STRATEGIC FINANCE November 2008
IN the long term, Americans will view the $700 billion bailout package Congress passed during the first week of October as a preview of a much more dramatic reordering of the federal regulatory system that will have more serious implications for American corporations than the short-term emergency steps this fall. History may cast the popular outrage over the need for a bailout (er, rescue) as a kind of preliminary political tremor, not unlike the February Revolution that shook St. Petersburg in March 1917 and led to Czar Nicholas II packing his bags and leaving town while a provisional government took over. Six months later, Vladimir Lenin and the Bolsheviks took over the entire country. Things were never the same again.
Neither Barack Obama nor John McCain (this is being written prior to November 4) is a Lenin, nor are Barney Frank or Chris Dodd, the two leading congressional Democrats on financial issues, Bolsheviks. In all cases, they are far from it. But they will be riding a populist wave generated by outrage over bad business decisionmaking, golden parachutes, faulty federal oversight, and a
number of other pre-election revelations—all of which spell potentially revolutionary regulatory changes for American business.
One Washington lobbyist noted that the earliest version of the bailout package included provisions expanding shareholder access to corporate proxies and allowing voluntary votes on executive pay. Those provisions were eventually kicked out. But this lobbyist does expect the new Congress to propose wholesale regulatory changes in numerous areas.
At its fall conference in Chicago, which took place the week after Congress passed the bailout bill, the Council of Institutional Investors “licked its chops” as its investor advocates and state pension fund directors pored over 10 pages of previously adopted corporate governance recommendations that were being sifted for inclusion in what one participant predicted would be “dramatic changes to our regulatory structure.”
Steve Seelig, executive compensation counsel at Watson Wyatt, explains that both Sen. Chris Dodd (D.-Conn.) and Rep. Barney Frank (D.-Mass.) included punitive executive compensation provisions in their respective initial versions of the bailout package. Frank’s provision was
included in the final bill. It contains such things as an expansion of the 280(g) rules on golden parachutes (expanding them to severance packages), limits on compensation if a pay package forced an executive to take excessive risks, and an expansion of limits on the 162(m)
corporate deduction for pay. In the bailout bill, these provisions apply to either companies the Treasury purchases or companies that avail themselves of more than $300 million in bailout relief. In the short term, these compensation knives won’t draw blood from too many
executives, and certainly not more than a tiny handful, if that, outside the financial services industry. But Seelig sees Frank getting much further down the warpath in 2009 than he did in the last session of Congress when his voluntary “say on pay” bill passed the House but got stuck in Dodd’s Banking Committee. “Barney Frank said in an interview on CNBC that he intends
to apply the compensation restrictions in the bailout bill to a broad cross section of U.S. companies,” Seelig reports, “and it seems like the stars are aligned for more action.”
MORE IMMEDIATE CONCERNS
Obviously, though, at the moment, U.S. corporations are worried about more immediate problems such as the inability to sell commercial paper and the costs of issuing
corporate bonds. The bailout package will probably help
alleviate corporate borrowing pressures by the time the
new Congress takes office, although it will do that indirectly
because neither corporations nor their pension
plans—that is, those at nonfinancial corporations—have
invested heavily in the kinds of mortgage-backed securities
that the Emergency Economic Stabilization Act
(EESA) was aimed at. That law established a Troubled
Asset Relief Program (TARP) that will purchase or insure
underwater assets and whose work is being overseen by a
Financial Stability Oversight Board.
The EESA certainly has some provisions that would
affect financial companies immediately. The legislation
prohibits golden parachutes for “senior executives” in
companies whose assets are purchased by the Treasury
Department. But that applies only to executives hired
after the bailout and at companies that auction more
than $300 million. For executives with existing contracts
prior to a company’s dealings with TARP, those golden
parachutes may be subject to a 20% excise tax. Companies
that auction assets will see their tax deductions for
executive compensation cut in half to $500,000.
ACCOUNTING ISSUES
The bill also includes two sections on fair value accounting.
Section 132 of the EESA simply restates the authority
for the Securities & Exchange Commission (SEC) to
suspend the application of Statement of Financial
Accounting Standards (SFAS) No. 157, “Fair Value
Measurements,” “if the SEC determines that it is in the
public interest and protects investors.” One Washington
lobbyist for consumer groups calls that “a nothing provision”
inserted to keep the American Bankers Association
happy. Section 133 requires the SEC, in consultation
with the Federal Reserve and the Treasury, to conduct a
study on mark-to-market accounting standards that has
to be completed in 90 days.
The accounting and executive compensation provisions
in the bailout bill are notable more as fuses for the bigger
bangs they will set off once Congress returns to town in
January.Meanwhile, financial companies especially hope
the TARP helps them quickly turn the corner on their
troubles.Most nonfinancial companies will ignore TARP.
Eric Palley, director, Americas Pensions Team, BNP
Paribas Securities Corp., says that, in some instances,
asset managers working for corporate pension plans mayhave purchased some questionable investments in an
effort to beat an index, thus providing a “kicker” to plan
growth. But Palley also says that because federal law
requires plans to diversify their investments, the impact
of any suspect investments will only be on the margin.
Very few pension plans are holding bonds issued by
Lehman Brothers or Bear Stearns. In fact, strange as it
may sound, corporate plans will benefit over the medium
term. “As credit spreads have widened, they made pension
liabilities look smaller, so companies will not have to put
as much cash into underfunded pension plans,” Palley
explains. “That will make balance sheets look better.”
OTHER PROBLEMS
Of course the stock market has clobbered the value of
pension funds. TARP’s purchase of illiquid assets, if this
calms public fears about the economy, will provide the
beginnings of a bounce to the market and pension fund
balances as well as a contraction of the gap between the
interest rates companies have to offer for corporate bonds
and the rate paid by Treasuries. The market for corporate
bonds would seem to be a more important issue than the
availability of commercial paper, which companies sell
for periods of one day to nine months in order to raise
working capital. One investment company executive who
doesn’t want to be quoted estimates that only the Fortune
400 depend on commercial paper. And among top companies,
many were having no trouble getting loans even
as the flames from the credit crisis roared. Tim Pistell,
CFO at Parker Hannifin Corp., a manufacturer of
hydraulic equipment, told The Wall Street Journal a few
days before the bailout passed Congress: “I can get all the
capital I need, as can most of my big customers—the
Boeings, the Cats, the Deeres.”
General Motors, of course; the other two Detroit biggies;
and other manufacturers with shaky credit ratings aren’t in
such a position. But Parker Hannifin and many others are
far from crippled. In fact, Pistell told the WSJ that Parker
Hannifin, rated single A (not even AAA), is getting calls
from members of its banking syndicate—the survivors of
the financial mess and now colossuses like Citigroup,
Morgan Stanley, Bank of America, and Goldman Sachs—
and going after acquisitions in Asia, where targets look
considerably cheaper than they were six months ago. On
October 1, Parker announced an acquisition of three companies
whose total sales for their most recently reported
fiscal years approaches a half billion dollars.
The inability to sell bonds may be a bigger problem.
Jim Turner, head of debt capital markets at BNP Paribas,cites the example of Union Pacific Railroad, which in late
September issued a 10-year bond whose interest rate was
425 basis points over the 10-year Treasury. In April 2007,
by contrast, Union Pacific issued a 10-year bond that was
93 basis points over the Treasury rate at that time. “The
Emergency Economic Stabilization Act will help if it succeeds
in restoring confidence and credit spreads return to
lower levels,” Turner notes. “And I think it will be helpful
in cleaning up the balance sheets of banks.”
Beyond deflating the interest rates companies pay on
bonds, the bailout package, to the extent it underlines the
consolidation of commercial lenders and underwriters,
may change the way corporate CFOs, treasurers, controllers,
and others view lenders. Citigroup, Bank of
America, and JPMorgan Chase hold more than 40% of
bank loans to corporations. And the number of underwriters
has shrunk considerably with the demise of
Lehman Brothers and Bear Stearns and the elimination of
the entire “investment bank” regulatory category.
Of course, BNP Paribas believes that this consolidation
means that the “Big Boys” will be better capitalized. But
to the extent that BNP, Citibank, and Goldman Sachs will
be loaning their own money, the costs to corporate borrowers
for lines of credit and the like will certainly go up
since the banks are paying more for that money, too.
Joseph C. Stein, managing director of Peter J. Solomon
Co., which employs about 50 people, says the difference
between his private boutique investment company and
the Goldman Sachses of the world is that the boutiques
don’t have their own capital. That means that when a corporation
comes to them to underwrite a loan, for example,
Solomon essentially holds an auction and takes the
banks that make the lowest bids in terms of interest rates.
“And CFOs and treasurers rely on independent firms like
us to analyze situations in an unbiased way,” Stein says. “If
we run the right competitive process, we can get financial
institutions to bid more competitively and therefore save
companies money.”
LONG-TERM IMPLICATIONS
Again, this “New World Order” of vendors serving corporations
for financing is just another indirect impact of the
financial crisis, one with long-term implications. The
same is true of the accounting provisions in sections 132
and 133 of the bailout package. Fair value accounting has
been an issue for a while, with banks pushing hard for
changes to SFAS No. 157, whose deadlines the Financial
Accounting Standards Board (FASB) had previously The SEC already has the authority to suspend
157, and it has shown no indication
that it has the slightest desire to do so. It
would be straining credulity, given all
the abuse SEC Chairman Chris Cox has
taken for allegedly abetting the crisis
with weak regulation of investment
banks, to think he would, as one of his
last efforts as chairman, send Congress
recommendations to gut SFAS No. 157.
What isn’t generally known is that
some of the nation’s biggest banks oppose
the American Bankers Association, which is
the leading critic of SFAS No. 157. An accounting
policy executive at a large money center
bank explained he was on an ABA conference
call in early October. “A number of small bank accountants
expressed frustration that they are pressured or bullied
by their auditors on valuations. I can understand why
they are pushing for suspension of SFAS No. 157,” he
explains. “I think the difference is that we have the depth
of staff to value and support the prices we use.We also
have the ability to second-guess our auditors if they
attempt to take issue with our valuations. Frankly, our
experts know more about valuations than their experts.”
In fact, what the financial fallout does is obscure the
need for more modest changes to SFAS No. 157 that both
large banks and many nonfinancial corporations agree
are necessary. Alfred M. King, vice chairman of Marshall
& Stevens, notes that the current FASB definition of fair
value strays considerably from the old definition of fair
market value, which depended on there being a willing
buyer and willing seller, among other tests. Now, fair value
is the price at which a market participant would buy
an asset, even if there is no buyer. The current definition
is confusing for nonfinancial companies, too. For example,
a consumer products company that sells toilet paper
buys the division of a second consumer products company,
also with a toilet paper product. The buyer takes the
second product, cancels its trade name, and stamps its
own trade name on the competitor’s product.What’s the
fair value of the second company’s toilet paper trade
name under the current fair value definition? It’s impossible
to tell.
SMALL STEPS
Unfortunately, the bailout package and the wave of public
revulsion that greeted it make it more difficult for the 157. For its part, the FASB has been taking
its sweet time anyway on its various projects
dedicated to SFAS No. 157 reform.
The September 30 FASB/SEC press
release containing guidance on 157—
which simply restated what everyone
already knew—mentioned the Valuation
Resource Group (VRG), an advisory
committee within the FASB that
has been meeting for the past year with
the aim of making recommendations on
changes to the Standard, a process the
FASB began in January 2007. The VRG’s
last meeting was on September 23, 2008.
But the VRG hasn’t made any recommendations,
nor has the FASB moved very far on any of
its internal revision projects, such as one on SFAS No.
157-c,“Measuring Liabilities under FASB Statement No.
157.” A staff proposal was issued on January 18, 2008.
The comment period ended February 18, 2008. There
was considerable pushback, mostly by accounting firms.
Then, at its April 9, 2008, meeting, the Board directed
the staff to make changes. Ronald Maples, the staffer
working on 157-c, says nothing has happened on this
since April.
The danger is that the current crisis won’t only scare
off the SEC and FASB, but also the International
Accounting Standards Board (IASB), which is wrestling
with convergence issues generally and SFAS No. 157
specifically.When the IASB sent out a draft consensus
document on 157 last spring, it essentially used the FASB
Standard. Al King notes there was significant sentiment
within the IASB to make changes to the Standard that
would move it back closer to the original definition of
fair market value. “The IASB could give FASB political
cover to make some changes to 157 without appearing to
be bowing to political pressure one way or the other,”
King says.
Of course, neither the new administration nor the new
Congress will need political cover to revolutionize federal
regulatory policies.With regard to the need for changes
to executive compensation, corporate governance, and
other aspects of corporate life, the voice of public opinion
will be the voice of the rabble. n
Stephen Barlas has covered Washington for Strategic
Finance since 1984. He is a full-time freelance journalist
and writes for numerous trade and professional magazines.
You can reach him at sbarlas@verizon.net.
SEC and the FASB to make needed changes to SFAS No.
relaxed for both financial and nonfinancial companies.
