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Targeting Executive Pay

The SEC sets its sights on exec comp; restatements soared in 2004; will Blockbuster's gamble on eliminating late fees pay off?; reports of material weaknesses have not been exaggerated; and more.
CFO Staff, CFO Magazine
March 1, 2005

It looks like 2005 could really be the year that regulators get tough on executive compensation.

In recent months, Securities and Exchange Commission officials have issued strong words on the subject. For example, Stephen Cutler, the SEC's head of enforcement, told a conference audience last year that the commission would bring cases against companies failing to properly disclose and value perks. SEC chairman William Donaldson has also called for greater clarity in reporting. "Total compensation is obfuscated and is very difficult to determine," he said in one interview with Dow Jones News Service. "While much of the information is included in public filings, it is difficult to dig out."

Now the SEC is walking the talk. Its recent enforcement action against General Electric Co. for failing to adequately disclose Jack Welch's retirement benefits, and its investigation into Tyson Foods Inc.'s accounting for perks grant to retired CEO Don Tyson, signal the commission's tough new stance on executive pay.

"This is by far the most intense and multifaceted approach to addressing executive compensation that I've ever seen," says David Johnson, a partner in the compensation practice at Ernst & Young. "There are a lot of interested parties weighing in: the SEC, the [Internal Revenue Service], Congress, institutional investors, you name it." The SEC is emphasizing its desire for full disclosure of all aspects of executive pay, he says.

For companies, the lesson is to "err on the side of caution," counsels Johnson. One example is corporate-aircraft use, a marquee issue for those critical of executive perks. "Don't just say there is personal use of corporate aircraft; describe the use in terms of its materiality and incremental cost," he says.

The SEC may soon make recommendations of its own. Anne G. Plimpton, of counsel with McDermott Will & Emery LLP, says she expects to see rule changes as early as this spring. "When the SEC says this is going to be an area of focus, it not only means they're going to be looking very hard at disclosure, it means they're thinking about amending the rules," she says.

While awaiting further guidance, CFOs should conduct a thorough inventory of all the types of compensation that officers and directors receive, making sure to capture informal perks like tickets, club memberships, and even occasional use of corporate assets like aircraft and cars. "The point," says Johnson, "is to avoid surprises." —Kate O'Sullivan


Mulligans

For corporations, it's akin to a group "do-over."

Last year, some 414 companies restated their financials, according to a study by Chicago-based Huron Consulting Group. That's an increase of 28 percent over 2003, when 323 companies restated due to accounting errors.

The main culprit cited was Sarbanes-Oxley, especially Section 404. Revenue-recognition issues prompted 16.4 percent of the restatements and equity accounting forced another 16 percent.

Some believe other factors were at work. "First, you're never going to be able to police a lot of the games being played in boardrooms," insists Paul Geller, a partner at law firm Lerach Coughlin Stoia Geller Rudman & Robbins LLP. "Second, auditors are taking their jobs more seriously."

Regardless of why they are done, financial restatements still have nasty consequences. In January, for example, Krispy Kreme restated its 2004 earnings and watched its stock price tumble more than 22 percent.

Restatements also trigger class-action suits. Not surprisingly, 212 shareholder lawsuits were filed in 2004, up from 181 in 2003, according to the Securities Class Action Clearinghouse at Stanford University. —Laura DeMars


Late Fees, Lost Profits

After being hammered for years by competitors' ads and late-night TV jokes, Blockbuster Video did away with its much-reviled late fees in December 2004. For the company, it was a welcome counterpunch against Netflix and video-on-demand providers. For CFO Larry Zine, it was a "double gulp" moment.

"Any decision to give up profitability in the short term is kind of a big gulp," explains Zine, who says the company had expected to make $250 million to $300 million in operating income from late fees in 2005.

Still, Zine says he was quick to support the "bold" move — and back it with a $50 million launch — after marketing executives told him fees were the top customer gripe. "When anything this big comes down, it clearly requires cooperation between finance and marketing."

"It is a market-share game," explains Southwest Securities analyst Arvind Bhatia of the flat market for video rentals. Subscription models such as Netflix, he says, are taking market share "because customers hate paying late fees." Blockbuster's "no late fee" move undercuts that threat to its stores, even as it looks to acquire competitor Hollywood Video. It is also rolling out its own subscription model.


Blockbuster's new policy isn't as simple as it sounds. After eight days, a customer's credit card is charged the sale price of the movie. Return the movie after that, and the amount is refunded, less a restocking fee of $1.50. After 30 days, the sale is final. "There's always that concern," Zine concedes, that customers will be confused by the fine print. But, he counters, customers in test markets see the new policy as fair. "In the customer's eyes, [the policy] wasn't fair before," says Zine, particularly since the penalty for an unreturned movie was "significantly more than we were selling it for."

Zine says the lost fees are "certainly a huge investment," but he expects the resulting traffic in Blockbuster's revamped stores to offset any revenue loss. "There's a lot of money at stake," agrees Bhatia. "Test-market results suggest they will be able to offset it. At the national level, we don't know yet." —Tim Reason


Not the Time for Weakness

The mea culpas are coming fast and furious. In January, 27 companies, including Eastman Kodak Co., SunTrust Banks Inc., and Toys "R" Us Inc., warned that they wouldn't be getting a clean bill of health on their internal-controls audit, according to Compliance Week magazine. Experts say that was the right thing to do.

"We're telling companies that they should disclose as quickly as possible" if an adverse opinion is likely, said Steve Galbraith, a principal with Maverick Capital, a $7 billion hedge fund, at a recent 404 conference hosted by Stanford Law School. Trevor Harris, managing director at Morgan Stanley, agreed. "Analysts rely on what management tells us," he said. "If you are opaque about your control problems, we will be asking what this tells us about everything else management says."

Being up front has its drawbacks, however. A study by Cornerstone Research and Stanford Law School reviewed cases in which companies disclosed internal-control problems over the past year. It found that stock prices fell 1.5 percent on average when management explained the problem fully and 3 percent when it didn't.

Some companies are being hit even harder. Consider Dearborn, Mich.-based Visteon Corp., which on January 31 announced an internal-control problem as well as a restatement. Visteon's stock price fell 6 percent after the announcement and Fitch Ratings downgraded the company the next day, citing weak performance and the control problems.

Interpublic Group is one firm erring on the side of full disclosure. Citing the challenge of imposing controls over 800 locations, Interpublic in its third-quarter 10-Q described a number of "material weaknesses" its auditors had found in internal controls. "You have to go out with this information as early as you can," says chief accounting officer Nick Cyprus. "The later you are, the harder the marketplace will come down on you."

The good news is that for well-managed companies, any drop in stock price may not last. "We think there will be a dip in prices when companies disclose their material weaknesses," said Galbraith. "And where we see prices drop for companies that we are convinced are well run, we will be buying on the dips." —Don Durfee


Some of the 27 firms warning of material weaknesses in January:

Visteon
Scottish Re
Ceridian
Friedman's
Eastman Kodak
BJ Services
Sun Trust Banks
Hollinger International
Volt Information Sciences
Purco Life Insurance


Bad Debt and Then Some

It was bad enough for Waste Management Inc. when a delinquent customer — a hazardous-materials recycler — declared bankruptcy in the midst of payment negotiations. With the customer facing $10 million in state and federal environmental claims, the Houston-based firm reluctantly wrote off as bad debt the $200,000 it was owed. Then, a year later, it spent $90,000 to clean up hazardous waste the customer had wrongfully dumped into the company's landfill.

But Waste Management customer-support manager Gary White was astounded in late 2002 when the customer — backed by the court — demanded the return of $132,000 in payments it had made to Waste Management. "That's adding insult to injury," says White.

Written into the 1978 bankruptcy code to prevent debtors from paying off friends in the 90 days before a bankruptcy filing, the right to reclaim so-called preference payments has become "a huge issue," says Robin Schauseil, president of the National Association of Credit Management (NACM).

That's because creditors bear the burden of proving payments were not preferential, or, in other words, that they hadn't been paid off by a debtor that knew it would soon be filing for bankruptcy. Ironically, that's harder to do if the creditor loosened terms to aid a struggling customer. "You may try to help contribute to their turnaround and end up getting whacked for it," says David Carere, vice president, finance — credits and accounts settlement at Rich Products Corp.

In the food industry, where terms of 20 days are common, says Carere, "that means a preference demand could go back four cycles of turnover. It's possible for someone to lose a million on a customer bankruptcy but then get sued for $4 million."


The NACM says the claims are multiplying, too. Although intended to provide equal distribution among unsecured creditors, says Schauseil, the law now "is being used to drive money back into the estate to fund secured [creditor] payouts."

Others argue that the money rarely goes to creditors, but goes instead to lawyers who indiscriminately send claims to every payee on the bankrupt company's ledger. "It has become a profit center for bounty hunters," complains Valerie Venable, corporate credit manager for GE Advanced Materials. —T.R.


Protecting Employee Identity

Each year about 10 million people in the United States have their identities stolen, according to the Federal Trade Commission. In 2004, the number of complaints jumped 15 percent, making it the top-reported fraud for the fifth year in a row.

One way companies such as Nokia are trying to ease the pain of such violations is with personal-identity-theft insurance. There is certainly a demand for such coverage, which such companies as AIG, St. Paul Travelers, and Chubb now offer. In addition to the frequency of the fraud, victims of ID theft often face expenses that banks and credit-card companies will not cover. These include the cost of credit reports, lost wages because of time taken off from work to clear their name, and — ominously — attorneys' fees.

"If you are stopped for speeding and it turns out that the person using your identity is wanted for other crimes, you could be arrested by mistake," says Joseph Lester, product manager for identify-theft master policy at St. Paul Travelers.

ID theft also poses costs for companies. The average time people need to clean up their credit is 200 hours. Inevitably, much of that time will fall into working hours. "The employer is really an indirect victim of identity theft," says Nancy Callahan, divisional vice president for AIG Affinity Group Services.

The new policies (insurers began selling them to employers last year) typically cover out-of-pocket expenses, lost wages, and reimbursement of legal expenses. According to AIG, which has sold more than 50 of the policies so far, companies buy the coverage and offer it to employees free of charge. Depending on the level of coverage, the annual cost is between $1 and $3 per employee.

JoAnne Laffey, spokeswoman for global HR services firm Hewitt Associates, says her company's studies show that inexpensive but appealing benefits are growing popular with employers — particularly as companies transfer more of the burden of health-care costs to employees. "We're seeing more companies look at low-cost benefits that give a big bang for the buck," she says. "Adoption benefits are one. Not many people in the company will use them, but it's a feel-good for everyone." Unfortunately, lack of use won't be an issue with ID-theft coverage. —D.D.


Sentencing with Discretion

When Kenneth Lay, Richard Scrushy, and Bernard Ebbers go to trial this year, could they have more to fear from judges than juries?

That's an open question now that the U.S. Supreme Court has determined that mandatory sentencing guidelines are unconstitutional. In two recent cases, U.S. v. Booker and U.S. v. Fanfan, the deeply divided court ruled that the guidelines violated the Sixth Amendment rights of defendants. Now those guidelines are simply advisory.

Moreover, in doling out jail time, judges can take into account "factors that might previously have been excluded from consideration," says Ellen S. Podgor, a professor at the Georgia State University College of Law. Those factors could include education, family ties, and the civic contributions of the defendant. Such considerations may actually translate into reduced sentences in "outlier" cases, adds Podgor, since extenuating circumstances previously were not allowed and "white-collar crimes were lumped together with street crimes." Of course, in some notorious cases, says Douglas Berman, a professor at Ohio State's Moritz College of Law, "judges may use their discretion to make the defendants' lives even more miserable."

Overall, Podgor doesn't believe the rulings will make a difference in "the vast number of cases." After all, the guidelines have been in place for the past two decades. Still, says Berman, "every lawyer in a white-collar crime case has to reorient his or her view of the case in light of this ruling." Appeals will also become more subjective, because the rulings added a "reasonableness" test to determine whether a lower-court sentence should stand.

The decisions are far from the last word on the subject. Already both houses of Congress are preparing to hold hearings on the matter. Meanwhile, lower courts are trying to sort out the implications of the majority decision — written by Justice Stephen G. Breyer — such as whether the rulings can be retroactive and whether guidelines for corporations must change. The latter question, however, may not be particularly pressing, says Podgor. "After what happened to Arthur Andersen," she notes, "how many corporations risk going to trial?" —Lori Calabro



Equity's Siren Song

Note to CFOs of companies with substantial debt: continue to resist shareholder demands for equity buybacks or increased dividends.

That seems to be the message of a recent study of Federal Reserve data by London investment firm Smithers & Co. The study found that the balance sheets of the companies in the S&P 500 index have not improved nearly as much since the equity bubble burst in early 2000 as is widely believed.

True, the percentage of nonfinancial corporate liabilities as a percentage of total assets has fallen, from 50.3 percent in 1998 to 49.2 percent as of the end of third-quarter 2004. But that's still high by historical standards (see chart). More worrisome, according to the study, is that more than half of the change is due to rising real estate prices or what the Fed calls "statistical discontinuities." While the Fed does not define those discontinuities, Smithers suspects they reflect the nonrecognition of stock-option expense, understatement of pension costs, and lower-than-justified depreciation write-offs. Without the effect of those and of real estate values, the debt-to-assets ratio would instead have risen to 57.6 percent.

The main reason leverage hasn't fallen? Improved cash flow has been used to buy back equity dividends rather than repay debt. The study contends that rewarding shareholders in this fashion is unsustainable, as the payout ratio of both traditionally defined dividends and equity buybacks exceeds 100 percent of nonfinancial corporate profits, even without adjustment for those pesky discontinuities.

"The 2004 waiver, which allowed firms to keep underfunding their pension funds, is under attack," says Smithers principal Andrew Smithers. "It seems most reasonable to assume that deteriorating U.S. cash flow, combined with poor balance sheets, will inhibit much additional spending on either fixed capital or R&D, unless buybacks fall sharply." Ultimately, he adds, "this poses a threat to the stock market." —Ronald Fink




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