Options backdating, tax shelters, and corporate culture.

(1) Marvin A. Chirelstein & Lawrence A. Zelenak, Tax Shelters and the Search for a Silver Bullet, 105 COLUM. L. REV. 1939 (2005).

(2) See id.

(3) See STAFF OF JOINT COMM. ON TAXATION, 109TH CONG., OPTIONS TO IMPROVE TAX COMPLIANCE AND REFORM TAX EXPENDITURES 14-30 (Joint Comm. Print 2005).

(4) Recent legislative changes require increased disclosure and step up penalty provisions. See also Alex Raskolnikov, Crime and Punishment in Taxation: Deceit, Deterrence, and the Self-Adjusting Penalty, 106 COLUM. L. REV. 569 (2006).

(5) See, e.g., Joseph Bankman, The Business Purpose Doctrine and the Sociology of Tax, 54 SMU L. REV. 149 (2001); Joseph Bankman, The Economic Substance Doctrine, 74 S. CAL. L. REV. 5 (2000); Noel B. Cunningham & James R. Repetti, Textualism and Tax Shelters, 24 VA. TAX REV. 1 (2004); Brian D. Galle, Interpretive Theory and Tax Shelter Regulation, 26 VA. TAX REV. 357 (2006); Deborah A. Geier, Commentary, Textualism and Tax Cases, 66 TEMP. L. REV. 445 (1993); Michael Livingston, Practical Reason, "Purposivism," and the Interpretation of Tax Statutes, 51 TAX L. REV. 677 (1996); Lawrence Zelenak, Thinking About Nonliteral Interpretations of the Internal Revenue Code, 64 N.C. L. REV. 623 (1986).

(6) Pun intended. I am indebted to Professor Susan Morse, whose paper in the Conglomerate Junior Scholars Workshop alerted me to the impact of the Sarbanes-Oxley Act (SOX) on tax directors. See Susan Cleary Morse, The How and Why of the New Public Corporation Tax Shelter Compliance Norm, 75 FORDHAM L. REV. 961 (2006); Christine Hurt, Junior Scholars Workshop: Susan Morse, The How and Why of the New Public Corporate Tax Compliance Norm (June 26, 2006), http://www.theconglomerate.org/2006/06/junior_scholars_3.html. Any errors in the analysis that follows are my own.

(7) I should note that, in theory, just as backdating was perfectly acceptable if properly approved by the board, properly disclosed to shareholders, and properly accounted for on the financial statements, backdating was legal from a tax perspective if employees did not treat any backdated options as incentive stock options (ISOs) and employers did not take a deduction for backdated options for covered employees subject to section 162(m). But I have yet to hear about any companies that followed this path. See infra note 40.

(8) See CLAYTON M. CHRISTENSEN & MICHAEL E. RAYNOR, THE INNOVATOR'S SOLUTION: CREATING AND SUSTAINING SUCCESSFUL GROWTH 178-89 (2003) (describing the resources, processes, and values that make disruptive innovation more likely to succeed). The term "disruptive technology" comes from Christensen's 1997 book, CLAYTON M. CHRISTENSEN, THE INNOVATOR'S DILEMMA: WHEN NEW TECHNOLOGIES CAUSE GREAT FIRMS TO FAIL (1997), largely based on his study of innovation among disk drive manufacturers. The term "creative destruction," which originally comes from Nietzsche, was imported into the economics literature by Schumpeter in JOSEPH A. SCHUMPETER, CAPITALISM, SOCIALISM AND DEMOCRACY (1942).

(9) See OFFICE SPACE (Twentieth Century Fox 1999). Office Space became a cult hit after its video and DVD release for its representation of cubicle culture. TPS reports, which were once just shorthand for "testing procedure specifications" in software engineering, now stand for "Totally Pointless Stuff."

(10) See Adam Lashinsky, Chaos by Design, FORTUNE, Oct. 2, 2006, at 86.

(11) Nor are all scofflaws brilliant, inspired engineers.

(12) See Tom Perkins, The "Compliance" Board, WALL ST. J., Mar. 2, 2007, at All.

(13) For a classic example of aggressive tax planning, see Jesse Drucker, Bermuda Triangle: How Merck Saved Itself $1.5 Billion Paying Itself for Drug Patents, WALL ST. J., Sept. 28, 2006, at A1 (describing the use of a partnership to allocate income to tax-indifferent counterparty). See also Karen C. Burke, Castle Harbour: Economic Substance and the Overall-Tax-Effect Test, 107 TAX NOTES 1163 (May 30, 2005).

(14) I borrow the phrase from ROGER LOWENSTEIN, WHEN GENIUS FAILED: THE RISE AND FALL OF LONG-TERM CAPITAL MANAGEMENT 102 (2000). Lowenstein used the phrase to describe Long-Term Capital's strategy of arbitraging small differences in prices (nickels) that were certain to converge in the long run. Id. at 102, 146-47. The problem was the slight risk that a liquidity crunch (a bulldozer) could intervene in the short run. Id. Which it did. Id. Long-Term Capital Management's innovative culture was, unsurprisingly, accompanied by a fast-and-loose attitude with the Internal Revenue Code. See Long-Term Capital Holdings v. United States, 330 F. Supp. 2d 122 (D. Conn. 2004).

(15) Those familiar with the fable about the two economists and the twenty-dollar bill lying on the sidewalk may disagree.

(16) See FIN. ACCOUNTING STANDARDS BD., STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 123 (REV. 2004), SHARE-BASED PAYMENT (2004); cf. Treas. Reg. [section] 1.421-1(c)(1) (2004).

(17) See, e.g., Text of Bed, Bath & Beyond Filing on Options Probe, WALL ST. J. ONLINE, Oct. 10, 2006.

(18) Pub. L. No. 107-204, 116 Stat. 745.

(19) Ownership Reports and Trading by Officers, Directors and Principal Security Holders, 67 Fed. Reg. 56,462, 56,462 (Sept. 3, 2002).

(20) Randall A. Heron & Erik Lie, Does Backdating Explain the Stock Price Pattern Around Executive Stock Option Grants?, 83 J. FIN. ECON. 271 (2007).

(21) David I. Walker, Some Observations on the Stock Options Backdating Scandal of 2006 (Boston Univ. Sch. of Law, Working Paper No. 31, 2006), available at http://ssrn.com/abstract=929702.

(22) Using assumption of a ten-year time until expiration, a 3% risk-free interest rate, and 80% volatility (Professor Walker's conservative estimate for technology stocks during this period), an at-the-money option is worth $32.82, while an in-the-money option with a strike price of $35 is worth $33.31. If one assumes that the effective life of the option is a shorter period of four years, reflecting the desire of employees to cash out options soon after they vest, the at-the-money option is worth $23.93, and the in-the-money option is worth $25.03. For consistency with Professor Walker, I make these valuations based on a Black-Scholes calculator available at http://www.option-price.com.

(23) See I.R.C. [section] 422(b)(4) ("[T]he option price is not less than the fair market value of the stock at the time such option is granted....").

(24) See I.R.C. [section] 162(m)(1), (4)(C).

(25) A relevant Treasury Regulation states:

Conversely, if the amount of compensation the employee will receive

under the grant or award is not based solely on an increase in the

value of the stock after the date of grant or award (e.g., in the case

of restricted stock, or an option that is granted with an exercise

price that is less than the fair market value of the stock as of the

date of grant), none of the compensation attributable to the grant or

award is qualified performance-based compensation because it does not

satisfy the requirement of this paragraph (e)(2)(vi)(A).

Treas. Reg. [section] 1.162-27(e)(2)(vi)(A) (1996).

(26) Section 83(e)(3) states that section 83 does not apply to the transfer of options without a readily ascertainable fair market value.

(27) Section 83(e)(3) only excepts the "transfer" of options from section 83, and so once the options have vested, the vesting could conceivably constitute a realization event for the employee. The general practice has been to treat only actual exercise of the options as a realization event giving rise to ordinary income. Section 409A changes this rule for nonqualified in-the-money options. See I.R.S. Notice 2005-1, 2005-1 C.B. 274, at A-4 (d)(ii)(1).

(28) Often, employees will immediately sell the stock. If they do not, then any further gain or loss will qualify as short-term or long-term capital gain or loss, depending on the holding period from the date of exercise. See I.R.C. [section] 1223(5) ("In determining the period for which the taxpayer has held stock or securities acquired from a corporation by the exercise of rights to acquire such stock or securities, there shall be included only the period beginning with the date on which the right to acquire was exercised.").

(29) At the extreme, with a deep-in-the-money stock option, the Internal Revenue Service (Service) could conceivably seek to recharacterize the transaction as a grant of restricted stock, which would give rise to income when the property vests rather than when the option is exercised. Most backdating, however, created options that were only in-the-money by relatively small amounts.

(30) The options must also be approved by a compensation committee consisting solely of outside directors, and based on terms disclosed to shareholders and approved by a majority of shareholders in a separate vote.

(31) I.R.C. [section] 162(m)(4)(C).

(32) Backdated options may also have violated section 162(m) in other ways. In some cases, the terms of backdated options depart from the terms approved by compensation committees. Lastly, the date of grant is, in most cases, a material term that must be shareholder-approved. Arguably, where the backdating was just the result of a brief delay in papering the transaction, the original shareholder approval, which normally contemplates at-the-money options, may have been sufficient. Spring-loaded options, for example, might properly be considered at-the-money, but if the holding back of inside information were to be deemed a material departure from the plan, then the options still would not qualify under section 162(m).