CANADA - Why did Paul Martin provide a tax bailout of Nortel’s CEO John Roth? - 16 April 2009

Saturday, April 18, 2009

Why did Paul Martin provide a tax bailout of Nortel’s CEO John Roth?

I
have enormous respect and gratitude for Paul Martin and his work as
Finance Minister in balancing Canada’s books in the aftermath of
Mulroney’s reckless deficits and in opposing bank mergers, a policy
that I have opposed myself from the very outset, and for all the
reasons that have now been made obvious.

So why did Paul Martin
provide a tax bailout of Nortel CEO John Roth, by granting capital
gains treatment to employee stock options, meaning they are taxed at
half the rate of the income from employment that they represent? This
is a policy that needs to be reversed. I made this very point at a
recent town Hall meeting held by Carolyn Bennett that featured John
McCallum and economist, Armine Yalnizyan, from the Canadian Center for
Policy Options.

This policy on the tax treatnent of employee
stock options was borne out of the hysteria of the Tech Bubble in the
early 00’s and was being advanced under the notion that granting
special tax treatment for some of the most privileged and well to do
Canadians was going to be the solution to Canada’s brain drain. What an
absurd proposition at the time, and what an even more absurd
proposition today. This change to our tax code is completely contrary
to a having progressive rates of taxation, whereby progessively higher
rates of earnings are taxes at progressively higher rates, until of
course you get to the really big money and the tax rates fall off a
cliff. Some of the largest sources of earnings realized in this country
is from the highly lucrative and often massive amounts received from
the exercise of employee stock options.

In order for tax policy
to be fair, it has to be inherently fair and any exceptions must prove
a valid social purpose in order to exist and be perpetuated. This carve
out for the tax treatment of employee stock option gains is neither
fair and nor does it serve a vaild social purpose to exist in the
context of how the world has unfolded. In fact, this tax measure
iserves a purpose that is counter to society’s interests, as I describe
later below.

Fails to meet test for fairness:

Employee
stock options are a benefit derived solely as a result of employment,
and as such they are income from employment, that like a bonus or
commission is contingent in nature. However unlike a bonus or a
commission they have been bestowed by the government and all taxpayers
with taxation at half the rate of a bonus or commission. Stock options
can only be granted to employees of a publicly listed company, and
therefore all other workers are precluded from this scheme and tax
benefit. The tax treatment accorded to stock options is the same tax
treatment that is accorded to investors who have capital at risk and
who earn a gain from that investment. Employee stock options represent
neither an investment in a company, and nor do they constitute capital
at risk. The capital at risk aspect of stock options is made even more
remote, when it is acknowledged that stock options are often “repriced”
(downwards, to reflect a reduced underlying stock price) and have been
subject to the widespread corporate and tax abuse known as
“backdating”. Since when were you able to “reprice” or “backdate” the
price at which you purchased a share, in order to manufacture a risk
free gain in your investment?

The act of treating stock option
gains at half the rate of income from employment that they represent,
means that the CEOs and the senior most executives of Canada’s largest
public companies are paying taxes, on the largest portion of their
compensation packages, at the same rate of tax as workers with taxable
earnings of $35,000. Multi-millions being taxed at the same rate as a
person earning middle income is not a progressive tax structure. Your
“moral compass” can decide if that aspect of my argument, results in
the tax treatment of employee stock options being fair or not. Whereas,
the rest of my arguments against fairness are, however, not really open
to debate, since they aren’t judgmental in nature

Fails to provide a valid socio-economic reason to exist:

As
mentioned before, this special tax treatment of stock options was
successfully championed by John Roth, the CEO of Nortel as the panacea
solution to Canada’s so-called “brain-drain” at the height of the
internet bubble/tech bubble, circa 2000. Policies born of hysteria
often fail to meet the test of time. The same can be said of Jim
Flaherty’s policy born of panic (twin conversions of BCE and Telus and
all the associated media induced hysteria and their propagation of
known lies about tax leakage), involving the double taxation of RRSPs
but not pension funds (read: income trust tax).

The effect of
this policy was to grant a huge tax break to Nortel’s CEO John Roth on
the bundles of stock options and stock option gains that he was then
sitting on. It is also instructive to observe what happened in the
aftermath of a world where employee tock options were taxed at half the
rate of income, at both Nortel itself and the world at large.

At Nortel itself:

When
John Roth was championing the great social cause (ahem) of “brain
drain” ( ahem, in that it was simply the ruse for lower tax rates for
himself), did you ever think this was meant to manifest itself into the
importance of having people like Frank Dunn stay in Canada and not take
his questionable accounting standards and ethics elsewhere, where the
tax regime was more conducive to falsifying the company’s books? Well
that’s exactly who took over from John Roth as CEO after john Roth rode
into the sunset exercising his boatload of stock options under the new
favorable tax regime he had orchestrated for himself. And what do you
suppose it was that motivated Frank Dunn to falsify Nortel’s books, if
not to drive the stock price to levels that were unwarranted, and in
order to cash in his stock options at unwarranted gains? Why in the
world would Canadian taxpayers want to subsidize a tax benefit for a
select group of people, if all it does is foster conditions and
compensation schemes that lead to bad results?

The world at large:

People
are no different than animals, in that we respond to carrots and stick,
in the manner predicted. On one level, you can’t blame people for
acting in the manner induced by their compensation schemes, which is
not to say you can’t question their behaviour on other levels. This
dynamic caused by compensation schemes that are driven by stock options
also finds an example with the corporate conduct of Dominic
D’Alessandro in exercising his management duties as the CEO of
Manulife. As the CEO of Manulife he had been successful in his efforts
to get the Harper government to shut down income trusts, as a
formidable competitor in the product arena for investors seeking
retirement income.

Serendipitously, this saw Manulife
extremely well positioned when they launched their competing product,
Income Plus, the very week following Jim Flaherty’s income trust
massacre. Talk about timing? This Income Plus, a form of “variable
annuity”, grew by leaps and bounds to some $5 billion. It represented a
play on the stock market with guarantees on return of principal. As
such this line of investment product diverted funds that were otherwise
being directed into the real economy (income trusts) and being directed
into synthetic and derivative investments, that had certain promised
returns and which represented risks on Manulife’s balance sheet. These
risks could be mitigated by the process known as hedging. Hedging costs
money that would eat into Manulife’s profit margin. Unlike his peers,
Dominic decided to not hedge these risks that ensued from his Income
Plus. This was a bad decision, and is what caused Manulife’s stock to
experience a 70% value decline during the recent meltdown. The decision
to not hedge these risks was driven by a desire on the part of the CEO
to drive higher earnings per share for Manulife, which in turn was
driven by the manner by which he is compensated, namely by stock
options, whose valued in directly tied to earnings per share, which is
the main driver for the price at which shares trade in the marketplace,
and which were being continuously exercised during the period during
which the decsion to noy hedge the risks of Income Plus was being made.
Cause and effect?

Executive compensation has become a highly
contentious and politically charged topic in the aftermath of the
global financial meltdown. Just take a look at the HUGE issue that
arose recently over the bonuses paid to the AIG workers at the
epicenter of the global financial meltdown: AIG’s financial products
branch. If there were ever an example of bad compensation schemes
driving bad behaviour that has to be the prime example, however we
continue to live in a world where these bad compensation schemes like
employee stock options exist. I am not saying that it is the
government’s role to start telling employees how and how much that they
should pay their employees or under what circumstance, but what I am
saying is that this global financial meltdown, was the result of two
things.

As everybody will tell you, the meltdown was caused by
the lack of regulation and the belief that the market was the best
regulator, by being self regulated and self modulated in effect. But
the second cause of the financial meltdown, and which needs to be
understood by everybody, was the role played by COMPENSATION schemes,
and the fact that the world of finance became dominated by a variety of
compensation schemes, stock options included, that incented people do
make the “wrong” decisions on the margin. Wrong in that they may have
been “right” for their compensation, but wrong for society. Decisions
were being made at the margin, that had huge ramifications, which were
the “right” thing to maximize that person’s compensation, but which
were adverse to the larger interests of society.

The freedom
from regulations and the manner by which people were compensated were
the two dance partners of the global financial melt down. Taken alone,
they would have been insufficient to bring about the scale of today’s
global meltdown, because without the ability to be able to do the
“wrong” thing, and without the incentive to do the “wrong” thing, then
this global meltdown would never have occurred. There would have been
no subprime mortage meltdown, there would have been no AIG and closer
to home their would have been no Income Plus or leveraged buyout of BCE
and a stock option induced self-inflicted insolvency of Canada’s
largest telco. Interesting to note that when BCE’s board was forced to
“reprice” their deal with Teachers’ due to Teacher’s professed
inability to fund the deal, (after all, they do sit on $100 billion in
capital), they did it by reneging on $1 billion in accrued and unpaid
dividends that had been promised to shareholders, rather than by
actually reducing the price of the deal by a corresponding amount. The
route chosen by management and the board of BCE, cost shareholders $1,
but cost the holders of employee stock options, not a penny? And to
think, the proponents of employee stock options argue that it aligns
the interests of management with shareholders. Tell that to the
shareholders of BCE or Manulife.....or AIG, Citibank, Bear Stearns,
etc, etc.

Bottom line:

And why Canadian taxpayers are subsidizing these schemes like employee stock options is beyond me and

For more information on Canadian Capital Gains Treatment for Stock Options.

Posted by Dan Walter

Performensation: Equity Compensation for High Performance Companies.