Wednesday, January 31, 2007

SEC Staff Clears Use of Market-Based Stock Option Valuation Method

The SEC Chief Accountant will allow a company to use the future issuance of employee stock option appreciation rights securities (ESOARS) as a market-based approach for valuing employee share-based payment awards under FASB Statement No. 123R. The SEC staff emphasized that each ESOARS auction must be analyzed to determine whether it results in an appropriate market pricing mechanism. The analysis should determine if the auction clearing price is representative of the fair valuation of the underlying employee share-based payments. Factors that should be considered in determining whether an auction was an appropriate market pricing mechanism include, but are not limited to, the size of the ESOARS offering relative to market demand and the number of bidders.

The letter to Zions Bancorporation was signed by Chief Accountant Conrad Hewitt. It is interesting that the chief accountant emphasized the advantages of the market-based over the model-based approach. For one thing, a market-based value can efficiently reflect a consensus view among informed marketplace participants about an expense, asset or liability's utility and future cash flows. In a press release, Zions said that, in addition to using ESOARS securities for its own FAS 123R stock option valuation, it intends to advise other public companies and facilitate their use of ESOARS for this purpose.

Tuesday, January 30, 2007

UK Tribunal Finds Auditor's Judgment Reasonable on Going Concern Issue

A UK Tribunal has found that a Big Four audit firm’s opinion that there was not a significant level of concern on the client company’s ability to continue as a going concern was a reasonable judgment based on the evidence the firm had collected and assessed. Thus a complaint brought against the firm by the UK audit oversight authority was dismissed. The audit firm’s conclusion was within the range of judgments that might reasonably be reached by a competent auditor on the basis of what the auditor understood, said the Tribunal, adding that the firm gave the going concern issue the considered appraisal that it required. PricewaterhouseCoopers LLP

In a 4-1 opinion, the Tribunal also noted that the company had a strong and highly experienced board of directors that purported to consider the going concern issue with care and with the guidance of experienced counsel. Evidence indicated that no member of the board had serious concerns about whether the business was a going concern when they signed the financial statements. Although refinancing was an uncertainty, it was not a significant uncertainty. The complaint was brought by the Accountancy Investigation and Discipline Board, an arm of the UK’s audit oversight body. The Tribunal was drawn from a panel maintained by the Board.

Monday, January 29, 2007

FSA Chair Rejects Home Regulator Approach for Global Firms

Returning to a familiar theme, the chair of the UK Financial Services Authority has rejected the idea that the exclusive regulator of multi-national financial institutions should be their home country regulator. In remarks to the Estonian Financial Supervision Authority, Callum McCarthy called this approach a ``simple nostrum’’ that does not recognize the realities of the situation. While recognizing the legitimate desire of firms to avoid duplicative regulation, he noted that host countries in which financial institutions have branch operations or subsidiaries have duties that cannot be ignored.

For example, host regulators are accountable for the activities of a large financial institution within their jurisdiction. In his view, they cannot simply refer questions about those activities to a distant home country regulator. In addition, there are substantial differences between the legal powers granted to different regulatory organizations in different countries.

This issue is simply not going away as global financial institutions continue to develop and sophisticated regulatory regimes are involved. There are also questions of political will since the degree of independence of financial regulators is not uniform across the world, nor even within the EU. Finally, according to the FSA chair, there are questions of competence. It is evident that not all countries are able to devote the resources, or have the experience, to discharge all the responsibilities that might be expected of a lead regulator even with the benefit of some collaboration with host authorities.

The growing prevalence of large banks and securities firms operating in a number of countries has led to an effort to find the most efficient and effective means of regulating them. Under the lead regulator approach, the bank or securities firm is supervised by the regulator of the country where it is headquartered or has its principal place of business. The allure of simplicity attaches to this approach.

Even if a bank did extensive business in another country, the host country, it would still be exclusively regulated by its home country regulator. For example, while Deutsche Bank is one of the largest players in the U.K. market, its lead regulator would be the German BaFin. Similarly, U.S. global banks and securities firms would be regulated solely by the Federal Reserve Board and the SEC despite their substantial activities in the U.K. or Germany.

But the FSA chair has now consistently expressed strong reservations with allowing one regulator to have authority over a bank or firm that has a large systemic financial presence in a host country. In these and in earlier remarks, he has amplified the concern that different regulators have differing levels of power and resources to deal with global firms that may pose systemic risk in the countries in which they operate.

Saturday, January 27, 2007

Drumbeat for Auditor Liability Reform Continues with European Commission

The European Commission is the latest body or group to call for a cap on auditor liability. The Commission has proposed four possible options for reforming auditor liability regimes in the EU. This action follows an independent study on the economic impact of current auditors' liability regimes issued last year. A conundrum has arisen under which the increasing risks of auditing large public companies has been accompanied by a sharp decrease in access to insurance for auditors of international and listed companies, thus leaving partners in audit firms with the unattractive prospect of entirely supporting the liability risks themselves.

Here are the four options. First, a fixed monetary cap could be implemented at the EU level, but this might be difficult to achieve. Second, there could be a cap based on the size of the audited company, as measured by its market capitalization. Third, liability could be capped based on a multiple of the audit fees charged by the auditor to its client company. The fourth option is proportionate liability, which means that each party (auditor and audited company) is liable only for the portion of loss that corresponds to the party’s degree of responsibility.

Currently, a small number of EU members, including Germany, have a statutory limitation on auditor liability; and in the U.K. a bill currently reviewed by Parliament foresees proportional liability by contract.

A debate about possible reform of auditor liability is also underway in the United States. In late 2006, the Committee on Capital Markets Regulation set up by the US Treasury considered whether Congress should be invited to explore further protecting audit firms from catastrophic loss. Two approaches have been suggested: either creating a safe harbor for certain defined auditing practices or setting a cap on auditor liability in specified circumstances.

Thursday, January 25, 2007

Bloomberg-Schumer Report Focuses on Internal Controls

The recently released Bloomberg-Schumer report is a very wide-ranging and well written document that includes specific recommendations designed to make the US capital markets more competitive. While the report confirms the advantages of deep, liquid, transparent markets supported by strong investor protection, it also posits that it is critical to implement changes designed to make US financial markets more competitive. The report was commissioned by NYC Mayor Michael Bloomberg and Senator Charles Schumer.

There is much to ponder in the report, but I want to focus on specific recommendations directed at the SEC and PCAOB. The report finds it imperative that the SEC and the PCAOB adopt their proposed revisions to the guidelines controlling the implementation of the internal control mandates of sec. 404 of the Sarbanes-Oxley Act. The report wants these proposals to ensure that the audit of internal controls takes a top-down perspective, is risk-based, and is focused on the most critical issues. The guidance should also enable auditors and management to exercise more judgment and emphasize materiality.

Critical to achieving this goal is the correct revision of the definition of material weakness. In the report’s view, the PCAOB’s proposal to shift the standard for material weakness from one of “more than remote” likelihood to one of “reasonable possibility,” still leaves significant room for interpretive uncertainty. In the highly visible and litigious environment in which audit firms operate, reasoned the report, such uncertainty is likely to lead to costly risk-averse behavior, undermining the benefits of the regulators’ adoption of a risk-based standard. Therefore, to the extent that there is still room to provide additional practical guidance with regard to the definition of “materiality,” the SEC and PCAOB should, after analyzing the comments, provide such further direction.

With regard to the SEC and PCAOB proposals for small company compliance with the internal control mandates, only time will tell if the proposed flexible approach will sufficiently alleviate the burden of 404-related compliance on smaller companies. The report suggested that the SEC and PCAOB continue to monitor the situation and, if compliance costs for smaller public companies fail to come down sufficiently, they should consider additional means of addressing these companies’ needs. One possible avenue for relief would be to give smaller companies the possibility of opting out of the more onerous provisions of Sarbanes-Oxley, provided that they prominently disclose that choice to investors.

According to the report, this alternative would have the virtue of effectively providing smaller companies and their investors with the ability to determine whether the lower cost of capital stemming from incremental investor confidence, which is itself tied to the safeguards of Sarbanes-Oxley, outweighs the associated compliance costs.

Wednesday, January 24, 2007

SEC Issues Guidance on Restatements for Option Grant Accounting Errors

Carol Stacy, the chief accountant in the SEC's Division of Corporation Finance, has issued guidance for companies that must restate their previously issued financial statements to correct accounting errors relating to the issuance of stock option grants. The guidance will allow companies to restate in one filing for a number of years rather than separately amending all of the previously filed reports. By reporting all of the information in one filing, companies believe it will more clearly reflect the impact of the restatement.

Stacey said the staff will not raise further comment with respect to a company's need to amend prior 1934 Act filings to restate financial statements and related MD&A if the company amends its most recent Form 10-K and includes certain comprehensive disclosure outlined in her letter. If a company's next Form 10-K is due within two weeks of the amendment the company would file in response to the guidance, Stacey advised that the staff would not comment if the company includes the specified disclosure in the next Form 10-K rather than in an amendment to the most recent Form 10-K.

The disclosure in the Form 10-K or 10-K amendment must include an explanatory note at the beginning that discusses the reason for amending the financial statements. The selected financial data for the most recent five years as required by Regulation S-K Item 301 must be disclosed in columns that are labeled "restated."

The MD&A based on the restated annual and quarterly financial information must explain the operating results, trends and liquidity during each interim and annual period that is presented. The interim period discussion may be incorporated into the annual period discussion or presented separately. The audited financial statements for the most recent three years should be restated, as necessary, and include columns that are labeled "restated."

Monday, January 22, 2007

PCAOB Details Auditor Duties Regarding Fraud Detection

A PCAOB report based on inspection results found that a number of outside auditors use a check-the-box approach to fraud detection. While checklists can be useful tools for identifying fraud, noted the Board, mechanical implementation of the relevant auditing standard is unlikely to be very effective in detecting fraud. According to Chairman Olson, the report is a constructive way to remind all auditors of what the Board's standards require of them in these areas. He urged careful attention to these requirements as crucial to best positioning auditors to detect material misstatements caused by fraud.

The interim auditing standard with respect to the consideration of fraud in a financial statement audit is AU §316, which was a pre-existing standard adopted by the Board on a transitional basis. The report is extensively based on Board inspection observations and does not reflect any determinations by the Board as to whether any firms or persons have engaged in any conduct for which the Board could sanction them.

The report contains solid Board advice on fraud detection. For example, the auditor's planning should include consideration of how the financial statements might be susceptible to fraudulent misstatement and how management could conceal fraudulent financial reporting. The Board also advised the audit team to hold brainstorming sessions to discuss those issues in order to be aware how fraud might be perpetrated and concealed.

The Board is fully aware that fraudulent financial reporting often involves management override of controls that otherwise may appear to be operating effectively. To address the risk of management override, the Board urged auditors to examine journal entries for evidence of possible fraudulent misstatements and review accounting estimates for biases that similarly could result in such misstatements.

Sunday, January 21, 2007

Hong Kong Official Lists Results of SEC-SFC Inspection of Hedge Fund Managers

A senior Hong Kong securities regulator recently detailed the results of the joint inspection of hedge fund managers carried out with the SEC on a sample of hedge fund managers registered with both regulators. Alexa Lam, executive director of the Securities and Futures Commission, noted that the joint inspections revealed areas of concern, particularly the use of side letters. Her remarks were delivered at a recent Investment Company Institute seminar.

The inspections revealed that some fund managers give preferential treatments to certain investors through side letters without adequate disclosure to other investors, which can lead to unfairness and conflicts of interest. These undisclosed side letters often offer enhanced liquidity and other preferential benefits to selected investors. Disclosure could be one of the solutions to this problem, emphasized the executive director, who advised fund managers to disclose to investors the existence of side letters and their material terms, such as preferential redemption rights and portfolio transparency rights.

The UK Financial Services Authority is also concerned about undisclosed side letters. The FSA believes that the failure of UK-based hedge fund managers to make adequate disclosure is a breach of the principle that a firm must conduct its business with integrity. As a minimum, the FSA also expects that, as an acceptable market practice, managers will ensure that all investors are informed when a material side letter is granted.

The SEC-SFC inspections also revealed that some managers did not have clear valuation policies, such as the valuation methods for complex and illiquid products.

Thursday, January 18, 2007

Frank to Produce GSE Legislation; Fed Official Calls for Prompt Action

New House Financial Services Committee Chair Barney Frank has pledged to pass legislation to reform the government-sponsored enterprises in this session of Congress. Chairman Frank said that his bill will substantially increase the ability of the regulator to oversee Fannie Mae and Freddie Mac to that point that the powers of that regulator will equal, if not surpass, the powers of the federal banking regulators.

Against this backdrop, St. Louis Federal Reserve Board President William Poole has emphasized that such legislation must contain three essential reforms in order to eliminate the GSEs’ threat to financial stability. First there must be a limit on their portfolio growth; and second, an increase in their minimal required capital. The third essential element is satisfactory bankruptcy legislation so that, should the worst happen, federal authorities can deal with the problem in an orderly way. There is a glaring need for legislation to clarify the bankruptcy process should a GSE fail, he proclaimed. At present, there is no process and no one knows what would happen if a GSE is unable to meet its obligations. Mr. Poole, who characterized the current period as one of ``uneasy waiting,’’ made his remarks recently to the Chartered Financial Analysts of St. Louis.

There is also the issue of derivatives accounting. Freddie Mac and Fannie Mae both got into trouble with accounting irregularities in part because of the complexities under GAAP rules of accounting for derivatives positions and rules determining which assets should be reported at market and which should be reported at amortized historical cost. In the view of the Fed official, sound risk management requires that GSEs base decisions on market values. The reason is simple, he said, since Fannie Mae and Freddie Mac pursue policies that inherently expose the firms to an extreme asset-liability duration mismatch. They hold long-term mortgages and mortgage-backed securities financed by short-term liabilities. Given this strategy, they must engage in extensive operations in derivatives markets to create synthetically a duration match on the two sides of the balance sheet. In turn, these operations expose the firm to a huge amount of risk unless the positions are measured at market value.

According to Mr. Poole, financial firms should also have an intense interest in reforming the GSEs. One reason is simply that banks and other financial firms, and many non-financial firms, hold large amounts of GSE obligations and GSE-guaranteed mortgage-backed securities. He believes that many risk managers simply accept that GSEs are effectively backstopped by the Federal Reserve without ever thinking through how such implicit guarantees would actually work in a crisis. The view seems to be that someone, somehow, would do what is necessary in a crisis. Good risk management requires that the “someone” be identified, said the Fed official, and the “somehow” be specified. He emphasized that before anyone starts thinking about the Federal Reserve as the “someone,” they should understand that the Fed can provide liquidity support but not capital.

Tuesday, January 16, 2007

NYC Bar Issues Report on Attorney Role in Corporate Governance

A recent report by a New York City Bar Association task force on the role of lawyers in corporate governance is a detailed and exhaustive look at the subject. It promises to be seminal. While the report does not recommend a fundamental change in a lawyer’s responsibilities, such as by recognizing a general legal or ethical duty to the investing public, it does posit that the effect of corporate action on the investing public must be a matter of active concern for the lawyer in advising the corporate client.

The task force was chaired by Thomas Moreland, a partner at Kramer Levin Naftalis & Frankel, and included federal district judge Jed Rakoff. In addition, the task force interviewed or consulted an array of heavyweights, including former Delaware Chancellor William Allen, former SEC Corporation Finance Director Alan Beller, former SEC Chairman Richard Breeden, Columbia Professor John Coffee, former SEC Enforcement Director Stephen Cutler, former SEC Commissioner Harvey Goldschmid, former SEC General Counsel Ed Greene, current SEC Enforcement Director Linda Thomsen, and former SEC Chief Accountant Lynn Turner.

The report also declined to impose general whistle-blowing or gatekeeping duties on
lawyers since such would be so contrary to their traditional role as confidential advisors to their clients at to be counterproductive. It probably would result in a chilling of client-lawyer communications, reasoned the tack force, and the exclusion of lawyers from some strategic meetings,

In addition, the report also examined the relationship between company lawyers and the outside auditor and made recommendations to strengthen it. Because most of the recent corporate scandals have involved accounting fraud, the task force recommended that lawyers advising public companies be actively consulted in connection with preparation of their client’s financial disclosures, and that lawyers advising on such disclosures be familiar with the accounting concepts impacting those disclosures. But the task force rejected the creation of a lawyer-auditor privilege.

Monday, January 15, 2007

SEC Comm. Evans Espoused Principles-Based Regulation Back in 1973

As the move towards principles-based regulation and standards gains steam, I have been concerned about a growing general perception that US federal securities regulation is prescriptive and behind the curve. Partially, this perception is fueled by the Sarbanes-Oxley Act, which is viewed internationally, particularly in the European Union, as a prescriptive-based regime. The basic tenor is that the US is not on the cutting-edge of principles-based regulation.

I believe that this view is somewhat unfair. I would point out that as early as 1973 SEC Commissioner John Evans was advocating steps to strengthen the outside auditors’ position in meeting their professional responsibilities by adopting rules intended to discourage accountant shopping when there are disagreements with the accountant over matters of accounting principles or practices. I view Commissioner Evans as one of the best and most thoughtful members of the Commission in recent memory.

In what I submit is a principles-based approach, Commissioner Evans said that, in addition to the analysis of various individual transactions, the overall impression left by the financial statements is part of the responsibility of the public accountants. Statements cannot simply be the accumulation of data relating to individual transactions viewed in isolation. In other words, he continued, the accountant has a responsibility to assure that the financial statements fairly represent the company’s financial condition. Fair representation may, and often does, require more than just the use of selected GAAP. This speech is posted on the SEC Historical Commission website.

Thus, as far back as 1973, the Commission was advocating a principles-based approach to financial statements and their independent audits. In 2002, SEC Chairman Harvey Pitt reiterated the Commission’s position that literal compliance with US GAAP is not enough if the financial statements do not fairly represent the company’s financial condition. The chairman alluded to a 1969 Second Circuit Court of Appeals opinion, in which the court held that literal compliance with GAAP does not insulate an accountant if the financial statements create a fraudulent or misleading impression in the minds of shareholders. US v. Simon (CA-2 1969), 1969-1970 CCH Dec. ¶92,511. This principle is now codified in Sarbanes-Oxley, which requires the CEO and CFO to certify that the financial statements fairly present the company’s financial condition.

Admittedly, this principle lost favor during the Enron-WorldCom era, but it was always there, lurking in the background. The return of this principle to prominence is a welcome event that demonstrates a US commitment to principles-based regulation. And let us reflect that, in Simon, Judge Friendly was on the cutting edge.

Saturday, January 13, 2007

Canadian Regulators Propose Registration of Hedge Fund Managers

After a review of hedge funds, the Canadian Securities Administrators have recommended that hedge fund managers be required to register. Registration is appropriate, reasoned the CSA, given the role that fund managers play in establishing and running investment funds and providing a broad range of services, including fund valuation. This recommendation has some power behind it since the review on Ontario, British Columbia and Quebec, which taken together have to constitute the center of gravity of Canadian asset management. The 2006 Allen Report on modernizing Canadian securities legislation had also recommended that hedge fund managers be registered. Currently, fund managers need not be registered unless they are also managing portfolio assets, in which case they must be registered as advisers.

We all know how historically difficult it has been to define hedge funds, i.e. the SEC has never done it, but the CSA took a crack at a definition for purposes of the review, and it is not a bad try. The CSA broadly defined hedge funds as investment pools that use alternative investment strategies not generally available to traditional mutual funds such as taking both long and short positions and using arbitrage, leverage, options, futures, bonds and other financial instruments to capitalize on market conditions.

In the view of the CSA, the registration requirements for fund managers should focus on ensuring that they have the resources to carry out their functions, or to properly supervise the functions if they are contracted to a third party, and to provide proper services to investors. They must also manage their conflicts of interest and have sufficient proficiency and integrity to carry out their functions. Finally, registration would ensure that they have adequate capital and insurance to provide protection for investors and minimize the risk of loss and disruption.

Wednesday, January 10, 2007

Supreme Court Tackles "Strong" Question on Scienter

By N. Peter Rasmussen
CCH, Inc.

Question Presented: Whether, and to what extent, a court must consider or weigh competing inferences in determining whether a complaint asserting a claim of securities fraud has alleged facts sufficient to establish a "strong inference" that the defendant acted with scienter, as required under the Private Securities Litigation Reform Act of 1995.
The U.S. Supreme Court agreed to tackle the question above in granting a petition for certiorari in Tellabs Inc. v. Makor Issues & Rights, Ltd. (published at ¶93,642 in CCH's Federal Securities Law Reporter). In that case, arising from allegations that a fiber optic cable manufacturer misrepresented the availability of and demand for its new products, the 7th U.S. Circuit Court of Appeals observed that while the PSLRA "did not impose a more stringent substantive scienter standard, it did unequivocally raise the bar for pleading scienter."

Analyzing the different approaches taken by other circuits for determining if a complaint pleaded a strong inference of scienter, the court concluded that the best approach was "for courts to examine all of the allegations in the complaint and then to decide whether collectively they establish such an inference." It also stated that the strong inference requirement did not mandate that only the most plausible of competing inferences were sufficient. Instead a complaint was sufficient if it alleged facts from which "a reasonable person could infer that the defendant acted with the required scienter." The court quoted the 10th Circuit opinion in Pirraglia v. Novell, Inc., in which the court stated that when "[f]aced with two seemingly equally strong inferences, one favoring the plaintiff and one favoring the defendant, it is inappropriate for us to make a determination as to which inference will ultimately prevail, lest we invade the traditional role of the factfinder."

While Congress may have hoped for the PSLRA to bring some certainty to the question of scienter pleading, the result has been far different. Both appellate and district courts have differed, and in some instances have seemed confused, on what the statute requires plaintiffs to plead to survive dismissal and to substantively prove in order to prevail at (the extremely rare) trial.

In the petition for certiorari, the company described the 7th Circuit approach in Tellabs "as a particularly lax standard for policing the scienter allegations in securities fraud complaints." A joint amicus brief from some major players, the U.S. Chamber of Commerce and the Securities Industry and Financial Markets Association, echoed this sentiment. According to these groups,

the Seventh Circuit’s scienter test moves in the opposite direction from that chosen by Congress, significantly easing plaintiffs’ burden and thereby encouraging the abusive strike suits that the PSLRA set out to prevent with heightened pleading requirements. The lax “could infer” test will also harm defendants and the markets without providing significant enforcement benefits.
In their response brief, the lead plaintiffs asserted that the petitioners were "straining to create an issue for review" in their characterization of the 7th Circuit holding. The brief took an interesting approach in its response to the question presented in the petition concerning whether, and to what extent, "competing inferences" should be considered. The respondents suggested that this issue was not squarely presented in this instance, because in their view, "fairly considered, there are no competing innocent inferences to be weighed against the powerful inferences of culpability in this case." According to the lead plaintiff's argument, the methodological approach to the evaluation of the sufficiency of the scienter inference was irrelevant in this case because any balancing of inferences would not have changed the result in this case. They concluded that the "allegations in this case are so strong and highly particularized that the complaint satisfies any formulation of the Public Securities Litigation Reform Act.”

The case (06-484) will be argued this spring, with an opinion expected by July 2007.

Tuesday, January 09, 2007

Interagency Statement on Complex Transactions May Not Comfort Law Professors

The SEC and the federal banking regulators have issued their final guidance for banks and securities firms that engage in complex structured finance transactions. The final statement takes a risk-based and principles-based approach to addressing the risks that these complex transactions may pose to institutions and focuses on those transactions that may present elevated levels of legal or reputational risk to financial institutions.

The final statement provides examples of transactions that may warrant additional scrutiny by a financial institution, including those lacking economic substance or business purpose, or those designed primarily for questionable accounting, regulatory, or tax objectives, particularly when the transactions are executed at year-end or at the end of a reporting period for the customer.

Some commenters, notably a consortium of law professors, contended that these examples of elevated risk transactions contained in the statement have characteristics that are signals, if not conclusive proof, of fraudulent activity. Consequently, they urged the agencies to inform financial institutions that transactions or products with any of these characteristics should be considered presumptively prohibited. They also argued that the statement encourages or condones illegal conduct by financial institutions. That was pretty strong language. The law professors actually asked the agencies to withdraw their statement because it could be read to encourage illegal conduct

While the agencies believe that financial institutions should conduct due diligence commensurate with identified risks, they do not believe it appropriate that all transactions initially identified as potentially creating elevated risks should be considered presumptively prohibited. A financial institution after conducting additional due diligence for a transaction initially identified as an elevated risk, reasoned the agencies, may determine that the transaction does not, in fact, have the characteristics that initially triggered the review. Or, the financial institution may take steps to address the risks that initially triggered the review.

But the agencies did give the law professors some solace by advising financial institutions to decline to participate in an elevated risk transaction if, after conducting due diligence and taking appropriate steps to address the transactional risks, they determine that the transaction presents unacceptable risks or would result in a violation of applicable laws, regulations or accounting principles.

Sunday, January 07, 2007

Options Backdating Must Be Seen in Corporate Governance Context

With issues on stock options backdating roiling the regulators and the markets, it is time to remind ourselves that the issue of stock option compensation is inextricably intertwined with corporate governance. This was the lesson taught by corporate governance guru Ira Millstein in testimony before the Senate Banking Committee on Feb. 27, 2002. (I am providing a link, but caution that it may not survive introduction of the new Sen. Dodd committee page). And it is a lesson for the ages.

The Weil Gotshal senior partner said that an effective system of corporate governance must strive to channel the self-interest of managers and directors into alignment with the corporate, shareholder and public interest. Yes, we are back to the age-old conundrum of corporate governance and modern corporations first identified by Berle and Means, which is, in an age when management of the company is divorced from ownership, how do we align the interest of the shareholders with management. Mr. Millstein urges stock compensation as a method of aligning the interests of management with shareholder interests. Citing Berle and Means, the senior partner emphasizes that the key issue of corporate governance throughout the history of the stock company has been what he calls ``the agency problem,’’ in which corporate management may not always subordinate their interests to those on whose behalf they are acting.

He reaches back beyond Professor Berle and praises Oliver Wendell Holmes for recognizing that humans can not be expected to act moderately, prudently, morally and ethically at all times. Justice Holmes noted that regulation must address the prospect that self-interest may cause persons to act badly by providing countervailing incentives and disincentives. In Mr. Millstein’s view, this Holmesian principle applies to corporate governance regulation as well. He posits that the self-interest described by the eminent Justice can interfere with the moral, ethical and legal obligations of directors and managers to protect and enhance the assets of the corporation that are committed to their care by, and for the benefit of, others.

It is in this context that stock option grants must be viewed. I believe that the use of options to align the interests of company management and the shareholders is legitimate. But the interests of the two groups must be completely congruent, that is, both groups must face the same risks. The practice of backdating options, and for that matter repricing options, favors the managers over the shareholders and destroys the true alignment of interests.

Thursday, January 04, 2007

New House Oversight Chair Pledges Legislation on Executive Compensation

Calling the relationship between corporate boards and CEOs collusive with regard to executive compensation, House Financial Services Committee chair Barney Frank said that shareholders must be the real check on excessive compensation. He promised legislation to increase the ability of shareholders to vote on compensation packages. Staff is currently working out the details of the legislation, which includes what will happen if the shareholders vote no. Mr. Frank made his remarks at a recent National Press Club luncheon.

In the first place, he noted, the CEO picked the board of directors; and they picked the CEO. It is a very collusive relationship, he posited, and, in his view, it is clear that boards of directors do not provide any real check on CEOs. He mentioned recent action by the board of directors of Home Depot, which finally decided the CEO had to go, and they gave him $210 million and asked him to please leave.

They have a shareholder vote in the UK, he added, and Britain has become an example that a lot of US corporate leaders have said that they admire. They believe that the Financial Services Authority is more flexible than the SEC. Since 2002, the United Kingdom has required a shareholder advisory vote on board pay, which was coupled with the introduction of required disclosure of key compensation data.

The chair said that the issue of executive compensation is not just a matter of envy. Rather, he emphasized that it has reached the point of having some macro economic significance. He cited a recent study by Lucien Bebchuk and others showing that the percentage of the profit of the top 1,500 corporations that goes to compensation for the top three officials has reached almost 10 percent.

In the 109th Congress, Rep. Frank introduced a bill that would have allowed shareholders to approve their company’s executive compensation. The Protection Against Executive Compensation Abuse Act, HR 4291, would also have allowed 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 have required that shareholders separately approve any additional ``golden parachute’’ compensation for top executives that coincides with the sale or purchase of substantial company assets.

Tuesday, January 02, 2007

European Accounting Group Calls for Int'l Audit Standards

The head of the European Federation of Accountants has endorsed principles-based international audit standards through the ultimate convergence of IAASB and PCAOB standards. The International Audit and Assurance Standards Board currently has a major project underway to complete its suite of audit standards, he noted, with about twenty six new exposure drafts expected over the next year or so. At a recent seminar on financial reporting, David Devlin, then federation president, also called for the rollback of the extraterritorial impact of auditor independence rules.

The IAASB standards aim to be principle-based and avoid what some have considered to be the PCAOB’s tendency to be overly prescriptive in its standards. An explicit drive towards IAASB-PCAOB convergence would in time force resolution on the point, Devlin believes. He emphasized that that auditing standards must be principle-based and give auditors the opportunity to exercise their professional judgment, without turning their work into primarily a box ticking, file building exercise which, whatever the intention, will have the inevitable effect of focusing on the clerical rather than the substantive when conducting audits.

He also observed that both the Sarbanes-Oxley Act and the Statutory Audit Directive provide for some extraterritorial inspection of audit work, which raises the specter of multiple regulatory and enforcement regimes and attendant increases in the costs of audits. It is thus critical, in his view, that auditor oversight be based on the home country principle and that regulators equip themselves with the means of ensuring equivalence in their work.

Turning to the issue of auditor independence, the FEE president urged regulators and legislators to roll back the extraterritorial impact of independence rules. Not only is it self-evidently appropriate to do this within the EU single market, he posited, but it would make sense if the SEC and the PCAOB were to do the same. This would then leave open the question of how to ensure the independence of auditors of foreign affiliates. In this regard, he commended the approach of the UK’s Auditing Practices Board, which regards as acceptable the application by auditors of foreign affiliates of UK companies the IFAC Code of Ethics, which is now under the aegis of the International Ethics Standards Board for Accountants. At the end of 2006, the IESBA proposed to strengthen its auditor independence rules. In support of his suggested position, Devlin took comfort in the fact that both the European Commission and IOSCO take part in the public oversight structures of IFAC.