Wednesday, February 28, 2007

Fund-Adviser-Transfer Agent SEC Enforcement Action Dismissed

In an interesting case written up in the Wall Street Journal of Feb 27, 2007, a federal judge rejected an SEC disgorgement claim against two senior executives of an investment adviser to mutual funds. In an enforcement action brought under Section 206 of the Advisers Act, the SEC alleged that the defendants aided and abetted the adviser’s violation. The SEC said that materials provided to the funds’ boards, prepared by one officer and reviewed by the other, did not disclose the adviser’s leveraging the funds’ transfer agent business to obtain reciprocal business and revenue guarantees benefiting only the funds’ sponsor. SEC v. Thomas Jones and Lewis Daidone, SD NY, 05 Civ. 7044, Feb 26, 2007.

The investment adviser was a business unit of Citigroup, Inc., and provided advisory and management services to Citigroup-sponsored mutual funds. The Commission sought to disgorge the amount of money by which defendants were enriched as a result of their alleged misrepresentations relating to the transfer agent proposal. However, ruled Judge Richard Conway Casey, the Commission was unable to set forth any evidence of specific
profits subject to disgorgement.

The only evidence the Commission offered in support of its disgorgement action against one defendant was that his compensation was based on how he performed on significant projects, that the transfer agent initiative was a large project, and that his compensation might have been affected by the initiative. In sum, the SEC did not provide the court with any guideposts for determining the proper amount of compensation subject to disgorgement.

Monday, February 26, 2007

SEC Staff Allows Exclusion of Shareholder Advisory Vote on Exec Comp as Misleading

The SEC staff will allow WellPoint, Inc. to exclude a proposal to allow a shareholder advisory vote on the board compensation committee’s report based on the company’s argument that such a vote would be materially misleading under SEC proxy rules, specifically Rule 14a-8(i)(3). The SEC staff saw some basis in the company’s view that the proposal's stated intent to allow stockholders to express their opinion about executive compensation practices would be potentially misleading since shareholders would be voting on the limited content of the new compensation committee report, which relates to the discussions and recommendations regarding the newly mandated Compensation Discussion and Analysis disclosure rather than the company's objectives and policies for senior executive officers as described in the CD&A.

While shareholders casting an advisory vote would likely believe they were voting on the company’s executive compensation policies, argued the company, they would instead be voting on the compensation committee report, which is not even part of the CD&A section of the proxy statement.

Under the SEC’s new executive compensation rules, the CD&A must discuss the objectives and implementation of the company’s executive compensation policies. The compensation committee report states whether the committee has reviewed and discussed the CD&A with management and, based on such, recommended to the board that the CD&A be included in the annual report and, as applicable, the proxy statement.

Cooperation Seen as Key as PCAOB Begins Inspections of Non-US Auditors

In the view of PCAOB Chair Mark Olson, it is critical for the Board to engage in cross-border cooperation with other audit oversight bodies when it inspects non-US audit firms so that regulatory arbitrage can be avoided. In recent remarks, he pledged that the Board would develop an oversight program that effectively takes into consideration the level of home country supervision for non-U.S. firms audit firms slated for PCAOB inspection.

To illustrate the importance of regulatory coordination to the PCAOB, he noted, more than 750 of the over 1750 firms registered with the Board are in countries outside the United States, although they may be affiliated with large, U.S- based audit firms. As required by the Sarbanes-Oxley Act, many of these firms are registered with the PCAOB because they audit non-U.S. companies whose securities trade in U.S. markets and are required to file audited financial statements with the SEC. In addition, a number of other non-U.S. firms are registered because they audit or wish to audit significant non-U.S. subsidiaries of multinational U.S. companies. With respect to both categories of firms, the PCAOB chair pledged that the Board will work closely with its foreign counterparts to minimize unnecessary overlap and achieve shared objectives in the oversight of these non-US firms.

Noting his role as a former back regulator, Chairman Olson expressed comfort with the concept of home and host regulators for international firms. Under the home-host regulatory model, emphasized the chair, each regulator, whether home or host, must maintain a robust oversight system, including the ability to routinely coordinate with other regulators and respond quickly and effectively to any concerns.

His remarks sound a similar theme as earlier remarks by EU Internal Market Commissioner Charlie McCreevy, who asked the PCAOB to develop a roadmap towards future cooperation between US and EU audit oversight bodies. This has been done in the accounting field, the commissioner noted, and should also be done for auditing. The starting point for cooperation between the PCAOB and EU should be the home country principle, he said, adding that regulatory duplication must be avoided.

Saturday, February 24, 2007

UK Abandons MD&A in Favor of Business Review Narrative

In a bow to deregulation, the UK has abandoned the operating and financial review, the UK’s version of the SEC mandated MD&A, and replaced it with the EU-driven business review. In a speech to the Confederation of British Industry, Chancellor of the Exchequer Gordon Brown said that the operating and financial review requirement was being dropped because it is an example of the goldplating of European regulation, which occurs when additional and unnecessary burdens are imposed in the process of translating EU Directives into UK law.

The business review, which arises out of the EU Accounts Modernization Directive, requires companies to provide narrative information on the following areas: a balanced and comprehensive analysis of the development and performance of the company during and at the end of the financial year, a description of the principal risks and uncertainties facing the company, financial and non-financial key performance indicators, and views on the trends and factors affecting company performance.

At the same time, the International Accounting Standards Board has floated a discussion paper on what the Board calls management commentary, which is known as MD&A in the US and Canada and operating and financial review in the UK. The paper assesses the role the IASB could play in improving the quality of the management commentary that accompanies financial statements and also how international convergence may be achieved in this area.

MD&A is widely regarded as an important part of companies’ annual reports and many jurisdictions have developed requirements or principles on management commentary. The discussion paper reviews those requirements and offers recommendations on how the IASB might promote the wider adoption of best practice in the interests of investors and other users of financial reports.

Friday, February 23, 2007

President's Working Group Sets Out Guidance for Hedge Funds

The President’s Working Group on Financial Markets has issued principles-based guidance for hedge funds and other private pools of capital. The principles are designed to guide U.S. financial regulators as they address public policy issues associated with the rapid growth of these alternative investment vehicles. They rely heavily on suitability and counterparty risk management. This is the Working Group’s first statement on these issues since 1999, which was in the wake of the Long Term Capital Management scandal.

A growing congressional concern has arisen over the fact that less sophisticated persons are exposed indirectly to hedge funds through the holdings of pension funds and fund of funds. The Working Group posits that these concerns can be addressed through sound practices on the part of the fiduciaries that manage the funds. They have a duty to perform due diligence to ensure that their investment decisions are prudent and conform to sound practices.

The Working Group urges fiduciaries to consider the suitability of an investment in a private pool within the context of the overall portfolio and in light of the investment objectives and risk tolerances. Fiduciary evaluation should include the investment objectives, strategies, risks, fees, liquidity, performance history, and other relevant characteristics of a private pool. Fiduciaries should also evaluate the pool’s manager and personnel, including experience and disciplinary history.

The Working Group also believes that hedge fund managers must devote sufficient resources to the creation and maintenance of risk management systems to ensure that material information can be delivered to creditors, counterparties, and investors in a timely fashion. Risk management and valuation policies employed by private pools of capital should comply with industry sound practices. These practices include protocols for completing trade confirmations, obtaining prior written consent for assignments, and using cash-settlement procedures for OTC credit derivatives following a credit event.

Thursday, February 22, 2007

Stress Testing Is Key in New Era of Complex Derivatives and Hedge Funds

As the financial system moves from being essentially bank-centered to market-centered with complex derivatives and global counterparties, the challenges of maintaining financial stability and fostering effective risk management have increased, noted Federal Reserve Board Vice Chair Donald Kohn in recent remarks at the Exchequer Club. But he assured that the historic mission of the Board remains fostering financial stability and managing financial crises. He also urged increased use of stress testing as a key to effective risk management.

This important speech by the Fed senior official highlights the fact that we are a long way from even the world of Long Term Capital Management. It also comports with similar comments by Fed Chair Ben Bernanke urging the stress testing of exposures at the level of individual hedge fund counterparties. In addition, New York Federal Reserve Bank CEO Timothy F. Geithner has noted that the proliferation of new forms of derivatives and structured products has dramatically changed the nature of leverage in the financial system and made potential risk harder to assess.

Speaking of Mr. Geithner, the vice chair praised the work being done by the NY Federal Reserve Bank in working with other domestic and international regulators to develop a stronger clearing and settlement infrastructure for the OTC derivatives markets.

At the urging of regulators, market participants set goals and implemented policies for reducing the huge backlogs of unconfirmed trades in credit derivatives. As a result, confirmation backlogs were reduced 94 percent between September 2005 and November 2006. Importantly, market participants also terminated the practice of assigning trades without the prior consent of the counterparty. While these efforts initially focused on credit derivatives, market participants have now agreed to turn their attention to equity derivatives, noted Mr. Kohn, for which large backlogs still exist. They are also providing regulators with data on backlogs of all types of OTC derivatives, which will allow them to monitor the industry's progress across the board.

The evolution of financial markets and instruments have made risk managers acutely aware of the need to ensure that financial firms' risk management systems are taking sufficient account of stresses that might not have been threatening ten or twenty years ago. Identifying risk and encouraging management responses are at the heart of the Fed’s efforts to encourage enterprise wide risk-management practices at financial firms, emphasized the central banker, and essential to those practices is the stress testing of portfolios for extreme events.

A recent Wall Street Journal piece identified Mr. Geithner as the Fed’s go-to guy for preserving financial market stability as many less-regulated players, such as hedge funds, have become increasingly more important. He has begun to do some heavy lifting in this regard, such as with credit derivatives, and can be expected to do more.

Wednesday, February 21, 2007

EU Directive on Shareholder Voting Rights Moves Forward

‘The European Parliament has reached agreement in a single reading on the European Commission’s proposal for a Directive on shareholder voting rights. According to Internal Market Commissioner Charlie McCreevy, the agreement is another step towards the goal of ensuring that shareholders, no matter where in the EU they reside, have timely access to complete information and simple means to exercise voting and other rights at a distance.

On average, about one-third of the share capital of EU listed companies is held by non-residents. Key obstacles to voting faced by non-resident shareholders include share blocking, insufficient or late access to information, and burdensome requirements on distance voting. The Directive would eliminate the main obstacles in the cross-border voting process and enhance other rights of shareholders.

More specifically, under the Directive, general meetings should be convened with at least one month's notice. All relevant information should be available on that date at the latest, and posted on the issuer's website. The meeting notice should contain all necessary information. Share blocking should be abolished and replaced by a record date which should be set no earlier than 30 days before the meeting. Further, the right to ask questions would be accessible to non-residents.

The maximum shareholding thresholds to benefit from the right to table resolutions would not exceed 5%, in order to open this right to a greater number of shareholders while preserving the good order of general meetings. In addition, proxy voting would not be subject to excessive administrative requirements, nor unduly restricted. A principle of the Directive is that shareholders should have a choice of methods for distance voting. Moreover, voting results should be available to all shareholders and posted on the issuer's website.
SEC Speaks Seminar Examines Accounting and Auditing Issues

Accounting and auditing issues took center state at the recent Practising Law Institute’s SEC Speaks conference in Washington, D.C. SEC Chief Accountant Conrad Hewitt said his key areas of focus are on auditor liability, convergence, the SEC's guidance for management under section 404 and the PCAOB's proposed standard to replace Auditing Standard No. 2 on internal controls.
The problem with auditor liability has no easy solution, in his view. Some countries have introduced the concept of a liability cap or limited liability. Mr. Hewitt referred to the European Commission's recent paper outlining four possible ways to protect the audit industry. On the issue of international convergence of accounting standards, he is pleased with the progress that has been made on the steps outlined in former Chief Accountant Donald Nicolaisen's roadmap. The eventual elimination of the reconciliation requirement has the potential to lower costs for issuers, he said.
Former SEC Chairman Harvey Pitt said it is constructive and courageous to speak out on auditor liability. He believes the SEC may have the ability administratively to have an impact. Pitt supports the move to a more principles-based system of accounting, but questioned its impact on liability. Liability may increase with less specificity, he said.
Noting that the PCAOB's proposed Auditing Standard No. 5 is very important, Mr. Hewitt said that he is interested in the feedback the PCAOB receives on its proposal. Smaller companies reportedly pay up to five times proportionally what larger companies pay to comply with the section 404 requirements. Mr. Hewitt hopes the upcoming guidance will help the 4,500 smaller companies that are coming on board with the requirements.

Former Commissioner Aulana Peters noted that the IASB is on a two-year track to convergence and asked whether the SEC would rethink its three-year roadmap on reconciliation. It would be helpful if the SEC, FASB and the IASB were on the same timetable, she said. Conrad Hewitt believes they are all on the same timeframe. Perhaps companies can be given the option to use IFRS or GAAP, he said. Europeans want to stay with their principles-based standards, but the U.S. is still rules-based. He indicated that it is going to take a couple of years.

John White, the Director of the Division of Corporation Finance, emphasized that there is a question of whether the U.S. users of financial statements are ready for a parallel system of financial statements without reconciliation. He believes the 2009 goal is workable, while something faster than that would be difficult. The SEC has a plan to reach out to the user community in the near future, he said.

Chief Accountant Hewitt advised that the staff is looking at all of the angles and working with the largest accounting firms to obtain their views. He added that there are likely to be just as many lawsuits with rules-based standards as with principles-based standards.
Zoe-Vonna Palmrose, the deputy chief accountant in the Office of the Chief Accountant, noted that the changes in the PCAOB's proposed standard on auditing for internal controls reflect what the PCAOB said was its intent all along. Still, she said the revisions are an important psychological change. Small companies were overwhelmed by the stories they have heard about implementing the section 404 requirements.

Tuesday, February 20, 2007

Appeals Court Examines Sovereign Event in Credit Default Swap Context

Recently, a panel of the US Court of Appeals for the Second Circuit had occasion to examine what a sovereign event is in the context of a credit default swap agreement. Aon Financial Products, Inc. v. Société Générale, CA-2, Docket No. 06-1080-cv.

A credit default swap is the most common form of credit derivative, i.e., a contract which transfers credit risk from a protection buyer to a credit protection seller. Credit default swaps do not, and are not meant to, indemnify the buyer of protection against loss. Rather, they allow parties to hedge risk by buying and selling risks at different prices and with varying degrees of correlation.

The case arose out of one of a series of transactions related to the financing of a condominium complex in the Philippines. Bear Stearns agreed to loan a company $9.3 million to build the complex and the company, in turn, agreed to repay Bear Stearns $10 million. As a condition precedent to that loan, Bear Stearns required the company to procure a surety bond from Government Service Insurance System (GSIS), an agency of the Philippine Government.

In order to protect itself against the risk of GSIS defaulting on the surety bond, Bear Stearns entered into a credit default swap with Aon under which Aon promised to pay Bear Stearns $10 million upon the occurrence of a credit event. In order to reduce its own risk exposure, Aon entered into a separate credit default swap agreement with SG under which SG promised to pay Aon $10 million upon the occurrence of a credit event, defined in part as a sovereign event.

About one year later, the company defaulted on its Bear Stearns loan and GSIS stated that it did not intend to pay on the bond because it had not been appropriately authorized on GSIS's behalf. Aon filed against SG, seeking payment of $10 million under the Aon/SG credit default swap agreement.

The appeals court concluded that GSIS's default was not a sovereign event as that term is used in the Aon/SG credit default swap agreement. With the Aon/SG credit default swap, Aon hedged the risk that it bought from Bear Stearns by selling to SG the risk of a credit event as defined by the Aon/SG contract. But the risk transferred to Aon and the risk transferred by it were not necessarily identical, said the court, since the terms of each credit swap agreement independently define the risk being transferred.

The default resulted from GSIS's decision that it was not legally bound to honor its putative obligation to pay. This was not a sovereign event, reasoned the appeals court, since such refers to large-scale events like the restructuring of the sovereign's debt, which may be expected to cause a general condition throughout the country.

Monday, February 19, 2007

Chairman Cox Opens SEC Speaks Conference

The always informative Practising Law Institute's "SEC Speaks" conference was recently held in Washington, DC. In his keynote address, SEC Chairman Christopher Cox reviewed the initiatives the SEC has undertaken in his 80 weeks as chairman, including the most comprehensive overhaul of the executive compensation rules in a decade. That initiative could not have been more timely, he said, given that the stock option backdating scandal was just coming to light.

Mr. Cox said that the SEC's investigations into backdating practices illustrate the value of interactive data. Once the SEC began receiving the Form 4 insider reporting transaction forms in an interactive data format, the information became much easier to analyze. He added that the SEC began to tag the data from the archival Forms 4 using the XML format. The SEC also adopted rules that accelerated the filing of the forms to within two days of the option grants. The result of these initiatives was the discovery of billions of dollars of backdated stock option awards.

The chairman also reviewed the Commission's enforcement process. He praised the SEC's Wells process as one of the most striking models of fairness that exists in the federal system. It provides an opportunity to present a counter-argument to a potential enforcement action.
In other developments at the seminar, the Division of Market Regulation expects to recommend the adoption of final rules this spring on proposals to prevent short sales during the period before pricing and then purchasing the security in the offering, and amendments to Regulation SHO. In addition, the staff expects to update its responses to frequently asked questions about Regulation NMS in the next couple of weeks. The staff also hopes to move quickly on its bank broker-dealer rules, which could be finalized by summer.

Commissioner Paul Atkins spoke about court decisions overturning the SEC's mutual fund governance rules and its hedge fund adviser registration rules, and Congressional action to prompt the SEC to adopt rules for credit rating agencies and bank broker-dealer activities. Mr. Atkins observed that Chairman Cox has taken the two judicial reprimands as an opportunity to conduct a top-to-bottom review of the SEC's process for assessing the economic impact of its rulemaking.

Sunday, February 18, 2007

European Court of Justice Advocate Finds Against German Anti-Takeover Law

In an eagerly anticipated case, the Advocate General of the European Court of Justice has opined that Germany’s anti-takeover ``Volkswagen Law’’ restricts the free movement of capital through the intervention of the public sector. In an action brought by the European Commission against the Federal Republic of Germany, the Advocate General found that the requirement of respect for the system of property ownership enshrined in the EC Treaty was not respected since provisions of the German law tend to keep property in the hands of those who own it in the face of a hostile takeover bid. Thus, the Advocate General proposed that the Court of Justice find against Germany. Commission of the European Communities v Federal Republic of Germany. Case C-112/05.

The legislation allows the federal government and the Land of Lower Saxony to each appoint two members of the supervisory board of the company (equivalent to the board of directors in the US).. It also limits voting rights to 20 per cent of the share capital where any shareholder exceeds that percentage. Further, the law increases to more than 80 per cent of the share capital represented for the adoption of resolutions of the general shareholders meeting.

It is interesting to note that, regarding the justification for restrictions on the free movement of capital based on the legislation’s objectives in terms of social and economic policy, the Advocate General considers that the German Government’s approach is too broad and too far removed from reality and is not based on overriding reasons relating to the public interest.

While the Advocate General’s opinion is not binding on the Court, it has been reported that the Court usually agrees with such opinions. The role of the Advocates General to propose to the Court a legal solution to the cases for which they are responsible. The Court of Justice is now beginning its deliberations in this case. Judgment will be given at a later date.

The Advocate General believes that allowing the government to appoint four members of the supervisory board dissuades those wishing to acquire a significant number of shares in the company. As regards the blocking minority and the limitation of voting rights, the Advocate General pointed out that the reduction of the voting rights to 20 per cent coincides with the percentage of shares held by the federal government and the Land of Lower Saxony at the time the law was passed. The Advocate General takes the view that, in those circumstances, anyone wishing to acquire a sufficient number of shares in the company to sit on the management bodies would have serious doubts about acquiring more than one-fifth of the capital because they would have no voting rights above that ceiling.

Moreover, even if they did succeed in mobilizing every small shareholder, there would be no real possibility of achieving any change with more than four-fifths of the company capital in the shareholders’ meeting because the federal government and the Land could block it with their minority holding. Thus, the national legislation strengthens the position of the federal government and the Land, preventing any intervention in the management of the company.

Wednesday, February 14, 2007

SEC Amicus Brief Rejects 7th Circuit Holding in Scienter Case

By N. Peter Rasmussen
Writer-Analyst
CCH, Inc.


The SEC filed an amicus brief in Tellabs Inc. v. Makor Issues & Rights, Ltd., a fraud pleadings standard case under consideration by the U.S. Supreme Court. The Commission brief squarely rejected the 7th Circuit's holding (published at ¶93,642 in CCH's Federal Securities Law Reporter) that "we will allow the complaint to survive if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent." According to the SEC, this approach "erroneously diluted" the Private Securities Litigation Reform Act requirement that fraud complaints must “state with particularity facts giving rise to a strong inference that the defendant acted with the requisite state of mind."

The brief stated that "Congress did not merely require a plaintiff to allege particular facts from which an inference of scienter could be drawn, but instead required a plaintiff to allege particular facts that `giv[e] rise' to a `strong' inference of scienter." The 7th Circuit's "reasonable person" standard failed to meet this requirement, concluded the SEC, because a "strong inference of scienter plainly requires something considerably more than a `reasonable' inference (or a permissible inference by a reasonable person)."

The Commission brief also asserted that the dismissal of the complaint as inadequately pleaded would not unconstitutionally interfere with the role of the jury under the Seventh Amendment. As stated by the SEC, the PSLRA pleading requirement "merely imposes a threshold legal hurdle that a plaintiff must surmount in order to state a claim (and thereby obtain discovery); it does not trench upon the jury’s prerogative to resolve disputed issues of fact."

Tuesday, February 13, 2007



UK FSA Doubts Benefits of IFRS-GAAP Convergence

In an interesting development, the UK Financial Services Authority is concerned that the costs of convergence between US GAAP and international financial reporting standards (IFRS) may outweigh the benefits. In particular, the FSA believes that a converged set of accounting standards acceptable to the SEC will need to be more like US GAAP and more detailed and prescriptive than current IFRS, which are principles based, albeit increasingly underpinned with more detailed rules. The FSA’s positions on convergence, as well as on threats to IFRS, were set forth in its recent report on risks to the financial system.

While acknowledging that the roadmap for the SEC to determine that IFRS are equivalent to US GAAP could potentially lead to a more transparent and lower-cost global capital market, the FSA emphasized that the progress made over the next 18 to 36 months will be critical in determining whether the potential benefits of convergence are realized or whether the costs connected and the ultimate outcomes experienced are potentially disproportionate or even negative.

Regarding the first full year of reporting under IFRS across the European Union, the FSA identified two major risks to the continued success of IFRS. The first risk is inconsistent interpretations of IFRS across national economies. The true benefit of IFRS can only be realized, reasoned the FSA, through enabling a better comparison of similar entities across national boundaries, which, in turn provides enhanced market transparency.

The second risk to IFRS is the potential direction of the future development of the IFRS framework. In this regard, there is a growing concern that IFRS will be interpreted and audited in a more prescriptive and rules-based way than was typically the case under UK GAAP.

Monday, February 12, 2007

Del. Chancellor Says Options Backdating May Not Be Protected by Business Judgment Rule

In the context of a shareholder derivative action, the Delaware Chancellor has ruled that allegations that stock options were backdated in intentional violation of a shareholder approved stock option plan, coupled with fraudulent disclosures regarding the directors’ purported compliance with that plan, constituted conduct that was disloyal to the company and therefore an act in bad faith. In addition, Chancellor Chandler said that the compensation committee’s alleged knowing and intentional decision to exceed the shareholders’ grant of express limited authority raised doubts regarding whether such decision was a valid exercise of business judgment and was sufficient to excuse a failure to make demand. Ryan v. Gifford, Civ. Action No. 2213-N, Feb. 6, 2007.

It was difficult for the court to conceive of a context in which directors may simultaneously lie to their shareholders regarding their violations of a shareholder-approved plan and yet satisfy their duty of loyalty. Backdating options qualifies as one of those rare cases in which a transaction may be so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists. Indeed, the shareholder alleged bad faith and, therefore, a breach of the duty of loyalty sufficient to rebut the business judgment rule and survive a motion to dismiss.

Allegations that the three members of the compensation committee of a six member board approved backdated options, and another board member accepted them, were sufficient to raise a reason to doubt the disinterestedness of the current board and suggest that they are incapable of impartially considering demand.

Later, the shareholder may have to rely on evidence presented at trial to demonstrate by a preponderance of the evidence that the directors in fact backdated options, and thus are not afforded the protections of the business judgment rule. Even at that point, the directors may still prevail by meeting the hefty burden of proving that the challenged transactions were entirely fair to the corporation and its shareholders.

Saturday, February 10, 2007

ABA Asks SEC to Modify Its Position on Attorney-Client Waiver

In a recent letter to SEC Chairman Christopher Cox, the American Bar Association strongly urged the Commission to stop the practice of requiring companies to waive their attorney-client protections as a condition of receiving credit for cooperating with SEC investigations. In the ABA’s view, the policies set forth in the SEC’s Seaboard Report contain language that could erode the protection afforded by the attorney-client privilege. The ABA believes that the Seaboard Report, along with similar Justice Department policies, is contributing to what it called a ``culture of waiver’’ that could lead to ``profoundly negative consequences.’’

The Commission’s Seaboard Report, formally known as the Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions, was issued on October 23, 2001 as Releases 34-44969.

While noting that many of the criteria for cooperation outlined in the Seaboard Report are reasonable, the ABA has serious concerns regarding the overly broad factors outlined in criteria no. 11 to the extent that they encourage companies to waive their attorney-client privilege as a sign of full cooperation.

In practice, said the ABA, the Seaboard Report has led to the routine compelled waiver of attorney-client privilege. Although the report does not expressly state that waiver is required in every situation, the policy has led SEC staff to pressure companies to waive their privileges on a regular basis as a condition for receiving cooperation credit during investigations. From a practical standpoint, reasoned the ABA, companies have no choice but to waive the privilege when encouraged or requested to do so because the risk of being labeled uncooperative will have a great effect not just on the Commission’s enforcement action decisions, but also on the company’s image and stock price.

Further, the ABA posits that the Commission’s waiver policy undermines, rather than
enhances, compliance. By making the privilege uncertain in the corporate context, continued the ABA, the SEC’s policy discourages companies both from consulting with their lawyers, thereby impeding their ability to effectively counsel compliance, and conducting internal investigations designed to quickly detect and remedy misconduct. The ABA believes that federal officials can obtain the information they most frequently seek from a cooperating company without resorting to requests for waiver of the privilege.


The ABA Task Force on Attorney-Client Privilege has recommended specific revisions
to the Seaboard Report that would preserve the attorney-client privilege during SEC investigations while ensuring the Commission’s continued ability to obtain the important factual information that it needs for effective enforcement. The task force suggested that the revised Seaboard Report prevent SEC staff from seeking privilege waiver during investigations, while preserving their ability to request important factual information from companies as a sign of cooperation without implicating broader privilege waiver concerns.

The suggested revisions would also clarify that a waiver of privilege should not be considered when assessing whether the company provided effective cooperation. The revised position would also recognize that cooperation credit can be given for providing factual information. Finally, the revised statement would clarify that, while Commission staff may consider a company’s reasonable efforts to secure its employees’ cooperation as a factor in determining whether the company has fully cooperated during an investigation, the company should not be asked or expected to punish any employee who chooses to assert his or her legal rights.

Thursday, February 08, 2007

Delaware Supreme Court Affirms Caremark; Says Good Faith Subsidiary Duty

In a seminal landmark ruling, the Delaware Supreme Court has affirmed the Caremark standard for director oversight liability and ruled that the duty of good faith is a subsidiary of the duty of loyalty. Thus, the court answered the question it had reserved in the Walt Disney case by holding that the fiduciary duty to act in good faith is a duty that, unlike the duties of care and loyalty, cannot serve as an independent basis for imposing liability upon corporate officers and directors. (Stone v. Ritter, No. 93, 2006)

Although good faith had previously been described as part of a triad of fiduciary duties, along with due care and loyalty, the court made clear that the obligation to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duties of care and loyalty. Only the latter two duties, where violated, may directly result in liability, whereas a failure to act in good faith may only do so indirectly.

In this derivative action that hinged on the futility of demand, the court held that, in the
absence of red flags, good faith in the context of corporate oversight must be measured by the directors’ actions to assure the existence of a reasonable internal system of information and reporting, and not by second-guessing after the occurrence of employee conduct that results in an unintended adverse outcome.

A corollary to the holding that good faith is not an independent duty is the fact that the duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith.

With regard to Chancellor Allen’s ruling in Caremark, the court said that it articulates the necessary conditions predicate for director oversight liability: (a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention. In either case, imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations.

Wednesday, February 07, 2007

What is Principles-Based Regulation; FSA Counts on Compliance Officers

The move towards principles-based regulation and away from rules-based regulation appears to be inexorable. And yet, no one appears to know exactly what a principles-based regime will look like and how it will function. And, I suspect that many people secretly find comfort in rules, even while outwardly professing loyalty to principles-based regulation. These are important issues as the SEC and the FASB have also genuflected at the altar of principles-based regulation.

As the UK Financial Services Authority moves more towards principles-based regulation, it is envisioned that compliance officers and senior management will have increased duties in making sure that firms abide by the principles, as well as the remaining rules. In recent remarks, FSA Director Thomas Huertas also noted that the shift to more principles–based regulation means that senior management will have more scope to decide for themselves how the firm should comply and therefore more scope to shape compliance to the overall needs of the business. Compliance officers will have the opportunity to decide, together with senior management, how to make their function more efficient in terms of achieving what the FSA believes are two complementary outcomes: 1) achieving the results summarized by the principles; and 2) achieving sound and lasting business results.

As the director correctly pointed out, the FSA has always been a principles-based regulator, with eleven high-level principles for authorized firms. The authority also has about 8,500 pages of rules, which embellish but do not supplant the principles. But in its Business Plan for 2007-2008, the FSA emphasizes that it will become a more principles-based regulator. Accordingly, the FSA has begun to subject its existing rule book to the same type of cost-benefit test employed when establishing a new rule.

An article in today’s Financial Times notes that the financial services industry will be handed a £50m bill from the FSA as it moves to principles-based regulation. The article notes that there is continued uncertainty in the City of London about the meaning of principles-based regulation and how it will work in practice.

In any event, the director said that the FSA expects firms to take a risk-based approach to compliance. This approach should focus on preventing material breaches to principles and to inform the FSA of any that are material, either singly or in aggregate. The director emphasized that the FSA will look closely at what the firm does in response to a breach, for example, whether it investigates the cause of the breach and takes appropriate corrective measures. The senior official warned that the FSA will not tolerate systematic and deliberate breaches of the principles and of the rules, adding that such a strategy may itself be a violation of Principle 1, which is that a firm must act with integrity.

The FSA also expects that firms will be able to tell the agency how they are tracking the effectiveness of the systems and controls that they have put in place to assure compliance with the principles. This need not be a census of all transactions, said the director, but could involve risk-based sampling or screening to gauge the overall frequency of breaches and to assure the detection of any material breaches.

Tuesday, February 06, 2007

Audit Committee Study Reveals Expectation Gap

A study on audit committees found an expectations gap between how the audit committees see their regulatory role and how their role is perceived by the media. This gap exists where the audit committee’s legal duties are at odds with public expectations. For example, some parts of the media and smaller shareholders appear to see the audit committee role as the prevention and detection of fraud.

But this view sits uncomfortably with the views of audit committee members, who see their role as an oversight function. Indeed, the general view discovered by the study is that, in practice, the audit committee is unlikely to be able to detect and prevent fraud since, by its very nature, the committee is at a distance from business operations. The report was prepared for the UK’s Audit Committee Chair Forum by Dr. Ruth Bender of the Cranfield School of Management. This a very interesting report that deals with best practices, such as how many meeting to have, and broader issues, such as shareholder access to audit committees.

The role of the audit committee is set forth in the Combined Code, the UK’s corporate governance code, and expanded on in the Smith Guidance. Under the Combined Code, the audit committee’s role is, among other things, to monitor the integrity of the financial statements, review the company’s internal financial controls, and, recommend appointment of the external auditor and approve its remuneration and terms of engagement.

The Combined Code also states that the audit committee should be composed of independent directors and not include the company chair. However, the study found that audit committee meetings were attended by many parties other than the actual members, including external and internal auditors, and the chair and the finance director.

The Smith Guidance suggests that the number of audit committee meetings in a year should be at least three. Of the companies reviewed in the study, the minimum number of meetings was three, and the maximum number of meetings found during the research was thirteen. The number of meetings will in part be a function of unusual circumstances during the year, such as the. initial application of Sarbanes-Oxley or international financial reporting standards. Audit committee meetings generally last between two and three hours.

The report found that the growing volume of governance regulation, and the related increased legal obligations of independent directors, can lead to inordinate focusing on process, or box checking, and too little time for other activities, such as risk management strategy. The report recommended scheduling time over the year for what it called a “white space” meeting to give the audit committee a chance to consider broader issues.

The role played by the audit committee chair was seen as critical in setting the tone and structure of the work. All of the audit committee chairs participating in the study were involved in determining the agendas for the audit committee meetings, generally in conjunction with the finance director and sometimes with the external auditor, with some having a policy of always meeting with the external auditor before a committee meeting.

There is a growing movement among institutional shareholders to have closer involvement with audit committees. The Combined Code states that audit committee chairs should be available at companies’ annual meetings to answer shareholder questions, but gives investors no further direct access. The report found that no benefit would be gained by allowing increased access. The crucial issue here is whether the audit committee exists for the benefit of the board or for the benefit of the shareholders. Generally, the view was that it is the board, since the audit committee is a sub-committee of the board to which certain responsibilities are delegated, and its role is to report to that board.

Sunday, February 04, 2007

UK Accounting Leader Calls for Audit Oversight Cooperation, Praises Levitt

Given multinational corporations and the global audit firms that audit their financial statements, it is imperative that the PCAOB and other audit oversight bodies work together to meet the challenges of convergence and the consequences of a global regulatory agenda. The standard setters must be ready also to meet the challenges that will arise when the PCAOB inspects the auditors of foreign private issuers and their subsidiaries, noted Richard Dyson, President of the Institute of Chartered Accountants in England and Wales, at a recent seminar.

Mr. Dyson also took the opportunity to praise former SEC Chairman Arthur Levitt for being prescient in a 1998 speech in which the chairman warned of impending dangers if the financial community did not change its practices. I think that Mr. Dyson must be referring to the now famous NYU speech of Sept. 28, 1998. Noting that Chairman Levitt must have had a crystal ball, Mr. Dyson said that the SEC chair correctly stated that the public faith in the integrity of the audit profession was becoming increasingly tarnished and that integrity of information must take priority over a desire for competitive advantage in the audit process. These 1998 remarks do indeed sound prophetic today.

Returning to the familiar theme of unfavorably contrasting US prescriptive rules with the lighter touch regulation of the UK and EU, My. Dyson foresaw possible problems even when the PCAOB works with home country regulators. In his view, this is because the US market is not the same as the UK or EU. The US market is based on securities law, he said, while the UK and EU markets are based on company law. There is a world of difference in approach and intent, he added, in financial reporting, in corporate governance, and in response to financial scandals. Moreover, the UK and EU have gone down a shareholder-based approach to corporate governance, supported by codes and the comply or explain principle.

In contrast, the US has adopted a regulatory approach, with Sarbanes-Oxley, that prescriptive and rules-based. For example, Dyson pointed to what he described as ``incredibly detailed’’ rules on auditor independence. This means that larger network audit firms must now operate global conflict databases to cover US independence requirements which reach across every border since the financial and reputation risks involved if a breach were to occur are too great not to do so.

Thursday, February 01, 2007

Big Four Firm Lists Red Flags for Hedge Fund Risk Management

The risk management and valuation practices of many hedge funds can best be characterized as in their adolescence, according to a new global study by Deloitte & Touche. The report also cautions hedge fund managers and investors to watch out for nine red flags in funds’ risk management practices. The report is based on a survey of the valuation and risk management practices of 60 hedge fund advisers from across the globe.

The nine areas identified in the report as risk management red flags include lack of position limits; and tracking liquidity and measuring off-balance sheet leverage without stress testing and correlation testing. Other red flags for risk managers are the lack of industry concentration limits for non-sector funds and not tracking liquidity. Also identified as red flags are the use of value at risk without back-testing; using leverage without tracking on-balance sheet leverage; the use of VAR, or other models, without stress testing and correlation testing; and holding assets with embedded leverage without measuring off balance sheet leverage.

The report also finds that a number of leading valuation practices have been widely adopted by the hedge fund industry, to the point of becoming standard industry practice, but not universal. Although 78 percent of the hedge funds reported using a third party administrator to provide their official net asset valuation, for example, only 47 percent reported that they engaged a third party to provide independent pricing validation. According to the report, the latter finding particularly suggests that investors need to carefully review valuation practices before investing and continue to monitor hedge funds’ practices once an investment has been made.