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Sarbanes-Oxley’s impact

GOVERNANCE RULES MULLED

BY DONNA MITCHELL

Retail real estate companies are striving to size up the impact of compliance with the Sarbanes-Oxley Act, passed in July 2002 to address corporate malfeasance. Proponents say that the law, which is being implemented in stages — rules are still being written — will do much to raise the credibility of companies in the eyes of investors, while critics insist that it does not go far enough.

Pretty much everyone agrees about one thing, though: Complying with Sarbanes-Oxley will be costly and time-consuming.

“It certainly increases the cost of being public,” said Kenneth F. Bernstein, president and CEO of White Plains, N.Y.-based development firm Acadia Realty Trust. “For small companies like Acadia, who have to watch every dollar we spend … $100,000 here and there adds up.”

Like other companies, Retail REITs are just starting to experience the costs of generating the documents and setting up the committees that compliance with Sarbanes-Oxley requires. It will be at least a year, REIT officials say, before they will fully know the financial impact.

Sarbanes-Oxley (named after Sen. Paul S. Sarbanes, D-Md., and Rep. Michael G. Oxley, R-Ohio) is meant to combat deceptive corporate practices, from accounting methods that mask fraud to the conflicts of interest that have plagued investment banking. The law requires corporations to verify disclosure of information and compliance with accounting standards.

Some provisions, such as toughened criminal penalties for fraud, were in force as soon as President Bush signed the law. Requirements that CEOs and CFOs certify periodic financial statements went into effect in August 2003. A section regulating internal controls of financial reporting was to take effect in September, but the Securities and Exchange Commission extended the deadline to June 2004, to give companies more time to establish the controls.

Among the mandates being phased in is one under which companies must create whole new internal audit regimes, including an audit committee consisting of independent directors and a financial expert. They also have to put a mechanism in place that makes it easier for auditors to verify proper procedures within the company.

Different companies are taking different approaches. Besides an audit committee, Acadia Realty has established corporate governance committees to identify qualified individuals to serve as trustees, recommend governance guidelines and lead an annual review of the board and of individual trustees’ performances, says Acadia Realty spokesman Jon Grisham. A new compensation committee will set appropriate compensation levels for senior management and trustees. Such checks and balances don’t come cheap, says Bernstein, but are important for all public companies.

Sarbanes-Oxley was enacted at a time when virtually every day there was yet another story about accounting trickery such as that at Enron Corp. and WorldCom. Both those companies filed for bankruptcy when their massive accounting-related losses could no longer be hidden.

For all this scandal, however, retail REITs have kept their dealings clean, for the most part. (In July 2001 JDN Realty, Atlanta, settled a $46 million class-action lawsuit accusing it of violating securities law through an improper compensation agreement.) The National Association of Real Estate Investment Trusts would not even comment on the law, saying it has no impact on REITs. The same can’t be said of all REIT tenants, though. Dutch supermarket chain Royal Ahold and Camp Hill, Pa.-based Rite-Aid have had to restate billions of dollars in earnings because of accounting irregularities.

In July 2000 Rite-Aid was forced to restate earnings downward by $1.6 billion, reported the Deseret News. At press time three Rite-Aid executives were embroiled in scandal, pleading guilty to numerous conspiracy charges. Former Chairman and CEO Martin L. Grass pleaded guilty in June to falsifying the drugstore chain’s books, defrauding stockholders and obstructing justice — all matters at the core of Sarbanes-Oxley.

Ahold first revealed accounting irregularities in February, as a result of internal investigations. As the company poked about further in its own books, it uncovered more falsification until, at press time, it had uncovered $1.1 billion in improperly booked profit. In early July, Dutch prosecutors raided the Zaandam, the Netherlands, offices of Royal Ahold as part of their own investigation.

Sarbanes-Oxley will help check such shenanigans, industry players hope.

“This requires us to pull together all the documentation in a form that could be audited,” says Barbara K. Baker, vice president of investor relations at Taubman Centers.

For companies that have long maintained high standards of financial accountability, the new law won’t seem so onerous, she says. “We’ve always had strong internal controls.” Taubman, for example, already has an independent audit committee and controls in place that ensure its accounting statements are accurate, she says. As part of those controls, multiple parties sign off on all cash transactions, and financial statements go through an extensive review. Internal auditors, in turn, make sure that the procedures are followed.

Sarbanes-Oxley also requires provisions by which employees can confidentially report accounting or auditing problems. Taubman maintains a special hotline for such purposes. The service, which is operated by an outside company, fields complaints from workers and conveys them to the auditing committee, Baker says.

Developers Diversified Realty is considering hiring a similar outside company to process such complaints from its workers, says Joan U. Allgood, the company’s senior vice president and general counsel. “I don’t think that is something anyone would have anticipated until Sarbanes-Oxley came into place.”

According to REIT officials, Sarbanes-Oxley does touch on the reporting of funds from operations, or FFO. Although FFO is widely used to help investors and outsiders measure a REIT’s performance, it does not conform to GAAP (generally accepted accounting principles), explains Tammy Battler, Developers Diversified’s manager of external financial reporting.

The Securities and Exchange Commission has agreed to recognize FFO as a measure important to the real estate sector. Now, however, to conform to accounting standards, REITs must reconcile FFO with some GAAP measure, such as net income per share. A REIT must present both numbers in its financial statements, with the GAAP interpretation presented equally or more prominently, says Battler.

Sarbanes-Oxley doesn’t have to go into great detail on the subject of FFO, Battler says, because as a mainly real estate industry accounting tool, its use is limited to a small percentage of public companies.

But Sarbanes-Oxley comes up short in other ways, says Bill Lynott, president of Lakewood, Colo.-based LandBank, such as environmental issues. Lynott argues that the law fails to require real estate companies to come clean about the contamination levels of certain properties. Normally, the extent to which a property is contaminated comes to light when the real estate company sells the property, or when two real estate companies merge, he says.

“Environmental liabilities are grossly underreported,” said Lynott, whose company buys brownfield properties to resell or to hold. “This [law] will not cause the dam to break, but there is a dam and pent-up water.”

The law does include, however, a clause requiring companies to disclose any liabilities that might cost a company more than $100,000 in litigation fees. If a company heeds Sarbanes-Oxley requirements, the threshold is low enough to flush out such expensive liabilities as ground contamination, proponents say.

“Most public companies are smart enough to know when to disclose information so that the public is not misled about various risks,” Acadia’s Bernstein opined.

Sarbanes-Oxley does not touch on another area that has been in the news lately: the special classes of stock that enable some holders to wield more control over companies than holders of common stock. Many retail REITs started as privately held companies run by families who, after going public, maintain voting control through special stock, even without holding a majority of shares. This issue lies at the center of the attempt by Simon Property Group and Westfield America to take over Taubman. In a lawsuit filed in December, Simon charged that the Taubman family holds an inordinate amount of voting power in the company, 33.6 percent, despite its 1 percent economic stake. The Taubman family obtained that power by obtaining preferred stock in 1998, something that Simon says was out of line. Simon executives could not be reached for comment on Sarbanes-Oxley.

The new law does not address the issue, nor should it, says James E. Maurin, chairman and CEO of Stirling Properties, a New Orleans-based development firm.

“We are more concerned about overcorrecting [corporate governance] and creating a witch-hunt mentality,” said Maurin. He says he doesn’t see any harm in companies issuing different share classes, which are usually created when a company launches its initial public offering and are fully disclosed to shareholders. If they are added post-IPO, shareholders have to approve them, he observes.

Still, Maurin says, the law is valuable to the industry by bringing REITs into line with other public companies. Because they don’t pay corporate taxes, REITs have always been viewed differently.

“To be able to maintain credibility in the public marketplace, REITs must meet the same standard as other companies with regard to corporate governance,” he said.

For all the money and effort REITs have expended complying with the law, their burdens are no heavier than those of other public companies, agrees Allgood of Developers Diversified.

“Yes, it has been difficult for REITs, but I understand it is something that everyone is struggling with,” said Allgood. “It has not been a wasted effort.”

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