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Double Standards?

How controlled companies avoid independence rules. Also: The Tortinator takes aim at punitive damages; stock-option legislation: politics or policy? the Fed warns on structured-finance deals; will the IRS finally step up enforcement?; more.
CFO Staff, CFO Magazine
July 1, 2004

With all the talk about governance and accountability, you might assume that all public companies have a majority of independent directors on their boards. Well, not exactly. In fact, a surprising number of companies, including Primedia Inc. and Weight Watchers International Inc., are identifying themselves as "controlled" in their financial reports, avoiding the independence rules entirely.

There's nothing sneaky about it. Under New York Stock Exchange and Nasdaq listing standards, controlled companies — in which more than 50 percent of the voting power is held by an individual, a family, or an investor group that votes as a block — are not required to have a majority of independent directors on their boards. They may also include nonindependents on their nominating and compensation committees.

The NYSE maintains that voting control generally entitles the holder to determine board makeup, and that it did not want to deprive holders of that right. But should controlled firms get to play by different rules than their peers?

It depends who you ask. At The Corporate Library, senior research associate Beth Young says controlled firms may be in the greatest need of outside board influence. "Often companies with controlling families are run more like private companies," she says. "The family can be very invested in the company's success, but there can also be instances where there's a lack of accountability."

But some controlled companies bristle at the idea that governance issues are ignored because they are family-run. Steve Hankins, CFO of Tyson Foods Inc., which is controlled by the Tyson family and does not have a majority of independent directors, says the company is committed to improving its governance — at its own pace. "[CEO] John Tyson is very focused on enhancing the board," says Hankins. "We are now 50-50, since we just added a new outside director." (Albert C. Zapanta, CEO of the U.S.­ Mexico Chamber of Commerce, became Tyson's latest independent member in May.)

Still, not all companies entitled to the exemption take it. The New York Times Co., for example, is controlled by the Ochs-Sulzberger family, but corporate secretary Rhonda L. Brauer says its board voted against designating the company as controlled. "We recognize that we're a public company," she says, "and we want to comply not only with the letter but also the spirit of all governance requirements." —Kate O'Sullivan

Name Game

Don't be surprised to see the names of jurors in the first Enron case pop up in press coverage of the trial. That's because a federal judge has denied the prosecution's request to keep them secret.

U.S. District Court Judge Ewing Werlein Jr. didn't find that the case — which concerns an alleged sham transaction of a Nigerian barge and does not involve the most notorious Enron defendants — warranted the measure, which is used in organized-crime cases. The prosecution hoped to avoid a repeat of the Tyco case, in which a mistrial was declared after a juror, who was identified in the Wall Street Journal and the New York Post, received a threatening letter.

The decision, says Michael Gass, a partner at Boston law firm Palmer & Dodge LLP, is in line with the trend to keep court proceedings as open as possible. "It's rare to keep the jurors' names secret," he explains. Other measures to limit jury tampering, such as sequestering the jury or closing the courtroom to the press, are also unlikely.

But jurors' names could still be kept secret during the trial of former Enron CEO Jeffrey Skilling. "It's such a high-profile case," says Gass. "And so many people were devastated by it." —Joseph McCafferty

Congress Weighs In — Again

It was bound to happen. Legislation to derail the Financial Accounting Standards Board's plan to expense stock options has taken shape on Capitol Hill. The question is: will it have legs?

In June, Rep. Richard Baker's (R-La.) bill to require companies to expense options only for their top five executives passed the House Financial Services Committee, 45­13. The bipartisan legislation, H.R. 3574, would also defer approval of FASB's expensing plan until the completion of a federal economic impact study.

The bill has provoked criticism from the finance community. The Financial Accounting Foundation, FASB's parent, warned Congress not to play politics with the standard-setting process — something it did quite effectively during the last stock-options showdown. "H.R. 3574 preempts and overrides FASB's ongoing effort to improve accounting for equity-based compensation through public due process," said FAF president Robert Denham in a statement. "Once Congress starts setting accounting standards through its political process, the integrity of accounting standard setting in this country will be dangerously compromised."

That hasn't stopped the momentum in the House, however. As CFO went to press, the number of co-sponsors for the Baker bill had grown from 58 to 118. And while similar legislation is expected to face tough resistance in the Senate, H.R. 3574 seemed destined for the House floor. "If I were a betting man," says Jeffrey Peck, chief lobbyist with the International Employee Stock Options Coalition, which has waged a concerted effort in favor of the bill, "I'd say that the full House will definitely consider this."


In Peck's view, the reason expensing is being taken up again is that "some of the emotion has died down" around the corporate scandals, allowing a "more rational analysis of where FASB is proceeding." Other insiders, however, say the issue is more about politics than policy.

Because this is an election year, Presidential politics could come into play in determining the outcome of the legislation, says Grace Hinchman, senior vice president at Financial Executives International. Specifically, she says, "this will really depend on how the Bush reelection is going and whether or not California is in play." If it is, she says, the priority will be to throw as many incentives at California, and its many pro-options companies, as possible, "not [to determine if] this is good accounting." —Lori Calabro

The Tortinator

Can California governor Arnold Schwarzenegger stem excessive jury awards against corporations? In May, his latest budget revision included an unexpected proposal to generate $450 million in state revenue by taking a 75 percent slice of punitive-damage awards from individual lawsuits.

Punitive damages have long been controversial, because the punishment meted out to the defendant is also an outsized windfall to the plaintiff, who in theory has already been "made whole" through compensatory damages. Currently, eight states have so-called split-recovery statutes mandating that some percentage of punitive damages goes to state treasuries or victims' funds, says Catherine M. Sharkey, an associate professor at Columbia Law School. Schwarzenegger's plan would create one of the strictest statutes in terms of the percentage seized. It would also allow punitive damages for corporate behavior to be levied only once, even if multiple lawsuits were filed.

Corporations hope both measures will limit suits. But don't say "Hasta la vista, baby" to your corporate counsel anytime soon. There is no empirical evidence that split recovery actually works, and it's significant that the California proposal first appeared in a budget.

"It's difficult to see how [California] could discourage punitive-damages claims and raise revenue at the same time," says Sharkey. Indeed, the California Legislative Analysts Office says Schwarzenegger is already shooting too high; a "more realistic estimate" of revenues from lawsuits would be $200 million, it says.

Moreover, says Sharkey, "if the state's recovery is 75 percent, that leaves a lot of room for defendant and plaintiff to settle, both pre- and postverdict." Even Victor Schwartz, general counsel at the American Tort Reform Association, sees the proposal as a mixed blessing. Since judges and juries will know the state's involvement up front, he says, "some believe that will make awards go higher." —Tim Reason

Taking Their Cut
Eight states already have split-recovery laws.
State% takenWho takes firstWhere state funds go
Alaska50LawyersTreasury
Georgia*75LawyersTreasury
Illinois****Unclear
Indiana75StateSpecial Fund
Iowa75LawyersSpecial Fund
Missouri50LawyersSpecial Fund
Oregon60StateSpecial Fund
Utah50LawyersTreasury
*Product-liability cases only.
**Determined case-by-case at court's discretion.
Source: Catherine M. Sharkey, Columbia Law School




Compliance Creep

It used to be that shorter monthly closes were considered a best practice. But these days, shorter is relative.

Thanks to increases in compliance demands and an internal focus on reliability, closes are actually getting longer. New data from The Hackett Group's 2004 "Finance Book of Numbers," in fact, shows that close times for median firms increased from 5.2 days in 2003 to 5.5 days in 2004. Even "world-class" firms — those that Hackett, a business advisory group, deems high in efficiency and value creation — have seen a 19 percent jump in close times, from 4.3 days in 2003 to 5.1 days in 2004.

"Monthly closes are taking longer, and they will continue to lengthen," says Richard T. Roth, Hackett's chief research officer. In fact, by year-end, Hackett estimates, closes will take almost six days. "Much of the problem," says Roth, is that "the pressure on CFOs for data and disclosure is worse, not better," both internally and externally.

What's happening, however, "might just be a bubble," says Steven M. Bragg, CFO of Premier Data Services and author of Just-in-Time Accounting (John Wiley & Sons, 2001). Because of the Sarbanes-Oxley Act of 2002, "companies are forecasting numbers to meet the Section 404 requirements," and that is adding to the process. What they're trying to avoid, he adds, "is having to run a fire drill if there is some control breakdown."

But how do longer closes mesh with new Securities and Exchange Commission rules to produce timelier financial reports? "Companies are being extraordinarily careful" with their numbers, and making up time on the back end, says Robert D. Kugel, a vice president at Ventana Research.

Kugel, however, sees an eventual return to shorter closes as compliance becomes automated. After all, he says, "shorter closes are the manifestation of good process execution, sound process design, and solid control systems."—L.C.

Giving Structure to Structured Finance

In May, the Federal Reserve Board announced new guidelines designed to rein in banks' sales of complex securitizations known as structured finance. Such deals were at the heart of the fraud that ultimately destroyed Enron and were arranged by several banks, including Citigroup and J.P. Morgan Chase & Co. at the behest of Enron's former CFO, Andrew Fastow. While Fastow has since been sentenced to 10 years in prison for his role in the case, Citigroup and JPMorgan Chase settled their federal complaints by agreeing to less-than-hefty fines.

The new guidelines, however, fall well short of prohibiting the kinds of deals that did in Enron. Instead, they amount to a list of steps banks should take to identify which transactions are likely to subject them to legal or reputational risk, which of course bank examiners themselves have some control over.

Curiously, along with the guidelines, the Fed released a letter from the Securities and Exchange Commission describing what activities amount to aiding and abetting securities fraud. The Fed originally distributed the letter — at the SEC's request — to financial institutions last December. Yet when CFO requested a copy of the letter as part of its preparation for a feature article on the Fed, an SEC spokesman said that public disclosure of such correspondence would be highly unusual.

(That article — "Playing Favorites," in the April issue — questioned whether the Fed was sufficiently concerned about the role that Citigroup and JPMorgan Chase played in Enron's failure.)

Observers have subsequently voiced dismay that the Fed and other banking regulators seem unconcerned about the interests of investors. In a letter to CFO, former SEC chief accountant Lynn Turner, now an accounting professor at Colorado State University, cited a meeting with the heads of the agencies, during which the chairman of one dissuaded him from proceeding with a proposal to require banks to more clearly disclose their loan losses to investors. And former SEC chairman Richard Breeden told CFO the same thing had happened earlier, when he had sought better disclosure of the value of banks' securities.

Perhaps the Fed's disclosure of the SEC letter to the banks means that bank regulators are taking such criticism to heart. Still, the Fed won't prove it is serious about this issue until the SEC initiates a case against a U.S. bank based on evidence turned over by bank examiners. —Ronald Fink

Where Have All the Audits Gone?

First the Securities and Exchange Commission got Congress to beef up its enforcement budget to stem the tide of corporate fraud. Now it looks like the Internal Revenue Service will be asking for similar consideration.

Back in 1998, Congress ordered the IRS to focus more on customer service and less on enforcement. The result? Audit numbers have dropped — dramatically. In fact, the IRS audited less than 1 percent of U.S. corporations last year, down from more than three times that number in 1997. And while the IRS audited a greater percentage of companies with assets of more than $10 million (12 percent), even that number fell by half during the same time period.


In a recent speech, IRS commissioner Mark Everson admitted that the agency had "backed away from enforcement." But the IRS maintains that the decreasing number of audits is also due to the time required to investigate complex tax shelters. That's one reason the agency has asked for $393 million for enforcement in its 2005 budget. The money, a 10 percent increase over 2004's budget, will be used to target high-income individuals, corporations, and offshore tax shelters in particular.

Until now, "the Clinton Administration and the Bush Administration have starved the agency," says David Burnham of Syracuse University's Transactional Records Access Clearinghouse, a nonpartisan research group. "They have not asked for enough money for the staffing needed to do this work." Enforcement staff at the IRS, in fact, has dropped 17 percent since 1998, and the work has gotten harder: the agency reports that more than one-third of new corporate cases opened in 2003 involved tax shelters.

Still, the General Accounting Office says even the new budget amount may not be enough. In its annual report on the IRS's budget request, the GAO notes that the agency requested more enforcement funding in the past five years, but spent some of that money in other areas. And a recent Treasury Department inspection found weaknesses in the agency's IT system.

The 2005 budget is still pending on Capitol Hill, but there is a larger issue at hand: have companies been taking advantage of the lax enforcement? "I think many companies are pushing harder not to pay taxes, because they see there's no enforcement," says Burnham. "I'm not saying that they're criminals, but everyone's being pushed very hard on the bottom line."

That pushing may soon invite the already enhanced SEC to step in, says Andrew Liazos, a partner with McDermott Will & Emery. "The IRS commissioner has been talking about sharing audit information with the SEC for purposes of enforcement action," he says. "Given the fact that they have to certify financial results, the last thing any CFO would want to do is [push too hard] in this area." —Kate O'Sullivan



Take My Car, Please

Like many companies, Philips Medical Systems tried to sell its used corporate vehicles to employees before resorting to dealer auctions. That proved difficult in 2001: Detroit car makers were offering zero percent financing and "there were literally thousands of rental cars on the market after the 9/11 tragedies," says Gage Wagoner, fleet manager at the Bothel, Wash.-based division of Royal Philips Electronics.

To solve the inventory problem, Wagoner and two other Philips executives approached Alpharetta, Ga.-based fleet-management firm LeasePlan USA Inc. to devise a tool — similar to eBay Motors — that sold cars to employees. And this spring, ReDrive, a partnership between LeasePlan and software maker Driveitaway.com Inc., began marketing Philips's cars internally in real time, with the potential of saving the company — and its employees — hundreds of dollars per vehicle.

ReDrive allows Philips to post vehicles on a customized Website 6 to 12 weeks before they come off lease. Included is information about the car's condition, financing availability, and delivery. But Wagoner concedes that "the biggest challenge is raising [employees'] comfort level about buying a car they've never seen."

The benefit to the company "lies in the gap between the retail and the wholesale price," says Bryan Calloway, senior vice president of marketing at LeasePlan, who adds that the difference averages $1,500 per car. The company can then pass on that savings to its employee customers. And companies broaden their buyer pool exponentially by offering vehicles to employees, says Driveitaway president George Muller. "Previously," he says, "the technology wasn't available to aggregate such a large number of buyers and vehicles."

Now if they can just do something about the price of gasoline. —L.C.




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