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Floorless Debt

Plus, the "death spiral" pulls firms out of bankruptcy; is the office Lothario an embezzler?; fallen angels are increasing; Regulation FD is no excuse for dodging the press; FleetBoston sweeps out bad loans; and more.
CFO Staff, CFO Magazine
March 1, 2001

FLOORLESS DEBT
The Devil's Candy

A once-obscure debenture dubbed the "death spiral" is becoming a popular option for desperate companies whose only other alternative is bankruptcy. Also known as floorless or convertible preferred debt, the fixed-income instrument translates into extreme risk for all players.

"I dislike the term death spiral," says Jody Eisenman, CEO of Perrin, Holden & Davenport, a New York­based investment bank. "They are convertible Regulation D instruments," he says, referring to the Securities and Exchange Commission's private placement designation.

Nomenclature aside, the debt instrument usually works like this: The issuer gives the lender the right to convert all or part of the outstanding principal amount of the debt into common shares of the company. Because of solvency problems, the debt is almost never repaid, nor are the bonds likely to be called.

A typical conversion has some sort of discount off the average of the last several trading days of the stock, explains Eisenman. Interest accrued on the debt is also converted into common shares.

Herein lies the spiral. Essentially, the lender can exercise its right and sell shares into the market, forcing the price down and allowing the lender to acquire more shares at lower prices. In theory, the bondholders can ac-quire control of the company as other shares are diluted ad infinitum.

"Companies would be very ill-advised to take this type of loan," explains David Beim, a professor of finance at Columbia University's Graduate School of Business. "A death spiral precipitates a crisis."

This debenture has been making the rounds at a number of cash- strapped dot-coms, and was even on the books of eToys before the high- flying E-tailer went bankrupt. While the company was experiencing severe financial problems last year, it still "structured a very intelligent deal," says Alex Cappello, CEO of investment banking firm CappelloGroup Inc., in Santa Monica, Calif.

According to Cappello, eToys's management, not its investors, decided when the stock conversions would take place, and exerted tremendous control over investors' money. Few realize that when eToys announced the deal, the stockactually shot up, adds Cappello.

-- Jake Wengroff

WISH LIST

CFOs want a cut in the income tax rate, a pay-down of the national debt with the budget surplus, and additional interest rate reductions, says an Association for Financial Professionals survey.

Cheating & Cheating

If you suspect a colleague of marital infidelity, double-check his or her expense reports. So says Gary Zeune, president of The Pros and The Cons, a speakers bureau for white-collar criminals, in Columbus, Ohio. "Most embezzlers are con artists," says Zeune, who conducted an informal study. "Philandering goes with the lifestyle, and nobody saves up for a possible affair."

Some embezzlers need so much extra scratch that they can hobble an organization. Zeune cites a former executive director of the Natural Gas Supply Association who had a series of affairs over 15 years. His tryst tab ran so high that he had to lay off a third of his workforce to stay afloat. The moral: trifling liaisons can become serious finance issues.

"Having an affair isn't smart, but it's also not illegal," says attorney Michael Nosler of Rothgerber, Johnson & Lyons LLP, in Denver. "And many states have statutes to prevent employers from prying into an employee's private life." Zeune is aware of such laws, but says that if you overhear a married co-worker bragging about sexual indiscretions, "your embezzlement antennae should go up." 

-- Leslie Schultz

IN THE LAST QUARTER of 2000, banks tightened lending standards faster than they had in the past 10 years, says the Federal Reserve.

CREDIT DOWNGRADES
Paradise Lost

How many fallen angels can dance on the head of a pin? If the pin is on Wall Street, the total is climbing.

The number of fallen angels, or investment-grade companies that have tumbled to speculative grade, rose substantially in the fourth quarter of last year, according to Moody's Investors Service, based in New York. And expectations for the first quarter of this year are fairly bleak, says John Puchalla, a senior economist at Moody's.

Fourth-quarter 2000 produced 57 investment-grade company downgrades and only 24 upgrades. Among the noteworthy companies that fell from grace last year were Tommy Hilfiger (Baa3 to Ba1), HealthSouth (Baa3 to Ba1), Champion Enterprises (Baa3 to Ba3), and USG (Baa1 to Ba2).

Downgrades sometimes have an upside, though: they usually increase a company's credit risk, which means if company bonds are sold, investors will require a higher rate of return. "In some cases, downgrades are an overt trade-off by companies that view the credit drop as an opportunity to increase shareholder return," says Puchalla. He adds that companies can choose to increase leverage, for example, by debt financing mergers or equity buybacks, thereby betting that a higher credit risk will yield higher returns.


This silver-lining strategy is risky during market slowdowns, says Randy Julian, a money manager with Brook Street Securities, in Irvine, Calif., because if the market worsens, companies should focus on reducing debt.

To date, first-quarter 2001 has produced 40 investment-grade downgrades and only six upgrades. Firms whose ratings dropped included Southern California Edison, Pacific Gas & Electric, Saks, and Ryerson Tull. 

-- Steve Bergsman

ALL IN FAVOR

A Microsoft-Dell-Unisys team wants to "de-chad" elections with a soup-to-nuts electronic voting system that integrates voter registration, ballot casting, tabulation, and results reporting.

REG FD
Gag Order?

Finance executives: Are you sick of talking to the business press, but concerned that a "no comment" will look suspicious? Just blame Regulation FD. That's what a company spokesman did when he tried to sidestep an uncomfortable question during a recent CFO magazine interview.

Similar reports have started to trickle in to the Securities and Exchange Commission regarding companies that cite Reg FD restrictions as the reason they can't talk to journalists.

Reg FD, enacted in October 2000, bans selective disclosure of nonpublic information to market professionals or shareholders who are likely to trade on the basis of that information. But companies that blame Reg FD for their silence to the press are hoping that reporters haven't read the law. For the record: It does not apply to "persons who are engaged in ordinary-course business communications with the issuer, or interfere with disclosures to the media."

--Kris Frieswick

SEC REVIEW
Internal Affairs

Armed with conviction, but not a timetable, Sen. Phil Gramm (R­Tex.), chairman of the Senate Banking Committee, is taking on the Securities and Exchange Commission. In December, Gramm ordered a thorough review of U.S. securities laws to determine whether the statutes, some almost 70 years old, need to be updated, says committee spokesperson Christi Harlan.

Although nothing specific prompted Gramm to act, Harlan says that the order should not have come as a surprise. Two years ago, when he was named to head the committee, Gramm indicated that oversight was a prime objective, asserting that "Congress spends too much time writing laws and not enough time looking over existing laws." Gramm has no preconceived notions about the outcome of the review, but confirms that the analysis will scrutinize the Securities Acts of 1933 and 1934, in an effort to close the technology chasm created by time.

Gramm's action has the backing of the Washington, D.C.-based Securities Industry Association. Stuart Kaswell, the trade group's senior vice president and general counsel, says the settlement cycle issue underscores the relevance of the review.

To protect investors, the Securities Act of 1933 requires the physical delivery of a prospectus before a securities trade can be settled. The settlement cycle is currently three days, and Wall Street will soon squeeze it down to one day, explains Kaswell. As a result, the SEC must adopt new rules to ensure that investors receive pertinent information in a commercially feasible time frame, says Kaswell. "We want to protect investors, but we need to reconfigure the system to accommodate the shorter cycle." -- S.B.

AVERAGE TOTAL compensation of S&P 500 outside board members hit a record high of $100,807 in 2000, according to Towers Perrin.

107th CONGRESS
Balancing Acts

The congressional committees that wield the most power over finance- related matters are taking shape, and, thanks to a bipartisan deal in January, Senate committee memberships are evenly split between parties, while House committees have slim Republican majorities. In addition, the tight margin in both houses may give the freshman class of 2001 unusual clout.

Also watch the 107th Congress for some interparty bickering caused by a massive reorganization of the former House Banking Committee, now called the Financial Services Committee. Michael G. Oxley was named the new chairman, a political payoff for this Republican faithful. Interestingly, the committee strips much of the finance oversight from the Energy and Commerce Committee, which set off internecine tensions between the chairman of that committee, Billy Tauzin, and his party rival, Oxley.

"It is important that accounting issues and SEC oversight remain in one committee so that policy-making is consistent," notes Washington, D.C.-based Grace Hinchman, senior vice president, public affairs, of Financial Executives International. But while Oxley has jurisdiction over the Securities and Exchange Commission, he is unlikely to wrest oversight of the Financial Accounting Standards Board and accounting issues from Tauzin.

John D. Dingell, the ranking Democrat on the Energy and Commerce Committee, makes no effort to hide his contempt for the change. "The GOP's wholly partisan decision to move jurisdiction is misguided and asinine," he said in an official statement. "I hope the securities and insurance industries do not suffer the same fate as the savings-and- loan industry, but I won't be holding my breath."


Ah, the spirit of bipartisanship.

-- Tim Reason

CAPITOL HILL SCORECARD 
Who holds the gavel on finance-related committees.

Committee

ChairmanRanking Opposition Member # of Dem./Rep.# of Dem./ Rep. Freshmen
SENATE
Banking, Housing, Urban Aff.Phil Gramm (R­Tex.)Paul S. Sarbanes (D­Md.)10/103/1
Small BusinessChristopher Bond (R­Mo.)John Kerry (D­Mass.)9/91/2
Finance Chuck Grassley (R­Iowa)Max Baucus (D­Mont.)10/100/0
HOUSE
Energy and CommerceW.J. "Billy" Tauzin (R­La.) John D. Dingell (D­Mich.)25/300/0
Financial ServicesMichael G. Oxley (R­Ohio)John LaFalce (D­N.Y.)32/37*5/7
Small BusinessDonald A. Manzullo (R­Ill.)Nydia Velazquez (D­N.Y.)NA/18NA/7
Ways and MeansWilliam M. Thomas (R­Calif.)Charles Rangel (D­N.Y.)17/241/2

SOURCE: COMMITTEE OFFICES 
*One Independent on the committee

FINANCIAL ENGINEERING
The Good, the Bad, and the Innovative

In a financial maneuver not seen in almost a decade, FleetBoston Financial Corp. resurrected a new version of the old "good bank/bad bank" model when it unloaded $1.35 billion in troubled loans. The Boston-based bank sold the loans in January for $725 million in cash, plus $203 million in securities, to New York fund manager Patriarch Partners LLC. Patriarch, in turn, put the loans into a so-called bad- bank fund to work on recovering their value.

The technique was introduced in the 1980s when the Federal Deposit Insurance Corp. and Resolution Trust Corp. cleansed banks of bad debt by pulling out troubled assets and then dumping them into "bad-bank" funds, says Richard Gugliada, a managing director at Standard & Poor's. "The difference now is that the banking industry is deregulated."

FleetBoston used the capital markets, mainly securitization, to remove the stressed assets from its balance sheet. Securitization requires a large, reasonably diversified loan pool, a hurdle the bank cleared easily. In fact, FleetBoston CFO Eugene M. McQuade called the transaction a "preemptive action," and attributed the success of the deal to the bank's financial strength.


The technique is not for every company, warns Thomas McCandless, senior bank analyst at CIBC World Market Corp., which arranged the deal. To securitize the loans, a bank must substantially cut the value of the asset, a hit that is not likely to generate any income or profit for the company. "A bank needs revenue depth to manage the lost income," he says. Also, it must write down the bad loans to a truly marketable level, so existing reserves are protected from other losses. FleetBoston wrote down the prices fairly conservatively throughout the year, says McCandless, and the loans were sellable. 

-- S.B.

WORTH MORE THAN $700 million, Corning heir Amo Houghton is the richest member of Congress, according to Roll Call newspaper. 

REAL ESTATE
This Hard Land

As the economy softens, some companies are looking to shed real estate to raise cash, an idea that is casting sale-leaseback deals back to center stage. Although the concept is not new, recent developments in the capital markets have pushed more companies to "monetize" their real estate, says Gordon DuGan, president of W.P. Carey & Co., in New York.

DuGan notes that the real estate market remains healthy, so the corporate CFO is not leaving a lot on the table when a company sells properties and leases them back. The seller also moves interest and depreciation off its balance sheets, and replaces them with lower lease costs. But such deals are not tax-driven transactions, he stresses.

Carey focuses on "keepers," properties that the sellers plan to lease back, not empty buildings, and DuGan says that the fourth quarter of 2000 was the company's busiest ever: it handled about $180 million in such deals.

Selling real estate is one way for corporations to increase capital that they can then invest in core operations, says Jim Leslie, president of The Staubach Co., in Dallas. He predicts a rise in sale- leaseback activity as the economy weakens, because "companies want capital to weather the slowdown." Leslie also notes that, although corporations are not yet selling into a soft real estate market, he expects to see a 10 percent to 20 percent drop in some commercial property values in the next year or so.

He cautions that, useful as they are, sale-leaseback transactions constitute only one component of a capital management strategy for companies that are experiencing financial stress.

-- Ray Pospisil

TIFFANY ADDRESSES 
The most expensive office space in North America, by city.*

  1. New York (Midtown) $80
  2. Boston $79
  3. San Francisco $72
  4. New York (Downtown) $53
  5. Washington, D.C. $50
  6. Chicago $49
  7. Seattle $41
  8. Toronto $40
  9. Los Angeles $31
  10. Atlanta $29

*Cost per square foot, total occupancy
Sources: Dtz Debeham Tie Leung, The Staubach Co., and Aew Capital Mgmnt.

ELECTRIC SHOCKER

Solid-state LED emitters may replace the lightbulb, say Sandia National Labs techies, who claim that worldwide energy costs savings could reach $100 billion by 2005.

DISCLOSURES
An Open Book

After two years of research, the Financial Accounting Standards Board has concluded that many leading companies are providing "extensive voluntary disclosures" beyond what is required by GAAP and the SEC. Why? Better business reporting is useful to investors, and it leads to cheaper capital for corporations, says FASB's Ed Trott, the only board member on the research team.

But getting companies to disclose information may be difficult, especially when it comes to releasing bad news. And some executives cringe at the thought of releasing additional data that could thwart a competitive advantage. That's why the voluntary approach is the right idea, notes former SEC commissioner Steven Wallman, who is now CEO of FOLIOfn, in Vienna, Va. At this point, FASB standards would be premature, he says, given the fast pace at which markets are evolving. "If standards were imposed today," he asserts, "it would be a deterrent to innovation." 

--Marie Leone

EMPLOYEE CHURN
Money Isn't Everything

Employees are talking, but some employers aren't listening. New research by The Conference Board and Accenture (formerly Andersen Consulting) concludes that companies are trying to retain valued employees by offering them more money. While that doesn't hurt, compensation is neither the main reason companies lose key employees, nor is it the cure. Rather, limited opportunities, bad relationships with managers, and an uncertain work environment are the top three reasons employees leave, according to the study. Making people feel valued goes a long way to keeping them, notes Ty Hawkins, CEO of executive search firm Hawkins & Associates International, in Palm Springs, Calif.

CEOs ranked the shortage of key skills--especially in information technology--as their number-one worry. Despite the pressure this imposes, companies still seem to be "caught in a time warp." For example, 81 percent of the companies surveyed claim that their efforts to handle turnover are based on traditional measures, such as salary and benefits, while 66 percent say they are "still in the reactive mode." Furthermore, only 16 percent make managers accountable for turnover.


Who is most likely to leave? First in line are information technology and computer staffers, followed by technical experts (engineers and scientists), top performers, frontline workers, women, and minorities. Top executives and line managers may be the last ones out the door, according to the survey. -- Joan Urdang

CHEERS: At $158.21 per square foot, London's West End is home to the world's most expensive office space, says The Staubach Co.16

RETIREMENT PLAN AUDITS
Labor-Intensive

The past few months have been a roller-coaster ride for some defined- benefits administrators. They've been locked in talks with the Department of Labor about interpretations of the Employee Retirement Income Security Act (ERISA).

The talks were sparked by an audit conducted by the DOL's Kansas City, Mo., office, which uncovered fee-related ERISA infractions in 29 of 40 cases it examined.

The audit cost employers $6.2 million in plan reimbursements. But it also exposed an ambiguity in ERISA language concerning fee allocation.

Since the passage of ERISA in 1974, it has been common practice to charge 100 percent of an expense to either the company or the plan, says David L. Wray, president of the Profit Sharing/401(k) Council of America. How-ever, there are some cases in which plan administrators must divide certain maintenance expenses--such as tax-discrimination testing and plan communication--between the company and the plan.

Most of the infractions associated with the Kansas City audit were clear-cut situations in which employee plans wrongly paid for the employer's accounting and legal costs, says Alan Lebowitz, a deputy assistant secretary at the DOL. In a handful of the cases, however, auditors found situations in which the costs should have been split.

The Kansas City audit pushed company advocates to call for clarification. As a result of this, in January the DOL explained which fees can be fully charged to employee plans, and which should be divided. A set of illustrative, hypothetical case studies are now posted on its Pension and Welfare Benefits Administration Web site (www.dol.gov/dol/pwba). DOL auditors have the final say on the splits. The case studies also expand on the long-standing ruling that expenses incurred for activities related to the formation, design, and termination of plans cannot be paid by the plan. "Whether you agree with the agency or not, the clarification gives a clear understanding of where the DOL stands on specific issues," says Steff Chalk, president of Chalk 401(k) Advisory Board. John Eskew, CFO of Windermere Real Estate Services Co., in Seattle, concurs: "The rules have been vague," he says, "but I think the clarification will help."

Still, administrators may want to revisit their fee-allocation practices, or at least visit the DOL Web site. The agency has scheduled audits in its Atlanta, San Francisco, and New York regional offices, and expects to scrutinize up to 400 companies by October. 

-- Alix Nyberg

CYBER SECURITY
Taking a Byte out of Crime

If Elliott Ness could see it now. In January, the Federal Bureau of Investigation rolled out InfraGuard, its private/public network for sharing information on cybercrime. Already, 518 companies--including The Coca-Cola Co. and Delta Air Lines Inc.--have signed up to create an Internet neighborhood watch of sorts. Self-funded chapters are running at all 56 FBI field offices, and members share information via the Internet, seminars, and meetings.

A company's price of admission is an FBI security check. After that, InfraGuard provides such things as intrusion alert services, a secure Web site for communications about suspicious activity, a help desk, and sanitized versions of FBI crime reports that can be circulated to members without compromising the confidentiality of the company involved.

Many cybercrimes go unreported, because executives fear a negative reaction from investors, insurers, suppliers, and consumers, says Diane Fraiman, vice president of marketing at Sanctum Inc., in Santa Clara, Calif. That makes it difficult to calculate how much a company loses. However, Michael Erbschloe, a vice president at Computer Economics, in Carlsbad, Calif., pegs last year's business losses at $17 billion from computer viruses alone.

Better security can curb losses, but it requires companies to boost spending. Erbschloe says that the average corporation spends 2 percent of its revenues on information technology. Of that, only 3 percent is allocated to security, and 20 percent of that is spent on virus and firewall protection.

Skeptics point out that programs like InfraGuard are usually one-way streets, with little information flowing from the government. "There hasn't been a great willingness to go public with breaches, compromises, or other types of cybercrime activities," contends Bruce Murphy, CEO of Vigilinx, a digital security solutions firm based in New York. 

-- John P. Mello Jr.

NABBED

An Insurance Information Institute study says kidnapping for ransom hit a record 1,728 in 1999. It also reports that insurers now cover loss of trade secrets and legal and psychiatric fees.


LARGE COMPANIES pay best-of- breed IT executives an average of $434,400 annually, according to Janco's 2001 salary survey.

GLOBAL CONFIDENCE SURVEY
That Sinking Feeling

CFOs are searching for a reason to believe. In the short-term economy, that is. U.S. financial executives have a particularly dreary outlook on the domestic situation as they face an economic slowdown punctuated by the evolving policies of a new President, a West Coast energy crisis, and a dot-com meltdown.

The general uneasiness is captured in CFO's quarterly Global Confidence Survey, which polls financial executives in the United States, Europe, and Asia about regional and global economic issues. The first-quarter 2001 survey finds that 40 percent of the 81 participants are either concerned or very pessimistic about the global prospects over the next year.

In the United States, 50 percent of the CFOs expressed concern about the U.S. economy over the next year, a dramatic change from last quarter's 10 percent. Just 36 percent are very optimistic or confident about the year's prognosis, and that too is off the mark from last quarter's 67 percent. Only 10 percent claim to have confidence in the short-term global economy, while 45 percent say they are "concerned."

The decline in European and Asian confidence levels is also evident. Of the European CFOs, 34 percent are either very optimistic or confident about the short-term global situation, down from 71 percent last quarter. Only 10 percent of the Asian CFOs feel the same.

The longer-term future looks brighter. Sixty-five percent of the U.S. CFOs are very optimistic or confident about global prospects for the next five years; 75 percent of the European CFOs and 65 percent of the Asian CFOs concur. The five-year regional forecast is just as rosy. A staggering 87 percent of U.S. CFOs think the country's economy will bounce back in the next five years; 73 percent of the European CFOs and 55 percent of the Asian CFOs are very optimistic or confident about their respective economies during the same period.

What will keep CFOs up at night over the next year? In the United States, executives are worried about the economic downturn. In Europe and Asia, increased competition is of most concern. 

-- M.L




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