Executive Tripped by 409A and Backdating Scandal

March 20, 2013 (PLANSPONSOR.com) – An executive who exercised stock options following the effective date of 409A regulations may not get the refund of taxes he requested.

The U.S. Court of Federal Claims concluded that a genuine issue of material fact exists, namely, whether the stock option was discounted at the time it was granted. The court found this is a necessary factual predicate to tax liability under Internal Revenue Code (IRC) Section 409A, and remanded the case to trial to determine whether the option was indeed discounted.  

Plaintiffs Dr. Sehat Sutardja and his wife, Weili Dai, argued that even if the option had been granted at a discount, Section 409A would not apply, as there was no actual compensation creating a taxable event until Sutardja exercised the vested portions and sold the shares. The court disagreed, noting that within a few months of 409A’s enactment, the Internal Revenue Service (IRS) issued Notice 2005-1, which offered transitional guidance regarding the types of arrangements that are covered by Section 409A, and a definition of “deferral of compensation.”The notice advises that if a stock option is granted with a per-share exercise price that is less than the fair market value per share of the underlying stock on the date of grant, then the option will be treated as a deferral of compensation and fall under the parameters of Section 409A.   

Sutardja also argued that even if the option grant was discounted, Section 409A still would not apply because he did not have a “legally binding right” to compensation until exercise, and thus no compensation was deferred to a later year. However, the court pointed out that the condition precedent under the option agreement was that Sutardja had to be employed by Marvell Semiconductor at the scheduled vesting dates to obtain the right to exercise the option. Once the option vested, Marvell was contractually bound to sell, and Sutardja had the irrevocable right to purchase shares at the option price.   

Sutardja was the president, chief executive officer and chairman of Marvell’s Board of Directors. The  Executive Compensation Committee of Marvell’s Board of Directors determined stock option awards to senior executive officers, which included Sutardja. This committee was composed solely of independent directors, and neither of the plaintiffs was a member.   

In 2003, the Executive Compensation Committee approved a grant to Sutardja of Marvell stock options covering 1.5 million shares of common stock at $36.50 per share, which was subsequently ratified in January 2004. The option did not have a readily ascertainable fair market value when granted. 

Meanwhile, regulations under IRC Section 409A were passed and were effective in January 1, 2005. 409A provides strict rules that must be applied to most deferred compensation arrangements accruing benefits after the effective date. Failure to comply with the IRC and the applicable Treasury Regulations can result in a 20% surtax plus interest on the amounts received under non-compliant deferred compensation arrangements.  

According to the court opinion, in January 2006, Sutardja exercised three fully-vested portions of the option, purchasing an aggregate of 399,606 shares at the split-adjusted price of $18.25 per share. Beginning in May 2006, the Board of Directors conducted an internal review of Marvell’s past stock option granting practices, appointing a Special Committee to report its findings (see “Marvell Technology and Former CEO Agree to Backdating Settlement”). The Special Committee found that “the appropriate ‘measurement date’ for the option for financial accounting purposes was January 16, 2004,” the date on which the Executive Compensation Committee ratified the grant of the option. Thereafter, Sutardja entered into a “Reformation of Stock Option Agreement” with Marvell and paid an additional $5,355,001, representing the excess of the amended exercise price over the original exercise price. Of this amount, $1,426,594 accounted for the discrepancy in exercise price of shares purchased by option exercises in 2006, and the balance was due to shares purchased by option exercises before 2006.   

In December 2007, Sutardja and Dai filed a joint Form 1040 U.S. Individual Tax Return for the 2006 tax year, reporting $4,849,791 in federal income tax. Plaintiffs also reported on this form that Marvell withheld $6,353,628 in federal income tax and the plaintiffs made $706,944 in federal estimated payments. In 2010, the plaintiffs received a Notice of Deficiency from the IRS concerning the 2006 tax year explaining it determined that the exercise of a Marvell Technology Group Ltd. stock option in 2006 is from a nonqualified deferred compensation (NQDC) plan, as defined under 409A and subject to additional tax. Sutardja and Dai paid the amount set forth in the notice, in addition to a late-filing penalty, and simultaneously claimed a refund for the total amount.  

The court opinion is here.