[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
THE FASB STOCK OPTIONS PROPOSAL: ITS
EFFECT ON THE U.S. ECONOMY AND JOBS
=======================================================================
HEARINGS
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
SECOND SESSION
__________
APRIL 21, MAY 4, 2004
__________
Printed for the use of the Committee on Financial Services
Serial No. 108-80
U.S. GOVERNMENT PRINTING OFFICE
95-438 WASHINGTON : DC
____________________________________________________________________________
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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 BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota RAHM EMANUEL, Illinois
TOM FEENEY, Florida DAVID SCOTT, Georgia
JEB HENSARLING, Texas ARTUR DAVIS, Alabama
SCOTT GARRETT, New Jersey CHRIS BELL, Texas
TIM MURPHY, Pennsylvania
GINNY BROWN-WAITE, Florida BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
Robert U. Foster, III, Staff Director
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises
RICHARD H. BAKER, Louisiana, Chairman
DOUG OSE, California, Vice Chairman PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware GREGORY W. MEEKS, New York
PETER T. KING, New York JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma DENNIS MOORE, Kansas
EDWARD R. ROYCE, California MICHAEL E. CAPUANO, Massachusetts
DONALD A. MANZULLO, Illinois HAROLD E. FORD, Jr., Tennessee
SUE W. KELLY, New York RUBEN HINOJOSA, Texas
ROBERT W. NEY, Ohio KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona JOSEPH CROWLEY, New York
JIM RYUN, Kansas STEVE ISRAEL, New York
VITO FOSSELLA, New York, MIKE ROSS, Arkansas
JUDY BIGGERT, Illinois WM. LACY CLAY, Missouri
MARK GREEN, Wisconsin CAROLYN McCARTHY, New York
GARY G. MILLER, California JOE BACA, California
PATRICK J. TOOMEY, Pennsylvania JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia STEPHEN F. LYNCH, Massachusetts
MELISSA A. HART, Pennsylvania BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota RAHM EMANUEL, Illinois
PATRICK J. TIBERI, Ohio DAVID SCOTT, Georgia
GINNY BROWN-WAITE, Florida NYDIA M. VELAZQUEZ, New York
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
C O N T E N T S
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Page
Hearings held on:
April 21, 2004............................................... 1
May 4, 2004.................................................. 51
Appendixes:
April 21, 2004............................................... 73
May 4, 2004.................................................. 163
WITNESSES
Wednesday, April 21, 2004
Grady, Robert E., Managing Director, Carlyle Venture Partners.... 24
Hassett, Kevin A., Director of Economic Policy Studies, American
Enterprise Institute........................................... 21
Holtz-Eakin, Douglas, Director, Congressional Budget Office...... 20
Kruse, Douglas, Professor, School of Management and Labor
Relations, Rutgers University.................................. 18
Scalise, George M., President, Semiconductor Industry Association 28
Smith, Phillips W., Chairman of the Board, TASER International,
Inc............................................................ 23
Thomas, Jeff, Field Applications Engineer, Altera Corporation.... 16
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 74
Gillmor, Hon. Paul E......................................... 77
Hinojosa, Hon. Ruben......................................... 81
Kanjorski, Hon. Paul E....................................... 82
Grady, Robert E.............................................. 84
Hassett, Kevin A............................................. 90
Holtz-Eakin, Douglas......................................... 107
Kruse, Douglas............................................... 125
Scalise, George M............................................ 148
Smith, Phil.................................................. 152
Thomas, Jeff................................................. 157
Additional Material Submitted for the Record
Baker, Hon. Richard H.:
FASB Chairman calls for Investors to Speak up on Options,
``The Wall Street Journal'' April 19, 2004................. 159
Royce, Hon. Edward R.:
Treausurer's Office, State of California, prepared statement. 161
WITNESSES
Tuesday, May 4, 2004
Batavick, George, Small Business Advisory Committee, Financial
Accounting Standards Board..................................... 60
Herz, Robert, Chairman, Financial Accounting Standards Board..... 57
APPENDIX
Prepared statements:
Royce, Hon. Edward R......................................... 164
Gillmor, Hon. Paul E......................................... 166
Batavick, George............................................. 168
Herz, Robert................................................. 168
Additional Material Submitted for the Record
Sherman, Hon. Brad:
U.S. Securities and Exchange Commission, letter to Hon. Paul
Kanjorski, May 3, 2004..................................... 210
Herz, Robert:
Written response to questions from Hon. Brad Sherman......... 212
THE FASB STOCK OPTIONS PROPOSAL: ITS
EFFECT ON THE U.S. ECONOMY AND JOBS
----------
Wednesday, April 21, 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 10:05 a.m., in
Room 2128, Rayburn House Office Building, Hon. Richard Baker
[chairman of the subcommittee] presiding.
Present: Representatives Baker, Ose, Gillmor, Lucas of
Oklahoma, Royce, Manzullo, Oxley (ex officio), Kelly, Ney,
Shadegg, Biggert, Capito, Hart, Kennedy, Tiberi, Kanjorski,
Hooley, Sherman, Inslee, Moore, Capuano, Frank (ex officio),
Hinojosa, Lucas of Kentucky, Crowley, Clay, McCarthy, Matheson,
Lynch, Miller of North Carolina, Emanuel, Scott and Velazquez.
Chairman Baker. [Presiding.] I would like to call this
meeting of the Capital Markets Subcommittee to order.
This morning we are convened for the purpose of reviewing
the pending Financial Accounting Standards Board stock option
expensing proposal and the potential effect its adoption may
have on job creation and our economic recovery, which I believe
to be fully engaged. I have given some thought to my opening
statement this morning and the past few days, but I had the
occasion to read press reports of yesterday that changed my
intentions to open the hearing.
The congressional process is a very open and public
process. No one ever has accused the Congress of moving too
fast, to my knowledge, on anything. It is a process subject to
hearings and review which we will benefit this morning from our
panel of witnesses in getting additional comment, and then
subject to our ability, a markup subsequent to recorded vote,
publicly recorded, then a full committee review, then if
leadership so chooses for consideration, then of course a
bicameral process and subject to the presidential veto.
Although many criticize the political process, it is the one
forum in which every person's perspective can be vented, can be
put on the public record, and elected officials held
accountable for the decisions they make.
In the matter before the committee today, it is the
presumption that the Financial Accounting Standards Board is an
entity which will conduct and review appropriate financial
standards absent such political necessities, and that
professionals for the public good shall make determinations in
the best interests of our economic stability. Given that
history of the Financial Accounting Standards Board, I am the
first to acknowledge that I have on prior occasions disputed
the decisions of the Standards Board on various other matters
of accountancy practice. I felt, as a public official, the
right to express those opinions and to disagree on occasion
where I thought it in the public interest to do so.
However, it has always been past practice of the Board to
refrain from engaging in the seamier side of the public policy
business and was surprised to learn that FASB now has engaged
its own lobbying firm. But what really got me more engaged in
this matter were the comments of the Chairman of the Board, and
again let me quickly add, if this press report is true, I have
also been on that side of the coin where my representations
have not always been accurately reflected, and quick to respond
that should this press account be accurate, from the Wall
Street Journal, it raises concerns which I think appropriate to
bring to the committee's attention.
When Chairman Herz yesterday criticized a well-organized
lobbying effort within the Congress, but then went on to say,
``One thing I cannot control is Congress.'' I would say, that
is a good thing. No one person should control the Congress, nor
enterprise. It acknowledged in the comment that the proposed
rule is now open to public comment until the end of June.
Apparently, members of Congress are the only group that can
have no comment on the matter until the close of the
consideration at the end of June, but calling on all in the
investor class and those within the business community to make
your views known to people in Washington; a call for investors,
again, to make your views known.
We cannot have it both ways. If you expect the Congress to
have a hands-off approach and allow a regulatory entity to act
without comment from anyone, I question the need for a public
comment period because in the midst of the public comment
period, this hearing has been called for the sole purpose of
having those make comment on the effect of this proposed rule
on the broader economy. To engage the resources of a lobbyist
and for the chairman of the board to then make a political
request of constituencies to affect and influence the Congress
has now opened the door. If you want to have a public
discussion where all interested parties express their opinion,
there is no more open venue, no more free of influence, no more
publicly recorded venue than the United States Congress.
Now, I do not always agree with the outcomes of the
congressional process, but I have great regard for the process
and respect the wisdom of 435 members of the House and 100
members of the Senate in coming to what is the best-balanced
conclusion for the public interest. I make no apologies today
about having introduced a bill and brought this matter to
public discussion. I happen to personally believe it is the
right thing to do. I will acknowledge there are other people
with different opinions and I may be wrong, but today we have
had a group historically known for its nonpolitical
determinations open the door to political judgments. I hope we
can do it going forward in a professional manner and all have
respect for each other at the conclusion of the process, that
professionals with differing opinions can come to some
resolution that ultimately is in the best interest of the
public.
I apologize to the committee for going on at length, but I
felt the necessity to express those views.
Mr. Kanjorski?
Mr. Kanjorski. Mr. Chairman, I am not aware of the press
comments, but it strikes me that it poses the question of
whether you will respect me in the morning.
Chairman Baker. No.
[Laughter.]
Mr. Kanjorski. Actually, Mr. Chairman, I think this is an
important issue, and we meet for the third time in the 108th
Congress to study the accounting treatment of stock options. I
have a prepared statement that I will submit for the record. I
guess the interests are that this is a recognized problem, one
for the accounting industry and the need for certainty in how
things are done.
I am not an accountant by profession, but I also feel that
it perhaps is a dangerous ground for us to tread on that the
Congress will interpose its position on a board that is
dedicated and structured to make these determinations. That is
not to say that that board's determinations come with the
weight of the Constitution or perhaps the actions of God to
Moses on the mount.
It is, however, a struggle that could be off-course in
terms of I think there are two major issues here. One is
whether or not this Congress supports the fact that we have a
structured entity in the private sector to make final
determinations of accounting rules. I think that is vitally
important for our system domestically and internationally. Two,
my interest in this is that I truly believe that accounting is
for the purposes of transparency of investors and people, that
they have a right and a want to know what is the structure and
the commitment of the organizations they potentially want to
invest in.
I have had the occasion over the last several weeks to
visit with people that are on both sides of this issue. I have
listened to them as hard as I can. I remember having a
discussion with the president and CEO of one of the major
California new-tech companies just 2 weeks ago. He struck me
with the importance of this for his industry. I have great
sympathy that in that particular industry, this could create a
problem, the rule as it is structured. But as we discussed it
together, he tended to agree with me with the need for
transparency; that we cannot have every company doing with
their stock options as they will and anticipate that analysts
will discern every one of the 27,000 public companies in the
United States. That is not going to happen, and particularly
with the loss of respect for the analysts over the last several
years. They probably will not be performing that function
sufficiently to give transparency.
So I do not understand why we get to the point of one way
and not another. I think potentially, and it is too bad we do
not have both the SEC and FASB here today, but I understand
most of those groups are on travel internationally and are not
available for us today. So in that regard, before we conclude
and go to markup on this subject, I think it is only right that
we bring representation of FASB and SEC before the committee so
that they can spell out their arguments, because quite frankly
I have a question that I would like to pose to them that I
think is very fundamental and important.
Are there other ways, in accordance with accounting
principles, that we can get to transparency without necessarily
going the full gamut of a single rule applying across the board
that could disadvantage some of our major technology companies?
I do not know what the answer to that is, but being rather
Burkean in my philosophy that unless you show me the benefits
of change, I am more apt to hold with tradition. My natural
proclivities lead me to support the institutions, whether they
are courts of law or organizations such as FASB, that they have
the ultimate insight and interest and intention of doing the
right thing and propounding the proper rules, always subject to
review.
But before we get to the final decision and whether or not
the Congress should take up singular activity of reviewing,
sometimes under pressure, the implementation of a rule across
the board, I think it could be fundamentally destructive to our
system if we encourage people to believe that FASB is okay to
some extent, but where there are interest groups that can rise
above that and put significant pressure on the Congress of the
United States to interpose their will and its will on an
organization like FASB, that could be very destructive to the
entire process of the system.
Those that favor that position today on a particular
accounting rule may find out that when they become less
significant or less important or less apt to be able to affect
the actions of Congress, they can have suppressive activity
brought on them by other special interest groups or pressure
groups within our system. That tends to go to the destruction
of the system as we have it.
With that in mind, Mr. Chairman, I do ask that we have an
additional hearing before we go to markup on this situation,
having in FASB and the SEC. I look forward to today's hearing.
I think the weight of the witnesses, as I discern them, are
significantly disadvantaged one side of this proposition right
now, although I look forward to the testimony particularly
given by some of our industrial leaders that are here today to
give us an insight on how the impact will be in the capital
markets and on these particular corporations that exist, and
that had some advantage by using stock options as a methodology
of not tapping into their capital assets when they were at the
beginning stage or formative stage of their endeavors.
With that in mind, I offer my full statement in the record,
Mr. Chairman, and look forward to it. I guess I will read The
Wall Street Journal the day before such hearings so that I am
fully equipped to respond to the Chairman's views.
[The prepared statement of Hon. Paul E. Kanjorski can be
found on page 82 in the appendix.]
Chairman Baker. I thank the gentleman for his statement. It
certainly will be made part of the record, as will all
members's opening statements.
Mr. Ose, did you have an opening comment?
Mr. Ose. Thank you, Mr. Chairman.
I am appreciative of the fact that you are having another
of these hearings. I remain somewhat bemused by our ongoing
debate here. We have yet to define a system whereby we can
accurately value these options, whether it be Black-Scholes or
binomial equation or something of that sort. And yet we are
hurtling down a path, at least from a regulatory standpoint, to
impose a requirement of a blanket nature on America's
corporations without defining yet exactly how we are going to
value it.
I would submit to the body that the various opinions that
are being put forth by people who have moved to expense options
on their financial statements, as opposed to those who have yet
not made that move, largely track the enterprise models that
they speak from. For instance, let us take Mr. Buffett. Mr.
Buffett has argued in favor of expensing options, but I think
if you look at Mr. Buffett's investments, you will find very
few of them in the technology business, where options are used
for significant compensation to employees.
I would submit to the body that the difference of opinion
in corporate America as to how to treat options, whether to
expense them or make them transparent within the notes to
financial statements, reflects the needs of different
enterprises to either compensate their employees or reduce
their tax liability. Those who are advocating for leaving
options in the current situation whereby they are disclosed
within the notes, are using options as a compensation tool, by
and large. Those who are advocating for the expensing of
options look at the net impact on their tax liability by
expensing those options. The net income for that enterprise
would be less.
It is perfectly logical, but we still come back to this
same point, and that is however you value these options,
whether you are a strong advocate for leaving it the way it is
or a strong advocate for changing the system, however you value
these options your valuations are based on assumptions. If it
is the assumptions that are driving FASB's concern, that is if
the assumptions may or may not be valid, we ought to talk about
that, rather than whether or not to put them into the financial
statements.
I thank the Chairman for having this hearing. I am still
waiting for somebody to definitively quantify for me how you
value these options. Thank you, Mr. Chairman.
Chairman Baker. I thank the gentleman for his interest in
the subject and his statement.
Ranking Member Frank?
Mr. Frank. Thank you, Mr. Chairman. I appreciate the
attention you are giving to this.
This is a very difficult issue for me. Intellectually, it
is one of the harder ones that we deal with. When I was in law
school, accounting overlapped with my duties as a state
legislator. I was absent a lot of times that day when we came
up with the issue. I am continually impressed both with the
complexity of accounting issues and even more difficult for us
with their fluidity.
We have an issue here, though, where I am conflicted. I
have been convinced by people, particularly in the high
technology industry, that this change could do them some
damage. I will get in a minute to what I think of that, but
facts have to be taken into account. On the other hand, setting
a very strong precedent of this Congress setting rules on a
specific and technical accounting issue is difficult. So we
often in this body use procedural arguments to reinforce our
substantive preferences. The tough time comes when you have
both a genuine procedural preference, as the Ranking Member
talked about, and a substantive view which will not be well
served by following that procedural preference. If it is up to
me, I would not be demanding that these be expensed, but I do
not want to go into a situation where we become the appellate
Financial Accounting Standards Board.
I must say, while I accept what the high technology people
tell me, they are a lot of very smart, very decent people who
have done a lot of good for this economy, and they are
overwhelming in their view. I must say that what they tell me
is somewhat distressing because I have to say in substantive
terms, this issue to me is frankly like some other issues where
the reality seems to me to have been swamped by perceptions
that have taken over. That is, whether or not the accounting is
changed, whether options are expensed or not, does not change
the reality.
Currently, I am told, they are available in the footnotes.
I am not a regular reader of the footnotes of financial company
statements. If we changed the rule, they will not be in
footnotes; they will be treated differently. The reality will
not change. So what we are being told, and this is a disturbing
fact for me, is that the investment community of America will
react very differently to an identical reality depending on how
it is presented in financial statements. That is disappointing
to me.
Perhaps one of my illusions was that these cold-headed,
hard-hearted financial people would be less influenced by
whether it was in the footnote or not in the footnote. But
being told that without a change in the reality, the method of
presentation of the reality will have an enormous impact, but
both sides seem to agree that it would have this impact,
whether or not there is a nominal profit or not. I am hoping
that people in the high tech industry if this does go through
will turn out to have underestimated the financial community,
and that they will be able to tell the difference between
reality and perception, but I understand this is troubling.
I have an alternative that I am going to be introducing
later. I will be filing the bill later in the week. As I have
looked at this, I find it hard to see what damage has been done
by the current accounting treatment of options. I have not had
anybody write to me and say I was terribly misled because they
did not expense the options and I invested in them, and look
what happened to me. But there have been problems with options.
It seems to me, from what I have learned in my role here on
this committee, is that the problem with the stock options in
our economy is the perverse incentive they have given in some
cases to the top decision makers in some corporations to spike
the stock price and then cash in and walk away. There have been
large corporate entities that have done things that made no
sense from the standpoint of the corporation over time, but did
make sense because there were some corporate executives who
benefited short-term.
I am going to file legislation that would direct the SEC to
promulgate rules that will deal with a situation in which the
top decision makers in corporations cash in stock options and
there is subsequently a drop in the value, because I think that
is the public policy issue. I am not at this point ready to
tell FASB what to do or what not to do on a subject which is
such a difficult one intellectually. But I would hope that the
existence of this option, the ability of the regulators to deal
with the abuse of the perverse incentives given by stock
options to chief executives, would be a relevant factor in the
field, because we do have a genuine comment period. I think it
is possible for some of us to say to the FASB that we are
skeptical of the rectitude of their action, without being
committed to overturning them congressionally because I am in
that bind.
So I am going to be filing this legislation later that
would direct the SEC to deal with what seems to me the serious
problem here, which is the perverse incentive that the current
stock option rules give to a handful of irresponsible and
unethical chief executives and their top aides, and hope that
that might be a factor in the debate.
Thank you, Mr. Chairman.
Chairman Baker. I thank the gentleman for his statement.
Chairman Oxley?
Mr. Oxley. Thank you, Mr. Chairman.
Let me congratulate my friend from Massachusetts, the
Ranking Member, for his thoughtful statement. I think his
statement does point out some of the difficulties that we as
policymakers have in dealing with this complicated issue.
This is the third time in this Congress that we will
discuss stock option accounting. The number of hearings this
subcommittee has held demonstrates how important this issue is.
I applaud Chairman Baker for his good work on this subject. In
light of the Financial Accounting Standards Board's recent
proposal, it is particularly important now.
The question of whether stock options should be expensed
has been debated for many years. Some, like the former Chief
Accountant of the Securities and Exchange Commission, Walter
Schuetze and numerous experts in accounting, believe that the
FASB's position that the issuance of employee stock options
creates an expense is simply improper accounting. Mr. Schuetze
observes that the issuance of a stock option to an employee
does not change the market capitalization of the corporation,
as measured by the market value of the outstanding shares and
the value of the outstanding option. Thus, there is no expense.
If there had been a true expense, which he defines as the
``using up'' of an owned asset or the decline in the value of
an owned asset, then the market value of the outstanding shares
and option should have declined, but that is not the case. It
also makes me particularly glad that I did not take accounting
in college.
Others, like FASB, as evidenced by its recently released
proposal, take the contrary view, arguing that employee stock
options do constitute a corporate expense. FASB's position is
that all employee stock options have value, which employees
purchase with the services they provide. Because they have
value, FASB asserts, when stock options are given to employees
they give rise to compensation costs that are properly included
in measuring an enterprise's net income.
Some point out that the grant of an employee stock option
is an opportunity cost to the issuer. They argue that if a
company were to grant stock, rather than options, to employees,
the company's cost for this transaction would be the cash it
otherwise would have received if it had sold the shares at the
current market price to investors. But this situation is not
analogous to that of the issuance of employee stock options.
Not only are employee stock options issued exclusively to
employees of the issuer, but each employee stock option is
written for a specific individual. Thus, there is, by
definition, no market into which these options can be sold.
Another significant problem is the accurate valuation of
stock options, and we have been through this many times. While
there is a diversity of opinion on the merits of requiring the
expensing of employee stock options, there is uniform agreement
on at least one aspect of this debate. It is extremely
difficult to value these options. This gives rise to concerns
that strike at the heart of financial statements. What use are
they if not for purposes of comparing one company's statement
against another's?
The FASB itself recognizes that there is no options-pricing
model that gives an accurate assessment of the value of options
across all enterprises. The Black-Scholes model has been shown
to have significant deficiencies for purposes of valuing
employee stock options. The Binomial method has similar
problems. FASB's solution is to provide no guidance as to what
method a company must use to calculate value.
The lack of a uniform, reliable valuation method creates
problems of comparability among companies, accuracy of the
financial statements themselves, and, as one of our witnesses
today suggests, even opens up the possibility of manipulation
of earnings by management. These are concerns that merit
further consideration. But as Craig Barrett, the CEO of Intel,
has observed, whether or not stock options should be expensed
is not just an accounting issue. It is also an economic issue.
And that is the focus of today's hearing.
Preserving the independence of the Financial Accounting
Standards Board is a consideration. That is an issue of process
and jurisdiction and certainly the members of this panel have a
great respect for FASB's expertise. However, some issues go
beyond that of accounting and enter the mainstream of economic
policy. If it is true that the adoption of FASB's employee
stock option expensing rule would cause significant and serious
damage to job creation, then it becomes an economic policy
issue and one that Congress should certainly review.
Dozens of chief executives have publicly stated that their
firms will reduce or eliminate options if the FASB proposal is
enacted in order to avoid the negative impact that expensing
will have on earnings per share, and in turn, the company's
share price. If this is the case, then shareholders and our
economy as a whole will sacrifice some measure of economic
growth.
The venture capital community has been quite outspoken on
this issue. One of our witnesses today discusses the great
extent to which venture-backed companies rely on stock options
to attract and retain talent. He also points out that in over
70 percent of venture-backed companies, stock options were
awarded to all employees, not just top executives. These
companies are a significant component of our economy. He cites
statistics illustrating that venture-backed companies directly
or indirectly accounted for 27 million jobs in 2000 and had
sales constituting about 11 percent of our GDP. These are
compelling figures. If the FASB proposal will undermine job
creation and economic growth, then it calls for closer scrutiny
by the Congress.
The Congressional Budget Office study concluded that
expensing employee stock options will not have a significant
effect on the economy. The study argues that the information
has already been disclosed in footnoted financial statements
and thus is reflected in the stock price. We will examine today
whether this analysis is correct.
While there are many informed experts on both sides of this
issue, there are some aspects of this debate on which there is
agreement. First, expensing employee stock options is not a
silver bullet for achieving better corporate governance.
Second, the importance of transparent, accurate financial
statements cannot be overstated.
Mr. Chairman, I look forward to hearing from our esteemed
panel of experts today as we consider once again the far-
reaching implications of the FASB proposal.
I yield back.
[The prepared statement of Hon. Michael G. Oxley can be
found on page 74 in the appendix.]
Chairman Baker. I thank the Chairman for his statement and
for his attendance here today.
Ms. Velazquez?
Ms. Velazquez. Thank you, Mr. Chairman.
First, I want to thank Chairman Baker and Ranking Member
Kanjorski for holding this important hearing. Stock options
have contributed significantly to the economic growth of the
U.S. economy, allowing smaller firms to grow and expand in a
time when the labor markets may have chosen otherwise. During
periods of strong economic growth and low unemployment, such as
the late 1990s, the demand for specialized labor outstripped
supply. As a result, wages and benefits were bid up to levels
unseen in previous periods.
During such previous periods, companies that were rich were
often able to attract and retain employees, effectively beating
out smaller firms that lacked the cash flow of the larger
competitors. During the 1990s, however, stock options leveled
the playing field and permitted startups to compete with
Fortune 500 companies for talented employees. Instead of
economic oligopoly, new firms sprouted up across the country,
providing the critical mass for new industries and markets.
The accounting treatment of stock options is a complex
issue. If it were not, this issue would not be before us today.
First and foremost, I am concerned about any regulatory change
that will threaten entrepreneurial activity. I believe that the
churning of ideas is necessary for the U.S. economy to move
forward and create the jobs that we so desperately need. Such
creative destructionism can provide the U.S. with a model for
long-term economic stability.
FASB has proposed a rule that will alter the accounting
treatment of stock options. While the proposed rule does not
prohibit firms from issuing stock options, it will require
firms to expense these options in their financial statements, a
distinct departure from FASB's current approach. I do have
serious concerns with this proposed rule as it appears that it
will disproportionately impact smaller companies relying on
stock options to finance their early development and growth.
While it is not clear to me that the proposed rule will
result in more accurate or comparable financial information for
public companies, it is apparent that the rule will impose
substantial compliance costs on startups. In addition, I am
suspicious of any proposal that restricts smaller firms's
access to the equity markets. By impeding smaller firms's
ability to be competitive, as I believe this proposed rule
does, our national economy and more importantly our local
communities will be less likely to realize the benefits that
innovation and risk-taking bring: new jobs, an expanded tax
base, and opportunity for future generations.
Mr. Chairman, I too echo Mr. Kanjorski's request for an
additional hearing with the FASB Chairman and the appropriate
SEC officials before we move to mark up the legislation. With
this in mind, I thank you for your leadership on this issue and
I look forward to hearing the testimony of the witnesses on
this complex issue.
Thank you, Mr. .Chairman.
Chairman Baker. I thank the gentlelady for her statement.
Mr. Royce?
Mr. Royce. Thank you, Mr. Chairman. Once again, I want to
thank you for the hearing, and I want to thank you for
introducing H.R. 3574, the Stock Option Accounting Reform Act.
Also, on behalf of my colleague from California,
Representative Eshoo, and Representative Eshoo is your lead co-
sponsor of H.R. 3574, I would like to submit for the record a
letter from our California Treasurer, Philip Angelides in which
he endorses this bill.
[The following information can be found on page 161 in the
appendix.]
Let me say, Mr. Chairman, that I am extremely troubled by
FASB's proposal which would require firms to expense employee
stock options. Expensing options will have very negative
consequences. In fact, just the threat of expensing has already
changed the behavior in many firms. Mandatory expensing of
employee options will effectively end the practice of granting
employee stock options as we know it.
Stock options enable firms, often new economy-oriented
firms, to attract talent that otherwise would go to companies
able to pay higher salaries through cash compensation
arrangements. Newer growth companies tend not to have large
stable cash flows. However, through stock options, they can
compete by offering employees an up-side in the event that the
firm succeeds.
Incentive is perhaps the most important driver of economic
growth. People advocating expensing are taking incentive for
success away from the very companies that could be producing
the next generation's goods and services. No economic model can
dispute this argument.
California rests on the banks of the Pacific Rim. All of
our country's new economy firms, but particularly those in
California face greater and greater competition from businesses
in Central and East Asia. I ask my colleagues to reflect on the
fact that companies in China are striving to take away our
global edge in technology. China graduates now 195,000
engineers and computer programmers annually. Many have made the
point that the Chinese government has embraced stock options in
its 5-year plan. Here is my point. I am worried that while
communist China is learning capitalism, we are forgetting it.
Again, Mr. Chairman, thank you for the leadership on this
issue. I look forward to the testimony of our distinguished
witnesses. I yield back.
Chairman Baker. I thank the gentleman.
Mr. Crowley?
Mr. Crowley. Thank you, Mr. Chairman. Thank you for holding
this hearing today. I want to thank the ranking member as well,
Mr. Kanjorski, for his input and his presence here today, as
well as the Chairman and the Ranking Member of the full
committee for their interest in this issue.
I want to begin by expressing my gratitude for FASB and the
role that it plays in our economy, that of ensuring
independence and credibility of our nation's accounting
systems. At the same time, I also have to state that I disagree
with FASB's recently proposed rule change, the mandatory
expensing of all stock options as I believe this rule does not
deal solely with accounting principles, but rather also deals
with economic policy as well.
While accounting standards should be left to FASB, economic
policy should and must remain with Congress and the executive
branch. I believe this differentiation between accounting
policy and economic policy must be made when discussing this
proposed rule change. This proposed regulation will not address
concerns about excessive executive compensation or reliability
of a company's financial statements. Rather, I believe this
rule will adversely affect employees who receive stock options,
especially employees whose companies provide broad-based stock
option plans, thereby hurting wealth creation and weakening or
eliminating the basic economic instrument that created the
economic boom of the 1990s and is still used frequently today
by venture capital startups.
Besides delving into economic policy, which is not I
believe the role of FASB, I have additional concerns about this
rule, such as that this expensing mandate will provide less,
not more, integrity in accounting. Supporters of this rule will
argue that it makes accounting more honest. I have to differ.
In fact, this rule will allow two different methods for
companies to expense their options, either binomial or Black-
Scholes, both of which are not considered accurate evaluation
models. In essence, this rule will allow companies to pick and
choose their accounting methods, providing more confusion, I
believe, and more dishonesty in financial statements. This rule
will allow corporate accountants to decide which expensing
system works best for their company's goals.
Whereas today, to keep accounting honest, those same firms
with stock options must, under FASB's guidelines, disclose the
value of their options in the company's financial footnotes, as
mentioned earlier, or charge it directly against income,
leaving no economic surprise for any investor.
Additionally, supporters of this rule will argue that there
is nothing in this rule that prevents the issuance of stock
options and that the CBO report states that expensing of
options will not have any adverse consequences. They go on to
argue that some companies such as Coca-Cola expense their
options now and have not seen a drastic adverse affect in their
stock price. But when referencing Coke as an example or using
the CBO report to justify this expensing mandate, supporters of
expensing do not take into account the issue of broad-based
stock option plans that benefit all company employees, not the
regular stock option plan that benefits the few at the top of
the corporate pyramid. Companies like Coke provide and expense
their options, but they are not broad-based plans. They are
options for top corporate executives.
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 help create the new economy of the 1990s, a new
economy, as I mentioned before, that we are still feeling the
effects of today. In fact, it is these broad-based plans that
have spread wealth throughout all sectors and to all employees
of our 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, and
most of these options go to the rank-and-file workers, helping
stimulate wealth creation for employees while allowing
employers to attract the best talent.
Contrary to popular belief, these people receiving broad-
based stock options are not all located in Boston and San
Francisco. Statistics show that 41 percent of those receiving
broad-based stock options live in the South and 24 percent live
in the Midwest. Unfortunately, we already are starting to see,
as was mentioned before, the negative effects of this FASB
rule. It has not even been finalized as of yet. Some companies
are already beginning to scale back their broad-based option
plans in anticipation of the FASB rule, and I believe this
hurts employees and not the executives.
I am supportive of an independent FASB for the purpose of
making accounting rules, but again this rule is not about
accounting. It is about economic policy, and I believe that
belongs with Congress and the executive.
I yield back the balance of my time.
Chairman Baker. I thank the gentleman for his statement.
I have no further members on our side seeking recognition
for an opening statement, so the next person to go to is Mr.
Scott.
Mr. Scott. Thank you very much, Mr. Chairman. Certainly,
this is an extraordinarily important and yet complex issue.
I think that as we move forward on this, and I have enjoyed
working with the Chairman on this issue, but it is clear that
the legislative process is really working here and raising some
questions and putting some issues on the table that certainly
need to be dealt with as we move forward.
My understanding of H.R. 3574 is that it does indeed
immediately dispense with the stock options requirement for the
top five executives in a corporation. It provides for a study
before moving forward, and certainly exempts small businesses
from the first three years. The question is, though, is that
enough.
I think there are three issues here that we certainly have
to exhaust before we move forward. First of all, what impact
does this have by immediately stopping the stock options for
the top five executives in a corporation, for the rank-and-file
members who for years have benefited from stock options. I
think we have to move gingerly to make sure that is continued.
The other issue, of course, is small startup businesses. Is
the exemption enough for the first 3 years, especially our
technology companies. It is very important that we respond to
that concern. The third area of concern for me, of course, is
to hear from the SEC, to hear from FASB, to make sure as we
move forward we are doing the right thing in dealing with the
abuses and to stop that and regain the confidence of the
American people in our most treasured possessions, and that is
in our corporations that are the bulwark of our economic
system, without doing tremendous damage otherwise.
So Mr. Chairman, I really look forward to this, going
forward, and I hope that we can address those three concerns as
we move forward as we deal with this very complex issue.
Thank you.
Chairman Baker. I thank the gentleman.
Mr. Sherman?
Mr. Sherman. Thank you, Mr. Chairman. As the only member
who will begin his statement by saying I am glad the FASB is
looking at this issue, I do have a lot to say.
Let me begin by looking at this whole idea of broad-based
options. I have drafted the option plans. I have consulted with
the companies on their option process. Yes, there are a few
companies that have broad-based plans, but in general you are
talking about 80 percent of this benefit going to the top 8
percent of the employees across the board in this economy. When
we look at the bill that is being proposed to deal with this,
it supposedly is there just to protect broad-based.
Look at two important details in the bill. First, even when
options are granted to the top five people in the company, you
have to assume zero volatility. So it is not just a bill to
protect broad options. It is a bill to massively undervalue
options given to the top five executives. Second, if you are
number six at GM, you are probably doing pretty good. We should
instead, if we want to focus on broad-based options, look at
options which when valued at time of grant are less valuable
than $100,000 per employee per year. That would allow us to
make sure that we are giving a special benefit only to those
options that are not being used for the purpose that options
have been used for, and that is to make our corporate
executives the richest corporate executives in the world by
far.
Now, we should be matching expenses and revenue. That is
basic accounting. So we are told that somehow a stock option is
not really an expense. It is not anything of value. Well, if it
was not anything of value that was being given up, why does
everybody want it? More importantly, what is an option? It is a
piece of the future growth of the company, transferred from the
current shareholders to the option grantees, the executives.
That is very much a transfer of something of value.
That is why if the company were to grant options which
could be very similar in their form to employee stock options,
would it grant those to private investors? That would be a
recognized transaction. The proof of what I am saying is this.
Let's say we really cared not about whether the executives got
compensated, but there was health care for the bottom half of
the employees, particularly in big companies that may not even
use stock options now.
We told corporate America, you can grant stock options to
insurance companies if those insurance companies are giving
health care to the bottom half of your employees. That is an
expense. It has always been an expense. That is why companies
do not use that as a device to pay their insurance companies.
Instead, they have to pay them in cash, and increasingly they
decide not to pay the cost of today's health care.
If the transfer of an option to acquire something use for
the company, like the work of the employees, is not an expense,
why just employee stock options? Why can't you buy your
building for stock options and not list that as a cost? Why
can't you pay your telephone bill with stock options and not
list that as a cost? The reason is because stock options is
another way of paying an expense.
Now, if we do things right and expense stock options, then
we will I think show the world that perhaps unlike China,
unlike some others, we have the best, clearest, most
transparent, fairest, most logical accounting system being
imposed, even when powerful interests disagree. The effect will
be to reduce executive compensation in this country. The effect
will also be, and it will not be a major effect, but it will be
an effect. There will be a slight reduction in the amount of
capital flowing to those companies that use stock options and
that capital will instead flow to some older companies that
tend not to use stock options. Is it better that a stock that
somebody invest in Intel than invest in Proctor and Gamble?
Gee, I do not know, but picking winners and losers has never
been a proper role for this Congress.
So I would like to argue that FASB is doing its job and we
should leave them alone. There is one problem. FASB is not
doing its job, two huge problems up there in Connecticut.
First, this exposure draft just kind of leaves drifting do you
use binomial? Do you use Black-Scholes? When do you use one?
When do you use the other? Any guidance? Or do you just hire
the accounting firm, there are not many left, but do you just
hire the accounting firm that will give you the lowest stock
option value? If they are going to do their job, they ought to
do it.
But there is a much greater problem with FASB and it is a
related issue. We cannot talk about stock options without
talking about research expense, because the biggest argument
against what FASB is doing is that it will hurt high tech.
Well, let's talk about something that really hurts high tech,
not just something that may disadvantage a few executives in
high tech, but rather that disadvantages high tech in general.
FASB will admit it is completely wrong as a matter of
accounting theory, but they have left it in place for over 30
years, and that is the expensing of all research. The effect is
for us as an economy to under-invest in research, for
stockholders to under-invest in companies that do research.
Why is this related? Because if we are going to hit tech
with bad accounting for research, should we also hit them with
good accounting for stock options? Is it fair to take a sector
of our economy and require them to expense stock options, which
is good accounting, while at the same time requiring them to
expense the nearly $2 billion they do every year of research,
which is bad accounting.
So when this bill comes up, I will propose an amendment
that it remains in effect only so long as FASB fails to allow
for the capitalization of successful research and development
expenditures. When FASB solves that problem, it will have a far
greater affect on encouraging investment in high tech than
anyone ever argued that this stock option thing has a negative
affect. If I am able to get that amendment passed, and I
realize it will be a matter of first impression to most of my
colleagues, I will support the bill, in which case, and I think
right now I am the only one speaking against it.
So we need to have a fair accounting system for tech
companies, one that recognizes that when you give a stock
option, you have given something, but when you have done
research and it is successful research, you have bought an
asset.
I yield back and I thank the Chairman for his indulgence.
Chairman Baker. I thank the gentleman.
Mr. Lucas?
Mr. Lucas. I am ready to hear from the witnesses.
Chairman Baker. Thank you, Mr. Lucas.
Mr. Miller?
Mr. Miller of North Carolina. I agree with Mr. Lucas.
Chairman Baker. And Mr. Hinojosa?
Mr. Hinojosa. Thank you, Mr. Chairman.
Chairman Baker and Ranking Member Kanjorski, I want to
thank you for holding this very important and timely meeting.
Chairman Baker, I want to note first and foremost that I am a
co-sponsor of your legislation, H.R. 3574, the Stock Option
Accounting Reform Act. I remain an ardent supporter of this
legislation despite FASB's March 31 proposed rulemaking that
would require companies to report as an expense the value of
stock options they give to executives and rank-and-file
employees.
In fact, FASB's recent proposed rulemaking demonstrates how
important it is that Congress pass your legislation,
particularly section three of your bill. Section three would
prohibit the SEC from recognizing as generally accepted any
accounting principle established by a standard-setting body
relating to the expensing of stock options pending the
completion of an economic impact study by the Secretary of
Commerce and the Secretary of Labor.
What everyone here needs to recognize is that stock options
are an important tool to attract talent to new ventures, and
that mandatory expensing of stock options will stifle their
issuance, reduce company profits, and deter innovation and
economic growth. FASB's proposed rulemaking likely would result
in the disappearance of stock options. The disappearance of
stock options will inhibit a company's ability to attract and
retain skilled employees.
If the FASB rule takes effect, many of the companies will
stop issuing options to their rank-and-file employees. There is
no reliable nor accurate formula to properly value them,
contrary to what FASB contends.
In closing, I want to include in my comments concerns that
I see in global competition with large importing nations like
China. Mr. Chairman, the Chinese government has incorporated
stock options into its 5-year economic plan to boost its
technology industry. As a member of the House Manufacturing
Caucus, I know all too well that many of America's
manufacturing jobs have already been outsourced to China, thus
negatively impacting our U.S. economy. FASB's proposed
rulemaking poses a similar risk in that venture capital
companies and high-tech companies might relocate to China or
other stock option-friendly nations if registered companies are
required to expense their stock options in the United States.
Mr. Chairman, I want to work with you and other co-sponsors
of your legislation to at least delay the implementation of
FASB's proposed rulemaking, either by passing your legislation
as a stand-alone measure, or working together to incorporate it
into other legislation to ensure its passage. Hopefully, we
will succeed in this endeavor.
I yield back the balance of my time.
[The prepared statement of Hon. Ruben Hinojosa can be found
on page 81 in the appendix.]
Chairman Baker. I thank the gentleman.
If there are no other members desiring to make an opening
statement, I want to welcome our witnesses to our hearing. I
hope you have enjoyed it today. We would like to remind each of
you that despite the length of members's comments, we do
request that each of you try to limit your remarks to 5
minutes. Your formal statement will be made part of our hearing
record. I welcome each of you. We look forward to your
comments.
I would turn first to Mr. Jeff Thomas, field applications
engineer, Altera Corporation. Welcome.
STATEMENT OF JEFF THOMAS, FIELD APPLICATIONS ENGINEER, ALTERA
CORPORATION
Mr. Thomas. Chairman Baker, members of the subcommittee, I
want to thank you for hearing my testimony today.
My name is Jeff Thomas. I am a field applications engineer
for the Altera Corporation in San Jose, California. Altera
Corporation manufactures and sells programmable logic devices,
which are semiconductor chips used in a broad range of
applications. In my role as an FAE, it is my responsibility to
provide on-site technical support to one of our largest
customers, which is a major telecommunications company.
In my daily work, I train engineers on how to use our
chips. I present our new technology to our customers and I
ensure that their systems are successful. I am here today
because I volunteered to participate in this hearing because
stock options have played a large role in my decision to pursue
a career in the high-tech field. I wanted to communicate to you
the impact that they have on employees as well as companies
that offer broad-based stock option plans.
I graduated from Carnegie Mellon University in 2000 with a
bachelor's degree in electrical and computer engineering. I had
job offers from a broad range of companies at the time of my
graduation. During my time at CMU, I had a couple of summer
internships at Fortune 500 companies, and both companies
offered me a job upon graduation. However neither offered a
broad-based stock option plan.
I also interviewed with a number of high-tech firms, and
every job offer that I got from a high-stock firm did include
stock options. So I decided that I wanted to work where I had a
stake in the success of the company. I decided I liked the idea
of being able to profit not only from my salary, but also from
the growth of the company.
In retrospect, I can definitely say I have seen a
difference in both the behavior and performance of employees in
high-tech firms that have a vested stake in their company,
compared to the people that I worked with at companies where
they did not have that ownership stake.
My first day at Altera, I was granted stock options that
would vest over the next four years. So after one year if I
stayed with the company, 25 percent of those options would
vest. If the stock price had gone up, I could buy and sell
those options and realize a profit. I could not transfer those
options or sell them on an open market of any kind. I could
only use them for my own personal gain.
Also each year at my annual review, I was granted a new
batch of stock options based on my performance that would
follow a similar vesting schedule. This ensures that I was
constantly motivated to stay with the company and continue to
work for its long-term growth .
Stock options are a great incentive for employees. People
work hard not only to advance their personal companies, but to
grow the company as a whole. They allow all employees to grow
into the success of the company. As the sales and profits of a
company increase, the employees benefit through the
appreciation of the stock price. This fosters an environment
where employees will go out of their way and beyond their job
descriptions to grow the company as a whole.
Stock options are also a strong motivation to stay with a
company. Because of their vesting schedule, employees are
incentivized to stay with a good company. Since I believe in
Altera's long-term vision, I want to stay with the company and
continue to build my ownership share in that company through
the stock option program. Because everybody at Altera has a
stake in the company, we are all committed to making the
company successful in the long term.
This behavior is not unique to Altera. I see this type of
dedication and work ethic at companies all around Silicon
Valley. All my friends, whether they work at big telecom
companies or small startups, share the same desire to see their
company become successful because they share a stake in that
company. Engineers in the valley often work long hours and
weekends to make sure their company succeeds because each
person has a personal stake in the enterprise beyond just their
salary.
Already in my career I can say I have seen the effect of
broad-base stock option plans in action. I have been able to
compare the atmosphere at a high-tech company in Silicon Valley
to some of the Fortune 500 companies I worked at as a summer
intern. I can definitely say that people in Silicon Valley work
harder, longer and care more about the long-term performance of
the company than employees that are just there to get a
paycheck.
Throughout my career, I want to continue to work at
companies like Altera that offer stock options to a broad base
of employees so that I can continue to work towards the shared
goal of increasing the company's value. I believe this promotes
an extremely valuable working environment.
I also believe that anything that would make it more
difficult for a company to grant stock options would hurt the
company's performance overall. The success of Silicon Valley is
based on the work ethic and dedication of its employees. This
work ethic is a direct result of the fact that employees know
that they will share in the success of their company. If
anything happens that would not allow the companies to offer
their employees a share in that success, I believe the overall
performance of that company would be hurt.
I sincerely hope you will consider these positive impacts
of stock options on both employees and their companies while
you are determining the fate of this bill.
Thank you again, Mr. Chairman and members of the
subcommittee. I am happy to answer any questions you have at
this time.
[The prepared statement of Jeff Thomas can be found on page
157 in the appendix.]
Chairman Baker. Thank you very much, sir.
I follow a script, Mr. Kruse, and I should have recognized
you first, but your name did not appear first on my list. So I
recognize you at this time, Mr. Douglas Kruse, professor,
School of Management and Labor Relations, Rutgers University.
Welcome, sir.
STATEMENT OF DOUGLAS KRUSE, PROFESSOR, SCHOOL OF MANAGEMENT AND
LABOR RELATIONS, RUTGERS UNIVERSITY
Mr. Kruse. Thank you. I am pleased to be here.
I am a professor at the Rutgers University School of
Management and Labor Relations. I am also Research Associate at
the National Bureau of Economic Research in Cambridge,
Massachusetts. At the NBER, I am working with Professor Richard
Freeman of Harvard University and my Rutgers colleague Joseph
Blasi. We are co-directing a project looking at shared
capitalist programs in U.S. companies.
I am also co-author of a book that came out last year, In
the Company of Owners, that looks at broad-based stock options
in U.S. companies, co-authored with Joseph Blasi and Aaron
Bernstein. I regret that I did not bring a copy of the book to
wave around. As Doug was pointing out, my publisher will never
forgive me for forgetting that today.
As part of the NBER project, we added some questions to the
2002 General Social Survey, a representative survey of working
Americans. I want to summarize a few results from that and some
other evidence for you very quickly. What we found was that 13
percent of private sector employees say they hold stock
options. That translates into 14 million stock option holders.
We also found that 23 million workers say they own company
stock, 15 million of them through employee stock purchase
plans.
Contrary to popular impression, most stock option holders
are not rich executives. In fact, a very striking finding, the
one that I would really point to, is in appendix one of my
testimony. It turns out that 79 percent of stock option holders
earn less than $75,000 a year, and well more than half earn
less than $50,000 a year. We provide a variety of breakdowns in
appendix two showing that the majority of the stock option
holders are non-managers. More than 90 percent say that they
are in the middle-or working-class, and they are spread across
regions and across the social and political spectrum. We do the
same thing in appendix three for holders of company stock, and
find very similar results. They are very representative.
I have strong reservations about expensing, since many
companies say that they are going to first cut broad-base stock
options if expensing takes place. There were four studies last
year in 2003 that analyzed hundreds of corporations. They found
that one-half to one-third were already making large cuts in
stock option plans. One-half to two-thirds planned cuts in
employee stock purchase plans.
One might say, well, maybe the companies are just crying
wolf. In the last few days, Joseph Blasi and I looked at the
first 10 companies to file SEC proxies for 2003 out of the
largest 20 companies, the Fortune 20 companies. Of these 10,
six had already announced that they will expense stock options.
Five of those six have already increased the share of stock
options going to the top five executives from 2002 to 2003, and
all six of them increased the share going to the CEO. If this
trend continues, we think it will be deeply troubling. It could
be bad not just for regular employees who will be cut out of
stock options, but it could be bad for company value as well.
We did a recent study on executive compensation over the
past 11 years in the 2,000 largest companies. We found that
increases in executive compensation, including different
measures of stock options, do not predict future shareholder
returns. In contrast, we surveyed over 20 years of evidence on
broad-based employee ownership, profit sharing and stock
options in chapter seven of our book, that I should be waving
around now. The evidence clearly shows that broad-based plans
are linked to higher productivity and shareholder return on
average; not in every company, of course, but on average.
It would be a shame if expensing discourages companies from
using and extending these plans that can improve performance.
Public policy should be encouraging policies that improve
performance.
So our conclusion is if there is expensing, it makes sense
to somehow preserve broad-based plans. One good approach could
be to expense just for the top five executives, as the current
bill proposes. If expensing does go through for all employees,
another possibility is to create a tax credit that would offset
the option expense only for companies with truly broad-based
plans. This could be an alternative to the existing deduction
when options are exercised, so it could end up actually being
revenue-neutral, a tax credit that would end up being revenue-
neutral.
Finally just as a last note, I call attention to another
House bill that would create a presidential commission on
employee ownership. Given the importance of all these issues,
given the debate around this, we think a presidential
commission on employee ownership could be a good way to explore
those issues.
Thank you very much.
[The prepared statement of Douglas Kruse can be found on
page 125 in the appendix.]
Chairman Baker. We thank you very much. You may wave the
book at any time you choose. Thank you.
[Laughter.]
We welcome next Mr. Douglas Holtz-Eakin, Director of the
Congressional Budget Office. Welcome, sir.
STATEMENT OF DOUGLAS HOLTZ-EAKIN, DIRECTOR, CONGRESSIONAL
BUDGET OFFICE
Mr. Holtz-Eakin. Mr. Chairman, Congressman Kanjorski,
members of the committee, the CBO recently delivered to
Congress a study entitled Accounting for Employee Stock
Options, which details the fact that employee stock options are
an economic cost to firms. They represent an exchange of value
in return for labor services, and displaying that value--
measured by the fair value or cash equivalent of the option and
recognized over a period that the labor services are used, the
vesting period--leads to a more accurate portrayal of net
income in economic terms.
Correspondingly, the failure to display this on financial
statements leads to an overstatement of economic net income.
Valuing employee stock options is a difficult task and is
complicated by features such as vesting periods, forfeiture
provisions and non-transferability of these options. However,
advances in financial analysis permit reasonable valuation of
such options, as they do comparable instruments such as
warrants which are currently held in many entities portfolios.
And such valuations are similar in their accuracy to those of
such complicated issues involving uncertainty as retiree health
benefits, the impairment of goodwill, or the cost of
environmental cleanup, which may occur in the future.
These are all currently displayed in the firm's financial
statements. One would anticipate that the increased use of
these techniques under the prospect of the proposed FASB
standard might lead to further advances in the ability to value
these options more accurately. Recognizing the expense of
employee stock options would not alter the economic
fundamentals of any business. It would not alter the markets in
which they compete for customers, their international or
domestic competitors, or the prices that they charge.
It would not have any impact on the labor markets in which
they hire their workers or the need for compensation and
appropriate incentives for those workers. It would not alter
the technologies that they currently deploy nor the incentives
to acquire and deploy new technologies. And fundamentally, it
would not alter the cash flows used to conduct their
operations.
Any potential economic impact of expensing employee stock
options will come through changes in investors's evaluations of
these firms. For savvy investors and for most firms, no new
information will be provided by moving the disclosure from the
current notes onto the face of the statement. Expensing would
simply make it easier and more broadly possible to do the same
valuations that are available today.
It is the case that some valuations may decline. If so,
those firms and their workers would suffer the costs and
experience disruption from the reduced availability of equity
capital to those firms in the near term. However some may also
rise, and on balance one would expect that there would be no
great overall impact on the U.S. economy and that any targeted
impacts on particular firms would be outweighed by the improved
allocation of capital on the economy, resulting in increased
employee productivity, and improved economic performance.
One cannot know for sure the overall economic impact in
advance of the adoption of the FASB standard. However, the
experience as displayed thus far for those firms which have
voluntarily undertaken expensing or from the experience from
countries such as Canada which has not only proposed, but
implemented an expensing standard, or the area of the European
Union which has announced a standard, but not yet implemented
it, all suggest that there would be no broad-based economic
impact.
Mr. Chairman, we thank you for the chance to discuss our
report today and look forward to your questions.
[The prepared statement of Douglas Holtz-Eakin can be found
on page 107 in the appendix.]
Chairman Baker. I thank you very much for your
participation in our hearing today and your statement.
Next, I wish to welcome Mr. Kevin Hassett. Please proceed
at your leisure.
STATEMENT OF KEVIN HASSETT, DIRECTOR OF ECONOMIC POLICY
STUDIES, AMERICAN ENTERPRISE INSTITUTE
Mr. Hassett. Thank you very much, Mr. Chairman.
I agree with Mr. Oxley and Mr. Ose, Mr. Chairman, that the
best reading of the literature is that right now the literature
is not exactly sure how to value these options. The literature
is not sure how to value these options because of issues
mentioned by Mr. Holtz-Eakin, but also because the options have
a much longer life than the type of options that are marketed
these days. To my mind, having been immersed in the technical
details since my dissertation, I think that is the most
relevant issue here.
Indeed, Warren Buffett himself said in the Financial Times
that the minute you get into longer-term options, it is crazy
to use Black-Scholes. The fact is that is true. In fact, this
issue has even made it into the leading text books, as is
mentioned in my testimony, and developed in more detail in a
recent paper prepared by Glenn Hubbard and Charles Calomiris
for the American Enterprise Institute.
So I think this explains why it is that FASB has been going
so slowly on this issue, given their clear designs on
expensing. The fact is, as you get close to expensing and think
about how to do it, contrary to Mr. Holtz-Eakin's statement,
you find that it is not the case that there is an accepted way
to do it, which is why FASB has refused to specify, it appears
to me in reading their documents, precisely how firms are
supposed to do it.
So in my testimony, what I do is really go after the
question that Mr. Frank raised in his opening statement. How is
it that you could actually change the world if the market is
efficient, if it is looking at the details on options already,
then if you move an expense calculation maybe that is incorrect
up to the top line, what effect does that really have on
anything? Just like if we subtracted 10 from earnings, then
what a rational investor would do is they would just add 10
back in. So if we do something wrong, the rational market ought
to see through it.
What I found after studying this issue with my colleague
Peter Wallison at the American Enterprise Institute, who as you
know is a very distinguished attorney who has worked for
President Reagan and has had other positions in town, is that
it is very likely that if we do not tell firms how to expense
options and know that we are basically giving them a problem to
solve that has not been solved by the literature, then we are
going to open up a real legal mess that will potentially tie
firms up in class action lawsuits for years and cause you to
have to consider new legislation.
In my testimony, I provide a simple example of the state
that I think we might end up in if FASB has its way. That is,
suppose that for example a publisher that finishes a book in
2003 and plans to send it to the book stores in 2004, is
required to forecast the sales in 2004 for that book by FASB
and include that in their 2003 statement. And FASB does not
tell them how to forecast it. They just say, you have to say,
since you paid for the expenses of the book in 2003 what the
sales are going to be in 2004.
Well, the firm would presumably try its best to develop a
model to forecast sales, but of course on average there would
be a whole lot of firms that would make errors. As soon as they
make those errors, the earnings will be misstated, and that
will open the firm up to class action lawsuits. It is my belief
and Mr. Wallison's belief, and we have spelled this out in
great detail in a paper that is just coming out in Regulation
magazine, that the real reason why the expensing of options is
going to cause firms to not use them as much as they do now,
and to shy away from them, is because if you do not specify a
model, then everybody is going to get the expense wrong.
Probably about half the firms at least are going to have over-
stated their earnings because their model led them to do that.
With that over-statement, they are going to find themselves
enmeshed in really difficult lawsuits.
So I think it would be a big mistake for FASB to require
the expensing of options without expressly stating how to do
it. If they expressly state how to do it, then the firm will at
least have the defense that we are just following FASB's
directions and that defense might well be a reasonable one and
a successful one. Absent that, I think that FASB is creating a
real mess for our corporations and one that will lead them to
shy away from the use of options.
Thank you.
[The prepared statement of Kevin A. Hassett can be found on
page 90 in the appendix.]
Chairman Baker. Thank you very much. I appreciate your
participation.
Our next witness is Mr. Phil Smith, chairman of the board,
Taser International. Welcome, sir.
STATEMENT OF PHIL SMITH, CHAIRMAN OF THE BOARD, TASER
INTERNATIONAL, INC.
Mr. Smith. Thank you, Mr. Chairman and subcommittee
members. It is a pleasure to be here. Let me give you a quick
background and then launch into what I have to say.
I have an undergraduate degree from West Point, MBA and I
have a PhD in business and a specialty in finance, so I clearly
understand all the theoretical arguments. I have been a
corporate officer in three Fortune 500 companies and I have
done five high-tech startups. I spent the last 35 years in this
business, so I have lived it from almost the inception.
I guess I am one of the few guys here who can talk from
practical reality and not some theory. I really get a kick out
of most of the people testifying yesterday in the Senate and
have never seen an option, used an option, have ever benefited
from an option or ever used them to try and attract employees
to a company. That is what is most disappointing to me. The
people that are really involved have had very little voice in
what is going on. I hope that this committee takes this to
heart.
I can give you one example, of these five startups. I did
one in the Silicon Valley in 1983 that we sold in 1985 very
successfully. The employees out of that company started 12 new
companies. They took the money they earned from the options and
literally like a thing exploding with seeds, 12 new companies
started in the Silicon Valley in 1985 from the people from that
company.
I can go through example after example. I do not have the
time. Options are used not only for employees. As I pointed out
in my testimony, when we went public 3 years ago at my current
company, Taser International, we were in need of some
interesting board members to comply with the corporate
governance that Chairman Oxley has been kind enough to levy on
all corporations in America. When you go out and talk to
significant board members and people with a strong background,
there is a real risk in coming on a public company's board
today. The trial lawyers love to have them. People are very
concerned about joining public boards, especially young public
companies. One of the ways we got the people we did, the
caliber we got, was the ability to use options.
Now, it turned out they have been very successful. They all
have made quite a bit of money as a result of that. But at the
time they took those options, they accepted the risk. You take
this option away from us and force to expense and I do not know
how we are going to attract these board members. We could not
have afforded to pay them the money it would have taken to get
them on our board and provide the governance that the Congress
is looking for.
The second thing is, it is a double whammy for small
companies. A current thing, our stock is extremely volatile. It
fell 32 percent yesterday, which happens to be just one data
point. The stock is up 6000 percent over the last 12 months. We
have what is called a very high volatility. We get penalized
because, one, we are a small company and secondly, we are
highly volatile. You take the measurement of our company. We
will get two penalties, not just one. One, we are small;
second, we are highly volatile.
Those will really impact the bottom line of our company,
and obviously a lot of our investors are retail investors. I
agree, the sophisticated investor can read the footnotes in our
balance sheet. They are cops. They are police officers around
the country that own 100 or 200 shares. They do not understand
the sophistication of footnotes, and they are not going to
understand when all of a sudden the earnings drop on the
company compared to other companies in the industry.
Third, I would like to talk about the issue of tax. Our
corporation has not paid tax for the last couple of years
because of employee options. When they exercise their option
and make the profit, they pay a personal tax. The corporation
gets the benefit. We have been able to retain that tax and use
it to grow, and we have grown our employee base to 199
employees from 70 a year ago by using that cash flow. It would
normally have been paid as corporate income tax. Nobody has
talked about the tax issue here, about the corporations that
are allowed to retain that tax, the cash on their balance
sheets and use it to grow.
Let me give you one last thing. We have stopped issuing
options. We have given all our employees their final options
this year. They vest by the end of the year, merely because of
this legislation. We do listen to what goes on in Washington.
We do watch what is going on and we are not about to penalize
our shareholders and ourselves by issuing a bunch of options
that we have to expense in future years. We have told our
employees there will be no more options if this passes, and the
only people that are going to get it are the top five.
My last comment, as Mr. Sherman mentioned, he tried to
contain executive compensation with the $1 million salary cap,
and we all see how effective that was. They just reported the
highest executive compensation in the country this past year, I
think it was in USA Today. So it had very little effect on the
top five. Your proposal will address the top five and let the
average employee have a chance to benefit in the success of
their company. At Taser, we have 20 millionaires, from
secretaries to production employees, right up the line. They
are the ones who are going to lose out. Those are the ones who
will not get the options. It will still go to the top five. I
certainly hope you are successful, Mr. Chairman.
Thank you.
[The prepared statement of Phil Smith can be found on page
152 in the appendix.]
Chairman Baker. Thank you very much for your contribution
here.
Our next witness is Mr. Robert Grady, managing partner,
Carlyle Venture Partners. Welcome.
STATEMENT OF ROBERT E. GRADY, MANAGING PARTNER, CARLYLE VENTURE
PARTNERS
Mr. Grady. Thank you, Mr. Chairman and members of the
subcommittee. I appreciate the opportunity to present this
morning, not only on behalf of the Carlyle Group, which is one
of the world's largest private equity firms, but also I serve
as a member of the board of directors of the National Venture
Capital Association. By coincidence, I also have taught for the
last decade on the faculty of the Stanford Business School,
which we will come back to in a minute.
The FASB has asked for comment on this exposure draft, and
our comment is simple. The proposal is inappropriate. It is
incorrect as a matter of financial and accounting theory. I
think it is poorly thought-out and it is very definitely
unworkable.
Before I comment directly on the exposure draft, let me
just offer a little context that makes clear the typical use of
stock options today in the economy.
The two venture capital funds that I spend every day
managing, which were started in 1997 and 2002 respectively,
have investments in about 38 different companies, all started
from the ground up. Those 38 companies employ over 4,000
people. In the five private companies on whose boards I sit,
Blackboard here in Washington, DC; Panasas in Fremont,
California; USBX in Los Angeles; Secure Elements out in the
Virginia suburbs; and Ingenio, also in California; incentive
stock options are granted to every single employee, from the
receptionist to the CEO. That is typical in the venture capital
world. In fact, according to a recent survey by the NVCA, over
70 percent of venture-backed companies award stock options to
every single employee. You heard Professor Kruse state that
half of all option holders in the country earn less than
$50,000 a year.
The standard type of grant in a venture-backed company is a
grant that is vested to encourage an employee to stay at the
company. A typical structure, in fact the most commonly used in
venture-backed companies, calls for the grant to vest over 4
years, just like the grants that Mr. Thomas received when he
joined his company, with so-called ``cliff vesting'' on the
first anniversary of employment of one-quarter of the options
and then monthly vesting of the remaining three-quarters each
month over the next 3 years.
That is an important point to understand about how options
work, because under the FASB's exposure draft, with its
provisions for graded vesting, the normal grant of stock
options, the one that virtually every venture-backed company in
America uses, will have to be valued 37 different times per
grant. Somehow, the FASB believes this will make financial
statements more understandable.
Let me turn to the FASB's exposure draft and how its
policies will work or not work if implemented. First, I do feel
compelled to start with a fundamental conceptual point, and
that is that options are units of ownership. They are shares.
They are not expenses. They are not claims of cash against the
company's resources. They are not the use of a company asset.
Basically, they should be treated and disclosed, in my view, in
the denominator, if you will, of the earnings-per-share
calculation. If you account for them in both the numerator and
the denominator, you are double-counting them.
So if in fact FASB were proposing in this exposure draft
that when companies report earnings per share, they had to
disclose in every case the fully-diluted share count, that is,
including all options outstanding in the denominator, I think
that would be a fair and very workable proposal. I think this
point is essential, because at its heart, what this debate is
all about is that many Americans, and in fact people all over
the world, are willing to trade off cash compensation for units
of ownership. They are willing to earn less cash today and
thereby create less in terms of ongoing expenses by the
company, so that over the long term the company will be worth
more. In other words, they are thinking like owners. It is good
for other shareholders who might choose to join them along the
way that they are thinking like owners, because their interests
are aligned as mutual owners of the securities of the company.
Ironically, the proponents of expensing say that requiring
it will not have the dire effect that many predict, that some
of us predict, because they say investors will just in effect
ignore it. Investors will basically strip out the effect of
expensing and look straight to cash EPS. So in other words,
they will ignore GAAP. The reason they will do it is precisely
because it will not be representative of the company's true
expenses. That is exactly what I believe Representative Frank
was saying, if reality does not change. So the irony of the
FASB proposal, in other words, is that it is likely to
undermine confidence in and the use of GAAP accounting, which
one presumes to be the exact opposite of the objective of the
proposal.
In the gymnastics that FASB has had to go through to get
over this fundamental point, in trying to define units of
ownership as expenses instead of shares, they have created a
number of problems that I would just like to touch on and
enumerate briefly.
The first obstacle, of course, is trying to define the
appropriate measurement date at which to value an option. There
are two different possibilities. The FASB has suggested that
the grant date is appropriate. The problem with this, of
course, is that the value of the option at grant date is highly
uncertain. It may never vest. The employee might leave. It may
never be exercised because the stock may never be ``in the
money'' during the appropriate time frame.
An alternative is to move the measurement date to the
exercise date, and that would even be worse because it would
simply penalize the most successful companies, those with the
brightest prospects, for the mere fact that their stock has
appreciated. You have heard the example of Taser. Their profits
would be wiped out by the mere fact that their stock had
appreciated, regardless of the performance of the company.
A second problem which the committee has discussed today is
how to value what an option would be worth. FASB suggests using
observable arms-length transactions, but of course for private
company options they have never traded, so the value of the
option has to be modeled somehow. There is a choice of modeling
and methodologies to use, and whatever choice you make leads to
a radically different assessment of value.
That, of course, leads to the third problem, which is that
any of the models that one could choose, including Black-
Scholes, named for the late Fisher Black and my former
colleague at the Stanford Business School, Myron Scholes, and a
binomial model for that matter, rely on one key variable and
that is the estimate of the volatility of the underlying stock.
Of course, since private company shares have not traded, any
estimate of volatility is basically a guess. Actually, FASB
makes it worse because they say we are not to look at
historical volatility; you are to estimate future volatility.
So any estimate of volatility will be subject to both potential
manipulation and inaccuracy.
That, of course, leads to a fourth problem, which is to try
to get around this problem of estimating in advance the
volatility, FASB has given private companies in the proposal
the option to use intrinsic value as a way of valuing options.
Under this methodology, the value of the option is adjusted for
every reporting period, every quarter, or in some cases of
private companies, every month, and is changed to reflect an
estimate of value or stock price if it is a public company.
That is basically a form of variable accounting which brings
stock price directly into the income statement of the company,
and of course introduces the potential for wild swings from
quarter to quarter of the value of any given option, so it will
be massively confusing for investors.
The fifth problem is that FASB ignored that most private
company employee options are highly restricted. That is, they
are not only subject to vesting, but they cannot be
transferred; they cannot be hedged; they cannot be pledged;
they cannot be sold. So it is very hard to value these
restrictions. Interestingly, FASB argues that no restrictions
that exist during the vesting period should even be considered
in valuing the options. Clearly, an option that is subject to
restrictions is worth less than an option that is subject to no
restrictions, yet FASB would have them be recorded at exactly
the same price. So much for the concept of fair value.
Finally, in seeking to identify the proper time period over
which to attribute the expense that the exposure draft would
require, the FASB creates a whole new set of problems. For
example, the exposure draft suggests that companies should try
to model or predict the groups of their employees for purposes
of predicting their exercise behavior. That is because the
proposal calls for them to adjust the contractual term for
expected early exercise or post-vesting behavior. Obviously,
that would be a completely speculative exercise that would be
almost preposterous in its unreliability.
All of these obstacles, by introducing theory, uncertainty
and subjectivity in place of the actual experience, which is
what financial statements are supposed to reflect, will make
the income statements of companies less reliable, not more
reliable.
In the end, Mr. Chairman, I think what is clear from FASB's
proposal is, as you suggested in your opening statement, that
it is responsive not to the volume of comments it has received
from the venture capital community or companies that use
options, but rather to the political process. I do believe this
is fundamentally a political proposal and, as you said, Mr.
Herz is quoted as inviting people to contact their
representatives. I do believe it is in response to something
that has nothing to do with employee options, which is the
reported abuses at places like Tyco, WorldCom, Adelphia, et
cetera, where people stole company resources, allegedly, or
reported incorrectly the financial performance of the company.
In this regard, the National Venture Capital Association
does support the legislation you have proposed. We believe it
is responsible. We believe it is appropriate to exempt private
companies where it is impossible to value the options from the
expensing requirement. Having taken 175 or so companies public
in my career, I believe it is appropriate to exempt companies
during their first three years of being a public company so
that you can get some trading experience and understand how to
assess the volatility of the stock. With that, we do hope that
the Congress will act on your proposal.
Thank you, Mr. Chairman.
[The prepared statement of Robert E. Grady can be found on
page 84 in the appendix.]
Chairman Baker. Thank you very much.
Our final participant this morning is Mr. George Scalise,
president of the Semiconductor Industry Association. Welcome.
STATEMENT OF GEORGE M. SCALISE, PRESIDENT, SEMICONDUCTOR
INDUSTRY ASSOCIATION
Mr. Scalise. Thank you, Mr. Chairman and members of the
committee. I am George Scalise. It turns out I have been in the
semiconductor industry for about 45 years, so I have seen it
from the very earliest days and I have seen what stock options
have done to help build this industry from a startup to what is
now a $200 billion a year industry. I also have been the
beneficiary of that process of stock options.
First of all, the SIA strongly supports H.R. 3574 and we
commend the leadership of the Chairman as well as the 30
members of the committee that are co-sponsors of the
legislation. Going back to the industry for just a moment, the
U.S. semiconductor industry, the U.S.-based companies, are the
most competitive in the world today and have been since the
onset of this industry. We currently have about 50 percent of
that $200 billion a year market. It turns out that only 20
percent of that market is here in the U.S. However, about 70
percent of our manufacturing is located here in the U.S. The
average employee earns about $97,000 and we have about 255,000
employees here.
So this program that we are talking about is very vital to
this industry and has been since the onset. Semiconductors, as
you probably know, are the building blocks for the whole
information technology market, which is now a $1 trillion
export market for the U.S. So whether you are talking about
equipment or software, it does not really matter; whether it is
games or automobiles, they all embody semiconductors.
The other thing that is important about this is that
semiconductors and the IT industry now represent about 8
percent of the economy, but it turns out they are more than 30
percent of the growth; they reduce inflation by about 1 percent
a year; they increase productivity by about 1 percent a year.
As a consequence, they make a major contribution to the overall
economy.
Keep in mind, our prices go down every year by at least 30
percent. Every year the prices go down by at least 30 percent.
So if you bought a bit of memory in 1995 for $1, you would be
paying about 2 cents for that today. In a few more years, you
will be paying 1/100th of a cent or less than that as we go
along. So this kind of contribution is something that we need
to find ways to encourage and support and make continue to
happen going forward.
Going on to the competition, as I said, this is a worldwide
market. It is also worldwide competition. As someone said
earlier, our competitors overseas have now seen the wisdom of
using stock options as a method of dealing with their
employees, compensating their employees. In a recent forum that
we had at Stanford University, about a month ago, we had
representatives from Taiwan, China, Korea and the U.S. talking
about the industry and what was going on, and what the
competition was all about. One of the folks from Taiwan pointed
out that they do not really have a cost associated with stock
options because there is no tax benefit, therefore they can
grant these very lavishly, if you will, and the employee gets a
great benefit from it.
As a consequence, they have now attracted about 5,000 of
some of the very best engineers we have in this industry, to go
to Taiwan to be a part of the industry there today. Now,
granted, a number of our employees are foreign-born. They come
to our universities, are trained, and they come to work with us
here. But up until very recently, they have been employees that
stayed with us. We are now beginning to see that migration
reversing and going the other direction. In large part, it is
because of the kind of compensation and the kind of tax
structure that is associated with stock options.
Let me just turn for a moment to the accounting side of
this, because I know that is one of the important arguments
that is being put out here. I think that our greatest concern,
I think you have seen editorials on the part of some of our
CEOs in the industry, who are making it very clear that if
there is going to be a change, the investing public is going to
have to see something that is very transparent, that is very
accurate, and is very comparable from company to company. I
think the evidence that we have heard about here today, and I
do not want to go into it again because I think you have heard
it, is that that is not possible with the proposal that is in
front of us today.
Therefore, I think the legislation that is being proposed
to take a hard look at this and make sure we understand just
what the consequences are, is very, very critical, so that we
do not make that mistake of adopting something that is not
going to be transparent, that is not going to be accurate, and
will not be comparable from company to company. That would
create more confusion, and in particular it will disadvantage
the small investor versus the professional investor by a wide
margin. That is the last thing that we should have happen.
The other point that I would like to make is on the stock
purchase plan, which is a very important part of all of our
companies. Again, the companies that have stock purchase plans
is for 100 percent of the employees, just like our stock
options are for anywhere from 80 to 95 percent of our
employees; in some cases 100 percent. That will absolutely
destroy the employee stock purchase plan if this proposal goes
forward.
Again, I think this is one of the great opportunities for
young people to get their first real shot at building equity
for themselves and their families is through these stock
purchase plans. They are very, very quick to unfold, and again
if the company does well, these people can do very well and
they can begin to buy their homes and do the other things that
young families do. So I think it is very important that we make
certain that we maintain the vigor and the opportunity
associated with employee stock purchase plans.
Finally, as far as international convergence is concerned,
I do not really see why we have to rush to try and come
together with IASB and whatever their proposal happens to be,
because first of all I do not think there is a timetable
associated with that that is going to necessarily come to pass.
There is a lot of controversy with the European companies on
the IASB proposal, and therefore I think we ought to set that
aside as having no real validity as far as consideration as we
take a look at this FASB proposal that is in front of us.
Thank you. I am ready to answer any questions.
[The prepared statement of George Scalise can be found on
page 148 in the appendix.]
Chairman Baker. Thank you, sir. Before I proceed with
questions of my own, I just want to yield time to Mr. Shadegg
for purposes of an introduction. Mr. Shadegg?
Mr. Shadegg. Thank you, Mr. Chairman.
I simply want to welcome Mr. Phil Smith of Taser
International, chairman of the board. I apologize. I was across
the hall in a hearing of the Commerce Committee which happens
to be dealing with some issues that affect Arizona, Luke Air
Force Base, the Goldwater Range right now, so I had to be there
and could not be here during opening statements.
I welcome Mr. Smith. Taser is located in the metropolitan
Phoenix area where my congressional district is. I appreciate
his testimony here today. Mr. Chairman, as you know as a member
of the Congress who is deeply concerned about the FASB proposal
and believes the better alternative is in fact the legislation
you have introduced, I appreciate Mr. Smith's comments on that
point, and I simply wanted to be able to welcome him to the
committee as a fellow Arizonan.
Thank you, Mr. Chairman. I yield back.
Chairman Baker. Thank you, Mr. Shadegg.
Professor Kruse, I am interested based on your study of
industry practice that is evident in the book. In identifying
the problem that started the current academic discussion, was
there evidence in your view of broad-based plans being
manipulated adverse to either the corporate or public interest?
Mr. Kruse. With respect to broad-based plans, no. We came
to this interest in broad-based plans out of a couple of
decades of research we have done on broad-based employee
ownership, profit sharing, programs that involved employees in
company performance. That is where we came at it from.
When we looked into broad-based plans, doing very extensive
research on this, both quantitative and qualitative research,
we did not find the broad-based plans being manipulated in the
way that a lot of the executive plans obviously have been.
Chairman Baker. Is it not true that with regard to SEC rule
treatment of the top five proxy requirements for disclosure and
disclosure of compensation, that there is now precedent for the
top five being treated differently today from others within a
corporate reporting structure?
Mr. Kruse. Yes, that is true.
Chairman Baker. So I can make the legitimate claim that the
selection of the top five is consistent with other body of law
and regulation by way of special disclosure for those set of
individuals?
Mr. Kruse. I believe so.
Chairman Baker. Thank you.
Mr. Grady, you made comment with regard to the difficulty
of predicting accurately volatility in a startup company. Is it
not the case that FASB now and has historically allowed
privately held corporations to set volatility at zero?
Mr. Grady. Yes. The current rule allows minimum value to be
the methodology used in calculating the value of an option, but
the proposed rule disallows the use of that going forward. It
actually complicates matters by allowing three different ways
for options to be valued. It says for the old options, you can
use minimum value, but going forward you have to switch to
using one of the models I suggested, one of the lattice or
binomial models.
Chairman Baker. Let me help make that point. Where you have
a historic record and could possibly predict volatility, you do
not have to; and going forward on startups that you can't, you
are going to be required to.
Mr. Grady. Right. Well, for all options going forward under
the proposal. Yes.
Chairman Baker. Mr. Smith, you discussed the fact that in
your corporation you have now given notice to employees going
forward that this year's grant of options is it. It has also
been stated by others on the panel and from other reports that
foreign competitors now put banners up at job fairs, ``options
granted.'' What is the potential impact from your perspective
on future startups on innovation if we, within the United
States, preclude granting of options without expensing, and our
competitive industries in international markets are allowed to
proceed as they have historically, given the allegations of job
economic recovery and all the concerns about outsourcing.
Mr. Smith. In our company today it is not as important as
it was. We are now a pretty visible company and we have a lot
of cash. But when we started the company, over the 11 years it
took to get there, it was extremely important. We were hiring
people at below-market wages, no question about it. Our average
people make $40,000 a year, by the way, that have the stock
options that I referenced in my written statement. So it is not
the high-paid people.
We have a lot of people who come into the company and take
those jobs. Think about it. A person is sitting in a large
corporation with a 401(k), a pension plan, great health
benefits, and you are going to give him a chance to come into a
less-than-ideal working environment, nothing is fancy in a
small startup company. It is pretty rough-going. You ask him to
work 12 or 14 hours a day, and they don't generally have very
good health benefits and certainly do not have 401(k) or
pension plans. What is the incentive for a person to do that?
And you are going to pay him less money?
I remember when I left Boston, I was working for
Computervision. It was a Fortune 500 company at the time. We
were standing in a 9,000 square-foot house, and my wife says:
let me understand this; you are taking a cut in pay to 40
percent of what you are making now; you have options in a
company which is out of money, it was a venture startup; and I
am going to have a house that is about as big as the garage on
this house. Why am I not excited about moving to the Silicon
Valley?
That is the issue. You have to have some compensation for
these people to take that risk and make those moves. I have
done it multiple times in my life. I have been broke more times
than I have made money by doing that, but that is the whole
part of an entrepreneur. Getting these people to take that
risk, you have to offer them something.
One thing I would like to point out. I do not know why we
are in such a rush to be like everybody else. The last thing I
want to be is like everybody else. Everybody else in the world
did not create the growth engine and jobs that we did in the
Silicon Valley, right out to the beltway here with AOL and MCI
and many great companies got started. These options were an
instrumental part of it.
I do not know why we are in such a heck of a hurry to go
out there and dismantle the machine that has worked and served
us so well in the past, especially now when we need to develop
the next new thing to put people back to work in this country.
I would not be tampering with anything in this area for the
next couple of years until we find what the next new thing is
and get these people back to work.
A long-winded answer.
Chairman Baker. I thank you for the answer. It is sort of
like the fire department showing up when the house is on fire
and simply burning the rest of the neighborhood. It just does
not seem to be a responsive solution to the problem at hand.
Mr. Frank?
Mr. Frank. Thank you, Mr. Chairman.
I would just say to the previous witness that I do not know
when you sold that house, but given what has been happening to
house prices in Massachusetts, a 9,000-square-foot house, you
would have to have some pretty good options to beat what you
could have made on that if you had held it.
I want to just expand on what I said before. Let me talk to
the people who are in the industry, who have told me, and I
take this with great seriousness, that if the expensing
requirement goes through they will stop giving options. I guess
we ought to be very specific why. Obviously, the reality will
not have changed. Why will you have to stop giving options? Is
it the reaction of the investor community, the lender
community? What will require you to stop granting these if the
reality has not changed, but the way in which you are to
account for them does?
Mr. Smith. Is that question for me, sir?
Mr. Frank. Any of you.
Mr. Smith. I will take a shot at it. We stopped it because
we do not want to impact our operating performance next year
for our shareholders because of these options being expensed.
Mr. Frank. Excuse me. The question is this, it is not the
reality. So the shareholders, what will cause the share price
to drop? Is it the reaction of an investor community that says,
hey, they moved this from the footnote to the bottom line. That
is my frustration.
Mr. Smith. Let me explain it to you. I think you were out
of the room. A lot of our shareholders are policemen. They are
cops. They own 100 to 200 shares of our stock. When they look
at the income statement, they have no idea what footnotes are
or anything else. All of a sudden they are going to see this
dramatic change next year. I would say a good 40 percent----
Mr. Frank. There are two problems with that. I would hope
we could try to just educate the community. Cops have to be
fairly sophisticated about something. The other thing is,
unfortunately your arguments cuts a little bit both ways
because one of the arguments people have now is, well, that
information about the options is already there. It is in the
footnote. When you argue that while it is in the footnote, they
will not read it, you are unfortunately frankly giving support
to some who say people do not know it is there. It cannot be
both. It can't be available and impervious.
Mr. Smith. I am going to make one comment and pass it off
to some of my colleagues. If it ain't broke, don't fix it.
Mr. Frank. I am sorry. That is not good enough for me. We
are here in a deliberative process and I am trying to express
the sympathy I feel. But sloganeering like that does not help
me. I am not a car. Don't put a bumper sticker on me. I am
asking you a question and I want an answer. There is a problem
here. It may lead us to a broader problem. Your argument
appears to be that the investor community on which you have to
depend, in particular an investor community because of the
nature of your product that is not the broader one, does not
understand this. We need to have more than just a bumper
sticker.
Mr. Grady?
Mr. Grady. Congressman Frank, I think it does beyond that.
What clearly will happen if you move it into the income
statement, it will reduce, of course, the reported
profitability of the company, even though the operating
circumstances of that company will not have changed, the cash
will not have changed, the cash expenses will not have changed.
Mr. Frank. No reality will have changed.
Mr. Grady. But it will radically reduce----
Mr. Frank. Okay. Who will be influenced by that?
Mr. Grady. I think investors will be influenced by that.
Mr. Frank. Okay.
Mr. Grady. As we have discussed during the hearing, the
method by which people will calculate how much that expense
will be will be highly variable from company to company. It
will make, in effect, the reported P/E ratios of all companies,
which is how the comparing is done, less comparable.
I will give you a real world example. The way people
calculate earnings will be just considerably more different
from company to company because there are all these
methodological issues.
Mr. Frank. But can't you say, then, look, this is the way
it used to be, and this is the reason for that volatility. It
is there now, the reality is there now. Options are clearly not
a nothing. They have some impact.
Mr. Grady. The reality is there now and most investors, to
your point, are sophisticated enough to look at the fully
diluted share price and calculate their EPS.
Mr. Frank. Are they able to make comparisons?
Mr. Grady. The sophisticated investor will strip out the
option expense and compare cash EPS, which means they will
render GAAP irrelevant.
Mr. Frank. Are you saying a sophisticated investor would
disregard the existence of options in deciding whether or not
to, you say, strip out. Please let me finish the question, Mr.
Grady.
You are telling me that the sophisticated investor would
simply ignore the existence of the options? I assume that is
what ``strip out'' means.
Mr. Grady. They would ignore it for purposes of comparing.
Mr. Frank. Mr. Grady, please stop, because I think you are
obfuscating, unintentionally.
Mr. Grady. No, I am not.
Mr. Frank. Then I may be, but here is the deal. I am an
investor and I am trying to make a decision. When I make a
decision based on, I do not invest in any real companies
because we get enough people claiming we are guilty of conflict
of interest, so fortunately I am free of that, but I am an
investor and I am looking, you say, well, after the FASB thing,
it will be hard to make comparisons. But how do I make the
comparison now?
Presumably, if I am a sophisticated investor and I am
trying to decide between one or another company and one has a
certain amount of options and one does not, and another has
options. How do I value those now? Or do I not take those into
account in deciding when to invest?
Mr. Grady. You do take them into account, as I said, in
determining the share count for the company in the denominator
of the earnings-per-share calculation. I believe that people
will continue to do that.
Mr. Frank. But is that easier to do now than it would be
later? Why? Why is it easier to make those comparisons now than
it would be if the accounting treatment differed?
Mr. Grady. The ability to calculate the number of shares
will be the same as it is now. What will be different will be
the quality of the earnings being reported.
Mr. Frank. I understand that. But you understand that those
are just affected by the accounting. The reality has not
changed, has it?
Mr. Grady. The reality is being proposed to be changed, and
that is that people have to take into----
Mr. Frank. They do not have to. Investors are free to make
his or her own decisions. The company is still there and those
things are still there and the investor can still make the
decisions based on----
Mr. Grady. Here is what will change, I believe, in reality.
The most common means by which investors compare stocks is
price/earnings ratio. You will now have a wildly different set
of assumptions that go into the ``E'' in a PE ratio.
Mr. Frank. Okay. My last question is this, because here is
what we are saying is that frankly the people who are getting
more beat up here are the investors who do not come out of this
looking all that smart.
Mr. Grady. But I think----
Mr. Frank. Excuse me, Mr. Grady, please stop interrupting.
This is just not helpful. The point is this, what you are
telling me is that if FASB's rule goes through, even though the
reality of the company will not have been changed if they
continue to give options, investors will look only at the P/E
and will make bad decisions. They will make decisions on
inadequate information. Inevitably, this has got to be
something of a negative judgment on the investor community
because you are saying if you do this, they will just look at
the P/E and that will make this enormous difference to them,
when in fact you were telling me it really should not, given
that this is a perfectly reasonable thing to continue to do.
Mr. Grady. May I make one comment?
Mr. Frank. Sure.
Mr. Grady. I believe that to avoid the confusion, which we
were both just speaking about, what will happen is people
creating the companies, people starting the companies, people
running the companies will say, to avoid the confusion I will
use more cash to reward employees and less options.
Mr. Frank. I understand. But the confusion is on the part
of the investor who is reading the situation.
Mr. Grady. Which means less companies will be started.
Mr. Frank. I understand that. The question is why that
would be the case. It really does come down to apparently a
lack of confidence that investors will be able to sort this
out.
Mr. Grady. Right. I believe this will make reporting more
confusing, not less confusing.
Mr. Smith. Let me add one thing. Reporting is one thing.
Hiring employees is another. If you are out there, Mr. Frank,
and you are trying to hire employees as a young startup company
and you are competing against well-established big companies
that have much better benefits, better pay, et cetera, what the
heck are you going to offer them?
Mr. Frank. Excuse me. You totally misunderstand my point. I
understand that, that options are attractive. What I was trying
to get at is, what about FASB would lead you to stop issuing
options? That is the question. So your answer is totally
irrelevant to what I was asking.
Mr. Grady. It is the cost, the cost on the bottom line.
Mr. Frank. I have gone over my time and I do not think this
is going to be enlightening.
Chairman Baker. If the gentleman would yield for just a
minute, I appreciate the gentleman's sincere effort at this. I
just want to make one small explanation if it might be helpful.
It does change economic reality in this case. If there is a
granting of an option at a fixed price, and going forward the
price does not move in the money and the option is not
exercised, the FASB requirement would require you to expense
that in the current dollar disclosure, so you would have a
negative impact on the corporate profit, which is not an
accurate disclosure of true financial condition.
However, going forward if the option is exercised at a
higher dollar price, I think argument can be made that
contributions of those individuals who are engaged in the
corporate structure as a result of the grant of the options,
have increased value and therefore the dilutive effect on the
residual shareholders is minimal, if at all. So it is not 100
percent accurate, but I think the negative effect of expensing
when they are not exercised is far worse than the residual
effect of expensing at the time of exercise, which is now
required.
Mr. Frank. I thank the Chairman. That is in the spirit of
what I was saying. Again, it all comes down, unfortunately, to
the way it is perceived. Let me just say one further thing, Mr.
Chairman. I just want to now, in the absence of the Ranking
Member of the subcommittee who had to leave, I just want to
notify you that we are going to use our Rule 11 rights to ask
for another day of hearings. A letter with the appropriate
number of signatures will be delivered to you before the end of
this hearing so that we can have another hearing.
Let me just say, this comes from people both for and
against the bill. This is not a sign that people are against
the bill. This is just an important subject and we will be
asking for it. There is no reason that they should hold up any
schedule of any action, so it is not to be taken as hostile to
the bill.
Chairman Baker. The Ranking Member had indicated to me his
interest in that, and I said I have no such reluctance, but out
of courtesy to the chairman I have not had a chance to visit
with him about the schedule.
Mr. Frank. That is why we thought we would use Rule 11,
because that is an option to the chairman. He is a busy fellow.
We do not like to bother him.
[Laughter.]
Chairman Baker. We always appreciate your creative
assistance in the conduct of the committee.
[Laughter.]
Mr. Frank. Mr. Chairman, I cannot take credit for creating
Rule 11. That somewhat pre-dates me.
Chairman Baker. I recognize that and am thankful for that.
Chairman Oxley?
Mr. Oxley. Thank you, Mr. Chairman. I certainly would not
have any objection to another hearing on this matter. It is
complicated and difficult, but very, very important in terms of
our economic future in this country.
Mr. Grady, good to see you again. Welcome back to Capitol
Hill.
Mr. Grady. Thank you, Mr. Chairman. It is good to be here.
Mr. Oxley. It is good to know that there is life after work
at the White House.
[Laughter.]
You had emphasized in your testimony the issue of
competition, particularly as the FASB proposal may very well,
as I understand your testimony, put us at a disadvantage versus
some of the Asian tigers, for example, that have learned some
things, apparently, from our system and are quite aggressive in
that area. I wonder if you would care to comment specifically
on the competitiveness issue. Mr. Scalise and others that want
to join in, I would be glad to hear from you as well.
Mr. Grady. I think you can look in both directions, both to
the east and toward Europe as well. I was struck by something
that the Director of CBO said regarding CBO's study and saying
that they did not see different effects in Europe versus the
United States, where IASB is now of course proposing expensing
of stock options.
What is observable is that I believe the United States has
outperformed the EU countries quite substantially, and I
believe one of the principal reasons that has been true is
because of the availability of risk capital, which has gone
into startups, and because of the contribution of startups to
U.S. GDP. What you now see is Europe has lower levels of
venture capital investment, lower economic growth, and
considerably higher unemployment. That has been the case for
some time.
We did a study at the National Venture Capital Association
to try to measure the contribution of venture-backed companies,
mainly startup companies, to the U.S. economy. I refer to it in
my written testimony, but I think it is important to highlight
the results to the members. It showed that venture-backed
companies in the year 2000 employed directly 12 million
Americans and directly and indirectly, as Chairman Baker said
earlier, 27 million Americans. Some of the other findings were
that these companies accounted for $1.1 trillion in sales or 11
percent of U.S. GDP on far less than 1 percent of the invested
capital in the country for the entire 30-year period measured.
So the job-creating leverage of these startup companies has
been very high. The principal tool that they have used, as
everyone on the panel has noted, has been to on the one hand
pay people less cash, but by allowing them to trade-off units
of ownership for cash compensation. That has been the model
that has worked. People have wanted a piece of the rock. I do
believe, as a number of witnesses and Mr. Smith have said,
Taser is witnessing it and other companies are witnessing it on
the competitive front, that people in both companies in Taiwan
and China and elsewhere are advertising their willingness to
give ownership to employees as a way of inducing them to come
to work there.
Mr. Oxley. So really one of the concerns, the latest buzz
word around here, is outsourcing, and we are hearing all about
that. In fact, this issue certainly cuts into that entire
issue, does it not?
Mr. Grady. I believe it does, because it will also raise
the cost of creating the jobs here in the United States, as I
was attempting to comment to Mr. Frank. I believe what will
happen is that at the margin, startup companies will be
required to raise more cash with which to compensate employees,
which just means there will be less startups funded because
there is only in effect so much cash to go around. So I think
this would be adverse to the job creation prospects of the
economy going forward.
Mr. Oxley. Thank you.
Mr. Smith, why are so many CEOs opposed to expensing? Is it
because it would lower the value of the options? From a CEO's
standpoint, what is the major issue that you have with the
proposal?
Mr. Smith. I think Mr. Grady covered it pretty well. It is
the valuation of the company. People look at price/earnings to
justify purchasing or not purchasing a stock, the availability
of capital in the equity markets. One of the things I pointed
out before you came into the room, and that is we were able to
attract some pretty significant board members on our company by
using options. Without those, I frankly do not know how we
would have gotten those people to come on and help us with the
corporate governance we are now facing.
That is a real issue for small companies. You do not have a
lot of cash. You have a lot of risk to offer people that come
on the board. The trial lawyers love small public companies
because their stock is pretty volatile and they generally get
into a lot of stockholder lawsuits in which directors do not
want to be involved. So I frankly am at a loss. This is going
to be my last startup. I would be concerned about how you are
going to get the right types of individuals to sit on these
boards if you take away some of these incentives.
We just stopped giving them. We have already told our
employees no more options. They all vest by the end of this
year. That is it. If this legislation passes, the only people
that are going to get them are going to be the four or five
senior people at the top. I do not know what we are going to do
in the future going forward.
Mr. Oxley. That is interesting. It hearkens back to our
hearings we had on securities litigation reform, which I think
really did enhance our knowledge about what was going on out
there. One area that has not been well discussed, and I am glad
you brought it out, was the large potential for litigation in
these areas, to the point where some of these trial lawyers
were having computers that essentially spit out complaints
based on a loss of value in the market. Quite extraordinary,
and that ultimately led, as you know, to passage of that
legislation, and I think I am right, the only veto President
Clinton had overridden, with a strong bipartisan effort on both
the House and the Senate.
So I think you have touched upon another interesting issue
that is certainly important in this debate, that I had not
considered until recently. I appreciate your testimony.
I yield back.
Chairman Baker. I thank the Chairman.
Mr. Scott?
Mr. Scott. Thank you very much, Mr. Chairman.
It is the general feeling on this committee that you
support H.R. 3574, the basically immediate expensing of the top
five executives's stock options. Correct? And that the concern
is that it goes no further, that there be no expensing of
options for rank-and-file employees. In this legislation, it
does not exactly, it is my understanding and I am a co-sponsor
of it, but what we are saying is that no further expensing of
these stock options until a couple of things take place; that
there be an economic cost-benefit analysis study of different
elements; and that the accountants come up with a more accurate
way of measuring cost.
What say you about that? Is that enough to register safety
on any concerns that we go beyond? I am not sure what I am
hearing here, and especially from you, Mr. Smith. Did that
satisfy you?
Mr. Smith. Let me just say one thing. My mother had some
ugly kids, but no dumb ones. What I have worked out is that we
are not going to get this thing through. I think expensing any
options is a bad idea, but I am practical enough to understand
to get some change, to hold off this gigantic force to get
options expensed, we are willing to concede to the five top
people.
I think we do need a study because I think there are some
real impacts people have not thought about, not only the
lawsuits that are going to erupt, the cash that young companies
are using from these employee options. The way it works is if
an employee exercises their option, they pay the government
taxes, but the company gets a credit for that. It keeps our
cash and allows us to hire more people. I do not know whether
anybody has even looked at that aspect of this thing.
There is an enormous tax base sitting out there of cash
being used by young startup companies to fund their operations.
If you take that availability of cash away and they now have to
pay taxes to the federal government, you are going to start
impacting these small companies's growth. So from those
aspects, I would like to see nothing expensed, but being a
practical person, as I said, my mother did not have any dumb
kids, we are deciding this is the best option we can see to go
forward. We think those economic studies will prove that out in
the future.
I will yield to my other colleagues.
Mr. Scott. Professor Kruse, what percentage of companies
that offer stock options offer them to a broad spectrum of
their employees?
Mr. Kruse. I do not have a ready answer to that off the top
of my head what percent do. We have found that at least in a
related survey of companies, we did find that about 3 percent
of companies gave broad grants to employees, to more than 50
percent of their employees in the past year. But the number
that may have done that in the years prior to that, we do not
know. Still, 3 percent of companies gave grants in the past
year and that is consistent with a BLS study as well.
Mr. Scott. And you believe the FASB rule would act as a
deterrent to incentives for the rank-and-file employees?
Mr. Kruse. Based on what companies are saying, that this is
going to be something that causes them great concern, that they
are likely to cut back on the broad-based plans and encourage
concentration of executive options.
Mr. Scott. Mr. Scalise, you mentioned that stock options
are granted to around 90 percent of high-tech employees. What
posture would we be in with this rule in terms of the
semiconductor industry especially, and its ability to compete
with foreign companies?
Mr. Scalise. I think it would have a major impact on our
ability to compete. Again, getting back to your prior question,
100 percent of our companies grant stock options. As you
pointed out, roughly 95 percent of those go to a broad base of
employees outside of the executive ranks.
I recently completed a study for the President's Council of
Advisors on Science and Technology dealing with manufacturing
and innovation. This is one of the issues that we dealt with. I
think what we have to recognize today is that we are truly in a
new competitive environment out there, not only in
manufacturing, but for people. I just gave you one data point
there saying that roughly 5,000 of our good engineers, these
are not just the rookies, these are the good well-trained
engineers that have been in the business for a number of years,
have now gone back to Taiwan. A number of them are going to
China now.
So we are going to be greatly impacted if they can offer
the stock option with the tax treatment they have, which is no
taxable event; versus ours which is a highly taxed event as it
currently stands. Then you have the other part of the problem
which is dealing with the expensing issue, which makes for the
volatility within the company, which the companies have to
dampen if they are going to avoid some of the litigation that
has been talked about here.
So it is a very complex set of issues that come together
here. Suffice it to say that for the two reasons, the expensing
and the volatility as associated with that, and the tax
treatment we have versus the tax treatment of our competitors
overseas, these are both working against us as far as
maintaining our technology leadership going forward.
Mr. Scott. Thank you very much.
Chairman Baker. Thank you, Mr. Scott.
Mr. Royce?
Mr. Royce. Thank you, Mr. Chairman.
I would like to begin by building on your last point, and
maybe ask Dr. Smith, if we look at these proposed rules and
let's say we take a hypothetical, and we have a company that
has to expense $100 million of option grants. So the accounting
rules would have that firm debit expense and credit paid-in
capital. So now we look forward 1 year, 2 years, 3 years into
the future, and let's say none of the options have been
exercised because the firm's stock has declined in value during
that time period.
So now what do we have? I would say we have a balance sheet
that borders on being fraudulent at this point, and investors
would be getting a false sense of the company's true financial
picture at that moment. At the same time, we have passed
Sarbanes-Oxley. Under Sarbanes-Oxley, we have dictated that you
signed under perjury that the financials reflect the true
operating income and expense and the correct balance sheet
position of the company.
The question that I have, Dr. Smith, is, given our
hypothetical, because you have now expensed that $100 million
in option grants several years prior, are you now in violation
of Sarbanes-Oxley? And more importantly, could some trial
lawyers believe you are in violation of Sarbanes-Oxley?
Mr. Smith. Let me just say one thing. The only employment
this is going to impact is the trial lawyers are going to make
more money and hire more trial lawyers. It is hard for me to
guess, but you can bet they will sue. If you look at most of
the cases out there, they never go to court. These lawyers are
into the idea of settling with these companies and insurance
companies outside of court.
So the answer is, anything like this that opens a door,
they will definitely come in.
Mr. Royce. More slap suits?
Mr. Smith. Absolutely. We may have been delivered a lawsuit
today. Our stock dropped 32 percent yesterday and that
generally brings them right out of the woodwork. That is the
one company fear of most of us here, so this is just one more
thing we have to deal with.
Mr. Royce. I will also ask you, we heard from the CBO
director. Director Holtz-Eakin argued that expensing will help
the economy because resources will be allocated more
efficiently. Do you agree with that argument?
Mr. Smith. Absolutely not. It is the big companies that
benefit from this. These are not the people who employ and
create the new jobs. They employ lots of people, but they are
not the growth gazelles that really provide a lot of
employment. Those are coming from young startup companies like
us. The big companies will benefit because they have no
volatility in their stock. They give very few options out to
people. The penalties will go to the people like us who are
creating the jobs, who are small and have the very volatile
stock. So I absolutely take issue with that, and I do not know
anybody at the CBO that ever started a company or ever gave out
a stock option or ever received a stock option.
Mr. Royce. I am going to ask Mr. Grady to respond to that
question as well. The other suggestion that was made by the CBO
director was that the venture capital community will fill the
void. I would just like to ask Mr. Grady, it seemed earlier
that you disagreed with that argument. I would like to hear
your reasons.
Mr. Grady. I do disagree because what will happen is the
venture capital community will have to use more cash to
compensate employees, which means we will create fewer
companies with fewer employees, by definition.
On the first question of the efficient allocation of
capital, I believe it will not increase the efficiency because
it will create some of the anomalies that you have suggested.
Your first question was not merely hypothetical. For example,
Intel Corporation, and maybe Mr. Scalise wants to comment on
this, I believe reported that they would have taken charges if
expensing were a requirement, into the several billions of
dollars, more than $2.5 billion, for options granted in 2001
and 2002 or 2003 that expired without being exercised; that
were never in the money and that therefore basically never
existed. Under this proposal, the accounting for those options
that never existed, those shares that never existed, would be
identical to the case in which Intel had spent $2.5 billion or
$3 billion of cash. Clearly, that is not an optimal or even
accurate result.
As I said in my earlier statement, that is the problem with
being required to value the options on grant date. You could
switch it and say, gee, we will value them on exercise date or
you could use this intrinsic value method that I mentioned.
That creates its own anomalies, because if you use the
intrinsic value and say a stock comes public at $20 and the
stock trades down, but you recorded a value the day the company
came public at $20 and the options had a certain assessed
value.
If the stock went down, you would actually decrease the
value of those options. So what you would be saying is, because
the stock went down you are judging that company now to be more
profitable.
Mr. Royce. We have an opportunity for a real-world response
if we could go to Mr. Scalise and just let him respond in terms
of the actual difficulty we would be putting a firm like Intel
into.
Mr. Scalise. I think it would be significantly more
difficult. Your mention of the Sarbanes-Oxley Act is really
critical here, because these two do come together. When you
look at the lack of transparency, the lack of comparability,
and then the volatility that results from that, and then the
requirement to attest to all of these documents when in fact
you will create expenses on issues that never really occurred
in the final analysis, as just pointed out by Mr. Grady here,
it is very complicated and it is very interrelated.
It is going to create a lot of hesitation with regard to
putting out more stock options because they are not going to do
it. They are not going to want to increase the volatility and
increase the risk of more and more litigation, because as we
all know we have folks just sitting out there waiting to drop
that next lawsuit.
Mr. Royce. Thank you, Mr. Chairman.
Chairman Baker. I thank the gentleman.
Mr. Sherman?
Mr. Sherman. Yes, as I count, we have six panelists who are
in favor of the bill. My guess is that that is reflected up
here as well.
We can compete with China to have the loosest accounting
standards so our companies can report the highest income, no
matter how much money they spend on this or that, report a lot
of income. Or we can compete with Europe to have the tough and
reasonable accounting standards uninfluenced by what would be
viewed at least by the public in a highly publicized first-ever
intervention to provide looser accounting standards to
encourage what is viewed as executive compensation. I think we
need to compete with Europe for capital by showing that we have
the best accounting standards.
What flabbergasts me is that this bill, if I hear Mr. Grady
and others correctly, would have the effect of helping high-
tech companies like the ones based in my state compete for
capital against these lower-tech companies that are most
associated with some of the other regions of the country. I
have folks from other regions of the country supporting the
bill and trying to help high-tech companies in my state get
capital. I thank them.
Mr. Smith points to this big practical problem. He could
not afford to adequately compensate board members. The company
could not afford to do that without the stock options. You
know, now and then I hear from one of my constituents that
board members are not being adequately compensated, or the
company cannot afford to compensate board members. But I hear
more often that the company cannot afford to provide health
care.
So if we want for the first time ever to tell the FASB to
do something because we want to encourage companies to do
something, why don't we tell them that what you pay for health
insurance should never be listed as an expense? Or at least
provide them with an avenue, if you give a 30-year promissory
note to the health insurance company, you do not have to list
it as an expense. Give stock options to a health insurance
company; provide coverage for your employees, you do not have
to list it as an expense.
Why have we decided that the first time Congress will
demand a departure from regular accounting is to encourage
companies to do something we think is vital. Stock options, not
health care.
Mr. Hassett points out that it would invite lawsuits if we
tell companies they have to expense stock options, but we do
not tell them how. And Mr. Grady echoes this. I could not agree
with you more. But Mr. Hassett, how is it that we have not had
a lot of lawsuits already because we have a requirement that
this information be disclosed in footnotes and we have no real
standards to tell companies how to put it in the footnotes.
Don't trial lawyers read footnotes? I know they are real small,
but you can blow them up and show them to a jury.
Mr. Hassett. Here is the state of affairs that concerns us.
When we put the account for options into earnings, we say,
well, it used to be we thought we were making $8 this year, but
now we are going to put in the expense for options and it is
$7. And then we run for a few years, say, at $7 as earnings
every year. And then at the end of that period, people vest and
realize, and it turns out that when we said that our earnings
were $7, which will be true for probably half the companies, we
were incorrect because it was a prospective figure.
Mr. Sherman. I understand the incorrectness.
Mr. Hassett. The point is that it is in the earnings
statement.
Mr. Sherman. So you are saying that you cannot go to a jury
and say, I am an investor; I thought that their adjusted
earnings adjusted for the expense of compensating people with
options was such and so, as disclosed in their footnote, and it
turned out to be such and so. I think we have some lazy trial
lawyers out there that are not taking advantage of the
vaguenesses of our current accounting standards.
Mr. Hassett. May I respond, Mr. Sherman?
Mr. Sherman. Yes.
Mr. Hassett. Thank you. I think that the current state of
the accounting rule suggests that we are not so sure precisely
whether it is $5 or $4 or $3 and that we are leaving it in the
footnotes. For the shrewd investor, it is his or her job to
figure out what he thinks they are worth when he is deciding
whether or not to buy the stock. I think that is the
appropriate state of affairs. I think when we put it in the
earnings statement, we are giving people the false impression
that we know exactly the value.
Mr. Sherman. You are making a policy argument. I was just
wondering why creative trial lawyers are not making the
counter-argument.
Mr. Hassett. I think because the ambiguity is there.
Mr. Sherman. Let me go on. This bill is being put forward
as protection for broadly based stock options. You can put a
lot of lipstick on a pig. Zero volatility for the options given
to the richest executives in America, and you put that in a
bill and you say you are trying to help secretaries? The number
six guy at GM; the number six guy at Intel are somehow
struggling manufacturing workers?
If the bill was well crafted to achieve its alleged
purpose, it would deserve a lot more support than a bill, a
huge portion of the benefit of which is going to go to the
number six guy at General Motors and the number one guy at
Intel whose options will be valued at zero volatility.
We have heard discussions of employee stock ownership
plans, ESOPs, none of which are affected by the FASB
pronouncement that we are here to discuss. In fact, those plans
are going forward. They are big in our economy and they do not
get any favored accounting treatment, nor is anybody arguing
that they should get a favored accounting treatment.
Mr. Kruse tells us that 79 percent of those who hold
options make under $75,000. Let's say in your survey there was
a company, because I have seen a company like this, 100,000
options held by each of the top two guys. Another 100
employees, all with incomes under $75,000, each get about 50 or
100 options. If you were surveying that company, wouldn't you
conclude that 98 percent of the option holders are people who
make under $75,000, if that was your whole population of the
survey?
Mr. Kruse. That is absolutely true.
Mr. Sherman. So what we do know is that there are a lot of
working-class folks and middle-class folks who have stock
options, but there may not be a lot of options in the hands of
working-class folks.
Mr. Smith. Let me answer that one because I have a
practical application.
Mr. Sherman. Your company is great.
Mr. Smith. Forty-five percent is going to the top; 55
percent goes to the working people below that.
Mr. Sherman. Your company is great, but that does not tell
us about the economy overall. If you were running all these
companies, things might be different.
Mr. Smith. GM does not tell us about the economy overall
either. It is the small companies that are providing the jobs.
The guys you are going to penalize are the job-creators. That
is the reason we are here today.
Mr. Sherman. Mr. Smith, I just want to comment. Not every
small company is giving stock options. Your beauty shop, no
stock options. Your local dry cleaner, no stock options. Lots
of small companies. Your machine shop, very rarely do they give
stock options.
So to take the idea that all the jobs created by small
business are driven by stock options, they are driven by other
things.
Mr. Smith. How about a few facts here? The facts are the
job gazelles, the small growth companies that are providing the
jobs are not the hairdressers and not the ones you mentioned.
They are companies just like us. Those other people that are
giving the jobs in this economy----
Mr. Sherman. Mr. Smith, it is my time. I did not even ask
you a question. Your gazelle-like feistiness is appreciated.
But the fact is that is we as a Congress decide to contort the
accounting rules for the purpose of pulling capital out of the
old economy and putting it into the kinds of companies that Mr.
Smith thinks should get the capital, that is a whole new
economic planning role for this Congress. I do not know whether
it is better to see stock purchased in Proctor and Gamble or in
Mr. Smith's company. I know he thinks that his company is the
best way for our society to allocate its capital.
I yield back.
Chairman Baker. Thank you, Mr. Sherman. I let you go on
well beyond time in recognition of your position on the issue,
but for members's purposes, I am going to try to recognize as
many as we can before adjourning. We have a set of five
recorded votes which would disrupt the committee process
significantly.
So Mr. Shadegg, if you have a comment?
Mr. Shadegg. Thank you, Mr. Chairman. Let me begin with one
question.
As I understand the FASB proposal, they do not say how to
do this. They say you simply have to do it. So let me begin,
since we can obviously make it clear as the questioning has
just suggested, I will ask each of you quickly, and I would
like you each to answer, is there a single agreed-upon method
by which this ought to be done that will make the reporting of
all companies parallel or comparable for stock evaluators? Just
yes or no.
Mr. Scalise. No.
Mr. Grady. No, there is not, and especially not for private
companies.
Mr. Smith. No.
Mr. Hassett. No.
Mr. Holtz-Eakin. No.
Mr. Thomas. No.
Mr. Kruse. No.
Mr. Shadegg. I think that kind of sums up my deep concern.
Mr. Grady, my friend Mr. Frank on the other side I do not think
ever let you get across that point. I am going to tell you what
I think your point was, and then you tell me if I am right. I
think your point was, look, yes there are footnotes now; yes,
people can evaluate this information; yes, sophisticated
investors can look at it. But if you compel it to be a much
more prominent factor in the reporting of the company's
performance and in this calculation of P and E, given that
nobody has agreed upon the right way to do it, then we are
going to have inconsistent results and it could lead to much
greater abuse of investors than what we currently have. Is that
the essence of your position?
Mr. Grady. I would agree exactly with that statement.
Mr. Shadegg. I just think this is a huge deal. We just
heard a comment about how we could create the loosest
accounting system in the world. I would suggest quite frankly I
think FASB is proposing that we make the accounting system
looser than it is right now. I understand IASB has said we are
going to do this in Europe. It seems to me, first of all, I am
aware that in some countries in Europe right now they require
stock expensing and in those countries there are essentially no
options or option expensing, and essentially there are no
options.
It seems to me perhaps what we ought to do this time, if
IASB has decided this is a great idea, why don't we let Europe
go first and watch them and see if in fact it does not damage
them. My concern, given a world market, is that if we do it and
some others do not do it, we could be putting ourselves at a
dramatic competitive disadvantage which I would rather not do
at this particular point in time.
Mr. Holtz-Eakin, I know that you did the study and the
analysis that looked at how stock options would affect both
stock prices and the company's access to capital. Is that
right?
Mr. Holtz-Eakin. We did a study on the accounting of
employee stock options.
Mr. Shadegg. Right. Here is the question I want to know.
How did you go about evaluating the question I have raised,
which is, how many companies would continue to offer stock
options and to what extent does your report give us the answer
to that question?
Mr. Holtz-Eakin. The report actually does not address the
individual decision by firms to offer options versus other
forms of compensation.
Mr. Shadegg. So it does not look at the issue of whether--
--
Mr. Holtz-Eakin. It looks at the accounting of those two
activities.
Mr. Shadegg. So it kind of assumes a static situation and
says, if these companies are offering stock options now, this
is how they are performing and they are not expensing them. If
they continue to offer them, here is what would happen under
that static kind of analysis. It was not looking at the
question of whether or not they would be disincented from
continuing to offer stock options.
Mr. Holtz-Eakin. I think a fairer way to say it would be
that it looks at the relative treatment of stock options as
employee compensation versus other forms of compensation. It
puts them on a level playing field and examines the accounting
treatment in that setting.
Mr. Shadegg. Given the great concern expressed by Mr. Smith
and others that the net effect of this rule is going to be to
disincent companies from offering stock options, and indeed
from my perspective since I like startup companies and I like
innovation and I like new people coming into the market and I
think that is where America leads the world, wouldn't you agree
that that is an issue we should look at before adopting a
change in policy?
Mr. Holtz-Eakin. I think it has been a bit frustrating to
hear the way the issue has been characterized today because the
key issue here is to remember that the income statement is
designed to display in a fair fashion the net income, the
matching of costs and the revenues generated by a firm for
purposes of financial disclosure. It is clearly the case that
stock options could still be a part of that employee
compensation.
Mr. Shadegg. Let me go back to Mr. Frank's style. You are
not answering my question. My question was as a policymaker,
not can they do it differently, my question was shouldn't we
look at the effect of the policy not just on what will it do to
stock prices, but rather on the incentives it would create to
continue or discontinue engaging in the process of offering
options?
Mr. Holtz-Eakin. It depends on the question you want
answered. If the question is, what will produce broad economic
performance in the United States, I do not think that is the
central question. If the question is, how many stock options
will be granted in the United States, it is a very central
question.
Mr. Shadegg. Since I think how many are issued affects our
economy and at the end of the day everything I look at I have
to put at least through that filter, it seems to me to be of
grave concern.
Mr. Chairman, I know you want to get to a number of other
witnesses. I strongly feel that with the concerns that have
been expressed here by all of the witnesses, before we leap off
into this abyss, we need to look at it more carefully. It is
odd to me. It seems to me strange that the IRS would put out a
regulation that says we want every taxpayer to report X, but
quite frankly we do not know how you are going to value X. I
have trouble with a policy that says we are going to solve this
problem; we are going to tell you to address this issue, but we
are not going to give you a uniform method for calculating it,
and we think we are bringing more certainty to the market. That
is just a grave concern on my part.
I yield back the remainder of my time.
Chairman Baker. Mr. Miller?
Mr. Miller of North Carolina. Thank you, Mr. Chairman.
Mr. Smith, I know that you expressed at the beginning a
frustration that no one who seems to be involved in this debate
on our side knows anything about stock options. I admit that I
never have had one, but my brother works for a bank. He has
described to me what he does. At the end of it, I knew he
worked for a bank.
[Laughter.]
He has some fairly impressive titles, but I also know that
banks pass out titles instead of compensation. I hope we never
have to value that.
[Laughter.]
I am trying to figure out how this works and whether it
really is going to provide any kind of useful information to
middle-class investors. Let me try to get a feeling for how
this works. My understanding is a mid-level employee may be
given 3,000 options. The market price of the company now is
$55, and one-third or 1,000 are exercisable in a year, say, at
$60; the next one-third a year later at $65; the next year, the
last 1,000 at $70. They expire if not exercised within 5 years
of when they vest and they cannot be transferred and they are
forfeited if they are not exercised at the time the employee
leaves the company. Is that generally the way it works? Kind
of, Mr. Grady?
Mr. Grady. That is generally the way it works. The only
slight correction I might make is that typically the strike
price on those options would be the $55 at which they were
granted. They probably might choose to exercise them if the
stock went up to $60 or $70 a year later; and if the stock went
down to $40, they would not exercise.
Mr. Miller of North Carolina. But if they have an option at
$60, they would rather buy it through the market rather than by
exercising the option.
Mr. Grady. Because it goes below, yes, sir.
Mr. Miller of North Carolina. But it has some value, but if
it is not traded, would you value it by what? If the company
has analysts and they project a 10 or 15 or 20 percent stock
price per year in the next 5 years. Do you look at that? If
there are no analysts following the company, do you look at
what the board of directors or the management forecasts are for
growth of earnings? How do you value something that can be
exercised in the future?
Is there any understanding at all whether these will be
valued at the time of exercise or when they vest, when you can
exercise them, or at the time of their issue in the first
place?
Mr. Grady. The exposure draft suggests valuing them at the
time of grant, when they are issued in the first place, when
their value is frankly highly speculative.
Mr. Miller of North Carolina. So even when you are being
granted something that is only at $70, that you can exercise at
$70, even though the stock is trading at $55, you have to
establish some value for that and declare it now.
Mr. Grady. Yes. You have to estimate what the value would
be.
Mr. Miller of North Carolina. Okay. If stocks are not
exercised in the next year or the year after that, is there any
requirement that the company go back and true up the cost
because the stock went up or down?
Mr. Grady. Generally, no. For public companies if they
value them at the time of grant, that is it. Now, there are
different methods. Some have said intrinsic value would be
allowed for private companies where you would go back and true
up each quarter. The FASB actually seeks comment on whether
instead of using grant date as the measurement period, you
should use exercise date.
As I mention in my testimony, while that would get around
the problem of how hard it is to value the options at grant
date, it creates a different problem which is if you require
them to be expensed on the exercise date, what you are in
effect doing is penalizing the most successful companies and
helping those whose stock price has languished.
Mr. Miller of North Carolina. I think most of the testimony
today has been about the effect on the economy of encouraging
or discouraging, or to use the current noun-verb, incentivize
or incent or disincentivize or disincent. But just looking at
this from the standpoint of middle-class average investors, is
this going to provide them more useful information than a
footnote telling them how many options are out there and what
the terms are under which they can be exercised.
Mr. Grady. I believe it will provide them with less
reliable information, far less reliable information for the
investor for all the reasons we said in our testimony.
Mr. Miller of North Carolina. Alright. I am probably the
last one to have anything. Mr. Smith, I want to assure you that
I have lived my brother's experience. My brother and his wife
and my wife and I have a beach cottage together. When the stock
of his company is doing well, he wants to go in together and
reupholster the furniture and buy a DVD for the cottage. When
the stock is not going well, he wants to sell.
Mr. Smith. My comments have related primarily to the people
testifying, not the people sitting on that side, obviously, the
policymakers. I am more frustrated by the fact that like
yesterday in the Senate, all the people that were testifying
basically there were no business people. They were people
having FASB, prior Federal Reserve chairmen, and all those
sorts of folks. Great folks, but never in my opinion ever
started a company.
Chairman Baker. The gentleman's time has expired.
I will get Mr. Lynch in, if I can.
Mr. Lynch. Thank you, Mr. Chairman.
I want to thank you, Mr. Chairman, for your good work and
the panel for helping us out. I apologize for having to rush
out here at the end. Prior to coming to the Congress, I was
actually an iron worker for about 20 years, so I am similar to
some of the production employees you have been talking about
earlier today. I also was a former union president of the iron
workers. So I spent a considerable amount of time working
toward greater corporate responsibility, greater corporate
accountability, transparency, and those issues.
That much being said, I have to say that I have some very,
very, very serious concerns about this FASB exposure draft that
is under consideration today. I think it is a real mistake. It
has been my own experience that the granting of stock options
has given a lot of opportunity for rank-and-file employees to
own a piece of the rock, as has been said earlier here today.
It does in fact incentivize the workplace for many of our
workers, if they know that if they work their tail off that
they are going to help the company succeed, and then by doing
so they themselves will be enriched. That is a good thing for
America and I think it is a good thing for our corporations
here.
Again, Gillette Safety Razor Corporation is in my district.
A lot of the young fellows and women who went to high school
with me, went to work. Some husbands and wives in the same
corporation for Gillette. They have a great stock purchase
program at Gillette. A lot of the folks that I went to high
school with went to work on the assembly line and now they are
looking pretty closely at retirement. Some of those people when
Gillette was at their high end were millionaires, based on the
amount of stock that they had purchased in their own company.
Good hard workers. I do not want to see that opportunity denied
from rank-and-file workers. I think that it would be a mistake
to adopt this rule that would basically kill that whole
process.
I know especially in the high-tech area, this is an
important tool in bringing bright young employees into the
workplace. I do have one question, and then I am going to run
out. I know that we have talked about H.R. 3574, which would
basically expense the options granted to the top five
employees. In thinking about this problem in a different way,
would it be better, and this is for the entire panel, and you
might have to holler your answers as I run down the hallway,
would it be better to look at some fixed percentage of the
stock options granted each year and expense those some small
percentage, so that it is not just the top five? Because the
top five companies, as Mr. Smith has pointed out, in a small
corporation to force expensing on that small group may have a
detrimental effect on the operation of the corporation itself.
I just wanted to get that out there. I think it is a great
suggestion in terms of a compromise, but there might be a
better compromise out there.
I want to thank you for coming here. Mr. Chairman, I want
to thank you for your enormous patience.
Chairman Baker. I thank the gentleman.
Did anyone care to respond?
Mr. Holtz-Eakin. The key for fair portrayal of net income
is the value of options granted, not the number of people that
you choose to expense, or to the extent that you have revealed
the value of options granted, you will become closer to net
income as measuring the economics of the corporation.
Mr. Lynch. Right. I understand that.
Mr. Holtz-Eakin. A fixed fraction of the value reveals the
value of options granted. That would be tremendous.
Mr. Lynch. Okay. Thank you. Thank you, gentlemen.
Chairman Baker. Let me express my appreciation to each of
the witnesses. We certainly do appreciate your participation.
This obviously is a difficult subject and we are doing our best
to achieve the best public policy.
There being no further members to be recognized, I do now
adjourn this meeting of the Capital Markets Subcommittee.
Thank you.
[Whereupon, at 12:40 p.m., the subcommittee was adjourned.]
THE FASB STOCK OPTIONS PROPOSAL: ITS
EFFECT ON THE U.S. ECONOMY AND JOBS
----------
Tuesday, May 4, 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 2:05 p.m., in
Room 2128, Rayburn House Office Building, Hon. Edward R. Royce
presiding.
Present: Representatives Shays, Royce, Hart, Sherman,
Moore, Frank (ex officio) and Hinojosa.
Mr. Royce. [Presiding] I would like to call this meeting of
the capital market subcommittee to order.
This afternoon we are going to convene for the purpose of
reviewing the pending Financial Accounting Standards Board
employee stock option expensing proposal, and we are also going
to be looking at the potential effects its adoption may have on
job creation and on the U.S. economy.
In previous hearings on this subject, I have expressed deep
concerns about the potential economic consequences of FASB's
proposal to require the mandatory expensing of employee stock
options.
Like other supporters of Chairman Baker's legislation, H.R.
3574, I believe that broad-based stock options have played an
important and positive role in our economy. Stock options
enable emerging companies which often do not have a tremendous
amount of excess cash or a tremendous cash flow to attract
talented employees that would otherwise not work for such
innovative firms.
Some people claim that issuing stock options represents an
expense to a firm. However, stock options do not represent a
cost to an entity. No cash is ever disbursed from the company's
treasury. Existing shareholders may see their ownership
diminished through dilution, but current accounting standards
already require potential dilution to be fully disclosed.
In the not-so-certain case that employee options are
actually exercised and the employing company then receives
cash, employees who accept options are taking a well-known
risk. There are no guarantees a firm will succeed and its stock
price will rise.
We hear about the successes in business, but we should not
forget there are far more failures. Creative destruction leaves
a wake of failed ideas.
The specific purpose of today's hearing is to explore the
economic impact of FASB's proposal. Economic behavior has
already changed because of this proposal. Many technology firms
have already announced that they will no longer issue employee
stock options. As a result, many firms have not been able to
attract needed employees. Whether an individual is risk-averse
or that individual is risk-taking, or even risk-loving, he or
she is not likely to leave their job with a large, mature firm
to go to a start-up for a compensation package containing less
cash and no stock options.
If one accepts the premise that FASB's proposal will end
broad-based stock option plans as we know them today, then we
should think about the potential long-term negative
consequences for our economy. Firms like Intel, Microsoft,
Cisco and Yahoo all used stock options at their early stages to
attract their employees. Other nations in Asia are now trying
to incubate an environment like the one that we had here.
Would these firms have reached their amazing levels of
success had stock options not been an available tool for
recruitment? Will this proposal inhibit the development of the
next Intel? Established firms will survive and prosper under
any new rule issued by FASB, but I think some of us are
concerned that new firms may not develop as a result, and I
believe that it is important for Congress to raise these
concerns.
We are very fortunate to have Mr. Herz and Mr. Batavick
here today to help deal with these issues, and I hope that in
your opening remarks you will address such questions as has
FASB field-tested valuation models? Has FASB considered the
economic consequences of mandating expensing? Has FASB
considered that mandatory expensing could give foreign-based
firms a competitive advantage in attracting employees? Is FASB
concerned that its proposal could make financial comparability
between firms more difficult? And lastly, is FASB still open to
considering other nonbinomial methods or models for this
approach?
I look forward to hearing answers to these and many other
questions, and I would like to turn to my California colleague
now, Mr. Brad Sherman, for any opening statement he might like
to make.
[The prepared statement of Hon. Edward R. Royce can be
found on page 164 in the appendix.]
Mr. Sherman. I thank my friend and colleague from the Los
Angeles area. I want to commend Chairman Baker for having
hearings where at least we finally hear from the FASB, since we
have had so many hearings criticizing their work or their
intended work. It would have been nice if the Chairman had gone
one step further and scheduled these hearings at a time when
most of our colleagues would be able to attend, and that these
hearings could be as widely attended as the hearings bashing
the FASB were. Of course, those were scheduled at a time when
there could be votes on the floor. These are scheduled many
hours before the first vote of the week, and it would have been
nice, I guess, if the Chairman had at least scheduled these
hearings at a time that was convenient for him to attend.
I have signed letters for a long time, as one of the few
CPAs in Congress, saying let the FASB do its job. My problem is
the FASB has not been doing its job in two areas, both directly
related to high-tech firms principally, although--stock options
go way beyond high-tech.
The first is stock options where for--going back to the
APBs, let alone the FASB announcements, you have punted on this
issue with a unique approach where you say, this is the right
way, but you are free to do it some other way.
Where are the plaintiff's lawyers when you need them in
that?
The second area is in research, where you and I have
talked, Mr. Herz. You know that demanding the write-off of
research is very harmful to our economy and is wrong accounting
and has been, and that there isn't a single accounting theory
book I can find published in the last century that would form a
basis for the immediate write-off of research; and, yet, what
we have here is, in some bizarre way, compensating errors. You
don't make high-tech firms write off their executive
compensation, but you do force them to treat every research
project as if it is a black hole that produces no asset.
Now you are undoing one part of the problem without the
other. It may very well be that we should wait to deal with one
issue until you can deal with the other. Correcting one of two
errors where there are compensating errors may give you a worse
appraisal of how the high-tech sector is doing than leaving the
matter alone until you can deal with both.
But let me put some dollar figures to contrast the size of
these two. Stock options, if expensed last year, total expense
would have been $47.6 billion. Some roughly $10 billion of that
was expensed as companies voluntarily decided to expense stock
options, but roughly $38.6 billion, to calculate it in a
variety of different ways, would have been expensed had this
provision been applicable last year.
In contrast, on the research side--and I think this number
is way too low, but the number I have been given by the
National Science Foundation is $176 billion, and I would
suggest that the private sector is probably doing a lot more
research than that.
So the research is at least triple in importance, perhaps a
factor of 5, a factor of 10. And so when you go to determine
what are the net results of our high-tech firms as compared
with firms that don't do much research and may not do much in
the way of stock options, you have these offsetting errors. The
one you are not--the one we are not dealing with, the one you
haven't dealt with yet, is at least five times as big and would
cause more investment in companies that do research.
Now, we are told that stock options aren't an expense.
Let's apply this to every use of stock options other than
compensation. Well, first we are told stock options are not
cash. Well, you could issue shares of stock, and that would not
be cash either, and I won't bother to ask this as a question,
because we all know the answer.
If you issue a bunch of shares of stock to compensate your
employees, you have to list it as an expense even though it
cost you no cash. The sole effect is to dilute the shares
outstanding. You have to list it as an expense. You issue stock
to your lower-level employees, to your upper-level employees,
to your board members an expense.
If you were to issue shares to the best charity in our
country, you would have to list it as an expense. If you were
to issue shares to an insurance company to provide health care
for your employees, an expense. And if you did options, if you
gave options to a charity, you gave options to a health
insurance company, you gave options to a special fund that was
rebuilding Iraq, it is on that we have decided that the only
thing that is so important that we as a Congress should
interfere with the FASB and interfere with the basic rules of
accounting theory is not in the area of charity. We could get
more charitable contributions if we just decided charity never
has to be listed as an expense, or if you use stock or you use
options to make a charitable contribution. We could have more
health care for employees if we just tweaked the accounting
rules and said cash or stock or options used to pay for health
care doesn't have to be listed as an expense. But health care
for our employees, charity paid for by the corporate sector,
these do not attract the attention of Congress. The only area
where Congress wants to tweak the employees is in executive
compensation.
Now, we are told that it is broad-based. We were told that
a lot of low-level employees get some options, but almost all
the options are going to some people who are at the top of
corporations, and it is that reason that the bill itself is
written to define broadly based as, well, you are just not one
of the top five employees, so if you are the number six person
in Intel or the number six person at Disney, you are a poor,
struggling secretary, I don't think so.
We are told about competitiveness. Well, we can compete for
capital around the world with two approaches. One is the
European approach, and it has always been the American
approach. That is, have tough accounting standards, do the best
job of enforcing them, give investors the most accurate
possible picture according to accounting theory. You guys
haven't done a good job on research in stock options, but on
everything else that has been our proposal. That is the
European approach.
The other way to compete is to emulate what I would call
the Bangladesh model. That is to say, let companies report what
they want. They will report high earnings, and everybody will
want to invest.
I would suggest nobody in this room has chosen to invest in
whatever stock market can give them the loosiest, goosiest,
rosiest accounting picture possible, but rather they turn to
those stock markets which have the toughest standards.
So I look forward to questioning my friends at the FASB on
whether their exposure draft really does do the job, and I have
got some severe problems with it, why they have decided to take
an industry that is punished unfairly by your rule on research
and punish them fairly by correcting your multiyear problem on
stock options, and to proceed with these hearings. But I would
say that before we tweak the accounting rules to encourage
executive compensation, we ought to tweak the accounting rules
to encourage health care coverage for rank-and-file employees.
Now, I do have--I would like unanimous consent to insert in
the record a letter from the SEC Chairman to the Ranking Member
of the subcommittee Mr. Kanjorski dated May 3rd in which he
states that the process established by the FASB to consider the
pending stock option proposal should be allowed to run its
course. I wonder if there is any objection.
Mr. Royce. Without objection.
[The following information can be found on page 210 in the
appendix.]
Mr. Sherman. I yield back.
Mr. Royce. If they are so ordered.
If there are no more opening statements, I would like to--
--
Mr. Sherman. There may be some.
Mr. Royce. All right. Let me turn to Mr. Shays and----
Mr. Shays. I would be happy to defer to the Ranking Member.
Mr. Royce. We will go to our Ranking Member.
Mr. Frank. I want to be brief, because I just want to,
first of all, make clear the Ranking Member of the subcommittee
Mr. Kanjorski had requested this and thought it was very
important, but a resident of his district was killed in Iraq,
and he is understandably at that funeral. So I want to make
clear that his absence is not anything that was avoidable, and
this remains a very important subject to him, and I appreciate
the fact that we are going ahead with the hearing at his
request.
And secondly, I want to say I am torn, as I have said
before. I am very reluctant to see us interfere with the FASB,
partly because while the previous speaker is an accountant,
almost nobody else around here is, and we as Members of
Congress inevitably have to deal with subjects where the
subject matter is very difficult for lay people. I am loathe to
get us into more of these.
Of all the roles I do not wish to play, it is being the
appeals board to the FASB. Indeed, I think one sure way to cut
down on campaign spending would be if Members knew that the
consequence of winning a congressional seat and spending all
that money was that you got to be the superappellate board on
the most arcane accounting issues, I think that would be a
severe disincentive.
On the other hand, I have listened to some people for whom
I have an enormous amount of respect in an industry which is
very important to us, both because of the inherent good it does
and because of the contribution it makes to our economy in
various forms of high technology, and I am struck by the
virtual unanimity of their concern. And so one of the things
that I am going to hope that Mr. Herz can address is who is
getting hurt by this.
Obviously there are technical questions to be resolved
about what is or isn't the appropriate accounting, but
accounting is, after all, the--a functional discipline. It is
not an abstract one. We use accounting so we can better
understand reality, and I do have a question as to whether or
not--and maybe this isn't within FASB's jurisdiction--but is it
the view of the Board and others who are advocates of this
change that there are now investors who are being misled? Are
there people who invest in these companies, and because options
are not expensed but are listed elsewhere--obviously, I think
we all agree, if people were giving the options and weren't
telling you, that would be a terrible problem, but that is not
what is currently allowed.
So the question is are there people now who are being
misled into investing, because while the information is being
presented, it is being presented in a form different than you
think accounting principals require? And that is really, I
think, a very important question for us, at least within the
FASB.
I continue to believe myself that the damage that I have
seen done by options has come in the perverse incentive in some
case options have given the heads of some corporations, in many
cases not high-tech corporations, who give themselves options,
cash them in after the stock price has been driven up, and
shortly thereafter the stock price tumbles, partly because some
of the things that drove the price up weren't very good things
for the long term. That is an abuse. I see it. I think we
should try and deal with that and ask the SEC to help.
But that is the central question, because I accept what I
hear from a large number of people in the high-technology area
that this will be damaging to them, and I want to know what
harm are we undoing.
So the last thing I would say is that it is also the case
obviously that I guess there are very few--we know the
perception and reality intermingle. This appears to be a case
where perception is everything, because the reality is not
being changed. The reality of options being granted won't
change. Apparently a lot of people on both sides of this issue
think in enormous-amount terms on how they are described, and I
would hope that we could address the implications of that.
Thank you, Mr. Chairman.
Mr. Royce. Thank you.
Mr. Royce. Mr. Shays.
Mr. Shays. Thank you. I just want to disclose the fact that
FASB is in the 4th Congressional District of Connecticut, so I
may be unduly influenced by that; to say that we are grateful
FASB is in the Fourth Congressional District, we appreciate the
good work the Board does, even if some of its members are not
enlightened enough to live in the 4th Congressional District.
And I would say to you that in my judgment, a tie goes to FASB.
Mr. Royce. Mr. Moore.
Mr. Moore. Thank you, Mr. Chairman. I just want to thank
the Chairman, the Ranking Member for convening this hearing. I
want to also extend my appreciation to the witnesses for
appearing. I look forward to your testimony. We will have
questions. Thank you very much.
Mr. Royce. Any other opening statements from the Members?
In that case we will go to an introduction of our
witnesses. First we have Mr. Robert H. Herz. Mr. Herz was
appointed Chairman of the Financial Accounting Standards Board
effective July 1st of 2002. Previously he was a senior partner
with PricewaterhouseCoopers.
Prior to joining the Financial Accounting Standards Board,
Mr. Herz was PricewaterhouseCoopers' North American theater
leader of professional, technical risk and quality, and a
member of the firm's global and U.S. Boards. He also served as
a part-time member of the International Accounting Standards
Board. Mr. Herz is both a certified public accountant and a
chartered accountant.
We are also fortunate to have here his colleague Mr. George
Batavick. Mr. Batavick was appointed to the Financial
Accounting Standards Board effective August 1st of 2003. Prior
to joining FASB, Mr. Batavick was most recently the former
controller of Texaco. In this post he had companywide
responsibility for strategy and policy matters covering all
aspects of accounting and financial reporting, special studies,
internal controls and tactical plan coordination.
Welcome back, Mr. Herz. You have the floor, and I would ask
both of our witnesses--you will be recognized for a 5-minute
summary of your testimony. Your written statements will be made
part of the record. Mr. Herz.
STATEMENT OF ROBERT H. HERZ, CHAIRMAN, FINANCIAL ACCOUNTING
STANDARDS BOARD
Mr. Herz. Thank you, Representative Royce and members of
the subcommittee. George is with me because he heads up our
Small Business Advisory Committee, and he will be talking about
some of that activity.
We are pleased to appear before you today on behalf of the
FASB. We are very happy to participate in this hearing,
particularly since H.R. 3574 or any similar legislation if
enacted would preempt and override our ongoing public due
process to improve the accounting and financial reporting for
equity-based compensation.
We have some brief prepared remarks, and we would
respectfully request that the full text of our testimony and
all the supporting materials be entered into the public record.
Mr. Royce. Without objection.
Mr. Herz. As you know, our ability to conduct our work in a
systematic, thorough and unbiased manner is fundamental to
achieving our mission of improving accounting and financial
reporting standards in this country. Those standards are
essential to the growth and stability of the U.S. economy
because investors, creditors and other consumers of financial
reports rely heavily on credible, transparent, comparable,
unbiased financial information to make their investment and
credit decisions.
Now, because the actions of the FASB affects so many
organizations, our decision-making process must be open,
thorough and as objective as possible, and therefore, our rules
of procedure require a very extensive and public due process.
We issue proposals for comment, and then after that, when
we get the comments, we hold roundtables, we actively
redeliberate all the key issues. Those redeliberations often do
result in significant changes and improvements to the
proposals.
The Board makes final decisions only after carefully
considering and analyzing the input of all interested parties.
We do our best to try and balance the often conflicting
perspectives of various parties and make independent, objective
decisions guided by the fundamental concepts and key
qualitative characteristics of sound, fair and transparent
financial reporting.
In March of 2003, at a public meeting, we decided to add a
project to our agenda to address issues relating to improving
the accounting for equity-based compensation. The project was
in response to the high level of public concern expressed by
many individual and institutional investors, financial
analysts, creditors, major accounting firms, many study groups
and many other parties, including many Members of Congress,
about the need to improve the accounting for equity-based
compensation.
Many believe that the existing reporting for equity-based
compensation results in significant distortions in the
reporting of earnings, operating results and operating cash
flows, distortions that they believe cannot be remedied solely
by improvements in disclosures. So the ultimate goal of our
project is to develop a standard that results in reporting that
more faithfully reflects the underlying economic effects of
equity-based compensation and that brings about greater
comparability of reporting.
The project also provides an opportunity to achieve greater
international convergence of accounting standards, an objective
that we have been specifically encouraged to pursue by the
Sarbanes-Oxley Act, by the U.S. SEC and by many other parties.
On March 31st of this year, we issued by a unanimous vote a
proposal for public comment to improve the accounting for a
wide range of equity-based compensation arrangements. That
proposal is a result of a very extensive public due process.
The process included the issuance of a preliminary document for
public comment, the review of over 300 comment letters and over
130 unsolicited letters, review of research and consultation
with many, many parties.
Based on our extensive public due process to date, the
Board believes that the proposal would significantly improve
the financial reporting for equity-based compensation
arrangements. By creating greater transparency, completeness
and a more level playing field in the accounting for different
forms of equity-based compensation, we believe that the
proposal would enhance the comparability of reported results
between enterprises that choose to compensate their employees
in different ways.
The proposal would achieve it through a number of
provisions, including eliminating the existing exception for
so-called fixed-plan employee stock options, which, as
Representative Sherman indicated, are the only form of equity-
based compensation that is not currently required to be
reported as an expense in the financial statements.
The proposal also includes provisions that we believe would
improve the transparency of the effects of equity-based
compensation on reported cash flows and that are aimed at
addressing what many believe have been significant distortions
in the reporting of operating cash flows by companies that make
significant use of employee stock options.
The proposal reflects the view that all forms of equity-
based compensation should be properly accounted for as such,
and that the existing exception for fixed-plan employee stock
options results in reporting that not only ignores the economic
substance of those transactions, but also distorts reported
earnings, profitability and other key financial metrics.
I would note in contrast that this distortion again, as
Representative Sherman indicated, does not occur when the same
company uses stock options or similar instruments such as
warrants for purposes other than compensating employees; for
example, in acquiring goods or other services, or in financings
or M & A transactions. In all those cases the current
accounting has long required that the options or warrants be
properly valued and accounted for in the financial statements.
In the public company arena, the proposal would bring about
greater comparability between the now over 575 companies that
have voluntarily opted to account for the cost of employee
stock options and the many others that have not done so.
It would also be responsive to the growing number of
companies, including a number of major technology companies,
whose shareholders by a majority vote have approved nonbinding
proxy resolutions mandating expensing of all employee stock
options. Managers of a number of those companies have indicated
that they are awaiting completion of our project in order to
respond to the demands of their shareholders.
The proposal would also result in substantial convergence
in the accounting for equity-based compensation between our
standards and international standards that are followed in over
90 countries around the world.
I would also note that in Canada, who often follows the
lead of the U.S. in improving accounting standards, they felt
they could not wait on this topic and decided to mandate
expensing of all employee stock options beginning in January of
this year, and I understand that implementation of their new
standard is going very smoothly.
Finally, with regard to the potential economic consequence
of our proposal, many economic experts that have addressed the
issue of the accounting for employee stock options, including
Federal Reserve Chairman Alan Greenspan, former Federal Reserve
Chairman Paul Volcker, Nobel Prize-winning economists Robert
Merton, and Joseph Stiglitz, and groups like the Financial
Economist Roundtable, the Republican staff of the Joint
Economic Committee of the Congress, the Conference Board
Commission on Public Trust and Private Enterprise co-chaired by
Pete Peterson and John Snow, major investment banks, and the
Congressional Budget Office have all indicated support for
mandatory expensing of employee stock options.
Indeed, many of these experts have also indicated that
mandatory expensing could have positive economic consequences
because of the improvements in capital allocation that would
result from having more credible, comparable and transparent
financial information, not to mention helping to continue to
shore up public confidence in financial reporting.
Now, we recognize that one size may not fit all, so I am
going to hand over to George in a second who will discuss the
several special provisions contained in our proposal relating
to small businesses and start-ups, as well as other matters
relating to our continuing work and due process on this topic.
I would like to assure you that we recognize the importance
of small business and start-ups to job creation, to
entrepreneurship and to our Nation's economy, so we also
understand that any standards we prescribe that apply to small
business must not only be conceptually sound, but also must be
operational and cost-effective.
Mr. Royce. Mr. Batavick.
STATEMENT OF GEORGE J. BATAVICK, BOARD MEMBER, FINANCIAL
ACCOUNTING STANDARDS BOARD
Mr. Batavick. Thank you, Mr. Royce, and thank you, Bob, and
good afternoon everyone. Before I outline the special small
business provisions contained in our proposal to improve the
accounting for equity-based compensation, I would first like to
provide some brief background on small businesses and financial
and accounting reporting standards.
First, there is no Federal law requiring nonpublic
enterprises to use FASB standards. Thus, for most small
businesses, the use of our standards is primarily a private
choice. For some small businesses, that choice may be
influenced by whether they have plans to become a public
enterprise. For other small businesses, the decision to follow
FASB standards may be influenced or controlled by their current
or potential lenders-suppliers, other contracting parties or
State regulators. To the extent that one of these parties
requires that the financial reports of small businesses comply
with our standards, that requirement presumably reflects the
party's opinion that our standards result in better, more
transparent information for their respective purposes.
Second, it is also important to note that the FASB has long
recognized as part of our public due process procedures that
the cost of complying with our standards can fall
disproportionately on small businesses. In recognition of that
fact, the Board actively solicits and carefully considers
requests from users, auditors and preparers of the financial
reports of small businesses to provide for special provisions
to alleviate the costs of implementing our standards. Those
requests come from our continuous and ongoing due process and
deliberations throughout the life of the project.
If you are following our project on equity-based
compensation, and you wanted to keep up on what was happening,
all interested parties, including small businesses, can take
advantage of our free weekly action alert, which is by e-mail.
We discuss current agenda items and past Board decisions.
Interested parties can also attend our Board meetings, call in
or listen to our free Webcast of our meetings on the day of the
meeting, with replays of our meetings available 1 week
thereafter.
Our meetings also get extensive news coverage by the top
news agencies, and our free Web site includes up-to-date
summaries of all equity-based compensation issues discussed in
our tentative decisions.
We actively seek input from various State CPA societies,
and membership in turn brief their clients, in many cases small
businesses, on the status of this and other Board activities.
In addition, liaison meetings with various groups having
small-business representation and Board member and staff
speaking engagements provide additional means of receiving
valuable input from the small-business community.
With respect to this proposal on stock-based compensation,
it is our understanding that although the use of employee stock
options is present at some small businesses, particularly
start-ups and venture capital-backed enterprises that plan to
become public enterprises, the vast majority of small
businesses, over 95 percent, in the U.S. do not grant employee
stock options.
As indicated earlier, however, for those small businesses
that are affected by our proposal, the proposal includes
several provisions intended to alleviate the cost of
implementation. First, the proposal includes a special
provision that would permit most small businesses, including
all that are not public, to measure compensation costs using a
simpler, less costly intrinsic value method rather than the
fair value method that would be required for most public
enterprises. Under the intrinsic value method, the amount of
compensation expense required to be reported would generally be
equivalent to the amount of the income tax deduction for stock
options.
Second, the proposal includes a special provision that
provides most small businesses that are nonpublic enterprises
with a simpler, less costly prospective transition to the new
requirements.
Finally, the proposal includes a special provision that
provides that the effective date of the proposed standard for
nonpublic enterprises would be delayed for 1 year until 2006.
I also would like to note that the proposal includes a
notice for recipients that highlights and describes all these
special provisions. The notice requests that respondents to the
proposal indicate whether there are other special provisions
for small businesses that might be appropriate and whether any
or all such special provisions should be extended to public
enterprises that are small business issuers under the Federal
securities laws.
The Board currently plans to discuss the proposal, special
provisions and other issues about the proposal with
representatives of small business at the inaugural public
meeting of our Small Business Advisory Committee next week, May
11th. Our request for agenda items for this meeting showed
interest in this proposal. We also plan to hold public
roundtable meetings in June with valuation and compensation
experts, and users, auditors, preparers of financial reports to
discuss a broad range of issues about the proposal.
Following the end of the proposal's comment period in June,
the Board plans to redeliberate at public meetings issues
raised in response to the proposal. Those redeliberations will
include very careful consideration of the ongoing input
received from all parties, including ongoing input from the
members of the Small Business Advisory Committee. Only after
carefully evaluating the input at public meetings will the
Board consider whether to issue a final standard.
The Board's current plans are to complete its deliberations
and be in a position to issue a final standard in the fourth
quarter of this year.
On behalf of myself and Bob, I would again like to express
our deep appreciation for inviting us to participate in this
hearing. All the information we obtain in connection with this
hearing will be carefully considered.
In conclusion, let me assure you that you, the users,
auditors and preparers of financial reports, including small
business financial reports, can have confidence that the Board
will continue to actively reach out and solicit input in
response to our proposal. That input will be carefully
considered in an open, thorough and objective manner. Our
ultimate goal is to develop an accounting standard that will
faithfully report the underlying economic effects of equity-
based compensation transactions and thus significantly improve
the transparency and integrity of financial reporting in the
United States.
Thank you again, Representative Royce and other
subcommittee members. Bob and I would welcome the opportunity
to respond to any questions.
Mr. Royce. I thank you, Mr. Batavick.
[The prepared statement of Robert Herz and George Batavick
can be found on pages 172 and 175 in the appendix.]
Mr. Royce. Let me begin by asking a question of Mr. Herz.
Mr. Herz, in a letter to the Financial Accounting Standards
Board dated December 29th of 1993, Coopers and Lybrand
contended that using option pricing models results in
unreliable information and would have an adverse impact on the
comparability and usefulness of financial statements, and your
name and number are provided as contact information to discuss
this letter. I wanted to ask you how you reconcile your
position in this letter with your position today. We are
assuming that the letter would not have provided your contact
information without your endorsement of the arguments that are
made there, which are some of the arguments that we have heard
on the Hill over the last month again replayed as we have
discussed this issue.
Mr. Herz. Well, I don't remember the particular
memorandums. I obviously take good faith that that is it.
Mr. Royce. Well, don't take it on faith. It says, if you
have any questions regarding our comments, please contact
Ronald Murray or Bob Herz at this number, or David Lookate.
Mr. Herz. Right. I think that, you know, at that time I did
believe on the face of it without a lot of investigation, I
just had come into the national office of Coopers and Lybrand,
and from the practice that, you know, those were the views.
Those were the views that we were hearing from many clients at
the time.
I have now had the benefit of an intensive look at this
subject, both on the International Accounting Standards Board
and also at the FASB, I mean, an intensive look at it, and you
live and you learn. I don't believe that those arguments, as
far as at least the valuation, hold water. Will they have an
impact on emerging businesses? Well, we have got special
provisions in our proposal, A; and, B, yeah, there are economic
consequences in terms of better information that arise from
changing accounting standards.
Mr. Royce. Well, let me ask you a question about that
intensive look, and I may be wrong on this, but to my
knowledge, as far as the Board is concerned, I don't think that
you field-tested valuation models when it comes to trying to
determine this new methodology. I don't know that you have
taken various valuation models by a cross-section of companies
so the significant data would be collected on the accuracy and
reliability of these different valuation models. And I was
going to ask you, are there any studies that you have relied on
that show specifically that the binomial method values employee
stock options accurately?
Mr. Herz. Well, we have done a lot of work on the valuation
area. We have convened a group of expert panel called our
Options Valuation Group, which are experts in valuation
compensation, equity derivatives, which a stock option is. Our
staff and the Board met with them a number of times. We did
have field visits to a number of companies that included a
cross-section of companies across industries and sizes of
companies, both public and private. We have reviewed the
results of research studies on data that exists.
Let me step back, though, that----
Mr. Royce. Let me explain where I am going with this so
that you better understand my point. Your spokesman Cheryl
Thompson defended the decision not to field-test valuation
models by telling the press that the ultimate field test has
already taken place. She added that public companies have been
performing this field test for 7 consecutive years, so the test
sample is huge. It involves thousands of companies.
I believe I am correct in assuming that Ms. Thompson is
referring to the use of Black-Scholes in footnote disclosures
over the past number of years. I suppose that one could argue
that it makes sense if the exposure draft required all
companies use the Black-Scholes model, but what we are now
doing is urging companies to use something different, which is
the binomial method. And so my question here is why not conduct
field tests on the accuracy of that particular model?
Mr. Herz. Well, the--first of all, there are now 575
companies that are expensing in their income statements. Some
of those use the binomial model, and we have talked to them.
Secondly, it is a misnomer to call them completely two
different models. They are basically related. They are derived
from the same financial economic theorem. The binomial model is
really opening up the Black-Scholes model. The Black-Scholes is
kind of a hard-wire model that you put in one set of
assumptions, and you get a result. The binomial works off of
exactly the same theory, but you can peer into the hard-wiring
and look at it period by period, and you can make adjustments
for better data period by period.
Mr. Royce. Well, you make the point that 576 firms, in your
words, have----
Mr. Herz. Can I----
Mr. Royce.--expense--let--let me just ask you, do any of
those companies have broad-based stock option programs? Because
there are thousands and thousands of companies that have not
embraced this, that do have broad-based stock option programs,
and that is where we are focused. And I will let you respond to
that, and then I have one last question before we go to my
colleague here.
Mr. Herz. Well, there are a number of companies with broad-
based plans that have gone to expensing, like Netflix and Home
Depot and Wal-Mart and the like.
My other point I was trying to make is that the binomial
model is regularly used on a daily basis to value equity
derivatives and other derivatives. It is a model that works.
Mr. Royce. My last question is this, and I realize the
Financial Accounting Standards Board is pretty far down the
path on this proposal, but that said, just yesterday I learned
of a new proposed method of expensing options that works very
differently than Black-Scholes and works differently than this
binomial method and that you have articulated, and I was going
to ask what your opinion would be in terms of being open to
consider this new proposal for expensing at this point in the
process.
Mr. Herz. Oh, we are open--we get suggestions almost daily,
so----
Mr. Royce. So what would the process and the timetable be--
--
Mr. Herz. The process is they should send us something in
writing, and then we will have a look at it, and we will meet
with them. And we have done that with many different parties.
And we also, when we get something like that, consult with our
panel of experts also.
Mr. Royce. Thank you, Mr. Herz.
We will go to Mr. Sherman.
Mr. Sherman. Thank you, Mr. Chairman.
Mr. Batavick, your testimony provided really useful,
personally, information. Right after these hearings I am going
to go out and sell all the stock in the company that makes
Ambien. That stock is going to crash once everyone becomes
aware that replays of FASB meetings are available for free.
It is rather absurd for you to say that small businesses
don't have to use FASB pronouncements in preparing their
financial statements if they choose not to go public. Every
bank wants statements prepared under Generally Accepted
Accounting Principles, and FASB pronouncements cannot be
ignored in determining what is generally accepted. And, of
course, our State corporate laws make certain dividends illegal
unless certain capital--certain amounts of capital are
available calculated under GAAP. So you understate the
importance of your Board if you say that you are not legally
binding on nonpublic companies in this country.
Speaking, though, of small businesses, the binomial method,
as I understand it, could be expensive to use, could involve
many thousands of dollars of accounting fees. Let's say you had
a small company, you used Black-Scholes, and you came out with,
say, half a million dollars of stock option compensation
expense. But that half million was material. Is there anything
in the exposure draft that says in order to help you save on
accounting fees, as long as your Black-Scholes number is under
half a million, you can use binomial; or does the exposure
draft say if you are tiny, then whatever amount that is
material to you, you have to go spend the money on the
accounting fees to use the more sophisticated approach? Do you
allow a less expensive calculation method for small companies?
Mr. Batavick. Right now we are not requiring one method
over the other. What we are saying is the fact that we have a
Black-Scholes method, we also have the binomial method, and the
statement we make in the proposal is that in certain
circumstances that may be preferable, but it is also based on
if you have the information available to----
Mr. Sherman. I would hope that--and I will get to this in a
second. I think it is a tragic flaw in your exposure draft that
you provide so little guidance as when to use one method or
when to use the other and----
Mr. Herz. Could I just interject, if I might?
Mr. Sherman. Yes.
Mr. Herz. In our proposal if a small business is a private
company, they don't even have to use option pricing models.
They can elect not to use option pricing models.
Mr. Sherman. Yes, but many of--if they are not someday
going to be public, nobody may want the stock options anyway.
Stock options are generally used for companies that intend to
go public. I realize there may be some exceptions to that.
Mr. Herz. We don't say if you are going to go public. If
you are private, you----
Mr. Sherman. You don't have to. I would hope that GAAP
would mean the same thing, that we would take the--I know you
can propose vague standards. That is what you have done the
last 30 years. You said you can expense them or not expense
them, your choice. Now you are going to say, well, by Black-
Scholes, binomial, or if you are not public, some other
guesstimate.
I would hope that you would provide real guidance to the
profession, that people reading financial statements are not
going to have to look at the footnotes and try to guess what
was done and how to make two statements comparable. The whole
idea here is you should be able to compare Coke and Pepsi, not
the taste test, the financial test. And for a while there, one
was expensing and one wasn't. Now we are going to have one
binomial and one Black-Scholes and then some small beverage
company using a third method or no method at all.
I would hope that if you are in the standards-writing
business, you would write standards, not guidelines, not
guesstimates, especially when those who oppose what you are
doing have said this could be a fertile area for lawsuits.
Now, I realize there are other areas of accounting where a
judgment is required, but here you are talking about executive
compensation, the juiciest thing to bring before a jury. You
are inviting lawsuits when you take that juicy area and you
don't provide guidance.
I would hope that guidance would factor in availability of
information, would factor in cost of calculation, and would
then say, okay, apply Black-Scholes. If you meet these
standards of materiality, if you meet this dollar figure, then
you have got to go use the binomial, and here's how you ought
to use it.
Let's see. My next question, though, is why don't you delay
this whole thing until you get the research thing right, and
are you concerned that you are now going to have--eliminate
this compensating error, and you are going to adopt an
accounting system for this country that discriminates against
our high-tech sector?
Mr. Herz. Let me go back to a few other points you made and
then go to the R&D point.
I think if you look at our exposure draft, there is plenty
of guidance on valuation. It may not be hard-wired guidance. It
is guidance that fulfills what we have been told to do in
objectives-oriented standards by the SEC in the report they
issued to you last summer, to Congress on Sarbanes-Oxley. It is
much more detailed, for example, than in many other areas of
valuation. I----
Mr. Sherman. As is executive compensation. Two accounting
firms should come up with the same answer. If they don't, there
is going to be lawsuits, and if there is going to be lawsuits,
that is a strong argument for us to pass this bill.
Mr. Herz. If you look at our notice to recipients, there
are several questions specifically on that point, how hard-
wired, how prescriptive would you like us to get, models,
assumptions. Now, we have already gotten some responses that
say we have already provided too much guidance. So there is a
diversity of views. I----
Mr. Sherman. Well, of course. The people who don't want to
expense options want as much looseness as possible so they can
state as low a number as possible.
Mr. Herz. But one of those responses is from a major audit
firm. Okay? So----
Mr. Sherman. But they tend to agree with their clients.
Surprise.
Mr. Herz. I don't know if their clients feel that way. I
mean, the point is there is a diversity of view. We have asked
the question specifically because we recognize that
sensitivity. We can hard-wire everything if that is what people
want.
Mr. Sherman. Or that one accounting firm could compete
under the slogan, we use the play in the joints to understate
your executive--to minimize the statement of your executive
compensation. It would be a whole new slogan.
Mr. Herz. I think one of the benefits of the Sarbanes-
Oxley, the auditors are doing more robust audits, I believe.
The SEC is certainly reviewing a lot more, and this is an area
they would intend to review.
On your R&D question--and, you know, you and I have had
discussions. I personally agree with you, but thousands don't.
And I will tell you there is good news on that front, or
potentially good news on that front, in that we met with the
International Accounting Standards Board, like we do every 6
months, and we, subject to our own agenda processes, agreed to
look at the area of both R&D and more broadly intangibles.
Mr. Sherman. But, Mr. Chairman, shouldn't you stop all work
on this stock option thing, which is going to hit high-tech
hard--and they are already screaming--when you are already
hitting them? And fairly, I might add, but you have been
hitting them hard and pounding them hard, much harder unfairly.
Shouldn't you abstain from correcting this mistake until you
can deal with that mistake, or do you think you should just
pound high-tech when they are right on the accounting and when
they are wrong on the accounting?
Mr. Herz. Well, again, the issue of R&D, you and I may
agree personally. There are many who don't, so----
Mr. Sherman. Is there any accounting theory textbook, that
supports the idea of expensing every research expenditure done
in-house no matter how valuable the results are and no matter
how provable the value of those results are?
Mr. Herz. The accounting rationale is that it is not
sufficiently measurable.
Mr. Sherman. You can't measure--yes. That is--you know
how--let's put it like this: There is no accounting theorist I
am aware of anywhere in this country that would come to the
conclusion that you should write off all R&D.
Mr. Herz. I would ask the--in response to your suggestion,
which, you know, I agree with--as you know, I agree with not
only capitalizing R&D per se, but I think the whole area of
intangibles that are big-business value drivers is something
that is missing off of contemporary balance sheets.
I will tell you, though, the history of this issue
being--the last time, I understand, it was raised by the
FASB a few years ago, the biggest opponents of it were the
high-tech firms.
Mr. Royce. Mr. Frank.
Mr. Frank. Mr. Herz, in the full text that you gave us, and
I appreciate it, on page 27, you address towards the end the
objections, and you list four of them. The last one is you
phrase the objection as mandatory expensing of employee stock
options will have negative economic consequences.
To me that is the nub of what we are here for. We are not
the plutonic board of perfect accounting. We get involved where
there are negative economic consequences, and I have to tell
you, I don't--I think if I were a judge and this was the
argument, you would lose on summary judgment. I mean, you make
a lot of good arguments, but there is none.
You kind of implicitly--and that may not be controlling,
but this is so you will understand the dilemma. Implicitly, in
the beginning of the second paragraph of that page, the Board's
operating precepts require it to consider issues in an even-
handed manner without attempting to encourage or to discourage
specific actions. That does not imply that improved financial
reporting should have no economic consequences, but it seems to
me to be a concession that--not a concession, a statement that
you are going to go ahead and do this, and that is the dilemma
many of us have, because I certainly agree on the accounting--
let me ask you, to go back to the question I posed, other than
aesthetically, who is getting hurt now by the current
accounting firm options? Who is the victim?
Mr. Herz. Well, I think this all kind of relates
together.You know, our mission is to improve financial
reporting----
Mr. Frank. I understand that, but if that is the answer,
okay, but is somebody being hurt now by the current situation?
Mr. Herz. Well, certainly the people who were surveyed the
financial analysts, surveys of investors, tech investors, all
say they want it in the score because it is not transparent
right now. They don't--they pick up numbers from databases. The
CBO said that it would be more transparent----
Mr. Frank. Please, I don't need you to tell me what the CBO
said. I rarely pay attention to them. And transparency is a
means, if not the end. And if the answer is it is wrong and it
doesn't make a difference if anybody is getting hurt, then
okay. But as far as transparency, let me say this: The
information is there now, isn't it? It is just not--if I were
going to invest in a company, which I--we get enough ethics
from--so I don't address individual companies. But if I was
going to invest in an individual company, I or somebody I was
paying to help me do this would read the footnote. So let me
put it this way: If I were going to invest in an individual
company, would I get more information about what is actually
happening one way versus the other?
Mr. Herz. You're going to get more information the way we
are proposing it
Mr. Frank. What information would I get from you that I
don't now get? I would get the fact that the options would be--
would I not now get the fact that the options were being
granted and how many there were? Would I not know that?
Mr. Herz. You would know that, but you would not know
things like operating margins, return on equity, all those
things that are just--by not running it through the financial
statements, you are not getting the full accounting
Mr. Frank. You are saying that I would be--that the
investors can't do that themselves. I get everything else and
then I get the options, and I wouldn't be able to, myself,
figure out or decide for myself to what extent the existence of
the options added to or detracted from the value of the
investment?
Mr. Herz. If you were a sophisticated investor and you took
the footnote, you would be able to get part of that
information, not all of it
Mr. Frank. What wouldn't I be able to get?
Mr. Herz. You wouldn't be able to get things like gross
margin, you wouldn't be able to get operating results, you
would have to recompute----
Mr. Frank. Well, those are things to which there is some
element of uncertainty, though; right?
Mr. Herz. Well, they are things that if you do the
accounting properly, they are just there.
Mr. Frank. Well, but isn't there some element of
uncertainty there? I mean, I was struck when you told Mr.
Sherman that the obstacle to dealing with research differently
is that it is hard to measure. Is it a lot easier to measure
than the options, or a lot harder?
Mr. Herz. No, the options are much easier to measure than
the early stage of research
Mr. Frank. And you couldn't just make available to people
what the measurements are and let them do it themselves?
Mr. Herz. We have been doing that
Mr. Frank. Okay, we have been doing that. Who has been
hurt? Have you gotten any complaints? Is there anyone we know
of that?
Mr. Herz. Yes.
Mr. Frank. No, I know they said we would rather. Did anyone
say I was misled?
Mr. Herz. Yes.
Mr. Frank. I invested unwisely?
Mr. Herz. Yes, we have lots of letters from individual
investors.
Mr. Frank. Well, I have read your comments and the samples
you gave. None of them say that. You gave one set of samples.
You didn't give the other. You gave people that said, oh, these
greed-mongers, they are terrible. You have people saying it
would be more desirable. But surely you understand the
difference between a general assertion that it would be
desirable and an assertion that an individual was hurt.
Does anybody anywhere--I will make a plea. There are other
people here from the SEC; would anyone bring forward to me some
individual who was misled because the options were not
expensed? Do you know of any claims of that sort, Mr. Herz?
Mr. Herz. Yes.
Mr. Frank. Where are they, Mr. Herz? They are not in your
statement. Point them to me. Which one did I miss?
Mr. Herz. I don't know, we have got hundreds and thousands.
Mr. Frank. Well, you picked some out. None of the ones you
picked out say that. None of the ones you picked say ``I was
misled,'' and I am reading them. I strongly recommend people
like me will stay away from the market as long as they are
passed out like funny money
Mr. Herz. Can we follow up with you?
Mr. Frank. Yes. Okay. And I am surprised we haven't heard
reports because this is the issue.
Mr. Herz. I think an important point is that it is a well-
known, well-accepted thing in accounting, that disclosure
doesn't cure bad accounting. And we get requests all the time
for just put it in the footnotes. When we were going through
the improvements----
Mr. Frank. Sir, you do realize this is totally irrelevant
to my question? If you want to give more general statements
about why you should do this, okay. And that is part of the
problem you have got.
I thank the Chairman for the indulgence. Here is the
problem you have got, and I don't want--I am not a co-sponsor
of the bill. I am really torn here. But I have people telling
me this is going to cause a problem. I mean, I have a technical
intellectual argument. Clearly these are not free. I understand
that. How you account for them there is a question.
But a lot of people are saying, look, this is going to
cause a problem; and they are going to cause a problem again
because of the way the market will perceive this. And so as a
public policymaker, not as an accounting technical specialist,
I say, okay, well, if there is a potential for the problem
here, what are we solving? What are we solving? What problem am
I solving other than an intellectual failure?
Frankly, if I was going to go around this city and resolve
every intellectual failure, I would be a wreck. So I am looking
for some public policy break. And, yes, I would appreciate it,
please follow up with me, because I think that is why you are
here. You are not here because people differ with you
technically on the accounting. As was implied in the question
from Mr. Sherman, no one cares about that. That is your job,
and we are glad you have it and are ready to do it.
The issue here is, is there some real economic harm that
could come? And that is the area I think in which further help
from you would help your cause, and so that is it.
Yes, I yield to my colleague from California.
Mr. Sherman. I would say the one obvious harm is that those
companies that choose not to use stock options are at a
disadvantage in attracting capital as opposed to those who do.
Mr. Frank. Okay. But I would say again, because people in
the market don't understand this, it all comes down--to some
extent I have to say I feel a little bit good about this in one
sense, having been for years told, listen--well, let me say
there was a former majority leader of this institution who used
to say government is dumb and markets are smart. Well, these
markets ain't the smart ones. These are the markets that are
confused because of the accounting.
So I am just a little glad to say that. I agree. But that
is the issue; it is not the investor being misled, it is the
competitive disadvantage to the other people.
I am sorry. Did the other gentleman from California want me
to yield?
Mr. Royce. No, I was just going to make the point that it
is easier just to point out the intellectual failures in this
city than in the market.
But we are going to go to Mr. Hinojosa.
Mr. Frank. Thank you
Mr. Royce. Mr. Hinojosa, you also had an opening statement
you wanted to make, and at this point we will give you that
opportunity, and then, please, go to your questions.
Mr. Hinojosa. I will submit my opening statement in
writing.
Mr. Royce. Without objection.
[The prepared statement of Hon. Ruben Hinojosa can be found
on page 81 in the appendix.]
Mr. Hinojosa. I would like to make a statement and ask a
question or two. Thank you, Chairman Royce.
I am very pleased that the subcommittee had the opportunity
to hear the views of the Financial Accounting Standard Boards,
or FASB, on its proposal to expand stock options, especially
since you are the entity that will be directly impacted by the
legislation I have co-sponsored and supported thus far, H.R.
3574, the Stock Option Accounting Reform Act.
I am aware of the allegations that have been made, that
FASB has been hiring lobbyists, or, rather, actually having
registered lobbyists on staff who have been encouraging Members
of Congress to support its proposed legislation, thus calling
into question the longstanding perception of FASB as an
independent agency. Certain individuals have come to my office
recently to express concerns about particular aspects of H.R.
3574. And after listening to you make your statement and the
questions that the Chairman and others have asked, I will
reread through today's testimony and have my staff obtain a
copy of it to determine if those concerns were addressed, as
well as having them follow up with FASB.
Mr. Batavick, what is your background?
Mr. Batavick. Most recently, I was the retired comptroller
of Texaco, Inc. We were acquired by Chevron a few years ago,
and because of that I left the combined company. Prior to that
I was with Getty Oil Company. That was acquired by Texaco. And
before that I was in public accounting.
Mr. Hinojosa. Those are very good companies, very large,
and I just cannot understand how you can be speaking so much
for the small businesses unless you ran small businesses before
you went to Texaco.
Mr. Batavick. Actually, when I was going through school, I
worked two summers at a public accounting firm that only did
the accounting for small businesses. I did both accounting as
well as auditing. Also, when I joined Getty Oil Company, most
of our service stations are not owned by the company
themselves, they are owned by small businesses. And I worked
very closely with those small businesses during my early years.
Mr. Hinojosa. Well, Mr. Chairman, and Ranking Member Barney
Frank, and Congressman Sherman, again thank you for calling
this important hearing and I look forward to working with you.
Mr. Royce. Thank you. Mr. Herz, you wanted to respond?
Mr. Herz. Yes, I wanted to respond to the question about
lobbyists. I want to be very clear on this. We have not asked
any firm to lobby for us with respect to our proposed standard
to improve the accounting for equity-based compensation.
Our Washington, D.C. Representative, Jeff Mahoney, since
1996 has provided information and responded to questions about
the FASB and its activities from staff and Members of Congress,
Federal Government officials and other interested parties in
Washington, D.C. He also works hard to keep interested parties
informed. And, yes, we do speak our minds when there is
proposed legislation that would intrude upon our independence
and upon our ability to do our work in a thorough, open, and
objective way.
Jeff also arranges for me to meet directly with Members of
Congress, Federal Government officials, and other interested
parties to provide them with timely information on our
activities.
Because our communications sometimes entail lobbying
contacts, as defined in the Lobbying Disclosure Act, relating
to proposed legislation like this one, relating to our mission
and activities, Jeff and I, and my predecessor since 1998, were
registered under the Lobbying Disclosure Act on behalf of the
Financial Accounting Foundation, our parent group.
Basically, the history of this is that when Chairman Baker
introduced a bill in 1998 relating to accounting for
derivatives, many Members of Congress solicited the views of
Mr. Mahoney and our then-chairman Ed Jenkins. They consulted
with legal counsel who advised them to be safe, to register as
lobbyists. When I came on board they registered me as a
lobbyist. That has nothing to do with this particular matter in
question.
In fact, I think it is a little bit like the pot calling
the kettle black. We have all read all the stories, and in a
Senate hearing last week one of the Senators used the term
high-tech lobbyists swarming all over Capitol Hill. We did not
start anything here in Congress. It is your purview. We welcome
the inquiry and all of that, but we try to respond to the
questions of Members about the proposed legislation. But that
is all.
Mr. Royce. Mr. Herz and Mr. Batavick, we want to thank you
both for appearing before our panel today. Let me also note
that some members may have additional questions for both of you
which they might want to submit in writing. If we can give them
30 days to submit those questions, and within those 30 days if
you would complete your response for the record, we will
collect those from you.
Again, we thank you both for making the trip here to
testify today. This hearing is adjourned.
[Whereupon, at 3:17 p.m., the subcommittee was adjourned.]
A P P E N D I X
April 21, 2004
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A P P E N D I X
May 4, 2004
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