Thursday, August 30, 2007

Buyers in Distressed Debt Market Not Subject to Equitable Subordination

In an opinion with broadly significant implications for secondary markets in distressed debt, including credit derivative swaps, a federal judge ruled that purchasers of distressed debt are protected from being subject to the personal disabilities of the sellers of that debt. This is an imperative principle in the distressed debt markets, said the court, where sellers are often anonymous and buyers of debt have no way of ascertaining if the seller has acted inequitably. No amount of due diligence will reveal that information, emphasized the court, and it is unclear how the market would price such unknowable risk. (Enron Corp. v. Springfield Associates, SD NY, Aug. 27, 2007, No. 01-16034).

The action arose during the Enron bankruptcy proceeding. Enron was a borrower under a credit agreement with a syndicate of banks, including Citibank. When Enron filed for bankruptcy, Citibank held a claim under the loan agreement. The banks transferred claims to other entities. One transferee acquired short-term debt from Citibank.

Enron sought equitable subordination of Citibank based on charges that the bank aided and abetted fraud and engaged in conspiracy with Enron insiders. Enron filed against the transferee-buyers for equitable subordination of their claims based on the misconduct of their transferor-sellers.

The Enron bankruptcy court accepted Enron’s argument, issuing a decision holding that improper conduct or receipt of an avoidable transfer by a prior holder of a claim taints the claim itself, rendering it worthless in the hands of a subsequent innocent purchaser

In an opinion with momentous implications for the functioning of the financial markets, the federal district judge vacated the bankruptcy’s court’s opinion. The court ruled that equitable subordination under the Bankruptcy Code could not be applied to claims held by transferees based on the alleged misconduct of the transferor. And here, said the court, there were no allegations of misconduct or inequitable actions by the transferees who purchased the distressed debt. Left standing, said the court, the bankruptcy court’s ruling threatened to wreak havoc on the markets for distressed debt.

Under the doctrine of equitable subordination, which the court called a drastic and unusual remedy, a bankruptcy court can subordinate a claim if it finds that the creditor’s claim resulted from the creditor’s inequitable behavior, such as fraud. The court held that equitable subordination is a personal disability of the claimant when a claim is sold and does not travel with the claim. It only travels with the claim if the claim is assigned.

Thus, the claim in the hands of transferee-buyers, be they hedge funds or other investors, is not subject to equitable subordination based on misconduct by the transferor. According to the court, this ruling should allay the concerns of the financial industry with the effects of the bankruptcy judge’s ruling on the markets for distressed debt. Equitable subordination arising out of the conduct of the transferee will not be applied to good faith open market purchasers of claims. This analysis, however, would not apply to bad faith purchasers or those with actual notice of the seller’s inequitable conduct.

According to an amicus brief filed by the financial industry, the bankruptcy court’s ruling would have inflicted significant damage on three segments of the financial markets: trading in loans, trading in physically settled credit derivatives; and trading in bonds. A credit derivative swap is essentially a risk transfer under which the holder of a bond, in exchange for a purchase price may obtain the right to be paid in full on the bond even if the obligor on the bond defaults.

The joint amicus brief was submitted by the Loan Syndications and Trading Association, the Securities Industry and Financial Markets Association, and the International Swaps and Derivatives Association, all leading financial industry trade associations.

Elliot Ganz, the General Counsel of the LSTA, noted that Judge Scheindlin’s opinion is a tremendous victory for the entire market. The decision lifts a horrible cloud that hung over every purchase and sale of debt in the secondary market, he emphasized, a cloud that threatened to choke off these otherwise vibrant markets.

Wednesday, August 29, 2007

SEC Staff Notes GLB Privacy Concerns with Fund Shareholder Data

In a letter to the Investment Company Institute, SEC staff reminded the industry that a fund’s use or disclosure of rule 22c-2 information for marketing purposes is prohibited under the Gramm-Leach-Bliley Act's privacy rules, unless consumers have been given notice and the opportunity to opt out of this information sharing. The letter, signed by Associate Director Robert Plaze, was prompted by a recent article in the financial press suggesting that funds may use for marketing purposes the shareholder identity and trading information they receive from intermediaries under rule 22c-2.

Rule 22c-2 under the Investment Company Act requires funds to enter into written agreements with their financial intermediaries, including those holding shares through omnibus accounts, under which the intermediaries must agree to provide funds with shareholder identity and transaction information upon request. Under the rule, funds must be able to request and promptly receive shareholder identity and transaction information pursuant to these agreements by October 16, 2007.

Use of this shareholder identity and transaction information for marketing purposes is covered by the privacy provisions of Gramm-Leach-Bliley, which require that investment companies provide consumers with notice and an opportunity to opt out before they are permitted to share their private personal information with non-affiliated third parties. The SEC has said that these disclosures are within the scope of the privacy rules exceptions for processing and servicing transactions at the consumers' request and complying with applicable legal requirements.

This position has two practical consequences, said Mr. Plaze. First, most intermediaries will not have to change their privacy or opt out notices in order to comply with rule 22c-2. The official explained that this is because the privacy rules permit information sharing under the exceptions if financial institutions include in their privacy notices a statement that they make disclosures to other non-affiliated third parties as permitted by law.

Second, it means that funds receiving rule 22c-2 information under the exceptions
are permitted to use or redisclose this information only for purposes of the exception, which does not include marketing purposes, unless permitted under the intermediary's privacy policy. This is because the privacy rules limit the redisclosure and reuse of information received under an exception to the purposes for which the information was received. The privacy rules also contain an example prohibiting the use of information received under the relevant exceptions for marketing purposes.

Thus, unless the intermediaries' privacy policies disclose this information sharing and the consumer has not opted out, investment companies are prohibited from using rule 22c-2 information for marketing purposes under the privacy rules' general. restrictions on sharing nonpublic personal information with nonaffiliated third parties.
Fifth Circuit Post-Tellabs Ruling Says Sarbanes-Oxley Certification Not Inference of Scienter

Interpreting the US Supreme Court’s recent ruling on how to plead scienter in a securities fraud class action, a Fifth Circuit panel rejected a reading that would allow the drawing of a strong inference of scienter from the fact that the senior executive and financial officers signed a Sarbanes-Oxley Section 302 certification. Investors were unable to explain the link between the certification statement that the signing officers designed effective internal controls and the actual accounting and reporting problems. (Central Laborers’ Pension Fund v. Integrated Electrical Services, Inc., CA-5, No.06-20135, Aug. 21, 2007).

Investors filed a securities fraud class action against the company, its CEO, and two CFOs who served at different times. They alleged that a number of false statements by the company regarding its financial condition caused an artificial inflation in the market price of the company’s securities. Under Section 302, the senior executive and financial officers have to sign the certification.

In Tellabs, the Supreme Court said that investors in a private securities fraud action must state facts that the defendants acted with a strong inference of scienter, which means 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. (Tellabs, Inc. v. Makor Issues & Rights, Ltd., Dkt. No. 06-484, FSLR ¶94,335.).

The appeals court rejected a reading of Tellabs that would allow a strong inference of scienter from the Sarbanes-Oxley certification alone. If this interpretation were accepted, reasoned the court, scienter would be established in every case where there was an accounting error or auditing mistake made by a publicly traded company, thereby eviscerating the pleading requirements for scienter set forth in the Private Securities Litigation Reform Act.

An inference of fraud might be proper in a Sarbanes-Oxley certification if the person signing the certification had reason to know, or should have suspected, due to the presence of glaring accounting irregularities or other red flags, that the financial statements contained material misstatements or omissions. But such was not the case here, said the court, and thus the certifications at issue did not allow an inference of scienter.

Monday, August 27, 2007

Externalizing Rule 12b-1 Fees Debated

According to a recently released transcript of the SEC’s roundtable on Rule 12b-1 fees, Richard Phillips of Kirkpatrick & Lockhart Preston Gates Ellis expressed strong support for externalizing such fees. Importantly, externalization would eliminate what Mr. Phillips believes is the most persistent and misguided criticism of the fund industry, namely that some very sophisticated observers do not seem to understand that 12b-1 fees are really largely a substitute for the front-end load. They condemn it as a hidden subsidy, a view that Mr. Phillips called misguided.

In his view, externalization would provide dollars and cents disclosure at the point of sale and the confirmation, and in account statements; and shareholders would know what they were paying for. Another benefit of externalization would be that directors would not have the duty of determining if a charge is reasonable, which duty makes them uncomfortable. It would also reduce complexity.

While the Kirkpatrick partner believes that the fund industry would be much better off with externalization, he acknowledged that there would be costs, Systems would have to be changed to accommodate each shareholder account. But he added that the fund industry is very sophisticated technologically and could handle it.

In a recent letter to the SEC, the Investment Company Institute raised strong objections to suggestions raised at the roundtable to externalize the fee, assessing it at the individual account level rather than deducting it from fund assets. Proponents have argued that an account level charge would make the fee more transparent and allow investors to more easily make price comparisons, said the ICI, which countered that externalization would increase investors' tax costs, reduce the tax efficiency of funds, and require extensive overhaul of fund operating and recordkeeping systems.

Thursday, August 23, 2007

Int'l Business Groups Urge Supreme Court to Reject Scheme Liability

In a very interesting brief, a consortium of international business organizations has urged the US Supreme Court to reject scheme liability for non-speaking secondary actors in private securities fraud actions. From the perspective of foreign companies in particular, said the brief, scheme liability is unworkable and would convert foreign companies in overseas transactions with U.S. entities into de facto auditors of their U.S-listed counterparty’s financial statements. In turn, the imposition of scheme liability would have a material chilling effect on the willingness of foreign companies to engage in general commercial transactions with US public companies.

More broadly, the brief, citing the German press, notes that scheme liability endangers transatlantic economic relations because it could be at odds with the spirit of the April 2007 U.S.-E.U. Economic Summit at which the parties agreed to work towards the harmonization of the regulatory environment for financial markets. The brief was filed by, among others, the International Chamber of Commerce and the Confederation of German Industries.

According to the international groups, scheme liability would inject into the United State’s carefully considered securities law enforcement system an unpredictable and potentially arbitrary mechanism for determining liability. Moreover, that mechanism would be placed in the hands of the class action bar, not the SEC. In the consortium’s view, that combination creates precisely the litigation risk that discourages foreign companies from doing business in the United States.

The brief posits that foreign companies are particularly ill-suited to this gatekeeper role. The legal structures in the world’s other major financial centers do not impose such illogical burdens.

For example, the UK Financial Services and Markets Act contains provisions akin to
Section 10(b) that impose civil liability for misleading statements made in financial statements. Under these provisions, issuers, as well as directors or other persons discharging managerial duties in relation to such issuers, may be liable for any false or misleading statements. But liability is not imposed by statute or regulation on third parties that enter into transactions with the issuer which the issuer then misreports.

Similarly, the German Securities Trading Act limits liability for misstatements to the issuer and, potentially, its directors and officers. But the Act does not provide for claims against silent third-parties to commercial transactions that the issuer misreports.

Tuesday, August 21, 2007

Solicitor General Says Scheme Liability Counter to Congressional Intent

The US Solicitor General has urged the Supreme Court to reject scheme liability for non-speaking secondary actors in private securities fraud actions since such an expansion of liability would upset the delicate balance Congress has crafted. In its brief, the government argued that scheme liability runs counter to the congressional balance between exposure to private actions for aiding and abetting and empowering the SEC alone to pursue secondary claims against non-speaking actors, such as lawyers and accountants.

At the same time, the Solicitor General maintained that non-verbal conduct by secondary actors can constitute deception within the meaning of Rule 10b-5. But in this particular case, although deception could be alleged, the investors did not really on any conduct by the non-speaking vendor.

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 defendants in the Stoneridge case.

In urging the Court to reject scheme liability, the Solicitor General said that allowing liability for a primary violation against a non-speaking vendor when the investors did not even allege that they were aware of the transactions that the vendors executed with the company would be a sweeping expansion of judicially implied private actions that could expose accountants and lawyers who advise issuers, as well as vendors far removed from the market, to potentially billions of dollars in liability when issuers make misstatements to the market.

Moreover, in the government’s view, scheme liability would considerably widen the pool of deep-pocketed defendants that could be sued for an issuer’s misrepresentations, increasing the likelihood that the private right of action would be employed abusively. This radical expansion of liability is a task for Congress, noted the brief, not the courts.

In this case, the parties allegedly backdated transactions as part of a scheme to inflate the issuer’s operating cash flow in the financial statements. While this alleged conduct could constitute a deception under Rule 10b-5, observed the brief, it could be no more than aiding and abetting since the investor alleged no reliance on the vendors’ alleged deceptive conduct. The investor relied only on the issuer’s alleged misstatements. According to the Solicitor General, secondary actors cannot be held liable in a private securities action by virtue of an investor’s reliance on misstatements made only by the company.

Moreover, the SG emphasized that the principle at the heart of the distinction between primary liability and secondary liability of the kind rejected in Central Bank is that words or actions by a secondary actor that facilitate an issuer’s misstatement, but are not themselves communicated to investors, cannot give rise to reliance, and thus primary liability in a private action.

More broadly, the brief contended that the issue has international repercussions. Extending liability to vendors, said the brief, could effectively and substantially expand liability for foreign companies that trade with publicly-listed companies.

Thursday, August 16, 2007

Former SEC Chairs Pitt and Hills Urge Supreme Court to Reject Scheme Liability

Former SEC Chairs Harvey Pitt, Rod Hills, and Harold Williams, along with a plethora of former Commissioners, have filed a brief urging the Supreme Court to reject scheme liability for non-speaking secondary actors in private securities fraud actions. The former SEC officials call scheme liability a semantic ploy designed to recast secondary conduct as a primary violation of Rule 10b-5 in order to get around the Court’s ruling in the Central Bank case that there is no private right of action against secondary actors who aid and abet securities fraud.

The former chairs warned that the approval of scheme liability would inject confusion into Rule 10b-5 actions since not even the proponents of scheme liability can consistently define this amorphous concept. They further contend that scheme liability exposes those engaging in commercial transactions with public companies to disproportionate damages orders of magnitude greater than the size of the transaction alleged to give rise to the liability.

Among former SEC Commissioners who joined the three chairs on the brief were Joseph Grundfest, Richard Roberts, Aulana Peters, Edward Fleischman, Stephen Friedman, Issac Hunt, and Laura Unger. Former SEC General Counsels James Doty and Simon Lorne also joined the effort.

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 defendants in the Stoneridge case.

Interpreting the 1994 Central Bank opinion, the former chairs said that scheme liability involves secondary conduct within the meaning of the Court’s opinion; and that mere knowing participation in another’s alleged fraud is not enough for liability to attach. Moreover, they maintain that Congress has sanctioned this approach since in the 1995 Private Securities Litigation Reform Act it specifically gave the SEC enforcement power against secondary actors who aid and abet securities fraud.

Since Congress expressly refrained form similarly empowering private investors, reasoned the former SEC chairs, the Court should not do by fiat what Congress declined to do by statute. The amici concluded that Central Bank and the congressional reaction to it clarify that the antifraud rule does not encompass scheme liability. More broadly, they emphasized that the implied private right of action under Rule 10b-5 is a judicial creation; and that the days of judicially implied private actions are ``long past.’’ Moreover, the Court has recognized that an expansive reading of the implied right is susceptible to abuse.

Wednesday, August 15, 2007

Former SEC Chairs Urge Supreme Court to Approve Scheme Liability

Former SEC Chairs William Donaldson and Arthur Levitt 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. Former SEC Commissioner Harvey Goldschmid also joined them on the brief.

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.

Calling the action one of the most important securities cases to be heard by the Supreme Court in many years, the former SEC senior officials said it is critical to the antifraud purposes of the federal securities laws that actors, other than issuers and their officers and directors, who actively engage in deceptive conduct for the purpose and with the effect of creating a false statement of material fact in the disclosure of a public company continue
to be held liable in private securities fraud actions.

In their view, the Court’s reaffirmation of liability for actors, such as investment banks and accounting firms, that actively engage in deceptive conduct as part of a fraudulent scheme will have a profound effect on the deterrence of fraud and the ability of investors to recover their losses.

On the other hand, the rejection of fraudulent scheme liability would make invulnerable those who purposely engage in deception and immunizes non-issuers who commit securities fraud from private liability merely because they were cunning enough to avoid making a public statement.

The former SEC officials pointed out that the Commission’s traditional position has been that a person may commit a manipulative or deceptive act constituting a primary violation of the antifraud rule without making a public statement. The SEC consistently has expressed this position through rulemaking, amicus briefs, and enforcement actions.

Monday, August 13, 2007

Market Discipline Key to Hedge Fund Regulation as SEC Shifts Gears

The SEC should not divert agency oversight resources from areas where retail investor assets are concentrated to the regulation of hedge funds whose investors have either the financial acumen or wherewithal to look out for themselves or to hire someone else to do so for them, said Commissioner Paul Atkins in remarks at the Chicago Federal Reserve Bank. Hedge fund investors can likely afford to bear a loss if they or their adviser makes a poor decision, he continued, since they are not betting their last dollar on a hedge fund manager. Further, if things go wrong, they have the means to take effective steps on their own, including private actions and reporting malfeasance to the proper authorities. His remarks are part of a growing SEC-FED consensus that market discipline, not direct regulation, is the key to the proper oversight of hedge funds.

The suggestion that hedge funds were drawing increasing numbers of retail investors is overblown, in his view, and is not supported by the staff report that preceded the adoption of the SEC rule requiring hedge fund advisers to register. He recognized that there are also worries about retail investors' indirect exposure to hedge funds through their pension funds; a fear shared by congressional leaders. However, he emphasized that retail investors with such indirect exposure to hedge funds are protected by a sophisticated intermediary who makes the investment decisions.

After the SEC mandatory hedge fund adviser registration rule was cut short by the D.C. Circuit Court of Appeals last year, the Commission decided to take an entirely different approach to unregistered funds. Mr. Atkins detailed a number of different threads making up this approach. For example, the SEC is intensifying its cooperation with other regulators, including the Federal Reserve Board, on issues of systemic risk and information collection. Unregistered funds are undeniably significant players in the capital markets, acknowledged Comm. Atkins, and regulators need to monitor systemic risk.

In his view, the restrained regulatory approach of relying on market discipline enunciated after the LTCM debacle has recently been affirmed as the market continues to demonstrate a capacity to minimize and absorb systemic risk. In this regard, the commissioner agrees with Fed chair Ben Bernanke that the market discipline approach has the added advantage of avoiding the moral hazard that could result from closer regulatory involvement, which in turn would inspire private counterparties of hedge funds to do less.

Another step the SEC has taken since the hedge fund registration rule was judicially overturned is a proposal to raise the threshold for investors in private pools of capital. The proposal would create a new category of accredited investor for private investment pools that would include anyone who satisfies the existing $1,000,000 net worth or the $200,000 net income test and owns at least $2.5 million in investments, which would exclude the person's home. The new investment minimum would be adjusted for inflation every five years. Essentially, the proposed rule would layer an additional requirement on top of the existing accredited investor requirements for Section (3)(c)(1) funds. Section (3)(c)(7) funds would not be affected since investors in those funds already are similarly subject to a two-part investment test.

The commissioner worries about how the new threshold will affect newly established advisors without much of a track record. These advisors will have to try to attract capital from what may prove to be a very small pool of potential investors, he fears. Thus, if adopted, the rule could prove to be a significant barrier to entry for new advisors.

Indeed, the SEC is continuing to look at whether the proposal got the accreditation levels right. He noted that the Commission will solicit additional comment in connection with a forthcoming proposal to amend Regulation D, a series of rules that apply to private placements. Soliciting comment in connection with the proposed changes to Regulation D should help the SEC work towards greater uniformity of approach across its rule book.

Friday, August 10, 2007

Dodd-Shelby Provision Gives SEC-PCAOB Time to Reform Internal Controls

A provision in the American COMPETES Act (PL 110-69) inserted by Senators Christopher Dodd and Richard Shelby would give the SEC and PCAOB more time, but not unlimited time, to reform the internal control reporting mandates under section 404 of the Sarbanes-Oxley Act. Specifically, section 8002 of the Act expresses the sense of Congress that the SEC and PCAOB should implement the section 404 mandates in a manner that limits the burdens placed on small and mid-size public companies. The act was passed by Congress and signed into law on August 9, 2007.

In section 8002, said Sen. Dodd, Congress makes a strong statement in two respects. First, that Congress will continue to protect investors in public companies; and second, that it supports efforts currently underway to ensure that small and mid-size businesses are not unduly burdened by rules intended to protect investors.

Sen. Dodd praised the deliberative process of rulemaking and standard-setting conducted by the SEC and PCAOB in reforming the internal control mandates of section 404 and commended the SEC for responding very well to the concerns about the section 404 requirements, particularly the smaller public companies.

Similarly, Sen. Shelby observed that the SEC’s management guidance and new PCAOB standard AS5 are mutually reinforceable and should significantly improve the implementation of section 404, making it more efficient and effective for small and medium-sized businesses.
Sen. Dodd does not believe that Sarbanes-Oxley should be opened up to an amendment at this time. Indeed, he believes that it would be irresponsible for Congress at this juncture to jump in and greatly reduce the number of companies that would have to comply with section 404.

The SEC must be allowed to do its job, he emphasized. If the Commission does not do the job, he continued, and the burdens of section 404 still exist, the senator would welcome an opportunity to address that. In his view, the provision sends a message to the SEC and the PCAOB that Congress is watching what they do very carefully.

While Sen. Shelby is willing to give the SEC and PCAOB additional time to fix the problem, he is not willing to give them unlimited time. He said that the Banking Committee will monitor closely their progress in this matter.

Thursday, August 09, 2007

SEC Issues Updated FAQ on Auditor Independence

The Office of the Chief Accountant has updated its responses to frequently asked questions about auditor independence. The updates cover areas related to financial relationships, prohibited and nonaudit services, audit committee preapproval, fee disclosures and the cooling off period. These are important new FAQs on the crucial issue of outside auditor independence.
The SEC staff said that an audit committee of the plan sponsor of an employee benefit plan does not have to pre-approve the audit of the plan.

The SEC's independence rules require pre-approval of services provided to the issuer and the issuer's subsidiaries, but not pre-approval of services provided to other affiliates of the issuer that are not subsidiaries. But audit committees are required to pre-approve services provided by the issuer's principal accountant to variable interest entities consolidated under FASB Interpretation No. 46.

FASB Interpretation No. 46 introduced a new set of criteria for addressing when companies need to consolidate variable interest entities. The staff said that auditors of the parent financial statements must be independent of entities consolidated solely due to the application of the interpretation.

Wednesday, August 08, 2007

Seventh Circuit Panel Interprets Supreme Court Tellabs Opinion

A Seventh Circuit appeals panel has rendered one of the first interpretations of the recent US Supreme Court opinion in Tellabs, Inc. v. Makor Issues and Rights, Ltd. No. 06-484, June 21, 2007. The case involved a securities fraud claim against a company that had to restate financial results in order to correct errors created by fraud at its Brazilian subsidiary.

In an opinion by Chief Judge Easterbrook, the court said that Tellabs stands for two propositions relevant to this case. First, a complaint will survive a motion to dismiss only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged. Second, in applying this standard, the court must take into account plausible opposing inferences.

One upshot of the Tellabs approach is that the panel was forced to discount allegations that the complaint attributed to five confidential witnesses, three of whom were former corporate employees. It is hard to see, reasoned the panel, how information from anonymous sources could be deemed compelling or how the court could take account of plausible opposing inferences. Perhaps these confidential sources have axes to grind, suggested the panel, or perhaps they are lying.

Anonymity frustrates the Tellabs requirement that courts weigh the strength of plaintiffs’ favored inference in comparison to other possible inferences. But notice that the court said that it would discount allegations from confidential witnesses, not ignore them. However, the panel said that the discount will usually be steep.

The court also noted that a complaint passes muster under Tellabs only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged, which the panel described as a higher standard than probable cause.

Tuesday, August 07, 2007

Cox Tells Advisory Committee Financial Reporting Overly Complex

At the first meeting of the Advisory Committee on Improvements to Financial Reporting, SEC Chairman Christopher Cox opined that financial reporting has become overly complex. He emphasized that financial statements are difficult for investors to understand and that companies incur excessive costs in complying with voluminous and overly prescriptive accounting and reporting rules.

He charged the committee with helping end what the chair called a ``destructive cycle’’ and get the financial reporting system back to first principles. The advisory panel must help the SEC reduce complexity and its costly burdens. When it comes to financial statements, he continued, most investors today probably feel the way Mark Twain did when he said, "The more you explain it, the more I don't understand it."

When it comes to giving investors the protection they need, he noted, information is the single most powerful tool in investor protection. In his view, the SEC will be unable to say that the goal of investor protection has been achieved until the information provided in financial statements is clearly understandable to average investors. Empowering investors does not just mean better access to information, he observed, it also means access to better information. Simply put, once SEC-mandated information is available, it must be understandable.

The SEC looks forward to the committee’s specific recommendations on how unnecessary complexity in the financial reporting system can be reduced and how the system can be made more useful to investors. In this regard, the committee is mandated to focus on the current approach to setting financial accounting and reporting standards and the current process of regulating compliance with those standards. In addition, the advisory panel will examine the factors that may drive unnecessary complexity and reduce transparency, as well as any lessons that can be learned from the growing use of international accounting standards.

Sunday, August 05, 2007

EU Moves Towards Director Independence

A European Commission report on the role of independent directors indicates movement towards stronger corporate governance in the EU based on earlier Commission recommendations. The Commission found widespread adherence to voluntary corporate governance codes on a comply or explain basis. In most of the EU, companies must comply with the independent director provisions of the code or explain why they did not comply.

A number of EU countries, such as Germany and the Netherlands, mandate a two-tier board structure under which the supervisory board is equivalent to the US board of directors and the executive board is composed of the CEO and the senior management team. The Commission recommended there be a sufficient number of independent directors on the supervisory board and that there be a cooling off period before a former CEO is named to the supervisory board.

The report said that all EU states now require or recommend the presence of independent directors on supervisory boards, but that different definitions of independence make standards uneven. In addition, the requirement of independence from the controlling shareholder has not been fully endorsed across the EU. For example, the absence of close links with the controlling shareholder is not recommended at all in Germany.

The Commission finds this problematic since independent directors have a role to play in companies where a controlling shareholder may exert strong control over management. In such cases, conflicts of interest may arise between the majority and minority shareholders, reasoned the Commission, and independence from the controlling shareholder may be an efficient way of alleviating such conflicts.

The Commission also recommended the creation of independent audit, nomination and remuneration committees. The Eighth Company Law Directive will require the creation of audit committees by June 30, 2008.

While the majority of states presently require the creation of such committees, the report revealed that a number of corporate governance codes no not recommend the strong presence of independent directors on audit and remuneration committees.

The creation of a remuneration committee is generally required on a comply or explain basis. In Germany, the creation of such a committee is recommended only and deviations from this rule need not be explained to the public.

About half of the EU has followed the Commission’s recommendation on the basic functions of board committees. The most important shortcoming is the absence of any provision regarding the responsibility for the audit committee in reviewing the effectiveness of the internal controls of the company.

Thursday, August 02, 2007

SEC Names Members to Advisory Committee on Financial Reporting

Former SEC Commissioner Joseph Grundfest and former Federal Reserve Board Governor Susan Bies have been named to the SEC Advisory Committee on Improvements to Financial Reporting. Other committee members named will each represent key constituencies in the capital markets. The advisory committee, established last month, has been instructed to make recommendations to the Commission that will increase transparency and reduce the costs of preparing and analyzing financial reports. SEC Chairman Christopher Cox has also named PCAOB Chair Mark Olson and FASB Chair Robert Herz as official observers to the advisory committee, which is chaired by Robert Pozen of MFS Investment Management.

As part of its mandate, the committee will focus on current systems for delivering and accessing financial information. The advisory group will also examine the impact of the growing use of international accounting standards. As part of its consideration of these areas, the advisory committee will focus on how technology can help address accounting complexity by making financial information more useful to a greater number of investors.

The advisory panel must also examine the current approach to setting financial accounting and reporting standards, including principles-based vs. rules-based standards. Moreover, as part of this aspect, the committee must determine if there is a hesitation on the part of professionals to exercise judgment in the absence of detailed rules. Finally, the group will decide to what extent financial reporting standards should include bright lines and safe harbors.

At the committee's first meeting today, member, and UGA professor, Dennis Beresford noted that complexity is a much more long-term problem than what the committee can resolve in a year. Beresford also believes that MD&A, while burdened with excessive legalisms and boilerplate, still provides a lot of meaningful information.