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Last month a small thicket in the vast forest of US capital markets regulation was cut back. This should lighten the hearts of issuers, which are regularly frustrated by the battles which break out between their underwriters, the auditors and the lawyers.
The change concerns a Statement of Auditing Standards (SAS) issued by the American Institute of Certified Public Accountants (AICPA). It affects all offerings which have a US tranche, even if made by non-US issuers. When an offering is made even in part in the US, the issuer's auditors are asked by the underwriters to provide them with what is known as a comfort letter.
Essentially, this letter confirms (1) that the financial statements included in the prospectus, and the auditors' opinion on those financial statements, are the ones the auditors actually audited (ie, tying the financial statements in the prospectus to the last set of audited accounts); (2) that certain procedures have been performed in respect of the other financial and statistical data in the prospectus (this usually says that the auditors have traced the figures back to accounting records or the financial statements) and; (3) that nothing has come to the auditors' attention which gives them reason to believe the issuer's financial state has materially adversely changed since the last audited accounts.
This last is called a negative assurance. Typically in an offering which includes a US tranche, the prospectus will contain three years of audited income statements and two years of audited balance sheets. That information, running through to the end of the last audit year, has, in market jargon, been "expertised" by the auditors. But there is a stub period, which runs from the end of the last audited year to the date of the sale of the securities, for which there are no audited financial statements in the prospectus. It is to this stub period that the negative assurance relates. The reason why underwriters want this assurance is because, in the litigious US, they need to be able to establish a defence of due diligence if the offering goes wrong and the investors sue. The negative assurance is a part (but not all) of that defence.
The plot thickens in the case of certain exempt offerings, such as private placements under section 4(2) of the Securities Act of 1933 and private placements to "qualified institutional buyers" under Rule 144A. In these cases, the AICPA allows auditors to give a negative assurance only if they in turn obtain from the underwriters a representation that, in effect, the due-diligence process has been carried out as stringently as it would have been for a registered offering, ie, one to retail investors, where the standards of due diligence are demanding. This is enshrined in SAS 72. Indeed, the precise words of SAS 72 are that the due-diligence process must be "substantially consistent with the due-diligence process" in a registered offering. This has led to much thoughtful scratching of legal heads over the years as to the meaning of "substantially consistent". The representation expected of the underwriters is called an SAS 72 Representation Letter.
On the face of it, then, the underwriters and auditors simply exchange letters. Why? The answer is risk. The auditors argue that they should not be on the hook if the due-diligence duty falls, as it should do, on the underwriters. After all, due diligence is their job. The underwriters get paid by commission whereas the auditors charge by time spent, not value. Why should they take risk without the reward?
This makes for further legal wrangling along the lines of the meaning of "substantially consistent" - fascinating for the lawyers, important to the underwriters and auditors but not something which the average issuer, especially one from outside the US, necessarily feels is worth the candle. The problem is that non-US issuers are likely to find that any auditing firm sufficiently large to be acceptable to the market is either a US firm or an international firm with a US arm and subject, therefore, to the various SAS requirements.
But it gets worse. If the underwriters refuse to provide an SAS 72 Representation Letter, SAS 72 says that the auditors cannot provide the negative assurance. Stalemate. To overcome this, auditors have, as directed by SAS 72, taken to handing over something called an Agreed-Upon Procedures Letter. The form of this letter is laid down by SAS 35 which allows auditors, after performing certain procedures (including discussions with officers of the issuer who are responsible for financial and accounting matters), to give a negative assurance as to whether certain unaudited financial statements of the issuer have been prepared in line with Gaap (generally accepted accounting standards).
"In a typical securities offering, SAS 35 is not actually responsive to the entire situation, since underwriters need comfort on the stub period," explains Alan Bannister, a New York attorney with UK law firm Clifford Chance, who advises on US and international securities transactions. "SAS 35 did, however, provide the framework for a form of negative assurance which, although not prescribed by SAS 35, had become a widely accepted compromise." The auditors would state that the issuer's officers had confirmed that, during the stub period, there had been no material adverse change in the issuer's capital structure or long-term debt or (as compared with the same period in the previous year) net income. Although this became market practice, the actual text of the negative assurance would have to be hammered out afresh for each issue in often extensive negotiations between the underwriters, the auditors and the underwriters' US lawyers, since the text itself was not laid down by SAS 35.
Fortunately, the AICPA has come to the rescue. At the end of April, SAS 76 took effect. "SAS 76 has embraced what had become widespread market practice," Bannister notes. It gives a green light to the previous practice adopted in reliance on SAS 35 while confirming that auditors cannot give a negative assurance in the absence of an SAS 72 Representation Letter from the underwriters. This may seem a small step for mankind, but it is a large one for global exempt offerings.
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