Thursday, September 28, 2006

Specter of Divergent Interpretation Haunts Basel II and IFRS

As the implementation dates for the new Basel Capital Accord grow closer, concern is also growing over a number of issues connected to the multi-jurisdictional implementation of Basel II. Since the US is implementing the accord after the European Union, there are timing issues. Of more lasting concern, however, are issues relating to differing interpretations of Basel II down the road. These issues were recently discussed by Financial Services Authority Chairman Callum McCarthy in speech given in Singapore.

What the chair called the ``striking difference’’ between the EU implementation of the new accord in about three months and the US timetable of Jan 1, 2009 can be worked out, in his view, since it is a transient difference. For EU financial institutions with substantial US operations, he continued, there will be complexity and costs. But, again, since the timing issues are transient, the impact is not that great.

A far more serious concern is that different interpretations of the accord in different jurisdictions could threaten the consistent convergence of Basel II. If I may be permitted to make an analogy, this concern strikes me as very similar to the fear of the IASB that differing interpretations of international financial reporting standards will ultimately defeat the effort to converge financial accounting standards. Since about 100 countries have adopted IFRS, including the EU, this is a real fear. As the IASB wrestles with how to combat this menace to convergence and consistency, the FSA chair’s remarks on the issue have import beyond the implementation of Basel II. I will go further. I believe that the specter of differing interpretations is the greatest threat to consistent IFRS, as well as Basel II.

In the senior official’s view, when the FSA is the primary regulator of financial institutions with activities in other jurisdictions, such as the US, the FSA will not start with the presumption that its interpretation must be applied throughout all the groups comprising the financial institution. Instead, the FSA will seek to incorporate the judgments of US regulators in its assessments, so long as the FSA has confidence in them. This approach strikes me as eminently reasonable. Admittedly, the determination of whether the confidence level in the non-UK regulator is sufficient to allow incorporation is a subjective one. Perhaps, in future remarks, the chair can set forth some objective guidelines to aid in this determination. But, that said, he has made an important contribution to this debate, which is crucial to the consistent global application of financial standards.

Wednesday, September 27, 2006

Strong Enforcement Is Condition Precedent of Principles-Based Regulation

The drive for principles-based regulation is becoming inexorable. From Sarbanes-Oxley to the European Union to the SEC to the IASB, and even to FASB, there is almost universal support and striving for this Holy Grail of regulation. Recently, John Tiner, the chief executive of the UK Financial Services Authority delivered remarks that were really about the philosophy of financial regulation. In that context, he had some very interesting things to say about principles-based regulation. Importantly, he emphasized that strong enforcement is a fundamental counterweight to the freedom that comes with a principles-based regulatory system. And he is absolutely correct in this brilliant observation. It is really a warning that principles-based regulation is not going to be easy.

Make no mistake; the FSA is a firm advocate of principles-based regulation. But, according to the chief executive, both regulator and regulated must be bold enough to accept some uncertainty and ambiguity in the new regime and manage consequent legal risks for the good of the financial markets. There must also be a good degree of trust between the regulator and the regulated and the regulator must have the market insight to make good judgments. Realistically, the former CESR-Fin chief believes that there will always be a combination of principles and detailed rules in the regulatory tool box.

The senior official also points out that both regulators and the regulated community finds a sense of safety and security in detailed rules that define the scope of their legal exposure. I believe that is a true statement. And I will go further. I believe, as some other regulators have said, that many people advocate principles-based regulation but, at the end of the day, they want the certainty of prescriptive rules. This is a very important debate that goes to the very heart of financial regulation. It will not be resolved any time soon. But John Tiner, one of the most thoughtful financial regulators on the planet, will have an important role to play in the debate.

Tuesday, September 26, 2006

Aussie Central Banker Views Geithner Hedge Fund Speech

The remarks on hedge fund regulation by NY Fed chief Timothy Geithner have created quite a buzz. I blogged about these seminal remarks and the Wall Street Journal has carried at least one article about them. Now, Glenn Stevens, Deputy Governor of the Reserve Bank of Australia has responded to Geithner’s remarks. Generally, the deputy governor generally agrees with the remarks but has his own unique take on some matters. For example, while all who examine hedge fund regulation sing the mantra that at least the funds help with liquidity, Stevens is skeptical of the conventional wisdom that hedge funds add to liquidity.

Liquidity means being able to change a position without affecting the price, explained the senior official, and depends on someone being prepared to make a price. Hedge fund activity adds turnover, he continued, which probably means that in good times there is more incentive for price makers. But under conditions of pressure, he concluded, leveraged investors are more likely to need to use the liquidity of the market than be able to contribute to it. When liquidity is most needed, he exclaimed, hedge funds are liquidity takers not providers.

Saturday, September 23, 2006

UK Shows the Way on Hedge Fund Regulation

Regulators need to engage hedge fund managers and the brokers who service the funds in a number of critical areas without actually regulating the hedge funds themselves, in the view of Hector Sants, Managing Director of Institutional Markets at the UK Financial Services Authority. In remarks at an IOSCO meeting in Shanghai, he outlined five areas for regulatory attention: market disruption, insider trading, operations, valuation of illiquid instruments; and the preferential treatment of selected investors.

While the senior official assured that the FSA does not seek to regulate the funds themselves, he emphasized that risks can be mitigated through existing authority over hedge fund managers and firms providing prime brokerage services to the funds. With this in mind, the FSA set up a center of hedge fund expertise in October 2005, with a priority to enhance oversight of 31 of the largest UK hedge fund managers. The FSA is in regular contact with the firms and conducts periodic risk assessments to develop individual risk mitigation plans with them. Lower impact firms are subject to baseline monitoring through regulatory returns and other types of alerts.

Turning to the specific problem areas and the FSA’s response, the director noted that the failure of a highly exposed hedge fund could cause serious market disruption and erode confidence in other hedge funds and counterparties. In response to this threat, the FSA established a regular six month survey on the exposures to hedge funds of the London-based banks that provide prime brokerage services in order to gather data on the exposures of the firms to major hedge funds, either via prime brokerage or via the trading of OTC derivatives.

The survey targets the largest prime brokers with two main data requests, with the first looking at their credit exposures to hedge funds, while the second focusing on the prime broker business. This effort has advanced regulatory discourse with firms with large risk exposures and encouraged the improvement of risk management systems in the prime brokers themselves. The FSA is also working with the banks on collateral and margin arrangements.
New CESR-Fin Head Calls for Accountants Discussion and Analysis

In a wide-ranging and thought-provoking address on the role of outside auditors, Paul Koster, the chair of CESR-Fin, advocated a new section in the annual report entitled the accountant discussion and analysis (AD&A), to be modeled on the MD&A. In recent remarks, Mr. Koster, who is also a Member of the Netherlands Financial Markets Authority, also advocated a total disconnect between audit and non-audit services performed by the independent audit firm. Member Koster recently replaced John Tiner as chair of the Committee of European Securities Regulators-Financial.

This is a very interesting concept, and, come to think of it, if we have an MD&A and now a CD&A, why not an AD&A so that the independent auditor can tell its story in a plain English narrative. In the new AD&A discussion, as envisioned by Mr. Koster, the accounting firm would be required to describe, in its own words, the company’s financial environment, explaining the key ratios, the financial performance, how margins could be improved and what additional auditing the firm has performed in that regard. The AD&A would also include the audit firm’s own explanatory notes on the governance environment and its experience of it, particularly the workings of the audit committee, and the matters requiring attention in the coming years such as the tax position, as well as an assessment of the risk management system and its evolution.

Member Koster also envisions the AD&A providing a better understanding of the workings of the audit committee and explanatory notes on the additional tasks that the auditor has carried out in light of findings and financial developments with regard to competitors, as well as explanatory notes on accounting policies and the choices made in that regard. In his view, the outside accountant is in a better position than anyone else to communicate in this way; and the disclosure will also create value added for the financial market.

Wednesday, September 20, 2006

UK Senior Official Warns of Risk Management Problems with Derivatives

In seminal remarks, Thomas F. Huertas, Director of Wholesale Firms and Banking at the UK Financial Services Authority said that the dramatic increase in hard-to-value illiquid derivatives threatens to overwhelm risk management practices at financial institutions. This is one of the best speeches that I have seen on managing the risk of derivatives.

Customized derivative products tend to be illiquid, noted the director, and they account for a high proportion of the value of derivatives on a bank's balance sheet. Since correct valuation is a cornerstone of risk management, he reasoned, this illiquidity makes risk management more difficult.

Interestingly, he observed that recently there have been instances of mismarking by traders of their derivatives books, leading to large losses for the banks involved. And, in the context of the discussion of best execution under MiFID, the industry is reported to have asserted that it cannot create benchmark prices for derivatives as they tend to be one-off products with no market. But if there is no market, questioned the director, how do firms mark to market and how does the industry value derivatives. More importantly, there is the issue of how regulators can be sure that firms are in fact valuing derivatives adequately for risk management purposes.

In an effort to answer these questions, the FSA conducted a hypothetical portfolio exercise with a number of investment banks. It is extremely noteworthy that this exercise revealed a wide dispersion in the value at risk that firms considered themselves to have in connection with an identical portfolio of structured derivatives. Separately, the director said that the FSA expects to provide a statement of good practice to the industry early next year; as well as to take action against firms that are not employing proper valuation techniques.

Tuesday, September 19, 2006

International Seminar Discusses Reasons for Fewer US Listings

In addition to the usual reasons given for the decline in US equity listings, such as the Sarbanes-Oxley mandates, a panel discussion at the International Bar Conference ongoing in Chiacgo cited other factors that are contributing to the intense listing competition and a senior SEC official applauded the emergence of an overseas equity culture. For example, Philip Boeckman, of Cravath, Swaine & Moore’s London office, noted the rise of deeper and more liquid markets outside the US, which means that a US listing is no longer needed for a successful distribution. Another factor cited by the panel is that US investors are willing and able to invest overseas, while still another is that US research analysts are now based in overseas locations. An important factor mentioned was that there are generally lower underwriting fees outside the US.

Another reason for the decline in US listings is the availability of sufficient alternatives that offer good access to emerging market investors. In this context, panelists mentioned the alternative investment market (AIM) of the London Stock Exchange, which is an international market for smaller growing companies with a pragmatic approach to regulation.

Paul Dudek, Chief of the SEC’s Office of International Corporate Finance, noted that the level of offshore equity markets and the spread of the equity culture is a good thing. Eventually, it will mean increased disclosure and sound corporate governance since investors will tolerate neither inadequate disclosure nor poor governance. According to the SEC official, any global forum shopping will not result in a regulatory race to the bottom. If anything, he believes that the worst case scenario is a race to the middle.

Sunday, September 17, 2006

Risk Management Not Total Answer to Hedge Fund Oversight

I have consistently taken the position that any collective entities that account for 50 percent of the equity trading on the NYSE on any given day should be subject to federal regulation. I am referring to hedge funds; and I want to cite a recent speech by Timothy Geithner, President of the NY Federal Reserve Bank, regarding hedge fund regulation. I view Mr. Geithner as one of the most thoughtful and insightful of regulators. His remarks are always very substantive.

In remarks before the Hong Kong Association of Banks, the senior official said that the Fed and other regulators will have to adapt the current regulatory framework to protect against systemic risk. As the size and importance of hedge funds increases, he continued, distress among financial institutions can have a greater impact on the markets and potentially increase risk. Although for the present, the central banker is content to improve regulatory incentives in an effort to make counterparty discipline more effective, he holds out the option that regulation may be needed, and it would have to be globally coordinated.

What is most interesting about his remarks is the view that risk management, while it is improving, cannot be the final answer on protecting against systemic risk in this area. One problem is that, just as generals are often accused of preparing to fight the last war, risk management tends to chase measures of direct exposure implicated in past crises. Another problem with relaying primarily on risk management is that individual firms may see only a piece of the hedge fund’s positions and, if their direct exposure to the fund is small, may perceive less need to worry about the overall risk profile of the fund. And public disclosure requirements designed to compensate for this information problem do not exist

The remarks of the NY Fed chief have been widely reported. But I think that the most important signal being sent here is that the mantra of risk management cannot be used to block federal regulation of hedge funds. We are well beyond the point where individual risk management initiatives will suffice.

Thursday, September 14, 2006

Audit Committes Cannot Ignore the PCAOB

Although the PCAOB has no authority to regulate audit committees, the Board and its staff interact with audit committees in a variety of ways that may not be readily apparent. At a Practising Law Institute seminar in Chicago today Mary M. Sjoquist, special counsel to the Board, outlined areas in which the Board and audit committees interact.

For example, the audit committee should ensure that the company’s outside auditors are registered with the PCAOB. Why? Because the filing of financial statements audited by an unregistered firm would constitute a violation of SEC rules and may cause the Commission to deem the financial statements to be unaudited. In addition, as part of reviewing audit engagements, the Board examines auditor-audit committee relationships. Sometimes, the inspection staff interview audit committee chairs to assess the accounting firm’s relationship and communications with the audit committee. This is not that onerous because the interviews are usually conducted by telephone. Inspectors are not trying to assess the audit committee, assured special counsel, but instead they are trying to get a handle on the auditor—audit committee relationship.

Wednesday, September 13, 2006

Minister Says UK Will Legislate to Protect ``Light Touch'' Regulation

More evidence that securities regulation in the UK and the EU generally are diverging from US federal securities regulation can be gleaned from speech by UK Economic Secretary Ed Balls in which he said that the government would legislate to protect the light-touch, risk-based regulatory regime under which the London Stock Exchange and its members and issuers operate. Light touch financial regulation is a term of art in the UK. It envisions a test under which the first question is whether the new regulation is needed. If the regulation is found to be needed, then there must be assurances that it will be implemented in a sensitive and light touch manner. The British firmly believe that their system of light touch regulation gives the UK a huge competitive advantage in attracting capital.

It does not take a genius to figure out whose system is counterpoised to the light touch regime. Yes, it is the US. Mr. Balls, who is City Minister, proudly asserts that the UK correctly resisted pressure for heavy-handed responses to corporate scandals. The minister flatly stated that Sarbanes-Oxley would have been wrong for Britain. Instead, he emphasized that the UK crafted a measured, proportionate response.

The minister explained that the proposed legislation would confer a new and specific power on the FSA to veto rule changes proposed by exchanges that would be disproportionate in their impact on the pivotal economic role that exchanges play in the UK and EU economies. It would also outlaw the imposition of any rules that might endanger the light touch, risk based regime that underpins UK market regulation. But the minister assured that nothing in the legislation would have any consequence for the nationality of the ownership of UK exchanges. It will neither make overseas ownership easier nor more difficult.

Tuesday, September 12, 2006

CalPERS, TIAA-CREF Defend Constitutionality of PCAOB

In a powerful amicus brief, national public interest groups have strongly defended the constitutionality of the PCAOB. The Council of Institutional Investors, CalPERS, and TIAA-CREF, among others, asserted that the PCAOB sits firmly and comfortably within the long-established constitutional framework of the modern administrative state. In a brief of broad themes, amici contended that the PCAOB incorporates the lessons learned through decades of experience with a deficient system of self-regulation in the accounting profession. In addition, the interest groups emphasized that the Board was carefully designed and given enough authority to carry out its mission while at the same time subjected to sufficient checks to preserve public confidence that investor interests are at the heart of that mission. Ira Millstein and former SEC Commissioner Harvey Goldschmid were of counsel on the brief.

An essentially broken self-regulatory regime creaked toward the new century as nominal overseer of an accounting and auditing profession that was being radically transformed, argued the brief. As audit fees declined, noted the interest groups, audit firms began offering a lucrative mix of non-audit services that threatened auditor objectivity. Enron and other major business frauds confirmed beyond any doubt the inability of the vintage self-regulatory system to effectively supervise the present day accounting industry. At the same time, there arose the legislative will to create the independent and publicly accountable PCAOB with real power to inspect auditors and enforce compliance.

Monday, September 11, 2006

SEC Will Move Quickly to Amend Shareholder Proposal Rule

The SEC has definitely decided to quickly amend the shareholder proposal Rule 14a-8 in light of a recent Second Circuit panel opinion. The proposed amendments will be announced at an open meeting on October 18.

The federal appeals panel ruled that a shareholder proposal seeking to amend a company’s bylaws to establish a procedure by which shareholder-nominated candidates may be included on the corporate ballot does not relate to an election within the meaning of Rule 14a-8 and thus cannot be excluded from proxy materials. The opinion raises the specter of non-uniform ad hoc proxy access bylaw proposals. This fearful scenario strikes at the basic principle that national securities markets demand uniform federal regulation.

I expect that the SEC will move very quickly to adopt this proposal after a short comment period in order to assure the nationwide application of Rule 14a-8. Indeed, Chairman Cox has promised that the final rule will go into effect in time for the 2007 proxy season.

Rule 14a-8 is an ancient rule (1942 adoption) that attempts to strike the proper balance between the shareholder’s right to engage in corporate democracy and a company’s desire not to spend time and money considering shareholder proposals lacking any substantial nexus to the company. Rule 14a-8 was completely overhauled in 1998 and recast in a novel Q&A format.

Saturday, September 09, 2006

Why Not Just Adopt IFRS for US Company Financials

Given the sturm und drang over the convergence of US GAAP with international financial reporting standards (IFRS), would it not be easier to just adopt IFRS for the financial statements of US public companies and move on. After all, about 100 countries around the world have adopted IFRS and only one country uses US GAAP. This solution would short circuit years of looming debate over how to converge IFRS and US GAAP and allow for the use of a single set of accounting standards for all financial statements in the US and European Union. And, fear not, IFRS has a very competent standard-setter in the International Accounting Standards Board (IASB). But therein also lies the problem.

At a recent SEC Institute seminar, Herschel Mann, KPMG Professor of Accounting at Texas Tech University posed the question and then answered it. Short answer: it ain’t gonna happen. One reason given by Professor Mann is partly political, in that it would not be politic to have the accounting standard-setter for US companies be the London-based IASB instead of a certain standard-setter located in Norwalk Conn. I completely agree with his position. I firmly believe that we are embarked on a road to the convergence of IFRS and US GAAP and, while the road may get rough at times, there will be no shortcuts to the destination.

Thursday, September 07, 2006

Appeals Court Rules in Favor of Proxy Director Access Proposal

In an important ruling, a federal appeals court panel (CA-2) has ruled that a shareholder proposal seeking to amend a company’s bylaws to establish a procedure by which shareholder-nominated candidates may be included on the corporate ballot does not relate to an election within the meaning of SEC proxy rules and thus cannot be excluded from corporate proxy materials. The proxy access bylaw proposal would amend the bylaws to require the company to publish the names of shareholder-nominated candidates for director positions together with any candidates nominated by the board of directors. (AFSCME v. American International Group, Inc).

The appeals court ruled that a shareholder proposal does not relate to an election under the exclusion if it simply seeks to amend the corporate bylaws to establish a procedure by which shareholders are entitled to include in the corporate proxy materials their nominees for the board of directors.

The SEC has proposed Rule 14a-11 to establish a process by which the shareholder proposal mechanism, subject to heightened eligibility requirements, may be employed to adopt a proxy access rule that is uniform across companies. The court recognized that its holding facilitates a process for adopting non-uniform proxy access rules that are less restrictive than that created by proposed Rule 14a-11. If the Commission ultimately decides to adopt Rule 14a- 11, then such an action, although certainly not necessary, would likely be sufficient to modify the interpretation of Rule 14a-8(i)(8) that the court adopted.

Reacting quickly to the court’s ruling, the SEC announced that the Division of Corporation Finance will recommend an amendment to Rule 14a-8 concerning director nominations by shareholders. Chairman Cox said that important shareholder rights in the proxy process are best secured under a consistent national application of Rule 14a-8 to shareholder proposals. Therefore, to provide certainty with regard to shareholder proposals in every judicial circuit, he has directed the staff to prepare recommendations for revisions to Rule 14a-8 that will assure its consistent nationwide application.

Wednesday, September 06, 2006

Don't Blame Tax Code for Options Mess

The Senate hearings on the backdating of stock options has cast into stark relief what I was blogging about recently. I have taken the position that the only legitimate use of stock options is to align the interest of company employees with the interest of the owners of the company, the shareholders. The need to do this came about, as Professor Berle noted, with the divorcement of corporate ownership from corporate management and the rise of the professional managerial class.

At the Senate Banking Committee hearings, SEC Chairman Christopher Cox gave an example of backdating as being when an executive is granted an in-the-money option with an exercise price lower than that day’s market price. This is done by misrepresenting the date of the option grant, to make it appear that the grant was made on an earlier date when the market value was lower. The purpose of disguising an in-the-money option through backdating is to allow the person who gets the option grant to realize larger potential gains without the company having to show it as compensation on the financial statements.

Under this scenario, the option does not pass the test I enunciated above. It does not align the interest of the executives with the shareholders, who obviously cannot backdate. We have to keep our eye on this ball.

One of the biggest red herrings in this entire debate is to blame the federal tax code for the proliferation of backdating. Since 1993, the Internal Revenue Code has limited the deduction companies may take for compensation paid to certain executive officers to $1 million, which presumably set off many contortions to try to get executives more compensation. But the tax code excludes performance-based compensation from this limit. And, stock option compensation may be treated as performance-based when the exercise price is equal to or more than the grant date’s market price. In which case, the interests of the executive would be aligned with those of the shareholders. Thus, the IRC does allow for the legitimate use of stock options and always has.

Tuesday, September 05, 2006


Good Disclosure Linked to Good Corporate Governance


There is a direct link between good disclosure practices and sound corporate governance, noted New Zealand Securities Commissioner David Jackson, and what academics call the ``informativeness of disclosure’’ can attract attention from analysts and ultimately drive market integrity. In remarks at the recent AIG Corporate Governance seminar, the commissioner observed that academic research has found that disclosure practices are an important link between corporate governance and market integrity and efficiency.

In what may be a case of first impression, the research found a strong correlation between the quality of governance in listed companies and how well informed the market is about those companies. The academics coined the term ``informativeness of disclosure’’ in an effort to quanity this link. Informativeness of disclosures is a variable that combines the frequency of disclosure with the actual utility of the disclosed information to market analysts, and the speed at which the information is reflected in stock prices.

By comparing the quality of corporate governance with the informativeness of disclosures, researchers concluded that better-governed firms are better at disclosure. More specifically, these companies made better disclosure of price-sensitive information and attracted more attention from market analysts. Moreover, the profit forecasts of those analysts tended to be more accurate than their forecasts for firms which had a lower corporate governance rating.

Sunday, September 03, 2006


SEC Defends Constitutionalty of PCAOB Against Court Challenge

It is not often that a full-blown constitutional issue intrudes upon the world of federal securities regulation. But such has happened with the challenge to the way members of the Public Company Accounting Oversight Board are appointed. The PCAOB was created by the Sarbanes-Oxley Act to essentially oversee the auditing of the financial statements of public companies and the audit firms that perform this function. The main constitutional attack on the PCAOB is that its members, of whom there are five, are principal US officers who must be appointed by the President with senatorial advice and consent. Instead, Sarbanes-Oxley commands that the SEC appoint the Board members.

In a joint brief with the Justice Department filed in federal district court for the District of Columbia, the SEC contended that the method for appointing Board members satisfies the Appointments Clause of the federal Constitution because the members are inferior US officers who can be appointed by Heads of Departments. In this regard, the SEC casts itself as a Department, with the commissioners as heads.

The issue really boils down to whether the Board members are principal or inferior officers of the United States. The SEC makes a strong argument for the fact that the members are inferior officers who report to their superior, namely the SEC. To bolster this argument, the SEC emphasized that it has pervasive review power over every final legal action that the Board takes. In addition to appointing the Board members, the SEC approves the PCAOB’s budget and all the rules and standards the Board adopts. Further, since it does not have subpoena authority, the Board must seek issuance by the SEC of a subpoena. I think that this is a compelling argument.

Sarbanes-Oxley also gives the SEC supervisory authority over the Board’s regular inspections of audit firms. Since Sarbanes-Oxley overwhelmingly gave the SEC plenary control over the PCAOB, concluded the Commission, it follows that PCAOB members are inferior officers and the SEC’s appointment of them is constitutional.