Thursday, January 31, 2008

New York's State Securities "Martin Act" Used to Prosecute Mortgage Fraud

New York Attorney General Andrew Cuomo and his Staff have begun using the State's 1921 "Martin Act," i.e., the State's Securities Act, to go after Wall Street Firms for allegedly packaging and selling mortgage securities improperly to an unsuspecting public. Subpoenas under the Martin Act have already been sent to Bear Stearns, Deutsche Bank, Morgan Stanley, Merrill Lynch and Lehman Brothers. What makes the Martin Act particularly favorable for prosecuting mortgage abuse is that it broadly defines securities fraud but does not require proof of intent to defraud and permits the Attorney General to go after civil and criminal penalties.

It is believed by the Attorney General's Office that in 2005 and 2006 when the mortgage securities business was at its height, investment bankers acting as underwriters bought home loans containing "exceptions" that did not meet the minimum lending standards set by rating organizations, and then repackaged and sold them to investors as mortgage securities without disclosing the exceptions that made these investments risky. The Attorney General's Office is now empowered to proceed against the Wall Street firms under the Martin Act because it recently obtained the cooperation of Clayton Holdings, one of the premier companies to provide due diligence about mortgage pools, that has disparaging information on the particular mortgage securities sold to investors.

Wednesday, January 30, 2008

EU Leaders Look at Credit Rating Agencies; Praise Hedge Fund Working Group

European Union political leaders have called for reform of the credit rating agency process and better risk management in the wake of the recent market turbulence triggered by the sub-prime crisis. While supporting a market-driven solution, the leaders said that regulation and legislation will be on the table if an appropriate market response is not forthcoming. In addition, the EU heads urged regulators to engage in cross-border cooperation and information exchange to prevent and manage financial market crises. With a nod to market-orientated solutions and the involvement of market participants, the EU leaders praised the recent voluntary best practice standards presented by the Hedge Fund Working Group, which dovetails with the Financial Stability Forum's five recommendations on hedge funds.

More immediately, however, the EU stressed that investor confidence must be rebuilt by increasing the transparency of financial markets, financial institutions, and the complex financial instruments that they trade in. Specifically, financial institutions must improve the quality of the information available to investors on derivatives and other complex structured products, including their valuation. At the same time, risk management must be enhanced and conflicts of interest avoided.

In particular, the EU leaders emphasized the need to improve the information content of credit ratings to increase investor understanding of the risks associated with derivatives and structured products. Action must be taken to address the potential conflicts of interest for rating agencies. While preferring market-led solutions, such as the IOSCO code of conduct, the leaders warned that, if market participants prove unable or unwilling to rapidly address these issues, regulatory alternatives will be considered.

Currently, the European Commission has tasked CERS with reporting on conflicts of interest and credit rating agencies. In earlier remarks, Commissioner for the Internal Market Charlie McCreevy recommended a governance structure involving a direct reporting line from fully ring-fenced rating assessment functions to a supervisory rating sub-committee of independent directors of the rating agency boards. He also urged rating agencies to give serious thought to this and other ways that will help to quickly and effectively restore trust in the process. They must create a framework under which conflicts of interest are properly and more effectively managed, he emphasized. The commissioner has been skeptical that a rating agency can give an objective rating to a bank’s structured securitized product if it has advised that same bank on how to structure that same product.

The involvement of this high a level almost assures an intense scrutiny of the role of credit rating agencies in the sub-prime crisis.

Tuesday, January 29, 2008

Panelists Consider Stoneridge, Tellabs Cases

The Supreme Court's recent decision in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. (CCH Federal Securities Law Reporter ¶94,556) will have a profound impact on private class action process, noted a panel at the Securities Regulation Institute sponsored by Northwestern University Law School. Another recent case, Tellabs v. Makor Issues & Rights, Ltd., Inc. (CCH Federal Securities Law Reporter ¶94,335), may turn out to be less than a "blockbuster," however.


In Stoneridge, which involved the alleged complicity of third-party vendors in round-trip transactions, the court held that the non-speaking third parties could not be held liable in private actions because investors did not rely on any public statements. Panel chair Prof. James D. Cox of Duke University asked if the decision effectively eliminated liability in private actions for non-speaking third parties. According to Sean Coffey of Bernstein Litowitz Berger & Grossman in New York City, a small window of opportunity may exist for plaintiffs if the market perceived the third party's deceptive acts, but he acknowledged that this approach is largely foreclosed.

Mr. Coffee also noted that the high court recently declined to hear the case against Enron's investment bankers, Regents of the University of California v. Merrill Lynch Pierce Fenner & Smith, Inc. (CCH Federal Securities Law Reporter ¶94,173), in which the 5th Circuit held that the banks may have aided and abetted Enron's deceit by making its misrepresentations more plausible, but that their conduct did not rise to primary liability under Rule 10b-5. While cautioning that it is difficult to draw conclusions from a denial of certiorari without comment, the panel indicated that the court may be indicating that its restrictive view of private aiding and abetting liability is not limited to its facts and non-speaking parties acting in the ordinary course of business, such as the Stonebridge vendors. As former SEC general counsel Giovanni Prezioso stated, the decision shows the Supreme Court "hates" private class actions.

Current SEC general counsel Brian Cartwright observed that the case had no impact on the ability of the Commission to prosecute these cases. Under the Private Securities Litigation Reform Act, the SEC has authority to bring these cases. Because Stonebridge was decided on reliance grounds, which is not a required element of liability in SEC enforcement actions, Commission authority was not effected.

With regard to the Tellabs scienter decision, Mr. Coffey indicated that the potential was there for this case to be a "blockbuster." While the Stonebridge-style third-party claims are relatively rare, scienter is an element in every fraud case. However, Mr. Coffee stated that he does not believe that the new standard will have a significant impact on private actions. The "tie goes to the plaintiff" holding actually lowered the pleading standard in some instances, noted Mr. Coffey, such as in the 6th Circuit, which required that the inference of scienter be more likely than competing non-culpable ones. In addition, the 7th Circuit's recent finding on remand that the fraud allegations in Tellabs were sufficient even under the new standard indicated that the Supreme Court's holding did not present a particularly difficult obstacle to successful fraud pleading.
SEC Official Discusses Executive Compensation Disclosure


The SEC seeks better executive compensation disclosure, stated Shelley E. Parratt, deputy director of the SEC's Division of Corporation Finance, not longer disclosures. Ms. Parratt spoke at the at the recent annual Securities Regulation Institute in San Diego, California.

In October 2007, the SEC completed its initial review of the executive compensation and related disclosures of 350 public companies. She said that the divisions's comments on these disclosures largely fell into two broad categories, the manner of presentation and the nature and scope of the companies' CD&A. According to Ms. Parratt, disclosures could be responsive without necessarily being clear, and longer disclosures did not equal better disclosures.

She emphasized that issuers should strive to improve the "how" and "why" discussions in their disclosures. In preparing their disclosures,the deputy director emphasized that it is important to read and understand the disclosure requirements and ensure that the information provided is responsive to the rules.

Ms. Parratt stated that the staff only commented on the disclosure format where it adversely effected the readability of the disclosures. Approximately two-thirds of issuers reviewed included material such as charts, tables and graphs, that were not required by the rules. Ms. Parratt stated that the staff generally found such additional information useful, and in general only commented upon their use if the additional material was confusing. If the alternative materials were presented more prominently than the required disclosures, she stated that the staff would ask the issuer to de-emphasize them so that readers would not confuse the additional information with the required tables.

In terms of CD&A, she said that companies should emphasize how their compensation philosophy resulted in the amounts paid to executives and disclosed in their filings. This is a principles-based approach, she noted, and added that the specific disclosure examples set forth in the adopting release are neither mandatory nor exhaustive. In general, she noted four major areas in which disclosures could be improved.

1) How issuers analyzed information and why their analysis resulted in the compensation they paid;
2) Why there were differences between the treatment of one officer and others. She noted that this can be sensitive, however, because they may implicate potential succession plans or other matters;
3) The use and impact of benchmarks; and
4) The use of performance targets.

Ms. Parratt stated that the disclosures concerning targets generated more comments than any other area. The questions turn on materiality, and these determinations are subject to each company's particular fact situation. Issuers should assess materiality from different perspectives, she advised,including whether the disclosures would have an impact on shareholders' investment decisions and their voting decisions.

The deputy director set forth a "decision tree" for companies to use in deciding whether to disclose information about the use of a particular performance target. The initial question is whether or not the company uses targets. While the discussion obviously ends if the answer is no, the next question is to assess materiality. If the matter is material, the company must then assess whether disclosure would result in real competitive harm. If the answer is no, the matter should be disclosed. If the answer is yes,the company should carefully review the guidance in the instructions to Item 402(b) and consider what it will say to the staff in support of their position.

Issuers should not wait for the staff to comment to do their competitive analysis, she advised, and it is important for companies to provide detail and "connect the dots" between the potential disclosure and actual competitive harm.

The comment process is meant to be a dialogue, Ms. Parratt stated. Comments do not necessarily indicate a rejection of a particular disclosure approach. She said that comments ask companies to re-think, rather than necessarily re-do, their disclosures.
SEC Staff Guides on Internal Controls Reporting for Acquired Business

The SEC staff has given guidance on a FAQ allowing a company to exclude internal controls related to acquired businesses from the scope of management's assessment of internal controls in the first Form 10-K following the business combination. Steven Jacobs, Associate Chief Accountant, emphasized that judgment is important when applying this exclusion. Specifically, the staff typically expects management's report on internal controls to include controls at all consolidated entities. That said, he continued, the staff understands that it may not be possible to assess the internal controls related to a recently acquired business if there is not adequate time between the consummation date and the assessment date.

In these cases, said the SEC official, management should use its judgment in making the determination as to whether it is possible to complete an effective assessment of the target in light of the timing. If an assessment of the target is clearly possible considering timing and other circumstances, he noted, it may be difficult for the SEC staff to understand how users are best served by excluding it.

In Mr. Jacobs’ view, the staff did not contemplate reverse mergers when responding to the FAQ. However, analogizing to that response, the staff acknowledges that there may not always be adequate time to complete an assessment of the acquirer's internal controls between the consummation date and the assessment date. In those situations, the staff would understand that completing the assessment may be impracticable. The earlier in the year in which the transaction is consummated, he reasoned, the more practicable an assessment may be.

On the question of full blown relief, he observed, one must ask whether any meaningful assessment of what is left over can be done. There are many factors to consider when making that determination. Again, timing becomes an issue. If the transaction occurs early in the year, he reasoned, there may be enough time to fully integrate controls and processes and complete an assessment of the merged entity's internal controls.

However, if the transaction occurs late in the year, it still seems that a meaningful assessment of the legal acquirer's internal controls may be possible. In some mergers, plans to integrate companies may just begin to be formed at the time the merger is consummated and actual integration of employees, systems, processes, and therefore internal controls, may not occur for months.

In these cases, the SEC staff finds it likely that the internal controls for the legal acquirer or issuer would still be in place as of the assessment date and an issuer would be able to conduct an assessment of its internal controls even if it were to exclude the internal controls of the accounting acquirer. This would seem even more likely if management of the legal acquirer stayed on board after the transaction closed leaving entity level controls generally intact as well.

Sunday, January 27, 2008

Rep. Baker to Lead Hedge Fund Association

Rep. Richard Baker (R-LA) will become CEO of the Managed Funds Association (MFA), the primary trade association of the hedge fund industry. He will succeed John. Gaine, who will move into a special advisor role and undertake the expansion of MFA’s global outreach with regulators, policy makers and market participants.

Congressman Baker has been a senior member of the House Financial Services Committee and one of the most respected voices in Congress on financial services and capital markets issues. When the Republicans controlled the House, Rep, Baker served as chair of the Capital Markets Subcommittee. While chair, he made investor protection the cornerstone of the subcommittee’s agenda, calling it the most critical component for healthy capital markets.

In that capacity, he introduced mutual fund reform legislation that passed the House by a bi-partisan vote of 418-2, but died in the Senate. The Mutual Funds Integrity and Fee Transparency Act, H.R. 2420, would have provided for greater transparency of fund fees, costs, expenses, and operations so that investors could make better informed decisions and help market forces drive fees down for fund investors. It was also designed to strengthen fund management, particularly the board's independent directors, and curb trading abuses. The bill also required all mutual funds to abide by the same audit committee standards required of exchange-listed companies under the Sarbanes-Oxley Act.

Thursday, January 24, 2008

SEC Corp Fin Director Examines Executive Compensation and Shareholder Access

As the SEC staff’s review of the new executive compensation disclosures in companies' proxy statements is winding down, Corporation Finance Director John White urged companies and their counsel to focus on the idea that disclosure in this area can be clear and understandable yet not meaningful or responsive to the new SEC disclosure regime for executive compensation. And, on the other hand, disclosure can be responsive in content but not clear and understandable. Though manner of presentation does not refer only to plain English, he added, plain English is a key part of all of this as well. He also discussed shareholder access to nominate directors and the expanded use of company websites to deliver information to investors. The director’s remarks were delivered at the Securities Regulation Institute in San Diego.

The new executive compensation disclosure rules require, for the first time, that companies include a Compensation Discussion and Analysis (CD&A) section to give investors a principles-based overview explaining the policies and decisions related to executive officer compensation. It is a narrative disclosure that puts the compensation picture in context.

Mr. White reiterated that the staff’s review of the analysis portions of the CD&A revealed frequent shortcomings. There is a real lack of disclosure in the CD&A of the how and why of compensation decisions, he emphasized. The new CD&A section is much like the MD&A, he said, and is intended to put into perspective for investors the numbers and narrative that follow it. He remains optimistic that the second year of CD&A disclosures will be more faithful to the SEC’s objectives when it adopted the new executive compensation disclosure rules.

On the separate issue of shareholder nomination of directors, the SEC official said that the Commission is gearing up to continue work in this area in 2008 based on Chairman Cox’s admonition that the broad question of shareholder access to nominate company directors remains vital. With the current proxy season impending, and a federal appeals court ruling that had to be addressed, the SEC codified its longstanding interpretation of the election exclusion. This exclusion allows companies to exclude from their proxy materials proposals that would result in an immediate election contest or would set up a process for shareholders to conduct an election contest in the future by requiring the company to include shareholders' director nominees in the company's proxy materials for subsequent meetings.

The director noted that the SEC has already seen a few no-action requests concerning shareholder proposals to set up procedures for shareholder director nominations from, among others, Bear Stearns and JP Morgan Chase. He said that the staff will be responding to those in the coming month or so in accordance with normal processes.

The codification of the SEC’s election exclusion position addressed a 2006 Second Circuit panel ruling that a shareholder proposal seeking to establish a procedure by which shareholder-nominated candidates may be included on the corporate ballot did not relate to an election within the meaning of SEC proxy rules and thus could not be excluded from corporate proxy materials. AFSCME v. American International Group, Inc.

Essentially inviting the SEC to take up the issue, the appeals court had reasoned that a 1976 SEC interpretation reflected the view that the election exclusion is limited to shareholder proposals used to oppose solicitations dealing with an identified board seat in an upcoming election and rejects the somewhat broader interpretation that the election exclusion applies to shareholder proposals that would institute procedures making such election contests more likely.

On issues involving the expanded use of corporate websites, Mr. White related that the SEC is seriously considering whether to update the interpretive guidance that the Commission issued in 2000 concerning the use of corporate websites for disclosures of information. In the past seven years, the avenues by which investors receive financial data has broadened to include blast emails, webcasts of meetings, blogs, RSS feeds, electronic shareholder forums, podcasts, XBRL, and electronic proxy solicitation. At the same time, he noted, technology can make it easier and more efficient for investors to find the financial data and analysis they are looking for.

Legal issues that may need to be addressed or updated in connection with the review of the use of corporate websites include the treatment of hyperlinked information on a company's website, liability for disclosures, and Regulation FD. The SEC’s review is affected by a draft recommendation of its Advisory Committee on Improvements to Financial Reporting that the Commission issue new interpretive guidance encouraging further creative use of corporate websites and promoting industry best practices.
US Supreme Court Rules Trust Investment Advisory Fees Not Fully Tax Deductible

A trust cannot fully deduct investment advisory fees it incurred from its federal taxable income, ruled the US Supreme Court, but instead is subject to the 2% floor on deductions. In a ruling of intense interest to the investment adviser community, a unanimous Court said that the exemption in the Internal Revenue Code from the 2% floor for costs which are paid in connection with the administration of a trust, and which would not have been incurred if the property were not held in trust, was not available here since individuals as well as trusts commonly incur such investment advisory fees. Knight v. Commissioner of Internal Revenue, No. 06-1286, Jan 16, 2008).

Section 67(a) of the Internal Revenue Code provides that miscellaneous itemized deductions are allowed only to the extent that their aggregate total exceeds 2 percent of adjusted gross income. Investment advisory fees are generally subject to this 2% floor. Section 67(a) is applicable equally to individuals and trusts, except that trust expenses that would not have been incurred if the property were not held in trust are not subject to the 2% floor and thus fully deductible.

In this case, since such investment advisory fees could just as easily have been incurred by an individual, noted the Court, it could not be said that the investment advisory fees would not have been incurred if the property were not held in trust. Thus, the investment advisory fees incurred by the trust were subject to the 2 % floor.

While the Court acknowledged that some trust-related investment advisory fees may be fully deductible if an investment advisor were to impose a special, additional charge applicable only to its fiduciary accounts, there is nothing in the record here to suggest that this particular investment adviser charged the trustee anything extra, or treated the trust any differently than it would have treated an individual with similar objectives.

It is conceivable, moreover, that a trust may have an unusual investment objective, or may require a specialized balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper. In such a case, conceded the Court, the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer would not be subject to the 2% floor. Here, however, the trust did not assert that its investment objective or its requisite balancing of competing interests was distinctive.

Wednesday, January 23, 2008

UK Hedge Fund Working Group Sets Standands for Fund Managers

The UK Hedge Fund Working Group has adopted voluntary standards and best practices for hedge fund managers. The standards are on a comply or explain basis and include valuation, disclosure, and risk management guidelines. The working group is chaired by Sir Andrew Large. The standards have an inescapable global dimension. For example, the Board seeks convergence of the standards with the hedge fund standards being developed by the US Treasury Department.

The working group also established a Hedge Fund Standards Board to be the custodian of the standards. The Board will publish an annual report on the hedge fund industry’s compliance with the standards. The Board will also maintain a registry of hedge funds that have signed on to the standards.

The standards encourage hedge fund mangers to deeply and broadly enhance disclosure, including disclosure of the investment strategies they employ and the risks involved, as well as the instruments, such as derivatives, that are likely to be included in the fund's portfolio. Investors should also be told how the fund would use leverage and the risks involved in such use. In addition, investors should be told the methodology used to calculate performance fees and the details of any other remuneration received by the fund manager. Fund managers should also disclose the existence of side letters which contain
material terms.

Hedge funds should disclose in their annual report how the fund has invested its assets in accordance with its published investment policy. The working group envisages that such a statement will comprise a high-level factual explanation as to how the fund has invested its assets during the period. It is not intended to be a review or confirmation of compliance with the fund's investment policy. The fund’s annual report should explain the management and performance fees in a way that allows investors to readily compare them.

Importantly, the standards call on hedge funds to establish an independent and well-documented valuation process designed to mitigate conflicts of interest in relation to asset valuation. A best practice would be to appoint a third party valuation service provider who reports directly to the fund’s board. For its part, the board should adopt what the working group calls a Valuation Policy Document, which should be made available to investors upon request on a confidential basis.

The board should also regularly review the document in consultation with the fund manager. The document should list the duties of each of the parties involved in the valuation process; as well as any procedures in place designed to ensure that conflicts of interest are managed effectively. Similarly, funds should disclose the controls and monitoring processes in place designed to ensure the satisfactory performance of any third party to whom the valuation function is outsourced.

With regard to hard-to-value assets, such as derivatives, the valuation procedures should ensure a consistent approach to determining fair value and ensure that such procedures are set out in the Valuation Policy Document. In addition, the percentage of the fund’s portfolio considered hard-to-value should be disclosed.

Another standard decrees that a risk management framework be established covering all relevant risk categories, including portfolio and operational risks. There must also be adequate governance of the risk function to ensure that potential conflicts of interest between the hedge fund manager and the investor are properly mitigated. Disclosure to investors that risk management practices are in place is also part of the standard. The process of monitoring risk management should be separated from management of the portfolio.

The standards call for hedge fund managers to produce a Risk Policy Document setting out the procedures they will employ in monitoring risk management. As part of their monitoring duty, hedge fund managers should conduct stress testing.

The guidelines also call for hedge fund managers to appoint an independent compliance officer to oversee all issues relating to regulatory compliance and market and professional conduct. The compliance officer should report regularly to a management committee or equivalent. Hedge fund manager should regularly provide to the fund governing body a report on regulatory compliance prepared by the compliance officer on a regular basis.

Monday, January 21, 2008

SEC Official Reaffirms Mutual Fund Advisory Contract Approval Process

Andrew Donohue, the SEC’s Director of Investment Management has strongly praised the mandated process by which a mutual fund’s independent directors approve the fund’s investment advisory contract. Actually, the SEC official’s remarks represent one of the strongest Commission affirmations of the current process for approving investment advisory contracts in recent memory.

Although the detailed and well-documented analysis of the advisory contract has increased the amount of time independent directors must devote to the approval process, he acknowledged, the ultimate result is beneficial for investors, while also strengthening the business judgment of the directors. His remarks were made at the Mutual Funds Directors Forum.

Section 15(c) of the Investment Company Act requires a fund’s independent directors to approve the investment advisory contract by an in-person vote at a meeting called for that purpose. In addition, section 36(b) of the Act imposes on fund advisers a fiduciary duty with respect to compensation or payments made to them by the fund or the shareholders.
In the director’s view, the section 15(c) approval process is appropriate since mutual funds and their investment advisers have a unique industry structure that does not exist in conventional corporate relationships. The adviser typically creates the fund and then operates it, he noted, and investors buy fund shares relying on the adviser's services.

Given the lack of arms-length bargaining between the adviser and the fund, he reasoned, the investment advisory contract must be approved by independent directors. Because both the adviser and the fund board know that the independent directors are required to engage in a detailed review of the adviser's compensation, this creates an incentive for both sides to work transparently and collaboratively to the benefit of the fund's investors.

As a practical matter, he noted, the primary threat that independent directors who do not approve of an advisory contract can wield is the ``nuclear option,’’ which is a vote not to approve the contract and replace the adviser. However, given the unique structure of the fund and its adviser, combined with the expectation of investors, replacing the adviser would most likely lead to what the SEC official called ``mutually assured destruction’’ because investors will flee the fund, thereby resulting in its closure.

Thus, in his view, an in-depth section 15(c) process is not only beneficial to the fund and its investors, but also directly benefits the adviser and the independent directors. Specifically, a detailed approval process minimizes the likelihood of a successful legal challenge.

This is because the legislative history of Section 36(b) suggests that courts are loathe to substitute their business judgment for that of the independent directors in the area of management fees. Thus, an adviser who provides robust information to the directors to enable them to make an informed decision whether to approve the advisory contract obtains the benefit of the directors' business judgment.

On the other hand, if the directors are not fully informed about all of the facts bearing on the adviser's services and fees, courts may give less credence to their judgment. Therefore, advisers seeking to prove that they have fulfilled their fiduciary duties have a strong incentive to provide the directors with detailed information about their compensation and the services they provide.
Similarly, the independent directors have a strong incentive to fully document their decision to vote to approve the adviser's contract.

The federal courts have indicated that the expertise of the directors, the extent to which they are fully informed, as well as the care with which they perform their duties, are factors to consider when deciding whether a breach of fiduciary duty occurred. Shareholders trying to challenge an adviser's fee must establish that the business judgment of the independent directors who voted to approve the investment advisory contract should not be relied upon by the court.

But by extensively documenting their decision, observed the official, the independent directors will have a record demonstrating that they conscientiously performed their duties and are more likely to have their business judgment relied upon. Moreover, the SEC official pointed out that a carefully documented record undermines a cynic's view that independent directors vote to approve the advisory contract in order to keep their jobs.

Friday, January 18, 2008

Corp Fin Director Would Vet Foreign Companies whose Shares Sold Through Mutual Recognition

These remarks by John White struck me as somewhat revolutionary. As part of mutual recognition of brokers and exchanges, he proposes that the SEC vet the foreign companies whose securities the foreign brokers would bring to the US market and US investors. The SEC would impose standards on those companies, including disclosure and corporate governance standards as part of the mutual recognition regime. The SEC would look at the company’s internal controls, among other things. But certainly the director’s reasoning for why the standards are needed is sound, and I like his analogizing imported cars to imported corporate securities.

As part of the incipient mutual recognition of foreign brokers and exchanges, Corporation Finance Director John White proposed standards for the foreign companies whose securities would be traded on a foreign exchange accessible by U.S. investors through a mutual recognition regime. While eventually such a regime could apply to all securities of all issuers, he said, initially the trading should be limited to the plain vanilla securities of companies with a broad market following. In that connection, the SEC would be guided by its definition of well know seasoned issuer, he said, and would use a $700 million global public float as a benchmark. In remarks before the PLI seminar on securities regulation in Europe, the director also outlined disclosure and corporate governance standards for such foreign companies.

In June 2007, the SEC hosted a roundtable on mutual recognition, a concept that would give U.S. investors greater cross-border access to foreign investment opportunities. The Commission envisions a regime permitting certain types of foreign financial intermediaries to provide services to U.S. investors under an abbreviated registration system, provided that they are supervised under a securities regulatory regime substantially comparable to that in the U.S.

In Director White’s view, issues relating to listed foreign companies are just as important as issues relating to the exchanges and brokers since the latter would become, under mutual recognition, significant conduits for bringing into the U.S. markets, and hence to U.S. investors, the securities of foreign issuers. Reasoning by analogy, the director said it would be as if the federal government regulated the companies that imported cars into the U.S., and the dealerships that sold those cars, but did not assure that the cars met emission and safety standards. A good regulator looks at the products that are offered and sold through an import arrangement, he emphasized, and with mutual recognition the product is corporate securities.

The mutual recognition model is largely premised on a determination that a home country regulatory regime provides comparable protections afforded to U.S. investors under the federal securities laws. According to the director, this determination would relate not only to brokers and exchanges, but also to the standards applicable to the listed companies involved. Issuer disclosure is one of the hallmarks of the U.S. regulatory regime and a key aspect of market transparency. Any assessment of comparability would consider a foreign jurisdiction's issuer standards with respect to financial and non-financial disclosure, as well as to corporate governance.

High quality annual disclosure documents should be available to investors free of charge over the Internet. In assessing the comparability of issuer disclosure, the SEC would consider a wide range of factors for each market and jurisdiction. No one set of standards would provide the sole template into which a foreign market would need to fit. As far as what disclosure would be considered high quality, Mr. White praised the international disclosure standards developed by IOSCO, including what he called its ``all important’’ MD&A requirement.

In the corporate governance area, the SEC would look at audit committees and internal control over financial reporting, which are widely acknowledged as being key to good governance. Recognizing the significant role that auditors play in the financial reporting system, the Commission would also look to whether a home country had in place an independent overseer of the overall activities of audit firms in that country. The SEC would also look to whether a home country enforced guidelines under which auditors' conflicts of interest are minimized, with limits on non-audit services that may undermine the integrity of the audit process.

A final standard would be whether the foreign companies treat, or whether their home country regulator or exchange requires them to treat, U.S. investors equally with home country investors, or equally with other foreign investors. This consideration could extend to diverse matters, observed the SEC official, such as whether U.S. holders receive the same mailings as other investors, whether proxies are solicited in the same manner, and whether rights offers are extended on an equal basis.
Tellabs: Different Standard, Same Result

The 7th Circuit again found that fraud allegations against Tellabs Inc. raised the required strong inference of scienter under the PSLRA. The U.S. Supreme Court reversed the 7th Circuit panel's earlier decision in June 2007. Applying the high court's more rigorous standard for scienter pleading, the appellate panel again found that the investor allegations were sufficient. Makor Issues & Rights, Ltd. v. Tellabs Inc., No. 04-1687 (CCH Federal Securities Law Reporter ¶94,560).

The complaint against Tellabs, a maker of equipment used in fiber optics network, arose from statements made primarily by CEO Richard Notebaert about demand for the company's principal product, a switching system. In its first review of the case, the 7th Circuit concluded that
Instead of accepting only the most plausible of competing inferences as sufficient at the pleading stage, we will allow the complaint to survive if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent.
The Supreme Court rejected the 7th Circuit view, concluding that
To determine whether the plaintiff has alleged facts giving rise to the requisite "strong inference," a court must consider plausible nonculpable explanations for the defendant's conduct, as well as inferences favoring the plaintiff. The inference that the defendant acted with scienter need not be irrefutable, but it must be more than merely "reasonable" or "permissible" --it must be cogent and compelling, thus strong in light of other explanations. A complaint will survive only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any plausible opposing inference one could draw from the facts alleged.
The high court did not determine, however, whether the allegations were actionable under this standard and remanded the case to the appeals court.

Circuit Judges Wood and Sykes, who were on the first panel, were joined by Judge Posner, who wrote for the court. The inferences of non-culpable conduct were "highly implausible" and "very unlikely," according to Judge Posner. He observed
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 court finally concluded that the inferences of fraudulent intent were cogent. The fact that the allegations were based in part of statements of confidential witnesses was not determinative because "are numerous and consist of persons who from the description of their jobs were in a position to know at first hand the facts to which they are prepared to testify."

Thursday, January 17, 2008

White Paper Out on Supreme Court Scheme Liability Ruling

I have prepared a white paper on the Supreme Court’s decision in Stoneridge rejecting scheme liability under Rule 10b-5. Click
here for white paper.

  • The opinion has broad implications for the business community and for securities professionals.
  • The opinion is primarily based on the reliance element of Rule 10b-5, which is an essential element of the private right of action under the antifraud rule.
  • The opinion strongly reaffirms the Court’s earlier Central Bank ruling that there is no private right of action under Rule 10b-5 for those who aid and abet securities fraud.
  • The opinion is partially based on the broad policy of not expanding an implied federal private right of action in the face of a congressional refusal to do so
  • The opinion is based on a fear that expanding securities fraud liability to secondary actors could harm the competitiveness of US markets at a critical time.
  • The Court reiterated that, since the SEC can bring an enforcement action, against aiders and abetters, there is a remedy to right a wrong.
  • The Court admitted that conduct by secondary actors can itself be deceptive.
  • The Court said that the Rule 10b-5 securities fraud is not congruent with common law fraud.

Tuesday, January 15, 2008



Supreme Court Rejects Scheme Liability Theory Under Rule 10b-5

Secondary non-speaking actors said to have participated with a company in a securities fraud scheme were not liable in a private action under Rule 10b-5 since the acts of suppliers said to have participated in the fraud were too remote to satisfy the antifraud rule’s reliance requirement. Since the company was free to do as it chose in preparing its books, conferring with its auditor, and issuing its financial statements, reasoned the Court, the investors cannot be said to have relied upon any of the deceptive acts of the suppliers said to have assisted the fraud. This was a 5-3 opinion, with the majority opinion rendered by Justice Kennedy. Stoneridge Investment Partners, Inc. v. Scientific-Atlanta, Inc. (No. 06-43, Jan. 15, 2008).

Rejecting the concept of scheme liability, the Court said that to accept that in an efficient market investors rely not only upon the public statements relating to a security, but also upon the transactions those statements reflect, would be an unauthorized and unwarranted extension of the Rule 10b-5 implied cause of action to embrace the whole marketplace in which the issuing company does business. Judicial precedent and congressional intent argue against this broad extension of the Rule 10b-5 private cause of action beyond the securities markets into the realm of ordinary business operations, which are essentially governed by state law.

In addition, the practical consequences of expanding an implied private right of action for securities fraud militate against the acceptance of scheme liability. The extensive discovery and the potential for uncertainty could allow investors with weak claims to extort settlements from innocent companies. It would also expose to such risks a new class of defendants, said the Court, namely overseas firms with no other exposure to U. S. securities laws, thereby deterring them from doing business the US. In turn, this would raise the cost of being a publicly traded company under U. S. law, thereby shifting securities offerings away from domestic capital markets.

The investors alleged losses after purchasing common stock. They sought to impose securities fraud liability on suppliers alleged to have participated in arrangements that the company used to mislead its auditor and issue a misleading financial statement affecting the stock price. Specifically, it was alleged that the suppliers produced documents falsely claiming that costs had risen and signed contracts they knew to be backdated in order to disguise the connection between the increase in costs and the purchase of advertising.

The suppliers had no role in preparing or disseminating the company’s financial statements, noted the Court, and their own financial statements booked the transactions as a wash, under GAAP. It is alleged that the suppliers knew or were in reckless disregard of the company’s intention to use the transactions to inflate its revenues; and knew the resulting financial statements would be relied upon by research analysts and investors.

Citing its Central Bank ruling, the Court observed that, since Rule 10b-5 implied private right of action does not extend to aiders and abettors, the conduct of a secondary actor must satisfy each of the elements or preconditions for liability; and reliance is an essential element of Rule 10b-5. The reliance element ensures that, for liability to arise, the requisite causal connection between a misrepresentation and an investor’s injury exists as a predicate for liability.

The Court has found a rebuttable presumption of reliance in two different circumstances. First, if there is an omission of a material fact by one with a duty to disclose, the investor to whom the duty was owed need not provide specific proof of reliance. Second, under the fraud-on-the-market doctrine, reliance is presumed when the statements at issue become public. Neither presumption applies to this case, said the Court, since the suppliers had no duty to disclose and their deceptive acts were not communicated to the public. Because no investor had knowledge of the deceptive acts during the relevant times, held the Court, no investor could show reliance upon any of suppliers’ actions except in an indirect chain that was too remote for liability.

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

The PCAOB is committed to cooperation with European Union and other non-US audit regulators and expects to conduct joint inspections in fifteen countries by 2009, according to Rhonda Schnare, Director of the Board’s Office of International Affairs. At a recent EU seminar, she presented the practical experience and history of PCAOB cooperation plans. A number of successful joint inspections have already been performed, she noted, and the Board’s objective is to perform inspections jointly with the home country regulators. Twelve joint inspections are currently planned for 2008, she related.

Beyond joint inspections, continued the PCAOB official, the independence of the inspection staff is a significant factor in the Board’s recognition of the system of a foreign oversight body. In response to panelists’ concerns, the PCAOB director confirmed that it is a Board objective to issue public reports on audit firms on a shorter timescale. But she also noted that audit firms do have early indication of the matters which need to be addressed.

Myles Thompson, an audit partner with KPMG UK, shared the experience of his firm with joint UK-US regulatory interventions. In practice, he said, the UK audit inspection unit led the inspection, reviewed the audit firm policies and procedures and performed in-depth reviews of audit files of major clients. For its part, the PCAOB reviewed audit files of key importance to them.

The joint process worked well, the audit partner emphasized, adding that cooperation and dialogue between regulators are the key. The full reliance model outlined by the PCAOB is the desired approach, he said. The PCAOB explained that the involvement of practitioners in inspections would prevent full reliance on the oversight system of a third country; but that joint inspections would not be excluded.

On December 5, 2007, the PCAOB proposed a full reliance regime under which the Board would rely upon a non-U.S. oversight entity to plan the inspection, carry out the inspection field work, and make findings based on its fieldwork. In addition, the Board would rely on the non-U.S. oversight entity 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. Thus, in a situation where full reliance is appropriate, the PCAOB generally expects to rely on the non-U.S. oversight entity's remediation determination.

The Swiss audit oversight system is seeking recognition in bilateral negotiations with the EU and the US, noted Thomas Rufer, Vice President of the Swiss Oversight Body. He emphasized that the new Swiss Oversight Body is an independent body. Under the new Swiss regime, audit firms will be subject to inspections every three years but the
larger firms will be subject to an inspection every year. Foreign audit firms that wish to
register in Switzerland will be expected to operate under a foreign oversight authority judged equivalent by the Swiss oversight authority. The Swiss audit overseer has a strong interest in developing one set of rules for all third countries.

Friday, January 11, 2008

SEC Claim Against Hedge Fund Manager for Illegal PIPES Transactions Fails

In an SEC enforcement action, a federal judge has ruled that a hedge fund manager and the managed funds did not violate Securities Act registration provisions in connection with PIPES transactions. The SEC did not state a plausible claim against the fund manager and the funds for distributing unregistered securities or for fraud arising from the distribution of unregistered securities. These claims were dismissed with prejudice. However, an insider trading claim against the fund manager and the funds was permitted to proceed. (SEC v. Lyon, et al, SD NY, 06 Civ. 14338, Jan 2, 2008).

The SEC alleged the unlawful distribution of unregistered securities based on the assumption that the shares ultimately used to cover a short sale are deemed to have been sold when the underlying short sale was made The Court finds that assumption Unwarranted

The fund manager and the funds participated in at least 36 PIPE transactions. PIPE securities are generally issued pursuant to a nonpublic offering exemption from the registration requirements of the Securities Act that allows the shares to be sold privately. In order to ensure the applicability of one of these exemptions, the PIPE issuers require investors to pledge that they will refrain from immediately redistributing their PIPE shares to the public.

Thus, each PIPE securities purchase agreement contained a provision requiring investors to represent that they were purchasing the securities for their own account and without any present intention of distributing the securities. The hedge fund manager signed these securities purchase agreements in connection with the PIPE transactions.

Upon the public announcement of the issuance of restricted shares in a PIPE offering, the price of the PIPE issuer’s publicly traded stock generally declines. Once they are issued, PIPE shares are considered restricted and cannot be publicly traded until the issuer files and the SEC declares effective a resale registration statement. In the interim between the acquisition of restricted shares and the effective date of corresponding resale statements, PIPE investors often hedge their investments by selling short the PIPE issuer’s publicly traded securities.

The funds hedged all but one of their PIPE investments by executing short sales that fully hedged or hedged as much as possible their PIPE positions. When the funds shorted the PIPE issuers’ publicly traded stock, no resale registration statement was in effect for the corresponding PIPE shares and no registration exemption applied to those shares. In order to cover their short positions, the funds waited until the SEC declared a PIPE resale registration statement effective and then used their formerly restricted PIPE shares to close out their short positions.

The SEC said that the fund manager and the funds made these representations falsely because they planned to distribute the PIPE securities through short selling and covering with the PIPE shares in violation of section 5.

Rejecting the SEC’s position, the court noted that the funds’ representations were not false because their short sales did not constitute a distribution under the Securities Act, and thus they did not misrepresent their investment intentions. The short sales did not violate section 5, ruled the court, and thus the funds’ alleged intention to short the PIPE issuers’ publicly traded securities did not undermine their pledge of compliance with
section 5.

under the SEC’s theory, defendants unlawfully sold PIPE shares to the public via an unregistered three-step distribution. First, defendants bought PIPE shares issued by publicly traded companies that were restricted from being sold publicly. Next, they sold short the PIPE issuers’ public shares prior to the effective date of a resale registration statement for the PIPE shares. Finally, after the resale registration statements for the PIPE shares became effective, defendants “covered” their short positions with those PIPE shares.

The delivery of once-restricted PIPE shares to close a short position did not convert the
underlying short sale into a sale of PIPE shares, reasoned the court, since securities used to close a short position are not sold or offered for sale at the time when a short sales is made. This holding effectively rejects the SEC’s contention that PIPE shares were sold or offered for sale by the funds when they transacted their short sales in favor of the funds’ position that publicly traded shares were offered and sold through those trades.

With regard to the insider trading claim, the SEC stated a plausible claim that the hedge fund manager and the funds were bound by a duty of confidentiality based on a confidential relationship with four PIPE issuers. The SEC alleged that a purchase agreement and offering materials required investors to keep the information conveyed in connection with the offerings confidential.

Thursday, January 10, 2008

FASB and IASB Issue First Converged Standard: It's on M&A Accounting

In a significant milestone towards international accounting standards, the FASB and the IASB have issued their first converged accounting standard as part of their long-range convergence initiative. The new M&A accounting standard was issued as FASB Statement 141 (R) and revised IFRS 3. The new standards are designed to improve and converge internationally the accounting for business combinations and acquisitions. In publishing its equivalents to IFRS 3, FASB made fundamental changes to its M&A accounting in order to bring US accounting into line with IFRS 3. The changes to IFRS 3, in contrast, were relatively small. Both the SEC and the European have blessed the FASB-IASB best efforts convergence project.

The new standards are substantially similar, with the prominent exception being that of measuring non-controlling interests. The revised IFRS 3 permits an acquirer to measure the non-controlling interests in an acquiree either at fair value or at its proportionate share of the acquiree’s identifiable net assets while SFAS 141(R) requires the non-controlling interests in an acquiree to be measured at fair value.

There are also some legacy differences. For example, the two Boards have different definitions of control. Consequently, it is possible that a transaction that is a business combination in accordance with revised IFRS 3 might not be a business combination in accordance with SFAS 141(R). The IASB will issue a discussion paper on this topic in 2008.

Under the new converged standards, acquisition-related costs will be recognized as expenses, rather than included in goodwill. In addition, the requirement to measure at fair value every asset and liability at each step for the purpose of calculating a portion of goodwill has been removed. Instead, goodwill will be measured as the difference at acquisition date between the fair value of any investment in the business held before the acquisition, the consideration transferred and the net assets acquired.

Further, restructuring charges will be accounted for as they are incurred, rather than allowing them to be anticipated at the time of the business combination. Moreover, in -process research and development will be recognized as a separate intangible asset, rather than immediately written off as an expense.The converged standards also clarified the requirements for how the acquirer accounts for some of the assets and liabilities acquired in a business combination that had been proving to be problematic, such as replacing the acquiree’s share-based payment awards, embedded derivatives; cash flow hedges; and operating leases.

With over 250 comments received on the proposal, the IASB decided to issue a feedback statement explaining how the comments affected the final standards. One important result from the comments was the decision to abandon the full goodwill model under which goodwill is derived by measuring the difference between the fair value of the business as a whole and the sum of the net assets acquired and liabilities assumed.

Commenters feared that the proposal placed too much emphasis on estimating the fair value of the business; and that this estimate can be unreliable. In response, the standard-setters shifted the focus back to the components of business combination transactions, being the consideration transferred and the assets, liabilities and equity instruments of the acquiree. Any difference between the consideration transferred and the components of the business would be attributed to goodwill.

Wednesday, January 09, 2008

Basel II Helps Japanese Banks Manage Risks of Securitization

The implementation of Basel II has helped Japanese financial institutions to better manage the risk associated with derivatives and other the complex financial products engineered by securitization. In recent remarks at an EU financial meeting, Commissioner Takafumi Sato of the Financial Services Agency said that there are embedded vulnerabilities in the securitization process, including inaccurate information about securitized products, such as mortgage-backed securities. In many cases, counterparties and investors did not fully understand the true nature of the risks they were bearing. As financial innovations led by securitization have scattered the risks of underlying assets over various parties around the world, he noted, it has become increasingly difficult to identify the location and the magnitude of risks in the financial system.

In his view, the Basel II Accord is a significant factor in achieving enhanced risk management and stronger market discipline. Pillar One of the accord requires financial institutions to calculate the minimum amount of capital in a more risk-sensitive manner than under the old Basel I framework. A typical example is the so-called look through approach with regard to banks' fund investments. The FSA has rigorously applied this approach within Japan’s Basel II framework, noted the commissioner, and banks are now required to keep larger amounts of capital for their fund investments if the components of the fund cannot be identified.

Therefore, banks are encouraged to look through the components of their fund investments. It has been reported that some banks have reduced their positions in funds for which detailed information cannot be obtained and also that some funds have improved their disclosure practices in response to the requests from Japanese banks. As these examples show, continued the official, Japanese banks have in general become more prudent and selective in choosing their portfolio.

As for the treatment of securitization exposures in Basel II, The FSA added some extra value to the original framework. In Basel II, banks are allowed to use external ratings in computing their capital charge for securitization exposures. Market discipline works less effectively for ratings of securitized products than those for conventional corporate bonds, he reasoned, since securitization ratings are difficult to validate given the very few actual default experiences for securitized products in Japan. In order for the securitization ratings to be eligible, the FSA requires that credit rating agencies publish, free of charge, not only general information such as rating criteria, but also detailed transaction-specific information such as the type of underlying assets. This has contributed to improved market transparency, he noted, as well as enhancing risk management.

The FSA has received positive responses on Pillar Three of Basel II, which requires banks to improve their disclosure of information on the risks they are taking. For example, banks must disclose information on their securitization exposures, including breakdowns by type of underlying asset and by risk weight. Market participants indicate that the Pillar Three disclosure requirements have helped a great deal in better understanding the magnitude of Japanese banks' involvement in the securitization business, leading to more transparency and contributing to calming down market concerns during a time of global market turbulence.

Turning to concerns over the rating of securitized products, the commissioner urged securitizers to be vigilant in regard to the quality of the credit they are bundling. Originators should keep a certain portion of the underlying assets, he said, and arrangers should keep a certain tranche of the structured products, as incentives for them to examine and monitor more carefully the quality of the credits and securitized products they are producing.

Commissioner Sato proposed a voluntary code of conduct requesting the disclosure of information on the portion kept by originators and arrangers so that credit rating agencies can take such information into account in their ratings. Securitized products with some portion kept by originators or arrangers might deserve higher ratings, he suggested, since the quality of credit for the underlying assets of these products is supposed to be more carefully examined and monitored by the originators and arrangers themselves.

Tuesday, January 08, 2008

SEC Official Examines IOSCO Accounting and Auditing Initiatives

An SEC official who represents the Commission on IOSCO’s Accounting Subcommittee said that the organization is committed to the development of high quality international auditing standards and uniform international financial reporting standards. In recent remarks, Associate Chief Accountant Janet Luallen noted that IOSCO has been actively monitoring the work of the IAASB and provides comments on the quality of proposed audit standards and the process for setting them, and also provides comments on the Board's agenda.

IOSCO is currently evaluating under what conditions it could endorse cross-border auditing standards. According to the official, the IAASB's responses to public interest concerns in its standard setting will be relevant to any IOSCO endorsement.

IOSCO is also exploring other issues related to audit quality, including the possible impact of audit firm concentration, auditor liability and other factors. IOSCO held roundtable discussions with its financial market stakeholders on topics related to the quality of audits in 2007. IOSCO and its members are also coordinating with auditor oversight bodies to examine and address issues affecting audit quality.

Similarly, IOSCO is currently exploring other issues related to audit quality, including the possible impact of audit firm concentration and auditor liability. IOSCO is also studying ways to make auditors' reports more relevant and informative to investors, noted the SEC official, and how to close the expectations gap by improving fraud detection by auditors.
On the accounting front, IOSCO is closely monitoring developments in IFRS. As part of this process, IOSCO comments on proposed changes and routinely discusses standard-setting work with the IASB. As part of this effort, IOSCO encourages a reduction in the complexity of accounting standards and in the number of exceptions to principles.

As jurisdictions adopt modified versions of IFRS for use by public companies, IOSCO fears that confusion may be sown among the community of financial statement users. Readers of financial statements may believe they are looking at IFRS financial statements when an issuer asserts that the standards have been used, reasoned the official, although the statements in question contain material differences from results that would be obtained using full IFRS as issued by the IASB. IOSCO believes that there is a need to inform investors as to the accounting framework used, she continued, and is currently considering what it might do encourage this.

Finally, the recently-formed IOSCO task force on market turmoil will examine issues raised by the accounting treatment of structured products. The task force will also look at special purpose entities in order to better analyze the mechanisms whereby these entities are reflected on or off the balance sheet and the possible implications in terms of risk measurement and information to investors where listed companies are involved

Monday, January 07, 2008

Guidance Proposed on Limiting Auditor Liability

A very significant event will occur on April 6, 2008. The UK Companies Act will come into force; and with it there will be provisions allowing outside auditors of financial statements to negotiate limits on their liability with client companies. The liability limiting agreements must be fair and reasonable; and a separate agreement would be required for each year’s audit, and each one must be approved by the company’s shareholders. In light of this development, the Financial Reporting Council, the UK audit oversight body, has proposed guidance on the use of agreements to limit the liability of auditors of public companies.

Among other things, the draft guidance sets out some of the factors that will be relevant when assessing the case for an agreement and explains what matters should be covered in an agreement. It also provides specimen clauses for inclusion in agreements. The draft guidance does not identify a preferred approach, but simply sets out the available options.

The key principle of the Companies Act is that any arrangement to limit liability must be fair and reasonable in the particular circumstances. This means that a court can override any contractual limits agreed to by the company and the auditors if it considers that they are less than fair and reasonable. The court may reach this conclusion notwithstanding the fact that the agreement was approved by the company’s shareholders.

Although the question of what is a fair and reasonable limit on the auditor's liability will ultimately be for the courts, the Companies Act sets out a number of factors that should be taken into consideration, such as the nature and purpose of the auditor's contractual obligations to the company and the professional standards expected of the auditor.

Also, the Act does not restrict the manner in which liability can be limited, which means that the limits could be set in a number of different ways. For example, a limit could be based on the auditor’s proportionate share of the responsibility for any loss. Under this approach, explained the FRC, the company would agree that if there is someone other than the auditor who is also liable to the company for all or part of the same loss, the auditor's liability would be limited to the extent to which the auditor was responsible for that loss. The agreement could also put a cap on the outside auditor’s liability, expressed either as a monetary amount or calculated on the basis of an agreed formula.

Even if the final guidance does indicate which options are most likely to be acceptable, noted the FRC, the guidance will not and cannot give firm assurances as to whether particular arrangements will ultimately be considered fair and reasonable. That is because every agreement will need to be assessed in the context of the specific circumstances. That judgment would be made by the courts in the event of a dispute, and cannot be defined in advance.

The proposed guidance advises companies and auditors to consider how any liability limiting agreement interrelates to the audit engagement letter. One option is for the principal terms to be part of the audit engagement letter. Another option is to have a separate agreement which just deals with the limitation of the auditor’s liability, cross-referencing to the audit engagement letter.

Companies and auditors will also need to consider whether there are any provisions in the audit engagement letter that would have the effect of limiting the auditor's liability in other ways, such as a limit on the period in which claims can be brought.

Sunday, January 06, 2008

Euro Central Bank Chief Urges More Disclosure on Securitization

In light of recent market turmoil, European Central Bank President Jean-Claude Trichet has called on the financial industry to provide more public information about securitization. As part of this effort, he emphasized the need for the consistent valuation of complex derivatives and adequate disclosure by banks of their exposures. In remarks at hearings held by the European Parliament, the official also praised the efforts of the regulatory community in coping with the current market situation.

In the view of the ECB chief, it is crucial to promote a widespread consistent valuation of derivatives and other complex structured products, in particular related to the US sub-prime mortgage sector. He welcomes the efforts of the Basel Committee on Banking Supervision and the Committee of European Banking Supervisors in considering joint measures to contain the potential effects of the turmoil. The official also underlined the importance in stress situations, like the current one, of effective and smooth cooperation and exchange of information between the regulators and central banks.

Clarity is also needed concerning liquidity commitments to off-balance sheet vehicles, he noted, and the magnitude of assets that may be re-intermediated back onto the balance sheets of financial institutions. The process of improving clarity started with Q3 2007 financial statements, he observed, and should be advanced further when institutions publish their annual accounts for 2007 as a whole.

As part of enhanced disclosure about securitization, the chief emphasized the need for credit rating agencies to review their methodologies for derivatives and other complex structured products and to address potential conflicts of interest. Investors must also reconsider their excessive reliance on ratings. This has been a consistent message from the ECB President.
While he has essentially rejected the call to give central banks a role in the credit assessments of securities and their issuers, the senior official supports initiatives to enhance the transparency of rating methodologies and facilitate more competition in the market for credit assessments. In this regard, he has favorably mentioned that European Commissioner for the Internal Market Charlie McCreevy has requested CESR to examine specific issues relating to the rating process of structured finance products and report back to the Commission. This could be an interesting year for examining the role that ratings agencies played in the crisis.

Friday, January 04, 2008

Senate Colloquy Clarifies CFTC-FERC Jurisdiction in Reauthorization Bill

A colloquy between Sen. Bingaman, Chair of the Energy Committee, and Senators Levin, Harkin and Feinstein clarified the respective jurisdictions of the FERC and the CFTC in the CFTC Reauthorization Act passed last month by the Senate as part of the Farm Bill. The colloquy revealed that nothing in the bill would prejudice or interfere with ongoing, energy market enforcement-related litigation or administrative proceedings currently involving FERC and the CFTC. Sen. Harkin, a sponsor of the Act, and Senate Agriculture Committee Chair, assured that the current jurisdictional boundaries between the two Commissions are maintained in the legislation, with respect to the authority of FERC under the Federal Power and Natural Gas Act and the CFTC under the Commodity Exchange Act. Sen. Harkin said that nothing in the bill would erode either Commission’s authorities under the statutes. Similarly, nothing in the bill would limit FERC’s existing ability to gain information from market participants.

Sen. Feinstein, a primary author of the Act, as well as one of the coauthors of sections 315 and 1283 in the Energy Policy Act of 2005, which gave FERC additional anti-manipulation authorities under the Federal Power and Natural Gas Acts, confirmed that nothing in the Act undermines or alters those authorities. Section 13203 of the Commodity Reauthorization Act, which preserves FERC’s existing authority, does not undermine or alter those authorities.

The bill expands the CFTC’s authority with respect to the requirements it may impose on transactions it deems significant price discovery contracts. This significant price discovery contract determination may be applied to contracts, agreements, and transactions that are conducted in reliance on the exemption included in section 2(h)(3) of the Commodity Exchange Act. In closing the Enron loophole, the bill extends the CFTC’s exclusive jurisdiction over these significant price discovery contracts.

As a forward-looking matter, Sen. Bingaman clarified the intent of the bill with respect to this new class of significant price discovery contracts. Electronic trading facilities that currently operate under the exemption included in section 2(h)(3) of the Commodity Exchange Act for purposes of trading energy swaps also trade physical or cash contracts in electricity and natural gas. For oversight and enforcement purposes, emphasized Sen. Bingaman, it is crucial that FERC retain its jurisdiction over these physical energy transactions.

According to Sen. Levin, in addition to the savings clause in the bill that preserves FERC’s jurisdiction under its statutes as a threshold matter, FERC’s jurisdiction
over these transactions would, in any event, be preserved. These kinds of cash transactions would not be captured within the bill’s significant price discovery contract test. The test is reserved for those transactions conducted in reliance on the exemption in paragraph 2(h)(3) of the Commodity Exchange Act. Because the CEA does not apply to cash transactions for purposes of regulation, these transactions cannot, by definition, be conducted in reliance on this exemption. As such, FERC’s authority in this area is preserved on all accounts.
Antitrust Laws Preempted in Short Sale Case

A firm that engaged in short sales could not pursue antitrust claims against brokerage firms based on allegedly inflated fees paid in connection with the borrowing and purported borrowing of securities for these short sales. According to the U.S. District Court for the Southern District of New York (In re Short Sale Antritrust Litigation, CCH Federal Securities Law Reporter ¶94,547), in light of the U.S. Supreme Court's June 2007 decision in Credit Suisse Securities (USA) LLC v. Billing, the securities laws implicitly precluded application of the antitrust laws to the conduct in question.

District Judge Victor Marrero cited the four factors identified by the Supreme Court for determining whether in a particular situation the antitrust and securities laws are incompatible. A finding of preemption is appropriate when 1) the possible conflict affected practices that lie squarely within an area of financial market activity that the securities laws seek to regulate, 2) there exists regulatory authority under the securities law to supervise the activities in question, 3) the responsible regulatory entities exercise that authority and 4) there is a resulting risk that the securities and antitrust laws, if both applicable, would produce conflicting guidance, requirements, duties, privileges, or standards of conduct.

As in Billing, which dealt with IPO practices, the fourth factor was the pivotal consideration. As stated by Judge Marrero,
The securities laws are in serious conflict with the antitrust laws within the short sale context at issue. After Billing, the serious conflict question now before this Court is, assuming that the SEC disapproves of (and will continue to disapprove of) the conduct at issue, whether "allow[ing] an antitrust lawsuit would threaten serious harm to the efficient functioning of the securities market."

The district court noted Justice Breyer's concern that "evidence tending to show unlawful antitrust activity and evidence tending to show lawful securities marketing activity may overlap, or prove identical." Preemption was appropriate in this instance because the
threat of a "nonexpert jury" mistaking lawful conduct under the securities laws as evidence of a conspiracy under the antitrust laws and exacerbated by the prospect of trebled damages, would place immense pressure on Defendants to curtail the open exchange of information. Such antitrust suits would likely chill a broad range of activities that the securities laws permit and encourage, and would likely inhibit the short selling activity that provides market liquidity and pricing efficiency.

Thursday, January 03, 2008

Senate Passes Bill to Close Enron Loophole

A measure reauthorizing the CFTC and closing the Enron loophole has been tacked on to a bipartisan Farm Bill and passed by the Senate. The Feinstein amendment to the Farm Bill regulates energy transactions that perform a significant price discovery function. This
is an issue Senators Feinstein and Levin have been laboring on for years. The amendment also addresses fraud and retail transactions in foreign exchange markets. The bill now goes to conference to resolve differences with a similar House bill. Congress is hopeful that the final bill will pass early this year.

The Enron loophole, included in the Commodity Futures Modernization Act of 2000, has allowed large volumes of energy derivatives contracts to be traded over-the-counter, OTC, and on electronic platforms, without the federal oversight necessary to protect both the integrity of the market and energy consumers.

The legislation will put an end to the Enron-inspired exemption from government oversight now provided to electronic energy trading markets set up for large traders. By ending that exemption, this legislation will restore the ability of the CFTC to police all US energy exchanges to prevent price manipulation and excessive speculation

The legislation has the general support of the CFTC, the electronic exchange known as ICE, the New York Mercantile Exchange, the Chicago Mercantile, and the President’s Working Group on Financial Markets.

The legislation also increases transparency in energy markets to deter traders from manipulating the price of oil and natural gas futures traded on electronic markets. It requires energy traders to keep records for a minimum of five years so there is transparency and an audit trail. It requires electronic energy traders to report trading in significant price discovery contracts to the CFTC so that the agency would have the information to effectively oversee the energy futures market. Manipulators could then be identified and punished by the CFTC.

The bill gives the CFTC new authority to punish manipulation, fraud, and price distortion. It requires electronic trading platforms to actively monitor their markets to prevent manipulation and price distortion of contracts that are significant in determining the price of the market.

These are the factors that the CFTC will consider in making that determination: the trading volume, whether significant volumes of a commodity are traded on a daily basis; price referencing, if the contract is used by traders to help determine the price of subsequent contracts; and price linkage, if the contract is equivalent to a NYMEX contract and used the same way by traders.

For example, when the Amaranth hedge fund was directed to reduce their position in regulated natural gas contracts, it simply moved its position to the unregulated electronic natural gas contracts. This requirement would essentially say that similar contracts on ICE and NYMEX will be regulated the same way.


The legislation would also require electronic exchanges, for the first time, to begin policing their own trading operations and become self-regulatory organizations in the same manner as futures exchanges like NYMEX.

In addition to requiring electronic exchanges to become self-regulatory organizations, the legislation would require the CFTC to oversee these exchanges n the same general way that it currently oversees futures exchanges like NYMEX. The legislation also, however, assigns the CFTC a unique responsibility not present in its oversight of other types of exchanges and clearing facilities. The legislation would require the CFTC to review the contracts on each electronic exchange to identify those which ‘‘perform a significant price discovery function’’ or, in other words, have a significant effect on energy prices.

A legal battle is going on in the courts right now over enforcement actions by the CFTC and the Federal Energy Regulatory Commission accusing Amaranth of manipulating or attempting to manipulate natural gas prices. According to Sen. Levin, this legislation is not intended to affect that court battle in any way. Congress is waiting to see how it plays out and how the courts will interpret the law. This legislation is intended to play an absolutely neutral role in those enforcement actions, and should not be interpreted as changing the status quo in any way.

Maine’s Take on Investment Adviser Hedge Clauses and Assets Under Management

Recently, an investment adviser queried the Maine Office of Securities whether a hedge clause such as the following placed in a client’s contract was appropriate:

"Except for negligence or malfeasance, or violation of applicable law, neither you nor any of your officers, directors or employees shall be liable hereunder for any action performed or omitted to be performed or for any errors of judgment in managing the account. The federal and state securities laws impose liabilities under certain circumstances on persons who act in good faith, and therefore nothing herein shall in any way constitute a waiver or limitation of any rights which the client may have under any federal or state securities laws. "

Maine replied that there was no appropriate or inappropriate hedge clause language but cautioned the investment adviser that the State, by rule, holds investment advisers (and investment adviser representatives) to a fiduciary duty that may not be disclaimed away in a contract. It was suggested that the investment adviser append the following language to the above hedge clause:

"In this regard, nothing shall abridge the fiduciary duty imposed on the adviser to Act for the benefit of the client nor any rights the client may have as a result of that duty. "


Next, the investment adviser posed the following hypothetical: Whether the Office of Securities would consider the adviser to be a state investment adviser for purposes of becoming licensed in Maine as opposed to a federal covered investment adviser, if the adviser only provided investment advice on a temporary basis and had no assets under management. The investment adviser cited an SEC definition stating that an investment adviser is one who provides continuous and regular supervision or management, thereby excluding one who provides advice on an intermittent or periodic basis. The adviser also disclosed that it listed all of its portfolios as “assets under management.”

The Office of Securities stated that its sole test for determining whether an investment adviser was state or federal covered is whether the adviser is registered under the Investment Advisers Act of 1940; that if “yes” the adviser was federal covered. The Office of Securities further cautioned the adviser that as it did not use an assets under management test to determine state or federal covered registration, its opinion could conflict with the SEC and that, therefore, the adviser should either pose the question to the SEC or read Section 5(b) of the Instructions to Form ADV pertaining to calculating assets under management.

Tuesday, January 01, 2008

Companies Urged to Dialogue with SEC Staff on Accounting Judgments

With the coming of judgment-driven principles-based standards, the SEC staff urges companies to engage in continuing upward dialogue regarding their accounting judgments made while preparing financial statements. Reasonable judgment is the foundation of the US financial reporting system, declared Associate Chief Accountant Todd Hardiman at a recent AICPA seminar. Reasonable accounting judgments are necessary for both rules-based standards and the more subjective principles-based standards, he said, as well as for transactions for which the accounting literature does not specifically apply. In his remarks, Mr. Hardiman also lays out the chain of command for a company to use if it disagrees with an SEC staff comment on professional accounting judgment. The chain goes right up though the Division of Corporation Finance accounting command all the way up to the SEC’s Office of the Chief Accountant.

The associate chief accountant advised issuers not to silently accept a staff conclusion that they do not agree with. Doing so stops the dialogue, he reasoned, and the staff may view the silence as validation of their comments. In that situation, the official urged issuers to seek a review of the staff’s decision by more senior SEC accounting staff.

Laying out a roadmap for going up the chain of command, the official noted that the issuer-SEC dialogue starts with the staff accountant and review accountant identified in the staff comment letter. An issuer that thinks their conclusion is not appropriate should continue the dialogue by asking for a review by more senior accounting staff of the Division of Corporation Finance.
The first layer of additional review will come from the senior assistant chief accountant; of which there is one for each of the division's eleven industry groups. If the issuer still does not agree with the staff decision, it should request a review by the division’s Office of Chief Accountant.

At that level, the decision will be reviewed by one of seven associate chief accountants. Depending on the course of the dialogue with division, either the Deputy Chief Accountant or Chief Accountant may be pulled into the dialogue. Finally, after working up the division’s chain of command, there is the opportunity to have the division's decision reviewed by the Office of Chief Accountant of the Commission.

Generally, companies and their management do a good job of making judgments, said the SEC official, and that is appropriate. Management is closest to the action and thus best-suited to make the delicate inferences and judgments unique to their facts and circumstances. But at times, he continued, their disclosure documents do not explain those important judgments and sometimes actually seem inconsistent with the exercise of appropriate judgment. When that happens, he noted, the SEC staff enters the mix.

The official explained that the staff will question accounting judgments when the basis for an important judgment is counterintuitive or unclear from the disclosure. The staff will also raise a question when the judgments appear to be inconsistent with other judgments or assumptions made by management. The staff will also query when the analogy to accounting literature cited by management to support a judgment has been superseded by more recent thinking in other more closely analogous accounting literature that existed at the filing date. Broadly, then, the SEC staff will question an important judgment when they cannot understand it or when on it seems inappropriate on its face.

But the SEC official assured that the staff’s questioning of an accounting judgment does not mean that they have concluded that the judgment is wrong. In virtually every comment that asks questions about judgment, he explained, the comment should be viewed as an invitation to a dialogue. While it is an invitation that may be difficult to decline, he acknowledged, companies must understand that the comment is intended to elicit a dialogue.

Indeed, the SEC needs issuers to fully participate in a dialogue since there is not always one right answer, especially when the judgment relates to principles-based standards or transactions where the accounting literature is not directly on point. In those circumstances, the SEC staff is trying to determine if the company's accounting is unreasonable. In order to answer that question, the staff needs help in understanding why the company made the judgment. Sometimes the reason why is self evident from the disclosure document, he observed, but if the staff is raising a question it probably is not.