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From Securities Regulation Daily, June 19, 2013

House Panel Marks Up and Approves Legislation on Pay Ratios, Private Equity Fund Advisers, Uniform Fiduciary Standard and Mandatory Audit Firm Rotation

By Jim Hamilton, J.D., LL.M

The House Financial Services Committee has marked up and approved four pieces of legislation dealing with mandatory audit firm rotation, exemption of private fund advisers, the Dodd-Frank pay ratio requirement, and the Department of Labor and SEC adoption of fiduciary standards for brokers and advisers. Committee Chairman Jeb Hensarling (R-Texas) said that the pieces of legislation are targeted, pragmatic, and hopefully bipartisan fixes to some provisions of the Dodd-Frank Act that many Committee Members may feel are unnecessary or unduly burdensome.

Mandatory Audit Firm Rotation. The Committee approved by a vote of 52-0 legislation that would prohibit the mandatory rotation of independent outside audit firms and remove the threat of unnecessary compliance costs for public companies. Introduced by Rep. Robert Hurt (R-Va.) and Rep. Gregory Meeks (D-N.Y.), the Audit Integrity and Job Protection Act, H.R. 1564, would amend Section 103 of the Sarbanes-Oxley Act to expressly prohibit the PCAOB from requiring that the outside audits of a company’s financial statements be conducted by different audit firms on a rotating basis. The Act would also prohibit the Board from requiring that audits be conducted by specific auditors. This is bi-partisan legislation and is expected to be approved by the Committee after mark up and to be sent to the House floor.

Rep. Hurt said that the legislation would eliminate the threat of mandatory audit firm rotation by prohibiting the PCAOB from moving ahead with a potential rulemaking. He mentioned that the Board has put out a concept draft on mandatory audit firm rotation and, to his knowledge, has not withdrawn it. Thus, the PCAOB has left the issue unresolved. In his view, Congress must act because mandatory audit firm rotation would impair auditors, reduce the role and significance of audit committees, reduce audit quality in the first years of the new audit firm’s tender, and create a disincentive to go public.

Rep. Meeks noted that mandatory audit firm rotation would cause significant disruption, could weaken audit quality and is essentially unworkable. He also pointed out that mandatory audit firm rotation was considered during the Dodd-Frank Act deliberations and was rejected. There was no data showing that it would improve audit quality. Rep. Meeks acknowledged that there is some merit to auditor rotation and that Sarbanes-Oxley deals with that by requiring mandatory rotation of the lead partner responsible for the audit.

The Committee’s Ranking Member, Rep. Maxine Waters (D-Cal.) has mixed feelings about H.R. 1564. On the one hand, she does not believe that mandatory audit firm rotation would enhance auditor independence, but on the other hand she does not believe that Congress should micromanage the PCAOB. The small number of audit firms and industry specialization means that requiring audit firm rotation will leave companies with little choice. Essentially, the dominance of the Big 4 makes mandatory audit firm rotation unworkable. But again, the Ranking Member is concerned with tampering with PCAOB authority at a time when it is not clear how serious the Board is about mandatory audit firm rotation. It is not unreasonable for the PCAOB to consider a wide and broad range of issues, she added. However, the Ranking Member cautioned the Board to keep in mind if there are any benefits to investors as it examines mandatory audit firm rotation.

Rep. Waters offered an amendment to H.R. 1564 that would sunset the prohibition on adopting mandatory audit firm rotation so as not to indefinitely constrain the PCAOB. The amendment would also require a study on the issue, updating the 2003 GAO study. Rep. Hurt opposed the amendment, stating that it would gut the bill and create uncertainty. Rep. Scott Garrett (R-N.J.) proposed an amendment to the Waters Amendment that would eliminate the sunset provision, but retain the study. Rep. Hurt agreed to the compromise amendment as long as it specifically required the study to consider the costs of mandatory audit firm rotation. Rep. Waters agreed to the changes, indicating that cost considerations should be included in the amendment. The amendment requiring a study of mandatory audit firm rotation, updating the GAO 2003 study, was unanimously approved by voice vote.

The Audit Integrity and Job Protection Act, as amended, was then approved by the Committee by voice vote.

Private Equity Fund Advisers. The Committee also approved a bi-partisan bill, the Small Business Capital Access and Job Preservation Act, H.R. 1105, by a 38-18 vote, which would exempt advisers to certain private equity funds from the new SEC registration requirements imposed by Title IV of the Dodd-Frank Act. Specifically, H.R. 1105 exempts from SEC registration private equity fund advisers that have not borrowed and do not have outstanding a principal amount in excess of twice their funded capital commitments. The bill was introduced by Rep. Robert Hurt (R-Va.), Jim Himes (D-Conn.), Scott Garrett (R-N.J.), Chair of the Capital Markets Subcommittee, and Cooper

The Dodd-Frank Act requires most advisers to private investment funds to register with the SEC, including advisers to private equity funds. Rep. Hurt said that the legislation is designed to give private equity firms the same exemption that venture capital firms enjoy under Dodd-Frank. The legislation would exempt advisers to private equity funds from SEC registration under the Investment Advisers Act. The legislation directs the SEC to define the term private equity fund and also directs the SEC to adopt rules requiring private equity fund advisers to maintain records and provide the SEC with reports the Commission deems necessary after considering fund size, governance, risk and investment strategy.

Committee members are concerned with the private equity registration requirement. They do not see private equity firms as a source of systemic risk. Chairman Hensarling said that the legislation is appropriate because private equity funds are not involved with systemic risk, are not particularly complex and have no interconnectedness. Associating himself with the Chair’s remarks, Rep. Hurt said that the private equity firms given relief by H.R. 1105 are not interconnected and pose no systemic risk. These are sophisticated investors, he added, like public pension funds. Rep. Himes said that the registration of private fund advisers was an overreach of Dodd-Frank and imposes a costly burden on private equity funds. These sophisticated investors don’t need the same investor protections as retail investors. Venture capital funds have the same kind of investors, he analogized, and they were excluded from Dodd-Frank registration.

Ranking Member Waters expressed serious concerns with H.R. 1105, stating that it carves out a large hole from regulatory oversight. She cited a letter that the Committee received from SEC Chair Mary Jo White stating the Commission’s belief that the markets would not be well served by narrowing SEC oversight of these advisers.

Rep. Waters said that the SEC’s letter is clear about the Commission’s need and desire to provide protection for private fund investors. The SEC said that investors in private equity funds are in need of the same protections as other private funds investors. Registration gives the Commission tools to discover and prevent violations of the federal securities laws. The SEC, as the capital markets regulator, must have an appropriate level of oversight of these entities. Rep. Waters emphasized that the SEC is trying to get a handle on investment pools in the shadow banking sector.

An amendment filed by Rep. Carolyn Maloney (D-N.Y.) would require a simplified disclosure form for private equity advisers to be filed with the SEC, allowing the Commission to retain some authority over private equity funds. Supporting the amendment, the Ranking Member said that light must be shone on all parts of the shadow banking sector.

Although the amendment was rejected, Chairman Hensarling said that the Committee has had little time to consider it and that he would work with Rep. Maloney on the amendment as the Committee crafts a bill for the House floor.

Dodd-Frank Pay Ratio. The Committee also approved H.R. 1135, the Burdensome Data Collection Relief Act by a 36-21 vote. Sponsored by Rep. Bill Huizenga (R-Mich.) and Chairman Garrett, the bill would repeal Section 953(b) of the Dodd-Frank Act. Section 953(b) requires public companies to calculate and disclose, in every filing with the SEC, (i) the median annual total compensation of all of its employees other than its chief executive officer, (ii) its chief executive officer’s annual total compensation, and (iii) the ratio of those two numbers. In the 112th Congress, Rep. Nan Hayworth (R-NY) introduced a similar bill (H.R. 1062), which passed the Committee by a vote of 33 yeas to 21 nays on June 22, 2011.

Rep. Huizenga said that Section 953(b) places a significant burden on public companies by requiring them to calculate the pay of every employee globally, using a variety of factors, with no true benefit to investors. He described Section 953(b) as a logistical nightmare for companies, adding that SEC Chair White has confirmed that this is a problem that needs to be looked at.

Chairman Hensarling described Section 953(b) as essentially unworkable. Rep. Huizenga noted that any SEC filing would engender a recalculation of the pay ratio.

Under Section 953, the SEC must adopt rules requiring new disclosures about the relationship between executive compensation and company performance, and the ratio between the median of the annual total compensation of an issuer's employees and the annual total compensation of the issuer's chief executive officer. In earlier testimony before the Committee, then SEC Corporation Finance Director Meredith Cross said that Congress could make the pay ratio disclosure more manageable by changing the median of the annual total compensation of an issuer’s employees to the average annual total compensation. She added that it is the SEC’s job to implement the statute in a workable manner. The SEC has yet to propose rules under Section 953 since Dodd-Frank set no deadline for SEC rulemaking. Director Cross allowed that the statute is fairly prescriptive and leaves no leeway for the SEC in the rulemaking process.

The Society of Corporate Secretaries and Governance Professionals supports the House legislation repealing the pay ratio provision of Dodd-Frank. Testifying in favor of the legislation, Society President Ken Bertsch said that it will be virtually impossible for large global companies to comply with Section 953 and that its implementation will impose a substantial burden even on smaller issuers. While acknowledging a public policy concern on pay gaps in the United States, the Society believes that the required ratio will be neither material or nor meaningful to investors.

According to the Society, the pay ratio under Section 953 will not provide useful information to investors because it is not comparable in any way across industries, companies, geographies, or employees. For example, companies located in certain areas of the country pay employees and executives more than others, given the cost of living in those areas. Moreover, some businesses have a large number of low-paid workers and some have a higher percentage of part-time employees or seasonal employees. These companies will likely have worse pay ratios.

The Committee rejected an amendment from Rep. Waters that would have required only annual disclosure of the pay ratio and given the SEC greater discretion to define terms of the requirement and methods of calculation.

Uniform Fiduciary Standard. The Committee approved H.R. 2374, the Retail Investor Protection Act by a 44-13 vote. Sponsored by Rep. Ann Wagner (R-Mo.). The legislative prevents the Secretary of Labor from prescribing any regulation under the Employee Retirement Income Security Act of 1974 defining the circumstances under which an individual is considered a fiduciary until the date that is 60 days after the SEC issues a final rule relating to standards of conduct for brokers and dealers pursuant Section 913 of the Dodd-Frank Act. Rep. Wagner said that Congress must act because the SEC and DOL are headed towards two separate and massive rulemakings, and the impact of this on retail investors has not been properly considered. The legislation says that the DOL must wait until the SEC acts before moving ahead.

Section 913(g)(1) of the Dodd-Frank Act authorizes, but does not require, the SEC to promulgate rules to extend the fiduciary standard of conduct applicable to investment advisors to broker-dealers when providing advice about securities to retail customers. H.R. 2374 requires the SEC, before promulgating such a rule, to determine whether retail customers are being systematically harmed or disadvantaged because broker-dealers are held to a standard different from that which applies to investment advisers, and to identify whether the adoption of a uniform fiduciary standard of care for brokers or dealers and investment advisors would adversely impact retail investor access to personalized investment advice, recommendations about securities, or the availability of such advice and recommendations. Provisions in the original bill requiring the SEC’s Chief Economist to assess the qualitative and quantitative costs and benefits of the rule and requiring the SEC to determine that the benefits of the rule justify its costs were dropped from the approved bill pursuant to an amendment offered by Rep. Patrick Murphy (D-Fla.). The amendment was agreed to by a voice vote.

Rep. Waters is deeply troubled with H.R. 2374 because it raises the same issues as the SEC cost-benefit bill, H.R. 1062, which Democrats overwhelmingly opposed on the floor last month. These concerns are also shared by SEC Chair White, said the Ranking Member, adding that the SEC opposes the bill. This appears to be yet another attempt to bog the SEC down to the point where it’s unable to put forward a rulemaking, noted Rep. Waters, even a rulemaking related to the crucial issue of protecting hard earned retirement savings. While sympathetic to the desire to require coordination between the Department of Labor and the SEC so that investors can rely on one strong standard of care no matter who is giving them advice, Rep. Waters said that the bill also puts in additional redundant cost-benefit analyses that will only slow down this important rulemaking, and possibly tie up a final rule in years of court litigation.

Reading from Chairman White’s letter to the Committee, the Ranking Member said that the SEC believes that the restrictions imposed by H.R. 2374 would make it difficult for the SEC to adopt a rule in this area should the Commission decide to do so. The layering on of new requirements before a final rule can be adopted and finalized would impede this investor initiative.

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