Cheap Talk or Deaf Ears?

Whistle-blower woes, hedge-fund worries, the good that companies do, who pays to clean up toxic waste, obvious patents, the great package race, bending to shareholder votes, and more.


If the saga of David Welch is any example, corporate employees who witness or suspect financial wrongdoing may want to think twice before speaking up. In 2002 Welch became the first person to seek whistle-blower protection under Section 806 of the Sarbanes-Oxley Act. In the ensuing five years his case has gone largely nowhere, and he now appears to be one appeal short of losing altogether.

He's far from alone. Of nearly 1,000 complaints filed under the whistle-blower provisions of Sarbox, not one has survived company appeals to result in an unequivocal win for the complainant. Many have been settled at some stage of the process (see the chart at the end of this article), but the lesson so far seems to be that if companies continue to fight they will ultimately prevail.

Welch served as CFO of Cardinal Bancshares, a bank holding company based in Floyd, Va. In 2002 he raised an alarm regarding $195,000 in loan recoveries that he believed had been misclassified as income. Welch refused to certify the company's financial statements and was suspended and then fired. The company has always maintained that the firing had nothing to do with Welch's questions about accounting practices but stemmed from his refusal to meet with an independent auditor and a company attorney unless his own attorney could be present.

In 2004, an administrative law judge recommended that Welch be reinstated and awarded back pay. The judge agreed with Welch that the company's external auditor, Larrowe & Co., had not properly communicated with him about matters that fell within his purview (Welch had contended that the auditor did an end run around him and went straight to CEO Ronald Leon Moore) and that the company's internal controls allowed people without financial expertise to make journal entries without Welch's review.

The judge also disagreed with the company when it argued that, because Welch had previously signed financial statements and Federal Reserve call reports without objecting to entries he later labeled as questionable, he could not have reasonably believed them to be improper.

In May, the Department of Labor's Administrative Review Board rejected the judge's findings. It argued that Welch's complaints about the company's auditor and the company's own internal controls did not qualify as "[Sarbox]-protected activity." Nor, the ARB argued, did his complaint about the handling of loan recoveries qualify as a legitimate Sarbox complaint, because Welch "could not have reasonably believed that Cardinal misstated its financial condition" as a result.

All of which raises the logical question, If those aren't Sarbox-protected activities, what are? "The ARB is restricting what is 'protected activity' [to a degree] far greater than what the act had intended," says D. Bruce Shine, Welch's attorney and a partner in Shine & Mason of Kingsport, Tenn. Shine admits that some early Sarbox whistle-blower cases were "junk and never should have been filed," but says Welch's concerns were valid given his background as a CPA and CFO and the fact that he brought in a forensic CPA to review the matter.

Welch plans to appeal to the Fourth Circuit Court of Appeals. Based on the resolution of previous Sarbox whistle-blower actions, his odds of prevailing seem to be literally 1,000 to 1. — Stephen Taub

Marching to Different Drummers

A report by the New York Federal Reserve on hedge funds set off alarm bells recently when the bank seemed to suggest that funds were stockpiling too many eggs in one basket.

Headlines based on the paper, by Federal Reserve economist Tobias Adrian, warned that hedge funds have concentrated risk in too few places, prompting fears that an economic blip could lead to a devastating domino effect.

But a careful reading of the report indicates otherwise. While Adrian did find that hedge-fund returns are closely correlated, that is not because funds are following similar investment strategies but because volatilities across a spectrum of investments are currently quite similar.

"Just because returns are correlated does not mean that the investments are," says Peter Morici, a professor at the University of Maryland. Rather, he says, "it's an indication that the markets are working efficiently and that competition is keeping returns within a [tight] range."

Ironically, the recent collapse of hedge fund Amaranth Investors offers proof of the overall health of the industry, according to Ed Easterling, founder of Crestmont Research, which follows the hedge-fund industry. That Amaranth's loss of more than $3 billion in natural-gas investments did not hasten a downfall in other funds indicates that "hedge-fund managers tend to stick to what they are good at," says Easterling, and collectively spread risk across many industries and investment options.

But Morici, for one, argues that closely correlated returns and a reliance on individual investing strengths still say little about the overall nature of the unregulated hedge-fund industry. "From what we know about hedge funds, we should still be skeptical," he says. Reports of an impending domino effect may have been mistaken, but the resulting sigh of relief will likely be brief as many observers resume holding their breath. — Joseph McCafferty

A Toxic Mess

It was a rare example of large companies banding together with environmental groups — not to mention landowners and the states — against the federal government. Last month the U.S. Supreme Court ruled in the groups' favor in United States v. Atlantic Research Corp., a case that could have a major impact on who pays for the cleanup of toxic-waste sites.

Atlantic Research, which modified rocket engines under contract to the U.S. government, contaminated land at its Arkansas facility. It voluntarily cleaned up the site, then sued the government to recoup some of the costs, citing a section of the Superfund law as justification. The government argued that parties can sue other parties only after an enforcement action has been brought against them.

That, argued supporters of Atlantic Research, would greatly slow cleanup because the Environmental Protection Agency is too short-staffed to ferret out every instance of environmental damage. A similar case two years ago went in the government's favor, but this case hinged on a different passage in the Superfund law.

This has the makings of a landmark case, says Reed Rubinstein, a partner at Greenberg Traurig. "If the Court had ruled for the government," he says, "companies that own or operate contaminated sites would have found that mitigating the expense of cleanups through cost recovery would be much more difficult."

The decision is not a complete victory for Corporate America, however. Companies that voluntarily clean up toxic sites can sue not only the government (under certain circumstances) but other companies that may bear some responsibility. "It's a good idea to get in on cleanup efforts and reach a settlement up front," says Ken Ayers, a managing director of insurer Aon's Environmental Services Group. Companies associated with "legacy sites" that they no longer own or operate can buy insurance that would protect against possible future claims.

Expect to see plenty of lawsuits: despite its name, the Superfund is currently without funds, because the tax on petroleum and chemical companies that financed it has expired. That has ratcheted up the fever regarding who can sue whom over cleanup costs. — Laura DeMars

Do Companies Do Good Well?

Large global companies are doing a fine job of serving the public good — according to executives at those companies, anyway. Consumers are much less impressed, and likely to express their displeasure by avoiding the products and services of companies they feel come up short. McKinsey & Co. surveyed consumers and executives internationally and found a substantial perception gap between the two regarding how successfully companies address a range of issues such as job creation, philanthropy, pollution, and other sociopolitical concerns. Both groups strongly agreed that companies should balance the needs of shareholders against the needs of the broader public good; 68 percent of executives believe companies do achieve that balance, but only 48 percent of consumers concur. The gap was even larger when looking at North America alone (see below). That gap may be explained in part by where respondents choose to look: for consumers, the environment is the top issue, followed by pensions/retirement benefits. Executives rank the environment third, behind job losses/offshoring and data security/privacy (pensions/retirement benefits rank fifth). — Scott Leibs

Companies must balance obligations to shareholders with obligations to the public good.84%89%
Contribution to the public good by large global companies is "generally" or "somewhat" positive.*75%40%
The environment ranks as a top issue for companies over the next five years.31%47%
*North America only

Patents Bending

The U.S. Supreme Court recently put the pedal to the metal in a case that many patent experts say will accelerate a drive toward a more rigorous interpretation of "obviousness." In KSR International Co. v. Teleflex Inc., the Court ruled unanimously that a Teleflex patent that combined an adjustable gas pedal with a sensor-based throttle control represented an obvious combination of two common design elements, and hence KSR had not violated Teleflex's patent when it introduced a similar pedal.

The decision was widely seen as having implications far beyond the automotive sector, and comes at a time when both the courts and Congress have taken a keen interest in intellectual-property rights. The ruling took issue with an objective, if narrow, test of an invention's "patent-worthiness" and instead found that "ordinary innovation" may not be patent-worthy.

Many patent experts praised the decision, pointing to the large jump in the number of patents granted since the mid-1990s, when the courts upheld "business methods" — such as techniques to facilitate E-commerce or other business processes — as valid patents. David L. De Bruin, a partner with Michael Best & Friedrich, says, "There was a perception that these patents were of questionable validity."

That question has now been at least partially answered in the negative, and attorneys say the result may be a frenzy of challenges given that obviousness is at the heart of most patents. The high-court decision coincided with the introduction of the Patent Reform Act of 2007 in both chambers of Congress and with actions by the U.S. Patent and Trademark Office, which wants to, among other moves, require patent seekers to provide more information as to why a proposed patent deserves protection. Last month the Patent Office began a Web-based pilot project in which it invites the public to offer peer reviews of proposed patents, a potentially efficient (and contentious) way to enable a range of experts to weigh in on patent-worthiness. — Karen M. Kroll

If It's Tuesday, This Must Be...

Data-entry errors, subcontractor snafus, three-day lags in "real-time" Web tracking systems, and the occasional head-scratcher as to where in the world a given place actually is — such were the perils and pitfalls of the annual "Great Package Race." Part logistics competition, part rite-of-spring for students at Georgia Tech's Supply Chain & Logistics Institute, the contest pits major freight carriers against one another to see which can deliver packages to remote corners of the world faster and cheaper.

Boxes full of Georgia Tech schwag (T-shirts, baseball caps, and so on) were sent via DHL, FedEx, and UPS to multiple continents and remote island nations. How remote? Most people couldn't find Florianopolis, Apia, or Yangon on a map even if they were labeled. While Prof. John Bartholdi says the race offers the thrill of "vicarious travel" (one package touched eight cities in five countries), the real goal is to test carriers' global distribution networks. "A huge part of the world is within range of these highly optimized distribution networks," he says, "but it's woollier out there at the edges."

Woolly indeed. One-fifth of the shipments never arrived, and costs fluctuated wildly: UPS charged $336.60 to send a package to Harare, Zimbabwe, while DHL (this year's winner) charged about a third that price. Subcontractors often handle the last mile, which is where many problems creep in. — Vincent Ryan

Backstage Pacification

Behind-the-scenes agreements seem to have kept annual shareholder meetings relatively drama-free this year, although the proxy season did offer a few onstage highlights. Corporate governance was the most common battleground, as more than 140 companies voted on changes to the board-election process. But at least 75 saw shareholder proposals on this matter withdrawn when companies took action in advance of their annual meetings.

Shareholder activists say they were pleased by companies' pre-emptive actions. "Our goal as investors is to get companies to be responsive, not to file resolutions," says Timothy Smith, director of socially responsible investing for Walden Asset Management, where more than half of the firm's 20-plus resolutions were withdrawn when the firm struck agreements with the companies involved. "You only see the shareholder resolutions when everything else fails," says Peter Clapman of Governance for Owners USA. His group did not launch any proposals this year but rather plans to work on getting companies to appoint independent lead directors through ongoing negotiations.

Compensation was another hot topic, and one again in which companies seemed ready to bend rather than force a vote. American Express avoided a shareholder proposal on executive retirement benefits by agreeing to limit the base upon which such benefits are calculated to one year's salary plus bonus. And Pfizer, along with about 12 other companies, agreed to work with a group of investors to create a viable "say-on-pay" mechanism for future years. Companies were also amenable to "clawback" provisions that would rescind bonuses in the wake of restatements.

Still, not everybody wanted to make nice. Environmental activists protested practices at such companies as Abbott Laboratories, Pfizer, and Wendy's, and a resolution to require Dow Chemical to report on its efforts to clean up toxic waste near its corporate headquarters garnered a notably high 20 percent vote in favor. "For social-responsibility stuff, 10 or 15 percent would be respectable, since many investors typically haven't considered those issues to be linked to shareholder value," says Carol Bowie, vice president of governance research services at Institutional Shareholder Services. — Alix Nyberg Stuart

What's the Buzz?
Key issues and how they fared among shareholders.
# of Proposals*
Say-on-pay (advisory on executive pay)2007: 43%
2006: 40%
Linking executive pay to performance2007: 35%
2006: 30%
Performance-based stock options2007: 46%
2006: 31%
Requiring a majority vote to elect directors2007: 64%
2006: 49%
Repeal classified (staggered) board structure2007: 72%
2006: 66%
Require disclosure of political contributions2007: 10%
2006: 21%
*As of 5/20/07 †75 withdrawn
Source: Institutional Shareholder Services

How Green Was My Tally

No sooner had Target Corp. announced in April that it had installed solar systems atop 4 California retail stores (with plans for more) than Wal-Mart announced a similar project for 22 of its stores. Last year a nearly identical battle took place in Silicon Valley when Microsoft's boast of having the largest solar array there was trumped by Google's plan to build "the largest solar installation on any corporate campus in the U.S." at its Mountain View, Calif., headquarters.

As companies in all sectors now look for ways to "green" themselves, any return-on-investment analysis of solar power has to include public-relations appeal. Customers respond well to environmental friendliness and seem inclined to punish companies that ignore this priority (see "A Toxic Mess," above).

The big impediment to solar power has always been cost. A photovoltaic array atop a 100,000-square-foot facility can run $3 million, according to Jigar Shah, CEO of SunEdison, a Maryland-based installer. The price can run even higher for tall buildings, due to safety concerns during installation.

But the spot price for polysilicon, a key ingredient in the panels, is starting to come down, and new financing options may also help. SunEdison offers "nonrecourse financing," in which it pays the installation cost and assesses the customer an annual fee based on the amount of power used. That may prompt companies to install solar at multiple sites rather than a single, image-boosting location.

The financial case for solar is further strengthened by state incentives and a 30 percent federal tax credit. But beware: in some states the rebate will be reduced over time, on the presumption that prices will drop. And despite falling costs, the current price for photovoltaic is more than double that of conventionally supplied electrical power. — Kate Galbraith


Read next:

Finance At BeyondCore