Wednesday, March 28, 2007

Investment Management Director Vows Review of Rule 12b-1

The review of 1940 Act Rule 12b-1 is a high priority for the Division of Investment Management this year announced Director Andrew Donahue in a keynote address to a mutual funds conference in Palm Desert, California. The staff will be reconsidering both the rule itself and the factors that fund boards must consider when approving or renewing a Rule 12b-1 plan. Rule 12b-1 permits mutual funds to bear expenses associated with the distribution of their shares, if they comply with certain conditions and procedures. Separately, the director also expressed grave concern with funds’ increasing use of derivatives.

The rule was adopted in 1980 during an entirely different era of net redemptions amid a fear that funds may not survive unless they were permitted to use a at least a small portion of their assets to facilitate distribution. At over $10 trillion in assets, the director noted, the fund industry does not seem to be in imminent threat of extinction. Further, the industry has not been through a recent period of sustained net redemptions.

Indeed, mutual funds are enjoying growing popularity and acceptance by average investors. Not surprisingly, in light of these developments, the primary use of 12b-1 fees has shifted from the limited marketing and advertising purposes that were originally envisioned to using such fees primarily as a substitute for a sales load or for servicing. Against that backdrop, and with a forward-looking perspective, he feels that it would be wise to reconsider Rule 12b-1.

In a December 2000 report on mutual fund fees and expenses, the SEC staff recommended that the Commission consider whether Rule 12b-1 needs to be modified to accommodate changes in the mutual fund industry. The study also suggested that the Commission consider whether to give additional or different guidance to fund directors with respect to their review of Rule 12b-1 plans.

On a separate matter, the SEC official has multiple concerns about the increasing use by funds of derivatives and other sophisticated financial instruments. For example, he said it is imperative that all relevant parts of a fund’s operations team understand a portfolio instrument and appreciate its use and implications. The portfolio manager and investment officers will be involved in the decision to use a new type of financial instrument. In addition, the legal, compliance and accounting groups must also understand the instrument and have implemented the proper techniques and controls.

There is additional concern because the compliance systems at many funds may not be sophisticated enough to effectively handle synthetic instruments. Since these instruments generally emanate from the sell side, he noted, it is the sell side that has the systems to manage them and the experience to better deal with their risks, pricing and volatility. Mutual funds, on the other hand, very often are newcomers. The director was not warning funds off investing in these instruments, but rather that they should do a lot of work up front before wading into uncharted territory. In this way, he concluded, the fund and its investors will not be disappointed later.

Campos Urges Europeans to Push for Proxy Access in US

In a recent speech at a London conference on governance, SEC Commissioner Roel Campos said it was ironic that he was asked to defend the lack of shareholder proxy access in the U.S. since he has been its strongest advocate. Campos said the SEC is on the wrong side of this issue and the current system for electing directors is an ``absolute joke.’’ Even large institutional shareholders have virtually no choice in the election of directors, Campos explained.

Many companies have adopted majority voting requirements, Campos noted, but they are often voluntary. The majority voting provisions to do not permit shareholders to nominate a director but make it easier to vote directors off of the board. Campos said the lack of proxy access in the U.S. is “a distinct negative.”

Campos said he has done all that he can to establish proxy access in the U.S. When the issue was before a federal appeals court last year, Campos explained that he had insisted that the SEC not formally submit a brief that supported the status quo. The court ruled in favor of the shareholders, which gave them access to the corporate proxy. The SEC must now decide what action to take, and Campos made clear there was no consensus view among the commissioners

Campos urged a letter writing campaign to bring about change, emphasizing the economic benefits of proxy access such as the potential for increased European investments. The SEC is at a critical point and European investors may make a difference, he explained

While conceding that one aspect of the U.S. governance system needs work, the commissioner refused to concede that the U.S. market is unattractive to foreign investors. He said that one of the great strengths of the U.S. market is the system of high standards and protections of capital. He posited that investors appreciate and desire this high level of protection for capital. Indeed, the available data indicates that savings in the cost of capital for companies cross-listed on the U.S. are several times greater than the costs of complying with U.S. regulations.
Fed's Geithner Spells Out Daunting Task of Risk Management

At the intersection of banks, securitization, risk management and derivatives stands Timothy Geithner, NY Fed CEO. who is carrying the Fed's banner into these uncharted waters. In remarks at a symposium hosted by the Richmond Federal Reserve Bank, he said that there is no strong empirical support for the proposition that derivatives increase volatility in financial markets, but that aspects of this latest wave of innovative financial instruments are different in substance and require attention. And, said the Fed official, even the most sophisticated participants in the derivatives markets find the risk management challenges associated with these instruments to be daunting.

The recent experience in subprime mortgages and related asset-backed securities and credit derivatives illustrate different types of surprises faced by the participants in these markets. They are a reminder of the dimensions of uncertainty that exist about the shape of the distribution of potential returns.

The senior official correctly said that it is impossible to turn back the clock or reverse the increase in complexity around risk management. Even more, the Fed does not have the capacity to monitor or control concentrations of leverage or risk outside the banking system; and thus cannot identify the likely sources of future stress to the system, and act preemptively to diffuse them.

But there are ways that regulators and policymakers can mitigate these risks, assured the Fed official. The most productive policy is to improve the shock absorbers at the core of the financial system in terms of capital and liquidity relative to risk and the robustness of the infrastructure.
These issues are the principal focus of market oversight in the global financial centers. For its part, the Federal Reserve is working closely with the primary regulators of global financial institutions and the critical parts of the financial infrastructure to encourage further progress. In this context, the Fed seeks a stronger regulatory capital regime and a strengthening of the capacity of firms to absorb losses in stress conditions.

In addition, the Fed is encouraging more sophisticated and more conservative management of credit exposures in OTC derivatives and structured financial products, as well as of exposures to hedge funds. Similarly, the Fed is promoting a range of efforts to modernize the operational infrastructure underpinning the OTC derivatives market, and to improve the capacity of market participants to manage a major default.

Tuesday, March 27, 2007

Atkins Says SEC Must Be Responsive to Capital Markets Reports

In a speech in Dublin, Ireland, Commissioner Paul Atkins said the SEC cannot ignore the recommendations of three recent reports on the U.S. capital markets. He said the reports, the most recent of by the Chamber of Commerce, can inform the SEC of whether it has struck the right balance between investor protection and market competitiveness. Atkins also took aim at the “coalition of contrarians” who contend that the U.S. capital markets are fine and need no recalibration. He believes that the SEC is duty-bound to analyze, understand and respond, if warranted, to the recommendations that pertain to the Commission.

Atkins said regulators must examine the costs they impose on market participants through regulations and to make sure the costs do not exceed the benefits. Government actions cannot be viewed in isolation, he emphasized. In the increasingly interconnected global financial services sector, Atkins said governments need each other’s cooperation and assistance to fight fraud, manage risk and maintain low costs and efficiency.

While the findings of the policy groups in the U.S. were unique, Atkins noted that they had a common thread with respect to SEC-related issues. Each report recommended quick and substantial changes to section 404, he said, as well as streamlined regulatory processes based on meaningful cost-benefit analyses. The reports also called for the members of the President’s Working Group to work together to bring transparency and predictability to the enforcement process.

In my opinion, these are welcome remarks from the commissioner. I have previously blogged about the Chamber of Commerce report, officially known as the report of the Commission on the Regulation of US Capital Markets in the 21st Century. This is a thoughtful report replete with detailed recommendations, fully deserving of an official response. Similarly, the earlier Bloomberg-Schumer report on sustaining the US Global Financial Services Leadership is a very good effort, whose recommendations are worthy of full consideration.
IOSCO Issues Principles for Hedge Fund Portfolio Valuation

The International Organization of Securities Commissions has issued nine principles for the valuation of hedge fund portfolios in an effort to ensure that the values of hedge fund financial instruments are not distorted to the disadvantage of fund investors. The principles are designed to be a transparent practical tool for hedge fund managers and governing bodies, and for those involved in the valuation process. They may also be helpful for institutional and sophisticated investors. The principles, which are applicable across all national boundaries, were issued in the form of a consultation, with public comments invited until June 21, 2007.

The UK Financial Services Authority quickly announced its support for the principles, noting that they will help mitigate conflicts of interest and enhance independent valuations. The FSA noted that some hedge fund strategies involve exposure to illiquid and complex financial instruments that can present valuation challenges. The Hong Kong Securities and Futures Commission encouraged the hedge fund industry and investors to comment on the principles. The Commission’s CEO Martin Wheatley said that valuation warrants the close attention of the market.

The IOSCO principles describe techniques which should strengthen the valuation process, thereby making it more likely that the resulting valuation is appropriate. They emphasize the importance of clear written procedures which are consistently operated and regularly reviewed, and which provide for an appropriate degree of independence to deliver effective checks and controls.

The principles apply to all hedge fund structures, but IOSCO recognizes that
hedge funds are varied in their size, structures and operations. Thus, the governing body of each hedge fund should take into consideration the nature of the fund's structure and
operations when seeking to apply the principles. The challenges of valuing complex and illiquid instruments arise in many hedge funds, wherever located, and however structured.

Similarly, conflicts of interest arise in the case of all hedge funds, wherever located and however structured. The principles are designed to assist hedge funds in valuing their portfolios so as to reduce the structural and operational conflicts of interest that may arise and help ensure that valuations are robust and appropriate.

Monday, March 26, 2007

CD&A Disclosure Is Disappointing So Far Says SEC Chair

The retail disclosure system has devolved into a self-serving exercise for issuers, underwriters, and their lawyers, noted SEC Chair Christopher Cox, and nowhere is this more evident than in the new Compensation Discussion & Analysis sections being filed with the Commission. After reviewing the first of this year's crop of proxy filings containing the CD&A, he noted, ``alarm bells are ringing’’ as the staff is seeing examples of over-lawyering that are leading to 30 to 40 page long executive compensation sections in proxy statements. His remarks were made at a recent corporate governance seminar at the USC Marshall School of Business.

The SEC is disappointed with the lack of clarity in much of the narrative disclosure that has been filed so far. Based on the early returns, he noted, the average CD&A section is not anywhere close to plain English. In fact, according to objective third-party testing, he said, most of it is as ``tough to read as a Ph.D. dissertation.’’

This lack of clarity is particularly troubling since the CD&A is the centerpiece of the SEC’s new executive compensation disclosure regime. The CD&A is designed to be a principles-based narrative overview explaining the policies and material elements related to the company’s executive officer compensation.

Since mandating the CD&A as part of its comprehensive overhaul of executive compensation disclosure, the SEC has been adamant that the CD&A be written in Plain English. But a private sector investor relations firm analyzed the CD&As of forty companies and determined that they all fell far short of accepted standards of readability. In fact, related Mr. Cox, the firm found that most of the disclosure documents failed even to meet the readability standards that states require for insurance forms. Among other things, the CD&A disclosures were verbose and fell well below a Plain English threshold. While the SEC was expecting that the CD&A would be just a few pages long, the median length for the CD&As came in at 5,472 words, with the longest at more than 13,500 words.

This private analysis, in addition to the SEC’s own qualitative review of the proxy statements, indicates that there is a long way to go before legalese and jargon are truly replaced by plain English. The SEC believes that many companies are letting lawyers have the final say on the CD&A. As the firm that undertook this study pointed out, many of the problems could easily have been fixed in just a few hours by a qualified copy editor.
Even more, the SEC intends to employ readability metrics tools to judge the level of compliance with the Plain English rules. These tools, similar to the Black-Scholes model for stock options, measure the readability of English prose based on sentence length and the number of complex words. This is one indication that the SEC is ``dead serious’’ about shedding seventy years of accumulated bad habits in writing, said Chairman Cox.

The CD&A is a brand new creation, he pleaded, so there is no tested boilerplate out there to be picked up and used. Similarly, there are no judicial or regulatory precedents to mark up and reuse. Thus, there is no reason for a company to match up its disclosure to that of its peers or competitors. There are no magic words to recite from court opinions and SEC interpretations. Thus, he urged every company to take this opportunity to start CD&A with a clean slate and plainly tell their executive compensation story to investors.

Thursday, March 22, 2007

PCAOB is Constitutional Declares Federal Judge

In a very important decision for the Sarbanes-Oxley Act, a federal judge has ruled that the PCAOB is constitutional and rejected the ``facial’’ claims of an audit firm inspected by the Board as nothing more than a hypothetical scenario of an over zealous or rogue PCAOB investigator. If such a scenario ever becomes real, said the court, the SEC could change the rules to prevent improper investigations or remove Board members for good cause. (Free Enterprise Fund and Beckstead & Watts et al. v. PCAOB, DC of DC, Civil Action No. 06-0217, Mar 21, 2007).

Judge James Robertson rejected the claim that the appointment of PCAOB members violates the Appointments Clause of the Constitution, which empowers the President to appoint officers of the United States, while allowing Congress to vest the appointment of inferior officers in Heads of Departments. The audit firm argued that PCAOB members are not inferior officers since they are neither appointed nor supervised on a daily basis by principal officers directly accountable to the President. But the court said that PCAOB members are inferior officers since they have no power to render a final decision on behalf of the US and are subject to oversight and removal by the SEC.

The court also rejected the argument that PCAOB members should have been appointed by the SEC chair rather than by the entire Commission. The audit firm lacked standing to bring this assertion, reasoned the court, since the SEC chair has voted for every member of the Board and the firm did not allege that its injuries were in any way attributable to the current PCAOB membership.

Finally, the court said that Congress constitutionally delegated legislative power to the PCAOB since the legislative delegation effected by Sarbanes-Oxley is squarely within the bounds of modern non-delegation doctrine. The court noted that the Board applies intelligible standards of auditing, quality control, and ethics that are either required by Sarbanes-Oxley or SEC rules or are in the public interest for investor protection.

The SEC had vigorously defended the PCAOB against this constitutional attack on the appointment process of Board members and the manner in which the Board conducts its operations. In a joint brief with the Justice Department, the SEC contended that the method detailed in Sarbanes-Oxley for appointing Board members satisfies the Appointments Clause. In addition, the brief said that the pervasive authority of the SEC to supervise and control the PCAOB’s activities refutes the depiction of the Board as a rogue agency running unchecked over the separation of powers. Also, the Commission said that the Board’s performance of diverse functions pursuant to a variety of intelligible principles defeats the argument that Sarbanes-Oxley unconstitutionally delegated legislative power to the Board.

In an unusual and possibly historic move, seven former SEC chairs, including William Donaldson, Arthur Levitt, Harvey Pitt, David Ruder, and Roderick Hills, had filed an amicus brief defending the PCAOB as constitutional. The former chairs described the PCAOB as being 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.
The Board exists, maintained the former SEC heads, because of a Congressional conclusion that the system of profession-dependent self-regulation of auditing contributed to the financial scandals of the recent past. And nothing in the federal Constitution denies Congress the power to make the policy judgments reflected in the legislative design of the PCAOB-SEC relationship, according to the brief.

Tuesday, March 20, 2007

Fifth Circuit: Investment Banks Owed No Duty to Enron Shareholders

Secondary actors, such as investment banks and accountants, who act in concert with public companies in schemes to defraud investors cannot be held liable as primary violators of Rule 10b-5 unless they directly make public misrepresentations; owe the shareholders a duty to disclose; or directly manipulate the market for the company’s securities through practices such as wash sales or matched orders. This was the ruling of a Fifth Circuit panel in an action alleging that investment banks engaged in transactions that allowed Enron to misstate its financial condition. (Regents of the University of California v. Credit Suisse First Boston, 06-20856, March 19, 2007).

At most, said the appeals court, the banks could have aided and abetted Enron’s deceit by making its misrepresentations more plausible but their conduct did not rise to primary liability under Rule 10b-5. And, under the Supreme Court’s Central Bank ruling, there is no private action for secondary aiding and abetting liability under Rule 10b-5. The investment banks owed no duty to Enron’s shareholders, emphasized the panel.

While acknowledging that the investment banks do escape liability for alleged conduct that was ``hardly praiseworthy,’’ the appeals court reasoned that Congress was not irrational to promote plain legal standards for actors in the financial markets by limiting secondary liability. In the antifraud statute, Congress is balancing competing desires to provide some remedy for securities fraud without opening the floodgates for nearly unlimited and frequently unpredictable liability for secondary actors in the securities markets. And, in Central Bank, the Supreme Court was seeking certainty through strict construction of § 10(b) against inputting aiding and abetting liability for secondary actors under the rubric of deceptive acts or schemes.

The district court held that the presumption of reliance applied because the facts indicated
that the banks had failed in their duty not to engage in a fraudulent ‘scheme. The court determined that a deceptive act within the meaning of Rule 10b-5(c) includes
participating in a transaction whose principal purpose and effect is to create a false appearance of revenues.

The appeals court addressed only the definition of deceptive act, because it was dispositive of the appeal, and not the district court’s scheme liability holding.

The appeals court held that the district court’s conception of deceptive act liability is inconsistent with the Supreme Court’s decision that § 10 does not give rise to aiding and abetting liability. An act cannot be deceptive within the meaning of § 10(b) where the actor has no duty to disclose. Presuming the allegations to be true, Enron committed fraud by misstating its accounts, but the banks only aided an abetted that fraud by engaging in transactions to make it more plausible. The investment banks owed no duty to Enron’s shareholders, said the appeals court.

In order to be true to the Supreme Court’s concerns when it ruled that section 10(b) does not give rise to aiding and abetting liability, noted the appeals panel, it is essential to ensure that lower courts do not misapply aiding-and-abetting liability under the guise of primary liability through an overly broad definition of deceptive acts.

In a concurring opinion, Judge Dennis said that the Fifth Circuit has now aligned itself with the Eighth Circuit and immunizes a broad array of undeniably fraudulent conduct from civil liability under Rule 10b-5, effectively giving secondary actors license to scheme with impunity, as long as they keep quiet. He described the majority’s interpretation of the statutory language of section 10(b) as ``cramped.’’ He concluded that the district court erred by construing too broadly the joint and several liability provision of the Private Securities Litigation Reform Act of 1995.

Monday, March 19, 2007

SEC Official Calls for Improved MD&A of Critical Accounting Estimates

Although the SEC staff believes that MD&A disclosure has improved both qualitatively and quantitatively since the last interpretative release in 2003, there is still room for improvement in discussions of critical accounting estimates and liquidity. According to Corp Fin Associate Chief Accountant Sondra Stokes, all too often the discussion of critical accounting estimates merely repeats the accounting policy disclosure found in the footnotes to the financial statements. An accounting policy footnote is not a synonym for a critical accounting estimate disclosure, cautioned the senior official, since the objectives are simply not the same.

In her view, the ideal critical accounting estimates discussion would provide insights into the quality and variability of information regarding financial condition and operating performance. Rather than describing the method used to apply an accounting principle, the discussion would present an analysis of the uncertainties involved in applying a principle at a given time or the variability that is reasonably likely to result from its application over time. Since the accounting policy disclosure is in the financial statements, she urged that MD&A be used to explain what the application of those policies means.

The first step, she advised, is to clearly explain why the accounting estimates or assumptions bear a risk of change. In order to communicate this point, companies should discuss how the estimate was arrived at and how accurate estimates have been in the past. In addition, there should be a discussion of how much the estimate has changed in the past and whether the estimate or assumption is reasonably likely to change in the future.

Because critical accounting estimates and assumptions are based on matters that are highly judgmental, the assistant chief accountant reasoned, companies should discuss the sensitivity of such estimates or assumptions to change, providing a quantified sensitivity analysis when possible. The SEC staff sees far too little quantification, she said, and the staff issues comments when quantification would provide an investor with meaningful information.

That said, she continued, the discussion of critical accounting estimates should be limited to only the most critical so these do not get lost in the disclosure. Truly critical accounting estimates are the valuation of long-lived assets, goodwill and other intangibles, post employment benefits, liabilities and reserves, derivatives, revenue recognition, income taxes, and environmental conservation costs. The SEC official cautioned that this list is neither comprehensive nor all-inclusive since the discussion of critical accounting estimates is specific to each company.

More broadly, she noted that the disclosure of critical accounting estimates may be appropriate where the impact of the estimates and assumptions on financial condition or operating performance is material. Disclosure becomes particularly important when the nature of the estimates or assumptions is potentially volatile, either due to the level of judgment necessary to account for highly uncertain estimates and assumptions, or when the estimates and assumptions are readily susceptible to change.

More importantly, the disclosure of critical accounting estimates has the potential to be some of the most relevant and crucial disclosure in the MD&A. This is because the average lay person often neither understands nor appreciates the extent to which the use of estimates and assumptions is inherent in the preparation of financial statements. There is the ever present risk that users of financial statements may assume when they see audited financial statements that the numbers are the numbers and there is little, if any, gray. This is not true, she emphasized, particularly as accounting moves towards the use of fair value. As these trends inexorably accelerate, it becomes increasingly important to make sure that the use of estimates and assumptions in the preparation of financial statements is adequately communicated to the users of those statements.

With respect to liquidity and sources and uses of cash, the official said that the MD&A must go beyond the information that is available on the face of the cash flow statement. The focus should be on the drivers of the company's cash flows, and other information necessary to help someone understand what the future requirements for cash are, and where management intends to obtain those funds.

If funds are going to be generated internally, there should be a clear explanation of cash flows from operations to help readers understand the key drivers behind that number. For example, rather than merely citing what the change in working capital was, which is evident from the face of the financials, the MD&A should discuss what is causing the changes in the underlying working capital components. Rather than saying cash increased because the company collected more of their accounts receivable, the MD&A should focus on explaining why that change occurred.

A second component of the liquidity discussion pertains to a company's borrowings. If financing arrangements have been material to the historical cash flows, additional information should be provided in the liquidity discussion, including the impact of known or reasonably likely changes in credit ratings, the company’s ability to access financing sources, and future plans to borrow material amounts.

When reviewing the liquidity discussion, management should ask what the company’s obligations are and how they can they be satisfied; and whether more cash can be readily accessed. If these questions are not clearly answered, said the assistant chief accountant, the disclosure probably needs to be enhanced.
Atkins Says Disparate IFRS Interps Imperil Roadmap to Reconcilation

A recent blog talked about the specter of inconsistent interpretations that is haunting international financial reporting standards. Now SEC Commissioner Paul Atkins indicates that the specter of multiple national versions of IFRS could imperil the goal of ending the requirement that IFRS-driven financial statements be reconciled to US GAAP. In remarks to the Institute of International Bankers, he said that multiple interpretations of IFRS could takes us back to a world of multifarious GAAPs, each with its own idiosyncrasies.

As the SEC staff beings reviewing IFRS-driven filings, it is troubling that in only 40 or so cases were foreign registrants' financial statements represented as being in accordance with IFRS as promulgated by the IASB. This number was significantly lower than expected. One reason for the low number is that many foreign registrants stated that their financial statements were prepared in accordance with IFRS as promulgated by their home countries, instead of IFRS as promulgated by the IASB.

These developments do seem to imperil the SEC’s roadmap to reconciliation. But Chairman Cox and Commission McCreevy are well aware of the threat to the roadmap posed by inconsistent IFRS interpretations, and CESR is also on the job. Thus, before the 2009 reconciliation deadline, there is still time to prevent derailment.

Friday, March 16, 2007

SEC Remains Divided on Independent Chair Rule

SEC Commissioner Roel Campos, speaking at the inaugural Directors Institute forum in Coral Gables, Florida, said he intends to push for finality on the proposed independent chair and 75% independent directors requirement for mutual funds. The SEC should be prepared to act on the rulemaking even if it results in a split vote, in his view. The comment period recently ended on two studies published by the SEC's Office of Economic Analysis that address the costs of the proposal. Commissioner Campos believes that various economic studies support the 75% independent board and chair requirement. He is troubled by attacks on the basic principle of the rules, which seem to be part of a broader strategy to keep the SEC from adopting any regulation.
It is likely that, if the independent chair rule is adopted, it will be by a split vote. In recent remarks, Commissioner Paul Atkins seems unconvinced of the efficacy of the governance rule. Citing the economic studies, he believes that the justification for what he called an industry-wide experiment seems even more tenuous. The studies instead lend support for the point that there is not a universally optimal governance structure, noted Commissioner Atkins, since independent chairs are better for some funds and interested chairs are better for other funds. Further, in his view, the optimal structure for a particular fund may differ over time.

Commissioner Campos emphasized that nearly every jurisdiction in the world has copied the SEC's and the exchanges' various independence rules for directors because they make sense and investors demand it. While acknowledging that independence does not guarantee that a director will act appropriately, he said it does removes an obvious financial interest or conflict of interest that may influence decisions in favor of the fund adviser over investors. He further emphasized that the purpose of the independent fund chair rule is not to improve performance but to eliminate a glaring conflict of interest.

In a recent letter to the SEC, the Mutual Fund Directors Forum said that it continues to believe that funds should be encouraged, at least as a best practice, to have an independent chair and a board composed of three-fourths independent directors. The Forum believes that a board with an independent chair and an independent super-majority will better represent shareholder interests.

Thursday, March 15, 2007

CFTC Chair Praises PWG Guidance for Being Principles-Based

In remarks today at the annual Futures Industry Conference, CFTC Chair Reuben Jeffery III praised the principles-based approach taken by the recent hedge fund guidance issued by the President’s Working Group on Financial Markets. More broadly, he announced his general support for a principles-based approach to market oversight.

The PWG’s principles are intended to guide market participants, as well as U.S. financial regulators, as they address investor protection and systemic risk issues associated with the rapid growth of hedge funds. Although the PWG principles specifically target private pools of capital, he noted, they contain valuable advice for every financial services provider. In his view, these principles are compelling at a time when the globalization of markets and innovation in financial products has created a much more complex financial environment.

According to the CFTC official, the current Depression-era rooted regulatory structure is ill-suited to meet the challenge of a dynamic, global market for financial services. A rigid prescriptive regime is simply incompatible with the flexibility needed in a global competitive environment, he insisted. Instead, joining a growing chorus, he praised the principles-based approach for establishing high level objectives and providing guidance on how regulated entities can achieve those objectives. What matters in a principles-based approach is not a focus on means, he reasoned, but rather effectiveness in achieving the desired policy outcomes.

But, similar to FSA Chair Callum McCarthy, he emphasized that a principles-based approach does not mean the elimination of all prescriptive rules. Relying solely on fixed rules may be appropriate in situations where, for example, the risks can be identified with a degree of confidence and uniform treatment is critical. Customer funds protection rules generally fall within this realm, he said. In addition, the principles-based approach must be accompanied by a vigorous enforcement program based on a zero-tolerance policy for those who seek to game the system through fraudulent acts. In my opinion, Chairman Jeffery takes a very realistic view of principles-based regulation.

In the end, it all comes down to how best to achieve the correct balance between rules and principles. In such a rapidly evolving industry, he said, having the option to rely upon a flexible, principles approach provides a useful tool in carrying out congressional mandates to promote responsible innovation and fair competition.

Wednesday, March 14, 2007

Corrigan Says PWG Hedge Fund Guidance Must Trigger Benchmarked Best Practices

While praising the recent hedge fund guidance issued by the President’s Working Group on Financial Markets, former Fed senior official Gerald Corrigan said that a common benchmark of best practices for hedge funds must be developed to augment the systemic risk principles in the guidance. Having in place a benchmark of best practices would provide real assurance across classes of institutions that best means best, he reasoned, and also encourage an environment that stresses competitive excellence rather than a gradual drift toward the least common denominator. In testimony before the House Financial Services Committee, Mr. Corrigan observed that major banks and securities firms are credit suppliers and trading counterparties for hedge funds.

Mr. Corrigan is the chair of the Counterparty Risk Management Policy Group, which published a far reaching report about 18 months ago. The report is a forward-looking, integrated framework of initiatives dealing with risk management, enhanced disclosure, transparency, and sound corporate governance.

According to the CRMPG chair, the major drawback to the creation of a common benchmark of best practices is the difficulty of drafting such a statement in a manner that guards against slippage into unwanted detail that compromises the principle-based approach called for by Working Group. While acknowledging that risk as very real, the former NY Fed president said that the potential benefits arising from the presence of common benchmarks of best practices are considerable. He indicated that many of the building blocks for the best practices are already available in the CRMPG Report.
Cox and Olson Speak at Chamber Event on US Capital Markets

Against the backdrop of a detailed blue-ribbon panel report urging securities regulation reform, SEC Chair Christopher Cox rejected the call for Congress to amend the Sarbanes-Oxley Act. He said it is wrong to condemn the entire Sarbanes-Oxley Act based on the problems in implementing section 404. He urged people to remember what had occurred before the passage of the Act. Cox sees no need to amend the Act, just the way it was implemented. The Act is only a few years old, he said, and should not be open for amendments. Cox was among the keynote speakers at today’s capital markets summit hosted by the Chamber of Commerce.

The summit also featured keynote addresses by PCAOB Chairman Mark Olson, House and Senate oversight chairs Rep. Barney Frank (D-MA) and Senator Christopher Dodd (D-CT). The Chamber financed the independent bipartisan blue-ribbon panel to present recommendations to improve the U.S. competitive position in the global markets.
Cox joked about the SEC’s uneasy acquaintance with the Chamber, having been the subject of several high profile lawsuits brought by the Chamber.

The SEC chair was criticized in some quarters for appearing at the Chamber event, but said he will not play the stereotype of a deregulatory Republican Congressman. It is not necessary for their interests to be at odds, according to Cox. He cited the words of the SEC’s first chairman, Joseph Kennedy, who said the SEC is the partner of honest business and the prosecutor of dishonesty. He welcomed the opportunity to study the report by the bipartisan panel, and expressed appreciation for the members’ energy and effort

Chairman Olson discussed the PCAOB’s proposal to revise its original standard for the audit of internal controls over financial reporting. About 170 comment letters have been received, he said, many with recommendations to further improve the standard. Olson said the recommendations are being carefully considered. He noted that the larger auditing firms have begun to train their engagement teams based on the proposed standard. He said the proposal will likely evolve somewhat before its final adoption in response to the comments, but believes the early training may result in a smoother transition once the standard is adopted.

Senator Dodd said the commission has presented a thoughtful report and has made an important contribution to the debate. He said the Senate Banking Committee will hold hearings in the coming weeks. There are a number of considerations to keep in mind, according to Dodd. The first is that the U.S. markets remain the most dominant in the world and have done so even in light of the 9/11 attacks, corporate scandals and the war in Iraq.

The U.S. markets remain strong because of the architecture by which they are governed according to Dodd. At the same time, the laws and regulations should not be entrenched. They should be subject to reexamination, in his view. Dodd also noted that American firms are leaders in foreign markets and have helped to shape and guide them. He said market growth overseas should be embraced because it opens new markets for American businesses.

Tuesday, March 13, 2007

Treasury's Paulson Endorses Principles-Based Regulation

Treasury Secretary Henry Paulson has urged the US to move towards more principles-based regulation similar to that in the UK and other jurisdictions. In remarks kicking off a conference on the capital markets, he eschewed a rules-based mindset that asks, "Is this legal?" in favor of a principles-based approach that asks, "Is this right?" I have recounted in earlier blogs how the UK is wrestling with just exactly what principles-based regulation means and that FSA Chair McCarthy believes that we will always have some mixture of rule-based and principles-based regulation.

He also emphasized that good corporate governance is a means to an end, not an end in itself. The Secretary noted that the basic principles that underpin a robust corporate governance system are accountability, transparency, and the need to identify and manage conflicts of interest.

He acknowledged that, as a result of Sarbanes-Oxley and other regulatory changes, corporate directors are more independent and more diligent about their fiduciary duties. Of course, directors must now spend much more time engaged in compliance processes and finding the right balance on the use of director time is critically important. But he reminded that the ultimate end-game of good corporate governance is better managed, more competitive corporations that earn investor confidence through sound leadership, thoughtful governance, and outstanding performance.

Monday, March 12, 2007

Blue Ribbon Panel Calls for Major Market Reforms

A blue ribbon panel of the US Chamber of Commerce has issued a far-ranging report on reforming the capital markets and revamping the SEC, as well as capping auditor liability and achieving converged international accounting and audit standards in five years. The panel also calls for the end of corporate quarterly earnings guidance. This could be a seminal report that could lead to major reform of federal securities regulation. Later blogs will more granularly explore other aspects of the report.

The central premise of the report is that the U.S. regulatory structure is deeply rooted in the reforms put in place in the 1930s, a period that was closer in time to the Civil War than it is to today, and thus it must be modernized to ensure that investor and business interests are best served in the global marketplace. The report is from the Commission on the Regulation of US Capital Markets in the 21st Century.

In a very important move, the panel urged Congress to make the freestanding Sarbanes-Oxley Act part of the Securities Exchange Act. With this change, the panel reasons, the SEC would be authorized to tailor its SOX regulations to account for practical variations among registrants, such as modifications for small company compliance with internal control requirements and an exemption from Section 404 for foreign registrants where comparable home-country requirements exist. The SEC could also then coordinate with bank regulators on the implementation of SOX, especially Section 404, as it applies to publicly traded banks subject to
similar bank regulatory requirements.

Further, in order to prevent the catastrophic loss of a major audit firm, the panel urges the SEC to work with Treasury to place the issue of developing a framework for support of multinational accounting firms on the agenda of the G-8. This framework could take many forms, including backup insurance sponsored by G-8 countries or international financial organizations.

Congress is asked to enact legislation creating the option of a federal charter for more than 10 to 15 of the largest national audit firms, which would include their ability to raise capital from shareholders other than audit partners of such firms, subject to addressing concerns about audit independence

Sunday, March 11, 2007

SEC to Provide Web Tool to Help Slice and Dice Exec Comp Data

Even before interactive data becomes the norm for all reporting companies, promised Chairman Christopher Cox, the SEC plans to tag the new executive compensation data using XBRL. In addition, by June, an interactive data tool will be on the SEC's website to let users slice and dice the executive compensation data any way they like, or do industry comparisons, or even do analyses of particular forms of compensation, such as stock options. This will be done for at least several hundred of the largest public companies.

In remarks at the Georgetown Law Center, Chairman Cox also noted that the XBRL codes are already written for most industries. And, he continued, by September, XBRL-US, the private sector organization that is responsible for interactive data in the United States, will have completed all the data tags for every industry. They intend to make it available to the world for free, he related.

Against the backdrop of a new executive compensation disclosure regime, the SEC chair said that the Commission is seeing examples of overlawyering, which is leading to 30 to 40 page executive compensation sections in proxy statements. Companies are including columns in the summary compensation tables even when there's nothing to report in those columns. He admonished that this kind of slavish adherence to boilerplate disclosure is what the SEC is trying to stamp out.

Noting that it was the birthday of Oliver Wendell Holmes, Chairman Cox wondered why, if Justice Holmes could cover great legal theories in one page of clean prose with no jargon, a proxy statement cannot tell readers what they need to know about the boss's pay in the same way.

Finally, the chair took the opportunity to extol the virtues of the new mandated Compensation Discussion and Analysis section. This chance for a company to detail the objectives of its compensation program, he enthused, is what good disclosure is all about and where inside counsel can play a vital role. He explained that the narrative in the CD&A provides a qualitative look at the company's executive compensation policies, and sheds light on the quantitative tabular data. He strongly urged companies to seize this chance to plainly tell their compensation story.

Saturday, March 10, 2007

UK Treasury to Review Private Equity Tax Policies, US May Do So

The UK Treasury plans to review the current rules that apply to the use of shareholder debt where it replaces the equity element in highly leveraged deals in the light of market developments in order to ensure that existing rules are working as intended. The review is consistent with the Government's broader focus on ensuring that commercial decisions are taken on a level playing field, take a long-term view, and maximize opportunities for employment and investment. In announcing the review, Economic Secretary Ed Balls MP noted that rules have changed from time to time over many years to adapt to the development of new financial instruments and forms of debt. Similarly, the Wall Street Journal reported on March 9, 2007 (p.C3) that Senate aides were evaluating whether to change tax rules for hedge funds and other pools of private capital.

In remarks at the London Business School, the UK official noted concerns that the tax system gives an unfair advantage to private equity over other forms of ownership, particularly as a result of the tax deductibility of interest. While there is nothing inherently specific to private equity in the tax deductibility of interest, since any kind of company can claim it, concerns have been raised with the Treasury that shareholder debt is replacing the equity element in highly leveraged private equity funding arrangements.

This shareholder debt is a form of risk-bearing equity that is treated as debt for tax purposes, noted the Treasury official, giving these arrangements a tax advantage that is inconsistent with the principle that interest is a business expense. Tax legislation already distinguishes between debt and equity and contains detailed provisions to ensure that equity is not disguised as debt to obtain a tax deduction.

Friday, March 09, 2007

UK Working Group to Develop Disclosure Code for Hedge Funds

The UK Private Equity and Venture Capital Association will form a working group to produce a voluntary comply-or-explain disclosure code of conduct for hedge funds. The group, which will issue a report in autumn, intends to examine ways in which levels of disclosure in companies backed by the UK private equity industry could be improved. The working group will be chaired by Sir David Walker, a former Executive Director of the Bank of England. In its work, the group will recognize the very different types of investment and issues relating to different segments of the industry from small start-up financing to large buyouts. It will also take account of the size of the portfolio companies concerned.

More specifically, the working group will address the appropriate levels of narrative and financial reporting, as well as the timing of any increased reporting for private equity-backed companies. Also, the group will examine the clarity and consistency of practice with regard to valuation methodology, its verification and disclosure to investors of returns and fees.

Currently, large private equity-owned companies are not required to provide operating and performance data of the same quality and depth as listed companies. And what they are required to publish can be published much later. While this difference is logically rooted in the distinction between keeping a small group of private shareholders informed and reporting to markets as a whole, UK officials nevertheless believe that large businesses have a wider duty to engage with the community in which they operate and to meet the legitimate interests of stakeholders, both employees and the wider public, in how their operations affect them. As the private equity sector has grown and as some major companies have moved from transparent public to opaque private markets, this need has become more acute, asserted Treasury Economic Secretary Ed Balls MP.

Praising the creation of the working group, the senior official said that additional disclosures would improve understanding of, and confidence in, private equity's stewardship of important UK businesses. It would also assist private equity in addressing fears that there is something inherently short-term or value-destructive about the industry's approach.

In recent remarks at the London Business School, the minister also said that there has been a lack of clear, consistent and complete information on the valuation and performance of private equity investments, and a consequent gap in the ability of institutional investors in handling the governance issues raised by this new investment opportunity. This is not good for either the industry or investors, he asserted.
SEC's IFRS Roundtable Hits the Right Notes

The SEC roundtable on international financial reporting standards (IFRS) was one of the most important roundtables in recent years. It featured panel discussions on the SEC's roadmap to eliminate the current requirement to reconcile IFRS-driven financial statements to U.S. GAAP by 2009. This effort is being watched closely by the global markets and by the over 100 countries that have adopted IFRS.

SEC Chairman Christopher Cox applauded the efforts of FASB and the IASB to converge accounting standards. Some believe that convergence is impossible, Cox noted. The SEC does not expect total convergence before it will eliminate the reconciliation requirement and remains committed to the roadmap. Cox contemplates that U.S. GAAP and IFRS will be available side-by-side. The roadmap has a destination and an estimated time of arrival, according to Cox. It is not dependent on FASB and the IASB resolving all of the differences between their regimes. Once reconciliation is eliminated, the chairman said there should be no roadblock to convergence.

Charlie McCreevy, the European Commissioner for the Internal Market, said that he is very pleased by what the SEC and the European Commission have accomplished. The changeover to IFRS has not been easy, he said, but the feedback is generally positive. The 40 new standards and attendant interpretations have raised a number of issues, but McCreevy said that is how it should be with a principles-based system.

Comm. McCreevy said the CESR/SEC work plan is an important step within the roadmap to ensure the consistent application of IFRS and U.S. GAAP. There is much work to be done, but they are on the right track, he said. In his view, the elimination of the reconciliation requirement will have a positive effect in the U.S. as well as in foreign jurisdictions. He agreed that differences between IFRS and U.S. GAAP should be narrowed but the standards need not be identical.

Wednesday, March 07, 2007

Specter of Inconsistent Interpretation Haunts IFRS

There is no turning back from the roadmap to eliminate the need to reconcile international financial reporting standards (IFRS) with US GAAP, emphasized SEC Chairman Christopher Cox in remarks at a roundtable on IFRS. The roadmap will not be refolded, he said to the gathering.

But he expressed fear that IFRS may be risky, not because of the quality of the standards, but because of the lack of consistent and uniform interpretations of the standards. A differing Babel of interpretations of IFRS would mean that financial statements prepared under IFRS could not be compared to one another. In my opinion, Chairman Cox has quite accurately pointed out the primary fear of IFRS both in the US and EU. There is a specter haunting IFRS, and it is the specter of differing interpretations by many different national authorities, leaving us no better off than when we started.

IASB officials also worry that individual authorities will publish their own interpretations of IFRS, just as they did under their national GAAP. If regulators find it absolutely necessary to issue implementation guidance, said IASB trustee Samuel DiPiazza, they must ensure that such guidance is consistent with global interpretations. He emphasized that the goal is compatibility, equivalence and comparable results, not necessarily wholesale uniformity.

Similarly, EU Commissioner for the Internal Market Charlie McCreevy has emphasized that the great challenge of IFRS is to achieve the consistent application of standards and interpretations. Principles-based standards will not always give the same result in all situations, he reasoned, but they should give similar results in similar situation. With consistency in mind, the EU strongly believes that difficult interpretive issues should be timely addressed by the IASB’s International Financial Reporting Interpretations Committee (IFRIC).

For his part, Mr. Cox also recognizes that there may be more than one reasonable interpretation or understanding, but he said it must be susceptible to explanation. He also assured that comment letters from the SEC staff reviewing IFRS-driven filings asking for more detail or greater explanation do not mean that the SEC is trying to impose its own interpretation of a standard.

He noted that the SEC and the Committee of European Securities Regulators (CESR) have entered into a joint work plan to further the consistent application of the accounting standards. The Work Plan provides a forum in which the SEC and EU securities regulators can discuss questions about the application of accounting standards.

Tuesday, March 06, 2007

Disclosure Not Answer to Hedge Fund Transparency Says NY Fed CEO

While acknowledging the enduring appeal of the call for more pubic disclosure of hedge funds’ risk profile and actual positions, NY Fed President Timothy Geithner said that such disclosure may provide false comfort and is in some ways unachievable. In his view, the potential gains from a disclosure regime of this type would be limited compared with the cost of trying to put such a regime in place on the global scale that would be necessary to make it effective. His remarks were delivered at a seminar sponsored by the Global Association of Risk Professionals in NYC. The Wall Street Journal recently described Mr. Geithner as the Fed’s ``go-to man’’ for financial crises with a ``bully pulpit,’’ but who cannot appear to be invading the turf of other domestic or international regulators.

The disclosure urged by some policymakers is of two distinct kinds. The first is information that would make it easier to evaluate the overall risk profile of major hedge funds and their counterparties, and thereby judge their vulnerability to a sharp movement in asset prices. The second is information about the actual positions of individual funds or institutions, which would make it easier to identify concentrated exposures to specific risk factors, and thereby assess more accurately the potential impact of the failure of a major fund or institutions on the markets.

While admitting that there are a number of crude measures of overall risk profile that, if disclosed, would give counterparties information they do not now typically get about the risk of failure of the hedge fund, the senior official cautioned that these would be lagging indicators carrying with them the risk of providing false comfort in some circumstances and excessive concern in others.

The central banker also acknowledged the enduring appeal of the second type of disclosure being proposed, which is information on the actual positions of major hedge funds. But this transparency is unachievable, he explained, because there is no feasible way to try to capture in real time the rapidly changing exposures of different institutions to different risks in any meaningful fashion.

But he promised that the Fed will continue to explore ways in which the provision of greater information to counterparties and to the markets more generally could help reduce vulnerability to financial crises. For now, though, the practical limitations on achieving greater transparency through disclosure underscore the importance of strengthening the robustness of the shock absorbers in the financial system.

In his view, the most sensible thing to do is to improve the capacity of the core of the financial system to handle adversity, which requires improving the strength of the capital and liquidity cushions, as well as the market infrastructure. In this regard, he said that the Fed is encouraging a global initiative for more sophisticated and conservative management of credit exposures in OTC derivatives and structured financial products, as well as of exposures to hedge funds.
Executive Incentive Plan May Have Been Corporate Waste Says Delaware Court

An executive incentive plan for three management directors may have constituted corporate waste, declared Delaware Vice Chancellor Strine in a wide-ranging opinion that dealt with other issues arising from the incentive plan, which was approved by the company’s compensation committee. Even in an age when compensation committees ``misunderstand the pertinence of Santa Claus to their work,’’ noted the court, the grants to the senior executives were extraordinary. (Sample v. Morgan, Del. Chan Ct, C.A., No. 1214-N)

For a tenth of a penny per share, or some $200 in total, the three executives got immediate control of nearly a third of a company’s voting power, its dividend flow, and its value in the event of any sale. On top of that, the executives got their taxes paid for them by the company, which had to go into debt in order to bestow that beneficence. In exchange, the company got the three executives to stay without any indication that they had offers to go elsewhere. These pled facts supported an inference of waste, got judicial nostrils to ``smell something fishy,’’and got the complainant shareholder past Go and to full discovery into the background of the transaction.

The doctrine of waste, explained the Vice-Chancellor, allows a plaintiff to pass Go even when the motivations for a transaction are unclear when economic terms are so one-sided as to create an inference that no person acting in good faith pursuit of the company’s interests could have approved them. This burden was satisfied here.

Monday, March 05, 2007

EU Commissioner McCreevy on Hedge Fund Regulation

EU Internal Market Commissioner Charlie McCreevy has voiced support for the guidance for hedge funds and other private pools of capital recently set forth by the President’s Working Group on Financial Markets. He also reiterated his position that no new regulation of hedge funds is needed in the European Union. And, importantly, he praised private equity funds for helping ensure that the businesses in which they invest adapt to the realities of rapidly changing markets.

Much of this was widely reported in the financial press, and some criticism was directed at the commissioner. But what was not widely reported was that, at the same time, he emphasized that regulators responsible for systemic risk must closely monitor the activities of financial institutions who take exposures to private equity and hedge funds.

In his view, regulators must be vigilant in their supervision of the risks inherent in private pools of capital. They must ensure that the financial institutions they regulate adopt state-of-the-art risk management techniques. More specifically, portfolio risk concentrations must be properly identified and managed.

The commissioner is clearly in the camp of those who believe that rigorous and closely monitored risk management can fend off calls for regulation. Stress testing is part of the picture. But the commissioner correctly points out that only when a major accident happens will the effectiveness of the supervision of financial institution risk management be tested.

Finally, the commissioner said that he wants to establish a common cross-border private placement regime to free up cross-border transactions in private equity funds between suitably qualified investors. He noted that the MIFID and Transparency Directives have put in place some of the building blocks of such a regime. However, the picture must be completed by identifying any remaining obstacles and assessing how they can be removed in a cost effective manner. He will be reporting within the next six to eight months on the steps needed to accomplish this goal in a measured and proportionate way.

Saturday, March 03, 2007

Bill Would Require Shareholder Advisory Vote on Executive Compensation

House Financial Services Committee Chairman Barney Frank has introduced a bill requiring public companies to include in their annual proxies a separate non-binding advisory shareholder vote on their executive compensation plans. The Shareholder Vote on Executive Compensation Act (HR 1257) is designed to ensure that shareholders have an opportunity to give their approval or disapproval on the company’s executive pay practices. As such, the bill represents a market-based approach that empowers shareholders to review and approve their company's comprehensive executive compensation plan. In that spirit, the bill would not establish any artificial restrictions on executive compensation. A similar bill introduced by Rep. Frank in the 109th Congress died in committee.

The bill also contains a separate advisory vote if a company gives a new, not yet disclosed, golden parachute to executives while simultaneously negotiating to buy or sell a company. This provision is designed to empower shareholders to protect themselves from senior management's natural conflict of interest when negotiating an agreement to buy or sell a company while simultaneously negotiating a personal compensation package.

The bill is designed to build on the SEC’s recently adopted executive compensation rules. The SEC is charged with rulemaking to implement the provisions of the legislation within one year of its enactment.

Shareholder advisory votes on executive compensation are mandated in the United Kingdom and other EU jurisdictions. The UK Companies Act requires a shareholder advisory vote on the directors’ remuneration report. In the Netherlands, a principle of the Tabaksblat Code on corporate governance provides that the supervisory board’s remuneration policy must be submitted to the shareholders for adoption.

Thursday, March 01, 2007

Treasury Official Provides Insights on Hedge Fund Guidelines

A senior Treasury official has emphasized that the hedge fund guidelines issued by the President’s Working Group on Financial Markets are not an endorsement of the status quo. Instead, they represent a uniform view from Treasury, the SEC, the Fed and the CFTC that heightened vigilance is needed to address market developments. Robert Steel, Under Secretary for Domestic Finance, also pointed out that there is no one-time regulatory fix that will solve the complex challenges presented by hedge funds.

He explained that the philosophy underlying the guidelines is to encourage and improve transparency and disclosure by hedge funds to counterparties and investors, as well as continued encouragement by regulators to strengthen market and counterparty discipline. Hedge funds should maintain information, valuation, and risk management systems that provide counterparties and investors with accurate and timely information.

A key motivation behind the guidelines is mitigating potential systemic risk posed by private pools of capital. In this context, he defined systemic risk as the potential that a single event, such as a financial institution's failure, may trigger broad dislocation or a series of defaults that affect the financial system so significantly that the real economy is adversely affected. The Working Group believes that the collective decisions of informed counterparties, reviewed by regulators, provide the very best protection against systemic risk.

The guidelines recommend that key counterparties commit resources and maintain appropriate policies and protocols to implement, and continually enhance, sound risk management practices. These are not static responsibilities, emphasized the official, but important ongoing obligations. It is critical that counterparties undertake effective due diligence before extending credit to a private pool of capital.

Similarly, the guidelines encourage lenders to hedge funds to frequently measure their exposures, taking into account collateral to mitigate both current and potential future exposures. Credit exposures, in addition to being measured frequently, should also be subject to rigorous stress testing, not just at the level of an individual counterparty, but also aggregated across counterparties.

The Working Group also believes that the senior managers of financial services firms with large exposures to private pools of capital have duties. Management should institute protocols so they are kept informed of large exposures, the senior official instructed, and they must appreciate the implications of these exposures and ensure that sound risk management practices are implemented. In doing so, senior management should ensure that a firm's aggregate exposure to hedge funds is consistent with its tolerance for bearing losses in adverse markets.

For their part, institutional investors in private funds have a responsibility to prudently evaluate the strategies and risk management capabilities of hedge funds and ensure that the funds’ risk profiles are compatible with their own appetites for risk. In doing so, they should undertake effective due diligence before investing in a hedge fund and perform due diligence on an ongoing basis after investing.

The Working Group expects regulators to communicate their expectations regarding counterparty risk management practices and use their authority to enforce these expectations.

Finally, noted the Treasury official, the guidelines encourage investors to consider the suitability of investments in hedge funds in light of their investment objectives, risk tolerances and the principle of portfolio diversification. Moreover, the standard of diligence for investors with fiduciary responsibilities who are investing on behalf of others should be an especially high one.