As The D & O Diary has previously noted (here and here), earlier this month the National Economic Research Associates (NERA) and Cornerstone Research (in conjunction with the Stanford Law School Securities Class Action Clearinghouse) released their respective studies of the 2006 securities class action lawsuit filings. The NERA study can be found here and the Cornerstone study can be found here. Although the two studies differ in some of their numerical details, the two studies agree in most of their important conclusions, including the fact that the number of 2006 filings represents the lowest annual total since the passage of the Private Securities Litigation Reform Act of 1995. Each of the studies has some interesting additional observations about the 2006 filings.

In the latest issue of InSights (here), I review the two studies’ observations and also take a closer look at the 2006 lawsuits to try to better understand the data. In particular I analyze the data (by SIC Code, Industry and Sector) to determine who got sued, where and when. In addition, I review NERA’s study’s conclusions about the 2006 securities class action settlements, assesses the possible reasons for the 2006 filings decline, and close with some thoughts about the possible impact of the decline on the pricing of D&O insurance.

Famous Last Words: "I’m confident it will work, the only thing is, we’re just not sure how much dynamite to use."

 

Photobucket - Video and Image Hosting One of the essential tenets of modern corporate governance is that shareholders control corporate managers through shareholder voting. This notion is founded on the premise that shareholders will vote their economic interests, and the weight of their vote will be proportionate to their economic interest. However, research by University of Texas law professors Henry Hu and Bernard Black reveals that as a result of recent capital markets developments, hedge funds and other investors can “decouple” voting rights from economic ownership of shares. For example, a hedge fund borrowing shares from institutional investors can acquire the voting rights of the borrowed shares, even though the shareholder who owns the shares retains the economic interest in the shares.

The professors’ legal research can be found here and here, and is discussed in a January 26, 2007 Wall Street Journal article entitled “How Borrowed Shares Swing Company Votes” (here, text courtesy of the Texas Law School web site).

The hedge funds or other investors who wish to obtain voting power do so by borrowing shares from large institutional investors, often as part of a short selling strategy. Borrowing the shares allows the hedge funds to gamble that the shares will decline, and they can use their vote to try to ensure that they will. The professors call the exercise of voting rights divorced from economic interests “empty voting.” The Journal article cites several examples where shortselling hedge funds used this technique as part of a successful short selling strategy.

The professors emphasize that no one knows how widespread this practice is. Their research examined 22 instances worldwide from 2001 through 2006. The Journal article notes that these kinds of votes have not yet affected outcomes in many general corporate elections. But the practice could become more important given current corporate governance momentum built around increasing “shareholder democracy,” such as the push for majority voting of directos and the right of shareholders to be able to propose board candidates.

The “empty voting” issue has attracted the attention of regulators. SEC Commissioner Paul Atkins, in a speech on January 22, 2007 (here), raised his concerns with the practice, and the Journal article quotes SEC Chairman Christopher Cox as saying that the practice is “almost certainly going to force further regulatory response to ensure that investors’ interests are protected.”

Finding a simple regulatory solution may be complicated by the fact that shareholder voting is largely controlled by state law. In addition, the vested interests in the status quo include not only hedge funds and others who might use the strategy to advance their interests, but also the institutional investors who profit by lending their shares. According to the Journal, brokerages and big banks now make $8 billion a year in fees they earn by lending their shares. CalPERS alone made $129.4 million by lending shares its holds in the year ending March 31, 2006.

The professors proposed solution puts less emphasis on regulation and more on disclosure. They propose an “integrated ownership disclosure reform,” that would require disclosure both of voting and economic ownership. The professors proposed solution would not eliminate some disclosure delays, and even allows the possibility that the disclosure might not take place until after the vote has taken place – but it would still ensure that the disclosure takes place eventually, which would both inform regulators and lawmakers for future remedial purposes, and act as some constraint on behavior.

An interesting perspective on this issue, and a presentation of the brief against further regulation on this issue, can be found on Professor Larry Ribstein’s Ideoblog, here. CFO.com also has an interesting January 26, 2007 article entitle “How to Beat the Hedge Fund Bullies” (here), that examines strategies that companies can use to identify who their shareholders are and analyze how the shareholders’ are voting.

Photobucket - Video and Image Hosting SEC Chairman Cox on Global Competitiveness: As The D & O Diary has noted on numerous recent posts (most recently here), the issue of the competitiveness of the U.S securities markets in the global economy has been the subject of a great deal of comment lately. Regular readers will recall my concern that while the U.S. should look to its competitive interests, it should take care to avoid compromising its regulatory integrity. In a January 24, 2007 speech (here), SEC Chair Christopher Cox added the following perspective on the threats to the competitiveness of the U. S. markets:

The threat comes not from fear of foreign competition, or foreign issuers, or foreign investors. Both competition, and the influx of foreign capital and issuers, promise only good for our markets. Rather, the threat comes from the increasing opportunities for fraud, unethical trading practices, and market manipulation that globalization brings with it. Just as investors and issuers can more easily seek each other out around the world, those with less honorable intentions can also reach across borders, to prey upon distant investors. And when they succeed, they damage confidence in all of our markets.

As the proposals for regulatory reform continue to emerge in the coming months, it will be important for us to remember what kind of investors and what kind of investment activity we do and do not want to attract to U.S. securities markets.

Photobucket - Video and Image Hosting Tellabs Goes to SCOTUS: On January 5, 2007, the U. S. Supreme Court granted certiorari (here) in the Tellabs case on the issue of the standard for pleading scienter under the Private Securities Litigation Reform Act of 1995 in securities fraud suits. An excellent brief summary of the issues involved in the case written by Jonathan Jacobs of the Wiley Rein firm can be found here.

Best in Class: Those readers who, like The D & O Diary, were fans of the late, lamented Securities Litigation Watch blog will be delighted to learn that its author Bruce Carton has launched a new blog, Best in Class, which can be found here. The early posts suggest that the new blog will be as timely and informative as the SLW.

Readers will also be interested to know that Bruce will be hosting a webcast on Tuesday January 30, 2007 at 1:00 p.m. EST on “Emerging Trends in Securities Class Actions.”

Hat tip to the 10b-5 Daily Blog for the information about Best in Class.

Next week: I will be in New York next week for the PLUS D & O Symposium (here). I hope that readers of The D & O Diary will please say hello to me during the Symposium and let me know what they think of the blog. See you all in New York.

Photobucket - Video and Image Hosting The Public Company Accounting Oversight Board (PCAOB) has been the target of extensive criticism for the timing and content (or lack thereof) of the public reports for its inspections of the Big Four accounting Firms. (Prior D & O Diary posts on this issue can be found here and here.) This issue is reviewed at length in a January 26, 2007 CFO.com article entitled "Why The Big Four Are Still a Mystery" (here), and the article is supplemented by an email interview (here) with PCAOB board member Charles Niemeier.

The article reviews the frequent criticisms that the public inspection reports reflect a "lack of context," because the PCAOB does not publicly reveal how many inspections it conducts on each firm. Without this kind of quantitative data, there is no way to assess how widespread the concerns are. The absence of this information means that the inspection process "is not producing the kind of results that it should for people who are using the results and trying to understand what this means," according to the former head of Deloitte, who is now the chair of four public company audit committees, and who is quoted in the article.

The delay in reporting the results is also a concern. For example, the reports for the 2005 inspections of Ernst & Young (here) and KPMG (here) were not released until January 2007. The audits inspected were obviously completed substantially before the inspections. The delay gives analysts and others "little leeway in being able to gauge the current performance of an audit firm."

Niemeier’s response to the concern about the lack of disclosure concerning the number of audits inspected is that it is "not a relevant figure" and "could encourage misleading, superficial comparisons between firms." Niemeier also is opposed to supplying further details about the audit concerns noted in the inspection reports, even information designed to convey how serious the problems noted were; Niemeier feels this would be inconsistent with PCAOB’s statutory confidentiality obligations.

Niemeier is also opposed to any overall qualitative evaluation of the firms audited, on the theory that this would "divert attention" from the PCAOB’s efforts to identify risks in the audit firm’s processes. With respect to the timeliness of the inspection reports, Niemeier says that the "timing of the reports has been due to internal operational processes" and that "the time between completion of an inspection and issuance of a report should be shorter in the future."

What to make of all of this depends on the purpose of the PCAOB’s public inspection reports. If, as with Niemeier, you believe the public reports are designed to provide the audit firms with appropriate incentive to remedy noted concerns, then the current process is adequate. But if that is the sole purpose, why bother with public reports at all? Why not simply reserve public disclosure for those concerns the audit firms fail to address during the 12-month cure period? But the reports clearly are made public (at least to the extent they are made public) for a separate purpose, which is to inform. On that score, as the CFO.com article notes, the inspection reports "don’t paint a clear enough picture about what the auditor overseer was probably trying to say in its reports."

Niemeier’s comments that added information, such as the number of audits inspected, might be misued amounts to an assertion that investors and others can’t be trusted with the information. Clearly, the policy decision to withhold the information is calculated for the audit firms’ protection, to the detriment of the investing public. These competing interests ought to militate that the PCAOB should go as far as it could to disclose information consistent with its statutory constraints – and subject only to the statutory constraints. The numerical and evaluative information critics argue that the inspection reports lack are not barred by the statutory constraints. The audit firm’s best protection against vulnerability to adverse information is in their power to control, through their own audit execution.

A good summary of the shortcomings of the PCAOB’s public inspection reports, with links to other sites, can be found on the White Collar Fraud blog, here and here.

Audit Liability Caps: In a prior post (here), The D & O Diary took a look at various proposals to cap auditors’ liability. In a January 25, 2007 speech (reported here), Conrad Hewitt, the SEC’s Chief Accountant, came out in favor of protecting the "major accounting firms" from legal liability if their audit clients become embroiled in accounting-related scandals. Hewitt is concerned about auditor liability because there are only four major accounting firms left. "It’s a concern to us if something should happen to any of the four firms."

So The D & O Diary wonders – is the PCAOB’s policy on its public reports of the Big Four firm’s audit inspections the product of a similar concern for the survival of the "remaining four?"

 

Regular D & O Diary readers know that I have been maintaining a running tally of options backdating related litigation (here). According to the most recent count, so far there have been 23 securities class action lawsuits raising allegations of options grant manipulations. (The Stanford Law School Securities Class Action Clearinghouse maintains its own tally on its home page, here, that agrees with my count.)

My running tally includes cases that did not originally involve (or feature prominently) allegations related to stock grant manipulations, but that were later amended to include or emphasize options backdating allegations. Because I have already made the decision to incorporate in my tally cases that included options backdating allegations by amendment, I feel compelled to revise my tally to include the Amkor Technology case.

The initial complaints in the Amkor Technology case, filed in January 2006, may be found here. The initial complaints did not contain options backdating allegations. In an Amended and Consolidated Complaint filed in the Amkor Technology case on August 14, 2006, the allegations in that lawsuit were significantly augmented to include detailed allegations of supposed options backdating, complete with the now standard stock price graphs showing arrows superimposed on stock price troughs when options allegedly were granted. (Links to the Amended and Consolidated Complaint are unavailable, but the Amended Consolidated Complaint in Amkor is available on PACER; anyone who wants a copy of the pleading but lacks a PACER subscription should drop me a note and I will email a copy).

I only became aware of the Amkor Amended and Consolidated Complaint by accident while I was looking for something else. I am concerned that there may be other pending securities fraud cases that did not contain options backdating allegations when initially filed that have been amended to include them. It would be extraordinarily helpful if D & O Diary readers who are aware of securities fraud lawsuits that have been amended to add options backdating allegations could let me know, so that I could adjust the options litigation tally accordingly.

With the addition of the Amkor Technology case, the tally of securities fraud lawsuits raising options grant manipulation allegations stands at 24.

As also noted in my running tally, the number of companies that have been named as nominal defendants in shareholders derivative lawsuits stands at 141. This count has been substantially revised this week thanks to information supplied by alert D & O Diary readers Bill Ballowe and Ben Eng. Hat tip to these gentlemen for their helpful information.

UPDATE: My request for help from readers has already yielded results. The list of securities fraud lawsuits involving options grant manipulations has been amended to include the lawsuit pending against Quest Software. The lead plaintiff’s counsel’s press release regarding the Quest Software case may be found here. With the addition of this case, the tally of securities fraud lawsuits now stands at 25. Hat tip to Adam Savett of the Lies, Damned Lies blog for the link to the press release.

 

Photobucket - Video and Image Hosting Based on the accumulated observations of its inspections of public company audits, the Public Company Accounting Oversight Board is concerned that auditors may not be doing all they could (or even all that is required) to detect the possibility of fraud at the companies they are auditing. In a January 22, 2007 release entitled “Observations on Auditors’ Implementation of PCAOB Standards Relating to Auditors’ Responsibilities with Respect to Fraud” (here), the PCAOB issued a report detailing its recurring observations in order to “focus auditors on being diligent about their responsibilities as they relate to fraud.” The report is not intended to create new standards, but rather to “remind all auditors of what the Board’s standards require of them in these areas.”

The report emphasizes that one of the key purposes of the audit, and an important point of concern of the PCAOB, is to “detect material misrepresentations caused by fraud.” The report reviews at considerable lengths the steps that auditors should be taking in planning and performing the audit to test for the possibility of fraud.

Among the more interesting discussion points is the PCAOB’s concern based on its recurring inspection observations that some audit teams are not designing their audit procedures based on an audit team “brainstorming session” to identify possible company-specific fraudulent practices. Essentially, the auditors are required to put themselves in the shoes of the would-be fraudsters, and imagine how they might go about defrauding the company, so that the auditors can then design tests to see if any of these things are actually happening. The report identifies a number of other procedural and substantive shortcomings that the PCOAB has observed (for example, failing to test for the possibility that management is overriding financial controls), but the failure to design audit tests based on company-specific fraud-imagination brainstorming is one of several apparently serious concerns.

Consistent with the PCAOB’s prior practices and statutory constraints, the PCAOB does not identify the auditors or audits on which its observations are based. As The D & O Diary has previously observed (here), the PCAOB could (and arguably should) consistent with its statutory constraints provide numerical information that would afford greater insight into how serious these problems are. For example, in connection with how many audit inspections were these concerns noted? On what percentage of the PCAOB’s inspections did these kinds of concerns arise? And, even more specifically, were there any inspections on which these concerns were noted where fraud was later found to have occurred but was not detected by the auditors? Without this kind of information, it is basically impossible to assess how serious these concerns are, and whether or not there might be fraud (and if so, how much) that is going undetected by the auditors. That said, the PCAOB is to be commended for compiling the observations and issuing the release, as it undoubtedly will have the salutary effect of focusing auditors’ attention on the need for targeted fraud detection procedures.

Hat tip to the AAO Weblog (here) for the link the to the PCAOB release.

To Catch a Thief?: Anyone who doubts the need for creative application of audit procedures actively designed to detect fraud may want to read the story (here) from the front page of today’s Cleveland Plain Dealer. This story might not have made the national press but here in snowy Cleveland it is pretty big news. According to the story, the former head of the international lending unit of KeyCorp will plead guilty to embezzling $40 million from the bank over the course of 9 years.

The official fabricated loans in the name of real European banks and then took the money himself. He used subsequent loans to cover earlier loans. He got caught when he used one of the European lines of credit to pay his personal credit card bill, and it came to the attention of another bank employee. (Coincidentally, the WSJ.com Law Blog has an account, here, of a separate embezzlement scam involving the former NBC Treasurer that was also detected because the bad guy used the embezzled funds to pay a personal credit card bill.)

According to the news report, the KeyCorp embezzlement scheme escalated in 2004 when the official developed a relationship with a younger woman he met while traveling, for whom he purchased multi-million dollar homes and a 12-carat engagement ring. (The official was married to another woman at the time; unsurprisingly, they divorced after the embezzlment and the use of the embezzled funds came to light.)

Auditors who want to jumpstart their brainstorming session about possible fraud may want to contemplate the apparent ease with which this individual evaded detection for 9 years and scammed his (publicly traded) employer.

In prior posts (here, here and here), I argue that the Committee on Capital Markets Regulation (popularly known as the Paulson Committee) made a "weak case" in its Interim Report for regulatory reform. Virtually all of my points apply equally to the recently released Bloomberg/Schumer report as well. The themes I sounded in my earlier posts are underscored in a January 25, 2007 Wall Street Journal article entitled "In Call to Deregulate Business, a Global Twist" (here, subscription required), which suggests that "the changing nature of global finance," rather than the U.S regulatory environment, explains U.S. markets’ declining share of global finance business.

The Journal article explores at length the improved competitiveness of foreign markets, which in recent years have closed their "quality gap" with the U.S. markets. Developing world markets are "deep enough and liquid enough" that listing companies no longer have any financial imperative to list or trade their shares on U.S. exchanges, as they may have had in the past.

The article also zeroes in on one of the prime points cited to justify regulatory reform – that is, the declining U.S share of global IPOs. With the exception of the London’s Alternative Investment Market (AIM), IPOs are down on all developed countries’ exchanges – "the London Stock Exchange’s blue-chip Main market has seen foreign listing decline 23% since 2000. The Deutsche Borse is down 58%; Tokyo down 39%." In other words, the declining IPO volume "is hardly an American disease." And even with respect to AIM, the article points out that many of the AIM companies don’t "meet U.S. requirements" or are "too small to attract interest from U.S. underwriters and investors." (My prior post, here, reviews the Bloomberg/Schumer report’s discussion of the AIM and the report’s conclusion that the U.S. markets should not lower its standards to compete for more of AIM’s business.).

The article also shows that overseas companies are now able to trade their shares freely, and even attract U.S. investors, without the need for a U.S. listing – or the need to pay the $1 million NYSE listing fee. In addition the article examines the fact that increased private equity takeover activity is a global phenomenon, not just a U.S. trait, and that rather than reflecting U.S. companies’ interests to "go private" and avoid public company regulation, the high level of private equity activity is simply a reflection of the fact that private equity firms have so much cash.

At the same time as global markets have become better, they have also closed the regulatory gap with the U.S. The article quotes the director of the SEC’s office of international affairs as saying that Sarbanes-Oxley has "not competitively disadvantaged U.S. markets, simply by virtue of the fact that they have been widely adopted elsewhere." Even though the U.S. regulatory burden has risen, the same is true for most countries’ markets.

The article gives the advocates for regulatory reform an opportunity for rebuttal. The best that Glenn Hubbard, the chair of the Paulson Committee, can offer, is the declining "investment premium" enjoyed by foreign companies based in developed countries that cross list their shares on U.S. exchanges. Hubbard argues that the declining investment premium for these developed world companies shows that for companies already meeting their more stringent governance standards at home, the costs of meeting the U.S. benefits exceeds the costs.

I have extensively examined the investment premium issue before (here), but it is worth noting here what a total non sequitur Hubbard’s argument is. First, it concedes that there is still an investment premium for companies based in developing countries – that is, the countries with the growing economies that are most likely to be the source of increased economic activity in the years ahead. Second, while the investment premium for companies based in developed countries has declined, it has not gone away, there is still an investment premium for listing on U.S. exchanges, and that is because of the integrity of the U.S. markets, which would be eliminated if regulation were relaxed. And third, to the extent the investment premium has declined, isn’t it obvious that it is because the integrity of many foreign markets has improved? If that is the case, then why does that argue in favor of weakening U.S markets’ regulation? It just seems to me that the only conclusion that can be drawn from the investment premium issue is that we would be best served by striving to maintain the integrity of our markets, not weakening our regulatory rigor in a race for the bottom.

All of this underscores the point I have made in prior posts that business interests in the U.S. may be seizing on the effects of the changing global finance environment as a pretext to undermine regulatory requirements that may occasionally prove uncomfortable because the requirements actually have teeth. The advocates for regulatory reform may want to advance U.S. competitiveness, but steps that threaten to weaken the integrity of the U.S regulatory structure could remove the greatest advantage the U.S. markets enjoy – that is, the U.S. markets are the most highly regarded precisely because they are the most tightly regulated.

That is not to say that none of the reformers’ ideas have validity. To the contrary, the Bloomberg/Schumer report’s suggestions for immigration reform and immediate adoption of the Basel II Capital Accords are sound and should be pursed, as should many of the report’s suggestions for harmonization of competing U.S. regulatory structures, and the harmonization of U.S and international accounting standards. But aggressive revision of the U.S regulatory and legal structure, at least in the name of the competitiveness of the U.S. markets, could represent a misplaced effort that could do more harm than good.

It is worth noting that the Journal article contains an interesting quote from former Treasury Secretary Lawrence Summers, who says that "well-functioning capital markets are central to the success of the economy. What faction of capital market transactions runs through New York is of much less broad-based significance." Summers’ observation is one that is not being heard much, but it is a point worth keeping in mind. Perhaps we should be more focused on adapting to the new reality of the global marketplace, rather than attempting to preserve the benefits of market advantages that no longer exist.

Finally, it is worth noting that several of the overseas companies discussed in the Journal article mentioned the high listing fees for U.S. exchanges. While the two task force reports released so far have tried to downplay the importance of listing fees and U.S underwriters’ fees (which also tend to be higher than European fees, as much as twice as high), evidence and logic suggest that these fees and costs are a factor affecting overseas companies’ willingness to list on U.S. exchanges. As I have argued before, the U.S. financial industry, rather than sniping at a regulatory structure that other countries are imitating, perhaps they should overhaul their cost structure, which the rest of the world has substantially improved upon.

UPDATE: The January 26, 2007 New York Times has an article (here) that raises many of the same themes as the Journal article linked about, including specifically the point that the U.S. should not be stressing about the loss of very small companies to the AIM.

 

On Monday January 22, 2007, Republican New York City Mayor Michael Bloomberg and Democratic New York Senator Charles Schumer released the joint report they commissioned from McKinsey & Company, entitled "Sustaining New York’s and the U.S.’s Global Financial Services Leadership." The report can be found here, and the joint press release describing the report can be found here. The report is written in the same vein as the Interim Report of the Committee on Capital Markets Regulation, or the Paulson Committee as it is popularly known, and the two reports are both of similarly impressive length. (My prior discussion of the Paulson Committee Report can be found here). There are, however, several important differences between the two reports, both in tone and in substance.

Among the more important visual differences is the explicit bipartisan support for the Bloomberg/Schumer report. Indeed, newly elected Democratic New York Governor Eliot Spitzer showed up for the ceremony to release the report, about which there is some significant irony, given the report’s concern about the problems caused by conflicting regulatory schemes. The Wall Street Journal’s discussion of the unsubtle irony of Spitzer’s involvement can be found here and here (subscription required).

The Bloomberg/Schumer report, like the Paulson Committee’s Interim Report, is focused on the competitiveness of the U.S. capital markets, but its recognition of the reasons for the heightened competitiveness of foreign securities markets is more comprehensive and detailed than the Paulson Committee’s Interim Report. The Bloomberg/Schumer report examines at length the "strong dynamics outside the U.S. driving international growth." Its review of the reasons why many foreign companies are seeking to list their shares on exchanges outside the U.S. examines at length the geographic and economic reasons for this shift, including in particular the increased availability of adequate capital in foreign markets and improved technology and communications that has opened these markets to all international investors (including even U.S.-based investors).

The Bloomberg/Schumer report is also much less concerned about the purported threat of London’s Alternative Investment Market (AIM) that then Paulson Committee’s Interim Report. While recognizing that the AIM has successfully tailored its listing requirements to attract smaller companies, the Bloomberg/Schumer report also notes that "small-cap markets are clearly riskier that their more established counterparts." The report also notes in a sidebar that while the AIM has attracted a growing number of listings in recent years, the growing number "masks the large and increasing number of de-listings (480 since the beginning of 2003) and low liquidity of most AIM stocks." The Bloomberg/Schumer report concludes that because of concerns over the "disproportionate impact a bear market might have on small-cap markets and investors," and the limited economic benefit of such markets, the report "does not recommend that U.S. exchanges lower their listing requirements to attract more small issuers.’

The Bloomberg/Schumer report also emphasizes several issues that are not addressed at all in the Paulson Committee’s Interim Report. For example, the Bloomberg/Schumer report takes a look at legal barriers that may prevent domestic markets from attracting top global financial talent and concludes that U.S immigration policies are making it harder to attract non-citizens to move to this country, and these barriers are undermining the competitiveness of U.S. securities markets. The report proposes a number of specific immigration reforms. The Bloomberg/Schumer report also recommends the rapid implementation of the Basel II Capital Accords, so that U.S.-based commercial banking institutions do not face higher capital level requirements than their foreign counterparts, which would put them at a competitive disadvantage.

Based on its conclusion that the regulatory and legal environment in this country is a substantial factor diminishing the attractiveness of U.S capital markets, the Bloomberg/Schumer report proposes a number of reforms. While the Bloomberg/Schumer report, like the Paulson Committee report, singles out Section 404 of the Sarbanes-Oxley Act, the Bloomberg/Schumer report comments that the fault does not lie with the Act itself but with the implementing regulations. (This observation coincides with the remarks of SEC Commissioner Paul Atkins on January 22, 2007 at the Corporate Directors Forum, here). The Blooberg/Schumer report urges the SEC and the PCAOB to proceed quickly with their current efforts to reform the implementing regulations (see the PCAOB’s press release on its current reform efforts, here), provide further guidance with regard to what constitutes a "material weakness" in internal controls, and help implement an internal control review that is "top-down, risk-based, and focused on what truly matters to the integrity of a company’s financial statement.’

The report also suggests that the SEC should consider giving "smaller companies" (the report does not define "smaller") the opportunity to opt-out of the more onerous requirements of the Sarbanes-Oxley Act, provided the choice is "conspicuously disclosed to investors." In addition, the report suggests that the SEC should consider exempting foreign companies from certain parts of the Act, provided they already comply with sophisticated, SEC-approved foreign regulators’ requirements.

The Bloomberg/Schumer report also proposes limited "securities litigation reform," which it proposes that the SEC implement through its authority under Section 36 of the Securities Exchange Act of 1934 to exempt certain companies from regulations when it deems such exemptions to be in the public interest. Specifically, the report suggest that the SEC choose to limit the liability of foreign companies with U.S. listings to securities related damages proportional to their degree of exposure to U.S. markets; and impose a cap on auditors’ damages that would maintain a deterrent effect but reduce the likelihood that the auditing industry would lose another major player. The report also repeats the suggestion that the SEC could allow companies to opt out of part of SOX (again, with "conspicuous disclosure.") The report also proposes that the SEC promote arbitration as a means of resisting disputes between public companies and investors.

The report also proposes two legislative changes to address "long-term structural problems." The report suggests that Congress should consider limiting punitive damages and allow litigants in federal securities actions to appeal interlocutory judgments immediately to the Circuit Courts. The report contains a number of suggestions to harmonize the various U.S. regulatory structures. It also suggests the creation of a permanent body (the "National Commission on Financial Market Competitiveness") to focus on the competitiveness of the U.S securities markets.

Compared to the Paulson Committee Interim Report, the Bloomberg/Schumer report is both more comprehensive (for example, with its reference to immigration reform and the Basel II Capital Accords) and, in some ways, more realistic (for example, in its recognition of the myriad reasons not to lower regulatory standards simply to attract smaller listing companies). The report also presents a few modest proposals that could help incrementally improve the competitiveness of the U.S. securities markets. The report struggles to maintain the air of modesty for reforms that may not be quite so modest or feasible (for example, using federal legislation to eliminate state law provisions for punitive damages, or using regulatory provisions to create damages caps). The proposal to create an arbitration remedy for investors disputes with public companies may seem superficially attractive, but even a brief referral to one of the more serious securities class action lawsuits will reveal that these kinds of lawsuits are peculiarly unsuited for that forum and process.

But with the arrival of the Bloomberg/Schumer report and its addition to the Paulson Committee’s Interim Report, and with the added prospect of the conference that the Treasury Department plans to hold this spring on the issue of the competitiveness of the U.S Securities markets (here), it is pretty clear that momentum is building for action to be taken to assist the U.S. markets. In this environment, particularly where there seems to be a bipartisan consensus emerging, it seems likelier that regulatory and even legislative reforms may well occur. In this environment, ideas such as the increased regulatory flexibility for smaller companies and foreign companies, may receive a more sympathetic reception, even though it would have to be asked whether these changes might represent a lowering of standards that arguably could weaken the overall strength and integrity of the markets.

It also appears the regulators are reading reading the newspapers. The PCAOB’s intiative to reform Auditing Standard 2 and argubly even the Department of Justice’s revision of the Thompson Memo with the release of the McNulty Memo are undoubtedly the result of a multitude of factors, but the timing of these reforms may be due to the growing calls for reform. The regulators may well be attempting to get ahead of the curve; there may be further regulatory intiatives ahead.

One final observation: it is interesting to note that the Bloomberg/Schumer report concludes, in examining the reason for the decline in the number of securities class action lawsuits in 2005 and 2006, that the decline in the number of lawsuits is largely attributable to favorable economic conditions and that "if economic conditions were to decline in the future, then a strong resurgence of lawsuits would likely follow."

Additional interesting commentary about the Bloomberg/Schumer report can be found at the AAO Weblog (here) and the SOX First blog (here).

 

Photobucket - Video and Image Hosting When the Committee on Capital Markets Regulation (popularly known as the Paulson Committee) in its Interim Report (here) recommended "setting a cap on auditor liability," the Committee relied for support on the steps in that direction that have been taken by the European Commission. In its latest effort along those lines, the European Commission on January 18, 2007 launched a "public consultation on whether there is a need to reform the rules on auditor liability in the EU." A copy of the Commission’s press release can be found here. A copy of the Staff Working Paper can be found here.

In the Working Paper, the Commission’s staff offered four alternative proposals to cap the liability accounting firms potentially face when auditing public companies. (The Commission is asking for comment on the four proposals by March 15, 2007.) The four proposals are: a fixed monetary cap on damages that could be sought from auditors; a cap based on the audited company’s market capitalization; a cap based on a multiple of the audit fees charged; or the introduction of proportionate liability , which would hold the auditor responsible only for the damages that could be specifically attributed to them.

The initiative to afford accountants some form of liability protection is being led by Charlie McCreevy, the European Commissioner for Internal Market and Services. The initiative would potentially extend protections across the EU’s 27 member countries, although the member countries would not be required to enact them. However, the Working Paper notes that "auditor’s liability is currently capped in five Member States (Austria, Belgium, Germany, Greece and Slovenia)."

The Commission’s motivation for exploring auditor liability caps is essentially the same as that noted by the Paulson Committee in its Interim Report. That is, the Commission is concerned that as the number of audit firms capable of auditing the largest companies has dwindled down to four, the potential consequences from the failure of one of the remaining firms would be harmful to investors. In an October 27, 2006 interview in the Financial Times (here), McCreevy expressed his concern that "further reduction in the number of global firms would make it very hard for companies to get accounts signed off and published – dealing a blow to investors." McCreevy himself advocates a cap on auditor liability.

A January 19, 2007 Wall Street Journal article entitled "EU Offers Plans for Accounting Firms’ Audit-Liability Caps" (here, subscription required) suggests that the EU proposals "could help a push by the largest firms for similar protection in the U.S." The article goes on to note that the "adoption of a European auditor-liability shield, even if the member countries weren’t required to enact it, would potentially add to a sense that U.S. markets are increasingly at a competitive disadvantage to those in Europe, and, in particular, London."

The competitiveness of the U.S. capital markets will be the theme of a conference that will convened in the spring by Treasury Secretary Henry Paulson. (For a description of the planned conference, announced on January 17, 2007, refer here.) The accounting industry will be one of the three major topics to be discussed at the conference, along with regulation and corporate governance. Robert Steel, the Treasury’s undersecretary for domestic finance, in describing the conference’s anticipated topics, said that (unnamed) officials are "concerned about the accounting industry," and that the conference will look at whether there are "structural issues" that hurt the industry, such as an "unattractive liability construction." Steel, along with Paulson, recently joined the Treasury Department from Goldman Sachs.

Photobucket - Video and Image Hosting Is the PCAOB Shielding the Big Four?: With the anxiety surrounding the possible investor consequences to investors were another of the Big Four accounting firms to fail, could it be that regulators are treading softly around the "remaining Four?" As The D & O Diary noted in a prior post (here), the Public Company Accounting Oversight Board (PCAOB) does not reveal much about its inspections of the Big Four accounting firms. For example, the PCAOB does not reveal the number of Big Four audits it inspects as part of its annual inspection process, or the percentage of audits inspected that proved to have concerns – even though it releases this information for smaller firms.

A January 18, 2007 post on CFO Blog (here) reports on a recent speech by PCAOB founder and board member Bill Gradison, in which Gradison suggests that the PCAOB considers itself a supervisory body rather than an enforcement agency, and so the agency wants to work with firms to restore "integrity" and even "luster" to the profession. For that reason, the PCAOB prefers to give the audit firms a 12-month grace period to fix problems, rather than to make them public when they happen, since "reputation is so important in a field like auditing."

While I am sure the accounting firm’s appreciate this deference to their reputation, investors’ interests are definitely forced into the back seat by this ordering of priorities. As my prior post linked above notes, the PCAOB’s annual inspection report disclosure leaves a great deal to be desired from the investors’ point of view. First and foremost, the PCAOB ought to inform investors what percentage of audits inspected produced inspection concerns. In addition, the PCAOB ought to tell the investing public how many of the audit concerns were material, which audit concerns were material, and what order of magnitude the material concerns represent.

 

Photobucket - Video and Image Hosting According to a January 20, 2007 Wall Street Journal article entitled “Executives Get Bonuses As Firms Reprice Options” (here, subscription required), some of the companies ensnared in the options backdating scandal are paying cash bonuses to executives whose options are being repriced, as the option exercise price is shifted to the actual grant date from the backdated date. According to the article, these bonuses are going to executives who weren’t involved in options wrongdoing, and who would otherwise see the overall value of their paid compensation shrink as a result of the repricing.

Although the repricing is designed to make the executives’ compensation whole, some executives could wind up better off as a result of the cash bonuses, because they are “swapping unrealized, potential profit” (since the share price could decline) for cash. In the examples cited in the article, the cash bonuses involve payments of hundreds of thousands of dollars.

Some companies are going even further and paying the 20% excise tax payable under IRS Section 409A on “discount” options whose exercise price is below the level of the stock on the day the option is granted.

The article does point out that there are a number of companies that have concluded that the problem “should be fixed without taking more out of shareholders’ pockets” and have accordingly declined to pay additional amounts to affected executives.

What are we to make of all this? On the one hand, as Professor Larry Ribstein points out on his Ideoblog (here), the executives receiving the cash bonuses weren’t involved in the backdating: “If they didn’t do anything wrong, why punish them by taking away some of their agreed compensation?”

While I see Professor Ribstein’s point, it is a struggle for me to see that the right thing for companies to do here is make a cash payment to the executives. The point of options compensation is to align corporate managers’ interests with those of shareholders by providing that managers only do well if shareholders do well. By converting that investment risk into fixed cash, the element of shared interest is eliminated. To the contrary, it converts the shared interest into exclusive service of executives’ interests at shareholders’ expense.

The reality of shareholders expense leads to another concern. The executives receiving the cash bonus may have been cleared of wrongdoing, but for the backdating to have taken place there had to have been some missing internal controls. Even if the executives were uninvolved in the wrongdoing, they were present when the errors occurred. As between the executives and investors, who ought to absorb the compensaion consequences involved with cleaning up the mess? Shareholders already are absorbing all of the costs of accountants’ and attorneys’ services required to clear up accounts. Why should shareholders also have to absorb additional costs for cash compensation to senior executives who were “on the bridge” when the malfunctions occurred?

There are also a couple of very serious atmospheric problems with the cash payments at this particular point in time. First, by communicating that the incremental additional value of the backdating options represents compensation to which the executives were entitled, the companies are inferentially suggesting that the backdating was an intended part of their compensation scheme. (This is a conclusion that Professor Ribstein overtly draws.) Whatever the theoretical debate might be about the propriety of backdating, now is a particularly poor time for companies to suggest that backdating was a calculated part of their intended compensation scheme.

Finally, with all of the scrutiny on executive compensation in general right now, providing executives with immediate cash payment for flawed variable compensation sends a very provocative message – particularly as at least some of the companies involved, according to the Journal article, have not yet determined how they will treat backdated options by nonexecutive employees.

These and other concerns are obviously the reason why many other companies are declining to reimburse executives for repriced options. The fact that many companies have declined to make these cash payments certainly puts the companies that are making the payments in a conspicuous spot – the front page of the Wall Street Journal, for starters.

H-P CEO Claims He Was Not “Bullet Dodging”: On January 19, 2007, the House Committee on Energy and Commerce forwarded to the SEC a letter that H-P CEO Mark Hurd sent to the Committee in response to the Committee’s questions about his exercising of H-P options shortly before the H-P pretexting scandal broke last fall. A copy of the Committee’s letter, to which Hurd’s letter is attached, can be found here. In his letter, Hurd defended the stock transactions, which took place two weeks before the pretexting scandal broke, and the same day as he was questioned by H-P’s outside counsel in connection with the internal investigation surrounding the abrupt resignation of former H-P board member Tom Perkins.

Hurd specifically wrote that “My August trade was not a case of bullet dodging.” Hurd stated that the trade was part of his regularly scheduled trading plan, established on the advice of his financial planner and broker, and consistent with the legal opinion he received from H-P’s counsel in advance of the trades. He also states that he began the process to execute the trades before anyone had asked to interview him. He also pointed out that the options exercised were granted, and the exercise price was set, long before the exercise date.

While the letter is interesting and its release has generated press attention (for example, this January 20, 2007 San Jose Mercury News article, here) this may all be much ado about nothing. As the While Collar Crime Prof blog points out (here), “while the timing is suspicious … the company’s stock price increased after Hurd’s sale,” so that rather than dodging a bullet, “he may actually have taken one instead.”

Oh, Behave: Some great quotes about behaving comme il faut (or not), here.

Eliot Spitzer sued former NYSE Chairman and CEO Richard Grasso to compel him to return the bulk of his nearly $190 deferred compensation and pension package, alleging that the pay package was “objectively unreasonable” under New York law governing nonprofit institutions and that Grasso had improperly influenced or misled the NYSE’s board directors to obtain their approval of the package. (The NYSE was a nonprofit institution while Grasso served as its Chair.) A copy of the complaint against Grasso can be found here.

Spitzer may have moved on the New York governor’s mansion (refer here), but the case lives on, as highly contested cases will do. The case is currently on appeal, as Grasso challenges the entry of partial summary judgment against him by New York Supreme Court Justice Charles Ramos. Justice Ramos ruled in October 2006 that Grasso had breached his fiduciary duty and that Grasso must return almost $100 million. A copy of Justice Ramos’s opinion can be found here.

Litigation at this level is expensive, but the magnitude of the expense involved may exceed even the inflated standards of our age. In a January 17, 2007 interview reported on Bloomberg.com (here), Grasso said that the “costs of all sides involved…may have exceeded $100 million,” which the article notes is an amount almost equal to the amount the New York Attorney General is seeking. Grasso is quoted as saying, “I would not be surprised if the legal bill were in excess of $100 million.” Grasso added that “This lawsuit is about honor. It is not about money any more.”

Indeed. It is always about honor. But the money does play a role, however slight it may concern Grasso, and unless the goal of the lawsuit is a massive wealth transfer to the legal community, the expense apparently involved does raise certain questions.

Of course, Grasso’s legal fee estimate may or not bear any relation to reality. Perhaps to a man accustomed to astronomical dollar figures, a number like $100 million is simply a proxy for a number of a very large size, sort of like the biblical author used the phrase 40 days and 40 nights. Grasso is also obviously motivated to characterize the lawsuit in a particular way, and so has every incentive to portray the lawsuit as excessive or even counterproductive.

But there unquestionably is something arresting about Grasso’s estimate. The prospect that the lawsuit might consume in fees as much as the case ultimately is worth brings to mind the litigation travails of another Richard, Richard Carstone, who exhausted himself pursuing his interests in the matter of Jarndyce and Jarndyce in Dickens’ novel, Bleak House. Perhaps the comparison between the two cases is not entirely apt, but there is a familiar resonance surrounding the magnitude of the fees and their relation to the matters in dispute.

The following excerpt from the novel (drawn from this source) captures the moment when the parties found the case to be “over” – not due to resolution on the merits, but because of the cumulative effect of the lawyers’ fees (the excerpt begins with the words of Mr. Kenge, an attorney):

“For many years, the–a–I would say the flower of the bar, and the–a–I would presume to add, the matured autumnal fruits of the woolsack–have been lavished upon Jarndyce and Jarndyce. If the public have the benefit, and if the country have the adornment, of this great grasp, it must be paid for in money or money’s worth, sir.”

“Mr. Kenge,” said Allan, appearing enlightened all in a moment. “Excuse me, our time presses. Do I understand that the whole estate is found to have been absorbed in costs?”

“Hem! I believe so,” returned Mr. Kenge. “Mr. Vholes, what do YOU say?”

“I believe so,” said Mr. Vholes.

“And that thus the suit lapses and melts away?”

“Probably,” returned Mr. Kenge.

“Mr. Vholes?”

“Probably,” said Mr. Vholes.

“My dearest life,” whispered Allan, “this will break Richard’s heart!”