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THE RENEWED DEBATE OVER STOCK OPTIONS
March 25, 2002In the wake of the Enron debacle, policymakers in Washington would do well to take a step back and heed the words of United States Supreme Court Justice Oliver Wendell Holmes, Jr.
“Great cases, like hard cases, make bad law,” Holmes wrote in a 1904 opinion. “For great cases are called great, not by reason of their real importance in shaping the law of the future, but because of some accident of immediate overwhelming interest which appeals to the feelings and distorts the judgment. These immediate interests exercise a kind of hydraulic pressure which makes what previously was clear seem doubtful, and before which even well settled principles of law will bend.”
Holmes’ words nearly a century later are relevant in regard to the damage Enron has done to the United State’s high-growth entrepreneurial economy. Consider the fact that high-growth entrepreneurial companies create roughly two-thirds of all the new jobs in the U.S. economy, are responsible for at least two-thirds of the innovation in the economy, and account for about two-thirds of the difference in the economic growth rates among industrialized nations. And according to U.S. Census Bureau data, only five percent of all U.S. businesses during the mid-1990s created new jobs at a rate of 15 percent or more per year.
It is these high-growth companies which are among the key victims of the accounting abuses at Enron. One of the key policy pillars that supports the U.S. entrepreneurial economy is the transparency and trustworthiness of our financial disclosure system and securities regulations regime. Small, high-growth companies depend on this system much more than larger corporations because they often are not big enough to be followed closely by independent market analysts who can provide additional comfort to investors.
Thus, repairing the damage caused by Enron’s actions is critical to the continued success of the American entrepreneurial economy. And among the reform proposals floated so far, there are several that seem promising, as long as the details are done right. For example, careful statutory changes that would separate auditing and consulting services with the same client and require quicker reporting of insider stock transactions make considerable sense.
At the same time, a second policy pillar that supports the American entrepreneurial economy is under siege by some in Congress. This other pillar is 30 years of favorable tax and accounting treatment afforded the stock options granted by entrepreneurial companies to their employees. Without the ability to offer stock options, entrepreneurial companies can never compete with larger, more established companies for the talented workers they desperately need to grow. Without stock options, companies like Intel, Federal Express, Genentech, Sun, Amgen, Apple, Dell, and even Starbucks would not have been built.
For most of the last 30 years, accounting rules provided that the value of outstanding stock options was not to be charged against a company’s earnings. Beginning in 1986, this provision was challenged and vigorously litigated in accounting policy circles. Finally, and after ten years of debate, the Financial Accounting Standards Board decided in 1995 to maintain the rule, provided that a company’s outstanding stock option grants be fully disclosed in a note to its financial statements. The required note must disclose the number and value of outstanding employee stock options, allowing investors to use their own assumptions about eventual exercise of these options to calculate their impact on company valuation.
Now, U.S. Senators Carl Levin (D-MI) and John McCain (R-AZ) have re-introduced legislation — also recently introduced in the House by U.S. Rep. Pete Stark (D-CA) — that would deny tax deductions to entrepreneurial companies which did not take the full current value of all outstanding stock options as a charge against earnings. The practical result of this bill for investors will be that company earnings will be distorted by reducing them by an amount calculated using the unreal assumption that all outstanding options were exercised as of the date of the financial statements, by all holders, at the current market value. And the practical result for entrepreneurial companies will be a huge disadvantage in the investor marketplace compared to large, well-entrenched corporations that do not need to rely so heavily on stock options to meet their employment growth needs.
The lesson here is we must be careful not to let, in Holmes words, this “great case” — Enron — make bad law. The entrepreneurial, high-growth companies of this nation have been our engine of growth for the last 30 years, and we must count on them for similar growth over the next thirty.