Tax Reform Hold Up

Congress battles over new corporate tax reform. Also: golden parachutes turn to lead; charities come under regulatory scrutiny; when to disclose an executive's illness; why PIPE financings are a lot less dangerous; more.


In an election year, congressional tax bills tend to be padded with lawmakers' pet interests, otherwise known as pork. This year is no different — except that this year, the sheer extent and diversity of the larding may actually sink the legislation to which it is attached.

In May and June, the House and the Senate passed bills intended to repeal a tax break for exporters — called the Extraterritorial Income Exclusion Act (ETI) — that has been declared illegal by the European Union, and replace it with an acceptable incentive. Two proposed alternatives would provide tax breaks to compensate for the repeal of the ETI, such as reducing the tax rate for manufacturers from 35 percent to 32 percent by 2008 and allowing companies to repatriate foreign earnings at a tax rate of 5.25 percent. "There are good things in both bills," says Robert Willens, a tax analyst at Lehman Brothers. "I like what they're doing."

Unfortunately, the bills also contain a hodgepodge of other tax breaks aimed at such narrow interests as cruise-ship operators, tackle-box makers, bow-and-arrow manufacturers, and NASCAR-track owners. "There are too many interests being served," says George Plesko, an assistant professor of management at the Massachusetts Institute of Technology's Sloan School of Management.

And too many discrepancies between the House and Senate versions of the legislation. The House bill, for example, contains a $9.6 billion buyout of a federal quota program for tobacco farmers. A number of senators oppose the buyout. The Senate bill contains provisions that would curb tax shelters and corporate tax loopholes — moves that are unpopular in the House.

Bickering about the different versions could delay passage of a compromise bill before Congress adjourns on October 1. "Everyone is pessimistic about the odds that this gets passed anytime soon," says Gary McGill, professor of accounting at the University of Florida. That could have consequences for U.S. businesses, as companies continue to face tariffs from EU members over the ETI.

Worse, instead of reforming corporate taxation, the new legislation could make it more complex. "The most troubling aspect of these bills is the numerous provisions that could complicate tax compliance and impose additional burdens on corporate tax departments," says Timothy McCormally, executive director of the Tax Executives Institute in Washington, D.C. —Joe McCafferty

Get Over It

To all the executives who have been griping about the negative effects of the Sarbanes-Oxley Act, its sponsors have two words: quit whining.

In separate interviews with the Financial Times in June, both lawmakers lashed out at executives who have been critical of the legislation. Rep. Michael Oxley (R­Ohio) said: "They're whining two years too late." Sen. Paul Sarbanes (D­Md.) told managers to just deal with it. "I think people should get with the program," he warned. "We have to clean up the situation."

That might not sit well with executives who have criticized the law. Borland Software Corp. CFO Kenneth Hahn has said that the act is nothing more than "an efficiency tax." And in an interview with CFO last year, Graham Perkins, CFO of LCC International Inc., said the legislation's authors didn't understand all of its adverse consequences.

While most finance executives concede that the law has had some benefits, plenty of them think the positives don't outweigh the high cost of compliance. Oxley disputes the claim: "It's pretty hard to argue that the cost is prohibitive, given the [importance of] restoring investor confidence." —J.McC.

Safety Net or Deal Breaker?

With exorbitant severance packages coming under fire, the golden parachute has become more lightning rod than safety net. Twice in recent months, the acquisition-triggered severance-pay packages for top managers have come close to breaking deals.

First, AXA Financial Inc.'s $1.5 billion acquisition of New York insurer MONY Group barely passed, with just 53 percent of shareholders approving the deal in May. Large institutional investors protested both the proposed price and the reported $90 million in severance MONY executives stood to make if they were terminated after the deal closed. (The company ultimately reduced the packages by $7.4 million.) Also in May, the California Public Employees' Retirement System urged opposition to Anthem Inc.'s $16.5 billion takeover of WellPoint Health Networks Inc., in part because of an estimated $600 million­plus payout to WellPoint executives upon completion of the deal. (Shareholders approved the merger in June, however, and the companies are awaiting regulatory approval.)

"There is a concern that the packages are so lucrative that they might in fact be inspiring the deals," says Carol Bowie, director of governance research at the Investor Responsibility Research Center (IRRC). That possibility is leading shareholders to oppose excessive golden parachutes in greater numbers: the IRRC is tracking 36 different shareholder proposals that seek to set limits on the compensation technique this year. Most of them ask companies to obtain shareholder approval when awarding severance packages that equal more than 2.99 times the total of the executive's base pay and bonus. The average level of shareholder support for proposals to limit golden parachutes was 57 percent of voted shares in 2003, up from 35 percent in 2002, according to the IRRC.

The backlash has had an impact at some companies. Hewlett-Packard, for example, announced last summer that it would seek shareholder approval for future severance agreements above the 2.99 multiple. But the tech giant is in the minority. Despite the spike in shareholder activity, says Lucian Bebchuk, director of the corporate governance program at Harvard Law School, "I haven't seen dramatic change at companies."

The Securities and Exchange Commission may force other companies' hands on the issue. According to Bebchuk, the SEC is reviewing the disclosure of executive-compensation policies overall and may reconsider disclosure requirements for golden parachutes. And if that doesn't happen, there could be a wave of shareholder suits challenging the payments or the lack of disclosure. —Kate O'Sullivan

Charitable Misgivings

Add charities to the roster of organizations on the hot seat. In June, the Senate Finance Committee held a wide-ranging hearing into the abuses of tax-exempt status. (Some 3 million U.S. organizations are tax-exempt, including 1 million charitable organizations.) In his opening statements, ranking senator Max Baucus (D-Mont.) warned that, among other misdeeds, some "charities were engaging in abusive tax shelters and even funding terrorist activities." Both items, of course, are hot-button topics on Capitol Hill.

Although quick to praise most charities as honest and "valuable," Internal Revenue Service commissioner Mark Everson cited "increasing indications" of wrongdoing by tax-exempt organizations, including an Enronesque reference to "inappropriate related-party transactions." (In fact, certain Enron transactions made use of foreign-based charitable trusts to hide debt.)

One likely outcome of the hearings is regular review of tax-exempt status. "Exemptions should not be permanent," testified William Josephson, New York's assistant attorney general in charge of charities. "Charities ought to periodically justify that they are doing the job they said they were doing when they applied for exemption." Another likely outcome: more audits. Everson is seeking a 17 percent increase in IRS funding for investigating tax-exempt entities to ensure that they meet the requirements.

Senate members also considered whether charities should be required to adopt the types of governance reforms mandated for public companies by the Sarbanes-Oxley Act. Mark Pacella, president of the Harrisburg, Pa.-based National Association of State Charity Officials, thinks they should. "Sarbanes-Oxley [requirements] are absolutely appropriate in the charitable sector," he asserts.

Chances are, those reforms are coming. As CFO went to press, committee chairman Charles Grassley (R-Iowa) had scheduled a July 22 "charitable-governance roundtable" to consider responses to wide-ranging reforms proposed by committee staff. —Tim Reason

California Dreamin'?

California is clamping down on skyrocketing workers' compensation costs. An estimated $17.9 billion in claims was paid in 2003, compared with just $6.4 billion in 1997. In response, the Golden State recently passed a law, championed by Gov. Arnold Schwarzenegger, that alters several key aspects of the workers' comp system.

Beginning January 1, 2005, employees will have to receive care from a doctor in a medical-provider network if their employer provides one. This will benefit both workers and companies, says Tim East, a director of risk management at The Walt Disney Co. and chair of the California Coalition on Workers' Compensation. "Workers' compensation is the last unmanaged fee-for-service system for delivering health care," he says. In most cases, the bill also reduces the maximum duration of payments for temporary disabilities from five years to two, and allows for the adjustment of permanent disability awards if there is a non-work-related component to an injury. Proponents estimate that statewide, employers could realize savings in the billions of dollars from the new legislation.

There are also benefits for workers in the new law. Employers will be required to pay for medical care immediately — even while a claim is being investigated — up to $10,000, which will not be refundable even if the employee's claim is denied. In the past, there was a 90-day period during which employers could decide whether to pay for care.

Employers shouldn't look for the California legislation to sweep across the country just yet, however. Richard Victor, executive director of the Workers Compensation Research Institute, in Cambridge, Mass., says the regulations that will determine treatment guidelines are still being worked out. And, says Stanton Long of insurer Marsh Inc., other states will want to see if California's cost savings materialize, which could take as long as two years. —Joan Urdang

No Need to Sweat These PIPEs

Once a finance option of last resort, private investment in public equity (PIPE) deals are going mainstream. The financing instrument, which involves selling equity securities in public companies to accredited private investors, has become safer for issuers and far more common.

An estimated 116 PIPEs closed in the first half of 2004, compared with just 68 deals in all of 2000, according to Thomson Financial. This year's transactions have generated $3.8 billion in funding so far.

The PIPEs of the 1990s "almost universally came with negative covenants," explains Ben Howe, CEO of Boston-based America's Growth Capital. Desperate for funding, companies agreed to such draconian terms as "death spirals," which allowed investors to convert their holdings into more shares as the stock fell, diluting the stock exponentially if it continued to perform poorly. Today, many are straight common-stock transactions sold at a 10 to 15 percent discount on the stock's market price. And the average deal size has increased to more than $10 million, attracting the attention of larger, more reputable investors like Fidelity Investments.

"Now PIPEs are recognized as a legitimate tool," says Eleazar Klein, a partner at law firm Schulte Roth & Zabel LLP in New York. "They're not this sleazy thing that's going to kill your company." For example, Ultimate Software Group Inc., a $60 million Weston, Fla., maker of workforce-management software, completed its second PIPE in May. CFO Mitchell Dauerman says he had reservations when he first considered the instrument, but quickly became more comfortable after conducting due diligence. "It's a way for us to get quality long-term investors into the stock," he says. Two large mutual funds invested in both of the company's PIPEs.

Since PIPEs are private investments and do not require registration with the Securities and Exchange Commission, they can be completed quickly — sometimes closing within two weeks — and with fewer administrative costs.

Still, some concerns about PIPEs linger. Short-term investors remain a fixture in some parts of the PIPE world. And finance executives should continue to look carefully at proposed terms to identify any "toxic" convertibles. Says Aaron Gurewitz, managing director of investment at Newport Beach, Calif.-based Roth Capital Partners LLC, "You've got to know the investment horizon of the institution putting the money in." — K.O'S.

The Materiality of Health

When do shareholders have a right to know that a key executive has a life-threatening illness?

In recent months, the serious health problems of key executives have plagued such companies as McDonald's, Clear Channel Communications, Enesco Group, and Kraft Foods. Lacking any specific direction from the Securities and Exchange Commission (and with none forthcoming, says an SEC spokesperson), companies are left to make their own best judgment.

Last September, when Dana Corp. CEO Joseph Magliochetti was hospitalized with pancreatitis, a treatable but occasionally deadly condition, vice president of communications Gary Corrigan found himself in need of some guidelines.

"It was like writing the rule book as you go," says Corrigan of the company's efforts to decide how and when to disclose Magliochetti's condition. "We had to weigh all the constituencies — his family and the investors. The overarching concern was for him. But the question was, 'When do you have an obligation to report?' "

Federal and state laws clearly state that an individual's right to keep medical information private trumps almost all other priorities.

The decision was further complicated by the fact that Magliochetti was not in a condition to be consulted about his wishes. (Sadly, he died two weeks later.) Corrigan says Dana CFO Robert Richter, corporate legal counsel, and other senior executives made the final decision to disclose the CEO's hospitalization after asking themselves a pivotal question: "If we don't disclose and this leaks out, what will shareholders think?"

Most legal experts believe that the only way to avoid a collision between materiality concerns and privacy law is to obtain consent in advance from all key executives to disclose material health information. Failing that, says Lisa Cassilly, a partner in Alston & Bird's Labor and Employment Law Group, companies must weigh the potential downside of disclosing without permission if they think they would otherwise be violating their fiduciary responsibilities. —Kris Frieswick

Unfair Opinions?

The latest move to clean up perceived conflicts of interest on Wall Street is coming from the Street itself, as NASD contemplates new rules for fairness opinions.

Formal opinions about whether a merger or acquisition price falls within a fair range have been standard in deals since 1985, when the Delaware Supreme Court ruled that their use demonstrated a level of basic care by boards of directors. The potential conflict arises when the opinion is rendered by an investment bank that is also acting as an adviser to the acquiring firm and stands to collect a contingency fee if the deal goes through.

"We have been looking at a number of possible approaches to dealing with conflicts of interest in fairness opinions, including working with disclosure requirements," says NASD spokesperson Nancy Condon.

But some critics say most companies already disclose contingency fees. "I don't see a significant problem out there," argues Jim Dawson, a securities attorney with Boston-based Nutter McClennen & Fish LLP.

Marjorie Bowen, head of Houlihan Lokey Howard & Zukin's fairness opinion practice, agrees that most conflicts are already disclosed. She says that could mean NASD would have to go beyond disclosure to truly address the conflict.

One possible solution would be to require that fairness opinions be issued by firms that do not have an advisory role in the deal. Houlihan, the leading provider of fairness opinions, claims that as many as 95 percent of its opinions are issued on deals in which the firm has no other interest. "Selfishly, of course, it would be great if NASD suggested independence would be more appropriate," says Bowen. But the association is unlikely to impose an independence requirement on its own members. "I would be shocked," says Dawson. "It's just not necessary."

NASD is more likely to make existing disclosures mandatory. A potential addition: disclosure of golden parachutes held by executives. Revealing that a deal will trigger an executive payout could prompt boards with executive members to set up independent "special committees" to evaluate it, a technique currently used only when some board members have large ownership stakes in the deal. "That would definitely [reflect] a heightened sense of governance," says Bowen. It would also put more focus on the deal-making motives of CEOs and CFOs.

Top Providers of Fairness Opinions
FirmNumber of Deals*
Houlihan Lokey23
JP Morgan16
Goldman Sachs13
Duff & Phelps10
Morgan Stanley10
* Through June 30, 2004
Source: Thomson Financial

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