Options backdating, tax shelters, and corporate culture.

It may seem counterintuitive to say, as I suggest here, that avoiding corporate taxes is a sign of bad management. But the evidence is there. In an important paper, Corporate Tax Avoidance and Firm Value, economists Mihir Desai and Dhammika Dharmapala find that the average effect of tax avoidance on firm value is zero; the effect is only positive for firms that are well-governed. (83) For typical firms, the market discounts the tax savings to account for the increase in agency costs associated with gamesmanship. The market, in other words, already seems to understand that tax avoidance and earnings management stroll together arm-in-arm.

V. IMPLICATIONS FOR LAW REFORM

In this Part, I consider where paying attention to culture might lead us.

A. Process-Oriented Solutions

The obvious place to start is to consider making changes to internal control structures. To a great extent--perhaps too great an extent--Sarbanes-Oxley has already ramped up internal controls. Although aimed at accounting problems rather than tax problems, the legislation may help narrow the corporate tax gap.

First, let's consider the impact of process-oriented solutions on backdating. Sarbanes-Oxley largely eliminated the backdating problem simply by forcing stock option grants to be disclosed promptly. Prior to Sarbanes-Oxley, many stock option grants were reported on an annual basis; now, grants must be disclosed before the close of business on the second business day following the grant. This change, even with spotty enforcement, has greatly reduced the backdating of options, and it has reduced (but not eliminated) spring-loading. (84)

The more rigid process of SOX reduces opportunism. Finance professor David Yermack's 1997 Article in the Journal of Finance discovered evidence of abnormal returns on executive stock options, which he interpreted as evidence that CEOs influence compensation committees to spring-load option awards. (85) Iowa economist Erik Lie, however, was troubled by a lingering fact: the abnormal returns were increasing. It seems unlikely that CEOs got better at managing the release of news. Lie's evidence showed that the striking abnormal returns suggested not just the manipulation of the timing of news, but that the date of grants was being set retroactively. (86) The effect intensified over time, suggesting that the practice of backdating spread from firm to firm. (87) Sarbanes-Oxley stopped the practice by limiting the opportunity to backdate and implementing internal controls on the executive compensation practice.

The details of process-oriented solutions matter. In a more recent paper, Professors Lie and Heron show that abnormal returns vanish when grants are reported within a day, but they persist and increase with each day of reporting delay. (88) Three other professors at the University of Iowa have found that unscheduled option awards provide greater opportunity for strategic behavior, that boards that are less independent of management allow greater opportunism, and that, in contrast, for firms that issue scheduled options, there was no correlation between board independence and the extent of managerial opportunism. (89)

The evidence from backdating suggests that compensation practices are quite sensitive to procedural changes, and that more rigid processes can be effective in curbing fraudulent practices. Perhaps the same techniques can be applied to tax compliance.

B. Shaping the Process of Tax Compliance

Indeed, there is some evidence that Sarbanes-Oxley has already shifted companies towards a culture of compliance. Santa Clara law professor Susan Morse argues that Sarbanes-Oxley, along with other changes, has led to the creation of a "new public corporation tax shelter compliance norm." (90) Relying on anecdotal evidence from Silicon Valley and national survey evidence, Professor Morse argues that compliance with tax accounting standards and internal control requirements has replaced effective tax rate management as the priority of tax directors. (91) Tax departments are becoming cost centers once again. (92)

Professor Morse attributes the development of this new compliance norm to, among other things, changes in the institutional decision-making process. (93) Before Sarbanes-Oxley, tax directors received consulting advice from the same accounting firms that conducted the audit. Now, the tax planning and audit functions are separated absent pre-approval by the audit committee of the company's board. In addition, a section 404 auditor also vets the process to ensure that adequate internal controls are in place. (94)

The meaning of Sarbanes-Oxley is still very much being contested. (95) As interest groups hammer it out, as tax scholars we might further benefit from drawing on compliance literature from outside the tax field.

Disclosure. It has long been widely assumed that sunlight is the best disinfectant, electric light the best policeman. (96) Recent experimental evidence backs up Brandeis's assumption. In a recent Article, University of Nevada, Las Vegas law professor Michael Guttentag finds that requiring disclosure reduces fraud. (97) It is widely acknowledged that disclosure may serve a role in reducing agency costs (although it is contested whether disclosure should be mandatory). Professor Guttentag's subtle but important point is that disclosure may have an independent value in reducing fraud by changing the internal dynamics of the firm. This is consistent with Professor Morse's suggestion that the more extensive reporting that results from increased attention to internal controls reduces tax shelter activity.

Distrust. Professor Guttentag also finds that an increase in the level of trust and cohesion within a group is associated with a higher probability that a group will act in an unethical manner. (98) It's not an increase in group size, per se, that decreases fraud, but rather the lack of confidence that everyone involved is willing to play it fast-and-loose. These experimental findings dovetail nicely with the suggestion of Professors Claire Hill and Erin O'Hara that an excessive level of trust between outside directors and management may have contributed to the problems at Enron and elsewhere. (99)

Identity. Economic incentives may not be terribly effective in curtailing the subset of tax shelters I've focused on in this Essay. Perhaps the most difficult challenge, from a regulatory standpoint, is figuring out how to get corporations to hire, as tax directors, people whose sense of identity prevents them from purchasing tax shelters. (100) One regulatory possibility is to force increased participation by outside counsel, who have different professional identities and reputational concerns. Law firm partners are less willing to write tax shelter opinions than accounting firm partners, especially if a law firm opinion committee thoroughly reviews the partner's written work product. And to the extent that one's professional identity is shaped by one's peers, strong statements by the tax bar may help. (101)

VI. CONCLUSION

Using compliance to change corporate culture is potent medicine. Sociologists Lauren Edelman and Mark Suchman have documented how compliance allows social norms to take root inside firms. (102) Sarbanes-Oxley arms interest groups who may do their own rent-seeking, including not just auditors, lawyers, and consultants but also departments competing for internal resources, like in-house legal departments. (103) Cost centers may never have the status of profit centers, but SOX makes it harder for executives to devalue compliance. The benefit to shareholders of all this attention to internal controls is somewhat delicate. (104)

This Essay suggests a further cautionary note. Extensive attention to internal controls may dampen innovation in more subtle ways beyond rent-seeking. As internal resources are shifted to compliance programs, fewer resources exist to experiment with new technologies. And strict monitoring may negatively impact morale. Economists George Akerlof and Rachel Kranton, for example, find that identity is an important supplement to monetary compensation, which as a sole motivator can be both costly and ineffective. (105) Strict monitoring of employee behavior adversely affects the employee's sense of identity with the firm, casting the employee in an adversarial role. (106)

It's difficult to weigh the positive social externalities of transparency and integrity against the positive social externalities of technological innovation. Just as free-market ideologues should not assume that fraud carries no social costs, neither should regulators assume that compliance is free. (107)

APPENDIX Show Me the Money! Project Steele Earnings Benefits (in millions) 1997 6.1 1998 23.4 1999 23.3 2000 24.7 2001 24.5 2002 18.6 2003-2004 12.2 Pre-Tax Operating Earnings 132.8

Victor Fleischer*

* Associate Professor, University of Colorado Law School; Associate Professor, University of Illinois College of Law (effective June 2007). For helpful discussions, comments, and blog exchanges, I am indebted to Matt Bodie, Wayne Gazur, Mike Guttentag, Claire Hill, Sarah Lawsky, Geoff Manne, Susan Morse, Miranda Perry Fleischer, Gregg Polsky, Larry Ribstein, Bill Sjostrom, David Walker, Phil Weiser, Josh Wright, Ethan Yale, Larry Zelenak, Joe Zihal, the participants of this Symposium, and the participants of the University of Colorado Law School Faculty Workshop.