Can Big Four Go to Big Five and Prevent Big Three?

The audit industry has responded to a Financial Reporting Council consultation paper on auditor choice in the UK public company market. The FRC oversees public company audit in the UK. The demise of Arthur Andersen has meant that only four firms of a similar size globally now remain to audit the financial statements of public companies. The remaining Big Four dominate the audit market in the UK and indeed globally. A number of critical issues arise due to the current situation, one of which is whether the Big Four can ever again become the Big Five, and conversely, how to prevent a withdrawal of a firm that would lead to the Big Three.

The view of the Big Four is that the current market for audits is highly competitive in price and quality. There is also the view that global companies demand auditors with a global presence, and that only the Big Four have sufficient global resources to satisfy this need.

There is also a consensus on the view that unlimited liability is the way the Big Four can become the Big Three. Thus, the Big Four strongly support the pending UK Company Law Reform bill that would allow auditors and client companies to agree, subject to shareholder approval, on limitations on liability. KPMG noted that the Big Four do not have sufficient capital to deal with a single catastrophic claim or indeed a series of lesser claims. Ernst &Young said that meaningful auditor liability reform must go beyond the UK and include the US and EU as well in order to be effective.

Ernst & Young viewed the main issue as being one of preventing the withdrawal of one of the Big Four from the audit market. If the Big Four were reduced to three, posited E&Y, there is a real risk that the entire profession would be put at risk since it would be unlikely that firms would be able to retain enough talented people to consistently deliver a quality audit product.

There was some pessimism that the Big Four could become the Big Five any time soon. According to KPMG, the issue of concentration of audits in the Big Four is a global issue and the appropriate solution can only be arrived at on a global basis taking account of market forces. The solution is likely to involve the merger of mid-tier firms, which would require significant investment. There are two critical changes that have to happen before such a merger could occur. First, there must be liability reform in all major economies where there is currently an unlimited liability regime. Second, there must be much faster progress towards convergence of accounting and auditing standards.

Eminent Persons Ask SEC to Reopen Options Expensing Debate

There is a growing buzz over a position paper in the Summer issue of the California Management Review asking the SEC to reopen for debate the FASB’s new standard requiring the expensing of employee stock options. Thirty of the nation's leading experts in accounting, economics, business, and finance signed the paper to express their concern that financial statements are being impaired by mandating the expensing of options. The thirty signatories include three Nobel Prize winners in economics, two former CEOs of Big Four accounting firms, and two former Treasury Secretaries.

Calling a stock option a gain-sharing instrument in which shareholders agree to share their gains, if any, with employees, the paper reasons that, by its nature, such an instrument has no accounting cost until there is a gain to be shared. When the stock price goes up and there is a gain to share, the paper continues, it must be located on the books of the party that reaps the gain, which is the shareholder not the company. By this reasoning, it follows that the cost of the stock option is borne by the shareholders.

Despite the heavyweights who ask the SEC to reopen the debate, I believe that this ship has already sailed. Neither the SEC nor Congress is likely to revisit this issue. And, there is no public sentiment to do so. If anything, the investing public favors the expensing of options. Bills in Congress to delay stock option expensing have uniformly failed to gain traction.

The debate over stock options has been with us for many years, at least since Professor Berle observed the growing divorcement of company management from company ownership and the dawning of the professional managerial class. I believe that the only legitimate reason for stock options is to align the interests of that managerial class with the owners of the company, the shareholders. That is why the repricing and backdating of options is wrong, not because of expensing or non-disclosure, but because it distorts the perfect alignment of corporate management with ownership. The shareholders do not get to reprice their shares.

Auditor Cert. of Financials Was Not Opinion on Management's Integrity

By James Hamilton, J.D., LL.M.

One of the most lucid judicial statements about what an outside independent auditor’s certification of a company’s financial statements actually means, and what it does not mean, is to be found in a recent opinion by a federal judge in the Southern District of New York. In this case. an outside auditor certified its audit of the company’s annual financial statements for the years 2003 and 2004. In each instance, the financial statements reported millions of dollars of losses and negligible revenue. Both of the auditor’s certifications included a going concern paragraph. The court noted that there were no false statements regarding the company’s financial condition in either of the annual financial statements audited by the outside auditor.

Instead, in their securities fraud action, investors asserted that the auditor’s certification of the financial statements contained a misstatement when the certifications said that the audit firm had conducted its audits in compliance with GAAS. The investors contended that the auditor could not have reasonably relied upon the integrity of management because red flags should have alerted it to management's lack of integrity.

In dismissing the securities fraud claims against the auditor, the court held that, in certifying the audits, the audit firm did not vouch for the integrity of management. Rather, its certification was addressed to the degree to which those financial statements comported with GAAP when audited with the degree of care mandated by GAAS.

In the court’s view, GAAS is relevant only insofar as it provides investors with a level of assurance that the financial statements accurately reflect the company's financial position when measured against GAAP. The court emphasized that an auditor's certification that a company's financial statements comport with GAAP is not also a representation about the integrity of management; and nothing in GAAS requires such a representation. In re Ramp Corporation Securities Litigation, (SD NY 2006), is reported in the CCH Federal Securities Law Reporter at ¶93,914.

PCAOB Member Says Valuation Premium Trumps SOX Cost

By James Hamilton, J.D., LL.M.

I have been discussing on the blog the great macro issue of whether the costs of the Sarbanes-Oxley Act, particularly Section 404 internal control mandates, are chilling foreign companies from listing on US exchanges. I believe that to some extent Sarbanes-Oxley has caused capital to stay away from US exchanges. But, in fairness, I want to discuss recent remarks made in Brazil by PCAOB Member Charles Niemeier disputing the view that burdensome US regulation is discouraging companies from entering the US capital markets. According to the Board Member, there is no evidence that the cost of maintaining a US listing exceeds the premium companies enjoy on a US market. Rather, the facts appear to confirm the continued attraction of US markets due to the significant valuation premium for companies that can meet the requirements of a US listing, which the NYSE has estimated at 30 percent.

The Member also observed that, despite the significant US valuation premium, companies will still list locally due to political and cultural factors. In this regard, the noted that the top five IPOs in 2005 were privatizations of state-owned entities in China and France which, not surprisingly, listed on the Hong Kong and Euronext markets. In the Member’s view, it is doubtful that weaker disclosure and corporate governance requirements would have attracted these IPOs to US markets. My comment is how can the Member know this since you cannot prove a negative. In addition, the Member does not address the fact that the increasingly growing number of foreign private issuers peaked around 2002 and has been flat ever since. Is it just a coincidence that Sarbanes-Oxley was passed in 2002?

New Book Addresses Executive Compensation Rule Changes

The SEC has completed the most sweeping overhaul of executive compensation and related party transaction disclosure in fourteen years. The revision puts in place a principles-based disclosure regime designed to give investors the information they need on executive compensation to make informed investment decisions and demystify any related transactions between executives and their companies. The new rules also enhance and consolidate into one item director independence and related corporate governance disclosure requirements. I have written a Law and Explanation book offered by CCH on these developments that I believe will be a valuable guide and reference to the new regulatory regime. The book examines in detail the revisons to executive compensation and related-transaction disclosure.

International Accountants Reject SOX Internal Control Model

I have been commenting on the emergence of an international consensus that has steadily and inexorably been building towards a principles-based, risk-focused approach to internal controls and away from the prescriptive approach embodied in Sec. 404 of the Sarbanes-Oxley Act. Now a seminal report by the International Federation of Accountants adds fuel to this fire. The report reveals broad support for a principles-based, non-prescriptive approach that recognizes the need for companies to develop an internal control system particular to their own specific internal and external environments.

Many jurisdictions are coming to the view that Sec. 404 and related guidance for auditors is the product of a unique rules-based US regulatory framework characterized by detailed and costly compliance mandates. Other jurisdictions, including the UK and Hong Kong, have recently endorsed principles-based and market-led internal control frameworks.

The IFAC report revealed that the preference of the corporate and auditing communities is for an internal control system that sits within a risk management
framework and is embedded within the company, with employees informed as to how it impacts on their roles and their requirements in terms of monitoring and reporting. Moreover, the importance of the tone at the top and the ethical framework throughout the company is considered essential to the successful implementation of an internal control system.

New Compensation Committee Report Is Bone to Corporate Community

In the recent adoption of a new executive compensation disclosure regime, commenters failed to get the SEC to retreat from mandating that the new Compensation Discussion and Analysis be filed and hence subject to Sarbanes-Oxley certification. But in an effort to take the sting out of the new certification document, the Commission did require a separate compensation committee report over the names of committee members as a means of emphasizing the committee’s involvement in the disclosure. And, most importantly, the report will provide additional information to which the principal executive officer and principal financial officer may look to in completing their personal Sarbanes-Oxley certifications of the CD&A.

The new compensation committee report responds to concerns that compensation committees should continue to be focused on the executive compensation disclosure process. This new report requires the committee to state whether it has reviewed and discussed the CD&A with management and, based on the review and discussions, has recommended to the board of directors that the CD&A be included in the company’s annual report on Form 10-K and, as applicable, the company’s proxy or information statement. And, the compensation committee report will have to be included or incorporated by reference into the company’s 10-K, so that it is presented along with the CD&A.

Fund Industry Pushes Back Again on SEC Independent Chair Rule

The SEC’s two-year Sisyphusian battle to impose an independent chair rule on the mutual fund industry drags on, the industry has pushed back hard at the latest iteration of the proposal. The Investment Company Institute strongly urged the SEC to abandon its attempt to require mutual funds to have an independent chair in the wake of an appeals court ruling delaying vacating the rule to give the Commission 90 days to seek additional public comment on its implementation costs. The comment period closed on August 21.

The ICI wasn’t even talking much about implementation costs. Rather, the Institute’s most compelling argument against the independent chair rule is that the culture of the boardroom has evolved to the point that it is not even needed. Through a variety of different means, the SEC's goals in proposing the independent chair rule have already been accomplished, argued the ICI, diminishing the possibility of benefits flowing from the requirement. In this regard, earlier in-place SEC fund governance reforms, which have gained wide acceptance, have obviated the need for the independent chair mandate.

According to the Investment Company Institute, regular executive sessions have increased cohesion among the independent directors, which has helped foster meaningful dialogue between the directors and fund management. Also, as a result of the annual board self-assessment requirement, directors continually revisit the effectiveness of how they operate. Even apart from any specific regulations, increased scrutiny, enforcement actions, and private litigation stemming from the trading scandals have heightened the attention of fund directors and fund management to the importance of maintaining a culture of compliance, regardless of whether the chair is independent.

In addition, the fact that the chief compliance officer must now meet at least annually in an executive session with the independent directors has created an opportunity for the chief compliance officer and the independent directors to speak freely about any sensitive compliance issues of concern to any of them. Similarly, the requirement that independent directors meet quarterly in executive session provides another opportunity for a full and frank discussion regarding the management of the fund.

New CD&A Destined To Be As Big As MD&A

I have earlier alluded to the heavy lifting that the Compensation Discussion and Analysis (CD&A) will have to do on options as part of the SEC’s new executive compensation disclosure regime. Well, after some retrospection and a detailed examination of the 436-page adopting release, I want to expand my earlier statement to say unqualifiedly that the CD&A will have to do some heavy lifting, not only with options, but with much else

The CD&A, which I believe is at the heart of the new disclosure regime, is a narrative principles-based explanation of the material elements of the company’s compensation for its five named executive officers. It also has to detail the objectives of the compensation program and what the program is designed to reward. The CD&A is destined to become as big and important as the MD&A.

The SEC has provided in Item 402 of Reg. S-K what the agency calls illustrative examples of topics worthy for discussion. But in addition to those examples, the SEC has also indicated in the adopting release that the CD&A could discuss hedging arrangements under which executives alter their economic interest in securities they beneficially own. This type of discussion could involve derivatives. The SEC also wants the CD&A to explain instances of double disclosure.

SEC Staff Advises in Wake of Hedge Fund Adviser Ruling

Buried in a no-action letter response is important interpretive guidance from the SEC staff on matters that have arisen since a federal appeals court struck down the SEC’s hedge fund adviser registration rule. In the wake of the Goldstein ruling, which the SEC will not appeal, the staff has provided broad guidance to the advisory community through the vehicle of responding to a request from the American Bar Association.

The staff advised that it will not recommend enforcement action if a hedge fund adviser that registered as a result of the SEC's rules withdraws its registration in reliance on the exemption provided by section 203(b)(3), regardless of whether the adviser held itself out to the public while it was registered and had more than 14 clients, counting each private fund as a single client, while it was registered.

The SEC's rules created a limited transition exception from the requirement that registered investment advisers maintain certain records that demonstrate the calculation of their performance information that is used in advertising. The staff advised that it will not recommend enforcement action if an investment adviser that registered as a result of the SEC's hedge fund adviser rules does not maintain the books and records required by rule 204-2(a)(16) as long as the adviser meets the terms and conditions of vacated rule 204-2(e)(3)(ii).

The SEC provided a grandfather provision when it adopted the hedge fund adviser rules to allow for existing advisory agreements on performance-based compensation for advisers that had to register as a result of the rules. The staff will not recommend enforcement action against a registered hedge fund adviser that receives performance-based compensation to the extent that the adviser would have been exempt from the prohibition on receiving such compensation under vacated rule 205-3(c)(2) or (3).

The staff also confirmed that the substantive provisions of the Investment Advisers Act do not apply to offshore advisers who remain registered with the SEC with respect to their dealings with offshore funds and other offshore clients. Offshore advisers must comply with the Act and other rules with respect to any U.S. clients they may have.

New CD&A Must Do Some Heavy Lifting on Options

Has anyone noticed that the SEC is using the new Compensation Discussion & Analysis adopted as part of the new executive compensation disclosure regime as the primary vehicle for options dating disclosure? It is a good vehicle to use because it will be in the annual report and is subject to Sarbanes-Oxley Section certification by the company’s chief executive and financial officers.

The CD&A, which is modeled on the MD&A, is envisioned as a narrative principles-based overview explaining material elements of the company’s compensation for named executive officers. The SEC requires companies to address option compensation in the CD&A, including the timing and pricing of stock option grants. The company should also discuss the reasons it selects particular grant dates and awards, as well as the methods used to select the terms of awards, such as the exercise prices of stock options. Importantly, any plan to select option grant dates in coordination with the release of inside information should be disclosed in the CD&A. Thus, the CD&A is looming as one of the most critical and hot sections of the financial statement.

EU Corporate Governance Forum Rejects SOX Internal Controls

Europe is definitely moving away from Sarbanes-Oxley Sec. 404 internal controls, The latest manifestation of this is the European Corporate Governance Forum’s emphatic rejection of the internal controls over financial reporting mandates of Sarbanes-Oxley for EU public companies. The forum was created by the European Commission as a high-level advisory group on corporate governance.

While acknowledging that the Sarbanes-Oxley mandates have inspired greater confidence in financial reporting, the forum also pointed out the serious concerns over the costs of implementing the internal controls rules and standards. In addition, internal control measures developed to enhance financial reporting must be proportionate and reflect the Better Regulation principles adopted by the European Commission, which require balancing the benefits of a regulation against the burden it places on a company.

The forum’s position builds on a growing consensus within the EU that the Sarbanes-Oxley prescriptions on internal controls are not the route to better corporate governance. Recently, after extensive consultations on internal controls reporting, the European Federation of Accountants concluded that it is not desirable to have a European equivalent of Sarbanes-Oxley Sec 404.

SEC Moves Aggressively on Hedge Funds after Losing Court Fight

By James Hamilton, J.D., LL.M.

In the wake of the judicial invalidation of its hedge fund adviser registration rule, the SEC is moving forcefully on a rulemaking and guidance agenda to regulate hedge funds. Chairman Cox emphatically declared that hedge funds are not, should not be, and will not be unregulated. I applaud the chairman’s efforts and his aggressive position. In my view, any entities that on a given day account for over 50% of trading on the NYSE, as hedge funds reportedly do, should be subject to regulation. It should not even be a matter of debate.

While the SEC said it would not appeal en banc the federal appeals court panel’s ruling in Goldstein, Chairman Cox said that a new antifraud rule under the Investment Advisers Act will be proposed, which would effectively look through a hedge fund to its investors. This would reverse the side effect of the Goldstein decision that the antifraud provisions of the Act apply only to clients as the court interpreted that term, and not to investors in the hedge fund.

At the chairman’s direction, SEC staff are also considering whether to increase the minimum asset and income requirements for individuals who invest in hedge funds. In addition, staff guidance can be expected to address the grandfathering, transition and other miscellaneous relief necessitated by the vacating of the rule. This will help eliminate disincentives for voluntary registration, and enable hedge fund advisers who are already registered under the rule to remain registered.

Pension Reform Act Creates Fiduciary Adviser for 401(k) Plans

In recognition of historic changes in worker retirement planning, Congress has passed pension reform legislation allowing companies to provide their employees with access to professional investment advice under fiduciary and disclosure safeguards. The Pension Protection Act includes a comprehensive investment advice provision allowing employers to provide rank-and-file workers with access to a qualified investment adviser who can inform them of the need to diversify and help them choose appropriate investments. The vehicle for the provision of this investment advice will be the fiduciary adviser, a new term in financial regulation, defined to mean a plan fiduciary who is also a registered investment adviser, registered broker dealer, bank trust department, or insurance company. The fiduciary adviser will provide the advice through an eligible investment advice arrangement. For the first time, qualified fiduciary advisers will be allowed to offer face-to-face, personally-tailored investment advice to help employees manage their 401(k) and other retirement options.

As additional protection, Congress commands that the terms of a recommended transaction must be at least as favorable to the plan as an arm's length transaction would be, and that the compensation received by the fiduciary adviser be reasonable. Fiduciary advisers must also comply with a six-year record-keeping requirement for records necessary to determine whether the conditions of the exemption have been met.

Disclosure Committees Must Prepare for New Exec Comp Regime

No one should overlook important remarks by John White, the SEC’s Corporation Finance Director, about how disclosure controls will impact the new executive compensation disclosure regime. Disclosure controls and procedures have been mandated since 2002 for all registered public companies, including foreign private issuers. Eventually, according to Director White, companies will have to ensure that their disclosure controls and procedures cover the new executive compensation disclosure requirements. Companies should begin immediately to plan how their disclosure controls will need to be revised to handle the new executive compensation disclosure regime.

As part of the disclosure controls, he emphasized, companies must ask who will collect and aggregate the different types of information, which may not fit neatly with information collected to meet existing disclosure rules. They must also ask who will be responsible for maintaining and analyzing the information; and ensuring that the company's compensation story in the new CD&A is told correctly. Importantly, companies must determine if their disclosure committees are properly positioned for the task. Finally, there is the question of what can be done to prepare to present executive compensation information in any tagged data format that becomes available in the future.

No Legislative Fix for Sarbanes-Oxley in This Congress

It is becoming increasingly clear that there will be no legislative reform of the Sarbanes-Oxley Act this year. This point was driven home at a recent Financial Services Forum roundtable attended by a senior Treasury official and three members of the House Financial Services Committee. According to Rep. Joseph Crowley, the 109th Congress is not going to do anything with regard to Sarbanes-Oxley. In his view, the earliest that legislators are going to do anything is in the next Congress or the Congress after that. Despite the introduction of the Feeney-DeMint COMPETE Act to essentially reform the internal control provisions of sec. 404 of the Act, there will be no reform until after the impending retirements of Sen. Paul Sarbanes and Rep. Michael Oxley.

White Paper on Executive Compensation Rules Available

My white paper on the executive compensation rules is available here.