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S. HRG. 109–945

EXECUTIVE COMPENSATION:

BACKDATING TO THE FUTURE

HEARING

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

SECOND SESSION

ON

OVERSIGHT OF CURRENT ISSUES REGARDING

EXECUTIVE COMPENSATION, INCLUDING BACKDATING OF

STOCK OPTIONS AND TAX TREATMENT OF

EXECUTIVE COMPENSATION, RETIREMENT, AND BENEFITS

SEPTEMBER 6, 2006

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

CHARLES E. GRASSLEY, Iowa, Chairman

ORRIN G. HATCH, Utah

TRENT LOTT, Mississippi

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

CRAIG THOMAS, Wyoming

RICK SANTORUM, Pennsylvania

BILL FRIST, Tennessee

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

MAX BAUCUS, Montana

JOHN D. ROCKEFELLER IV, West Virginia

KENT CONRAD, North Dakota

JAMES M. JEFFORDS (I), Vermont

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

RON WYDEN, Oregon

CHARLES E. SCHUMER, New York

KOLAN DAVIS, Staff Director and Chief Counsel

RUSSELL SULLIVAN, Democratic Staff Director

(II)

(III)

C O N T E N T S

OPENING STATEMENTS

Page

Grassley, Hon. Charles E., a U.S. Senator from Iowa, chairman, Committee

on Finance ............................................................................................................ 1

Baucus, Hon. Max, a U.S. Senator from Montana ................................................ 2

WITNESSES

McNulty, Hon. Paul J., Deputy Attorney General, U.S. Department of Justice,

Washington, DC ................................................................................................... 4

Everson, Hon. Mark, Commissioner, Internal Revenue Service, Washington,

DC .......................................................................................................................... 7

Thomsen, Linda, Director, Division of Enforcement, U.S. Securities and Exchange Commission, Washington, DC ................................................................ 8

Minow, Nell, editor, The Corporate Library, Portland, ME ................................. 24

Bebchuk, Lucian A., William J. Friedman and Alicia Townsend Friedman

Professor of Law, Economics, and Finance; and director, Program on Corporate Governance, Harvard Law School, Cambridge, MA .............................. 26

Elson, Charles M., Edgar S. Woolard, Jr. Chair, John L. Weinberg Center

for Corporate Governance, Lerner College of Business and Economics, University of Delaware, Newark, DE ....................................................................... 28

Balsam, Steven, professor of accounting, The Fox School of Business and

Management, Temple University, Philadelphia, PA ......................................... 29

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Balsam, Steven:

Testimony .......................................................................................................... 29

Prepared statement .......................................................................................... 39

Responses to questions from committee members, with attachments ......... 45

Baucus, Hon. Max:

Opening statement ........................................................................................... 2

Bebchuk, Lucian A.:

Testimony .......................................................................................................... 26

Prepared statement .......................................................................................... 107

Elson, Charles M.:

Testimony .......................................................................................................... 28

Prepared statement with attachments ........................................................... 113

Responses to questions from committee members ......................................... 237

Everson, Hon. Mark:

Testimony .......................................................................................................... 7

Prepared statement .......................................................................................... 241

Responses to questions from committee members ......................................... 250

Grassley, Hon. Charles E.:

Opening statement ........................................................................................... 1

McNulty, Hon. Paul J.:

Testimony .......................................................................................................... 4

Prepared statement .......................................................................................... 260

Responses to questions from committee members ......................................... 269

Minow, Nell:

Testimony .......................................................................................................... 24

Prepared statement .......................................................................................... 272

Responses to questions from committee members ......................................... 277

Page

IV

Thomsen, Linda:

Testimony .......................................................................................................... 8

Prepared statement with attachment ............................................................. 280

Responses to questions from committee members ......................................... 292

(1)

EXECUTIVE COMPENSATION:

BACKDATING TO THE FUTURE

WEDNESDAY, SEPTEMBER 6, 2006

U.S. SENATE,

COMMITTEE ON FINANCE,

Washington, DC.

The hearing was convened, pursuant to notice, at 10:04 a.m., in

room SD–215, Dirksen Senate Office Building, Hon. Charles E.

Grassley (chairman of the committee) presiding.

Present: Senators Hatch, Snowe, Thomas, Crapo, Baucus, Bingaman, and Wyden.

OPENING STATEMENT OF HON. CHARLES E. GRASSLEY, A U.S.

SENATOR FROM IOWA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. Welcome, everybody. Thanks to all of my colleagues who are in attendance.

We all know that the American work ethic is unrivaled anywhere

in the world. We have always wanted a better life for our children

and our grandchildren. It seems to be part of our heritage that

brings us all together with one economic goal in mind.

Not only do we work harder than most societies around the

world, but we also work smarter. The fact is, we even have to work

smarter if we are going to keep up with international competition.

Entrepreneurship, innovation, and technological advancement

have been hallmarks of our economy from the beginning of our history. We remember the spirit of invention of our founding fathers:

Benjamin Franklin, Thomas Jefferson, and later on, Edison, Ford.

Today, the pioneers are in Silicon Valley.

It is America’s work ethic, coupled with our relentless search for

innovation, that has led us to be the great economy that we are.

The greatness of our economy and our society also rests on some

very fundamental principles.

We are a capitalist society that believes strongly in the power of

free markets to improve standard of living, not just here, but we

believe that for other societies as well. We believe in the American

dream, as I define it: the idea that we all have an opportunity to

achieve as much and advance as far as our ability and our hard

work will take us.

Underpinning that concept, we always have the idea that things

ought to be done in a fair way, that an honest day’s work will mean

an honest day’s pay. The factory worker who puts in his 8 hours—

and maybe today a lot more than 8 hours—knows that he will be

paid for those hours he works: no more, no less.

2

* For additional information on this subject, see also, ‘‘Present Law and Background Information Relating to Executive Compensation,’’ Joint Committee on Taxation staff report, September

5, 2006 (JCX–39–06).

Similarly, a person in my profession of farming, who worked

hard in the fields all season, takes his crop to market, gets paid

the market price of that delivery date. He or she does not have the

option to say, I want to sell my crops for the price 2 months earlier

when the market was better. This is the concept of an honest day’s

work for an honest day’s pay in our free market economy.

Our capitalist system creates winners and losers, but it is supposed to do so in a way that is fair to all and from which we all

ultimately benefit. These are American values. We, as Americans,

also believe in the supremacy of the rule of law as the ultimate enforcer of these American values.

When anyone threatens our fundamental principles, we must

take it very seriously or we risk losing our greatness as a Nation.

So today, at this hearing, we will hear about behavior at some of

our largest corporations that is such a threat.

It is behavior that, to put it bluntly, is repulsive. It is a behavior

that ignores the concept of an honest day’s work for an honest

day’s pay and replaces it with a phrase that we hear all too often

today: ‘‘I am going to get mine.’’

Even worse in this situation, most of the perpetrators had already gotten ‘‘theirs’’ in the form of six- or seven-figure compensation packages, of which most working Americans can never dream

of receiving, or maybe dream about, but never receive.

But apparently that was not enough for some. Instead, shareholders and rank-and-file employees are ripped off by senior executives who rig stock option programs through a process called backdating which further enriches themselves.

And, as we have found far too often in corporate scandals in recent years, boards of directors were either asleep at the switch, or

maybe in some cases willing accomplices.

We will hear today then from the Justice Department, the SEC,

and the IRS about how they are responding to these unfolding

scandals and what we, as a Congress, can do to aid their efforts.

We will also hear about executive compensation issues more generally, both from our panel of government witnesses and from the

second panel of experts in this area.*

It is important that we defend the American principles of capitalism and free market innovation, but it is also important that we

defend the equally important American principles of fairness and

rule of law. These are not conflicting principles. I think they are

the backbone of our Nation. Those who violate them need to answer for it.

The CHAIRMAN. Senator Baucus?

OPENING STATEMENT OF HON. MAX BAUCUS,

A U.S. SENATOR FROM MONTANA

Senator BAUCUS. Thank you, Mr. Chairman.

In the wilderness of Sinai where the children of Israel gathered

manna from heaven, the book of Exodus reports, ‘‘He who gathered

much did not have too much and he who gathered little did not

have too little.’’

3

Unfortunately, these days we cannot say the same about executive compensation. We regularly hear reports about executives who

gathered much, and not infrequently hear reports of some executives who gathered much too much.

For example, in 2001 the CEO of Tyco received a compensation package of $36 million. The CEO was later indicted for grand larceny, enterprise corruption, falsifying records, and sales tax evasion.

In 2002, the CEO of Sun received $25 million. And we cannot

forget Lee Raymond, who retired from Exxon-Mobil in January. It

was in April we read that he received a retirement compensation

package valued at about $400 million.

In 2004, the average compensation for top executives at the coun- try’s largest publicly held companies rose to $9.6 million. That is

average. That is more than 300 times the wages of the average

worker.

From 2003 to 2004, executive compensation increased by about

16 percent for that 1 year. At the same time, compensation to rankand-file workers rose by about 2 percent. Last week’s news reported that wages for working-age Americans actually declined in

2005.

As the Congressional Research Service found, these firms that

announced layoffs tend to give their CEOs comparatively larger

pay packages and a greater percentage of raises than do firms that

did not announce layoffs.

How have companies been able to pay their executives such large

compensation packages? That is what we are here to talk about

today. Today we will address executive compensation and how the

tax law treats it.

Now, I have nothing against people earning a good living. America is a land of opportunity. America is a place where people can

invent that new idea, make the new product, and make a good deal

of money doing it. God bless them.

We are also reading reports that some in corporate America are

apparently backdating stock options to boost top executive compensation. We read that the authorities are investigating dozens of

companies and executives for this latest corporate scandal. Today

we will look into the backdating of stock options.

Today we will hear about the interplay between the tax rules

and executive compensation. Yes, America is a land where people

can make a great deal of money. That is one of the reasons that

we have a progressive income tax. So today we will talk about

whether America’s tax system helps to promote fairness.

Fairness is important. No one wants to pay too much money to

the Federal Government, or to anyone else, for that matter. Most

folks simply want to pay their fair share, no more.

But some appear to be working to buck that system. Some appear to be spending their time searching for loopholes in the tax

laws. These people appear to be working aggressively to avoid paying their fair share of taxes.

So I am glad that the committee is looking into the subject of executive compensation. It is high time that we discussed some of the

abuses that have taken place, it is high time that we tried to close

some of these loopholes, and it is high time that we focused on the

4

fairness of the tax code. A fair tax code should not be as rare as

manna from heaven.

Thank you, Mr. Chairman.

The CHAIRMAN. Thank you very much.

Now we go to our first panel. We have Deputy Attorney General

Paul McNulty. We have Commissioner Mark Everson of the Internal Revenue Service, and I would take a moment just to thank him

for the efforts he is making to follow Congressional intent on debt

collection from people who do not pay taxes that we think are

owed, and would express my gratitude to you because one of the

firms you selected competitively was the CBE Group of Waterloo,

IA.

Commissioner EVERSON. That was just by chance, Mr. Chairman.

I do not want anybody to think that Iowa got a break here. [Laughter.]

The CHAIRMAN. I said ‘‘selected competitively.’’ [Laughter.]

And, finally, we are going to hear from Linda Thomsen, Director

of the Division of Enforcement of the Securities and Exchange

Commission.

Mr. McNulty, then Mr. Everson, then Ms. Thomsen.

STATEMENT OF HON. PAUL J. McNULTY, DEPUTY ATTORNEY

GENERAL, U.S. DEPARTMENT OF JUSTICE, WASHINGTON, DC

Mr. MCNULTY. Thank you, Mr. Chairman and members of this

committee. I appreciate the opportunity to be here to discuss the

practice of backdating stock option grants to executives at publicly

held corporations. Your interest in this issue and your initiative, as

demonstrated by this hearing, will certainly help to discourage illegal conduct in this area.

Stock option grants are contractual rights to purchase a share of

stock on a future date at a set price, known as the strike price.

They are often granted to corporate employees as part of their compensation package.

Typically, the strike price is the market or trading price of the

stock on the day the option was granted by the corporation’s board

of directors, commonly acting through its compensation committee.

The employee can buy the stock, usually at the end of a vesting

period, at the strike price and realize a profit by selling it when

the stock is trading at a higher price than the strike price.

Options are often granted to give employees incentive to work

hard. Their hard work will theoretically result in more profit for

the company and a corresponding increase in the market price of

the stock.

Options with a strike price equal to the current trading price of

the underlying stock are referred to as being ‘‘at-the-money,’’ and

options with a strike price below the current trading price of the

stock are ‘‘in-the-money.’’ The practice we are investigating and

here to discuss today involves stock options that are backdated so

that they are ‘‘in-the-money’’ at the time of the grant.

When options are backdated in this way, the strike price is fixed

on an earlier date when the market price for the stock was significantly lower, even though the options were actually granted at a

later date when the share price of the stock was higher. The practice of backdating allows corporate wrongdoers to fix a lower strike

5

price for the options, locking in an immediate gain to the option

holder.

In order to avoid significant accounting, disclosure, and tax consequences resulting from option grants ‘‘in-the-money,’’ some corporate executives have engaged in schemes to falsify corporate

books and records, to mislead the corporation’s board of directors

and outside auditors, to file false reports and financial statements

with the Securities and Exchange Commission, and to mislead

shareholders, the investing public, and the financial media.

And, Mr. Chairman and members of the committee, that is how

stock option backdating becomes a crime. A grant of ‘‘in-the-money’’

options is treated, under accounting principles, as compensation to

the option holder, and therefore is an expense by the corporation

and should be deducted from the reported revenue.

If a corporation backdates options and prices them ‘‘in-themoney’’ without properly disclosing this fact, the corporation is falsifying its books and records, fraudulently decreasing expenses,

and falsely inflating profits.

Backdating of stock options also conceals the fact that employees

are being given the right to purchase the underlying stock at a discount from the fair market value on the date the option was really

granted, and that misrepresents the employee’s compensation.

Corporations are required to accurately report compensation and

other remuneration to officers, including the nature of the compensation. Corporations are also required to accurately describe the

stock option plan for which they request shareholder approval.

When stock options are surreptitiously backdated, the corporation will file false and misleading reports and financial statements

with the SEC and other regulatory authorities. By doing that, the

corporation disseminates false and fraudulent information to the

investing public.

Grants of backdated options, contrary to the terms of the shareholder-approved option and compensation plans, can also be considered an embezzlement of corporate assets because the defendants

are misappropriating shares of the company at an unauthorized

and discounted value.

Secretly backdating options to a date with a lower market price

may also have tax consequences for the employee and the corporation, and I will defer to my colleague, Commissioner Everson, to explain this issue.

When this practice was first disclosed, the Department of Justice

moved quickly to initiate appropriate investigations. Many companies have restated their earnings and made public filings to that

effect.

At the same time, U.S. Attorney’s Offices throughout the country,

assisted by agents of the Federal Bureau of Investigation, initiated

contact with the SEC and began to investigate.

In Silicon Valley, where much of this backdating occurred, an organized team approach to assess the criminal implications of backdating was needed. On July 13, 2006, the U.S. Attorney for the

Northern District of California announced the formation of a Stock

Options Backdating Task Force to investigate allegations that corporations and individuals in northern California had retroactively

changed the grant dates of stock options with the intent to defraud.

6

The task force, consisting of personnel from the U.S. Attorney’s

Office and the FBI, is investigating companies in the Northern District of California to determine whether any of these companies or

individuals engaged in fraudulent option backdating or related

criminal conduct.

Fraudulent conduct involving backdating options can be investigated and prosecuted under traditional mail and wire fraud statutes and the prohibition against filing of false statements.

We can also use criminal statutes enacted as part of the Sarbanes-Oxley legislation, such as securities fraud, knowingly certifying false statements filed with the SEC, destroying, falsifying, or

altering records in Federal investigations, and destroying corporate

audit records.

Of course, some of this conduct may pre-date Sarbanes-Oxley,

and, in those instances, that legislation cannot be used. These

cases may also be amenable to prosecution under criminal statutes

relating to obstruction of justice, perjury, and criminal tax violations. Thus, the Department of Justice can rely on a number of

statutes in charging this conduct.

To date, there have been two criminal cases filed alleging backdating of options in violation of Federal securities laws and other

criminal statutes. I have summarized the allegations in these two

cases in my written testimony.

Our theories of prosecution are concerned with the accuracy and

adequacy of disclosure of material information, and in that respect

they are similar to many other DOJ prosecutions for corporate

fraud.

The practice of stock option backdating to conceal information

from corporate boards and regulatory authorities can only be seen

as brazen abuse of corporate power to artificially inflate the salaries of corporate wrongdoers at the expense of shareholders.

Like other forms of corporate fraud, the Department of Justice

takes stock option backdating seriously, and we will continue to

use our best efforts to uncover criminal conduct where it occurs.

While we cannot say at this juncture how many cases will result

in criminal charges or how many will be treated as civil matters,

we are committed to using the resources of our experienced securities fraud prosecutors and investigative agencies throughout the

country to ensure that each matter we open is thoroughly investigated.

Mr. Chairman, I chair the Corporate Fraud Task Force, and we

took this issue up at our July 27th meeting and discussed ways in

which we could work better as a group of agencies, coordinated in

an effort against this emerging problem.

We owe a duty to the American people, whose hopes, dreams,

and futures are tied more and more to the integrity of the stock

markets. I thank you again for the opportunity to be here today,

and I look forward to answering your questions.

The CHAIRMAN. Thank you.

[The prepared statement of Mr. McNulty appears in the appendix.]

The CHAIRMAN. Now, Mr. Everson?

7

STATEMENT OF HON. MARK EVERSON, COMMISSIONER,

INTERNAL REVENUE SERVICE, WASHINGTON, DC

Commissioner EVERSON. Good morning, Chairman Grassley,

Ranking Member Baucus, and members of the Finance Committee.

Thank you for inviting me to testify on the timely and important

subject of corporate executive compensation and the backdating of

stock options.

I would like to say, it is not in my written testimony, but listening to the numbers from Senator Baucus, I think we have had a

couple of pretty good years, and I would like you to consider a salary increase for me. [Laughter.]

Senator BAUCUS. Is that performance based? [Laughter.]

Commissioner EVERSON. I think so. I think we can prove that at

least as well as 162 would say. [Laughter.]

This is the first time that I have testified before the committee

since passage of the Pension Protection Act. I want to thank the

Chairman for his leadership, as well as the Ranking Member and

the other members of the committee for supporting several vital

provisions of that Act which strengthen tax administration, particularly those involving charities and the sharing of information

with State charity officials.

Before I describe our activities in the areas of executive compensation, I want to repeat my request for you to support the

President’s fiscal year 2007 budget for the IRS. Over the past several years, the Service has increased its audits of both high-income

individuals and large corporations, the taxpayer groups which we

will discuss today.

I want to continue to increase our activities in this area, and a

primary way to do this is by funding the President’s request. The

Senate budget bill calls for slightly more than the President’s request, while the House of Representatives’ bill falls short by over

$100 million.

In each of the past 4 years, Congress has enacted less than what

has been requested by the President for the IRS. I ask for your continuing support as the 2007 budget request moves towards resolution.

Turning to the subject of backdated stock options, I would like

to make several points. I find this behavior abhorrent. These executives are already plenty rich and do not need to cheat on their options. The IRS is an active member of the President’s Corporate

Fraud Task Force, chaired by Deputy Attorney General McNulty.

The Service is also working directly with the SEC in our investigation of abuses in the area of backdated stock options. The IRS

will follow up on every company and the relevant executives for

each case where it is determined that abuses have occurred.

Where we determine that inappropriate deductions were taken

by a company as a result of backdating, under section 162(m), we

will take action. We will act with respect to corporate executives

who violate new section 409(a), which will likely impact a smaller

universe of cases where option exercises occurred beginning in

2005.

In working with the SEC, we have benefitted considerably from

the quality and specificity of the information they have, and will

8

continue to provide us. As you know, the Service is prohibited from

sharing taxpayer-specific information with the SEC.

As our collaborative efforts with the SEC unfold, I ask whether

the time has come for Congress to consider authorization of targeted and protected sharing of information about public companies,

and potentially their top executives, by the Service with the SEC

and the Department of Justice.

While tax privacy laws continue to occupy a primary role in our

tax administration system, the unquenchable appetite for exorbitant compensation on the part of executives and the sheep-like willingness of boards to feed it yet again raise the issue of whether

modification to the standards of section 6103 is warranted.

Thank you.

The CHAIRMAN. Well, that was strong testimony. Thank you very

much.

[The prepared statement of Commissioner Everson appears in

the appendix.]

The CHAIRMAN. Now, Ms. Thomsen?

STATEMENT OF LINDA THOMSEN, DIRECTOR, DIVISION OF ENFORCEMENT, U.S. SECURITIES AND EXCHANGE COMMISSION, WASHINGTON, DC

Ms. THOMSEN. Thank you. Good morning, Chairman Grassley,

Ranking Member Baucus, and members of the Finance Committee.

Thank you very much for inviting me to testify today about options

backdating.

I am very pleased to testify with Deputy Attorney General Paul

McNulty and Internal Revenue Service Commissioner Mark

Everson.

While each of us has different law enforcement responsibilities,

options backdating can impact criminal and tax laws, as well as

the Federal securities laws. Because of this, I want to assure the

committee that the SEC’s enforcement staff has been sharing information with the Department of Justice and the Internal Revenue

Service, as warranted and appropriate.

Indeed, the Commission and the Department of Justice jointly

announced the filing of two enforcement actions concerning backdating earlier this year.

Hardly a day has gone by this summer when this issue and the

scandal it has raised have not been in the press. It is of intense

public interest because it strikes at the heart of the relationship

among a public company’s management, its directors, and its

shareholders.

My main objective today is to highlight, from an enforcement

perspective, some of the incentives that Federal tax and accounting

laws may have given companies and individuals to backdate, and

the resulting Federal securities law implications.

The type of backdating I am referring to is the practice of misrepresenting the date of an option award to make it appear that

the option was granted at an earlier date and at a lower price than

when the award was actually made.

In a simple stock option grant, a company grants an employee

the right to purchase a specified number of shares of the company’s

stock at a specific price, known as the exercise price. The exercise

9

price is usually set as the market price of the stock on the grant

date, or ‘‘at-the-money’’.

If an option is awarded at a lower market price, it is said to have

been granted ‘‘in-the-money’’. Typically, an employee cannot exercise the option and acquire the underlying stock until the passing

of a specified period of time known as the vesting period.

Like all employee compensation, option grants can have significant Federal tax consequences, both for companies and for employees. Backdating option grants disguises ‘‘in-the-money’’ options.

Backdating allows the option recipients potentially to realize

larger eventual gains, but still characterize the options as having

been granted at-the-money for tax, financial and executive compensation reporting purposes.

The tax incentives for companies to grant stock options increased

in 1993, when Congress capped the tax deductibility of certain top

executive compensation at $1 million. The intention may have been

to limit executive pay, but the reality is that compensation migrated to other forms, and particularly to performance-based compensation to which the cap did not apply, such as at-the-money

stock option grants.

Until last year, companies had an accounting incentive to grant

at-the-money options because they generally were not required to

record an expense for options compensation unless the options were

‘‘in-the-money’’ when granted. And, of course, all other factors remaining constant, recording less expense results in reporting higher earnings.

Financial Accounting Standards Board statement 123R, which

became effective last year, substantially eliminates the advantageous accounting treatment previously afforded to grants of atthe-money options because, unlike prior accounting guidance, statement 123R requires all option grants, including at-the-money options, to be expensed at their fair market value on the grant date.

For employees, stock options, and particularly at-the-money

grants, can be more advantageous than other forms of no-risk compensation for two tax-related reasons. First, until options are exercised, there is no taxable event for an employee. Second, unlike salary, when incentive stock options are granted at-the-money and

subsequently an employee exercises the option and holds the stock

for the statutory holding period prior to sale, 1 year after exercise

and 2 years after grant, the entire gain generally is taxed at the

highly favorable capital gains tax rate.

For individuals in higher tax brackets, this can effectively reduce

the tax liability of option-based compensation by up to 50 percent.

This favorable tax treatment does not apply to in-the-money option

grants.

Option backdating can result in companies reporting materially

false and misleading financial and executive compensation information, and in executives making false disclosures concerning their

individual stock option transactions.

Because option vesting periods can last for several years, the impact backdating can have on a company’s financials can last years.

Even backdated options granted in the late 1990s can impact recently reported financial statements.

10

To date, the Enforcement Division has brought several actions

against individuals and companies for backdating practices. We

currently are investigating over 100 additional companies concerning possible fraudulent reporting of stock option grants. While

we do not believe that all of the ongoing investigations will result

in enforcement proceedings, I do expect there will be additional enforcement actions.

Our expectation is that most of the fraudulent practices found

will have started in periods prior to 2003, before the SarbanesOxley Act required officers and directors to publicly report option

grants and exercises within 2 business days.

Backdating is much less advantageous within a 2-day window of

opportunity. There simply is not as much time to cheat on the

dates. Additionally, statement 123R greatly reduces companies’ incentives to backdate options.

Mr. Chairman, that concludes my testimony. Thank you very

much again for inviting me to appear before you today on this very

important subject. I am happy to take any additional questions.

[The prepared statement of Ms. Thomsen appears in the appendix.]

The CHAIRMAN. Thank you.

We will have 5-minute rounds. The first four will be: Grassley,

Baucus, Thomas, and Hatch.

For any of you on the panel, but I would ask you not to be repetitive of somebody else answering, I want to start with the fact that

a significant number of cases that the Federal Government is reviewing are in response to companies coming forward after conducting their own internal reviews.

The fact that companies are trying to clean up now, even though

it is after the lights have been turned on, is still very good news

because it saves the taxpayers enforcement money. However, I

want to make certain that the government is not waiting for the

phone to ring.

So, three questions, and I will ask them all at one time. First,

what percentage of backdating cases being worked on now are due

to the government’s own efforts, and what percentage are cases

where the corporation turned itself in?

Second, what action is the government taking to identify and

knock on the doors of corporations that it believes are engaged in

backdating?

And, last, it would be my hope that the government would take

a different view towards those corporations that failed to fess up.

Is the government treating corporations differently who come clean

as opposed to those who require the government to spend taxpayers’ dollars to locate them and make the case? Whatever order

you want to go in.

Mr. MCNULTY. Mr. Chairman, I will start first, just by saying

that the general approach in this area is similar to a good bit of

the corporate fraud enforcement work, in that the SEC is sort of

a front line in its oversight and has a number of cases that it looks

at and then refers to the Department of Justice cases where they

believe that criminal conduct has occurred and it is appropriate for

criminal charges.

11

So I think, in terms of what we see first, a lot of it comes up in

the context of refilings by corporations as a result of information

that they become aware of.

It is important to note that the conduct we are dealing with is

very difficult to identify because it is an insider’s game, where individuals have control of certain power and authority within a company and can manipulate records, reports, and other kinds of filings and deceive the compensation committee and create an appearance that the options were granted on a certain date and not

backdated to a much better time. So, there has been some delay

in discovering these things.

Once the problem came to light, more and more companies

looked at their own books and found this and then made their refilings, so that has triggered a large number of cases.

I will defer to Linda on this, but I am not aware of any breakdown of percentage between those cases that we have seen which

are discovered somehow on our own initiative versus those that

have been reported to us. We would have to go back and check on

that.

Ms. THOMSEN. Well, to follow up on that, I do not know of a percentage either. I would say that this issue is one that we have been

pursuing at the SEC for some time and not waiting for the issue

to be identified publicly or by companies.

Indeed, beginning in 2003, we brought our first case involving

options. We brought one in 2004, and then some this year. We have

also been working with academics to identify the potential for backdating, that is, suspicious optimal options grants, if you will.

Our own Office of Economic Analysis worked with the data so

that we could identify likely sources of problems, and then we have

been pursuing those and building on that record. As we have built

on it, companies have indeed come forward, for which we are grateful.

We think it is the right thing for companies to do and we appreciate those efforts. We have had whistle blowers in this arena. We

have followed leads in ongoing investigations. I think, cumulatively, we have developed a pretty decent record on pursuing this

particular issue.

In part to answer your second question, as a result of the economic analysis we did, as well as the analysis we saw from academics, we did go knocking on doors to gather additional information, and continue to do so.

Finally, on the third question about how we treat people who fess

up as opposed to those who do not, I think we and the Department

of Justice have long been of the view that a company that acts responsibly when confronted with a problem will be treated better

than those who do not.

Our policy is documented in an October 2001 document frequently referred to as the Seaboard Memorandum, although it is

a report of the Commission. I know the Department of Justice

Thompson Memorandum also addresses those issues.

The CHAIRMAN. My time is up. But do you have anything to add,

Mr. Everson? I will not ask another question.

12

Commissioner EVERSON. The taxes do not drive this, sir. Most of

the front end and the detection of this would come through the

SEC, as my colleagues have indicated.

The CHAIRMAN. All right.

Senator Baucus?

Senator BAUCUS. Thank you, Mr. Chairman.

Turning to a related subject, and that is tax extenders and the

failure of this Congress to extend those tax extenders.

A question to you, Mr. Everson. What is the cost going to be to

the IRS if these are not extended soon? That is, it is my understanding that about mid-October, as sort of a drop-dead date, then

the IRS is going to have to incur significant additional expenditures, whether it is with the contractors, its paperwork, its publications, website, forms, and so forth. Is that true?

Commissioner EVERSON. The longer the Congress waits to act in

any year on tax matters, the tougher it makes it for us. If you look

at last year with Hurricane Katrina and the legislation that did not

come in until early December, we did not have all our forms ready

until January or February. This is due to the fact that there are

a lot of procedures and re-coding of the information system.

You are entirely correct. The longer you wait, the tougher it is.

There are some costs, but the larger issue is the risk of mistakes

and failures to do it correctly because of stress on the system. I

urge you, if you are going to do anything more in the tax area,

please do it quickly. [Laughter.]

Senator BAUCUS. Well, I am with you. Obviously, I am asking the

question to get others to act more quickly.

Commissioner EVERSON. I am trying to be delicate in my response. [Laughter.]

Senator BAUCUS. Well, I am hoping that the Majority party hears

what you just said, and what we are all saying. We have to, Mr.

Chairman, get these extenders passed ASAP. If we do not, we are

going to incur lots of additional costs in lots of different ways.

In fact, I think it is true, Commissioner, at least I have heard,

that many companies now have to restate their financials because

of the lack of extension of the R&D tax credit for this year. Is that

correct or not?

Commissioner EVERSON. I have not heard directly of any particular numbers, sir, but I have heard that the issue has surfaced

and this is a concern.

Senator BAUCUS. I think there is one in Iowa.

The CHAIRMAN. Yes.

Senator BAUCUS. One Iowa company, in fact, has written the

Chairman to that effect. Word to the wise.

Commissioner EVERSON. My vote is with action.

Senator BAUCUS. All right.

I do not mean to be critical here. I am wondering, is there a

problem here with the Justice Department and/or the SEC and IRS

in uncovering this fraud? I say that because I understand that this

was first brought to our attention by some statistical analysis,

some firms looking at what is happening, and, lo and behold, discovered.

13

There is a lot of backdating, a lot of fraudulent backdating, a lot

of in-the-money, if you will. It was only then that our agencies

started to get cracking. Can somebody comment on that, please?

Ms. THOMSEN. I actually think that the increase in stock options,

the use of stock options, is a phenomenon largely of the 1990s, particularly in the technology sector. I think that with Form 4s, for example, we have had better information after Sarbanes-Oxley.

Academics have gotten on top of this information, and I think we

have followed the information as soon as we found it, and we were

developing it before it surfaced dramatically, as it has recently. But

as the Deputy Attorney General said, fraud is, almost by definition,

collusive to a certain extent and hidden. So it is going to take some

time after it starts to occur before we will detect it.

Senator BAUCUS. Right. But I understand that the problem came

to light not because of IRS audits or SEC investigations, but because of statistical analysis by outside researchers. That is when

this first came to light.

Ms. THOMSEN. It was a combination of academic research of data

that we then followed up on. The data identified the potential for

problems and then we, with our own Office of Economic Analysis,

pursued that data and the companies highlighted to take those investigative leads to develop a case. What the data identified was

the opportunity, if you will, the notion that there appeared to be

fortuitous grants given.

Senator BAUCUS. This gets to another issue, as you well know,

Mr. Everson, and that is the tax gap and resources to address the

tax gap. As you well know, this committee—I, especially—has had

ongoing discussion with the Treasury Department in order to come

up with a plan to solve that tax gap, the $320, $330 billion, whatever it is, of income taxes legally owed but not collected every year

that we have to begin collecting. It is only fair to U.S. taxpayers.

I am sure a lot of that depends on the resources that the IRS

has, or maybe other agencies have, in order to determine the various components of that gap.

You mentioned in the beginning of your statement that you

wanted us to support the President’s budget, and in fact I will try

to get additional resources to you. But to what degree are inadequate resources a problem in identifying and solving option backdating or excessive compensation or other issues here that are related to the tax gap question?

Commissioner EVERSON. Let me broaden the question just a little

bit from the backdating of the options. In terms of the money that

is at stake, it is not that great on the tax side compared to some

of the many other components of the tax gap that we are familiar

with.

What you are getting to is a very important point. It is about the

harnessing of technology and the use of analytics to risk-assess and

select what we look at.

As the committee knows, we mandated, at the end of 2004, the

electronic filing of tax returns by large corporations and the largest

not-for-profit entities. That is for the tax year 2005, the returns

that are being filed now. This was resisted by corporations, who

screamed like stuck pigs, but we are now getting this done. We are

14

reaching the real peak now, and we have had many of the largest

returns filed.

For example, General Electric—I can say this publicly because

they agreed to do this—has an extremely complex return, and that

came in, and we have had other very complex returns come in. The

final peak is just next week, and I am hopeful that will all go

smoothly.

The ability to take that data, these thousands of pages of entries,

and then to array that will give us the ability to make significant

strides in our work. We will have the ability to be able to take a

big company, that we might not be able to look at the whole return

each year, but we will look at the areas where the ratios are out

of line with other industry competitors and focus on that and get

to issues like this.

So the question of the health of our systems, the infrastructure

that we have, and the funding of all that is very pertinent to our

ability to do that, sir.

Senator BAUCUS. But do you have the resources to do the analytic work, the algorithms? Google has all these algorithms to figure out how to get the right answer to your search request.

Commissioner EVERSON. No, we are not where we should be.

Senator BAUCUS. You need to develop algorithms so that you can

get the right answers to your search request as to whether this

person is or is not, potentially, properly filing or violating the law.

Commissioner EVERSON. You are absolutely right. We need to

greatly enhance our analytical capabilities. Again, this does come

back to the funding question, because the $1.8 billion that we

spend each year on the combined base IT spending and modernization program, has not been fully funded each year by the Congress

when we have requested it.

Senator BAUCUS. Well, maybe when we get this plan together of

closing the tax gap, you can plug that in.

Commissioner EVERSON. That is certainly an element of any

plan.

Senator BAUCUS. When you are talking to the Treasury Department and Secretary Paulson and the crew, because we have not

closed on that yet, you can add a lot there.

Commissioner EVERSON. Since we have raised this, I would like

to make a pitch. It would be helpful for us to have an Assistant

Secretary for Tax Policy to finish up that plan. [Laughter.]

Senator BAUCUS. I think they are integrally related. You get the

plan and you will get the Assistant Secretary.

The CHAIRMAN. Senator Thomas?

Senator THOMAS. This is an interesting issue. I am a little surprised by the implication that high executive pay and criminal behavior are inextricably linked. Now, I cannot imagine that this

kind of behavior is the rule rather than the exception. You act like

every high thing is illegal somehow. Would you comment on that?

Mr. MCNULTY. The issue of stock option grants has to be looked

at——

Senator THOMAS. Well, stock option grants are not the only way

people get paid, are they?

Mr. MCNULTY. No, certainly not. Maybe I did not understand

your question.

15

Senator THOMAS. My question is, is high executive pay tied so

closely to illegal things? That is the implication that you all have

laid out here.

Mr. MCNULTY. That is not the implication that I certainly intend

to communicate. As part of our corporate fraud effort we look at

criminal wrongdoing, not something like the size of someone’s pay,

or whatever.

I mean, there may be tax issues that are involved in compensation questions, but as far as the question of enforcing Federal

criminal laws, that is a very clear distinction of conduct that is not

connected to just a dollar value, it is associated with a certain type

of behavior, of deception and false filings of information, and those

kinds of things. So, hopefully my testimony has laid out how we

look at the criminal side of this particular subject of stock options.

Senator THOMAS. All right.

Does anyone else want to comment?

Commissioner EVERSON. I do not think high pay, in itself, will

lead to illegality. I have said that I am very concerned about incentive compensation, particularly in the areas for the CFO, the general counsel, and the chairman of the corporation. This is because

I believe that, in the area of corporate governance, the temptation

to do the wrong thing is greatly increased if the stakes are as staggeringly high as they are.

I do think it is a risk factor that needs to be considered if individuals, particularly those who have a direct fiduciary responsibility, will personally benefit to the staggering degree that they

have if the stock price goes up. The vast majority of compensation

these days comes through the stock price, so, I think it is an issue.

I certainly do not mean, sir, to say that more money is necessarily going to cause a problem. I find this particular practice

shocking, because these people are paid in the tens of millions of

dollars, and the idea that they need to get a little bit more says

that the controls within the companies and the attitudes within the

companies certainly have gone out of kilter in those circumstances.

Senator THOMAS. So you are suggesting that the high pay is generally a result of stock options?

Commissioner EVERSON. I would defer to my colleague, but I

think that the stock options certainly have been a major driver as

to the component of the compensation.

Senator THOMAS. My time is going to run out. But let me just

say, publicly traded companies are subject to a host of public disclosure statements, boards of directors, shareholders. I guess sometimes I wonder, is the system not there, if these are excessive kinds

of things, you have a number of ways to react to it, do you not?

Ms. THOMSEN. Well, indeed, if I may step in. The recently enacted executive compensation rules by the SEC are geared entirely

towards disclosure of compensation, and the Commission’s approach is one that I think is neutral as to the amount of compensation, but quite clear that, whatever it is, it needs to be disclosed

clearly and accurately.

Our focus from a law enforcement perspective is going to be on

those situations where that is not going on, not so much geared towards the amount, but rather——

16

Senator THOMAS. I guess you have to think, when we are talking

about this topic, certainly what you have said is true, but on the

other hand, this is a free market system. This is a system where

it is up to the people to disclose. We are not there to control the

salaries that people are paid.

Commissioner EVERSON. I would not suggest that. If there is any

inference of that, that the government should step in, sir, that is

not where I am. I do find it disappointing that the boards of these

companies have not done a better job of making sure we did not

get to where we are.

Mr. MCNULTY. Mr. Chairman, may I make a real quick point?

That is the issue, though, for us. You have identified these oversight structures that exist and are in the private sector and are

very important, and we rely on them. The integrity of the marketplace depends upon truthfulness. What these cases are about is deception of those very systems that we count on for oversight and

ensuring integrity.

Senator THOMAS. I understand that. I just hope we do not infer

that most everybody is breaking the rules. Anyway, thank you.

The CHAIRMAN. Now the Senator from New Mexico.

Senator BINGAMAN. Thank you very much, Mr. Chairman. Thank

you all for being here.

Let me ask Mr. Everson. My understanding is that, under the

tax code, the general rule is, amounts paid in compensation to executives are deductible as long as they are reasonable. There is

some reasonable test in there. Am I accurate about that?

Commissioner EVERSON. Section 162(m) has been in the law

since 1993. I believe it pertains to the top five executives. I think

it parallels what Linda and the SEC drive the disclosure on, the

very most senior people.

There is a potential limit as to the deductibility of amounts over

$1 million if it does not meet certain standards. Those standards,

as I think you will hear from the follow-on panel, are relatively

easy to meet.

Senator BINGAMAN. But, as a general matter, you are not aware

of any requirement that, in order for an expense of the company

to be deductible, it must be a reasonable expense and some kind

of general requirement of reasonableness must apply.

Commissioner EVERSON. There are several standards about performance-based compensation, but some companies, in our experience, will even forego the deduction and continue to pay the high

compensation.

Senator BINGAMAN. All right. So there is no effective limitation

by virtue of a requirement of reasonableness on the ability of a

company to compensate its executives.

Commissioner EVERSON. I would say at this stage, if there is a

belief that the standards of 162(m) have changed practices in that

regard, I do not think that that is correct.

Senator BINGAMAN. One of the witnesses on the next panel, Prof.

Bebchuk from Harvard Law School, makes the point that ‘‘the massive use of deferred compensation plans has enabled getting around

the limitations of non-performance pay established by section

162(m).’’

17

He goes on to point out that ‘‘as long as the payment of the

amount is deferred until the executive leaves, then the law does

not in any way restrict the ultimate deductibility of that by the

firm.’’

Would you agree that, if we are going to try to limit the deductibility of excessive executive compensation, we ought to close that

loophole?

Commissioner EVERSON. I would not comment, sir, on any particular loophole. I would suggest to you that, by nature of the constituency that this affects, corporations work extremely hard to

lawyer up and make sure that they are in compliance with standards that you would set in law.

So if you are going to review these areas, you want to step back

and do it very carefully because they will find ways to find where

those lines are and go right up to them.

Senator BINGAMAN. All right.

Let me ask, Ms. Thomsen, I gathered from your statement that

you think this problem of backdating of options is largely a preSarbanes-Oxley problem and that the law now under SarbanesOxley, which requires the reporting of these option grants within

2 days, pretty much solves the major abuses that we are now

aware of. Am I right about that or not?

Ms. THOMSEN. I think that—in combination with the change in

the accounting rules—has done a lot to reduce the opportunity for

abuse of options by backdating, yes.

Senator BINGAMAN. Is there anything more that you recommend

that Congress do to try to solve this problem? Is there any change

in statute that is required in order for us to be sure that this backdating problem is not there? I mean, anything in the reporting that

people need to do to the IRS?

I was particularly struck by this response, Mr. Everson, that you

gave to Senator Kerry earlier in August, where you said, ‘‘to my

knowledge we were not aware of, nor had found in income tax returns, any indication of options backdating prior to the media reports that backdating had likely occurred.’’ So is there anything

that we should be doing to increase reporting requirements?

Commissioner EVERSON. I guess, sir, what I would say is, it does

raise a question. The well-paid corporate executive fills out the

same forms that the simple farmer does in Iowa. So the question

is, if people want more reporting, more reporting could potentially

surface some additional issues. This is not something we would see

on the face of the tax return, though, or did see.

Senator BINGAMAN. Did you have any comment on this, Ms.

Thomsen, if there is anything else that would be an appropriate action by Congress?

Ms. THOMSEN. I think at this point, given the new compensation

rules that the SEC has just enacted, we are quite hopeful that that

will also truly reduce the opportunity. We have not seen those in

effect yet, so at this point I think it may be premature.

But I think the combination of the change in the accounting

rules, the Sarbanes-Oxley reforms, as well as the new executive

compensation disclosure rules, are going to go a long way in this

arena to clear out some of these abuses.

Senator BINGAMAN. Thank you, Mr. Chairman.

18

The CHAIRMAN. Please do not use the word ‘‘simple’’ in front of

a farmer. [Laughter.]

Commissioner EVERSON. My apologies, sir.

The CHAIRMAN. Senator Wyden?

Senator WYDEN. Thank you, Mr. Chairman.

Mr. Everson, picking up on your last point, I do not think people

want more dumb bureaucracy and more reporting.

Commissioner EVERSON. I agree.

Senator WYDEN. But I think they do want an end to the double

standard. I think there is a sense now that the people at the top

can manipulate the system, including stock options, and get a

windfall, while the gal, say, in the secretary pool with a modest income does not get a fair share of the pie.

What I want to ask you about picks up on this question of what

I think is a woefully inadequate law, what is called 162(m), with

respect to the unfair, unwarranted compensation. But what are the

options for strengthening that, in your view, so as to get at this

double standard question?

Commissioner EVERSON. I think Senator, that you are raising a

lot of policy questions that I would——

Senator WYDEN. I asked you for the options for strengthening

162(m). Not what you are even in favor of, but what are the options?

Commissioner EVERSON. I have not thought too much about what

the options are. I will reflect on it with my colleagues from Treasury and we will get back to you. I would simply make the observation that, right now, as I indicated, because the standards are reasonably simple—as Senator Bingaman has already indicated—people will very closely study them and comply with them. I do not

think it is having the impact that was anticipated. I would want

to look at options before I would surface them for you.

Senator WYDEN. I would like you to do that, because I think

some of these performance-based measures are really a joke. I

mean, it is one thing to talk about something that really does reward a proven performance and track record that lifts all the boats,

and another to set the bar so low with respect to performancebased goals as to make it, I think, pretty much a joke. That is what

I think is troubling.

I would like to have you provide to the Chairman and to Senator

Baucus, so we all can have it, your opinion with respect to the options on strengthening that.

Commissioner EVERSON. Yes. If I could go back to Senator Thomas’s broader point, though, I think this is an area where the government ought to be careful in terms of writing things into the tax

code here.

Senator WYDEN. Of course.

Commissioner EVERSON. These are decisions that are ultimately

taken by the boards, and it would appear over these recent years,

and certainly from what we see, if the boards want to pay somebody, they will pay them regardless of the tax consequences. I do

not necessarily think you are going to fix this by changing the tax

law, is what I would say, sir.

Senator WYDEN. I share your view and Senator Thomas’s concern

that we not have a caucus for price controls and the like.

19

Commissioner EVERSON. Yes.

Senator WYDEN. But I am interested particularly in ways to use

disclosure, which I have thought was a pretty good disinfectant.

Frankly I think, on Senator Thomas’s point, there has been a lot

of public backlash on this backdating kind of question. The companies’ stocks go down in a hurry. So the bigger question is the executive compensation, in my view, dealing with the double standard.

Commissioner EVERSON. Well, as you know, sir, there is no disclosure in our area.

Senator WYDEN. Right.

Let me ask you a question that is specifically about disclosure,

Ms. Thomsen. Another area that the public is very concerned about

is ‘‘go-away’’ packages for executives. When they head out the door,

it does not seem, for example, that some pretty deluxe health care

benefits get disclosed.

Now, again, what a blue-collar person says coming to one of my

town meetings, or Senator Thomas’s town meetings, is they do not

want some huge price control regime and the like, but they would

like to know about that kind of information.

Do you think that these kinds of deluxe health care benefit packages for ‘‘go-away’’ executives ought to be disclosed?

Ms. THOMSEN. Under the new regime, the new rules, they will

be. The new rule which was enacted by the Commission—again,

this is an area where I really do need to defer to my colleagues in

the Division of Corporation Finance, but I am sure they will correct

me if I get it wrong.

Generally speaking, the new rule has a couple of components.

One is a compensation discussion and analysis, where a company

will discuss its compensation practices. There is also tabular disclosure of all forms of compensation to executives with a total number

so that they are all comparable.

Included in that information will be health benefits, to the extent

they are different than the rank and file, if you will. The deluxe

benefits should be included in that and will be specifically broken

out if they exceed certain levels or percentages.

Senator WYDEN. My time is up. I just know I saw something in

the Wall Street Journal recently that raised some questions with

respect to what actually is going to be disclosed. So could you get

us a copy of that?

Ms. THOMSEN. I would be delighted to.

[The information appears in the appendix on p. 300.]

Senator WYDEN. I am going to get you this Wall Street Journal

article that ran recently because it raised, in my view, some troubling questions about what will be disclosed.

Thank you, Mr. Chairman.

The CHAIRMAN. Thank you very much.

For the panel, we have been reading these stories about backdating and it always focuses upon the executive involved. It is hard

to believe, though, that the executives did this all by themselves.

To be honest, the idea that all executives at different companies

came up with this idea at the same time stretches the imagination.

So, I go back to an experience that the Commissioner and I have

had, that when we looked into tax shelters, we found a whole army

20

of enablers putting tax shelters together and, in fact, they were

usually the ones coming up with the ideas.

Now, that certainly does not excuse the executives who were involved in those tax shelters, and today it would not excuse those

involved in backdating. But what are you finding in regard to lawyers, accountants, and compensation consultants assisting, proposing, and signing off on the backdating of stock options?

Were there promoters? That is the basic question. If so, describe

them, or if you know who some of them are, say who they are. To

be blunt, what can we expect in terms of actions taken against

those who aided and assisted in this effort, and sometimes in criminal activity?

Mr. MCNULTY. Mr. Chairman, in the two cases where we brought

criminal charges, one of the two cases includes the general counsel

of the company. My own sense is that the legal complexity here is

not so great that inside counsel could very easily be able to work

in collusion with the others to create the kind of false information

necessary to deceive the compensation committee and to commit

criminal acts.

In cases more broadly speaking, we would have no difficulty

bringing cases against accountants and attorneys so long as we can

meet the bar that is significantly high when it comes to criminal

charges of the proper criminal intent. As I said, we have now

charged general counsel, and we will always look at the actors in

these schemes to know who meets that criminal intent standard.

The CHAIRMAN. I think you are saying that you do not see an

outside industry then.

Mr. MCNULTY. Well, I think I see it as being less significant, at

least in the cases we have charged, because of the small number

of people who are involved in the particular fraud. Some of the

other accounting scandals we have looked at in recent years are

much different and much more complex and involve a lot of different players, outside and inside.

The CHAIRMAN. Do either of the other two of you have anything

to add to that? [No response.] All right. Then I think I will just

have one more question, then go to Senator Baucus.

Last November, the bipartisan Tax Reform Panel—in other

words, Senators Mack and Breaux led this—recommended broad

reforms to our Federal tax laws. Many of those reforms were aimed

at expanding the tax base. One of the Tax Panel’s recommendations was to cap the tax-free health insurance exclusion.

At the same time, there have been numerous press reports of lavish benefit packages and gold-plated health insurance coverage for

senior executives that are not provided to rank-and-file employees.

Most of these special benefits that are received by senior executives

are not taxed under existing rules.

Ms. Thomsen, what do the SEC’s new rules provide in terms of

requiring disclosure of executive health and other benefits? Mr.

Everson, I would like to have you comment on the Tax Reform

Panel’s recommendations and whether it would broaden the tax

base and help level the tax playing field to some extent.

Ms. THOMSEN. Again, I hope I will be able to confirm this with

my colleagues in the Division of Corporation Finance. The new

rules generally provide that all forms of compensation be disclosed

21

so that, at the end of the day, top executives know the total package, however it is distributed to them through their corporation.

That means that, to the extent an executive is on a health plan,

for example, on the same basis as every other employee, that is not

disclosed. To the extent that there are special health benefits, they

are part of the tabular disclosure. They will be disclosed.

And to the extent that, truly, the value is high enough, they will

be specifically disclosed and that value would be keyed off either

amounts or percentages of a like kind of benefit.

The CHAIRMAN. All right.

Mr. Everson?

Commissioner EVERSON. Sir, I would say that, this is a smaller

issue in terms of dollar amount compared to the other compensation piece we are talking about today.

Backing up to the general premise, there are very few areas

where the executives are really treated any differently than anybody else. Under the code, this is one of them. Obviously, from a

principal’s point of view, that would bring them more in conformity

with them treatment of everybody else.

The CHAIRMAN. All right.

Senator Baucus?

Senator BAUCUS. Thank you, Mr. Chairman.

Commissioner Everson, on March 14th of this year you were

speaking before the National Press Club. There you suggested that

corporate executives receive ‘‘generous, but fixed, compensation for

a specific contract period rather than compensation packages that

include stock options.’’

In a sense, it sounds like you were suggesting a fixed compensation package at a certain level, say $5 million, but then that is it.

If the company wants to pay more than that it certainly can, but

it would not be a deductible expense.

Commissioner EVERSON. What I got to is not quite that, but it

was a limitation on that. It is interesting you raised this, because

I thought this was going to draw a lot of attention.

Senator BAUCUS. It is drawing a little.

Commissioner EVERSON. With the remarks on transparency and

the (m)(3) and everything, that kind of overshadowed this.

Senator BAUCUS. Right.

Commissioner EVERSON. As we started to say to Senator Thomas,

I am very worried about the impact on behaviors, on people—the

CFOs, the general counsel, and the chair of the board—of all of the

incentive compensation, because who is minding the cookie jar?

Those are the people in the companies who I think are supposed

to play it totally straight. And I am not suggesting that Congress

step in here.

I think that as a matter of board policy, if you pay the CFO

$5 million more than the CEO, and that is more than the CEO

would typically get as a matter of straight compensation, and that

is for a fixed term, then that guy is not going to fudge backdating

stock options. His reputation is going to go down the tubes if he

does that. He has no reason to do it.

I like the British system, where there are more non-executive

chairs of companies because they take an independent look. I am

22

not suggesting that Congress step in on this. That was more of a

general remark.

I think there is a difference, and we have lost track of this to

some degree, between the work—I was trained as an accountant—

the accountants do or the lawyers do and the work that the operators or the people who are trying to develop the product do.

I was, perhaps, trying to provoke a little bit of a discussion on

that. It was before backdating, but I think the backdating sort of

fuels this issue again.

Senator BAUCUS. But generally you tend to think that that is an

idea that is worth pursuing, that is, a limit, a reasonable limit,

high limit, maybe indexed, but nothing beyond that. Everything beyond that would not be deductible.

Commissioner EVERSON. It was not a deductibility question. I

was not asking the government to step in. I was suggesting that

maybe boards would be better served by knowing that the CFO has

a 5-year contract and absolutely no incentive to pull his or her

punches on questions like what we are talking about today. That

is what I was getting at, not undeductibility, sir.

Senator BAUCUS. I understand. But, so how do we get there, if

that is an admirable goal? If Congress does not——

Commissioner EVERSON. I am not sure. I keyed up the issue and

nobody bit on it until now. So, we will see. [Laughter.]

Senator BAUCUS. But you are asking us not to bite. So who is

going to bite?

Commissioner EVERSON. Ultimately, I think that these issues

that the committee is getting at today will not be reformed by the

Congress. They are going to have to be reformed by American business through a variety of solutions.

Senator BAUCUS. We all admire American business. We have

done a great job in America over the years. But I think we are honest with ourselves. We also think that a lot of executives are going

to kind of pad their pockets a little bit here and do something that

they do not want fully known to the public, or to their shareholders, or to their employees.

It is a little bit of a club. A lot of them tend to talk to each other.

They are in the same associations, the same clubs they belong to,

and so on, and so forth. They say, well, Joe is getting this, so I

should get it, too. There is a little of that going on.

It gets a little bit embarrassing, I think, even to some of them,

but they do not want to disclose it all because it would be even

more embarrassing. So I do not know for sure that all this is going

to be self-policed. I just do not think that is going to happen.

And you yourself said, or as maybe Mr. McNulty said, often the

intricacies are devised in a way that are hidden from the compensation committee so the compensation committee is not fully

aware of what is going on here. So what are we going to do here?

Is this a problem that should not be addressed because it is not

that big? That is a deeper public policy question. My personal view

is, it is becoming a big problem. The gap is becoming too large. It

is starting to undermine employee morale.

As backdating shows, the value of a lot of these companies’ stock

has fallen after the backdating, the in-the-money, has been exVerDate 11-MAY-2000 14:22 Aug 10, 2007 Jkt 095484 PO 00000 Frm 00026 Fmt 6633 Sfmt 6633 36595.000 SFIN1 PsN: SFIN1
23

posed. They are not doing the right thing for their companies or

stockholders. They are not helping their employees.

If we are going to compete in the world effectively, and for our

kids and grandkids, so they can have the same standard of living

that we enjoy, it seems to me—and I do not want to overstate this

point—that we are going to have to have a little more working together in America, employees as well as the executives.

Commissioner EVERSON. Let me be clear here, Senator, because

I think it is an important issue. I think Sarbanes-Oxley and the

things we have done on taxes, and a few of the other factors, the

Corporate Fraud Task Force, all these have contributed to better

controls and better actions on the part of companies.

I do think that this incredible compensation continues to require

people sometimes to display heroic virtue rather than normal virtue in doing some of these jobs that they do, because the money

is so much at stake in what they are looking at in terms of some

of these decisions.

Senator BAUCUS. I think a lot of CEOs, frankly, are going to perform, because if they do not, they get booted out, irrespective of the

compensation. That often happens, too, by the board of directors.

I could name lots of examples recently where the board says, hey,

it is not so much a compensation issue, it is that you are not performing for the company, so you are out of here.

So, compensation is helpful, but I do not know that performancebased compensation and all the loopholes that have evolved around

it really helps the company do any better. I think it is kind of irrelevant, in my view.

The CHAIRMAN. Senator Bingaman?

Senator BINGAMAN. Let me just follow up on a line of questions

that I raised a little bit earlier with Mr. Everson. Section 162(a)

of the code says, ‘‘There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable

year in carrying on any trade or business, including, (1) a reasonable allowance for salaries and other compensation for personal

services actually rendered.’’

Has the IRS ever considered challenging the deductibility of executive compensation, any executive’s compensation, on the ground

that it was not a reasonable allowance?

Commissioner EVERSON. I would want to go back and get an answer for you, Senator. I know that we have made some adjustments over recent years in the hundreds of millions of dollars on

162(m).

Senator BINGAMAN. But 162(m) is separate.

Commissioner EVERSON. I do not know whether that has been

implied by the 162(a) section that you are referencing. I do not

know the answer to that question, so I will go back and inquire

about it. You are saying we have a choice as to what we can pursue. I do not know if we pursued that element of it.

Senator BINGAMAN. Yes. It strikes me that you have discretion

under this statute, and perhaps you have more than discretion, you

have direction under this statute, to ensure that if compensation is

to be taken as a deduction, that it be reasonable.

Commissioner EVERSON. I guess I share a lot of the views of my

colleague at the table here. I think it would be pretty tough to put,

24

as a general rule, our auditors in the shoes of making that decision

in all but the most outrageous situations.

I mean, I think we would have a lot of litigation on just what

that meant, so I am not terribly surprised if that standard is there,

or if it has not been used as much as a lot of the sort of bright

line tests that are out there.

Senator BINGAMAN. I agree. But I think there are some pretty extreme situations that we read about in the papers about compensation levels. I think the IRS would have a pretty strong case that

some of these compensation levels are not reasonable and, therefore, if the company wants to compensate at that level they can

certainly do so, but they will not be able to claim a deduction for

it.

Commissioner EVERSON. Well, you have brought something to my

attention that I was unaware of. I think this committee knows I

am pretty pro-enforcement, so we will take a look at it.

Senator BINGAMAN. Very good. I would appreciate that.

Thank you, Mr. Chairman.

The CHAIRMAN. Do you have more questions, Senator Baucus?

Senator BAUCUS. No, thank you.

The CHAIRMAN. All right. We thank the panel very much for your

expert testimony.

We now hear from Prof. Lucian Bebchuk, professor of law, economics, and finance, and director of the Program on Corporate Governance at Harvard Law; Prof. Charles Elson, director of the

Weinberg Center of Corporate Governance, University of Delaware;

and Prof. Steven Balsam, professor of accounting, Fox School of

Business and Management at Temple University. We thank each

of you for being here.

I left out somebody, our first witness. I left out Ms. Nell Minow,

editor and co-founder of The Corporate Library. I am sorry.

We will start with you, then the way you folks are seated is the

way we will take you. Your entire testimony will be put in the

record, as we have asked you to summarize. Thank you.

STATEMENT OF NELL MINOW, EDITOR,

THE CORPORATE LIBRARY, PORTLAND, ME

Ms. MINOW. Thank you very much, Mr. Chairman and members

of this committee. It is a great honor to be here. I am very, very

pleased that the committee is looking into this vital area of concern.

Backdating and springloading of options are only the latest in a

series of abuses and dodges that have escalated CEO pay to levels

that Marie Antoinette would be embarrassed by.

If I may just mention an issue that was brought up by the questions before, I think one of the most distressing aspects of this

backdating problem is how widespread it is. We have documented

a lot of abuses of CEO pay over the years at The Corporate Library, and many of them fall into patterns where companies have

consistent problems in a number of areas, accounting, et cetera,

and problems with pay.

But this backdating thing, what is so distressing about it, is it

has occurred in such a widespread fashion at many companies that

25

have had otherwise exemplary records, so we really have to ask

ourselves what the systemic problem is.

I am particularly outraged by those who suggest, like the Wall

Street Journal editorial page, that there is nothing wrong with this

manipulation. Everything is wrong with it.

We believe in pay for performance; nobody is a more passionate

capitalist than I am. But what this is, is pay for pulse. We are paying people for the fact that they are still breathing, and we do not

even check to make sure that is the case.

I look at CEO pay like any other allocation of corporation resources. What is the return on investment of the money that is

being paid out? As Senator Baucus had raised earlier, we have had

a number of recent cases of extraordinary abuses of departure

packages for CEOs who have performed very badly, et cetera, that

really undermine the credibility of the capitalist system.

The entire justification for options is to align the interests of

management with those of the shareholders. That is the great challenge of capitalism, exactly this issue. How do you keep the managers as committed to creating shareholder value as those who are

providing the capital?

Well, options seem like a good answer, and that was the theory

behind 162(m), but as you know, that well-intentioned provision

has had unanticipated perverse consequences.

Options only work when executives make money based on how

the company does, not on how the overall market does, and when

the number of options is not so excessive that you get a mountain

of payout for a molehill of performance, and all information relating to the options is promptly, clearly, accessibly, and comprehensively disclosed.

Backdating is just one of a series of abuses, like, for example,

springloading, when you issue options knowing that you are about

to make an announcement that is going to raise the price of the

stock. So there is a tremendous amount of manipulation, not all of

which is currently illegal.

I am appalled by the people who, as I said, suggest there is nothing wrong here. If it is not illegal, it is only because it is such an

obvious outrage no one thought outlawing it was necessary.

One Wall Street Journal piece said that ‘‘it was a clever way to

grant executives more compensation in the pre-expensing days

without having to take a hit to the income statement.’’

Well, if that is true, why hide it? If it is a clever way, do we not

want to all know about it? If the company is clever, does that not

want to make us invest in it? Why would we want to give executives more compensation if it was not tied to performance? Executive compensation is an important element, not just in motivating

executives, but also in informing investors about what the company’s priorities are and how effective they are.

I documented, in the very first report issued by The Corporate

Library in January of 2000, a problem with a company that was

doing essentially the same thing as backdating, except that they

were public about it.

They gave the CEO 2 million options at $10 a share below market. I said, gee, I think maybe the CEO thinks the stock is going

to tank. People laughed at me, because it was the fastest-rising

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stock in the history of the New York Stock Exchange, and became

the fourth-largest bankruptcy in U.S. history, and that was Global

Crossing.

I was happy that some of the earlier questions referred to the

board of directors. I think obviously they are involved, whether

they are knowledgeable or not. They should be knowledgeable

about abuses like backdating, and if backdating occurs, they should

be held responsible.

Other than that, I am happy to answer your questions. Thank

you again for inviting me to appear.

The CHAIRMAN. Thank you, Ms. Minow.

[The prepared statement of Ms. Minow appears in the appendix.]

The CHAIRMAN. Prof. Bebchuk?

STATEMENT OF LUCIAN A. BEBCHUK, WILLIAM J. FRIEDMAN

AND ALICIA TOWNSEND FRIEDMAN PROFESSOR OF LAW, ECONOMICS, AND FINANCE; AND DIRECTOR, PROGRAM ON

CORPORATE GOVERNANCE, HARVARD LAW SCHOOL, CAMBRIDGE, MA

Prof. BEBCHUK. Chairman Grassley, Senator Baucus, and distinguished members of the committee, thank you very much for inviting me to be here today to testify.

I was asked by the staff to discuss executive retirement plans.

As my written statement explains, these plans have provided top

executives over the years with very large amounts of non-performance compensation that both fell below investors’ radar screens and

got legally around the limitations of section 162(m).

So, first, a few words about executive pensions. In a recent empirical study, Robert Jackson and I documented the large significance of executive pensions in the executive compensation landscape.

We looked at the pension plans of S&P 500 CEOs and we found,

first, that the pension plans of the CEOs had a median value of

$15 million per CEO. Second, the median plan was worth twice as

much as the aggregate salary payments received during the CEO’s

whole service as CEO. Third, the value of the median pension plan

comprised 34 percent of the total compensation, and that includes

both equity and non-equity compensation that was paid during the

service of the CEO.

When you look at pensions, at first glance the massive use of defined benefit pensions for executives might appear puzzling. That

is because firms have been moving away from defined benefit plans

for non-executive employees, and defined benefit structures actually look more valuable to non-executive employees who are less

able, relative to top executives, to bear the investment risks that

are associated with defined contribution plans.

So what explains the executive pension plans? One possible explanation is that non-performance compensation that was provided

via pension plans, however large, has not been subject to the limits

of 162(m). Our study showed that the amount of non-performance

pay that escapes 162(m) in this way was quite large. Lack of disclosure was obviously another reason.

Let me now turn to say a few words about deferred compensation. The great majority—some surveys say 90 percent—of public

27

firms offer their top executives deferred compensation plans that

are outside the framework of 401(k) accounts.

With those plans, the executive defers the receipt of compensation until retirement, and in the meantime enjoys tax-free investment returns. These tax savings come at the expense of the company, the taxpayers, and sometimes both of them.

Again, the question is, why do firms commonly offer non-qualified deferred compensation arrangements to executives, but rarely

do so for non-executive employees? One reason is that those plans

provide another legal way of getting around 162(m).

Any amount of non-performance compensation that is granted in

a given year, no matter how large it is, escapes 162(m) if it is

placed in a deferred compensation plan. On top of the original

amount that was deferred, the gains to the executive from the taxfree accumulation of returns also escape 162(m).

I would like to note that past disclosure requirements allowed

firms to provide very, very little information about deferred compensation plans. Indeed, the lack of disclosure has made it impossible for outsiders to form even ballpark estimates of the compensation that had been provided via deferred compensation plans.

In the next proxy season, the SEC’s disclosure reform will force

companies to disclose for the first time the amounts that are credited to executives in such plans, and public officials should be paying close attention to the figures that come out.

I would like to conclude by stressing the importance of strengthening shareholder rights. The motivation for the SEC’s recent disclosure reform and for the adoption earlier of 162(m) came partly

from recognizing that, without some push from the outside, both

cannot be expected to make pay sufficiently tied to performance.

However, as long as shareholder rights are not strengthened as

well, neither disclosure requirements nor tax penalties can, by

themselves, address the problem. What needs to be done? Shareholders’ power to remove directors must be turned from a fiction

into a reality, and there are a number of ways that we can do that.

Furthermore, shareholders should have more power to influence

the setting of company’s governance arrangements. In the past, the

role of shareholders has been limited to passing advisory resolutions that boards often elect not to follow.

In the end, executive pay arrangements reflect the quality of the

government processes that produced them, and strengthening the

rights of shareholders is essential for making boards more accountable and attentive to shareholders, and in this way enhancing

shareholder value.

Thank you.

The CHAIRMAN. Thank you very much, Prof. Bebchuk.

[The prepared statement of Prof. Bebchuk appears in the appendix.]

The CHAIRMAN. Prof. Elson?

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STATEMENT OF CHARLES M. ELSON, EDGAR S. WOOLARD, JR.

CHAIR, JOHN L. WEINBERG CENTER FOR CORPORATE GOVERNANCE, LERNER COLLEGE OF BUSINESS AND ECONOMICS, UNIVERSITY OF DELAWARE, NEWARK, DE

Prof. ELSON. Thank you, Chairman Grassley, Senator Baucus,

and distinguished members of the committee. I am delighted to be

here to speak to you today to testify both as an academic and a

public company director.

The problem with backdating is pretty obvious. Number one, it

is sort of like betting on a horse race after the race is over with;

it offends our sense of fairness. But number two, it defeats the

whole point of the option and is, I think, devastating to the notion

of option-based compensation.

Frankly, as an issue, it is over. Due to the Sarbanes-Oxley director/officer option reporting requirement, it is no longer going to

happen. But, more importantly, the cause of the problem remains

and I think has led to other current problems in the compensation

area affecting the health of the corporation, shareholder value, and

shareholder confidence in our public companies.

There is an overt compensation problem in corporate America. It

is caused by, number one, over-reaching executives, and number

two, compliant management-dominated boards who fail either to

negotiate or exercise appropriate oversight over executive compensation and the compensation process.

So what is the solution? It is actually pretty straightforward. You

have to encourage better and greater board negotiation and oversight over management through change in board composition, period.

Well, what will that be? Number one, independence on the part

of the outside directors, financial and quasi-financial independence

from management to promote objectivity, and number two, equity

ownership, stock ownership in the company by the directors. That

aligns the boards’ and shareholders’ interests and incents the board

to exercise the objectivity that the independence brings. I think

those two facts are critical.

There is some good empirical evidence out there on the link between equity ownership by directors and a reasoned pay package.

I think we see, frankly, much the same problems coming up visa`-vis ineffective board composition in the nonprofit sector as well.

I know it is something that this committee has some interest in.

But I think changes are in the works to encourage board independence and stock ownership. Sarbanes-Oxley, the New York

Stock Exchange, the NASDAQ listing requirements, investor pressure, and State law actions, particularly on the part of the Delaware judiciary, have led to greater independence on the part of

boards and greater ownership.

But what about disclosure as a solution, the current SEC proposals? Well, on the Federal level, the recent SEC changes in executive compensation disclosure requirements, I think, are helpful—

very helpful—but ultimately they are not the solution to the problem because it was board composition that created the problem, not

lack of disclosure.

What about taxation? I know you were talking about this today.

Taxation-based changes are not the solution, in my view, at all. In

29

fact, I wrote an article about it in 1993 when this first came up,

162(m), and I submitted it for the record.

The problem is, 162(m) has just not been effective. It can either

be lawyered around by a compliant board, or the company, frankly,

simply chooses just to not take the deduction at all. The problem

is, the shareholders lose on both accounts, whether it is over-compensation or, in fact, whether they choose not to take the deduction.

The key here is incentivizing the directors to negotiate with management as owners and not simply the ancillaries of corporate

management. But this actually is a matter of State law and the

marketplace, unfortunately, rather than a Federal issue.

But is there anything that can be done on the Federal level here?

I think there are a couple of things. Number one, heightened disclosure in two big areas. One, director independence, particularly

quasi-financial linkages between the directors and management of

the company, such as charitable donations by the company directed

by management to director charities.

Second, the issue of compensation consultants who play a critical

role in designing these compensation plans. Compensation consultants have independence issues. I think it has to be disclosed in the

proxy, any work that the compensation consultant does, not simply

for the board, but other work for the company itself, because I

think that does affect the advice that they are giving the board

itself. That has not been disclosed. It was proposed. There were

some good comment letters to the SEC, but they did not go forward

with it, and I think that needs to be worked on.

Finally, I think State and Federal rule changes that encourage

director stock ownership and independence are quite helpful. I also

think that State and Federal rule changes that encourage greater

shareholder involvement in the director selection process, such as

a proposed expense reimbursement scheme for short-slate director

contests, I think, are quite helpful as well.

But in the end, it is going to be the marketplace that is going

to encourage the change in director composition, and ultimately,

frankly, it is the director itself that has to fix the problem in this

controversy and, frankly, restore shareholder confidence in our system of compensation.

Thank you.

The CHAIRMAN. Thank you, Prof. Elson.

[The prepared statement of Prof. Elson appears in the appendix.]

Prof. Balsam?

STATEMENT OF STEVEN BALSAM, PROFESSOR OF ACCOUNTING, THE FOX SCHOOL OF BUSINESS AND MANAGEMENT,

TEMPLE UNIVERSITY, PHILADELPHIA, PA

Prof. BALSAM. Mr. Chairman, I would like to thank you for inviting me to appear before your committee today. It is a pleasure to

have this opportunity to discuss with you the effectiveness of section 162(m).

Based on my own research, the research of others, and anecdotal

reports, section 162(m) has, at best, been only marginally effective

in reducing executive pay and/or tying pay to performance. It is

30

clear that executive compensation has gone up dramatically since

the passage of 162(m).

Why has the tax code failed to restrain the growth in executive

pay? Section 162(m) capped the deduction for executive compensation at $1 million per executive, providing an exception for performance-based compensation. This gave the corporation three choices.

The first choice was to limit executive pay to the $1 million cap.

There is limited evidence that this has occurred. From my own research I found that, in 2005, more than 250 corporations paid their

CEOs or other executives at least $1 million in salary, i.e., nonperformance-based compensation.

A second choice is for corporations to restructure their compensation packages to fit the criteria of section 162(m) and the performance-based exception. In fact, we have observed companies doing

that.

David Ryan, one of my colleagues at Temple University, and I

have done research and have shown that stock options have increased since 162(m) and have increased in those firms and executives that are affected by 162(m). So, 162(m) has had an effect of

encouraging stock option compensation.

However, one of the problems is that economic theory suggests

that, when you add risk to the executive compensation package,

you also increase the reservation price of the executive. In fact, research has shown that compensation has gone up since 162(m).

The shift to performance-based compensation also accentuates

the incentives for executives to manage earnings, as missing targets adversely affects both bonus plan pay-outs and stock options,

which are tied to share prices.

The third choice is to forfeit deductions. In research conducted

after the passage of 162(m), David Ryan and I noted that many

firms that qualified their performance plans to meet the performance-based exception explicitly reserved the right to pay nondeductible compensation if they determined it was in the best interests of the corporation.

In research conducted using data from the mid-1990s, Jennifer

Yin and I found that at least 40 percent of corporations admitted

to forfeiting deductions because of section 162(m).

My prediction is that that percentage is much higher today, especially as firms switch from stock option compensation, which is deductible, to restricted stock, now that Statement of Financial Accounting Standards no. 123R requires the expensing of stock options.

I should note that the choice to forfeit deductions is not limited

to section 162(m). Many corporations are willing to not only forgo

deductions for excess parachute payments, as defined under section

280(g), but are also grossing up the executives’ compensation to pay

the excise taxes levied on the executive.

My recommendations to strengthen and fine-tune section 162(m):

First of all, provide increased disclosure of details in plans submitted to shareholders. To qualify as performance-based under section 162(m), corporations have to obtain shareholder approval of

their bonus plans.

31

While ostensibly the plans presented to shareholders disclose

their material terms, in reality they do not. That is, they lack details about actual plan parameters, targets, thresholds, et cetera.

Disclosure of these details would allow shareholders to evaluate

if indeed the thresholds, targets, et cetera were adequate, in other

words, if the bar is not being set too low.

A second proposal or recommendation is that we require stock

options be market adjusted so that the executive will only benefit

if the firm’s share price out-performs the market index.

Under section 162(m), stock options were, de facto, assumed to

be performance-based as long as they were not in-the-money at the

time of grant and a plan was approved by shareholders. In reality,

stock options are pay for performance with a threshold of zero.

That is, any increase in a firm’s stock price increases the value

of an executive’s stock options, even if the firm under-performs the

market, its industry index, or even risk-free investment such as

treasury securities.

My final recommendation is to require numerical disclosures of

actual deductions forfeited and additional taxes paid. Currently,

many firms discuss forfeiture of deductions in their proxy statements, but are exceedingly vague.

For example, Wal-Mart’s most recent proxy statement said ‘‘a

significant portion of the company’s executive compensation satisfies the requirements for deductibility under Internal Revenue code

section 162(m).’’

Other companies, for example, Exxon-Mobil and General Motors, while paying their top executives’ salary far in excess of $1 million,

give no indication of whether they forfeit deductions or not.

Disclosure of details would allow shareholders to evaluate if

amounts are material and put the onus on directors to justify those

forfeitures, which I believe would make them less likely to do so.

In closing, I would like to thank the committee for the opportunity to testify today, and look forward to answering any questions you may have.

[The prepared statement of Prof. Balsam appears in the appendix.]

The CHAIRMAN. Yes. My first question deals a little bit with what

you just spoke about, Prof. Balsam, but I want other panelists to

address it. So let me state it as I was going to state it for everybody.

There seems to me to be wide agreement that 162(m) has failed

to achieve its policy goals in regard to high corporate salaries. So

the question is, now what do we do? I am going to suggest four options, but if you have other options, I would be willing to consider

them.

These options vary with reality. We could repeal it, but that is

very CBO-expensive. We could tighten up the performance goals,

but you know how the English language is. That is tough to do and

get done what you want done, or this policy would be working in

the first place.

Three, we could just eliminate the performance goals altogether and just state that pay and benefits over $1 million are not deductible. There are many examples in the tax code, like home mortgage

deductions, where that is done. But then you get into the policy of

32

Congress setting corporate executive pay, and that is not very wise

policy, or you get the inconsistency of some movie that is bombing

and not hitting the movie stars the same way, or the baseball players that are batting 200 and still getting a good salary.

So to the rest of you, or even Prof. Balsam if he wants to go further, those are four ideas I see. I just want your reaction to them,

or anything else you have to suggest.

Ms. Minow?

Ms. MINOW. Thank you, Mr. Chairman. I am glad you mentioned

movie stars and baseball players, because of the people in the

stratosphere of pay, that is basically it. We have athletes, movie

stars, rock stars, investment bankers, and CEOs. The other four

are the ultimate pay for performance. Believe me, Tom Cruise’s pay

package has just gone down significantly because of his poor performance, and it will go back up; look at John Travolta over the

years.

So the reason is, as Prof. Elson has said, that CEOs are the only

people who get to decide who picks their pay. They get to decide

who is on their board. Nobody understands better than you gentlemen what the term ‘‘election’’ means, but corporate America does

not really seem to understand the definition of the term, because

management nominates the candidates and counts the votes, and

no one runs against them. So, it is a very closed system.

So if it were up to me, let me just make ‘‘my wish come true’’

proposal first, then I will make a more realistic one. My ‘‘make my

wish come true’’ proposal would be to say that no executive compensation would be deductible unless the company has adopted a

majority vote provision, so that if shareholders do not like what

they see, they can change the board of directors. That will make

the board of directors more responsive to shareholders.

I realize that, under principles of federalism, corporate governance has been left to the States since 1789, and you are not likely

to change that in this committee.

So, therefore, my more realistic proposal would be something

like, that stock option plans would only be deductible to the extent

that they are tied to specific company performance and not the

overall market as a whole. Therefore, we would only capture plans

that are indexed to the market or to the competitors, or premiumpriced options. I think that would really make pay for performance.

The CHAIRMAN. Prof. Bebchuk?

Prof. BEBCHUK. There are two considerations that should guide

whatever the committee comes out with on this. One is that it

would be important to have a level playing field among different

forms of compensation so that companies do not make distorted

choices. That has been a big problem in the past.

Second is that the very problems that led originally to the adoption of 162(m)—and the very problems being, one, we do not have

arm’s length contracting, and two, that pay is only weakly linked

to performance—are still very much there. So one thing we cannot

do is declare victory in this draw.

The CHAIRMAN. Prof. Elson?

Prof. ELSON. Actually, I kind of like option one, which was just

getting out of 162(m) altogether, getting out of the sort of tax regulation, if you will, of executive compensation, because I think it

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does not get at the problem. In the end, the losers here are the

shareholders. They are the ones we are really concerned about in

this issue.

The whole point of it was to force reasoned compensation packages vis-a`-vis shareholder wealth. It did not happen. I think using

tax policy in this area is not very helpful and, in the end, is quite

harmful, I think, to the investors.

So I think we go ahead and think about repealing it, sunsetting

it, and then think about other means to strengthen negotiating on

the part of the board so that in the end you create real shareholder

value and, more importantly, greater corporate profitability, which

in the end brings greater tax revenues, much more so than this deduction.

The CHAIRMAN. And Prof. Balsam, you probably do not have anything to add. You had a long list.

Prof. BALSAM. Well, I always have things to add. [Laughter.] I

would just like to follow up on what Prof. Elson said, that depending on the points that you pursued, the shareholders could be the

real losers.

For example, limiting deductibility over $1 million and forgetting

about a performance-based exception. Companies are going to pay

those amounts and the shareholders are going to pay. So that is

one thing to be careful about.

What is your goal? Is it to reduce executive compensation? Limiting deductions will not do it. Is it to make compensation more

performance-based? Limiting deductions will not do that, either. So

the best potential solution there is your second solution, which was

to tighten performance goals, combined with more disclosure of

those goals. Thank you.

The CHAIRMAN. Thank you.

Senator Baucus?

Senator BAUCUS. Yes. Let me play Devil’s Advocate here and ask

any of you, why in the world should Congress care about what companies pay their executives? Why should it matter? Anybody? Why

should Congress get involved in this issue, as long as the compensation is fully disclosed?

Ms. MINOW. Congress already is involved. The question is whether they should continue to be involved, or how they should continue

to be involved.

Senator BAUCUS. Why not repeal this provision, the 162(m), for

example?

Ms. MINOW. Congress will continue to be involved. I think it was

Senator Bingaman who quoted the overall tax provision about the

reasonableness of salary expenses. In other words, Congress is involved in this in many, many ways. You could unplug this one provision and Congress would still be involved, it would just be changing their involvement.

Senator BAUCUS. Why should Congress care? Anybody?

Prof. ELSON. You should care. You should care. The problem is,

it really has undermined, in my view, shareholder confidence in the

system. If shareholders are not confident, they are not going to invest, and then we really do have a larger problem. So, yes, you

should be concerned about it.

34

The question is, what do you do about it? I think 162(m) was

well-intentioned at the time, but I do not think it has carried out

its results. I think you have to go in a different direction.

Senator BAUCUS. All right. Say that is repealed, as you suggest.

What do we do, if anything?

Prof. ELSON. I think that you create rules that encourage better

disclosure, full disclosure of compensation, and particularly director

conflicts of interest that really have not been brought out in the

proxies as they should.

The SEC has made some good inroads in that area, but I think

we need to go further. I think that conflicts of interest vis-a`-vis the

compensation consultants is an easy fix, and I think we should

move in that direction.

I think the key, though, is going to be in State law, liberalizing

a bit how directors are elected. The majority voting provision was

a good idea, I think, some sort of scheme where you reimburse director candidates for elections. It is like we have in campaign financing in this country—to aid more vibrant shareholder elections

to create greater accountability.

Prof. BEBCHUK. If I may add, I think we should care a great deal

about this, because it is an important economic issue. It is not just

symbolic. It has an impact on shareholders in two ways.

First of all, the numbers are quite large. In a study I did, we

found that aggregate top five compensation over a 10-year period

added up to about $350 billion, and that is before you include gains

from pensions and deferred compensation arrangements.

Second, the cost to shareholders from flawed compensation arrangements is not just excess pay, it is the poor incentives that are

provided by such arrangements. So, you have to add to that.

Last, executive compensation is not something that we can just

say, let us leave it to the system to work things out, because some

of the impediments right now that prevent the systems from working are as a result of legal rules.

So shareholders right now are impeded by Federal proxy rules

from putting candidates on the corporate ballot, and sometimes for

putting buy-out amendments on the corporate ballot.

Senator BAUCUS. So are you saying that the SEC should relax

those? More disclosure, for example? The corporate bylaws. Is that

State law or is that something the SEC can address?

Prof. BEBCHUK. There are important things here that are a result

of Federal law, so the SEC could allow shareholders to put candidates on the ballot, which is something the SEC considered 2

years ago, but they withdrew the proposed ruling.

Senator BAUCUS. So what is the proper role of the Finance Committee in this area? One of you suggested repeal of the most relevant statute. Does the Finance Committee have a role? Should the

tax code be used to address excessive executive compensation or

should that be left, again, to States, to the SEC, and so forth?

Ms. MINOW. I think it is generally not a tax issue. I think that

the failure of the very well-intentioned 162(m) shows how treacherous that territory is. It is always, always, always, as you know,

tempting to bring the tax power in to address a number of policy

issues, but I think it has not been effective here and is unlikely to

be effective in the future.

35

Senator BAUCUS. All right.

Do any of the other three of you disagree with that statement?

Go ahead.

Prof. ELSON. I agree with Nell.

Senator BAUCUS. One agrees. The other two?

Prof. BALSAM. I basically agree. I mean, as was pointed out,

there is, without section 162(m), the reasonableness criteria, that

really outrageous cases could be taken up by the IRS.

Traditionally, at least the way I was taught and have taught it,

the IRS does not challenge compensation in widely held companies,

and it is a provision that is just used for closely held companies.

Senator BAUCUS. And that is for tax purposes? Because they are

usually trying to get around another provision in the code in closely

held companies.

Prof. BALSAM. Correct.

Senator BAUCUS. All right.

Prof. ELSON. But in the end, if they disallow the deduction, the

losers are the shareholders, and they were the whole group you

were supposed to protect with this provision. That is the problem.

It is the problem of using other people’s money. When boards play

with other people’s money, not their own, that is the issue. That

is, I think, what we are seeing.

Senator BAUCUS. Doctor?

Prof. BEBCHUK. I think that we use tax incentives for many

things. The problem that we had in the past was the difficulty of

defining when you have pay sufficiently sensitive to performance,

and that is a very tricky exercise.

But there is another way of providing incentives, and I talked

about it: providing incentives to governance structures. That is

something that is more amenable to a clear definition in which taxpayer subsidies can be provided.

Senator BAUCUS. Well, this has all been very interesting, and

hopefully helpful. Thank you.

Thank you, Mr. Chairman.

The CHAIRMAN. All right. I had a couple of other questions I

wanted to ask.

The first question would be for anybody on the panel who would

like to tackle it. In recent years we have heard through numerous

press reports and court cases of lavish benefit packages for senior

executives that are not provided to rank-and-file employees, even

when we have these non-discrimination rules that were supposed

to prevent the inequitable treatment.

Most of these special benefits that are received by executives are

not taxed. Moreover, it is hard for shareholders and investors to

find out exactly what kind of executive-only benefits are being paid.

What should we be thinking about in terms of possible changes to

disclosure requirements or tax rules governing these types of benefits?

Ms. MINOW. Mr. Chairman, I am really delighted that you raised

this as an issue, because it is a particular problem for me. I know

that this committee has already made some progress on this, but

I particularly am concerned about the use of corporate jets for personal travel.

36

That is a good example, where executives are allowed to reimburse for the lowest commercial fare and they do not declare the

difference as income. I think that is terrible.

So, obviously, what I would like to see is that any benefit that

the executive gets should be considered income and that any disclosure that he must make about income for the purposes of his tax

payments should be required also for the purposes of the SEC filing

so that we get a full picture of what the pay includes.

Prof. BEBCHUK. As I explained in my written statement and a little bit here earlier today, executives can make very substantial

gains from tax savings which often come at the company’s expense

when they have deferred compensation plans.

We do not have, and we should have, information about both the

benefits to the executives from those tax gains, as well as the cost

to the company. Those are figures that would be very important to

have disclosed in a clear way.

Senator BAUCUS. I am sorry. You mean, the SEC has to ask for

that information? Who would ask for that information?

Prof. BEBCHUK. The SEC could ask for this. In the recent reform,

which I very much applaud, at some point they were considering

adding increases in deferred compensation balances in the aggregate compensation tables, but in the end they did not do that.

So they just are going to have information about the balances out

there, but it is not going to get into, kind of, the salient total compensation figures. It would be helpful if companies were required

to put a dollar figure on their own tax costs from subsidizing the

taxpayer returns and on the executives’ gains from this taxpayer

accumulation.

Senator BAUCUS. Thank you. Thank you, Mr. Chairman.

The CHAIRMAN. Anybody else?

Prof. ELSON. I concur with Nell. I mean, I think greater transparency is critical disclosure of these benefits. I particularly agree

on the corporate aircraft. I mean, the idea of an executive using a

corporate aircraft for personal purposes is sort of like taking the

company car to Disney World: you do not do it. A board that would

permit it, I think, is problematic.

Senator BAUCUS. It happens a lot.

Ms. MINOW. All the time.

Prof. ELSON. It does. It is wrong. It is a misuse of shareholder

funds, shareholder assets. The asset was not bought for personal

use of the executive. The executive gets paid enough. Let them

charter a plane if they really want it. They get paid plenty. But to

use it on the company’s time, shareholders’ time, I think is inappropriate. A taxation change to change how, in fact, the benefit is

calculated, I think, is helpful. Again, disclosure. It goes back to the

board of directors. A board that would permit it is the problem.

Prof. BALSAM. I would like to actually address two issues here.

One is disclosure, or the current lack of disclosure. Corporate aircraft, souped up health plans, they all fall under the category of

prerequisites. Currently, they are disclosed if the total is greater than $50,000

or as an ‘‘other’’ compensation. Individual items have to be disclosed if they are more than 25 percent of that total. Unfortunately,

a lot of the little items fall under that radar.

37

So if the executive is getting extra medical benefits, extra life insurance, it usually does not catch up to that 25-percent threshold

and is not disclosed separately, so we actually have very little data

on what is being done. So, improved disclosure would be nice.

The other issue is the tax code. Mr. Chairman, you did mention

in your opening question that, under the tax code, most provisions

need to be non-discriminatory in order to qualify for favorable

treatment. Yet, many of these executive benefits are both discriminatory, yet treated favorably for tax purposes.

Again, to refer to the executive health plans, they are deductible

by the corporation and they may be excluded by the executive from

taxable income, even though they are not offered to other employees. That is a loophole in the tax code that I believe your committee could address.

The CHAIRMAN. On another question, for any of you—and maybe

everything that corporations can think of to pay people in ways

that are not taxed has been known—but if there are any new

things out there in executive compensation that should give us

pause or should be considered by Congress, do you want to mention

any of those, if you know about them?

Ms. MINOW. Oh, boy. Yes. Absolutely. Thank you, Mr. Chairman.

I would really like to mention the fact that I pay my taxes, you pay

your taxes. I do not think that CEOs should have the shareholders

paying their taxes. That is a very, very popular provision these

days. We call it the Leona Helmsley provision. I think that is an

outrage.

The CHAIRMAN. All right. Anybody else?

[No response.]

The CHAIRMAN. Everything has been mentioned then that can be

mentioned? All right.

We have a vote. I have one other question that I am going to

submit to you for answer in writing. Besides thanking you today,

I would like to kind of sum up with these thoughts that I have.

First of all, I think we have had a very informative hearing. This

is oversight of the tax code, and we need to do more of that. I think

it is clear that we have learned that 162(m) is broken.

The 1993 law—by the way, part of a bill that I did not support

or vote for—was meant by its advocates to deny deductions when

there was a great deviation between what executives got paid and

what people further down the ladder got paid.

I do not have any doubt it was well-intentioned, but it really has

not worked. Companies have found ways to get around it. Quite

frankly, it has more holes in it than Swiss cheese has in it. Of

course, we want to know what went wrong. We want to consider

whether it makes sense to make changes. This panel has discussed

that very well.

Eliminating the deduction for performance-based pay entirely, or

at least tightening up the eligibility for it, are possibilities that I

think members of the Finance Committee will want to consider,

based on the comments that I have heard at this hearing. Today’s

hearing has been helpful in sorting through the pros and cons of

that issue.

It is challenging for Congress to stay one step ahead of some of

the companies that try to exploit tax loopholes faster than we can

38

close them. I think we have done a good job lately of closing some

of them, but we still have a long ways to go.

I will be reviewing today’s record, submitted materials, and questions for the record on what to consider as our next step, and I will

be working with Senator Baucus on that.

If we are going to keep this code section, I think a question that

needs to be answered is whether it is equitable to treat high-salary

top executives at publicly-traded companies differently from highsalaried other individuals.

On another note, I wonder if, sometimes in legislating, we set

ourselves up for disappointment. Sometimes, it is clear what we

are driving at. Sometimes, we are reacting. When we are reacting,

it may not be clear where we’re heading. I think that may be the

case with section 162(m).

Back in 1993, when section 162(m) was being processed by this

committee, Senator John Chafee raised concerns about the provision’s design. Cetainly, Senator Chafee was no defender of highpaid CEOs or other corporate titans. He did raise the question

about what we’re trying to get at with a limit on deductible compensation.

Senator Chafee raised the example of athletes. Senator Chafee

cited examples of Boston area athletes who were paid under highend guaranteed contracts and then didn’t perform.

Senator Chafee cited Glenn David, a baseball player, and Robert

Parish, a Boston Celtic. Both athletes were highly paid, but not

subject to the rule. By the way, back in 1993, Senator Chafee referred to Michael Jordan, as a performance pay example. I guess

that example was proven right over time.

We have also heard today troubling testimony about a wide disparity of treatment between regular workers and top executives

when it comes to deferred compensation. The President’s Panel on

Tax Reform touched on some of these same issues.

I think that that panel, hopefully with the President making

some recommendations, will get some attention next year. Workers

who make their living paycheck to paycheck have a right to expect

fair tax treatment; you folks have made that very clear.

Finally, I fear that we have a new set of problems behind this

backdating: all the individuals who support the illegal activity.

This includes board members, attorneys, accountants, and outside

consultants.

In response to this hearing, I intend to write to several major

corporations that have been involved in backdating of stock options.

I want these corporations to provide me with board minutes regarding the decision to backdate, as well as any and all materials

from advisors, including attorneys, accountants, and compensation

consultants who assisted in this effort. We need to understand and

bring enforcement action against all the actors.

Thank you all very much for your participation. Very good testimony.

[Whereupon, at 12:09 p.m., the hearing was concluded.]

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