A link between options timing and taxes?
The Wall Street Journal recently reported on the growing scandal involving the "back-dating" of stock options issued as compensation to corporate executives. The scheme here, according to the news reports and some academic studies, is to issue the options as of a certain past date when the stock was at a lower level. In other words, if the stock is trading at $50 today but $20 dollars two months ago, the firm could issue the options (with a strike price equal to the market price) as of two months ago, allowing the executive to cash out $30 per share immediately. There is nothing illegal about this. So long as the appropriate corporate procedures (e.g., shareholder and board approval) were followed, a firm can issue any options, including back-dated options, it wants.
So why the big fuss?
For one, the failure to disclose this fact, however, would likely be a material misstatement or omission under securities laws. This perhaps explains the investigation that the SEC is turning up the heat on every day. For another, some of the allegations involve claims that corporate procedures weren't followed -- CEOs manipulated documents and/or the board in such a way as to hide the true nature of their compensation. While surely possible, none of this is proved, and we should withhold judgment until it is. Whether ultimately proved or not, this is further evidence for corporate critics, especially critics of executive compensation, that corporate governance is in need of fundamental reforms.
I don't want to rehash all of the arguments regarding the possible issues here, but instead want to consider the impact of a particular tax rule on compensation practices. In the early 1990s, the Congress passed a bill, signed by President Clinton, that capped the allowable tax deduction for executive compensation at $1 million. An important exemption was made, however, for "performance-based" compensation, and stock options are presumptively performance based. This rule severely constrains a firm in the manner in which it can compensate its executives, a tricky task to begin with given the complexities of designing incentive contracts and the firm’s lack of knowledge about an executive’s wealth and private financial dealings.
Consider the following case: a firm that wants to pay an executive $5 million in cash and provide the executive with $10 million worth of stock options (to create incentives to maximize shareholder value), can write this contract just like that, but will be able to deduct only $1 million of the cash compensation. Alternatively, the firm can pay a cash salary of $1 million, give the $10 million worth of stock options, and, make up the $4 million shortfall in cash, by back-dating some options to create an automatic $4 million profit based on the current trading price. (The firm could not as easily just write the make-up options at a strike price that guaranteed a certain and immediate $4 million profit, since they would not, on their face, satisfy the "performance-based" requirement of section 162(m) of the Internal Revenue Code. Of course, back-dating once discovered also does not meet this standard. Expect the IRS to visit this issue with the firms in question.)
Without defending these firms, since we don't know what they did or why, it is a serious question whether this rule encourages this type of misleading behavior. I don't know if this is what some firms were doing, but it is possible that a rule effectively requiring firms to use incentive contracts when they didn’t want or need to, encouraged the deception, whether it was legal or illegal. I tend to think that firms should be able to pay what they want to whom they want in the form they want, so long as it is properly disclosed. Insofar as the tax rule in question biases one form over another or encourages deception, and especially since it has not in anyway constrained executive pay, it must be viewed as a failure.