Friday, October 31, 2014

E.U. Parliament Approves New Commission, with Lord Hill as Financial Services Commissioner

The E.U. Parliament has approved the new European Commission, with Lord Hill as Financial Services Commissioner, by a vote of 423 to 209, with 67 abstentions. The Commission, which will take office on November 1, 2014, is headed by Jean-Claude Juncker. In a statement ahead of the vote, President-designate Juncker said that he will introduce in the first three months of his mandate a legislative package to spur jobs and investment growth. Noting that the level of investment in the E.U. dropped by just under €500 billion, or 20%, after its latest peak in 2007, he warned that the E.U. is facing an investment gap and must work to bridge that gap. In that spirit, the Commission will create a Capital Markets Union designed to create vibrant equities funding through securities offerings and decrease the E.U.’s heavy reliance on bank funding. He vowed to oppose too prescriptive, too detailed and burdensome regulations, notably when it comes to small and medium sized enterprises (SMEs), which he said are the backbone of the economy, creating more than 85% of new jobs in Europe.

Lord Jonathan Hill will replace Michel Barnier of France as the E.U.’s top securities and banking regulator. Similar to Commissioner Barnier, Lord Hill emphasized that the avoidance of regulatory arbitrage is a paramount concern, both within the E.U. and with the United States. He will continue Commissioner Barnier’s fight to achieve financial regulatory convergence with the U.S. He has emphasized that the free flow of capital, to which he is totally committed, greatly depends on restarting a private, high quality securitization market. This will be one of his top priorities. He said the choice between regulation and growth is a false dichotomy. Regulators can encourage better securitization without increasing risk.

SEC Notes Passing of Former Chair Hills, Champion of Strong Corporate Governance

Former SEC Chair Roderick Hills, a strong proponent of sound corporate governance, has passed away. In a statement, SEC Chair Mary Jo White praised Chairman Hills as a true champion for America’s investors. The SEC has lost a strong leader and friend, she noted. Roderick Hills served with distinction as SEC Chairman from 1975 to 1977.

His lifelong commitment to sound corporate governance was strong and consistent. For example, in 2006, Mr. Hills chaired a subcommittee on corporate governance as part of an effort by the Committee for Economic Development to restore public trust in U.S. corporations. The Committee issued a report addressing corporate governance issues that then SEC Chair Christopher Cox said was of vital importance to the SEC's mission of investor protection.

As part of his commitment to corporate governance, former Chair Hills was a strong proponent of independent audit committees. In 2002, in the run up to the passage of the landmark Sarbanes-Oxley Act, he testified before the Senate Banking Committee and urged Congress to clarify that audit committees have the responsibility of protecting the independence of the outside auditors of company financial statements. He noted that appointment to an audit committee is not a "passive assignment."

SEC Asks Supreme Court to Deny Review of Disgorgement Order

The SEC asked the Supreme Court to deny review of an appeals court ruling that ordered disgorgement in an SEC enforcement action. In a brief, the SEC noted that a Fourth Circuit panel said that not all intervening market events or conditions will suffice to break the causal chain between illegal activities and subsequent profits for purposes of disgorgement of illicit profits. The appeals court thus did not treat principles of causation as irrelevant, posited the SEC, but simply recognized that an event, here the receipt of large profits from their ultimate sales of target company stock in a tender offer, can have more than one cause. Thus, even if petitioners had successfully demonstrated that their profits were attributable in part to intervening market events, those profits could also be attributable to petitioners’ own unlawful conduct.

The Court has been asked to answer the question of whether the court of appeals correctly affirmed the district court’s order that petitioners disgorge profits that the district court concluded were caused by their violations of securities laws. The case is set to be considered at conference on November 14, 2014, after which the Court will decide whether or not to grant certiorari. Teo, et al. v. SEC, Dkt. No., 14-19.

In SEC civil enforcement actions, federal courts employ a three-step burden-shifting approach to determine the amount by which a defendant has been unjustly enriched. In the first step, the SEC must establish an amount that is a reasonable approximation of profits causally connected to the violation. In the second step, the defendant has the burden clearly to demonstrate that the disgorgement figure established by the SEC is not a reasonable approximation. In the third step, the burden shifts back to the SEC to rebut the defendant’s evidentiary showing.

After a jury trial in federal court, the petitioners were found to have violated antifraud and shareholder reporting provisions of the Exchange Act. Employing the three-prong test, the appeals court concluded that the petitioner, a holder of target company stock, had not demonstrated that the tender offer was an intervening event that broke the causal connection between their violations and the profits at issue.

Disgorgement. In affirming the disgorgement order, the appeals panel rejected the contention that the tender offer had broken the causal connection between petitioners’ illegal conduct and the profits received as a result of the stock sale. The panel agreed with the district court that the SEC had produced evidence demonstrating that petitioners obtained over $21 million in profits from the portion of the shares that were tainted with reporting violations, and that this evidence presumptively demonstrated a reasonable approximation of the profits arising from transactions tainted by the fraud and reporting violations.

The petitioners asked the Supreme Court to decide if defendants in SEC enforcement actions can be ordered to disgorge profits earned as a result of intervening events unrelated to their securities violations. The SEC contended that review of that question is not warranted because it is not squarely presented here and is not the subject of a conflict among the courts of appeals.

Petitioners do not contest the court of appeals’ primary rationale for affirming the disgorgement order, which is that they presented insufficient evidence to establish that the relevant profits were attributable to an intervening event unrelated to their illegal conduct. The shareholders instead challenge the court of appeals’ alternative rationale that, even if the tender offer was the most direct cause of the profits that were ordered to be disgorged, those profits were also attributable to petitioners’ securities law violations, since accurate reporting of petitioners’ trades would likely have triggered the poison pill and thereby prevented petitioners from realizing those profits. Besides being unnecessary to the court’s ultimate decision, reasoned the SEC, that analysis was correct and consistent with other appellate authority. Thus, the petition for a writ of certiorari should be denied.

Wednesday, October 29, 2014

Assistant AG Lauds Cybersecurity Planning, Cooperation

[This story previously appeared in Securities Regulation Daily.]

By Amy Leisinger, J.D.

In remarks at the U.S. Chamber of Commerce’s Third Annual Cybersecurity Summit today, Assistant Attorney General John Carlin highlighted the importance of preparation in responding to potential cyber incidents and of public and private cooperation to effectively prevent, mitigate the damage from, and answer these attacks. Applauding the Chamber’s commitment to encouraging proactive cyber risk management and reporting incidents to law enforcement, the official agreed in his remarks that cybersecurity issues affect us all and that the business world should not have to face threats or cope with the fallout of an attack alone.

Cybersecurity planning. Noting recent statistics showing that 97 percent of Fortune 500 companies have been hacked, Mr. Carlin cautioned that “it is a question of when, not if, a major public breach will happen.” Cybersecurity attacks threaten privacy and the vitality of the U.S. economy, he explained, and “disrupting them is our collective responsibility.” A threatened or attacked business will want to say that it did everything possible to protect the company, as well as its customers, employees, and shareholders, the official maintained, and to do this, cybersecurity must be considered as a crucial part of risk management. According to Mr. Carlin, corporate cyber risk management should involve four activities: (1) creation of a comprehensive and understandable cyber incident response plan; (2) evaluation of the potential threats posed by business contacts and other third parties and ensuring that vendors also adopt appropriate practices; (3) consideration of obtaining cyber insurance to provide additional protection; and (4) cooperation among the private sector, lawmakers and regulators, and law enforcement authorities.

Cooperation. As businesses develop cybersecurity response plans, Mr. Carlin noted that the federal government is committed to working with them to protect networks and to identify and stop perpetrators. “At the Department of Justice, this is among our top priorities,” he said. Further, the official continued, indictments and prosecutions, together with disruptions, will play a key role in order in deterring future attacks. “[W]e rely on cooperation from the private sector to bring many of these cases,” he said. In exchange, he stated, the government will provide data and support to aid in businesses’ private efforts to respond to and deter intrusions and will work to decrease the impediments to sharing information with the government, including antitrust issues and threats to proprietary information.

“[W]hen intrusions happen, consumers expect companies to respond promptly, acknowledge the intrusion publicly, and cooperate with law enforcement to mitigate the damage,” Mr. Carlin explained, and the government and the private sector working together will be increasingly necessary to respond to security threats.

Tuesday, October 28, 2014

Entire Fairness Review Not Triggered Where Investment Firm Was Not Controlling Stockholder

[This story previously appeared in Securities Regulation Daily.]

By Lene Powell, J.D.

The Delaware Chancery court dismissed a shareholder challenge to the merger of two oil and gas companies, finding that entire fairness review was not triggered because an investment firm that controlled a third of the acquired company’s stock was probably not a controlling stockholder, and even if it were, had not engaged in a conflicting transaction. The court also concluded that the plaintiff shareholders did not sufficiently show bad faith on the part of the directors to survive the business judgment rule (In re Crimson Exploration Inc. Stockholder Litigation, October 24, 2014, Parsons, D.)

Background. Contango Oil & Gas Co. (Contango) and Crimson Exploration, Inc. (Crimson) were both independent natural gas and oil companies headquartered in Houston, Texas. Contango, the acquiring company, sought to diversify its asset base, while Crimson was looking for more working capital to exploit its existing opportunities and increase growth. Many members of Crimson’s management expected positions in the new company.

Oaktree Capital Management, L.P. is an investment management firm that held about 33.7 percent of Crimson’s outstanding shares before the merger. The plaintiff shareholders alleged that a group of affiliated defendants, including Oaktree, constituted controlling stockholders of Crimson and breached their fiduciary duties by selling the company below market value for self-serving reasons. Specifically, they argued that Oaktree received significant side benefits not shared with the minority common stockholders, including an agreement by Contango to pay off a lien held by Oaktree (Prepayment) and a Registration Rights Agreement (RRA) allowing it to sell its stock in the combined entity in a private placement. The plaintiffs challenged the merger on the grounds of inadequate process, inadequate price, and inadequate disclosure.

Unlikely that investment firm was a controlling stockholder. Under Delaware law, entire fairness review may be triggered when a controlling stockholder engages in a conflicting transaction. The court first examined whether Oaktree was a controlling stockholder of Crimson.

The court rejected the contention that Oaktree, executive officers, and the Crimson board together represented a control group that controlled 52.15 percent of the vote. Under Delaware law, multiple stockholders together can constitute a control group, with each of its members subject to the fiduciary duties of a controller. However, the alleged members of a control group must be connected in some legally significant way to work together toward a shared goal, such as by contract, common ownership, agreement, or other arrangement. The plaintiffs failed to meet that element, as they did not show that the executive whose shares they sought to include signed any voting agreement, or that there was any agreement, formal or otherwise, between Oaktree and a shareholder that held about 15 percent of Crimson’s common stock. The simple fact that the interests of two entities were aligned was not legally sufficient to establish the existence of a control group, said the court.

Next, the court dismantled the plaintiffs’ overarching theory that Oaktree sought to exit its investment in Crimson, and thus was willing to undersell its shares. Oaktree would suffer the most from a low merger price, given its holdings of over 15.5 million shares, and thus would need to secure significant side benefits to overcome that loss. Inferring that Crimson’s management would favor their own interests over those of the stockholders was inconsistent with Oaktree’s alleged control over management, because management’s successfully securing new corporate perquisites in that way would not advance Oaktree’s interests. The court concluded that there were no specific allegations from which it could reasonably infer that Oaktree, alone or in combination with others, actually exercised control over Crimson or the negotiation of the merger.

No conflicting transaction. Even drawing all inferences in the plaintiffs’ favor and assuming that Oaktree did control Crimson, the court concluded that entire fairness review still did not apply. The plaintiffs had alleged that Oaktree “competed” for consideration with Crimson’s minority stockholders, alleging a combination of disparate consideration (the Prepayment) and receipt of a unique benefit (the RRA), constituting a conflicting transaction triggering entire fairness review.

Side deals between an acquirer and a controller, which the board did not approve and to which the corporation is not a party, do not implicate entire fairness, said the court. Regarding the Prepayment, at the time the merger was signed, there was no agreement to repay the debt early. Even though the Prepayment was anticipated, mere anticipation is not equivalent to having a term in a definitive merger agreement. There were no allegations that the Crimson board was involved in negotiating or approved the debt repayment as part of the merger agreement. Furthermore, the court doubted that the 1 percent prepayment fee would compensate Oaktree sufficiently to cause it to take a lower price for its shares.

As to the RRA, it was not part of the actual merger agreement and was not alleged to have been approved by the Crimson board, so it did not qualify as additional consideration. Moreover, it did not confer a unique benefit on Oaktree. The court found unconvincing plaintiffs’ contention that Oaktree was motivated by a need for liquidity. If Oaktree wanted to exit its investment, the obvious method would be a cash-out merger, not a stock-for-stock transaction. Oaktree did not propose the transaction or attempt to spring it on the board; rather, Crimson’s CEO and another executive began the negotiations with Contango and then contacted Oaktree.

The court also rejected allegations that the Crimson board lacked independence. None of the directors worked for, held stock in, or had any other disqualifying relationship with Contango. The only colorable challenge with any reasonable traction was to Crimson’s CEO. At least four members of the board, and possibly as many as six—in either case, a majority—were independent and disinterested in approving the merger.

No bad faith. Having found that Oaktree, if a controller, was not conflicted and that a majority of the board was disinterested and independent, the court concluded that the Crimson board’s decision to enter into the merger was protected by the business judgment rule unless the board had acted in bad faith. The plaintiffs did not meet this pleading standard.

Regarding the merger price, there was no rule that a low premium represents a bad deal, much less bad faith. The plaintiffs failed to allege that a higher price reasonably was available or that there was another bidder ready and willing to buy Crimson for a higher price. The court also declined to conclude that a $117 million accounting impairment was suspicious or that the valuation method was flawed and unreliable.

Because the underlying breaches of fiduciary duty were dismissed, the claim that Contango aided and abetted breaches of fiduciary duty failed as well.

The case is No. 8541-VCP.

Monday, October 27, 2014

Key Senators Say CFTC Must Work with FERC on Oversight of Energy Markets

Three U.S. Senators are profoundly disappointed by the CFTC’s settlement with a former hedge fund trader who sold massive volumes of futures contracts in order to manipulate the price of natural gas and make illicit profits. In a letter to CFTC Chair Tim Massad, Senators Dianne Feinstein (D-CA), Maria Cantwell (D-WA) and Carl Levin (D-MI) said that the CFTC’s fine of a mere $750,000 is an embarrassment, especially considering that the hedge fund trader would have been fined $30 million by FERC had the CFTC not intervened. Noting these actions, the Senators raised concerns about whether the CFTC’s authority as currently exercised can effectively regulate energy markets and prohibit market manipulation.

Specifically, they have two primary concerns. The first is that by intervening in this case the CFTC subverted Congressional intent to expand FERC’s regulatory and enforcement authority. The second is that the Commission undermined FERC’s case knowing that the CFTC’s existing statutory authority would result in an enforcement action of significantly less impact than what FERC’s authorities would have enabled. The result is unacceptable, emphasized the Senators. After undermining FERC’s $30 million fine, the CFTC settled for a $750,000 fine and failed to secure an admission of guilt from the trader.

The Senators asked the CFTC to provide an explanation for its actions and respond to their concerns by October 24, 2014. The CFTC should submit an action plan outlining in detail how the Commission plans to work proactively with FERC to carry out meaningful market regulation and enforcement in cases of manipulation going forward.

Senator Crapo Calls for Reform of Gramm-Leach-Bliley Privacy Notice.

The Ranking Member on the Senate Banking Committee urged Congrhhs to quickly pass legislation eliminating the Gramm-Leach-Bliley Act requirement for financial firms to mail annual privacy notices to customers even when they do not share information with third parties and their privacy policies have not changed, . Senator Mike Crapo (D-ID) said in a American Banker op-ed piece that the House of Representatives passed legislation eliminating the privacy notice in these circumstances by voice vote, and a companion bill in the Senate, S. 635, has more than 70 bipartisan co-sponsors.

Under current law, financial institutions of all sizes are required to provide annual privacy notices explaining information-sharing practices to all customers. Financial firms are required to give these notices each year, even if their privacy policies have not changed.

Legislation amending the privacy provisions of the Gramm-Leach-Bliley Act to exempt financial institutions from providing an annual privacy notice if they have not changed their privacy policies in the last year passed the House by voice vote. Introduced by Rep. Blaine Luetkemeyer (R-Mo), the Eliminate Privacy Notice Confusion Act, H.R. 749, is designed to reduce an unnecessary burden facing consumers and financial institutions alike.

Michigan Secondary Market Crowdfunding Bill Enacted

[This story previously appeared in Securities Regulation Daily.]

By Jay Fishman, J.D.

Michigan is the first state to legalize the creation of a secondary market for privately crowdfunded securities now that Governor Rick Snyder signed House Bill 5273. The bill, complementing January 2014-effective crowdfunding legislation, allows broker-dealers to sell Michigan securities on the secondary market for investors having an equity ownership in Michigan businesses.

Legislative specifics. The legislation, placed in Michigan’s Uniform Securities Act as new article 4A, does the following:
  • Defines an “intrastate offering exemption” as an exemption in section 451.2202a or any other from federal securities regulation under Securities Act, Section 3(a)(11) and Rule 147. And defines a “Michigan investment market,” as well as the terms “online,” “personal identifying information,” “resident of this state,” “service,” and “web portal”;
  • Requires that only a Michigan-registered investment market transacts business in the state, by submitting a written application, consent to service of process, fee and other prescribed information;
  • Mandates that the Michigan-registered or to-be-registered investment market create, maintain and preserve for at least seven years after the transaction date, written or electronic records of each transaction conducted between users through the investment market;
  • Requires the Administrator to publish the Michigan investment market’s notice filing on the Administrator’s managed website where interested persons can submit written comments about the application, and where the administrator may revoke, suspend, condition or limit the investment market’s registration and/or impose a civil fine for violations; and
  • Prohibits a Michigan investment market from: (1) servicing a business that has already used a portal, market or exchange to facilitate a secondary market for intrastate securities; (2) selling an individual’s personal identifying information to a third party without the individual’s consent; (3) effecting transactions except with Michigan residents; or (4) engaging in Michigan-specified fraudulent activities.
In addition to new article 4A, existing article 2’s exempt transaction section adds an exemption for any secondary market offer, sale, purchase or trade of securities facilitated by a Michigan investment market, provided this market effects the transaction in accordance with article 4A, and has made available to any secondary purchaser, within a reasonable period before effecting the transaction, general management and financial information about the securities issuer which includes the issuer’s preceding calendar or fiscal year’s financial documents, as well as interim financial information as of the issuer’s most recent calendar or fiscal quarter-end.
Lastly, existing article 4’s broker-dealer registration section adds a broker-dealer exemption for “a person that is registered as a Michigan investment market under article 4A and that deals in securities solely in its capacity as a Michigan investment market.

Friday, October 24, 2014

SIFMA May Challenge Exchange Fees

[This story previously appeared in Securities Regulation Daily.]

By Matthew Garza, J.D.

The SEC’s Chief Administrative Law Judge has determined that the Securities Industry and Financial Markets Association (SIFMA) has standing to challenge rule changes made by NYSE and NASDAQ that establish fees for access to depth-of-book data. Administrative Proceedings Rulings Release No. 1921, October 20, 2014.

SIFMA challenged changes made by the NYSE and NASDAQ to rules governing fees charged for access to this “non-core” depth-of-book data, which was free prior to 2006 rule amendments. Chief ALJ Brenda Murray explained in a footnote that the exchanges are required to make available “core” data, which includes information such as best price offered and bid for each security, whereas non-core depth-of-book data is not required to be made available. Depth-of-book data, known as “ArcaBook” at the NYSE, refers to information on outstanding limit orders to buy stocks at prices lower than, or to sell stocks at prices higher than, the best prices on a respective exchange.

Background. The NYSE originally proposed the rule change to allow it to charge fees for depth-of-book data in May 2006, an action that was approved by the Commission but vacated by the D.C. Circuit after the court found that the economic justification of the rule change was not adequately established. In 2010 the Dodd-Frank Act changed the procedures for implementation of SRO rules. It allowed new rules to become effective immediately upon filing with the SEC, subject to the Commission’s authority to suspend the rules within 60 days. NYSE and NASDAQ then re-proposed amendments regarding depth-of-book fees and the SEC declined to suspend them.

A petition filed by SIFMA to the D.C. Circuit to review the re-proposed rule changes were refused by the court, which cited the Dodd-Frank SRO rulemaking process changes. The court said however, “we take the Commission at its word ... that it will make the section 19(d) process available to parties seeking review of unreasonable fees charged for market data, thereby opening the gate to our review.” SIFMA continued to petition the SEC to set aside the rule changes.

Challenge. Exchange Act Sec. 19(d)(2) says that SRO action shall be subject to regulatory review on its own motion, or “upon application by any person aggrieved.” SIFMA asserted that it had had associational standing to challenge the rule changes as a “person aggrieved.” The NYSE argued that the association did not establish that its members were aggrieved. The SIFMA declarations “do nothing more than assert each SIFMA Declarant is aggrieved ‘simply because it has to pay something for ArcaBook,’” NYSE argued.

The exchange also asserted that its 2010 re-proposed rule responded to the D.C. Circuit’s concerns and was based on a new and different record. SIFMA countered that the exchange conflated the issues of jurisdiction and the merits, and that it is not required to show that the fees at issue are unreasonable in order to establish standing.

The ALJ agreed, saying that the only question at this stage of the challenge was whether SIFMA has established that its members are subject to limitation of access to depth-of-book data. “The question here is not whether SIFMA showed that the rules at issue have imposed unreasonably high fees, but whether it should have an opportunity to do so.” The judge ruled that SIFMA met its burden to establish association standing, and scheduled four hearings, starting on December 22, to determine if the rule changes should be vacated.

Thursday, October 23, 2014

LIBOR Administrator Proposes Reforms to Calculation of Benchmark

[This story previously appeared in Securities Regulation Daily.]

By Lene Powell, J.D.
The Intercontinental Exchange group ICE Benchmark Administration (IBA) published a position paper on LIBOR, the widely referenced interest rate benchmark administered by IBA. The group called for LIBOR to be generated from observable market transactions “to the greatest extent possible” and calculated using a unified, prescriptive methodology featuring a waterfall approach.
Background. ICE LIBOR is a benchmark rate published for five currencies, with seven maturities quoted for each, indicating the interest rate that banks pay when they borrow from each other on an unsecured basis. LIBOR is referenced by about $350 trillion of outstanding business in maturities ranging from overnight to more than 30 years.
Following the discovery by regulators of widespread LIBOR manipulation and resulting sanctions for a number of banks, Martin Wheatley, head of the U.K. Financial Conduct Authority (FCA), published a review in September 2012 that concluded that there should be statutory regulation of LIBOR. The Wheatley Review set out a ten-point plan for the reform of LIBOR, including the transfer from the British Bankers’ Association (BBA) to a new administrator. IBA became authorized and regulated by the FCA as the new LIBOR administrator in February 2014. 
After the Wheatley Review, changes were made to the LIBOR process, including the implementation of a surveillance system by IBA, external auditing of administrators and submitters, and the introduction of statutory regulation featuring an Approved Persons regime. As a result of these and other changes, LIBOR is now harder to manipulate, and there are appropriate legal punishments for any attempts at manipulation, said IBA. 
Findings. The IBA paper confirmed some key assumptions. First, the inter-bank unsecured lending market declined precipitously during the financial crisis of 2007-2009, and is still too low in some tenors to support an entirely transaction-based rate. This decline has been driven by a significant increase in perceived risk of bank counterparty default, as well as regulatory capital charges and an increase in liquidity available to banks due to crisis measures taken by major central banks. In addition, the benchmark submitters to LIBOR have committed resources to strengthen submission processes and internal governance. Further, each benchmark submitter has developed its own methodology for establishing LIBOR submission, using a wide range of transactions to anchor their LIBOR submissions within the existing waterfall of methodologies referenced in the Wheatley Review.
Proposed enhancements. To replace the variety of methodologies used by benchmark submitters, IBA called for the adoption of a more unified transaction-based methodology. The proposed methodology will use a more prescriptive calculation, with pre-defined parameters that the IBA Oversight Committee will keep under review. 
All wholesale and professional entities should be regarded as eligible counterparty types, including central banks and large corporates. Some transactions should be directly included, including submitters’ unsecured wholesale funding deposits, Commercial Paper, and primary issuance Certificates of Deposit. Other transaction types, such as OIS, Repos, FX Forwards, FRAs, and FRNs, should be included only when a bank’s lack of direct transactions means that the submitter has to rely on expert judgment.
IBA will implement a waterfall of calculation methodologies in order to ensure the rate is always available, even in times of market stress. Where transactions are not available for a currency and tenor, or are below minimum transaction size or aggregate volume, interpolation techniques should be used. To ensure consistency, IBA will issue interpolation formula guidelines. If interpolation is not possible, then expert judgment should be used as a last resort. The submission and supporting data are reviewed both by additional individuals at the submitting bank and by the surveillance team at IBA.
The paper also made recommendations as to the timing of transactions, reasonable market size for transactions, panel composition, and delayed publication of individual submissions.
Timetable for change. Following recommendations of the Financial Stability Board, the IBA set out the following timetable:
  • By end Q1 2015: IBA will have worked with contributing banks to analyze available transaction data.
  • By end Q2 2015: In conjunction with the Bank of England and FCA, IBA will have considered the recommended LIBOR methodology and the viability of each LIBOR tenor.
  • By end 2015: IBA will have publicly consulted on changes.
To inform the evolution of LIBOR, IBA requested feedback generally on the position paper, and also issued a questionnaire to gather information about the usage and importance of individual tenors.

Tuesday, October 21, 2014

CFTC Global Roundtable Examines Clearing for Non-Deliverable Forwards

As the CFTC readies a proposal on the clearing of non-deliverable forwards, the Commission convened a global meeting to discuss whether mandatory clearing should be required of NDF swaps contracts. The meeting was under the auspices of the CFTC’s Global Markets Advisory Committee, chaired by Commissioner Mark Wetjen. At the start of the meeting, Commissioner Wetjen announced the formation of a subcommittee on foreign exchange (FX) experts.

Brian O’Keefe, CFTC Deputy Director, Division of Clearing and Risk, noted that, with regard to the NDF clearing mandate, there is no specific recommendation currently on the table , but that there has been some staff work done on this.

Without going into all of the details of the recommendation because it is subject to change, he said that one of the first questions to be addressed about the mandate is which currency pairs should the CFTC be focusing on. There are a number of trading activities and a variety of different pairs, but the liquidity characteristics are different depending on the pair.

The staff is also thinking about creating a clearing requirement. In his view, there are a number of factors that need to be considered in determining mandatory clearing, including outstanding notional amounts, trading liquidity, adequate pricing data, framework capacity and operational expertise to clear these products, and the effect of mitigation of systemic risks on competition.

Essentially, the proposed class would have 12 reference currencies and those 12 represent the ones that have been submitted to the CFTC. The settlement currency would be U.S. dollars. The staff is doing its analysis with regard to liquidity around that.

He noted that the staff conducted an initial analysis using the real time reporting data at the end of 2013 and into the spring of 2014 that showed that there was approximately $7.4 trillion in the NDF currencies. What is striking, he said, and needs to be addressed, is that most of this is in uncleared transactions. This goes to the factor of capacity and the ability that clearinghouses have to take on that additional volume.

Rodrigo Buenaventura, Head of Markets Division at the European Securities and Markets Authority (ESMA), noted that ESMA has six months to decide whether to propose clearing for this type of derivative. ESMA has already sent a proposal to the European Commission on interest rate derivatives, he said, and a proposal on credit default swaps is expected by the end of November. That leaves the third instrument, NDFs. ESMA will concentrate on whether that particular class should or should not be subject to compulsory items.

Under the E.U. process, after ESMA submits a proposal and the European Commission approves it, the E.U. Parliament or Council could intervene upon a belief that the standard is contrary to Level 1 legislation, in this case ,the EMIR Regulation. While this has not yet happened in the last three years, he noted, it remains a possibility that must be respected.

In terms of the criteria of the product, ESMA must assess three elements: standardization, reliability of pricing and liquidity. Regarding standardization, ESMA found that the level of standardization of is very high and comparable to credit and interest rates swaps.

But there are some peculiarities with NDFs, he cautioned, one of which is maturity, with the maturity of most trades being below three months, which he described as being very short. Indeed, 90% of maturities are below three months, 30% are below 30 days, and 10% are less than seven days.

David Bailey, Director of Financial Market Infrastructure for the Bank of England, spoke from the perspective of a supervisor of the clearinghouses. From that oversight aspect, he noted, when considering a clearing mandate the focus is the capacity of the central counterparty. While that is something regulators have usually considered when authorizing a central counterparty to clear a product, he observed, it is very important that regulators refresh their analysis when a clearing mandate is considered. Other factors that must be considered are size and scale, and liquidity.

E.U. Set to Resume Work on Money Market Fund Legislation

The new E.U. Parliament and the new Financial Services Commissioner signaled their intent to resume work on legislation enhancing the regulation of money market funds, an effort that stalled in the last Parliament and Commission. In a letter to the E.U. Council, Martin Schultz, President of the European Parliament, indicated that the body would take up the unfinished business of a Regulation on Money Market Funds (2013/0306). 

In his confirmation hearings before a Parliamentary panel, Financial Services Commissioner-designate Lord Jonathan Hill vowed to move forward with the money market fund reform proposals that are currently on the table. He said that the E.U. must find a solution that will allow money market funds to play a role in economy while at the same time ensuring financial stability. He believes that under the current regulatory regime money market funds can pose a systemic risk. He will try to build a consensus on regulations that are effective and at the same time encourage investment.

What is currently on the table is a proposal requiring money market funds to have a capital cushion buffer of 3 percent for constant NAV funds that can be activated to support stable redemptions in times of decreasing value of the fund’s investment assets. The proposed Regulation would also require certain levels of daily and weekly liquidity in order for the money market fund to be able to satisfy investor redemptions. Money market funds are obliged to hold at least 10 percent of their assets in instruments that mature on a daily basis and an additional 20 percent of assets that mature within a week.

Parliamentary Panel Approves Lord Hill as E.U. Financial Services Commissioner

After two contentious hearings, the E.U. Parliamentary Committee on Economic and Monetary Affairs favorably reported out the nomination of Lord Jonathan Hill of the U.K. as Commissioner for Financial Services and Financial Stability by a vote of 45-13. A final vote by the whole Parliament is set for October 22, with the new Commission expected to begin its duties on November 1. Lord Hill will replace Michel Barnier of France as the E.U.’s top securities and banking regulator. Similar to Commissioner Barnier, Lord Hill emphasized that the avoidance of regulatory arbitrage is a paramount concern, both within the E.U. and with the United States. He will continue Commissioner Barnier’s fight to achieve financial regulatory convergence with the U.S.

Recently, Commissioner Barnier called on Lord Hill to continue the effort to have mandated cross-border financial regulatory convergence included in the trade talks with the United States and convince U.S. regulatory partners that this approach will not lower standards but will achieve greater financial stability. During his conformation hearings, Lord Hill addressed the concerns of some MEPs that U.S. regulators have implemented increasingly stringent extraterritorial requirements for financial firms operating cross-border. The Commissioner-designate noted that, while the U.S. tries to regulate its global financial firms even when they are operating in the E.U., the Commission should recognize U.S. regulations as equivalent when it can; and defer to such regulations. 

On the issues around shadow banking, Lord Hill said that the Commission must be alert to the emergence of new risks in this sector. Shadow banking is a broad term, he noted, and it encompasses some activities that policy makers and regulators may want to encourage. The challenge is to implement effective regulation while not suppressing innovation.

He emphasized the free flow of capital, to which he is totally committed, greatly depends on restarting a private, high quality securitization market. This will be one of his top priorities. He said the choice between regulation and growth is a false dichotomy. Regulators can encourage better securitization without increasing risk.

The Commissioner-designate is also committed to the principle of regulatory proportionality, and eschews a one-size-fits-all approach to regulation. The Commission should look at the size of the firm and scale the regulation accordingly.

While noting that corporate governance is not part of his remit, it will go to the Justice Commissioner, Lord Hill said that incentive compensation should be aligned with performance and the long-term interests of the company. That alignment broke down during the run up to the financial crisis, he noted, when executive compensation was not geared to the long-term interest of the company and its shareholders. He supports clawbacks of bonuses and other forms of incentive compensation.

Sunday, October 19, 2014

PCAOB Panel Discusses Valuations of Financial Assets

The PCAOB Standing Advisory Group (SAG) discussed one of the most controversial and complex issues of financial accounting and auditing, estimates and measurements of financial assets, at a special meeting today. This discussion came against the backdrop of a consultation on the issues previously set out by the PCAOB.

International Accounting Standards Board Member Patrick Finnegan detailed five concrete recommendations to the PCAOB on the consultation. First, he endorsed a single standard aligning risk assessment standards with substantive testing. Second, he called for the use of third-party estimates of fair value. Complexity abounds in this area, he noted, and the use of third parties, such as for collecting data and applying it to models, could be useful and even necessary.

The IASB member’s third point involved the expectation gap. He believes that a single set of principles in this area would send a strong signal to the marketplace.

His fourth recommendation is that auditors should have access to the committee process of any entity assigning values to financial instruments. Auditors need a seat at the table to observe management’s discussion of valuations. His fifth and final recommendation is to place a heavy emphasis on auditor education in this area. There is a close nexus between experience and evaluating complex estimates and measurements. For example, auditors must have significant education to properly evaluate any impairment of assets. They must, for example, understand how credit risk changes in relation to events.

FASB Member Larry Smith said there is no silver bullet for auditing estimates and measurements of financial assets. Auditors have been auditing estimates forever, he noted, but fair value estimates have raised the level of concern over estimates and measurements.

SAG members had concerns about a single standard for all measurements, including fair value estimates. Philip Johnson cautioned the PCAOB not to be too prescriptive in the standard.

Former FASB Chair, and SAG member, Robert Herz said that this is a very important subject in moving financial accounting and auditing forward. The fair value standard reflects the view that sometimes management has to come up with best estimates, but, at the same time, actual market values should not be ignored. One of the problems that came out of the financial crisis was that some derivatives have no active trading. The reforms put derivatives on exchanges, he noted, and that will help to get a fair value estimate, but will not solve the problem completely. Quoted market price is a good metric, he added.

Mr. Herz chairs the Morgan Stanley audit committee. In that role, he likes to hear about any changes from quarter-to quarter in this area from the auditors or from management. Consistency is important in the area of valuation of financial assets and, similarly important is the need to detect any management bias. Risk management also plays a role in this area, said the former FASB Chair, as does understanding the challenges as they develop. Also, more broadly, this is part of good corporate governance. Standard setting should consider behavioral aspects, how people would react to situations.

The use of specialists in developing a valuation was debated. SAG member Jean Joy said that third-party specialists can be most useful in valuing assets and liabilities in acquisitions and business combinations, as well as in valuing Level 3 illiquid assets. But she cautioned that a troubling aspect of Level 3 is that here, even specialists have a wide variety of estimates.

Robert Herz, while noting that more and more firms have internal specialists, agreed with Ms. Joy that outside specialists are needed for valuing assets in business combinations.

SAG member Douglas Maine opined that it would be useful for the Board to issue guidance for the use of specialists in valuing financial assets and also ensure that audit committees are the first line of defense in this area. PCAOB Chief Auditor Marty Baumann revealed that the Board has asked the staff to prepare a consultation paper on the use of valuation specialists and that this project is on the staff’s agenda.

In conclusion, Barbara Vanich, PCAOB Associate Chief Auditor, said that there appears to be support for a single standard that emphasizes auditor skepticism and risk assessment. She said that the staff is interested in hearing the views of people on how the standard could be more principles-based.

Saturday, October 18, 2014

Chairman Massad Addresses the CFTC’s Most Pressing Issues

[This story previously appeared in Securities Regulation Daily.]

By Matthew Garza, J.D.

In remarks before the Outlook 2014 conference, sponsored by the Managed Funds Association, CFTC Chairman Timothy Massad shared his views on two of the most pressing issues currently before the CFTC—tweaking the rules mandated by the Dodd-Frank Act, and cross border harmonization.

End-users. Massad said that it should be expected that rules as significant as those mandated by the Dodd-Frank Act would require clarification and adjustment, noting that part of the CFTC’s job is to make sure the rules do not impose undue burdens or unintended consequences on nonfinancial commercial companies that rely on the derivative markets, such as manufacturers and farmers. “They were not responsible for the crisis or the excessive risks that have come out of this market,” he stated.

To accomplish this, the CFTC has reproposed rules on margin for uncleared swaps to exempt end-users from the requirements. He said the CFTC was able to shift the views of banking regulators to bring their respective rules on the subject in line. The CFTC has addressed the ability of many local utility companies to access the energy swap market, and is now looking at other issues involving commercial end-users, such as contracts with embedded volumetric optionality and certain record keeping obligations. He said he expects the CFTC to act on those matters before year end.

Cross border harmonization. Massad said that he shares the concern of many that harm could result if derivative reforms adopted by different jurisdictions are not in harmony. He said the CFTC is making progress, but the OTC derivatives industry developed into a global industry without any regulation, so historical perspective on this issue is necessary to understand the challenges. He pointed out that the rules for securing bank loans aren’t the same in the states, and asked how many would expect the rules governing the sale of securities to be the same in all the G-20 nations. “Now we are seeking to regulate it through the actions of the various G-20 nations, each of which has its own legal traditions, regulatory philosophy, administrative process and political dynamics. There will inevitably be differences.”

The CFTC issued substituted compliance determinations for many of its rules last December, he said, and the agency expects to do more once other jurisdictions issue rules. He did say that he believes the E.U. should recognize the U.S. central clearinghouses as equivalents, but they have not yet issued any equivalence determinations. He said the E.U. believes that changes are necessary in U.S. treatment of clearinghouses that are located in Europe but are also registered in the U.S.

The U.S. dual registration regime has worked, he said, partially because the U.S. simply required that clearing of futures take place at clearinghouses that are registered in the U.S. and meet U.S. standards, which tie into U.S. bankruptcy laws. “We have seen this work in MF Global and Lehman most recently. We built our swap mandates on this framework of dual registration, and as a result, clearing of swaps for Americans largely takes place overseas.” He said that the issue is very important to the industry and he believes that the dual registration approach a good one. “Regulators must work together to make sure clearinghouses operate transparently and do not pose risks to financial stability.”

Thursday, October 16, 2014

Maryland Adopts Intrastate Small Business Exemption

[This story previously appeared in Securities Regulation Daily.]

By Jay Fishman, J.D.

The Maryland Legislature adopted, effective October 1, 2014, a non-crowdfunding intrastate small business exemption.

Legislation. The exemption covers any security issued by a Maryland-organized entity that:
  • Conducts a securities offering in accordance with Securities Act Section 3(a)(11)/SEC Rule 147 and in accordance with any Maryland Securities Commissioner-adopted additional conditions such as issuer restrictions, offering limitations, and required disclosures and notice filings;
  • Offers and sells the securities only to Maryland residents;
  • Caps the aggregate price of the securities offering at $100,000;
  • Caps the consideration paid by any single purchaser at $100; 
  • Allows commissions or other remuneration to be paid to only Maryland-registered broker-dealers or agents; and
  • Is not subject to any Maryland Securities Commissioner-defined disqualification or to the Maryland Securities Act anti-fraud provisions.
Regulation. The Maryland Securities Commissioner adopted by administrative order, effective October 1, 2014, the following additional conditions that an issuer must meet to claim the statutory intrastate small business exemption.
  • The issuer must be an entity organized under Maryland law, qualified to do business in Maryland, and have its principal place of business in Maryland. Additionally, the issuer must use at least 80 percent of its net proceeds from sales made under the exemption to operate its Maryland business or to provide services in Maryland.
  • Offers and sales must be made exclusively in Maryland, i.e., offerees and purchasers must be “Maryland residents” as defined. 
  • The aggregate offering price during any 12-month period may not exceed $100,000.
  • Investors may cancel an investment at any time before the issuer has raised the minimum offering amount.
  • The issuer, before selling the security, must deliver to each prospective purchaser: (1) for a note offering, a complete Form MISBE-2 or a disclosure document containing the Form MISBE-2- required information; or (2) for a Commissioner-approved non-note offering, a disclosure document containing the Form MISBE-2 required information that has been adapted to the non-note offering.
  • The issuer must file with the Maryland Securities Commissioner not later than 15 days after the first sale of securities under the exemption: (1) a Form MISBE-1 or a document containing the MISBE-1 required information; and (2) a $100 filing fee.
  • The sold securities may not be resold.
The exemption is available only for promissory notes, but the Maryland Securities Commission may extend the exemption to other security-types.

The “bad boy” disqualification provisions for the Maryland limited offering exemption (MLOE) apply to this intrastate small business exemption. The integration provisions and the insignificant deviation provisions for MLOE also apply.

In addition, the issuer must, in connection with the documentation of any securities sold under this intrastate small business exemption: (1) place a legend on the securities-evidencing documentation stating that the securities have not been registered under the Maryland Securities Act and setting forth the resale restriction; and (2) obtain from each purchaser a written representation of the purchaser’s residence.

In connection with any offer or sale under the exemption, the issuer must also: (1) disclose the resale restriction in writing; and (2) comply with the SEC’s guidance regarding the issuer’s use of its website to promote the offering and intrastate offerings found in Question 141.05 at

Wednesday, October 15, 2014

SIFMA Tells Fed to Give Banks More Time to Conform Funds

[This story previously appeared in Securities Regulation Daily.]

By Mark S. Nelson, J.D.

The Securities Industry and Financial Markets Association (SIFMA) asked the Federal Reserve to give banks new guidance and a one-year delay to help them meet the 2015 conformance deadline for bringing covered funds into compliance with the Volcker rule. Banks are likely to flood the Fed with extension requests in Q4 2014, SIFMA told the Fed’s general counsel in a letter published yesterday.

Fed guidance. The lack of Fed guidance for illiquid funds is one of the main worries for SIFMA’s members. SIFMA said not many funds will fall within the conformance rule, despite the Dodd-Frank Act’s plan to include them, because of the delay between the adoption of the final conformance rule (issued in February 2011 and later clarified in June 2012) and the final Volcker regulations (December 2013). Specifically, SIFMA asked the Fed to find a way to let illiquid funds partake of the stable run-off period until 2022 by aligning the Dodd-Frank Act’s intent with its regulatory implementation to close the two-year gap.

“Our members are at a loss as to how to proceed in the absence of further guidance from the Federal Reserve staff,” said SIFMA. According to SIFMA, 14 of its members with illiquid funds, who represent nearly 3,000 funds, planned to ask the Fed to extend the time to meet the conformance rule. The numbers include illiquid hedge fund interests for which a buyer may exist, but the fund cannot be sold in secondary markets.

Likewise, SIMFA estimates that over 1,500 funds will need a delay to satisfy asset management rules. This will include the time needed to “sell down” or conform employees’ stakes in covered funds. Logistics also will play a role in extension requests because of the time funds may need to get investor and regulatory approvals to rename covered funds or fund families, especially if the bank has ceded control of the fund or its adviser to another entity.

Other recommendations. SIFMA also wants banks to be able to finish their contractual duties owed to a fund for its lifetime, even if the fund is in its late stages and will be wound up. Yet another recommendation is to grant a one-year categorical extension to the conformance period to all currently registered investment companies and foreign public funds to let sponsors dilute seed capital. This latter request could be augmented by separate relief creating a presumptive seeding period for some non-legacy funds.

SIFMA listed many other ways the Fed can provide guidance or more time to meet Volcker rule mandates. SIFMA also said it will soon ask the Fed for a one-year delay related to the conformance period for banking entities’ interests in all foreign funds. An extension would help to ease the Volcker rule’s burden on overseas markets.

The preliminary data cited by SIFMA in its letter to the Fed came from a survey of its members. SIFMA said that despite the lack of data on assets under management or market valuations, the results of the 19-member sample cited in its letter show the likelihood that many banks will ask the Fed for extensions later this year. In fact, SIFMA said its data may “substantially underestimate” the volume of requests.

Monday, October 13, 2014

CFTC Chair Vows to Work with New E.U. Financial Services Commissioner on Cross-Border Swaps Regulation

CFTC Chair Tim Massad committed to working with his E.U. counterpart on harmonizing cross-border derivatives regulation. In an interview at the Financial Services Roundtable Global Summit, the CFTC Chair said that he looks forward to working with the E.U. Financial Services Commissioner-designate, Lord Hill, on issues of equivalence and substituted compliance around OTC derivatives regulation. Chair Massad said that he would reach out to Lord Hill after the E.U. Parliament confirms him as Commissioner for Financial Services, Financial Stability, and Capital Markets, which is now expected to occur by November 1.

Chair Massad that cross-border regulatory harmonization is a difficult challenge since it must go through nation states with different philosophies and legal traditions.

On the recognition of derivatives clearinghouses, he noted that E.U. authorities have not yet recognized U.S. clearinghouses as equivalent. They should do so as soon as possible, he advised. The CFTC Chair observed that clearinghouses are registered in a number of countries. The rules should be harmonized. The risk of fragmentation came when the E.U. said they would impose capital charges if they do not recognize a U.S. clearinghouse.

Chairman Massad pointed out that CFTC rules protect U.S. customers and are tied to the U.S. Bankruptcy Code. For example, if a futures commission merchant (FCM) defaults, bankruptcy rules provide for the transfer to another intermediary in order to ensure customer protection and avoid a cascade of defaults.

There is now mandated clearing of some swaps, noted the Chair, but there will always be uncleared swaps due to, for example, a lack of liquidity or new products. The CFTC is working with the Fed and the E.U. on margin for uncleared swaps to ensure that the rules are very similar. He added that margin for uncleared swaps is a big part of risk mitigation.

The Chair also mentioned a recent federal court ruling recognizing that the some oversaes derivatives activity could import risk into the U.S. and endorsed CFTC rulemaking to address that scenario. He added that E.U. authorities have the same view as the CFTC that the derivatives market is a global market and that market participants can do things in one jurisdiction that impacts another jurisdiction.

Finally, Chairman Massad spoke on CFTC resources and budget constraints. He noted that the OTC derivatives market is eight times the size of the futures markets, and Congress has given the SEC the challenging job of regulating this market. The CFTC is building the infrastructure to facilitate a big date collection effort, he observed, and the budget challenge makes this job harder. For example, he pointed out that the CFTC cannot examine large derivatives clearinghouses as frequently as it would like to on what he described as a very small budget.

Standards Adopted Implementing E.U. Credit Rating Agency Regulation

The European Commission adopted three proposed standards needed to implement key provisions of the Regulation on Credit Rating Agencies. The standards, which were proposed by the European Securities and Markets Authority (ESMA) set out the disclosure requirements for issuers, originators and sponsors on structured finance instruments; reporting requirements to credit rating agencies for the European Rating Platform; and reporting requirements for rating agencies by ESMA. Financial Services Commissioner Michel Barnier stated that implementing the revised Regulation on credit rating agencies by setting out reporting and disclosure requirements in three important areas marks another step in improving transparency and restoring confidence in the financial system.

The standard requiring enhanced disclosure around structured finance instruments is designed to improve investors’ ability to make an informed assessment of the risks related to such complex financial instruments. This disclosure obligation aims in particular at reducing investors’ dependence and reliance on credit ratings and reinforcing competition between credit rating agencies.

Another standard determines the content and the presentation of the information, including structure, format, method and timing of reporting that credit rating agencies must disclose to ESMA for the purpose of the European Rating Platform. ESMA will set up this Platform, which will allow investors to consult and easily compare all available credit ratings for all rated instruments.

Finally, the Commission approved a standard setting out the content and format of data on fees charged by credit rating agencies to their clients to be periodically reported to ESMA for the purpose of its ongoing supervision of rating agencies. The information collected under this standard will allow for the verification by ESMA of whether pricing practices are discriminatory and thereby facilitate fair competition and mitigate conflicts of interest.

Saturday, October 11, 2014

Germany Remains Strong for Financial Transaction Tax

Germany remains strongly in favor of implementing an E.U. financial transaction tax, reaffimed Federal Finance Minister Wolfgang Schäuble, but it is a complicated matter, he added. In an interview with Badische Zeitung, the Minister said he is convinced that once the tax is implemented E.U. members that now oppose it will end up adopting the financial transaction tax. He said that the E.U. definitely plan to make good progress on implementing the tax this year.

But he acknowledged that some member states are against the financial transaction tax because they are afraid that the financial sector will take its business elsewhere. Even the 11 countries that want to move forward with the tax have differences of opinion. Germany supports a comprehensive financial transaction tax, but right now ``we just need an agreement.’’

In recent remarks, European Commissioner for Taxation Algirdas Semeta urged E.U. members to agree on the implementation of the first step of the FTT before the end of this year, with the ultimate goal of a broad based tax. priority should be given to the discussions on the Financial Transaction tax under enhanced cooperation.