In recent weeks, everyone from Fidelity Investments to the California Public Employees’ Retirement System to state treasurers to the Securities and Exchange Commission has weighed in. The controversy boils down to four issues: whether to divide the roles of CEO and chairman; whether to split the NYSE’s operational and regulatory arms; what to do about the size and composition of the exchange’s bloated, 27-member board; and whether to ditch the specialist system.
There’s no doubt change is needed. The board includes many of the Wall Street firms the NYSE regulates. “It’s a classic case of the fox guarding the henhouse,” says Michael Caccese, a securities lawyer with Kirkpatrick & Lockhart. This board structure has helped fuel a perception that the NYSE’s regulatory arm is weak—a perception only strengthened by recent reports of misdeeds by the specialist trading firms. Separating the roles of CEO and chairman is an obvious step—an independent chairman could better concentrate on board oversight while the CEO focused on operations. Similarly, making the regulatory arm of the exchange more independent could help restore credibility.
The question of board composition is trickier. Stanley Keller, a partner at Palmer & Dodge LLP and former chair of the American Bar Associa-tion’s Committee on the Federal Regulation of Securities, argues that “the larger a board gets, the more it ends up looking like a gentleman’s club as opposed to an effective oversight governance body.”
But excluding member companies may make less sense. “You need to have the support of the key Wall Street firms and involve them in the oversight, because they’re such huge players in the market,” says Caccese. One solution—proposed by Goldman Sachs CEO Henry M. Paulson Jr.—would be to have the NYSE member companies sit on an advisory board.
Whatever it does, the NYSE will have to act fast to stem the loss of investor confidence. Given the Big Board’s pivotal role in the financial markets, its declining credibility could cost Wall Street far more than the $140 million former CEO Dick Grasso has to spend in his retirement. —Don Durfee
Does Not Compute
Computer Associates International Inc.’s CFO and two other finance executives stepped down in October after an audit-committee report detailed revenue-recognition issues at the company for the fiscal year ended March 31, 2000.
Some software contracts were allegedly signed after the quarter in which revenue from them was recognized, according to committee chair Walter P. Schuetze. However, it found no evidence that the revenue was not genuine. CA’s accounting practices are also being investigated by the SEC and the U.S. Attorney’s Office for the Eastern District of New York.
The executives—Ira Zar, CA’s finance chief; Lloyd Silverstein, senior vice president, finance; and David Rivard, vice president, finance—resigned at the request of Sanjay Kumar, CA chairman and CEO.
Many analysts were surprised that Kumar was not forced out as well. “The reaction by CA was less than what most people on the Street expected,” says Nitsan Hargil, a senior analyst at Friedman, Billings, Ramsey & Co.
While the company searches for a new CFO, Douglas Robinson, senior vice president, finance, will serve as finance chief. Robinson joined CA in 1989. —Joseph McCafferty
Watch Your Demeanor
Note to CFOs: Next time you talk with analysts in any setting, relax, stand up straight, and smile, smile, smile.
That may be the message of the latest Reg FD enforcement action by the Securities and Exchange Commission. In September, the agency charged that Schering-Plough Corp. and its former CEO, Richard Kogan, violated the three-year-old rule—which prohibits selective disclosure—”through a combination of spoken language, tone, emphasis, and demeanor.” The case is leaving other companies wondering if they should reevaluate their external-communication policies or perhaps eliminate individual analysts meetings altogether.
This ruling may sound “the death knell for one-on-ones,” says Boris Feldman, a securities lawyer with Wilson Sonsini Goodrich & Rosati, in Palo Alto, Calif. Now, he explains, how a CFO or CEO discloses information may be as important as what he or she says. In other words, he says, executives shouldn’t “look depressed when they talk to analysts.”
Others, however, believe this case is about more than body language. “If you read the complaint, you realize that [Kogan] gave information that was a material breach” of Reg FD, says Elizabeth Saunders, chairman of Ashton Partners, a Chicago-based IR consultancy. During the 2002 meetings in question, she explains, Kogan not only appeared disheartened, he allegedly said that the company’s 2003 earnings would be “terrible,” among other things—a combination that led to a stock drop of 17 percent. There is a huge distinction, says Saunders, between “how important the statement was versus how dour he was when he said it.”
Still, the National Investor Relations Institute’s president and CEO, Louis Thompson Jr., maintains that many “lawyers are going overboard on this one” and advising clients to resort to only Webcasted communication. Moreover, Thompson, who has written to SEC commissioner Harvey J. Goldschmid seeking clarification, insists that the SEC did not set out to cause a major overhaul of communication policies. “I’d put this in the category of unintended consequences,” he says.
Whatever the intention, though, some observers say the SEC is sending a clear message. Previously, as long as a company didn’t deliberately violate the selective-disclosure rules, says Robert Profusek, a partner at the New York office of Jones Day, it was given the benefit of the doubt under Reg FD. Now, he says, “there is no room for accidental, inadvertent anything anymore.” —Lori Calabro
Goodbye to Net Income?
Is this the beginning of the end of the income statement as we know it? In a September speech at a conference hosted by the New York State Society of Certified Public Accountants, Robert Herz, chairman of the Financial Accounting Standards Board, reportedly said FASB would introduce an exposure draft sometime next year on a controversial project to overhaul this pillar of corporate reporting.
People who have worked on the innocuously named “financial performance reporting project” suggest that it could eliminate operating income, net income, and even earnings per share as standard measures of company performance.
The new income statement would include items currently included in other comprehensive income and would be subdivided into three categories: business activities, financing, and other gains and losses. Some observers worry that companies will have different interpretations of what belongs in each category. “The broad definition of ‘business activities’ could present comparability issues between companies,” says Bob Laux, director of external reporting at Microsoft. “That’s something FASB needs to consider.” Microsoft was one of five companies in a FASB-sponsored “field test” that involved rearranging line items from its actual financial results to fit into the proposed categories.
Charles W. Mulford, professor of accounting at the DuPree College of Management at the Georgia Institute of Technology, says separating other gains and losses from business activities would be helpful. Yet he’s concerned that the possible elimination of net income as a measure could cause confusion. “Sure, [net income] has problems,” he says. “But at least we know where to focus our attention. I hope we won’t need to take out a calculator to figure out earnings available for the shareholder.”
Although they are the intended beneficiaries of the changes, “users were not enthralled with the presentation” at the FASB User Advisory Council meeting last month, says a council member. —Tim Reason
Rolling Out the Little Perks
Faced with skyrocketing health-care costs, many employers are making the counterintuitive move of offering employees more benefits. By adding an array of voluntary, employee-paid plans, companies hope to ease the pain of rising co-pays or deductibles for medical insurance.
Jasmine Jeske, human-resources director at Vesta Corp., a payment-systems technology company based in Portland, Oreg., says her company has started subsidizing commuters’ public-transportation costs. “We were taking so much away from employees, we thought it would be a nice balance point,” says Jeske.
Other companies have begun offering such perks as pet insurance (provided by 8 percent of large companies, according to HR consultancy Towers Perrin), legal insurance (25 percent), and supplemental life insurance (94 percent). Many offer flexible-spending plans in which employees can store pretax dollars to pay for benefits, including child-care expenses. And a new ruling from the Internal Revenue Service will allow workers to use pretax dollars to pay for over-the-counter drugs.
A common feature of all of these new benefits: they cost employers next to nothing. In the case of transit subsidies, the fee a company pays to set up the program is largely offset by the tax savings it receives for offering the benefit. For pet insurance, employees receive a bulk-rate discount on premiums through the company, but pay the premiums themselves. The company incurs only the cost of organizing the program.
Debbie Hevner, director of benefits at San Antonio-based Valero Energy Corp., which has 20,000 employees, says the company offers multiple medical and dental plans, as well as voluntary legal insurance, long-term care insurance, and a supplemental cancer-insurance plan. “The only thing [the benefits are] costing a company is the administration, because most of the time it’s not subsidizing them,” she says.
Richard Ostuw, a principal with Towers Perrin, says he sees supplementary benefits not as a substitute for employer-paid medical coverage, but as a low-cost way to help employees. And with monthly health-care premium costs forecast to rise by 12 percent in 2004, low-cost benefits are looking pretty good. —Kate O’Sullivan
FirstEnergy Flunks Typing and Math
It’s been a tough few months for First-Energy Corp., an Akron-based energy utility. Still reeling from the continued shutdown, for safety reasons, of one of its nuclear facilities, the company has been accused of causing the massive blackout of August 14. Then, later that month, it was forced to revise an accounting restatement for the most embarrassing of reasons: the utility admitted that its financial reports for 2002 and the first quarter of this year contained “typographical and minor computational errors.”
A spokesperson for FirstEnergy said the errors were contained in the “management discussion and analysis” section, not in the financials themselves, and didn’t affect bottom-line results. Some numbers were off by as much as tens of millions of dollars. FirstEnergy also says the Securities and Exchange Commission made an informal request for information related to its recent restatement of its 2002 financials.
The spokesperson blamed the errors on the fact that the company had only two weeks to complete the restatement, which was originally made to reflect changes in the accounting-for-transition costs. “Regrettably, errors were made, and we’re not happy about them,” says FirstEnergy’s Kristen Baird. “We’re hopeful it won’t occur again.”
The errors could indicate bigger problems in the finance department, says Warwick Busfield, an analyst with Oppenheimer & Co. A few weeks before the restatement, Busfield lowered his recommendation on FirstEnergy from a buy to neutral because of concerns about operational issues.
Paul Zarowin, an associate professor of accounting at the Stern School of Business at New York University, suggests that mistakes of this kind are very rare. “I’ve never heard of a case like this,” he says. “In this day and age, with the technology companies have, it’s very surprising.”
One possible explanation for the mishap could be the complexity of accounting in the energy industry. “There is so much regulatory oversight from a variety of competing agencies; I sympathize with how difficult it is to keep up with it all,” says Busfield. However, he adds, “something like this just shouldn’thappen.” —Joseph McCafferty
FASB Eyes New Disclosure
For now, the Financial Accounting Standards Board seems to be deferring a major overhaul of pension-accounting rules in favor of new disclosure requirements for defined benefit plans.
The exposure draft released in September proposes that companies use greater transparency in their accounting for pensions. But the draft is more notable for what it is not calling for. “There would be no change in the measures, just how they are disclosed,” says Ari Jacobs, east region actuarial leader at Hewitt Associates. “The numbers are not going to change.” Critics of the proposal were hoping FASB would eliminate smoothing mechanisms that allow companies to soften the impact of pension gains and losses from year to year.
Under the proposal, companies would be asked to divide plan assets by class, such as equity, debt, and real estate. They would have to show expected rates of return and target allocation percentages for each category. Cash flows would have to include projections of future benefit payments and an estimate of next-year’s fund contributions. The disclosures would be made in the footnotes to the financial statements.
Some say the new rules don’t go far enough. “I’m disappointed that they weren’t more aggressive about requiring sensitivity analysis,” says Gene Imhoff, director of the Paton Accounting Center at the University of Michigan Business School. He says that many companies have unrealistic expectations about pension-plan returns. Sensitivity analysis, he says, would show the impact of flawed assumptions, and make it easier to compare pension accounting across companies.
Nonetheless, Imhoff says the new disclosures are a step in the right direction. “Some plans are so underfunded that the plan strategy is to take an extremely risky position,” he says. “The new disclosures would bring them to light.”
If the proposal were adopted, it would be effective for fiscal years ending after December 15, 2003. —Joseph McCafferty
You Can Take It with You
Businesses are about to get a big break on wireless service, compliments of the Federal Communications Commission. Beginning November 24, the FCC will require wireless-phone carriers to allow subscribers to keep their phone numbers when they switch service providers. Instead of sticking with a wireless plan for fear of losing a well-publicized number, executives will be free to shop around, which should result in greater price competition on the part of carriers.
The impact of number portability, which is expected to go into effect in the top 100 metropolitan areas this month, will be huge, says Nick Wray, vice president of sourcing at Teldata Control Inc., an East Rutherford, New Jersey-based company that advises clients on telecommunications costs. “You can knock 20 to 30 percent off whatever you’re paying now,” says Wray.
Many businesses currently allow employees to choose their own wireless plans and expense the cost to the company. The regulation will make it easier for those businesses to make aggregate purchases and negotiate group discounts.
Harry Patel, executive director and head of telecom sourcing at UBS Investment Bank in Chicago, has already negotiated a contract with UBS’s carrier that will allow the company to change providers when number portability becomes available. “We agreed that we would benchmark the market continuously during the term of the contract,” says Patel, who built in a clause that will allow UBS to get out of the three-year agreement if the deal does not remain competitive.
Since carriers were still fighting about the switch this summer, some question whether they’ll meet the deadline. On the technical side, they’re prepared, says Roger Entner, program manager for the wireless research practice at The Yankee Group. But on the business side, he says, “I would not be surprised if we have a few hiccups.” While consumers will likely lead the switching charge, businesses may want to hold off until the carriers have had some time to adjust. “Companies do not want to disrupt their operations,” says Entner. “I wouldn’t advise them to rush out on November 24 to try to do this.” —Kate O’Sullivan
Junk Food for Dealmakers
American investors pumped $103.4 billion into high-yield (“junk”) bonds in the first nine months of 2003—more than twice the amount invested in the same period last year, according to research firm Dealogic, and on track to approach the record of $139.8 billion in 1998. Will all that cash send junk issuers on a shopping spree?
Robert Child, executive vice president at the brokerage firm vFinance Investments Inc., based in Boca Raton, Fla., says the movement in the high-yield market indicates transactions to come. “The high-yield bond market has outperformed all other markets this year,” he says. “Since that’s where the action is, you’ll see a lot of M&A activity with these types of companies.”
John Lonski, chief economist at Moody’s Investors Service, agrees that more junk-financed deals are likely, citing both the “lively pace” of high-yield bond issuance and the narrowing of high-yield spreads over Treasuries. For example, battery-maker Rayovac, with revenues of $573 million last year, purchased Remington Products Co., the venerable $360 million razor producer, for $322 million in a fully debt-financed deal. Industrial-equipment maker JLG Industries, with $770 million in 2002 revenues, bought OmniQuip in August for $100 million, issuing $125 million in high-yield debt to fund the purchase of the $217 million Textron subsidiary.
A debt-financed acquisition can be a risky move for a highly leveraged company though, as many learned in the late 1980s, when junk-fueled purchases abounded and left companies burdened with crushing debt loads. Adding debt to an existing load can also lead to a ratings downgrade, warns Lonski. Indeed, the Rayovac purchase of Remington was greeted by a downgrade from Moody’s and Standard & Poor’s.
But today’s high-yield issuers are different, says Kingman Penniman, president of KDP Investment Advisors, an independent high-yield research group based in Montpelier, Vt. “When we look at the late ’80s, those were LBOs, and what they were doing was financial engineering,” says Penniman. “Now people are looking at buying real companies, real assets.”
Despite the risks, in a market with some appealing bargains—and for companies with few other options, with little cash, and suffering stock prices—high-yield debt financing may be the way to go. “Shareholders may be willing to accept an even lower credit rating if they believe the acquisition will improve the company’s longer-term outlook,” says Lonski. —Kate O’Sullivan
The End of Split-Dollar Life?
Final rules from the Internal Revenue Service could make many split-dollar life-insurance plans so tax prohibitive that they no longer make financial sense. Now many firms are scrambling to either fix them or terminate them completely.
Split-dollar policies used to be a popular way to provide tax-beneficial deferred compensation to senior managers. According to Mellon Financial in Pittsburgh, 56 percent of Fortune 1,000 companies offered them. Under the new IRS rules, however, executives will be taxed annually on the cash buildup inside employer-owned plans. Executives can avoid taxes on the cash buildup if they own their policies, but are likely to face taxes on premium payments they receive through company loans if the loans’ interest rate is below the applicable federal rate.
“The bottom line is that these regulations make the tax costs associated with split dollar higher,” says Andrew Liazos, a partner in the Boston office of law firm McDermott, Will & Emery. Companies and executives that have existing arrangements have until December 31, 2003, to restructure the plans or terminate them without paying a tax on the cash value, he says.
“If you get out before the end of the year, once you repay the employer there will be no tax on the equity until you access the cash,” says Liazos. —Joseph McCafferty