[Senate Hearing 110-141]
[From the U.S. Government Publishing Office]


                                                        S. Hrg. 110-141
 
                  EXECUTIVE STOCK OPTIONS: SHOULD THE 
               INTERNAL REVENUE SERVICE AND STOCKHOLDERS 
                    BE GIVEN DIFFERENT INFORMATION? 
=======================================================================
                                HEARING

                               before the

                PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                                 of the

                              COMMITTEE ON
               HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
                          UNITED STATES SENATE

                       ONE HUNDRED TENTH CONGRESS

                             FIRST SESSION

                               __________

                              JUNE 5, 2007

                               __________

        Available via http://www.access.gpo.gov/congress/senate

                       Printed for the use of the
        Committee on Homeland Security and Governmental Affairs

                     U.S. GOVERNMENT PRINTING OFFICE

36-611 PDF                 WASHINGTON DC:  2007
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            COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS

               JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan                 SUSAN M. COLLINS, Maine
DANIEL K. AKAKA, Hawaii              TED STEVENS, Alaska
THOMAS R. CARPER, Delaware           GEORGE V. VOINOVICH, Ohio
MARK PRYOR, Arkansas                 NORM COLEMAN, Minnesota
MARY L. LANDRIEU, Louisiana          TOM COBURN, Oklahoma
BARACK OBAMA, Illinois               PETE V. DOMENICI, New Mexico
CLAIRE MCCASKILL, Missouri           JOHN W. WARNER, Virginia
JON TESTER, Montana                  JOHN E.SUNUNU, New Hampshire

                  Michael L. Alexander, Staff Director
     Brandon L. Milhorn, Minority Staff Director and Chief Counsel
                  Trina Driessnack Tyrer, Chief Clerk


                PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                     CARL LEVIN, Michigan, Chairman
THOMAS R. CARPER, Delaware           NORM COLEMAN, Minnesota
MARK L. PRYOR, Arkansas              TOM COBURN, Oklahoma
BARACK OBAMA, Illinois               PETE V. DOMENICI, New Mexico
CLAIRE McCASKILL, Missouri           JOHN W. WARNER, Virginia
JON TESTER, Montana                  JOHN E. SUNUNU, New Hampshire

            Elise J. Bean, Staff Director and Chief Counsel
                     John C. McDougal, IRS Detailee
  Mark L. Greenblatt, Staff Director and Chief Counsel to the Minority
          Mark D. Nelson, Deputy Chief Counsel to the Minority
                        Guy Ficco, IRS Detailee
                        Ruth Perez, IRS Detailee
                     Mary D. Robertson, Chief Clerk



















                            C O N T E N T S

                                 ------                                
Opening statements:
                                                                   Page
    Senator Levin................................................     1
    Senator Coleman..............................................     9

                               WITNESSES
                         Tuesday, June 5, 2007

Stephen F. Bollenbach, Chairman, Board of Directors, KB Home, Los 
  Angeles, California............................................    16
John S. Chalsty, Chairman, Executive Compensation and Human 
  Resource Committee, Occidental Petroleum Corporation, Los 
  Angeles, California............................................    17
William Y. Tauscher, Member and Former Chairman, Compensation 
  Committee, Safeway, Inc., Pleasanton, California...............    19
Kevin M. Brown, Acting Commissioner, Internal Revenue Service....    30
John W. White, Director, Division of Corporation Finance, 
  Securities and Exchange Commission.............................    31
Lynn E. Turner, Former Securities and Exchange Commission Chief 
  Accountant, Broomfield, Colorado...............................    39
Mihir A. Desai, Arthur M. Rock Center for Entrepreneurship 
  Associate Professor, Harvard University, Graduate School of 
  Business Administration, Boston, Massachusetts.................    42
Jeffrey P. Mahoney, General Counsel, Council of Institutional 
  Investors, Washington, DC......................................    44

                     Alphabetical List of Witnesses

Bollenbach, Stephen F.:
    Testimony....................................................    16
    Prepared statement...........................................    55
Brown, Kevin M.:
    Testimony....................................................    30
    Prepared statement...........................................    72
Chalsty, John S.:
    Testimony....................................................    17
    Prepared statement...........................................    60
Desai, Mihir A.:
    Testimony....................................................    42
    Prepared statement with attachments..........................    95
Mahoney, Jeffrey P.:
    Testimony....................................................    44
    Prepared statement with attachments..........................   124
Tauscher, William Y.:
    Testimony....................................................    19
    Prepared statement...........................................    63
Turner, Lynn E.:
    Testimony....................................................    39
    Prepared statement...........................................    90
White John W.:
    Testimony....................................................    31
    Prepared statement...........................................    79

                                EXHIBITS

 1. GExexutive Stock Option Compensation--Book versus Tax Return 
  Diffential For Exercised Stock Options, chart prepared by the 
  Permanent Subcommittee on Investigatons Staff..................   236
 2. GExexutive Stock Option Compensation--Book versus Tax Return 
  Diffential For Exercised Stock Options, (detailed version), 
  chart prepared by the Permanent Subcommittee on Investigatons 
  Staff..........................................................   237
 3. GKB Home Exexutive Stock Option Compensation--Book versus Tax 
  Return Diffential, chart prepared by the Permanent Subcommittee 
  on Investigatons Staff.........................................   238
 4. GOccidental Petroleum Exexutive Stock Option Compensation--
  Book versus Tax Return Diffential, chart prepared by the 
  Permanent Subcommittee on Investigatons Staff..................   239
 5. GCisco Systems Exexutive Stock Option Compensation--Book 
  versus Tax Return Diffential, chart prepared by the Permanent 
  Subcommittee on Investigatons Staff............................   240
 6. GUnitedHealth Group Exexutive Stock Option Compensation--Book 
  versus Tax Return Diffential, chart prepared by the Permanent 
  Subcommittee on Investigatons Staff............................   241
 7. GSafeway Exexutive Stock Option Compensation--Book versus Tax 
  Return Diffential, chart prepared by the Permanent Subcommittee 
  on Investigatons Staff.........................................   242
 8. GMonster Exexutive Stock Option Compensation--Book versus Tax 
  Return Diffential, chart prepared by the Permanent Subcommittee 
  on Investigatons Staff.........................................   243
 9. GMercury Interactive Exexutive Stock Option Compensation--
  Book versus Tax Return Diffential, chart prepared by the 
  Permanent Subcommittee on Investigatons Staff..................   244
10. GComverse Exexutive Stock Option Compensation--Book versus 
  Tax Return Diffential, chart prepared by the Permanent 
  Subcommittee on Investigatons Staff............................   245
11. GApple Exexutive Stock Option Compensation--Book versus Tax 
  Return Diffential, chart prepared by the Permanent Subcommittee 
  on Investigatons Staff.........................................   246
12. GNote To Charts Prepared By the Permanent Subcommittee On 
  Investigations Staff...........................................   247
13. GResponses to questions for the record submitted to Kevein M. 
  Brown, Acting Commissioner, Internal Revenue Service...........   248
14. GResponses to questions for the record submitted to Stephen 
  F. Bollenbach, Chairman of the Board of Directors, KB Home.....   250


                  EXECUTIVE STOCK OPTIONS: SHOULD THE
                      INTERNAL REVENUE SERVICE AND
                    STOCKHOLDERS BE GIVEN DIFFERENT
                              INFORMATION?

                              ----------                              


                         TUESDAY, JUNE 5, 2007

                                     U.S. Senate,  
              Permanent Subcommittee on Investigations,    
                    of the Committee on Homeland Security  
                                  and Governmental Affairs,
                                                    Washington, DC.
    The Subcommittee met, pursuant to notice, at 9:02 a.m., in 
room SD-342, Dirksen Senate Office Building, Hon. Carl Levin, 
Chairman of the Subcommittee, presiding.
    Present: Senators Levin and Coleman.
    Staff Present: Elise J. Bean, Staff Director and Chief 
Counsel; Mary D. Robertson, Chief Clerk; John McDougal, 
Detailee, IRS; Guy Ficco, Detailee, IRS; Ross Kirschner, 
Counsel; Genevieve Citrin, Intern; Mark L. Greenblatt, Staff 
Director and Chief Counsel to the Minority; Mark D. Nelson, 
Deputy Chief Counsel to the Minority; Timothy R. Terry, Counsel 
to the Minority; Emily T. Germain, Staff Assistant to the 
Minority; Ruth Perez, Detailee, IRS; Kunaal Sharma, Intern; 
Adam Healey (Senator Tester); and Chris Pendergast (Senator 
Carper).

               OPENING STATEMENT OF SENATOR LEVIN

    Senator Levin. Good morning, everybody. The Subcommittee 
will come to order, and what we would like to do is begin with 
a moment of silence in tribute to our friend and our colleague, 
Craig Thomas of Wyoming, who passed away yesterday after a 
courageous battle with leukemia. And I would ask everybody to 
stand for a moment in silence.
    [Moment of silence.]
    Senator Levin. Thank you.
    The subject of today's hearing is executive stock options. 
Stock options give employees the right to buy company stock at 
a set price for a specified period of time, typically 10 years. 
Stock options are a key component of executive pay.
    According to Forbes magazine, in 2006, the average pay of 
the chief executive officers (CEOs), of 500 of the largest U.S. 
companies was $15.2 million. Nearly half of that amount--$7.3 
million--came from exercised stock options. On the high end, 
one CEO cashed in stock options for $290 million, another for 
$270 million. Forbes also published a list of 30 CEOs in 2006, 
who each had at least $100 million in vested stock options that 
had yet to be exercised.
    J.P. Morgan once said that CEO pay should not exceed 20 
times average worker pay. In the United States, in 1990, 
average CEO pay was 100 times average worker pay; in 2004, the 
figure was 300 times; today, it is nearly 400 times. Stock 
option grants to executives are a big part of the modern chasm 
between executive pay and the pay of average workers.
    Stock options have been portrayed as a way to align 
corporate executives' interests with those of stockholders 
because they produce income for an executive only if the 
company's stock price rises. But stock options have also been 
associated with a litany of abuses ranging from dishonest 
accounting to tax dodging--from Enron, to the backdating 
scandal to the Wyly brothers in Texas, who, as our hearing 
showed last summer, tried to dodge U.S. taxes by sending $190 
million in stock options to offshore shell companies that they 
secretly controlled.
    Today's hearing is looking at a stock option issue that 
does not involve allegations of wrongdoing. Rather, today's 
hearing focuses on a set of mismatched accounting and tax rules 
that are legal. These rules require companies to report one set 
of stock option compensation figures to investors and the 
public on their books, and a completely different set of 
figures to the Internal Revenue Service (IRS) on their tax 
returns. In most cases, the resulting tax deduction has far 
exceeded the expense shown on the company books.
    When a company's compensation committee learns that stock 
options often produce a low compensation cost on the books 
while generating a whopping tax deduction frequently, it is a 
pretty tempting proposition for them to provide their 
executives with large amounts of stock options. The problem is 
that the mismatch in stock option accounting and tax rules also 
shortchanges the Treasury to the tune of billions of dollars 
each year while fueling the huge gap between executive pay and 
average worker pay.
    Calculating the cost of stock options may sound 
straightforward, but for years companies and their accountants 
engaged the Financial Accounting Standards Board (FASB), in an 
all-out, knock-down battle over how companies should record 
stock option compensation expenses on their books. In the end, 
FASB issued a new accounting rule, Financial Accounting 
Standard (FAS) 123R, which was endorsed by the SEC and became 
mandatory for all publicly traded corporations in June 2005. In 
essence, that rule requires all companies to record a 
compensation expense equal to the fair value on grant date of 
stock options provided to employees in exchange for their 
services.
    Opponents of the new accounting rule predicted that it 
would severely damage U.S. capital markets. They warned that 
stock option expensing would eliminate profits, discourage 
investment, depress stock prices, and stifle innovation. Last 
year, 2006, was the first year in which all U.S. publicly 
traded companies were required to expense stock options. 
Instead of tumbling, both the New York Stock Exchange and 
NASDAQ turned in strong performances, as did initial public 
offerings by new companies. The dire predictions were wrong.
    In contrast to the battle raging over stock option 
accounting, relatively little attention was paid to the 
taxation of stock options. Section 83 of the Tax Code, first 
enacted in 1969, is the key statutory provision. It essentially 
provides that when an employee exercises stock options, the 
employee must report as income the difference between what the 
employee paid to exercise the options and the market price of 
the stock received. The corporation can then take a mirror 
deduction in the same amount as a compensation expense.
    For example, suppose an executive had options to buy one 
million shares of company stock at $10 per share. Suppose 5 
years later the executive exercised the options when the stock 
was selling at $30 per share. The executive's income would be 
$20 per share, for a total of $20 million. The executive would 
declare $20 million as ordinary income, and in the same year 
the company would take a corresponding tax deduction of $20 
million.
    Although in 1993, Congress enacted a $1 million cap on the 
compensation that a corporation can deduct from its taxes so 
taxpayers would not be forced to subsidize millions of dollars 
in executive pay, an exception was made for stock options, 
allowing companies to deduct any amount of stock option 
compensation without limit.
    The stock option accounting and tax rules now in place are 
at odds with each other. Accounting rules require companies to 
expense stock options on the grant date. Tax rules require 
companies to deduct stock option expenses on the exercise date. 
Companies have to report the grant date expenses to investors 
on their financial statements and exercise date expenses on 
their tax returns. The financial statements report on all stock 
options granted during the year, while the tax returns report 
on all stock options exercised during the year. In short, 
company financial statements and tax returns report expenses 
for different groups of stock options using different valuation 
methods, resulting in divergent stock option expenses for the 
same year.
    Now, to test just how far these figures diverge, the 
Subcommittee contacted a number of companies to compare the 
stock option expenses that they reported for accounting and for 
tax purposes. The Subcommittee asked each company to identify 
stock options that had been exercised by one or more of its 
executives from 2002 to 2006. The Subcommittee then asked each 
company to identify the compensation expense that they reported 
on their financial statements versus the compensation expense 
on their tax return. In addition, we asked the companies' help 
in estimating what effect the new accounting rule would have 
had on their book expense if it had been in place when their 
stock options were granted. And we very much appreciate the 
cooperation and the assistance which has been provided by the 
nine companies whose data is being disclosed today, 
particularly including the companies that were asked to 
testify. We are grateful to all of them for their cooperation 
and for their information, and we are particularly, again, 
grateful to the three companies who are before us today to 
provide us with that information.
    The data showed that under then existing accounting rules, 
the nine companies generally showed stock options as a zero 
expense on their books. The one exception was Occidental 
Petroleum, which in 2005, began voluntarily expensing its 
options and recorded an expense for a few options. When the 
Subcommittee asked the companies what their book expense would 
have been if the new FASB rule had been in effect, all nine 
calculated a book expense that remained dramatically lower than 
their tax deductions.
    The chart which I am putting now before us, Exhibit 1,\1\ 
shows the book-tax differences, using the book expense 
calculated under the new FASB rule. It shows that the nine 
companies alone produced $1 billion more in tax deductions than 
the expense shown on their books, even using the tougher new 
accounting rule. There tax deductions far exceeded their book 
expenses, not because the companies were doing anything wrong, 
but because the current stock option accounting and tax rules 
are so out of whack.
---------------------------------------------------------------------------
    \1\ See Exhibit 1 which appears in the Appendix on page 236.
---------------------------------------------------------------------------
    KB Home, for example, is a company that builds residential 
homes. Its stock price has more than quadrupled over the last 
10 years. Over the same period, it repeatedly granted stock 
options to its then-CEO. Company records show that over the 
past 5 years, KB Home gave him 5.5 million stock options, of 
which he exercised more than 3 million.
    With respect to those 3 million stock options, KB Home 
recorded a zero expense on its books. Now, had FASB's new rule 
been in effect, KB Home calculated that it would have reported 
on its books a compensation expense of about $11.5 million. KB 
Home also disclosed that the same 3 million stock options 
enabled it to claim compensation expenses on its tax returns 
totaling about $143.7 million. In other words, KB Home claimed 
a $143 million tax deduction for expenses that on its books 
under current accounting rules, the new accounting rules, would 
have totaled $11.5 million. That is a tax deduction 12 times 
bigger than the book expense.
    Occidental Petroleum, the next company on the chart, 
disclosed a similar book-tax discrepancy. This company's stock 
price has also skyrocketed in recent years, dramatically 
increasing the value of the 16 million stock options granted to 
its CEO since 1993. Of the 12 million stock options the CEO 
actually exercised over the past 5 years, Occidental Petroleum 
claimed a $353 million tax deduction for a book expense that 
under current accounting rules would have totaled just $29 
million. That is a book-tax difference of more than 1,200 
percent.
    Similar book-tax discrepancies apply to the other companies 
that we contacted. Cisco Systems' CEO exercised nearly 19 
million stock options over the past 5 years and provided the 
company with a $169 million tax deduction for a book expense 
which under current accounting rules would have totaled about 
$21 million.
    UnitedHealth's former CEO exercised over 9 million stock 
options in 5 years, providing the company with a $318 million 
tax deduction for a book expense which would have totaled about 
$46 million.
    Safeway's CEO exercised over 2 million stock options, 
providing the company with a $39 million tax deduction for a 
book expense which would have totaled about $6.5 million.
    Altogether these nine companies took stock option tax 
deductions totaling $1.2 billion--a figure five times larger 
than their combined stock option book expenses of $217 million. 
The resulting $1 billion book-tax difference represents a huge 
tax deduction windfall for the companies simply because they 
issued lots of stock options to their CEOs. Tax rules that 
produce outsized tax deductions that are many times larger than 
the related stock option book expenses give companies an 
incentive to issue huge stock option grants because they know 
that the stock options can produce a relatively small hit to 
profits and probably a much larger tax deduction that can 
dramatically lower their taxes.
    To gauge just how big the tax gap is for stock options, the 
Subcommittee asked the IRS to perform an analysis of its 
overall data on stock option book-tax differences. The new 
Schedule M-3, which went into effect last year for large 
corporations, asked companies to identify differences in how 
they report corporate income to investors versus what they 
report to Uncle Sam. The resulting M-3 data applies mostly to 
2004 tax returns.
    The IRS found that corporations took tax deductions on 
their tax returns for stock option compensation expenses which 
were $43 billion greater than the stock option expenses shown 
on their financial statements for the same year. Those massive 
tax deductions enabled corporations as a whole to legally 
reduce their taxes by billions of dollars, perhaps by as much 
as $15 billion.
    When asked to look deeper into who benefited from the stock 
option deductions, the IRS was able to determine that the 
entire $43 billion book-tax difference was attributable to 
about 3,200 corporations nationwide, of which about 250 
companies accounted for 82 percent of the total difference. In 
other words, a relatively small number of corporations were 
able to generate a $43 billion tax deduction by handing out 
substantial stock options to their executives.
    The current differences between stock option accounting and 
tax rules make no sense. They require companies to show one 
stock option expense on their books and a completely different 
expense on their tax returns. They allow companies to take tax 
deductions that overall are many times larger than the stock 
option expenses shown on their books, which not only 
shortchanges the Treasury but also provides an accounting and 
tax windfall to companies giving out huge stock options and 
creates an incentive for companies to keep right on giving out 
those options.
    The book-tax difference is fueling an ever deepening chasm 
between executive pay and the pay of average workers. The stock 
option book difference is a historical product of accounting 
and tax policies that have not been coordinated or integrated. 
Right now stock options are the only compensation expense where 
companies are allowed to deduct much more on their tax returns 
than the expense shown on their books. And I emphasize that is 
the only compensation expense where that is allowed.
    In 2004, companies used the book-tax difference to claim 
$43 billion more in stock option deductions than the expenses 
shown on their books. We need to examine whether we can afford 
this multi-billion-dollar loss to the Treasury, not only in 
light of the deep Federal deficits but also in light of the 
evidence that this stock option book-tax difference is 
contributing to the gap, the growing gap, between the pay of 
executives and the pay of average workers.
    In past years, I have introduced legislation to require 
stock option deductions to match the stock option expenses 
shown on company books. I hope our witnesses today will 
indicate whether they agree that Federal tax policy should be 
brought into line with accounting policy and provide that 
corporations deduct on their tax returns only the amount of 
stock option expenses that is shown on their books.
    [The prepared statement of Senator Levin follows:]
                  PREPARED STATEMENT OF SENATOR LEVIN
    The subject of today's hearing is executive stock options. Stock 
options give employees the right to buy company stock at a set price 
for a specified period of time, typically 10 years. Stock options are a 
key contributor to executive pay.
    According to Forbes magazine, in 2006, the average pay of the chief 
executive officers (CEOs) of 500 of the largest U.S. companies was 
$15.2 million. Nearly half of that amount, 48 percent, came from 
exercised stock options that produced average gains of about $7.3 
million. On the high end, one CEO cashed in stock options for $290 
million, another for $270 million. Forbes also published a list of 30 
CEOs in 2006, who each had at least $100 million in vested stock 
options that had yet to be exercised. J.P. Morgan once said that CEO 
pay should not exceed 20 times average worker pay. In the United 
States, in 1990, average CEO pay was 100 times average worker pay; in 
2004, the figure was 300 times; today, it is nearly 400 times.
    Stock options have been portrayed as a way to align corporate 
executives' interests with those of stockholders, because they produce 
income for an executive only if the company stock price rises. But 
stock options have also been associated with a litany of abuses ranging 
from dishonest accounting to tax dodging--from Enron, to the backdating 
scandal, to the Wyly brothers in Texas who, as our hearing showed last 
summer, tried to dodge U.S. taxes by sending $190 million in stock 
options to offshore shell companies they secretly controlled.
    Today's hearing is looking at a stock option issue that does not 
involve allegations of wrongdoing. Rather, today's hearing focuses on a 
set of mismatched accounting and tax rules that are legal. These rules 
require companies to report one set of stock option compensation 
figures to investors and the public on their books, and a completely 
different set of figures to the Internal Revenue Service (IRS) on their 
tax returns. In most cases, the resulting tax deduction has far 
exceeded the expense shown on the company books.
    When a company's compensation committee learns that stock options 
often produce a low compensation cost on the books, while generating a 
whopping tax deduction, it's a pretty tempting proposition for them to 
pay their executives with stock options instead of cash or stock. The 
problem is that the mismatch in stock option accounting and tax rules 
also shortchanges the Treasury to the tune of billions of dollars each 
year, while fueling the growing chasm between executive pay and average 
worker pay.
    Accounting Battle. Calculating the cost of stock options may sound 
straightforward, but for years, companies and their accountants engaged 
the Financial Accounting Standards Board in an all-out, knock-down 
battle over how companies should record stock option compensation 
expenses on their books.
    U.S. publicly traded corporations are required by law to follow 
Generally Accepted Accounting Principles (GAAP), issued by the 
Financial Accounting Standards Board (FASB), which is overseen by the 
Securities and Exchange Commission (SEC). For many years, GAAP allowed 
U.S. companies to issue stock options to employees and, unlike any 
other type of compensation, report a zero compensation expense on their 
books, so long as, on the grant date, the stock option's exercise price 
equaled the market price at which the stock could be sold.
    Assigning a zero value to stock options that routinely produced 
millions of dollars in executive pay provoked deep disagreements within 
the accounting community. In 1993, FASB proposed assigning a ``fair 
value'' to stock options on the date they are granted to an employee, 
using a mathematical valuation tool such as the Black Scholes model, 
and then including a grant date expense on companies' financial 
statements. Critics responded that it was impossible accurately to 
estimate the value of executive stock options on their grant date. A 
bruising battle over stock option expensing followed, involving the 
accounting profession, corporate executives, FASB, the SEC, and 
Congress.
    In the end, FASB issued a new accounting standard, Financial 
Accounting Standard (FAS) 123R, which was endorsed by the SEC and 
became mandatory for all publicly traded corporations in June 2005. In 
essence, FAS 123R requires all companies to record a compensation 
expense equal to the fair value on grant date of stock options provided 
to employees in exchange for their services.
    The details of this accounting rule are complex, because they 
reflect an effort to accommodate varying viewpoints on the true cost of 
stock options. Companies are allowed to use a variety of mathematical 
models, for example, to calculate a stock option's fair value. Option 
grants that vest over time are expensed over the specified period so 
that, for example, a stock option which vests over four years results 
in 25% of the cost being expensed each year. If a stock option grant 
never vests, the rule allows any previously booked expense to be 
recovered. On the other hand, stock options that do vest must be fully 
expensed, even if never exercised, because the compensation was 
actually awarded. These and other provisions of this hard-fought 
accounting rule reflect painstaking judgements on how to show a stock 
option's true cost.
    Opponents of the new accounting rule predicted that it would 
severely damage U.S. capital markets. They warned that stock option 
expensing would eliminate profits, discourage investment, depress stock 
prices, and stifle innovation. Last year, 2006, was the first year in 
which all U.S. publicly traded companies were required to expense stock 
options. Instead of tumbling, both the New York Stock Exchange and 
Nasdaq turned in strong performances, as did initial public offerings 
by new companies. The dire predictions were wrong.
    Tax Treatment. In contrast to the battle raging over stock option 
accounting, relatively little attention was paid to the taxation of 
stock options. Section 83 of the tax code, first enacted in 1969, is 
the key statutory provision. It essentially provides that, when an 
employee exercises stock options, the employee must report as income 
the difference between what the employee paid to exercise the options 
and the market value of the stock received. The corporation can then 
take a mirror deduction for the same amount of income.
    For example, suppose an executive had options to buy 1 million 
shares of company stock at $10 per share. Suppose, five years later, 
the executive exercised the options when the stock was selling at $30 
per share. The executive's income would be $20 per share for a total of 
$20 million. The executive would declare $20 million as ordinary 
income, and in the same year, the company would take a corresponding 
tax deduction for $20 million. Although in 1993, Congress enacted a $1 
million cap on the compensation that a corporation can deduct from its 
taxes, so taxpayers wouldn't be forced to subsidize millions of dollars 
in executive pay, an exception was made for stock options, allowing 
companies to deduct any amount of stock option compensation, without 
limit.
    Book-Tax Differences. The stock option accounting and tax rules now 
in place are at odds with each other. Accounting rules require 
companies to expense stock options on the grant date. Tax rules require 
companies to deduct stock option expenses on the exercise date. 
Companies have to report grant date expenses to investors on their 
financial statements, and exercise date expenses on their tax returns. 
The financial statements report on all stock options granted during the 
year, while the tax returns report on all stock options exercised 
during the year. In short, company financial statements and tax returns 
report expenses for different groups of stock options, using 
dramatically different valuation methods, resulting in widely divergent 
stock option expenses for the same year.
    Company Data. To test just how far these figures diverge, the 
Subcommittee contacted a number of companies to compare the stock 
option expenses they reported for accounting and tax purposes. The 
Subcommittee asked each company to identify stock options that had been 
exercised by one or more of its executives from 2002 to 2006. The 
Subcommittee then asked each company to identify the compensation 
expense they reported on their financial statements versus the 
compensation expense on their tax returns. In addition, we asked the 
companies' help in estimating what effect the new accounting rule would 
have had on their book expense if it had been in place when their stock 
options were granted. We very much appreciate the cooperation and 
assistance provided by the nine companies whose data is being disclosed 
today, including the three companies that were asked to testify.
    The data showed that, under then existing accounting rules, the 
nine companies generally showed stock options as a zero expense on 
their books. The one exception was Occidental Petroleum which, in 2005, 
began voluntarily expensing its options and recorded an expense for a 
few options. When the Subcommittee asked the companies what their book 
expense would have been if the new FASB rule had been in effect, all 
nine calculated a book expense that remained dramatically lower than 
their tax deductions.
    This chart, which is Exhibit 1, shows the book-tax differences, 
using the book expense calculated under the new FASB rule. It shows 
that the nine companies alone produced $1 billion more in tax 
deductions than the expense shown on their books, even using the 
tougher new accounting rule. Their tax deductions far exceeded their 
book expenses, not because the companies were doing anything wrong, but 
because the current stock option accounting and tax rules are so out of 
whack.
    KB Home, for example, is a company that builds residential homes. 
Its stock price has more than quadrupled over the past 10 years. Over 
the same time period, it repeatedly granted stock options to its then 
CEO. Company records show that, over the past five years, KB Home gave 
him 5.5 million stock options of which he exercised more than 3 
million.
    With respect to those 3 million stock options, KB Home recorded a 
zero expense on its books. Had FAS 123R been in effect, KB Home 
calculated that it would have reported on its books a compensation 
expense of about $11.5 million. KB Home also disclosed that the same 3 
million stock options enabled it to claim compensation expenses on its 
tax returns totaling about $143.7 million. In other words, KB Home 
claimed a $143 million tax deduction for expenses that on its books, 
under current accounting rules, would have totaled $11.5 million. 
That's a tax deduction 12 times bigger than the book expense.
    Occidental Petroleum, the next company on the chart, disclosed a 
similar book-tax discrepancy. This company's stock price has also 
skyrocketed in recent years, dramatically increasing the value of the 
16 million stock options granted to its CEO since 1993. Of the 12 
million stock options the CEO actually exercised over the past five 
years, Occidental Petroleum claimed a $353 million tax deduction for a 
book expense that, under current accounting rules, would have totaled 
just $29 million. That's a book-tax difference of more than 1200%.
    Similar book-tax discrepancies apply to the other companies we 
contacted. Cisco System's CEO exercised nearly 19 million stock options 
over the past five years, and provided the company with a $169 million 
tax deduction for a book expense which, under current accounting rules, 
would have totaled about $21 million. UnitedHealth's former CEO 
exercised over 9 million stock options in five years, providing the 
company with a $318 million tax deduction for a book expense which 
would have totaled about $46 million. Safeway's CEO exercised over 2 
million stock options, providing the company with a $39 million tax 
deduction for a book expense which would have totaled about $6.5 
million.
    Altogether, these nine companies took stock option tax deductions 
totaling $1.2 billion, a figure five times larger than their combined 
stock option book expenses of $217 million. The resulting billion-
dollar book-tax difference represents a huge tax deduction windfall for 
the companies simply because they issued lots of stock options to their 
CEOs. Tax rules that produce outsized tax deductions that are many 
times larger than the related stock option book expenses give companies 
an incentive to issue huge stock option grants, because they know the 
stock options will produce a relatively small hit to profits and a much 
larger tax deduction that can dramatically lower their taxes.
    To gauge just how big the tax gap is for stock options, the 
Subcommittee asked the IRS to perform an analysis of its overall data 
on stock option book-tax differences. The new M-3 Schedule, which went 
into effect last year for large corporations, asked companies to 
identify differences in how they report corporate income to investors 
versus what they report to Uncle Sam. The resulting M-3 data applies 
mostly to 2004 tax returns.
    The IRS found that stock option compensation expenses were one of 
the biggest factors in the difference between book and tax income 
reported by U.S. corporations. The data shows that, in 2004, stock 
option compensation expenses produced a book-tax gap of about $43 
billion, which is about 30% of the entire book-tax difference reported 
for the period. That means, as a whole, corporations took deductions on 
their tax returns for stock option compensation expenses which were $43 
billion greater than the stock option expenses shown on their financial 
statements for the same year. Those massive tax deductions enabled the 
corporations, as a whole, to legally reduce their taxes by billions of 
dollars, perhaps by as much as $15 billion.
    When asked to look deeper into who benefitted from the stock option 
deductions, the IRS was able to determine that the entire $43 billion 
book-tax difference was attributable to about 3,200 corporations 
nationwide, of which about 250 corporations accounted for 82% of the 
total difference. In other words, a relatively small number of 
corporations was able to generate a $43 billion tax deduction by 
handing out substantial stock options to their executives.
    There are other surprises in the data as well. One set of issues 
involves unexercised stock options which, under the new accounting 
rule, will produce an expense on the books but no tax deduction. Cisco 
told the Subcommittee, for example, that in addition to the 19 million 
exercised stock options mentioned a moment ago, their CEO holds about 8 
million options that, due to a stock price drop, would likely expire 
without being exercised. Cisco calculated that, had FAS 123R been in 
effect, the company would have had to show a $139 million book expense 
for those options, but would never be able to claim a tax deduction for 
them since they would never be exercised. Apple pointed out that, in 
2003, it allowed its CEO to trade 17.5 million in underwater stock 
options for 5 million shares of restricted stock. That trade meant the 
stock options would never be exercised and so would never produce a tax 
deduction. In both cases, under FAS 123R, it is possible that stock 
options would produce a reported book expense greater than a company's 
tax deduction. While the M-3 data suggests that, overall, accounting 
expenses lag far behind claimed tax deductions, the possible financial 
impact on an individual company of a large number of unexercised stock 
options is additional evidence that stock option accounting and tax 
rules are out of kilter.
    Another set of issues has to do with how the corporate stock option 
tax deduction depends upon decisions made by individual corporate 
executives on whether and when to exercise their stock options. 
Normally, a corporation dispenses compensation to its employees and 
takes a tax deduction in the same year for the expense. With respect to 
stock options, however, corporations may have to wait years to see if, 
when, and how much of a deduction can be taken. UnitedHealth noted, for 
example, that it gave its former CEO 8 million stock options in 1999, 
of which, by 2006, only about 730,000 had been exercised. It does not 
know if or when it will get a tax deduction for the remaining 7 million 
options.
    If the rules for stock option tax deductions were changed so that 
the annual deduction matched the expenses shown on a company's books in 
the same year, companies could take the deduction years earlier, 
without waiting for exercises, and it would allow companies to deduct 
stock options that vest but are never exercised. It would treat stock 
options in the same manner as every other form of corporate 
compensation by allowing a deduction in the same year that the 
compensation was granted.
    Conclusion. The current differences between stock option accounting 
and tax rules make no sense. They require companies to show one stock 
option expense on their books and a completely different expense on 
their tax returns. They allow companies to take tax deductions that, 
overall, are many times larger than the stock option book expenses 
shown on their books, which not only shortchanges the Treasury, but 
also provides an accounting and tax windfall to companies doling out 
huge stock options, and creates an incentive for companies to keep 
right on doling out those options. The book-tax difference is fueling 
an ever deepening chasm between executive pay and the pay of average 
workers.
    The stock option book-tax difference is a historical product of 
accounting and tax policies that have not been coordinated or 
integrated. Right now, stock options are the only compensation expense 
where companies are allowed to deduct much more on their tax returns 
than the expense shown on their books. In 2004, companies used the 
book-tax difference to claim $43 billion more in stock option 
deductions than the expenses shown on their books. We need to examine 
whether we can afford this multi-billion dollar loss to the Treasury, 
not only in light of the deep federal deficits, but also in light of 
evidence that this stock option book-tax difference is contributing to 
the growing gap between the pay of executives and the pay of average 
workers.
    In past years, I've introduced legislation to require stock option 
tax deductions to match the stock option expenses shown on the company 
books. I hope the witnesses today will help us analyze the policy 
issues, and indicate whether they agree that federal tax policy should 
be brought into line with accounting policy, and provide that 
corporations deduct on their tax returns only the amount of stock 
option expenses shown on their books.

    Senator Levin. Senator Coleman.

              OPENING STATEMENT OF SENATOR COLEMAN

    Senator Coleman. Thank you. Thank you, Mr. Chairman. I want 
to thank you for initiating this investigation and for the 
dedicated focus and long effort you have given to ensure that 
investors in America's publicly traded companies have full 
access to important information regarding executive 
compensation.
    I have a longer statement that I would like entered into 
the record, Mr. Chairman, but let me discuss perhaps three 
issues in my opening.
    First, why are we concerned? The Chairman has detailed the 
explosion of executive pay. In 2006, CEOs earned almost 400 
times the wage of the typical rank-and-file employee, and while 
it is said that exceptional performance demands exceptional 
pay, it is troubling when mediocrity is rewarded with a king's 
ransom. But why are we in government concerned about this? One 
of the concerns is that this excess, including the exorbitant 
severance packages paid to executives ejected from their 
companies, at times under cloud of scandals, robs shareholders 
of earnings that are rightfully theirs and draws on the 
retirement savings of America's hard-working families.
    Without a closer link to performance, extraordinary CEO pay 
packages threatens to undermine the average investor's trust in 
our markets. More than 80 percent of Americans and 90 percent 
of institutional investors, including pension and retirement 
funds, think CEOs of large companies are overpaid. More 
disturbing, 60 percent of corporate directors--the very people 
who determine executive pay--believe CEOs of large companies 
make more than they deserve. Warren Buffett once argued that 
CEO pay ``remains the acid test'' to judge whether corporate 
America is serious about reform. If so, the results so far are 
anything but encouraging. Ultimately, some semblance of reality 
should be restored to executive pay.
    There was a column yesterday in the Minneapolis Star 
Tribune, one of my hometown papers, by Charles Denny, a former 
CEO, and he noted that ``our Nation's great wealth is a product 
of free market capitalism operating within, and ultimately 
governed by, the political system of democracy.'' And what Mr. 
Denny offers--and it was a very timely piece--is unique insight 
in concluding that if the current corporate excesses ``continue 
unchecked, the electorate's support of the political/economic 
concept of democratic capitalism will be severely tested.'' I 
share Mr. Denny's concern, and if the business community does 
not do something soon, companies are going to get more pressure 
from the Federal Government and from Congress in particular.
    So how did we get here? Clearly, there are a number of 
factors that have propelled executive salaries into the 
stratosphere. First, it cannot be overlooked that as CEO 
salaries have grown over the past 25 years, so too has the 
average size of large American companies. Indeed, the companies 
that will testify today exemplify this important point, as they 
have all produced substantial increases in profits over the 
past 15 years, much to the benefit of their shareholders. 
Moreover, the competition for high-performing CEOs is higher 
than ever, and the costs associated with recruiting and 
retaining top managers have bid up the compensation packages 
for all executives. That said, the pink elephant in the room is 
the stock option. When one considers the numbers that Senator 
Levin mentioned in his opening statement--that in 2004, stock 
options resulted in a book-tax gap of $43 billion--it becomes 
clear that the impact of stock options on executive 
compensation cannot be overstated.
    In fact, for the past 15 years, executive pay has been 
defined by the option. In 1992, for example, Standard & Poor's 
500 companies issued only $11 billion in stock options. In the 
year 2000, when option compensation reached its peak, companies 
issued options worth more than $119 billion. And although 
somewhat abated, companies still issued tens of billions of 
dollars' worth of stock options last year.
    To be clear, stock options are valuable and legitimate 
incentive tools, and the increased use of stock-based 
compensation reflects a logical attempt by publicly traded 
companies to align the self-interests of their executives with 
the best interests of the shareholders. By replacing cash with 
long-term incentives, stock options are meant to make managers 
think like owners and ensure that executive pay is linked to 
company performance. And during the early 1990s, options worked 
as intended--executive pay increased as shareholders profited.
    But in the overvalued market of the late 1990s, it became 
clear that the link between performance and pay had grown 
tenuous at best. As the bull market charged, it seemed that 
executives got rich just by showing up for work, and investors 
began to deride stock options as ``pay for pulse.'' Worse, 
executive decisionmaking seemed more short term than ever. 
Earning manipulations in Enron, WorldCom, and elsewhere 
underscored what many investors already feared; stock options 
provided company managers with perverse incentives to 
personally profit from artificial, even fraudulent, inflation 
of share values.
    The intent behind stock-based compensation--to align 
managers' and shareholders' interests and to reward and retain 
high-performing executives--is noble, but anything can be 
destructive in excess. The meteoric rise in executive pay, 
especially where undeserved, has caused shareholders to 
complain that companies issued far too many stock options on 
terms that were far too generous. Options often vest too 
quickly, rarely include true performance hurdles, and upon 
exercise, shares can frequently be sold without restriction.
    Regrettably, Congress must take some blame for this 
excessive and at times unwarranted executive compensation. We 
changed the rules. In 1993, as the Chairman mentioned, Congress 
attempted to rein in executive pay by enacting Section 162(m) 
of the Tax Code. This section limits to $1 million the tax 
deductions companies can take for salaries of their top 
executives. Congress did not, however, extend this cap to stock 
option pay, and almost immediately companies shifted to this 
fully deductible and, therefore, cheaper form of compensation. 
As a result, when the stock market booms, as it did during the 
early 1990s and the last few years, total executive 
compensation skyrockets, often regardless of executive 
performance.
    To make this point clear, consider that in 1994, 1 year 
after Section 162(m) was passed, the average CEO was earning 
$1.7 million in total compensation, including about $680,000 
from stock option exercises. By 2004, CEO compensation had 
risen by more than 400 percent, to more than $7 million 
annually. Notably, more than three-quarters of that 
compensation, or more than $5 million, came from stock options. 
In other words, Congress' attempt to limit executive salaries 
had just the opposite effect. As Chairman Cox of the SEC, who 
will testify later this morning, recently told another Senate 
committee, Section 162(m) ``deserves pride of place in the 
museum of unintended consequences.'' For the record, I agree 
with Chairman Cox.
    So where do we go from here? Well, the good news is the 
climate is changing. The Chairman noted that FAS 123R is in 
place. It has provided some long overdue reform. Before it 
became effective in 2005, accounting rules--contrary to 
economic logic--did not require companies to report the cost of 
stock options to investors, but under the new rule, companies 
must now subtract the total value of stock option compensation 
from their financial earnings. This corrects a longstanding and 
poorly conceived policy that required companies to hide the 
true cost of stock option compensation from their investors 
while reporting that amount to the IRS in order to claim a tax 
deduction.
    This point bears repeating. As Senator Levin noted earlier, 
most companies that report large book-tax gaps for stock 
options do so simply because different tax and accounting rules 
require them to do so. Although it is too early to assess the 
full impact of FAS 123R, it is already clear that companies are 
issuing fewer stock options, requiring longer vesting and 
holding periods, and hopefully setting truer performance 
benchmarks. So it is hoped that as a result of FAS 123R, the 
book-tax gap should narrow.
    I am concerned, however, that while the book-tax gap for 
stock options is closing, the information gap for executive pay 
remains much too large. Too often, shareholders are left in the 
dark regarding how much their top executives really make. And 
even when this information is disclosed, shareholders still 
have little, usually no input into executive compensation. 
Equally troubling, shareholders often perceive that the so-
called independent directors who set executive salaries have 
cozy relationships with the CEO, often to the detriment of the 
investors they are supposed to represent. In an environment 
that allows collegiality to trump independence, investor 
confidence can and will be undermined.
    It is, therefore, imperative that companies take steps to 
ensure that top executives' pay is fair and deserved. In doing 
so, I encourage the industry that often reminds us that the 
market, not the government, should set prices to practice what 
it preaches. This requires that companies open their 
compensation decisions to shareholder scrutiny. Companies must 
provide clear, plain-English disclosures of CEO pay to their 
investors and encourage more contact between independent 
directors and shareholders. Moreover, companies should consider 
submitting executive pay to shareholder votes, or even allowing 
shareholders to vote on the directors themselves. In this way, 
the interaction between the investors and directors will take 
place before lawsuits and proxy fights and in the form of 
constructive negotiation rather than costly litigation.
    I should add that I am encouraged by the SEC's new rules 
that require proxy statements to include summary tables and 
plain-language disclosures of top executives' pay. But more 
work remains to ensure that investors receive full, easily 
digestible disclosures of executive compensation. Shareholders 
cannot be left to believe that the executive pay game is rigged 
against them. Executive pay must be determined by those it 
affects, and where poor performance has distorted compensation, 
companies must act quickly to put things right. If they do not, 
I can assure that this will not be the last congressional 
hearing on executive pay.
    You will note, Mr. Chairman, that my focus here is on 
shining a light on what is going on, giving investors 
information. I do worry, as we move forward, that we avoid 
unintended consequences, that we avoid the danger of repeating 
what we did in 1993 as we moved into this area. Clearly, the 
gap is real. It is there. I would note, however, that on the 
total reported tax deduction, the companies take. The 
individual is paying taxes on that amount, so the government is 
getting some compensation there. When you look at some of the 
best-growing companies, if the market were to go down, would 
the proposed rule changes have the same effect? Or, in fact, if 
we have companies taking deductions up front and then the 
options never vested, would we be giving companies a tax break, 
a shadow tax break, for which the IRS would never get the 
revenue?
    So as we move forward, let us be clear as to what the 
consequences are. I do think there is a responsibility that the 
corporate community has not responded to. And so I thank the 
Chairman for this hearing, and I look forward to the testimony.
    I have two meetings that I have to attend, Mr. Chairman, 
but I will be coming back. Thank you.
    [The prepared statement of Senator Coleman follows:]
                  OPENING STATEMENT OF SENATOR COLEMAN
    Thank you for attending today's hearing. I want to thank this 
Subcommittee's Chairman, Senator Levin, for initiating this 
investigation and I want to commend him on his many years of dedicated 
focus on this issue. Today's hearing continues your long effort to 
ensure that investors in America's publicly traded companies have full 
access to important information regarding executive compensation.
    For the past 25 years, the pay checks cashed by America's top 
executives have grown exponentially. During the 1990s in particular, 
executive pay exploded to unprecedented levels, and by 2002, the 
average American worker earned in a year what the average CEO took home 
every evening. Last year alone, CEOs at America's 500 largest companies 
earned an average of $15.2 million apiece--a staggering increase of 
almost 40 percent from just the year before.
    It seems inconceivable that in 2006 CEOs earned almost 400 times 
the wage of the typical rank-and-file employee. And while it is often 
said that exceptional performance demands exceptional pay, it is 
troubling when mediocrity is rewarded with a king's ransom. There are 
far too many examples of excessive pay for poor performance, of 
executives and their families receiving millions of dollars in 
undisclosed company perks, and of exorbitant severance packages paid to 
executives who have been ejected from their companies under the cloud 
of scandal. Such excess robs shareholders of earnings that are 
rightfully theirs and draws on the retirement savings of America's 
hard-working families.
    Without a closer link to performance, extraordinary CEO pay 
packages threaten to undermine the average investor's trust in our 
markets. More than 80 percent of Americans and 90 percent of 
institutional investors'including pension and retirement funds--think 
CEOs of large companies are overpaid. More disturbing, 60 percent of 
corporate directors--the very people who determine executive pay--
believe CEOs of large companies make more than they deserve. Warren 
Buffet once argued that CEO pay ``remains the acid test'' to judge 
whether corporate America is ``serious'' about reform. If so, the 
results so far are anything but encouraging. Ultimately, some semblance 
of reality must be restored to executive pay.
    I am concerned by the widening loss of confidence in the business 
community. Charles Denny, who is a former CEO, noted in an article that 
ran yesterday in one of my home town newspapers, the Star Tribune, that 
``[o]ur nation's great wealth is the product of free-market capitalism 
operating within, and ultimately governed by, the political system of 
democracy.'' As a former CEO, Denny offers unique insight in concluding 
that if current corporate excesses ``continue unchecked, the 
electorate's support of the political/economic concept of democratic 
capitalism will be severely tested.'' I share Mr. Denny's concern, and 
if the business community doesn't do something soon, companies are 
going to get more pressure from the Federal Government and from 
Congress in particular.
    So how did we get here? Obviously, a number of factors have 
propelled executive salaries into the stratosphere. First, it cannot be 
overlooked that, as CEO salaries have grown over the past 25 years, so 
too has the average size of large American companies. Indeed, the 
companies that will testify today exemplify this important point--as 
they have all produced substantial increases in profits over the past 
15 years, much to the benefit of their shareholders. Moreover, the 
competition for high-performing CEOs is higher than ever, and the costs 
associated with recruiting and retaining top managers have bid up the 
compensation packages for all executives. That said, the pink elephant 
in the room is the stock option. When one considers the numbers that 
Senator Levin mentioned in his opening--that in 2004, stock options 
resulted in a book-tax gap of $43 billion--it becomes clear that the 
impact of stock options on executive compensation cannot be overstated.
    In fact, for much of the last 15 years, executive pay has been 
defined by the option. In 1992, for example, S&P 500 companies issued 
only $11 billion in options. In 2000, when option compensation reached 
its peak, companies issued options worth more than $119 billion. And 
although somewhat abated, companies still issued tens of billions of 
dollars worth of stock options last year.
    To be clear, stock options are valuable and legitimate incentive 
tools. And the increased use of stock-based compensation reflects a 
logical attempt by publicly traded companies to align the self-
interests of their executives with the best interests of their 
shareholders. By replacing cash with long-term incentives, stock 
options are meant to make managers think like owners and ensure that 
executive pay is linked to company performance. And, during the early 
1990s, options worked as intended--executive pay increased as 
shareholders profited.
    But in the overvalued market of the late 1990s, it became clear 
that the link between performance and pay had grown tenuous at best. As 
the bull market charged, it seemed that executives got rich just by 
showing up for work, and investors began to deride stock options as 
``pay for pulse.'' Worse, executive decision making seemed more short-
term than ever. Earnings manipulations at Enron, Worldcom, and 
elsewhere underscored what many investors already feared; stock options 
provided company managers with perverse incentives to personally profit 
from artificial, even fraudulent, inflation of share values. The intent 
behind stock-based compensation--to align managers' and shareholders' 
interests and to reward and retain high performing executives--is 
noble, but anything can be destructive in excess. The meteoric rise in 
executive pay, especially where undeserved, has caused shareholders to 
complain that companies issued far too many stock options on terms that 
were far too generous. Options often vest too quickly, rarely include 
true performance hurdles, and upon exercise, shares can too frequently 
be sold without restriction.
    Regrettably, Congress must take some of the blame for this 
excessive, and at times unwarranted, executive compensation. In 1993, 
Congress attempted to rein in executive pay by enacting Section 162(m) 
of the tax code. This section limits to $1 million the tax deductions 
companies' can take for the salaries of their top executives. Congress 
did not, however, extend this cap to stock option pay, and almost 
immediately companies shifted to this fully deductible, and therefore 
cheaper, form of compensation. As a result, when the stock market 
booms, as it did during the 1990s and in the last few years, total 
executive compensation skyrockets, often regardless of executive 
performance.
    To make this point more clear: Consider that in 1994, 1 year after 
Section 162(m) was passed, the average CEO earned about $1.7 million in 
total compensation, including approximately $680,000 from stock option 
exercises. By 2004, average CEO compensation had risen by more than 400 
percent, to more than $7 million annually. Notably, nearly three-
quarters of that compensation, or more than $5 million, came from stock 
options. In other words, Congress' attempt to limit executives' 
salaries has had just the opposite effect. As Chairman Cox of the SEC, 
which will testify later this morning, recently told another Senate 
committee, Section 162(m) ``deserves pride of place in the museum of 
unintended consequences.'' For the record, I agree with Chairman Cox, 
as long as that museum is the hall of fame.
    So where do we go from here? Well, the good news is that the 
climate surrounding executive pay is already beginning to change. FAS 
123R, a recent change to the accounting rules for stock options, has 
provided long overdue reform. Before FAS 123R became effective in 2005, 
accounting rules--contrary to economic logic--did not require companies 
to report the costs of stock options to their investors. Under the new 
rule, companies must now subtract the total value of stock option 
compensation from their financial earnings. This corrects a long 
standing, and poorly conceived, policy that required companies to hide 
the true cost of stock option compensation from their investors, while 
reporting that amount to the IRS in order to claim a tax deduction.
    This point bears repeating. As Senator Levin stated earlier, most 
companies that report large book-tax gaps for stock options do so 
simply because different tax and accounting rules require them to do 
so. Although it is still too early to assess the full impact of FAS 
123R, it is already clear that companies are issuing fewer stock 
options, requiring longer vesting and holding periods, and hopefully 
setting truer performance benchmarks. Moreover, although differences 
between the tax rules and accounting rules governing stock options 
remain, now that every option issued represents a direct hit to the 
company's bottom line, the $43 billion book-tax gap that existed in 
2004 should narrow significantly.
    I am concerned, however, that while the book-tax gap for stock 
options is closing, the information gap for executive pay remains. Too 
often, shareholders are left in the dark regarding how much their top 
executives really make. And even when this information is disclosed, 
shareholders still have little, and usually no, input into executive 
compensation. Equally troubling, shareholders often perceive that the 
so-called independent directors who set executive salaries have cozy 
relationships with the CEO, often to the detriment of the investors 
they are supposed to represent. In an environment that allows 
collegiality to trump independence, investor confidence is undermined.
    It is therefore imperative that companies take steps to ensure that 
top executives' pay is fair and deserved. In so doing, I encourage the 
industry that often reminds us that the market, not the government, 
should set prices, to practice what it preaches. This requires that 
companies open their compensation decisions to shareholder scrutiny. 
Companies must provide clear, plain-English, disclosures of CEO pay to 
their investors, and encourage more contact between independent 
directors and shareholders. Moreover, companies should consider 
submitting executive pay to shareholder votes, or even allowing 
shareholders to vote on the directors themselves. In this way, the 
interaction between investors and directors will take place before 
lawsuits and proxy fights, and in the form of constructive negotiation 
rather than costly litigation. I should add that I am encouraged by the 
SEC's new rules that require proxy statements to include summary tables 
and plain-language disclosures of top executives' pay. But more work 
remains to ensure that investors receive full, easily-digestible 
disclosures of executive compensation. Shareholders cannot be left to 
believe that the executive pay game is rigged against them. Executive 
pay must be determined by those it affects, and where poor governance 
has distorted compensation, companies must act quickly to put things 
right. If they don't, I can assure that this will not be the last 
Congressional hearing on executive pay.
    In closing, I would like to thank each of the witnesses that are 
here today. I look forward to your testimony.

    Senator Levin. Thank you so much, Senator Coleman.
    Let us now welcome our first panel to this morning's 
hearing: Stephen Bollenbach, Chairman of the Board of Directors 
for KB Home; John Chalsty, Chairman of the Compensation 
Committee for Occidental Petroleum Corporation; and William 
Tauscher, member and former Chairman of the Compensation 
Committee for Safeway. We welcome you to the Subcommittee, 
gentlemen. Pursuant to Rule 6, all witnesses who testify before 
the Subcommittee are required to be sworn, and at this time I 
would ask all of you to please stand and raise your right hand.
    Do you swear that the testimony you will give this morning 
before this Subcommittee will be the truth, the whole truth, 
and nothing but the truth, so help you, God?
    Mr. Bollenbach. I do.
    Mr. Chalsty. I do.
    Mr. Tauscher. I do.
    Senator Levin. We are using a timing system today, and 1 
minute before the red light comes on, you will see the light 
change from green to yellow, which will give you an opportunity 
to conclude your remarks, and your written testimony, of 
course, will be printed in the record in its entirety. We would 
ask that you limit your oral testimony to no more than 5 
minutes.
    Again, we thank each of you and your companies for 
providing us with the information that we have requested. It is 
very important and useful to us, and, Mr. Bollenbach, we will 
have you go first, followed by Mr. Chalsty and then Mr. 
Tauscher.

   TESTIMONY OF STEPHEN F. BOLLENBACH,\1\ CHAIRMAN, BOARD OF 
          DIRECTORS, KB HOME, LOS ANGELES, CALIFORNIA

    Mr. Bollenbach. Good morning, Chairman Levin. My name is 
Stephen Bollenbach, and I recently joined KB Home as the first 
non-executive chairman of the board. I am currently CEO of 
Hilton Hotels Corporation as well as co-chairman of the board 
of that company. On behalf of KB Home and its 4,500 employees 
nationwide and its thousands of subcontractors doing business 
with the company, I would like to thank you for the opportunity 
to appear here today.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Bollenbach appears in the 
Appendix on page 55.
---------------------------------------------------------------------------
    Before I turn to matters raised by the Subcommittee, I 
would like to introduce you briefly to KB Home. This year, we 
are proud to be celebrating 50 years of building quality homes, 
a story that began with two visionaries from Detroit--Eli Broad 
and Donald Kaufman. They established this company to serve the 
needs of entry-level housing with homes that are well designed 
and affordable. Fifty years later, we have developed over 1.5 
million--for 1.5 million families we have developed homes. They 
come from all walks of life, but with a focus on first-time 
homeowners, we have been able to make the dream of 
homeownership possible for young families, immigrants, 
minorities, and in the high-cost metropolitan areas of America, 
for teachers, nurses, firemen, policemen, and other folks 
otherwise priced out of the communities in which they work. 
Last year, about 40 percent of the families who came to KB Home 
were buying their first home, and 66 percent were minorities. 
Continuing our tradition of civic engagement, KB Home is the 
only national home building company to have come to New Orleans 
following Hurricane Katrina. We have made nearly a $20 million 
investment in Louisiana.
    Now let us turn from the business of KB Home and to the 
business of this meeting. I will speak to two issues: The 
accounting issues and the recent changes at KB Home.
    First the issues related to accounting. I want to stress 
that KB Home has no view on the accounting and tax treatment of 
stock options. We have taken no position on this issue, and we 
really do not expect to. We will follow whatever rules are in 
effect, and we follow them as they change from time to time.
    With that, I think the Subcommittee should understand that 
KB Home tax-books differential on the chart that we saw a 
minute ago is due to the extraordinary business performance of 
the company and the very large increase in its stock price 
between 2000 and 2005. During that time KB Home's stock price 
increased 600 percent. Over the same period, the S&P 500 
managed to increase only .002 of 1 percent. If KB Home's stock 
price had merely performed as the S&P 500 had performed, our 
tax-book differential would have been negligible.
    Recent corporate changes at KB Home. KB Home has made a 
number of corporate changes in the past 6 months following a 
comprehensive independent investigation into its stock option 
practices. That investigation discovered that in certain 
instances our former CEO and the head of Human Resources picked 
stock option grants using hindsight. As a result of that 
investigation, both our former CEO and the head of Human 
Resources have left the company.
    KB Home also restated its financial statements to reflect 
an additional $41 million in compensation expense plus related 
tax charges over 6 years. While $41 million is a lot of money, 
to put that number in perspective KB Home's net income over the 
same period was nearly $3 billion. Of more importance for the 
future of KB Home, our Board of Directors took strong and swift 
action to reform the company's compensation and governance 
practices. The board separated the position of CEO from the 
chairman of the board, eventually selecting me as KB Home's 
first non-executive chairman. Our directors used to be elected 
for 3-year terms; now they are elected for 1-year terms. The 
employment agreement we recently signed with our new CEO 
embodies the best practices in the compensation area.
    The board made other governance changes in the process, 
more than doubling the ISS corporate governance rating. Among 
companies in our industry, our rating is now in the 97th 
percentile. KB Home, like other home builders, is currently 
operating in a very challenging environment. We have worked 
diligently to put the issues of the last several months behind 
the company. Its employees and many of its shareholders can 
look forward to the future, and so KB Home can continue helping 
Americans achieve the dream of homeownership.
    So thank you for giving me the opportunity to make this 
statement on behalf of KB Home, and I will attempt to answer 
any questions you may have.
    Senator Levin. Thank you very much, Mr. Bollenbach. Mr. 
Chalsty.

     TESTIMONY OF JOHN S. CHALSTY,\1\ CHAIRMAN, EXECUTIVE 
COMPENSATION AND HUMAN RESOURCE COMMITTEE, OCCIDENTAL PETROLEUM 
              CORPORATION, LOS ANGELES, CALIFORNIA

    Mr. Chalsty. My name is John Chalsty. I have spent most of 
my professional career working in investment banking and 
finance. From 1986 to 2000, I served as Chief Executive Officer 
and then Chairman of DLJ. In connection with my service on the 
Occidental's board, I currently serve as Chairman of 
Occidental's Executive Compensation and Human Resources 
Committee. I would like to make two important points.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Chalsty appears in the Appendix 
on page 60.
---------------------------------------------------------------------------
    First, the Compensation Committee only grants stock options 
pursuant to plans that have been approved by Occidental's 
shareholders, and the company fully discloses to its 
stockholders the granting of such stock options as required by 
law and regulation. The granting of stock options to officers 
and employees is a longstanding practice well understood by the 
company's stockholders, who have seen the management transform 
and refocus the company from 1990 to 2006. During that period, 
the company has increased core profits from $191 million to 
more than $4.3 billion, reduced debt by 65 percent from more 
than $8 billion, and increased its stock market value by 650 
percent to $41 billion. Occidental's transformation increased 
the oil and gas sales from 17 percent of total sales in 1990 to 
72 percent in 2006. The use of stock options, which align the 
interests of management and stockholders, as a part of the 
company's compensation program is not a surprise to the 
stockholders, the investment community, the regulators, or the 
public.
    Second, throughout this period the company's treatment of 
stock options for both tax and accounting purposes complied 
fully with all applicable laws, rules, and regulations, and no 
one has contended otherwise. No stock options were backdated. 
No restated SEC financial statement filings have been required 
in the last 15 years.
    Occidental has complied fully with all Federal, State, 
local, and foreign tax laws. The result of this compliance with 
the law has been that over the past 5 years, from 2002 to 2006, 
Occidental has paid more than $4 billion in corporate income 
taxes in the United States. In sum, Occidental is a successful 
U.S. company that complies fully with the law and pays 
substantial taxes.
    As the Subcommittee has requested, I would like to provide 
a brief overview of Occidental's policies and procedures for 
granting stock options. Stock options are granted by the 
Compensation Committee, which is composed entirely of 
independent directors. The Compensation Committee may, as it 
deems appropriate, engage special legal or other consultants to 
report directly to the committee.
    All new stock plans and amendments to existing stock plans 
must be reviewed by the Compensation Committee before being 
submitted to Occidental's Board of Directors for approval. In 
making its recommendation to the Board of Directors, the 
Compensation Committee takes into consideration the potential 
dilutive effect of such awards, as well as changes in 
compensation practices. New stock plans must first be approved 
by stockholders before they can be implemented.
    The Compensation Committee grants stock awards at regularly 
scheduled meetings. No stock options granted by Occidental have 
ever been backdated.
    Accordingly, the intrinsic value of the options on the date 
of the grant is zero. The plans do not permit re-pricing of 
options without the approval of stockholders, and Occidental 
has not re-priced any options. The stock options granted by 
Occidental vest one-third each year over a 3-year vesting 
period, are exercisable for a 10-year term, and are subject to 
forfeiture. In making grants to the executive officers, the 
Compensation Committee considers personal performance, industry 
practices, prior award levels, outstanding awards, and overall 
stock ownership in an effort to foster a performance-oriented 
culture and to align the interests of executive officers with 
the long-term interests of the company and its stockholders.
    Occidental complies fully with both the accounting and tax 
rules with respect to stock options. From an accounting 
perspective, pursuant to FAS 123R, on July 1, 2005, Occidental 
began recognizing fair-value compensation. Compensation is 
measured using the Black-Scholes option.
    With reference to Occidental's Federal tax returns, in 
accordance with IRS regulations, Occidental has reported 
deductions in its corporate tax returns for non-qualified stock 
options in the year they were exercised. For non-qualified 
stock options, the amount of Occidental's corporate tax 
deduction is the same as the amount included in taxable income 
by the exercising executives on their individual Federal income 
tax returns--that is, the difference between the fair market 
price and the option exercise or strike price. Any variations 
in these two numbers are the result of a difference between the 
applicable accounting and tax regulations.
    The accounting rules and the tax rules are designed to 
pursue different objectives using different approaches with 
frequently different results. I cannot say that one is 
``right'' and the other ``wrong''. What I can say with 
certainty is that Occidental has complied, and will comply, 
with whatever accounting and tax regulations the respective 
accounting and tax standard setters apply to the granting and 
exercising of stock option awards. Thank you.
    Senator Levin. Thank you very much, Mr. Chalsty. Mr. 
Tauscher.

    TESTIMONY OF WILLIAM Y. TAUSCHER,\1\ MEMBER AND FORMER 
 CHAIRMAN, COMPENSATION COMMITTEE, SAFEWAY, INC., PLEASANTON, 
                           CALIFORNIA

    Mr. Tauscher. Thank you, Chairman Levin. I am William Y. 
Tauscher, and I am appearing today on behalf of Safeway. I have 
been a member of the Board of Directors of Safeway since 1998 
and also a member of Safeway's Executive Compensation Committee 
since 1998. I served as Chair of the Executive Compensation 
Committee from 1998 until 2006. Besides being a Safeway 
Director, I am the Chairman and Chief Executive Officer of 
Vertical Communications, a public communications technology 
company, and I have previously been Chairman and Chief 
Executive Officer of Vanstar, a national computer services 
company, and before that Chairman and Chief Executive Officer 
of FoxMeyer, another public nationwide health care distributor.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Tauscher appears in the Appendix 
on page 63.
---------------------------------------------------------------------------
    Safeway is one of the largest food and drug retailers in 
North America, operating approximately 1,750 stores in the 
United States and Canada. Our revenues in 2006 were $40 
billion, and we have about 200,000 employees. We have received 
a number of national recognition awards in environmental 
sustainability and social responsibility. We received a 
corporate governance rating of 93.1 from Institutional 
Shareholder Services. The company has also been instrumental in 
advancing important public policy discussions. Safeway has 
recently taken a lead position among American businesses to 
advance health care reform, building a coalition of nearly 50 
large companies.
    Our compensation program has been instrumental to our 
success. Safeway's Executive Compensation Committee has 
designed its compensation program to attract and retain the 
best management. Our compensation program closely links the 
compensation of company executives with the company's financial 
performance and substantially aligns that compensation with the 
long-term interests of the shareholders. Because of that 
linkage, our board has been able to retain for nearly 15 years 
one of the best CEOs in corporate America.
    Under Steve Burd's leadership, the company has outperformed 
97 percent of the companies listed in the S&P 500 over the last 
14.5 years he has served. The compound annual growth rate of 
Safeway's stock price over this time period, at 19.8 percent, 
has been twice that of the S&P 500. Safeway has outperformed 
many outstanding U.S. companies during this period. From 1992 
to 2006, the company's market capitalization increased from 
$1.3 billion to $15.2 billion. The Company's annual earnings 
per share during that period increased from 9 cents to $1.94. 
These are extraordinary accomplishments considering the 
maturity of the sector and the nature of its competition. This 
has been accomplished, by the way, while helping the 
communities we serve by donating or raising more than $1.25 
billion in cash or goods, or 18 percent of net income, to 
charitable organizations.
    The company's recent performance has been excellent. In 
2006, the return on investment in our stock was 47 percent, 
about 3 times the 15.8 percent return experienced by the S&P 
500. An article in Bloomberg News last month noted that 
Safeway's performance since 2004 was better than 75 percent of 
the companies in the S&P 500, and in 2006 was in the 94th 
percentile.
    We compete with a peer group of companies and numerous 
other companies for executive talent and, therefore, we need to 
pay, we believe, at market levels. The task for the 
Compensation Committee is to keep an eye on compensation levels 
at comparable companies and determine how to reward for 
extraordinary results. At Safeway, the Committee intentionally 
sets executive salary levels below market and uses bonuses and 
stock options to provide compensation slightly above 
competitive norms when the company performs well. Even given 
the recent success of the company, Mr. Burd's compensation has 
been within the lower range of large companies in the United 
States. In fact, his total compensation ranks in the bottom 10 
percent of the companies in the S&P 100--we are about in the 
middle of that group from a size standpoint--and his equity 
compensation ranks in the bottom 5 percent of that group.
    Because of the company's success over the past 10 to 15 
years, Mr. Burd's stock options have increased in value, and he 
has been rewarded along with other investors in Safeway's 
stock. Unlike many other CEOs, Mr. Burd behaved like a long-
term stockholder, typically holding his options until the end 
of the option period--historically, 10 to 15 years. By doing 
so, he has missed out on opportunistic peaks in the share 
price. This practice has also caused options to produce gains 
at a single point in time rather than spread out over many 
years, and these gains may not coincide with good performing 
years for the company. For example, Mr. Burd's 2003 and 2004 
option exercises occurred at relatively low price points for 
the company's stock. This was not an opportune time to 
exercise, but the terms were expiring. When looking at these 
blocks of exercised options, it is important to consider them 
as 10-year compensation instruments and not associate them with 
1 year's performance in the year of exercise.
    Much of the criticism leveled at executive compensation 
these days relates to extraordinarily large severance packages 
that are given to CEOs upon their departure. Safeway is proud 
of the fact that none of its executive officers has an 
employment contract or a severance agreement. The CEO and other 
executive officers serve at the will of the board. If our CEO 
was terminated for any reason, we would have no obligation to 
pay him any severance.
    With respect to the accounting rules, Safeway adopted FAS 
No. 123R, the accounting rule governing the expensing of stock 
options, in the first quarter of 2005. With the advice of 
expert consultants, Safeway has used the Black-Scholes 
methodology for valuing options for expense purposes, by far 
the most commonly used methodology for this purpose.
    We understand the Subcommittee is examining several issues 
at this hearing, including how a company's accounting expense 
for stock options, determined using Black-Scholes or other 
options valuation methodologies, compares with the tax 
deductions a company takes when those options are exercised. We 
have three quick principal observations.
    First, we believe any evaluation of the accounting expense 
for stock options should appropriately focus on all option 
grants, not merely option exercises. A snapshot comparing the 
accounting expense for exercised stock options to subsequent 
tax deductions for specific option exercises will result in a 
distorted picture. For example, such a comparison will not 
account for the expensed amounts on options that are never 
exercised because they expire with the exercise price higher 
than the company's current stock price. Thus, such a snapshot 
might exaggerate what seems, at first, to be a disparity 
between the accounting expense and the tax deductions.
    Second, we believe the Subcommittee should assess this 
issue across a broad range of companies. The disparity between 
accounting expense and tax deductions will be greatest in 
companies that have outperformed their historical performance, 
like the group gathered here. By contrast, the accounting 
expense may significantly exceed tax deductions in companies 
that have underperformed their historical performance. A more 
accurate assessment of this issue requires an examination of 
numerous companies--outperformers and underperformers.
    Finally, third, the Subcommittee, we believe, should not 
view the exercise of an option in a particular year as 
compensation simply for that year. When an option is exercised, 
the executive will receive the benefit of the appreciation in 
the value of the stock since the grant of the option. This may 
represent compensation for the executive's service for many 
years, possibly a decade or more, especially when the executive 
exercises the option at the end of the option period. As I have 
already commented, the extraordinary growth in Safeway's stock 
value from 1992 through 2006 resulted in a very significant 
value for options granted early in that period. This 
extraordinary increase in value is properly viewed as the 
result of more than 10 years of effort to improve stockholder 
value.
    I hope Safeway's participation today helps illuminate these 
accounting and tax policy rules for the Subcommittee, and I 
stand ready to answer questions.
    Thank you, Mr. Chairman.
    Senator Levin. Thank you, Mr. Tauscher. Let me start with 
you, Mr. Tauscher, and work the other way. Take a look at Chart 
1,\1\ if you would, in your book. According to the data that 
Safeway provided to the Subcommittee, the total amount deducted 
by Safeway on its tax returns for stock options exercised by 
the chief executive officer between 2002 and 2006 was $39 
million. Is that figure accurate?
---------------------------------------------------------------------------
    \1\ The chart referred to appears in the Appendix on page 236.
---------------------------------------------------------------------------
    Mr. Tauscher. Yes, Mr. Chairman, it is.
    Senator Levin. And because the options exercised in those 
years were granted before accounting rules required an 
accounting expense to be taken on your books, the company took 
no book expense for any of those options at that time. Is that 
correct?
    Mr. Tauscher. Yes, Mr. Chairman, that is correct as well.
    Senator Levin. Now, your company also did a computation at 
the Subcommittee's request--and we appreciate your doing so--of 
what the expense would have been booked for those options if 
the new Financial Accounting Standard had been in effect during 
those years, and the total book charge would have been about 
$6.5 million. Is that correct?
    Mr. Tauscher. That is also correct.
    Senator Levin. All right. So in your case, options with a 
$6.5 million book expense under today's rules would produce a 
tax deduction six times that amount. Is that correct?
    Mr. Tauscher. That is correct.
    Senator Levin. Now, in the Occidental Petroleum case, Mr. 
Chalsty, the options granted to your CEO would have caused a 
book expense under the new rules of about $29 million and 
ultimately generate total tax deductions for the company on 
exercise of those options of about $353 million. Is that 
correct?
    Mr. Chalsty. Yes, sir.
    Senator Levin. And the deduction is about then 12 times the 
book expense. Is that correct?
    Mr. Chalsty. Yes.
    Senator Levin. Mr. Bollenbach, KB Home's CEO exercised 
stock options between 2002 and 2006 that the new accounting 
rules would have required to be expensed on the company books 
at a total of $11.5 million while the tax rules allowed it to 
deduct almost $144 million or over 12 times the book expense. 
Is that correct?
    Mr. Bollenbach. Yes, sir.
    Senator Levin. Let me ask each of you whether or not at the 
time you award options and issue these options you are aware of 
the fact that there is a potentially greater tax deduction 
available to the corporation than the book value of those 
options. Is that something you are aware of, Mr. Bollenbach?
    Mr. Bollenbach. Yes. We understand the rules both from the 
accounting standpoint and from the tax standpoint, we 
understand that they are different and there will, therefore, 
be differences.
    Senator Levin. And that there is at least a potential--and 
you hope a great potential because you hope the company will be 
profitable--that the tax deduction that will be available will 
be significantly greater than the book number that is shown?
    Mr. Bollenbach. I think that what the company and the 
directors think about is that they need to comply--and they 
have no choice. They need to comply with two sets of rules, and 
that is simply the result of the set of rules. I do not think 
there is any other thoughts around that.
    Senator Levin. So you are not aware of the fact when you 
issue options that if the company does well, which is your 
hope, that you will have a significant tax deduction upon the 
exercise of those options? That is not something you think 
about, a tax deduction for your own company?
    Mr. Bollenbach. It is not something that I would think 
about in the context of the stock options, but I agree with you 
that, given what you have said, if the company performs well 
and its stock goes up, then there will be potentially a tax 
deduction that is larger than the accounting charge that was 
booked. Yes, I am aware of that.
    Senator Levin. But you are saying that is not something 
that goes through your mind when you decide to issue large 
numbers of stock----
    Mr. Bollenbach. It is not in my mind, it is not a tax 
planning----
    Senator Levin. Is it, as far as you know, in any of the 
company personnel's mind?
    Mr. Bollenbach. I do not know what is----
    Senator Levin. You do not know. Mr. Chalsty, is that 
something in your mind?
    Mr. Chalsty. No, it is not, and I do not know if it is in 
any others' minds. I am aware that any reported--any excess of 
tax deduction of total expense is, of course, offset by the 
recipient, who pays taxes on exactly the same amount.
    Senator Levin. So in terms of the company tax bill, you are 
saying that the award of stock options in large numbers that 
could potentially and hopefully from a company's perspective, 
because it wants to be very profitable, result in a large tax 
deduction but without any similar number being taken from the 
bottom line on the books is not something which goes through 
your mind?
    Mr. Chalsty. No, it does not. We are a Compensation 
Committee.
    Senator Levin. All right. Mr. Tauscher, is that something 
which goes through your mind?
    Mr. Tauscher. I can honestly tell you that in all the time 
of doing this, I have never thought about the tax deduction as 
some kind of corporate benefit for what we are doing. We 
literally are trying to design a program first that we test 
against market; second, we hope the company outperforms and the 
option outperforms. There is no question, though, that under 
the current way the rules work, if the company outperforms, as 
these three companies have, there will be a larger tax 
deduction than the book accounting that is set now under the 
new FASB rules. That is just a fact.
    Senator Levin. Are you aware----
    Mr. Tauscher. When we sit and plan for that, we are not 
sitting and talking about a great tax deduction. We are talking 
about motivating a chief executive for a great result.
    Senator Levin. I am sure of that. But is there not a 
secondary benefit, a huge benefit, in terms of tax deductions 
for the company if the company performs well? The more 
profitable a company is, the more its stock goes up, the more 
valuable that stock option is when it is cashed in, the greater 
the tax deduction instead of taxes being paid commensurate with 
greater profitability as to the stock option. I know companies 
pay taxes based on profits, but the exercise of that option 
reduces the taxes, and the greater the profits, the greater the 
number of options, if they have been issued, the greater the 
deduction.
    Mr. Tauscher. All of that is absolutely true, Mr. Chairman. 
The only comment I would add to that is I do not think we look 
at it terribly differently than if there was some kind of 
incentive bonus program that was paid in cash, the company did 
very well, the employee would get a cash bonus, the cash bonus 
would be deductible, the employee would pay tax on it. So the 
same thing is happening here.
    Now, whether that is causing a certain behavior, I can only 
tell you again it is not contemplated as part of the activity 
that is going on here.
    Senator Levin. Have you ever issued bonuses in this amount, 
cash bonuses contingent----
    Mr. Tauscher. No, I have not.
    Senator Levin. Contingent on performance.
    Do you, Mr. Chalsty, if cash bonuses contingent on 
performance have ever been issued in this amount?
    Mr. Chalsty. No, we have not.
    Senator Levin. Mr. Bollenbach.
    Mr. Bollenbach. I am not aware of them.
    Senator Levin. Thank you. Senator Coleman.
    Senator Coleman. Thank you, Mr. Chairman.
    I want to focus, if I can, on transparency, but I want to 
go back to Mr. Tauscher's comments first.
    In effect, in 1993 when Congress limited compensation to 
the $1 million figure, stock options really then became the 
preferred choice of compensation. Would you agree that the 
growth in stock options or the use of stock compensation was a 
direct result of the law in 1993, which basically allowed you 
to issue options that did not show up on the company's books at 
that point in time as any expense, but at the same time it was 
a way to provide, obviously, compensation for executives and it 
worked out rather well? Is there any question about cause and 
effect between 1993 accounting changes and the growth of stock 
options?
    Mr. Tauscher. Well, Senator Coleman, I do not draw as 
direct a connection, though I will say to you, without 
question, that when the base salary all of a sudden had limits 
in terms of tax deductibility and the other forms of 
compensation did not, I am sure that it had an effect. I am not 
sure it was sort of a direct thing where people said, OK, we 
have to issue a lot more stock options now because we have a 
limit on base salary. But it had to have some connection, 
without question.
    Senator Coleman. And in part of your fiduciary 
responsibility, you want to show growth in the company. If 
there are those things that are going to impact perceived 
growth and you can legally avoid that, there is no nefarious 
purpose here. We simply set in place a process that limited 
executive compensation in one area, but did not limit it in the 
other, and if you want to compensate people, I presume you 
followed the law. Is that right?
    Mr. Tauscher. That is right. But I think there is also a 
factor here that stock options tend to make executives look 
longer term. They are more strategic. They align them more, at 
least in the view of our Compensation Committee, with the 
shareholders as opposed to short-term compensation. Of course, 
base salary has no incentive or no performance part to it. So I 
think there was some of that at work as well.
    Senator Coleman. And I think we are in agreement here, but 
I will express my concern that we are only looking at high-
performing companies here. We also have to look at options that 
are not exercised. Among the proposals that folks have looked 
at is to equalize book value and tax value in year one, so 
companies would get their deductions right up front. But then 
in the end, if the options are not exercised, if the stock goes 
down, your company would have received a deduction but the IRS 
would have nothing because they are never getting taxes from 
the executive on option's if they are not exercised. They are 
not getting any tax revenue from that. So that would be a 
concern, which you mention in your point about bringing all the 
companies in to the equation. Here we have high-performing 
companies. They have done well. We have this graph. And clearly 
these companies have outperformed and have strong performance. 
If you bring in a low performer, however, one whose options are 
not exercised, then, in fact, IRS, the government, would lose 
in that example.
    So I understand, and I am very concerned about this law of 
unintended consequences. I really do believe that in 1993 we 
made a mistake. And in the zeal to say we are going to put a 
lid on executive compensation, it is kind of like squeezing a 
balloon. You squeeze it on one end, and it pops out on the 
other.
    On the other hand, I am deeply concerned about the public 
perception of executive pay. You have all these stories of, as 
I said before, pay for pulse, not pay for performance. So to me 
the issue becomes one of transparency. Can we get investors 
more involved in these things? Can we do things to heighten the 
level of public confidence? Because I think there is a 
consequence if we lose that public confidence.
    Congress is considering a bill that would require publicly 
traded companies to give shareholders an advisory vote on 
corporate compensation committees. I have read that a number of 
companies are out in front of this proposed legislation and are 
already considering adopting such proposals voluntarily. To all 
three of you gentlemen, have your companies considered doing 
so? Why or why not? Mr. Bollenbach.
    Mr. Bollenbach. We have looked at that and have not adopted 
that at this point. I think if it becomes a general practice of 
industry we would adopt such a policy.
    Senator Coleman. Any benefits or negatives to it? What is 
your reaction to it? Rather than just following the herd, is 
there a sense that this would be a positive or negative?
    Mr. Bollenbach. Well, for me, personally, I think it has 
both the potential to be positive in terms of making more 
public the compensation, and it has the possibility of being 
negative because I am concerned about special interest groups 
that really do not represent the shareholders, might have a 
very small holding and be vocal at meetings and vote against 
it. So I think it has both potential for good things and bad 
things.
    Senator Coleman. Mr. Chalsty.
    Mr. Chalsty. We have not adopted that. We have, however, 
looked at it, and we are also, as Mr. Bollenbach says, holding 
a watching brief, if you will, on what happens. I do not really 
see that too much is to be gained by it, but we will watch and 
see what happens.
    Senator Coleman. Mr. Tauscher.
    Mr. Tauscher. I think we are pretty much in the same 
position, Senator. We do have a practice, however, that we have 
initiated in the last few years of going out to our largest 
shareholders and informally talking about aspects of our 
various compensation programs, and that does help in that you 
can get specific discussions on specific issues rather than 
sort of a broad reach thing that may be difficult to interpret. 
We have found that to be a good practice.
    Senator Coleman. My last comment in this round. My sense is 
that folks are cautious and kind of seeing which way the herd 
is going. I would urge you gentlemen to figure out a way to get 
ahead of the pack, because Congress will herd you in a 
direction because the shareholders, our constituents, are 
upset. They cannot understand these widening gaps. They cannot 
understand the pay-for-pulse mentality. And I would urge you, 
rather than kind of see which way the wind is blowing, to 
figure out the direction we can move in to provide greater 
transparency. And I think it would be very helpful. Thank you, 
Mr. Chairman.
    Senator Levin. Thank you. I think each of you has said that 
the potential tax savings are not a factor in terms of the 
number of options that you would grant. Is that correct? I 
think each of you said that is not a factor.
    Mr. Chalsty. Yes.
    Mr. Tauscher. Yes.
    Mr. Bollenbach. Yes.
    Senator Levin. Would you then have no objection if the tax 
rules were changed so that the tax deduction were the same as 
the book value?
    Mr. Bollenbach. Well, for us we do not really have an 
opinion on that, and----
    Senator Levin. So you would not object if the law were 
changed?
    Mr. Bollenbach. No. We really would simply follow the law.
    Senator Levin. But you would not take a position as to 
whether or not the law should be changed?
    Mr. Bollenbach. No. I just truly think that is what the 
government does, is it sets these policies, particularly in the 
area of tax, and companies follow the law.
    Senator Levin. Well, I know that you will follow it, but 
you would not have any position or objection to our changing 
the law to put in sync the book value and the tax return value?
    Mr. Bollenbach. As a company, no.
    Senator Levin. Mr. Chalsty.
    Mr. Chalsty. Chairman, I think we would have no objection 
either. We would follow the law. But I am curious as to exactly 
how you would do that. Are you saying that the companies would 
pay tax--would have to declare it and would not get the tax 
advantage while the recipient would still pay taxes?
    Senator Levin. Sure.
    Mr. Chalsty. Now, it seems to me there is double counting 
there.
    Senator Levin. But in terms of the taxing of the 
corporation, putting aside tax policy, you would not object 
from a corporate point of view?
    Mr. Chalsty. I understand the effect on the corporation, 
but on tax as a whole, it seems to me with the individual 
paying taxes on the award that is given and a company not 
getting a tax write-off, it seems to me that in the total 
package, there is double counting of taxes.
    Senator Levin. I would disagree with you because the person 
who is selling his stock, buying and selling his stock, is 
getting that money from a different source, not from the 
company. So I would disagree with you on that. But in terms of 
your company's position, you would not object if the tax law 
were changed so that your tax deduction was the same as you 
showed on the books?
    Mr. Chalsty. I can only state again the company would 
follow the laws as written.
    Senator Levin. I know, but in terms of lobbying Congress, 
if we were looking at that, would your company take a position 
for or against that change?
    Mr. Chalsty. Chairman Levin, I cannot speak for the company 
as a whole.
    Senator Levin. Fair enough. Mr. Tauscher, do you have any 
objection if the law were changed to put in sync the value on 
the books with the tax deduction amount?
    Mr. Tauscher. I think I would echo something I heard 
Senator Coleman say. I would want to make sure that there had 
been a fairly comprehensive look at the way the numbers really 
work in matching book expense to tax expense. Generally 
speaking, I think matching book and tax expense is a good 
thing. So I am not personally opposed to it--we would certainly 
follow whatever rules were asked, as the other two gentlemen 
said.
    But I do think, as I said in some of my comments, it is 
very important to work with some of the data here because I am 
not sure that when you work with the data comprehensively, look 
at options not expensed, etc., it will turn out in quite the 
same way that the macro numbers that we are talking about here 
today imply.
    Senator Levin. Well, I think that may be--we do not know 
what the macro numbers will turn out to be because we do not 
have the finished product yet from the IRS. We got part of it 
and we are very grateful for it, but it surely suggests 
something very strongly, which is that there is not only a gap 
between the book value for stock options that is taken at the 
time of the grant, but there is an overall significant gap--we 
do not know precisely how much--between that amount and the 
amount that is shown on tax returns by corporations. And my 
question is whether or not all of you who seem to say, well, 
this is not a factor in your compensation, which is--I take 
your testimony and there is no basis to disagree with you. I am 
not on a compensation committee. But I would think that any 
corporation would consider the possibility that if it grants a 
whole bunch of stock options and hoping its profits go up, by 
God, we are going to get a huge tax deduction as well. Our 
executives are going to do very well if our stock price goes 
up--that is the intent--and we get a big tax deduction as a 
result. Wow. How many times does that happen?
    I will take your word for it. It is not a factor that goes 
in your mind, but I think the opposite side of that is what you 
testified to, Mr. Bollenbach. You just would not mind if we 
changed the law to make sure that the tax deduction is no 
different from the book amount. And I think that follows 
logically, and, Mr. Chalsty, your point is perfectly 
appropriate, that the person receiving all the money when he 
sells his stock pays taxes which are larger than the 
corporation got as a tax deduction. I would disagree with your 
conclusion, but it is a fair question. And, Mr. Tauscher, your 
point is certainly fair that you have to look at the overall 
picture, which we do not quite have. We do not know, for 
instance, how many corporations would then get a tax deduction 
for options which are never exercised because the value goes 
down. We know there are some of those, by the way. We do not 
know the amount. But given what has gone on at least recently, 
we would know and believe that it would be a significant 
amount. There would be a significant gap which would remain, 
perhaps not as big percentage-wise because of the reasons 
Senator Coleman gave. Some stock value obviously goes down and 
options are not exercised at the end. But, nonetheless, the 
company got a deduction up front based on Black-Scholes or 
whatever, so that is a legitimate point as well.
    But the key point, which I hope Congress will look into, is 
this gap, and this is a group--we do not know if it is exactly 
that big or this big until the IRS finishes with all of its 
data. But when it does finish with its data, we will have an 
idea as to whether it is that big or this big. But it is there, 
and it represents both a loss to the Treasury, but also it 
represents a fueling of this gap between executive pay and the 
average worker, which has gone up now to an amount that no one 
believed it could ever reach.
    You have all been very helpful. You have been forthright. 
We are grateful to you. We are grateful to your companies. We 
are glad you are profitable. And we appreciate your testimony 
and your being here today. As I pointed out--and I think 
everybody appreciates that this is a case where what is being 
done is legal. We are not looking into something which is 
illegal. And we particularly appreciate people showing up with 
a risk that it will be misunderstood, that what we are doing 
here would be misunderstood. We hope it will not be 
misunderstood. We are looking at a current tax law which has a 
bizarre feature in it which we think needs. I do not want to 
speak for any other Senator, but which I think needs to be 
changed.
    Senator Coleman, do you want to add anything?
    Senator Coleman. Yes, just very briefly. First of all, I 
want to make clear, Mr. Chairman, that I am not sure in the end 
we will be in the exact same place on what we do legislatively, 
but I think this issue has to be looked at. I applaud your 
putting this hearing together. There is a lot of concern out 
there in my State about this issue, and so I think we have got 
to deal with it.
    Just very quickly, Financial Accounting Standard 123R is 
just in effect. Has that at all changed--are you changing your 
view of using stock options? Can you look into the future a 
little bit for me and talk to me about the use of stock options 
as compensation pre-123R versus post FAS 123R? Mr. Tauscher.
    Mr. Tauscher. Well, I can only tell you that we are seeing 
data from various research firms that are being served up as a 
part of our practice with the Compensation Committee that says 
stock options have fallen now as amount issued by almost 30 
percent. So given we are following market, that is a guideline 
that we are trying to do to retain executives. There is no 
question it has had an effect we have not seen yet, and given 
the timing of these options issued being previously granted 
years ago and the new FAS 123 effect just really starting, I 
think we are going to have some changes in these numbers as we 
go forward given the data we are seeing so far.
    Senator Coleman. Mr. Chalsty.
    Mr. Chalsty. We are having a change in the allocation of 
stock options, but the change is really because of the dilution 
effect of stock options. We looked at it, and we have felt that 
the stock options are providing significant dilution to the 
number of shares. So they are being changed for performance-
related stock, and that has the effect of not increasing the 
dilution, but it also has the effect of putting essentially all 
of the management's compensation at risk for performance, which 
we think has been very good.
    Senator Coleman. Can you give me a sense of the scope of 
the change in terms of use of options?
    Mr. Chalsty. Well, options have been reduced. In fact, 
options as such have been eliminated. The company awards SARs, 
stock appreciation rights which have essentially the same 
impact. But there are these performance-related awards which 
are--if the company meets certain criteria going forward, then 
the management will receive these awards.
    Senator Coleman. Mr. Bollenbach.
    Mr. Bollenbach. You know, I am so new to the company that I 
really cannot answer that for you today, but I would be happy 
to have it investigated and respond to your counsel or to you 
directly
    Senator Coleman. Great. Last, I would just comment again 
regarding my point about transparency. The SEC has rules about 
executive pay disclosure. I would urge all you gentlemen and 
others who are listening to look at that disclosure and work to 
make it simpler and make it clearer so your shareholders 
understand what you are paying your executives. I think there 
is concern about confidence, and those things that can be done 
to make disclosures digestible for the average investor, I 
think it would be very helpful and would be very worthwhile.
    Thank you, Mr. Chairman.
    Senator Levin. Thank you, Senator Coleman. And, again, Mr. 
Chalsty, thank you for raising an issue which is an important 
aspect of the stock option issue, which is the dilution issue, 
the average stockholder, by the large number of options when 
they are granted, that is an important issue. It is important 
to stockholders. It is important to us. It is not the focus of 
this Subcommittee, but it is something that we should have 
mentioned. And I am glad that you raised it.
    Thank you all and you are excused.
    Let me now welcome our second panel of witnesses this 
morning: Kevin Brown, the Acting Commissioner for the IRS, and 
John White, the Director of the Division of Corporation Finance 
at the Securities and Exchange Commission.
    Pursuant to Rule 6, as I have mentioned, all witnesses who 
testify before this Subcommittee are required to be sworn, and 
I would then ask both of you to stand and raise your right 
hand.
    Do you swear that the testimony you will give before this 
Subcommittee will be the truth, the whole truth, and nothing 
but the truth, so help you, God?
    Mr. Brown. I do.
    Mr. White. I do.
    Senator Levin. Mr. Brown, let us call on you first, then 
followed by Mr. White. Thank you for being here.

 TESTIMONY OF KEVIN M. BROWN,\1\ ACTING COMMISSIONER, INTERNAL 
                        REVENUE SERVICE

    Mr. Brown. Good morning, Chairman Levin and, Ranking Member 
Coleman. I am pleased to appear before you this morning to 
discuss executive stock options and the book-tax differences 
between financial statements and tax returns filed by 
companies. Former Commissioner Everson met with this 
Subcommittee several times and enjoyed a positive relationship. 
I hope that we can continue that relationship, and I truly 
appreciate the important work that this Subcommittee and its 
staff have performed on behalf of tax law enforcement.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Brown appears in the Appendix on 
page 72.
---------------------------------------------------------------------------
    Let me begin with the difference between taxable income and 
book income, the income companies report under Financial 
Accounting Standards. The goal of tax administration is to 
measure income and deductions in accordance with the provisions 
that Congress establishes in the Internal Revenue Code. The 
goal of financial reporting is to provide data that are 
comparable between companies according to applicable accounting 
standards. Where tax law and accounting standards diverge, 
companies sometimes attempt to show the smallest possible tax 
profit and the largest possible book profit.
    A divergence between tax and book income and deductions is 
reflected in the so-called book-tax difference for stock 
options. This book-tax difference reflects differences between 
the tax and accounting regimes. Absent additional evidence, a 
book-tax difference does not itself indicate noncompliance with 
our tax laws.
    Let me offer a few words about administration of our tax 
laws regarding stock options.
    First, the provisions of the code with respect to stock 
options, with several notable exceptions I will mention 
shortly, have generally not proven difficult for large 
corporations to comply with if they have the requisite 
governance and appropriate recordkeeping. This is true for both 
qualified and non-qualified stock option plans.
    Second, the IRS is generally unable to identify most stock 
option issues until a tax return is filed and an examination 
started. For executive stock options granted under non-
qualified plans, these would be returns for the years in which 
the stock options were exercised, not granted, generally 1 to 
10 years after the date of grant. As a result, stock option 
problems are often identified by others first--the media, 
shareholders, stock analysts, and the Securities and Exchange 
Commission. This was the case most recently with backdated 
stock options.
    Third, the IRS is not responsible for the examination of 
corporate governance with respect to executive stock options. 
Our role is limited to enforcement of those provisions that 
address how corporations and executives must treat stock 
options under the Internal Revenue Code, regardless of the 
motivation for or cause of the noncompliance. Where the Service 
identifies possible stock option or other executive 
compensation noncompliance, we attempt to deliver appropriate 
and focused examination and compliance responses.
    For example, the IRS is undertaking the review of over 180 
companies with confirmed or potential issues with respect to 
the backdating of stock options. We are well underway with our 
work in this area and will carefully scrutinize the tax returns 
and other information of companies implicated in this arena.
    Notably, the Service also addressed the tax shelters that 
involved the improper transfer of stock options to family-
controlled entities. A settlement initiative commenced in 2005 
has resulted in the completion of 156 examinations and assessed 
taxes, penalties, and interest totaling over $211 million.
    The Service appreciates the Subcommittee's keen interest in 
the subject of executive stock options. I look forward to 
answering your questions about the items I have touched upon as 
well as any other areas of interest to you. Thank you.
    Senator Levin. Thank you, Mr. Brown. Mr. White.

     TESTIMONY OF JOHN W. WHITE,\1\ DIRECTOR, DIVISION OF 
    CORPORATION FINANCE, SECURITIES AND EXCHANGE COMMISSION

    Mr. White. Chairman Levin, Senator Coleman, thank you for 
inviting me to testify before you today on behalf of the 
Securities and Exchange Commission on issues concerning stock 
option compensation.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. White appears in the Appendix on 
page 79.
---------------------------------------------------------------------------
    Let me first review the Commission's role in this regard. 
The Commission is a neutral observer in matters relating to the 
form and amount of executive pay. As a disclosure agency, we 
focus on ensuring that a company's disclosure of its 
compensation decisions and practices is sufficiently 
transparent so that investors can properly assess the 
information and reach their own conclusion. It is not the role 
of the Commission to judge what constitutes the right level of 
compensation, correct types of compensation, or to place limits 
on what is paid.
    Sir, as you know--and it has been discussed earlier today--
the growth of equity-based compensation, particularly in the 
form of employee stock options, has been dramatic. In the use 
of option compensation, as it has increased, we have seen both 
abuses and the need for enhanced disclosure and transparency. 
And the Commission has been very active in that regard.
    First, our Division of Enforcement is currently 
investigating more than 140 companies concerning possible 
fraudulent reporting of stock option grants and exercises. 
Including the actions that were announced last week, the 
Commission has charged four companies and 18 individuals 
(affiliated with nine different companies) with improper stock 
option grant practices. Fortunately, future opportunities for 
these kinds of abusive practices have been reduced considerably 
as a result of Sarbanes-Oxley, accounting changes, and a number 
of Commission initiatives. I would like to outline three of 
those initiatives.
    The first is in 2002, following the passage of Sarbanes-
Oxley, the Commission adopted rules requiring that officers and 
directors publicly report the grants of options 2 business days 
after the date of grant instead of after year-end, making 
backdating considerably more difficult.
    Second, in 2004, of course, the Financial Accounting 
Standards Board issued FAS 123R, requiring, in effect, employee 
options to be expensed commencing in 2006.
    And, third, in 2006, the Commission substantially revised 
its executive compensation disclosure rules effective for the 
current 2007 proxy season, including many new disclosures 
relating to options. For the first time, the dollar amount of 
compensation attributable to options must be disclosed. This is 
the same amount that is expensed under FAS 123R. This amount 
must be included as part of the employee's total compensation 
in the disclosure. Separately, and in addition, the full grant 
date fair value of option awards must also be disclosed.
    So those are the principal changes that have been made. I 
would like to take the remainder of my time to briefly describe 
how FAS 123R changed option accounting and to contrast that 
with the tax requirements that Commissioner Brown has 
described.
    Dating back to 1972, under APB Opinion 25, no compensation 
expense was recorded for the typical employee stock option 
grant if the option was granted ``at the money,'' which is what 
most companies did.
    In 1995, FASB changed the rules and issued FAS 123, which 
permitted companies to elect either to expense options or, if 
they made certain footnote disclosures, to continue to follow 
APB Option 25 and record no expense. Most companies elected to 
make the footnote disclosure and continue to record no expense. 
That was in 1995.
    In 2004, of course, the FASB issued FAS 123R, which 
eliminated that election that was available under FAS 123 and 
generally requires the expensing of options. Under this 
approach, compensation expense is based on the option's fair 
value at the date of grant and is recognized over the vesting 
period. Fair value is typically measured using an option 
pricing model such as Black-Scholes.
    In contrast, as Commissioner Brown has described, for tax 
purposes for non-statutory stock options, when an employee 
exercises an option the company is permitted a deduction equal 
to the option's intrinsic value, and the employee recognizes 
ordinary income in the same amount. So that is contrasting the 
two sets of rules.
    Just one final observation. I know your Subcommittee is 
looking at the new aggregate Schedule M-3 data for 2004, and 
FAS 123R did not become effective for most companies until 
2006. So there is no surprise if there is a substantial book-
tax difference for 2004. But starting in 2006, when all 
companies were required to follow FAS 123R, presumably that 
tax-book difference will be less. But I think it is very 
important to realize that even when FAS 123R is fully 
implemented, there will be significant company-to-company 
differences between the book expense and the tax deduction for 
a variety of factors. You have alluded to a number of them, but 
I at least was able to list down four of them, so let me just 
list the four and then I will be done.
    First, the amount involved is calculated differently, fair 
value versus intrinsic value.
    Second, the timing of the measurement of the amount is 
different (the grant date versus the exercise date). And, thus, 
if you have unanticipated movements in stock price, either up 
or down, you will have no impact on the book expense but a very 
significant impact on the tax deduction, as was mentioned on 
the previous panel.
    Third, the period of recognition is different. It is either 
over the vesting period versus at the exercise date.
    And, fourth--and I guess one that often is not mentioned--
the event-triggering measurement and recognition is under the 
control of a different party. It is a company decision to grant 
versus an employee decision to exercise, for whatever the 
employee's circumstances are.
    So, Mr. Chairman, that completes my opening remarks. I 
would be pleased to take any questions.
    Senator Levin. Thank you, Mr. White.
    Mr. Brown, first, let me thank you and thank the IRS for 
performing the data analysis which we requested on the stock 
option material that is in the new Schedule M-3. Your staff was 
helpful and cooperative. We appreciate that. Would you tell us 
about the Schedule M-3 data on the book-tax difference that you 
have put together for us?
    Mr. Brown. Well, roughly 31,000 companies filed Schedule M-
3s; approximately 3,000 of them showed a book-tax difference. 
The net there was about $43 billion, and as you mentioned 
before, Mr. Chairman, a small number of companies contributed 
to a great deal of that. Roughly 250 companies comprised about 
82 percent of the book-tax difference for stock options.
    Senator Levin. Now, of the $43 billion which you indicate 
is the difference, the total book-tax difference for Schedule 
M-3 filers in 2004 with respect to stock options. Is that 
correct?
    Mr. Brown. That is correct, sir.
    Senator Levin. All right. Of the 250 companies which you 
say represented 82 percent of that $43 billion gap, how many of 
the 250 companies represented over half? Do you have that 
offhand? In other words, our figures are that the top 100 
companies represented 56 percent of the gap. Is that something 
that your figures also show?
    Mr. Brown. Yes, that is correct.
    Senator Levin. All right. And the top 50 companies 
represented 42 percent of the gap. Is that what your figures 
show?
    Mr. Brown. Yes, sir.
    Senator Levin. Were you surprised to see that 250 companies 
were responsible for 82 percent of the total?
    Mr. Brown. I do not know if ``surprised'' would be the 
right word. It certainly was a number that piqued my curiosity, 
and when you look at this, part of it is explained by the fact 
that the data is not complete yet, that this requirement is 
just coming online, as Mr. White mentioned. I would actually 
like to look at future years' numbers before I draw a 
conclusion.
    Senator Levin. Does the $43 billion in a single year 
represent a significant differential?
    Mr. Brown. It is a lot of money, yes, sir.
    Senator Levin. Even at the IRS.
    Mr. Brown. Even at the IRS. [Laughter.]
    Senator Levin. Now, there are differences, obviously, which 
we have been discussing this morning, between the financial 
accounting and the tax reporting rules. Have your two agencies 
had any discussions either in the context of stock options or 
on a much broader level of the possibility of having consistent 
reporting of corporate transactions for book and tax? Have you 
had discussions about that issue?
    Mr. Brown. I did not before yesterday. I believe our staffs 
have had some discussions about this.
    Mr. White. I am not aware of any discussions other than the 
ones we have had preparing for this.
    Senator Levin. Do you have any conclusions or opinions on 
the subject, whether there ought to be consistent reporting? We 
will start with you, Mr. Brown.
    Mr. Brown. I do not have an opinion on that. Obviously, we 
like both the symmetry and the precision in the current system. 
It is relatively straightforward. It is easy to administer. We 
like that as tax administrators.
    Senator Levin. Is the amount shown on the books now after 
FASB's rule precise?
    Mr. Brown. I am not an expert in Black-Scholes valuation.
    Senator Levin. Mr. White, is the amount that is shown on 
the books a precise amount now? In other words, once it is on 
the books, is it a precise amount?
    Mr. White. Once the amount is determined at the date of 
grant, it remains fixed.
    Senator Levin. Would you say ``fixed'' is the same as 
``precise''?
    Mr. White. Yes.
    Senator Levin. All right. So that once the method is 
utilized and the dollar figure is determined, it is a precise 
figure and it is on the books. Is that correct?
    Mr. White. That is correct.
    Senator Levin. And you are interested in precision, aren't 
you, Mr. Brown?
    Mr. Brown. Yes, sir.
    Senator Levin. Is that a precise figure, then?
    Mr. Brown. Obviously, our agents would have to educate 
themselves about Black-Scholes and the other methods for----
    Senator Levin. No, not how it is reached, but is the figure 
that is on the books a precise figure?
    Mr. Brown. I will take his word for it that it is precise, 
yes.
    Mr. White. I might clarify that in some cases companies 
follow the liability method and you could have a variable 
number.
    Senator Levin. Right. I understand. But whichever method is 
used, after the method is utilized, there is a specific figure 
that is put on the company's books. Is that correct?
    Mr. White. That is correct, sir.
    Senator Levin. OK. And that would be precise from your 
definition of ``precise,'' Mr. Brown?
    Mr. Brown. Yes, sir.
    Senator Levin. Are stock options the only kind of 
compensation that you are aware of, Mr. Brown, where the 
corporation gets to deduct more than the expense shown on its 
books?
    Mr. Brown. Yes.
    Senator Levin. In those cases where the price of the stock 
that is sold after the exercise of the option is greater than 
the price that is shown on the books, that is what we are 
referring to.
    Mr. Brown. They are the only ones that I am aware of.
    Senator Levin. And we do not know whether that represents 
60, 70, 80, or 90 percent. It would depend on the stock market 
and a lot of other things. Is that correct?
    Mr. Brown. Yes.
    Senator Levin. But in your analysis that you have done of 
that 1 year, that seemed to represent a significant percentage 
of the gaps.
    Mr. Brown. Yes. It is the third largest number behind 
depreciation and reportable transactions.
    Senator Levin. All right. Senator Coleman.
    Senator Coleman. One of the questions that comes up is the 
valuation models with Black-Scholes or binomial lattice models, 
kind of the two used most often?
    Mr. White. Yes, they are.
    Senator Coleman. Is your sense, Mr. White, that they 
provide an accurate--we have looked at, obviously, some of the 
figures provided by the Chairman, and clearly there is a 
question whether these are accurate means of estimating option 
values. Have you assessed the accuracy of these SEC-approved 
valuation models? Are there other options that are out there?
    Mr. White. ``SEC approved'' is probably not exactly the 
terminology I would use. FAS 123R was a rule that came about 
through the deliberative process that occurs at the FASB, which 
is an independent standard setter which is overseen by the SEC. 
Obviously, FASB went about this process over a substantial 
period of time and came to the conclusion that using a model is 
an acceptable way of doing this. Black-Scholes is the model 
that has emerged as the most common one.
    Senator Coleman. Companies have flexibility, as I 
understand it, in choosing the model. They do not have to use 
Black-Scholes. They can use something else. Is there some 
value, some benefit, in requiring all companies to use the same 
valuation model? Or is there some concern that standardization 
would result in less disclosure? Why the flexibility? And is 
there an issue with standardization?
    Mr. White. Again, the rules were set by FASB here, and 
given in this world where I think we are focused on principles-
based accounting, their decision to provide some latitude in 
terms of the method would seem to make sense.
    What FASB said was that the best choice would be a model 
that looked at a market-based instrument that was similar or 
the same as the options. But if that is not available, then you 
should look at a model that met--there were a number of 
criteria that are listed in the rules that the model needs to 
meet, and Black-Scholes and the lattice model in most 
circumstances meet those criteria. But, I mean, certainly the 
rule gives you some flexibility to choose the method.
    Senator Coleman. One of the things that we do not have in 
front of us, because we do not have the data yet, is the impact 
of this gap, tax-book gap, post-FAS 123R. Do we have any sense 
as to whether most publicly traded companies report similar 
gaps once FAS 123R is in effect? Do we have any data as to--
and, again, it is early, but can you give us a sense, perhaps 
Mr. Brown, or even Mr. White, of where we are going with post-
use of FAS 123R?
    Mr. Brown. We do not have any data to offer, anything more 
than just a guess.
    Senator Coleman. As I listened to the data from the 
Chairman, if I am correct, 82 percent of the gap comes from 250 
companies. I think you indicated that the $43 billion results 
from a survey of 3,200 companies, so there are about 3,000 
companies that have--82 percent from 250, so 18 percent results 
from the rest, the 3,000 companies. My sense is that the book-
tax gap is not as large for a large number of companies that 
issue stock options even before FAS 123R. And, again, I am 
trying to get a sense of where we are going to be after FAS 
123R.
    Mr. Brown. I think one of the problems was the rule was 
not--it is just coming online, so it is difficult to predict.
    Senator Coleman. What do you do with the issue--one of the 
concerns that I--again, look back, and my sense is that the 
changes that we made in 1993, in Section 162(m) which capped 
companies' deductions for salaries paid to top executives, 
caused companies to switch from cash to stock option 
compensation. They are giving compensation--the value of the 
company is not diminished in terms of an SEC perspective, 
though there are these obligations out there. And yet those are 
real obligations. In the end, when they capitalize on those 
obligations, this huge benefit to the individual, and also 
benefit to the company by way of the deduction. So that is the 
world that the Congress created with Setion 162(m).
    My concern is as we go--if the solution is one in which we 
kind of cap--equalize tax value and book value early on, for 
instance, in the scenario if the market is not rising and, in 
effect, we give deductions up front based on what we project 
equalizing tax and book value, and if options are not exercised 
or if there is a diminution of stock price, what happens in 
terms of monies coming to the IRS?
    Mr. Brown. Well, you would have the deductions claimed in 
the years during the vesting period, and you would not have 
income recognized by the employee on the back-end if the stock 
was not in the money.
    Senator Coleman. So you would have shadow deductions. You 
would have deductions taken with the company, in effect, not 
giving anything to the--they would get the value of the 
deduction but, in fact, not submitting anything to the IRS.
    Mr. Brown. You would lose the symmetry there.
    Senator Coleman. So how do you account for that? How do you 
find a system that does not have that problem?
    Mr. Brown. Well, the current system does not have that 
problem because you match exactly the income with the 
deductions.
    Senator Coleman. Again, I keep wanting to get back to 
disclosure, disclosure, disclosure, disclosure.
    Last question, Mr. White. The SEC has provided new proxy 
disclosures. How satisfied are you with them? Could we push the 
envelope on proxy disclosures?
    Mr. White. Well, the new disclosures are just coming in, in 
the month of--in April, May, and June, so in terms of a 
thorough analysis of them, we are just starting that process, 
actually in my division. But as a general matter, I think we 
are optimistic and pleased.
    One of the concerns that has been expressed is one that you 
have alluded to several times this morning of how well people 
have done in following plain English and in clarity in writing 
the new disclosures. I know Chairman Cox has commented on that 
as well, that is probably an area that is going to require a 
little bit of work, and is one of the things we are looking at.
    But I think as a general matter, just as a preliminary 
look, we are pretty happy with what has come in.
    Senator Coleman. We look forward to working with you on 
that issue. It is important. We have seen it with our review of 
credit card companies and disclosures to individuals there, 
and, again, concern to the average shareholder. I think they 
are at a substantial disadvantage today with the lack of easy 
access to information, so hopefully this will be a step in the 
right direction.
    Thank you, Mr. Chairman.
    Senator Levin. Thank you. Mr. Brown, under the current FASB 
system, when options are granted to employees, the companies 
take an expense now. Is that correct?
    Mr. Brown. That is correct.
    Senator Levin. And that is true whether or not the employee 
gets any benefit from it at all. For instance, if the stock 
becomes worthless, the employee would get no benefit 
whatsoever?
    Mr. Brown. That is correct.
    Senator Levin. Do you support the FASB rule?
    Mr. Brown. It is sort of out of my province.
    Senator Levin. Mr. White, do you support the FASB rule? 
Does SEC support the FASB rule?
    Mr. White. The SEC believes that the FASB has gone through 
the appropriate deliberative process to pass the rule, and we 
have reviewed that as they have gone along, and through our 
oversight role of the FASB in this regard, we are satisfied.
    Senator Levin. OK. So assuming that it is a satisfactory 
rule now, Mr. Brown, it does result in the company being able 
currently to take an expense. Is that not correct?
    Mr. Brown. That is correct.
    Senator Levin. On its books.
    Mr. Brown. That is correct.
    Senator Levin. Even though there may not be any benefit 
whatsoever to the taxpayer.
    Mr. Brown. That is correct. To the employee, the employee 
tax----
    Senator Levin. Potential tax----
    Mr. Brown. That is right.
    Senator Levin. Employee taxpayer. Do you have a problem 
with that?
    Mr. Brown. My area is making sure that the deductions and 
the income are properly reported, so what happens with regard 
to the books is not an area the IRS focuses on.
    Senator Levin. You are going to receive, I believe, the 
2005 data sometime later this year. Is that correct, Mr. Brown?
    Mr. Brown. That is correct.
    Senator Levin. And then as soon as that information becomes 
available, will you make the same kind of analysis of that data 
as you did for the 2004 data for this Subcommittee?
    Mr. Brown. Yes, sir.
    Senator Levin. And let us know what the results are?
    Mr. Brown. Yes.
    Senator Levin. Then would you at that time also include an 
estimate of what the revenue effect would have been for 2005 if 
the stock option tax deduction had matched the stock option 
book expense? Are you going to be able to do that for us?
    Mr. Brown. Yes, sir. We will give it our best try.
    Senator Levin. OK. I know Senator Coleman has a number of 
other things he is trying to cover this morning, so he is 
covering a lot of territory.
    Thank you both very much for your testimony and for your 
cooperation.
    We will call our third panel. Let us now welcome our final 
panel of witnesses for this morning's hearing: Lynn Turner, 
former SEC Chief Accountant; Professor Desai, the Arthur Rock 
Center for Entrepreneurship Associate Professor at Harvard 
University's Graduate School of Business Administration; and 
Jeff Mahoney, who is General Counsel of the Council of 
Institutional Investors.
    We welcome you to this Subcommittee. In the case of Mr. 
Turner, we are going to welcome you back to the Subcommittee. 
You testified before this Subcommittee in 2002 on the role of 
financial institutions in Enron's collapse, and it is still 
very much an issue in the news and the courts. We appreciated 
your testimony then.
    Mr. Turner. Thank you, Senator.
    Senator Levin. Under Rule 6, again, all witnesses who 
testify are required to be sworn. We would ask that each of you 
stand and raise your right hand.
    Do you swear that the testimony you will give before this 
Subcommittee today will be the truth, the whole truth, and 
nothing but the truth, so help you, God?
    Mr. Turner. I do.
    Mr. Desai. I do.
    Mr. Mahoney. I do.
    Senator Levin. You were here for the explanation of the 
timing system, I believe, and we will have you, Mr. Turner, go 
first, followed by Professor Desai, followed by Mr. Mahoney. 
And, again, we appreciate your appearance here today.

TESTIMONY OF LYNN E. TURNER,\1\ FORMER SECURITIES AND EXCHANGE 
       COMMISSION CHIEF ACCOUNTANT, BROOMFIELD, COLORADO

    Mr. Turner. Thank you, Chairman Levin, as well as Ranking 
Member Coleman, for inviting me here today. I think this issue 
of stock options is certainly an important issue, so I commend 
both of you for holding this hearing in this Subcommittee.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Turner appears in the Appendix on 
page 90.
---------------------------------------------------------------------------
    My views, I am going to try to summarize in light of the 
time we have here, so I would ask that the written testimony be 
entered into the record.
    Senator Levin. It will be made part of the record, as will 
all the testimony.
    Mr. Turner. My views are also going to be fashioned based 
on the fact that I currently serve as a corporate board member, 
also a member of trustees of a mutual fund who invest in these 
companies, having served in my prior life as a chief financial 
officer and SEC Chief Accountant as well as managing director 
of an investment proxy and financial research firm. And 
certainly, as you have mentioned, the issue of executive 
compensation has been one that has attracted a lot of interest 
in the past, regardless of the perspective from which one 
observes it. However, in the past decade, many of the 
newspapers on the front pages have heralded the excesses in 
compensation at more than just a few public companies. 
Certainly these excesses are due in no small part to abuses in 
the use of stock options. Recent decisions of the Delaware 
courts have highlighted the activities of illegal backdating 
and spring-loading of options and the lack of transparency 
surrounding that process, as well as the lack of fiduciary 
fulfillment of their obligations on the part of directors. And 
research has suggested that during the period from 1996 to 
December 2005, over 13 percent of all stock option grants were 
done inappropriately and manipulated in some fashion or form.
    But backdating has not been the only option. We have seen 
re-pricing of stock options become all too common in a 
situation where, in essence, the holders of those options were 
given a mulligan when the prices went down that obviously the 
average investor--the 90 million Americans investing in these 
companies were not given the same economic benefit.
    We have seen over 1,000 occasions where public companies 
have accelerated the date on which options were considered 
vested such that employees did not even have to work the entire 
time they were supposed to work for those options. And in some 
cases, that resulted in great intrinsic value going to the 
people who held those options.
    We have heard a lot of discussion this morning about the 
new FASB accounting pronouncement, FAS 123R, and yet no sooner 
was the ink drying on that document than people were trying to 
get around how the calculation was made. And it brought on some 
practices, including manipulation of key assumptions. It 
appears that they are once again managing the numbers that are 
reported to investors as opposed to really trying to manage the 
business.
    On this point, I would just like to say, Chairman Levin, 
you deserve tremendous kudos, because when the fight was on 
about whether or not to really show the true economic value of 
these options and the financial statements, you yourself were a 
key supporter in improving the transparency for investors in 
that regard. And as an investor, I would just like to thank you 
and the other Members of Congress who helped get us where we 
needed to be on that.
    But I guess my biggest concern, when you look at the abuses 
and you look at things on options, is that there has been now 
more than one--a number of economic studies by academics that 
indicate that there is a direct linkage between the use of 
stock options and heightened fraud in public companies. I do 
think that options have become like an addictive drug for 
executives because of the tremendous upsides that are there. I 
am certainly not the only one. Former Federal Reserve Chairman 
Paul Volcker has also raised some of the same type of concerns.
    In light of that, I think we ought to really consider what 
steps can be taken to help foster good governance and 
management and lawful behavior and greater transparency. And I 
think it can.
    As a former business executive and partner in a major 
international accounting firm, I have seen up front how income 
tax laws and regulations do affect business decisions, 
sometimes in a negative fashion. It should be no surprise that 
my experience has shown that management often tries to maximize 
both the amount and timing of expense deductions for income tax 
purposes while minimizing them for purposes of financial 
reporting to investors. It is simply a matter of minimizing net 
income for tax purposes and maximizing net income reported to 
investors.
    Income tax deductions can have a very significant impact on 
the cash flow of any company, and so it behooves management to 
maximize them. And, of course, the analysis of any stock option 
program is going to include the impact of the cost to the 
company on a net basis, after factoring in any benefits from 
income tax deductions. As such, these tax implications also 
provide a strong incentive for management to see how close to 
the line they can get when preparing their income tax returns 
and encourage taking of aggressive income tax positions. This 
is especially true for public companies. And as we have seen 
with recent corporate scandals, some seem blinded to when they 
are getting close to the line as opposed to going over it.
    As a result, I would strongly recommend the creation of tax 
legislation and regulations that would foster a consistent 
calculation of the amount of the deduction for the fair value 
of options for both financial reporting and income tax 
purposes. I firmly believe there is an economic cost to the 
issuance of options. That cost should not vary simply because 
it is reported to the Internal Revenue Service on a Form 1120 
as opposed to investors on a Form 10-K.
    Unfortunately, current income tax regulations have created 
incentives that have led to the abuses noted earlier and should 
be considered for appropriate modifications. In that regard, I 
echo some of the comments of Ranking Member Coleman with 
respect to Section 162(m).
    Legislation that did result in symmetry would create a very 
positive incentive for companies to stop manipulating and 
minimizing the amount of expense they report to investors. 
Rather, it would result in a more balanced approach in which 
both transparency for investors and income tax considerations 
would be balanced. In essence, the desire to report higher 
earnings to investors by manipulating the amount of stock 
option expense downward would be appropriately balanced by the 
desire to maximize income tax deductions, and in doing so 
maximizing cash flow.
    Legislation giving shareholders an advisory vote on 
compensation, such as that recently passed in the House, should 
also be adopted. Many foreign countries such as the United 
Kingdom, the Netherlands, and Australia have already adopted 
such legislation, and it is an important part of their 
regulatory scheme, and I think would be important to the 
competitiveness of our U.S. capital markets.
    Finally, I believe active and appropriate oversight by the 
SEC of reporting of executive compensation is needed as well. 
Actions taken to date indicate that many responsible for the 
option backdating scandal will either never be known or will 
avoid accountability for behavior outside the law. We have over 
260 companies announce that they are investigating for option 
backdating. Academic research indicates that there are hundreds 
more that have never come out and fully disclosed it. As we 
heard from the SEC earlier this morning, despite several 
hundred cases, we have only had four cases brought against 
companies to date, and only 18 executives, which is basically a 
drop in the bucket compared to what is happening. That is 
hardly what I would call an effective law enforcement system. 
Likewise, the use of models to fair value options that are 
intended simply to minimize and manipulate the value of stock 
options should be more closely examined by the SEC and 
prohibited.
    That concludes my remarks, and I would be happy to take any 
questions.
    Senator Levin. Thank you, Mr. Turner. Professor Desai.

   TESTIMONY OF MIHIR A. DESAI,\1\ ARTHUR M. ROCK CENTER FOR 
   ENTREPRENEURSHIP ASSOCIATE PROFESSOR, HARVARD UNIVERSITY, 
      GRADUATE SCHOOL OF BUSINESS ADMINISTRATION, BOSTON, 
                         MASSACHUSETTS

    Mr. Desai. Chairman Levin and Senator Coleman, it is a 
pleasure to appear before you today. I am an Associate 
Professor of Finance at Harvard Business School, where I 
conduct research on corporate finance and public finance and 
their intersection, specifically about how taxation influences 
firm behavior.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Desai with attachments appears in 
the Appendix on page 95.
---------------------------------------------------------------------------
    Independently, the topics of financial accounting, tax 
accounting, and stock options are extremely confusing. Taken 
together, they can be overwhelming and, frankly, mind-numbing. 
While my written comments below are much more nuanced, I 
thought I would begin with a thought experiment that I have 
found helpful for simplifying the relevant issues and then 
summarize five conclusions that are detailed in my written 
comments.
    Imagine if you were allowed to represent your income to the 
IRS on your 1040 in one way and on your credit application to 
your mortgage lender in another way. In a moment of weakness, 
you might account for your income favorably to your prospective 
lender and not so favorably to the IRS. You might find yourself 
coming up with all kinds of curious rationalizations for why 
something is an expense for the tax authorities but not an 
expense to the lender.
    You do not have this opportunity and for good reason. Your 
lender can rely on the 1040 they review when deciding whether 
you are creditworthy because you would not overly inflate your 
earnings given your desire to minimize taxes. Similarly, tax 
authorities can rely on the use of the 1040 for other purposes 
to limit the degree of income understatement given your need 
for capital. The uniformity with which you are forced to 
characterize your economic situation provides a natural limit 
on opportunistic behavior.
    While individuals are not faced with this perplexing choice 
of how to characterize their income depending on the audience, 
corporations find themselves in this curious situation. A dual 
reporting system is standard in corporate America and, judging 
from recent analysis, the system can give rise to opportunistic 
behavior. As we have heard today, a significant cost for 
corporations--the cost associated with compensating key 
employees with stock options--was until recently treated as an 
expense for tax purposes but not for financial accounting 
purposes. This can be viewed as the most advantageous way to 
treat an expense--reducing the firm's tax liability while not 
detracting at all from its financial bottom line.
    Recent changes in financial accounting have changed this 
asymmetry so that there is now an expense associated with stock 
options, but a considerable difference still exists with tax 
rules. Specifically, the amount and timing of the deduction are 
distinctive. Grant and exercise values, as well as their 
timing, will differ significantly. Historically, the 
distinctive treatment of stock options has contributed 
significantly to the overall difference between financial and 
tax accounting reports, as shown in my work and recent work 
based on the Schedule M-3 reconciliation.
    Does this situation make sense? In order to consider this 
question, my written statement reviews the nature of the dual 
reporting system in the United States, the debate over changing 
this system to one where conformity would be more common, the 
international experience with increased conformity, evidence on 
the behavioral consequences of stock options, and international 
variation on the tax treatment of stock options. Several 
conclusions emerge.
    First, as suggested by the example above and further 
elaborated on below, the dual reporting system can enable 
opportunistic behavior by managers at the expense of both 
investors and tax authorities. This insight, from an emerging 
body of work labeled the ``corporate governance view of 
taxation,'' suggests that tax authorities can be meaningful 
monitors that complement the activities of shareholders 
concerned with opportunistic insiders. Under the current dual 
reporting system, it is impossible for investors to tell what 
firms pay in taxes. A major part of a cost structure of a firm, 
its tax payments, are completely unavailable to an investor, 
and this clouds what a firm's true economic performance is. The 
evolution of the two parallel universes of financial and 
accounting reporting systems appears to be a historical 
accident rather than a manifestation of two competing views of 
what profits should be. Aligning tax definitions with financial 
accounting standards can have payoffs to investors and tax 
authorities, can lower compliance costs of the corporate tax, 
and potentially allow for a lower corporate tax rate on a wider 
base. Concerns over greater alignment between tax and financial 
accounting are important, but many of these concerns are 
overstated, as I discuss below.
    Second, changing financial accounting standards has 
stimulated debate worldwide on the virtues of greater 
conformity. Many countries, including notably the United 
Kingdom, have shifted toward greater alignment of tax and 
accounting reports with little apparent disruption. More 
broadly, tax authorities in many countries in the European 
Union explicitly reference financial accounting treatments in 
several parts of the tax treatment of corporations. Indeed, the 
European Union is contemplating yet a more aggressive alignment 
between tax and accounting rules. The relative segregation of 
financial accounting and tax treatment of corporate income 
appears to make the United States somewhat anomalous by 
international standards. By itself, this international 
experience is informative but hardly decisive as the United 
States may choose quite different rules for good reasons. 
Nonetheless, it is enlightening to see that increased 
conformity can work and need not represent a doomsday outcome 
as some have suggested.
    Third, stock options are a critical part of our economic 
system today. They are extremely valuable tools that have 
numerous benefits and several costs. Their use is influenced by 
their accounting treatment and by their tax treatment. Research 
is quite clear on this. As such, changing the accounting and 
tax treatments of stock options can be expected to change their 
use. Existing evidence, though scant, is consistent with the 
recent increased disclosure limiting the use of stock options 
but also with investors appreciating the disclosure and 
changing their valuations of firms accordingly.
    Fourth, there exists considerable variation internationally 
on the tax treatment of stock options. In particular, some 
countries, such as Canada, do not allow any tax deduction for 
stock options while others take the deduction at the time of 
grant and others follow the United States and provide a 
deduction at the time of exercise. Again, this international 
experience is informative but hardly conclusive as the United 
States may choose quite different rules given that stock option 
compensation is much more central to compensation in the United 
States than elsewhere. Nonetheless, it is enlightening to 
realize that there are many different ways to solve this 
problem and that the current situation is not a natural 
solution.
    Fifth, and finally, bringing the tax treatment of stock 
options into alignment with the recent changes to the 
accounting treatment has a number of virtues. First, it would 
make the tax treatment consistent with the accounting 
profession's well-reasoned analysis of when this deduction is 
appropriate and what the right amount of the deduction is. 
Second, as with other movements toward greater alignment, 
reducing the reporting distinction in how managers are paid can 
create greater accountability and reduce distortions to the 
form of managerial compensation. Third, there is limited reason 
to believe that the purported costs typically attributed to 
greater alignment between tax and financial accounting would be 
relevant in this setting. There are a number of nontrivial 
complications associated with such a change, particularly 
related to the matching principles and issues that came up 
previously. While these complications are nontrivial, they can 
be overcome readily if legal and political will exists.
    In sum, this example of increased alignment between 
financial and tax accounting has much to recommend it and need 
not be viewed as a radical departure from global practice. It 
will still allow for the many benefits of incentive 
compensation to accrue to the U.S. economy without continuing 
the distortions associated with the current anomalous 
distinction between tax and accounting reports.
    Thank you, Mr. Chairman, for the opportunity to share these 
views, and I look forward to answering any questions.
    Senator Levin. Thank you, Professor Desai. Mr. Mahoney.

TESTIMONY OF JEFFREY P. MAHONEY,\1\ GENERAL COUNSEL, COUNCIL OF 
            INSTITUTIONAL INVESTORS, WASHINGTON, DC

    Mr. Mahoney. Chairman Levin, I am Jeff Mahoney, General 
Counsel of the Council of Institutional Investors. I am pleased 
to appear before you today on behalf of the council. The 
council is a not-for-profit association of more than 135 
public, labor, and corporate pension funds with assets 
exceeding $3 trillion. Council members are generally long-term 
shareowners responsible for safeguarding assets used to fund 
the pension benefits of millions of participants and 
beneficiaries throughout the United States. Since the average 
council member invests approximately 75 percent of its entire 
pension portfolio in U.S. stocks and bonds, issues relating to 
U.S. corporate governance are of great interest to our members. 
The council has long believed that executive compensation is 
one of the most critical and visible aspects of a company's 
governance. Analyzing and evaluating pay decisions, including 
decisions involving the granting of executive stock options, is 
one of the most direct ways for shareowners to assess the 
performance of boards of directors. As a result, approximately 
one-half of the council's corporate governance ``best 
practices'' policies focus on executive compensation issues. In 
recent months, the council has been active on three important 
corporate governance fronts involving executive stock options.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Mahoney with attachments appears 
in the Appendix on page 124.
---------------------------------------------------------------------------
    First, in March of this year, the council's general 
membership approved a revision to the council's corporate 
governance policies that recommended that companies provide 
annually for advisory shareowner votes on compensation of 
senior executives. In approving this policy, council members 
generally agreed that an annual advisory vote on executive 
compensation would benefit investors and company governance 
because it would provide a mechanism for shareowners to provide 
ongoing input to company boards on how a company's general 
compensation policies for executives, including their policies 
relating to stock options, are applied to individual pay 
packages of those executives.
    Second, the council has publicly raised concerns about the 
Securities and Exchange Commission's December 2006 amendments 
to the Commission's new proxy statement disclosure rules on 
executive compensation and related-party disclosures. Those 
amendments, we believe, lessened the usefulness of the 
information contained in company proxies by changing the 
requirements for the reporting of the amount of executive stock 
option and equity-based awards that appear in the new summary 
compensation table in those disclosures. As a result of the 
change, the summary compensation table, as now revised by the 
amendments, no longer informs investors of the compensation 
committee's current actions regarding executive stock options 
and similar equity-based awards. Moreover, the change sometimes 
results in the reporting of a negative compensation amount 
which I believe most parties would agree is not particularly 
useful information when assessing the performance of 
compensation committees. We, however, are pleased that the SEC 
staff has publicly acknowledged our concerns and other investor 
concerns that have been raised about the initial implementation 
of the new rules. The SEC staff has indicated that they are 
initiating a review project that will result in a report this 
fall that analyzes the first year compliance with the new 
rules, and we look forward to reviewing and commenting on the 
report.
    Finally, we have been monitoring the implementation of the 
FASB's Statement 123R. That standard, which became effective 
last year for most companies, is important to investors 
because, as the Chairman knows, it closes a significant 
loophole in financial reporting. That loophole had a number of 
effects, one effect being that it encouraged companies to issue 
an excessive amount of so-called fixed-price stock options to 
the exclusion of other forms of stock options and other forms 
of compensation that are more closely linked to long-term 
performance; and, second, the loophole also had the effect of 
permitting companies to understate their compensation costs, 
thereby distorting their financial reports and as a result 
diverting investment and capital resources away from their most 
efficient employment.
    The ongoing stock option backdating scandal provides a 
reminder that the financial accounting and reporting for 
executive stock options is an area in which there is a high 
risk of misapplication of reporting requirements. The council, 
therefore, has been advocating that audit committees, external 
auditors, the Public Company Accounting Oversight Board, and 
the Commission should all actively support the high-quality 
implementation of the new FASB standard on accounting for stock 
options. In that regard, representatives of the council staff 
and the CFA Institute recently met with staff of the SEC's 
Office of the Chief Accountant to discuss our concerns about 
the potential use in financial reports of prices that Zions 
Bancorporation has received in its recent offerings of a 
financial instrument they developed called ``Employee Stock 
Option Appreciation Rights'' or ``ESOARS.'' Zions has proposed 
that the price for its ESOARS qualify as a market-based 
approach for valuing stock option awards for financial 
reporting purposes for its own options and they plan to market 
this product, to other public companies as well.
    After consulting with leading valuation and accounting 
experts from around the country, the council staff has 
concluded that, as presently constructed, Zions ESOARS results 
in a downward biased valuation for stock option awards. The 
lowball valuation would systematically underreport compensation 
costs, thereby distorting company financial reports. The 
council, therefore, has respectfully requested that the Office 
of the Chief Accountant prohibit Zions and all other public 
companies from using Zions ESOARS for financial reporting 
purposes unless and until the fundamental failings of the 
product have been remedied.
    We look forward to continuing to work cooperatively with 
the SEC, this Subcommittee, and other interested parties to 
address these and other corporate governance issues relating to 
executive stock options. Our goal is to ensure that the issues 
are resolved in a manner that best serves the needs of 
investors and the U.S. capital market system.
    Thank you, Mr. Chairman, for inviting me to participate at 
this hearing. I look forward to the opportunity to respond to 
any questions.
    Senator Levin. Thank you, Mr. Mahoney.
    This is an issue which was raised with the first panel, not 
exactly the focus of the hearing, but I think it is important 
that we get your comments on it. Given the millions of options 
that are being handed out to executives, does that have a 
negative effect on existing shareholders, other shareholders? 
Mr. Turner, what is the effect of the large number of stock 
options granted particularly to executives on the other 
shareholders? Does it water down their stock?
    Mr. Turner. Certainly, if you look over the years, the use 
of options has grown, especially since the mid-1980s, and that 
has resulted in a significant increase in the growth of 
overhang and dilution and potential dilution to existing 
shareholders. In fact, if you looked at reports that have been 
put out by rating agencies such as Fitch's, they have noted 
that it has actually become a significant drain on investor 
assets and that to avoid increasing dilution, many companies 
have had to go out and spend cash on fund share buybacks. And 
as a result, it has certainly had a significant impact, 
negative impact on cash. So the significant growth in the use 
of options has had a very real impact. I think it is why the 
Conference Board in part recommended and others have 
recommended--and I certainly think it is a good 
recommendation--that companies start to look at other vehicles 
such as restrictive stock, which I know has gotten increasing 
use in recent years.
    Senator Levin. Thank you. Professor Desai.
    Mr. Desai. I think the major consequence for other 
shareholders is not quite so much the dilution issue as the 
behavioral response to the stock options, and by that I mean 
two things. One is, on the positive side, it makes them 
potentially more performance oriented. And on the negative 
side, it has been shown to, first, increase risk taking; 
second, it has been associated with more aggressive accounting 
treatments; and, third, it is questionable whether there is a 
way to have CEOs set their own pay in an arm's-length way.
    So to me, the major consequences to the other shareholders 
are all the behavioral responses that the CEO undertakes, which 
can be potentially good and can in many cases be quite 
negative, and it has been shown to be negative.
    Senator Levin. Thank you. Mr. Mahoney.
    Mr. Mahoney. The council agrees that the potential dilution 
represented by stock options is a direct cost to shareholders. 
As I pointed out in my testimony, we prefer that compensation 
be performance based, and prior to FAS 123R, many of the stock 
options granted were not performance based. And that is why we 
supported the expensing of stock options.
    Senator Levin. The IRS has now released the data showing 
that overall in 2004, about 3,200 corporations claimed $43 
billion more in stock option expenses on their tax returns than 
they reported to investors on their financial statements. Mr. 
Turner, does that number surprise you?
    Mr. Turner. No, not at all, especially given the accounting 
rules at the time. But I think that even when you get good data 
for 2005 and subsequent years after the implementation of FAS 
123R, I suspect that you are still going to see that the 
deduction for tax purposes runs ahead of what it is for book 
purposes. Perhaps the best indication of that is if business 
and tax lobbyists obviously thought that they were going to get 
a bigger deduction for FAS 123R, I suppose they would be at 
your desk signing up to support you. And so far I have not seen 
anyone standing outside your door looking to support you on 
that, so I think that probably is a pretty good indication of 
which one is going to be the bigger deduction for them.
    Senator Levin. Professor Desai.
    Mr. Desai. No, it does not. Those numbers jibe with numbers 
that myself and others produced prior to the Schedule M-3 
reconciliation being available, so they do not surprise me. And 
I should mention nor does the concentration of that gaps 
amongst a relatively small set of firms surprise me. That, too, 
is something that has been in the data for a while and is 
clearly true.
    Just by way of perspective, the reason that is so 
concentrated is because, in fact, market values of firms are 
highly concentrated. So I think those numbers make a lot of 
sense.
    Senator Levin. Thank you. Mr. Mahoney.
    Mr. Mahoney. No, it does not surprise me. It is my 
understanding that financial reporting and tax reporting 
historically have had very different purposes. Where financial 
reporting attempts to reflect the underlying economic substance 
of an activity in the periods that that activity occurs, tax 
reporting has not always had economic substance as an 
underlying factor. I am not an expert on tax accounting, but 
certainly there are a number of areas of tax law where the 
underlying economic substance of the activity is not the basis 
for the tax treatment.
    Senator Levin. Well, as far as we can tell, the only type 
of compensation where corporations are allowed to deduct from 
their tax as an expense that is larger than the expense on 
their books is stock options. Is that your understanding, too? 
Do any of you know of any other form of compensation where that 
is true?
    Mr. Turner. Senator, I heard you ask that question of the 
IRS Commissioner, and I think he confirmed that is true. 
Certainly, as I was thinking about that, I tried to think back 
to days when I was signing these income tax returns, and I 
think that was certainly consistent with what my understanding 
was.
    Senator Levin. Professor Desai, do you know of any other 
example of this?
    Mr. Desai. No, I do not. I will say that there is a 
dizzying array of new financial contracts being awarded to 
management, and it is not clear to me that all of those--for 
all of those things this is true. So I do not quite know, but I 
think the IRS Commissioner----
    Senator Levin. Do you know any, Mr. Mahoney?
    Mr. Mahoney. No, I do not.
    Senator Levin. For each of you, looking at the new rule, 
FAS 123R, would you say that the--first of all, do you support 
the rule? Do you think it is a good rule? Mr. Turner.
    Mr. Turner. I think getting the expensing of stock options 
into the financial statements and really showing a true picture 
to investors was long overdue and a good rule. There are pieces 
of it that I would probably change, but overall I think it was 
a very good rule.
    Senator Levin. Professor Desai.
    Mr. Desai. Agreed.
    Senator Levin. Mr. Mahoney.
    Mr. Mahoney. We agree. It is consistent with our policies.
    Senator Levin. All right. Now, under the current tax rule 
that we have, you can get a much larger tax deduction than your 
book value shows is the value of the--or the expense for the 
option that you granted. Does it make sense for companies that 
do very well, hand out a lot of stock options, when their stock 
price goes up, they get bigger tax deductions and lower taxes? 
Is that, from a tax policy, good, that incentive to give tax 
options, since they do well, if the company does well, result 
in a larger deduction, it means the more profitable the 
company, the larger the tax deduction rather than the larger 
the tax? Is that good tax policy, Mr. Turner?
    Mr. Turner. Well, I have for a long time been a believer 
that absent some real driving policy that Congress wants to get 
into, such as creating additional capital investment, which we 
do on depreciation and asset acquisitions, I have long been a 
believer that we should have symmetry and more economic 
substance to what goes into our tax rules. And in that regard, 
I have always been a supporter of getting more symmetry between 
the economic substance that is reported in financial reports 
and what goes into our income tax returns. I think the income 
tax returns should show more economic policy than what they 
are. And so to the degree that they differ, I do not think that 
is good tax policy. Therefore, I think it would be good to have 
symmetry in the executive compensation. I would also, quite 
frankly, have symmetry in other areas, such as for 
uncollectible accounts receivable and for inventories that have 
gone bad and are obsolete. There are differences there that I 
think also fall into the same categories, and I do not see a 
reason, a real good tax policy for having differences there as 
well.
    So I am a fan of trying to keep it simple, if you will, 
make it more simple. I think most Americans would like to see 
the Tax Code greatly simplified, and I think this would be an 
opportunity to do that in a number of areas.
    Senator Levin. OK, but including in terms of today's 
hearing, having the tax deduction be the same as the amount 
shown on the books?
    Mr. Turner. Absolutely.
    Senator Levin. Professor Desai, do you have any comment?
    Mr. Desai. Yes, I would agree with what Mr. Turner said. I 
think greater alignment generally is a smart idea, and 
particularly in this context makes sense. I have two points on 
that.
    First, typically tax policy tries to accelerate a deduction 
when times are bad, so the situation you are describing is 
unusual. And then the second point I would make----
    Senator Levin. When you say ``unusual,'' you also mean not 
desirable, particularly, or----
    Mr. Desai. Hard to rationalize, yes.
    Senator Levin. OK.
    Mr. Desai. And then the second point would just be that in 
some sense it is a simple issue, which is when was this 
compensation for and how much was the compensation. And I have 
great faith in FASB and the ability of experts to come up with 
a good answer to that. And it seems like if we can piggyback 
off that answer in the Tax Code, that would seem to make sense.
    Senator Levin. Mr. Mahoney.
    Mr. Mahoney. The council has not established any policies 
on taxation at all, but as a taxpayer myself and a small 
investor, I agree with my other two panelists that that is not 
good tax policy.
    Senator Levin. Is this feature of stock options, is this 
particular feature that the company does well, that they then 
get a much bigger tax deduction in their income tax reports 
than they show on their books a driving force in the use of 
stock options, one, in your judgment? And, two, in the gap that 
exists, which seems to be growing, between executive pay and 
average worker pay, would you say that it is a driving force in 
both?
    Mr. Turner. I do not know. The way I think I would put it, 
Senator, is to say there are a number of factors that enter 
into the consideration of using options and the magnitude of 
the options that you are going to use. Certainly the 
opportunity for a company to go up in value, which any 
management team strives for, creates a real incentive to use 
options. And now I am speaking as a former executive and CFO--
when you look at option plans along with anything else, you are 
trying to look at what is a reasonable compensation level for 
the people, especially vis-a-vis the peers. And I think that 
becomes first and foremost, but certainly the tax implications 
of the ability to use options is one of the factors that one 
would consider. Even at the board level it is considered, 
because in almost every proxy the board discusses and discloses 
Section 162(m) as well.
    And certainly I would have to say the Section 162(m), as 
Ranking Member Coleman has noted, is a factor here that I 
think, quite frankly, Congress should also take a look at. I 
would view it as, in a way, a package situation. I think your 
move to get symmetry is superb and excellent and should be 
undertaken. I would undertake that with reconsideration of 
Section 162(m), and at the same time, though, I would also want 
to put in there the shareholder advisory vote that has been 
adopted in the House. I think if you could put a package like 
that together, that would be a marvelous tax package.
    Senator Levin. We heard earlier this morning from the first 
panel that they do not look at the tax aspects of the options 
that they recommend or decide upon on compensation boards. Do 
you buy that?
    Mr. Turner. No, I do not buy that because--and, again, 
sitting on corporate boards, I think most corporate boards do 
sit down, at least in the compensation committee, and have a 
discussion about the implication of Section 162(m). And, in 
fact, often, where I have been the managing director of 
research and provide voting recommendations on proxies, one 
issue that often comes up for a vote is the issue of does the 
compensation package meet Section 162(m) requirements.
    Senator Levin. But does this feature of stock options that 
it potentially has this huge tax deduction without showing it 
as an expense to the same extent on the books, is that a 
feature which would be in your mind as a member of the 
compensation committee?
    Mr. Turner. It certainly is, and I have chaired three audit 
committees now, and not only is it on my mind as a matter of 
stock compensation, and certainly much more in my mind since 
the option backdating scandal. Senator Grassley had a fine 
hearing here in the Finance Committee last September that got 
into that whole issue. And so I would be surprised if people 
said it does not enter into my consideration as the CFO or as a 
board member. I think I would be negligent if I had not 
considered the overall cost package. So I was somewhat 
surprised by that.
    Again, that is often discussed and laid out in a proxy, 
which I would hope every corporate board member reads before 
they get filed. So to say ``I did not even think about it,'' is 
somewhat surprising.
    Senator Levin. Professor Desai.
    Mr. Desai. I would concur. On your first question, has it 
been an important driver of the growth of options, I think if 
firms do not factor in the tax consequences and boards do not 
think about that, then there is a question of whether they are 
pursuing their fiduciary responsibility. So I would think they 
would be, and, in general, I think people are pursuing their 
fiduciary responsibility. So I think that it does matter.
    And then the second related point is there is evidence that 
tax departments inside corporations are becoming more active 
participants in financial decisionmaking, and they are becoming 
viewed as places where you can squeeze profits out of. And so 
it would be surprising if tax concerns were just not visible.
    On your second question about whether this relates to the 
overall gap in income inequality, that is a much harder 
question. The available research on that suggests that the gap 
is surely due in part to this kind of pattern but also has many 
other determinants, which I am sure you are well aware of.
    Senator Levin. Mr. Mahoney.
    Mr. Mahoney. I have never sat on a corporate board, but as 
a close observer of financial accounting and reporting for over 
a decade, certainly tax implications are a very important 
factor or feature to the structure of many, if not most, 
corporate transactions.
    Senator Levin. If we close this gap and we have the tax 
return reflect the amount shown on the books for the value of 
the stock option when granted, at that point the taxpayer, the 
stock option holder who exercises that option down the road, if 
that stock goes up--which it obviously would need to, or else 
the option would not be exercised--will be paying a larger tax 
on a larger amount than the company got as a tax deduction. 
That does not trouble me particularly for the reason I gave, 
but it did trouble one of our witnesses.
    Mr. Turner, if you get symmetry where you have described 
and I have described and you support and I support, does that 
eliminate asymmetry which is important or relevant as between 
the tax deduction given to the company and the taxable income 
to the option holder when that option is exercised?
    Mr. Turner. Again, I thought for a while about the question 
that you asked earlier this morning, and I guess my initial 
take is, no, I am not that troubled by it because, in fact, 
part of that gain is in essence a holding gain from the date 
that the vesting ended until the time period they actually 
exercise and sell their stock. So for that reason, I am not 
particularly troubled.
    The other thing is that we have done research at Glass, 
Lewis that indicates 80 to 85 percent of these options are 
cashless exercises anyway, so as you appropriately noted this 
morning, it is not the company that is paying in the cash, if 
you will. So given the magnitude of the cashless exercise in 
these, which are really nothing more than turning it back into 
a bonus type cash payment, I really do not have a problem that 
that income is going to be a higher number. And certainly they 
have the cash in the pocket, if you will, if in fact it is 
higher.
    If, on the other hand, the options are never exercised--and 
we all need to keep in mind that some of these options never 
are exercised--certainly then in that case the employee will 
not be getting taxable income for that because they would not 
have ever exercised.
    Senator Levin. Professor Desai.
    Mr. Desai. Sir, I think it is useful to frame this as a 
transition from one kind of symmetry to another kind of 
symmetry. So the current symmetry is within the Tax Code for 
the corporate and the individual, and the symmetry you are 
talking about is at the corporate level between financial and 
tax.
    As to whether I am bothered by the potential that the 
individual is going to have a larger income than we gave a 
deduction for, I do not think that is terribly problematic. I 
mean, in some sense, one way to think about this is if we 
believe symmetry--or if we believe the compensation happens at 
the time of grant, as accounting standard setters have 
suggested, then we are affording some relief to the income 
taxpayer by delaying the taxable event until the time of 
exercise, meaning the natural time, if we really believe the 
matching principle is important, then again at the time of 
grant under this new system. So there is actually some relief 
being afforded to that taxpayer, and I think in that setting, 
not just relief in terms of time, but also relief in terms of 
not having phantom income and also relief in the sense of only 
having a tax obligation in the good state in the world.
    So all of that makes me think that these concerns can be 
mitigated.
    Senator Levin. Mr. Mahoney.
    Mr. Mahoney. I have very little tax expertise, but my view 
would be that I do not think this is a significant problem. I 
would agree with my co-panelists.
    Senator Levin. Just a few more questions. Let me ask you, 
Mr. Mahoney, this question. You described in your prepared 
statement some concerns with the new SEC disclosure rules for 
executive compensation, particularly how stock options are 
valued in the summary compensation table. You presented an 
example of a CEO who might be listed as receiving negative 
compensation. Would you just elaborate on that for a moment?
    Mr. Mahoney. The SEC's executive compensation disclosure 
rules, as originally adopted back in August, they require that 
stock and option awards be reported in this new summary 
compensation table at their full grant date fair value. That 
decision in the original final rules was consistent with the 
council's recommendations and the recommendations of many 
investors.
    However, the SEC's December 2006 amendments to the original 
final rules made a change requiring that stock and option 
awards be reported in the summary compensation table in an 
amount equal to the dollar amount recognized in the financial 
statements in accordance with FAS 123R, though there are some 
exceptions to that as well.
    By more directly linking the compensation disclosure in the 
proxy statement to the amount of compensation expense 
recognized under FAS 123R, that creates some circumstances 
where a named executive officer's reported stock-based 
compensation in the new summary compensation table can be 
negative. Now, those circumstances may occur, for example, when 
the change in the market value of an award that is classified 
as a liability award for FAS 123R purposes is negative in a 
period. That would be one example.
    Another example would be where it becomes unlikely that the 
performance condition of a previously recognized performance-
based award will no longer be achieved. That circumstance may 
also create a negative amount in the summary compensation 
table.
    We believe that the SEC's December 2006 amendments are 
inconsistent with the use of proxy statements by shareholders 
because proxy statement disclosures are intended to provide 
investors with information to evaluate the annual decisions of 
the compensation committee. We believe that showing the full 
grant date fair value in the summary compensation table is the 
better way to report stock and option awards.
    Senator Levin. Thank you. Do either of the other witnesses 
have a comment on that?
    Mr. Turner. At Glass, Lewis we obviously do recommendations 
on over 11,000 companies and their proxy and on this specific 
issue of the magnitude of compensation and the compensation 
committee, and I would just say that I think Jeff's 
understanding is very consistent with ours. Our large 
institutional investors, who manage over $10 trillion in value, 
typically want to assess the compensation committee based upon 
their decision in a particular year, and one of the key factors 
they use in making that assessment is the value of the options 
granted in that particular year. And, therefore, to get that 
information, they need the disclosure of the amount of the fair 
value of the options granted in that particular year.
    When the SEC made the last-minute midnight change, if you 
will, just before Christmastime, they eliminated that 
transparency for institutional investors, and we heard time and 
time again from those how it made it much more difficult to 
analyze that table. So I would concur with what Mr. Mahoney 
said.
    Senator Levin. Professor, do you have----
    Mr. Desai. Nothing.
    Senator Levin. Let me now conclude with just a very brief 
comment.
    We have received evidence today that companies are legally 
claiming tax deductions for their stock option expenses that 
are far in excess of the expenses actually shown on the books. 
Nine companies claimed $1 billion more in stock option 
deductions than they would have shown on their books even with 
the new stricter accounting rule that FASB has adopted for 
stock options. Altogether in 2004, companies claimed $43 
billion more in stock option deductions than they showed on 
their books under that IRS data.
    Right now, stock options are the only form of compensation 
where a company is allowed to deduct more than the expenses 
shown on its books. It is as if the Tax Code allowed a company 
to pay an employee $10,000 for their services and then deduct 
$100,000, 10 times as much. It contradicts common sense. It 
treats stock options differently from all other forms of 
compensation. It costs the Treasury billions of dollars each 
year. It creates an incentive for companies to give out huge 
stock option grants, further inflating executive pay compared 
to average worker pay and diluting the stock of other 
stockholders.
    One solution which I favor is to make stock option tax 
deductions match stock option book expenses. Doing that would 
bring stock options into alignment with all other types of 
compensation in the Tax Code. It would save billions of dollars 
by revising an overly generous stock option tax deduction to 
make the deduction match actual book expenses. And I believe it 
would also eliminate a book-tax difference that encourages and 
gives incentives to hand out more stock options than companies 
otherwise would, which drives executive pay even higher 
compared to the pay of average workers. And it also is giving 
incentive for some companies to play games with the accounting 
rules and how they value stock options on their books, and that 
is something which we also ought to try to prevent.
    In 2006, CEO pay averaged over $15 million with half coming 
from exercised stock options. CEO pay is now 400 times average 
worker pay. It is out of whack with average worker pay, and 
part of the reason is that accounting and tax rules for stock 
options are also out of whack. The best way, I believe the only 
way that I can foresee, to fix this problem is to bring stock 
option accounting and tax rules into alignment with each other. 
I introduced a bill to accomplish that back in 1997. I did it 
again in 2003. There was not a lot of traction at that time for 
either of those bills, mainly, I think, due to the battle which 
was raging over stock option accounting. Now that that 
accounting issue is resolved and the number is fixed, once it 
goes onto the books, as FASB has decreed, there is now a clear 
fixed number that goes on the books. Once one of the methods is 
used, we now, it seems to me, have no justification to have a 
different number in the books for the value of stock options 
than is taken by companies in their tax returns.
    So we are going to try again. I think that the environment 
is now sufficiently different with the resolution of the 
accounting rule that we may be able to get the traction which 
was missing in prior years.
    I was glad to hear from at least one of our witnesses in 
the first panel that that was OK with them, that companies were 
totally neutral on that subject--at least his company was. I 
look forward to neutrality on the part of all of our corporate 
community when this bill is forwarded. I say that with some 
irony. I am sure that we will not have total neutrality, but, 
nonetheless, we hope that companies and, most importantly, that 
stockholders and investors will see the value in having this 
symmetry finally between what the books show and what the tax 
returns show as well.
    To our witnesses, you have been very helpful, forthcoming, 
thoughtful, and we appreciate all of your testimony, and we 
will stand adjourned.
    [Whereupon, at 11:37 a.m., the Subcommittee was adjourned.]

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