Behind Shadow Accounts

Shining a light on shadow retirement accounts; Congress takes aim at underfunded pensions; what states are doing to alleviate the health-care burden; going public in Canada; out-of-town shareholder meetings; and more.


Of the alleged misdeeds that former MassMutual CEO Robert J. O'Connell stands accused of, none has stirred as much outrage as his alleged abuse of a notional, or unfunded, account set up to track his deferred compensation. O'Connell, who was dismissed from MassMutual in June, is accused of improper trading in that account.

Critics have focused their attention not only on the trading, but also on how the account was set up in the first place. MassMutual offers top executives a way to "invest" the deferred funds without actually moving the funds into the investment vehicles, which would defeat the tax-friendly status of the accounts. Instead, hypothetical gains and losses are tracked and paid out to executives upon retirement. No real assets are kept in the account. Known as shadow or phantom accounts, they are actually a common tool for deferred compensation, and similar setups are available at many companies that offer such plans.

But most companies that provide this option limit the hypothetical trading to the same types of investments available in the rank-and-file 401(k) plans, namely mutual funds and money-market funds. Other companies tie returns to a set interest rate. O'Connell is accused of playing "fantasy" stock market, and making hypothetical trades in individual stocks and even IPOs. In one instance, he is charged with allotting to his account more shares of an IPO at the initial offering price than he could ever get in the real world. The gain on that stock, and others, helped his deferred-comp account grow 37 percent annually between 1998 and 2005. O'Connell has told the MassMutual board that he had permission to execute those trades.

The day trading of which O'Connell is accused is very rare. But it is not entirely unheard of for a company to allow executives to play the stock market, making daily, even hourly trades with their deferred-compensation notional account balances. Experts would not name these companies, "but they are out there," says Joe Hessenthaler, principal at HR consulting firm Towers Perrin.

While new rules were passed recently that make deferred-comp plans less flexible (see "The Danger of Deferrals," Newswatch, April), they don't address trading options. But for most companies that offer such plans, trading in individual stocks is difficult to administer and often too controversial to touch. Executive-compensation consultants who have marketed the plans have found it a tough sell. "The companies were telling us the plans didn't pass the smell test," says one consultant. — Kris Frieswick


Talk about getting a dose of its own medicine. Milberg Weiss Bershad & Schulman LLP, the law firm that has profited handsomely from lawsuits against companies accused of securities fraud, is in some hot water of its own.

A former client of the firm was charged with taking as much as $2.4 million in illegal kickbacks to file lawsuits against publicly traded companies. Milberg Weiss, which is the target of a three-year federal probe, could be accused of paying those kickbacks.

The big question is whether Milberg Weiss will be indicted next, says Michael Gass, an attorney at Palmer & Dodge LLP. "Clearly [the prosecution] would like to get to the firm, since it would be the more culpable party if the allegations are true," says Gass. He adds that the firm could face conspiracy or fraud charges.

Nothing would please former targets more. "There is no shortage of people who want to see something stick against this firm," says Gass.

Others say it would be the first step toward cleaning up an area of law that is fraught with problems. Says Thomas Peisch of Conn Kavanaugh Rosenthal Peisch & Ford LLP: "The whole class-action landscape needs some fumigating."

— Joseph McCafferty

Targeting Underfunded Plans

With U.S. corporate pension plans facing a record $450 billion shortfall, legislation that would force firms to contribute more to those plans is steaming ahead this summer.

In January, President Bush proposed that sponsors fully fund current liabilities as early as 2006 and pay higher Pension Benefit Guaranty Corp. premiums, among other items. Rep. John Boehner (R-Ohio) introduced a similar bill in June, and senators Charles Grassley (R-Iowa) and Michael Enzi (R-Wyo.) have promised to take up the issue in the Senate.

Experts consider the Boehner approach a big improvement over the Bush proposal. Some of its major advantages: the plan preserves asset smoothing and the use of credit balances (but with restrictions on both) and simplifies the yield curve recommended by the Administration as the basis for calculating liabilities. The House bill also uses the plan's funded status, rather than the sponsor's credit rating, to determine whether the plan is at risk.

Still, the combination of higher funding targets, less-valuable credit balances, and more volatility in asset and liability calculations will make the plans pricier to maintain. "Even some plans that are well funded will go from enjoying a contribution holiday to having to make payments," says Ethan Kra, a chief actuary at Mercer Human Resource Consulting.

While the Boehner bill is likely to be modified and ultimately incorporated into an expected proposal on Social Security, it may well prove to be more attractive than offerings from the Senate. Grassley, head of the Senate Finance Committee, said in June that he would support the President's efforts to eliminate asset smoothing.

As Congress hammers out the details, corporations are already concerned that the revisions will come too quickly. "The proposed legislation fundamentally changes the current funding regime," said Lynn Franzoi, senior vice president of benefits for Fox Entertainment Group Inc., in her June testimony before the House.

Without an adequate transition period for companies to meet the new costs, she warned, "there could be massive disruptions to [their] capital spending and long-term business plans."

Some experts expect more companies to abandon their pension plans altogether. "You're going to end up driving many [companies] out of the system," says Judy Schub, managing director for the Committee on the Investment of Employee Benefit Assets. Already in 2004, 11 percent of the Fortune 1,000 plan sponsors had frozen or terminated their plans, up from 7 percent in 2003, according to Watson Wyatt.

— Alix Nyberg Stuart

States to the Rescue?

As employers and employees struggle to afford consistently rising health-care premiums, the number of uninsured workers across the country is increasing. With no end in sight, some states are stepping up to provide assistance.

States are considering a variety of methods to help employers offer affordable coverage, says Sharon Silow-Carroll, a vice president at the Economic and Social Research Institute, including premium assistance, reinsurance, and direct subsidies.

"As fewer workers can afford health care, enrollment drops and the states end up footing the bill," says Jeff Munn, a consultant at Hewitt Associates. States are also concerned that the burden of providing expensive health coverage could harm the economic prospects of the states' employers.

In New York, employers with 50 or fewer employees, and with at least 30 percent earning less than $34,000 a year, are eligible for Healthy NY. The program pays for 90 percent of claims between $5,000 and $75,000. During the past few years, enrollment in the program has increased to more than 90,000 participants. Similar programs are now being developed in Maine and New Mexico. Connecticut and West Virginia are implementing plans to bargain with coverage providers on behalf of employers.

Some states are taking a more heavy-handed approach, says Munn. In California, legislators are trying to pass "pay or play" laws, which would require employers to either provide health care or pay into a state fund that goes toward the cost of services for the uninsured. And the Maryland legislature is considering requiring companies to report the number of uninsured individuals they employ. "It's more a matter of shifting costs from the states to the employers," says Munn, "than helping employers reduce costs."

— Laura DeMars

A Helping Hand
Some states are providing (or are planning to provide) employers with health-care assistance.
ConnecticutState negotiated
IdahoPremium assistance
IllinoisPremium assistance
MaineSubsidized health plans
MassachusettsPremium assistance
MichiganPremium assistance
New MexicoSubsidized health plans
New YorkReinsurance
PennsylvaniaPremium assistance
Rhode IslandPremium assistance
UtahPremium assistance
West VirginiaState negotiated
Source: Employee Benefit News

Not in My Backyard

An increasing number of corporations are moving their shareholder meetings away from headquarters. Over the past five years, 8 of the 50 largest public companies in Minnesota, including Northwest Airlines, U.S. Bancorp, and Imation, held their annual meetings out of state. In May, Boston-based Gillette Co., whose merger with Procter & Gamble was just approved, held its annual shareholder meeting in Rye, N.Y., home to CEO James Kilts and, claim critics, far away from shareholders and their tough questions.

Gillette says it has held its meetings in Rye since 2003 to be closer to its shareholders in New York. But Marjorie Francis, a Gillette and Procter & Gamble shareholder, thinks otherwise. She believes companies that move their meetings are shirking their responsibility to shareholders by making it difficult to get to the meetings. "It's a terrible way to treat us," she says.

California-based Sempra Energy also raised eyebrows this year when it held its shareholder meeting in London, nearly 6,000 miles from its San Diego headquarters. The company said it wanted to raise its profile in Europe and expose its directors to its European operations. But as in the Gillette case, critics believe Sempra moved the meeting to avoid inquisitive shareholders.

Of course, some companies have always held annual meetings far from headquarters. Atlanta-based Coca-Cola Co. has held its meetings in Wilmington, Del., since the 1930s, and Burbank, Calif.-based Walt Disney Co. holds its meetings in a different city each year.

"The issue is not how far from headquarters a company holds the meeting, but whether it is purposely moving the meeting to a place inaccessible to shareholders," says Charles Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware. "Corporations should want to have their meetings where the [greatest] number of investors can attend."

Some shareholders are unhappy with the remote meetings. After expressing her concerns to the Gillette board at the meeting in Rye, Francis was told she should attend the next P&G meeting — in Cincinnati.

"Go way out there?" she said. "No way, Jose." — L.D.

Boardroom Baddies

Do you have a problem child on your board of directors? If you do, expect to take some heat from The Corporate Library. The independent research firm that provides corporate-governance data is singling out underperforming board members and designating them "problem directors." Its goal is to pressure fellow directors, executives, and shareholders into holding the board more accountable for company performance and getting rid of ineffective directors.

"Failed CEOs and directors of failed companies still serve on boards today," says Nell Minow, editor and co-founder of The Corporate Library. "So it's been our job to identify, and in fact embarrass, directors if they do a bad job." That includes directors involved in corporate bankruptcies, major litigation, regulatory infractions, major accounting restatements, and other corporate scandals.

The Corporate Library flagged Ronald Ferguson, a former consultant for General Re and an outside director for Colgate-Palmolive Co. Ferguson is listed as a problem director because he refused to answer questions from regulators about a transaction between General Re and insurer American International Group that allowed AIG to inflate reserves.

To some people, the designation is the financial equivalent of a scarlet letter. Gavin Anderson, CEO of corporate-governance ratings agency GovernanceMetrics International, is quick to point out that Ferguson's behavior is not an accurate reflection of either Colgate's or its board members' integrity. "Colgate is known for excellent governance. It has a high degree of transparency and disclosure," he says. (Colgate declined to comment on Ferguson.)

A harder look should instead be given to directors with long tenures at companies that struggle for years, says Anderson. "That suggests to me that the board hasn't taken actions to rectify problems," he says.

According to Beverly Behan, a partner in the corporate-governance practice of Mercer Delta Consulting LLC, addressing and removing underperforming directors is not as simple as it seems. "Historically, boards would rather turn a blind eye to underperformers. Most members are distinguished colleagues or well respected in their fields, so approaching them and telling them to shape up or leave can be awkward," she explains.

But board members that do nothing, says Minow, are equally to blame. "If they don't have the courage to stand up to someone who has a bad reputation and say, 'You need to step it up,'" she counters, "then they shouldn't be on the board either."

— James Montalto

Going Public, Eh?

Faced with a challenging regulatory environment and a lukewarm market for IPOs in the United States, some U.S. companies are heading north to Toronto, using an increasingly popular vehicle known as an income security to make their public debut.

The income security is a blended instrument in which equity and subordinated debt are combined, paying shareholders interest as well as dividends. The securities are issued by a Canadian holding company known as an income fund, which serves to distribute much of the cash flow from the operating business in the form of dividends and interest. The issuing company minimizes its tax burden by deducting the interest paid on the debt.

Although the model has yet to take off in the States, the structure is popular in Canada. "Of the 115 IPOs done on the TSX last year, more than 20 percent were income funds," says Jeffrey Singer, a partner at Stikeman Elliott LLP in Toronto.

Five U.S. companies have listed on the Toronto Stock Exchange in the past 12 months via income security offerings. Medical Facilities Corp., a $135 million hospital business with operations in South Dakota and Oklahoma, went public using income securities in Toronto in March 2004. "The transaction provided the physician-owners with a good return and investors with some income and growth," says CFO Michael Salter. The company chose to focus on the Canadian market "because we felt we would get more recognition up there at our size," says Salter.

U.S. firms are also expressing greater interest in traditional equity offerings in the Canadian marketplace, says Kevan Cowan, senior vice president of TSX Venture Exchange. "I have had more calls about the exchange in the last two to three months than in the year prior," says Cowan, who attributes part of the interest to more-flexible governance requirements for small firms. On the Toronto Venture Exchange, firms need not certify their internal controls. "Our governance regime in Toronto [resembles Sarbox], but we have managed to carve out something more proportionate for smaller companies," says Cowan. — Kate O'Sullivan

I'll Take Toronto
Recent income-fund filings by U.S. companies.
Company Industry
Atlantic Power Energy
FMF Capital Group Mortgage lending
Keystone North America Funeral services
Medical Facilities Health care
Royster-Clark Agriculture
Student Transportation of America Transportation
Westcom Global Networks Telecommunications

The Best-laid Plans

Can budgeting, planning, and forecasting be considered internal controls? And if so, are they subject to Section 404 of the Sarbanes-Oxley Act?

Within days of the act's passage, it seemed, opportunistic marketers were touting budgeting-and-planning software packages as 404-compliance tools. Yet at first glance, B&P hardly seems like the sort of internal control Congress had in mind.

B&P rarely came up in debates about overkill on internal-control audits, but finance executives are evenly divided on whether 404 applies. In a recent CFO survey, 49 percent of respondents subject to the law said their companies or their auditors had reviewed B&P, while 51 percent said they had not.

Many of those who underwent a review said it was perfunctory. "[Our] Sarbox team did a cursory review of our planning process," said one respondent, while another described the auditor's check as "an overview that a process is in place and working." That's fine with Jim Winett, managing director of IC Consulting Services LLC. "Auditors are just trying to check it off their lists," he says. He tells companies to keep documentation of B&P processes simple to avoid unnecessary scrutiny. "We advise companies to formalize and document it, but don't go overboard."

One area that auditors can lay claim to: budget-to-actual reviews, on which management may in part base their 404 certifications. The reviews are a key control, says Winnett. Greg Bozigian, a director of financial planning for Carnival Corp., says the company documented its budgeting-and-planning process for Sarbox compliance.

Despite the ongoing debate over just how much Section 404 covers, even companies not subject to Sarbox are starting to rethink their B&P as a result of the act. Jay DuBose, CFO of AAA Life Insurance Co., says he expects the National Association of Insurance Commissioners to require 404-type controls within two years. Among the reasons he chose to move to an enterprise B&P software package this year, he says, is that "there were not adequate controls within Excel to ensure the integrity of the data."

— Tim Reason

  • Is budgeting, planning, and forecasting an internal control? CFOs disagree.
  • Auditors do look at B&P, but most reviews are cursory.
  • Documenting the B&P process is a good idea, but keep it simple.
  • Budget-to-actual reviews are usually considered a control.

Laws without Borders

A recent Supreme Court ruling could expand the application of the wire-fraud statute to cover foreign-tax evasion. The case, Pasquantino et al. v. United States, involved the smuggling of liquor from the United States into Canada, but it could also have consequences for business.

Because of a common-law doctrine known as the revenue rule, U.S. prosecutors were barred from indicting the smugglers on charges of foreign-tax evasion. Recovery of foreign-tax revenue, as well as prosecution of the underlying tax evasion, is understood to be the responsibility of the defrauded nation. Instead, the prosecutors charged the smugglers with domestic wire fraud, claiming that the defendants used a U.S. telephone system to defraud the Canadian government. The U.S. Supreme Court upheld that charge.

Since the U.S. government did not seek to recover the lost Canadian revenue, Justice Clarence Thomas asserted in his majority opinion, the revenue rule has only an "attenuated" link to the wire fraud.

In addition, since the Pasquantino convictions punish the defendants for using the U.S. telephone system, "their offense was complete the moment they executed the scheme inside the United States," wrote Thomas. The wire-fraud statute "punishes the scheme, not the success."

For U.S.-based corporate tax managers who avoid foreign laws, sometimes in the name of "aggressive tax planning," Pasquantino could lead to federal investigations — even convictions. And for managers who exploit legal loopholes but still adhere to the letter of the law regarding tax shelters, transfer pricing, or the characterization of foreign revenue, the ruling brings uncertainty to areas once considered settled.

Some tax experts wonder if the Supreme Court did enough to clear up ambiguities in the case law. In broad terms, the court failed to "adequately appreciate the complexity of [foreign] tax laws," says Philip R. West, former international tax counsel for the Department of the Treasury.

Thomas F. Carlucci, a partner in the San Francisco office of law firm Foley & Lardner LLP, warns that if companies are already under investigation by federal regulators, then their tax shelters and transfer-pricing procedures may invite extra scrutiny. "It's not likely a wire-fraud charge would be the sole violation being investigated," notes Carlucci, "but it introduces a new risk exposure."

— Marie Leone

Cash from Trash

Insurance reimbursements for damaged property, plant, and equipment (PP&E) may be boosting operating cash flow (OCF) at some firms by millions of dollars a year. But according to a recent report, the classification of the cash flies in the face of accounting rules.

A study by the Financial Analysis Lab at the Georgia Institute of Technology argues that insurance reimbursements for the loss of PP&E are supposed to be classified as cash flow from investing, not OCF, according to accounting rule SFAS 95, since the original purchase of such items is classified as a use of cash for investing.

According to Charles Mulford, the study's author and professor of accounting at Georgia Tech, insurance reimbursement for damaged PP&E is akin to receiving cash from the sale of the damaged assets, which would normally go back into the investing cash-flow line item. "I won't say it's widespread," says Mulford, "but there are enough examples to know that there is some confusion on reporting of these kinds of insurance proceeds."

One company cited in the report, Network Equipment Technologies Inc., boosted its OCF by more than 193 percent in its 2003 fiscal year, thanks to insurance reimbursements stemming from a flood at one of its leased facilities. Mulford says the proceeds were improperly applied as OCF. The company's CFO, John McGrath Jr., says the reimbursement was solely to cover the business-interruption claim the company filed, although proceeds were used to build out the new leased facility. "Even if this were a gray area," says McGrath, "the implication that [our accounting for the reimbursement] is misleading is not true, because of the fact that it's disclosed in half a dozen places in the financial statement."

Mulford stands by his analysis. He adds that many analysts and investors are unaware that companies often include nonrecurring items in their OCF. — K.F.

Did some companies inflate operating cash flow (OCF) with insurance proceeds? (in $ millions)
Company FY End OCF OCF less PP&E Proceeds* % Decrease in OCF
Eagle Picher Holdings 11/30/03 ($0.96) ($8.80) 819%
Network Equipment Tech 3/28/03 (1.79) (5.24) 193
Spacehab 6/30/03 19.78 2.11 89
Gulfport Energy 12/31/03 9.38 6.87 27
Home Products International 1/1/05 (8.03) (9.09) 13
Finish Line 3/1/03 $31.96 $28.96 9%
*OCF excluding insurance proceeds related to PP&E, as could be determined from the disclosures provided.

Georgia Tech College of Management's Financial Analysis Lab

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