The Committee of Corporate General Counsel of the ABA Business Law Section presented a program on March 16 that included a panel ("ABA Panel") entitled "New Commissions, New Recommendations: U.S. Capital Markets and Corporate Reforms." The panel discussed three reports containing recommendations to improve the competitiveness of U.S. capital markets and the institutions that use them. These reports are (1) Report and Recommendations of the Commission on the Regulation of U.S. Capital Markets in the 21st Century established by the U.S. Chamber of Commerce ("Chamber Report"), (2) Interim Report of the Committee on Capital Markets Regulation ("CCMR Report") and (3) Sustaining New York's and the U.S.' Global Financial Services Leadership ("Bloomberg/Schumer Report").
The Editor interviews Christine Edwards, the moderator of the ABA panel, who is a Partner of Winston & Strawn LLP, and one of fourteen Commissioners of the Chamber Capital Markets Commission ("Commission"). Chris played a key role in the Commission's Financial Services Working Group where she served as facilitator. Chris is a member of the ABA Committee and, before joining Winston and Strawn, had extensive experience as corporate counsel at increasing levels of responsibility, including most recently as Executive Vice President and General Counsel of Bank One.
The views of the interviewee do not necessarily represent the views of the Commission.
Editor: Why is it that three reports appeared about the same time?
Edwards: All three reports reflect the growing consciousness that, although the U.S. historically has had the premier capital markets with seemingly unlimited access to capital, it now must face up to the fact that there is a finite pool of capital in the U.S. and that the U.S. financial services industry faces serious competition from other countries. Borrowing heavily from us, other countries have built their capital markets and established court systems and regulatory environments to support them. Research reflected in the three reports confirms that there are now vibrant capital markets throughout the world and that this country is experiencing a decline in its market share. Consequently, in order to preserve the competitive position of our capital markets, we must take steps to make sure that our infrastructure remains the best and that we continue to have needed talent, technology and access to capital.
At the same time, there is a strong perception outside the country that you enter the U.S. capital markets at your peril. Part of that has to do with the regulatory and litigation environments. In addition, there is discomfort from a cost standpoint about the rigor with which we approach disclosure, transparency and reporting.
In the Chamber Report, we said that we are proud of the disclosure, transparency and reporting requirements that contribute to the integrity of our capital markets system - but that the details of those requirements need economic review to assure that the benefits outweigh the costs.
Editor: Tell us about the Chamber Report's recommendation that public companies discontinue providing quarterly earnings guidance?
Edwards: Short-term thinking by business can undermine our economy's potential for future growth. One of the principal recommendations we made is that public companies consider refraining from giving quarterly earnings guidance, and, if they feel they must give guidance, do so only once a year and provide ranges. The Commission was concerned that the widespread practice of providing quarterly earnings guidance and then meeting the forecast to the penny results in sacrificing long term benefits to meet short term goals. A 2004 study by the National Bureau of Economic Research found that more than 78% of the executives surveyed would reduce discretionary spending in areas such as research and development, advertising or maintenance to maintain a smooth pattern of earnings. If it meant missing the current quarter's earnings consensus, 55% of corporate managers would forgo a transaction that was good for a company in the long run.
The exact numbers given in quarterly earnings guidance are not appropriate when you think about the judgments that must be made to produce credible financial statements. It is not a matter of adding a bunch of numbers. Public company financial reports are a series of assessments, ranges, judgments, valuations and so forth that are subject to differing views.
The big problem in weaning companies away from the practice of earnings guidance is that an overwhelming majority of companies that have announced that they will stop providing guidance have done so in a quarter in which they will disappoint investors. The signal that is sent in those instances is negative. The Chamber Capital Markets Commission is hopeful that a report like ours strongly urging public companies not to provide quarterly earnings guidance may serve as a basis for public companies to refrain from providing such guidance in an overall atmosphere where the decision is viewed as positive.
Editor: The Chamber Report also made recommendations that look to the desirability of enhancing the viability of the accounting firms serving public companies.
Edwards: Bob Pozen headed the Commission's Public Company Issuer and Auditor Working Group in which I also was interested. Post-Arthur Andersen, it has become evident that four big accounting firms for public companies are not enough. If we lose another, it would be much worse. The relationships among the large multi-national public companies and the four accounting firms are so intertwined that to lose one would be a major disaster.
The legal structure governing accounting firms includes extensive state statutory provisions regulating the firms as fiduciaries and, separately their employees as certified accountants. These regulations determine when fiduciaries can continue to do business on a state by state basis. That fiduciary assessment makes an indictment life- threatening to audit firms. An indictment will impact their ability to maintain licenses. In addition, the SEC has authority to disallow any public company filing by an auditor subject to criminal indictment unless exempted by the SEC. That is why the threat of an indictment is such a difficult prospect for audit firms. We recommended that the Big Four should have an opportunity to get out from under those 50 different state provisions and have the option of obtaining a federal charter.
We also recommended that these federally chartered and regulated accounting firms be permitted to raise private equity capital. Right now the Big Four are operating on razor thin margins and any one of them could be wiped out by damages in a major civil lawsuit. They need additional capital to serve as a cushion. To avoid conflicts of interest, this capital would have to come from independent sources and not from employees.
The long term prospects of the Big Four are good. Sarbanes-Oxley has created tremendous business opportunities for auditing firms not only in connection with their regular audits, but also for their specialists such as forensic auditors who can be called in to investigate a suspected fraud or to set up systems to deter fraud. Auditing firms have developed great technological capabilities to aid in controlling and uncovering fraud and in consulting with respect to e-discovery and providing systems to collect and review data required as a result of e-discovery. When we sat with members of the private equity community, they thought that opening the door to private equity investment was an excellent idea.
Editor: What was the rationale for placing most of provisions of Sarbanes-Oxley in the 1934 Act? Why was Section 404 treated differently?
Edwards: That was something that my working group focused on. Most of the provisions of Sarbanes-Oxley take the form of amendments to the 1934 Act to ensure that the SEC has rule making authority with respect to those provisions. But, Section 404 was not an amendment to the 1934 Act. One of the reasons given was that Senator Sarbanes did not want the SEC to have the authority to grant exemptions. For that reason, we are seeing instances where the SEC's authority to grant exemptions is being raised as an issue.
The industry wants the SEC to have the flexibility to exempt certain organizations. Smaller public companies need permission to implement 404 in a different way from larger companies. The SEC also needs the authority to modify the 404 certifications for foreign companies or to exempt them from 404 certifications. The SEC should have exemptive authority in those situations where another regulator has 404-type controls. It may be necessary to ask Congress for legislation that would give the SEC the authority to modify the requirements of Section 404 and to grant exemptions.
Editor: Why did the Chamber Report's recommend that the SEC reorder two of its divisions into three divisions?
Edwards: Monitoring and guiding securities industry and public company practices is the job of the SEC. Their role should take priority over all other regulators and law enforcement agencies. Over the last 10 years, an enormous amount of capital has been devoted to its enforcement activities. The Chamber report said nothing about changing the SEC's enforcement authority. However, we recommended that this be the decade where SEC devotes time and capital to the process of providing guidance to the industry and place greater emphasis on acting as a prudential regulator and replacing the sole reliance on lessons taught by enforcement. We recognize that the SEC should be the primary regulator of the capital markets not U.S. Attorneys or state attorneys general. Over the last 10 years these groups have stepped into the regulation of the financial business in ways they consider very important through forcing companies to negotiate settlements. Those settlements had the effect of changing practices of particular firms which then was translated as "best practices" for the rest of the industry. For instance, the mutual funds settlements changed industry practices with respect to disclosure, pricing, timing of transactions and dealing with investors. Unfortunately, setting public policy that way is not in the best interest of the industry and is not consistent with the SEC's practices.
To get such matters out of the hands of the state AGs and U.S. Attorneys, it is necessary for the SEC to allocate more resources to its advisory role. Now, any time that you communicate with the SEC, you have to assume that they may turn over information to the enforcement division. That does not foster open communication. It also hurts the SEC by cutting off valuable guidance they need from the industry. The SEC should be open to more direct communication and a more prudential role as essential ways to uncover the real problems that it needs to address through regulatory guidance. In doing so, the SEC should provide guidance that is not threatening to the institutions it regulates.
To do this effectively, we recommended that the SEC reorder two of its divisions into three divisions. Such a reorganization would put it in a better position to carry out the notion of a prudential regulator that communicates actively with those it regulates in a way that does not, except in limited circumstances, subject them to possible enforcement actions.
Editor: Did the Commission's recommendations include proposals that encourage companies to share information with the SEC and to engage in more effective self-regulation?
Edwards: We recommended that the SEC implement an examiners' privilege where all communications that exist between SEC and the institution it regulates would be privileged. Those communications would belong to the SEC and could not be requested in civil litigation. That is the same document protocol that exists with the bank regulatory agencies.
We also recommended that companies be provided with a federal self-evaluation privilege. In the absence of such a privilege, management and general counsel, if they are candid with you, will tell you that you do not want to know. That is not what you want.
If the consequence of looking and correcting is that you trigger a wave of class action suits, it will chill the incentive of companies to look at their own practices. We did research on the genesis of a self-evaluation privilege. It goes back to the early 1900s with medical peer review. We found a variety of states that now have various types of self-evaluation privileges. There are also industry groups that represent the insurance industry that have been very active in trying to get self-evaluation privileges. For public companies that operate in 50 states, having just a few states that recognize a self-evaluation privilege is not enough.
Because encouraging companies to engage in self-regulation through self-evaluation offers such immense benefits for investors, we recommended that there be a federal self-evaluation privilege. There would be some constraints built into the legislation. If a material compliance failure is uncovered, the self-evaluation would not change existing requirements that the information be turned over to the SEC. However, the document would continue to be privileged from having to be turned over in civil litigation.