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SEC Investor Advisory Committee Meeting

Securities and Exchange Commission

Investor Advisory Committee Meeting

Thursday, February 27, 2020

Discussion Panels

Opening Statements

Commissioner Allison Herren Lee, Securities and Exchange Commission

In her opening statement, Lee expressed gratitude for the Investor Advisory Committee’s (IAC) focus on issues relating to audits and accounting. She emphasized the importance of auditor independence assurance for investor confidence. Lee highlighted the Securities and Exchange Commission (SEC) work on updating audit and accounting rules, adding that the rules are currently out for public comment. She concluded that she looks forward to hearing thoughts on how to address risks and set forth management plans associated with the transition away from the London Interbank Offered Rate (LIBOR).

Anne Sheehan, Investor Advisory Committee, Chair

In her opening statement, Sheehan echoed Lee’s comments and added that the integrity of auditors is crucial for investor confidence. Sheehan also highlighted SEC Chair Jay Clayton’s remarks about the importance of marketplace stability and proper disclosure requirements with the transition away from LIBOR.

Panel I: Update for Investors Regarding Accounting and Auditing Trends

Panel Presentation

Zach Gast, President, CFRA Research, stated that his firm provides analysis for equity and fund research, including for mutual funds and exchange-traded funds (ETFs). He provided commentary that there has been a proliferation of changes for accounting standards as well as investment standards. The three areas he highlighted included: 1) SEC disclosure proposals for management discussion and analysis (MD&A) definitions around material changes; 2) reverse chain financing; and 3) concerns about the lack of clarity for non-Generally Accepted Accounting Principles (non-GAAP). He suggested that the SEC remove the requirement of tabular disclosures and longitudinal financial data requirements. Gast also opined that tax adjustment disclosures should transition to a line item model.

Keith Higgins, Chair of the Securities & Governance Practice, Ropes & Gray LLP, remarked on the role of the audit committee, mentioning the history of the audit process creation under the Sarbanes Oxley Act of 2002. He stated that the core mission of the audit committee is to oversee the relationship between the auditor and financial reporting. Higgins continued that members manage financial reporting, GAAP standards, auditor independence, and the whistleblower program. He highlighted that the audit committee is particularly focused on non-GAAP financial measures, Critical Audit Matters (CAMs), quality control, updates set by the Public Company Accounting Oversight Board (PCAOB), cybersecurity concerns, the compliance of the whistleblower program, sustainability policies, transparency as well as environmental, social and governance (ESG).

James Kroeker, Vice Chairman, the Financial Accounting Standards Board (FASB), noted that high-quality accounting standards play a vital role in market efficiency and help with capital allocation and economic growth. He added that accounting standards help provide and educate stakeholders with useful information as well as help investors make informed decisions. He highlighted that the FASB has been working to improve revenue recognition standards, currently expected credit losses (CECL) methodology, and revenue standards. Kroeker continued that the FASB has an interest in other areas, such as distinguishing characteristics between liability and equity, segment aggregation activities, and reference rate reforms. He concluded by stating that the FASB is best positioned to address accounting standards when it has a deep understanding of investor needs.

Jeff Mahoney, General Counsel, Council of Institutional Investors, said that accurate and reliable audit reports are critical for the well-being of capital markets. He added that the primary role of audits should be to satisfy the investor’s needs. Mahoney emphasized that the adoption of CAMs and the role of the PCAOB has significantly improved internal controls and management disclosures. He noted that CAMS helps provide informative, accurate and independent audit reports.

Andrew G. McMaster, Jr., Former Chairman, the Financial Accounting Standards Advisory Council, and Retired Deputy CEO and Vice Chairman, Deloitte & Touche LLP, stated that the role of the audit committee has continued to evolve and that topics of oversight or risk management are not limited to financial accounting. He added that audit committees must also consider oversight of ethics and compliance and third-party risk management. McMaster opined that the PCAOB has improved audit quality and should remain independent in order to provide adequate audit and accounting guidance. He concluded by applauding the PCAOB’s outreach and inclusive approach.

Katherine Schipper, Thomas F. Keller Professor of Business Administration, Duke University’s Fuqua School of Business, highlighted her research, which analyzes the materiality judgment and management process. She suggested that financial reporting is supposed to be material and that lower materiality judgments correlate with performance factors. Schipper suggested that the looseness of materiality often leads to restatements. She noted her support for CAMs and the PCAOB’s work to improve audit quality.

Question & Answer

Barbara Roper, IAC, asked about the importance of auditor independence and ways to enhance such independence. McMaster suggested that firms have substantially increased their audit quality controls, but the challenge is eliminating bad actors. He said that no model would fully achieve that goal. Kroeker said it comes down to who the auditor sees as the client.

Heidi Stam, IAC, asked about ways to better serve the main street investor and the less sophisticated investor. Kroeker suggested that more could be done to improve accounting standards, particularly with liabilities and equities. He said that there should be ways to simplify access to information for investors.

Jerome Solomon, IAC, asked if FASB intends to back-test their revenue recognition changes. Kroeker said they call it post-implementation, and that the FASB intends to monitor anticipated and unanticipated costs, internal efficiencies and inefficiencies, and will continue to track trends two or three years from the date of implementation.

Sheehan asked about auditor rotation and disclosure materiality requirements. McMaster stated that most audit committees analyze their servicing team and should consider a rotation now and then. However, he cautioned against creating a mandatory rotation requirement. Mahoney said that he believes audit committees should put out bids but agreed not to mandate a rotation. Schipper encouraged the SEC to revisit staff bulletin 99 to improve disclosure materiality requirements.

Mina Nguyen, IAC, asked about the impact of digital assets on auditor transparency. Kroeker stated that digital assets standard-setting is an area the FASB will continue to monitor and that models for securities should be utilized for audit practices. He said, if warranted, the FASB would consider changing accounting standards.

John Coates, IAC, asked for an overview of accounting improvements. Kroeker said that there have been significant increases in auditor performances. The other panelists agreed.

Rick Fleming, IAC, asked about segment reporting. Kroeker said that it is an ongoing discussion of how the FASB can better implement the segmentation of information that is disclosed.

Jennifer Marietta-Westberg, IAC, asked about governance structures of audit committees. Higgins and McMaster noted that there are certain areas, such as cyber and ESG, that audit committees could have oversight over without the primary responsibility of the process.

Damon Silvers, IAC, asked the panelists about PCAOB independence. McMaster and Mahoney reiterated their belief for the PCAOB to remain independent. Higgins said that he believes changes to auditor independence and the role of the PCAOB are different.

Panel II: Discussion Regarding Potential Impact of LIBOR Transition on Investors

Panel Presentation

Richard Berner, Clinical Professor of Management Practice and Co-Director of the Stern Volatility and Risk Institute, Leonard N. Stern School of Business, New York University, shared concerns about the need for parties involved to accelerate their transition away from LIBOR. He added that the transition to the Secured Overnight Financing Rate (SOFR) has been controversial due to credit risk concerns. Berner emphasized that there has not been much supply or demand for SOFR notes, aside from the derivatives market. He suggested that there is a need for faster adoption of SOFR, as well as fallback language for legacy LIBOR contracts. He added that the transition could cause liquidity concerns for investment products. Berner highlighted the Alternative Reference Rates Committee’s (ARRC) published a checklist for the transition.

David Bowman, Senior Associate Director, Board of Governors of the Federal Reserve System, provided an overview of what is creating the need for the transition away from LIBOR and said that users need to use the time from now until the end of 2021 to prepare for a post-LIBOR market. He noted that the Financial Conduct Authority (FCA) kept LIBOR “alive” for as long as they could and helped investors “dodge a bullet.” Bowman emphasized the need for issuers and investors to stop using LIBOR and to transition to a robust alternative rate, such as SOFR. He added that the SEC’s IAC could play a role and welcomed broader discussion from the investor community. Bowman also highlighted the work of some ARRC members in New York for legislation and suggested other jurisdictions. He added that there could be a need for the federal government in assisting investors with the transition.

Jon M. DeBord, Director & Associate General Counsel, Citi, shared his concerns about litigation risks and challenges arising out of the transition away from LIBOR. He echoed previous comments about liquidity concerns and fallback language. DeBord noted that the futures and derivatives markets are not markets of concern. He added that he has been working with regulators to address concerns of unintended consequences that may trigger uncleared margin requirements and clearing requirements. DeBord also suggested the need to address problematic and unclear contracts in order to avoid litigation. He also stated that other potential issues include mismatches between swaps and cash products and recommended the issuance of regulatory guidance moving forward.

Urban J. Jermann, Safra Professor of International Finance and Capital Markets, Wharton School of the University of Pennsylvania, expressed his concern about the transition from LIBOR to SOFR being extremely complex. He opined that the impact stems from the fundamental difference that SOFR is secured and LIBOR is unsecured. Jermann said that SOFR could impact the credit risk premium for bank loans and outlined his research for how SOFR would have affected markets if it was the preferred rate during the financial crisis. Jermann suggested that lenders would have ended up with roughly one percent less interest yield on their loans, amounting to a significant dollar amount. He suggested considering a credit-sensitive rate be implemented as the transition occurs.

Alex Roever, Managing Director, Head of U.S. Interest Rate Strategy, J.P. Morgan Securities LLC, noted that LIBOR will sunset by the end of 2021 and that sustainable progress to transition to SOFR in the derivatives and cash markets has been made. He stated that key ARRC benchmarks have been completed and that they are well ahead of schedule. However, he added that there would be a need for fallback language as well as for corporations and industrials to speed up their transition. Roever said that it could be helpful for the official sector to implement intermediary deadlines for issuers and investors to meet before the start of 2022.

Question & Answer

Coates asked about legislative solutions and the consequences of not having fallback language. Bowman responded that most contracts have fallback language, except that corporate bond contracts lack adequate fallback language. He said if nothing were to happen, it would most likely lead to litigation. Bowman noted that the International Swaps and Derivatives Association (ISDA) will be issuing a protocol to amend legacy trades and reiterated ARRC members’ goals to get legislation in the State of New York. DeBord added that it would be difficult to amend contracts for floating rate notes or securitizations.

Coates and Mahoney asked about other indexes that stopped working and what is being done to account for those transitions. Bowman answered that there had been other instruments that stopped working, but nothing ever as significant as the transition away from LIBOR. He added that there is LIBOR exposure across much of the financial system, including in the municipal markets, in government-sponsored enterprises (GSEs), and the Department of Education and Department of Housing and Urban Development contracts. Berner emphasized that LIBOR is widely intertwined in the financial market.

Solomon asked about the U.K. transitioning to the Sterling Overnight Index Average (SONIA). Roever said that SONIA has existed for some time and that the U.K. authorities have implemented intermediary benchmarks. He suggested the U.S. could achieve a similar approach. Bowman said the ARRC is currently discussing intermediate benchmarks for securities issuance.

Solomon also inquired about SOFR spreads, fallback language, and other alternative rates. Jermann stated that the transition should happen with as little impact on the market as possible. Bowman said the spread would need to be set to be higher for new contracts, but for existing contracts, the ARRC is consulting on how to account for the spread. He added that the ARRC has met its mandate and has selected SOFR as the new rate. Roever suggested that there is protocol in place for banks using overnight rates for pricing.

Marietta-Westberg asked about the role of the SEC. Berner suggested the SEC help by furthering the ARRC’s checklist and informing investors of how to account and hedge for risks associated with the transition. Bowman added that the SEC promoting investor awareness and SEC disclosures would be helpful.

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