Segment 1 Of 2 Next Hearing Segment(2)
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THE FASB STOCK OPTIONS PROPOSAL: ITS
EFFECT ON THE U.S. ECONOMY AND JOBS
Wednesday, April 21, 2004
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance,
And Government Sponsored Enterprises
Committee on Financial Services,
The subcommittee met, pursuant to call, at 10:05 a.m., in Room 2128, Rayburn House Office Building, Hon. Richard Baker [chairman of the subcommittee] presiding.
Present: Representatives Baker, Ose, Gillmor, Lucas of Oklahoma, Royce, Manzullo, Oxley (ex officio), Kelly, Ney, Shadegg, Biggert, Capito, Hart, Kennedy, Tiberi, Kanjorski, Hooley, Sherman, Inslee, Moore, Capuano, Frank (ex officio), Hinojosa, Lucas of Kentucky, Crowley, Clay, McCarthy, Matheson, Lynch, Miller of North Carolina, Emanuel, Scott and Velazquez.
Chairman BAKER. [Presiding.] I would like to call this meeting of the Capital Markets Subcommittee to order.
This morning we are convened for the purpose of reviewing the pending Financial Accounting Standards Board stock option expensing proposal and the potential effect its adoption may have on job creation and our economic recovery, which I believe to be fully engaged. I have given some thought to my opening statement this morning and the past few days, but I had the occasion to read press reports of yesterday that changed my intentions to open the hearing.
The congressional process is a very open and public process. No one ever has accused the Congress of moving too fast, to my knowledge, on anything. It is a process subject to hearings and review which we will benefit this morning from our panel of witnesses in getting additional comment, and then subject to our ability, a markup subsequent to recorded vote, publicly recorded, then a full committee review, then if leadership so chooses for consideration, then of course a bicameral process and subject to the presidential veto. Although many criticize the political process, it is the one forum in which every person's perspective can be vented, can be put on the public record, and elected officials held accountable for the decisions they make.
Page 2 PREV PAGE TOP OF DOC Segment 1 Of 2 In the matter before the committee today, it is the presumption that the Financial Accounting Standards Board is an entity which will conduct and review appropriate financial standards absent such political necessities, and that professionals for the public good shall make determinations in the best interests of our economic stability. Given that history of the Financial Accounting Standards Board, I am the first to acknowledge that I have on prior occasions disputed the decisions of the Standards Board on various other matters of accountancy practice. I felt, as a public official, the right to express those opinions and to disagree on occasion where I thought it in the public interest to do so.
However, it has always been past practice of the Board to refrain from engaging in the seamier side of the public policy business and was surprised to learn that FASB now has engaged its own lobbying firm. But what really got me more engaged in this matter were the comments of the Chairman of the Board, and again let me quickly add, if this press report is true, I have also been on that side of the coin where my representations have not always been accurately reflected, and quick to respond that should this press account be accurate, from the Wall Street Journal, it raises concerns which I think appropriate to bring to the committee's attention.
When Chairman Herz yesterday criticized a well-organized lobbying effort within the Congress, but then went on to say, ''One thing I cannot control is Congress.'' I would say, that is a good thing. No one person should control the Congress, nor enterprise. It acknowledged in the comment that the proposed rule is now open to public comment until the end of June. Apparently, members of Congress are the only group that can have no comment on the matter until the close of the consideration at the end of June, but calling on all in the investor class and those within the business community to make your views known to people in Washington; a call for investors, again, to make your views known.
We cannot have it both ways. If you expect the Congress to have a hands-off approach and allow a regulatory entity to act without comment from anyone, I question the need for a public comment period because in the midst of the public comment period, this hearing has been called for the sole purpose of having those make comment on the effect of this proposed rule on the broader economy. To engage the resources of a lobbyist and for the chairman of the board to then make a political request of constituencies to affect and influence the Congress has now opened the door. If you want to have a public discussion where all interested parties express their opinion, there is no more open venue, no more free of influence, no more publicly recorded venue than the United States Congress.
Page 3 PREV PAGE TOP OF DOC Segment 1 Of 2 Now, I do not always agree with the outcomes of the congressional process, but I have great regard for the process and respect the wisdom of 435 members of the House and 100 members of the Senate in coming to what is the best-balanced conclusion for the public interest. I make no apologies today about having introduced a bill and brought this matter to public discussion. I happen to personally believe it is the right thing to do. I will acknowledge there are other people with different opinions and I may be wrong, but today we have had a group historically known for its nonpolitical determinations open the door to political judgments. I hope we can do it going forward in a professional manner and all have respect for each other at the conclusion of the process, that professionals with differing opinions can come to some resolution that ultimately is in the best interest of the public.
I apologize to the committee for going on at length, but I felt the necessity to express those views.
Mr. KANJORSKI. Mr. Chairman, I am not aware of the press comments, but it strikes me that it poses the question of whether you will respect me in the morning.
Chairman BAKER. No.
Mr. KANJORSKI. Actually, Mr. Chairman, I think this is an important issue, and we meet for the third time in the 108th Congress to study the accounting treatment of stock options. I have a prepared statement that I will submit for the record. I guess the interests are that this is a recognized problem, one for the accounting industry and the need for certainty in how things are done.
I am not an accountant by profession, but I also feel that it perhaps is a dangerous ground for us to tread on that the Congress will interpose its position on a board that is dedicated and structured to make these determinations. That is not to say that that board's determinations come with the weight of the Constitution or perhaps the actions of God to Moses on the mount.
Page 4 PREV PAGE TOP OF DOC Segment 1 Of 2 It is, however, a struggle that could be off-course in terms of I think there are two major issues here. One is whether or not this Congress supports the fact that we have a structured entity in the private sector to make final determinations of accounting rules. I think that is vitally important for our system domestically and internationally. Two, my interest in this is that I truly believe that accounting is for the purposes of transparency of investors and people, that they have a right and a want to know what is the structure and the commitment of the organizations they potentially want to invest in.
I have had the occasion over the last several weeks to visit with people that are on both sides of this issue. I have listened to them as hard as I can. I remember having a discussion with the president and CEO of one of the major California new-tech companies just 2 weeks ago. He struck me with the importance of this for his industry. I have great sympathy that in that particular industry, this could create a problem, the rule as it is structured. But as we discussed it together, he tended to agree with me with the need for transparency; that we cannot have every company doing with their stock options as they will and anticipate that analysts will discern every one of the 27,000 public companies in the United States. That is not going to happen, and particularly with the loss of respect for the analysts over the last several years. They probably will not be performing that function sufficiently to give transparency.
So I do not understand why we get to the point of one way and not another. I think potentially, and it is too bad we do not have both the SEC and FASB here today, but I understand most of those groups are on travel internationally and are not available for us today. So in that regard, before we conclude and go to markup on this subject, I think it is only right that we bring representation of FASB and SEC before the committee so that they can spell out their arguments, because quite frankly I have a question that I would like to pose to them that I think is very fundamental and important.
Are there other ways, in accordance with accounting principles, that we can get to transparency without necessarily going the full gamut of a single rule applying across the board that could disadvantage some of our major technology companies? I do not know what the answer to that is, but being rather Burkean in my philosophy that unless you show me the benefits of change, I am more apt to hold with tradition. My natural proclivities lead me to support the institutions, whether they are courts of law or organizations such as FASB, that they have the ultimate insight and interest and intention of doing the right thing and propounding the proper rules, always subject to review.
Page 5 PREV PAGE TOP OF DOC Segment 1 Of 2 But before we get to the final decision and whether or not the Congress should take up singular activity of reviewing, sometimes under pressure, the implementation of a rule across the board, I think it could be fundamentally destructive to our system if we encourage people to believe that FASB is okay to some extent, but where there are interest groups that can rise above that and put significant pressure on the Congress of the United States to interpose their will and its will on an organization like FASB, that could be very destructive to the entire process of the system.
Those that favor that position today on a particular accounting rule may find out that when they become less significant or less important or less apt to be able to affect the actions of Congress, they can have suppressive activity brought on them by other special interest groups or pressure groups within our system. That tends to go to the destruction of the system as we have it.
With that in mind, Mr. Chairman, I do ask that we have an additional hearing before we go to markup on this situation, having in FASB and the SEC. I look forward to today's hearing. I think the weight of the witnesses, as I discern them, are significantly disadvantaged one side of this proposition right now, although I look forward to the testimony particularly given by some of our industrial leaders that are here today to give us an insight on how the impact will be in the capital markets and on these particular corporations that exist, and that had some advantage by using stock options as a methodology of not tapping into their capital assets when they were at the beginning stage or formative stage of their endeavors.
With that in mind, I offer my full statement in the record, Mr. Chairman, and look forward to it. I guess I will read The Wall Street Journal the day before such hearings so that I am fully equipped to respond to the Chairman's views.
[The prepared statement of Hon. Paul E. Kanjorski can be found on page 82 in the appendix.]
Page 6 PREV PAGE TOP OF DOC Segment 1 Of 2 Chairman BAKER. I thank the gentleman for his statement. It certainly will be made part of the record, as will all members's opening statements.
Mr. Ose, did you have an opening comment?
Mr. OSE. Thank you, Mr. Chairman.
I am appreciative of the fact that you are having another of these hearings. I remain somewhat bemused by our ongoing debate here. We have yet to define a system whereby we can accurately value these options, whether it be Black-Scholes or binomial equation or something of that sort. And yet we are hurtling down a path, at least from a regulatory standpoint, to impose a requirement of a blanket nature on America's corporations without defining yet exactly how we are going to value it.
I would submit to the body that the various opinions that are being put forth by people who have moved to expense options on their financial statements, as opposed to those who have yet not made that move, largely track the enterprise models that they speak from. For instance, let us take Mr. Buffett. Mr. Buffett has argued in favor of expensing options, but I think if you look at Mr. Buffett's investments, you will find very few of them in the technology business, where options are used for significant compensation to employees.
I would submit to the body that the difference of opinion in corporate America as to how to treat options, whether to expense them or make them transparent within the notes to financial statements, reflects the needs of different enterprises to either compensate their employees or reduce their tax liability. Those who are advocating for leaving options in the current situation whereby they are disclosed within the notes, are using options as a compensation tool, by and large. Those who are advocating for the expensing of options look at the net impact on their tax liability by expensing those options. The net income for that enterprise would be less.
It is perfectly logical, but we still come back to this same point, and that is however you value these options, whether you are a strong advocate for leaving it the way it is or a strong advocate for changing the system, however you value these options your valuations are based on assumptions. If it is the assumptions that are driving FASB's concern, that is if the assumptions may or may not be valid, we ought to talk about that, rather than whether or not to put them into the financial statements.
Page 7 PREV PAGE TOP OF DOC Segment 1 Of 2 I thank the Chairman for having this hearing. I am still waiting for somebody to definitively quantify for me how you value these options. Thank you, Mr. Chairman.
Chairman BAKER. I thank the gentleman for his interest in the subject and his statement.
Ranking Member Frank?
Mr. FRANK. Thank you, Mr. Chairman. I appreciate the attention you are giving to this.
This is a very difficult issue for me. Intellectually, it is one of the harder ones that we deal with. When I was in law school, accounting overlapped with my duties as a state legislator. I was absent a lot of times that day when we came up with the issue. I am continually impressed both with the complexity of accounting issues and even more difficult for us with their fluidity.
We have an issue here, though, where I am conflicted. I have been convinced by people, particularly in the high technology industry, that this change could do them some damage. I will get in a minute to what I think of that, but facts have to be taken into account. On the other hand, setting a very strong precedent of this Congress setting rules on a specific and technical accounting issue is difficult. So we often in this body use procedural arguments to reinforce our substantive preferences. The tough time comes when you have both a genuine procedural preference, as the Ranking Member talked about, and a substantive view which will not be well served by following that procedural preference. If it is up to me, I would not be demanding that these be expensed, but I do not want to go into a situation where we become the appellate Financial Accounting Standards Board.
I must say, while I accept what the high technology people tell me, they are a lot of very smart, very decent people who have done a lot of good for this economy, and they are overwhelming in their view. I must say that what they tell me is somewhat distressing because I have to say in substantive terms, this issue to me is frankly like some other issues where the reality seems to me to have been swamped by perceptions that have taken over. That is, whether or not the accounting is changed, whether options are expensed or not, does not change the reality.
Page 8 PREV PAGE TOP OF DOC Segment 1 Of 2 Currently, I am told, they are available in the footnotes. I am not a regular reader of the footnotes of financial company statements. If we changed the rule, they will not be in footnotes; they will be treated differently. The reality will not change. So what we are being told, and this is a disturbing fact for me, is that the investment community of America will react very differently to an identical reality depending on how it is presented in financial statements. That is disappointing to me.
Perhaps one of my illusions was that these cold-headed, hard-hearted financial people would be less influenced by whether it was in the footnote or not in the footnote. But being told that without a change in the reality, the method of presentation of the reality will have an enormous impact, but both sides seem to agree that it would have this impact, whether or not there is a nominal profit or not. I am hoping that people in the high tech industry if this does go through will turn out to have underestimated the financial community, and that they will be able to tell the difference between reality and perception, but I understand this is troubling.
I have an alternative that I am going to be introducing later. I will be filing the bill later in the week. As I have looked at this, I find it hard to see what damage has been done by the current accounting treatment of options. I have not had anybody write to me and say I was terribly misled because they did not expense the options and I invested in them, and look what happened to me. But there have been problems with options.
It seems to me, from what I have learned in my role here on this committee, is that the problem with the stock options in our economy is the perverse incentive they have given in some cases to the top decision makers in some corporations to spike the stock price and then cash in and walk away. There have been large corporate entities that have done things that made no sense from the standpoint of the corporation over time, but did make sense because there were some corporate executives who benefited short-term.
Page 9 PREV PAGE TOP OF DOC Segment 1 Of 2 I am going to file legislation that would direct the SEC to promulgate rules that will deal with a situation in which the top decision makers in corporations cash in stock options and there is subsequently a drop in the value, because I think that is the public policy issue. I am not at this point ready to tell FASB what to do or what not to do on a subject which is such a difficult one intellectually. But I would hope that the existence of this option, the ability of the regulators to deal with the abuse of the perverse incentives given by stock options to chief executives, would be a relevant factor in the field, because we do have a genuine comment period. I think it is possible for some of us to say to the FASB that we are skeptical of the rectitude of their action, without being committed to overturning them congressionally because I am in that bind.
So I am going to be filing this legislation later that would direct the SEC to deal with what seems to me the serious problem here, which is the perverse incentive that the current stock option rules give to a handful of irresponsible and unethical chief executives and their top aides, and hope that that might be a factor in the debate.
Thank you, Mr. Chairman.
Chairman BAKER. I thank the gentleman for his statement.
Mr. OXLEY. Thank you, Mr. Chairman.
Let me congratulate my friend from Massachusetts, the Ranking Member, for his thoughtful statement. I think his statement does point out some of the difficulties that we as policymakers have in dealing with this complicated issue.
This is the third time in this Congress that we will discuss stock option accounting. The number of hearings this subcommittee has held demonstrates how important this issue is. I applaud Chairman Baker for his good work on this subject. In light of the Financial Accounting Standards Board's recent proposal, it is particularly important now.
Page 10 PREV PAGE TOP OF DOC Segment 1 Of 2 The question of whether stock options should be expensed has been debated for many years. Some, like the former Chief Accountant of the Securities and Exchange Commission, Walter Schuetze and numerous experts in accounting, believe that the FASB's position that the issuance of employee stock options creates an expense is simply improper accounting. Mr. Schuetze observes that the issuance of a stock option to an employee does not change the market capitalization of the corporation, as measured by the market value of the outstanding shares and the value of the outstanding option. Thus, there is no expense. If there had been a true expense, which he defines as the ''using up'' of an owned asset or the decline in the value of an owned asset, then the market value of the outstanding shares and option should have declined, but that is not the case. It also makes me particularly glad that I did not take accounting in college.
Others, like FASB, as evidenced by its recently released proposal, take the contrary view, arguing that employee stock options do constitute a corporate expense. FASB's position is that all employee stock options have value, which employees purchase with the services they provide. Because they have value, FASB asserts, when stock options are given to employees they give rise to compensation costs that are properly included in measuring an enterprise's net income.
Some point out that the grant of an employee stock option is an opportunity cost to the issuer. They argue that if a company were to grant stock, rather than options, to employees, the company's cost for this transaction would be the cash it otherwise would have received if it had sold the shares at the current market price to investors. But this situation is not analogous to that of the issuance of employee stock options. Not only are employee stock options issued exclusively to employees of the issuer, but each employee stock option is written for a specific individual. Thus, there is, by definition, no market into which these options can be sold.
Another significant problem is the accurate valuation of stock options, and we have been through this many times. While there is a diversity of opinion on the merits of requiring the expensing of employee stock options, there is uniform agreement on at least one aspect of this debate. It is extremely difficult to value these options. This gives rise to concerns that strike at the heart of financial statements. What use are they if not for purposes of comparing one company's statement against another's?
Page 11 PREV PAGE TOP OF DOC Segment 1 Of 2 The FASB itself recognizes that there is no options-pricing model that gives an accurate assessment of the value of options across all enterprises. The Black-Scholes model has been shown to have significant deficiencies for purposes of valuing employee stock options. The Binomial method has similar problems. FASB's solution is to provide no guidance as to what method a company must use to calculate value.
The lack of a uniform, reliable valuation method creates problems of comparability among companies, accuracy of the financial statements themselves, and, as one of our witnesses today suggests, even opens up the possibility of manipulation of earnings by management. These are concerns that merit further consideration. But as Craig Barrett, the CEO of Intel, has observed, whether or not stock options should be expensed is not just an accounting issue. It is also an economic issue. And that is the focus of today's hearing.
Preserving the independence of the Financial Accounting Standards Board is a consideration. That is an issue of process and jurisdiction and certainly the members of this panel have a great respect for FASB's expertise. However, some issues go beyond that of accounting and enter the mainstream of economic policy. If it is true that the adoption of FASB's employee stock option expensing rule would cause significant and serious damage to job creation, then it becomes an economic policy issue and one that Congress should certainly review.
Dozens of chief executives have publicly stated that their firms will reduce or eliminate options if the FASB proposal is enacted in order to avoid the negative impact that expensing will have on earnings per share, and in turn, the company's share price. If this is the case, then shareholders and our economy as a whole will sacrifice some measure of economic growth.
The venture capital community has been quite outspoken on this issue. One of our witnesses today discusses the great extent to which venture-backed companies rely on stock options to attract and retain talent. He also points out that in over 70 percent of venture-backed companies, stock options were awarded to all employees, not just top executives. These companies are a significant component of our economy. He cites statistics illustrating that venture-backed companies directly or indirectly accounted for 27 million jobs in 2000 and had sales constituting about 11 percent of our GDP. These are compelling figures. If the FASB proposal will undermine job creation and economic growth, then it calls for closer scrutiny by the Congress.
Page 12 PREV PAGE TOP OF DOC Segment 1 Of 2 The Congressional Budget Office study concluded that expensing employee stock options will not have a significant effect on the economy. The study argues that the information has already been disclosed in footnoted financial statements and thus is reflected in the stock price. We will examine today whether this analysis is correct.
While there are many informed experts on both sides of this issue, there are some aspects of this debate on which there is agreement. First, expensing employee stock options is not a silver bullet for achieving better corporate governance. Second, the importance of transparent, accurate financial statements cannot be overstated.
Mr. Chairman, I look forward to hearing from our esteemed panel of experts today as we consider once again the far-reaching implications of the FASB proposal.
I yield back.
[The prepared statement of Hon. Michael G. Oxley can be found on page 74 in the appendix.]
Chairman BAKER. I thank the Chairman for his statement and for his attendance here today.
Ms. VELAZQUEZ. Thank you, Mr. Chairman.
First, I want to thank Chairman Baker and Ranking Member Kanjorski for holding this important hearing. Stock options have contributed significantly to the economic growth of the U.S. economy, allowing smaller firms to grow and expand in a time when the labor markets may have chosen otherwise. During periods of strong economic growth and low unemployment, such as the late 1990s, the demand for specialized labor outstripped supply. As a result, wages and benefits were bid up to levels unseen in previous periods.
During such previous periods, companies that were rich were often able to attract and retain employees, effectively beating out smaller firms that lacked the cash flow of the larger competitors. During the 1990s, however, stock options leveled the playing field and permitted startups to compete with Fortune 500 companies for talented employees. Instead of economic oligopoly, new firms sprouted up across the country, providing the critical mass for new industries and markets.
Page 13 PREV PAGE TOP OF DOC Segment 1 Of 2 The accounting treatment of stock options is a complex issue. If it were not, this issue would not be before us today. First and foremost, I am concerned about any regulatory change that will threaten entrepreneurial activity. I believe that the churning of ideas is necessary for the U.S. economy to move forward and create the jobs that we so desperately need. Such creative destructionism can provide the U.S. with a model for long-term economic stability.
FASB has proposed a rule that will alter the accounting treatment of stock options. While the proposed rule does not prohibit firms from issuing stock options, it will require firms to expense these options in their financial statements, a distinct departure from FASB's current approach. I do have serious concerns with this proposed rule as it appears that it will disproportionately impact smaller companies relying on stock options to finance their early development and growth.
While it is not clear to me that the proposed rule will result in more accurate or comparable financial information for public companies, it is apparent that the rule will impose substantial compliance costs on startups. In addition, I am suspicious of any proposal that restricts smaller firms's access to the equity markets. By impeding smaller firms's ability to be competitive, as I believe this proposed rule does, our national economy and more importantly our local communities will be less likely to realize the benefits that innovation and risk-taking bring: new jobs, an expanded tax base, and opportunity for future generations.
Mr. Chairman, I too echo Mr. Kanjorski's request for an additional hearing with the FASB Chairman and the appropriate SEC officials before we move to mark up the legislation. With this in mind, I thank you for your leadership on this issue and I look forward to hearing the testimony of the witnesses on this complex issue.
Thank you, Mr. .Chairman.
Chairman BAKER. I thank the gentlelady for her statement.
Page 14 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. Royce?
Mr. ROYCE. Thank you, Mr. Chairman. Once again, I want to thank you for the hearing, and I want to thank you for introducing H.R. 3574, the Stock Option Accounting Reform Act.
Also, on behalf of my colleague from California, Representative Eshoo, and Representative Eshoo is your lead co-sponsor of H.R. 3574, I would like to submit for the record a letter from our California Treasurer, Philip Angelides in which he endorses this bill.
[The following information can be found on page 161 in the appendix.]
Let me say, Mr. Chairman, that I am extremely troubled by FASB's proposal which would require firms to expense employee stock options. Expensing options will have very negative consequences. In fact, just the threat of expensing has already changed the behavior in many firms. Mandatory expensing of employee options will effectively end the practice of granting employee stock options as we know it.
Stock options enable firms, often new economy-oriented firms, to attract talent that otherwise would go to companies able to pay higher salaries through cash compensation arrangements. Newer growth companies tend not to have large stable cash flows. However, through stock options, they can compete by offering employees an up-side in the event that the firm succeeds.
Incentive is perhaps the most important driver of economic growth. People advocating expensing are taking incentive for success away from the very companies that could be producing the next generation's goods and services. No economic model can dispute this argument.
California rests on the banks of the Pacific Rim. All of our country's new economy firms, but particularly those in California face greater and greater competition from businesses in Central and East Asia. I ask my colleagues to reflect on the fact that companies in China are striving to take away our global edge in technology. China graduates now 195,000 engineers and computer programmers annually. Many have made the point that the Chinese government has embraced stock options in its 5-year plan. Here is my point. I am worried that while communist China is learning capitalism, we are forgetting it.
Page 15 PREV PAGE TOP OF DOC Segment 1 Of 2 Again, Mr. Chairman, thank you for the leadership on this issue. I look forward to the testimony of our distinguished witnesses. I yield back.
Chairman BAKER. I thank the gentleman.
Mr. CROWLEY. Thank you, Mr. Chairman. Thank you for holding this hearing today. I want to thank the ranking member as well, Mr. Kanjorski, for his input and his presence here today, as well as the Chairman and the Ranking Member of the full committee for their interest in this issue.
I want to begin by expressing my gratitude for FASB and the role that it plays in our economy, that of ensuring independence and credibility of our nation's accounting systems. At the same time, I also have to state that I disagree with FASB's recently proposed rule change, the mandatory expensing of all stock options as I believe this rule does not deal solely with accounting principles, but rather also deals with economic policy as well.
While accounting standards should be left to FASB, economic policy should and must remain with Congress and the executive branch. I believe this differentiation between accounting policy and economic policy must be made when discussing this proposed rule change. This proposed regulation will not address concerns about excessive executive compensation or reliability of a company's financial statements. Rather, I believe this rule will adversely affect employees who receive stock options, especially employees whose companies provide broad-based stock option plans, thereby hurting wealth creation and weakening or eliminating the basic economic instrument that created the economic boom of the 1990s and is still used frequently today by venture capital startups.
Besides delving into economic policy, which is not I believe the role of FASB, I have additional concerns about this rule, such as that this expensing mandate will provide less, not more, integrity in accounting. Supporters of this rule will argue that it makes accounting more honest. I have to differ. In fact, this rule will allow two different methods for companies to expense their options, either binomial or Black-Scholes, both of which are not considered accurate evaluation models. In essence, this rule will allow companies to pick and choose their accounting methods, providing more confusion, I believe, and more dishonesty in financial statements. This rule will allow corporate accountants to decide which expensing system works best for their company's goals.
Page 16 PREV PAGE TOP OF DOC Segment 1 Of 2 Whereas today, to keep accounting honest, those same firms with stock options must, under FASB's guidelines, disclose the value of their options in the company's financial footnotes, as mentioned earlier, or charge it directly against income, leaving no economic surprise for any investor.
Additionally, supporters of this rule will argue that there is nothing in this rule that prevents the issuance of stock options and that the CBO report states that expensing of options will not have any adverse consequences. They go on to argue that some companies such as Coca-Cola expense their options now and have not seen a drastic adverse affect in their stock price. But when referencing Coke as an example or using the CBO report to justify this expensing mandate, supporters of expensing do not take into account the issue of broad-based stock option plans that benefit all company employees, not the regular stock option plan that benefits the few at the top of the corporate pyramid. Companies like Coke provide and expense their options, but they are not broad-based plans. They are options for top corporate executives.
The mandatory expensing of stock options would effectively destroy broad-based stock option plans which enhance financial opportunities for workers at all levels, stimulate economic growth, and help create the new economy of the 1990s, a new economy, as I mentioned before, that we are still feeling the effects of today. In fact, it is these broad-based plans that have spread wealth throughout all sectors and to all employees of our new economy, from CEO to secretary. Ninety-eight of the nation's top 100 largest high-tech firms that focus on the Internet provide options to most or all of their employees, and most of these options go to the rank-and-file workers, helping stimulate wealth creation for employees while allowing employers to attract the best talent.
Contrary to popular belief, these people receiving broad-based stock options are not all located in Boston and San Francisco. Statistics show that 41 percent of those receiving broad-based stock options live in the South and 24 percent live in the Midwest. Unfortunately, we already are starting to see, as was mentioned before, the negative effects of this FASB rule. It has not even been finalized as of yet. Some companies are already beginning to scale back their broad-based option plans in anticipation of the FASB rule, and I believe this hurts employees and not the executives.
Page 17 PREV PAGE TOP OF DOC Segment 1 Of 2 I am supportive of an independent FASB for the purpose of making accounting rules, but again this rule is not about accounting. It is about economic policy, and I believe that belongs with Congress and the executive.
I yield back the balance of my time.
Chairman BAKER. I thank the gentleman for his statement.
I have no further members on our side seeking recognition for an opening statement, so the next person to go to is Mr. Scott.
Mr. SCOTT. Thank you very much, Mr. Chairman. Certainly, this is an extraordinarily important and yet complex issue.
I think that as we move forward on this, and I have enjoyed working with the Chairman on this issue, but it is clear that the legislative process is really working here and raising some questions and putting some issues on the table that certainly need to be dealt with as we move forward.
My understanding of H.R. 3574 is that it does indeed immediately dispense with the stock options requirement for the top five executives in a corporation. It provides for a study before moving forward, and certainly exempts small businesses from the first three years. The question is, though, is that enough.
I think there are three issues here that we certainly have to exhaust before we move forward. First of all, what impact does this have by immediately stopping the stock options for the top five executives in a corporation, for the rank-and-file members who for years have benefited from stock options. I think we have to move gingerly to make sure that is continued.
The other issue, of course, is small startup businesses. Is the exemption enough for the first 3 years, especially our technology companies. It is very important that we respond to that concern. The third area of concern for me, of course, is to hear from the SEC, to hear from FASB, to make sure as we move forward we are doing the right thing in dealing with the abuses and to stop that and regain the confidence of the American people in our most treasured possessions, and that is in our corporations that are the bulwark of our economic system, without doing tremendous damage otherwise.
Page 18 PREV PAGE TOP OF DOC Segment 1 Of 2 So Mr. Chairman, I really look forward to this, going forward, and I hope that we can address those three concerns as we move forward as we deal with this very complex issue.
Chairman BAKER. I thank the gentleman.
Mr. SHERMAN. Thank you, Mr. Chairman. As the only member who will begin his statement by saying I am glad the FASB is looking at this issue, I do have a lot to say.
Let me begin by looking at this whole idea of broad-based options. I have drafted the option plans. I have consulted with the companies on their option process. Yes, there are a few companies that have broad-based plans, but in general you are talking about 80 percent of this benefit going to the top 8 percent of the employees across the board in this economy. When we look at the bill that is being proposed to deal with this, it supposedly is there just to protect broad-based.
Look at two important details in the bill. First, even when options are granted to the top five people in the company, you have to assume zero volatility. So it is not just a bill to protect broad options. It is a bill to massively undervalue options given to the top five executives. Second, if you are number six at GM, you are probably doing pretty good. We should instead, if we want to focus on broad-based options, look at options which when valued at time of grant are less valuable than $100,000 per employee per year. That would allow us to make sure that we are giving a special benefit only to those options that are not being used for the purpose that options have been used for, and that is to make our corporate executives the richest corporate executives in the world by far.
Now, we should be matching expenses and revenue. That is basic accounting. So we are told that somehow a stock option is not really an expense. It is not anything of value. Well, if it was not anything of value that was being given up, why does everybody want it? More importantly, what is an option? It is a piece of the future growth of the company, transferred from the current shareholders to the option grantees, the executives. That is very much a transfer of something of value.
Page 19 PREV PAGE TOP OF DOC Segment 1 Of 2 That is why if the company were to grant options which could be very similar in their form to employee stock options, would it grant those to private investors? That would be a recognized transaction. The proof of what I am saying is this. Let's say we really cared not about whether the executives got compensated, but there was health care for the bottom half of the employees, particularly in big companies that may not even use stock options now.
We told corporate America, you can grant stock options to insurance companies if those insurance companies are giving health care to the bottom half of your employees. That is an expense. It has always been an expense. That is why companies do not use that as a device to pay their insurance companies. Instead, they have to pay them in cash, and increasingly they decide not to pay the cost of today's health care.
If the transfer of an option to acquire something use for the company, like the work of the employees, is not an expense, why just employee stock options? Why can't you buy your building for stock options and not list that as a cost? Why can't you pay your telephone bill with stock options and not list that as a cost? The reason is because stock options is another way of paying an expense.
Now, if we do things right and expense stock options, then we will I think show the world that perhaps unlike China, unlike some others, we have the best, clearest, most transparent, fairest, most logical accounting system being imposed, even when powerful interests disagree. The effect will be to reduce executive compensation in this country. The effect will also be, and it will not be a major effect, but it will be an effect. There will be a slight reduction in the amount of capital flowing to those companies that use stock options and that capital will instead flow to some older companies that tend not to use stock options. Is it better that a stock that somebody invest in Intel than invest in Proctor and Gamble? Gee, I do not know, but picking winners and losers has never been a proper role for this Congress.
So I would like to argue that FASB is doing its job and we should leave them alone. There is one problem. FASB is not doing its job, two huge problems up there in Connecticut. First, this exposure draft just kind of leaves drifting do you use binomial? Do you use Black-Scholes? When do you use one? When do you use the other? Any guidance? Or do you just hire the accounting firm, there are not many left, but do you just hire the accounting firm that will give you the lowest stock option value? If they are going to do their job, they ought to do it.
Page 20 PREV PAGE TOP OF DOC Segment 1 Of 2 But there is a much greater problem with FASB and it is a related issue. We cannot talk about stock options without talking about research expense, because the biggest argument against what FASB is doing is that it will hurt high tech. Well, let's talk about something that really hurts high tech, not just something that may disadvantage a few executives in high tech, but rather that disadvantages high tech in general. FASB will admit it is completely wrong as a matter of accounting theory, but they have left it in place for over 30 years, and that is the expensing of all research. The effect is for us as an economy to under-invest in research, for stockholders to under-invest in companies that do research.
Why is this related? Because if we are going to hit tech with bad accounting for research, should we also hit them with good accounting for stock options? Is it fair to take a sector of our economy and require them to expense stock options, which is good accounting, while at the same time requiring them to expense the nearly $2 billion they do every year of research, which is bad accounting.
So when this bill comes up, I will propose an amendment that it remains in effect only so long as FASB fails to allow for the capitalization of successful research and development expenditures. When FASB solves that problem, it will have a far greater affect on encouraging investment in high tech than anyone ever argued that this stock option thing has a negative affect. If I am able to get that amendment passed, and I realize it will be a matter of first impression to most of my colleagues, I will support the bill, in which case, and I think right now I am the only one speaking against it.
So we need to have a fair accounting system for tech companies, one that recognizes that when you give a stock option, you have given something, but when you have done research and it is successful research, you have bought an asset.
I yield back and I thank the Chairman for his indulgence.
Chairman BAKER. I thank the gentleman.
Page 21 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. Lucas?
Mr. LUCAS. I am ready to hear from the witnesses.
Chairman BAKER. Thank you, Mr. Lucas.
Mr. MILLER OF NORTH CAROLINA. I agree with Mr. Lucas.
Chairman BAKER. And Mr. Hinojosa?
Mr. HINOJOSA. Thank you, Mr. Chairman.
Chairman Baker and Ranking Member Kanjorski, I want to thank you for holding this very important and timely meeting. Chairman Baker, I want to note first and foremost that I am a co-sponsor of your legislation, H.R. 3574, the Stock Option Accounting Reform Act. I remain an ardent supporter of this legislation despite FASB's March 31 proposed rulemaking that would require companies to report as an expense the value of stock options they give to executives and rank-and-file employees.
In fact, FASB's recent proposed rulemaking demonstrates how important it is that Congress pass your legislation, particularly section three of your bill. Section three would prohibit the SEC from recognizing as generally accepted any accounting principle established by a standard-setting body relating to the expensing of stock options pending the completion of an economic impact study by the Secretary of Commerce and the Secretary of Labor.
What everyone here needs to recognize is that stock options are an important tool to attract talent to new ventures, and that mandatory expensing of stock options will stifle their issuance, reduce company profits, and deter innovation and economic growth. FASB's proposed rulemaking likely would result in the disappearance of stock options. The disappearance of stock options will inhibit a company's ability to attract and retain skilled employees.
If the FASB rule takes effect, many of the companies will stop issuing options to their rank-and-file employees. There is no reliable nor accurate formula to properly value them, contrary to what FASB contends.
Page 22 PREV PAGE TOP OF DOC Segment 1 Of 2 In closing, I want to include in my comments concerns that I see in global competition with large importing nations like China. Mr. Chairman, the Chinese government has incorporated stock options into its 5-year economic plan to boost its technology industry. As a member of the House Manufacturing Caucus, I know all too well that many of America's manufacturing jobs have already been outsourced to China, thus negatively impacting our U.S. economy. FASB's proposed rulemaking poses a similar risk in that venture capital companies and high-tech companies might relocate to China or other stock option-friendly nations if registered companies are required to expense their stock options in the United States.
Mr. Chairman, I want to work with you and other co-sponsors of your legislation to at least delay the implementation of FASB's proposed rulemaking, either by passing your legislation as a stand-alone measure, or working together to incorporate it into other legislation to ensure its passage. Hopefully, we will succeed in this endeavor.
I yield back the balance of my time.
[The prepared statement of Hon. Rubén Hinojosa can be found on page 81 in the appendix.]
Chairman BAKER. I thank the gentleman.
If there are no other members desiring to make an opening statement, I want to welcome our witnesses to our hearing. I hope you have enjoyed it today. We would like to remind each of you that despite the length of members's comments, we do request that each of you try to limit your remarks to 5 minutes. Your formal statement will be made part of our hearing record. I welcome each of you. We look forward to your comments.
I would turn first to Mr. Jeff Thomas, field applications engineer, Altera Corporation. Welcome.
STATEMENT OF JEFF THOMAS, FIELD APPLICATIONS ENGINEER, ALTERA CORPORATION
Page 23 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. THOMAS. Chairman Baker, members of the subcommittee, I want to thank you for hearing my testimony today.
My name is Jeff Thomas. I am a field applications engineer for the Altera Corporation in San Jose, California. Altera Corporation manufactures and sells programmable logic devices, which are semiconductor chips used in a broad range of applications. In my role as an FAE, it is my responsibility to provide on-site technical support to one of our largest customers, which is a major telecommunications company.
In my daily work, I train engineers on how to use our chips. I present our new technology to our customers and I ensure that their systems are successful. I am here today because I volunteered to participate in this hearing because stock options have played a large role in my decision to pursue a career in the high-tech field. I wanted to communicate to you the impact that they have on employees as well as companies that offer broad-based stock option plans.
I graduated from Carnegie Mellon University in 2000 with a bachelor's degree in electrical and computer engineering. I had job offers from a broad range of companies at the time of my graduation. During my time at CMU, I had a couple of summer internships at Fortune 500 companies, and both companies offered me a job upon graduation. However neither offered a broad-based stock option plan.
I also interviewed with a number of high-tech firms, and every job offer that I got from a high-stock firm did include stock options. So I decided that I wanted to work where I had a stake in the success of the company. I decided I liked the idea of being able to profit not only from my salary, but also from the growth of the company.
In retrospect, I can definitely say I have seen a difference in both the behavior and performance of employees in high-tech firms that have a vested stake in their company, compared to the people that I worked with at companies where they did not have that ownership stake.
Page 24 PREV PAGE TOP OF DOC Segment 1 Of 2 My first day at Altera, I was granted stock options that would vest over the next four years. So after one year if I stayed with the company, 25 percent of those options would vest. If the stock price had gone up, I could buy and sell those options and realize a profit. I could not transfer those options or sell them on an open market of any kind. I could only use them for my own personal gain.
Also each year at my annual review, I was granted a new batch of stock options based on my performance that would follow a similar vesting schedule. This ensures that I was constantly motivated to stay with the company and continue to work for its long-term growth .
Stock options are a great incentive for employees. People work hard not only to advance their personal companies, but to grow the company as a whole. They allow all employees to grow into the success of the company. As the sales and profits of a company increase, the employees benefit through the appreciation of the stock price. This fosters an environment where employees will go out of their way and beyond their job descriptions to grow the company as a whole.
Stock options are also a strong motivation to stay with a company. Because of their vesting schedule, employees are incentivized to stay with a good company. Since I believe in Altera's long-term vision, I want to stay with the company and continue to build my ownership share in that company through the stock option program. Because everybody at Altera has a stake in the company, we are all committed to making the company successful in the long term.
This behavior is not unique to Altera. I see this type of dedication and work ethic at companies all around Silicon Valley. All my friends, whether they work at big telecom companies or small startups, share the same desire to see their company become successful because they share a stake in that company. Engineers in the valley often work long hours and weekends to make sure their company succeeds because each person has a personal stake in the enterprise beyond just their salary.
Page 25 PREV PAGE TOP OF DOC Segment 1 Of 2 Already in my career I can say I have seen the effect of broad-base stock option plans in action. I have been able to compare the atmosphere at a high-tech company in Silicon Valley to some of the Fortune 500 companies I worked at as a summer intern. I can definitely say that people in Silicon Valley work harder, longer and care more about the long-term performance of the company than employees that are just there to get a paycheck.
Throughout my career, I want to continue to work at companies like Altera that offer stock options to a broad base of employees so that I can continue to work towards the shared goal of increasing the company's value. I believe this promotes an extremely valuable working environment.
I also believe that anything that would make it more difficult for a company to grant stock options would hurt the company's performance overall. The success of Silicon Valley is based on the work ethic and dedication of its employees. This work ethic is a direct result of the fact that employees know that they will share in the success of their company. If anything happens that would not allow the companies to offer their employees a share in that success, I believe the overall performance of that company would be hurt.
I sincerely hope you will consider these positive impacts of stock options on both employees and their companies while you are determining the fate of this bill.
Thank you again, Mr. Chairman and members of the subcommittee. I am happy to answer any questions you have at this time.
[The prepared statement of Jeff Thomas can be found on page 157 in the appendix.]
Chairman BAKER. Thank you very much, sir.
I follow a script, Mr. Kruse, and I should have recognized you first, but your name did not appear first on my list. So I recognize you at this time, Mr. Douglas Kruse, professor, School of Management and Labor Relations, Rutgers University. Welcome, sir.
Page 26 PREV PAGE TOP OF DOC Segment 1 Of 2 STATEMENT OF DOUGLAS KRUSE, PROFESSOR, SCHOOL OF MANAGEMENT AND LABOR RELATIONS, RUTGERS UNIVERSITY
Mr. KRUSE. Thank you. I am pleased to be here.
I am a professor at the Rutgers University School of Management and Labor Relations. I am also Research Associate at the National Bureau of Economic Research in Cambridge, Massachusetts. At the NBER, I am working with Professor Richard Freeman of Harvard University and my Rutgers colleague Joseph Blasi. We are co-directing a project looking at shared capitalist programs in U.S. companies.
I am also co-author of a book that came out last year, In the Company of Owners, that looks at broad-based stock options in U.S. companies, co-authored with Joseph Blasi and Aaron Bernstein. I regret that I did not bring a copy of the book to wave around. As Doug was pointing out, my publisher will never forgive me for forgetting that today.
As part of the NBER project, we added some questions to the 2002 General Social Survey, a representative survey of working Americans. I want to summarize a few results from that and some other evidence for you very quickly. What we found was that 13 percent of private sector employees say they hold stock options. That translates into 14 million stock option holders. We also found that 23 million workers say they own company stock, 15 million of them through employee stock purchase plans.
Contrary to popular impression, most stock option holders are not rich executives. In fact, a very striking finding, the one that I would really point to, is in appendix one of my testimony. It turns out that 79 percent of stock option holders earn less than $75,000 a year, and well more than half earn less than $50,000 a year. We provide a variety of breakdowns in appendix two showing that the majority of the stock option holders are non-managers. More than 90 percent say that they are in the middle-or working-class, and they are spread across regions and across the social and political spectrum. We do the same thing in appendix three for holders of company stock, and find very similar results. They are very representative.
Page 27 PREV PAGE TOP OF DOC Segment 1 Of 2 I have strong reservations about expensing, since many companies say that they are going to first cut broad-base stock options if expensing takes place. There were four studies last year in 2003 that analyzed hundreds of corporations. They found that one-half to one-third were already making large cuts in stock option plans. One-half to two-thirds planned cuts in employee stock purchase plans.
One might say, well, maybe the companies are just crying wolf. In the last few days, Joseph Blasi and I looked at the first 10 companies to file SEC proxies for 2003 out of the largest 20 companies, the Fortune 20 companies. Of these 10, six had already announced that they will expense stock options. Five of those six have already increased the share of stock options going to the top five executives from 2002 to 2003, and all six of them increased the share going to the CEO. If this trend continues, we think it will be deeply troubling. It could be bad not just for regular employees who will be cut out of stock options, but it could be bad for company value as well.
We did a recent study on executive compensation over the past 11 years in the 2,000 largest companies. We found that increases in executive compensation, including different measures of stock options, do not predict future shareholder returns. In contrast, we surveyed over 20 years of evidence on broad-based employee ownership, profit sharing and stock options in chapter seven of our book, that I should be waving around now. The evidence clearly shows that broad-based plans are linked to higher productivity and shareholder return on average; not in every company, of course, but on average.
It would be a shame if expensing discourages companies from using and extending these plans that can improve performance. Public policy should be encouraging policies that improve performance.
So our conclusion is if there is expensing, it makes sense to somehow preserve broad-based plans. One good approach could be to expense just for the top five executives, as the current bill proposes. If expensing does go through for all employees, another possibility is to create a tax credit that would offset the option expense only for companies with truly broad-based plans. This could be an alternative to the existing deduction when options are exercised, so it could end up actually being revenue-neutral, a tax credit that would end up being revenue-neutral.
Page 28 PREV PAGE TOP OF DOC Segment 1 Of 2 Finally just as a last note, I call attention to another House bill that would create a presidential commission on employee ownership. Given the importance of all these issues, given the debate around this, we think a presidential commission on employee ownership could be a good way to explore those issues.
Thank you very much.
[The prepared statement of Douglas Kruse can be found on page 125 in the appendix.]
Chairman BAKER. We thank you very much. You may wave the book at any time you choose. Thank you.
We welcome next Mr. Douglas Holtz-Eakin, Director of the Congressional Budget Office. Welcome, sir.
STATEMENT OF DOUGLAS HOLTZ-EAKIN, DIRECTOR, CONGRESSIONAL BUDGET OFFICE
Mr. HOLTZ-EAKIN. Mr. Chairman, Congressman Kanjorski, members of the committee, the CBO recently delivered to Congress a study entitled Accounting for Employee Stock Options, which details the fact that employee stock options are an economic cost to firms. They represent an exchange of value in return for labor services, and displaying that valuemeasured by the fair value or cash equivalent of the option and recognized over a period that the labor services are used, the vesting periodleads to a more accurate portrayal of net income in economic terms.
Correspondingly, the failure to display this on financial statements leads to an overstatement of economic net income. Valuing employee stock options is a difficult task and is complicated by features such as vesting periods, forfeiture provisions and non-transferability of these options. However, advances in financial analysis permit reasonable valuation of such options, as they do comparable instruments such as warrants which are currently held in many entities portfolios. And such valuations are similar in their accuracy to those of such complicated issues involving uncertainty as retiree health benefits, the impairment of goodwill, or the cost of environmental cleanup, which may occur in the future.
Page 29 PREV PAGE TOP OF DOC Segment 1 Of 2 These are all currently displayed in the firm's financial statements. One would anticipate that the increased use of these techniques under the prospect of the proposed FASB standard might lead to further advances in the ability to value these options more accurately. Recognizing the expense of employee stock options would not alter the economic fundamentals of any business. It would not alter the markets in which they compete for customers, their international or domestic competitors, or the prices that they charge.
It would not have any impact on the labor markets in which they hire their workers or the need for compensation and appropriate incentives for those workers. It would not alter the technologies that they currently deploy nor the incentives to acquire and deploy new technologies. And fundamentally, it would not alter the cash flows used to conduct their operations.
Any potential economic impact of expensing employee stock options will come through changes in investors's evaluations of these firms. For savvy investors and for most firms, no new information will be provided by moving the disclosure from the current notes onto the face of the statement. Expensing would simply make it easier and more broadly possible to do the same valuations that are available today.
It is the case that some valuations may decline. If so, those firms and their workers would suffer the costs and experience disruption from the reduced availability of equity capital to those firms in the near term. However some may also rise, and on balance one would expect that there would be no great overall impact on the U.S. economy and that any targeted impacts on particular firms would be outweighed by the improved allocation of capital on the economy, resulting in increased employee productivity, and improved economic performance.
One cannot know for sure the overall economic impact in advance of the adoption of the FASB standard. However, the experience as displayed thus far for those firms which have voluntarily undertaken expensing or from the experience from countries such as Canada which has not only proposed, but implemented an expensing standard, or the area of the European Union which has announced a standard, but not yet implemented it, all suggest that there would be no broad-based economic impact.
Page 30 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. Chairman, we thank you for the chance to discuss our report today and look forward to your questions.
[The prepared statement of Douglas Holtz-Eakin can be found on page 107 in the appendix.]
Chairman BAKER. I thank you very much for your participation in our hearing today and your statement.
Next, I wish to welcome Mr. Kevin Hassett. Please proceed at your leisure.
STATEMENT OF KEVIN HASSETT, DIRECTOR OF ECONOMIC POLICY STUDIES, AMERICAN ENTERPRISE INSTITUTE
Mr. HASSETT. Thank you very much, Mr. Chairman.
I agree with Mr. Oxley and Mr. Ose, Mr. Chairman, that the best reading of the literature is that right now the literature is not exactly sure how to value these options. The literature is not sure how to value these options because of issues mentioned by Mr. Holtz-Eakin, but also because the options have a much longer life than the type of options that are marketed these days. To my mind, having been immersed in the technical details since my dissertation, I think that is the most relevant issue here.
Indeed, Warren Buffett himself said in the Financial Times that the minute you get into longer-term options, it is crazy to use Black-Scholes. The fact is that is true. In fact, this issue has even made it into the leading text books, as is mentioned in my testimony, and developed in more detail in a recent paper prepared by Glenn Hubbard and Charles Calomiris for the American Enterprise Institute.
So I think this explains why it is that FASB has been going so slowly on this issue, given their clear designs on expensing. The fact is, as you get close to expensing and think about how to do it, contrary to Mr. Holtz-Eakin's statement, you find that it is not the case that there is an accepted way to do it, which is why FASB has refused to specify, it appears to me in reading their documents, precisely how firms are supposed to do it.
Page 31 PREV PAGE TOP OF DOC Segment 1 Of 2 So in my testimony, what I do is really go after the question that Mr. Frank raised in his opening statement. How is it that you could actually change the world if the market is efficient, if it is looking at the details on options already, then if you move an expense calculation maybe that is incorrect up to the top line, what effect does that really have on anything? Just like if we subtracted 10 from earnings, then what a rational investor would do is they would just add 10 back in. So if we do something wrong, the rational market ought to see through it.
What I found after studying this issue with my colleague Peter Wallison at the American Enterprise Institute, who as you know is a very distinguished attorney who has worked for President Reagan and has had other positions in town, is that it is very likely that if we do not tell firms how to expense options and know that we are basically giving them a problem to solve that has not been solved by the literature, then we are going to open up a real legal mess that will potentially tie firms up in class action lawsuits for years and cause you to have to consider new legislation.
In my testimony, I provide a simple example of the state that I think we might end up in if FASB has its way. That is, suppose that for example a publisher that finishes a book in 2003 and plans to send it to the book stores in 2004, is required to forecast the sales in 2004 for that book by FASB and include that in their 2003 statement. And FASB does not tell them how to forecast it. They just say, you have to say, since you paid for the expenses of the book in 2003 what the sales are going to be in 2004.
Well, the firm would presumably try its best to develop a model to forecast sales, but of course on average there would be a whole lot of firms that would make errors. As soon as they make those errors, the earnings will be misstated, and that will open the firm up to class action lawsuits. It is my belief and Mr. Wallison's belief, and we have spelled this out in great detail in a paper that is just coming out in Regulation magazine, that the real reason why the expensing of options is going to cause firms to not use them as much as they do now, and to shy away from them, is because if you do not specify a model, then everybody is going to get the expense wrong. Probably about half the firms at least are going to have over-stated their earnings because their model led them to do that. With that over-statement, they are going to find themselves enmeshed in really difficult lawsuits.
Page 32 PREV PAGE TOP OF DOC Segment 1 Of 2 So I think it would be a big mistake for FASB to require the expensing of options without expressly stating how to do it. If they expressly state how to do it, then the firm will at least have the defense that we are just following FASB's directions and that defense might well be a reasonable one and a successful one. Absent that, I think that FASB is creating a real mess for our corporations and one that will lead them to shy away from the use of options.
[The prepared statement of Kevin A. Hassett can be found on page 90 in the appendix.]
Chairman BAKER. Thank you very much. I appreciate your participation.
Our next witness is Mr. Phil Smith, chairman of the board, Taser International. Welcome, sir.
STATEMENT OF PHIL SMITH, CHAIRMAN OF THE BOARD, TASER INTERNATIONAL, INC.
Mr. SMITH. Thank you, Mr. Chairman and subcommittee members. It is a pleasure to be here. Let me give you a quick background and then launch into what I have to say.
I have an undergraduate degree from West Point, MBA and I have a PhD in business and a specialty in finance, so I clearly understand all the theoretical arguments. I have been a corporate officer in three Fortune 500 companies and I have done five high-tech startups. I spent the last 35 years in this business, so I have lived it from almost the inception.
I guess I am one of the few guys here who can talk from practical reality and not some theory. I really get a kick out of most of the people testifying yesterday in the Senate and have never seen an option, used an option, have ever benefited from an option or ever used them to try and attract employees to a company. That is what is most disappointing to me. The people that are really involved have had very little voice in what is going on. I hope that this committee takes this to heart.
Page 33 PREV PAGE TOP OF DOC Segment 1 Of 2 I can give you one example, of these five startups. I did one in the Silicon Valley in 1983 that we sold in 1985 very successfully. The employees out of that company started 12 new companies. They took the money they earned from the options and literally like a thing exploding with seeds, 12 new companies started in the Silicon Valley in 1985 from the people from that company.
I can go through example after example. I do not have the time. Options are used not only for employees. As I pointed out in my testimony, when we went public 3 years ago at my current company, Taser International, we were in need of some interesting board members to comply with the corporate governance that Chairman Oxley has been kind enough to levy on all corporations in America. When you go out and talk to significant board members and people with a strong background, there is a real risk in coming on a public company's board today. The trial lawyers love to have them. People are very concerned about joining public boards, especially young public companies. One of the ways we got the people we did, the caliber we got, was the ability to use options.
Now, it turned out they have been very successful. They all have made quite a bit of money as a result of that. But at the time they took those options, they accepted the risk. You take this option away from us and force to expense and I do not know how we are going to attract these board members. We could not have afforded to pay them the money it would have taken to get them on our board and provide the governance that the Congress is looking for.
The second thing is, it is a double whammy for small companies. A current thing, our stock is extremely volatile. It fell 32 percent yesterday, which happens to be just one data point. The stock is up 6000 percent over the last 12 months. We have what is called a very high volatility. We get penalized because, one, we are a small company and secondly, we are highly volatile. You take the measurement of our company. We will get two penalties, not just one. One, we are small; second, we are highly volatile.
Page 34 PREV PAGE TOP OF DOC Segment 1 Of 2 Those will really impact the bottom line of our company, and obviously a lot of our investors are retail investors. I agree, the sophisticated investor can read the footnotes in our balance sheet. They are cops. They are police officers around the country that own 100 or 200 shares. They do not understand the sophistication of footnotes, and they are not going to understand when all of a sudden the earnings drop on the company compared to other companies in the industry.
Third, I would like to talk about the issue of tax. Our corporation has not paid tax for the last couple of years because of employee options. When they exercise their option and make the profit, they pay a personal tax. The corporation gets the benefit. We have been able to retain that tax and use it to grow, and we have grown our employee base to 199 employees from 70 a year ago by using that cash flow. It would normally have been paid as corporate income tax. Nobody has talked about the tax issue here, about the corporations that are allowed to retain that tax, the cash on their balance sheets and use it to grow.
Let me give you one last thing. We have stopped issuing options. We have given all our employees their final options this year. They vest by the end of the year, merely because of this legislation. We do listen to what goes on in Washington. We do watch what is going on and we are not about to penalize our shareholders and ourselves by issuing a bunch of options that we have to expense in future years. We have told our employees there will be no more options if this passes, and the only people that are going to get it are the top five.
My last comment, as Mr. Sherman mentioned, he tried to contain executive compensation with the $1 million salary cap, and we all see how effective that was. They just reported the highest executive compensation in the country this past year, I think it was in USA Today. So it had very little effect on the top five. Your proposal will address the top five and let the average employee have a chance to benefit in the success of their company. At Taser, we have 20 millionaires, from secretaries to production employees, right up the line. They are the ones who are going to lose out. Those are the ones who will not get the options. It will still go to the top five. I certainly hope you are successful, Mr. Chairman.
Page 35 PREV PAGE TOP OF DOC Segment 1 Of 2 Thank you.
[The prepared statement of Phil Smith can be found on page 152 in the appendix.]
Chairman BAKER. Thank you very much for your contribution here.
Our next witness is Mr. Robert Grady, managing partner, Carlyle Venture Partners. Welcome.
STATEMENT OF ROBERT E. GRADY, MANAGING PARTNER, CARLYLE VENTURE PARTNERS
Mr. GRADY. Thank you, Mr. Chairman and members of the subcommittee. I appreciate the opportunity to present this morning, not only on behalf of the Carlyle Group, which is one of the world's largest private equity firms, but also I serve as a member of the board of directors of the National Venture Capital Association. By coincidence, I also have taught for the last decade on the faculty of the Stanford Business School, which we will come back to in a minute.
The FASB has asked for comment on this exposure draft, and our comment is simple. The proposal is inappropriate. It is incorrect as a matter of financial and accounting theory. I think it is poorly thought-out and it is very definitely unworkable.
Before I comment directly on the exposure draft, let me just offer a little context that makes clear the typical use of stock options today in the economy.
The two venture capital funds that I spend every day managing, which were started in 1997 and 2002 respectively, have investments in about 38 different companies, all started from the ground up. Those 38 companies employ over 4,000 people. In the five private companies on whose boards I sit, Blackboard here in Washington, DC; Panasas in Fremont, California; USBX in Los Angeles; Secure Elements out in the Virginia suburbs; and Ingenio, also in California; incentive stock options are granted to every single employee, from the receptionist to the CEO. That is typical in the venture capital world. In fact, according to a recent survey by the NVCA, over 70 percent of venture-backed companies award stock options to every single employee. You heard Professor Kruse state that half of all option holders in the country earn less than $50,000 a year.
Page 36 PREV PAGE TOP OF DOC Segment 1 Of 2 The standard type of grant in a venture-backed company is a grant that is vested to encourage an employee to stay at the company. A typical structure, in fact the most commonly used in venture-backed companies, calls for the grant to vest over 4 years, just like the grants that Mr. Thomas received when he joined his company, with so-called ''cliff vesting'' on the first anniversary of employment of one-quarter of the options and then monthly vesting of the remaining three-quarters each month over the next 3 years.
That is an important point to understand about how options work, because under the FASB's exposure draft, with its provisions for graded vesting, the normal grant of stock options, the one that virtually every venture-backed company in America uses, will have to be valued 37 different times per grant. Somehow, the FASB believes this will make financial statements more understandable.
Let me turn to the FASB's exposure draft and how its policies will work or not work if implemented. First, I do feel compelled to start with a fundamental conceptual point, and that is that options are units of ownership. They are shares. They are not expenses. They are not claims of cash against the company's resources. They are not the use of a company asset. Basically, they should be treated and disclosed, in my view, in the denominator, if you will, of the earnings-per-share calculation. If you account for them in both the numerator and the denominator, you are double-counting them.
So if in fact FASB were proposing in this exposure draft that when companies report earnings per share, they had to disclose in every case the fully-diluted share count, that is, including all options outstanding in the denominator, I think that would be a fair and very workable proposal. I think this point is essential, because at its heart, what this debate is all about is that many Americans, and in fact people all over the world, are willing to trade off cash compensation for units of ownership. They are willing to earn less cash today and thereby create less in terms of ongoing expenses by the company, so that over the long term the company will be worth more. In other words, they are thinking like owners. It is good for other shareholders who might choose to join them along the way that they are thinking like owners, because their interests are aligned as mutual owners of the securities of the company.
Page 37 PREV PAGE TOP OF DOC Segment 1 Of 2 Ironically, the proponents of expensing say that requiring it will not have the dire effect that many predict, that some of us predict, because they say investors will just in effect ignore it. Investors will basically strip out the effect of expensing and look straight to cash EPS. So in other words, they will ignore GAAP. The reason they will do it is precisely because it will not be representative of the company's true expenses. That is exactly what I believe Representative Frank was saying, if reality does not change. So the irony of the FASB proposal, in other words, is that it is likely to undermine confidence in and the use of GAAP accounting, which one presumes to be the exact opposite of the objective of the proposal.
In the gymnastics that FASB has had to go through to get over this fundamental point, in trying to define units of ownership as expenses instead of shares, they have created a number of problems that I would just like to touch on and enumerate briefly.
The first obstacle, of course, is trying to define the appropriate measurement date at which to value an option. There are two different possibilities. The FASB has suggested that the grant date is appropriate. The problem with this, of course, is that the value of the option at grant date is highly uncertain. It may never vest. The employee might leave. It may never be exercised because the stock may never be ''in the money'' during the appropriate time frame.
An alternative is to move the measurement date to the exercise date, and that would even be worse because it would simply penalize the most successful companies, those with the brightest prospects, for the mere fact that their stock has appreciated. You have heard the example of Taser. Their profits would be wiped out by the mere fact that their stock had appreciated, regardless of the performance of the company.
A second problem which the committee has discussed today is how to value what an option would be worth. FASB suggests using observable arms-length transactions, but of course for private company options they have never traded, so the value of the option has to be modeled somehow. There is a choice of modeling and methodologies to use, and whatever choice you make leads to a radically different assessment of value.
Page 38 PREV PAGE TOP OF DOC Segment 1 Of 2 That, of course, leads to the third problem, which is that any of the models that one could choose, including Black-Scholes, named for the late Fisher Black and my former colleague at the Stanford Business School, Myron Scholes, and a binomial model for that matter, rely on one key variable and that is the estimate of the volatility of the underlying stock. Of course, since private company shares have not traded, any estimate of volatility is basically a guess. Actually, FASB makes it worse because they say we are not to look at historical volatility; you are to estimate future volatility. So any estimate of volatility will be subject to both potential manipulation and inaccuracy.
That, of course, leads to a fourth problem, which is to try to get around this problem of estimating in advance the volatility, FASB has given private companies in the proposal the option to use intrinsic value as a way of valuing options. Under this methodology, the value of the option is adjusted for every reporting period, every quarter, or in some cases of private companies, every month, and is changed to reflect an estimate of value or stock price if it is a public company. That is basically a form of variable accounting which brings stock price directly into the income statement of the company, and of course introduces the potential for wild swings from quarter to quarter of the value of any given option, so it will be massively confusing for investors.
The fifth problem is that FASB ignored that most private company employee options are highly restricted. That is, they are not only subject to vesting, but they cannot be transferred; they cannot be hedged; they cannot be pledged; they cannot be sold. So it is very hard to value these restrictions. Interestingly, FASB argues that no restrictions that exist during the vesting period should even be considered in valuing the options. Clearly, an option that is subject to restrictions is worth less than an option that is subject to no restrictions, yet FASB would have them be recorded at exactly the same price. So much for the concept of fair value.
Page 39 PREV PAGE TOP OF DOC Segment 1 Of 2 Finally, in seeking to identify the proper time period over which to attribute the expense that the exposure draft would require, the FASB creates a whole new set of problems. For example, the exposure draft suggests that companies should try to model or predict the groups of their employees for purposes of predicting their exercise behavior. That is because the proposal calls for them to adjust the contractual term for expected early exercise or post-vesting behavior. Obviously, that would be a completely speculative exercise that would be almost preposterous in its unreliability.
All of these obstacles, by introducing theory, uncertainty and subjectivity in place of the actual experience, which is what financial statements are supposed to reflect, will make the income statements of companies less reliable, not more reliable.
In the end, Mr. Chairman, I think what is clear from FASB's proposal is, as you suggested in your opening statement, that it is responsive not to the volume of comments it has received from the venture capital community or companies that use options, but rather to the political process. I do believe this is fundamentally a political proposal and, as you said, Mr. Herz is quoted as inviting people to contact their representatives. I do believe it is in response to something that has nothing to do with employee options, which is the reported abuses at places like Tyco, WorldCom, Adelphia, et cetera, where people stole company resources, allegedly, or reported incorrectly the financial performance of the company.
In this regard, the National Venture Capital Association does support the legislation you have proposed. We believe it is responsible. We believe it is appropriate to exempt private companies where it is impossible to value the options from the expensing requirement. Having taken 175 or so companies public in my career, I believe it is appropriate to exempt companies during their first three years of being a public company so that you can get some trading experience and understand how to assess the volatility of the stock. With that, we do hope that the Congress will act on your proposal.
Page 40 PREV PAGE TOP OF DOC Segment 1 Of 2 Thank you, Mr. Chairman.
[The prepared statement of Robert E. Grady can be found on page 84 in the appendix.]
Chairman BAKER. Thank you very much.
Our final participant this morning is Mr. George Scalise, president of the Semiconductor Industry Association. Welcome.
STATEMENT OF GEORGE M. SCALISE, PRESIDENT, SEMICONDUCTOR INDUSTRY ASSOCIATION
Mr. SCALISE. Thank you, Mr. Chairman and members of the committee. I am George Scalise. It turns out I have been in the semiconductor industry for about 45 years, so I have seen it from the very earliest days and I have seen what stock options have done to help build this industry from a startup to what is now a $200 billion a year industry. I also have been the beneficiary of that process of stock options.
First of all, the SIA strongly supports H.R. 3574 and we commend the leadership of the Chairman as well as the 30 members of the committee that are co-sponsors of the legislation. Going back to the industry for just a moment, the U.S. semiconductor industry, the U.S.-based companies, are the most competitive in the world today and have been since the onset of this industry. We currently have about 50 percent of that $200 billion a year market. It turns out that only 20 percent of that market is here in the U.S. However, about 70 percent of our manufacturing is located here in the U.S. The average employee earns about $97,000 and we have about 255,000 employees here.
So this program that we are talking about is very vital to this industry and has been since the onset. Semiconductors, as you probably know, are the building blocks for the whole information technology market, which is now a $1 trillion export market for the U.S. So whether you are talking about equipment or software, it does not really matter; whether it is games or automobiles, they all embody semiconductors.
Page 41 PREV PAGE TOP OF DOC Segment 1 Of 2 The other thing that is important about this is that semiconductors and the IT industry now represent about 8 percent of the economy, but it turns out they are more than 30 percent of the growth; they reduce inflation by about 1 percent a year; they increase productivity by about 1 percent a year. As a consequence, they make a major contribution to the overall economy.
Keep in mind, our prices go down every year by at least 30 percent. Every year the prices go down by at least 30 percent. So if you bought a bit of memory in 1995 for $1, you would be paying about 2 cents for that today. In a few more years, you will be paying 1/100th of a cent or less than that as we go along. So this kind of contribution is something that we need to find ways to encourage and support and make continue to happen going forward.
Going on to the competition, as I said, this is a worldwide market. It is also worldwide competition. As someone said earlier, our competitors overseas have now seen the wisdom of using stock options as a method of dealing with their employees, compensating their employees. In a recent forum that we had at Stanford University, about a month ago, we had representatives from Taiwan, China, Korea and the U.S. talking about the industry and what was going on, and what the competition was all about. One of the folks from Taiwan pointed out that they do not really have a cost associated with stock options because there is no tax benefit, therefore they can grant these very lavishly, if you will, and the employee gets a great benefit from it.
As a consequence, they have now attracted about 5,000 of some of the very best engineers we have in this industry, to go to Taiwan to be a part of the industry there today. Now, granted, a number of our employees are foreign-born. They come to our universities, are trained, and they come to work with us here. But up until very recently, they have been employees that stayed with us. We are now beginning to see that migration reversing and going the other direction. In large part, it is because of the kind of compensation and the kind of tax structure that is associated with stock options.
Page 42 PREV PAGE TOP OF DOC Segment 1 Of 2 Let me just turn for a moment to the accounting side of this, because I know that is one of the important arguments that is being put out here. I think that our greatest concern, I think you have seen editorials on the part of some of our CEOs in the industry, who are making it very clear that if there is going to be a change, the investing public is going to have to see something that is very transparent, that is very accurate, and is very comparable from company to company. I think the evidence that we have heard about here today, and I do not want to go into it again because I think you have heard it, is that that is not possible with the proposal that is in front of us today.
Therefore, I think the legislation that is being proposed to take a hard look at this and make sure we understand just what the consequences are, is very, very critical, so that we do not make that mistake of adopting something that is not going to be transparent, that is not going to be accurate, and will not be comparable from company to company. That would create more confusion, and in particular it will disadvantage the small investor versus the professional investor by a wide margin. That is the last thing that we should have happen.
The other point that I would like to make is on the stock purchase plan, which is a very important part of all of our companies. Again, the companies that have stock purchase plans is for 100 percent of the employees, just like our stock options are for anywhere from 80 to 95 percent of our employees; in some cases 100 percent. That will absolutely destroy the employee stock purchase plan if this proposal goes forward.
Again, I think this is one of the great opportunities for young people to get their first real shot at building equity for themselves and their families is through these stock purchase plans. They are very, very quick to unfold, and again if the company does well, these people can do very well and they can begin to buy their homes and do the other things that young families do. So I think it is very important that we make certain that we maintain the vigor and the opportunity associated with employee stock purchase plans.
Page 43 PREV PAGE TOP OF DOC Segment 1 Of 2 Finally, as far as international convergence is concerned, I do not really see why we have to rush to try and come together with IASB and whatever their proposal happens to be, because first of all I do not think there is a timetable associated with that that is going to necessarily come to pass. There is a lot of controversy with the European companies on the IASB proposal, and therefore I think we ought to set that aside as having no real validity as far as consideration as we take a look at this FASB proposal that is in front of us.
Thank you. I am ready to answer any questions.
[The prepared statement of George Scalise can be found on page 148 in the appendix.]
Chairman BAKER. Thank you, sir. Before I proceed with questions of my own, I just want to yield time to Mr. Shadegg for purposes of an introduction. Mr. Shadegg?
Mr. SHADEGG. Thank you, Mr. Chairman.
I simply want to welcome Mr. Phil Smith of Taser International, chairman of the board. I apologize. I was across the hall in a hearing of the Commerce Committee which happens to be dealing with some issues that affect Arizona, Luke Air Force Base, the Goldwater Range right now, so I had to be there and could not be here during opening statements.
I welcome Mr. Smith. Taser is located in the metropolitan Phoenix area where my congressional district is. I appreciate his testimony here today. Mr. Chairman, as you know as a member of the Congress who is deeply concerned about the FASB proposal and believes the better alternative is in fact the legislation you have introduced, I appreciate Mr. Smith's comments on that point, and I simply wanted to be able to welcome him to the committee as a fellow Arizonan.
Thank you, Mr. Chairman. I yield back.
Chairman BAKER. Thank you, Mr. Shadegg.
Professor Kruse, I am interested based on your study of industry practice that is evident in the book. In identifying the problem that started the current academic discussion, was there evidence in your view of broad-based plans being manipulated adverse to either the corporate or public interest?
Page 44 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. KRUSE. With respect to broad-based plans, no. We came to this interest in broad-based plans out of a couple of decades of research we have done on broad-based employee ownership, profit sharing, programs that involved employees in company performance. That is where we came at it from.
When we looked into broad-based plans, doing very extensive research on this, both quantitative and qualitative research, we did not find the broad-based plans being manipulated in the way that a lot of the executive plans obviously have been.
Chairman BAKER. Is it not true that with regard to SEC rule treatment of the top five proxy requirements for disclosure and disclosure of compensation, that there is now precedent for the top five being treated differently today from others within a corporate reporting structure?
Mr. KRUSE. Yes, that is true.
Chairman BAKER. So I can make the legitimate claim that the selection of the top five is consistent with other body of law and regulation by way of special disclosure for those set of individuals?
Mr. KRUSE. I believe so.
Chairman BAKER. Thank you.
Mr. Grady, you made comment with regard to the difficulty of predicting accurately volatility in a startup company. Is it not the case that FASB now and has historically allowed privately held corporations to set volatility at zero?
Mr. GRADY. Yes. The current rule allows minimum value to be the methodology used in calculating the value of an option, but the proposed rule disallows the use of that going forward. It actually complicates matters by allowing three different ways for options to be valued. It says for the old options, you can use minimum value, but going forward you have to switch to using one of the models I suggested, one of the lattice or binomial models.
Page 45 PREV PAGE TOP OF DOC Segment 1 Of 2 Chairman BAKER. Let me help make that point. Where you have a historic record and could possibly predict volatility, you do not have to; and going forward on startups that you can't, you are going to be required to.
Mr. GRADY. Right. Well, for all options going forward under the proposal. Yes.
Chairman BAKER. Mr. Smith, you discussed the fact that in your corporation you have now given notice to employees going forward that this year's grant of options is it. It has also been stated by others on the panel and from other reports that foreign competitors now put banners up at job fairs, ''options granted.'' What is the potential impact from your perspective on future startups on innovation if we, within the United States, preclude granting of options without expensing, and our competitive industries in international markets are allowed to proceed as they have historically, given the allegations of job economic recovery and all the concerns about outsourcing.
Mr. SMITH. In our company today it is not as important as it was. We are now a pretty visible company and we have a lot of cash. But when we started the company, over the 11 years it took to get there, it was extremely important. We were hiring people at below-market wages, no question about it. Our average people make $40,000 a year, by the way, that have the stock options that I referenced in my written statement. So it is not the high-paid people.
We have a lot of people who come into the company and take those jobs. Think about it. A person is sitting in a large corporation with a 401(k), a pension plan, great health benefits, and you are going to give him a chance to come into a less-than-ideal working environment, nothing is fancy in a small startup company. It is pretty rough-going. You ask him to work 12 or 14 hours a day, and they don't generally have very good health benefits and certainly do not have 401(k) or pension plans. What is the incentive for a person to do that? And you are going to pay him less money?
Page 46 PREV PAGE TOP OF DOC Segment 1 Of 2 I remember when I left Boston, I was working for Computervision. It was a Fortune 500 company at the time. We were standing in a 9,000 square-foot house, and my wife says: let me understand this; you are taking a cut in pay to 40 percent of what you are making now; you have options in a company which is out of money, it was a venture startup; and I am going to have a house that is about as big as the garage on this house. Why am I not excited about moving to the Silicon Valley?
That is the issue. You have to have some compensation for these people to take that risk and make those moves. I have done it multiple times in my life. I have been broke more times than I have made money by doing that, but that is the whole part of an entrepreneur. Getting these people to take that risk, you have to offer them something.
One thing I would like to point out. I do not know why we are in such a rush to be like everybody else. The last thing I want to be is like everybody else. Everybody else in the world did not create the growth engine and jobs that we did in the Silicon Valley, right out to the beltway here with AOL and MCI and many great companies got started. These options were an instrumental part of it.
I do not know why we are in such a heck of a hurry to go out there and dismantle the machine that has worked and served us so well in the past, especially now when we need to develop the next new thing to put people back to work in this country. I would not be tampering with anything in this area for the next couple of years until we find what the next new thing is and get these people back to work.
A long-winded answer.
Chairman BAKER. I thank you for the answer. It is sort of like the fire department showing up when the house is on fire and simply burning the rest of the neighborhood. It just does not seem to be a responsive solution to the problem at hand.
Page 47 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. FRANK. Thank you, Mr. Chairman.
I would just say to the previous witness that I do not know when you sold that house, but given what has been happening to house prices in Massachusetts, a 9,000-square-foot house, you would have to have some pretty good options to beat what you could have made on that if you had held it.
I want to just expand on what I said before. Let me talk to the people who are in the industry, who have told me, and I take this with great seriousness, that if the expensing requirement goes through they will stop giving options. I guess we ought to be very specific why. Obviously, the reality will not have changed. Why will you have to stop giving options? Is it the reaction of the investor community, the lender community? What will require you to stop granting these if the reality has not changed, but the way in which you are to account for them does?
Mr. SMITH. Is that question for me, sir?
Mr. FRANK. Any of you.
Mr. SMITH. I will take a shot at it. We stopped it because we do not want to impact our operating performance next year for our shareholders because of these options being expensed.
Mr. FRANK. Excuse me. The question is this, it is not the reality. So the shareholders, what will cause the share price to drop? Is it the reaction of an investor community that says, hey, they moved this from the footnote to the bottom line. That is my frustration.
Mr. SMITH. Let me explain it to you. I think you were out of the room. A lot of our shareholders are policemen. They are cops. They own 100 to 200 shares of our stock. When they look at the income statement, they have no idea what footnotes are or anything else. All of a sudden they are going to see this dramatic change next year. I would say a good 40 percent
Page 48 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. FRANK. There are two problems with that. I would hope we could try to just educate the community. Cops have to be fairly sophisticated about something. The other thing is, unfortunately your arguments cuts a little bit both ways because one of the arguments people have now is, well, that information about the options is already there. It is in the footnote. When you argue that while it is in the footnote, they will not read it, you are unfortunately frankly giving support to some who say people do not know it is there. It cannot be both. It can't be available and impervious.
Mr. SMITH. I am going to make one comment and pass it off to some of my colleagues. If it ain't broke, don't fix it.
Mr. FRANK. I am sorry. That is not good enough for me. We are here in a deliberative process and I am trying to express the sympathy I feel. But sloganeering like that does not help me. I am not a car. Don't put a bumper sticker on me. I am asking you a question and I want an answer. There is a problem here. It may lead us to a broader problem. Your argument appears to be that the investor community on which you have to depend, in particular an investor community because of the nature of your product that is not the broader one, does not understand this. We need to have more than just a bumper sticker.
Mr. GRADY. Congressman Frank, I think it does beyond that. What clearly will happen if you move it into the income statement, it will reduce, of course, the reported profitability of the company, even though the operating circumstances of that company will not have changed, the cash will not have changed, the cash expenses will not have changed.
Mr. FRANK. No reality will have changed.
Mr. GRADY. But it will radically reduce
Mr. FRANK. Okay. Who will be influenced by that?
Mr. GRADY. I think investors will be influenced by that.
Page 49 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. FRANK. Okay.
Mr. GRADY. As we have discussed during the hearing, the method by which people will calculate how much that expense will be will be highly variable from company to company. It will make, in effect, the reported P/E ratios of all companies, which is how the comparing is done, less comparable.
I will give you a real world example. The way people calculate earnings will be just considerably more different from company to company because there are all these methodological issues.
Mr. FRANK. But can't you say, then, look, this is the way it used to be, and this is the reason for that volatility. It is there now, the reality is there now. Options are clearly not a nothing. They have some impact.
Mr. GRADY. The reality is there now and most investors, to your point, are sophisticated enough to look at the fully diluted share price and calculate their EPS.
Mr. FRANK. Are they able to make comparisons?
Mr. GRADY. The sophisticated investor will strip out the option expense and compare cash EPS, which means they will render GAAP irrelevant.
Mr. FRANK. Are you saying a sophisticated investor would disregard the existence of options in deciding whether or not to, you say, strip out. Please let me finish the question, Mr. Grady.
You are telling me that the sophisticated investor would simply ignore the existence of the options? I assume that is what ''strip out'' means.
Mr. GRADY. They would ignore it for purposes of comparing.
Mr. FRANK. Mr. Grady, please stop, because I think you are obfuscating, unintentionally.
Mr. GRADY. No, I am not.
Page 50 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. FRANK. Then I may be, but here is the deal. I am an investor and I am trying to make a decision. When I make a decision based on, I do not invest in any real companies because we get enough people claiming we are guilty of conflict of interest, so fortunately I am free of that, but I am an investor and I am looking, you say, well, after the FASB thing, it will be hard to make comparisons. But how do I make the comparison now?
Presumably, if I am a sophisticated investor and I am trying to decide between one or another company and one has a certain amount of options and one does not, and another has options. How do I value those now? Or do I not take those into account in deciding when to invest?
Mr. GRADY. You do take them into account, as I said, in determining the share count for the company in the denominator of the earnings-per-share calculation. I believe that people will continue to do that.
Mr. FRANK. But is that easier to do now than it would be later? Why? Why is it easier to make those comparisons now than it would be if the accounting treatment differed?
Mr. GRADY. The ability to calculate the number of shares will be the same as it is now. What will be different will be the quality of the earnings being reported.
Mr. FRANK. I understand that. But you understand that those are just affected by the accounting. The reality has not changed, has it?
Mr. GRADY. The reality is being proposed to be changed, and that is that people have to take into
Mr. FRANK. They do not have to. Investors are free to make his or her own decisions. The company is still there and those things are still there and the investor can still make the decisions based on
Page 51 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. GRADY. Here is what will change, I believe, in reality. The most common means by which investors compare stocks is price/earnings ratio. You will now have a wildly different set of assumptions that go into the ''E'' in a PE ratio.
Mr. FRANK. Okay. My last question is this, because here is what we are saying is that frankly the people who are getting more beat up here are the investors who do not come out of this looking all that smart.
Mr. GRADY. But I think
Mr. FRANK. Excuse me, Mr. Grady, please stop interrupting. This is just not helpful. The point is this, what you are telling me is that if FASB's rule goes through, even though the reality of the company will not have been changed if they continue to give options, investors will look only at the P/E and will make bad decisions. They will make decisions on inadequate information. Inevitably, this has got to be something of a negative judgment on the investor community because you are saying if you do this, they will just look at the P/E and that will make this enormous difference to them, when in fact you were telling me it really should not, given that this is a perfectly reasonable thing to continue to do.
Mr. GRADY. May I make one comment?
Mr. FRANK. Sure.
Mr. GRADY. I believe that to avoid the confusion, which we were both just speaking about, what will happen is people creating the companies, people starting the companies, people running the companies will say, to avoid the confusion I will use more cash to reward employees and less options.
Mr. FRANK. I understand. But the confusion is on the part of the investor who is reading the situation.
Mr. GRADY. Which means less companies will be started.
Mr. FRANK. I understand that. The question is why that would be the case. It really does come down to apparently a lack of confidence that investors will be able to sort this out.
Page 52 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. GRADY. Right. I believe this will make reporting more confusing, not less confusing.
Mr. SMITH. Let me add one thing. Reporting is one thing. Hiring employees is another. If you are out there, Mr. Frank, and you are trying to hire employees as a young startup company and you are competing against well-established big companies that have much better benefits, better pay, et cetera, what the heck are you going to offer them?
Mr. FRANK. Excuse me. You totally misunderstand my point. I understand that, that options are attractive. What I was trying to get at is, what about FASB would lead you to stop issuing options? That is the question. So your answer is totally irrelevant to what I was asking.
Mr. GRADY. It is the cost, the cost on the bottom line.
Mr. FRANK. I have gone over my time and I do not think this is going to be enlightening.
Chairman BAKER. If the gentleman would yield for just a minute, I appreciate the gentleman's sincere effort at this. I just want to make one small explanation if it might be helpful. It does change economic reality in this case. If there is a granting of an option at a fixed price, and going forward the price does not move in the money and the option is not exercised, the FASB requirement would require you to expense that in the current dollar disclosure, so you would have a negative impact on the corporate profit, which is not an accurate disclosure of true financial condition.
However, going forward if the option is exercised at a higher dollar price, I think argument can be made that contributions of those individuals who are engaged in the corporate structure as a result of the grant of the options, have increased value and therefore the dilutive effect on the residual shareholders is minimal, if at all. So it is not 100 percent accurate, but I think the negative effect of expensing when they are not exercised is far worse than the residual effect of expensing at the time of exercise, which is now required.
Page 53 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. FRANK. I thank the Chairman. That is in the spirit of what I was saying. Again, it all comes down, unfortunately, to the way it is perceived. Let me just say one further thing, Mr. Chairman. I just want to now, in the absence of the Ranking Member of the subcommittee who had to leave, I just want to notify you that we are going to use our Rule 11 rights to ask for another day of hearings. A letter with the appropriate number of signatures will be delivered to you before the end of this hearing so that we can have another hearing.
Let me just say, this comes from people both for and against the bill. This is not a sign that people are against the bill. This is just an important subject and we will be asking for it. There is no reason that they should hold up any schedule of any action, so it is not to be taken as hostile to the bill.
Chairman BAKER. The Ranking Member had indicated to me his interest in that, and I said I have no such reluctance, but out of courtesy to the chairman I have not had a chance to visit with him about the schedule.
Mr. FRANK. That is why we thought we would use Rule 11, because that is an option to the chairman. He is a busy fellow. We do not like to bother him.
Chairman BAKER. We always appreciate your creative assistance in the conduct of the committee.
Mr. FRANK. Mr. Chairman, I cannot take credit for creating Rule 11. That somewhat pre-dates me.
Chairman BAKER. I recognize that and am thankful for that.
Mr. OXLEY. Thank you, Mr. Chairman. I certainly would not have any objection to another hearing on this matter. It is complicated and difficult, but very, very important in terms of our economic future in this country.
Page 54 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. Grady, good to see you again. Welcome back to Capitol Hill.
Mr. GRADY. Thank you, Mr. Chairman. It is good to be here.
Mr. OXLEY. It is good to know that there is life after work at the White House.
You had emphasized in your testimony the issue of competition, particularly as the FASB proposal may very well, as I understand your testimony, put us at a disadvantage versus some of the Asian tigers, for example, that have learned some things, apparently, from our system and are quite aggressive in that area. I wonder if you would care to comment specifically on the competitiveness issue. Mr. Scalise and others that want to join in, I would be glad to hear from you as well.
Mr. GRADY. I think you can look in both directions, both to the east and toward Europe as well. I was struck by something that the Director of CBO said regarding CBO's study and saying that they did not see different effects in Europe versus the United States, where IASB is now of course proposing expensing of stock options.
What is observable is that I believe the United States has outperformed the EU countries quite substantially, and I believe one of the principal reasons that has been true is because of the availability of risk capital, which has gone into startups, and because of the contribution of startups to U.S. GDP. What you now see is Europe has lower levels of venture capital investment, lower economic growth, and considerably higher unemployment. That has been the case for some time.
We did a study at the National Venture Capital Association to try to measure the contribution of venture-backed companies, mainly startup companies, to the U.S. economy. I refer to it in my written testimony, but I think it is important to highlight the results to the members. It showed that venture-backed companies in the year 2000 employed directly 12 million Americans and directly and indirectly, as Chairman Baker said earlier, 27 million Americans. Some of the other findings were that these companies accounted for $1.1 trillion in sales or 11 percent of U.S. GDP on far less than 1 percent of the invested capital in the country for the entire 30-year period measured.
Page 55 PREV PAGE TOP OF DOC Segment 1 Of 2 So the job-creating leverage of these startup companies has been very high. The principal tool that they have used, as everyone on the panel has noted, has been to on the one hand pay people less cash, but by allowing them to trade-off units of ownership for cash compensation. That has been the model that has worked. People have wanted a piece of the rock. I do believe, as a number of witnesses and Mr. Smith have said, Taser is witnessing it and other companies are witnessing it on the competitive front, that people in both companies in Taiwan and China and elsewhere are advertising their willingness to give ownership to employees as a way of inducing them to come to work there.
Mr. OXLEY. So really one of the concerns, the latest buzz word around here, is outsourcing, and we are hearing all about that. In fact, this issue certainly cuts into that entire issue, does it not?
Mr. GRADY. I believe it does, because it will also raise the cost of creating the jobs here in the United States, as I was attempting to comment to Mr. Frank. I believe what will happen is that at the margin, startup companies will be required to raise more cash with which to compensate employees, which just means there will be less startups funded because there is only in effect so much cash to go around. So I think this would be adverse to the job creation prospects of the economy going forward.
Mr. OXLEY. Thank you.
Mr. Smith, why are so many CEOs opposed to expensing? Is it because it would lower the value of the options? From a CEO's standpoint, what is the major issue that you have with the proposal?
Mr. SMITH. I think Mr. Grady covered it pretty well. It is the valuation of the company. People look at price/earnings to justify purchasing or not purchasing a stock, the availability of capital in the equity markets. One of the things I pointed out before you came into the room, and that is we were able to attract some pretty significant board members on our company by using options. Without those, I frankly do not know how we would have gotten those people to come on and help us with the corporate governance we are now facing.
Page 56 PREV PAGE TOP OF DOC Segment 1 Of 2 That is a real issue for small companies. You do not have a lot of cash. You have a lot of risk to offer people that come on the board. The trial lawyers love small public companies because their stock is pretty volatile and they generally get into a lot of stockholder lawsuits in which directors do not want to be involved. So I frankly am at a loss. This is going to be my last startup. I would be concerned about how you are going to get the right types of individuals to sit on these boards if you take away some of these incentives.
We just stopped giving them. We have already told our employees no more options. They all vest by the end of this year. That is it. If this legislation passes, the only people that are going to get them are going to be the four or five senior people at the top. I do not know what we are going to do in the future going forward.
Mr. OXLEY. That is interesting. It hearkens back to our hearings we had on securities litigation reform, which I think really did enhance our knowledge about what was going on out there. One area that has not been well discussed, and I am glad you brought it out, was the large potential for litigation in these areas, to the point where some of these trial lawyers were having computers that essentially spit out complaints based on a loss of value in the market. Quite extraordinary, and that ultimately led, as you know, to passage of that legislation, and I think I am right, the only veto President Clinton had overridden, with a strong bipartisan effort on both the House and the Senate.
So I think you have touched upon another interesting issue that is certainly important in this debate, that I had not considered until recently. I appreciate your testimony.
I yield back.
Chairman BAKER. I thank the Chairman.
Mr. SCOTT. Thank you very much, Mr. Chairman.
Page 57 PREV PAGE TOP OF DOC Segment 1 Of 2 It is the general feeling on this committee that you support H.R. 3574, the basically immediate expensing of the top five executives's stock options. Correct? And that the concern is that it goes no further, that there be no expensing of options for rank-and-file employees. In this legislation, it does not exactly, it is my understanding and I am a co-sponsor of it, but what we are saying is that no further expensing of these stock options until a couple of things take place; that there be an economic cost-benefit analysis study of different elements; and that the accountants come up with a more accurate way of measuring cost.
What say you about that? Is that enough to register safety on any concerns that we go beyond? I am not sure what I am hearing here, and especially from you, Mr. Smith. Did that satisfy you?
Mr. SMITH. Let me just say one thing. My mother had some ugly kids, but no dumb ones. What I have worked out is that we are not going to get this thing through. I think expensing any options is a bad idea, but I am practical enough to understand to get some change, to hold off this gigantic force to get options expensed, we are willing to concede to the five top people.
I think we do need a study because I think there are some real impacts people have not thought about, not only the lawsuits that are going to erupt, the cash that young companies are using from these employee options. The way it works is if an employee exercises their option, they pay the government taxes, but the company gets a credit for that. It keeps our cash and allows us to hire more people. I do not know whether anybody has even looked at that aspect of this thing.
There is an enormous tax base sitting out there of cash being used by young startup companies to fund their operations. If you take that availability of cash away and they now have to pay taxes to the federal government, you are going to start impacting these small companies's growth. So from those aspects, I would like to see nothing expensed, but being a practical person, as I said, my mother did not have any dumb kids, we are deciding this is the best option we can see to go forward. We think those economic studies will prove that out in the future.
Page 58 PREV PAGE TOP OF DOC Segment 1 Of 2 I will yield to my other colleagues.
Mr. SCOTT. Professor Kruse, what percentage of companies that offer stock options offer them to a broad spectrum of their employees?
Mr. KRUSE. I do not have a ready answer to that off the top of my head what percent do. We have found that at least in a related survey of companies, we did find that about 3 percent of companies gave broad grants to employees, to more than 50 percent of their employees in the past year. But the number that may have done that in the years prior to that, we do not know. Still, 3 percent of companies gave grants in the past year and that is consistent with a BLS study as well.
Mr. SCOTT. And you believe the FASB rule would act as a deterrent to incentives for the rank-and-file employees?
Mr. KRUSE. Based on what companies are saying, that this is going to be something that causes them great concern, that they are likely to cut back on the broad-based plans and encourage concentration of executive options.
Mr. SCOTT. Mr. Scalise, you mentioned that stock options are granted to around 90 percent of high-tech employees. What posture would we be in with this rule in terms of the semiconductor industry especially, and its ability to compete with foreign companies?
Mr. SCALISE. I think it would have a major impact on our ability to compete. Again, getting back to your prior question, 100 percent of our companies grant stock options. As you pointed out, roughly 95 percent of those go to a broad base of employees outside of the executive ranks.
I recently completed a study for the President's Council of Advisors on Science and Technology dealing with manufacturing and innovation. This is one of the issues that we dealt with. I think what we have to recognize today is that we are truly in a new competitive environment out there, not only in manufacturing, but for people. I just gave you one data point there saying that roughly 5,000 of our good engineers, these are not just the rookies, these are the good well-trained engineers that have been in the business for a number of years, have now gone back to Taiwan. A number of them are going to China now.
Page 59 PREV PAGE TOP OF DOC Segment 1 Of 2 So we are going to be greatly impacted if they can offer the stock option with the tax treatment they have, which is no taxable event; versus ours which is a highly taxed event as it currently stands. Then you have the other part of the problem which is dealing with the expensing issue, which makes for the volatility within the company, which the companies have to dampen if they are going to avoid some of the litigation that has been talked about here.
So it is a very complex set of issues that come together here. Suffice it to say that for the two reasons, the expensing and the volatility as associated with that, and the tax treatment we have versus the tax treatment of our competitors overseas, these are both working against us as far as maintaining our technology leadership going forward.
Mr. SCOTT. Thank you very much.
Chairman BAKER. Thank you, Mr. Scott.
Mr. ROYCE. Thank you, Mr. Chairman.
I would like to begin by building on your last point, and maybe ask Dr. Smith, if we look at these proposed rules and let's say we take a hypothetical, and we have a company that has to expense $100 million of option grants. So the accounting rules would have that firm debit expense and credit paid-in capital. So now we look forward 1 year, 2 years, 3 years into the future, and let's say none of the options have been exercised because the firm's stock has declined in value during that time period.
So now what do we have? I would say we have a balance sheet that borders on being fraudulent at this point, and investors would be getting a false sense of the company's true financial picture at that moment. At the same time, we have passed Sarbanes-Oxley. Under Sarbanes-Oxley, we have dictated that you signed under perjury that the financials reflect the true operating income and expense and the correct balance sheet position of the company.
The question that I have, Dr. Smith, is, given our hypothetical, because you have now expensed that $100 million in option grants several years prior, are you now in violation of Sarbanes-Oxley? And more importantly, could some trial lawyers believe you are in violation of Sarbanes-Oxley?
Page 60 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. SMITH. Let me just say one thing. The only employment this is going to impact is the trial lawyers are going to make more money and hire more trial lawyers. It is hard for me to guess, but you can bet they will sue. If you look at most of the cases out there, they never go to court. These lawyers are into the idea of settling with these companies and insurance companies outside of court.
So the answer is, anything like this that opens a door, they will definitely come in.
Mr. ROYCE. More slap suits?
Mr. SMITH. Absolutely. We may have been delivered a lawsuit today. Our stock dropped 32 percent yesterday and that generally brings them right out of the woodwork. That is the one company fear of most of us here, so this is just one more thing we have to deal with.
Mr. ROYCE. I will also ask you, we heard from the CBO director. Director Holtz-Eakin argued that expensing will help the economy because resources will be allocated more efficiently. Do you agree with that argument?
Mr. SMITH. Absolutely not. It is the big companies that benefit from this. These are not the people who employ and create the new jobs. They employ lots of people, but they are not the growth gazelles that really provide a lot of employment. Those are coming from young startup companies like us. The big companies will benefit because they have no volatility in their stock. They give very few options out to people. The penalties will go to the people like us who are creating the jobs, who are small and have the very volatile stock. So I absolutely take issue with that, and I do not know anybody at the CBO that ever started a company or ever gave out a stock option or ever received a stock option.
Mr. ROYCE. I am going to ask Mr. Grady to respond to that question as well. The other suggestion that was made by the CBO director was that the venture capital community will fill the void. I would just like to ask Mr. Grady, it seemed earlier that you disagreed with that argument. I would like to hear your reasons.
Page 61 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. GRADY. I do disagree because what will happen is the venture capital community will have to use more cash to compensate employees, which means we will create fewer companies with fewer employees, by definition.
On the first question of the efficient allocation of capital, I believe it will not increase the efficiency because it will create some of the anomalies that you have suggested. Your first question was not merely hypothetical. For example, Intel Corporation, and maybe Mr. Scalise wants to comment on this, I believe reported that they would have taken charges if expensing were a requirement, into the several billions of dollars, more than $2.5 billion, for options granted in 2001 and 2002 or 2003 that expired without being exercised; that were never in the money and that therefore basically never existed. Under this proposal, the accounting for those options that never existed, those shares that never existed, would be identical to the case in which Intel had spent $2.5 billion or $3 billion of cash. Clearly, that is not an optimal or even accurate result.
As I said in my earlier statement, that is the problem with being required to value the options on grant date. You could switch it and say, gee, we will value them on exercise date or you could use this intrinsic value method that I mentioned. That creates its own anomalies, because if you use the intrinsic value and say a stock comes public at $20 and the stock trades down, but you recorded a value the day the company came public at $20 and the options had a certain assessed value.
If the stock went down, you would actually decrease the value of those options. So what you would be saying is, because the stock went down you are judging that company now to be more profitable.
Mr. ROYCE. We have an opportunity for a real-world response if we could go to Mr. Scalise and just let him respond in terms of the actual difficulty we would be putting a firm like Intel into.
Page 62 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. SCALISE. I think it would be significantly more difficult. Your mention of the Sarbanes-Oxley Act is really critical here, because these two do come together. When you look at the lack of transparency, the lack of comparability, and then the volatility that results from that, and then the requirement to attest to all of these documents when in fact you will create expenses on issues that never really occurred in the final analysis, as just pointed out by Mr. Grady here, it is very complicated and it is very interrelated.
It is going to create a lot of hesitation with regard to putting out more stock options because they are not going to do it. They are not going to want to increase the volatility and increase the risk of more and more litigation, because as we all know we have folks just sitting out there waiting to drop that next lawsuit.
Mr. ROYCE. Thank you, Mr. Chairman.
Chairman BAKER. I thank the gentleman.
Mr. SHERMAN. Yes, as I count, we have six panelists who are in favor of the bill. My guess is that that is reflected up here as well.
We can compete with China to have the loosest accounting standards so our companies can report the highest income, no matter how much money they spend on this or that, report a lot of income. Or we can compete with Europe to have the tough and reasonable accounting standards uninfluenced by what would be viewed at least by the public in a highly publicized first-ever intervention to provide looser accounting standards to encourage what is viewed as executive compensation. I think we need to compete with Europe for capital by showing that we have the best accounting standards.
What flabbergasts me is that this bill, if I hear Mr. Grady and others correctly, would have the effect of helping high-tech companies like the ones based in my state compete for capital against these lower-tech companies that are most associated with some of the other regions of the country. I have folks from other regions of the country supporting the bill and trying to help high-tech companies in my state get capital. I thank them.
Page 63 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. Smith points to this big practical problem. He could not afford to adequately compensate board members. The company could not afford to do that without the stock options. You know, now and then I hear from one of my constituents that board members are not being adequately compensated, or the company cannot afford to compensate board members. But I hear more often that the company cannot afford to provide health care.
So if we want for the first time ever to tell the FASB to do something because we want to encourage companies to do something, why don't we tell them that what you pay for health insurance should never be listed as an expense? Or at least provide them with an avenue, if you give a 30-year promissory note to the health insurance company, you do not have to list it as an expense. Give stock options to a health insurance company; provide coverage for your employees, you do not have to list it as an expense.
Why have we decided that the first time Congress will demand a departure from regular accounting is to encourage companies to do something we think is vital. Stock options, not health care.
Mr. Hassett points out that it would invite lawsuits if we tell companies they have to expense stock options, but we do not tell them how. And Mr. Grady echoes this. I could not agree with you more. But Mr. Hassett, how is it that we have not had a lot of lawsuits already because we have a requirement that this information be disclosed in footnotes and we have no real standards to tell companies how to put it in the footnotes. Don't trial lawyers read footnotes? I know they are real small, but you can blow them up and show them to a jury.
Mr. HASSETT. Here is the state of affairs that concerns us. When we put the account for options into earnings, we say, well, it used to be we thought we were making $8 this year, but now we are going to put in the expense for options and it is $7. And then we run for a few years, say, at $7 as earnings every year. And then at the end of that period, people vest and realize, and it turns out that when we said that our earnings were $7, which will be true for probably half the companies, we were incorrect because it was a prospective figure.
Page 64 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. SHERMAN. I understand the incorrectness.
Mr. HASSETT. The point is that it is in the earnings statement.
Mr. SHERMAN. So you are saying that you cannot go to a jury and say, I am an investor; I thought that their adjusted earnings adjusted for the expense of compensating people with options was such and so, as disclosed in their footnote, and it turned out to be such and so. I think we have some lazy trial lawyers out there that are not taking advantage of the vaguenesses of our current accounting standards.
Mr. HASSETT. May I respond, Mr. Sherman?
Mr. SHERMAN. Yes.
Mr. HASSETT. Thank you. I think that the current state of the accounting rule suggests that we are not so sure precisely whether it is $5 or $4 or $3 and that we are leaving it in the footnotes. For the shrewd investor, it is his or her job to figure out what he thinks they are worth when he is deciding whether or not to buy the stock. I think that is the appropriate state of affairs. I think when we put it in the earnings statement, we are giving people the false impression that we know exactly the value.
Mr. SHERMAN. You are making a policy argument. I was just wondering why creative trial lawyers are not making the counter-argument.
Mr. HASSETT. I think because the ambiguity is there.
Mr. SHERMAN. Let me go on. This bill is being put forward as protection for broadly based stock options. You can put a lot of lipstick on a pig. Zero volatility for the options given to the richest executives in America, and you put that in a bill and you say you are trying to help secretaries? The number six guy at GM; the number six guy at Intel are somehow struggling manufacturing workers?
If the bill was well crafted to achieve its alleged purpose, it would deserve a lot more support than a bill, a huge portion of the benefit of which is going to go to the number six guy at General Motors and the number one guy at Intel whose options will be valued at zero volatility.
Page 65 PREV PAGE TOP OF DOC Segment 1 Of 2 We have heard discussions of employee stock ownership plans, ESOPs, none of which are affected by the FASB pronouncement that we are here to discuss. In fact, those plans are going forward. They are big in our economy and they do not get any favored accounting treatment, nor is anybody arguing that they should get a favored accounting treatment.
Mr. Kruse tells us that 79 percent of those who hold options make under $75,000. Let's say in your survey there was a company, because I have seen a company like this, 100,000 options held by each of the top two guys. Another 100 employees, all with incomes under $75,000, each get about 50 or 100 options. If you were surveying that company, wouldn't you conclude that 98 percent of the option holders are people who make under $75,000, if that was your whole population of the survey?
Mr. KRUSE. That is absolutely true.
Mr. SHERMAN. So what we do know is that there are a lot of working-class folks and middle-class folks who have stock options, but there may not be a lot of options in the hands of working-class folks.
Mr. SMITH. Let me answer that one because I have a practical application.
Mr. SHERMAN. Your company is great.
Mr. SMITH. Forty-five percent is going to the top; 55 percent goes to the working people below that.
Mr. SHERMAN. Your company is great, but that does not tell us about the economy overall. If you were running all these companies, things might be different.
Mr. SMITH. GM does not tell us about the economy overall either. It is the small companies that are providing the jobs. The guys you are going to penalize are the job-creators. That is the reason we are here today.
Mr. SHERMAN. Mr. Smith, I just want to comment. Not every small company is giving stock options. Your beauty shop, no stock options. Your local dry cleaner, no stock options. Lots of small companies. Your machine shop, very rarely do they give stock options.
Page 66 PREV PAGE TOP OF DOC Segment 1 Of 2 So to take the idea that all the jobs created by small business are driven by stock options, they are driven by other things.
Mr. SMITH. How about a few facts here? The facts are the job gazelles, the small growth companies that are providing the jobs are not the hairdressers and not the ones you mentioned. They are companies just like us. Those other people that are giving the jobs in this economy
Mr. SHERMAN. Mr. Smith, it is my time. I did not even ask you a question. Your gazelle-like feistiness is appreciated. But the fact is that is we as a Congress decide to contort the accounting rules for the purpose of pulling capital out of the old economy and putting it into the kinds of companies that Mr. Smith thinks should get the capital, that is a whole new economic planning role for this Congress. I do not know whether it is better to see stock purchased in Proctor and Gamble or in Mr. Smith's company. I know he thinks that his company is the best way for our society to allocate its capital.
I yield back.
Chairman BAKER. Thank you, Mr. Sherman. I let you go on well beyond time in recognition of your position on the issue, but for members's purposes, I am going to try to recognize as many as we can before adjourning. We have a set of five recorded votes which would disrupt the committee process significantly.
So Mr. Shadegg, if you have a comment?
Mr. SHADEGG. Thank you, Mr. Chairman. Let me begin with one question.
As I understand the FASB proposal, they do not say how to do this. They say you simply have to do it. So let me begin, since we can obviously make it clear as the questioning has just suggested, I will ask each of you quickly, and I would like you each to answer, is there a single agreed-upon method by which this ought to be done that will make the reporting of all companies parallel or comparable for stock evaluators? Just yes or no.
Page 67 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. SCALISE. No.
Mr. GRADY. No, there is not, and especially not for private companies.
Mr. SMITH. No.
Mr. HASSETT. No.
Mr. HOLTZ-EAKIN. No.
Mr. THOMAS. No.
Mr. KRUSE. No.
Mr. SHADEGG. I think that kind of sums up my deep concern. Mr. Grady, my friend Mr. Frank on the other side I do not think ever let you get across that point. I am going to tell you what I think your point was, and then you tell me if I am right. I think your point was, look, yes there are footnotes now; yes, people can evaluate this information; yes, sophisticated investors can look at it. But if you compel it to be a much more prominent factor in the reporting of the company's performance and in this calculation of P and E, given that nobody has agreed upon the right way to do it, then we are going to have inconsistent results and it could lead to much greater abuse of investors than what we currently have. Is that the essence of your position?
Mr. GRADY. I would agree exactly with that statement.
Mr. SHADEGG. I just think this is a huge deal. We just heard a comment about how we could create the loosest accounting system in the world. I would suggest quite frankly I think FASB is proposing that we make the accounting system looser than it is right now. I understand IASB has said we are going to do this in Europe. It seems to me, first of all, I am aware that in some countries in Europe right now they require stock expensing and in those countries there are essentially no options or option expensing, and essentially there are no options.
Page 68 PREV PAGE TOP OF DOC Segment 1 Of 2 It seems to me perhaps what we ought to do this time, if IASB has decided this is a great idea, why don't we let Europe go first and watch them and see if in fact it does not damage them. My concern, given a world market, is that if we do it and some others do not do it, we could be putting ourselves at a dramatic competitive disadvantage which I would rather not do at this particular point in time.
Mr. Holtz-Eakin, I know that you did the study and the analysis that looked at how stock options would affect both stock prices and the company's access to capital. Is that right?
Mr. HOLTZ-EAKIN. We did a study on the accounting of employee stock options.
Mr. SHADEGG. Right. Here is the question I want to know. How did you go about evaluating the question I have raised, which is, how many companies would continue to offer stock options and to what extent does your report give us the answer to that question?
Mr. HOLTZ-EAKIN. The report actually does not address the individual decision by firms to offer options versus other forms of compensation.
Mr. SHADEGG. So it does not look at the issue of whether
Mr. HOLTZ-EAKIN. It looks at the accounting of those two activities.
Mr. SHADEGG. So it kind of assumes a static situation and says, if these companies are offering stock options now, this is how they are performing and they are not expensing them. If they continue to offer them, here is what would happen under that static kind of analysis. It was not looking at the question of whether or not they would be disincented from continuing to offer stock options.
Page 69 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. HOLTZ-EAKIN. I think a fairer way to say it would be that it looks at the relative treatment of stock options as employee compensation versus other forms of compensation. It puts them on a level playing field and examines the accounting treatment in that setting.
Mr. SHADEGG. Given the great concern expressed by Mr. Smith and others that the net effect of this rule is going to be to disincent companies from offering stock options, and indeed from my perspective since I like startup companies and I like innovation and I like new people coming into the market and I think that is where America leads the world, wouldn't you agree that that is an issue we should look at before adopting a change in policy?
Mr. HOLTZ-EAKIN. I think it has been a bit frustrating to hear the way the issue has been characterized today because the key issue here is to remember that the income statement is designed to display in a fair fashion the net income, the matching of costs and the revenues generated by a firm for purposes of financial disclosure. It is clearly the case that stock options could still be a part of that employee compensation.
Mr. SHADEGG. Let me go back to Mr. Frank's style. You are not answering my question. My question was as a policymaker, not can they do it differently, my question was shouldn't we look at the effect of the policy not just on what will it do to stock prices, but rather on the incentives it would create to continue or discontinue engaging in the process of offering options?
Mr. HOLTZ-EAKIN. It depends on the question you want answered. If the question is, what will produce broad economic performance in the United States, I do not think that is the central question. If the question is, how many stock options will be granted in the United States, it is a very central question.
Mr. SHADEGG. Since I think how many are issued affects our economy and at the end of the day everything I look at I have to put at least through that filter, it seems to me to be of grave concern.
Page 70 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. Chairman, I know you want to get to a number of other witnesses. I strongly feel that with the concerns that have been expressed here by all of the witnesses, before we leap off into this abyss, we need to look at it more carefully. It is odd to me. It seems to me strange that the IRS would put out a regulation that says we want every taxpayer to report X, but quite frankly we do not know how you are going to value X. I have trouble with a policy that says we are going to solve this problem; we are going to tell you to address this issue, but we are not going to give you a uniform method for calculating it, and we think we are bringing more certainty to the market. That is just a grave concern on my part.
I yield back the remainder of my time.
Chairman BAKER. Mr. Miller?
Mr. MILLER OF NORTH CAROLINA. Thank you, Mr. Chairman.
Mr. Smith, I know that you expressed at the beginning a frustration that no one who seems to be involved in this debate on our side knows anything about stock options. I admit that I never have had one, but my brother works for a bank. He has described to me what he does. At the end of it, I knew he worked for a bank.
He has some fairly impressive titles, but I also know that banks pass out titles instead of compensation. I hope we never have to value that.
I am trying to figure out how this works and whether it really is going to provide any kind of useful information to middle-class investors. Let me try to get a feeling for how this works. My understanding is a mid-level employee may be given 3,000 options. The market price of the company now is $55, and one-third or 1,000 are exercisable in a year, say, at $60; the next one-third a year later at $65; the next year, the last 1,000 at $70. They expire if not exercised within 5 years of when they vest and they cannot be transferred and they are forfeited if they are not exercised at the time the employee leaves the company. Is that generally the way it works? Kind of, Mr. Grady?
Page 71 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. GRADY. That is generally the way it works. The only slight correction I might make is that typically the strike price on those options would be the $55 at which they were granted. They probably might choose to exercise them if the stock went up to $60 or $70 a year later; and if the stock went down to $40, they would not exercise.
Mr. MILLER OF NORTH CAROLINA. But if they have an option at $60, they would rather buy it through the market rather than by exercising the option.
Mr. GRADY. Because it goes below, yes, sir.
Mr. MILLER OF NORTH CAROLINA. But it has some value, but if it is not traded, would you value it by what? If the company has analysts and they project a 10 or 15 or 20 percent stock price per year in the next 5 years. Do you look at that? If there are no analysts following the company, do you look at what the board of directors or the management forecasts are for growth of earnings? How do you value something that can be exercised in the future?
Is there any understanding at all whether these will be valued at the time of exercise or when they vest, when you can exercise them, or at the time of their issue in the first place?
Mr. GRADY. The exposure draft suggests valuing them at the time of grant, when they are issued in the first place, when their value is frankly highly speculative.
Mr. MILLER OF NORTH CAROLINA. So even when you are being granted something that is only at $70, that you can exercise at $70, even though the stock is trading at $55, you have to establish some value for that and declare it now.
Mr. GRADY. Yes. You have to estimate what the value would be.
Mr. MILLER OF NORTH CAROLINA. Okay. If stocks are not exercised in the next year or the year after that, is there any requirement that the company go back and true up the cost because the stock went up or down?
Page 72 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. GRADY. Generally, no. For public companies if they value them at the time of grant, that is it. Now, there are different methods. Some have said intrinsic value would be allowed for private companies where you would go back and true up each quarter. The FASB actually seeks comment on whether instead of using grant date as the measurement period, you should use exercise date.
As I mention in my testimony, while that would get around the problem of how hard it is to value the options at grant date, it creates a different problem which is if you require them to be expensed on the exercise date, what you are in effect doing is penalizing the most successful companies and helping those whose stock price has languished.
Mr. MILLER OF NORTH CAROLINA. I think most of the testimony today has been about the effect on the economy of encouraging or discouraging, or to use the current noun-verb, incentivize or incent or disincentivize or disincent. But just looking at this from the standpoint of middle-class average investors, is this going to provide them more useful information than a footnote telling them how many options are out there and what the terms are under which they can be exercised.
Mr. GRADY. I believe it will provide them with less reliable information, far less reliable information for the investor for all the reasons we said in our testimony.
Mr. MILLER OF NORTH CAROLINA. Alright. I am probably the last one to have anything. Mr. Smith, I want to assure you that I have lived my brother's experience. My brother and his wife and my wife and I have a beach cottage together. When the stock of his company is doing well, he wants to go in together and reupholster the furniture and buy a DVD for the cottage. When the stock is not going well, he wants to sell.
Mr. SMITH. My comments have related primarily to the people testifying, not the people sitting on that side, obviously, the policymakers. I am more frustrated by the fact that like yesterday in the Senate, all the people that were testifying basically there were no business people. They were people having FASB, prior Federal Reserve chairmen, and all those sorts of folks. Great folks, but never in my opinion ever started a company.
Page 73 PREV PAGE TOP OF DOC Segment 1 Of 2 Chairman BAKER. The gentleman's time has expired.
I will get Mr. Lynch in, if I can.
Mr. LYNCH. Thank you, Mr. Chairman.
I want to thank you, Mr. Chairman, for your good work and the panel for helping us out. I apologize for having to rush out here at the end. Prior to coming to the Congress, I was actually an iron worker for about 20 years, so I am similar to some of the production employees you have been talking about earlier today. I also was a former union president of the iron workers. So I spent a considerable amount of time working toward greater corporate responsibility, greater corporate accountability, transparency, and those issues.
That much being said, I have to say that I have some very, very, very serious concerns about this FASB exposure draft that is under consideration today. I think it is a real mistake. It has been my own experience that the granting of stock options has given a lot of opportunity for rank-and-file employees to own a piece of the rock, as has been said earlier here today.
It does in fact incentivize the workplace for many of our workers, if they know that if they work their tail off that they are going to help the company succeed, and then by doing so they themselves will be enriched. That is a good thing for America and I think it is a good thing for our corporations here.
Again, Gillette Safety Razor Corporation is in my district. A lot of the young fellows and women who went to high school with me, went to work. Some husbands and wives in the same corporation for Gillette. They have a great stock purchase program at Gillette. A lot of the folks that I went to high school with went to work on the assembly line and now they are looking pretty closely at retirement. Some of those people when Gillette was at their high end were millionaires, based on the amount of stock that they had purchased in their own company. Good hard workers. I do not want to see that opportunity denied from rank-and-file workers. I think that it would be a mistake to adopt this rule that would basically kill that whole process.
Page 74 PREV PAGE TOP OF DOC Segment 1 Of 2 I know especially in the high-tech area, this is an important tool in bringing bright young employees into the workplace. I do have one question, and then I am going to run out. I know that we have talked about H.R. 3574, which would basically expense the options granted to the top five employees. In thinking about this problem in a different way, would it be better, and this is for the entire panel, and you might have to holler your answers as I run down the hallway, would it be better to look at some fixed percentage of the stock options granted each year and expense those some small percentage, so that it is not just the top five? Because the top five companies, as Mr. Smith has pointed out, in a small corporation to force expensing on that small group may have a detrimental effect on the operation of the corporation itself. I just wanted to get that out there. I think it is a great suggestion in terms of a compromise, but there might be a better compromise out there.
I want to thank you for coming here. Mr. Chairman, I want to thank you for your enormous patience.
Chairman BAKER. I thank the gentleman.
Did anyone care to respond?
Mr. HOLTZ-EAKIN. The key for fair portrayal of net income is the value of options granted, not the number of people that you choose to expense, or to the extent that you have revealed the value of options granted, you will become closer to net income as measuring the economics of the corporation.
Mr. LYNCH. Right. I understand that.
Mr. HOLTZ-EAKIN. A fixed fraction of the value reveals the value of options granted. That would be tremendous.
Mr. LYNCH. Okay. Thank you. Thank you, gentlemen.
Chairman BAKER. Let me express my appreciation to each of the witnesses. We certainly do appreciate your participation. This obviously is a difficult subject and we are doing our best to achieve the best public policy.
Page 75 PREV PAGE TOP OF DOC Segment 1 Of 2 There being no further members to be recognized, I do now adjourn this meeting of the Capital Markets Subcommittee.
[Whereupon, at 12:40 p.m., the subcommittee was adjourned.]
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