Friday, November 30, 2007

SEC Adopts Shareholder Access (Non-Access?) Proposal

Spurred into action by a Second Circuit panel decision, a four-member SEC wrote another chapter in the saga of shareholder access by adopting an amendment to the proxy proposal rule to codify the longstanding interpretation of the rule which allows companies to exclude from their proxy statements proposals that would result in an election contest or would set up a process for conducting an election process in the future. Commissioner Annette Nazareth voted against the amendment, which she termed the “non-access proposal” because she believes it stands in the way of shareholders' rights to elect directors for the companies they own.

The appeals panel invalidated the SEC staff's long standing interpretation of Rule 14a-8(i)(8). That interpretation had been applied since 1990, but the court found it inconsistent with a prior interpretation. The court said that it would "take no side in the policy debate regarding shareholder access to the corporate ballot," noting that such issues are appropriately the province of the SEC

Chairman Christopher Cox explained that the proposal to codify the SEC's interpretation was the only proposal that would gain the three votes necessary for adoption. To do nothing in the aftermath of the appeals court decision, which called that interpretation into question, would open the door to a potential end-run around the proxy and antifraud rules, he said. The result of the majority vote will be no change to the way the rule was enforced for the last 17 years, according to Cox.

Cox also noted that he has received numerous requests to wait until there is a full Commission to act, but he believes that doing nothing would put all investors at risk. He pledged to use the time between now and the next proxy season to do something other than maintain the status quo.

One of the persons requesting that the SEC delay action was Senate Banking Committee Chair Christopher Dodd, who cautioned the SEC not to adopt any shareholder access proposals until the Commission is at its full complement of five members. In a letter to Chairman Cox, Sen. Dodd said that the shareholder access rules do not have to be completed in time for the 2008 proxy season. In his view, it is better to formulate rules that are thoroughly vetted with all interested parties and subject to decision-making by five commissioners rather than hastily completing a final rule. Currently, there are four commissioners, with one of the four having announced her resignation.

The shareholder access debate has been going on inside the shareholder democracy debate for some time. In 1984, SEC Chairman Shad said that the disenfranchisement of shareholders poses a present and real issue that must be debated and addressed.

I think that one has to admit that the debate over shareholder access has become somewhat political, with the Republican commissioners lined up against increasing access and the lone Democrat for expanding shareholder access (former Democratic Commissioner Campos was also in favor of expanded shareholder rights). Chairman Cox is somewhere in the middle right now.

In 2008, of course, changes will be coming one way or another. It may take a Democratic majority Commission before we see an expansion of shareholder access. And that, of course, hinges on the 2008 presidential election. It is unfortunate that an issue of basic securities regulation has become so politicized.

Wednesday, November 28, 2007

McCreevy Rejects EU SEC as EC Reviews Lamfalussy Process

As the European Commission conducts a broad review of the process for implementing financial services legislation, Commissioner for the Internal Market Charlie McCreevy opted for enhanced multi-dimensional authority for national regulators instead of a super SEC-type regulator for the European Union. In remarks at a seminar in Frankfurt, he said that any changes should be accompanied by the introduction of a European dimension into the mandates of national regulatory authorities. The requirement to cooperate with other regulators to enhance European regulatory convergence will both enable and encourage the national regulators to adopt a European view and strive towards EU-wide convergence.

The Lamfalussy process has been used to implement the Financial Services Action plan in the EU, most recently the MiFID Directive. Lamfalussy is a four level process involving Level 1: the framework Directive, Level 2: the implementing Directive, Level 3: the rulemaking and interpretation of the Directive, by committees such as CESR, and Level 4: cooperative enforcement by national regulators.

The Commission is not proposing major institutional changes to the current process since, according to the commissioner, these are neither desirable nor politically feasible at this stage. But the EC has proposed some practical improvements for all levels of the Lamfalussy structure as part of an effort to ensure greater consistency and convergence in national implementation and enforcement and enhance cooperation between national regulators.

With a view to improving the legislative process, the Commission will also strive for better alignment of the timetables for the adoption and transposition of co-decision and implementing measures. Impact assessments will be extended to implementing measures. The objective at Level 4 will be to enhance the transparency of national implementing measures. Disclosure mechanisms embedded in the Directives will continue to be applied in order to improve Member States’ performance.

In the view of Comm. McCreevy, Level 3 deserves particular attention. The most significant innovations will be introduced at Level 3, he said, with the creation of committees of regulators responsible for ensuring greater regulatory convergence across the EU. It is also in relation to the Level 3 committees that the expectations were the highest.

The Level 3 committees are expected to adopt non-binding guidelines on the Directives. Results have not always met expectations. For example, CESR has had difficulty in establishing a common transaction reporting format under MiFID.

At a time when markets are increasingly integrated and dominated by large pan-European groups, he reasoned, greater regulatory cooperation and convergence is badly needed. In particular, a stronger political impetus is needed to foster regulatory convergence and cooperation. To this end the Commission has proposed targeted improvements.

In order to enhance the accountability of level 3 committees like CESR, the Commission proposes a two-step procedure. First, the European Parliament will adopt, after prior consultation with the Level 3 committees, a short statement outlining the main achievements expected from the Level 3 committees going forward. Second, the Level 3 committees would report on their achievements, or alternatively, the reasons which prevented them from meeting the objectives set.

One of the key questions in this review is whether the legal standing of the Level 3 committees needs to be modified. The Commission and the Level 3 committees themselves are willing to explore this issue. Therefore, the Commission will examine whether and what changes need to be brought into the current legal framework. In particular it should be possible to refer to CESR in the framework Directive.

Finally, the Commission believes that the efficiency and effectiveness of the decision-making procedures of the Level 3 committees needs to be strengthened. The EC recommends that the committees introduce in their charters qualified majority voting for all advice to the Commission and any measure aimed at fostering regulatory convergence.
Olson and McCreevy Detail Cross-Border Oversight of Audit Firms

Against the backdrop of a global seminar on the cross-border regulation of audit firms, PCAOB Chair Mark Olson and European Commissioner for the Internal Market Charlie McCreevy outlined a cooperative approach to audit oversight based on the equivalence of third-country oversight systems. Chairman Olson went on to detail upcoming proposed PCAOB staff guidance on the circumstances that will allow the Board to place full reliance on audit firm inspections conducted by non-US oversight authorities. Generally, full reliance envisions an independently staffed and funded transparent audit regulator with a history of proper enforcement and appropriate sanctions.

The Statutory Audit Directive allows the European Commission to recognize the equivalence of third-country auditor oversight systems. As a result, the inspections of audit firms carried out by their home oversight bodies can be recognized as being equivalent to EC inspections. Home country oversight by the PCAOB will thus replace the oversight by a European body. As a practical matter, noted Comm. McCreevy, this will mean that both sides will have to rely on each others' inspections of audit firms. What must be avoided, he emphasized, is the costly exercise of sending European inspectors to the US or US inspectors to Europe.

While acknowledging that joint inspections may be inevitable in some cases, the commissioner said that the ultimate goal is to establish a system based on mutual trust and mutual reliance which avoids unnecessary duplication and the extraterritorial application of national audit standards.

For his part, Chairman Olson said that the Board would proceed to implement the collaborative framework by proposing guidance to its Rule 4012, which generally outlines the criteria that the Board considers when determining how to work with another regulator. The rule provides a sliding scale, so that the more independent and rigorous an oversight system, the more the PCAOB may rely on that system. The PCAOB’s requirements in this area are similar to those provided in the European Union’s Audit Directive.

The key concept of the guidance is the Board placing full reliance on the inspection programs of non-US audit regulators. Full reliance envisions the Board’s reliance on the non-U.S. oversight entity to plan and carry out the inspection, and make findings based on its fieldwork. In addition, the Board would rely on the non-U.S. regulator to assess the firm’s efforts after receipt of an inspection report to address any criticisms of, or potential defects in, its quality control system. When full reliance is employed, the Board’s role is reduced to consultation with the non-US inspection staff.

According to Chairman Olson, there will be a transition period to full reliance during which the Board and its counterparts would reach agreement on specific procedures through the execution of bilateral agreements. Moreover, in order for both parties to understand each other’s systems fully, joint inspections would be conducted as part of the transition process. The PCAOB expects to begin the move toward full reliance by 2009 with those entities with which it has been able to conclude bilateral agreements and successfully conduct joint inspections.

Monday, November 26, 2007

European Commission Seeks Cooperation with PCAOB on Audit Oversight

The PCAOB and the European Commission need to agree on a common framework for the oversight of foreign audit firms, emphasized Commissioner for the Internal Market Charlie McCreevy in remarks at the Congress of German Public Auditors. Legislation in the European Union empowers the Commission to assess the equivalence of the oversight of audit firms in third countries. If PCAOB oversight is deemed equivalent, said the commissioner, EU member states would not need to carry out the oversight of foreign audit firms themselves but could rely on PCAOB oversight. EU officials have had numerous meetings with the Board. PCAOB Chair Mark Olson and Member Charles Niemeier have been important driving forces in this process.

Noting the importance of high quality audits of financial statements, Comm. McCreevy said that audit oversight bodies are also working on the issue of quality assurance. The Commission wants to give guidance to statutory auditors and audit firms on how to carry out high quality audits of listed companies. For other types of audits it would seem that the Statutory Audit Directive already provides a sufficient set of principles and that there would be no need for further recommendations. The audit profession has been included in the Commission’s deliberations.

More broadly, the commissioner views public oversight of audit firms as essential in improving audit quality by strengthening public confidence in auditing. It is not enough for them to write a law providing for the establishment of an oversight system, he continued, it mist be an effective oversight system. Independent oversight under the new Directive means that the times of self-regulation are over, he declared.

With regard to international auditing standards, continued the official, the Commission is considering the merits of introducing such standards in the European Union. Before the end of the year, the Commission will launch a study on the costs and benefits of introducing international auditing standards, as well as any potential differences with US standards. After completion of the study, the EC will be able to reassess the situation.

The commissioner has long held the view that the Directive on Statutory Audit foresees the eventual use of international auditing standards. But he cautioned that these standards must be subject to strict conditions. He said that the Commission will first have to determine if the current governance structure of the International Auditing and Assurance Standards Board is adequate both in terms of standard setting and public oversight. To help with this process, the Public Interest Oversight Board has been created. The Commission expects further improvements of the IAASB’s governance, including with regard to the funding of its standard-setting.

Tuesday, November 20, 2007

SEC Ends Reconcilation of IFRS to US GAAP

In an effort to promote the global consistency of financial accounting standards, the SEC has eliminated the requirement that foreign private issuers reconcile their IFRS-driven finnacial statements to US GAAP. But the new rule applies only if the IFRS being used by the foreign private issuers were the IFRS as adopted by the IASB. The fly in this particular ointment is that, according to commenters, no nation is the world has adopted IFRS as prepared by the IASB. Even the European Union has adopted its own version of IFRS. These so-called jursdictional IFRS profiletate based on national needs that are at least perceived and hence become real. The SEC is, of course, correct in its efforts to promote consistent IFRS. But, the gold plating of IFRS is a reality. Many people, including IASB Chair David Tweedie, have recognized inconsistent interpretations of IFRS as the main impediment to IFRS, thatis why we have IFRIC. This issue is not going away and will likely intensify in the wake of the SEC's action.

White Paper on Basel II Implementation Available

I have prepared a white paper on Basel II’s implementation in the United States.

The federal banking agencies have approved the final regulations for implementation of the Basel II Accord in the United States. It replaces the 1988 Basel I Accord, which had become outdated for large, complex banking organizations. Retaining Basel I for these institutions would have widened the gap between their regulatory capital requirements and their actual risk profiles, generating further incentives for regulatory arbitrage to take advantage of that gap. Essentially, the expanded use of securitization and derivatives in secondary markets, along with vastly improved risk management systems, rendered Basel I obsolete for large international financial institutions. The entire paper may be found

Friday, November 16, 2007

House Passes Bill to Curb "Culture of Waiver" in Federal Investigations

The House has passed a bill prohibiting federal agencies from pressuring companies to waive their privileges or take punitive actions against their employees as conditions for receiving cooperation credit during investigations. At the same time, HR 3013 specifically preserves the ability of prosecutors and other federal officials to obtain the important, non-privileged factual material they need to punish wrongdoers. H.R. 3013 is an effort to strike the proper balance between effective law enforcement and the preservation of essential attorney-client privilege, work product and employee legal protections.

The Attorney-Client Privilege Protection Act is a bipartisan bill, sponsored by Representatives Bobby Scott, John Conyers, Lamar Smith, Randy Forbes, and eight other Members of Congress. A companion bill in the Senate, S. 186, is still in committee.

H.R. 3013 is a comprehensive reform measure designed to roll back a number of federal agency policies that the House believes are eroding the attorney-client privilege, the work product doctrine and the constitutional rights of employees. The genesis of the policies is a series of Department of Justice memoranda, the latest of which is the 2006 McNulty Memorandum, that pressures companies and other organizations to waive their privileges as a condition of receiving cooperation credit during investigations.

While the McNulty Memorandum bars prosecutors from requiring companies to not pay their employees' legal fees in some cases, according to a letter from the American Bar Association, it continues to allow the practice in many instances. The ABA cited a report by former Delaware Chief Justice Norman Veasey, recently sent to congressional leaders, indicating that the McNulty Memorandum has not significantly reduced the incidence of government coerced waiver, and federal prosecutors continue to routinely demand waiver of the privilege during investigations despite the new policy.

While the McNulty Memorandum does state that the waiver requests should be the exception rather than the rule, it continues to threaten the viability of attorney-client privilege in business organizations by allowing prosecutors to request a waiver of privilege upon the finding of legitimate need.

According to the Housed committee report, these policies have created a culture of waiver despite the fact that their tone may be moderate and the officials representing these government agencies may stress their intent to implement them in reasonable ways. By creating a differential in the treatment of a company based upon whether that company waives these policies put undue pressure on companies to relinquish fundamental rights.
HR 3013 prohibits an agent of the United States in any investigation or criminal or civil enforcement matter from conditioning a charging decision upon, or using as a factor in determining cooperation, any one of five specified actions.

· making a valid assertion of attorney-client privilege or attorney work product;
· providing counsel or contributing legal defense fees or expenses to an employee;
· entering into joint defense, information sharing, or common interest agreements with an employee;
· sharing relevant information with an employee; and
· failing to terminate or otherwise sanction an employee because of that employee's decision to exercise legal protections

California Continues NASDAQ Listed Securities Exemptions Following SEC Certification of NASDAQ Stock Market as a National Securities Exchange

The former exemptions from issuer and nonissuer qualification requirements for securities listed or approved for listing on the NASDAQ National Market System were reestablished by the California Corporation Commissioner as exemptions for securities listed or approved for listing on the NASDAQ Global Market, following the SEC's certification of the NASDAQ as a national securities exchange with the new name of NASDAQ Global Market. The exemptions from issuer and nonissuer qualification requirements under Sections 25100(o) and 25101(a) of the California Securities Act, respectively, cover securities listed or approved for listing upon notice of issuance on either the NASDAQ Global Market and NASDAQ Global Select Market, the two tiers of the NASDAQ Global Market, as well as any warrant or right to purchase or subscribe to one of these securities.

More States Adopt Uniform Securities Act of 2002

Minnesota adopted the Model Uniform Securities Act of 2002 on August 1, 2007. Hawaii and Indiana will be the next two states to adopt the new Act on July 1, 2008.

Regarding Minnesota, the State’s Department of Commerce reestablished, by order, the accredited investor, limited offering, existing security holder, merger, and employee benefit exemptions, as well as federally registered investment company offerings and Rule 506 offerings under Sections 18(b)(2) and 18(b)(4)(D) of the Securities Act of 1933 of NSMIA, to conform to the new Uniform Securities Act.

Investment company offerings under Section 18(b)(2). A notice must be filed by the issuer on Form NF, Investment Company Notice Form, together with a consent to service of process (but only with the initial filing). A $100 fee is required with the initial filing. An additional fee of 1/20 of 1% of the maximum aggregate offering price at which the securities will be offered in Minnesota during the notice period is required for redeemable securities issued by an open-end investment company or unit investment trust.

Rule 506 offerings under Section 18(b)(4)(D) . A notice must be filed by the issuer consisting of a copy of Form D, Notice of Sale of Securities Pursuant to Regulation D, (including the appendix), a consent to service of process signed by the issuer, and a $100 fee plus an additional fee of 1/10 of 1% of the maximum aggregate offering price at which the securities will be offered in Minnesota with a maximum combined fee of $300. The notice must be filed no later than 15 days after the first sale of the securities in Minnesota.

Limited offering exemption. Issuers claiming the limited offering exemption must file Form SI, Statement of Issuer Form, at least 10 days before any sale is made (or file Form SI in a shorter period determined by the Commissioner). NOTES: (1) An issuer selling to 10 or fewer purchasers in Minnesota during a consecutive 12-month period need not file a notice; and (2) A fee is not required.

Existing securityholder, merger and employee benefit plan exemptions. Issuers claiming either the existing securityholder, merger or employee benefit plan exemption must file a notice consisting of a description of the transaction and a consent to service of process at least 10 days before any sale is made (or file the notice in a shorter period determined by the Commissioner). NOTE: A fee is not required.

Accredited investor exemptions. A registration exemption for broker-dealers without a place of business in Minnesota whose transactions are limited to certain classes of persons applies to broker-dealers whose only transactions are with accredited investors. A registration exemption for investment advisers whose only clients in Minnesota are certain designated classes of persons applies to investment advisers whose only clients are accredited investors. A notice filing exemption for federal covered investment advisers without a place of business in Minnesota whose transactions are limited to certain classes of persons applies to federal covered investment advisers whose only clients are accredited investors.

ABA Comments on SEC Proposals to Amend Private Offering Rules

The Federal and State Securities Subcommittees of the American Bar Association (ABA) submitted comments to the SEC on October 12, 2007 regarding the SEC’s proposal to amend its private offering rules, including Regulation D and Rule 144A. The significant comments included the following:

1. That the prohibition on advertising and general solicitation be eliminated for the Regulation D, Rule 506 exemption or in the alternative that the prohibition be removed for Rule 506 offerings made to accredited investors.

2. That the “bad boy” disqualification provisions currently a part of the Regulation D, Rule 505 exemption not be expanded to apply to Rule 506. The ABA contended that attaching the Rule 505 disqualification provisions to Rules 504, 506 and 507 would overburden legitimate issuers’ capital raising efforts and have the effect of steering them away from using any of Regulation D exemptions, forcing them instead to claim the safe harbor of Section 4(2) of the Securities Act of 1933. By having to rely on Section 4(2), the exemption for “transactions not involving a public offering,” issuers subject themselves to the non-uniformity of each state’s private placement exemptions.

3. That in the proposed new Rule 507 exemption, radio and television broadcasts be allowed to advertise the offering, with the antifraud power used to combat abusers on a case-by-case basis. The proposal would only allow print communication to advertise the offering.

4. That Rule 507 fall under the safe harbor of Section 4(2) of the Securities Act of 1933 rather than under the general exemptive authority of Section 28 as proposed. The ABA stated that authorizing Rule 507 under Section 28 would require the large accredited investors of Rule 507 to be defined as “qualified purchasers” for the offered securities to be “federal covered securities,” thereby making safe harbor rules 152 and 155 unavailable unless they are amended, and excluding pooled investment funds from being used in connection with Rule 507.

5. That the federal across-the-board restrictions on resales in Rule 504 offerings not be adopted. The ABA declared that the $1 million offering amount in Rule 504 is small enough not to warrant federal concern, and that the regulation of this exemption should be left exclusively to the states. The proposed amendment to Rule 504 would make securities issued under subsection (b)(1)(iii) subject to resale restrictions [(b)(1)(iii) is the solely accredited investor prong of the Rule 504 that permits general solicitation].

6. The ABA supports the proposed reduction of the Regulation D integration period from six months to 90 days. The ABA, however, does not want a subsequent public offering to be integrated with the initial private offering.

7. That the prohibition against general solicitation be eliminated from private investment vehicles because these offering are made only to qualified purchasers who are sophisticated enough to know if the investment is appropriate for them.

8. The ABA supports the proposal to exclude advertising under Rule 507 from being an improper activity under Rule 144A. However, the ABA believes the better approach would be to eliminate the restriction on offers to persons who are not qualified institutional buyers since Rule 144A is premised on sales solely to QIBs. Furthermore, the ABA recommends revising the QIB definition and expanding the class of investors entitled to purchase under Rule 144A.

The ABA sees the SEC private offering proposals as but a first step toward reform that will require ongoing evaluation and refinement in light of changing technology and globalization.
House Passes Bill Imposing Liability on Mortgage-Backed Securities

A comprehensive bill to combat abuses in the mortgage lending market and provide basic protections to mortgage consumers and investors has passed the House by a vote of 291-127. Introduced by House Financial Services Chair Barney Frank. The Mortgage Reform and Anti-Predatory Lending Act, HR 3915, 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.

The bill 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.

The House committee report, 110-441, noted that concerns initially surfaced when lenders to two leveraged hedge funds demanded additional security as collateral against the hedge funds' subprime-backed investments. The subsequent closure of these hedge funds put pressure on other market participants to reprice similar securities. The general threat of such repricing of subprime mortgage risk subsequently led to the present conditions largely for one reason: No credit provider, bond dealer, or investor knows the extent to which other parties are exposed to subprime residential mortgage-backed securities.

Wednesday, November 14, 2007

Armed With Study, US Chamber Seeks Delay of SOX 404

After releasing a study showing that, despite recent reforms, Sarbanes-Oxley section 404 disproportionately burdens small businesses, the US Chamber of Chamber called for a one-year delay in small company implementation of the internal control mandate and urged Congress to hold hearings on the issue. The study shows why small companies complying for the first time with 404 should not be the guinea pigs for the improved rules adopted by the SEC and the PCAOB, said Michael J. Ryan, Jr., executive director of the Chamber's Center for Capital Markets Competitiveness.

Almost 90 per cent of the survey respondents were public companies, observed the Chamber, with half of them describing their public float as $75 million. The companies are primarily in the financial services industry (24.7%), followed by the manufacturing industry (15.7%). There was a consensus that, while 404 was well-intentioned, its implementation was misplaced and impractical, with costs far outstripping benefits.

Unless the SEC or Congress takes action, the current timeline will require non-accelerated filers with a calendar year-end to begin complying with the 404(a) management report on internal control effectiveness in early 2008 and the 404(b) auditor attestation in early 2009. While the SEC predicted that non-accelerated filers would not engage their auditors for 404 compliance until the first half of 2008, noted the Chamber, more than 83 per cent of respondents have already done so with respect to 404(a) and more than 58 per cent have done so with respect to 404(b).

The study also shows that more than half of the companies responding with less than $75 million in market value will spend more than 3 per cent of net income on 404(a). Moreover, 63 percent anticipate a cost increase in the next year due to compliance with 404(a) and (b). More than 58 per cent of the respondents believe that 404 will not help detect and prevent fraud.
FSA Proposes New Disclosure Regime for Hedge Fund Positions

In an effort to prevent hedge funds and other market participants from using derivative contracts for difference to influence corporate governance and build up undisclosed stakes in companies, the UK Financial Services Authority proposed two alternative disclosure regimes. The first approach would strengthen the current disclosure regime by requiring a disclosure of any contracts for difference written in reference to 3 per cent or more of total voting rights attached to a company's shares. The alternative approach is a general disclosure regime which would achieve the same objectives by requiring holders to reveal all economic interest of stakes of 5 per cent or more in a company's shares.

Both approaches would have the benefit of providing greater transparency for
issuers and for the market at least in terms of who holds economic interest in them
and therefore who their potential shareholders are. The consultation period ends on 12 February 2008.

A contract for difference is a share in a derivative product giving the holder an economic
exposure to the change in price of a specific share over the life of the contract. Hedge funds are the typical holders of contracts of difference, which allow them to take an economic exposure to a movement in the referenced share at a small fraction of the cost of securing a similar exposure by acquiring the shares themselves. Essentially, the hedge fund or other holder of such a contract has an economic interest in the company without direct ownership of shares in the company. Currently, contracts for difference fall outside the FSA’s transparency and disclosure rules.

Disclosure under the 3 percent rule would not be required if it was clear that the holder could not exercise voting rights and had made a clear statement to that effect; and there were no arrangements in relation to the potential sale of the underlying shares by the holder. The FSA expects the majority of the contracts to fall within this safe harbor, removing the need for disclosure.

In addition, this proposal would enable companies to request a notification if they believed a holder had an economic interest of 5% or more of the company's shares regardless of safe harbors. It would also make clear the responsibilities of a hedge fund to ensure that any statements made about voting rights in a company are not misleading. The proposals would also make it harder for hedge funds to build up significant stakes in companies without disclosure.
Any rule changes would only apply to contracts relating to UK shares admitted to trading on a regulated or prescribed market, including shares admitted to the regulated markets of UK Recognized Investment Exchanges and the Alternative Investment Market.

The proposed disclosure would allow companies to verify claims by hedge funds as to their holdings. Currently, companies approached by individuals claiming to have an economic interest in their shares have no way to verify such claims. The proposal would allow companies to make appropriate enquiries into such claims and then disseminate the conclusions to the market. In turn, said the FSA, such a verification process will reduce the number of misleading statements being made in respect of significant holdings

Finally, the FSA intends to coordinate the new disclosure rules with existing takeover rules in order to avoid duplicative disclosure. There are two ways of achieving this dovetailing. The first would be for the new rules to state that they do not apply if the information regarding the same holdings has already been publicly disclosed pursuant to the takeover rules, even if to a different level of detail. The second would be to switch off the new rules when an offer period begins.

Monday, November 12, 2007

Basel II Brings New Securitization Framework

As financial institutions move towards an originate and distribute model of securitizing loans into asset-backed securities, the Basel II Accord just adopted by the Federal Reserve Board provides a new securitization framework with concomitant disclosure mandates. A central principle of Basel II is that external ratings for securitization exposures retained by an originating bank, which typically are not traded, are subject to less market discipline than rating for exposures sold to third parties,. In the Fed’s view, this disparity in market discipline warrants more stringent conditions. Thus, Basel II requires that two external ratings be obtained

Basel II also requires that banks disclose the amount of credit risk transferred and retained by the organization through securitization transactions and the types of products securitized. These disclosures are designed to provide users a better understanding of how securitization transactions impact the credit risk of the bank.

Generally, the Fed believes that banks will be able to fulfill some of their disclosure requirements by relying on disclosures made in accordance with accounting standards, SEC mandates, or regulatory reports. In these situations, banks must explain any material differences between the accounting or other disclosure and the disclosures required under Basel II.

As recently noted by Jean-Pierre Landau, Deputy Governor of the Bank of France, the current model of securitization has two distinctive features. One is the increasing complexity of customized derivatives, which has made valuation and risk assessment more difficult. The second is the fragility of off-balance sheet structures and vehicles which underpin securitization. Structured investment vehicles are not built to absorb shocks.

Their relationships with sponsor banks are sometimes very ambiguous, he noted, and there may be a gap between the legal commitments taken by the banks through liquidity support and credit enhancements and the true level of responsibility they felt obliged to take to protect their reputation. But the central banker predicted that the implementation of Basel II will bring significant improvements in risk management of securitization exposures. Had it been in place some years ago, he speculated, current problems may have been avoided.

Echoing these remarks, Fed Governor Randall Kroszner said that the enhanced public disclosures under Basel II should allow market participants to better understand a bank’s risk profile, adding that recent market events have underscored the importance of such transparency.

In his view, Basel II requires banks to assess the creditworthiness of borrowers and individual loans and investments, such as highly structured asset-backed securities, and to hold capital commensurate with that risk. This enhanced risk-sensitivity requires banks to hold a larger capital cushion for higher-risk exposures and thereby creates positive incentives for banks to lend to more creditworthy counterparties.

Thursday, November 08, 2007

Financial Services Roundtable Calls for Principles-Based Regulation

The Financial Services Roundtable has added to the drumbeat for principles-based regulation in a blueprint for reform recommending that Congress mandate guiding principles for US financial regulators. The President’s Working Group on Financial Markets would be given the job of seeing that the regulators implemented the guiding principles.

The guiding principles would not replace regulations. However, once enacted into law, they would become a touchstone against which all existing and new national and state financial regulations would be evaluated in a policy and legal context. Regulations that are inconsistent with the principles would be identified, analyzed, and then revised or

The blueprint envisions six guiding principles. 1) fair treatment for customers and investors; 2) financial regulation should promote competitive and innovative financial markets; 3) the cost and burden of regulation should be proportionate to the benefit; 4) prudential regulation based on a cooperative dialogue promoting best practices; 5) giving financial firms a wide range of options to serve customers; 6) management policies enabling a financial services firm to operate successfully and maintain the trust of consumers.

Wednesday, November 07, 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. Please view a white paper that I did on MiFID

Thursday, November 01, 2007

EU Court Rules German Anti-Takeover Law Restricts Cross-Border Investment

In an eagerly anticipated opinion, the European Court of Justice has ruled that Germany’s anti-takeover ``Volkswagen Law’’ restricts the free cross-border movement of capital through the intervention of the public sector. In an action brought by the European Commission against the Federal Republic of Germany, the Court found that capping the voting rights of every shareholder at 20% regardless of their shareholding violates the requirement that there be a correlation between shareholding and voting rights. The Court also held that provisions in the law conferring two seats each on the company’s supervisory board for the Federal Republic and the State of Lower Saxony, regardless of their shareholding, also constituted a restriction on the cross-border movement of capital. (European Commission v. Federal Republic of Germany, No. C-112/05).

The Volkswagen law was hammered out in 1960 with the participation of workers and trade unions that, in return for relinquishing their claim of ownership rights in the company, secured protection against any large shareholder gaining control. The legislation allows the federal government and Lower Saxony to each appoint two members of the supervisory board (equivalent to the board of directors in the US), for a total of four government seats, and gives them each a 20% stake. It also limits voting rights to 20 per cent of the share capital. Further, the law increases to more than 80 per cent of the share capital represented for the adoption of resolutions of the general shareholders meeting.

The Court found that, by capping voting rights at 20%, the VW law creates a framework giving federal and state authorities a blocking minority on the basis of a lower level of investment than would be required under general corporate law. This situation could deter cross-border investment in the company, reasoned the Court, thus constituting a restriction on the free movement of capital.

Similarly, the Court found that conferring four seats on the Federal Republic and Lower Saxony enables those entities more influence on the supervisory board than their shareholder status would normally allow which, in turn, reduces the influence of other shareholders. Since this situation is liable to deter cross-border investment, the Court found it to be a restriction on the free movement of capital.

The Court rejected the Federal Republic’s argument that the provisions are needed to protect workers since Germany was unable to explain how workers would be protected by giving government a strengthened and irremovable position in the company’s capital. The Court also noted that, under German legislation, workers are represented on the supervisory board.

Finally, the fact that the supervisory board is a monitoring body does not diminish the influence of the Federal Republic and Lower Saxony on that board. The Court noted that the supervisory board has significant powers, including the hiring and firing of executive board members and approving the establishment and transfer of production facilities.
New Era of Best Execution Ushered in by MiFID

Best execution is a core principle of MiFID and is fundamental for investor protection. When providing investment services to their clients, investment firms are obliged to act honestly, fairly and professionally in accordance with the best interests of their clients. This fiduciary duty an investment firm owes its client is further developed in the best execution obligations contained in Article 21.

Best execution means that, when firms execute client orders, they must take all reasonable steps to deliver the best possible result for their clients, taking into account a variety of factors, such as the price of the financial instrument, speed of execution of the order and cost. For retail clients, best possible means the most favorable result in terms of the price of the instrument and the costs associated with the execution.

This area is singled out because of the information asymmetry arising between the service provider and the client. Under normal circumstances, clients have very little opportunity to monitor whether the investment firm that executes orders on their behalf has indeed acted in their best interest since they are unlikely to have the access to the relevant information that would help them assess the quality of the service.

There is thus a danger that some investment firms could take advantage of this information asymmetry by giving unfair treatment to their clients without necessarily suffering the usual reputational consequences in a competitive market. This is why MiFID established a clear obligation for the execution of client orders.

MiFID establishes a regime where multiple trading venues will be able to compete for client order flow. Competition between trading venues should lower the cost of transacting financial instruments and thus contribute to the greater efficiency of European capital markets. However, it is well known that liquidity pools are extremely sticky, which means it is extremely hard for new trading centers to attract new business even if they can provide better services than their competitors.

As trades are driven to those venues that can consistently provide the highest quality results, the best execution obligation will help ensure that firms are not able to ignore such venues. Apart from promoting competition, best execution obligations should thus also contribute to greater market integration.

Best execution is not limited to shares but applies to all financial instruments. However, investment firms, though always subject to best execution obligations, are not expected to meet these obligations in the same way for each type of instrument.

When assessing a particular firm's compliance with MiFID, regulators will decide whether the firm's policy is adequate and whether the firm adheres to its policy in practice. The policy will also have to be dynamic. Investment firms must monitor its effectiveness in order to identify and, where appropriate, correct any deficiencies.

In particular, firms must regularly assess whether the execution venues included in the policy are actually delivering best execution and make appropriate changes when necessary. For example, the policy may have to be amended to take account of the emergence of new venues.
In most cases, in order to have a reasonable chance of securing the best possible result for their clients, firms should assess a choice of venues. This will allow them to determine which venue is offering the best conditions and to route the order to that venue.

The European Commission has noted that it is possible that a firm using a single venue for the execution of its client orders could comply with the best execution rules, depending on specific circumstances such as type of clients and financial instruments. But the Commission expects that the greatest competition among execution venues will be in the area of share trading. As more venues attract liquidity and compete, reasoned the Commission, it will become harder for investment firms to execute orders at only one venue and still meet the best execution obligations. CESR has published detailed guidance on this subject at