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Backdaters Get Clocked

The backdating-options scandal widens; why some airports are getting into the energy game; when naked short-sellers attack; Congress tackles financial literacy; monthly financial statements; what readers think of the Enron guilty verdicts; and more.
CFO Staff, CFO Magazine
July 1, 2006

Charges of backdating stock options have swelled, with more than three dozen companies reporting investigations by the Securities and Exchange Commission for suspicious options-grant dates. At press time, the Department of Justice had served at least 10 issuers with subpoenas related to backdating.

CFOs at companies involved are feeling the sting. So far, five current or former CFOs — Comverse Technology's David Kreinberg, Mercury Interactive's Douglas Smith, Power Integrations's John Cobb, and Vitesse Semiconductor's Yatin Mody and Eugene Hovanec — have lost their jobs over the scandals.

The question at many companies, though, is whether the CFO is really to blame. For one thing, options were not expensed when most of the backdating allegedly occurred, and thus were not accounting items. "As a CFO, I had little to do with the stock option–granting process," says Chuck Noski, former CFO of AT&T and current board member at Microsoft and Morgan Stanley. Since the granting of stock options didn't trigger any financial consequence except for a footnote disclosure, he says, HR generally handled the details of the grant and recordkeeping. For a CFO to later fudge the date would be "a big violation," says Bruce Ellig, an executive-compensation consultant.

Backdating options alone isn't necessarily illegal. What gets companies in trouble is if their plan explicitly states that grants must be dated as of their board's decision. Options that start in-the-money, as they often did in these cases, also raise tax issues.

It is telling that so far CFOs at the majority of companies under investigation have not been incriminated, even when the CEOs have been. One class-action attorney who filed a suit against Vitesse's CFO even admitted he was not able to say what level of involvement the CFO may have had with the backdating. "Who knows if he was just a sacrificial lamb?" says the attorney.

However, CFOs are clearly expected to be watchdogs in such cases, regardless of explicit duties. Any breach of internal controls is likely "lethal" to a CFO, says Noski. Mercury Interactive forced out its CFO, Douglas Smith; the CEO; and general counsel, because they "knew or should have known" about the alleged backdating and "personally benefited" from it, according to a company press release.

Will the widening probes lead to more finance firings? Stay tuned. At least one study, by finance professors M.P. Narayanan and H. Nejat Seyhun at the University of Michigan's Ross School of Business, shows evidence that backdating practices persist, so CFOs may remain in the crosshairs. — Alix Nyberg Stuart


Market Timers
Companies under investigation for options backdating*

American Tower
UnitedHealth Group
Juniper Networks
Monster Worldwide
Safenet

*Partial list of companies that have received subpoenas from the Department of Justice


Under the Runway

Talk about developing additional sources of revenue. Dallas/Fort Worth International Airport may very well be sitting on a gold mine, or at least a natural-gas field.

The airport is knee-deep in plans to conduct exploratory drilling on its 18,076 acres, which lie on the eastern edge of the Barnett Shale, one of the country's highest-producing gas fields. "We've known about the potential gas field for a few years, but decided that now was the time to pursue it," says CFO Chris Poinsatte.

If it does prove successful, D/FW's land contract could yield a one-time cash bonus of at least $36 million, based on the minimum $2,000-per-acre bonus the airport initially set when the land went up for bid. It could be much higher, though: other municipalities in the area have earned $75 million to $90 million in similar deals. Add in D/FW's 25 percent royalty minimum, and natural-gas drilling could become one of its top revenue generators.

As the airline industry continues to struggle, the potential hidden resource comes at a good time for D/FW. Nearly two years ago, Delta Air Lines decided to close 90 percent of its hub at the airport. "With the airline industry the way it is, our organization has been trying to strategically diversify the revenue stream," says Poinsatte. The revenues from the project will be added to capital funds and will most likely be used to supplement the airport's budget, which is expected to face a deficit of $35 million this year.

D/FW isn't alone when it comes to airports looking below ground for new opportunities — Fort Worth Spinks and Denver airports have already tapped into underlying gas fields. D/FW's project is expected to be the largest to date for any airport in the country. Poinsatte says the natural gas can be explored at a relatively low cost. Currently, only 2 of the airport's nearly 1,700 employees have been dedicated full-time to the project. "Gas mining is not a core competency of ours," notes Poinsatte, "so we'll let a third party take care of the logistics, and we'll share in the revenues." — Laura DeMars



Airports Developing Fossil Fuel Projects
Dallas/Ft. Worth International Natural gas
Denver International Oil & natural gas
Fort Worth Spinks Natural gas
Tulsa International Oil
Will Rogers (Oklahoma City) Oil

Enron: End of an Era

The hand of justice may be sure, but it isn't swift.

Fifteen weeks after the trial first began, and 54 witnesses later, prosecutors finally secured guilty verdicts in the case against Enron's Kenneth Lay and Jeffrey Skilling. CFOs had little doubt about the outcome: a CFO magazine survey of 183 finance executives found that nearly all of them expected the verdicts. The defendants argued that aside from former CFO Andrew Fastow's thievery, Enron was a perfectly law-abiding and healthy company. Not surprisingly, few CFOs bought that argument. Once the curtain was pulled back, it was clear that Enron was a deeply troubled organization. And as most CFOs will tell you, an organization infected with ethics problems is rarely healthy at the very top.

Certainly, Enron has changed how companies operate. Some of those changes are for the best: nearly half of survey respondents say their managers are now more apt to ask tough questions about business performance. A study of workforce attitudes (2001–06) by HR consultancy ISR found a sharp rise in the number of employees who say their companies act ethically.

Other changes have been less constructive. Three-quarters of the companies CFO surveyed say they are spending more time on compliance — time that's presumably not being spent running the business — and 37 percent of respondents say their managers are more risk averse. Only a minority of CFOs think that the verdicts will deter future Jeffrey Skillings. Fifty-nine percent say there is at least a 50/50 chance that companies will engage in Enron-style fraud over the next 10 years. Indeed, three-quarters say that the lesson they draw from Enron is that regulation can't stop a determined fraudster.

As for Skilling and Lay, finance executives have little sympathy for them. The two are expected to be sentenced on September 11. Eighty percent of CFO respondents say that the likely punishment (12 to 25 years in jail) is appropriate or too lenient for Lay; 84 percent say the same for Skilling. One CFO had a better idea: forced employment at the SEC. — Don Durfee



The Longer View

Corporate America has a worsening case of short-termism. A 2005 survey of more than 400 financial executives revealed that 55 percent would delay starting a project with a positive net present value in order to avoid falling short of quarterly consensus earnings.

In response, a small group of businesspeople has set out to find a cure. In May 2005, the Business Roundtable Institute for Corporate Ethics at the University of Virginia and the CFA Centre for Financial Market Integrity created a task force to recommend ways to combat the fixation on short-term performance at publicly held companies.

The task force's recommendations, released last month, fall into five broad categories: earnings guidance, incentives and compensation, leadership, communication and transparency, and education. "In each, we talked about the role that the others can play," says Matthew Orsagh, senior policy analyst with the CFA Centre. For example, moving away from a focus on quarterly earnings would require compensation plans and investment materials centered on long-term value creation.

Panel members aren't advocating additional regulation. Instead, Orsagh says they hope market participants will take the lead in concentrating on sustained value creation, not short-term performance. — Karen M. Kroll


Frequent Filer

Progressive Insurance doesn't provide earnings guidance. Instead, the insurer provides something few other companies do — complete financial statements to the public every month.

Plenty of companies give monthly sales figures or financial summaries, but Progressive is thought to be one of the only companies to provide a full set of financials. "We don't play the earnings game," says treasurer Thomas King. "But in our eyes, we do something better by laying all our cards on the table each month."


King explains that the company doesn't want earnings guidance to influence how loss reserves, which can have a massive impact on earnings, are calculated. "We want actuaries to be able to make adjustments without any concern over the accounting effects," he says.

The statements are unaudited and released about two weeks after the end of each month. King says they don't put any extra burden on the finance department, nor do they require additional staff. In fact, he says, this approach makes the quarterly close easier, because "we don't have the craziness of trying to get the quarterly financials out the door." King says the company just adds the last month in, and then the statements are ready to go.

Progressive, which began providing the monthly financial statements in 2001, says investors welcome the frequent reports. And, adds King, the monthly financials don't lead to a focus on the company's short-term results. "Investors get good insight into where we are each month, so there are no surprises," he explains. — Joseph McCafferty


Don't Know Much about Liquidity

If some members of Congress get their way, terms like "Sarbanes-Oxley," "securitization," and "liquidity" could soon become more entrenched in the American lexicon. A cross-governmental body, known as the Financial Literacy and Education Commission (FLEC), is pushing to place financial literacy alongside staples of education like reading, writing, and arithmetic.

It could take some time. While FLEC, a commission that cuts across 20 federal agencies including the Securities and Exchange Commission and the Federal Reserve, was established by Congress in 2003, it has kept a low profile until recently. In May, the Senate Committee on Banking, Housing, and Urban Affairs held hearings to discuss FLEC's agenda of boosting financial literacy in the United States, educating investors, encouraging "plain English" disclosures, and protecting the growing number of seniors from investment scams.

At the hearings, SEC chairman Christopher Cox noted that a growing population of retirees is being targeted by financial scam artists. He called for more education and scrutiny of "free lunch" investment seminars aimed at seniors. "Sadly, some industry professionals target seniors for inappropriate investments," Cox testified.

Sen. Daniel Akaka (D-Hawaii), a proponent of financial literacy, says progress is being made on promoting more-user-friendly investment resources. "I've noticed that the materials are becoming less complex," he says.

Colleen Cunningham, president and CEO of Financial Executives International, says regulators could benefit from simplification, too. She hopes FLEC's efforts will help reverse an increasingly complex regulatory environment. For example, she says many companies have struggled with FAS 133, the accounting standard on derivatives that runs more than 800 pages. "If the best and brightest have difficulty following the standards," she notes, "it's that much more difficult to explain them to investors." — Allan Richter


Verbatim

"A wise man once said you should pick battles that matter, but are small enough to win. This battle mattered, but it was too big to win." — Carol Tomé, CFO of Home Depot, explaining that the company would return to the normal format for annual shareholder meetings. The retailer was widely criticized for the format of this year's meeting, which was not attended by most directors and did not allow for shareholder questions. (See www.CFO.com /governance for the full story.)


Attack of the Naked Shorts

Short selling has always been a despised but accepted fact of life for public companies. More recently, though, an increase in naked short-selling — that is, when traders sell stock short without borrowing it first to cover the position — has wreaked havoc on some companies. Vonage's recent IPO disaster, for example, is thought to be the work of naked short-selling by hedge funds. The attacks, often accompanied by vicious rumor campaigns, have been so bad that one company was forced to change its name after being targeted.

As naked short-selling becomes more widespread, regulators are looking at ways to combat the practice. In May, Utah adopted a law that fines brokers that facilitate naked short-selling. The amount can range from $10,000 a day to millions of dollars to cover all unsettled trades. Other states could soon follow Utah's lead.

Naked short-selling occurs when brokers fail to deliver securities to the buyer within the typical three-day period after "selling" shares by sending IOUs through a stock clearinghouse. The increase in selling volume, unhindered by shares available to borrow, can send the stock price into a tailspin. The practice is usually considered illegal, but not always: a loophole in federal securities laws gives market makers that sell short "thinly traded, illiquid stock" extra time to obtain the securities for delivery, according to the Securities and Exchange Commission.

In January 2005, the SEC enacted a new rule, known as Regulation SHO, to guard against naked short-selling. The rule requires all exchanges to provide a list of stocks that have been shorted and not delivered to a buyer for 5 consecutive trading days. After 13 trading days, the broker or dealer must settle the trade by buying securities "of like kind and quantity." So far, Reg SHO has not always been effective at discouraging naked shorting, says Tom Ronk, chief executive of Buyins.net, a Website that tracks short selling. He thinks the Utah law will help. "It's getting too expensive to not properly borrow stock," he explains.


It could be too late to help some companies. Shares of Nanopierce Technologies tumbled in 2001 when it became the target of naked short-sellers. The organic-feed company survived by restructuring and changing its name to VytaCorp. But CEO Paul Metzinger says other companies suffer a far worse fate: "Naked short-selling leads to the demise of a lot of small companies." — A.R.


Long Live the Local Branch

A few years ago, the outlook for local bank branches was grim. The conventional wisdom was that small-business banking would move online, eliminating the need for trips to the local branch. But that hasn't happened. Instead, small-business owners and managers are making even more trips to the bank these days than they did three years ago. A survey by Greenwich Associates released in May found that 37 percent of respondents visit their bank branch at least once a day, and 35 percent visit it every two to three days.



The AICPA: Heading South?

The American Institute of Certified Public Accountants is on the move. Starting in August, the association is relocating many functions, including human resources, finance, and publishing, to Durham, N.C. With only about 50 employees — of the 400 positions affected by the move — making the transfer from the AICPA's current offices in New York, New Jersey, Texas, and Washington, D.C., some are wondering how well the organization will adjust to this latest disruption.

The move comes after a tumultuous period for the group. "The AICPA has gradually lost influence over the past decade," says J. Edward Ketz, associate professor of accounting at the Smeal College of Business at Pennsylvania State University. "When the accounting scandals hit in 2002, the [AICPA] leaders were caught flat-footed," Ketz says. "They created a culture that diminished the importance of external audits."

The implosions of Enron and other companies prompted the passage of the Sarbanes-Oxley Act of 2002 and the creation of the Public Company Accounting Oversight Board. The PCAOB assumed responsibility for setting the standards used to audit public companies — previously the purview of the AICPA. "The AICPA had no political capital during the final debate on Sarbanes-Oxley," says Daniel D. Morris, managing partner with Morris and D'Angelo, a San Jose–based accounting firm.

The move to North Carolina stems from a desire to "do more with members' dues," says Anthony Pugliese, senior vice president of finance and operations at the AICPA, which, with 330,000 members, is the leading professional group for accountants. It makes sense to go where its budget will stretch further, he says. The relocation is expected to save the organization $10 million annually.

Pugliese notes that the AICPA has an effective working relationship with the PCAOB and continues to develop audit standards for privately held firms, nonprofits, and government entities. It also acts as an advocate for the accounting profession. Now, the AICPA management team must ensure that the organization's staff can provide quality service to members while the relocation is under way. — K.M.K.


Ups and Downs for the AICPA
10/01 Enron announces it is being investigated by the SEC
1/02 AICPA members vote against a global credential known as the "Cognitor"
6/02 Arthur Andersen found guilty of obstruction of justice in the Enron case
7/02 Sarbanes-Oxley Act passed. AICPA loses audit standard setting power to the newly created PCAOB
4/03 William McDonough appointed chairman of the PCAOB
10/03 AICPA members vote to strengthen CPA ethics enforcement
2/04 Barry Melancon elected to a third 5-year term as president and CEO of AICPA
4/04 First computerized CPA exam launched
5/05 AICPA calls for separate GAAP for private companies
10/05 AICPA announces relocation of some operations to Durham, N.C.

Warming Up to Climate Change


Al Gore is not the only one confronting the threat of global warming these days. In fact, some companies, like General Electric with its Ecomagination initiative, are turning climate change into a business opportunity. A recent report by Ceres, a shareholder environmentalist group, ranked 100 industrial companies on their strategies for addressing the financial risks and opportunities from climate change. BP and DuPont received the highest scores. Not surprisingly, ExxonMobil ranked near the bottom, with a score of 35 out of 100.


Top 10 global industrial companies on climate-change strategies*
Company Sector Score
BP Oil & gas 90
DuPont Chemical 85
Royal Dutch Shell Oil & gas 79
Alcan Metals & mining 77
Alcoa Metals & mining 74
AEP Electric power 73
Cinergy Electric power 73
Statoil Oil & gas 72
Bayer Chemical 71
Nippon Steel Metals & mining 67
Source: "Corporate Governance and Climate Change: Making the Connection," Ceres.
*Scores based on commitment to controlling emissions, disclosure practices, support of regulatory actions, and strategic planning to address climate change.



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