Bull!

by Maggie Mahar

  But what of the millions of middle-class shareholders who bought stock in these companies, not at a discount but at full market price, so that they, too, could make a down payment on a house or send a child to college?

  However, FASB was not asking the senators to choose between these middle-class shareholders and middle-class workers. The accounting board was simply suggesting that shareholders of all classes had a right to know what options cost. This was the point that Carl Levin was struggling to make clear, and now, at last, it was his turn to testify.

  WARREN BUFFETT WEIGHS IN

  Levin began bravely: “I am not alone,” he declared. “There are many in the Senate as a matter of fact that concur with my view that we should not be reversing FASB.”

  As Levin knew, this was not quite true. When it came to options reform, he had few allies among his colleagues. Yet he did have one very strong ally outside of Congress: Warren Buffett. The chairman of Berkshire Hathaway stood foursquare in favor of FASB’s proposal.

  By 1993, Buffett was seen by many, not merely as a brilliant investor, but as one of the most ethical voices in the business community. Two years earlier, when Salomon Brothers was caught red-handed in a bond-trading scandal, and John Gutfreund, Salomon’s chairman, was driven out of the firm, Buffett was chosen to come in and clean house. Wall Street’s cynics called him “St. Warren of Omaha.” Nevertheless, when Buffett had finished, the battered bank was once again profitable.

  As for Buffett’s own company, Berkshire Hathaway, his style of value investing was flourishing: the previous year, investors lucky enough to own Berkshire watched the stock soar 70 percent. Meanwhile, Buffett’s own personal wealth had doubled. Three days before the subcommittee hearing, Forbes announced that Buffett was now the wealthiest person in the United States—unseating Microsoft’s Bill Gates.

  Admittedly, Buffett’s stand on options invited that special resentment reserved for billionaire preachers: just because he didn’t need options, why should he begrudge other CEOs the opportunity to make an extra million or two? But Buffett would demonstrate that he practiced what he preached. Four years later, when he bought General RE Corp., Buffett replaced the company’s options plan with a cash-based incentive program—which meant taking a $36 million charge against earnings. In making acquisitions, Buffett almost always chose to cancel the options plan—a costly decision, because it meant taking a hit to earnings. Sometimes the cost was so high it killed the deal.35

  Unquestionably, Buffett was, as Levin observed, “a pretty powerful voice” on FASB’s side. But unfortunately, that voice would not be heard that morning. “He wanted to be here,” Levin noted, “but [the subcommittee hearing] couldn’t be arranged at a time when he was able to make it.” No one explained why the meeting could not be scheduled at a time when Buffett, one of the nation’s most respected and successful CEOs, could appear. Certainly, this leading capitalist’s opinion as to whether or not FASB’s reforms could “destroy capitalism” would be worth hearing. His reckoning as to how much stock options were costing shareholders would be of considerable interest. And without question, Buffett’s colorful presence and witty voice would have drawn the media, focusing public attention on what most viewed as a dry and dreary accounting issue.

  Perhaps those arranging the committee meeting were reluctant to let such a popular figure weigh in on FASB’s side of the fight. Perhaps Buffett was simply too busy to travel to Washington anytime that fall. Senator Levin’s staff was not sure. Whatever the reason, he would not appear. Nevertheless, Buffett had submitted written testimony, and now Senator Levin used it to good purpose, quoting Buffett liberally as he made his argument.

  First, Levin reminded the committee of the basic contradiction before them: “Stock options are the only kind of executive pay which a company can deduct from its taxes as an expense, but which it is not required [to include] in its books as an expense.” This, Levin told the committee, was why Warren Buffett called options accounting “the most egregious case of let’s not-face-up-to-reality behavior by executives and accountants.” Buffett noted that FASB’s critics argued that options should not be expensed because they aren’t really compensation. After all, the Council of Institutional Investors noted, they “aren’t dollars out of a company’s coffers.”

  Levin quoted Buffett’s reply: “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

  Buffett’s common sense cut across the tangle of financial issues: An expense by any other name is still an expense. “Managers thinking about accounting issues should never forget one of Abraham Lincoln’s favorite riddles,” Buffett advised. “How many legs does a dog have if you call his tail a leg? The answer: four, because calling a tail a leg does not make it a leg. It behooves managers to remember that Abe’s right even if an auditor is willing to certify that the tail is a leg.”

  Levin then turned to the argument that options should not be counted as an expense because it was too difficult to price them. If the company’s share price sank, the option might never have any value. If, on the other hand, the stock rose, its value would soar.

  Buffett would have none of it: “It is both silly and cynical to say that an important item of cost should not be recognized simply because it can’t be quantified with pinpoint precision. Right now, accounting abounds with imprecision. After all, no manager or auditor knows how long a 747 is going to last, which means he also does not know what the yearly depreciation charge for the plane should be. No one knows with any certainty what a bank’s annual loan loss charge ought to be…Does this mean that these important items of cost should be ignored simply because they can’t be quantified with absolute accuracy?” he asked. “Of course not. Rather, these costs should be estimated by honest and experienced people and then recorded.

  “Moreover,” Buffett continued, “options are just not that difficult to value.” After all, FASB’s supporters pointed out, the market values stock options all the time. Employee stock options are not, at bottom, all that different from “call” options, which trade in the open market. Like employee stock options, these options give the investor the right to buy shares at a fixed price at some point in the future. The major difference, as Mary Barth, a Harvard accounting professor who supported FASB’s proposal, pointed out in her testimony, is that while the investor who buys a call option pays cash to acquire it, employees acquire options by providing services to their company. The options, then, are part of the employee’s compensation for those services.

  And companies routinely calculate the value of those options in order to explain total compensation to their executives.36 When an executive accepts stock options in place of a cash bonus, he knows that there is always the risk that the options will expire worthless. This is the same risk that an investor faces when he buys a call option. He does not know how much—or how little—it will be worth in the end. But he does know that even though a profit is not guaranteed, the chance to buy the stock at a fixed price has value. That is why he pays for it.

  To underline his point, Buffett issued a challenge “to any CEO who says that his newly issued options have little or no value…. I’ll make [him]an offer. On the day of issue, Berkshire will pay him or her a substantial sum for the right to any future gain he or she realizes on the option…. Intruth we have far more confidence in our ability to determine an appropriate price to pay for an option than we have in our ability to determine the proper depreciation for our corporate jet.”

  Levin then addressed the idea that it is “in the national interest” to let technology companies, in particular, make lavish use of options packages. In truth, Levin declared, options reduced the capital available for research and development: “CEOs exercising stock options drain hundreds of millions of dollars each year from the capital needed to make American companies more competitive. In one case last year, a CEO and
his wife exercised options for $84 million, capital which their high-tech company could have used to ease serious cash flow problems,” said Levin, referring to the fact that if the company had sold those newly issued shares in the open market to an outsider, they would have fetched a much higher price. Instead, when the CEO exercised his options, he bought the shares at a discount—meanwhile, “cash flow problems [at that company led to] two quarters of losses, extensive layoffs and a slash in stockholder dividends.

  “The Wall Street Journal reports that more than 9 percent of company stock is now set aside for executive stock options,” Levin observed. “That’s triple the 3 percent set aside a few years ago…. The millions of dollars going to feed the stock-option frenzy are diverting capital from the research and development and capital improvements that companies need to become competitive. So it’s not just where the money is going that’s the problem; it’s also where it’s not going. Stock options divert that capital from other productive uses.”

  Meanwhile, Levin noted, there was very little evidence that stock options boosted a CEO’s performance. Just that year, Fortune’s survey of executive compensation shot a hole in the theory that CEOs who received options would have an incentive to do a better job. Indeed, the numbers in the report showed that executives who received the most generous stock options that year did no better for shareholders than those who received the smallest packages.37

  In the end, Levin argued, stock options only undermine the competitiveness of U.S. industry. Here he displayed a chart comparing executive pay in America to corporate pay in other countries. “Our corporate pay is twice as much for the same-size companies as corporate pay in Germany and Japan, our main competitors,” he observed. “Twice as much. And there is no connection to performance.”

  He concluded by quoting Buffett: “True international competitiveness is achieved by reducing costs, not by ignoring them.”

  WHY CONGRESS SHOULD NOT SET ACCOUNTING RULES

  As soon as Levin finished speaking, the objections began. Senator Shelby led the hectoring:

  “Are you basically against giving executive compensation where people really perform and lead a company?” he demanded.

  “Quite the opposite, quite the opposite,” Levin replied.

  Shelby ignored him. “You’re talking about salaries and bonuses in Europe as opposed to the United States. Are you trying to get the government to mandate what private enterprise can pay and should pay?”

  Levin tried again. “Quite the opposite. I think government here—”

  Shelby cut him off. “It sounds like it. Are you against people making big salaries or making big profits because of stock options?”

  “No,” Levin replied, “I just want them treated the way the independent accountants say they should be treated…so that we have honest financial statements….”

  Shelby refused to meet the argument: “You believe the United States should follow Europe as a model, considering what is going on over there?” It was clear where he was heading: at best, Levin was unpatriotic, at worst a Socialist, and probably a Francophile to boot.

  Levin tried again. “You know what I think…if we have honest accounting standards….”

  “Answer my question,” Shelby demanded. “Do you believe that the United States should follow the European model to compensate their executives? Do you believe that?”

  The comparison to CEO salaries in Europe had become a red herring, and Shelby would not let it go. Levin repeated his arguments about independent accounting standards and honest financial statements, but no one seemed terribly interested.

  Barbara Boxer then zeroed in on Levin’s claim that less than 2 percent of all U.S. companies give options to all employees. Boxer was skeptical:

  “I just want to know where you got this figure,” she said, “because what I have been hearing, all over California, at least, is that many, many companies use stock options to pay the lowest level of their employees.” Boxer’s question revealed the degree to which she, like most senators, was relying mainly on anecdotal evidence supplied by the lobbyists, rather than hard facts and figures.

  Levin, by contrast, had the data: “There are two studies: one is the Executive Compensation Report that says of the 1,100 companies that they look at, less than 2 percent give stock options to all employees. And The Wall Street Journal reports that less than 5 percent of all U.S. companies using stock options give them to anyone below management.”

  Boxer pounced on the word “management.”

  “I think that is an important clarification because when you talk about management, you talk about some pretty mid-level people, even some low-level people. So, I think that is a little misleading.

  “In other words, you can have mid-management people who are earning maybe—correct me if I am wrong—you know, $40,000, $30,000 and still be considered management.”

  Of course—that was it. When The Wall Street Journal said “management,” it really meant people earning $30,000 to $40,000. Without a single piece of evidence to support her claim, Boxer had made Levin’s numbers disappear.

  Now Senator Shelby turned on Levin. “Why would you want to take that away from them?” he demanded.

  Levin attempted to defend himself: “That is the last thing I would do. The last thing I would do is take it away from them. I want it honestly reported. According to the independent accountants, the only way to honestly report it is to show it as an expense on their books.”

  Boxer brushed away the whole issue of accurate accounting: “We could debate an academic argument here—accounting principles—[but] if I see an accounting rule that is going to go in and really hurt our job opportunities and our business opportunities, it gives me cause for concern.”

  In other words, the numbers did not matter; the truth about earnings did not matter, and the cost to shareholders did not matter. In Silicon Valley options were popular, and from Boxer’s point of view it was her job to represent what was popular in her home state.

  In that moment, Boxer demonstrated why Congress should not be responsible for setting accounting rules. First, most politicians are not mathematicians; they have neither the training nor the inclination to delve into the details of corporate accounting. Secondly, senators and congressmen are elected to represent the financial interests and social goals of their particular states—goals that, however admirable, have little to do with clean accounting.

  The gnomes of Norwalk, on the other hand, represented the numbers, nothing more and nothing less. But in the minds of most of the congressmen at the hearing that morning, options reform was not a financial issue, it was a political issue.

  THE POLITICAL WINDS

  The debate continued for another year. Treasury Secretary Lloyd Bentsen and Goldman Sachs joined Lieberman, rallying around the corporate lobbyists. On the other side, Warren Buffett, The Washington Post, and Bill Seidman, the former head of the FDIC who had overseen cleaning up the S&L scandal, supported FASB and Levin. As for the White House, “President Clinton, characteristically, has expressed sympathy for both sides,” The Washington Post reported.38

  The SEC chairman remained on the sidelines. “I was careful not to take a personal stand on any of these issues,” Levitt recalled in a 2002 interview. “If FASB is going to be independent of politics, the SEC chairman can’t be seen taking a stand.”

  Nevertheless, Levitt was watching which way the political winds were blowing, and privately, he was worried. Seven months after the subcommittee hearing, the resolution declaring that FASB’s reform would have “grave consequences” for the economy passed the Senate by an overwhelming margin: 88–9. Six months later, in the 1994 midterm elections, the Republicans took over the House, putting Georgia’s Newt Gingrich into the Speaker’s chair. “I thought the country was swinging to the right, and the mood was antiregulation,” Levitt recalled.39 He feared that if FASB continued to push for options reform, Congress might well punish FASB by passing legislation that undercut its autho
rity.

  Senator Carl Levin continued to stand his ground, but now Arthur Levitt backed down. Privately, Levitt remained convinced that FASB was correct. “Arguments otherwise did not sway me.” But “politics did,” he admitted eight years later.

  Levitt went to FASB and, behind closed doors, urged the private-sector accounting board to back off. “I warned them that, if they adopted the new standards, the SEC would not enforce it.” Levitt had pulled the rug out from under FASB. Without the SEC to implement the rule, there was no point in pressing forward. Not long after, FASB agreed to a toothless compromise that required only that companies disclose stock options grants in the footnotes to their financial statements. As long as executives were paid in options, and not in cash, the cost would not be shown as an expense.

  In a 2002 interview, Levitt explained his actions. “I was afraid that if FASB continued to fight, Congress might override their authority—and put FASB out of business. In restrospect, I was wrong,” he added. “In fact the country had begun to swing back to the center. I don’t believe that Congress could have overridden FASB. I misread the political climate.”

  Yet, even from a political point of view, would it not have been better to force the issue out into the open, and let Congress bring Lieberman’s bill to a vote? That way, even if FASB lost a floor fight, the issues would have been laid bare for all to see. In 2002, Levitt agreed. “Yes,” he said quietly. “I now think that if I had let FASB bring it to a head, and let them bring the issues out in public, it would have been the best thing to do—even if I thought they would lose a floor fight.40

  A more proactive regulator might have encouraged FASB to move forward, much as FDA Commissioner David Kessler forced Congress to address questions about the health hazards associated with smoking—what the tobacco industry knew, when they knew it, and whether they hid that knowledge from the American public. Kessler made many enemies, and ultimately, he lost his fight to bring tobacco under FDA regulation. But the firestorm did focus all eyes on the issue.