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In “The Non-Option,” David Walker expertly dissects one of the puzzles of employee stock option compensation: why stock options are always granted at the then-current market price for the stock, resulting in “at-the-money” options.  If parties could tailor their compensation packages to individual needs and desires, one would expect that at least some firms would agree to give their employees stock options that had an exercise price lower than market price (known as “in-the money” options).  Indeed, the desire for in-the-money options was so strong that hundreds of companies essentially created them through illegal option backdating.  Recent changes to accounting rules were thought to have dampened the disparity in regulatory treatment between at-the-money and in-the-money options.  Walker’s article, however, explains how tax law has stepped in to continue this familiar bifurcation in treatment.

The narrative of the rise and fall of stock options begins in the early 1990s.  In order to encourage shareholder primacy and efficient corporate management, scholars and policymakers set upon a course of promoting incentive-based executive compensation.  This programme found its instantiation in IRC § 162(m), which allowed companies to take unlimited tax deductions for compensation earned “solely on account of the attainment of one or more performance goals.”  Since the deduction for other pay (such as salary) was limited to $1 million, this gave substantial corporate tax savings to performance-based pay.  Stock options became a natural way to provide this kind of pay.  Longstanding accounting rules took a “face-value” approach to the valuation of options because of the difficulty in calculating their value.  Under these rules, a company incurred no expense (for accounting purposes) when issuing at-the-money options; the options only needed to be expensed when the employee exercised them.  As a result, “costless” and deductible stock options fueled the Internet boom and the late-1990s stock surge.  However, increasing pressure to account for the real value of options led the Financial Accounting Standards Board (FASB) to change its rules in 2005.  FASB now requires that at-the-money options be expensed.  This change, along with the stock market bust in the early 2000s, cooled companies on options and led to more of a mix between options and restricted stock (as Walker describes in this article).

FASB’s change in its rules regarding stock options was expected to level the playing field between at-the-money options and in-the-money options, since both would have to be valued and expensed.  However, companies continue to avoid the in-the-money option in their compensation packages.  The reason, according to Walker, is no longer accounting but tax.  In 2004 Congress enacted IRC § 409A to deter certain kinds of deferred compensation strategies.  Section 409A’s provisions are fairly complicated, but at-the-money options are given a safe harbor under the Treasury regulations.  In-the-money options, on the other hand, are taxed as income at vesting, rather than exercise, and subject to an additional twenty percent penalty tax.  Section 409A essentially obliterates any incentive for companies to provide in-the-money options.

Why does § 409A continue this artificial divide between at-the-money and in-the-money?  After all, the dichotomy under the old accounting rules was generally blamed for the backdating scandal; companies and executives wanted to game the system to provide the most compensation at the least acknowledged cost.  FASB was applauded for eliminating this differential treatment in 2005, but § 409A perpetuates it.  What’s the justification?  Walker argues that in-the-money options can be problematic for tax purposes.  Options are not taxed until they are exercised, while restricted shares are taxed when they vest.  For this reason, tax policy prefers restricted stock over options.  And ultimately, Walker argues, this policy may not be all that harmful to actual compensation practices.  Although a world without in-the-money options may not provide an optimal level of contracting flexibility, a mix of at-the-money options and restricted stock can approximate in-the-money options while avoiding the negative tax consequences.

Walker’s article continues his fascinating work on executive compensation, particularly equity compensation.  He skillfully cuts across doctrinal categories to get to the heart of the compensation issues he examines.  Walker is adept at mixing discussions of corporate law, securities regulation, tax policy, accounting rules, and law and economics theory in his analysis, and his diagnosis is thereby much more tethered to reality than a view limited to one subject area.  Indeed, Walker’s work challenges all who work on compensation and governance issues to move beyond doctrinal categories to look more holistically at the interaction of law and business.

Under Jotwell’s categorization scheme, Walker’s article could easily be characterized as a tax law article or a corporate law article.  And that is part of my point in singing its praises in the labor and employment category.  Employee compensation is a labor and employment concern.  Yet stock options tend to be considered only under corporate law or securities regulation.  As Walker’s article demonstrates, tax law plays a huge role in corporate behavior related to options – a role that has generally been understudied.  (Others doing great work in the area include Gregg Polsky and Ethan Yale.)  Moreover, stock options tend to be lumped into discussions of executive compensation more generally, rather than being singled out for their unique attributes and effects.  Options are more than just a tool of CEO pay packages; they are often granted to wide swaths of a company’s workforce, and they are seen as a way for “ordinary” employees to participate in corporate success.  In fact, much of the lax treatment that stock options received around the turn of the century was justified by the opportunities that options afforded to lower-level workers.  The heightened concern for excessive compensation – and the role of the option in inflating that compensation – has dimmed the emphasis on this rationale.  But some scholars still see the option as a way of encouraging employee “ownership” without the expense and lack of diversification afforded by ESOPs and other traditional ownership vehicles.  (See, for example, In the Company of Owners, by Blasi, Kruse & Bernstein.)

As Walker notes in his article, options granted to executives are much easier to study than those given to lower-level employees, thanks to the disclosures mandated by federal securities laws.  But just because they are not disclosed does not mean they don’t exist.  I hope that Walker’s careful exegesis of these issues will encourage scholars from many fields, but particularly labor and employment law, to consider stock options and other compensation instruments as part of their research.  And I hope his example encourages scholars to cut across academic categories in order to more fully understand the law and its consequences.

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Cite as: Matt Bodie, Deconstructing Stock Options, JOTWELL (May 26, 2010) (reviewing David I. Walker, The Non-Option: Understanding the Dearth of Discounted Employee Stock Options, 89 B.U. L. Rev. 1505 (2009). ), http://worklaw.jotwell.com/deconstructing-stock-options/.