12 - Dec 98: Parish & Company Provides Details of Financial Pyramid at Microsoft and Cisco Systems in Open Letter to Robert Parry, President of the Federal Reserve Bank of San Francisco.
PORTLAND, OR - It was a pleasure meeting you at the breakfast in Portland on Friday December 4th and congratulations on your success at the Federal Reserve.
The question I asked you during the televised broadcast was, as you noted, rather technical in nature. I apologize for that and please do allow me to summarize the question again in the hope that you might engage your research staff to explore this area which appears to have created a $1 trillion financial pyramid within a narrow sector of the equity market, not unlike the debt pyramid created by the Long-term Capital hedge fund. More details are available at www.billparish.com
The question was the following: “In October, Arthur Levittt, Chairman of the SEC, announced a major initiative designed to improve corporate accounting practices, including the non recognition of significant liabilities such as employee stock option programs. In the initiative he noted that reality was giving way to illusion. Could you please comment briefly on your relationship with the SEC and whether you will become involved in reviewing this issue?”
In your response you referred to the Long-Term Capital hedge fund as one example of such involvement and highlighted the importance of investor confidence in the markets. You also noted that it is important for the Federal Reserve to maintain a strong focus on its own specific objectives.
Responding to another unrelated question pertaining to the Japanese banking situation, you mentioned that many of these bad loans probably need to be written off the books. Of course in Japan a major contributor to their situation was also a breakdown in accounting practices. Many expenses, rather than being charged to income, were set up as assets to be amortized in future years. Assets became inflated, loans made against those inflated assets and when the bubble burst it was discovered that there was no economic value to repay the loans.
Here in the US their was a bitter struggle between the accounting and investment communities regarding one controversial accounting practice that has led to this $1 trillion asset bubble that could seriously threaten the stability of the financial markets. This practice involves how to disclose and account for stock option commitments and, like the Long-Term Capital investment strategies, is based upon a math model designed by Myron Scholes. This is the “Black Scholes” option pricing model.
Stock option programs can be an excellent incentive yet they are now being used in a classic pyramid style structure, most notably at Microsoft and Cisco Systems, in which employees are prepaying their own future wages and being left with potentially inflated shares. Here is how it works using Microsoft as an example. Tables, charts and more background are available at www.billparish.com
When employees exercise stock options they must pay tax immediately. For example, if Sue pays an exercise price of $20 and get a share worth $100, she must pay tax on the gain of $80. Interestingly, the tax is not going to the IRS. This is because the company takes a tax deduction for compensation expense for the same amount. To the IRS it is a wash. Simply put, the tax goes right back to the company in the form of increased cash due to paying less tax.
Since 1995 Microsoft has claimed $10 billion in compensation expense on options exercised by employees yet due to a major accounting loophole, this expense is not reflected on the income statement, which greatly inflates earnings and makes their results non comparable with other companies, introducing a major market inefficiency.
In addition to the distortion of past earnings, Microsoft as of December 12, 1998 has a future liability of almost $55 billion in stock option commitments, half of which are now exercisable. This is a real liability, what their CFO has publicly referred to as their most important liability, yet there is no recognition of this liability on the income statement or balance sheet. The Black Scholes model is a footnote only disclosure based upon solid theoretical assumptions yet it does not recognize the practical financial reality.
With approximately $40 billion in gains to be recognized based upon the $55 billion commitment outstanding to employees, Microsoft knows that it will be able to create cash of almost $14 billion as these options are exercised. In addition, they know that for every $1 increase in the stock price, 35 percent of that increase is cash in the bank.
When compared to the company's gross annual sales of $18 billion, one must wonder if there has been a breakdown in accounting practices, as Arthur Levitt notes. These inflated earnings of course fuel the stock price, especially as earnings slow in other sectors. Microsoft is now the most widely held and highest market capitalized stock in the country.
Many other companies, although they also use this model, manage their programs well to ensure that the overall company finances remain solid. Two examples are Hewlett Packard and Sun Microsystems per a review of SEC 10K reports. In both cases their stock option commitments do not exceed more than 10 percent of gross sales.
My concern is that unless you work with the SEC and achieve reform or at least publicly disclose these practices, simply lowering rates will further fuel the pyramid, narrow the equity markets and risk destabilizing the overall financial structure.
My projections, based upon SEC filings, indicate that in 1999 almost 50 percent of Microsoft's entire operating expenses will be financed through the exercise of employee stock options. Your staff might conclude a higher percent. Employees are clearly prepaying their own wages in a classic financial pyramid.
More alarming is that in the most recent quarter Microsoft earned $225 million selling put contracts on its own stock. Of course they are convinced the stock will not decline and realize that index based mutual funds are required to buy the stock. If Microsoft makes up 4 percent of the S&P 500 Index, then all mutual funds based upon the S&P 500 are required to dedicate 4 percent of all new cash received to Microsoft.
Meanwhile, the Department of Justice is aggressively pursuing its case against Microsoft, claiming a monopoly. Frankly, I have never met a Microsoft employee that I did not respect for their passion, commitment and ability. They are extraordinary yet should their management have the unchecked ability to construct such a financial pyramid, not fully disclose these practices to employees and also potentially destabilize the equity markets?
It is also noteworthy that 401K balances are the primary cash source for new equity investments. One might ask if the average company looks at their 401K retirement plan as a mutual savings bank which holds their employee's life savings or is it looked at as just another benefit? To date, these plans are loosely regulated, generally do not have adequate independent oversight and are actually starting to look much the like the Savings and Loan banks of the 1980's before they began failing.
A second accounting practice aggressively used by Cisco Systems, no longer used by Microsoft, is the pooling method to account for acquisitions. This further fuels the pyramid and is separate discussion.
If this sounds a little far fetched please do ask the banking CEO sitting on your left at the breakfast regarding the integrity of my work.
For good background information please refer to the 9/30/98 also available at www.billparish.com which furthur explains underlying mechanics of this pyramid that resulted in a leading British paper, the Independent, running a editorial on the subject and also declaring Microsoft a financial pyramid. Please do let me know if you would like any additional information. Here in the United States we often take for granted what an extraordinary advantage we have via the good work of the Federal Reserve and SEC. Thank you for your efforts and best regards.
Sincerely,
Bill Parish
www.billparish.com
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