Minding the Store: Analyzing Customers, Best Buy Decides Not All Are Welcome --- Retailer Aims to Outsmart Dogged Bargain-Hunters, And Coddle Big Spenders --- Looking for `Barrys' and `Jills'

By Gary McWilliams
2,312 words
8 November 2004
The Wall Street Journal
(Copyright (c) 2004, Dow Jones & Company, Inc.)

Corrections & Amplifications

BEST BUY Co. had net income of $705 million in the fiscal year that ended in February 2004 and $570 million in fiscal 2002. A page-one article Monday transposed the net income figures.

(WSJ Nov. 10, 2004)


Brad Anderson, chief executive officer of Best Buy Co., is embracing a heretical notion for a retailer. He wants to separate the "angels" among his 1.5 million daily customers from the "devils."

Best Buy's angels are customers who boost profits at the consumer-electronics giant by snapping up high-definition televisions, portable electronics, and newly released DVDs without waiting for markdowns or rebates.

The devils are its worst customers. They buy products, apply for rebates, return the purchases, then buy them back at returned-merchandise discounts. They load up on "loss leaders," severely discounted merchandise designed to boost store traffic, then flip the goods at a profit on eBay. They slap down rock-bottom price quotes from Web sites and demand that Best Buy make good on its lowest-price pledge. "They can wreak enormous economic havoc," says Mr. Anderson.

Best Buy estimates that as many as 100 million of its 500 million customer visits each year are undesirable. And the 54-year-old chief executive wants to be rid of these customers.

Mr. Anderson's new approach upends what has long been standard practice for mass merchants. Most chains use their marketing budgets chiefly to maximize customer traffic, in the belief that more visitors will lift revenue and profit. Shunning customers -- unprofitable or not -- is rare and risky.

Mr. Anderson says the new tack is based on a business-school theory that advocates rating customers according to profitability, then dumping the up to 20% that are unprofitable. The financial-services industry has used a variation of that approach for years, lavishing attention on its best customers and penalizing its unprofitable customers with fees for using ATMs or tellers or for obtaining bank records.

Best Buy seems an unlikely candidate for a radical makeover. With $24.5 billion in sales last year, the Richfield, Minn., company is the nation's top seller of consumer electronics. Its big, airy stores and wide inventory have helped it increase market share, even as rivals such as Circuit City Stores Inc. and Sears, Roebuck & Co., have struggled. In the 2004 fiscal year that ended in February, Best Buy reported net income of $570 million, up from $99 million during the year-earlier period marred by an unsuccessful acquisition, but still below the $705 million it earned in fiscal 2002.

But Mr. Anderson spies a hurricane on the horizon. Wal-Mart Stores Inc., the world's largest retailer, and Dell Inc., the largest personal-computer maker, have moved rapidly into high-definition televisions and portable electronics, two of Best Buy's most profitable areas. Today, they rank respectively as the nation's second- and fourth-largest consumer-electronics sellers.

Mr. Anderson worries that his two rivals "are larger than us, have a lower [overhead], and are more profitable." In five years, he fears, Best Buy could wind up like Toys `R' Us Inc., trapped in what consultants call the "unprofitable middle," unable to match Wal-Mart's sheer buying power, while low-cost online sellers like Dell pick off its most affluent customers. Toys `R' Us recently announced it was considering exiting the toy business.

This year, Best Buy has rolled out its new angel-devil strategy in about 100 of its 670 stores. It is examining sales records and demographic data and sleuthing through computer databases to identify good and bad customers. To lure the high-spenders, it is stocking more merchandise and providing more appealing service. To deter the undesirables, it is cutting back on promotions and sales tactics that tend to draw them, and culling them from marketing lists.

As he prepares to roll out the unconventional strategy throughout the chain, Mr. Anderson faces significant risks. The pilot stores have proven more costly to operate. Because different pilot stores target different types of customers, they threaten to scramble the chain's historic economies of scale. The trickiest challenge may be to deter bad customers without turning off good ones.

"Culturally I want to be very careful," says Mr. Anderson. "The most dangerous image I can think of is a retailer that wants to fire customers."

Mr. Anderson's campaign against devil customers pits Best Buy against an underground of bargain-hungry shoppers intent on wringing every nickel of savings out of big retailers. At dozens of Web sites like FatWallet.com, SlickDeals.net and TechBargains.com, they trade electronic coupons and tips from former clerks and insiders, hoping to gain extra advantages against the stores.

At SlickDeals.net, whose subscribers boast about techniques for gaining hefty discounts, a visitor recently bragged about his practice of shopping at Best Buy only when he thinks he can buy at below the retailer's cost. He claimed to purchase only steeply discounted loss leaders, except when forcing Best Buy to match rock-bottom prices advertised elsewhere. "I started only shopping there if I can [price match] to where they take a loss," he wrote, claiming he was motivated by an unspecified bad experience with the chain. In an e-mail exchange, he declined to identify himself or discuss his tactics, lest his targets be forewarned.

Mr. Anderson's makeover plan began taking shape two years ago when the company retained as a consultant Larry Selden, a professor at Columbia University's Graduate School of Business. Mr. Selden has produced research tying a company's stock-market value to its ability to identify and cater to profitable customers better than its rivals do. At many companies, Mr. Selden argues, losses produced by devil customers wipe out profits generated by angels.

Best Buy's troubled acquisitions of MusicLand Stores Corp. and two other retailers had caused its share price and price-to-earnings ratio to tumble. Mr. Selden recalls advising Mr. Anderson: "The best time to fix something is when you're still making great money but your [price-to-earnings ratio] is going down."

Mr. Selden had never applied his angel-devil theories to a retailer as large as Best Buy, whose executives were skeptical that 20% of customers could be unprofitable. In mid-2002, Mr. Selden outlined his theories during several weekend meetings in Mr. Anderson's Trump Tower apartment. Mr. Anderson was intrigued by Mr. Selden's insistence that a company should view itself as a portfolio of customers, not product lines.

Mr. Anderson put his chief operating officer in charge of a task force to analyze the purchasing histories of several groups of customers, with an eye toward identifying bad customers who purchase loss-leading merchandise and return purchases. The group discovered it could distinguish the angels from the devils, and that 20% of Best Buy's customers accounted for the bulk of profits.

In October 2002, Mr. Anderson instructed the president of Best Buy's U.S. stores, Michael P. Keskey, to develop a plan to realign stores to target distinct groups of customers rather than to push a uniform mix of merchandise. Already deep into a cost-cutting program involving hundreds of employees, Mr. Keskey balked, thinking his boss had fallen for a business-school fad. He recalls telling Mr. Anderson, "You've lost touch with what's happening in your business."

Mr. Anderson was furious, and Mr. Keskey says he wondered whether it was time to leave the company. But after meeting with the chief operating officer and with Mr. Selden, Mr. Keskey realized there was no turning back, he says.

Best Buy concluded that its most desirable customers fell into five distinct groups: upper-income men, suburban mothers, small-business owners, young family men, and technology enthusiasts. Mr. Anderson decided that each store should analyze the demographics of its local market, then focus on two of these groups and stock merchandise accordingly.

Best Buy began working on ways to deter the customers who drove profits down. It couldn't bar them from its stores. But this summer it began taking steps to put a stop to their most damaging practices. It began enforcing a restocking fee of 15% of the purchase price on returned merchandise. To discourage customers who return items with the intention of repurchasing them at an "open-box" discount, it is experimenting with reselling them over the Internet, so the goods don't reappear in the store where they were originally purchased.

"In some cases, we can solve the problem by tightening up procedures so people can't take advantage of the system," explains Mr. Anderson.

In July, Best Buy cut ties to FatWallet.com, an online "affiliate" that had collected referral fees for delivering customers to Best Buy's Web site. At FatWallet.com, shoppers swap details of loss-leading merchandise and rebate strategies. Last October, the site posted Best Buy's secret list of planned Thanksgiving weekend loss leaders, incurring the retailer's ire.

Timothy C. Storm, president of Roscoe, Ill.-based FatWallet, said the information may have leaked from someone who had an early look at advertisements scheduled to run the day after Thanksgiving.

In a letter to Mr. Storm, Best Buy explained it was cutting the online link between FatWallet and BestBuy.com because the referrals were unprofitable. The letter said it was terminating all sites that "consistently and historically have put us in a negative business position."

Mr. Storm defends FatWallet.com's posters as savvy shoppers. "Consumers don't set the prices. The merchants have complete control over what their prices and policies are," he says.

Shunning customers can be a delicate business. Two years ago, retailer Filene's Basement was vilified on television and in newspaper columns for asking two Massachusetts customers not to shop at its stores because of what it said were frequent returns and complaints. Earlier this year, Mr. Anderson apologized in writing to students at a Washington, D.C., school after employees at one store barred a group of black students while admitting a group of white students.


Mr. Anderson says the incident in Washington was inappropriate and not a part of any customer culling. He maintains that Best Buy will first try to turn its bad customers into profitable ones by inducing them to buy warranties or more profitable services. "In most cases, customers wouldn't recognize the options we've tried so far," he says.

Store clerks receive hours of training in identifying desirable customers according to their shopping preferences and behavior. High-income men, referred to internally as Barrys, tend to be enthusiasts of action movies and cameras. Suburban moms, called Jills, are busy but usually willing to talk about helping their families. Male technology enthusiasts, nicknamed Buzzes, are early adopters, interested in buying and showing off the latest gadgets.

Staffers use quick interviews to pigeonhole shoppers. A customer who says his family has a regular "movie night," for example, is pegged a prime candidate for home-theater equipment. Shoppers with large families are steered toward larger appliances and time-saving products.

The company hopes to lure the Barrys and Jills by helping them save time with services like a "personal shopper" to help them hunt for unusual items, alert them to sales on preferred items, and coordinate service calls.

Best Buy's decade-old Westminster, Calif., store is one of 100 now using the new approach. It targets upper-income men with an array of pricey home-theater systems, and small-business owners with network servers, which connect office PCs, and technical help unavailable to other customers.

On Tuesdays, when new movie releases hit the shelves, blue-shirted sales clerks prowl the DVD aisles looking for promising candidates. The goal is to steer them into a back room that showcases $12,000 high-definition home-theater systems. Unlike the television sections at most Best Buy stores, the room has easy chairs, a leather couch, and a basket of popcorn to mimic the media rooms popular with home-theater fans.

At stores popular with young Buzzes, Best Buy is setting up videogame areas with leather chairs and game players hooked to mammoth, plasma-screen televisions. The games are conveniently stacked outside the playing area, the glitzy new TVs a short stroll away.

Mr. Anderson says early results indicate that the pilot stores "are clobbering" the conventional stores. Through the quarter ended Aug. 28, sales gains posted by pilot stores were double those of traditional stores. In October, the company began converting another 70 stores.

Best Buy intends to customize the remainder of its stores over the next three years. As it does, it will lose the economies and efficiencies of look-alike stores. With each variation, it could become more difficult to keep the right items in stock, a critical issue in a business where a shortage of a hot-selling big-screen TV can wreak havoc on sales and customer goodwill.

Overhead costs at the pilot stores have run one to two percentage points higher than traditional stores. Sales specialists cost more, as do periodic design changes. Mr. Anderson says the average cost per store should fall as stores share winning ideas for targeting customers.



Tech's Next Big Thing? The Cellphone -- and All That Can Go With It

By Lee Gomes
895 words
8 November 2004
The Wall Street Journal
(Copyright (c) 2004, Dow Jones & Company, Inc.)

YOU KNOW ALL about Google, the Internet-based IPO that has been the big story much of this year in technology. There is, though, another recent but less well-known initial public offering that says just as much as Google about the state of play in the tech world: Jamdat Mobile.

The Los Angeles company went public last month based on the strength of Jamdat Bowling, one of the most popular of a new breed of games that run on cellphones. The game, which you download from your cell carrier, lets you use the keypad to launch a bowling ball down a lane. I don't quite get the appeal either, but it's apparently extremely popular and quite addictive, in a Tetris kind of way.

Jamdat Mobile is far from a Nasdaq powerhouse. While its stock has risen 25% since trading began Oct. 1, its market capitalization is just over 1% of Google's or Yahoo's, and the company has yet to prove it will be more than a one-hit wonder.

Still, for those who fretted that the mojo seemed to be missing from the tech scene since the popping of the Internet bubble, the fact that a company could hit the IPO jackpot by marketing a $1.99 game should be all the proof you need that exuberance, possibly even the irrational sort, is alive and well.

THE EVIDENCE CONTINUES to mount that games, ring tones, rudimentary online video and everything else involving cellphones are becoming tech's fabled Next Big Thing. Wireless conferences are drawing big crowds; venture capitalists are putting money into start-ups; aspiring entrepreneurs who a few years back might have concocted a me-too e-commerce company are instead writing business plans for, well, me-too cellphone bowling games.

The fact that Japan and Europe were years ahead of the U.S. in their embrace of cellphones has always been well-known but not considered particularly relevant to anything. Now, American executives ask endless questions about the overseas wireless experience and what it does and doesn't portend for the U.S. market.

One of the surprises of this particular turn of the technology wheel is the extent to which it doesn't involve the personal computer. For a generation, the desktop PC has been the lodestone around which tech players arranged themselves.

No one thinks the computer is going to go away. It's just that suddenly, the world of telephony looks more vibrant and exciting, and seems to offer more of the open frontiers and unlimited growth potential that folks used to associate with computers. The hits seem to keep on coming, too: The next step in cellphones will be the spread of instant-messaging capabilities, the very same sort of IM that so engrosses many PC owners.

While cellphones are clearly emerging as a new "platform," one thing that is not at all clear is what the rules of engagement for this platform are going to be. In the past few weeks, there have been a handful of cellphone conferences in and around Silicon Valley, and the most frequently asked questions at all of them involved who, if anyone, would be the big cellular winners.

THERE ARE MANY aspirants. Game companies -- there is a growing list of them -- think they will become important new online brands. Existing household names -- Disney, Fox, ESPN -- see the cellphone world as a way to repackage their existing programming, as well as a new avenue for marketing future movies, reality shows and sports events. The big cellphone system operators like Verizon and Sprint currently enjoy a position as gatekeepers, able to control access to their networks. They are going to fight to keep that tollbooth function by preventing cell networks from morphing into Web-style open roads to which anyone can have access.

The epic success stories of the PC world, like Microsoft, are still trying to make a big wireless play. So far, they haven't exactly set the cellphone world on fire, and a lot of people would just as soon keep it that way.

It will be a great story to watch unfold. And it will be happening on a global scale. This is one technology revolution that won't just be limited to the most affluent homes and offices of the industrial West. The World Wide Web is a phenomenal edifice, but the emerging planetary cellular system is likely to dwarf it. The manufacturing efficiencies of semiconductor chips, which are the main building blocks of cellphones, are making them so cheap that soon, a huge percentage of the world will either have a cellphone or have reasonably easy access to one.

Before, that used to mean people could talk to each other. Now, it is becoming clear that phones can be used for so much more -- anything, in fact, that a smart entrepreneur can think up, from bowling games on up.

No wonder the tech world is so excited. There will surely be froth and excess in all of this. There always is. But it seems a little early to take away the punch bowl. Let people have their fun.

News Corp. Strengthens Its Takeover Defenses

By Martin Peers
854 words
8 November 2004
The Wall Street Journal
(Copyright (c) 2004, Dow Jones & Company, Inc.)

NEW YORK -- In a sign that Rupert Murdoch is anxious about a possible threat to his control of News Corp., the media giant abruptly adopted a "poison pill" aimed at blocking any hostile advances by Liberty Media Corp. or anyone else.

News Corp. last night announced the board's adoption of the plan, just days after Liberty Media -- the investment vehicle of cable pioneer John Malone -- bought the right to nearly double its voting stake in News Corp. to about 17%. The family of Mr. Murdoch, chairman of News Corp., owns roughly 30% of the voting stock.

If it exercises the right, Liberty would pay about $1.5 billion for the extra stock.

News Corp.'s array of global media properties include the Fox broadcast-television network, Fox News Channel, 20th Century Fox movie studio, the New York Post and a controlling stake in DirecTV Group, as well as satellite TV and newspapers elsewhere in the world.

The development suggested that Mr. Murdoch, who has run News Corp. unthreatened for roughly 50 years, is worried about Mr. Malone's intentions towards the company. People close to the situation estimate that Liberty could easily lift its voting stake to signficantly more than 17%, financing stock purchases by selling non-voting stock it already owns. A heavy volume of News Corp. shares is beginning to come onto the market because Australian investors are selling News shares as the company is shifting its corporate domicile to Delaware from Australia. That domicile switch becomes fully effective this week.

Liberty Media has so far insisted it isn't a hostile investor in News Corp. A spokesman for the Liberty Media repeated that view last night, saying "we view ourselves as allies, not as hostile." A person close to News Corp. said the company also doesn't think Liberty is hostile, but said "you have to protect yourself."

News Corp. said in a statement the stockholder-rights plan was intended "to protect the best interests of all shareholders."

Still, while Mr. Murdoch doesn't think Mr. Malone's intentions are hostile, he isn't happy about Liberty's buying. Mr. Murdoch is in "a little bit of a vulnerable position," said a person close to both companies, given that his family owns only about 30%. Another person close to the situation said Liberty's buying had reminded senior News Corp. executives that the Murdoch family's control of the company could be threatened by hostile raid mounted by anyone.

Speculation about Mr. Malone's intentions have swirled since he disclosed earlier this year a 9% voting stake in News Corp. that made Liberty the second biggest voting share holder behind the Murdoch family. Liberty last week gained the right to buy additional voting stock owned by Merrill Lynch & Co. Liberty expects to buy the stock if it gets regulatory approval from authorities in Australia and the U.S., the company said last week.

News Corp. said in its statement that its board had adopted the poison pill, technically called a "shareholder rights plan," partly because Liberty had bought the right to buy more stock "without any discussion with, or prior notice to, News Corp."

The plan would be triggered if someone buys more than 15% of NewsCorp.'s voting stock. If that occurred, the buyer would be massively diluted because all other shareholders would be able to cheaply buy extra News Corp. shares.

Existing holdings, including exercise of Liberty's recently-acquired option, wouldn't trigger the poison pill. But the additional acquisition of any meaningful amount would trigger it.

That suggests Liberty can purchase the extra stock it now has an option on, but it won't be able to buy any significant amount more. News Corp. added that, within a month, its board is expected to review whether the shareholder rights plan should be maintained.

Poison pills are the "only available defensive structure" that companies threatened with a corporate raider can adopt, according to Chuck Nathan, co-chair of the Latham & Watkins mergers-and-acquisitions practice.

Still, News Corp's adoption of such a plan is likely to prompt complaints from corporate-governance advocates as it will be seen as an effort by Mr. Murdoch to cement his control of the company.

Analysts speculate that Mr. Malone is making the purchases as a way to put pressure on Mr. Murdoch to buy some of Liberty's assets. Earlier this year Mr. Malone hinted he was interested in such a transaction, saying there were certain assets within Liberty that would fit better with News Corp.

The most likely assets that would fit with News Corp. would be Liberty's cable-programming interests, including its 50% stake in Discovery Communications and its Starz-Encore movie network company. One theory is that Mr. Malone wants to put these assets into a company, together with the News Corp. stake, and either spin it off or sell it.

While Mr. Murdoch may be interested in buying some of these assets, it isn't clear the two could reach agreement on the price.

Outside Auditing Of Oil Reserves Pushed by Calpers

By Chip Cummins
579 words
9 November 2004
The Wall Street Journal
(Copyright (c) 2004, Dow Jones & Company, Inc.)

One of the most influential U.S. institutional investors is pushing major oil companies to subject their energy-reserve estimates to independent audits, boosting pressure on the global oil industry to improve the transparency of its reserves accounting.

The call by the California Public Employees' Retirement System, the largest U.S. public pension fund, comes in the wake of major reserves-accounting controversies at several large oil companies this year, including Royal Dutch/Shell Group and El Paso Corp. In the wake of these disclosures, the Securities and Exchange Commission has weighed whether auditors should be required to provide more oversight of reserves estimates, a step that large oil companies have resisted.

In a joint statement expected to be released today, Calpers and New York-based Knight Vinke Asset Management, a fund that campaigns for improved corporate governance, praised Shell for a sweeping corporate restructuring unveiled late last month in response to its reserves overstatements. Shell's parent companies, Royal Dutch Petroleum Co., of The Hague, and Shell Transport & Trading Co., of London, last month agreed to merge.

But fund executives also called for Shell and others to bring in independent auditors to examine their reserve numbers.

"If Shell agrees to an external audit of its reserves, this would strongly encourage others in the industry to do likewise and would help to eradicate inconsistencies in the application of SEC standards . . . that have undermined the market's confidence in the sector," said Eric Knight, managing director of Knight Vinke, in the statement. Knight Vinke coordinated a public-relations campaign with Calpers this year calling for changes at Shell.

Reserves are the estimate of oil and natural gas an energy company has in the ground that it is reasonably certain to pump and sell. The SEC requires so-called proved reserves to be reported each year as supplemental information to a company's financial statements.

The move by Calpers, a giant institutional investor, significantly bolsters calls by some industry experts for more-consistent reserve-reporting rules among international oil companies. Reserves are an important metric for oil-sector investors. But American accounting guidelines leave companies with wide discretion in coming up with their estimates. That has left reserves accounting in somewhat of a gray area.

Outside auditors who sign off on a company's financial statements aren't required to certify reserve estimates, though U.S. accounting guidelines require them to check that internal processes for making those estimates are sound.

A handful of independent petroleum consultants are often used by smaller oil companies to provide outside assurances that reported reserve tallies are accurate. Larger oil companies typically have shied away from using them extensively, however, preferring to rely on in-house expertise to make the complicated assumptions about geology and economics that go into the estimates.

Shell, in response to its energy-accounting scandal, now relies on outside contractors to help review its tally, though it hasn't committed to a full-blown external reserves audit. BP PLC executives have said they support moves to provide consistent, industrywide standards for reserve reporting, but the London-based giant has stopped short of calling for outside auditing.

Exxon Mobil Corp. has opposed such a move. A spokeswoman for Exxon, of Irving, Texas, said Exxon doesn't "understand what value would be added" by a review by outsiders, who may not have the same technical qualifications as its in-house staff.

Deals & Deal Makers

Accounting Body Plans to Clarify Rules for Booking New Tax Break

By Lingling Wei Dow Jones Newswires
440 words
10 November 2004
The Wall Street Journal
(Copyright (c) 2004, Dow Jones & Company, Inc.)

NEW YORK -- Accounting-rule makers will clarify how companies should book a huge tax break under the newly enacted tax law.

The legislation, dubbed the "American Jobs Creation Act of 2004," cuts by three percentage points, to 32%, the top tax rate on American manufacturers that engage in "domestic production." The reduction will save an estimated 200,000 companies $76.5 billion over 10 years.

The Financial Accounting Standards Board, at a meeting today, will decide whether the tax break should be accounted for as "a special deduction" or as "a rate reduction," said Russell Golden, a senior technical adviser at the FASB.

A special deduction would reduce companies' taxable income over time -- just as long as they perform, on a continuing basis, the manufacturing activity that qualifies them for the tax benefits.

A rate reduction, by comparison, would require companies to immediately recalculate their deferred income-tax balances, resulting in a one-time effect on earnings. Specifically, the effect of "a tax rate reduction" on earnings would depend on whether a company carries on its balance sheet more in deferred tax liabilities or deferred tax assets.

Those that have booked more in liabilities, which represent expected future tax payments, would recognize a one-time gain to earnings. Those that have booked more in assets, which reflect future tax deductions, would recognize a one-time charge against earnings.

Robert Willens, a tax and accounting specialist at Lehman Brothers Holdings Inc., said most companies, namely those that carry net deferred tax liabilities, would prefer that the tax break be booked as a special deduction because that would help their "income from continuing operations" over time, rather than just one time.

The current standard on income taxes, known as Statement No. 109, doesn't define clearly what amounts to a "special deduction," experts say, thus making it necessary for the FASB to offer further guidance. The FASB, in Norwalk, Conn., plans to propose related guidelines in a week and to finalize them by year end.

Another top provision of the tax bill, signed into law by President Bush on Oct. 22, cuts for about one year to 5.25% from 35% the tax rate on profits repatriated from abroad. However, many companies have said they won't be able to evaluate the effects of this provision on their financials until the Treasury Department issues guidelines for applying the provision of the law. The FASB will decide whether companies should be allowed more time to assess the effects of the repatriation provision.

Moving the Market: SEC Moves Ahead to Strengthen Governance of U.S. Stock Markets

By Siobhan Hughes Dow Jones Newswires
352 words
10 November 2004
The Wall Street Journal
(Copyright (c) 2004, Dow Jones & Company, Inc.)

WASHINGTON -- Securities regulators took steps toward strengthening governance of the nation's stock markets and requiring exchanges to separate their regulatory functions from market operations to avoid conflicts such as those that plagued the New York Stock Exchange.

The Securities and Exchange Commission voted unanimously to seek public comment on a proposal that would require the NYSE, the Nasdaq Stock Market and eight other exchanges to have more independent members on their boards and to disclose details about executive compensation.

The exchanges "are not immune from governance missteps," said SEC Chairman William Donaldson, who once ran the NYSE. "After a period of intense focus on public-company governance, we would be remiss if we did not seek to apply the lessons learned."

The SEC also raised the possibility of even broader changes by voting 5-0 to publish a "concept release" seeking comment on "self-regulatory organization" governance. Among the options the SEC plans to float: whether to create a single agency to replace the multiple self-regulators at each of the U.S. stock exchanges.

The SEC regulates the markets in partnership with the stock exchanges, which are known as self-regulatory organizations because they have their own regulatory arms to oversee trading and other activities. This arrangement has created potential conflicts of interest, as the markets essentially wear two hats as a regulator and a marketplace.

Under the SEC rule proposal, the exchanges would be required to separate their regulatory and business units, formalizing structures that already are in place at exchanges such as the NYSE.

The Nasdaq Stock Market already operates separately from its regulatory arm.

Scott Peterson, a spokesman for the NYSE, said the exchange planned to review the details of the proposal. As for the SEC's concept release, he said the NYSE believes "the most effective regulation occurs when the regulator is as close as possible to the regulated activity."

A Nasdaq spokeswoman said the exchange needed to review the details of the plan before commenting.

IRS Is Auditing Bank of America Over Pension, 401(k) Tax Returns

By Carrick Mollenkamp and David Enrich
354 words
10 November 2004
The Wall Street Journal
(Copyright (c) 2004, Dow Jones & Company, Inc.)

The Internal Revenue Service is auditing the 1998 and 1999 tax returns of Bank of America Corp.'s pension plan and 401(k) plan in a review that is looking at whether it was legal for the bank's employees to transfer 401(k) assets to the company's pension plan.

The Charlotte, N.C., banking company disclosed the audit in its quarterly filing with the Securities and Exchange Commission. Bank of America's report didn't elaborate on the nature of the IRS review or the company's position on the legality of transferring 401(k) assets to the pension plan.

The report of the audit comes on the heels of a lawsuit filed this summer by Bank of America employees. The suit asserts that the company used its cash-balance pension plan as part of an "arbitrage scheme" to boost the company's bottom line at the expense of plan participants.

According to that complaint, the bank, the nation's third largest in terms of assets, encouraged employees to transfer more than $2.7 billion of 401(k) assets into the bank's pension plan in 1998 and 2000. The employees' lawsuit, filed June 30 in a federal district court in Illinois, alleges that those transfers allowed Bank of America to invest the money for higher returns than what the bank would dole out to employees. The suit says the asset transfers violated the Employee Retirement Income Security Act, or Erisa.

The bank has said that its cash-balance plans were designed and operated in accordance with applicable law and that it planned to defend itself against the claims in the lawsuit.

In addition to the original employee lawsuit, a lawsuit was filed Sept. 29 against FleetBoston Financial Corp., which Bank of America acquired, according to yesterday's SEC filing. That suit, filed in federal court in Connecticut, contends that FleetBoston violated Erisa by changing Fleet's retirement plan to a cash-balance plan without notifying plan participants about the impact of the change.

Deloitte Faces $2 Billion Claim Over Audits of Reinsurance Firm

By Mark Maremont
1,620 words
11 November 2004
The Wall Street Journal
(Copyright (c) 2004, Dow Jones & Company, Inc.)

In a case that shows how the insurance industry's woes could spread to its auditors, Deloitte & Touche LLP faces a potential $2 billion legal claim related to the type of earnings-management insurance products that are the subject of government investigations at other companies.

The dispute involves Deloitte's audits of Fortress Re Inc., a closely held North Carolina insurance company. Fortress, which specialized in reinsurance for aviation risk, collapsed after the Sept. 11, 2001, terrorist attacks. Two Japanese insurers that had relied on Fortress to minimize their risk with additional insurance charge that its use of unconventional coverage and its fraudulent accounting resulted in an estimated $3.5 billion in total losses for them and for a third insurer that was forced into bankruptcy. Deloitte denies any liability in the dispute.

The case, which is entering court-ordered mediation this week, could be one of the most troublesome legal claims Deloitte faces. The accountant also is being sued in connection with its audits of Italy's scandal-plagued Parmalat SpA and cable-TV firm Adelphia Communications Corp.

In the broad crackdown on corporate fraud of recent years, the trail often has led to legal problems for auditors. Arthur Andersen LLP essentially dissolved after being convicted of criminal behavior in connection with its audits of Enron Corp.

The current probes into the insurance industry are at a relatively early stage, but they already have touched on the accounting profession. The Securities and Exchange Commission, the Justice Department and New York Attorney General Eliot Spitzer recently have launched investigations into the industry's use of products similar to those involved in the Deloitte case.

Last year, now-defunct Andersen was faulted by an Australian government investigator for an "insufficiently rigorous" audit in connection with the 2001 collapse of HIH Insurance, Australia's largest bankruptcy. Andersen wasn't directly blamed in the case, in which Australian authorities found that "audacious" and suspect insurance transactions played a role in the bankruptcy.

For nearly three decades, Fortress managed a large reinsurance business for the three Japanese companies. They put up all the money while Fortress arranged policies, kept the books and charged a management fee. Reinsurance provides protection for insurance companies, which can collect on the policy if they get slammed with big claims. By the late 1990s, the Fortress pool was among the world's largest players in the field of aviation reinsurance -- meaning it would have to pay up if a plane crashed almost anywhere on the globe.

In suits being heard jointly in North Carolina state court, Sompo Japan Insurance Inc. and Aioi Insurance Co. claim that Deloitte failed to tell them of huge hidden liabilities that Fortress had incurred on their behalf. The Japanese companies say Fortress told them it had obtained insurance that would cover losses on their policies, but they eventually learned that Fortress was relying instead on "financial reinsurance."

This type of coverage is cheaper and like a loan, and it had the effect of forcing the Fortress pool to absorb additional losses on every claim. While Fortress was telling the Japanese insurers that their business was profitable, they claim that instead they were incurring the loan liability as well as the initial policy loss.

In a statement, Deloitte said that "the entire premise of this lawsuit -- that two of Japan's largest and most sophisticated insurance companies did not understand their own high-risk business strategy -- is demonstrably false and incredible on its face." The accounting firm said it communicated the extent of the liabilities to its client, Fortress. If Fortress failed to provide the Japanese insurers with accurate information, Deloitte added, "any claim would be against their own agent, Fortress, not Deloitte."

In a court hearing earlier this year, Robert S. Bennett, a former defense attorney for President Bill Clinton hired to defend the accounting firm, called the case "a life and death situation" for Deloitte. Deloitte said this week that was an overstatement and it believes "it will win this case."

Sompo already has won a ruling that it was defrauded. An arbitration panel earlier this year ruled that Fortress's two principals had committed fraud by using misleading accounting, ordering the duo to pay more than $1 billion. The men later settled with all the Japanese insurers by turning over nearly their entire net worth, including lavish homes, antiques, a Gulfstream III jet, and other assets valued at more than $400 million.

Now the Japanese insurers have focused on Deloitte. In discovery, they have found what they believe is a smoking gun -- a series of e-mails and other memos from a Deloitte actuary who raised questions about why the liabilities related to the loan-type of insurance weren't being recorded.

"I have a concern over the lack of recognition" of future liabilities, the actuary, John Slusarski, wrote in one 1999 e-mail quoted in plaintiff filings. A year later, he quantified the unbooked liabilities at $1.4 billion, the filings say. The actuary's warnings were ignored by Deloitte partners, the plaintiffs claim.

Deloitte is expected to argue that the Japanese insurers were well aware of the use of the loan-type of insurance, and indeed took advantage of the unusual accounting practices to post large profits from the Fortress pool. The Japanese insurers cried foul only after the Sept. 11 attacks made the situation untenable, the accounting firm is expected to claim.

It's unclear if the two sides will be able to resolve their differences in the nonbinding mediation that started yesterday and was ordered by Judge Ben Tennille, who is presiding over the North Carolina suits. People familiar with the case believe it's unlikely Deloitte will offer enough money to satisfy the Japanese firms, in which case the companies would resume their court battle.

Sompo has estimated that the Fortress debacle resulted in about $3.5 billion in losses for the three Japanese insurers in the pool. One, Taisei Fire & Marine Insurance Co., became only the second Japanese casualty insurer since World War II to file for bankruptcy.

The dispute started after the Sept. 11 attacks, when Sompo, alarmed by the potential claims that could arise from the destruction of four commercial airliners that day, ordered an audit. The Fortress pool also had been exposed to big losses in the late 1990s from a series of airline disasters with substantial fatalities, including the 1998 Swissair crash off Nova Scotia.

Sompo says it had previously thought its real losses would be minimal, because Fortress was contractually obliged to buy the Japanese insurers reinsurance. In other words, most losses incurred by the Fortress pool when a plane crashed would then be passed on to somebody else, in a kind of global daisy chain.

Sompo says its auditors discovered that Fortress had instead been purchasing the cheaper financial-reinsurance product that was akin to a line of credit. Sompo claims it wasn't fully informed about the switch, and if it had been, it would have withdrawn from the pool earlier and limited its losses. By saving money on insurance, Sompo contends, Fortress executives were able to inflate their profit figures and gain hundreds of millions of dollars in commissions.

In traditional risk-transfer reinsurance, if a plane crash caused a $100 million claim on the Fortress pool, Fortress would pay it, and then collect the same amount from its own reinsurers. Under U.S. accounting the net loss to Fortress would be zero.

But with loan-type insurance, Fortress would be obliged to repay the $100 million to its reinsurers -- with interest -- in, say, five annual "premiums" of $25 million. U.S. accounting rules would require Fortress to show both a $100 million loss and a corresponding liability on its balance sheet to cover the repayment obligation.

In its books, which are part of court documents, Fortress had been treating the second type of insurance as though it were identical to the first. That allowed Fortress to continue telling the Japanese the pool was extremely successful. It reported profits of $275 million from 1998 to 2000 before Fortress's commissions. Under U.S. accounting practices, all that would have been improper.

But Fortress's accounting treatment and financial reports to its Japanese pool members were governed not by U.S. rules but by a contract between Fortress and the pool members. Such contractual accounting is unusual, and is limited to private dealings between parties.

The annual opinion Deloitte provided to the Japanese companies specifically warned that Fortress's financial statements "were not intended to be a presentation in conformity" with U.S. accounting principles. An annual footnote to the statement generally described differences from U.S. accounting practices, but didn't provide many details.

One piece of ammunition the plaintiffs believe they have is the unusual nature of Deloitte's engagement for Fortress, in which the auditing firm helped prepare the insurer's financial statements as well as audited them. According to Sompo's suit, Fortress's executives in annual letters told Deloitte that "we do not have expertise" in financial accounting matters, and therefore hired Deloitte to "assist us in the preparation of our financial statements and to advise us in matters related to generally accepted accounting principles."

Big accounting firms typically act only as independent auditors, and defend themselves in fraud suits by saying they were only offering opinions on statements prepared by management. A lack of independence would leave Deloitte vulnerable to charges it was a participant in any fraud.

Deloitte says it "gave advice" on the financial statements, but Fortress prepared them, and "Deloitte was independent in all respects."

Technology Journal

PeopleSoft Rejects Oracle's New Bid

By Mark Boslet and Don Clark
436 words
11 November 2004
The Wall Street Journal
(Copyright (c) 2004, Dow Jones & Company, Inc.)

PeopleSoft Inc.'s board rejected Oracle Corp.'s $9.2 billion bid for the company, arguing that the software company's business is now worth substantially more to its suitor.

The rejection of the recently sweetened bid sets the stage for what could be a conclusion to the long-running takeover battle next week. Oracle, based in Redwood Shores, Calif., has set a Nov. 19 deadline in its 17-month campaign to acquire PeopleSoft, of Pleasanton, Calif., and vowed that its $24-a-share bid will be withdrawn if a majority of its rival's shares aren't tendered by midnight on that day.

PeopleSoft executives, meanwhile, vowed to continue to resist Oracle even if a majority of holders tender their shares. Unless Oracle persuades a Delaware judge to lift PeopleSoft's "poison pill" takeover defense, the two sides are likely to mount a proxy fight at the company's annual meeting next year that would settle the battle.

"We recognize a tender offer for what it is: a nonbinding straw poll," said Kevin Parker, PeopleSoft's chief financial officer. Any such poll could lead to a proxy fight, "which we certainly see in our future."

Oracle has shown little willingness to increase the offer further after recently boosting it from $21 a share. The big database company appears to be betting that the prospect of a potential drop in the value of PeopleSoft's shares will persuade institutional holders to tender their shares.

PeopleSoft executives said they would be willing to discuss an offer but indicated they would hold out for well above $24 a share. Any offer from Oracle must reflect "the fact that PeopleSoft is materially more valuable to Oracle now than it was when Oracle made its inadequate $26-per-share offer" in February, said director A. George "Skip" Battle, chairman of PeopleSoft's transaction committee.

Oracle fired back, reiterating that its board had concluded $24 was the "absolute maximum" that it is prepared to pay. "Beyond that, there are better uses of our capital, including other acquisitions and repurchasing our own shares," said Larry Ellison, Oracle's chief executive officer.

The shareholders' will remains unclear. Clark Chang, an analyst for Fulcrum Global Partners, noted that the stock price hasn't fallen sharply, suggesting that holders feel a deal may get done.

At 4 p.m. in Nasdaq Stock Market trading, PeopleSoft shares were off 23 cents at $22.79. Following the announcement, in after-hours trading, they eased to $22.45.