Thursday, November 30, 2006

Capital Markets Committee Urges Major Reforms

A high-level committee on reforming the US capital markets has issued a wide-ranging report making recommendations in many areas of federal securities regulation. The Committee on Capital Markets Regulation is an independent, bipartisan committee composed of 22 corporate and financial leaders from the investor community, business, law, accounting, and academia. The committee made a number of action recommendations on issues ranging from Sarbanes-Oxley internal controls, shareholder rights, SEC rulemaking procedures, market regulation, and enforcement. The report is 152 pages long and will be the subject of future blogs on discrete topics.

I consider this committee to be the equivalent of what the European Commission would call an expert group. This white paper is destined to be seminal and is highly likely to be the genesis of legislation and regulations. The committee posits that US markets are losing their competitiveness to foreign and private equity markets. There are a number of reasons for this, including differing legal regimes.

The committee does not recommend any statutory changes to the Sarbanes-Oxley Act, not even to section 404. But it noted that the implementation of the internal control mandates of 404 by the SEC and the PCAOB has produced a regime that is overly expensive. The report urges regulatory changes to the 404 regime, including a redefinition of materiality, more guidance from the PCAOB, and multi-year rotational testing permitted within an annual attestation.

The report concludes that the US, compared with other countries, is falling behind best practices in shareholder rights. In order to restore some balance, the group recommends that shareholders be given the right to approve poison pills in companies with staggered boards. The committee also approves of the trend toward the adoption of majority voting requirements.

The expert group is concerned about auditor liability and the concentration of independent audits of company financial statements in four audit firms. In light of the Arthur Andersen experience, the committee believes that criminal enforcement should truly be a last resort reserved solely for companies that have become criminal enterprises from top to bottom. Going where others have feared to tread, the committee urged Congress to carefully examine the case for caps on auditor liability or safe harbors to prevent the failure of another audit firm.

More granularly, the committee recommends specific changes in SEC rulemaking procedures, For example, the SEC should systemically implement and carefully apply a cost-benefit analysis of its proposed regulations. Rules should not only be evaluated initially at the front-end, but also should be reviewed periodically to ensure that they are achieving their intended effect at an acceptable cost.

With the passage of Gramm-Leach-Bliley and the advent of financial institutions offering a wide range of securities and banking products, there has been a welcome increase of cooperation between bank and securities regulators. Thus, the SEC is urged to apply more bank-like prudential regulation to broker-dealers and investment advisers.

On federalism, Congress is asked to improve enforcement coordination between the SEC and state securities regulators. The states should be able to pursue civil enforcement in the absence of parallel SEC action and the SEC should have the final say on settlements involving structural remedies of national importance.

Tuesday, November 28, 2006

FSA Chief Executive Examines Audit Concentration in Big Four Firms

Describing the high concentration of audit services in the Big Four accounting firms as barely tenable, FSA Chief Executive John Tiner still disfavors a cap on auditor liability. Rather, he applauded the UK approach to auditor liability that enables auditors to take advantage of proportionate liability. Proportionate liability has at least two advantages over liability caps, he said. First, it avoids the possibility that auditors would suffer unlimited claims in a disproportionate manner for events which were not totally in their control. Second, in the interest of fairness, auditors are still liable for any claims arising from their negligence. Mr. Tiner, the former head of CESRfin, is one of the most thoughtful regulators on the planet. He delivered his remarks at a recent IOSCO conference.

Noting that a failure of a Big Four firm is not inevitable, the chief executive suggested three ways in which the audit firms themselves could ensure they are taking sufficient action to mitigate the risks of such a failure occurring.

First, he said that the audit firms should review and continually assess their internal processes for ensuring that the quality of audit work meets regulatory standards, as well as the firm's internal standards. Second, audit firm operating structures must be examined. Third, audit firms should put in place effective governance and oversight of their global business activities.

Turning to a recent white paper presenting the vision of six international audit firms, which he dubbed the Big 4+2, the FSA chief expressed surprise that the paper underplayed concerns about audit concentration in the Big Four. From his perspective as a European securities regulator there is a great concern about audit market concentration. Re-badging the Big Four as the Big Six for the presentation of the report was not enough to assuage his concerns. For example, he noted that EU regulators are concerned about the impact on market confidence if one of the Big Four firms was forced to withdraw from the market.

Friday, November 24, 2006

New Senate Banking Chair Believes Independent Financial Statement Audit Key to Investor Confidence

Senator Christopher Dodd (D-Conn), the new chair of the Senate Banking Committee, has a long history of involvement in federal securities regulation, particularly in areas involving financial accounting and the audits of public companies. His main guiding principle has been that investor confidence in the accuracy of the outside audit of corporate financial statements is absolutely crucial to the successful functioning of the securities markets. In his view, transparent, accurate and unbiased financial information, and investor access to such, are the crucial ingredients for the proper functioning of free markets. Senator Dodd was a principal architect of Title I of the Sarbanes-Oxley Act, which created the PCAOB and endorsed the standard-setting role of an independent FASB under a secure funding scheme.

Over a number of years, Sen. Dodd has been either the chair, or the ranking Democrat, of the Securities Subcommittee of the Banking Committee. In that capacity, he has worked very closely on a variety of issues affecting the securities industry.

He believes that audit firms have a federal mandate to provide an accurate and independent audit of the financial statements of public companies. Acting on this belief, he has actively worked to strengthen the independence and objectivity of financial audits. At the same time, he believes that outside audits should be done by private audit firms, albeit with PCAOB and SEC oversight. He rejects direct federal audits of public companies by some government agency or a huge division within the SEC. (See Cong. Rec., Jan 23, 2002, p. S9).

In his view, the accounting and auditing profession deserves credit for the incredibly important role it has played in ensuring investor confidence by providing a seal of approval on corporate financial statements. But he has cautioned that, once lost, that trust is difficult, if not impossible, to recover, at least in the short term. He has said that conflict of interest, even the perception of conflict, undermines the confidence of the investing public.

As a precursor to Sarbanes-Oxley, Sen. Dodd introduced the Investor Confidence in Public Accounting Act of 2002 (S. 2004). The legislation would have created for the first time an independent regulatory organization to review audit quality and auditing standards under SEC oversight. It would have done other things as well, such as doubling the size of the SEC accounting staff and restricting accounting firms from providing non-audit services to a client while at the same time performing auditing services for the same client. It would also have banned any accounting firm from providing a public audit for a company whose CFO had worked for such firm in the previous two years. In addition, the bill clarified auditor independence standards.

Provisions in his bill were essentially incorporated into Sarbanes-Oxley, particularly the creation of the fully independent PCAOB. In addition the bill’s endorsement of an independent FASB secured by a steady funding source found its way into Sarbanes-Oxley. The new Banking Committee chair firmly believes that FASB should be the accounting standard setter. He rejects the idea that Congress should legislate accounting practices that the FASB would have to sanction. He described the idea that Congress would get into the business of legislating accounting standards as a ``frightening prospect.’’ He believes that FASB needs to remain independent and not be subjected to political pressure. See Cong. Rec., Jan 23, 2002, p. S10).

One issue that has greatly concerned Sen. Dodd is the independence of the outside auditor. He recognizes the inherent conflict in the fact that the auditor's compensation is paid for by the very company being audited. We cannot change that, he adds, but that is why independent and objective financial statement audits are so critical to investor confidence.

Thursday, November 23, 2006

Threat of Differing Interpretations Haunts IFRS

There is a growing chorus of concern that differing interpretations of international financial reporting standards will derail the IFRS train before it reaches the ultimate destination of a uniform global accounting regime for financial statements. The latest voice added to this chorus is that of IASB trustee Samuel A. DiPiazza, Jr., who is also CEO of PricewaterhouseCoopers.

In remarks to world standard setters, he feared that individual authorities will publish their own interpretations of IFRS, just as they did under their national GAAP. If regulators find it absolutely necessary to issue implementation guidance, said the trustee, they must ensure that such guidance is consistent with global interpretations. He emphasized that the goal is compatibility, equivalence and comparable results, not necessarily wholesale uniformity. His refusal to call for complete uniformity is consistent with the majority view that, even under IFRS, there will still be room for the stamp of national identity.

That said, it appears that a consensus is building among senior officials that the greatest threat to IFRS is a babel of differing interpretations of international accounting standards. With over 100 countries having adopted IFRS, and with the European Union having mandated IFRS, this is a very real worry.

For example, European Commissioner for the Internal Market Charlie McCreevy has emphasized that the great challenge of IFRS is to achieve the consistent application of standards and interpretations. Principles-based standards will not always give the same result in all situations, he reasoned, but they should give similar results in similar situation. With consistency in mind, the EU strongly believes that interpretations of IFRS should be made by the IASB’s International Financial Reporting Interpretations Committee. Importantly, he said that IFRIC must be staffed so that difficult interpretive issues can be timely addressed.

On a separate topic, Mr. DiPiazza said that the preparation of IFRS financial statements must move from crash projects using work- arounds to business-as-usual flexible systems generating IFRS-compliant data. He said that many companies managed to meet the 2005 deadline to publish their first IFRS financials only because they established dedicated project teams to work on the transition. In some cases the objective was met by deploying work-arounds, such as using spreadsheets to generate some numbers and disclosures. While that may have worked for the first year, he urged companies to migrate IFRS from the finance function to their business units. If they don’t do that, he predicted, there will be financial reporting control issues that could result in restatements.

Wednesday, November 22, 2006

PCAOB Member Issues Ringing Endorsement of 404 Internal Controls

On the eve of what is expected to be major SEC-PCAOB revisions to the internal controls regulations, PCAOB Member Charles Niemeier has set forth a vigorous defense of the internal control mandates of Sarbanes-Oxley. He has even found a new use for the outside auditor internal control reports, urging state boards of accountancy to use the reports to obtain information about the adequacy of internal accounting personnel. In recent remarks to the Nat’l Association of State Boards of Accountancy, he related that a leading cause of reported material weaknesses in corporate controls is a problem with in-house accounting personnel, including competency, training, and experience. Indeed, he continued, in both of the last two years approximately one-half of companies that have reported material weaknesses did so because of such personnel problems.

While making the by now obligatory reference to the high cost of the internal controls mandate, he said that Section 404 of Sarbanes-Oxley has produced real and measurable benefits on a number of fronts. For example, it has spurred companies to perform long-delayed maintenance on the internal controls, as well as assisiting companies and their auditors in predicting the risk of future financial reporting failure. The Member also posited that internal control reports are serving as an important tool to expose material misstatements in past and current financial statements.

Monday, November 20, 2006

EC White Paper Proposes Reform of Mutual Fund Regulation

A European Commission white paper proposes a barrier-free market for investment funds that will ensure investors receive cost and performance discl+osures when they select funds. The white paper sets forth targeted reforms to the current EU framework for investment funds embodied in the UCITS Directive. It builds on a green paper issued in 2005 and reports from expert groups issued this year.

In addition to improving fund disclosures, the reforms would create a framework for the cross-border merger of funds, as well as for asset pooling. The proposals would also enable fund managers to manage funds domiciled in other member states. Further, the reforms would strengthen regulatory cooperation to monitor and reduce the risk of cross-border investor abuse. More broadly, the white paper sets out options for creating a private placement regime allowing financial institutions to offer investments to qualified investors across the EU.

The white paper embodies investor protection in a number of significant ways. For example, it commits the Commission to implement regulations ensuring that fund distributors put the interests of the end investor first when recommending or selling investment funds. The EC believes that fund selection should not be influenced by the level of commissions paid by fund managers to distributors.
UK Bill Would Give FSA Veto Power over Exchange Rules

A bill giving the Financial Services Authority veto power over rule changes by UK-recognized exchanges that would have a disportionate and excessive regulatory impact has been introduced by Treasury senior official Ed Ball MP. The Investment Exchanges and Clearing Houses Act is partially an effort to preserve the UK’s proportionate risk-based approach to regulation in the face of NASDAQ’s interest in acquiring the London Stock Exchange. The MP was confident that the legislation would ensure that the UK can maintain its approach to financial market regulation without imposing a disproportionate burden on the exchanges and clearing houses. In the UK and probably elsewhere, the phrase disproportionate burden is code for the Sarbanes-Oxley Act and particularly the Section 404 internal control mandates.

Under the bill, the FSA would not need to vet every single rule change proposed by an exchange or clearing house. The new power is intended to be a back stop. The bill would authorize the FSA to specify in its rules the kind of regulatory provision it needs to see, Mr. Ball explained, and to specify what it does not want to vet. He predicted that a great deal of the ordinary regulatory provision of the exchanges and clearing houses, the large majority of it, would not need to be vetted.

Fundamental to the bill is the principle that the government is blind to ownership of exchanges so long as the regulatory environment is protected. The legislation will apply to all UK recognized investment exchanges and clearing houses from the outset. It will not just apply after there has been a change of control and it will not apply only to those exchanges and clearing houses which are in foreign hands. The senior official assured that the new powers will not make foreign ownership of UK exchanges and clearing houses any easier or more difficult than it is at the moment.

Thursday, November 16, 2006

Finders
by Jay Fishman

Senior Writer Analyst, CCH, Inc.

An emerging “hot” topic in Blue Sky law is that of finders. A “finder” can be a broker-dealer or agent that introduces a customer to the broker-dealer or agent who will make the actual offer or sale of the issuer’s security to that customer. Similarly, a finder can be an investment adviser or investment adviser representative that introduces a client to an investment adviser or investment adviser representative who will provide the client with the actual investment advice. The question becomes what, if any, regulation should the state impose on the finder, i.e., the introducing broker-dealer or investment adviser.

The two states that have most recently adopted regulations on finders—in 2006—are South Dakota and Texas. South Dakota defines a finder as a person who directly or indirectly: (1) locates, introduces or refers any person to an issuer; (2) does not give investment advice about the advantages or disadvantages of an investment; (3) does not participate in any presentations or negotiations about any material term of an investment; (4) does not receive compensation based on the amount of any investment made but may otherwise receive compensation, with the compensation contingent on a potential investor actually investing; and (5) does not receive any compensation unless the amount is disclosed by the issuer to the investor before the sale of any security. A "finder" does not include a broker-dealer or agent. South Dakota allows a commission to be paid to a finder for soliciting prospective buyers in connection with the State’s intrastate limited offering transactional exemption. South Dakota has also determined that a commission paid to a finder does not violate the conditions of the state’s 25-purchaser limited offering transactional exemption.

Texas defines a finder as an individual who receives compensation for introducing an accredited investor to an issuer or an issuer to an accredited investor for the sole purpose of creating a potential investment in the issuer's securities. The finder is prohibited from negotiating the terms of the investment or from advising either party about the advantages or disadvantages of entering into the investment. An individual registered as a finder may not register in any other capacity but a registered general dealer may engage in finder activity without becoming separately registered as a finder. The activities, required disclosures and records for finders are specified. Finders are exempt from dealer supervisory requirements.

States that previously issued regulations on finders include Iowa and Michigan. An Iowa interpretive opinion from 2001 determined that investment adviser representatives, banks, attorneys, certified public accountants, broker-dealers, agents or insurance agents who refer clients to an investment adviser for no special compensation are excluded from the "investment adviser" definition but not from the "investment adviser representative" definition because the SEC definition of an investment adviser representative, relied on by the states, does not contain exclusions. Michigan defines a "finder" as a person who, for consideration, participates in the offer to sell, sale, or purchase of securities or commodities by locating, introducing, or referring potential purchasers or sellers but excludes from its “broker-dealer” definition a person acting solely as a finder and registered under the Michigan Securities Act or acting as finder incident to the state’s merger transaction exemption. Michigan’s definition of an investment adviser includes a person who acts a finder in conjunction with the offer, sale or purchase of a security.

California has solicited comments from the securities industry, due December 28, 2006, on how the state should regulate finders.


Tuesday, November 14, 2006



Why More States Have Not Adopted the Model Uniform Securities Act of 2002
by Jay Fishman

Senior Writer Analyst, CCH, Inc.

It has been four years since the National Conference of Commissioners on Uniform State Laws adopted the Model Uniform Securities Act of 2002 and yet since that time only 10 jurisdictions out of 54 have adopted it: Missouri (2003); Idaho, Iowa, Oklahoma, South Dakota (2004); Kansas, Maine, South Carolina, Virgin Islands (2005); and Vermont (2006). Hawaii and Minnesota are slated to adopt the Act in 2007 and Washington State in 2008. Adding fuel to the fire, the National Securities Markets Improvement Act of 1996 essentially told the states that their non-uniformity would be punished by federal preemption; the 1999 Gramm Leach Bliley Act evidenced the need to regulate the securities, insurance and banking industry altogether because of each industry’s escalating cross-over activities into the others’ territory; and globalization of the world economy came to prominence at the dawn of the Twenty-First Century. With all of these events converging over a short five-to-seven year period, one would think all the state securities commissions would eagerly adopt the Model Act to have in place provisions for regulating these new activities and to demonstrate a continuing move toward uniformity as proof to the SEC that any further federal preemption is wrong.

Yet an Act whose thoroughness largely succeeds in capturing today’s securities trends is still not adopted by a majority of jurisdictions four years after it’s adopted as a model act. Why? The primary reason comes down to two provisions and it’s most interesting—and ironic—because these provisions, while in a securities act, primarily impact the banking and insurance industries. As the impact has been seen as negative, the banking industry lobbied to strike the “banking” provision while the insurance industry lobbied to strike the “insurance” provision, resulting in both industries so far successfully stalling the entire Act’s passage in many jurisdictions that had considered adopting it.

Banking provision. The Model Uniform Securities Act of 2002 contains two banking provisions, one in the definition section and one in the exemption section. The provision in the exemption section is a modernized version of the old banking exemption from the 1956 Uniform Securities Act and is not particularly controversial.
The controversial provision is an exclusion from the definition of “broker-dealer.” A “broker-dealer” does not include, among other listed persons and entities:

“a bank or savings institution if its activities as a broker-dealer are limited to those specified in subsections 3(a)(4)(B)(i) through (vi), (viii) through (x), and (xi) if limited to unsolicited transactions; 3(a)(5)(B); and 3(a)(5)(C) of the Securities Exchange Act of 1934 (15 U.S.C. Sections 78c(a)(4) and (5)) or a bank that satisfies the conditions described in subsection 3(a)(4)(E) of the Securities Exchange Act of 1934 (15 U.S.C. Section 78c(a)(4)); an international banking institution; or a person excluded by rule or order issued under this Act.”

The above provision is controversial and seen by the banking industry as having a negative impact because it is more restricted than the broker-dealer definition exclusion for banks in the Securities Exchange Act of 1934. The 1934 Act excludes banks from the broker-dealer definition when they make private securities offerings under section 3(b), 4(2) or 4(6) of the Securities Act of 1933. The Model Uniform Securities Act of 2002 does not grant this exclusion from the definition of broker-dealer for banks. The other departure occurs with de minimis exclusion in the 1934 Act for banks that effect no more than 500 transactions in securities in any calendar year (other than transactions made under any of the other exclusions), provided these “no more than 500 transactions” were not effected by an employee of the bank who is also an employee of a broker or dealer. The Model Uniform Securities Act of 2002 limits this exclusion to unsolicited transactions.

Insurance provision. The insurance provision even more than the banking provision has been the single greatest reason for failure to adopt the Model Act in many jurisdictions. What makes this provision so contentious is that it revolves around variable annuities, a risky investment. As with the banking provision, there are actually two provisions in the Model Uniform Securities Act, one in the exemption section and one in the definitions section. The provision in the exemptions section is not particularly controversial. The controversial provision is in the definition section--it is an exclusion from the definition of a “security.” Specifically, the Model Act excludes from the definition of a security:

“an insurance or endowment policy or annuity contract under which an insurance company promises to pay a fixed [or variable] sum of money either in a lump sum or periodically for life or other specified period.”

Historically, variable annuities were regulated solely by the insurance industry but in the age of Gramm Leach Bliley, securities broker-dealers and agents have begun to sell these products to investors, causing a stir by the securities industry that now asserts its own right to regulate variable annuities. In truth, variable annuities can be great investments for persons in particular financial circumstances that favor them, but the complexity of these products combined with the high commissions on them create a conflict of interest for the sales representatives. The reps. have begun a practice of holding free lunch seminars to discuss variable annuities with attendees, resulting in many sales made to unsuitable persons. In the last two or three recent years this trend toward unsuitable has snowballed, with horror stories of people losing their life savings. Many of the victim have been senior citizens.

The fraud to seniors has escalated the fight by the securities industry for control of variable annuities. At the state level, the Model Act of 2002 was drafted to give states the option to include or exclude variable annuities from their securities definition. But the insurance industry has fought back with a huge lobbying effort to prevent states contemplating adoption of the Model Act from including variable annuities within their “security” definition, and this insurance industry effort has been largely successful because nine of the ten “adopting” states have adopted the Act with an exclusion for variable annuities. Furthermore, the insurance industry has stalled adoption of the entire Act in many other jurisdictions, e.g., Hawaii, because of the variable annuities provision. Whether the insurance industry will try to repeal the Act of the one state—Vermont—that does include variable annuities in its securities definition remains to be seen.

Sunday, November 12, 2006



UK Official Details Hedge Risks and FSA Response

The UK Financial Services Authority has identified six primary risks posed by hedge funds and is acting to defuse them. FSA Director of Retail Policy Dan Waters details the risks as market disruption, market abuse, operational, retailization, incorrect valuation of illiquid instruments, and transparency failures. In remarks at the recent AsiaHedge seminar in Hong Kong, he outlined the FSA’s response to these risks.

For example the failure or significant distress of a large and highly exposed hedge fund could cause serious market disruption. To counter this, the FSA established a regular six month surveys on the exposures to hedge funds of the main London-based banks that provide prime brokerage services. The aim of the survey is to enhance the FSA’s understanding of prime brokerage and to gather data on the exposures of the firms to major hedge funds, either via prime brokerage or via the trading of OTC derivatives.

With regard to the valuation of complex illiquid instruments, the director mentioned that IOSCO is developing good practice valuation policies and pricing procedures for hedge fund managers. There is a mandate to develop a single set of valuation principles with a reasonable level of granularity. IOSCO will be focusing on the existence of robust, written policies and procedures, the effective day-to-day operation of them, the role of the hedge fund manager, the role of independent parties in producing and/or verifying prices, and the adequacy of disclosure to investors.
Cox Endorses Single Joint SRO for NYSE and NASD

As the NYSE and NASD move towards the harmonization of their rules, SEC Chairman Christopher Cox envisions the further step to a single SRO at some time in the future. In recent remarks to the Securities Industry and Financial Markets Association, he said that the time has come for a significant restructuring of the self-regulatory model as exchanges consolidate globally and ownership structures change.

Although incremental changes over the years to the SRO system by the SEC and Congress have assisted the SROs in meeting their statutory duties, said Cox, incremental progress may no longer be enough. What may be needed is a fundamental reevaluation of the system of self regulation, which has never occurred since the establishment of the system.
The current system of multiple SROs is costly and inefficient, he emphasized, with multiple rulebooks, duplicative inspection regimes, and redundant staff. In addition, the increasing prevalence of cross-market trading is making it ever more difficult for multiple SROs to conduct market surveillance.

He did note that a major restructuring of the model has already begun. Earlier this year, the NYSE and NASD agreed to submit to the SEC proposed changes that would harmonize inconsistencies in their two rulebooks, as well as report to the Commission on which of the rules have not been reconciled. Chairman Cox reported that the resulting recommendations are being reviewed internally at the NYSE and NASD. He expects that the proposed rule changes will soon be filed with the SEC for the purpose of harmonizing the NYSE and NASD rules.
But ultimately this will not be enough. While rulebook harmonization will be an important step in reducing regulatory costs and improving investor protection, noted the SEC chair, it will not address the broader problems of conflicting enforcement and interpretations, or the potential for duplicative examinations, that result from having multiple SROs. Thus, he firmly believes that, until there is a joint regulatory entity, any progress will only be incremental.
International Audit Regulator Forum Created

An International Forum of Independent Audit Regulators has been created to share knowledge of the audit market environment and practical experience of independent audit regulatory activity. The forum will also promote regulatory collaboration and provide a focus for contacts with other international organizations that have an interest in audit quality. The PCAOB participated in the initial roundtable meeting as an observer. Other organizations that participated at the roundtable as observers were the Financial Stability Forum, IOSCO, the Basel Committee, and the European Commission.

At the initial roundtable, the independent audit regulators discussed a number of issues, including the methods audit regulators can employ to share the information necessary for their effective oversight. They also examined the drivers of audit quality and reviewed what audit regulators can do collectively to enhance the quality of audit. The roundtable also took note of the debate in the UK on competition and choice in the audit market and discussed the issues arising from it. Members of IFIAR will continue to exchange views on developments in this area from the regulators’ perspective.

The Forum appointed as inaugural chair Jeffrey Lucy, Chairman of the Australian Securities and Investments Commission, to serve for a one-year term. The Vice-Chairman will be Paul Boyle, CEO of the UK Financial Reporting Council, who will serve for a term of 18 months. The first full meeting of the IFIAR will take place in March 2007 in Tokyo, to be hosted by the Japanese Certified Public Accountants and Auditing Oversight Board (CPAAOB).
PCAOB Changes Implementation Period for Tax Service Rule

The PCAOB has adjusted the implementation schedule of a rule prohibiting audit firms from providing any tax services to persons in a financial oversight role at the company being audited. Rule 3523 applies to all tax services performed during both the audit period and the professional engagement period. The audit period is the period covered by any financial statements being audited, while the professional engagement period begins when the audit firm either signs the engagement letter or begins audit procedures.

The Board has decided to revisit the application of Rule 3523 to tax services provided during the audit period. While revisiting, the Board has adjusted the rule’s implementation schedule as it applies to tax services during the audit period. Specifically, the Board will not apply the rule to tax services provided on or before April 30, 2007 when they are provided during the audit period and completed before the professional engagement period begins.

Thursday, November 09, 2006

International Audit Firms Call for New Reporting Model and Int'l Audit Standards

In what may well become a seminal document, the CEOs of six international audit firms have called for a new corporate reporting model based on the Internet and digitization that can provide investors with real-time customized financial information. The new model would provide a mix of forward-looking non-financial information and historical financial information under a principles-based system. At the same time, the firms urged the FASB and the IASB to complete the harmonization of reporting standards, with a tilt towards the IASB’s principles-based regime. The six firms are the Big Four, plus Grant Thornton International and BDO International. The full text of the white paper is on the IASB website.

They also advocated the launching of a similar process to implement international auditing standards. The ultimate goal is the disclosure of reliable and timely information that can be compared across jurisdictions and that measures past performance and provides the best possible projections about future performance.

In addition, while recognizing that enforcement will also be impacted by national sovereignty, the firms urged auditors to minimize the national differences in the oversight of auditors and the enforcement of audit standards. The recently established International Forum of Independent Audit Regulators (IFAR) could be the vehicle to harmonized regulation. The audit firms are encouraged by recent statements from the PCAOB that it intends to join and actively participate in IFAR.

An underlying presumption of these goals is that the current system of auditor liability will be reformed so that audit firms are not the insurers of last resort for the markets. Entire firms should not be put a risk because of the conduct of some fraudulent actors.

Wednesday, November 08, 2006

Incoming SEC Oversight Chair Will Focus on Executive Compensation and Hedge Funds

With the Democrats having retaken control of the House of Representatives, Rep. Barney Frank is poised to become chairman of the House Financial Services Committee in the 110th Congress. From his record as the committee’s Ranking Member, it is expected that Rep. Frank will focus on executive compensation and hedge fund issues. He is also a strong advocate for the proper implementation of the Fair Fund provisions of the Sarbanes-Oxley Act.

Rep. Frank introduced a bill that would allow shareholders to approve their company’s executive compensation. The Protection Against Executive Compensation Abuse Act, HR 4291, would also allow for a company policy for recapturing any form of incentive compensation, such as when the company pays bonuses or grants stock options to executives for meeting performance targets only to later learn that these numbers were inaccurate and must be restated. Similarly, the bill would require that shareholders separately approve any additional ``golden parachute’’ compensation for top executives that coincides with the sale or purchase of substantial company assets. This provision is designed to empower shareholders to protect themselves from senior management’s natural conflict of interest when negotiating an agreement to buy or sell a company while simultaneously negotiating a personal compensation package.

Finally, the bill would require that companies include on their websites clear and simple disclosures on the company’s compensation filings made to the SEC. Rather than forcing shareholders to regularly monitor and decipher what Rep. Frank called the SEC’s ``arcane’’ EDGAR database, shareholders could get this information right on the company’s website.

Rep. Frank is also interested in hedge fund regulation. He was instrumental in getting the House to pass a bill directing the President’s Working Group on Financial Markets to conduct a study and report to Congress on the hedge fund industry. The Hedge Fund Study Act, HR 6079, has the support of House leaders and represents an effort by Congress to learn more about both the risks and benefits of hedge funds in light of their explosive growth. The bill has been received in the Senate and, in order to become law, would have to be passed by the Senate during the upcoming lame duck session of Congress.

One topic that must be analyzed in the study is the growth of pension funds that invest in hedge funds. Noting his concern about the interface between pension funds and hedge funds, Rep. Frank vowed to deal with the issue further next year.

Separately, Rep. Frank has introduced legislation, HR 5712, to authorize the registration and monitoring of hedge funds, effectively reversing a recent federal appeals court decision declaring arbitrary an SEC rule requiring hedge funds to register with the SEC if they had more than fourteen clients and managed a specific amount of assets. The bill would give the SEC clear authority to require registration and monitoring. The Investment Advisers Act exempts from registration investment advisers with fewer than fifteen clients. In Goldstein v. SEC, the appeals panel rejected the SEC’s suggestion of counting the investors in the hedge fund as clients of the fund’s adviser in order to get over the fourteen client limit. Specifically, Frank’s bill would authorize the SEC to interpret the term “client” to require the registration of advisers to funds that have more than 15 investors.
Rep. Frank has also shown great interest in the proper implementation of the Fair Fund provisions of Sarbanes-Oxley, which provided a new tool to help the SEC to return lost money to investors harmed by corporate wrongdoing. Rep. Frank released a report by the Government Accountability Office (GAO) that reviewed the efforts of the SEC and the CFTC to track and manage the collection and distribution of civil fines and ill-gotten gains from corporate wrongdoers. While the GAO report determined that the SEC has made progress in more effectively managing its collection of penalties and disgorgement funds and that it has successfully used the Fair Fund to collect money to help investors harmed by corporate misdeeds, the agency has encountered difficulties in expeditiously returning these funds to investors.
The incoming oversight chair called on the SEC to continue to focus on improving its administration of the Fair Fund and asked the Commission to identify additional legislative reforms needed to improve the implementation of the Fair Fund. He believes that the SEC needs to find ways to turn the Fair Fund into a more effective mechanism for returning funds to wronged investors, given the limitations of the law and the difficulties of identifying those injured by securities fraud. If the SEC needs additional statutory reforms to protect innocent investors, Frank stands ready to consider such changes.

Tuesday, November 07, 2006

SEC Enforcement Director Wants Consistent Process for Granting Options

The SEC’s Division of Enforcement is moving vigorously against the abusive backdating of stock options, noted Director Linda Chatman Thomsen in recent remarks, with over one hundred matters under investigation. The investigations are being conducted by SEC offices throughout the country and are being centrally coordinated and tracked in Washington. In addition, there is substantial criminal interest in options matters from U.S. Attorneys' Offices nationwide. The SEC does not expect to bring 100 enforcement cases regarding stock options, she noted, but is focusing on the worst conduct. That said, she indicated that more enforcement actions can be expected in addition to the four that have already been brought.

One reason that stock options grants became a monster, said the director, is that companies either abandoned or compromised their processes in granting options. Once released from a process designed to ensure legal compliance and fairness, she reasoned, stock option grants were allowed to ``run amok.’’ Also, many companies failed to comprehend that a stock option can be granted either in the money or at the money, but not both. You can take your pick, she emphasized, but you have to accept the consequences of your choice.

The director advised companies to devise a specific lawful process for granting employee stock options and always follows it. By following a standard options grant process, a company gets fair and transparent results, and there should be no random anomalies to explain. Further, in her opinion, the cost associated with creating a standard process for the award of stock options pales when compared with the costs of backdating to companies involved.

Sunday, November 05, 2006

Martin Feldstein Examines Corporate Governance

Recently, the eminent economist Martin Feldstein gave his views on corporate governance in an interview with the Minneapolis Federal Reserve Bank. He believes that the recent SEC and NYSE rules have strengthened the role of corporate boards in a good way. In his view, boards are working harder and treating themselves as more independent of management. Mr. Feldstein is a professor of economics at Harvard and chaired the Council of Economic Advisers during the Reagan presidency.

In his opinion, the most basic aspect of corporate governance is whether the outside directors meet alone on a regular basis. Not much happens during those meetings, he reasoned, but you have the meeting so you have a chance to say, without management present, “Well, how do you think management is doing? And what message should we give management that would make things better?”A board doesn't run a company, he explained, but it can provide useful feedback to management. He believes that aspect of board independence to be a useful. And when management is failing, he emphasized, a good independent board will force a change of management or even sell the company.

Personally, I think that it is good to have someone from outside the legal and regulatory community provide a perspective on issues such as corporate governance. It appears that Professor Feldstein believes that the most useful aspect of corporate governance is for the outside directors to provide independent advice to the company’s management after due deliberation outside of the presence of management or management directors. This benefit of sound governance has not, in my opinion, been paramount in the legal literature. His advice also raises the further issue of what constitutes a meeting on a regular basis, ie, once a month, once a week.

Friday, November 03, 2006

Study Shows Foreign Private Issuers Ready to Implement Sarbanes-Oxley

A study conducted by Mazars, a large international audit firm, reveals that the majority of surveyed foreign private issuers are prepared for the implementation of the Sarbanes-Oxley Act, including the sec. 404 internal control mandates. While the great majority of issuers said that Sarbanes-Oxley forms an appropriate response to their main risks, they also recognize the high cost of compliance. But despite what is seen as excessive costs, most foreign private issuers do not envision delisting from US exchanges.

According to the survey, Sarbanes-Oxley is well appreciated by foreign private issuers for its strong focus on major risks in internal controls. The Act has required firms to develop an internal strategy adapted to their needs, based on analysis and documentation of risks and internal control procedures for accounting and financial information. Interestingly, European companies are less pro-SOX than their Asian and South American counterparts. Further, with the exception of British and Dutch companies, the majority of European foreign private issuers wish to see an increased investment from European authorities in establishing common rules in terms of internal controls.

Wednesday, November 01, 2006

FSA Chair Says UK Will Not Have Only Principles-Based Regs

There is no prospect of the UK Financial Services Authority moving to a regime based exclusively on principles, noted Chairman Callum McCarthy, since there will always be a mixture of specific rules and general principles. The great policy question, in his view, is to find the correct balance of principles and rules. In recent remarks, he noted that there is a constant flow of new rules from the European Union and the trade associations, all in theory committed to principles rather than rules. Further, there is very often a contrast between the expressed wish of senior management to embrace principles and the concerns of their lawyers and compliance officers who prefer the certainty of rules. Thus, while the balancing will not be easy, said the chairman, the FSA is determined to achieve it.

The FSA chief said that senior management will play a crucial role as the FSA moves toward more principles-based regulation. The FSA expects them to think hard about the principles being adopted, not in terms of mechanics, but rather in terms of the outcomes the FSA is seeking.