Sunday, December 30, 2007

Walker Report Looks At Private Equity Duties to Stakeholders

Noting that business leadership represents the largest concentration of power that is not derived from or accountable to an elected body, the recent Walker report on private equity transparency discusses the legitimizing of corporate power with regard to stakeholders such as employees and suppliers.. The UK private equity working group, headed by Sir David Walker, has issued a set of guidelines for private equity firms. A previous blog dealt with the proposed disclosure and transparency guidelines. But the report is also concerned about the obligations private equity assumes when it takes a controlling stake in a company.

According to the report, in Europe, the social democratic view has historically been that the authority of business leaders needs to be legitimated politically through regulation and direct state control of the most important business activities. A US perspective tends to adopt what may be characterized as a unilateral concept, whereas the European approach tends to be more sympathetic to the notion that ownership entails obligations as well as rights.

But in either society, the broad question to be considered is how much weight to give to stakeholder interests. In that context, the report emphasizes that the promotion and demonstrable achievement of high standards of behavior in all portfolio companies, extending beyond compliance with the law, should be powerfully supportive of private equity as a whole.

In addition, the report points out that there are important implicit contractual relationships, for example with employees who believe that the company is a good one in which to work, and with suppliers who value the continuity and depth of their relationship with the company. Such contractual relationships are implicit partly because explicit contracts cannot be sufficiently wide-ranging or anticipate every possible relevant contingency, and because the nature of the behavior and relationships expected is often defined by the context rather than by the contract.

The Walker report cautioned that this does not mean that implicit contracts are merely what all stakeholders would like them to be. For example, the existence of implicit contractual commitments does not mean that jobs cannot be cut where this is necessary to the continuing viability of a business. But it does mean that reasonable expectations as to behavior in matters such as appropriate communication, including its style and timeliness, should not be disappointed. Part of the concern that gave rise to this review is a sense, rightly or wrongly, that some private equity portfolio companies may have acted in relation to employees in violation of such implicit contracts which, despite being implicit, are nonetheless regarded as real and substantive, with reliance reasonably placed upon them.

Saturday, December 29, 2007

Japanese Regulator Proposes Broad Market Reforms

The Japanese Financial Services Authority has proposed wide-ranging reforms of the markets with a package of securities, banking and taxation changes. The reforms are designed to increase the global competitiveness of Japanese financial markets and increase the diversity of financial products while ensuring market fairness and transparency.

There will be measure to enable the diversification of exchange-traded funds. In addition, legislation will be introduced to make it possible to invest in a wide range of products, including financial and commodity derivatives. This will be part of an alliance between financial and commodities exchanges to enable exchanges groups to offer a full line of products from equities, bonds, financial derivatives to commodity derivatives. A taxation scheme will also be implemented stocks and investment trusts that will facilitate a shift from savings to investment. In addition, civil money penalties will be made more effective against market misconduct; and market surveillance will be enhanced.

As part of a better regulation initiative, the FSA will improve the regulatory environment by engaging in an intensive dialogue and sharing of principles with the financial services industry. There will also be enhanced transparency and predictability of regulation. At the same time, the FSA will strengthen its co-operation with foreign authorities.

Proposed legislation would also revamp the firewalls among banking and securities. For example, the ban on interlocking officers and employees would be lifted. Similarly, the restrictions on the sharing of undisclosed corporate customer information between banking and securities businesses would be relaxed. At the same time, foreign fund managers would be encouraged to participate in Japanese markets by removing taxation risk in carrying out business through independent agents in Japan.
Cox Examines Global Exchanges and Markets

With global markets growing apace, SEC Chairman Christopher Cox recently addressed the benefits and the challenges posed by global competition among exchanges. He said that it is time for regulators to take collaboration to the next level; from information-sharing, which has traditionally been focused on enforcement, to supervisory matters. Regulators must see each other as partners when it comes to ensuring sound regulation and efficient markets.
Among the regulatory challenges posed by the demutualization of exchanges is the integrity of the self-regulatory function, Cox said. The SEC looks at the control structure of the exchange and its approach to conflicts of interest, with particular concerned about the risks of a member controlling an exchange. The SEC has supported the functional separation of regulation from an exchange’s business activities through the creation of an independent regulatory operation within the exchange.

With global exchange alliances and mergers, the SEC must work closely with its counterparts overseas. Cox reviewed a number of combinations where the SEC and its counterparts have coordinated their efforts. He reviewed the NYSE Euronext combination in which the exchange agreed to refer possible rule violations to NYSE Regulation and to provide adequate funding for NYSE Regulation.

Chairman Cox noted that his international responsibilities are much greater than any of his predecessors. He serves as the vice chair of IOSCO; and will become the chair next year with the assent of the other members.

The chairman also emphasized that the SEC has developed relationships enabling the regulators to address concerns in Europe that the NYSE Euronext transaction would result in the export of U.S. laws such as the Sarbanes-Oxley Act. The SEC quickly issued a statement to make clear that common ownership of the markets would not trigger SEC registration or the application of the U.S. federal securities laws.

Enforcement is a key focus of international securities regulatory cooperation, according to Cox, but regulators can also serve investors by reducing duplicative and overlapping regulation, as well as by sharing information to ensure the effective regulation of cross-border market operations. The creation of a global securities regulator is unlikely, in his view, but the coordination of national regulators is a positive development.

Thursday, December 27, 2007

SEC Official Outlines MD&A Disclosure on Fair Value in Wake of Sub-Prime Crisis

As negative news about the current credit environment multiples, the MD&A must give investors information about companies' exposure to sub-prime securities or other higher risk loans, noted an SEC official, risks related to off-balance structures which have the potential to become on-balance sheet structures, and exposure to investments that are not easily valued. According to Associate Chief Accountant Stephanie Hunsaker, the SEC staff has been reviewing disclosures of many firms that are significantly impacted by the current environment of impairment of securities and liquidation of collateralized debt obligations and has noted some improvements from their prior MD&A disclosures.

For example, some firms have expanded their discussion of the exposure to the sub-prime industry, some have expanded their discussion about fair values, and some have expanded their disclosures about off-balance sheet arrangements. In addition, firms have added new risk factors about transactions with off-balance entities and the fact that those transactions could cause them to recognize future gains or losses, or have to consolidate the entity, or new risk factors warning that the firm may experience additional write-downs in the securities or loan portfolio.

In the associate chief accountant’s view, the MD&A is the best place to disclose information about the most difficult and judgmental areas since just complying with the minimum GAAP financial statement disclosures often will not give investors all of the information they may need to evaluate a company's results and performance.

MD&A disclosure related to the sub-prime crisis can also fall under critical accounting policies. While firms with a significant amount of financial instruments measured at fair value disclosed that the determination of fair values was a critical accounting estimate, noted the official, some of these disclosures did not provide very insightful analysis as to how the fair values were determined.

She cautioned that it is not enough to simply disclose that the valuation of financial instruments becomes more subjective and involves a higher degree of judgment where market data is not available. Also, just stating the names of other types of techniques that may be used, such as simulation models, is not helpful unless investors are familiar with these techniques and all of the key inputs into them.

When market data is not available, instructed the associate chief accountant, firms with a material amount of financial instruments measured at fair value should consider discussing the types of models used in these situations, the significant inputs into the models, disclosure of the assumptions that can have the greatest impact on the value derived, and whether and how those assumptions have changed from prior periods and, if so, why. The staff is not suggesting that every single instrument should have this level of disclosure. Rather, the staff is focused on the valuations that could have the biggest impact on the company's results of operations, liquidity or capital resources.

Thus, expanded disclosure is proper for firms with securities whose valuation is based on models and the impact of such valuation could be material to the financial statements, as well as for firms that believe that valuation of securities is one of the most significant critical accounting estimates and are disclosing that fact in risk factors and other disclosures. In these instances, the firms should disclose the specific assumptions they are using and how they were derived.

They should also give investors a real insight into how their estimates could be impacted by future events. Then, in future periods, when values materially change, either positively or negatively, the firms should consider disclosing any significant changes in their methodologies and assumptions so investors can understand what happened.

Tuesday, December 25, 2007




SEC and European Commission Seek More Transparency for Sovereign Wealth Funds

As sovereign wealth funds grow larger than all of the world's hedge funds combined, the SEC and European Commission are trying to increase the transparency in the funds while avoiding protectionism. In recent remarks, both SEC Chairman Christopher Cox and EU Commissioner for the Internal Market Charlie McCreevy said they will work together to make the funds more transparent.

Sovereign wealth funds are the investment arms of governments. They also encompass a broad range of funds and a variety of investment strategies and management. For example, several sovereign wealth funds are directly managed through the central bank or the finance ministry, such as in Norway and Qatar. Others are incorporated as private companies with at least some degree of independence, such as Dubai International Capital.

According to McCreevy, sovereign wealth funds should be transparent in their operations, preferably on the basis of an international code of best practices. The EC is working with international organizations and bilaterally with the SEC to bring this about. An agreement has been reached to launch an investment dialogue to promote open investment regimes globally in a fully safe environment.

With respect to transparency, McCreevy would like to see sovereign wealth funds publish their investment strategies, detail their investment conduits and agents and provide an audited yearly report of their holdings in every company. Interested parties would then know which shares the fund holds and its investment strategy.

From the SEC's standpoint, working to ensure the transparency of sovereign business and investment will be of paramount importance. The mutual trust and investor confidence that transparency would establish will address many of the special concerns these activities raise. To the extent that sovereign investing is conducted through professional management of these funds, Cox said that it could help to depoliticize the process both in practice and in perception.

Cox also pointed out that the SEC currently has the power to pursue enforcement actions against sovereign wealth funds for violating U.S. securities laws. Neither international law nor the Foreign Sovereign Immunities Act renders these funds immune from the jurisdiction of federal courts in connection with their commercial activity conducted in the United States.

When a foreign private issuer is suspected of violating U.S. securities laws, the SEC can almost always expect the full support of the foreign government in investigating the matter. However, if the same government from whom the assistance is sought is also the controlling person behind the entity under investigation, Cox said that a considerable conflict of interest would arise.

Another concern is the conflicts of interest that arise when the government is both the regulator and the regulated. When the government becomes both referee and player, Cox said, the game changes dramatically for every other participant. He fears that rules rigorously applied to private sector competitors will not necessarily be applied in the same way to the sovereign who makes the rules.

Investors and regulators alike have to ask themselves whether government-controlled companies and investment funds will always direct their affairs in furtherance of investment returns, or will use business resources in the pursuit of other government interests. If the latter is the case, Cox questioned the effect on the pricing of assets and the allocation of resources in the domestic economies of other nations. Cox cautioned that the track record of transparency to date of most sovereign wealth funds does not inspire confidence.

Monday, December 24, 2007

Treasury and SEC Call for Best Practices for Sovereign Wealth Funds

Sovereign wealth funds have exploded into the regulatory consciousness and the result has been a call from the Treasury and the SEC for best practices for these opaque vehicles. US regulators will work through the vehicle of the President's Working Group on Financial Markts to develop bi-lateral and multilateral initiatives to achieve greater transparency for these sovereign investment pools.

The accumulation of official reserves far beyond established benchmarks of reserve adequacy has led an increasing number of countries to establish sovereign wealth funds. Thus, SWFs represent a large and rapidly growing stock of government-controlled assets, invested more aggressively than traditional reserves, with implications for the international financial system.

While there is no single, universally accepted definition of a SWF, a Treasury report defines them to mean a government investment vehicle which is funded by foreign exchange assets, and which manages those assets separately from the official reserves of the monetary authorities. Because relatively little is known about most SWFs, market estimates of their size vary widely. Treasury estimates aggregate assets of known SWFs from $1.5 – 2.5 trillion. And the IMF projects that sovereigns will continue to accumulate foreign assets at a rate of $800-900 billion per year. Currently, SWF holdings are larger than the total assets under management by either hedge funds or private equity funds, and are set to grow at a much faster pace. Some private analysts project that aggregate SWF assets could grow to $7-8 trillion by 2012 and to $12-15 trillion by 2015.

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Like many things, SWFs are a double-edged sword. On the one hand, they have the potential to promote financial stability because they are, in principle, long term, stable investors providing significant capital to the system. Moreover, they are typically not highly leveraged and cannot be forced by capital requirements or investor withdrawals to liquidate positions rapidly.

On the other hand, SWFs raise potential concerns. On the investment side, SWFs could provoke investment protectionism since transactions involving SWF investment may raise legitimate national security concerns. On the financial markets side, SWFs may raise concerns related to financial stability. They can represent large, concentrated, and often non-transparent positions in certain markets and asset classes.

The Treasury, in coordination with the SEC and other U.S. regulators, is working to shape an appropriate international policy response to financial market and investment issues raised by SWFs. For example, Treasury has asked the international community to develop a code of best practices for SWFs. The IMF should take the lead in developing best practices for SWFs, building on existing best practices for foreign exchange reserve management. These would provide guidance to new funds on how to structure themselves, reduce any potential systemic risk, and help demonstrate to critics that SWFs can be responsible, and constructive participants in the international financial system.

Treasury has also created a working group on SWFs that draws on the expertise of Treasury's offices of International Affairs and Domestic Finance. More broadly, the President's Working Group on Financial Markets, which also includes the SEC and the FED, will review SWFs. Finally, there has been bilateral outreach to ensure an ongoing dialogue with countries with significant SWFs and their management, including the United Arab Emirates, Norway and the Kingdom of Saudi Arabia.

Saturday, December 22, 2007

SEC Senior Official Examines Auditor Independence Issues

At a recent conference, a senior SEC accounting official made some interesting remarks on the ever-popular issue of auditor independence, particularly on the factors the SEC considers when deciding on what is a network firm and on what advice outside auditors could give a company client without impairing their independence. Given the complexity associated with current accounting standards the SEC staff is constantly asked how much advice an outside auditor may provide to a company audit client without impairing its independence. The independence threat is that auditors in the course of providing such advice might find themselves either in the position of auditing their own work or acting as management. Associate Chief Accountant Vassilios Karapanos listed a number of services that will not impair an outside auditor's independence when providing accounting application assistance to an audit client.

For example. He said that auditors can discuss the requirements and the related concepts, terminology and implementation issues related to an accounting application. They can also provide sample journal entries that help management understand the accounting application. Auditors can also discuss factors to be considered in making judgments that may become critical in the accounting process. Similarly, without sacrificing their independence, auditors can discuss the nature of relevant model inputs and related market sources of information.

There are also independence issues surrounding the concept of network firm. The independence rules define accounting firm, noted the official, and within that definition include associated entities of an accounting firm. The SEC staff continues to wrestle with questions regarding what is an associated entity of an accounting firm by interpreting the existing rules and by analyzing each situation in light of all relevant facts and circumstances.

Some of the facts that the staff considers are whether auditors refer to another firm in its audit opinion or do they take responsibility for the work performed by the other firm. Another factor considered is whether the firms have common ownership, profit sharing or cost sharing agreements. The staff also asks if the firms share management, have a common brand-name or use shared professional resources. More granularly, the staff determines if the firms have common quality control policies and procedures.

The staff is frequently asked whether a predecessor auditor has to be independent in order to issue a consent for a previously issued opinion. While auditors have to be independent during the audit and professional engagement period, noted the SEC official, they do not have to be independent once the audit and professional engagement period has ended. Thus, issuing a consent for a previously issued opinion does not constitute a new audit and professional engagement period for which the auditor needs to be independent. However, if there is going to be a restatement of previously issued financial statements, and auditors are required to dual date their opinion on restated financial statements, they have to be independent.

Thursday, December 20, 2007

Key Senator Calls on SEC to Fully Use SRO Audits and Resources

In a letter to SEC Chairman Christopher Cox, Senator Charles Grassley asked the Commission to remedy its failure to tap investigative resources provided by the SROs by implementing a plan allowing the SEC to consider such information as part of its work to safeguard market integrity. Sen. Grassley, Ranking Member on the Finance Committee, made his appeal following the completion of a new GAO audit indicating that the securities industry reports mountains of information about suspicious transactions but SEC computer systems cannot search the data. The senator asked for an explanation of why the SEC has been so slow to act on this matter and a description of the Commission’s plans for ensuring that the SEC begins to routinely obtain and review internal SRO audits and investigations. SROs include the New York Stock Exchange and the Financial Industry Regulatory Authority.

The GAO report is the second of two reviews that Sen. Grassley requested as part of his congressional oversight work. The first report, issued in September, criticized the SEC for failing to close cases and keeping them open for years even though there was no ongoing investigation. Both requests stemmed from allegations made by a fired SEC Enforcement Division attorney and, according to the senator, in both cases the GAO findings validated those charges.

In the senator’s view, the SEC also needs to review the internal audits that the SROs put together in order to make sure they are credible and even-handed. Reliance on SROs to police their members can work effectively only if their operations are open and transparent, said the member, who was disturbed to learn that the SEC does not obtain copies of internal audits and investigations conducted by SROs.

According to the GAO, he continued, it recommended four years ago that the SEC routinely use such internal audits and investigations to plan and conduct inspections of SROs. The SEC did not implement that recommendation. Recent SEC guidance calls for SROs to merely allow on-site access to internal documents during SEC inspections. The senator emphasized that this is not an adequate substitute for actually implementing the GAO recommendation by obtaining copies and reviewing the documents to inform the planning of SRO inspections.

He urged the SEC to ensure that Commission staff obtain and review internal SRO audit reports on a routine basis. While the SEC told GAO that it intends to study and consider how reliable such reports may be, he noted, that does not go far enough toward implementing GAO's recommendation from four years ago. If the SEC had begun routinely obtaining these reports four years ago, remarked Grassley, it would already have an idea of how reliable they are. It should not take this long to do something so basic, he said. Given that the SROs are entrusted with direct regulation of the securities industry, there is no excuse for them being anything less than completely transparent to the SEC.

For its part, the GAO made three recommendations designed to strengthen the SEC’s oversight of SROs. First, the SEC chair should establish a written framework for conducting inspections of SRO enforcement programs and broaden current guidance to SRO inspection staff to have them consider to what extent they will use SRO internal audit reports when planning SRO inspections. Second, Market Regulation should make certain that SROs include in their periodic risk assessment of their IT systems a review of the security of their enforcement-related databases, and SEC staff should review the comprehensiveness of the related SRO-sponsored audits of SRO enforcement-related databases. Third, the SEC should ensure that any software developed for tracking SRO inspections includes the ability to track SRO inspection recommendations and consider IT improvements that would increase the staff’s ability to search for, monitor, and analyze information on SRO advisories and referrals

More broadly, the GAO noted that, despite the inherent conflicts of interest because of the dual role of SROs as both market operators and regulators, Congress adopted self-regulation, as opposed to direct federal regulation of the securities markets, in order to prevent excessive government involvement in market operations. But part of this arrangement is that, for industry self-regulation to function effectively, the SEC must ensure that SROs are fulfilling their regulatory responsibilities.

Tuesday, December 18, 2007

4th Circuit Finds Venue Proper Through EDGAR Server

A fraud defendant who did business in Las Vegas will have to defend criminal charges in the Eastern District of Virginia based on the filing of allegedly false Form 10-Q reports. In a December 14, 2007, decision, a 4th Circuit panel found that venue was proper in the Eastern District, even though, as the court acknowledged, the defendant's "lone contact with the Eastern District for the purposes of this offense" was the fact that "EDGAR’s Management Office of Information and Technology and the system’s computer servers, which store the transmitted files and make them publicly available through the EDGAR website, are located in Alexandria, Virginia, in the Eastern District of Virginia."

The court rejected the defendant's claim that the electronic transmission of a fraudulent document to a computer server in Alexandria did not constitute a "venue-sustaining act," and that the defendant could not have reasonably foreseen that the form filed on EDGAR would be transmitted to the Eastern District of Virginia. According to the court, "this process was part of the SEC’s normal course of business...as all such documents are filed, stored, and disseminated to the public through the EDGAR website in Alexandria, Virginia."

The panel, in a unanimous opinion, found that the "venue-sustaining act need not constitute the core of the alleged violation," but merely one that is material to the charged offense.The appeals panel concluded that "[b]ecause a material act that constituted the violation occurred in the Eastern District of Virginia, namely the transmission of a fraudulent Form 10-Q into the district, the Eastern District is a proper venue."

The court also rejected the defendant's foreseeability argument. According to the court,
If Congress had wanted to limit venue to those districts where the defendant could have reasonably foreseen his criminal conduct taking place, it could have easily done so. Instead, it enacted a broad venue provision, one that lacked any reference to a defendant’s mental state or predictive calculus, and focused solely on whether "any act or transaction constituting the violation" took place in the district.
The panel finally concluded that its holding would not render every public company that filed a document through EDGAR subject to prosecution in the Eastern District, "no matter how tenuous its links to the district otherwise are," as "we in no way impose a rule that all securities fraud prosecutions based on the filing of fraudulent documents through EDGAR must take place where the EDGAR server is located. Rather, we simply hold that such a district is one permissible venue." In addition, the court advised that the venue rules in the Federal Rules of Criminal Procedure provided adequate safeguards against litigating in inconvenient or burdensome venues.

U.S. v. Johnson (4thCir 2007), CCH Federal Securities Law Reporter ¶94,539.
SEC Examining Possible Abuse in Rule 10b5-1 Plans

As a result of academic studies suggesting that Rule 10b5-1 plans may be being abused, the SEC staff is looking into the situation to make sure that people are not doing here what they were doing with stock options. If executives are in fact trading on inside information, noted Enforcement Director Linda Chatman Thomsen, the plan will provide no defense.

Rule 10b5-1 plans allow corporate executives to make a plan, at a time when they are not in possession of inside information, to make prearranged trades at specified prices or dates in the future. According to the director, the idea behind the Rule 10b5-1 plans was to give executives the opportunity to diversify or become more liquid through the use of plans with prearranged trades without facing the prospect of an insider trading investigation. Rule 10b5-1 provides appropriate flexibility to those who would like to plan securities transactions in advance at a time when they are not aware of inside information, and then carry out those pre-planned transactions at a later time, even if they later become aware of inside information.

Since the plans were first authorized in 2000, more than 35 percent of all S&P companies have had at least one executive sell shares under a 10b5-1 plan. In 2006 alone, executives sold more than $8.5 billion in stock through 10b5-1 plans.

The academic studies cited by the staff show that executives who trade within a 10b5-1 plan outperform their peers who trade outside of such a plan by nearly 6 percent. Presumptively, reasoned the SEC official, plan participants should be no more successful on average than those who trade outside a plan. While there may be perfectly legitimate reasons for the discrepancy, she continued, the data suggests that executives with plans sell more frequently and more strategically ahead of announcements of bad news. This raises the possibility that plans are being abused essentially to facilitate trading on inside information.

If executives are in fact trading on inside information and using a plan for cover, the plan will provide no defense. The SEC is looking at the disclosures surrounding 10b5-1 plans. The agency is also looking at multiple and seemingly overlapping 10b5-1 plans; as well as at asymmetrical disclosure around plans, that is, disclosure of entry into a 10b5-1 plan, without timely disclosure of related plan modifications or terminations.

One of the studies that drew the SEC’s attention was a Stanford Graduate Business School study stating that, despite its requirement that insiders plan trades when not privately informed, Rule 10b5-1 appears to enable strategic trading. The study suggests that, on average, trading within Rule 10b5-1 does not solely reflect uninformed diversification. Participating insiders' sales systematically follow positive and precede negative firm performance, the study found, generating abnormal forward-looking returns larger than those earned by non-participating colleagues. Further, the observed association did not appear to be explained by market transaction disclosure response or general periodic price declines.

Sunday, December 16, 2007


House Report Finds Deficiencies in Disclosure of Exec Comp Consultants

A House oversight committee report found widespread and pervasive conflicts of interest among executive compensation consultants. Indeed, over 100 large public companies hired compensation consultants with substantial conflicts of interest in 2006. In many cases, the consultants advising on executive pay were simultaneously receiving millions of dollars for other services from the corporate executives whose compensation they were hired to assess. The report further found that over two-thirds of the Fortune 250 companies that hired compensation consultants with conflicts of interest did not disclose the conflicts in their SEC filings. Some companies informed shareholders that the compensation consultants were independent when in fact they were being paid to provide other services to the company.

The report was prepared by the Committee on Oversight and Government Reform, chaired by Rep. Henry Waxman. Concomitant with the release of the report, the Committee held hearings on the role of compensation consultants.

SEC rules require companies to disclose the identity of their compensation consultants and describe the nature of their assignment. The rules do not, however, require companies to disclose whether the consultant has other business relationships with the company or the fees received for providing executive pay advice and other services.

Corporate governance experts recommend that companies hire independent executive
compensation consultants that are free of conflicts of interest and can provide objective
advice regarding executive pay. One leading expert, Professor Charles Elson, testified that the best practice is for the consultant advising the compensation committee to be hired exclusively by the committee and perform no other tasks for the company or its management. Professor Elson emphasized that directors who negotiate pay must receive completely objective advice from outsiders solely responsible to the compensation committee, uncompromised by managerial relationships. This approach is similar to that taken with regard to outside company auditors under the Sarbanes-Oxley Act, he explained, and has been endorsed by numerous business and investor organizations, including the National Association of Corporate Directors.

The Committee’s investigation also uncovered evidence that companies may not be disclosing the identity of all consultants hired to provide executive compensation advice. SEC rules require companies to disclose any role of compensation consultants in determining or recommending the amount or form of executive compensation and identify such consultants. Further, according to SEC guidance, companies must disclose all consultants that played a role in determining executive pay, not just the consultant advising the board or its compensation committee.

The committee found that companies used executive compensation consultants that they did not disclose. In some cases, the companies paid hundreds of thousands of dollars to undisclosed consultants for executive compensation services. One explanation for these discrepancies may be that the compensation consultants used a different definition of executive compensation services in reporting to the Committee than the companies used in their SEC filings.

The executive compensation services reflected in the consultants’ submissions to the Committee could include a broader range of activities than those required by the SEC to be disclosed to shareholders. If a company hired a consultant only to provide survey data on executive pay, for example, this work could have been reported by the consultant to the Committee as executive compensation services, but the company may not have considered the consultant’s work to involve “determining or recommending” the amount of executive pay under the SEC disclosure rules.

Alternatively, although it appears inconsistent with the SEC guidance, a company may have disclosed in its SEC filings only the compensation consultants that provided services to the company board.
Securities Industry Backs SEC Proposal to Let US Issuers Report in IFRS

A joint industry working group supports the SEC’s proposal to allow U.S. issuers to prepare their financial statements in accordance with IFRS rather than GAAP. In a letter to the Commission, the group praised IFRS as high quality accounting standards that provide a means for faithful representation of economic events and transactions, and that provide investors and creditors with transparent and comparable financial information needed to make economic decisions. The letter was signed by the International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets Association (SIFMA).

The working group believes that the widespread use of IFRS will lead to improved comparability in financial reporting among global enterprises and among entities that operate within the same industry sectors. Also, over time, IFRS will reduce financial statement preparation costs and resources requirements.

But the group cautioned that the use of IFRS must be linked to the broad-based acceptance of IFRS by all relevant U.S.-based constituencies. Potential problems might arise, for example, if tax authorities insisted upon continued use of financial statements prepared under US GAAP.

The industry urged the SEC and the Treasury, perhaps operating under the auspices of the President’s Working Group on Financial Markets, to establish a task force, including preparers, auditors, taxing authorities, and banking regulators to assist in facilitating the acceptance in the U.S. of financial statements prepared in accordance with IFRS, whether the issuers are foreign or domestic companies.

In the group’s view, the use of IFRS could substantially impact the reporting of financial positions and performance of U.S. issuers as well as impact liquidity and solvency measures, such as a bank’s leverage ratio or a company’s loan covenant measures. It is thus important for the SEC to play an active role in coordinating broader acceptance of IFRS.

More specifically, the working group is concerned that, should the SEC provide U.S. issuers the opportunity to report under IFRS, very few banks would be able to realize the benefits of this opportunity unless current banking regulations are modified. For example, due to the remaining differences between IFRS and U.S. GAAP in areas such as derecognition, consolidation and offsetting of derivative fair value amounts, the reported leverage ratios would be appreciably lower for the same positions reported under IFRS versus U.S. GAAP. Absent a change in banking regulations, reasoned ISDA, this would represent a significant barrier to many financial institutions in adopting IFRS.

Another significant barrier to a successful implementation of IFRS reporting in the United States is regulator-specific or jurisdiction-specific interpretations of IFRS. This phenomenon exists in the European Union and elsewhere, which have differing gold plated versions of IFRS.
The group strongly opposes jurisdiction-specific interpretations of IFRS since such would diminish many of the benefits of providing an option for U.S. issuers to report under IFRS, including a reduction in comparability among companies that report under differing interpretations. Jurisdiction-specific interpretations may also impair users’ confidence in IFRS financial statements.

Given the principles-based nature of IFRS, there is also concern that the U.S. could be one of the jurisdictions in which specific interpretations of IFRS are applied. While the SEC concept release suggests that interpretations by securities regulators may be limited to interim views on accounting issues not yet addressed by the IASB or its International Financial Reporting Interpretations Committee (IFRIC), the group remains concerned about the willingness to accept the diversity in practice that may result from principles-based standards. Reasonable judgments that are consistent with the principles in IFRS standards should be accepted.

That said, the group asked the SEC to refrain as much as possible from issuing interpretations on narrow technical topics within areas that are broadly addressed in IFRS. In their view, interpretations that are specific to the U.S. are just as harmful to the comparability of, and confidence in, IFRS financial statements as any other jurisdiction-specific interpretation. Rather, the SEC should participate in the IASB’s existing standard setting process, where the experience and knowledge of the SEC’s staff could be of enormous benefit in developing high quality standards and interpretations for all IFRS users

Friday, December 14, 2007

SEC Staff Suggests MD&A Disclosures on Structured Investments and CDOs

In an open letter to the chief financial officers of banks and other entities that have investments in structured investment vehicles or collateralized debt obligations, the SEC staff identified a number of disclosure issues that they may wish to consider in preparing the Management's Discussion and Analysis section of upcoming annual reports on Form 10-K or 20-F.

With regard to the off-balance sheet arrangements disclosure required by Item 303 of Reg. S-K, the companies should consider disclosing a number of items for structured investment vehicle or CDOs for which the firm has material exposure. The firms should disclose categories and rating of assets, as well as the weighted-average life of assets that the off-balance sheet entity holds. Also to be disclosed are the forms of funding and the weighted-average life of the funding that the off-balance sheet entity holds. Any material difficulties the off-balance sheet entity experienced in issuing its commercial paper or other financing during the period should also be disclosed, as well as material write-downs or downgrades of assets.

The staff would also like to see disclosure of the maximum limit of the losses to be borne by any first loss note holders. In addition, affected companies should detail the types of variable interests they hold in the off-balance sheet entity.

The SEC staff also favors the detailed disclosure of the company’s obligations under the liquidity facilities. In doing so, the CFOs should consider whether there are triggers associated with the obligations to fund and whether there are any terms that would limit the firm’s obligation to perform.

Further, any obligations under the facilities and their material terms should be disclosed, such as the duty to purchase commercial paper the off-balance sheet entity issued. Investors should be informed if there are any other liquidity providers, and if so, how the company’s obligation ranks with the other liquidity providers.

Companies should consider disclosure of whether they purchased commercial paper or other securities issued by any off- balance sheet entities that they manage, and whether any agreement required them to make those purchases. If not, companies should discuss their reasons for the purchase. Similarly, companies should disclose if they provided or assisted the off-balance sheet entity in obtaining any other type of support, or whether it is their current intention to do so.

Further, the potential impact on debt covenants, capital ratios, credit ratings, or dividends should be disclosed if it is necessary to consolidate the entity or significant losses are incurred associated with the entity.

To the extent that companies have identified consolidation and variable interest entities as a critical accounting policy, they should consider discussing in their filings the scenarios where they would have to consolidate the off-balance sheet entity and their expectation of the likelihood of such a consolidation. The companies should also disclose the frequency of which they reconsider, and the typical triggers which require them to reconsider, whether they are the primary beneficiary of the entity.

Finally, the SEC staff reminded the CFOs of the Item 303 requirement to discuss any known trends or uncertainties that they may reasonably expect to have a material favorable or unfavorable impact on income from operations, liquidity and capital resources. In this regard, financial officers need to consider, to the extent material in light of their particular facts and circumstances, disclosing the amount of any material loss expected to be realized as a result of the firm’s involvement with any material off-balance sheet entity.

Thursday, December 13, 2007

UK Weighs in on Reform of Lamfalussy Process

As the European Commission conducts a review of the Lamfalussy arrangements for adopting EU financial regulations, UK authorities provided significant input designed to enhance the process. The Lamfalussy process has been used to implement the Financial Services Action plan in the EU, most recently the MiFID Directive.

The Lamfalussy process consists of four levels. Level One consists of framework Directives, while Level Two involves Implementing Directives. Level Three, where much of the reform is expected to take place, involves committees of national supervisors, such as CESR, which advise the Commission on implementing measures and work to ensure more consistent implementation. Level Four focuses on strengthening enforcement.

Generally, the Commission is not proposing major institutional changes to the current process. Rather, the EC has proposed some practical improvements for all levels of the Lamfalussy structure as part of an effort to ensure greater consistency and convergence in national implementation and enforcement and enhance cooperation between national regulators. In the view of Commissioner for the Internal Market Charlie McCreevy, Level Three deserves particular attention. The most significant innovations will be introduced at Level Three, he recently said, with the creation of committees of regulators responsible for ensuring greater regulatory convergence across the EU.

Overall, UK authorities believe that the Lamfalussy arrangements are structurally sound, and have made a major contribution to the regulation of financial markets. Nevertheless, the UK authorities set forth practical and ambitious proposals that they believe will deliver further tangible benefits in terms of the efficiency of the regulatory process and the effectiveness in the way the Lamfalussy committees conduct their day-to-day business.

The proposals, embodied in a joint Treasury-FSA report, follow two principles. First, that regulation should not be an end in itself, but should aim to improve markets and deliver economic benefits. To do that, regulations should be proportionate; support innovation, competition and efficiency; and promote financial stability. Second, that regulation should recognize the need for regulators to be accountable to national governments.

At the same time, Economic Secretary and City Minister Kitty Ussher rejected a pan-European regulator for financial services, saying that it would not have the flexibility needed to allow EU markets to prosper. She said that to legislate for a common method of regulation would create a massive and dislocating economic distortion rather than increased prosperity.

More specifically, the UK authorities want to see greater economic evidence used by the national regulators, and by CESR and other Level Three committees, when preparing advice to the Commission on EU directives. In addition, they want consistent implementation to facilitate cross-border competition.

In that regard, member states should limit their use of discretion to the minimum extent necessary. The Level Three committees were also urged to introduce a comply or explain regime for regulators departing from the majority view, coupled with a system of peer review to ensure legislation is being properly implemented in all jurisdictions.

Further, there is room to improve the regulation of groups that operate across borders, making it more efficient both for them and for regulators. That means more co-operation and trust between regulators. In order to support that, the Level Three committees were urged to put in place guidance setting out the different roles of home and host regulators. Similarly, there is a need to increase co-operation in cross-border crisis management.

Wednesday, December 12, 2007

PCAOB Official Tells How Ending IFRS-GAAP Reconciliation Affected Appendix K

The SEC’s elimination of the need for foreign private issuers to reconcile financial statements prepared under IFRS to US GAAP has raised some questions about one of the PCAOB’s interim quality control standards, known as Appendix K, according to Chief Auditor Tom Ray.

Appendix K seeks to enhance the quality of SEC filings by SEC registrants whose financial statements are audited by foreign associated firms. It does this by setting out procedures to be performed by persons knowledgeable in U.S. accounting, auditing, and independence requirements on certain SEC filings, the filing review, and annually in connection with internal inspection programs.

With respect to an SEC filing that includes financial statements prepared in accordance with IFRS, and for which the U.S. GAAP reconciliation is not required, noted the Chief Auditor, there are several provisions of Appendix K that are affected.

Among other things, the filing reviewer is directed to discuss with the partner-in-charge of the engagement the engagement team’s understanding of U.S. accounting and financial reporting standards and the significant differences between the accounting and financial reporting standards used in the filing and those applicable in the U.S. These provisions, noted Mr. Ray, which are specific to U.S. GAAP, are not applicable to a filing that contains no U.S. GAAP or U.S. GAAP reconciliation.

Other filing review procedures address reading the document to be filed with the SEC, discussing with the partner-in-charge of the engagement the team's understanding of applicable U.S. auditing and independence standards, and significant differences between these applicable U.S. standards and the auditing and independence standards of the foreign associated firm's domicile country; and discussing with the partner-in-charge of the engagement significant auditing, accounting, financial reporting, and independence matters that come to the attention of the filing reviewer when performing the filing review procedures. According to the Chief Auditor, these filing review procedures remain applicable even after the termination of the need to reconcile IFRS-driven financial statements to US GAAP. Similarly, the documentation and resolution of differences provisions of Appendix K remain applicable.

Finally, the Chief Auditor related that the PCAOB staff is evaluating whether changes should be made to Appendix K, including whether it should be replaced with something else or eliminated. More broadly, the Board is also looking at other possible changes to its standards and rules that may be necessary to clarify how PCAOB standards apply when financial statements are prepared according to IFRS.

Tuesday, December 11, 2007

PCAOB Censures Big Four Audit Firm for First Time

In its first disciplinary proceeding against a Big Four audit firm and one of its former engagement partners, the PCAOB censured Deloitte & Touche and imposed a $1 million penalty against the firm. Without admitting or denying the Board’s findings, the firm also agreed to implement changes to its quality control policies for identifying and addressing potential audit quality concerns regarding the performance and deployment of its audit partners. (In the Matter of Deloitte & Touche, LLP, Release No. 105-2007-005). Similarly, without either admitting or denying the Board’s findings, the engagement partner was barred from associating with a PCAOB-registered firm for at least two years. (In the Matter of Fazio, Release No. 105-2007-006).

In an interesting development, Deloitte established a Leadership Oversight Committee, consisting of senior members of its audit practice and firm leadership to address at the national level deployment and supervision issues relating to audit partners about whom quality or other audit performance concerns have been identified. This committee has the duty and the authority to subject personnel to special oversight of their audit work, refer individuals for counseling or additional training, restrict individuals from serving audit clients in specific capacities, or seek an individual's separation from the firm.

Claudius B. Modesti, Director of the Division of Enforcement, emphasized that firms must take reasonable steps to assure that their audit partners and other audit professionals are competent to conduct public audits. When concerns about an auditor’s competency arise, he noted, a firm must act with dispatch to protect audit quality.

The proceedings centered on the revenue recognition policies of a client company with a right of return. The Board found that, during the audit, the partner failed to perform adequate audit procedures related to reported revenue from sales of products for which a right of return existed and failed to adequately supervise others to ensure the performance of such procedures.
Audit procedures did not adequately take into account the existence of factors indicating that the company’s ability to make reasonable estimates of product returns may have been impaired. Moreover, in evaluating the reasonableness of the company’s estimates of future returns, the partner failed to take into account the extent to which the company had consistently and substantially underestimated its product returns.

In auditing reported revenue, the Board found that the partner failed to evaluate these factors with the due care and professional skepticism required under the circumstances. He also failed to identify and appropriately address issues concerning the company’s policy of excluding certain types of returns from its estimates of future returns and the adequacy of disclosure of this accounting policy.

In the Deloitte order, the Board found that, before the firm issued its audit report, management was aware of facts and circumstances that raised questions about the partner’s ability to lead public company audit engagements. Members of Deloitte’s management concluded first that the partner should be removed from public company audits and ultimately that he should be asked to resign from the firm. Yet the firm left him in place as the engagement partner and did not take meaningful steps to assure the quality of the audit work before issuing its audit report.

More than a year after the audit, the company restated its financial statements because its recognition of revenue from product sales upon shipment was not in accordance with GAAP.
The Board concluded that the firm’s quality control system did not function effectively to cause the audit to be appropriately staffed and led by a practitioner-in-charge with the necessary competencies. Further, in order to evaluate whether the recognition of revenue upon product delivery complied with GAAP, the firm was required to assess, among other things, whether the company had the ability to make reasonable estimates of future product returns. Without this ability, companies that sell products with a right of return cannot, consistent with GAAP, recognize revenue from these sales until the right of return substantially expires or a reasonable estimate of the returns can be made.

Various factors, such as the newness of a product and lack of actual return history, may impair a company’s ability to make reasonable estimates of future product returns. Here, the Board found that Deloitte's audit personnel documented the existence of each of these factors but did not adequately analyze whether they impaired the company’s ability to make reasonable estimates of returns.

Monday, December 10, 2007

Risk Management Elements for Asset-Backed Securities Detailed by SEC Official

Citing the Amaranth hedge fund implosion, an SEC senior official cautioned that from a risk management perspective concentrations are clearly undesirable and should be avoided. The question is however, recently stated Director of Trading and Markets Erik Sirri, how much concentration is too much. While in retrospect it is easy to look at what happened to that hedge fund and chalk up its demise to a concentrated natural gas bet gone wrong, or attribute the distress of other hedge funds to concentrated subprime exposures, prospective identification of risky concentrations is hard because bright line tests for how much is too much are elusive.

In addition, concentration must be assessed across many different dimensions. For example, the official asks how concentrated is a portfolio of fund derivatives of $15 billion notional hedged with the underlying hedge fund shares. Diversification across specific funds can offset concentration in a particular strategy.

Another complication is the possibility of a position suddenly becoming concentrated because of the actions of other market participants. As trading comes to a halt when liquidity dries up, positions that appeared to be modest in size relative to market activity can prove virtually impossible to exit, leaving little or no ability to actively risk manage the position through hedging activities.

A separate problem arises with securitized products such as mortgage-backed securities, which rely on the diversification of an underlying pool of assets. But reliance on diversification adds a new risk factor, said the director, namely the correlation among defaults or losses on underlying collateral. This correlation exhibits a form of negative convexity that is particularly difficult to capture and manage.

Another key component of risk management for securitized products and OTC derivatives is the valuation process. While it is tempting to rely on dealer quotes for the valuation of derivatives trading in liquid over-the-counter markets, noted the official, it is also a very risky proposition since one is relying on the continued liquidity of the market for marking. Even more, he continued, relying on dealer quotes is an abdication of the basic responsibility of a trader to understand risks.

While mark-to-model has taken on an ugly connotation in recent months, noted the director, it must be remembered that the process of modeling the positions' value ensures that complex risks, such as out-of-the-money puts, are understood. Simply relying on a price from another market participant involves no such understanding of risks, he averred, and is tantamount to flying blind.

Yet another fundamental rule of risk management is that risk is fungible. A trading firm that carefully measures and limits risk of a particular type is likely to find its traders and counterparties exposing the firm to risks of a type that are not as easily identified.

For example, firms may try to limit market risk exposure by limiting the balance sheet allocated to particular traders or businesses. But, given the availability of off-balance sheet funding arrangements, noted the official, the efficacy of such governance tools is obviously quite limited. And there is also a possibility that relatively straightforward market risk will be transformed to less easily measured liquidity risk. In a similar vein, a variety of market risk exposures can be easily transformed into counterparty credit risk using over-the-counter derivatives.

In the director’s view, a particular challenge to risk management is presented by asset backed securities collateralized debt obligations, which are essentially re-securitizations of already securitized products. These instruments create tranches with differing risk-return profiles intended to appeal to different investors. The riskiest tranche bears losses first. The least risky tranches are called super seniors. Since At deal inception super seniors are all rated AAA, risk managers are lulled into complacency.

The AAA ratings in particular made market participants comfortable holding concentrations that would have been unthinkable otherwise. But, while super seniors receive principal and interest payments until the lower tranches are wiped out, observed the SEC official, from a fair value perspective the price at which the investor can sell the position will decline.

In addition, the concentrated positions in super seniors emerged as a result of specific governance policies intended to minimize other risks. For example, the riskiest tranches were priced attractively relative to expected cash flows. Since the overall cash flow from the underlying assets is invariant to the capital structure, the cost for skewing distribution toward the lower tranches was that higher tranches such as super seniors were relatively overpriced and thus more difficult to sell.

In this way, governance mechanisms intended to limit one type of risk effectively led to other risks being assumed that were more complex and difficult to analyze. In turn, a risk management problem occurred when concentrated positions in super seniors developed into a risk that suddenly became illiquid. Once markets start moving adversely and liquidity goes away, said the official, there is little left other than to hope.

Thursday, December 06, 2007

MFA Issues Best Practices for Hedge Fund Managers

The Managed Funds Association has issued its latest edition of sound practices for hedge fund managers, including substantive updates on valuation, risk management and responsibilities to investors. The best practices are also heavy on disclosure to investors, including soft dollar arrangements. They also embrace risk management and best execution. The MFA also introduced a model due diligence questionnaire designed for all types of investors, including high net worth individuals, pension fund managers and nonprofits.

Generally, hedge fund managers should establish management policies and oversight appropriate for the size and complexity of the fund and for its trading activities. They should also determine the risk and trading policies for each fund they manage based on the specific investment objectives described in the offering documents.

Importantly, hedge fund managers should carefully select and monitor any mission critical, third-party service providers performing key business functions, such as prime brokerage.

Disclosure to investors is a centerpiece of the sound practices. Hedge fund managers should disclose any relationships between themselves and service providers that may give rise to potential material conflicts of interest. They should also provide investors with information regarding the fund’s investment objectives and strategies, range of permissible investments, and material risk factors.

Of significance to hedge fund managers with UK operations is disclosure of side letters and other similar arrangements containing terms enhancing an investor’s ability to redeem shares or interests or make a determination as to whether to redeem shares or
interests that might reasonably be expected to put other investors in the same class at a material disadvantage.

The best practices also call for fund managers to develop and maintain a code of ethics and personal trading policies and communicate the material aspects of this code to investors.

Hedge fund managers should disclose their use of soft dollar arrangements to investors in each fund that they manage. Disclosure should be made prior to engaging in such arrangements. They should evaluate the types of products and services subject to the soft dollar arrangements. The evaluation should determine the extent to which products or services have research functions or are developed by a third party and provided by a broker.

Risk management is also a key component of the best practices. Hedge fund managers should have a risk management process appropriate to the fund’s size, complexity, and portfolio structure. As part of risk management, hedge fund managers should perform stress tests to determine how potential large changes in market prices and other risk factors could affect a hedge fund’s value.

The principle of best execution is also embedded in the best practices. When seeking best execution for all types of instruments, hedge fund managers should execute transactions in such a manner that the execution quality on an aggregate, periodic basis is the most favorable under the circumstances. In assessing whether this standard is met, they should consider the full range and quality of a counterparty’s services.

Monday, December 03, 2007

SEC Senior Official Reminds on Hedge Fund Valuation and Risk Management

In the wake of recent market events, the SEC’s Director of Investment Management reminded advisory firms managing hedge funds that they have a fundamental duty to value appropriately and fairly even if a vehicle or account is not subject to the Investment Company Act’s valuation requirements. In remarks before the CCOutreach national seminar, Andrew Donohue also said it was important that chief compliance officers and compliance professionals go back and review the disclosures that have been made to clients regarding valuation procedures.

As part of this review, he continued, compliance professionals should make sure that those valuation procedures are consistently implemented in accordance with the disclosures provided to clients. In the current market conditions, he reasoned, both compliance officers and regulators alike should have a heightened awareness of the importance of valuation and its impact on advisory clients. The director also mentioned the special compliance concerns related to fixed income investments and derivatives. In terms of valuation, investments in fixed income securities and derivative instruments present unique challenges for compliance officers that may not be readily apparent.

In earlier remarks before the Investment Company Institute, the director focused on the need to move from historical models of risk management to a new dynamic reflecting the advent of operational risk and new complex investment products, such as OTC derivatives. Historically, a common approach has been to develop complicated algorithms to guide risk management systems and procedures.

In developing these algorithms, firms took into account the details of past negative events and account for the circumstances that ultimately led to their occurrence. As a result, over the years these algorithms have become finely tuned to address the known risks and contingencies that have occurred over time.

Using such an historical approach may have been appropriate in the past, he noted, when the risks were narrowly-defined and generally known. But now, operational contingencies cannot always be categorized and losses can result from a complicated mix of events, making it hard to predict or model contingencies.

Firms have shifted their focus to the more amorphous area of operational risk. Recently, the Basel Committee set forth a definition of this new area of risk focus as being the risk of loss resulting from inadequate or failed internal processes, people or systems or from external events. Even with this definition, opined the SEC official, it is still difficult to nail down as to what it exactly entails. Indeed, its undefinable nature is what makes operational risk all the more daunting to manage.

The development of complex investment products have caused operational risk to arise as constraints in the back-office threaten important functions, such as managing the settlement, valuation and confirmation processes. In addition, the escalating trading volume of complex derivative instruments has put tremendous constraints and exposed weaknesses in firms’ systems for clearing complex products.

Sunday, December 02, 2007




Walker Group Issues Final Guidance for Private Equity Disclosure

A UK working group headed by Sir David Walker has issued final guidance to enhance disclosure by private equity firms and companies they acquire, called portfolio companies in the report. The guidance is on a comply or explain basis. Any explanation for non-compliance should be posted alongside other related relevant disclosures called for under the guidelines on the website of the private equity firm or portfolio company.

The guidelines call for a portfolio company to disclose in its audited annual report the identify of the private equity fund or funds that own the company and the senior executives or advisers of the private equity firm in the UK who have oversight of the company on behalf of the fund. The report should also detail the composition of the board, identifying separately executives of the company, directors who are executives or representatives of the private equity firm and directors brought in from outside for industry experience.

The financial review should also cover risk management objectives and policies in the light of the principal financial risks and uncertainties facing the company, including those relating to leverage, with links to appropriate detail in the footnotes to the balance sheet and cash flow section of the financial statements.

The guidelines recommend that private equity firms annually or regularly disclose on their website a commitment to conform to the guidelines on a comply or explain basis and to promote conformity on the part of the portfolio companies owned by its fund or funds. The firm should also disclose the most senior members of the management or advisory team and confirm that arrangements are in place to deal with conflicts of interest, in particular where it has a corporate advisory capability alongside its fiduciary responsibility for management of the fund. The Walker group also asks for a description of UK portfolio companies in the private equity firm’s portfolio.

The guidelines also call for private equity firms to act responsibly at a time of significant strategic change. Specifically, a firm should ensure timely and effective communication with employees at the time of a strategic initiative or a transaction involving a portfolio company as soon as confidentiality constraints cease to be applicable. In the event that a portfolio company encounters difficulties that leave the equity with little or no value, the private equity firm should be attentive not only to full discharge of its fiduciary obligation to the limited partners but also to facilitating the process of transition as far as it is practicable to do so.

The Walker report also addressed what it called ``private equity-like’’ investors, principally sovereign wealth funds that use leverage in a similar way to private equity. While there was no mandate to bring sovereign wealth funds within the scope of the guidelines, the report urged investors who operate in a “private equity-like” manner to observe the guidelines as good citizens in their own best interest. The report also cited the general principle that investment activities that are similar in substance should be subject to broadly similar reporting and disclosure provisions.