August 8, 2008

Impact of Executive Compensation Disclosures on Creditors

In this podcast, Chris Plath of Moody’s Investors Service discusses Moody’s new report entitled “Expanded Disclosure On U.S. Executive Compensation Offers New Clues For Creditors,” including:

– Why has Moody’s issued this new report?
– How can better disclosure of performance metrics targets enhance a creditworthiness evaluation?
– What type of peer group benchmarking disclosure is Moody’s looking for?
– How about for payments following a change in control?

SEC Amends Definition of “Eligible Portfolio Company” Under the ’40 Act

A while back, the SEC adopted amendments to the rule under the Investment Company Act of 1940 to more closely align the definition of eligible portfolio company – and the investment activities of business development companies – with the purpose that Congress intended by expanding the definition to include certain companies that list their securities on a national securities exchange, among other things. Here is the SEC’s press release. And here is an interview with Harry Pangas of Sutherland Asbill about business development companies in a nutshell…

Gatekeepers: The Professions and Corporate Governance

I haven’t done much in the way of book reviews, so I thought’s Jim McRitchie’s review of the new book – “Gatekeepers: The Professions and Corporate Governance” – by well-known Columbia Professor John Coffee was worth repeating below given all the reforms currently on the table:

Although the book was written in the wake of Enron and WorldCom, it is equally applicable to the subprime debacle in its analysis of “gatekeeper failure.” In a personal note to me, Professor Coffee laments, “perhaps I should have waited a year longer to write this book.” Better he should have written it a couple of years earlier, with copies to Alan Greenspan and others charged with regulating and rating the mortgage industry.

However, the book’s timing could hardly be better, since substantive reform only seems to occur with a crisis. Implosion of the savings and Loan Industry brought us the Federal Institutions Reform, Recovery and Enforcement Act of 1989. Accounting scandals at Enron, WorldCom, etc. brought us the Public Company Accounting Reform and Investor Protection Act of 2002 (Sarbanes Oxley). The subprime debacle is likely to bring significant reform as well.

It would be great if those advising Presidential candidates would consult Gatekeepers in preparing such proposals. Coffee focuses on auditors, attorneys, securities analysts and credit-rating agencies who inform and advise corporate managers, boards and shareholders. After a brief introduction explaining the failure of gatekeepers and a comparative overview of their roles internationally, Coffee devotes a chapter to each of the four groups. He typically provides an informative history, a review of current issues such as conflicts of interests, and an evaluation. He wraps up the book with a thematic discussion of what’s gone wrong and how it might be fixed.

In general, gatekeepers act as “reputational intermediaries” by verifying corporate statements to investors. When trusted and successful, this lowers the cost of capital. However, as Coffee notes, “Watchdogs hired by those they are to watch typically turn into pets, not guardians,” especially in the euphoric environment typified by stock or housing bubbles, when the public is typically lulled into complacency.

As management incentives were aligned with shareholders through options, income smoothing gave way to robbing the future for earnings that could be recognized immediately. Coffee explains how Enron’s audit committee was blinded by professional advisers who fed it only the information senior management wanted them to have. Auditors were retrained and incentivized to sell consulting services. He explains why fund managers and gatekeepers tend to herd and why, until four days before Enron declared bankruptcy, its debt was rated “investment grade.’ Only those with a financial self-interest, the short-sellers, searched beyond the surface and predicted Enron’s accounting restatements. At WorldCom, “the limited due diligence that was conducted appears to have been constrained by the need not to offend the client” and the actual fraud was detected by the firm’s internal auditors.

Coffee helps the reader see from a different perspective. For example, while some studies have found that audit firms with high consulting revenues were more likely to acquiesce to questionable earnings management, others found no such correlation. Coffee points out that instead of looking what is already in hand, we should look to possibilities. “The real conflict lies not in the actual receipt of high fees, but in their expected receipt.” That explains why audits became a “loss leader” to obtain consulting services.

Similarly, disclosure of conflicts of interests often does not lead to expected results. Social psychologists find those on the receiving end often let down their guard, thinking because conflicts were disclosed they are being dealt with fairly. However, the conflicted party often feels that, having made the disclosure, they are now free to pursue their own interests aggressively. Gatekeepers is filled with such insights.

The major problem is that gatekeepers have come to view corporate managers, not shareowners, as their principals. Their livelihood depends on being viewed as flexible, problem-solving and cooperative, rather than rigorous or principled. “If left to their own devices and subjected to a significant threat of private litigation, professionals will respond by defining GAAP and auditing standards in their own interest, rather than that of investors.” “Absent a litigation threat, professionals acquiesce in dubious and risky practices that their ‘client’ wants; but once subjected to an adequate litigation threat, professionals insist upon narrow duties, hopelessly specific safe harbors and a rule-base system that often seems devoid of meaningful principles.”

According to Coffee, “The challenge for the regulator is not to take discretion out of the system, but to preserve and expand it. But discretion must be accorded to the gatekeeper, not the client (whereas present-day GAAP does the reverse).” The gatekeeper must assess not simply whether GAAP contains a rule authorizing a given treatment, but whether discretion so exercised is reasonable. Pressure to reform must come from regulators, investors and the young that the profession hopes to recruit who would find that greater discretion enhances the professions’ image in their own eyes and those of the public.

Some of Coffee’s more interesting recommendations, at least as I read them:

– Break-up the major accounting firms to provide more competition.
– Establish an intermediary that receives payment from the issuer but then selects the analyst based on objective criteria, such as their record of predictions.
– Restore “aiding and abetting” liability for professionals instead of de facto immunity for knowingly or recklessly participating in fraud.
– Formalize the role of “disclosure counsel” by requiring audit committees to retain them to investigate and test corporate disclosures on an on-going basis.

– Broc Romanek