Sorting Through Probabilities, Possibilities For 2006

Over 500 years ago, while anchored off the coast of Jamaica, Columbus found his food supplies running low, but locals were unwilling to sell him any more. Planning ahead, Columbus noticed that his almanac predicted a lunar eclipse a few days later. On the day of the anticipated eclipse, Columbus warned the leaders that he would blot out the moon that very evening, if he was refused the opportunity to purchase more food. The locals reiterated their position. But that evening, as the eclipse began, they sought out Columbus in a state of high anxiety and extracted an agreement from him to cease their lunar deprivation in return for the sale of food supplies. Columbus's quick thinking afforded him the opportunity to stave off starvation and ruin, but better foresight and planning might

have obviated the need for deceit.

For many companies, the ability to look ahead and plan accordingly is a very difficult task: it requires focus and concentration; it requires the ability to distinguish between probabilities and possibilities on the one hand, and fanciful or wishful thinking on the other; and it requires sober judgment and an awareness of nascent trends. This month, we try to sort through the probabilities and the possibilities, and offer our take on what companies are likely to be contending with next in 2006.

Compensation. It doesn’t take a predictive ability to recognize that the compensation packages of senior managers will become a front burner issue in 2006. For one thing, SEC Chairman Cox has said it will, and he has the ability to make his predictions ring true. For another, institutional investors and Congressional leaders have targeted compensation concerns as a major issue. But the business community has had a long and unfortunate history of ignoring this issue. What are the main compensation issues?

Disclosure. The SEC is likely to propose, and then adopt, far-reaching disclosure requirements that will make it easier for investors to assess compensation plans across companies and across industries. While the SEC says it isn’t interested in the amount of executives’ compensation, the obligation on companies to express options, restricted stock programs, phantom stock, perks, pension plans, medical and other retirement funds in terms of wages will surely lead some to gasp about the amounts of “virtual” pay senior executives actually receive.

Process. Running global companies well is worthy of handsome compensation. But the difficulty is in ascertaining whether a company is being well run, or not. Compensation committees can make this task a lot easier by rejecting the “NFL First-Round Draft” format of executive compensation. Today, most committees are fed a lot of irrelevant data about supposedly comparable companies, and then target their own executives for about 75 percent of the spectrum paid to similar officials. But, that methodology defies credulity. Instead, Compensation Committees need to identify the objective criteria they wish to set for management, articulate how they will assess whether those criteria are being met, and then justify the compensation they offer for management’s performance.

Expensing options. The issue has always been not whether options should be expensed, but when and how. Far too few companies have spent far too little time considering ways in which they can come up with a valuation methodology that actually produces realistic results. While the Financial Accounting Standards Board’s expensing requirement, FAS 123(R), is now in place and accounting planning has occurred, there is still much that can be considered and implemented.

Transparency. As a result, smart companies will consider the likely direction of promised SEC rulemaking, and attempt to come up with a disclosure regime that ensures that a company’s carefully-followed procedures will be understood and appreciated by large and small shareholders alike.

Shareholder input/corporate governance. In the aftermath of the Disney decision—not to mention the past four years of multiple scandals and crises—the effort to ensure better governance is not dead. Many companies are assuming that the SEC will not pursue its ill-advised and ill-fated “proxy access” rules, by which institutional shareholders of certain companies would have been given the ability to nominate competing slates. That assumption is undoubtedly correct. But that doesn’t mean the issue itself is dead. Far from it. Rather, it means that companies should be reflecting on the way they handle shareholder participation in corporate democratic practices. A number of companies have voluntarily pursued requiring all candidates for their boards to receive a majority of the votes cast, and—in the absence of such support—requiring boards to consider whether to seat directors or not.

The simplest solution—and the one most likely to obviate the need for any governmental action—is for companies to adopt a requirement for a majority of votes cast, with those receiving less than a majority required to stand down or face another election. Companies that try to improve their governance in advance of any initiative from institutional shareholders or government regulators are apt to have the least difficulty over this potentially thorny issue.

Directorial liability. In the wake of the Disney decision, it is entirely likely that companies failing to procure adequate D&O coverage will be unable to obtain or retain quality directors. While the Disney case did not result in the imposition of personal liability on the company’s board, that decision is a text-book example of how not to perform directorial responsibilities. Disney’s directors can consider themselves “lucky” they were found to have owed no liability to anyone, but the next case will definitely not be as kind. As a result, outside directors need to consider several specific approaches to this liability issue:

Proactivity. The outside directors need to evidence that they not only did what they were asked to do, but that they also took the initiative to make as certain as possible that the company and its senior managers were performing as anticipated and required. This includes utilizing available resources to ensure that everything is actually going as well as it seems (or as management claims).

Creating an agenda and assigning responsibilities. Outside directors need to start each year off with an effort to identify issues that they wish to examine in detail, and then assign the responsibility for making presentations on those issues to specific directors and outside experts. Of course, once an agenda is established, it must be fulfilled.

Providing training for directors and managers. Being a good director is not an innate trait, it is a learned skill. Directors need assistance in understanding what the best approaches are to doing their jobs. By the same token, managers need training on how to utilize outside directors to ensure the best protection for the company and it's shareholders.

The effect of anti-money laundering and SEC registration regulations on hedge funds. Since 2002, the Financial Crimes Intelligence Center—known as FinCEN, a unit of the U.S. Department of the Treasury—has been promising final AML rules. Many (if not most) hedge funds have assumed that waiting for the final rules is a lot like waiting for Godot—they’ll never come. But the smart folks know that the rules will be finalized in early 2006, and many hedge funds will be caught short. Smart hedge funds are already preparing for the adoption of the final rules. Similarly, reports of the poor judicial response at oral argument over the validity of the SEC’s controversial, and ill-advised, hedge fund registration rules have caused some funds to cease their efforts to become compliant with the adopted rules. But, even if the SEC’s rules are stricken down, and even if it is assumed that Chairman Cox will not seek to readopt them, the aftermath of the Refco and Bayou contretemps makes it a sure guarantee that the SEC’s Enforcement Division will be targeting hedge funds and looking for fraud.

Section 404 costs. Companies with good enterprise risk management will find relief from the burgeoning costs of compliance with the internal control provisions of Sarbanes-Oxley. The SEC and Congress want to preserve the spirit of Section 404, but limit its costs. The desire is to allow a less-regimented SOX 404 examination in favor of a more top-down examination, tailored to individual companies. Unfortunately, this approach is in direct conflict with the issue of auditor liability, which will not be addressed this year. The result will be that only those companies with a risk system capable of qualifying possible risks and quantifying the financial exposure associated with those risks will be able to use a top-down approach for Section 404 internal control examinations.

Enterprise risk management. Control of Section 404 costs requires solid enterprise risk management. The assertion that there aren’t any material weaknesses in internal controls depends upon an assessment of the probability of a lapse in controls as well as of the potential severity of the lapse. The ability to assess these factors is a direct result of superior enterprise risk management. In order to move from the current exhaustive examination of procedures and controls for 404 compliance to a more selective top down approach, as has been suggested by the SEC, companies will require a functioning and viable risk management system. Effective risk management requires that top management and corporate boards:

Understand the risks facing the company;

Quantify the potential exposure to the different risks;

Have systems in place for identifying any changes to the potential exposures;

Have processes in place to deal with any events that represent a realization of a potential risk; and

Review the risk assessment process frequently in order to understand any additional risks that may have arisen.

Consequences of unaddressed auditor liability. The Big 4 accounting firms, as well as the next tier of public accounting firms, each face exposure to levels of liability that are potentially catastrophic. While there is a need for the SEC and Congress to address these issues, it is unlikely to occur in 2006. As a result, what is likely is that public accounting firms will continue to take self-help steps to minimize their exposure to additional liability, including:

Continuing to refuse to share intelligence as part of the due diligence process of investment banking firms, a result that will almost surely dictate government intervention in the process at some point;

Paring the existing list of public companies for whom the Big Four will continue to provide external audit services, and increasing the standards for taking on new public company audit clients;

Continuing high costs of SOX compliance efforts, especially in the area of Section 404 certifications;

The potential for more adversarial relationships between outside auditors and the public companies they audit.

Continuing and increasing convergence between U.S. GAAP and IFRS. Given the initiatives already underway, the gap between U.S. and international GAAP will continue to diminish. As global competition continues to heat up, smart U.S.-registered companies will want to assess how their financial statements would read if they followed each system. To the extent there are significant differences in results, the smart ones will consider whether disclosure is in order, both for reasons of transparency and for reasons of competition.

Litigation, enforcement and crisis management. As we enter a period of decreasing reliance on prescriptive rulemaking, the essential corollary must be kept in mind. For every decrease in prescriptive rules, there is an equal and significant increase in individual enforcement initiatives. Most companies spend little time worrying about where the SEC’s next initiatives will come—his is a mistake. Worrying about future enforcement trends is a better way of avoiding or minimizing a company’s next crisis.

MD&A and corporate transparency. Chairman Cox has declared a “war on confusion,” and that means an overhaul of our current disclosure processes. As we’ve noted for some time, today’s disclosures are not designed to inform, but rather are predicated on the assumption that, with enough verbiage and obscurity, future liability can be minimized. Management and directors should read their companies’ disclosures as if they were outsiders rather than insiders, and then ask themselves whether they find the information disclosed, as disclosed, to be adequate and informative, and the basis on which they could predicate major operating and strategic decisions. At a minimum, greater emphasis should be placed upon:

Key business indicators. Management should tell investors the ten things that management watches in order to monitor the direction of the company. Keeping more than ten things in one’s head at any point is often difficult.

Competition. Who are your competitors, and what are they doing better and worse than you are? What steps are you taking to stay ahead or catch up? If a company’s performance lacks the context of the industries and the economies in which it exists, it is less than half the picture.

Goals. Company documents should give a sense of management’s long- and short-term goals. Shareholders ultimately approve compensation and the compensation should be a reflection of management’s achievements. Management’s best defense to pressures to limit compensation will be a good story, clearly told, on performance and how it meets or exceeds the standards originally set.

General issues. Apart from specific securities regulatory issues, it’s always advisable to consider and prepare for anticipated generic developments. Several of these include:

Death of the PIPES market. Given the regulatory scrutiny under way, as well as general regulatory trends, it is entirely possible that the currently-active PIPES market—that is, “private investing in public equities”—may start to cool down, dissipate and perhaps even disappear. Mid-cap companies will be thinking about dealing with that eventuality before it ever arises.

Bernanke’s anti-inflation policy. Will the new Federal Reserve chairman Ben Bernanke “out-Greenspan” Alan Greenspan? If he does, the economy may become more sluggish, having a profound impact on all publicly-traded companies.

The price of oil. While no one can actually predict the anticipated price of oil, the critical question for most companies is what happens if oil stays at, or exceeds, $60 a barrel?

In early December, 1941, then U.S. Navy Secretary Frank Knox asserted: “No matter what happens, the U.S. Navy is not going to be caught napping.” Of course, three days later the Japanese bombed Pearl Harbor. In looking ahead, it’s always possible to pay lip service to the effort, but avoid the rigors of a real discipline. For those companies seeking to stay ahead of the curve, and avoid a crisis, forewarned is forearmed, and forearmed is fundamentally the best defense against bad things happening to good companies.

Click here for over 20 Harvey Pitt columns exclusively available at Compliance Week, including his thoughts on executive compensation, dealing with employee complaints, the changing face of transparency, guidelines for directors, and more.

This column solely reflects the views of its author, and should not be regarded as legal advice. It is for general information and discussion only, and is not a full analysis of the matters presented.

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