"Equivalence" Of US GAAP With IAS/IFRS? – Major Issues For US Companies Issuing Securities In The EU

This briefing is not intended to, and does not, constitute legal advice. The implications of the Prospectus Directive,¹ Transparency Directive² and the draft technical advice will be different for each issuer depending on its particular circumstances. Any reader interested in the impact of the Prospectus Directive, Transparency Directive or the draft technical advice on its activities should contact its legal advisers.

CESR (the Committee of European Securities Regulators) has issued draft technical advice to the European Commission which at first blush seems to conclude that "as a whole" US GAAP is equivalent to IAS/IFRS (International Financial Reporting Standards).³

However this "equivalence" is in fact subject to a whole range of additional "remedies", as they are termed: supplementary financial statements or quantitative or qualitative disclosures with respect to specific differences between the two accounting standards, supported by auditors’ opinions, plus a general requirement for issuers to consider, and their auditors to attest to, other differences not specifically identified by CESR, but which could be significant to investors.

If the European Commission adopts the draft technical advice as it stands, US issuers with securities (other than wholesale debt) admitted to an EU regulated market (e.g. listed in London, Ireland or Luxembourg) or offered to the public in the EU (e.g. employee share offers) may incur substantial additional costs because of the requirement to prepare and provide the required supplementary statements, disclosures and auditors’ opinions.

Urgent action to be taken by US issuers:

• issuers should consider reviewing the draft technical advice¹ and assessing with their auditors the cost of preparing such "remedies" and auditors’ reports, and consider their options in the light of their cost/benefit analysis
• issuers should consider lobbying CESR and the European Commission, providing reasoned explanations and concrete data as to potential costs where possible, and urging a simple "yes" decision on the general equivalence of US GAAP, or at least a narrowing of the remedies required to a specified list without imposing a general duty to consider what other differences between US GAAP and IAS could be significant to investors, and a removal of any requirement for auditors to issue opinions
• the International Primary Market Association will shortly be circulating a questionnaire seeking from non-EU issuers an indication of the costs implications for them of the draft technical advice and their intended actions in consequence (e.g. delisting from EU regulated markets), and issuers are encouraged to respond to assist in IPMA’s lobbying efforts
• issuers who prepare their financial statements otherwise than under US GAAP (e.g. statutory accounts in the case of insurance companies) should also consider lobbying the European Commission to have the GAAP they use assessed as to equivalence with IAS as soon as possible
• issuers may wish to review the documentation of their existing debt issues to see whether they will be able to delist their issues if they consider the remedies too burdensome or costly, and new debt issues should also consider including a provision permitting delisting and the transfer of listing outside the EU (or to a listed but unregulated market like the UK Professional Securities Market where IAS financial statements would not be required - although marketing of the securities concerned would be effectively limited to professionals, and investors may be subject to investment constraints in relation to securities listed on such markets).

As from 1st January 2007 (or in the case of the Transparency Directive any earlier determination by the European Commission of whether the accounting principles non-EU issuers are using are equivalent), the EU Prospectus Regulation⁴ (made under the Prospectus Directive) and Transparency Directive both require non-EU issuers who:

• have securities admitted to trading on an EU regulated market (e.g. listed in London, Ireland or Luxembourg), or
• who wish to make a public offer of their securities in Europe,
• to prepare and present financial statements on the basis of:
• EU endorsed IAS/IFRS accounting standards, or
• the issuer’s own national accounting standards, provided they have been endorsed by the European Commission as equivalent to IAS/IFRS.

(For more details see the Sidley Austin Brown & Wood memoranda of March 2004 at http://www.sidley.com/db30/cgi-bin/pubs/110603-EU%20Prospectus%20Bkgd.pdf and October 2004 at http://www.sidley.com/db30/cgi-bin/pubs/110603-EU%20Prospectus%20ES.pdf. Note that IAS financial statements are not mandatory (though a description is required of significant differences between the GAAP used and IAS and any departures from International Standards on Auditing) for wholesale debt, i.e. securities with minimum denominations of at least €50,000 which are neither shares nor convertible into shares of a group company, and so this memorandum addresses only securities which are not wholesale debt.)

The European Commission’s decision as to the "equivalence" of US GAAP for this purpose is therefore critical to US issuers who already have securities admitted to trading on an EU regulated market (e.g. listed in London, Ireland or Luxembourg) or who may in future wish to consider offering securities to the public in the EU (e.g. employee share offers) or having their securities admitted to trading on an EU regulated market if such securities have a minimum denomination of less than €50,000.

To assist them to determine the equivalence of Canadian, Japanese and US GAAP to IAS, the European Commission requested technical advice from CESR, which conducted a technical assessment and on 27 April 2005 issued for consultation their resulting draft technical advice. The consultation period is short, ending on 27 May 2005, and the European Commission has requested CESR’s final advice by 30 June 2005 to allow sufficient time for parties affected by the application of the Prospectus Directive (which will take effect from 1 July 2005) and the Transparency Directive (expected to apply from the Autumn of 2006) to address the consequences.

CESR’s draft technical advice, while at first sight seeming to conclude that "as a whole" US GAAP is equivalent to IAS/IFRS (International Financial Reporting Standards), would in fact require a whole range of certain additional "remedies" (supplementary financial statements or quantitative or qualitative disclosures), supported by auditors’ opinions, in order for a US issuer to be able to claim "equivalence".

The table shows the areas identified by CESR in relation to US GAAP, in increasing order of level of additional disclosure required in the prospectus and in the financial statements published as required by the Transparency Directive⁵:

In addition, the onus would be on issuers and their auditors to decide whether these additional "remedies" are applicable to the individual issuer, on the basis of materiality to the issuer’s financial position and significance to investors. A major problem is that the list of GAAP differences and associated remedies provided by CESR is not exhaustive. Issuers would be subject to the general rule under IAS 1 that issuers must provide additional disclosures when necessary for enabling users to take informed investment decisions where there are other differences in GAAP not specifically identified by CESR which could be significant due to the particular issuer’s business, operations, financial position or industry. Again, attestation by auditors as to compliance with this general rule may be necessary. In order to confirm that there are no other significant differences for which additional disclosures may be needed, effectively a full reconciliation may be needed.

Therefore, if the European Commission decides to adopt the technical advice substantially in the form of the current draft, in practice the exercise to be undertaken by US issuers and their auditors to produce the necessary "remedies" and opinions may need to be nearly as extensive and thorough (and as expensive) as what would be needed for a full reconciliation between US GAAP and IAS and the production of an auditor’s report on it. This is despite the draft advice specifically stating that reconciliation was not proposed as a remedy in the case of the GAAPs examined, and even though the Prospectus Directive did not envisage auditors’ reports - quite apart from the difficulty auditors may have with being asked to opine on the significance to investors of particular differences between GAAP and IAS.

Furthermore, in relation to securities issues after 1 July 2005, in the light of the sweeping requirements of the draft technical advice there is a risk that Article 5 of the Prospectus Directive (which sets out a general duty of disclosure) may be interpreted as meaning that this duty will not be satisfied (and issuers could therefore potentially be liable to investors for its breach) unless any material differences revealed by a line by line reconciliation of local GAAP with IAS are included in prospectuses as from 1 July 2005 – if the advice as it stands is adopted by the European Commission later this year or next year.

It is also not clear from the advice whether "remedies" for interim financial statements, which do not normally have to be audited, will have be attested by auditors.

In relation to equity securities, or debt securities with minimum denominations of less than €50,000, US issuers with such securities listed in the EU who consider the "remedies" required for US GAAP equivalance too burdensome or costly may, as discussed in previous SABW memos,⁶ wish to consider (if their documentation so permits):

• redenominating those securities so as to have minimum denominations of at least 50,000 or equivalent in other currencies, or
• removing those securities from EU regulated markets and delisting them from EU stock exchanges where the listing is conditional on admission to such markets, and either:
• listing outside the EU instead, or
• transferring to listed but unregulated markets within the EU, to which the Prospectus and Transparency Directives will not apply (the UK is currently establishing such a market for that purpose, to be known as the "Professional Securities Market", as are Luxembourg and Ireland).

However, note that securities listed on an unregulated EU market can only be marketed and sold under an exemption from the Prospectus Directive, such as that for sales to qualified investors. Therefore, a general marketing of the securities to individuals will not be possible. Furthermore, it is unclear whether institutional investors will be subject to any regulatory or internal restrictions which prevent them from investing in securities only admitted to such market or which limit such investments.

Note also that US issuers who also wish to take advantage of an exemption from the obligation to publish a prospectus for employee share schemes applicable to employees who are resident in an EU member state may only do so if they continue to have securities admitted to trading on a regulated market. (The exemption will apply if the issuer’s securities were so admitted before the making of the employee share offer – but the already-admitted securities do not need to be shares, they could be debt securities, even wholesale debt.)

As for US issuers who produce their financial statements on the basis of statutory GAAP, such as insurance companies, CESR’s mandate did not extend to the consideration of statutory GAAP so such issuers will need either to produce full IAS financial statements with its associated costs, or else to consider delisting or transferring their listings as mentioned above. Such issuers may also wish to consider lobbying the European Commission for statutory GAAP to be granted equivalent status to IAS by 1 January 2007.

It is worth noting that although the European Commission will take into account CESR’s technical advice, it is not bound to follow it, and so the opportunity may be taken to lobby at all levels.

The Prospectus Regulation strictly requires a decision by the European Commission as to whether certain countries’ GAAPs are equivalent to IAS for this purpose, or whether they are not so equivalent. It does not allow for a middle ground of "will be treated as equivalent only if certain additional statements or disclosures are made". However, the European Commission’s mandate to CESR specifically asked them to consider this middle ground. Therefore the Prospectus Regulation will require to be amended if the Commission adopts this middle ground approach (the Transparency Directive is silent on the point).

Given the short timescale, US issuers who want their securities to be admitted to trading on an EU regulated market or offered to the public within the EU should urgently consider lobbying CESR and the European Commission to provide a simple equivalence decision regarding US GAAP. Issuers may also wish to consider a compromise solution whereby they would be required to include only a general risk factor type warning concerning the material areas of discrepancy between US GAAP and IFRS identified by CESR without qualification.

Alternatively they could consider lobbying for the exclusion of the general requirement to consider other differences which may be significant to investors so that it should be sufficient for the auditors to confirm that the specific remedies for particular GAAP provisions have been applied appropriately. It may also be worth seeking clarification that the general duty of disclosure of information in prospectuses under Article 5 of the Prospectus Directive should not be solely by reference to IAS.

It seems unlikely that CESR will materially change the substance of their draft technical advice, so lobbying efforts directed at the European Commission may be more effective. Toru Shikibu, deputy commissioner for international affairs at the Japanese FSA, has been reported as saying "These required remedies could result in a de facto denial of access of Japanese issuers to the EU capital market," which may "force Japanese issuers to stop global offering of securities despite the globalization of the capital market." The EU’s Financial Services Action Plan was intended to create a large and liquid capital market within the EU. That objective will surely be defeated if retail investors within the EU lose access to the securities of non-EU issuers because non-EU issuers delist their securities from EU regulated markets and cease offering their securities to the public within the EU.

This article has been prepared by Sidley Austin Brown & Wood LLP for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Readers should not act upon this without seeking professional counsel.