Saturday, November 29, 2008

LLC Managers Not Subject to Florida Long Arm Jurisdiction

A Florida appellate court has ruled that the non-resident managers of a limited liability company were not subject to personal jurisdiction in Florida for the LLC's violations of the Florida Blue Sky Law. A receiver appointed for the LLC had sought damages from the managers for the company's sales of timeshare interests in luxury motor coaches. The receiver alleged that the sales of the interests, which contained an investment component, violated the registration and anti-fraud provisions of the Florida securities laws, provisions of the Florida Timesharing Act, and prohibitions against fraudulent transfers.

In reversing the decision of the lower court, the Fifth District Court of Appeal held that the evidence did not support a finding that the managers conducted a business venture or committed a tortious act in Florida. Although the managers attended board meetings by telephone, they testified that they did not provide any services to the LLC, and their affidavits refuted any allegations in the complaint that they personally developed, marketed, or sold the timeshare interests. Moreover, the depositions filed by the receiver to support long arm jurisdiction did not conflict with the affidavits, but indicated that the managers only acted in their capacity as corporate officers. Consequently, the managers' actions were shielded by the corporate shield doctrine and personal jurisdiction could not be asserted over them, the appellate court concluded.

The appellate court also rejected the receiver's argument that long arm jurisdiction could be asserted against the managers because the complaint alleged fraud. A statutory action for securities fraud under Florida law is not tantamount to a common law fraud action, the appellate court observed, but requires a showing that a defendant personally induced the investors to purchase the securities. As the receiver failed to make such a showing, the allegations underlying the statutory fraud actions could not support jurisdiction.
Clement v. Lipson, (Fla. Dist. App. 2008)

Wednesday, November 26, 2008

Risk Management at Top of List for Financial Regulatory Reform

It has become clear that the financial market crisis was partially caused by a failure of risk management. This is somewhat perplexing because the concept of risk management has been around for some years. But jawboning did not work, even the very excellent jawboning of Federal Reserve Board Governors Randy Kroszner and Susan Schmidt Bies. So now, there will be mandatory risk management for financial institutions under some form of federal oversight.

Effective risk management is part of sound corporate governance. It comes from having the right tone at the top and strong support at the board and senior management level. The risk management officer must report to a senior officer who has responsibility for effective risk management. Risk management must be independent of line duties and its officers must not have their compensation tied to performance incentives. There must be effective stress testing.

NASAA to Host Regulatory Reform Roundtable

The North American Securities Administrators Association (NASAA) has announced that it will host a Regulatory Reform Roundtable on December 11 to outline the essential elements that the incoming administration and Congress should consider in the ongoing debate over the future of the nation’s financial services regulatory structure.

According to NASAA, state securities regulators will use the Roundtable to present their policy recommendations to ensure that the any new regulatory structure is "collaborative, efficient, comprehensive and strong." NASAA President Fred Joseph said policymakers can achieve these objectives by applying five core principles of regulatory reform:

- Preserve the system of state/federal collaboration while streamlining where possible;
- Close regulatory gaps by subjecting all financial products and markets to regulation;
- Strengthen standards of conduct, and use “principles” to complement rules, not replace them;
- Improve oversight through better risk assessment and interagency communication; and
- Toughen enforcement and shore up private remedies.

The Roundtable has been scheduled for Thursday, December 11 at the Phoenix Park Hotel in Washington, DC. Persons interested in attending should contact Lonnie Martin at, or 202-737-0900 by December 9. Additional event details are available on the
NASAA website.

Monday, November 24, 2008

Missouri Implements Electronic Form D Filing Procedures

Issuers intending to make a Rule 506 securities offering in Missouri during the electronic Form D transition period--September 15, 2008 to March 15, 2009--must paper file directly with the Missouri Securities Division: (1) One manually signed copy of the SEC-filed Form D (including the appendix); (2) a Form U-2, Uniform Consent to Service of Process; and (3) $100. The notice must include a cover letter specifying the date the first sale of securities took place in Missouri. The notice must be filed within 15 calendar days after the first sale of securities in Missouri.

CAUTION NOTES: (1) During the six-month transition period, the SEC allows issuers to either paper file a current Form D (also called "Temporary Form D"), paper file new Form D, or electronically file new Form D through EDGAR. However, Missouri requires that whatever version of Form D is filed with the SEC, whether paper filed or electronically filed, must be paper-filed in Missouri. None of the states are yet able to accept electronic filings of Form D.

(2) The ABA State Securities Subcommittee noted some inconsistencies between the SEC and Missouri: (a) that Missouri requires the appendix to Form D even though new Form D does not require it; and (b) that Missouri requires Form U-2 even though new Form D does not require it. It is the Committee's belief that these two conflicts will be resolved when Missouri amends it's Rule 506 offering rule at 30-54.210(3) [CCH par. 35,520A]. Missouri's 18(b)(4)(D) statutory provision is contained in Sec. 409.3-302(c) of the Missouri Uniform Securities Act [CCH par. 35,111].

Missouri's electronic Form D filing procedures are contained in the State's Advisory Release -08-03 at

Saturday, November 22, 2008

Probable Treasury Pick Called for Reform of Securitization Earlier This Year

NY Fed President Timothy Geithner, who is the likely Treasury Secretary under President Obama, called for the reform of securitization in the first quarter of this year based on strongly enhanced risk management. Mr. Geithner said that the financial crisis exposed a weakness in the risk management systems of global finncial institutions. Federal regulators must insist that banks and other financial institutions have in place effective risk manageent processes. It would appear from his remarks that he would be on board with a federal systemic risk regulator, an idea favored by a number of policymakers, including House Financial Services Chair Barney Frank. The NY Fed chief also mentioned that the current overlapping and inconsistent system of federal financial regulation encourages regulagtory arbitrage.

Friday, November 21, 2008

Fund Disclosure, Money Market Redemption Rules Adopted

The SEC adopted rule amendments designed to improve mutual fund disclosure by providing investors with a summary prospectus containing key information in plain English in a clear and concise format, and by enhancing the availability on the Internet of more detailed information to investors. The commissioners also adopted related amendments to Form N-1A dealing with exchange-traded funds.

Under the amended rules, every mutual fund must include key information at the front of its statutory prospectus about the fund’s investment objectives and strategies, risks, and costs. The summary will also include brief information regarding investment advisers and portfolio managers, purchase and sale procedures, tax consequences, and financial intermediary compensation. Funds will be required to provide the summary information in plain English and in a standardized order.

The SEC also adopted a new rule that permits sending a summary prospectus to satisfy prospectus delivery requirements if the mutual fund’s summary prospectus, statutory prospectus, and other specified information are available online. The summary prospectus must have the same information in the same order as the summary at the front of the statutory prospectus. In addition:

The online materials must be in a user-friendly format that permits investors and other users to move back and forth between the summary prospectus and the statutory prospectus and

Investors have to be able to download and retain an electronic version of the information. The statutory prospectus and other information must be provided in paper or by e-mail upon request so investors can choose the format in which they receive more detailed information.
The rule changes are effective on February 28, 2009, and funds must begin complying with the form changes on January 1, 2010. The text of the adopting release is not yet available.

The Commission also adopted an interim final temporary Investment Company Act rule and issued a request for comment concerning money market funds participating in a temporary guaranty program established by the Treasury Department.The guaranty program establishes a procedure for the orderly liquidation of money market fund assets in certain circumstances. Interim final temporary Rule 22e-3T will permit money market funds that commence liquidation under the guaranty program to temporarily suspend redemptions of their outstanding shares and postpone the payment of redemption proceeds. The rule is effective upon publication in the Federal Register and will remain effective until October 18, 2009, unless terminated earlier in connection with termination of the guaranty program.

The adopting release is available

The Commission postponed consideration of rule changes that would have imposed additional requirements on nationally recognized statistical rating organizations in order to address concerns about the integrity of their credit rating procedures and methodologies.

Thursday, November 20, 2008

SEC Chair Will Convene Meeting of International Securities Regulators

With many commenters noting that this is an international financial crisis needing an international regulatory response, SEC Chairman Christopher Cox said that he will convene a meeting of the International Organization of Securities Commissions (IOSCO) Technical Committee on Monday, November 24 by teleconference to discuss urgent regulatory issues in the ongoing credit crisis.

In addressing turbulent market conditions, said the chair, it is essential not only that regulators act against securities law violations, including abusive short selling, but also that there be close coordination among international markets to avoid regulatory gaps and unintended consequences. This high-level coordination among international regulators will allow for a review of the steps taken thus far and ensure that ongoing and future actions are effective and mutually reinforcing.

The Technical Committee meeting will consider, in addition to short selling, OTC derivatives, international accounting standards, regulation of credit rating agencies, and other issues. It is becoming clear that any regulatory and legislative reform of the financial crisis must and will have an international component. Indeed, one of the key guiding principles enunciated by the President-elect is that international regulatory cooperation and harm0nization is crucial to the effective reform of the financial markets, and that includes the accounting and auditing standard setters, as well as the securities regulators.
Sixth Circuit's "Most Plausible" Standard Did Not Survive Tellabs

A 6th Circuit panel recognized that the law in that circuit, that plaintiffs are "only to the most plausible of competing inferences," was no longer valid after the U.S. Supreme Court's Tellabs decision. The 6th Circuit adopted the more stringent standard in its 2001 Helwig v. Vencor, Inc. decision. Because Tellabs required that "where two equally compelling inferences can be drawn, one demonstrating scienter and the other supporting a nonculpable explanation...the complaint should be permitted to move forward," the court concluded that Helwig was no longer good law.

The appeals court did not reach the merits of the question, and remanded the case for the district court to apply the new "at least as compelling" standard. The result in such a fact-based determination of the difference between what is "most plausible" and what is "as least as compelling" is obviously quite subjective and impossible to predict.

Frank v. Dana Corp.
"Stormy" Weather? The 2nd Circuit Didn't "Notice"

So-called "storm warnings" that a district court found sufficient to derail a fraud action against The Hartford Financial Services Group failed to put investors on inquiry notice for limitations purposes. According to a 2nd Circuit panel, various "warnings" in media reports, related lawsuits and regulatory filings were "too vague and non-specific to suggest to an investor of ordinary intelligence the probability of fraud" and that the information that supposedly provided notice "was not reasonably accessible to the ordinary investor."

The case arose from alleged undisclosed contingent commissions (called "kickbacks" by the court) paid by insurers to induce brokers to steer business to them. The district court dismissed the case under the two-year Sarbanes-Oxley limitations provision because the investors should have been aware of the potential fraud because of publicly available information.

Initially, the panel found that the district court properly took judicial notice of the various exhibits introduced by The Hartford defendants, including news stories, filings and court documents. The documents "were offered to show that certain things were said in the press, and that assertions were made in lawsuits and regulatory filings, which is all that is required to trigger inquiry," wrote District Judge Colleen McMahon (sitting by designation), and "[n]one of those materials were offered for the truth of the matter asserted."

The panel disagreed with the district court's reading of the documents, however. The defendants presented 17 media stories, mostly from industry-specific publications. With regard to one New York Times account, Judge McMahon wrote that "this article, and the remaining small amount of public information available about contingent commissions at The Hartford, was not enough to create a duty to inquire." As a matter of law, an ordinary investor who "stumbled across" this article would not "have inferred that The Hartford was involved at all." In her opinion, this was " a far cry from the District Court’s conclusion that it was `especially likely' that The Hartford was implicated by the article." Three out of four of the mainstream stories did not mention The Hartford, and 12 of the 13 industry publications also did not mention the company by name.

The court declined to find that company-specific storm warnings are a necessary precondition for inquiry notice. However, "the fact remains that the specificity of storm warnings bears directly on the determination of whether, under the totality of the circumstances, a plaintiff should be charged with a duty to inquire." The generic nature of the articles cited did not raise any such duty.

The regulatory filings were also insufficient in the panel's opinion. The descriptions of the commissions paid were "seemingly benign" and "did not indicate that the contingent commission expenses stemmed from fraudulent schemes."

The closest call came with the issue of previously-filed state court lawsuits. The panel dismissed three of the four proceedings immediately, as two of them did not mention the company and a third did so only in passing. However, one California case directly involved company subsidiaries and similar issues.

This case could have triggered the duty to inquire if an investor of ordinary intelligence would have been reasonably aware of the complaint, stated Judge McMahon. The dispositive issue, therefore, was whether the complaint was reasonably accessible to an ordinary investor. Because the case received little publicity and was not mentioned in any of the cited news articles, the court found that reasonable investors would not have known of it. The fact that this particular individual detected sufficient problems to file the earlier action was also not sufficient. This plaintiff was a California insurance lawyer who regularly filed such actions. "The fact that an investor of more-than-ordinary intelligence filed a lawsuit against subsidiaries of The Hartford in 2001 cannot be used as a bellwether for the adequacy of the storm warnings at that time.

Staehr v. The Hartford Financial Services Group, Inc.

Wednesday, November 19, 2008

European Commission Proposes Methods to Add to Big Four Audit Firms

In an effort to increase the number of global audit firms, the European Commission has embarked on a consultation presenting two possible ways forward: the deregulation of the capitalization of audit firms and lowering other non-capital barriers to access. Internal Market Commissioner Charlie McCreevy has noted that current conditions prevent the entry of new players in the international audit market, as well as threaten existing audit firms. Left alone, noted the commissioner, the combination of high concentration and limited choice of audit firms could lead to damaging consequences for the capital markets.

The Commission has been trying to increase the Big Four for some time now. That was the idea behind proposed limitations on auditor liability. This effort is in response to the increasing trend of litigation and the lack of sufficient insurance coverage in the sector. The proposal is also designed to ensure that enough audit firms are available to carry out the audits of public companies in the European Union. Studies have shown that liability risks for audit firms act as a barrier for mid-tier audit firms entering the market for the audit of listed companies at the international level.

The proposed deregulation of the capitalization of audit firms (unbundling) as the catalyst for opening up the audit market would require changes in the Directive on Statutory Audit, which requires that auditors hold a majority of the voting rights in an audit firm and that a majority of auditors control the management board. A main non-capital proposal designed to allow new players to enter the game is the harmonization of auditor independence rules.

The Commission noted that the current financial turmoil might also contribute to widening the gap between the Big Four and the mid-tier audit firms. Although there is no evidence about the role of auditors in the crisis, and they have not been subject to criticism so far, said the Commission, the risks inherent in the auditor's role might be perceived as higher. This situation might reinforce the lack of interest of mid-tier audit firms for the market of the audit of financial institutions, which is currently even more dominated by the Big Four than the market for large non-financial companies.

Tuesday, November 18, 2008

DC Circuit Denies Full Review of PCAOB Constitutional Challenge by 5-4 Vote

The US Court of Appeals for the DC Circuit has denied full or en banc review of a split panel decision upholding the PCAOB as constitutional by a 5-4 vote. Given that four circuit judges wanted a full review of the constitutional issues surrounding the Board’s creation makes it almost certain that Supreme Court review will be sought.

The full circuit court denied the rehearing en banc in a one page order, with no written opinions. Judge Kavanaugh, who dissented in the panel opinion, would have granted review He was joined by Circuit Judges Ginsburg and Griffith, and Chief Judge Sentelle. Voting to deny full court review were Judges Brown and Rogers, who were the majority on the panel decision, and Judges Henderson, Tatel, and Garland.

The split federal appeals court panel ruled that the PCAOB is constitutional and rejected the claims of an audit firm inspected by the Board that SEC rather than presidential selection of Board members ran afoul of the Appointments Clause of the US Constitution. The panel concluded that Board members are inferior officers of the United States within the meaning of the Appointments Clause; and thus properly appointed by the SEC. The fact that the Sarbanes-Oxley Act limited the SEC’s authority by providing that Board members can only removed for cause did not elevate Board members to the status of principal officers of the US worthy of presidential appointment. Despite the for-cause removal, said the panel, the fact remained that the Act gave the SEC comprehensive and pervasive control of the PCAOB, including the approval of the Board’s budget. Free Enterprise Fund v. PCAOB, No. 07-5127, DC Circuit Court of Appeals, Aug. 22, 2008).

The Appointments Clause empowers the President to appoint officers of the U.S., while allowing Congress to vest the appointment of inferior officers in Heads of Departments. The audit firm argued that PCAOB members are not inferior officers since they are neither appointed nor supervised on a daily basis by principal officers directly accountable to the President. Rejecting this argument, the appeals court held that the SEC is a Department; that the commissioners are Heads of a Department under the Appointments Clause; and that PCAOB members are inferior officers subject to appointment and removal by the SEC. Thus, the Sarbanes-Oxley Act provisions creating the PCAOB did not violate the Appointments Clause.

The SEC’s power over the PCAOB is broad and complete, noted the court, since no Board rule or standard is promulgated and no Board sanction is imposed without the Commission’s stamp of approval. Further, all Board adjudications are subject to Commission review. Indeed, any policy decision of the Board is subject to SEC oversight.

The SEC can also relieve the Board of any enforcement authority. Audit firms inspected by the Board can seek SEC review of their inspection report. The SEC can modify the Board’s investigative authority as it sees fit and may mandate that all decisions regarding enforcement actions be approved by the Commission.

The audit firm’s argument that the SEC is not a constitutional Department of the federal government capable of appointing Board members was also rejected. The court said that the Commission is “Cabinet-like” because it exercises executive authority over a major aspect of government policy, and its principal officers are appointed by the President with the advice and consent of the Senate. The SEC is not a subordinate body attached to an executive department, noted the court, but is in itself an independent division of the Executive Branch with certain independent duties and functions.

Moreover, the commissioners are heads of a Department under the Appointments Clause because they, as a group, exercise the same final authority as is vested in a single head of an executive department. Congress gave the SEC rulemaking, investigative, and adjudicatory authority. And, emphasized the court, Congress can authorize multi-member commissions to appoint inferior officers.

Finally, the appeals panel rejected the argument that the legislative creation of the PCAOB violated the separation of powers doctrine by directly encroaching on the Executive Branch’s appointment, removal, or decision making authority. The court said that the double for-cause limitation on removal of Board members did not constitute an excessive attenuation of Presidential control of the Board.

The President is not completely stripped of his ability to remove Board members. Like-minded SEC Commissioners can be appointed by the President, noted the panel, and they can be removed by the President for cause; and Board members can be appointed and removed for cause by the commissioners. Although the level of Presidential control over the Board reflects Congress’s intention to insulate the Board from partisan forces, acknowledged the court, this statutory scheme preserves sufficient executive influence over the Board through the Commission so as not to render the President unable to perform his or her constitutional duties.

Further, there is no thought that the Board’s creation represents an unprecedented congressional innovation. The SEC’s wide-ranging oversight over the Board was modeled after the rules regarding Commission authority over self-regulatory organizations in the securities industry, which has existed for over seventy years.

Monday, November 17, 2008

Senator Will Reintroduce in 111th Congress Bill Requiring SEC Registration of Hedge Fund Advisers

Sen. Charles Grassley said that he would reintroduce in the 111th Congress a bill requiring hedge fund advisers to register with the SEC, effectively providing a legislative override of the federal appeals court Goldstein ruling. He said that the bill would be modeled on the Hedge Fund Registration Act, S. 1402, that the senator introduced in May of 2007. That legislation was referred to the Senate Banking Committee but never brought up for consideration.

The Grassley bill would authorize the SEC to require all investment advisers, including hedge fund managers, to register with the SEC. The bill would, however, exempt investment advisers who manage less than $50 million, have fewer than fifteen clients, do not hold themselves out to the public as investment advisers, and manage the assets for fewer than fifteen investors, regardless of whether investment is direct or through a pooled investment vehicle, such as a hedge fund.

Specifically, the bill would amend section 203(b)(3) of the Investment Advisers Act to narrow the current exemption from registration for certain investment advisers. This exemption is used by large, private pooled investment vehicles, commonly referred to as hedge funds. According to Sen. Grassley, who is the Ranking Member on the Finance Committee, hedge funds are operated by advisors who manage billions of dollars for groups of wealthy investors in total secrecy. They should at least have to register with the SEC, he emphasized, like other investment advisers do.

Currently, the exemption applies to investment advisers with fewer than fifteen clients in the preceding year and who do not hold themselves out to the public as an investment adviser. The Hedge Fund Registration Act would narrow this exemption and close a loophole in the securities laws these hedge funds use to avoid registering with the SEC and operate in secret.

According to Sen. Grassley, Congress needs to act because of the appeals court decision, which struck down as arbitrary an SEC rule that required registration of hedge fund advisers. The appeals panel rejected the SEC’s suggestion of counting the investors in the hedge fund as clients of the fund’s adviser within the statute’s meaning of clients in order to get over the statutory client level. (Goldstein v. SEC, CA DofC 2006). That decision effectively ended all registration of hedge funds with the SEC, unless and until Congress acts.

Sen. Grassley explained that the Hedge Fund Registration Act would respond to that court decision by narrowing the current registration exemption and bringing much needed transparency to hedge funds. He views the Act as a first step in ensuring that the SEC simply has clear authority to do what it already tried to do, adding that Congress must act to ensure that federal securities law is kept up date as new types of investments appear. Noting estimates that these pooled investment vehicles account for nearly 30% of the daily trades in U.S. financial markets, the legislator emphasized that Congress must ensure that the SEC knows who is controlling these massive pools of money in order to ensure the integrity and security of the markets.
North Dakota Implements Temporary Form D For Rule 506 Offerings

Issuers intending to make an offering under Rule 506 of federal Regulation D must file Temporary Form D (including the state appendix), a Form U-2, Uniform Consent to Service of Process, and $100 fee within 15 days after the first sale of the securities in North Dakota. A $250 fee is required if the filing is not made within the 15-day period. An original signature is not required for Parts D and E of Form D. A copy of Form D is permitted.

There is no renewal provision. The documents and fee for the original filing must be resubmitted if the offering extends beyond the one year period, except for the Form U-2 that may be incorporated by reference. No commission or remuneration may be paid for soliciting any prospective buyer in North Dakota except for a commission paid to a North Dakota-registered broker-dealer or agent.


Saturday, November 15, 2008

President-Elect Obama Details Key Principles to Guide Federal Financial Regulation Reform

As the nation approaches the most fundamental reform of federal regulation of the financial and securities markets since President Franklin Roosevelt’s New Deal, the most central personality to the effort will obviously be President Barack Obama. It is thus instructive to examine the six key principles that must guide next year’s reform legislation, which are contained in a briefing
paper setting out Mr. Obama’s beliefs in this area. Obviously, events can work changes during the interregnum before Mr. Obama is sworn in as President next January. I recall from history that conditions deteriorated significantly during the President Hoover-President Roosevelt interregnum, which was longer because FDR was not sworn in until March of 1933. We are perhaps fortunate that this experience led to the shortening of the presidential interregnum so that the needed reform process can begin sooner.

A first broad principle enunciated by the President-elect is that the nation must devise a financial regulatory regime for the 21st century to replace one that is still essentially a 1930s regulatory apparatus. This means first and foremost ending the current balkanized framework of overlapping and competing regulatory agencies. Prior to the 1999 repeal of the Glass-Steagall Act, financial institutions fell into easily delineated categories such as commercial banks and investment banks and were regulated by specific entities such as the SEC, the FDIC and the CFTC. However, the large, complex institutions that currently dominate the financial landscape no longer fit into discrete categories. Thus, President- elect Obama endorses a streamlined system of federal oversight.

A second principle is that the Fed must have authority over any financial institution to which it may make credit available as a lendor of last resort. The Federal Reserve does not exist to bail out financial institutions, declared the President-elect, but rather to ensure stability in the financial markets. There must be prudential oversight commensurate with the degree of exposure of specific financial institutions.

In light of the widespread valuation problems of complex financial instruments such as mortgage-backed securities, a third principle of the Obama reforms will be enhancing capital requirements and the development and rigorous application of new standards for managing liquidity risk. President Obama will also call for an immediate investigation into the ratings agencies and their relationships to securities’ issuers, similar to the investigation the European Union conducted, which led to a proposal to require the registration of credit rating agencies in the EU and the end of voluntary regulation.

A fourth principle is to regulate financial institutions for what they do rather than who they are. The current oversight structure is rooted in the legal status of financial firms. This must end, said the President-elect, since this fragmented structure is incapable of providing the oversight necessary to prevent bubbles and curb abuses. President-elect Obama believes that regulation should identify, disclose, and oversee risky behaviors regardless of what kind of financial institution engages in them. This is essentially a regulation by objective approach favored by many, including the recent Volcker report. Former Fed Chair Paul Volcker is a senior adviser to the President-elect.

Barack Obama also believes, as a fifth principle, that the SEC should aggressively investigate reports of market manipulation and crack down on trading activity that crosses the line to fraudulent manipulation. In the last eight years, the SEC has been sapped of the funding, manpower and technology to provide effective oversight. The SEC’s budget was left flat or declining for three years and is currently less than it was in 2005. The President-elect cited a 2007 GAO report finding that the SEC lacked the computer systems to effectively make use of internal audits conducted by stock exchanges, which may limit the SEC’s ability to monitor unusual market activity, make decisions about opening investigations, and allow management to assess case activities, among other thing.

As a result, during a period of increasing market uncertainty and opacity, the SEC enforcement division has not effectively policed potentially manipulative behavior. The SEC’s FY2009 budget request itself shows that the percentage of first enforcement actions filed within two years of opening an investigation or inquiry fell from 69 percent in 2004 to 54 percent last year. Mr. Obama believes that there must be an effective, functioning cop on the beat to identify market manipulation, protect investors and avoid excessive speculation in financial markets.

More broadly, a sixth principle of financial markets reform is to establish a mechanism that can identify systemic threats to the financial system and effectively address them. The President-elect calls for the creation of a Financial Market Oversight Commission that would meet regularly and report to the President, the President’s Financial Working Group and Congress on the state of the financial markets and the systemic risks that face them. He also calls for the establishment of a standardized process to resolve such systemic risk in an orderly manner without putting taxpayer dollars at risk. This goal may presage the creation of a systemic risk regulator as some congressional leaders are championing.
G20 Sets Forth Goal of Massive Global Reform of Financial Regulation

The G20 has proposed a massive overhaul of the entire system of financial regulation based on transparency, risk management, the convergence of accounting standards, and the global sharing of information among regulators. The group also endorsed a college of regulators concept for global financial institutions, which has found some favor in the EU. In a communiqué, the G20 set out a number of immediate benchmarks to be accomplished in the first quarter of 2009; and longer range goals with no set timetable. The proposals, which are surprisingly granular, establish an ambitious reform blueprint for regulators like the SEC and standard setters like the IASB and FASB.

Immediately, the FASB and IASB must enhance guidance for the valuation of complex illiquid securities and mandate more disclosure for off-balance sheet vehicles. Even more, regulators and standard setters must enhance the disclosure investors receive about complex financial products. On another front, the governance of the IASB must be enhanced to ensure transparency and a relationship between the Board and securities regulators such as the SEC. As a longer range goal, the G20 fully endorsed a single set of global accounting standards of high quality.

Another immediate goal is the registration of credit rating agencies under regimes that avoid conflicts of interest, provide greater disclosure to investors and issuers, and differentiate ratings for complex products. The European Commission recently proposed the regulation of credit rating agencies under a regime based on differentiation.

Also immediately, regulators should build on the imminent launch of central counterparty services for credit default swaps, in the US the NY Fed is vetting such a system, and speed efforts to reduce the systemic risks of credit default swaps and OTC derivatives transactions. Market participants must be required to support exchange-traded or electronic platforms for credit default swaps contracts. Overall, regulators must ensure that the infrastructure for OTC derivatives can support growing volumes.

Risk management is a central principle of the reform of financial regulation. Enhanced guidance must be developed immediately to bolster the risk management practices of financial institutions. Banks and other firms must examine their internal controls and implement sound risk management practices. In particular, banks should have effective risk management and due diligence over structured products and securitization.

For their part, regulators must require that firms have risk management practices that can measure risk concentrations and large counterparty risk positions across products and borders. The Basel Committee should develop new stress testing models. Importantly, executive compensation schemes must not reward excessive short-term returns or risk taking. Rather, incentives should promote stability.

Finally, it is crucial that regulators cooperate on regional and international levels. They must share information about cross-border threats to market stability. Specifically, the G20 said that colleges of regulators should be immediately established for all global financial institutions as part of the oversight of cross-border firms. Major global banks should meet regularly with their oversight college for a comprehensive review of their risk management regimes.

Friday, November 14, 2008

SEC Urged Not to Suspend Fair Value Accounting; but Rather Use MD&A to Help Investors Understand FAS 157 in Illiquid Markets

In a letter to the SEC giving input on the Commission’s study of mark-to-market accounting mandated by the Emergency Economic Stabilization Act, the Center for Audit Quality said that the current use of fair value measurements for financial instruments under FASB Standard No. 157 is appropriate and should not be changed. Blaming the current financial crisis on the use of fair value measurements in financial reporting, continued the CAQ letter, misreads the fundamental economic and regulatory underpinnings of the crisis. Importantly, CAQ emphasized that disclosure, particularly in the MD&A, could be employed to enhance the use of FAS 157 in illiquid markets. While fully aware of the great challenges in applying fair value measurements in today’s distressed markets, CAQ believes that fair value remains the most relevant and useful measure for users of financial statements. CAQ is affiliated with the AICPA.

CAQ also urged the SEC not to suspend FASB 157 since the suspension of fair value accounting, even on an emergency basis, would be a radical change in financial reporting resulting in severe economic dislocation. If alternatives to FAS 157 are to be developed, reasoned CAQ, that development should be through a new FASB rulemaking following formal notice and comment.
In addition, the center cautioned that fair value measurements cannot simply be suspended without putting something else in their place. Reverting to historical cost accounting (including amortized cost) would result in values that would bear no relationship to actual current values, warned CAQ, and using intrinsic values based on management’s subjective judgments would result in inconsistent and unverifiable results.

And both of these alternatives would result in diminished transparency and comparability for investors, said CAQ, representing an abandonment of the last thirty years of improvements in financial reporting. At the end of the day, reminded the center, financial reporting is undertaken for the benefit of investors, who need timely, complete, accurate, and consistent information in order to evaluate the potential risk and return of securities and determine appropriate valuations for them.

That said, CAQ acknowledged the need to improve FAS 157, especially in light of efforts to value securities in the current illiquid markets. For example, guidance could be provided on the circumstances in which it is appropriate to shift from Level 2 to Level 3 inputs when valuing an asset in a time of disrupted market conditions. Moreover, guidance on determining when a market is active or inactive, or when a particular transaction would be considered a distressed sale not constituting evidence of fair value, would assist in exercising judgment in this area. In addition, while FAS 157 creates a valuation method based on first principles and provides certain examples in its appendices, providing more specific examples of the fair value measurements of various types of assets and liabilities under varying assumed market conditions would be very useful.

More broadly, noting that FAS 157 is a principles-based standard relaying on professional judgment, CAQ urged the SEC and PCAOB to develop a framework for the exercise of accounting and audit judgment. Recently, the SEC advisory committee on financial reporting recognized the trend toward increasing the exercise of accounting and audit judgments and urged the SEC and the PCAOB to adopt policy statements clarifying how the reasonableness of such judgments would be assessed.

CAQ also suggested that the SEC consider using disclosure to enhance the transparency of the application of FAS 157 in illiquid markets. Disclosure could include information about the conditions present in a particular market and the assumptions and methods applied in the fair value measurement process.

Entities applying fair value accounting to financial assets and liabilities should also consider providing disclosure in the Management’s Discussion and Analysis about the hold-to-maturity values of those assets and liabilities. In CAQ’s view, such disclosure would help address concerns that fair value accounting forces institutions to use overly pessimistic market prices to value their assets. Investors could look to these disclosures to make an informed judgment about the financial position and estimated future cash flows of the entity.

CAQ noted that the SEC’s Dear CFO letters are good examples of the types of additional disclosures that investors may find useful. In March 2008, the SEC staff sent 30 letters to CFOs addressing disclosures in MD&A about fair value measurements in increasingly illiquid markets. Similar follow-up letters were sent in September 2008.

Thursday, November 13, 2008

Former SEC Chair Ruder Calls for Regulation of Hedge Funds with SEC as Risk Management Assessor

As Congress examines the role of hedge funds in the ongoing financial crisis, former SEC Chair David Ruder urged Congress to empower the SEC to register hedge fund advisers and require them to disclose hedge fund risks and other activities. In testimony before the House Oversight and Government Reform Committee, he said that the Commission should also be authorized to monitor and assess the effectiveness of hedge fund risk management systems. As part of any legislation, he continued, the SEC should be required to share risk information about hedge funds on a confidential basis with the Federal Reserve Board, which should be given primary responsibility for systemic risk regulation.

Separately, the former official said that Congress should repeal the swaps exclusion included in the Commodity Futures Modernization Act of 2000 so that non-exchange traded derivative instruments can be regulated in a manner that will protect investors and help prevent destabilization of the financial markets.

While the main participants in the current crisis were loan originators, investment banks, rating agencies, and sellers of credit default swaps, noted the former chair, hedge funds were participants in several phases of the crisis. Hedge funds contributed to declines in stock and asset prices by liquidating stocks and other assets in order to meet other obligations and in order to pay investors seeking to withdraw funds.

According to the former SEC Chair, new regulations are needed in order to protect hedge fund investors and monitor hedge fund contributions to systemic risk. Systemic risk regulation of hedge funds is necessary because hedge funds’ size, strategies, and opacity pose risks to the financial markets. Highly leveraged hedge funds that borrow large sums and engage in complex transactions using exotic derivatives may severely disrupt the financial markets if they are unable to meet counter party obligations or must sell assets in order to repay investors.

Hedge funds are also major users of non-exchange traded derivatives. Although general characteristics of derivatives are well known, a tremendous void exists regarding the specific characteristics of many of these instruments, the amounts at risk, and the identity of their counter parties. The terms of these instruments are often unique and complicated, and the instruments are frequently not easily settled or offset.

A primary problem identified in the credit crisis has been the loss of confidence among market participants regarding the ability of counter parties to honor contractual obligations and to repay their debts. The main reason for the lack of confidence is lack of information, said Mr. Ruder. Regulation should exist allowing information about hedge fund risk positions to be known by regulators.

Noting that steps to prevent systemic calamities in the financial market should be based on comprehensive risk information, Mr. Ruder advocated a system requiring hedge funds to disclose to regulators information regarding the size and nature of their risk positions and the identities of their counter parties.

The SEC is the proper entity to obtain hedge fund risk information, he said, because the Commission understands the markets and the need to allow innovative risk taking. By monitoring and assessing hedge fund risk management systems, the Commission will be able to determine whether those systems are effective in meeting their protective goals.

Protection of investors must be a major goal of hedge fund regulation, declared the former chair. The SEC already has the power to discipline hedge fund investment advisers who defraud hedge fund investors. SEC powers over hedge fund investment advisers through registration and inspection will allow the Commission to learn about potential fraudulent activities at an earlier stage than is possible through after the fact enforcement activities.

Finally, Mr. Ruder opined that Congress made a serious mistake when it included in the CFMA a swaps exclusion preventing regulation of a broad range of non-exchange traded derivative instruments by either the CFTC or the SEC. These OTC derivatives, including credit default swaps, should be subject to federal regulation, he emphasized.

He urged Congress to repeal the swaps exclusion so that the non-exchange trading of derivative instruments can be regulated in a manner that will help protect investors and prevent destabilization of the financial system. One approach to regulating the systemic risk involved in derivatives would be to standardize the terms of OTC derivatives, such as credit default swaps, andcause those instruments to be traded on futures or options exchanges. Standardization would have the great benefit of reducing the opaque nature of the derivatives.
IASB Overseer Advises G20 to Work with Standard Setters on Fair Value Accounting

In a letter to the G20 Summit, IASB oversight chair Gerritt Zalm warned against changing fair value accounting standards without going through the IASB and FASB. In his view, the integrity of the entire standard-setting process would be compromised if fair value accounting standards were changed on an ad hoc basis outside of the process set up by the Boards. He also warned that the success in developing international accounting standards would be set back by any action that would weaken the independence of the standard-setting process.

He also noted that the IASB and FASB have established a high level advisory group that will comprise senior leaders with broad international experience with financial markets. The group will consider how improvements in financial reporting could help enhance investor confidence in financial markets in light of the ongoing financial crisis.

Mr. Zalm noted that, in response to the financial crisis, the IASB has issued guidance on the fair value measurement of illiquid securities that is consistent with the guidance issued by the SEC and FASB. The IASB noted that both US GAAP and IFRS will now permit entities to reclassify financial instruments that are in the form of securities from their trading portfolio, measured at fair value, to held to maturity, measured at amortized cost and subject to testing for impairment. But reclassification will not be allowed if the fair value option was previously selected. In addition, reclassification to loan category (cost basis) will be permitted if the intention and ability is to hold for the foreseeable future (loans) or until maturity (debt securities).

The chair endorsed the concept of fair value accounting, noting that the use of fair values has received support from both the regulatory and investor communities. The move to mark-to-market accounting in financial reporting has fostered transparency and a more timely recognition of risk exposures, and has contributed to sharpening market discipline. Investors generally support fair value because it delivers a picture of what is actually happening.

The chair emphasized that any further IASB action on fair value accounting must take into account the views of all stakeholders in order to develop accounting standards that provide transparent financial information to market participants. Stakeholders, particularly investors, have been very clear about this point in representations to the Board. Issues related to fair value accounting are complex, said the senior official, with consequences that demand careful evaluation. The area of fair value accounting is not necessarily conducive to immediate fixes.
Ohio Proposes Electronic Filing Rule for Investment Company and Rule 506 Offerings and Prohibition Against Senior-Specific Professional Designations

Rule changes proposed bythe Ohio Securities Division would permit investment companies andRule 506 issuers to make electronic filings, prohibit industry personsfrom using certain senior-specific professional designations, requireinvestment advisers to file Part II of Form ADV, clarify an investmentadviser's use of the IARD and CRD, retitle the NASDAQ to be consistentwith federal nomenclature, add the NASDAQ to the exchange listing exemption and substitute "FINRA" for "NASD."

Visit here for more information.
Kansas Implements Electronic Form D

Between September 15, 2008 and March 16, 2009, issuers offering or selling securities under Rule 504, 505 or 506 of federal Regulation D, or Section 3(a)(11) of the Securities Act of 1933 and Rule 147, that intend to claim the Kansas uniform limited offering, Rule 506 or accredited investor exemptions must file:

* Temporary Form D; or
* Printed version of the notice of sale on Form D that was filed electronically with the SEC

A paper filing with $250 made payable to the Kansas Securities Commissioner must be sent to the Office of the Kansas Securities Commissioner at 618 South Kansas Avenue, Topeka, Kansas 66603-3804. Form D must be filed no later than 15 calendar days after the first sale of the securities in Kansas, unless the 15th days falls on a Saturday, Sunday or holiday, in which case the due date is the first business day following. NOTE: Late filings are subject to a late filing fee.

Link to the Kansas Securities Commissioner's office.

here for SEC Release 33-8891.

Link to Edgar access code information.
Colorado Modifies Investment Company Securities and Section 3(b)/4(2) 1933 Act Exemptions and Adopts Prohibition Against Industry Persons' Use of Senior Certifications or Designations

Effective December 1, 2008:

Modifications to exemptions for securities issued by investment companies and for transactions in securities made under Section 3(b) or 4(2) of the Securities Act of 1933 are put in place by the Colorado Securities Division. Additionally, the NASAA Model Rule on the use of senior-specific certifications and professional designations is adopted for Colorado. t

Open-end investment companies and unit investment trusts intending to claim the exemption under Section 11-51-307(1)(k) for initial and subsequent issuances of securities must file Form NF, Uniform Investment Company Notice Filing, with the Colorado Securities Commissioner. A claim of exemption and any amendments filed electronically with an approved designee are considered "filed" with the Securities Commissioner.

Issuers intending to claim the exemption under Section 11-51-308(1)(p) for transactions made in reliance on Section 3(b) or 4(2) of the Securities Act of 1933 are required to send the Colorado Securities Commissioner or his or her designee a paper or electronic copy (if permitted) of the required SEC-filed forms, along with the applicable fee. The form filing must be submitted to the Colorado Securities Commissioner no later than the time it is required to be filed with the SEC. Amendments: Issuers may file amendments to a previously-filed Form D at any time. The prescribed circumstances when Form D amendments must be filed with the SEC are the required circumstances when Form D amendments must also be filed with the Colorado Securities Commissioner.

Click here for more information.

Wednesday, November 12, 2008

Delaware Court Applies Business Judgment Rule to Merger Driven by Financial Crisis

Taking judicial notice of the roiling market crisis, the Delaware Chancery Court applied the business judgment rule to a merger effectuated over a weekend and found that a shareholder challenging the deal stated a colorable claim for violation of the directors’ duty of care. The case implicated important issues of Delaware corporate governance law in light of the current difficult market conditions. The merger was essentially a takeover of the brokerage firm Merrill Lynch by Bank of America. (County of York Retirement Plan v. Merrill Lynch & Co., Del. Chancery Court, No. 4066-VCN).

The shareholder claimed that the directors hastily negotiated and agreed to the merger over a single weekend without adequately informing themselves as to the true value of the company or the feasibility of securing an alternative transaction. It is also alleged that the directors failed to conduct the proper due diligence for the transaction as a result of the speed with which it was put together and did not conduct a pre-agreement market check.

At their essence, reasoned Vice Chancellor Noble, these claims merely attack the speed with which the merger was negotiated, drawing the conclusion that the Merrill board could not have sufficiently informed itself to justify business judgment rule protection over the course of a weekend. No single blueprint exists to satisfy a director’s duty of care, noted the court, and, while such speed might be suspicious, it is not dispositive.

The directors justified their haste by claiming the existence of severe time-constraints and an impending crisis absent an immediate transaction. While taking notice of the state of the markets in early September 2008 along with the share price of Merrill stock during that period, the court would not and should not take notice of the internal affairs of the firm that drove the board’s decision to sell the company over the course of a single weekend. The need to consummate the deal within a mater of days, or even hours, was a business judgment, entitled to deference only if informed. The shareholder claimed that this judgment was uninformed, noted the court, and at this stage the court’s task is to access whether the shareholder raised a colorable claim.

The court concluded that the shareholder did present a colorable claim since to hold otherwise would notice as fact the very essence of the directors’ factual argument and allow inference and conjecture to serve as a factual record. This the court would not do, even though such inference and conjecture might be viewed as reasonable.

The court acknowledged that market pressures on the directors to close the deal so quickly may have existed, adding that Delaware case law supports shaping fiduciary obligations to reflect such a reality. However, the contextual contours of the directors’ fiduciary obligations are fact driven, emphasized the court, and it cannot undertake such a nuanced evaluation by way of an informal scheduling motion.
CFTC Chair Urges Regulation by Objective by Three New Regulators; Replacing SEC and CFTC

Acting CFTC Chair Walter Lukken has called for a complete rewrite of the federal securities and commodities laws and the creation of three new regulators under principles-based regimes. The three new regulators would be: the Systemic Risk Regulator, the Market Integrity Regulator, and the Investor Protection Regulator, with all three operating under an objectives–based framework focused on risk. In remarks at a recent FIA seminar in Chicago, he rejected the idea of merging the SEC and CFTC as ineffective and only reinforcing the current outdated regulatory structure. Under his plan, the different functions of the CFTC, the SEC and the various banking regulators, would be dispersed among the three new regulators.

The Systemic Risk Regulator would have the responsibility of policing the entire financial system for risks that could cause a contagion event and take preventive action against such occurrences. Such a regulator does not exist in the current framework, he said, but is absolutely necessary given the global interconnections of the financial markets. The Market Integrity Regulator would oversee the safety and soundness of key financial institutions, including exchanges, investment firms and commercial banks whose failure may jeopardize the integrity of the markets. The Investor Protection Regulator would broadly oversee investor protection and business conduct across all firms in the marketplace.

In Chairman Lukken’s view, this objectives approach would significantly improve financial market transparency across-the-board, but most importantly in the current unregulated OTC markets. Regulation by objective rather than function will ensure that all products and institutions are properly overseen based on identified public risks rather than futile and difficult determinations of whether an instrument is a security, a future, or a swap contract. Under this approach, the Systemic Risk Regulator would have broad access to information from the entire marketplace as it monitors concentrations of risk, while the Market Integrity and Investor Protection Regulators focus more specifically on their respective missions.

The flexibility of a principles-based system also would help to manage the important but different missions of the futures and securities regulators. For example, the CFTC is charged with promoting price discovery and risk management in the markets, he noted, while the SEC upholds the important mission of investor protection and the banking regulators focus on the safety and soundness of depository institutions. As products converge, these differing missions can conflict and agencies are left attempting to balance the competing public interests. In his opinion, a new objectives-based, principles-based system would provide the new regulators with the tools to better coordinate and manage the critical but sometimes competing public missions of these industries while avoiding the rules-based tripwires that bog down the current system.

This new structure would require reporting of exchange and over-the-counter market data to regulators, particularly when such products begin playing a public pricing role or when their size creates the risk of a systemic event. He said that the credit default swaps market would meet this threshold. The resulting enhanced transparency would enable the Market Integrity and Systemic Risk Regulators to police the markets for misconduct and concentration of risk.

In building such a framework, he urged Congress to look to the model adopted in the Farm Bill for the OTC energy swaps market, which triggers additional oversight and transparency when a product begins to serve a significant price discovery function. Such an approach enjoys the advantage of allowing the over-the-counter market to continue to serve as an incubator model for product innovation and tailored risk management, he believes, but would trigger additional oversight when certain public risks arise.

He emphasized that the proposed restructuring must be accompanied by a complete rewrite and modernization of the laws and regulations governing the financial markets, including the securities and futures laws, to adopt a more consistent principles-based regulatory approach.

One of the lessons from the crisis is that the current rules-based regulatory approach was not able to keep up with the speed and innovation of the financial markets. A principles-based structure complements tailored rules by adding needed guidance and flexibility to desired policy objectives. This helps prevent institutions from making end runs around static rules when such actions violate a broader public policy. The CFTC currently utilizes such an approach, coupled with strong enforcement, which has enabled the agency to keep pace with fast moving global markets.
European Commission Proposes Regulation of Credit Rating Agencies

With the financial crisis still roiling, the European Commission has proposed the strict regulation of credit rating agencies in an effort to restore confidence in the markets. The regulations are designed to ensure that the ratings issued by the agencies are independent, objective, and of the highest quality. The new regime is based on concepts of transparency, independence, and sound corporate governance. The proposal signals the failure of voluntary regulation through codes of conduct for rating agencies. According to Commissioner for the Internal Market Charlie McCreevy, the proposed regime for credit rating agencies will ensure that regulators with responsibility for oversight will have at their disposal sufficient resources and expertise to keep up with financial innovation and to challenge the rating agencies in the right areas, on the right issues, and at the right time.

But the Commission ensured that regulators under the new regime will not interfere in the content of the ratings. Credit rating agencies will be solely responsible for the methodologies, model and rating assumptions they use and the opinions they develop on that basis.

Under the proposal, credit rating agencies will have to comply with rigorous rules to make sure that ratings are not affected by conflicts of interest, that rating agencies remain vigilant on the quality of the rating methodology and the ratings, and that credit rating agencies act in a transparent manner. The proposal also mandates the registration of credit rating agencies under an effective surveillance regime whereby European regulators will oversee the rating agencies.

Under the new regulatory regime, credit rating agencies may not provide advisory services. They will not be allowed to rate financial instruments if they do not have sufficient quality information to base their ratings on. Further, they must disclose the models, methodologies and key assumptions on which they base their ratings; and will have to publish an annual transparency report. The rating agencies will also have to create an internal function to review the quality of their ratings.

With regard to governance, the rating agencies must have at least three independent directors on their boards whose remuneration cannot depend on the business performance of the rating agency. The directors will be appointed for a single term of office which can be no longer than five years. Moreover, they can only be dismissed in case of professional misconduct; and, at least one of them should be an expert in securitization and structured finance.

Credit rating agencies based in the US and other non-EU countries will be required to have a legal presence in the EU in the form of a subsidiary, which must apply for registration in the EU jurisdiction where its registered office is located. The agency will be expected to comply with all the requirements under the proposed regulations.

The new regulations seek to ensure more accurate ratings by requiring rating agencies to systematically use all data available to them and which they have declared important to their rating. They should also have measures to establish whether the information used is of sufficient quality and from reliable sources. In particular, with regard to structured finance instruments they should state to what extent they have verified the information themselves or relied on third party assessment of due diligence processes at the level of underlying assets. Further, credit rating agencies will not be allowed to rate instruments in cases where they do not have sufficient quality information to do so.

In addition, while the proposed regulations do not stipulate how the rating methodologies should be structured and reviewed, they do require that the methodologies be subject to independent internal scrutiny performed by a dedicated review function within the credit rating agency, but separate from the business lines. This function will have a direct reporting line to the independent members of the board.

The proposal embodies the principle of differentiation under which rating agencies must either differentiate rating categories for structured finance instruments so that they are not confused with rating categories for other types of financial instruments or produce a comprehensive report attached to each structured finance rating. It is envisioned that such a report would provide a detailed description of the rating methodology used to determine the credit rating and an explanation of how it differs from the determination of ratings for any other type of rated entity or financial instrument, and how the credit risk characteristics associated with a structured finance instrument differ from the risks related to any other type of rated instrument.

Very importantly, under the new regime, rating agencies will have to improve the way they deal with conflicts of interest in order to regain markets' confidence. To ensure the independence of ratings, they will be required to prevent conflicts of interest and adequately manage unavoidable conflicts. They will have to disclose conflicts of interest in a complete, timely, specific, and prominent manner and record all significant threats to the rating agency’s independence or that of its employees involved in the credit rating process, together with the safeguards applied to mitigate those threats. The rating agencies will also have to implement adequate internal policies and procedures to insulate employees involved in credit rating from conflicts of interest and ensure the quality, integrity and thoroughness of the rating and review process.

There are other more specific prohibitions and limitations in the rules designed to prevent conflicts of interest. For example, rating agencies will have to disclose to the public the names of the rated entities from which they receive more than 5 per cent of their annual revenue. Further, a rating agency will not be able to issue a credit rating or will have to withdraw an existing credit rating when itself or its analyst involved in the credit rating have ownership of financial instruments in the rated entity or control links.

Also, a rating agency will not be allowed to provide consultancy or advisory services to the rated entity or any related third party regarding the corporate or legal structure, assets, liabilities or activities. Rating agencies will only be permitted to provide ancillary services in cases that do not present conflicts of interest with its rating activity. Moreover, analysts will not be allowed to make proposals or recommendations, either formally or informally, regarding the design of structured finance instruments on which the agency is expected to issue a rating.
"Lost Causes?"--Fraud Pleading in the 5th Circuit

In light of two decisions by 5th Circuit panels and a recent district court decision within the circuit, it appears that the 5th may be the place where class actions go to die, and the cause of death is likely to be loss causation.

Oscar Private Equity Investments v. Allegiance Telecom, Inc., a 2007 5th Circuit decision, is the starting point. Although the court decided this case after the Supreme Court's Dura decision, the 5th Circuit made virtually no mention of the Dura holding. In Oscar, the appeals panel, in an interlocutory appeal, vacated a class certification that was based on a presumption of reliance under the fraud on the market theory. The appellants, a telecommunication provider's officers and directors, successfully argued that the investors did not prove loss causation between the provider's allegedly false statements and the loss to the investors from a lower stock price.

According to the majority opinion, "[e]ssentially, we require plaintiffs to establish loss causation in order to trigger the fraud-on-the-market presumption." The panel rejected the district court's conclusion that the class certification stage was not the proper time for the defendants to rebut the lead plaintiffs' fraud on the market presumption. As characterized by the appellate panel, the district court "suggested that the presumption of reliance was rebuttable, but only as related to a summary judgment motion." The appellate court described this as "an outdated view that fails to accord this signal event of the case its due," because the separation of the merits of the claim from certification was not appropriate with regard to "a class exceeding purchasers of millions of shares in a volatile and downward-turning market over a ten-month period, claiming injury from one of several simultaneous disclosures of negative information." In effect, the 5th Circuit reversed the burden of proof involved with the fraud on the market presumption. Rather than requiring the defendant to rebut the presumption, plaintiffs were required to prove by a preponderance of the evidence the existence of a sufficient and specific causal link.

The court concluded that "[w]e cannot ignore the 'in terrorem' power of certification, continuing to abide the practice of withholding until 'trial' a merit inquiry central to the certification decision, and failing to insist upon a greater showing of loss causation to sustain certification, at least in the instance of simultaneous disclosure of multiple pieces of negative news."

In a dissenting opinion, Circuit Judge Dennis criticized what he called "a breathtaking revision" and an "an unjustified revision of securities class action procedure." He disagreed with the majority's required showing of loss causation at the class certification stage. The holding, noted Judge Dennis, dramatically expands the scope of class certification review in this circuit to effectively require a mini-trial on the merits of plaintiffs' claims at the certification stage.

In an unpublished September 2008 opinion, Catogas v. Cyberonics, Inc., dealing with the review of a dismissal motion rather than class certification, the 5th affirmed the dismissal of claims based on allegations concerning stock option backdating. The district court had dismissed the action on scienter grounds, but the appeals panel affirmed on loss causation without addressing whether scienter was adequately pleaded. The plaintiffs pointed to a press release which disclosed that the company's internal investigation was ongoing and that its 10-K filing would be delayed. The press release also revealed a Nasdaq staff letter informing the company that it was subject to delisting from the exchange if it did not file its Form 10-K. According to the plaintiffs, the press release was "the first time that the market learned the full ramifications of the backdating and repricing scheme," and that before the press release, "the investing public did not know and was never told that the illegal scheme could eventually lead Cyberonics' market to stop trading on the Nasdaq exchange." After this release, the company's stock price dropped by almost 25 percent.

The appeals court disagreed, as it found that the press release did not "reveal anything regarding the accounting of options that had not already been disclosed to the investing public." The court said that the market had been apprised of the stock option problems through analyst reports and disclosures concerning an SEC investigation and subpoenas from the U.S. Attorney. The only new information in the press release, according to the panel, involved the delisting possibility. Because this information "did nothing to reveal previous misstatements with respect to Cyberonics' stock-option accounting," it was not relevant with regard to the loss causation question.

The last sentence of the opinion's introductory paragraph also raises an interesting question. Dura did not directly address the question of whether loss causation was subject to the more stringent pleading rules for fraud under the Federal Rules of Civil Procedure. The court in Catogas did not answer the question, but it certainly hinted at a stricter view in stating that the "plaintiffs failed to plead loss causation with the requisite particularity.

The effect of Oscar can be seen in a decision handed down in November 2008 by the U.S. District Court for the Northern District of Texas. In Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Co., the court refused to certify a class on loss causation grounds. The court agreed that the plaintiffs met all the requirements for certification except the Oscar loss causation requirement, which "imposes an exceedingly high burden on Plaintiffs at an early stage of the litigation." Because the plaintiffs failed to link "the alleged corrective disclosures with prior actionable misrepresentations," the court declined to certify the class.

A Split Between the Circuits?

The answer to the question above is yes, but the follow-up response to that is likely to be"So?" While the 5th and 9th Circuits have taken dramatically different approaches to the loss causation question, it is unlikely that the Supreme Court will re-visit the issue to resolve these unanswered questions.

In Gilead Sciences Securities Litigation, a 9th Circuit panel reversed a lower court dismissal on loss causation grounds. The appellate court stated that "[p]erhaps what truly motivated the dismissal was the district court's incredulity" with regard to loss causation claims. In stark contrast to the 5th Circuit in Catogas, the panel noted that "a district court ruling on a motion to dismiss is not sitting as a trier of fact." While trial courts need not "accept as true conclusory allegations, nor make unwarranted deductions or unreasonable inferences," the appellate panel held that "[s]o long as the complaint alleges facts that, if taken as true, plausibly establish loss causation, a Rule 12(b)(6) dismissal is inappropriate."

Tuesday, November 11, 2008

French Central Bank Head Calls for Macro Prudential Regulation and Securitization Reform

Echoing the call of the US Treasury blueprint and other policy makers, French central bank governor Christian Noyer said that macro prudential must be an essential component of reforming financial regulation. In remarks at the National Federation of the Credit Agricole, he called for a review of the very foundations of current financial system regulations. France has been in the forefront of a move towards the creation of a brand new international financial order. No stone should be left unturned, he said, in efforts to improve regulation in many areas, from rating agencies to risk management, executive compensation, and the entire organization of the financial markets.

The general principle behind macro prudential regulation is straightforward, he noted, consisting of ensuring that regulation manages to limit risks for the stability of, not only a particular institution but also of the entire financial system. Its implementation, however, is complex.

On a more micro level, he observed that very significant reforms of accounting rules are in the process of being finalized. The first reform aims to bring the current framework in line with what is best practice in the world today, It will allow banks to transfer instruments hitherto booked at market value to portfolios where that will no longer be the case. The second reform will introduce greater flexibility in marked-to-market accounting rules, allowing assets whose market is no longer active to be valued at amortized historical cost. This will ensure that the valuation of these products is better suited to current market conditions.

Finally, he noted that this crisis is at root a crisis of securitization. Thus, complex structured securitization must be reformed. While traditional securitization was a successful tool for bundling loans into asset-backed securities, he said, in the last decade it morphed into the short-term financing of complex illiquid securities whose value had to be determined by theoretical models. The inherent fragility of this new securitization model was masked by the actions of market intermediaries, particularly credit rating agencies. The collapse of structured securitization revealed the ugly reality that, far from managing and dispersing risk, it had increased leverage and concentrated risk in the hands of specific financial institutions.
Appellate Courts Struggle with "Core Operations," "Collective Scienter" Inferences

Courts have long recognized that an actionable inference of scienter may not be drawn merely from the fact that individual defendants were senior officers of a company. However, recent circuit court cases issued in light of the Supreme Court's Tellabs, Inc. v. Makor Issues & Rights decision have reached different conclusions on the question of whether an inference may be drawn that senior management must be aware of matters involving the company's "core operations," including any fraudulent conduct, and whether "collective scienter" may be actionable in the absence of a sufficient inference of scienter attributable to a particular individual.

Core Operations Inference

The 9th Circuit has addressed this issue in two recent and somewhat contradictory decisions. In Berson v. Applied Signal Technology, Inc., issued in June 2008, a 9th Circuit panel found that the plaintiffs pleaded with sufficient particularity that the contractor's alleged practice of counting work suspended to government "stop-work orders" as "backlog" could be actionable. Because the named CEO and CFO "were directly responsible for Applied Signal's day-to-day operations," the court observed that "it is hard to believe that they would not have known about stop-work orders that allegedly halted tens of millions of dollars of the company's work" and that these facts were prominent enough that it would be `absurd to suggest' that top management was unaware of them.

However, three months later in South Ferry LP, #2 v. Killinger, the same court severely narrowed Berson. In distinguishing its earlier opinion, the court specifically noted that the defendants in Berson knew of the adverse conditions two weeks after they made their statements. However, despite this fact, that the awareness came after the statements were made, the 9th Circuit relegated Berson to that "exceedingly rare category of cases in which the core operations inference, without more, is sufficient under the PLSRA."

In South Ferry, the 9th Circuit held that allegations that rely on the core-operations inference are "among the allegations that may be considered in a complete PSLRA analysis." The court noted, though, that a "question remains, however, about reliance on the core-operations inference when it is the only basis for scienter in the complaint...where a complaint relies on allegations that management had an important role in the company but does not contain additional detailed allegations about the defendants' actual exposure to information, it will usually fall short of the PSLRA standard."

According to the 9th Circuit panel, the core operations pleadings could be relevant in three circumstances, when 1) the allegations are used in conjunction with other allegations that together raise an inference of scienter that is "cogent and compelling," thus strong in light of other explanations, 2) the allegations alone are "particular and suggest that defendants had actual access to the disputed information," or 3) the allegations, although lacking additional particular allegations, are based upon a "relevant fact" so prominent that it is "absurd" to suggest that management was without knowledge of the matter.

An obvious difficulty with the panel's holding is the notion of "absurdity." As Tellabs requires courts to weigh and evaluate competing inferences qualitatively and quantitatively, a standard of absurdity" seems ambiguous and difficult to apply.

In its review on remand of the Tellabs case, the 7th Circuit seemed to embrace the core operations inference. According to Judge Posner, it was "extremely unlikely" that the allegedly false statements "were the result of merely careless mistakes at the management level based on false information fed it from below, rather than of an intent to deceive or a reckless indifference." The reason for such a conclusion, said Judge Posner, was that the products in question "were Tellabs's most important products"...described by the company as its "flagship." Because of the importance of these products to the company, Judge Posner wrote "that no member of the company's senior management who was involved in authorizing or making public statements about the demand for the 5500 and 6500 knew that they were false is very hard to credit, and no plausible story has yet been told by the defendants that might dispel our incredulity."

The 11th Circuit rejected the core operations presumption in Mizzaro v. Home Depot, Inc. in October 2008. The court stated that "we indulge at least some skepticism about allegations that hinge entirely on a theory that senior management `must have known' everything that was happening in a company as large as Home Depot" and that the complaint "must at least allege some facts showing how knowledge of the fraud would or should have percolated up to senior

The 8th Circuit expressed doubts about the viability of a core operations inference in an October 2008 decision, Elam v. Neidorff. The plaintiffs argued that the company "must have known about the additional $9.7 million in medical costs in April and June of 2006, when the allegedly false statements were made, because Centene touts its ability to predict medical costs." The court found the complaint inadequate without squarely addressing the core operations question. "We need not determine whether the core operations approach can be utilized to plead scienter," stated the court. The panel stated that "even if the proper factual allegations could warrant its application, plaintiffs have not made such a order to attribute knowledge of the additional medical costs to Centene's officers at the time of the April or June statements on this basis, we would at least require a showing that this information was known within the company at that time."

One observation by the Eighth Circuit panel merits closer examination. In refusing to recognize the core operations inference, the court stated that "the Fifth and Ninth Circuits have rejected it," and cited the In re Read-Rite Corp. Securities Litigation decision in support of that proposition. This is significant because the 8th Circuit did not address the South Ferry decision above, entered more than a month earlier, in which the 9th Circuit stated that Tellabs "suggests that perhaps Silicon Graphics, Vantive and Read-Rite are too demanding and focused too narrowly in dismissing vague, ambiguous, or general allegations outright." Although the 9th Circuit in South Ferry found the pleadings to be insufficient, that panel clearly used a different analytical frame than that applied by the Read-Rite court.

Collective or Corporate Scienter

Corporations can only act through their agents, their officers and directors. An important issue addressed by several circuit courts with different results recently has been the question of whether a corporation can be found to have acted with the requisite scienter if no individual officer or director possessed that level of intent. Under a "collective scienter" approach, courts consider the state of mind and conduct of individual actors collectively, and that in the aggregate can constitute corporate scienter even if insufficient to show scienter in any individual instance.

In a 2004 decision, Southland Securities Corp. v. Inspire Insurance Solutions, Inc., the 5th Circuit rejected this notion According to the court, a "defendant corporation is deemed to have the requisite scienter for fraud only if the individual corporate officer making the statement has the requisite level of scienter, i.e., knows that the statement is false, or is at least deliberately reckless as to its falsity, at the time he or she makes the statement. This is consistent with the general common law rule that where, as in fraud, an essentially subjective state of mind is an element of a cause of action also involving some sort of conduct, such as a misrepresentation, the required state of mind must actually exist in the individual making (or being a cause of the making of) the misrepresentation, and may not simply be imputed to that individual on general principles of agency."

In a 2005 case, City of Monroe Employees Retirement System v. Bridgestone Corp., the 6th Circuit took the opposite view. The court found specifically that the officer in question did not act with scienter, but found that sufficient intent could be imputed to the corporate defendant. The court recognized that "at first glance, it might seem incongruous to reach this conclusion after relying in part on Ono's knowledge of the claims settlements as a basis for Bridgestone's scienter on that claim," but concluded that "while an individual officer's knowledge may be attributed to the corporation, liability for the corporation's act does not, absent independent evidence, generally flow from the corporation to the corporate officer."

Finally, in 2008, the 2nd Circuit reached a mixed result on the question in Teamsters Local 445 Freight Division Pension Fund v. Dynex Capital Inc. The panel concluded that the lack of individual scienter did not preclude a similar finding against the corporate entity, but in this instance, the plaintiffs failed to show the requisite fraudulent intent by other means. As the court stated, although there are circumstances in which a plaintiff may plead the requisite scienter against a corporate defendant without successfully pleading scienter against a specifically named individual defendant, the plaintiff here has failed to do so.

In this case, the district court held that the fraud complaint against the defendant, a financial services company, for misrepresentations concerning its underwriting guidelines for bonds collateralized by pools of mobile home installment sales contracts was sufficient to survive a motion to dismiss. While the complaint failed to establish a strong inference of scienter against individual company officers, the allegations that the corporation systematically disregarded various indicia of borrowers' creditworthiness in order to quickly consummate large volumes of loans and ignored signs that the bond collateral was defective after the loans were originated were sufficient to infer scienter on the part of the corporation itself, held the court.

Subsequently the district court declined to reconsider its finding on collective scienter, but certified the question for interlocutory appeal. Judge Baer wrote that the defendants "have not demonstrated that I overlooked controlling authority in denying Dynex's motion to dismiss. However, defendants have demonstrated that the permissibility of pleading corporate or collective scienter within this Circuit constitutes `a controlling question of law' as to which there is substantial ground for difference of opinion on the issue.

On appeal, the 2nd Circuit, despite its recognition that a lack of individual scienter is not conclusive at the pleading stage, used language in the opinion that seems to suggest otherwise, at least with regard to proving the claim as compared to pleading it and surviving an initial motion to dismiss. The court stated that in order to recover, "someone whose scienter is imputable to the corporate defendants and who was responsible for the statements made was at least reckless toward the alleged falsity of those statements." Accordingly, it is important to distinguish between what must be pleaded to raise a sufficient inference and what must be proven in order to recover. To prevail and recover, "a plaintiff must prove that an agent of the corporation committed a culpable act with the requisite scienter, and that the act (and accompanying mental state) are attributable to the corporation." The court in this case found that the inferences raised in the complaint were not "at least as compelling as the competing inference and that "the statements either were not misleading or were the result of merely careless mistakes at the management level based on false information fed it from below. "

A collective scienter inference in the absence of actionable individual intent has been criticized for effectively divorcing the culpable conduct from the culpable state of mind. As described by Bruce G. Vanyo of Katten Muchin Rosenman LLP at PLI's recent Securities Litigation and Enforcement Institute, collective scienter is adding zero plus zero plus zero and coming up with actionable intent. In contrast, however, as described by Seth Aronson of O'Melveny & Myers LLP, the collective scienter inference may be reconciled with the PSLRA strong inference standard through the Supreme Court's "holistic" view of fraud complaints as set forth in Tellabs.

The various circuit courts that have addressed collective scienter or the core operations inference after the Tellabs decision have reached different and often contradictory results. Courts seem to be trending away from finding these inferences sufficient, but given the conflicts between and sometimes within the circuits, the fact-intensive nature of these questions and the introduction of potentially ambiguous standards such as "absurdity" into the mix, the balkanization of fraud litigation and circuit-specific pleading appears likely.