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Hollywood Hits Up Wall Street

Film studios turn to Wall Street for financing; corporate social responsibility reports; a new IRS ruling reinterprets some tax-code provisions; Big Blue and the SEC; the IRS cracks down on tax-shelter abuse; and more.
CFO Staff, CFO Magazine
September 1, 2005

As film executives continue to bank on the combination of star power and tantalizing special effects, the production costs of summer blockbuster movies, like the Paramount/DreamWorks sci-fi thriller War of the Worlds, continue to soar. The adaptation of the H.G. Wells classic, starring Tom Cruise, is reported to have cost between $125 million and $135 million to make. Increasingly, film studios are turning to Wall Street to bankroll such budget-busting flicks and diversify risk.

Paramount raised $230 million last year to help cover production costs for a portfolio of films expected to be made in the next three years. With the help of Merrill Lynch's global structured-finance division, the studio created a vehicle called Melrose Investors to lure hedge-fund and institutional investors to finance up to 25 percent of Paramount's net production costs for each film. In return, investors will receive up to 25 percent of net revenues generated by each film. Paramount will finance the remaining 75 percent itself, or by partnering with other studios.

While film revenue securitization is not necessarily a new phenomenon, Michael Blum, head of global structured finance at Merrill Lynch, says institutional investors, like insurance companies and banks, are playing a more dominant role in Hollywood financing. "There's an increase in the appetite for this type of asset," he says.

Shareholders invest in a slate of films and choose from different classes of securities that usually include a mix of bonds and equity. "An investor backs a portfolio of films, so the successful ones offset the bombs," says Jay Eisbruck, team managing director of the Asset Financing Group at Moody's Investors Service. Investors will typically know which films, directors, and actors are involved in the films to be made in the first two years of the deal. After that, they rely on studio management to choose new projects.

The most common type of film financing is a line of credit. Marvel Entertainment secured $525 million in non-recourse financing that is backed by production and distribution rights for movies based on their vault of comic-book characters, including Captain America, due out in 2007, and the recently released Fantastic Four. "Marvel is currently pursuing a 100 percent financed arrangement through Merrill Lynch and other investors for as many as 10 films over eight years," says Marvel CFO Kenneth West. It is also counting on a mix of tax savings, direct sales, and promotional tie-ins to finance the films.

With box-office receipts down this year, Marvel will need all the help it can get. As more and more studios look to outside investors for financial backing, the real thriller could be how Wall Street fares in its supporting role. The results could determine how long it remains starstruck. — Jim Montalto

Financial Thrillers
Top-grossing films of 2005 (U.S. market, through August 7).
Star Wars: Episode III $378 million
War of the Worlds $225 million
Batman Begins $199 million
Madagascar $189 million
Mr. and Mrs. Smith $181 million
Hitch $179 million
Source: Box Office Mojo

Beyond the Bottom Line

In an effort to show that they can walk the walk on business ethics, more companies are issuing corporate social responsibility (CSR) reports that detail their environmental, labor, and corporate- giving practices. A study by the Social Investment Research Analyst Network (SIRAN) found that 40 percent of the S&P 100 issue CSR reports, up from roughly a quarter in 2002. "I get a new report from a different company each week," says Paul Hilton, portfolio manager at The Dreyfus Corp. and co-chair of SIRAN.


United Technologies Corp. is one of the latest companies to jump on the CSR-report bandwagon. Jim Geisler, vice president of finance, says UTC has been reporting various aspects of its corporate-responsibility progress for more than a decade and decided that with so much external interest in the subject, it was time to reveal its practices to the public in a single report. "More people on the outside are interested in what we are doing and how it impacts our bottom line," says Geisler.

One reason more companies are revealing their social practices is because socially responsible investors often require the reports. Intel Corp., which has been issuing environmental, health, and safety reports since 1994, takes great care to ensure its reporting is accurate. Intel also solicits feedback from end users of the report, says Dave Stangis, Intel's director of corporate responsibility.

Some companies are even having their CSR reports evaluated by outside auditors. Office Depot Inc. started the practice last year. Tyler Elm, director of environmental affairs, says outside auditing solidifies the company's reputation and sets it apart from the rest of the industry. — Laura DeMars


When Is Insurance Not Insurance?

Small businesses and other corporations that create captives as a way to garner a tax break may find that their efforts no longer qualify as insurance activities. A new ruling from the Internal Revenue Service reinterprets tax-code provisions that allow certain insurance companies to claim a tax deduction on premium income. Recent manipulations in the insurance market, such as questionable transactions between AIG and General Re, among others, have prompted the government to take a closer look at insurance arrangements.

The new ruling, issued in June, disallows the premium deduction for a company that is the sole client of an insurance company. Since such coverage fails to spread risk among more than one policyholder, the IRS maintains that the coverage does not qualify as a true insurance transaction. In effect, say IRS officials, these single policyholders are simply insuring themselves. In the eyes of the federal government, the transaction might be considered a deposit, a loan, a contribution to capital, or a noninsurance indemnity arrangement — none of which are tax-deductible — but it may not be considered insurance.

Of course, the best guidance on what, for tax purposes, constitutes an insurance arrangement remains the definition handed down by the U.S. Supreme Court in its 1941 decision Helvering v. LeGierse. The justices concluded that two criteria must be met: risk of economic loss must be transferred, and it must be distributed among several parties.

Although the new ruling "does not add a tremendous amount of knowledge" to the tax code, says Lehman Brothers tax expert Robert Willens, "it may be incrementally helpful." Willens believes that the IRS ruling was the agency's way of telling small-business owners that they "won't get away with this kind of activity anymore." — Marie Leone


Verbatim

"In recent months, [Federal Reserve chairman Alan Greenspan] has been given to talking about 'froth' in the property market — though he walks all around the whole issue. The man has difficulty actually mouthing the word bubble, I think. It is really difficult for him to form that word. It is kind of like a Baptist ordering a beer." — Paul McCully, Portfolio Manager, PIMCO


So You Say

In business, new ideas are rare. New jargon, in contrast, seems to spawn like guppies. American poet David Lehman once wrote that "jargon is the verbal sleight of hand that makes the old-hat seem newly fashionable." Consider the variants of "offshoring," itself a variant of "outsourcing," with which it is often confused. Outsourcing as a concept dates back to the 19th century, and even offshoring has several decades under its belt. But with the recent popularity of the practice comes a parade of terms to describe sometimes dubious variations on the theme. "Bestshoring" and "rightshoring" — coined by EDS and Capgemini, respectively — have something to do with actually thinking about where to send your work (rather than spinning a globe to decide, presumably).

Other terms remind you that you don't have to buy everything in one place ("twoshoring" and "multishoring") or that Canada and Mexico are foreign countries, too ("near-shoring"). After last year's offshoring backlash, a crop of politically sensitive jargon has sprouted. Firms can "same-shore" (outsource within the States), "inshore" (shared services), and "homeshore" (telecommute). — Don Durfee


Coffee, with Cream, Sugar, and Interest

Fair-Trade Certified (FTC) coffee has been a hit at upscale coffee sellers like Starbucks. But with the Venti skim coffee comes an interesting blend of financing: coffee importers that buy FTC coffee must avail credit to their suppliers, if asked, for up to 60 percent of the value of their purchasing contracts. That means if they buy $1 million in coffee, they're on the hook for supplying as much as $600,000 in credit.


The FTC imprimatur is licensed by TransFair USA, an Oakland, Calif.-based nonprofit that has expanded the label to tea, sugar, rice, and other agricultural products. FTC rules require coffee purchasers to pay a floor price of $1.26 per pound ($1.41 for organic coffee), well above the commercial composite rate, which was 86 cents per pound as of July 26.

Buyers must also provide the financing. Just this summer, Starbucks pledged $2.5 million in loan capital for the financing of farming cooperatives in Latin America and Africa, bringing the total it has invested in sustainable coffee financing to $8.5 million. (In 2004, Starbucks purchased 4.8 million pounds of FTC coffee.)

The credit is welcomed by small farmers, who often can't get loans from traditional channels. "There is a long history of coffee farms defaulting," explains Ted Lingle, executive director of the Specialty Coffee Association of America. There is less of a chance farmers will default on these loans, because of how they are structured. Roasters partner with lenders like EcoLogic Finance, based in Cambridge, Mass., which specializes in purchase-order financing (cash up front loaned to farming co-ops in proportion to purchasing contracts). When roasters buy coffee, their payment goes directly to lenders like EcoLogic, which first repay the principal on the loan, plus interest, then remit the balance to the co-ops. Equal Exchange, a $19 million wholesaler based in West Bridgewater, Mass., that sources 100 percent Fair Trade coffee, estimates that between 60 and 70 percent of its payments go through lenders like EcoLogic.

The loans are not purely altruistic. Purchasers of FTC get a reliable source of premium coffee in return. "There is a real business case for pre-harvest financing, in terms of receiving consistent supplies of high-quality coffee," says Rick Peyser, director of social advocacy for Green Mountain Coffee Roasters, a $137 million wholesaler based in Waterbury, Vt. — Ilan Mochari


Big Blue's Reporting Blues

As if valuing stock options weren't complicated enough, another snag has emerged: how to report the expense. As IBM can attest, it doesn't come easy.

In late June, Big Blue announced that the Securities and Exchange Commission was conducting an informal investigation into its "first-quarter earnings and expensing of equity compensation." IBM began reporting the cost of stock options in the first quarter of this year, ahead of the Financial Accounting Standards Board's requirement to do so by the first reporting period after June 15. The investigation may stem from IBM CFO Mark Loughridge's comments to analysts on April 5, in which he suggested that the options would reduce earnings by 14 cents per share. When the results were reported on April 14, option expenses cut only 10 cents per share. Some analysts immediately accused the company of intentionally misleading them on the options number to cushion the blow of disappointing earnings, which came in 6 cents below expectations.

Some attribute the inconsistency to the difficulty of estimating the options expense. "Whenever you're trying to calculate the fair-market value of something for which there is no market, it's going to be just a guess," says Colleen Cunningham, president and CEO of Financial Executives International.

The bigger issue, says Lou Thompson, CEO of the National Investor Relations Institute, is whether or not companies are using the best option-valuation method in order to satisfy analysts, investors, and the SEC. "I think companies will continue to have difficulties with this," he adds.

IBM seems to be putting its problems behind it, though. When the company released second-quarter results, not only did it beat analyst expectations by 9 cents, but the cost of expensing options, $221 million, was not an issue. — J.M.

IBM Equity-Based Compensation Expenses
Q1 2004 Q1 2005 Q2 2005
Stock Options $291 $228 $221
Employee Stock Purchase Plan $49 $18 $0*
Restricted Stock/Performance Units $57 $41 $42
Nonrecurring** $(12)
Total $396 $286 $251
Note: All figures are in $ millions.
*Employee stock purchase plan rendered noncompensatory in Q2 2005
**Related to sale of PC unit
Source: IBM

Helter-Shelter


The Internal revenue service is continuing its aggressive crackdown on tax-shelter abuse. In July, the agency announced that 80 executives and 33 companies have agreed to settlement terms to resolve cases of tax avoidance related to stock-option compensation.

The executives accepting the settlement agreed to pay full taxes on all of the option income, with applicable interest and a 10 percent penalty, which could add a total of $500 million to their taxable income. "The response reflects higher standards for corporate governance and less tolerance for abusive tax transactions," said IRS commissioner Mark Everson in a statement announcing the settlements. The executives, often with the help of their employers, transferred stock options to family-controlled partnerships set up for that purpose, with the hope of deferring tax on the proceeds for up to 30 years. The IRS estimates that another 19 executives who refused the settlement may have underreported income by a combined $400 million. They face a continuing investigation.

Meanwhile, the Public Company Accounting Oversight Board (PCAOB), which oversees audit firms, issued new rules governing tax services by auditors. The rules provide guidance on what types of tax services auditors can provide without jeopardizing their independence. Auditing firms that provide tax planning, "based on an aggressive interpretation of applicable tax laws," will lose their "independent" status. "These rules draw clear lines to distinguish inappropriate services that impair auditor independence," said PCAOB chairman William McDonough at a meeting to approve the new rules.

Auditors, however, may find that the rules aren't so clear. The regulations define an "aggressive" tax treatment as one that is "more likely than not" to be unallowable under applicable tax laws. That provision could still leave auditors guessing at how the IRS will view the treatment. — Joseph McCafferty


Net Minders

Now that players and owners have agreed to terms, the National Hockey League is back on the ice. But in addition to accepting lower salaries — both sides agreed to a salary cap — the players might need to find themselves some good accountants. That's because the cap will be linked to club revenues. More than 160 pages of the collective-bargaining agreement define hockey-related revenue and penalties for underreporting. To keep the owners honest, the players want a closer look at the books. The players' union can request an independent audit of any 20 of the league's 30 teams each year. Teams caught hiding revenue will face a $1 million fine and the loss of a first-round pick. — J.McC.


Deal Booty

CEOs and other top executives are coming under fire for the massive payouts they are set to receive when their companies get acquired. Critics say the exorbitant packages can influence companies to make deals that might not make the most strategic sense. The huge paydays are often due to instant vesting of stock options. In other cases, CEOs have built up large stakes in the companies they run, or, as founders, have large holdings. Below is a sampling of some of the largest payouts.


John Stanton, CEO James Kilts, CEO Bruce Hammonds, CEO John Zeglis, CEO John Chapple, CEO
Company Western Wireless Gillette MBNA America AT&T Nextel Partners
Buyer Alltel Procter &
Gamble
Bank of America Cingular Sprint
Payout $500M $164M $125M $27M $55M
Status Completed Approved Proposed Completed Approved



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