October 28, 2008

The Perils of Pledging

One of the topics discussed several times at last week’s “Tackling Your 2009 Compensation Disclosures: The 3rd Annual Proxy Disclosure Conference” and the “5th Annual Executive Compensation Conference” was pledging of securities by executives, typically done under margin arrangements. A NY Times article from last week was among the latest media reports to note the rise in insider sales of securities necessary to satisfy margin requirements. The article notes the inadequacy of disclosure regarding pledged securities, despite the fact that the SEC specifically required disclosure of pledged shares in the Beneficial Ownership Table when it adopted the 2006 amendments to the executive compensation disclosure requirements.

Volatility in the stock market will continue to drive this trend – along with all of its potential pitfalls for executives and their companies. Because company stock may be pledged as collateral for margin on an account where an executive maintains a more diversified portfolio of securities, broad market swings can result in margin calls and the forced liquidation of company securities even in situations where the company’s share price remains relatively stable. Unfortunately, this issue may often be a “blind spot” in company policies on stock ownership, insider trading, codes of conduct, etc. As a result, many companies will need to re-examine this issue in light of the current turmoil – and before year-end – so that any necessary changes can be highlighted in the Compensation Discussion & Analysis for the 2009 proxy statement.

Look for more on this critical topic in the upcoming issue of The Corporate Executive. If you aren’t a subscriber to The Corporate Executive, take advantage of a “Rest of ’08 for Free” no-risk trial. If you are a current subscriber, be sure to renew for ’09 since all subscriptions are on a calendar-year basis.

A Banner Year for SEC Enforcement?

Last week, the SEC announced that the agency had the second highest number of enforcement actions take place in fiscal 2008, with 671 actions brought through the September 30, 2008 end of the fiscal year. The glowing press release notes that the SEC brought the highest number ever of insider trading cases during fiscal 2008, as well as a sharp increase in the number of market manipulation cases. The press release also notes the obvious uptick in Foreign Corrupt Practices Act cases, with 15 such cases filed in 2008 and a total of 38 FCPA cases brought since January 2006. Interestingly, the press release does not note how many cases the agency brought to suspend trading in and/or revoke the registration of delinquent filers, which has been a significant focus (in terms of the number of cases) over the past few years. The SEC notes that, for a second year in a row, more than $1 billion was returned to harmed investors through Fair Funds distributions.

The Division of Enforcement and the Commission’s attitude toward Enforcement matters have been under quite a lot of scrutiny recently, so it is good to still see these impressive numbers. While much might be made of the mix of cases that the SEC has brought (i.e., too much insider trading and not enough accounting fraud), it is important to keep in mind that priorities change over time and the agency always has to make due with its limited resources by focusing its enforcement efforts. Further, the Enforcement process – even with the many improvements made in recent years – remains relatively slow and will lag to a great extent the issues that are in the immediate public consciousness. All in all, these results should be taken as a positive sign that the SEC remains “on the beat.”

Unfortunately, the same might not be said for the FBI in its efforts to investigate financial fraud. This NY Times article notes that the FBI’s staff of white collar investigators shrank as the agency’s role shifted toward terrorism and intelligence. Most disturbing is the possibility that the shrinking ranks of white collar investigators may have thwarted efforts to investigate financial fraud occurring in the housing market in 2003 and 2004, when perhaps the criminal authorities could have made a real difference in how the financial crisis ultimately played out.

PCAOB Proposes Audit Risk Standards

Last week, the Public Company Accounting Oversight Board announced seven proposed auditing standards relating to “the auditor’s assessment of and responses to risk.” The PCAOB notes that these proposed standards would supersede the interim auditing standards related to audit risk and materiality, audit planning and supervision, consideration of internal control in an audit of financial statements, audit evidence, and performing tests of accounts and disclosures before year end. These new standards are all built around the concept of audit risk, which is the risk that an auditor will express an inappropriate opinion when financial statements are materially misstated. The titles of the proposed standards are:

– Audit Risk in an Audit of Financial Statements
– Audit Planning and Supervision
– Identifying and Assessing Risks of Material Misstatement
– The Auditor’s Responses to the Risks of Material Misstatement
– Evaluating Audit Results
– Consideration of Materiality in Planning and Performing an Audit
– Audit Evidence

The proposals are out for a generous 120-day comment period, ending February 18, 2009.

– Dave Lynn