In the two years since Enron's collapse, a host of companies have followed it into Chapter 11, or infamy, or both. Business may be bad for the corporate executives who are struggling with the aftermath of white-collar crime and bankruptcy — but for the corporate cleanup industry, business is good. In the feature story of our special report, senior editor Marie Leone takes a wide-ranging look at the litany of corporate scandals and the efforts to repair the damage. The editors of CFO.com then focus on the lessons learned from five cases of corporate remediation.

Stronger Than Dirt

The litany of corporate accounting scandals is wide-ranging, some might say ingenious. Efforts to repair the damage -- and to guard against scandals in the first place -- must be even more so.
Marie Leone, CFO.com | US
October 17, 2003

Juval Aviv hunts down stolen money — $10 billion over the last 10 years, or about 86 cents out of every dollar he seeks. As CEO of Interfor Inc., the retired commando and former operative for Mossad, the Israeli intelligence agency, works primarily for pension funds and bondholders who need to track and recover funds pilfered by white-collar criminals.

Not all these missions are cloak-and-dagger exercises, but Aviv maintains that he's has uncovered enough phantom contractors, kickback schemes, secret commissions, and embezzlement plots to fill several John Le Carré novels. Lately, business has been good.

For the corporate cleanup industry, times are good all around. According to new research from the nonprofit Turnaround Management Association, 77 percent of its 6,400 member companies had to turn away clients this past year, slightly down from last year's 83 percent. Most business referrals came from big stakeholders, such as banks and other lenders, as well as law firms.

Only 13 percent came directly from company management (though Aviv points out that businesses may "use the cover of a law firm" so that reports are covered by attorney-client confidentiality). But for companies that aren't focused on cash recovery, where are they focused?

Sometimes More Seems Like Less
In the two years since Enron's collapse, a host of companies have followed it into Chapter 11, or infamy, or both. Taking up the banner of corporate reform, new laws and regulations — to say nothing of commercially available "solutions" — were introduced faster than CFOs could empty their in-boxes. Yet many of these efforts — especially those intended as preventive measures, not as fixes — often seemed to do little more than cloud the issues.

Most reform measures, says Harvard Business School professor Quinn Mills, dance around the main problem — conflict of interest. Even those measures that do "a nice job" never address core incentive and behavioral problems, laments Mills, who adds that "in America's largest corporations, the CEO has too much power and ability to enrich himself and close associates."

Some of the new rules, such as the Sarbanes-Oxley financial literacy requirements for audit committee members, he considers "bureaucratic idiocy." Indeed, one finding of a recent CFO survey of senior financial executives — examined in the magazine's September cover story "Sticker Shock" — is that only 30 percent of respondents said that the benefits of Sarbanes-Oxley compliance outweigh the costs.

A more direct approach to addressing conflicts of interest, says Mills, would be to split the roles of chairman and chief executive officer, so the same person won't serve two masters — management and shareholders. But at most companies, he quips, "One sure way to get thrown off the board is to propose that the CEO not be chairman." (This measure, and many others that follow, apply just as well to businesses in good corporate health — but trying to be healthier — as they do to businesses on the mend.)

He also makes a case for rethinking stock options. While acknowledging that option grants are an important incentive, Mills joins many economists in suggesting that options should be decoupled from the company stock price. If options were indexed against the performance of peer companies, an industry, or the economy in general, he maintains, executives would be encouraged to focus on performance rather than stockmarket volatility.

Finally, Mills is an ardent proponent of an independent CFO and head of human resources. The two executives who control finance and compensation, says Mills, should be hired by, and report to, the board rather than the CEO. Appointing a corporate governance officer can be worthwhile, adds Diane Frankle, a partner with Palo Alto-based law firm Gray Cary, but only if the CGO has the authority to revise policies and provide governance training.

Mills has a ally in Stephen Roulac, a San Rafael, California-based financial and management consultant who likens good corporate governance to the U.S. Constitution. "Separation of powers" promotes appropriate decision making, declares Roulac. To that end, he offers a three-step process for corporate "decisions of consequence."

First, an individual or group originates and advocates an idea. Next, a second group conducts an internal evaluation of the plan, including the associated budget, capital resources, financial risk, and business processes. Finally, a third group — an independent board or committee — produces a quantitative and qualitative assessment.

Too time consuming? Perhaps Roulac's proposal is an example of how, in theory, most executives agree with corporate governance reform, but in the implementation, things get sticky. One former CEO, now a board member at a financial services company, agreed with Mills's idea that CFOs should report directly to the board. He added, though, that "it's not necessary at my company, because our culture doesn't foster conflict-of-interest problems." Self-examination, too, can be a sticking point.

Get It Together — or Break It Up
To integrate, or not to integrate — that is a question which, rightly, should be asked very early on. Say, sometime during M&A planning. But better late than never, says Joe Phelps, who sees fertile ground for improvement in Time Warner's organizational structure. Phelps, the CEO of Santa Monica, California-based marketing communications firm the Phelps Group, would seek to eliminate the accounting problems associated with intercompany barters by eliminating competition between the company's internal profit centers: broadcast, cable, film, magazines, online.

Phelps says that by becoming a one-stop shopping conduit built around major accounts and not major Time Warner business units. the parent company could outbid competitors with broad-based media packages. The company would also be able to free itself from internal turf battles — and their attendant accounting games.

Joel Goldhar would go to the other extreme. A professor at the Stuart Graduate School of Business at Chicago's Illinois Institute of Technology, Goldhar contends that the only way to keep Time Warner out of trouble is by splitting it into separate operating companies linked only by external marketing agreements. There have been whispers from Wall Street — but nothing more — about spinning off the AOL division.

As for companies that are already in dire straits, "The most important thing to remember about bankruptcy is that there are no second chances," says Paul Brown, CFO of Portland, Oregon-based PSC Inc., a supply-chain management company. If a company fails to emerge from Chapter 11, he explains, liquidation is the alternative.

Key ingredients in Brown's formula — in addition to clear direction, active management, and candid communication — are getting control of cash flow and not allowing any "sacred cows." Of the five companies that Brown has been called on to help survive bankruptcy, he's met with success four times. The one failure, he maintains, was a sacred cow — the CEO's favorite business segment, which he was unwilling to jettison to salvage the rest of the company. Eventually, says Brown, "cash flow problems just rolled over the company and sunk it."

Building — or Rebuilding — Confidence
Rebuilding credibility with investors is best handled by management, not sell-side analysts, says Peter Ausnit, a San Francisco-based financial marketing consultant. He admonishes executives who issue terse financial press releases and opaque financial filings that barely meet minimum SEC and stock-exchange requirements. This lack of transparency, Ausnit maintains, is the reason that Wall Street became an intermediary between companies and investors.

Executives may be reluctant to release too much information into the public domain for fear of surrendering a competitive advantage — or even of piquing the SEC's interest in the company's accounting. Regulation Fair Disclosure also has to shoulder some of the blame for chilling communications between companies and investors, according to John Isaf, a senior vice president at Magnet Communications. But on issues that really matter, counters Ausnit, management always communicates with investors directly. Just take a look, he says, at the full-page advertisements that appear in daily newspapers when a merger needs investor support or a proxy fight breaks out.

One company that seems in step with Ausnit's suggestion is the nicely named Progressive Corp. Two years ago the Ohio-based insurer became the first publicly held company to issue operating results every month. This summer Progressive captured another public-company first when management announced intentions to release earnings-per-share data every month. Indeed, after earnings warnings in 1999 and 2000 sent Progressive's stock price on a rollercoaster ride, executives snuffed out the volatility, they maintain, by feeding investors more information, more frequently. Officials at the company also say that additional transparency makes any thoughts of "smoothing" results much less inviting.

The transparency of financial footnotes also could use some sprucing up, says Northeastern University business school professor David Sherman. For example, he supports adding earnings ranges to footnotes that clarify subjective accounting judgments. "You can't take accounting judgments out of the process," says Sherman, but earnings ranges can spell out the impact of accounting treatments and provide a rationale for choosing one method over another.

While Wall Street may put the focus on investor confidence, Isaf insists that employees should be the number-one communications target, since they'll actually be setting the ship aright. He warns executives against placing blame and making up excuses for the company's woes, and tutors them to be frank about expectations and progress. When management leaves an information void, adds Isaf, the rumor mill will fill it.

The Great Profile?
Accounting scandals gnaw at the heart of a company because accounting is the basic fiber of a corporation, asserts branding expert James Bell, a senior partner with Lippincott Mercer. The situation tends to be worse for high-profile companies than for their wallflower counterparts, he adds; press coverage, especially since it often focuses on the bad news, tends to prolong the problem.

The best response to a scandal? "Be clear, concise, and quick," coaches Roulac, the management consultant. He applauds the message sent by Edward Breen immediately after taking office, when the new Tyco CEO restocked the entire board and sacked 50 top executives. Roulac does worry, however, that the grand gesture left Tyco with little corporate memory. He suggests that the company might have done better to keep two or three hand-picked officials from the prior regime, perhaps granting them emeritus status.

Joe Phelps notes that product recalls are easier to recover from than accounting scandals. He maintains that it's easier for a company to repair a product — or the perception of safety — than to regain trust after a greedy executive has fudged the numbers. That loss of trust is exacerbated, says Aviv, when stakeholders are insulted by an atmosphere of old-boy politicking and arrogance.

Unsurprisingly, a new corporate name may come across simply as a further insult, as if the company were trying to sell the public a bill of goods. And as for repeat offenders, "If the same problems comes around again, it's much worse [for the company image] the second time around," counsels Phelps.

And not to be totally cynical, but "The public tends to be very forgiving if a company turns a profit," says Marc Holland, the CEO and a host of in-flight-programming company Sky Radio Network. "I wouldn't be surprised if the public forgave Enron if the company became profitable." Interfor's Aviv adds that although time may not always heal, at least it puts the right amount of distance between a scandal and public acceptance.

Each of the companies we examine in our cleanup profiles has plenty of work ahead — though as for the cleanups themselves, a single "strategic misstep," however major, must be approached far differently than "breakdowns in financial controls." Perhaps the lesson here comes not from Le Carré, but from Tolstoy: "All happy families are alike; every unhappy family is unhappy in its own way."

Kmart: Out of the Box?

Even if the company's accounting scandal was a one-off occurrence, Kmart must still overcome the legacy of what many see as major strategic misstep. One in a series of ''corporate cleanup'' profiles.
David M. Katz, CFO.com | US
October 20, 2003

Compared with its weightier business woes, Kmart's accounting scandal seems more of a nagging problem than a looming catastrophe.

Much more troubling is the question of whether or not the discount retailer, which emerged from bankruptcy in May, can resurrect its brand and explain to consumers why they should shop at its stores, Kmart watchers say.

To be sure, they credit the chain with bounding out of Chapter 11 two months ahead of schedule and with an impressive $2 billion in exit financing. They also praise its renovated management, merchandising logistics, and financial reporting. But they question whether it can put the brakes on its market-share slide and gain any ground at all on its vaunted competitors, Wal-Mart Stores and Target Corp.

To do that, Kmart Holding Co., as the parent organization is now called, must overcome the legacy of what many see as a major strategic misstep: Trying to compete with Wal-Mart on price.

The struggle to vie head-to-head with the formidable competitor put tremendous pressure on Kmart to maintain its profit margins in the years running up to bankruptcy, according to Gary Ruffing, a former Kmart vice president of sales and marketing. During that time, the company slashed both its everyday prices and the cost of goods featured in advertised sales, notes Ruffing, who says he left in February 2001 after thirty years the company because he disagreed with that policy. "You've taken two hits in the same year," he says. "That's very hard to manage."

The strategy of slashing prices also meant that the company had to move many more products through its pipeline to maintain its gross-profit margins.

Besides increasing the need for cash to pay suppliers, the surge in inventory placed a crushing burden on out-of-date systems. "When goods moved from distribution centers to stores, it was not an optimal process," says Richard Hastings, chief retail analyst at Bernard Sands, a credit advisory firm.

The supply-chain breakdowns threatened the credibility of the company's financial reporting. "If you don't know where the boxes are, you don't know what they're worth," says Hastings, who noted that such problems created "a lot of questions about the validity of Kmart's accounts-payable numbers."

Apparently, the problems were longstanding. A software programming flaw in Kmart's accounts-payable system involving one of the company's vendors led to an understatement of the company's cost of sales from 1999 through 2001. The error was one reason given by the company for a December 2002 restatement that boosted its net loss for that period by not quite $100 million. (At the time, the company also restated its results for the first two quarters of 2002, lowering its net loss for that period by roughly the same amount.)

Another reason Kmart gave for that restatement was the premature recording of vendor allowances, also called slotting fees, paid to Kmart (and many other retailers) by suppliers to keep their products on store shelves. Indeed, alleged improper reporting of vendor allowances have been the source of an accounting scandal at the company.

The same profit squeeze that damaged Kmart's logistics seems to have played a big role in its accounting problems. In February, the Securities and Exchange Commission sued two former Kmart executives, Enio Montini and Joseph Hofmeister, charging them with improperly booking the entirety of a $42 million slotting fee paid by American Greetings in the fourth quarter of 2001, rather than over the five-year life of the deal. Their alleged motivation: to hit quarterly gross-margin performance targets on which their incentive pay was based.

Besides the SEC action, Montini and Hofmeister face criminal charges of securities fraud, lying to the commission, and conspiring to commit those offenses. The SEC and the U.S. Attorney's office for the Eastern District of Michigan are also conducting broader investigations into how Kmart has accounted for vendor allowances.

Sprucing Up
Despite the investigations, however, the company has done an excellent job of pulling itself out of its operational and accounting quagmire, some observers say. Last month management signaled a willingness to repair its logistics, according to Ruffing, by naming Bruce Johnson senior vice president of supply chain and operations. Previously Johnson served as director of organizations and systems at grocery giant Carrefour, which has more than 9,500 stores in 30 countries.

Further, since filing for Chapter 11 protection, Kmart's financial reporting has gone "from somewhat unreliable to highly credible and reliable today," says Hastings, the credit analyst. Part of the reason for Kmart's new transparency, he thinks, is that the bankruptcy occurred during a particularly robust period of regulatory reform that included the Sarbanes-Oxley Act. But he also credits Albert Koch, who served as Kmart's temporary CFO during the bankruptcy, with sprucing up the company's books.

The installation of Koch and temporary Kmart treasurer Ted Stenger, members of turnaround management firm Jay Alix & Associates, were part of a considerable housecleaning. Nearly all of the top executives who ran Kmart before its January 2002 Chapter 11 filing have left the company. Among the departed were a group executives granted retention loans by former chairman and CEO Charles Conaway as the company headed down the tubes. Conaway and Mark Schwartz, the former president and chief operating officer — and a Wal-Mart veteran — were the architects of the price-cutting strategy.

The new top executives, led by president and CEO Julian Day and chairman Edward Lampert, are given high marks for their roles in the company's quick escape from the ranks of the bankrupt. The hands-on approach of Lampert — a hedge-fund manager whose firm, ESL Investments, owns more than 50 percent of the company's shares — reportedly played a big part in the company's swift emergence.

But was the fast track too fast? "There's speculation that they could have benefited from a longer period in bankruptcy" to have more time to plot strategy, thinks Nancy Aversa, a research analyst with Victory Capital Management in Cleveland. She also questions whether Kmart's closing of about 600 stores during the bankruptcy was enough to "rationalize its base." If Kmart were to undertake a second round of closings, even of fewer stores, the public perception might be even more damaging.

Another potential problem is the vacancy where the CFO should be. In its complaint against Montini and Hofmeister, the SEC noted that the men were able to freeze out a key finance official — Montini's direct report — from the vendor-allowance negotiations with American Greetings. If the company doesn't come up with a strong replacement for Koch, whose role as interim CFO concluded when Kmart emerged from Chapter 11 in May, questions could arise about the company's ability to enforce its internal controls.

To be sure, a fair number of Kmart watchers now see the accounting scandal as a one-off occurrence with no lasting impact on the company's core business. But if the government investigations become prolonged, and "Kmart's name keeps coming up in a negative way," that would hurt its ability to attract loyal customers, thinks Ruffing. The former Kmart vice president, by the way, is now a now a senior director at BBK Ltd., a Southfield, Michigan-based firm specializing in turnaround advice.

Shopping — especially bargain-hunting — may be a favorite American pastime. But fail to restore a company's good name, says Ruffing, and customers might well come to ask, "Why should I shop somewhere where people are taking advantage?"

MCI: Ringing in Reform

When the audit committee chairman foresees ''a substantial amount of work,'' emerging from the biggest bankruptcy in U.S. history may be only half the battle for the company formally known as WorldCom. One in a series of ''corporate cleanup'' profiles.
Craig Schneider, CFO.com | US
October 21, 2003

There's no rest for the bankrupt.

Indeed, MCI managers have been locking horns with regulators and creditors for months, endeavoring to emerge from beneath the largest bankruptcy in U.S. history. The telecom company also plans to shed its old WorldCom skin, hoping to distance itself from an $11 billion accounting-fraud scandal and reinvent itself as a role model for corporate governance and ethics.

By most accounts, MCI's fate now rests in the U.S. bankruptcy court for the Southern District of New York, where the company will face a final vote on its reorganization plan. Bob Blakely, MCI's chief financial officer, announced last month that it is "on track to emerge from Chapter 11" following a settlement with two dissident creditor groups that opposed the plan.

One creditor group, originally slated to get nothing under the plan, will now reportedly be paid 44.5 cents on the dollar; the other group, originally scheduled for 36 cents on the dollar, will now receive about 52 cents. If all goes well with the bankruptcy judge, MCI's debt load would undergo the equivalent of corporate liposuction, dropping from $32.5 billion in debt to just $5.5 billion.

Dennis Beresford, a member of MCI's board of directors and chairman of its audit committee, is not celebrating just yet, however. "We still have a substantial amount of work to do," says the former chairman of the Financial Accounting Standards Board, noting the massive restatements that still await. "We are still going through and making the appropriate changes as a result of the accounting fraud that took place."

Ruin to Role Model
It's been more than a year since WorldCom fired CFO Scott Sullivan after uncovering accounting irregularities of $3.8 billion in expenses that hid a net loss for 2001 and the first quarter of 2002. Additional re-audits looking as far back as 1999 have since ballooned WorldCom's improper booking to $11 billion.

Shortly after the scandal broke, WorldCom filed for bankruptcy and hired former Hewlett-Packard president Michael Capellas to replace Bernard Ebbers, on whose watch Sullivan's alleged illegal bookkeeping took place. MCI also agreed to a settlement with the Securities and Exchange Commission in which the company would make a $750 post-bankruptcy payout to shareholders.

MCI's board, which was subsequently fitted with independent directors such as Beresford, adopted 78 new and somewhat radical corporate governance reforms intended to restore investor trust and institute internal controls where apparently there were none. "One cannot say that the checks and balances against excessive power within the old WorldCom didn't work adequately," noted Richard Breeden, MCI's bankruptcy-court-appointed monitor, in his governance report. "Rather, the sad fact is that there were no checks and balances."

The General Services Administration (GSA) came to a similar conclusion in June and suspended WorldCom's eligibility to bid on government contracts, on the grounds that it lacked "the internal controls and business ethics necessary to be considered 'presentably responsible.'"

MCI is working on it. In the coming months Beresford plans to wrap up the necessary restatements associated with the accounting scandal under former management, so that by the time the company exits bankruptcy protection, only accurate records remain. The trouble, he says, is picking through the company's highly fragmented accounting system — the byproduct of years of poorly integrated acquisitions made by former finance chief Sullivan.

"It's been the Achilles' heel for the organization, and we want to make it the opposite — a very valuable contributor to the success of the company," says Beresford, who also serves as a professor of accounting at the University of Georgia. "The accounting records were frankly in shambles."

Beresford noted 27 different accounting systems to record revenues. "Clearly," he says, "that's not an efficient way to operate." The systems still include a manual override. Beresford observes that "senior accounting leaders were either making or authorizing some phony adjustments that overrode the results of the basic accounting systems." The override function, he adds, will need to be eliminated in an eventual system upgrade.

Blueprint for Action
Breeden's report for MCI's governance is also expected to help convince the GSA to drop its ban. Aside from several internal controls, one of the dozens of new initiatives to restore trust will be to improve shareholder communication through an open investor forum. Specifically, the board of directors is required to establish an electronic "town hall," where shareholders will be able to communicate directly with the board and to propose resolutions for consideration, whether or not the resolution would be allowed under SEC proxy regulations.

The company has taken other measures to ensure that the improper acts of the past stay in the past. Aside from retaining new C-level executives from outside MCI, the company has restructured its accounting department and accounting functions, doubled the ranks of the internal audit staff, and instructed that function to report directly to the audit committee of the board. The company has also established a corporate ethics office and a zero-tolerance policy for any actions that do not meet the highest standards of integrity.

If MCI isn't re-certified to bid as a government contractor until July 1, 2004, the company has warned that the loss of business would reduce revenue by nearly $1.02 billion and earnings by $250 million over three years. Still, the loss of government contracts isn't expected to have any effect on the feasibility of its plan to emerge from bankruptcy.

Beresford, however, wants MCI to be "best of breed" in corporate governance and ethics. "We can't afford to be anything less," he says. "With all of the problems we had in the past, we can't just become acceptable, [by implementing] a bare minimum of compliance."

I Just Called to Say I'm Sorry
While few would argue with improving MCI's governance and ethics, not everyone agrees that changing the company's name from WorldCom will do anything to restore the public's trust.

Mike Paul, president of MGP & Associates PR, calls the idea "a huge mistake." "Everyone knows that MCI equals WorldCom," says Paul, a former managing director of business strategy and marketing at the old MCI before it acquired WorldCom. He adds that the general public is willing to forgive and forget when they're told the truth, starting with a humble apology. "Crisis PR and reputation management starts with ego management," he says.

Peter Ausnit, an investor-relations consultant based in California, begs to differ when the general public is the investing public. He notes that a mea culpa can be a costly statement to make, however grand the gesture. Consider, he says, that Cendant Corp. "suffered for their honesty," paying a record $3.2 billion settlement in a class action lawsuit against a predecessor company.

"There's no analyst that can assess the risk of WorldCom until after the state attorney general or regulatory agencies finish their cycle of litigation," says Scott E. Wendelin, CEO of Prospect Financial Advisors. "That can be years." The real litigation risk is in the civil courts, he adds, where "it's open season for the foreseeable future."

Litigation aside, Gary Hindes, managing director of Deltec Asset Management, thinks management is better focused on the future. "I think the accounting scandal is a thing of the past," he says. "I don't think people think of that when they dial one plus an area code."

If You Rebuild It, Will They Come?
Eric K. Tutterow, a high-yield bond analyst with KDP Investment Advisors, believes that MCI will emerge from bankruptcy a much stronger player in the telecom space. Under the reorganization plan, most of the debt holders will own new equity of the new MCI.

Tutterow also makes some conservative assumptions in his calculations for valuing bonds — for example, that post-bankruptcy, MCI will have to pay out $1.5 billion to shareholders, double the $750 million already settled on with the SEC. The company has about $3.5 billion in cash on its balance sheet.

With just under $400 million in debt service or interest payments, the majority of the cash flow — over $4 billion expected in fiscal 2004, up from nearly $3 billion this year — can be used to reduce debt further or increase networks. "With those leverage numbers, on the surface," says Tutterow, "they could emerge as an investment-grade company."

Time Warner: Branded Again

Despite accounting miscues, Time Warner's balance sheet appears healthy, and the company's attention will focus more on governance and investor confidence and less on cash flow and finances. One in a series of ''corporate cleanup'' profiles.
Marie Leone, CFO.com | US
October 22, 2003

A company beset by accounting problems, by any other name, is still, well, under investigation. So goes the story of Time Warner Inc., which recently dropped the AOL tag from its corporate title. Executives at the media giant certainly didn't rename the company to sidestep alleged accounting improprieties at its online division — but the name change probably didn't hurt.

The AOL name-dropping, which became effective on October 16, should help boost the confidence of Time Warner employees, partners, and investors. Indeed, jettisoning the online moniker will clear up confusion between brand and corporate identities, as well as emphasize that management does not support all of AOL's aggressive accounting strategies — some of which are currently under investigation by the Securities and Exchange Commission and the Department of Justice.

The federal probes primarily focus on accounting and disclosure practices at AOL, including advertising arrangements and methods used by the online unit to report its subscriber numbers. Recall that the company's accounting problems came to a head in January, when Time Warner's amended 10-Q reported that it would restate two year's worth of results by $190 million. (Though this was the largest accounting restatement in U.S. history, the financial impact of the adjustment represented just 1 percent of AOL's revenues for the period in question.)

Still unresolved, however, is a row between the SEC and AOL over an intercompany advertising transaction involving Bertelsmann AG's interest in AOL Europe. The commission contends that AOL inflated advertising revenues by booking an advertising barter deal worth $400 million as revenue. AOL management and the company's auditors, Ernst & Young LLP, maintain that the accounting treatment is correct in light of current information.

Time Warner also faces pending shareholder litigation that could affect company operations, according to the top brass. As of August, about 40 class action and shareholder derivative lawsuits had been filed, accusing executives and board members with breaching fiduciary duties.

But despite the accounting miscues, Time Warner's balance sheet appears healthy. For the first six months of 2003, the company generated $3.8 billion in cash flow from operations and threw off $2.5 billion in free cash flow, while increasing revenues by 6 percent to $21 billion. Net income for the first half of the year was $1.5 billion.

As a result, Time Warner's cleanup efforts will concentrate more on governance and restoring investor confidence than on cash flow and finances. Indeed, AOL Time Warner's stock price dropped from 76 at the time of the 2001 merger to 16 in September 2003.

As expected, the corporate brand lost some footing, too. According to BrandEconomics CEO Al Ehrbar, the value of the AOL Time Warner brand declined in several categories during the 18 months prior to June 2002 when the company was sorting out the restatement. For instance, AOL slipped 9 percent when measured for "trustworthiness," declined 25 percent in its "high quality" ranking, and sunk 60 percent in "prestige."

Rebuilding brand equity and investor confidence may prove a tough assignment — even tougher after a missed opportunity in May 2002, says Harvard Business School professor Quinn Mills. The board of directors named Richard Parsons CEO, and "with the whole country watching," recalls Mills, Parsons "requested the company chairmanship, too."

Mills insists that the board should have used the occasion to announce that it would split the positions of chairman and CEO, sending a clear signal to investors — and other companies — that Time Warner was committed to good corporate governance. He also blames the SEC, Congress, and the Bush Administration for remaining silent when Parsons made his request. In essence, says Mills, their silence was an indirect approval of the dual-role structure — and the inherent conflict of interest it creates.

Six months after Parsons became chief executive, the board combined the two top positions and unanimously elected Parsons to both posts. Perhaps sensing a need, the board "reaffirmed its strong governance measures," pointing out that executive sessions of all non-management directors would be held without the CEO and other management present.

While Mills would split one job in two, Joel Goldhar would "break up the company into AOL, Time, and Warner." Goldhar, a professor at the Stuart Graduate School of Business at the Illinois Institute of Technology, maintains that this is "the only way to 'clean up' both the books and the brand image."

Like other experts, Goldhar saw trouble in the merger between the original companies. His argument wasn't focused on the often-debated overvaluation of pre-merger AOL (although he contends that based on a replacement value of between $25 billion and $35 billion, AOL was grossly overvalued at more $60 billion).

By Goldhar's lights, size did not generate economies of scale in the AOL-Time Warner merger. The vertical integration of strategic business units — in this case, production and distribution companies — did not add to profitability, says Goldhar, because the units operate in each other's businesses. The same advantages could have been gained through partnership or marketing contracts.

More importantly, Goldhar says that a breakup would encourage transparency in financial reporting. "Some companies," he maintains, "create complex financial and organizational structures to reduce transparency."

Did the Brand Take a Licking?
Brand expert Neil Morgan, a professor at the University of North Carolina's Kenan-Flagler Business School, doesn't think that the specter of investigations, restatements, and lawsuits will require much image cleanup. He maintains that the lasting negative effects associated with federal accounting investigations have been diluted over the past two years because, frankly, they have become commonplace. The same goes for restatements and protracted lawsuits — until the courts imposes damage awards.

What's more, he doesn't believe the AOL brand hurt the Time Warner brand at all. Morgan believes that erasing the moniker, or even spinning off the online company, probably would be driven by corporate politics or culture and not commercial reasons tied to brand value.

Time Warner managers shouldn't worry about looking bad by defying the SEC either, at least not in the case of the Bertelsmann deals. "I would recommend pushing back if the case is defensible," says Charles Lundelius, a securities and accounting expert with Annapolis-based FTI Consulting and the former CFO of Unimark Inc. and Markman Co.

Lundelius advocates a lot of "give and take" between the SEC staff and company executives during an investigation. "Finding that gray area is healthy," he says, and so is" reaching a compromise" on subjective accounting calls. In a post-Enron environment, he muses, both the SEC and company executives tend to be more strict in their interpretation of generally accepted accounting principles

Amy Hutton agrees. A professor at Dartmouth's Tuck School of Business, Hutton says the SEC has the advantage of 20/20 hindsight. She speculates that the SEC staff may think that AOL Time Warner was not conservative enough with the Bertelsmann accounting treatment, but adds that "the SEC might not have investigated the issue at all if the 'good times' had continued."

She reckons that the SEC may be playing a weak hand regarding the Bertelsmann transactions. If the deals turn out to be simply Old Economy-style barters and are valued fairly, they can be recognized as revenue under FAS 63. The bigger problems might be whether details of the Bertelsmann barter were properly disclosed — and that this is not the first time AOL has had to clean up after messy accounting.

In the late 1990s, AOL incorrectly booked subscriber acquisition costs after introducing flat-rate pricing for online services. An audit enforcement action resulted in a charge of $385 million in 1998, to represent the balance of deferred subscriber acquisition costs dating back to September 1996, and the company was slapped with a fine.

But to their credit, AOL executives cleaned up the company's image and its books; soon afterward they orchestrated one of the biggest merger deals in U.S. history. The question remains: Can Time Warner make history repeat itself?

Tyco: The Long Haul

Cleaning out the executive suite, and identifying breakdowns in financial control, are a start; now Tyco must adhere to a long-term blueprint for change. One in a series of ''corporate cleanup'' profiles.
Marie Leone, CFO.com | US
October 23, 2003

By one measure, Dennis Kozlowski helped clean up Tyco International. The indicted ex-CEO gave laser-sharp focus to his successor, making it easy for new CEO Edward Breen to identify his top remediation task: restore investor confidence by exorcising Kozlowski's inner circle.

Breen, formerly president of Motorola, wasted little time. Immediately following his July 2002 appointment, he ousted about 50 executives who worked for Kozlowski — as well as the entire board that had hired Breen himself. Breen then assembled his own clean team, installing nine independent directors (Breen, the chairman, is the tenth), bringing aboard former United Technologies CFO David FitzPatrick as Tyco's new finance chief, and hiring Eric Pillmore, former CFO of Multilink Technology Corp., as chief governance officer.

Breen displayed good governance know-how, say experts, by having Pillmore answer to the board's nominating and governance committee, rather than another C-level executive. Tyco management maintains that the reporting structure, which they believe is unique, bolsters the board's oversight power.

Breen's mighty, swift sword encouraged interested observers. As brand expert and Lippincott Mercer senior partner James Bell tells it, Tyco is a capital markets brand, not a consumer brand, so cleanup efforts had to start with distancing the new Tyco from the old, corrupt Tyco.

Indeed, the Tyco tarnish was heavy. In January 2002, an in-house probe revealed major breakdowns in financial controls, including transparency problems in the plastics division and suspect operating income, related to dealer accounts, at the ADT unit.

Eventually Kozlowski and former CFO Mark Swartz resigned after being indicted on personal tax evasion charges — but not before the duo allegedly pilfered $600 million from the company. Federal charges chronicled lavish living by Kozlowski and his lieutenants at the expense of shareholders. The main offenses: abuse of executive loan programs, self-dealing transactions, unapproved bonuses, unauthorized pay, and fraudulent stock sales.

In short order, Breen expanded the ongoing internal audit into a full-scale, independent investigation that kept 25 lawyers and 100 accountants busy for five months. The forensic team uncovered breakdowns in the control processes associated with executive compensation, and problems with reported revenues, profits, cash flows, use of reserves, and non-recurring charges, among other financial shortcomings.

So far, several repair measures have been implemented, says a Tyco spokesman Gary Holmes, including splitting up the plastics group into two reporting segments, changing the definition of free cash flow to include cash paid for the acquisition of new dealer accounts, detailing free cash flow by reporting segment, and providing details of how "organic growth" is calculated.

Planning for the Long Term
Recall that growth at Tyco under Kozlowski and Swartz was anything but organic. It was a "smash and grab mentality," says research analyst Brian Langenberg, a principal at Langenberg & Co in Chicago. "The focus was to make short-term gross margins, and they did," but Kozlowski and Swartz never wanted to spent time on integrating companies to extract efficiencies, says Langenberg. "They weren't hitting their numbers the right way."

On the other hand, says Langenberg, Breen and FitzPatrick hail from companies with long-term perspectives and are more patient about growth. Lippincott Mercer's Bell, agrees, noting that he likes the way Breen has laid out a blueprint for change "and is sticking to his outline." But Bell doesn't expect Tyco to heal overnight: "Breen is running a real business, not a speculative one, and the cleanup will take time."

It's been a little over a year since Breen took the reins, and several operational and financial reporting hurdles remain to be cleared. "Breen's on track, but he's been left with no systems in place to track what's going on," opines Langenberg. "There's no operating plan or strategic forecasting methodology."

Perhaps more startling, confirms Langenberg, is that Tyco lacks a central purchasing department — despite spending $14 billion annually on goods and services. Furthermore, Tyco lacks a companywide IT system, operates redundant manufacturing plants, is still in the process of closing two of its four headquarters, suffers from a rising customer attrition rate in its fire and security units — and continues to be the subject of an investigation by the Securities and Exchange Commission.

If that laundry list isn't enough, Tyco's 2,150 operating units seemed rife with accounting and financial reporting problems, and spooked suppliers are calling for cash, not credit.

Considering the hand that Breen has been dealt, analysts who watch Tyco believe that the new CEO is doing a fairly good job, if perhaps too eager to announce good news.

Breen was criticized by analysts earlier this year for jumping the gun when he announced that Tyco's restatements for prior quarters were a thing of the past — only to see the company restate two more times. So far the company has made $1.4 billion worth of adjustments since Breen's arrival. Langenberg, whose personal holdings include Tyco, thinks that the company may restate its results for one more quarter, but he doesn't expect the adjustments to be significant.

Company officials have assured investors that the restatements won't trigger debt covenants. However, Carol Levenson, head of research at Gimme Credit, notes that she's uncomfortable with controversial accounting methods that "keep popping up," such as changing the definition of cash flow.

Indeed, research analyst Albert Meyer, general partner of 2ndOpinionResearch.com, was the first to point out that Tyco overstated free cash flow in the third quarter by $152 million. Meyer emphasizes that Tyco "has cleaned up" and that he doesn't expect any more scandals. Nevertheless, he sees room for improvement in the clarity of Tyco's financial disclosures.

More importantly, claims Meyer, Tyco management fumbled during the company's most recent earnings call by admitting that the debt reduction payoff was "not readily apparent on our financial statements." Says Meyer, "If they knew it wasn't apparent, why not clarify it in the financial statements?"

The breakup of Tyco is another issue. Until the SEC finishes its investigation, Breen can count on a reprieve from analysts who are calling for the spin-off of the company's flagship fire and security unit, ADT. Langenberg says the spin-off doesn't make sense and claims that the idea is being advocated by investment banks hungry for fees. He reckons the value of ADT as a part of Tyco "will be reflected over time as operational and revenue synergies develop."

While Tyco's management remains focused on strengthening operating performance, they do admit that some divestitures will probably occur during the next few quarters. According to Tyco's Holmes, the divestitures will represent less than 10 percent of the company's assets, but would enable Tyco "to prune our portfolio of non-core assets."

Despite Tyco's woes, Meyer reckons that the company is correctly valued (as of the second quarter this year). Meanwhile, Tyco's portfolio is strong, says Langenberg, who notes that many of the companies rank either first or second in their industry. By his lights, Tyco's stock prospects are "more bull than bear."

Xerox: New Lease on Life

The copy machine maker has survived a SEC investigation and billion-dollar restatements, and attention is finally shifting from its problems to its products. One in a series of ''corporate cleanup'' profiles.
Craig Schneider, CFO.com | US
October 24, 2003

Revenue recognition has long been a hot topic for the Securities and Exchange Commission — all the more reason to learn from Xerox Corp.'s protracted affair with the agency.

The SEC began its investigation into Xerox in June 2000; in April 2002 it charged the company with fraud. The commission alleged that Xerox management accelerated the revenue recognition of leasing equipment over a four-year period by more than $3 billion, and inflated pre-tax earnings by $1.5 billion, to meet or exceed Wall Street expectations and hide its true operating performance.

Xerox settled the charges, agreeing to a $10 million fine — at the time the largest civil penalty against a public company for financial reporting violations — as well as a restatement of its financials from 1997 through 2000 and an adjustment of previously announced 2001 results. The company, in classic SEC form, did not have to admit or deny any wrongdoing in the settlement.

After the settlement, Xerox chairman and CEO Anne Mulcahy, who was named president a month before the SEC launched its investigation and stepped up to the helm in August 2001, talked of moving forward with her turnaround initiatives for improving the health of the business. "Xerox is best served by putting these issues with the SEC behind us," she said in a statement at the time.

Revenue: Back to the Future
It took some time, however, to emerge from beneath the accounting scandal. In June 2002, Xerox restated $6.4 billion of equipment sales from 1997 through 2001 — twice the SEC's estimate in its claim — and reduced earnings by $1.4 billion for that period.

The company said that of the total restatement, $5.1 billion in revenue was allocated among service, rental, outsourcing, and financing revenue streams over the five years, while $1.9 billion in revenue was recognized in 2002 and beyond.

The restatement came just days after WorldCom admitted it had improperly accounted for $3.9 billion in expenses, so a mass exodus from the stock was to be somewhat expected. Xerox even defended itself from those claiming it might be the next Enron. As many an executive and corporate spokesperson explained, the company's accounting woes were tied not to phony revenue or fictitious transactions, but rather to the timing and allocation of real revenue — specifically, the lease revenue in equipment, service, and finance revenue steams.

As one former equity analyst described the scandal, Xerox was "robbing the future to pay for the present." After the restatement, the revenue didn't disappear; it shifted back to future periods beginning in 2002. Some critics have gone so far as to say that during the company's recovery, the accounting change actually helped it to report higher-than-expected numbers.

Long before the settlement and restatement, Xerox rid itself of the executives that, according to the SEC, had participated in a scheme to defraud investors by using accounting devices to meet short-term goals. The SEC charged six in all, including former CFO Barry Romeril and CEO Paul Allaire, with using improper accounting to increase equipment revenue and inflate earnings.

In July 2002, the individuals settled the civil suit with a $22 million payment that included penalties and forfeiture of profits. No one was required to admit or deny wrongdoing. Romeril was barred for life from being the director or officer of a public company and from practicing as an accountant before the SEC.

More Profits, Less Debt
Mulcahy has been credited with spearheading the company's turnaround, which included a return to profitability after some two years of losses. In addition to moving the business to higher-margin products, she laid off 30 percent of the workforce and outsourced functions including the internal audit.

As of June 30, 2003, Xerox's total debt stood at $14.4 billion, compared with $19.3 billion at year-end 2000. The company's cash reserves, just $132 million at the end of 1999, had risen to $1.75 billion by 2000. As of June 30 of this year, the company held $2.28 billion in cash and cash equivalents.

Indeed, things are looking up for Xerox these days. On June 25, Xerox completed a $3.6 billion recapitalization, reflecting strong investor confidence and demand for Xerox. The recapitalization includes public offerings of common stock, mandatory convertible preferred stock, and senior unsecured notes, as well as a new $1 billion credit facility. Shares, which had fallen to an all-time low of $4.20 on October 2002, stood at about $10 a year later.

Eric Tutterow, a high-yield bond analyst with KDP Investment Advisors, is one analyst encouraged by Xerox's recent financings. "They have total access to the capital markets," he says, and because the company can either refinance or issue more stock, "they have a lot of options financially."

Richard Stice, an equities analyst with Standard & Poor's, attributes the recent appreciation in Xerox's share price to the company's progress in cutting costs, restructuring its sales force, and selling assets. While the SEC's investigation likely "brought more of the restructuring to the forefront and hastened many of the changes from the strategy standpoint," he says, "they are basically two separate things."

Xerox also appears to be making changes to its finance department, whether for Sarbanes-Oxley compliance or as a direct response to its past. The major initiative in the last year has been to realign the global accounting function within the office of the chief accountant, Gary Kabureck.

Xerox is also investing about $10 million to $15 million to update its financial IT systems with IBM, to help ensure greater control as well as timely and precise consolidation of its financial results. The first key component to the upgrade, a new financial consolidation system, is expected to be completed early next year and is being spearheaded by controller Harry Beeth, who left Big Blue last year to join Xerox.

KDP's Tutterow doubts Xerox will relive its accounting woes under its new leadership. "Anytime the SEC comes in and breathes down your neck, you're going to make sure your internal controls are impeccable," he says. "Management is also very forward-looking in the market and has done a good job of refocusing the company on different market segments and moving the company to higher margin products."

New Board Blood
The California Public Employees' Retirement System has also been trying to effect change at Xerox. In March 2003, Calpers put the company at the top of its corporate governance focus list, in part for having "one of the most ineffective boards."

Calpers asked Xerox to take immediate steps to add three independent directors; at the time, the board still comprised the same members who oversaw Xerox during its accounting scandal. Xerox also apparently had a policy that its board members were "'strongly recommended' not to communicate directly with institutional investors," noted Rob Feckner, chairman of the Calpers investment committee. "This is reason enough to ensure that a fresh perspective is added to this board."

In response, Xerox appointed an independent director, Ann Reese, and said it would add at least one additional independent director by the end of the year. The board, however, remains less amenable to some of Calpers' other requests, including the separation of the chairman and CEO titles.

While high debt and the SEC investigation have weakened Xerox's market share, Tutterow doubts that the company's brand image suffered much in the wake of the accounting scandal. Prospective customers "care a lot less about the corporate image of Xerox and more about the quality of the product," he says. "From the investor perspective, you are concerned about how [the SEC investigation] will impact earnings going forward, and whether they have the cash flow streams to work through the problems." Nowadays, he adds, "everyone is really focused on the turnaround and how the restructuring efforts have improved the quality of earnings."

Investment Grade
Management's attempt to rebuild investor confidence after the SEC probe suffered a setback when Xerox announced another restatement in December 2002. This time, the company said it had miscalculated interest expense stemming from a debt instrument and a related interest-rate swap agreement. The error caused Xerox to understate interest expense by about $5 million to $6 million after tax, or less than 1 cent per share, in each quarter of 2001 and the first three quarters of 2002.

Stice, who like other analysts was told that the company had put its problems behind it and implemented certain safeguards, remain cautious on the stock because of the surprise. "They're still not out of the woods yet," he adds. "It takes awhile to regain credibility."

Tutterow is decidedly more bullish about Xerox's prospects. He's modeling for the company to generate $2.9 billion in cash flow this year and $3 billion in 2004. Much of that is free cash flow because Xerox's annual interest expense is under $800 million. Considering Xerox's fairly low capital expenditure, Tutterow expects Xerox to generate between $1.5 billion and $2 billion each year of free cash flow; that figure was $1.93 billion for the trailing twelve months as of June 30.

"They're on their way, probably on the way back to an investment-grade rating," Tutterow adds. "It may take some time, but they'll get there eventually."

Adelphia Comes Clean

Can Vanessa Wittman help bring scandal-wracked Adelphia out of bankruptcy -- and back into investors' good graces?
Joseph McCafferty, CFO Magazine
December 1, 2003

When Vanessa Wittman came to Adelphia Communications Corp. as CFO last March, the cable-television giant was in danger of being disconnected. A victim of alleged fraud and plundering by its controlling shareholders, the Rigas family, Adelphia had been mired in Chapter 11 bankruptcy since June 2002. Even after seven months, an interim management team had failed to improve the company's poor performance, and now a new CEO was assembling a new team. At one point, liquidation had been a distinct possibility—the fifth-largest cable company in the nation, after all, had billions of dollars in assets that could be sold off.

"There was a lot of anxiety about whether the business was fixable or not," says Wittman. Yet the decision was made to salvage the company—clean up the toxic remnants of fraud and get Adelphia back in the good graces of customers, investors, and even employees, who had been demoralized by the scandal. And Wittman, who had just finished guiding Vancouver-based broadband provider 360networks Corp. out of bankruptcy, was tapped to help lead the effort.

At first she was surprised—and then relieved—at how little the finance rank and file really knew about what may be one of the largest frauds in corporate history. Instead of a corrupt environment, full of people who had winked or looked the other way, Wittman found a staff more or less in shock over what had transpired. "There was no culture of greed," she says, and thus no need for a wholesale purging of the ranks. Indeed, Wittman recalls making a jesting query to Adelphia CEO William Schleyer: "Where did you hide all the jerks?"

That sense of humor has helped Wittman maintain her balance while doing one of the toughest jobs in finance: cleaning up a scandal-plagued company (see "Sweeping Up," at the end of this article). Today, Adelphia is striving to regain both its solvency and its credibility. The Rigas family—John and his sons, Timothy, Michael, and James—left the building in May 2002, followed by former vice president of finance James Brown and assistant treasurer Michael Mulcahey. Armed with $1.5 billion of debtor-in-possession (DIP) financing, the company is now preparing a reorganization plan that includes updating its cable systems and emerging from bankruptcy completely intact.

Easier said than done. Adelphia, claims Wittman, is "the most complicated bankruptcy the country has ever seen." Not only must Wittman steer Adelphia through the shoals of Chapter 11, she must also contend with shareholder lawsuits and criminal investigations.

Then there's the matter of separating fact from fiction in Adelphia's accounting. "Nothing was as it seemed," recalls Wittman. "Not only were there the issues of fraud and scandal that had really wracked the company, but the fraudulent accounting masked some pretty poor management. This was a company that had been reporting margins approaching 40 percent—and there were over 10 margin points of alleged fraud in there."

All in the Family
The first public indication that something was amiss came in a footnote to Adelphia's March 27, 2002, earnings release. That footnote revealed the amount of off-balance-sheet debt that had been incurred through co-borrowings by the Rigases—$2.3 billion. (The sum later swelled to $3 billion.) When asked during the earnings conference call what the family was using the money for, Timothy Rigas, then CFO, replied that some of it had been used to buy more shares of Adelphia. The stock price dropped 18 percent on the news.

The loans and other related-party transactions became the object of SEC scrutiny and grand-jury investigations in Pennsylvania and New York. Eventually, on September 22, 2002, a federal grand jury in Manhattan indicted the five former Adelphia executives—John, Timothy, and Michael Rigas, James Brown, and Michael Mulcahey—on 24 counts of securities fraud, wire fraud, and bank fraud. Their actions, charged U.S. Attorney James B. Comey, constituted "one of the most elaborate and extensive corporate frauds in history." (Brown later pleaded guilty to fraud and conspiracy charges and agreed to cooperate with authorities.)

It was a shocking end to the ruling family's hold on an empire that was built over 50 years. John Rigas founded the company in 1952 in Coudersport, Pennsylvania, with the purchase of a tiny cable franchise for $300 and a $40,000 loan from a local doctor and a state senator. Eventually, Adelphia grew—mainly through acquisitions—into the fifth-largest cable company in the country, with more than 5 million customers. But Rigas never wavered from his extremely centralized management style. "It was still being run as if it were a small family business," says Michael Kramer, managing director of Greenhill & Co., an adviser to the creditors in the bankruptcy proceedings.

Rigas, chairman and CEO, and his sons controlled every move: Michael was executive vice president of operations, James was executive vice president of strategic planning, and Timothy was CFO. All held seats on a board of directors that also included John's son-in-law, Peter Venetis. Their ownership of a special class of voting shares made it impossible for other shareholders to challenge their control.

The Rigases seemingly ran the company as if it were their own private cash machine. The family has been accused of commingling the accounts of Adelphia with their other businesses, borrowing—and at times allegedly stealing—to pay for lavish homes and other personal expenses, including a private jet and construction of a golf course.

The Rigases didn't play by the rules on the accounting and control side, either; in fact, there were virtually no internal controls. CFO Timothy Rigas was chairman of the board's audit committee, an outrageous conflict that the Wharton School graduate should certainly have known was wrong. According to reports and company insiders, Adelphia capitalized millions of dollars in costs that clearly should have been expensed. U.S. Attorney Comey charged that the Rigases "exploited Adelphia's Byzantine corporate and financial structure to create a towering facade of false success, even as Adelphia was collapsing under the weight of its staggering debt burden."

The alleged fraud made it impossible for the company to file its 10K for 2001, causing it to be delisted from Nasdaq in June 2002. The delisting put the company in default on $1.4 billion worth of convertible bonds, leaving bankruptcy, which it filed for later that month, the only option. In the filing, Adelphia reported $18.6 billion in debt and $24.4 billion in assets. "If what [the defendants] are accused of is true, the behavior is much more egregious than what happened at Enron and WorldCom," argues Greenhill's Kramer, "because they didn't just manipulate the accounting—they stole from the company."

Under New Management(s)
The first attempts to right the company after the Rigases left didn't go as smoothly as many had hoped. Although John Rigas resigned in May 2002, the board remained full of his cronies. The new CEO, a retired Fleet Bank executive named Erland Kailbourne, was a longtime friend.

Under pressure from creditors and shareholders, the board replaced Kailbourne in February 2003 with William Schleyer, former CEO of AT&T Broadband and a respected cable-industry veteran. Schleyer brought along his right-hand man at AT&T Broadband, Ronald Cooper. There was controversy over the duo's compensation—almost $65 million over two years, contingent on emerging from Chapter 11 and hitting certain valuation targets—and as a result, the package was scaled back somewhat.

The hiring of Wittman went smoothly, but the departure of Christopher Dunstan, who was hired by Kailbourne to replace Timothy Rigas as CFO, did not. In his resignation letter, Dunstan alleged that Adelphia failed to appoint an independent investigator to examine transactions with one of its directors. The company later negotiated a settlement with the former CFO that included more than $700,000 in severance, and he agreed to help with any continuing investigations and court proceedings.

But if Dunstan was gone, his charges lingered. Many wondered why board members, who somehow failed to notice the Rigas family's alleged plundering, were allowed to keep their seats even after a new management team was installed. In January 2003, shareholders filed suit aiming to "remove the company from its continued domination by a Rigas-elected board of directors." In June, four board members appointed during the Rigas era finally agreed that they would step down when the company emerges from bankruptcy.

Still, the interim team is to be commended, maintains Wittman. "The prior board did a stand-up job of stepping into a very difficult situation and making hard decisions," she says. "They basically had to take the family out of a family-run business. They kept the wheels from flying off."

Now the wheels are snarled in a tangle of litigation. In addition to multiple class-action shareholder suits, Adelphia itself has sued the Rigas family and the company's former auditor, Deloitte & Touche LLP. Most recently, the creditors' committees filed a lawsuit on Adelphia's behalf against a group of more than 450 banks, including Bank of America Corp. and Wachovia Corp., which they accuse of knowing about the improper loans. "The pending litigation has slowed everything," explains Kramer.

Sleepless Nights
Despite these initial missteps, industry experts say Adelphia has done a remarkable job of getting its house in order quickly. One early decision was to move the company from Coudersport to Denver, where Schleyer and Cooper had worked at AT&T Broadband before it was sold to Comcast. "It was a smart move," comments Mark Kersey, a senior analyst at Current Analysis Inc., a Sterling, Virginia-based technology market research firm. "It would be [much more] difficult to attract top management to Couders-port [than to Denver]."

Convincing Wittman (one of the few new executives at Adelphia who didn't come from AT&T Broadband) to come aboard was also a major coup, says Kersey. Having just finished helping 360networks through a successful bankruptcy, says Wittman, "there were those who asked, 'Why in the world would you go and do another bankruptcy? It's a total mess. Wasn't it bad enough the first time?'" Her answer: she enjoys a challenge.

But Wittman didn't realize how big a challenge Adelphia posed. Every day during her first six weeks on the job, she found out "something more stunning than the last [day]," she says. During her first days as CFO, she found herself getting up in the middle of the night to work. When she mentioned her inability to sleep to one of the senior lawyers on the team, he sympathized. "Yeah," he said, "that happens to everyone for the first few months."

Wittman's first order of business was to help Adelphia get its hands on $1.5 billion in DIP financing. Although the company had already arranged the loan, it couldn't access all of the funds until it had an interim budget in place. "In record time, we negotiated the covenant with the banks and got access to the DIP facility at the end of May," says Wittman.

An even more daunting task for the new finance team was to restate Adelphia's results for fiscal years 1999, 2000, and 2001, which meant also compiling 1998 numbers to get an opening balance. "It was a giant ball of hair," declares Wittman. "There were over 7 million transactions that had to be reviewed." Chief accounting officer Scott McDonald concentrated on the restatements so the CFO could focus on bankruptcy duties. McDonald found plenty of fraud—and sloppy work. "There was horrible record-keeping, lots of financial manipulation, and inconsistently applied policies where policies existed," says Wittman. Working lots of overtime, McDonald and his colleagues finished the restatements in eight months and delivered them to Adelphia's new auditor, Pricewaterhouse-Coopers, in November.

Meanwhile, the finance team is working on the sale of noncore assets, including cable-system interests in Latin America and, adds Wittman, "grass seed for the golf course." The staff also completed the construction of the intercompany balances—necessary for developing a valuation model for the company—and a five-year plan. "We have been going with our hair on fire since May," says Wittman, who is quick to credit Schleyer, Cooper, and her finance staff for their hard work. "There is no way you could clean up a mess this big," she says, without a "really deep, very dedicated team."

The Credibility Question
In addition to the messy bankruptcy, Adelphia has major operational hurdles ahead. Industry experts say the company lagged its competitors in providing subscribers with high-end services, such as digital cable, high-speed Internet access, video on demand, and high-definition television. "This is where all the growth in the industry is coming from," says Current Analysis's Kersey. While the networks of most of the large cable providers have been about 95 to 99 percent updated to provide high-end services, Adelphia's stand at only 70 to 80 percent. "That certainly puts them in a more vulnerable position," says Kersey. He says Adelphia will continue to lose market share until it can update those subscribers.

Still, he's not ready to count Adelphia out. "They have some great markets, and very valuable assets," he notes. "The key is how quickly they can emerge from bankruptcy, and how quickly they can upgrade their systems." Unfortunately, the answer to that question could be later rather than sooner, thanks to the amount of litigation holding up the reorganization plan.

Even when Adelphia does exit Chapter 11, it must win back its credibility with customers and investors. "There is no question that what happened at Adelphia hurt it with customers," says Stephen Effros, president of cable-TV consultants Effros Communications. And it happened at a critical time in the industry. Many cable companies are looking to become one-stop communications providers for the home, offering cable-TV, phone, and Internet service. "Customers need to have a lot of trust in a provider before they go to a single supplier," says Effros. "That means companies need to provide the best customer service possible."

Adelphia can do that, he says, only by first regaining the trust of its employees. Wittman, who spent the first few days of her tenure meeting with employees and customers, hopes the decentralization of the company will enable employees to take more ownership of their jobs. She says morale is on the mend: "People are very charged up about getting this thing fixed."

Adelphia hopes to deliver a preliminary reorganization plan to its DIP creditors by the end of 2003, and is pushing to emerge from bankruptcy in mid-2004. Wittman is confident that the company will emerge in good condition. "This is a really terrific business," she says. "It should not have been in bankruptcy in the first place." She is also sure that what happened at Adelphia can never happen again: "We have to be beyond reproach, on every front."

Joseph McCafferty is news editor of CFO.

Restoring Adelphia

2002

May: John, James, Michael, and Timothy Rigas resign as Adelphia executives and directors.

June 25: Adelphia files voluntary petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code. That same day, lenders agree to provide $1.5 billion in debtor-in-possession (DIP) financing.

June 28: Court grants Adelphia immediate access to $500 million of $1.5 billion DIP financing.

July 24: Adelphia files lawsuit against John Rigas and other former executives and board members of Adelphia.

August 23: Adelphia's $1.5 billion DIP financing is approved.

November 6: Adelphia files a lawsuit against its former auditors, Deloitte & Touche LLP.

2003

January 17: Adelphia announces it has entered into agreements with William Schleyer and Ronald Cooper.

January 28: Adelphia board authorizes the move of corporate headquarters to Denver.

March 7: Bankruptcy court approves employment agreements of chairman and CEO Schleyer and president and COO Cooper.

March 21: Adelphia names Vanessa Wittman CFO.

March 25: Adelphia announces the resignation of CFO Christopher Dunstan.

May 13: Adelphia elects two additional directors.

May 28: Adelphia forges agreement with DIP lenders for access to $1.5 billion facility.

June 4: Four carryover directors announce plans to resign from Adelphia's board.

July 31: Adelphia files its schedules of liabilities and statement of financial affairs.

October 23: Adelphia amends its schedules of liabilities and statement of financial affairs.

October 24: Bankruptcy court sets the bar date for January 9, 2004.

Source: Adelphia Communications

Sweeping Up
New executive brooms at WorldCom and Tyco clear out the remnants

Adelphia isn't the only high-profile, scandal-plagued company in need of an extreme makeover. Both WorldCom Inc. and Tyco International are striving to restore their good business names, even as the executives who sullied their reputations await trial.

Amazingly, WorldCom, author of the biggest scam of all—where former CFO Scott Sullivan and others are alleged to have cooked the books by a stunning $11 billion—is already poised to exit bankruptcy under the moniker of its largest acquisition, MCI. And instead of staggering under the weight of $40 billion in debt, it will have a manageable $5.5 billion.

The new MCI will also boast a state-of-the-art system of controls and corporate-governance practices. "They seem to be on their way from worst in class to best in class," says Nell Minow, chairman of The Corporate Library, a corporate-governance research firm. "They are doing all the right things."

Those things include sweeping out the board room and executive offices and hiring Michael Capellas, former president of Hewlett-Packard Co. The board appointed independent board members known for their integrity, including former U.S. Deputy Attorney General Eric Holder and Dennis Beresford, former chairman of the Financial Accounting Standards Board. Last April, MCI hired Robert Blakely, a respected former CFO of Tenneco with 21 years of experience, as CFO.

MCI also conducted a vigorous internal investigation, headed by former Securities and Exchange Commission director of enforcement William McLucas. When it was finished, the company asked for the resignations of 50 employees. Many were not accused of taking part in the fraud, but had a high likelihood of being aware of it. "People who looked the other way have demonstrated their uselessness," says Minow. "They have to go. They are no less culpable."

The company has also established a corporate-ethics office that reports to Capellas. "We can't afford to be anything less than 'best of breed' in corporate governance and ethics," asserts Beresford.

Breen Sweeps Clean
At Tyco, meanwhile, CEO Edward Breen wasted no time in exorcising the inner circle of former CEO Dennis Kozlowski. Immediately following his July 2002 appointment, he fired about 50 executives, as well as the entire board that had hired Breen himself. He then assembled his own team of nine independent directors.

Next, Breen tapped former United Technologies CFO David FitzPatrick to replace the post vacated by Mark Swartz, who, like Kozlowski, is under indictment for looting the company of some $600 million. "Breen and FitzPatrick hail from companies with long-term perspectives, and are more patient about growth," says Brian Langenberg, a principal at Langenberg & Co. in Chicago.

But getting rid of Kozlowski and Swartz—whose alleged offenses include self-dealing transactions, unapproved bonuses, and fraudulent stock sales—was just the beginning. An in-house probe revealed major breakdowns in financial controls, including transparency problems in the plastics division and suspect operating income in the ADT unit.

In short order, Breen expanded the ongoing internal audit into a full-scale, independent investigation that kept 25 lawyers—led by superstar attorney David Boies—and 100 accountants busy for five months. The investigation uncovered breakdowns in the control processes associated with executive compensation, and problems with reported revenues, profits, cash flows, use of reserves, and nonrecurring charges, among other financial shortcomings.

So far, several repair measures have been implemented, says Tyco spokesman Gary Holmes, including splitting the plastics group into two reporting segments, changing the definition of free cash flow to include cash paid for the acquisition of new dealer accounts, and providing details of how "organic growth" is calculated.

FitzPatrick asked all financial managers and executives to sign an ethical code of conduct, and he is confident that the problems have been addressed. "During 2003, a considerable portion of my time was spent looking backward," says FitzPatrick. "Now, I'm ready to look forward."

Still, several hurdles remain to be cleared. "Breen's on target, but he's been left with no systems in place to track what's going on," observes Langenberg. "There's no operating plan or strategic-forecasting methodology." Then there are the continuing reporting gaffes. When the internal review was completed, in late 2002, Tyco pronounced itself free of fraud, and Breen said that restatements for prior quarters were a thing of the past—only to see the company restate one more time. So far, Tyco has made $1.1 billion worth of adjustments since Breen's arrival.

Despite Tyco's woes, the company's prospects are good. Its portfolio is strong, says Langenberg; many of the companies rank first or second in their respective industries. By his lights, Tyco's stock prospects are "more bull than bear." As long, that is, as it keeps the bull out of its financial reporting.

Joseph McCafferty, with Marie Leone and Craig Schneider

Citi's New Stance

After more than a year of scandal and public penance, Citigroup CFO Todd Thomson is determined to rebuild the reputation of the financial-services giant.
A CFO Interview, CFO Magazine
November 1, 2003

In business, nothing speeds forgiveness like success. Citigroup cranked out a record $4.1 billion in earnings from continuing operations in the first quarter of this year, and followed it with $4.3 billion the following quarter. That performance moved investors, who had driven the stock price down to $24.42 last summer as a result of Citigroup's repeat appearances in financial scandals, to nearly double it by mid-October.

But forgiveness didn't come without some very public penance for the financial-services giant. In April, the firm's Salomon Smith Barney division (now called Citigroup Global Markets) forked over $300 million in fines plus $100 million in additional restitution as part of the so-called global settlement with regulators over misleading research. As employer of the poster child for conflicted research—telecommunications analyst Jack Grubman—Citigroup's fines were the largest of any financial institution (see "The Global Settlement" at the end of this article).

Critics will note that the fines amount to less than a week's worth of earnings so far this year. Somewhat harder to dismiss are public expressions of regret by Citigroup executives—particularly given the number of still-looming shareholder suits—and the firm's laundry list of internal reforms (see "New Leaf or Fig Leaf?" at the end of this article). Prudential Equity Group's Mike Mayo derided some of those reforms last year as "just-in-time corporate governance," but even that notoriously bearish analyst had to bow to Citigroup's financial performance, upgrading the firm from "sell" to "hold" this past July. That same month, Citigroup settled enforcement proceedings with the Securities and Exchange Commission over structured financings for Enron and Dynegy, earning a curt acknowledgement for its cooperation.

CFO Todd Thomson insists Citigroup isn't just playing catch-up when it comes to reform—he claims it's now trying to use its enormous market presence to lead the way. And that includes setting some standards for what it will and won't do for its corporate customers.

"Anything Citigroup can do to show leadership in regaining trust with investors we should do," says the 42-year-old Thomson. That includes obvious corporate moves such as expensing options (despite his historical opinion that the accounting treatment is incorrect) and raising Citigroup's dividend by 75 percent.

When it comes to actually turning over a new leaf, of course, results are harder to gauge. The true test of Citigroup's reforms will be its ability to remain scandal-free despite its staggering breadth of financial offerings and sprawling global operations.

When it comes to his own finance organization, which spreads across more than 100 countries, Thomson, who took over as CFO in March 2000, shuffles finance executives around the world to make sure their ultimate allegiance is to his office in New York, not their local business unit. "I want to establish—and have established—a culture of integrity in the finance organization," he says. "That happens only if I'm viewed as having personal integrity."

At the very least, one can certainly say Thomson puts his money where his mouth is. Under Citigroup's so-called blood oath, executives must hold at least 75 percent of Citigroup shares they receive. "I have never sold a share yet," says Thomson. "One-hundred percent of my net worth is in Citigroup stock."

Senior writer Tim Reason sat down with Thomson in mid-September to discuss just how much Citigroup has changed, and what that might mean for its customers.

You had a record $4.3 billion in income from continuing operations in the second quarter. Given the turmoil of the past 18 months, you must be very pleased.
Yes, I think these are tremendous results. It's a testament to the dedication of the management team. To not be distracted by newspaper stories, but to stay focused on customers and on building a growing business was a terrific challenge. It's also a testament to the franchises we have here. We've got a credit-card business, a consumer-finance business, our corporate investment bank—those are all the biggest and the best-run in the industry. That allowed us to continue in a very difficult economic environment globally and deliver terrific financial results.

Last year was a terrible one for your stock price. Now your stock is back up.
Well you know, as CFO you're never satisfied with where the stock is. We're not getting nearly the premium we deserve. But I think it will come.

Is the premium low because of the economy, or is it the result of a lingering aftertaste of Enron, WorldCom, and all those other distractions?
I think it has less to do with some of those issues and more to do with the fact that the company really is only about five years old. It was created by combining CitiCorp and Traveler's at the end of 1998. If you look back over the past 10 years, earnings per share have grown more than 20 percent a year. But it takes a while for investors to get comfortable that going forward, the new company will deliver the same kind of performance.

Also, as the world has changed, there has been concern about big, complicated, global companies, and we are one of the biggest and most complicated. Over time, people will get comfortable that a company this size can be managed very well for growth, and that we can continue to deliver quarter-on-quarter.

And we're hopeful that the geopolitical situation will settle down a bit. I think that will be helpful to the stock as well.

You think the geopolitical situation is hurting Citigroup's stock?
I think those are bigger overhangs than the specific issues from last year.

Citigroup sponsors major conduits for issuing asset-based commercial paper. What affect did FIN 46 [FASB's ruling on consolidation of variable interest entities] have on the special-purpose entities [SPEs] that serve as those conduits? You did not ultimately have to consolidate them onto your balance sheet.
Right. The Financial Accounting Standards Board scoped out qualifying SPEs, so things like our securitization vehicles for credit cards were [not changed by] FIN 46. I don't think there are abuses in those. [Qualified SPEs] help the U.S. capital markets operate more efficiently, and securitization of credit cards has been a very valuable part of the development of the capital markets.

Commercial-paper conduits were [not excluded from FIN 46.] We provide a service, essentially, for customers. They have assets, they want to get funded, and they want to issue commercial paper backed by those assets. We offer a way to intermingle various customers' assets and then offer [commercial paper backed by those assets] to the marketplace. We provide a service that's not that much different from a mutual fund.

According to FIN 46, we would have had to consolidate about $55 billion of customer assets under our balance sheet. I don't think it's reasonable for us to do that. So we asked, "Is there a way to structure these vehicles that meets the new FIN 46 requirements to keep the customers' assets off our balance sheet?" And we realized that we could restructure the assets by selling off some first-loss positions to outside, unaffiliated investors.

Because if outside investors hold the expected-loss tranche, FIN 46 defines them as the primary risk taker, and they must consolidate the assets on their balance sheet, correct?
Yes. And we have actually gone through—in detail—with the SEC, with the Federal Reserve, and with FASB the approach we're using for restructuring. So I think that's well understood at this point. As a result, we are not consolidating these customer assets on our balance sheet.

It must have been a pretty big scramble to do that by this summer's deadline.
Well, it's sort of a matter of course around here; when things change, you get out in front of them and address them.

Presumably, your cost of lending could have gone up, or the cost of borrowing could have gone up for your customers. Do you think that when FASB put FIN 46 together it gave adequate consideration to the potential economic impact?
I can't speculate on what FASB thought when it was issuing Fin 46. I would say that the commercial-paper market works very well. The commercial-paper conduits that we and other banks offer are a valuable service to customers.

Our fees are very small for the service we provide. You can't be in the business with that level of fees and justify having $55 billion of assets on the balance sheet as long as they are risk-weighted by the Fed. So either the fees would change dramatically, or we and others, I believe, would have gotten out of the business. That would have been a real shame, because this is an important funding mechanism for a number of our customers.

You mentioned that you spoke with FASB about your restructuring effort. But when this was all being hashed out, FASB chairman Bob Herz spoke at a Bond Market Association meeting and gave the impression that the economic impact on the banks was not FASB's concern; that the concern was "getting the accounting right." By continuing to keep the conduits off your balance sheet, do you feel nonetheless that you're operating within the spirit of FIN 46?
Yes. I think everything we've done fits within how FIN 46 was written. It addresses the structural requirements to have things off the balance sheet. We've reviewed those with everybody, so I believe it does.

And the ultimate cost impact of FIN 46?
It did increase the cost for us in the sense that we needed to restructure these things, which cost us some money. Essentially, we end up sharing our fees with outside investors, so our revenue will be lower than before. But the amount of revenue we get from commercial-paper conduits is—in the context of corporate investment-banking revenues—very small.

FIN 46 may also affect trust-preferred securities [TRUPS]—in this case by requiring that they be taken off your balance sheet. What impact would that have on Citigroup?
Trust-preferreds have been designated by the Federal Reserve as Tier 1 capital up to a certain amount [25 percent] of a bank's total Tier 1 capital. So it's an important way to get equity in Tier 1 capital as a bank holding company. The accounting—it's interesting, and I believe this was an unintended consequence of FIN 46—raises the question of whether you would have to deconsolidate TRUPS. We've written a letter to the SEC and we, as well as a number of accounting firms, believe FIN 46 will not cause a change in consolidation for the purpose of TRUPS. But it's an ongoing debate.

Bottom line, is there potential for a big financial impact? Your 10Q says you would be well capitalized regardless of the outcome.
It won't matter to us in terms of capitalization. Some smaller banks could feel some pressure. But the Federal Reserve has said that for the time being, it will grandfather in any existing TRUPS for Tier 1 capital purposes. From the Fed's perspective, the nature of the instrument hasn't changed, regardless of how it is accounted for. It has said that those who have issued new TRUPS since FIN 46 came out will also receive Tier 1 capital treatment. We issued $500 million in trust-preferreds a couple of weeks ago. We checked with the Fed in advance and it said yes, they will receive Tier 1 capital treatment.

The conflicts between the Fed and the SEC seem to increase as FASB moves ahead to try to simplify accounting....
[Laughing] Simplify accounting!

Maybe that's the wrong phrase. As FASB tries to change GAAP to react to some of the excesses of recent years, accounting changes aimed at regular companies often conflict with the complicated financial mechanisms in place at banks. And that increasingly seems to put the Fed and the SEC at odds. As CFO of Citigroup, it sounds as though you often end up in the middle, writing letters and trying to explain the issues to both regulators.
FASB has been writing a number of staff papers on a number of issues, partly in response, as you said, to the excesses and abuses that have occurred. I think fixing abuses is good; no question about that. But as FASB comes up with new interpretations or rules, it is important that there be a very serious dialogue with us and others in the industry to make sure that we end up with only intended consequences. A lot of these things aren't as simple as they might appear. Some of them have more-complicated application for financial-services firms. We are trying very hard to make sure that we're involved in that dialogue. Eliminating abuse? Terrific. But we need to be careful of potential unintended consequences.

Are you spending more of your time on that dialogue?
Yes. Four years ago, we might have spent five minutes on accounting-policy issues once a month. Now, in my weekly staff meetings, we typically spend 15 to 20 minutes on such issues, plus special meetings. It's been very demanding.

In the wake of a lot of negative publicity last year, Citigroup has made it a point to present itself as a leader in business practices and corporate governance. During your second-quarter earnings call, Sanford Weill said, "We got the message on reputational risk." What exactly was the message you got?
he message is that the world has changed. We've changed from a period of excess, from a period of glorifying IPOs without profits and dot-comers who went to work and then six months later became multimillionaires on paper. Complicated off-balance-sheet structures were considered clever, and people were lauded for creating complicated structures and attempting to evade things. [Even] your magazine was part of that.

I think the message we got was that it's time to get back to integrity and good disclosure and good corporate governance. And frankly, I think everybody feels better about that. At Citigroup, we feel we should help lead that process. We should lead by example, because we have some influence on how the rest of the business community acts.

We've tried to work hard regarding instituting a number of reforms in how we operate the business, what we do and don't do with our customers, and how we handle corporate governance at Citigroup itself. We've done everything from eliminating cross-board seats to expensing stock options, establishing business-practices committees within each of our businesses, and putting in the reforms you saw in the corporate investment bank. Everything from separating research from investment banking to establishing the net-effect rule about which structured financings we are willing—or not willing—to do with customers.

Of all the firms involved in the global settlement, it's safe to say Citigroup made the most public statements of contrition—within the obvious bounds of what could be said given the litigation that is still pending. Yet Citigroup also wound up paying the largest fine. Is it possible that publicizing your internal reform efforts actually cost you more, or made you more of a target for regulators?
In hindsight, some of the industry practices around research, around IPO allocations, around structured products were inappropriate. They seemed appropriate at the time. If I can talk about structured products, bankers viewed their job as structuring things subject to accounting firms and law firms signing off on their accounting and legal appropriateness.

We decided we'd have to take some responsibility for how and why our clients do things, and how they disclose them. I don't know whether that sets us up to be more of a target or less of a target with the regulators.

On the other hand, in a separate structured-financing settlement, the SEC specifically mentioned Citigroup's cooperation.
The fact that the SEC noted how cooperative we were in the Enron and Dynegy structured-products settlement is a good thing. I want Citigroup to be viewed by regulators as a company that "gets it." And I think we do get it. I want regulators to view us as a company that is not dragging its feet on reform, but is leading reform. And if it costs us a little bit more money, I think it's a good price to pay.

During congressional hearings after the Enron meltdown, one of your officers testified, "We do not dictate our clients' accounting practices. Once we're satisfied that our clients' proposed tax and accounting treatments seem reasonable, the accounting judgments are left to the client and its accounting professionals." Has that changed?
The standard has changed.

So how do you police that among your customers? For example, under your net-effect rule, how do you police how a customer discloses a structured financing?
I don't think we can be in the business of policing our customers' accounting and disclosure. That's why the SEC exists and why external accountants and law firms exist. That's their job, not ours. If we believe there's a structured-finance product that is really financing, we ask the company to commit to us that the product will be disclosed as a financing on its balance sheet. If it's not going to be disclosed as we think appropriate, then the company will have to go elsewhere because we're not interested in doing that business.

But again, the environment hasn't only changed for us, it has changed for our customers. There were a number of them that might have been interested in doing the fancier off-balance-sheet things that were being done in the late 1990s, but they're not interested anymore. I think our customers are on board with the net-effect rule.

In theory, though, what recourse would you have if they reneged on their commitment to disclose it? Do customers have to sign a document stating how they will disclose it?
They have to commit to us that they're going to do that. But again, we're not the SEC, so our job isn't to enforce accounting rules.

Do they have to make some sort of written commitment to a particular type of disclosure with you?
They just have to commit to us that that's how they're going to do it.

Initially, Citigroup's net-effect rule exceeded GAAP and SEC requirements. Now that off-balance-sheet financing must be disclosed anyway, do any of your requirements exceed what is required by GAAP or regulators?
It's hard to say. There may be things that, from our perspective, should be disclosed clearly as debt although the accounting rules might permit some flexibility. You'd be fine from a Sarbanes-Oxley [Act] point of view because you're signing that your statements are based on GAAP, but that might not be consistent with our net-effect rule. In those situations, if a customer is looking for us to do the structuring, it must disclose it appropriately.

All this is important, but the most important thing is the change in tone and business culture since the go-go 1990s. There's always the potential for fraud. If somebody like WorldCom is going to perpetrate a fraud, no amount of rules is going to keep that from happening.

Have you had to walk away from deals as a result of your net-effect rule?
We initially had a couple of tough conversations with clients on the rule. More recently, our clients, as I said, have been on board with this.

What types of structured-finance deals are no longer done?
There's very little that's not done. I think some of the more-structured things that Enron was doing—those became very popular as off-balance-sheet financing instruments for utilities. I think those are a lot less popular today for utilities.

The issue with Enron was how it was disclosed and how they talked about it, and what this really meant for their operating business. There's nothing evil about structured finance per se. It is just that when it is not disclosed properly, there is the potential for misleading investors.

You're one man. How do you stay on top of all that's going on at a company with the size and diversity of Citigroup?
This is a big place. We're in more than a hundred countries. We're in every major financial-services product. It's a fantastic perch from which to see what's going on almost anywhere in the world. That's one of the exciting things about the job.

The flip side of that is that anything that happens anywhere has an impact on us. So we have to be on top of the risks that exist in the company. And from my perspective—a control perspective—I've got to make sure that the controls are in place to ensure that we're reporting accurate financials and not having operational breaks.

Most important is maintaining a culture of integrity in the finance organization, because regardless of how many controls you try to put in place, if the culture isn't right, somebody will take advantage of the situation. We spend a lot of time on internal training. We deliberately transfer finance people across businesses on a regular basis to make sure that nobody goes too native anywhere. That's very important as a control mechanism.

We also have an accountability approach. This was started years ago, way before Sarbanes-Oxley. At the very lowest level of a P&L of a product and a country, the finance person responsible for those numbers has to sign that those are the right numbers, and then that cascades up to the next level.

So there's a culture of accountability and integrity. That gives me the ability to sleep well at night. The final part is you have to have really, really talented people working with you. We have one of the finest finance functions of any business in the world.

I suppose the upside to being exposed to risks worldwide is that your diversification also gives you natural hedging capabilities.
The most important risk-management tenet is diversification, because you almost never have perfect foresight into the future. We just don't allow large concentrations of risk anywhere, in any credit, in any country, or in any market.

Second, there must be independence from the businesses. A risk manager who signs off on a loan can't be the loan officer who is paid for making loans. We've structured an independent risk-management organization to provide the right kind of checks and balances as we continue to push business managers to drive revenue growth.

Third, you have to pay attention to risk daily; it's got to get senior management's attention. The people in the risk-management function have to feel that they're doing really important work; they have to have good career paths.

We hate losing money. We just hate it. When you're in the business of taking risk, every once in a while you're going to lose money, and we do. In our business plan every year, we have expectations of billions of dollars of credit losses, but we hate it. So we spend a lot of time and energy trying to minimize the losses that we take.

That's the legacy of Sandy Weill, I assume.
Sandy wants all the return and none of the risk. [Laughs] And he considers that a reasonable request.

One way that banks have minimized risk in recent years is to spread it out into the marketplace. Isn't there also a danger of spreading credit risk out to market participants that are less able to handle it, are less regulated, or are simply less aware of what types of risk they're assuming?
I think there may be some players out there that end up taking on credit risk—because they're buying bonds or credit derivatives or whatever—that are less sophisticated than others. But the reason Moody's has been so pleased with the performance of the financial-services industry through this downturn is that banks and financial-services firms can take losses that might otherwise be concentrated in a fairly small number of players and spread them out to a large number of players in the marketplace. The result is a stronger banking system. And I think the market has plenty of ability to absorb those.

New Leaf or Fig Leaf?

Citgroup's list of internal reforms was derided by one analyst as "just-in-time corporate governance," but CFO Todd Thomson says he wants Citigroup to be a leader, not a laggard. A partial list of Citigroup's "business-practices initiatives" includes the following:

• All research is housed in a new retail brokerage unit, Smith Barney.

• Research analysts may not attend pitches, roadshows, or other efforts to solicit investment-banking business.

• Investment banking is banned from any involvement in setting analyst compensation.

• Analysts must certify to the accuracy and impartiality of their views.

• Analysts may not own any securities they cover.

• Customers are required to publicly disclose the net effect of structured finance transactions on their financial condition.

• Citigroup's tax department must review and approve all tax-sensitive financial products or strategies.

• Stock options are expensed as of January 2003.

• Stock-option repricing is prohibited.

• Pension-return assumption has been lowered to 8 percent from 9.5 percent.

• Interlocking directorships between Citigroup executives and companies affiliated with Citigroup directors have been eliminated.

• Directors and their families are forbidden from receiving IPO allocations.

• Long-standing policy requires directors and senior executives to hold 75 percent of the Citigroup stock they own.

Whistle-Blower Woes

Many companies think the whistle-blower provisions of Sarbanes-Oxley will spark nuisance suits by disgruntled employees. The truth is far more complex.
Alix Stuart, CFO Magazine
October 1, 2003

When Matthew Whitley was laid off from his job last March as a finance manager at The Coca-Cola Co., along with about 1,000 other employees, he didn't take it lying down. Two months later, Whitley approached his former employer seeking a whopping settlement—$44.4 million—on the grounds that he had been fired in retaliation for raising concerns about accounting fraud. When Coke balked, Whitley turned for relief to a new ally: the Sarbanes-Oxley Act of 2002. He filed for whistle-blower protection under the act's Section 806 provisions, and initiated federal and state lawsuits that charged seven Coke executives, including CFO Gary Fayard, with crimes ranging from racketeering to mail and wire fraud.

"This disgruntled former employee has made a number of allegations accompanied by an ultimatum: that the company pay him almost $45 million or he would go to the media," said Coke in a May statement announcing the claims. Since then, a Georgia state court judge has dismissed most of the charges, including those related to racketeering and breaches of fiduciary responsibility. While Coke may still have to defend itself against claims related to wrongful termination, "we are confident we will prevail once the facts are presented in a court of law," said Coke in a statement.

One of Whitley's allegations, however, has already had some effect. His contention that Coke falsified a marketing test of Frozen Coke at Burger King restaurants in Virginia led the company to make a public apology and an offer to pay Burger King $21 million. In July, the Department of Justice (DoJ) announced it was launching a criminal investigation of the alleged fraud.

CFOs may be forgiven for fearing that cases like Whitley's are a harbinger of things to come—that, thanks to the protections afforded by Sarbanes-Oxley, irate workers will accuse their employers of financial wrongdoing in order to wring large settlements from them. Indeed, on August 27, a federal judge refused to dismiss a whistle-blower lawsuit accusing TXU Corp., an energy company, of earnings manipulation; unless the case is settled, it will become the second suit filed under Section 806 to reach a federal court (the first involved JDS Uniphase Corp.).

But it remains to be seen whether Sarbanes-Oxley will have a significant impact on whistle-blower litigation. Although the number of such filings has increased, most will probably be dismissed as lacking merit. And even with the new protections of Section 806, would-be whistle-blowers still face a painful cost-benefit decision: whether a lawsuit with uncertain chances of success is worth the professional and personal sacrifices that will assuredly be required.

A Reasonable Belief
In theory, disgruntled ex-employees have always been able to accuse their ex-employers of misdeeds in order to claim wrongful termination. But until the passage of Sarbanes-Oxley, most public-company employees had little to gain financially if the company denied the charges and refused to settle. Since the mid-1980s, the federal government has protected whistle-blowers whose work affects public welfare, including, for example, federal employees, government contractors, power-plant operators, and airline staff. But people who spoke out about financial fraud had no legal protection except for a handful of state laws—and then, often, only if the matter affected the general public.

Today, the law says that an employee needs only "a reasonable belief" that his or her employer is violating a securities law or is in any other way imperiling shareholder value to qualify for government protection from retaliation. "Retaliation" encompasses everything from firing to verbal threats and missed promotions. Within 90 days of experiencing retaliation, an employee can file for protection, which means anything from reinstatement with back pay to a full federal court trial with the potential of compensation for pain and suffering. These protections apply even if the employee is wrong about his or her accusations.

"The employee could be wrong, but if they have a reasonable belief there's been a violation and the company retaliates against them in any way, it triggers the whistle-blower protection in Section 806 and leaves the company wide open," says Neil Aronson, a partner with Mintz Levin Cohn Ferris Glovsky and Popeo in Boston.

A separate section of the law puts managers who allow retaliation against a whistle-blower at risk of jail time or fines. That, in turn, exacerbates the enormous public-relations risk to the company. Add to that the praise heaped on whistle-blowers like Enron's Sherron Watkins and WorldCom's Cynthia Cooper, and what does an angry employee have to lose?

Plenty, it turns out. Most people who have publicly accused their companies of securities fraud say Sarbanes-Oxley does little to mitigate the high personal price of coming forward.

"It's the exception that a whistle-blower is looking to get even, because it's very painful to break ranks with [your company], even if [you] have strong legal rights," says Thomas Devine, an attorney who has counseled more than 2,000 whistle-blowers protected by other federal statutes through the Government Accountability Project, a nonprofit group based in Washington, D.C. Even with legal protection, once whistle-blowers go public, their reputations are called into question and their future career prospects hampered, all for the dubious goal of reinstatement to a work environment in which they are considered troublemakers.

Even if a case does go all the way to a federal court, whistle-blowers would probably have to change industries if they ever want to work again, says Devine, since they will be considered "wild cards" regardless of the outcome. And despite the attention given Watkins et al., most whistle-blowers are rebuffed, not supported, by the federal government. Since Sarbanes-Oxley was passed, about 131 public-company employees have reported violations of whistle-blower protections to the Occupational Safety and Health Administration (OSHA) of the Department of Labor (DoL). (The agency was directed to oversee these violations because it has handled the industry-specific whistle-blower statutes.) Most of these investigations—83 percent of the 60 completed so far—have been dismissed or withdrawn.

True, the percentage of cases upheld may increase, since about one-third of claims have been thrown out for technical reasons—for instance, because the company is private or the alleged retaliation began before passage of the law. But in general, says John Spear, OSHA's head of investigative services, 75 percent of cases brought each year under other whistle-blower statutes are found to lack merit.

Even when the claims of fraud and retaliation are justified, it's unclear what the whistle-blower will gain. Attorneys can name wildly different figures depending on whether the underlying assumption is that the whistle-blower will never work again, will work but won't be promoted, or will have to retrain for a new profession. No one yet knows what civil juries or federal-court judges will accept.

Final Straw at Coke
From that perspective, Matthew Whitley represents all the reasons whistle-blowers are more to be pitied than feared. As he tells it, losing his $140,000-a-year job was the final straw in what had been a long personal battle against earnings management.

In his 11 years at Coke, 9 of them as an internal auditor, the 37-year-old Whitley claims he caught various attempts to minimize current expenses, using such techniques as stretching out capitalization periods or booking payments to bottlers as assets. Under previous CEO Robert Goizueta, he says, such concerns were heard and addressed. Since Goizueta's death in late 1997, though, Whitley says he has seen a progressive deterioration in accounting controls and an increasing reluctance to fully correct problems.

For example, Whitley led an internal investigation in 2001 that found vice president John Fisher had used fraudulent marketing schemes to sell Frozen Coke products and equipment to Burger King. Since the scheme violated Coke's code of conduct, among other problems, Whitley recommended the executive be fired. Instead, Coke's audit committee, which includes Warren Buffett, simply demanded that Fisher forfeit half of his 2000 bonus and 2001 stock-option award. Fisher was later promoted to a senior vice president post, while Burger King was allegedly never informed of the incident.

When outsider Steve Heyer (he had been COO of Turner Broadcasting) was promoted to COO in December 2002, Whitley saw hope for more systemic changes. On December 30, Whitley sent an E-mail to Heyer outlining some of his concerns about recent incidents. Heyer mailed back an invitation to provide more details, and a month later Whitley sent Heyer an E-mail with a nine-page memo attached, listing many of the violations of Coke's code of conduct he had helped investigate and the subsequent light punishments that generally resulted.

Heyer, who through a spokesperson claims he received but never opened the twice-sent attachment, never responded, according to the complaints Whitley filed in May. Nor did any word come from CFO Fayard, with whom Heyer had indicated he would share the memo. But in mid-February 2003, Whitley received the worst performance review of his career, according to his complaint, after a history of above-average marks and positive comments about his integrity. On March 26, he was laid off as part of a companywide reorganization.

When Heyer stopped responding to Whitley's ongoing attempts to follow up by E-mail, Whitley sent a copy of the memo to Coke's general counsel, Deval Patrick, in mid-March, offering to meet with him. Whitley says he continued to press for a meeting after his layoff, but finally gave up in order to file for whistle-blower protection within the 90-day window.

"I didn't want to go public, but I didn't know what choice I had because no one would listen to me," says Whitley. The proposed $44.4 million settlement "was intended to get Coke's attention," he says, adding that he never expected Coke to pay that amount.

Coke has not responded so far to any of the specific allegations, but the company denies that it fired Whitley in response to the claims he raised, and downplays the claims themselves. "As we have investigated all of the allegations raised by Mr. Whitley, we have found nothing material that requires a restatement of our financial statements, or we would be doing that right now," said Heyer in July's second-quarter conference call.

Still, while the issues might not be material to Coke at a corporate level, it's hard to say Whitley was just grousing. In response to his lawsuit, Coke conducted an internal investigation and subsequently agreed to pay Burger King $21 million as recompense for the marketing frauds, after firing Fisher in April for a further (and unrelated) violation of the corporate conduct code. The company announced in June that it was writing down $9 million due to overvalued assets in its Fountain division, and said it would continue to investigate financial arrangements with its suppliers. In August, Coke announced that Tom Moore, Fountain president and a named defendant in Whitley's suit, was stepping down.

Whose story—Whitley's or Coke's—is the real thing could be decided by a civil-court jury or the DoJ, which is investigating the alleged Frozen Coke fraud. But Whitley isn't pinning his hopes solely on Section 806 and OSHA. Why? "In many ways, Sarbanes-Oxley is toothless," says Marc Garber, Whitley's attorney, "because the [DoL] has no subpoena power and no authority to interview employees without a company representative present." That makes it difficult to gather the evidence necessary to win a case.

Thus, while OSHA is still investigating Whitley's case, Garber, a former federal prosecutor, is also relying on broader state and federal lawsuits. The latter offer the opportunity for fuller investigation, he explains, and the potential for a larger settlement.

Hanging on at Duke
Other whistle-blowers who have endured OSHA investigations agree that the protections aren't as strong as they might seem. "People ask me, do I think Sarbanes-Oxley will cause more people to come forward? I don't think so, not if they know their careers will be forever altered," says Barron Stone, an 18-year employee of Duke Energy Corp.'s finance department.

Stone's efforts to blow the whistle at Duke started in early 1999, when he told the American Institute of Certified Public Accountants, the South Carolina Board of Certified Public Accountants, and the Securities and Exchange Commission that Duke was intentionally understating revenues for its regulated energy division to avoid having its rates lowered. Stone says he waited in vain for regulators to catch the problems on their own, and finally, in July 2001, he decided to step forward. He put in an anonymous call to the company's ethics hotline and met with the head of the Public Service Commission of South Carolina (PSCSC).

As a result of the call and the meeting, both Duke and the PSCSC launched investigations into the accounting disputes, which to varying degrees vindicated Stone's claims that earnings had been understated. In November 2002, Duke agreed to pay the states of North Carolina and South Carolina $25 million to be applied toward rate reductions in connection with the charges.

Stone went public with his story last August because he believed that Duke officials had apprised senior finance staff of his call to the ethics line and had dropped hints to his colleagues as well (see "Talk, or Walk?" October 2002). Since then, Stone has also revealed that he tipped off the SEC about some other efforts to manipulate earnings in Duke's unregulated businesses.

Through it all, incredibly, Stone has hung on to his job (and even received an 8 percent raise)—but not to his career prospects, he says. Once a senior forecast analyst, Stone says he was essentially demoted to an undefined role in February 2002, and passed over for a new position that August after a history of frequent promotions and increasing responsibilities. He has been assigned to execute entry-level projects, and has been moved to an office far away from the rest of his unit. While he is technically a manager, he has no employees to manage—and has been told he will not get any. "They have been very calculated and very precise in trying to wear me down," he says. "They would never promote me again. They probably never will if I stay here 30 years."

For that reason, Stone and his attorney, Gerry Bos, sought whistle-blower protection under Sarbanes-Oxley in November 2002. But the DoL dismissed the case in March 2003, in part because the alleged retaliation started before the law went into effect, and in part because of insufficient evidence.

Stone and Bos contend that the dismissal was based on OSHA's deficiencies, not theirs. For instance, Stone says that for lack of subpoena power, OSHA investigator Dale Boyd "told me point-blank, 'I can talk to the controllers and the vice presidents, et cetera, but if they lie to me, I accept whatever they tell me.'" Boyd was also of little help in building Stone's case, the accounting manager says, eschewing much of the critical information he had previously provided to regulators. "He was very unclear about what he wanted, how he wanted it, and the ramifications of what had happened," says Stone. "I spent inordinate amounts of time getting him what he said he needed, and then he didn't use most of it."

Duke, for its part, sees the dismissal as the final chapter in the case. "Obviously, the [DoL] has looked at this case and found no wrongdoing on Duke's part," says spokesperson Randy Wheeless. Duke has contended all along that Stone's manager didn't know that Stone was a whistle-blower when he transferred him. The company maintains the transfer was part of a larger reorganization. "From our perspective, it's pretty much settled," says Wheeless. Stone notes that there is still a complaint pending in federal court in Charlotte filed on his behalf.

Waiting for OSHA
Anyone waiting to be rescued by OSHA is liable to be waiting for Godot," charges Devine of the Government Accountability Project. He says that given OSHA's track record handling other whistle-blower cases, "it's a black hole...cases languish indefinitely."

Although Sarbanes-Oxley gave OSHA new responsibilities, the agency received no additional resources to go along with them. It did bring in representatives from the SEC and DoJ to speak with its investigators, says OSHA's Spear, and "familiarize them with issues related to Sarbanes-Oxley." In any case, connecting the dots between a red flag raised and a subsequent act of retaliation—particularly if it doesn't involve a layoff or a salary cut—is always difficult.

Moreover, the remedies OSHA can offer are weak. None of its initial findings are binding, so it must broker a voluntary settlement between employee and employer. Even then, at best an employee can hope to be reemployed at the same seniority level—potentially in another division—with back wages plus interest for lost time, along with litigation costs, expert-witness fees, and attorneys' fees. OSHA has no power to order accounting procedures reformed, numbers restated, or other employees fired. "We focus on making the complainant whole, not on changing the work environment," says Spear.

A whistle-blower's allegations of fraud, in general, fall to more-powerful agencies, like the DoJ and the SEC. But those agencies also offer little in the way of subsequent reward, protection, or even information about the case. "The SEC is kind of a one-way street," says Stone, who had provided documents to the SEC's regional Atlanta office. So far he has not been deposed by the SEC, which is reportedly investigating Duke.

Others complain that investigations go nowhere. Roy Olofson, a former vice president of finance at Global Crossing who made allegations of accounting fraud, was interviewed only once—by the U.S. Attorney's office in winter 2002, according to his attorney, Paul Murphy. "After that, we saw no follow-up," says Murphy. The investigation has since been dropped, despite a $1 billion earnings restatement related to Olofson's concerns in late 2002.

Some whistle-blowers say they can't get heard at all. "I'm starting to feel like the wallflower at the dance," says Lynn Brewer, who worked in various divisions of Enron from 1998 to 2000. She has been trying to share her Enron documents and experiences with the DoJ and various members of Congress since the day the company filed for bankruptcy in December 2001 and nullified her confidentiality agreement with Enron. "At that point, I was getting desperate to get my story out there, because I was getting concerned about my own culpability," she says.

Yet getting government officials even to return her phone calls has been a challenge. For instance, she says she E-mailed and phoned Sen. Byron Dorgan (D—N.Dak.), but never heard back, nor has she heard from anyone from the SEC or the DoJ. Now on the lecture circuit for organizations such as The Conference Board and the Association of Certified Fraud Examiners, Brewer says she gets 15 to 20 E-mails or phone calls per month from people who feel trapped by illegal activity at their companies. "My official answer is to send them to OSHA," she says, "but I also give them the name of a good lawyer." In the long run, of course, there's hope that Sarbanes-Oxley may have the desired effects on whistle-blowing. "A case could be made that there will be fewer claims in the future," says OSHA's Spear, "because the act puts more mechanisms in place for companies to hear from whistle-blowers early. Plus, there's a criminal penalty attached to [retaliation], which tends to get people's attention."

But reporting ethics violations is still perilous. While Coke, for example, now has a link on its Website for employees who want to report issues regarding accounting, controls, auditing, or other matters, all comments are forwarded to senior management rather than to the board or a third party. And while the site's FAQs section assures employees that they can "report suspected violations of the [conduct] code without fear of reprisal or retaliation," few are likely to do so after Whitley's experience.

Meanwhile, whistle-blowers still have to find their next job. Olofson is now consulting as he looks for permanent employment. "While this cloud is hanging over him, it's very difficult for him to find work that would make sense for him otherwise," says Murphy, his attorney. "His career path has been dramatically impacted by coming forward with his concerns."

And after sending out about 150 résumés, networking with about 50 people, and working with six recruiters, Whitley has had one interview in three months. For anyone else, that could be chalked up to the state of the economy. But Whitley has no doubt what has blown an ill wind on his job prospects: blowing the whistle at Coke.

Alix Nyberg is a staff writer at CFO.

How to Respond to Whistle-Blowers

Many companies are scrambling to establish toll-free hotlines and Web-based mechanisms that allow audit-committee members to hear directly from employees, suppliers, and customers who want to voice concerns about accounting or internal controls. According to the Sarbanes-Oxley Act of 2002 and Securities and Exchange Commission rules, such systems must allow for anonymity and be in place by a company's first annual meeting after January 15, 2004, or by October 31, 2004, whichever comes first.

But CFOs may do well to become better listeners. Most whistle-blowers say they never would have gone public with their concerns about the financial statements if senior management had been more attentive to them. And opening up the lines of communication doesn't necessarily mean opening Pandora's box.

Only about 5 percent of anonymous employee complaints received at United Technologies Corp. (UTC) each year relate to possible financial wrongdoing, says Patrick Gnazzo, the vice president in charge of investigating such claims. (UTC employees can report abuse anonymously through the company's Dialog program, which uses printed and online forms, or its ombudsman office, which fields phone calls.) Neither that percentage, nor the absolute volume, has changed much in the 17 years the office has been in existence, he says, not even after Sarbanes-Oxley. "If you're all trying to do the right thing in the first place, what's the fear of hearing from people?" asks Gnazzo.

The big question, of course, is how to separate the wheat from the chaff when confronted with an allegation. In fact, attorneys say the threshold for launching an investigation is pretty low. "If it violates the laws of nature, you don't have any obligation to investigate," says Jeff Stone, an attorney with McDermott, Will and Emery in Chicago. "But if it could be true, the prudent and wise thing to do would be to conduct an investigation." Indeed, at UTC, Gnazzo will check out accounting-related complaints even when the financial exposure is extremely low, or even zero. "If you take care of the $120 cases, you take care of the larger issues at the same time," he says.

Once a complaint is received, companies need to make every effort to protect a whistle-blower's anonymity, attorneys say. That task is considerably easier at big companies like UTC, where internal audits are routine. At smaller companies, they say, the best option may be to question senior-level managers in confidence before broadening the inquiry to rank-and-file workers.

Companies should also keep track of complaints, since OSHA's 90-day statute of limitations starts when the alleged retaliation occurs, not when the concerns are raised. "This means every time you let someone go or reduce compensation or turn them aside for a promotion, the audit committee has to ask the question: Has this person in any way questioned our audit practices?" says Neil Aronson, a partner at Mintz Levin Cohn Ferris Glovsky and Popeo. "Theoretically, you could disagree now with the CFO, and then bring a claim when the CFO demotes you two years later."

So is it ever OK to fire someone who has previously raised concerns? Of course, say attorneys. "If it turns out the person has maliciously spread false information about the company, you'd have good grounds to consider terminating that relationship," says Stone.

Neither of these attorneys, however, advocates rewarding employees who report allegations that turn out to be true. Says Aronson: "What you're asking them to do is their job, and you don't want to create a bounty system that might further skew incentives." —A.N.

Telling on Yourself

Almost from the day he joined medical-equipment maker Vital Signs Inc. in late 2001, Joseph Bourgart had suspicions about the Totowa, New Jersey­ based company's accounting choices. As a result, he approached CEO Terry Wall, audit-committee members, and the general counsel as many as 30 times between January and November 2002 about what he considered to be inflated valuations for inventory and an investment in China, as well as understated values for expenses such as supplier rebates and taxes, among other issues.

Bourgart was summarily demoted and then forced to resign in January. Since then, the $175 million firm has taken charges of about 40 cents per share to correct many of those concerns. So why hasn't he been protected by whistle-blower statutes? Bourgart was CFO at the time, and as such certified the financial statements he was challenging.

Bourgart filed a civil lawsuit in New Jersey state court in May. His attorney, Jon Green, of Green Lucas Savitz and Marose LLC, insists that his client was bullied into signing the statements by Wall, who is also chairman, founder, and majority stockholder, but later realized the error of his ways. Wall, meanwhile, claims Bourgart had conceded that the accounting was appropriate after an audit-committee review last summer and furthermore "voiced no objection" to any part of the 10-K in December. Vital Signs has moved to dismiss the case, and has threatened to countersue. Under Section 906 of Sarbanes-Oxley, Bourgart could face fines of up to $1 million or 10 years in jail for "knowingly" signing erroneous statements. Meanwhile, Green says he has eschewed the law's whistle-blower statutes, "because we felt they didn't provide adequate protection." Instead, Bourgart is making his case under the long-standing New Jersey Conscientious Employee Protection Act, a whistle-blower-protection law with higher damage payouts.

Other attorneys say that, hypothetically, such a case isn't impossible for a CFO to win. "The question is really whether he exhausted his responsibilities of due diligence before he signed, and took action on anything that didn't pass the smell test," says Jeff Lerer, an attorney with Foley Hoag in Boston. Provided Bourgart can show why he couldn't have known the truth at the time of the filing, he's probably off the hook, Lerer speculates, at least for criminal penalties. —A.N.

Blowing the Whistle: Six Recent Cases

Sticker Shock

When Congress passed the Sarbanes-Oxley Act of 2002, it didn't worry about how much it would cost companies. Today, CFOs are totting up the compliance bill -- and they don't like what they see.
Alix Stuart, CFO Magazine
September 1, 2003

Bill Teuber prickles a bit at the notion that the landmark Sarbanes-Oxley legislation has forced major reforms within EMC Corp. "I think about internal controls all the time; I didn't need the law to get me to think about them," says the CFO of the $5.4 billion information-storage giant. For the past decade, Hopkinton, Massachusetts-based EMC has carefully tracked its financial results with monthly closes and updated forecasts, says Teuber. In the same spirit, his regional controllers have been attesting to their compliance with EMC's procedures since mid-2001 — before Enron imploded. Teuber has also been thinking about financial transparency since being promoted to CFO in 1998, breaking down revenue streams by product classes rather than broad categories, and disclosing the quarterly earnings impact of stock options as early as July 2002.

Yet by the end of the year, EMC will have spent more than $1 million and thousands of man-hours complying with two of the main statutes in the Sarbanes-Oxley Act of 2002 — Section 404, related to internal controls; and Section 302, mandating CEO and CFO certifications of quarterly financial statements. Teuber won't even speculate on the price tag for full compliance, except to say "it's not insignificant." Moreover, he doesn't expect that burden to lift, thanks to ongoing testing and disclosure requirements. "Even maintenance mode will require a sizable effort," he says.

Like Teuber, CFOs across America say they are spending more time and money trying to shoehorn existing practices into legally acceptable formats. Forty-eight percent of companies will spend at least $500,000 on Sarbanes-Oxley compliance, according to finance executives who participated in a recent CFO magazine survey. Unlike Teuber, however — who sees the increased internal-controls documentation as "a chance to get best-of-breed solutions in our sales offices across 50-plus countries" — other CFOs (nearly 40 percent) see the increased burden as having "very little" or "no effect" on their current processes. Moreover, only 30 percent believe the benefits outweigh the costs.

In fact, many CFOs, such as Borland Software Corp.'s Ken Hahn, who expects to spend $3 million on compliance — including having some 25 percent of Borland's employees sign papers "saying they're not doing anything wrong" — see Sarbanes-Oxley as nothing more than "an efficiency tax." Stephen P. Bishop, CFO of Berkshire Hathaway­owned NetJets Inc., speaks for many when he says the "documenting and papering" of internal controls for Section 404 compliance will result in little "value-add." And E. Follin Smith, CFO of $4.7 billion Constellation Energy Group, goes so far as to say the law could eventually make the "fear of personal liability so great that managers are afraid to take risks on innovation."

Indeed, many finance executives believe that in seeking to curb the freewheeling ways of the likes of Enron, Tyco International, and WorldCom, Congress has committed some excesses of its own. Part of the problem, of course, was the haste with which the law was written. "If Congress had given the [Securities and Exchange Commission] more time to promulgate the regulations and the SEC had given companies more time to comply, costs would have been lower," says Goodwin Procter LLP partner Steve Poss. Instead, by rapidly legislating a whole set of processes, the law has become a windfall for auditors and lawyers and a time drain on overburdened finance departments. Moreover, the liability implications have "put people so on edge that they're looking over their shoulders all the time to see whether they're perceived as doing the right thing, not whether they are doing the right thing," says LCC International senior vice president and CFO Graham Perkins. "I don't think the legislators really understood all of the adverse consequences."

Perception Versus Reality
It's hard to know exactly what Congress expected, since it did not assess any costs when it passed the law. That's not unusual, since "there's no formal process for Congress to calculate benefits or costs of legislation," says Thomas McCool, head of financial markets and community investment at the General Accounting Office. "Sometimes they try to get indications from various parties, but when it's something prospective like this, [costs] would be very hard to tell."

The SEC, though, is required to estimate the burdens associated with its information requests under the Paperwork Reduction Act of 1995, and so has offered some guesses at future costs in piecemeal fashion. Such guesstimates have been chronically low. For one thing, they are typically limited to disclosure activities, and don't attempt to quantify costs like software purchases, audit-fee increases, or management and staffing requirements. The agency also tends to lowball the number and costs of hours of external help involved. "Most professionals look at these estimates and laugh," says Poss.

Reg FD compliance, for example, was projected to add a maximum $49.5 million to total annual disclosure costs when the rule was passed in August 2000, but actually cost somewhere between $250 million and $450 million, according to a Securities Industry Association (SIA) study in May 2001. That divergence was in large part based on the SEC's assumption that hourly legal fees were $85 to $175, compared with the $450 to $550 the SIA reported.

The same mistakes plague Sarbanes-Oxley, says Poss. The agency's new assumption is that outside legal fees will run $300 per hour, a figure with which most CFO respondents concur. Poss argues that fees will run higher. "These are not quick consultations, and they're usually with senior partners," whose rates run from $400 to $700 per hour in most big cities, he says.

No doubt, the SEC's biggest miscalculation was its original estimate that Section 404 compliance would require an additional five hours' worth of work per annual and quarterly filing. The figures were too low "by at least a factor of 100" if not more, wrote Cary Klafter, director of corporate affairs for Intel's legal department, in a November letter to the SEC. "We can only hope that the Commission's burden estimates are not used for any substantive governmental purpose, since they are completely incorrect."

While the SEC typically receives few comments on such estimates, this one raised the ire of so many companies that the agency was forced to recalculate — ending up instead with an average 383-hour workload per company, for a total annual price tag of $91,000, not including additional auditors' fees. "We recognize the magnitude of the cost burdens and we are making several accommodations to address commenters' concerns and to ease compliance," the agency said in its final rules on Section 404, released June 5.

Those accommodations included changing the requirement to test internal controls from a quarterly to an annual activity (unless they are materially changed) and extending the compliance deadline from September 30, 2003, to fiscal years ending on or after June 15, 2004, for accelerated filers; all others will have a compliance deadline of April 15, 2005. The delay "was an effort to help reduce the burden in general, and help make sure it was done right," says SEC commissioner Cynthia A. Glassman. "We did not want a system where [companies] were going to have to redo things."

Just doing it the first time, however, will not be a picnic. While the year extension has prevented a lot of what SPSS CFO Edward Hamburg calls "unnecessary thrashing and spending," the rules make little accommodation for companies of different sizes and growth stages. And even the revised cost estimates are considered "low" or "very low" by more than 80 percent of survey respondents. That irks those who believe the SEC should be held to the same standard as the firms it regulates. "In Corporate America, if you make a bad prediction of what cost of sales or revenues are going to be in a future period, you're likely to get grilled by the SEC about why you thought it was reasonable," says Poss. "It would be interesting to see the same standard applied to regulators."

The Usual Beneficiaries
The yearlong respite reduces the need for outside help, and hence the cost. However, it won't change the fact that two constituencies — auditors and lawyers — stand to reap great gains as firms plow ahead. And given the uncertainty over what will get a pass from the SEC, the final tab is a moving target.

EMC has hired Deloitte & Touche to help sift its balance sheet and income statement into 30 processes (like sales and stock-option granting) and 250 subprocesses (like order taking, shipping, and billing), document them, test them, and package them into a central database for future audit purposes. But EMC's external auditor, PricewaterhouseCoopers, is also "part and parcel of the process," according to Teuber, giving informal approval to the firm's compliance strategy and fielding audit-committee questions on how well EMC is doing on compliance compared with other firms. (Companies can't use their external auditors to help them prepare the controls, but can consult with them on compliance strategies.)

Teuber says it's helpful to have two of the Big Four audit firms on the project. "It's all virgin territory," he says, "so you wouldn't want to do this in a vacuum." But those firms will be the ones collecting the bulk of EMC's $1 million compliance payments for 2003, excluding the final attestation fee.

Many of the Section 404 projects, such as documentation, are one-time efforts. But Sarbanes-Oxley is also guaranteeing audit firms a future income stream by requiring them to attest to the soundness of management assessment of internal controls once a year starting with 10-Ks filed on or after June 15, 2004. The final annual tab for that exercise is uncertain. The Public Company Accounting Oversight Board has yet to issue standards regarding how many controls must be tested, in what manner, and according to what criteria, so audit firms appear to be taking their time estimating the fees for attesting to internal controls. But so far, according to a Financial Executives International survey, CFOs expect to see audit fees increase 35 percent on average, and up to 100 percent at some companies.

What exactly audit firms will do to justify such increases is also cause for consternation. At Digene Corp., a Gaithersburg, Maryland, biotech firm, for example, president and CFO Charles M. Fleischman has watched his audit bill with Ernst & Young and other compliance-related fees increase by 72 percent for 2003. He is currently negotiating fees for 2004, which could jump by another 70 percent. And while he insists he has a good relationship with his auditor, Fleischman just wants "to understand what the scope of the work is — and how that matches up against the bill." So, before he authorizes payment for 2004, he is working with his audit committee and E&Y to determine exactly "what they are doing and where they are going to draw the line between assuring quality in financial reporting and just adding costs."

Legal costs are also on the rise, although CFOs say they are not generally as onerous as audit fees. Magma Design Automation Inc. CFO Greg Walker expects to spend an incremental $200,000 to $300,000 for legal work in the next 12 to 18 months, including efforts to monitor compliance, set up a whistle-blower program, and train employees. That's on top of an additional $750,000 in audit and consulting fees. On average, legal fees nearly doubled, to $404,000, between 2002 and 2003, according to an April survey by law firm Foley & Lardner.

Ranking low on the list of costs is software. Forty percent of finance executives say compliance will not affect their IT budgets, while another 25 percent say it will involve minimal IT costs, according to a CFO IT survey. "Tools are often bundled with consulting fees; I don't think [software is] an integral part of the solution," says Kim Roll-Wallace, vice president of consulting for The Johnsson Group Inc. EMC, in fact, uses Excel. "We've found it works quite well in this regard," says chief accounting officer Mark Link, largely because "everyone already knows how to use it."

Multiple Price Tags
Then there are the indirect costs. The requirement to disclose off-balance-sheet structures more clearly has encouraged some companies to bring these structures on the balance sheet and others to collapse them entirely. Financial experts have become hot properties now that companies are required to disclose if they have one on their board. Restrictions on nonaudit work that a company's auditor can perform has left CFOs scrambling for new tax consultants. Meanwhile, the whistle-blower provision has sparked untold numbers of costly internal investigations.

Of course, there's also an opportunity cost associated with compliance activities. In fact, 33 percent of respondents say they've delayed or canceled projects as a result of Sarbanes-Oxley. Internal staff development is the most common casualty. Moreover, executives say the focus on compliance has also left them frazzled, with less time to mull strategic decisions, as compliance efforts absorb more than 10 percent of a CFO's time in roughly 4 out of 10 companies.

One example of the strain: LCC's Perkins says he has made more lengthy and complicated trips, partly to spearhead compliance efforts across operations at more than 10 locations in six countries. "Instead of being a business partner and doing all the positive things you'd like to do, you're doing the negative things, like triple-checking a filing," says Perkins. In fact, he says he might have thought twice about taking his job at the $100 million wireless-services firm last January if he had known how much compliance-related work it would involve. "I did not anticipate when I joined this company that I would become a surrogate for the SEC," he says.

And this is just the beginning. About 35 percent of survey respondents expect annual compliance efforts to absorb at least $500,000 of their revenues and more than 10 percent of their time going forward, thanks in large part to Section 404's mandate for ongoing controls testing and auditor attestation. That's not counting, of course, the price of changing auditors every five years, as Sarbanes-Oxley mandates.

No one should look for additional relief from the SEC. Glassman says she believes changes could be a possibility "if we start hearing that companies are spending a lot of money to comply but there are no apparent benefits, or if we hear there are more efficient ways to accomplish the same objectives." However, there are no formal efforts under way within the government to test cost assumptions, and she says such a study would be hard to design. "It's a very difficult equation. The costs are explicit. There's also some distraction from running the business. But the benefits are very intangible."

No Guarantees
Indeed, survey respondents are about evenly split on whether going through the compliance process has yielded internal benefits, such as more-efficient processes or more respect for the finance department. "It's a constant struggle to try to get benefit out of 404 work," says consultant Roll-Wallace. "In any given company, about 50 percent is work that puts in best practices and the other 50 percent is a dog-and-pony show, putting everything into a neat package for the auditors."

There may be some external benefits, however, says Magma's Walker. The legislation has sped up his time frame for reporting improvements at the $75 million company, he says, but to good effect. "I probably do better deals with customers — the earlier you can detect issues, the better you can structure a contract," he says. And there may be spillover effects, says Borland's Hahn, who is hoping to leverage his new director of financial governance as a "process-improvement specialist."

As for the SEC's larger goal of improving investor confidence, though, there's little agreement on how that will be achieved. On one hand, "you're more confident that senior people are taking extra care to derive the best possible information," says Robert D. Spremulli, a TIAA-CREF senior analyst. But it's hard to see the direct effects of those sentiments, given the multivariate nature of the market. Indeed, major indices showed varying degrees of improvement on Sarbanes-Oxley's one-year anniversary, with the Nasdaq composite index closing up 30 percent from its year-earlier level, but the New York Stock Exchange, the S&P 500, and the Dow Jones Industrial Average up by only 8, 8, and 6 percent, respectively.

And many still question whether Sarbanes-Oxley is an effective inoculation against future financial frauds. "Just having a good control environment doesn't guarantee that people will act ethically," says Deloitte & Touche enterprisewide risk-service partner Stephen Curry. Enron's trading operations, he points out, were cited as a model for enterprisewide risk management in former Andersen partner James DeLoach's 2000 book on the topic. Those close to the company agree. "What allowed Enron to melt down was its culture, and I don't think Sarbanes-Oxley would have changed that," says Sterling Chemical Inc. controller John Beaver, whose Houston office is across the street from Enron's headquarters.

Even companies touched by scandal are skeptical of Sarbanes-Oxley's healing powers — at any price. Tyco, for example, is spending north of $5 million to comply with the act and generally clean up its image by developing new editions of its controllership guide and ethics manual. Still, "that's not to say that we can document routines and controls and be assured that nothing improper will happen," says corporate-governance head Eric Pillmore. "What we hope is that by doing this, we detect problems earlier."

Across the Board

With the Sarbanes-Oxley act of 2002 raising expectations and liabilities for directors, it's no surprise that board-related costs are rising for most public companies — albeit slowly. To date, only about 14 percent of companies have seen those costs jump by more than 50 percent, according to the CFO survey, while 17 percent have not seen any hikes yet.

Those numbers are likely to increase as more companies confront higher directors' and officers' insurance premiums. Many are also in the process of adding new directors to comply with independence requirements and sweetening the pots for current ones. At its annual meeting in August, for example, Computer Associates International Inc. was seeking shareholder approval to boost the value of its annual directors' compensation from about $95,000 last year to $150,000 this year, and reversing its longtime policy of stock-only payments to allow directors to take up to half of that fee in cash.

"Board members, audit-committee members in particular, have been given a whole host of new duties," says CA corporate-governance head and corporate secretary Robert Lamm. (Audit committees, for example, must now oversee the auditors, preapprove any nonaudit services they provide, and decide how to classify nonaudit services in annual filings.) The fee increases "represent the time involved in additional documentation, for better or worse, and the checking of additional boxes."

A Silver Lining for Some

At this point, many companies are still performing low-tech risk-mapping processes to gauge the impact of Sarbanes-Oxley. But the technology sector has high hopes that soon that will give way to a need for new tools. In fact, First Albany technology strategy analyst Gerard Hallaren expects spending on compliance-related technology to grow by $8 billion to $12 billion in the next year. "We've seen a modest push from Sarbanes-Oxley so far, but I think the real spending will kick in at the end of this year," he says.

Content and document management tools, along with analytics, are likely to be among the first beneficiaries of the law, predicts Hallaren, since "auditors are going to have a hard time auditing lots of individual spreadsheets" in the Excel formats that many companies now use. Data-storage companies are likely to be next in line, as analytical and data-management systems become more voluminous.

EMC Corp., which recently debuted the "compliance edition" of its Centera product, is one of the companies waiting for the windfall. The product codes information with a unique identifier, and can automatically delete documents at the end of their required retention period. "It's more accidental offense than planned," says CFO Bill Teuber, "but any number of regulations out there...require more information to be stored, and clearly our products help in that regard."

Tough Act to Follow In August, CFO Magazine E-mailed a questionnaire on Sarbanes-Oxley compliance to senior financial executives drawn randomly from our circulation list. We received 220 responses; 139 from executives at publicly traded companies. The results below represent a combination of both public and private company responses. Note: Numbers may not add up to 100%, due to rounding. 1) Who is responsible for Sarbanes-Oxley compliance at your company? CFO 55% Controller 30% Assistant Controller 2% Treasurer 1% Other 12% 2) Are you tracking the costs to your company of implementing Sarbanes-Oxley? Yes 44% No 56% 2a) If not, when do you expect to do so? Within 3 months 13% Within 6 months 16% Within 12 months 16% More than 1 year 7% Never 48% 3) What do you estimate to be the total costs to your company to implement all portions of Sarbanes-Oxley requirements in the first year (including external audit, legal, and consulting fees; new hires; and software purchases, but not board-related costs)? Less than $500,000 52% $500,000 to $999,000 23% $1 million to $2.9 million 16% $3 million to $5 million 6% More than $5 million 3% 4) What do you expect annual compliance costs to be going forward (including external audit, legal, and consulting fees; new hires; and software purchases, but not board-related costs)? Less than $500,000 65% $500,000 to $999,000 22% $1 million to $2.9 million 7% $3 million to $5 million 3% More than $5 million 3% 5) What percentage of your time has been spent on Sarbanes-Oxley compliance, on average, per month, over the past year? None 14% 1% to 10% 51% 11% to 20% 20% 21% to 35% 9% 36% to 50% 3% More than 50% 3% 6) Going forward, how much time do you expect to spend on Sarbanes-Oxley compliance monthly? None 10% 1% to 10% 56% 11% to 20% 24% 21% to 35% 6% 36% to 50%   0% More than 50% 3% 7) Have projects or initiatives been delayed or canceled as a result of Sarbanes-Oxley compliance? Yes 33% No 54% Not sure 13% 7a) If yes, please check all that apply. Internal staff dvlpmnt. 24% Technology purchases 14% Other capital expenditures 9% M&A activity 6% Other 9% 8) How much have internal processes changed in response to compliance-related efforts at your company? Very much 6% Some 56% Very little 28% Not at all 10% 9) Has going through the Sarbanes-Oxley compliance process yielded any internal benefits for your company? Yes 49% No 52% 9a) If yes, please check all that apply. More efficiencies in reporting processes 23% More accurate numbers 10% Cost savings 3% Other 22% 10) Overall, do you think the benefits of compliance outweigh the costs? Yes 30% No 70% 11) How much have total costs to retain directors (including salaries and directors' and officers' insurance) increased over last year? None 28% 1% to ­10% 20% 11%­ to 25% 27% 26%­ to 50% 15% 51%­ to 100% 9% More than 100% 1%

Not Adding Up How realistic are the following cost assumptions made by the SEC? Note: Numbers may not add up to 100%, due to rounding. 1) External legal and audit fees run an average of $300 per hour. Very low 3% Low 24% Accurate 56% High 16% Very high 1% 2) Internal professional staff costs are $125 per hour. Very low 2% Low 13% Accurate 47% High 33% Very high 5% 3) Complying with Reg G (reconciling pro forma to reported earnings) can be accomplished by an in-house junior accountant in about 30 minutes per filing, at a cost of $13 including overhead. Very low 50% Low 39% Accurate 11% High 0% Very high 0% 4) Disclosure associated with off-balance sheet arrangements costs $10,000, including in-house staff time and outside professional fees. Very low 15% Low 45% Accurate 33% High 5% Very high 2% 5) Additional disclosure associated with nonaudit fees and changes in practices to promote auditor independence takes about two hours, half a page of a proxy and/or 10-K, and costs about $418 per filing, including internal and external staff fees. Very low 23% Low 53% Accurate 23% High 2% Very high 0% 6) The average annual cost of implementing Section 404 is around $91,000 per company. Very low 23% Low 53% Accurate 13% High 6% Very high 0%

You Have the Right to an Attorney

But will you be comfortable asking for advice? A new SEC rule governing attorney conduct puts a strain on relations between finance executives and corporate counsel.
Craig Schneider, CFO.com | US
August 20, 2003

Signing off on a company's financial results is one more good reason that CFOs might seek out the sage advice of corporate counsel. Whether they will feel comfortable enough to ask for that advice is another matter.

Under a Securities and Exchange Commission rule that went into effect August 5, in fact, the relationship between CFOs and attorneys — both inside and outside counsel — may have gotten a whole lot icier. If an attorney representing a public company comes across evidence of such things as a material violation of federal or state securities law or a "breach of fiduciary duty," he or she must report the misstep up the chain of command — way up.

That means either the chief legal officer or the CEO, according to the SEC rule, which was mandated under Section 307 of the Sarbanes-Oxley Act. If the officers don't respond appropriately — by taking remedial action or issuing sanctions, for instance — lawyers must take the matter to the audit committee, another committee of independent directors, or the full board.

The new rule also allows for a way that reporting attorneys can give management an even wider birth. Instead of heading for their bosses or the CEO, lawyers could go straight to a qualified legal compliance committee (QLCC) of the board of directors, if the corporation has set one up. It's unlikely that many CFOs would go for the idea, however, since "management loses control of the process," says Mark Bonenfant, a partner at Buchalter, Nemer, Fields & Younger.

Even without a QLCC, finance chiefs might well feel left out of the information loop. "CFOs and their staff work directly with securities lawyers on a regular basis, but they don't get the [attorney's] report," says Diane Frankle, partner at Gray Cary and co-chair of the law firm's corporate governance advisory group. "It's got to create some concern."

An even worse worry is the possibility that a misinterpreted question to an attorney might land a finance executive before the SEC. That could make CFOs wary of sharing information with corporate counsel or seeking advice from them on tough reporting decisions, thinks Stephen Glover, a partner with Gibson, Dunn, and Crutcher.

For their part, attorneys might start to over-report as a precaution, fearing that an activity that previously appeared legal could draw fire from regulators if serious improprieties later arise, according to Glover. "They don't want personal liability or exposure to SEC sanctions," he says.

The proposed "noisy withdrawal" rule pending before the SEC could open up even wider rifts. Depending on the circumstances, lawyers reporting violations would be permitted — perhaps even required — to alert the commission that they're pulling out from representing the company.

At issue in such withdrawals is the sticky wicket of attorney-client privilege. How sacred the privilege is, when it comes to the relationship between corporate executives and corporate lawyers, is apparently up for grabs. Last week, in fact, the American Bar Association amended its rules of professional conduct so that corporate counsel are allowed (but not required) to sacrifice attorney-client privilege and bring otherwise confidential information to government authorities.

To be sure, the ABA's rules are simply guidelines for conduct, and the SEC might never choose to ratify its own related proposals. But even the fear that attorney-client privilege might be eroding could make finance executives tight-lipped around corporate counsel. And holding back on information could compromise the legal advice CFOs do get, says Jonathan Newton, a partner at Baker & McKenzie.

More broadly, the SEC rule upsets a firmly held belief among CFOs and CEOs that the corporation's lawyers are their lawyers. Indeed, the rule enforces the principle that the attorney's first priority is to the company, not to the executives, says Bart Schwartz, general counsel of The MONY Group, a financial services company.

The legal star does appear to be on the rise at many corporations. Even setting aside the new rule, governance and compliance duties have "raised the general counsel to almost the same level [as] the CFO," says Thom Weatherford, a retired finance chief of software provider Business Objects who serves on the boards of three publicly traded companies.

The increased independence that the new rule seems to confer on attorneys, however, could be a boon to some CFOs. "In companies that react in the most constructive way, these rules will actually strengthen the relationship between the CEO and CFO and general counsel and cause them to spend more time together," says MONY's Schwartz. "Certainly where the issue involves an area of disclosure or accounting for financial transactions, it would be natural for me, before going to the CEO, to go the CFO and work through the issue with him."

Who Rules Accounting?

Congress muscles in on FASB -- again.
Craig Schneider, CFO Magazine
August 1, 2003

Dennis Beresford is having flashbacks these days, and they are anything but pleasant. Congress is once again trying to derail the Financial Accounting Standards Board's efforts to require companies to expense stock options. And for the former FASB chairman, the lawmakers' moves are a painful reminder of what happened during his tenure at the board's helm nearly a decade ago. "It's déjà vu all over again," says Beresford, now a professor of accounting at the University of Georgia.

Under intense pressure from Capitol Hill, FASB under Beresford backed off of a similar proposal in 1994, compromising not only the board's position on expensing but its very independence as a standard setter. It took years for the board to buck congressional pressure again, this time on new, far-reaching rules on derivatives and business combinations. Of course, FASB's submission to Congress did nothing to prevent lawmakers from scolding the board for the cautious pace of its its deliberations on accounting issues related to the Enron scandal.

No one in Washington, D.C., claims to desire an end to the independent setting of accounting rules, at least in public. The legislators insist they are merely trying to aid the struggling economy by encouraging greater use of entrepreneurial incentives.

But will keeping stock options off the income statement have the desired effect? Many observers contend that while FASB's 1994 decision not to require options expensing may have inspired entrepreneurs, it also certainly motivated executives to pump up their companies' stock prices by whatever means necessary. In fact, the widespread use of nonexpensed stock options is generally thought to have led not to economic strength, but to inflated stock-market valuations, excessive executive compensation, accounting frauds, bankruptcies, and the loss of approximately $5 trillion.

Some managers may welcome congressional efforts to reinflate the stock- market bubble, but forcing FASB to back down on options could instead undermine whatever confidence in the financial markets investors have since regained. "The capital markets need high-quality, unbiased information to make allocation and pricing decisions," says FASB board member G. Michael Crooch. "Managing accounting data for some hoped-for economic result is too risky and dangerous."

A Simple Bill
The current fight is still in its early stages. Until recently, in fact, the latest debate over expensing was limited to arcane issues involving valuation methodology. But now Congress has reentered the picture, and its legislative steps would render the outcome of the debate about valuation methods all but moot.

At first glance, the bill introduced in March by Rep. David Dreier (R-Calif.) and co-sponsored by Rep. Anna G. Eshoo (D-Calif.) — H.R. 1372, or the Broad-based Stock Option Plan Transparency Act of 2003 — sounds innocuous enough, calling as it does for enhanced disclosure of stock-option plans.

But the bill, which has attracted considerable bipartisan support, including that of half the Democratic presidential hopefuls, first demands a three-year study by the Securities and Exchange Commission to assess the potential impact of broad-based stock-option plans on the economy.

Meanwhile, the legislation would impose a moratorium on new FASB rules related to stock options, so if the board went ahead and mandated expensing anyway, the SEC would be barred from recognizing the rule as part of generally accepted accounting principles (GAAP).

So much for independently set accounting standards.

Back to the Future
In the face of similar pressure nine years ago, FASB's retreat enabled it to live to fight another day. But board members and others involved in that decision now regret the move. Former SEC chairman Arthur Levitt admits that urging FASB to back off was "the biggest mistake I made" during his eight-year tenure.

The International Accounting Standards Board (IASB), FASB's international counterpart, is clearly concerned about the impact the bill could have on accounting standards in general. "If the U.S. Congress or political authorities in other countries seek to override the decisions of the competent professional standard setters...accounting standards will inevitably lose consistency, coherence, and credibility," warned Paul A. Volcker, former Federal Reserve Board chairman and current chairman of the foundation that oversees the IASB, in written testimony.

But Eshoo and Dreier represent districts in California where incentive stock options are still sacrosanct. And to be sure, high-tech companies, many in their early stages and strapped for cash, rely on stock options as incentives for employees as well as for executives. According to these lawmakers, expensing would hobble the ability of such start-ups to attract talent and, in turn, stifle innovation in the U.S. economy. "This is a public-policy issue," said Dreier in his testimony at the hearing in June. "This is not an accounting issue."

Yet it's hard to see how accounting is not public policy when the public relies on financial statements prepared under U.S. GAAP to determine whether companies deserve its capital. In FASB's view, options should be included in the income statement like other forms of compensation expense, because that would give shareholders a more honest picture of a company's finances than burying the impact of options in the footnotes. Investors applaud the stance. "If the result of having [option-based pay] expensed means you do away with the plans," says Peter Clapman, senior vice president and chief counsel of corporate governance at TIAA-CREF, "it means that it was never a particularly good form of compensation in the first place, because it shouldn't depend on accounting treatment."

The IASB, for its part, agrees with FASB. And there's nearly universal agreement that the capital markets would benefit from a single global standard for financial reporting on this item as well as others.

Of course, it's not surprising that FASB's congressional opponents claim their legislation does nothing to compromise FASB, which was established in 1973 as a replacement for the American Institute of Certified Public Accountants's Accounting Principles Board.

With a board of seven paid, full-time members intended to keep standard setting a function of the private sector, FASB's structure is supposed to ensure its independence from private interests that might interfere with its primary objective of creating neutral accounting rules. And while the Securities Exchange Act of 1934 gives the SEC the authority to set standards, the commission delegates that authority to FASB.

Lest Congress forget these facts, current FASB chairman Robert H. Herz reminded members during a recent House subcommittee hearing on H.R. 1372. "The moratorium," he proclaimed, would likely establish a "potentially dangerous precedent" and "signal that Congress is willing to intervene in the independent, objective, and open accounting standard-setting process based on factors other than the pursuit of sound and fair financial reporting." Herz also noted that such interference would be "inconsistent with the language and intent" of the Sarbanes-Oxley Act of 2002, which includes added measures to ensure FASB's independence. He warned Congress that unlike his predecessors, he's "not gun-shy" about promulgating that view.

But Herz's warnings fell on deaf ears. Eshoo agrees that Congress "should not get into writing accounting standards" and that "FASB should be able to retain its independence." How exactly can that circle be legislatively squared? "If we are prevented from issuing what we consider to be a better and high-quality standard," notes FASB's Crooch, "that's not very far from setting a standard."

Damned Economy
Dreier and Eshoo, however, adamantly defend their efforts. "I'm not doing anything that's counter to my constitutional obligations," Dreier insists. Eshoo says much the same thing. "I wish there were a meeting of the minds [with FASB]," she says, "but if there isn't, then I believe that it is absolutely appropriate. It is not interference, it is Congress exercising its responsibility relative to our nation's economy." She adds: "FASB has not been willing to examine anything except expensing, and economic issues be damned. I think we can do better than this."

Dreier jests that he could — but wouldn't — flip FASB's claim by saying "that they're tampering with our ability to create policies that encourage economic growth."

But there's reason to believe that Dreier and Eshoo are mistaken about the need to restrain the board to help the economy. Consider Netflix, an online DVD rental service that went public in May 2002 and announced this past June that it would expense options. Expensing, says CFO Barry McCarthy, provides the company with "consistency in financial reporting." And he doesn't expect the decision to have a negative impact on his ability to raise new capital. "In my experience," he says, "investors increasingly distinguish between accrued expenses and real cash expenses."

What's more, McCarthy suggests lawmakers are being disingenuous about the intended beneficxiaries of the legislation. "Whenever you have large public companies that think their ox is going to be gored by a change in accounting principles," he says, "there's going to be a battle about the outcome."

Battle-hardened FASB members aren't taken aback by what's happening. "Standard setting is not a popularity contest and shouldn't be a popularity contest," notes Jim Leisenring, who was vice chairman of FASB during the earlier debate over expensing, and one of the two members who did not succumb to congressional pressure in the final vote. Leisenring, now a member of the IASB, says, "I believe FASB made a mistake in backing down, but they did so in the context of having no support from anyone."

A Delaying Tactic
How will the new battle turn out? Because of the dangers posed by the proposal in Congress, some observers predict it won't get very far. "I don't believe in the face of continuing revelations of accounting misdeeds that Congress is likely to destroy the standard-setting process," says Levitt. "It's just a delaying tactic."

Levitt isn't alone in dismissing the threat. TIAA-CREF's Clapman believes some lawmakers who may have been comfortable 10 years ago openly favoring the high-tech-industry position on options are reluctant to do so today. "A congressman or -woman who looks at this knows that their position is being scrutinized in ways that were not the case back in 1993," he says.

What's more, big accounting firms like Ernst & Young and shareholder lobbyists like the Council of Institutional Investors have reversed their opposition to expensing, while nearly 300 public companies, including Microsoft, have adopted it during the past 18 months in anticipation of a change in the rules. While Microsoft recently abandoned new options grants in favor of restricted stock, the technology bellwether has also decided to expense options already granted.

The SEC has historically supported FASB's decisions, and chairman William H. Donaldson is on record as favoring the board's efforts to expense options. FASB "has put itself on the line and said there's an expense attached to stock options," Donaldson told the Economic Club of New York in May. "I am waiting restlessly for this to happen." But will Donaldson stick to that position under pressure from Congress or the White House?

With enough political support for the bill, Eshoo predicts that the head of the SEC would find it difficult not to go along. "Certainly, chairman Levitt did," she observes. Levitt himself thinks Donaldson will stick to his guns. "We have an SEC chairman that is solidly behind the expensing proposal," he says.

To be sure, Donaldson also said publicly that he plans to visit with executives in California who oppose expensing options. "I am willing to listen," he said in May. But he told them not to get their hopes up. "As far as I'm concerned," he warned, "we have crossed the Rubicon."

Perhaps. Congressional support for the bill is by no means overwhelming at this point. But Beresford fears that Sarbanes-Oxley has inadvertently made FASB more vulnerable to political pressure. Previously, about a third of FASB's annual budget came from voluntary contributions from public accounting firms, the AICPA, and some 1,000 individual corporations.

Under Sarbanes-Oxley, those voluntary contributions are replaced by mandatory fees from all publicly owned corporations based on their individual market capital-ization. But the fees are to be collected by the newly formed Public Company Accounting Oversight Board. And the SEC oversees the PCAOB.

While Beresford believes the new setup gives FASB more independence from the business community, he says, "it's not clear that it has more independence from the political process. In fact, it may have less [independence] from Congress and other people in Washington." Under the new arrangement, it's a pretty simple matter for the SEC to pressure FASB. "The SEC could give them a hard time with their budget," notes Beresford, "and just not get around to collecting the money they made."

In other words, how FASB votes on options expensing may depend on how William Donaldson handles the board's paychecks.

FASB's Surgeons
On its own terms, the legislation now before Congress poses less of a threat to FASB's independence than a bill introduced a decade ago.

In 1993, legislation introduced by Sen. Joe Lieberman (D-Conn.) would have not only nullified the effect of the proposed FASB standard on stock options but also effectively put the board out of business, notes then-FASB chairman Dennis Beresford.

The bill, which garnered broad support, required the Securities and Exchange Commission to redo the whole standard-setting process. Faced with its likely passage and virtually no support for its project by executives, the accounting industry, or the SEC, FASB backed away from expensing, instead requiring disclosure of the cost of options only in the footnotes of financial statements.

The Senate ultimately voted 88 to 9 for a nonbinding resolution that urged FASB not to expense stock options. "It was basically a warning shot," says Beresford, "but the bigger concern was the actual legislation proposed by Lieberman."

"The difference now is that they're dealing only with the stock-options issue," Beresford says of the bill introduced in March by Rep. David Dreier (R-Calif.) and co-sponsored by Rep. Anna G. Eshoo (D-Calif.). "It's more of a surgical strike."

Since a House subcommittee hearing on the bill in June, 13 representatives have joined as co-sponsors, for a total of 53 bipartisan supporters. That represents more than 12 percent of the total 435 House representatives. A companion bill, S. 979, introduced in the Senate in May by John Ensign (R-Nev.) and co-sponsored by Barbara Boxer (D-Calif.), faces a more uncertain future despite having a higher level (19 percent) of bipartisan support. Senate Banking Committee chairman Richard Shelby (R-Ala.) recently said he would deny that bill a hearing in the Senate, believing as he does that lawmakers shouldn't be interfering in FASB's affairs.

But as the outcome of Congress's last battle with FASB over stock options suggests, legislation needn't be enacted to have the desired effect. —C.S.

D.C. Versus the Board
Stock options haven't been the only source of friction between the Financial Accounting Standards Board and its federal overseers. To be sure, the Securities and Exchange Commission has only officially overridden FASB once since the board's inception in 1973. That decision came a few years later, as FASB was writing rules for oil and gas exploration and development costs.

Congress, for its part, has taken an interest in several other FASB projects over the years, including accounting for derivatives and the business combinations and goodwill project. The latter issue, which ultimately eliminated pooling of interests accounting, spawned legislation and arguments that are strikingly similar to those stemming from today's options-expensing debate.

During hearings on the proposed elimination of pooling, for instance, Cisco Systems Inc. CFO Dennis Powell, then corporate controller, warned during a Senate hearing that the proposal "will certainly stifle technology development, impede capital formation, and slow job creation in this country." He further argued that a switch to the purchase model would lead companies with a higher percentage of acquired intangible assets "to report an arbitrary, artificial net-income number that is irrelevant and misleading."

Of course, that view assumes that investors' perceptions are more important to economic growth than business fundamentals, and the bursting of the Internet bubble has thrown cold water on such thinking, at least for the time being. But that hasn't prevented industry lobbyists from rehearsing the argument in the latest battle with FASB.

Yet Barry McCarthy, CFO of online DVD rental service Netflix, thinks such concerns are vastly overblown. "Our investors focus on EBITDA and free cash flow just as much as on net income and net loss in deciding what the enterprise is worth," he says. "The conventional wisdom on Wall Street has been that investors look right through the stock-option charges for tech companies."

According to Silicon Valley, however, they won't if the charges are no longer buried in the footnotes. The question is, is that a good thing or a bad thing? —C.S.


The Same Old Story
The debate over accounting for stock options is 30 years old and counting.

File Under 'Nightmare'

Information overload has acquired a regulatory dimension, forcing senior executives to take notice.
Bob Violino, CFO IT
June 16, 2003

Not long ago, the topics of data retention and records management elicited yawns from senior executives. After all, the storing of old documents and E-mails hardly seemed like a strategic imperative. But if those executives are yawning now, it's not from boredom but from being up all night worrying.

Data retention is yet another new priority created as a result of corporate accounting scandals and Sarbanes-Oxley. What had once been the domain of file clerks has suddenly become an agenda item for CEOs and corporate boards concerned about the consequences of failing to keep certain records for specified periods of time.

"Records-keeping was something many people didn't give a lot of thought to," says Ronald Folwell, CFO at DiMare Home-stead, an agricultural company in Homestead, Florida. "Now we're thinking about the kinds of data we have, where we keep it, and how we keep it."

Senior financial executives, in particular, need to help drive efforts to better manage data and lend support to IT projects that achieve that goal. "At the end of the day, the CFO is the gatekeeper who has to make sure we keep good records and document the things we do and the business decisions we make," says Marc Teal, CFO at Boston Capital, a real-estate financing and investment company.

Sarbanes-Oxley has made gatekeeping more hazardous, threatening heavy fines and prison sentences for those who alter, destroy, or falsify financial records or data that might be needed for proceedings such as government investigations and trials. Sarbanes-Oxley specifies how long certain data must be kept, but raises enough questions in other areas to create a field day for lawyers and consultants.

There are other data-retention regulations and laws, although they don't all specify the length of time particular records must be kept. The Internal Revenue Service requires companies to retain accounting records and other financial data to support tax filings. The Uniform Electronic Transactions Act, approved by the National Conference of Commissioners on Uniform State Laws and passed by a majority of states, has data-retention requirements. The Occupational Safety and Health Administration has rules for retaining data about employees.

Retention requirements vary by industry. Financial firms must comply with Securities and Exchange Commission rules on data retention, including rules on how long to keep particular types of E-mail messages. The Food and Drug Administration (FDA) regulates the retention and security of electronic records in the pharmaceuticals and biotechnology industries. The Environmental Protection Agency has rules for managing environmental records and reports, whether paper or electronic. And health-care companies must take into account the Health Insurance Portability and Accountability Act when dealing with records retention. HIPAA focuses mainly on security and privacy but also involves data retention of patient records. Some data — such as customer-profiling information and sales trends — is of historical or business value and should be kept even if there's no legal requirement to do so.

It may be tempting to keep everything, but companies should avoid the potentially costly problem of information overload. Many documents don't need to be kept for more than two or three days, or for as long as they're needed for business. This includes, for example, information used for background research, memos about company social events, and E-mails about trivial matters that don't pertain to business.

Experts say that in many cases, "data" isn't considered a "record" until it's put into a readable format that has context. Such data doesn't have to be kept unless it's needed for business. For example, information such as someone's name, telephone number, or address might not mean much. But when it's part of an invoice, that's a record that might have to be kept.

Before stocking up on hardware, software, or archiving services, however, companies should develop a records-retention schedule and policy that clearly states how long various types of records should be kept and when they were or should be disposed of.

"If a company that doesn't have a schedule of retention destroys records in the regular course of business and then ends up in court, saying they don't have a retention policy is not going to be good enough," says Rae Cogar, an attorney who heads RCS Consulting, a Hamburg, New York, firm that focuses on records-management issues. "Lots of companies have been fined and sanctioned because they had no policy," and the fines can run into millions of dollars.

An advisory committee that includes the CFO and other senior business executives, a senior IT representative, a records manager, and corporate attorneys should oversee the records-retention policy and schedule. The schedule must be based on legal and regulatory requirements, as well as business needs.

While this may sound obvious, many companies aren't doing it. "Most companies are in a mess; they don't have a good fix on electronic records retention," says Julie Gable, founder and principal of Gable Consulting in Wyndmoor, Pennsylvania, a firm specializing in records and document management.

Some companies have always taken records-keeping seriously. Guidant Corp., an Indianapolis manufacturer of medical devices, has had a retention policy since the 1980s, largely because the FDA requires it to have records-control procedures in place. The Guidant policy calls for some data to be kept for as long as 20 years, says Alan Lybeck, group leader of quality, information, and technology, and a certified records manager.

"Records-keeping has gotten incredibly complex," notes Lybeck. "When I started doing this 15 years ago, most of our records were still on paper or microfilm, and you could see them in the filing cabinets. Today, probably 95 percent of the information is electronic, which can make it very hard to find." Electronic storage is cost-effective, of course, but creates its own headaches: as operating systems and other technologies evolve, there is no guarantee that records stored electronically will be able to be read in the future.

Adding to the complexity is the ever-growing reliance on E-mail, both as a source of communication and as a means of sharing files. Some data-retention laws and regulations pertain to E-mail because, as Lybeck notes, "much of the content can be considered a record that needs to be retained."

But E-mail can require a message-by-message evaluation. "You can have one message that says 'Do you want to go to lunch?' and another that details sensitive auditing issues, and they have totally different retention requirements," explains Cogar. "One can be deleted today, and the other needs to be kept" where it can be easily retrieved, possibly for years.

Find It Fast(er)
While no single technology offers a magic solution to the complex problems of records retention, a growing array of products addresses some facets of it. Storage-management software, document-management systems, data backup and recovery systems, and programs that classify E-mail content are all being marketed with a Sarbanes-Oxley or related regulatory hook. And while that may seem opportunistic, it doesn't mean it's off-base.

Guidant is using imaging and document-management software from Hummingbird Ltd. to meet FDA requirements to retain such information as patent data, design specifications, and quality-assurance information for a product's lifetime and for two years after it is retired. Guidant also has to retain records under EPA, Department of Labor, and IRS regulations.

One major advantage of today's records-keeping products is that they bring significant automation to processes that are usually manual. For example, previously when Guidant staffers filed a document, they had to fill out a form and send it with the document to a records center. There, someone would enter the data from the form into a database before filing the record. With five manual steps along the way, the process was time-consuming and error-prone. And despite all that, it was difficult to find specific data and documents. With the Hummingbird software, which was implemented in June 2001, employees fill out an online version of the form, and once documents are filed, there's a single point of access via the Internet for data queries.

The software supports Guidant's records-retention schedule for electronic and paper records, Lybeck says, so it automatically knows how long to keep certain information. By placing all these documents in an electronic repository, the system provides a handy way to keep information centralized, which is an additional benefit.

Boston Capital is in the process of implementing a close cousin of document-management systems, an enterprise content management system from Documentum, to manage the retention of all paper and electronic records associated with transactions, finances, and property information. The system manages documents, Web content, records, E-mail, scanned images, and other data. Companies can apply automated retention and destruction policies to any type of content. CIO Tom Gardner says Boston Capital, which for years has retained "everything" related to its corporate partnerships as a matter of course, is creating a formal records schedule to work in conjunction with the content management system.

CFO Teal says one of the things that drove the investment in the system was the rising cost of holding on to so much information, be it electronically or in paper form. In fact, there may be a dual role for the CFO in this regard: while the risks of fines should drive the creation of a corporate policy for records retention, the difficulty of calculating just what it costs to manage information today, versus what it might cost to address it in a more automated fashion, requires leadership.

The costs of data retention and records management are scattered across the organization, making it very tough to get a clear view. Someone at the top needs to insist that such work be done so that any future investments can be made in the proper context. And if cost savings aren't motivation enough, consider the risk of legal entanglements. E-mail, documents, and other forms of "reference data" can often become electronic evidence in court cases. Just ask the major Wall Street firms pilloried by New York State Attorney General Eliot Spitzer.

A range of "forensic computing" techniques can be brought to bear to ferret out data, but it's certainly cheaper to manage it better up front. Vendors see plenty of opportunity here, not only in services but also in new products. Later this year, for example, Austin, Texas-based RenewData will offer ActiveVault Enterprise, a software/hardware combination that stores E-mail and other data and includes a rules engine that helps companies locate all the disparate E-mail and documents relevant to a given query.

Given that judges have cited companies for failing to provide electronic evidence in a timely manner, data management is taking on new importance by the day. Almost any company may eventually be asked, "What did you know, and when did you know it?" If data-retention policies and the underlying technologies that support them are deficient, the (non)answer could be ugly.

Sidebar: Paper Chase
Since many of today's business processes involve electronic data, records-management experts issue this reminder: don't forget about paper documents when planning a records-retention schedule and policy.

All laws and regulations governing retention apply to both paper documents and electronic data. Some records managers say the notion that automated processes replace paper is a myth. "As our electronic records have increased in volume, the paper records being produced have also increased," says Alan Lybeck, group leader of quality, information, and technology at Guidant Corp. and a certified records manager. "All these electronic systems are actually producing more paper."

Rae Cogar, an attorney who heads RCS Consulting, says a records-retention program should include requirements for safely maintaining paper documents. This includes having the proper environmental controls to preserve documents for very long periods of time.

Sidebar: Not-So-Deep Storage
The growing emphasis on data retention is having an impact on the storage-products market, says Roy Sanford, vice president of content-addressed storage at EMC in Hopkinton, Massachusetts. EMC last year introduced Centera Compliance Edition, a specialized content-addressed storage system designed to help companies meet regulatory requirements for data retention.

Centera, which enables records managers to set retention periods on numerous types of electronic records and tags individual documents with identifiers and time-date stamps to facilitate tracking, quickly became EMC's fastest-growing product line. In 2002 the company sold the equivalent of 4 petabytes of Centera systems to customers. To put that into perspective, Sanford says, that's equal to twice the information stored in the Library of Congress.

Among the companies using the product are an insurance company that's required to keep records on 160 million policies and a financial-services firm that needs to retain 600 million check images. So far, the products have been aimed primarily at companies in heavily regulated industries such as financial services, pharmaceuticals, health care, and life sciences. Charles King, an analyst at the Sageza Group, says that EMC has set a new standard, offering a disk-based storage system specifically optimized for data retention and retrieval. Most archiving systems rely on tape or optical media, which lack sophisticated search functions and other features associated with disk storage.

New companies see an opportunity here as well. Persist Technologies this month came out of the gate with what it bills as a "plug-and-play appliance" designed specifically to archive E-mail, documents, and digital media. The company emphasizes that its product makes fast retrieval of information possible, and cited SEC and NASD requirements for records retention as a prime driver behind its offering. The Enterprise Storage Group, a consulting organization, found that "reference data," which it defines loosely as "any digital asset retained for active reference and value" is piling up at twice the rate of "flat" data at most companies. Reference data tends to entail larger files that need to be accessed more quickly by more people, requires more security/authenticity protection, and must be kept for varying lengths of time. All of that, Enterprise says, will make storage a critical issue for companies in the years ahead.

Sidebar: Tips For Records Retention
While a number of technologies are pivotal to data retention, experts say that it is fundamentally a management issue. Key steps include the following.

• Form an advisory committee consisting of senior financial, business, and IT executives; a records manager; and legal representatives to help develop and maintain a retention and destruction policy and schedule.
• Thoroughly research state and federal laws and industry regulations pertaining to retention to ensure that the company is meeting requirements.
• Periodically update the retention schedule as needed to comply with laws and regulations, and educate employees about the schedule and policy.
• Periodically inspect electronic documents and files, as well as appropriate IT systems to ensure that the storage media and systems are adequate for maintaining data integrity.
• Establish a policy regarding the retention of E-mail messages, based on overall retention policy and legal requirements, and inform all employees about the policy.
• Don't overlook newer mobile devices that may place critical data on laptops or personal digital assistants, as well as employees' home computers.

CFOs: Risk Magnets

New certification and internal control requirements are heaping new hazards on finance chiefs.
Marie Leone, CFO.com | US
June 4, 2003

A few weeks before every quarterly close, John Adamovich receives 225 representation letters from 75 reporting locations in 30 countries. The letters come to Adamovich, the CFO of Pall Corp., from three sources: in-country general managers and controllers, operations committee members that have oversight responsibilities, and group controllers. In some cases, the letters are three or four pages long.

J.D. Edwards & Co. CFO Rick Allen collects about 75 rep letters from his managers every quarter, while John Hendrix, the finance chief at the smaller Cornell Companies Inc., reviews the same kind of upstream certifications from eight managers on a quarterly basis.

The flood of letters vouches for the validity of material financial and non-financial information bubbling up from each company's far-flung operations. Getting such testimonials became imperative after July 30, 2002. On that day, Pres. Bush signed into law the sweeping Sarbanes-Oxley Act, which was intended to restore public confidence in corporate accounting. Toward that, Sarbox requires executives, among other things, to certify financial statements (Sections 302 and 906) and verify that internal control systems are adequate (Section 404).

Whether the wide-ranging provisions of Sarbanes-Oxley actually keep corporate corruption in check remains to be seen. In a recent poll of finance executives conducted by Parson Consulting, only 6 percent of the respondents said they thought the law would curb accounting abuses.

The burdensome requirements spelled out in the law may curb CFOs' enthusiasm for their jobs, however. One headhunter recounts a job-hunting finance chief who told him, "[Since Sarbox], being a CFO just isn't as much fun anymore."

Adamovich, Allen, and Hendrix, for instance, all say they've started requesting upstream certification of data to satisfy sections of the new legislation -- an onerous task. And all are looking hard to see if their internal controls pass regulatory muster. "There are no if, ands, or buts," notes Adamovich. "We have to comply with Sec. 404, and in the short term, that's our main focus."

Anything less would be short-sighted. A slew of experts, including lawyers, risk managers, auditors, and finance chiefs all say CFOs are clearly charged with managing the law's daunting mandates -- and the attendant risks that come with it. "[Sarbanes-Oxley] increases some risks for CFOs, at least for those who take their job seriously," notes Allen of J.D. Edwards. "But risks have always been there."

Maybe so. But these days, all roads seem to lead to CFOs. Indeed, in the Parson survey, 58 percent of the executives polled said they expect the company finance chief to bear the primary responsibility for overseeing the entire compliance effort. And with that responsibility comes liability -- a lot of it. "CFO are in a more precarious position [since Sarbox was passed]," insists John Challenger, of outplacement firm Challenger, Gray & Christmas Inc. "They are in the direct line of fire, and can wind up as a scapegoat."

The scope of Sarbanes-Oxley alone should worry CFOs. As John Tonsick, managing director at risk consultancy Citigate Global Intelligence and Security, points out: "What CFOs are now being asked to certify is very broad."

The Hours
Then again, some of the provisions of Sarbanes-Oxley are quite well-defined. A CFO convicted of signing off on misleading or inaccurate financial statements, for instance, will be subject to a fine of up to $5 million and a prison sentence not to exceed 20 years.

But Congress's draconian punishment for rogue CFOs is more PR than IR -- the legislators way of looking like they're getting tough on corporate crime. In short, a headline grabber.

What doesn't generate headlines is that Sec. 404 requires a company's CFO and CEO (and external auditors) to vouchsafe for the effectiveness of internal control procedures for financial reporting. Says Richard Rubin, an attorney with Jenkens & Gilchrist: "The real issue regarding certification resides in Sec. 404 requirements that call for attestation of internal controls by executives and auditors."

Indeed, Sec. 404 mandates continuous monitoring, testing, and appropriate improvements to internal controls processes -- a much more onerous and complicated task than keeping tabs on disclosure controls.

Moreover, that trio of internal control controls is interrelated. In fact, Deloitte & Touche Partner Steven Wagner says he wouldn't be surprised if the Securities and Exchange Commission turns the triad into a single certification by the end of the year.

Such a move would likely heap more work on already-overworked finance executives. In the Parson survey, 66 percent of the respondents said they're spending more time on risk assessment than in the past.

To handle this extra work wrought by Sarbox, some finance chiefs are adding staff. John Cox, CFO of BMC Software, Inc. says the Houston-based software vendor added two new full-time positions to the 400-strong global accounting staff to help with the increased disclosure. BMC has also added another staff member to the company's 12-person internal audit team.

With the recession still on, however, not all CFOs will be eager -- or able -- to staff up their finance departments. Rick Fumo, executive vice president at Parson, predicts that over the next few months, the workload for corporate finance departments at mid-size and large companies will increase by two hours per week for each staffer, thanks to Sarbox compliance requirements. He expects senior financial executives to put in three more hours per week because of the legislation.

Three hours a week may not sound like much. But assuming a typical CFO works from 8 a.m. to 6 p.m., that's another 15 days of work per year. Shoe-horning three additional business weeks into an already cramped schedule means CFOs may need to show some ID to get into their own homes.

In This Corner
Of course, spending long hours at the office is nothing new for finance chiefs. What is new: trying to cope with accounting requirements that seem more concept than concrete. According to the Parson Consulting survey, fully a quarter of the finance managers polled said that the Sarbox is "very confusing."

Some of the uncertainty comes from lack of SEC guidance, argues BMC's Cox. He notes that the legislation was passed in rapid fashion as politicians pushed policy through to restore investor confidence quickly. "It's unfathomable that all the Sec. 404 rules will be finalized by September -- and companies will be in compliance by the end of the year -- without SEC guidance," says Cox.

Deloitte & Touche's Wagner, who is also co-leader of the firm's Sarbanes-Oxley Sec. 404 steering committee, figures that the SEC will weigh-in on some Sec. 404 issues by the end of May. So far, though, he says final rules are a moving target.

That's not good news for the folks doing the shooting. What's more, attempts to comply with Sarbox are triggering some unexpected problems. For one thing, the new regulatory regimen is changing trusted business partnerships, asserts Robert Williamson, chairman and CFO of CityMerch Corp. in Miami Beach. Says Willliamson: "The relationship between CFOs and external auditors has become more adversarial."

By Williamson's lights, this tilting of the auditor/client relationship is the most dramatic corporate event for finance chiefs since the Enron fiasco.

You don't have to tell that to Keith Gorman. Gorman, former CFO of Universal Health Services Inc., was fired in February over a row with company auditor KPMG about certification of the auditor's management representation letter.

Gorman, a 16-year company veteran, reportedly wrote a candid letter to KPMG explaining that, while he was willing to sign the management rep letter (attesting that the financial statements he submitted for audit were, to the best of his knowledge, accurate), he was relying on the Big Four firm to ensure that the accounting treatment was in accordance with GAAP. Turns out that Gorman, who has a reputation on Wall Street for being "brutally honest about coming forward with the good and bad news," was a bit too straightforward this time.

By admitting that he was leaning on KPMG for accounting treatment advice, Gorman lived up to the spirit of Sarbanes-Oxley -- if not the letter of the law. But his candor cost the Universal Health CFO his job. "Gorman was fired for his temerity," asserts Williamson, adding that the finance chief "said publicly, what other CFOs say and think privately."

But Universal Health is not the only example of the souring of the auditor/client relationship. In April, Amerco Inc. sued its former auditor, PricewaterhouseCoopers, for seven years of alleged bad advice on how to properly account for special purpose entities.

Swimming Upstream
Clearly, a retooling of internal finance processes -- not to mention external relationships -- will take time.

Everett Gibbs, managing director of financial consulting specialist Protiviti Inc., says that most companies have a certification process in place. But he claims the maturity of the programs vary. In fact, Gibbs predicts it will take many companies up to two years to bring their compliance procedures in line with Sarbanes-Oxley.

At Pall Corp., CFO Adamavich is taking a three-prong approach to Sarbox compliance. First, he's working on improving the reporting from the financial and operations side of the business. Second, he's encouraging thorough disclosure committee discussions (the Sarbanes-Oxley Act requires the formation of such groups). And finally, Adamavich says he's requring upstream certification of financial data.

That's not uncommon. In an attempt to create a paper trail, most CFOs appear to be insisting on certification of financial and operating data from other managers and department heads.

While upstream certification doesn't guarantee that CEOs and CFOs won't be hearing from the SEC, experts say the process does show a good faith effort to ensure correctness.

But even upstream certification has its limitations. Rubin of Jenkens & Gilchrist points out that a sign-off has to be properly targeted so the manager certifying reports is privy to the work being performed. In addition, Rubin says controls must ensure that the reports are actually being read and reviewed, and not just rubber-stamped. Rubin believes upstream certifications should be designed to force employees to think about the materiality of entries.

Even then, senior executives are still required to address exceptions that managers list on the lower-level certifications. What's more, Rubin says they're still obliged to resolve any conflicts that might mislead investors or omit material information.

Stratego?
Not surprisingly, all this certifying and addressing and resolving has many CFOs flat-out worried. The fact is, nobody in finance land is exactly sure what Sarbox landmines await, or where -- or whether the SEC will aggressively enforce the law's provisions.

For his part, Parson's Fumo believes many of the best practices for handling the new risks will emerge from peer group discussions facilitated by auditors and other financial consulting firms. That's particularly true for small and mid-size companies which don't have accounting staffs big enough to juggle accounts payable, new GAAP guidance, and internal controls design.

In fact, CityMerch's Williamson suggests that such companies should consider hiring a third-party accounting firm to mitigate certification risks. "During the audit season last year, it seemed like the SEC changed rules once a week," explains Williamson, who was at the time CFO of Vfinance Inc., a small public financial services company. "8-Ks were flying out the door because the SEC was asking companies to resubmit filings based on the new rules."

According to Williamson, there was no way he could physically keep up with the changes, plus tend to his CFO duties, without the help of outside accounting counsel.

So Williamson brought in Ahearn, Jasco + Co., an accounting firm that also did Vfinance's tax work. Interestingly, Frank Jaumont, a partner at the audit and financial services firm, says that Sarbox compliance is really hurting companies in the $30-million-and less revenue range. Why? Because CFOs at those companies focus on operations and raising funds, rather than non-revenue producing activities such as tax accrual schedules or MD&A drafts to explain new events.

Since the passage of Sarbox, the 25-person Florida-based accounting firm has taken on the role of accounting advisers for four new clients. The price tag for hiring a second accounting firm is not cheap, however -- about $150,000 annually, says Jaumont. For the fee, a company generally gets an SEC audit partner, a tax attorney, and an audit staff with internal audit expertise.

I Believe You Know My Attorney
Ultimately, however, it's the CFO's signature -- and not a consultant's -- that goes on the quarterly and annual certification forms sent to the SEC. And consultants aren't likely to go to jail or lose their homes if they proffer bad advice to CFOs. A finance chief who signs off on a moderately inaccurate 10-K...well...who knows? /p>

Ironically, Tom Malone, CEO of Portland-based SRC Software, thinks the added risks now shouldered by CFOs will eventually lead to higher salaries for CFOs. "No one is ignoring the fact that risk exists," he notes. "And executives expect different compensation because of it." Malone thinks compensation negotiations will focus more on severance triggers and parameters than salary, however.

Others say it's too soon to tell whether CFOs will command larger salaries because of Sarbox risk. But John Wilson, president and CEO of J.C. Wilson Associates LLC, a recruitment firm that specialize in CFO searches, confirms that finance chiefs are looking for "either protection, reward, or both," since Sarbox became law. "A CFO knows that his net worth can be wiped out by one bad scenario," says Wilson. "So he wants assurance."

An exaggeration? Possibly. But consider this: Wilson notes that an increasing number of CFO candidates are bringing in lawyers to scrutinize employment contracts. "[CFOs] are more serious and more on guard then ever before," he claims. "They are pouring over details about employment terms and conditions, severance, causes for dismissal, and offer letters."

And backing off if they don't like what they find. Wilson says finance executives appear reluctant to snatch up coveted CFO positions these days, even with the lousy job market. In part, he believes the hesitance comes from newfound concerns about accountability. Says the recruiter: "Personal liability always trumps a bad market."

Fraud Squad

Federal investigators are on a crusade to elevate corporate misdeeds to criminal offenses.
Alix Stuart, CFO Magazine
April 1, 2003

U.S. Attorney Patrick Meehan hasn't yet caught any companies engaging in the fraudulent accounting tactics that Enron used to boost revenues. But should one turn up in the Philadelphia jurisdiction where Meehan represents the Department of Justice, well, he wouldn't be sorry.

"I'm not wishing that there be some major corporate scandal with Eastern Pennsylvania nexus," says Meehan, an antiterrorism expert and member of the DoJ's newly formed Corporate Fraud Task Force. "That doesn't mean we aren't very aggressively scrutinizing activity in our area."

To that end, Meehan has been changing the way he does business. For one thing, he's getting weekly, rather than ad hoc, updates on suspicious corporate activity from his white-collar-crime expert. More important, he's teaming with other agencies, such as the Internal Revenue Service and the U.S. Postal Service, to pursue corporate cases that have potential criminal implications. Already, he and Arthur S. Gabinet, the Philadelphia-area head of the Securities and Exchange Commission, have planned staff cross-trainings and reviewed cases of mutual interest.

Meehan is hardly alone in tightening his scrutiny. While the 93 Presidentially appointed U.S. Attorneys who represent the DoJ nationwide have broad discretion in choosing cases, it's hard for them to ignore the fact that their bosses have put revenue inflation and expense miscapitalization on a par with terrorism and drug pushing. "When financial transactions are fraudulent and balance sheets are falsified, the invisible hand that guides our markets is replaced by a greased palm," said Attorney General John Ashcroft as he pressed charges against WorldCom executives last August. "Corporate executives who cheat investors, steal savings, and squander pensions will meet the judgment they fear and the punishment they deserve."

Beyond the rhetoric, the federal government has taken unprecedented measures to strengthen its corporate fraud-fighting resources. Before last summer, there was no "home" for such cases within the DoJ, which relied on its various subdivisions, including the FBI, securities-fraud and white-collar-crime units, and local U.S. Attorneys, to handle them on an as-needed basis. Now the inter-agency Corporate Fraud Task Force, formed last July, is coordinating investigations into alleged misconduct at such major firms as Adelphia Communications Corp. and Qwest Communications International Inc., and equipping local staffs with the resources and expertise they need to hasten indictments. President Bush's proposed budget, meanwhile, offers $24.5 million to the cause, some of which will be used to hire 88 new staff members in the U.S. Attorneys' offices and 118 new workers at the FBI.

Add to these moves the public outrage at Enron and WorldCom officials, and no wonder prosecutors like Meehan feel compelled to jump on business-fraud cases. "Until now, most [U.S. Attorneys'] offices outside the major metropolitan centers haven't had the resources or experience to take these cases on," says John Falvey, a former assistant U.S. Attorney and now a white-collar defense attorney in Boston. "Thanks to the political climate, though, every office is now looking to make them."

That means that executives — particularly finance executives — have become targets for prosecutors looking for a win with superiors. "Many of the [accounting] cases I'm involved in, and my colleagues say the same thing, would not have been the subject of criminal investigations a few years ago," says Jan L. Handzlik, a partner at Kirkland & Ellis. Adds Thomas E. Dwyer Jr., a white-collar defense attorney at Dwyer & Collora in Boston, "Every office is looking for its own Enron."

More Than Tough Talk
Of course, the DoJ has long talked tough about corporate fraud, and has brought action against executives at companies that created massive investor losses, such as Cendant and McKesson. Yet, while prosecutors have had the legal authority to bring criminal fraud charges since the 1930s, the agency has historically stuck to crimes that yield more tangible evidence, such as murder, kidnapping, or illegal arms possession.

"[Accounting] cases are not easy to prosecute, since they have to prove that an executive knew or should have known about the fraud in order to indict," says John K. Markey, a partner with Mintz Levin Cohn Ferris Glovsky and Popeo PC and a former assistant U.S. Attorney. That's a higher burden of proof than SEC investigators typically require for civil cases, which are contingent on proving only that a filing contained incorrect information. Given the volume of resources required for the DoJ to build such cases, most prosecutors have found it worthwhile to take on corporations in only the most egregious or clear-cut instances.

Thanks to recent legislative changes, however, lawyers see a future in which many common accounting snafus, including restatements, could put executives at risk for jail time. "With the new Sarbanes-Oxley requirement to have strong internal controls and officer certification of financial statements, the bar has been lowered on the 'knew or should have known' standard," says Markey. "The presumption will be that the CFO must have known if something has gone wrong."

Just how fierce this chase will be and how long it will last is anyone's guess. At press time, the DoJ had opened more than 150 investigations into allegations of corporate fraud. The FBI alone claims to have opened more than 50 major corporate-fraud investigations since initiating the Enron investigation in December 2001. And if the geographic scope of the investigations and the speed with which prosecutors are bringing indictments are any indication, there is good reason for many more companies to be concerned.

The U.S. Attorney's Office in St. Louis, Missouri, for example, best known for prosecuting drug pushers and counterfeiters, is now investigating Charter Communications Inc. for alleged accounting fraud. Kmart Corp.'s management decisions are being probed by the Eastern District of Michigan. And the indictments against four former Qwest executives for allegedly booking revenue that should have been deferred were issued from the Colorado U.S. Attorney's Office, which credited the Task Force's oversight with speeding up the investigation.

At the same time, the Task Force is also helping offices clear out backlogs of older cases and deploying resources to take on smaller cases. In December, the U.S. Attorney's Office in Tulsa completed a four-year investigation into now-defunct Commercial Financial Services Inc., thanks to additional staff from the DoJ's Washington, D.C., office. In several districts, including the Southern District of New York and the Central District of California, a number of formerly unknown executives have been indicted for frauds involving relatively small amounts of money. U.S. Technologies Inc. chairman and CEO C. Gregory Earls, for one, is facing up to 50 years in jail and $3 million in fines for bilking investors out of $13.8 million.

In addition, at the Task Force's urging, DoJ officials have demonstrated a newfound willingness to bring partial cases and add charges later. That helps explain why Enron executives have been charged in such a piecemeal fashion, starting last August with Michael Kopper and continuing most recently with two accounting managers involved with the company's Braveheart scheme. That strategy also lends logic to why Kmart managers were charged with prematurely booking $42 million of vendor allowances as revenue in February, when the company's own investigation turned up some $92 million in such improper allocations.

A Task Force Approach
The biggest weapon the Task Force has in combating fraud, however, may be the closer ties it is forging with other agencies. The group of 17, formed by President Bush last July and headed by Deputy Attorney General Larry D. Thompson, includes seven U.S. Attorneys, like Meehan, from major metropolitan areas, plus FBI head Robert Mueller, SEC chairman William H. Donaldson, and Labor Secretary Elaine L. Chao, among others. As an interagency team, the Task Force's criminal authorities have easier access to corporate cases, as well as the topical expertise the Task Force needs to prosecute.

The group meets whenever necessary to discuss ways to leverage resources. "If you're all sitting around a table, it's much easier to get that tag-team help," says U.S. Attorney for the Central District of California Debra W. Yang, whose district led the nation with charges against 483 white-collar defendants last year. She says her manpower temporarily tripled on one recent case after she mentioned it to Mueller.

Such cooperation between the SEC and the DoJ has long been a factor in several regions known for high-profile corporate-fraud cases, but the Task Force is broadening and deepening that relationship. Besides working with Donaldson and Stephen Cutler, the SEC's head of enforcement in Washington, D.C., the DoJ has been tapping regional SEC officials with unprecedented frequency and eagerness. "I feel like a prom queen, I've been pinned by so many U.S. Attorneys who want to work with me," says Harold F. Degenhardt, SEC district administrator in Fort Worth, referring to the six DoJ pins that have graced his lapel as a result of recent meetings with prosecutors.

David Nelson, director for the SEC's Southeast region, agrees. "The receptiveness of the DoJ is higher down here now than at any time before," he says. A cross-training program that puts one of his staff members in the Miami U.S. Attorney's office full-time has already boosted the flow of SEC cases to the DoJ, he says, and he expects to see it increase thanks to the encouragement from Washington.

So far, neither Degenhardt nor Nelson has scored an indictment as a result of these partnerships. But the fruits of such collaboration can be seen in central California, where efforts between Yang's office and the Los Angeles SEC branch office have produced four indictments and five guilty pleas against the corporate officers at four companies — Homestore.com, eConnect, Motorcar Parts & Accessories, and Newcom — since last July. "The old model, in which we finish our own investigation, bring our case, and then make a referral to the U.S. Attorney's Office, often no longer applies," says Randall R. Lee, director of the SEC's Pacific region. Instead, "we'll call criminal authorities immediately" when an SEC case seems to have criminal elements.

Lines of Cooperation
So what's the best advice for companies and finance executives in dealing with this new united front? Lie down and roll over, say lawyers. "One of the few ways a company or an individual can gain any benefit with prosecutors is by cooperating with them," says Handzlik.

In fact, the access a company is willing to give the government to its employees and to its information can actually determine whether or not charges are pressed against the entity, say prosecutors, as well as how high the fines should be. "When a company walks in and says, 'Here are the books, and all witnesses are available,'" says Patrick Fitzgerald, U.S. Attorney for the Northern District of Illinois, "that's a very important factor in deciding whether or not to charge them if we find a crime took place."

Such conduct is what made Homestore.com, an online real-estate concern, such a model cooperator, say authorities. Although four of the company's former executives, including two former CFOs, were charged for a scheme to buy revenues, "we did not charge the company, in large part because of its behavior," says Yang. "When we started investigating, they turned over all their documents without trying to hide anything, and they made an effort to root out the cause of the problem by getting the officers out of there." Safety-Kleen Corp. and Aurora Foods Inc. also managed to avoid corporate charges when their executives were indicted.

Cooperation is not risk free, however. First, it carries with it no guarantees of leniency. Arthur Andersen signed its own death warrant by admitting to authorities that its Houston office had destroyed documents, say many attorneys, based on the fact that it later sank on a single charge of obstruction of justice related to the shredding. A similar situation now appears possible at Credit Suisse First Boston, according to published reports, where company-produced E-mails now look likely to be the basis of charges against former investment banker Frank Quattrone.

Second, cooperation often means a company may turn against its executives, says E. Lawrence Barcella, who is representing Homestore.com co-founder and former CEO Stuart Wolff. So far Wolff has not been indicted, but he is under investigation by the DoJ. But that has been enough to deny Wolff access to records he might have used to build any future defense, says Barcella, "even though the company's internal investigation did not show any wrongdoing on his part."

Most seriously, by waiving its right to keep confidential information confidential, a company may end up seeing that information "fall into the hands of civil plaintiffs or other federal agencies," says Handzlik. Columbia/HCA (now HCA Inc.), for example, made internal coding audits available to investigators looking at its billing practices. The firm claimed that it was not waiving its attorney-client privilege or work-product privilege when it set up a confidentiality agreement with the DoJ that ostensibly protected the information from leaking. Shortly after settling in 2000 for an $840 million fine, though, "innumerable" plaintiffs — private insurers and individuals — tried to acquire the documents to build their own cases. The U.S. Sixth Circuit Court of Appeals ruled in favor of those plaintiffs, upholding the prevailing view that "once a client waives the privilege to one party, the privilege is waived in toto," according to its June 2002 decision.

The DOJ vs. the CFO
For executives caught in the DoJ's crackdown, prosecutors have a slightly different yet equally powerful incentive to induce cooperation — lesser charges and less jail time. And given new federal sentencing guidelines, it often behooves executives to work with the DoJ up front.

Those guidelines — introduced in 1987 — give minimum sentences that make it difficult for federal judges to shorten. In addition, recent revisions suggest even longer minimum sentences for crimes committed after January 25, 2003. For example, the minimum sentence for an obstruction-of-justice charge was boosted from 18 months to 24 months.

Prosecutors are eager to wield the new standards. "Our emphasis is to make sure we follow through not just on prosecuting but [also on] arguing for a particularly tough sentence," says Fitzgerald. And that sentence will be made even tougher, thanks to a recent Task Force-inspired DoJ directive to assign white-collar convicts to standard prisons, rather than low-security facilities. "They clearly want to eliminate any perception that white-collar criminals get favorable treatment," says James M. Becker, an attorney with Saul Ewing in Philadelphia.

But could the DoJ be going too far in eliminating that perception? Some experts say it is possible. "When the playing field is tilted so heavily in favor of enforcement officials and the members of juries are viewing executives as criminals, it's much harder to get fair treatment," says Handzlik. He says that in many cases he knows of, executives will "take the pragmatic way out and plead guilty," even when their cases are considered defensible. "That means, in my view, the system is not working properly."

Only time will tell if the DoJ's new aggressiveness will root out any real rot in Corporate America or if it is simply a legal witch-hunt. In the meantime, however, most attorneys expect more CFOs to go to jail. "In a case involving falsified financial statements of a public company, executives are very much at risk for jail time, and that's only going to get worse," says Falvey. Already, 200 individuals have been charged in such cases, and guilty pleas or verdicts have been secured against 60. "In the white-collar defense world, you win the case preindictment," says Markey. "Once they [the DoJ] indict, they are emotionally and institutionally committed to the conviction of the individual."

Alix Nyberg is a staff writer at CFO.

Attention Grabbers
What's sure to grab the Department of Justice's interest these days? Good clues can be found in the March 2002 issue of the United States Attorneys' Bulletin, which outlined four "brazen accounting frauds" — side agreements, swap transactions, backdating, and concealing debt or expenses through special-purpose entities, deferred expenses, or accelerated recognition of losses — that make for good criminal cases.

By all accounts, prosecutors are taking the advice to heart. A side agreement with American Greetings Corp. was the basis of indictments against former Kmart Corp. executives. Alleged manipulations that boosted revenue without actual sales are at the heart of the Homestore.com Inc. case, as well as investigations of many telecom companies. And investigations at WorldCom, among others, hinged on concealing operating expenses as capital expenses.

How long ago the fraudulent activity occurred, how many people were involved, and how much money was lost are also key factors in deciding whether to take a case, say DoJ officials. Still, any willful violation of an accounting law can be construed as a criminal case — a long-standing policy under U.S. law that the Sarbanes-Oxley Act only clarified. The government, however, can charge only on what it can prove was willful, which can be a tall order. That, in part, explains why the DoJ charged just four former Qwest Communications Inc. executives for a single revenue-boosting scheme in late February, while the SEC brought concurrent civil charges against eight for two separate schemes. It wasn't that the second case — a deal in which Qwest executives (including former Global Business unit CFO Grant Graham) "bought" revenues from Genuity — couldn't lead to criminal charges later. It's just that the evidence needed to prove criminal intent takes longer to develop, say experts, because the standard of proof is higher.

Securing that evidence has led to a renewed emphasis on whistle-blowers and employee testimonies. "One common mistake in the prosecution of accounting-fraud cases is to focus on the paper to the exclusion of key witnesses," the Bulletin article reads. It goes on to advise prosecutors to " 'flip' lower-level participants like narcotics prosecutors would," noting that cooperation can usually be induced by making noncooperators targets of the investigation.

To further that approach, the FBI has set up an agency-staffed hotline to "provide the general public with the opportunity to furnish information concerning suspected corporate- fraud matters directly to the FBI," according to a press release. The FBI expects the hotline to generate four or five new corporate-fraud cases each month. —A.N.

Under Pressure

Sarbox is just one of many new regulatory requirements companies face. Can IT help?
Scott Leibs, CFO IT
March 17, 2003

Last year, in a speech before the American Society of Corporate Secretaries, the Securities and Exchange Commission's Cynthia Glassman took the corporate-governance group for a not-terribly-invigorating walk down Memory Lane. "The public eagerly sought stocks of companies in certain 'glamour' industries...in the expectation that they would rise to a substantial premium — an expectation that was often fulfilled," she said. "Within a few days or even hours after the initial distribution, these so-called hot issues would be traded at premiums of as much as 300 percent above the original offering price. In many cases, the price of a 'hot' issue later fell to a fraction of its original offering price."

Then she delivered the kicker: she wasn't quoting from an account of the dot-com bubble, but from an old SEC document about the mania for electronics stocks that dominated Wall Street in the late 1950s and early '60s.

Her point was that the current raft of regulations is not new, and it's high time that companies take corporate governance seriously. As part of that, she suggested they engage in "real self-examination and learning...."

All in the Timing
She meant it in the sense that the unexamined corporate life may ultimately be lived in jail, but other interpretations spring to mind. They especially spring to the minds of software companies and other purveyors of IT, which see in the Sarbanes-Oxley Act of 2002 and other recently enacted or proposed regulations a prime opportunity to sell products to their corporate customers.

Some of these efforts have to be chalked up to opportunism. As we noted in CFO in December 2002 (see "Partial Clearing"), there is nothing in Sarbanes-Oxley that unequivocally mandates a technology upgrade. While the technology sector would certainly benefit from another Y2K-like buying frenzy, this is not likely to trigger one. Longer term, however, regulatory pressure may have a substantial impact on a range of IT buying decisions.

Today most CFOs we spoke to agree with Terry J. McClain of Valmont Industries Inc., a designer and manufacturer of irrigation systems, utility poles, and other products. "Sarbanes-Oxley is a costly exercise for us, both in terms of time and money, but very little of that involves IT," he says. Consultants and lawyers, he says, are the current beneficiaries. "I can see a role for IT in providing some systematized checks and balances," he states, "and maybe we'd use software as a sort of checklist to keep us on track, but it's really more about your processes and governance structure."

Yet McClain also says the full implications of new regulatory requirements can be difficult to fathom because "they come out a spoonful at a time, and there haven't been any test cases that can shed light on areas that are wide open to interpretation."

That murkiness is at the heart of many IT companies' marketing pitches, which essentially argue that companies shouldn't focus too closely on the letter of the law, but rather on the spirit. And the spirit emphasizes visibility, accountability, and better governance. There's a strong role for IT, they say, in all three areas.

"Half of all the calls I get involve Sarbanes-Oxley," says John Van Decker, an analyst at Meta Group Inc. who focuses on financial applications, "so I'm certainly seeing signs that IT spending will get a boost from this." Most likely, he says, companies will view Sarbanes-Oxley as a catalyst, making long-delayed upgrades to financial systems in order to meet the faster reporting times now mandated, and to give them greater confidence that the numbers their CEOs and CFOs are liable for are accurate.

Some software companies are making their own upgrades, tweaking products to meet new regulatory requirements. PeopleSoft Inc., for example, had already started down the road toward performance management before Sarbanes-Oxley came along, but is now adding an investor portal to its Financial Management Solutions Blueprint product suite, as well as new workflow and approval capabilities to its financials modules to speed the preparation of 10-K and 10-Q reports.

"One prospect had set aside three to four months to review potential IT solutions," says Renee Lorton, senior vice president and general manager of PeopleSoft's financial solutions group, "but then met with us and said, 'We have to make a choice and begin implementation within a month — our board is demanding it.' "

While she says that such top-level pressure will boost sales, particularly among the many companies that still use older, "legacy" applications, she also believes such forthcoming rules as Sarbanes-Oxley Section 404, which would require management to state in annual reports how it has addressed a range of internal controls and financial-reporting procedures, "could be a huge driver" for financial software.

"Could be," because Section 404 is one of two provisions that have no specified deadline; the other, Section 409, concerns "real-time" disclosure of any material change in a company's financial condition. Thus, two of the mandates with the most potential to demand IT fixes will trail behind other provisions of the legislation. "Software companies would love to offer ready-made products for internal control," says Scott Bohannon, executive director of the Working Council for Chief Financial Officers, a membership organization that researches best practices in financial management. "But no one knows what the final rules are yet."

Oracle Corp. is already producing a series of white papers and workshops built around the specific regulatory pressures facing various vertical industries; in many cases, Sarbanes-Oxley is just one of several new laws that companies must comply with.

Phase Value
Despite the uncertainty, there are enough information-oriented provisions within Sarbanes-Oxley, from Section 302 (corporate responsibility for financial reports) to Section 806 (accommodation of and protection for whistle-blowers), that the implications for IT are already becoming clear — at least to some companies. "It often comes down to whether companies are in the rationalization phase, the realization phase, or the optimization phase," says Brian Kinman, leader of the enterprise risk management practice at PricewaterhouseCoopers LLP.

Kinman says companies tend to evolve through all three phases, at first believing they already comply with Sarbanes-Oxley requirements, then realizing they have work to do, and finally moving on to optimization, in which they don't simply comply but put systems in place to make sure they remain compliant even as requirements change. "That often involves an IT investment," he says. "For example, putting in automated reporting systems to make sure you always have control over and visibility into current financial results."

Very few CFOs seem to be at that stage today. "Most are focused on creating an internal-control framework that allows auditors to attest to the validity of management assertions," says Steve Wagner, co-chair of the Sarbanes-Oxley internal-control committee at Deloitte Touche LLP. "IT tends to play into that via a 'controls repository,' a place to document your goals and activities."

While that could be as simple as a spreadsheet, many software companies — particularly ones that don't concentrate on financial software — see this as a ready opportunity to extend products that were originally developed for other purposes. Compli Corp. has offered software since 2002 that addresses employment practices, helping companies fend off lawsuits by communicating policies on, for example, sexual harassment, and then allowing them to track complaints and log actions taken by human-resources departments. The company says its software is well suited to issues of financial compliance, providing a Web-based means of creating and communicating policies, assessing their effectiveness, and providing well-documented follow-up.

Similarly, shareholder.com and CCBN Inc., among others, have expanded their Web-based investor-relations services to include corporate-governance issues. In a sense, this brings the practice of leveraging Sarbanes-Oxley for marketing purposes full circle: companies with solid governance policies and internal controls can let investors know all about them, possibly making their stock more attractive. (In fact, a survey by Parson Consulting found that companies that release financial results earlier than their peers achieve an average 15.5 percent premium in their P/E ratios.)

If to date there has been more talk than action regarding the role of IT in helping companies deal with regulatory pressures, there are signs that technology will eventually become a bigger part of the discussion. Last month, Nationwide Financial Services Inc. announced it had developed an internal system based on Lotus Notes technology that documents 178 "unique processes" pertaining to internal audit, so that the financial-services firm's CFO and CEO can be comfortable with its internal controls. Bohannon says products such as "electronic audit committees," audit dashboards, and E-learning systems designed to communicate ethics policies are being developed by a number of software companies.

And Bill Hurley, national practice leader at Parson Consulting, says the Sarbanes-Oxley marketing spin isn't coming just from technology vendors. "We have clients who have wanted to reengineer their internal controls for years," he says. "Now Sarbanes-Oxley gives them the justification to get the money they need to build better systems." United Technologies Corp. may go even further: having upgraded its internal whistle-blower system to be Web-based, it's considering whether to offer it commercially. Maybe regulations aren't so bad after all.

Sidebar: Confidence Check

In light of Sarbanes-Oxley, how confident are CFOs that spreadsheet-based reporting processes provide adequate central control?

• Not confident: 47%
• Somewhat confident: 42%
• Very confident: 11%

Dial ''M'' for Malfeasance

New regulations will require companies to put in complaint systems for employees. But CFOs say setting up good lines of communication can be a real pain.
Craig Schneider, CFO.com | US
March 12, 2003

According to a recent report by The Association of Certified Fraud Examiners, organizations lose about 6 percent of their revenue to occupational fraud and abuse. The study also noted that occupational fraud was most commonly detected by a tip from an employee, customer, vendor, or an anonymous source.

You don't have to tell Thom Weatherford about the value of inside information.

Years ago, when serving as CFO of Ungermann Bass (then owned by Tandem Computers), Weatherford received a tip from an employee that a country manager was coercing workers to record "revenue that wasn't really revenue." Weatherford launched an internal investigation, which ultimately confirmed the employee's disturbing allegation. "Luckily, there was no harm on the revenue side," recalls Weatherford. "But there was always that potential."

Weatherford, who recently retired as finance chief of analytics software maker Business Objects, still serves on the boards of two companies. He says the ugly incident at Ungermann Bass provided a valuable lesson that might have otherwise gone unheeded. "It did bring up that maybe our internal controls could be strengthened," he acknowledges.

Turns out the internal controls at a lot of companies could stand some strengthening. Over the past 18 months, shareholders have witnessed a seemingly endless parade of corporate scandals, revenue restatements, and Securities and Exchange Commission investigations.

To restore some faith in corporate accountability, lawmakers have attempted to ratchet up the control function at publicly traded companies. Part of that ratcheting up involves expanding the role — and responsibilities — of audit committees.

But legislators and regulators also seem intent on making it easier for whistle-blowers like the Ungermann Bass employee to rat out their bosses. The Sarbanes-Oxley Act of 2002, for example, includes a proposed rule requiring audit committees to establish procedures for the receipt, retention, and treatment of anonymous and confidential complaints by employees on accounting or auditing matters.

The SEC plans on issuing the final rules governing the compliance notification systems by April 26. SEC spokesman John Heine says the Commission could come out with the final rules even sooner. Either way, publicly traded companies must be in compliance with the law within a year of its publication in the Federal Registrar.

There's just one problem. Observers say the current design of the SEC's complaint notification system is so vague that they're not quite sure what compliance entails.

Take Gary Barton, senior audit manager at J.C. Penney Co. Barton says he believes the retailer will be able to comply with the proposed system without using one of the many third-party providers that offer hotline services. But Barton also concedes that he's been meeting with compliance officers at other companies to figure out best practices for addressing the whistle-blower requirements of Sarbanes-Oxley.

And the audit manager acknowledges that uncertainty about the new law may eventually force him to contact an outsourcer. "If we go further and they tell us where the complications are," he says, "then we'll look further into outsourcing."

Hotline Hang-ups
One complication Barton and others may encounter: potential conflicts of interest. Companies must have a reporting system that allows for confidential and anonymous reporting by employees. In addition, they must maintain an appearance of independence once those complaints come through. "There must also be frank, open and clear channels of communication so that information can reach the audit committee," says the proposal.

Indeed, concerns over independence and anonymity have some employers turning to third-party providers to at least manage the recording requirement in their complaint notification systems. Certainly, there's no shortage of providers to turn to. These are halcyon days for outsourcers of corporate hotlines, and in recent months, a number of vendors (including Edcor, Report it, and The Network) have started aggressively hawking their services.

Complaint notification system outsourcers also like to point to data from The Association of Certified Fraud Examiners showing that organizations with fraud hotlines cut their fraud losses by approximately 50 percent per scheme. But critics warn that setting up a hotline through a third party doesn't fully get employers off the compliance hook.

They're right. An outsourcer who receives a legitimate complaint from an employee must still pass that information on to somebody at the company — typically, the company's compliance officer. Depending on the setup, a member of the internal audit or general counsel's staff may also be assigned to investigate and relay a validated claim to a company's audit committee for review.

Some corporate executives also doubt that third-party hotline operators will be able to handle complex allegations coming from disaffected finance workers. Some believe relatively low-paid operators will not be able to always ask the next logical question that would make an anonymous caller's complaint complete for investigative purposes. Vendors deny that charge. But it's also uncertain — if calls are truly anonymous — how corporate officers will be able to follow up on an inconclusive report from an outsourcer.

What is crystal clear, however, is that any complaint notification system works best if the notifier of a complaint trusts the system. Says Lesley Ann Skillen, a partner at law firm Getnick & Getnick: "The key to making one of the hotlines work is to make employees feel comfortable about making a report without fear of retaliation or retribution."

Get-Out-of-Jail Fee Card
That's no small task — particularly given recent headlines.

In August 2001, for instance, Roy L. Olofson, then a finance vice president at Global Crossing Ltd., reportedly sent a letter to the telco's top ethics official alleging that the company swapped fiber-optic capacity with other carriers to artificially boost revenues. Olofson was laid off three months later in what the company insists was part of a companywide reduction. Global Crossing's management also claims that the VP of finance sought a large payment in exchange for his silence on the subject, a claim Olofson denies.

Regardless, the Olofson case would seem to confirm what some workers already suspect: whistle-blowers often end up on the street. Certainly, Sherron Watkins' testimony that former Enron CFO Andy Fastow tried to get her fired for going directly to CEO Kenneth Lay with her now-famous E-mails may make comfort a bit of a hard sell. Says Skillen: "That doesn't give everyone a wonderful feeling for going over the head of their bosses and reporting something to senior management."

Hotline experts say there are things companies can do to help protect the confidentiality of complaints, however. Mostly, it's a matter of getting good information upfront so a company's audit committee doesn't have to track down the whistle-blower.

To ensure a complete report, David Mair, former director or risk management at the U.S. Olympic Committee, recommends that employers require hotline callers to provide some basic information when calling in. He says employees should recount the exact nature of the fraud, such as "I believe that this transaction was improperly reported."

He says workers should also be asked when they first become aware of the action being reported, how they came to possess the information they are reporting, and if they participated in the transaction. It's also important to make sure that employees indicate whether they actually witnessed the alleged transgression. Many third-party providers are familiar with the questions and say they can customize support to cover all the necessary bases.

As employers get better at dealing with tips and complaints, it's possible that employees will become less fearful about reporting indiscretions. There's some evidence, in fact, that employees are already getting more comfortable blowing the whistle on employers — and sharing their identity when doing it.

Over the past six months, only 48 percent of callers to the corporate ethics hotlines run by The Network Inc. have requested anonymity. That's a steep drop from an average of 75 percent over the past 20 years, says CEO Tony Malone, whose company provides hotline services to about 1,000 companies.

Malone ascribes the change — which predates the anti-retaliatory measures in Sarbanes-Oxley — to a growing awareness among employees of the harm that unethical corporate behavior can cause. Says Malone: "Employees are profoundly aware that inappropriate behavior can bring about the ruin of their company and damage them personally."

Is This Where We Go to Complain?
Meanwhile, employers seem to be profoundly aware that retaliation against a whistleblower can damage them financially.

To date, relatively few suits alleging retribution against whistle-blowers have made it to trial. In fact, corporate boards seem hell-bent on keeping such cases from ever reaching a courtroom.

It doesn't take a super-genius to figure out why. Bob McMullan, CFO of GlobespanVirata Inc., says that when whistle-blowers bring litigation against management of a company for such claims as wrongful termination, the American justice system tends to run in reverse. "Companies have to prove their innocence," he asserts. "[The claim] is deemed to be correct."

Darryl Rains, an attorney at Morrison & Foerster, concurs. "Two-thirds of jurors come to court believing that corporate executives are dishonest and will lie to make a buck," he notes. "Those statistics predate Enron."

Such jury predilections may explain why Walt Disney Co. recently settled a reported $20 million "whistle-blower" lawsuit for an undisclosed amount. A former executive brought the suit, claiming she was fired for refusing to help the company allegedly cheat the Internal Revenue Service. Disney management declined comment for this story, but has reportedly called the allegations "shameful and untrue."

Nonetheless, the mere prospect of jaw-dropping jury awards may convince some CFOs to bring in third-party hotline vendors to handle employee complaints. Some observers say contracting an outsourcer could prove crucial if a whistle-blower is later fired for, say, poor performance. With an outsourcer running a hotline and information kept confidential and anonymous, they assert a supervisor would likely be free of blame if they fired an underachieving employee. Why? There would be no way for the supervisor to know that the individual was the one who lodged a complaint.

Other experts warn that complaint hotlines set up entirely in-house for Sarbanes-Oxley compliance can overload the directors or officers handling the calls. "My concern would be that they would not have the time to do it effectively or management's position wouldn't be able to independently deal with employee complaints," says attorney Rains.

The issue, however, is up for debate. Hugh Donnelly, vice president of audit at Pfizer, notes that the company uses a third-party hotline vendor. The drug maker's compliance officer serves as the initial point of contact with the company's outsourcer.

While Donnelly says Pfizer's audit committee will have the final say on whether the company's current practice will come up to the SEC's requirements, he's comfortable leaving the filtering to his compliance officer. "If any financial items would come through that," Donnelly explains, "my compliance offer would clearly get me involved to assist on the investigation, if that's required."

Jocelyn Arel, partner with Testa, Hurwitz & Thibeault, LLP, suggests that companies that want to take the most conservative approach to complaint notification systems should have allegations go directly to the audit committee — without going through senior management. "It depends how an individual company defines anonymous," she says.

Realistically, though, Arel concedes that even with a small number of cases to validate, audit committee members are generally too busy to handle more than a few complaints.

Mayhem or Maytag?
Whether they get more than that remains to be seen. For the moment, though, J.C. Penney's Barton is worried how to best filter thousands of worker phone calls once the retailer rolls out its hotline in the next few months. Barton says he's come to expect the avalanche after discussing Sarbanes-Oxley hotline compliance with the general counsel at retail rival, Sears.

Eckerd Corp., J.C. Penney's drugstore chain subsidiary, may also provide Barton with a glimpse of what he can expect. Eckerd already has an operational hotline that is staffed at all hours by the company's loss prevention group. But just six calls out of thousands made to the center over the last six months were related to accounting or auditing matters. The group's manager passed the reports to the compliance officer who serves as the gatekeeper for further investigation by appropriate members of the staff. "I assume they are resolved," Barton says of the six calls, "and are not a big issue."

To be sure, Eckerd's hotline is not compliant with the Sarbanes-Oxley proposed rule because it does not allow for employees to make their calls anonymously. But Barton says that will soon change: "The way to do it is to assign a case or claim number to the individual," he explains.

The individual can then call back and reference that same number to learn of any progress in the claim's investigation. Many times, Barton says, the complaint comes from a lower-level individuals whose lack of full understanding on accounting practices "may lead them to do what they believe is a whistle-blower activity."

In fact, some experts say it's not real likely that dozens of complaints will merit review by the company's audit board, let alone its board of directors. Mair says he's helped establish ethics hotline programs at eight organizations. So far, he says all but one considers what they've done a success. "I think the one that isn't happy overspent on what they could have done," he says, noting that the company hired a full-time person to staff the hotline and do the follow-up.

In the end, Mair says, the staff member simply had no reports to investigate. "It was like the Maytag repair man."

Most companies would love to have that problem.

What Hotline Outsourcers Charge

With the Securities and Exchange Commission set to issue final guidelines on complaint notification systems, some CFOs aren't sure how much setting up those systems will cost.

There is a growing belief among corporates that merely spending enough to hook up a phone line with a voicemail that has caller-ID disabled will not be enough to satisfy the SEC. And as John Robertson, CEO of hotline outsourcer Edcor, notes, a big part of the expense is just getting the message out. "Communication costs can far exceed the cost of the line itself," he says.

Anthony Lavalle, CEO of Report It, a third-party provider based in Great River, New York, explains his company's sliding scale: The system ranges from $5 per employee for smaller companies to as little as 95 cents for businesses with more than 20,000 employees (per employee, per year).

Corporations with 100,000 employees or more can purchase dedicated servers, which are typically tied into longer-term service agreements. It will also be on a per-employee charge but with costs of hardware, software, and setup. The regular hotline annual service agreement, in contrast, can be terminated if the client is not happy.

Edcor's Robertson claims to be able to have hotline services up for clients in less than 24 hours. Report It is currently promising setup within five days for its hotline service. "But as we get closer to the April 26 date," says Lavalle, "we may have to extend that if many are waiting."