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The (as published by CNET), February 19, 2007 article

For SEC, tech switch spurs stock option probes

Investigations into "crooked accounting" take dramatic leap forward with combination of real-time reporting, programming language.

By Donna Block and Ron Orol

Published: February 19, 2007, 6:00 AM PST

The head of the U.S. Securities and Exchange Commission is crediting the incorporation of interactive data into SEC filings for the discovery of "a pandemic of crooked accounting" linked to stock option backdating.

At the Practising Law Institute's annual "SEC Speaks" event earlier this month, SEC Chairman Christopher Cox said XBRL, the Internet programming language newly adopted by the agency, is helping his staff root out fraud by tagging financial data so computers can track it and sift through it quickly.

The chairman even compared his team of enforcers to the characters in the hit TV show Heroes--everyday people with extraordinary abilities they didn't know they had. Cox said his enforcement staff comprise a group of otherwise ordinary people with extraordinary talent and dedication.

"In other words, 'Save the cheerleader, save the world,'" Cox said, intoning the show's mantra.

He added that while his staff may not possess superpowers, "by sheer willpower and hard work, they routinely accomplish great deeds. And, to all the Americans who depend on them, they are very real heroes, in every sense."

More than 170 companies have been investigated by the SEC or have conducted internal inquiries into whether option dates were changed to benefit executives.

Cox said the timing of the option-backdating scandal coincided with the SEC's decision to begin converting Form 4 submissions--the form companies use to report stock option exercise transactions--into interactive documents.

Before 2003, information filed on the SEC's Form 4 was analyzed the old-fashion way--retyped into SEC databases and spreadsheets before being scrutinized. "Not surprisingly, for all of that time, the backdating phenomenon was never uncovered," Cox said.

More recently, however, the SEC started collecting Form 4 data in an interactive format, which made analyzing the information easier. The SEC also issued new rules around the same time requiring real-time reporting of option awards--within two days of the grant. "Once real-time disclosure was combined with interactive data...we began to find clues that had previously gone undetected. That led directly to the discovery of what we now know were billions of dollars of backdated stock option awards," Cox said.

Cox advocates using technology to improve disclosure, and regulation is pressing companies to use the interactive system. The SEC has invested $54 million into its development this year.

But many companies have been slow to adopt XBRL for a variety of reasons, including cost.

Cox said other technology initiatives are also in development at the agency. He said the SEC is using new technology to "help accurately track, collect and distribute billions of dollars of penalties and disgorgements."

The agency is also introducing new software tools to manage its enforcement cases and be prepared to operate in a disaster or emergency.

Separately, agency officials said at the conference that regulation should have a global perspective in which authorities engage with each other on international standards.

"Market convergence and innovation will challenge us even more to be responsive and thoughtful in adjusting market regulation to market needs and realities," SEC Commissioner Kathleen Casey said at the conference.

The pending $14 billion merger of NYSE Group, parent of the New York Stock Exchange, with Euronext, which operates the Paris, Amsterdam, Brussels and Lisbon exchanges, will result in the first trans-Atlantic exchange and has the SEC collaborating with European regulators to oversee the merger and coordinate their supervisory efforts.

In January, the exchanges signed a memorandum of understanding with respect to their regulation whereby the SEC and the College of Euronext Regulators pledged to cooperate "to promote investor protection, foster market integrity, and maintain investor confidence and systemic stability in connection with the regulation of the combined group."

The memorandum confirmed that the deal will not result in foreign companies being subject to the domestic laws of any of the countries where the exchanges are based. Some foreign investors worried that companies traded on the European exchange would be subject to provisions of the Sarbanes-Oxley corporate-governance law.

Nevertheless, SEC Commissioner Annette Nazareth, a Democrat, said at the conference that she is seeing other markets adopt similarly tough rules over financial reporting, even though Sarbanes-Oxley, most notably its internal-control requirement contained in Section 404, has been greatly criticized.

"It is interesting that several jurisdictions are adopting regulations similar to SOX in an effort to improve investor protections, encourage private investment and, as a result, increase the depth of their markets," she said.

However, Casey, the newest commissioner and a Republican, said the SEC needs to continue reaching out to regulators both at home and abroad, and regulators "need to fix 404."

"The commission needs to continue in its efforts to engage cooperatively with other regulators both domestically and internationally," she said.

Questions about new rules for investing in hedge funds were also raised at the conference. SEC staffers were grilled on the agency's proposal to raise the requirements investors must meet to invest in hedge funds. Existing regulations call for an individual hedge fund investor to have $1 million in assets or an annual income of $200,000 for at least two years prior to making the investment. In December, the commission introduced a draft rule that would change the net worth threshold to $2.5 million in invested assets, excluding a primary residence, with the SEC adjusting the new investment minimum every five years for inflation.

Steven Wallman, CEO of Vienna, Va.-based brokerage and consulting business Foliofn, said the SEC sought to prohibit investors with lesser means from investing in hedge funds but hasn't produced concrete evidence that the strategy is more risky than investing in mutual funds.

But Doug Scheidt, SEC associate director and chief counsel for the Division of Investment Management, defended the proposal. He argued that many hedge funds lack sufficient disclosure and aren't required to open up their books to commission examiners for periodic inspections. "Hedge funds are notoriously untransparent," Scheidt said.

Scheidt conceded, however, that he couldn't say definitively that investing in hedge funds is riskier than mutual funds. After Wallman pressed him on the subject, Scheidt declined to comment on whether the agency would produce a study examining the risks associated with each type of investment.

Laura Unger, a former SEC commissioner, pointed out that critics of the measure argue that the new prohibition would reduce the numbers of people investing in hedge funds, reducing the diversification of the funds, thus increasing the risks for those remaining.

"A smaller pool of investors has the perverse effect of making it riskier to invest in hedge funds, because the funds are spread out among fewer investors," Unger said.

Scheidt said the new limits made sense, in part, because hedge fund managers aren't seeking to raise investment capital from the people that the measure will exclude.

Interested investors and managers have until March 6 to comment on the proposal. So far, the SEC has received about 200 comments, most of which have been from investors and managers deriding the agency's proposal on grounds that it will have a chilling effect on competition in the industry and prohibit sophisticated investors with fewer assets.



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