The Options Fight

In 1993, the Financial Accounting Standards Board (FASB) proposed closing an accounting loophole that allowed companies to avoid recording stock options on their balance sheets. According to a Merrill Lynch study, expensing stock options would have slashed profits among leading high-tech companies by 60 percent on average. Corporate America aligned with the accounting industry to fight the FASB proposal, with the result that in 1994, the Senate, led by Senator Joseph Lieberman (D-Conn.), passed a non-binding resolution condemning the proposal by a vote of 88-to-9.

It wasn’t an accounting debate, says Jim Leisenring, the vice chairman of FASB from 1988 to 2000. We switched from talking about, ‘Have we accurately measured the option?’ or, ‘Have we expensed the option on the proper date?’ to things like, ‘Western civilization will not exist without stock options,’ or, ‘There won’t be jobs anymore for people without stock options.’. People tried to take the argument away from the accounting to be just plainly a political argument.

It was the first time that accounting principles had become very, very much influenced by commercial interest and political interest, James Hooton, who was then chief of Andersen’s worldwide auditing, tells FRONTLINE. If you move accounting and accounting standards into the political environment, then you’ve lost control over whether those standards are the best standards.

Here are excerpts from FRONTLINE’s interviews with three figures involved in the stock-options debate: Senator Lieberman; Arthur Levitt, who was SEC chairman from 1993 to 2001; and Sarah Teslik, executive director of the Council of Institutional Investors, which represents large pension funds.

Joe Lieberman (D-Conn.) is chairman of the Senate Governmental Affairs Committee that has been holding hearings on the collapse of Enron.

Very simply, the concern that I had back in 1993 and 1994, and that I still have, is how do you accurately value an option on the day it’s granted? It has no real value. The value is when somebody exercises the option and actually buys the stock, because then there’s a market value. The accounting board, I think, came up with a pretty good compromise here, which was, instead of requiring so-called expensing from income, it said the company has to disclose by some formula — which is a real sort of guesswork, but better than nothing — what impact the expensing of options at the time they were granted would have on the earnings of the company. It’s right there in any report. It’s probably a lot clearer than a lot of the other stuff that are in those reports that the companies put out.

Companies don’t have any trouble figuring out how much options cost them when they list them on their tax returns to reduce their taxes.

That’s a separate question, which is an important question. Usually that’s done, and it’s done more effectively at the time they’re exercised, because at the time of exercise, there’s a tax impact on the employee and on the company, and they adjust it in that way.

So you think the action in 1994 that the Senate took in your resolution and then the ultimate compromise was a good action?

Yes, I think it was a good action, because the contrary action would have been to try to put a hard value on something that one can’t value.

There were a lot of people arguing, particularly from Silicon Valley, that if you expensed options, it would hurt their ability to recruit, it would raise their expenses and hurt their income. Do you think it would have hurt the economy?

Yes, absolutely. Look, the granting of options is one of the ways in which capitalism has been democratized in America over the last 20 years. Silicon Valley companies, which drove the technology industry, which increased the productivity of our economy during the 1990s and in large part created the boom that we had, came to me at that time and said, We need to use these stock options to lure the brilliant minds from the big companies that are paying them the kinds of salaries we can’t pay them, because we’re going to give them a stake in the company.

So yes, I think that if we had forced the expensing of stock options at the granting, not only would we have forced something that is impossible to do rationally — because the option has no value, really, at that moment — but we would have hurt the economic growth of the company and the enormous benefit that came to many employees from stock options.

Let me just say a final word about this. Stock options, I think, are a device. They can be used well or not well. In too many companies, a disproportionate percentage of the options were given to the very top people in the company. In fact, I put legislation in to try to create a system that would have required half of the options given by any company to be given to so-called non-highly compensated employees.

Chairman of the SEC from 1993 to 2001.

In the 1990s Silicon Valley was saying essentially you’re going to kill the golden goose. What do you say?

I don’t buy that argument one single bit. Stock options have been a useful device. They’re part of the culture of American business. That’s not going to disappear overnight. If it takes a stock option to induce an employee or an executive to come to a company, and that stock option has to be represented as a cost on the balance sheet, in my judgment, America’s executives are going to pay that price. It is not the end of stock options. It is not the end of entrepreneurship in America.

So FASB came up with this new rule. What happened?

When I came to the SEC, this new FASB rule to expense stock options had galvanized the American business community and brought literally hundreds of CEOs to my office in Washington to urge me to prevent the FASB from going ahead with this proposal.

But what happened during the course of this fierce debate and dialogue was that the Congress changed, and Newt Gingrich brought to power a group of congresspeople who were determined to keep FASB from enacting this rule proposal. My concern was that if Congress put through a law that muzzled FASB, that would kill independent standard setting. So I went to FASB at that time, and I urged them not to go ahead with the rule proposal.

It was probably the single biggest mistake I made in my years at the SEC.

Investors should care deeply about expensing stock options, because those options represent a distortion of the earnings of the company. Right now, options are treated as a footnote, but that’s not good enough. Those options represent a claim on the company, and a claim that may very well and has been exercised.

Now the Senate passed a [resolution]. Why did they do it? There was no question in my mind that campaign contributions played the determinative role in that Senate activity. Corporate America waged the most aggressive lobbying campaign I think that they had ever put together on behalf of this issue. And the Congress was responsive to that.

You have Senator Joe Lieberman of Connecticut leading the charge. What were his arguments?

The arguments were the arguments being used by the business community, that this was a break on entrepreneurship; that this would keep companies from being able to hire good people; that this would destroy companies; that this would distort their earnings. All the arguments used by the business community were the ones set forth by Senator Lieberman in his opposition.

Executive director of the Council of Institutional Investors, which represents pension funds.

Had the FASB rule on expensing stock options passed, would that have been some deterrent to what Enron ultimately did?

Had FASB changed the rules and required companies to show stock options as an expense, I think Enron and a number of the other companies that have tanked through fraudulent bookkeeping would have been held back considerably, because their schemes depended on postponing public revelation of the losses. And if stock options had to show up as an expense, then a lot of the money that was quietly being siphoned off would have been publicly siphoned off, and it would have been a deterrent.

There was a massive lobbying campaign that went on to prevent the charging of stock options to earnings. We were in the middle of it, so I experienced it. And I have never experienced a more carefully organized, highly orchestrated, across-the-board effort to prevent something from happening.

You had groups, mainstream business lobbies; you had the Silicon Valley lobbies; you had the accountants, who in theory shouldn’t care what the rules are, they should just want to apply them. [They were] all calling on every senator and congressman, leaning on the SEC, visiting members of FASB, threatening the budget of FASB, threatening the budget of the SEC, working with any kind of trade association they could swing in, kicking in large campaign contributions.

It was one of the most impressive lobbying efforts on earth. It was protecting CEOs’ pay packages. I mean, there’s nothing in CEOs’ salaries that compares to the number of CEO stock options. It was protecting CEOs’ pay packages. They were out in force.

What were you doing at that point? Were you testifying for or against [FASB’s proposed rule]?

We actually wanted a change that was not charging stock options to earnings, but that was not leaving it quite uncharged. It was kind of a complex middle ground, because stock options are a weird thing from an accounting point of view. They are a way that money is transferred from shareholders to executives. When you print up extra stock options, the stock that the average shareholder has becomes less [valuable]. And we proposed a solution that was trying to capture the fact that it was compensation — it was valuable; it was a cost of production, but it wasn’t transferred from the company to the executives. It was transferred from the shareholders.

Senator Joe Lieberman sponsored the resolution that overwhelmingly passed in the Senate to oppose the expensing of stock options. Why would Lieberman of Connecticut be so desperately interested in this, to take the lead?

The insurance companies are in Connecticut and the accountants are heavily based in Connecticut. FASB is in Connecticut. Both Senator Lieberman and Senator Dodd have historically been very protective of accountants and very protective of executives, even though they talk a good liberal Democratic line. If you look at the votes and you look at the actions, it’s not there.

The Battle Over Tort Reform

In the fall of 1994, the so-called Gingrich Revolution led to the takeover of the House of Representatives by pro-business Republicans. Tort-reform legislation to curb shareholder lawsuits against companies and accountants was at the top of the agenda. Silicon Valley high-tech firms again aligned with the accounting industry to lobby Congress to pass a tort-reform bill, which it did by large majorities in both houses.

Although President Clinton vetoed the bill, called the Private Securities and Litigation Reform Act of 1995, asserting that it would close the courthouse door on investors with legitimate claims, the Senate — led by Sen. Christopher Dodd (D-Conn.), chairman of the Democratic National Committee — overturned the president’s veto in December 1995. Sen. Dodd received almost a quarter of a million dollars in political donations from the accounting industry in the 1995-96 election cycle, although he was not up for re-election.

Chris Dodd, here he is chairman of the Democratic Party, but he’s also the leading advocate in the U.S. Senate on behalf of the accounting industry, says Charles Lewis of the Center for Public Integrity. And he helps overturn the veto of his own president, who installed him as Democratic chairman. Dodd might as well have been on the accounting industry’s payroll. He couldn’t have helped them any more than he did as a U.S. Senator.

But supporters of the legislation maintain that it was a much-needed break on runaway lawsuits, many of them frivolous, which threatened to damage the accounting business. Tort reform was something that the [accounting] profession had talked about for years, says Joseph Berardino. the CEO of Andersen Worldwide who stepped down in March. Tort reform was an attempt to at least reign in or limit damages so accounting firms wouldn’t go out of business.

Here are excerpts from FRONTLINE’s interviews with SEC Chairman Harvey Pitt and former SEC Chief Accountant Lynn Turner.

Chairman of the SEC since August 2001, he is a prominent securities lawyer who represented the accounting industry in its push for tort-reform legislation.

From 1991 to 1995, you were a strong advocate of the tort-reform law on behalf of the accounting industry. Has your position changed?

The sole goal of the bill — and this was a bill that was introduced by Sen. Dodd, and I supported his notion on this bill, and I think it’s a very positive bill — the sole thing the bill was aimed at curtailing were frivolous lawsuits. I believe the legislation has done that.

I will say that there have been cases that were filed. that I thought raised frivolous issues, and in which companies were in effect blackmailed into settling, or else required to spend extraordinary amounts of time and energy getting rid of.

[Has the deterrent of private securities litigation been weakened by the 1995 tort-reform law?]

Well, first of all, I’ve said that in light of Enron nothing is off the table, and so if there are statistical and empirical data that establish that problem, then I think we all have an obligation to fix it

What I think the statistics will show, however, is that since the passage of the Private Securities Litigation Reform Act, there have actually been more litigations filed, there have been more settlements, and the settlements have been for larger dollar amounts.

There have also been hundreds more corporate restatements —

There’s absolutely [what] seems like [a] clear question and problem with respect to the number of restatements. But the fact is if the PSLRA was creating a haven for people, there wouldn’t be more litigation and the recoveries wouldn’t be exponentially higher than they were before the legislation. The only thing that’s occurred has been to get rid of frivolous litigation, not to get rid of well-intended and well-balanced litigation.

It’s also been an effort to get the most responsible institutional representatives of the individual investor to take a role in making sure that the litigation protects the investors, not the plaintiffs lawyers who seek to recover. The plaintiff’s lawyers have a very, very effective political lobby and they are very upset with anything that will challenge their ability to make fees. What we need is appropriate legislation like the PSLRA to make sure that investors are the ones who benefit from any litigation, not their lawyers.

SEC chief accountant from 1998 to 2001.

Where did the SEC stand on the 1995 [tort-reform] law when it was being debated?

At the time the 1995 tort-reform act was being debated, we were in a situation that was not healthy in this country where, quite frankly, there were probably lawsuits being litigated that just didn’t have a real basis. Some people called it ambulance chasing, even on the part of some of the attorneys. That wasn’t healthy, and that cost investor money, because some companies had to pay out money just to settle, even though the suits didn’t have merit.

The problem is that I think we turned around and made it much too tough for investors to turn around and pursue their claims in court when they were wronged by whoever — it might have been management, the auditors, whatever. There have been things that have changed, whereby even if a professional aided and abetted in the fraud that went on — not necessarily because they did it directly themselves, but stood by and watched it happen and could have done something — it is now unlawful to be able to go after people in those situations.

I don’t think the average investor is going to think that it’s right that people can stand by — especially the professionals, the experts in these cases — can stand by and watch things happen, thereby aiding and abetting those things occurring, and think that they should go without punishment. Neither do I.

Do you think the passage of the 1995 tort-reform law affected the behavior of accountants, of corporate boards, of corporate officers, of law firms, of investment banks in any way?

. No one likes to be sued, and without a doubt, it’s in the back of all of their minds. But probably what’s at the forefront of their minds is the fact that now there is, without a doubt, less litigation exposure. The chance of getting sued has been reduced. People say, Well, there’s been more financial fraud lawsuits. That’s true, but it’s because there’s been more financial fraud.

Given the limitations of the staff at the SEC, given the limitations of funding, were private lawsuits to some extent an enforcement tool that was helping you?

There’s no question that private lawsuits are a big part of the existing deterrent in the country today. Private lawsuits probably have a much greater impact, even [more] than the SEC, on the behavior of company executives and auditors.

The War Over Consulting

By the late 1990s, corporations had put the squeeze on auditing fees, and consulting, which had once been a small fraction of the accounting industry’s business, became the main profit center. Arthur Levitt. then the chairman of the SEC, saw a conflict of interest undermining tough audits: accountants feared losing lucrative consulting deals if their audits offended corporate clients. He proposed a solution to the Big Five accounting firms — that they stop doing major consulting jobs for their audit clients.

Three of the Big Five firms — KPMG, Deloitte & Touche, and Arthur Andersen — saw Levitt’s proposal for auditor independence as a threat to their entire business model. To block Levitt, the accountants turned to friends on Capitol Hill such as Rep. Billy Tauzin of Louisiana, a powerful House Republican who chaired the committee with oversight of the SEC. [Read a letter from the House committee to Arthur Levitt.] Tauzin had received nearly $300,000 from the accounting industry since 1989 — even though he never had a serious challenger for his seat. In their war against Levitt, the accounting firms unleashed a massive lobbying campaign, spending nearly $23 million in campaign contributions to both parties.

Among the flood of mail Levitt received pressuring him to back off from the proposal was a letter from Kenneth Lay. the influential CEO of Enron. Ken Lay wrote me a letter during the debate over the issue of auditor independence, Levitt tells FRONTLINE, urging me not to proceed with this rulemaking because his relationship with his accountant, Arthur Andersen, has been such that consulting was terribly important to the well being of Enron.

Ultimately, with Congress going so far as to threaten the SEC’s funding, Levitt was forced to back down. He modified the rule so that auditing firms could keep their consulting business if they disclosed potential conflicts of interest to corporate audit committees.

Here are excerpts from FRONTLINE’s interviews with Arthur Levitt, Harvey Pitt, Joseph Berardino, and former Federal Reserve Chairman Paul Volcker, whose unsuccessful effort to save Andersen hinged on reforming it as an audit-only firm, stripped of its non-auditing-related consulting practices.

Chairman of the SEC from 1993 to 2001.

In April 2000, you proposed reforming the accounting industry. What happened? What was the industry’s reaction?

The number of cases of financial fraud that we were seeing at the commission had absolutely exploded. Managed earnings became the regular way of going rather than the exception. So I went to the leaders of the Big Five accounting firms and I said that we have got to change the rules, and that means the conflicts that exist have got to be eliminated.

Two of the firms, Ernst & Young and PriceWaterhouse, said that they would try to work with us on trying to change those rules. Three of the firms — KPMG, Deloitte, and Arthur Andersen — at a private meeting that we had, said, We’re going to war with you. This will kill our business. We’re going to fight you tooth and nail. We’ll fight you in the Congress and we’ll fight you in the courts..

[The industry] hired no fewer than seven lobbying firms to represent them on the Hill. I spent probably over half my time in my final months at the SEC on Capitol Hill, responding to queries from members of Congress, talking to congressional committees, trying to explain why this is a matter of national economic interest.

I have a letter that you got in April. What is this letter?

This is a letter from the overseers of the SEC, the congressional committee that oversees the SEC that has a chokehold on the existence of the SEC, that can block SEC funding, that can block SEC rulemaking, that can create a constant pressure in terms of hearings and challenges and public statements, that can absolutely make life miserable for the commission.

And here are the three leaders: Tom Bliley, the chairman; Mike Oxley, the head of the subcommittee; and Billy Tauzin, the chairman of another subcommittee. [They] were directing me to go slow on this issue, to go through a process.

They kept the heat on me by telephone calls, by letters, by congressional hearings, and ultimately by threatening the funding of the agency, by threatening its very existence. As we got down toward the end of the congressional session the threats were made, Arthur, if you go ahead with this proposal, it is likely that a rider will be placed upon your appropriations bill which says that the SEC will not be funded if they proceed with the issue of auditor independence..

Today American business goes directly to the Congress. A few years ago, they’d stop at the regulator if they had a problem and talk to them. Now, they go right to their congressman, and the congressman writes me a letter. I even had a congressman say to me, Arthur, don’t pay too much attention to this letter. I have to write it because I’m getting pressure from some fanatic.

In the end, this process was driven by the very effective lobbying efforts of both the accounting profession and certain elements of the business community that went to the Congress and persuaded them that this was a rule that was worth opposing.

CEO of Andersen Worldwide from January 2001 to March 2002.

In retrospect, do you regret having fought Arthur Levitt when he was trying to separate the bulk of consulting from auditing [in 2000]?

I regret fighting anybody. On the other hand, I do believe the market is a better place than the government in deciding how the market should be formed. And among other things I disagreed with at the time is that the government was forcing the whole profession to a certain model. And what I said to him, and I’d still say, is. give the marketplace some options, give them some alternatives. And the better model will win. I didn’t know what the best model was two years ago. I don’t know what the best model is today. Let the marketplace decide.

So that is the first reason I disagreed at the time. The second is that I do not feel that there is any evidence that consulting fees cause auditors to restrict the conclusions on their older clients. But given all the noise that’s existent, particularly in this last year, I’ve given up on that discussion. The market just doesn’t buy it, and so we should respond to the market. And that’s what we were going to do with Anderson. And yes, I regret fighting, but only because I think we should be able to work these things out.

Chairman of the SEC since August 2001, he is an attorney who has represented the accounting industry, including Arthur Andersen.

Sen. Corzine and others have gone back to the idea that Arthur Levitt proposed at one point, separating auditing and consulting. Where do you come down on this issue?

My view is that combining functions can create clear conflicts, so there have to be clearly understood and bright-line tests for what auditors can do and what they can’t do.

The problem with the total separation, as for example Mr. Levitt has proposed, is that it actually can produce lower quality audits instead of higher quality audits. He’s right to worry about whether people are focused on what they should be: namely, how good an accounting job and an auditing job is being performed. The difficulty is if you strip the firm of all of its consulting work, it would give up a lot of its tax consulting, for example, and we would probably not think that a firm that didn’t have a broad-based tax practice would be competent to do public company audits. They simply wouldn’t understand the intricacies of the tax code and the way individual companies were set up.

The issue isn’t whether you do it as a consultant. The issue is whether there is an economic incentive for the firm and for individuals to pay less attention to the needs of the public investor. That’s the problem.

There are two ways to solve that problem. The first is to say that the people who actually do the audits have to be the people who get no compensation for cross-selling consulting services. That has never been proposed until we have proposed it, and that in my view is a major and critical step we have to take.

The second issue deals with the firm as a whole, because if a large accounting firm thinks that it can get tens of millions of dollars of business from a client, it may have an incentive not to be as focused in terms of the audit work. The way to solve that problem is to leave the hiring, firing and retention of auditors in the hands of an independent audit committee. We would say that the only way an auditing firm can be independent is if its selection, its retention, its firing, or the assignment of any other non-audit function, is done by the audit committee [of the client’s board], not by senior management.

Chairman of the Federal Reserve Board from 1979 to 1987, he was brought in to lead an oversight panel in an attempt to restructure Andersen as an audit-only firm in the wake of the Enron scandal.

You’ve made a major issue out of the importance of separating the auditing function from the consulting function. Why?

Because I think that’s one of the pressure points that tends to create pressure on the auditor itself to not be as disciplined as it might otherwise be with the client, when he knows that there’s a lot at stake in terms of consulting fees, as well as auditing fees.

Now, there is a basic conflict and a problem, because the audit itself, of course, is paid. The auditor is hired by the company, the company pays the auditor. So, there’s a relationship there that can create pressure. But that is increased, it’s multiplied, if there are large other fees at stake.

And I don’t think there’s any question that as these firms have become conglomerates, so to speak, an auditor is aware that a lot is at stake in terms of fees from other activities outside the auditing itself. They may even be rewarded themselves in terms of whether their clients use other services of the company.

Well, to be specific, was David Duncan, the Houston partner for Arthur Andersen, looking at Enron’s books thinking, We’re making $27 million a year from consulting services and $25 million a year from auditing services. I don’t want to displease this client?

Well, I don’t know anything about David Duncan and his mind. All I know is that there is an appearance there — whether it’s in Enron or anyplace else — that the audit may be subconsciously affected by his knowledge that a lot of revenue is at stake in his judgments.

And will that affect his independence of judgment? You hope not. But I think that, you know, we’re better off by removing that appearance, that possibility — that reality, in some cases. And that’s why I think it’s a good idea to keep them separate — so that suspicion doesn’t arise, that pressure doesn’t arise.

I think to the extent the conflict exists, and the extent to which we can reduce the conflict — both the reality and the appearance — it’s a good thing to do. And that’s why I have been advocating separating the auditing function from the variety of other services that these firms are providing. And they were on a track where more and more non-auditing services were being provided. Now, in reality I think what’s happened is the market itself is pushing back in the other direction now. And I think that’s a healthy thing.

Most of the auditing firms are selling or disposing of some of the really expensive, complicated consulting — particularly in the high-tech area and the information technology area. They’ve stopped selling them in many cases — most cases — to their auditing clients. So changes are under way as we talk.