The Congressional Band-Aid Approach.

Did you ever look at your computer keyboard and wonder what idiot decided to put the keys in that order? In fact, the QWERTY keyboard (named after the upper leftmost six letters) was something of an engineering masterpiece for its time, the mid-1800s. This engineering masterpiece was forcing secretaries to type more slowly to prevent the typewriter keys from getting jammed. Despite these built-in flaws and tests showing that other designs could double typing speed, the QWERTY became so widely accepted that it survived improvements in typewriters that eliminated jamming and, more recently, became the standard for computer keyboards.

Often, our laws seem to resemble the QWERTY -- anachronistic remnants from another age that have a difficult time keeping pace with innovation. This is the story of one such law -- the Fair Labor Standards Act (FLSA) -- and how, in one isolated case, Congress stepped in and cobbled together important relief from what could have been a catastrophic snafu. That relief came at a price.

The issue here involved stock option plans covering rank-and-file workers. While stock-based compensation has grown to play a vital role in today's economy, the bulk of federal labor law (and most other federal law, for that matter) was written before stock options became a critical element in the compensation and incentive structure of the American workplace. The FLSA, for example, includes a number of workplace mandates, including the requirement that employers pay non-exempt employees who work overtime (i.e., more than 40 hours in a week) one and a half times the employee's regular rate of pay for all overtime hours.

The term "regular rate of pay" is broadly defined to include all remuneration for employment paid to, or on behalf of, the employee -- with a number of exceptions provided. Not surprisingly, because the statute was drafted in another era, there was not, until recently, a clear exception from the definition of "regular rate of pay" for stock-based compensation programs or awards.

Earlier this year, the Department of Labor (DOL) dropped a bombshell on employers offering stock option plans. In an advisory opinion the DOL ruled that because the FLSA did not contain an explicit exception for stock-based compensation programs, income resulting from the exercise of stock options might have to be included in the regular rate of pay in calculating an individual's overtime pay. The DOL then proposed an extremely complex mechanism for retroactively crediting back overtime pay, based on this expanded definition of the regular rate of pay.

If the DOL's position had been broadly applied, it would have created an administrative nightmare for employers providing broadly available stock option arrangements to non-management employees. Indeed, it is likely that the DOE approach would have had a devastating effect on the establishment and continued maintenance of many broad-based stock option programs -- causing many employers to abandon or retarget their option plans. The effects on compensation strategies and the economy as a whole could have been substantial.

It's easy to see why. The growth of stock-based compensation has been one of the driving forces of the new economy, providing a flexible and efficient way to compensate employees and align the interests with the goals of the firm. Once reserved exclusively for management-level employees, broad-based stock option programs are increasingly open to a cross-section of non-managerial, unionized and hourly employees. According to recent surveys, 39 percent of large companies now have option programs covering more than half of their workforce, up from 17 percent in 1993.

It did not take long for the implications of the DOL's inflexible interpretation of the overtime law to sink in. When it did, the outcry was overwhelming, leading to the swift development, passage and enactment of corrective legislation. In the end, Republicans and Democrats worked together to craft legislation that provides a new exception to the FLSA's regular rate-of-pay definition for stock option and other stock-based compensation programs. Some degree of comfort can be derived from seeing that even in this year's fractured, election-year political landscape, Congress can still pass important and necessary legislation if the result of not acting appears sufficiently harmful.

Yet, there was a price to be paid for obtaining swift legislative action: Relief was provided only for arrangements meeting a series of statutory requirements. The result of this compromise is a complex new regulatory scheme that all broad-based, stock-based compensation arrangements must take into account to remain in compliance with the FLSA.

For employers offering stock based compensation programs, this means that a thorough review of their arrangements is needed to ensure that the plan either: (1) does not (and cannot) cover any employee who is subject to the FLSA requirements, or (2) satisfies each of the conditions of the new FLSA exception.

Not So Bad

As these types of compromises go, the FLSA relief is better than most. The conditions are not overly onerous, and employers will, in most cases, be able to modify their plans. Of equal importance, Congress -- in a relatively unusual move -- provided generous retroactive relief. Specifically, no employer is liable under the FESA for any failure to include income or value from stock options or similar stock-based compensation programs obtained before the effective date of the law (generally, Aug. 16, 2000). This unusual protection eliminates the threat of future enforcement action against employers who might have no idea that they may not have been in compliance with the FLSA.

Yet, this success story is also a case study of what can be wrong with our legislative process. The FLSA fix is a relatively well designed band-aid that stops the bleeding without dealing with the major underlying flaws in this antiquated statute. This is not unusual; Congress frequently conditions legislative relief on satisfying a number of requirements, which are often the price that must be paid to win support from wavering members of Congress, Executive Branch officials or interest groups. Indeed, in today's "scorched-earth" political landscape, general agreement on a proposal is practically required before that proposal has any chance of becoming law. Unfortunately, this often makes it impossible to perform the major surgery that is necessary to bring out-of-date laws into the 21st Century.

But band-aids are not always the best way to deal with problems; sometimes, more drastic surgery is required. The QWERTY keyboard has been improved, but the fundamental-flaw of key placement has not been addressed and probably will not be addressed any time soon. Similarly, the FESA and many other outdated laws are in need of major modernization to reflect the demands of a new, more diverse economy. ERISA, the Nixon-era statute governing employee benefits, and an overly complex Internal Revenue Code that discourages investment and savings are two that immediately come to mind.

Although aggressive modernization of our laws has been proposed in a number of areas, history teaches us that in most cases our legislative system will not engage in major surgery. More likely, we will continue to see a patching-up of problems as they arise. That is effectively what happened with the FLSA fix for stock options. In that event, one can only hope that the band-aids will be as well-designed as possible.

Randy Hardock is a partner and John O'Neill is an associate in the Washington, D.C., law firm of Davis & Harman. Both specialize in tax and legislative issues surrounding compensation, retirement plans and other employee benefits issues. Hardock has served as Benefits Tax Counsel in the U.S. Department of the Treasury and as Tax Counsel to the U.S. Senate Committee on Finance.