November 30, 2006

Compliance Lawyers as Gangstas: Field Day for Litigators?

So much has been written already about the Committee on Capital Markets Regulation Interim Report – which was released this morning – but there still should be plenty of fodder for academic-oriented blogs to chew on for months. For me, I focused first on a Committee recommendation that hits close to home for corporate finance lawyers: that the SEC adopt regulations that rely on principles-based rules and guidance.

In yesterday’s WSJ, Alan Murray scrutinized this recommendation in his column, which included an interview with someone who has tried to implement such a framework – the UK’s Financial Services Authority recently has been down this road with mixed results. The column also delved into the dominance of lawyers in the rulemaking process and how the SEC would have to hire more economists to implement this Committee recommendation. While it might be reasonable for the SEC’s Office of Economic Analysis to staff up and participate more in the rulemaking process, it could get dangerous if the OEA winds up dominating the process.

I fear that if there were a lack of specific and detailed rules (and guidance) from regulators, it would be too easy for companies to fall down the slippery slope of principles-based regulation. Not only are there plenty of executives out there not naturally inclined to implement sound practices (which is understandable because “compliance” is not a profit center), there are many companies that simply don’t have the resources to figure out what “everyone else is doing” – and figuring that out would become even more important under a pure principles-based regulatory framework.

I like a middle ground here, such as the path that Corp Fin followed in its executive compensation rulemaking. That set of rules is comprised of a mix of principles-based rules and very detailed line items. Corp Fin Director John White has been out speaking on what his principles-based approach means in a series of recent speeches. I am convinced that under an overly principles-based framework, more litigation would erupt over vast grey areas – thereby, paradoxically creating much more work for lawyers (although the Committee’s report has recommendations on how to neuter the plaintiff’s bar). Let me know your 10 cents.

Summary: Committee on Capital Markets Regulation Interim Report

From FEI’s “Section 404” Blog, here is a summary of the five broad areas where regulatory reform is needed, according to the Committee on Capital Markets Regulation Interim Report:

– competitiveness/”loosen capital controls” (e.g. to make deregistration from U.S. market easier for foreign companies; providing them easier exit may reduce their hesitation to enter),

– reform the regulatory process (SEC and SROs must do more rigorous cost benefit analysis before and after rulemaking; focus on principles-based approach; federal and state enforcement should not be used for ad hoc rulemaking),

– enforcement (SEC should resolve uncertainties arising from conflicting court opinoins as to Rule 10b-5 liability, particularly regarding materiality, scienter and reliance; DOJ should revise Thompson memorandum to prohibit prosectors from seeking denial of legal fees and waiver of attorney-client privilege; Congress should consider liability cap for auditors/preventing catastrophic liability; regulators should not indict entire firm unless exceptional circumstances; SEC should reverese longstanding position that indemnification of directors is against public policy, and increase ability of directors to rely on auditors and company exec’s as part of due diligence),

– shareholder rights (e.g. supports majority voting over plurality voting; SEC should address shareholder access debate), and

– Sarbanes-Oxley Section 404 (Committee does not call for amendments to statute – Sarbanes-Oxley Act – but calls on SEC, PCAOB need to provide guidance to improve cost-benefit balance, such as revised definition of materiality, rotational testing in support of annual assessment, encourage more use of judgment. After these changes are in place, depending on result of updated cost-benefit assessment, Congress may need to consider if special treatment for smaller companies is necessary. However, Committee does not support one approach that has been suggested for smaller companies, to limit scope of auditors or management’s report to “design” of control).

Another good summary is in this WSJ opinion column, written by two of the Committee’s members.

MD&A Risk Factors (Nelson Rocks Preserve-Style)

As Bruce Carton shutters his “Securities Litigation Watch” Blog (he is moving on to a new job), I thought I would pay tribute by repeating the following blurb he penned a few months back:

Courtesy of, I found this inspiring Disclaimer on the Nelson Rocks Preserve website. Nelson Rocks Preserve is an outdoor recreation area located in West Virginia that is apparently tired of people suing them when they fall off cliffs, get bit by snakes, etc. They are responding with a disclaimer that reminds would-be users of the preserve of important things like “a whole rock formation might collapse on you and squash you like a bug” or
…climbing is extremely dangerous. If you don’t like it, stay at home. You really shouldn’t be doing it anyway. We do not provide supervision or instruction. We are not responsible for, and do not inspect or maintain, climbing anchors (including bolts, pitons, slings, trees, etc.) As far as we know, any of them can and will fail and send you plunging to your death. There are countless tons of loose rock ready to be dislodged and fall on you or someone else. There are any number of extremely and unusually dangerous conditions existing on and around the rocks, and elsewhere on the property. We may or may not know about any specific hazard, but even if we do, don’t expect us to try to warn you. You’re on your own.

Inspired by Nelson Rocks, I have come up with a securities disclosure version of their disclaimer, designed to meet all of the MD&A “Risk Factors” needs of your favorite public company. It looks like this:

Risks Related to our Business and Ownership of our Securities

Our business is unpredictable and unsafe. The stock market, including the market for our securities, is dangerous. Many books have been written about these dangers, and there’s no way we can list them all here. Read the books.

The path to success for our business is littered with land mines. Seriously-anything could happen. Our competitors try their best every day to crush us, and they could succeed. We could get rich and complacent following our IPO and fail to innovate. Our customers could abandon us. Key members of our management team could quit to sail their yachts around the world for a decade. We could grow so fast that our business spirals out of control. Any or all of these could occur and our business would go down the toilet, along with your investment.

Real dangers are present even if none of the above occurs. New technologies may be developed that will render ours obsolete. A patent troll could come along who claims to own the intellectual property rights to our technology, costing us tens of millions of dollars in defense costs (best case) or destroying our entire business (worst case). Third parties such as malicious hackers could emerge to undercut our business. Even the government could torpedo us by passing new laws that hurt our business. The bottom line is that our business and the stock market are unsafe, period. Live with it or stay away.

Totally unforeseen things can happen. There could be a SARS epidemic. There could be a terrorist attack. There could be a natural disaster, such as a hurricane. A herd of elephants could escape from the zoo and trample our headquarters, squashing our business and your investment you like a bug. Don’t think it can’t happen.

Even if none of these things happen, the stock market could go down for no reason whatsoever. That is to say, you may make a wise investment, we may work our tails off, our business may thrive, and you may still lose all of your money. It happens all the time.

If you engage in particularly dangerous trading such as uncovered options or naked short selling, you may lose everything you own. This is true whether you are experienced or not, trained or not, educated or not, or intelligent or not. It’s a fact, such trading is extremely dangerous. If you don’t like that, don’t do it. You really shouldn’t be doing it anyway. We do not provide supervision or instruction. We are not responsible for the financial ruin that may result. As far as we know, any of these types of trades can and will fail and send you plunging to your financial death. You’re on your own.

Financial bail-out services are not provided by our company. If you lose your shirt investing in our company after reading all this, don’t come running to us (or your class action lawyers). We assume no responsibility.

By investing in our business, you are agreeing that we owe you no duty of care other than not being crooks. We promise you nothing else. This is no joke. We won’t even try to warn you about any dangerous or hazardous conditions not required of us by the SEC, whether we know about it or not. If we do decide to warn you about something, that doesn’t mean we will try to warn you about anything else. We and our employees or agents may do things that are unwise and dangerous. In fact, we probably will. Sorry, we’re not responsible. We may make bad decisions or give out mistaken guidance. Don’t listen to us. In short, INVEST IN OUR COMPANY AT YOUR OWN RISK. And have fun!