Options backdating, tax shelters, and corporate culture.

Innovative companies may worry less about legal compliance because their cultures tend to be dominated by entrepreneurial founders with strong personalities. Entrepreneurs may cede some control to venture capitalists as the companies grow, but they often retake control after they go public. Having successfully led the company from infancy to IPO in a context relatively free from internal controls, founders may see little reason to rush to implement them.

C. Empirical Findings

The empirical evidence from backdating suggests a cultural tension between technological innovation and legal compliance. (58) The empirical literature shows that the practice of backdating was widespread, but it also reveals some patterns. Professors Heron and Lie, using both univariate analysis and multivariate regression analysis, find that (1) small and medium-sized firms, (2) technology firms, (3) firms with volatile stock prices, and (4) firms audited by non-big-five auditors are more likely to have backdated options. (59) The authors posit that volatile firms are more likely to backdate because the options volatility gives those firms more to gain. (60)

But the same volatility that makes options more valuable makes the backdating cushion less valuable. Boston University law professor David Walker tells a more nuanced story to explain the link between volatility and backdating, concluding that options backdating was a gimmick designed to boost the value of fixed-value option grants. (61) Neither Walker's theory nor Heron and Lie's theory, however, explains why technology companies and smaller companies, after adjusting for volatility in a multiple regression analysis, would be more likely to engage in backdating.

Culture may be part of the explanation. Small firms, technology firms, and firms with volatile stock prices are all more likely to have corporate cultures that encourage product innovation over compliance. They tend to have decentralized organizational structures, weak internal controls, and plenty of organizational slack. (62) Further empirical work may help us understand the link more clearly, which in turn may allow us to target regulatory design with more precision.

The loose corporate culture and the porous boundaries of Silicon Valley firms are key aspects of the region's success. (63) The culture may also breed noncompliance. The temporal evidence from backdating shows that the practice accelerated over time as it was adopted at different firms. Geographic evidence suggests that the practice spread from firm to firm, first in Silicon Valley, then to other firms across the country. It is unclear whether the practice spread through the movement of employees and executives, or perhaps through a change agent; in this case, compensation consultants may have been involved. (64)

It is not the goal of this Essay to find someone to blame for backdating. Gleaning insight for regulatory design purposes is a much more exciting proposition. In this regard, introducing culture as an omitted variable or "X-factor" upsets the typical assumptions used to model the behavior of corporate actors. (65) As Professor Weisbach has emphasized, the mystery of tax compliance is not why there is so much cheating, but why there is so little. (66) Identifying the cultural attributes associated with noncompliance may help us solve the puzzle.

IV. TAX SHELTERS AS A COMPLIANCE PROBLEM

Conventional wisdom attributes much of the corporate tax gap--the difference between what public companies actually make and what they report to the Internal Revenue Service (Service)--to sophisticated tax shelters. (67) In contrast, when it comes to small private companies and individuals, we recognize that simple noncompliance is the heart of the problem, especially the noncompliance of small business owners. It may be the case that the ancestry of the problem is similar in each instance.

Supply vs. demand. The academic literature has focused mostly on the supply side of tax shelters. Reformers seek to impose additional costs (a tax, if you will) on the production of shelters by increasing penalties, tweaking the rules, or forcing a change in interpretive theory. But there are close substitutes available for existing shelters; imposing a tax on a product for which there is a close substitute available does little but create deadweight loss. Perhaps we should focus our scholarly efforts more intensely on the demand side of the equation. Are there tools other than penalties we might use? Might disclosure play a role other than increasing the risk of detection by the Service? Why do some people develop a taste for tax shelters, when others don't?

Cost center vs. profit center. A useful litmus test is to ask whether management views the tax planning function as a method of generating profits or as a method of managing costs. When the tax planning function is viewed as a profit center, then the demand for shelters rises, as there are limits to the tax savings one can generate from transactions motivated by a nontax business purpose. Shelters provide a source of revenue in the form of tax savings, which effectively increase accounting profits just as real profits do. (68)

Enron. Enron provides a clear example. (69) Enron's corporate culture was geared towards innovation, with few hierarchies, weak internal controls, fierce competition for internal resources, and significant financial incentives. (70) Andrew Fastow's metamorphosis of the CFO office from a cost center to a profit center is a familiar tale. His stunning disregard for internal controls is described in painful detail in Kurt Eichenwald's Conspiracy of Fools. (71) Less well-known is the similar path of the tax department.

As with other departments at Enron, the tax department was expected to generate financial accounting benefits, which it did by a variety of means, including accelerating future tax benefits into the present. (72) (See Appendix A for a graphic example of what mattered at Enron.) R. Davis Maxey, an in-house tax lawyer, traveled the country meeting with bankers and lawyers to come up with new schemes. Journalists Bethany McLean and Peter Elkind report that after Jeffrey Skilling became Enron's COO:

the company increasingly turned to its tax department to act like just

another profit center--and help the company hit earnings targets by

taking more and more of the tax savings early. "In effect, we have

created a business segment for Enron that generates earnings," Maxey

wrote in an e-mail." (73)

The tax department, like every other department, was expected to hit the numbers. (74)

Maxey's efforts achieved a high return on investment. McLean and Elkind estimate that the company entered into eleven "mind-numbingly complex" tax-motivated transactions that generated $651 million in artificial tax losses. (75) Strategies included:

* Structured transactions that duplicated losses based on a single economic loss;

* Using partnership entities to shift tax basis from a nondepreciable to a depreciable asset;

* Abuse of the nonqualified deferred compensation rules (which ultimately let to the enactment of section 409A);

* Corporate-owned life insurance (COLI) and trust-owned life insurance arrangements; and

* Structured financings, including tiered preferred securities, investment unit securities, and commodity prepay transactions. (76)

A report issue by the Joint Committee on Taxation estimates that $2 billion in financial accounting benefits (and slightly less in tax benefits) were received in exchange for $88 million paid to advisors and promoters. (77)

Loose-loose. Jeffrey Skilling liked to use the phrase "loose-tight" to describe Enron's culture, by which he meant that the company could be managed loosely (and thereby encourage innovation and meritocratic competition) because of its "tight internal-control mechanism." (78) Of course, we now know that the culture, like a maniac at the poker table, was not loose-tight, but loose-loose. Enron's highly touted Risk Assessment and Control department was powerless. The dealmakers sat on performance-review panels of the risk-assessment officers asked to review their deals. Saying no to deals wasn't part of anyone's job description. Controls were so weak that Fastow himself seemed to lack the understanding that things were as bad as they were. (79)

When Enron entered into these transactions, no one seriously questioned whether they "worked." So long as the transaction would generate the right financial accounting benefits, and so long as someone was willing to provide the advice (and someone always is, given the right price (80))--Enron would enter into the transaction. Similarly, the KPMG scandal suggests that the designers of the shelters questioned their validity. (81) Significantly, the government has alleged that in some of the KPMG shelters the parties failed to actually enter into the transaction (an inconvenient fact that reveals the sham nature of the transaction). (82)

This last point is worth underscoring. After designing a tax shelter with (supposedly) enough economic substance to make it "more likely than not" to succeed in court, the parties didn't bother to execute the transaction. Once you've shown that you could do the backflip, why bother? The lack of attention to the economic formalities of the transaction belies the nature of the transaction as a sham. No one really cared if the transaction "worked" or not; taxpayers were simply buying tax benefits from promoters. Tweaking the substantive rules or codifying the economic substance doctrine seems unlikely to help address this sort of blatant noncompliance.