Like most human beings, I somewhat wish derivatives had never been invented—not because they aren’t useful (they are), but because discussion of how to regulate the derivatives trade makes my head hurt. I’m sure I am not alone on this.

Nevertheless, how derivatives are created, traded, and disclosed to the public is indeed an important discussion to have. Congress is in the final stages of hashing out its regulatory reform bill—which at last count has hit more than 1,900 pages—and apparently derivatives have become a late-stage battleground before the final legislation passes and becomes law.

To many executives, this may seem like an obscure fight that only matters to the corporate treasurer or maybe the risk-management office if your company works in financial services. It isn’t. The more you dig into exactly what the derivatives business might look like after reform, the more queasy accounting, financial reporting, and compliance officers should feel. Let me give you a simple, hypothetical example.

Acme Airlines is an international airline that has to worry about fluctuations in the price of oil. It wants to purchase derivative instruments that will off-load those risks to another party more willing to shoulder them. Those derivatives will cost Acme some money, yes, but that’s a small price to pay for stability in a very uncertain part of Acme’s business.

Right now, Acme can buy those derivatives by calling around to various investment bankers, hedge funds, or anyone else willing to enter into the deal. XYZ Bank steps forward and says it is happy to provide oil for $72 per barrel for the next 12 months, in a deal worth a total of $100 million. Of course, XYZ wants some protection in case Acme goes bankrupt during that time, so Acme posts one of its jets as collateral. The deal is done.

Now let’s consider that deal in a post-reform world.

At the core of Washington’s reforms is the idea of a clearinghouse to manage derivatives trading. Instead of Acme shopping around for derivatives and buying them from XYZ, it approaches the New York Derivatives Exchange and buys its derivatives directly from the exchange. The Derivatives Exchange, in turn, then sells that derivative exposure to another party—perhaps XYZ Bank, but perhaps some other party or even several parties, each getting a piece of the $100 million in exposure.

What’s happened here? The risk of the derivative instruments has shifted from the counter-party (XYZ Bank) to the clearinghouse. That prevents Acme from getting screwed should XYZ ever fail to deliver its end of the contract—but it also means that our clearinghouse, New York Derivatives Exchange, carries a lot of risk. And that, in turn, means the exchange will need sky-high capital reserves.

You, Acme Airlines, will be paying for those higher reserves.

Exactly how much more this new clearinghouse model will drive up costs is still anyone’s guess. Lawmakers hope that multiple clearinghouses will emerge, competing against each other for business and keeping price increases minimal. I see the Econ 101 logic in that, but I’ll believe it only when I see it.

We have two other headaches in our clearinghouse world. First, remember that jet Acme posted as collateral to XYZ? That option flies away. The clearinghouse will want cash as collateral. After all, if Acme does default on its end of the contract, what good is it for the clearinghouse to take possession of a plane? Second, the amount of cash the clearinghouse will want as collateral will fluctuate as well, every day, to offset the clearinghouse’s own risks and capital reserve requirements.

Again, nobody yet knows exactly how much cash this new model will cost, although I suspect the Wall Street quants are already working on that. But it will cost something.

Foremost, accounting and financial reporting executives should feel the most unease here. They’ll be the ones calculating all these shifting derivative prices, and they’ll be part of that finance team ensuring that the company has enough cash on hand to meet the clearinghouse’s demands every day. None of that will be easy.

Compliance and risk officers won’t get off the hook either. Risk officers will need to pay more attention to whether the company should take out derivatives contracts in the first place, given the higher cost of purchasing them. They’ll need to ensure that the company stays within any financial restraints (say, a debt covenant or some key leverage ratio) that might trigger higher collateral requirements from the clearinghouse. Compliance officers will need to ensure all reporting is done accurately, promptly, and properly. And of course, all that cash going to collateral payments has to come from somewhere—like, say, that anti-bribery training program you wanted to launch in 2011.

All this is not to say that reforming derivatives is a bad idea; on the contrary, this is one part of the financial world that desperately needs more oversight. But Congress is down to brass tacks now, and no matter how boring or complicated derivatives oversight may seem, it’s worth paying attention. Occasionally those folks in Washington do stuff that actually matters.

Yet again, the chorus of Sarbanes-Oxley critics out there have been shouted down by one bald fact: SOX compliance prevents financial restatements.

According to a new study due out this week from Audit Analytics, restatements fell for the third year in a row in 2009, from 923 in 2008 to 674 last year. The restatements themselves were down in every category that matters: average number of days restated, average number of issues per restatement, average dollar losses per restatement. Even the time necessary to calculate a restatement dropped in 2009. Any way the accounting department wants to cut it, the restatement crisis of the mid-2000s has receded. (Compliance Week is working to secure a copy of the report for publication as soon as possible, but I have seen an advance copy personally.)

The causes of restatements in 2009 were largely the same sorts of problems that always dog companies: debt, warrants and equity headaches; accounts receivables; compensation problems. Audit Analytics ranks the top five causes of restatements last year as:

• debt, quasi-debt, warrants & equity (BCF) security issues;
• expense (payroll, SGA, other) recording issues;
• accounts/loans receivable, investments & cash issues;
• deferred, stock-based and/or executive compensation issues;
• liabilities, payables, reserves and accrual estimate failures.

Compliance Week will have a full analysis of the report in the next week or two. The early facts, however, suggest that the Sarbanes-Oxley Act, as much as we all hate to admit it, is achieving its intended goal of making financial statements more reliable for investors. If you want evidence, compare the annual number of restatements between accelerated filers and non-accelerated filers for the past decade. Accelerated filers saw a steady march upward in restatements from 2002 until 2005—the year they first had to start complying with Section 404 of SOX, which requires strict testing of internal controls. From 2006 onward, the number of restatements fell, and continues to fall today.

Non-accelerated filers, however, have been exempt from most Section 404 even to this day. Restatements for that group reached the nosebleed number of 888 in 2006; they have since floated downward to 374 restatements in 2009, but that’s still well above the numbers the accelerated filers have been seeing. And remember, external auditors haven’t yet started any internal controls testing at non-accelerated filers.

The anti-SOX critics say Sarbanes-Oxley is a waste of time and money because it doesn’t prevent financial meltdowns. Well, Audit Analytics’ data shows a decrease in meltdowns since SOX compliance went into effect. The critics also SOX is a waste of time and money because we did all this improvement, and still had a financial crisis in 2008. Again, remember that SOX was passed to make financial statements more reliable for investors, and now we’ve seen fewer restatements since it went into effect.

As maddening as the financial crisis has been, it has largely been a crisis of flawed assumptions and reckless risk management coming home to roost—not accounting fraud. If Congress wants to pass another massive law to remedy the problems of the financial crisis, that’s fine. But it should not start rewriting Sarbanes-Oxley wholesale. That law is working just fine.

It’s hip to be square: Yale University’s Millstein Center for Corporate Governance has just announced the recipients of its second annual Rising Stars of Corporate Governance awards. The prizes go to various folks under the age of 40 who have made some notable contribution to the field. Full disclosure: Yours truly won a Rising Star award last year.

This year’s recipients are:

The Rising Stars of Corporate Governance for 2009 are:


· Nada Abdelsater-Abusamra, partner at the law firm Raphaël & Associés;

· George M. Anderson, partner at Tapestry Networks;

· Stephen L. Brown,  associate general counsel, corporate governance, at TIAA-CREF;

· Evelynne Change, coordinator for corporate governance at the African Peer Review Mechanism (APRM) Secretariat, New Partnership for Africa’s Development (NEPAD);

· Deborah Gilshan, corporate governance counsel at Railpen Investments;

· David Hess, assistant professor of business law and business ethics at the University of Michigan;

· Elizabeth Ising, associate at the law firm Gibson, Dunn & Crutcher;

· Alexis B. Krajeski, associate director for governance and sustainable investment, F&C Investments;

· Rachel C. Lee, senior corporate counsel at EMC Corp.;

· Julieta Rodríguez Molina, associate at the law firm of Galindo, Arias & López.

Hats off to all!

All right, we’re going to say it: Occasionally prosecutors go overboard.

This is a big admission for Compliance Week, because like good reporters everywhere, we tend to be cynical people. When we hear the word “indicted” we assume “guilty” and wonder when the person in question will resign. 

Lately, however, we’ve seen two instances of heavy-handed prosecution. Most notable was the case of Ted Stevens, the former Alaska senator, whose conviction on corruption charges was tossed out by a federal judge on April 7 because of prosecutorial misconduct. The judge was so incensed over the prosecutors’ behavior he referred them for criminal investigation. We’re not sure how much of a salve that is to Stevens, who was convicted in late October and promptly lost his job on Election Day.

Likewise, we have the hollow victory of Kent Roberts, former general counsel for IT security company McAfee. Roberts was indicted in February 2007 for alleged improprieties over backdated stock options. He was acquitted by a jury of some charges in October 2008, and the Securities and Exchange Commission dropped all other remaining charges against Roberts in March.

Again, that’s probably not much solace to Roberts. He was fired from McAfee in 2006, and was named countless times by the media—including Compliance Week—as an “alleged offender” in the backdating frenzy that swept Corporate America in 2006 and 2007.

Roberts’ and Stevens’ innocence is worth noting, since they’re not the only ones out there tarred by prosecutors and the media.

So what’s to be done?

First, Compliance Week is putting corporate investigations in the spotlight at our annual conference in June. We’ve corralled Roberts’ defense attorneys, Neal Stephens and William Freeman from the law firm Cooley Godward, to speak about investigations and the balancing act compliance officers face: how to demonstrate good-faith cooperation to prosecutors, what can go wrong, and how to keep legal troubles and costs to a minimum for your company. We encourage all our subscribers to attend; our full conference agenda makes it well worth the cost.

Second, keep hope alive. Congress has been yammering at the Justice Department for years to ease up its strong-arm habits of forcing companies to waive attorney-client privilege and the like. At least on paper, the Justice Department has been doing that with successive revisions of its policies for investigating and indicting corporations.

The cynics—and yes, we’re still among them—will be quick to say revised policies don’t matter as much as the people enforcing them. Well, on April 8, Attorney General Eric Holder assigned Marshall Jarrett, long-time director of the Justice Department’s Office of Professional Responsibility, to run the Executive Office of U.S. Attorneys and oversee what the 94 U.S. attorneys are doing.

Jarrett and Holder worked together closely in the 1990s, when Holder was deputy attorney general and Marshall served in his office. At the time, Jarrett helped to shape federal criminal law enforcement policy and supervised the prosecution of corrupt officials. Holder, meanwhile, was drafting “ the Holder Memo,” the department’s first-ever guidelines on corporate investigation and indictment.

So the key players know each other, have worked together, and presumably have a clear sense of what they want to do. Let’s hope that ending prosecutorial abuses is part of that.

Back in the 1990s, I was a big fan of The X Files. Little did I know that the central tenets of that program—distrust, cynicism, and a deep suspicion that people in Washington are controlled by aliens—would be so useful when analyzing the economic stimulus bill. 

Compliance officers and corporate secretaries in the financial sector have spent the last two weeks with one watchful eye on the Treasury Department and the other on Capitol Hill, as lawmakers whirled out all manner of attacks on executive pay. Politically, walloping overpaid CEOs has been great theater. Practically, the theatrics have led to increasing confusion about exactly what is supposed to be included in the corporate proxy statement due later this spring. And the Fox Mulder disciples out there, trusting nobody, have been wondering when the new pay restrictions would start applying to all companies, not just those receiving government bailouts.

Then came Friday, and things started to get really weird.

Earlier in the week, the Senate had passed a stimulus bill with severe restrictions on executive pay. Most notorious was a provision that merit pay (that is, bonuses and performance-based compensation) could not be more than one-third of an executive’s total pay package. That was more far-reaching than anything the House had passed or the Treasury Department wanted to see, so late in the week that provision was deleted as part of the usual haggling that goes on when important bills are near a vote. Everything looked splendid; on Friday morning I even checked a copy of the House bill myself (the only version available to the public) and nary a peep was included about the Senate’s restrictions.

Then Sen. Christopher Dodd, chairman of the Senate Banking Committee, slipped the provisions back in sometime later in the day. By evening, when the final bill was passed, those original, severe Senate restrictions on executive pay were the law of the land. And they apply to the top 20 executives at any company taking government bailout funds.

Were this an election year, I’d assume Dodd had the pure and age-old motive of pillorying an unpopular group to score points with the public. But we just staggered through an election, and Dodd is actually interested in the business of governing—which is all about doing favors for the special interest groups that support you financially.

So I can’t help but notice the other major provision Dodd slipped into the stimulus bill: a clause letting TARP recipients repay their government loans much more quickly, which in turn would let them evade these onerous pay restrictions and resume their normal, bloated lifestyles. Nobody is saying that quick repayment is a good thing; in fact, the banks could well return back to their under-capitalized state too quickly and be just as endangered as they were in the first place. But they would also be able to give their executives whatever fat compensation they like—which is what the bank executives wanted all along.

The banks didn’t like the Treasury Department’s pay restrictions. Then along come even worse restrictions, and a neat way to escape the whole mess of compensation reform entirely. It makes you wonder: Were the banks behind Dodd’s seemingly bone-headed stunt in the first place?

Like Fox Mulder said, trust nobody.

All you chief compliance officers with hotshot deputies, here’s your chance to do something nice for them so they won’t decamp to greener pastures: The Millstein Center for Corporate Governance is accepting nominations for its second annual Rising Stars of Corporate Governance award.

The award recognizes up-and-coming players in corporate governance, and is open to anyone anywhere in the world who does anything plausibly related to furthering good governance: corporate executives, independent analysts, outside activists, and the like. Nominees can hail from corporations, academic bodies, institutional investors, auditors, advisory firms, rating agencies, proxy services, professional associations, and others. The only restriction is that nominees must be under 40 as of June 10, 2009. (Full disclosure: I won a Rising Star award last year.) 

Nominations must be submitted by March 31, 2009. If you have someone in mind, submit a brief summary of why—including the candidate’s name, title, biography, and contact information, as well as your own contact information—to Meagan Thompson-Mann</a> at the Millstein Center. You can also find more information at the center’s website.

Rising Star winners will be acknowledged at a reception on June 10, 2009 as part of the 2009 Yale Governance Forum. I can vouch that it’s quite a party.

Compliance Week Editor-in-Chief Matt Kelly is in China. This blog posted by Compliance Week Publisher Scott Cohen:

As expected, it hasn’t taken the plaintiffs bar long to leap down the throats of companies involved in the current financial meltdown. Merrill Lynch, for example, is being sued for grabbing onto the lifeboat that is Bank of America; a suit filed in New York claims the proposed $29 acquisition price “compares poorly to Merrill’s 2007 value” (no duh—Merrill’s stock exceeded $90 per share last year). According to the suit, the acquisition attempts to “unlawfully divest Merrill public stockholders of their controlling interest in the company for grossly inadequate consideration.”

Fannie Mae has also been named in several class actions already, and it won’t be the last; a few hours after the Merrill suit was filed, a shareholder lawsuit was brought against Northern Trust for “materially misrepresent[ing] the liquidity of and risks associated with auction rate securities.”

Class action trends are something Compliance Week tracks rigorously, and of course we publish a regularly updated list of filings and settlements. We’ll continue to keep our eyes on this issue in the coming months and years, especially as IFRS convergence becomes a reality; its principles-based tenets will likely clash with our market’s current (e.g., dysfunctional) litigation scheme.