Subject: File No. S7-24-06
From: Keith P. Bishop

July 1, 2007

Dear Ms. Morris:

The proposed definition of "significant deficiency" should not be adopted as proposed. Rather than defining a "significant deficiency" in terms of what it is, the Securities and Exchange Commission ("Commission") has proposed to define the term by what it is not (i.e., not a "material weakness"). The problem with this via negativa approach is that it relies upon the definition of "material weakness". Unfortunately, the Commission has adopted a definition of "material weakness" that has no logical meaning whatsoever.

The Commission has defined a material weakness in terms of a "reasonable possibility". Thus, a control deficiency constitutes a material weakness if there is "a reasonable possibility that a material misstatement of the registrants annual or interim financial statements will not be prevented or detected on a timely basis." While this definition has existed in the accounting literature, it is fraught with problems that the Commission should not ignore.

At the outset, it must be understood that an event is either possible or or it is not. The concept admits no middle ground - either something can occur or it cannot. If an event can occur, its probability can be assessed - that is, the likelihood that it will occur. In the Commission's Proposing Release, it appears to have embraced the accounting literature's confusion of possibilities with probabilities: "There is a reasonable possibility of an event when the likelihood of the event is either reasonably possible or probable as those terms are used in Financial Accounting Standards Board Statement No. 5, Accounting for Contingencies." Under FAS No. 5, something is "reasonably possible" if the "chance of the future event or events occurring is more than remote but less than likely." The probability of an event is "remote" if "The chance of the future event or events occurring is slight." The probability of an event is "probable" if "The future event or events are likely to occur."

These definitions are not capable of rationale application. First, probability is determined in two ways. The first is the classical or frequentist view. This view defines probability as "the event's occuring in a particular trial as the frequency with which it occurs in a long sequence of similar trials." M. Granger Morgan and Max Henrion, Uncertainty p. 48 (1990). In contrast, the Bayesian view is subjective. The probability of an event under this view is the "degree of belief that a person has that it will occur, given all the relevant information currently known to that person." Id. at 49. Neither the FASB nor the Commission specify which view of probability it intended to adopt. However, given the difficulty of conducting trials, it is unlikely that the frequentist view is at all practical in the context of assessing deficiencies in internal control over financial reporting.

The subjective nature of Bayesian probability necessarily means that there can be no single probability assigned to any event. Each individual will have his or her own view as the probability based upon what that individual knows at the time. Thus, the probability of an event involves not just the event, but the person's state of information on which the event is conditioned. This latter function of probability is overlooked in the Commission's existing definition of "material deficiency" and would be carried over to the proposed definition of "significant deficiency". Because the Commission will inevitably evaluate these matters post hoc, it is important that the Commission's rule take into account the fact that the probability is a function not only of the event but the state of information available to the person in question.

Even after assigning a probability to an event, the Commission's rule adds another significant level of subjectivity to the analysis by not defining "slight" or "likely". These terms are inherently contextual. Some people may view the chance of rain as "slight" when it is given as .2. Others, perhaps those planning a wedding or other significant outdoor event, may view the chance of showers as likely. Thus, even when agreement is reached on the probability of an event, different people may characterize the probability differently within the context of the terminology used by FAS No. 5.

In conclusion, I urge the Commission to adopt a more meaningful and accurate definition of "material weakness". Any definition of "material weakness" and ultimately "significant deficiency" should recognize that any probability assessment in the context of assessing internal control over financial reporting will be subjective and a function of both the event and the information available to the person at that time that the assessment is made.

By way of background, I previously served as California's Commissioner of Corporations and as Interim Savings Loan Commissioner. I am a past Co-Chair of the Corporations Committee of the Business Law Section of the California State Bar and Chairman of the Business Corporate Law Committee of the Orange County Bar Association. I previously served as a member of the California Senate Commission on Corporate Governance, Shareholder Rights and Securities Transactions. I am an adjunct professor of law at Chapman University. The foregoing views are my own and do not represent the views of the foregoing committees, Chapman Law School, my law firm or its clients.

Very Truly Yours,

Keith Paul Bishop