[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.
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\1\ The prepared statement of Mr. Chalsty appears in the Appendix
on page 60.
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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.
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\1\ The prepared statement of Mr. Tauscher appears in the Appendix
on page 63.
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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?
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\1\ The chart referred to appears in the Appendix on page 236.
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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.
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\1\ The prepared statement of Mr. Brown appears in the Appendix on
page 72.
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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.
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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.
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\1\ The prepared statement of Mr. Turner appears in the Appendix on
page 90.
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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.
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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.]
A P P E N D I X
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