Tuesday, October 30, 2007

Markets in Financial Instruments Directive to Take Effect

A sweeping reform of financial services regulation in the European Union is represented by MiFID, the Markets in Financial Instruments Directive, 2004/39/EC, which takes effect on November 1, 2007. It replaces the Investment Services Directive which was adopted in 1993. MiFID is a central element of the European Commission's Financial Services Action Plan, which is intended to create a single market for financial services across the EU.

MiFID is a far-reaching piece of legislation that sets out a comprehensive regulatory regime covering investment services and financial markets in the European Union. It contains measures which will change and improve the organization and functioning of investment firms, facilitate cross-border trading and thereby encourage the integration of EU capital markets. At the same time, it will ensure strong investor protection with a comprehensive set of rules governing the relationship that investment firms have with their clients.

The Commission's overriding objective is to provide a single, predictable set of rules for firms operating throughout the EU and greater security for consumers buying investment services. In an effort to avoid gold plating, MiFID establishes a highly harmonized regime under which it should not be necessary for Member States to add supplementary rules over and above what is in the Directive. Indeed, they are only allowed to do so in exceptional and strictly defined circumstances to address national or emerging issues which affect investor protection or the stability of their markets.

MiFID abolishes the concentration rule, which means that Member States can no longer require investment firms to route orders only to stock exchanges. Thus, exchanges will be exposed to competition from multilateral trading facilities (MTFs), which broadly are non-exchange trading platforms and systematic internalizers, such as banks or investment firms who systematically execute client orders internally on their own account rather than sending them to exchanges.

MiFID is also good news for consumers. They will have a bigger choice of investment service providers, who will be required to conform to high standards of behavior to their clients. This should allow them to seek out services of the best quality at the cheapest price.

MiFID envisages two types of investor protection mechanisms. On the one hand, firms will have to provide their clients with information about the investment firm, the services it provides and the financial instruments that are the object of these services. This is important. If clients receive sufficient information, they should be able to detect and reject inefficiency and unprincipled conduct by firms. However, this mechanism cannot be relied on entirely. It is no good swamping clients with large amounts of complex information and hoping that they will be able to analyze and evaluate it all and then draw the appropriate conclusions.

MiFID therefore also places considerable emphasis on the fiduciary duties of firms towards their clients. It imposes a number of specific obligations on firms, including best execution and the obligation, when providing investment services, to collect sufficient information to ensure that the products and services which they provide are suitable or appropriate for their clients. It also imposes strict limits on the inducements which banks or financial advisers can receive in respect of the services which they provide to their clients.

Friday, October 26, 2007

FSA CEO Says Rules Will Have a Place in Principles-Based Regulation

Anyone worried that rules will have no place in the FSA's new principles-based regime will be buoyed by the recent remarks of its CEO. While reaffirming the efficacy of principles-based regulation, particularly in light of the recent market turmoil, Financial Services Authority CEO Hector Sants said that detailed rules will remain an integral part of the regulatory regime. The FSA intends to maintain a balance of detailed rules, higher level rules, and principles. Indeed, he noted that in some cases detailed rules will continue to be the best means of delivering a regulatory outcome or mitigating a market failure. For example, consumers may benefit from rules prescribing the way in which firms provide key information to them.

The FSA’s discretion in minimizing the number of rules is somewhat prescribed by European Union Directives, observed the CEO, but he emphasized that the implementation of Directives will not compromise the move to principles-based regulation. Far from being incompatible with the principles-based approach, the Directives are often intentionally high-level and outcome-focused.

More broadly, the senior official said that a combination of rules and principles will afford firms more flexibility in their interpretation of FSA mandates. Principles-based regulation gives firms the opportunity to apply FSA requirements to their business models and make them relevant to those models.

In fact, in his view, the major consequence of granting firms this flexibility is that the FSA needs to understand the context in which firms are exercising their interpretive discretion. Just as firms will be able to interpret FSA principles in line with their business models, so FSA staff must be able to make outcome-focused judgments relating to the principles.

Thus, the key to the success of principles based regulation is that the FSA and regulated firms must work together to understand mutual aims and concerns. In that regard, the FSA needs to build lasting partnerships with the firms and the trade associations that represent them.
The FSA chief firmly rejected calls to reexamine principles-based regulation in light of recent market volatility. Quite the contrary, he emphasized that the market disturbances underline the benefits of the move to principles-based regulation. He said that principles are a more efficient and real-time means than rulemaking in enabling the FSA to meet its statutory objectives and assist firms' management to deal with the challenges they face.

Principles-based regulation means that firms are under a constant obligation to review the conformity of their business practices, he explained, whether in calm or in turbulent markets. In his view, the daily management review of questions such as whether customers are being treated fairly, whether conflicts of interest are being managed appropriately and, critically, whether business risks are being managed, should be the norm in the more principles-based world.

The FSA is not operating a no fail regulatory regime, assured Mr. Sants, adding that a successful financial marketplace requires innovation and competition, which in turn means some failures. But a principles-based regime provides the best chance of achieving the requisite balance between the benefits and risks of innovation.

Thursday, October 25, 2007

House Bill Would Impose Liability on Mortgage-Backed Securitizers

A comprehensive bill to combat abuses in the mortgage lending market and provide basic protections to mortgage consumers and investors has been introduced by House Financial Services Chair Barney Frank. The bill, H.R. 3915, the Mortgage Reform and Anti-Predatory Lending Act, would, among others things, attach limited liability to secondary market securitizers who package and sell mortgage-backed securities in home mortgage loans outside of standards enunciated in the bill. However, individual investors in these securities would not be liable.

During committee hearings on HR 3915, Federal Reserve Board Governor Randall Kroszner cautioned that any legislation in this area must not have a detrimental impact on the ability of lenders to securitize loans. For their part, securities industry groups testified that liability in the secondary market for actions of brokers or originators is inappropriate.

Section 204 of the Act provides that, for loans violating the minimum standards for reasonable ability to repay and net tangible benefits, a consumer has an individual cause of action against securitizers for rescission of the loan and the consumer’s costs. But a safe harbor in the bill states that securitizers will not be liable for a loan that violates the minimum standards if they conform the loan to the minimum standards within 90 days of receiving notice from the consumer or have a policy against buying mortgage loans that are not qualified mortgages and exercise due diligence to adhere to such policy through an adequate and consistently applied sampling procedure. In addition, liability will not apply to pools of loans or investors in pools of loans.

While securities industry groups believe that liability for the secondary market for actions of brokers or originators is inappropriate, they do appreciate that the bill limits the exposure of the secondary market investors and trusts. The bill also limits the damages that a securitizer of the trust has should the worst-case scenario arise. The views of the Securities Industry and Financial Markets Association (SIFMA) and the American Securitization Forum were delivered by SIFMA CEO Marc Lackritz.

The industry asked the committee to ensure that the safe harbor is made preferable to rescission by clarifying that the 90-day cure period starts from the time the securitizer receives the claim notice either directly from the borrower or indirectly through the servicer or other third party. The bill should also affirmatively state that consumers lose the right to rescission if they reject a qualifying offer to cure. Moreover, borrowers should not have the right to rescind a loan that they procured through fraud or misrepresentation.

One of the elements of the safe harbor provides that the securitizer must exercise due diligence based on a sample of loans to make sure that the loans are qualified mortgages. Concerned that finding one ineligible loan would cause the safe harbor to evaporate, the groups suggested that the bill clarify that the exercise of commercially reasonable due diligence based on a sample of loans is intended to prevent the securitizer from knowingly purchasing or taking assignment of a pool of mortgages as to which a material portion of such mortgages are not qualifying mortgages.

Wednesday, October 24, 2007

FASB Chair Calls for Moving All US Public Companies to IFRS

In a very significant event, FASB Chair Robert Herz told a Senate subcommittee that a blueprint is needed to transition US companies to IFRS. His testimony before the Securities Subcommittee was echoed by IASB Chair David Tweedie, who noted that the widespread global acceptance of IFRS has changed the public equation with GAAP. He noted that IFRS now extends well beyond Europe’s borders to108 countries, which require or permit the use of IFRSs. And the IASB expects this number to rise substantially within a relatively short time.

Moving all U.S. public companies to an improved version of IFRS will be a complex process, warned the FASB chair, and will need buy in from all major stakeholders. The blueprint should identify the most orderly and least costly approach to transitioning to an improved version of IFRS and should set a target date for U.S. companies to move to IFRS that allows adequate time for making the many necessary changes.

The blueprint should identify the changes considered necessary both in the U.S. and internationally to reach the goal of a single set of common, high-quality standards. Specifically, the blueprint should address a range of institutional issues, including examining the post-issuance endorsement processes currently in place in many jurisdictions to reduce or eliminate the different flavors of as-adopted versions of IFRS, which are inconsistent with the goal of a single set of standards. The blueprint should also address strengthen the IASB as an independent, global standard setter by ensuring the sufficiency and stability of its funding and staffing.

Regarding the U.S., continued Mr. Herz, the blueprint should establish timetables to
accomplish changes to the financial reporting infrastructure necessary to support the move to IFRS, including training auditors and educating investors and other users of financial statements about IFRS. There must also be an examination of how a transition to IFRS will affect audit firms and audit standards. Similarly, the move to IFRS could change regulatory policies and legal requirements currently based on U.S. GAAP financial reports.

Similarly, the blueprint should enumerate the steps U.S. public companies would need to implement significant changes to align to IFRS, including training and internal control changes, and various contractual matters. FASB expects that the myriad changes to the U.S. financial reporting infrastructure would take a number of years to complete.

During that time, the FASB and IASB will continue their cooperative efforts to develop common, high-quality standards in key areas where neither existing U.S. GAAP nor IFRS provides relevant information for investors. Those common standards, issued by both the Boards would be adopted by both US and international companies when issued. In other areas that are not the subject of those joint improvement projects, FASB envisions that U.S. public companies would adopt the IFRS standards “as is” over a period of years.
KPMG Advises on FIN 48

The FIN 48 approach to accounting for uncertainty has been the subject of considerable discussion and controversy. Effective for fiscal years beginning after December 15, 2006, FIN 48 requires companies to assess their tax positions to determine whether they are more likely than not to be sustained upon IRS examination. Ultimately, the FIN disclosure appears in the company’s financial statements.

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 company 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 by the IRS upon examination. This determination is based on the individual facts and circumstances of that position evaluated in light of all available evidence.

In a recent publication called Frontiers in Tax, KPMG provided some advice on FIN 48. The firm noted that a significant new requirement is the disclosure of tax positions for which it is reasonably likely that the total, unrecognized tax benefits will increase or decrease significantly within 12 months of the reporting date.

Tax authorities may well be interested in these disclosures, noted the firm, and Tax Directors should consider their disclosures carefully and test their view of their anticipated disclosures before the year end with their auditors.

The disclosures under FIN 48 might also arouse regulatory interest if subsequent changes in recognized benefits greatly exceed previous estimates of reasonably possible changes. Such differences may cast doubt on the transparency of the earlier disclosure and the adequacy of the systems and controls supporting their preparation.

In the view of KPMG, the role of Tax Directors in addressing FIN 48 is to craft a system that fosters compliance, but is practical and can be implemented and understood by their tax reporting teams. FIN 48 is an important interpretation of one aspect of one accounting standard in one of the GAAPs that affect the group and its requirements should be integrated with a company’s overall reporting system.

Sunday, October 21, 2007

SEC Experience in First Year of Executive Comp Disclosure Recounted

The life of the law has not been logic, it has been experience: Oliver Wendell Holmes

The first year returns are coming in on the SEC’s new executive compensation disclosure regime and the results are that, while the Commission is generally pleased, there is more work to be done on disclosing more and better analysis. An SEC staff review of the executive compensation disclosure of 350 public companies reveals overall very positive results, with most companies having either met or exceeded the Commission's high hopes for better disclosure. That said, SEC officials call for increased analysis in the new Compensation Disclosure & Analysis section.
As one could expect, a great deal of SEC concern in the first year disclosures is centered on the CD&A. Generally, the SEC staff found that in many cases the CD&A could have done a better job of explaining how particular levels and forms of compensation were determined, as well as why companies pay what they pay.

According to Corporation Finance Director John White, the biggest failure of the first year disclosures is that meaningful analysis was often missing from the CD&A. In order to cure the problem, the staff suggested that companies make some items more prominent by emphasizing material information and de-emphasizing less important information. Specifically, the CD&A should emphasize why the company established the compensation levels, and de-emphasize compensation program mechanics.

Further, CD&A is meant to be a narrative overview at the beginning of the compensation disclosure, putting into perspective the numbers in the tables that follow it. Thus, companies placing compensation tables before the CD&A should relocate those tables so that they would follow the CD&A.

The SEC staff found that a significant number of companies could improve their analyses of how and why they made certain executive compensation decisions. Adding or enhancing analysis does not necessarily mean lengthening disclosure, the staff explained. Rather, careful drafting consistent with plain English principles can result in a more concise and effective discussion.

John White offered advice on drafting the CD&A. The first thing to do is ask every key participant from the compensation committee chair on down to turn in one page of analysis. Then give each participant a copy of the SEC staff report so that they see SEC concerns about missing analysis. Then ask for bullets reflecting what the participants see from their perspective as the key hows and whys, including the key analytic tools used by the compensation committee, the findings that emerged from the analysis, and the resulting actions taken impacting executive compensation.

While fully recognizing that there is a learning curve, the SEC expects companies to take the staff’s guidance to heart as they enter the second season under the new executive compensation regulations; and the Commission’s expectations will be higher.

Director White provided a roadmap for companies as they embark on the second year of executive compensation disclosure. First, he cautioned them not to let the second year’s disclosures be simply a mark-up of the first year. Instead, he advised taking a step back and asking some very important questions. Companies should determine what information is material to their investors as they examine the compensation of company executives and make their voting and investment decisions. Similarly to be determined are the material elements of individual executive and corporate performance that are considered in setting executive compensation. Further, the relationship between the objectives of the compensation program and the different elements of compensation must be decided, as well as the material factors relating to compensation decision-making.

After conducting that exercise, companies should focus on two important aspects of disclosure: analysis and presentation. Regarding analysis, the focus must be on how and why the firm reached the compensation decisions made in the CD&A. Far from providing a laundry list of facts, the disclosure must analyze the elements of the decision-making.

A final thought: The CD&A is modeled on the Management Discussion and Analysis section of the financial statements, which is designed to allow investors to see the company through the eyes of management by providing an analysis of the company’s business. The MD&A mandate was adopted by the SEC in 1980 and there is still back and forth between Commission staff and the financial reporting community on how to get it right.

Friday, October 19, 2007

FASB Urged to Delay FIN 48 Effective Date

The Private Company Financial Reporting Committee has asked FASB to delay the effective date of FIN 48 for private companies. In a letter to FASB Chair Robert Herz, the committee said that the effective date should be delayed until guidance is issued on FIN 48’s implications for pass-through entities and until further consideration is given to the usefulness of FIN 48’s disclosure requirements for private companies.

In the committee’s view, the delay will allow for a higher level of awareness and education about FIN 48. In the meantime, the committee intends to conduct further outreach on FIN 48. Among other things, the committee will conduct deeper research into the cost-benefit considerations for private company constituents when adopting FIN 48.

Moreover, the PCFRC believes that many private company financial statement users and preparers are unaware or just becoming aware of the implications of FIN 48. Importantly, this includes a lack of awareness of FIN 48’s applicability to pass-through entities, which applies to many private company structures.

Many private companies do not have the resources to follow FASB proceedings and they often learn about new requirements like FIN 48 at continuing education sessions after the effective date. Similarly, continued the committee, many public companies are still struggling with implementation issues. This means that best practices are not in place as examples for private companies.

FASB Statement No. 109, on accounting for income taxes does not directly address pass-through entities. As a result, many private company financial statement preparers and their CPA practitioners are unaccustomed to accounting for income taxes and are unaware of the implications of FIN 48, despite the attempts of many organizations to create that awareness.

A number of issues arise from FIN 48’s applicability to pass-through entities, including nexus for state income taxes, the level at which taxes are assessed, and the ramifications of FIN 48’s requirements on acquisitions and tax indemnification. FIN 48 may apply to entities to which FASB Statement No. 109 does not apply, noted the committee, adding that pass-through entities will encounter a significant compliance hurdle when assessing the implications of FIN 48.

Thursday, October 18, 2007

World Standard Setters Conference Focuses on IFRS Implementation

Against the backdrop of the SEC proposal to eliminate the reconciliation of IFRS-driven financial statement to US GAAP, standard setters and regulators detailed the global implementation of ISFR at a recent conference of world standard setters. SEC Deputy Chief Accountant Julie Erhardt praised IFRS as affording investors in global markets an efficient compare way to compare investment opportunities.

That said, the SEC official noted that often a company's financial statements are likely to be prepared in accordance with IFRS as published by the IASB and/or a jurisdictional adaptation of IFRS. In these situations, an investor may not be sure what the distinction between the two means and how significant it is for a particular company. Indeed, in the foreign registrant filings the SEC has seen so far, she continued, there are varying ways that issuers have referred to their basis of presentation that utilize the term IFRS. For example, issuers have referred to IFRS as approved by the IASB and IFRS as adopted in Jurisdiction X.

Paul Cherry, chair of the Canadian Accounting Standards Board said that the target date for ISFR is January 1, 2011; and that Canadian GAAP is the same as ISFR. He pledged that there would be no carve-out mechanism in the adoption of ISFR, but that unique Canadian circumstances would be considered. The chair also questioned whether more industry-specific standards are needed, specifically mentioning the oil and gas industry. In addition, there are some troublesome areas, such as securitizations, special purpose entities, and the impairment of long-lived assets.

Ikuo Nishikawa, chair of the Japanese Accounting Standards Board, said that the convergence of IFRS with Japanese GAAP is proceeding apace, with a goal of completing short-term convergence projects by 2008 and other convergence topics by mid-2011. The short-term convergence projects are the major ones, the chair noted, including asset retirement obligations, disclosure of fair values, business combinations, and intangible assets. The 2011 target date does include segment reporting.

Korean GAAP is now almost equivalent to IFRS, said Hyoik Lee, chair of the Korean Accounting Standards Board, but Korea is still viewed as non-compliant with IFRS. The chair believes that the adoption of IFRS will enhance accounting transparency in Korea. He noted that Korea will phase in IFRS, rather than using a ``big bang approach.’’ Any company will be allowed to adopt IFRS starting in 2009, with all listed companies required to adopt by 2011. Korea has over 30 companies listed on EU markets, he noted, which is third behind the US and India.

Speaking of the Australian experience, which began in 2005, David Boymal, chair of the Australian Accounting Standards Board, said that most large companies were well prepared, but small companies and small accountants were not prepared. A big surprise was the extent of additional disclosures. In addition, while the transition was a great technical success, many CFOs still do not think that it was worth the effort.

Tuesday, October 16, 2007

Shareholder Rights Group Criticizes German Shareholder Law

Proposed German legislation that would redefine normal shareholder activities so that they are captured in the rules relating to shareholders acting in concert would chill dialogue between shareholders and companies and be inimical to sound corporate governance. In a letter to the German Finance Minister, the Int’l Corporate Governance Network expressed concern that the proposed law makes no distinction between shareholders discussing normal corporate governance issues in advance of voting at a company general meeting and shareholders working together with the intention to change control of a company.

According to the ICGN, constructive dialogue between shareholders and companies and intelligent voting by shareholders are the key ingredients for a purposeful general meeting of shareholders. And, continued the network, those discussions are best conducted in private prior to the general meeting. Governance issues are often complex and sometimes quite sensitive, the group reasoned, and it is not helpful if those concerns are aired in the public domain, especially if the exact nature of the concern is not yet clear.


The ICGN is concerned that the proposed law will introduce uncertainty as to whether shareholders discussing corporate governance matters might be captured within the concert party rules. That uncertainty is likely to lead to shareholders taking a cautious approach and either not engaging with one another or only discussing governance concerns that have been aired in the press. Neither of these approaches is conducive to a system of good governance, said the ICGN.

Shareholders voting without thought, or not voting at all, would be a retrograde step, lamented the ICGN, especially given the improved shareholder participation in general meetings that has been achieved by German companies in recent years. Moreover, it is doubtful that company directors will want to learn through the newspaper that one or more of their shareholders are concerned about a governance issue.

Sunday, October 14, 2007

Qualified Support Shown for SEC Proposal to End Reconciliation of IFRS to GAAP

While there is broad support for the SEC’s proposal to eliminate the reconciliation of the IFRS-prepared financial statements of foreign private issuers to US GAAP, a firestorm is brewing over the perceived narrowness of the proposal. The reconciliation can be dispensed with only for issuers who use IFRS as published by the IASB. The problem with this requirement is that no company anywhere in the world is legally required to use this standard. And it appears that no jurisdiction has adopted the identical set of IFRS as published by the IASB.

In its comment letter to the SEC, the Cleary Gottlieb firm pointed out that, if the proposal is limited to IFRS as published by the IASB, then companies that are legally required to publish financial statements in accordance with IFRS as adopted by the European Union will have the burden of determining, as of each financial statement date, whether there is any material difference between their legally required standard and IFRS as published by the IASB. Currently, the sole difference is a hedge accounting option for banks, but that could change.

While there is great respect for the IASB as an independent and sophisticated standard setter, there is the also the question of whether it is appropriate for the SEC to adopt a rule that relies exclusively on the IASB, with no regulatory oversight.

But even more, the European Commission is not happy with the fact that IFRS as adopted by the EU will not satisfy the SEC’s proposal, which means that European companies would not benefit from the proposal but instead would still have to draw up another set of financial statements solely for US listing purposes. The Commission urged the SEC to recognize IFRS as adopted by the EU as equivalent to IFRS as published by the IASB.

The EU is working on the possibility for US issuers listed in the EU to continue filing their financial statements using US GAAP without any reconciliation requirement. But the Commission cautioned that such a possibility requires a common understanding of the Commission and SEC on the equivalence of IFRS as adopted by the EU and US GAAP.

The German Accounting Standards Board was blunter, warning that not recognizing IFRS as adopted by the EU could result in the EU ceasing its current efforts to continue allowing U.S. companies to file U.S. GAAP financial statements without reconciliation to IFRS, which GASB said would lead to a scenario that cannot be desirable from anyone’s point of view.

Friday, October 12, 2007

Changes to UK Corporate Governance Code Proposed

The UK’s Combined Code on Corporate Governance would be amended to allow individuals to chair more than one FTSE 100 company at the same time and to allow independent chairs of smaller companies to serve on the company’s audit committee. Currently, the Code provides that all members of the audit committee must be independent non-executive directors. It also states that no individual should be appointed to a second chairmanship of a FTSE 100 company.

Other than those two proposed changes, the Financial Reporting Council concluded that the Code is working reasonably well and there is thus no need for major changes. The FRC is the UK’s independent regulator of corporate reporting and governance. With consultation on the proposed changes starting in November, the FRC expects that the revised Code will take effect in June of 2008. This will be at the same time as new Financial Services Authority listing rules will implement new EU requirements on corporate governance.

While concluding that there is neither need nor demand for a significant overhaul of the Code, FRC chair Sir Christopher Hogg warned that the Code’s flexible comply or explain approach has not always been applied as intended. The chair emphasized that all parties share responsibility for ensuring that the comply or explain regime remains an effective alternative to regulation. For this to be so, he said, companies must provide robust explanations when they choose not to follow the Code; and investors and their advisors must assess each explanation on its merits rather than applying a rigid set of rules. Under the revised 4th EU Company Law Directive, all listed companies will be required to publish annual corporate governance statements, of which the main part will be a comply or explain report.

Wednesday, October 10, 2007

European Commission Abandons One Share, One Vote Initiative

In a very significant move, the European Commission has abandoned its one share, one vote initiative primarily because of recent findings that there is no evidence of a causal link between deviations from one share, one vote and the economic performance of companies. In remarks to the European Parliament, Commissioner for the Internal Market Charlie McCreevy said that, instead of one share, one vote, shareholders should push for enhanced transparency and better dialogue with their companies. Separately, he stated that the Commission will propose legislation to create a European Private Company.

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.

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.
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According to Comm. McCreevy, existing EU Directives can effectively address transparency with regard to control enhancing mechanisms. In this regard, he mentioned the Transparency Directive and the Takeover Directive. A further layer of EU regulation on one-share, one vote is not the way to go, he emphasized.

Separately, the commissioner reasoned that a European Private Company statute would enhance the ability of the EU’s small and medium-sized companies to operate cross-border. Thus, the objective of the statute is to make it easier for small and medium-sized enterprises to conduct cross-border business by providing them with a European legal form, uniform in each Member State. The possibility to operate in various Member States according to the same corporate rules should significantly reduce compliance costs and, therefore, enhance mobility and competitiveness.

Monday, October 08, 2007

European Central Bank Chief Rejects Direct Regulation of Hedge Funds

European Central Bank President Jean-Claude Trichet has rejected a call by a member of the European Parliament for the direct regulation of hedge funds in light of the recent crisis in the financial markets. Similarly, the President endorsed the continued private sector role of credit rating agencies to assess securities and their issuers.

Werner Langen, member from Germany, urged the ECB to introduce reporting requirements and greater transparency for hedge funds, so as to enable central banks and investors to obtain adequate information on constantly emerging new structures. But, in a letter to Member Langen, the ECB chief confirmed the existing international consensus on the prevailing indirect regulatory approach based on the close scrutiny of hedge funds.

This indirect regulation is based on the close scrutiny of hedge fund counterparties and investors along the lines of recommendations in a report of the Financial Stability Forum. The ECB head called on counterparties, hedge fund managers and investors to implement the recommendations. The report triggered a market-led initiative to review best practices and to work out industry-wide voluntary standards which, the central banker said, is an initiative the ECB has always called for.

In earlier remarks, he has noted an emerging consensus for a voluntary code of conduct for hedge funds. He envisions that the code of conduct would cover risk management and disclosure issues, as well as relationships with prime brokers

With regard to credit ratings agencies, Member Langen raised fundamental questions about the lack of transparency and the need for monitoring. Since a few high-profile rating agencies control the business worldwide, he noted, and the assessment rules are opaque, uncertainty is on the rise both in the banking sector and among investors.

In his view, the responsibility for creditworthiness assessment should be transferred to independent establishments and institutions which do not have a vested interest in achieving the maximum number of the best possible assessments. One option mentioned by the Member would be to build up assessment capacity at national central banks or, where appropriate, the European Central Bank, thus enabling the banking sector to obtain reliable ratings for funds and undertakings. He also emphasized that best practice would be to deal with credit ratings on an international level.

While recognizing the concerns over the ratings of complex structured securities products, Mr. Trichet essentially rejected the call to give central banks a role in assessing the creditwortiness of funds and firms. This would be a huge undertaking also requiring international regulation, he said, and would necessitate a flow of confidential financial information from issuers that could be difficult to obtain.

Overall, the ECB chief believes that credit assessments of securities and their issuers should continue to be predominantly provided by the private sector. That said, he will support initiatives enhancing the transparency of rating methodologies and facilitating more competition in the market for credit assessments. In this regard, he mentioned that European Commissioner for the Internal Market Charlie McCreevy has requested CESR to examine specific issues relating to the rating process of structured finance products. According to the President, CESR’s reply might allow for a more definitive assessment of possible regulatory action.

Tuesday, October 02, 2007

SEC-Fed Reg. R: The Gramm-Leach-Bliley Bank Broker Exception Rules

Ending eight years of stalled negotiations and impasse, the SEC and the Federal Reserve Board have adopted rules that will finally implement the bank broker provisions of the Gramm-Leach-Bliley Act of 1999. The joint rules, codified as Regulation R, are designed to accommodate the business practices of banks while protecting investors. (Release No. 34-56501). Please see my white paper on Regulation R for more details.

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 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.

Monday, October 01, 2007

Bank of Canada Gov. Says Securitization Originators Must Maintain Standards

The banks and non-bank financial institutions that originate loans and then securitize them must be incentivized to maintain credit standards, advised Bank of Canada Governor David Dodge. In remarks to the Vancouver Board of Trade, he also noted that a reduction in securitization now seems likely, as well as a degree of re-intermediation by financial institutions. More broadly, he wondered if regulators fully appreciated just how much the increase in securitization represented an easing of credit conditions. Loans were being shifted off balance sheets, allowing more loans to be made.

The governor also rejected calls for tighter regulation of credit-rating agencies, reasoning instead that those credit-rating agencies that do not work harder to ensure that users understand the nature of their ratings will soon have fewer clients. But he did urge credit-rating agencies to more clearly explain the rationale for, and limitations of, their ratings for highly structured securities products. They should make it clear that their ratings should not be used with the same degree of certainty as ratings for conventional, single-name issuers, and that the securities involved do not trade with the same degree of market liquidity. At the same time, he urged investors to do their own homework instead of simply relying on the word of credit-rating agencies.

The originators of mortgage and other loans are immune from default risk once the loans are securitized and sold, he noted, and thus currently lack the proper incentives to adequately assess the creditworthiness of the borrower. While market forces may rebalance incentives, there may also be an active role for policy-makers in this regard. Another issue related to securitization concerns the capitalization of banks. The governor wonders that, if banks are moving securitized loans off their balance sheets but still providing liquidity guarantees for these securities, how much capital should they be required to set aside. He raised the specter of the Basel Committee revisiting this issue in light of recent experiences.

While the process of securitization is not new, he observed, increasingly complex securities have been developed in response to the demand for higher returns. And as these securities have become more complex and opaque, it has become harder to determine the quality of the assets at the root of the security and to assess the counterparty risk. Securitizing means bundling the loans together into securities backed by the cash flows generated by the loan repayments. These securities are then often sold in tranches offering varying degrees of protection from the default risk involved. In turn, these structures allow higher risk assets to take on the qualities of lower-risk assets.

Because of the complexity and opacity of these securities, it is extremely difficult for investors to confidently determine both the creditworthiness of the assets backing a particular security and the market value of the security itself. In these circumstances, uncertainty can lead to contagion and dislocated money markets. According to Gov. Dodge, investors should demand greater transparency, which in turn should force vendors of financial instruments to structure them so that market players can clearly see what they are buying..
Treasury Official Calls Asset Managers to Action

A senior Treasury official has asked hedge fund and other asset managers to answer the call to action and develop best practices to mitigate systemic risk and protect investors. The primary vehicle to do this is the newly-formed private sector committee of asset managers, said Assistant Secretary Anthony Ryan before the SIFMA asset managers group.

Specifically, he emphasized that asset managers must make their counterparty lending institutions understand the risks inherent in the funds’ investment strategies. They must determine appropriate credit terms. In doing so, they must assess liquidity risk and operational risk. They also need to be disciplined and independent in quantifying valuations. Furthermore, they need to guard against the risks to their reputation. Regulators will closely monitor the lending institutions' management of these risks and assess whether their performance is in line with expectations set out in regulatory guidance.

To deal with these challenges, continued the Treasury official, asset managers must be part of the solution and maintain appropriate policies and protocols. Current practices must be reviewed and continually enhanced. Besides counterparty risk management, asset managers also have a responsibility to continue to strengthen the clearing, and settlement arrangements for all securities, particularly OTC derivatives. The recent principles announced by the President’s Working Group on Financial Markets focused on the importance of counterparty risk, he noted, but this is a foundation that must be built upon by the asset management community.

More broadly, the official noted that institutional investors, such as pension plans, have a large influence on the asset management industry, with their assets invested on behalf of millions of beneficiaries. Noting that fiduciaries to pension plans include asset managers, the official reminded the managers that they represent the first and most important line of defense. Fiduciaries have an ongoing responsibility to perform due diligence and must continually ensure that their investment decisions are prudent and conform to sound practices, including diversification. It is therefore important to ensure that governance and asset management practices are as robust as possible.

While acknowledging that portfolio managers must sometimes take risks, the official added that they must excel in risk management as much as return management. Risk management is not some part-time responsibility, he emphasized, rather it is fundamental to a fiduciary's duty. In this context, he praised hedge fund managers for evolving in response to institutional investors' demands for more detailed information, higher quality business standards and increased transparency.