Options backdating, tax shelters, and corporate culture.

(56) See Editorial, The Lawyer Behind the Throne, ECONOMIST, Sept. 16, 2006, at 70 (describing Larry Sonsini's ties to Brocade, Pixar, Echelon, Lattice Semiconductor, LSI Logic, and Novell, all of which are implicated in the backdating scandal). While Wilson Sonsini and several other Silicon Valley firms are capable of performing high-quality legal work, there is substantial evidence that Silicon Valley companies are mainly concerned with renting the prestigious reputation of counsel. See Steven L. Schwarcz, To Make or To Buy: In-House Lawyering and Value Creation (Duke Law Sch. Legal Stud., Paper No. 133, 2006), available at http://ssrn.com/abstract=941135. During the dot-com boom of the 1990s, where demand for legal services outstripped the available supply, the quality of legal work declined. See Bruce M. Price, How Green Was My Valley? An Examination of Tournament Theory as a Governance Mechanism in Silicon Valley Law Firms, 37 LAW & SOC'Y REV. 731, 744-51 (2003).

(57) Google provides a nice illustration of the point. Google was represented by supremely talented counsel, with David Drummond (a former Wilson Sonsini partner) serving as general counsel, and Wilson Sonsini employed as outside counsel. And yet in its period of staggering growth before going public, legal compliance was difficult to maintain. This led to some embarrassing stories in the press. Google failed to properly register some employee stock options. It almost accidentally became a "back door" public company. The founders gave an ill-advised interview to Playboy magazine that delayed the IPO. And the founders pushed hard to conduct the IPO itself in an unusual fashion. In addition to conducting the largest-ever auction IPO, Larry and Sergey asked Wilson Sonsini to use their first names in the prospectus and engaged in math humor in the deal design. In the end, Wilson Sonsini, led by Seattle partner Chris Montegut, helped Google complete the transaction and satisfied its innovative, demanding client. No respected commentator has suggested that the Google founders intentionally sought to violate the securities laws. But Google's "do no evil" motto didn't make it an easy client to please. Legal compliance just isn't at the top of the list of things that they spend time thinking about.

(58) Many press accounts have suggested a link between backdating and the corporate culture of Silicon Valley. At the same time, nontechnology companies, such as Barnes & Noble, Bed Bath & Beyond, Home Depot, and the Cheesecake Factory have also been caught up in the scandal. It is useful, then, to consider the empirical evidence.

(59) See Randall A. Heron & Erik Lie, What Fraction of Stock Option Grants to Top Executives Have Been Backdated or Manipulated? 14, 18-20 (Working Paper, Oct. 24, 2006), available at http://home.kelley.iupui.edu/rheron/grants%2010-24-2006.pdf.

(60) See id. at 19.

(61) See Walker, supra note 21.

(62) I do not mean to suggest that the strength or weakness of internal controls, and the culture that creates that strength or weakness, explains everything. But it seems to present a more promising story than three explanations offered to date: (1) greed, (2) prospect theory, and (3) compromised independence of gatekeepers. Even if it is a small part of the story, it may be the low-hanging fruit for regulators to grab.

(63) See generally ANNALEE SAXENIAN, REGIONAL ADVANTAGE: CULTURE AND COMPETITION IN SILICON VALLEY AND ROUTE 128 (1994). Stanford law professor Ron Gilson has suggested that California's refusal to enforce noncompete clauses in employment agreements may have been the cause. See Ronald J. Gilson, The Legal Infrastructure of High Technology Industrial Districts: Silicon Valley, Route 128, and Covenants Not To Compete, 74 N.Y.U. L. REV. 575 (1999)

(64) See also Carolyn Said, Options Scandal Grew Out of 1990s Strategy, S.F. CHRON., July 30, 2006, at F1 (attributing the spread of the scandal to the interlocking networks of Silicon Valley). There is simply not yet enough evidence of interlocking networks, law firms, auditors, or compensation consultants to draw any useful conclusions. A recent report by The Corporate Library raises the possibility that the practice spread through interlocking directors, and the media spun the report in this fashion, as a corrupt-gatekeeper story. The Corporate Library's actual report, however, emphasizes weak internal controls as well, and focuses on interlocking directors more as an avenue for further research. See PAUL HODGSON, BACKDATING STOCK OPTIONS: ARE THERE COMMON CHARACTERISTICS AMONG THE COMPANIES IMPLICATED? 18-19 (2006).

(65) For an example from the tax shelter literature, see Graeme S. Cooper, Analyzing Corporate Tax Evasion, 50 TAX L. REV. 33 (1994). Cooper states:

This Article focuses exclusively on the economic analysis of tax

evasion principally because, as I later argue, in so far as corporate

tax evasion is a systematic practice undertaken by corporate managers,

it is best understood as driven by financial goals and incentives that

lend themselves well to economic analysis.

Id. at 47-48. Cooper elaborates:

This Article makes the assumption that the incentives that motivate

the management of both publicly and privately held corporations to

evade corporate tax are principally financial and that other

noneconomic constraints of the kind noted above do not effectively

prohibit evasion, although they may operate as constraints changing

its price.

Id. at 74.

(66) See David A. Weisbach, Ten Truths About Tax Shelters, 55 TAX L. REV. 215 (2002).

(67) See David Cay Johnston, Tax Moves By Enron Said To Mystify the I.R.S., N.Y. TIMES, Feb. 13, 2003, at C1. Johnston states:

Corporate profits reported to the I.R.S. in 1998 were $155 billion

less than those reported to shareholders, according to Mihir A. Desai,

a Harvard economist. His study and others suggest that tax shelters

may be the primary reason for this difference, which is costing the

government as much as $54 billion in taxes each year.

Id.

(68) I recognize that, from an economic standpoint, increasing profits and managing costs amount to the same thing. But the distinction is nonetheless useful, as it reveals how tax directors approach their jobs. It explains why a tax director may spend $50,000 ensure that $1 million in gain on the sale of a subsidiary is deferred, but won't spend $50,000 to enter into a tax shelter that generates $1 million in losses.

(69) Other examples, like Tyco, come to mind. While it can be dangerous to generalize based on stories, see Gregory Mitchell, Case Studies, Counterfactuals, and Causal Explanations, 152 U. PA. L. REV. 1517 (2004), quantitative evidence about tax shelters is difficult to unearth, even with subpoena power. Importantly, I am not claiming that all firms that use tax shelters are like Enron, but rather that Enron's lack of internal controls is typical of a subset of firms that use shelters.

(70) See generally LOREN FOX, ENRON: THE RISE AND FALL (2003).

(71) KURT EICHENWALD, CONSPIRACY OF FOOLS: A TRUE STORY (2005).

(72) The Joint Committee on Taxation report explains:

As Enron's management came to realize that tax-motivated transactions

could generate financial accounting benefits, Enron looked to its tax

department to devise large transactions that would increase its

financial accounting income. Enron came to view the role of its tax

department as more than managing its Federal income tax liabilities.

Rather, Enron's tax department became a source for financial

statement earnings, thereby making it a profit center for the company.

With an emphasis on short-term profitability and cash flow, Enron used

various techniques to generate current financial statement net income

and increase cash flows. Enron also used techniques with respect to

its tax planning by engaging in [twelve] large structured transactions

during the period from 1995 until it filed for bankruptcy. At their

core, Enron's structured transactions were designed to permit Enron to

take the position that its long-term tax benefits could be converted

to current or short-term financial statement net income. In most of

the structured transactions discussed in this Report, the origin of

the financial accounting benefits was the reduction in Federal income

tax that the transaction was anticipated to provide either currently

or in the future.

STAFF OF JOINT COMM. ON TAXATION, 108TH CONG., REPORT OF INVESTIGATION OF ENRON CORPORATION AND RELATED ENTITIES REGARDING FEDERAL TAX AND COMPENSATION ISSUES, AND POLICY RECOMMENDATIONS 8 (Joint Comm. Print 2003).

(73) BETHANY MCLEAN & PETER ELKIND, THE SMARTEST GUYS IN THE ROOM: THE AMAZING RISE AND SCANDALOUS FALL OF ENRON 129 (2003).

(74) Financial benefits, not identity benefits, were given primacy at Enron. "'I've thought about this a lot, and all that matters is money,' Terry Thorn, an Enron managing director, recalls Skilling telling him. 'You buy loyalty with money. This touchy-feely stuff isn't as important as cash. That's what drives performance.'" Id. at 55.

(75) See id. at 128; see also Fox, supra note 70, at 254-55 (reporting an estimate of $1 billion in tax savings).

(76) STAFF OF JOINT COMM. ON TAXATION, supra note 72, at 8.

(77) See id. at 9.

(78) See MCLEAN & ELKIND, supra note 73, at 121.