The following is a brief recap of regulatory work by the Securities and Exchange Commission, U.S. Treasury, and audit and accounting standards agencies.
For years, the NVCA has worked with the exchanges to raise the level of share ownership that creates regulatory concerns with the independence of a board member, particularly of an audit committee member. Both the NYSE and NASDAQ have recently shown a willingness to modify their rules on audit committee member independence, indicating a comfort level with shareholdings of 20% or less. However, those rules are on hold while the SEC finalizes rules on independence required under Sarbanes-Oxley.
The NVCA used the SEC’s rulemaking initiative on financial experts to also highlight the difficulty that an overly literal reading of Sarbanes-Oxley would cause for companies with audit committee members who represented more than 5% of the stock of the issuer. That advice seems to have registered. The SEC’s audit committee rule proposal, which must define a non-independent “affiliated person” for Sarbanes-Oxley purposes, takes the approach recommended in our “financial expert” comment letter. While the new proposal does not mention a 20% shareholder level, it does accept the form of analysis that exchanges have used in the past-one based on control, and a “facts and circumstances” analysis, rather than a mechanical test based on share ownership.
The NVCA has filed a comment in response to the proposed rule recommending a safe harbor level of ownership at 20%. The letter also tries to educate the SEC on the value of large shareholders who are independent of management and the very low risk that a VC director would use any control to abuse other shareholders.
With regard to audit commitees, the SEC has approved final rules requiring issuers to disclose in 10Qs and 10Ks whether they have an “audit committee financial expert” as defined in the statute. The final rule offers more flexibility than the initial SEC proposal, which would have made it difficult for any non-CPA to qualify. As the NVCA recommended in its comment letter to the SEC, the new rule states that characteristics that qualify someone to serve as an audit committee financial expert could be acquired through relevant experience. It also changed the designation to “audit committee financial expert” to reflect the more specific purpose of the position. In addition, it provides a “safe harbor” to clarify that designation, as the audit committee financial expert does not carry increased liability. It is still unclear who will qualify for the designation.
As part of the ongoing scrutiny of conflicts of interest by securities analysts, the Sarbanes-Oxley Act trumped NASD and NYSE efforts to address the issue. The legislation may have precluded any regulatory flexibility for addressing the disproportionate impact that rules separating research from investment banking would have on smaller regional investment banking firms. The NVCA will ask the NYSE/NASD IPO Advisory Committee to do what it can to ensure the continued viability of regional investment banking firms whose business model is being undermined by these new rules.
Proposed AICPA Statement
The NVCA is evaluating the exposure draft of an AICPA Statement of Position (SOP) that may have the effect of changing the accounting for VC funds. Because the SOP allows for little judgment as to its application, there is concern that it could cause some funds to switch from fair value accounting, as required of investment companies, to either equity or consolidation accounting, which would be required for funds that do not qualify as investment companies. The NVCA will comment on the “exposure draft” and work with AICPA staff and accounting experts to ensure that the new guide is workable for VC funds.
The NVCA commented in favor of Treasury Department draft rules on the application of Patriot Act anti-money laundering program requirements to “unregistered investment companies.” We supported the liquidity-based distinction based on a 2-year lock-up by which most venture capital funds should be exempt from the new requirements. We emphasized the need to allow for certain investors to redeem their interests based on legal requirements. The rules were set to be finalized by the end of Q1.
SEC on Private Equity
The SEC continues to investigate whether hedge funds should be subject to more regulation. Since venture capital firms are exempt from SEC regulation under the same provisions as hedge funds, we are monitoring this situation closely. The principal exposure now seems to be the risk that the SEC would re-define “client” to mean an individual investor in a fund, rather than a fund, for purposes of the fewer-than-15-client exception from registration under the Investment Advisers Act.
New FASB Rule
The Financial Accounting Standards Board has published a new standard on consolidation of off-balance sheet entities. The NVCA is evaluating the potential impact of the new rule on venture capital funds. There have been concerns that investors in funds with only a few investors could be caught in the effort to require consolidation of previously off-balance sheet entities onto the financial statements of the investor.
Brian T. Borders is Of Counsel in the Washington office of Mayer, Brown, Rowe & Maw. Borders has served the NVCA as Regulatory Counsel since 1999. He also serves on the Board of the NASD.