Naked Hunch

Overstock.com kicks its fight against short-sellers up a notch; the PCAOB debates the merits of mandatory fraud audits; state health-care reforms could cause headaches for Corporate America; and more.

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Overstock.com CEO Patrick Byrne, who made headlines last year when he blasted Wall Street short-sellers, has put his lawyers where his mouth is. In February, his company filed suit against 10 prime brokers, accusing them of intentionally manipulating the company’s stock through naked shorting. The suit names, among others, Bear Stearns, Citigroup, Credit Suisse, Goldman Sachs, Merrill Lynch, and Morgan Stanley. So-called naked shorting occurs when a brokerage sells stock it does not own and then fails to borrow the shares to cover the position, thus artificially boosting the supply of shares and deflating their price. The suit, filed in a California state court, seeks nearly $3.5 billion in damages.

In 2002, the same consortium of attorneys handling the Overstock case helped Jag Media file similar charges in a Texas court against 100 brokerages, only to have the claims dismissed. But this time, says one of the lead attorneys, Wes Christian of Christian Smith & Jewell, more information about the phantom shares is available, thanks in part to the Securities and Exchange Commission’s 2004 Reg SHO. “The evidence just gets better and better,” he says. Eight other companies have lodged similar complaints against brokers in state courts, Christian says, with more suits likely to follow; clearinghouses Depository Trust and The Clearing Corp. also face legal action.

Not all the suits involve companies whose stock was shorted. Last year, two hedge funds — Electronic Trading Group and the Quark Fund — filed claims against brokers for charging the funds interest on shares the banks never bought.

Despite all the activity, many are skeptical that suing will work. One Overstock.com director, John Fisher, resigned over his disagreement with the lawsuit. Other companies with naked-shorting problems are reluctant to do battle with the banks. Former True Religion Apparel CFO Charles Lesser (now a consultant with the company) is “very concerned” about his stock being a frequent target of naked short-sellers but prefers to focus on business fundamentals rather than pursue lawsuits, expecting that “over time, the shorts will go away” if performance improves.

Of the 10 banks contacted by CFO, 6 declined to comment and 2 claimed that the case is without merit. Experts say the banks are likely to avoid problems — regardless of the facts. “It’s very hard for companies to prove malfeasance by prime brokers,” says Josh Galper, managing principal of the Vodia Group, a consulting firm specializing in securities lending. “There is nothing obvious, short of turning the books upside down, that would show intent to defraud.” — Alix Nyberg Stuart

Long Campaign Against Naked Shorts

2005: Byrne sues Gradient Research for allegedly conspiring with a hedge fund to issue negative reports on Overstock.com’s stock, after blasting both (and financial journalists) in an earnings conference call.

2006: Byrne successfully lobbies Utah state legislators to pass a bill requiring brokers to quickly report trades that failed, aimed at curbing naked shorts.

2007: Byrne sues prime brokers. The SEC shuts an investigation prompted by Overstock.com’s 2005 lawsuit without filing any charges. Utah moves to overturn its bill.

Debating a Policy for Honesty

The Public Company Accounting Oversight Board is convinced that fraud is a major problem for U.S. firms and is determined to do something about it. That leaves audit and financial professionals worried about exactly how the PCAOB will tackle the problem — and how much it will cost.

At a February meeting of the Board’s Standing Advisory Group, experts who were quizzed on a variety of options largely dismissed the most extreme option — periodic mandatory forensic audits — as too expensive, and ineffective to boot. Brad Preber, managing partner at Grant Thornton, said the idea would be “outrageously expensive and [would raise] significant issues of potential liability because you’d be searching for something that you aren’t sure exists.”

But the tepid response has not dissuaded the PCAOB from considering some sort of requirement, according to associate chief auditor Greg Scates. “Fraud is a serious problem and has been for some time now,” he says, adding that the Board is currently struggling with two concerns: that auditors are not adequately complying with existing anti-fraud provisions in the accounting standards (a fact highlighted in a scathing report issued by the PCAOB in January) and that even if existing standards were followed to the letter a significant amount of fraud would still go undetected.

Some forensic-accounting specialists doubt that the PCAOB can create a truly effective standard. To develop accounting rules designed to uncover fraud, “you have to know what triggers to put in place,” says former KPMG principal Ellen Zimiles, now CEO of Daylight Forensic & Advisory, a firm specializing in management of fraud risk. Because the indicators of fraud are so variable, Zimiles says, “you need a detailed understanding of the industry and even of the individual company.”

As interested as the PCAOB may be, Scates says it will not take action hastily. “We want to make sure we get it right, so we are going to be cautious. We are not going to run out the door tomorrow with a proposed standard.” The number of SEC actions involving fraud has actually been trending down (see “Fraudian Slip” at the end of this article), but Scates says that “the numbers don’t tell the whole story,” because investigations of large companies require significant time to complete.

He anticipates several opportunities for industry to offer its views prior to the drafting of any new rules, but offered no timetable. — Rob Garver

Mixed Results

The recent volatility on Wall Street manifested itself in two ways for companies: stock values plunged, but some listing fees increased. Effective January 1, annual fees for companies that list on Nasdaq increased from $75,000 to $95,000 (for companies with more than 150 million shares outstanding) and to $45,000 (from $39,600) for companies with 50 million to 75 million shares outstanding. Companies in between saw moderate fee increases, as did those with fewer than 50 million shares outstanding. At the rival NYSE, which is holding fees steady for now, the prices are higher, ranging from $46,500 to $139,000 and up.

One source suggested the fee increases are intended to help Nasdaq fund future acquisitions. Mary Dunbar, a board member at the National Investor Relations Institute, says that “private-equity investors and shareholder activism by hedge funds are driving consolidation, which translates into fewer issuer listings to be had.” Nasdaq increased its fees to make up for the loss, says Dunbar. Nasdaq had no comment.

On the other hand, fees at the Securities and Exchange Commission are heading down. In mid-February, security registration costs dropped 71 percent, and securities and transaction fees fell 50 percent (such fees are priced per million dollars of stock sales transacted on the exchange). The SEC proposed the changes last year but needed congressional action to put them into effect.

Dunbar sees those cuts as a sort of Sarbox rebate program. “I believe this is an attempt by the SEC to do its bit to make U.S. markets more attractive and user-friendly,” she says, “offsetting some of the heightened regulatory and disclosure requirements that have seemingly made our markets less competitive.” — Kayleigh Karutis

Paperless Proxies

The long-anticipated “eProxy” ruling from the Securities and Exchange Commission will go into effect on July 1, to the relief of companies and their investor-relations departments. The new rule may allow companies to almost entirely bypass the costly process of printing and shipping proxy statements by providing the information via the Web.

“It’s definitely a step in the right direction,” says John Stantial, director of financial reporting for United Technologies Corp. With the new rules, UTC is likely to save about $1 million in shipping, graphics, and printing costs, not to mention what Stantial describes as “hundreds of man hours.”

Thomas Murphy, a partner with McDermott Will & Emery, says the benefits of the eProxy rules go beyond savings. They should also speed up voting and increase participation because most investors and shareholders are already comfortable using the Internet. According to the SEC, 10.7 million shareholders agreed to receive their proxy materials electronically last year and about 88 percent of shares voted were voted electronically or by phone during the 2006 proxy season.

There is one possible downside, says Jason Simon, an attorney at Greenberg Traurig: companies could see more shareholder fights because shareholders can now use eProxies to more cost-effectively pitch their own board candidates or bring other matters to a vote.

Still, Stantial says, the eProxy ruling is worth that risk because it paves the way for companies to go completely electronic. “Eventually, sending anything by paper will be seen as unconventional,” he says. For many, eventually can’t come soon enough. — Laura DeMars

Verbatim

“We have to welcome the great minds in this world, not shut them outÂ…. Our immigration policies are driving away the world’s best and brightest precisely when we need them most.”

— Microsoft chairman Bill Gates on Capitol Hill, March 7

Fill ‘Er Up

Purchasing cards are getting a makeover. Several banks, including PNC and SunTrust, are now peddling so-called unfunded p-cards that streamline vendor payments and disperse the ability to pay bills across the enterprise while providing centralized control over accounts payable.

An unfunded p-card, or “ghost card,” is held by the supplier and holds no value until a purchase order is approved. Approval triggers an automatic loading of the exact dollar amount onto the card, which suppliers can then access by swiping the card in their credit-card merchant terminal. The added controls and automatic reconciliation offered by such a system, says Greg Hammermaster, senior vice president of Treasury & Payment Solutions at SunTrust Banks, mean that p-cards finally have “a viable role in the payments mix.”

At Invacare Corp., a home-medical-care products company, about 400 suppliers have been given unfunded Visa cards over the past 10 months, says Christine Potoczak, manager of accounts payable. Since then, the company has paid for everything from drug-screening services to freight costs via the cards. Potoczak says the cards allow her company to take advantage of extended payment terms and also provide more security than the old system — a check in the mail. Proponents say that p-cards can reduce disputes, facilitate revenue-sharing programs, help reduce bank fees, and provide a “cash float benefit” because the billing cycle and payment terms are consolidated with the card issuer.

The cards are not a panacea, however, and will most likely coexist with ACH and check-payment services. Potoczak says that some suppliers will require encouragement and others may be reluctant to participate if they have already negotiated beneficial pricing and payment terms. Hammermaster acknowledges some “constraints,” but says that suppliers should not feel “they’re being beat up on” by customers who push for the use of p-cards. — Lori Calabro

States of Health

While President Bush devoted a portion of his State of the Union address to the issue of health care, many Beltway observers expect federal gridlock for the next 20 months. “It’s difficult to have dramatic change when the White House and Congress are controlled by different parties,” says Edgar “Jed” Morrison Jr., a partner at Jackson Walker LLP in San Antonio.

But major changes are already brewing at the state level. According to Ted Nussbaum, director of health-care consulting at Watson Wyatt Worldwide, health-care legislation is pending in about 30 states. Those states, Nussbaum says, are motivated by the fact that they spend billions of dollars a year to cover the medical expenses of the uninsured.

In January, California governor Arnold Schwarzenegger proposed extending health-insurance coverage to the state’s 6.5 million uninsured residents. To accomplish this, he would, among other steps, require individuals to carry health insurance, expand access to Medi-Cal (California’s Medicaid program), and enhance tax breaks for employers and individuals purchasing insurance. Massachusetts, Minnesota, and Oregon have ambitious efforts under way, while many others have or are exploring a range of options (see map at the end of this article).

This could result in what Nussbaum calls “a compliance nightmare,” as different states mandate different funding thresholds or tax penalties for failing to offer health insurance. Add in the confusion over whether certain state demands will be struck down as Employee Retirement Income Security Act violations and battles over whether stronger state laws can take precedence over federal laws (an issue affecting the Mental Health Parity Act of 2007) and health care could be a wildly moving target, gridlock or no. — Karen M. Kroll

Nix Degrees of Separation

Tuition-assistance programs (TAP) are an often overlooked employee benefit — overlooked by employers, that is. Employees understand the value of such programs all too well, often using them to underwrite a degree that will lead to a new job or even a new career.

The problem, according to E. Faith Ivery, founder of Education Advisory Services, is that most companies allow their human-resources departments to administer rather than “manage” such programs. They need to understand, says Ivery, that “these programs have a very strong financial component, which CFOs should be monitoring.” Given that companies spent about $20 billion on TAP last year, but 40 percent say they don’t know what impact that spending had, some fresh thinking seems called for.

Ivery cites one company that had an 18 percent turnover rate among employees participating in the tuition program, compared with a 2 percent overall rate. “They were spending all this money for employees to get degrees and then watching [those employees] walk out the door,” she says. Ivery says companies can cut TAP spending by 35 percent simply by limiting employees to schools and degrees that pertain to their current jobs and career paths. And companies could guard against attrition by rewarding students who complete degrees with a bonus, pay raise, or other compensation. That, she says, will motivate employees to finish degrees quickly (thus saving money) and stick around.

Diebold spent more than $650,000 last year on 284 employees who participated in its tuition-assistance program. By helping them plan an education track tailored to their career goals, the company saved nearly $12,000 per degree and cut the typical time to graduate in half. Marsha Friedman, strategic project manager at Diebold, says companies can cut costs by, among other steps, alerting employees to competency tests or life-experience credits that allow them to skip introductory classes, which can speed them toward graduation. — L.D.

Tapping In

87%: Companies offering tuition reimbursement

47%: Set an annual dollar maximum

$5,000: Median maximum

22%: No dollar maximum

Source: Hewitt Associates survey of 795 cos., 2006

Will ESOARS Fly?

The push toward fair-value accounting continues its fitful progress as a new method for valuing stock options wins approval but also raises concerns.

In January, the Securities and Exchange Commission signed off on the approach, dubbed ESOARS (Employee Stock Option Appreciation Rights Securities), which uses an auction process to assign a value to the options. The high bidder owns the option and receives a payment from the company for the ESOARS when the employee exercises the option.

In February, early press reports that the ESOARS formula produced option valuations just half those generated by the Black-Scholes-Merton model raised an alarm. Jeff Mahoney, general counsel with the Council of Institutional Investors (CCI), wrote a letter to the SEC requesting that the commission defer further approvals of companies’ use of ESOARS for 30 days.

Evan Hill, a vice president at Zions Bancorporation, which developed the ESOARS approach, says the CCI “got spooked by the media.” He contends that several glitches, including timing (the auction was held not on the grant date but on a date when the stock price was lower than the strike price) and technical difficulties, marred the test auction. Those problems, he says, have been resolved.

Still, Mahoney isn’t the only one questioning the ESOARS approach. Cindy Ma, a vice president at NERA Economic Consulting, says that in a market-based approach, investors have to determine a value for the ESOARS. Given that investors would not have as much information as the company itself, she says, they would “likely apply a higher risk discount or ascribe a lower value to the instrument.”

The SEC has acknowledged that some aspects require improvement and that each ESOARS auction would need to be reviewed. Nevertheless, while agreeing that more work is needed, Jack Ciesielski, publisher of The Analyst’s Accounting Observer, says, “I think we’re on the road to fair value.” — K.M.K.

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