April 23, 2008

Next Steps on the Credit Rating Fiasco

At yesterday’s hearing of the Senate Committee on Banking, Housing and Urban Affairs entitled “Turmoil in U.S. Credit Markets: The Role of the Credit Rating Agencies,” Chairman Cox defended the SEC’s implementation of the Credit Rating Agency Reform Act of 2006 and spelled out some possible new rulemaking efforts on the credit rating front.

In his testimony, Chairman Cox outlined the SEC Staff’s efforts in conducting ongoing examinations of the nationally recognized statistical rating organizations (NRSROs). Those efforts have included the review of thousands of pages of internal records and emails, public disclosures and rating histories by around 40 Staff members. While the examinations are not yet complete (a report is expected by early summer), Cox noted that the Staff has found so far that there was a substantial surge in ratings for structured finance deals from 2004 – 2006, with those deals involving increasingly complex products. The examination Staff’s preliminary observations have been that the “ratings process used to rate these products may have been less quantitatively developed, particularly as the products became more complicated and involved different types of loans, than was generally believed.” While the SEC is trying to avoid engaging in substantive regulation of the ratings process, it is interested in the adequacy of the NRSRO’s disclosure about their procedures and methodologies, and whether such factors as a desire to maintain or increase market share may have caused the NRSROs to be “less conservative” than their disclosed methodologies.

Now that the SEC’s NRSRO registration system is in place and other rules implementing the 2006 legislation are effective, the SEC is looking at other areas of rulemaking within its authority. Chairman Cox outlined the following possibilities:

1. Enhanced disclosure about ratings performance – this would include disclosures that allow market participants to better compare the ratings of one NRSRO with another.

2. Accountability for managing conflicts of interest – new rules might prohibit certain practices, as well as establish requirements that address potential conflicts that could impair the process for rating structured products (e.g., consulting services provided by NRSROs to issuers).

3. Annual reporting – new rules could required the NRSROs to furnish the SEC with annual reports describing internal reviews and how well the firms adhere to ratings procedures, manage conflicts of interest and comply with securities laws.

4. Enhanced disclosure of underlying assets – new rules may require disclosure of information about the assets underlying MBS, CDOs and other structured products so market participants could better analyze creditworthiness without the benefit of ratings (and to enhance the availability of data – and thus level the playing field – for subscriber-based NRSROs as compared to the “issuer pays” NRSROs).

5. Enhanced disclosure about ratings – new rules could also mandate enhanced disclosures about how the NRSROs determine their ratings for structured products, as well as ratings information that will make it possible for investors to distinguish between ratings for different types of securities.

6. Access to information – potential rules may seek to eliminate advantages (including access to information) that NRSROs following the “issuer pays” model may have over subscriber-based NRSROs.

7. SEC reliance on ratings – The SEC is revisiting its own reliance on ratings throughout its rules. This could be a big shift in the SEC’s rules, including those related to corporation finance.

These new rules could substantially change the ratings landscape, and most likely for the better. It certainly can’t get much worse.

For a great breakdown of the history behind securities ratings and what went wrong with the ratings on mortgage backed securities, check out Roger Lowenstein’s piece entitled “Triple-A Failure” which will be published in this Sunday’s New York Times Magazine.

PCAOB Adopts Audit Committee Communications and Tax Services Rule

Yesterday, the PCAOB announced that it had adopted new Rule 3526, Communication with Audit Committees Concerning Independence, and an amendment to Rule 3253, Tax Services for Persons in Financial Oversight Roles. The adopting release for these rules was posted shortly after the PCAOB’s open meeting. The rules changes are now off to the SEC for final action.

Rule 3526 will – if adopted by the SEC – supersede Independence Standards Board Standard No. 1, Independence Discussions with Audit Committees, and two related interpretations. The new rule will require registered audit firms – at the time of the initial engagement – to provide a detailed written description of all relationships between the firm and its affiliates and the issuer or persons in a financial reporting oversight role that may reasonably be thought to bear on independence. Registered audit firms will also be required to discuss the potential effects of these relationships with the audit committee. Similar communications will then be required annually.

The amendment to Rule 3523 will – if adopted by the SEC – exclude from the scope of that rule any tax services that are provided during the portion of the audit period that precedes the beginning of the professional engagement period. Under this change, tax services provided to persons in a financial reporting oversight role prior to the beginning of the professional engagement period would not necessarily impair a firm’s independence.

In other PCAOB news, earlier this week it was announced that Sharon Virag, Director of Technical Policy Implementation, will be leaving the PCAOB at the end of the month. Sharon was the project leader for the development of AS No. 5 and she recently participated in our webcast “The PCAOB Speaks: Latest Developments and Interpretations.” Best wishes for Sharon in her new position.

Options Backdating: Broadcom Settles

Last month the SEC settled an Enforcement action against Nancy Tullos, the former Vice President of Human Resources of Broadcom, for her involvement in the company’s five-year-long options backdating scheme – which resulted in Broadcom’s January 2007 restatement to include a whopping $2.22 billion of unreported compensation expense in its financials. I believe that was the largest restatement in the short and sordid history of options backdating.

Now the SEC has settled with Broadcom itself, and interestingly enough the SEC extracted only a $12 million civil penalty in addition to a permanent injunction. While this penalty is higher than the $7 million civil penalty paid by Brocade Communciations in its settlement of backdating charges, it is significantly lower than the $28 million civil penalty paid by Mercury Interactive. A number of the other companies charged with backdating-related violations paid no penalty whatsoever. It is still hard to say how the Commission arrives at these penalty amounts (even with the added transparency about the process issued a couple of years back), but certainly I think the Commissioners have not historically been big fans of imposing monetary penalties on corporations.

As noted in this article, the former CFO of Mercury Interactive Corp., Sharlene Abrams, was indicted on charges related to Mercury’s options backdating scheme. Abrams was charged with one count of income tax evasion and two counts of aiding and assisting in the preparation of false tax returns for two other Mercury executives. This is the third time an executive has been charged with tax evasion arising from options backdating.

– Dave Lynn