by T. GormanPosted on Posted in SECActions

The Public Company Accounting Oversight Board published a proposed rule designed to create a framework for determinations to be made under the Holding Foreign Companies Accountable Act passed last year (HFCAA). That Act amends the Sarbanes-Oxley Act of 2002 or SOX which mandates that the PCAOB conduct inspections of registered accounting firms that audit companies whose shares are traded in the United States.

While the Board has conducted the required inspections for years, there is an exception – China. The PRC government and the China Securities Regulatory Commission or CSRC have steadfastly declined to permit the required inspections with few exceptions.

The HFCAA was designed to try and address the impasse. The statute requires that firms publicly traded in the U.S. disclose information to the SEC on foreign jurisdictions that prevent the PCAOB from conducting inspections. The Board’s proposed rule-making is designed to create a framework to guide decision making when a report of non-compliance with the inspection requirement is made to the SEC.

While the Board’s proposed rule-making appears to faithfully follow the dictates of Congress as reflected in HFCAA, the real question is to what end? The process here is being written on a slate tinged with decades of failure. In 2011 and 2012, for example, the SEC brought enforcement actions against foreign affiliates of the major accounting firms centered on this issue. Those actions, brought as Commission administrative proceedings, ultimately ended with an agreement between the PCAOB and CSRC under which the parties pledged the “fullest assistance permissible to secure compliance with the respective Laws and Regulations of the Authorities.” The MOU went on to detail procedures to facilitate the arrangement. Yet little in the way of tangible results can be found despite the fact that ultimately under SOX firms that are not in compliance can be delisted.

HFCAA may have passed Congress with rare bipartisan support. The Board’s new procedures may create a process for evaluating difficulties with or refusals to comply with the inspection process. There is nothing, however, to suggest that CSRC and the PRC are about to join the international community and help ensure that the Board can properly conduct the required inspections to safeguard public investment and trading markets which benefit everyone.

If there is no reason to expect that the new approach of Congress and the Board will yield positive results, then perhaps it is time to search for alternatives. One is to simply delist any issuer that refuses a SOX inspection, an approach nobody seems willing to pursue. A second may be to urge investors as the SEC Chair did last year to carefully evaluate the situation before investing in firms that have substantial operations in China or any other country that adopts its approach – that is, accept the risk of fraud or don’t invest, an equally unattractive approach.

An alternative may offer a solution. Consider fashioning auditing standards for use in recalcitrant jurisdictions like China in such a manner that sufficient information is available to the company outside of that country so that inspectors can assure themselves that the work has been done properly. While this is not the same as sending the inspectors into China to look at the work papers as envisioned by SOX, it may result in processes that achieve the desired result: reasonable assure of a proper audit.

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by T. GormanPosted on Posted in SECActions

SEC Chair Gary Gensler detailed an agenda that is likely to chart in part the direction of the agency over at least the next several months in his testimony last week before the House Committee on Financial Services (here). The agenda includes the following: 1) Gamification and Unser Experience; 2) Payment for Order Flow; 3) Equity Market Structure; 4) Short Selling and Market Transparency; 5) Social Media; 6) Market Plumbing: Clearance and Settlement; and 7) System Wide Risk.” These issues which will be discussed in a report to be issued later this summer.

The six issues listed reflect the rapidly changing market environment created by evolving technology as well as the events in the markets earlier this year. The critical question presented by this evolution is, according to Mr. Gensler: “When new technologies come along and change the face of finance, how do we continue to achieve our core public policy goals and ensure that markets work for everyday investors?” The answer to this question is not simple as illustrated by a brief look at each question:

1) Gamification is a term that encompasses an expansive range of ideas. It begins with the game-like features used with online devices, builds on tech that includes behavioral prompts designed to encourage users to engage with an app and links to features that employ predictive data analytics. While the prompts can be useful and enhance user experience, “following the wrong prompt on a treading app . . . could have substantial effect on a saver’s financial position,” the Chair noted. To evaluate this question the Commission plans to seek public input.

2) Payment for Order Flow, which is prohibited in some countries, comes in two forms: Payments from wholesalers and those from exchanges to market makers and brokers. Mr. Gensler is focused on those from wholesalers to brokers since they transmit information to the purchasers who are not obligated to offer fair access to it – the wholesalers can use it as they determine. This creates a competitive edge. It also presents questions that include potential conflicts of interest and best execution. These are questions that must be evaluated by the staff.

3) Equity Market Structure today presents issues regarding concentration. Currently about 53% of the orders are executed by the large public markets; 47% are executed by either off-exchange wholesalers (38%) or alternative trading systems (9%). Since concentration can result in a competitive edge the agency is going to examine the question in view of its rule making authority.

4) Short Selling was one of the key issues in the market events earlier this year. While there are reports available on the question that afford transparency into the practice, the Commission is going to examine this issue.

5) Social Media is having an impact on the markets as reflected in the events that took place earlier this year. One point to consider, Mr. Gensler notes, involves “sentiment analysis” which is being used by some sophisticated investors. It involves following public communications to assess relationships between words and prices. Since it can be used for nefarious practices such as to manipulate a market, the agency will study the process.

6) Market Plumbing is a question that focuses in part on settlement time, currently T+ 2, the gap between the order and the transfer of the cash and securities. While the time has varied over the years – in the 1920s a one day cycle was used – Mr. Gensler believes that “the standard settlement cycle could reduce costs in our markets” if shortened.

7) System-wide Risks includes there key points: a) the impact of broker liquidity when large sums of capital need to be raised quickly as occurred earlier this year; b) the potential impact of losses suffered by certain hedge funds this year; and c) the concentration among market makers or brokers at clearing houses which can also have market impact. Each of these points will be evaluated by the staff.

Evaluation of these difficult and complex issues will chart much of the Commission’s path for at least the next several months. As the assessment evolves at least one report will be issued to update Congress and the markets. In addition, there will be opportunities for the public to give input to the agency and possibly enforcement actions. By the time those occur they may well represent not the end of these projects but the beginning of assessing the ever evolving impact of tech on markets that originated decades ago – a new era for the SEC.

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