MARKET FOCUS: Rewriting the rules

Paul Cordasco looks at how the Sarbanes-Oxley Act is changing the IR landscape.

Paul Cordasco looks at how the Sarbanes-Oxley Act is changing the IR landscape.

It had been close to eight months since Enron had filed for bankruptcy. Although a few smaller scale corporate scandals broke in the interim, initial calls for new corporate reform legislation that followed the Enron debacle had lost much of their early momentum on Capitol Hill. Enter WorldCom. On June 25, 2002, word surfaced that a handful of executives at the telecom giant appeared to have engaged in the largest corporate accounting fraud the US had ever seen. Whereas, Enron's alleged fraud had been mind-numbing in its complexity, WorldCom's accounting deception was perhaps more shocking in its blatant simplicity and lack of sophistication. The WorldCom scandal ratcheted-up the political pressure for new reform laws in Washington to critical mass. With the mid-term elections coming up, Congress and the White House had to act on corporate reform legislation. The result was the Sarbanes-Oxley Act, the largest piece of corporate and securities reform legislation since the Depression era. (The act is named after its two congressional sponsors, Sen. Paul Sarbanes [D-MD] and Rep. Michael Oxley [R-OH].) Sarbanes-Oxley was designed to tackle several significant issues raised by the scandals that prompted it, including measures to reform aspects of corporate governance, auditing, and disclosure. The law had implications for nearly every securities attorney, corporate accountant, and finance executive in corporate America. It was also perhaps the biggest piece of federal legislation to affect the IR function in decades, and would institute some of the biggest IR changes since Regulation Fair Disclosure was adopted in 2000. IR ramifications "Sarbanes-Oxley has given a lot of direction and mandate to the SEC," says Dennis O'Boyle, who spent ten years as an attorney for the SEC, and is now a lawyer at Chicago-based Shefsky & Froelich. "I have about two feet worth of files tracking proposed rules and final rules related to the act so far, and I'd be willing to bet it doubles in size before we're done." While nearly all of Sarbanes-Oxley has some implication for the IR space in one way or another, some rules will have more of a direct affect than others. The part of the act that deals with the most basic IR issue - disclosure - is known as Title IV, and is called "Enhanced Financial Disclosures." Title IV calls for or implements new regulations on everything from corporate loans for executives to a proposal mandating that companies publish their code of ethics if they have one. It is probably worth a read by most corporate IROs and IR consultants. So far, the biggest impact on the IR profession was the highly anticipated rule change adopted by the SEC on January 15, which sets guidelines for the use of so-called pro forma accounting, one of the hot-button issues in the IR space in recent months. (See PRWeek, October 28, 2002.) Pro forma is an unregulated form of number-crunching that companies have historically used to exclude certain "one-time" charges and gains from financials. It has no set rules or standards, and almost always strays from the officially sanctioned accounting standard, the Generally Accepted Accounting Principles (GAAP). Firms that employ pro forma results in earnings releases argue that such figures prepared under the more stringent GAAP standard, which often includes such one-time items, do not accurately reflect the health and profitability of their underlying business. Such has been the criticism of pro forma accounting in recent years that Section 401 of Sarbanes-Oxley mandated that the SEC develop new pro forma guidelines by late January 2003. The SEC ruled that when pro forma is used, it must not "contain an untrue statement of a material fact or omit to state a material fact" that could be misleading. The rule also says that pro forma results must be reconciled back to the recognized accounting standard or GAAP accounting. In short, companies must explain how they derived their pro forma numbers using GAAP figures as the base of comparison. Most find the rule is very straightforward, not overly cumbersome, and along the lines of what they'd expected. "It's a good rule," says NIRI CEO Lou Thompson of the SEC change. "It's clear and fair." Last year, NIRI suggested that its members place GAAP financials first in their earnings releases, and mention any pro forma accounting only after the officially recognized GAAP numbers have been presented. Still, the new environment may take some getting used to. Thompson says he recently received a complaint from one of his members involving a pro forma-related incident. The IRO of a small-cap company had sent out an earnings release in accordance with NIRI's pro forma guidelines, only to have this good-faith effort come back to haunt the company. After putting out the release, the IRO was unpleasantly surprised to see his company listed on a published report disseminated by First Call, the company that monitors any earnings estimates disseminated by brokerage analysts, stating that his company was among those whose earnings fell below Wall Street's expectations. The IRO felt burned because he knew Wall Street's analysts had made their estimates based on a pro forma result that analysts and the company agreed upon. Nevertheless, First Call/ Thomson Financial compared the results to the GAAP figure that topped the press release. Since the GAAP figure was below the pro forma figure the analysts allegedly used as their benchmark, First Call reported that the company missed Wall Street's target. The company called for a correction, but none was immediately forthcoming. Thompson says such incidents show that the new environment depends on cooperation from several groups. "This kind of thing is inexcusable on First Call's part," says Thompson. "Here's a company doing the right thing, and they get burned for it. Everybody has a role in this, not just the companies - even though the regulatory burden falls on them - the rest of the market also has a responsibility to get itself in gear on these changes." Others are less forgiving of a company in such circumstances. "Knowing the environment we're in, if you're still guiding your analysts to a pro forma figure, then that's questionable IR practice," says Beth Saunders cofounder of Chicago-based IR firm Ashton Partners. "We knew six to nine months ago that the SEC was clamping down on pro forma, so companies should have been preparing for it. Although it's frustrating, I think good IR can avoid situations like this." The SEC also established a rule that now requires companies "to furnish to the commission" their earnings releases in an 8-K filing. An 8-K filing is also referred to as a "current report" that is used to tell of significant business changes at a company that occur in between the times when the company files its quarterly reports, known as a 10-Q. The rule marks the first time the SEC has looked to increase its oversight of earnings releases. In fact, the SEC does not mandate companies issue earnings releases. In most cases, this requirement is mandated by the stock exchanges, which have historically maintained most of the oversight of the releases. Nevertheless, securities lawyers say there is an important distinction between documents that are "furnished" as part of a filing and the actual filing itself that IR pros who help prepare the earnings release should consider. Furnishing the release as an exhibit in a company's SEC filing does not make it subject to the same strict legal standards faced by an SEC filing. SEC filings are liable for nearly any material inaccuracies contained within in them. Furnished documents are still subject to anti-fraud rules, experts say, but are not bound by the much tougher standards that filings face. "If your filings are found to be materially inaccurate - even if not fraudulent - you can face a violation," says Tom Dougherty, partner and securities lawyer at global law firm Skadden Arps, Slate, Meagher & Flom. "So the difference is if you furnish, as long as you did your best and did not intend to defraud anyone, you're pretty much in the clear as the release is concerned." More changes to come So what's next from the SEC on Sarbanes-Oxley? According to some SEC watchers, the IR community may see disclosure rules resulting from Section 409 of the act. Section 409 states that public companies should disclose, "on a rapid and current basis, such additional information concerning material changes in the financial condition or operations of the issuer." So far, the SEC has used Section 409 to mandate the furnishing of earnings releases. Some feel the SEC's next step is a rule that clearly defines what the section's so-called "material changes" may encompass. "My gut tells me there will something further on this," says Shefsky & Froelich's O'Boyle. "I estimate we'll get a definition of their proposal (on Section 409) sometime this spring," says Dougherty. "If it's left open-ended, it'll create a gray area." An SEC spokesman wouldn't address specifics of Section 409, but did say, "The commission continues to seek ways to improve corporate disclosure." The SEC is now under the leadership of former investment banker William Donaldson, and it's unsure what regulatory priorities top his agenda. "[Former SEC chairman] Harvey Pitt repeatedly said he wanted to move towards a regime of what he called, 'current disclosure,'" says a source close to the SEC. "But it's impossible to say what kind of enthusiasm Donaldson has for moving forward on that." ----- Three ways IR is affected Title IV ("Enhanced Financial Disclosures") Deals with issues such as the publishing of a company's code of ethics and disclosures about its board of directors Pro forma rule Defines rules about how companies may use pro forma accounting Furnishing of earnings releases in form 8-K Says companies must furnish earnings releases to the SEC through a so-called form 8-K

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