WSJ: Tax Origins of Stock Option Scandals

Interesting front-page story in today's Wall Street Journal:  Bosses' Pay:  How Stock Options Became Part of the Problem; Once Seen as a Reform, They Grew Into Font of Riches And System to Be Gamed, by Mark Maremont & Charles Forelle:

The [stock option] bandwagon got two big boosts from an unlikely source: Congress.

First, it passed a law, pushed by President Clinton, seeking to rein in executive pay by limiting the tax break for it. The 1993 law said companies couldn't deduct yearly compensation of more than $1 million for any one of their top five officers. But it exempted certain kinds of pay linked to performance, which included stock options. Companies rushed to restructure pay plans to grant more options. In 1994, the first year the law was in effect, the value of option grants to CEOs at S&P 500 firms leapt by 45% on average, according to Mr. Murphy, and nearly doubled again over the next two years. The 1993 law "deserves pride of place in the Museum of Unintended Consequences," said Christopher Cox, chairman of the Securities and Exchange Commission, this fall.

Then in 1994, Congress helped beat back a proposed rule requiring companies to treat a stock-option grant as an expense and deduct it from profits. The plan, backed by the SEC and accounting rule makers, sparked intense corporate opposition. Congress stepped in to fight it, and after a long battle, the accounting rule makers caved. They issued a watered-down rule saying all that companies had to do was disclose in a footnote what options would have done to their profits, had the proposal passed.

Meanwhile, Congress left alone an older law that gave companies a tax deduction whenever stock options were exercised. Under that rule, which applied to the most common type of option given to executives, the employer can deduct a dollar from its income for tax purposes for every dollar of option gains pocketed by employees.

With rules like these, "what wasn't there to like about a stock option?" says Paula Todd, a compensation expert at consulting firm Towers Perrin. "You could grant them in unlimited amounts, with no expense, and claim a tax deduction. [Companies] would pay their dry cleaners if they could with stock options."