Sunday, April 29, 2007

FSA Official Examines IOSCO Hedge Fund Valuation Principles

Investors in hedge funds that are not compliant with the recently-announced IOSCO principles for hedge fund valuation are accepting greater risk than they probably realize, warned Financial Services Authority Director Dan Waters. While no system is foolproof and the principles are not a failsafe, emphasized the FSA director, failure to raise industry standards around the valuation process risks repeating costly mistakes of the past. He went on to state that independence, consistency, and transparency are principles underlying the guidance, but that the key principle is independence. The director is chair of IOSCO’s Hedge Fund Valuation Subcommittee.

In remarks delivered at IOSCO’s annual meeting, the director explained that the IOSCO principles cover the valuation process up until the point at which all the financial instruments in the hedge fund portfolio are valued. But they do not address events taking place later in the process, such as the timeliness and method by which the net asset vale is communicated to investors. Moreover, IOSCO did not venture into the difficult territory of debating appropriate audit or accounting standards that should be applied to hedge funds and their assets, or to resolving differences in international approaches.

Although independence is central to the valuation process, noted the official, the principles do not demand that hedge funds hire an independent evaluation administrator. Principle 5 mandates a high level of independence in the application and review of the valuation policies and procedures. IOSCO provides three specific ways in which to introduce appropriate independence: (i) third party pricing services; (ii) independent reporting lines within the manager; and/or (iii) a valuation committee.

Even if a fund does hire an independent administrator of valuation, he cautioned, that is not the end of the matter. IOSCO expects the fund’s governing body to formally review the capability of the external valuation provider. Under Principle 8, the governing body should conduct initial and periodic due diligence on third-party valuation services.

One reason that IOSCO did not mandate independent valuation administrators is that hedge fund investors, the vast majority of whom are institutions and high-net worth individuals, have not universally demanded it. It seemed disproportionate to suggest that a particular business model should be mandated, when the principal investors in hedge funds, who are well placed to make such demands, have not generally done so.
UK Minister Rejects Central Registry for Hedge Fund Positions

The UK Minister for the financial sector flatly rejected a proposal to require the disclosure of hedge fund portfolio positions to regulators in some sort of central register. Calling the proposal counterproductive, Economic Secretary Ed Balls, MP said it was not clear what regulators could usefully do with that information. In addition, it risks giving the false impression that regulators are overseeing specific investment decisions, creating a further risk of moral hazard. Further, were such information to be made public, the Minister feared that it could seriously compromise the working of the market, raising risks to financial stability.

Given the international nature of hedge funds activity, however, the senior official believes that there is a role for international monitoring and appropriate action. He emphasized that regulators must ensure that any steps taken are proportionate, risk-based, evidence-based, and properly designed so that they achieve the desired outcomes. In that respect, the Minister awaits with interest the results of the work of the Financial Stability Forum and fully supports the IOSCO work on operational issues such as valuation.

The Minister also set forth a proposal to expand the Financial Services Authority’s six-month collection of data on banks’ exposures to hedge funds through derivatives and prime brokerage to all major counterparties. Similarly, the six-month surveys would be broadened to include other major regulators.

Following discussion with the FSA, the Minister believes that the quality of prudential supervision of hedge fund activity would be enhanced if there were greater co-operation between the key regulators in monitoring the main counterparties' exposures to hedge funds and pooling that information. He said that the proposal will be discussed among international regulators in the run-up to the impending G8 Finance Ministers meeting.

Wednesday, April 25, 2007

IFRS on Segment Reporting Hits Roadblock

The international accounting standard for segment reporting has run into strong opposition from industry groups as it awaits European Commission approval. Adopted by the IASB as part of the movement towards the convergence of US GAAP and IFRS, the standard (IFRS 8) embodies the management approach to segment reporting set out in FASB Standard No. 131. A failure to approve IFRS 8 would certainly be a blow to the US GAAP-IFRS convergence roadmap.

Generally, the information to be reported under IFRS 8 would be what management uses internally for evaluating segment performance and deciding how to allocate resources to operating segments. Such information may be different from what is used to prepare the income statement and balance sheet. The standard therefore requires explanations of the basis on which the segment information is prepared and reconciliations to the amounts recognized in the income statement and balance sheet.

In a letter to the European Commission, the UK Investment Management Association said that an endorsement of IFRS 8 would essentially be the unilateral adoption of a US standard that is completely different from the underlying legal framework of many EU nations. Further, IFRS 8 will not result in meaningful disclosure because the standard does not provide for an analysis of cash flows, which are important to an analysis of a financial statement.

In addition, the association criticized the standard’s management approach to segment reporting, arguing that the accounting policies management uses for segment information may differ from those used in the company’s financial statements since internal management reports tend to be prepared in accordance with national GAAP. Moreover, since IFRS does not require liabilities to be analyzed by segment, users of the financial statement will not be able to determine returns on capital for each segment.
SEC Promotes IFRS for Foreign and Domestic Issuers

In an announcement of enormous import, the SEC said that it would consider giving US issuers the choice of reporting financial statements in GAAP or international financial reporting standards. In addition, this summer the SEC will propose rules allowing foreign private issuers to use IFRS, which is part of the roadmap towards the elimination of the reconciliation of ISFR-driven financial statements to US GAAP.

At the same time, the SEC, the UK Financial Reporting Council, and the Financial Services Authority signed a protocol for implementing the work plan between the SEC and the Committee of European Securities Regulators (CESR) as it relates to sharing information on the application of IFRS by issuers listed in the UK and the US. This is an important parallel development because CESR’s role is seen as crucial to the consistent interpretation of IFRS.

IFRS are principles-based standards promulgated by the International Accounting Standards Board (IASB). They have been adopted by over 100 countries and their use is mandated in the European Union. Last summer, I noted that people were asking why not end the sturm und drang over convergence of accounting standards by simply adopting IFRS in the US. The SEC’s concept may be a step in that direction, albeit that it envisions a choice between GAAP and IFRS.

In the view of Corporation Finance Director John White, the rulemaking is a critical step towards a future regulatory framework in which IFRS may be used on a stand-alone basis by foreign private issuers and possibly also by U.S. issuers.

The possible inconsistent interpretation of IFRS by national authorities is being increasingly viewed by regulators as the primary threat to uniform international accounting standards. The information-sharing protocol implementing the work plan agreed to by the SEC and CESR last August is important because CESR is viewed as the primary bulwark against the inconsistent interpretation of IFRS.

Thus, the work plan envisions a dialogue on the consistent global application of IFRS. Chairman Cox has emphasized that the consistent application of IFRS is critical to the future of global accounting standards.

Saturday, April 21, 2007

House Passes Bill Requiring Shareholder Advisory Vote on Executive Compensation

A bill requiring public companies to allow a non-binding advisory shareholder vote on corporate executive compensation plans has passed the House of Representatives by a vote of 269-134. On the day of passage, April 20, 2007, Sen. Barack Obama introduced a companion bill in the Senate (S 1181) requiring a shareholder advisory vote on executive compensation.

The House bill requires that companies include in their annual proxy to investors the opportunity to vote on the company’s executive pay packages. This is an advisory vote that in no way binds the company’s board. And, the bill does not attempt to cap executive compensation or dictate the form of such compensation. According to Rep. Barney Frank, the Act in no way intrudes Congress or the SEC into the process of setting management compensation. That said, the House Financial Services Committee chair does believe that boards of directors are not likely to disregard an advisory opinion from the shareholders.

The Shareholder Vote on Executive Compensation Act (H 1257) 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 rare second vote 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.

An amendment during mark-up by Mr. Frank, who sponsored the Act, delays the shareholder advisory vote until 2009. According to Rep. Frank, the effective date of the Act was delayed at the request of the Business Roundtable so there would be no burden in paperwork on companies. (Cong. Rec., Apr 20, 2007, H3706).

Friday, April 20, 2007




Committee Report on Shareholder Vote on Exec Comp Bill Published

The House Financial Services Committee has published a committee report (110-088) to accompany Barney Frank’s Shareholder Vote on Executive Compensation Act (HR 1257), which was reported out of committee on April 16, 2007. The bill was reported out with no committee report

The committee report states that the Act requires companies to include in their annual proxies a nonbinding shareholder vote on their executive compensation disclosures; and hold an additional nonbinding advisory vote if the company awards a new golden parachute package while simultaneously negotiating the purchase or sale of the company.

The report explains that the rare second vote is designed to help address a CEO's natural conflict of interest when negotiating the price of a company while simultaneously negotiating an additional personal exit package. The fear is that CEOs may be willing to sell the company for less or pay more for another if they personally receive a larger package, thereby reducing shareholder value. The report clarifies that this provision would not apply to long-disclosed change in ownership agreements; and would only apply to new provisions added while negotiating the sale/purchase.

The report states that the annual nonbinding advisory vote is designed to give shareholders a mechanism for supporting or opposing a company's executive compensation plan without micromanaging the company. Knowing that they will be subject to some collective shareholder action will help give boards more pause before approving a questionable compensation plan. As is the case in other countries, the committee expects this tool will improve dialogue between management and shareholders on compensation and make compensation a more efficient tool for improving and rewarding management performance.

Wednesday, April 18, 2007

UK FSA Officials Discuss Principles-Based Regulation

Principles-based regulation places the responsibility squarely on the shoulders of a firm’s senior management, said UK Financial Services Authority CEO John Tiner, since senior managers are in a position to judge how best to deliver the outcome that will satisfy investors and the markets. At the same time, the principles-based regime will give senior managers greater flexibility to decide how to do this in the most cost-effective way.

The CEO called the FSA’s move to principles-based regulation an audacious step involving firms, investors and the authority. Analogizing the implementation of principles-based regulation to a movie production, the official cast the industry in the lead role, with the FSA in the director’s chair. However, he also said that there will still be many rules for those who take comfort in prescription. This statement dovetails with recent remarks by FSA Chair Callum McCarthy that UK financial regulation will remain a mix of principles-based and rules-based regulation.

I consider John Tiner to be one of the most thoughtful regulators on the planet. That said, I believe that even he is having a hard time fully explaining what a principles-based regulatory regime will look like and how well it will function.

But make no mistake, principles-based regulation is on a roll and many people have jumped on the bandwagon. I also believe that it is an elusive concept with no consistently acceptable definition.

Principles are themselves rules, explained FSA Deputy Chair Deidre Hutton, they set forth the outcomes the FSA expects firms to deliver. That is an interesting statement. Given that rules and principles will co-exist in the new regime, she continued, the FSA is going to rebalance the mix between principles and detailed rules and tip that balance significantly towards a more principles-based approach. In her view, the trick is to strike the right balance between helping firms to meet their responsibilities and being overly prescriptive. And that balance will vary from one area of regulation to another.

Weighting the balance towards principles is proper, noted the deputy chair, since detailed rules allow firms follow the letter but not the spirit of such rules. Moreover, detailed rules cannot cover every circumstance and are not responsive to market innovations. They also foster a narrow approach to compliance. That was well said by the deputy chair.
SEC Cautions Wal-Mart on Shareholder Surveillance

Responding to reports that Wal-Mart is investigating its shareholders who submitted proposals to be acted on at the company’s upcoming shareholder meeting, SEC Chair Christopher Cox emphasized that the right of shareholders to propose matters for consideration at annual meetings is an indispensable element of the federal securities laws. In a strongly-worded statement, he condemned any attempt by company fiduciaries to intimidate shareholders exercising these rights as antithetical to the core principles of corporate governance and the proper expression of shareholder rights.

The SEC chair was mainly reacting to a letter from New York City Comptroller William Thompson urging the Commission to investigate what the NYC official called Wal-Mart’s chilling and outrageous surveillance of those shareholders who introduced resolutions the company disagreed with. The Comptroller said that Wal-Mart senior managers have confirmed that the company considers this conduct to be justifiable and intends to continue these activities.

According to the Comptroller, Wal-Mart’s conduct raises significant questions regarding the company’s commitment to its shareholders, as well as to the public markets. Without prejudging what has occurred, Chairman Cox forwarded the Comptroller’s letter to the SEC’s New York Regional Office for appropriate action.

Monday, April 16, 2007

SEC Chair Adds Voice to Complete Review of Rule 12b-1 Fees

Echoing earlier remarks by the Director of the Division of Investment Management, SEC Chairman Christopher Cox said that the Commission will conduct a thorough review of 1940 Act Rule 12b-1. The tenor of the chair’s remarks to the Mutual Fund Directors Forum was that whatever merit the rule had during the infancy of the modern fund industry that is no longer the case. In fact, he said that collecting an annual fee from mutual fund investors that is supposed to be used for marketing is no more consumer friendly than forcing cable TV subscribers to pay a special fee of $250 a year so the cable company can advertise HBO and Showtime to lure potential new customers. He promised that the Commission would take a hard look at current Rule 12b-1 practices.

These remarks dovetail with remarks by Andrew Donahue, the Investment Management director, who recently called for a review of Rule 12b-1 fees. Taken together, these twin remarks presage a complete review of the rule and raise the possibility of substantive changes. The SEC plans to revisit the original intent of Rule 12b-1, and consider its meaning in light of today's market realities and current practice.

Given that the Commission has so thoroughly bound the decision to charge 12b-1 fees to the independent judgment of the fund's disinterested directors, noted Chairman Cox, both the independent directors and the SEC must together tackle head-on the problem of brokers' sales commissions masquerading as fund marketing costs.

Friday, April 13, 2007

Supreme Court Ready to Review Its Antifraud Aiding and Abetting Ruling

It may be that the US Supreme Court’s Central Bank opinion will be completely revisited this year or next based on petitions filed with the Court and one cert. already granted. Simply put, in Central Bank, the Court ruled that there is no private action for aiding and abetting securities fraud by secondary actors, such as lawyers and accountants. However, there can still be aiding and abetting liability in SEC enforcement actions since the Court’s ruling is limited to private actions.

The Central Bank ruling was issued in 1994. As I recall, at the time some people called for Congress to legislatively overrule the opinion, but Congress never did. As a rule, legislative overrulings of Supreme Court opinions are difficult and rare. But now it appears that the Court is about to review the 1994 precedent.

Enron investors have asked the Supreme Court to review a Fifth Circuit split panel decision that 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. (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.

In their petition to the Supreme Court, the investors note that the Fifth Circuit found there is a conflict in the circuits as to Rule 10b-5 and Central Bank regarding scheme liability, which is liability of secondary actors for primary violations of the antifraud rule. The investors argue that the SEC disagrees with the Fifth Circuit’s narrow reading of the antifraud rule and that the Supreme Court’s precedents support scheme liability.

The Supreme Court has already agreed to review a ruling by the Eighth Circuit Court of Appeals rejecting scheme liability in the Central Bank context. In re Charter Communications Securities Litigation, CA-8 2006, No. 06-43.

The investors in the Enron petition argue that Central Bank did not immunize bankers from liability for engaging in complex securities frauds. Since the majority in the Enron ruling relied heavily on Charter, which the Court has accepted for review, the investors ask that their case be reviewed with Charter as a superior vehicle to resolve the scheme liability issues.

Thursday, April 12, 2007

Fed Chair Affirms Light Touch Regulation for Hedge Funds

The light market-based approach to the regulation of hedge funds has worked well, said Federal Reserve Board chairman Ben Bernanke in remarks at NYU Law school, although many improvements can still be made, especially in the area of risk management. In a system of market-based discipline, he noted, hedge fund managers have both the incentive and the duty to manage risk effectively, to develop consistent methods for valuing assets and liabilities, and to provide timely and accurate information to their investors, creditors, and counterparties.
He believes that the light regulatory touch is justified because hedge funds deal with highly sophisticated counterparties and investors make no claims on the federal safety net. That said, however, the growing market share of hedge funds has raised concerns about possible systemic risk. Their complexity and the rapid change inherent in their strategies make hedge funds relatively opaque to outsiders. They are also either highly leveraged or hold positions in derivatives that make their net asset positions very sensitive to changes in asset prices.

The Fed chair observed that the failure of a highly leveraged hedge fund holding large, concentrated positions could involve the forced liquidation of those positions, possibly at fire-sale prices, thereby imposing heavy losses on counterparties. In the worst case scenario, these counterparty losses could lead to further defaults or threaten systemically important institutions.

The market discipline provided by creditors and investors can fail, he said, and an example of this is the 1998 collapse of the hedge fund Long-Term Capital Management, whose investors and counterparties did not ask the tough questions necessary to understand the risks they were taking. In his view, these risk-management lapses were a major source of the LTCM crisis.

While Congress could have responded to the LTCM episode by imposing an intrusive regulatory regime on private pools of capital, the regulatory approach taken in the United States has followed recommendations set forth in 1998 by the President’s Working Group on Financial Markets and recently reaffirmed in a set of principles by the same group. This market-discipline approach to regulating hedge funds imposes responsibilities on four sets of actors: hedge fund investors, counterparties, regulators, and the hedge funds themselves.

Additional protection is provided by the fact that the securities laws allow only institutions and high-wealth individuals to invest in hedge funds, assured the Fed chair, and these investors have the resources and incentive to monitor the activities of the hedge funds. Large investors are well equipped to assess the strategies and risk-management practices of individual hedge funds, he pointed out, and also have the clout to demand the information that they need to make their evaluations.

The Fed official conceded that small investors may obtain indirect exposure to hedge funds through pension funds. But he added that pension fund managers have a fiduciary duty to their investors to understand their investments and ensure that their overall risk profile is appropriate for their clientele. In practice, he said, most pension funds have only a small exposure to hedge funds.

In Bernanke’s view, counterparties are an important source of market discipline. The principal counterparties of most hedge funds are large commercial and investment banks, which provide the funds with credit and a range of other services. As creditors, he reasoned, they have an economic incentive to monitor and impose limits on hedge funds’ risk-taking, as well as an incentive to protect themselves from large losses should one or more of their hedge-fund customers fail.

Counterparties seek to protect themselves against large losses through risk management and risk mitigation. Risk management includes the use of stress tests to estimate potential exposure under adverse market conditions, he noted, while risk-mitigation include collateral agreements under which hedge funds must daily mark to market and fully collateralize their current exposures.

While the incentives of hedge fund counterparties dovetail with regulatory objectives, he said, private counterparties may not fully account for risks to general financial stability. Thus, regulators must ensure that hedge-fund counterparties protect themselves and, in so doing, protect the broader financial system. Regulators should also monitor markets and key institutions, coordinate with their domestic and foreign counterparts, and work with the private sector to strengthen market infrastructures. In this context, he praised the Federal Reserve Bank of New York’s joint public-private effort to improve the clearing and settlement of credit derivatives as just the type of coordination that improves market functioning and reduces risks to financial stability without harming market discipline.

At the end of the day, market discipline does not prevent hedge funds from taking risks, suffering losses, or even failing, he noted, nor should it. According to Chairman Bernanke, if hedge funds did not take risks, their social benefits of providing market liquidity, improving risk-sharing, and supporting financial innovation would largely disappear.

Wednesday, April 11, 2007

Bill Mandating Shareholder Advisory Vote on Executive Compensation Goes to Full House

A bill requiring public companies to include in their annual proxies a separate non-binding advisory shareholder vote on their executive compensation plans has been favorably reported out of the House Financial Services Committee to the floor of the House. Introduced by committee chair Barney Frank, 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.

The bill was reported out with no committee report. An amendment during mark-up by Mr. Frank delays the advisory vote until 2009. The committee emphasized that the shareholder vote is advisory in nature, which means that the board and the CEO of a company can ignore the will of the shareholders if they so choose.

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.

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.

Tuesday, April 10, 2007




Funds Request Additional Guidance on FIN 48

Fidelity Investments, Massachusetts Financial Services Co. and OppenheimerFunds, Inc. have withdrawn a rulemaking petition submitted to the SEC last year which sought interpretive guidance and an extension of the effective date of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, but repeated their request for additional interpretive guidance on its implementation. The SEC issued a no-action letter last December which provided for a six month delay in the implementation of FIN 48 for mutual funds and provided guidance in response to some of the questions that were raised by the Investment Company Institute in a December 11, 2006 letter. However, the funds continue to believe that additional guidance is needed to prevent certain adverse effects of FIN 48.

The funds outlined the potential adverse effects that FIN 48 may create due to the unique nature of registered investment companies and the way they are taxed. The problems include the potential for false tax liabilities, the daily net asset value calculation and its impact on share pricing, and unintended consequences such as arbitrage and frequent trading. In their rulemaking petition, the funds had argued that FIN 48 should not apply to registered investment companies at all.

The SEC issued its response to ICI on the same day the funds submitted their rulemaking petition. The staff letter addressed one of the problems raised by ICI relating to the danger of a false tax liability and the incorrect reduction in net asset value. The staff assured ICI that FIN 48 does not limit the types of evidence that may be considered in determining that a tax position is more likely than not to be sustained upon examination by the relevant taxing authority.

The staff letter did not address two other scenarios identified by the ICI, but urged the industry to make good use of the additional time that was granted to carefully assess all of the issued related to the implementation of FIN 48.

FASB met in January to consider whether to delay FIN 48 for a year and whether to issue additional guidance, but voted to do neither. The funds noted that FASB may now be considering whether to provide additional guidance on the treatment of third-party reimbursements. The funds said that guidance is needed to ensure the consistent application of FIN 48, especially since there may be a complete lack of authority and audit experience in some areas.

The funds said they fully intend to use the additional time the SEC has afforded them by the delay of FIN 48’s effective date to address their unique implementation issues. However, the issues raised in their letter require additional guidance once the extension period ends, according to the funds.

Monday, April 09, 2007

Nazareth Suggests Prudential Approach to Portfolio Margining

SEC Commissioner Annette Nazareth recently described the Commission’s approach to prudential regulation, which in her view means meeting regulatory obligations without one-size-fits-all requirements. It means more efficient regulation, she said, not less effective regulation. In remarks at a recent SIFMA compliance and legal conference in Phoenix, Nazareth explained that a prudential approach to regulation can serve more complex business models well, but rules-based regulations may be more effective for smaller firms.

The SEC has had to adopt a more prudential approach to regulating certain broker-dealers and their holding companies, according to Nazareth. She said the events involving Drexel Burnham helped lead the SEC to a more prudential approach for broker-dealer entities that are part of a complex financial conglomerate.

One initiative that followed the Drexel Burnham experience was the formation of the Derivatives Policy Group. This initiative was important because it gave the SEC its first comprehensive look at the securities firms’ off-balance sheet exposures, she said. It was also one of the first times the SEC responded to a topical issue in a manner other than rulemaking.

Nazareth said the best example to date of a prudential regulatory approach is the SEC’s Consolidated Supervised Entity program. She believes the success of the program is a preview of the direction that regulation should take in the future. The SEC has benefited from the program by gaining insights about subprime lending problems, energy trading operations, hedge fund derivative innovations and other evolving issues, she said.

The question is whether this approach could be applied more broadly throughout the SEC’s regulatory program, especially where it would benefit certain business models. Nazareth suggested one area in which it may apply is portfolio margining. She said that progress has been made to permit firms that can demonstrate that they have adequate procedures to manage the credit risk associated with portfolio margining to use self-regulatory organization models to calculate margin on a portfolio basis. One day, firms may be able to use their own proprietary models for portfolio margining, she said.

One-size-fits-all regulatory approaches are becoming outmoded, according to Nazareth. However, smaller firms with more traditional broker-dealer businesses may find rules-based regulations more efficient and effective than creating unique proprietary models. A prudential approach would require a large investment in internal controls and infrastructure that may be too burdensome for some firms, she said.

Sunday, April 08, 2007

UK Minister Views US Securities Regulation Reform White Papers

The Minister for the UK financial sector believes that the three recent white papers on reforming US securities regulation merit close attention and vowed that the points they detail will be closely studied in the UK. In the view of Economic Secretary Ed Balls MP, the three reports are aimed at making the US regulatory framework for its capital markets more internationally competitive. In a speech at a recent real estate conference, he also mentioned that the UK has formed a High Level Group on Competitiveness, chaired by the Chancellor of the Exchequer.

The three reports are the Bloomberg/Schumer report, the report of the Committee on Capital Markets Regulation, and the Chamber of Commerce report on the Regulation of US Capital Markets.

While the three reports have different areas of focus, he noted, their unifying theme is the need to reform the way in which the internal control mandates of Section 404 of Sarbanes Oxley are implemented, and the linked issue of the high cost of excessive litigation within the US system. In his view, the UK's principles and risk-based regulation is the key to London's success and has proved to be highly effective, while being flexible and adapting to change. But he assured that market regulation is not a zero sum game and that integrated global financial markets will all benefit from the SEC’s ongoing efforts to lighten the burden of Section 404 internal controls reporting.

The senior official noted that both the Bloomberg/Schumer and the Chamber of Commerce reports focus on the importance of international cooperation, including recognition and adoption of international standards such as international accounting standards and Basel II, in promoting international competitiveness. The Minister said that the EU has worked hard to agree to a sensible roadmap towards ensuring continued acceptance of US accounting standards subject to an acceptable level of convergence with international standards by the end of next year. He emphasized that it is now up to the standard setters and regulators to deliver that roadmap and the necessary convergence.

As part of the work of the UK High Level Group, he noted, a working group is developing a proposal for an international center for financial regulation. In a changing global economy, he said, it is important to understand and explore the contribution efficient systems of financial regulation make to global growth. As financial markets integrate further, he sees a trend towards greater regulatory co-operation and mutual recognition.

The Center will be aimed at stimulating debate on these types of issues, analyzing trends and generating potential solutions. The Government has committed to making a contribution to the start up costs for the Center, which underlines its commitment to promoting world-class regulation in the UK.

Friday, April 06, 2007

UK to Allow Retail Investment in Hedge Funds

The UK Financial Services Authority proposes to allow retail consumers to invest in funds of hedge funds and other alternative investments. UK retail investors are already able to get exposure to hedge funds and other alternative products in a variety of ways, including structured products. The FSA believes now is the right time to allow the development of retail-oriented funds of alternative investment funds (FAIFs) within its regulatory regime. This proposed expansion of retail investment would involve substantial structural and operational safeguards, including requiring independent depositaries, timely redemptions, and strict rules on the independent valuation of underlying assets.

A key element in the proposed regime is the expectation that the fund manager will operate with due diligence. In this context, the FSA proposed guidance for the fund managers to consider in making, and maintaining, significant investments in unregulated schemes. The FSA has also accompanied the proposal with a case study illustrating the respective responsibilities of providers and distributors of these products.

According to FSA Director Dan Waters, it is important for consumers to gain access to the innovative alternative investment products as they manage their own savings and investments. The proposal allows investors more choice and a better opportunity for risk diversification, he emphasized, while maintaining investor protection through FSA rules on the operation of the products.

Wednesday, April 04, 2007

SEC Enforcement Chief Reviews Age Old Themes Involving Conflicts of Interest

SEC Enforcement Director Linda Chatman Thomsen believes there really is nothing new under the sun when it comes to conflicts of interest in the financial services industry. In remarks before a recent IA Week and Investment Adviser Association summit, Thomsen explained how the staff "follows the money" to uncover the variations on age old themes of misconduct. Thomsen's prepared remarks are on the SEC's Web site.

One area in which the interests of a mutual fund adviser may conflict with the interests of its clients is distribution, according to Thomsen. The staff has seen problems where advisers face conflicts with respect to payments made for distribution but fail to disclose the information to the fund boards. She gave an example of a recent series of cases brought against fund advisers that used brokerage to satisfy their own revenue sharing obligations with select broker-dealers, but failed to disclose the practice to the boards or shareholders.

Thomsen doubts these cases will be the last in which mutual fund advisers have found ways to benefit from distribution payments without disclosing the information. She urged compliance professionals to look for variations on this theme.

Thomsen said the SEC also remains concerned about advisers that use their influence to structure or to recommend mutual fund service arrangements in a way that benefits the adviser at the expense of the funds. She cited the case against Citigroup as an example. Compliance officers should be vigilant in looking for instances of overreaching, she said, and should ensure that adequate controls are in place to prevent it.

The staff also has followed the money to hedge funds, Thomsen reported. There are numerous examples of fraud by hedge fund managers, including the theft of assets, fraudulent valuations of the securities held by the fund, and false information about performance. Thomsen said that in some cases, the managers started out with the intent to deceive investors, but in most cases, managers got in over their heads and tried to cover their tracks.

The staff has seen an increase in trading violations by hedge fund managers, according to Thomsen. The violations include market manipulation, deceptive market timing and late trading, illegal short selling and insider trading. The staff is also concerned about conflicts that exist when an advisory firm manages hedge funds or other highly profitable accounts as well as other client accounts. This arrangement can provide a powerful incentive to benefit the hedge fund over the other clients through trading strategies or allocation practices, she explained.

Brokerage is a client asset, Thomsen said, and it must be treated that way. There are many temptations to use client brokerage in a manner that benefits the advisers and their personnel at the expense of clients, she warned. She said similar concerns may be raised with soft dollars. The staff has uncovered aggressive undisclosed soft dollar practices that violate the law, she advised.

Thomsen said that one of her pet peeves is firms that turn a blind eye to how big producers are making their money. These big producers often became big by engaging in misconduct, she noted. Some firms appear to want to avoid questioning the "cash cow" too closely, she explained, and some firms become complicit in the misconduct. She reminded management that it is responsible for ensuring that all employees, including the top producers, are complying with the federal securities laws. If the staff finds situations where management has turned a blind eye to misconduct, Thomsen it will seek to hold management and the firm accountable.

Monday, April 02, 2007

Federal Appeals Court Strikes Down SEC Fee-Based Broker Exemptive Rule

A federal appeals court has vacated an SEC rule exempting brokers who receive fee-based compensation for incidental advisory services from regulation under the Investment Advisers Act. A split panel of the DC Circuit Court of Appeals ruled that the SEC exceeded its authority and flouted six decades of consistent understanding when it broadened the existing statutory exemption for brokers. (Financial Planners Association v. SEC, No. 04-1242, March 30, 2007).

The Advisers Act exempts brokers whose performance of advisory services is solely incidental to the conduct of their brokerage business and who receive no special compensation for the advisory services. A catch-all exemption allows the SEC to exempt other persons; and that exemption is the crux of the case since the SEC adopted Rule 202(a)(11)-1 to exempt brokers whose provide incidental investment advice but receive a fee-based compensation keyed to the amount of assets in the customer’s account.

The appeals panel said that legislative intent does not support an exemption for brokers that is broader than the statutory exemption. Congress identified the specific persons that it wished to exempt from the Act, said the court, and the SEC cannot expand that category by using the catch-all exemption. When the statute is clear, reasoned the panel, the SEC cannot use general clauses to redefine the statutory boundaries.

Judge Rogers said that Congress, in the Advisers Act, intended to broadly define investment adviser and create only a precise exemption for brokers. Moreover, Congress established a broad federal fiduciary standard governing the conduct of investment advisers. This statutory regime is inconsistent with a construction of the SEC’s authority under the catch-all exemption enabling persons that Congress said should be subject to the Advisers Act to escape the Act’s restrictions.

Rejecting the SEC’s assertion that Congress was also concerned about the regulation of broker-dealers under both the Advisers Act and the Exchange Act, the court noted that Congress enacted the Advisers Act at a time when broker-dealers were already regulated under the Exchange Act and Congress expressly acknowledged that the brokers it covered could also be subject to other regulation.

The court also emphasized that the rule flouts six decades of consistent SEC understanding of its authority under the catch-all exemption, which does not authorize the Commission to rewrite the statute. Rather, the SEC has historically invoked the catch-all to exempt persons not otherwise addressed in the specific exemptions established by Congress. According to the court, the catch-all exemption serves the clear purpose of authorizing the SEC to address persons or classes involving situations that Congress had not foreseen in the statutory text; and not to broaden the exemptions of the classes of persons, such as brokers, that Congress had expressly addressed.

Similarly, the court rejected the SEC’s suggestion that broker-dealer marketing developments fall within the scope of its authority under the catch-all since this ignores the Commission’s own contemporaneous understanding of congressional intent to capture such developments. Although an agency may change its interpretation of an ambiguous statute, instructed the panel, all elements of the traditional tools of statutory interpretation confound the SEC’s effort to walk away from its long-settled view of the limits of its authority under the catch-all exemption.

Being unable to derive an unambiguous meaning from the statute in question, Judge Garland, in dissent, would therefore defer to the SEC’s reasonable interpretation of the statute it administers and uphold the Commission’s fee-based brokerage rule.

I think that Judge Garland's dissent makes it clear that, in the end, it all comes down to whether one believes that the statute is ambiguous or clear. If ambiguous, you can go forward and determine the reasonablesness of the SEC's rulemaking. If clear, the inquiry is at an end.

Recent Case Law Sides with the States Against Federal Preemption of Rule 506 Offerings

The National Securities Markets Improvement Act of 1996 preempted state law from applying to offerings under Rule 506 of under federal Regulation D but preserved to the states the right to require a notice filing on Form D, a consent to service of process (if the state requires it) and a fee. Increasingly, the Rule 506 offering has become one of the most popular, if not the most popular, offering among Blue Sky practitioners. In fact, at securities conferences it's not uncommon to the find attorneys, paralegals and law librarians asking each other how they accomplished making Rule 506 offerings in the various states.

Depending on who you talk to some will say that most Rule 506 are filed without problems and succeed as offerings; others will say that many Rule 506 filings are suspected of being deficient or fraudulent in some way. In any event, it has seemed for a long time that as long as the issuer filed Form D, the consent to service of process and the applicable fee within the prescribed 15 day period after the first sale in the state, NSMIA pretty much preempted the states from saying much about the securities offering, unless of course the state decided to use its enforcement power to investigate fraud, or go after the broker-dealer or agent for selling without a license or claiming a licensing exemption.

In 2006, however, cases began to surface and find in favor of state regulation of Rule 506 offerings. In a California case, Consolidated v. DuFauchard, Consolidated filed a notice on Form D, consent to service of process and $300 fee with both the SEC and California Commissioner Preston DuFauchard to make a Rule 506 offering in the state. The Commissioner order Consolidated to cease and desist from marketing unregistered securities. In an administrative hearing, the Commissioner argued that Consolidated did not have a preexisting relationship with the persons it was marketing to, so that its using mass mailings and seminars to market the securities violated the terms of offering and did not federally preempt state authority. Consolidated then sued in Federal District Court claiming that Rule 506 federally preempted state regulation. The Federal District Court abstained from adjudicating the matter, holding that the plaintiff's claims against the Commissioner could be litigated in state court.

In another case from Ohio, Blue Flame Energy Corporation v. Ohio Division of Securities, the Ohio Court of Appeals overturned the trial court's determination that federal preemption of state regulation in a Rule 506 offering applied. The Appellate Court agreed with the Ohio Division of Securities' assertion that the securities were not federally covered securities because the Blue Flame Corporation violated the conditions of the offering by engaging in general solicitation and advertising in offering the securities on publlic postings of its website. Blue Flame had argued that its offerings did not need to comply with Rule 506 conditions as long as the securities were offered and sold in reliance on Rule 506.

What's common to both cases is a state securities commission alleged violation in the issuer's manner of offering the securities, i.e., using general solicitation and general advertising to offer the securities that, thereby, violates the private nature of the Rule 506 offering and renders it no longer federally preempted from state law.

It's interesting to note that in a March 22, 2007 White Paper by the ABA State and Federal Securities Subcommittee to John White, Director of Corporate Finance, SEC, in which the ABA requests the rewriting of SEC private offering rules [See separate Blog article] to better distinguish these rules from recently rewritten public offering rules, one of the requests calls for the elimination of the limitation on the manner of offering ["general solicitation," "general advertising" provisions at least with respect to Rule 506.

Oh, the battle for Rule 506 goes on.



ABA State and Federal Securities Committee Requests Rewrite of Private Offering Rules

by Jay Fishman
Senior Writer Analyst, CCH, Inc.

The ABA State and Federal Securities Subcommittees submitted a White Paper to John White, Director of the Corporate Finance Division of the Securities Exchange Commission on March 22, 2007. The ABA State and Federal Subcommittees believe that over the years the demarcation between what is a “public offering” and what is a “private offering” has become muddled. The SEC has already taken action (applauded by the ABA) to clarify its rules and interpretations on public offerings. Now the ABA recommends a similar venture be undertaken for private offerings. Specifically, the ABA recommends that the SEC amends (or eliminates) portions of the rules and staff interpretations it has adopted over the past 75 years to interpret Section 4(2) of the Securities Act of 1933, that exempts “issuer transactions not involving a public offering.” Some of the recommendations include:

(1) eliminating the “general solicitation” and “general advertising” requirements from Regulation D (at least for Rule 506 of Reg. D);
(2) liberalizing Rule 144 to enhance liquidity for investors while retaining a suitable period to ensure they are not acting as conduits for the issuer (control person), i.e., reduce holding periods for securities of reporting issuers from one year and two years to six months and one year;
(3) streamline Rule 144A by, among other things, eliminating the restriction on “offers”;
(4) define the term “control” to simplify the application of private placement law without diminishing investor protection;
(5) eliminate the presumptive underwriter and resale provisions of paragraphs (c) and (d) of Rule 145;
(6) review certain staff interpretations of Rule 152;
(7) make available Form S-3 for all resale registrations, whether or not the issuer is listed on an exchange or eligible to use the form for primary offerings;
(8) consider extending “testing the waters” beyond Rule 163 and Rule 254 under Regulation A;
(9) consider eliminating restrictions on “directed selling efforts” in Regulation S; and
(10) take no action to interfere with existing legitimate derivatives and other hedge fund activity.