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Advocacy Update

 

July 2008

 

Where Do You Stand? ... on Mutual Fund Reform
The CFA Institute Centre is examining whether mutual fund products and similar global, collective-investment schemes are efficiently regulated and attentive to market integrity and efficiency. This sector has been cited as one rife with duplicative regulation, and one where there may be a false sense of independent oversight and a lack of true investor protection and fairness. We’re interested in hearing your views on the industry and whether the Centre should engage in further work related to regulatory and professional conduct reforms.

 

There have been concerns expressed that mutual fund boards are not really independent and that mutual funds are just products of the sponsoring firm. One view is that the sponsoring firm, the fund board, and the fund manager are really all the same. People point to the fact that many fund boards never replace the manager, and that the sponsoring firm is always involved and handling all sales and administrative matters.

 

Top Story: At the Centre of CRA Reforms
In line with our continuing efforts to spark debate and encourage reforms, the CFA Institute Centre spoke out on the results of a CFA Institute membership survey on credit rating agency (CRA) practices. The Centre has been an active participant in global cries for CRA reform, and has worked extensively with investors and regulators to promote improved practices.

 

“In the wake of the subprime crisis, we have met with several representatives from ratings firms,” said Kurt Schacht, CFA, managing director of the CFA Institute Centre. “They were concerned about the hype and insinuation that CRAs easily inflate their ratings in response to pressure from issuers and underwriters, implicating the integrity of their process and ratings.” Following a query on the subject from CFA Institute CEO Jeff Diermeier, CFA, in his monthly letter to members, 211 investment professionals said they have seen a CRA change a rating following external pressures.

 

“In exploring that topic,” adds Schacht, “we were very surprised by the results of our member poll where some 11 percent of the 1,956 respondents said they have indeed witnessed a CRA change ratings in response to pressures from issuers or underwriters.”

 

“At the very least these results suggest that the CRAs have more than just a perception problem about their processes and integrity, which must be addressed,” said James Allen, CFA, director of the Centre’s Capital Markets Policy Group. “They should take prompt action to manage or eliminate conflicts in a comprehensive fashion and improve any practices that expose the CRA to ethical problems. And this may go beyond what has already been proposed by the SEC and other regulators.”

 

Many respondents noted that the payment structure between CRAs and issuers presents the largest conflict of interest. One respondent said, “The fundamental flaw is that the agencies are paid by issuers, not by investors. No amount of regulation can fix that conflict of interest.” Another respondent anonymously said, “Exchanges are self-regulating. Ratings can be as well. But the incentives should be established so that their interests are aligned with investors.”

 

In other results, 55 percent of all respondents agreed with the statement that CRAs should group themselves into an international standard-setting and monitoring self-regulatory body of all stakeholders with powers of enforcement, something the CFA Institute Centre has encouraged as part of any CRA industry reform package.

 

Finally, nearly half of all respondents are in favor of using different rating symbols for structured products. The concern is that not all AAA-rated securities are created equal. As demonstrated in the current credit crisis, structured products typically perform very differently from traditional corporate bonds, despite the identical symbols. As one of the respondents commented, whereas corporate default is typically related to one or two factors, “default on structured debt is dependent on hundreds or thousands of individual defaults [e.g., an underlying mortgage pool] that are estimated given some distribution. They are not the same analysis so they should not be the same ratings.”

 

Charles Cronin, CFA, head of the Centre in the Europe, Middle East, and Africa region said, “We feel that a different rating scale is an essential aid to trustees and fiduciaries, to help them evaluate and quantify the amount of structured product exposure they desire in their portfolios. We have expressed this thought and others in response to the CESR (PDF) and IOSCO (PDF) consultations on the subject.”

 

“Clearly the respondents to this survey raise some serious concerns about the integrity of the ratings process and support for further CRA reform. We urge CRAs and regulators to consider the views expressed by our members and to consider such additional reforms as are warranted, both to the CRA process and to the ratings they apply to structured instruments,” concluded Schacht. This overwhelmingly endorses the position we have advanced through outreach to regulators and the broader investment community.

 

In other CRA news, the U.S. SEC has released three proposed steps so far toward reforms in CRA practices, and we are actively pursuing opportunities to provide input. Watch this space for further updates on our contribution to the ongoing move to enhanced investor protection through improved CRA nomenclature, disclosures, and consistency.

 

In Other News

 

“What's in a Name?”: A Review of Your Stand on Auditors, by Managing Director Kurt Schacht
Our inaugural “Where Do You Stand?” advocacy question generated a great deal of interest; see full results of more than 600 responses online. Frankly, I was surprised by the clear message heard in response to our first question, “Do you, as an investment analyst, care whether or not a reporting company uses a ‘brand-name’ audit firm?” More than 40 percent of you said yes, brand name matters when it comes to audit services. I find that faith in brand curious, as it suggests there is at least a perception among investors that the level and quality of audits and the level of diligence brought to an audit assignment by “the big four” is a degree — perhaps a significant degree — higher than audits performed by lesser-recognized firms. Is this fair to the long list of second-tier firms that are not in the rarified air of the largest four?

 

It is particularly intriguing to consider your preference for branded auditors, as one thinks about how differently the audit business has evolved as compared to other professions, such as legal services. Any major city in the world has multiple options for high-quality and globally experienced legal services. Why the difference when it comes to audit? As markets struggle to increase the capacity and breadth of the audit profession around the world, we’ll all do well to answer that question and work toward a solution. Much has been made of the notion that another audit firm failure of the like of Arthur Andersen will throw the world audit market and the public companies they serve into great turmoil. We are not so sure.

 

Given that nearly 40 percent said “no” to our second question as to whether they believe a company’s switch to a lesser-known auditor detracts from the attractiveness of the company as an investment, and given that fully a third indicated on the first question that they are in fact comfortable with the use of a lesser-known firm “where circumstances permit,” there is hope yet for “off-brand” firms. Indeed, we think circumstances often do permit use of lesser-known auditors, and encourage companies to investigate a large and growing sector of audit firms that offer more direct attention to client service, sophisticated experience, and reduced costs, especially for smaller public companies. Investors want a management that works to make its entire organization most efficient and cost-effective. Your responses support the idea that, rather than just paying for the name, looking beyond the name-brand firms for better service and cost can be a good option and is increasingly attractive to investors.

 

More importantly, such a shift to using a broader range of auditors is one step toward increasing the audit capacity and options for public companies, thereby reducing the danger lurking in the current concentration of work in just a few firms. This is a subject of keen interest to the Centre; I recently provided testimony before the U.S. Treasury Advisory Committee on the Auditing Profession addressing this subject. 

 

Thanks for commenting in June; please take a few moments to respond to this month’s questions on mutual fund reform.

 

Matt Orsagh, CFA, CIPM, Named Rising Star of Corporate Governance
The Millstein Center for Corporate Governance and Performance at the Yale School of Management named the Centre’s own Matt Orsagh — senior policy analyst with the Capital Markets Policy Group — one of the 2008 “Rising Stars of Corporate Governance.” The Millstein Center’s list recognizes corporate governance professionals under the age of 40 who are making their mark as outstanding analysts, experts, activists, and managers. Honorees were nominated by their peers and selected by a committee of leaders in corporate governance based on criteria such as past accomplishments and thought leadership, future projects and endeavors, reputation among existing industry leaders, and potential to influence the industry in the future. We certainly appreciate Orsagh’s many contributions to the Centre’s work on corporate governance, and are delighted both his accomplishments and potential have been recognized by his peers as well.

 

Among recent projects on which Orsagh has taken the lead, Environmental, Social, and Governance Factors at Listed Companies is a newly published manual that offers help in identifying and properly evaluating the risks and opportunities certain nonfinancial factors present to investors. During research for the manual, it became clear that a wide range of naming conventions for the various categories of factors exists, further confusing an already complex area of interest. Are we speaking of ESG, SRI, sustainable, socially responsible, or just plain “green” issues? You can help inform future dialogue on the topic; please take a moment to respond before 14 July to a survey conducted by a group of our colleagues seeking investor input on the naming of these issues.

 

Front and Centre: Schacht Reaches Out
Kurt Schacht visited Toronto in June to meet with the Canadian Minister of Finance, the Honorable James Flaherty. The two discussed issues and priorities related to the subprime crisis, including fair value reporting and off balance sheet entities.

 

Update from APAC
Lee Kha Loon, CFA, head of the Centre in the Asia-Pacific region, and Abe De Ramos, policy analyst, attended the International Corporate Governance Network’s Annual Conference in Seoul. The conference focused on “Globalization of Capital Markets: Impact on Corporate Governance,” and Lee led a session on financial-sector governance and the subprime meltdown. Panel members and participants discussed, among other topics, the role of risk management, executive compensation, and banking and securities regulation in the current market turmoil.

 

Update from EMEA
Charles Cronin expanded European outreach for the Centre in June with presentations to the media and to CFA Austria on the current credit crisis and the role of credit rating agencies; to the European Parliament Financial Services Forum and an open hearing on financial education for the general public; to the director and members of the Free Movement of Capital at the European Commission on investor stakeholder representation in EU advisory bodies. 

 

The EMEA team submitted a response to the U.K. Financial Reporting Council (FRC) (PDF) on proposed guidance to audit committees in listed companies. The FRC proposed changes to the guidance on audit committees (the Smith Guidance) in the U.K.’s Combined Code on Corporate Governance. The Centre supported the FRC’s proposed changes regarding independence requirements, disclosure of auditor appointment and re-appointment decisions, and related disclosures on contractual obligations.

 

The Centre’s EMEA staff also submitted a response to Her Majesty’s Treasury (HMT) (PDF) on updating the Myners principles for pension scheme trustees. HMT proposed a revised set of principles for pension scheme trustees, based on updating the original Myners Principles for pension scheme governance first published in 2001. The Centre broadly supported the proposals, as they focused on simplifying the existing principles and making them less prescriptive. The Centre also supported proposals to introduce best practice guidance and trustee tools to help trustees effectively implement the principles, in accordance with principles outlined in the Centre’s recently published Code of Conduct for Members of a Pension Scheme Governing Body.

 

In further support of our work on best practice for pension funds, the Centre participated in a pensions conference co-hosted by the CFA Society of The Netherlands, during which Jon Stokes, director of the Centre’s Standards of Practice Policy Group joined Cronin to launch the new pension trustee code. 

 

News from the Financial Reporting Front
Vincent Papa, CFA, a senior policy analyst in the Financial Reporting Policy Group in the EMEA office, attended the International Accounting Standards Board Analyst Representative Group (IASB-ARG) meetings as they considered several issues, including the impact of the credit crisis on financial reporting and proposals to improve disclosure in liabilities and equity classification, pensions, and management commentary. Two Centre volunteers, Dane Mott and Christian Dreyer, CFA, are also members of the IASB-ARG. Mott, as a member of the IASB Standards Advisory Council and IASB’s Employee Benefits Working Group, participated in the June meetings in London as well.

 

Ray DeAngelo, the managing director of Member and Society services for CFA Institute, represented the organization at a series of roundtable panel discussions convened by the IASC Foundation, which is the body of trustees responsible for appointment and oversight of the IASB. The discussions were part of a consultation and review of the trustees’ constitution, resulting in constitutional amendments aimed at improving the governance and public accountability of the IASB while safeguarding the independence of the board. One of the key proposals in the constitutional review is the establishment of a monitoring group with responsibilities for the appointment and review of the trustees. In his presentation to the IASCF, one of the key messages DeAngelo delivered was the need to ensure investor involvement in the proposed monitoring group.

 

In response to proposed FASB improvements to reporting companies’ trading inventory, we reiterated our view on moving toward increased use of fair value measurements and support the FASB staff proposals; we requested that they add improved disclosure requirements, and of particular interest, we called for the separation of inventory used in trading activities and the effects of hedging activities.

 

Georgene Palacky, director of the Centre's Financial Reporting Policy Group, was a panelist at the FAF-FASB forum "High-Quality Global Accounting Standards: Issues and Implications for U.S. Financial Reporting" in June. The forum was designed to open a dialogue on whether and how to continue moving the U.S. toward global accounting standards. Panelists discussed whether IFRS and U.S. GAAP should ultimately converge and, if so, how and when; how to prepare the United States for a possible shift to IFRS; accounting education, professional certification, regulatory, and tax issues; potential effects on reporting by private companies and not-for-profit entities; and the future role of the FASB. The results of a five-question member survey on the subject in May 2008 were helpful preparation for Palacky's participation in the forum; view further analysis of these results (PDF).

 

Speaking of Conferences
CFA Institute joins with EFFAS and the IASC Foundation to host a one-day conference on XBRL in London on 26 September 2008; find further details and register for XBRL for Investment Professionals: What Interactive Data Will Do for You.

 

GIPS Standards News
The GIPS Standards Annual Conference is scheduled for 25-26 September 2008 in Boston, and will cover key topics in the performance measurement industry as well as a preview and implications of the proposed changes to the GIPS standards. Last year's conference sold out and space is limited, so register early. The GIPS Standards Interactive Workshop in Boston, on 24 September, will help participants master the requirements of the GIPS standards, including composite construction, performance calculation, and the creation of a compliant presentation. Get more information on either event. 

The GIPS Executive Committee (EC) met via open conference call on 18 June and approved the Error Correction Guidance Statement, which is now available on the GIPS website (PDF).  

 

The GIPS EC voted to endorse the Canadian Investment Performance Committee (CIPC) as the official Country Sponsor of the GIPS standards for the Canadian market. An application for a Russian Country Sponsor has also been submitted and is under review.

 

High Praise for Centre’s Contribution to Market Integrity
During his speech at a recent conference, U.S. SEC Chairman Christopher Cox offered strong praise for the efforts and impact of CFA Institute Centre advocacy and guidance.

 

Latest Outreach
Along with other recent commentary from the CFA Institute Centre as noted above, outreach this month has included:

Visit the CFA Institute press room to view recent press releases and media coverage of CFA Institute Centre outreach.

 

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