Verizon, Ford, and ExxonMobil, pay attention. It looks as though pensions and other retiree benefits are about to graduate from the footnotes to the balance sheet. And companies that have previously been able to hide underfunded retirement programs may have to count them as liabilities — often multi-billion-dollar liabilities.
In November, the Financial Accounting Standards Board voted to move toward a proposal that would require companies to report the difference between the net present value of their pension- and other retirement-benefit obligations and the amount the company has set aside to meet those obligations. And although a final decision is a year or more away, the numbers won’t be pretty. (See “Will Washington Really Act?”)
Standard & Poor’s, in fact, estimates a retirement-obligations shortfall of some $442 billion in the S&P 500 alone. Indeed, it is difficult to understate the potential impact of the FASB plan, which is expected to be only the first phase in a larger effort to overhaul the accounting treatment of pensions and benefits. “We believe this FASB project will have a significant impact on stock evaluations, income statements, and balance sheets, and will become the major issue in financial accounting over the next five years,” S&P wrote in its December report.
The news was welcome to many in the accounting business who have been concerned that current rules allow companies to hide retiree obligations in the footnotes. John Hepp, a senior manager with Grant Thornton LLP, praised the board’s decision to move toward a “simplified approach. We think this will be a big step forward.”
But it won’t be without pain for many companies faced with adding a large negative number to their balance sheets, such as telecom giant Verizon Communications Inc. Standard & Poor’s reported in December that Verizon has underfunded the nonpension portion of its postretirement benefits by an estimated $22.5 billion. The company is clearly trying to get a handle on retirement benefits and health-care costs, announcing that same month that it will freeze the pension benefits of all managers who currently receive them.
While the company refused to comment, Verizon is far from alone. Ford and General Motors have underfunded their retirement obligations by $44.7 billion and $69.0 billion, respectively, and other big names facing a shortfall include ExxonMobil ($16.4 billion) and AT&T ($14.8 billion).
If any of these companies think the markets will treat these obligations as a one-time problem, they had better think again, says S&P equity market analyst Howard Silverblatt. “Moving this onto the balance sheet is going to wake people up,” he says. “The bottom line is that shareholder equity [in the S&P 500] is going to be decreased by about 9 percent.” And as companies begin to explore their legal options for limiting the financial damage — including paring back benefits even further — Silverblatt predicts that the issue will become more politicized and remain in the public eye for years to come. — Rob Garver
The Top 5 Underfunded Plans
Who’ll Fall Short?
(In Negative $ Mill.)*
|*Includes pension- and other retirement-benefits obligations as of 2004.
Source: Standard & Poor’s
Under the Covers
How far should a business go to protect its compensation information? For The Capital Group Cos., a holding company for asset-management firms including the American Funds, the distance extends all the way to divorce court.
The Los Angeles–based firm recently sought and won an order to seal practically all divorce-trial proceedings of one of its top fund managers, Timothy D. Armour. The reason? The privately held company feared that the documents would reveal salary, equity, and benefits information for the 22-year company veteran, and spark jealousy among his colleagues.
“To have [Armour’s] compensation made public is not only a violation of privacy, but is bad for morale,” says Capital Group spokesperson Chuck Freadhoff, adding that it would be “very difficult” and “counterproductive” to try to explain Armour’s pay.
It’s certainly not the first time that corporate interests have come to the fore in a private divorce. At one point in his 1997 divorce trial, former GE Capital Services head Gary Wendt asked to have his testimony sealed to protect GE’s stock price, while former CEO Jack Welch agreed to repay GE for certain perks when the lavish lifestyle his 2003 divorce papers revealed incited shareholder ire.
Attorneys who handle executive divorces, however, say Capital Group’s direct intervention is unusual. While individuals are increasingly seeking privacy in divorce cases, going so far as to hire private judges, it’s rare for a company to get involved in the fray. “It’s routine that the privacy issues of the privately held company will be asserted, [but divorcing spouses] usually find a way to reach an acceptable level of confidentiality by themselves,” says James H. Feldman, partner in the Chicago office of Jenner & Block LLP.
Capital Group’s success in court is also surprising, since judges tend to prefer redacting small portions of testimony rather than sealing the bulk of a trial, notes attorney Cheryl Lynn Hepfer, president of the American Academy of Matrimonial Lawyers.
The trial was ongoing at press time. News media organizations initially contested the efforts to keep the papers secret, but later dropped their case. Armour’s ex-wife, Nina Ritter, had also tried to keep the trial public. Her attorney, Dennis Wasser, would not comment on whether she would continue that effort. — Alix Nyberg Stuart
Just a few short years ago, strategic alliances were decidedly out of favor as companies focused on consolidation and restructuring. No longer.
“Strategic alliances are coming back quicker now than M&A activity,” says Kees Cools, co-author of “The Role of Alliances in Corporate Strategy,” a November 2005 report by Boston Consulting Group. In fact, BCG says, strategic alliances in the United States were up 20 percent last year. Similarly, alliance activity grew 30 percent year-to-year in Asia.
This latest round, however, is benefiting from lessons learned in the 1990s, when companies viewed alliances strictly as “vehicles of growth,” says Cools. Many couplings — particularly in the airline industry — failed partly due to a lack of clear governance policies and exit strategies, he adds. Others didn’t take full advantage of complementary assets.
Still, the benefits of forming alliances to achieve growth while reducing new product development and marketing costs are as real as ever. For example, General Motors, DaimlerChrysler, and BMW, playing catch-up with Toyota and Honda, recently joined forces to bring a new hybrid engine to market faster than either could on its own. In addition to sharing design costs, says Eric Ridenour, Chrysler Group chief operating officer, “our goal is to find efficiencies in such areas as engineering, working with suppliers to develop and purchase components, and in purchasing manufacturing equipment.”
Going forward, Cool expects strategy alliances to “continue to grow some 10 to 15 percent in the next few years before stabilizing.” — Doug Bartholomew
Is there a happy medium between speed and practicality? When it comes to filing deadlines, the Securities and Exchange Commission thinks so.
In December, the SEC created new schedules for annual and quarterly reports for different tiers of companies — and delayed the effective dates again. The new rule creates a category known as “large accelerated filers” for companies with a public float of $700 million or more. In fiscal years ending on or after December 15, 2006, such firms will have 60 days from the last day of the fiscal year to file their 10-Ks and 40 days to file their 10-Qs. Companies between $75 million and $700 million will continue to face a 75-day filing deadline for 10-Ks and 40 days for 10-Qs.
This marks a retreat, of sorts, for the SEC, which had hoped to impose the 60-day 10-K deadline and a 35-day 10-Q deadline on all firms over $75 million. When he announced the proposal in September, SEC chairman Christopher Cox said the change sprang from “an appropriate balancing of the need for information to be provided rapidly to markets and investors against the need that companies be given sufficient time to ensure that the information is accurately prepared.”
This makes sense to financial professionals, many of whom have questioned the benefits of shorter deadlines when material developments must already be disclosed in the 8-K. Still, there is concern that faster filing will make it more difficult to avoid errors. For example, Enoch C. Jen, CFO of Zeeland, Mich.-based Gentex Corp., has already begun filing under the 60-day deadline. But he points out that the feat was accomplished, in large part, because Gentex is a very centralized firm with relatively few business lines. “A lot of companies that are more decentralized have a lot more procedures to go through,” he says.
What choice will companies make if faced with potential fines for being late versus filing an inaccurate report? “The trade-off between a fine and the potential loss in shareholder value in the case of a misstatement is very significant,” says Erik Linn, a managing director with Navigant Consulting Inc., adding that in most cases “accuracy [will be] more important.” — R.G.
Will Washington Really Act?
Still stinging from its failure to overhaul Social Security, the Bush Administration is setting its sights on pension reform for 2006. And while it’s far from certain what Congress will serve up for approval, it’s clear there will be plenty of action.
To date, both the House of Representatives and the Senate have passed pension-reform legislation. Congress insists that an overhaul of the system is one of its top priorities for the 110th session. And the Bush Administration, while reserving comment on the differences in the House’s Pension Protection Act (H.R. 2830) and the Senate’s Pension Security and Transparency Act (S. 1783), has warned legislators not to “kick this problem down the road,” as U.S. Secretary of Labor Elaine L. Chao put it recently.
But cobbling together legislation that will pass the President’s muster will not be easy. Both bills differ significantly from the Administration’s own proposal. And the key sticking points — funding phase-in, asset smoothing, and the use of credit balances — are far from unstuck.
“The Senate bill excessively delays full funding of pensions to a very long rules phase-in for the funding targets,” says a Department of Labor spokesperson. Moreover, “both bills allow underfunded plans to avoid making their required annual contributions by counting their past contributions as pension credits.” Under current rules, companies can make such voluntary prepayments as credit balances, offsetting their future funding requirements, a tactic the Administration’s original proposal disallowed.
Smoothing is another rough spot. At present, firms are permitted to smooth fluctuations in the market value of plan assets by averaging this value over a five-year period within an allowable range of 80 to 120 percent of the assets’ fair-market value. Bush’s proposal would end this practice. But while both bills reduce smoothing, they do so by different amounts. The House bill, for example, restricts smoothed-asset valuations to no less than 90 percent or no more than 100 percent of the assets’ fair-market value. “The devil is in the details,” says James Klein, president of The American Benefits Council, in Washington, D.C.
From his vantage point, however, Mark White, CFO of SAP America, is concerned less with the Bush Administration’s opposition than with the possibility of special interests derailing pension reform. “I don’t think [congressional] actions should be heavily influenced by a few industries with current problems, such as the automotive industry or the airline industry,” White says.
Still, many observers say the political winds may be in favor of pension reform. “I fully expect that Congress will iron out the differences,” says Klein. “With Social Security reform a bust, pension reform is a must.” — Russ Banham
Fraud Filings Fall
It looks like securities-fraud lawsuits went on hiatus last year, with 17 percent fewer securities-fraud class-action filings than in 2004. The year also saw a decrease in investor losses related to such suits. Experts say tougher governance, the fact that suits arising from the post-1990s bust are in the past, and lower market volatility kept filings below average. Still, suits alleging misrepresentation and false forecasting were on the rise, prompting Joseph Grundfest, director of Stanford Law School’s Securities Class Action Clearinghouse, to point out that CFOs continue to be “in the crosshairs of securities litigation. So while the aggregate numbers are down, the importance of accuracy in the financial-reporting process is greater than ever.”
|Securities-fraud class-action suits||176 filings||213 filings|
|Investor losses related to securities-fraud class-action suits||$99 billion||$147 billion|
|Filings with disclosure losses of more than $10 billion||1 filing||3 filings|
|Filings alleging misrepresentation||89%||78%|
|Charges of false forward-looking statements||82%||67%|
|Sources: Stanford Law School and Cornerstone Research|
All Together Now
Nonuniform state tax laws wreak havoc on corporate collection procedures. But relief may be in sight now that the Streamlined Sales Tax Project (SSTP) agreement — which promises to standardize sales tax and use regulations — has been enacted.
“The project makes sales-tax collection easier for everyone,” says David Bunning of law firm Greenberg Traurig LLP. “Businesses will have one set of regulations they need to comply with in all participating states.”
Percolating since 2000, the voluntary project was formally launched last fall to standardize product definitions, rates, and administrative aspects. Currently 44 states support the SSTP and 19 have enacted or are working toward legislation to harmonize their regulations. “Before, businesses would have to know whether chocolate was considered a food in one state and a candy in another because they are taxed differently,” says Bunning.
But experts like Curtis Ruppal, director of state and local tax at Plante & Moran PLLC, a consultancy in Southfield, Mich., caution that some benefits won’t be realized for some time. “It’s going to take years before everything is settled,” he says. Ruppal adds that many issues — such as discrepancies between regulations in states that have remodeled laws to fit SSTP standards and those that have not — are still unresolved. “These changes concern every business,” he says. “CFOs need to keep an eye on them and understand how they will affect their sales-tax responsibilities.” — L.D.
Cushioning the Blow
Choose your auditor wisely — in tough times, that choice may protect your stock price.
At least that’s what the authors of a new study from Indiana University concluded after delving into the correlation between material weaknesses and engaged auditors in some 336 companies. Specifically, the study found that the negative impact of announcing an internal-control weakness could be cushioned by using one of the Big Four auditors.
“It’s a second-order effect,” says Leslie Hodder, former CFO of Levy Bancorp and an assistant professor at Indiana’s Kelley School of Business who co-authored the study. She says the Big Four impact is mostly one of perception. Investors, explains Hodder, are more apt to believe top firms have the most thorough auditing practices, which “can help companies maintain investor confidence when problems arise.”
Of the companies that reported an internal weakness in 2004, those with smaller auditors had a 3 percent negative impact on their stock, while the overall impact ranged from 1.5 to 2 percent. For example, Technology Flavors and Fragrances Inc., which employs BDO Seidman LLP as its auditor, experienced a three-day cumulative drop of 13 percent in stock price after reporting weaknesses in internal controls. In contrast, Bioanalytical Systems Inc., with Ernst & Young as its auditor, experienced a 2 percent drop in stock price after reporting internal-control weaknesses.
James Pajakowski, managing director of Protiviti Inc., cautions, however, that other factors help determine the impact of internal disclosures on stock price. “The impact of disclosures depends on investor confidence,” says Pajakowski, “which could be based on [faith] in the managing team, the nature of the disclosures, and how many disclosures are made at one time, as well as the auditor you choose.” Moreover, he says, the Big Four have become pickier in choosing clients and are basing their choices on how companies manage their risk. — Laura DeMars
Where the Listings Are
There may not have been many Googles in the mix, but last year was reasonably successful for initial public offerings worldwide — especially in Europe, where some 600 companies went public. One reason for the IPO strength there is the less stringent listing rules on the AIM (Alternative Investment Market), says M. Benjamin Howe, managing partner of investment bank America’s Growth Capital. Still, signs point to all indices welcoming newcomers in the next few months. “IPOs in 2006 will be better than 2005, and maybe substantially better,” he says.
|Number of IPOs in 2005 (YTD)||346||120||141||74||69|
|Total capital raised in 2005||$10.0b||$9.5b||$13.3b||$19.4b||$10.5b|
|Median amount raised in 2005||$9m||$64m||$58m||$191m||$69m|
|Median market cap for IPOs in 2005||$31m||$254m||NA||$651m||$74m|
|2005 IPO aftermarket performance (YTD)||7%||10%||(5%)||12%||8%|
|Note: IPO data through 12/31/05.
TSX=Toronto Stock Exchange; LSE=London Stock Exchange.
Source: America’s Growth Capital