAQs in the Life Events: Divorce sections of myStockOptions.com.

Lawsuits And Court Cases Of Interest That Involve Stock Compensation

Here at myStockOptions.com, we keep an eye on major court cases and rulings that involve stock compensation or stock holdings, as these developments can influence both stock plans and the actions of stock plan participants. A few recent lawsuits and court decisions have drawn our interest.

Class-Action Lawsuit Claims Uber Made Unfair Changes In Stock Grants

Uber is facing a lawsuit related to changes it made in its stock grants, according to the complaint in a class action recently filed against the company. The acquisition centers around the technical ISO rule that only grants with an aggregate value of $100,000 can be exercisable in any one calendar year. Any grants that vest in a year with a value over that automatically become NQSOs, and income, Social Security, and Medicare taxes are withheld at exercise. According to the complaint, Uber recruited software engineers with whom it had employment agreements to grant ISOs with a vesting schedule of 25% after the first 12 months and then monthly vesting thereafter (see Exhibit 1). However, the company changed the provision to allow all of the shares to become exercisable after six months, forcing some ISOs to become NQSOs (see Exhibit 2). This situation raises the issue of whether "exercisable" means "vested" in the related tax-code provision, which was adopted before a distinction between exercisability and vesting existed in certain pre-IPO stock options with early-exercise provisions.

Various news publications picked up on this lawsuit, including TechCrunch and Courthouse News Service. TechCrunch reports a statement issued by Uber, which explains that the company gives employees a "real stake" in its success and that it is "proud to offer equity compensation in service of that goal."

State Supreme Court Confirms Nonresidents Cannot Escape Taxation On Options Earned In The State

You cannot escape state taxation of vested stock options by moving to a state without an income tax. In Allen v. Commissioner of Revenue Services, the Connecticut Supreme Court confirmed that Connecticut can tax income from option exercises by a nonresident if the options were granted as compensation for performing services within the state. Connecticut, like many states, has a provision that authorizes the taxation of income "derived from or connected with sources within this state of each nonresident." The court rejected the plaintiff's creative positions, including the argument that it is "unconstitutional" to impose a tax on income derived from the exercise of nonqualified stock options by someone who at exercise is a nonresident. For more about this case, see an article about it at the website of Forbes. The taxation of mobile employees in the US and in other countries shows the eagerness of governments to find tax revenue in stock compensation.

Supreme Court Issues A Major Decision On Insider Trading

Everyone working for or advising a public company needs to know the insider-trading rules. Even if you unintentionally violate the laws of insider trading, you can face a serious punishment. (For details, see the FAQs on insider trading at myStockOptions.com and the Think Twice video series for insider-trading prevention.) It is not hard to imagine a situation in which you casually tell a relative or a friend about upcoming important company news, and that this person then uses that information to make a stock-trading profit. Although the tipoff would probably be a violation of your company's confidentially rules, you might not have miscreant intentions or expect anything in return from the tipped-off person, and therefore might (wrongly) not view this act as insider trading.

The US Supreme Court has issued a major decision on insider trading that involves just that type of situation. In its ruling on Salman v. United States, the Supreme Court makes it very clear that whenever a friend or relative is tipped, insider trading has occurred, regardless of whether the tipster receives a benefit. Prosecutors do not need to show something of value was received for providing the valuable information. In the court's view, "the tipper personally benefits because giving a gift of trading information to a trading relative is the same thing as trading by the tipper followed by a gift of the proceeds." The tipper does not need to receive something of a "pecuniary or similarly valuable nature" in exchange for this gift to a trading relative.

The ruling is seen as a victory for the US government, as it strengthens the position of federal prosecutors and their will to bring insider-trading cases. The case prompted several commentaries, including articles from the law firms Morgan Lewis & Bockius and Goodwin Procter and an analysis in the blog of the Supreme Court itself.