Fall 2011

Greetings!

Invotex® Group is pleased to share insights about current reorganization topics with companies, counsel, lenders and others who have an interest in reorganization. We welcome your feedback and invite you to share Reorganization Perspectives with your colleagues and business acquaintances.

In this Issue

1. Delayed Disclosure of Asset Impairments Invites Securities Fraud Claims
2. Distressed Contractors - How to Save Your Surety Marriage: When to Make the Call Part 1 in a Series
3. “How can I be losing money, I’ve got money in my checking account?” and Other Things a Surety Always Hears from its Troubled Contractor
4. Gregory R. Marsh Joins Invotex Group as a Managing Director and Shareholder in the Firm’s Philadelphia Office

Delayed Disclosure of Asset Impairments Invites Securities Fraud Claims
by Gregory R. Marsh

Gregory R. Marsh, CPA/ABV/CFF, ASA As a Managing Director with Invotex, Greg oversees engagements in the areas of business valuation and reorganization... more

“The doctrine of bespeaks caution provides no protection to someone who warns his hiking companion to walk slowly because there might be a ditch ahead when he knows with near certainty that the Grand Canyon lies one foot away.”^[1]

The breadth and utility of section 10(b) of the Securities Exchange Act of 1934 has recently been employed in securities litigation in an effort to enforce the right of owners and lenders to be informed of a company’s declining financial condition in a timely manner.^[2] A collection of vague disclosures littering the pages of most corporate financial statements is often relied upon by managements and auditors to fend off charges of manipulative and deceptive practices. However, the mere existence of such disclosures is routinely rejected by the courts as a valid defense, and managements are increasingly being held to a higher standard, especially in situations where their fiduciary duties are specified in detail.^[3] Although virtually all of the circuit courts of appeals have adopted the bespeaks caution doctrine in some form, its application protects only forward-looking statements and not misrepresentations of historical or current facts.^[4]

In an ongoing class action for securities fraud, three retirement funds contend that adverse changes in the business climate required CBS Corporation to test for an impairment of the value of its goodwill in the first quarter of 2008 and that if it had conducted such a test, it would have recognized an impairment.^[5]

CBS’ decision to test for goodwill impairment in the third quarter of 2008 but not earlier was not, according to the plaintiff, a discretionary judgment by management but actionable fraud. The plaintiff maintains that the very same conditions existed six months earlier, and management’s delay was both intentional and motivated by a desire to maintain a higher stock price to benefit its majority shareholder, Sumner Redstone.^[6]

The basis for the plaintiff’s charge of securities fraud is their allegation that CBS knew of required goodwill impairment charges before the end of the first quarter in 2008 and, knowingly or recklessly, failed to test for it. The plaintiff cited several cases in which claims of securities fraud were upheld when timely impairment charges were not made despite management’s knowledge of clear evidence that assets were impaired.^[7]

CBS’s defense consists primarily of two arguments. One is that it issued a generic warning that “the Company could suffer losses due to asset impairment charges for goodwill, intangible assets, FCC licenses and programming” and that it would “continue to assess whether factors or indicators, such as the continuation of existing market conditions, would require an interim test.” CBS’s second argument is that in 2008, the Statement of Financial Accounting Standard 142, Goodwill and Other Intangible Assets (FAS 142) did not require interim goodwill impairment test if events such as an adverse business climate, declines in revenue or declines in stock price occurred. FAS 142 specified that goodwill is subject to a two-step impairment test:

1. Assess if the reporting unit fair value is less than its book value; if so, then
2. Derive the implied fair value of goodwill by subtracting the fair value of the tangible and identifiable intangible assets of the reporting unit from the fair value of the reporting unit; if the implied fair value of the goodwill is less than its book value, the difference is the goodwill impairment.

As part of its defense, CBS cited Paragraph 28 of FAS 142, which stated that the value of goodwill on the balance sheet of a reporting unit must be tested for impairment annually and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount:

The market value of CBS stock had declined by 42% from $33 per share in June 2007 to $19 in June 2008. Instead of an impairment charge, CBS issued a disclosure at the end of the second quarter that an interim impairment test may be required before the end of 2008 if there was a continuation of existing market conditions.

In October 2008, after its stock price declined another 50% to just over $9 per share, CBS did recognize a $14 billion impairment to its goodwill and other intangible assets, representing more than one-third of the book value of total assets and 58% of the book value of equity. Over the following six months, CBS’ stock continued its decline to less than $4 per share.

The case is currently before the U.S. Court of Appeals.^[8] In its September 26, 2011 appellate brief, CBS maintained that FAS 142 did not provide that a decline in revenue, market capitalization or business conditions is a trigger for an interim goodwill impairment test.

In September 2011, the FASB issued Accounting Standards Update (ASU) No. 2011-08, which the FASB asserts was drafted to reduce complexity and costs by allowing an entity to make a qualitative evaluation of whether it is more likely than not that an impairment has occurred. Only if it is “more likely than not” that an impairment has occurred is an entity now required to compare the fair value of an entity with its carrying amount (step one).^[9] If the fair value is less than the carrying amount, then the amount of the loss must be measured (step two).

This apparent easing of the impairment testing requirements has been lauded by many as the most significant change in anticipation that it will reduce costs by reducing the frequency of goodwill impairment testing. However, a thorough reading of ASU 2011-08 reveals that it is more likely to induce management to test for impairment more frequently, if only to satisfy financial auditing standards or to avoid charges of securities or bank fraud.

It is of great significance that the “triggers for an interim impairment test” enumerated by CBS as missing from FAS 142 are now included among the expanded list of 20 example indicators specified in ASU 2011-08.

The additional examples appear to explicitly invalidate many of the arguments presented by CBS in its defense. Since the original list of examples was clearly affirmed by the FASB to be not inclusive, the revisions to FAS 142 could change the outcome of the CBS case if the appellate court considers the ASU revisions as merely descriptive of the same events originally contemplated by the FASB to indicate the necessity of an impairment test.

For more information, contact Greg Marsh.

______

^[1] In re Prudential Securities Inc. P’ships Litig., 930 F. Supp. 68 72 (SDNY 1996)
^[2] Promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10(b) of the Securities Exchange Act of 1934, Rule 10b-5, prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security.
^[3] Iowa Public Employees’ Retirement System v. MF Global, Ltd., in which the U.S. Court of Appeals for the Second Circuit addressed the bespeaks-caution doctrine and loss causation defense in the context of securities claims brought under §§11 and 12 of the Securities Act of 1933.
^[4] The Private Securities Litigation Reform Act (PSLRA) of 1995 codified the common-law “bespeaks caution” doctrine, which provides that a forward-looking statement is not actionable if it was (1) “accompanied by meaningful cautionary statements,” and (2) not known to be false at the time of issuance. However, neither the safe harbor, nor the bespeaks caution doctrine, protects misstatements of historical or current fact.
^[5] On March 16, 2011, Nebraska Civilian Employees’ Retirement System and the City of Omaha Police and Fire Retirement System filed a securities action against CBS and certain of its officers alleging violations of securities laws.
^[6] In October, 2011, Redstone sold 19.5% of his holdings in CBS through a controlled entity, National Amusements Inc., on the same day that CBS announced a $14 billion impairment charge. These holdings were financed with debt for which repayment would be accelerated in the event of a decline in CBS financial condition.
^[7] One of these is In re Flag Telecom Holdings, Ltd. Sec. Litig., 352 F. Supp. 2d 429, 465-66 (S.D.N.Y. 2005)
^[8] On May 24, 2011, the United States District Court for the Southern District of New York granted the motion to dismiss the action and entered judgment in favor of defendants on May 25, 2011. On June 23, 2011, plaintiffs filed a Notice of Appeal.
^[9] Effective for financial reporting periods beginning after December 15, 2011.  Early adoption is permitted.

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Distressed Contractors - How to Save Your Surety Marriage: When to Make the Call. Part 1 in a Series
by Philip M. Ermer and Raymond J. Peroutka

Raymond J. Peroutka, Jr., Esq., CPA/ABV/CFF Managing Director and CEO for Invotex, Raymond focuses on providing services related to receiverships, bankruptcy and... more

As the construction industry struggles to remain viable, the sureties that indemnify their projects are getting more than their fair share of attention and claims filings. In this series of articles, Invotex professionals take a look inside the contractor-surety marriage, including a relationship that is love-hate at best, what to expect when a surety is called to come to the rescue, how contractors and sureties can make the relationship work, and can there be a happily ever after? The first article discusses proper timing for bringing in the surety - when do you make the call?

Sureties are not a contractor’s partner by choice but rather by mandate of either government regulation or a private owner who is financially risk conscious. In the world of contractual work, they are commonplace – an arranged marriage if you will. The surety doesn’t lay a brick or frame a piece of wood, but it still gets its premium. In good times, contractors with a significant backlog in bonded work rarely give their surety a second thought. It’s when trouble comes along in the form of unprofitable jobs, tightening cash flow and mounting disputes with owners that the contractor should consider calling in the surety. Waiting to make the call will certainly impact the contractor’s relationship with the surety as well as the outcome of the crisis.

Sureties are the key to a contractor’s future work. Generally, they hold the personal indemnity of shareholders, and, when called upon, they have a number of powerful legal and operational rights over the contractor’s business. Further, the claim side of a surety is generally an unknown to a contractor. These factors often cause concern and, in many cases, may cause the contractor to attempt to mitigate insurmountable problems without bringing in the surety. Unfortunately, the longer the situation goes on, the worse the problem becomes, and frequently the surety is finally called in when the situation is beyond repair, project funds are irreparably comingled, and the surety is facing a mountainous loss. At this point, the contractor has lost credibility with the surety, trust has left the station, and the marriage is on the rocks.

Knowing when to call the surety is difficult and requires evaluating factors that will help both parties determine whether claims against the surety are just a possibility or are likely inevitable. The call will begin a flurry of activity, some of which may be undesirable, but if it is made soon enough, events may still be controllable, the contractor may still be vital to operations, and the surety may consider itself a partner in the resolution and not the last resort called in merely to organize the mess and bail out the parties.

To help determine if it’s time to call the surety, the contractor should:

Update and critically evaluate job profitability. Are projects and backlog composed of profitable winners, break evens or pure losers? Are under-billings actually hiding un-booked job losses? Such a critical review should be as pragmatic as possible, omitting unproven extra claims, disputed change orders, outdated cost estimates, unrealizable labor efficiencies, stale vendor discounts and other cost or revenue contingencies that will not be readily achieved.

Update and critically evaluate cash flow. Although job profitability impacts cash flow, even profitable backlogs can be strapped with funding old losses, excessive overhead burden, litigation and completion delays, which in turn delay retainer payments and change order recognition and other events that cost money or delay payments. Are project receipts being paid in contravention of state trust fund statutes? Consider all potential impacts on the company’s cash flow and the probability of occurrence.

Review bank relationships. Is the line of credit at or near its limit? Has the bank begun shortening its evaluation periods for loans and credit lines? Does it appear that the bank is becoming more uncomfortable with its position? Are cash flow needs for operations becoming more reliant on borrowing and in increasing amounts?

Review vendor relationships. Are accounts payables becoming equal to or exceeding accounts receivable? Do your books reflect unpaid bills from completed work? Is there more discussion of cash on delivery terms from your suppliers? Are suppliers hinting at filing a payment bond claim?

Review project owner relationships. Are vendors and subcontractors complaining to project owners? Is there a growing number and increasing frequency of communications relating to project staffing, scheduling delays or other matters that are being interpreted as your responsibility? Is the surety being copied on these communications, or is the surety making inquiries with you about the projects?

Are you borrowing from non-traditional sources? Are you up to date with withholding tax payments? Are shareholders considering advancing personal funds to the company or providing additional collateral to creditors?

If such evaluation points to negative operations trends, then the contractor should consider bringing in the surety sooner rather than later. When the surety is brought in sooner, the contractor’s position may be bolstered if it has ongoing projects, which even if handicapped are still under the contractor’s direction and control. Further, the surety will bring a wealth of experience and professional help to the situation, and indemnitors may be in a position to negotiate repayment terms and collateral assignments.

The contractor needs to remember that the surety-contractor union has a common obligation: to effect completion of the projects and satisfaction of financial obligations to project creditors. The surety’s goal is to do this while minimizing its losses. Therefore, bringing the surety in sooner may allow a trust to develop as both parties meet their shared obligations. Such a relationship may provide the contractor with greater influence and control over operations as the marriage moves forward.

For more information, contact Philip M. Ermer or Raymond J. Peroutka.

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“How can I be losing money, I’ve got money in my checking account?” and Other Things a Surety Always Hears from its Troubled Contractor
by Philip M. Ermer and Raymond J. Peroutka

Philip M. Ermer, Esq. As a Director with Invotex, Phil is experienced with surety claims, insurance claims, distressed business evaluation and ... more

The marriage between a contractor and its surety was certainly not one made in heaven. Call it arranged. Call it a marriage of convenience. The two parties may live their business lives in complete oblivion for years until the contractor runs into trouble. Then, well, the marriage may look more like the War of the Roses. Regardless of the relationship and regardless of the circumstances that compel the contractor to call its surety, five things are always certain – what the contractor tells the surety and what that means to the surety:

1. “How can I be losing money, I’ve got money in my checking account?”

This is the telltale sign to the surety that the contractor lacks a working accounting system. The contractor’s check book does not account for unpaid bills, job over billings, payroll accruals, unposted liabilities and many other accruals and adjustments to the financial statement.

The surety needs to take a critical look at the contractor’s accounting systems and bookkeeping procedures. Are invoices being posted in a timely fashion to the accounts payable ledger and to expenses? Are adjustments being made to the accounts receivable ledger for the owner’s adjustments to billings? When was the last time the contractor did a cost to complete analysis of the projects? Can the contractor’s accounting system produce a reliable monthly trial balance within days of closing?

2. “If you would only approve final bonds on that low bid, I can work my way out of this.”

The surety’s desire to limit its exposure and reduce its payout under its bond obligations requires it to have a skeptical eye. The contractor may be correct, but the surety will come to its own decision on how to approach the problem with the new job. The surety’s choice is to either take a more immediate and measurable loss on the bid bond or tie itself for a year or more on another project with an unknown future.

Even if a future job is assured to be profitable, that profit needs to be measured against the financial hole the contractor is standing in and the potential for additional losses from ongoing projects. Has the contractor put together a realistic and verifiable plan for the surety that shows positive cash flow, reduced liability under the bonds and a foreseeable end to the current problems?

3. “I have this extra claim that will resolve this problem.”

All troubled contractors have an extra claim. The surety will look to be sure this is not a diversion from the true underlying problem with the contractor’s operations. In due time, extra claims, change orders and request for adjustments will be evaluated and may add to the contract balances that will offset losses.

The surety will work with the contractor to prepare the claim package. Have contractual notice periods been met? Have required requests for information, change orders and other documents been filed? Have the proper parties been notified - the owner, GC’s surety, subcontractors? Does the contractor need legal assistance? By addressing each of these items, the surety has not rejected the contractor’s extra claim but has put it in perspective as a future potential recovery and not as a solution to immediate problems.

4. “Don’t you have to advance me money?”

The surety may be tempted to set reserves and demand to be placed in funds by the contractor and personal indemnitors. The indemnity agreement and the nature of the relationship usually demonstrate that the opposite may be true.

The contractor’s demand for funding won’t be the first heard by the surety, but it certainly will signal that he is out of cash, he potentially has maxed out his ability to put off vendors and subcontractors, he may be borrowing from the IRS, and the bank is walking away from providing further credit. The surety will rely on its own experience and practices to address these situations. If the decision is made to advance funds, it’s a key time for gaining commitments in writing from the contractor and indemnitors along with collateral and asset liens. The contractor should be aware that the Thursday afternoon call to advise the surety of its need to fund Friday’s payroll or face job shutdown will many times fall on deaf ears.

5. “If you don’t do that, I’ll file bankruptcy!”

Regardless of what “that” is, the surety generally cannot forbid a contractor from filing bankruptcy. In fact, a surety may want the contractor in bankruptcy to freeze other creditor actions and initiate a review of preference payments, fraudulent transfers and other remedies that would be more difficult to procure outside of bankruptcy. Such threats are familiar to the experienced surety claim handler and are an irritation more than a concern.

If the contractor is considering filing bankruptcy, the surety will retain bankruptcy counsel and discuss options, benefits and shortcomings. A surety has certain rights based in equity and law that are further defined in the indemnity agreement. Sureties will jealously guard them in the bankruptcy process. Whether a plan can be worked out to the best advantage of both parties will be based upon open and frank discussions not threats.

Invotex examines the complex love-hate relationship between contractors and sureties in its surety series. Join us next quarter for the next installment.

For more information, contact Philip M. Ermer or Raymond J. Peroutka.

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Gregory R. Marsh Joins Invotex Group as a Managing Director and Shareholder in the Firm’s Philadelphia Office

Invotex Group, a financial and economic consulting firm providing intellectual property, dispute, investigation, insolvency, insurance and valuation services, has announced that Gregory R. Marsh, CPA/ABV,CFF, ASA has joined the firm as a Managing Director and shareholder. 

Mr. Marsh joined the firm as a Managing Director and shareholder in the firm’s Philadelphia office. He has more than 20 years of financial and accounting experience and is responsible for performance and oversight of client engagements in the areas of business valuation and reorganization services. With a focus on valuation for financial reporting, tax and restructuring purposes, Mr. Marsh values intangible assets, intellectual property, options, debt and equity securities and corporate reporting units of both private and public companies. He has testified before various district courts and the New York Stock Exchange Arbitration Panel as an expert witness on business and securities valuation, insolvency and fraudulent conveyance issues. Prior to joining Invotex, Mr. Marsh most recently worked as a director at LECG and a risk manager at GE Capital. Mr. Marsh is a Certified Public Accountant, Accredited in Business Valuation and Certified in Financial Forensics as well as an Accredited Senior Appraiser.

Read the full press release.

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