Option Play

by John B. Judis | May 6, 2002

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 Justice Department 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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