Monthly Archives: December 2011

How Effective is Internal Control Reporting under SOX 404?

The following post comes to us from Sarah Rice and David Weber, both of the Department of Accounting at the University of Connecticut.

In the paper, How Effective is Internal Control Reporting under SOX 404? Determinants of the (Non-) Disclosure of Existing Material Weaknesses, forthcoming in the Journal of Accounting Research, we examine the effectiveness of SOX 404 internal control reports in identifying existing material control weaknesses, as well as the determinants of the relative effectiveness of those reports across firms. While SOX 404 has received significant attention, largely due to the perceived burden of the associated compliance costs, how reliably the resulting reports identify weaknesses has remained largely overlooked in the academic literature. We address this void by studying a sample of firms that restate previously-issued financial statements to correct misstatements and that can be identified as having had existing control weaknesses during the time of their misstatements. We examine the internal control reports that accompanied the original (misstated) financial statements to determine whether firms reported their control weaknesses as required. Thus, our paper differs from previous research such as Doyle et al. [2007] and Ashbaugh et al. [2007] in that we are able to separate the reporting of internal control weaknesses from their underlying existence. Because weaknesses exist for all of our sample firms, we are able to focus on the reporting of those weaknesses and thus provide evidence on the factors that affect detection and disclosure. We sharpen the interpretation of our evidence by also conducting analyses that distinguish between factors that affect detection versus those that affect disclosure.


December 2011 Dodd-Frank Rulemaking Progress Report

The following post comes to us from Margaret E. Tahyar and Gabriel D. Rosenberg of the Financial Institutions Group at Davis Polk & Wardwell LLP. This post discusses a Davis Polk report which is available here. A post about the previous progress report is available here. Other posts about the Dodd-Frank Act are available here.

This posting, the December Davis Polk Dodd-Frank Progress Report, is the ninth in a series of Davis Polk presentations that illustrate graphically the progress of the rulemaking work that has been done and is yet to occur under the Dodd-Frank Act. The Progress Report has been prepared using data from the Davis Polk Regulatory Tracker™, an online subscription service offered by Davis Polk to help market participants understand the Dodd-Frank Act and follow regulatory developments on a real-time basis.

In this report:

  • No New Deadlines. No new rulemaking requirements were due in November.
  • 3 Requirements Proposed. Rules satisfying three rulemaking requirements were proposed this month. Two of the proposed rules address deadlines that have already passed.

Non-U.S. Issuer IPOs Will Face Greater Public Disclosure

Editor’s Note: Richard J. Sandler is a partner at Davis Polk & Wardwell LLP and co-head of the firm’s global corporate governance group. This post is based on a Davis Polk client update.

The SEC staff has traditionally allowed non-U.S. issuers to file IPO or other first-time registration statements on a “draft” non-public basis, enabling them to avoid the scrutiny associated with a public EDGAR filing. The staff significantly limited this accommodation today.

Beginning December 8, 2011, the staff will review initial registration statements of non-U.S. issuers that are submitted on a non-public basis only where the registrant is:

  • 1. a foreign government registering its debt securities;
  • 2. a foreign private issuer that is listed or is concurrently listing its securities on a non-U.S. securities exchange;
  • 3. a foreign private issuer that is being privatized by a foreign government; or
  • 4. a foreign private issuer that can demonstrate that the public filing of an initial registration statement would conflict with the law of an applicable foreign jurisdiction.


Say-on-Pay: An Update for 2011

Editor’s Note: Joseph Bachelder is founder and senior partner of the Bachelder Law Firm. This post is based on an article by Mr. Bachelder that first appeared in the New York Law Journal.

Thus far during the 2011 proxy season approximately 2500 of the Russell 3000 index companies have reported a Say-on-Pay vote. Say-on-Pay is a nonbinding vote by a company’s shareholders on its executive pay program. [1] A majority of the votes cast at approximately 98½ percent of these companies was favorable to the executive compensation program at the company. In fact, at the companies with favorable say-on-pay votes an average of 90 percent of the votes cast were in favor of the compensation program under review.

Those favorable votes occurred at the same time that large institutional shareholder advisors such as Institutional Shareholder Services Inc. (ISS) and Glass, Lewis & Co., LLC (GL) were recommending that shareholders vote against executive pay at hundreds of these public companies. ISS recommended negative votes at 340 companies (as of Sept. 1) and GL recommended negative votes at 474 companies (as of June 30).

Approximately 40 public companies have had a majority of votes cast at their shareholder meetings held during 2011 that were negative on executive pay programs. Shareholders at approximately 10 of these companies have brought lawsuits based on these negative votes.


Bank Board Structure and Performance

The following post comes to us from Renee Adams, Professor of Finance at the University of New South Wales, and Hamid Mehran of the Federal Reserve Bank of New York.

Banks clearly appear to have different governance structures than non-financial firms. The question is whether these governance structures are ineffective and whether implementing independence standards imposed by Dodd-Frank, SOX and the major stock exchanges will improve bank governance. In our paper, Bank Board Structure and Performance: Evidence for Large Bank Holding Companies, which was recently made publicly available on SSRN, we try to provide an answer to this question by examining the relationship between board composition and size and bank performance. We focus on large, publicly traded bank holding companies (BHCs) in the U.S., which are the banks that are mentioned most often in the context of the crisis.

We first examine the relationship between board composition and size and performance in a sample of data on 35 BHCs from 1986-1999. We deliberately focused on a relatively small number of BHCs over a longer period of time to ensure that there would be sufficient variation in governance variables which typically do not change much over time. In addition, we collected detailed data on variables that have received attention in the law, economics, and organization literature and which are recognized to be correlated with sound corporate governance, but that are generally not studied as a group due to high data collection costs.


The City Code on Takeovers and Mergers

Eduardo Gallardo is a partner focusing on mergers and acquisitions at Gibson, Dunn & Crutcher LLP. This post is based on the introduction to Gibson Dunn’s guide to the City Code, which is available in full here. The guide was authored by Selina Sagayam, Jeff Roberts, and James Barabas.

The City Code is a set of general principles and rules governing the conduct of takeovers and mergers of companies with registered offices in the UK, the Channel Islands and the Isle of Man. It also applies to a limited extent to companies in other European Economic Area (EEA) countries. The Code is designed principally to ensure that shareholders are treated fairly and provides an orderly framework within which takeovers are conducted. It is issued and administered by the Takeover Panel (the Panel), which has been designated as the supervisory authority to carry out certain regulatory functions in relation to takeovers under the EU Takeover Directive. The Panel is an independent body made up of representatives from UK financial institutions and professional associations and other members appointed by the Panel. The Panel‘s day-to-day business is carried out by an Executive comprising full-time employees and secondees from the investment banking community, accountancy firms, law firms and the civil service. It is headed by a Director General who is usually a director of an investment bank seconded for generally a two year period.


Another SEC Clawback Settlement

Wayne Carlin is a partner in the Litigation Department at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum by Mr. Carlin, John F. Savarese, David A. Katz, and David B. Anders.

On November 15, 2011, the SEC announced a settlement in which it “clawed back” incentive based compensation from a former CEO who was not accused of any wrongdoing.  The result, however, may send mixed signals.  On the one hand, the SEC’s ability to achieve this result in a no-fault clawback case may very well encourage the SEC staff to continue to enforce this remedy, even in cases where the CEO or CFO has no personal responsibility for misconduct.  On the other hand, the settlement of $2.8 million was less than the $4 million that the SEC originally sought to recover from the former CEO.

The case, SEC v. Jenkins, No. CV 09-1510, involved Maynard L. Jenkins, the former CEO of CSK Auto Corporation.  Although civil and criminal charges were brought against four other CSK Auto executives, the SEC did not charge Jenkins with any wrongdoing in connection with the accounting fraud that occurred at CSK.  Nevertheless, relying on Section 304 of Sarbanes-Oxley, the SEC filed a complaint seeking to claw back $4 million of incentive compensation that Jenkins received during the period of the fraud.  Jenkins moved to dismiss the complaint, but that motion was denied in June 2010.  (See our memo, “Sarbanes-Oxley Clawback Developments”, June 16, 2010.)


The Effect of Auditor Expertise on Executive Compensation

The following post comes to us from  Sudarshan Jayaraman of the Department of Accounting at Washington University in Saint Louis and Todd Milbourn, Professor of Finance at Washington University in Saint Louis.

In our paper, The Effect of Auditor Expertise on Executive Compensation, which was recently made publicly available on SSRN, we examine how auditor expertise influences the amount of equity-based compensation that firms grant to their executives. Our empirical tests are motivated by recent theoretical models that examine how the potential for financial statement manipulation influences managerial equity-based compensation. While more equity incentives may induce better strategic decisions and greater effort, they also encourage the manager to manipulate financial reports to artificially inflate the stock price, especially if the manipulation is unlikely to be detected. These theories predict that managers will be granted more equity-based compensation when financial misreporting is more likely to be detected, as the costs of granting such compensation are lower.

Following prior studies that find that greater auditor expertise reduces the incidence of earnings management and improves audit quality, we expect firms audited by an auditor with greater industry expertise to grant their executives more equity-based compensation. We find strong evidence in favor of our prediction. In particular, greater the expertise of the firm’s auditor, more is the amount of equity-based compensation that firms grant to their CEOs. This result is not only statistically robust, but also economically significant – a one standard deviation increase in auditor expertise increases CEO equity compensation by 1.4% relative to the mean. As most of our sample firms are audited by a Big Five (or Big Four) auditor, our tests effectively compare differences in equity-based managerial compensation between Big Five industry experts versus Big Five non-industry-experts.


The Interrelationship Between Public and Private Securities Enforcement

Editor’s Note: Elisse B. Walter is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Walter’s recent remarks before the FINRA Institute, which are available here. The views expressed in the post are those of Commissioner Walter and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

It should be a fairly non-controversial first principle that a statute is merely a suggestion, rather than a mandate, if it cannot be enforced. Thus, for the federal securities laws to be effective, they need to be enforceable. I am referring to enforcement both by public and quasi-public action, such as that taken by the Securities and Exchange Commission, criminal authorities, state authorities, and self-regulatory organizations like FINRA, and action taken privately by investors in class actions and other litigation.

I believe that both the public and private aspects of securities enforcement are critical, that they complement each other, and that they are interrelated. The Commission as an institution has taken this view for quite a long time—in fact, I wrote more than a few Commission amicus briefs expressing it during my first tour of duty at the agency. Recent court decisions have led me to revisit this topic and to focus anew on the implications of the interrelationship between private and public rights of action.


Top Ten Issues For Boards in 2012

Francis H. Byrd is Senior Vice President, Corporate Governance & Risk Practice Leader at Laurel Hill Advisory Group. This post is based on a Laurel Hill newsletter by Mr. Byrd.

As we approach the end of the year, it is time to start thinking about the hot button issues that will face boards and senior management – and that may show up in proxy statements – in 2012. Here are my top ten broken out by four categories:

A. Executive Compensation/Say on Pay

1. Responding to your SOP vote – Compensation committees should prepare with a similar level of intensity as last year. Many institutional investors, like ISS, usually revise their voting guidelines annually and could make changes that negatively impact on how they view your compensation program;

2. Problematic Pay Practices – Boards should seriously consider last year’s SOP votes as a wake-up call for compensation committees that have failed to remove or end practices that both proxy advisory firms and large shareholders have deemed problematic;

3. Say-On-Pay Engagement – Compensation committees should be asking, especially those at firms that either lost or sustained their SOP vote by narrow margins, how best to reach out and engage their shareholders on these issues. The compensation committee and senior management should be prepared to consult with advisors before reaching out.


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