WALL STREET REFORM

August 2002
		How can the Bush administration and Congress clean up Wall Street and restore investor confidence in the wake of corporate scandals?

Forum Introduction Do stock options act as invitations for corporate fraud and misleading financial statements? Did Enron's trading of energy futures on the Commodity Futures Exchange enable it to mislead investors? How much should people with mutual funds worry about corporate corruption and accounting scandals? What is the role of a corporate board of directors? Will the conviction of corporate executives have any real influence on the markets? What would have happened if legislation to privatize a portion of Social Security had been approved? What happened to all the money that people lost -- was it ever 'real'? Why not limit the amount of time an accounting firm can serve as a company's independent auditors?

John Leone of Del Mar, California asks: ________________________________ What does mark-to market accounting mean -- in lay terms? Mark-to-market accounting (MTM) without transparency for forward receivables appears to be a blanket invitation to steal. Why not roll back SEC rules on that issue to 1990? Why do some people say stock options for chief executive officers and other senior-level executives invite corporate fraud and misleading financial statements? Ronald Berenbeim responds: ________________________________ Mark to market enables a company to state immediately as earnings all forecasted revenues for a transaction in which actual revenues and costs have not yet been determined. In this way Enron was for a time able to realize revenues that had not actually materialized. Why not indeed. The SEC did not formally approve mark to market procedures until early 1992 so consideration of rules in effect in 1990 is appropriate. Stock options create an opportunity for moral hazard -- a situation where the decision-makers' interests are in potential opposition to the interests of other stakeholders. The temptation is to "manage" earnings to achieve a higher stock price at the time that the option can be exercised. At least one company [Bear Stearns] has known since 1999 that the use of stock options results in misstated profits. Patricia O'Connell of that firm estimates that for 287 of the 500 Standard & Poor's companies, the cost of options has risen from $21 billion in 1999 to $47 billion in 2001. Earlier this year S&P also announced that it would deduct the cost of options in calculating earnings. Some companies -- notably Coca-Cola and GE have followed suit. Frank Torres responds: ________________________________ Today, corporate officers can earn a large share of their income in the form of stock options. This gives them a strong incentive to boost the company's share price, thus increasing the value of their options. In some cases options may create an incentive to push the envelope of acceptable accounting practices. Legislation introduced by Senators John McCain (R-Ariz.) and Carl Levin (D-Mich.) would require companies to expense stock options. This approach would reduce the temptations that exist to manipulate company earnings by playing with the books. Last month, several major U.S. companies including Coca-Cola, Bank One, and The Washington Post announced that they would voluntarily expense options. Some, especially among the hi-tech community, argue that new start-up companies use stock options to attract employees and that having to expense those options would undermine that new growth. Olivia Kirtley responds: ________________________________ Mark to market is required accounting treatment for certain financial instruments and derivatives on the balance sheet --meaning they must be adjusted to the current market value -- with gains or losses on those instruments directly affecting the income statement. With regard to stock options, the concern is if the compensation packages and incentives for executives are too focused on the stock price at a certain point in time, then there could be incentive to do whatever one can in order to report the most favorable financial results possible and drive up the price of the stock. Stock options are excellent incentives for executive performance, but they should be appropriately balanced with cash and other incentives to accomplish both short-term and long-term objectives.