[Senate Hearing 108-671]
[From the U.S. Government Publishing Office]
S. Hrg. 108-671
OVERSIGHT HEARING ON EXPENSING STOCK
OPTIONS: SUPPORTING AND STRENGTHENING
THE INDEPENDENCE OF THE FINANCIAL
ACCOUNTING STANDARDS BOARD
=======================================================================
HEARING
before the
FINANCIAL MANAGEMENT, THE BUDGET, AND INTERNATIONAL SECURITY
SUBCOMMITTEE
of the
COMMITTEE ON
GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
ONE HUNDRED EIGHTH CONGRESS
SECOND SESSION
__________
APRIL 20, 2004
__________
Printed for the use of the Committee on Governmental Affairs
94-481 PDF
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COMMITTEE ON GOVERNMENTAL AFFAIRS
SUSAN M. COLLINS, Maine, Chairman
TED STEVENS, Alaska JOSEPH I. LIEBERMAN, Connecticut
GEORGE V. VOINOVICH, Ohio CARL LEVIN, Michigan
NORM COLEMAN, Minnesota DANIEL K. AKAKA, Hawaii
ARLEN SPECTER, Pennsylvania RICHARD J. DURBIN, Illinois
ROBERT F. BENNETT, Utah THOMAS R. CARPER, Delaware
PETER G. FITZGERALD, Illinois MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama MARK PRYOR, Arkansas
Michael D. Bopp, Staff Director and Chief Counsel
Joyce A. Rechtschaffen, Minority Staff Director and Counsel
Amy B. Newhouse, Chief Clerk
------
FINANCIAL MANAGEMENT, THE BUDGET, AND INTERNATIONAL SECURITY
SUBCOMMITTEE
PETER G. FITZGERALD, Illinois, Chairman
TED STEVENS, Alaska DANIEL K. AKAKA, Hawaii
GEORGE V. VOINOVICH, Ohio CARL LEVIN, Michigan
ARLEN SPECTER, Pennsylvania THOMAS R. CARPER, Delaware
ROBERT F. BENNETT, Utah MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama MARK PRYOR, Arkansas
Michael J. Russell, Staff Director
Richard J. Kessler, Minority Staff Director
Nanci E. Langley, Minority Deputy Staff Director
Tara E. Baird, Chief Clerk
C O N T E N T S
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Opening statements:
Page
Senator Fitzgerald........................................... 1
Senator Akaka................................................ 5
Senator Bennett.............................................. 5
Senator Levin................................................ 7
Senator Lieberman............................................ 13
WITNESSES
Tuesday, April 20, 2004
Hon. Mike Enzi, a U.S. Senator from the State of Wyoming......... 16
Hon. Barbara Boxer, a U.S. Senator from the State of California.. 20
Robert H. Herz, Chairman, Financial Accounting Standards Board... 23
Hon. Paul A. Volcker, Chairman, International Accounting
Standards Committee Foundation, and former Chairman, Board of
Governors, Federal Reserve System.............................. 26
Jack T. Ciesielski, President, R.G. Associates, Inc.............. 46
Damon Silvers, Associate General Counsel, The American Federation
of Labor--Congress of Industrial Organizations (AFL-CIO)....... 49
Donald P. Delves, President, The Delves Group.................... 51
Mark Heesen, Presdient, National Venture Capital Association..... 52
James K. Glassman, Resident Fellow, American Enterprise Institute 54
Alphabetical List of Witnesses
Boxer, Hon. Barbara:
Testimony.................................................... 20
Prepared statement........................................... 77
Ciesielski, Jack T.:
Testimony.................................................... 46
Prepared statement with an attachment........................ 89
Addition to written statement................................ 97
Delves, Donald P.:
Testimony.................................................... 51
Prepared statement with an attachment........................ 100
Enzi, Hon. Mike:
Testimony.................................................... 16
Prepared statement........................................... 73
Glassman, James K.:
Testimony.................................................... 54
Prepared statement........................................... 112
Heesen, Mark:
Testimony.................................................... 52
Prepared statement........................................... 105
Herz, Robert H.:
Testimony.................................................... 23
Prepared statement........................................... 80
Silvers, Damon:
Testimony.................................................... 29
Volcker, Hon. Paul A.:
Testimony.................................................... 26
Prepared statement........................................... 86
Appendix
Prepared statements from:
American Institute of Certified Public Accounts.............. 126
Association for Investment Management and Research........... 128
William R. Sweeney, Jr., Vice President, on behalf of
Electronic Data Systems Corporation........................ 143
Coalition to Stop Stock Options.............................. 145
Letter to The Honorable Robert H. Herz from Senator Enzi dated
December 5, 2003............................................... 148
Article from the Wall Street Journal entitled ``FASB Chairman
Calls For Investors To Speak Up On Options,'' submitted by
Senator Enzi................................................... 150
Letter of clarification from Mark Heesen, President, NVCA, dated
April 30, 2004................................................. 152
``The Analyst's Accounting Observer,'' submitted by Mr.
Ciesielski..................................................... 153
The study entitled ``Corporate Governance, Executive
Compensation, and Strategic Human Resource Management From
1992-2002, A Portrait Of What Took Place,'' by Professors
Joseph R. Blasi and Douglas L. Kruse........................... 212
Questions and Responses for the Record from:
Mr. Herz..................................................... 270
Mr. Volcker.................................................. 285
Mr. Ciesielski............................................... 290
OVERSIGHT HEARING ON EXPENSING STOCK OPTIONS: SUPPORTING AND
STRENGTHENING THE INDEPENDENCE OF THE FINANCIAL ACCOUNTING STANDARDS
BOARD
----------
TUESDAY, APRIL 20, 2004
U.S. Senate,
Financial Management, the Budget, and
International Security Subcommittee,
of the Committee on Governmental Affairs,
Washington, DC.
The Subcommittee met, pursuant to notice, at 2:33 p.m., in
room SD-342, Dirksen Senate Office Building, Hon. Peter G.
Fitzgerald, Chairman of the Subcommittee, presiding.
Present: Senators Fitzgerald, Bennett, Akaka, Levin, and
Lieberman.
OPENING STATEMENT OF SENATOR FITZGERALD
Senator Fitzgerald. This meeting will come to order. I
would like to thank all of the witnesses who are here today to
testify. Some of you came very long ways and made special
arrangements in otherwise very busy schedules to be here, and
we definitely appreciate that very much.
This oversight hearing is to examine the new Financial
Accounting Standards Board rule which will require companies to
expense an estimate of the value of stock option compensation
to their employees and management. I will state up front that I
agree with FASB's new rule and that I favor it.
Several bills regarding this issue have been introduced in
Congress, both in the House and the Senate, and there is going
to be a hearing on the House side tomorrow to examine some of
those bills. We will hear today from Senator Enzi, who is a
proponent of one of these bills. The bills in varying forms
would move to disallow FASB's new rule or to mandate the
treatment of stock option compensation for accounting purposes
as a matter of Federal law.
I disagree with those bills, and I oppose them for two
reasons: One, I agree with the new FASB rule, although I think
it could be stronger. I think it is actually thoroughly
permissive, but I nonetheless support it. But two, I believe
that political interference with our private sector standards
accounting board is a dangerous precedent, and one can think of
all sorts of other areas in which we could follow this
precedent. What if Congress started usurping the authority of
the Food and Drug Administration to allow a new pharmaceutical
to be introduced on the market? I think it is a bad idea for
politicians in the House and the Senate to be substituting
political decisions for an expert agency, or in this case, an
expert private sector accounting standards board.
We have been down this road before. Back in 1993-94 FASB
proposed a new rule that would have required the expensing of
stock option compensation. At that time Senator Lieberman
introduced a resolution in the Senate which condemned FASB's
new rule. I think the vote was 88 to something. It was very
lopsided in favor of Senator Lieberman's resolution. And a
separate bill was introduced that would have effectively put
FASB out of business if they did not back down from their new
rule that would have required the expensing of stock options. I
think Congress' interference with that 1993-94 proposal of FASB
resulted in disastrous consequences.
One of my most vivid recollections in my last 5 plus years
in the Senate was sitting in on the Enron hearings in the
Commerce Committee, where we saw a company which had its top 29
executives cash in 1.1 billion in stock option compensation in
the months immediately prior to the company's stock market
collapse and eventual bankruptcy. I think that the Senate
opened the floodgates to an anything goes accounting mentality
in the late 1990's, and many other companies wound up like
Enron, Global Crossing, WorldCom, and so forth.
Opponents of the new FASB rule say that it is difficult to
estimate the value of options. I am not sure I really agree
with that. I think options can be sold for cash which makes
them as good as cash. Warrants are similar if not functionally
the same as options, and they are valued and sold all the time.
Options on stocks are traded on markets all over the world. In
Chicago we have the world's largest option exchange, the
Chicago Board Options Exchange. My guess is that many
executives who have copious amounts of options sometimes assign
huge values to them on their own personal financial statements
when they go to borrow from a bank. In fact, as a former
banker, I recall seeing financial statements where executives
holding large amounts of options would list them as a
substantial asset on their personal financial statements.
In any case, it is difficult to value a lot of other things
for which we require companies to account. It is certainly
difficult to estimate pension liabilities, the value of
derivative positions. If you are a bank, it is very difficult
and a matter of imprecision to estimate what your loan loss
reserve should be. Impairment of goodwill is very difficult to
assess, and even the age-old question of what is the useful
life of plant and equipment. That is a very difficult
accounting decision. Yet no one argues that for these other
items, difficulty to estimate gives a company license to
pretend that these expenses do not exist either.
Opponents say that stock options require no cash outlay by
a company and that they therefore need not be expensed. But
depreciation, for example, requires no cash outlay either, and
no one argues that we should not try to account for the real
expense of the using up or the exhausting of plant and
equipment that a company will have to replace. Furthermore,
large amounts of stock options often later necessitate large
cash outlays. Companies sometimes have to use more cash on
share repurchases to stem shareholder dilution than they would
have on cash compensation for their employees.
Opponents say stock options are not a real expense to a
company. If that is so, why do we allow companies to take a tax
deduction for the expense of issuing stock options? If the
opponents were consistent in their thinking, they would support
changing the current IRS rules which allow for the tax
deductibility of stock option compensation.
Opponents say that requiring options to be expensed would
penalize the earnings of young promising companies, and thereby
make it more difficult for such companies to survive and
succeed. But as Warren Buffett has written, ``Why then require
cash compensation to be recorded as an expense given that it
too penalizes the earnings of young promising companies?''
Going further, Mr. Buffett asks, ``Why not allow companies to
pay all of their expenses in options and then pretend that
these expenses don't exist either?'' In fact, I know that many
companies have in fact paid a lot of their bills in options. I
have talked to a lot of law firms in Chicago that took stock
options in lieu of cash in the late 1990's for their legal
bills.
I would like to focus for just a moment on the shareholder
dilution impact of stock options. Last night it occurred to me
to pull out the classic 1934 edition of ``Security Analysis''
by Benjamin Graham and David Dodd. I looked to see if they had
anything in there about stock options, and they do in fact have
a whole section on what in 1934 they called ``stock option
warrants,'' which seem effectively the same thing. They said
stock option warrants were frequently paid to managers or
insiders in companies or to promoters of stock. In the 1920's
and early 1930's it was common when someone would sell your
stock, you would give them stock option warrants as
compensation. Benjamin Graham and David Dodd, I think, are very
eloquent in describing what the effect is when companies issue
options.
In a company that has common shares only and no options,
the common shareholders will capture 100 percent of any future
rise in the value of the company. Common shareholders have an
inherent right to the future enhancement or improvement in the
value of a company. When you issue options, you are allowing
someone else a claim on the future enhancement in the community
that is diluting the formerly 100 percent claim on the future
enhancement or growth in the company that the shareholders had.
If a company's prospects for future revenue and earnings growth
are strong, the value that is taken away from common
shareholders by issuing stock options and given to the option
holders can be quite substantial. In fact, if enough stock
options are issued, nearly all of the common shareholders'
stake in the future rise in the value of the company can be
taken away from them. From my standpoint, there is nothing
inherently wrong with taking a share of the future rise in the
growth of a company away from the shareholders and giving it to
the management or the employees or someone else. There is
nothing inherently wrong with that. In fact, when we pay cash
compensation, you are taking cash away from the shareholders
and giving it to someone else.
What troubles me is that this taking away, this subtraction
from the shareholders' interest, is not disclosed to the
shareholders or to other investors who may be looking at this.
The trouble is that current accounting standard do not require
that the taking away of value from the shareholders by virtue
of the issuance of stock options be fully disclosed. Companies
are not now required to reflect the expense of issuing options
on their income statements. Moreover, the dilution of
shareholders' claims to the earnings of the company is only
disclosed for so-called ``in the money'' options, but is not
required to be disclosed for options that have been issued and
are not yet in the money.
Benjamin Graham and David Dodd had a very simple way of
looking at this. They said that the value of common stock plus
the value of stock options equals the value of the common stock
alone if there were no stock options. Thus, the way they put
it, when you give stock options to someone, you are taking away
something of value from the shareholders and this needs to be
reflected. It should be reflected. If I could just read a
paragraph from this book because Benjamin Graham went on to
describe stock option warrants as a very dangerous device for
diluting stock values. ``The stock option''--and he refers to
it as the option warrant. I am just going to call it the stock
option. ``The stock option is a fundamentally dangerous and
objectional device because it affects an indirect and usually
unrecognized dilution of common stock values. The stockholders
view the issue of warrants with indifference, failing to
realize that part of their equity in the future is being taken
away from them. The stock market, with its usual heedlessness,
applies the same basis of valuation to common shares whether
warrants or stock options are outstanding or not. Hence,
options may be availed of to pay unreasonable bonuses to
promoters or other insiders without fear of comprehension or
criticism by the rank and file of stockholders. Furthermore,
the option device facilitates the establishment of an
artificially high aggregate market valuation for a company's
securities, because with a little manipulation large values can
be established for a huge issue of options without reducing the
quotation of common shares.''
Under current rules, the financial statements of companies
that do not expense stock option compensation are, in my
judgment, fictitious. The Financial Accounting Standards
Board's proposed new rule would make earnings reports more
accurate and would move financial statements from the fiction
to the nonfiction section of the public domain. When it comes
to stock options, expensing them should not be an option. Truth
in financial reporting should be mandatory.
Finally, in closing, I would like to note that there were
many companies lobbying furiously in support of the bills that
would overturn FASB's new rule. They are all over. Lobbyists
are swarming the halls of the Capitol, lobbying furiously. We
asked several of them to appear before our Subcommittee and
explain their views in public. None of them was willing to do
so. I think the fact that none of them was willing to appear
publicly and explain why the company is in favor of the bills
suggests that they are sheepish about what they are doing, and
that perhaps deep down, they too recognize the unwholesomeness
of the fiction that they are hoping to perpetuate.
Without further ado, I would like to turn it over to our
Ranking Member, Senator Akaka from Hawaii. Senator Akaka, thank
you for being here.
OPENING STATEMENT OF SENATOR AKAKA
Senator Akaka. Thank you very much, Mr. Chairman. It is
always a pleasure to work with you, and I want to commend you
for conducting this hearing today.
I want to add my welcome to our friends and colleagues,
Senator Enzi from Wyoming and Senator Boxer from California,
and also our witnesses today.
Mr. Chairman, Enron, WorldCom and other corporate
governance failures demonstrate the dangers of not having
independent accounting and auditing standards. The landmark
Sarbanes-Oxley accounting reform and legislation included a
provision that strengthened the independence of the Financial
Accounting Standards Board, FASB, by providing a more secure
funding mechanism through mandatory assessments on publicly-
traded companies. FASB is intended to be independent and make
their accounting rules on the basis of its judgment.
Now that FASB has proposed that all forms of share-based
payments to employees, including stock options, be treated the
same, the same as other forms of compensation by recognizing
the related costs in the income statement, the reinforced
independence of FASB will be tested.
If Congress interferes with the FASB proposal, the
dangerous precedent of intervention into accounting standards
will be set. Congressional interference is detrimental to the
independent nature of FASB, and accounting treatment of stock
options is a matter best left to FASB to determine.
We must have an independent organization establishing
standards of financial accounting and reporting in an open
environment that is both fair and objective. These standards
are essential to investors having access to transparent and
understandable information.
The Securities Exchange Act of 1934 provides the Securities
and Exchange Commission with authority over financial
accounting and reporting standards for publicly-held companies.
Throughout its history, the SEC has relied on the private
sector for this critical function. We must protect the
integrity of the standards for developing the process and
exercise Congressional restraint on this matter to ensure that
FASB is allowed to pursue policies that it considers to be in
the best interest of the public.
I thank you, Mr. Chairman, for this hearing, and look
forward to the witnesses' testimony.
Senator Fitzgerald. Thank you, Senator Akaka. Senator
Bennett.
OPENING STATEMENT OF SENATOR BENNETT
Senator Bennett. Thank you very much, Mr. Chairman. I
appreciate you holding the hearings.
This is an issue that has been with us a long time, and it
is an issue that does not seem to go away and does not seem to
get resolved, and I am not quite sure I understand why, because
there are good people of good faith on both sides of the issue.
Let me outline that I am in favor of expensing stock options.
Let me state that I am in favor of FASB independence, and agree
that Congress should not be the one to be making accounting
standards.
Having said both of those things, and feeling very strongly
about both of those things, I think FASB has missed the boat
badly on this particular issue and is in danger of doing
significant harm to our economy, and that raises the question
of whether or not policy makers in the Congress should be
heard, not because I do not believe in FASB independence and
not because I am not in favor of expensing stock options. But I
go back to the fundamental rule of medicine, which is do no
harm, and there is a potential here for significant harm.
I think the reason that there is this gulf between your
position, Mr. Chairman, and my concern, is that we are assuming
that a stock option is a stock option is a stock option, and
they are clearly not. I am glad you quoted from the 1934 book,
Mr. Chairman, because it represented an attitude in 1934 that
all of these things are created equal, and they are either good
or bad. They should be either expensed of not expensed. They
are very clearly, in today's economy and in today's corporate
world, nowhere near created equal. The kind of stock option
that you were talking about, Mr. Chairman, which you said can
be sold as cash, and you talked about a market for options in
your home State of Illinois, is not a definition of the kind of
stock option that has given rise to the concern here.
Let me give you an example to illustrate this. The kind of
stock option that can be traded immediately upon being granted,
obviously has a significant value and a market, not that this
kind exists, but theoretically a stock option that is
exercisable only in 30 years has no value whatsoever. Well,
nobody issues stock options that vest in 30 years, but I put
those two as to outside parameters of where we are. There are
people who give options that vest in 3 years and options that
vest in 5 years, and options that vest longer period of time
that are obviously on this continuum and somewhere away from
the options that vest the day they are granted.
When I was working for a New York Stock Exchange listed
company in my youth and got some stock options, they were
vested the day I received them, and back in the 1960's that was
the norm, and therefore, a statement that they ought to have
been expensed, to me was a logical statement. Today that is no
longer the norm. Today you have these many gradations of the
kind I have described, and so as I say, I am in favor of an
expensing statement with respect to options, and I am in favor
of FASB's independence, but I am tremendously disappointed that
from all of the comments FASB has received from companies that
extend options that vest at different times and have clearly
different values, have received no consideration whatsoever in
the FASB rule that has come down. Maybe I just do not
understand the rule and that is why I am here at the hearings,
but there is no question in my mind that the use of stock
options in creative ways that an author in 1934 never
contemplated has created significant economic value in our
overall economy in ways that cannot be measured by either of
the two methods that FASB had adopted.
And to come back to the fundamental question that you
raise, Mr. Chairman, where I am 100 percent in agreement with
you on the principle, but in disagreement with you on the
outcome. We want our financial statements to be accurate. We
want our financial statements to record what is happening in
the marketplace, and in my view, a financial statement that
values an option that does not vest for 5 years at the same
price as an option that vests in 24 hours is a financial
statement that is inaccurate and misleading, and therefore, a
problem for our investors.
As I have talked to people on Wall Street about this, they
have said, well, we are smart enough to figure out the real
impact of these options, and we will ignore the article value
being attached to these options by FASB because we understand
that that information is wrong. So therefore, this whole thing
will be a nullity. If that is the case, why in the world are we
doing it if it is going to be a nullity?
I have not signed on to Senator Enzi's bill. I have some
problems with Senator Enzi's bill, but I have real problems
with the way this whole thing has come down to an either/or,
yes, you are in favor, no, you are not; yes, they should, no,
they should not. I will sign up with the ``yes, they should''
guys as long as we understand that an option is not necessarily
an option is not necessarily an option. Just because it has the
same name, by no means says it has the same value. You have to
look at the details of the option and value it according to
those details before I will be comfortable with the position
that FASB has taken.
Thank you very much.
Senator Fitzgerald. Senator Bennett, thank you. Senator
Levin, I believe you were here first.
OPENING STATEMENT OF SENATOR LEVIN
Senator Levin. Thank you, Mr. Chairman, and thank you for
holding these hearings. It is a very significant subject that
we are discussing here today, and there is a long history to
it. As we all know, 10 years ago when the effort was made by
FASB to address this issue in the way that they felt was the
proper way to do it as an independent standard-setting body,
the political pressure was so heavy that they had to back off,
and I admire FASB for doing what they think is the right thing
to do, and I am going to do everything I can to protect that
independence.
It is one of the toughest accounting issues that they have
had in their history, but I think for us to intervene here and
to say that we know better than they do how to set an
accounting standard here in the Congress, would be to go in
exactly the opposite direction as Sarbanes-Oxley which was to
try to increase the independence of FASB, as Senator Akaka
said, by giving it an independent source of revenue.
The issue for me is not whether or not Congress is for or
against stock options any more than whether or not we are in
favor of bonuses or other forms of incentive pay. Those other
forms of incentive pay, no matter how conditional they are, are
all treated as expenses. They are all valued one way or
another, the best way that you can. As the Chairman said, there
are many things that are valued that are very difficult to
value, but there are ways of valuing, the best way that
accountants can figure out how to do it. There is an
independent standards board to set those rules. Without that
independence we are going to be politicizing accounting rules
around here which is the worst thing we can do, as far as I am
concerned, for this market.
Stock options, since the 1980's, have provided the majority
of CEO pay. Every year since then the CEO compensation has gone
up, good times and bad, while leaving average worker pay
further and further behind. JPMorgan once said CEO pay should
not exceed 20 times the average worker pay. In 1990 the pay gap
between CEOs and average workers was at 100 times the pay of an
average worker. Average CEO pay in this country is now 300
times the average worker pay. Stock options are the largest
single factor in that pay gap. They operate as stealth
compensation because most U.S. companies do not show stock
option compensation as an expense on their books. Those
companies do deduct stock option pay as an expense on their tax
returns. That is the double standard. That is the gimmick that
allows companies to show a huge compensation expense deduction
on their tax returns but zero expense on their company books.
Stock options are the only form of compensation that companies
are allowed to deduct as an expense on their tax returns,
although they do not appear as an expense on their books. There
are many additional forms of compensation which are very
difficult to value, as Senator Bennett pointed out, that are
nonetheless valued as an expense on the company's books. So
there is only one exception, and that is stock options. It is
not because of the difficulty either. It is because of the
political pressure against doing what the accounting board has
long ago determined was the only way that you could properly
reflect compensation expenses on a company's books, and that is
to show it as an expense.
FASB wants to end that double standard, and it seems to me
that we should not intervene and say that somehow or other we
know better than FASB. The International Accounting Standards
Board, whose standards affect 90 countries, is now requiring
stock option expensing. Canada began requiring stock option
expensing this year. A 2002 survey of financial experts by the
Association for Investment Management and Research found out
that more than 80 percent support stock option expensing. All
four major accounting firms also favor expensing.
There are many arguments that have been used against it,
and I am going to ask that part of my statement, addressing
those arguments, be made part of the record, Mr. Chairman.
Senator Fitzgerald. Without objection.
Senator Levin. One claim which I will spend one minute
addressing is that somehow or other if we allow FASB to proceed
independently that is going to depress the share prices of
individual companies but also damage the stock market or the
economy as a whole, and well-respected financial analysts
disagree. Goldman Sachs's Global Equity Research recently
issued a report supporting stock option expensing and said:
``We do not expect a material impact on the share prices of
most firms.'' UBS Investment Research said that expensing is a
``long past due change,'' and ``medicine for the long-term
health of companies and investors. It will shed light on the
true profitability of many companies, helping to separate those
that deserve investor capital from those that do not.''
Merrill Lynch says the argument that expensing options will
harm U.S. technology leadership and job creation is based on
``the following faulty logic. U.S. technology leadership and
job creation depend on the systematic misrepresentation of
financial statements.'' They went on, ``One might as well argue
that money spent on R&D should not count as an expense because
it provides employment and helps industries advance.''
There is one additional point I want to make, and that has
to do with the Enron investigation. I was chairing the
Permanent Subcommittee on Investigations when we had the
hearings into Enron, and even though I do not think Congress
should be substituting its judgment on accounting standards,
because I do not think we are the right people to do it, we
sure as heck can reflect our experience when it comes to
investigations of Enron. I could not figure out how it was that
Enron executives could be cooking the books, making loans, for
instance, look like income, and not run into the problem of
their books showing these huge revenues which therefore inflate
their stock price, which therefore make their huge amount of
options worth more, but not have to worry about paying taxes on
those revenues.
How is it that somehow or another an executive could figure
out that we could show phony inflated revenue over here but not
worry about coughing up the bucks to pay Uncle Sam the income
taxes on those revenues which we show on our books? This is a
little known but a very important part of Enron. The answer was
those same stock options that were used to enrich those
executives in a company that went bankrupt. Those stock
options, because they are taken as a tax deduction, allowed
Enron, 4 out of 5 years, to pay no taxes despite huge apparent
earnings shown on their books. Just the year they went
bankrupt, CEOs at Enron took home $123 million from exercising
stock options, the same year that so many lost their life
savings.
These stock options played a very vital but yet
unrecognized role in the Enron scandal, and it was part and
parcel of that scandal. It probably could not have happened but
for the role of stock options being used as a tax deduction.
For the last 5 years before it declared bankruptcy, from
1996 until the year 2000, while Enron was telling the world it
was earning these huge revenues, and claiming a 5-year U.S.
profit of $1.8 billion, the analysis of Enron's public filings
by the Citizens for Tax Justice, showed that they deducted $1.7
billion in stock option compensation from its tax returns as a
business expense.
I think we ought to support the independence of FASB and we
ought to base that, first, on their independence, and our
determination hopefully to reflect their courage with our own
courage; but second, we ought to base it on the experience that
we have recently had with Enron that shows that the role of
stock options is more than just giving huge amounts of grants
mainly to executives, not exclusively, but probably 90 to 95
percent overall to executives, but also to permit the kind of
deceptive accounting practices to occur without being seen for
what they are, which is deceptive accounting practices that
made Enron look a lot better than it really was.
Thank you, Mr. Chairman.
[The prepared statement of Senator Levin follows:]
PREPARED STATEMENT OF SENATOR LEVIN
Beginning in 2001, a wave of corporate scandals engulfed the U.S.
business world. Enron, Aldephia, Quest, Tyco, Worldcom--an alphabet of
corporate misconduct undercut investor confidence in our financial
systems, our markets and our financial regulators. To stop the
wrongdoing and restore investor confidence, Congress held hearings,
issued reports, and enacted landmark legislation, the Sarbanes-Oxley
Act of 2002. Our work focused in particular on halting the accounting
abuses infecting so many corporate books. Among other measures, we
created a new Public Company Accounting Oversight Board, required
companies to disclose material off-balance sheet transactions, and
strengthened the independence of the private sector body that sets U.S.
accounting standards, the Financial Accounting Standards Board, or
FASB, by providing it with independent funding.
Today, because FASB has finally tackled one of the toughest
accounting issues in its history by proposing to require companies to
treat stock option compensation as an expense in their financial
statements like all other forms of compensation, opponents of stock
option expensing want Congress to override FASB's independent judgment,
politicize the standard-setting process, and roll over FASB's
independence. To do so would be to undermine key accounting reforms,
signal that accounting maneuvers to prop up earnings is still
acceptable, and turn our backs on the lessons of Enron. It would be a
grave mistake.
The issue isn't whether Congress is for or against stock options,
any more than whether we favor bonuses or other forms of incentive pay,
but whether FASB should be overriden when it determines that stock
option pay should be accounted for on company books as an expense, just
like every other form of compensation. All other forms of
compensation--salaries, cash bonuses, stock grants, stock appreciation
rights, golden parachutes, retirement pay--appear as an expense on a
company's books. The only exception has been stock options. The issue
today is whether FASB will be allowed to maintain its independence when
it decides to eliminate that exception and treat stock options as an
expense, like all other forms of compensation.
In this country, stock options have typically been provided to
corporate executives. Since the 1980s, stock options have provided the
majority of CEO pay, boosting CEO compensation every year through good
times and bad, while leaving average worker pay further and further
behind. J.P. Morgan once said that CEO pay should not exceed 20 times
average worker pay. In 1990, the pay gap between CEOs and average
workers was already 100 times. Last year, CEO pay at about 350 of the
largest U.S. public companies averaged $8 million, a 9 percent increase
over the prior year. Average CEO pay in this country is now 300 times
average worker pay, and stock options are the largest single factor in
that pay gap.
Stock options operate as stealth compensation, because most U.S.
companies don't show stock option compensation as an expense on their
books. But those companies do deduct stock option pay as an expense on
their tax returns. That's the double standard, the gimmick that allows
companies to show a huge compensation expense deduction on their tax
returns but zero expense on their books. In fact, stock options are the
only type of compensation that companies are allowed to deduct as an
expense on their tax returns even if the stock options never appear as
an expense on their books. FASB's proposal would put an end to that
double standard by requiring companies to treat stock option
compensation as an expense on their financial statements.
FASB proposes taking this action because it views stock option pay
as compensation. It has concluded that omitting this expense from a
company's financial statement produces misleading accounting results,
including making the company's earnings appear larger than they really
are. FASB's view is the consensus position in the accounting field. The
International Accounting Standards Board, whose standards affect 90
countries, is requiring stock option expensing beginning next year.
Canada began requiring stock option expensing this year. A 2002 survey
of financial experts by the Association for Investment Management and
Research found that more than 80 percent support stock option
expensing. All four major accounting firms also favor expensing.
But opponents predict a parade of horribles if FASB goes ahead with
its plan. They predict this accounting change will stifle investment
and innovation, hurt our stock markets, lead to outsourcing of high
tech jobs, and wreak havoc in our economy. But a reality check shows
these dire predictions are overblown. Since 2002, nearly 500 companies
have voluntarily agreed to begin expensing stock options on their
books. These companies represent about 20% of the number of companies
on the Standard and Poor's index of companies and 39% of that index
based on market capitalization. None of the predicted horribles has
happened.
Let's look at some of the claims more closely.
Some opponents claim expensing stock options will stifle innovation
in business. But many of the 500 companies expensing options are
successful, high tech innovators like Microsoft, Netflix, and Amazon.
They also include such diverse companies as General Motors, Dow
Chemical, Boeing, BankOne, UPS, and Coca-Cola, each of which relies on
technical innovation for business success. The CEO of Netflix, a high
tech company that began expensing stock options last year, has stated:
``[I]nnovation continues unabated. . . . We innovate because it thrills
us, not because of some accounting treatment.''
Other opponents claim that stock option expensing will lower their
earnings which will, in turn, cause their stock prices to fall and
devastate their investment prospects. But the facts, again, show
otherwise. Just last month, a leading executive pay expert, Towers
Perrin, issued a study examining 335 companies that switched to stock
option expensing and found that stock performance was the same, on
average, as the rest of the S&P 500 and mid-cap 400 indices. Expensing
did not affect their stock prices.
Despite this factual evidence, some opponents go even farther and
warn that expensing will not only depress the share prices of
individual companies, but also damage the stock market or the U.S.
economy as a whole. Well-respected financial analysts disagree.
-- Goldman Sachs Global Equity Research recently issued a
report supporting stock option expensing and stated: ``We do
not expect a material impact on the share prices of most
firms.''
-- UBS Investment Research has stated that expensing is a
``long past due change'' and ``medicine for the long-term
health of companies and investors. It will shed light on the
true profitability of many companies, helping to separate those
that deserve investor capital from those that do not.''
-- Merrill Lynch says the argument that expensing options will
harm U.S. technology leadership and job creation is based on
``the following faulty logic: U.S. technology leadership and
job creation depend on the systematic misrepresentation of
financial statements. One might as well argue that money spent
on R&D shouldn't count as an expense because it provides
employment and helps industries advance.''
-- Credit Suisse First Boston Equity Research says: ``We expect
companies to pay closer attention to the economic cost of their
stock option plans. Companies don't focus much on costs that
they don't have to account for. . . . [W]e expect to see a
decline in the number of options granted, potentially replaced
by restricted stock, cash, incentive options, or nothing if the
company had been overcompensating its employees.''
-- Congress' own economists at the nonpartisan Congressional
Budget Office have also forecast a minimal economic impact,
issuing a recent report which concludes: ``[R]ecognizing the
fair value of employee stock options is unlikely to have a
significant effect on the economy . . . however, it could make
fair value information more transparent to less-sophisticated
investors.''
Honest accounting, in other words, doesn't hurt the economy.
Other leaders in the financial and accounting world also support
stock option expensing as good for investors and good for markets. They
include Federal Reserve Chairman Alan Greenspan, Treasury Secretary
John Snow, SEC Chairman William Donaldson, Public Company Accounting
Oversight Board Chairman William McDonough, former SEC Chairman Arthur
Levitt, former Comptroller General Charles Bowsher, investors Warren
Buffett, John Biggs and Pete Peterson, Nobel Prize Winners Joseph
Stiglitz, Robert Merton and Myron Scholes, as well as respected groups
such as the Council of Institutional Investors, the Investment Company
Institute, Financial Services Forum, Consumer Federation of America,
National Association of State Treasurers, Institute of Management
Accountants, and The Conference Board's Commission on Public Trust and
Private Enterprise.
President Bush, who doesn't support expensing stock options,
nevertheless opposes Congressional interference with FASB's independent
accounting judgment.
One of the newer claims of opponents is that stock option expensing
will somehow force high tech companies to outsource more jobs. But a
number of high tech companies, like Cisco, Dell Computers, IBM, and
Intel, have already sent hundreds or thousands of jobs offshore, while
opposing stock option expensing. Intel began outsourcing software
research and development operations to India several years ago; in
2003, its CEO was quoted by the Indian press as saying, ``I can tell
you that the headcount in India will continue to grow and a lot of back
office work is also coming.'' Cisco Systems announced in 2003 that it
was ``going to increase outsourcing to India in all areas'' including
software development, and in October announced a ``China-based staffing
solution'' for Cisco's Global Technical Response Center.
Dell Computer, which is based in Texas, recently set up customer
and technical support centers in India, China, Morocco, Slovakia, and
design centers in China. It also has manufacturing plants in Brazil,
Malaysia and China. Although only 36 percent of its revenue comes from
overseas sales, Dell has 23,000 employees in other countries and only
22,000 here at home.
These offshoring companies are increasingly paying third world
wages for high-end products and handsome profits. The stock option
expensing proposal is no excuse for their outsourcing decisions: these
companies don't expense their stock options. Worse, by invoking
outsourcing fears to justify Congress' overriding the expertise and
independence of FASB, these companies undermine the integrity of our
financial reporting systems and accounting standards setting process,
both of which are critical to investor confidence and long-term capital
investment in U.S. companies.
Another red herring argument is that requiring stock option
expensing will eliminate broad-based stock option plans and hurt
average employees. The facts are to the contrary. Companies that
currently offer broad-based plans to their workforce such as Home
Depot, Wal-Mart, and Netflix, have already determined that they can
expense options without having to terminate their stock option plans.
Other companies, such as Microsoft, are replacing stock options with
stock grants, but I haven't heard of their employees complaining about
getting actual shares of stock. It is also important to remember that
most U.S. employers, including many private companies, small
businesses, and partnerships, don't offer stock option compensation to
their employees; a nationwide survey by the Bureau of Labor Statistics
in 2000, a banner year for stock options, found that only 1.7 percent
of non-executive U.S. workers actually received any options that year.
In short, honest accounting doesn't hurt average workers.
A final argument used by many opponents is that precisely
estimating the value of stock options is difficult. But that's true of
many items on a financial statement, from the value of goodwill to the
reserves required to protect against uncollectible receivables or
loans. As Warren Buffett once said, the only value that everyone agrees
is incorrect for a stock option is zero.
The valuation issue, as well as other technical aspects of stock
option accounting, ought to be resolved by the accounting experts, of
which Congress isn't one.
What Congress can add to the debate is its understanding of the
role played by stock options in too many of the corporate scandals that
have come before us. I chaired the Enron hearings before the Permanent
Subcommittee on Investigations and saw how the books were cooked to
make loans and fake sales look like income so Enron could impress Wall
Street analysts and boost its stock price. Stock options were the fuel
for Enron's dishonest accounting. Enron's CEO took home $123 million
from exercising stock options in the same year the company went
bankrupt, and so many lost their jobs and life savings.
In addition to enriching executives, stock options played a second
vital, but as yet unrecognized, role in the Enron scandal by enabling
Enron to show huge paper profits without having to pay taxes on them.
During our Subcommittee investigation, I wondered how Enron executives
could create huge phony profits to increase the company's stock value
and make their own stock options worth a fortune, without sapping the
company's treasury to pay income taxes on the inflated income. I
learned the answer was those same stock options, which at the same time
they were enriching executives, provided Enron with a big enough tax
deduction to eliminate any worries about taxes.
For the last five years before it declared bankruptcy, from 1996
until 2000, Enron told its stockholders that it was rolling in
revenues, claiming a 5-year U.S. profit of $1.8 billion, according to
an analysis of Enron's public filings by Citizens for Tax Justice.
During those same years, Enron deducted about $1.7 billion in stock
option compensation from its tax returns as a business expense--cutting
its taxes by $600 million and eliminating its tax liability entirely in
4 out of the 5 years. In other words, the stock option double standard
allowed Enron to dole out this form of compensation to its executives,
claim a huge tax deduction, and escape paying U.S. taxes, while not
showing any stock option expense on its inflated financial statements.
Enron had a lot of company, by the way, in benefiting from the stock
option double standard.
FASB and the folks we rely on to set accounting standards resisted
enormous pressure from corporate executives when they decided to end
the accounting that keeps stock options off corporate books as an
expense, thereby making a company's earnings look better than they are.
Hopefully, Congress will also stand up to the powerful political forces
being brought to bear to overrule FASB. Congress should protect FASB's
independence and its resolution of controversial accounting issues
based on accounting expertise rather than political considerations.
That's what we committed to do two years ago when we enacted the
Sarbanes-Oxley Act, and it is critical that, in this first big test, we
continue to champion, preserve, and fortify FASB's independence.
Senator Fitzgerald. Thank you, Senator Levin. Senator
Lieberman.
OPENING STATEMENT OF SENATOR LIEBERMAN
Senator Lieberman. Thank you, Mr. Chairman, for convening
this discussion, I believe, of a seriously misunderstood
problem, which is stock options and the abuse of stock options.
For much of the past decade stock options have been the
subject of an intense debate, which of course, heated up
particularly after the collapse of Enron and the succeeding
wave of crime by executives of a number of American
corporations. Many people obviously believe that the silver
bullet to stop this corporate crime is to change the accounting
rules for stock options, force companies to count options as
expenses when they are granted, they say, and the scams and
rip-offs would stop.
I wish it were that easy. Changing the accounting rules is,
in my opinion, highly unlikely to change the unethical, illegal
or scandalous behavior of a corporate executive who does not
have the scruples to stop himself or herself from taking action
that satisfies their own greed, and in the process rips off
investors and employees and consumers. But I do fear that
changing the accounting rules is likely to deny access to
options to average workers who have done nothing wrong, and in
the process put the brakes on the revolutionary democratization
of capital in this country that has occurred over the last 20
years or more. I hope that our goal, and I believe our goal
should be to stop the abuse of stock options, not to stop the
granting of stock options. I do not believe this proposed FASB
rule will do that.
Options are a very innovative way to help expand the
winner's circle for millions of Americans and improve the
growth and productivity of our economy. In other words, we must
not throw the options baby out with the corporate corruption
bath water. I believe the way to make sure we do not do that is
to reform the way stock options are approved and distributed
and ultimately widen access to them instead of restricting it.
I have introduced legislation which I believe will do that.
As has been said, my views and interest in this subject go
back more than a decade to 1993 when FASB first floated that
plan to require stock options to be treated as an expense
against earnings on profit and loss statements at the time they
are granted. Many of us who opposed that rule change did so for
two reasons. First we believed it did not make sense; it was
bad accounting. Second, we were concerned that it would
significantly deter the kind of entrepreneurship that grows our
economy and expands the middle class. I do not think any of us
were primarily motivated by a desire to compromise the
independence of FASB, but if FASB is about to promulgate a rule
that we think, and thought then, would have an adverse effect
on a lot of people in our country and on our economy generally,
I take it to be my responsibility to express that point of
view. Our goal here again should be to stop the abuse of stock
abuse, not their granting.
Let me go back to 1993. Why did we do that? We were never
convinced that there is an accurate way to value an option on
the day it is granted. I know Warren Buffett has now famously
said that options are compensation and therefore compensation
should be expensed. Of course options are probably
compensation. I emphasize the ``probably.'' They are a form of
compensation, but the compensation occurs not when they are
granted, but when they are exercised. At the extreme, options
that go under water when the stock price drops below the price
on the day that the options were granted never become
compensation at all. They are effectively worthless, as
tragically, thousands of Enron employees can tell you. We only
know, as far as I understand this, options are compensation
when they are exercised. I hope most people listening to this
or watching it understand we are talking about two dates, the
date the company says, OK, John Smith, you have got options,
but then there is another day that comes, usually after a
holding period required of some years, in which the options are
actually exercised, they are sold. That is when they become
compensation.
Incidentally, that is when the company can take as a
deduction the difference between the price of stock on the day
the option was granted and the price when it was exercised or
sold and money was made. The employee on the date of exercise
pays a tax on the difference and the company takes it as a
deduction. That is the IRS. What we are talking about is
accounting rules on the day that it is granted, and I continue
to see no way you can actually value on that day.
I wonder if the advocates of expensing stock options could
point to a single case where a company's disclosure of stock
option values and cost at the time of granting, which is what
they have been required to do under the FASB compromise rule
since 1995, has proved to be accurate. The Enron footnotes, for
example, which I have looked at, estimated stock option values
and costs that proved to be wildly inflated and inaccurate
because they did not anticipate the collapse in Enron's stock
price that came about as a result of the corrupt behavior of
some Enron executives. So that is what, in 1993, we were not
convinced of, that you could value an option on the day it was
granted, but here is what we were convinced of, that mandatory
expensing of stock options would inhibit their use, and that
would hurt a lot of people who were getting stock options, not
the top executives, and it would also hurt our economy because
of the role that the options play in attracting innovative
employees away from big companies to start-up companies.
Experience has proven that options are an effective mechanism
for doing that, and for spreading wealth, because they give
employees a direct stake in their companies, and of course
business leaders, particularly from the high tech community,
made clear that they would issue fewer options if they had to
subtract their estimated value from their profits on the
statement as required.
Much has changed since that original debate and vote here
in the early 1990's, but I say with all respect that the
problems that I have with FASB's approach have not changed.
Requiring firms to predict the values of options at the time of
granting still looks to me like bad accounting. I just do not
know how you can do it, and I am still troubled that it would
have damaging repercussions on our economy overall, on
thousands of businesses or would-be start-up businesses, and
certainly on millions of workers who would otherwise get these
options.
To be specific, it would significantly reduce earnings for
many companies with option plans, which in turn would reduce
the value of their stock in particular, maybe the market in
general, and business would almost certainly decide to grant
fewer options. Of course, the first to be cut out would not be
the top executives including the relatively small number among
business executives in America who have been proven to have
acted unethically or illegally in the recent wave of corporate
crime. What would be hurt? The guys at the top and the women at
the top would be cutting out the other workers in the company
from the opportunity to have options, and that is the last
thing we need now with the average income of American workers
dropping.
I will give you an interesting statistic, Mr. Chairman.
Just 12 years ago, around the time the first FASB debate
occurred, a little bit before it, one million Americans owned
stock options. Today more than 14 million people in this
country hold stock options. It is astounding. And a growing
number of companies, very diverse, like Staples, Intel, Wells
Fargo and the Vermont Teddy Bear Company, to name a few that
are diverse, offer broad-based plans that distribute most of
the options to rank and file workers, not senior executives.
Are there problems with options? Yes, there are. But again,
I believe the FASB rule is very unlikely to solve them and will
cause its own problems. Number one problem: Too high a
percentage of options are still rewarded to high-level
executives. The National Center for Employee Ownership
estimates, ``That while the growth of broad-based options has
been an important economic trend, our data nonetheless indicate
that even in plans that do share options widely, executives
still get an average of 65 to 70 percent of the total options
granted.'' That is their right, but in my opinion, that is
unfair, and it does contribute to the inequity in income
distribution in our country. It is this skewed distribution,
not the accounting, that I feel is the root of the problem.
Obviously, we have seen examples where some executives, loaded
up with tens of thousands of options, have engaged in the kinds
of practices that have increased their earnings and their share
price if cashed out at the right time, and then very often they
have left the company.
To counter these abuses, I have introduced what I believe
is a better, tougher stock option reform proposal, and the
purpose of my legislation, if you will allow me to put it this
way, is to mend, not end, stock option distribution.
First, my proposal will prohibit a company from deducting
the cost of options when exercised if it does not offer the
majority of those options to rank and file workers. I define
that in the bill as those who make less than $90,000 a year,
which is an existing standard, and are not among the firm's top
20 percent of highest-paid employees.
Second, my proposal would set a mandatory holding period
for stock option grants and block top executives from selling
their shares while they are employed by the company.
Third, it would require all stock option plans to be
approved by a majority of shareholders, guaranteeing greater
accountability and transparency.
I offer this, Mr. Chairman, as a tougher, more sweeping,
and I believe ultimately more effective, response to stock
option abuse and its consequences. Rather than retard the
revolutionary democratization of capitalism in our country,
this proposal will help accelerate it by putting more options
and more wealth in the hands of more working Americans. That is
a solution we can all count on, and I believe account for.
Thank you very much.
Senator Fitzgerald. Senator Lieberman, thank you.
Now I would like to introduce our first two witnesses,
Senator Enzi and Senator Boxer, and I understand Senator Enzi
may have a scheduling conflict.
Senator Enzi. I do not.
Senator Fitzgerald. The normal tradition would be that
Senator Boxer has seniority in the Senate, but she is----
Senator Boxer. Senator, that is very kind, but I think
because Senator Enzi has a bill that I am very supportive of, I
think it is just fine if he goes first, and I am happy to go
after him.
Senator Fitzgerald. Thank you, Senator Boxer. Senator Enzi,
I would just like to introduce you.
Senator Enzi is the Senator from Wyoming, and was here to
testify at our recent hearing on financial literacy. Senator
Enzi was elected to the Senate in 1996, and he is an accountant
and former small business owner. He serves on the Committee on
Banking, Housing and Urban Affairs, where he chairs the
Securities and Investment Subcommittee.
Senator Enzi is the sponsor of S. 1890, the Stock Option
Accounting Reform Act, which would require an issuer of
registered securities to expense stock options granted to
executive officers.
Senator Enzi, thank you. Welcome back to our Subcommittee,
and thanks for your patience as well.
TESTIMONY OF HON. MIKE ENZI,\1\ A U.S. SENATOR FROM THE STATE
OF WYOMING
Senator Enzi. Thank you very much, Mr. Chairman, Senator
Akaka, and Subcommittee Members, for allowing me to testify
before you today.
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\1\ The prepared statement of Senator Enzi appears in the Appendix
on page 73.
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I also want to thank Senator Boxer for all the work that
she has done on the bill that we have, and all of the interest
that she has shown and her knowledge in it.
I would also like to associate myself with the remarks of
Senator Bennett when he was talking about the independence of
FASB, and the need to expense stock options.
But having said that, I am here today to speak solely on
behalf of the millions of small businesses in the United States
that may or may not even be aware of the proposal by the
Financial Accounting Standards Board to require expensing the
stock options. I have to tell you, a reporter from Wyoming
today at lunch asked me if I thought my bill would pass. I
said, if FASB listens once, it will not have to pass, and if
they do not listen, it could be a landslide to pass it. So that
is the position that I am coming from.
There are small businesses in the United States that number
nearly 23 million, and they represent 99 and 7/10ths percent of
the employers. They employ half of all private sector employees
and they generate 60 percent of the net new jobs annually. In
addition, small businesses produce 13 to 14 times more patents
per employee than large patenting firms. It is not an
exaggeration to state that the health and strength of our
Nation's economy rests on the ability of small businesses,
small businesses, to start and grow. Our Nation's
entrepreneurial spirit and climate are the envy of the world.
Today many countries are trying to replicate our small business
system. In fact, news articles of late last year showed that
China is trying to build its own Silicon Valley. You know what
their business plan calls for? Stock options. Yes. We must be
very careful not to cause unintended consequences that might
disrupt small business and the job creation.
The reason I am here today is to voice small business
concerns that I believe are being overlooked or pushed aside as
not relevant to the discussion of stock option expensing. At
first glance, the question of whether to expense stock options
appears to be very simple and media friendly. However, before
getting to the question of expensing stock options, one must
first ask how those will be valued?
As the traditional saying goes, the devil is in the
details. Based upon the recent proposal by FASB one must be
versed in the differences between the fair value method,
intrinsic value method, lattice structures, and binomial and
Black-Scholes expensing valuation models. As an accountant, I
found that these terms are not in the general accounting world
but are unique to this particular accounting proposal. So for
small business owners and their accountants that are
encountering these terms for the first time, the evaluation of
the FASB proposal will be daunting.
The valuation approach, as proposed by FASB, would set up
small businesses to wake up in a nightmare. The proposal itself
is more than 230 pages long. This is the little document that
small businessmen need to wade through to be sure they are not
violating the accounting standard. Rather than addressing small
business concerns head on, FASB has just thrown together a
series of criteria for small business to consider.
Small businesses have no choice but to hire expensive
experts to delve into this voodoo valuation. Some believe that
only the largest accounting firms would be able to produce the
proper valuation models, and I am hearing that it could cost up
to $500,000. Both small business and small accountants would be
victims of the FASB proposal. A frequent concern heard by the
Governmental Affairs Committee is that small business owners
are very busy building and running their businesses, and cannot
pay attention to many Federal regulators in Washington, DC--I
know you have heard that a lot--for this sole reason: Congress
created the Regulatory Flexibility and the Small Business
Regulatory Enforcement Fairness Acts. These Administrative
Procedure Act laws require Federal regulatory agencies to
undertake economic analysis when a proposed regulation may
disproportionately burden small entities. In addition, the law
requires agencies to conduct vigorous outreach and establish
compliance assistance for small business.
FASB, as an independent standard setter, is not bound by
the Regulatory Flexibility nor the Small Business Regulatory
Enforcement and Fairness Acts. Accordingly, FASB, as a standard
setter recognized by the Federal Government, should establish
equivalent small business review practices for itself.
In November, I held a hearing in the Committee on Banking,
Housing, Urban Development entitled ``FASB and Small Business
Growth.'' At that hearing we heard from a variety of witnesses
that FASB's consideration of small business concerns on several
different FASB proposals, not just stock options, several
different FASB proposals, was severely deficient.
At the hearing I requested that a Small Business Advisory
Committee be established by FASB to listen and address small
business concerns. I envision this Subcommittee to operate in
the same manner as NASD's Small Firm Advisory Board, in that
all proposals would be reviewed and evaluated by the
Subcommittee. I even wrote a letter to Mr. Herz and asked if
that was not the case.\1\ I did not get a response that said
that that was not the case. But FASB has since indicated to me
that the Small Business Advisory Committee would meet twice a
year and would receive only proposals on an ad hoc basis.
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\1\ The letter to Mr. Herz from Mr. Enzi, dated December 5, 2003,
appears in the Appendix on page 148.
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While I am pleased that FASB has established the committee,
I still have serious doubts about FASB's commitment to
listening on the small business issues. For example,
immediately following the hearing, FASB conducted field tests
with 18 businesses on stock option expensing. None of the
businesses were small businesses. Now, as FASB is rushing to
implement the proposal on stock option expensing by the end of
the year, I am very much concerned that small business issues
will be pushed aside or not addressed at all. For example, the
proposal will apply not only to publicly traded companies, but
also to privately held companies. Many of these privately held
companies are start-ups and very small companies, and many that
I have spoken to recently have no idea that this proposal will
apply to them.
In addition, FASB, without advanced warning, extended the
proposal to include companies with employee stock purchase
plans. Have you been talking about stock options or employee
stock purchase plans? That is the smallest business thing that
I know of where the mom and pop operation is trying to sell to
their employees. They are going to have to pay attention to
that now because they have been included. We did not know about
that. It was a surprise to me when I looked through there and
found that. While some of the companies will be able to
participate in the two roundtables to be held by FASB in
Connecticut and California, thousands of others may not find
out about the roundtables until it is too late.
In addition, the first meeting of the Small Business
Advisory Committee is on May 11. However, an issue as complex
as this may not be addressed fully. It is quite possible that
the committee could spend all day on the proposal's glossary of
terms in this 230-page book, and have very little time to
discuss anything else.
For this reason, a hearing has been scheduled next week by
the Committee on Small Business and Entrepreneurship that will
give a limited number of small businesses a chance to discuss
the proposal on stock option expensing.
As the Governmental Affairs Committee has jurisdiction over
Regulatory Flexibility and Small Business Regulatory
Enforcement Acts, I will leave the Subcommittee with a couple
of questions that should be considered in this hearing.
First: What are the duties and responsibilities of a
standard setter, recognized by the Federal Government for
analyzing the economic impact of proposals? Should those duties
and responsibilities rise to the level of statutory mandates of
Federal agencies?
Second: What is the level of outreach that is required to
ensure that small businesses throughout the country are able to
participate in the standard-setting process?
Third: What is the remedy for when a small business
believes that the independent standard setter gets the standard
wrong for small business, or that the standard setter has
completely pushed aside small business concerns? Small
businesses, pursuant to the Regulatory Flexibility Act, may sue
a Federal agency to set aside a rule if the small business has
been unjustly aggrieved. As one of the principal authors of the
Sarbanes-Oxley Act, I support an independent accounting
standard setter. However, an independent accounting standard
setter has to live up to a very high standard. With respect to
FASB's oversight of small business concerns, I believe there is
still a significant way to go.
Finally, I should mention that in today's Wall Street
Journal there is an account of Chairman Herz conducing a
conference call with institutional investors yesterday. In that
call he urges institutional investors to make your views known
to the people in Washington so that FASB can go forward with
its proposal by the end of the year.
I thought we were in a period of comment when FASB should
be encouraging everybody, and particularly small business,
particularly the small businesses that do not even know they
are about to have this thrust on them, to be commenting on the
rule, not to be lobbying Congress not to be interested in this
rule. I am really disappointed in that. That is further
evidence that Chairman Herz will bypass the due process for
small businesses in order to impose his will upon process. I
have been trying to get some recognition of small business
since this first came up, and having a little difficulty with
it.
I do have an article that I would like to have made part of
the record that covers that conference call.\1\
---------------------------------------------------------------------------
\1\ The article from the Wall Street Journal entitled ``FASB
Chairman Calls For Investors To Speak Up On Options,'' appears in the
Appendix on page 150.
---------------------------------------------------------------------------
Senator Fitzgerald. Without objection.
Senator Enzi. Interestingly, Chairman Herz's call was with
institutional investors, and recent news articles have shown
that institutional investors, including public pension funds,
readily invest in hedge funds. I find it extremely troubling
that institutional and pension fund managers will invest in
unregulated hedge funds, but cannot interpret stock option
information that is currently available in extremely detailed
notes of registered, publicly traded companies.
In addition, I also would like to introduce a very recent
study on the use of stock options into the record, and that is
the study of Professors Joseph Blasi and Douglas Kruse.\2\ They
found that stock options are widely held by true workers and
middle management of many companies and not just used by
executives.
---------------------------------------------------------------------------
\2\ The study entitled ``Corporate Governance, Executive
Compensation, and Strategic Human Resource Management From 1992-2002, A
Portrait Of What Took Place,'' by Professors Joseph Blasi and Douglas
Kruse appears in the Appendix on page 212.
---------------------------------------------------------------------------
Senator Fitzgerald. Without objection.
Senator Enzi. I would mention that to give you something a
little more current than the 1934 book, that they have also
written a book called ``In The Company of Owners: The Truth
About Stock Options,'' which I highly recommend to everybody to
understand how this revolution to stock options has resulted in
the kind of an economy that we have come to expect in the
United States and the value that has had.
It is a matter of executive compensation. A recent article
in the Washington Post detailed that with or without stock
options, top executives will receive their compensation.
Therefore, this proposal will hurt only small businesses and
employees.
I thank you for this opportunity to testify.
Senator Fitzgerald. Senator Enzi, we appreciate your being
here today. Thank you very much.
Senator Boxer, thank you for waiting patiently.
Senator Boxer. Mr. Chairman, you want me to try to do my
testimony in 5 minutes; would that be your desire? I will try
that.
Senator Fitzgerald. We will not strictly enforce that, but
we would appreciate it because we have two other panels coming.
Thank you.
Senator Boxer. I am going to try to do that. So first I
will start off with putting my statement in the record, if that
is OK with you.
Senator Fitzgerald. Without objection.
Senator Boxer. Then I will try to summarize this within 5
minutes or a minute over.
Senator Fitzgerald. That is great.
TESTIMONY OF HON. BARBARA BOXER,\3\ A U.S. SENATOR FROM THE
STATE OF CALIFORNIA
Senator Boxer. First of all, thank you so much for this
chance because this is a big issue to California, and I have
been involved with it for a long time with Senator Enzi, going
before that, Senator Lieberman, when I was a House member and I
just came over to the Senate, Senator Allen, just a whole group
of us from both sides of the aisle, and I just appreciate this
chance.
---------------------------------------------------------------------------
\3\ The prepared statement of Senator Boxer appears in the Appendix
on page 77.
---------------------------------------------------------------------------
What I would like to do is first of all comment on the
various presentations each of you has made, first of all, to
rebut them in some cases or to support them in others, but
second, to prove to you that I was listening to you, that I was
hanging on every word.
I would start off with you, Mr. Chairman, kind of bemoaning
the fact that the lobbyists did not come up here. Lobbyists
should not be testifying in these meetings. I really believe
that because there are lobbyists on both sides of every issue.
They get paid for that and it is our job to ferret out what is
in the best interest of the people, and it is our job to come
up here and not their job. It would be awful, so I am sort of
glad that did not happen.
Second, to Senator Bennett's point, I think he makes--he is
struggling with this deal because he believes in the
independence of FASB, but yet he believes what I believe, and
that is, that a one-size-fits-all kind of rule could have
tremendous ramifications. I am the daughter of a CPA. I love
accountants, so this is nothing against the accounting
profession, but they do have blinders on when it comes to
policy. That is their work. It is their job. They see things in
a narrow fashion, and policy is not their thing. That is fine
for a lot of things, but when you are dealing with options,
when you are dealing with the potential ramifications here
which have been stated by Senators Bennett and Lieberman, you
are dealing with serious business, and of course, very
eloquently stated by my colleague.
I would agree that I do not think FASB has listened to us
one bit. We gave them every chance. We had a hearing. Remember
that one? What would you call it? A seminar. And we said, well,
look, this does not make sense, and we went through how do you
evaluate these and so on and so on. And then they just could
not care. For those of you who wanted them to stick with what
they came up with 10 years ago, do not worry, there is not a
chance they will change to try to reach out and look at some of
the ramifications of what they are doing. It is very
discouraging. For me to be told, as a U.S. Senator who cares
about jobs and cares about a middle class and cares about
making sure there is prosperity, that I should not speak up
against a group that I think is not considering the
ramifications of their act, that is not a good approach with me
because I think that is our job. Otherwise, things could go
haywire around here, and they sometimes do.
To Senator Akaka, who mentioned Enron and WorldCom and
Senator Levin who did the same, these were crooks and thieves,
these people. They made a false electricity crisis in my State,
Enron did. I am familiar with what they did. They spent day and
night trying to thieve from people, and they did, to the extent
of $11 billion that I know of. That is what it cost my
consumers in Enron's case. And options are not--they should be
thrown I jail. Meanwhile, what is happening, because of their
acts and because some people think options was the problem, not
the fact that they were thieves, then what you are saying is
not only the people there are at a disadvantage because they
lost their jobs, they lost their pension, they lost everything,
but as a result of FASB, we are going to have a whole group of
other workers, who had nothing to do with these things, being
punished. That would be just the ultimate irony, being punished
for the likes of Enron and WorldCom when all they want to do is
get a chance at the dream.
So I hope you will think about that. After FASB gets done
with their rule, the people at the top are going to get their
options. Make no mistake about it. But the people that I fight
for in my State, and Cisco Systems is a perfect case in point,
I believe it is 95 percent of the employees there have options.
So now you think you are doing this great thing to punish the
fat cats, and you are hurting everybody else because the fat
cats will still keep getting their options.
Let me just, because I do not want to take too much of your
time, I want to give you a sample of what some of my
constituents are saying, maybe the ones that voices have not
been raised yet, although they have been alluded to. Bill
Griffin, who works for Auto Desk in Palo Alto, wrote to the
FASB, ``Stock options are the last bastion of the hard-working
middle manager. For 2 years the only thing that helped me pay
for my two kids in college has been stock options. Without
stock options mortgaging my home would have been my only
option.''
David Dorr from San Jose wrote to the FASB, ``In my
opinion, stock option compensation at Silicon Valley companies
is what helped form this valley in the first place. Do not
destroy it because some companies abused it by only giving
options to the top.''
Listen to what Kelly Simmons wrote to the FASB. Quote, ``If
you eliminate broad-based employee stock options from hard-
working individuals like me, you are taking away more than you
think. You are taking away the dream of someday owning a home
here in the Silicon Valley.''
So FASB got lots of these letters, but they listened to
them just as much as they listened to Senator Enzi and I, and
Senator Lieberman and others. So I have respect and admiration
for FASB, but I do not want to put the future of our economic
expansion in the hands of folks who refuse to look up from
their eyeshades and see the big picture, and the big picture
has an impact on hard-working people, on shareholders and
people who are only just doing the right thing every single
day.
Last, we have a great alternative. And by the way, I love
Senator Lieberman's bill. I am going to look at it and
hopefully go on it, but we have a great bill. Senator Ensign
and I have worked with Senators Enzi and Reid, and others on
legislation that would mandate the expensing of stock options
for the top five executives at a company, but not for the
options granted to rank and file workers. Start-up companies
would be exempt. Let me just stop here.
It just seems like everybody is frozen into their position
except for Senator Bennett, who still looks like we can grab
him, one side or the other. I just hope you will think a little
bit about some of your premises, those of you who are just
saying no legislation interfere. If it was a small matter, that
would be one thing. This is a huge matter. It is going to
impact the lives of real people who really believe, and have
told me--and a lot of them are women, by the way, I have to
tell you--who are telling me this is their only shot at the
dream, and let us not take that away because of some rule that
we do not want to interfere with some group of folks who are
dedicated, and I respect them, but that is not their job to
worry about policy. It is our job.
Thank you very much.
Senator Fitzgerald. Senator Boxer, Senator Enzi, thank you
very much. We appreciate your being here and appreciate your
interest in the subject. Thank you so much for coming.
At this point we would like to invite our second panel to
the witness table. We have two witnesses on our second panel.
Our first witness on this panel is Robert H. Herz, who was
appointed Chairman of the Financial Accounting Standards Board
effective July 1, 2002. Prior to joining FASB, Mr. Herz served
as PriceWaterhouseCoopers' North America Theater Leader of
Professional, Technical Risk and Quality, and he was also a
member of the firm's board. Mr. Herz has served as a part-time
member of the International Accounting Standards Board, and has
chaired the SEC Regulations Committee of the American Institute
of Certified Public Accountants and the Trans-National Auditors
Committee of the International Federation of Accountants. Mr.
Herz has also served as a member of the FASB Financial
Instruments Task Force and the American Accounting
Association's Financial Accounting Standards Committee.
Our second witness is the Hon. Paul A. Volcker, the former
Chairman of the U.S. Federal Reserve Board, and the current
Chairman of the International Accounting Standards Committee
Foundation. Mr. Volcker has nearly 30 years of distinguished
service with the Federal Government, and served two terms as
the Chairman of the Board of Governors of the Federal Reserve
System from 1979 to 1987. More recently, Mr. Volcker served as
Chairman and CEO of Wolfensohn and Company, from which he
retired in 1996 upon its merger with the Bankers Trust Company.
Mr. Volcker currently serves as chairman, director of, or
consultant to, a number of corporations and nonprofit
organizations.
Gentlemen, we deeply appreciate your taking the time to
appear before this Subcommittee and we would like to invite you
to offer your full written statements into the record. We can
simply have them accepted as part of the record, and it would
help if you could attempt to summarize your comments within 5
minutes, so that we can then proceed with questioning. Thank
you.
Mr. Herz, would you please go first?
TESTIMONY OF ROBERT H. HERZ,\1\ CHAIRMAN, FINANCIAL ACCOUNTING
STANDARDS BOARD
Mr. Herz. Thank you, Chairman Fitzgerald, Ranking Member
Akaka, and Members of the Subcommittee.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Herz appears in the Appendix on
page 80.
---------------------------------------------------------------------------
Mr. Herz. As you know, the FASB is an independent private
sector organization. Our ability to conduct our work in a
systematic, thorough, and unbiased manner is fundamental to
achieving our role in the system--that is, to establish and
improve standards of financial accounting and reporting for
both public and private enterprises, including small
businesses.
The FASB's independence, the importance of which was
recently reaffirmed by the Sarbanes-Oxley Act, is also
fundamental to our mission because our work is technical in
nature and designed to provide preparers with the guidance
necessary to report on their underlying business transactions.
Now, while the current efforts by certain parties to block
our proposed improvements to the accounting for equity-based
compensation may seem attractive to some in the short run, in
the long run biased accounting standards are harmful to
investors, to creditors, to the capital markets, and to the
U.S. economy.
Because the actions of the FASB affect so many
organizations, our decisionmaking process must be open, it must
be thorough, and it must be objective, as objective as
possible. And so our rules of procedure require a very
extensive and public due process.
On March 31, as has been noted, we issued a proposal for
public comment to improve the accounting for equity-based
compensation. It covers not just stock options but a whole
variety of equity-based compensation arrangements because we
wanted to get consistent accounting and a level playing field
between the various forms of equity-based compensation, as well
as with other compensation.
The proposal was a result of a very extensive public due
propose that began in November 2002. That process included the
issuance of a preliminary document for public comment, the
review of over 300 comment letters and over 130 unsolicited
letters, consultations with our advisory councils, field visits
to companies--which, by the way, did include small businesses--
public and private discussions with hundreds of individuals,
including users, auditors, and preparers of financial reports,
valuation experts, compensation experts, and active, open
deliberations at 38 public FASB Board meetings.
The Board believes that our proposal will significantly
improve the financial reporting for equity-based compensation
transactions in many ways, including, as has been the main
topic of discussion, the elimination of the existing exception
for so-called fixed plan employee stock options, which, as
Senator Levin remarked, are the only form of equity-based
compensation that is not currently required to be recorded as
an expense in the financial statements. Our 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
ignores the economic substance of those transactions.
In that regard, I would note that when enterprises use
stock options and other instruments, like long-dated stock
purchase warrants, for purposes other than compensating
employees--for example, to acquire goods and services, as you
mentioned, Chairman Fitzgerald, to pay for legal services and
the like--they have long been required to value those
instruments and to properly account for them in the financial
statements.
We believe the elimination of the fixed plan stock option
exception is also responsive to the demands and concerns
expressed by numerous hundreds of individual and institutional
investors, pension funds, creditors, financial analysts, the
major accounting firms, and many other parties. We also believe
it will provide greater transparency and consistency in the
reporting of various forms of equity-based compensation and
greater comparability between enterprises that compensate their
employees in different ways and between the now nearly 500
companies that have voluntarily chosen to account for the cost
of employee stock options and the many others that continue not
to do so.
The proposal also has a secondary benefit--an important
one, I believe--of achieving much greater international
comparability in the area of accounting for equity-based
compensation. In that regard, as noted, our international
counterpart, the International Accounting Standards Board,
issued a final standard in February of this year requiring the
expensing of all equity-based compensation, including all forms
of stock options. The IASB standard will be followed by
companies in over 90 countries beginning next year.
Our proposal includes a lengthy Notice for Recipients that
highlights and describes over 20 specific issues that
respondents may wish to consider in developing their comments
to us, including a number of issues that focus on the
proposal's measurement approach and on the special provisions
that we have proposed relating to small business.
The Board also plans to hold public roundtables, four of
them, with interested users, auditors, and preparers of
financial reports, and valuation and compensation experts to
discuss the issues raised by the proposal. We also will be
discussing the impact on small businesses and their views at
the inaugural meeting of our Small Business Advisory Committee
in a couple of weeks.
Following the end of the comment period on June 30, we plan
to redeliberate, at public meetings, the issues raised in
response to our proposals. Those redeliberations will address
all the key conceptual, measurement, disclosure, and cost/
benefit issues raised in the comments and will include careful
consideration of the input received from all parties.
Only after carefully evaluating that input at public
meetings will the Board consider whether to issue a final
standard. Our current plan is to complete the redeliberations
and be in a position to issue the final standard in the fourth
quarter of this year.
I would like to conclude my statement by noting that we
have all witnessed the devastating effects and loss of investor
confidence in financial information that have resulted, at
least in part, from companies intentionally violating or
manipulating accounting requirements. Investors, creditors, and
other consumers of financial reports are continuing to demand
improvements in accounting and financial reporting. The
existing accounting for equity-based compensation, not just as
regards CEO compensation but the basic flaw in the accounting
model, has been an area of great concern, and our proposal is
intended to be responsive to that concern and to what we have
seen in our extensive process of looking at the economic
attributes of those instruments.
Thank you, Mr. Chairman. After Chairman Volcker talks, I
would be happy to respond to any questions.
Senator Fitzgerald. Thank you very much, Mr. Herz.
Mr. Volcker, thank you for being with us. You may proceed.
TESTIMONY OF HON. PAUL A. VOLCKER,\1\ CHAIRMAN, INTERNATIONAL
ACCOUNTING STANDARDS COMMITTEE FOUNDATION, AND FORMER CHAIRMAN,
BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. Volcker. Well, thank you. I will just summarize my
comments briefly, but let me make two preliminary statements
after listening to the earlier conversation.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Volcker appears in the Appendix
on page 86.
---------------------------------------------------------------------------
Expensing stock options is not about eliminating stock
options. The question is how to account for them properly. And
to the extent that stock options have been abused--and I have
no doubt they have been abused in many cases to the extent that
that abuse is related to the fact they are not accounted for,
obviously that should be taken care of. That is in favor of
expensing stock options. And nobody is saying in the accounting
world that they must be eliminated. All we are saying is
account for an expense in ways comparable to other expenses.
The other point I would make is that small business has a
problem in many elaborate accounting areas. They have gotten
extremely complex for big businesses, I am afraid. That is a
problem, and in my responsibilities with the International
Accounting Standards Committee Foundation--a cumbersome word--
we are reviewing our procedures now to try to make sure that
small businesses and their views and problems are sufficiently
taken care of in determining accounting standards.
I am the Chairman of the Trustees of the International
Accounting Standards Committee Foundation. I emphasize that
because our responsibilities are to appoint members of the
board that make the decisions, not to make the decisions
itself, but it is also our responsibility to satisfy ourselves
that there has been sufficient consultation and due process
before the board we appoint does arrive at conclusions.
I have been interested in this. The only reason that I have
agreed to become Chairman of the Foundation is that I think
commonality in international accounting standards is a good
thing. The world is globalizing. We are not going to stop that.
The financial world is globalizing. If we are going to have an
efficient system of international capital, you better have a
common set of accounting standards. And, in part, that is what
is at issue in this debate.
As Mr. Herz just mentioned, the International Board has
decided a standard on expensing stock options. That is somewhat
controversial in other areas of the world, but not to the
extent it is here. I have every reason to believe the Europeans
will adopt that standard and it will become compulsory in
Europe and most other major countries in the next year.
Now, oddly enough, or maybe interestingly enough, there is
another accounting standard that the International Board has
put out that is extremely controversial in Europe, and it is
not been yet adopted by the European Union, and there is
intense political pressure in the European Union to reject that
standard, so-called IAS 39, which involves, importantly,
accounting for derivatives. In the European world, derivatives
are not accounted for, and this standard is an important
initiative to bring that important area of accounting on the
books. It is not controversial in the United States because the
standard already exists in the United States. It was
controversial when it was applied in the United States some
years ago, but American companies are now used to it, and I
don't think anybody is suggesting that the United States should
abandon that standard.
Now, I point this out because we have political pressures
on the standard setters, two different standards from different
directions. And I think you have to ask yourself what are the
prospects for finally achieving coherent, consistent, high-
quality international standards if the political authorities,
whenever they find one they don't like, reject it. And that
will obviously have a kind of snowballing effect. You will lose
discipline in maintaining independence if in different cases
considered important the independence is overcome.
I am sensitive to that, and in Sarbanes-Oxley, and in all
my conversations with the SEC and up here on the Hill when I
agreed to this assignment, I kept getting drilled into me: You
must be independent, you must have a framework that protects
these decisions from political ``interference.'' That is the
way our system is set up. The so-called constitution for the
International Board is set up with elaborate arrangements to
protect the independence. That is supposed to be part of my
responsibility to protect that independence. So I feel rather
strongly about it.
I think that is the essence of my statement. I don't
comment on the substance of the rule. I am not supposed to.
That is the Board's idea. I am supposed to respect their
independence. But I do think this is very important in terms of
the overall objective of getting international consistency.
Senator Fitzgerald. Mr. Volcker, thank you very much for
that statement. I appreciate both of you being here.
I would just like to make a couple of statements in the way
of response to some of the things other Members have mentioned
in their opening remarks, or the two Senators who were
testifying.
First of all, the book ``Security Analysis'' is still in
print. I just happen to have the original edition because I
wanted to buy that. You can still buy the original edition, but
it has been republished and updated many times. It is one of
the classic all-time books, and Benjamin Graham was updating it
almost to when he died in the 1970's. Warren Buffett refers to
Benjamin Graham's book, ``The Intelligent Investor,'' which I
have also read, as the single best book on investing ever. And
almost all of his books, as far as I know, are still in print
and selling widely. It is just that I only have the classic
edition on my home bookshelf, and that is why I cite it. There
may well be some better language that I could have referred to
in more recent editions.
Also, I do, of course, recognize that the options that are
traded on the Chicago Board Options Exchange or other exchanges
are much different. However, they are similar in that they both
represent a call on the future growth and profitability of the
company. And so I just wanted to mention that, and certainly
many options issued to employees or executives of a company may
not be transferable by that employee or executive.
I now have a few questions for Mr. Herz and Mr. Volcker.
Mr. Herz, how many of the seven FASB Board members supported
the issuance of this proposal? And how many of the seven Board
members disagreed with the conclusions contained in the
proposal?
Mr. Herz. The proposal was voted out as a proposal
unanimously by all seven Board members.
Senator Fitzgerald. So there was not a single member of
your expert Accounting Board who opposed the issuance of the
proposal?
Mr. Herz. That is correct. It was unanimous. Now, we all
may have slightly different views on particular issues, minor
differences. But you look at the proposal as a whole, its
consistency, and decide whether or not to vote for it as a
whole. And all seven Board members voted for that.
Senator Fitzgerald. And how are the FASB Board members
chosen? Who chooses them? And how do you get on that Board?
Mr. Herz. They are selected by a group of trustees of the
Financial Accounting Foundation. They are selected from diverse
backgrounds. Right now we have three people from public
accounting, two from industry, one was a senior global equity
analyst, another person with a business background.
Senator Fitzgerald. So you have two from industry.
Mr. Herz. Yes.
Senator Fitzgerald. Who aren't necessarily accountants? Or
are they?
Mr. Herz. They were CFO types.
Senator Fitzgerald. OK.
Mr. Herz. What we call preparers.
Senator Fitzgerald. OK. So they are from companies that may
be issuing options themselves.
Mr. Herz. Yes. In fact, actually two of our Board members
have been the recipients of options.
Senator Fitzgerald. And, nonetheless, they supported the
expensing of stock options.
Mr. Herz. Oh, yes.
Senator Fitzgerald. So of the seven Board members, you have
two who are from public companies. How many of the Board
members are CPAs, accounting professionals?
Mr. Herz. Three.
Senator Fitzgerald. Three. And then you have two other
members?
Mr. Herz. A business school professor, and a person from
Wall Street who was a senior global equity analyst.
Senator Fitzgerald. OK. So, it is fair to say that all of
these people have great expertise. If you are a CPA, a CFO of a
publicly traded company, a business school professor, or a
respected Wall Street analyst, you are very sophisticated in
this area.
Mr. Herz. I think it is interesting to note that the
International Board, who separately deliberated this whole
issue, they have 14 people on their Board from nine different
countries, and, again, a range of backgrounds in terms of
preparers, auditors, users of financial information. I believe
they were also 14-0.
Senator Fitzgerald. Maybe Mr. Volcker could comment on the
composition of the International Accounting Standards Board.
You have 14 people?
Mr. Volcker. Fourteen people, two of whom are part-time.
But as I look at them here, I think there are four who are
basically so-called preparers, chief financial officers; and
four or five accountants or standard setters from other
countries, past standard setters from other countries; and
three of them are so-called users, analysts, with an analyst
background. One professor.
Senator Fitzgerald. Now both of you just generally, leaving
aside the merits of the proposed rule--and you saw I am in
favor of the proposed rule. Some of my other colleagues are
also in favor of it; others are opposed to it.
Leaving aside the merits of the proposal, what effect do
you think it would have on our domestic Financial Accounting
Standards Board if politicians were to step in, a political
authority were to step in, and block the new FASB rule? And I
think Mr. Volcker indicated in his opening remarks the likely
effects on the international board if they were to see us in
Congress step in. For a rule that actually isn't that
controversial in Europe, it would have ramifications to the
extent that some European companies which are opposed to a new
rule on derivatives accounting that has already been widely
accepted in the United States would possibly object to.
But what would be the effect of political interference in
either of your boards?
Mr. Herz. Well, I think, as I said, there are a number of
issues coming down the pike, major topics, where users of
financial information believe that the current accounting
standards are not as good as they might be, and even in some
cases really need major revision. And some of those are areas
like revenue recognition and reporting on financial
performance, but also pension accounting has been severely
criticized by a number of people, lease accounting.
I think that any intervention at this point would kind of
be a signal down the road that anytime you want to block
something to maintain the status quo and block the proposed
standard, go to Washington and lobby through the political
process.
Senator Fitzgerald. Would you care to comment on that, Mr.
Volcker?
Mr. Volcker. Well, I think if I was a member of FASB, I
would be wondering what my responsibilities were. I know that
in choosing the International Board and getting the kind of
quality of people that we thought we got, what was important to
them was that they had some independence. And if they lost that
sense of independence and acceptability of their decisions,
they would not be interested in serving. And I don't know who
you would get to go on the Board. You are not going to get the
kind of people that we got. I think that is simply the fact of
the matter.
But I must say, I think there is a balance here which, one
way or another, much of what has been said both on that side of
the table and here is relevant. These decisions cannot be made
in a vacuum. They cannot be made by a group of abstract
accountants kind of figuring out what they think of the
theoretical niceties of an accounting rule and ending up with
260 pages sometimes. They have to be exposed to the real world.
And in a sense, I think that is my job and our counterpart's
job in the United States to make sure that the Boards do have
the kind of consultation that Mr. Herz was talking about and
take it seriously and do testing and checking of their
proposals.
I should not be speaking as an old Federal Reserve
Chairman--but it is easy to get isolated. We have to keep--in a
way that is impossible to avoid for the Federal Reserve because
you haul them up all the time--and you have these kinds of
debates and criticism and comments. And I think that is an
important part of the process.
We happen to be reviewing the so-called constitution of the
International Commitment now, and that is the main comment we
have had, and that is the main concern that we have in
reviewing the constitution, that there be ample and suitable
consultation and testing.
Senator Fitzgerald. Yes, Mr. Herz?
Mr. Herz. I couldn't help pass that by when Paul mentioned
the 260 pages and Senator Enzi the 230 pages. The actual
proposed standard is eight or nine pages. The rest of the
document is explaining our thoughts, rationale, alternatives we
looked at and then lots and lots of different examples to help
people. So, the whole thing of helpful guidance and explanation
of our thought process is 230 pages, but the actual standard is
very short.
Senator Fitzgerald. It is eight pages, OK.
Now, just one final question before I hand it over to my
colleagues. Both Senator Boxer and Senator Enzi talked a lot
about the effect on companies, small businesses. They raised
the specter of employees being denied stock options. And I know
Senator Lieberman talked about the democratization of company
ownership via widespread distribution of stock options.
But neither Senator Boxer nor Senator Enzi, at least the
way I understood them, seemed to mention the effect on
shareholders or investors. That is something I referred to in
my opening statement, that by granting stock options, you are
taking the existing common shareholder's right to own 100
percent of the up side of a company, and you are transferring
it to someone else. And that is OK, I said, as long as it is
disclosed to the shareholders or prospective investors, that
they know that somebody else has a claim on these future growth
prospects of the company and the stock.
But isn't there a problem with so many Americans owning
stocks today? Just in mutual funds alone you have 95 million
Americans who own mutual funds, for example. Either directly or
indirectly today, well over half of Americans own equity
securities. And many people are investing on their own without
any professional advice and, I would venture to say, many
without the ability to recognize the dilutive effect of options
that have been issued because they are so buried.
Was that at all a part of the thinking of the Financial
Accounting Standards Board? Were you worried about that effect
on shareholders of the dilution?
Mr. Herz. Well, we are trying to measure the instrument
that is granted as a cost to the company, and it is a cost to
the company, and that cost is represented by exactly what you
say. And it is measurable. It is measurable with well-
established models. It takes a little bit of work to do it in
some cases, particularly when they are more complicated. But
that is exactly the point, that there is a cost to the company,
and that cost to the company should be measured just like any
other cost to the company.
Senator Fitzgerald. And if employees are paid in cash or in
gold bullion, you require them to expense that. But it didn't
seem logical if they are paid in stock options, because they
don't have to reflect the cost?
Mr. Herz. Yes, that is right. And just to get to--I would
love to visit with Senators Bennett and Lieberman just to
explain----
Senator Fitzgerald. We would be happy to give you that
opportunity.
Mr. Herz [continuing]. How the measurement works and why
they have been able to do it for 8 years, in audited footnotes,
why many companies are now being able to do it, and why there
are other very long dated type instruments like convertible
bonds which may be contingently exerciseable. Those are valued
every day.
The other point I would make, which is, I think, a point
that when we discuss this people say well, gee, it didn't turn
out to be the right value. Well, we are measuring the value at
a point in time. We are not predicting the future value of that
instrument. Just as if you award a share of stock today, that
is not predicting what it will be worth 5 years from now. It is
the value of the instrument now. That is what is being valued,
not the future prediction of its value.
Senator Fitzgerald. And there is a present claim or call on
the future growth of the company's prospects that is being----
Mr. Herz. That is exactly what the model is.
Mr. Volcker. And it does take account of the vesting.
Mr. Herz. The vesting also, if you don't vest, there is no
expense. There are adjustments in our proposal for vesting, for
non-transferability, for restrictions and all the like.
Senator Fitzgerald. Senator Akaka.
Senator Akaka. Thank you very much, Mr. Chairman.
Chairman Volcker, there are some opponents of the FASB
proposal who argue that expensing stock options would slow job
creation and potentially increase the use of outsourcing. What
is your evaluation of these arguments?
Mr. Volcker. They are not correct.
Senator Akaka. Thank you.
Mr. Herz, accounting rules have long required companies to
estimate and report as an expense the cost for remediating
environmental contamination, providing pension and post-
retirement benefits to employees, settling product liability
claims and litigation, and providing warranty coverage on
products sold to consumers. The question is: Will the proposed
measurement approach for employee stock options result in a
more precise measurement than approaches currently used for
those other costs and can you give me the reasons why?
Mr. Herz. Well, you are touching on a key aspect of what we
considered: Is there sufficient reliability in our view behind
these measures? And by that, we mean that the range of
dispersion of the likely outcomes, if it is done correctly, is
within acceptable limits. And we then thought about that and
compared it with some of these other measurements that you are
talking about and some that I think Chairman Fitzgerald talked
about, loan loss reserves, insurance reserves, impairments of
good will, sometimes just depreciation calculations because
they involve estimates of life and salvage value. And we think
that certainly the established models here--and, by the way,
people say that you didn't choose a model. Well, they are just
different parts, variations of the same financial economic
theorem. They are not different models. One is more flexible or
open than the other. You can put more inputs in it and get a
more refined answer. But our basic conclusion is that these
measures are of sufficient reliability to put in the financial
statements and are far better than the current situation where
the current accounting is totally unreliable and completely
ignores an economic transaction.
Senator Akaka. Mr. Volcker, what lessons regarding the use
and accounting for stock options should be learned from the
failures in corporate governance by companies such as Enron and
WorldCom?
Mr. Volcker. Well, my view is--and it has already been
expressed in this hearing earlier--that I really do think stock
options have been abused, and too much concentrated on
relatively few officials at the top, and the incentives that
have been created have been perverse. It has created a kind of
concentration on the stock price that has led to manipulation
of earnings and other manipulation in order to affect the stock
price at the long-run expense of the company itself. And we
have seen that demonstrated. It is very hard for me to justify
the use of an instrument that has rewarded, as someone said
earlier, tens of millions of dollars, even hundreds of millions
of dollars, to executives of a company that went bankrupt that
very year. It just does not make sense.
What is evident and why people like stock options so much
is that we have just in the 1990's had the greatest boom in the
stock market in all of history. And if you had a stock option,
you did very well. You did very well whether your company was
doing relatively well or whether it was doing relatively
poorly. Everything was going up, not because you were suddenly
a great genius, but because the whole market was going up.
I think we better think about it here. I don't make up the
rules, but I think the effort is to put compensation in the
form of stock options on a level playing field with other forms
of compensation so that you do not distort the instrument that
is used simply because it is accounted for differently, and
accounted for in a way that logically is hardly sustainable.
Senator Akaka. Mr. Herz, this month the Congressional
Budget Office released a report which found that net income
will be overstated if firms do not recognize as an expense the
fair value of employee stock options measured when options are
granted. What is your evaluation of CBO's conclusion?
Mr. Herz. Their conclusion is exactly the same as our
conclusion. It is the same as the IASB's conclusion. It is the
same as the conclusion that has been reached after study by
many different groups over a long period of time.
Senator Akaka. Mr. Volcker, if Congress intervenes to block
the FASB proposal, what impact will this have on investor
confidence, on the financial markets, and the ability of
analysts to evaluate the financial condition of public
companies?
Mr. Volcker. Well, I think the influence would be adverse
in all those terms. I don't know how striking it would be. They
have not been accounted for in the past so you are not changing
the situation.
What I am certain of, it would clearly undercut the efforts
to get international consistency. And I think over time that is
to the disadvantage of both companies raising money and
investors investing money.
You want both intelligent, comprehensive accounting
standards, and you want them the same in different
jurisdictions when both investors and companies are operating
in a lot of jurisdictions. It is very difficult for our biggest
companies--forget about the small companies--our biggest
companies that may be operating in 60, 70, 80, or 100 countries
to follow 100 different accounting rules. And the effort is to
reduce those differences as much as possible.
Senator Akaka. Mr. Herz, can you please describe for the
Subcommittee the shortcomings of disclosing stock options in
footnotes of financial statements compared to FASB's proposal?
Mr. Herz. I think it is a longstanding principle in
accounting and financial reporting that disclosure is not meant
to be a substitute for wrong accounting. And that has been
borne out by numerous academic studies in general and on this
topic as well.
I think the CBO report comments that individual investors
do not comb the footnotes, and they just take the score as is.
That is the score as reported, and that is the way they look at
it.
I think in talking with a number of institutional investors
and quantitative analysts, they also do that because they take
numbers from databases and don't take as adjusted footnote
numbers. They just take the score. And so that is why we have
gotten so many--all the surveys you see of investors, analysts,
portfolio managers by an overwhelming margin say they want this
number in the score.
Senator Akaka. Thank you very much for your responses.
Thank you, Mr. Chairman.
Senator Fitzgerald. Senator Bennett.
Senator Bennett. Thank you, Mr. Chairman.
Let me say what I said in my opening statement again so
that it is clear. I am in favor of expensing stock options. I
am in favor of maintaining FASB's independence. The points that
Paul Volcker is making are absolutely on point. We need to do
what we can to standardize around the world. So let's not
revisit that, OK? Let's deal with what I think the real
problems are, which I think FASB has ignored.
Let me give you a hard, firm example here. You say it is
eight or nine pages, it is fairly simple. I am delighted. I
have a stock option which, according to Black-Scholes, is worth
$10. It can be exercised tomorrow. I give my employees a stock
option with a 10-year vesting at the same strike price as the
stock option that I get. What is that worth? What does the 10-
year vesting do? What is it worth? Look at your nine pages and
give me a number.
Mr. Herz. OK. The first stock option would be expensed all
right now, $10. The $10 on the second one would be spread over
10 years, but if the fellow left, there would not only be no
more compensation, there would be no compensation.
Senator Bennett. OK. So it is still worth $10, even though
it can't be----
Mr. Herz. Not from an accounting point of view.
Senator Bennett. You just said that it would be----
Mr. Herz. There is a measurement----
Senator Bennett. You just said the $10 would be stretched
over the 10 years.
Mr. Herz. The measurement would be 10. It would be
stretched over the 10 years, but only to the extent the person
worked to get it. That was the deal.
Senator Bennett. No. I am talking about putting it on my
balance sheet as an accountant, putting it on my P&L. I have
got one P&L; I deduct $10. That is very simple. Do I deduct $1
this year and $1 next year, etc., for the other one?
Mr. Herz. As long as the guy kept working to get it, yes.
Senator Bennett. So he drops dead of a heart attack in year
9, and my balance sheet shows a cumulative expense of $9.
Mr. Herz. The balance----
Senator Bennett. In fact, do I get that $9 back?
Mr. Herz. Yes.
Senator Bennett. So that becomes profit.
Mr. Herz. It is not on the balance sheet, by the way.
Senator Bennett. Well, the P&L goes to the balance sheet.
What happens to that $9? Does it become profit? Does it run to
the balance sheet?
Mr. Herz. Yes, it runs back through the income statement
and back through equity that was never created.
Senator Bennett. So in year 9, magically I have got $9
worth of income. Do I pay taxes on that?
Mr. Herz. Do you pay taxes on $9?
Senator Bennett. On that $9 that suddenly comes back in 9
years.
Mr. Herz. The awardee of these stock options?
Senator Bennett. The company. Forget the company. I have
got to keep the books.
Mr. Herz. No, the company does not pay any taxes. It is
not----
Senator Bennett. I get $9 worth of income and I do not pay
any taxes on it? That is going to get Senator Levin really
upset.
Mr. Herz. That is accounting income.
Senator Levin. I would like to hear his answer to that.
Senator Bennett. Well, I would kind of like to hear the
answer, too.
Mr. Herz. Well, first of all, you would have estimated for
the whole group on day one how many people were going to be
there through the 10 years. So you would have made an estimate
of what is called forfeitures.
Senator Bennett. Right.
Mr. Herz. But in that situation, you would take back the
$9. The deal was never completed. You had estimated wrongly.
Senator Bennett. But I got income on my income statement.
Mr. Herz. That is correct.
Senator Bennett. And I do not pay taxes on that income.
Mr. Volcker. That would depend upon the IRS.
Mr. Herz. Well, it would depend on--not in the United
States you wouldn't, because the tax deduction, the stock
option tax deduction actually occurs for the excess, the
windfall of the value given.
Senator Bennett. All right. Let's go back to the first one.
The first one, no problem, Black-Scholes says it is $10. I put
$10 as expense. Do I get a $10 tax deduction?
Mr. Herz. Yes.
Senator Bennett. So if I am a small businessman----
Mr. Herz. You get the $10 tax deduction or a higher tax
deduction when the person actually exercises the option.
Senator Bennett. Well, wait a minute. I am drawing up my
tax return for this year, and I have got $10 worth of expense.
Mr. Herz. You have $10 of accounting expense.
Senator Bennett. Right. Can I take a tax deduction to that?
Mr. Herz. Not on your tax return. What you have is a
deferred tax benefit for accounting purposes.
Senator Bennett. OK. When do I get to take the tax
deduction?
Mr. Herz. As Senator Levin said, when there is an exercise
of the option by the employee. Let's say when the employee
exercises and that employee--let's say the stock has gone to
$100, and he makes a profit of $50, say, because the strike
price was, say, $50. The employee would declare taxable income
of $50, and the company would get a tax deduction of $50 for
taxable compensation.
Senator Bennett. So I take the expense in year 1, but I do
not get the tax deduction until, say, year 5.
Mr. Herz. Right.
Senator Bennett. And you say that is making the financial
statements clearer and more accurate if I don't get the tax
deduction in the same year that I take the expenses?
Mr. Herz. Well, the Tax Code and accounting are not the
same. They are not designed to be the same.
Senator Bennett. Bingo.
Mr. Herz. Right.
Senator Bennett. That is the point that so many people are
missing in this debate. The Tax Code and the accounting for
expenses are different. So you are going to say to me as a
company, you have to show in your statement to a shareholder
that you just made no profit. Let us say the total cost of the
options matches total amount I make, so you just show you have
made no profit.
Mr. Herz. Correct.
Senator Bennett. In the footnote you have to say you have
really got a lot of cash.
Mr. Herz. We have a cash flow statement. There are four
basic financial statements.
Senator Bennett. Yes, you have got a cash flow statement.
As a manager running a business, when I was running a small
business, I looked for every deduction I could possibly find.
Why? Because I didn't want to pay any taxes. I managed the
business to make sure that we didn't earn a dime.
Now, this is not a public company. This is a private
company. I have run public companies and private companies. And
I will tell you, private companies are a whole lot more fun.
But we didn't want to earn any money, accounting-wise, because
we needed every penny of cash to make that fledgling business
survive. So I looked for every possible deduction.
So you come along and say, Here, you can deduct the cost of
your stock options, and I say, Wonderful, do as many as you can
so I can build as many deductions so I can save cash. The IRS
says, no, we don't recognize those as real expenses.
Mr. Herz. That is right.
Senator Bennett. Now, as soon as I go public, yes, FASB
says they are real expenses, but IRS does not. I have to charge
them against my income statement, and, therefore, they end up
on the balance sheet as a lower reduction in retained earnings.
But I do not get any tax benefit for doing that--except in
certain countries, apparently, as we begin to go international.
Mr. Herz. In certain countries, they have an economic
valuation like we do for accounting, rather than an outcome
approach.
Senator Bennett. OK. The point of all this--and I will quit
belaboring it. I am late to another meeting, and I apologize
for just dumping this on you and having to leave. I want the
financial statement to be as clear as possible, and so do you.
That is why I favor expensing. But I am convinced that the way
you have drawn this up is going to make the financial statement
absolutely incomprehensible to somebody that does not have the
kind of experience and background you do. And I guarantee you
that Senator Enzi's concern about small business is not ill-
placed.
Mr. Herz. Well, for Senator Enzi and small business, we
have proposed an alternative method, which is like the tax
method.
Senator Bennett. So as soon as you get above a certain
level, the rules change.
Mr. Herz. No. It is because for a private company you do
not have liquid stock. There is a cost/benefit issue, and we
think that makes--it is not pure, but it is a decent
alternative, just like what you are saying.
Senator Bennett. How can you be sure that we do not have
liquid stock if we do not have a public market? My brother-in-
law might want my stock.
Mr. Herz. Well, then we are going to let you--the
alternative then would be to do the right method and value it
economically.
Mr. Volcker. Brothers-in-law are not usually very liquid.
[Laughter.]
Senator Bennett. Each of us is a prisoner of his own
experience. And my experience running little companies,
handling start-up companies, one or two of which actually
became big companies and ended up listed on the New York Stock
Exchange--and they were a lot more fun to run, again, when they
were private before we had to deal with analysts. It tells me
that--sorry to disagree with my tall friend--there are some
consequences that will affect the economy if this thing does
not become a whole lot more user-friendly to the brand-new kind
of stock option that has just grown up in the relatively recent
future where you say we are going to have long-term vesting and
we are going to have wide participation and it is going to be
in start-ups. And that has helped fuel the growth of the
American economy, and I do not think you have paid enough
attention to that.
At the end of the day, I am still with you that we ought to
expense. I am still with you that we ought not to pass
legislation. But I am very troubled that the consequences of
what you have done seem to be so skewed towards the public
company, the General Motors, the Coca-Colas, and the Microsofts
of this world, that you could do significant harm in the
entrepreneurial area. And that is what Senator Boxer is saying.
As I say, I have not signed on to the Enzi bill. I have
been under a lot of pressure to do it. I look at the Enzi bill,
and I see a lot of things wrong with it. But I hope I have
gotten across to you that even though technically I am in your
camp, I am very troubled at the results that I see in the work
that you have done.
Mr. Herz. Well, if I could respond?
Senator Bennett. Sure.
Mr. Herz. First, as I said, we have still a lot of due
process left. We are meeting with the Small Business Advisory
Committee. We have specifically crafted questions about not
only private companies but small business issuers as to what
ought to be appropriate there.
As I said, we have proposed an alternative method, which is
closer to what you are proposing, which would not require
option pricing models, which would be more on what you seem to
favor in general, what is called an exercise date type
approach, which is kind of the accounting version of the Tax
Code. And those are all things that we have invited comment on.
So, rest assured we will be looking at all that, and we are
very sensitive to the cost/benefit burdens, to the
understandability. We have a question specifically in the
notice to recipients about understandability. That is why we
have lots of examples, as I said, in the document.
So, I hope you will also have an open mind, and maybe we
can visit with you.
Senator Bennett. I would be delighted to. Thank you, Mr.
Chairman.
Senator Fitzgerald. Thanks, Senator Bennett. Senator Levin.
Senator Levin. It seems to me there are two key issues: One
is the difficulty, allegedly, of valuing something at a date
which it is given to the employee, because you have got to
estimate its value and it is not exercisable until some future
date. And I would like to get some more examples from you as to
how they work and about other forms of compensation which are
also based on uncertainties where we do value. You have used
two terms that I do not think--at least I am not familiar with
one of them. Long-dated stock warrant, I think was the term.
Another one was a convertible bond. And I think if you could
just give us a word or two on each of those, it might be useful
to show this is not some unusual, novel feature here, that we
apparently do value things which are difficult to value.
Now, we talked about good will and a number of other things
which we are familiar with, even depreciation. But just in
terms of these kinds of--I think you called them equities. What
is a long-date stock warrant? And how is that similar to----
Mr. Herz. Well, companies will use stock purchase warrants,
which are like a stock option. It gives the counterparty, the
holder, the person that you grant it to, the ability, the right
to buy your stock, a share of your stock at a fixed price for a
fixed term. And it may have various conditions in it. For
example, it may be to a provider of services to your company
that says you can do this as long as, if you are a lawyer, we
win the next following five cases. Or if we only win four
cases, then the terms of the warrant will change a little bit.
I mean, these can get quite complicated, but----
Senator Levin. Are they valued now?
Mr. Herz. Yes, they have been required to be valued for
many years and accounted for.
Senator Levin. At the time that they are granted?
Mr. Herz. Yes.
Senator Levin. All right. So there are models, there are
ways of valuing those kinds of conditional grants or transfers
of stock.
Mr. Herz. Right.
Senator Levin. What about the convertible bond?
Mr. Herz. Well, a convertible bond is a bond that contains
a stock option in it. It basically allows at a fixed price the
person to convert the bond into a certain number, a pre-
specified number of shares. And those terms can go out 10, 15,
20, or 30 years. There has been in vogue recently what are
called contingently convertibles, which not only have that
feature but you can only actually do the conversion based upon
some kind of formula of the stock price in the future meeting
certain target levels. It only gets contingently triggered, yet
you have to----
Senator Levin. Those contingent triggers are, nonetheless,
valued in some way.
Mr. Herz. Sure. The instruments are valued every day in the
marketplace.
Senator Levin. But these can't be valued in the
marketplace, I gather--or can they?
Mr. Herz. Yes, they can. The convertible bonds are traded--
--
Senator Levin. No, I am talking about the stock option
given to an employee. Can they be valued in the marketplace
since they cannot be exercised by anyone other than that
employee?
Mr. Herz. No, they do not trade in the marketplace,
although as the CBO report comments, individuals, if you have
enough of them, you can find ways to extract the value, protect
the value through hedging devices.
Senator Levin. So through a hedging device you actually can
extract, as you put it----
Mr. Herz. You can monetize the value at a point in time.
Senator Levin. Even though it cannot be exercised by anyone
other than the employee?
Mr. Herz. Right.
Senator Levin. OK.
Senator Fitzgerald. They are not transferable, is that why
they cannot be sold?
Mr. Herz. That is correct. And as part of our methodology,
we recognized that, and, in fact, there is a big hair cut
effectively for that in the modeling.
Senator Levin. All right. Now, that is extremely helpful
information, I believe, because one of the issues we hear a lot
from people who want to override FASB is you cannot value
these. And you are saying there are all kinds of contingent
instruments, conditional instruments, which are valued all the
time that are similar to these instruments.
Mr. Herz. And often more complicated.
Senator Levin. And even more complicated.
Now, the other issue has to do with, I think, your
conversation with Senator Bennett, if I followed it, and that
had to do with there may be an option open to small businesses
where you are going to allow them--particularly if they are not
publicly owned, I gather--to opt into the certainty of saying,
OK, you do not want to do that when they are exercised, if they
are exercised, if you take a tax deduction at that point they
show up on your books. Did I hear you correctly?
Mr. Herz. Yes, well, what we are doing is saying take, as
you go along, what the difference between the current value of
the stock and the strike price is, and then finally at exercise
date, you would have the final measurement there. So it is kind
of each period you would be showing what the status is.
Senator Levin. Would it be the same as a tax deduction?
Mr. Herz. The final measurement overall would be the same
as a tax deduction for non-qualified stock options.
Senator Levin. All right.
Mr. Volcker. Then you know what the value of the stock is,
and there is no----
Senator Levin. Excuse me, Mr. Volcker. What were you
saying? Repeat that so we can all hear it.
Mr. Volcker. I don't know how you keep adjusting the value
of the option when there is no market for the stock.
Mr. Herz. You would value the stock just like you do for
tax purposes in order to figure out the tax deduction.
Senator Levin. But at the end of the day----
Mr. Volcker. You don't have a market.
Senator Levin. Wait a minute, if you are going to speak,
which is fine, I think we have got to get this on the record so
we understand what you two guys are saying. This is an unusual
hearing in this regard, but it is welcome, provided we can--I
would welcome it on my time, providing I understand what you
are saying to each other.
Now, at the end of the day, however, the amount of the tax
deduction would equal the amount of the expense shown on the
books under that option. Is that correct?
Mr. Herz. The cumulative expense, yes.
Senator Levin. OK, but that is the bottom line at the end
of the day.
Mr. Herz. That is right.
Senator Levin. Putting aside the difficulty that Mr.
Volcker is talking----
Mr. Herz. By the way, we have also said that if you are a
public company and you really don't think you can do the grant
date valuation with sufficient reliability, and you convince
your auditors of that, and possibly you might get chosen for
SEC review and you would have to convince them. But you could
use that alternative method in that circumstance as well.
Senator Levin. That is the certainty approach. Have you
gotten much support from the business community for that
approach?
Mr. Herz. No, and I think for two reasons. One is--I think
they believe that the value--the cost is the grant date because
that is the date the deal is made and it is based on today's
price and you kind of figure out what the value is then.
Senator Levin. So the business community wants the grant
date to be the date that the valuation takes place, and yet it
is the same community that says you cannot value on that date.
Mr. Herz. Well, I think certain elements of the business
community.
Senator Levin. Well, it is part of the business. But part
of the argument you get from the opponents is you cannot value
on the date that you give the right away. But part of the
opposition we also hear is you cannot value on that date. It
seems to me that those are two inconsistent arguments. At least
the same person should not make both arguments.
Mr. Herz. I agree.
Senator Levin. Now, do you know how many companies now
expense stock options? There are quite a few that are actually
now doing it.
Mr. Herz. The last tally I saw that either already are or
said they will be in the near future was about 500.
Senator Levin. And those would be fairly significant size
companies?
Mr. Herz. Yes. I mean, there are, as I remember, about 115
of them are in the S&P 500 and----
Senator Levin. And have they shown any loss in stock price
as a result, do you know? Have you seen any studies on that?
Mr. Herz. I saw a study by Towers Perrin recently that said
they didn't.
Senator Levin. Did not?
Mr. Herz. They did not suffer a loss in stock price. I also
saw another study by some professors--I think one was at
Stanford as I remember--that said they actually got a very
short-term bounce, probably on the view that they got some
reward for better accounting, better corporate governance.
Senator Levin. Thank you. My time is up.
Senator Fitzgerald. Thank you. Senator Lieberman.
Senator Lieberman. Thank you, Mr. Chairman. This has been a
really interesting and important hearing. I wanted to share an
observation and then ask a few questions, and it is about this
question of the independence of FASB, which I respect.
We are not accountants up here. Senator Enzi happens to be
the only accountant in the Senate, as far as I know. So why did
I get interested a decade ago? Because I was concerned hearing
from people in business about the impact of the accounting
change that FASB was proposing on the economy, on millions of
workers who are benefiting from options, etc.
If I understand the history here, you are essentially a
private group--really, a professional group, exercising an
authority that has significant public effects. And if I get it
correctly, this is a public authority that was granted by
statute to the SEC to set accounting standards, which it in its
wisdom delegated to FASB.
So you have got a situation where a public authority has,
for reasons that make a lot of sense in most cases--because we
should not be doing accounting standards. That is not our
business. But you have got a public authority granting this
power to a private entity, and then it makes a judgment that
has, at least in my opinion, and obviously a lot of others, in
this case a big effect on public policy, on the economy. And
yet part of my concern is that with independence in this case
comes no accountability. So your decisions cannot be appealed
to court, can they?
Mr. Herz. I am not sure about that, but----
Senator Lieberman. Can I ask one more question and then let
you respond? Just as a factual basis, can the SEC--I assume--
let me state it as my on-one-leg opinion--that the SEC retains
the authority to override a FASB ruling. Is that correct?
Mr. Herz. Yes, that is exactly correct, and we are subject
at the technical level to very detailed oversight, monitoring,
and involvement by the SEC staff. They have been following
every aspect of what we do on this project and every other
project. They can and have on occasion said, gee, we don't
agree with what you are coming up with, either stop or we will
override it. That has happened on one occasion in the past, on
another occasion back in the 1960's with the investment tax
credit Congress overrode the then Accounting Principles Board.
You raise a good point, and it is, to a certain extent, a
difference in philosophies or public goods. The view of
accounting standard setting, whether it be our Board or the
International Board, is that we really have to be unbiased and
neutral as to the economic consequences. The economic
consequences do flow from better information. What you measure
matters and the like, and that is the best way to assist the
capital markets and the credibility of overall financial
information.
Now, there are other people who would assert another public
policy good, but that is not, in fact, in the SEC document that
re-recognized us after Sarbanes-Oxley, it basically said,
reaffirmed that what we do has to be objective and neutral.
Senator Lieberman. Right. So that gives me some comfort, if
you will, and I would welcome your responding in writing
afterward about my assumption that FASB's rulings are not
subject to appeal in court. But the way to balance what FASB's
independence brings and the possibility whether in this
decision or another one--let's assume that this decision is a
debatable one. Arguably, FASB might do something that most of
us up here and in America would think was lunacy, whatever it
is.
The accountability and the public interest in that then
goes to the SEC, which has the authority to override, and
obviously that is something that they can consider as this
particular proceeding goes on.
Listening to Senator Bennett, he said he is for the
expensing of stock options, but I think his questioning really
brought out why those of us who have said we are not for the
expensing of options at the time of granting have such a
problem with this, because we do not know how you can do it
accurately. At one point, I think you said if the value--the
point here is to try to put a value on the option now, on the
day it is granted. But the only value that I can see that the
option has on the day it is granted that I would have any
confidence in is the stock price on that day, the market price
on that day. But, of course, it is not going to be exercised.
You said earlier that since 1995, when FASB required the
footnote disclosing, according to Black-Scholes, the value of
the options that people have been doing it and living with it.
But is there any basis for--in other words, they have been
applying the formula, but is there any basis for having any
confidence that it is accurate, that the result of it is
accurate?
Mr. Herz. Well, it is accurate based upon the accuracy of
the valuation. Again, these valuations are based upon models
that are basic financial economic theorems and that are tested
every day in the markets for these other instruments. There are
certain adjustments you make for employee stock options because
of the transferability aspects, the vesting aspects, and those
kinds of things. But the basic models themselves are tried and
tested in the marketplace.
Senator Lieberman. Let's say that on the day of granting,
the market price is $10 a stock and, according to Black-
Scholes, the value of it is $20.
Mr. Herz. No, it cannot be more than the stock.
Senator Lieberman. I am sorry. It is the--well, OK. I am
sorry. I am going to the deductibility.
Here is my point. Let's say that when we get to the date of
exercise there is an obvious difference between what Black-
Scholes predicted and what the value really was to the
employee. Is there any way to alter the expenses if they turn
out to be inaccurate so that the company is not--this is, I
guess, in a way what Senator Bennett was asking you--is not
stuck with the impact of having expensed at a greater, or even
a lesser rate, in the interest of equity, than it turned out to
be?
Mr. Herz. Well, we are continuing to talk a little bit past
each other, but because, again, the grant date value is the
value at the grant date, the model takes into account Black-
Scholes, a million different possibilities of where the stock
might end, not just----
Senator Lieberman. Yes, but that is my problem. It is only
going to end in one place.
Mr. Herz. That is correct. But I would commend you to read
the CBO report as to why the grant date is the right cost to
the company.
Senator Lieberman. I will. Let me ask this question: If the
Black-Scholes system has been working so well, why in the
released exposure draft have you urged companies to use the
binomial or lattice model to value employee stock options?
Mr. Herz. The lattice models are--it is like taking Black-
Scholes and opening it up. Black-Scholes is kind of hard-wired.
You have to put a set of uniform assumptions into it, and then
it cranks out a value. The binomial model allows you to, for
example, say, well, I am going to sell division and, therefore,
my volatility and dividend policy is going to change next year.
It allows you to take the assumptions and change them by
periods, just as you would if you were going to, for example,
value an intangible or value an in-process R&D project, which
are regularly done. It is taking the Black-Scholes and opening
it up.
So what it means is that you can, getting the right
information, you can get a more refined estimate than just the
simple Black-Scholes because it is less flexible.
Senator Lieberman. My time is running out, and I want to
let the next panel come on.
Why not avoid all of these problems that we have talked
about, about the difficulty of predicting the value of a stock
a year or 5 years or 10 years forward, when there are so many
variables, by requiring the expensing to occur on the day it is
granted, when to me it has no value. The value comes to the
employee, as the tax system recognizes, when he exercises it
because he pays a tax on the spread between the price of the
stock on the day he got the option and the price of the stock
that he exercised it--and, incidentally, as has been pointed
out, the company gets to deduct the spread.
So in what Senator Levin refers to as a double standard, we
disagree on that--the same thing is bothering both of us but we
have come to different conclusions. Why not resolve the problem
by requiring an expensing of stock options on the date of
exercise?
Mr. Herz. Well, we could do that. We do not think it is the
proper measure of the compensation. It is what the individual
actually gets out of it, but it is not the measure of the cost
to the company.
Again, I would commend you to the CBO report to understand
why----
Senator Lieberman. Talk a little bit about that. It is what
the individual gets out of it. It is what the company----
Mr. Herz. As Chairman Fitzgerald said, once you issue this,
what happens is there is a wealth transfer that goes on after
that between the existing stockholders and these new equity
owners.
Senator Lieberman. But it is of indeterminate value.
Mr. Herz. No, it can be valued----
Senator Lieberman. It dilutes the stock to some extent, but
we don't know how much until it gets exercised.
Mr. Herz. You don't know the final measure of what that is,
but you know the value at any point in time.
Now, we could do that, but then the question would be:
Would we also do that for every other instrument that takes
these same kinds of things, like a convertible? If I issue to
you a convertible and 15 years down the road you may convert
that, and although you only paid $1,000 for that bond, you may
convert it--this was a very successful company--at $30,000.
Should we measure the expense to the company at $30,000?
I will give you another example: Stock purchase warrants
that are issued to suppliers. I give you 10 of my stock
purchase warrants for 10 of your widgets, and we will agree
that your widgets are each worth $5 and my warrants are each
worth $5, so we have a fair value exchange of $50. Those
warrants entitle you to exercise or to buy the stock at a fixed
price for 10 years. Nine years down the road, I am, again, a
successful company; you exercise it for $300. Should we have
said that the cost of the goods that I got from you, the five
widgets, was $300, not $50? It is incongruous.
Senator Lieberman. My time is up, but I would really urge
you to do everything you can to open up the hearings that you
are going to hold and make sure you hear from people on all
sides and think about what they say. And then obviously I hope
that the SEC will follow what you are doing and exercise the
authority that it has delegated to you if it thinks that FASB
has done something that is not right. Thank you very much.
Incidentally, this is very difficult for me to go through
this debating process with Mr. Herz because he and FASB, I am
proud to say, are located in Norwalk, Connecticut.
Senator Fitzgerald. Well, thank you, Senator Lieberman.
I have just a couple of wrap-up questions. Have you had any
indication from the SEC as to their views on this new rule?
They haven't given any indication that they----
Mr. Herz. Well, they completely support our process. I
think both the chairman and the chief accountant have said they
are in favor of expensing. Many of their staff have been
involved and actually helped with crafting a lot of suggestions
along the way, more in terms of crafting the questions and the
like. But they will continue to----
Senator Fitzgerald. So we have the SEC, Alan Greenspan, his
predecessor Paul Volcker, Warren Buffett, and others, all
supporting the concept of expensing stock options.
On the Tax Code and accounting, isn't it true that what
companies tell the IRS is that their earnings are far less than
what they report to the public? In fact, companies now report
to their shareholders many times the earnings than what their
earnings are that they report to the IRS. We used to have
pretty good parity between what you reported to the IRS as your
earnings, probably until the early 1960's or so. As an investor
I would like to see the tax returns that a company I might
invest in submitted to the IRS, because I tend to believe their
real earnings are closer to what they report to the IRS than
what they report to the public.
Mr. Volcker.
Mr. Volcker. I think there is no question that there is a
discrepancy. It seems to be increasing, and something ought to
be done about it. But if the accounting is correct, presumably
something ought to be done about it from the tax side.
Senator Fitzgerald. That is right.
Now, I just wanted to clarify one point. Senator Boxer said
that it was not appropriate for lobbyists to be testifying. I
did not invite lobbyists to testify. I invited the CEOs of
Cisco, Intel, Hewlett-Packard to testify or send a high-ranking
corporate official, CFO or other officer. None of them wanted
to do that. We tried other companies, as well. Nobody who was
refusing to expense stock options wanted to come and trumpet
that to America in a public hearing. I thought that was very
telling because I thought they weren't necessarily really
wanting--they were not really proud of what they were doing.
They are a little bit sheepish about it.
And, with that, I want----
Senator Levin. Could I just ask Mr. Volcker if he might be
willing to expand for the record, perhaps, his one-word answer,
``No,'' when he was asked by Senator Akaka whether or not he
thought this rule would increase the amount of outsourcing or
slow job creation? I know that we have taken a lot of time now,
but if he would be willing for the record just to expand on
that answer.
Mr. Volcker. Well, all I mean to say is that nobody is
prohibiting stock options, if that is considered a uniquely
advantageous way of rewarding people, and it may be for some
start-up companies. But I don't think the way they are going to
account for it should dominate that consideration, and that if
it is really the right way to compensate, go ahead and do it.
If you don't compensate that way, do it some other way. But it
will appear as an expense.
Senator Levin. Thank you, Mr. Chairman.
Senator Fitzgerald. And somebody mentioned China, too.
Isn't it true that China will require the expensing of stock
options?
Mr. Volcker. I believe so. [Laughter.]
Senator Fitzgerald. OK.
Mr. Volcker. China will follow international accounting
standards, which apparently will--I mean the present
international accounting standard requires.
Senator Fitzgerald. Well, thank you, gentlemen. We are
delighted that you were here today, and your testimony was
interesting. Senator Bennett is also on the Banking Committee,
and he declined an opportunity to question Alan Greenspan at
his hearing to be here to talk to both of you. So thank you
both very much for being here.
Senator Fitzgerald. At this point I would like to invite
our third and final panel up to the witness table. I have to
warn everybody that I have to leave at 5:30 p.m. If Senator
Levin is still here, I would be happy to allow him to take
over, but this is going to necessitate that we move pretty
rapidly through our final panel.
Our first witness is Jack T. Ciesielski, the owner of R.G.
Associates, Inc., an investment research and portfolio
management firm located in Baltimore, Maryland. Mr. Ciesielski
is the publisher of ``The Analyst's Accounting Observer,'' an
accounting advisory service for securities analysts. Before
founding R.G. Associates in 1992, he spent nearly 7 years as a
security analyst with the Legg Mason Value Trust. From 1997 to
2000, Mr. Ciesielski served as a member of the Financial
Accounting Standards Advisory Council, which advises the FASB,
and he currently serves on the FASB's Emerging Issues Task
Force.
Our second witness on the panel is Damon Silvers, who is an
Associate General Counsel for the AFL-CIO. Mr. Silvers' work at
the AFL-CIO includes corporate governance, pension, and other
business law issues. He is a member of a number of boards and
advisory groups, including the Public Company Accounting
Oversight Standing Advisory Group, the Financial Accounting
Standards Board User Advisory Council, and the New York Stock
Exchange Stock Options Voting Task Force. Prior to his work at
the AFL-CIO, Mr. Silvers was the Assistant Director of the
Office of Corporate and Financial Affairs for the Amalgamated
Clothing and Textile Workers Union.
Our third witness is from my home State, Donald P. Delves,
who is the President and Founder of The Delves Group, which
works to foster the growth and development of businesses
through evaluating and building effective total compensation
systems. Mr. Delves, as I said, is from Illinois and he has
over 20 years of consulting experience in the area of
compensation and incentive systems. He is a popular speaker on
executive compensation, stock options, and corporate
accountability. He recently sent me a copy of his new book,
``Stock Options and the New Rules of Corporate Accountability:
Measuring, Managing,'' which was published just last year, in
October 2003. Mr. Delves, thank you for being here.
Our fourth witness is Mark Heesen, who is President of the
National Venture Capital Association, NVCA. The NVCA is a
member-based trade association that works to maintain high
professional industry standards and foster an understanding of
the importance of venture capital in the United States and
global economies. Since 1991, Mr. Heesen has worked on behalf
of the venture capital community to enact a wide range of
policies that benefit the venture capital and entrepreneurial
communities, including the significant capital gains
differential securities litigation reform, accounting treatment
of stock options, and reform of the Food and Drug
Administration's pre-market approval process.
Our final witness is someone whose columns I love reading
in the Sunday Washington Post. They are normally very
insightful and very good, and the column was very good this
past week. It is James K. Glassman, who is a resident fellow at
the American Enterprise Institute for Public Policy Research,
AEI. Mr. Glassman's research addresses such areas as Social
Security, economics, the Federal budget, interest rates, the
stock market, and taxes. During the past 10 years, Mr. Glassman
has written a weekly syndicated column for the Washington Post
on investing. He is the author of ``The Secret Code of the
Superior Investor.'' He has written two books geared toward
small investors and has published numerous articles on
investing topics in publications such as the Reader's Digest
and the Wall Street Journal.
Again, I would like to thank you all for being here. As I
said, we are going to have to end at 5:30 sharp. I am,
therefore, asking you to please submit your lengthier written
statements for the record. But please try and summarize your
remarks in 5 minutes or less so we can finish on time. In fact,
that won't leave us much time even for questions, so the
quicker, briefer, and more succinct you can be in your opening
statements, we would really appreciate it.
Mr. Ciesielski, will you begin. Thank you.
TESTIMONY OF JACK T. CIESIELSKI,\1\ PRESIDENT, R.G. ASSOCIATES,
INC.
Mr. Ciesielski. Thank you. Chairman Fitzgerald, Ranking
Member Akaka, and Members of the Subcommittee, I am Jack
Ciesielski, President of R.G. Associates. It is my pleasure to
be participating in this hearing, and I look forward to
answering your questions if we have time.
---------------------------------------------------------------------------
\1\ The prepared statement with an attachment and an accompanying
addition to the written statement of Mr. Ciesielski appear in the
Appendix on pages 89 and 97 respectively.
---------------------------------------------------------------------------
I have a brief prepared statement, and I would respectfully
request that the entire text of my testimony and the
accompanying written statement be entered into the public
record.
Senator Fitzgerald. Without objection.
Mr. Ciesielski. Let me preface my remarks with a brief
description of my business and how it relates to this hearing.
My firm, R.G. Associates, Inc., is primarily an independent
investment research firm and is dedicated to the analysis of
corporate accounting issues. We have a small asset management
business, but our main focus is the publication of a research
service entitled ``The Analyst's Accounting Observer,'' which
analyzes and explains accounting trends to both buy-side and
sell-side analysts.\1\ Frequently, Observer reports are devoted
to new or pending pronouncements of the Federal Accounting
Standards Board. Our client base of approximately 70 firms is
diverse. Readers of our research range from some of the world's
largest mutual fund families and well-established brokerage
firms and rating agencies, all the way down to money management
firms with only a handful of employees and assets under
management. In short, our client base is a unique cross-
sectional view of the many different kinds of financial
statement users.
---------------------------------------------------------------------------
\1\ ``The Analyst's Accounting Observer,'' appears in the Appendix
on page 153.
---------------------------------------------------------------------------
I have been writing the Observer for over 12 years, and as
I have composed reports about new FASB standards, I have had
plenty of interaction with the Board and its staff. I have
participated in the Board's hearings and roundtables on
proposed standards, and as a member of the Financial Accounting
Standards Advisory Council and Emerging Issues Task Force, I
have had ample opportunity to observe the deliberations and the
due process that goes into the development of FASB standards. I
have had the chance to see how the standard-setting process
benefits from the inputs provided by accounting firms and
financial statement preparers--from people who are close to the
issues being considered by the Board and whose experience with
those issues helps the Board develop more durable standards. In
my view, the FASB's system of listening, learning, and then
improving their proposals works very well as it exists.
With that, I would like to turn my attention to the purpose
of this hearing. On the surface, this hearing is all about an
accounting standard dealing with stock options given to
employees, but there is a much larger issue that merits our
attention. That issue is the independence of the FASB, for if
there were not attempts by some parties to legislate action
that robs the FASB of its independence, we would not be having
this hearing today.
The FASB plays a unique and indispensable function in our
country's capital market system--as is the role of any standard
setter. Progress in society would be impossible if there were
not uniform standards for many of the things we take for
granted: For instance, something as simple as the design of
electrical outlets. That is what makes the FASB's role
critical: By being the independent arbiter of principles at the
foundation of financial reporting, investors benefit from
financial information that is more comparable and robust than
would exist if every preparer had their own way of presenting
information.
In my years of observing the standard-setting process, I
have seen the Board develop improved accounting standards with
an unmatched level of openness and fairness. Their standards
will not make everyone happy--in addressing the complicated
issues they are charged with, it is impossible to satisfy all
parties involved. The reason we are here is because some of
FASB's constituents are so unhappy with their attempts to
reform the accounting for stock option compensation that they
have pulled Congress into the process. They are seeking a
legislative answer to an accounting rule they oppose and, in
doing so, usurping the FASB's authority to set standards. I
believe that the FASB's ability to develop impartial standards
resulting in robust information for investors to use would be
seriously hampered if legislative intervention becomes the norm
for disagreeing with their pronouncements, and a blueprint for
such behavior was created the last time the Board attempted to
remedy option compensation accounting 10 years ago. While it
may benefit a few of the Board's constituents to preserve the
present broken accounting model, in the long run our capital
markets would likely suffer and result in capital being
misallocated in the economy at large.
I would like to focus the remainder of my remarks more
specifically on the accounting issue under consideration,
arguably the most contentious project ever taken up by the
FASB. Despite the claims of vocal opponents, I do not view the
FASB's proposal for equity-based compensation accounting as
somehow dangerous or reckless. In my judgment, the Board has
listened fairly to the views of its constituents and learned
much as this project has wended its way from an ``invitation to
comment'' document in 2003 to the exposure draft of a standard
at the end of March.
I believe that the issuance of a final standard requiring
the recognition of stock option compensation would
significantly benefit the users of financial statements. I
believe the argument that options cannot be valued and,
therefore, should reflect no compensation expense when given to
employees is without merit. Companies use option pricing models
such as the Black-Scholes model to value illiquid options and
warrants they hold in their corporate portfolios. They use them
to value options on their stock given as consideration in
making acquisitions. Yet they will claim that the same models
cannot be used to value options given to employees as
compensation. It seems that the only acceptable value such
options can have is zero.
Some of the opponents of FASB's proposals claim that the
option compensation information should be relegated to a
footnote as it is currently displayed. I disagree. The current
presentation is a substitution of disclosure in place of paper
accounting. It resulted from a Board that was badly compromised
in 1994 due to the political actions that interfered with its
independence. The information reported in the footnotes since
1996 were real transactions that occurred with employees, and
financial statements are supposed to contain transactions that
occurred in a firm for a given period. By our count for the S&P
500, net earnings were overstated by more than $175 billion
from 1993 to 2002. That is information about transactions which
was presented only once a year to investors rather than as it
occurred each quarter, and it directly related to the resources
under the firm's disposal, which management is supposed to
employ for the benefit of its shareholders. That is one of the
tenets of capitalism and one that has been ignored when it
comes to reporting equity-based compensation.
Opponents of the FASB proposal often claim that stock
prices will fall if option compensation is recognized in
earnings. I cannot think of a more patronizing argument.
Markets are supposed to allow capital to flow to wherever it
can best earn the best return. Information about how capital is
being managed allows capital providers to make rational
investment decisions. If stock prices fall because capital is
not being allocated properly in certain firms, then markets are
allowing capitalism to function as it should.
For decades, accounting standards have done a poor job in
depicting how capital is being used when it comes to equity-
based compensation, and consequently, we have seen how capital
has been misallocated in the past.
The interference surrounding the FASB equity compensation
project is very much like a decade ago, when the Board proposed
that health care benefits promised to employees----
Senator Fitzgerald. I'm going to have to ask you to wrap
up, because we have to keep on going. We've gone past 5
minutes.
Mr. Ciesielski. OK. The situation is similar to the one we
had the tussle over accounting for other post-employment
benefits. The world didn't come to an end. We now have a
referendum on how these things should be managed.
Earlier in my comments I mentioned that a large variety of
financial statement users contacted me in connection with the
accounting observer. One question that they continually asked
from analysts of all stripes is not can we stop this from
happening. The most frequent question I hear is when will this
go into effect. We want to start adjusting our models.
Investors and analysts are ready now for such information,
and would like to roll back the uncertainty that surrounds the
way they will do their jobs. That will diminish if the FASB
completes its project independently.
Senator Fitzgerald. Thank you very much. Mr. Silvers.
TESTIMONY OF DAMON SILVERS, ASSOCIATE GENERAL COUNSEL, THE
AMERICAN FEDERATION OF LABOR-CONGRESS OF INDUSTRIAL
ORGANIZATIONS (AFL-CIO)
Mr. Silvers. Thank you, Mr. Chairman. I will do my best at
shortening this up. I am here on behalf of the American
Federation of Labor and Congress of Industrial Organizations,
of our 13 million members who have $5 trillion invested in the
capital markets, in retirement plans.
The AFL-CIO strongly supports the Financial Accounting
Standards Board in its effort to close the accounting loophole
that has allowed corporations to radically understate the trust
cost of executive compensation. We strongly oppose S. 9769, S.
1890, and other efforts to exempt stock options from the normal
accounting rules and the normal processes by which accounting
rules are made.
In the mid-1990's, as many of the previous witnesses have
discussed, FASB attempted to require option expensing but was
pressured by Congress into abandoning its position. We believe
that this thwarting of FASB's role as an independent body was a
key contributor to the chain of events that led to the
corporate scandals of the last several years that did profound
damage to our members and our funds.
Ten years later, there can be no doubt that this issue has
been studied to death, most recently by the Congressional
Budget Office. The Big 4 auto firms, the Conference Board, the
chairs of the SEC and the PCAOB and every investor organization
we are aware of agree, that at long last Congress should simply
let FASB do its job.
Against this background, efforts to prevent FASB from
acting on its conclusions in the name of further study would
simply lead to continued subsidy of excessive executive
compensation, and at the cost of undermining the integrity of
our accounting rules and the processes by which they're made.
Substantively, the AFL-CIO views stock options as one
appropriate form of medium-term compensation for line
employees. However, we think options are a poor form of
executive compensation because they do not fully expose
executives to downside risk in the same way that shareholders
are. Options are also an inappropriate substitute for the basic
wages and benefits needed to support a family. Not
surprisingly, nonexecutive options are generally held by upper
income Americans, whose base salaries already meet their
fundamental economic needs.
At the height of the stock market boom in 1999, only 1.7
percent of private sector employees received stock options,
according to the BLS, and that was heavily concentrated among
individuals earning more than $75,000 a year. Only 0.7 percent
of those earning under $35,000 received options.
Consequently, the labor movement opposes giving options
preferential accounting treatment over other more important
employee benefits, such as wages, pensions, or health care.
Nonetheless, we do agree with the conclusions of the CBO study,
that options expensing will not end option use or anything like
that at cash short firms where they make strategic sense. And
we're fine with that. We think that's a good thing, that those
firms continue to use options.
Two bills in this Congress, S. 1890 and H.R. 3574, purport
to require the expensing of stock options for the top five most
highly paid executives. However, that is a sham. These bills
would require companies using an option pricing model, like
Black-Scholes, to assume that the underlying stock prices has
zero volatility. This minimum value approach allows companies
to set the exercise price of the option equal to the current
market price and book the value of the option at zero.
Of course, in real life, the prices of publicly traded
stocks are volatile, and these executive stock options have
real value. Passing a bill that says that public company stock
prices do not move and directing FASB to run an accounting
system on that basis is the equivalent of passing a bill saying
the Earth does not move around the sun, and then asking NASA to
run a space program on that basis. You can do it, but don't be
surprised if something crashes.
This slight of hand involving volatility is the latest
example of misleading arguments surrounding the technical
details of option valuation. My written statement goes into
that in detail and I would be happy to answer questions on it.
Today, the executives of the international stock options
coalition have one billion dollars in options, in the money
option value held, not one penny of which has been expensed. It
should not be any mystery as to what their motives are. What is
mysterious is how these executives of companies like Texas
Instruments and Hewlett-Packard reconcile the expenditures they
are making in the cause of distorting their financial
statements against the express wishes of the majority of their
shareholders at both companies who voted on this, with those
same executives' fiduciary duties of loyalty and care.
What is the bottom line of all of this? Let me refer you to
the congressional testimony of former Enron CEO Jeffrey
Skilling. As he put it, ``You issue stock options to reduce
compensation expense and, therefore, increase your
profitability.'' Surely we have learned enough from Enron not
to mandate by statute that the Enron approach to not accounting
for stock options be the law of the land.
Thank you very much.
Senator Fitzgerald. Thank you very much, Mr. Silvers. Mr.
Delves.
TESTIMONY OF DONALD P. DELVES,\1\ PRESIDENT, THE DELVES GROUP
Mr. Delves. Thank you very much, Mr. Chairman.
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\1\ The prepared statement of Mr. Delves with an attachment appears
in the Appendix on page 100.
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I have been advising boards of directors and management on
executive compensation for almost 20 years. Based on my
experience, there is absolutely no question in my mind that we
must have an expense for options, and it must be meaningful,
significant, and soon. And there is no question that the FASB
should decide how that expense will be determined.
Ten years ago, the FASB tried to implement an expense for
options. Congress intervened and the FASB backed down. Let's
look at the results. Over the last 10 years, executive pay has
spiraled out of control, mostly due to excessive grants of
stock options. Stock options use has more than tripled and
boards of directors have done a poor job of getting more
performance from this unprecedented increase in compensation.
I believe that had the FASB been allowed to do its job and
implement an expense 10 years ago, we would not be in the mess
that we're in today with regard to executive pay and corporate
governance.
Now let's look at what's happening around the country
today. Because the FASB has put this expense out there, and
most companies are taking this seriously, the good news is that
in board rooms across the country boards of directors are
reexamining their use of stock options and are coming up with
new solutions and, in some cases, they're even lowering
executive pay.
Boards are asking tougher questions about the true cost of
options and what they're getting in exchange for it. For
example, we were asked to do an analysis for a company to show
the board what the total cost to the shareholders had been of
their stock option program. We were able to show that board of
directors, over 10 years, $1.2 billion of shareholder wealth
had been transferred from shareholders to executives. There was
no way that we could have done that using publicly available
data.
Now, interestingly, we also showed that same board that,
over that 10 year period, had they expensed options using
FASB's proposed method, the expense would have been $600
million, roughly half of the total cost to shareholders.
Now, our research shows that we expect that to be true over
time and across companies, that roughly 50 percent of the
ultimate cost to shareholders will be captured in the
accounting expense. However, that expense occurs up front when
the options are granted. If it's a high performing company and
the stock price goes up, the total cost to shareholders could
be much greater. But for the poor performing company, the cost
to shareholders could be much lower. It could even be zero.
For that reason, I prefer the intrinsic value method that
Mr. Herz discussed, which is the alternative method that is
allowed for certain private companies. I think it does a better
job of capturing the true cost to shareholders. It would
provide better information to board of directors and could
result in more creative solutions in executive pay.
However, the debate over how the expense should be
determined belongs with the FASB. I look forward to engaging
with them in that debate according to their proscribed process.
So, in summary, there must be a significant and meaningful
expense for stock options, and FASB must decide how.
Thank you.
Senator Fitzgerald. Thank you, Mr. Delves. Mr. Heesen.
TESTIMONY OF MARK HEESEN,\1\ PRESIDENT, NATIONAL VENTURE
CAPITAL ASSOCIATION
Mr. Heesen. Good afternoon.
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\1\ The prepared statement of Mr. Heesen appears in the Appendix on
page 105.
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I'm going to address this question as it really relates
around private companies and newly public companies. That's
where the venture capital industry concentrates and that's
where 11 percent of the employment opportunities are right now.
Almost without exception, young, growth oriented venture
backed companies use options to attract the brightest talent at
a time when cash is scarce, just as Senator Bennett was saying.
These employees take a considerable risk to work at unproven
companies, knowing that through their stock option program they
may be rewarded, if and only if the company succeeds.
Should FASB's proposal go through, we believe stock options
will be artificially too costly for many of these young
companies to offer to all their employees, thus seriously
hindering their ability to attract human capital to compete and
providing a false picture of their financial health, which will
ultimately lengthen their reliance on venture capital.
This is the important point from our angle. The longer
these companies stay artificially in the red, the longer it
takes our companies to be acceptable to the public. Because
there aren't analysts following these kinds of companies, we
will have to continue to work with those companies at the
expense of putting new money into new companies. That means
fewer venture backed companies will be funded, fewer new
technologies will be funded, because our industry does not
scale. There are only a certain number of venture capitalists
who know how to basically grow companies, and they will only be
able to do so much in this period.
We have seen this in the past. You will see a reduction in
the number of emerging growth companies being funded by venture
capital.
One of the largest challenges of mandatory option expensing
for small companies is the burden of valuation, which we've
been talking about. FASB has put forth three models for
valuation. The first two models, Black-Scholes and the lattice
method, require a volatility number as a critical input. Yet,
the underlying shares of a privately held company have never
been liquid, so there is no precedent to derive a volatility
number, thus creating a significant and costly accounting
quagmire.
When issuing FAS 123 in 1994, FASB agreed. They stated the
Board recognizes that estimating expected volatility for the
stock of a newly formed entity that is rarely traded, even
privately, is not feasible. The Board therefore decided to
permit a nonpublic entity to omit expected volatility in
determining a value for its options. The result is that a
nonpublic entity may use the minimum value method.
Rather than to continue to offer private companies the
minimum value method, which sets volatility at zero, FASB now
advises these organizations to use Black-Scholes, the lattice
method, or as we've been hearing a lot here today, the
intrinsic value reporting. We believe that this intrinsic value
reporting model really is akin to offering no choice at all.
In its proposal, FASB has modified the intrinsic value
calculation to require that the share options and similar
options be remeasured at intrinsic value at each reporting
period through the date of settlement. Historically, this
calculation has taken place only once, recognizing that
companies rarely have the information to reset a stock price
that is not tradeable. A continuous recalculation of intrinsic
value is too costly for most organizations to bear, resulting
in invariable accounting which is the result--which experts
have recognized is unwieldy and impractical, but a gold mine
for newly admitted valuation consultants, accountants, and
let's not forget the trial board.
Unfortunately, GAAP is not a matter of choice for private
companies. Most start up and report their financials under GAAP
because they expect or hope to ultimately move through an
initial IPO process or be acquired by a public company. Again,
by placing this accounting burden on young companies, FASB is
lengthening the reliance on expensive, high risk capital to the
start-up sector.
Should FASB move forward with its current stock option
accounting mandate, the Board will be acting in direct conflict
with its stated goals: ``The cost imposed to meet that standard
as compared to other alternatives are justified in relation to
the overall benefits from improvements in financial
reporting.'' The Board has long acknowledged that the cost of
any accounting requirement falls disproportionately on small
entities because of their limited accounting resources and the
need to rely on outside professionals.
As the Chicago Tribune stated in its April 6 editorial,
``Expensing isn't a panacea for investors and it carries a cost
that could hurt entrepreneurship.''
Thank you.
Senator Fitzgerald. Thank you.
Before I go on to Mr. Glassman, because I'm from Illinois,
I have to respond to the Chicago Tribune. I have Mr.
Ciesielski's Analyst Accounting Observer Report that shows that
the Tribune Company, which owns the Chicago Tribune--and I love
the Chicago Tribune, I've read it all my life, and they always
endorse me. They're a wonderful paper.
But the last time I checked, their earnings were overstated
more than any other company in my State. According to this
report, their earnings in 2003 were overstated by 10 percent by
virtue of their failure to expense stock option compensation.
They are heavy users of stock option compensation. Their
earnings per share, as reported last year, were $2.61. If they
had expensed their stock option compensation, it would be
$2.38.
I only wanted to disclose that because I thought they
should have disclosed that in the editorial they wrote opposing
the new FASB rule.
Mr. Heesen. And I would love to see the Washington Post do
the same thing, frankly, on the other side, with Mr. Buffett
owning a good chunk of the Washington Post. That would also be
helpful.
Senator Fitzgerald. Mr. Buffett does, and he favors the
expensing of stock options----
Mr. Heesen. And we would never see----
Senator Fitzgerald. Also, I think they have a shareholder
there, Donald Graham, who doesn't want to give all his value
away necessarily, so he's really watching the company. He's an
owner more than just a manager, and he's representing the
interests of the owners. We'll leave some time for questioning,
though. Mr. Glassman works for the Washington Post, but
apparently does not share their editorial viewpoint.
Thank you, Mr. Glassman.
TESTIMONY OF JAMES K. GLASSMAN,\1\ RESIDENT FELLOW, AMERICAN
ENTERPRISE INSTITUTE
Mr. Glassman. Thank you, Mr. Chairman, and thank you for
the kind introductory remarks, Senator Levin.
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\1\ The prepared statement of Mr. Glassman appears in the Appendix
on page 112.
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Let me just comment on what you just said. I obviously have
no reaction to what you're saying about the Washington Post. I
do have a number of very good friends who work for the Chicago
Tribune at upper management levels, and I can tell you that one
of the reasons they are there and diligently working is,
indeed, because of their stock options, which they talk to me
about all the time.
Let me begin my testimony. One in two American families own
stock, and one in eight U.S. private sector workers hold stock
options. Senator Lieberman calls this revolutionary
democratization. I agree with that.
The FASB proposal of March 31 will adversely affect these
Americans. The proposal is likely to depress the value of
securities and, for many firms, it will lead to the elimination
or reduction of broad-based stock options, 94 percent of which,
according to a new study, go to employees below the top
management level. Discontinuing or reducing these options
programs will have an adverse effect on U.S. competitiveness,
innovation, and job creation. It will needlessly damage the
U.S. economy.
In 1972, when FASB's predecessor first looked at this
question--not 10 years ago, but 1972--it decided against
expensing options when issued. The reason, ``Because of the
concern that stock options could not be reliably valued at the
exercise date.'' That is still true.
Now, the current regime gives investors the information
they need in the form of copious material and financial
statements. Mr. Chairman, with your permission, I would like to
enter into the record--this is the Intel Corporation annual
report. You can look at virtually any annual report of a
company that issues options. Here under earnings per share it
lists the effect of the dilution of stock options, reducing
earnings per share, which is what investors care about, and it
goes on for three pages with notes on stock options. That's
more information than most companies include on things that I
think are a lot more important, such as the sources of their
revenue, other forms of compensation, patents, debt, all sorts
of things. This information is in these annual reports.
Now, I would just like to focus briefly on the issue of
FASB's accountability. Much has been made of FASB's
independence. But accountants need to be accountable, too. As
Mr. Volcker just said, they need to be exposed to the real
world--that is, to the people's representatives. America's
elected representatives not only have the authority, they have
the moral and legal responsibility to oversee the activities of
FASB just as they oversee the activities of the SEC, which in
1973 ceded responsibility itself for these standards to FASB.
Now, this does not mean modifying or overruling common,
day-to-day decisions. Of course, not. But it does mean
carefully examining the impact of a tremendously important
decision like this one on options and accounting. This is not
interference. This is not intervention. This is not tampering.
This is a responsible execution of your job.
FASB has a single mission, which it states this way: ``To
establish and improve standards of financial accounting and
reporting for the guidance and education of the public,
including issuers, auditors, and users of financial
information.'' FASB executives have said clearly that the
economic consequences of their decisions do not concern them,
and they're right. But you, as Federal policy-makers, have a
far broader mission: Encouraging economic growth, preserving
and increasing jobs, innovation and competitiveness.
Now, even if FASB's expensing proposal were cogent from an
accounting and financial viewpoint--and in my opinion it is
not--it would be the duty of Congress to consider its economic
impact.
Finally, FASB on the one hand states that it is
independent, so hands off. On the other, it has been vigorously
lobbying. As I believe Senator Enzi originally said, there is
an article today in the Wall Street Journal, and let me just
quote from it, about a conference call yesterday:
``During the conference call Monday, Sir David Tweedy,
chairman of the International Accounting Standards Board, said
to institutional investors, it would be a `real disaster' if
Congress blocked FASB. `We would be horrified if politicians in
the United States stepped in,' he said.''
Sorry, Sir David. Congress has work to do, and I
congratulate you, Mr. Chairman, on holding this hearing and
doing that work.
Thank you.
Senator Fitzgerald. Mr. Glassman, thank you.
On your remarks about Intel disclosing their in the money
options, they don't disclose in that footnote their stock
options that aren't in the money; isn't that correct?
Mr. Glassman. Well, they disclose the number of them that
are not in the money. In other words, they say there are--
believe it or not, there are a lot of----
Senator Fitzgerald. They're disclosing the dilution,
though, in the earnings per share, and they disclose the
dilution in the earnings per share of only in the money
options.
Mr. Glassman. That is correct. And that is the rule----
Senator Fitzgerald. And then in the footnote, do they show
the potential dilution from all the options, not just the ones
that are currently in the money?
Mr. Glassman. I'm not sure they make the calculation. I
can't actually--I think that they do. But I can tell you that
in the P&L, where they do the earnings per share, they show the
dilution of stock options that are in the money, and they tell
you the number of stock options which are not in the money--By
the way, as I remember, I just flipped a page and missed it,
but I think I've got it down within a few million. There are
100 million options in the money, and 400 million out of the
money. I think this shows the problem, in fact, in trying to
value stock options when they are issued.
Unfortunately, as everyone here knows, stock prices have
dropped for a lot of tech companies, and a lot of these options
are way out of the money.
Mr. Heesen. They call that super dilution. There have been
a lot of companies who said they would love to put that
information out. A couple of business periodicals have actually
said, if we could do that, that would be fine as an additional
part of the disclosure, to put in basically the worst case
scenario. If tomorrow, every option you had was exercised, what
would that impact be on your company.
Senator Fitzgerald. OK. Just going back to Mr. Glassman,
you are on an advisory board for Intel, right?
Mr. Glassman. That is correct.
Senator Fitzgerald. You heard my opening statement where I
was quoting from Benjamin Graham's book, ``Security Analysis--
''
Mr. Glassman. A great book. I congratulate you for quoting
from it.
Senator Fitzgerald. I haven't read the whole thing, but I
looked up the part on what he called stock option warrants.
Do you agree with him when he said the basic fact about
options--he calls them option warrants--is that it represents
something which has been taken away from the common stock? The
equation is a simple one. The value of the common stock, plus
the value of stock options, equals the value of the common
stock alone if there were no options.
In other words, if you own a company--let's say you own 100
shares of a company and that is all the company has in
outstanding shares--you own all of it. All of a sudden the
company gives me 100 options to buy shares in your company.
Something has been taken away from you, right? You're going to
share equally with me now in the upside participation of any
future enhancement or rise in the profitability of the company.
Do you agree with that?
Mr. Glassman. I do agree with it. But what is being taken
away is something that is extremely contingent and difficult to
value. If you're simply giving out warrants, which are things
that anybody can convert immediately into stock, and that are
tradeable in most cases, that's one thing. But if you're giving
me an option which requires me, for example, to stay in the
company and not get fired, not leave for a number of years, and
I don't know whether the price is going to go up or down,
that's something that is contingent, which I think is handled
quite well, and I think has been for decades----
Senator Fitzgerald. I agree it's difficult to value, but
depreciation is difficult to measure, the wearing out of a
useable life of plant and equipment, that's an age old debate,
but it nonetheless is a real expense to a company. As a capital
asset runs out of its useful life and approaches obsolescence,
the company is actually going to have to expend cash to buy new
plant and equipment. It is a real expense and we do try to
capture it. We don't argue that we'll just ignore that expense
and pretend it doesn't exist, too. The same with pension
liabilities, amortization of good will or impairment of good
will, and the value of derivatives. Those are all difficult
questions, aren't they?
Mr. Glassman. They are difficult questions, there's no
doubt about that. I think, however, that we're going down
exactly the wrong road here. What we're trying to do is take a
lot of information, which is, indeed, provided to investors,
and shoehorn it into one number, which is not going to be an
accurate number.
I don't think that really helps investors at all. I think
the current regime actually helps investors a lot more than
trying to pluck a number out of the air, which is almost
certainly going to be inaccurate. All but the back testing has
shown that whatever system is going to be used is not going to
produce accurate numbers. That's the problem.
What I find somewhat ironic, I know that Mr. Herz has made
comments in the past about the importance of really getting to
work at the true challenge for accounting, which is how, in a
knowledge-based economy, can you provide the proper information
to investors. I don't think that proper information is one
number to represent a very complex phenomenon.
Senator Fitzgerald. OK. I have a meeting I'm going to go to
in the anteroom, and I'm now going to turn the questioning over
to Senator Levin. Then I'm going to try and come back and
continue on with my questions.
Senator Levin [presiding]. Mr. Glassman, I think you said
somebody from the International Accounting Standards Board said
he would be horrified if Congress acted?
Mr. Glassman. He said he would be horrified. He didn't say
Congress. He said if politicians--I guess he was referring to
Congress--in the United States stepped in.
Senator Levin. I thought you said, in introducing that
comment, said it was FASB that was lobbying us. Did FASB put
them up to it, the IASB?
Mr. Glassman. I don't know if they put them up to it, but
there was a joint conference call which FASB, according to the
Wall Street Journal, held with a number of institutional
investors yesterday.
You heard from the testimony, obviously, that part of the
impetus here is to have a convergence of international
accounting standards and U.S. accounting standards----
Senator Levin. That's just stating a position, right? Is
that lobbying, what you would call it? If they're just stating
their position as to why they're doing what they're doing, and
we call them in front of us today and they gave us their
position--I just want to find out something else.
Are you suggesting that FASB somehow or other has urged
people to lobby for their rule, because I would like to hear
from Mr. Herz on that.
Mr. Glassman. I think Mr. Herz will tell you that FASB has
at least one full-time lobbyist on its--a registered lobbyist
on its staff.
Senator Levin. Let's find out what the lobbying is.
Mr. Herz is sitting out there. What lobbying do you do?
Mr. Herz. Our registered lobbyist is Mr. Mahoney, who is
here as a staff person to answer your staff's questions and
help prepare my testimony. It is to provide people on the Hill
and Federal agencies information when they ask----
Senator Levin. OK. I just wanted to clear that up. Anyway,
Sir David Tweedy is on the International Accounting Standards
Board.
The next question. Is the problem that you two have, Mr.
Heesen and Mr. Glassman, is it mainly on the valuation issue,
or if they were easily valued, readily valued, would you still
object to them because they're such a valuable incentive for
folks to join companies and invest their time and so forth?
Which is the bigger issue for you?
Mr. Heesen. We have a fundamental issue with the idea that
these should be expensed, that these options----
Senator Levin. Even if they were easily valued?
Mr. Heesen. No. But having said that, under where we are at
this point, we believe that the valuation issue is extremely
important, particularly for young, privately held companies,
where it's almost impossible to come up with a logical number.
Senator Levin. Are you saying it's more difficult than
other kinds of valuations which we've heard about this
afternoon?
Mr. Heesen. It's more difficult, and it's going to be more
costly, particularly for small companies.
Senator Levin. More difficult than the convertible bonds
and long dated stock warrants and all those other things?
Mr. Heesen. A young company is not going to be using any of
those things. It's great for Cocoa Cola, but we're not in that
boat.
Senator Levin. But it's more difficult than all the other
items that are difficult to value that you heard about today?
Mr. Heesen. All the other things that a small community
would use at the end of the day are going to get trued up.
That's the important thing. The stock options, you put them out
and that valuation is wrong, it's not going to get trued up at
the end of the day. You're going to have to carry it forward
with that bad number.
Senator Levin. One easy way to do it is the alternative way
of valuation. Do you have a problem with that?
Mr. Heesen. Yes. As I stated in my statement, intrinsic
value is not--what we believe, when we looked at it carefully,
it is not a way, a proper way of doing accounting.
Senator Levin. I was referring to the alternative way which
I heard at the end of the testimony by Mr. Herz, about small
businesses being able to take the same valuation on their books
as they do on their taxes.
Mr. Heesen. That we have not looked at. I have not
specifically looked at that at this point.
Senator Levin. I thought that was part of your proposal.
Mr. Heesen. No. The intrinsic value----
Senator Levin. No, something else.
Mr. Herz, what do you call that alternative approach that
you were thinking about having small businesses have the option
to use? Is that the intrinsic value approach?
Mr. Herz. Yes.
Senator Levin. OK. Thank you. Then I'm wrong. The intrinsic
value approach I guess is what they call that.
Mr. Heesen. Exactly. And as I stated in my statement, what
that does is force you, instead of only once, to go out and get
a valuation consultant to do this quarterly, so the cost
imposed really does not make this a choice at all at the end of
the day.
Senator Levin. If you were given a choice, if small
business were given a choice of simply taking the same figure
that they take on their tax returns and putting it on their own
books, would that be a problem for you?
Mr. Heesen. I don't know. We would have to look at that.
Senator Levin. Well, it's been out there for 10 years, Mr.
Heesen. I've been around and around with folks on that issue
for 10 years, and then people say they've got to take a look at
it.
Mr. Heesen. Well, the difference is----
Senator Levin. Logically, is there any problem with that?
Mr. Heesen. I don't know, because tax accounting is very
different, as the chairman of FASB said, as opposed to
accounting.
Senator Levin. It usually is. But if you're looking for
certainty and you want to make sure that no one is trying to
figure out how to do something in advance which is difficult to
assess, then one way to do it is to say, OK, we'll give you a
choice. You can either take it the complicated way, which you
think is a complicated way, or you can take it the simple way,
which is, if you want a tax deduction for a business expense,
show that on your books. That's real simple.
You're not telling me that you're willing to do that?
Mr. Heesen. We would have to look at that. I'm not going to
say that a small business, when they have all these other
issues in front of them, is going to take that very quickly. I
don't know.
Senator Levin. OK. Will you let the Subcommittee know?
Mr. Heesen. Absolutely.\1\
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\1\ Letter of clarification from Mr. Heesen, dated Apri. 30, 2004,
appears in the Appendix on page 152.
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Senator Levin. Mr. Glassman, do you have a problem with
that?
Mr. Glassman. No. I think that, just as a principle, I
think tax accounting, and whatever we want to call this
reporting accounting, GAAP accounting, ought to be as close as
possible to the same thing.
Senator Levin. So that if we gave small businesses, let's
say, an option of putting the same business expense on their
books as they take as a tax deduction on their taxes, you would
say that makes good sense to you?
Mr. Glassman. I guess I would have to answer the question
in a broader way, which is that tax accounting and GAAP
accounting should be the same. But I think that would mean we
would need to look at the entire Tax Code as a result. I think
we should, but----
Senator Levin. I don't know that we're going to be able to
look at the entire Tax Code as a result of looking at one bill.
Since that's your general principle, would you apply it here?
Mr. Glassman. Yes.
Senator Levin. OK. That's helpful. I think that's going to
be a very useful alternative, and I predict to you what the
outcome will be when we consider that alternative. It will be
the same throwing up of hands and saying no, we don't want to
do that. That's even worse than what FASB is proposing, because
that frequently is a bigger number than what FASB is proposing.
But I will predict right now, Mr. Heesen--I shouldn't predict
your answer, but I look forward to your answer with unbaited
breath.
Now, the only reason I say that, by the way, is because
I've been around that track before. About 10 years ago I made
that suggestion, and the immediate instinct was hey, that makes
sense, and then within 24 hours, folks who opposed FASB came
back and said they're very much opposed to that. I hope your
answer is different.
Mr. Heesen. And I'm looking at it from a small business
perspective, not from probably the people you were talking
about, from the bigger companies 10 years ago.
Senator Levin. No, these weren't the bigger companies.
These were start-up companies. OK. At any rate, thank you for
getting back on that.
The only other question I think I will ask before I ask our
Chairman to come back is the numbers, Mr. Glassman, that you
gave us, and then I would like to talk to Mr. Silvers about the
number of workers that hold stock options in the private
sector. You said one in eight employees in the private sector--
--
Mr. Glassman. Yes. This is in my written testimony.
Senator Levin. It was a Harvard study or something----
Mr. Glassman. You had two Rutgers professors and one
Harvard professor.
Senator Levin. OK. Then it's a Rutgers study in that case.
Mr. Silvers, is that your experience at the AFL-CIO, about
the one in eight?
Mr. Silvers. That's about 12 percent. That doesn't sound
off the track. The professor, Professor Blasi at Rutgers, is a
recognized expert in this area.
Senator Levin. In the one question I have on that study,
are these people who own stock options as a result of getting
them at work as part of their compensation?
Mr Glassman. Yes, sir. It's part of the compensation stock
options. Actually, it's very interesting because the figure
that they use is 13 percent. I just made it one out of eight,
which is 12\1/2\ percent, including 57 percent of workers in
computer services, 43 percent of workers in communications, and
27 percent in the finance industry.
Senator Levin. And that other figure that you cite, 94
percent of options being held by employees below the top levels
of management?
Mr. Glassman. That also comes from the same study.
Senator Levin. What is that level? That's a much
different----
Mr. Glassman. Actually, I don't know that.
Mr. Silvers. Senator, if I might, I think part of the
confusion here is that the 94 percent number is broad-based
plans. If you look at all options, I believe the correct number
is the National Center for Employee Ownership number that
Senator Lieberman mentioned earlier in the hearing, which is, I
guess, about 70 percent of the options that are out there in
total, that are issued by employers to employees at all levels,
are held by the very top level of management.
Senator Levin. And do we know how ``top level'' is defined?
Mr. Silvers. I believe in that number--I'm not sure. My
guess is that number is looking at the SEC disclosing top five
executives. I may be wrong, though. It may be a slightly larger
slice.
Mr. Glassman. I'm pretty sure that is correct.
Actually, if I could just intervene for a second, you asked
me the same question you asked Mr. Heesen. I think this would
be my answer to your original question, which is more
important. I think it's very important that more and more
Americans have the opportunity to own stock options and other
ways to participate in ownership of the companies that they
work for.
Senator Levin. I agree.
Mr. Glassman. I think that's a great thing, and this----
Senator Levin. I think all of us would agree with that.
Mr. Glassman. Clearly, according to just about everyone who
has opined on this subject, from whatever position, this will
discourage that. There is no doubt about that. I think you can
take that into----
Senator Levin. How about grants of stock?
Mr. Glassman. I like grants of stock. The problem with
grants of stock is that they do not provide as much of an
incentive to many employees as options, because there's much
more leverage in options, obviously.
Senator Levin. Say you have a stock grant that is
conditioned upon the company reaching certain levels.
Mr. Glassman. I think that's fine, and I really do believe
that----
Senator Levin. Is that treated as compensation on the
books?
Mr. Glassman. I don't know the answer to that.
Mr. Heesen. Yes, it is.
Senator Levin. Sure, it is. So why is this different?
They're both valuable.
By the way, I agree with you. I'm all for stock grants
conditioned on companies doing well. I think it's great. I'm a
big Aesop man. Russell Long taught us about that. I believe in
stock options. I think it's fine. The only question is how you
account for them, and why would we want to account differently
for conditional stock grants on how a company does and stock
options based on how a company does? What's the logic in
treating those two things differently? Mr. Glassman.
I'm stalling here while our Chairman comes in.
Mr. Glassman. It's a good question. I guess I would turn
the question around and say, why do we need to make a change if
this information is broadly available to investors and anyone
else who wants to make a decision about valuing a company. It's
all right there. By making the change, you are actually going
to incent businesses or push businesses into abandoning these
programs, which are good programs.
Senator Levin. The reason for the change is honest
accounting according to the Independent Accounting Board.
That's the reason for the change. The answer to the question is
how do you logically treat those two conditional grants
differently. In fact, as I understand it, even a grant of a
stock option dependent upon whether a company does certain
things or the stock goes up in value is also valued under
current law, under current standards.
The one exception to all these uncertain types of
compensation, the one exception is stock options. If I tell
you, if you will come with my company, you're going to get a
thousand shares of stock, if you can double the value of this
stock within the next 10 years, at any time during that 10
years, that grant, conditional as it is, uncertain as it is--we
don't know if the company stock is going to go up or down or
not--but I offer that to you to get you to come to my company,
to be an executive at my company, that is expensed now. But the
stock option isn't, and there is no logical basis that I can
see for differentiating there, and there's no reason why we
ought to say you get a tax deduction for the expense but you
don't have to show the expense on your books.
Why should we then give a tax deduction? If you want the
accounting to be the same, OK, maybe we then ought to say you
don't get a tax deduction. Would that then satisfy your rule
about keeping tax accounting the same as regular accounting?
You don't get a tax deduction?
Mr. Glassman. Well, the tax deduction doesn't come until
the end----
Senator Levin. Right. But it's still not shown as an
expense on your books. Wouldn't we then, to follow your rule,
say OK, we won't show it as an expense on the books, but we're
not going to give you an expense on your taxes, either. That
would then be consistent with your generic accounting
principle, would it not?
Mr. Glassman. I guess it would. I think those things ought
to be consistent. But I think the main principle here is that
broad based stock options have been tremendously beneficial to
the U.S. economy, whether they're exactly in concert with this
kind of incredibly complex GAAP accounting system we have now,
with some other instrument or not. They are very valuable in
real life to our real economy. This measure will cause
companies, will certainly incent companies, to abandon these
programs.
I must tell you, I don't think that's very good. I do think
this is the responsibility of Congress to examine and to see
what it can do about it. I don't think that in any way impairs
the independence of FASB, not in the least.
Senator Levin. I'm for incentive pay of any kind, frankly.
I think it does perform a very important economic function,
subject to some of the qualifications which Mr. Silvers put out
there, too, where the main beneficiaries are, depending upon
how you incentivize it. But I happen to agree with the
principle that incentive pay is a good thing, but that is the
only form of incentive pay which is treated the way it is. That
makes no sense----
Mr. Glassman. Well, maybe all the other ones should be
treated the same way that options are, because I think, as
public policy, we want to encourage this. We really do. We
don't want to encourage companies to be sloppy and to take
undue risks and to do all sorts of other things, so we would
have to watch it. But in general, we want to encourage this
kind of practice, and this will discourage it. That's my only
message.
Senator Levin. Thank you.
Senator Fitzgerald [presiding]. Senator Levin, thank you
for covering for me.
I now would ask for unanimous consent--and I will grant it
to myself--to introduce Mr. Ciesielski's April 2004 Analyst's
Accounting Observer Report into the record.\1\
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\1\ ``The Analyst's Accounting Observer,'' appears in the Appendix
on page 153.
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You developed tables, and one table shows the 50 companies
whose unreported stock compensation caused earnings to be
overstated by 10 percent or more, ranked by descending order of
overstatement.
The company which most overstated its earnings was Yahoo!.
It overstated its earnings by 640 percent. You derived that
calculation by looking at their earnings per share as reported,
which was 37 cents per share in 2003, but if they had expensed,
I assume, using the Black-Scholes model--is that right?
Mr. Ciesielski. I believe that's what they used. Only a
handful had used other than binomial, and I can remember those.
Senator Fitzgerald. OK. If they expensed their stock option
compensation, their earnings per share would have been reduced
from 37 cents a share to 5 cents a share. So their
overstatement of their earnings to the public was 640 percent.
That's a pretty whopping deception in my judgment.
But when you think about it, I noticed just looking last
night on the computer, it looked like Yahoo! was now selling at
a trailing 12-month PE of 128, which is a humongous PE. But
that PE assumes that their real earnings were their reported
earnings. If one looks at their real earnings as their earnings
as reported minus an expense item for stock option
compensation--if I were to do the math on their closing price
at December 31, their closing price was $45.03, and their
earnings per share were 5 cents a share--then their PE at
December 31, 2003 looks to me to have been 900. So am I
correct, that investors would be paying $900 to get a claim to
one dollar's worth of earnings?
Mr. Ciesielski. That's the linear math, yes.
Senator Fitzgerald. Am I doing that----
Mr. Ciesielski. I think you're doing that correctly. I
don't have a calculator to verify, but it sounds like it's in
the ballpark.
EVENING SESSION [6 p.m.]
Senator Fitzgerald. Now, going back, Mr. Glassman, to where
we were talking about--you said you agreed with Benjamin
Graham's analysis, that the value of common stock plus options
equals the value of common stock if there were no options.
Let's assume the new FASB rule does deter companies from
issuing as many options. Let's assume it deters them from
issuing options altogether and a company like Yahoo! stops
issuing options. I don't think that will happen. I think they
will just start expensing them and be more discreet about
issuing them. They won't be gorging themselves on stock options
any more.
Going back to that company that you and I talked about that
had 100 shares, and you own all the shares, and we no longer
give 100 options to me or anybody else in your company. Then
aren't your 100 shares in your company worth more because
you're back to having a 100 percent claim on the future
earnings of your company, and you're not giving options to
participate in the future appreciation to anyone else? Wouldn't
your shares be worth more?
Mr. Glassman. Well, except for the fact that my company,
the company whose shares I own, would not have been able to
attract the kind of people that Yahoo! has attracted, that
Microsoft has attracted, that Intel has attracted, that Dell
has attracted, because of employee broad-based stock options. I
mean, this is the reason these options are offered. They are
offered to attract really good people. I think anyone in
Silicon Valley will tell you----
Senator Fitzgerald. Where are these employees going to go,
though, in the new world where the same accounting rules apply
to everybody?
Mr. Glassman. I hope the new world is competitive so that
we don't have converging--we could do that with the tax codes,
too.
Can I just comment on what Mr. Ciesielski's work----
Senator Fitzgerald. But isn't it possible your stock price
could go up because now there's no longer these options out
there diluting you?
Mr. Glassman. Maybe. It really depends on what investors
think. If all of a sudden Yahoo! said ``well, we're giving up
our stock options; we don't think they're going to work'',
investors may feel well, that's fine, so now the value is
higher or it's the same. But they may get very distressed by it
and say, well, that happens, and then Google is going to take
all the good people that Yahoo! had.
This issue of Mr. Ciesielski's work, where he found the 640
percent overstatement, the information that he got, I'm pretty
sure, is public information. Every investor, every smart
analyst like Mr. Ciesielski, is----
Senator Fitzgerald. But he had to spend a lot of time and
he has been a life time professional doing this. Do you think
the average guy could do this?
Mr. Glassman. Well, guess what? He just published it. So
one would expect that other people then get the information.
It's the way markets work.
Senator Fitzgerald. They pay him.
Mr. Glassman. According to your theory, that would drive
the price of this stock down to virtually nothing, or certainly
about a sixth of its value. But the fact is people already know
about this.
Senator Fitzgerald. I think you're right, and that's why I
don't think stock prices will necessarily go down. In fact, I
think they may go up because the shareholders of Yahoo! will
then get all of the future rise in the value of the company
which inherently belongs to them anyway. They won't have to
give a part of their stake in the future of the company to
anyone else, so I think their stock could actually go up.
Let's go back to Mr. Heesen. Initially you said the longer
a company stays artificially in the red--I don't agree with you
that it's artificially in the red; I think it's artificially in
the black when you are bringing them to the market now, and I
think we will have a more accurate picture once the FASB rules
go into effect. But you said it will take longer to bring them
public.
But don't you think that I should be, as a government
policy maker, concerned not just about the venture
capitalists--who want to unload their investment on the public,
close out their fund, and make a big return--but about the
people out there who are going to buy the shares in this
company that you're going to try to unload on them?
Mr. Heesen. Absolutely. If you look at the venture-backed
companies versus nonventure-backed companies on NASDAQ, they
have traditionally done much better. So if you're going to be
looking at companies between whether they're venture backed or
not venture backed----
Senator Fitzgerald. Over how long a period?
Mr. Heesen. That's been historical for 20 or 30 years,
since the venture capital industry has been in existence by and
large.
Senator Fitzgerald. They've done better than other
companies for how long, though, after they've gone public?
Mr. Heesen. They have consistently gone--going out, and
long run, because they are----
Senator Fitzgerald. Twenty, 30 years down the road
companies that had venture capitalists at the start?
Mr. Heesen. When you look at the Federal Expresses, the
Cisco's, the Intels, the entire buyer technology industry,
literally has all been financed by venture capital at one point
or another. Those are the companies that are driving this
economy and continue to drive it.
Just this quarter, you look at the venture-backed IPOs that
went out, there were 13 venture-backed IPOs. One of those was
the biggest venture-backed IPO ever that went public in the
United States. Unfortunately, it's a Chinese semiconductor
company, so that's how we're starting to see the changes here,
and that company is giving options and it's going to be a very
effective company.
And you know what? All the institutional investors like
that company and they're putting money into it and it's doing
very well right now. That's kind of where we're going in this
environment.
Senator Fitzgerald. Mr. Delves, you looked like you had
your hand up.
Mr. Delves. Yes, thank you. I wanted to make a comment on
the discussion you were having with Mr. Glassman. You were
debating the cost to shareholders of stock options versus the
benefits to shareholders of the incentive provided by options.
That debate can't happen and doesn't happen, and hasn't
happened, in board rooms because there's no expense for stock
options.
With an expense for stock options, boards of directors can
now start having that debate and balance the cost versus
benefits to shareholders.
Mr. Heesen. I would disagree on that from a small company
perspective, in the respect that venture capitalists happily
dilute their ownership in a company, and knowingly do that, to
give those options to employees, because they know at the end
of the day those companies are going to grow as a result of it.
Senator Fitzgerald. But it also, as you said, allows you to
bring a company to an IPO sooner.
Mr. Heesen. Yes, but also, if you look at----
Senator Fitzgerald. So you have a good reason to suffer
that dilution because, otherwise, you might have to hold on to
it longer.
Mr. Heesen. Yes, but as a Harvard study 2 years ago put
out, a venture backed company actually takes longer to go
public than a nonventure backed company, contrary to popular
belief.
Senator Fitzgerald. Now, I know venture capitalists all
over the country; I know people in the Texas Pacific Group out
West; I know the Madison Dearborn Partners people in my State.
I know Ned Heiser, who brought----
Mr. Heesen. Most of the buyouts are not venture capital,
but----
Senator Fitzgerald [continuing]. Federal Express public
many years ago. And I know Thayer Capital, the Carlyle Group,
and so forth. The venture capitalists I have talked to from the
Midwest and the East have had a different approach than those
coming from the Silicon Valley area--the Kleiner, Perkins of
the world--that are very heavily invested in high tech. I do
think there's a big difference between the midwestern venture
capitalists. They are simply not as concerned about the
expensing of stock options as the ones out West, based on----
Mr. Heesen. Well, I think that's a definitional issue, in
that venture capital in the Midwest is more buyouts, to be
perfectly honest, than it is true venture capital.
The other unfortunate thing there is when you look at a
Milken study that just came out last week, you look at where
they are looking at, where are the next science and technology
centers in the country are going to be, and they rated each
State. In the Midwest, there was only one State in the Midwest,
Minnesota, that broke the top 20, in the ability to attract
companies that are science and technology based to their
States. Maybe there is something that the middle part of the
country should be looking at, that the East coast and West
coast have been.
Senator Fitzgerald. Clearly, there is a much greater
reliance on options in the high tech industry. The
overstatement of the earnings of the top 100 NASDAQ firms, last
year was 44 percent, I think it was.
Mr. Ciesielski. I didn't do that study.
Senator Fitzgerald. No, I think that was Bear Sterns'
analysts who did that study. It's high tech firms primarily and
a few other industries that rely so heavily on options.
Going back to Jeffrey Skilling's testimony, who brought up
the Skilling's testimony? Mr. Silvers, I'll let you comment on
this.
I remember him testifying. We were talking about how the
executives at Enron, the top 29 executives cashed out a billion
one in options in the 3 years before the company's stock
collapsed and it filed for bankruptcy, and there was a pattern
that I detected of executives cashing in their options and then
leaving the company. Remember the Army Secretary, Tom White, he
cashed out his options and left? The fellow who committed
suicide, unfortunately, Frank Baxter, he cashed out his options
and had left the company? Skilling, of course, cashed out $70
million in options in 1991, and then left the company in July
or August.
Ken Lay cashed out about $250 million in options and had
lined up a job apparently as the CEO of another company. He had
to come back as CEO at Enron because otherwise he was left
holding the bag.
The one who blew the whistle in the Enron case, came
forward, they had made a mistake. They allowed an executive
into Fastow's office who didn't have stock options. Her name
was Sharon Watkins. She wrote that famous memo, ``I ain't
getting nothing out of this. Why am I going to go along with
the deception?'' Implying that everyone else was going along
with the deception. It was a very simple Ponzi operation and
the company was borrowing money and booking it as earnings.
Almost all their transactions boiled down to that, and they
parked the borrowings on off-the-books partnerships, but they
would borrow money and book it as earnings. They had very
little in the way of legitimate operations that I could tell.
They were doing this, in my judgment, because they were
getting very rich very quickly, pumping up their share prices,
cashing in their options, and then they leave the company
before the whole house of cards collapsed.
We were talking to Skilling about the options and the fact
that they were taking tax deductions for it, that they were
just gorging themselves on stock options, and that there is no
expense being reported for that so their earnings were grossly
overstated, just by virtue of their failure to expense options.
Skilling came right back at us and said, I agree, the
accounting rules are absurd, but it's Congress that interfered
with FASB that allowed that to go on, so you should be looking
in the mirror.
Now, I wasn't in the Senate when that happened. Senator
Lieberman was leading the fight against FASB back in those
days. Believe me, we met with a lot of ordinary shareholders
who really got taken in by that whole scam. They lost all their
life savings, and all the employees who had been encouraged by
company executives to keep buying Enron stock and tucking it
into their 401(K) plan, they lost everything. A lot of people
lost everything on that. A lot of that was due to the
incentives of the excessive issuance of options, in my
judgment.
Mr. Silvers.
Mr. Silvers. Senator, let me say that in the AFL-CIO I
represented a number of those people who were the victims of
that situation, who were left with nothing but severance, and
not even that. We were very proud to do that. I think they
would have a view on some of these discussions.
There are systematic reasons why options tended the
direction you indicated. This is why in the brief formal
testimony I gave I indicated we feel that options are an
inferior form of executive compensation. It's not just that the
accounting is not correct; it's that substantively they're not
a good form of executive compensation.
The reason is--and some of the reasons are fixable, meaning
that the typical executive stock option is a three-vesting
period, historically. Some of that is changing right now. That
could be changed easily. That 3-year period makes it pretty
easy to cash out and leave. To manage the company with an eye
towards maximizing your cash out at that moment, it's a pretty
bad thing from the perspective of a pension fund that's holding
the company long term.
But there are other aspects of stock options that simply
cannot be fixed in relation to this problem, which is why we
favor restricted stock as a means of linking--long-term
restricted stock as a means of linking paid performance.
Senator Fitzgerald. Explain the difference between
restricted stock and stock options.
Mr. Silvers. Restricted stock is simply stock in the
company. It is not an option. It is only the upside. You have
the full exposure to the upside and the downside. The
restrictions around restricted stock are similar and can be
stronger than those associated with options, restrictions in
terms of when you can sell it, in terms of vesting periods and
so forth.
The critical difference here is that when an executive is
not exposed----
Senator Fitzgerald. If you have restricted stock, then you
don't just have a call on the future price.
Mr. Silvers. Precisely. You have----
Senator Fitzgerald. If the stock goes down--it's a two-way
elevator.
Mr. Silvers. A two-way elevator, exactly.
Mr. Glassman. No, it's exactly the opposite. If you're
given restricted stock--anybody can buy stock, and then there's
a downside. But the way restricted stock works is that you are
given the stock. So let's say you're given the stock at $20,
you pay zero, usually, and now it goes down to $15, now you've
got $15, which you never had before. That's the difference.
In fact, if the stock price goes down and you've got an
option, you've got zero.
Senator Fitzgerald. So it's really no better than options,
except that it does have to be expensed.
Mr. Glassman. It's not better. It's not worse. It's a
choice. With options, basically you're getting more leverage.
In other words, if it goes up, you make a lot more. If it goes
down, you make nothing.
Senator Fitzgerald. OK. What's the public policy rationale
for requiring issuance of restricted stock to be expensed but
not the issuance of stock options?
Mr. Heesen. In our view, it's pay for--in restricted stock,
it doesn't matter. You get it today at $20, you've got $20, and
if it goes down to $10, you still have $10. If you work a
little hard, it might get up to $30. But if you have an option,
you have nothing until----
Senator Fitzgerald. But we require the issuance of
restricted stock to be expensed because we recognize we're
taking away something from the company.
Mr. Heesen. You are taking from the company at that point,
exactly. That's a very different thing than an option.
Senator Fitzgerald. You don't think they're taking anything
from the shareholders?
Mr. Heesen. Dilution, absolutely. And we talk about that,
and that's why when we look at this, we look at shareholder
dilution as being the main key here.
Mr. Silvers. Senator, these gentleman are simply wrong. Let
me explain why, if they will allow me to do so without being
interrupted.
Senator Fitzgerald. OK. You go ahead.
Mr. Silvers. As a shareholder, you care a great deal if
your company is in trouble, whether at the end of the day the
value of your stock--for example, say you bought it at $40. If
the company is in trouble, you care a great deal about whether
or not at the end of the day the stock price is $10, $20 or
$30. It makes a big difference.
If you hold an option and the exercise price is at $40, and
the company gets in trouble, you don't care. It's true that
options involve a lot of leverage, and perhaps leverage is a
good thing. That's a public policy decision that I disagree
with. But what they're wrong about is that options are a better
of way of aligning the interests of executives with the
interests of shareholders in a stressed situation, which is
what Enron was. The reason why options encourage people to
cheat and lie in distressed situations is because financially,
if they can somehow get the stock price over the exercise
price, they win. And it doesn't matter to them if the true
value of the company----
You see, if the true value of the company is, say, 30, and
it's trading--they know it's 30 and they're insiders--and it's
trading at 40, they have got to figure out some way to get that
thing over 40 long enough to exercise. If they do that, they
win.
Senator Fitzgerald. And then they dump the stock.
Mr. Silvers. Yes. But even if the strategy they have for
getting it over 40 is so risky, that it's actually money
losing--for instance, cheating, that's very risky. If you're
caught cheating, things tend to collapse completely and all the
value drains out of the firm.
WorldCom, for example, is a classic instance of this. There
was real value in WorldCom. They cheated and they blew it up.
This is why stock options are so dangerous to our corporate
governance system as opposed to restricted stock.
I would like to also add another point here, which is
again----
Senator Fitzgerald. And you favor the FASB rules that
impose discipline on their issuance. You don't favor doing away
with the stock options?
Mr. Silvers. What we favor is the replacement--I think
there are unique issues involved in private companies, in their
transition issues, and I think those are complex and the FASB
process ought to deal with them.
In terms of public companies, we favor restricted stock
over options. We don't favor banning options as a statutory
matter. We believe that if they are properly accounted for,
that the corporate governance process will act to reduce their
use and substitute restricted stock for them. In fact, that is
what is going on right now.
Senator I would also add, if you will allow me, that a
great deal has been made in this debate of two points by the
opponents of stock options expensing. One point is the notion
that the information is already there and so it's not
necessary. The other point is the notion that, if it's
expensed, somehow managerial practices in relation to options
will change radically, particularly with respect to broad-based
options at companies that are cash limited.
You can't hold those two positions simultaneously. Either
one or the other has to be true. Both cannot be. If you believe
that the one that's true is that there will be radical
managerial behavior changes as a result of option expensing,
what you're actually saying is that the current accounting
rules, and what some would urge the public policy and law of
the United States should be, is that we will, by hiding the
true cost of stock options, subsidize that form of employee
compensation. And some arguments have been put forward for why
we should subsidize them.
I would suggest that if we're subsidizing employee
compensation, we might not want to focus on a form of
compensation 70 percent of which is going to the top five
officers, and that perhaps we might want to look at things like
the 40 million Americans who have no health care if we were in
the business of subsidizing one form of employee compensation
over another.
Senator Fitzgerald. Mr. Heesen, do you personally own any
stock options in any companies?
Mr. Heesen. No.
Senator Fitzgerald. Mr. Glassman.
Mr. Glassman. I have to say that I made a very lucrative
deal with my partner, the former Chairman of the SEC, Arthur
Levitt, when we were partners in Roll Call, which is a
congressional newspaper. It is not a publicly traded company,
but my incentive was, indeed, options. I had options to buy
shares of the company, which originally Arthur owned most of,
and I did so, and we eventually sold the company.
I can tell you that the spur of options was quite
substantial to me. I think it was very important. I certainly
can sympathize with people, with the 14 million Americans who
own stock options. I think it's a good thing.
By the way, I just want to be clear, Mr. Silvers, I am not
wrong. The reason that I intervened was because you were saying
something that was incorrect about restricted stock. In fact,
if you get restricted stock and the price goes down, you lose
whatever the price decline was, but if you get options and the
price goes down, you get nothing. That's the whole point.
I absolutely did not say--and I'm not sure whether Mr.
Heesen did--I absolutely did not say that I prefer one over the
other. Quite the contrary. I think that those are decisions
that need to be made by businesses themselves, their boards of
directors and their shareholders: What is the best way to
compensate employees. Sometimes it's restricted stock;
sometimes, as in the case of Warren Buffett, whose stock I
own----
Senator Fitzgerald. But you favor accounting rules that
would prefer stock options to any other form of compensation?
Mr. Glassman. I think that's another--I think that's a
different issue.
Senator Fitzgerald. You don't think the accounting rules
should be neutral, though. You believe that all employee
compensation should be expensed, except stock options, correct?
Mr. Glassman. I think that the current regime, which
handles the very thorny issue of how to value stock options, by
providing investors with the kind of information I just showed
from the Intel statement and for just about any other statement
you want to look at, is the best way to do it. That is my
belief right now, and that we don't need this change.
Senator Fitzgerald. Mr. Delves, very quickly, and then I
will have to adjourn the hearing. I absolutely have to leave.
Mr. Delves. Thank you very much.
My point is that it is not this simple. This is what I do
for a living, as I design incentives. Stock options work. They
make people take more risks than they ordinarily would. If you
grant too many of them, they take too many risks.
Senator Fitzgerald. Performance stock options are better,
though, right?
Mr. Delves. Anything tied to performance is better,
including restricted stock.
Senator Fitzgerald. But we require performance stock
options to be expensed, but not ones that are not tied to
performance?
Mr. Delves. That's correct.
Senator Fitzgerald. So sometimes the stock options that
maybe come into money just because the economy is good and the
market is going up, it's like rewarding the weatherman because
the weather turns out well.
Mr. Delves. If we don't have an expense, we can't make the
tradeoffs between one type of incentive versus another and come
up with the best one.
Senator Fitzgerald. Thank you. All of you have been
wonderful witnesses. You have been great, and I wish we could
have had another hour, but we do not.
The record will remain open until the close of business
next Tuesday, April 27, for any additional statements or
questions.
If there is no further business to come before the
Subcommittee, this hearing is now adjourned. Thank you all very
much.
[Whereupon, at 6:25 p.m., the Subcommittee adjourned.]
A P P E N D I X
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