Delisting: A solution to SOX woes...or not.

The current mortgage and overall credit market crisis can be partly attributed to the lack of adequate regulation. Even when regulation is put in place it is not always effective. The increasing number of disclosures related to write offs and losses that once seemingly invincible companies are making today ultimately point towards weak internal controls . The Sarbanes Oxley Act was put into place in order to prevent lapses in the internal control environment of a company that could potentially have an adverse impact on a company’s financial statements. There have been cases of companies exiting the U.S. stock exchanges only to rid themselves of the ‘high SOX compliance cost’. Recently, I talked to a senior employee of a foreign company who happened to mention that his company (of U.K. origin) was contemplating delisting from the stock exchange in the U.S., solely attributing this decision to the high cost of SOX compliance. Christian Leuz, an accounting professor at the University of Chicago’s Graduate School of Business found 484 firms that had delisted from a major U.S. exchange between 1998 and 2004. Out of the total companies that delisted, 370 delisted between 2002 and 2004. According to Leuz, not every delisting can be attributed to SOX, yet most companies have citied high SEC reporting costs as the primary motivator behind the delisting.

Basically, there are two ways in which a foreign company can get listed on any U.S. exchange.
1. They can issue shares by registering with the SEC thereby listing their shares either exclusively or primarily on U.S. exchanges.
2. A foreign company can issue an American Depository Receipt (ADR) backed by shares issued in their home country.

According to Steven Siesser, chairman of the Lowenstein Sandler’s specialty finance group, overseas companies are staying out of the U.S. stock market because of SOX related concerns citing high compliance costs, officer liabilities and burdensome internal control requirements.

However, a deeply contrary view has been presented in a paper by a group of researchers from Northwestern University, The Chinese University of Hong Kong, USC and the University of Massachusetts. Their research indicated that foreign companies that ultimately delisted from the U.S. stock exchanges had weak governance characteristics to begin with. Good governance is measured by the number of independent directors on the board, nature of their shareholding, segregation of voting and ownership rights. They have also concluded through their analysis that foreign companies that delisted from the U.S. stock exchanges ultimately suffered a sharper decline in their share price. Shareholders perceived compliance with SOX as a form of an enhanced investor protection tool. A direct result of delisting was a sharper decline in their share price given the negative perception that the delisting had in the minds of their shareholders. This ultimately lends credence to the theory that if the delisting from U.S. stock exchanges was motivated by cost considerations (i.e. increased SOX compliance) there would have been an expected price increase as a result of the delisting and not the opposite effect.

The authors of this paper were also driven to conclude that the delisting decision was driven to a larger extent by the controlling manager’s or controlling shareholders desire to protect their interests that would not have been possible due to the internal control requirements that SOX stipulated. Their research indicates that U.S. capital markets have not lost their competitiveness due to large SOX compliance costs but possibly due to SOX requirements that take away sole control from ‘corporate insiders’.

Please feel free to send in your comments on this post and thoughts on delisting as a way to get away from SOX.

Basel Committee unveils plans to strengthen global financial markets.

On the close heels of the report presented last week by the Financial Stability Forum (FSF) , comes an additional report from the Basel Committee on Banking Supervision(BCBS).

In its report to the G-7 ministers, the FSF provided a brief outline of the steps that are planned to improve market resiliency. The BCBS in its report presented on April 16th, provides additional details with a general timeline for the implementation of these measures.

The measures are addressed towards five main areas: Capital, Risk Management, Liquidity Management, Disclosures and Valuation.

1. Capital: Economists, central bank governors and others have attributed the weakening of financial markets to inadequate capital maintenance by banks and other financial institutions that did not commensurate with the level of risk that these banks took on over the years. Towards this end, the BCBS will introduce measures to ensure adequate capital, to better capture off balance sheet exposures and to 'improve regulatory capital incentives'.
Specifically, the committee will revise the BASEL framework to establish higher capital requirements for certain complex structured credit products. Besides this, the capital requirements associated with the liquidity extended to support off balance sheet vehicles will also be strengthened.Details of this proposal are expected to be provided later this year. The Committee, in cooperation with the International Organization of Securities Commissions (IOSCO), is extending the scope of its existing proposed guidelines for "incremental default risk" to include other potential event risks in the trading book.This is planned for 2010. Until this is put in place, an interim treatment will be used for complex securitisations that are held in the trading book. The Committee expects to issue its proposal for public consultation later this year, and it also will conduct a quantitative impact assessment.
The committee also plans to monitor Basel II minimum capital requirements and capital buffers over the credit cycle. If these are found to be inadequate, then such requirements laid out in Basel II will be enhanced in order to provide a sound capital framework commensurate with the banks' risk profiles.

2. Risk Management: The committee plans to revise Pillar 2 associated with the Supervisory review process by providing additional tools and guidance.

3. Liquidity Management:The committee plans to publish global sound practice standards for the management and supervision of liquidity risks. This is planned to be published in July and will be open for consultation.

4. Disclosures: Pillar 3 (market discipline) of the framework ensures adequate disclosures in the area of complex securitization. There will be additional guidance in the area of market discipline by 2009.

5. Valuation: The bank plans to develop guidance that supervisors can use to determine the strength of the banks valuation processes. The committee believes that weak valuation practices contributed to the recent market turbulence. This measure will hopefully reduce a recurrence of such an event.

One step closer to an enhanced Basel II.

The Financial Stability Forum (FSF) today presented a report to the G 7 finance ministers, recommending actions for achieving strong and resilient financial markets. The FSF is a body that consists of Central Bank Governors, international financial institutions, regulatory bodies and others with a specific purpose to promote financial stability across the world. The FSF was formed in 1999 at the behest of the Finance Ministers and Central Bank Governors of the G 7 countries.

The G-7 includes the U.S., the United Kingdom, France, Germany, Italy, Canada and Japan.

The reportpresented to the G 7 ministers recommends specific actions relating to capital and liquidity requirements, risk management, strengthening disclosure requirements under Basel II as well as standards for off balance sheet vehicles and valuations. The report also addresses the role and use of credit rating agencies. Rating agencies should distinguish between ratings on structured products versus those on bonds. Enhanced information disclosure will also be required from institutions about securitised products and their underlying assets.

Addressing the need for a swift response by authorites to changes in the environment, the report also recommended that a supervisory body will be put in place by end 2008 'for each of the largest global financial institutions.'

The FSF member firms also include the Bank for International Settlements(BIS). The standing committees at the BIS supports central banks by providing guidance and recommendations on monetary and financial matters. One of these committees includes the Basel Committee on Banking Supervision. With the FSF having recommended changes to capital and liquidity requirements in its report to the G 7 ministers, enhancements in Basel II should be expected before the end of the year.

Weak Internal Controls at Verifone Prompt Large Financial Restatement.

In December 2007, weak internal controls on Inventory processes, forced the management of Verifone Holdings Inc.,(the maker of electronic payment equipment) to restate their financial statements for the Quarters ended January 2007, April 30, 2007 and July 31, 2007. Verifone's fiscal year ends October of each year.

At the time of the initial December 2007 announcement, management estimated reductions to previously reported inventories of approximately $7 million, $16 million and $30 million as of January 31, 2007, April 30, 2007 and July 31, 2007, respectively, and reductions to previously reported pre tax income of approximately $8 million, $7 million and $13 million for the three month periods ended January 31, 2007, April 30, 2007 and July 31, 2007, respectively.

Almost three months later and with the help of 70 staffers from an independent general counsel as well as a forensic accounting firm, Verifone's management is ready with their 'final' estimate.

A few days back, Verifone managment reported that the audit committee had completed their investigation. Their final tally on reduction in the value of inventories was pegged at approximately $13 million, $23 million and $40 million at January 31, 2007, April 30, 2007, and July 31, 2007 These are considerably higher as compared to the originally reported estimates of reductions. These are also unaudited and subject to the review of their public accounting firm.

The cause of such a large restatement has been attributed to weak internal controls surrounding the inventory financial reporting and accounting process.

Specific remedial measures have been recommended in the audit committee's final report:
-- Implementation of a more stringent voucher approval process for manual journal entries;
-- Implementation of enhanced information technology/enterprise resource planning systems commensurate with the increased size and complexity of VeriFone's businesses;
-- Adding appropriate accounting and finance resources through additional centralized staffing with individuals having sufficient knowledge and experience in cost accounting and other GAAP principles;
-- Enhanced segregation of duties between the financial planning and the accounting and control functions;
-- Improvements in governance and compliance functions to improve control consciousness and appropriate adherence to generally accepted accounting principles, as well as improved tone, communication, documentation, education and training for employees involved in the financial reporting process, including the appointment of a chief legal and compliance officer; and
-- Personnel actions, including the termination of the Company's supply chain controller, enhanced supervision and other actions.

Besides the obvious accounting gaps, the recommendations also indicate a weak Human Resource function. Inadequately trained and incompetent personnel combined with weak oversight will almost certainly lead to disastrous results.

Manual Journal entries are one of the few items that receive maximum scrutiny from auditors.

Inadequate seggregation of duties is an issue that receives a high severity rating in an audit report. How could such issues have escaped audit attention?

The company's external auditors, Messrs Ernst & Young LLP issued an unqualified, clean audit report for the year ended October 2006. The Management assertion that is required under the Sarbanes Oxley Act, 2002 also held no indication of any weak internal controls. The managment stated "our management (including our chief executive officer and chief financial officer) concluded that our internal control over financial reporting was effective as of October 31, 2006.Management’s assessment of the effectiveness of our internal control over financial reporting as of October 31, 2006 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report included at Item 8 in this Annual Report on Form 10-K." There has been nothing in any statement from Verifone's management that can assure investors and authorities that the same inventory issues from 2007 were not creep into the prior years financial statments.

The SEC has sent an informal letter to Verifone managment asking to interview a few present and previous employees. Does the SEC or the PCAOB plan to involve the public accounting firm as well? I have written to the PCAOB to comment on this issue. Their response is awaited and once received will be posted on this blog.

SEC support to Basel Committee.

In the light of the recent financial market turmoil, the Basel Committee's Working Group on Liquidity has planned some key updates to their liquidity management guidelines for banks.

Mr. Christopher Cox, chairman of the SEC recently wrote to Dr. Wellink, chairman of the Basel Committee on Banking Supervision. Although the objective of the letter was to express support for upcoming updates in the guidance for liquidity management, yet the bulk of the letter addressed the Bear Stearns collapse. It attributed the collapse to rumours and a 'self fulfilling prophecy' than inadequate liquidity management.

Mr. Cox provided the capital and liquidity position of Bear Stearns prior to and up to the days leading to the take over by J P Morgan Chase. It showed the liquidity pool on Jan 31 up until March 13th. Mr.Cox remarks how the liquidity pool of Bear Stearns diminished from $18 billion on Mar 10th to $2 billion on March 13th which resulted in Bear's collapse.
Interestingly, towards the beginning of the year (Jan 31st) the liquidity pool stood at only $8 billion.

According to Mr.Cox, although Bear Stearns' holding company and the bank's 2 SEC registered brokerage dealers had adequate capital to fulfill the Basel II standards, yet "evaporation of market confidence" led to liquidity being impaired.

An obvious question that comes to mind is: how did the current regulatory structure at SEC miss this impending debacle? By reassuring the Basel Committee about the adequacy of Bear's capital structure, the SEC has failed to answer a very important question which is how did the bank crumble in spite of such an apparently strong capital position? Does the SEC truly believe that rumor mongers and market whispers were the sole reason for Bear's downfall?
Innovative financial products fared very well in an unregulated market. But their failure also meant the crumbling failure of the biggest financial markets and consequently a weakening in the economy.

It will be interesting to see how Treasury Secretary Mr.Paulson's plans to overhaul the financial regulatory environment actually plays out in the coming months.