Paulson Tries Again

Henry Paulson, the Secretary of the Treasury, is trying again on regulatory reform of the capital markets.  This time, he is creating a committee to “address auditing industry concentration, and to consider options available to strengthen the industry's financial soundness and its ability to attract and retain qualified personnel.”  No disagreement on the importance of this topic.  Many of the costs laid at the feet of SOX can best be explained by a public accounting industry reduced to four firms and the concomitant lack of competition with respect to auditing fees.  A serious look at the entire industry is overdue.  

But as Paulson launches these efforts, we at The Race to the Bottom offer a bit of unsolicited advice, mostly arising out of his prior efforts at "reform."  Last year, Paulson formed the “independent” Committee on Capital Markets Regulation to examine the competitiveness of US markets. The Committee issued a report that called for, among other things, the SEC to recommend to Congress that smaller companies be exempt from Section 404 of SOX.  A student analysis of this report is here.  

The Report did call for a number of reforms ostensibly designed to improve shareholder rights, including the use of majority rather than plurality voting, shareholder approval of poison pills, and allowing shareholders to choose the forum for resolving disputes with the company. The proposals were largely vapid and would not have provided shareholders with meaningful additional authority. The evidence that the Committee was not truly serious about shareholder rights?  With respect to the hot button issue of access by shareholders to management’s proxy statement to elect directors, the Report could do little more than offer the suggestion that the SEC “should resolve” the matter.

The Committee’s Report largely got lost in a cacophony of criticism, much of it related to the perception of bias on the part of the Committee, with the two co-chairs having ties to the Bush Administration (for the members of the committee, go here), and, as CFO Magazine reported, the receipt of financial support from a charity “tied to former AIG chairman Maurice Greenberg . . . and donations from two prominent investors on the committee.”

The latest foray into the accounting industry has gotten off to a more auspicious start. Paulson announced that he would ask Arthur Levitt, former SEC chairman and a strong advocate of shareholder rights, and Donald Nicolaisen, a well respected former SEC chief accountant,  to serve as co-chairs of a “non-partisan” committee.  The choice of Levitt and Nicolaisen suggests that Paulson really wants answers and credible solutions rather than the implementation of a particular agenda.  It is likely that any report emerging from this committee will have far greater credibility and be in a better position to actually influence reform efforts.

Having said that, it is somewhat disconcerting to have Paulson indicate that a primary complaint is the number of restatements being made by public companies. In the editorial announcing the formation of the committee, he made the following observation:

• “Another emerging challenge is the soaring number of financial restatements over the past decade. In 1997, there were 116 restatements; in 2006, there were 1,876, or more than 10 per cent of public companies. Restatements pose significant costs on our capital markets. They have the potential to confuse investors and erode public confidence in financial reporting. Some of these restatements might not be material to investors, and others may simply reflect new accounting standards interpretations.”

In other words, he was presuming that the restatements demonstrated weaknesses in the system of regulation.  Nothing in his editorial suggests another, perhaps more likely, possibility:  That restatements resulted from accumulated errors and mistakes that arose out of poor internal controls. This has been suggested by some in the Commission (describing many of the restatements as arising from "flat out" errors), albeit based upon anecdotal evidence. Nor did Paulson mention that the number of restatements was falling for larger companies, those that had adjusted to the full impact of Section 404, and rising for smaller companies, those not yet subject to Section 404.  

We look forward to the report and, hopefully, the clarity that it will bring to some of the often unsupported assertions that plague this area.  If the Commission is truly "non-partisan," Paulson may discover that the restatements are better explained by weak internal controls than conservative attitudes of accounting firms.  In other words, Section 404 was a useful and beneficial endeavor.

In analyzing this industry, the Commission will also need to consider a series of cases that may minimize liability for accounting firms by employing a strict definition of primary liability under Rule 10b-5.  One of these cases is currently pending before the US Supreme Court.  We will address this matter in subsequent posts.   

By the way, we invite anyone who reads this blog to participate in a survey (anonymous answers are fine) that will help us better provide useful commentary.   Thanks in advance!