Thursday, April 15, 2010

SEC Proposals, PCAOB Alert, Lehman Update

Following is an update on recent SEC and PCAOB activity.

SEC Proposes Rules Relating to Options Markets, Large Trader Reporting
At yesterday's open commission meeting, the SEC voted to release a number of proposed rules. See SEC press release on proposed amendments to Reg NMS that would impact the activities of - and fees charged by - options exchanges, and SEC press release on a proposed rule that would create a Large Trader Reporting System. The latter proposal is aimed at enhancing the SEC's ability to would identify large market participants, collect information on their trades, and analyze their trading activity.

SEC Proposes Rule Amendments On Asset-Backed Securities
On April 7, the SEC proposed rule amendments that would revise the disclosure, reporting and offering process for asset-backed securities (ABS). The comment deadline will be 90 days after the proposed rule is published in the Federal Register. SEC press release; proposed rule.

PCAOB Releases Staff Practice Alert on Significant Unusual Transactions
On April 7, the PCAOB released Staff Audit Practice Alert No. 5, Auditor Considerations Regarding Significant Unusual Transactions (Practice Alert No. 5). The Practice Alert compiles relevant requirements from existing PCAOB auditing standards regarding significant unusual transactions to assist the auditor in reviews of interim financial information and audits of financial statements. PCAOB press release; Practice Alert 5.

Lehman Update: Congressional Hearing, DOJ Investigation
Some commentators (I like that word better than 'pundits') have expressed the belief that PCAOB Audit Alert No. 5 referenced above, along with the SEC's recent "Dear CFO" letter on repos, are a response to one of the major issues identified in the bankruptcy examiner's report on Lehman Brothers (the "Lehman report"), which questioned the accounting treatment given to, and alleged a lack of sufficient disclosure related to, a financing transaction done at quarter-end in the last couple of quarters of the firm's life, specifically a repurchase transaction (in which securities are sold under an agreement to repurchase them), dubbed 'Repo 105' at Lehman.

Numerous bloggers have covered the Lehman report and offered their own take on the matter, among the most prominent in the field of accounting/auditing, specifically, being Francine McKenna of Re: The Auditors (numerous posts), Jim Petersen of Re: Balance (numerous posts), Tom Selling of The Accounting Onion, and Prof. Dave Albrecht of The Summa. [I also wish to note my appreciation to the above group of bloggers, who I have had offline discussions with from time to time, sometimes in anticipation of quoting them in this blog, and although I have not had the chance to write up any indepth interviews, the insights you have shared are appreciated.]

Also of note on this subject, on March 19, 2010 Chairman Chris Dodd of the Senate Banking Committee announced: Dodd Calls for DOJ Task Force to Investigate Criminal Activities at Lehman and Elsewhere

Additionally, the House Financial Services Committee, Chaired by Rep. Barney Frank, recently announced they will convene a hearing on April 20, 2010 on: Public Policy Issues Raised by the Report of the Lehman Bankruptcy Examiner

My two cents on the question of Lehman's accounting and disclosure re: "Repo 105," - and before I begin, allow me to remind you of the disclaimer posted in the right margin of this blog - I know I'm risking having all kinds of negative labels thrown at me for saying this, but 'window dressing' or transactions that take place near quarter-end or year-end, whether expressly or implicitly aimed at meeting certain ratios or targets, such as leverage ratios, capital ratios, sales/revenue/contribution quotas, etc. , is not per se 'illegal' to my knowledge, nor is it necessarily per se a sign of fraud or even deceit.

A similar view was earlier expressed by Wharton Prof. Jeremy Siegel in the article, "Lehman's Demise and Repo 105: No Accounting For Deception," published by Knowledge@Wharton on March 31, in which Siegel said:

The use of outside entities to remove risks from a company's books is common and can be perfectly legal. And, as Wharton finance professor Jeremy J. Siegel points out, "window dressing" to make the books look better for a quarterly or annual report is a widespread practice that also can be perfectly legal. Companies, for example, often rush to lay off workers or get rid of poor-performing units or investments, so they won't mar the next financial report. "That's been going on for 50 years," Siegel says.

However, a more critical view was expressed in the article by three other Wharton Prof's, Richard Herring, Brian Bushee and Franklin Allen, who alleged, respectively, that mispresentation, circumvention, and/or deception took place with respect to the role of the staff of Lehman and/or its auditors.

Another important point is that one would assume sophisticated parties (at a minimum, analysts, regulators and examiners, and possibly sophisticated investors) would pay as much or more attention to average ratios (i.e., average ratio for the quarter or year), and not solely on quarter-end or year-end ratios, although certain metrics are defined at period-end, in terms of examining the health of an institution, i.e. to account for any 'window dressing' factor. Among the disclosures specifically requested in the SEC's 'Dear CFO' letter, for example, are certain average quarterly balances for the past three years.

Regarding the questions identified in the Lehman examiner's report about 'Repo 105,' I believe the ultimate judgment - not necessarily in the court of public opinion, but in the court of law (although I speak as a non-lawyer on this) is that the judgement will turn on two matters: (1) whether the 'accounting' or recognition and measurement of Repo 105 was proper, i.e. 'in accordance with GAAP,' and (2) whether the disclosures, including MD&A and other disclosures, were sufficient, i.e. in accordance with GAAP and SEC rules. Looking ahead, there may be changes to accounting rules (although there have already been major changes to GAAP since the fall of Lehman, among the new standards issued by FASB over the past year), but I'd say its more likely that there may be changes in SEC disclosure rules or other regulatory capital or disclosure rules building on the SEC's 'Dear CFO' letter. The April 20 Congressional hearing may shed some light on this issue.

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