The Rating Game

Plus, stock option exercises may foretell share-price movement; the longer the 10-K, the worse the stock?; credit insurance for cybertransactions; and more.



Credit Watch

When utility parent CP&L Energy Inc. acquired Florida Progress last November for $5.8 billion, treasurer Tom Sullivan could guess what would happen to the credit rating of the new company, Progress Energy. "We knew our rating would drop based on the significant amount of leverage and the increase in business risk," says Sullivan. But guessing wasn't good enough to calculate the cost of raising, and paying off, the deal's $3.5 billion cash component. So CP&L drew up three plans, and paid Standard & Poor's Corp. $75,000 to tell it exactly what credit rating each scenario would garner.

Paying for credit-rating counsel is increasingly popular among consolidating industries, such as utilities and telecommunications. Miles Federman, product manager at S&P, claims that the agency has performed 380 evaluations since unveiling its Rating Evaluation Service in 1996. Rival Moody's Investors Service has provided about 90 evaluations, says managing director Roger Arner, including those it performed before it formalized its Rating Assessment Service offering last October. Fees at both agencies, on average, range from $75,000 to $120,000.

Fitch Inc. also provides evaluations, says group managing director Nancy Stroker, and is considering a formal offering in response to its competitors. That's a change of heart for Fitch, whose CEO was quoted in The Economist in April as saying that his ratings firm would not offer such services, because of "potential conflicts."

Historically, corporations have paid to be rated. So the suggestion that credit analysts are now "selling" a rating in advance hasn't created as much controversy as the perceived conflict of interest between equity analysts and underwriters that hail from the same company. All three services insist that ratings will change if companies don't rigidly adhere to the plans they present.

Sullivan believes it: Progress Energy rejected its more aggressive plan, which earned a high S&P rating, in favor of one that offered a lower rating with more flexibility. --Tim Reason


Searching for clues to predict your company's near-term stock price movement? Consider tracking the stock option exercises of lower-level employees. A new study suggests that in the aggregate, low-rung employees foretell accurate stock price movement through these decisions. It takes six months for these junior-level predictions to play out, but researchers say option exercises increase before a stock price downturn and decrease prior to a stock price rise.

Furthermore, the information does not have to be reported to the market, notes Steven J. Huddart of Pennsylvania State University's Smeal College of Business, who penned the research with Mark Lang of the University of North Carolina. Huddart also says that to extrapolate the most useful information, companies should avoid placing exercise restrictions on lower-level employees, thereby allowing workers to act freely on the generally available inside skinny.

Does using the inside information as a crystal ball invite regulation? Not according to the Securities and Exchange Commission. The agency says it isn't considering any type of disclosure rule that relates to the corporate proletariat. -- Marie Leone

THE INSIDER: Prodded by the GAO, the SEC has agreed to publish its internal procedures regarding how it reviews accounting issues.


Bridging Fast Growth

Too tiny for venture capitalists or banks and too risky for angel investors, promising young businesses are often hamstrung by cash needs, despite climbing profits. To help solve the dilemma, a coalition of business trade organizations, led by Tatum CFO Partners LLP, is hoping Congress will agree that Uncle Sam can wait when it comes to extracting taxes from newly profitable businesses.

"In just about every business, there's a point where the cash flow turns negative even though the company is profitable, and a capital gap emerges," says Doug Tatum, CEO of the eponymous 300-person CFO practice. The needed capital infusion, usually $500,000 to $1.5 million, is too small for traditional capital markets, he says, but too large to be raised through personal loans. What's more, the tax burden that accompanies profits can be the straw that breaks the camel's back. "Companies are so fragile when the capital gap emerges that the cash requirements of the taxes can jeopardize the profit momentum," he says.

The trade groups are working with House of Representatives Small Business Committee members Jim DeMint (R­S.C.) and Brian Baird (D­Wash.) on the Bridge Act bill. If passed, the bill would allow high-growth firms with annual sales below $10 million to bank up to $250,000 in owed taxes for future borrowing or loan collateral. The firms would pay the federal interest rate for such borrowing, and would have up to four years to repay the deferred taxes, along with accrued interest. To qualify as high growth, a firm's current annual gross receipts must be at least 10 percent higher than its average receipts for the previous two years, and must use accrual accounting. All deferred taxes would be due immediately in the event of a sale or merger.

Patrick Von Bargen, of the National Commission on Entrepreneurship, estimates the measure could benefit up to 200,000 high-growth firms, especially "knowledge-intensive" firms that own few physical assets they can secure loans against. A side benefit of the measure, he notes, is the opportunity for young companies to establish bank relationships early, giving nascent businesses the chance to secure loans more easily. --Alix Nyberg


Supreme Double Play

Corporations struck out in two recent U.S. Supreme Court decisions involving wage awards, and both cases underscored financial liability issues. In United States v. Cleveland Indians Baseball Co., the team doled out back pay in 1994 as the result of a free-agency settlement. It paid taxes at the 1994 rate, then asked for a refund from the IRS, claiming that it should have been taxed at the 1986 and 1987 rates, when the wages were due. A district court awarded the team a $97,202 refund. However, the Supreme Court overturned the ruling in April, deferring to the IRS's "reasonable" interpretation of its own rules.

CFOs should also be cognizant of the FICA tax ramifications of back- pay settlements, says Stephen Kinnaird of Sidley Austin Brown & Wood. Kinnaird points to settlement structures that stretch payments over several years, which may occur with large awards of $500,000 or more. Because there is a wage cap on FICA taxes for the first $80,421 (after reaching the annual threshold, salaries are FICA-tax-free), corporations would wind up paying more in Social Security taxes over multiple years than in a one-time payment.

In the second case, Pollard v. E.I. du Pont de Nemours & Co., the high court overturned the U.S. Court of Appeals for the Sixth Circuit and declared that "front pay" tied to discrimination suits is not subject to compensatory damage limits. The Sixth Circuit, which reviews appeals from Kentucky, Michigan, Ohio, and Tennessee, is one of the last federal circuits to place front-pay restitution under the $300,000 cap for damages under Title VII of the Civil Rights Act, notes Mike Marshall, vice chair of the employment law practice at Stokes Bartholomew Evans & Petree in Memphis. Front pay is often awarded in wrongful dismissal suits to compensate for wages lost from the time of the judgment until reinstatement, or instead of reinstatement.

"Once a corporation is found guilty of violating the Civil Rights Act, there isn't much it can do to mitigate the financial effects," says Marshall. -- Joan Urdang

CORPORATE VENTURE investing fell 81% during Q1, compared with a 39% drop by stand-alone funds, says PricewaterhouseCoopers.


Backing Up Buyers

More than a year ago, major banks began offering online B2B suppliers credit instruments to back their promises to deliver products to customers. Now, insurers are offering to cover online buyers' obligations to pay.

One proponent of the insurance product is Joshua ten Brink, vice president of online seafood exchange He contends that vendors around the world are interested in trading with new partners, but most are wary of extending credit to unfamiliar companies that could present payment collection problems. While the industry has traditionally used letters of credit, the process of securing one takes hours--sometimes days--making it unsuitable for speed-seeking Internet merchants.

Hoping to boost the ex-change's transaction volume, ten Brink offers buyers credit ratings and insurance products from the France-based credit giant The Coface Group. New buyers pay up front for a credit rating that is executed and backed by Coface. "The rating is an alternative to a letter of credit," says ten Brink.

But differences do exist between traditional and cyber letters of credit. Most notably, the Internet gives insurers access to real-time credit information on buyers, so insurance companies can parcel out coverage on a transaction-by-transaction basis. That's a significant departure from traditional plans, in which merchants pay for portfolio coverage allowing insurers to spread risk over many transactions.

Such automation can be crucial to making the coverage cost- effective. Witness Earthking Alliance's The online marketplace bears the buyer's risk on transactions ranging from $500 to $50,000. To mitigate the risk without creating an internal credit department, vice president Patrick Carroll turned to eCredible, a unit of Swiss Re's NCM, for credit checks, as well as insurance for up to 90 percent of the dollars promised. "It takes a little bit of the margin on all open account transactions, but that's far less than any other structure would take to handle the volume."

To date, few buyers have used rating and coverage packages, but insurers predict that will change when online markets become more liquid. To that end, heavyweights like Coface and NCM, along with Gerling Credit Insurance Group and AIG, are leveraging their huge corporate credit history databases and moving buyer credit instruments to the Web. --A.N.


Could Less Be More?

Those daunting 10-Ks are getting their fair share of scrutiny from some notable quarters.

Technical analysts from brokerage giant Merrill Lynch & Co. recently released a study that notes an inverse relationship between the length of a company's 10-K and the price movement of its stock. The conclusion: the longer the 10-K, the worse the stock performance.

Meanwhile, the Financial Accounting Standards Board finalized recommendations to the Securities and Exchange Commission that address redundancies between 10-K disclosure requirements and GAAP standards. The final report on streamlining 10-K reporting was delivered in March, but has yet to elicit SEC comment.

Is it much of a stretch to find a relationship between the Merrill Lynch study and FASB's redundancy concerns? Not really. "Complicated explanations of financial dealings seem to make investors wary, if not suspicious," says Zhen-Hong Fan, a technology strategist for Merrill Lynch who helped prepare the study. Merrill Lynch analysts correlated the size of a firm's electronic filing on the SEC's Edgar Web site with its stock price performance. For example, Adobe Systems Inc. boasted an 11 kilobyte filing and a stock price that fared relatively well (down only 37 percent) from March 31, 2000, to March 31, 2001, compared with Redback Networks Inc., which had more than 900 kilobytes in its filing and a price that lost 91 percent of its value.

FASB's initiative to address redundancies may help boost stocks that are sagging from the weight of encyclopedic SEC filings, and that may make things easier. Robert H. Herz, chairman of the FASB working group that prepared the report, notes that financial reporting requirements "create confusion and inefficiency for preparers of financial statements." -- Leslie Schultz

BIG MOVE: Over 50% of the top relocation packages from 1998-2000 went to inside executives, not new hires, says Towers Perrin.


Tax Bill Feathers Nest Eggs

As Americans start receiving their government rebate checks this month, thanks to President Bush's $1.3 trillion tax cut, corporate retirement plan sponsors find themselves sifting through a slew of new pension provisions that are also part of the bill, and that could completely reshape plan designs.

The majority of the 417-page Economic Growth and Tax Relief Reconciliation Act, signed in late May, outlines more than four dozen rules that promise sponsors greater design flexibility and some simplification, in an effort to increase employee participation and encourage employers to initiate or expand their savings programs.

"Companies now have substantial opportunities to make their retirement plans more effective at attracting, retaining, and motivating employees," says David Wray, president of the Chicago-based Profit Sharing/401(k) Council of America. "This is a chance to take out a blank sheet of paper."

Receiving the most headlines has been the tax bill provision that gradually raises the limit on annual contributions to 401(k) plans from $10,500 to $15,000. Wray predicts the new law will increase savings levels by more than 50 percent by 2006, when the new maximum contribution level will take effect. But additional regulations for both defined contribution and defined benefit plans go even further, and are expected to increase the number of small companies that offer retirement plans, improve pension portability, and permit greater participation by higher-paid employees. The following are some of the highlights.

  • The tax deduction limits on employer contributions to profit- sharing plans will increase up to 25 percent of total employee compensation. The current level of 15 percent was considered low for smaller businesses, some of which established money-purchase plans to provide more savings. The effects of the change, notes Tom Veal, an employee benefits expert at Deloitte & Touche LLP, will be simplification for companies with dual plans, and higher contributions for those that stopped at 15 percent.

  • The "same-desk" rule is repealed. Companies can now distribute plan assets to employees after a merger, rather than maintain a separate plan. The liberalization of the rollover rules should reduce the administrative burdens on larger plans.

  • Modifications are made to the "top-heavy" rule, which requires companies to kick in extra funds for all non-key workers when the savings balances of key employees exceed 60 percent of plan assets. Essentially, the changes redefine who is a key employee, and count employer-matching contributions when calculating the top-heavy minimums. "This change will en-courage more small businesses to create retirement plans," predicts Jeff Bograd, a consultant with New York Life Benefit Services, because fewer plans will be deemed top-heavy.

  • The new law expands the deductions for larger companies that give employees the option to collect dividends or reinvest in employee stock. Veal estimates that tens of millions of dollars of new deductions will now be available.

  • For defined benefit plans, the law increases the maximum benefit that can be provided to a participant in a qualified plan. This allows companies to distribute more of a top executive's benefits through a qualified plan and to deduct more of the contributions to the plan. "There is greater security for participants, and fewer funds are subject to tax," says Veal, who anticipates a renewed interest in defined benefit plans, especially among middle-market employers, thanks to this change.

While these provisions don't take effect until January, and await guidance from the Internal Revenue Service, it's not too soon for plan sponsors to determine the potential impact of the new law on a company's benefits structure, experts say. But they add that these are among the most substantial changes to come along in 25 years, and advise stepping back and taking a fresh look. "I would work to make specific changes that connect the plan to the company's strategic goals," says Wray, "and not just implement changes on an ad hoc basis." --Stephen Barr

THE PRICE OF VACATION 2001: Vacation time cost U.S. companies an average of 68 cents per hour, says the Bureau of Labor Statistics.


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