A recent article in the Wall Street Journal indicated that new research has found a correlation between variable prepaid forward contracts, which are in essence complex executive stock-sale deals designed to protect executives from declines in their company's stock prices, and a disproportionate decline in company stock prices shortly after executives enter into such deals. Typically, the contracts involve arrangements between executives and brokerage firms whereby the executives agree to deliver to the brokerage firms a variable amount of shares at some future date in exchange for up-front cash equal to approximately 75% to 85% of the market value at the time of the arrangement.
Variable prepaid forward contracts are an attractive investment for executives because they protect them from a decline in company stock prices while allowing the executives to enjoy appreciation in stock prices up to a threshold limit established by the agreement. Some companies have banned these arrangements, noting that executives who enter into such deals are doing so against the interests of the company.
The discovery of a correlation between the execution of variable prepaid forward contracts and a subsequent decline in companies' stock prices now reveals the emergence of yet another executive compensation scandal. Although not illegal in and of itself, stock options backdating raises a number of legal issues. For instance, in the past few years there have been countless civil enforcement actions, criminal prosecutions and class action lawsuits brought against companies that have engaged in stock options backdating on behalf of their executives without properly disclosing the agreements in their financial records or their SEC filings.
Ultimately, the new developments may create another round of civil and criminal litigation as investors and governments at all levels try to crack down on securities fraud engaged in by company executives. The most common notion is that executives who enter into variable prepaid forward contracts have inside knowledge of a troublesome future for their company and are looking for a way to protect themselves. By in effect hiding the sale of their company stock through forward-looking sales contracts, executives create a false sense of stability. As the WSJ article indicated, these arrangements are also drawing the attention of the IRS and the SEC because they allow executives to gain up-front cash but defer the taxes on their capital gains until the termination of the contract.