Wednesday, December 13, 2006

Busy agenda for SEC today -- SOX 404, deregistration and mutual funds

Today's open meeting of the SEC (currently being webcast and in the future archived here) has several significant items on the agenda:

  1. New exemptions for banks that have stock brokerage arms (see here);
  2. New SEC guidance on management's implementation of Sarbanes-Oxley Section 404;
  3. A new rule proposal to permit foreign private issuers to deregister from the SEC;
  4. A new rule proposal on who can invest in hedge funds;
  5. A new rule proposal on the internet availability of company proxy materials; and,
  6. An additional request for comment on whether mutual fund company chairmen should be separated from the mutual fund's top manager.
The new management guidance on SOX Section 404 is designed to make it much less costly for U.S. and foreign companies to implement the internal controls requirement of the Act. It pushes auditor testing of a company's internal controls into a "risk-based" and "scalable" model designed to reduce auditing costs and relieve some of the burden on smaller companies. The guidance actually offers relatively few examples of what it means, in an effort to make the guidance more of a "principle" and less of a "rule". (Examples tend to become rules under the U.S. securities law system -- lawyers tend to point to the examples the SEC gives as a bright-line description of what is permitted, even if the example, applied to a particular circumstance, doesn't seem to apply.) Ironically, this approach was criticized by SEC Commissioner Paul Atkins, who said that the lack of examples doesn't provide enough comfort to issuers. (Didn't I say this would happen? For example, here?)

The new foreign issuer deregistration proposal greatly increases the abilities of foreign issuers to leave the U.S. market and stop following all those pesky SEC rules. Currently, it is relatively easy for a foreign company to "delist" from a U.S. stock exchange, but even when a foreign issuer does this, it is still required to make financial disclosures and follow other SEC rules unless it has less than 300 (or 3000, depending on the circumstances) U.S. resident shareholders. Of course, many foreign companies that have never even sold shares in the United States have more than 300 U.S. shareholders, since U.S. residents often invest abroad. Consequently, this rule has been called the "Roach Motel" rule (roaches check in, but they don't check out) or the "Hotel California" rule (you can check out but you can never leave). The new proposal says that a foreign issuer can deregister with the SEC if less than 5 percent of its total trading occurs in the U.S. This was a compromise decision -- some in the SEC wanted a rule that said that a foreign issuer could leave if 25 percent or less of its shareholders were outside the U.S., others wanted something that said 5 percent but excluded institutional investors, still others argued for drawing a distinction between where the U.S. investors bought their shares (in the U.S. or abroad). The new proposal is designed to be something easily measured and achievable, while still offering a modicum of protection to U.S. investors (though this could be argued).

Unlike previous preposals, it does not focus on actual U.S. ownership of the foreign securities, but where these securities are traded. (Also, the proposal focuses exclusively on secondary trading. If you had an initial offering in the U.S., you're still on the hook.) There is also a 12 month waiting period between when securities can be traded on the U.S. market and when a foreign company could seek deregistration. The focus on trading rather than shareholders is designed to get around the institutional/retail issue (which is not always easy to detect). And, since many foreign companies trade the majority of their shares on their home markets, the 5 percent hurdle supposedly won't be onerous.

It will make for an interesting academic study in 5 years whether this new rule decreases the premium investors pay for U.S.-registered securities of companies from developing markets, since under the new proposal, a company could announce a deregistration at any time after a year of entering the U.S. market, provided less than 5 percent of the shares trade in the United States. It will also be interesting to see how many foreign companies take advantage of this new deregistration rule. I suspect there will be a host of smaller foreign companies that deregister, just as SOX has pushed a number of smaller U.S. issuers to "go dark" (stop public trading so they can stop needing to comply with SEC regulations). However, I'd be amazed if many large foreign companies deregister. The signal sent to investors would be bad, and the reactions of even foreign investors may well be dire.

The funny thing about the new request for comments on the mutual fund governance issue is that the SEC has already received more than ten thousand comments from the public on this very topic. (I understand it is the second largest set of comments the SEC has ever received.) This is, of course, an attempt by SEC Chairman Christopher Cox to delay having to propose a rule on this topic when there is a deep division among the five commissioners (the past two proposals on this subject where approved by 3-2 votes, with former Republican SEC Chairman William Donaldson voting with the two Democrats on the Commission against his Republican colleagues.)

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