CEOs Signed. So What?

Aug. 14 was the first day for CEOs and CFOs of 900-plus public companies to certify their financials. Newly passed legislation extends the requirement to all companies that file with the SEC. Failure to certify or a slew of restatements are serious, but investors should also investigate companies that won't expense stock options, that inflate pension plan income, or whose board members have too-cozy relationships with management.

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By Tom Jacobs (TMF Tom9)
August 15, 2002

With every media outlet in the universe -- including -- watching yesterday's SEC deadline for CEO and CFO certification of company financials, investors naturally ask, "What does it mean for us?" Yesterday, we suggested that while we're waiting for the first certifications to come in, we might all certify our own finances. We also enjoyed a massive one-day jump for all the major stock market indexes. 

Today, we have the early returns for the 947 companies, so let's examine what the company CEOs and CFOs must do, and how that affects individual investors.  

What's the new requirement?
On June 27, the SEC ordered CEOs and CFOs to sign the following sworn statement:

I, [Name of principal executive officer or principal financial officer], state and attest that: 

(1) To the best of my knowledge, based upon a review of the covered reports of [company name], and, except as corrected or supplemented in a subsequent covered report:

no covered report contained an untrue statement of a material fact as of the end of the period covered by such report (or in the case of a report on Form 8-K or definitive proxy materials, as of the date on which it was filed); and 

no covered report omitted to state a material fact necessary to make the statements in the covered report, in light of the circumstances under which they were made, not misleading as of the end of the period covered by such report (or in the case of a report on Form 8-K or definitive proxy materials, as of the date on which it was filed).

(2) I [have/have not] reviewed the contents of this statement with [the Company's audit committee] [in the absence of an audit committee, the independent members of the Company's board of directors].

(3) In this statement under oath, each of the following, if filed on or before the date of this statement, is a "covered report":

[identify most recent Annual Report on Form 10-K filed with the Commission] of [company name]; 

all reports on Form 10-Q, all reports on Form 8-K and all definitive proxy materials of [company name] filed with the Commission subsequent to the filing of the Form 10-K identified above; and  

any amendments to any of the foregoing.

The June 27 order applies to 947 companies -- all companies that reported annual revenues of more than $1.2 billion in their last fiscal year -- and requires that they certify information in the most recent annual report (Form 10-K) and for all quarterly reports (Forms 10-Q) since then. Ten days before, the SEC proposed a rule to make this certification a continuing requirement and for all companies that file, not just for meeting a certain revenue threshold. Congress stepped in to make that proposal in the Sarbanes-Oxley Act, signed into law by the president on July 30. The SEC will write the implementing rules for the Act, but it's expected to spread the certification requirement to all companies publicly traded on U.S. exchanges -- from 9,000 to 14,000, depending on your definition.

While the current SEC requirement only applies to the most recent fiscal year, consider that any 10-K or 10-Q contains both information about prior years and current numbers based on prior ones. That's likely why some companies yesterday, such as Household International (NYSE: HI), announced restatements for much earlier periods, too -- $386 million over nine years.

So what's the big deal?
Some have suggested that the deadline offers a kind of amnesty -- 'fess up, take your licks, and go forth to sin no more. As with all amnesties, the idea is not only to flush out corporate numbers games, but also to deter them by promising stiffer future penalties. Here's how.

Corporations have always been liable for penalties for knowingly filing false or misleading material (legal for "important") information with the SEC, and corporate executives have always been liable personally, that is, individually, for fraud. But with the new requirement, corporate executives are liable personally for knowingly filing false statements. 

These fine distinctions actually matter in the real world, where law enforcement officials have limited resources and have to choose their cases very carefully. If they have to prove fraud, they will choose fewer cases, because fraud requires proving many difficult elements, notably intent to defraud. It's easier to show that someone has knowledge -- did something knowingly -- than what that person intended the action to do. The goal is of course to deter malfeasance. If it's easier to jail or penalize you for bad deeds, you are less likely to do them. 

Aren't you glad you chose [insert your livelihood here] instead of law school?

The SEC will likely pursue the worst stuff that comes up, and Sarbanes-Oxley provides stiffer penalties for individuals: up to 20 years in the jug and up to $5 million in fines. Sure, real crooks may just certify and hope for the best, but let's hope that new money for more staff at the SEC, as well as more educated, vigilant individual shareholders, will continue to expose the riffraff.

What happened?
Companies can certify, obtain a five-day extension, restate results, and certify them, or fail to certify. As the deadline approached, we saw preparations. Last Friday, sportswear maker Cutter & Buck (Nasdaq: CBUK) announced its CFO's resignation, and on Monday the company's recently hired CEO announced restatements for 2000 and 2001. Dying telecom Qwest (NYSE: Q), already under SEC investigation, announced on Aug. 8 that it would not file its 10-Q on time, and would provide "more detailed financial disclosure" by Aug. 19. Interpublic Group (NYSE: IPG) raised eyebrows on Aug. 5 when it postponed releasing quarterly results. On Aug. 13, it announced it would restate results going back to 1997 and meet yesterday's certification deadline as well.

On the day itself, we learned Capital One (NYSE: COF) more than doubled its most recent year's stock option expense from $44.7 million to $97 million. AOL Time Warner (NYSE: AOL) confirmed a $49 million barter transaction that was improper. Several companies disclosed relationships that meant board members were hardly independent.

More seriously, Adelphia Communications and CMS Energy (NYSE: CMS) said they wouldn't file certifications. But the verdict so far is that there hasn't been a flood of restatements or failures to certify. SEC staff is reportedly sorting the submissions into two piles -- one for certifications with no changes to financial statements, and the other for everything else. We'll learn if more will surface in the coming days.

How do I find out if/when my company's execs certified?
The SEC website has a table for the 947 companies required to make this initial certification. You'll note that not every company is required to file by Aug. 14, but at their next SEC filing deadline on or after that date. Aug. 14 is the deadline for those whose quarters ended June 30. Also, it will likely take the SEC a few days to completely update the table. In the meantime, the SEC also asked companies to announce their certification in a Form 8-K filing, so you can check for that filing, too.

Should I sell a company that fails to certify?
As my colleague Bill Mann puts it, failure to certify is a yellow flag. So are material (more than just a little amount of money) restatements. If your company execs won't certify, why should you do so by owning the stock? First, get to the bottom of things. If your company is on the list of companies required to certify after a couple of days (we don't assume the SEC updates immediately), check for press releases explaining that it obtained an extension or any other explanation. If you can't find an explanation, call the company's investor relations department.

When you think you have an answer, look at other possible warning signs.

What else is important?
Another yellow flag waves if your company does not expense stock options. One weak argument execs make is that stock options aren't expenses but only a transfer of shareholder's equity from existing shareholders to those who cash in their options. Uh, "only"? Let's see. I take cookies from your jar without asking, or at least I leave only a note written in fine print and steal your glasses, and give the cookies to others, who eat them. Do you think that's "just a transfer" of your favorite cookies? Hardly. I don't want anyone who says this to be raising children -- or running a corporation. They are soft in the head. Or as Morgan Stanley's Chief Investment Strategist Byron Wien more politely puts it, "[A]nyone who says that stock options aren't an expense destroys his credibility on all other issues."

By the way, the Financial Standards Accounting Board (FASB) has just proposed to require companies to report the value of stock options quarterly rather than annually. Still fine print and not anywhere near the expensing we want, but it's a step.

Does the company inflate earnings with absurd expected returns on company pension-plan assets? Former Fool Alex Shay advised, "How does the 'expected return' outlined in the [financial] disclosure jibe with the return that has actually been earned on the plan assets? Expectations of a higher return will increase earnings immediately without any increase in cash for the coffers. Checking the pension-plan footnote disclosures can help an investor discover whether or not an overfunded pension plan is producing pension income rather than expenses."

Find out how independent the company's directors are. Does the company have rules governing independence? Several companies disclosed yesterday some very cozy relationships. The more chummy, the less likely to scrutinize management actions.

A good first step
Most of us who own shares of individual stocks have at least a few that didn't rake in $1.2 billion in revenues last year. But under the new Sarbanes-Oxley law, it appears that their CEOs and CFOs will also be required to certify each 10-K and 10-Q filing. Whether the SEC will keep tables for these 9,000 to 14,000 companies remains to be seen, but you can check each quarter's 10-Q when it comes -- way late, if your brokerage firm sends it -- or online. Check for an 8-K announcing the certification; watch for press releases; hang out on your stock's discussion board; or call the company. Investigate any failure to certify or a slew of restatements. If you're not satisfied, that may be reason enough to sell. Even further reason? If there's also failure to expense stock options and overstated expected returns from pension funds. 

Aug. 14 was only the start of positive change in our public stock markets. Expect more fun and games as more companies report under Sarbanes-Oxley. Stay tuned!

Tom Jacobs (TMF Tom9) thinks Stephen Carter's The Emperor of Ocean Park is a must-read. At press time, he owned no shares in companies mentioned in this story. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.