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 completely lacking in rhyme or reason. Sorry Paul Martin, if you had to pick two out of three to gave gotten right, you picked the right two. Now, those in government can correct something that had good intentions at the outset, but which has proven to be anything but, by eliminating the capital gains treatment of employee stock options at half the rate of income and thereby eliminate the absurd notion that any capital is being out at risk or that this measures serves any larger purpose at all.