November 17, 2020
Stock Option Controls: A Cautionary Tale
– Liz Dunshee
As if the folks at Eastman Kodak weren’t having a hard enough year already, the Form 10-Q that the company filed last week disclosed that five former executives made millions by exercising forfeited stock options and selling the underlying shares. The exercises occurred in July – which was right about when Kodak was in the news for its short-lived federal loan. Here’s an excerpt from the notes to financials:
The options exercised in 2020 included 0.3 million options exercised by ex-employees of Kodak that had previously been forfeited. The Company issued shares to the ex-employees in exchange for proceeds based on the exercise prices of the forfeited options. The Company is accounting for the exercise of the forfeited options as a modification of the original awards.
The Company recognized compensation expense of approximately $5.1 million in the three months ended September 30, 2020, related to the 0.3 million previously forfeited options representing the fair value of the shares issued to the ex-employees less the exercise proceeds received from the ex-employees, which is reported in Selling, general and administrative expenses in the Consolidated Statement of Operations.
The Company is seeking to recover the fair value of the shares at the time of the sale of the shares by the ex-employees less the exercise proceeds and withholding (approximately $3.9 million) and the right to retain any refund of the withholding taxes the Company is seeking to obtain on behalf of the ex-employees (approximately $3.0 million). There are no assurances the Company will be successful in its claims against the ex-employees or in its recovery of the withholding taxes.
The company’s discussion of controls & procedures sheds some light on how this occurred – and shows why it’s important to promptly reconcile internal award updates with data maintained by a third-party stock administrator. My experience is that companies do have to be really explicit with service providers on things like forfeitures and blackouts. Here’s more detail from Kodak’s 10-Q (also see this WSJ article):
During the quarter ended September 30, 2020 the Company discovered deficiencies in controls required to safeguard Company assets. The Company did not prevent the unauthorized issuance of the Company’s common stock when previously forfeited non-qualified stock options were exercised by five former officers and employees in July 2020.
Errors existed in employee equity accounts for the five former officers and employees as well as other current and former officers and employees which could have resulted in additional inappropriate exercises. Controls were inadequate with regard to the timely input and verification of master data updates for equity grants, the maintenance of audit documentation of grant activity in the repository of grants serviced by a third-party administrator, and the performance of independent reconciliations of the repository to supporting company records for the detection of errors or misstatements in employee equity account balances.