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Did Former Enron CFO Andrew Fastow get all he deserved? Also: why equity research is moving to India; the effect of Medicare reform on retiree benefits; Citigroup in the hot seat, again; the tax-friendly status of online commerce may be in jeopardy; more.
CFO Staff, CFO Magazine
February 1, 2004
Last month Andrew Fastow agreed to accept a plea bargain that will land the former Enron CFO in jail for a decade, while his wife serves five months and the couple pay a fine of at least $20 million. The deals had fallen apart earlier in the month over a federal judge's refusal to guarantee Lea Fastow, who pleaded guilty to tax evasion, the five-month term. A compromise was later reached that could add five months of house arrest to her sentence.
Andrew Fastow's 10-year prison sentence is one of the longest ever handed out to a white-collar criminal. Junk-bond dealer Michael Milken was also sentenced to 10 years after pleading guilty to securities fraud in 1990, but in the end, he served only 2 years.
Times have changed. "Federal sentencing guidelines have gotten a lot stricter," says Michael DeMarco, a partner at the Boston office of law firm Kirkpatrick & Lockhart LLP. He says that 10 years is probably close to the minimum Fastow, 42, could have received under the guidelines. And he is likely to serve at least 90 percent of it, since reduced sentences are now a rarity.
Certainly, 10 years is not easy time, but other white-collar criminals have gotten nearly as much for lesser crimes. ImClone founder Samuel Waksal was sentenced to more than 7 years for insider trading. And in January 2002, former Leslie Fay Cos. CFO Paul Polishan received 9 years for devising the financial fraud that left the Pennsylvania clothing company bankrupt.
By these standards, Fastow's deal looks like a good one. After all, Leslie Fay shareholders lost only $460 million and Waksal pleaded guilty to illicit trading of a mere $5 million in ImClone stock. Fastow, in contrast, masterminded a fraud that caused an $89 billion market-cap loss, deprived thousands of employees of their retirement funds, led to the demise of a Big Five firm, and contributed significantly to a bear market that lasted three years.
The relatively low sentence—Fastow was facing 100 years by some estimates—could be an indication that he can provide solid evidence against former Enron kingpins Jeffrey Skilling and Kenneth Lay. DeMarco says that level of cooperation is a key determinant in setting the length of a federal sentence. He also says that prosecutors usually learn exactly what testimony the defendant can provide before they cut a deal. "They're not going to buy a pig in a poke," he says.
No doubt former WorldCom CFO Scott Sullivan and former Tyco International CFO Mark Swartz are watching the Fastow case closely. His deal is a good indication of what they can expect to get. In this way, Fastow is making one last market, the market for time served. And once again, Andy got himself a hell of a deal. —Joseph McCafferty
Last to First
When is a CFO not entirely thrilled to see the company's stock price go through the roof? When it suddenly means that he or she will be working weekends.
That's the fate of Scott Youngstrom, CFO of Compex Technologies Inc. After the New Brighton, Minn.-based maker of medical devices received the first clearance from the Food and Drug Administration to distribute an electronic abdominal-fitness belt, its stock price shot up. But the appreciation was bittersweet: it put the company's market cap over $75 million—the threshold that the Securities and Exchange Commission is using to determine the deadline for compliance with Section 404 of the Sarbanes-Oxley Act of 2002.
The higher market cap ($100 million at the end of 2003) made Compex an accelerated filer, meaning the company would have to have audited documentation of its financial controls by its fiscal year-end of June 30, 2004. "Instead of being among the last to comply, we are now among the first," complains Youngstrom.
Worse, he says, it is still unclear what level of detail auditors will require and how much they will charge. Youngstrom does not relish the thought of being a guinea pig. "This is about to make my life miserable," he laments. —J.McC.
The offshoring trend has taken another surprising turn. Having successfully outsourced to India such back-office functions as IT, investment banks are now sending some of their financial analysis and research overseas. In recent months, firms including J.P. Morgan and Morgan Stanley have quietly hired Indian firms or set up their own subsidiaries in India to handle basic financial modeling and comparable analysis.
Two main factors are driving this trend. First, it's cheaper. According to Dushyant Shahrawat, a senior analyst with Needham, Mass.-based TowerGroup, a financial-services industry research firm, the fully loaded cost of hiring an experienced junior analyst in India is between $20,000 and $25,000, compared with between $85,000 and $90,000 in New York. Such savings are especially attractive now that banks are no longer subsidizing sell-side research with investment-banking fees.
Second, banks hope that by freeing senior analysts to concentrate on analysis rather than running numbers, they will produce better—and more—research. "The bank always has to have the equity analyst sitting in New York, being able to talk to CEOs," says Joseph Sigelman, co-CEO of OfficeTiger, one of the Indian firms serving Wall Street. "But if we can take away some of the very structured, repetitive tasks, the number of companies the analyst can cover increases significantly."
This will sound like good news for coverage-starved companies. During the past few years, there has been a steep dip in analyst coverage, particularly for small- and midcap firms. According to Thomson First Call, 6,100 companies had at least one analyst covering them in 1998; today that number is 4,142. Coverage will naturally increase as the economy improves, says Chuck Hill, Boston-based director of research at First Call, although not to the levels of the exuberant 1990s.
But will sending research to India quickly improve things for companies that have lost coverage? Probably not. Despite talk of severing the links between research and investment banking, sell-side analysts still have few incentives to cover companies that don't generate investment-banking fees for their companies. For now, at least, this will likely mean more-intensive analysis of the fee-generating Fortune 500, not broader coverage. "The focus is not to send your research abroad to cover more companies," says Shahrawat, "but to do a much better job with the companies you're covering now." And do it for less. —Don Durfee
The Medicare Reform Effect
As health-care costs increased, many companies cut back on the medical benefits they offer to their retirees. So when President Bush signed the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 into law in December, some claimed the legislation would mean the end of such benefits altogether.
That's because a provision of the act lets employers set up pretax health savings accounts (HSAs) for workers who have high-deductible plans. And, says Derek Guyton, principal at Mercer Human Resource Consulting, some companies may decide to offer HSAs instead of an outright plan for all retirees.
In spite of such predictions, however, many companies are taking a wait-and-see approach. Eastman Kodak Co., for example, which covers approximately 40,000 U.S. retirees, has seen its health-care costs for both employees and retirees increase by $121 million since 2000. But the company is not making changes to its plan just yet. "It will take us some time to sort out all of the [act's] ramifications," says director of worldwide benefits Rita Metras, "but we think it is a very positive move for retirees." She argues that the act will actually encourage employers to keep their plans. The incentives for companies—such as a 28 percent subsidy for those that offer prescription-drug coverage that is "actuarially equivalent" to that offered by Medicare—make the legislation attractive, says Metras.
Companies are also waiting before making any changes because there has been little regulatory, accounting, or disclosure guidance on how the HSAs and subsidies should be treated. Although the Financial Accounting Standards Board has issued interim guidance that defers any accounting for the effects of the act, its official position is not expected until later this year. —Joan Urdang
Citigroup Back in the Storm
Just when Citigroup was hoping it had shed the taint of its Enron-era dealings, it got sucked back in—by a black hole, of all things.
Shortly before its year-end bankruptcy filing, ailing Italian dairy giant Parmalat issued an explanation of a deal with a Citigroup subsidiary called Buconero LLC. Reported as an investment by a Parmalat subsidiary, Buconero was in fact a conduit for 117 million euros in camouflaged loans from Citigroup to other Parmalat subsidiaries. "Regrettably," notes a Citigroup official, buconero means "black hole" in Italian.
Regrettably, indeed. In an internal reform adopted in 2002, Citigroup pledged not to provide structured financing unless the client agreed to disclose the true impact—or "net effect"—of the transaction on its financial position. That was after Enron used structured financing from Citigroup and others to understate its debt by billions of dollars.
Citigroup spokeswoman Christina Pretto described the Parmalat deal as "appropriate," but added that "consistent with the net-effect policy Citigroup adopted in 2002, today we would do this type of transaction only if the client agreed to provide greater disclosure."
What the Parmalat case reveals is that Citigroup's net-effect reform applies only to new deals. That raises the question of how many structured-financing transactions are still out there obscuring corporate debt. Citigroup declined further comment.
The Parmalat deal, signed in 1999, wasn't set to expire until December 2004, and it had a renewal clause. Recent changes to U.S. GAAP should require U.S. companies to disclose such financings anyway, but those new rules have yet to be tested against the ingenuity of Wall Street's financial engineers.
In an interview in the November 2003 issue of CFO, Citigroup CFO Todd Thomson stressed the "change in tone and business culture since the go-go 1990s." Asked if the net-effect rule had forced Citigroup to walk away from deals, Thomson replied: "We initially had a couple of tough conversations with clients on the rule."
Thomson also said "the standard has changed" when it comes to considering an accountant's blessing of a deal as sufficient. But that too appears to be a prospective change—Pretto defended the Parmalat deal by noting that independent auditors approved the transaction's accounting treatment. —Tim Reason
Restarting the Spin Cycle
The return of the initial public offering market could unleash a flurry of spin-offs this year, especially among companies that have consolidated during the downturn. Several companies have already announced plans for spin-offs in 2004, including EDS, LSI Logic, and Motorola.
While the total number of spin-offs hit a 12-year low of just 21 in 2003, the tail end of the year yielded some significant deals that seemed to break the dam for 2004, says Mark Minichiello, a principal at Spin-Off Advisors LLC, an independent research firm based in Chicago.
The war, the adverse economy, and the uncertainty of the stock markets kept the deals at bay for most of the year, he says.
Many believed spin-offs would continue to be difficult when the Internal Revenue Service stopped the practice of issuing private letter rulings in August 2003. The suspension will continue for at least a year. But the upswing in the economy trumped concerns over the inability to get and IRS tax ruling, says Minichiello.
One of the most significant deals last quarter was the $575 million IPO spin-off of Overnite Corp. from railroad company Union Pacific. "The Overnite deal sent the message that it was OK to jump back into the pool," says Minichiello. The deal which was first entertained back in 1998, finally closed on November 5, 2003, and was repriced at $19, up $2 from its original price. Kathryn Blackwell, a spokesperson for Union Pacific, says the time was right for the deal.
There have already been six spin-offs announced for the first half of 2004, including Motorola's semiconductor unit and EDS's PLM Solutions, a software division. LSI Logic Corp., a Milpitas, Calif.-based semiconductor company, has plans to spin off its storage unit early this year.
"A lot of firms have restructured over the past couple of years, and now they can separate the units," says Minichiello. "Yesterday's merger is tomorrow's spin-off.—Kris Frieswick
The Mezzanine Machine
Investors are building up mezzanine funds, but companies are turning to them only reluctantly.
In September, Goldman Sachs announced that it had closed the largest mezzanine debt fund ever raised—$2.7 billion. Later that month, Castle Harlan, a middle-market private-equity provider, put the finishing touches on its $1.2 billion fund. The funds are now eager to finance deals, but companies have pursued the financing cautiously.
That's because the financing instrument, which fills the gap between equity and senior debt, comes at a steep price. Mezzanine is usually used to finance a specific transaction, such as a change of control—for example, when a leveraged buyout firm purchases a company—or an acquisition. Because mezzanine lenders take greater risks than their senior counterparts, they structure the deals with an equity kicker.
The experience of Aviall Inc., a Dallas-based aerospace-parts distributor, shows both the advantages and the drawbacks of mezzanine. CFO Colin Cohen says the management team turned to mezzanine financing after a high-yield debt transaction fell through in the wake of September 11. The company organized gap financing of $80 million from a group of investors, including Blackstone Mezzanine Advisors.
While news of the massive Goldman Sachs fund made a splash, industry experts say the asset class is simply coming back to life slowly along with the mergers-and-acquisitions market. "Compared with 2002, people enjoyed a better year in 2003, but that's relative," says Michael Hall, general partner at Norwest Mezzanine Partners. "The recovery is slow." —Kate O'Sullivan
Who'll Follow the Script?
This may or may not be the year companies finally rein in excessive executive pay. But they now have the tools to try.
In mid-December, an advisory panel sponsored by the Washington, D.C.-based National Association of Corporate Directors released a list of best practices that compensation committees and boards of directors can use for setting executive pay. Among the recommendations cited: the elimination of CEO contracts, a ban on compensation consultants working for both management and the board, and a requirement for executives to hold their employer's stock for at least six months after they leave.
The 34-member panel, officially called the NACD Blue Ribbon Commission on Executive Compensation and the Role of the Compensation Committee, included eight current or former CEOs, who—together with academics, governance experts, and consultants—devised the guidelines. The private sector group hopes if enough firms adopt the proposals, it will stem any government regulation. "Legislation is not the answer in this case," says William W. George, author of Authentic Leadership, former CEO of Medtronic Inc., and the commission's co-chair. "It's a matter of boards doing their jobs."
The report tackled some long-standing compensation-committee practices. For example, the panel recommended that committees hire the compensation consultant, in much the same way that audit committees now hire the auditors. Currently, says Robert B. Stobaugh, professor emeritus at Harvard Business School and vice chairman of the commission, many advisers are hired by the managers who stand to benefit from their recommendations. "That's clearly a conflict of interest," he says. Once hired, those consultants should set executive-pay packages that are consistent with internal equity, not simply based on external peer comparisons, says Barbara Hackman Franklin, a former Secretary of Commerce and the commission's other co-chair. —Lori Calabro
No More Free Ride?
The tax-friendly status of online commerce and Internet access could be in jeopardy: legislators are beginning to warm up to the idea of taxing Internet commerce more consistently. Currently, merchants are obliged to collect state and local taxes only for sales to jurisdictions where they have a presence, or nexus.
In November, the Internet Tax Non-discrimination Act (formerly the Internet Tax Freedom Act), which made such Internet access services as America Online tax-free, expired. Further efforts by legislators to make the moratorium permanent have come under fire from cash-strapped states, clouding the act's future. (At press time, legislators were reintroducing the moratorium in Senate bill 150 and House of Representatives bill 49 in the hope of making it permanent.) So far, most states have not started to collect taxes on Internet access services, but experts say they could start if the moratorium is not quickly reinstated.
Meanwhile, an initiative to streamline sales-tax policies among states is gaining momentum. The Streamlined Sales Tax Project, a model law that would standardize definitions of taxable goods across states and limit each state to a single sales-tax rate, has been ratified by more than 20 states and supported at the federal level by bills proposed in both the Senate and the House. The initiative would nullify the central argument for not requiring online merchants to collect sales tax—that keeping track of all the tax laws of all state and local jurisdictions would be overly burdensome—opening the door for collection of the taxes.
"It seems inevitable that there will be more regulation coming to the Internet. It's only a matter of time before E-commerce will be taxed with more predictability," says Kate Delhagen, principal retail analyst at Forrester Research.
One reason the states are eyeing Internet taxes is that online commerce is growing. Estimates for 2003 put total online commerce in the United States at more than $100 billion. "It's starting to add up to real money," says Delhagen. "This is millions of dollars to some states that they are missing out on." —J.McC.
An Industry Shoulder to Lean On
No two CFO jobs are alike. For this reason, a number of industry-specific finance associations have cropped up to provide networking opportunities and support to CFOs in the same industry.
There is the Private Equity CFO Association, for example, the Healthcare Roundtable for CFOs, and such industry associations as the Information Technology Association of America (ITAA), which have separate CFO components.
The last entrant into this space is the Indian Gaming CFO Association. The group, which is planning to hold its first roundtable in April, was founded by T. Drake Harris, former CFO of Viejas Casino. Harris says that CFOs of Native American casinos, which have grown rapidly in the past few years, face difficult issues that are foreign to other finance executives. "[These] CFOs felt like they had no one to talk to," he says. Meeting with peers keeps us from making the same mistakes over again."
Industry-based groups also offer finance executives a way to speak with one voice on topics that are important to specific industries. For example, the CFO Roundtable of the ITAA meets to discuss the members' position on the controversial topics of expensing stock options and revenue recognition.
Sandra Curry, CFO of Softseek, a software subsidiary of Fujitsu Ltd., says that CFOs are increasingly seeking out peers to discuss ever-changing regulatory issues. "In the past, these were conversations we might have had with our audit partners," she says. But since auditors are playing a less-consultative role, "an industry group offers a safe environment to discuss the issues."
Some CFOs may fear sharing information with their competitors, but Curry, a member of the ITAA's CFO Roundtable, says that technology executives are used to viewing their peers as partners and competitors: "Competition is how technology companies survive a rapidly changing environment; now CFOs are incorporating that into their role." —J.Mc.C.