Wednesday, September 26, 2007

COSO Emphasizes Tone at the Top and Outside Auditors in Monitoring Internal Controls

COSO has proposed guidance on monitoring internal controls that relies heavily on tone at the top and risk assessment, as well as having a role for the outside auditors of the company’s financial statements. The board and its audit committee also have key roles to play in the effective monitoring of internal controls. According to COSO, monitoring is an integral part of internal control over financial reporting. Further, it is important that internal control be viewed as a continuous process and that effective monitoring be implemented as a component of that process.

The COSO guidance comes against the backdrop of a new SEC-PCAOB initiative to significantly revise the internal control reporting mandates of Section 404 of Sarbanes-Oxley. COSO, the sponsoring organizations of the Treadway Commission, supports the PCAOB’s new risk-based internal control audit standard, AS5 and finds that its focus on a top down risk-based approach is consistent with COSO’s own internal control framework. However, COSO is concerned that many companies have not fully integrated the monitoring component of its internal control framework into their overall control structures.

According to COSO, a primary element of monitoring is the control environment in which monitoring operates. This aspect requires a proper tone at the top regarding the importance of internal controls and monitoring, as well as an organizational structure that places evaluators with appropriate skills and authority in monitoring roles.

Another critical element is to devote monitoring resources commensurate with the underlying level of risk. It is the job of management to specify financial reporting objectives with sufficient clarity to enable the identification of risks to reliable financial reporting. Regarding financial reporting risks, management identifies risks to the achievement of financial reporting objectives as a basis for determining how the risks should be managed. With respect to fraud risk, said COSO, the potential for material misstatement due to fraud is explicitly considered in assessing risks to the achievement of financial reporting objectives.

A third key element to effective monitoring is the company’s communication structure and the ability to report results of monitoring, including control weaknesses, to the right people in a timely manner. The results of monitoring should be reported to management in a reasonable time frame. To whom and how often the general results of monitoring are reported depends on the level of risk and the importance of the related controls.

In COSO’s view, controls performed below the senior-management level can be monitored by management personnel. However, controls performed directly by senior management, and controls designed to prevent or detect senior-management override of other controls, cannot be monitored objectively by senior management. In these circumstances, noted COSO, monitoring should be performed by the audit committee.

The board is also in the best position to evaluate whether management has implemented
effective monitoring procedures elsewhere in the organization. It makes this assessment by gaining an understanding of how senior management has met its responsibilities. In most organizations, it is neither feasible nor necessary for the board to understand all of the details of every monitoring procedure, but the board should have a reasonable basis for concluding that management has implemented an effective monitoring system.

COSO expects directors to obtain persuasive information in support of their conclusions through inquiry of management; the internal audit function, hired specialists, and external auditors. The board’s consideration of the external auditor’s results is an important issue.

Auditors must maintain their objectivity in both fact and appearance, and, as such, they are not part of an audit client’s internal control system. However, an organization that does not appropriately consider the results of the external auditor’s work would have a weakness in its monitoring procedures.

If the external auditor’s work identifies possible errors or control weaknesses, the company should consider those results in the context of its own monitoring. However, neither management nor the board should plan to reduce its monitoring efforts in other areas simply because the auditor did not find errors or control weaknesses.

Wednesday, September 19, 2007

Grant of Spring-Loaded Options May Be Beyond Bounds of Business Judgment Rule

By James Hamilton, J.D., LL.M.

Spring-loaded stock options granted to key company directors and executives by independent directors may not have been granted consistent with a fiduciary’s duty of utmost loyalty, ruled the Delaware Chancellor, since it could reasonably be inferred that the board of directors later concealed the true nature of the options grant. (In re Tyson Foods Inc. Consolidated Shareholders Litigation, Del. Chan. Ct. Aug 15, 2007).

More broadly, Chancellor Chandler explained that directors should not take a seat at the board table prepared to offer only conditional loyalty, tolerable good faith, reasonable disinterest or formalistic candor. It is against these standards, and in this spirit, that alleged actions of spring-loading or backdating should be judged.

On three separate occasions, the directors suspected that the share price would climb once the market learned what the board already knew. Armed with this knowledge, members of the compensation committee granted non-qualified stock options to select employees, ensuring that these options would shortly be in the money. When the option grants were later revealed to shareholders, however, the outside directors did not straightforwardly describe such strike-price prestidigitation. Rather, they provided minimal assurances to investors that these options rested within the limits of the shareholder-approved plan. A scheme that relies upon bare formalism concealed by a poverty of communication, said the court, does not sit within the scope of reasonable, good faith business judgment.

Against this backdrop, the court noted that executive compensation is not a realm in which less than forthright disclosure somehow provides a company with an advantage with respect to competitors. Thus, when directors speak out about their own compensation or that of management, shareholders have a right to the full, unvarnished truth. Sophism and guile on this subject does not serve shareholder interests. When directors seek shareholder consent to a stock incentive plan, or any other quasi-contractual arrangement, emphasized the Chancellor, they do not do so in the manner of a devil in a dime-store novel, hoping to set a trap with a particular pattern of words.

The conclusion that a grant of spring-loading options may not be an exercise of a good faith fiduciary rests upon at least two premises, said the court, each of which should be alleged by a plaintiff in order to show that a spring-loaded option issued by an independent board is nevertheless beyond the bounds of business judgment.

First, it must be alleged that the options were issued according to a shareholder-approved employee compensation plan. The second allegation is that the directors that approved spring-loaded options possessed material inside information soon to be released that would impact the company’s share price, and issued those options with the intent to circumvent otherwise valid shareholder-approved restrictions upon the exercise price of the options.

SEC Adopts Gramm-Leach-Bliley Bank Broker Exception Rules

By James Hamilton, J.D., LL.M.

Ending eight years of stalled negotiations and impasse, the SEC today voted to adopt, jointly with the FED, new rules that will finally implement the bank broker provisions of the Gramm-Leach-Bliley Act of 1999. The FED will consider these final rules at its Sept. 24, 2007 meeting.

The rulemaking process that culminated in the Commission's vote of final approval has been an arduous one. After a series of interim proposals and regulatory actions that proved mostly fruitless between 1999 and 2005, the SEC made a fresh start 18 months ago. Congress also helped end the logjam by directing the SEC to work with the FED to promulgate joint regulations to fully implement the functional regulation vision of the Gramm-Leach-Bliley Act. The Financial Services Regulatory Relief Act was designed to ensure that regulators did not create a new and burdensome maze of requirements that would disrupt or interfere with the business practices of banks that offer traditional bank products and services

The Gramm-Leach-Bliley Act repealed the blanket exemption banks had historically enjoyed from the Exchange Act definition of broker and replaced it with a set of limited exemptions that allow the continuation of some traditional activities performed by banks. Thus, a bank will be considered a broker under the Exchange Act and subject to the full panoply of SEC regulation if it engages in the business of effecting transactions in securities for the accounts of others. However, at the same time, the Act carves out a number of exemptions from the definition of broker.

The joint SEC-FED rules are designed to implement GLB’s removal of the blanket exemption from SEC registration for banks that engage in securities activities. The exemptions embrace a number of activities and transactions traditionally performed by banks and those involving identified excepted banking products. If a bank limits its brokerage activities to those described in the exceptions, the bank will not be subject to broker-dealer registration.

Under the new rules, a networking exception will allow banks to receive compensation for referring bank customers to broker-dealers. The trust and fiduciary activities exception will permit a bank to effect securities transactions in a trustee or fiduciary capacity if it is chiefly compensated for those transactions, consistent with fiduciary principles and standards, on the basis of specifically enumerated types of fees. The rules establish a test to determine how a bank is chiefly compensated, and permit a bank to choose either an account-by-account or bank-wide approach.

The sweep accounts exception permits a bank to sweep deposits into no-load, money market funds. The rules define terms used in the sweep accounts. The safekeeping and custody exception permits banks to perform specified services in connection with safekeeping and custody of securities. Under the exemption, banks can take orders for securities transactions from employee benefit plan accounts and individual retirement and similar accounts for which the bank acts as a custodian, as well as from other safekeeping and custody accounts on an accommodation basis.

The rules include an exemption that permits banks to effect certain transactions in mutual funds and in certain variable insurance products that are registered, and funded by a separate account. Moreover, there is an exemption to permit a bank to effect a transaction in the securities of a company directly with a transfer agent acting for the company as long as certain conditions are met, including that no commission may be charged with respect to the transaction and the transaction must be conducted solely for the benefit of an employee benefit plan.

Tuesday, September 18, 2007

Senate Bill Would Close Enron Loophole in Wake of Hedge Fund Collapse

By James Hamilton, J.D., LL.M.

Senator Carl Levin has introduced a bill closing the so-called ``Enron loophole’’ and restoring the CFTC’s ability to police all U.S. energy exchanges to prevent price manipulation and excessive speculation. In particular, S. 2058 would restore CFTC oversight of large-trader energy exchanges that were exempted from regulation by the Commodity Futures Modernization Act of 2000 by means of the ``Enron loophole,’’ which was, at the request of Enron and others, inserted into the Act at the last minute during a Senate-House conference.

This loophole exempted from federal regulation the electronic trading of energy commodities by large traders The Levin bill would require the CFTC to oversee these facilities in the same manner and according to the same standards that currently apply to futures exchanges like NYMEX.

The genesis of the bill is an earlier Senate report on the collapse of a hedge fund that dominated the natural gas market because the ``Enron Loophole’’ in federal commodities law exempted electronic energy exchanges from CFTC regulation. Indeed, Sen. Levin believes that current federal commodity laws are riddled with exemptions and limitations, making it virtually impossible for regulators to police U.S. energy markets.

The Commodity Futures Modernization Act’s exemption for electronic energy exchanges left NYMEX both self-regulated and regulated by the CFTC, while at the same time leaving ICE not required to be self-regulated and not regulated by the CFTC. The Senate report found that ICE's exemption from regulation undermined the effectiveness and market integrity of both ICE and NYMEX in pricing U.S. energy commodities.

The natural gas market entered a period of extreme price volatility punctuated by the collapse in September 2006 of Amaranth Advisors LLC, one of the largest hedge funds in that market. The report concluded that the current regulatory system was unable to prevent the hedge fund’s excessive speculation in the 2006 natural gas market. Under current law, NYMEX is required to monitor the positions of its traders to determine whether a trader's positions are too large.

If a trader's position exceeds pre-set accountability levels, the exchange may require a trader to reduce its positions. According to the report, the Amaranth case demonstrates two critical flaws in current regulation. First, NYMEX has no routine access to information about a trader's positions on ICE in determining whether a trader's positions are too large. It is therefore impossible under the current system for NYMEX to have a complete and accurate view of a trader's position in determining whether it is too large.

Second, even if NYMEX orders a trader to reduce its positions on NYMEX, the trader can simply shift its positions to ICE where no limits apply, which is precisely what Amaranth did after NYMEX finally told the hedge fund to reduce its positions in two contracts nearing expiration. Unlike NYMEX, there are no limits on the trading on ICE, and no routine government oversight.

McCreevy Urges Approval of International Accounting Standard on Segment Reporting

By James Hamilton, J.D., LL.M.

IFRS 8, the international financial reporting standard for segment reporting, would have a positive effect on financial statements and should be quickly approved, said EU Commissioner for the Internal Market Charlie McCreevy in remarks to the European Parliament. IFRS 8 was adopted by the IASB as part of the Board’s joint convergence project with FASB. IFRS 8 adopts the management approach to segment reporting that is embodied in FASB Standard No. 131.

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

Referencing a recent Commission report, Mr. McCreevy said that the use of the management approach in IFRS 8 has an overall positive effect on the quality of segment information, whose usefulness and relevance would increase, which, in turn, will outweigh concerns expressed about the comparability of financial reports. IFRS 8 appropriately addresses the global needs of users of financial statements for geographical disclosures and, in practice, would not reduce this information by comparison with the old standard IAS 14.

The commissioner also emphasized that IFRS 8 does not create problems relating to corporate governance in the EU. The standard would also provide appropriate segment reporting rules for smaller listed companies. It is in the interest of smaller listed companies to provide the same information as larger companies, he reasoned, since the information needs of investors do not substantially differ according to company size.

Urging early approval by the European Parliament, the commissioner noted that IFRS 8 would remove uncertainty about the treatment of segment information in 2007 financial statements. He said that issuers are pressings for an early indication of the Commission’s intentions. An endorsement of IFRS 8 would also support the EU's overarching objective of IFRS as adopted in the EU being recognized in all jurisdictions, including the US, without requirement for reconciliation.

The European Parliament had earlier expressed its concern that an endorsement of IFRS 8 would imply moving from a regime which clearly defines how listed EU companies should define and report on segments to the FAS 131 approach that permits management itself to define operating segments as management finds suitable.

Monday, September 17, 2007

FSA Looks for Mutual Recognition with SEC as Two-Way Street

In the wake of the SEC’s recent roundtable on mutual recognition, the UK Financial Services Authority looks forward to engaging further with the Commission on issues of mutual reliance to facilitate business on a cross border basis. UK senior officials believe that mutual recognition represents a more promising route to widening cross border access than full convergence. The authority has worked within the context of mutual recognition for many years, noted FSA Director Verena Ross, and is trying to balance the targeted and proportionate regulation of firms with the need for investor protection and market confidence. The director’s remarks were made at a British Bankers Association securities forum.

While the FSA still needs to see a formal SEC policy proposal, noted the director, the SEC is showing increasing willingness to consider placing added reliance on overseas regulators. In the terminology that has been adopted by the SEC, this means to allow for substituted compliance.

In considering the latest ideas from the SEC, said the director, the FSA will be mindful of the EU dimension and the role of the European Commission. Also, the FSA will need greater specificity from the SEC before it is able to offer a fuller response on mutual recognition or substituted compliance. More broadly, the continuing expansion of cross-border financial services heightens the need to clarify the relations of home and host supervisors in respect of multinational firms and markets and make these work as smoothly as possible.

FSA-SEC cooperation has already begun on prudential issues. For example, with the implementation of the EU's Financial Groups Directive, the SEC developed its Consolidated Supervised Entity regime and assumed the role of the global consolidated supervisor of the largest US broker-dealers. The FSA director praised this as a welcome move, given that these firms have significant operations in the UK and other European markets.

While cross-Atlantic convergence and mutual recognition in the accounting arena has progressed, observed the official, progress has not been as fast in other areas as the UK financial services industry had hoped. A prominent example of this is secondary market trading. The UK has a regime based on unilateral recognition and equivalent protection, which is the FSA’s Recognized Overseas Investment Exchange (ROIE) regime.

Under this regime, explained the senior official, US exchanges can establish themselves in the UK based essentially on the regulatory regime in their home country. Once the FSA makes sure that the home country regime and the rules of the exchange in question deliver equivalent consumer protection, the arrangements ensure that there is no duplicative regulatory effort.

The FSA relies entirely on the SEC's regulation of the exchange in question. At that point, all the FSA requires is that it be given updates on significant developments that might impact the UK market and its players. In addition, US intermediaries can become remote members of a UK exchange without requiring FSA authorization, as long as they do not undertake regulated activities in the UK. Finally, US issuers listed on US exchanges, where the exchange operates as ROIEs, do not need to register in the UK.

But, noted the director, while the CFTC in many ways has a fairly similar approach to the FSA in secondary market trading, the SEC operates on a rather different basis. Thus, a UK exchange needs to register with the SEC to do business in the US. Also, while UK intermediaries can be remote members of a US exchange, they must register with the SEC in order to do this. Since UK exchanges would like to have the ability to place screens in the US without the need for full SEC registration, there is great UK interest in recent statements by senior SEC staff about the potential for widening the scope for mutual recognition going forward.

Saturday, September 15, 2007

Former SEC Chair Cohen Explains Genesis of Staff Comment Letters

The SEC staff comment letters on corporate filings, which are now publicly available, are an example of the Commission’s flexible approach to regulation and its willingness to develop informal working procedures. This was explained by former Chairman Manual Cohen at a PLI seminar in NYC in 1964.

According to Chairman Cohen, the genesis of the comment letter is that the statute set up no procedure for the processing of registration statements. It seemed to offer only a choice between automatic effectiveness upon the lapse or acceleration) of the statutory period or the institution of formal proceedings looking to a stop order banning the sale of the securities involved. If, in those cases where revision of the registration statement seemed required, resort could only be had to formal proceedings, serious delays would be caused and securities flotation would otherwise be hampered.

Since this appeared to be contrary to the Congressional intent, and since the staff was, in any event, required to review the registration statement as a basis for Commission action, an informal procedure was devised which would make available to registrants the benefit of the staff review and permit appropriate revision or modification without formal proceedings.

Over time, the letter of comment technique was adapted to the additional duties undertaken as administration of new statutes was delegated to the Commission. It is now also employed in connection with analysis of registration statements and reports under the Securities Exchange Act of 1934, as well as the processing of documents filed pursuant to the Investment Company Act.

Thursday, September 13, 2007

SEC Charges Audit Firms for Failure to Register with PCAOB

By James Hamilton, J.D., LL.M.

The SEC has charged auditors for issuing audit reports on public companies’ financial statements without being registered with the PCAOB. The Sarbanes-Oxley Act requires that accounting firms which prepare and issue reports on the financial statements of public companies must be registered with the PCAOB. The SEC’s administrative orders name 37 unregistered audit firms and 32 audit partners who participated in the preparation and issuance of the audit reports. Enforcement Director Linda Chatman Thomsen said the failure to register with the PCAOB represents a violation of one of the key requirements of the Sarbanes-Oxley Act by avoiding PCAOB oversight.

There is no explicit rule that requires issuers to inquire or to determine that their accounting firm is registered with the PCAOB. Issuers are obligated to have their financial statements certified by a registered accounting firm. The failure to have their financial statements audited by registered firms could lead to a series of consequences affecting issuers’ listing status and their ability to access the public markets. According to SEC officials, the Division of Enforcement does not anticipate any actions against the issuers whose financial statements were audited by unregistered firms.

Wednesday, September 12, 2007

Senate Bill Would Require Hedge Funds to Set Up Anti-Money Laundering Programs

A Senate bill would require hedge funds to know their offshore clients by requiring them to establish anti-money laundering programs like other U.S. financial institutions, under regulations to be issued by the Treasury Department. S. 681 is a bi-partisan measure sponsored by Senator Carl Levin, Chair of the Subcommittee on Investigations. The primary focus of the Stop Tax Haven Abuse Act is to restrict the use of offshore tax havens and abusive tax shelters.

Currently, unregistered investment companies, such as hedge funds and private equity funds, are the only class of financial institutions under the Bank Secrecy Act that transmit substantial offshore funds into the United States, yet are not required by law to have anti-money laundering programs, including know your customer, due diligence procedures. Sen. Levin is concerned that this growing sector of the financial services industry is serving as a gateway into the U.S. financial system for monies of unknown origin

Although Treasury proposed anti-money laundering regulations for these groups in 2002, it has not yet finalized them. The bill would require Treasury to issue final regulations within 180 days of the enactment of the bill. Treasury would be free to work from its existing proposal, but the bill would also require the final regulations to direct hedge funds and private equity funds to exercise due diligence before accepting offshore funds and to comply with the same procedures as other financial institutions if asked by federal regulators to produce records kept offshore.

The Senate expects that, as in the case of all other entities covered by the Bank Secrecy Act, the regulations issued in response to the bill would instruct hedge funds and private equity funds to adopt risk-based procedures that would concentrate their due diligence efforts on clients that pose the highest risk of money laundering.

According to Sen. Levin, a subcommittee investigation showed that persons have used hedge funds and private equity funds they controlled to funnel millions of untaxed offshore dollars into U.S. investments. Because hedge funds, private equity funds, and company formation agents are as vulnerable as other financial institutions to money launderers seeking entry into the U.S. financial system, the bill is aimed at ensuring that these groups know their clients and do not accept or transmit suspect funds into the U.S. financial system.

RICO Challenge to Exchange Demutualization Fails

By James Hamilton, J.D., LL.M.

A federal judge (ED Pa) ruled that a member of the Philadelphia Stock Exchange could not challenge the demutualization of the exchange under federal racketeering laws. The RICO claims levied against exchange senior executives were derivative or otherwise non-actionable, said the court, and did not confer standing on the member for any of its RICO claims because there was no proximate cause. Here, Judge Brody cited the Supreme Court’s landmark 1992 decision in Holmes v. SIPC, CCH Fed. Sec. L. Rep. ¶96,555, for the proposition that RICO liability attaches only for harm proximately caused by RICO violations. Finding that amending the RICO claims would be futile, the court dismissed the member’s complaint with prejudice. (Penn Mont Securities v. Frucher, ED Pa., No. 05-CV6686, Aug. 15, 2007).

Demutualization is the conversion of a mutual non-profit organization into a for profit corporation, which issues stock. In connection with the plan of demutualization, trading privileges were separated from corporate ownership of the exchange and made available exclusively through trading permits. The SEC approved the demutualization of the exchange on January 16, 2004 in Release No. 34-49098. Exchange demutualizations are generally effected to expand sources of capital and revenue and facilitate the exchange’s ability to enter into relationships with strategic or financial partners.

It is axiomatic that RICO prohibits racketeering activity and entitles a victorious plaintiff to treble damages. Standing under civil RICO is conditioned on suffering an injury to
business or property interest by reason of a violation of section 1962, which contains a list of distinct injuries. The Supreme Court taught in Holmes that the ``by reason of’’ language in the statute means that the RICO violation must have proximately caused the injury to business or property. Indirect or derivative claims do not confer RICO standing.

Here, the exchange member said that it was injured by RICO violations in a number of distinct ways, primarily that shareholders lost seat rent and suffered share dilution through demutualization. The member also alleged that it incurred legal fees on account of investigations by internal regulatory officers of the exchange who targeted the member at the behest of the exchange CEO.

But the court concluded that these alleged injuries were derivative under RICO and failed to confer standing to bring federal racketeering claims against exchange senior officers. For example, the member’s allegation of share dilution absent a controlling shareholder describes a derivative injury to the corporation. Even assuming that dilution resulted from a RICO injury, reasoned the court, the violation would have directly injured the corporation under a proximate cause analysis; and only then have indirectly injured the member. This type of derivative injury is too attenuated to support a RICO claim.

Similarly, the member’s allegation that it incurred legal fees to defend against internal regulatory proceedings brought by the exchange did not save its RICO claim because, although legal fees may constitute direct, actionable injuries under RICO, the member did not allege that these injuries were proximately caused by any predicate act.

Tuesday, September 11, 2007

Senate Bill Would Allow IRS to Share Tax Abuse Information with SEC

A Senate bill would provide a powerful new tool to combat tax shelter abuses by ending outdated communication barriers between the IRS and other enforcement agencies such as the PCAOB, the SEC, and the bank regulators. The bill, S. 681, is sponsored by Carl Levin, chair of the Subcommittee on Investigations.

Currently, the federal tax code bars the IRS from communicating information to other federal agencies that would assist those agencies in their law enforcement duties. For example, the IRS is barred from providing tax return information to the PCAOB, SEC, and federal bank regulators even when that information might assist the SEC in evaluating whether an abusive tax shelter resulted in deceptive accounting in a public company’s financial statements or help the PCAOB judge whether an accounting firm had impaired its independence by selling tax shelters to its audit clients.

To address this problem, the bill would authorize the Treasury Secretary, with appropriate privacy safeguards, to disclose to the PCAOB and SEC, upon request, tax return information related to abusive tax shelters, inappropriate tax avoidance, or tax evasion. The agencies could then use this information only for law enforcement purposes, such as preventing accounting firms from promoting abusive tax shelters, or detecting accounting fraud in the financial statements of public companies.

Monday, September 10, 2007

Board Committee Can Reschedule Merger Vote, SEC Unwritten Policy Noted

By James Hamilton, J.D., LL.M.

The Delaware Chancery court has ruled that a special committee of independent directors can reschedule an imminent meeting of stockholders to consider an all cash, all shares offer from a third-party acquirer when they believe that the merger is in the best interests of the stockholders and know that if the meeting proceeds the stockholders will vote down the merger and the acquiror will irrevocably walk away from the deal and the company’s stock price will plummet.

The special committee also wanted more time to provide information to the stockholders before their vote on the merger. Finally, the meeting was rescheduled within a reasonable time period and the committee did not preclude or coerce the stockholders from freely voting on the merger. (Mercier v. Inter-Tel Inc., Del. Chancery Court, Aug 14, 2007, CA No. 2226).

In finding that the committee acted in good faith, Vice Chancellor Strine found no evidence that it failed to explore the possibility of a more valuable alternative takeover bid from interested parties. By contrast, it appears that the special committee diligently responded to all interested parties and tried to facilitate attractive bids.

Thus, the court rejected a request for a preliminary injunction based on the argument that the directors had no discretion as fiduciaries to reschedule a vote once a stockholder meeting is imminent and they know that the vote would not go their way if it was held as originally scheduled.

In an interesting aspect of the ruling, the court noted that the proxy materials also indicated that the stockholders would vote on a second ballot item, which involved a proposal to adjourn the special meeting to solicit additional proxies if there were not sufficient votes in favor of the adoption of the merger. Apparently, the second ballot item was included as a result of a general practice of the SEC that encourages issuers to seek stockholder pre-approval for an adjournment. Here, the court cited an SEC roundtable discussion on the proxy rules and state corporation laws held on May 7, 2007 discussing the fact that the SEC has some unwritten policies regarding shareholder voting on adjournments of meetings.

The fact that, at the SEC’s prodding, the company included on its proxy ballot a proposal regarding whether or not to adjourn the special meeting if there were not sufficient votes to approve the merger, and that a majority of stockholders voted against an adjournment, did not put the special committee in a graceful position to seek to justify its actions in calling a time out on the merger vote. But as a formal matter, noted the court, the special meeting was not adjourned because it was never convened in the first place. Rather, the committee postponed the special meeting on the morning it was scheduled, and their legal authority to do so was unquestioned.

Apparently, the court’s cite to the SEC roundtable was to remarks by panelist James Hanks of the Venable firm, who expressed concern that there is a lot of confusion among the corporate bar and among state corporate lawyers on the SEC’s view of voting for adjournments of meetings. He noted that the SEC has some unwritten policies that some people know about and some people don't know about. Adjournments are becoming an increasingly important thing in corporate governance, said Mr. Hanks, adjournments to win, adjournments for other purposes. If the SEC has a policy on adjournments or on the use of proxies to vote for adjournment, he urged that such policy be published in the usual way.

Sunday, September 09, 2007

NY Fed Study Says Counterparty Risk Management Still Best Defense to Hedge Fund Risk

However imperfect it may be, counterparty credit risk management is still the best way to limit the potential for hedge funds to generate systemic disruptions, according to a study by the Federal Reserve Bank of New York. The study’s conclusion dovetails with the fact that financial regulators in the United States and abroad have for many years been guided by the principle that counterparty credit risk management, not hedge fund regulation, is the optimal way to control hedge fund leverage and limit systemic vulnerabilities. This position was recently reaffirmed by the President’s Working Group on Financial Markets.

Largely unregulated hedge funds, which interact with banks and securities firms via such channels as prime brokerage relationships, complicate risk management through their unrestricted trading strategies, liberal use of leverage, opacity, and convex compensation structure. An important part of these relationships is the extension of credit to the hedge fund, exposing the financial institution to counterparty credit risk. But the study points to developments such as enhanced risk management techniques by counterparties, improved supervision, more effective disclosure, and more efficient hedging and risk distribution techniques.

As a result, traditional counterparty risk management remains the first line of defense between unregulated hedge funds and regulated financial institutions. An integral part of this risk management is margining and collateral practices, which are designed to reduce counterparty credit risk in leveraged trading by providing a buffer against increased exposure to the dealer providing the financing or derivatives contract.

But to be sure, the study concedes that the unique nature of hedge funds may generate market failures that make counterparty credit risk for exposures to the funds intrinsically more difficult to manage, both for regulated institutions and for policymakers concerned with systemic risk. In addition, there is concern over factors causing a breakdown of effective counterparty risk management.

For example, the apparent profits to be earned in this business may create competitive pressures that weaken credit risk mitigation practices. Both Fed Chair Bernanke and the Financial Stability Forum have noted how competition for new hedge fund business may be eroding counterparty risk management through lower than appropriate fees and spreads, or inadequate risk controls, such as lower initial margin levels or exposure limits.

Another concern is that the opacity of the hedge fund counterparty makes it harder for outsiders who are less informed of the fund’s risk profile to determine the appropriate counterparty risk ratings that drive credit terms.

A recent concern is that, while hedge funds have typically been viewed as liquidity providers, they have been moving increasingly into less liquid markets, with structured credit and distressed debt at the top of the list. In the presence of leverage, the combination of relatively illiquid assets and short-term financing exposes the
hedge fund to possibly significant liquidity risk.

Thursday, September 06, 2007

McCreevy Holds Hedge Funds Blameless in Market Crisis

While some people want to demonize hedge funds, they are not the cause of the current difficulties in the market, EU Commissioner for the Internal Market Charlie McCreevy told the European Parliament. Rather, he said the present crisis has its roots in poor quality lending, compounded by the securitization of the loans in off balance sheet vehicles.

Many hedge funds have been particularly active in the structured credit markets and incurred losses, conceded the commissioner, but that is the way markets go. Sophisticated players in hedge funds know that financial markets function on risk.

But, in his view, the crucial fact is that hedge fund failures did not spill over into the wider financial system. Investment fund rules under the UCITS Directive have held up. Reaffirming the European Commission’s light touch financial regulation, the commissioner said the prudential framework and bank risk controls in place have prevented hedge fund failures from triggering wider systemic disruption.

The transfer of mortgage loans and their risks to other parties through securitization has been at the center of the crisis, said the commissioner. These risks have sometimes returned to the originating bank when their financial vehicles could not sell off or finance the bank-originated securities.

He vowed that the Commission will examine the mechanisms at play, including the role of special purpose vehicles, and their relevance for banks. The problems of valuation of complex securitized products and clearing mechanisms in stressed markets will also be analyzed. The market crisis has also highlighted the importance of reputational and liquidity risk as important drivers to properly assess the risk exposures of banks to complex securitized transactions.

The commissioner also criticized credit rating agencies for being too slow in downgrading their ratings for structured finance backed up by sub-prime lending. He is also concerned about the potential conflicts of interest of the rating agencies. The conflict arises because they act as advisors to banks on how to structure their offerings to get the best mix of ratings, while also providing ratings widely relied upon by investors. Another concern is the importance of the ratings for the calculation of banks' capital requirements.

Wednesday, September 05, 2007

Industry Guidance Will Supplement UK Principles-Based Regulation

In the new era of principles-based financial regulation in the UK, industry guidance will be permitted to supplement the Financial Services Authority regulations, according to a new FSA policy statement. The FSA defines industry guidance to be information that is developed by the industry in an effort to assist firms, their staff and their advisors in understanding how they can meet FSA requirements.

The FSA recently confirmed industry guidance on outsourcing, suitability and appropriateness issues, as well as investment research prepared by MiFID Connect, which is a grouping of trade associations formed to prepare guidance on aspects of the implementation of the Markets in Financial Instruments Directive. Although these industry guidances were issued before the policy statement, said the FSA, they are in substantive compliance with it and will now be confirmed as industry guidance under the new arrangements.

But the FSA cautioned that it would not retrospectively confirm any other existing guidance. The FSA has set up a dedicated industry guidance section on its website which will include all current confirmed guidance.

Since industry guidance is produced for the industry by the industry, the FSA does not intend to monitor its use once it is confirmed, nor does the FSA expect the guidance provider to do so. However, where there is a market solution to a market failure and industry guidance supports this, the FSA may want to monitor or review whether that market solution continues to address the failure.

While some industry groups would prefer to limit the availability of industry guidance they produce to their members, the FSA has determined that industry guidance must be publicly available and free. Industry guidance must also be voluntary. The guidance must help firms meet their regulatory duties, not tell them what they must do.

Moreover, industry guidance must not claim to be an exhaustive or definitive statement of what FSA rules require. That would move the guidance closer to being a safe harbor, which is not what the FSA intends. That said, however, industry guidance can provide examples of how firms could comply, or key points for firms to consider. Since industry guidance augments principles-based regulation, firms must be permitted the flexibility of tailoring it to their own circumstances.

The FSA expects that guidance providers will ensure that the guidance is kept up-to-date and relevant and notify the FSA of any changes. They will also be expected to work with other trade bodies, if required to develop guidance. But the FSA does not expect industry groups to monitor or enforce compliance with the guidance. Similarly, the FSA will not monitor how firms use the guidance.

Saturday, September 01, 2007

Chamber of Commece Calls Scheme Liability a Label in Search of a Cause of Action

The theory of scheme liability under which non-speaking actors, such as auditors and investment banks, can be held liable for securities fraud is no more than aiding and abetting liability disguised behind a new name, asserts the US Chamber of Commerce in a brief filed with the Supreme Court. It is instructive to note, said the Chamber, that scheme liability emerged after the Court and Congress rejected aiding and abetting liability in private securities fraud actions. The theory has been extended to counterparties involved with an issuer merely through a commercial or financial transaction. Moreover, scheme liability has no effective limiting principle, which the Chamber believes is reason enough to reject the theory.

The Chamber further contends that scheme liability would put US companies at a tremendous competitive disadvantage. For example, issuers of securities would have to price their commercial transactions to reflect the substantial added risk of liability for their counterparties. Moreover, in order to avoid litigation risk, both domestic and foreign companies would have significant incentives to do business with companies listed on foreign exchanges, or with private companies. Business choices would be based on factors like price, efficiency, quality, and service, said the Chamber, rather than on litigation risk.

In the case of Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. (No. 06-43), the Supreme 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 Chamber’s brief addressing this question, a concept known as scheme liability, was filed in support of the defendants in the Stoneridge case.

Calling scheme liability the antithesis of the legal certainty that business requires, the Chamber observed that a counterparty has no ability to audit or dictate accounting decisions made by the company’s management and auditors. Moreover, business transactions are often subject to complex, changing, or inherently subjective accounting rules. Requiring a business to monitor its counterparty’s accounting in every commercial transaction, said the Chamber, will greatly expand costs and litigation risk. The Chamber questions the very efficacy of a theory of scheme liability that would subject business to such extreme hazards.

The Court’s approval of scheme liability, warned the Chamber, would send a chill through boardrooms worldwide since any firm, anywhere, doing business with US companies would have to live with the risk that the transaction could later be portrayed as fraudulent.

Unlike scheme liability, argued the Chamber, a duty to disclose is individual, not derivative, and provides an objective and workable, bright line standard that looks at the relationship between the parties rather than the defendant’s subjective intent. Duty to disclose is a legal question, and there is well-developed law to guide businesses concerning when such a duty exists.