PORTLAND, Ore., Oct. 4 - Bill Parish of Parish & Company Portfolio Advisors of Portland, Oregon today released an official response to numerous requests for an expanded analysis of the relationship between the failure of the Long-Term Capital Management Hedge Fund, 401K retirement plans and employee stock option programs at leading technology firms based upon recent 10K SEC disclosures.
For background information please refer to a previous press release on Employee Stock Options issued 9/30/98.
Please also refer to the SEC web site at www.sec.gov and Chairman Arthur Levitt's major initiative announced last week to improve the quality of corporate accounting. In it he notes his concern that the quality of corporate reporting may be eroding and ``integrity may be losing out to illusion.'' Also refer to the Business Week's cover story on 10/5/98 available at www.businessweek.com titled ``Corporate earnings, who can you trust when companies fudge their numbers, when accountants turn a blind eye and when analysts have a conflict of interest.''
In developing this analysis Parish & Company identified a direct link between the investment techniques of Long-Term Capital and the FASB's treatment with respect to the accounting for employee stock options. This link is Myron Scholes, who not only made investment calculations for Long-Term Capital yet is also a primary architect of the ``Black Scholes'' valuation model used under accounting rule SFAS 123 to value option commitments made to employees. To examine a standard financial footnote utilizing this model and its various assumptions please refer to printed page 188 of the Cisco Systems 1998 10K report available at www.sec.gov.
Parish & Company has also identified a direct connection between hedge funds such as Long-Term Capital and employee retirement plans, including 401K and 403B plans. For additional background here, please refer to www.oregonlive.com and search under Julie Tripp. This will bring up an article written in the Oregonian by her about 401K plans. In the article Alexis Herman, Secretary of Labor, notes that Americans are paying too much in fees for too little with their 401K plans and that this will have significant consequences with respect to their retirement.
These significant asset based management fees have resulted in the creation of large pools of new wealth at investment companies, which have been a primary source of capital for the hedge funds. In a related event, BBC news did also report on 10/2/98 that US based universities were prominent investors in another hedge fund based in Bermuda that recently incurred losses of $1.3 billion. Parish & Company calculates that more than $100 billion has been earned on management fees of 401K, 403B and other managed accounts, including university foundation accounts during the last year.
A recent story in the New York Times also noted that several of the key investors in Long-Term Capital were partners at a major brokerage firm, the CEO himself having invested heavily into the hedge fund. Other partners there even had automatic deductions from their paychecks going directly into the Long-Term Capital fund, expressing great confidence in the funds capacity to perform.
The main observation here is that these large entirely unregulated hedge funds, like Long-Term Capital, have to a large extent been created from management fees based upon large pools of assets that in the case of Long-Term Capital were able to become highly leveraged. So leveraged that Alan Greenspan noted that the failure of Long-Term Capital, one hedge fund, could disrupt the entire global financial system. Most historians agree that a primary cause of the stock market crash of 1929 was the ability to leverage 10 to 1, that is, buy $10 worth of stock with $1 in your account. This resulted in the creation of the Federal Reserve margin limitations along with the SEC to help preserve the integrity of the financial markets. It is reported that Long-Term Capital at one point was leveraged 50 to 1.
Parish & Company now officially supports the position that any domestic financial institution lending into a hedge fund be required to classify such loans as highly speculative and make a special capital reserve to account for this risk. In addition, Parish & Company advocates the Federal Reserve working toward establishing a margin requirement for hedge funds.
In order to maximize management fees from mutual funds and managed accounts, fund managers and brokers have identified top companies with outstanding employees and a bright future. Cisco Systems is a good example. They have then aggressively purchased these securities and promoted the company's strategies openly in the press. A 9/29/98 Investors Business Daily article notes that one fund includes both Cisco Systems and Microsoft as top holdings at 6.9 and 4.2 percent of assets respectively. The article also quotes the manager as stating that they are ``Narrowing their holdings.''
There is no mention of the widely reported issue regarding the stock option liability nor the fact that Cisco Systems has not repurchased any stock in 1998, per a review of the cash flow statement on their 1998 10K released last week. A Cisco press release dated 10/14/96 notes that ``Cisco Systems Inc. announced that its Board of Directors has rescinded the company stock repurchase program, due to uncertainty over recent interpretations by the SEC.'' In plain English, the press release means that they have a dispute with the SEC over their accounting practices.
As more money managers narrow and focus on high quality tech stocks this demand increases the stock price and correspondingly the management fees that have been a primary source of capital for the hedge funds. In a 8/17/98 Fortune article titled ``Ten Stocks You Can Love Forever'' both Cisco Systems and Microsoft were listed. The article made no mention of employee stock options nor Cisco's dialogue with the SEC yet did note ``The Software giant now equals 3.1% of the value of the S&P Index, so index funds have to buy plenty of shares.
Another fund manager in a 10/2/98 article when asked by Investors Business Daily if he retreated to cash during the recent downturn replied, ``No, we bought more Microsoft among other stocks.
With the G7 meeting this weekend and the IMF looking for ways to restore confidence in the financial markets, Parish & Company would again like to state its official position that the SEC should drive this dialogue. Parish & Company also supports focusing on these issues rather than interest rate deductions which might actually extend the current difficulty through increased speculation.
Parish & Company has also identified a direct link between 401K and other retirement plans and the recent instability in global capital markets. This link is the average turnover ratio in growth mutual funds, which was more than 100 percent for the most recent year. Fund managers should be encouraged by 401K participants to think long-term and thereby introduce more stability into capital markets. It does also seem clear that more basic research could be conducted before making investments with participant's life savings, especially since most participants are coached to think long-term.
Parish & Company also officially adopts a position that the Senate Banking Bill, which would lift depression-era barriers between the banking and insurance industries, not be approved until the SEC is able to restore confidence in the financial reporting area.
It appears most unusual that Robert Rubin and Alan Greenspan are publicly coaching the Japanese government to reform their banking sector and deal with its $1 trillion dollar debt when here in the US we have a speculative bubble, perhaps even larger, due to an accounting practice based upon the ``Black-Scholes'' option pricing model.
Perhaps the current situation is best summarized by Microsoft's CFO in a 9/28/98 interview in Computerworld in which he states, If Microsoft took stock options away, it would have to pay people two to 10 times more to make up the difference. He added that compensation-and how Wall Street continues to inflate Microsoft's valuation-is ``a huge, overarching issue we think about constantly.''
In both cases these models use a highly leveraged strategy that significantly underestimates the financial impact of debt, thereby inflating asset values. Using Cisco Systems recently filed 10K as an example, which can be accessed at www.edgar.com and referring to printed pages 187-189, this ``Black Scholes'' model indicates that the restatement to earnings to account for stock options is roughly $242 million for fiscal 1998.
Parish & Company notes in a 9/30/98 press release that based upon footnote disclosure and the market price of the stock on that date, Cisco's outstanding obligation to employees had grown to more than $15 billion. Also noted was that Cisco took a business tax deduction pertaining to the exercise of employee stock options in 1998 for $1.2 billion which is not reflected on its externally published income statement. This amount is unrelated to the future $15 billion obligation. The net effect of the Black Scholes model, in terms of disclosing the aforementioned economic circumstances is a footnote disclosing that after accounting for the options net income would have been $242 million lower.
Based upon restated earnings and assuming an adjusted valuation given Cisco Systems and Microsoft's strong gross revenue growth and industry leading positions, Parish & Company calculates their expected market capitalization to be approximately $27 billion and $60 billion respectively. This calculation does not include consideration of Cisco Systems current conflict with the SEC over their accounting methods regarding acquisitions.
Based upon this analysis, it is quite clear that technology employees have been used in a widespread interlocking financial pyramid designed to generate assets based management fees that has resulted in destabilizing the global financial system. Given Alan Greenspan's remarks it would seem appropriate for key leaders in this industry to engage a powerful public figure from outside the financial arena, perhaps Oprah given the success of her book club, to create a dialogue regarding this issue and examine it might affect the average American.
Parish & Company encourages anyone interested in this issue to visit the sec web site, closely review Arthur Levitt's comments and then also visit www.vanguard.com which is an excellent site with respect to investor education. This site includes discussions on most key topics such as asset allocation and diversification.
Parish & Company is an independent fee based investment advisor that accepts no fees from the investment industry, either directly or indirectly. This service includes advising individuals, trusts and pension plans. The focus with respect to pension plans is empowering employees to make better choices via a benchmarking system designed to improve diversification and minimize management fees. Bill Parish may be contacted at www.billparish.com or by telephone at 503-643-6999.
SOURCE: Parish & Company