Legal Unease

Plus, a good board member is hard to find; the high price of audit reform; Congress takes aim at deferred compensation; and more.


Legal Unease

The Sarbanes-Oxley Act of 2002 requires corporate lawyers to report evidence of misconduct to the CEO or independent directors. The new law also gives the Securities and Exchange Commission the obligation to set guidelines for company attorneys. The rules have provoked the ire of some lawyers, who fear the regulations could tread on the sacred ground of attorney-client privilege.

"The American Bar Association isn't happy about this," says Ted Sonde of Washington, D.C., law firm Crowell & Moring. He says there's been a running debate between the ABA and the SEC over the role of lawyers at public firms. "The SEC has held the position that they should, in effect, be policemen," he says. "Lawyers don't think they should have that obligation."

In an August speech, SEC chairman Harvey Pitt warned of the new responsibility. "Lawyers for public companies represent the company as a whole and its shareholder-owners," he said, "not the managers who hire and fire them."

For unscrupulous CFOs, that could be an important distinction. In the past, says Sonde, they have been able to keep things from the board. "They won't be able to do that any longer." -- Joseph McCafferty

Corporate Governance

Empty Seats on Board

Back in the good old pre-Enron days, serving on corporate boards was a pretty cushy job--a few meetings, a couple of conference calls, and some fancy dinners for a nice fee and maybe some stock options for your trouble. But these days, directors of public companies are facing a whole new ball game. New rules adopted by the stock exchanges and Congress have heaped new responsibilities and potential risks on corporate directors--particularly members of audit committees. "The days of showing up and nodding off in the corner are over," says Peter Crist, vice chairman of recruiting firm Korn/Ferry International. "There's going to be more work, more scrutiny, and more sensitivity."

And probably fewer people willing to take on the job. A study by executive search firm Christian & Timbers found that estate planners are advising their clients to get off corporate boards because of the liabilities they might face. CEO Jeffrey Christian estimates that Fortune 1,000 companies could lose up to half of their directors in the next year. "People may decide they've worked too long and hard to risk sitting on corporate boards," says Olivia Kirtley, a retired CFO. Not her, though; Kirtley intends to remain audit- committee chair for three public companies.

That seat is the toughest to fill--and the hottest. Not surprisingly, CFOs are the most sought-after candidates for the job. "I have four clients asking for a sitting or former CFO," says Crist.

The candidate pool is also shrinking because companies are asking their CEOs to reduce the number of boards they sit on. And tighter definitions of independence adopted by the stock exchanges are further reducing the number of qualified candidates.

For their part, potential candidates are spending more time vetting companies; they want to make sure there are good corporate-governance practices already in place. When Jeff Rodek, CEO of software maker Hyperion Solutions, interviewed candidates for the company's board recently, they asked about everything from directors' and officers' insurance to how Rodek reacts to being challenged. "It's a big commitment now," says Rodek, who has hired one new director and is looking for another. "It's already difficult recruiting people. We may have to cast a wider net." How about financial journalists? --Andrew Osterland

Maybe Crime Does Pay

From 1999 to 2001, CEOs at 23 companies under investigation by the SEC earned 70% more than other top executives, says the Institute for Policy Studies (IPS).

Outside directors' pay increased by 10.9% in an economically difficult 2001, according to a recent survey by Mercer.

Securities Suits

That Unsettling Feeling

Many of the new reforms look to make companies sitting ducks for more and costlier shareholders' lawsuits. The federal statute of limitations on such cases has jumped from one year to two, and accounting fraud is now labeled a crime, which makes it uninsurable. So how can companies stem the tide of lawsuits? At least one says the answer lies in playing chicken with plaintiffs' lawyers.

"We have sent very strong signals to the attorneys that we don't plan on settling," says Pre-Paid Legal Services Inc. CFO Steve Williamson. "It just puts blood in the water." After settling 97 customer lawsuits for $1.5 million in January 2001, and seeing the ensuing copycat claims triggered by the settlement, the company decided to fight its current cases to the end, including a class-action securities suit related to the restatement of its 2000 earnings. "Although it may make sense from a strict cash-flow perspective to write a check for less than what you would pay in future legal fees, the settlement itself brings on additional litigation," argues Williamson.

So far, the strategy seems to be paying off for the Ada, Okla.-based provider of legal-expense plans. In March, an Oklahoma federal judge dismissed the securities suit with prejudice. Then in August, a major shareholder plaintiff conceded that there was no merit to the case and dropped its $30 million claim.

With an appeal pending, the case is far from over. If the dismissal is overturned, the company will have a hard time sticking to its "no settlement" vow, says Eric Benink, an attorney with Krause & Kalfayan, a San Diego law firm specializing in securities litigation. "I can't remember the last time a case like this made it to trial," he adds.

Still, Pre-Paid isn't about to back down. Having eschewed directors' and officers' insurance for at least the past three years, the company is on the hook for legal fees and any cases it loses. "My contention is, you make better financial decisions if you don't have a big wallet behind you," says Williamson. --Alix Nyberg

Who's Prepared?

Only 52 percent of companies have a plan in place to deal with a major corporate calamity, according to a KPMG survey.


Reform: The Prix to Fix

Better usually means more expensive. So it's no surprise that audit bills have gotten a whole lot bigger, thanks to a raft of new projects--such as internal control certifications--that the Sarbanes-Oxley Act of 2002 handed to auditors.

"Audit committees are asking us to do more work, visit more locations, and get involved with different types of issues," says Dennis Nally, PricewaterhouseCoopers's U.S. chairman and senior partner. "That translates into more audit fees."

Overall, prices at the Big Four are likely to rise between 15 and 25 percent this year, according to industry experts--and that's just "tranche one," says Greg Weaver, national managing partner at Deloitte & Touche. "We will probably see another increase next year."

Some say audit firms will also be forced to raise per-hour fees to make up what they'll lose on consulting. "The only alternative will be to increase audit fees," says Jay Nisberg of Jay Nisberg & Associates, a consultancy for audit firms.

Auditors don't see it that way. Instead, they say a client's risk factors will make the big difference in price. "We really didn't differentiate [on risk] as much as we should have in the past," says Weaver. Deloitte is currently culling its portfolio to drop companies that are too risky, he says. "We'll be more like a bank that's lending a company money."

Then there is the contention that the small oligopoly of four firms will have more power to raise prices. The comptroller general will complete a study on the effects of consolidation in the accounting industry, including pricing, by next July. "I wouldn't be at all surprised if the SEC steps in and tells the audit firms what prices they can charge," says Nisberg.

One way for small and midsize businesses to save money: switch to a local auditing firm. Their fees are some 35 to 40 percent lower than the Big Four's, according to Bowman's Accounting Report editor Arthur Bowman. While there hasn't been a massive exodus to smaller firms yet, that could change. Bowman estimates their fees will increase only 3 to 16 percent. -- A.N.

Smaller Is Cheaper

Companies moving from Big Five to smaller audit firms.

Number of companies*

% of all auditor changes


*Firms with over $100 million in revenues or assets
**As of 9/4/02
Source: Auditor-Trak

The average salary increase for U.S. salaried-exempt employees is projected to be 3.9%, according to a survey by Hewitt.

Stock Options

The Value Proposition
With each company that announces plans to start expensing options, the griping about figuring out what they're worth grows louder. "Current valuation methods available for expensing stock options are not ideal," complained General Motors CFO John Devine at the time he announced GM's decision to expense options.

The most common pricing model, Black-Scholes, wasn't designed to handle employee options, which cannot be traded and are lost if an employee leaves before they are exercised. Both restrictions should result in a price discount, but because there's no market standard, FAS 123 doesn't al-low companies to estimate what the discount should be. (The Financial Accounting Standards Board does define a calculation for expected pre-vesting forfeitures.)

The bottom line? "The numbers appearing in footnotes are way too high--by about 50 percent," says John Finnerty, a finance professor at Fordham University and a principal at New York­based Analysis Group/Economics. No wonder CFOs are unhappy about moving those numbers onto their income statements.

Enter Coca-Cola. One of the first companies to announce plans to expense options, Coke plans to determine fair value by soliciting bids from at least two investment banks and averaging the result. The plan was devised by board member Warren Buffett. "There are a lot of decisions that need to be made when you apply Black-Scholes, and they are subjective," explains spokesperson Kari Bjorhus. "We felt it would be more fair and objective to ask third parties."

Objectivity may not be the only benefit. The banks are likely to use Black-Scholes in their pricing models, too. But under FAS 123, the resulting bids presumably would qualify as a "quoted market price"--which can include discounts for nontransferability and forfeiture potential. That could mean Coke's options expenses will be a lot lower than those of companies that do their own Black-Scholes calculation. In theory, however, they will be more accurate, since Coke could require the banks to act on the bids. Bjorhus says Coke has yet to work out all the details.

Finnerty applauds Coke's approach, but suggests the banks probably will act more as consultants than actual bidders, since employee options can't actually be sold. Although investment banks might be willing to humor a few big clients like Coke, it's unlikely that they will be willing to regularly make futile bids on options for every public company that offers them. "I suspect they'll be well paid by Coke," says Finnerty. --Tim Reason

Option Right
According to a Mercer survey, 87% of large employers believe that option expensing will be mandated in the U.S. in the next five years.

Deferred Compensation

Show Us Your Money
As Congress returns to work on Capitol Hill this fall, deferred-compensation plans are squarely in lawmakers' sights. Before the August recess, both the House and Senate lined up provisions imposing new restrictions on the popular plans for highly paid executives.

The House's approach is getting plenty of groans from executive-compensation experts. The bill, sponsored by Rep. Robert Matsui (D­Calif.), eliminates some flexibility in the plans, and requires deferred pay amounts to be available to a company's creditors before a bankruptcy filing. If passed, that provision could effectively end the use of so-called rabbi trusts, which allow payments into a trust to be protected from changes at the company prior to insolvency.

"There is a feeling on Capitol Hill of 'Let's do something bad to executives,'" says Catherine Creech, an executive-compensation attorney at Davis & Harman LLP in Washington, D.C. "But the changes in the deferred-compensation plan rules will hurt a lot of people and make the plans much less attractive."

The bill, which was still under consideration by the Ways and Means Committee in September, would also eliminate executives' ability to make early withdrawals or changes to their payout-date elections. The new restrictions are in response to the early withdrawal of about $32 million in deferred compensation by executives at Enron before the energy company filed for bankruptcy.

Benefits experts generally applaud the more limited approach approved by the Senate Finance Committee in July, which is likely to be considered on the floor of the Senate as part of the broader pension-reform bill. The Senate provision targets offshore deferred-compensation trusts and directs the Treasury to consider new rules for all deferred-compensation plans.

"Malfeasance by some corporations wiped out retirement accounts and devastated countless individuals and families," said Sen. Charles Grassley (R­Iowa), co-sponsor of the provision, in August. "It's another assault on workers when companies hide compensation for high-level executives in offshore trusts." -- Ian Springsteel

Going solo: Challenger, Gray & Christmas found that 11.4% of executives laid off in 2002 went into business for themselves.

Document Retention

Should It Stay or Should It Go?
A federal district court judge in Arkansas ordered sanctions against Cooper Tire & Rubber Co. earlier this year for destroying documents related to a product-liability case. Although the documents were shredded in accordance with the company's existing document-retention policy, the judge ruled that Cooper "should have known [the documents] were relevant to litigation" and therefore they "should have been preserved."

The Sarbanes-Oxley Act of 2002 looks at Cooper's behavior--known as spoliation--even more harshly. The new law makes it a crime to intentionally change or destroy a record that might be germane to any federal investigation. The punishment? Up to 20 years in jail.

Not so long ago, the question of whether to keep or destroy a company's documents was often answered by someone in the facilities or waste-management department. No more. High-profile fiascos like that at Arthur Andersen have raised the stakes. "Document-retention policies are now corporate-governance issues, with responsibility going to the top," says Bob Johnson, executive director of the National Association for Information Destruction Inc.

As senior managers try to find the right balance between what to save and what to destroy, some say they have gone from one extreme to the other. "Companies are saving too much now," says attorney Simon Lorne of Munger, Tolles & Olson in Los Angeles. They are being driven to do so, he says, not by their auditors, but by newspaper headlines.

"A lot of public companies are in a defensive posture," contends Quentin Faust, an attorney in the Dallas office of Arter & Hadden LLP.

There are legitimate reasons for destroying documents, as long as a clear policy is in place. While there is no such thing as a "one-size-fits-all" approach, there are certain guidelines, says Faust. First, it should be applied in a consistent way: it's hard to say that something was destroyed in accordance with a company's policy if the policy is applied randomly. Second, it must also be able to accommodate requests for documents that were scheduled to be destroyed if they are needed for legal or other reasons. -- Joan Urdang

Poor Judgment?
Former WorldCom CFO Scott Sullivan lost $13,059 on shares he was offered in nine IPOs, according to the House Financial Services Committee.

Offshore Registration

Expat Companies Face Pension Divestments
Companies that recently reincorporated abroad to lower their annual U.S. taxes have faced ferocious criticism from Congress, unions, and corporate-governance activists. Caught in that maelstrom, The Stanley Works Inc. reversed its plans to incorporate in Bermuda in August. But companies already over the fence, such as Coopers Industries and Tyco International Ltd., can add to the list of critics some of their largest potential shareholders--public pension and investment funds.

At a summit of public pension managers in August, California state treasurer Phil Angelides led the call for public funds to divest themselves of firms that, in his view, are freeloading. Such expatriations will cost the U.S. Treasury an estimated $2.1 billion during the next 10 years, according to Congress's Joint Committee on Taxation. "Corporations hiding behind a mailbox in Bermuda are shirking their duty as Americans and undermining confidence in the financial markets," argues Angelides. "We need to use our clout as investors to let companies know we won't tolerate this type of conduct."

It's not just talk. In July, Angelides banned investments in such "expatriate" companies by California's $45 billion Pooled Money Investment Account, of which $10 billion is invested in corporate securities.

But now the California Public Employees' Retirement System and the California State Teachers' Retirement System--two of the largest U.S. pension funds, with more than $250 billion in combined assets--are considering pulling investments in these companies as well. The boards of the funds met in September, and they could begin divesting more than $750 million of equity and bonds held in expatriate companies.

Other state pension leaders, including New York comptroller (and gubernatorial candidate) H. Carl McCall and North Carolina treasurer Richard Moore, support the policy as well.

If a number of major public pension funds heed Angelides's call in the coming months, "there would undoubtedly be an impact on the stock prices of these companies," says Patrick McGurn, special counsel at Institutional Shareholder Services, a proxy-services and corporate-governance analysis firm. -- I.S.

Big Pull?

Pension plan expat holdings


Source: California State Treasurer's Office

Employee theft accounts for 45% of retailer losses and 30% of all business failures, according to a National Retail Security survey.

White-Collar Crime

Leave the Clubs Home
Early last month, Alan Gauthier was sentenced to five months in prison after being convicted of consumer fraud. The former CFO of Exide Technologies admitted sending the Securities and Exchange Commission a false audit opinion letter involving a scam in which Exide sold defective batteries to retailer Sears, Roebuck & Co.

It's been a busy year for prosecutors, who are bringing a startling number of criminal actions against finance executives. At least five CFOs have been sentenced to serve prison time this year for various frauds. Another, former Media Vision Technology Inc. CFO Steven Allan, was found guilty of financial fraud and awaits sentencing. CFOs in high-profile cases like Enron, WorldCom, and Tyco International also face charges that could land them in prison for years if they are found guilty.

What can these bad boys expect if they end up on the wrong side of a conviction? Certainly not the mythical country-club federal prison camp that has long been rumored to provide cushy digs for convicted white-collar criminals who are doing time.

"Nothing could be further from the truth," says Herb Hoelter, director of the National Center on Institutions and Alternatives, which counsels executives facing trial and jail time. "It's not an easy life. They do menial jobs, live in small cells, and are subject to strip searches and shakedowns." Although minimum-security federal prisons are known to provide decent food and to be clean and safe, their reputation as "Club Fed" is way off, says Hoelter, who routinely visits clients in prison.

"You don't want to be there," concurs Stephen Loeb, a professor at the University of Maryland's Robert H. Smith School of Business who runs a program where he takes his MBA students to visit federal prisons. "It's not a pleasant environment." He says students are usually shocked at the cramped, dismal quarters.

Matters could get a whole lot worse for those convicted of white-collar crimes. The law increases the maximum sentence for certain types of securities fraud from 10 years to 20. And executives sentenced to longer prison terms are likely to be sent to higher-security prisons, as their risk of flight increases. Sentences of more than 10 years are served in a medium-security facility or higher, with high walls and barbed wire. Says Loeb: "As undesirable as it is to serve time in a minimum-security facility, a medium-security facility is much worse." --J.McC.

Hey, Teacher
Over 80% of prospective MBA students think programs need to be re-tooled to include more emphasis on ethics, says

Investor Relations

No News Is Bad News
Regulatory reform from Congress and the stock exchanges has forced companies to undertake a raft of changes in their audit processes and corporate governance. But companies in varying states of compliance are struggling with what to communicate to Wall Street.

"Clearly the landscape has changed," says Louis Thompson, CEO of the National Investor Relations Institute (NIRI). He says that some lawyers are telling firms to keep mum on what they are doing to satisfy new regulations until the Securities and Exchange Commission finalizes the rules. In fact, a recent survey by Shareholder Value magazine found that 57 percent of respondents have taken no action to secure investor confidence in their firms. That tactic, argues Thompson, is flawed. "Companies can no longer sit back and say, 'Our finances are clean, we have nothing to worry about.' They have to get out in front of investors," he says.

That's exactly what Diebold Inc. has been doing. Vice president of global communication and NIRI chairman Donald Eagon recently organized a road show to get senior management together with investors. The North Canton, Ohio-based maker of ATM machines spent most of the time discussing corporate-governance issues and the certification process. Eagon says that even companies that aren't yet in compliance with new rules, such as the New York Stock Exchange's independent board requirements, need to outline what they are doing to get there. "The Street isn't going to wait; they want action," he says.

Medtronic Inc. vice president of investor relations Rachael Scherer says that the Minneapolis-based medical-technology firm accelerated its certification date to August 8, instead of waiting until its September deadline, when the issue started getting so much attention. "It made a big difference," she says.

Bob Goldstein, president of New York investor-relations firm The Equity Group Inc., says investors are interpreting silence to mean that something is wrong. "They are very conscious of everything that is--and is not--being said," he warns. "Being quiet means that things aren't good, and won't be for awhile." -- J.McC.

No vacancy: 42% of global companies surveyed by Ernst & Young plan to occupy more space in the next 12 months.


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