Senate Banking, Housing and Urban Affairs Committee

Securities Subcommittee

Oversight Hearing on the Financial Accounting Standards Board and
its Proposed Derivatives Accounting Standard

SUMMARY OF TESTIMONY

The following is a summary of the major points raised by the testimony of Hershey Foods Corporation Chairman Kenneth L. Wolfe before the Securities Subcommittee of the Senate Committee on Banking, Housing, & Urban Affairs.

Hershey supports FASB's continuing role as a financial accounting standards-setting body, but strongly opposes FASB's proposed new rule on derivatives. The proposed rule would have a detrimental impact on Hershey's ability to manage the risk of changes in the market price of cocoa. It would harm and mislead the very investors FASB says it seeks to protect.

FASB pronouncements have the force of law, because the SEC requires adherence to them. However, the SEC does not test those pronouncements against the competitive and other considerations Congress requires of SEC rulemaking. Hershey believes this process raises fundamental questions concerning the manner in which FASB pronouncements are developed and imposed, and merits further examination by Congress.

Hershey uses commodities futures contracts to hedge against price swings in the price of cocoa. These futures contracts are not innovative and complex financial instruments. Hershey has been using these contracts to manage its cocoa price risk since 1925.

FASB's rule would cause Hershey to reveal detailed information about Hershey's cocoa hedging activities -- both to Hershey's principal competitors in the confectionery business and to traders in the cocoa futures market -- which would be extremely harmful to Hershey's ability to conduct its business. The validity of our concern is supported by an attached letter from the President of the New York Coffee, Sugar & Cocoa Exchange.

FASB's rule would disclose little or no useful additional information to investors, particularly in light of the SEC's own recently adopted rules requiring extensive disclosure concerning derivatives. To the contrary, showing "gains" and "losses" from our hedging contracts could be extremely misleading to investors, because it would show only half of an integrated procurement strategy.

While the SEC acknowledged the validity of Hershey's competitive concerns and adjusted its derivative disclosure rules to avoid requiring disclosures of competitively harmful information, FASB has declined to do so. It is strikingly incongruous that FASB is proposing to require Hershey to make disclosures which the SEC, the government agency responsible for such disclosures, declined to require in its own rules.

If FASB's proposal is adopted, Hershey could not afford to provide its competitors with the information FASB's rule would reveal. Hershey is exploring other means of managing the risk of cocoa price movements; every alternative risk management strategy we are considering would increase our costs or our risks.

No one has given any compelling reason why FASB needs to rush its rulemaking project to a premature conclusion, in light of the SEC's own recently adopted disclosure rules on this subject. It is more important to get it right than to get it done.

COMPLETE TESTIMONY OF KENNETH L. WOLFE

Chairman Gramm, Senator Dodd, and Members of the Subcommittee. I am Kenneth L. Wolfe, Chairman and Chief Executive Officer of Hershey Foods Corporation.

Thank you for giving me the opportunity to testify at this important hearing.

Let me begin by commending you for holding this hearing. Financial accounting standards and disclosure requirements for derivatives are complex and, some would say, arcane subjects -- and therefore not the kind of subjects one would expect a congressional subcommittee to tackle with the thoroughness that you have.

But, as you have recognized, these subjects significantly influence the ability of companies to manage risk and to be competitive, profitable, job-producing organizations.

Hershey strongly opposes FASB's proposed new rule on derivatives. The proposed rule would have a detrimental impact on our ability to manage the risk of changes in the market price of cocoa. Moreover, it would harm and mislead the very investors FASB says its seeks to protect.

Hershey supports FASB's continuing role as a financial accounting standards-setting body. We also support the SEC's general deference to FASB. We believe neither the SEC, nor the Congress, for that matter, should be writing detailed accounting standards.

But we are concerned because the SEC requires public companies to comply with FASB pronouncements, without expressly testing those pronouncements against the competitive and other considerations Congress requires of SEC rulemaking. This is especially troublesome where a FASB pronouncement dramatically alters generally accepted accounting principles, breaks important new ground and directly impacts substantial business operations.

Some have argued that Congress should not be involved in this debate because it in some way "politicizes" private sector accounting standards. However, FASB pronouncements have the force of law, because the SEC requires adherence to them. If an aggrieved citizen or corporation -- in our case, a company with 14,000 employees and at least 100,000 shareholders --- cannot come to Congress when a requirement having the force of law is unfairly imposed, where is our avenue of redress?

My testimony will address these points:

• First, Hershey uses commodities futures contracts to hedge against swings in the price of cocoa. These futures contracts are not innovative and complex financial instruments. Hershey has been using these contracts to manage its cocoa price risk since 1925.
  
  
• Second, FASB's rule would cause Hershey to disclose detailed information about our cocoa hedging activities which would be extremely harmful to our ability to conduct our business.
  
  
• Third, the additional disclosures that FASB's rule would require would provide little or no useful additional information to investors, but would create a significant risk of misleading investors.
  
  
• Fourth, while the SEC acknowledged the validity of Hershey's competitive disclosure concerns and adjusted its derivatives disclosure rules to avoid requiring disclosures of competitively harmful information, FASB has declined to do so. It is strikingly incongruous that FASB is proposing to require Hershey to make disclosures which the SEC, the government agency responsible for such disclosures, declined to require in its own rules.
  
  
• Fifth, if FASB's proposal is adopted, Hershey simply could not afford to provide its competitors with the information FASB's rule would reveal. We would have to explore other means of managing the risk of cocoa price movements; every alternative risk management strategy we are considering would increase our costs or our risks.
  
  
• Sixth, this situation raises fundamental questions concerning the manner in which FASB makes its decisions and the accountability of FASB.
  
  
• Finally, no one has given any compelling reason why FASB needs to rush its rulemaking project to a premature conclusion. It is more important to "get it right" than to "get it done."

Hershey's principal products are chocolate candy products. Many of you may be familiar with our HERSHEY chocolate bars, KISSES and other chocolate products. In making these products, we use a substantial amount of cocoa beans, the major ingredient in the manufacture of chocolate. The price of cocoa fluctuates over time, however, depending upon weather patterns in the cocoa growing regions of the world and other variables. We cannot readily increase or decrease the price of a candy bar each time cocoa prices change, so we need to know long before the manufacture date what our production costs are going to be.

To manage the risk of cocoa price fluctuations and to ensure ourselves of access to an adequate supply of cocoa, Hershey uses a long-term integrated procurement strategy. That strategy includes both long-term supply agreements without fixed prices and the purchase of cocoa futures contracts which are traded on the New York Coffee, Sugar & Cocoa Exchange. Those futures contracts are used to hedge against market price increases we would have to pay to purchase cocoa if prices rise. The hedging works like this:

• If cocoa prices rise, we will have to pay a higher price for the cocoa we purchase, but the value of the related futures contracts will also rise, and that increased value will offset the increased price we pay under the supply agreements.
  
  
• If the market declines, on the other hand, the price we will have to pay for cocoa will be reduced, but that savings will be offset by the decline in the value of the related futures contracts.

The effect of this hedging strategy is that it essentially fixes the price at which we will buy cocoa for a specified delivery period. The extent to which we use such a strategy at any point in time for any future delivery period depends primarily on our projections of the future market price for cocoa. In other words, at any point in time we will be hedging the price of future deliveries to a lesser extent or to a greater extent.

Those who have urged greater disclosure of companies' uses of derivatives have pointed out that many of those "derivatives" are innovative and complex financial instruments which are not yet fully understood either by the companies using them or by readers of financial statements. Hershey's use of cocoa futures contracts, as described above, is neither new nor overly complex. Hershey has been using cocoa futures contracts to manage its cocoa price risk since 1925. Commodities futures contracts have been widely used in this manner to manage the price that farmers receive for their products and that users pay for those products for well over 100 years, long before there was a Securities and Exchange Commission and certainly long before there was a Financial Accounting Standards Board.

The information FASB's rule would require to be disclosed concerning our hedging transactions would reveal key information, which could be used to our significant disadvantage, both:

1. to our principal competitors in the confectionery industry; and
   
2. to traders with whom we have to compete in the cocoa futures markets.

Our concern with FASB's proposed rule relates to the detailed information that it would require companies to disclose. FASB's rule would require that "gains" and "losses" from our hedging activities be disclosed in the footnotes to the financial statements and in a new "comprehensive income" statement. Those "gains" and "losses" disclosures would be categorized in several ways. For example, the amount of the "gains" or "losses" from futures contracts held during the accounting period would have to be disclosed in the quarterly and annual financial statements. FASB would also require separate disclosure of the amount of "gains" and "losses" that relate to cocoa costs to be incurred within the next 12 months.

A. Competitive Harm in the Confectionery Industry. Here is an example of the way in which our confectionery industry competitors could use this information.

Example: Assume that at December 31, 1996 Hershey disclosed that it had a $25 million "loss" on its futures contracts because of declining prices of cocoa. Disclosure of that information would give our competitors the ability to see that our cost of cocoa for products to be sold in the coming 12 months would be $25 million above the market price of cocoa at December 31, 1996. This information could be used by competitors in setting their own selling prices for the coming months and, particularly, in deciding when to conduct price discounting and other promotions to gain a competitive advantage against us.

Our principal competitors would not be subject to these same disclosures. Hershey's shares are traded on the New York Stock Exchange, and we are subject to the SEC's and FASB's disclosure requirements. Our biggest competitors, however, are Mars, which is a private company and therefore makes none of these same disclosures, and Nestl‚, which is a foreign company and in part for that reason does not make the same disclosure as Hershey would have to make under the SEC and FASB's rules.

B. Competitive Harm in the Futures Trading Market. Participants in the cocoa futures market could also use to Hershey's disadvantage the information that FASB's rule would require to be disclosed. Futures market traders could, in most market conditions, use that information to determine Hershey's view of the market price direction, to determine our relative coverage level and to anticipate our futures market transactions.

FASB's rule would require us to disclose each quarter the amount of our "gains" and "losses" from hedging transactions. Because price movements in those futures contracts is publicly available information, our competitors in the confectionery industry and in the futures market would be able to approximate in most market conditions the extent to which our cocoa needs are hedged. In addition, because FASB would require disclosures on a quarterly basis, market participants would be able to determine whether Hershey is generally adding to or reducing its aggregate hedging positions. It is not necessary for a futures market trader to be able to anticipate Hershey's transactions on a daily basis in order to take advantage of this information. A long-term hedging strategy in a commodity such as cocoa is not a strategy that unfolds over a day or a week or even necessarily a month.

Enclosed as Exhibit 1 is a letter to the Subcommittee from James J. Bowe, President of the New York Coffee, Sugar & Cocoa Exchange. Asked whether -- with knowledge that Hershey is generally increasing or generally decreasing its aggregate hedging positions -- traders would use that knowledge to influence how they trade in the futures market, Mr. Bowe responded: "Definitely." As he explained, "that information would signal to market participants the large user's purchasing interest in the futures market." He went on to explain,

"Moreover, I believe that the resulting trading on the part of such market participants would likely disrupt the trading market and make it more difficult for the large user to implement its trading strategy. Indeed, if the large user was maintaining a relatively low level of hedging positions, expecting prices to decline, knowledge of that fact in the market place would undoubtedly lead to efforts to buy up available futures contracts before the large user seeks ultimately to lock in its final purchase prices. The end result of this scenario is that the large user's hedging strategy is likely to be frustrated. Indeed, I believe that this scenario will disrupt normal market forces and the proper functioning of commodities futures markets such as that conducted on our Exchange."

This same point was made to Congress in 1978 by the President of the Board of Trade Clearing Corporation, in support of an amendment to the Commodities Exchange Act to protect the confidentiality of large market positions in the commodities futures trading market:

"Information on the size of a particular firm's position can be very important to others. As a general rule, if the market knows that a large position will have to be liquidated, the market will move against that position. The adverse movement is not based on an anticipation of supply and demand conditions, but rather on the assumption that a sizeable profit can be extracted because of the necessity for a large position to be closed. The real effect of disclosure of market positions in this case will be a dramatic and artificial increase in the cost of liquidation."

Congress amended the Commodities Exchange Act in that year to expressly provide that, with certain exceptions, the Commodities Futures Trading Commission "may not publish data and information that would separately disclose the business transactions or market positions of any person." This provision was adopted in recognition of the fact that such confidentiality was necessary "to protect the market from the threat of disruption or otherwise to protect the interest of producers and consumers." FASB's rule, however, would permit market participants to discern Hershey's market positions, threatening the disruption of the cocoa market in the very manner which Congress intended to prevent by the 1978 amendments to the Commodities Exchange Act.

Hershey is not alone in urging that competitive harm be avoided by proposed disclosure requirements. A special committee for the American Institute of Certified Public Accountants, in a 1994 report making recommendations concerning financial and business reporting, recommended that:

"Companies should not be required to disclose information that would harm their competitive positions significantly. It is not in the interests of existing investors . . . to require disclosures that would undermine the value of their investments . . . . Such disclosures would undermine national competitiveness if, for example, U.S. companies were required to disclose competitively sensitive information that competitors in other countries need not disclose."

The current Chairman of FASB was the chairman of that AICPA Special Committee.

One of the key points I would like to make is that the "gains" and "losses" FASB would require us to disclose are not really "gains" or "losses" in any meaningful sense. Our hedging activities basically consist of using cocoa futures to set the price of cocoa that we actually use in our operations to make chocolate. We do not speculate in cocoa or any other futures. Because we do not speculate, whatever theoretical "gains" or "losses" in the value of cocoa futures that occur as a result of price changes are offset by a higher or lower price we pay for actual cocoa delivered in the future. We are in business to buy cocoa as efficiently as we can to make into chocolate bars, not to make money speculating in cocoa futures. Indeed, we do not take issue with FASB's proposed inclusion in earnings of changes in the value of derivatives not used for hedging purposes, but effective hedging using futures contracts does not create the risk of "losses" or the opportunity for "gains."

FASB apparently believes that information on deferred "gains" and "losses" from hedging transactions is important to permit investors to understand how companies are using derivatives and the effect of that use on financial position and current and future results of operations. It is difficult to understand what use investors would have for information concerning one piece of an integrated procurement strategy in which all of the so-called "gains" and "losses" are directly offset by equal and corresponding changes in the price we will have to pay for cocoa. In other words, these futures contracts simply help us to fix the price we will be paying for cocoa. As far as the need for investors to understand how we are using derivatives, that objective is being accomplished by the extensive narrative disclosures Hershey is now making and will make under the new SEC rules.

Hershey currently discloses to investors the manner in which it uses cocoa futures contracts to manage the risk of price fluctuations in cocoa. We are currently augmenting that disclosure to comply with the SEC's recently adopted derivatives disclosure requirements. The SEC adopted its requirements, as it explained, to "help investors understand registrant's market risk activities and help place those activities in the context of the business." In addition, the SEC imposed quantitative requirements "to provide investors with forward-looking information about a registrant's potential exposure to market risk." As the Subcommittee may recall from its March hearings, the SEC's requirements will result in the disclosure of significant information to investors concerning these matters, wholly apart from any additional disclosure requirements imposed by FASB.

Moreover, the "gain" and "loss" information FASB's rule would disclose could be extremely misleading to investors. For example, the FASB rule would require that we disclose at the end of an accounting period the "gains" and "losses" in our cocoa futures contracts relating to cocoa costs we expect to incur in the next 12 months. Suppose that Hershey had purchased a large number of futures contracts relating to the coming 12 months and that prices had risen substantially, producing a "gain" in futures contracts of $25 million. This is not a real gain for Hershey, because we would have to pay that $25 million in higher prices to purchase cocoa under our existing supply contracts. But FASB would have us disclose this information as a "gain" attributable to the next 12 months. An investor may view this $25 million "gain" as a reason to buy our stock, when in fact any such "gain" is illusory. Shareholders are likely to be mislead by that "disclosure," not helped by it.

When the SEC proposed its derivative disclosure rules, Hershey expressed to the SEC our substantial concern, as did others, that that proposal would reveal competitively harmful information. (This Subcommittee is aware of those concerns, as reflected in the Subcommittee's Report dated April 21, 1997.) Before final adoption, the SEC made a number of changes to its proposed rule "to address proprietary concerns." When then Commissioner Steven M.H. Wallman testified before this Subcommittee in March in this regard, he explained to the Subcommittee, both in his prepared statement and in his oral testimony, that changes had been made to the proposed rule to address such concerns. Indeed, we were appreciative of the SEC's responsiveness to our concerns and for its adoption of requirements permitting disclosures to be made in a manner which will not reveal such competitively harmful information.

Chairman Jenkins of the FASB and his colleagues and FASB's staff gave Hershey the opportunity to explain our competitive concerns to them, an opportunity we deeply appreciated. However, while the SEC ultimately acknowledged the validity of our concerns and adjusted its proposed rules accordingly, FASB responded to us that it was more important to require disclosure to investors of details about our hedging activities than to protect companies against the competitive harm about which we are concerned.

FASB's rules only take on the force of law because the SEC enforces companies' compliance with those rules. It is highly incongruous that the FASB is proposing to require us to make disclosures which the SEC, the government agency responsible for such disclosures, specifically and knowingly declined to require.

If FASB's proposal is adopted, Hershey simply could not afford to provide our competitors in the chocolate market or our competitors in the futures trading market with the information that FASB's rule would reveal. We have determined that we would have to explore other means of managing the risk of cocoa price movements than the means that we have employed for the last 75 years. Every alternative risk management strategy we are considering would result in increased costs or increased risks to our Company. Those additional costs will either result in higher prices to consumers for our chocolate products or lower profits for our shareholders.

We do not believe that the mere adoption of accounting rules for disclosing the results of business operations should directly, substantively, and, in this case, negatively impact the business operations themselves to the detriment of a company and its shareholders. As I said previously, the SEC -- and we commend them for this -- agreed with us on this and changed their derivatives disclosure rule accordingly. We are at a loss to understand why FASB is unwilling to do the same.

Hershey urges the Subcommittee to address the manner in which FASB views its mission and carries out its rulemaking projects.

If our concerns were the only ones raised by FASB's proposal, it would be understandable if this Subcommittee decided to accept the FASB rule for the arguably "greater good." However, there are many other problems with FASB's proposal, and you are hearing from others today about those problems. We do not for a minute question the good faith of the professionals at FASB who have worked so hard on these rules. However, the strong opposition that you are hearing to FASB's proposal suggests that there are serious questions in need of attention.

When the SEC engages in rulemaking proceedings, it is subject to a number of federal statutes. Those statutes not only regulate the procedures to be followed by the agency, but also require the SEC to take into account such factors as the competitive burdens that its proposed rules would impose. Moreover, the persons determining the results of such proceedings are Commissioners who have been nominated by the President of the United States and confirmed by the United States Senate. Those Commissioners are subject to the oversight jurisdiction of this Subcommittee. Finally, if a person is aggrieved by a rule of the SEC, there is recourse in the federal courts to determine whether the SEC has duly applied those legal requirements.

FASB, on the other hand, is not governmentally accountable to anyone for its rules or the process and standards used to set such rules. FASB apparently does not consider itself subject to the statutory requirements applicable to SEC rulemaking. While we certainly support FASB's continued role in setting accounting standards, some accountability needs to be introduced into the process.

The SEC wields substantial influence over FASB and the Commission has even explained its role as one of "oversight" of the FASB. Moreover, it is the SEC's enforcement of FASB's rules which give those rules the force of law. Why, then, should FASB's rulemaking process not be subject to the statutory requirements Congress believes are essential when the SEC engages in rulemaking? We believe that those requirements are applicable and that they should be applied. Those provisions, among other things, prohibit rulemaking which imposes undue competitive burdens.

No one has given a reason why there should be any rush for FASB to complete its rulemaking project. The concerns which were previously expressed by Congress and others concerning innovative and complex new financial derivatives have been largely addressed by the market place, by the SEC's new derivatives disclosure rules, and by other measures which have been taken in recent years. All of the financial institution regulatory agencies are urging FASB to at least slow down its consideration of these issues. Further consideration by FASB is needed to properly address the issues raised by these regulatory agencies as well as the competitive harm issue about which we are most concerned.

It is more important to "get it right" than to "get it done."

I urge the Subcommittee to ask FASB and the SEC to work constructively to resolve the important issues that we and others have raised with FASB's proposed rule. I also urge the Subcommittee to review and consider appropriate action to address the serious questions raised about a rulemaking process that is not subject to basic statutory standards and safeguards.

Once again, I appreciate the opportunity to testify here this morning, and I look forward to answering your questions concerning these matters.

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