Late on Friday, the SEC posted a 143-page proposing release for its mandatory XBRL rulemaking. Based on a quick glance, here are some additional thoughts to the ones I blogged a few weeks ago based on what was said at the open Commission meeting:
1. The Proposed Liability Framework – During the open Commission meeting, it was unclear what liabilities might attached to filing in XBRL – giving the impression that this important issue had not been fully worked out yet. Now that we have the proposing release, we can see on page 60 that the SEC is proposing two very different standards – (i) that the interactive data be considered “furnished” as it is under the pilot program versus (ii) that it be considered “filed” as the “viewable interactive data as displayed through software available on the Commission’s Web site… would be subject to the same liability under the federal securities laws as the corresponding portions of the traditional format filing.” I guess this was a compromise to get the proposal out of the building.
Some of you may be asking – what did he just say? I know that this is confusing. The SEC’s proposal has different liability standards for the XBRL data itself and for the “viewable” data. The former is what the machines read; the latter is what humans read (yes, there is a difference – a big difference; more on this later). So, in other words, the raw XBRL data (the “non-viewable” XBRL data) would essentially carry forward the pilot program’s liability regime (but note that no liability for Section 12 has been added – the voluntary filers program didn’t have this immunity) – and the “viewable XBRL data” would have the same type of liability as the official HTML or ASCII filings have today (and so viewable data would be considered “filed”).
2. Late Filers and “Springback” of Current Status – Under the proposal, the financials in XBRL would be filed as an exhibit under Item 601 of Regulation S-K and be considered part of the company’s “official” filing, rather than as a supplement as is the case in the pilot program. Even though a company would lose its Form S-3, etc. eligibilty if it was late in filing its XBRL data, it could regain its current status once the XBRL information was filed. This is a new concept under the SEC’s regulatory framework. (And there is a proposed pair of 30-day grace periods for the first two years.)
3. Possible Alternative Regulatory Frameworks – As with most SEC proposing releases, the Staff does a great job of posing questions to help solicit comments. In the proposing release, I particularly like the list of questions beginning on page 26. Read them to help you better understand what XBRL is all about.
4. Costs – As Dominic Jones notes in his “IR Web Report,” costs are expected to go up significantly in Years 2 and 3 (when “deep-tagging” will be required) and then will decrease rapidly as each company develops its own customized templates that can be re-used.
5. Foreign Private Issuers – As Dominic notes, the proposed rules would not require foreign private issuers that prepare their financial statements in accordance with a variation of IFRS as issued by the IASB to provide XBRL. Foreign private issuers that provide financial information on Form 6-K or any financial information prepared with non-US GAAP that must be reconciled to US GAAP in the foreign private issuer’s ’34 Act reports will not have to be provided in XBRL.
Just added! We are excited that David Blaszkowsky, Chief of the SEC’s Office of Interactive Disclosure, has joined the panel for our July 16th webcast: “XBRL: Understanding the New Frontier.”
By the way, I’ve learned that the Bush Administration’s moratorium on rulemaking doesn’t apply to the SEC because the agency is considered “independent.” So it shouldn’t impact the SEC’s ability to propose and adopt rules whenever it sees fit (although the SEC may voluntarily decide to abide by the Administration’s edict).
XBRL: A New Enforcement Tool?
This recent Reuters article claims XBRL will help uncover suspicious trading and accounting patterns. The example in the article is the option backdating scandal which was based on a study of the information filed in Form 4s (note that Section 16 forms are not being proposed by the SEC to be tagged in XBRL; they already are tagged in XML). If you recall, uncovering backdating practices gathered steam after Professors Randall Heron and Erik Lie’s study, which gathered Form 4 data starting in ’96 – well before Section 16 reports were required to be electronically filed. The professors relied on the Thomson Financial Insider Trading database to obtain the datapoints necessary for their study (and Thomson filled its database manually until Section 16 reports were required to be filed electronically after SOX).
But if memory serves, the SEC’s Enforcement Staff has to work hard to break open a financial fraud case; it’s not typical that the Staff can discern that numbers are “funny” on their face – rather, the fraud is uncovered by digging beyond the information in the SEC filings. So I don’t think that just running the numbers in XBRL is gonna help much. Most analysts (and I presume the SEC Staff) have long had the technology to crunch numbers using computers. In fact, you can access 10 years worth of financials tagged in XBRL right now for all public companies on TryXBRL.com.
Anyways, I worry that this type of promise about XBRL benefits adds to the boatload of misinformation already swirling around XBRL – but maybe someone can give me some concrete examples to show otherwise? I am certainly not an XBRL expert.
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Last Thursday, SEC Chair Chris Cox delivered a speech on the future of IFRS – including a public policy oversight body that would oversee the IASB trustees (the speech notes that the IASC Foundation will consider a new monitor as part of its ’08 Constitution review). This is an important topic that I could literally blog about every day. But, to be honest, I’m not following it as closely as I probably should because I’m only human and there are still so many other developments to cover.
From reading comment letters, etc., I understand one considerable concern is the lack of a strong IFRS enforcement mechanism. The amazing circumstances of the fraud at Société Générale are often held up to illustrate the point of how easy it is for a company to break international accounting rules, get away with it, have its independent auditors bless it, with no major regulatory ramifications (read this Floyd Norris column and an Accounting Onion blog for more). Also held up is the fact that the IASB standards have not been enforced in the past. Finally, there have been concerns raised about how the FAF recently has managed the FASB.
So there are these – and many other – issues to deal with, but it’s clear that the globalization of accounting standards is something that is inevitable. We just need strong regulators – and ones that work together. This will be quite a feat to pull off since there are many cultural obstacles and regulatory differences among jurisdictions. But it is happening – here is a February statement from IOSCO urging companies to clarify which accounting standards they use. IOSCO is the organization whose members are comprised of securities regulators from around the world and who will be a key player in this movement.
Is IFRS Compatible with US-Style Corporate Governance?
This blog below from Tom Selling’s “The Accounting Onion” is several months old, but still interesting and relevant reading:
I just finished reading a brief, highly readable and interesting article by a Columbia Law School professor, John C. Coffee, Jr., entitled “A Theory of Corporate Scandals: Why the U.S. and Europe Differ.” The purpose of this post is to piggyback on his framework to also provide an explanation for the difference in basic approaches between U.S. GAAP and IFRS; and most importantly, why political pressure to trash U.S. GAAP and adopt IFRS should be resisted.
How and Why, According to Coffee, U.S. and European Scandals Differ
Coffee’s thesis is that corporate governance of majority-owned corporations (predominant in Europe) should be fundamentally different than corporate governance of corporations that lack a controlling shareholder group (predominant in the U.S.). It’s not necessarily because there are fewer incentives to rip off other shareholders, but the feasible means to do so will differ.
Scandals in Europe involving majority-owned corporations usually do not feature an accounting manipulation. First, financial reporting is less important to the majority owners because they rarely sell shares; and if they do, they usually receive a control premium that is uncorrelated with recent earnings (and generally larger than control premia in U.S. transactions). Second, fraud is more easily accomplished by misappropriation of the private benefits of control: authorization of related-party transactions at advantageous prices, below-market tender offers, are prime examples. Any trading that takes place between minority owners has less to do with recent earnings reports, and more to do with an assessment of how minority shareholders will be treated by controlling interests.
In dispersed-ownership corporations, managers do not possess private benefits of control. Moreover, a significant portion of manager’s compensation may be in the form of stock options or other forms of equity. Therefore, stock price can have a significant effect on a manager’s compensation, providing them with strong incentives to manipulate accounting earnings.
The Implications for Accounting
Professor Coffee’s thesis is that differences in ownership patterns have important implications for the selection of gatekeepers: auditors, analysts, independent directors, etc. His observations and recommendations are interesting, but I want to advance a related thesis, namely that different ownership patterns call for different types of accounting regimes.
It stands to reason that accounting should be difficult to manipulate, if it can be used to rip off shareholders. Thus, the evolution of U.S. GAAP can be seen as a response to the need for specific rules that minimized the role of management judgment because of their strong self-interest in the reported earnings and financial position. This has occurred in part because U.S. gatekeepers have shown themselves to often lack sufficient resolve or power to prevent management from under-reserving, overvaluing, or just plain ole making up numbers. U.S. managers effectively control the “independent” directors and auditors; and prior to Regulation FD, analysts bartered glowing assessment in exchange for tidbits inside information. Without empowered gatekeepers to prevent accounting fraud, we have had to place our hopes on very inflexible accounting rules, and sheriffs like the SEC and private attorneys to catch the cases where management has attempted to surreptitiously cross the bright line.
Thus, it should be self-evident that IFRS-style accounting, replete with gray areas, would be a gift to U.S. managers. Outright fraud would be replaced by more subtle means of “earnings management,” rendering the SEC and private attorneys much less potent. Is it any wonder why U.S. corporations and their auditors are practically begging to have IFRS available to them?
In short, it would be a grave mistake to adopt IFRS in the U.S. simply because it seems to work well elsewhere. As corporate ownership patterns in Europe change, it may well be that IFRS may evolve to look more like U.S. GAAP. Only after that occurs may it make more sense to have a single worldwide financial reporting regime.
Imagine if Enron Had Applied IFRS
One of the scapegoats of the Enron scandal was “rules-based” U.S. GAAP. The libel was that Andrew Fastow was a mad genius, capable of walking an accounting tightrope by creating complex special-purpose entities (SPEs). But, GAAP wasn’t the culprit in the Enron scandal. Frustrated Fastow was only able to get the accounting treatment he needed past the auditors by hiding from them side agreements that unwound critical provisions requiring the new investors to have a sufficient amount of capital at risk in the SPEs.
The enduring legacy of the libel is the erroneous conventional wisdom that GAAP is responsible for Enron; and what’s more, Enron et. al. might not have happened if our financial reporting system were more like IFRS. More likely, if IFRS had been the basis of accounting for Enron instead of GAAP, it might have taken longer to discover the fraud, or to pin the blame for the fraud where it belonged.
Neither GAAP nor IFRS are principles-based, but GAAP certainly has more rules and bright lines. At least there seems to be some method to the madness, but it would be nice if more of the rules were based on sound principles.
Peggy Foran: Moving On Up
Congrats to my good friend Peggy Foran, who is leaving Pfizer after a long stint to become General Counsel of Sara Lee (here is the press release). At Sara Lee, Peggy will be surrounded by friends – including Helen Kaminski, who will be speaking at our upcoming webcast: “E-Proxy’s First Season: Lessons Learned.”
As many of you know, Peggy is one of the most prolific persons in our profession. Besides being a very kind soul, Peggy has an incredible background, having worked a number of interesting jobs over the course of her long career. One of the reasons why Peggy is so knowledgeable is that she is a tireless networker. Being an avid networker myself, I am amazed at how much more Peggy is able to do – and Peggy uses her network, always asking probing questions to become even better at what she does. Now that Peggy is entering the executive suite, I hope we haven’t seen the last of her at the many events that she graces today!
Last month, a three judge panel of the DC Circuit Court of Appeals heard oral arguments in Free Enterprise Fund, et al. v. Public Company Accounting Oversight Board, et al.. The lawsuit, originally filed in February 2006, alleges that the provisions of the Sarbanes-Oxley Act establishing the PCAOB are unconstitutional because those provisions violate separation of powers principles. With no separability clause in the Sarbanes-Oxley Act, a finding that one provision of the law is unconstitutional could bring down the whole Act. The pending appeal is from a March 2007 District Court ruling in favor of the PCAOB.
Based on the transcript of the oral argument, the focus of the Court was on the uniqueness of the PCAOB’s structure as essentially a government entity for constitutional purposes, but not a government entity for statutory purposes. While the appellants conceded the SEC’s role in overseeing the PCAOB’s rulemaking, they targeted their attack on the PCAOB’s allegedly unchecked enforcement and inspection function. In addition, the Court focused its questioning on the “for cause” requirement for removal of PCAOB Board members (as opposed to an at will removal standard), which is likewise the standard for removal of SEC Commissioners and thus puts the PCAOB’s leadership two “for cause” steps away from the President. While the government argued that the PCAOB was built around the self-regulatory organization model, the appellants (and the Court) pointed out the significant distinctions with the PCAOB, principally in that its board is appointed by the SEC and board members are only removable by the SEC for cause.
While it is certainly difficult to tell solely from the oral argument, this case may not be a slam dunk for the PCAOB and the government. Certainly the consequences of a ruling against the PCAOB are difficult to imagine – reopening the PCAOB and all of Sarbanes-Oxley at this point would undoubtedly be a bad idea.
In this commentary, Jonathan Weil of Bloomberg points out the views expressed during the oral argument by Judge Kavanaugh, who was by far the most vocal of the three judges on the panel.
LIBOR on Shaky Ground
I can’t think of anything more ubiquitous as a benchmark in financings and derivatives than the London Interbank Offered Rate (LIBOR), which has come under attack in the last few months for being out of synch with market developments. Yesterday’s WSJ featured an interesting article on the problems with LIBOR and some data suggesting how far out of whack LIBOR has become. Later today, the British Bankers Association will announce plans to make the first changes to LIBOR in over ten years.
Before becoming a lawyer, I managed assets and liabilities for a bank, and I can recall anxiously awaiting for the moment shortly after 11:00 a.m. London time when the BBA would post the day’s LIBOR and it would pop up on my Telerate screen. I always envisioned a bunch of guys in bowler hats (kind of like the bankers in Mary Poppins) drinking tea and setting the daily rates, but in reality, the BBA surveys its 16 member banks on how much it would cost them to borrow from each other for 15 periods ranging from overnight to one year (in currencies including dollars, euros and yen), and then averages the results of that survey data. Always taking the numbers as gospel, it never occurred to me that LIBOR’s reliability could ever be called into question, given the tendency of any survey and average to potentially distort reality. Notably, the WSJ article indicates that during times of market turmoil like we have faced in the past several months, banks have an incentive to avoid submitting rates to the survey that are higher than those submitted by their peers, lest they signal financial problems or desperation. This incentive tends to force the rates used to compute LIBOR to cluster together. This trend is perhaps confirmed by the fact that when the BBA threatened a month ago to ban from the survey any banks that misquoted their rates, the three month rate shot up 18 basis points over the next two days.
I doubt that the current troubles with LIBOR will push too many players to other benchmarks, particularly given how entrenched LIBOR is in the US and abroad. There are of course other alternatives for benchmarking short-term rates, such as the US Fed Funds rate. The principal difference between LIBOR and the Fed Funds rate is that while LIBOR is based on survey data, the Fed Funds rate is a target interest rate fixed by the Federal Open Market Committee and implemented through the open market operations carried out by the New York Federal Reserve.
2008: The Year of the Hedge Fund Activist
We have just posted the transcript for the DealLawyers.com webcast: “2008: The Year of the Hedge Fund Activist.” Catch the companion webcast – “How to Handle Hedge Fund Activism” – on July 15th.
Like last year’s blockbuster conferences, an archive of the entire video for both conferences will be right there at your desktop to refer to – and refresh your memory – when you are actually grappling with drafting the disclosures or reviewing/approving pay packages. Here are FAQs about the Conferences.
For those choosing to attend by coming to New Orleans, I encourage you to also register for the “16th Annual NASPP Conference,” where over 2000 folks attend 45+ panels. And if you attend the NASPP Conference, you can take advantage of a special reduced rate for the Exec Comp Conferences.
If you have questions or need help registering, please contact our headquarters at info@thecorporatecounsel.net or 925.685.5111 (they are on West Coast, open 8 am – 4 pm).
SEC Nominations Move Forward
A Senate Banking, Housing and Urban Affairs Committee hearing is now scheduled for Tuesday, June 3rd to consider the nominations of Luis Aguilar, Elisse Walter and Troy Paredes. The hearing will include a number of other nominees for open positions at various federal agencies, including the Treasury Department, HUD, GNMA, the National Credit Union Administration Board and the President’s Council of Economic Advisors. Once the Senate Banking Committee has considered the nominations, it remains to be seen whether the SEC nominees will be fast-tracked for a vote by the full Senate.
This article from yesterday’s Washington Post notes the government-wide exodus of senior officials as the current administration winds down, as well as the difficulties faced in moving nominees forward. I agree with some of the experts cited in the article that the process of changeover in agencies is exceptionally difficult for the staff and tends to go on for way too long these days. Even for agencies like the SEC, which doesn’t have any political appointees beyond the Commissioners, the unwritten rule is that directors and perhaps other senior Staffers can expect to be replaced when a new Chairman comes aboard. Even in the best of circumstances, this makes for at least a couple of years of uncertainty about the direction of SEC policy and a lot of Staff distraction.
SEC Settles an Auction Rate Securities Case
The SEC recently settled an administrative proceeding instituted against First Southwest Company for its role as an underwriter of and agent for auction rate securities. The auction rate securities market has seen some significant disruptions throughout the credit crisis, and the activities of market participants in connection with recent auctions may receive more attention from Enforcement in the coming months. Back in 2006, the SEC had reached a $13 million settlement with 15 investment banks, and the industry agreed to impose a voluntary code of conduct for the auction-rate market.
The SEC’s Order in the First Southwest case indicates that, without adequate disclosure, the broker-dealer intervened in the auctions that served to reset the interest rate on the securities by bidding for its own account in order to prevent failed auctions and to prevent “all hold” auctions (when a below market rate is set because no securities are for sale in the auction). In some of these interventions, First Southwest’s activity had an effect on the clearing rate derived from the auction, which is the rate that determines the interest rate or yield that the issuer must pay to investors until the next auction. The only charge brought by the SEC on this conduct was for violation of Securities Act Section 17(a)(2), based on the misstatements and omissions about the potential for such intervention in the auctions.
In determining the penalty assessed on First Southwest, the SEC noted the firm’s cooperation, but also noted that First Southwest had not self-reported the potential violations to the SEC. The SEC noted that it “aims to promote voluntary disclosures in industry-wide investigations and to encourage firms to provide comprehensive information to the staff in such investigations.”
We just put the finishing touches and mailed the May-June ’08 issue of The Corporate Counsel, which includes analysis of:
– More on Obtaining Staff Guidance
– Amended Rule 144—Impact on Pledgees and Donees
– More on the New 8-K CDIs
– Parsing the Integration Safe Harbors
– Corp Fin’s Mini Re-Org
– S-3 Eligibility Waivers—8-K Latitude?
– Staff Says No Non-GAAP Financial Statements
– Use of Company Stock to Make Matching Contribution to 401(k) Plan—NYSE Notice and Shareholder Approval Requirements
– 8-K Reporting of JPMorgan Chase’s CEO Option/SAR Grant
– Bebchuk Status Report
If you are not a subscriber to The Corporate Counsel, try a no-risk trial today. If you still need to renew your subscription for this year, do so today so you won’t miss this critical guidance.
Using SOX 302 Certifications to Plead Scienter
Since the enactment of the Sarbanes-Oxley Act, courts have been split on the extent to which CEO/CFO certifications may be used by private plaintiffs to satisfy the requirement for pleading scienter under Section 10(b) and Rule 10b-5.
In this podcast, Howard Suskin and Jennifer Lawson of Jenner & Block provide insight into the use of SOX Section 302 certifications to plead scienter, including:
– How are Section 302 certifications being used by plaintiff’s lawyers in lawsuits?
– What are the courts’ reactions so far? Are they drawing an inference of scienter?
– What do you advise companies to do now to minimize the risk of scienter being found?
If International Financial Reporting Standards (IFRS) is really going to come to pass for US issuers in the next five years or so, then some radical changes will need to be made to our US GAAP-based system – and soon. One of the most important areas where this change needs to occur is in the accounting departments of our colleges and universities, on the theory that accounting majors should not be wasting their time learning the intricacies of US GAAP, if what they will have to apply in four years is IFRS as established by the IASB.
This CFO.com article notes that the Big Four accounting firms are moving forward with efforts to help develop IFRS-focused curricula and to provide other resources that may be used by academia. These efforts are encouraging, but perhaps may not be enough to accomplish the real sea change that is needed to make IFRS a reality on such a relatively short timetable. Ultimately, perhaps the ideal would be for graduating students to have a better handle on IFRS than the partners that they go to work for at accounting firms!
The SEC announced that it signed protocols with financial regulators in Belgium, Bulgaria, Norway and Portugal to share information on the application of IFRS. These protocols, which are based on a model protocol developed between the SEC and the Committee of European Securities Regulators, provide for the confidential exchange of issuer-specific information that will be relevant toward implementing IFRS. The SEC has a similar arrangement with the UK Financial Reporting Council and the UK Financial Services Authority.
It is now obvious that the Staff has been very busy drafting “Small Entity Compliance Guides” under Section 212 of the Small Business Regulatory Enforcement Fairness Act of 1996. While the requirement to prepare these guides has been in place since SBREFA was originally enacted 12 years ago, the Staff’s efforts on this front seem to have gotten a boost from the enactment of the Fair Minimum Wage Act of 2007, which requires that: (1) the guides be posted on agency websites; (2) they be made available at the same time a rule becomes effective; and (3) they include an explanation of actions a small business must take to comply with the rule. The Fair Minimum Wage Act also requires each federal agency head to report to Congress annually on the status of their agency’s compliance with revised requirements for making the compliance guides available to small businesses. The requirement to prepare a small entity compliance guide is triggered whenever the SEC prepares a Final Regulatory Flexibility Analysis under SBREFA as part of its rulemaking, which is usually found in the “back-end” of the adopting release that folks often skip over.
Each guide makes clear that it is intended to summarize and explain the rules, but should not be looked at as a substitute for the rule itself. Interestingly, SBREFA gave the small entity compliance guide a special status from a litigation perspective. The Act provides that “[a]n agency’s small entity compliance guide shall not be subject to judicial review, except that in any civil or administrative action against a small entity for a violation occurring after the effective date of this section, the content of the small entity compliance guide may be considered as evidence of the reasonableness or appropriateness of any proposed fines, penalties or damages.” For this reason alone, it is probably a good idea to know what these guides say.
Last week, Corp Fin posted a new compliance guide regarding e-proxy, which includes a handy chart comparing key differences between the notice only and full set delivery options. The compliance guide phenomenon is not just limited to Corp Fin, however – the Division of Trading and Markets also recently posted a new page collecting some of its compliance guides that meet the SBREFA requirements.
While these guides don’t include any new interpretive guidance, as I noted in the blog earlier this year, they can serve as a useful resource if you are looking for a quick overview of the rules, or something written in plain English that you can refer to in order to easily explain the rules to clients or others. One guide that I have always found particularly useful (although I don’t think it started out life as a small entity compliance guide) is the Division of Trading and Markets’ Guide to Broker-Dealer Registration, which was last updated in April 2008.
Controlling Person Liability: Joint and Several, Proportional or Both?
Recently, the Eleventh Circuit decided a case of first impression on the issue of whether – following enactment of the Private Securities Litigation Reform Act of 1995 – a controlling person is jointly and severally liable as specified in Exchange Act Section 20(a), or rather is subject to the proportionate liability scheme of Exchange Act Section 21(D)(f) (which was added by the PSLRA). In LaPerriere v. Vesta Insurance Group, Inc. (11th Cir.; Apr. 30, 2008), the Eleventh Circuit reversed the District Court’s conclusion that the proportionate liability regime set out in Section 21(D)(f) “trumps” Section 20(a). Instead, the Eleventh Circuit stated “[r]ecognizing that implicit repeals of statutory provisions are disfavored, we hold that section 21(D)(f) and section 20(a) should be read in harmony to preserve both the PSLRA’s proportionate liability scheme and a controlling person’s derivative liability under section 20(a).”
The court essentially set forth a two-part test in seeking to reconcile the two statutory provisions. In this regard, the court stated:
“Section 21(D)(f) is not superfluous, however. It does have a role to play. As the Conference Committee Report also explained, while the PSLRA did not modify ‘in any manner’ the standard of liability under the securities laws, including section 20(a), it did change the rules for allocating damages among the parties once liability has been established by the fact finder. Before the PSLRA was enacted, if one of those parties was found liable as a controlling person of violating section 20(a), it would have been responsible jointly and severally for the damages to the same extent as the primary violator. Under the proportionate liability provisions of the PSLRA, if a party is found liable as a controlling person under section 20(a), there is a new standard for allocating damages. What has changed is not the standard of liability that applies to controlling persons – the ‘Applicability’ provision states that has not been modified ‘in any manner’ – but their responsibility as liable persons for the damages. The proportionate liability provisions of section 21(D)(f) are applicable only after liability is determined, and liability is governed by the standard set out in section 20(a).”
– M&A Targets Today: Seeking Deal Certainty in an Uncertain Environment
– How to Negotiate an M&A Engagement Letter with Your Investment Banker
– Structuring Portfolio Companies: Director Independence
– Ten Practice Tips for Negotiating the Letter of Intent
– How to Do a Deal Without Shareholder Approval: The “Financial Viability Exception”
– A Moment of Clarity: How to Avoid Ambiguities in Your Advance Notice Bylaws
Try a no-risk trial to get a non-blurred version of this issue for free.
Last week’s ruling permitting plaintiffs to move forward on some claims in a derivative suit against Countrywide Financial Corp. received quite a bit of attention (see, e.g., this NY Times article and this Bloomberg article), but perhaps the most interesting elements of the case detailed in the order were allegations about insiders’ sales of substantial amounts of Countrywide stock right around the time of a company repurchase plan and pursuant to Rule 10b5-1 plans.
I blogged about reports of the SEC’s interest in Countrywide CEO Angelo Mozilo’s use of Rule 10b5-1 plans last Fall, and his trades under 10b5-1 plans were a topic of great interest during the hearing before the House Committee Oversight and Government Reform earlier this year. Now, with the May 14th Order of Judge Mariana Pfaelzer on the motions to dismiss for In re Countrywide Financial Corp. Derivative Litigation, much more detail about the trading activity of Countrywide insiders in advance of the company’s troubles has come to light.
Among the most notable allegations regarding insider sales were large trades conducted around the time of the announcement of Countrywide’s stock repurchase programs in November 2006 and May 2007. The judge asks regarding these trades: “how could the Board members approve a repurchase of $2.4 billion dollars worth of stock, and nearly contemporaneously liquidate $148 million of their personal holdings just months before the stock dropped some 80-90%?” Ultimately, while noting that these trades appear to be suspicious, the judge didn’t find sufficient detail in the complaint for the allegations to survive a motion to dismiss.
It was a very different story when considering Mozilo’s trades. Noting that Mozilo actively amended and modified his 10b5-1 plans, Judge Pfaelzer states: “Mozilo’s actions appear to defeat the very purpose of 10b5-1 plans, which were created to allow corporate insiders to ‘passively’ sell their stock based on triggers, such as specified dates and prices, without direct involvement…[a]ccordingly, his amendments of 10b5-1 plans at the height of the market does not support the inference ‘that the sales were pre-scheduled and not suspicious.'” The judge rejected claims that inferences of scienter were mitigated by the fact that Mozilo’s trades involved amounts of stock that represented only a small proportion of his substantial holdings, citing a 9th Circuit holding that “where, as here, stock sales result in a truly astronomical figure, less weight should be given to the fact that they may represent a small portion of the defendant’s holdings.” Nursing Home Pension Fund, Local 144 v. Oracle Corp., 380 F.3d 1226, 1232 (9th Cir. 2004).
While not discussed in the Order, it appears from Countrywide’s filings that the company actually instituted a special kind of repurchase program around the time of the insiders’ sales called an “accelerated share repurchase program,” which usually involves a company purchasing shares of its own stock from a broker-dealer at a set price on one or more specified dates. The broker-dealer borrows the shares that are sold to the issuer and thereby puts itself in a short position, which it then covers by conducting open market purchases over time. From the disclosures, it appears that the company financed the purchase of the stock through the issuance of debt securities.
One thing that makes an accelerated share repurchase program different from the usual buyback program is that companies often complete the buyback all at once or over a very short period of time, rather than entering the market over a long period of time to buy back stock at attractive prices.
SEC Publishes CIFiR Subcommittee Reports for Comment
Last week, the SEC published for public comment the four subcommittee reports that were presented to the Advisory Committee on Improvements to Financial Reporting at its May 2, 2008 open meeting. The Subcommittee Reports largely reflect additional considerations and comment on previously identified proposals.
The “Delivering Financial Information” Subcommittee’s report reflects some further consideration of issues briefly identified in the Committee’s February Progress Report as issues for future consideration. For example, the Subcommittee has developed some “Preliminary Hypotheses” with respect to the use of Key Performance Indicators (KPIs), improvements to quarterly earnings release disclosure and timing and the use of executive summaries in Exchange Act periodic reports (similar to summaries found in offering documents). The Subcommittee’s report outlines some suggestions and considerations that could ultimately result in Committee recommendations in these areas.
In more accounting committee news, the Treasury Department’s Advisory Committee on the Auditing Profession posted a notice regarding the Committee’s activities, along with a request for comment on the Committee’s draft report until June 13.
– What is a “sovereign wealth fund”?
– How are they working with activist investors, particularly in a post-Dubai Ports World politically charged environment?
– What about sovereign wealth fund as activists themselves?
– What are regulators in Washington doing regarding sovereign wealth funds?
Now that the Supreme Court has weighed in against the notion of “scheme” liability in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S.Ct. 761 (2008), the federal courts have begun applying the Stoneridge holding to securities fraud claims against various types of third parties. (In Stoneridge, the Court held that “the private right of action [under Section 10(b) and Rule 10b-5] does not reach the customer/supplier companies because the investors did not rely upon their statements or representations.”)
In Pugh v. Tribune Co., (7th Cir.; April 2, 2008), the first appellate court to apply Stoneridge rejected the notion of finding “scheme liability” in a situation where a company employee was allegedly involved in a scheme to defraud that ultimately led to a securities fraud. Employees of Tribune and its subsidiaries had participated in a scheme to falsely inflate circulation figures for two Tribune publications in order to increase the amounts charged for advertising. Once the fraud was uncovered, Tribune took a $90 million charge to earnings and several employees pled guilty to fraud charges. The plaintiffs sued Tribune Co. and several individual defendants under Exchange Act Sections 10(b) and 20(a) for losses caused by the inflated revenue generated through the fraudulent circulation number scheme. The District Court dismissed the claims with prejudice.
The Seventh Circuit affirmed, most notably applying Stoneridge to plaintiff’s claims against Louis Sito – the Tribune employee allegedly behind the circulation scheme – and finding that he was not liable for securities fraud based on a theory that it was “foreseeable” that that the circulation fraud would lead to an overstatement of the company’s revenues. The court indicated that Sito “had participated in a fraudulent scheme but had no role in preparing or disseminating Tribune’s financial statements or press releases.” The court concluded that the Supreme Court’s holding “indicates that an indirect chain to the contents of false public statements is too remote to establish primary liability.”
In another recent case, In re DVI Inc. Securities Litigation (E.D. Pa.; April 29, 2008), the District Court in the Eastern District of Pennsylvania applied Stoneridge in addressing class certification for claims against a law firm. The plaintiffs had alleged that the firm (Clifford Chance) “initiated and masterminded” a “workaround” that allowed DVI to fraudulently misrepresent the adequacy of the company’s internal controls. The court noted that the misleading 10-Q in which the internal controls disclosure was included “was issued solely by DVI and contains no indication that any statement therein is attributable to Clifford Chance.” Because investors did not rely upon the allegedly deceptive conduct of Clifford Chance and the conduct was not “publicly disclosed such that it affected the market for DVI’s securities,” the court found that the plaintiffs were not entitled to the fraud on the market presumption in establishing reliance on a class-wide basis with respect to the activities of the firm.
These cases may indicate that the lower courts will apply the Supreme Court’s Stoneridge holding relatively broadly – including (somewhat surprisingly) to situations where there is some affiliation between the defendant and the issuer, such as an employee.
Convertible Securities: New Accounting for Cash-Settled Instruments
This WSJ article from last Friday noted that convertible securities are very cheap right now, given the widespread exit from the market earlier this year by those hedge funds pursuing a convertible arbitrage strategy. Financial firms in need of cash have been going to the market with convertible deals, given the attractiveness of convertibles over selling common stock at depressed levels or issuing long-term debt. The article notes that recent issuances have offered relative high yields and some attractive add-ons, such as compensation for changes in dividends or takeovers that come at lower prices.
Companies considering a convertible debt issuance or that have convertibles already on their books should take look at the new FASB Staff Position (FSP) No. APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash Upon Conversion (Including Partial Cash Settlement).” This new position will be effective for fiscal years (and interim periods) beginning after December 15, 2008, and is to be applied retrospectively to all past periods presented – even in those situations where the convertible instrument has matured, converted or has otherwise been extinguished as of the effective date of the FSP.
The FSP will likely have a big impact on the financial statements of companies that have issued the relatively popular flavor of convertible debt securities that, upon conversion, may be settled by the company fully or partially in cash. While today most types of convertible debt instruments are treated as debt securities for accounting purposes, under the new FSP companies will need to allocate between the liability and equity components of the instrument. Splitting up the debt and equity components will inevitably result in a debt discount, which will need to be amortized to interest expense over the expected life of the debt. As a result of the FSP, companies that have issued cash-settled convertible securities will see an increase in interest expense associated with those instruments (and a resulting reduction in earnings and earnings per share), with a decrease in the net carrying amount of debt on the balance sheet along with an increase in the amount of equity.
The Firm, but Fair, Hand
First there was Adam Smith’s “Invisible Hand,” then there was “Slowhand” (aka Eric Clapton), and now apparently we have the “Firm, but Fair, Hand.” I ran across this advertisement on the editorial page of my local newspaper. I can’t recall ever seeing this kind of “campaign-style” ad from an interest group defending the record of the SEC and its Chairman, but then again there have been a lot of things over the past few years that I don’t recall seeing before…
General Electric’s recent high-profile failure to meet its own earnings guidance may well revive the debate over providing quarterly guidance. As noted in this FT.com piece, while some major companies such as Coca-Cola and Google have avoided the quarterly guidance game, the practice still remains entrenched.
In this new “Quick Survey on Earnings Guidance,” we ask about your company’s guidance practices. Please take a moment to complete the four questions.
Disclosing Beneficial Owners of Private Companies
A bill introduced in the Senate earlier this month by Senators Levin, Coleman and Obama would, if enacted, require disclosure about the beneficial ownership of private corporations and LLCs. S. 2956 would set, beginning in fiscal 2011, standards for state incorporation systems that would require the name and current address of each beneficial owner, and if the beneficial owner exercises control of over the corporation or LLC through another legal entity, the identity of the legal entity and each beneficial owner who will use that entity to exercise control over the corporation or LLC. This beneficial ownership information would need to be updated annually if the state requires an annual filing; however, if no annual filing is required, then the information would need to be updated whenever there is a change in beneficial ownership. Additional requirements would apply for any beneficial owner who is not a U.S. citizen or lawful permanent resident.
The legislation would define “beneficial owner” as “an individual who has a level of control over, or entitlement to, the funds or assets of a corporation or limited liability company that, as a practical matter, enables the individual, directly or indirectly, to control, manage, or direct the corporation or limited liability company.” The bill would specifically carve-out from the definition of corporation or LLC “any business concern that is an issuer of a class of securities registered under section 12 of the Securities Exchange Act of 1934 (15 U.S.C. 781) or that is required to file reports under section 15(d) of that Act (15 U.S.C. 78o(d)), or any corporation or limited liability company formed by such a business concern.”
The text of S. 2956 notes that all countries in the EU require information about beneficial ownership of corporate entities, and that the U.S. has been criticized for the lack of information about the ownership of companies that could potentially be involved in terrorism, money laundering, fraud and other misconduct. The bill has been referred to the Committee on Homeland Security and Governmental Affairs.
This legislation appears to reflect some frustration with the states for not improving their corporate registration systems to capture ownership information, particularly for law enforcement purposes. The bill notes that a person forming a corporation or LLC typically provides a state with less information than is needed to obtain a bank account or a driver’s license!
Third Party Disclosure of Undisclosed SEC Investigations
Last summer, I blogged about varying practices as to when to disclose pending SEC inquiries or investigations of a company or its officers and directors. Various factors may be pushing the timing of disclosure forward, and one recent development may force some companies to make the disclosure sooner than they otherwise might have under the rules.
Disclosureinsight.com is now offering free e-mail updates regarding companies that appear to have undisclosed enforcement activity, based on information derived from FOIA requests. As noted in this article from the Minneapolis-St. Paul Star Tribune, this new site was created by John Gavin, who started his SEC Insight service back in 2000 based on information derived through the FOIA process. Gavin sued the SEC in 2004 over the agency’s FOIA practices, namely the blanket denial of FOIA requests using the “Glomar response” (see Broc’s blog about this litigation from 2005).
As noted on the FEI Financial Reporting Blog last Friday, the White House Chief of Staff recently sent a memorandum to agency heads stating that all rules expected to be finalized by the end of the administration must be proposed by June 1, and that final rules must be adopted by November 1 – except in extraordinary circumstances. This Dow Jones Newswire article (subscription required) notes that the memo probably did not come as a surprise to the agencies, given that the policy had been telegraphed ahead of time. It still appears possible under this policy for agencies to propose rules after the June 1 deadline, but only if the rules are expected to be ultimately adopted (or reconsidered) after President Bush leaves office.
Given this latest directive and the lack of full slate of Commissioners at the SEC, it doesn’t appear likely that we will see much in the way of controversial proposals (e.g., shareholder access) coming up for a vote in the next couple of weeks – but there will no doubt be some proposals trying to “beat the clock.” Will the SEC’s “summer reading” be a bit lighter than it has been in the past couple of years? We will have a better sense in just a couple of weeks…
Survey Results: Rule 144 Practices
In response to some questions we have been asked about Rule 144 practices, we posted a survey – here are the survey results, which are repeated below:
1. If asked to render a legend removal opinion regarding restricted securities of a reporting issuer that is current in filing its 1934 Act reports, where the securities have been held more than six months but less than twelve months, we are:
– Not willing to provide such a legend removal opinion until the end of the twelve month period – 35.1%
– Willing to provide a legend removal opinion – 16.2%
– Undecided regarding what our practice will be – 21.6%
– Depends on the circumstances of each situation – 27.0%
2. Where a pre-February 15, 2008 registration rights agreement provides that a holder of restricted securities may demand registration of the securities until all of the securities may be resold in a single sale under Rule 144(k), we are taking the following position in the case of reporting issuers:
– If the securities have been held for at least six months but less than twelve months, the issuer is not obligated to register the securities so long as the issuer is current in filing its 1934 Act reports – 55.2%
– The issuer must register the securities unless they have been held for at least twelve months – 44.8%
Only One Day Left! Early Bird Discount for Compensation Conferences
Like last year’s blockbuster conferences, an archive of the entire video for both conferences will be right there at your desktop to refer to – and refresh your memory – when you are actually grappling with drafting the disclosures or reviewing/approving pay packages. Here are FAQs about the Conferences.
For those choosing to attend by coming to New Orleans, I encourage you to also register for the “16th Annual NASPP Conference,” where over 2000 folks attend 45+ panels. And if you attend the NASPP Conference, you can take advantage of a special reduced rate for the Exec Comp Conferences.
Register by end of tomorrow for Early-Bird Rates: Whether you attend in New Orleans or by video webcast, take advantage of early-bird rates by registering by May 20th. You can register online or use this order form to register by mail/fax. Note that we have combined both of our popular Conferences – one focusing on proxy disclosures and the other on compensation practices – into one package to simplify registration.
If you have questions or need help registering, please contact our headquarters at info@thecorporatecounsel.net or 925.685.5111 (they are on West Coast, open 8 am – 4 pm).
