Shadow and Phantom Stocks lead to miss-marking Short Sale orders

Although rewarding employees with company stock can provide numerous benefits for both employees and employers, there are times that legal concerns can cause companies that do not require the issuance of actual stock shares.

Also unwillingness to issue additional shares or shift partial control of the company to an employee can cause companies to use an alternative form of compensation that does not require the issuance of actual stock shares.

Phantom stock plans and stock appreciation rights (SAR’s) are two types of stock plans that don’t really use stock at all but still reward employees with compensation that is tied to the company’s stock performance.

Also known as shadow stock, this type of stock plan pays a cash award to an employee that equals a set number or fraction of company shares times the current share price.

The amount of the award is usually tracked in the form of hypothetical units (known as phantom shares) that mimic the price of the stock. These plans are typically geared for senior executives and key employees and can be very flexible in nature.

Basically a Phantom stock is a contractual agreement between a corporation and recipients of phantom shares that bestow upon the grantee the right to a cash payment at a designated time.

Or otherwise in association with a designated event in the future, which payment is to be in an amount tied to the market value of an equivalent number of shares of the corporation.

There are two main types of phantom stock plans.

Appreciation only plans do not include the value of the actual underlying shares themselves and may only pay out the value of any increase in the company stock price over a certain period of time that begins on the date the plan is granted.

Full value plans pay both the value of the underlying stock as well as any appreciation.

Both types of plans resemble traditional non-qualified plans in many respects, as they can be discriminatory in nature and are also typically subject to a substantial risk of forfeiture that ends when the benefit is actually paid to the employee, at which time the employee recognizes income for the amount paid and the employer can take a deduction.

Phantom stock plans frequently contain vesting schedules that are based on either tenure or the accomplishment of certain goals or tasks as covered in the plan charter.

This document also dictates whether participants will receive cash equivalents that match dividends or any type of voting rights.

Some plans also convert their phantom units into actual stock shares at the time of payout in order to avoid paying the employee in cash.

Unlike other types of stock plans, phantom stock plans do not have an exercise feature, per se; they only grant the participant into the plan according to its terms and then confer either the cash or an equivalent amount into actual stock when vesting is complete.

Phantom stock plans can appeal to employers for several reasons. As an example, employers can use them to reward employees without having to shift a portion of ownership to their participants.

For this reason, these plans are used primarily by closely-held corporations, although they are used by some publicly traded firms as well.

Also, like any other type of employee stock plan, phantom plans can serve to encourage employee motivation and tenure and can discourage key employees from leaving the company with the use of a golden handcuff clause.

Employees can receive a benefit that does not require an initial cash outlay of any kind and also does not cause them to become over-weighted with company stock in their investment portfolios.

The large cash payments that employers must make to employees, however, are always taxed as ordinary income to the recipient and may disrupt the firm’s cash flow in some cases.

The Financial Industry Regulatory Authority, Wall Street’s self-funded watchdog, fined Goldman Sachs Inc (GS.N) $3 million on Tuesday for mistakenly marking some of its stock orders as “long” instead of “short”, and for trade reporting violations.

From October 2015 to April 2018, Goldman miss-marked around 60 million short sale orders totaling more than 14 billion shares as “long” sales, with nearly eight million of those orders, totaling more than a billion shares, being executed, FINRA said.

The miss-marked orders were caused by the failure to add a single line of computer code during an upgrade to automated trading software Goldman used to simplify its order flow.

Because they were inaccurately marked as “long,” 12,335 of the executed orders were executed at or below the best displayed price available while a short sale circuit breaker was in effect.

Short sale circuit breakers prohibit the execution or display of a short sale in that security at a price that is less than or equal to the current national best bid.

The orders, which represented less than 1% of Goldman’s total principle sell orders during the period, were auto-generated to hedge Goldman’s Synthetic Product Group’s synthetic risk exposure resulting from its execution of equity swap transactions with clients.

The miss-marked orders also caused Goldman to submit inaccurate trade reports to FINRA and maintain inaccurate books and records, the regulator said.

Goldman also failed to establish and maintain a supervisory system reasonably designed to achieve compliance with short sale regulations SHO and rules relating to accurate trade reporting.

Goldman accepted and consented to FINRA’s findings without admitting to or denying them.

Investopedia.com / Reuters / ABC Flash Point News 2023.