Jul 8, 2008

SEC Complexity Comm. To Vote on Report as Congress Gets Into the Act; Treasury ACAP Update

The SEC Advisory Committee on Improvements to Financial Reporting (CIFiR or the Pozen Committee for Chair Robert Pozen) is slated to vote at its July 11 meeting on the recommendations contained in its Draft Final Report, posted on SEC’s website yesterday.

Kudos to CIFiR for reducing complexity for readers of its 180-page report by providing a 10 page “Compendium of Recommendations” in the Executive Summary.   

Following their July 11 meeting, there will be a teleconference on July 31 at which CIFiR will vote on issuing its final report to the SEC. According to its charter, the committee will terminate on August 2^nd. Further background on CIFiR’s previous deliberations can be found here, here, here, here, here, here, here, here, here and here.

Securities Act of 2008 Reportedly Will Include Provision on Complexity

Today’s Wall Street Journal (“SEC’s Reach is at Heart of Bill”) reports that the Securities Act of 2008 being considered by Congress would provide new authority to the SEC in certain enforcement areas and would ‘impose few new restrictions on the SEC, other than calling for its chairman to give annual testimony on efforts to reduce complexity in financial reporting.”

Indeed, the House Capital Markets Subcommittee is slated to consider the Securities Act of 2008 during a committee markup on July 9.

Based on the description of the Securities Act of 2008 in the Wall Street Journal, it appears it will incorporate a bill originally proposed by Cong. Geoff Davis in 2006 as H.R. 5024, the Promoting Transparency in Financial Reporting Act of 2006, reintroduced by Davis in 2007 as H.R. 755, and passed unanimously by the House on Feb. 28, 2007. The bill was introduced in the Senate last year as S. 834 by Sen. Orrin Hatch; as far as I know it remained in the Senate Banking Committee.

As described in this press release issued by Cong. Davis in 2007, the ‘promoting transparency’/’reducing complexity’ bill passed by the House in 2007 would have required the chairman of the SEC - and the chairmen of FASB, PCAOB; in the bill currently before the House, the Securities Act of 2008, I’m not sure if it will reach to FASB, PCAOB chairmen as well - to provide annual testimony (for a 5 year period) to the House Financial Services committee (with a similar provision in Hatch’s bill requiring annual testimony to the Senate Banking Committee) on SEC’s (and possibly FASB and PCAOB’s) efforts in:

• Reassessing complex and outdated accounting standards;
• Improving the understandability, consistency, and overall usability of the existing accounting and auditing literature;
• Developing principles-based accounting standards;
• Encouraging the use and acceptance of interactive data;
• Promoting disclosures in “plain English.”

If called upon to testify as set forth in the bullets above, the SEC would have a lot to talk about in terms of CIFiR’s deliberations – although putting CIFiR’s recommendations into action is another step to be taken involving action by standard setters and other stakeholders in the financial reporting process. The SEC would also be able to reference its proposed rule that would mandate interactive data reporting in XBRL (comment deadline Aug. 15), and its recently announced ‘21^st Century Disclosure Initiative’ featuring one of the ‘gurus’ of plain English, Dr. Bill Lutz.

Treasury ACAP Receives Comment Letters from FEI, Others as July 9 Deadline Approaches

The pace of comment letters filed on the U.S. Treasury Department Advisory Committee on the Auditing Profession’s (ACAP) Draft Report and Addendum has picked up recently in light of the June 13 comment deadline on the Draft Report, and July 9 deadline on the Addendum. As a practical matter, many letters are being filed on the two documents simultaneously.

ACAPs recommendations aimed at improving the sustainability of the auditing profession address areas including human capital (including education, diversity, recruitment and retention), audit firm structure and finances, and concentration and competition. The ‘elephant in the room’ which some observers claim was not addressed sufficiently by ACAP (although a sub-issue of court jurisdiction is addressed in the Addendum) is the issue of potential catastrophic liability that could put an audit firm out of business. 

FEI’s Committee on Corporate Reporting (CCR) filed its comment letter on ACAP’s Draft Report and Addendum on July 3.   The FEI letter was signed by CCR Chairman Arnold Hanish.

Other comment letters filed with ACAP in the past week include those of the six largest accounting firms, the Center for Audit Quality (CAQ), and the Ethics Resource Center.

See our previous coverage of ACAP here, here, here and here.

8:19 AM by Edith Orenstein

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Jul 7, 2008

Deconstructing Fair Value

According to the agenda and list of panelists released in advance of SEC’s July 9 Fair Value Roundtable, the panels will address “the benefits and potential challenges associated with existing fair value accounting and auditing standards.”

The SEC’s roundtable and other forums such as the IASB’s Expert Advisory Panel on Valuation in Inactive Markets are responding to requests by the G-7, the Financial Stability Forum, and Presidents Working Group (PWG) to address concerns about application of fair value accounting in illiquid markets.

Background

To illustrate these concerns, some observers (e.g. Blackstone CEO Steven Schwarzman in Andrew Ross Sorkin’s NYT Dealbook July 1, “Are Bean Counters to Blame,” and Prof. Tom Selling in his blog, The Accounting Onion) have questioned the accounting standards - primarily FAS 157, Fair Value Measurement -  for requiring portfolios to be written down to an observed or hypothetical market value  when applied in illiquid or inactive markets. Some observers would challenge those who would accuse them of simply not wanting to face reality, by noting that in illiquid markets, ‘reality’ is difficult to pin down (ask anyone trying to sell a house these days). They believe that when actual transaction prices (or hypothetical versions thereof) are few and far between, the resulting liquidity discount overstates risk and understates the underlying value of the security if it were held to maturity (or even for the intermediate if not long term). More ominously, some have further claimed that accounting standards may have contributed to a downward spiral in the subprime market and credit markets generally, allegedly causing procyclical effects due to credit or investment standards requiring portfolio liquidations in response to steep drops in valuation of certain securities, leading in turn to pressure to sell those securities at even more deeply discounted prices, with the remaining portfolio then marked to the now-lower market value, thereby repeating the cycle.

For further background see our June 2 “Detailed Summary of FASB Webcast on Credit Markets” [this summary can downloaded by FEI members only, see info on FEI membership], and “Subprime: Not Ready for Prime Time,” in the July-August issue of Financial Executive Magazine [nonmembers will be prompted to create free online login account to read magazine article]

Holistic Approach Needed

Note the important inclusion of “and auditing standards” in the agenda for SEC’s upcoming “Roundtable on Fair Vale Accounting.” As noted previously in this blog (see last two bullets of our March 24 post), many observers on the fair value scene talk almost exclusively about the accounting standard, FAS 157 and its fairness (or alleged lack thereof)  - when applied in the kind of illiquid markets (subprime and credit markets generally) that coincidentally arose when FAS 157 became effective in 2007 - without connecting the dots to the role auditing standards and ‘nonauthoritative guidance’ can play in implementing a FASB standard.

It seems to me there are five sets of issues that perhaps could be considered holistically with respect to fair value, at least in the U.S. market, taking into account authoritative and nonauthoritative guidance in the realm of accounting and auditing standards. Such guidance includes, besides FAS 157,  the white papers issued by the Center for Audit Quality (CAQ - affiliated with the AICPA) in Oct. 2007 (including CAQ’s White Paper on Measurements of Fair Value in Illiquid (or Less Liquid) Markets), and the PCAOB’s Staff Audit Practice Alert No. 2 issued in Dec., 2007 on “Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists.” The five issues are: 

• Does FAS 157 permit flexibility in adjusting ‘market prices’ (observable or unobservable ‘hypothetical’ market prices) in arriving at ‘fair value’ for securities? [Note: Hypothetical values are based on a transaction that ‘would have’ occurred, a required construct companies must consider under FAS 157 when there are no observable market values for an instrument or a similar instrument. (The answer according to FAS 157 para. 7, 29 and 30 appears to be ‘sometimes,’ with particular criteria listed.)
• Is flexibility for adjusting actual market prices (or ‘hypothetical’ market prices) for identical or similar instruments only available when sales are ‘forced’ or ‘distressed’? And, are illiquid conditions (inactive markets) considered ‘forced’ or ‘distressed’? If not, does FAS 157 otherwise offer flexibility in adjusting market prices in illiquid markets other than when ‘forced’ or ‘distressed’? (This is a key question which CAQ’s and PCAOB’s guidance tries to address in attempting to distinguish between ‘forced’ sales and ‘illiquid’ or ‘inactive’ markets. It would be instructive to see if there are still divergent views on what FAS 157, para. 7 permits in this regard, particularly since the CAQ guidance appears to be ‘nonauthoritiative’ and even PCAOB staff guidance appears to be ‘nonauthoritative’ in the same sense that SEC staff speeches are deemed ‘nonauthoritative.’ See, e.g. the disclaimer at the top of the PCAOB’s Staff Audit Practice Alert: “The statements contained in Audit Practice Alerts are not rules of the Board and do not reflect any Board determination or judgment about the conduct of any particular firm, auditor, or any other person.”)
• If it is determined that, as currently written, FAS 157 (or related guidance) does not provide sufficient flexibility for adjusting market prices to arrive at ‘fair value’ in illiquid markets, what should be done (e.g. amendments? further guidance?)
• In light of efforts like those of the SEC Advisory Committee to Improve Financial Reporting (CIFiR or Pozen Committee for chair Robert Pozen) are any of the current requirements in FAS 157 and related guidance unnecessarily complex to achieve useful, understandable financial reporting?
• Is disclosure under FAS 157 appropriate to inform investors and other users of financial statements that a range of values may be obtainable for certain securities (financial instruments), and regarding factors that could cause underlying values to change? If not, and in light of the responses to #3 and #4 above, could disclosures be improved? 

Observations on Nonauthoritative Guidance Pertaining to FAS 157

CAQ’s white paper on measuring fair value in illiquid markets states,  “The purpose of this paper is to discuss existing guidance on measurement of fair value, most of which is contained in Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157).”

Before we deconstruct CAQ’s guidance, let’s focus on scope for a moment. In general, when Party A ‘discuss[es] existing guidance’ of Party B, (unless Party A is the SEC, FASB or PCAOB, and particularly the commission or boards thereof, vs. their respective staff), Party A’s guidance is generally called ‘interpretive’ or ‘implementation’ guidance. Moreover, CAQ’s guidance falls into the ‘nonauthoritative’ camp, which the SEC’s ‘complexity’ committee (CIFiR) focused on in ‘developed proposal 2.4’ (pdf pg 53) in their Feb 14 Progress Report. As noted in FEI’s summary of CIFiR’s May 2 meeting, a panel testifying to CIFiR provided diverse views on the extent to which they believe nonauthoritative guidance increases rather than decreases complexity, with auditors on the panel generally looking at nonauthoritative guidance more favorably. CAQ guidance was among the sources of nonauthoritative guidance mentioned by panelists and CIFiR members.

On this topic, it is also interesting to note that when the SEC released guidance in March in the form of a sample letter sent to public companies on MD&A disclosure re: FAS 157,  some members of the press initially alleged SEC was creating a new ‘loophole’ for FAS 157 – see e.g. NYT’s Floyd Norris’ blog post, “If Market Prices Are Two Low, Ignore Them, which Norris later updated to say:  “the posting should have noted that the phrases the S.E.C. used [in its disclosure guidance] are taken from the original rule [FAS 157].” See also “SEC Spurs New Mark to Market Conspiracy Theories” by Jon Weil in Bloomberg, April 2. In reality, if the SEC did not stray from FAS 157– then why did it appear to have done so to established commentators like Norris and Weil? Here is where the role of nonauthoritative guidance may be at play, albeit below the surface, in that SEC’s guidance may have been perceived as different from FAS 157 in light of the playbook released by CAQ. 

CAQ, an affiliate of the AICPA, seeks input from investors and others at ‘town hall’ gatherings, conducts research, makes recommendations (e.g. in comment letters filed), and “issue[s] technical support for public company auditing professionals.” Does CAQ’s issuance of ‘technical support’ equate to ‘auditing standards’? Technically, in the post-Sarbanes-Oxley era, only the PCAOB issues auditing standards for public company audits, although to some it appears murky as to the role of CAQ vis-à-vis the PCAOB.

As noted above, PCAOB issued a Staff Audit Practice Alert on fair value a couple of months after CAQ issued their white papers in 2007. The PCAOB staff alert addressed the central question, as did the CAQ white paper, on differentiating between ‘forced’ sales and illiquid markets, by stating:” the fact that transaction volume in a particular market is lower than in previous periods may not necessarily support an assumption that transactions in that market constituted forced or distressed sales.”

The CAQ white paper, as noted above, said the existing guidance on fair value measurement was  ‘most[ly]’ in FAS 157. There are three areas in which CAQ’s white paper goes beyond FAS 157.

• CAQ cites a key paragraph from FAS 157, para. 7, [which begins: “A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date”] but CAQ adds a twist by saying: “As discussed in FAS 157, paragraph 7, if orderly transactions are occurring between market participants in a manner that are usual and customary for transactions involving such assets, then those transactions are not “forced” sales.” Note that the precise wording of FAS 157, para 7 does not contain an ‘if…then’ clause when it references forced or distressed sales. Rather, one could potentially interpret FAS 157 para. 7 that if you don’t reject the “usual and customary’ or ‘orderly transaction’ hurdle on its own in light of current market illiquidity, the ‘forced or distressed’ sale hurdle would stand on its own as an indicator that current transaction prices in the market may require significant adjustment before they can be taken as an indicator of, or as FAS 157 likes to say, an ‘input’ in determining fair value.
• CAQ generically references an SEC enforcement release, implying precedent for issues of fair valuation in illiquid markets. Although not identified by name/number in the white paper, based on the description of the AAER and the date CAQ says it was issued (2004) it appears to be AAER 2132, in which the SEC states, in part, “Morgan Stanley overvalued certain bonds in the portfolio in 2000 by taking a ‘longer view’ as to their value, which entailed discounting current market conditions such as imbalances in supply and demand. Morgan Stanley's taking a ‘longer view of the market’ was not in conformity with GAAP.” Some may argue market conditions in 2007 arising from the crash of the subprime market and related credit market turmoil pose a uniquely different precedent-setting situation then that contemplated by AAER 2132 in 2004.
• CAQ provides its own definition of ‘longer view’ (which is not defined as such in the AAER it cites) as ‘a view that assumes equilibrium will occur and facilitate transacting at more ‘rational’ prices.’

If Markets Are Not ‘Rational’ – Can Market Prices Be ‘Fair’?

But, if markets aren’t ‘rational’ – can market prices be ‘fair’? Analysts like Vinny Catalano, CFA, author of the Musing on the Markets blog, President and Global Investment Strategist with Blue Marble Research and a past President of the New York State Society of Security Analysts, would probably think not, as noted in our coverage of Catalano’s comments in our March 21 summary, “Articles On Subprime Crisis, Market Turmoil That Mention Accounting.”

CAQ does acknowledge, “Some observers of current market conditions have asserted that market pricing is irrational, and they have suggested that entities should instead default to a model-based measurement that is based on the economic ‘fundamentals’ of the asset.” CAQ then notes that, “FAS 157 states that the use of an entity’s own assumptions about future cash flows is compatible with an estimate of fair value, as long as there are no contrary data indicating the marketplace participants would use different assumptions. If such data exist, the entity must adjust its assumptions to incorporate that market information.” How companies and their auditors interpret how to ‘incorporate that market information,’ even when based on ‘irrational’ markets, is where the rubber meets the road.

What Did The CFA Institute Survey Show?

As an analyst or CFA, Catalano’s views sometimes differ from those of the CFA Institute, which released survey results in April on analysts’ views of the usefulness of FAS 157.  

One thing of note is the CFA Institute’s survey results are sometimes portrayed homogenously - including as portrayed in an ITAC comment letter filed on May 23 with FASB and the IASB by FASB’s Investors Technical Advisory Committee (ITAC), signed by ITAC member Rebecca McEnally, Senior Policy Analyst at the CFA Institute - in support of fair value measurement.

However, a closer analysis of the CFA’s survey results depicts some diversity of opinion even among its analyst members. For example, 55 percent of CFA’s survey respondents answered “Yes” to the question: “Are fair value requirements aggravating the global credit crisis” - a statistic not cited on the face of CFA Institute’s press release, but available if you drill down by clicking on the link to the underlying survey results, and not cited  in ITAC’s comment letter to FASB/IASB. The results on the other 2 survey questions shown on the face of CFA’s press release and in ITAC’s letter note that 79 percent of CFA’s analyst member respondents believe that fair value requirements improve transparency and contribute to investor understanding of financial institutions’ risk, and 74 percent think fair value requirements will improve market integrity. Perhaps ITAC left out the first statistic cited above if they considered the 55/45 split to be statistically insignificant, but it is significant to note the cc’s on the ITAC letter included Sen. Chris Dodd, Chair of the Senate Banking Committee, Congressman Barney Frank, Chair of the House Financial Services Committee, other members of key congressional committees, the SEC commissioners, and CIFiR chair Robert Pozen. 

Narrative comments shown on CFA Institute’s 32 page detailed survey results shed further light on some of the nuanced views of the analyst respondents. Many of the comments not surprisingly are fully consistent with the ¾ favorable response rate supporting fair value, as shown in these responses:  

• “Reporting at fair value simply reveals the volatility that already exists...it does not introduce volatility as some would argue,” and
• “while this hurts the current situation as 'fair market value' is hard to find, this does encourage management not to 'hide' l[o]sing positions.”

Other comments disclose some concern among some of the analyst respondents, even among those who voted ‘yes’ to the ‘improve transparency/ contribute to investor understanding’ question regarding fair value, and ‘yes’ to the ‘improve market integrity’ question. Such comments included:  

• “While fair value produced improved results (and bonuses) when economy and overall scen[a]rio was good, the reverse is true with a greater degree and killing effect. Afterall the trust in each other is eroded a great deal mainly due to complexity in measurement of fair value of diverse products in the ab[s]ense of liq[u]idity. If there are no customers to bid for a product, how do you value them? Does it mean that it is worthless, [e]specially a home or an a[p]artment? It is high time we learn from this crisis and put in place a system that will help to avoid similar pro[bl]ems.” 
•  “We have been debating this internally at my organization for a while now. Since all of us are first CPAs, we are very familiar with the increasing use of fair value as an accounting measurement and because we work in the financial services industry (both traditional and investment banking) we have always supported the use of fair value as the most relevant measurement for financial instruments. However, recent market events have caused us to question whether the use of fair value is appropriate when market participants become irrational as a result of rumors and fear. For example, the ABX indices, which are being used by many as a basis for FV measurements are being driven down each time another financial institution reports a loss, which puts more pressure on the indices and leads to more writedowns. It has been argued that the fundamentals of the underlying securities do not warrant such writedowns and we tend to agree. In this case the use of fair value seems to have created a self fulfilling prophecy of writedowns. However, we do believe that this is an a[b]er[ra]tion and do not believe that the use of fair value (for financial instruments) should be abandoned …”
• “These questions are tough because there is a lot of gray area. Fair value requirements do help investors, but only compared to not having them. There does seem to be room for guidelines that better define these requirements by, for example, asking for ranges of fair value. What is the value of a fully performing residential mortgage? I would say that on the books, it is par, but if you tried to sell it, you would likely not find a willing buyer at that price.” Here is one more: “In the absence of trading fair value is rather difficult to establish. The traders and hedge funds are currently 'being killed' by the momentum fad they themselves made so big. The real money is just waiting for the last of the leveraged players to 'leave the field'.”

Let the Roundtable Begin!

In a speech at USC on May 29, SEC Chief Accountant Conrad Hewitt referenced the ITAC letter, and said, “While I must admit that I believe the use of fair value has its limitations for certain transactions, I believe that, as it relates to the type of financial instruments that we are dealing with in the context of the current credit turmoil, fair value has better informed investors than historical cost or a smoothing method would have.”

Hewitt added, “We have heard from investors and many preparers that the use of fair value has provided a level of transparency that is needed particularly in the current market place. While fair value also introduces volatility, I believe that when this volatility reflects the underlying change in the economics of a transaction, investors are better informed. Now, in order to make sure the issue gets discussed in a more public setting rather than on the internet blogs, the SEC will be holding a roundtable on fair value on July 9th to discuss the issue. “

As a blogger, I hope you’ve found some of the information we provide useful, on this topic and others, but personally, I am glad to see the SEC bring the conversation about fair value out into the open; as they say, ‘sunshine is the best disinfectant’.  In spite of emotions running high on this topic, as was the case when SEC convened two roundtables on another topic a couple of years ago - implementation of Sarbanes-Oxley Section 404, those roundtables led to important improvements in SEC and PCAOB standards, following the input on the implementation experience. The challenge in some ways may be greater now in trying to tame financial market turmoil, but getting views of a wide range of parties at a public roundtable is a great start, in addition to other efforts underway at the IASB, FASB and elsewhere.

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8:20 AM by Edith Orenstein

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Jul 5, 2008

IFRS is Front Page News...

… in an article by Stephen Labaton in today’s (July 5) New York Times: “Accounting Plan Would Allow Use of Foreign Rules.”

Referring to SEC’s anticipated roadmap that is expected to permit – or require – U.S. public companies to file with the SEC in International Financial Reporting Standards (IFRS) established by the International Accounting Standards Board (IASB), Labaton states: “The commission is preparing a timetable that will permit American companies to shift to the international rules, which are set by a foreign organization and give companies greater latitude in reporting earnings.” (For background, see also our coverage of FASB’s June 16 Forum on High Quality Global Accounting Standards.)

The timing of release of SEC’s ‘roadmap’ or proposal(s) may be imminent, according to at least the  message between the lines of Labaton’s article - as he notes the SEC is now at its full panoply of 5 commissioners, and adds that SEC Chairman Christopher Cox would need just two commissioners to vote with him to release the proposal. [Note: as we reported on June 27, the Senate confirmed the nominations of Luis Aguilar, Troy Paredes, and Elisse Walter to become commissioners of the SEC, filling the positions formerly held by Commissioners Roel Campos, Paul Atkins (who agreed to stay until his successor is named), and Annette Nazareth. Upon being sworn in, the three will join Chairman Cox and Commissioner Kathleen Casey.] 

Although SEC leadership has called for a global strategy in a world of increased mobility of capital and trading platforms, as noted by Labaton, some fear turning over responsibility for accounting standards, oversight of foreign broker-dealers and inspection of foreign audit firms, to foreign entities. 

Labaton quotes Duke law professor James D. Cox, [a previously rumored candidate to fill one of the open commissioner positions at the SEC] as saying, “’We would not for a moment tolerate having American auto safety standards set by China or India. Why should we do it for financial safety standards? There has to be some accountability.’” NYT’s Labaton then provides some specifics on how mutual recognition may play out in enforcing the securities laws.

Further on the topic of IFRS, you can find highlights from FEI’s June 5 conference, “The World is Moving to IFRS – Are You?” sponsored by BNA Tax and Accounting, in the Financial Reporting column of the July-August issue of Financial Executive Magazine. [Nonmembers of FEI will be prompted to create a free login account to read articles posted online; FEI members receive hardcopy of the award-winning magazine and can read articles online, see info about FEI membership] See also the online exclusive, “The Road to IFRS Implementation,” by KPMG Partner Paul Munter. UPDATE: To learn more about Canada's experience in implementing IFRS, see Darla Sycamore's blog, IFRS Canada: The Devil is in the Details. With stints as a CFO and accounting professor, Sycamore is a member of the board of trustees of FEI Canada's Financial Executives Research Foundation (CFERF), but writes her blog in her personal capacity.

FEI has taken a leadership role in educating its members – CFOs, Treasurers, Controllers, Tax Directors, and other senior financial executives – on major issues like eXtensible Business Reporting Language (XBRL), continuous improvement in corporate governance, and IFRS. Upcoming conferences of interest include our annual Current Financial Reporting Issues (CFRI) conference scheduled for Nov. 17-18 in NYC, and a one day IFRS boot camp on Nov. 19 in NYC sponsored by Deloitte entitled, “Tools for Converging to a Single Set of Standards.” See also our Women in Financial Leadership conference scheduled for Sept. 17 in NYC, and our Private Company Forum set for Sept. 23 in Chicago.

7:26 PM by Edith Orenstein

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Jun 27, 2008

MOU - SE; Senate Confirms 3 To SEC

The Memorandum of Understanding (MOU) aimed at coordinating supervision and examination (MOU-SE?) of financial institutions, including investment banks, being worked out between the Federal Reserve and SEC, is reportedly close to being issued, according to recent comments of SEC Chairman Christopher Cox as cited in this article by Rachelle Younglai of Reuters. “’We are making good progress,’” Cox said on June 25 of his work with Federal Reserve Board Chairman Ben Bernanke in developing the MOU, as reported by Younglai. As to timing, Cox added, according to Younglai, “‘I don't think we'd be discussing it publicly at all if we didn't think that we were close to doing it. It's just a question of whether it's before or after the Fourth of July at this point.’”

However, earlier today (June 27) Sen. Chris Dodd (D-CT) and Sen. Richard Shelby (R-AL), Chairman and Ranking Member, respectively, of the Senate Banking Committee, sent a letter to Cox, Bernanke and U.S. Treasury Secretary Henry M. Paulson, recognizing the agencies’ efforts to streamline and improve regulation, but cautioning them: “Given the limited authority of the Fed and the SEC to regulate investment banks with primary dealer status, and Congress’s ultimate responsibility for formulating financial regulatory policy, we ask that no action regarding implementation of the MOU be taken before we can determine that it is in the best interests of our nation’s economy and the well being of its citizens.”

Meanwhile, support for coordinated supervision for all ‘systemically significant institutions,’ was offered by Citigroup CEO Vikram Pandit in his op-ed appearing in today’s Wall Street Journal, “Toward a Transparent Financial System.” Pandit says three principles are key: systemic oversight, a level playing field, and transparency. “Markets cannot clear without transparency,” he said, adding, “Transparency concerns can lead to illiquidity. Yet transparency is difficult to achieve.”

Pandit’s suggestions were far-reaching. In the area of accounting standards, he noted the need for “Global coherence and consistency," and called for “clear guidelines regarding off-balance-sheet instruments.” He added, “Accounting based on a mark-to-model has been severely tested by unobservable inputs intended to estimate the market. This has fed into difficult, far-reaching decisions that impacted capital and other factors as one misinformed trade set off a chain of similar trades.”

“This raises an important question," says Pandit. "Are there alternative accounting approaches we should apply, particularly in dysfunctional markets?”

An expedited review of accounting standards for valuation and off-balance sheet treatment is already underway at the IASB, FASB and SEC. As we have previously reported:

• The IASB’s Expert Advisory Panel on valuation in inactive markets is one of the groups addressing questions about valuation in illiquid markets and will also address issues of consolidation of special purpose vehicles involved in securitizations.
• FASB is addressing issues concerning QSPEs and other off balance sheet entities involved in securitizations in its upcoming revision to FIN 46R and FAS 140.
• The SEC is holding a Fair Value Roundtable on July 9.  

Senate Confirms Commissioners for SEC
In other SEC news, the Senate voted today (June 27) to confirm the three nominees for commissioner of the SEC, Dems Luis Aguilar and Elisse Walter, and Republican Troy Paredes, as noted in this article by Manu Raju in The Hill. 

In a statement issued today, SEC Chairman Christopher Cox said, “The President and the Senate have given the SEC three outstanding Commissioners. I look forward to welcoming them to their important positions of leadership in the finest securities regulatory agency in the world. The SEC has laid out an ambitious agenda to improve investor protection and financial markets regulation, and a full complement of Commissioners will help us achieve those important objectives."

As we near the end of June, remember our Do You Know Somebody offer to interview 2 new subscribers (and the current subscribers who refer them) who sign up for our blog by June 30. 

We usually post this blog once a day; today’s post is a bit later than usual due to the FEI Staff Picnic, 2008, a fun-filled day complete with water balloon toss, piñata, and a kickball game. Our NJ office HQ staff was pleased to be joined this year by our Washington DC office staff, including Michelle Coleman, Manager, Business Development, Serena Dávila, Director, Technical Activities, and Matt Miller, Director of Tax and Economic Policy. (Miller’s membership in the World Adult Kickball Association (WAKA) may have helped Captain Rudy Katzenberger’s team win 6-4 in today’s FEI kickball match.) Katzenberger, Senior Accountant at FEI, and the entire Activities Team did a great job planning the event. Opening remarks were given by former FEI Chairman Jim Abel, who will serve as interim CEO and President of FEI beginning July 1, as FEI searches for a new President and CEO. As previously announced, FEI’s current President and CEO, Michael P. Cangemi, resigned effective June 30, after which he will continue in a role as senior advisor for FEI, with a focus on accounting policy issues and associated advisory councils. Read more about FEI here.

6:19 PM by Edith Orenstein

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Jun 25, 2008

SEC Proposes Rules on Rating Agencies, Annuity Contracts, More

At its open commission meeting on June 25, the SEC voted to release for public comment rule proposals relating to credit rating agencies, regulation of certain annuity contracts, and foreign broker-dealers. Separately, the SEC agreed to adopt interpretive guidance and related rule amendments to streamline the rule filing process of Self Regulatory Organizations (SROs).

Credit Rating Agency Proposals Will Affect Rating Agencies, Issuers
The credit rating agency (CRA) proposal approved for release on June 25 was the third in a series of proposals relating to CRAs considered by the SEC this month. (See our coverage of the first two proposals, voted on at the June 11 meeting.) 

As described in SEC Chairman Christopher Cox’ opening remarks on June 25. the third CRA proposal (actually, a set of proposals) is “focused on the way the Commission's own rules refer to and rely upon credit ratings.”  

Cox summarized the objectives of the third set of CRA proposals, based on the SEC staff’s review of existing rules, recent events in the subprime and credit markets, and related recommendations of the Financial Stability Forum:

• “[I]n some rules and forms, the reference [in SEC rules] to credit ratings isn't really necessary at all. In those cases, the proposed new rules would simply eliminate the reference.
• “In other cases, the staff has found that there is value in the use of a credit rating, but that the current way ratings are incorporated in the particular rule or form should be changed. In these cases the proposed rules would clearly state the regulatory purpose we are seeking to achieve, and then permit reliance on a credit rating as one way to achieve that purpose.
• “Finally, in just a few cases, the staff has concluded that the reference to a credit rating continues to be appropriate exactly as it is. In these cases, because there is no hazard of inducing undue reliance on the ratings by investors, the recommendation before us is to leave the rules as they are.”

Besides rule amendments proposed by the Division of Trading and Markets and Division of Investment Management (including as relate to money market funds), certain CRA-related amendments proposed by the Division of Corporation Finance (Corp Fin), relate to eligibility to use Form S-3, shelf offerings, and offerings of asset-backed securities, as summarized in this statement by Corp Fin’s Steven Hearne.

As noted in our subsequent coverage of the SEC’s June 11 meeting, issuers may have direct disclosure obligations under the CRA proposals approved at the June 11 meeting, in addition to having to provide certain information to the CRA or arranger (underwriter) to disclose. Potential additional disclosure obligations for issuers in the proposals considered on June 25 were noted in Hearne’s remarks as follows:

“[T]he release does not propose to amend the Commission's policy on security ratings, as it is currently outlined in Item 10(c) of Regulation S-K. Information on ratings is permitted under Item 10(c) and in that item the Commission recommends issuers consider additional disclosure regarding the ratings. The release requests comment as to whether the Commission should instead mandate this disclosure and whether additional information regarding any material limitations or qualifications on the rating and any related designation or other published evaluation of non-credit payment risks assigned by the credit rating agency with respect to the security would be valuable to investors.”

Narrows Exemption of Certain Annuity Contracts from Federal Securities Laws
In other rulemaking action on June 25, the SEC voted to release a proposed rule relating to annuity contracts that would clarify the status under the federal securities laws of indexed annuities, under which payments to the purchaser are dependent on the performance of a securities index. A ‘more likely than not’-based determination of payments under the contract is proposed to determine if such contracts offered by insurance companies will remain exempt from the securities laws, or be subject to the securities laws. 

The SEC’s proposal would exempt insurance companies from filing reports under the Securities Exchange Act of 1934 with respect to indexed annuities and certain other securities registered under the Securities Act and regulated as insurance under state law. The proposed exemption would be subject to the existence of state regulation of the insurer’s financial condition and the absence of trading interest in the securities;  additionally, the insurer would have to takes steps to ensure a trading market in the exempted annuity does not develop. Prospective treatment is proposed (applying to indexed annuities issued on or after the effective date of a final rule, if adopted) and the proposed effective date is 12 months after the final rule (if adopted) is published in the Federal Register.

Foreign Broker Dealers Operations Can Expand
Also at the June 25 meeting, the SEC voted to release proposed rule amendments to expand the ability of foreign broker dealers to operate in the U.S.

One such amendment would expand the category of U.S. investors to whom foreign broker dealers could provide research reports to and interact with, changing the current requirement from “institutional investors that own or control greater than $100 million in total assets,” to “all registered investment companies, corporations, companies, or partnerships that own or invest on a discretionary basis $25 million or more, and natural persons who own or invest on a discretionary basis at least $25 million.”

Additional proposals, including a proposal to remove a ‘chaperone’ requirement, whereby foreign broker dealers are currently required to be ‘chaperoned’ by U.S. broker-dealer personnel on certain interactions with U.S. investors, are aimed at expanding the ability of foreign broker dealers to operate in the U.S. without triggering registration, reporting or other requirements under the securities laws.

Commissioner Atkins said, “I commend Chairman Cox for your leadership on these long overdue amendments,” noting he was particularly pleased the proposed expansion of eligible investors included covered institutions as well as natural persons.

“I have to admit,” he added, “if we ultimately adopt these proposals, I will miss the opportunity for cheap jokes like the chaperone rule affords.”  

SRO Proposals Respond to Inspector General Findings
Not only were NRSROs on the agenda at SEC’s June 25 meeting, so were SROs, as the SEC voted to release proposed rules to streamline the SRO rule filing process. These rule changes would streamline processes followed by SROs, and by the SEC with respect to its own Notice and filing requirements of SRO rulemaking.

Chairman Cox noted in his remarks on the SRO proposals, that the SEC’s Office of the Inspector General (IG) found that, although a requirement states that the SEC approve or institute proceedings to disapprove an SRO rule proposal within 35 days of its publication (which can be expanded to 90 days in certain cases), “The IG found that, on average, it took the Commission 57 days to issue a notice of a rule filing submitted pursuant to Section 19(b)(2) of the Exchange Act. The IG also identified two proposed rule changes where the Commission took more than five months and more than eight months to publish notices. The IG also analyzed an audit sample of rule filings that had been open for more than a year. The IG found that, on average, these rule filings had been open for well over two years, with the longest having been open for four years.” [See: report of the Inspector General, March 2008.]

The issue of timeliness of the SRO filing process has been around for a while. Commissioner Atkins observed that when he previously served on the staff of former Chairman Arthur Levitt, Jr., “One of the first assignments I had from Chairman Levitt, back [in] 1993, was to look at the SRO filings [backlog],” and he found at the time “some were decades old.”

The guidance proposed on June 25, said Cox, “should encourage SROs to file greater numbers of rule changes for immediate effectiveness where appropriate.”He added, “Importantly, however, SROs should understand that, as the volume of such rule changes increases, so may the possibility that certain rule changes could be abrogated. Undoubtedly, many market participants affected by such rule changes might try to persuade the Commission that a rule change filed for immediate effectiveness should be abrogated and re-filed for full Commission review. In my view, this would be a healthy outcome and one fully contemplated by the framework established under the Exchange Act.”

Thus, Cox explained, “In anticipation of this change in the Commission's processes, the staff also has recommended that the Commission now consider any such abrogations directly. Accordingly, the staff has recommended removing the provision delegating this authority to the Division of Trading and Markets. This change would enhance the Commission's involvement in this area, where industry and Commission practice likely will undergo a period of rapid transition over the coming months and years. Once the Commission and industry have had a chance to adjust to the new process and it has become more routinized, the Commission could once again call on the staff to administer abrogations by delegation.”

Are you a new reader of our blog? If you received this posting from ‘a friend,’ enter your email address here to receive the blog directly. As a reminder, our “Do You Know Somebody” offer runs through the end of June.

10:05 PM by Edith Orenstein

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Jun 24, 2008

SEC Launches Disclosure Study; Advisory Committee To Be Formed

Earlier today (June 24) the SEC announced the kickoff of its “21^st Century Disclosure Initiative,” to study how information is obtained by the SEC from public companies, mutual funds, brokers and other regulated entities, and how it is made available to, and used, by investors and the markets.

The study will be led by Dr. William (Bill) Lutz, professor emeritus at Rutgers University. Lutz played a major role in the SEC’s Plain English initiative in the 1990s.

Besides the SEC’s Plain English Handbook, which Lutz had a significant role in developing, he is the author of numerous books and articles on the importance of plain language disclosures and avoiding doublespeak. (Some examples of Lutz’ work which I found also include his “39 Steps to Writing in Plain English” posted in 2005 by the Plain Language Association INternational (PLAIN),   and “Life Under the Chief Doublespeak Officer” posted on a website called dt.org which appears to be a collection of various writings by various authors.)

The aim of 21^st Century Disclosure Initiative, said the SEC, is “to outline the attributes of the disclosure system for the future that incorporates technology, the new ways in which investors get their information, and recent developments in how companies compile and report the information in their SEC-mandated disclosures.”

Blueprint Will be Published; Advisory Committee Will Be Formed
“The internal study will produce, by the end of 2008, a blueprint for future Commission action to improve the usefulness and timeliness of disclosure for investors,” stated the SEC. Additionally, the blueprint will aim to “streamline and modernize the collection of disclosure from companies and regulated entities.”

An advisory committee will be formed as part of this initiative, noted the SEC

‘Fundamental Rethinking’ of Financial Disclosure; I.T. Key
“The study will be a fundamental rethinking of financial disclosure,” said the SEC, “beginning with the basic purposes of disclosure from the perspective of investors and markets.”

Information Technology (I.T.) will be a key aspect of the study, as the SEC notes: “Essential to the study will be the determination of how to match the capabilities of today’s information technology with the SEC’s regulatory aims and the needs of investors.”

All Existing SEC Forms, Reporting Requirements To Be Reviewed
The scope of the 21^st Century Disclosure Initiative study, says the SEC, will include a review of:

• all existing SEC forms and reporting requirements,
• the manner in which information is provided to the Commission, 
•  with a special focus on needless redundancy.“ 

Additionally, the study will:

• consider various alternative strategic approaches to acquiring and publishing disclosure information
• consider ways that regulatory requirements for the collection of information might be tailored to get the best real-time distribution of financial and narrative disclosure to investors, and
• examine how best to integrate public disclosure with the SEC’s proposed new post-EDGAR architecture for investor search, assembly, and comparison of data.

3:45 PM by Edith Orenstein

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Jun 24, 2008

Audit Firm Litigation,Fin'l Info Released By Treasury, CAQ;Att'y-Client Priv. Bill Gains Support;FASB, Lawyers Meet on FAS 5

In a little noticed development, the U.S. Treasury Advisory Committee on the Auditing Profession (ACAP) released information on the litigation exposure and other financial, governance and human resource information of the six largest audit firms. The information consists of 3 separate reports provided to ACAP earlier this year by the Center for Audit Quality (CAQ), affiliated with the AICPA. CAQ gathered the information from the audit firms for consistency, used a law firm to help organize the data, and provided detail in the aggregate, or in some cases, in the form of averages, to protect confidentiality of the individual firms. See “Reports of the Major Public Company Audit Firms to the Department of the Treasury Advisory Committee on the Auditing Profession” – which were posted via a link on ACAPs website posted June 16 under “Data Matrices.”

ACAP’s discussion during its open meetings on the topic of auditor liability was commented on by Jim Peterson in his blog, Re: Balance on Friday. Peterson, who formerly served as a senior in-house lawyer with a major accounting firm, and whose columns have appeared in the International Herald Tribune, Journal of Accountancy, and elsewhere, wrote: “Did anyone really think that the endless chatter about saving the system of privately-provided audits for large global companies would come to anything? If so, that fantasy was dispelled on June 3, in the closing minutes of the latest meeting of the U.S. Treasury’s Advisory Committee on the Auditing Profession – webcast here. In his summation, Co-Chairman Don Nicholaisen explicitly stated that, with an insubstantial exception, the Committee’s recommendations ‘do not address catastrophic risk’ of the loss of the Big Four.” See also our earlier coverage of the June 3 ACAP meeting (our June 9 blog post), and related analysis by Francine McKenna, author of the Re: The Auditors blog (and her earlier post here).   

Attorney-Client Privilege Bill Gains Support

Lynnley Browning reported in yesterday’s New York Times, in her article, “Bill to Protect Companies in Inquiries Adds Support,” that, “Nearly three dozen former federal prosecutors have thrown their weight behind a Congressional bill intended to safeguard confidential communications between lawyers and their clients, a legal bedrock that has come under attack amid corporate fraud scandals.”

“The closely watched bill,” Browning continues, “would make it illegal for prosecutors and other federal enforcement officials, including those at the Securities and Exchange Commission, to demand that a company under investigation disclose confidential legal communications or risk being indicted — a corporate death knell.”

The bill in question is the Attorney-Client Privilege Protection Act of 2007, sponsored in the Senate by Senate Judiciary Chair Sen. Arlen Specter, (see related info here), with a similar bill sponsored in the House Committee on the Judiciary, chaired by Congressman John Conyers, Jr.

Dan Slater provided a link to the letter in his post in the Wall Street Journal Law Blogyesterday, along with a link to related info on the proposed legislation on the website of the National Association of Criminal Defense Lawyers.

See also info on the Association of Corporate Counsel website; ACC’s SVP and Corporate Counsel Susan Hackett was interviewed in Browning’s NYT article. We had the ‘privilege’ of interviewing Hackett and others in this article in Financial Executive Magazine Sept. 2006 (Note: the article predates issuance of DOJ’s “McNulty Memo” which superceded the Thompson Memo; however the proponents of the current bill before the House and Senate argue the McNulty Memo did not go far enough in addressing concerns about the erosion of attorney-client privilege in efforts by DOJ and the SEC (through policy described in its “Seaboard Memo”) to ‘give credit’ for ‘cooperation,’ including cooperating by means of waiving privilege.

FASB Meets With Legal Profession To Discuss Privilege, Other Issues in FAS 5 Amendments

FASB board member George Batavick told the 1,200 attendees on FASB’s Mid-Year Update webcast yesterday that FASB met with representatives of the legal profession last week to discuss certain matters relating to proposed amendments to FAS 5 on disclosures of loss contingencies. Batavick described it as a good discussion, adding the attorneys plan to provide FASB with “examples of loss contingencies, how they ended up on the balance sheet, what the delays were.”

FASB Director Russ Golden added, “We recognize changes may need to be made relating to the ‘treaty’ between the American Bar Association (ABA) and the AICPA relating to ….[privileged information and] the audit process.”

Here’s some info about FASB’s proposal, Disclosure of Certain Loss Contingencies: an amendment of [FAS 5] and [FAS 141R], as described on FASB’s webcast yesterday:  

• August 8 is the comment deadline on the proposal.
• Proposed disclosures for loss contingencies include: Description of nature and risk of loss, factors likely to affect outcome, and most likely outcome, Amount of claim, Detailed reconciliation of changes, and disclosure of loss contingency if severe and expected to occur in one year.
• Golden said he expects the proposal to be ‘extremely controversial.”
• A ‘prejudicial exception’ is included in the proposal, said Golden, to address concerns expressed by companies that such disclosures would be ‘prejudicial’ in impacting the ability of those companies to defend themselves in certain lawsuits. Golden explained the proposed ‘prejudicial exception’: “In the event the case is so unique, so significant, a company is unable to describe the nature of the risk and amount of claim without giving away … information, the company would not have to disclose that information.”  However, he added there are those who believe the proposed prejudicial exception would not be in the best interests of financial reporting.
• FASB plans to hold a roundtable and “perhaps do an academic study” to improve loss contingency disclosures, said Golden, “with hopes we can finalize [the standard] by the end of the year.”

A broad array of subjects was covered on the FASB’s Mid-Year Update, including recently issued standards and projects in process, as well as convergence projects under the FASB-IASB Memorandum of Understanding. An archived version of the webcast will be posted by FASB; see also our Detailed Summary of FASB’s Mid-Year Update (note: our detailed summary can only be downloaded by FEI members, see info on FEI membership).

As a reminder, our Do You Know Somebody offer holds till the end of June.

8:25 AM by Edith Orenstein

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Jun 20, 2008

All's Fair, and 404:SEC Seeks Comment on Issues For Fair Value Roundtable;Adopts Final Rule Delaying Sarbox 404b for Small Cos

On Friday afternoon (June 20), the SEC announced that it adopted a final rule delaying the Sarbanes-Oxley Section 404(b) requirement for small public companies (i.e., ‘non-accelerated filers,’ generally defined as  those with less than $75 million market cap) to have an external auditor perform and report on an audit of internal control. This means small co’s, which just this year had to file their first management report on internal control under Sarbox Section 404(a), will have an additional year (i.e., effective fiscal years ending on or after Dec. 15, 2009) to comply with Sarbox Section 404(b). Without the delay announced June 20, small co’s would have become subject to 404b in fiscal years ending on or after 12/15/08. 

Additionally, the SEC said it received approval from the U.S. Office of Management and Budget (OMB) on June 19 “to proceed with data collection for a study of the costs and benefits of Section 404 implementation.” The cost-benefit study reportedly ‘commenced’ on Feb. 1, according to an earlier press release, but one step along the way apparently involved obtaining OMB approval, which is now in place.

Besides “focusing” the study on “the consequences for smaller companies and the effects of the Section 404 auditor attestation requirements,” the SEC notes the study will also “help determine whether the new management guidance on evaluating the internal controls over financial reporting issued by the Commission in June 2007 and the Public Company Accounting Oversight Board's (PCAOB) Auditing Standard No. 5 approved by the Commission in July 2007 are having the intended effect of facilitating more cost-effective internal control evaluations and audits of smaller reporting companies.” Additionally,”The study includes gathering new data from a broad array of companies about the costs and benefits of compliance with the Section 404 requirements. The study also pays special attention to those smaller companies that are complying for the first time with the requirements that are currently in effect.”

Some will criticize the delay, noting 404 has been around for years now, and small co’s have had ample time to get on board. However, others – like NYSE Euronext CEO Duncan Niederauer – are calling for a ‘rationalization’ of Sarbox for small co’s, and the breather allowed by this delay will enable the SEC and others to take a look at some objective (and subjective) data about cost-benefit obtained through the SEC’s study. 

In other Friday afternoon news emanating from 100 F Street … the SEC announced it invites comment on the following issues to be addressed at its July 9 roundtable on fair value measurement:

• the usefulness of fair value accounting to investors
• potential market behavior effects from fair value accounting
• practical experience and potential challenges in applying fair value accounting standards
• aspects of the current standards, if any, that can be improved