Page 1       TOP OF DOC


Wednesday, March 3, 2004
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance and
Government Sponsored Enterprises
Committee on Financial Services,
Washington, D.C.
    The subcommittee met, pursuant to call, at 10:04 a.m., in Room 2128, Rayburn House Office Building, Hon. Richard Baker [chairman of the subcommittee] presiding.
    Present: Representatives Baker, Shays, Gillmor, Bachus, Shadegg, Biggert, Capito, Hart, Kennedy, Brown-Waite, Kanjorski, Ackerman, Sherman, Meeks, Inslee, Moore, Lucas of Kentucky, Crowley, Israel, Clay, McCarthy, Matheson, Miller of North Carolina, Emanuel, Scott and Velazquez.
    Chairman BAKER. [Presiding.] If I could get everyone to please take their seats, we will call the meeting of the Capital Markets Subcommittee to order.
    This morning, we are here to conduct a hearing on the elements of H.R. 3574, the Stock Option Accounting Reform Act. Historically in our country, it has been granted that individuals with good ideas, a lot of hard work and the willingness to take a risk could form business enterprises, and if able to convince others of the validity of their vision, could encourage their participation in business formation by granting them a potential slice of future profitability through the granting of options. It has been I think without any dispute a valid methodology for economic activity, job creation and in some cases profitability.
 Page 2       PREV PAGE       TOP OF DOC
    Although in recent days there have been concerns about the granting of these options and the inappropriate exercise of those grants by a relatively small number of executives in the corporate structures, the value of this method continues to be clear in the overall world of business creation, particularly in the world of high technology.
    H.R. 3574 preserves the opportunity to take dreams and turn them into reality and success, but I believe would eliminate the opportunity for manipulative management to flip options for fortunes. In support of this view, 84 percent of options granted in the high tech industry have been found to go to the broad class of employees, while 14 percent of options granted went to the executives, which this bill would prohibit from engaging in that practice.
    As to the voice or concern of those reporting financial condition accurately, even those who are advocates of expensing will acknowledge that accurate calculation of present-day value is a difficult consideration. Others would say it is not possible to achieve fairly.
    What, then, is the most responsible public policy to maintain an engine of economic opportunity and job creation when there are many who are calling the current recovery a jobless recovery, or to adopt an admittedly inaccurate accounting standard in the spirit of accurate financial disclosure. I think these are troubling questions that are worth examination.
    Certainly, I have regard for the Financial Accounting Standards Board and their professional conduct on matters of accounting accuracy, but there have been instances in the past where we have not viewed their responsible conduct in similar light. I think primarily in the treatment of derivatives reporting and most recently and troubling in the requirement to reduce loan loss reserves at financial institutions in the face of every financial regulator saying that that position was unsupported and ill advised. I do not believe any governmental grant of authority to set regulatory constraints could be above review by the Congress, and the discussion that follows in the public forum.
 Page 3       PREV PAGE       TOP OF DOC
    To that end, we are here today to receive testimony of those who have differing perspectives on the advisability of the adoption of this measure. I look forward to their testimony in helping the committee reach appropriate public policy determinations.
    Mr. Kanjorski for an opening statement?
    Mr. KANJORSKI. Mr. Chairman, we meet for the second time in the 108th Congress to study the accounting treatment of stock options. Specifically, we will today examine H.R. 3574, a bill that would unnecessarily interfere with the independence of the Financial Accounting Standards Board. Without question, stock options have played an important and crucial role in the ongoing success of many American businesses and the creation of wealth for many American households.
    The accounting treatment of stock options, however, has also caused significant controversy for more than two decades. The decisions of the Financial Accounting Standards Board to revisit this matter last year and issue a draft rule later this month have therefore rekindled a fiery debate. In the wake of the recent tidal wave of accounting scandals, support for mandatory expensing has increased significantly. A recent survey by Merrill Lynch found that more than 90 percent of the institutional investors want stock options expensed. The four largest accounting firms have also now called for the expensing of stock options. Moreover, many respected financial experts have effectively made the case for options expensing, including William Donaldson, William McDonough, Warren Buffett, Alan Greenspan, Paul Volcker and Joseph Stiglitz.
    In addition, nearly 500 countries have adopted or are in the process of adopting fair value expensing of stock options. Respected corporations like Home Depot, General Motors, General Electric, Wal-Mart, Microsoft and Amazon have all decided to treat stock options as expenses. Several companies headquartered in Pennsylvania have also done the same, including Mellon Financial, Hershey Foods, and First Keystone Corporation in Berwick.
 Page 4       PREV PAGE       TOP OF DOC
    As we proceed today and in the future, I must caution my colleagues about the ongoing need to protect the independence of the Financial Accounting Standards Board. A decade ago, the Congress unfortunately strong-armed this private regulatory body into abandoning its efforts to adopt a rule regarding stock options expensing. We now know that this retreat contributed to the financial storm on Wall Street in 2001 and 2002.
    To protect against similar incidences in the future and safeguard the public interest, we incorporated into the Sarbanes-Oxley Act a provision granting an independent funding stream to the Financial Accounting Standards Board. The active consideration of the Stock Options Accounting Reform Act by our panel, in my view, would threaten this recently approved and enhanced independence, intervening in the board's ability to make unbiased decisions and disrupting an objective process for reasons other than sound financial reporting.
    Other leaders on Capitol Hill agree with me about the wisdom of protecting the independence of the Financial Accounting Standards Board. Earlier this year, Senator Shelby and Senator Sarbanes, the two most powerful members of the Senate Banking Committee, asserted their bipartisan opposition to intervening in the activities of the board. Chairman Oxley has also previously said that compromising the independence of the board, ''could negatively impact efforts to improve the transparency of financial reports.'' I wholeheartedly agree.
    Deciding what should be accounted for and how it should be accounted for is the job of the Financial Accounting Standards Board, not the Congress. Although the board has not yet released its draft rule on expensing stock options, I am pleased that the agency is working to address this important issue. Employee stock options are a type of compensation just like a salary or a bonus. Because compensation is an expense and because expenses influence earnings, employee stock options should be counted against earnings and subtracted from income.
    Mandatory stock option expensing would further help investors to make better decisions. Individuals, for example, might have previously made different choices about the stock of AOL Time-Warner. In 2001, the failure to account for employee stock option on the company's balance sheet resulted in a profit of $700 million, instead of an operating loss of $1.7 billion. Unlike the current system where some businesses expense options and others do not, a mandatory expensing rule would also facilitate comparisons between companies, helping investors to make apple-to-apple evaluations, rather than apples-to-oranges assessments.
 Page 5       PREV PAGE       TOP OF DOC
    In closing, Mr. Chairman, our capital markets remain the strongest in the world only when the rules are clear and credible, corporate activity is transparent, and the data is unbiased and comparable. Stock options are expenses. To strengthen investor confidence and promote the international convergence of corporate reporting standards, the Financial Accounting Standards Board must therefore proceed with diligence and without political interference in these matters.
    Thank you, Mr. Chairman.
    [The prepared statement of Hon. Paul E. Kanjorski can be found on page 46 in the appendix.]
    Chairman BAKER. I thank the gentleman for his statement.
    Mr. Gillmor, did you have an opening statement?
    Mr. GILLMOR. Thank you very much, Mr. Chairman, and also thank you for holding what is a very important and timely hearing.
    The issue of how to account for employee stock options in a company's financial statements is a very significant one, particularly given the many high profile cases of accounting fraud in large publicly traded companies. As a member of the Committee on Energy and Commerce, which used to have jurisdiction in this area, and the House Financial Services Committee since 1994, I have been monitoring the Financial Accounting Standards Board rulemaking process on the accounting of stock options. I was supportive of their final rule addressing stock options and allowing them to be recorded as an expense on their annual profit and loss statements.
    Unfortunately, I have to say I oppose H.R. 3574, the Stock Option Accounting Reform Act which we are reviewing this morning. I feel that Congress and this committee should stand by our statement in the Sarbanes-Oxley Act of 2002 and the recent SEC policy statement reaffirming FASB as the nation's accounting standard setter, and we should allow them to do their job and retain the independence mandated in these matters by Congress itself.
 Page 6       PREV PAGE       TOP OF DOC
    This week, I am circulating a letter to all my colleagues that I received from the Ohio Public Employees Retirement System, a $56 billion fund and the tenth-largest state pension fund in the United States, expressing their support of FASB's actions and opposition to the bill. As Laurie Hacking, who is the executive director of that organization, states in her letter, ''FASB has considerable financial expertise and is best-suited to consider complex financial accounting issues. It also has a measured process in place for soliciting public feedback on proposed accounting standards.''
    U.S. financial markets remain the envy of the world due to the quality, the timeliness, and the credibility of financial information and disclosures provided by companies. The result is a better allocation of resources and lower overall cost of capital. We ought to ensure that this remains the case by allowing our standards setter to operate independently of public and private special interests.
    I encourage my colleagues to support the role of FASB. We should not be setting accounting standards on a political basis. Also, the failure to expense options provides false and misleading statements to shareholders because it does not accurately reflect the true cost to the company and the shareholders. That, I think, explains the broad support for stock option expensing by financial experts such as SEC Chairman Bill Donaldson, Federal Reserve Chairman Alan Greenspan, former FED Chairman Paul Volcker, and Warren Buffett.
    Thank you, Mr. Chairman, for calling this hearing and I look forward to the debate. I would also, if it is appropriate, Mr. Chairman, request unanimous consent to enter into the record a statement I have received from the Ohio Highway Patrol Retirement System.
    [The following information can be found on page 116 in the appendix.]
    Chairman BAKER. Without objection. I thank the gentleman.
    Mr. Crowley, did you have an opening statement?
    [The prepared statement of Hon. Paul E. Gillmor can be found on page 44 in the appendix.]
 Page 7       PREV PAGE       TOP OF DOC
    Mr. CROWLEY. Thank you, Mr. Chairman. I want to thank you, Chairman Baker and Ranking Member Kanjorski for conducting this important hearing this morning and for our panelists before us today on the expensing of stock options and the possible effects that this could have on our economy.
    The Financial Accounting Standards Board will soon issue a proposal on the accounting treatment for employee stock options. While I welcome the role the FASB plays in our economy, that of ensuring the independence and credibility of our nation's accounting system, I must disagree with FASB on their expected upcoming actions dealing with the expensing of stock options. I do not believe that any prohibition on the mandatory expensing of options would cloud basic accounting principles. Investors and analysts who are interested in adjusting an issuers income statement for the cost of stock options already have the necessary information available in the footnotes included in their annual reports.
    Additionally, while many supporters of expensing will argue that it would help restore credibility and investor confidence to our markets, again I would respectfully argue the opposite would occur. The mandatory expensing of stock options would effectively destroy broad-based stock option plans which enhance financial opportunities for workers at all levels, stimulate economic growth and helped create the new economy of the 1990s, a new economy that resulted in a burst of new wealth, productivity and ingenuity that we still enjoy today in America.
    In fact, it is these stock options that have spread wealth throughout all sectors and to all employees of the new economy, from CEO to secretary. Ninety-eight of the nation's top 100 largest high-tech firms that focus on the Internet provide options to most or all of their employees. Most of these options go to the rank-and-file workers, helping stimulate wealth creation for employees, while allowing employers to attract the best and top talent.
    Why did and do educated people flock to corporations that offer their employees stock options? Because they understand the value of options for their company's bottom line and for their own personal bottom line. Stock options promote wealth sharing and we should not hamper that as a means to address what some see as a questionable issue of corporate governance. While the stories of the high-tech boom gone bust are everywhere, can anyone honestly say our nation or economy or our people would be better off without the Internet boom of the 1990s and resulting and long-lasting benefits it provides to America and the world today and every day?
 Page 8       PREV PAGE       TOP OF DOC
    That is why I am a strong supporter and cosponsor of both H.R. 1372 by Congressman Dreier and Congresswoman Eshoo, both of California; and H.R. 3574 by Chairman Baker and Congresswoman Eshoo. I believe these are important bills that will protect job and wealth creation in America, while not threatening our nation's accounting standards or FASB's independence.
    Once again, I want to thank Chairman Baker and Ranking Member Kanjorski and all the witnesses. I yield back the balance of my time.
    Chairman BAKER. I thank the gentleman.
    Mr. Shadegg, did you have a statement this morning?
    Mr. SHADEGG. Thank you, Mr. Chairman. I want to thank you for holding this hearing.
    Let me state at the outset that I am a supporter and cosponsor of H.R. 3574, the Stock Option Accounting Reform Act. However, I would have ideally preferred the Dreier legislation that was referred to. It is my preference that there be no statutory requirement for stock options. I believe this is an issue which needs to be resolved in the marketplace on a case-by-case, corporation-by-corporation basis. However, I do recognize that there is a significant movement toward some sort of expensing, and I believe that the limited expensing coupled with an absolutely necessary study of the economic effects of expensing contained in H.R. 3574 is appropriate.
    There are numerous reasons why I oppose statutory requirements for the expensing of stock options and I associate myself particularly with the comprehensive discussion of this issue contained in the written testimony of Arthur Coviello. There are two points which deserve special mention. First, requiring the expensing of stock options will stifle the ability of small companies on the cutting edge of innovation to attract and retain the high quality employees they need to turn concepts into real-world products. Time and again throughout our nation's economic history, and especially during the high-tech revolution of the 1990s, small firms that were long on ideas, but short on earnings, have been able to conceive of, develop and bring to the market new products which have had profound impacts on all of the economy. To do so, small companies have relied above all on their human capital, on intelligence, motivated, hard-working employees who are able to think outside the box.
 Page 9       PREV PAGE       TOP OF DOC
    The primary way they have been able to attract and retain these individuals is by offering them the opportunity to grow with the company, to share directly in the success of their innovations through stock option grants. By increasing the cost of granting stock options, the playing field will be tilted away from these small firms and innovation in the marketplace will suffer.
    The second and perhaps more critical point is the democracy which broad-based employee stock options bring to corporations. Employees who own stock in their company are far more than labor. They are the owners of the company. They share both financially and psychologically in its success to a much greater degree than mere numbers on a balance sheet can ever capture. It would be a sad triumph of myopia to decide that the placement of another, and quite frankly not very accurate, number on a corporation's balance sheet is more important than the commitment to the success of that corporation brought by employee ownership.
    Again, Mr. Chairman, I commend you for holding this hearing and for introducing H.R. 3574. I look forward to working with you to enact this legislation into law.
    [The prepared statement of Hon. John B. Shadegg can be found on page 49 in the appendix.]
    Chairman BAKER. I thank the gentleman.
    Ms. Moore?
    Mr. MOORE. Thank you, Mr. Chairman. I would like to thank you for holding this hearing today on H.R. 3574, the Stock Option Accounting Reform Act. I look forward to working with you, with my members and colleagues on both sides of the aisle on this issue, as I have in the past. I hope we can move this legislation in the 108th Congress.
    The members of this subcommittee and our invited witnesses are well aware of the issues surrounding the mandatory stock options expensing debate, so I will not discuss those at length here today. It is worth noting why the Baker-Eshoo bill would take necessary and important steps toward curbing many of the abuses in stock options that have given them a bad name.
 Page 10       PREV PAGE       TOP OF DOC
    The various corporate scandals of the late 20th and early 21st century exposed the need for Congress to ensure that highly compensated senior executives cannot misuse stock options. As we have seen, the prominence of options and executive compensation packages has actually served as an incentive for executives of certain now-defunct companies like Enron to engage in complex structured finance deals that had the practical effect of manipulating the company's stock price. Enron executives had every reason to work to maintain an artificially high stock price. The higher the stock price of the company, the more valuable these executives's options became.
    It is important to remember that options do not inherently lend themselves to abuse. I am concerned that proposals to require public companies to expense all employee stock options may have the unintended consequence of decreasing the number of options that companies will offer their employees in the future. Broad-based employee stock options played a significant role in the capital formation that led to the technology boom, and consequent productivity gains of the late 1990s. Congress should be focused on putting an end to the abuses that threaten to curtail broad-based options issuance and the Baker-Eshoo bill, Mr. Chairman, is an important step forward in that regard.
    Finally, while I generally believe that Congress should allow FASB to set accounting standards without congressional interference, I think it is entirely appropriate that we continue to monitor the issue of options expensing and take action if necessary to ensure that proposals affecting stock options expensing will not overreach. FASB should be extremely careful to take into account the differences between rank-and-file employee stock programs and nonqualified option grants that have led to the corporate abuses we have discussed earlier.
    Thank you again, Mr. Chairman, for holding this hearing. I look forward to hearing the witnesses's testimony.
    Chairman BAKER. I thank the gentleman.
 Page 11       PREV PAGE       TOP OF DOC
    Mr. Scott, did you have a statement?
    Mr. SCOTT. Thank you very much, Chairman Baker.
    This is an important issue, given the pending action by the Financial Accounting Standards Board, to issue rules requiring companies to report the value of their stock options and their income statements. I am a cosponsor of H.R. 3574 and I commend Chairman Baker and Representative Hooley for introducing this balanced legislation.
    As we move forward in this committee, we should make sure that rank-and-file employees who have benefited from broad-based stock option plans in the past can continue to reap these benefits in the future, while combating abuse in executive compensation.
    We also must ensure that companies have all the tools they need to stay on the cutting edge of innovation and maintain all the tools we have to expand the jobs based here in the United States. H.R. 3574 encourages small companies to innovate, rather than stifling them.
    I look forward to hearing from today's distinguished panel about H.R. 3574 and the pending regulatory action by the Financial Accounting Standards Board.
    Thank you, Mr. Chairman.
    Chairman BAKER. I thank the gentleman.
    Mr. Emanuel, did you have a statement?
    Mr. EMANUEL. Yes, Mr. Chairman. Thank you and I will try to be quick because I know we want to get to the panel. Thank you for holding this hearing.
    In general, my view is that this decision should be left to the FASB board and the private sector. I have expressed that view in the past, but I also believe we should be sensitive to startups and young businesses if we are going to make any decisions about the expensing of options. But I firmly believe it is the jurisdiction of FASB and the private sector to regulate this area. It needs some reforms as there clearly were abuses in the past.
    I want to caution us that we should not micromanage the private sector on issues like expensing options and board independence, and at the same time leave major issues that we actually should be involved in, such as health care, retirement security and employment safety, untouched. So my view is that we shouldn't be setting a precedent by getting involved in things that might better be left to the private sector; and things that we should be involved in.
 Page 12       PREV PAGE       TOP OF DOC
    I understand that some of the issues I raised are beyond the jurisdiction of this committee, but it worries me that we are micromanaging private sector interests, when the major social issues are left undiscussed and untouched by this Congress.
    Thank you.
    Chairman BAKER. I thank the gentleman.
    Mr. Sherman?
    Mr. SHERMAN. Thank you.
    As one of two CPA on this subcommittee, I take a strong interest in these hearings. Only as I understand it, one out of five of all those testifying are skeptical or opposed to the bill in front of us. That is not surprising, because the most powerful people in our society as a group are corporate executives, and the best way for a corporate executive to get rich is on stock options. Stock options have had a favorable treatment both under our tax law and especially under our accounting rules for a long time.
    I should point out that we should be loyal here to investors. Investors should be given the truth. We should not fool investors or steer investors into companies just because the companies are doing good things. If a company has a democratic process of spreading the wealth, that is a good thing. But that does not mean we should fool investors as to the total costs of compensating their employees.
    Likewise, if a company was going to add 1,000 jobs to its payroll and every single added employee was a former welfare recipient, who would propose that in order to encourage that great corporate activity, that we would say that the money spent for those employees as their payroll should not be charged against income? No one would say we are penalizing a company by making them record as an expense the cash that they pay, the very people we most desperately want them to hire.
    Now, I think one ultimate solution to all this, and I agree with my friend from Illinois that it should be the FASB that wrestles with these issues, is that we let 1,000 flowers bloom; that we provide to investors an income statement, an earnings per share number that reflects what I would call the Coca-Cola approach, and what was up until I believe recently the Pepsi approach. One soft-drink company expensing stock options; the other I believe until recently capitalizing. Actually, both changes were recent, but I guess Coke was the original on this.
 Page 13       PREV PAGE       TOP OF DOC
    So if we provided both, then we would eliminate this as an issue. Those investors who wanted to invest in companies based on their earnings per share unadjusted for stock option expense could do it on that basis. And those who believe that they would make better decisions with the other number could use that number.
    Now, it is not a penalty against a company to list something as an expense if it really does cost the shareholders something. An example of that would be, say, health care coverage. You folks, we are all talking here about employee stock options. If you gave the exact same option to a health care company and the corporation said, you know, we cannot afford health care coverage. Our people are going to be going to emergency room. They are going to be dying because we do not give them health care coverage, so here is what we are going to do. We do not have the cash. Those stock options we were going to give the investors, we are going to give to a health care company, and because we are a hot company, because they have faith in us, they are going to take stock options instead of cash.
    Every single person in this room would say you have to book it as an expense. If you pay the health care company in stock options or you pay him in cash, you have to book it as an expense.
    So we are in a position here to say that stock options when given to executives, that is such a noble purpose that its favored position must be continued, if we give it to executives or even if more democratically around the company. But if we use it to provide health care, that is an expense.
    I would also add that this is a matter of fairness among sectors. I will wrap up soon. I have more high-tech companies than the Chairman. Well, proportionately, you probably have more steel companies. I am guessing.
    Chairman BAKER. Oil and gas.
    Mr. SHERMAN. Okay, excuse me.
 Page 14       PREV PAGE       TOP OF DOC
    Chairman BAKER. We used to.
    Mr. SHERMAN. In any case, there still is an old economy that does not use stock options. If the company in my district that uses stock options has to report 7 cents per share earnings instead of 9 cents, what it means is the capital flows to the chairman's district. There is a certain amount of capital, 8 cents a share, if his company, old-tech, not providing stock options is reporting 8 cents a share, and what we are debating here is whether the high-tech company is reporting 7 cents or 9 cents, let us not forget it is all comparative, and the capital that flows to that stock option-using company is flowing away from the company that does not use stock options.
    Finally, I may add that there is one area where FASB has it wrong. They know the have it wrong. And that is the area of expensing research. If you go buy a research result, you buy a patent, that is purchasing an asset. But if you do the research in-house, that is booked as an expense. That is a penalty and there is a reason why we do not have all that corporate power fighting against that penalty. It is not because research is not just as important to this country as executive compensation. It is because executive compensation is more important to those who have the most power in our country.
    If we want to start second-guessing what the FASB is doing, we ought to take a look at the genuine penalty they impose on companies who do research in-house. We know why the FASB has imposed that penalty. It is because the accountants do not want to figure out whether a research project has been successful or unsuccessful. So they penalize a company with a successful research project and say every research project will be deemed unsuccessful and we will penalize. So there are penalties in what the FASB does, but they are for research.
    I yield back and thank you for the time.
    Chairman BAKER. I had to exercise my option. I am sorry.
 Page 15       PREV PAGE       TOP OF DOC
    Mr. Shays, did you have a comment?
    Mr. SHAYS. Yes, Mr. Chairman, just to say that I want to state that my position is basically to go with what FASB suggests, unless I see overriding evidence here before any decision has to be made. So my sense is very clearly that expensing makes sense, but I am here to learn and see if I should be changing my opinion.
    Thank you.
    Chairman BAKER. Thank you, Mr. Shays.
    Mr. Inslee?
    Mr. INSLEE. Thank you.
    I would normally be reluctant to have Congress delve into a FASB issue, but I think it is required here and I cosponsored this bill. I just want to make two points. First, my friend Mr. Sherman referred to letting 1,000 flowers bloom. The problem, though, is that right now a lot of those flowers are blooming in India and China . We would prefer them to bloom here. By this action by FASB, we add to the possibility that there will be a competitive advantage in hiring talent in India and China, where I think this will be treated differently.
    We are now in the midst of a real national domestic crisis dealing with job loss. This potential issue could lead to that where we give a competitive advantage to India and China and this is not the moment for doing so.
    The second point is that we are doing a lot of research in my district, the First District of Washington, and we are doing lots of research with DNA and the like. I think we ought to be spending our hard-earned dollars in research on DNA, not research on CPAs trying to figure out how many thousand angels can dance on the head of a pin, on trying to figure out a right number for expensing this. Let us focus on research and science, rather than the abstractions that could lead economists to go crazy.
    I will yield to Mr. Sherman.
 Page 16       PREV PAGE       TOP OF DOC
    Mr. SHERMAN. I thank the gentleman for yielding.
    I would point out that if the FASB changes the rules, whether those stock options are given to an Indian engineer or Chinese engineer or an American engineer, they would all be treated the same way. How things are treated on the Indian stock market is of little relevance because all the companies in high tech are turning to the American capital. So we are talking about rules that will apply to whether it is French companies, Indian companies, American companies doing business wherever, and their use of stock options and other mechanisms to compensate their people.
    Mr. INSLEE. Reclaiming my time, the fact is that we are talking about competition between Indian companies and American companies; Indian capital formation and American capital formation. And you have an antiquated view, I believe, of reality in thinking there is not capital growing in China and India. Half the cranes in the world are in China right now building new capital investment and using a lot of Chinese capital. Our entire federal debt is financed with Chinese capital at this moment, according to Mr. Greenspan.
    So I think the future is, we have to pay intimate attention to international competition right now to keep jobs in this country. I think this is one issue, although we do not think of it in terms of outsourcing, we ought to start thinking about these terms in every public policy we have.
    Thank you.
    Chairman BAKER. I thank the gentleman.
    Mr. Bachus, did you have a statement?
    Mr. BACHUS. Yes. I thank the Chairman.
    I will tell this to the Chairman and the Members, and also to the panel, one reason that we are here today is because we have not been able to reach any middle ground with FASB. They have simply taken a mandatory approach. We are going to require all employee stock options to be expensed. It does not matter whether it is a phantom expense to the company. It does matter whether it is difficult on how to value these expenses. It does not matter that really tech companies, one of the reasons they have been able to flourish, grow and we are at the leading edge of technological development, and that even FASB agrees that is in large order because of employee stock options.
 Page 17       PREV PAGE       TOP OF DOC
    They have made no efforts to find a middle ground. I actually think that what they are doing violates generally accepted accounting principles, because you are going to require companies to expense these stock options when there may never be an expense. These companies, a lot of their innovation is from employees who were promised a share of the company. That is no longer going to be possible. Employee stock options have resulted in large numbers of people having an equity ownership in a company. In fact, companies that give employee stock options, the employees in many of these companies own 10, 15, 20 percent of the company, sometimes 30 percent and more.
    I think we are really threatening to take one of the things that makes our companies the most competitive and the most innovative, and slam the brakes on it. Apparently, we are going to do that with a rule that is going to go into effect January 1. I think it could have broad-based negative effects on our country, on our most innovative companies, our fastest growing companies. There are certain things FASB has not been able to answer. They have answered to me in incomplete ways. One is, where do we get the models to accurately say what these expenses will be? They have said there are models available, but those models are not models that are used to value employee stock options. They are models that are intended to simply model stock options in general. There is a big difference in an employee stock option and other stock options.
    So I have real concerns. I am going to, for the record and in the interest of time, submit a two-page statement outlining probably 15 or 20 different objections to this. I think there is some middle ground, but I can tell you that what FASB is proposing is not a middle ground. It is a radical departure from not only what we are doing now, but it to me will shock the market and could have broad-based effects on the creation of jobs, productivity, and keeping our country competitive in a world environment. Also, I think it will harm a lot of middle class workers.
    With that, I yield back the balance of my time.
 Page 18       PREV PAGE       TOP OF DOC
    Chairman BAKER. I thank the gentleman.
    Ms. McCarthy, did you have a statement?
    Mrs. MCCARTHY OF NEW YORK. Thank you, Mr. Chairman.
    I am going to reserve my opinions at this point, because that is what a committee hearing is supposed to be about. So I will offer my statement, and I am looking forward to hearing the testimony. I will say you can see that both sides of the aisle, Republicans and Democrats, need to have as much information as possible because we are split on this. We are trying to find the right solution for all of you. So I look forward to the testimony.
    Thank you, Mr. Chairman.
    Chairman BAKER. I thank the gentlelady.
    Mr. Israel?
    Mr. ISRAEL. Thank you, Mr. Chairman.
    Very briefly, I am not a big believer in throwing the baby out with the bathwater. I do not believe that we should allow the clear financial abuses of some institutions and firms to impinge on the ability of all entrepreneurs, all small businesses, all high-tech businesses including many that I represent, in surviving and growing.
    Many firms in my congressional district rely on stock options as the most feasible way of sustaining themselves. I believe that we should proceed very cautiously and not take the financial abuses of some and use them to essentially destroy the ability of so many of these firms to compete and grow, create jobs and expand.
    Thank you, Mr. Chairman. I yield back.
    Chairman BAKER. I thank the gentleman.
    Mr. Matheson?
    Mr. MATHESON. No opening statement for me. I look forward to hearing from the witnesses. Thank you, Mr. Chairman.
 Page 19       PREV PAGE       TOP OF DOC
    Chairman BAKER. I thank the gentleman.
    Mr. Ackerman?
    Mr. ACKERMAN. I am happy to be here.
    Chairman BAKER. We are happy to have you, Mr. Ackerman.
    If there is no member wishing to make any additional statements, then at this time I would like to welcome our long-suffering panel to our hearing this morning. We do appreciate your willingness to participate and give us your perspectives.
    Let me just do the formalities. To the extent possible, constrain your remarks to a 5-minute statement. Your official statement will certainly be made part of the hearing record. We look forward to hearing your various perspectives.
    Our first witness is Miss Karen Kerrigan, chairman of the Small Business Survival Committee. Welcome.
    Ms. KERRIGAN. Good morning, Chairman Baker, Ranking Member Kanjorski and members of the subcommittee.
    First, let me thank you for inviting the Small Business Survival Committee to present our views on H.R. 3574, the Stock Option Accounting Reform Act, indeed, to endorse and support this piece of legislation which we think is necessary to sustain economic growth, certainly broad-base employee stock options, and innovation in this country.
    Again, I am Karen Kerrigan, chair of the Small Business Survival Committee. We are a nonpartisan small business advocacy organization headquartered here in the nation's capital. SBSC works to advance legislation and policies that help to create a favorable and productive environment for small business growth, job creation and entrepreneurship.
    In our view, H.R. 3574 is an appropriate response to what seems to be general indifference at the Financial Accounting Standards Board with respect to the business community's concerns about mandatory stock option expensing. The board is about to unveil a stock option expensing rule that would be particularly complex and costly for small businesses.
 Page 20       PREV PAGE       TOP OF DOC
    In our judgment, it would not lead to the sort of financial transparency and accountability sought by FASB, shareholders, and elected leaders or regulators. Instead, broad-based employee stock option plans would suffer, leaving small firms at a competitive disadvantage to larger and more mature entities whose resources allow them to recruit and attract the best and the brightest. This would be a shame, as small businesses are a key source of innovation and job creation in the United States.
    I know that committee members are keenly aware of the important role America's small business and entrepreneurial sector plays in job creation, innovation, economic growth and in the overall health and vitality of our economy. They produce 55 percent of innovations; they obtain more patents per sales dollar than large businesses; they employ 38 percent of high-tech workers. Incentives and tools that help small firms add to their innovative capacity and their productivity like stock options are integral to their success and our general economic well being.
    Indeed, through the leadership of the small business and entrepreneurial sector, and more specifically the high-tech sector, the concept of employee ownership and participation has enriched our economy and our workforce in a variety of ways. The spread of what is called partner capitalism, as the authors of the book In the Company of Owners describe it, is a good thing as it boots employee productivity, profits and stock returns.
    The mandatory stock option expensing rule proposed by FASB in our view is archaic and out of step. It would vastly curtail the capability of small firms to offer stock options as an employee recruitment, retention and incentive tool. It makes little sense to erect barriers and rules that eviscerate these programs, as stock options have allowed millions of America's workers to have ownership in the companies where they work.
    While FASB's intention to increase financial recording and transparency is a worthy goal, we are baffled that they would continue down the mandatory expensing of stock options path, or more specifically, untested valuation models to achieve that. I am not an accountant, as many of you will find out probably in the Q and A session of this, yet the proposal does not seem to make accountant sense. There is no true consensus on the identification of a model to place an accurate and reliable number on the so-called costs of employee stock options. Indeed, all indications are that the FASB is going to rely on either the Black-Scholes method or the binomial method, both of which many experts agree produce bad numbers.
 Page 21       PREV PAGE       TOP OF DOC
    As a result, the mandatory expensing of employee stock options will not make financial statements more accurate, reliable and transparent. A recent decision by FASB to reject field-testing of various valuation models is unfortunate. From our perspective, it made sense for FASB to take the time to run valuation tests on a wide sample of companies to determine impact.
    H.R. 3574 is a prudent solution which comes at an important time. The proposed legislation incorporates sound and targeted reforms with a reasonable requirement that a study be conducted to understand the economic impact of the mandatory expensing of all employee stock options. The latter is very important, as policymakers must make every effort to review whether proposed policy initiatives weaken or strengthen U.S. job-creating capacity and competitiveness.
    SBSC certainly appreciates the measure to protect small businesses and startup companies. The exemption for companies with less than $25 million in revenues and the protection for companies 3 years after the initial public offering strike a reasonable balance. In essence and most importantly, H.R. 3574 will help preserve broad-based stock option plans and the ability of small firms to offer these plans.
    Let me just add as a wrap-up that we are hopeful that this instance or this current controversy serves as an opportunity for FASB to review its standard-setting process. Already, they have reached out to the small business community, specifically to the Small Business Survival Committee, to let us know that they are putting together a small business advisory board and they have asked us for recommendations for people to serve on that board. We have recommended someone to serve in that capacity.
    In closing, let me reiterate SBSC's support for H.R. 3574. We encourage Congress to act quickly. With the economy getting back on track, we believe Congress would be taking a prudent step in shielding America's workforce and businesses from the proposed action that would undermine economic growth.
 Page 22       PREV PAGE       TOP OF DOC
    Thank you.
    [The prepared statement of Karen Kerrigan can be found on page 82 in the appendix.]
    Chairman BAKER. I thank the gentlelady for her statement.
    Our next witness is Mr. Mark Heesen, President of the National Venture Capital Association. Welcome, sir.
    Mr. HEESEN. Thank you. Good morning.
    I am Mark Heesen, President of the National Venture Capital Association, which represents 460 venture capital firms in the United States. Venture-backed companies are very important to the U.S. economy as a whole in terms of creating jobs, generating revenue and fostering innovation. In fact, U.S. companies that were originally funded with venture capital now represent 11 percent of annual U.S. GDP and employ over 12 million Americans.
    I am testifying today in support of H.R. 3574, as this bill reflects a thoughtful and balanced approach to employee stock option accounting. The bill mitigates to a considerable degree the critical flaws surrounding the impact of expensing on small and emerging growth businesses, an impact that FASB has simply refused to address.
    Since the last Senate hearing this past November on this issue and the last meeting of this subcommittee in June, the FASB has made no meaningful progress toward making any distinction between the effects its proposal would have on large publicly traded entities versus small private businesses, despite countless calls to do so and promises from Chairman Herz to members of this committee to do just that.
    We fully concur with Congress's reluctance to involve itself in the setting of accounting standards. Yet FASB's exposure draft is expected in a matter of days and frankly we have nowhere else to turn. The voices of our country's emerging growth businesses have gone ignored by FASB. We see an urgent need for checks and balances in our system at this time.
 Page 23       PREV PAGE       TOP OF DOC
    Employee stock options are a critical factor in fueling entrepreneurial innovation and economic growth. For example, the biotechnology industry today simply would not exist without venture capital and without employee stock options. Almost without exception, young venture-financed companies use options to attract the best and the brightest talent when cash is scarce, and cash is always scarce in these companies. Should FASB require stock option expensing, they will seriously harm the economic tool that has given U.S. companies a major competitive advantage over its foreign counterparts.
    The mandatory expensing of stock options will place a serious burden on small companies so that most will be forced to curtail their broad-based option programs. Today, just as in 1994 when this issue was last addressed by Congress, an acceptable method for the valuation of employee stock options has not been identified by FASB. Therefore, the option expense number will be perpetually inaccurate, particularly for private companies where it is impossible to measure volatility in mandatory input into the valuation models currently supported by the FASB.
    By requiring companies to disclose a highly suspect expense number, the FASB is creating a cost on the income statement that will have a significant long-term impact on a company striving to reach profit levels necessary for an IPO or to become an attractive acquisition target.
    Aside from inaccurate financials, a more practical concern is the monetary and human costs that will be required for young companies to undertake the valuation process. These organizations cannot afford the outside expertise required to work through these complex valuation models, nor can they afford the time to do it themselves. But FASB's mandate will force them to address these accounting issues, distracting management, raising expenses, and lengthening the reliance on expensive high-risk capital to the startup sector.
    We believe H.R. 3574 seeks to preserve broad-based employee stock options and addresses serious implications of expensing for emerging businesses. By limiting mandatory expensing to the top five executives, this bill targets executive compensation, while simultaneously preserving the ability of companies to deliver options to rank-and-file workers.
 Page 24       PREV PAGE       TOP OF DOC
    By exempting the expensing requirement for small businesses until 3 years after an IPO, the bill relieves compliance burdens for young companies seeking to go public, and allows the company's stock to settle down from the volatility of an IPO. By setting the volatility at zero for valuation purposes as allowed under current FASB rules, H.R. 3574 removes a key variable that creates highly inaccurate expense figures.
    Finally, by requiring the Secretaries of Commerce and Labor to complete a joint study on the economic impact of mandatory expensing, the bill thwarts a rush-to-regulate effort by the FASB and prevents severe unintended consequences for our economy and our international competitiveness.
    Should FASB move forward with this current stock option accounting mandate, venture-backed companies will have inaccurate financial statements prepared at a significantly greater cost. Entrepreneurial businesses will be unduly impacted as they do not have the adequate resources to comply. The entrepreneurial energy that now accounts for over 10 percent of the U.S. economy will be drained at a time when our global competitiveness is increasingly challenged by economic conditions overseas.
    International convergence of accounting standards such as mandatory expensing will touch Europe and the United States, but not China and India, where we feel accounting standards more supportive of stock options will drive more highly skilled jobs offshore. Today we applaud the congressional leadership for addressing the practical impact of FASB's stock option expensing proposal and we urge passage of H.R. 3574.
    Thank you very much.
    [The prepared statement of Mark G. Heesen can be found on page 75 in the appendix.]
    Chairman BAKER. Thank you, sir.
    Our next witness is Mr. Reginald Reed, who is the manager for software development from Cisco Systems. Welcome, sir.
 Page 25       PREV PAGE       TOP OF DOC
    Mr. REED. Thank you. Good morning. Chairman Baker, Ranking Member Kanjorski, members of the subcommittee, thank you for the opportunity to testify this morning in support of broad-based stock option programs and H.R. 3574, the Stock Option Accounting Reform Act.
    My name is Reginald Reed. I am the manager in the software development area for Cisco Systems, Incorporated. I work for Cisco in the Research Triangle Park near Raleigh, North Carolina. I have been with Cisco for 7 years. We are most appreciative, Chairman Baker, for your incredible leadership on this important issue. Thank you for standing up to preserve broad-based employee stock options for the over 10 million U.S. employees who have received them. We need the House and Senate to pass this legislation soon because the future of broad-based employee stock option plans is in jeopardy.
    Every day, I see the difference that employee stock options make in the workplace. In my opinion, there is no better way to motivate talented employees. In fact, I had underestimated their power to motivate. Because of Cisco's broad-based employee stock option plan, our customers and shareholders benefit. When something is a positive for employees, customers and shareholders, it is a very powerful tool.
    At Cisco, employees are tied to the company's bottom line in large part because of the stock option grants we receive that make us all owners. Employee stock options allow us to better understand how hard work and innovation play a central role in the company's overall success. The sense of ownership created by stock options at Cisco and other companies is part of the driving force behind the advances in information technology that take place throughout the industry.
    The Cisco stock option program has helped turn our Research Triangle Park operation into a major engineering hub on the East Coast. At Cisco, I see the benefits of employee stock options everywhere I look. I have five engineers who report directly to me. I see first-hand how stock options make them think and act like owners. I see the extra mile they go, the extra energy they provide, and how they act like owners.
 Page 26       PREV PAGE       TOP OF DOC
    I also know how stock options incentivize me. As I look at my managers, I see the same dynamic. Our CEO, John Chambers, has put it very well. He has said that the difference between workers who receive employee stock options and those who do not is a lot like the difference between owning a home and renting one. The mindsets are totally different. When you own a home, it is a reflection of you. From the basement to the attic, you want everything to be perfect. When you rent, you just want to make sure that you get the security deposit back.
    The 35,000 employees who make up Cisco Systems are owners. We want to make the most innovative products. We want to develop the newest technologies. Employee stock options are an essential part of that commitment that binds us all together. If stock options are expensed, many companies will be forced to cut back on programs that benefit rank-and-file employees, and instead only give them to top executives. If this happens, we will lose much of our ability to attract, retain and motivate dedicated employees.
    The call for expensing of employee stock options, as I read it, came about because people were concerned about bad executive behavior. The irony is that these misdirected reforms to expense all stock options will largely impact rank-and-file employees like myself. This is why, Chairman Baker, your legislation addresses those initial concerns so well, while also preserving broad-based employee stock option programs.
    A little over a year ago, my wife Julie and I welcomed our first child into our family. The stock options I exercised 5 years ago went towards a down payment for the house that our child calls home. In the future, my goal for stock options are for a good education for my daughter and a more secure retirement.
    I am not an accountant. I am not an expert in financial statements or footnotes or the securities laws, but I do know the benefit of stock option plans that are broad-based. Like the millions of other workers in this country who receive employee stock options, I am worried that unelected accounting regulators are going to make a decision that effectively eliminates broad-based employee stock option plans and negatively affects our economy and our country.
 Page 27       PREV PAGE       TOP OF DOC
    We need your help. We need our elected officials in the United States Congress to step in and preserve broad-based employee stock options. That is why on behalf of the employees of Cisco, I ask you to pass H.R. 3574.
    Thank you very much for inviting me here today and taking the time to listen to my testimony. I will be pleased to answer any questions that you might have.
    [The prepared statement of Reginald Reed can be found on page 113 in the appendix.]
    Chairman BAKER. Thank you, Mr. Reed. We appreciate your participation here today.
    Our next witness is Professor Robert Merton from the Harvard Business School. Welcome, sir.
    Mr. MERTON. Good morning. As you said, I am Robert Merton. I am a professor at the Harvard Business School. I am also a co-founder and the chief science officer of a firm called Integrated Finance Limited.
    Mr. Chairman, I thank you and the subcommittee for inviting me to testify on the Stock Option Accounting Reform Act. The focus of my remarks on this bill addresses three points. Compensatory stock options are a real cost to the company and should be an expense. Second, the costs to the firm of these options can be estimated. And third, what are some of the potential public policy issues associated with expensing of these options.
    As to the first point, the function of financial accounting is to provide clear, comparable and unbiased information to inform investment decisions. It is a basic principle of accounting that financial statements should record economically significant transactions. Issuing stock options is just such a significant transaction and footnote reporting is not a substitute for recognition on the income statement.
 Page 28       PREV PAGE       TOP OF DOC
    Even if no cash changes hands, issuing stock options to employees incurs a sacrifice of cash, an opportunity cost that needs to be accounted for. Both accounting earnings and labor expenses relative to operating revenues are used by analysts to estimate performance of the firm and to compare efficiency and profit margins among firms. The form in which such compensation is paid by the firm should not determine whether it is expensed or not.
    H.R. 3574 holds that only options granted to the CEO and the top four most highly compensated executive officers of the firm should be expensed. That is not consistent with reflecting the entire economic cost of using options to pay for labor services to the firm. Other forms of compensation, including salary, cash bonus, restricted stocks, performance options and other benefits are expensed for all employees, and not just the top five officers of the firm.
    As to my second point, the value of these options should be the economic cost to the firm of granting those options, and not the value placed on these options by the employees who receive them. The value of those options can be estimated using market prices or pricing models. Financial institutions value and execute transactions involving all kinds of options and other derivative securities in large volume every day all around the world.
    Examples range from convertible bonds, warrants, some with 25-year maturities, and institutions routinely in large size offer over-the-counter securities both customized options and so-called exotic options, the terms of which are far more complex than the kinds of instruments that we are trying to assess and value here.
    Like real estate appraisals or other non-traded items, estimates from option pricing models often differ from each other and market prices. Those differences are associated with the simplicity of the model, how much accuracy you really want to get, the data, but they tend to be much better than almost any of the other areas on which you do accounting valuations.
    That fact does not imply that it is not possible to value an option with terms that are not precisely traded in the market. Financial statements should strive to be approximately right in reflecting economic reality, rather than precisely wrong. H.R. 3574 holds that if a pricing model is used to determine the fair value of an option, the assumed volatility of the underlying stock shall be zero. It is the case that under that assumption of zero volatility, any pricing model used will give about the same estimate of value.
 Page 29       PREV PAGE       TOP OF DOC
    Thus, in effect H.R. 3574 specifies the option-pricing model to use for expensing. This is not a fair value calculation. No recognized expert would be willing to say so. I would strongly advise anyone who asked me against signing any document that would assert that this is a fair value valuation. I have in mind, among other things, CEOs or CFOs signing Sarbanes-Oxley-type documents. I would strongly urge them, do not sign if you think that this is given as the fair value assessment.
    But there is no need for you to take my word for it. I would suggest you ask your staffs to get Black-Scholes model, or a binomial model. I am sure any number of financial firms will give you access to their proprietary option models. Plug in zero volatility and valuate Cisco, General Motors, Intel, General Electric, IBM or any of your other favorite companies using that model with zero volatility, and apply it to their traded options which trade in large volume every day, and see how close it comes. You will discover that the valuations are very different, that the valuations given by zero volatility are dramatically less than the market prices.
    Furthermore, you will discover that the firms whose equities are more volatile, the difference between this procedure and the market price will be even larger. Since these are also the firms who are often using large amounts of stock options, this would suggest that this valuation procedure is grossly in error in any assessment of fair value.
    You might even ask, and I say this somewhat tongue-in-cheek, because I do not think any firm would do it, whether firms would be willing to issue options to third parties at the price that is being suggested they be valued at for expensing in H.R. 3574. I do not think they will.
    Current accounting standards require the estimation of useful economic life for depreciating plant and equipment, or as mentioned earlier, the value of acquired in-process R&D, the cost of employee pensions and other retirement benefits, and even contingent liabilities such as environmental cleanups. These estimates are surely made with error and none of these is traded precisely on the markets. And these estimates can significantly impact reported earnings. FASB sets standards for making these estimates and changes take place as new techniques evolve. Why should the case of setting standards for estimating cost for option expense be singularly different?
 Page 30       PREV PAGE       TOP OF DOC
    My third point, will expensing stock options hurt young businesses? This is an important issue. Many critics of the expensing, as we have heard this morning, are concerned that life will be more difficult for businesses that rely heavily on options to reward their entrepreneurial talent. We all recognize the vitality and wealth that entrepreneurial ventures, particularly those in high tech, bring to the U.S. economy. I, for one, have no objection to policy measures that encourage and assist new ventures.
    I do question the policy effectiveness of doing so by essentially creating the benefits to those companies from a deliberate accounting distortion proportional to a company's use of one particular form of employee compensation. Indeed, some forms of incentive compensation, such as restricted stock, performance cash award options, and indexed for performance options, arguably do a better job of aligning executive and shareholder interests than conventional stock options do. Yet current accounting standards hold and require that these and virtually all other compensation alternatives be expensed. The provisions of H.R. 3574 would, in effect, exempt only at-the-money stock options from expensing.
    If options are a more efficient means to compensate employees because of incentives, then the superior performance of such firms who use them instead of cash should be demonstrated by the larger revenues generated, not by underreporting the expenses. If option grants really do drive employees to work harder, produce, make the firm worth more, that should manifest itself in higher output of the firm. I would recommend that we not try to adjust for that by understating the actual costs.
    On the other public policy issues, I think if you pass an Act, as I understand this, which sets a valuation procedure, it would take an act of Congress to change it, but I am not a lawyer. If this were to pass, it could not be changed other than by act of Congress. That seems pretty static to me, relative to having policy set by a standards board which can evolve with new technology and experience.
 Page 31       PREV PAGE       TOP OF DOC
    The second thing I would point out as a public policy matter is a little more latent. That is, I think that the past accounting treatment of options versus other forms of compensation has stifled innovation and variety in compensation plans. It is no accident that virtually every company in the past that uses significant amounts of stock options always issues at-the-money options, or as we are hearing now, maybe out-of-the-money options. Performance options and others are not issued, even though many believe they are far better. It could well be that the previous accounting treatment, which de facto will be the accounting treatment going forward under this bill, is important in having created that stifling of innovation.
    Now, on the matter I have heard allusions to that it is seen as a potential comparative advantage for the U.S. if it were to continue to understate certain operating expenses vis-a-vis Europe or other places that do. I do not think so. I do think it is a comparative advantage for the U.S. to maintain the gold standard for financial accounting and disclosure to investors here and abroad. Options can be a powerful incentive tool, but failing to record a transaction that creates such dramatic effects is economically indefensible and encourages companies to favor options over these alternative compensation methods. It is not the proper role of accounting standards to distort compensation by subsidizing one form of incentive compensation relative to all others.
    I thank you.
    [The prepared statement of Robert Merton can be found on page 90 in the appendix.]
    Chairman BAKER. I thank the gentleman for his statement.
    Our next witness is Mr. Arthur Coviello, President and CEO of RSA Security. Welcome, sir.
 Page 32       PREV PAGE       TOP OF DOC
    Mr. COVIELLO. Thank you, Chairman Baker and thank you, Ranking Member Kanjorski and other members of the subcommittee. My particular thanks once again to you, Chairman Baker, for your outstanding leadership on H.R. 3574.
    This is indeed must-pass legislation. Congress and FASB must resolve the issues that bear directly and significantly on issues of accounting, valuation, corporate governance, entrepreneurial capitalism, economic growth and jobs. But by its own admission, FASB deals only with accounting and valuation. I am here to tell you that they have the accounting and valuation fundamentally wrong.
    The mandatory expensing standard that FASB intends to put into place will force demonstrably inaccurate and unavailable numbers into the financial statements. Let me give you an example from my own company. I am very proud of the fact that we engineered a successful turnaround last year, generating $39 million in operating cash flow and $14 million in after-tax earnings on a GAAP basis, that is GAAP without expensing stock options. Had we expensed stock options we would have recorded a $21 million loss, a $21 million loss. That is a $36 million swing had we expensed stock options.
    Would there be a decrease in any of our assets? No. Would there be an increase in any of our liabilities? No. But there would be a marked change in our price-earnings ratio because we would have a price-earnings ratio with income, whereas we would not with a loss. Now, members, I respectfully ask you, who does this fool? Is it easier to evaluate my company based on the current method or is it easier to evaluate my company based on the expensing of stock options?
    Multiply this by thousands of public companies in the tech sector that have the exact same issue. Let me give you another example. Sun Microsystems granted options to its employees in the year 2000 at the height of the tech bubble. Those stock options would have resulted in a $700 million charge to earnings. Those stock options were priced at roughly $60 a share. They are not likely to ever be exercised. As a matter of fact, I suggest it would be highly unlikely that they will ever be exercised. However, a $600 million to $700 million expense would have been recorded.
 Page 33       PREV PAGE       TOP OF DOC
    Warren Buffett who was mentioned a couple of times by the members this morning has said that he would gladly trade some of his yards of carpet from one of his Berkshire Hathaway companies for some of those Silicon Valley stock options. I suggest to you that the employees of Sun would gladly take the carpet for the options that they have at $60 a share.
    But let us move on from the issue of accounting and valuation specifically, and the issues that should really pique your interest. That is jobs, the economy, and innovation. The high-tech industry, by many estimates, has been responsible for two-thirds of the productivity growth in the economy since 1995. In terms of job creation, my own subsector of the economy, the software industry, has generated over 900,000 jobs since 1993 to 2002. I have not seen the stats for 2003, but I can tell you that we at RSA added 50 engineering jobs last year as we started to rebound. The balance of trade that the software industry, again a subset of the high-tech industry, generated in 2002 was a favorable balance of trade of $25 billion.
    What do stock options have to do with all of these statistics? Well, I think they are a very important element in the incentives that are behind all of this job creation, economic growth, innovation and productivity. Let's compare ourselves to the Europeans. They fundamentally lost jobs in the 1990s. They have no broad-based stock option plans. Let's take a look at our competitors in Asia, the Chinese and the Indians. The Chinese, as part of their five-year plan, have a heavy incentive on issuing employees, engineers that are graduating from their universities at a far greater rate than American universities, they have as part of their 5-year plan a desire to implement significant broad-based stock option plans as an incentive.
    The real cost of stock options is already calculated in the dilution of earnings per share. It is already reflected in the calculation. That is a standard that was created well over 20 years ago. Why must it change? If we need to have reform of executive compensation, then let's have reform of executive compensation, but let's not throw the baby out with the bathwater.
 Page 34       PREV PAGE       TOP OF DOC
    Let us talk about investors for a moment. I think the existing reforms that are already in place between Sarbanes-Oxley and some of the reforms on the various stock exchanges have gone a long way. You can no longer re-price stock options. Shareholders have to approve new stock option plans. This Act goes further to require the expensing of the officers's stock options, again I think a very reasonable approach for compensation reform.
    But there will be confusion if we expense stock options. There will not be more transparency. In the example I gave you, how would an investor evaluate us based on the investment criteria that all investors use when they make a decision to invest in a company? The price-earnings ratio. I, as a CEO of a company, could not continue to sustain a broad-based stock option program if I had to take that kind of a hit to my P/E ratio because if I needed to go to the capital markets to raise money, to be able to generate more innovative inventions for my firm, I would have to take into consideration my price-earnings ratio. So it would be difficult in terms of my own capital formation. Again, apply my specific example to many, many companies that are not even public.
    In 10 years, FASB has come up with hardly a single improvement to this valuation issue. They have been intractable. We are before you today because there is a problem that they seem unwilling to address. Left to its own devices, FASB will substitute an arbitrary value that cannot be ascertained. I respectfully disagree with Professor Merton in that some valuation is better than none at all. I don't think it works, especially when you take into consideration that stock options are already reflected in the dilution of an earnings-per-share calculation.
    Against this backdrop, you would think FASB would enthusiastically embrace the stock option coalition's suggestion that FASB go out in to the real world and actually test multiple valuation models before implementing an entirely new standard across the board, the same one they have been arguing for over 10 years.
 Page 35       PREV PAGE       TOP OF DOC
    Let me conclude by giving a more specific example of the impact of a couple of our own employees. One is a person by the name of Leslie Hoffman who was formerly my secretary and now works in our purchasing department. She is a single mom and through the exercise of stock options at RSA Securities she was able to purchase a home and provide for childcare for her son Sebastian. She works very hard at home. She knows the importance of her role in helping to contain costs for the company.
    We also have a gentleman by the name of Dave Chabot, who is an engineering manager. Dave is another gentleman who works very hard, late into the nights, who has benefited from stock options, moving out of a condo with his children, purchasing a home and still having enough money to be able to set aside tuition college expenses for his two children. Hopefully, some day they will grow up to be engineers and start up a high-tech company. He also recognizes the value of incentive stock options and being an owner of the firm.
    This is not an issue of compensation, as has been suggested by some of my other members of the panel. It is an issue of ownership. It is an issue of building sweat-equity into something that you believe in. This will continue to fuel innovation and jobs and economic growth for the country. Let's not eviscerate such a fine program.
    Thank you very much.
    [The prepared statement of Arthur W. Coviello can be found on page 51 in the appendix.]
    Chairman BAKER. Thank you, sir.
    I will start our questions going, professor, directly to Mr. Coviello's examples. Taking the Sun Microsystems $60 exercise question, resulting in a $700 million charge in the year of granting, that subsequently might not later be exercised. If you do not dispute those facts, is implementation of an expensing rule in those conditions fair value reporting?
    Mr. MERTON. I will stipulate for the purpose of answering your question that those are the facts. I think it is a little more complicated in terms of how the expensing would actually be done. But for this purpose, I would ask you again on the question of financial accounting, there is an issue of comparability. Imagine that there was a firm just like Sun who chose instead to pay its employees in cash the amount of those options, their value at the time. It then had the employees use that cash to buy the options. How would the accounting treatment have been of that sister company? They would have expensed as labor costs the amount of cash that was paid to the employees. The employees would have bought options with the cash.
 Page 36       PREV PAGE       TOP OF DOC
    As it turned out the options went down and became a lot less valuable. That is very bad for the people who are invested in them, so I am not suggesting in any case that that is a good thing. But in terms of the accounting treatment, the response is, why should that sister firm expense $700 million because it chose to do it that way, when Sun did it its way, it would have no expense. We have to distinguish between what is an expense for our labor and then what we do with the fruits of that labor in terms of investment risk. In this case, in effect, the employees have exchanged the cash compensation for options.
    Chairman BAKER. But the examples goes to the underlying point of predicting future values, and there is not, or at least I do not believe there is defended, a particular valuation model that is held up to be accurate in predicting future economic value. That is the core of my concerns about this, is having a snapshot that represents to shareholders and potential investors true economic condition, but that we have one that is a fairly reasonable calculus of true value. You have no concerns about valuation models in the current debate?
    Mr. MERTON. In the context of predicting future values, it is a difficult task, but it is a task that has to be undertaken every day. That is what is happening when you see valuations of stocks, when managements make decisions about how to value projects, when underwriters go and decide where to price things. They are always engaged in that. We have lots of references to valuing things that represent uncertain events in the future. So in terms of the value of an instrument as of today that I have conveyed to someone, there is nothing especially unusual about doing that valuation. I do not mean to say it is trivial, but it is not something that, my God, how do we do it?
    The fact that conditions change and often come out not as expected is a reality of life that we all face. All the investors in Sun who bought the stock at $60 or who held external options at $60 suffered as a result of that decline. If they knew that was going to happen, they would not have bought the instrument. But I think you can separate what happened afterwards from what the value conferred at the time was.
 Page 37       PREV PAGE       TOP OF DOC
    Chairman BAKER. Certainly, and I understand the difference between risk-taking and the actuarial responsibility to report financial condition accurately. Risk-taking is an art form. To the best extent possible, FASB represents accounting as a science, not as an art. I think the problem is we have a proposed interface of artistic view with scientific expectations. I fear the consequence of that is to further misrepresent, not make more clear, true financial condition.
    Let me jump quickly, because I know we are going to have a lot of questions, at least I think we are, from other members as well. Mr. Reed, in your statement with regard to Cisco, can you, and you may not be the appropriate Cisco official to ask this particular question, but in your view what is the likelihood that without the options-granting ability that Cisco engaged in, that Cisco would be the company that it is today, given the talent and resources brought into your corporation as a result of those grants?
    Mr. REED. Specifically, in the Research Triangle Park area, there is an excellent example of how we made great strides against IBM, which was a much larger company than Cisco was at the time, to bring in IBM networking into the basically Internet protocols. Talent was basically attracted away from IBM using stock options in the very early days. The movement of that talent has basically allowed Cisco to take over that entire market. So it is definitely very important. It would not be in the same place that we are today.
    Chairman BAKER. I thank the gentleman.
    Mr. Kanjorski?
    Mr. KANJORSKI. Mr. Coviello, you are a public corporation being traded?
    Mr. COVIELLO. Yes, we are.
    Mr. KANJORSKI. Did I hear you say you recorded a profit of $14 million, but if you had expensed your options you would have shown a $26 million loss?
 Page 38       PREV PAGE       TOP OF DOC
    Mr. COVIELLO. $21 million loss.
    Mr. KANJORSKI. $21 million loss. It seems to me I am trying to get a handle on this. Four members of the panel are obviously not for expensing stock options, and professor, you are a purist. I am trying to become a realist. I think there are compelling arguments in terms of Mr. Heesen's talking about the use of stock options for purposes of avoiding use of raw capital at the very beginning, which is very expensive and difficult to get. We all recognize that and we certainly do not want to turn off the faucet of venture capital.
    I think Ms. Kerrigan makes the point on small businesses. She questions whether it increases transparency and reliability. Quite frankly, I always ask the question, why do we want transparency and reliability? It is basically we are trying to weigh the advantage of having a well-informed investor, and that presupposes a public market. As far as I am concerned, if we were to have a separate rule in terms of stock options for non-publicly traded corporations, I could care less. I am not even worried about the venture capitalists. I think they have sharp enough teeth to do due diligence and they know what the hell the company is really worth and what is the value out there. So they are sort of protected.
    I guess I am a little disturbed with Mr. Reed's situation, that they want to go on. So let me ask you this for my own clarification. Would you call the non-expensing of stock options a loophole in accounting? And where did it come from? Was it just an invented figment of someone's accounting imagination that said this is a great way not to show an expense on the balance sheet?
    Mr. MERTON. I rarely attribute such a conspiratorial element to it. I think if you would like something of the history of options, I think where in part they may have come from is a clear realization, as we have heard here, that it is important to have the management and employees incentives aligned with the shareholders. So you start out by saying, so why not give them stock.
 Page 39       PREV PAGE       TOP OF DOC
    Mr. KANJORSKI. Yes, that can be done in various ways, though.
    Mr. MERTON. I am about to get to that, going one step at a time.
    Mr. KANJORSKI. Okay.
    Mr. MERTON. I think what was discovered is that sometimes you wanted to give more exposure to the movement of the stock than cash. Let's say I wanted to give a particular member of my company a sensitivity to what the fortunes of the shareholders is, which is equivalent to 10,000 shares of stock. But if the 10,000 shares, if I gave them the shares, were worth $1 million, the problem is that is just too much money.
    Mr. KANJORSKI. Right.
    Mr. MERTON. So one of the ways you could say to solve that is, give them $10,000 shares of stock and then lend them part of the money. Okay, that would be the next step. The problem there is that if you do that and the stock goes down no fault of their own, they go bankrupt.
    Mr. KANJORSKI. More of a problem, as Mr. Coviello pointed out, you do not have the money at the time to make that available. They are giving chits. They would not be able to make the loan.
    Mr. MERTON. The loan is fictitious in the sense you are giving them shares and they are giving you a note back, so there is no cash involved.
    Mr. KANJORSKI. Okay, and that would be all right if you are not a publicly traded corporation, but if you are publicly traded, that is going to show up on your balance sheet in a very negative way.
    Mr. MERTON. I think you were asking me where I think they came from. I think in making that loan no recourse, there was no risk of personal bankruptcy, and that is exactly what an option is. By the way, anyone who knows my background should certainly not think I am opposed to options, either to be used or other tools. But rather, that the question in each of these things that is being raised here, some of it is that there is a connection that somehow says that if options are expensed, we cannot issue them anymore. If options are a good idea, why don't you?
 Page 40       PREV PAGE       TOP OF DOC
    Mr. KANJORSKI. They will survive. Right.
    Mr. MERTON. Okay? And explain it. In the case of the public company, the question comes, if your shareholders understand your business, then at least the ones that do will understand that you had those options whether or not you expensed them. So if they did, let's first assume if they did, then now expensing them, what difference does it make? It is the same information. The alternative is that they did not understand it. Once you put it in the earnings, it is going to influence their valuation.
    Mr. KANJORSKI. Okay. Let me ask you this, suppose we used a mechanism like profit-sharing contracts, particularly to attract extraordinary talent. Would that show up on the profit-loss statement?
    Mr. MERTON. Yes.
    Mr. KANJORSKI. How would it show up? Would it show up for the very value of it, because a profit-sharing contract for next year's profit is before——
    Mr. MERTON. Well, the realized profit sharing, it would show up there.
    Mr. KANJORSKI. Just for that year, but it would not show up for the future profit sharing.
    Mr. MERTON. No.
    Mr. KANJORSKI. In other words, you are a great scientist and you come to Cisco, and you are not about to go to work and give your brilliance to Cisco without getting some valuation on what you are contributing into equity. They want you so much that they are going to give you a cumulative profit-sharing contract for the next 10 years.
    Mr. MERTON. Yes.
    Mr. KANJORSKI. The only thing that is ever going to show up on their balance sheet is the actual payment of the profit-sharing plan for the year in place. Isn't that correct?
 Page 41       PREV PAGE       TOP OF DOC
    Mr. MERTON. That is correct.
    Mr. KANJORSKI. You are not going to have to indicate or advertise that there is that profit-sharing contract out there, and if you did it would only be done by a footnote.
    Mr. MERTON. It would be a disclosure.
    Mr. KANJORSKI. What would be the difference of that kind of a construct as compared to the option, other than the stock option has a ready available market? We do not have profit-sharing contracts markets yet, but I am sure the Chicago Board will come up with it.
    Mr. MERTON. I think that it goes back to the earlier question from the Chairman. If the options are not owned at all, in other words they are contingent on future labor, that part of their valuation arguably should not be charged until it is earned. But once the options are in effect owned and no longer a condition of employment, then the ownership of that option——
    Mr. KANJORSKI. Yes, but that is——
    Mr. MERTON. I am sorry to interrupt. I was answering your question that if the future profits are something that I have even if I do not stay, then I think you should expense that or put that on there because that is payment for now. It is not contingent on my future work.
    Mr. KANJORSKI. Okay. I would tend, if we are going to be purists, to agree with you. But then I am struck with the cost factor that Mr. Heesen talked about in terms of if I am a little startup company, I really do not need to spend $50,000 or $100,000 or $200,000 trying to figure out this formula on the stock option program. It does not get me anything. It costs me a great deal of money to do that at the precise moment in time that I want to put that $100,000 into research and development or into things that are going to make a viable product. So I see a distinction between Cisco or General Motors or somebody else. It is somewhat like our CRA problem up here in years past. You know, banks have to do CRA. They are great for Citicorp because it costs them $50,000 or $100,000 and they have their accountants make all these reports and everybody knows.
 Page 42       PREV PAGE       TOP OF DOC
    But if the cost is the same thing for mini-corporation that is struggling with $2 million in the back garage trying to come up with a product, they are not about to spend that $100,000 or $200,000 to comply with the accounting rule. Is there some difference that we should be looking at or encouraging the Standards Board to look at between stock option disclosures for publicly traded corporations or when they are going to IPOs or at some stage, for purposes of transparency. I back into this, and the only reason I could give a damn about a company accounts is I want to be able to compare equal things when I am making recommendations to apply my portfolio or if I am assisting someone else, how their money is expended.
    Other than that, why do we care? If it is a startup company or a small business, why do we care? I don't care if they even have accounting. If they can get along without carrying on accounting, who cares? If they are making money, they are operating, they are not going to the investor market, they are not borrowing money from the bank, or if they are borrowing money from the bank, their relationship with the bank is of such a nature that it is a character situation and they know that they are a substantial producing company. So what do we care how they keep their books?
    Mr. HEESEN. In answer to your question about public versus private, in today's FASB standard, there is a distinction. Today, if you are a private company, you can either disclose or you can value your options under minimum value. That is the FASB pronouncement today. They are talking about basically disallowing minimum value for private companies going forward, so that we would be treated just like a public company. FASB, we have asked for months why suddenly are you making this radical change and we have gotten no answer. So they are actually making it worse for private companies.
    Mr. KANJORSKI. Okay. And I am a little sympathetic to that problem, but the testimony that I hear from Ms. Kerrigan, there is now an advisory board for small business. You are going to have an ability to work with this rule or mold a rule or comment on the rule. Aren't we a little premature jumping in here and granting an exemption for this particular area, memorializing it? We are never going to close the door.
 Page 43       PREV PAGE       TOP OF DOC
    I sympathize with both sides, but most of all I am sort of a purist. I think we have accounting for the purposes of real transparency so that everybody can see what is promised out there, what is committed out there, what are the future obligations of the company. I would hate to invest in Cisco and find out that they have $10 billion off-share options out there that I never heard of, and that in reality only 1 percent of the value of the company is returnable to me in a dividend. I would be rather shocked. So I think they have to disclose at some level.
    But on the other hand, I find some great sympathy with startup companies in attracting talent and wanting to share ownership with that talent. I just think there has got to be something in the rule management here that allows to accomplish both good purposes. Maybe I should go to the professor.
    Mr. HEESEN. Unfortunately, on the committee that you are talking about, that came about as a result of the Senate hearing, FASB small business committee. Now, that was in November. It is now March. They just a couple of weeks ago sent out invitations to put in names for that.
    Mr. KANJORSKI. That is very fast, Mr. Heesen. You are not in Washington long enough to know that is very fast.
    Mr. HEESEN. The FASB standard is going to come out the end of this month. If you think that they are suddenly going to say, oh, let's stop the train here and we will create this commission and let small business, I think that is unrealistic. I think they are going to move forward and we are going to be part of that.
    Mr. KANJORSKI. All right. Do you see anything here?
    Mr. MERTON. I certainly say that in the case of costs imposed on companies, particularly smaller companies, I am 100 percent in favor of trying to avoid that. I do not want to impose just to report numbers because, so I endorse that, no question.
 Page 44       PREV PAGE       TOP OF DOC
    In terms of how it is done with private companies, I also share the view that is less important, although it depends on whom the other stakeholders are with that firm. With public companies, it is comparability and as I mentioned before, the ability to sort of let competition decide what is the best way. They should turn it around and ask why should one particular form of compensation be given special treatment.
    Mr. KANJORSKI. That goes to your puritanical——
    Mr. COVIELLO. Mr. Chairman, may I respond to a couple of these points?
    Chairman BAKER. Yes, briefly. We have run over time a little bit.
    Mr. COVIELLO. First, I take great exception to the use of the word that this is a loophole that needs to be closed. In the earnings per share, the $14 million of earnings that we had last year, we had 24 cents of earnings per share. Included in that calculation was roughly a 10 percent impact of dilutive stock options. Also, in the footnotes to our financial statements, we disclose every single option and at what price those options were struck. So I do think we calculate the economic effects of stock options already in the financial statements.
    You asked earlier, Ranking Member Kanjorski, about why did they do it this way in the first place. Because it makes total logical sense.
    Mr. KANJORSKI. Mr. Coviello, we could make that argument and say the reason my company offers Hummers to all my workers is it makes eminent good sense to get to work on time, and then say we do not have to expense them on our books.
    Mr. COVIELLO. I am talking about the accounting principles board that came out with the original accounting for stock options. It made a lot of sense then. It still makes sense now in the context that I was describing.
 Page 45       PREV PAGE       TOP OF DOC
    Second, I also want to take exception to something that the professor said about, well, investors that know the company can understand what the impact of the dilutive effects was and work their way through it. Why should you have to be an applied mathematician to understand what the heck all of this stuff means?
    Also, we have thousands of shareholders. Having a shareholder base is all about mind-share. It is a lot easier for me to capture mind-share if I do not have to make some convoluted explanation of why I had $14 million of income and all of a sudden it is a $21 million loss. It is a lot easier for me to get mind-share. That will have an impact on my stock price. That will have an impact on my ability to raise money, and that is why it is so important.
    Chairman BAKER. The gentleman's time has expired.
    Mr. Shays?
    Mr. SHAYS. Thank you.
    This is a fascinating issue and I think it is an extraordinarily important one. I can feel the intensity that people feel. But I would like to ask each of you first off, if the FASB rules go in, is it your statement that there will be no stock options?
    Mr. COVIELLO. I will respond to that. I think it is going to be a period of intense confusion. People will look at all sorts of methods. They will wonder how the street is going to react. The bottom line to answer your question is, I am not entirely sure what the heck we are going to do. It is going to create a tremendous amount of chaos.
    But if the end result is that Wall Street in their wisdom decides that it is a big negative to have a huge expense on your books from stock options, then absolutely yes, it will eviscerate broad-based stock options programs and that would be a tragedy.
    Mr. HEESEN. From an emerging company vantage point, venture capitalists are smart people. They would have figured out a different way to do things over these last 10 years if they could have come up with something better than a stock option. We do not have a choice in the matter. We will continue to give options, but what happens if we continue to give options? That means we have less money to put into other companies. So instead of funding five startups, we are going to fund three startups. And those companies are going to take longer to go public or be acquired because of the drag of these numbers. So it is going to affect venture capitalists directly. They have religion on this issue.
 Page 46       PREV PAGE       TOP OF DOC
    Mr. SHAYS. Let me hear from the others as well. Yes?
    Ms. KERRIGAN. From a small business perspective, I definitely believe they will diminish their use. Small firms are going to take a direct hit to the bottom line from an earnings perspective, number one. Number two, they just simply do not have the resources from a valuation perspective, to hire the type of investment bankers and other type of experts, I believe, to make this happen.
    So it is costly. It will be complex from a small business entrepreneurial perspective. I do think they will go by the wayside.
    Mr. SHAYS. Thank you.
    Mr. Reed?
    Mr. REED. In my opinion, and I believe it is the opinion of many engineers that I work with as fellow rank-and-file employees, that as Mr. Coviello mentioned, the way that the street reacts to these changes is going to highly affect what happens. We believe that there is a very good chance that if they were not eliminated altogether, that they would be cut back severely.
    Mr. SHAYS. Professor?
    Mr. MERTON. We should recall that other than the expense, which we have noted before, there is no cash difference here. It is just a question of whether it is reported. So then the issue is, how is The Street or other investors going to react? Well, I think particularly if it is widespread, they will adjust to it. It is not clear to me that there will be any material impact on valuations.
    Whether companies then choose to change their form of which they provide incentive compensation, I think that will vary and I do not know. But I do not think there will be a big effect on value. I think also the fact that investors, particularly sophisticated institutional investors, want to see the expensing, I do not see that as an issue of being punitive about compensation, but it would suggest that is something they want. They do not want to hurt their investments.
 Page 47       PREV PAGE       TOP OF DOC
    Mr. SHAYS. I hear you.
    Mr. Coviello, one of the things that I found kind of striking is I had a lot of constituents who called me up because their kids got screwed with stock options. Their companies went down and they still had to pay tax on an option that was not at all attractive anymore or nonexistent. How do you let young people know the potential risk with an option, as well as the potential benefit?
    Mr. COVIELLO. There are a couple of issues there. First, I think it helps to prove my point that options are in essence a form of risk capital for the individual who is earning and investing those. I think in the instance you described, what may have happened is employees exercised stock options at a high price, and then held them. During the holding period, the stock price might have gone down precipitously.
    We issue a lot of nonqualified stock options. I think most of the stock options are nonqualified. That creates a taxable event as soon as you exercise, which actually has the impact of literally forcing the employee to sell as they exercise because they are going to be taxed at the exercise point value. So in those instances, I find it unfortunate that they did not get better advice. We do try and do a good job with our employees in that regard so that they understand the tax consequences around stock options.
    Mr. SHAYS. I am all set.
    Thank you, Mr. Chairman.
    Chairman BAKER. Yes, Mr. Shays. On reflection, I do believe that was an IRS problem where the person exercised, stock price deteriorated, and employees generally did not sell their options at the higher price.
    Mr. SHAYS. Thank you.
    Thank you, gentlemen and lady.
    Chairman BAKER. Ms. Velazquez?
 Page 48       PREV PAGE       TOP OF DOC
    Ms. VELAZQUEZ. Thank you, Mr. Chairman.
    This is my first hearing, having been recently assigned to serve on this subcommittee and this is quite an interesting topic to me. I serve as the Ranking Member on the Small Business Committee, so I am very much concerned about the regulatory burden and the effects of this regulation on smaller companies.
    Mr. Heesen, from your perspective, would increased compliance costs associated with going public deter many smaller companies from pursuing an IPO?
    Mr. HEESEN. You are always going to want an IPO. If you can get into the market, you are going to go there. The question is, every day means something in the IPO market. It could be open one day and closed the next. And it costs money. Every day costs money from a venture capitalist perspective. That means less money going into other companies. So you want that company to go out at the best possible time at the least possible cost. So money does matter.
    Ms. VELAZQUEZ. So how will this affect the venture capital industry?
    Mr. HEESEN. I think it could have an impact in that fewer companies at the end of the day, fewer innovative companies get funded. The important thing to note here is that we love to talk about our successes, but many venture capital-backed companies fail. We give options to all those people, all those people have options underwater. We hope that we get a couple of companies that hit that IPO mark or get bought out by the Cisco's and Intel's of the world.
    Ms. VELAZQUEZ. Far from broad-based expensing proposals, H.R. 3574 will still impose costs on smaller companies. Have you estimated the regulatory burden and compliance costs associated with this legislation?
    Mr. HEESEN. Looking at the different valuation models that FASB has talked about. They have said, oh, you can just get these off the shelf and plop them in. We have not been able to verify what FASB has said on that by any means.
 Page 49       PREV PAGE       TOP OF DOC
    If you are a Coca-Cola, you can go out and get an investment bank and do these sorts of things. If you are a small emerging growth company, try even to find someone who is going to do this for you, let alone what the cost is going to be. Just finding a person to do this is going to be extremely difficult.
    Ms. VELAZQUEZ. Thank you.
    Professor Merton, as with any model, the output is only as good as the data and assumptions that are used. If the assumptions are faulty, you will get faulty valuations regardless of how good the model is. The key assumptions in valuing employee stock options are the risk-free rate, stock volatility, dividends if any, and the life of the option. These are things to estimate because of the many underlying valuables involved. More importantly, they can be manipulated by adjusting any one or a combination of these assumptions. Management can lower the value of the stock options and thus minimize the options's adverse impact on earnings.
    What is your view of the potential for manipulation and abuse by corporations seeking to lower their expenses for stock options?
    Mr. MERTON. I think the best protection on out and out manipulation is a combination of, first, I think most managements want to do the right thing. I like to think that.
    Mr. COVIELLO. Thank you.
    Mr. MERTON. I want to make that statement because it sometimes sounds like these are a bunch of people we have to keep in a corral because if you just turn your back on them, they are going to go and steal everything. That is not my experience with executives, people who build companies. They care about doing the right thing. That is the first thing.
    The second thing is, to the extent that you have public accounting firms that are responsible for this, they have to render opinions. We know that that, too, can sometimes go amok. But the general practice is to do the right thing, and there is a discipline here. There have been laws passed recently to put some more teeth into that if you do fool around with it. So I think deliberate efforts to manipulate, I do not see as a really material thing.
 Page 50       PREV PAGE       TOP OF DOC
    The second thing is that investors, firms get reputations for how they manage their books even now. If you play games with these things, you do get a reputation with investors that can be costly.
    Ms. VELAZQUEZ. Thank you.
    Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, Ms. Velazquez.
    Mr. Sherman?
    Mr. SHERMAN. I fear that this bill is going to reduce the total amount of capital available to all of the companies in this country, because our capital is international. Capital has a choice. Are they going to go to the stock market that reports the highest earnings, then they might as well invest in Bangladesh. Or are they going to go to the stock markets and the countries with the toughest rules? Again and again and again, money floods into this country from third world countries and from Europe and from Japan because they want honest earnings, toughest standards.
    My fear is that this bill will be the first step in converting GAAP, generally accepted accounting principles, into GAAP, generally adulterated accounting politics. So the first question is, will this bill encourage foreign investors to invest in our stock markets? I have not heard anybody say yes, and clearly again and again they seem to want the toughest standards. But even if the capital in America remains the same, then all this bill does, it does not just help some companies. Every company that gets helped, another company gets hurt. There is so much capital and if you are investing in the new economy, you are taking it away from the old economy.
    What this bill does is it turns to those companies that provide health care for all, but do not provide stock options, and it takes capital away from them and shifts it to, say, a company that provides stock options for the top 10 percent. In every other area, especially those of the other party, say that the government should not pick winners and losers. In this one case, we are picking winners and losers and we are doing so on the basis of this, that companies that are most generous to their executives are going to be winners, by government fiat.
 Page 51       PREV PAGE       TOP OF DOC
    I know we are told that some secretaries get options and buy houses, but keep in mind, at least 90 percent of the benefit of these options are going to the top 1 percent or the top 5 percent. More importantly, for every secretary who buys a home because the accounting rules encouraged stock options, there are 1,000 secretaries who lose their health care coverage because the accounting rules fail to encourage providing health care coverage.
    We are also told that employee stock ownership is good. I could not agree more. But the plan that creates broad-based employee stock ownership, ESOP, employee stock ownership plans, under those plans you have to recognize, professor you confirm this for me, if you contribute to the ESOP, that is an expense and you have to book the expense. I see the professor is nodding. I think every other accountant in the room is nodding.
    So the plan that creates broad-based stock ownership for everybody, in new companies, old companies, big companies, small companies, that gets the tough accounting treatment. But the best system for enriching the very richest people or the most powerful people in America, that is getting favored coverage.
    I do want to bring to the subcommittee's attention, and I do have a question after this, that I intend to offer three amendments to the bill should we move to markup. The first is, I should point out that we have a special rule for options granted before December 31, 2004. That ought to be January 3, 2004, because I do not want a lot of companies issuing a lot of stock options for Christmas just to sneak in under whatever rule we provide.
    Second, this idea that we are going to assume volatility is zero: if you are going to apply the Black-Scholes method, at least apply the Black-Scholes method. As the professor points out, assuming volatility is zero, that is to say hijacking the method, produces inferior results.
    Finally, if we are going to have special rules for companies organized in the United States and Canada, how about Mexico? Either strike Canada from this bill or put in Mexico. America has two neighbors. It has a northern border and a southern border.
 Page 52       PREV PAGE       TOP OF DOC
    Now, the professor commented somewhat adversely on this compromise idea I have, and that is to publish it both ways. Why would it be a disadvantage to let investors decide? Perhaps they want to invest in companies based on one accounting system, and perhaps they think the other. We are preparing these financial statements for investors. Why force them into one or the other?
    Could you also comment on whether today's financial statements would allow sophisticated analysts to re-cast the financial statements so that they could compare Coke and Pepsi? That is to say, if you were a stock analyst today, could you calculate the income statement and earnings per share of a company based on the idea that they had expensed all their stock options, and use that number if you thought it was more helpful. There is a question there.
    Mr. MERTON. Is that a question to me?
    Mr. SHERMAN. Okay.
    Mr. MERTON. Starting at the reverse one, you said, couldn't they reproduce this. The answer is yes, in most cases, with enough data, if that was the only thing they had to do, one company.
    Mr. SHERMAN. I am saying, could an analyst sit down today with the amount of information published by Pepsi today, and re-cast, assuming Pepsi did not extend stock options, I think they may have changed their mind. There was a while Pepsi did not; Coke did. Could they sit down with Pepsi's or some other company's financial statements and SEC report, and determine what would be the earnings per share for the most recent year if that company had expensed stock options, just a Coca-Cola does?
    Mr. MERTON. Yes, they could.
    Mr. SHERMAN. They could. So why is it that the analysts are so lazy that they go out and tell their investors, well, this is the earnings per share from Coke, and we could make the Pepsi earnings per share comparable so that you could compare them, but we are no going to bother. Why is it that the market does not embrace either an expense it all earnings-per-share number or expense none of it earnings-per-share number? Why is it instead that the market embraces a whatever the company happens to publish, that is what we will use, even if they are using different systems?
 Page 53       PREV PAGE       TOP OF DOC
    Mr. MERTON. Well, if you will forgive me, why stop there with options? Why not, if you went back to research R&D, why not allow them to do it there? The problem that happens is, yes, in any one case, you can do it.
    Mr. SHERMAN. This is the only case where Congress is plotting to overrule the FASB. Considering, excuse me.
    Mr. MERTON. What I meant by one case, I did not mean this case. I meant if you want me to calculate today as an analyst for Pepsi for this year, yes I can do it.
    Mr. SHERMAN. How long would that take you?
    Mr. MERTON. Depending on the day, maybe a couple of hours.
    Mr. SHERMAN. Okay.
    Mr. MERTON. Depending on how complex.
    Mr. SHERMAN. There are a lot of hard-working people on Wall Street. You would think one of them would do it.
    Mr. MERTON. But then I would also have to do it for all prior years in order to have comparables through time.
    Mr. SHERMAN. Okay.
    Mr. MERTON. And then if I am in the business of doing comparables across Coca-Cola and all these other companies, I would have to do it for all these other companies, even ones I do not follow.
    Mr. SHERMAN. So obviously, we cannot just have one stock analyst do this. Either somebody is going to do it and publish it and make it available and talk about it, or we can make it easier and tell the companies to publish it both ways and do the work for all those hard-working stock analysts. But we should never have a circumstance where if somebody wants to know what the earnings per share is over time across industries, based on expensing stock options, that they are prohibited by practical considerations from knowing.
 Page 54       PREV PAGE       TOP OF DOC
    If the witnesses in favor of the bill are right, then investors should get their information, too. What would be wrong with requiring companies to publish it both ways, staying away from some of the real small companies that might not have the resources to publish both ways?
    Mr. MERTON. I would say just cost.
    Mr. SHERMAN. Costs, okay.
    Mr. MERTON. The costs of doing that. We have that happen now.
    Mr. SHERMAN. And the cost actually argues for the bill because implementing the new FASB standards, should they be adopted, that is the expensive thing. If you had a company that only had five employees, was only going to spend $10,000 to publish their financial statements, such a company could not do it except under the existing system.
    I know this FASB formula that they are considering, I cannot imagine that you could implement that for only a few thousand dollars for a company. You need a Black-Scholes study and the whole thing. So we could let small companies use the old system, the system that exists still today, and bigger companies could publish it both ways. What would be the disadvantage there?
    If I have time, I will ask anyone else on the panel to comment on that. Anybody have a comment? Okay, I am done.
    Chairman BAKER. Being somewhat responsive to the gentleman's observation about the practice being aimed primarily at the benefit of the higher level executives, frankly that is what led me to direct our effort in this vein was to try to identify the problem that started the reform effort in the first place, without inhibiting the growth of small business enterprise, which clearly can be established, I think Professor Merton will even agree, that it does play a role in business formation, without arbitrarily reversing a business practice which has had positive economic consequences.
 Page 55       PREV PAGE       TOP OF DOC
    So I appreciate the gentleman's navigation through the problem. There is movement.
    Mr. SHERMAN. If the Chairman would yield, we could perhaps better effectuate that purpose if in addition to saying the top five executives, because I know the number six guy at Disney and he is pretty well off.
    Chairman BAKER. I know the top 20 at Fannie Mae and they are really doing well.
    Mr. SHERMAN. That, too. Perhaps we would want a system that in addition to saying the top five executives of the average company, said anybody who was getting more than $100,000 worth of stock options in any year would also be put in this rarefied company. Being the top five at a medium-size company is no big shakes compared to being number six at, say, Fannie Mae.
    Chairman BAKER. I appreciate the gentleman's perspectives.
    You may not have knowledge of this factual circumstance, Professor Merton, and if you don't, I understand, but with regard to the well established company and the view that it may be easier for publicly traded companies to comply with the expensing requirement, I am aware that Coca-Cola recently tried to market some of its options to two investment banks. The investment banks preliminarily interested in that opportunity, ultimately turned it down because their obligation is to hedge against the risk. In trying to place the appropriate hedges against that potential investment, they were unable to achieve a valuation sufficiently accurate to warrant engaging in the transaction. Is that a correct observation about those circumstances? Or do you have the ability to make a comment today on that?
    Mr. MERTON. I do not know that specific case. There was a case, in the case of Microsoft, when they moved to restricted stock, where they entered into an arrangement with a large bank to take care of the out-of-the-money options. I think this would have been a parallel type transaction. I do not think that is the most efficient way, with all respect, to accomplish it, but yes, they would have to do some hedges if they are going to hold them primarily and not reissue them. Absolutely. But that does not affect the price.
 Page 56       PREV PAGE       TOP OF DOC
    Chairman BAKER. Oh, no. I was not suggesting that. All I was saying is that in the case of a company as well established as Coca-Cola, who was trying for whatever reason engage in this transaction for some business purpose, unable to reach a conclusion because at the end of the day someone trying to make a future value calculation could not do it sufficiently accurately enough for their risk profile to engage in it. Let me get the more detailed facts and I might just correspond with you on that to get your views about it at a later time.
    Mr. Kanjorski, do you have any further questions?
    Mr. KANJORSKI. I think that I have heard, and it is just rumor to me, there is some tax advantage to the corporation in offering stock options. Is that correct?
    Mr. MERTON. Are you asking me?
    Mr. KANJORSKI. Yes.
    Mr. MERTON. I am not a tax expert. But you have to stay relative to something, to say that it is a tax advantage.
    Mr. KANJORSKI. Yes. I understand they get a deduction for tax purposes on the value of the options offered.
    Mr. COVIELLO. If the options are exercised.
    Mr. MERTON. Yes. At the time they are exercised, then it becomes a taxable even to the employee.
    Mr. KANJORSKI. To both the corporation and the employee at the time of exercise.
    Mr. MERTON. Yes.
    Mr. SHERMAN. If the gentleman will yield. There are two kinds of stock options. With incentive stock options, the company gets no deduction and the employee does not have to pay any taxes for the most part. But those are very restricted. There are all kinds of rules to qualify. For a nonqualified stock option, the employee gets hit with a tax and the employer gets a tax deduction.
 Page 57       PREV PAGE       TOP OF DOC
    Mr. KANJORSKI. At the time of exercise.
    Mr. SHERMAN. Yes.
    Mr. KANJORSKI. So by issuing, there is no tax benefit in one current year if they are going to be taken down another year.
    Mr. MERTON. No.
    Mr. COVIELLO. No.
    Mr. KANJORSKI. Mr. Chairman, I do not want to delay this. I think we have had a very fine panel here today. They have certainly brought to my mind a lot of questions that we should further look at. I am tending to lean with my accountant friend here. Why not give the dual option that they have to record it both ways so we can level the playing field. I think ultimately what we are looking for is transparency. Who cares how they do it or how we arrive at it, as long as we get the information, and not every individual investor or every banking house has to do every one of the 17,000 public corporations on their own. Efficiency says have every corporation do it, if that were the case.
    I also think that there is some merit on us looking at the impact on startup businesses and particularly venture capital businesses that we would not want to front-load the cost of getting into business or doing business at that precise moment where it would stress the company and more than likely add a burden that may sink them ultimately, even though it could be a successful corporation.
    With all that in mind, I ask unanimous consent to submit for the record statements in favor of the Financial Accounting Standards Board's efforts to adopt a mandatory stock options expensing standard, from the Council of Institutional Investors, the AFL-CIO, and the International Brotherhood of Teamsters. Without objection.
    [The following information can be found on pages 117, 121 and 123 in the appendix.]
 Page 58       PREV PAGE       TOP OF DOC
    Chairman BAKER. Without objection.
    Mr. Kennedy, did you have a comment?
    Mr. KENNEDY. I would just like to thank you, Mr. Chairman, for hosting this hearing on this very important topic. As a CPA, I know the complexities of having to deal with stock options, but I also understand the power they have to motivate people. Do earnings become meaningless at the variability from recording stock options, bring earnings up and down so much that it discourages businesses from offering them at all. The incentives that drives in our economy is critical, and this bill is something that I think needs to be given serious consideration. I thank you for hosting this hearing.
    Chairman BAKER. I thank the gentleman for his remarks.
    Mr. Sherman, did you have any further comments or are you done?
    Mr. SHERMAN. Believe it or not, I am done.
    Chairman BAKER. Terrific. We have run your balance sheet finally.
    I want to express my appreciation to each member of the panel for your insight. It has been very helpful to the committee in its consideration of this matter. We look forward to working with you and other interested parties in the days ahead.
    Our meeting stands adjourned.
    [Whereupon, at 12:15 p.m., the subcommittee was adjourned.]