Terry Stevens gathers reference books and a few family photographs for an elevator trip from the sixth floor to the fourth. Perhaps a dozen employees of Raleigh-based Highwoods Properties Inc. will join him there. They’ve got a lot of work ahead. Eleven-hour days, probably. For the next few months — what remains of 2005 — Highwoods has dibs on one day each weekend.
The company, a real-estate investment trust that claims to be the Southeast’s largest suburban-office landlord, has missed deadlines for filing its financial reports with federal regulators. The preceding year, it suffered the embarrassment of having to correct its income statement, and it’s about to do it again. Investors hate that. It suggests shaky, if not shady, hands at the helm.
Highwoods has avoided sharp, lasting drops in its stock price, but September has become October. Numbers for the latest fiscal year should have been out in March. If Highwoods can’t file by the end of the year, it could lose its listing on the New York Stock Exchange. Its stock would plummet. So would employee morale. About a week earlier, analysts at Baltimore-based Legg Mason had written in a report for clients and other investors: “We wonder what could cause a public REIT to be so administratively incompetent that it cannot fix its historical reporting over a period that now exceeds a year.”
As Stevens, Highwoods’ chief financial officer, and his team set up shop on the fourth floor, the company hopes to climb out of a pit any public company can stumble into. Accounting problems raise the specter of scandal even when they’re honest mistakes or differing interpretations of rules. Some people in and close to the company feel angry, frustrated and persecuted. It made mistakes, but so far nothing major has turned up — nothing to warrant more than a year in accounting limbo. The business is doing well, thanks to a resurgent economy, but it’s hard to get that message out in the absence of up-to-date financial statements.
Some think that its independent auditor, Ernst & Young, is pushing too hard, that the company is paying the price for the accounting industry’s troubles. In 2002, Arthur Andersen, a giant in the field, imploded amid charges it obstructed justice by destroying documents of its client, Houston-based energy trader Enron. That same year, Congress passed the Sarbanes-Oxley Act, tightening corporate governance and bringing greater scrutiny to accounting firms still reeling from Andersen’s collapse.
All summer and fall, the Highwoods employees working on the latest restatement have put in long days. Stevens and CEO Ed Fritsch worry about burnout. The group needs esprit de corps. It’s given a name, the Keep Us Listed Team — KULT — and special T-shirts. It needs a place to work undisturbed by the hurly-burly of buying, selling and managing buildings, so it moves to a vacant suite at headquarters, stocked with snacks and couches. A team from Ernst & Young occupies offices one floor up. As the deadline approaches, they work even longer hours. Finally, on Dec. 22, 2005 — just nine days before the deadline — Highwoods files its annual report for 2004.
The worst is over. But cleaning up the books has cost millions of dollars, consumed thousands of man-hours and left a bad taste in the mouths of people in and around the company. “When I get into that, I just want to throw up,” former CEO Ron Gibson says. “Because it’s a whole lot of hoo-ha about nothing.”
Highwoods owns all or part of 417 office, retail and industrial properties in 10 states — about 35 million square feet, roughly equal to five Pentagon buildings. Operating in a triangle formed by Richmond, Va., Kansas City, Mo., and Tampa, Fla., the 477-employee company derived most of its $410.7 million revenue last year from offices. When Stevens came aboard in December 2003, he had no idea anything was amiss. “I had the impression that this was a very well-run shop at the time. That was everyone’s view.”
“We never made a significant accounting decision without the full input and knowledge of Ernst &Young,” former CEO Ron Gibson says. “Not one.”
Gibson had started Highwoods’ predecessor in 1978, with about 100 acres in north Raleigh and the backing of five investors. Their goal merely was to become a player in the local office market. Exxon signed on as the first tenant the following year. In 1986, the company sold 14 buildings to the California Public Employees Retirement System for about $70 million. “It allowed us to expand our base,” Gibson says. “We became better capitalized with less debt.”
When Highwoods went public in 1994, Gibson discovered life in a public company wasn’t easy. It had cash to grow outside Raleigh but also had to hit quarterly targets and pay 90% of taxable income to investors. “It was absolutely necessary and the right thing for the company to take it public,” he says. “But it took a lot of the entrepreneurial aspects out of the business, and that was the part that I enjoyed the most.”
Assets expanded from $225 million in 1994 to $4 billion by 2000. Annual revenue grew from $34 million to $585 million, according to Highwoods’ original financial statements. Nobody knew it yet, but the company’s ability to do deals and boost revenue had outstripped its ability to account for them correctly. Highwoods dutifully compiled its financial statements; Ernst & Young reviewed and approved them. “We never made a significant accounting decision without the full input and knowledge of Ernst & Young,” Gibson says. “Not one.”
In May 2004, Highwoods received a letter from the U.S. Securities and Exchange Commission seeking clarification of parts of its previous annual reports. That didn’t cause much concern. “It’s a very common thing,” Stevens says. “About every two or three years, you can expect to get such a letter from the SEC.” But by midsummer, after discussions with Ernst & Young and the SEC, he realized Highwoods would have to delay its second-quarter filing and adjust its accounting for some sales in prior years. The company announced the delay and restatement to investors Aug. 4. It also said it had terminated discussions about “a possible strategic transaction,” which some analysts speculated was the sale of Highwoods itself to Malvern, Pa.-based Liberty Property Trust or Indianapolis-based Duke Realty. The company still won’t say what kind of transaction it was.
The SEC letter had asked about incentives Highwoods gave to buyers of its properties. In the late ’90s, it had started selling some assets acquired during its post-IPO shopping spree. Incentives included guarantees that tenants wouldn’t default on leases and options that could force it to buy back a property at the market rate at a specified time. In reviewing about 160 deals from ’98 to ’03, Highwoods discovered a handful of incentives so big that, by Stevens’ interpretation of generally accepted accounting principles — GAAP — it hadn’t transferred all the risks and rewards of ownership. It had to account for the transactions as financings, not sales. “We had to put them back on our books, so we had to add them back onto our balance sheet, and we also began to include the revenue and expenses and all the other operating aspects of those buildings on our books, as well,” Stevens says.
He and Fritsch had hoped to straighten things out by the end of the month. But as the accounting team and the auditors went through the books, they spotted other problems. Highwoods had restructured some debt in early ’03 and began expensing its costs over the term of the new loan. A closer look suggested they should have been expensed immediately. That decreased 2003 net income by $14.7 million. Highwoods also decreased its accounting expense for the shares of minority owners in its operating partnership, through which it conducts most of its business. That increased net income available to common shareholders. In November 2004, the company restated its earnings for 2001-03. Stevens and the auditors were confident they had covered all the bases. “Then the auditors turned and we turned, as well, to closing the books for ’04.”
They discovered still more problems. Some were minor and didn’t affect the bottom line, including lease incentives that should have been a reduction in revenue instead of a cost. They also noticed that slow paperwork had delayed booking costs for improving leased space, in some cases for several months after a tenant began paying rent. The team examined each lease, Stevens says. “At any one time, we probably have 4,000 leases across our company, so that became a fairly time-consuming process.” Because they would have to restate years prior to 2004 anyway, they decided to re-examine the books and see what else needed adjusting. For example, they decided to look again at how they handled interest and other costs associated with projects going back nearly to Highwoods’ IPO in 1994.
The restatements dropped net income 25 to 37 cents a share annually from 2001 to 2003; the restatement for 2004 didn’t alter net income. “When you look at ’02, ’03 and ’04 combined, the impact of all of these restatements, both sets that we went through, was a little over 4% of the overall net income,” Stevens says. “I’m not excusing it, but it didn’t change us from a big income to a big loss.” He can’t put a dollar value on the man-hours Highwoods spent, but its audit fees shot from $640,000 for the 2003 annual report to $7 million for 2004’s. It paid $2.9 million for the 2005 report and expects to pay a little less for this year’s.
Though Stevens insists it was worthwhile to get the books right, Gibson disagrees. “When you look at this restatement and everything that’s occurred and the cost to Highwoods and the net result to the shareholders, it is absolutely ridiculous what that company has been through, the way it was put through it, the suspicion and innuendo. And the net result is, there wasn’t much to it at all.”
Who’s to blame? Highwoods executives try to strike a noble tone. “They’re our books,” says Fritsch, who joined Highwoods in 1982, one year out of UNC Chapel Hill, and became chief operating officer in 1998. “We take sole responsibility for them.”
Part of the problem was success: the company’s expansion in the late ’90s. “When we grew so rapidly, I think we just got off track and did things not quite the way they should have been done, and those practices just continued,” Stevens says. “I think our staff often felt, ‘Well, what we’re doing wasn’t corrected by the auditors, and I guess it must be OK.’ And it turned out in hindsight that some of those things were not OK.”
Highwoods was slow to recognize it needed more muscle on its financial side. Until Stevens — a Wharton MBA who had been CFO of Johnstown, Pa.-based Crown American Realty Trust, director of financial-systems development for Morristown, N.J.-based AlliedSignal and an audit partner in Price Waterhouse’s Baltimore and New York offices — came in 2003, it had relied on a young, overworked CFO.
Carman Liuzzo was just 34 when he took the job in 1994. “He was doing investor relations. He was intimately involved in all the merger-and-acquisition activity and financial modeling. And he was also trying to be the CFO,” Fritsch says. “It was a lot.” Liuzzo is now vice president of investments. The company wouldn’t make him available for comment. Stevens says, “The ability of our accounting department to apply generally accepted accounting principles today is far, far better than it was in the past. We just have more people. We have more experienced people now.”
Fritsch is loath to blame Ernst & Young, though he allows “there were things that they changed their position on after more careful study.” Accounting firms must change the lead auditor on an account every five years. In early 2004, Mark Kaspar replaced Robert Thorburn on Highwoods’. Soon after, Ernst & Young seemed hell-bent on finding fault with the work it had done before, Gibson says. “They changed the lead auditor, and they came in and, lo and behold, they had a witch hunt within their own company.”
“I think we just got off track and did things not quite the way they should have been done, and those practices just continued,” Stevens says.
The accounting firm had been paid to keep Highwoods’ books out of trouble, Chairman Temple Sloan says, but it didn’t. “We have documented correspondence in our files that says, ‘This is the way you book something.’ Then they come along two years later and say, ‘No, that wasn’t right.’ Well, you’re sitting here in a world that’s not your top expertise and you depend on your CPAs to guide you through this stuff.”
Ernst & Young won’t comment on client matters, spokesman Charles Perkins says. But after Sarbanes-Oxley, accounting firms were fretting about the Public Companies Accounting Oversight Board, which the law set up to protect investors. Some auditors took the view that it was better to restate and risk alienating a client than wind up like Andersen. “They were scared to death,” says Dennis Beresford, a University of Georgia professor and former chairman of the Financial Accounting Standards Board. “They didn’t want the same thing to happen to them. They were extremely careful.”
Stevens defends Ernst & Young, saying the accounting rules involved could be reasonably interpreted in different ways. “I can’t deny that it’s a little bit frustrating that things that we thought we were doing OK turned out not to be done exactly right, but we all needed to do the right thing.”
In February, the audit committee of Highwoods’ board of directors dumped Ernst & Young and hired Deloitte & Touche as independent auditor. “Given what we had gone through with two restatements,” Stevens says, “I think there was a feeling that it was time for a fresh start.”
Despite its accounting woes, Highwoods’ stock stayed strong, dipping from about $26 in March 2004 to about $21 in May, when Highwoods received its first notice from the SEC. But the price rose above $25 later that year and, despite the dearth of financial information, rarely has slipped below that since. In 2005, it climbed above $30 for the first time since 1998 and kept going up. In late June, it reached an all-time high of $36.40.
Part of that is luck, Fritsch admits. The economy has been growing, and expanding companies need more office space. Also, Highwoods has made a point of communicating its progress — on submitting its filings and other parts of its business —- with Wall Street. Finally, the company has a map for success that analysts seem to like and has been hewing to it. That plan came from Fritsch. In 2003, Gibson, who turned 59 that year, told the board he planned to retire in ’04. Sloan asked Fritsch to take over as CEO. He agreed to but wanted to meet individually with directors and put together his own management team and strategic plan.
He meant no disrespect to Gibson. They are close. While a high-school student in Wendell, Fritsch did odd jobs for Gibson and spent nearly his entire career working for him at Highwoods. “I was fortunate to be able to run in his shadow and help support him in what he was doing. He’d give me just another foot of rope each day, and that’s how I was able to progress.” But they have different personalities. Gibson is blunt and opinionated. Fritsch is polite, self-effacing, deliberate and prefers to build consensus. “Ron was an entrepreneur,” Sloan says. “Ed is more of a manager.”
Fritsch developed his plan in characteristically methodical fashion. After talking with directors and staff, he decided that Highwoods needed to reduce debt, which meant selling properties. The proceeds also would finance new projects — buildings that are attractive to tenants and investors because of where they are, how they are built or how they are managed, not just because of the incentives that Highwoods offers to fill them.
When he became CEO in July 2004, the accounting problems postponed his plan, which didn’t go in effect until January 2005. Since then, selling older buildings has raised $510 million, exceeding the goal of $450 million by 2008. Highwoods has lined up $327 million of new projects, beating its target of $200 million, again ahead of schedule. One prize is rights to develop a 29-story skyscraper in downtown Raleigh, a place with more cachet than its typical suburban settings. The building will be home to RBC Centura bank’s headquarters, stores and 10 floors of condominiums.
The project was announced in December, as Stevens and his KULT were trying to wrap up the second restatement. Maybe when it opens in 2008 the problems will be faint memories for investors. Talk of the company selling itself heated up again in late June — it publicly spurned one offer — but the SEC still hadn’t closed its investigation, and the company likely won’t start filing financial statements on time until later this year.
Just after it filed its 2005 annual report, Fritsch went to an investor forum in New York, where he was congratulated. He appreciated it, he says, but wasn’t about to let it go to his head. “Saying congratulations on getting your ’05 filings done in early June is a bit like saying congratulations on getting out of detention. There are plenty of kids that didn’t have to go to detention.”