Hello, I Must Be Going

Harvey Pitt's legacy of unfinished business. Also: Why some large companies are enamored of reverse stock splits; stock-option hedging could soon be extinct; FASB's possible move to principles-based accounting; and more.

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Harvey Pitt may be gone, but what he left undone can’t be forgotten.

The perpetually embattled chairman of the Securities and Exchange Commission resigned on Election Night after 15 tumultuous months in office. Criticized for being too close to his former Wall Street clients, unable to build consensus, and arrogant to boot, he finally succumbed to criticism over his selection of William Webster to head the Public Company Accounting Oversight Board.

The leadership vacuum he leaves behind, however, especially coupled with the subsequent resignation of chief accountant Robert Herdman, could have a major impact on how regulatory reform is carried out. The SEC is charged with devising 24 sets of rules, completing six major studies, hiring 200 new employees, and reviewing one out of three filings by next year. By law, these duties must be fulfilled, says Greg Bruch, a partner at law firm Foley & Lardner, but the lack of a chairman could mean they are done in “a compromised way” that could lead to “more legal challenges and less public acceptance.”

Georgetown law professor Donald C. Langevoort agrees that without a permanent chairman, “there will be little effort to be aggressive” on the rule-making side. And with the White House warning that finding a replacement could take months, don’t be surprised, says Bruch, if other forces step in. “For corporations, not having an SEC chairman could mean more actions from the states,” he says, citing as an example the campaign of New York State Attorney General Eliot Spitzer.

Retired judge Stanley Sporkin, who’s been mentioned as a possible successor, speculates that the next chair might have it easier. Where Pitt was consumed by the accounting scandals and political upheaval, he says, his successor “will have time to study what went wrong and be proactive rather than reactive.”

Not that he or she won’t be busy. “There is so much the SEC has to do in regards to [the] Sarbanes-Oxley [Act of 2002],” says Dennis Beresford, professor of accounting at the University of Georgia, “that there will hardly be time to do anything else.” —Lori Calabro

Is This the End?

When is a recession over? When these folks say it is.

So, while many economists agree that the recession that began in March 2001 ended earlier this year, the official arbiter — the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) — has yet to call it over.

Part of the problem is that economists disagree over the indicators of a recession. “If you ask three economists, you’ll get four answers,” jokes Ken Goldstein, an economist at The Conference Board. The common notion that a recession is defined by two or more consecutive quarters of decline in gross domestic product (GDP) is just “a rule of thumb,” explains Goldstein.

The NBER doesn’t even use GDP in its analysis. Instead, it focuses on such monthly indicators as unemployment, personal income, and industrial production.

The committee may be delaying its call to see if the economy worsens again. Then it will have to decide if the recession ended and began again — the dreaded double dip — or if it was one protracted decline. According to Goldstein, another downturn “is just not going to happen.” Ask another economist, though, and you’ll get a different answer. —Joseph McCafferty

Somebody’s Watching You

If you’re looking to launder money, a pawnbroker is a better bet than a bank — at least for now.

While banks labor under the strict guidelines of the anti-money-laundering Patriot Act, the Treasury Department is still laboring to set rules for small businesses that deal with large purchases, such as used-car dealers, pawnbrokers, jewelers, travel agencies, and a host of others.

The Patriot Act, passed in October 2001 in hopes of tripping up terrorist financing, requires all such institutions to establish anti-money-laundering programs within six months. In April, the Treasury Department issued regulations to the traditional financial-services sector, but so far it has failed to do so for the odd coterie of remaining companies.

Why the delay? The rules for banks are absurd for certain small businesses, which typically don’t even have CFOs. “Having an individual trained in [money-laundering] compliance makes sense if you’re American Express, but not if you’re two guys with a jewelry cart at the mall,” explains Karen Shaw Petrou, managing partner at consulting firm Federal Financial Analytics Inc.

But large financial institutions aren’t complaining about the disparity. Instead, they’re in overdrive to avoid “reputational accidents” that could prove far worse than the money-laundering scandals that plagued some major banks in recent years, says Alan Abel, head of PricewaterhouseCoopers’s money-laundering compliance practice. “September 11 put money laundering and terrorist activity high in everyone’s thoughts.” That means even corporate banking customers will find themselves under tighter scrutiny.

“Customers are going to have to provide lots more information to banks and broker/dealers,” agrees Petrou. “Banks want to determine not only that their own customers and counterparties are reputable, but that their customers in turn deal only with reputable people. There is a lot of contagion risk that everyone wants to insulate themselves from.” —Tim Reason

Introducing the Boardroom Scoreboard

Amid all the hand-wringing about boards of directors, several well-known — and some not so well-known — players in corporate governance have introduced board-ratings systems.

Last month, for example, GovernanceMetrics International Inc. was scheduled to launch its GMI Ratings. According to CEO Gavin Anderson, the more than 600 metrics in the start-up’s database rate companies in seven categories ranging from board accountability to shareholder rights. “We issue eight scores per company — one overall and one for every subcategory,” says Anderson. Subscribers pay a flat fee of $18,000 for the rating, which is accompanied by a written analysis that “red flags” areas of weakness.

GMI’s offering is the latest in a crowded field. Last June, Institutional Shareholder Services introduced the Corporate Governance Quotient into its proxy reports for the Russell 3,000. Standard & Poor’s jumped into the game in October, offering both governance-transparency ratings for the S&P 500 and individualized company assessments. Next year, The Corporate Library and the Investor Responsibility Research Center (in conjunction with TrueCourse Inc.) are set to offer systems.

Most of the systems are geared toward giving investors an overview of a firm’s corporate-governance practices. For firms, however, they offer different insights. Aside from benchmarking a firm’s own governance practices, says Anderson, GMI’s rating offers a glimpse into “the governance practices of [potential acquisition] targets.” And for anyone thinking of joining a board, the system is a useful due-diligence tool, he adds.

Skeptics worry about the snapshot nature of many of the ratings. Because most use only public information, says Richard M. Steinberg, corporate-governance leader at PricewaterhouseCoopers LLP, they cannot “capture how the board operates inside the boardroom.” Still, says Patrick McGurn, vice president of ISS, the best thing that could come out of the flurry of mechanisms would be if companies “adopted better standards.” —L.C.

Thanks a Lot, Enron!

It’s the best of times and the worst of times for growth-oriented companies in troubled sectors. One dramatic example: energy trading and management company TBC Consolidated Fuels Marketing & Management Corp.

Thanks to the problems of big players like Enron, El Paso, and Dynegy, the $21 million company now has scads of new clients to chase. “There has never been a [better] opportunity to grow our market share,” says TBC ConFuels president and CEO Peter Bryant, who has seen his annual revenues increase steadily from $300,000 since entering the sector in 1997. Based on his pipeline of potential clients, he says he could easily buy 10 times the $1.5 million worth of energy he’s now purchasing monthly for Fortune 500 clients like Miller Brewing and Texas Instruments.

On the other hand, the loss of competition has also spooked the bankers, leaving TBC ConFuels without the credit financing it needs to expand business. Even armed with signed contracts from customers, bank statements, and details about the company’s hedging strategy to keep cash flow strong, TBC ConFuels was refused credit by 37 banks. Thanks to Enron, “we have found that domestic lenders are still a little gun-shy about commodity lending,” says Jacqueline Arthur, TBC ConFuels’s part-time CFO. “It’s a bit of a herd mentality.”

Indeed, “the banks are just fleeing the sector,” says Peter Rigby, an energy analyst for Standard & Poor’s. “They’re looking at an enormous number of nonperforming loans, so it’s a brave banker that brings a new loan to a credit in this sector.” Moreover, small companies are at a disadvantage, he notes, since they are more vulnerable to liquidity crunches when systemic breakdowns like energy shortages or delivery delays occur.

Patrick Von Bargen, executive director for the National Commission on Entrepreneurship, argues that it’s not Enron’s fault, and that TBC ConFuels’s problems with banks are typical for asset-light start-ups. Credit conditions “have always been bad,” he says. “When you think about entrepreneurial ventures, where the assets are often people or a brand, how does a bank foreclose on those things?”

The good news for TBC ConFuels: Bryant and Arthur discovered that international banks, including Amalgamated Bank of South Africa, French BNP Paribas, Bank of Ireland, and several smaller Canadian banks, were more willing to consider taking a chance than their U.S. counterparts. At press time, TBC ConFuels was expecting to close a deal “imminently” with one international bank, which it declined to name. —Alix Nyberg

Reverse Psychology Today

For years, reverse stock splits have been seen as window dressing, or a desperate attempt by tiny companies to avoid being delisted. But what about the reverse splits now being completed or considered by such companies as AT&T Corp., Lucent Technologies Inc., and Palm Inc.?

Despite analysts’ disdain for them, there are some practical reasons for doing reverse splits. One reason is to appease institutional investors. “A lot of investment funds have covenants that don’t let them buy stocks under certain prices — usually $3 or $5,” says Vincent Sbarra, a senior partner with HBC Capital. Adds Ulrico Font, senior analyst for Ned Davis Research, everybody feels most comfortable with stocks priced between $5 and $50.

The loss of institutional investors was one reason Palm conducted its 1-for-20 reverse split in October, admits CFO Judy Bruner. But both Bruner and Chuck Noski, former CFO of AT&T, say the primary reason for their reverse splits is restructuring efforts that involve spin-offs. Palm, for example, plans to separate into two companies — one for its handheld devices, the other for its operating system. Yet with its presplit stock trading barely above Nasdaq’s $1 minimum, the resulting shares of both companies wouldn’t otherwise meet listing requirements.

Noski says that if AT&T sold off its cable TV unit, its remaining shares would trade at $4 to $5. Without the planned one-for-five reverse split, that would put AT&T in the red zone for institutional investors. The post-sale price would be way below the median share price of others in the S&P 500. Which brings up another practical reason for reverse splits: fear of embarrassment. —T.R.

Gambling with Buybacks

Given the trouble EDS Corp. has incurred from its equity-based hedging program, it’s little wonder such techniques are under fire. In late September, the Plano, Tex.-based company announced that it had to issue $225 million in commercial paper to buy back 3.7 million of its own shares, thanks to put options it had sold on them through June. The price was $60.61 a share, when EDS stock was selling on the open market for $17. The announcement, coming on the heels of a surprise profit warning, sent the stock down 66 percent in the week following.

“The mistake that EDS made was waiting in the hope that the stock price would go back up to the $60 level,” says Banc of America Securities LLC analyst Prakash Parthasarathy. It should have closed out the contracts earlier, he says, although “even if all the stars are aligned right, it shouldn’t be done when there is so much unpredictability in the market.”

But EDS wasn’t alone. When stock prices were soaring, many companies, including Dell, Microsoft, and McDonald’s, sold put options against their own stocks to help pay for the cost of stock option cash-outs. “The whole point was to offset the dilutive effect that stock options have on shares,” says Dell spokesperson Mike Maher. Dell stopped issuing the puts in 2000, when it saw the economy softening, but said it was liable for up to $1 billion to settle options that will expire this year.

Still, some say this type of equity-based hedging is a valid strategy. “When you know you’re going to need some shares, I think you [can] argue that some policies around puts and calls are a good idea,” says analyst Mark Specker of SoundView Technology Group. Explains Joe Elmlinger, a managing director in Salomon Smith Barney’s equity derivatives group, “It wasn’t the derivative that caused the loss, it was the decision to buy back shares.”

But even if the market comes back, companies may stay wary. By the end of this year, the Financial Accounting Standards Board is slated to issue new accounting rules on equities and liabilities related to company stock, including a requirement that will force transactions, including some types of equity forwards, to be considered as liabilities and marked-to-market on income statements.

Meanwhile, the repercussions for EDS are only intensifying. The company received notice of an “informal inquiry” from the Securities and Exchange Commission in early October. —A.N.

A Matter of Principles

The Financial Accounting Standards Board announced in October that it is considering a shift from rule-based toward principles-based accounting standards. The move would bring U.S. accounting closer to international standards, which some argue could have helped prevent the recent accounting scandals.

“We’re looking at whether a more principles-based approach would help reduce the level of detail and complexity in U.S. standards,” FASB chairman Robert H. Herz said in November at a Financial Executives International conference.

Proponents argue that shifting the emphasis to principles could reduce the temptation for accountants to comply with the letter but not the spirit of a rule. “Manipulators love detail-based systems because they like to find ways to get around the rules,” says Vincent O’Reilly, a professor at the Carroll School of Management at Boston College. “Look at Enron. It’s hard to look quickly at what they were doing and say it doesn’t conform to the rules of GAAP. But anybody can see that what they were doing wasn’t a fair representation of the company.”

Critics, on the other hand, caution that a principles-based system could increase litigation. “I’m doubtful that it would work,” says Chuck Hill, director of research at Thomson Financial First Call. “It’s difficult to rely on companies to follow the spirit of the law. I think a lot of CEOs figure that as long as the lawyers tell them it’s OK, it’s not only legally OK, it’s also morally OK.”

Even Herz expressed some hesitation about moving to principles-based accounting. “Some are concerned that a principles-based approach could reduce the comparability of financial information and leave too much room for judgment by companies and auditors,” he said.

O’Reilly says it is unlikely that FASB would move completely to a principles-based model, but that some combination of the two would be ideal. FASB will hold a roundtable meeting this month, and has requested comment letters on the proposal by January 3. —J.McC.

Global Confidence Survey: Let’s Try This Again

The U.S. economy is once again poised to take a run at a recovery, say CFOs, but concerns about future prospects at home and abroad linger. Certainly turmoil at the Securities and Exchange Commission has done little to allay those concerns. But the hope that the wave of big accounting scandals is ebbing is clearly reflected in CFOs’ cautious optimism about the future. After the outlook dampened last quarter, finance executives are once again more hopeful that economic conditions are improving.

According to our quarterly Global Confidence Survey, 30 percent of U.S. respondents say their attitude toward the domestic economy in the next year is either “confident” or “very optimistic,” up from 24 percent last quarter. But worries about the economy persist. Nearly 44 percent of U.S. respondents are “concerned” about the economy in the next year, and another 6 percent are “very pessimistic.” Still, those numbers are down from last quarter, when 58 percent of respondents held negative outlooks.

CFOs are also increasingly upbeat about the state of the economy over the long haul. A full 88 percent of respondents hold positive views about the U.S. economy in the next five years, up from 77 percent last quarter. And fewer are pessimistic — only 3 percent of the CFOs polled said they had a negative view of the long-term U.S. economic picture, down from 12 percent last quarter (9 percent were neutral).

Views of the global economy by CFOs around the world are more mixed. Half of the respondents, including finance chiefs in Europe and Asia, say they are concerned about the global economy over the next year. Those concerns fade over the long term, with only 6 percent of CFOs in those regions reporting negative views of the global economy over the next five years. If anything stands out on the global front, it’s that European CFOs are more worried about their own economy and the global economy than are their counterparts in the United States or Asia. A stout 65 percent were “concerned” about the European economy in the next year, and another 4 percent were “very pessimistic.”

As for when conditions in the United States might improve, respondents are split. The largest group, 40 percent, don’t expect a broad economic recovery to begin until the second half of 2003. Others are more hopeful: almost 30 percent are looking for a rebound in the first half of next year. Indeed, 13 percent believe that a broad economic recovery was already under way when the survey was conducted in late October.

The possibility of a war with Iraq is to blame for some of the anxieties of finance executives. Forty-four percent of the respondents believe a war would have a “slightly negative” impact, and another 11 percent say it would have a “very negative impact.” Still, a majority — 71 percent — approve of President Bush’s intentions to pursue a regime change in Iraq. — J.McC.


CFO Global Confidence Survey Results

Based on responses from 214 CFOs in the United States, Europe and Asia.

Attitudes of U.S. CFOs toward the domestic economy:
  One Year 5 Years
Very optimistic 3% 28%
Confident 27% 60%
Neutral 20% 9%
Concerned 44% 2%
Very pessimistic 6% 1%
Attitudes of U.S. CFOs toward the global economy:
  One Year 5 Years
Very optimistic n/a 9%
Confident 16% 59%
Neutral 33% 27%
Concerned 43% 5%
Very pessimistic 8% n/a
Attitudes of European CFOs toward the global economy:
  One Year 5 Years
Very optimistic n/a n/a
Confident 6% 65%
Neutral 27% 25%
Concerned 61% 6%
Very pessimistic 6% 4%
Attitudes of Asian CFOs toward the global economy:
  One Year 5 Years
Very optimistic n/a 15%
Confident 17% 51%
Neutral 26% 28%
Concerned 53% 4%
Very pessimistic 4% 2%

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