by Maggie Mahar
It would be tempting to say that Levitt was naïve, but even a glance at his history belies that proposition. As the son of New York State Comptroller Arthur Levitt Sr., it is safe to say that Levitt Jr. grew up knowing something about both money and politics. He launched his own financial career selling cattle tax shelters in Kansas City before making his way to Wall Street, where he would spend 28 years, winding up as chairman of the American Stock Exchange (Amex). In the course of his career, Levitt also made some money: newspaper reports put the figure at around $30 million, mostly from the American Express stock he received when the financial services company bought Shearson Lehman Brothers, the firm where he had worked before joining the Amex.13
During his years on Wall Street, Levitt had ample opportunity to see the Street’s seamier side, and he came to the SEC with a clear understanding of Wall Street’s culture: “Actually, there were two conflicting cultures,” Levitt wrote in his memoir of his tenure as SEC chairman: “One rewarded professionalism, honesty, and entrepreneurship…. The other culture was driven by conflicts of interest, self-dealing and hype. This culture, regrettably, often overshadowed the other.”14
When he was appointed to the SEC, many on Wall Street saw Levitt as their special envoy to the Capitol. Indeed, as he himself remarked, “I feel like the parish priest who has been elected Pope.”15 Nevertheless, he harbored few illusions about the market: “Let’s face it—investing is gambling,” Levitt said, with a shrug, in 1993. “But don’t quote me saying that,” he added, careful not to upset any one of his multiple constituencies.16
The new SEC chairman also understood Washington’s culture. After leaving the Amex in ’89, he had purchased Roll Call, a Washington newspaper that covered Capitol Hill, and during the four years he owned the paper, he learned, in his words, “how to work the legislative process—where to apply the pressure and how to find common ground with lawmakers, regardless of political party.”17
Yet, despite all that he knew about both money and power, Levitt came to the SEC convinced that he could regulate with a velvet glove. If he was not naïve—and he was not—perhaps it was hubris, the fatal flaw of many a would-be hero, which made him believe that his powers of persuasion would prevail.
During his first months in Washington, the new SEC chairman set out to “build up political capital,” confident that he had “several advantages over the typical CEO type.” After all, Levitt explained, “At the American Stock Exchange, I had formed the American Business Conference, a research and lobbying group made up of the CEOs of high-growth companies…. I often led the group when it traveled to Washington to meet with members of Congress and cabinet officials…. The experience taught me much about the symbiotic nature of Washington. For the CEOs, the ability to have access to and rub shoulders with well-known people who represented America’s political elite had an addictive allure. The politicians, in turn, used these meetings as an opportunity to raise funds. And White House officials saw their chance to lobby the business community to push their own policy goals.”18
In a nutshell, everyone quite graciously scratched everyone else’s back. In the summer of ’93, when he took up his post as SEC chairman, Levitt felt confident that he could use his considerable social skills to good advantage in these circles where government policy makers, politicians, and the titans of the business community met to exchange favors and set the agenda not only for the business world but, to a large degree, for the nation. When he arrived in Washington, just a few months before the banking subcommittee’s hearing, Levitt found himself at the center of a controversy that could threaten his goal of “building political capital” by making friends and forging alliances.
Almost before he unpacked, the new SEC chairman was drawn into the fight over options accounting reform. CEOs lined up at his door, howling for his attention.
In a 2002 interview, Levitt recalled their pleas: “‘Earnings will sink!’…‘You’ll confuse investors!’…‘You could kill capitalism!’”19 If options had to be set against profits, the lobbyists cried, they would become too expensive, and companies would have to cut back on their options programs.
But in truth, the new accounting rule would not make options expensive: it simply would measure the expense.
Corporate lobbyists liked to pretend that options were more than an executive perk, claiming that millions of middle-level employees benefit from options programs. If FASB’s proposal became a final rule, they warned, companies would have to pare back their use of options, and rank-and-file employees would be the first to lose their benefits. The SEC chairman recognized this argument for what it was—a self-serving ruse. The Executive Compensation Report’s survey showed that only 2 percent of all companies that issued stock options gave them to all employees. A survey of 350 major corporations by William M. Mercer revealed that less than 6 percent awarded options to even half of their workers.20 And even in those cases, the majority of employees received piddling packages that would allow them to buy, at most, a few hundred shares. The truly costly packages were reserved for the executive suite.
“The whole thing was ridiculous,” said Levitt, recalling the CEOs’ arguments. “The cynicism of giving minor amounts of options to junior employees and using that as a cover for justifying huge grants of options to top management…. They just wanted an opportunity to pay themselves more.”21
In his heart Levitt agreed with Carl Levin, the Michigan senator championing FASB’s fight for reform: by burying the cost of options, corporations were deceiving their shareholders.
THE MEETING
Nevertheless, when Senator Levin appeared at the Banking, Housing, and Urban Affairs subcommittee meeting on that October morning in 1993, he did not know whether he could count on the SEC to support him publicly. Levitt had not yet taken a public stand, and neither Levitt nor any member of the SEC staff would be appearing to testify before the committee. As for the other congressmen who would testify that morning, Levin knew where they stood. Of the dozen senators and representatives present, he alone would speak out in favor of FASB’s reform.
The list of those lined up against FASB ran the gamut from liberal Democrats to conservative Republicans, including both Alfonse D’Amato, a Republican from New York, and Bill Bradley, a liberal Democrat from New Jersey; Barbara Boxer, a California Democrat, and Phil Gramm, a conservative Texas Republican; Anna Eshoo, a Democrat from California, and Richard Shelby, a Dixiecrat from Alabama.22 Leading the opposition, Senator Joseph Lieberman, Democrat from Connecticut. Already, Lieberman had introduced legislation that would bar the SEC from enforcing FASB’s proposal if and when it became a final rule.
From the moment that the hearing began, it was clear that many minds were made up. “They just jumped all over him,” a member of Levin’s staff later recalled.23
Senator Alfonse D’Amato led the attack: FASB’s reforms, he declared, could “destroy capital formation.” After all, if companies had to deduct the cost of options from their earnings, earnings per share would drop, and they might have a more difficult time attracting new capital. New Jersey Senator Bill Bradley followed up on D’Amato’s objections and suggested a compromise: expanding the footnotes that provided information about the cost of options. In an ideal world, such disclosure might be sufficient—but only if all shareholders could afford sophisticated financial advisors to read through all of the footnotes in a corporate report and then do the calculations necessary to estimate just how options might affect earnings.24
Nevertheless, Senator Bradley opposed showing options as an expense. If companies were forced to come clean on their cost, earnings could take “a large hit,” he warned, citing a study that revealed that in the technology sector, if companies charged the cost of options against profits, they would have to admit that their earnings were only about half of what they claimed.25
“Better not to let the cat out of the bag” seemed to be the gist of the argument. After all, if one admitted that companies were hiding expenses, shar
e prices might slide. The SEC’s Levitt later summed up this circle of reasoning: “The argument that expensing stock options might hurt share prices was akin to complaining that investors would pay less for shares if they knew that profits were inflated. Of course they would! And that was the whole point,” Levitt exclaimed.26
But Levitt did not testify at the subcommittee hearing in the fall of 1993. Instead, politicians led the discussion, and each brought his or her own political agenda to the table. Some, like California Senator Barbara Boxer, were defending companies in their home states; others, like Senator Bradley, saw themselves as protecting workers and jobs; still others, like Alabama Senator Richard Shelby, believed that they were defending capitalism itself.
No one except Senator Levin spoke for the small investor. “Individual investors do not have a lobby in Washington—what they need is something like the AARP [American Association of Retired Persons],” Arthur Levitt observed in a 2002 interview.27
Indeed, Senator Shelby charged that, by trying to champion the rights of shareholders, FASB was turning “antibusiness,” making it clear that, from his point of view, the interests of American business were best served by serving the interests of management—and a pox on pesky shareholders who questioned their stewardship.
Texas Republican Senator Phil Gramm spoke next. He, at least, did acknowledge that stock options cost something. Options “dilute the wealth of shareholders,” he admitted. “[They do] dilute their earnings.” Gramm had conceded a key point. When insiders exercised their options, they added to the pool of outstanding shares, shaving earnings per share.
THE COST TO SHAREHOLDERS
But this was only one way that options programs could undermine the value of a long-term investor’s stake. As options grants grew, companies would try to offset the dilution by buying back their own shares: Award 10 million options to insiders, buy back 10 million shares, and the cost of options disappeared—or so it seemed. As the bull market spiraled, companies found themselves paying exorbitant prices for their own stock, using capital that could have been used to pay off debt, finance research—or pay dividends to shareholders. Normally, responsible management buys back its company’s stock only when it is a bargain. But as share prices climbed, fewer and fewer stocks were undervalued. Many were overvalued—particularly in the technology sector, where options were widely used. Yet to counter the effects of dilution, companies issuing generous stock options packages had no choice but to buy back shares, whatever the price. Often they were forced to take on new debt in order to finance the buybacks.28
Options packages also encouraged management to reduce dividends. Typically, share prices drop immediately after a corporation pays out dividends. For outside shareholders, the dividend offsets any slide in the share price. But the insider who holds options does not receive a dividend. The value of his options depends entirely on the share price. This was one reason why dividends were becoming less and less popular. In 1988, companies in the S&P 500 had paid out dividends averaging well over 4 percent; by 1995, the average yield would slip below 3 percent. Meanwhile, share repurchase programs were growing—but not fast enough to keep up with new stock being issued. In fact, over the preceding two years, the net effect of lower dividends, share dilution, and share repurchase programs had a negative effect on the value of shares listed on the S&P 500, reducing an outside shareholder’s total return.29
Finally, when a company lets an insider buy shares at a discount, it loses the cash it might have raised by selling those shares at full price. Later in the hearing, GE vice president and comptroller James Bunt would breeze past this point. “What is the expense to the company?” he asked rhetorically, then answered his own question: “Actually the company receives cash when employees exercise options.” Bunt utterly ignored the fact that if a company sold the same newly issued shares to outside shareholders paying full market price, it would raise far more capital. For example, in the fall of 1998, when Bunt himself exercised the right to buy 35,000 shares of GE at prices ranging from $24.16 to $31.94, and promptly sold 25,000 shares in the open market at $74.31 to $83.70, he took home the roughly $1.25 million that would have flowed into the company coffers if GE had sold those shares on the open market.30
But Senator Gramm did not elaborate on the various ways that shareholders paid for options. He simply admitted the obvious point—options cost something—then slid right past it, as if that cost were inconsequential. “The bottom line here is, this is a stupid proposal,” Gramm declared.
SENATOR LIEBERMAN
Connecticut Senator Joe Lieberman followed Gramm. Levin braced himself—he knew what was coming. Already, Lieberman had launched a preemptive strike, introducing legislation that would bar the SEC from enforcing FASB’s rule if and when it was finalized. Going a step further, the Connecticut Democrat was threatening to strip FASB of its independent authority.
Lieberman brandished a big stick: FASB’s independence was based on the fact that it was funded, not by Congress, but by private contributions and the sale of its publications. These private-sector contributions kept the lights on at FASB’s Norwalk, Connecticut, headquarters. The location, along with the independent funding, insulated “the gnomes of Norwalk,” as FASB’s accountants were known in Washington, from beltway politics. But if Lieberman’s measure passed, every FASB decision would have to be ratified by the SEC. Since the SEC was beholden to Congress for its funding, this meant that, for all practical purposes, Congress would have a veto over any accounting reforms that might be politically unpopular.
Lieberman recognized that many congressmen might be reluctant to tell the SEC that it could not implement a rule proposed by a private-sector accounting board. But he had a backup plan: in case his legislation did not fly, he had sponsored a congressional resolution declaring that FASB’s proposal would have “grave consequences for America’s entrepreneurs.” Congressmen who might resist voting for legislation that told the SEC what accounting rules it should enforce would be much more likely to acquiesce to a nonbinding resolution that simply expressed the will of Congress. At the same time, everyone knew, even a congressional resolution would be enough to serve notice that the Hill was dead set against the reform. The SEC would have to pay attention.
It was not clear why Lieberman led the fight. Since options were widely used in Silicon Valley, many saw this as California’s battle. But like most senators, Lieberman relied on campaign contributions from a variety of large corporations, whether or not they were headquartered in his home state. Moreover, the accounting industry was an important lobby in Connecticut, and, no surprise, the Big Six accounting firms that depended on consulting fees from the nation’s largest corporations sided with the CEOs. Then, too, Wall Street was important to Lieberman: in 2002, when Wall Street’s campaign contributions to the Senate were totted up, Lieberman ranked 13th among his colleagues.31
Finally, Joe Lieberman harbored national aspirations. Options reform was an incendiary issue. Anyone who supported FASB could probably forget about a run for the White House. Or, as Arthur Andersen partner Benjamin Neuhausen warned two months later in a letter to Dennis Beresford, FASB’s chairman, “This issue is extremely divisive…. Some battles are better not fought.”32
SEC Chairman Arthur Levitt would find himself at the center of Washington’s options controversy for nearly a decade, and thus was probably in as good a position as anyone to understand why Lieberman led the drive against reform. In a 2002 interview, he offered his explanation: “Senator Lieberman is”—Levitt hesitated, and for a moment his blue eyes narrowed, then hardened—“pragmatic, extremely pragmatic.”
Whatever his private motives, on that morning in October Lieberman based his public argument on the populist line that had become the lobbyists’ rallying cry: “The overwhelming number of people who benefit from stock option plans are middle-income Americans, not upper-income Americans.”
This simply was not true. Even later in the decade, when options programs had
been broadened in an effort to draw attention away from the size of executive pay, only 2 or 3 million Americans received options in a given year, and most were executives. The National Center for Employee Ownership, a nonprofit group based in Oakland, California, that championed options plans, acknowledged that only a tiny percentage of middle-class employees benefited from the programs. When the Center looked beyond the executive suite later in the decade, it found that just 4.2 percent of employees earning $50,000 to $74,999 received options, while only 1.5 percent of those earning $35,000 to $49,999 shared in the programs. Even among employees who earned $75,000 or more, only 12.9 percent of those who were not executives took home options—and most received small grants.33
Moreover, by claiming that “the overwhelming number of people who benefit from stock option plans are middle-income Americans,” Lieberman was sliding over the real issue. What was important was not how many people received options, but how many options they received, what they cost, and who paid for them. Ultimately, the bulk of all options flowed to the top of what MIT economist Lester Thurow would call the New Economy’s “golden pyramid.” By the end of the decade, the National Center for Employee Ownership would report that 75 percent of all options were in the hands of executives who ranked among the top five officials in their companies.34 By then, options grants represented an unparalleled transfer of wealth from shareholders to corporate management.
But Lieberman ignored the cost and shifted the focus from shareholders’ rights to employees’ benefits. He painted a picture of hardworking Americans depending on options to realize the American Dream: “For these hundreds of thousands of middle-income Americans,” he told the committee, stock options “represent the extra bonus, that dividend which will allow them to put down a payment on a house, send a child to college, or begin to put together a retirement nest egg.”
