Options backdating, tax shelters, and corporate culture.

This Essay examines the problem of tax noncompliance through the prism of the options backdating scandal. The noncompliance of backdating was obvious, at least to tax lawyers. Backdating wasn't a sophisticated tax scheme. Rather, the noncompliance was collateral damage from weak internal controls and, in some cases, the rent-seeking of executives.

Noncompliance in the face of clear rules is an overlooked problem in the corporate tax shelter literature, which tends to focus on disclosure, deterrence, or statutory interpretation. We should also study what creates the demand for tax shelters. The evidence from backdating suggests that a fast-and-loose attitude can develop when innovative companies outgrow their internal controls. When viewed in institutional context, this subset of corporate tax shelters, although adorned with more formal attire than backdating, may also be best understood as a compliance issue rather than a problem of textualism or inadequate penalties.

The implication for law reform is that process matters. Culture matters. We may have more success in closing the tax gap if we support procedural changes in the way companies approach tax compliance rather than altering the substantive rules in ways that may have unintended consequences for nonfraudulent transactions.

I. INTRODUCTION

The academic literature on corporate tax noncompliance focuses mainly on sophisticated tax shelters. Reform proposals either aim to make shelters more difficult (or costly) to produce by substantively limiting opportunities for gamesmanship, or they aim to alter the cost-benefit calculation that taxpayers make when they enter into shelters by increasing penalties or increasing the risk of detection.

In a recent Columbia Law Review Essay, for example, Professors Chirelstein and Zelenak aim to limit gamesmanship by following the lodestar of the at-risk and passive loss limitations. (1) They unveil one version of the elusive silver bullet that, by disallowing noneconomic losses, would take out corporate tax shelters once and for all. (2) Practitioners have noted, however, that their proposal may have unintended consequences on nonfraudulent transactions.

The Joint Committee on Taxation, taking an incremental approach, has recommended that Congress codify the economic substance doctrine. (3) Codifying the economic substance doctrine would make some tax shelters less likely to find sympathy with textualist judges, and it would have the added benefit of making shelters a bit more costly to design and execute. Other proposals jiggle the design of penalties. (4) Still others focus on interpretive theory. (5)

Many of these ideas have a great deal of merit and deserve serious consideration. What surprises me is that, for the most part, the literature stands about where it was in the pre-Enron era. My modest contribution to this Symposium is the following claim: In pursuing the goal of lasting, effective tax reform, tax scholars may glean some insight from the corporate governance scandals of the last decade and the strengths and weaknesses of the regulation that followed. The lesson I focus on here is that process-oriented solutions may be quite effective (too effective?) in establishing a culture of compliance. This insight will not blow the socks off of many corporate governance scholars, but it may nudge the tax literature in a new direction. (6)

This Essay examines the problem of tax noncompliance through the prism of the latest corporate scandal: options backdating. Options backdating violated the accounting rules and, in many cases, the securities laws. It also violated the tax law. (7) Unlike some of the murky issues related to securities disclosure, the tax analysis is relatively straightforward. Backdating was not a sophisticated tax scheme. Rather, the noncompliance was collateral damage from weak internal controls and, in some cases, the rent seeking of executives.

Noncompliance in the face of clear rules is an overlooked problem in the corporate tax shelter literature. A noncompliance norm--perhaps better characterized as a fast-and-loose attitude--can develop when innovative companies outgrow their internal controls. When viewed in institutional context rather than as an abstract economic problem, a subset of corporate tax shelters may be better understood (like backdating) as a problem of noncompliance rather than a problem of statutory interpretation. Although tax shelters are adorned with more formal attire than backdating, both problems are similarly rooted in corporate culture. Corporate tax shelters are more likely to be adopted by tax directors who view their departments as profit centers rather than cost centers.

The implication for law reform is that process matters. We may have more success in closing the tax gap if we encourage procedural changes in the way companies approach tax compliance rather than altering the substantive rules in ways that may have unintended consequences for nonfraudulent transactions.

We should proceed with caution in implementing reforms aimed at cultivating compliance norms. Corporations may face a trade-off between creativity and compliance. They want to encourage innovation and flexibility, embracing disruptive technologies and creative destruction. (8) Too little creativity and the firm stagnates, stifling employees with demands for TPS reports. (9) A "Googley" culture of chaos encourages product innovation. (10) The quandary is that the selfsame lack of internal controls that gives managers the freedom to innovate may also lead some managers down the garden path of earnings management, tax shelters, and other forms of regulatory gamesmanship.

The evidence from options backdating suggests that, broadly speaking, firms that cultivate an innovative corporate culture also tend to carry this imaginative attitude into the regulatory arena. This is not to say that all innovative firms "get creative" with their financial statements and tax returns. (11) The evidence simply suggests a positive correlation between product innovation and weak internal controls. The trick is to come up with a regulatory design that constrains gamesmanship without suffocating product innovation under a blanket of paperwork. (12) Recent research on the economics of identity and trust suggest some promising avenues for further research.

This Essay is organized as follows. Following this introduction, Part II describes the mechanics of backdating and its tax consequences. Part III describes the link between options backdating and corporate culture and reviews the quantitative empirical evidence. Part IV explores the "corporate culture" aspects of tax shelters. Part V examines the implications for law reform.

II. THE TAX CONSEQUENCES OF BACKDATING

Most corporate tax shelters take the form of a complicated transaction with multiple entities. (13) The execution of the transaction, coupled with a literal reading of the Internal Revenue Code (Code), generates noneconomic tax losses for the taxpayer and, if necessary, the allocation of taxable income to a tax-indifferent counterparty.

In contrast, the tax analysis of options backdating is simple. It isn't really a tax play at all. Rather, it's best characterized as simple noncompliance, like winning the March Madness NCAA office pool and not reporting the income. The relevant regulations are as clear as could be reasonably expected. If one were planning to evade taxes on executive compensation, backdating would be a senseless plan, "picking up nickels in front of bulldozers." (14) But the rules are somewhat counterintuitive to executives, rank-and-file employees, and nontax lawyers. If one doesn't know to look for the bulldozers, bending down to pick up a twenty-dollar bill off the sidewalk is a rational action, not a reckless one. (15)

These two types of transactions--options backdating and complicated tax shelter transactions--have more in common than one might think. In neither instance is a company's regular outside counsel involved. In both cases, the corporate actors charged with compliance shirk their compliance duties in favor of creatively producing revenue. In this sense, options backdating and corporate tax shelters represent two shades of the same rainbow. Both stem from a corporate culture of noncompliance and a lack of internal controls.

A. The Mechanics of Backdating

Corporations often offer stock options to executives and rank-and-file employees. These options form part of a compensation package that may also include cash salary, stock, cash or equity bonuses, and other instruments like stock appreciation rights. Executive stock option grants are normally awarded as part of a shareholder-approved plan. Rank-and-file employees usually receive options from a separate pool set aside to recruit and retain employees.

At-the-money pricing. A call option gives the holder the right, but not the obligation, to buy stock at a fixed price (the exercise price or strike price) at a future date or during some period of time in the future. The common practice is to give employees call options with an at-the-money strike price. The options have no intrinsic value (the difference between the stock price and the exercise price) at the time of grant; the options are only valuable if the underlying stock price rises. Until recently, public companies could avoid reporting options as a compensation expense on their financial accounting income statements so long as the options had no intrinsic value.