From All of Us

Middle managers certify their numbers. Also: Auditors make a company fire its sterling CFO; blind trusts for stock options; the SEC levies fines but doesn't collect them; and more.


Soon the CFO and the CEO won't be the only ones in your company suffering sleepless nights. Unnerved by the Sarbanes-Oxley Act's requirement that senior managers certify Financial statements, a growing number of arms are requiring lower-level employees to swear on the accuracy of their own numbers reported to management.

According to James Harrington, leader of U.S. accounting technical services for PricewaterhouseCoopers LLP, the process, called "upstream certification" or "subcertification," typically mirrors the Securities and Ex-change Commission's certification requirement: business heads and middle managers must sign letters stating that their units' reported numbers are accurate.

Alliant Techsystems Inc., an Edina, Minn.-based defense contractor, pushed certifications down to the staff level last year. When Sarbanes-Oxley was passed, "we immediately developed a process that cascades down the organization," says corporate controller John Picek. The company requires certifications from the operating heads and controllers of each division, as well as from any corporate functions that have input into the filings.

Such certifications could provide some protection for CFOs. Kenneth Winer, a partner in the Washington, D.C., office of law firm Foley & Lardner, says subcertifications show that management took reasonable steps to verify the numbers. "It would give me a lot to talk about as an SEC defense lawyer," says Winer. "But it's not an invulnerable shield. If there's a red flag that you're aware of, you still have to address it."

An upstream certification process could also lead employees to take a more active role in financial reporting. Alliant is already seeing a change in employee behavior, says Picek. "We're getting a lot more input up front, which makes the process more streamlined," he says.

Employees facing this new responsibility are unlikely to be as happy. Winer suggests that an employee who knowingly — or perhaps even negligently — signs a false upstream certification could be found liable by the SEC, and possibly by the courts. To make matters worse, the typical firm's directors' and officers' coverage does not extend to middle managers. Indeed, those managers may have their own word for the outcome of this process: insomnia. —Don Durfee

Pay Pals

Who says nonprofits don't pay well? While scandals at a number of companies have forced a closer examination of executive-compensation practices, a new corporate-watchdog group has caused a stir with compensation excesses of its own.

Members of the Public Company Accounting Oversight Board (PCAOB) were recently taken to task for voting themselves large compensation packages — $452,000 for themselves and $560,000 for the chairman (still not selected at press time).

That's more than the total cash compensation for the average CFO, estimated at $432,000 in 2002 by Mercer Human Resource Consulting. President Bush makes only $400,000, and former Securities and Exchange Commission chairman Harvey Pitt earned a modest $142,500. But since the PCAOB was set up as a nonprofit and will be funded by fees from public firms, the members' pay is not limited by legislation.

Supporters of the salaries, including Pitt, argue the competitive pay is needed to lure qualified candidates from the private sector. Not everyone agrees. Says Rep. Barney Frank of Massachusetts, the ranking Democrat on the House Financial Services Committee: "I think it was a mistake, but we're past it now." —Joseph McCafferty

Universal Disagreement

When Universal Health Services Inc. asked CFO Kirk Gorman to resign in February at the urging of its auditor, KPMG LLP, analyst Nancy Weaver of investment-banking firm Stephens Inc. downgraded the stock, but not because she thought the ousting hinted at accounting problems at the King of Prussia, Pa.-based health-care provider. Rather, she thought the company had lost one of its vital components.

"He is an incredibly capable CFO," says Weaver. "I have profound respect for him." Other analysts speak just as highly of Gorman. "He's the straightest shooter in the industry," says B. Kemp Dolliver, managing director at SG Cowen Securities Corp.

Despite Gorman's sterling reputation, KPMG refused to endorse Universal's quarterly financial statements until he was removed.

The dispute arose over the signing of the management representation letter, verifying that the company's financial statements were prepared in accordance with generally accepted accounting principles. Gorman agreed to sign the letter, but noted his anxiety in a letter to the audit firm. "I'm neither a certified public accountant nor a securities lawyer," wrote Gorman. "I do review and analyze the financial statements and disclosures in our 10-Q and 10-K filings, but I can't personally verify that all of our accounting is in accordance with GAAP." He asked the firm to also sign a representation letter attesting to its review of the disclosures. KPMG not only refused, it went to Universal's board and argued that it couldn't approve the company's financial statements as long as Gorman was CFO. The company later accepted Gorman's resignation over what it called "philosophical differences." (Gorman did not return calls from CFO seeking comment.)

Gorman confessed to KPMG what other CFOs admit only in private: that personally attesting to the accuracy of every detail of the financial statements is difficult. "It's a bummer that you can't tell it like it is these days," says Dolliver. "What he is really doing is pointing out the quasi-absurdity of the situation."

One CFO, speaking anonymously lest he too be forced to resign, says that he empathizes with Gorman. "I don't know every nuance of GAAP," he admits. "I don't think the individual auditors know everything there is to know about GAAP. But the reality is that at times we rely on their input."

Arthur Bowman, editor-in-chief of Bowman's Accounting Report, says that Gorman's departure highlights problems with the certification requirement demanded by the Sarbanes-Oxley Act. "It's a stretch of the imagination to think that every CEO and CFO really understands [the documents] to that level of detail," he says. "It's a weakness in the legislation."

Weaver agrees. "In most cases, executives just hold their breath and sign [the certification]."

Dolliver attributes the escalation of the dispute to a new rigidity among audit firms, which are being extra careful not to suffer the fate of Arthur Andersen. "There is a hardball attitude on the part of auditors, even on accounting technicalities," he says. "That is why they reacted so harshly."

Others say KPMG's actions were proper, not harsh. "There is no question that the auditors were right in this case," says John C. Coffee Jr., a law professor at Columbia University. "It is very clear that the auditor is supposed to be the watchdog of the manager, not an agent of the manager," he says.

Edward Terino, CFO of ATG Inc., says that the answer is for companies to improve controls. "We rely on accounting staff and legal counsel for assurance," says Terino, who is in the process of reviewing and improving internal controls at the $100 million Cambridge, Mass.-based software firm. "The CFO has a responsibility to assure that financial statements are prepared in accordance with GAAP and that there is an adequate system of internal controls in place," he says. Still, Terino identifies with the difficulty that Gorman faced. "Our business just isn't that complex. I don't know how I could ever certify everything with certainty at a large multinational company." —Joseph McCafferty.

Putting Faith in Blind Trusts

Executives at Hyperion Solutions Corp. think that the way to earn investors' trust is to go the way of the blind trust. So officers at the Sunnyvale, California-based enterprise-software firm have agreed to put their stock options and company stock into individual brokerage accounts managed by professional investment advisers. The vehicles lessen conflicts of interest and diminish the likelihood of insider trading, since investment decisions, such as when to sell company stock, are made without the knowledge of company officials.

While the plan is voluntary, all of Hyperion's eligible officers with vested stock options have agreed to participate. "This is a new era of responsibility in corporate life," says CFO David Odell. He says the blind-trust-like arrangements increase corporate accountability. "It is a best practice in corporate governance."

Blind trusts — typically used by politicians and public officials — are growing in popularity among corporate executives. "We've seen the use of blind trusts in Corporate America increase fourfold since 1999," says Edmond M. Ianni, vice president of private client advisory services at Wilmington Trust Co.

That trend is likely to continue, as the sting of scandals — like the insider-trading charges against former Capital One Corp. CFO David Willey (see "Down with the Ship") — create questions about the motives of top executives. "Now people want to avoid even the appearance of impropriety," says J. David Washburn, an attorney in the Dallas office of Arter & Hadden LLP, "and blind trusts do that." They also have a legal advantage. The Securities and Exchange Commission's Rule 10b5-1(c), which went into effect in October 2000, says that blind trusts can be used as a defense against charges of insider trading.

There may be some ancillary financial benefits to the approach as well. Although it's too early to gauge how the Hyperion executives are faring, according to Wilmington Trust's studies, in the past two years executives who used blind trusts achieved average returns almost 13 percent higher than those of executives who sold their stock during open-window periods. "It forces you to take an analytical, not an emotional, approach to managing your investments," explains Hyperion's Odell.

Still, blind trusts have one important drawback: shareholders may feel that managers, as passive investors, don't have as much skin in the game, says Colin Blaydon, director of the Foster Center for Private Equity at Dartmouth College. "Investors want to feel that the executives' interests and their own are aligned." —Joan Urdang

The New Math

The Financial Accounting Standards Board's decision in March to overhaul employee stock option accounting will undoubtedly encounter fierce rear-guard resistance from those unequivocally opposed to expensing options. But others see the writing on the wall, and are pragmatically shifting their attention to the question of how options are valued. Not surprisingly, several new models make the case for expensing less.

Companies that expense options under existing rules must estimate their fair value by using Black-Scholes or binomial models. FASB modifies those models to account for unique features of such options, but detractors say the methods are still inaccurate. "There is universal agreement...that standard option pricing models overstate the value of employee stock options," noted Financial Executives International and the Institute of Management Accountants in a joint letter to FASB. That's a serious concern if those values may soon move from the footnotes to the income statement.

Among the 293 comment letters FASB received since it reopened the expensing debate last November, several suggested modifications or alternatives to existing valuation methods that would lower the calculated fair values of options. One is a Black-Scholes-based model called NERA ESO, devised by Al Remeza, a senior consultant with NERA Economic Consulting. "The purpose of NERA ESO is to correct for the tendency of Black-Scholes to overprice by 5 to 10 percent," says Remeza. NERA's model recognizes that employees may exercise their options any time after they vest and before they expire, resulting in more potential variation in price than the heavily criticized use of an average "expected life" by FASB's modified Black-Scholes. —Tim Reason

The Currency of Time

In March, The Goodyear Tire & Rubber Co. announced it was getting a much-needed cash infusion from JP Morgan Chase & Co. and Citigroup Inc. The banks promised a $1.3 billion asset-backed credit facility with just one catch: it is contingent on Goodyear's ability to amend loan covenants it has breached with other lenders. Signs look good; Goodyear has already obtained waivers from creditors that buy the company time to forge new deals.

Goodyear is not alone: the soft economy has pushed plenty of businesses into violation of their loan covenants. Some of the lucky ones, including Tweeter, Atlas Air, Conseco, and Beta Brands, have also received waivers.

"An awful lot of companies are busting covenants and obtaining waivers these days," says Carter Pate, managing partner of PricewaterhouseCoopers LLP's Financial Advisory Services.

Obtaining a waiver is usually the final step in renegotiating loan terms with lenders. This comes at a price. Typically, banks can charge as much as 1 percent or more of the outstanding loan to rewrite the loan structure, says Pate. He adds that the difficulty of obtaining a waiver depends on the situation; breaking substantial covenants such as free-cash-flow targets will likely result in lengthy negotiations.

Patrick Chow, CFO of Tarrant Apparel Group, says the ease of getting a waiver often depends on the lender. "Banks that understand your business are more sympathetic," he says. "But no bank wants to put you into default and have a loss." Tarrant was forced to obtain a waiver from lenders GMAC and Bank of America Corp. when softness in the apparel business put the Los Angeles-based private-label apparel maker out of compliance with its loan covenants. When approaching the bank, "you have to be honest with yourself," warns Chow. "Setting unrealistic objectives and trying to paint a rosy picture to bankers will kill the company." You don't want to end up knocking on their door again the next quarter, he adds. —Joseph McCafferty

This Is Not Your Beautiful House

In late February, the Securities and Exchange Commission filed civil fraud charges against eight former and current managers of Qwest Communications International Inc. Among the punishments the SEC is seeking to impose are civil money penalties and disgorgement of ill-gotten gains.

But even if the executives are found guilty, investors may never get back a dime. That's because the SEC has a poor record of collecting on the fines it levies on those who have been found guilty of fraud. In fact, a report by the General Accounting Office found the SEC collected only 14 percent of the $3.1 billion in fines it issued against securities-law violators between 1995 and 2001.

"In the past, the SEC hasn't done a very good job at collecting on the penalties that it has imposed," says Alan R. Bromberg, a professor at the Dedman School of Law at Southern Methodist University. He explains that the SEC has typically been understaffed, and that limited resources have kept it from being able to pursue laggard fines. In addition, myriad state laws, such as those that protect a residence from collection efforts, make it difficult for the SEC to enforce the fines.

"Wrongdoers often hide assets to hinder collection efforts," noted Stephen Cutler, director of the SEC's division of enforcement, in testimony to Congress on February 26. The SEC is now taking steps to improve its ability to collect fines, including petitioning Congress to enable the agency to pursue expensive homes that are protected by some state laws. "The SEC is also seeking more latitude for civil penalties to be put toward disgorgements and paid back to wronged investors," says Bromberg. Previously, most of what was collected went to the U.S. Treasury.

Bromberg says the new provisions should improve the SEC's ability to enforce its penalties. "In the future, you're going to see an SEC that is more aggressive at collecting the penalties it imposes." —Joseph McCafferty


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