Wednesday, August 18, 2010

Key Senators Urge the SEC to Adopt Regulations Enhancing Off-Balance Sheet Disclosures

Six key Democratic Senators have urged the SEC to use its existing authority under Sarbanes-Oxley to require that companies write detailed descriptions of all their off-balance sheet activities in their annual Form 10-K reports and not just descriptions of those activities that are reasonably likely to affect the firm’s financial condition, as the regulations currently state. In a letter to SEC Chair Mary Schapiro, the senators also urged the Commission to require companies to explicitly justify why they have not brought those liabilities onto the balance sheet. As regulators implement the Dodd-Frank Wall Street Reform and Consumer Protection Act, noted the senators, the complete disclosure of all off-balance sheet activities is particularly crucial for the largest and most interconnected companies, including both banks and non-banks. Without such disclosure, they emphasized, it will be almost impossible for regulators to set appropriate capital and leverage requirements under Dodd-Frank and for investors and counterparties to make wise decisions about where to put their money.

Moreover, the senators urge the SEC to encourage the FASB to improve financial reporting rules for all types of off-balance sheet activities and to monitor FASB’s efforts to prohibit off-balance sheet financing. The letter to the SEC Chair was signed by Senators Robert Menendez, Ted Kaufman, Barbara Boxer, Diane Feinstein, Carl Levin, and Sherrod Brown.

The Sarbanes-Oxley Act authorized the SEC to require reporting of off-balance sheet activities. While the SEC did issue rules on off-balance sheet activity pursuant to Sarbanes-Oxley, noted the senators, they are troubled that, despite these rules, widespread off-balance sheet accounting arrangements allowed large financial firms to hide trillions of dollars in obligations from investors, creditors, and regulators. As Frank Partnoy and former SEC Chief Accountant Lynn Turner wrote in a recent report, noted the senators, abusive off-balance sheet accounting was a major cause of the financial crisis. The report indicates that these abuses triggered a daisy chain of dysfunctional decision-making by removing transparency from investors, markets, and regulators. Off-balance sheet accounting facilitated the spread of the bad loans, securitizations, and derivative transactions that brought the financial system to the brink of collapse.

For example, said the senators, Citigroup reportedly kept $1.1 trillion worth of assets off its books in various financing vehicles and trusts that were used to handle mortgage-backed securities and issue short-term debt. In addition, State Street shareholders saw their investment value drop by 60% in a single day when hidden off-balance sheet conduits sustained heavy losses under credit turmoil in January 2009. Neither of these companies adequately disclosed the risks posed by their off-balance sheet activities to investors. Had they done so, said the senators, investors and creditors might have made better decisions.

The senators also urged the SEC to pay particular attention to the large market for repurchase agreements. They are concerned by both the risks of using short-term funding for longer-term holdings and that firms may be engaging in these transactions with the intent to hide their true debt and risk levels. As an example of such, they cited Lehman Brothers use of the Repo 105 transaction as particularly troubling. According to the Lehman Brothers Examiner’s Report, Lehman took advantage of accounting rules to temporarily book a loan as a sale, and by carefully timing this transaction just before the release of its quarterly financial report, Lehman was able to deceive the public and regulators into thinking it was much better capitalized than it actually was.

The federal bankruptcy court examiner concluded that there were colorable claims against Lehman’s outside auditor for its failure to question and challenge improper or inadequate disclosures in Lehman’s financial statements. Similarly, the examiner found colorable claims against the Lehman senior officers who oversaw and certified the firm’s misleading financial statements. Further, although repo transactions engaged in by the firm may not have been inherently improper, the examiner found a colorable claim that their sole function as employed by Lehman was balance sheet manipulation. On September 15, 2008, as the financial crisis roiled, Lehman Brothers Holdings, Inc. sought Chapter 11 protection in the largest bankruptcy proceeding ever filed.

In order to prevent this from happening in the future, the senators urged the SEC to require disclosure of period end and daily average leverage ratios in quarterly and annual reports. This would provide useful information to investors and creditors to assist their decision-making processes. Rather than relying on carefully-staged quarterly and annual snapshots, said the senators, investors and creditors should have access to a complete real-life picture of a company’s financial situation.

The SEC was founded on the premise that when investors and creditors have full and accurate information about companies’ finances, they can allocate capital effectively. But when companies use accounting gimmicks to mislead investors and creditors, capital markets malfunction. As the financial markets attempt to recover from the latest meltdown, the senators want the SEC, in addition to aggressively investigating and prosecuting past misconduct, tol put in place new rules that will make it harder for companies to mislead investors and creditors in the future.