Your Next Activist Shareholder May Not Want More Money

Shareholders are driving changes in corporate policies and disclosures unthinkable a decade ago, on issues ranging from protecting rain forests to human rights. Even the threat of a proxy vote can be enough to bring company executives to the negotiating table.

So far this year, environmental and social issues have accounted for 56% of shareholder proposals, representing a majority for the first time, according to accounting firm Ernst & Young LLP. That is up from about 40% in the previous two years, and means shareholders are increasingly voting on things like greenhouse-gas emissions, political spending and labor rights.

While such proposals usually don’t grab the same headlines as changes sought by activist investors, their proponents often are effective at persuading companies to meet them halfway.

The proposals are “really meant to get the attention of the corporate leadership,” said Thomas DiNapoli, the New York comptroller who oversees the $160.7 billion New York State Common Retirement Fund. “Profitability that is at a sustainable and responsible level is very, very important to us.”

Mr. DiNapoli filed about 65 resolutions this past year, and he often succeeds in getting companies to agree to his requests before they come to a vote.

Last week, he persuaded grocer Safeway Inc. to make products with palm oil produced in ways that don’t hurt rain forests. In February, in response to proposals from Mr. DiNapoli and others, AT&T Inc. published its first “transparency report” on requests from the National Security Agency and law-enforcement agencies for customer data and phone records.

In both cases, he withdrew his proposal after the companies agreed to make changes.

Resolutions calling on companies to report their political spending and lobbying efforts are the top two shareholder proposals this year, according to EY’s review of some 700 proposals. By contrast, last year’s proposals were dominated by traditional corporate-governance topics, such as eliminating staggered terms for directors and appointing independent board chairmen.

More surprising still are the results. Nearly 80% of companies in the S&P 500 index now disclose at least some information about their political-spending policies, according to the Center for Political Accountability, a practice virtually unheard of a decade ago. Some 53% now publish sustainability reports, according to the Governance and Accountability Institute, addressing such matters as their energy efficiency and labor standards.

And, about 22% have human-rights policies, according to the Conference Board, a private research group.

Among the reasons for this year’s surge in social and environmental proposals is the strong stock market, which has left shareholders little room for complaints about performance.

“You’re not seeing the same sort of push-back on executive compensation this year,” said Wendy Hambleton, national director of the Securities and Exchange Commission practice at accounting firm BDO USA LLP.

The shareholders who push for these proposals aren’t agitating for higher returns like activists Dan Loeb and Carl Icahn but rather are long-term investors at pension funds, unions and coalitions of socially conscious shareholders.

For example, the American Federation of State, County and Municipal Employees, a labor union for public employees, has been pressuring dozens of companies to disclose their lobbying activity this year. Ceres, a nonprofit group that advocates sustainable business practices, is helping investors at many companies write environmental resolutions.

As investors win battles at some companies, they hope peer pressure will convince others to follow suit.

On Monday, Exxon Mobil Corp. issued its first carbon risk report, explaining whether changing emissions regulations might move it to abandon high-cost oil and gas reserves. Sustainability-focused investment firm Arjuna Capital had submitted a shareholder resolution seeking that information.

Exxon said it was “confident” that none of its hydrocarbon reserves would become “stranded.”

“This is helping set the standard for what companies should be disclosing,” said Danielle Fugere, president of As You Sow, a nonprofit group that worked with Arjuna on the resolution. The group is circulating the agreement as an example for other oil companies where it has similar proposals pending, including Consol Energy Inc.,  Hess Corp., Chevron Corp. and Anadarko Petroleum Corp.

Of course, environmental and social resolutions generally aren’t binding and many never make it to a vote. Companies often can exclude them on technicalities, and about 30% are withdrawn after their backers negotiate or reach deals with companies.

Typically, the environmental and social proposals that make it onto the ballot receive about 21% of shareholder votes, compared with 33% for shareholder proposals overall, according to EY.

But even failures can have an impact, especially if investors target an issue that resonates with a company’s customers. Activists often cite a 1999 vote to halt sales of wood from old-growth forests at Home Depot Inc. Around 12% of the home-improvement chain’s shareholders supported the proposal, but the retailer stopped selling that lumber.

A handful of these resolutions have garnered a majority of votes. Last year, at fertilizer maker CF Industries Inc., shareholder proposals calling on the company to disclose political contributions and publish a sustainability report each received more than 65% support.

CF Industries initially objected, saying the reports would be costly to produce and “an imprudent consumption of our resources.” But it began producing them after the shareholder votes.

CF spokesman Daniel Swenson said the engagement with shareholders has “resulted in valuable feedback” and contributed to the company’s decision making. He wouldn’t say how much the reports cost to produce.

Shareholder proposals on these issues are expected to gather steam as more companies agree to disclosures. Boston-based Walden Asset Management has submitted several political-spending disclosure proposals to companies this year on behalf of clients. According to Timothy Smith, a director at Walden:

“We’re getting to the point where companies are not just listening to a squeaky shareholder, but doing this because they believe it is a good thing to do for the company,” 

By Emily Chasan at the Wall Street Journal 

Friendly Accounting at Facebook

This post is courtesy of the Accounting Onion


U. S. Senator Carl Levin recently spoke on the Senate floor, referencing the discrepancy between tax and accounting treatment of stock options in the (then upcoming) Facebook IPO:


"According to its filings, when Facebook goes public, Mr. [Mark] Zuckerberg plans to exercise options to purchase 120 million shares of stock for 6 cents a share. Mr. Zuckerberg's shares, obviously, are going to be worth a great deal more than 6 cents, a total of about $7 million; they will apparently be worth more than 600 times as much, something in the neighborhood of $5 billion.


Here's where the tax loophole comes in. Under current law, Facebook can – perfectly legally – tell investors, the public, and regulators that the stock options he received cost the company a mere 6 cents a share – that's the expense shown on the company's books. [This is wrong – see later.] But the company can also – perfectly legally – later file a tax return claiming that those same options cost the company something close to what the shares actually sell for later on – perhaps $40 a share. And the company can take a tax deduction for that far large [sic] amount. So the books show a highly profitable company – profitable, in part, because of the relatively small expense the company shows on its books for the stock options it grants to its employees. But when it comes time to pay taxes, to pay Uncle Sam, the loophole in the tax code allows the company to take a tax deduction for a far larger expense than they show on their books. …


Now, the end result is that a profitable U.S. corporation – a success story – could end up paying no taxes at all for years, even decades."
To Levin, the Facebook IPO is a dramatic illustration of an inequitable "loophole" in the tax law. As Levin and Sherrod would have it, Facebook's tax deduction for using stock options to compensate executives – as opposed to any other form of compensation – would be essentially zero (that's probably a little dramatic on my part, but the point is the same); yet, Zuckerberg's tax liability when he exercises the options could be somewhere in the area of $3 billion.


The strong implication of Levin's narrative is that the extra amount of expenses would have wiped out every dollar of Facebook's reported net income that it had ever 'earned.' On top of that, there could be other outstanding options held by Zuckerberg and other employees extending way down the organization, which are going to have the same effect on future reported net income.


Which brings me to my second question: For all practical purposes, could Zuckerberg be taking Facebook public at this point in time with no history of profitability, perhaps negative shareholders' equity, and perhaps no hopes for earnings for some for years to come?


My inclination is to say "no," but I can only speculate. So, I will answer that question with another question: Since the FASB's rules understate the economic cost of options granted to employees, did the FASB provide a perverse incentive to Facebook to grant more options (or at terms overly favorable) to employees than it should have?


If one accepts the maxim that "what gets mismeasured gets mismanaged," then the answer to that question should be "YES." The stock option problem lies not with the tax rules that eventually recognize the full cost of the options to shareholders, but with the financial reporting rules that allowed Facebook to grant options without recording their full cost.


Surely, the senators can see that different accounting rules would have wrought different compensation policies from Facebook. Senator Levin would not have had a story to tell and Mark Zuckerberg would be a few billion dollars poorer.


Footnote: It is my distinct pleasure to provide Senator Levin (and his staff) with yet another accounting lesson. The amount of expense to be reported by Facebook is not, as the senator claims, the exercise price of the options (i.e., 6 cents per share). Assuming that the options were issued without any intrinsic value, then their "grant-date present value" (i.e., the amount upon which periodic option expense is measured) could end up being more or less than 6 cents per share. Although this technical correction to Senator Levin's story it doesn't fundamentally change the message, it once again reveals a lack of understanding that makes one question if Senator Levin has an adequate grasp on the issues.

CFOs Exit Restating Companies, Study Finds

But they overwhelmingly tend to resign rather than get fired, companies report.
Good article by David M. Katz, of CFO.com

Restatements of financial reports usually convey bad news about a company to the stock market, and CFOs, as chief stewards of financial reports, tend to like nothing less than bearing such tidings. In fact, when companies restate, their finance chiefs show a pronounced tendency to leave, new research confirms. Usually, however, it's their own decision to walk — or at least that's what the companies are reporting.

From 2005 to 2009, companies in general had a 14.88% to 19.47% chance of having a CFO departure in a given year, according to Audit Analytics, a data-research firm. But the situation changed dramatically for companies that filed a restatement. In such cases, the probability of a finance chief leaving in the period beginning three months before and ending nine months after a restatement rose to a range of 19.06% to 28.99%.

The finance chiefs mostly resigned, rather than receiving pink slips. Overall, the companies studied had a resignation rate of between 14.45% and 18.57%, while the restated companies experienced a rate from 18.06% to 27.68%. (The researchers looked at a total of 48,200 10-K filers that also filed an audit opinion over the five-year period.)

Companies rarely report that they have dismissed a CFO regardless of the reason, according to the Audit Analytics report, CFO and Auditor Departures Occurring Near the Issuance of a Restatement. Overall, companies experienced a dismissal rate ranging from 0.40% to 0.99% over the five-year period. If the companies filed a restatement, the chance of a finance chief's dismissal jumped to between 1.00% and 1.30% — a very large difference, but involving very low numbers.

"What a CFO can take out of this [study] is that the chance of getting fired and having it shot out as an 8-K disclosure really doesn't increase near the occurrence of a restatement," says Donald Whalen, the firm's director of research.



But are all those finance chiefs actually leaving on their own? While Whalen says that such information generally can't be gleaned from financial statements, he grants that CFOs threatened with dismissal might negotiate with their employer to have the move reported as a resignation. The "You can't fire me, I quit" scenario may also exist in some cases.

A company, however, has an interest in not reporting turmoil in its senior ranks. To report a resignation rather than a dismissal is usually preferable, says Whalen, because "at least it shows a better relationship than companies that come right out and say, 'Hey, we kicked this guy out.'"

CFOs might also want to take pains to avoid certain types of restatements rather than others. Restatements involving revenue recognition tend to have an especially malign effect on share prices, while those involving corporate cash flow rarely make a dent, according to Whalen.

As is the case with CFOs, companies and their auditors tend to sever relations more frequently during a restatement, according to the Audit Analytics report. For all the companies studied, the departure rate varied from 10.19% to 15.69% during the five-year period. But among those filing restatements, the departure rate rose to between 20.79% and 25.75%.

Politics and Accounting

This article, from an anti globalization rabble-rouser, does contain some interesting stuff.

The Obama administration’s good offices have encouraged the big banks to launch a multi-front offensive to block any measures that would limit their profit-making, and to weaken already existing regulations.

Last February, for example, financial firms and banking organizations launched a multi-million-dollar lobbying drive to change mark-to-market accounting rules that forced banks to report losses or write-downs totaling $175 billion in 2008. Mark-to-market essentially requires banks to value their assets according to prevailing market prices. The banks have balked at this standard, demanding instead the right to assign their own values to their bad debts, using "internal models."

With the aid of $286,000 in campaign donations to the 33 members of a key House subcommittee, the Fair Value Coalition, the lobby group set up by the banks, succeeded in getting the industry rule-making body, the Financial Accounting Standards Board, or FASB, to give the banks immense latitude in suspending mark-to-market rules.

The Wall Street Journal on June 3 published an investigative report detailing the banks’ use of campaign fund monies to get their way. The Journal reported that the banking coalition spent a total of $27.6 million in the first quarter of 2009 on its lobbying effort.

It focused its drive on a House Financial Services subcommittee chaired by Rep. Paul Kanjorski, a Pennsylvania Democrat. Kanjorski received $18,500 from Fair Value Coalition members in the first quarter. Over the past two years, Kanjorski has received $704,000 in contributions from banking and insurance companies, the third-highest among members of Congress.

Barney Frank of Massachusetts, the Democratic chairman of the Financial Services Committee, received $8,500 from the coalition.

Kanjorski and other recipients of the bankers’ largess from both parties grilled the head of FASB, Robert Herz, at a committee hearing on March 12, demanding that he expedite a review of mark-to-market rules and threatening him with a bill to broaden government oversight of his board if he failed to comply.

Herz got the message, and on April 12, in advance of the stress test results and early enough to enable the banks to pad their first-quarter financial reports, FASB announced the changes demanded by the lawmakers.

According to the Journal, the American Bankers Association was the biggest contributor to the campaign funds of committee members in the weeks before the March 12 hearing. The newspaper quotes ABA President Edward Yingling as boasting, "We worked that hearing. We told people that the hearing should be used to talk about the big problems with ‘mark to market,’ and you had 20 straight members of Congress, one after another, turn to FASB and say, ‘Fix it.’"

The Journal notes: "The change helped turn around investor sentiment on banks.... Wells Fargo & Co. said the change increased its capital by $4.4 billion in the first quarter. Citigroup Inc. said the change added $413 million to first-quarter earnings." The newspaper cites a tax and accounting analyst, who estimates that the accounting changes will increase bank earnings in the second quarter by an average of 7 percent.

The Journal quotes Lynn Turner, the former chief accountant of the Securities and Exchange Commission and a former FASB member, as saying "he doesn’t think the banking industry will be satisfied until mark to market accounting is dismantled completely. ‘Despite efforts by FASB to give ground to the banks, enough is never enough, he says."

CEO of Goldman Sachs: Fix System; Keep Mark-to-Market Accounting

Lloyd C. Blankfein, CEO of Goldman Sachs Group, recently endorsed mark-to-market accounting and transparent financial reporting.

In a speech in Washington, Blankfein took a shot at critics of fair value accounting and those who claim that mark to market accounting caused or made worse the current financial crisis.

Blankfein stated: “If more institutions had correctly valued their positions and commitments at the onset, they would have been in a much better position to reduce their exposure,”

“To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk. How can one justify that the same instruments or risks are priced differently because they reside in different parts of the balance sheet within the same institution?”

The full text of his speech is a good read and is reproduced below.

Good morning. I appreciate the opportunity to speak with you today. For more than two decades, the Council of Institutional Investors has committed itself to the values of accountability, transparency, and responsible ownership. I'm pleased to be able to speak to those principles in front of a group that has played such a powerful role in advancing them over the years.

To begin with an obvious point, much of the past year has been deeply humbling for my industry. We held ourselves up as the experts, and the loss of public confidence from failing to live up to the expectations that we created will take years to rebuild. Worse, decisions on compensation and other actions taken and not taken, particularly at banks that rapidly lost a lot of shareholder value, look self-serving and greedy in hindsight.

Financial institutions have an obligation to the broader financial system. We depend on a healthy, well functioning system, but we collectively neglected to raise enough questions about whether some of the trends and practices that became commonplace really served the public's long-term interests.

Meaningful change and effective reform are vital and should naturally emanate from the lessons learned. I will discuss a few of the more important lessons from this crisis. I'd also like to highlight some of the regulatory guideposts that may help us to improve the broader systemic management of risk, increase the level of institutional accountability, and enhance investor confidence.

Without trying to shed one bit of our industry's accountability, we would also further our collective interests by recognizing other contributing causes to the severity of the cycle we are living through.

As a matter of policy, we allowed housing prices to be subsidized, including through implied government support of Fannie Mae and Freddie Mac. We watched as high consumption and low savings rates as well as entitlement spending were increasingly encouraged and financed through the twin deficits.

Factors from both Main Street and Wall Street contributed to today's circumstances. Neither part of our economy acted completely independent of the other. So, any examination of how we got to this point must begin with an understanding of some of the global economic and financial dynamics of the last two decades.

Certainly, what started in a localized part of the U.S. mortgage market spread to virtually every corner of the global financial markets. But the genesis of the problem wasn't in sub-prime. Instead, the roots of the damage to our financial system are broad and deep. They coalesced over many years to create a sustained period of cheap credit and excess liquidity. The resulting underpricing of risk led to massive leverage across wide swaths of the economy -- from households to the corporate sector to the public sector.

I see at least three broad underlying factors:

First, there has been enormous growth in the amount of foreign capital, much of it held in large pools, and a very significant shift in the balance of payments of many emerging markets;

Second, and linked to this, nearly ten years of low long-term interest rates; and

Third, the official policy of subsidizing homeownership in the United States.

Let's take each in turn, beginning with the growth in foreign capital.

Between 1992-2007, the U.S. current account deficit increased by more than 1,300 percent. During the same period, China's current account surplus increased by over 5,700 percent, as did the surplus for the oil exporting nations.

After previous financial crises, emerging economies began to self-insure against a repeat of those events by building up their foreign currency reserves. Their primary objective was to reduce their dependence on dollar-denominated domestic debt.

Of course, the other, perhaps more significant factor in the growth in current account surpluses had been the record run-up in oil prices since 2000. Increases in global savings run almost parallel with the increase in petrodollar flows.

The growth in foreign capital had a profound effect on the global economy. Foreign holdings of U.S. government and corporate debt skyrocketed. China's monthly average purchases of U.S. long-term securities went from less than $2 billion in 2001 to over $15 billion in 2007.

The flood of foreign capital into safe and liquid assets, particularly U.S. Treasurys, helped push relatively low long-term interest rates down even further. And they stayed low, even after the Federal Reserve began raising short-term rates in 2004.

This was accompanied by a significant reduction in inflation. Between the period 1985 and 1995 versus the next 12 years, inflation in advanced economies fell by more than one-half.

Enormous excess liquidity, strong global economic growth, and low real-interest rates created a desire to find new investment opportunities. Many of the best were thought to be in the housing market. The reasons are threefold.

First, governments, particularly the U.S., explicitly supported homeownership through a variety of government programs and initiatives. Second, mortgage assets were considered relatively impervious to sharp downturns. And lastly, the creation of more flexible and varied mortgage products attracted even more capital in search of higher returns.

These factors, to varying degrees, contributed to a housing bubble -- not just in the U.S. but in many other countries as well. While real home prices increased nearly 50 percent in the U.S. between 1998 and 2006, they increased more than 130 percent in Ireland, 120 percent in the U.K. and Spain and over 100 percent in France.

Not surprisingly, in the U.S., mortgage origination as a percentage of total mortgage debt outstanding rose from an average of 6.3 percent between 1985 and 2000 to 10 percent between 2001 and 2006. Subprime debt, in particular, grew from just over 2 percent in 2002 to 14 percent in 2008. In a sustained environment of cheap capital, lending standards for residential mortgages simply deteriorated.

As I have thought about our industry's understanding of the previous years' risks, it is important to reflect on some of the lessons.

At the top of my list are the rationalizations that were made to justify that the downward pricing of risk was different. While we recognized that credit standards were historically lax, we rationalized the reasons with arguments such as: The emerging markets were more powerful, the risk mitigants were better, there was more than enough liquidity in the system.

We rationalized because our self-interest in preserving and growing our market share, as competitors, sometimes blinds us -- especially when exuberance is at its peak.

A systemic lack of skepticism was equally true with respect to credit ratings. Too many financial institutions and investors simply outsourced their risk management. Rather than undertake their own analysis, they relied on the rating agencies to do the essential work of risk analysis for them. This was true at the inception and over the period of the investment, during which time they did not heed other indicators of financial deterioration.

This overdependence on credit ratings coincided with the dilution of the coveted triple A rating. In January 2008, there were 12 AAA-rated companies in the world. At the same time, there were 64,000 structured finance instruments, like CDO tranches, rated AAA. It is easy to blame the rating agencies for their credit judgments. But the blame is not theirs alone. Every financial institution that participated in the process has to accept part of the responsibility.

More generally, risk management will come to define the events of 2007 and 2008. First, models, particularly those predicated on historical data, were too often allowed to substitute for judgment.

In the last several months, we have heard the phrase, "multiple standard deviation events" more than a few times. If events which were calculated to occur once in twenty years in fact occurred much more regularly, it doesn't take a mathematician to figure out that risk management assumptions did not reflect the distribution of actual outcomes. Our industry must do more to enhance and improve scenario analysis and stress testing.

Second, size matters. For example, whether you owned $5 billion or $50 billion of (supposedly) no-risk super-senior debt in a CDO, the likelihood of losses would appear to be the same. But the consequences of a miscalculation were obviously much bigger if you had a $50 billion exposure.

Third, a lot of risk models incorrectly assumed that positions could be fully hedged. After LTCM and the crisis in emerging markets in 1998, new products like basket indices and credit default swaps were created to help offset a number of risks. However, we didn't, as an industry, consider carefully enough the possibility that liquidity would dry up, making it difficult to apply effective hedges.

Fourth, risk models failed to capture the risk inherent in off-balance sheet activities, such as Structured Investment Vehicles. It seems clear now that managers of companies with large off-balance sheet exposure didn't appreciate the full magnitude of the economic risks they were exposed to; equally worrying, their counterparties were unaware of the full extent of these vehicles and, therefore, could not accurately assess the risk of doing business. Post Enron, that is quite amazing.

Fifth, complexity got the better of us. The industry let the growth in new instruments outstrip the operational capacity to manage them. As a result, operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.

Lastly, financial institutions didn't account for asset values accurately enough. I've heard some argue that fair value accounting -- which assigns current values to financial assets and liabilities -- is one of the major reasons for exacerbating the credit crisis. I see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures.

For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in positions that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions. We mark-to-market, not because we are required to, but because we wouldn't know how to assess or manage risk if market prices were not reflected on our books.

While this is not an exhaustive list of what went wrong, our focus is on learning from these lessons and others that will undoubtedly emerge as we work our way through this period.

The administration, legislators, and regulators have begun to consider the important regulatory actions to be taken and our firm pledges to be a constructive participant in that process. In that vein, I believe it is useful, in light of the lessons we take away from this crisis, to consider important principles for our industry, for policy makers and for regulators.

For the industry, we can't let our ability to innovate exceed our capacity to manage. Given the size and interconnected character of markets, the growth in volumes, the global nature of trades and their crossasset characteristics, managing operational risk will only become more important.

Risk and control functions need to be completely independent from the business units. And clarity as to whom risk and control managers report is crucial to maintaining that independence. Equally important, risk managers need to have at least equal stature with their counterparts in revenue producing divisions.

If there is a question about a mark or a disagreement about a risk limit, the risk manager's view should prevail.

Understandably, compensation continues to generate a lot of controversy and anger. We recognize that having TARP money creates an important context for compensation. That is why, in part, our executive management team elected not to receive a bonus in 2008, even though the firm produced a substantial profit. Beyond TARP, public scrutiny, a renewal of common sense and, perhaps, regulation will naturally affect compensation practices going forward.

More generally, we should apply basic standards to how we compensate people in our industry. Compensation should reflect an individual's ability to identify and create value, including his or her contribution to the client franchise, enhancing the firm's reputation and contributing to the better functioning and efficiency of markets.

Equally important, compensation should take into account strict adherence to a firm's management and controls, especially with respect to a person's judgment and exercising that judgment in terms of risk in all of its forms. That evaluation must be made on a multi-year basis to get a fuller picture of the effect of an individual's decisions.

And, individual performance must not be viewed in isolation. Individual compensation should not be set without taking into strong consideration the performance of the business unit and the overall firm. Employees should share in the upside when overall performance is strong and they should all share in the downside when overall performance is weak.

No one should get compensated with reference to only his or her own P&L. Compensation should encourage real teamwork and discourage selfish behavior, including excessive risk taking, which hurts the longer-term interests of the firm and its shareholders.

We also believe it is important to set forth specific guidelines on how we compensate in our industry.

Compensation should include an annual salary plus deferred compensation, which is appropriately discretionary because it is based on performance over the entire year.
The percentage of compensation awarded in equity should increase significantly as an employee's total compensation increases.

For senior people, most of the compensation should be in deferred equity. Only the firm's junior people should receive the majority of their compensation in cash.

As I mentioned earlier, an individual's performance should be evaluated over time so as to avoid excessive risk taking and allow for a "clawback" effect. To ensure this, all equity awards should be subject to future delivery and/or deferred exercise over at least a three-year period.

And, senior executive officers should be required to retain the bulk of the equity they receive until they retire. In addition, equity delivery schedules should continue to apply after the individual has left the firm.

At Goldman Sachs we believe attracting and retaining the best people is vital to our effectiveness and that incentives are an important element in that process. But we also recognize that, misapplied, they can also encourage excess. As an industry, we need to do a better job of understanding when incentives begin to work against the social good rather than for it and take action to redress the balance.

For policymakers and regulators, it should be clear that self-regulation has its limits. At the very least, fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.

While all of us in the industry have a common responsibility to ensure the system's operational integrity, it is not realistic to expect that one firm alone can fix a system-wide problem like unsigned trade confirmations or the establishment of a central clearing facility.

Capital, credit and underwriting standards should be subject to more "dynamic regulation." Regulators should consider the regulatory inputs and outputs needed to ensure a regime that is nimble and strong enough to identify and appropriately constrain market excesses, particularly in a sustained period of economic growth. Just as the Federal Reserve adjusts interest rates upward to curb economic frenzy, various benchmarks and ratios could be appropriately calibrated.

To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk. How can one justify that the same instruments or risks are priced differently because they reside in different parts of the balance sheet within the same institution?

As recognized at the recent G20 summit, the level of global supervisory coordination and communication should reflect the global interconnectedness of markets. Regulators should implement more robust information sharing and harmonized disclosure, coupled with a more systemic, effective reporting regime for institutions and major market participants. Without these, regulators will lack essential tools to help them understand levels of systemic vulnerability in the banking sector and in financial markets more broadly.

In this vein, all pools of capital that depend on the smooth functioning of the financial system, and are large enough to be a burden on it in a crisis, should be subject to some degree of regulation. Yes, that includes large hedge funds and private equity funds.

After the financial shocks and unsettling developments of recent months, I understand the desire for wholesale reform of our regulatory regime. And, in many cases, it is warranted. But we also should resist a response that is solely designed to protect us against the 100-year storm.

As long as human emotions influence decisions, this won't be the last financial crisis the world has to contend with. But, most of the last century has been defined by markets that fund innovation, reward entrepreneurial risk taking and act as an important catalyst for economic growth.

History has proven that a vibrant, dynamic financial system is at the heart of a vibrant, dynamic economy. The U.S. brand of that system has produced growth nearly one-third higher than the rest of the industrialized world over the last two decades.

The events of the last year have put into stark relief the tension between innovation and stability. But, if we abandon, as opposed to regulate, market mechanisms created decades ago, like securitization and credit default swaps, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.

Certain developments of recent decades, like changes in the structure of financial institutions post Glass-Steagall, have brought the risk of less frequent but more intense upheavals. The diverse income streams of mega financial conglomerates reduce the effects of the 10-year storm, but their size and ubiquity exacerbate the consequences of the 20- or 30-year storm.

Over the last several months, there have also been a number of broader policy lessons. Many had previously accepted the bifurcation of Wall Street and Main Street as well as the decoupling of the United States from the international economy. Both have proven false. In 2007, there were pitched debates over whether policy was being geared towards Wall Street at the expense of Main Street. Today, Wall Street remains destabilized, impeding the broader economy.

In terms of international implications, we have also seen actions that, for all intents and purposes, are protectionist and self-defeating. For instance, recent legislation constrains the ability of financial institutions to hire employees through the H-1B visa program. This program helps bring the most highly trained and technical people into our labor market.

The U.S. has always been a magnet for many of the most talented, hungry and qualified people in the world. Especially at this time in our economy, do we really want to tell individuals who will help companies to grow and innovate -- ultimately creating more jobs -- that they should go work elsewhere?

Equally significant and using Goldman Sachs as an example, we have approximately 200 employees who are in the U.S. because of the H-1B program. But, we have 2,000 employees who are working overseas and pay U.S. taxes. Do we want to invite other countries to take punitive measures against us?

This may be a relatively minor issue in the midst of the significant challenges we face, but I think it speaks to a potentially dangerous trend of withdrawing at a time we should do the opposite. While I don't dismiss political considerations, short-term salves like the "Buy America" provision or mandating a certain level of domestic lending will only end up harming the process underlying economic growth.

All along, we have known that market events and economic trends are interwoven on a global basis. But the events of the last year have shown that the connections are more direct and immediate than perhaps we previously appreciated.

In times of economic distress, the relationships between creditor and debtor countries take on even more complex dynamics ... especially as we are the largest debtor. We have learned that when a major financial institution fails in a debtor country, a creditor country is likely to pull back from its financing relationship in one way or another and, maybe, in every way.

For the United States at this time, the relationship is not just a matter of here and abroad; it is also a relationship between a debtor and its creditors. Certain of our economic decisions that have implications for our international partners could reverberate back to us very quickly and with great consequences in the current environment.

I want to conclude today with the following thought: We are fighting for nothing less than the immediate health and security of every person. We can never forget the products of economic growth -- more accessible health care, better education, less crime, tolerance of diversity, social mobility and a commitment to democracy.

In so many respects, change is the order of the day. We have much to do to repair our financial system and reinvigorate our regulatory structure. At the same time, our financial system, rooted in the belief of putting risk capital to work on behalf of ideas and innovation, has helped produce a long-term record of economic growth and stability that is unparalleled in history.

We have to safeguard the value of risk capital, which is at the heart of market capitalism, while enhancing investor confidence through meaningful transparency, effective oversight and strong governance. But, there should be no doubt: Markets simply cannot thrive without confidence.

Though honest disagreements will occur, the best companies don't shy away or selfishly frustrate efforts to compel better industry practices. These companies recognize that they are the first to benefit from better standards, especially if their business requires extensive dealings with partners or counterparties. But, we have to recognize a higher responsibility: to speak up, to draw attention to potentially destabilizing trends and to act like an owner responsible for the integrity of the system.

I, for one, know we have not done the best job in the recent past but working with you, as many of the world's most important investors, Goldman Sachs pledges to recommit itself to this fundamental obligation.

Thank you very much.

FASB Approves Fast Tracked Fair Value Changes

The FASB voted to adopt its most recently proposed changes to fair-value rules. The changes to mark-to-market accounting rules will now allow companies to use “significant judgment” when pricing certain investments in distressed or inactive markets. Analysts say the changes may reduce banks’ write-downs and goose Q1 earnings.

Congress had threatened FASB Chairman Robert Herz at a March 12 Senate hearing to change the fair-value rules or Congress would unilaterally. FASB came out with changes four days later, and fast-tracked them on a two-week comment period. Investors and accountants opposed the changes.

Arthur Levitt is chair of the Investors Working Group and commented “The group is deeply concerned about the apparent FASB succumbing to political pressures, which prevent U.S. investors from understanding the true obligations of U.S. financial institutions.”

A few reference points in the debate on fair value:
Arthur Levitt’s remarks to Congress
FASB Technical Accounting Advisory Group views on MTM
The long-running campaign by banks against fair value
Summary of the rule changes
Politics and Accounting
CFO Views on MTM
The Politics of Fair Value
A Warren Buffet Advisor’s View on MTM
Former SEC Chair Comments on Independence of Accounting Standard Setters

WSJ Says Banks Making Bogus Claims about Mark-to-Market

At times Wall Street Journal articles almost seem to be written by bank lobbyists. Below is an opinion piece that refutes the banks' claims that MTM is wrecking the banking system and the economy.

Accounting Rules Should Avoid Impairment

Plenty of banks have succumbed to the credit crunch. Now, accounting rules look set to join the list of casualties.

Accounting rule makers will vote Thursday on proposals to soften "mark-to-market" accounting, the controversial rules requiring companies to peg their investments' value to the market's ups and downs. Many banks blame the rules for worsening their current problems, by locking in losses that they say are merely temporary.

The banks' claims are largely bogus -- after all, no accounting rule forced them to create and invest in the toxic securities that helped cause this crisis. But the Financial Accounting Standards Board is being pressured to water down the rule.

And one of the proposals that the board will vote on Thursday, to relax the standards under which companies must take impairment charges on their "available-for-sale" investments, would be particularly worrying for investors.

Companies record declines in their value of these securities as "unrealized" losses that get assessed on the balance sheet but don't affect earnings or regulatory-capital levels.

If the losses are later determined to be "other than temporary," however, companies must take impairment charges that lower net income and regulatory capital.

FASB's proposal makes it much less likely that stressed banks would take those charges in a timely fashion. Under the plan, all banks would have to do is say they don't intend to sell an "available-for-sale" investment that has incurred mark-to-market losses and probably won't be forced to sell before it recovers. Then, only "credit losses," the amount a company expects to lose if it holds an investment to maturity, would have to be recognized in earnings. The other declines in market value would only go onto the balance sheet, as now.

The loophole is big enough to fit a bloated bank balance sheet through: The risk is that banks wouldn't admit to a major credit loss on such securities unless the losses really were so obvious they simply couldn't be ignored. Banks could instead try to explain away low market values because of external factors such as liquidity risk, and many losses would never get recognized on the income statement.

That could be very important for some banks where toxic securities, with serious mark-to-market losses, comprise a big part of the capital structure. The unrealized losses on "available-for-sale" securities in effect for at least a year are equivalent to 6.6% of risk-weighted capital at U.S. Bancorp and 3.2% at Wells Fargo. That is another reason why investors should focus on tangible common equity as a capital measure instead, which does include such unrealized losses.

A rule change would be good for the banks -- not good for investors who need accurate valuations of companies' assets, reported clearly, on which to base their investment decisions. In fact, making things easier on the banks may only make already-cynical investors even more suspicious of the numbers that the banks are reporting.

This is happening now because of pressure on FASB Chairman Robert Herz from politicians who, at a recent hearing, threatened to eviscerate fair-value accounting if the changes didn't happen. So it isn't just the fair-value rules that are at stake here -- it is FASB's independence in setting all accounting rules. The risk is that plans to water down mark-to-market rules are only the start.

By Michael Rapoport at the Wall Street Journal.

Selling Your Soul for $186,000 a year

The SEC complaint against Bernie Madoff's auditor, alleges that David Friehling enabled Bernard Madoff's Ponzi scheme by falsely stating, in annual audit reports, that F&H audited Madoff's financial statements. In fact, the complaint alleges, the defendants did not conduct anything remotely resembling an audit.

Friehling & Horowitz is enrolled in the program but hasn't submitted to a review since 1993, says AICPA spokesman Bill Roberts. That's because the firm has been informing the AICPA -- every year, in writing -- for 15 years that it doesn't perform audits.

Meanwhile, Friehling & Horowitz has reportedly done just that for Madoff. For example, the firm's name and signature appears on the "statement of financial condition" for Madoff Securities dated Oct. 31, 2006.

New York state is one of only six states that does not require accounting firms to be peer-reviewed. Recently, the New York State senate passed legislation that requires such a process.

F&H also allegedly made false representations that BMIS financial statements were presented in conformity with GAAP. Finally, Friehling allegedly falsely stated that he had reviewed internal controls at BMIS, including controls over the custody of assets, and found no material inadequacies.

If properly stated, the Madoff financial statements, along with related disclosures regarding reserve requirements, allegedly would have shown that the firm owed tens of billions of dollars in additional liabilities to its customers and was therefore insolvent. The complaint alleges that Friehling and F&H obtained ill-gotten gains through compensation of $186,000 per year from Madoff. They are also accused of withdrawing $5.5 million from Madoff funds held in the name of Friehling and his family members (with a balance of $14 million as of November 2008).

The Old Fake Auditor Trick

Following is the story of a hedge fund that allegedly defrauded investors and eluded regulation over several years by having a non-existent auditor.

In the Westgate case, the SEC charged that James M. Nicholson and his company, Westgate Capital Management, an investment management firm based in Pearl River, N.Y., defrauded investors of millions of dollars by significantly overstating investment returns and misrepresenting the value of assets under management in 11 unregistered hedge funds.

The SEC's complaint alleges that Nicholson and Westgate solicited new investors with sales materials that claimed a nearly impossible record of investment success, including one Westgate fund that claimed positive returns in 98 of 99 consecutive months.

Nicholson also allegedly created a fictitious accounting firm and provided some of his investors with bogus audited financial statements. By late 2008, the funds had sustained such losses that Nicholson and Westgate could no longer honor redemption requests.

They allegedly hid the losses from investors with misrepresentations, false sales brochures and other deceptive devices. Nicholson closed one fund that was heavily invested in bankrupt Lehman Brothers and folded its assets into another Westgate fund.

Nicholson allegedly issued bad checks to some investors seeking to cash out, and ultimately suspended all investor redemptions due to what he called investors' "irrational behavior." Nicholson was already barred from the brokerage industry in 2001 for failing to reply or supplying false information in response to inquiries.

The SEC is prosecuting the case.

Arthur Levitt: FASB Caved in to Banks and Political Pressure

Arthur Levitt, former chair of the SEC doesn't like the FASB/IASB changes to mark to merket rules. Some of his comments:

The FASB's proposal goes against what we know investors prefer: Stronger rules for the reporting of changes in the values of investments in income statements. Under the proposed rule, no matter how toxic the investment, whether it's a penny stock or the bonds of a government ward such as AIG, companies can choose to largely ignore the fundamental reasons behind the investments' decline. All that companies have to do is say they don't intend to sell those investments until their value rebounds.

Such a subjective judgment is bound to decrease investor confidence in reported income.

In a strange twist of fate, the FASB's proposals may create even greater opportunities for short sellers who are adept at digging into numbers that do not tell the whole story.

The real scandal here is not the decision by the FASB, rather it is how the independence of regulators and standard-setters is being threatened. This isn't just about the income statements of banks. It's about further eroding investor confidence, precisely at a moment when investors are practically screaming for more protection.

In seeking to protect its independence, the FASB has surrendered some of it in the bargain.

Independence from public pressure has a value, and when you give some of it away, you've lost something that takes years to rebuild.

The rule change agreed to by the FASB on Tuesday followed only one public meeting on this topic, and the board is giving investors just two weeks to comment, with a final vote the next day. This is a rush job.

The FASB should rethink its approach to these rules.

Above all, the Securities and Exchange Commission should take a firm stand on the side of investors and vigorously resist all political efforts to reduce the independence of financial rule-making agencies and boards.

Investors once believed that U.S. markets were sufficiently protected from political pressure and manipulation by a system of interlocking independent agencies and rule-making bodies -- some government-run, some not. That system is being dismantled, piece by piece, by political jawboning and rushed rule rewrites. Now, investors find themselves with fewer protections and weakened.

Full article here.

Bernanke: Keep, Improve Mark-to-Market Accounting Rules

U.S. Federal Reserve Chairman Ben Bernanke has supported accounting rule makers in their efforts to determine how to apply mark-to-market rules in illiquid markets such as the recent financial crisis. The banking and investment community has blamed accounting rules that they feel are too strict for worsening the global financial crisis. At issue are valuations for assets previously traded as liquid assets that suddenly become illiquid when markets freeze up.

The mark to market rules (“MTM”) require companies to write down assets every quarter to reflect market value. Bernanke doesn’t fully agree completely with the banks, who have always rejected fair value.

In testifying before a U.S. Congressionsl Committee this week, Bernanke said:

MTM is “a good principle in general” and shouldn’t be suspended completely.
“Accounting authorities have a great deal of work to do to try to figure out how to deal with some of these assets, which are not traded in liquid markets,”
“I don’t see a suspension of the whole system as being constructive, because there is a great deal of information in valuing many of these assets.”

Bankers hold strong and long-standing views that mark-to-market accounting has harmed banks and the economy. They say that harm comes from rules that require banks to state investments at fair-value, and that that accounting doesn’t work in illiquid markets because there isn’t enough market data to determine the real value of assets. Treasury Secretary Geithner, the SEC, the FASB and the international Accounting Standards board (IASB) all have stated that the rules should stay because they enhance transparency of corporate reporting.

The SEC wants to keep fair-value accounting, despite calls from the banks to suspend the fair value rules until the financial crisis is over or until the rules can be sorted out. An SEC report released in December advocated that the fair value rules should be improved. They also countered bank claims, saying that “[fair value] did not appear to play a meaningful role” in bank failures last year. The FASB is currently engaged in a study to clarify how the mark to market rules apply when markets are inactive.

Got Goodwill? Part 11: Bad News

News Corp reported writedown of $8.4 billion on Dow Jones and other assets. The impairment charge mainly consisted of a $4.6 billion writedown of the value of its broadcast licenses and a $3.6 billion writedown of goodwill in its newspaper and information services group.

News Corp purchased Dow Jones, the publisher of the Wall Street Journal, in 2007 for an estimated $5.6 billion. It did not say how much of the writedown related to that acquisition.

News Corp's market cap is about $18 billion.

Chairman Rupert Murdoch: "While we anticipated a weakening, the downturn is more severe and likely longer lasting than previously thought."

Fair Value, IFRS and Obama

Paul Volcker is the Chair of Obama’s financial advisory team and Chairman of the Trustees of the "Group of Thirty". Recently the Group of Thirty Working Group on Financial Reform published Financial Reform A Framework for Financial Stability. Volcker alsonhas an important history, as Chair of the U.S. Fed and as Chair of the IASB's oversight organization. he is thought to be a propornent of IFRS in the U.S. Below are a few comments by Volcker and an excerpt from the Fair Value section of the report. Fair Value was important enough to comprise one of 17 recommendations in the report.

Quotes from Chariman Volcker:

"The issue posed by the present crisis is crystal clear: How can we restore strong, competitive, innovative financial markets to support global economic growth without once again risking a breakdown in market functioning so severe as to put the world economies at risk? We hope that our proposals, which explicitly relate to the weaknesses that have become evident in the financial system over the last year, will be a useful contribution to the debate about needed reforms both by private financial institutions and by public authorities."

"The pervasive and deep-rooted financial crisis has amply demonstrated that our financial system is broken and it requires thorough-going repair,"

There were no representatives from the accounting community on the group that authored the report.

Excerpt from: FINANCIAL REFORM A Framework for Financial Stability

Fair Value Accounting
Recommendation 12:

a. Fair value accounting principles and standards should be reevaluated with a view to developing more realistic guidelines for dealing with less liquid instruments and distressed markets.

b. The tension between the business purpose served by regulated financial institutions that intermediate credit and liquidity risk and the interests of investors and creditors should be resolved by development of principles-based standards that better reflect the business model of these institutions, apply appropriate rigor to valuation and evaluation of intent, and require improved disclosure and transparency. These standards should also be reviewed by, and coordinated with, prudential regulators to ensure application in a fashion consistent with safe and sound operation of such institutions.

c. Accounting principles should also be made more flexible in regard to the prudential need for regulated institutions to maintain adequate credit loss reserves sufficient to cover expected losses across their portfolios over the life of assets in those portfolios. There should be full transparency of the manner in which reserves are determined and allocated.

d. As emphasized in the third report of the CRMPG, under any and all standards of accounting and under any and all market conditions, individual financial institutions must ensure that wholly adequate resources, insulated by fail-safe independent decision- making authority, are at the center of the valuation and price verification process.

SEC Roundtable: Accountants Battle it Out

SEC Gets Conflicting Advice On Mark-to-Market Accounting

U.S. securities regulators received conflicting advice Wednesday on whether to dispense with mark-to-market accounting rules that critics say are deepening the nation's economic woes.

The issue was debated at a public forum at the Securities and Exchange Commission, which is under pressure to suspend or repeal mark-to-market accounting for certain financial instruments. Congress ordered the SEC to examine the matter and provide a written report by Jan. 2. SEC Chairman Christopher Cox said regulators will hold a second public session on the topic on Nov. 21, and seek written input from the public through Nov. 13.

Supporters and opponents of fair-value, or mark-to-market, accounting clashed at Wednesday's session on whether the approach is helping or harming investors.

Former Federal Deposit Insurance Corp. Chairman William Isaac called for fair- value accounting to be suspended or repealed immediately, saying it is " transparently wrong" and "senselessly destructive" to force companies to slash the values of loans and other financial assets to unrealistically low levels.

Yet changing the rules on fair-value accounting could increase uncertainty among investors and make markets more anxious rather than less, countered University of Chicago accounting professor Ray Ball.

"I think it would be a terrible shame if we shot the messenger and ignored the message," said Ball.

PricewaterhouseCoopers LLP partner Vincent Colman defended the current rules and said the Norwalk, Ct.-based Financial Accounting Standards Board should be kept "free from political pressures" and undue outside influence.

Although the SEC oversees the FASB, it rarely overrules it. Isaac recommended more direct oversight, requiring U.S. accounting rules to be approved by the Federal Reserve and the Federal Deposit Insurance Corp. He endorsed a return to historical accounting, which values assets and liabilities at their original cost, terming that vastly superior to the more volatile mark-to-market approach.

Mark-to-market accounting rules require companies to adjust valuations of certain assets and liabilities they intend to trade or sell to reflect current market prices. Critics say it makes earnings too volatile and intensifies market downturns. Even supporters of the approach concede that it is much harder to apply when markets aren't functioning normally, requiring companies to estimate values using computer models, or look to distressed "fire-sale" transactions.

While it's "deeply deluded" to think some battered assets will recover anytime soon, efforts to value something that isn't trading could produce "mark to mush, " worried AFL-CIO associate general counsel Damon Silvers.

"There is a real risk that things here are not what they seem to be," said Silvers.

Mark-to-market accounting rules also are crimping mergers because companies have to adjust valuations of assets they acquire even if they don't intend to sell them, a nasty side-effect that only makes bad markets worse, warned Aubrey Patterson, chairman and chief executive of BancorpSouth Inc. (BXS), based in Tupelo, Miss.

Cleveland-based KeyCorp (KEY) abandoned some acquisitions for that reason, according to accounting policy director Chuck Maimbour. He said the bank "just couldn't make it work" and walked away from deals due to the potential hit from mark-to-market accounting rules.

PwC's Colman suggested that the current fair-value accounting rule could be tweaked to distinguish between actual credit losses and other factors, such as declines in value due to illiquid markets. The idea drew a mixed response, with some questioning whether companies could make such calls easily, or if that would make it even harder to determine the fair value of an illiquid asset.

Cindy Ma, a managing director and valuation expert with Houlihan Lokey Howard & Zukin, said she would be afraid to use that approach, fearing it would rely heavily on computer models that "can be manipulated," and create a "nightmare" for auditors who have to sign off on a company's financial reports.

Swiss Reinsurance Co. (SWCEY) Managing Director and Chief Claims Strategist Richard Murray, who chairs the U.S. Chamber of Commerce Center for Capital Markets Competitiveness, said there is no easy way to value a company, with or without mark-to-market accounting rules. He stressed the need for companies and auditors to bring judgment to bear and asked regulators to consider offering a "safe harbor" from legal liability for honest valuation mistakes.
By Judith Burns, Dow Jones Newswires

PricewaterhouseCoopers' Survey: Bank, other Financial Services Board Members Say Mark to Market is Not to Blame for Crisis

Pricewaterhouse Coopers recently completed a survey of 300 board members, two-thirds of whom sit on the audit committee of financial institutions, taken between September 22nd and October 4th at the 2008 PricewaterhouseCoopers Financial Services Audit Committee Forum.

Respondents were surveyed about mark to market accounting: Nearly two-thirds (65%) of financial services board members surveyed agree that mark-to-market accounting, also known as fair valuation, creates volatility in the markets. However, 83 percent disagreed with the statement that mark-to-market accounting is to blame for the current credit crisis.

About the current financial crisis:

• 30 % view the situation as a reminder of the need for more disciplined risk taking during periods of growth
• 20 % say it is a reflection of too much focus on the short-term (investing, reporting, compensation).
• 13% found the positive in the tumultuous economic climate and regard the situation as an opportunity that will eventually strengthen the financial services industry.
• 25%sees this as an example of the urgent need for modernization of the financial services regulatory framework to reflect today's global, integrated capital markets system.

Other findings:

• 96 percent of board members said they think that financial institutions that retain risks to off-balance sheet entities should in the future publicly disclose aggregate information on a regular and timely basis, including the quantity and sensitivity to credit, market and liquidity risks and any changes to those risk exposures over time.
• 65 percent of respondents feel that corporate boards lack the tools and transparency to properly assess risks and exposure.
• 88 percent said the scope of risk management for financial institutions does not adequately account for their exposure to off-balance sheet entities.
• 80% feel they could do more to reduce the chance of future industry instability, according to findings of a survey released today by PricewaterhouseCoopers' Financial Services Industry Group. However, the survey also revealed a desire for greater transparency to accurately measure exposure to risk.
• More than 95 percent of the board members asked said they believe greater clarity is required as it relates to what is and what is not reported on an organization's balance sheet
• 77 percent said existing valuation tools are not robust enough.
  

When asked to rank their four top priorities over the next twelve months, audit committee board members ranked them as follows (in order of importance):

• Transparency and financial reporting
• Internal controls and tightened margin/collateral controls
• Enterprise-wide risk management and buy-in from business lines
• Systematic risk management across the industry

The Bankers’ Case Against Fair Value--Going Back 20Years

The American Bankers’ Association has launched its latest salvo in its long-running opposition to fair value use in financial institutions. The bankers have have written to Henry Paulsen asking for changes to the mark to market rules and have asked the SEC to force a change as well. The Bankers state that the most recent pronouncements of the FASB/SEC so not address current problems.

The Bankers’ case goes back a long way--at least as far as 1999 (and further) with the release of this comment letter, back when the the FASB first began to advance the case for greater fair value use in determining the income of financial institutions. Portions of their case from that letter (remember this is from 1999):

• Users of bank financial statements do not support the proposed change to full fair value accounting. This is because a full fair value system does not provide a sound basis for predicting banking book net cash flows and lacks relevance.
• Banking book income is earned on an ongoing basis over time and not from taking advantage of short term fluctuations in prices; the accruals accounting method provides a dynamic and faithful representation of both this earning process and the manner in which a bank’s management operates. It, therefore, provides a more relevant and reliable representation of this earning process. A notional fair value snapshot taken at a historic balance sheet date fails to achieve this.
• The reality is that fair values for a banking operation are significantly more subjective than values derived under the mixed measurement accounting model and this would reduce both the reliability and comparability of financial statements.
• Within any given accounting measurement model, it is not possible to encapsulate in a single measure everything that an investor needs to know. Both fair value and historical cost accounting need to be supplemented by appropriate risk-based and other disclosures in order to provide investors with a complete picture.
  

The Bankers' points in other older comment letters are eerily relevant to today’s dilemma: "Notwithstanding the development of securitization techniques and credit derivatives, it remains the case that customer loans are generally held to maturity by banks without variation of the original contractual terms of the loan. Accounting for these loans on an historical cost basis, therefore, most closely reflects the economic substance and cash flows, namely, that income is earned over the period of the loan. The bank is exposed to risk on the non-repayment of the principal advanced. "

"It has been argued that the fair value of a customer loan provides relevant information about the current credit quality of that loan; as a borrower’s credit standing deteriorates, the credit spread demanded rises and therefore the fair value falls and a loss occurs. However, this loss is theoretical because the widening of the spread neither has an impact on the existing loan contract nor on the ultimate repayment of the loan in the majority of cases. "

We do not support the FASB's move toward fair value accounting. This will have a significant impact on all industries and will significantly impair the comparability of financial statements. The indication on the FASB's website that the IASB " believes that the fair value option will enable constituents to become more familiar with using fair value as a measurement attribute for financial instruments" is frightening. Experimental accounting, without sufficient study, should not be used for financial reporting measurement purposes, particularly because it can have such a significant impact on an entire industry. If this is the goal, then the FASB and IASB should provide a discussion document for comment on fair value. This document would need sufficient study and consultation with industry and users prior to issuing a standard. Without sufficient study, this experiment could fail. The indication on the FASB's website that the IASB " believes that the fair value option will enable constituents to become more familiar with using fair value as a measurement attribute for financial instruments" is frightening. Experimental accounting, without sufficient study, should not be used for financial reporting measurement purposes, particularly because it can have such a significant impact on an entire industry.

Canary In the Fair Value Coal Mine

In his public blog at the AAO Weblog (Public), (which is required reading for anyone connected to the world of financial reporting) Jack Ciesielsk has one of his usual highly insightful, hard hitting posts, reproduced in its entirety below.

Take a moment away from the financial horror show you've been watching for weeks to contemplate an imaginary one: a coal mine disaster. After the dust settles and rescue efforts are mounted, a canary is lowered into the coal mine - and it promptly keels over. What to do?Well, if you're Congress the answer is obvious: you launch an investigation of the canary-breeding industry, because there must have been a genetic flaw that made the canary susceptible to the stress induced by the mine shaft's impure air.

That is the kind of logic being shown in the halls of Congress these days when it comes to figuring out the troubles roiling the capital markets. Fair value reporting in the financial system is the canary in the coal mine that informs investors when companies have made poor investment decisions and have dubious capital levels. If it's telling us unpleasant news about the state of things, then it can't be right. Order up an investigation of the canary-breeding industry, and that looks like what Alabama Congressman Spencer Bachus is intending to do in this letter to Representative Barney Frank.

It can't be that fair value reporting might actually be saying something about the financial condition of banks; there must be something wrong with fair value reporting. So let's investigate. It's conventional wisdom and political hay-making at its worst. It's testament to the low regard for investors held by Congress and the firms thirsty for their capital. Don't give them figures in balance sheets that show the state of the economic world as it IS; show investors the world the way we think it SHOULD be. That's a very dangerous idea that will probably be extended to other areas of financial reporting when other financial after-effects of current market instability begin to show.

[One possible area: pensions. While there are plenty of GAAP-permissible ways to minimize the funding level damage being currently wrought by markets, there are bound to be outcries over the fact that firms now show the unfunded balance of plans in their balance sheet more clearly than a couple years ago before Statement 158 went effective. The same kind of illogic applied to investigating and neutering fair value accounting could well be extended to pension and other benefits reporting. Let's hope not.]

To repeat one more time: fair value reporting is nothing new; firms have always had to report assets at what they're worth. Statement 157 did not extend fair value reporting to any new areas of balance sheets; it just gave investors more information about the integrity of fair values reported. And right now, integrity is pretty far out of fashion when it comes to the banking industry and Congress.

Mark to Market--the Middle Ground

In its current cover story, “Let it Flow”, Barrons provides some insights into the middle ground on mark to market accounting.

"Ending the credit crisis will be highly unlikely without some type of accounting accommodation," according to Bridgewater Associates, the highly respected institutional money manager. "Because mark-to-market accounting on existing assets threatens bank capital today, it increases solvency concerns today, which raises funding costs and accelerates the need to sell assets today, which depresses the prices of those assets, which threatens capital and raises funding costs.

This cycle can be broken if banks communicated an accurate or conservative assessment of the fair value of their assets in the footnotes of their financial statements, thereby telling equity and bond investors what they need to know to value the company. But if these losses were accrued over the remaining life of the assets, thereby avoiding the immediate hit to the book value of capital, the selling pressure would be reduced, which might even allow prices to rise and reverse the cycle and improve sentiment. This seems pretty obvious without any knowledge of history, but history overwhelmingly confirms the need for such a change."

Bridgewater's proposal isn't the same as more radical suggestions to suspend so-called fair-value accounting. Indeed, ignoring current market values of assets would only heighten the lack of faith investors display for current book values.

"Many of the current requirements stem from the Savings & Loan crisis in the 1980s, when we learned that not knowing the real, current values of financial instruments held by financial institutions can be devastating when the bubble finally bursts and institutions are forced to close their doors," executives at the Center for Audit Quality wrote in a letter to the heads of the Fed, Treasury and SEC, urging them not to back off from mark-to-market standards.

But there should be a middle ground between simply accepting a historical cost and forcing assets that are not in default to be written down to current prices, notably those based on indexes of credit derivatives that frequently diverge from the prices of the actual underlying assets.

Last week, the SEC and the Financial Accounting Standards Board attempted to forge such a via media, or middle way. When no active market for a security exists, management may estimate values from market expectations of future cash flows and an appropriate risk premium, they wrote in a release. In other words, assets don't have to be valued based on current low-ball bids in a dysfunctional market. But the assets do have to reflect reasonable expectations of their payoff and risks, to satisfy investors and auditors. Does Arthur Andersen ring a bell?

THE KEY REASON TO limit mark-to-market losses is to preserve capital, whose conservation is the main constraint on the financial system.

Wolves Circle Mark to Market

Momentum Gathers to Ease Mark-to-Market Accounting Rule
Critics of the proposed changes to the "mark to market" rules say gains created by easing the rules would be illusory and would delay resolving genuine doubts about the value of mortgage assets that has caused the recent crisis in confidence. As of Wednesday, the industry appeared to be gaining support for easing the rules, in part because some lawmakers believe it could cut the cost of a potential financial-industry bailout.

Banks and a diverse coalition of lawmakers scored a victory on the issue Tuesday, when the SEC and Financial Accounting Standards Board issued "clarification" to the mark-to-market accounting rules.

The SEC and FASB stopped short of bowing to pressure for a complete suspension of fair-value accounting. But that pressure could intensify when the rescue bill reaches a House vote. Financial-industry lobbyists' work on the financial-markets bill has given them another opportunity to press their case through allies in Congress, many of whom are big recipients of campaign money from the industry. More than 60 lawmakers -- all but five of whom voted against the bill Monday -- wrote to the SEC Wednesday, urging the regulator to immediately suspend the mark-to-market rule.

Accounting firms and investors groups put up a united front Wednesday in opposition to the changes. "Suspending fair value accounting during these challenging economic times would deprive investors of critical financial information when it is needed most," said the Council of Institutional Investors, Center for Audit Quality and CFA Institute in a joint statement. "It would not help solve our economic difficulties."

Republican presidential candidate John McCain, in a statement, praised the SEC clarification, saying, "There is serious concern that these accounting rules are worsening the credit crunch, making it difficult for small businesses to stay afloat and squeezing family budgets."

"We have all seen what can happen when institutions are allowed to mask huge losses in asset values," PricewaterhouseCoopers LLC Chairman Dennis Nally wrote in a letter to Congress. Suspending the rules, he said, could "plant the seeds for the next crisis."

That hasn't swayed fiscal conservatives in the House, who cite the need to suspend mark-to-market rules in explaining their opposition to the rescue bill. "One of the best reasons to fire [SEC Chairman] Chris Cox is the refusal to deal with the problem of mark to market," Rep. Darrell Issa (R., Calif.) said on MSNBC this week. "You do that, and you put trillions of dollars back into the lending pool. ... It's a tool that's available [to] the SEC, the Fed, the FDIC and the Treasury secretary, and they're not using it."

Is Debate Over Mark-to-Market Just a Waste of Time?
In an excellent post on the Curious Capitalist blog, Justin Fox makes a point that may make the whole debate moot. “Investors and regulators and reporters and corporate executives need to learn not to take any financial reporting numbers, whether marked-to-market or not, at face value. The health of a bank or any corporation can never be adequately measured by a single bottom-line number. Understanding the assumptions and uncertainties inherent in accounting numbers is crucial to understanding how to use them,” he writes.

In the current environment, everyone seems to be taking Fox’s advice. That may be one reason why these markets are frozen in the first place. Even if mark-to-market rules are suspended immediately, it won’t change the makeup of a company’s balance sheet. Investors have decided that these assets are toxic and no matter how a bank accounts for them in its books, that sentiment isn’t likely to change unless investors see some proof that the instruments are actually undervalued. So far, there’s been little to suggest otherwise.

Steve Forbes: Ease Mark-to-Market Rules
Famed business magazine publisher Steve Forbes says there's a relatively simple way to help solve the financial mess on Wall Street — ease mark-to-market accounting rules. "Short-term assets should not be given arbitrary values unless there are actual losses. The mark-to-market mania of regulators and accountants is utterly destructive. It is like fighting a fire with gasoline," Forbes wrote in the Oct. 6 issue of Forbes magazine.

Forbes recommends that investors think of the mark-to-market mess by using the following metaphor: A person buys a house for $250,000 and then takes out a $250,000 fixed-rate mortgage for 30 years. The person's income is adequate to make the monthly payments. "But under mark-to-market rules, the bank could call up and say that if your house is not sold immediately, it would fetch maybe $200,000 in such a distressed sale. The bank would then tell you that you owe $250,000 on a house worth only $200,000 and to please fork over the $50,000 immediately or else lose the house," said Forbes.

"Absurd? Obviously. But that's what, in effect, is happening today. Thus, institutions with long-term assets are having to drastically reprise them downward. And so the crisis feeds on itself."

Making the case for mark-to-market rules
There's a segment of the political and banking world that wants to toss out mark-to-market accounting rules, on the logic that they create those nasty, inconvenient writedowns. There's a growing constituency telling regulators and politicians to leave mark-to-market accounting rules just as they are, thank you very much.

There is no debate over the real financial pain that can result when the value of a illiquid, complex security has to be pegged in a market plagued by unprecedented chaos. But the alternative to pain is denial, or worse.
Trust me accounting – allowing banks and other financial players flexibility in setting the values of securities they hold - isn't likely to solve the credit crunch. It's just going to make it worse. It creates an enviorment rife with uncertainty, and open to fraud.