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Yesterday I heard on the radio that DoJ has ordered to close the operations of an internet based "auto-club" pyramid scheme. SEC is cracking-down on the companies who do a lot of merger related writeoffs to boost future earnings. It is really heartening to know that DoJ and SEC are performing their duty well. Or is it? Bill Parish (http://billparish.com/index.html) is fighting a one man's battle against the "pyramid" accounting practices, though legal, at industry giants like Microsoft, Intel, Cisco, Dell and AOL. Effectively, these practices lead to transfer of wealth (or company earnings) from shareholders and tax payers to the company insiders. He writes: (http://billparish.com/19981208pyramiddetails.html) Here in the US there 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 gets 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. Though he is not the first to notice these issues, he certainly stands out in his crusade against the companies who are doing this. His comments are not unfounded. He dug though the SEC documents filed by these companies to throw spotlight on these "pyramid" schemes. His analses are NOT at all challenged by the biggest of the accused companies, MSFT! (http://www.wweek.com/html/business.html) Microsoft spokeswoman Caroline Boren doesn't dispute Parish's analysis of the options program. "It lowers Microsoft's taxes and accordingly increases net income," Boren says. "Is the company able to take a deduction? Sure. Because those are the tax rules." Now what are the implications of this? Not much as long as these stocks keep going-up. But when the dynamics of the stock market change and the bubble bursts, there will be an outrage. That is when most shareholders will start blaming the companies for failure to adequately disclose the datails of the options scheme. That is simply passing the blame. Yes, the companies have not issued a press release saying that they are employing a "pyramid" scheme. But, they did adequate legal disclosure. It is the responsibility of the shareholders to take necessary steps to protect their interests. Given the magnitude of the problem, it is the responsibility of SEC, DoJ and the US Treasury to take actions necessary to plug this loophole. One common fear, though seems justified, is that any stern action taken against such parctices will lead to a meltdown in the share prices of these companies which could possibly result in a stock market collapse. Unless of course there is a strong reason to believe that the share prices will continue to rise forever, and an unwillingness to deal with the consequences of doing the "right" thing, there is really no justification for NOT taking an action to curb these practices. I hope this thread will help Bill Parish in his efforts to increase awareness of the implications of the stock options financial pyramid at mega corporations. The primary purpose of this thread is to create awareness among the Silicon Investor community regarding this issue. Hopefully this will lead in to something. | ||||||||||||
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