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1 the LEGAL IMPLICATIONS of OFF BALANCE SHEET View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by Wolverhampton Intellectual Repository and E-theses THE LEGAL IMPLICATIONS of OFF BALANCE SHEET FINANCING: A COMPARATIVE ANALYSIS OF UK and US POSITIONS POH SENG (PETER) YEOH LLM (DISTINCTION), LLB (HONS.), MBA, B.ECONS (HONS.), CIM, ADV DIP CONSULTANCY, TEFL TEACHING CERT. A thesis submitted in partial fulfilment of the requirements of the University of Wolverhampton for the Degree of Doctor of Philosophy July 2007 This work or any part thereof has not previously been presented in any form to the University or to any other body whether for the purposes of assessment, publication or for any other purpose (unless otherwise indicated). Save for any express acknowledgements, references and/or bibliographies cited in the work, I confirm that the intellectual content of the work is the result of my own efforts and of no other person. The right of Poh Seng (Peter) Yeoh to be identified as the author of this work is asserted in accordance with ss.77 and 78 of the Copyright, Designs and Patents Act 1988. At this date copyright is owned by the author. Signature………………………………. Date……………………………………. 1 Abstract Off balance sheet financing (OBF) is either not visible or only partially visible in financial reporting for a number of reasons. It has attracted controversy in the light of its employment in a number of major corporate scandals. Previous investigations dominated by short works and consultancy papers have focused mainly on the financial aspects of OBF. This academic cross-country research on the use of OBF in the UK and US capital markets was undertaken to extend the published analyses to include a legal perspective by studying its legal implications for directors, financial advisers, auditors and financial regulators. The study’s legal focus prompted relying primarily on the doctrinal approach, which was in turn completed by the use of a modified case study in order to help address the how and why issues of the research phenomenon. The study found that OBF instruments are double-edge financial instruments with good and bad consequences. When corporations used OBF for liquidity enhancement or to realise financial savings, they result in positive outcomes. In contrast, when used for aggressive window-dressing or in the manipulation of financial reporting for fraudulent ends, OBF mechanisms generated serious legal liabilities for directors, auditors, and financial advisers in terms of compensation suits or even criminal sanctions. Financial regulators were nonetheless found to be less likely to face legal consequences as a result of current judicial attitudes on the tort of public misfeasance. However, the extensive applications of OBF in conjunction with other forms of creative accounting have resulted in various regulatory responses. On a comparative note, litigation and enforcement actions were found to be relatively more extensive in the US because of the higher incidence of large corporate frauds and the work of regulatory champions especially in New York using deferred prosecution agreements. 2 Contents Dedication Acknowledgements Introduction 9-10 Chapter One: Research Approach, Scope, and Limitations Introduction 11 The Research Aims 11-14 The Research Context 14-19 Significance of the Study 19-26 Prior Research and Theoretical Background 27-34 The Research Question 34-35 Research Approach 35-41 Research Scope and Limitations 41-42 Chapter Two: Corporate Financial Reporting and Financial Governance Introduction 43 The Role of Financial Information 43-45 Financial Information and the Capital Market 45-47 Financial Information and Firm Valuation 47-51 Auditing and the Quality Assurance Function 51-52 Audit Function in the UK and US 52-57 Regulation of Financial Reports 57 Parliamentary (UK) and Congressional (US) Acts 57-68 The ‘True and Fair View and ‘Present Fairly’ Rules 68-70 Comparative Analysis of UK and US Financial Regulations 70-72 3 International Accounting Standards 72-74 Principles (UK) versus Rules-Based (US) Financial Reporting 74-78 Financial Regulators UK: FSA 78-82 US: SEC 82-85 Comparative Analysis of UK and US Financial Regulators 85-93 Chapter Three: OBF Reporting Practices: Making Debts Less Visible or Invisible and Earnings Exaggeration Introduction 94 OBF Instruments 94-96 International Finance Reporting Standard’s (IFRS) Treatment of OBF 96-97 UK Response to IFRS 97-98 US Position to IFRS 98-99 OBF Reporting Practices: US Position: Earnings Exaggeration via Consignment Reporting and Others 100 Investment Reporting Manipulation 100-103 Pension Financial Reporting 103-106 Lease Financing 106-110 Factoring 110-111 Securitisation and USE of Special Purpose Vehicles/ Enterprises (SPVs) 111-114 Financial Derivatives 114-121 Management Options Backdating 122 UK Position: Earnings Exaggeration via Consignment Reporting 4 and Others 123-124 Redeemable Preference Shares and SPVs 124-126 Lease Financing 126 Factoring 127 Pension Financial Reporting 127-129 Comparative Analysis of OBF Applications in the UK and US 129-134 Chapter Four: Financial and Legal Implications of OBF Introduction 135 The Nature of Financial Risk and Risk Management 135-138 Financial Risk in OBF 138-140 Legal Implications of OBF UK Position: Directors 140-152 Auditors 152-159 Financial Advisors and Other Gatekeepers 160-165 Compliance Risks in Financial Services Sector 166-168 Financial Regulators 168-176 US Position: Directors 176-183 Financial Advisors and Other Gatekeepers 183-185 Auditors 185-190 Aggressive Enforcements 190-191 UK and US Comparative Positions 191-198 Chapter Five Introduction 199 US Cross-Case Analysis: 5 Manipulative Use Cases 200-206 Financial Window-Dressing Cases 206-210 Financial Benefit Cases 210-212 UK Cross-Case Analysis: Manipulative Use Cases 212-219 Financial Window-Dressing Cases 219-225 Financial Benefit Cases 225-228 Comparative Cross-Country Case Analysis: Manipulative Use Cases 228-234 Financial Window-Dressing Cases 235-237 Financial Benefit Cases 237-239 Options Backdating 239-240 Hidden Share Ownership 241 Other UK/US Differences 241-245 Chapter Six: Conclusions Background 246-247 Motivations and Manner of OBF Applications 247-250 Legal Implications 250-255 Suggestions for Future Research 255 Concluding Remarks 255 Bibliography 256-285 Appendix 1: Case Studies Summary US Cases 286-322 UK Cases 322-351 6 Dedication This work is dedicated to my parents and friends. 7 Acknowledgements I wish to express my deepest gratitude to my panel of supervisors, namely; Dr. Andrew Haynes (first supervisor), Professor Stephen Griffin (second supervisor), Associate Dean Martin Cartwright (third supervisor); and my LLM thesis supervisor, Mrs. Helen Barker. This ‘advisory team’ have provided me with invaluable guidance and assistance. My gratefulness also extends to Dean Brian Mitchell of the School of Legal Studies. 8 Introduction This cross-national investigation is undertaken to examine the legal consequences arising from off-balance sheet financing (OBF) in the corporate world. OBF like other forms of creative accounting emerged in the 1960’s when some corporations saw the need to window-dress their financial statements. These needs range from the need to facilitate access to cheaper funding sources, preparation for takeovers, share value enhancement, board and management remuneration justifications, and the more seedy aim of financial fraud. Previous works looked at the subject mainly from the financial perspective, with primary focus on its beneficial or negative effects. This comparative country case study seeks to gather further insights on the motives behind its employment and how these might give rise to various legal implications to the users, financial advisers, and financial gatekeepers (comprising internal audit committees, external auditors, and financial regulators) in the UK and US capital markets. Further details of the purpose and aims of this investigation, together with the research approach and study methodology employed are provided in chapter one. As the use of OBF instruments are linked to corporate financial reporting, chapter two of this study will examine and compare the usefulness and challenges posed by them to preparers and users in both jurisdictions. The analysis will also cover the statutory obligations behind its preparation and disclosure and the roles played by accounting and financial regulators to ensure the quality of financial reporting. The varied nature of OBF instruments and how these are reported in financial statements will be addressed in chapter three. This chapter will compare and contrast 9 its applications in both the defined capital markets and will also analyse how its manner of use may impact upon the quality and reliability of corporate financial reporting. Like other forms of borrowing, OBF may pose serious financial and legal risks to the preparers, their advisers and financial gatekeepers; depending on the motives behind its employment and the manner of its disclosure. These will be explored and discussed further in chapter four of this investigation. Deeper insights into the motives behind the use of OBF will be accessed from three pairs of corporate case studies from each jurisdiction. One pair from each will cover those using OBF for viable financial benefits; a second will cover those with financial window-dressing aims, and; the third on those with dishonourable or fraudulent objectives. Details of these intra and cross-case analysis will be provided in chapter five.
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