Tuesday, July 31, 2007

House Leaders File Brief in Scheme Liability Case

Although the SEC and DOJ did not file an amicus brief in the scheme liability case now before the Supreme Court, two House senior leaders have filed a brief on behalf of investors urging the Court to hold that non-speaking actors who engage in deceptive acts as part of a scheme to defraud investors may be liable under Rule 10b- 5 even if they did not directly issue fraudulent statements. This is also the position of the SEC, said Representations Barney Frank and John Conyers, respective chairs of the Financial Services and Judiciary committees.

The House chairs filed the brief because they believe the law in the case is clear that third parties who knowingly engage in manipulative or deceptive acts as part of a scheme to defraud investors should be held liable for their actions under the federal securities laws. In the brief, the members note that, if the Supreme Court decides against investors in this case, third parties will effectively be immune from suit no matter how reprehensible their conduct.

In the case of Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. (No. 06-43), the Court is slated to determine whether non-speaking actors, such as investment banks and auditors, that knowingly commit securities fraud can be held liable for their actions. The brief addressing this question, a concept known as scheme liability, was filed in support of the investors in the Stoneridge case.

The brief noted that the Solicitor General rejected the SEC’s specific recommendation that the United States file an amicus brief in support of investors and urge the Court to follow the Commission’s long-standing interpretation of the statutory and regulatory provisions at issue. Disturbingly, said the House leaders, this appears to have been done as a result of White House intervention. The House chairs called the Solicitor General’s decision to follow the directives of the President rather than support the SEC’s position a dangerous course to follow.

The rejection of scheme liability for non-speaking actors elevates a policy argument over the clear text of the antifraud statute, reasoned the brief, and is an invitation to engage in the policy-based judicial activism the Court has repeatedly condemned in statutory interpretation cases. Unless and until Congress so amends Section 10(b), continued the brief, the Court should honor the legislative policies established by the Congress reflected in the clear language of the statute and in SEC rules, as well in the Court’s precedents.

In that context, said the brief, the Financial Services committee stands ready to facilitate through hearings a discussion of whether to amend Section 10(b) to immunize from liability persons who knowingly engage, directly or indirectly, through conduct or speech, in manipulative or deceptive acts as a part of a scheme to defraud investors.

Monday, July 30, 2007

SEC Approves New PCAOB Internal Control Audit Standard

The SEC has approved the PCAOB's new audit standard on internal controls and the key components are in place to reform the internal control mandates of Section 404 of Sarbanes-Oxley. Only time will tell if the joint SEC-PCAOB actions, the SEC concomitantly issued management guidance, will reduce the costs of compliance while preserving investor protection and the accuracy of corporate financial statements.

SEC Chairman Cox has noted that Section 404 has posed the single biggest challenge to companies under the entire Act. Without question, it has imposed the greatest costs, he noted, but it has also contributed significantly to more reliable financial reporting as companies improved their internal controls to meet the statutory requirements

With Congress closely watching, the SEC and PCAOB worked together to create a new risk-based, principles-based regime for reporting on the effectiveness of internal control over financial reporting. Section 404 remains unchanged, but the rules, guidance, and standards promulgated pursuant to the statute have been reformed in response to concerns that internal controls compliance was overly costly and harmful to the competitiveness of U.S. financial markets. The reforms build on the guidance issued by the SEC and PCAOB in May of 2005.

The SEC issued management guidance and amended a number of internal controls rule. For its part, the PCAOB adopted a new Auditing Standard No. 5 on the audit of internal control over financial reporting, to replace Auditing Standard No. 2, and adopted a rule requiring audit committee pre-approval of non-audit internal control services.

Chairman Cox has pledged to analyze real-world information to determine that the costs and benefits of implementing section 404 are in line with SEC expectations. In addition, through SEC oversight of the PCAOB's inspection program, the Commission will monitor whether audit firms are implementing Auditing Standard No. 5 in a manner designed to achieve the intended results of audit efficiency and cost reduction and whether the PCAOB is inspecting audit firms in a manner consistent with expectations.

New AS5 will become effective for audits of fiscal years ended on or after November 15, 2007. However, it is important to note that the SEC allows early adoption of the new standard. In fact, the SEC staff encourages early adoption by auditors so that issuers and investors can begin to benefit from the improvements that have been made relative to effectiveness and efficiency in the conduct of internal control audits.

The Commission’s recent amendments to Regulation S-X become effective on August, 2007 and the SEC will begin accepting the single auditor’s attestation report on the effectiveness of internal control over financial reporting prescribed in Auditing Standard No. 5 in timely filings received starting on that date.

The SEC and the PCAOB really tried to get on the same page with this reform, and I think they succeeded in doing so. For example, the definition of significant deficiency adoped the SEC is the same as that in AS5.

Friday, July 27, 2007

IOSCO Roundtable on Audits Examines Fraud Detection and Liability

Participants at a recent IOSCO roundtable on public company audits agreed that the current certification is not entirely adequate. They suggested that the auditors’ position be expanded to include judgments, with additional information to be provided, such as business matrices and other information used by the industry to estimate the future value of companies. The roundtable also believes that audits of large and complex companies could be enhanced through the use of internal auditors. It might also be useful to implement some fraud enhancement mechanisms within the regular audit process, although separate forensic investigations were generally not deemed appropriate.

Former SEC Chief Accountant Lynn Turner said it is crucial that the numbers presented in financial statements be accurate. Financial statements are a snapshot of a company at a given moment, he noted, and the role of auditors is to provide a high level of assurance that this snapshot is accurate. If they are unable to offer such assurance, he posited, it would significantly change stock pricing and capital allocation activities.

On the question of auditor liability, the former chief accountant said that, before applying any liability caps, greater transparency should be required on the part of auditors. Since auditors have not made their financial information public, they have not provided any financial reason for imposing caps. Auditing firms would not even adopt the good governance practices required of public companies, which the former SEC officials sees as problematic, considering the important public function they provide to the worldwide capital markets.

Michael Cook former Deloitte CEO, mentioned that, following the financial debacles of Enron and others, there has been a pronounced cultural shift within the financial reporting community from making the numbers to doing it right. In his view, the large number of material weaknesses and restatements is actually proof that the system is working properly, since people are making significant changes in their reporting systems.

Paul Koster, chair of CESR-FIN, related that the European Commission has made great efforts, within the Financial Services Action Plan, to improve the reliability of financial statements. Many directives have been introduced, such as the Transparency Directive, and the Audit Directive.

Mr. Koster, who is also a member of the Netherlands Authority for Financial Markets also reiterated his position that financial statements should include an accountant’s discussion and analysis. Such information would also help the auditing profession make a better impression on the financial markets, by communicating how well they are performing their tasks.

On the issue of auditor fraud detection, Lynn Turner advocates the adoption of a better fraud standard in the context of a regular audit, and eschews the conducting of a separate forensic audit. He also noted that auditors are still not using procedures that are used by other professionals, such as hedge fund analysts, to greatly enhance the possibility of detecting fraud.

Consequently, it is not unusual for an analyst to detect fraud where an auditor failed, although the latter has access to the company records. In Enron, he noted, two large hedge funds managed to detect that the company’s books were cooked, while the outside auditor did not.
Choice of Audit Firms Market Driven; No Mandated Big Five

There should be no regulatory intervention to create a Big Five audit firm. That was the tenor of a UK audit oversight group’s recommendation that increasing the choice of audit firms should be driven by market solutions, not by regulation. This position received the support of a broad industry consensus. Comments to the report by the Market Participants Group of the Financial Reporting Council, which oversees audits of public company financial statements, expressed the belief that market-based solutions will be more enduring than shorter-term regulatory measures.

In the wake of the implosion of Arthur Andersen, a number of groups are examining the issue of auditor choice, including the European Commission and the US Paulson Committee. A recent survey indicated that global institutional investors would welcome greater auditor choice.

One main objective of the FRC report is to reduce the perceived risks to investors of selecting a non-Big Four audit firm to audit the company’s financial statements, as well as to improve the accountability of boards for their auditor selection. Another important objective is to reduce the risk of audit firms leaving the market without good reason and to reduce disruption costs when a firm leaves the audit market.

The Institute of Chartered Accountants in England and Wales believes that market-based actions are the most effective means to achieve an impact. As such actions tend to involve information dissemination, persuasion and education, they may not have an immediate effect. They do however, tend to be more effective since, once accepted, they work with the market and avoid the unintended consequences that often follow from regulation.

The market group recommended that the FRC provide guidance on a company’s use of joint audits in which more than one audit firm network works on the audit. The Institute said there may be circumstances where audit quality would not be harmed by the use of auditors from more than one network.

But PricewaterhouseCoopers said that it would generally by unwilling to be the group auditor where its network firms were not also auditors of all or substantially all of the group. There are good reasons why large audit firms developed global networks, said PwC, and good reasons why companies employ a single network as worldwide auditor.

KPMG was concerned that the use of more than one audit network firm would have an adverse impact on audit quality. It is important for the parent company auditor to control the work performed by the auditors of the company’s subsidiaries, emphasized KPMG, and this is enhanced when all the firms involved in the audit use a common methodology. KPMG cited Parmalat as an example of what can go wrong when more than one audit firm is involved. Deloitte said that, in this area, nothing must be done that could damage audit quality.

Wednesday, July 25, 2007

McCreevy Explains Better Regulation in Hedge Fund Context

The European Commission’s principle of better regulation is embodied in how the Commission has approached the regulation of hedge funds, said Commissioner for the Internal Market Charlie McCreevy. In remarks at the Public Affairs Ireland seminar, he noted the better regulation in of the financial industry aims to simplify regulations, reduce burdens, and create a level playing field. The Commission works through a consultative process and impact assessments.

Regarding hedge funds, Mr. McCreevy said that the Commission could have designed a complex and ill-prepared regulatory framework. They is still a drumbeat for such an approach, he added. However, the Commission talked extensively to all the participants in the hedge fund industry, including market professionals, regulators, and investors. The EC also thoroughly examined financial stability issues.

After this deliberative process, the Commission decided to rely on an indirect approach involving the upstream monitoring and regulation of prime brokers and the investment banks dealing with the hedge funds, which is where the real prudential risks lie. This approach is working well, reported the commissioner, and allows financial innovation to prosper. A hedge fund industry is now developing in Europe at a remarkable pace.

Monday, July 23, 2007

SEC Market Reg Director Outlines Impact of CSE Program

The Director of Market Regulation Erik Sirri provided a detailed and rare snapshot of how the SEC’s consolidated supervised entity (CSE) program interacts with and impacts hedge funds in testimony before the House Financial Services Committee. Under the CSE program, the Commission supervises five global securities firms on a group-wide basis. For such firms, the Commission oversees not only the U.S-registered broker-dealer, but also the consolidated entity, which may include foreign-registered broker-dealers and banks, as well as unregulated entities, such as derivatives dealers and the holding company itself.

The CSE program is designed to provide holding company supervision that is broadly consistent with Fed oversight of bank holding companies. The aim of this program is to diminish the likelihood that weakness in the holding company itself or any of its unregulated affiliates places a regulated bank or broker-dealer, or the broader financial system, at risk.

All five of the CSEs are of potentially systemic importance since they trade a wide range of
financial products, connected through counterparty relationships to other large institutions. The primary concern of the CSE program with regard to hedge funds revolves around the risks they potentially pose to the firms specifically and, through the CSEs, to the financial system.

Hedge funds present a variety of management challenges to CSEs, said the SEC official. For example, a hedge fund may grow so large in absolute terms that a forced liquidation could lead to a broader unwinding of positions and otherwise disrupt the markets.

The rapid development of risk transfer mechanisms, such as credit derivatives and securitization, evidences that markets have better shock absorbers today than in the past. However, noted the director, the transfer of risk from banks and securities firms to hedge funds and other market participants may not be as definitive as some believe.

The CSE program monitors and assesses these risks in several ways. First, SEC staff meet monthly with senior risk managers at the CSEs to review risk exposures, including those to hedge funds. This process provides information not only concerning the potential risks to CSEs, but also a broad window into their relationship with hedge funds and these hedge funds’ potential impact on the broader financial markets. Importantly, the meetings allow SEC staff to monitor trends in the extension of credit to hedge funds through a variety of channels, including prime brokerage relationships, secured financings, and OTC derivative trades.

Through this monthly process, the SEC tracks changes in margin terms and other credit mitigants. Where warranted and where the information is timely, the SEC can respond with respect to CSEs by requiring that they hold additional capital against such exposures.

The director also said that SEC staff recently engaged in targeted discussions with the CSEs about the challenges of measuring credit exposures to hedge funds. For example, risk managers cite the need for stress testing their exposures to hedge fund counterparties. There is a general consensus that measures such as value-at-risk may not be sufficient for judging the risk presented by hedge fund counterparties implementing complex strategies, observed Mr. Sirri, and hence the adequacy of the collateral protecting the bank and securities firms that provide financing.

Friday, July 20, 2007

Non-EU Auditors to be Regulated through Equivalence and Reciprocity

There is growing support in the European Union for an equivalence regime for the regulation of non-EU audit firms based on reciprocity and equivalent oversight systems. Responses to a European Commission consultation on the issue also said that non-EU audit firms should be allowed to use international audit standards or PCAOB standards for registration purposes during a transitional period. Commissioner for the Internal Market Charlie McCreevy emphasized that the Commission wants to find the most efficient way to regulate non-EU audit firms and invited the PCAOB and other audit regulators to participate in a cooperative process.

In addition to using the sophistication of the oversight board as an equivalence standard, the commenters suggested using the size of the companies being audited and the volume of the company’s trading on EU-regulated markets. Naturally, the majority also emphasized the importance of close co-operation between the oversight bodies of EU member states and the PCAOB and other audit overseers. There is also widespread support for the Commission to make the equivalence determination on non-EU audit oversight boards rather than consigning such decisions to each member state.

The new Directive on Statutory Audit empowers the Commission to regulate non-EU auditors. The Directive requires non-EU auditors conducting audits on companies incorporated outside the EU whose securities are admitted to trading on an EU-regulated market to register with the relevant authority in each EU state in which their clients' securities are admitted to trading and to be subject to that state's oversight.

However, an audit firm can be exempted from registration based on reciprocity and provided that the firm is subject to an oversight system that the European Commission has recognized as equivalent. An exemption is thus conditioned on both reciprocity and equivalence.

Wednesday, July 18, 2007

Walker Report Suggest Enhanced Disclosure by Private Equity Firms

A blue ribbon report indicates that private equity firms needs to become more open and transparent without eroding their capacity to act as positive market forces. The report by the working group chaired by Sir David Walker recommended that managing partners of private equity firms publish a website-accessible annual review on the values that inform their business approach and the governance of their portfolio companies. Given the cross-border nature of private equity, said the report, there is a need for pro-active engagement with industry bodies in the UK, Continental Europe and North America, to promote the guidelines put in place in the UK as at least a reference benchmark.

The broad approach envisaged us for the adoption of voluntary guidelines after a consultation process that will be completed by October 9, 2007. The guidelines will be on a comply or explain basis.

The annual review to be published by the private equity firm’s general partners should include an indication of the leadership team of the management company, identifying the most senior members of the general partner team or general partner advisory group. It should also contain a commitment to conform to the proposed guidelines on a comply or explain basis.

Further, under the rubric of the values of the private equity firm and the general partners,
The annual review should contain the philosophy of their approach to employees and the working environment in their portfolio companies, to the handling of conflicts of interest that may arise, and to corporate social responsibility.

The review should also give a broad indication of the performance record of their funds, with an attribution analysis to indicate how much of the value enhancement achieved on realization and in the unrealized portfolio flows from financial structuring, from growth in the earnings multiple in the market in the industry sector, and from their strategic and operational management of the business.

Investors in the funds should be characterized, including pension funds, insurance companies, corporate investors, funds of funds, banks, government agencies, endowments of academic and other institutions, private individuals and others.

Alongside the annual reviews, the working group expects private equity firms to be more accessible to specific enquiries from the media. While confidentiality concerns will constrain responses, the Walker group draws the between openness and secretiveness with much greater flexibility, especially in respect of large transactions which would attract very full public presentation.

Tuesday, July 17, 2007

Hedge Fund and Risk Management Newsletter Available

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Hedge Funds Fail to Place Candidates on Company Board

Two hedge funds failed in their effort to get their slate of two candidates elected to the board of directors of a Delaware company in which they had a 13 percent interest after the Chancery Court rejected the funds’ contention that the company’s by laws on nominating directors were so confusing as to excuse compliance. Vice Chancellor Lamb ruled that the incumbent directors were the only properly nominated candidates and, thus, were rightfully reelected. (Openwaves Systems, Inc. v. Harbinger Capital Partners Master Fund I, Ltd., Del. Chan Ct, May 18, 2007).

Far from being confused, said the court, the hedge funds were simply dilatory in researching the advance notice bylaws while taking the public position of being a passive investor until the very last minute, by which time it was too late for them to muster their candidates and propose a slate.

While acknowledging that the bylaws were not the most well drafted of corporate instruments, the court could not conclude that they left an unreasonably short time period for compliance. Rather, the hedge funds had a reasonable opportunity to submit their nominations and chose not to either out of neglect or indecision, or perhaps to gain a tactical advantage by remaining a passive 13G filer even while they were preparing to wage a proxy contest.

Whatever the reason, continued the Vice Chancellor, the funds did not comply with any deadline under any reasonable reading of the bylaws. The court concluded that the funds’ plea of confusion was merely a litigation device that bore no relationship to the timing of its decision to nominate directors after both possible deadlines for doing so had passed.

Under the federal securities laws, when the funds formed an intent to nominate directors, they were required to amend their filing to disclose the additional information required by Schedule 13D. Throughout the entire relevant time period, the funds were a 13G filer. A Schedule 13G is similar to a Schedule 13D, but it may be filed only if the purchasers have no intent to change or influence the company.

In the court’s view, the funds’ status as a 13G filer further undermined their already weak argument that their failure to comply with the advance notification bylaws was caused by some confusion. On the contrary, the funds’ continued representation that their share purchases were for investment only was entirely consistent with the other evidence tending to show that they did not begin to focus on the process of making board nominations until such time that they could never have complied with either deadline.

Sunday, July 15, 2007

SEC to Propose Mutual Recognition of Foreign Exchanges and Brokers

Against the backdrop of continuing cross-border exchange mergers, Chairman Cox has directed the SEC staff to develop a proposal regarding the mutual recognition of foreign exchanges and brokers by this Fall. In a statement delivered at hearings of the Senate Securities Subcommittee, the SEC emphasized that the goal is to develop a regulatory approach that strikes a balance between securing the benefits of greater cross-border access to investment opportunities, while vigorously protecting investors.

The mutual recognition approach would permit foreign exchanges and foreign broker-dealers to provide services and access to U.S. investors under an abbreviated registration system. This approach would depend on these entities being supervised in a foreign jurisdiction providing ``substantially comparable oversight’’ to that in the U.S. In addition, this approach could require that the home jurisdiction of the foreign exchange and the foreign broker-dealer provide reciprocal treatment to U.S. exchanges and broker-dealers seeking to conduct business in that country.

Currently, a foreign exchange conducting business in the U.S. for example must register the exchange and the securities trading on the exchange with the SEC. In addition, foreign broker-dealers inducing trades by investors in the U.S. generally must register with the SEC and at least one SRO. The SEC has, however, provided exemptions to foreign broker-dealers engaging in a limited U.S. business, such as effecting transactions with U.S. institutional investors with the participation of a U.S.-registered broker or dealer.

The mutual recognition regime contemplated by the SEC would consider under what circumstances foreign exchanges could be permitted to place trading screens with U.S. brokers in the U.S. without full registration. Mutual recognition would also consider under what circumstances foreign broker-dealers subject to an applicable foreign jurisdiction's regulatory standards could be permitted to have increased access to U.S. investors without the need for intermediation by an U.S.-registered broker-dealer. While this approach could reduce frictions associated with cross-border access, cautioned the SEC, it would not address the significantly greater custodial and settlement costs that are incurred when trading in foreign markets.

The exemptions from registration would depend on whether the foreign exchange and the foreign broker-dealer are subject to comprehensive and effective regulation in their home jurisdiction. To make this determination, the Commission would need to undertake a detailed examination of the foreign jurisdiction's regulatory regime, considering whether it adequately addresses such things as: investor protection, fair markets, fraud, insider trading, registration qualifications, trading surveillance, sales practice standards, financial responsibility standards, and dispute resolution.
EU Shareholder Rights Study Is Inconclusive

In the wake of a European Commission study on shareholder rights, Commissioner for the Internal Market Charlie McCreevy declared that there is currently no systematic call for imposing the one share, one vote principle. The aim of the study was to facilitate Commission evaluation of whether the present regime concerning shareholders' voting rights across the EU is an obstacle for financial market integration, and whether measures at EU level would, therefore, be appropriate. According to the commissioner, the picture is not clear cut.

But he has instructed staff to examine the issues with an open mind and determine if there is a need for Commission action. Also, an impact assessment to this end is under preparation, with all views on the issues to be properly taken into account. In addition, the European Corporate Governance Forum, which is a high level body advising the Commission, will review the study and may contribute its own recommendations.

The study was led by Institutional Shareholder Services (ISS), associated to a European network of leading academics, the European Corporate Governance Institute (ECGI) and the law firm Shearman & Sterling. The study provides a useful factual background to the issue of proportionality between capital and control, or the one share, one vote issue as it is more commonly referred to.

The core concept of the proportionality principle is that shareholders with capital at risk in a company should have a say about the conduct of that company and that their voice should be proportionate to the risk they take. Common deviations from the principle, which the Commission calls control enhancing mechanisms, are multiple-voting rights and non-voting shares, for example.

The study found that, overall, investors globally perceive control enhancing mechanisms as something negative. Supermajority provisions, however, are seen as almost neutral. Although there is no strong consensus, more large investors tend to perceive preference non-voting shares as neutral, on a weighted average.

Investors did contend that transparency is necessary in order to improve the level of information on the existence and impact of any of the control enhancing mechanisms. When a company features a control enhancing mechanism, investors want disclosure of such mechanisms in the annual report, as well as a clear and recurring statement by the board as to why the mechanism is kept in place.

Friday, July 13, 2007

PCAOB Reporter Available from CCH

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Netherlands Supreme Court Rules for ABN AMRO in LaSalle Bank Sale

The Netherlands Supreme Court has ruled that ABN AMRO’s sale of its LaSalle Bank subsidiary did not require prior shareholder approval as a principle of proper Dutch corporate governance. The court said that the board of directors must put the interest of the company and the enterprise connected therewith first. The fact that the shareholders aim at selling their shares at the highest possible price involves no obligation for the board of ABN AMRO to obtain the shareholders' approval of the sale of LaSalle, nor does such an obligation arise from the prevailing views of the law in The Netherlands. ABN AMRO Holding, NV v. VEB

Wednesday, July 11, 2007

Private Equity Firms Doing IPOS Not Investment Companies Says SEC Official

Two private equity firms currently doing IPOS are not investment companies under either the orthodox or inadvertent tests developed under the Investment Company Act, emphasized SEC Investment Management Director Andrew Donahue in testimony before the Senate Finance Committee. Thus, the Fortress Investment Group LLC and The Blackstone Group L.P. are not subject to the substantive provisions of the 1940 Act.

The Investment Company Act has two main tests for determining whether an issuer is an investment company. The first test is whether the issuer is primarily engaged in the business of investing in securities. This orthodox investment company test defines issuers that hold themselves out, or otherwise are clearly recognizable, as investment companies.
The second test is whether the issuer is engaged in the business of investing, reinvesting, owning, holding, or trading in securities and owns investment securities the value of which exceeds 40% of its total assets. Companies that fall within this second test are often referred to as inadvertent or prima facie investment companies because they view themselves as industrial or operating companies rather than investment companies.

According to the director, the SEC staff carefully reviewed the registration statements and other information provided by Fortress and Blackstone and concluded that they are not investment companies under the 1940 Act.

Applying the orthodox investment company test, the staff found that Fortress and Blackstone are engaged primarily in the business of providing asset management and financial advisory services to others and not primarily in the business of investing in securities with their own assets.

With respect to determining if the two firms constitute inadvertent investment companies, the key test established by Congress is whether more than 40% of a company's assets are investment securities. The main assets relevant to the inadvertent investment company test are the general partnership and limited partnership interests in the underlying funds of the two firms. While limited partnership interests are treated as investment securities, general partnership interests are not securities if the profits relating to those interests generally come from the efforts of the general partners, as opposed to the efforts of others.

In the case of Fortress and Blackstone, noted the director, the issuers maintain control over the day-to-day management of the underlying funds, with senior employees exercising such management through wholly owned subsidiaries. The profits to the general partnership interests result from the efforts of the managers, not others, and those interests would thus not constitute securities. The fact that the public investors in the securities sold by Fortress and Blackstone have no voting rights with respect to the management of the underlying funds would not change this conclusion. Thus, the general partnership interests would not be securities and therefore not investment securities for Investment Company Act purposes.

Tuesday, July 10, 2007

Global Corp Gov Group Praises US Bill on Shareholder Advisory Vote

A leading global voice on corporate governance has praised a House bill mandating a shareholder advisory vote on compensation. In a letter to Barney Frank, Chair of the House Financial Services Committee, the International Corporate Governance Network expressed strong support for H.R. 1257, which the group believes will increase the competitiveness of the U.S. capital markets which are viewed internationally as relatively weak in this area.

Sponsored by Chairman Frank, HR 1257 would require companies to conduct a non-binding advisory shareholder vote on executive compensation plans. It recently passed the House of Representatives by a vote of 269-134. The Shareholder Vote on Executive Compensation Act also mandates 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.

In the view of the corporate governance group, H.R. 1257 properly balances the rights of shareholders for input into the important policy of executive compensation and the need for companies to have flexibility. The advisory vote is non-restrictive and non-intrusive, yet provides compensation committee members with sharpened accountability to owners. This fact, coupled with the improved SEC executive compensation disclosure rules, will permit shareholders to participate constructively in broad policies related to executive compensation.

The message companies receive from a shareholder advisory vote reflects a strong commitment to pay-for-performance, reasonable compensation levels, and the avoidance of rewards for failure. According to the ICGN, the advisory vote mandated in HR 1257 will also work a good long-term alignment between the interests of executives and shareholders.

ICGN members in the UK and the Netherlands, for example, have commented that the practical impact of this dialogue between companies and shareholders has been positive. Compensation is becoming more closely aligned to long term performance. In addition, the discussion on the shareholder advisory vote allows companies to communicate their strategic goals and tailor executive pay around specific objectives rather than market wide targets.

Monday, July 09, 2007

Atkins Views Hedge Fund Advisers

In remarks recently released by the SEC, Commissioner Paul Atkins noted that 488 hedge fund advisers have withdrawn from SEC registration since the hedge fund adviser registration requirement was vacated by a federal appeals court. Speaking to the Investment Adviser Association in Austin, the commissioner said that a primary reason for the registration withdrawals is the problems with existing SEC recordkeeping rules for advisers, which often arise in connection with examinations by SEC staff.

In many of these exams, the staff has focused increasingly on emails and other electronic messages, he said, which can provide important insight into what is going on at a firm. Investment Advisers Act Rule 204-2 requires advisers to retain records, communications and other types of information. Over the last several years, the SEC staff, through the inspection and enforcement process, has informally applied the rule to e-mail. Commenters have noted that this has raised a host of difficult compliance issues for investment advisers.

In the view of Comm. Atkins, the intensified interest in e-mail has proven frustrating and costly for firms. Some firms have complained that the SEC staff's e-mail requests go beyond the scope of the records that the rules require them to keep. Even if firms have copies of the requested e-mails, he noted, they incur substantial costs in searching for and producing them within the deadlines set by the staff. He posited that these concrete costs might be dwarfed by lost efficiencies and impeded customer service if firms elect to stop or curtail e-mail usage in order to avoid having the burden of complying with staff requests. He advised the SEC staff to look at e-mails as part of its examinations, but to also give advisory firms clear guidance on what electronic messages they need to keep, how they need to keep them, and how long they need to keep them.

Thursday, July 05, 2007

Supreme Court Urged to Approve Scheme Liability in Securities Fraud Actions

Although the SEC and DOJ did not file an amicus brief in the scheme liability case now before the Supreme Court, a number of other entities did, including the state securities administrators association, the council of institutional investors, state attorneys general, and eminent law professors.

In the case of Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. (No. 06-43), the Court is slated to determine whether secondary actors, such as investment banks and auditors, that knowingly commit securities fraud can be held liable for their actions. The briefs addressing this question, a concept known as scheme liability, were filed in support of the investors in the Stoneridge case.

The battle over scheme liability is joined when investors argue that an investment bank or auditor need not have made misleading statements or omissions to be liable for securities fraud since participating with scienter in a sham transaction with no legitimate business or economic purpose should suffice. The countervailing argument is that the actors must make a misleading statement to be held liable under Rule 10b-5; and thus scheme defendants who remain silent and owe no duty of candor to investors are categorically exempt.

The circuit courts are split on this issue. The Ninth Circuit articulated a test under which participants in schemes with the principal purpose and effect of defrauding investors are held liable whether or not they made misleading statements to investors. By contrast, the Eighth Circuit in Stoneridge and the Fifth Circuit in Enron have adopted what amici contend is a narrow interpretation of scheme liability based on an erroneous interpretation of the Supreme Court’s 1994 decision in Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164.

Amici contend that the broader standard is proper because the plain language Rule 10b-5 reflects a congressional purpose that defendants should be immune from scheme liability when they possess the requisite intent to deceive and actually engage in conduct that does in fact deceive investors. The entire system of monitoring and eliminating securities fraud would be severely undermined if the securities laws allow culpable individuals or companies actively participating in fraud schemes to escape liability for their actions.

In its brief, the North American Securities Administrators Association argued that a decision that holds all parties accountable for their role in a fraudulent scheme, regardless of whether their deception was perpetrated through words or deeds, will help repair the damage done to investors and deter future violations. At a time when large scale financial fraud shows little sign of abating, NASAA urged the Court to ensure that injured investors have the opportunity to seek relief in federal court.

Several of the nation’s foremost academic experts in securities law, including Professors James D. Cox, Jill E. Fisch, and Donald C. Langevoort, explained in their brief that, without scheme liability, market integrity will suffer and victims will too often be left without recourse. Unless investors can recover from any person who engages in deceptive sham schemes, they argued, market integrity will suffer because centrally and recurrently involved third party schemers will face far weaker disincentives to avoid participating in sham transactions which they know are at the heart of a company’s fraudulent misstatements. In some cases, where the company making misstatements is insolvent, such active schemers will be the only source of recovery.

Attorneys General representing more than 30 states pointed out in their brief that without scheme liability many defrauded investors would have no redress. Eliminating scheme liability for what the state officials called ``non-speaking actors’’ will significantly diminish victims’ right to compensation under the securities laws. They pointed out that virtually all of the record $7.1 billion settlement to investors in Enron came from such non-speaking actors…Without those funds, many individual Enron shareholders would have received nothing; and without scheme liability, many more defrauded investors will receive nothing.
The Council of Institutional Investors, which represents more than 130 public, labor and corporate pension funds, stated that the adoption of the strict test for primary liability would undercut lessons learned in the aftermath of recent financial scandals regarding the complexity of securities fraud today and the importance of deterring secondary actors from participating in fraud. It would give accountants, investment bankers, lawyers, and other third parties a safe harbor for fraud so long as they do not publicly announce their involvement with an issuer’s misstatements. Contrary to the reasoning of some courts, the strict test is not required to stem a tide of frivolous litigation against secondary actors. Finally, the Council emphasized that neither lawsuits against issuers themselves nor SEC enforcement will adequately compensate investors in the face of the strict test.
Support Growing in EU for Limiting Auditor Liability

There is growing support in the EU for limiting auditor liability, according to a consultation conducted by the European Commission. The audit firms favor a cap on liability, while others urged the Commission to implement proportionate liability. Some respondents to the consultation suggested that the Commission adopt a more holistic approach where action on auditor liability might take place in the context of a broader package of reforms designed to increase competition and choice in the audit market.

But regardless of what form of limitation is adopted, there is agreement that member states should be given maximum flexibility to adopt the limitation that suits their national needs. Importantly, CESR does not favor reform of auditor liability at the EU level. Moreover, CESR sees no clear link between auditor liability and the concentration of audit firms.

Respondents to the consultation were divided between those who consider that a reform on auditors' liability could protect against catastrophic losses, and those who reject the idea that catastrophic losses represent a real risk that should be addressed. But the majority recognizes that the lack of choice in the audit market could jeopardize the efficiency of financial markets and that comprehensive action to reduce barriers of entry to this market should be taken. However, not all agreed that limiting auditors' liability would be an appropriate means to address the issue.

Investors do not think that the case for reform at the EU level has been made. They see no evidence of potential catastrophic claims that could bring down a network. Although generally opposed to reform, they consider that proportionate liability is the least problematic option.

The corporate community is divided on the question of auditor liability limitation. Those who are opposed consider that there is not sufficient evidence of a major threat to the public interest in the EU. Similar to the banks, they believe that the failure of a network appears to be linked essentially to a reputation risk, and not to financial liability.

For their part, banking and securities regulators believe that there is no convincing evidence that EU audit firms have left or are considering leaving the audit market as a result of liability problems. Further, there is no evidence that limiting auditor liability will help mid-tier audit firms become significant players in the international audit market. The main barriers to entry are perceived to be the reputation of the audit firm and the investment needed to enter such a market.

The Big Four audit firms favor a limitation of auditor liability using a combination of proportionality and absolute cap. Specifically, the Big Four seek a system of multiple caps that would vary depending on the characteristics of the audited company.

The mid-tier audit firms generally favor proportionate liability as an appropriate reform of auditor liability. In their view, the UK experience indicates that introducing proportionate liability by having it enshrined in statute would be preferable.

Tuesday, July 03, 2007

SEC Guides Funds on Applying FIN 48 to NAV Calculations

In a letter to three prominent fund families, SEC Chief Accountant Conrad Hewitt advised that accounting for tax positions should be performed in accordance with FIN 48 for all of a mutual fund’s net asset value (NAV) calculations. The letter was sent to Fidelity Investments, the Oppenheimer Funds, and Massachusetts Financial Services Company. Richard F. Sennett , Chief Accountant of the Division of Investment Management, also signed the letter. The SEC officials specifically noted that the guidance is limited to assessing tax positions reflected in NAV calculations subject to the Investment Company Act and should not be applied by analogy in other cases.

Noting that financial statements prepared in accordance with GAAP are prohibited from using FASB Statement No. 5 on accounting for contingencies for assessing tax positions, the chief accountant rejected the funds’ suggestion that they should not record a tax liability in NAV if no reduction is required by an analysis performed under FAS 5. The SEC officials believe that the accounting for tax positions should be performed in accordance with FIN 48 for all NAV calculations To do otherwise, they reasoned, could result in application of two different standards, a practice that not only would be confusing to investors but, more importantly, leave significant uncertainty as to the value of a fund share.

FIN 48 was written to clarify the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109 on accounting for income taxes. It requires a fund to determine whether a tax position, based on its technical merits, meets the more-likely-than-not recognition threshold that the position will be sustained upon examination. This determination is based on the individual facts and circumstances of that position evaluated in light of all available evidence.

Although FIN 48 was written to provide guidance on financial reporting, it does not address how tax positions should be accounted for in the calculation of NAV for purposes other than financial reporting, such as for shareholder transactions. FIN 48 challenges funds because they calculate NAVs much more frequently than they prepare financial statements, recognized the SEC, which is somewhat unique to the fund industry. For example, open-end funds generally calculate NAVs daily in order to effect transactions in their shares.

Monday, July 02, 2007

House Appropriations Bill Restricts SEC Enforcement of 404 Internal Controls

A provision in the House financial services appropriations bill (HR 2829) would, according to its sponsor Rep. Scott Garrett (R-NJ), extend the small business exemption from the internal control mandates of Section 404(a) of Sarbanes-Oxley through the end of FY 2008. Section 905 states that none of the funds made available under HR 2829 may be used by the SEC to enforce the requirements of section 404 of the Sarbanes-Oxley Act with respect to non-accelerated filers under section 210.2-02T of title 17, Code of Federal Regulations. The provision came by way of the Garrett amendment, which passed the House 267-154. The Financial Services Appropriations Act for Fiscal Year 2008 passed the House on June 28, 2007, and has been referred to the Senate Appropriations Committee.

Section 404(a) of the Act requires that annual reports filed with the SEC must be accompanied by a statement by company management that management is responsible for creating and maintaining adequate internal controls over financial reporting. Management must also present its assessment of the company’s intermal controls.
White Paper Issued on Tellabs Opinion

The requirement that investors in a private securities fraud action state facts that the defendants acted with a strong inference of scienter has been interpreted by the Supreme Court to mean that the fraud claim will survive only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference. This was the Court’s ruling on a provision of the Private Securities Litigation Reform Act (PSLRA) providing that plaintiffs must state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. Tellabs, Inc. v.Makor Issues & Rights, Ltd. (US S. Ct. 2007), Dkt. No. 06-484, FED. SEC. L. REP.¶94,335

My white paper on the opinion is available here

Sunday, July 01, 2007

Supreme Court Firmly Accepts Rule 10b-5 Private Right of Action

The US Supreme Court may never squarely decide if there is an implied private right of action under Rule 10b-5. I believe that the closest we have gotten to an affirmation of such an implied right of action is Justice Marshall’s statement in Herman & MacLean v. Huddleston (CCH Fed. Sec. L. Rep. ¶99,058) in 1983 that the existence of an implied private right of action under Rule 10b-5 is ``simply beyond peradventure.’’(that is a great phrase)

In an amicus brief filed with the Supreme Court in the Charter Communications case, a group of eminent law professors said that, when it passed the Private Securities Litigation Reform Act in 1995, with all of its procedural and substantive standards for private suits, Congress effectively made the private right of action explicit. I agree with that statement.

If I may be permitted to reason by analogy, I also believe that the recent Supreme Court ruling in the Tellabs case (CCH Fed. Sec. L. Rep. ¶94,335), with its intricate examination of how to plead a strong inference of scienter, demonstrates that the Court has essentially accepted the implied private right of action under Rule 10b-5. Scienter is a very critical element of Rule 10b-5. Unless the Court accepted that there is an implied private right of action under Rule 10b-5, it would be a futility to devote an entire opinion to how to state a strong inference of scienter in a private Rule 10b-5 action.

Further, and importantly, Justice Ginsburg begins the Tellabs opinion by stating that the Court has long recognized that meritorious private actions to enforce federal antifraud securities laws are an essential supplement to criminal prosecutions and civil enforcement actions brought by the DOJ and the SEC. In my view, this is a strong affirmation that there is an implied private right of action under Rule 10b-5.