Infectious Greed (28 page)

Nevertheless, when FASB proposed new rules for derivatives, in an attempt to make financial statements more accurate, the financial lobby and many members of Congress opposed—and killed—them. There were two notable examples of proposed rules during the mid-1990s: accounting treatment of options and mark-to-market requirements for derivatives more generally.

The regulatory treatment of stock options became a hot issue in the new Clinton administration. The issue arose out of President Clinton's campaign promise to do something about allegedly excessive corporate-executive pay. In reality, CEO compensation was not excessive, based on historical measures, and was trivial compared to other corporate expenses, at roughly one-sixteenth of one percent of an average shareholder's annual returns in 1992.
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But voters had been moved by various television programs on CEO pay, as well as Graef Crystal's exposé,
In Search of Excess.
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Following up on his promise, Clinton pushed Congress to limit the tax deduction for the salaries of top corporate executives to $1 million.
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Never mind that only forty-nine CEOs had base salaries of more than $1 million.
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The law had popular appeal and easily passed.

However, the tax deduction contained a loophole large enough to fly a private jet through. The $1 million cap didn't apply to “performance-based compensation,” which Internal Revenue Service regulations said required “objective performance goals.”
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The stated purpose of the regulations was to remove discretion from the corporate directors who determined the pay of top executives. Instead of trusting directors to make judgments based on qualitative factors, the rules required directors to follow quantitative ones, based on metrics easily measured by the market. The prime example of performance-based compensation was a stock-option plan.
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The value of a stock option was based, at least in part, on a simple objective factor: the price of the company's stock. In
response to the new regulations, companies began shifting executive compensation from salary to stock options, in part to preserve the rather small tax deduction but, more important, to assure shareholders and commentators that they were following the letter of the new law.

This relatively minor legal change would have unanticipated, insidious effects. As companies shifted to stock options and other forms of market-based compensation, executives began to focus almost exclusively on those quantitative factors. The more a CEO could increase the company's stock price (or its earnings per share, or some other objective measure), the more money he would make, regardless of how the board thought he had performed. As the board's power was reduced, a mercenary culture developed among corporate executives. Corporate executives began managing their company's earnings, buying potentially higher-growth companies, and in too many cases even committing accounting fraud, all of which resulted in higher compensation. Much of the crisis of confidence in the financial markets in recent years can be traced back to the cultural change that began in 1993, with new tax rules encouraging performance-based executive compensation.

This tax change was reinforced by the FASB accounting rule for stock options, which did not require companies to include options as an expense. This rule—established in October 1972—said the cost of an option to a company was the difference between the market price and the exercise price at the time the option is granted.
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In other words, if a stock is trading at $10, a company can give an executive the right to buy stock for $10 with no accounting charge. To an investor looking at a company's financial statements, such options would appear to be “free.”

Just a few months after this rule was established, economists Fischer Black, Myron Scholes, and Robert Merton had published research showing how options could be valued. The accounting rule was demonstrably wrong, and stock options had an ascertainable value. Yet even as traders began using financial models to track changes in the value of stock options on a minute-by-minute basis, the 1972 rule remained unchanged.

FASB officials knew that the $1 million cap on non-performance-based pay would lead companies to switch to stock options, and they were concerned that investors wouldn't understand how much those stock options were costing the company. The officials began considering a proposal to require that companies include, as a compensation expense, an estimate of the value of the stock options they awarded to
executives. The proposal seemed reasonable enough: the options clearly had a cost, and options models such as Black-Scholes had been churning out options valuations for two decades.

But companies—especially high-technology companies in Silicon Valley—didn't want to include the options as an expense, because it would limit their ability to match executives' pay to the performance of their stock. It also would hurt the value of their stocks. In theory, the accounting change shouldn't have mattered—efficient-market theorists said that as long as the options compensation was disclosed in footnotes or appendices to financial statements, the stock price would reflect that compensation. (Existing disclosure rules for stock options and other compensation required companies to describe all compensation in a footnote, including a summary compensation table and performance graphs, but did not require companies to include the cost of stock options in their financial statements. Theoretically, these rules should have had the same effect as requiring that companies include stock options as an expense in both financial statements and footnotes.)
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Yet the difference mattered. Corporate CEOs—especially those from Silicon Valley—lobbied aggressively against FASB's proposal. They obviously did not think markets were efficient, or that stock prices reflected the costs of stock-option compensation. They were afraid the proposal would hurt their stock prices, and they told regulators about their concerns. They claimed that, without favorable treatment of options, they wouldn't be able to attract top executives, because they didn't have enough cash to pay them. Lobbyists sent out hundreds of comment letters and distributed thousands of “Stop FASB Action Kits.”

Again, individual shareholders were powerless to lobby against such forces. The day before FASB was to issue its new rule for options, Senators Joseph Lieberman, Barbara Boxer, Dianne Feinstein, and Connie Mack introduced a bill to force FASB to drop the proposal.
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Senator Carl Levin was a lonely voice in Congress supporting FASB, although he had plenty of company among accounting and finance experts. Arthur Levitt—who earlier had expressed concern about stock-options accounting during his confirmation hearing—abruptly caved in, and announced his opposition to the FASB options proposal. In May 1994, the U.S. Senate passed a resolution condemning the proposal, by a vote of 88 to 9. Facing this opposition, FASB backed down. Arthur Levitt would later describe his timid flip-flop on the accounting proposal as his “greatest mistake.”

Senator Lieberman's position was that, “As a matter of abstract accounting theory, FASB's approach to stock option accounting may be defensible. But from a public policy, job creation, and competitiveness perspective, it simply is unnecessary and unusually disruptive.”
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Lieberman certainly was correct in arguing that some options—particularly complex, long-term options—were difficult to value, as the losses at Bankers Trust and Salomon Brothers established. But if companies couldn't figure out what long-term stock options were worth, should they really have been giving those options to their CEOs, instead of simply paying them in stock, which had an obvious value?

The next chapter describes the effect of large stock-option grants on the behavior of corporate executives. It isn't pretty. For now, it is sufficient to note that the increase in the use of stock options coincided with a massive increase in accounting fraud by corporate executives, who benefited from short-term increases in their stock prices. More than half of the profits from some major high-technology firms were from the accounting treatment for options. The accounting treatment of stock options also was a dangerous precedent in allowing companies to use stock to affect their own income. When Jeffrey Skilling, formerly Enron's CEO, was challenged at a congressional hearing to name one example of when a company was entitled to use its own stock to affect its income statement, he cited the accounting rules for stock options.

A second example of a FASB proposal failing in the face of well-funded lobbying involved the question of whether derivatives contracts should be marked to market, so that companies would record changes in value over time. With such a requirement, corporate financial results would be more volatile, but investors would receive more accurate and timely information. For example, investors would have known more about the losses stemming from the Fed's rate hike. In October 1994—after forty-five months of work in the face of intense lobbying—FASB still couldn't agree on rules, and it adopted only a watered-down “interim” proposal, which gave companies great discretion in deciding which instruments to mark to market.
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Banking regulators, including Alan Greenspan, consistently opposed these changes, saying they would introduce too much volatility. Commentator Martin Mayer was skeptical of the regulators' motives, and said, “The Fed has no interest in honest mark-to-market accounting and never has. Their interest is that they, and they alone, should value the banks' portfolio. They don't want the market to do it.”
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Senator Lauch
Faircloth from North Carolina—home state to First Union, Bank of America, and Wachovia—played the role of Senator Lieberman in this debate, introducing a bill to prevent FASB's new rules from taking effect. FASB's mark-to-market proposal died, just as its options proposal had.

FASB later resurrected both proposals. In the aftermath of Enron's collapse, Congress and FASB again began debating the issue of accounting for stock options, and some change appeared likely in early 2003. The mark-to-market proposal actually passed, in a grossly mutated form, as part of an 800-page set of rules (called Financial Accounting Standard 133) so watered down and complex as to be incomprehensible. FAS 133 now requires companies to add several more garbled pages to their annual reports, but few analysts pay attention to those disclosures, because they do not accurately portray a company's derivatives risks. If you think you really understand a company whose stock you own, a perusal of the section of its annual report discussing FAS 133 probably will change your mind.

The SEC, to its credit, proposed some regulatory changes to improve disclosure of derivatives risks,
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and many of these changes were adopted in 1997.
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After surveying the annual reports of 500 public companies, the SEC staff found that companies accounted for derivatives with similar economic characteristics in different ways. They also focused on the section of companies' reports entitled “Management's Discussion and Analysis of Results and Operations,” known as MD&A. With some prodding by the SEC, companies began telling investors a bit more about their accounting procedures related to derivatives, but not enough for investors to know with certainty how much of a particular company's profit was from volatile financial businesses.
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Moreover, the SEC's new MD&A rules didn't exactly flush out information. Companies were only required to disclose material information, and “materiality” was a very loose term. The SEC tried to clarify the definition by requiring that companies examine future earnings, fair values, and cash flows from “reasonably possible” near-term changes in market rates or prices. But that term wasn't any clearer, so the SEC advised in a footnote that “reasonably possible” meant that “the chance of a future transaction or event occurring is more than remote but less than likely.”
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These definitions weren't encouraging anyone to make useful disclosures.

The difficulties posed in these regulatory debates centered around the problem that new legal rules would simply encourage private parties to figure out ways around them, or even move offshore. The first four
chapters of this book described numerous instances of such “regulatory arbitrage.” Those practices didn't change during the mid-1990s. For example, in 1995, when FASB adopted new rules requiring companies to account for certain foreign-exchange hedging, Bankers Trust quickly developed a way around the rules, by creating a financial contract with an unlikely contingency related to a company's offshore activities.
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Accounting for derivatives continued to be open to novel interpretations because, although accounting is based on the notions of assets and liabilities, derivatives are not really either.
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In other words, many accounting concepts were too crude to be useful in modern finance.

Some academics—most notably Professors Henry T. C. Hu and Lynn A. Stout—argued that, because unregulated derivatives markets had flaws, legal rules might improve market imperfections, but these scholars were in the minority.
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In 1995, Alan Greenspan testified: “It would be a serious mistake to respond to these developments by singling out derivative instruments for special regulatory treatment. Such a response would create artificial incentives to structure transactions on the basis of regulatory rules rather than of the economic characteristic of the transactions themselves.” Joseph A. Grundfest—a former SEC commissioner—described “an escalating cycle in which regulatory initiatives inspire financial innovations that trigger further regulations that in turn give rise to additional rounds of innovation. At the end of this cycle, the rule books are thicker, but the capital markets often restructure themselves to block the regulatory regimes' goals.”
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