Tuesday, October 31, 2006

Atkins Seeks Stronger SEC Oversight as PCAOB Revises Internal Control Standard

As the PCAOB prepares to revise its standard on internal control over financial reporting (AS2), SEC Commissioner Paul Atkins said it is incumbent on the Commission to make sure that the Board gets it right. Calling the PCAOB ``our ward,’’ Mr. Atkins noted that the SEC is overseeing the Board’s rewrite of AS2. In remarks before the Federalist Society, he went on to opine that the SEC has been taking too light a hand in the drafting of audit standards. He warned that getting the AS2 revision right could involve invoking untried and unwieldy SEC oversight powers.

Moreover, once the revised AS2 is adopted, he emphasized that the SEC will be vigilant to ensure that the PCAOB staff is not interpreting AS2 in a manner inconsistent with the spirit of the revisions. He decried the abandonment of a planned Regulation PCAOB, which would have formalized the SEC’s oversight of Board staff actions. He recommended dusting off Regulation PCAOB and using it as a baseline for the SEC’s relationship with the Board. To support this position, Comm. Atkins cited a recent PCAOB staff alert on accounting for options in which the staff weighed in on the legality of options granting practices, a matter he said was clearly outside the Board’s purview, let alone its staff. Currently, the SEC has little opportunity to change either the wording or the substance of PCAOB staff guidance. Interestingly, Mr. Atkins related that Regulation PCAOB was shelved due to a personal plea from Chairman McDonough to Chairman Donaldson complaining that it would give SEC staff undue authority over Board operations.

Saturday, October 28, 2006

Global Pension Funds Ask SEC to Give Shareholders Access to Director Elections

A consortium of the largest institutional pension funds in the world have weighed in on the current debate on the role of shareholders in the corporate director election process. In a recent letter to SEC Chairman Christopher Cox, the funds expressed concern about the implications of the SEC’s original announcement that clarification of the Exchange Act’s shareholder proposal rule is necessary in light of a recent Second Circuit panel opinion. The funds believe that the court’s decision breaks a significant logjam in the evolution of procedures to encourage more responsive boards.

Calling the panel’s opinion a critical juncture in US business history, the funds urged the SEC to seize this historic opportunity and allow shareholders access to the proxy for resolutions relating to the director electoral process. In both principle and practice, emphasized the funds, US board electoral processes are outdated and detrimental to maximizing shareholder value. The signatories to the letter included, among others, the California State Teachers Retirement System, the London Pensions Fund Authority, PGGM in the Netherlands, and the Ontario Teachers Pension Fund. There is power behind the letter since the funds aggregately represent $3.4 trillion in invested assets. The SEC intends to consider the issue at a Dec. 13 open meeting.

The appeals court panel ruled that a shareholder proposal seeking to amend a company's by-laws to establish a procedure by which shareholder-nominated candidates may be included on the corporate ballot did not relate to an election within the meaning of the SEC's proxy rules and could not be excluded from proxy materials. An SEC no-action letter and a federal district court ruling allowed the company to exclude the proposal based on rule 14a-8(i)(8), which allows the exclusion of a proposal relating to an election for membership on a company's board of directors. However, the appeals court found that a shareholder proposal does not relate to an election under the exclusion if it simply seeks to amend the by-laws to establish a procedure by which shareholders are entitled to include in the proxy materials their nominees for the board of directors. AFSCME v. American International Group, Inc., CA-2, September 5, 2006, CCH Fed. Sec. L. Reps. ¶93,942. Reacting to the court's ruling, the SEC announced that the Division of Corporation Finance would recommend an amendment to rule 14a-8 regarding director nominations by shareholders.

It is very difficult for investors outside the US to understand the fact that shareholders of US companies lack basic shareholder rights taken for granted in other developed markets, said the funds, who added that experience in the UK, Australia and the Netherlands has shown that boards whose members may be removed by shareholders are more sensitive to shareholder opinion and more likely to engage in meaningful dialogue with the institutions that hold their shares. Moreover, the right of shareholders to reject nominees, to propose a nominee, and to call an extraordinary general meeting to vote on changes to board composition neither destabilizes companies nor leads to contested elections.

In the view if these institutional investors, the recent practice of the SEC staff has made it more difficult for a better method to evolve in the US. Under Rule 14a-8(i)(8), shareholders have been denied the right to vote on efforts to address the situation. The funds find it remarkable that this use of the rule granting companies no-action letters in the face of evolving shareholder democracy standards in other countries has been used more consistently since 1990 than it had before.

Wednesday, October 25, 2006

Fed Gov Bies Gives Blueprint for Enterprise Risk Management

With the advent of Gramm-Leach-Bliley and the concomitant repeal of the Glass-Steagall Act, financial institutions are composed of banking and securities components under the principle of functional regulation. Risk management across the entire enterprise has assumed great importance since no one wants one component of the organization to pull down the whole edifice. In addition, as complex derivatives instruments evolve and new technologies emerge, noted Federal Reserve Board Governor Susan Schmidt Bies, it is critical that financial institutions implement successful enterprise risk management procedures in order to determine the amount of risk they are willing to accept and ensure that they have the appropriate controls in place to limit risk.

In my view, Gov. Bies is one of the most articulate voices on enterprise risk management in the regulatory arena. In recent remarks before the American Bankers Association annual conference, she said that a sound enterprise risk management system has a number of specific components, including enhanced risk response and the alignment of the financial institution’s risk appetite with its strategies. The system must also identify and manage multiple and cross-enterprise risks.

The Federal Reserve expects organizations to have in place an infrastructure that can identify, monitor, and effectively control the risks they face in complying with applicable regulations and codes of conduct. While this can be a daunting task, acknowledged Gov. Bies, the institution must understand compliance risk across the entire organization and evaluate the risks and controls annually. In order to avoid having a program that operates on autopilot, continued Ms. Bies, a financial institution must continuously reassess its risks and controls. If compliance is seen as a one-off project, she reasoned, an organization faces the risk that its compliance program will not keep up with changes. Importantly, the board of directors also needs to ensure that the organization has a top-to-bottom compliance culture that is well communicated by senior management.

Tuesday, October 24, 2006

COSO to Issue Guidance on Monitoring Internal Control Systems

The Committee of Sponsoring Organizations of the Treadway Commission (COSO) intends to issue guidance designed to help companies monitor the quality of their internal control systems as part of complying with the internal control mandates of the Sarbanes-Oxley Act. COSO believes that companies have not explored the basic linkage of effective monitoring to the evidence needed by management to support its assertion regarding the effectiveness of internal controls over financial reporting as required by Section 404(a). COSO pledged that the guidance will be consistent with the SEC guidance expected to be issued in late 2006 or early 2007 and the PCAOB guidance expected by Spring of 2007.

COSO’s timetable for the guidance is to issue a white paper by March 15, 2007 and approve the full document for a two-month comment period by July 30, 2007. The final guidance is to be issued by December 22, 2007
Sarbanes-Oxley and EU Comply-or-Explain Not That Far Apart

The debate over whether it is better to mandate sound corporate governance or achieve such through corporate governance codes is raging, with many in Europe favoring the codes and eschewing what they see as the prescriptive mandates of Sarbanes-Oxley. In my opinion, the two schools of thought are not that far apart. The corporate governance codes generally employ a comply-or-explain tool. For example, an independent audit committee is a component of sound corporate governance. Sarbanes-Oxley mandates independent audit committees, but a governance code may require a company to have such a committee or explain why it does not have one. In my view, it is very awkward and very embarrassing for a company to try to explain to its shareholders and investors why it does not have an independent audit committee. Thus, the two methods achieve the same governance result in many if not most cases.

I believe that this is also the vision of former EU Internal Market Commissioner Frits Bolkestein, who has said that transatlantic convergence must be promoted even though the U.S. and the EU have taken different paths toward effective corporate governance. The European approach is essentially based on the principle of comply-or-explain, he has noted, while the U.S. approach is rule-based and relies more on law enforcement. Despite this divergence, the former commissioner has emphasized that both the EU and U.S. must aim for the same basic goals and converge their thinking. If this does not happen, he has warned that friction will arise, accompanied by a need for difficult downstream regulatory repair. The former commissioner is a visionary and I love the phrase ``downstream regulatory repair.’’ I think that he is saying that global companies, be they US or EU, will have to implement convergent sound corporate governance if not now, then in the future in order to satisfy the expectations of investors and the markets.

Monday, October 23, 2006

Former SEC Chairmen Defend Constitutionality of PCAOB

Seven former SEC chairmen, including Arthur Levitt, William Donaldson and Harvey Pitt, have filed an amicus brief defending the PCAOB as constitutional in the face of a federal court action challenging the Board’s legitimacy. The other amici chairmen are Bradford Cook, Roderick Hills, David Ruder and Harold Williams. The brief argued that the PCAOB is the centerpiece of the Sarbanes-Oxley Act and exists because of a congressional conclusion that the system of profession-dependent self-regulation of auditing contributed to the corporate financial scandals of the recent past. Nothing in the federal Constitution, emphasized the brief, denies Congress the power to make the policy judgments reflected in the legislative design of the PCAOB-SEC relationship. More broadly, the former SEC chairs pointed out that the Board is squarely within the historical structure of federal regulation of the capital markets, which has relied for decades on a unique combination of public-private institutional relationships under SEC oversight.

A Board-registered audit firm is seeking to have the PCAOB declared unconstitutional as violating the appointments provisions of the Constitution. The firm argued that, while Board members exercise significant, core governmental powers, they are appointed by the SEC rather than in the manner required by Article II of the Constitution. Among other things, the firm contended that Board members are principal officers whose appointments must be made by the President by and with the advice and consent of the Senate. Accordingly, argued the firm, the appointment of Board members by the SEC violates the Appointments Clause of the Constitution. (Free Enterprise Fund and Beckstead and Watts, LLP v. PCAOB, DC of DC, No. 1:06CV00217

The Appointments Clause divides all officers of the US into two categories: principal officers who are appointed by the President with senatorial advice and consent; and inferior officers who may be appointed by Heads of Departments. The brief filed by the former SEC chairs contended that Congress can constitutionally create administrative agencies with diverse structures, including independent entities that function under the control of these agencies. In amici’s view, the Appointments Clause limits Congress only in that Congress cannot retain any legal right to participate itself directly in the appointment or removal of officials who implement federal law, nor can the national legislature retain any right to veto an agency’s policymaking or adjudicatory decisions. Because Congress has granted itself none of these powers over the Board or the SEC, reasoned the former chairs, the Act is constitutional.

The brief also argues that the Appointments Clause permits Congress to give independent agencies, such as the SEC, the power to appoint their inferior officers. Were it otherwise, reasoned the brief, much of the organizational structure of the independent agencies would be unconstitutional. By statute, numerous independent agencies appoint their inferior officers, the former chairs continued, and nothing in the Constitution or any Supreme Court decision requires the illogical conclusion that Congress cannot give an agency the power to appoint its own legal subordinates. The brief also posits that the SEC is a Department within the meaning of Article 2 and the SEC Commissioners are properly the Head of this Department.
Thank you, Professor Paredes

I would like to thank Professor Troy Paredes for his insightful and topical contributions to the blog last week. It was an honor and a privilege to have Professor Paredes as a guest blogger. If we are lucky, Professor Paredes will return as a guest blogger at a future time.

Friday, October 20, 2006

When Is CEO Pay “Excessive?”
Guest Blogger: Prof. Troy A. Paredes

Yesterday, we got news of a decision handed down by Justice Ramos of the Supreme Court of the State of New York finding that former NYSE Chairman and CEO Richard Grasso had to pay back millions of dollars in compensation he had received while on the job. I want to flag some general points that might bear on a consideration of Grasso’s pay and on executive compensation more generally.

Critics of executive pay assert that CEO pay is “excessive.” But what does it mean for CEO pay to be “excessive”? Some say that CEOs just shouldn’t be paid more than a certain amount, period. Others argue that CEO pay is “excessive” when CEOs earn several hundred times what the average worker gets. At least CEOs should have to perform to get paid, critics say; they shouldn’t get paid just for showing up.

The only point I want to make here is this: Determining when CEO pay is “excessive”-–in other words, determining how much a CEO “deserves” – can’t be reduced to conclusory claims about what is “too much.” The intimation often seems to be that a CEO should accept his or her reservation price, or something approaching it, as opposed to having an opportunity to take home a larger share of the pie – a view that seems to be colored by the fact that a CEO is bound by a fiduciary duty of loyalty. To say “too much,” though, has no more content than to say “too little.” In either case, one needs a theory of compensation grounded in efficiency, equity, or both.

More to the point, why not view the negotiation between the CEO and the board over the CEO’s pay through the lens of market contracting and not through the lens of fiduciary duty? If one views executive pay through the lens of market contracting, it’s not clear that the CEO would have a duty in effect to negotiate against himself in dealing with the board. That said, CEOs should not be allowed to set their own pay by controlling the board. However, corporate governance changes have already been made – as a result of both regulation and market pressure – to better ensure arm’s-length bargaining. At public companies, for example, independent directors and shareholders now have a greater say over the compensation awarded to executives. In addition, the SEC has revised disclosure
requirements to make executive pay more transparent, further empowering shareholder oversight. These tactics for reforming the process by which executive compensation is set are preferable to more substantive regulation that tends toward capping executive pay.
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As this is my final post as a guest blogger on Jim Hamilton’s wonderful blog, I again want to thank Jim for allowing me to contribute. It’s been a lot of fun.

Those of you interested in my research can find out more by visiting my author page on ssrn.com at

Thursday, October 19, 2006

Two Cheers for XBRL
Guest Blogger: Prof. Troy A. Paredes

The SEC’s XBRL initiative should be applauded. Through interactive data, XBRL has the potential to make a body of information easier to search, process, and understand. Consequently, XBRL is expected to lead to more transparency and thus better decision making by investors.

XBRL raises a more general point that is sometimes overlooked. That is, in designing an effective disclosure regime, it is important to consider not only “what” information is disclosed, but also “how” the information is disclosed. The focus is often on more and more disclosure without enough attention paid to how the disclosure is formatted and presented. Yet the same information, when formatted and presented in a more accessible, straightforward manner, is more understandable, making it simpler for securities market participants to evaluate a company as well as to compare companies.

The question of understandability of disclosures is more acute today than ever. Businesses are more complex than ever; more information is disclosed than ever; and there are more investment opportunities to assess than ever. The sheer volume of information itself can tax the resources of investors and analysts, leading to information overload.

Efforts such as XBRL (or MD&A summaries, tabular and graphical presentations, charts, etc.) that can make information easier to search, process, and understand should be welcome. When information is easier to access and interpret, transparency improves. And as transparency improves, investors will make better decisions.

Tuesday, October 17, 2006

Hedge Fund Regulation and Best Practices
Guest Blogger: Prof. Troy A. Paredes

In the aftermath of the Goldstein decision (451 F.3d 873 (D.C. Cir. 2006), ¶93,890) overturning the SEC’s hedge fund rule, the Commission has been reevaluating its options for regulating hedge funds. Among other things, Chairman Cox has suggested increasing the financial thresholds for individuals to qualify as “accredited investors.” This makes good sense, as the financial thresholds have been fixed for years. I support this move even though I opposed the SEC’s original hedge fund rule.

I opposed the SEC’s original hedge fund rule for a number of reasons, one of which was my belief that the SEC, in adopting the rule, elided an animating principle of federal securities regulation that demarcates the limits of such regulation. That is, the SEC (with the exception of Commissioners Atkins and Glassman who dissented) looked past the ability of sophisticated and wealthy hedge fund investors to protect themselves. The fact that well-heeled investors (let alone large institutions) may lose money because of a hedge fund fraud or because of risky hedge fund bets is not a basis for more hedge fund regulation. (And there has been no finding of meaningful “retailization.”) Indeed, the risk of loss incentivizes investors to do the kind of diligence that enables them to protect their own interests. If such investors are “accredited,” we assume that they are able to assess and price the risks they identify. That they may fail to do so is not grounds for government intervention in the name of investor protection. (On the other hand, hedge funds are, and should be, subject to longstanding prohibitions against fraud and market manipulation. Hedge funds should not get a free pass when they engage in illegal conduct. And the SEC should continue working with the President’s Working Group on so-called systemic risk concerns.)

If regulators are concerned that current accredited investors can’t fend for themselves, the proper fix is to reconsider who qualifies as an accredited investor. The proper fix is not for the SEC to engage in more regulation of the underlying investment vehicle (even in the form of investment adviser registration). More to the point, if the SEC steps in to regulate if it decides that sophisticated and wealthy hedge fund investors can’t fend for themselves, then what stops regulators from turning their attention to venture capital and private equity firms?

This does not mean that the SEC has to be entirely hands off once it redefines who is and is not an accredited investor. Rather, the SEC could do more to facilitate such investors in doing diligence. The SEC, in other words, can bolster market discipline. For example, the SEC could articulate best hedge fund practices. The SEC could express its view of best practices formally through releases or informally through the speeches of commissioners and division directors. For example, instead of the new hedge fund rule, the SEC could have emphasized particular best practices for the hedge fund industry that hedge fund managers and investors would have been encouraged, but not required, to follow. The SEC could still do this concerning valuation, back-office operations, compliance, and other topics.

By emphasizing best practices, the SEC can provide investors concrete guidance to use in assessing hedge funds or any other investment opportunity. Such guidance provides a yardstick against which investors can evaluate the opportunity to see how it measures up. Investors can then allocate their capital as they see fit with the benefit of the SEC’s input.

Monday, October 16, 2006

Corporate Strategy and Corporate Corruption
Guest Blogger: Prof. Troy A. Paredes

I’d like to thank Jim Hamilton for allowing me to be a guest blogger. Jim’s blog is wonderful, and I appreciate the opportunity to contribute to it.

Let me dive in by questioning the post-Enron era reforms.

Fraud, looting, and disloyalty are problems, and such agency costs are worth addressing. That said, the singular attention aimed at going after wrongdoing has been misplaced. More emphasis needs to be placed on crafting corporate strategy instead of policing corporate corruption.

It is appropriate to stress the importance of rooting out fraud, looting, etc. But more attention needs to be paid to improving the strategic decision making of corporate actors who are well-intentioned and hard-working and who are acting in good faith. Sometimes corporate actors have bad information; sometimes they suffer from bounded rationality; and sometimes they just exercise poor judgment. Whatever the cause, bad business decisions and faulty execution can destroy much more firm value for many more companies than huge CEO pay packages or financial restatements.

At a minimum, top managers and boards need to get back to running their businesses full-time, even if this means that officers and directors will dedicate less time and attention to compliance. Improving corporate decision making, however, is about more than just redirecting the efforts of executives and directors from compliance to strategy. Corporate governance changes also could be adopted to promote the crafting and implementation of strategy. One fairly significant change would be to institutionalize dissent in firms by having companies appoint a formal devil’s advocate on the board. This suggestion responds to the concern that the CEO dominates corporate decision making too much and isn’t challenged enough. While boards are certainly more independent today than pre-Sarbanes-Oxley, my sense is that independent directors are focused primarily on compliance, not strategy. (By the way, even if the devil’s advocate exists to improve strategy, it may also improve compliance.) Others have floated another possibility – that is, to have more "friendly" directors who might be willing and able to dissent without the CEO taking it personally or feeling threatened (see, e.g., Adams & Ferreira, "A Theory of Friendly Boards" (forthcoming, Journal of Finance)). This suggestion is in direct tension with the push for more board independence.

As we focus on headlines and scandals – the most recent of which concern stock option backdating – we should not lose sight of the fact that the business of corporate America is business. Better business decisions benefit all corporate constituencies.

Friday, October 13, 2006

Professor Troy Paredes Will Be Guest Blogger

I am pleased to announce that Troy Paredes, professor of law at Washington University School of Law in St. Louis, will be a Guest Blogger here from October 16-20, 2006. Prof. Paredes teaches corporations, securities regulation and corporate finance, and has written extensively on corporate governance and executive compensation. He is also the co-author of Securities Regulation, 4th Edition, and Fundamentals of Securities Regulation. I would like to thank Prof. Paredes and I look forward to his contributions.
House Passes Hedge Fund Study Measure

A bi-partisan bill directing the President’s Working Group on Financial Markets to conduct a study and report to Congress on the hedge fund industry recently passed the House by voice vote. The Hedge Fund Study Act, HR 6079, has the support of House leaders and represents an effort by Congress to learn more about both the risks and benefits of hedge funds in light of their explosive growth. While the numbers fluctuate, there are an estimated 8000 hedge funds managing approximately $1 trillion in assets. The bill has been received in the Senate and, in order to become law, would have to be passed by the Senate during the lame duck session of Congress next month. I believe that there is a good chance that this bill will pass the Senate and become law.

I think that there is a sense in Congress that they must be seen as doing something to address the hedge fund issue this year. And certainly, giving the Working Group an order to study and issue a report on hedge funds is the least controversial of any of the measures currently pending and the one with the best chance of passing in the waning days of the 109th Congress. The industry even supports the measure, with the Managed Funds Association applauding its passage in the House.

This is not to question the sincere concern among some members about the issues surrounding the explosive growth of hedge funds, particularly the number of pension funds that invest in hedge funds. A report on the interface between pension funds and hedge funds is particularly important to Rep. Barney Frank, the Ranking Member on the Financial Services Committee, who vowed to deal with the issue further next year. Mr. Franks’ vow is important because some speculate that he is slated to become the chair of the committee if the Democrats retake the House.

Wednesday, October 11, 2006

Preemption Provision in Rating Agency Reform Act to be Narrowly Construed
The recently enacted Credit Rating Agency Reform Act has a federal preemption provision that gives the SEC the exclusive right to register and qualify nationally recognized statistical rating organizations (NRSROs). There is, however, a carve out for states to bring enforcement actions to combat fraud.

There is also some imporatant legislative history on the preemption provision that should not be overlooked. According to Rep. Paul Kanjorski, a leading member of the House Financial Services Committee, the provision should be viewed narrowly as limiting a state’s authority to regulate the day-to-day activities of credit rating agencies. The preemption provision should not be construed to apply to typical state governmental functions in which states are users of credit ratings. Thus, states will continue to have the ability to continue to oversee their departments, programs, and political subdivisions with regard to debt issuance conditions, contract specifications, and investment standards for governmental funds, such as pension portfolios and financial reserves. Similarly, the preemption should not be taken to apply to the regulation of insurers and bank solvency standards and generic business licensing requirements normally applied to entities performing business within a state. (Cong. Rec., Sept 27, 2006, p. H7569).

Sunday, October 08, 2006

Congress Reforms Process for Designating Credit Rating Agencies

A process begun in 2002 by the Sarbanes-Oxley Act has culminated in the legislative reform of the procedures for designating nationally recognized credit rating agencies. Now, four years, one SEC report, and seven congressional hearings later, the Credit Rating Agency Reform Act (P.L. No. 109-291) creates a new regulatory system for identifying and overseeing the nationally recognized agencies that issue credit ratings. The Act establishes a transparent registration process through the SEC for rating agencies wishing to become nationally recognized and a time certain in which a decision must be made. The measure balances the need to increase the number of credit rating agencies from the current five with the need to ensure quality ratings.

Under the Act, applicants seeking to become rating agencies will be required to disclose procedures used to determine ratings, policies to prevent the misuse of inside information, conflicts of interest, a code of ethics, and the type of ratings that the applicant intends to use. A preemption provision gives the SEC exclusive NRSRO registration and qualification authority. Through examinations and enforcement, the SEC will oversee the registered NRSROs. The Act also directs the SEC to issue rules regarding NRSROs’ conflicts of interest and the misuse of inside information. The centerpiece of the reformed ratings regime is new Section 15E of the Exchange Act.

The Act reforms an opaque process that provided applicants with little guidance on the substance and procedures by which they would be evaluated. Currently, only five ratings agencies are designated NRSROs by the SEC, with two of the agencies essentially constituting a duopoly with an 80% market share. Many more aspire to be so designated but languish for years without an up-or-down vote on admission to this elite club.
Congress Mandates Adoption of Long-Delayed Bank Broker Rules

Congress has ended the nearly-seven-year logjam over the SEC’s proposed Regulation B for bank brokerage activities by directing the SEC to work with the Federal Reserve Board to promulgate joint regulations to fully implement the functional regulation vision of the Gramm-Leach-Bliley Act. The Financial Services Regulatory Relief Act of 2006, S. 2856, passed the House by a vote of 417-0; passed the Senate by voice vote; and has been cleared for the President. The measure is intended to ensure that regulators do not create a new and burdensome maze of requirements that would disrupt or interfere with the business practices of banks and thrifts that offer traditional bank products and services.

Before passage of Gramm-Leach-Bliley, banks were exempt from registering as brokers under the Securities Exchange Act. Gramm-Leach-Bliley repealed the blanket exemption enjoyed by banks and replaced it with a series of activity-specific statutory exceptions. Thus, as long as a bank is engaged in these traditional banking activities, it would not be subject to SEC broker-dealer regulation. These activities would, however, continue to be supervised by the federal banking regulators.

While the SEC has proposed rules to implement these exceptions, the agency has never finalized these rules in the face of intense criticism from the federal banking agencies. Section 101 of the relief act directs the SEC and the Federal Reserve Board to adopt final rules implementing the exceptions to the definition of broker granted by GLB. Moreover, the Act mandates that these rules must be jointly proposed within 180 days.

Anticipating passage of the Act, SEC Chairmen Christopher Cox pledged that the deadline set by Congress would be met and possibly exceeded. In fact, with the expectation that proposed new rules will be issued by year end, the Commission extended the current exemption from the definition of broker until January 15, 2007 in order to give time to complete the rule-writing and propose new rules before the exemption expires.

If the new rules are proposed with a 90-day comment period beginning at year end, final rules could be expected in late spring or early summer 2007. In addition, since the SEC recognizes that banks will need time to implement systems to ensure compliance with the new bank broker provisions, the SEC anticipates that the final rules would have a delayed effective date.

Thursday, October 05, 2006

Former Delaware Chancellor Discusses Controlling Shareholders

Former Delaware Chancellor William Allen has delivered an interesting assessment of controlling shareholders and the sale of control at a recent corporate governance seminar.

Broadly, the well-respected former jurist said that the US legal system contains an array of imperfect protections against abuse, which do allow the economy to gain the efficiency benefits that controlling shareholders can produce. Generally, judicial remedies and an active class action bar are effective in limiting the amount of exploitation by controlling shareholders. While the system is not perfect, in his view it works well as an ex ante system to constrain abuses in controlling shareholder transactions; but ex post as a remedy it works less well because the courts are poor at determining fair value. Mr. Allen is currently the Nusbaum Professor of Law and Business at NYU, and of counsel at Wachtell, Lipton, Rosen & Katz.

He pointed out that fiduciary duty of loyalty applies to all persons who exercise actual control. The duty requires that any interested transaction be on intrinsically fair terms, meaning fair price and fair process. He noted that courts tend to be active in demanding fairness and the controlling shareholder has the burden of proof.

He advised boards to hire capable and independent advisors to advise on law and price. Courts will be skeptical and look at the relationship between the advisors and the controlling shareholder, he emphasized, and will be very skeptical about advisor contingency fees. He also believes that the company’s general counsel be kept away from this process. Finally, he noted that the general rule is that controlling shareholders can transfer control by selling their shares and owe no duty to other shareholders to share any premium their control block may command on the market.

Monday, October 02, 2006

Hedge Funds May Be Responsible for Rise in Insider Trading

In recent testimony before the Senate Judiciary Committee, Professor John Coffee of the Columbia Law School suggested that hedge funds could be responsible for the increase in suspicious insider trading. More broadly, he called hedge funds the principal destabilizing force in corporate governance today. Hedge funds are different than mutual funds in two principal respects, explained the professor, they need not diversify and they can sell short. As a practical matter, mutual funds and pension funds do neither; the former must diversify, and latter are largely indexed. Thus, neither is as prepared to make a large firm-specific investment as a hedge fund.

That is part of the story, he continued, but the other part is that hedge funds are unregulated and their managers are not monitored as closely by compliance officers and counsel. Therefore, he said that hedge fund behavior may ``often resemble the Wild West.’’ There is the question of who would leak to a hedge fund since they are not loved by the business community. Here, emphasized the professor, the answer may be that because they trade in larger increments than more diversified institutional investors they will also pay more for useful tips. This point has a further implication: as usual, the most promising prosecutorial strategy is to “follow the money.”

Sunday, October 01, 2006

McCreevy Updates EU Corporate Governance Plan and Wants Consistent IFRS

Recently, EU Commissioner for the Internal Market Charlie McCreevy gave an update of the progress made on the corporate governance action plan. Essentially, the first phase of the plan has been completed and the Commission is consulting with stakeholders before embarking on the second phase. The commissioner mentioned that there is a growing consensus that issues surrounding shareholder democracy should be addressed, including one share, one vote. The EC has launched a study on the deviation from proportionality principle across member states, with results to be published next Spring and a possible recommendation in the offing. Based on the consultations on this issue and others, the commissioner said he will soon be making a more detailed statement of coming priorities. He also noted it is crucial to get the balance right in the area of corporate governance.

On a separate issue, the commissioner reiterated a grave concern of his, and others, that international financial reporting standards (IFRS) be consistently interpreted. I have previously blogged about the strong concerns shared by a number of regulators that the inconsistent interpretation of IFRS by different nations would doom the convergence of financial accounting standards. Commissioner McCreevy is placing great trust in the Committee of European Securities Regulators CESR) to play a leading role in assuring consistent interpretations. In this regard, CESR has created several working groups and will create a public database of enforcement decisions. The commissioner also urged accountants and auditors to help attain consistent interpretations by improving communications among themselves. Finally, he pledged that the Commission will also play an active role by providing a roundtable for discussion by interested parties, with issues of widespread significance referred to the IASB’s interpretative arm. But he said that the Commission will not itself provide European interpretations or guidance.