Corporate Governance and Financial Reporting

• Philip Morris works against illegal cigarette trade in EU
• Pension funds hit back at auditors
• Fair value hit to share payment schemes

Philip Morris works against illegal cigarette trade in EU

Cigarette maker Philip Morris is on the brink of finalising a settlement with the European Commission to end a long running conflict over allegations that the company colluded in tobacco smuggling. Philip Morris is expected to make a payment of 1bn euros, presumably on a no blame basis, with the money going into an EU drive against cigarette counterfeiting and smuggling. Parallel Commission action against another leading manufacturer, RJ Reynolds, continues.

European budget commissioner Michaele Schreyer issued a statement saying: �Negotiations contemplated broad areas of co-operation by Philip Morris International with European law enforcement agencies that would build upon Philip Morris International�s existing procedures to ensure that its tobacco products are sold appropriately and lawfully. Included are customer oversight policies and provisions for the tracking and tracing of products manufactured by Philip Morris International. The draft agreement would contemplate substantial payments over a number of years. These payments, contrary to certain press interpretations, are not and should not be viewed as fines or recoveries. The funds could be made available to fund anti-counterband and anti-counterfeit measures.�

A spokesman for Philip Morris International said that the draft agreement had not been finalised and was still subject to the approval of member states and the board of directors of Philip Morris International. But he confirmed that negotiations focused on general areas of co-operation with European law enforcement agencies.

Philip Morris� payment, assuming it is finalised, will be the largest ever made to the EU and considerably in excess of the penalty of $611m imposed on Microsoft, which the Commission alleges has abused its dominant position in the software market.

The Philip Morris settlement will bring to an end legal action initiated as a lawsuit filed in New York by the EU in 2001, and a conflict long pre-dating this. That civil action was struck off in February on the grounds that the EU had not succeeded in proving US jurisdiction over the dispute. But the EU indicated its intention to initiate a fresh legal claim that the company�s actions had illegally assisted money laundering by criminal gangs. The likely settlement allows both sides to move on constructively.

Cigarette smuggling is the biggest cause of revenue loss to the European Commission�s member states. According to the Commission, cigarette manufacturers such as Philip Morris have effectively colluded in smuggling by supplying their products to Central and Eastern Europe - where excise duties are low - in numbers that they knew were much too high to meet domestic demand. Manufacturers, including Philip Morris, have vigorously denied the allegations - a view upheld by several courts.

Enormous variations in European excise duty rates produce a strong incentive to the smuggling of tobacco products. Duty rates range from 10% in Latvia to 211% in the UK. Losses to EU member states are estimated at around 1bn euros a year. Similarly, there are big differences in duty rates charged by states within the US.

A key element to the European agreement is that Philip Morris and the EU will work in partnership to attack two aspects of the illegal cigarette trade. While evasion of excise duties removes massive revenue from governments, Philip Morris is damaged by the growing trade in counterfeit products. The company estimates counterfeit versions of its own brands - including Marlboro, L&M and Chesterfield - are its fourth biggest competitor. The payment, likely to be spread over 12 years, will assist the Commission to expand its existing fight against brand copying, which it is pursuing over a wide range of product areas.

The UK�s Department of Trade and Industry has completed its own investigations into allegations that British American Tobacco had abetted smuggling of tobacco products and concluded that there is no basis for action. And five years ago the Canadian Government began proceedings against RJ Reynolds, whose brands include Camel, claiming it had set up a network of offshore companies which illegally supplied the Canadian market. Canada�s action fell, as did a similar claim by Colombia against BAT and Philip Morris. However, Philip Morris and the Colombian Government signed their own settlement agreement last year under which the company again paid for an anti-contraband and anti-counterfeiting drive.

The threat posed by illegal trade has accelerated in recent years as a result of increased international travel and the growing use of the Internet for trade. This is especially true in the US. The US General Accounting Office investigated 148 Internet sites and found all breached a 1949 federal law requiring mail order companies to provide details of cigarette shipments to state taxation authorities. The GAO concluded that Internet sales are likely to cost states some $1.4bn in lost tax revenues annually by next year.

Philip Morris itself has initiated a range of lawsuits against companies selling counterfeit cigarettes. It believes that many �Marlboro� packets currently on sale in the US domestic market were actually manufactured illegally in China. In one month alone, Philip Morris began legal actions against 325 retailers.

It is clear that Philip Morris is keen to put an end to the various legal actions taken against it and to improve its image. Last year the group changed its name to Altria, recognising that the group has significant non-tobacco interests. These include Kraft - which produces Maxwell House coffee, Suchard chocolate and Philadelphia cream cheese - and Miller Brewing. Tobacco sales still account for more than 60% of group turnover, but represent a gradually decreasing share.

Yet the general trend of judgements against tobacco companies awarding punitive payments for inducing cancers may have been reversed. In California, under a judgement regarded as significant, a now deceased plaintiff was initially awarded $1.7m in damages for lung cancer, but the case has just been returned for retrial. Other recent lawsuits have also gone the tobacco companies� way.

The most expensive case against Philip Morris was the first class action lawsuit taken against a tobacco manufacturer, heard in Florida four years ago, in which the jury awarded damages against the company of $145bn. This, too, was returned for retrial on appeal - though that decision has also been appealed.

The tobacco companies have also won recent legal cases brought by smokers and victims of passive smoking. Tobacco manufacturers won a further case in which asbestos producers sued them for contributing to the early deaths of smokers who contracted asbestosis. The court ruled that any injuries could not be reliably ascribed to smoking and consequently that tobacco companies could not be held liable. The major tobacco companies did, though, sign a $200bn settlement with the US Federal Government in 1998, under which they will pay 46 states money over a quarter of a century as contributions towards the cost of treating sick smokers.

Increasingly, lawyers who built their careers taking legal actions against tobacco companies are now moving into other areas - particularly against food manufacturers who are alleged to have added excessive levels of sweeteners and salt to their products. Ironically, the focus on diversification by companies such as Philip Morris may just lead companies to a fresh exposure to law suits. Kraft, indeed, has already faced legal actions which has led to it changing ingredients in one of its leading products.

The tide which has been fiercely eroding the finances of the tobacco sector for some years may now have receded - and begun heading firmly in the direction of manufacturers of unhealthy foods.

Pension funds hit back at auditors

Indeed, the National Association of Pension Funds has gone so far as to call on the DTI to initiate a Competition Commission investigation into the accountancy sector�s Big Four oligopoly of audits of listed companies. As the UK�s powers are clearly constrained in a globalised environment, this could be regarded as effectively a plea for the European Commission to intervene more rigorously in the accountancy market.

�The dominance of the Big Four is attributed to their being a �global� network,� argued the NAPF submission. �Nonetheless, it is thought that the existing �global� network is not always what it appears to be. Broadly-speaking, these are alliances of auditors in their own national countries working under a common brand. There is insufficient transparency to indicate whether they operate common standards throughout the alliance and, as has recently been seen in Italy, can readily be disowned by other members of the same group. Thus, there is no comfort to investors that the use of large global firms is somehow a �gold standard�, it is not. The NAPF would, therefore, support an enquiry by the Competition Commission into whether choice in the UK market is sufficiently broad and, if not, what could be done to encourage a larger pool of auditors from which UK companies and their shareholders can select.�

The call by NAPF had echoes around other parts of the investment world. Hermes Fund Management backed the call, saying the question of auditor liability should not even be considered until after audit quality standards were raised. This view was endorsed by Morley Fund Management - part of the giant Aviva insurance group - which argued that too many auditor reports were too vague to be useful. �Audit today does not provide investors with the meaningful assurance that it should,� said Morley�s submission.

Michael McKersie, deputy head of investment at the Association of British Insurers, backed the approach of fund managers. �The ABI does not favour capping liability of auditors,� said McKersie. �We believe there are more appropriate ways of addressing auditor liability, such as proportionate liability.�

NAPF went further by also implicitly asserting members� rights to sue auditors for damages where a company failed because of some form of wrongdoing. �Where instances occur where there have been major failures, perhaps occasioned by serious misrepresentation, fraud or negligence, it is entirely reasonable that shareholders should look for sources to redress their loss,� it said.

Fair value hit to share payment schemes

It hardly counts as a shock that proposals from the IASB - subsequently endorsed by the FASB and ASB - to report the value of share options as expenses in company accounts have been met by a barrage of flak in the United States.

Announcing the IFRS 2 measures, even Sir David Tweedie, chairman of the IASB, recognised the bottom line hit that many companies would take. He was reported as saying that listed European companies could expect to lose 10% of reported profits and it is assumed that US companies would be hit far harder, perhaps at an average of 15%.

Sir David Tweedie said: �Typically, transactions in which share options are granted to employees are not recognised in an entity�s financial statements. As a result, the entity�s expenses are understated and its profits are overstated, which is potentially misleading to users of financial statements. The objective of IFRS 2 is to require that, no matter what form of remuneration is used, the entity recognises the associated expenses.�

ACCA points out that there are few if any countries where there is an existing comparable standard - IFRS 2 will mean an entirely new cost in company accounts and a new accounting method. But the concept has gained widespread acceptance outside the technology sector and now the questions are how to calculate the cost and when to charge it against profits.

�Typically with these schemes there are three important dates,� said Richard Martin, ACCA�s head of financial reporting. �When the scheme is established - grant date - employees are given the shares or options subject to their staying with the company, or meeting certain performance targets. When those conditions have been fulfilled is the vesting date. In the case of options there may be a third - exercise date - when they turn the options into shares that can be sold for cash.

�IFRS 2 requires the cost to be based on the fair value of the shares or options at grant date. The cost is then spread over the period up to vesting date and reflects the extent to which performance has been achieved and the final number of shares or options issued. The cost is, however, not reduced by the extent to which the options might �go under water� and therefore lapse unexercised. Nor will the cost to the company equal the gain made by the employees - that would only be achieved by measuring the cost based on exercise date value.

�There are a series of complications that may have to be tackled, which IFRS 2 addresses. For example, cases where instead of shares, bonuses are paid in cash based on share performance, or cases where there might be an option to be either paid in shares or cash. Estimating the fair value of options can be difficult and will have to involve complex pricing models. It is even more difficult where shares granted are unlisted, say in the run-up to an IPO. Share-based payments can be made to parties other than employees, and here it is assumed that the fair value of the services or goods received can be reliably estimated and should be used instead of the fair value of the shares or options granted.�

Several years ago, when the FASB previously intended introducing a similar measure, Congress threatened to cut-off its funding if it proceeded. But EDS and IBM are already moving towards implementation of the new standard, while Microsoft is intending to scale back its use of stock options in recognition of the changes coming in. The International Employee Stock Options Coalition (IESOC) is no longer as focused on opposing the plans, as demanding the �field testing� of various methods for valuing the options.

�FASB�s exposure draft removes any and all doubt that field tests of different valuation methods are absolutely imperative,� said IESOC chairman, Rick White. White added: �By urging companies to use the untested, unproven and extraordinarily complex binomial method, FASB owes it to investors, companies, auditors and others to determine whether the binomial method actually works, particularly for companies with broad-based stock option plans.�

White argued that while the �Black-Scholes model� had been used by thousands of public entities since 1995, the FASB is now urging companies to use �the binomial method�. �Both were designed for something entirely different - options freely traded on the open markets - than employee stock options,� explained White. �Furthermore, one method - Black-Scholes - has been thoroughly discredited. The other - binomial - requires such a complex and dizzying array of assumptions and inputs that it will create an accounting free for all.�

White said that both the Black-Scholes and binomial methods were seriously flawed because they assumed an open market for trading options, that options are freely transferable and saleable, can be hedged, are short dated, have an expected life and are issued without restrictions, when in practice these assumptions were untrue.

Even if the debate is now resolved on whether to expense share options, it looks as if the question of �how to do it� may continue for some time.