Adapting to a Rapidly Changing Regulatory

and Financial Environment

Isam Salah
Partner
King & Spalding LLP
New York City

ENRON – December 2001 Bankruptcy Filing Largest in U.S. Corporate History

WORLDCOM – July 2002 Bankruptcy Filing Overtakes Enron as largest in U.S. Corporate History

Enron’s Abuses

Legal Response to Enron’s Abuses

Enron’s Abuses

• Not fully disclosing the extent and nature of transactions with related parties

• Improperly excluding the debt of SPEs from its balance sheet

• Treating certain transactions as asset sales without actually transferring the risks of ownership

• Engaging in commodities transactions that were in fact disguised loans

• Engaging in transactions that purported to hedge risk but in fact were designed to keep losses off its books

Legal Response to Enron’s Abuses

Passage of the Sarbanes-Oxley Act in July 2002

Sarbanes-Oxley – Sweeping reform that affects relationships between public companies, their directors and officers and their auditors.

• Certification of financial statements by CEOs and CFOs of public companies

• Restrictions on personal loans to directors and officers

• Forfeiture of bonuses and profits from sales of securities during 12 month period following publication of financial statements that are later restated

• Audit committees to adopt procedures for the processing of complaints about accounting practices and to protect whistleblowers

Additional Features of Sarbanes-Oxley

• Securities and Exchange Commission (SEC) to review public company reports periodically

• Prohibitions on auditing firms performing certain non-audit functions

• Accounting firms to be regulated by Public Company Accounting Oversight Board

• Securities analysts subjected to formal conflict of interest rules

• Increases in fines and penalties for violations

Board of Directors – A majority must be independent, Must hold regular meetings of
non-management directors, Financial experts – Audit Committee , must have at least one,

New Restrictions on Auditors to Enhance Independence

• Limitation on services provided by auditors

• Audit committee must pre-approve all non-audit services

Other Auditor Requirements

• Rotation of lead audit partner every five years

• Report critical accounting policies to audit committee, including alternative treatment

Public Company Accounting Oversight Board

• Five members appointed by SEC

• Not a U.S. government agency

• All public accounting firms must register if they participate in audit of a public company

Public Company Accounting Oversight Board

• Required to establish auditing standards, quality control standards, ethics standards and independence standards

• SEC to inspect registered accounting firms every one year or three years, depending on size of firm

• Power to conduct investigations and disciplinary proceedings and to suspend

Lessons to be Learned

• Islamic finance sector is young and the effects of its own “Enron” would be severe

• Islamic finance sector has a strong interest in having safeguards in place to avoid an “Enron”

Use of Special Purpose Entities (SPEs)

• Widely used by Enron to facilitate abusive practices

• Regularly used in Shari’ah compliant transactions, especially in the U.S. to address regulatory issues

• Must make clear the reasons why SPEs are used

Disguised Transactions

• Enron used financing disguised as commodities trades

• Commodities trades are often used in Shari’ah compliant transactions

• Must make clear that commodities transactions are not used to perpetrate misleading financial statements

Conclusions

• Importance of strong private and public gatekeepers

• Importance of strong and independent board of directors and audit committee

• Importance of preserving the independence and integrity of auditors

• Crucial role of the regulators

• Distinguish use of SPEs and commodity transactions to avoid taint

• Continue the development of improved and streamlined financing structures