Options backdating, tax shelters, and corporate culture.

(79) See generally EICHENWALD, supra note 71. Enron had no method of determining, for example, how much cash it had. Weak internal controls were apparent everywhere, including not just Fastow's office but the tax department, risk management, human resources, and the office of the corporate secretary. The Joint Committee on Taxation noted that specialized compensation arrangements for particular individuals were not handled in the same manner as other arrangements. No single department or person handled compensation arrangements; many deals were not cleared by the Human Resources Department. The Corporate Secretary's office was responsible for compiling proxy information, but was not responsible for setting up or implementing the arrangements. According to the Joint Committee on Taxation, "[b]ased on interviews with Enron employees, it was difficult to identify the persons who were knowledgeable about specialized arrangements, particularly arrangements involving top management." STAFF OF JOINT COMM. ON TAXATION, supra note 72, at 406. Everyone at Enron was concerned with hitting the numbers; no one was concerned with the integrity of the numbers.

(80) The supply side of shelters is also more complicated than standard models assume. There are two different markets for tax advisors: the tax bar and the tax shelter bar. This view of the tax bar is widely accepted by tax practitioners but it is not properly accounted for in the literature. Many laypersons, law students, and even some nontax lawyers think the whole game is rigged. Transactions go into the black box of the tax department, and after the tax lawyers have twisted the form of the transaction into the shape of a pretzel, it magically produces tax benefits.

This conventional view of tax lawyers as high-priced masters of sortilege is, needless to say, not the way elite tax lawyers view themselves. There is a difference between the tax bar and the tax shelter bar, as Wachtell Lipton partner Peter Canellos has written. See Peter C. Canellos, Business Purpose, Economic Substance, and Corporate Tax Shelters: A Tax Practitioner's Perspective on Substance, Form and Business Purpose in Structuring Business Transactions and in Tax Shelters, 54 SMU L. REV. 47 (2001). Where there is a real underlying business transaction such as a financing or an acquisition, real tax lawyers help the client structure the transaction in such a fashion as to maximize tax deductions (say, by ensuring that a new financial product is classified as debt for tax purposes but equity for financial accounting purposes) or to defer gain recognition (for example, by ensuring that an acquisition qualifies as a tax-free reorganization). Real tax lawyers won't do pure loss-generators: transactions that have no real business purpose other than to reduce tax liability, little or no economic substance, and are frequently accompanied by lengthy, opaque, "more likely than not" tax opinions aimed at obscuring the real issues on audit and shielding clients from tax penalties.

The tax bar and tax shelter bar are at odds with one another. The elite tax bar, through the tax section of the New York State Bar Association, often promotes regulatory reform. The section has failed to advocate strong reforms against tax shelters only because of the difficulty of defining the term and the relentless opposition of practitioners like Sullivan & Cromwell's David Hariton and Cleary Gottlieb's James Peaslee, who worry about the impact of broad anti-abuse rules on nonfraudulent transactions.

(81) See Tanina Rostain, Travails in Tax: KPMG and the Tax Shelter Controversy, in LEGAL ETHICS: LAW STORIES 89 (Deborah L. Rhode & David J. Luban eds., 2006).

(82) See Superseding Indictment, United States v. Stein, 435 F. Supp. 2d 330 (S.D.N.Y. 2006) (No. 05 Cr. 888 (LAK)). I am indebted to Larry Zelenak for calling my attention to this aspect of the KPMG case.

(83) See Mihir A. Desai & Dhammika Dharmapala, Corporate Tax Avoidance and Firm Value (Nat'l Bureau of Econ. Research, Working Paper No. 11241, 2005), available at http://www.nber.org/papers/w11241; see also Jeffrey N. Gordon, What Enron Means for the Management and Control of the Modern Business Corporation: Some Initial Reflections, 69 U. CHI. L. REV. 1233, 1238 (2002) (noting the carryover mindset from tax planning to accounting planning); Mihir A. Desai & Dhammika Dharmapala, Corporate Tax Avoidance and High-Powered Incentives, 79 J. FIN. ECON. 145 (2006); Mihir A. Desai, Alexander Dyck & Luigi Zingales, Theft and Taxes, J. FIN. ECON. (forthcoming 2007), available at http://dx.doi.org/10.1016/j.jfineco.2006.05.005; Mihir A. Desai & Dhammika Dharmapala, Earnings Management and Tax Shelters (Harvard Bus. Sch. Fin. Working Paper No. 884812, 2006), available at http://ssrn.com/abstract=884812.

(84) See Daniel W. Collins, Guojin Gong & Haidan Li, The Effect of the Sarbanes-Oxley Act on the Timing Manipulation of CEO Stock Option Awards (Working Paper, Nov. 16, 2005), available at http://ssrn.com/abstract=850564.

(85) See David Yermack, Good Timing: CEO Stock Option Awards and Company News Announcements, 52 J. FIN. 449 (1997); see also Keith W. Chauvin & Catherine Shenoy, Stock Price Decreases Prior to Executive Stock Option Grants, 7 J. CORP. FIN. 53 (2001) (finding evidence of spring-loading). Accounting professors David Aboody and Ron Kasznik, writing in 2000, found additional evidence of abnormal returns, concluding that CEOs manage the timing of the disclosures of good news and bad news to maximize the value of scheduled share awards. See David Aboody & Ron Kasznik, CEO Stock Option Awards and the Timing of Corporate Voluntary Disclosures, 29 J. ACCT. & ECON. 73 (2000).

(86) Erik Lie, On the Timing of CEO Stock Option Awards, 51 MGMT. SCI. 802 (2005).

(87) See id.

(88) Heron & Lie, supra note 20; see also M.P. Narayanan & H. Nejat Seyhun, Effect of Sarbanes-Oxley Act on the Influencing of Executive Compensation (Working Paper, Nov. 2005), available at http://ssrn.com/abstract=852964 (finding that SOX grant date reporting requirement reduces but does not eliminate opportunism).

(89) See Daniel W. Collins, Guojin Gong & Haidin Li, The Timing of CEO Stock Option Grants: Scheduled Versus Unscheduled Awards (Working Paper, Mar. 1, 2005), available at http://ssrn.com/abstract=696982.

(90) See Morse, supra note 6.

(91) See id. at 963.

(92) There is some contradictory evidence suggesting that earnings management through effective tax rate management continues unabated. See Kirsten A. Cook, G. Ryan Huston & Thomas C. Omer, Earnings Management Through Effective Tax Rates: The Effects of Tax Planning Investment and the Sarbanes-Oxley Act of 2002 (Working Paper, Dec. 4, 2006), available at http://ssrn.com/abstract=897749.

(93) Morse examines other factors that may have contributed to the development of a compliance norm, including clearer rules (such as the listing of shelter transactions) and more aggressive enforcement. See Morse, supra note 6, at 23-42.

(94) In particular, a section 404 auditor gauges the tax department's ability to monitor changes in the tax law, to properly record intercompany transactions, and to document reporting transactions with memoranda or opinions from outside advisors. The auditor also employs a sampling/testing process, which involves inquiring whether the tax director has an established decision-making process and then reviewing a sample set of records to ensure that the process is, in fact, implemented. If the sample reveals weaknesses, further testing follows. A large number of "material weakness" qualifications and adverse audit opinions are tax-related; the category is second only to internal controls related to revenue recognition. Id. at 18.

With respect to the institutional changes, Morse attributes the new compliance norm to the increase in the size of the group making tax decisions. Social science evidence, however, suggests that the size of the group cuts both ways; groups may also be susceptible to "groupthink"; small, highly cohesive groups may act in more aberrant ways than individuals working alone. See IRVING L. JANIS, GROUPTHINK: PSYCHOLOGICAL STUDIES OF POLICY DECISIONS AND FIASCOES (2d ed. 1982); Michael D. Guttentag, Christine L. Porath & Samuel N. Fraidin, Brandeis' Policeman: Results from a Laboratory Experiment on How to Prevent Corporate Fraud, at 11 (Working Paper) (on file with author).

(95) See Donald C. Langevoort, The Social Construction of Sarbanes-Oxley, 105 MICH. L. REV. (forthcoming 2007).

(96) Law professor David Weisbach has questioned the value of disclosure as a strategy for deterring shelters. His criticism, however, rests on the fact that what is disclosed under current law is not likely to increase the number of successful audits. To be effective, Weisbach notes, a much broader set of transactions would have to be disclosed, so as to avoid the problem of distinguishing ex ante between legitimate and illegitimate transactions. I would add to this analysis the added benefit that disclosure may disrupt the internal dynamics of the tax department. Even with a low risk of audit, the act of disclosure itself tends to change the behavior of the actors.

(97) See Guttentag, Porath & Fraidin, supra note 94, at 7.

(98) See id.

(99) See Claire A. Hill & Erin A. O'Hara, A Cognitive Theory of Trust, 84 WASH. U.L.Q. (forthcoming).