Don't Blame Tax Code for Options Mess

The Senate hearings on the backdating of stock options has cast into stark relief what I was blogging about recently. I have taken the position that the only legitimate use of stock options is to align the interest of company employees with the interest of the owners of the company, the shareholders. The need to do this came about, as Professor Berle noted, with the divorcement of corporate ownership from corporate management and the rise of the professional managerial class.

At the Senate Banking Committee hearings, SEC Chairman Christopher Cox gave an example of backdating as being when an executive is granted an in-the-money option with an exercise price lower than that day’s market price. This is done by misrepresenting the date of the option grant, to make it appear that the grant was made on an earlier date when the market value was lower. The purpose of disguising an in-the-money option through backdating is to allow the person who gets the option grant to realize larger potential gains without the company having to show it as compensation on the financial statements.

Under this scenario, the option does not pass the test I enunciated above. It does not align the interest of the executives with the shareholders, who obviously cannot backdate. We have to keep our eye on this ball.

One of the biggest red herrings in this entire debate is to blame the federal tax code for the proliferation of backdating. Since 1993, the Internal Revenue Code has limited the deduction companies may take for compensation paid to certain executive officers to $1 million, which presumably set off many contortions to try to get executives more compensation. But the tax code excludes performance-based compensation from this limit. And, stock option compensation may be treated as performance-based when the exercise price is equal to or more than the grant date’s market price. In which case, the interests of the executive would be aligned with those of the shareholders. Thus, the IRC does allow for the legitimate use of stock options and always has.