Pitt On The Spot

Plus, trade-show taxes; split-dollar life insurance; our quarterly Global Confidence Survey; and more.

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In the wake of Enron Corp.’s bankruptcy, Securities and Exchange Commission chairman Harvey Pitt is under mounting pressure to restore confidence in the U.S. accounting industry. His initial response, announced in January, is to replace the Public Oversight Board (POB), created in 1977 by the SEC to monitor accounting ethics, with a new Public Accountability Board (PAB), which will be more independent of the profession. Although the five-member POB is made up of nonaccounting professionals, Pitt contends that its objectivity is compromised, because the American Institute of Certified Public Accountants funds the $5.2 million operation.

“Regulation by the private sector but not by the [accounting] profession” is how Pitt describes the new board’s mission. That, however, also describes the POB’s. The difference between them, presumably, would be in the PAB’s funding, but Pitt hasn’t specified how the money will be raised. Suggestions range from a National Association of Security Dealers-like structure, funded through member dues and penalty fines, to a fee-based system similar to bank examinations. – Marie Leone

Partnership Liability

Enron’s Domino Effect

Most securities lawyers agree that investment banks that underwrote off-balance-sheet partnerships run by former Enron Corp. CFO Andrew Fastow bear a fiduciary responsibility to Enron shareholders. But the liability among Enron’s limited partners doesn’t end there, according to securities lawyer Stanley Grossman of Pomerantz,

Haudek Block Grossman & Gross. Grossman, who is representing Enron lenders in a suit against underwriters of convertible bonds issued by the Houston energy company, contends that limited partners may have liability to both Enron and Enron shareholders.

To back up his claim, Grossman cites the Supreme Court case of Jackson v. Smith, as well as several recent lower-court decisions. A federal appeals court in 1977, for instance, ruled that “others who knowingly participate with a fiduciary in a breach of trust are liable to the beneficiary for any damage caused thereby.” That leads to Grossman’s view that limited partners are “equally culpable” with the general partner.

Three of the special purpose entities (SPEs) run by Fastow–LJM, Jedi, and Chewco–hid Enron’s debt and inflated its income, according to information filed with the Securities and Exchange Commission. Recall that last November, after Enron reduced shareholder equity by $1.2 billion and lowered its previously stated earnings for the years 1997 to 2001 by some $600 million, the SEC deemed that the debt-laden SPEs belonged on the energy trader’s balance sheet. The reworking of Enron’s financials eventually led to the company’s bankruptcy, the largest in U.S. corporate history. As a result of their investments in the partnerships, Grossman maintains, limited partners could share fiduciary liability with Fastow for Enron’s demise.

According to CFO.com and other press reports, the list of limited partners in the SPEs includes AON, Credit Suisse First Boston, General Electric Capital, J.P. Morgan Capital, Lehman Brothers, Morgan Stanley, and Merrill Lynch. The Senate Governmental Affairs Committee is said to be looking into the role third-party investors played in Enron’s meltdown.

While some securities lawyers contend that limited partners will remain off the hook unless they helped promote the partnerships, securities attorney Stephan Haimo of Gibson, Dunn & Crutcher notes that “all kinds of legal theories” will be tested as a result of the Enron debacle. –Ronald Fink

Change in the Air

After publicly calling for tax-code reform, House Ways & Means chair Bill Thomas (R-Calif.) hired former White House economist Alex Brill to put a rewrite in motion.

Retirement systems in Georgia, Ohio, Washington, and Alabama were among the first to join a class-action suit against Enron Corp.

Executive Compensation

Split Decisions

After raising the specter of higher tax burdens for executives who hold split-dollar life insurance arrangements last year, the Internal Revenue Service this year offered up some handy ways to escape the coming doom. Transitional guidance issued in January says that policies crafted before January 28, 2002, can retain their typically low valuations on current taxable benefits even after the new regulations are passed. And executives who don’t like the changes associated with future final regulations can close out their contracts anytime between now and December 31, 2003, without incurring tax penalties on the remaining cash values.

“The notice gives people the time to review alternatives for recategorization, and a bonus opportunity to go back and say, ‘Is this really the best value?'” says Boston-based Heidi Toppel, a senior executive compensation consultant for Watson Wyatt Worldwide.

Split-dollar arrangements, in which an employer and executive share the cost and benefits of a whole life insurance policy owned by the executive, are part of deferred compensation packages at about 95 percent of Fortune 500 companies, estimates Toppel.

While the final regulations aren’t expected before 2004, the IRS has given some clear clues about what the rules will look like. For example, current taxable benefits of new plans will either have to be valued at federally set rates or treated as company loans to the executive, with both options likely to increase executives’ personal income tax bills. For non-loan-split-dollar arrangements, the notice suggests that final regulations will allow deferral of income taxes to an employee on policy cash values in excess of employer premium payments only until termination of the arrangement, notes Andrew Liazos, a partner in McDermott, Will & Emery’s Boston office.

One thing is certain: the new rules will force more detailed reporting from corporate finance departments. Still, Toppel doesn’t expect the use of the arrangements to decrease, because “they’re still a good deal.” –Alix Nyberg

No More Waffling

In the recent EEOC v. Waffle House Inc. case, the Supreme Court upheld an employee’s right to file a discrimination suit, despite having signed an arbitration agreement.

Giving Credit

A Loaded Revolver?

Is the corporate credit crunch about to get worse? In late December, the Financial Accounting Standards Board decided that banks must mark to market certain types of commercial-loan commitments–such as revolvers–as well as financial guarantees.

The ruling applies to only a small percentage of loan commitments–essentially those that meet the definition of a derivative under FAS 133, because they can be easily resold. And that’s a determination that “needs to be assessed on virtually a case-by-case basis,” says consultant Ira Kawaller, who is a member of the FASB Derivatives Implementation Group (DIG).

Behind the ruling, however, is a quiet but fierce debate among banks about whether they should be required to apply fair value accounting to more of their offerings. For CFOs, the concern is that such a change might raise prices of backup credit.

Some banks, particularly those with a mix of commercial- and investment-bank offerings, such as J.P. Morgan Chase and Citigroup, do not want to mark lines of credit to market, in part because providing backup credit lines is a way of encouraging customers to purchase other financial services. This is a very sensitive issue because outright bundling raises antitrust concerns.

Other, more-traditional investment banks–such as Goldman Sachs, which marks all of its products to market–consider credit lines that can be drawn down at a predetermined interest rate to be the equivalent of an option.

Ernst & Young partner Michael S. Joseph, also a sitting member of the DIG, says he doubts the current decision will change the cost or availability of credit. In fact, he says, “the loans affected are, for the most part, originated by larger banks that plan to sell them, and they tend to manage them on a mark-to-market basis anyway.”

But, warns an insider at a bank that opposes mark-to-market accounting, that could change if the FAS 133 ruling is extended. “We’re already starting to see upward pressure on pricing because of fears of having to mark-to-market commercial-paper backup facilities.” – Tim Reason

By Any Other Name

Despite a host of exceptions, FAS 133 uses the following properties to define derivatives:

  • Having one or more underlying variables
  • Settled in terms of cash or cash equivalent
  • Requiring insignificant or zero initial investments

Source: A. Chua, Society of Actuaries Spring Conference, 2001

The AICPA has lost its $5 million campaign to create a global credential; 63% of the association’s membership voted against it.

Accounting Showdown

To Expense or Not to Expense

It’s back. The battle over stock-option accounting is rearing its ugly head again. This time it’s a transatlantic showdown between U.S. companies–including General Electric, Compaq, Sun Microsystems, and Oracle–and the London-based International Accounting Standards Board (IASB), the organization charged with establishing common accounting rules for companies in the European Union by 2005, and ultimately the United States and the rest of the world.

Under current U.S. GAAP, employee stock options are valued on the date they are granted using the intrinsic value accounting method. As long as companies fix an option’s exercise price at the prevailing market price on the date of grant, no expense is booked on the income statement. This favorable treatment, embodied in FAS 123, was the result of nine years of exceedingly nasty debate between the Financial Accounting Standards Board and the U.S. corporate community.

Then, late last year, the IASB proposed that options be measured at fair value on the date they vest with employees, and that the compensation expense be accrued over the vesting period of the options. Not surprisingly, the U.S. corporate community came out swinging. “Our initial reaction…is one of dismay,” wrote Philip Ameen, controller of GE, in a letter to David Tweedie, chairman of the IASB. Ameen, a committee chair of Financial Executives International, suggested that the issue could be a deal breaker for the international accounting standards movement, and predicted a “quick erosion of corporate participation and support” if the IASB pushed the stock-option issue.

“Conceptually, most people believe that options are a compensation expense,” says Robert Herz, a partner with PricewaterhouseCoopers LLP and one of 14 members of the IASB. “But the issue of measurement is a very difficult one.”

Essentially, U.S. corporate leaders argue that the fair value of employee options cannot accurately be determined. Unlike exchange-traded options, they have vesting periods–usually two years or more–and they can’t be sold or transferred to another person. Neither the Black-Scholes option-pricing model nor any other derivative-valuation method can accurately incorporate these characteristics into their methodologies. Therefore, says a U.S.-based group dubbed the International Employee Stock Option Coalition, the expense shouldn’t be recognized in financial statements. –Andrew Osterland

Trade Dispute

U.S. KO’d in WTO Bout

In January, the Geneva-based World Trade Organization (WTO) ended a two-year trade subsidy dispute by striking down a U.S. appeal and crowning the European Union the victor. The potentially arduous impact of the decision is that under WTO rules, the EU has the right to choose which U.S. industries will bear the burden of trade sanctions–duties that could reach, in aggregate, $4 billion annually. The sanction ceiling was set by the original $4.04 billion trade damage claim filed by the EU in November 2000. A WTO arbitration panel is slated to announce the amount of the sanction later this month.

Trade experts don’t expect the WTO to impose the maximum sanction level, citing the strong interdependency between the U.S. and EU economies as a deterrent. However, even levying “a $100 million sanction on a weak industry could cause significant damage,” says Kimberly Pinter, director of corporate finance and tax at the National Association of Manufacturers, in Washington, D.C.

As for the industry list, “it includes everything but the kitchen sink,” quips Pinter. But she admits that she would have done “exactly the same thing” to ensure flexibility in targeting industries.

The new ruling will likely force Congress to tinker with the tax laws, notes William B. Sherman, an international tax attorney with Holland & Knight, in Fort Lauderdale. This is the third time that the WTO, or its predecessor, the General Agreement on Tariffs and Trade, has ruled against the United States on trade subsidies, each time sparking a tax-code rewrite, he adds.

Currently, such U.S. exporters as General Electric Co., Microsoft Corp., and Boeing can avoid paying taxes on some overseas sales by directing profits through subsidiaries based in offshore tax havens. But the ruling determined that this subsidy, which is related to the Federal Sales Corporation Repeal and Extraterritorial Income Exclusion Act of 2000, violates international trade rules by providing an illegal subsidy to U.S. exporters. – M.L.

East to West

Western Europe led all regions in cross-border mergers in 2000, with $240 billion of its $320 billion in outward investment landing in North America, says KPMG.

Dubious honor: 771 state and local sales tax rate changes were filed in 2001, 17 shy of the record set in 1992, says Vertex Inc.

Disclosure Rules

Show Us Your Options

The Securities and Exchange Commission’s 2001 end-of-year meeting gave investors an unexpected bonus– and corporate finance departments additional work. The SEC ruled that starting in April, companies must include tables in their 10-K reports disclosing information about all employee stock option plans. Historically, only plans voted on and approved by share- holders had to be disclosed, and then only in footnotes. There was no requirement to disclose nonapproved plans, and investor advocates are increasingly concerned that use of such plans is growing rapidly.

“I know our members are going to be looking closely at this disclosure,” says Ann Yerger, director of research for the Council of Institutional Investors (CII), which has pressed for such a ruling for years. “There’s been real concern among our members that shareholders don’t have a clear picture of the prevalence and potential dilution of stock option plans.”

The rule mandates that the new tables comprise the number and weighted-average exercise price of outstanding options; warrants and rights; and the number of securities available for future issuance under a corporation’s existing equity compensation plans. Companies must also include the information in proxy statements if they are asking shareholders to approve a compensation plan. Shedding light on stock options giveaways isn’t just a compensation issue, says Yerger; it’s also a way for CII’s members to evaluate the stewardship of corporate directors. “There is a general sense that companies are adopting more and more non[shareholder]-approved plans,” she says.

While some firms may not be thrilled about the added disclosure requirement, many may consider it the lesser of two evils. A proposal by the International Accounting Standards Board that stock options be expensed raised howls of protest in mid-December. The International Employee Stock Option Coalition, which represents trade associations and organizations ranging from the U.S. Chamber of Commerce to Oracle Corp., sent a strongly worded letter of objection to IASB chairman David Tweedie. “If the IASB continues on this controversial track,” the letter warned, “the debate on this one issue could endanger the current consensus supporting the IASB.” –T.R.

Out in Front

The first IPOs for 2002 were completed in January, with Lowes Corp., Zymogenetics, and Synaptics raising a total of $1.16 billion, reports IPO.com.

Tax Nexus

Trade-Show Tax Trap

Trying to decide whether your company should participate in an upcoming trade show? Here’s one more factor to consider: some states require companies to collect sales or use tax on items sold at the show and/or to pay state income tax on the sales. What’s more, if a connection, or nexus, with the state is created, that nexus could subject other parts of the business to the same tax treatment.

The nexus area in general is contentious, says David Colmenero, a tax lawyer in the Dallas office of Jones Day Reavis & Pogue and the author of a new report on the subject. “It’s important for companies to understand that some states aggressively impose tax based on attendance at trade shows, while others offer a tax safe harbor.”

Unfortunately, most state statutes on trade-show nexus are fuzzy, so interpreting the law may be cumbersome. But don’t expect time to be on your side. Many states don’t impose a statute of limitations, says Colmenero. In fact, “we’ve seen states assess taxes back to a company’s date of incorporation or the beginning of the company’s instate activities,” he says.

Once trade-show nexus is established, a corporate ripple effect may soon follow. Indeed, once a company’s connection to the state requires filing sales tax returns, all sales and shipments into the state, not just those resulting from the trade show, are generally subject to sales and use tax, notes Colmenero. “Similarly, for income tax purposes, the company’s entire income may be subject to the state’s income tax.”

The Trade Show Exhibitors Association says its standard policy is to remind members to consider the tax implications of taking part in trade shows. However, Amy Mandel, the group’s communications director, says she is not aware of any exhibitor ever choosing not to participate for that reason. – Joan Urdang

Exhibitor Beware

These states take a hard line on trade-show nexus.

  • Illinois: One appearance at a show may be enough to create nexus for use-tax purposes.
  • Massachusetts: Soliciting sales at a show for three or more days subjects vendors to use-tax collection.
  • Texas: Based on a recent ruling, actual sales (as opposed to solicitation of orders) are subject to franchise tax.

Source: State Tax Return, Jones Day Reavis & Pogue, November 2001

Since 1996, about 19% of total assets in 401(k) plans have been put in company stock, says the Employee Benefit Research Institute.

Global Confidence Survey

Keeping the Faith

Are things looking up? U.S. finance chiefs think so. Fewer CFOs are fretting about the short-term domestic and global economies compared with a year ago, and more are registering a vote of confidence than was the case last quarter, according to our quarterly Global Confidence Survey. Furthermore, despite operating in a marketplace that has been buffeted by a war on terrorism and the Enron debacle, 30 percent of the finance chiefs plan to increase capital spending next quarter, while 40 percent intend to do so over the next fiscal year.

The survey, which polled finance executives about regional and global economic issues, reveals that 33 percent of the respondents are either confident or very optimistic about the domestic economy over the next year, a 22 percentage point rise over last quarter. Also significant is that only 16 percent of U.S. finance executives are either concerned or very pessimistic about the short-term domestic economy, a big improvement over the 50 percent who felt that way a year ago and the 71 percent that were gloomy about the same prospects last quarter. Another hefty jump came from executives who seem to be reserving their judgment for the next survey: 51 percent were neutral on the short-term domestic economy, while only 18 percent played it that close to the vest last quarter.

The newly found assurance may be tied to the confidence CFOs place in their companies’ second-quarter sales and profit performance. A whopping 70 percent say that Q2 2002 profits will increase compared with those of Q2 2001; 59 percent predict a rise in second-quarter revenues over last year’s mark.

U.S. finance executives are less hopeful about the world economy over the next year. Only 19 percent are confident or very optimistic about the short-term global outlook, a slight rise in confidence over last quarter’s 11 percent. Meanwhile, 36 percent say they are either concerned or very pessimistic, though that isn’t as dismal as last year’s 45 percent and last quarter’s 71 percent.

The top four concerns this quarter are the economic downturn, increasing competition, lack of capital, and an increase in the cost of capital.

Despite current fund-raising constraints, 32 percent of the CFOs surveyed will tap the capital markets during the next 12 months to raise funds. Of those executives, 60 percent will access both the public and private markets, while 30 percent will stick to the public markets exclusively. In addition, 30 percent of the finance chiefs who are raising capital this year will issue debt and 10 percent will issue equity, but most–60 percent–will issue both.

Apparently, time heals all confidence problems. An astonishing 91 percent of the CFOs polled say they are either confident or very optimistic about the U.S. economy over the next five years; 75 percent feel the same way about long-term global prospects, which is a 10 percentage point rise over last year. – M.L.

CFO Global Confidence Survey Results

Attitudes of U.S. CFOs over the next year:
  Domestic Economy Global Economy
Very optimistic 7% n/a
Confident 26% 19%
Neutral 51% 45%
Concerned 13% 32%
Very pessimistic 3% 4%
Attitudes of U.S. CFOs in the next five years:
  Domestic Economy Global Economy
Very optimistic 20% 10%
Confident 71% 65%
Neutral 6% 19%
Concerned 3% 6%
Very pessimistic n/a n/a%
Capital Spending predictions for the next:
  Quarter Fiscal Year
Increase 30% 40%
Decrease 20% 23%
No change 50% 37%
Next quarter’s performance predictions:
  Profit Revenue
Increase 70% 59%
Decrease 20% 31%
No change 10% 10%

 

Not Again: The Council of Institutional Investors calls for legislative reform in auditing and governance to prevent “future Enrons.”

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