Financial Reporting Newsletter

May 2006

Issues Covered

Introduction

The Legislative and Regulatory Environment

Boards of directors

Executive compensation

Audits and audit committees

Understanding the financial statements

Management's plans and strategies

Business ethics and coporate social responsibilities

Shareholder communications and investor relations

Shareholder Questions on Timeless Topics - Audits and Audit Committees

Shareholder Questions on Timeless Topics - Management's Plans and Strategies

Shareholder Questions on Timeless Topics - Understanding Financial Statements

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The Legislative and Regulatory Environment

Companies and their boards of directors must adapt to a changing legal landscape after a year of mega-settlements and soaring SEC fines.

Lawmakers and regulators are slowly bringing order to the complicated world of punishments and deterrents for corporate crime. But the changing legal and regulatory landscape adds to the complexities for management and directors, leaving investors with new reasons to ask old questions. At issue is how effectively companies are monitoring compliance with laws and regulations, preventing litigation and avoiding fines.

Shareholder Litigation

The legal landscape continues to evolve after a year of well-publicized mega-settlements of class action lawsuits and landmark court decisions.

Recent headlines have focused on settlements involving large companies, such as WorldCom and Enron. But studies show class action lawsuits have hit smaller companies as well, especially in high growth industries.

Earnings volatility and fraud are among the top reasons for lawsuits directed at smaller companies, and a common denominator among the lawsuits facing both large and small companies has been the allegation of misrepresentations in financial documents, such as SEC filings and press releases.

To gauge the full extent of the trends in shareholder litigation over the past decade, the Stanford Law School Securities Class Action Clearinghouse in cooperation with Cornerstone Research conducted a study of several thousand federal class action filings in calendar years 1996 through 2005.

The results showed that:

The percentage of filings alleging misrepresentations in financial documents grew to 89% in 2005, up from 78% in 2004.
The percentage of filings alleging false forward-looking statements climbed to 82%, up from 67% in 2004.

These findings suggest that shareholder litigation is becoming increasingly focused on financial reporting and forecasts.

Two landmark court decisions have eased the impact of shareholder lawsuits and may help address questions about the prevention or outcome of litigation:

In April 2005, the Supreme Court ruled that plaintiffs must prove their losses were due to fraud or corporate wrongdoing, rather than market conditions, such as an overall decline in the market. (Dura Pharmaceuticals v. Broudo)
In March 2006, a Supreme Court ruling severely limited the viability of shareholder lawsuits brought in state courts by investors who say they were fraudulently lulled into continuing to hold stock rather than buy or sell it. (Merrill Lynch v. Dabit)

At the same time that corporate exposure to private securities litigation may have been easing a little, sanctions imposed by the SEC have been increasing.

SEC Fines and "Fair Funds"

Fines imposed by the SEC for accounting fraud have soared to record levels in recent years.

The Sarbanes-Oxley Act of 2002 empowered the SEC to levy fines in "Fair Funds" from which money is returned to defrauded shareholders. A key challenge for the SEC is how to levy a fine for an act committed years ago without unduly penalizing current investors.

In early 2006, the SEC agreed on a set of guidelines for basing fines on the following factors:

The presence or absence of a direct benefit to the corporation as a result of the violation.
The degree to which the penalty will repay or further harm the injured shareholders.
The need to deter the particular type of offense.
The extent of complicity in the violation throughout the corporation.
The level of difficulty in detecting the particular type of offense.
The extent of cooperation with the SEC and other law enforcement.

Shareholders may want to know how companies are adapting and if the guidelines are useful in reducing uncertainty about penalties and encouraging good corporate compliance programs.

Other Laws and Regulations

Shareholders may also ask about the effects on the company of laws, regulations and government policies related to pension funding and immigrant workers.

Pension Funding. During 2005, the White House called for tougher laws for pension plans. Bills introduced in Congress would require that employers pay more for insurance for traditional defined benefit plans. The pending legislation would
Immigrant Workers. Faced with mounting concern about the immigrant workers who lack authentic working papers, the Secretary of the U.S. Department of Homeland Security has announced that his department will start filing criminal charges against employers caught hiring illegal immigrants. Currently, employers must request documents that prove a worker's identity and right to work, but they are not required to verify the authenticity of these documents.

The subject of how to deal with illegal immigrant workers is controversial. President Bush has called for accommodations for illegal immigrants, and the Senate is considering a bill (S.2612) that would offer most of the nation's 11 million to 12 million illegal immigrants a work permit and an opportunity to obtain U.S. citizenship.

Shareholder Questions

Relationships with legal counsel

— Does the company have an in-house legal function?

— Which outside firms are used to provide general legal advice and SEC counsel, if separate? Are any members of these firms also directors of the company?

— Does the board have the ability to retain independent legal counsel for potential conflicts of interest on matters that management has a personal interest in, such as a retirement plan for senior executives?

— Do both the in-house and outside counsel have direct access to the board?

— Have any in-house or outside attorneys resigned or been terminated by the company during the last year? If so, what were the circumstances?

Compliance with laws, regulations and publicly known problems

— How does the board monitor the company’s compliance with legal requirements?

— Do the directors feel they are adequately apprised of changes in laws and regulations, including federal securities laws, federal sentencing guidelines, stock exchange governance requirements, and state laws?

— Do the directors feel they are adequately apprised of relevant court decisions?

— Are the company’s attorneys instructed to report any illegal acts to the board or the audit committee on a timely basis?

— Has the board discussed any problems that were cited in security analysts’ reports, press articles, or other media during the past year? What actions, if any, were taken in response to these matters?

— Has the company had any difficulty maintaining its stock exchange listing?

— Is the company in compliance with immigration rules and regulations? How is this compliance monitored?

— Does management have adequate policies and procedures in place to ensure that information collected about the company’s customers, vendors, or other trading partners remains private?

— When is the last time the directors participated in compliance training?

Prevention of problems and penalties

— Has the company taken steps to prevent fraudulent financial reporting or other corporate wrongdoing?

— Does the board regularly review to ensure the CEO and senior management are setting a “tone at the top” that stresses legal compliance?

— Has the company taken all necessary steps to minimize the fines or sentences that might be imposed in response to fraudulent financial reporting or other corporate wrongdoing?

— How does management ensure that no illegal immigrants are employed by the company or its contractors?

— Has the company considered including alternative dispute resolution clauses in contracts and other agreements with its customers, suppliers, and employees?

— Does the company conduct periodic assessments of the strength of its patent portfolios?

— Has the company taken appropriate legal actions to protect its patents, trademarks, and other proprietary property?

— How does the company protect the integrity of existing patents, technology, and intellectual property overseas?

— Is the company prepared for patent or anti-trust challenges?

— Does the company have a “crisis plan” to deal with big mistakes and crises such as investigations, restatements, or research reports that get negative press?

Investigations and pending litigation

— Is the company under investigation by any Federal or state regulatory agency? What issues are involved, and how will the issues be resolved? When will the investigation end?

— Has the SEC or any other regulatory body investigated the company or its management or questioned any of its reporting practices? What is the status of the matter, and what is management doing to resolve the issues?

— If the company operates in a regulated industry, has it been subject to a regulatory examination during the past year? What were the results of the examination? How is management planning to address any problems identified?

— Does the company have a policy of self-reporting and cooperating, should an SEC or other regulatory agency initiate an investigation?

— Were any of the company’s products taken off the market due to decisions by the FDA or other government agencies? What is the impact on revenues and earnings?

— Is any government agency investigating the company’s importing and exporting practices? If so, what is the status of the investigation?

— What matters are currently being litigated? What is the likely outcome?

— Will damages, if any, from pending litigation be covered by insurance? Are there any issues about insurance coverage?

— Has the company adequately reserved for liabilities from pending litigation?

— If the company is a plaintiff in any actions, what are the damages claimed and how long will it take to resolve the suits?

— What expenses were incurred for legal fees, and what amounts were paid in settlements this year and last year? What legal services were provided and by whom?

Other legislative and regulatory matters

— Is the company having difficulty obtaining general liability insurance or insurance for directors and officers?

— How much is it costing the company to comply with Section 404 of the Sarbanes-Oxley Act of 2002?

— In light of the costs of the Sarbanes-Oxley Act, would the company consider plans to deregister or go private? If so, how would current shareholders be assured that they will receive a fair price?

— How will the company be affected by the proposed changes in funding requirements for pension plans?

— Why has it taken so long for the company’s patent applications to be approved? Why does it take so long for FDA or other approvals to be obtained? What is the likely impact on sales and earnings if they are (or are not) obtained?

— Does the company employ lobbyists to influence Congressional action? Which matters are of interest to the company and how much is being spent on lobbying efforts?

— Did the company adopt or amend any retirement plans this year? What were the costs or savings?

— Does the company limit the amount of its own stock that may be held in retirement plans?

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Copyright © 2006, BDO Seidman,LLP. Material discussed in this Financial Reporting newsletter is meant to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual facts and circumstances.