Wall Street Problem: Warren Buffett
Jude Wanniski
July 22, 2002


Memo To: Dick Armey, House Majority Leader
From: Jude Wanniski
Re: Please Don't Feed the Bear

If you are not clear on why the stock market has been taking such a beating, the assault on stock options by the Old Guard business world is a perfect example. It is not that the old guys are opposed to the new guys handing out stock options. They are not. But they want the accountants to change the way they are treated on a company's income statement. They want options "expensed." They argue that it is not fair for a company to NOT list an employe's gain on the income statement when he exercises his option. Whitney Tilson, a portfolio manager with the outlook of the Old Guard, explained it in a recent column for the Motley Fool. Here is the key paragraph:

3) Companies also receive a tax break when employees exercise options. Let's say an option has a strike price of $10 and the stock price is at $30. For every option exercised, as noted above, the company collects $10 from the employee -- but it also gets to deduct the $20 profit earned by the employee as a compensation expense, just as if it had paid the employee a $20 cash bonus. Fair enough, since this is clearly a form of compensation, but then why shouldn't this expense appear on the income statement, just like a cash bonus?! The tax savings for some companies are truly amazing: for Dell last fiscal year, it was $929 million (vs. $958 million of reported taxes paid on the income statement), and for Microsoft, it was $3.1 billion (vs. $4.1 billion of reported taxes on the income statement). As a taxpayer, do you smell a rat?

Nobody really complained about this treatment of options before the so-called New Economy came along, where equity values did jump by leaps and bounds. In those good old days, if the strike price was $10, an employe would be lucky to exercise the option at $12. More likely, the strike price would be $75 and the option would be exercised at $80, with luck. Since the Microsofts and Dells came along, the eye-popping numbers presented here by Whitney Tilson are routine in the high-tech world, where the entrepreneurs are still in business. There are zillions of dollars of stock options that are now wallpaper, given the decline of the dot.coms since March 2000. Have you heard of "sweat equity" going down the drain when a person starts up a little business and works night and day to make it work, only to see it have to close when it runs of out capital? This happens millions of times a year. The equivalent in Silicon Valley is "intellectual equity," where a man or woman takes a big chance on a new company that has a small chance of survival.

What the critics do not see is that there is no reason in the world for a company expense of this kind to be treated "just like a cash bonus." It isn't a "cash bonus," but a payment for intellectual equity that is still at risk. If the employee wants to get "cash" for the shares he acquires, he must declare the gain on his personal income-tax form and pay taxes on it. As far as the company is concerned, it simply exchanged one form of security for another. One piece of paper for another. If it would be listed on the company's income statement, it would add an equal amount to corporate profits that would be taxable! As you can see, this little accounting change would crush the new little intellectual enterprises, not only those in existence, but those which are now just a gleam in somebody's eye. It would abort most new such companies, acting as a kind of back door increase in the capital gains tax. Microsoft and Dell would be able to weather the change because they have already grown to late youth and are sure to survive the blows to their equity values. Those who would be hurt most are those minorities, including women, whose potential as entrepreneurs would be struck down by the beancounters. It would not only be a disaster here, but would quickly be followed by the International accountants who are getting ready for this change in GAAP rules next year. Corporatists would win!! Unborn businesses, you see, have a hard time lobbying Congress, which is why this poison has moved so far.

But wait a minute? Didn't the Senate reject the whole idea of expensing options when Sen. Carl Levin [D MI] proposed it two weeks ago Friday. And didn't the stock market go up like crazy that afternoon when it was killed? Yes, but that's so that nobody would have to vote DIRECTLY for this assault on entrepreneurial capitalism. What it is doing instead is granting POWER to a private accounting oversight board that will be able to oversee this reform when the Financial Accounting Standards Board (FASB) puts it into place. The Old Guard has been pushing FASB for years to make this change, but the Young Turks have threatened to withhold financial support from FASB if it does so. Senate Banking Chairman Paul Sarbanes [D MD] over the weekend told CNN's Novak, Hunt & Shields that his committee has already checked with lawyers to be assured that this huge GRANT OF POWER to a private group was constitutional. Sarbanes also said the legislation will provide financial support for the FASB, so they will no longer be intimidated by the Young Turks!! If you do not believe me, Dick, please read the transcript. I think you have let this one smoke past you, as there is nobody in Congress I have more identified with low tax rates on Entrepreneurial America than you. If you think the market is going to go up, you better strangle this devil in its cradle.

Old Guard? Didn't you notice that Coke was the first company to step forward and announce that it was going to VOLUNTARILY expense options. Coke is probably the best example of a major corporation that always loses money when it tries something new and makes money when it sticks to its hundred-year old formula. Then there is Warren Buffett, the most successful investor in Old Guard corporations in our time, a fierce opponent of any changes that might benefit entrepreneurial America, including supply-side Reaganomics. Oh yes, The Washington Post Company has bravely stepped forward to announce its support for expensing of options.