Option Play

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Not long ago, the Enron scandal seemed destined to become the Bush

administration's Whitewater. One reason it hasn't is that the

Democrats and the media haven't turned up a smoking gun showing that

the Bushies tried to bail out Enron. Another is that the Bush
JusticeDepartment has come down on Enron's auditor, Arthur Andersen, like a

ton of bricks. But third, and perhaps most important, the

administration quickly endorsed reforms aimed at discouraging the

practices that allowed Enron--and many other companies fueling the

late 1990s bubble--to deceive investors about their financial
health.

"This much is clear," the president declared soon after the scandal

broke, "To properly inform shareholders and the investing public, we

must adopt better standards of disclosure and accounting practices

for all of corporate America."

If only he'd meant it. Several months later, with Enron off the
front

page, the Bush administration has not only neglected the accounting

reforms needed to prevent Enron from happening again, but it is

actively working with the business lobbies trying to block them. A

perfect example is the debate over stock options and how companies

list them on their financial statements and tax returns.

During the '90s companies increasingly resorted to stock options to

pay their top executives and managers. The practice spread from tiny

start-ups to the Fortune 500, where stock options today account for

almost 60 percent of executive pay. Now, there's nothing

intrinsically wrong with stock options; they can motivate employees

by granting them a stake in their company's success. What is

problematic is the way companies count them on their financial

records and tax returns. As the law now stands, companies don't have

to deduct stock options from the profit totals on their financial

statements even though, like wages, the options are a form of

compensation. This omission played a key role in creating the wildly

inflated profits and consequent euphoria that fueled the '90s stock

market bubble. According to the Federal Reserve, if stock options
had

been counted from 1995 to 2000, Fortune 500 companies would have
seen

their annual profit margins drop from 12 percent to 9.4 percent.
Among

some high flyers the deflation would have been larger still:
Counting

stock options, Cisco Systems' profits in 2000 would have been 40

percent lower and Lucent Technologies' 32 percent lower.

But it gets worse. The same firms that have not deducted the cost of

options from their profit statements have deducted the cost on their

tax returns. And as a result, many of America's most prosperous
firms

enjoyed a lucrative tax loophole. In 2000, for instance, Microsoft

saved $2.06 billion in taxes and Cisco $1.4 billion by deducting

stock-option costs. According to Citizens for Tax Justice, Enron

turned what would have been a $112 million tax bill into a $278

million refund. This cycle of inflated profits and deflated tax

payments helped push America's high-tech sector in the late '90s
from

fast, sustained growth into manic overdrive and then--when reality

finally intruded--into the slump and disillusionment from which it

has still not fully recovered.

Federal Reserve Chairman Alan Greenspan, former Fed Chairman Paul

Volcker, superinvestor Warren Buffett, and former Securities and

Exchange Commission head Arthur Levitt--the cream of America's

financial establishment--all want to require companies to deduct the

costs of stock options on their financial balance sheets. So do the

Council of Institutional Investors (the country's main shareholding

organization) and Standard %amp% Poor's (the main credit-rating
agency).

Senators Carl Levin and John McCain have introduced legislation that

would go part of the way toward doing this: The Levin-McCain bill

says that if companies want a tax deduction on their stock options,

they have to make the same deduction on their financial statement.
If

they decide not to deduct options on their financial statement, they

can't deduct them from their taxes. (California Representative Pete

Stark has introduced parallel legislation in the House.)

But the business lobbies that pack K Street are determined to block

any change in accounting and tax rules, as they did in 1994 and
again

in 1997 when Levin and McCain introduced similar legislation. The

Business Roundtable, the American Electronics Associations, the US

Chamber of Commerce, and the National Association of

Manufacturers--acting through the newly formed Coalition to Preserve

and Protect Stock Options--have lined up squarely against

Levin-McCain. And in spite of George W. Bush's avowed commitment to

reform, they've found an ally in the president. On April 8 Bush told

The Wall Street Journal, "Alan Greenspan is very smart. I'd hate to

get into a debate with him." He then proceeded to do exactly that,

explaining that he opposed any change in the way businesses counted

stock options.

Here, in brief, is how stock options work. Employees who get stock

options from their employer as payment acquire the right to buy the

company's stock after a fixed period at the price at which it was

initially selling. If the stock's price has risen in the meantime,

the employee can make money by buying the stock from the company at

its original price and then reselling it on the market at its
current

price.

Companies claim stock options should not count as costs because they

are not cash payments from the firm to the employee. But Greenspan

and Buffett call them noncash costs, like depreciation, which

ultimately come out of a company's earnings. After all, when

employees exercise their stock options, the company has to forego

selling its stock at the higher market price in order to sell it at

the original price to the employee. The Internal Revenue Service

(IRS) also considers stock options a cost, which is why it allows

companies to deduct the difference in what they could have received

from selling their stock on the open market from their earnings for

tax purposes.

Companies that provide stock options also pay a cost in what is

called the "dilution" of their stock values. When employees exercise

their stock options, companies have to put new stock on the market,

thus diluting the earnings per share of the old stock. To avoid
this,

companies frequently buy back and retire their own stock, so there
is

no net increase in the number of shares on the market. These

repurchases, which became extremely common in the late '90s, are

another cost on the firms' earnings from issuing stock options.

The Coalition to Preserve and Protect Stock Options has marshaled

three basic arguments in favor of retaining the status quo. First,
as

it argued in one press release, reforms like Levin-McCain would

"discourage broad-based, rank-and-file access to stock options." But

it's hard to see how. Perhaps if the only benefit companies received

from issuing stock options was inflating their profit margins, then

Levin-McCain would persuade them it wasn't worth it. But companies

have long claimed that they benefit in many ways from issuing stock

options, including by fostering employee identification with the

company and deferring compensation costs.

Second, the Coalition claims the reform will "lead to investor

confusion and less accurate financial statements." But it's hard to

imagine that any new disclosure requirements would be more confusing

than the current system, which dates back to 1994, when business

successfully beat back an effort by the Financial Accounting

Standards Board (FASB)--the private, independent body that sets

accounting policy--to require companies to deduct stock-option costs

from their profits. The FASB ultimately settled for merely requiring

companies to include a footnote about stock options in their

financial reports--a footnote it often takes a trained stock analyst

to find and interpret. In Cisco Systems' annual report for 1997, for

instance, it took me a half-hour to locate the relevant footnote: It

was the second item of the ninth heading of the seventh section of

the report's seventh (and last) chapter.

Finally, the Coalition argues that the legislation will "raise taxes

on companies issuing employee stock options." And to be sure, some

liberal critics of stock options, like Randall Dodd of the

Derivatives Study Center, want to do exactly that--by simply ending

the tax deduction for stock options. But the Levin-McCain bill would

do nothing of the sort. It would end the deduction on stock options

only for companies that excluded stock options from their

profit-and-loss statements. The business groups worry that the
FASB's

formulas for calculating the cost of stock options could produce a

number less than the IRS's formula for calculating a tax deduction,

thus limiting the deductions and, in effect, raising taxes on

companies. But that could be easily solved by adjusting the formula

for determining stock options' impact on profits so that it equaled

the calculated tax deduction, as FASB contemplated doing in 1993.
(At

the time companies weren't interested because they feared equalizing

the two numbers would take too big a bite out of their published

profit figures.)

But the really depressing thing about the stock-options battle isn't

that the administration--and most Republicans--are backing the K

Street lobbies. It's that key Democrats are too. Senator Joe

Lieberman, who helped block reform in 1994, sent a letter to
Commerce

Secretary Donald L. Evans and Treasury Secretary Paul H. O'Neill
last

month charging that the Levin-McCain bill would "deprive investors
of

information about stock options and reduce the availability of broad

based stock option plans." According to Michael Siegel, spokesman
for

the Senate Finance Committee, Chair Max Baucus "is inclined not to

support the legislation, but he does believe the issue should be

addressed in a thoughtful way." Thanks a lot. Senate Majority Leader

Tom Daschle backed an earlier Levin bill on the topic but has now

turned publicly noncommittal; Lieberman's staff say Daschle is

against it. And if he and Baucus are opposed, Levin-McCain might not

even make it to a Senate vote.

That's not just stupid policy; it's stupid politics. After all,
Enron

drove a truck through the stock-options loophole. From 1996 to 2000

the company failed to figure $600 million in stock-option deductions

into the $1.8 billion in earnings it claimed on itsfinancial

statements. And thanks to stock options, it didn't pay taxes for
four

out of these five years. The real Enron scandal, as this magazine
has

said from the beginning, is the policies that allowed the company to

perpetrate its fraud. And on stock options at least, the Democrats

aren't merely neglecting to hold the Bush administration accountable

for that scandal; they've become part of it themselves.

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