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Is the Big Four too big?; hire private jets by the hour; what a formal investigation by the SEC really means; why energy deregulation needs more regulation; the IRS is faulted for lax pursuit of tax offenders; and more.
CFO Staff, CFO Magazine
October 1, 2003
Audit-firm consolidation and—in the case of Arthur Andersen—extinction will result in higher fees, along with less competition, says a recent study by the General Accounting Office. But midsize companies, according to some finance executives, are already feeling the pinch.
"If we were to do an auditor search again today, we might not solicit bids from the Big Four," says the finance chief of a technology firm that recently switched from one Big Four auditor to another. The CFO, who asked not to be named, fearing auditor retaliation, says that with only four major firms left, midsize companies can't get a good deal on auditing. "There is still plenty of competition among the Big Four for big accounts, but we're not a top-tier account for them; we're a take-it-or-leave-it account."
Another problem, he says, is that Big Four firms are so risk-averse that they often turn down new business. And that's what really hurts the ability of small and midsize firms to achieve competitive Big-Four audit pricing. In fact, the GAO study predicts that increased risk aversion will begin to affect the ability of larger companies to convince the Big Four to bid for their business.
Of course, there are second-tier auditors, but the report finds that most lack the industry knowledge, geographic presence, and reputation to bid successfully for large accounts. One problem, the study indicates, is the lack of a middle ground: there's a big gap between the Big Four and the second tier.
To make sure the Big Four doesn't turn into the Big Three, the GAO report also suggests a return to previous enforcement standards in which partners and employees, rather than entire firms (as was the case with Arthur Andersen), are sanctioned for wrongdoing. "It is important that regulators and enforcement agencies continue to balance the firms' and the individuals' responsibilities when problems are uncovered and to target sanctions accordingly," the study notes.
Earlier this year, the Securities and Exchange Commission announced a new enforcement model in which it planned to hold an entire audit firm responsible for a partner's actions. —Kris Frieswick
In early August, the Internal Revenue Service officially stopped issuing private letter rulings (PLRs) for tax-free transactions. It's a dramatic shift. The yearlong pilot program, which could become permanent, may lead companies to scuttle any potential spin-offs without a solid business purpose beyond the tax benefit. That's because executives wouldn't know whether a spin-off meets IRS standards until it's audited—up to three years after closing.
The danger of getting it wrong, says Cravath, Swaine & Moore tax attorney Lewis Steinberg, is that the IRS could hit a company with a huge retroactive tax bill if a spin-off's stock appreciates and the deal is stripped of its tax-free status.
Some companies are purchasing tax-opinion insurance policies, which generally pay tax penalties, fines, and interest if a spin-off fails the tax-free test. In June 2001, Georgia-Pacific purchased $500 million worth of coverage to protect the spin-off and later merger of The Timber Co. with Plum Creek after the IRS refused to issue a PLR. Says Lehman Brothers's Robert Willens: "Since the IRS stopped issuing PLRs, companies are looking for other means of protection." —Marie Leone
Tired of commercial flights but unwilling to shell out big bucks for fractional jet ownership? There's an alternative: Marquis Jet Partners Inc., Sentient, Delta AirElite, and others let members pay a flat rate for a set number of flight hours on a variety of airplanes. "Our market is midcap companies, not the Fortune 500," explains Marquis executive vice president Kenneth Austin.
For around $100,000 and $300,000, depending on aircraft type, Marquis customers buy flight time in 25-hour increments. Much like a phone card, an annual prepaid travel card allows time to be subtracted. Only actual flying time is deducted, plus six minutes for each takeoff and each landing.
New York-based Marquis must be on to something: first-quarter revenues and flight activity rose more than 350 percent and 320 percent, respectively, from the same time period in 2002.
That news doesn't surprise Joseph Moeggenberg, president of Cincinnati-based Aviation Research Group/US Inc. "Companies are getting smart about how they use corporate airplanes," he says. Although the program is more expensive than individual commercial airline tickets, membership offers much more flexibility and convenience. The planes can be available on as little as a few hours' notice, 365 days a year, and can use airports that commercial planes can't. And unlike with chartered flights, customers pay only for time they use.
Marquis customer Jimmy de Castro, former president and CEO of AMFM Inc. (now part of Clear Channel Communications), says the arrangement has "the benefit of ownership without the tax implications." Clients don't own an asset, as with fractional shares, so membership is a T&E expense, not on the balance sheet. "The only negative," adds de Castro, now CEO of Chicago-based holding company Nothing But Net, "is how fast I burn through the hours." —Joan Urdang
Those Mysterious SEC Investigations
This summer, companies ranging from MetLife Inc. and the American Stock Exchange to video-game makers Activision Inc. and THQ Inc. announced they were part of "formal" investigations by the Securities and Exchange Commission into possible securities violations. Others, including Alstom, Tenet Healthcare Corp., and Freddie Mac, noted that the SEC had upgraded "informal" inquiries into formal investigations.
For investors, few events are more worrisome—or misunderstood—than SEC investigations. Because the SEC won't confirm or deny investigations, companies themselves must announce if they are being investigated. That has enshrined a largely meaningless distinction between formal and informal investigations.
"That can be very misleading," says Gregory S. Bruch, former SEC assistant director of enforcement and now a Washington, D.C., attorney with Foley & Lardner. "When markets move because someone announces that an investigation has been 'upgraded,' that's unfortunate. An investigation is an investigation."
Typically, company or press reports of formal investigations refer to a request by the SEC staff for subpoena power from the commissioners—known as a "formal order of investigation." But that's a rubber-stamp process, and subpoenas are a poor measure of an investigation's seriousness, says Bruch. Insider-trading cases, for example, require subpoenas (for phone and trading records), while major accounting-fraud cases could, in theory, proceed without subpoenas.
All investigations begin with entering basic information on "matters under inquiry" into an SEC database. In fiscal 2002, 479 investigations were opened, with formal orders sought in 300.
As it turns out, it's harder to close an investigation than to open one. The SEC closed about 100 more than it opened in fiscal 2002, but still had 2,302 cases pending at fiscal year-end. Companies typically choose to announce investigations because they are "material events," but few are anxious to remind the SEC when a case is languishing. Despite periodic internal efforts to reduce the overhang, says Bruch, SEC staffers are reluctant to close cases. "Once you open a case, you are responsible for it," he says. "You don't want to be the one that closed the preliminary investigation into WorldCom. So you put it aside." —Tim Reason
In the wake of the blackout that paralyzed customers in eight states and Ontario this past August, businesses that spent a few days in the dark—and even some that were spared—are rethinking their need for backup power systems.
Some CFOs, especially those in New York, report that they had already shored up their defenses after the trauma of 9/11. "We had 12 emergency generators here and fared very well during the blackout," says Joseph A. Pisani, CFO of Westchester Medical Center, a 1,000-bed facility in Valhalla, N.Y., that added power capacity after the terrorist attacks.
But companies that didn't fare so well in the blackout are wondering how they can prepare for future outages. "More companies are contacting us now, and we're helping them look at their vulnerabilities," says Frank MacInnis, chairman and CEO of Emcor Group, a Norwalk, Conn.-based construction company that designs and maintains backup systems. "Companies are asking themselves, 'How long can we afford to be without power?'"
While typical office operations can run for days on generators, and supplies for a setup cost less than $100,000, it might cost $400,000 to protect a 150,000-square-foot factory, says Glenn Ellis, president of Hitec Power Protection Inc., in Houston. Double that price, or more, for an uninterruptible power supply that relies on energy-storage flywheels to protect continuous-manufacturing and data-crunching processes.
Stewart's Shops, a Saratoga Springs, N.Y.-based convenience-store chain, was ready for a blackout last summer, as it had lost power in an ice storm several years ago. All locations have power-outage kits with such items as flashlights, batteries, and calculators. Still, two dozen diesel generators, rotated among the 100 or so blacked-out locations, saved the day. "We were keeping the North Country alive," says CFO David Farr.
Not everyone is convinced that full backup systems are needed. Mercer Management Inc. decided against the $40,000 or more that it would have needed for backup juice, even after a ferocious July storm knocked out much of its Memphis office. "It was a matter of expense," says Ken Patton, Mercer's president. "The only companies I saw using generators around town were Fortune 500 types that could afford it." He does plan, however, to buy backup power sources to keep Mercer's telephones operating through an outage. —Dale Buss
Why Deregulation Failed
Relatively few CFOs consider electricity a major expense, but all of them care when the lights go out. So none should be pleased with deregulation, which has thus far failed to produce lower prices for many commercial customers, yet has led to massive blackouts on both coasts.
Anticipating that deregulation would create separate power, transmission, and distribution companies, about 15 years ago utilities began deferring maintenance of transmission lines (the "grid") and curtailing new power-plant investments. When deregulation began—piecemeal and state by state—those systems were physically unable to handle the growing pains of a competitive market. Shortages led to market manipulation in the West. In the East, the recent blackout resulted in part from transmission lines being stretched thin by electricity trading, and from breakdowns in utility cooperation.
This is not the first time poorly regulated utility competition has hurt consumers. In the 1880s, New Yorkers risked their lives walking down the street or leaning against an iron lamppost. More than 40 electric, telegraph, and telephone companies competed in Manhattan, and when losing companies didn't maintain lines, falling and damaged wires quickly became a fatal hazard.
The state eventually forced those wires underground, but continued to encourage competition by designing tunnels beneath the streets that any utility could use. Federal regulation of U.S. utilities did not come about until 1935, when massive monopolies reigned. In exchange for a regulated rate of return, monopoly utilities agreed to provide unparalleled reliability. The resulting system—coupled with federally sponsored power projects and rural electrification during the Great Depression—helped foster 75 years of incredible economic growth.
That system is now being dismantled in the name of deregulation. But, as we learned a century ago, utility competition without regulation is dangerous. A free energy market requires oversight to ensure a level playing field and a stable supporting infrastructure. —Tim Reason
Little Hope for Shareholders
It wasn't the news Polaroid Corp. shareholders were hoping for. A court-appointed examiner assigned to look into Polaroid's financials has alleged that the now-bankrupt company manipulated its accounting to make it look more financially sound than it was. The findings give shareholders and pensioners of the Waltham, Mass., instant-photography company little hope of recouping any losses.
That's because the report, compiled by Perry Mandarino, appointed as examiner by U.S. Bankruptcy Court judge Peter Walsh in February, also says the company did not undervalue assets, even though it incompletely listed them in its bankruptcy filings and failed to file timely financial reports. So while One Equity Partners (OEP), a private-equity arm of Bank One, paid a mere $60 million in new equity for an estimated $700 million in assets during the July 2002 sale, the assets were not unfairly liquidated in the sale, the report said. There was a fair and open sale process in which all bidders had access to documents, says Mandarino. "Most bidders in these types of sales don't rely on filed financial statements anyway," he argues.
The report also says Polaroid probably should have declared bankruptcy sooner—the reverse of what shareholders originally alleged. They had claimed that management forced the company into unnecessary and premature bankruptcy, and handpicked the eventual buyer. Mandarino found that even though some shareholder accusations were true, the eventual sale price wasn't materially affected. "I think [Mandarino] has a strange definition of what 'material' means," says shareholder leader Stephen J. Morgan.
The findings might not have an effect on the sale of Polaroid's assets to OEP. But two family trusts that bought stock at the time of the accounting misstatements now have filed suit against Polaroid's auditor, KPMG, and three former Polaroid executives, alleging roles in the falsifying of financial statements. Securities and Exchange Commission investigations, and even criminal probes, could ensue.
The report says KPMG failed to warn investors of Polaroid's deteriorating finances with a going-concern qualification in its 2000 annual report. "Based on all the facts and circumstances, it was entirely appropriate" not to qualify the report, says KPMG's Greg Dvorken. —Kris Frieswick
IRS Faulted for Lax Pursuit of Tax Offenders
The Internal Revenue Service, known for aggressively hunting down tax offenders, is taking heat for its laggard pursuit of perpetrators of a common corporate tax-avoidance scheme. Although a number of offenders have been identified, the IRS has followed up on few, says a report by the Treasury inspector general for tax administration.
The tax scheme targeted by the IRS is the Employer Abatement Program. Some employers incorrectly claim that Section 861 of the Internal Revenue Code contains a loophole that can render some income wages nontaxable because they don't meet the code's legal definition of gross income. For a fee, promoters sometimes offer to prepare legal briefs justifying the scheme.
"Such scams are not new," says Robert J. Bricker, an accounting professor at Case Western Reserve University's Weatherhead School of Management. "Some naive employers—typically small ones strapped for cash—go along with this scheme to justify not withholding employees' taxes or paying the employer's share of payroll taxes."
The inspector general faulted the IRS's Small Business/Self-Employed Division for failing to take actions to prevent noncompliance, alleging inadequate controls over 247 of the 480 cases sampled (out of a total of 1,841). "These are 'slam-dunk' cases," says Jacob Friedman, chair of the tax department at New York law firm Proskauer Rose LLP. "There shouldn't be any delay at all."
Larry Langdon, who recently retired as IRS commissioner for the Large and Mid-Size Business Division and is now in private practice, attributes the problem to a lack of resources at the IRS, and says the cases are not that lucrative. About 70 to 90 percent of the employers are small and often on the verge of bankruptcy, so collection is difficult, he adds. "Go after the promoters of this scheme and put a few in jail," says Langdon. "That'll solve this problem real fast." —Milt Zall
A sample of 60 IRS Employer Abatement cases.
|Started within legal limits of 30 days||70%|
|Started within 41 to 263 days||13%|
|Not started, but past 30-day limit||7%|
|Timeliness determination couldn't be made||10%|
|Source: Treasury Inspector General For Tax Administration|
Into Their Own Hands
One company's shareholders are taking a novel approach to dealing with directors who, they allege, bilked the company out of millions of dollars. They are demanding it back.
Shareholders of Ullico Inc., a union-owned company that provides insurance and financial services to union members and others, called a special shareholders' meeting where they voted to remove all directors who failed to return profits gained on questionable trading in the company's stock. (Although the company is private, it issues stock that can be purchased by certain officers and directors and union-related institutions.)
The alleged wrongdoing was detailed in a report by James Thompson, former governor of Illinois, whom the board had hired to conduct a special investigation into the improper trading. He concluded that "a compelling argument exists" that some of the company's directors had breached their fiduciary duties when they manipulated stock offerings and repurchase programs for their own benefit. "They were given an opportunity to buy and sell the stock that most shareholders were not," says Damon Silvers, counsel to the chairman of Ullico.
The report shows that 18 board members made a total of $5.6 million from the sale of company stock. Robert Georgine, Ullico's CEO, president, and chairman at the time and former head of the AFL-CIO's Building and Construction Trades department, made as much as $840,000.
At the time the shareholder meeting was called, only six of the directors who had made questionable trades remained on the board. Three of them resigned immediately before the vote and one was removed shortly thereafter. Two of the company's directors, Morton Bahr and Martin Maddaloni, returned the money and remain on the board.
Maddaloni, who agreed to return $184,000 in profits, wrote a check for $50,000 and promised the balance after mortgaging property, says Silvers. "We believe they acted in an appropriate manner and did the right thing," he adds. "They deserve a lot of credit." Three others also returned money, but are no longer on the board.
Georgine, who, Silvers says, was persuaded not to pursue another term on the board, and other former board members have yet to return their profits. "The board has authorized the company to take the necessary steps to pursue the return of that money," says Silvers. For these cases, Ullico may be forced to try to get the money back the old-fashioned way—by going to court. —Joseph McCafferty
Cash Balance Unsteadied
Two court decisions could have a devastating impact on a class of pensions that, according to Federal Reserve economists, made up 11 percent of all defined benefit plans in 1998 and contained 30 percent of their assets.
A decision by federal judge G. Patrick Murphy of the Southern District of Illinois dealt a blow to IBM Corp., which converted to a cash-balance plan (CBP) in 1999. It had been sued by IBM pension participants. "The CBF [cash-balance fund] doesn't work within the long-standing statutory framework regarding defined benefit plans," wrote Murphy. "The 1999 plan looks like a defined contribution plan trying to pass for a defined benefit plan."
If upheld, the ruling essentially would outlaw CBPs, which became popular among large companies in the late 1990s, but have been criticized for discriminating against older employees. "Virtually every cash-balance plan would be illegal," says Carol Connor Flowe, a partner at law firm Arent Fox Kintner Plotkin & Kahn, in Washington, D.C.
In another case, Xerox Corp. lost a federal appeal in which it had hoped to reverse a lower court's ruling that Xerox underpaid employees in its CBP. Xerox used an improper calculation, ruled the appeals court, resulting in lower lump-sum pension payouts than required by pension-benefits rules. It ordered Xerox to pay nearly $300 million in damages.
Because the law appears murky, some experts believe only Congress can resolve the problem. Still, Eric Lofgren of Watson Wyatt Worldwide sees appeals sorting it out "not only in IBM's favor, but in the favor of all cash-balance plans." —John P. Mello Jr.
|In The Balance|
The largest plans that offer cash-balance pensions.*
|Company||Pension assets ($mill.)||Pension obligation ($mill.)|
|*Data from 10-Ks and annual reports for year ended 12/31/02.|