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Windows into Valuation

Microsoft weighs in on the debate over expensing stock options; the battle for shareholder proxy access heats up; health-care costs are still soaring; a conversation with FEI's Colleen Sayther; GM's record bond deal; and more.
CFO Staff, CFO Magazine
September 1, 2003

Microsoft Corp.'s July announcement that it would stop issuing employee stock options — and expense all existing equity compensation, including stock grants — represents a huge break from the rest of the technology industry. But if anything, the software giant is now even more embroiled in the contentious debate over whether — and how — to expense stock options.

Microsoft plans to allow employees to sell existing underwater options to JP Morgan, but so far the investment bank has offered just a fraction of the price Black-Scholes puts on them. Opponents of expensing say the bank's low bids prove that existing pricing models overvalue options. "When JP Morgan is willing to pay 25 cents and Black-Scholes says $7.97, it illustrates that current valuation methods don't work," says Kim Boylan, counsel to the International Employee Stock Options Coalition.

Current option-accounting rules allow companies to use either market price or models like Black-Scholes. However, historically, market prices haven't been available, because stock options have not been transferable. But some observers think Microsoft's move may presage the development of a real market. A record of those transaction prices "could be a key step in getting markets for options going," insists John Finnerty, a finance professor at the Fordham University Graduate School of Business, "and in helping value employee stock options for financial-reporting purposes."

This is all still speculation, but an actual market for trading employee stock options is a prospect that has long tantalized investment banks. Before Microsoft's move, Finnerty and others figured that creating a market would require complex derivatives contracts that could mirror the underlying options.

"Microsoft is doing what it does well, which is acting as a bellwether," says Eric Reiner, a managing director at UBS AG. Yet historically, finance has not been the company's strong suit — a fact it tacitly admitted in July when it placed CFOs at the head of each of its seven reorganized business units. Thus, if the software giant ultimately helps solve an issue that has challenged the brightest minds on Wall Street, it will be almost as ironic as the fact that it gave up stock options in the first place.—Tim Reason

What's an Option Worth?
Microsoft OptionBlack-Scholes*JP Morgan Price
$33$10.24$2.00
$42$8.46$0.60
$45$7.97$0.25
* Based on Black-Scholes assumptions in Microsoft's 2002 10-K
Source: IESOC



Ticker Tales

When word leaked out in late July that the Pentagon was working on a plan to create a futures market on the likelihood of such events as a terrorist attack, criticism was so harsh the plan was scrapped the next day.

The idea was that trading in futures based on political events could help predict and thus prevent them. And while terrorism futures might be a terrible idea, Hal Varian, a business professor at the University of California-Berkeley, insists the underlying concept is not as nutty as it sounds. "Markets do an awfully good job of forecasting many events and trends," he says.

Markets can aggregate many small pieces of information into a bigger picture. For example, orange-juice futures accurately predict cold weather in Florida, says Varian. And the Iowa Electronic Markets have been predicting political elections with great success for 15 years. "Changes in supply and demand move information quickly and efficiently," adds Robert Forsythe, co-founder of the market at the University of Iowa.


That doesn't mean predictive markets aren't susceptible to manipulation. Just like financial markets, they need to be regulated — which may be a reason that terrorism futures failed. How do you charge a terrorist with insider trading? —Joseph McCafferty

Ballots over Board Ways

If new Securities and Exchange Commission chairman William Donaldson gets his way, shareholders could have a lot more say in how companies are run, and who runs them.

The SEC issued a proposal in August that would dramatically change the proxy-balloting process. The agency is addressing the issue in two stages. First, it proposed requiring companies to increase the transparency of board nominations. Charles Elson, director of the University of Delaware's Weinberg Center for Corporate Governance, notes that there is little opposition to new disclosure about how companies choose their boards. This month or next, however, the SEC will address the more-controversial second stage: giving shareholders more access to the proxy process.

Under current rules, while shareholders may nominate candidates for director, companies do not have to put their names on the proxy ballot. That can make it difficult and expensive to mount campaigns for directors not endorsed by company management. "A few companies created these concerns by being serial ignorers," says Elson.

But some proponents of reform say that the problem is widespread. "The process is totally broken," says Ivo Welch, a professor of finance at Yale School of Management. "It's as if the inmates are choosing the prison guards."

Some companies are concerned, however, that giving shareholders more access to proxy balloting might increase companies' vulnerability to takeovers, or add directors with narrow special interests. "Much mischief and damage can be done if access to management's proxy is made too easy," argued D. Craig Nordlund, general counsel at Agilent Technologies Inc., a technology company based in Palo Alto, Calif., in a letter to the SEC. —Joseph McCafferty

Home Rules

A recent decision by a New York state court could have a wide-ranging impact on the nation's 32 million telecommuters and their employers.

In July, the New York State Court of Appeals ruled that a woman who had worked for a New York company from her home in Florida was not eligible to collect unemployment in New York. She had already been denied benefits in Florida, after her telecommuting arrangement ended when her employer requested that she move to New York and she declined.

The ruling sets a precedent in New York and could influence other cases in which telecommuters attempt to file for unemployment in the state where their employer is located, either because they were turned down in their own state or because the employer's state pays higher unemployment compensation. "The decision says that [telecommuters] are not at liberty to shop for the best state to collect unemployment in," says Laura Schneider, a senior partner at Boston law firm Hale and Dorr LLP. —Joseph McCafferty

The Never-ending Story

Two new studies confirm what CFOs already feared: health-care cost increases will continue to soar through 2004.

One forecast, by insurance brokers and consultants Aon Corp., estimates that health-plan rates will rise by more than 14 percent, making this the fifth year of double-digit increases. Bill Sharon, a senior vice president of Aon's health and welfare practice, says that trends in health costs typically go in five-to-seven-year cycles. "The end should be near, but experts are concerned that this cycle will last much longer," he says. He blames the usual suspects: the aging population, costly drugs, greater use of technology, and higher malpractice premiums. What's more, hospital consolidations and relaxation of managed-care controls have upped hospital costs. "That one is catching people by surprise," says Sharon.

But the overall jump is hardly a shocker. A study by insurance consulting firm Milliman USA expects rates for HMOs to rise 14 percent in 2004.

"There is no end to it on the horizon," says Helen Darling, president of the Washington (D.C.) Business Group on Health, an organization for large purchasers of health care. While the news is not good, Darling says that some employers' efforts are starting to show results. For example, there has been a sharp increase in the use of generic drugs. "There is a little bit of optimism," she says, "but there is still a lot of work to do." —Joseph McCafferty

Hyperinflation
Rate increase for '04
Medical *
HML14.7%
POS14.5%
PPO14.4%
Indemnity15.4%
Dental
PPO7.6%
Indemnity7.6%
Pharmacy17.7%
Vision3.8%
* Excluding pharmacy benefit
Source: AON Consulting




The Advocate

Colleen Sayther, who took over as president of Financial Executives International in March, comes to the professional association at a turbulent time for senior financial executives. FEI, with 15,000 members and 85 chapters, hasn't been as vocal as one might expect during the past year, when finance executives were hit with so much change. Sayther, former CFO of the North American operations of French advertising giant Havas Advertising SA and former chief accountant at AT&T Corp., is hoping to change that by increasing FEI's role as an advocate for finance executives.

What would you say is your chief duty as president of FEI?
Providing our members with the tools and a forum to be at the front lines of restoring investor confidence.

Has the role of the CFO changed in light of the accounting scandals?
Yes, in good ways and bad. In a good way, CFOs are more often at the bargaining table because their expertise in governance and corporate controls is valued a bit more. The bad thing is that because of the compliance and regulation demands, CFOs are not able to focus as much on operations and strategic thinking.

What are the top priorities of CFOs, and how is FEI addressing them?
Governance and ethical issues are clearly top of mind. To that end, we require members to sign a code of ethics with their membership renewal. And cost-cutting initiatives are still important. But clearly this year, the Sarbanes-Oxley Act is a priority. Most CFOs have a love-hate relationship with the rules.

What do you like about it, and what do you think is problematic?
What's good is the code-of-ethics requirement, which FEI played a part in putting together, and the financial-expert portion of the audit-committee requirements. On the other hand, there are some aspects of the legislation that require quite a bit of documentation and cost that otherwise might have been less formal, but equally effective, in the past.

Are you referring to the need to document internal controls?
Yes. The level of documentation that auditors are requiring is beyond what anybody expected. So you have to wonder, if the controls are there and management is comfortable with them, but they have to go through all this crossing T's and dotting I's to make sure it is auditable, how much does that add and will that address the governance issues and accounting fraud?

What's your view of the job the Securities and Exchange Commission has done?
They have been very open to listening and to understanding where the implementation of some of these standards is creating problems.

What is FEI's view on expensing options?
This issue is pretty divisive within the CFO community, depending on the industry. We believe that regardless of whether you voluntarily choose to expense options or you are against expensing them, we like the fact that you currently have an option. We've been through this before, and until we come up with a good valuation method, we don't see anything wrong with keeping FAS 123.

Where do you stand on rules- versus principles-based accounting standards?
A move toward principles-based standards makes a lot of sense. The rules-based approach that currently exists created an entire industry to help companies get around the rules — Enron was a good example of that. But as we move toward principles, we need to be careful that the audit firms don't become quasi accounting-standard setters.

Has FEI adequately brought the concerns of finance executives to the reform table?
I think so. We do a lot of that through our technical committees. And our committee for corporate reporting — the one that responds to FASB, the SEC, the IASB rules — has a due process that includes ballots to gather comments and determine the right approach. So they well represent corporate finance executives.

What experiences were significant turning points or milestones in your career?
Being at AT&T through divestiture and then trivestiture and having the opportunity to be on the front lines of three initial public offerings — two of which were the largest ever at the time — was invaluable.

Interview by Joseph McCafferty

Getting Out the Float

The average paper check now logs an astounding number of miles as it travels back to its originating bank for verification after it is cashed. The trip affords cash-strapped companies a few extra days between writing the check and ponying up the funds. But a new law, known as Check 21, is likely to shorten that journey, dramatically reducing float.

Check 21 gives banks broader authority to clear checks based on their electronic images rather than their physical presence. Experts say it will likely mean companies need to make cash available sooner to cover the checks they write. But it will also speed their own collections and could reduce fraud.

"This should take at least a day or two out of float, so money will be debited much more quickly," says Brian Black, managing director at the Bank Administration Institute, a Chicago-based financial-services industry organization. "But the ability to move information more quickly should also lessen the opportunities for fraud. If there's a problem, you'll see it almost immediately," he says.


The bill passed both houses of Congress as of late June and at press time was before a reconciliation committee to resolve the timeline for it to be effective. Regardless, Alenka Grealish, manager of the banking group at Celent Communications LLC, predicts that 83 percent of midsize to large banks will have image-clearing capabilities by 2005, up from less than 20 percent now. Although the transition will cost the industry more than$2 billion, Grealish projects that banks will save up to one-third of their current check-processing costs in the long run.

Generally, corporate executives see the law as a boon. "The checks we write will have float taken out, but hopefully there will be faster availability on the collections side," says Don Hollingsworth, assistant treasurer at St. Louis-based Ameren Corp., a $3.8 billion power company, and chair of the payments advisory group for the Association for Financial Professionals. The bill also encourages the legal acceptance of electronic check images, which most large companies rely on for record-keeping, he says. —Alix Nyberg

GM Pulls a Fast One

When General Motors Corp. summoned 55 investment bankers from 16 firms to the cafeteria of its Fifth Avenue office this past June — and piped in dozens more on speakerphone — it was clear the company had something big in mind. And it wasn't wasting any time on niceties. "There was no meal served; there was no alcohol — although some of them could have used it. Just some bad cookies," says GM assistant treasurer Sanjiv Khattri.

GM had been talking to individual firms about various deals it was contemplating, but few knew the full extent of its plans: the auto giant intended to raise $13 billion in the bond market in one shot. It would be the largest one-time U.S. debt offering ever, eclipsing the $11.9 billion WorldCom raised in 2001. "We wanted all of Wall Street working for us that week," says Khattri.

When the dust had settled, GM had surpassed even its own lofty expectations, raising a total of $17.9 billion in debt. The deal, which took a week to arrange, included $9.2 billion in GM debt and $4.3 billion in convertible bonds. GM's finance arm, General Motors Acceptance Corp., which rode piggyback on the deal, will take an additional $4.4 billion of the proceeds. "By offering debt in multiple markets, currencies, and maturities, we were able to appeal to a broader base of investors," says GM CFO John Devine.

The bulk of the proceeds will go to GM's pension plan, which the automaker says had a $19.3 billion deficit. "With an attractive interest-rate environment, we saw an opportunity to do a large chunk of that immediately and replace it with debt that matures in excess of 10 years," explains GM treasurer Walter Borst.

The financing will save GM from making a planned $15 billion in contributions to the pension plan in the next five years, as it hopes to shake off its reputation as the poster child for underfunded pensions. "This won't resolve the underfunded position entirely," says Devine, "but it's an important step in that direction." —Joseph McCafferty

A Little More Secure

The United States doesn't calculate how much Corporate America spends for homeland security — a stunning shortcoming, give that more than 80 percent of the infrastructure is in private industry's hands. And little of the nearly $40 billion in annual federal and state spending for security goes to the companies on the front lines, including those in such critical industries as electric power, chemicals, and transportation.

In the absence of spending data, a survey conducted among 33 corporate security officers by The Conference Board and sponsored by ASIS International, which represents security professionals, offers at least limited guidance, and the results are surprising. The survey indicates that there has been only modest uptick in security spending at the average company since 9/11. Indeed, the median spending for firms in critical and non-critical industries combined rose only 4 percent. The heaviest increase is in the Northeast, where median security spending rose 9 percent, compared with 2.8 percent elsewhere.

Of the security directors surveyed, 56 percent say they spend from $1 million to $10 million on security, while 15 percent spend more than $10 million. In a way, though, security spending says little about real deterrence of terrorism. Higher awareness is making workplaces less vulnerable, and many companies have been tightening security in ways that their budgets don't reflect — joining security-oriented industry groups and creating hacker-resistant IT policies, for example.

And the figures do not include higher insurance-related spending, according to Conference Board senior research associate Tom Cavanagh. A separate question shows that a third of risk managers have seen insurance costs rise from 20 percent to 49 percent, while a "remarkable 21 percent of risk managers report that their costs have at least doubled since 2001," says Cavanagh. —Roy Harris

Small Comfort
Changes in total corporate security spending since 2001.
Less
8.3%
The same
29.2%
1% to 9% higher
31.8%
10% to 19% higher
16.7%
20% to 49% higher
6.8%
50% to 99% higher
5.7%
100% higher or more
1.6%
Source: The Conference Board and ASIS International




What's in a Name?

Along with current efforts to solidify controls and revamp questionable policies, some companies have engaged in a bit of window dressing in their attempt to regain investor trust. A case in point: the recent proliferation of corporate governance officers, or CGOs.

Some 60 major companies have designated CGOs in the past year or so, according to Robert Lamm, CGO of Computer Associates International Inc. Lamm was hired last October--part of a corporate makeover after a bruising proxy battle and investigations by the Department of Justice and the SEC badly dented the company's image. Another example: Tyco International Ltd.'s senior vice president of corporate governance, Eric Pillmore, hired in August 2002 after a management shakeout.

Other examples also suggest the new moniker is as much about image as function. Although Lamm and Pillmore are both new hires, newly minted CGOs frequently are no strangers to their companies. Ann Mulé, CGO of Sunoco, and Suzanne Suter, CGO of Anadarko Petroleum Corp., are longtime corporate secretaries who added the CGO title to their business cards last fall.

Corporate secretaries have traditionally been responsible for "governance." These officers, typically attorneys versed in securities law, administer board meetings and serve as liaison between the board and management. The American Society of Corporate Secretaries notes that its members "are in a unique position to provide value to their chairmen and boards of directors by functioning as their company's [CGO] in fact, if not also in title."

Lamm, Suter, and Mulé are quick to explain that their CGO titles do not imply responsibility for compliance. They also aren't directly involved in financial reporting, although Lamm says investors with governance questions are now routed to him, rather than the finance department.

So what does the CGO title add? "It shows that companies really take their governance seriously," Suter, Anadarko's corporate secretary for 16 years, noted at a recent governance conference hosted by institutional Investor magazine. That impression, in turn, can have a financial payout, says Mulé. Will companies that appoint a CGO see a reduction in their D&O insurance? "Yes," she says. "But simply adding a CGO will not be enough to satisfy insurers. You have to show a solid history of good corporate-governance practices as well." —Tim Reason




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