[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
____________________________________________________________________________
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                 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

                              ----------                              
                                                                   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

                              ----------                              


                        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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