An Option to Steal

Two U.S. Senate panels held hearings last week on the growing stock option backdating scandal. But overpaid corporate executives have absolutely no reason to feel their gig might be up. We explain.

September 11, 2006

By Sam Pizzigati

In a plutocracy, a society where the rich rule, the wealthy don’t always win. But they hardly ever lose.

The latest case in point: the furor over backdated stock options.

Earlier this year, news reports revealed that many of America’s biggest corporations were playing games with the options to buy company stock they were granting top executives. Corporate boards were, in effect, handing their CEOs lottery tickets they already knew to be winners.

Last week, the backdating scandal finally hit Capitol Hill. Two different U.S. Senate committees held hearings on the ins and outs of backdating and various other related schemes that artificially — and even illegally — pump up executive pay.

And what did the hearings produce? A Senate consensus on legislative proposals that could deflate overstuffed executive pockets? Not exactly.

A new consensus, to be sure, does seem to be emerging on Capitol Hill. But that consensus has CEOs grinning. The public clamor to “do something” about backdating options is morphing into legislative maneuvering that will likely cut taxes on companies that overpay their execs.

Of course, that’s not how senators “concerned” about backdating are spinning their new-found interest in CEO pay. They insist they just want to “fix” the 1993 reform law that was supposed to end CEO pay excess once and for all.

Back in 1993, just like today, executive excess had Americans deeply upset. CEO pay had been skyrocketing all through the 1980s, from 42 times average worker pay at the start of the decade to 107 times in 1990.

Congress, in response, passed legislation in 1993 that denied companies tax deductions on any executive salary over $1 million a year. But the legislation came with a giant loophole. Companies could still deduct off their taxes, as a legitimate business expense, any pay tied to “performance” incentives.

At last week’s hearing, witnesses and senators blamed that loophole for triggering the 1990s stock option boom. Companies, they pointed out, didn’t stop overpaying executives after the 1993 million-dollar limit became law. They merely shifted executive compensation from salary into options.

All throughout the 1990s, corporate leaders hailed stock options as the ultimate in pay for performance. Their logic appeared impeccable. By giving executives an option to buy company shares at some point in the future, at the current share price, corporate boards were giving their executives a powerful incentive to “perform” and raise share prices.

If share prices did rise, executives would then be able to “exercise” their option to buy shares at the old low price, then immediately turn around and sell those shares at the new — and higher — market price, making, in the process, millions of dollars in profits.

In the 1990s, with the stock market blasting along, these millions of dollars in profits came easily. Option income soon became the single biggest component of CEO pay. In 2000, at the height of the stock market boom, executives were taking home an incredible 525 times what average workers were making, notes Executive Excess 2006, the latest annual CEO pay report from United for a Fair Economy and the Institute for Policy Studies.

Along this merry ride up the income ladder, executives discovered some neat tricks that could keep option windfalls coming even if share prices stopped soaring. They could, for instance, have their option grants “backdated” — to a day when their company shares were selling at a particularly low price.

Backdating, as pioneering analysis from academics like the University of Iowa’s Erik Lie has shown, would soon reach epidemic proportions. Between 1996 and 2005, Lie and his colleague Randy Heron found after a study of 39,888 option grants to executives at 7,774 different enterprises, companies “backdated or otherwise manipulated” 23 percent of the option grants their executives received.

Until this year, federal regulators and prosecutors paid little attention to this backdating fever. But the federal Securities and Exchange Commission is now investigating over 100 backdating cases, and executives at two companies have actually been indicted on criminal charges.

More charges, federal officials are indicating, will almost certainly be filed. So does this mean that backdating, as a practice, will soon be dying out?

Experts at last week’s hearings differed on that question. One set contended that backdating no longer poses any sort of major problem.

The four-year-old Sarbanes-Oxley corporate reform law makes backdating next to impossible, testified Christopher Cox, the former GOP congressman who now chairs the SEC. Sarbanes-Oxley requires corporations to disclose option grants within two business days. Under the old law, companies could legally wait months before reporting their option grants, time that gave them plenty of opportunity to fix a phony date.

Other experts disagreed. Sarbanes-Oxley, the University of Iowa’s Erik Lie testified, has been poorly enforced. Many companies are filing late, without significant penalty.

Even more importantly, these other experts emphasized, executives don’t have to “backdate” to manipulate options and score huge windfalls. They still can — and do — have their options “springloaded,” granted right before a corporate announcement that figures to send a company’s share price skyrocketing.

A real move against option manipulation, these experts contended, would combine much tougher enforcement of Sarbanes-Oxley filing requirements with moves against springloading.

But this course of action didn’t excite senators at last week’s hearings. The GOP lawmakers who set the Senate agenda seem much more interested in revisiting the 1993 legislation that jumpstarted the option boom.

Senator Charles Grassley, the chair of the Senate Finance Committee, charged last week that this 1993 law “really hasn't worked at all.”

“I want to know what went wrong,” Grassley said, “and how we can fix it.”

One easy fix, naturally, would simply deny corporations tax deductions on all executive compensation over $1 million, not just salary income. That would remove a major incentive to grant — and manipulate — stock options.

Such a move would also raise corporate taxes. The 1,800 corporations in the Standard & Poor's ExecuComp database, the Wall Street Journal reported last week, deducted off their taxes about $10.8 billion in executive option gains last year.

“If the $10.8 billion had been subject to standard tax rates,” the Journal pointed out, “the government would have raised an additional $3 billion or more last year.”

At last week’s hearings, GOP senators signaled they aren’t eager to go down that road. Instead, they railed against the idea of setting any corporate tax deductibility limit on executive pay.

“We should remove the limit on the deductibility for cash paid to a chief executive,” announced Utah Senator Robert Bennett.

“If a company wants to pay the CEO $5 million in cash,” added Bennett, “it should do so and be able to deduct it as a legitimate business expense.”

Ending the limit on deductibility, as Bennett suggests, would actually reduce taxes for the companies that lavish the most compensation on their executives. The more these companies pay their executives, the lower their tax bill would be.

SEC chair Christopher Cox didn’t explicitly endorse Bennett's end-the-limit approach. But he did, in answer to a question about the 1993 rule from Idaho Senator Mike Crapo, call the $1 million limit on deductibility “unworkable.”

Grassley, in his closing statement at last week’s Senate Finance Committee hearing, gave another hint that Senate leaders may soon be pushing CEO-friendly “reforms” of the 1993 tax code limit on deductibility.

“If we are going to keep this code section,” concluded Grassley, “I think a question that needs to be answered is whether it is equitable to treat high salaries of top executives at publicly traded companies differently than high salaries of other individuals.”

Meanwhile, the real equity question — whether Congress ought to start taking significant steps that narrow the vast pay gap between corporate executives and average corporate employees — goes unasked.

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Labor journalist Sam Pizzigati, the author of Greed and Good: Understanding and Overcoming the Inequality That Limits Our Lives, edits Too Much, an online weekly published by the Council on Economic and Political Affairs.

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