[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
H.R. 3574--THE STOCK OPTION
ACCOUNTING REFORM ACT
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE AND
GOVERNMENT SPONSORED ENTEREPRISES
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
__________
MARCH 3, 2004
__________
Printed for the use of the Committee on Financial Services
Serial No. 108-69
93-718 U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2003
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512�091800
Fax: (202) 512�092250 Mail: Stop SSOP, Washington, DC 20402�090001
HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana MAXINE WATERS, California
SPENCER BACHUS, Alabama CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio GREGORY W. MEEKS, New York
JIM RYUN, Kansas BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North MICHAEL E. CAPUANO, Massachusetts
Carolina HAROLD E. FORD, Jr., Tennessee
DOUG OSE, California RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois KEN LUCAS, Kentucky
MARK GREEN, Wisconsin JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania WM. LACY CLAY, Missouri
CHRISTOPHER SHAYS, Connecticut STEVE ISRAEL, New York
JOHN B. SHADEGG, Arizona MIKE ROSS, Arkansas
VITO FOSSELLA, New York CAROLYN McCARTHY, New York
GARY G. MILLER, California JOE BACA, California
MELISSA A. HART, Pennsylvania JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia STEPHEN F. LYNCH, Massachusetts
PATRICK J. TIBERI, Ohio ARTUR DAVIS, Alabama
MARK R. KENNEDY, Minnesota RAHM EMANUEL, Illinois
TOM FEENEY, Florida BRAD MILLER, North Carolina
JEB HENSARLING, Texas DAVID SCOTT, Georgia
SCOTT GARRETT, New Jersey CHRIS BELL, Texas
TIM MURPHY, Pennsylvania
GINNY BROWN-WAITE, Florida BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
Robert U. Foster, III, Staff Director
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises
RICHARD H. BAKER, Louisiana, Chairman
DOUG OSE, California, Vice Chairman PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware GREGORY W. MEEKS, New York
PETER T. KING, New York JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma DENNIS MOORE, Kansas
EDWARD R. ROYCE, California MICHAEL E. CAPUANO, Massachusetts
DONALD A. MANZULLO, Illinois HAROLD E. FORD, Jr., Tennessee
SUE W. KELLY, New York RUBEN HINOJOSA, Texas
ROBERT W. NEY, Ohio KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona JOSEPH CROWLEY, New York
JIM RYUN, Kansas STEVE ISRAEL, New York
VITO FOSSELLA, New York, MIKE ROSS, Arkansas
JUDY BIGGERT, Illinois WM. LACY CLAY, Missouri
MARK GREEN, Wisconsin CAROLYN McCARTHY, New York
GARY G. MILLER, California JOE BACA, California
PATRICK J. TOOMEY, Pennsylvania JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia STEPHEN F. LYNCH, Massachusetts
MELISSA A. HART, Pennsylvania BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota RAHM EMANUEL, Illinois
PATRICK J. TIBERI, Ohio DAVID SCOTT, Georgia
GINNY BROWN-WAITE, Florida NYDIA M. VELAZQUEZ, New York
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
C O N T E N T S
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Page
Hearing held on:
March 3, 2004................................................ 1
Appendix:
March 3, 2004................................................ 41
WITNESSES
Wednesday, March 3, 2004
Coviello, Arthur W., President & CEO, RSA Security............... 22
Heesen, Mark G., President, National Venture Capital Association. 15
Kerrigan, Karen, Chairman, Small Business Survival Committee..... 13
Merton, Robert, Professor, Harvard Business School............... 19
Reed, Reginald, Manager, Software Development, Cisco Systems..... 17
APPENDIX
Prepared statements:
Castle, Hon. Michael N....................................... 42
Gillmor, Hon. Paul E......................................... 44
Kanjorski, Hon. Paul E....................................... 46
Royce, Hon. Edward R......................................... 48
Shadegg, Hon. John B......................................... 49
Coviello, Arthur W........................................... 51
Heesen, Mark G............................................... 75
Kerrigan, Karen.............................................. 82
Merton, Robert............................................... 90
Reed, Reginald............................................... 113
Additional Material Submitted for the Record
Gillmor, Hon. Paul E.:
Highway Patrol Retirement System on behalf of the State of
Ohio Public Employee Pension Funds, prepared statement..... 116
Kanjorski, Hon. Paul E.:
American Federation of Labor and Congress of Industrial
Organizations.............................................. 117
Council of Institutional Investors, prepared statement....... 121
International Brotherhood of Teamsters, prepared statement... 123
H.R. 3574--THE STOCK OPTION
ACCOUNTING REFORM ACT
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Wednesday, March 3, 2004
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance and
Government Sponsored Enterprises
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to call, at 10:04 a.m., in
Room 2128, Rayburn House Office Building, Hon. Richard Baker
[chairman of the subcommittee] presiding.
Present: Representatives Baker, Shays, Gillmor, Bachus,
Shadegg, Biggert, Capito, Hart, Kennedy, Brown-Waite,
Kanjorski, Ackerman, Sherman, Meeks, Inslee, Moore, Lucas of
Kentucky, Crowley, Israel, Clay, McCarthy, Matheson, Miller of
North Carolina, Emanuel, Scott and Velazquez.
Chairman Baker. [Presiding.] If I could get everyone to
please take their seats, we will call the meeting of the
Capital Markets Subcommittee to order.
This morning, we are here to conduct a hearing on the
elements of H.R. 3574, the Stock Option Accounting Reform Act.
Historically in our country, it has been granted that
individuals with good ideas, a lot of hard work and the
willingness to take a risk could form business enterprises, and
if able to convince others of the validity of their vision,
could encourage their participation in business formation by
granting them a potential slice of future profitability through
the granting of options. It has been I think without any
dispute a valid methodology for economic activity, job creation
and in some cases profitability.
Although in recent days there have been concerns about the
granting of these options and the inappropriate exercise of
those grants by a relatively small number of executives in the
corporate structures, the value of this method continues to be
clear in the overall world of business creation, particularly
in the world of high technology.
H.R. 3574 preserves the opportunity to take dreams and turn
them into reality and success, but I believe would eliminate
the opportunity for manipulative management to flip options for
fortunes. In support of this view, 84 percent of options
granted in the high tech industry have been found to go to the
broad class of employees, while 14 percent of options granted
went to the executives, which this bill would prohibit from
engaging in that practice.
As to the voice or concern of those reporting financial
condition accurately, even those who are advocates of expensing
will acknowledge that accurate calculation of present-day value
is a difficult consideration. Others would say it is not
possible to achieve fairly.
What, then, is the most responsible public policy to
maintain an engine of economic opportunity and job creation
when there are many who are calling the current recovery a
jobless recovery, or to adopt an admittedly inaccurate
accounting standard in the spirit of accurate financial
disclosure. I think these are troubling questions that are
worth examination.
Certainly, I have regard for the Financial Accounting
Standards Board and their professional conduct on matters of
accounting accuracy, but there have been instances in the past
where we have not viewed their responsible conduct in similar
light. I think primarily in the treatment of derivatives
reporting and most recently and troubling in the requirement to
reduce loan loss reserves at financial institutions in the face
of every financial regulator saying that that position was
unsupported and ill advised. I do not believe any governmental
grant of authority to set regulatory constraints could be above
review by the Congress, and the discussion that follows in the
public forum.
To that end, we are here today to receive testimony of
those who have differing perspectives on the advisability of
the adoption of this measure. I look forward to their testimony
in helping the committee reach appropriate public policy
determinations.
Mr. Kanjorski for an opening statement?
Mr. Kanjorski. Mr. Chairman, we meet for the second time in
the 108th Congress to study the accounting treatment of stock
options. Specifically, we will today examine H.R. 3574, a bill
that would unnecessarily interfere with the independence of the
Financial Accounting Standards Board. Without question, stock
options have played an important and crucial role in the
ongoing success of many American businesses and the creation of
wealth for many American households.
The accounting treatment of stock options, however, has
also caused significant controversy for more than two decades.
The decisions of the Financial Accounting Standards Board to
revisit this matter last year and issue a draft rule later this
month have therefore rekindled a fiery debate. In the wake of
the recent tidal wave of accounting scandals, support for
mandatory expensing has increased significantly. A recent
survey by Merrill Lynch found that more than 90 percent of the
institutional investors want stock options expensed. The four
largest accounting firms have also now called for the expensing
of stock options. Moreover, many respected financial experts
have effectively made the case for options expensing, including
William Donaldson, William McDonough, Warren Buffett, Alan
Greenspan, Paul Volcker and Joseph Stiglitz.
In addition, nearly 500 countries have adopted or are in
the process of adopting fair value expensing of stock options.
Respected corporations like Home Depot, General Motors, General
Electric, Wal-Mart, Microsoft and Amazon have all decided to
treat stock options as expenses. Several companies
headquartered in Pennsylvania have also done the same,
including Mellon Financial, Hershey Foods, and First Keystone
Corporation in Berwick.
As we proceed today and in the future, I must caution my
colleagues about the ongoing need to protect the independence
of the Financial Accounting Standards Board. A decade ago, the
Congress unfortunately strong-armed this private regulatory
body into abandoning its efforts to adopt a rule regarding
stock options expensing. We now know that this retreat
contributed to the financial storm on Wall Street in 2001 and
2002.
To protect against similar incidences in the future and
safeguard the public interest, we incorporated into the
Sarbanes-Oxley Act a provision granting an independent funding
stream to the Financial Accounting Standards Board. The active
consideration of the Stock Options Accounting Reform Act by our
panel, in my view, would threaten this recently approved and
enhanced independence, intervening in the board's ability to
make unbiased decisions and disrupting an objective process for
reasons other than sound financial reporting.
Other leaders on Capitol Hill agree with me about the
wisdom of protecting the independence of the Financial
Accounting Standards Board. Earlier this year, Senator Shelby
and Senator Sarbanes, the two most powerful members of the
Senate Banking Committee, asserted their bipartisan opposition
to intervening in the activities of the board. Chairman Oxley
has also previously said that compromising the independence of
the board, ``could negatively impact efforts to improve the
transparency of financial reports.'' I wholeheartedly agree.
Deciding what should be accounted for and how it should be
accounted for is the job of the Financial Accounting Standards
Board, not the Congress. Although the board has not yet
released its draft rule on expensing stock options, I am
pleased that the agency is working to address this important
issue. Employee stock options are a type of compensation just
like a salary or a bonus. Because compensation is an expense
and because expenses influence earnings, employee stock options
should be counted against earnings and subtracted from income.
Mandatory stock option expensing would further help
investors to make better decisions. Individuals, for example,
might have previously made different choices about the stock of
AOL Time-Warner. In 2001, the failure to account for employee
stock option on the company's balance sheet resulted in a
profit of $700 million, instead of an operating loss of $1.7
billion. Unlike the current system where some businesses
expense options and others do not, a mandatory expensing rule
would also facilitate comparisons between companies, helping
investors to make apple-to-apple evaluations, rather than
apples-to-oranges assessments.
In closing, Mr. Chairman, our capital markets remain the
strongest in the world only when the rules are clear and
credible, corporate activity is transparent, and the data is
unbiased and comparable. Stock options are expenses. To
strengthen investor confidence and promote the international
convergence of corporate reporting standards, the Financial
Accounting Standards Board must therefore proceed with
diligence and without political interference in these matters.
Thank you, Mr. Chairman.
[The prepared statement of Hon. Paul E. Kanjorski can be
found on page 46 in the appendix.]
Chairman Baker. I thank the gentleman for his statement.
Mr. Gillmor, did you have an opening statement?
Mr. Gillmor. Thank you very much, Mr. Chairman, and also
thank you for holding what is a very important and timely
hearing.
The issue of how to account for employee stock options in a
company's financial statements is a very significant one,
particularly given the many high profile cases of accounting
fraud in large publicly traded companies. As a member of the
Committee on Energy and Commerce, which used to have
jurisdiction in this area, and the House Financial Services
Committee since 1994, I have been monitoring the Financial
Accounting Standards Board rulemaking process on the accounting
of stock options. I was supportive of their final rule
addressing stock options and allowing them to be recorded as an
expense on their annual profit and loss statements.
Unfortunately, I have to say I oppose H.R. 3574, the Stock
Option Accounting Reform Act which we are reviewing this
morning. I feel that Congress and this committee should stand
by our statement in the Sarbanes-Oxley Act of 2002 and the
recent SEC policy statement reaffirming FASB as the nation's
accounting standard setter, and we should allow them to do
their job and retain the independence mandated in these matters
by Congress itself.
This week, I am circulating a letter to all my colleagues
that I received from the Ohio Public Employees Retirement
System, a $56 billion fund and the tenth-largest state pension
fund in the United States, expressing their support of FASB's
actions and opposition to the bill. As Laurie Hacking, who is
the executive director of that organization, states in her
letter, ``FASB has considerable financial expertise and is
best-suited to consider complex financial accounting issues. It
also has a measured process in place for soliciting public
feedback on proposed accounting standards.''
U.S. financial markets remain the envy of the world due to
the quality, the timeliness, and the credibility of financial
information and disclosures provided by companies. The result
is a better allocation of resources and lower overall cost of
capital. We ought to ensure that this remains the case by
allowing our standards setter to operate independently of
public and private special interests.
I encourage my colleagues to support the role of FASB. We
should not be setting accounting standards on a political
basis. Also, the failure to expense options provides false and
misleading statements to shareholders because it does not
accurately reflect the true cost to the company and the
shareholders. That, I think, explains the broad support for
stock option expensing by financial experts such as SEC
Chairman Bill Donaldson, Federal Reserve Chairman Alan
Greenspan, former FED Chairman Paul Volcker, and Warren
Buffett.
Thank you, Mr. Chairman, for calling this hearing and I
look forward to the debate. I would also, if it is appropriate,
Mr. Chairman, request unanimous consent to enter into the
record a statement I have received from the Ohio Highway Patrol
Retirement System.
[The following information can be found on page 116 in the
appendix.]
Chairman Baker. Without objection. I thank the gentleman.
Mr. Crowley, did you have an opening statement?
[The prepared statement of Hon. Paul E. Gillmor can be
found on page 44 in the appendix.]
Mr. Crowley. Thank you, Mr. Chairman. I want to thank you,
Chairman Baker and Ranking Member Kanjorski for conducting this
important hearing this morning and for our panelists before us
today on the expensing of stock options and the possible
effects that this could have on our economy.
The Financial Accounting Standards Board will soon issue a
proposal on the accounting treatment for employee stock
options. While I welcome the role the FASB plays in our
economy, that of ensuring the independence and credibility of
our nation's accounting system, I must disagree with FASB on
their expected upcoming actions dealing with the expensing of
stock options. I do not believe that any prohibition on the
mandatory expensing of options would cloud basic accounting
principles. Investors and analysts who are interested in
adjusting an issuers income statement for the cost of stock
options already have the necessary information available in the
footnotes included in their annual reports.
Additionally, while many supporters of expensing will argue
that it would help restore credibility and investor confidence
to our markets, again I would respectfully argue the opposite
would occur. The mandatory expensing of stock options would
effectively destroy broad-based stock option plans which
enhance financial opportunities for workers at all levels,
stimulate economic growth and helped create the new economy of
the 1990s, a new economy that resulted in a burst of new
wealth, productivity and ingenuity that we still enjoy today in
America.
In fact, it is these stock options that have spread wealth
throughout all sectors and to all employees of the new economy,
from CEO to secretary. Ninety-eight of the nation's top 100
largest high-tech firms that focus on the Internet provide
options to most or all of their employees. Most of these
options go to the rank-and-file workers, helping stimulate
wealth creation for employees, while allowing employers to
attract the best and top talent.
Why did and do educated people flock to corporations that
offer their employees stock options? Because they understand
the value of options for their company's bottom line and for
their own personal bottom line. Stock options promote wealth
sharing and we should not hamper that as a means to address
what some see as a questionable issue of corporate governance.
While the stories of the high-tech boom gone bust are
everywhere, can anyone honestly say our nation or economy or
our people would be better off without the Internet boom of the
1990s and resulting and long-lasting benefits it provides to
America and the world today and every day?
That is why I am a strong supporter and cosponsor of both
H.R. 1372 by Congressman Dreier and Congresswoman Eshoo, both
of California; and H.R. 3574 by Chairman Baker and
Congresswoman Eshoo. I believe these are important bills that
will protect job and wealth creation in America, while not
threatening our nation's accounting standards or FASB's
independence.
Once again, I want to thank Chairman Baker and Ranking
Member Kanjorski and all the witnesses. I yield back the
balance of my time.
Chairman Baker. I thank the gentleman.
Mr. Shadegg, did you have a statement this morning?
Mr. Shadegg. Thank you, Mr. Chairman. I want to thank you
for holding this hearing.
Let me state at the outset that I am a supporter and
cosponsor of H.R. 3574, the Stock Option Accounting Reform Act.
However, I would have ideally preferred the Dreier legislation
that was referred to. It is my preference that there be no
statutory requirement for stock options. I believe this is an
issue which needs to be resolved in the marketplace on a case-
by-case, corporation-by-corporation basis. However, I do
recognize that there is a significant movement toward some sort
of expensing, and I believe that the limited expensing coupled
with an absolutely necessary study of the economic effects of
expensing contained in H.R. 3574 is appropriate.
There are numerous reasons why I oppose statutory
requirements for the expensing of stock options and I associate
myself particularly with the comprehensive discussion of this
issue contained in the written testimony of Arthur Coviello.
There are two points which deserve special mention. First,
requiring the expensing of stock options will stifle the
ability of small companies on the cutting edge of innovation to
attract and retain the high quality employees they need to turn
concepts into real-world products. Time and again throughout
our nation's economic history, and especially during the high-
tech revolution of the 1990s, small firms that were long on
ideas, but short on earnings, have been able to conceive of,
develop and bring to the market new products which have had
profound impacts on all of the economy. To do so, small
companies have relied above all on their human capital, on
intelligence, motivated, hard-working employees who are able to
think outside the box.
The primary way they have been able to attract and retain
these individuals is by offering them the opportunity to grow
with the company, to share directly in the success of their
innovations through stock option grants. By increasing the cost
of granting stock options, the playing field will be tilted
away from these small firms and innovation in the marketplace
will suffer.
The second and perhaps more critical point is the democracy
which broad-based employee stock options bring to corporations.
Employees who own stock in their company are far more than
labor. They are the owners of the company. They share both
financially and psychologically in its success to a much
greater degree than mere numbers on a balance sheet can ever
capture. It would be a sad triumph of myopia to decide that the
placement of another, and quite frankly not very accurate,
number on a corporation's balance sheet is more important than
the commitment to the success of that corporation brought by
employee ownership.
Again, Mr. Chairman, I commend you for holding this hearing
and for introducing H.R. 3574. I look forward to working with
you to enact this legislation into law.
[The prepared statement of Hon. John B. Shadegg can be
found on page 49 in the appendix.]
Chairman Baker. I thank the gentleman.
Ms. Moore?
Mr. Moore. Thank you, Mr. Chairman. I would like to thank
you for holding this hearing today on H.R. 3574, the Stock
Option Accounting Reform Act. I look forward to working with
you, with my members and colleagues on both sides of the aisle
on this issue, as I have in the past. I hope we can move this
legislation in the 108th Congress.
The members of this subcommittee and our invited witnesses
are well aware of the issues surrounding the mandatory stock
options expensing debate, so I will not discuss those at length
here today. It is worth noting why the Baker-Eshoo bill would
take necessary and important steps toward curbing many of the
abuses in stock options that have given them a bad name.
The various corporate scandals of the late 20th and early
21st century exposed the need for Congress to ensure that
highly compensated senior executives cannot misuse stock
options. As we have seen, the prominence of options and
executive compensation packages has actually served as an
incentive for executives of certain now-defunct companies like
Enron to engage in complex structured finance deals that had
the practical effect of manipulating the company's stock price.
Enron executives had every reason to work to maintain an
artificially high stock price. The higher the stock price of
the company, the more valuable these executives's options
became.
It is important to remember that options do not inherently
lend themselves to abuse. I am concerned that proposals to
require public companies to expense all employee stock options
may have the unintended consequence of decreasing the number of
options that companies will offer their employees in the
future. Broad-based employee stock options played a significant
role in the capital formation that led to the technology boom,
and consequent productivity gains of the late 1990s. Congress
should be focused on putting an end to the abuses that threaten
to curtail broad-based options issuance and the Baker-Eshoo
bill, Mr. Chairman, is an important step forward in that
regard.
Finally, while I generally believe that Congress should
allow FASB to set accounting standards without congressional
interference, I think it is entirely appropriate that we
continue to monitor the issue of options expensing and take
action if necessary to ensure that proposals affecting stock
options expensing will not overreach. FASB should be extremely
careful to take into account the differences between rank-and-
file employee stock programs and nonqualified option grants
that have led to the corporate abuses we have discussed
earlier.
Thank you again, Mr. Chairman, for holding this hearing. I
look forward to hearing the witnesses's testimony.
Chairman Baker. I thank the gentleman.
Mr. Scott, did you have a statement?
Mr. Scott. Thank you very much, Chairman Baker.
This is an important issue, given the pending action by the
Financial Accounting Standards Board, to issue rules requiring
companies to report the value of their stock options and their
income statements. I am a cosponsor of H.R. 3574 and I commend
Chairman Baker and Representative Hooley for introducing this
balanced legislation.
As we move forward in this committee, we should make sure
that rank-and-file employees who have benefited from broad-
based stock option plans in the past can continue to reap these
benefits in the future, while combating abuse in executive
compensation.
We also must ensure that companies have all the tools they
need to stay on the cutting edge of innovation and maintain all
the tools we have to expand the jobs based here in the United
States. H.R. 3574 encourages small companies to innovate,
rather than stifling them.
I look forward to hearing from today's distinguished panel
about H.R. 3574 and the pending regulatory action by the
Financial Accounting Standards Board.
Thank you, Mr. Chairman.
Chairman Baker. I thank the gentleman.
Mr. Emanuel, did you have a statement?
Mr. Emanuel. Yes, Mr. Chairman. Thank you and I will try to
be quick because I know we want to get to the panel. Thank you
for holding this hearing.
In general, my view is that this decision should be left to
the FASB board and the private sector. I have expressed that
view in the past, but I also believe we should be sensitive to
startups and young businesses if we are going to make any
decisions about the expensing of options. But I firmly believe
it is the jurisdiction of FASB and the private sector to
regulate this area. It needs some reforms as there clearly were
abuses in the past.
I want to caution us that we should not micromanage the
private sector on issues like expensing options and board
independence, and at the same time leave major issues that we
actually should be involved in, such as health care, retirement
security and employment safety, untouched. So my view is that
we shouldn't be setting a precedent by getting involved in
things that might better be left to the private sector; and
things that we should be involved in.
I understand that some of the issues I raised are beyond
the jurisdiction of this committee, but it worries me that we
are micromanaging private sector interests, when the major
social issues are left undiscussed and untouched by this
Congress.
Thank you.
Chairman Baker. I thank the gentleman.
Mr. Sherman?
Mr. Sherman. Thank you.
As one of two CPA on this subcommittee, I take a strong
interest in these hearings. Only as I understand it, one out of
five of all those testifying are skeptical or opposed to the
bill in front of us. That is not surprising, because the most
powerful people in our society as a group are corporate
executives, and the best way for a corporate executive to get
rich is on stock options. Stock options have had a favorable
treatment both under our tax law and especially under our
accounting rules for a long time.
I should point out that we should be loyal here to
investors. Investors should be given the truth. We should not
fool investors or steer investors into companies just because
the companies are doing good things. If a company has a
democratic process of spreading the wealth, that is a good
thing. But that does not mean we should fool investors as to
the total costs of compensating their employees.
Likewise, if a company was going to add 1,000 jobs to its
payroll and every single added employee was a former welfare
recipient, who would propose that in order to encourage that
great corporate activity, that we would say that the money
spent for those employees as their payroll should not be
charged against income? No one would say we are penalizing a
company by making them record as an expense the cash that they
pay, the very people we most desperately want them to hire.
Now, I think one ultimate solution to all this, and I agree
with my friend from Illinois that it should be the FASB that
wrestles with these issues, is that we let 1,000 flowers bloom;
that we provide to investors an income statement, an earnings
per share number that reflects what I would call the Coca-Cola
approach, and what was up until I believe recently the Pepsi
approach. One soft-drink company expensing stock options; the
other I believe until recently capitalizing. Actually, both
changes were recent, but I guess Coke was the original on this.
So if we provided both, then we would eliminate this as an
issue. Those investors who wanted to invest in companies based
on their earnings per share unadjusted for stock option expense
could do it on that basis. And those who believe that they
would make better decisions with the other number could use
that number.
Now, it is not a penalty against a company to list
something as an expense if it really does cost the shareholders
something. An example of that would be, say, health care
coverage. You folks, we are all talking here about employee
stock options. If you gave the exact same option to a health
care company and the corporation said, you know, we cannot
afford health care coverage. Our people are going to be going
to emergency room. They are going to be dying because we do not
give them health care coverage, so here is what we are going to
do. We do not have the cash. Those stock options we were going
to give the investors, we are going to give to a health care
company, and because we are a hot company, because they have
faith in us, they are going to take stock options instead of
cash.
Every single person in this room would say you have to book
it as an expense. If you pay the health care company in stock
options or you pay him in cash, you have to book it as an
expense.
So we are in a position here to say that stock options when
given to executives, that is such a noble purpose that its
favored position must be continued, if we give it to executives
or even if more democratically around the company. But if we
use it to provide health care, that is an expense.
I would also add that this is a matter of fairness among
sectors. I will wrap up soon. I have more high-tech companies
than the Chairman. Well, proportionately, you probably have
more steel companies. I am guessing.
Chairman Baker. Oil and gas.
Mr. Sherman. Okay, excuse me.
Chairman Baker. We used to.
[Laughter.]
Mr. Sherman. In any case, there still is an old economy
that does not use stock options. If the company in my district
that uses stock options has to report 7 cents per share
earnings instead of 9 cents, what it means is the capital flows
to the chairman's district. There is a certain amount of
capital, 8 cents a share, if his company, old-tech, not
providing stock options is reporting 8 cents a share, and what
we are debating here is whether the high-tech company is
reporting 7 cents or 9 cents, let us not forget it is all
comparative, and the capital that flows to that stock option-
using company is flowing away from the company that does not
use stock options.
Finally, I may add that there is one area where FASB has it
wrong. They know the have it wrong. And that is the area of
expensing research. If you go buy a research result, you buy a
patent, that is purchasing an asset. But if you do the research
in-house, that is booked as an expense. That is a penalty and
there is a reason why we do not have all that corporate power
fighting against that penalty. It is not because research is
not just as important to this country as executive
compensation. It is because executive compensation is more
important to those who have the most power in our country.
If we want to start second-guessing what the FASB is doing,
we ought to take a look at the genuine penalty they impose on
companies who do research in-house. We know why the FASB has
imposed that penalty. It is because the accountants do not want
to figure out whether a research project has been successful or
unsuccessful. So they penalize a company with a successful
research project and say every research project will be deemed
unsuccessful and we will penalize. So there are penalties in
what the FASB does, but they are for research.
I yield back and thank you for the time.
Chairman Baker. I had to exercise my option. I am sorry.
Mr. Shays, did you have a comment?
Mr. Shays. Yes, Mr. Chairman, just to say that I want to
state that my position is basically to go with what FASB
suggests, unless I see overriding evidence here before any
decision has to be made. So my sense is very clearly that
expensing makes sense, but I am here to learn and see if I
should be changing my opinion.
Thank you.
Chairman Baker. Thank you, Mr. Shays.
Mr. Inslee?
Mr. Inslee. Thank you.
I would normally be reluctant to have Congress delve into a
FASB issue, but I think it is required here and I cosponsored
this bill. I just want to make two points. First, my friend Mr.
Sherman referred to letting 1,000 flowers bloom. The problem,
though, is that right now a lot of those flowers are blooming
in India and China . We would prefer them to bloom here. By
this action by FASB, we add to the possibility that there will
be a competitive advantage in hiring talent in India and China,
where I think this will be treated differently.
We are now in the midst of a real national domestic crisis
dealing with job loss. This potential issue could lead to that
where we give a competitive advantage to India and China and
this is not the moment for doing so.
The second point is that we are doing a lot of research in
my district, the First District of Washington, and we are doing
lots of research with DNA and the like. I think we ought to be
spending our hard-earned dollars in research on DNA, not
research on CPAs trying to figure out how many thousand angels
can dance on the head of a pin, on trying to figure out a right
number for expensing this. Let us focus on research and
science, rather than the abstractions that could lead
economists to go crazy.
I will yield to Mr. Sherman.
Mr. Sherman. I thank the gentleman for yielding.
I would point out that if the FASB changes the rules,
whether those stock options are given to an Indian engineer or
Chinese engineer or an American engineer, they would all be
treated the same way. How things are treated on the Indian
stock market is of little relevance because all the companies
in high tech are turning to the American capital. So we are
talking about rules that will apply to whether it is French
companies, Indian companies, American companies doing business
wherever, and their use of stock options and other mechanisms
to compensate their people.
Mr. Inslee. Reclaiming my time, the fact is that we are
talking about competition between Indian companies and American
companies; Indian capital formation and American capital
formation. And you have an antiquated view, I believe, of
reality in thinking there is not capital growing in China and
India. Half the cranes in the world are in China right now
building new capital investment and using a lot of Chinese
capital. Our entire federal debt is financed with Chinese
capital at this moment, according to Mr. Greenspan.
So I think the future is, we have to pay intimate attention
to international competition right now to keep jobs in this
country. I think this is one issue, although we do not think of
it in terms of outsourcing, we ought to start thinking about
these terms in every public policy we have.
Thank you.
Chairman Baker. I thank the gentleman.
Mr. Bachus, did you have a statement?
Mr. Bachus. Yes. I thank the Chairman.
I will tell this to the Chairman and the Members, and also
to the panel, one reason that we are here today is because we
have not been able to reach any middle ground with FASB. They
have simply taken a mandatory approach. We are going to require
all employee stock options to be expensed. It does not matter
whether it is a phantom expense to the company. It does matter
whether it is difficult on how to value these expenses. It does
not matter that really tech companies, one of the reasons they
have been able to flourish, grow and we are at the leading edge
of technological development, and that even FASB agrees that is
in large order because of employee stock options.
They have made no efforts to find a middle ground. I
actually think that what they are doing violates generally
accepted accounting principles, because you are going to
require companies to expense these stock options when there may
never be an expense. These companies, a lot of their innovation
is from employees who were promised a share of the company.
That is no longer going to be possible. Employee stock options
have resulted in large numbers of people having an equity
ownership in a company. In fact, companies that give employee
stock options, the employees in many of these companies own 10,
15, 20 percent of the company, sometimes 30 percent and more.
I think we are really threatening to take one of the things
that makes our companies the most competitive and the most
innovative, and slam the brakes on it. Apparently, we are going
to do that with a rule that is going to go into effect January
1. I think it could have broad-based negative effects on our
country, on our most innovative companies, our fastest growing
companies. There are certain things FASB has not been able to
answer. They have answered to me in incomplete ways. One is,
where do we get the models to accurately say what these
expenses will be? They have said there are models available,
but those models are not models that are used to value employee
stock options. They are models that are intended to simply
model stock options in general. There is a big difference in an
employee stock option and other stock options.
So I have real concerns. I am going to, for the record and
in the interest of time, submit a two-page statement outlining
probably 15 or 20 different objections to this. I think there
is some middle ground, but I can tell you that what FASB is
proposing is not a middle ground. It is a radical departure
from not only what we are doing now, but it to me will shock
the market and could have broad-based effects on the creation
of jobs, productivity, and keeping our country competitive in a
world environment. Also, I think it will harm a lot of middle
class workers.
With that, I yield back the balance of my time.
Chairman Baker. I thank the gentleman.
Ms. McCarthy, did you have a statement?
Mrs. McCarthy of New York. Thank you, Mr. Chairman.
I am going to reserve my opinions at this point, because
that is what a committee hearing is supposed to be about. So I
will offer my statement, and I am looking forward to hearing
the testimony. I will say you can see that both sides of the
aisle, Republicans and Democrats, need to have as much
information as possible because we are split on this. We are
trying to find the right solution for all of you. So I look
forward to the testimony.
Thank you, Mr. Chairman.
Chairman Baker. I thank the gentlelady.
Mr. Israel?
Mr. Israel. Thank you, Mr. Chairman.
Very briefly, I am not a big believer in throwing the baby
out with the bathwater. I do not believe that we should allow
the clear financial abuses of some institutions and firms to
impinge on the ability of all entrepreneurs, all small
businesses, all high-tech businesses including many that I
represent, in surviving and growing.
Many firms in my congressional district rely on stock
options as the most feasible way of sustaining themselves. I
believe that we should proceed very cautiously and not take the
financial abuses of some and use them to essentially destroy
the ability of so many of these firms to compete and grow,
create jobs and expand.
Thank you, Mr. Chairman. I yield back.
Chairman Baker. I thank the gentleman.
Mr. Matheson?
Mr. Matheson. No opening statement for me. I look forward
to hearing from the witnesses. Thank you, Mr. Chairman.
Chairman Baker. I thank the gentleman.
Mr. Ackerman?
Mr. Ackerman. I am happy to be here.
Chairman Baker. We are happy to have you, Mr. Ackerman.
If there is no member wishing to make any additional
statements, then at this time I would like to welcome our long-
suffering panel to our hearing this morning. We do appreciate
your willingness to participate and give us your perspectives.
Let me just do the formalities. To the extent possible,
constrain your remarks to a 5-minute statement. Your official
statement will certainly be made part of the hearing record. We
look forward to hearing your various perspectives.
Our first witness is Miss Karen Kerrigan, chairman of the
Small Business Survival Committee. Welcome.
STATEMENT OF KAREN KERRIGAN, CHAIRMAN, SMALL BUSINESS SURVIVAL
COMMITTEE
Ms. Kerrigan. Good morning, Chairman Baker, Ranking Member
Kanjorski and members of the subcommittee.
First, let me thank you for inviting the Small Business
Survival Committee to present our views on H.R. 3574, the Stock
Option Accounting Reform Act, indeed, to endorse and support
this piece of legislation which we think is necessary to
sustain economic growth, certainly broad-base employee stock
options, and innovation in this country.
Again, I am Karen Kerrigan, chair of the Small Business
Survival Committee. We are a nonpartisan small business
advocacy organization headquartered here in the nation's
capital. SBSC works to advance legislation and policies that
help to create a favorable and productive environment for small
business growth, job creation and entrepreneurship.
In our view, H.R. 3574 is an appropriate response to what
seems to be general indifference at the Financial Accounting
Standards Board with respect to the business community's
concerns about mandatory stock option expensing. The board is
about to unveil a stock option expensing rule that would be
particularly complex and costly for small businesses.
In our judgment, it would not lead to the sort of financial
transparency and accountability sought by FASB, shareholders,
and elected leaders or regulators. Instead, broad-based
employee stock option plans would suffer, leaving small firms
at a competitive disadvantage to larger and more mature
entities whose resources allow them to recruit and attract the
best and the brightest. This would be a shame, as small
businesses are a key source of innovation and job creation in
the United States.
I know that committee members are keenly aware of the
important role America's small business and entrepreneurial
sector plays in job creation, innovation, economic growth and
in the overall health and vitality of our economy. They produce
55 percent of innovations; they obtain more patents per sales
dollar than large businesses; they employ 38 percent of high-
tech workers. Incentives and tools that help small firms add to
their innovative capacity and their productivity like stock
options are integral to their success and our general economic
well being.
Indeed, through the leadership of the small business and
entrepreneurial sector, and more specifically the high-tech
sector, the concept of employee ownership and participation has
enriched our economy and our workforce in a variety of ways.
The spread of what is called partner capitalism, as the authors
of the book In the Company of Owners describe it, is a good
thing as it boots employee productivity, profits and stock
returns.
The mandatory stock option expensing rule proposed by FASB
in our view is archaic and out of step. It would vastly curtail
the capability of small firms to offer stock options as an
employee recruitment, retention and incentive tool. It makes
little sense to erect barriers and rules that eviscerate these
programs, as stock options have allowed millions of America's
workers to have ownership in the companies where they work.
While FASB's intention to increase financial recording and
transparency is a worthy goal, we are baffled that they would
continue down the mandatory expensing of stock options path, or
more specifically, untested valuation models to achieve that. I
am not an accountant, as many of you will find out probably in
the Q and A session of this, yet the proposal does not seem to
make accountant sense. There is no true consensus on the
identification of a model to place an accurate and reliable
number on the so-called costs of employee stock options.
Indeed, all indications are that the FASB is going to rely on
either the Black-Scholes method or the binomial method, both of
which many experts agree produce bad numbers.
As a result, the mandatory expensing of employee stock
options will not make financial statements more accurate,
reliable and transparent. A recent decision by FASB to reject
field-testing of various valuation models is unfortunate. From
our perspective, it made sense for FASB to take the time to run
valuation tests on a wide sample of companies to determine
impact.
H.R. 3574 is a prudent solution which comes at an important
time. The proposed legislation incorporates sound and targeted
reforms with a reasonable requirement that a study be conducted
to understand the economic impact of the mandatory expensing of
all employee stock options. The latter is very important, as
policymakers must make every effort to review whether proposed
policy initiatives weaken or strengthen U.S. job-creating
capacity and competitiveness.
SBSC certainly appreciates the measure to protect small
businesses and startup companies. The exemption for companies
with less than $25 million in revenues and the protection for
companies 3 years after the initial public offering strike a
reasonable balance. In essence and most importantly, H.R. 3574
will help preserve broad-based stock option plans and the
ability of small firms to offer these plans.
Let me just add as a wrap-up that we are hopeful that this
instance or this current controversy serves as an opportunity
for FASB to review its standard-setting process. Already, they
have reached out to the small business community, specifically
to the Small Business Survival Committee, to let us know that
they are putting together a small business advisory board and
they have asked us for recommendations for people to serve on
that board. We have recommended someone to serve in that
capacity.
In closing, let me reiterate SBSC's support for H.R. 3574.
We encourage Congress to act quickly. With the economy getting
back on track, we believe Congress would be taking a prudent
step in shielding America's workforce and businesses from the
proposed action that would undermine economic growth.
Thank you.
[The prepared statement of Karen Kerrigan can be found on
page 82 in the appendix.]
Chairman Baker. I thank the gentlelady for her statement.
Our next witness is Mr. Mark Heesen, President of the
National Venture Capital Association. Welcome, sir.
STATEMENT OF MARK G. HEESEN, PRESIDENT, NATIONAL VENTURE
CAPITAL ASSOCIATION
Mr. Heesen. Thank you. Good morning.
I am Mark Heesen, President of the National Venture Capital
Association, which represents 460 venture capital firms in the
United States. Venture-backed companies are very important to
the U.S. economy as a whole in terms of creating jobs,
generating revenue and fostering innovation. In fact, U.S.
companies that were originally funded with venture capital now
represent 11 percent of annual U.S. GDP and employ over 12
million Americans.
I am testifying today in support of H.R. 3574, as this bill
reflects a thoughtful and balanced approach to employee stock
option accounting. The bill mitigates to a considerable degree
the critical flaws surrounding the impact of expensing on small
and emerging growth businesses, an impact that FASB has simply
refused to address.
Since the last Senate hearing this past November on this
issue and the last meeting of this subcommittee in June, the
FASB has made no meaningful progress toward making any
distinction between the effects its proposal would have on
large publicly traded entities versus small private businesses,
despite countless calls to do so and promises from Chairman
Herz to members of this committee to do just that.
We fully concur with Congress's reluctance to involve
itself in the setting of accounting standards. Yet FASB's
exposure draft is expected in a matter of days and frankly we
have nowhere else to turn. The voices of our country's emerging
growth businesses have gone ignored by FASB. We see an urgent
need for checks and balances in our system at this time.
Employee stock options are a critical factor in fueling
entrepreneurial innovation and economic growth. For example,
the biotechnology industry today simply would not exist without
venture capital and without employee stock options. Almost
without exception, young venture-financed companies use options
to attract the best and the brightest talent when cash is
scarce, and cash is always scarce in these companies. Should
FASB require stock option expensing, they will seriously harm
the economic tool that has given U.S. companies a major
competitive advantage over its foreign counterparts.
The mandatory expensing of stock options will place a
serious burden on small companies so that most will be forced
to curtail their broad-based option programs. Today, just as in
1994 when this issue was last addressed by Congress, an
acceptable method for the valuation of employee stock options
has not been identified by FASB. Therefore, the option expense
number will be perpetually inaccurate, particularly for private
companies where it is impossible to measure volatility in
mandatory input into the valuation models currently supported
by the FASB.
By requiring companies to disclose a highly suspect expense
number, the FASB is creating a cost on the income statement
that will have a significant long-term impact on a company
striving to reach profit levels necessary for an IPO or to
become an attractive acquisition target.
Aside from inaccurate financials, a more practical concern
is the monetary and human costs that will be required for young
companies to undertake the valuation process. These
organizations cannot afford the outside expertise required to
work through these complex valuation models, nor can they
afford the time to do it themselves. But FASB's mandate will
force them to address these accounting issues, distracting
management, raising expenses, and lengthening the reliance on
expensive high-risk capital to the startup sector.
We believe H.R. 3574 seeks to preserve broad-based employee
stock options and addresses serious implications of expensing
for emerging businesses. By limiting mandatory expensing to the
top five executives, this bill targets executive compensation,
while simultaneously preserving the ability of companies to
deliver options to rank-and-file workers.
By exempting the expensing requirement for small businesses
until 3 years after an IPO, the bill relieves compliance
burdens for young companies seeking to go public, and allows
the company's stock to settle down from the volatility of an
IPO. By setting the volatility at zero for valuation purposes
as allowed under current FASB rules, H.R. 3574 removes a key
variable that creates highly inaccurate expense figures.
Finally, by requiring the Secretaries of Commerce and Labor
to complete a joint study on the economic impact of mandatory
expensing, the bill thwarts a rush-to-regulate effort by the
FASB and prevents severe unintended consequences for our
economy and our international competitiveness.
Should FASB move forward with this current stock option
accounting mandate, venture-backed companies will have
inaccurate financial statements prepared at a significantly
greater cost. Entrepreneurial businesses will be unduly
impacted as they do not have the adequate resources to comply.
The entrepreneurial energy that now accounts for over 10
percent of the U.S. economy will be drained at a time when our
global competitiveness is increasingly challenged by economic
conditions overseas.
International convergence of accounting standards such as
mandatory expensing will touch Europe and the United States,
but not China and India, where we feel accounting standards
more supportive of stock options will drive more highly skilled
jobs offshore. Today we applaud the congressional leadership
for addressing the practical impact of FASB's stock option
expensing proposal and we urge passage of H.R. 3574.
Thank you very much.
[The prepared statement of Mark G. Heesen can be found on
page 75 in the appendix.]
Chairman Baker. Thank you, sir.
Our next witness is Mr. Reginald Reed, who is the manager
for software development from Cisco Systems. Welcome, sir.
STATEMENT OF REGINALD REED, MANAGER, SOFTWARE DEVELOPMENT,
CISCO SYSTEMS
Mr. Reed. Thank you. Good morning. Chairman Baker, Ranking
Member Kanjorski, members of the subcommittee, thank you for
the opportunity to testify this morning in support of broad-
based stock option programs and H.R. 3574, the Stock Option
Accounting Reform Act.
My name is Reginald Reed. I am the manager in the software
development area for Cisco Systems, Incorporated. I work for
Cisco in the Research Triangle Park near Raleigh, North
Carolina. I have been with Cisco for 7 years. We are most
appreciative, Chairman Baker, for your incredible leadership on
this important issue. Thank you for standing up to preserve
broad-based employee stock options for the over 10 million U.S.
employees who have received them. We need the House and Senate
to pass this legislation soon because the future of broad-based
employee stock option plans is in jeopardy.
Every day, I see the difference that employee stock options
make in the workplace. In my opinion, there is no better way to
motivate talented employees. In fact, I had underestimated
their power to motivate. Because of Cisco's broad-based
employee stock option plan, our customers and shareholders
benefit. When something is a positive for employees, customers
and shareholders, it is a very powerful tool.
At Cisco, employees are tied to the company's bottom line
in large part because of the stock option grants we receive
that make us all owners. Employee stock options allow us to
better understand how hard work and innovation play a central
role in the company's overall success. The sense of ownership
created by stock options at Cisco and other companies is part
of the driving force behind the advances in information
technology that take place throughout the industry.
The Cisco stock option program has helped turn our Research
Triangle Park operation into a major engineering hub on the
East Coast. At Cisco, I see the benefits of employee stock
options everywhere I look. I have five engineers who report
directly to me. I see first-hand how stock options make them
think and act like owners. I see the extra mile they go, the
extra energy they provide, and how they act like owners.
I also know how stock options incentivize me. As I look at
my managers, I see the same dynamic. Our CEO, John Chambers,
has put it very well. He has said that the difference between
workers who receive employee stock options and those who do not
is a lot like the difference between owning a home and renting
one. The mindsets are totally different. When you own a home,
it is a reflection of you. From the basement to the attic, you
want everything to be perfect. When you rent, you just want to
make sure that you get the security deposit back.
The 35,000 employees who make up Cisco Systems are owners.
We want to make the most innovative products. We want to
develop the newest technologies. Employee stock options are an
essential part of that commitment that binds us all together.
If stock options are expensed, many companies will be forced to
cut back on programs that benefit rank-and-file employees, and
instead only give them to top executives. If this happens, we
will lose much of our ability to attract, retain and motivate
dedicated employees.
The call for expensing of employee stock options, as I read
it, came about because people were concerned about bad
executive behavior. The irony is that these misdirected reforms
to expense all stock options will largely impact rank-and-file
employees like myself. This is why, Chairman Baker, your
legislation addresses those initial concerns so well, while
also preserving broad-based employee stock option programs.
A little over a year ago, my wife Julie and I welcomed our
first child into our family. The stock options I exercised 5
years ago went towards a down payment for the house that our
child calls home. In the future, my goal for stock options are
for a good education for my daughter and a more secure
retirement.
I am not an accountant. I am not an expert in financial
statements or footnotes or the securities laws, but I do know
the benefit of stock option plans that are broad-based. Like
the millions of other workers in this country who receive
employee stock options, I am worried that unelected accounting
regulators are going to make a decision that effectively
eliminates broad-based employee stock option plans and
negatively affects our economy and our country.
We need your help. We need our elected officials in the
United States Congress to step in and preserve broad-based
employee stock options. That is why on behalf of the employees
of Cisco, I ask you to pass H.R. 3574.
Thank you very much for inviting me here today and taking
the time to listen to my testimony. I will be pleased to answer
any questions that you might have.
[The prepared statement of Reginald Reed can be found on
page 113 in the appendix.]
Chairman Baker. Thank you, Mr. Reed. We appreciate your
participation here today.
Our next witness is Professor Robert Merton from the
Harvard Business School. Welcome, sir.
STATEMENT OF ROBERT MERTON, HARVARD BUSINESS SCHOOL
Mr. Merton. Good morning. As you said, I am Robert Merton.
I am a professor at the Harvard Business School. I am also a
co-founder and the chief science officer of a firm called
Integrated Finance Limited.
Mr. Chairman, I thank you and the subcommittee for inviting
me to testify on the Stock Option Accounting Reform Act. The
focus of my remarks on this bill addresses three points.
Compensatory stock options are a real cost to the company and
should be an expense. Second, the costs to the firm of these
options can be estimated. And third, what are some of the
potential public policy issues associated with expensing of
these options.
As to the first point, the function of financial accounting
is to provide clear, comparable and unbiased information to
inform investment decisions. It is a basic principle of
accounting that financial statements should record economically
significant transactions. Issuing stock options is just such a
significant transaction and footnote reporting is not a
substitute for recognition on the income statement.
Even if no cash changes hands, issuing stock options to
employees incurs a sacrifice of cash, an opportunity cost that
needs to be accounted for. Both accounting earnings and labor
expenses relative to operating revenues are used by analysts to
estimate performance of the firm and to compare efficiency and
profit margins among firms. The form in which such compensation
is paid by the firm should not determine whether it is expensed
or not.
H.R. 3574 holds that only options granted to the CEO and
the top four most highly compensated executive officers of the
firm should be expensed. That is not consistent with reflecting
the entire economic cost of using options to pay for labor
services to the firm. Other forms of compensation, including
salary, cash bonus, restricted stocks, performance options and
other benefits are expensed for all employees, and not just the
top five officers of the firm.
As to my second point, the value of these options should be
the economic cost to the firm of granting those options, and
not the value placed on these options by the employees who
receive them. The value of those options can be estimated using
market prices or pricing models. Financial institutions value
and execute transactions involving all kinds of options and
other derivative securities in large volume every day all
around the world.
Examples range from convertible bonds, warrants, some with
25-year maturities, and institutions routinely in large size
offer over-the-counter securities both customized options and
so-called exotic options, the terms of which are far more
complex than the kinds of instruments that we are trying to
assess and value here.
Like real estate appraisals or other non-traded items,
estimates from option pricing models often differ from each
other and market prices. Those differences are associated with
the simplicity of the model, how much accuracy you really want
to get, the data, but they tend to be much better than almost
any of the other areas on which you do accounting valuations.
That fact does not imply that it is not possible to value
an option with terms that are not precisely traded in the
market. Financial statements should strive to be approximately
right in reflecting economic reality, rather than precisely
wrong. H.R. 3574 holds that if a pricing model is used to
determine the fair value of an option, the assumed volatility
of the underlying stock shall be zero. It is the case that
under that assumption of zero volatility, any pricing model
used will give about the same estimate of value.
Thus, in effect H.R. 3574 specifies the option-pricing
model to use for expensing. This is not a fair value
calculation. No recognized expert would be willing to say so. I
would strongly advise anyone who asked me against signing any
document that would assert that this is a fair value valuation.
I have in mind, among other things, CEOs or CFOs signing
Sarbanes-Oxley-type documents. I would strongly urge them, do
not sign if you think that this is given as the fair value
assessment.
But there is no need for you to take my word for it. I
would suggest you ask your staffs to get Black-Scholes model,
or a binomial model. I am sure any number of financial firms
will give you access to their proprietary option models. Plug
in zero volatility and valuate Cisco, General Motors, Intel,
General Electric, IBM or any of your other favorite companies
using that model with zero volatility, and apply it to their
traded options which trade in large volume every day, and see
how close it comes. You will discover that the valuations are
very different, that the valuations given by zero volatility
are dramatically less than the market prices.
Furthermore, you will discover that the firms whose
equities are more volatile, the difference between this
procedure and the market price will be even larger. Since these
are also the firms who are often using large amounts of stock
options, this would suggest that this valuation procedure is
grossly in error in any assessment of fair value.
You might even ask, and I say this somewhat tongue-in-
cheek, because I do not think any firm would do it, whether
firms would be willing to issue options to third parties at the
price that is being suggested they be valued at for expensing
in H.R. 3574. I do not think they will.
Current accounting standards require the estimation of
useful economic life for depreciating plant and equipment, or
as mentioned earlier, the value of acquired in-process R&D, the
cost of employee pensions and other retirement benefits, and
even contingent liabilities such as environmental cleanups.
These estimates are surely made with error and none of these is
traded precisely on the markets. And these estimates can
significantly impact reported earnings. FASB sets standards for
making these estimates and changes take place as new techniques
evolve. Why should the case of setting standards for estimating
cost for option expense be singularly different?
My third point, will expensing stock options hurt young
businesses? This is an important issue. Many critics of the
expensing, as we have heard this morning, are concerned that
life will be more difficult for businesses that rely heavily on
options to reward their entrepreneurial talent. We all
recognize the vitality and wealth that entrepreneurial
ventures, particularly those in high tech, bring to the U.S.
economy. I, for one, have no objection to policy measures that
encourage and assist new ventures.
I do question the policy effectiveness of doing so by
essentially creating the benefits to those companies from a
deliberate accounting distortion proportional to a company's
use of one particular form of employee compensation. Indeed,
some forms of incentive compensation, such as restricted stock,
performance cash award options, and indexed for performance
options, arguably do a better job of aligning executive and
shareholder interests than conventional stock options do. Yet
current accounting standards hold and require that these and
virtually all other compensation alternatives be expensed. The
provisions of H.R. 3574 would, in effect, exempt only at-the-
money stock options from expensing.
If options are a more efficient means to compensate
employees because of incentives, then the superior performance
of such firms who use them instead of cash should be
demonstrated by the larger revenues generated, not by
underreporting the expenses. If option grants really do drive
employees to work harder, produce, make the firm worth more,
that should manifest itself in higher output of the firm. I
would recommend that we not try to adjust for that by
understating the actual costs.
On the other public policy issues, I think if you pass an
Act, as I understand this, which sets a valuation procedure, it
would take an act of Congress to change it, but I am not a
lawyer. If this were to pass, it could not be changed other
than by act of Congress. That seems pretty static to me,
relative to having policy set by a standards board which can
evolve with new technology and experience.
The second thing I would point out as a public policy
matter is a little more latent. That is, I think that the past
accounting treatment of options versus other forms of
compensation has stifled innovation and variety in compensation
plans. It is no accident that virtually every company in the
past that uses significant amounts of stock options always
issues at-the-money options, or as we are hearing now, maybe
out-of-the-money options. Performance options and others are
not issued, even though many believe they are far better. It
could well be that the previous accounting treatment, which de
facto will be the accounting treatment going forward under this
bill, is important in having created that stifling of
innovation.
Now, on the matter I have heard allusions to that it is
seen as a potential comparative advantage for the U.S. if it
were to continue to understate certain operating expenses vis-
a-vis Europe or other places that do. I do not think so. I do
think it is a comparative advantage for the U.S. to maintain
the gold standard for financial accounting and disclosure to
investors here and abroad. Options can be a powerful incentive
tool, but failing to record a transaction that creates such
dramatic effects is economically indefensible and encourages
companies to favor options over these alternative compensation
methods. It is not the proper role of accounting standards to
distort compensation by subsidizing one form of incentive
compensation relative to all others.
I thank you.
[The prepared statement of Robert Merton can be found on
page 90 in the appendix.]
Chairman Baker. I thank the gentleman for his statement.
Our next witness is Mr. Arthur Coviello, President and CEO
of RSA Security. Welcome, sir.
STATEMENT OF ARTHUR COVIELLO, PRESIDENT AND CEO, RSA SECURITY
Mr. Coviello. Thank you, Chairman Baker and thank you,
Ranking Member Kanjorski and other members of the subcommittee.
My particular thanks once again to you, Chairman Baker, for
your outstanding leadership on H.R. 3574.
This is indeed must-pass legislation. Congress and FASB
must resolve the issues that bear directly and significantly on
issues of accounting, valuation, corporate governance,
entrepreneurial capitalism, economic growth and jobs. But by
its own admission, FASB deals only with accounting and
valuation. I am here to tell you that they have the accounting
and valuation fundamentally wrong.
The mandatory expensing standard that FASB intends to put
into place will force demonstrably inaccurate and unavailable
numbers into the financial statements. Let me give you an
example from my own company. I am very proud of the fact that
we engineered a successful turnaround last year, generating $39
million in operating cash flow and $14 million in after-tax
earnings on a GAAP basis, that is GAAP without expensing stock
options. Had we expensed stock options we would have recorded a
$21 million loss, a $21 million loss. That is a $36 million
swing had we expensed stock options.
Would there be a decrease in any of our assets? No. Would
there be an increase in any of our liabilities? No. But there
would be a marked change in our price-earnings ratio because we
would have a price-earnings ratio with income, whereas we would
not with a loss. Now, members, I respectfully ask you, who does
this fool? Is it easier to evaluate my company based on the
current method or is it easier to evaluate my company based on
the expensing of stock options?
Multiply this by thousands of public companies in the tech
sector that have the exact same issue. Let me give you another
example. Sun Microsystems granted options to its employees in
the year 2000 at the height of the tech bubble. Those stock
options would have resulted in a $700 million charge to
earnings. Those stock options were priced at roughly $60 a
share. They are not likely to ever be exercised. As a matter of
fact, I suggest it would be highly unlikely that they will ever
be exercised. However, a $600 million to $700 million expense
would have been recorded.
Warren Buffett who was mentioned a couple of times by the
members this morning has said that he would gladly trade some
of his yards of carpet from one of his Berkshire Hathaway
companies for some of those Silicon Valley stock options. I
suggest to you that the employees of Sun would gladly take the
carpet for the options that they have at $60 a share.
But let us move on from the issue of accounting and
valuation specifically, and the issues that should really pique
your interest. That is jobs, the economy, and innovation. The
high-tech industry, by many estimates, has been responsible for
two-thirds of the productivity growth in the economy since
1995. In terms of job creation, my own subsector of the
economy, the software industry, has generated over 900,000 jobs
since 1993 to 2002. I have not seen the stats for 2003, but I
can tell you that we at RSA added 50 engineering jobs last year
as we started to rebound. The balance of trade that the
software industry, again a subset of the high-tech industry,
generated in 2002 was a favorable balance of trade of $25
billion.
What do stock options have to do with all of these
statistics? Well, I think they are a very important element in
the incentives that are behind all of this job creation,
economic growth, innovation and productivity. Let's compare
ourselves to the Europeans. They fundamentally lost jobs in the
1990s. They have no broad-based stock option plans. Let's take
a look at our competitors in Asia, the Chinese and the Indians.
The Chinese, as part of their five-year plan, have a heavy
incentive on issuing employees, engineers that are graduating
from their universities at a far greater rate than American
universities, they have as part of their 5-year plan a desire
to implement significant broad-based stock option plans as an
incentive.
The real cost of stock options is already calculated in the
dilution of earnings per share. It is already reflected in the
calculation. That is a standard that was created well over 20
years ago. Why must it change? If we need to have reform of
executive compensation, then let's have reform of executive
compensation, but let's not throw the baby out with the
bathwater.
Let us talk about investors for a moment. I think the
existing reforms that are already in place between Sarbanes-
Oxley and some of the reforms on the various stock exchanges
have gone a long way. You can no longer re-price stock options.
Shareholders have to approve new stock option plans. This Act
goes further to require the expensing of the officers's stock
options, again I think a very reasonable approach for
compensation reform.
But there will be confusion if we expense stock options.
There will not be more transparency. In the example I gave you,
how would an investor evaluate us based on the investment
criteria that all investors use when they make a decision to
invest in a company? The price-earnings ratio. I, as a CEO of a
company, could not continue to sustain a broad-based stock
option program if I had to take that kind of a hit to my P/E
ratio because if I needed to go to the capital markets to raise
money, to be able to generate more innovative inventions for my
firm, I would have to take into consideration my price-earnings
ratio. So it would be difficult in terms of my own capital
formation. Again, apply my specific example to many, many
companies that are not even public.
In 10 years, FASB has come up with hardly a single
improvement to this valuation issue. They have been
intractable. We are before you today because there is a problem
that they seem unwilling to address. Left to its own devices,
FASB will substitute an arbitrary value that cannot be
ascertained. I respectfully disagree with Professor Merton in
that some valuation is better than none at all. I don't think
it works, especially when you take into consideration that
stock options are already reflected in the dilution of an
earnings-per-share calculation.
Against this backdrop, you would think FASB would
enthusiastically embrace the stock option coalition's
suggestion that FASB go out in to the real world and actually
test multiple valuation models before implementing an entirely
new standard across the board, the same one they have been
arguing for over 10 years.
Let me conclude by giving a more specific example of the
impact of a couple of our own employees. One is a person by the
name of Leslie Hoffman who was formerly my secretary and now
works in our purchasing department. She is a single mom and
through the exercise of stock options at RSA Securities she was
able to purchase a home and provide for childcare for her son
Sebastian. She works very hard at home. She knows the
importance of her role in helping to contain costs for the
company.
We also have a gentleman by the name of Dave Chabot, who is
an engineering manager. Dave is another gentleman who works
very hard, late into the nights, who has benefited from stock
options, moving out of a condo with his children, purchasing a
home and still having enough money to be able to set aside
tuition college expenses for his two children. Hopefully, some
day they will grow up to be engineers and start up a high-tech
company. He also recognizes the value of incentive stock
options and being an owner of the firm.
This is not an issue of compensation, as has been suggested
by some of my other members of the panel. It is an issue of
ownership. It is an issue of building sweat-equity into
something that you believe in. This will continue to fuel
innovation and jobs and economic growth for the country. Let's
not eviscerate such a fine program.
Thank you very much.
[The prepared statement of Arthur W. Coviello can be found
on page 51 in the appendix.]
Chairman Baker. Thank you, sir.
I will start our questions going, professor, directly to
Mr. Coviello's examples. Taking the Sun Microsystems $60
exercise question, resulting in a $700 million charge in the
year of granting, that subsequently might not later be
exercised. If you do not dispute those facts, is implementation
of an expensing rule in those conditions fair value reporting?
Mr. Merton. I will stipulate for the purpose of answering
your question that those are the facts. I think it is a little
more complicated in terms of how the expensing would actually
be done. But for this purpose, I would ask you again on the
question of financial accounting, there is an issue of
comparability. Imagine that there was a firm just like Sun who
chose instead to pay its employees in cash the amount of those
options, their value at the time. It then had the employees use
that cash to buy the options. How would the accounting
treatment have been of that sister company? They would have
expensed as labor costs the amount of cash that was paid to the
employees. The employees would have bought options with the
cash.
As it turned out the options went down and became a lot
less valuable. That is very bad for the people who are invested
in them, so I am not suggesting in any case that that is a good
thing. But in terms of the accounting treatment, the response
is, why should that sister firm expense $700 million because it
chose to do it that way, when Sun did it its way, it would have
no expense. We have to distinguish between what is an expense
for our labor and then what we do with the fruits of that labor
in terms of investment risk. In this case, in effect, the
employees have exchanged the cash compensation for options.
Chairman Baker. But the examples goes to the underlying
point of predicting future values, and there is not, or at
least I do not believe there is defended, a particular
valuation model that is held up to be accurate in predicting
future economic value. That is the core of my concerns about
this, is having a snapshot that represents to shareholders and
potential investors true economic condition, but that we have
one that is a fairly reasonable calculus of true value. You
have no concerns about valuation models in the current debate?
Mr. Merton. In the context of predicting future values, it
is a difficult task, but it is a task that has to be undertaken
every day. That is what is happening when you see valuations of
stocks, when managements make decisions about how to value
projects, when underwriters go and decide where to price
things. They are always engaged in that. We have lots of
references to valuing things that represent uncertain events in
the future. So in terms of the value of an instrument as of
today that I have conveyed to someone, there is nothing
especially unusual about doing that valuation. I do not mean to
say it is trivial, but it is not something that, my God, how do
we do it?
The fact that conditions change and often come out not as
expected is a reality of life that we all face. All the
investors in Sun who bought the stock at $60 or who held
external options at $60 suffered as a result of that decline.
If they knew that was going to happen, they would not have
bought the instrument. But I think you can separate what
happened afterwards from what the value conferred at the time
was.
Chairman Baker. Certainly, and I understand the difference
between risk-taking and the actuarial responsibility to report
financial condition accurately. Risk-taking is an art form. To
the best extent possible, FASB represents accounting as a
science, not as an art. I think the problem is we have a
proposed interface of artistic view with scientific
expectations. I fear the consequence of that is to further
misrepresent, not make more clear, true financial condition.
Let me jump quickly, because I know we are going to have a
lot of questions, at least I think we are, from other members
as well. Mr. Reed, in your statement with regard to Cisco, can
you, and you may not be the appropriate Cisco official to ask
this particular question, but in your view what is the
likelihood that without the options-granting ability that Cisco
engaged in, that Cisco would be the company that it is today,
given the talent and resources brought into your corporation as
a result of those grants?
Mr. Reed. Specifically, in the Research Triangle Park area,
there is an excellent example of how we made great strides
against IBM, which was a much larger company than Cisco was at
the time, to bring in IBM networking into the basically
Internet protocols. Talent was basically attracted away from
IBM using stock options in the very early days. The movement of
that talent has basically allowed Cisco to take over that
entire market. So it is definitely very important. It would not
be in the same place that we are today.
Chairman Baker. I thank the gentleman.
Mr. Kanjorski?
Mr. Kanjorski. Mr. Coviello, you are a public corporation
being traded?
Mr. Coviello. Yes, we are.
Mr. Kanjorski. Did I hear you say you recorded a profit of
$14 million, but if you had expensed your options you would
have shown a $26 million loss?
Mr. Coviello. $21 million loss.
Mr. Kanjorski. $21 million loss. It seems to me I am trying
to get a handle on this. Four members of the panel are
obviously not for expensing stock options, and professor, you
are a purist. I am trying to become a realist. I think there
are compelling arguments in terms of Mr. Heesen's talking about
the use of stock options for purposes of avoiding use of raw
capital at the very beginning, which is very expensive and
difficult to get. We all recognize that and we certainly do not
want to turn off the faucet of venture capital.
I think Ms. Kerrigan makes the point on small businesses.
She questions whether it increases transparency and
reliability. Quite frankly, I always ask the question, why do
we want transparency and reliability? It is basically we are
trying to weigh the advantage of having a well-informed
investor, and that presupposes a public market. As far as I am
concerned, if we were to have a separate rule in terms of stock
options for non-publicly traded corporations, I could care
less. I am not even worried about the venture capitalists. I
think they have sharp enough teeth to do due diligence and they
know what the hell the company is really worth and what is the
value out there. So they are sort of protected.
I guess I am a little disturbed with Mr. Reed's situation,
that they want to go on. So let me ask you this for my own
clarification. Would you call the non-expensing of stock
options a loophole in accounting? And where did it come from?
Was it just an invented figment of someone's accounting
imagination that said this is a great way not to show an
expense on the balance sheet?
Mr. Merton. I rarely attribute such a conspiratorial
element to it. I think if you would like something of the
history of options, I think where in part they may have come
from is a clear realization, as we have heard here, that it is
important to have the management and employees incentives
aligned with the shareholders. So you start out by saying, so
why not give them stock.
Mr. Kanjorski. Yes, that can be done in various ways,
though.
Mr. Merton. I am about to get to that, going one step at a
time.
Mr. Kanjorski. Okay.
Mr. Merton. I think what was discovered is that sometimes
you wanted to give more exposure to the movement of the stock
than cash. Let's say I wanted to give a particular member of my
company a sensitivity to what the fortunes of the shareholders
is, which is equivalent to 10,000 shares of stock. But if the
10,000 shares, if I gave them the shares, were worth $1
million, the problem is that is just too much money.
Mr. Kanjorski. Right.
Mr. Merton. So one of the ways you could say to solve that
is, give them $10,000 shares of stock and then lend them part
of the money. Okay, that would be the next step. The problem
there is that if you do that and the stock goes down no fault
of their own, they go bankrupt.
Mr. Kanjorski. More of a problem, as Mr. Coviello pointed
out, you do not have the money at the time to make that
available. They are giving chits. They would not be able to
make the loan.
Mr. Merton. The loan is fictitious in the sense you are
giving them shares and they are giving you a note back, so
there is no cash involved.
Mr. Kanjorski. Okay, and that would be all right if you are
not a publicly traded corporation, but if you are publicly
traded, that is going to show up on your balance sheet in a
very negative way.
Mr. Merton. I think you were asking me where I think they
came from. I think in making that loan no recourse, there was
no risk of personal bankruptcy, and that is exactly what an
option is. By the way, anyone who knows my background should
certainly not think I am opposed to options, either to be used
or other tools. But rather, that the question in each of these
things that is being raised here, some of it is that there is a
connection that somehow says that if options are expensed, we
cannot issue them anymore. If options are a good idea, why
don't you?
Mr. Kanjorski. They will survive. Right.
Mr. Merton. Okay? And explain it. In the case of the public
company, the question comes, if your shareholders understand
your business, then at least the ones that do will understand
that you had those options whether or not you expensed them. So
if they did, let's first assume if they did, then now expensing
them, what difference does it make? It is the same information.
The alternative is that they did not understand it. Once you
put it in the earnings, it is going to influence their
valuation.
Mr. Kanjorski. Okay. Let me ask you this, suppose we used a
mechanism like profit-sharing contracts, particularly to
attract extraordinary talent. Would that show up on the profit-
loss statement?
Mr. Merton. Yes.
Mr. Kanjorski. How would it show up? Would it show up for
the very value of it, because a profit-sharing contract for
next year's profit is before----
Mr. Merton. Well, the realized profit sharing, it would
show up there.
Mr. Kanjorski. Just for that year, but it would not show up
for the future profit sharing.
Mr. Merton. No.
Mr. Kanjorski. In other words, you are a great scientist
and you come to Cisco, and you are not about to go to work and
give your brilliance to Cisco without getting some valuation on
what you are contributing into equity. They want you so much
that they are going to give you a cumulative profit-sharing
contract for the next 10 years.
Mr. Merton. Yes.
Mr. Kanjorski. The only thing that is ever going to show up
on their balance sheet is the actual payment of the profit-
sharing plan for the year in place. Isn't that correct?
Mr. Merton. That is correct.
Mr. Kanjorski. You are not going to have to indicate or
advertise that there is that profit-sharing contract out there,
and if you did it would only be done by a footnote.
Mr. Merton. It would be a disclosure.
Mr. Kanjorski. What would be the difference of that kind of
a construct as compared to the option, other than the stock
option has a ready available market? We do not have profit-
sharing contracts markets yet, but I am sure the Chicago Board
will come up with it.
Mr. Merton. I think that it goes back to the earlier
question from the Chairman. If the options are not owned at
all, in other words they are contingent on future labor, that
part of their valuation arguably should not be charged until it
is earned. But once the options are in effect owned and no
longer a condition of employment, then the ownership of that
option----
Mr. Kanjorski. Yes, but that is----
Mr. Merton. I am sorry to interrupt. I was answering your
question that if the future profits are something that I have
even if I do not stay, then I think you should expense that or
put that on there because that is payment for now. It is not
contingent on my future work.
Mr. Kanjorski. Okay. I would tend, if we are going to be
purists, to agree with you. But then I am struck with the cost
factor that Mr. Heesen talked about in terms of if I am a
little startup company, I really do not need to spend $50,000
or $100,000 or $200,000 trying to figure out this formula on
the stock option program. It does not get me anything. It costs
me a great deal of money to do that at the precise moment in
time that I want to put that $100,000 into research and
development or into things that are going to make a viable
product. So I see a distinction between Cisco or General Motors
or somebody else. It is somewhat like our CRA problem up here
in years past. You know, banks have to do CRA. They are great
for Citicorp because it costs them $50,000 or $100,000 and they
have their accountants make all these reports and everybody
knows.
But if the cost is the same thing for mini-corporation that
is struggling with $2 million in the back garage trying to come
up with a product, they are not about to spend that $100,000 or
$200,000 to comply with the accounting rule. Is there some
difference that we should be looking at or encouraging the
Standards Board to look at between stock option disclosures for
publicly traded corporations or when they are going to IPOs or
at some stage, for purposes of transparency. I back into this,
and the only reason I could give a damn about a company
accounts is I want to be able to compare equal things when I am
making recommendations to apply my portfolio or if I am
assisting someone else, how their money is expended.
Other than that, why do we care? If it is a startup company
or a small business, why do we care? I don't care if they even
have accounting. If they can get along without carrying on
accounting, who cares? If they are making money, they are
operating, they are not going to the investor market, they are
not borrowing money from the bank, or if they are borrowing
money from the bank, their relationship with the bank is of
such a nature that it is a character situation and they know
that they are a substantial producing company. So what do we
care how they keep their books?
Mr. Heesen. In answer to your question about public versus
private, in today's FASB standard, there is a distinction.
Today, if you are a private company, you can either disclose or
you can value your options under minimum value. That is the
FASB pronouncement today. They are talking about basically
disallowing minimum value for private companies going forward,
so that we would be treated just like a public company. FASB,
we have asked for months why suddenly are you making this
radical change and we have gotten no answer. So they are
actually making it worse for private companies.
Mr. Kanjorski. Okay. And I am a little sympathetic to that
problem, but the testimony that I hear from Ms. Kerrigan, there
is now an advisory board for small business. You are going to
have an ability to work with this rule or mold a rule or
comment on the rule. Aren't we a little premature jumping in
here and granting an exemption for this particular area,
memorializing it? We are never going to close the door.
I sympathize with both sides, but most of all I am sort of
a purist. I think we have accounting for the purposes of real
transparency so that everybody can see what is promised out
there, what is committed out there, what are the future
obligations of the company. I would hate to invest in Cisco and
find out that they have $10 billion off-share options out there
that I never heard of, and that in reality only 1 percent of
the value of the company is returnable to me in a dividend. I
would be rather shocked. So I think they have to disclose at
some level.
But on the other hand, I find some great sympathy with
startup companies in attracting talent and wanting to share
ownership with that talent. I just think there has got to be
something in the rule management here that allows to accomplish
both good purposes. Maybe I should go to the professor.
Mr. Heesen. Unfortunately, on the committee that you are
talking about, that came about as a result of the Senate
hearing, FASB small business committee. Now, that was in
November. It is now March. They just a couple of weeks ago sent
out invitations to put in names for that.
Mr. Kanjorski. That is very fast, Mr. Heesen. You are not
in Washington long enough to know that is very fast.
Mr. Heesen. The FASB standard is going to come out the end
of this month. If you think that they are suddenly going to
say, oh, let's stop the train here and we will create this
commission and let small business, I think that is unrealistic.
I think they are going to move forward and we are going to be
part of that.
Mr. Kanjorski. All right. Do you see anything here?
Mr. Merton. I certainly say that in the case of costs
imposed on companies, particularly smaller companies, I am 100
percent in favor of trying to avoid that. I do not want to
impose just to report numbers because, so I endorse that, no
question.
In terms of how it is done with private companies, I also
share the view that is less important, although it depends on
whom the other stakeholders are with that firm. With public
companies, it is comparability and as I mentioned before, the
ability to sort of let competition decide what is the best way.
They should turn it around and ask why should one particular
form of compensation be given special treatment.
Mr. Kanjorski. That goes to your puritanical----
Mr. Coviello. Mr. Chairman, may I respond to a couple of
these points?
Chairman Baker. Yes, briefly. We have run over time a
little bit.
Mr. Coviello. First, I take great exception to the use of
the word that this is a loophole that needs to be closed. In
the earnings per share, the $14 million of earnings that we had
last year, we had 24 cents of earnings per share. Included in
that calculation was roughly a 10 percent impact of dilutive
stock options. Also, in the footnotes to our financial
statements, we disclose every single option and at what price
those options were struck. So I do think we calculate the
economic effects of stock options already in the financial
statements.
You asked earlier, Ranking Member Kanjorski, about why did
they do it this way in the first place. Because it makes total
logical sense.
Mr. Kanjorski. Mr. Coviello, we could make that argument
and say the reason my company offers Hummers to all my workers
is it makes eminent good sense to get to work on time, and then
say we do not have to expense them on our books.
Mr. Coviello. I am talking about the accounting principles
board that came out with the original accounting for stock
options. It made a lot of sense then. It still makes sense now
in the context that I was describing.
Second, I also want to take exception to something that the
professor said about, well, investors that know the company can
understand what the impact of the dilutive effects was and work
their way through it. Why should you have to be an applied
mathematician to understand what the heck all of this stuff
means?
Also, we have thousands of shareholders. Having a
shareholder base is all about mind-share. It is a lot easier
for me to capture mind-share if I do not have to make some
convoluted explanation of why I had $14 million of income and
all of a sudden it is a $21 million loss. It is a lot easier
for me to get mind-share. That will have an impact on my stock
price. That will have an impact on my ability to raise money,
and that is why it is so important.
Chairman Baker. The gentleman's time has expired.
Mr. Shays?
Mr. Shays. Thank you.
This is a fascinating issue and I think it is an
extraordinarily important one. I can feel the intensity that
people feel. But I would like to ask each of you first off, if
the FASB rules go in, is it your statement that there will be
no stock options?
Mr. Coviello. I will respond to that. I think it is going
to be a period of intense confusion. People will look at all
sorts of methods. They will wonder how the street is going to
react. The bottom line to answer your question is, I am not
entirely sure what the heck we are going to do. It is going to
create a tremendous amount of chaos.
But if the end result is that Wall Street in their wisdom
decides that it is a big negative to have a huge expense on
your books from stock options, then absolutely yes, it will
eviscerate broad-based stock options programs and that would be
a tragedy.
Mr. Heesen. From an emerging company vantage point, venture
capitalists are smart people. They would have figured out a
different way to do things over these last 10 years if they
could have come up with something better than a stock option.
We do not have a choice in the matter. We will continue to give
options, but what happens if we continue to give options? That
means we have less money to put into other companies. So
instead of funding five startups, we are going to fund three
startups. And those companies are going to take longer to go
public or be acquired because of the drag of these numbers. So
it is going to affect venture capitalists directly. They have
religion on this issue.
Mr. Shays. Let me hear from the others as well. Yes?
Ms. Kerrigan. From a small business perspective, I
definitely believe they will diminish their use. Small firms
are going to take a direct hit to the bottom line from an
earnings perspective, number one. Number two, they just simply
do not have the resources from a valuation perspective, to hire
the type of investment bankers and other type of experts, I
believe, to make this happen.
So it is costly. It will be complex from a small business
entrepreneurial perspective. I do think they will go by the
wayside.
Mr. Shays. Thank you.
Mr. Reed?
Mr. Reed. In my opinion, and I believe it is the opinion of
many engineers that I work with as fellow rank-and-file
employees, that as Mr. Coviello mentioned, the way that the
street reacts to these changes is going to highly affect what
happens. We believe that there is a very good chance that if
they were not eliminated altogether, that they would be cut
back severely.
Mr. Shays. Professor?
Mr. Merton. We should recall that other than the expense,
which we have noted before, there is no cash difference here.
It is just a question of whether it is reported. So then the
issue is, how is The Street or other investors going to react?
Well, I think particularly if it is widespread, they will
adjust to it. It is not clear to me that there will be any
material impact on valuations.
Whether companies then choose to change their form of which
they provide incentive compensation, I think that will vary and
I do not know. But I do not think there will be a big effect on
value. I think also the fact that investors, particularly
sophisticated institutional investors, want to see the
expensing, I do not see that as an issue of being punitive
about compensation, but it would suggest that is something they
want. They do not want to hurt their investments.
Mr. Shays. I hear you.
Mr. Coviello, one of the things that I found kind of
striking is I had a lot of constituents who called me up
because their kids got screwed with stock options. Their
companies went down and they still had to pay tax on an option
that was not at all attractive anymore or nonexistent. How do
you let young people know the potential risk with an option, as
well as the potential benefit?
Mr. Coviello. There are a couple of issues there. First, I
think it helps to prove my point that options are in essence a
form of risk capital for the individual who is earning and
investing those. I think in the instance you described, what
may have happened is employees exercised stock options at a
high price, and then held them. During the holding period, the
stock price might have gone down precipitously.
We issue a lot of nonqualified stock options. I think most
of the stock options are nonqualified. That creates a taxable
event as soon as you exercise, which actually has the impact of
literally forcing the employee to sell as they exercise because
they are going to be taxed at the exercise point value. So in
those instances, I find it unfortunate that they did not get
better advice. We do try and do a good job with our employees
in that regard so that they understand the tax consequences
around stock options.
Mr. Shays. I am all set.
Thank you, Mr. Chairman.
Chairman Baker. Yes, Mr. Shays. On reflection, I do believe
that was an IRS problem where the person exercised, stock price
deteriorated, and employees generally did not sell their
options at the higher price.
Mr. Shays. Thank you.
Thank you, gentlemen and lady.
Chairman Baker. Ms. Velazquez?
Ms. Velazquez. Thank you, Mr. Chairman.
This is my first hearing, having been recently assigned to
serve on this subcommittee and this is quite an interesting
topic to me. I serve as the Ranking Member on the Small
Business Committee, so I am very much concerned about the
regulatory burden and the effects of this regulation on smaller
companies.
Mr. Heesen, from your perspective, would increased
compliance costs associated with going public deter many
smaller companies from pursuing an IPO?
Mr. Heesen. You are always going to want an IPO. If you can
get into the market, you are going to go there. The question
is, every day means something in the IPO market. It could be
open one day and closed the next. And it costs money. Every day
costs money from a venture capitalist perspective. That means
less money going into other companies. So you want that company
to go out at the best possible time at the least possible cost.
So money does matter.
Ms. Velazquez. So how will this affect the venture capital
industry?
Mr. Heesen. I think it could have an impact in that fewer
companies at the end of the day, fewer innovative companies get
funded. The important thing to note here is that we love to
talk about our successes, but many venture capital-backed
companies fail. We give options to all those people, all those
people have options underwater. We hope that we get a couple of
companies that hit that IPO mark or get bought out by the
Cisco's and Intel's of the world.
Ms. Velazquez. Far from broad-based expensing proposals,
H.R. 3574 will still impose costs on smaller companies. Have
you estimated the regulatory burden and compliance costs
associated with this legislation?
Mr. Heesen. Looking at the different valuation models that
FASB has talked about. They have said, oh, you can just get
these off the shelf and plop them in. We have not been able to
verify what FASB has said on that by any means.
If you are a Coca-Cola, you can go out and get an
investment bank and do these sorts of things. If you are a
small emerging growth company, try even to find someone who is
going to do this for you, let alone what the cost is going to
be. Just finding a person to do this is going to be extremely
difficult.
Ms. Velazquez. Thank you.
Professor Merton, as with any model, the output is only as
good as the data and assumptions that are used. If the
assumptions are faulty, you will get faulty valuations
regardless of how good the model is. The key assumptions in
valuing employee stock options are the risk-free rate, stock
volatility, dividends if any, and the life of the option. These
are things to estimate because of the many underlying valuables
involved. More importantly, they can be manipulated by
adjusting any one or a combination of these assumptions.
Management can lower the value of the stock options and thus
minimize the options's adverse impact on earnings.
What is your view of the potential for manipulation and
abuse by corporations seeking to lower their expenses for stock
options?
Mr. Merton. I think the best protection on out and out
manipulation is a combination of, first, I think most
managements want to do the right thing. I like to think that.
Mr. Coviello. Thank you.
[Laughter.]
Mr. Merton. I want to make that statement because it
sometimes sounds like these are a bunch of people we have to
keep in a corral because if you just turn your back on them,
they are going to go and steal everything. That is not my
experience with executives, people who build companies. They
care about doing the right thing. That is the first thing.
The second thing is, to the extent that you have public
accounting firms that are responsible for this, they have to
render opinions. We know that that, too, can sometimes go amok.
But the general practice is to do the right thing, and there is
a discipline here. There have been laws passed recently to put
some more teeth into that if you do fool around with it. So I
think deliberate efforts to manipulate, I do not see as a
really material thing.
The second thing is that investors, firms get reputations
for how they manage their books even now. If you play games
with these things, you do get a reputation with investors that
can be costly.
Ms. Velazquez. Thank you.
Thank you, Mr. Chairman.
Chairman Baker. Thank you, Ms. Velazquez.
Mr. Sherman?
Mr. Sherman. I fear that this bill is going to reduce the
total amount of capital available to all of the companies in
this country, because our capital is international. Capital has
a choice. Are they going to go to the stock market that reports
the highest earnings, then they might as well invest in
Bangladesh. Or are they going to go to the stock markets and
the countries with the toughest rules? Again and again and
again, money floods into this country from third world
countries and from Europe and from Japan because they want
honest earnings, toughest standards.
My fear is that this bill will be the first step in
converting GAAP, generally accepted accounting principles, into
GAAP, generally adulterated accounting politics. So the first
question is, will this bill encourage foreign investors to
invest in our stock markets? I have not heard anybody say yes,
and clearly again and again they seem to want the toughest
standards. But even if the capital in America remains the same,
then all this bill does, it does not just help some companies.
Every company that gets helped, another company gets hurt.
There is so much capital and if you are investing in the new
economy, you are taking it away from the old economy.
What this bill does is it turns to those companies that
provide health care for all, but do not provide stock options,
and it takes capital away from them and shifts it to, say, a
company that provides stock options for the top 10 percent. In
every other area, especially those of the other party, say that
the government should not pick winners and losers. In this one
case, we are picking winners and losers and we are doing so on
the basis of this, that companies that are most generous to
their executives are going to be winners, by government fiat.
I know we are told that some secretaries get options and
buy houses, but keep in mind, at least 90 percent of the
benefit of these options are going to the top 1 percent or the
top 5 percent. More importantly, for every secretary who buys a
home because the accounting rules encouraged stock options,
there are 1,000 secretaries who lose their health care coverage
because the accounting rules fail to encourage providing health
care coverage.
We are also told that employee stock ownership is good. I
could not agree more. But the plan that creates broad-based
employee stock ownership, ESOP, employee stock ownership plans,
under those plans you have to recognize, professor you confirm
this for me, if you contribute to the ESOP, that is an expense
and you have to book the expense. I see the professor is
nodding. I think every other accountant in the room is nodding.
So the plan that creates broad-based stock ownership for
everybody, in new companies, old companies, big companies,
small companies, that gets the tough accounting treatment. But
the best system for enriching the very richest people or the
most powerful people in America, that is getting favored
coverage.
I do want to bring to the subcommittee's attention, and I
do have a question after this, that I intend to offer three
amendments to the bill should we move to markup. The first is,
I should point out that we have a special rule for options
granted before December 31, 2004. That ought to be January 3,
2004, because I do not want a lot of companies issuing a lot of
stock options for Christmas just to sneak in under whatever
rule we provide.
Second, this idea that we are going to assume volatility is
zero: if you are going to apply the Black-Scholes method, at
least apply the Black-Scholes method. As the professor points
out, assuming volatility is zero, that is to say hijacking the
method, produces inferior results.
Finally, if we are going to have special rules for
companies organized in the United States and Canada, how about
Mexico? Either strike Canada from this bill or put in Mexico.
America has two neighbors. It has a northern border and a
southern border.
Now, the professor commented somewhat adversely on this
compromise idea I have, and that is to publish it both ways.
Why would it be a disadvantage to let investors decide? Perhaps
they want to invest in companies based on one accounting
system, and perhaps they think the other. We are preparing
these financial statements for investors. Why force them into
one or the other?
Could you also comment on whether today's financial
statements would allow sophisticated analysts to re-cast the
financial statements so that they could compare Coke and Pepsi?
That is to say, if you were a stock analyst today, could you
calculate the income statement and earnings per share of a
company based on the idea that they had expensed all their
stock options, and use that number if you thought it was more
helpful. There is a question there.
Mr. Merton. Is that a question to me?
Mr. Sherman. Okay.
Mr. Merton. Starting at the reverse one, you said, couldn't
they reproduce this. The answer is yes, in most cases, with
enough data, if that was the only thing they had to do, one
company.
Mr. Sherman. I am saying, could an analyst sit down today
with the amount of information published by Pepsi today, and
re-cast, assuming Pepsi did not extend stock options, I think
they may have changed their mind. There was a while Pepsi did
not; Coke did. Could they sit down with Pepsi's or some other
company's financial statements and SEC report, and determine
what would be the earnings per share for the most recent year
if that company had expensed stock options, just a Coca-Cola
does?
Mr. Merton. Yes, they could.
Mr. Sherman. They could. So why is it that the analysts are
so lazy that they go out and tell their investors, well, this
is the earnings per share from Coke, and we could make the
Pepsi earnings per share comparable so that you could compare
them, but we are no going to bother. Why is it that the market
does not embrace either an expense it all earnings-per-share
number or expense none of it earnings-per-share number? Why is
it instead that the market embraces a whatever the company
happens to publish, that is what we will use, even if they are
using different systems?
Mr. Merton. Well, if you will forgive me, why stop there
with options? Why not, if you went back to research R&D, why
not allow them to do it there? The problem that happens is,
yes, in any one case, you can do it.
Mr. Sherman. This is the only case where Congress is
plotting to overrule the FASB. Considering, excuse me.
Mr. Merton. What I meant by one case, I did not mean this
case. I meant if you want me to calculate today as an analyst
for Pepsi for this year, yes I can do it.
Mr. Sherman. How long would that take you?
Mr. Merton. Depending on the day, maybe a couple of hours.
Mr. Sherman. Okay.
Mr. Merton. Depending on how complex.
Mr. Sherman. There are a lot of hard-working people on Wall
Street. You would think one of them would do it.
Mr. Merton. But then I would also have to do it for all
prior years in order to have comparables through time.
Mr. Sherman. Okay.
Mr. Merton. And then if I am in the business of doing
comparables across Coca-Cola and all these other companies, I
would have to do it for all these other companies, even ones I
do not follow.
Mr. Sherman. So obviously, we cannot just have one stock
analyst do this. Either somebody is going to do it and publish
it and make it available and talk about it, or we can make it
easier and tell the companies to publish it both ways and do
the work for all those hard-working stock analysts. But we
should never have a circumstance where if somebody wants to
know what the earnings per share is over time across
industries, based on expensing stock options, that they are
prohibited by practical considerations from knowing.
If the witnesses in favor of the bill are right, then
investors should get their information, too. What would be
wrong with requiring companies to publish it both ways, staying
away from some of the real small companies that might not have
the resources to publish both ways?
Mr. Merton. I would say just cost.
Mr. Sherman. Costs, okay.
Mr. Merton. The costs of doing that. We have that happen
now.
Mr. Sherman. And the cost actually argues for the bill
because implementing the new FASB standards, should they be
adopted, that is the expensive thing. If you had a company that
only had five employees, was only going to spend $10,000 to
publish their financial statements, such a company could not do
it except under the existing system.
I know this FASB formula that they are considering, I
cannot imagine that you could implement that for only a few
thousand dollars for a company. You need a Black-Scholes study
and the whole thing. So we could let small companies use the
old system, the system that exists still today, and bigger
companies could publish it both ways. What would be the
disadvantage there?
If I have time, I will ask anyone else on the panel to
comment on that. Anybody have a comment? Okay, I am done.
Chairman Baker. Being somewhat responsive to the
gentleman's observation about the practice being aimed
primarily at the benefit of the higher level executives,
frankly that is what led me to direct our effort in this vein
was to try to identify the problem that started the reform
effort in the first place, without inhibiting the growth of
small business enterprise, which clearly can be established, I
think Professor Merton will even agree, that it does play a
role in business formation, without arbitrarily reversing a
business practice which has had positive economic consequences.
So I appreciate the gentleman's navigation through the
problem. There is movement.
Mr. Sherman. If the Chairman would yield, we could perhaps
better effectuate that purpose if in addition to saying the top
five executives, because I know the number six guy at Disney
and he is pretty well off.
Chairman Baker. I know the top 20 at Fannie Mae and they
are really doing well.
Mr. Sherman. That, too. Perhaps we would want a system that
in addition to saying the top five executives of the average
company, said anybody who was getting more than $100,000 worth
of stock options in any year would also be put in this rarefied
company. Being the top five at a medium-size company is no big
shakes compared to being number six at, say, Fannie Mae.
Chairman Baker. I appreciate the gentleman's perspectives.
You may not have knowledge of this factual circumstance,
Professor Merton, and if you don't, I understand, but with
regard to the well established company and the view that it may
be easier for publicly traded companies to comply with the
expensing requirement, I am aware that Coca-Cola recently tried
to market some of its options to two investment banks. The
investment banks preliminarily interested in that opportunity,
ultimately turned it down because their obligation is to hedge
against the risk. In trying to place the appropriate hedges
against that potential investment, they were unable to achieve
a valuation sufficiently accurate to warrant engaging in the
transaction. Is that a correct observation about those
circumstances? Or do you have the ability to make a comment
today on that?
Mr. Merton. I do not know that specific case. There was a
case, in the case of Microsoft, when they moved to restricted
stock, where they entered into an arrangement with a large bank
to take care of the out-of-the-money options. I think this
would have been a parallel type transaction. I do not think
that is the most efficient way, with all respect, to accomplish
it, but yes, they would have to do some hedges if they are
going to hold them primarily and not reissue them. Absolutely.
But that does not affect the price.
Chairman Baker. Oh, no. I was not suggesting that. All I
was saying is that in the case of a company as well established
as Coca-Cola, who was trying for whatever reason engage in this
transaction for some business purpose, unable to reach a
conclusion because at the end of the day someone trying to make
a future value calculation could not do it sufficiently
accurately enough for their risk profile to engage in it. Let
me get the more detailed facts and I might just correspond with
you on that to get your views about it at a later time.
Mr. Kanjorski, do you have any further questions?
Mr. Kanjorski. I think that I have heard, and it is just
rumor to me, there is some tax advantage to the corporation in
offering stock options. Is that correct?
Mr. Merton. Are you asking me?
Mr. Kanjorski. Yes.
Mr. Merton. I am not a tax expert. But you have to stay
relative to something, to say that it is a tax advantage.
Mr. Kanjorski. Yes. I understand they get a deduction for
tax purposes on the value of the options offered.
Mr. Coviello. If the options are exercised.
Mr. Merton. Yes. At the time they are exercised, then it
becomes a taxable even to the employee.
Mr. Kanjorski. To both the corporation and the employee at
the time of exercise.
Mr. Merton. Yes.
Mr. Sherman. If the gentleman will yield. There are two
kinds of stock options. With incentive stock options, the
company gets no deduction and the employee does not have to pay
any taxes for the most part. But those are very restricted.
There are all kinds of rules to qualify. For a nonqualified
stock option, the employee gets hit with a tax and the employer
gets a tax deduction.
Mr. Kanjorski. At the time of exercise.
Mr. Sherman. Yes.
Mr. Kanjorski. So by issuing, there is no tax benefit in
one current year if they are going to be taken down another
year.
Mr. Merton. No.
Mr. Coviello. No.
Mr. Kanjorski. Mr. Chairman, I do not want to delay this. I
think we have had a very fine panel here today. They have
certainly brought to my mind a lot of questions that we should
further look at. I am tending to lean with my accountant friend
here. Why not give the dual option that they have to record it
both ways so we can level the playing field. I think ultimately
what we are looking for is transparency. Who cares how they do
it or how we arrive at it, as long as we get the information,
and not every individual investor or every banking house has to
do every one of the 17,000 public corporations on their own.
Efficiency says have every corporation do it, if that were the
case.
I also think that there is some merit on us looking at the
impact on startup businesses and particularly venture capital
businesses that we would not want to front-load the cost of
getting into business or doing business at that precise moment
where it would stress the company and more than likely add a
burden that may sink them ultimately, even though it could be a
successful corporation.
With all that in mind, I ask unanimous consent to submit
for the record statements in favor of the Financial Accounting
Standards Board's efforts to adopt a mandatory stock options
expensing standard, from the Council of Institutional
Investors, the AFL-CIO, and the International Brotherhood of
Teamsters. Without objection.
[The following information can be found on pages 117, 121
and 123 in the appendix.]
Chairman Baker. Without objection.
Mr. Kennedy, did you have a comment?
Mr. Kennedy. I would just like to thank you, Mr. Chairman,
for hosting this hearing on this very important topic. As a
CPA, I know the complexities of having to deal with stock
options, but I also understand the power they have to motivate
people. Do earnings become meaningless at the variability from
recording stock options, bring earnings up and down so much
that it discourages businesses from offering them at all. The
incentives that drives in our economy is critical, and this
bill is something that I think needs to be given serious
consideration. I thank you for hosting this hearing.
Chairman Baker. I thank the gentleman for his remarks.
Mr. Sherman, did you have any further comments or are you
done?
Mr. Sherman. Believe it or not, I am done.
Chairman Baker. Terrific. We have run your balance sheet
finally.
I want to express my appreciation to each member of the
panel for your insight. It has been very helpful to the
committee in its consideration of this matter. We look forward
to working with you and other interested parties in the days
ahead.
Our meeting stands adjourned.
[Whereupon, at 12:15 p.m., the subcommittee was adjourned.]
A P P E N D I X
March 3, 2004
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