Options backdating, tax shelters, and corporate culture.

By moving options into the money at the date of grant, backdating disqualified many ISO awards. Employees who thought that they received ISOs in fact may owe tax on the difference between the fair market value of the stock and the exercise price on the date of exercise, and they may owe tax on the difference between the short-term and long-term capital gains rates if the stock appreciated after exercise and was held for less than one year. Employers may also be liable for failing to withhold the appropriate amounts under the withholding rules. In addition, disqualified ISOs may give rise to Federal Insurance Contributions Act (FICA) (employment tax) liability. (37)

3. Section 409A

Section 409A, which applies to compensation earned or vested after January 1, 2005, has limited applicability to the backdating scandal. There is some evidence, however, that backdating continues even today, and some backdated options may have vested after 2004.

Section 409A was targeted at deferred compensation abuse associated with the Enron scandal. Compensation which runs afoul of section 409A may not be deferred, but rather must be included in income as it vests, even if the executive has not yet received any cash. An additional excise tax may apply.

At-the-money and out-of-the-money stock options are exempt from section 409A. (38) If options were in-the-money at the time of grant, however, then under section 409A the income is realized and must be recognized as it vests (i.e., when it is no longer subject to a substantial risk of forfeiture). Executives may not wait until they exercise the options before recognizing income.

In sum, backdated options gave rise to serious negative tax consequences. While the Code can be difficult to interpret, this was not such an instance.

C. Where Was Outside Counsel?

The wisdom of denying a deduction for in-the-money options is questionable as a matter of tax policy. (39) The rules, however, are clear. I spoke to several practitioners representing companies implicated in the backdating scandal, and no one has suggested that any law firm offered comfort to backdating firms. No tax lawyer concluded that in-the-money options qualify as performance-based pay under section 162(m) or that the in-the-money options qualify as ISOs. It would have been an awfully difficult opinion to write. Backdating is not a story about the compromised independence of gatekeepers. Options backdating took place behind the backs of outside counsel and underneath the noses of the auditors. (40)

Executives never thought to seek out legal advice about the dating of options. The companies involved lacked the internal compliance controls that would have made seeking such legal advice routine. When outside counsel were involved in the drafting of documents, they had no reason to believe that the price of the options was anything other than the market price on the grant date (the date when the compensation committee approved the grant). (41) A typical Form of Nonqualified Stock Option Agreement--which is as much as outside counsel would draft in the usual case--may specify that the strike price must equal at least 100% of fair market value, but it says nothing about the date on which that historical fact must be true. (42) In-house general counsel (GC) were involved in at least some backdating cases, but somehow GCs did not worry about the legal consequences of choosing a pricing date other than the grant date. Presumably, their attention was elsewhere. No one saw the bulldozers because no one thought to look down the road at what might be coming. (43)

III. THE LINK BETWEEN OPTIONS BACKDATING AND CORPORATE CULTURE

Some of the evidence from backdating suggests sloppiness rather than intentional fraud. (44) Greed cannot explain all backdating practices. Backdating increased the value of the options, but not by as much as one might think. (45) If one had been inclined to loot the company, more efficient ways were available. Executive self-indulgence is part of the story, but focusing on greed may obscure other essential aspects. (46) It is useful to consider how options backdating occurred, at which firms it tended to proliferate, and why.

This Essay raises the possibility that the corporate culture that many "good" companies cultivate (a culture of innovation, marked by decentralization, creativity, internal competition, and managerial "slack") may also be associated with a high risk of fraud (a culture of noncompliance, marked by weak internal controls). The empirical evidence shows that options backdating is more common among smaller firms, technology firms, and firms with volatile stock prices (holding each variable constant in a multiple regression analysis)--precisely the same kinds of firms that one associates with product innovation. (47)

A. "The Way We Do Things Around Here"

Corporate culture may be defined as the shared beliefs and values of the members of a firm. Or, to put it more concretely, corporate culture is "the way we do things around here." Corporate culture is an essential aspect of industrial organization; it's not just window-dressing. If there were no corporate culture, every time an employee faced a new problem she would have no idea what values should guide that decision. Corporate culture reduces the transaction costs associated with monitoring employees, making it easier for firms to move factors of production inside the boundaries of the firm. When the culture fits closely with the employee's sense of identity, culture also provides employees with nonpecuniary "identity" benefits. (48) It thus may serve as an efficient (partial) substitute for financial compensation.

How do employees learn "the way we do things around here"? Mission statements, strategic plans, and corporate mottos abound. These can help. Because the cost of producing such documents is low compared to the cost of implementation, however, the risk of hypocrisy is acute. Employees thus look primarily to the behavior of peers and the revealed preferences of superiors for guidance. Another place they may look to is their offer letters, employment contracts, stock option agreements, and other contracts that the firm creates. The corporate culture may be reflected in these contracts. (49)

B. Product Innovation and Compliance Norms

Innovative companies frown on internal controls. Mature companies with market power tend to establish processes and promote values that ensure the orderly satisfaction of sensible goals, like holding on to one's customer base and adopting sustaining technologies to hold on to market share. Organizations where control is centralized in the hands of a few individuals tend not to be innovative. Similarly, organizations with formalized rules and procedures tend to be slow in adopting or producing innovative technologies. Growth companies, on the other hand, focus on disruptive technologies that have the potential to change entire product markets. Organizations with decentralized authority structures, lots of "slack" in the form of uncommitted resources, and a lack of internal controls are quicker to adopt change. (50) In recent years, mature companies have recognized the catch-22 of focusing on sustaining technologies, a problem popularized in Clayton Christensen's The Innovator's Dilemma. Technology companies like Hewlett-Packard have increasingly adopted strategies to mimic their more flexible growth company competitors. For example, large, bureaucratic organizations sometimes develop "skunkworks": small, subversive units within a larger organization charged with developing technological innovation. (51)

This focus on technological innovation can cause some collateral damage to compliance functions, including legal compliance. Consider how Silicon Valley companies treat their own in-house lawyers. Many Silicon Valley companies, and even some public companies, don't employ any attorneys at all, or only use them for technology transfer. According to the Wall Street Journal, some notable Valley companies such as Cypress Semiconductor (market capitalization $2.5 billion) and Novellus Systems Inc. (market capitalization $3.4 billion) don't have general counsel. (52) Even where companies employ in-house general counsel, the GC's office carries little respect or influence. One in-house lawyer explained, "you've got one hand tied behind your back.... You have to do the job, but you're just not empowered or funded." (53) General counsel is "regarded as a necessary evil." (54) Power flows to departments that generate revenue, while the legal department is viewed as a mere cost center. (55) Notably, in-house intellectual property licensing and technology transfer experts, while they are often attorneys, do not primarily serve a compliance function. Tech transfer is a profit center, not a cost center.

Silicon Valley companies rely extensively on outside counsel, most notably Wilson Sonsini, which represents about half of the Valley's public companies. (56) Wilson Sonsini attorneys generally do a superb job of doing what they are hired to do, which is to add value to major transactions in the lifecycle of innovative technology companies. They are not trained, hired, or ethically obligated to serve as hall monitors inside the companies themselves, ensuring legal compliance on mundane, day-to-day matters. (57)