Corporate Finance

Bad Sign

Plus, companies beat lawmakers to the punch by revamping 401(k) policies; net present value for dummies, a return to normalcy and cash flow; and more.
Marie LeoneApril 1, 2002

Fraud comes in all sizes. In late February, a former Bear, Stearns & Co. secretary pleaded guilty to using disappearing ink to make more than $800,000 fade from her boss’s bank accounts, according to an Associated Press report. Anamarie Giambrone used the trick pen to write checks for senior managing director Eli Wachtel. After the checks were signed, Giambrone would erase the name of the payee and rewrite them for cash.

Using erasable ink is a very common fraud technique used by bookkeepers in small companies, says Gary Zeune, president of The Pros and The Cons, a Columbus, Ohio-based speakers bureau for white-collar criminals. It works because the bookkeeper figures out that management never looks at the bank statement. That’s “a big mistake,” cautions Zeune, who says eyeing bank statements is a standard internal-control procedure.

Statistics back up his warning. In a key 1996 study, the Association of Certified Fraud Examiners discovered that the average organization loses about 6 percent of annual revenue to employee fraud and financial abuse. By the way, Giambrone broke the glass ceiling for fraud: the median loss caused by women is about $48,000; by men, about $185,000. — M.L.

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401(k) Plan Backlash

Heading Off the Feds

Just as companies get ready to overhaul their 401(k) plans in the wake of the 2001 tax-cut legislation, further changes may soon be in order. At least eight different legislative proposals are ready for debate–all aimed at giving employees greater control over their 401(k) plan assets. Also roiling the water are several potentially precedent-setting lawsuits that have been filed against Enron Corp. and other plan sponsors for mishandling company stock investments in these plans. The bottom line: executives will be pressured to review company policies regarding retirement savings programs, to increase and enhance investment diversification, and to monitor blackout periods during a change in plan record-keepers.

The losses suffered by Enron employees who invested a large part of their 401(k) plan benefits in Enron stock may be a touchstone for change, “but aspects of the Enron case are atypical,” cautions benefits attorney Jan Steinhour of Denver-based Rothgerber Johnson & Lyons LLP. Nevertheless, “the Enron crisis provides a lablike setting for dissecting 401(k) plan operations to learn whether the existing rules require reform,” adds Steinhour.

In addition to provisions that cap investments in company stock and allow participants to diversify out of company stock more quickly, bill proposals are trained on fiduciary responsibility. A fiduciary, in this case, is anyone with discretionary control over plan investment or man-agement, including the employer or a third party hired by the employer.

Ideas range from lifting safe-harbor rules for fiduciaries during blackout periods (when employees lose control of assets) to making it illegal for fiduciaries to knowingly misrepresent information relating to the present or expected value of company stock. There’s even a proposed tax for corporate insiders who sell or exchange company stock when lower-level employees cannot.

A few companies have beaten lawmakers to the punch. Gannett Co. amended its plan in February, calling plan restrictions “outmoded.” Now, for example, employees at the media giant have the immediate right to diversify all plan investments, including Gannett common stock they receive through a company match program. (Previously, they had to wait until at least age 55.) ChevronTexaco Corp. and International Paper put similar changes into effect on April 1. Both companies say the amendments were part of merger-integration efforts started before Enron’s fall. –Marie Leone

Mightier Than Sword

After journalists were disinvited to a recent Bear, Stearns event, the N.Y. Financial Writers’ Association fired off a letter to the SEC charging a Reg FD violation.

In the Family: Company stock represents 29% of total defined contribution plan assets, says the Assn. for Financial Professionals.


Get Real

What true fan wouldn’t pay a king’s ransom to own the football that decided the New England Patriots’s 2002 Super Bowl victory? More than 130 million television viewers watched that ball sail through the uprights for the historic field goal, but what they didn’t see was the mark proving it was a genuine Super Bowl game ball. That’s because it was tagged in invisible ink, which in turn was laced with synthetic DNA–part of the National Football League’s effort to protect its memorabilia from counterfeiters.

The NFL is not alone. According to the International Anti-Counterfeiting Coalition, Fortune 500 companies spend an average of $2 million to $4 million a year fighting counterfeiting, and some spend as much as $10 million. The problem goes well beyond knockoffs of watches and upscale pocketbooks: the software industry loses an estimated $12 billion to $16 billion per year in sales; auto-parts manufacturers lose $12 billion. Sometimes more than sales are lost–investigators of the deadly American Airlines crash in the Rockaway area of Queens, N.Y., last November now suspect the cause may have been a used part that was packaged and resold as new.

The response to counterfeiting in general has been a new wave of both overt and covert authentication marks on products. DNA Technologies, the company that provided the ink for the Super Bowl balls, also provides ink for the labels of Australia’s Hardy’s Wine–laced with DNA from the grapevine itself. Insurer Marsh, meanwhile, now offers insurance to help companies pursue trademark counterfeiters in court.

Such measures also help manufacturers battle the so-called gray market, in which authentic products are diverted to distributors that sell them at unauthorized discounts. “Gray marketing has more of a direct financial impact on a company’s P&L than counterfeiting,” notes Stephen Polinsky, co-founder of Boston-based GenuOne. “If there’s a stream of cheap product in your supply channel, your factory won’t receive as many orders.” In addition to providing DNA-coded ink markers to companies, GenuOne will track coded products and monitor sale prices. –Tim Reason

Do As They Say…

While 95% of executives from large companies say they should seriously consider hiring a chief security officer, only 25% are truly ready to do so, says Christian & Timbers.

Asset Valuation

A Beautiful Find

With bankruptcies and restructurings soaring, billions of dollars’ worth of distressed corporate assets are up for sale. But establishing their net present value (NPV) is tricky, as precise valuations hinge on complex calculations–which consume critical time in deal negotiations, especially in bidding for a grab bag of items.

Buried in valuation consultant Jay B. Abrams’s new book, Quantitative Business Valuation: A Mathematical Approach for Today’s Professionals, is a quick way to estimate the collective NPV of diverse assets. In essence, Abrams pushes the investment horizon out to infinity, rather than coming up with a lowest common multiple. In practice, the methodology would let, for example, a company compare the NPV of a new ship with 25 years of useful life against the NPVs of used ships that are 1, 2, and 3 years old in “about a minute,” claims Abrams. The alternative method of getting a common length of time, he adds, would require calculating 13,800 years of cash flows.

The slick equation isn’t a perfect solution. Abrams’s approach “definitely cuts down on the calculations, but it doesn’t solve the inherent problem of assumptions,” says Jim Mahar, a finance professor at St. Bonaventure University, in Olean, N.Y. “If you mess up the cost of capital or growth rate, you’re going to end up with the wrong decision.”

In any event, Abrams’s method came in handy for Ice Management Systems Inc. (IMS) last year, when the company considered buying a testing facility it had been leasing time from.

Ostensibly, IMS had little leverage. The seller was going to mothball the facility unless the aircraft-deicing-system maker anted up about $9 million, based on discount cash-flow rates calculated at 12 percent. Working with Abrams, IMS was able to factor in complex future costs–six different types of equipment and structures that would need replacing at varying times during the next 45 years. The result: the seller’s discount rate was too low, and the price tag was $3.5 million too high.

The owner ultimately killed the deal, but kept the plant open, says IMS CEO Mark Bridgeford. “They just couldn’t refute Jay’s numbers.” — Alix Nyberg

Short Stay: Average job tenure fell to 7 years in 2001, from 8 years in 2000, reports workplace consultants Drake Beam Morin.

Audit Committee Recruiting

Can’t Give It Away

The accounting snafus of Enron and other corporations have turned up the pressure on corporate audit committees. As a result, one of the biggest challenges corporate officers will face this year is convincing qualified executives to accept directorships and audit-committee nominations, says Bob Williamson, CFO of investment bank vFinance Inc. and a former audit-committee member and CFO of Equinox Systems Inc.

Stakeholders, hell-bent on curbing corporate financial failure, will spend the next year meticulously reevaluating the makeup of audit committees. For instance, several institutional investors now want audit committees to examine off-balance-sheet transactions and special-purpose entities, as well as to decipher those complicated footnotes.

Given such requirements, executives and shareholders may have little choice but to court top-flight financial pros for directorships. In fact, says Samuel Winer, a partner at law firm Foley & Lardner and a former Securities and Exchange Commission attorney, an SEC-appointed blue-ribbon panel recently issued guidelines that recommend audit committee members be financially “literate.” And there’s evidence that the guidelines are being taken seriously. Managers at executive search firm Christian & Timbers already report a dramatic shift in client requests. They say they’ve seen a 50 percent rise over the last few years in requests for board member candidates who possess strong financial backgrounds–or CFO experience.

However, as committee workloads increase, so will potential liability, and attracting talent may become nearly impossible. “Recruiting directors for the audit committee is like calling them on deck for a kamikaze attack,” quips Williamson.

Nevertheless, if the executive committee doesn’t recruit financial top-guns for their boards, at least some institutional investors will. One example is Herbert Denton, founder of investment firm Providence Capital. Denton is big on sponsoring director nominations to prevent boards from being dominated by cronies of the executive committee.

Last year, Providence submitted alternative director slates to two portfolio companies: ICN Pharmaceuticals and Trover Solutions Inc. (formerly Healthcare Recoveries Inc.). All told, Providence has submitted 16 alternative slates over the past five years–and placed 19 of its nominees on 11 boards. Still, Denton concedes that the average institutional investor doesn’t delve too deeply into governance issues. Why? “Because the process is contentious, often litigious,” he says.

Yet, Enron could change that. –M.L.

Corporate Culture

The Enron Difference

Remember Gordon Gekko’s “Greed is good” speech in the movie Wall Street? It would have fallen mostly on deaf ears at a recent executive conference sponsored by CFO magazine. More than half of the finance leaders in attendance attributed Enron’s financial failure to greed and a lack of integrity. Yet another 51 percent said that their initial reaction to the quick demise of the Houston-based energy giant was shock and disbelief, says Jonathan Schiff of Monsey, N.Y.-based Schiff Consulting Group. Schiff, who conducted the survey, is also a professor of accounting at Fairleigh-Dickinson University.

Says Schiff, who polled executives attending “Excellence in Finance,” a CFO Executive Program, held in Phoenix in February: “They were surprised at how quickly Enron collapsed compared with, say, Kmart, which took years to unravel.” One result, he notes, is that boards and shareholders will demand better accountability controls for compensation structures that foster accumulation of extreme wealth.

The survey also found that 76 percent of the participants said that the Enron failure would have a “very significant impact” on the accounting profession, while only 13 percent felt that way about their own companies. Noting that it’s much easier to look outward at the accounting profession than inward at their own corporations, Schiff believes that internal reassessments will pick up in the second half of the year. — M.L.

Institutional Investor TIAA-CREF is urging Congress to create a new regulatory agency to oversee the accounting industry.

A Return to Discipline

Crank It Down

With inhospitable capital markets and weak demand hurting finances, corporate pruning efforts to free up cash are in full swing. Witness energy giant Mirant Corp.’s pledge to slash its already slashed capital spending budget for this year and next, Deere & Co.’s plans to further slow heavy equipment production, and DaimlerChrysler AG’s three-year cost-cutting initiative, which is at the halfway point.

But can such companies cut costs without destroying their capacity to exploit growth opportunities? At this point, that’s impossible to predict. Yet a new joint study from Ernst & Young and Cap Gemini Ernst & Young offers grounds for optimism.

The study, entitled “Business Redefined: Generating Returns,” is based on the opinions of more than 60 CFOs and financial executives from three industries hard hit by the economic slowdown–telecommunications, technology, and media and entertainment. It suggests that executives aren’t blindly wielding a corporate machete, which bodes well for growth in cash flow.

To be sure, the study finds that senior management is counting on CFOs to restore the basic financial discipline that was abandoned during the last phase of the 1990s bull market by focusing much more closely on projected returns. More specifically, finance chiefs are likely to make smaller investments pegged to shorter return cycles, says Stephen Almassy, Ernst & Young’s global vice chair of technology, communications, and entertainment.

But the study also finds that astute CFOs aren’t likely to make blunt, across-the-board cuts. Instead, they’re more likely to “polarize” investments; that is, to focus on “either infrastructure or customers–not both,” notes Billie Williamson, national industry leader for technology at Ernst & Young.

The study also indicates that companies are not likely to shed valuable assets to raise cash for debt reduction. “Companies cannot cut assets that are catalysts of free cash flow,” declares Williamson. There are always exceptions, of course. Carol Levenson, director of research at Chicago-based Gimme Credit, a research service for institutional bond investors, cites Lucent Technologies’s recent decision to sell off its optical fiber solutions business. –M.L.

Coming Soon

Nearly 60% of senior executives from large multinationals expect M&As in their industry to increase during the next 12 months, reports PricewaterhouseCoopers.

Southern Discomfort

Suing Auditors after Bum Deals

If a recent court case in Georgia serves as precedent elsewhere, it could lower the bar on seeking damages based on what company insiders are expected to know and, as a result, pull more third-party auditors into lawsuits.

In January, the Georgia Court of Appeals reinstated a $44 million verdict against Chicago-based accounting firm BDO Seidman LLP, which was charged with misleading an acquirer by overvaluing a target’s inventory.

Three months after the deal was completed in 1993, a subsequent audit revealed that the acquired company’s inventory was worth $70 million less than reported by BDO.

What’s interesting about the award–which was originally thrown out by the trial judge–is that it applies the negligent misrepresentation doctrine to accountants, which is unusual, says Oscar N. Persons, the plaintiff’s attorney and a litigation partner in the Atlanta office of Alston & Bird LLP. The doctrine is used in many states to sue professionals, notes Persons, but accountants are rarely part of the mix.

The other odd twist emerges from the case specifics, says Elliot Cohen, a partner in the New York office of Jenkens & Gilcrest Parker Chapin LLP, who points out that target company insiders were part of the acquisition group. What’s troubling, says Cohen, is that the accountants were held responsible for facts that the company’s own officers thought were incorrect.”The ruling somewhat dilutes the meaning of when reliance is justifiable,” explains Cohen.

Indeed, BDO argues that the plaintiff, Georgia-based Mindis Acquisition Corp., could not have reasonably relied on the target company’s financial statements, because its own chairman and CEO testified at trial that he knew they were wrong. Persons notes that the insiders never said the audit opinion was “wrong,” but rather that they did not have the expertise to make an inventory determination, and therefore relied on BDO.

Nevertheless, should company insiders be allowed to claim that they rely on third-party audits? Georgia’s second-highest court says yes. But BDO has filed a petition with Georgia’s Supreme Court seeking to overturn the ruling. m M.L.

Credit Losses due to corporate bond defaults hit record levels in 2001; 212 issuers defaulted on a total of $135 billion, says Moody’s.