Tax Update Blog: Permalink

« Previous · Tax Update Blog Home · Next »

IT'S NOT WORKING? HIT IT AGAIN, HARDER.

September 07, 2006

The Senate Finance Committee got together yesterday to look at stock option backdating. The result is likely to be more vindication of the saying "when all you have is a hammer, everything looks like a nail." The Finance Committee's hammer is the tax law.

Dozens, perhaps hundreds, of public corporations apparently backdated their stock option grant dates to make exercising options cheaper for their executives. This will usually cost the company deductions they would otherwise get for executive pay. Failure to disclose the options could mean criminal problems. What do you do when the taxpayers ignore the tax laws you've already passed? If you're Senator Grassley, you ponder passing more tax laws:

Companies have found it easy to get around the law. It has more holes than Swiss cheese. And it seems to have encouraged the options industry. These sophisticated folks are working with Swiss watch-like devices to game this Swiss cheese-like rule.

I want to know what went wrong and consider whether it makes sense to make changes. Modifying the deduction for performance-based pay or at least tightening up the eligibility are possibilities I think members of the Finance Committee will want to consider based on comments made at this hearing. Today's hearing is helpful in sorting through the pros and cons of changing the deduction and possible alternatives. It's challenging for Congress to stay one step ahead of some companies that try to exploit tax loopholes faster than we can close them.

CONGRESS AND THE OPTION PROBLEM

In one of its periodic spasms of self-righteousness, Congress passed a law in the 1990s (Code Section 162(m)) limiting deductible compensation of public company executives to $1 million annually. It then carved out loopholes for "incentive based compensation," including stock options (Backdated options fall outside the exclusion because the compensation is not "solely" from appreciation after the grant date). This deduction limit discouraged straight cash pay and made options a better after-tax compensation vehicle. The absurd accounting rules that allowed companies to not expense option compensation on their financial statements - rules largely resulting from Congressional interference - also favored options over cash compansation.

There are philosophical disagreements about how much executive compensation should be in cash, how much should be in options, and whether straight stock bonuses are more appropriate than options (with stock bonuses, the executives are at risk for stock declines, too; with options, its all upside and no downside). In any case, it's impossible to see why Congress should make these calls in place of the compensation committees of public company boards.

WHY DID THEY BACKDATE?

Companies backdated options because of the natural tendency of public company executives to carve for themselves. Economists call this the "agency problem." By backdating the options to a lower price, the executives could pay less for the options and make more. This violates the justification for options - motivating the executives to increase share price - because share price is built in. From the viewpoint of the executive, though, the response is, "So?".

There are several reasons they thought they could get away with it. The securities rules used to allow a lag between the granting of options and the reporting of the options. This gave the companies time to cherry-pick the grant dates. I suspect that country club banter helped the idea get around among executives. Corporate culture probably tended to favor backdating ("Who do you think you are, complaining about backdating options? The IRS? Or the SEC?"). And they never thought they'd get caught; it didn't occur to them that statistical modeling could identify habitual backdating as clearly as a dirty face identifies a little boy who's been sneaking chocolate chip cookies:

(Source: Wall Street Journal)

Once the securities rules were tightened to require disclosure of options within 2 days, backdating opportunities pretty much disappeared (though there may be residual problems with late filings). Problem solved - no tax legislation required.

THEN WHY NEW TAX LEGISLATION?

It's what legislators do. The smart thing would be for Congress to admit that it has no role in deciding the compensation of public company executives by repealing Section 162(m). Highly unlikely; rather than leaving the grown-ups on corporate boards to do their jobs, Congress is likely to "close loopholes" in Section 162(m). This will mean more billable time for CPAs and attorneys while doing nothing for corporate governance or, for that matter, to make American companies competitive. But they have a hammer, so...

Links:

Senate Finance Committee Hearing member and witness statements

Real-player feed of hearings

Complete Tax Update coverage of option backdating

Wall Street Journal option backdating scorecard

 • Backdated Options       Bookmark: del.icio.us • Digg • reddit