Thursday, February 28, 2008




FASB Will Be Reduced to Five Members and Chair Will Set Agenda

The FASB would be reduced from seven to five members on July 1, 2008, with simple majority voting retained, under changes approved by its overseer the Financial Accounting Foundation. It is envisioned that the new five-member FASB would be composed of an auditor, a preparer, an academic, a financial statement user, and one at-large, best-qualified member.

In an effort to increase investor participation on the Board, the FAF also broadened the requirement that FASB members have investment experience. More specifically, FASB members must now have experience in investing, business, accounting education, and a concern for the investor and the public interest in matters of financial accounting and reporting. The foundation also changed FASB’s agenda-setting to a leadership process under which the FASB chair is authorized, following appropriate consultation, to set the Board’s agenda and priority of projects.

Interestingly, the reduction in FASB’s size was opposed by a number of heavyweight commenters, including former FASB member and current IASB member James Leisenring, who said that it was most inopportune to propose a reduction when pressures have increased on Board members to much more extensively deal with outside constituents. The FASB needs, if anything, more not less resources, he emphasized, to deal with the issues inherent in world-wide convergence.

Similarly, SIFMA, while recognizing the desire for a more nimble Board, opposed the reduction in size. SIFMA believes that any perceived nimbleness is outweighed by the need for well thought-out standards. The association feared that a reduction in FASB’s size could endanger the quality of discussion of new standards. Sometimes discussion of a particular issue is dominated by one or two FASB members, noted SIFMA, and a reduction in size concentrates decision making power, which in turn could lead to the perception that the new standards lacked widespread support.

Grant Thornton saw no convincing case for reducing the size of FASB. A smaller FASB is bound to be limited in the experience and expertise needed to address a range of technical accounting issues for a diverse constituency. Noting FAF’s point that a five-member Board is consistent with the operations of the SEC and PCAOB, GT pointed out that the smaller size of those bodies, and their proportionately larger staffs, is in part a function of their role as regulators of capital market activities.

While the foundation found support in comments by PricewaterhouseCoopers that a smaller board should be more nimble and operate more efficiently, Ernst & Young did not support the proposal to reduce the size of FASB. While acknowledging the need for enhancing the efficiency of FASB, E&Y said that reducing the Board could
sacrifice the quality of new standards for speed of issuance.

E&Y also had reservations about the governance aspects of centering the Board agenda in the chair. While this reform will help FASB to act with greater speed, the firm said it is equally important to achieve a consensus on new accounting standards. The ability to control the agenda is a powerful tool, reasoned E&Y, and should not be wielded by a single individual regardless of his or her talents. It is unclear what limits, if any, would be placed on the FASB chair's agenda-setting authority, but it is expected that the chair will work closely with fellow board members on all agenda-setting matters.

Echoing these concerns, Grant Thornton said that providing the FASB chair with decision making authority for the technical agenda would not contribute to the goals of an independent Board setting high quality standards. In GT’s opinion, agenda-setting should be insulated from political concerns. Giving this authority to one person could infuse political factors into selection of the chair that are not present today. James Leisenring said that agenda-setting authority should not rest with the FASB chair or any group other than the full FASB.

Wednesday, February 27, 2008




Management Conduct Taints Board Election, VC Strine Orders New One

A contested corporate election of directors was so tainted by management’s inequitable conduct that the Delaware Chancery Court set the results aside and ordered a new election. The court ruled that management failed to disclose an agreement to obtain the votes of one insurgent shareholder by promising to expand the board and let the insurgent name the new director. Similarly, in an effort to secure another key bloc of votes, management used a combination of threats of ending a key project and the inducement of removing a restrictive legend on the shares of the shareholder it sought to enlist. Management also delayed the annual meeting in order to win the election, was dishonest about the reasons for the delay, and failed to use the time to release an adverse 10-Q. (Portnoy v. Cryo-Cell International, Inc., Del. Chan Ct, CA No. 3142).

Vice Chancellor Strine ordered a new prompt election to be presided over by a special master, with the management slate to bear the costs of their own proxy solicitations, the costs of the meeting, and the cost of the special master. The court rejected management’s plea that the annual report is not ready and the SEC will not let them solicit proxies. Management should seek relief from the SEC, said the court.

While the SEC’s requirements are well-intended ones designed to protect stockholders; noted the court, they are no basis to insulate corporate insiders from their obligations under the corporation law governing their company’s relations to its stockholders. Nothing in the Exchange Act proxy provisions suggests any purpose to interfere with the power of state courts to require that stockholder meetings be held in accordance with the requirements of state corporation law in situations where the company is delinquent in its SEC filings.

The contest began with two separate insurgent shareholder groups. Management made a deal with one insurgent by giving him a seat on the board, which was disclosed to shareholders, and allowing him to also name a new director, which was not.. Vice Chancellor Strine said that the arrangement under which the insurgent was promised a seat on the board for his support of the management slate was not illegal vote buying.

This type of arrangement was not per se improper, noted the court, and would not be judged under an entire fairness standard. Since it had been disclosed, reasoned the court, the arrangement was subject to policing by the shareholders at the ballot box. It would run counter to the business judgment rule, said the court, for judges to ``chew over the complicated calculus’’ made by incumbent boards in adding votes to the management slate. Citing Caremark, the court said that to objectively evaluate the decision would expose directors to substantive second-guessing by ill-equipped judges.

But the undisclosed arrangement to allow the insurgent to name a new member of the board was quite different because, for one thing, it did not go before the shareholder electorate. The failure to disclose this material event was improper and tainted the election.

Directors are under a fiduciary duty to disclose fully and fairly all material information within the board’s control when they seek shareholder action. That disclosure obligation attaches to proxy statements and any other disclosures in contemplation of stockholder action.

The court concluded that stockholders would have found it material to know that
corporate management’s cooperation with the insurgent had now extended to a bargain whereby he would buy up more shares and votes in exchange for having two seats on the board. Reasonable stockholders could have come to the conclusion that they did not want the insurgent to have so much influence

With regard to the threats and inducements used to secure another shareholder’s votes, the court found that management breached its fiduciary duties by intentionally using corporate assets to coerce the shareholder into voting for the management slate. It was inequitable to use powerful tools for entrenchment purposes.

Tuesday, February 26, 2008

GAO Report Finds Market Discipline Alone Cannot Manage Hedge Fund Risk

While market discipline is becoming more effective for managing hedge fund risk, concluded a GAO report, it may not be enough by itself since a number of factors limit its effectiveness and it is not always properly exercised. For example, because most large hedge funds use multiple prime brokers as service providers, no one broker may have all the data necessary to assess the total leverage of a hedge fund client. Further, the GAO found that, if the risk controls of creditors and counterparties are inadequate, their actions may not prevent hedge funds from taking excessive risk. These factors can contribute to conditions that create systemic risk if breakdowns in market discipline and risk controls are sufficiently severe that losses by hedge funds in turn cause significant losses at key intermediaries or in financial markets.

The exhaustive report also found that financial regulators and industry participants remain /concerned about the adequacy of counterparty credit risk management at major financial institutions because it is a key factor in controlling the potential for hedge funds to become a source of systemic risk. The GAO applauded regulators for using risk-focused and principles-based approaches to better understand the potential for systemic risk and respond more effectively to financial shocks that threaten to affect the financial system.

For example, regulators have collaborated to examine some hedge fund activities across regulated entities. In addition, the President's Working Group on Financial Markets has issued guidance for hedge funds and formed two private sector groups to develop best practices for investors and asset managers. The President’s Working Group is composed of the Secretary of the Treasury and the chairs of the SEC, the CFTC, and the Federal Reserve Board.

The SEC, CFTC, and the bank regulators are authorized to establish capital standards and reporting requirements, conduct risk-based examinations, and take enforcement actions, to oversee activities, including those involving hedge funds, of broker-dealers, of futures commission merchants, and of banks, respectively. While these financial regulators do not specifically monitor hedge fund activities on an ongoing basis, they have increased targeted examinations of systems and policies to mitigate counterparty credit risk at the large regulated entities. For their part, regulated entities have the responsibility to practice prudent risk management standards, noted the GAO, but prudent standards do not guarantee prudent practices. As such, it will be important for regulators to show continued vigilance in overseeing the hedge fund-related activities of regulated institutions.

The GAO found that hedge fund advisers have improved disclosure and become more transparent about their operations, including risk management practices, partly as a result of recent increases in investments by institutional investors with fiduciary responsibilities, such as pension plans, as well as guidance provided by regulators and industry groups. But the report also noted that, despite the requirement that fund investors be sophisticated, not all prospective investors have the capacity or retain the expertise to analyze the information they receive from hedge funds, and some may choose to invest largely as a result of the fund’s prior returns without fully evaluating its risks.

Regulators and market participants also said that creditors and counterparties have been conducting more extensive due diligence and monitoring risk exposures to their hedge fund clients since the LTCM debacle. Creditors and counterparties exercise market discipline by tightening their credit standards for hedge funds and demanding greater disclosure.
But the actions of creditors and counterparties may not fully prevent hedge funds from taking excessive risk if their risk controls are inadequate. For example, the risk controls may not keep pace with the increasing complexity of financial instruments and investment strategies that hedge funds employ. Similarly, regulators have been concerned that, in competing for hedge fund clients, creditors sometimes relax credit standards.

The SEC’s ability to directly oversee hedge fund advisers is limited to those that are required to register or voluntarily register with SEC as investment advisers. That said, the SEC actually regulates 1,991 hedge fund advisers that are registered as investment advisers, which include 49 of the largest U.S. hedge fund advisers that account for about one-third of hedge funds’ assets under management in the United States. As registered investment advisers, hedge fund advisers are subject to SEC examinations and reporting, record keeping, and disclosure requirements.

Saturday, February 23, 2008

IRS Revenue Ruling on Executive Comp Plans Appears to be Prospective

The Internal Revenue Service revenue ruling that cast doubt on the exclusion of some performance-based executive compensation from the $1 million pay cap mandated by IRC §162(m) if a company wants to deduct an executive’s pay from its income tax will apparently be applied prospectively. Revenue ruling 2008-13 essentially backed up an earlier private letter made public by the IRS (LTR 200804004).

Under IRC 162(m), compensation in excess of $1 million paid by a public company to its covered employees generally is not deductible. Notice 2007-49 states that the term "covered employee," for purposes of §162(m), will apply to the principal executive officer and the three highest compensated officers (other than the principal executive officer and principal financial officer).
Performance-based compensation is not subject to the deduction limitation and is not taken into account in determining whether other compensation exceeds $1 million. In general, performance-based compensation is compensation payable solely on account of the attainment of performance goals.

In the letter ruling, the IRS said that provisions in a company’s compensation scheme allowing for payment of performance-based compensation even if the performance goals are not met upon an executive's involuntary termination without cause or voluntarily termination with good reason do not meet the exception in section 1.162-27(e)(2)(v) of IRS regulations allowing compensation to be payable upon death, disability or change of ownership or control. Thus, the compensation cannot be excluded from the $1 million calculation

In Revenue Ruling 2008-13, the IRS backed up the letter ruling by essentially saying that the performance goals must be met before the payment of performance-based awards can be excluded from calculating the $1 million cap. In the revenue ruling, the IRS set forth two separate scenarios that would not qualify as performance-based compensation under Code Section 162(m). In the first scenario, the executive did not meet the performance but received the performance-based compensation anyway after being terminated involuntarily without cause or voluntarily ending his/her employment for good reason. In such a situation, said the IRS, the compensation would not be considered payable solely on account of the attainment of a performance goal under the 162(m) exclusion. In the second scenario, the employee voluntary retired and the performance-based compensation was paid even though the performance goal was not attained. Similarly, this award is not qualified performance-based compensation under Code Section 162(m).

A letter from 90 global corporate and securities law firms noted that, consistent with prior IRS rulings, many public companies entered into compensation arrangements patterning the treatment of involuntary and good reason terminations after what the regulation authorized for death and disability. In the firms’ view, these prior rulings, now apparently reversed, represent a reasonable interpretation of the regulations and taxpayers who conformed their compensation plans to them acted in good faith.

The publication of this new position has significant repercussions for many public companies, said the firms, with an accounting impact that will affect financial reporting. In addition, the ruling presents considerable difficulty for companies that are currently making decisions regarding 2008 awards and proxy reporting regarding award deductibility. The situation is further complicated by the fact that many of the affected arrangements are bilateral contracts that will require negotiation with the affected employees.

Thus, the firms urged the IRS to apply the new ruling prospectively. With regard to that, the revenue ruling states that it will not be applied to disallow a deduction for performance-based compensation paid under plan with payment terms similar to the those set forth in the ruling if either: 1) the performance period for the compensation begins on or before January 1, 2009; or 2) the compensation is paid under an employment contract in effect on February 21, 2008, the day of the ruling, but there can be no future renewals or extensions, including those that occur automatically.

Friday, February 22, 2008

IRS Revenue Ruling Impacts Executive Compensation Plans and Disclosure

In response to a letter from 90 global securities law firms, the Internal Revenue Service issued a revenue ruling essentially backing up an earlier private letter made public by the IRS (LTR 200804004) that cast doubt on the exclusion of some performance-based executive compensation from the $1 million pay cap mandated by IRC §162(m) if a company wants to deduct an executive’s pay from its income tax. The firms who signed the letter included Skadden Arps, Wachtell Lipton, Cleary Gottlieb, Baker Botts, and Clifford Chance.

Under IRC 162(m), compensation in excess of $1 million paid by a public company to its covered employees generally is not deductible. Notice 2007-49 states that the term "covered employee," for purposes of §162(m), will apply to the principal executive officer and the three highest compensated officers (other than the principal executive officer and principal financial officer).
Performance-based compensation is not subject to the deduction limitation and is not taken into account in determining whether other compensation exceeds $1 million. In general, performance-based compensation is compensation payable solely on account of the attainment of performance goals.

In the letter ruling, the IRS said that provisions in a company’s compensation scheme allowing for payment of performance-based compensation even if the performance goals are not met upon an executive's involuntary termination without cause or voluntarily termination with good reason do not meet the exception in section 1.162-27(e)(2)(v) of IRS regulations allowing compensation to be payable upon death, disability or change of ownership or control. Thus, the compensation cannot be excluded from the $1 million calculation.

In Revenue Ruling 2008-13, the IRS backed up the letter ruling by essentially saying that the performance goals must be met before the payment of performance-based awards can be excluded from calculating the $1 million cap. In the revenue ruling, the IRS set forth two separate scenarios that would not qualify as performance-based compensation under Code Section 162(m). In the first scenario, the executive did not meet the performance but received the performance-based compensation anyway after being terminated involuntarily without cause or voluntarily ending his/her employment for good reason. In such a situation, said the IRS, the compensation would not be considered payable solely on account of the attainment of a performance goal under the 162(m) exclusion. In the second scenario, the employee voluntary retired and the performance-based compensation was paid even though the performance goal was not attained. Similarly, this award is not qualified performance-based compensation under Code Section 162(m).

The law firms’ letter to the IRS comes against the backdrop of pressing deadlines for SEC-mandated financial and proxy disclosure. The letter cites the IRS regulation allowing performance-based compensation to be considered qualified for the exclusion if paid upon death, disability, or change of control even if the performance goal remains unsatisfied.

According to the law firms, consistent with prior IRS rulings, many public companies entered into compensation arrangements patterning the treatment of involuntary and good reason terminations after what the regulation authorized for death and disability. In the firms’ view, these prior rulings, now apparently reversed, represent a reasonable interpretation of the regulations and taxpayers who conformed their compensation plans to them acted in good faith.

The publication of this new position has significant repercussions for many public companies, said the firms, with an accounting impact that will affect financial reporting. In addition, the ruling presents considerable difficulty for companies that are currently making decisions regarding 2008 awards and proxy reporting regarding award deductibility. The situation is further complicated by the fact that many of the affected arrangements are bilateral contracts that will require negotiation with the affected employees.

Thus, the firms urge the IRS to apply the new ruling prospectively and also allow grandfathered tax treatment, consistent with the prior rulings, for compensation awards that are made prior to the publication of the new ruling, with special transition relief for binding, written agreements that obligate an employer to provide future grants that conform to these prior rulings; with such transition relief to continue, absent a material modification, for a period that provides an adequate opportunity to negotiate and implement revised agreements.

It should also be noted that, when it adopted the new executive disclosure regime, the SEC emphasized that any tax or accounting treatment, including a company’s section 162(m) policy, that is material to the company’s compensation policy or decisions with respect to a named executive officer is covered by Compensation Discussion and Analysis and should be discussed. Tax consequences to the named executive officers, as well as tax consequences to the company, may fall within this example.

Thursday, February 21, 2008

McCreevy Urges Hedge and Private Equity Funds to Adhere to Codes of Conduct

The continued light regulation approach to hedge and private equity funds is conditioned on these funds complying with the recent codes of conduct adopted by the Hedge Fund Working Group and the Walker Working Group, in the view of EU Commissioner for the Internal Market Charlie McCreevy. While reiterating his preference for a self-regulatory approach, he said that a lot depends on whether industry codes work in practice. Compliance with high levels of professional codes is a precondition for continued regulatory confidence in the alternative investment sector, he noted, since regulators and policymakers require reassurance.

The Hedge Fund Working Group adopted voluntary standards for hedge fund managers on a comply or explain basis. The standards deal with valuation, disclosure and risk management; and have a global dimension. A UK working group headed by Sir David Walker issued final guidance to enhance disclosure by private equity firms and companies they acquire, called portfolio companies in the report. The guidance is also on a comply or explain basis.

Commissioner McCreevy continues to resist increasing pressure from policymakers for regulation of alternative investment vehicles. And, indeed, there are significant policy concerns regarding transparency, governance, and accountability. The European Parliament is conducting its own review of private equity and hedge fund investment in an effort to decide if action is needed at the EU level to monitor the opportunities and risks that this industry introduces.
Their response will be prepared over the coming months and is expected to be finalized by July.

For his part, the commissioner believes that the private equity industry in managing portfolio companies needs to have the freedom to act quickly and flexibly, and to be able to respond to rapidly changing global market conditions by restructuring the businesses in which they invest. Noting that private equity portfolios tend to be highly leveraged and therefore need to adapt faster than most to survive, he vowed to fight efforts at heavy-handed regulation of this sector.
He also assured that private equity is not central to the difficulties surrounding the structured credit and asset backed securities markets. But it is certain to be affected in a number of different ways, he said, such as by the tighter credit markets for raising capital to finance deals.

Wednesday, February 20, 2008

ISDA Promotes MiFID for Harmonized Regulation of Complex Structured Securities

An ISDA led consortium told the European Commission the model provided by the Markets in Financial Instruments Directive (MiFID) is best adapted to the creation of a product-blind harmonized regulatory regime for complex structured securities products, The Commission is exploring the need for a harmonized legal framework regarding product transparency and distribution requirements for complex retail investment products. Other consortium members who signed on to the ISDA letter to the Commission were the European Securitization Forum he London Investment Banking Association, and the Securities Industry and Financial Markets Association.

ISDA emphasized that the basis of consumer protection in the securities market is the suitability obligation imposed under MiFID. The suitability of a particular product for a particular investor is a function of the investor’s knowledge and experience, financial situation and investment objectives. The complexity of a product is not a relevant characteristic in the making of this determination, said ISDA, what matters is whether the investor understands what the risks are and what the returns are likely to be.

MiFID adopts a service-based rather than a product-based approach to regulation, observed ISDA, and is considerably simpler than the approaches adopted in the other Commission Directives. To the extent that it makes sense to compare the relevant regimes, ISDA strongly believes that the MiFID approach is the best and most effective approach in terms of delivering effective consumer protection.

Securities products are offered to the public in the EU through distributors who are subject to the provisions of MiFID. In the view of ISDA, the key aspect of MiFID for this purpose is the suitability obligation, which is imposed on any financial intermediary executing an order on behalf of a retail customer. MiFID also permits an alternative, lower, standard of care, appropriateness, under which a retail customer positively declines to seek advice from the intermediary.

ISDA believes that the vast majority of complex securities products are sold by intermediaries who owe investors a suitability obligation. Securities may be sold to retail investors outside the scope of these protections, but this is only permissible for noncomplex products, continued ISDA, and derivatives and other retail structured securities will almost all fall within the definition of complex products in MiFID terms.

Because the securities markets are generally regulated on a distribution basis, noted ISDA, there is no limit on the complexity of the structures which can be created. But a false link is sometimes made between product complexity and product risk, continued ISDA, which leads to the illusion that complex securities are automatically high-risk securities. This is clearly not the case, in ISDA’s view.

In fact, ISDA pointed out that many structured products are structured specifically to provide investors with protection, that is, investors gives up some part of their potential return in order to increase the predictability of their final return. Products of this kind are optimized for investors with lower risk tolerances, and are likely to be unsuitable for investors who are actively seeking higher levels of risk.

Tuesday, February 19, 2008

Australian Regulator Adopts Principles for Sovereign Wealth Funds

As the debate rages in the EU and US about the best way to achieve transparency for sovereign wealth funds, the Australian Treasurer has adopted principles for sovereign wealth fund investments. The principles embody transparency and sound corporate governance for sovereign wealth funds. If the Treasurer decides, after applying the principles, that a sovereign wealth fund investment would be inconsistent with Australia's national interest, it may be blocked or made subject to conditions to address any identified problems.

Generally, proposed investments by sovereign wealth funds are assessed on the same basis as private sector proposals, with national interest implications determined on a case‑by‑case basis. However, the fact that these investors are owned or controlled by a foreign government raises additional factors that must also be examined.

One principle emphasizes the independence of the sovereign wealth fund investor from the foreign government. In considering issues relating to independence, the regulator will focus on the extent to which the prospective investor operates at arm's length from the relevant government. Also to be considered is whether the prospective investor's governance arrangements could facilitate actual or potential control by a foreign government, including through the investor's funding arrangements. Any partial privatization of the sovereign wealth fund would be considered as it impacts independence.

Another principle mandates the consideration of the extent to which the sovereign wealth fund has clear commercial objectives and has been subject to adequate and transparent regulation in other jurisdictions. Under this rubric, the corporate governance practices of the fund would come into play, as well as its investment policy and how it proposes to exercise voting power in relation to Australian companies. Sovereign wealth funds already operating on a transparent and commercial basis are less likely to raise additional concerns than those that do not.

Yet another principle dictates a weighing of whether investment by the sovereign wealth fund could hinder competition or lead to undue concentration or control in the industry or sectors concerned. More broadly, there must be a consideration of the extent to which investments might affect Australia's ability to protect its strategic and security interests. Finally, there must be a determination of how much Australian participation in ownership, control and management of an enterprise would remain after a sovereign wealth fund investment, including the interests of employees, creditors and other stakeholders.

Sovereign wealth funds have exploded into the regulatory consciousness. The US Treasury and the SEC have called for best practices for these opaque vehicles. US regulators will work through the vehicle of the President's Working Group on Financial Markets to develop bi-lateral and multilateral initiatives to achieve greater transparency for these sovereign investment pools. As part of this effort, the SEC and European Commission are trying to increase the transparency in the funds while avoiding protectionism. Both SEC Chairman Christopher Cox and EU Commissioner for the Internal Market Charlie McCreevy have pledged to work together to make the funds more transparent.

With respect to transparency, Commissioner McCreevy would like to see sovereign wealth funds publish their investment strategies, detail their investment conduits and agents and provide an audited yearly report of their holdings in every company. Interested parties would then know which shares the fund holds and its investment strategy.

Sovereign wealth funds are the investment arms of governments. They also encompass a broad range of funds and a variety of investment strategies and management. For example, several sovereign wealth funds are directly managed through the central bank or the finance ministry, such as in Norway and Qatar, while others are incorporated as private companies with at least some degree of independence. There is no single, universally accepted definition of a SWF, but the US Treasury defines them as government investment vehicles funded by foreign exchange assets managed separately from the official reserves of the monetary authorities.

Monday, February 18, 2008

FSA Chair Seeks Global Standards on Managing Liquidity Risk

In a major address to the Basel Committee on Banking Supervision, FSA Chair Callum McCarthy called for a uniform international policy on liquidity risk to provide clarity to global financial institutions and other market participants. The senior official’s remarks come as the FSA begins a broad review of its current regime for managing liquidity risk. The Basel II Accord has improved the measurement of capital adequacy, he noted, particularly in its treatment of off balance sheet vehicles. But he urged the Basel Committee to speed up its consideration of liquidity risk since, in his view, it was liquidity problems that started the present market turmoil.
Liquidity risk is the risk that a firm, although solvent in balance sheet terms, does not have enough cash to meet its payment obligations in full as they fall due. The corollary is that liquidity risk management means mitigating the risk that a financial institution is not able to do this. Managing liquidity risk is a significant issue not only for banks, but also for securities firms since they are typically active in the same money and debt securities markets as banks.

The FSA chair said all this with full knowledge of how difficult managing liquidity risk can be, involving judgments about the stresses which have to be withstood rather than the more statistical analyses which underpin capital. Grappling with liquidity risk also depends on understanding the attitude of the relevant central bank or banks as the ultimate providers of liquidity towards the eligible collateral they will accept, when policy manifestly differs between central banks and is not necessarily clear to market participants in advance.

While the FSA has begun a review aimed at changing its current liquidity risk management regime, the official emphasized that there must be more effective international action. The informal cross-border links between central banks and regulators must be strengthened.
That said, the FSA will move forward with its own initiative on managing liquidity risk. At a recent appearance before a Treasury Select Committee, the FSA committed to examine: the extent to which its framework for assessing risk within firms should place further importance on liquidity issues; the interrelationship between the UK's and other countries' liquidity risk management regimes; and the strengthening of stress-testing within firms.

Being a principles-based regulator, the FSA approaches liquidity risk from the high level principle that a firm must maintain adequate financial resources (Principle 4). Also coming into play is Principle 3, which states that a firm must implement effective risk management systems. Taken together, these two Principles mean that, in the first instance, it is the financial institutions themselves, not the regulators, that are responsible for the effective management of liquidity risk.
Chairman Cox Details SEC's Sub-Prime Agenda for 2008

Chairman Christopher Cox outlined the SEC's top priorities in 2008 in an appearance at the Practising Law Institute's "SEC Speaks" conference in Washington DC. A large part of the Commission’s agenda will be to examine the role of market participants in the recent financial markets turmoil.

The full impact of the subprime mortgage crisis for the U.S. and global markets is not fully known, but Cox said the SEC has begun investigations into whether fraud or breaches of fiduciary duty were implicated with respect to collateralized debt obligations. The SEC will examine whether bank holding companies and securities firms properly disclosed information about their CDO portfolios and valuations.

Moreover, Cox said the staff will examine whether brokers adhered to the suitability requirements when they sold complex debt-related derivatives and whether insiders traded on nonpublic information to sell these securities.

The SEC chair also indicated that the role of the credit rating agencies will be examined. Currently, the European Commission is also looking into the role that rating agencies played in the valuation of complex securitized financial products.

The problems with the subprime market also raise significant accounting questions, he said, so the Office of the Chief Accountant plays a significant role as a member of the task force. The Division of Corporation Finance will focus on disclosure-related concerns.

Sunday, February 17, 2008

Feinstein Amendment to Farm Bill Would Close Enron Loophole

A measures reauthorizing the CFTC and closing the Enron loophole have been tacked on to a bipartisan Farm Bill and passed by the Senate. The bill is now in conference with a House-passed Farm Bill. The Feinstein amendment to the Farm Bill will put an end to the Enron-inspired exemption from government oversight now provided to electronic energy trading markets set up for large traders. It will ensure the ability of the CFTC to police all US energy exchanges to prevent price manipulation and excessive speculation. This bipartisan provision, championed by Senators Carl Levin (D-MI) and Dianne Feinstein (D-CA), would give the CFTC the ability to scrutinize these transactions in energy commodities and prosecute traders that are manipulating these energy prices.

The amendment also reauthorizes the Commodity Exchange Act until 2013. 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 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.

One prime genesis of the measure was the fact that, when the Amaranth hedge fund was directed to reduce its position in regulated natural gas contracts, it simply moved its position to an unregulated exchange. The bill would essentially say that similar contracts on ICE and NYMEX will be regulated the same way. Last October, the four CFTC Commissioners released a report underscoring the critical need for increased oversight in U.S. energy markets. According to Sen. Feinstein, this bill includes what they asked for.

Congress determined that the current system regarding exempt commercial markets lacks
transparency. Traders are able to avoid revelations of their identity within these exempt commercial markets. In fact, based on a Senate investigation, it was discovered that the Amaranth hedge fund had excessively traded natural gas contracts to such a degree that it controlled 40 percent of all natural gas contracts on the New York Mercantile.

The New York Mercantile, which is subject to CFTC regulation, required Amaranth to reduce its holdings of natural gas contracts. The hedge fund’s response was simply to move its dealings to the exempt commodity market, thereby defeating the entire purpose of CFTC regulation and cloaking its potentially manipulative market power.

This was pursuant to the Enron loophole in the law, included in the Commodity Futures Modernization Act of 2000, which has allowed large volumes of energy derivatives contracts to be traded over-the-counter and on electronic platforms without federal oversight. The Enron loophole was inserted at the last minute into the CFMA and passed by Congress in late December 2000, in the waning hours of the 106th Congress. This loophole exempted from federal oversight the electronic trading of energy commodities by large traders. The loophole has helped foster the explosive growth of trading on unregulated electronic energy exchanges.

The Feinstein Amendment would grant the CFTC new authority to impose important requirements on electronic, OTC transactions that rely on the current exemption contained in Section 2(h)(3) of the CEA, but serve a significant price discovery function. These requirements include the implementation of market monitoring, the establishment of position limitations or accountability levels, the daily publication of trading information, and a number of other standards key to restoring transparency to this important corner of the energy markets.

The legislation would do more than require CFTC oversight; it 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. Specifically, the legislation would establish five core principles to which electronic exchanges must adhere, each of which parallels core principles already applicable to other CFTC-regulated exchanges and clearing facilities.

Implementing these core principles would require an electronic exchange to monitor the trading of contracts which the CFTC has determined affect energy prices, ensure these contracts are not susceptible to manipulation, require traders to supply information about these contracts when necessary, supply large trader reports to the CFTC related to these contracts, and publish daily trading data on the price, trading volume, opening and closing ranges, and open interest for these contracts. In addition, the electronic exchanges would have to establish position limits and accountability levels for individual traders buying or selling these contracts in order to prevent price manipulation and excessive speculation.

Electronic exchanges are intended to implement these position limits and accountability levels in the same way as futures exchanges like NYMEX. Moreover, it is intended that the CFTC will take steps to ensure that the position limits and accountability levels on all exchanges are comparable to prevent traders from playing one exchange off another.

The legislation would also require electronic exchanges to establish procedures to prevent conflicts of interest and anti-trust violations in their operations. These provisions parallel core principles already applicable to other CFTC-regulated exchanges and clearing facilities and are intended to function in a similar manner. These provisions are not restricted to trades involving contracts that affect energy prices, but apply to the entire exchange to ensure it operates in a fair manner.

In addition to requiring electronic exchanges to become self-regulatory organizations, the legislation would require the CFTC to oversee these exchanges in 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.

Saturday, February 16, 2008

Federal Court Rules Sarbanes-Oxley Whistleblower Statute Applies Outside US

In a seminal ruling of broad application, a federal judge held that the Sarbanes-Oxley whistleblower protection statute embraced a US employee of a foreign company who worked in the firm’s French subsidiary and who alleged that US-based executives retaliated against her for questioning the firm’s fraudulent evasion of French social security taxes. While the employee worked in France and was paid by the French subsidiary, said the court, the US was the center of gravity of the alleged retaliation. The court also broadly construed Section 806 to include allegations of mail and wire fraud unrelated to a fraud against shareholders. (O’Mahony v. Accenture, Ltd., SD NY, 07 Civ. 7916, Feb. 5, 2008).

The opinion was a broad construction of Section 806 on two levels. First, it means that the whistleblower statute applies outside the territory of the US. Second, the protected activity is not limited to only reporting fraud against shareholders.

The employee said that she informed the firm that it was committing mail and wire fraud by refusing to pay, and concealing the fact that it was obligated to pay, French social security taxes and that she would not be a party to tax fraud. : Less than two months, the firm reduced her level of responsibility with a corresponding reduction in pay.

The federal court asserted jurisdiction based upon the ``conduct test’’ used in the Second Circuit. The firm perpetrated the alleged fraud by deciding in the US not to pay French taxes and then acted upon that decision in the US by not making the payments in question. Further, the retaliation against the whistleblower was said to have been done by US-based executives. And, the decision to essentially reduce her compensation occurred in close proximity to her allegations of fraud against the firm.

The assertion of jurisdiction here does not raise the specter of a clash between US and French law, assured the court, since the whistleblower is not seeking enforcement of US law in France by requiring payment of French taxes. Rather, she is seeking the application of US law for money damages suffered due to the alleged retaliation that occurred in the US.

Section 806 protects whistleblower providing information about a violation of federal mail and wire fraud statutes, bank and securities fraud statutes, any SEC rule, or any provision of federal law relating to fraud against shareholders. The court rejected the argument that the whistleblower statute protects only an employee’s reporting of fraud against shareholders. There is no indication that Congress intended to link whistleblower protection for information on mail and wire fraud to a fraud against shareholders. Rather, the plain meaning of Section 806 is that an employee who alleges any of the frauds listed in the statute is protected regardless of whether the misconduct relates to shareholder fraud.

Friday, February 15, 2008

Southern District of New York Rejects Selective Privilege Waiver

"I conclude that selective waiver is not in the long-term best interests of the government, the adversarial system, or litigants," wrote U.S. District Judge Shira Scheindlin of the Southern District of New York. Judge Scheindlin ordered Credit Suisse Securities (USA) LLC to turn over to private plaintiffs documents that were prepared in an internal investigation and previously revealed to the SEC and U.S. Attorneys.

The company's general counsel began an internal investigation into alleged misconduct concerning the allocation of shares in IPOs, and the company employed outside counsel to interview employees and prepare written summaries of their investigation. Credit Suisse disclosed the documents to the U.S. Attorney and the SEC pursuant to confidentiality agreements. Documents were also discussed with officers of NASDR and disclosed to some former employees in an arbitration proceeding.

The court initially found that the documents did qualify as "fact" work product, which is generally afforded a lower level of protection than "legal" work product. However, the court found that Credit Suisse had waived any privilege.

Judge Scheindlin found the company's claim that it shared "common interests" with the U.S. Attorneys and the SEC to be "baseless," as the government entities were investigating potential wrongdoing and "Credit Suisse disclosed the Memoranda to escape or limit liability." In addition, the mere fact that a confidentiality agreement existed did not establish the disclosures as a selective waiver, and the company showed no special circumstances to negate a waiver finding.

Judge Scheindlin concluded that "[a]ny confidentiality that may have existed between Credit Suisse and its attorneys has been abandoned." According to the court, "[p]rotection of the Memorandum would serve Credit Suisse's strategic purposes, not any societal interest in fostering communications between attorneys and their clients."

In re Initial Public Offering Securities Litigation (Dkt No. 21 MC 92 (SAS))


Thursday, February 14, 2008

IRS Letter Ruling Impacts Executive Compensation Disclosure

A private letter ruling recently made public by the IRS (LTR 200804004) cast doubt on the exclusion of some performance-based compensation from the $1 million pay cap mandated by IRC §162(m) if a company wants a deduction.

Under present law, compensation in excess of $1 million paid by a publicly-held corporation to the corporation's covered employees generally is not deductible. Notice 2007-49 states the term "covered employee," for purposes of §162(m), will apply to the principal executive officer and the three highest compensated officers (other than the principal executive officer and principal financial officer).

Performance-based compensation is not subject to the deduction limitation and is not taken into account in determining whether other compensation exceeds $1 million. In general, performance-based compensation is compensation payable solely on account of the attainment of one or more performance goals and with respect to which certain requirements are satisfied.
The IRS responded to a requested ruling that compensation paid under the a compensation plan upon attainment of a performance goal will be considered performance-based compensation under 162(m)(4)(C) even though the compensation could have been paid upon an executive's termination without cause or by the executive for good reason, without attaining the performance goal.

The IRS said that the provision allowing for payment of performance share or performance unit awards under the plan upon an executive's termination without cause or by executive with good reason does not meet the exception in section 1.162-27(e)(2)(v) of the regulations that allows compensation to be payable upon death, disability or change of ownership or control. Thus, compensation paid to the executive with respect to performance share or performance unit awards is not payable solely upon attainment of a performance goal, for purposes of section 162(m)(4)(C) of the Code. It thus followed that compensation paid to an executive in the scenario presented would not be considered performance-based compensation under section 162(m)(4)(C) of the Code.

It should be noted that, when it adopted the new executive disclosure regime, the SEC emphasized that any tax or accounting treatment, including a company’s section 162(m) policy, that is material to the company’s compensation policy or decisions with respect to a named executive officer is covered by Compensation Discussion and Analysis and should be discussed. Tax consequences to the named executive officers, as well as tax consequences to the company, may fall within this example.

Tuesday, February 12, 2008

IOSCO: Tell Investors What Accounting Standards Used in Financials

IOSCO urges companies to disclose to investors the accounting standards that were used to prepare their annual report and other financial statements. Michel Prada, Chairman of the IOSCO Technical Committee, expressed concern that, with the convergence of global accounting standards, investors may assume that all company accounts are generally comparable when that may not be the case.

Put another way, regulators and issuers can no longer assume that investors will automatically be familiar with the jurisdiction in which an issuer company is based and the accounting standards that have been used. The tendency of investors and other users of financial statements to assume that all accounts are generally comparable exists particularly when IFRS as adopted by the IASB have been modified or adapted to the particular circumstances of a national market. This raises the specter of investors making investment decisions without a full understanding of financial statements because they are not fully aware of the basis on which they are prepared, and of the accounting standards that underpin the company's policies.

Thus, IOSCO recommends that companies preparing their annual and interim financial statements on the basis of IFRS should inform investors if they are using IFRS as adopted by the IASB or IFRS as modified by national standards and, if so, how the modified IFRS differ from the IASB variety. Those companies should also include, at a minimum, a clear statement of the reporting framework on which the accounting policies are based and the accounting policies on all material accounting areas. They should also disclose an explanation of where the accounting standards that underpin the policies can be found. IOSCO believes that the risk of misunderstanding can be mitigated by this type of disclosure.

Monday, February 11, 2008

House Bill Would Mandate Study of Tax Treatment of Hedge Funds

A
bill to create a commission of ten members to study the tax treatment of hedge funds and private equity has been introduced in the House by Rep. John Larson. Membership of the commission would be comprised of experts chosen by House and Senate leaders within thirty days of the bill’s enactment. Once members have been appointed, the commission would have ninety days to complete its study and report back to Congress and the President. The commission will sunset after filing its report. The Commission on the Tax Treatment of Hedge Funds and Private Equity Act (H.R. 3417) has been referred to the Ways and Means Committee.

More specifically, the bill orders the commission to study and report back on the fairness and equity of various tax treatments of hedge funds and the impact of any proposed changes to such tax treatment on job creation, investors, including institutional investors like pension funds, and US competitiveness. The study must also examine the regulatory structure of these entities.

The bill comes against the backdrop of efforts in Congress to change the tax treatment accorded to hedge fund managers and other asset managers, as well as the tax treatment of offshore funds.

A House bill introduced by Rep. Sander Levin would allow
tax-exempt entities such as pension funds to invest directly in US-based hedge funds rather than routing their investments offshore. According to Rep. Levin, HR 3501 would fix a problem that unfairly forces pension funds, universities and foundations to make certain investments.Under current law, tax exempt entities that invest in hedge funds are subject to unrelated business income tax UBIT) due to the debt incurred by the fund.

The debt-financed income rules were created decades ago to address a separate issue, said Rep. Levin, but have forced tax exempt investors to channel their investments in hedge funds through offshore blocker corporations. These rules were never meant to apply to this kind of investment, he noted, and the bill would allow these institutions to bring their investments home.The bill would create an exception to the debt-finance income rules that would allow all tax exempt entities to invest directly in onshore hedge funds without being subject to UBIT. The bill is modeled on the exception to these rules that currently allows pension funds and universities to invest in debt-financed real estate. However, this exception would be available to all tax exempt entities, including foundations.

Congress is also looking into the taxation of hedge fund and other asset managers. Currently, hedge and private equity funds are typically structured as partnerships for federal tax purposes. Managers of these funds often receive an asset-based management fee paid annually of 2 percent of the fund’s committed capital and an interest of 20 percent in the profits of the fund. The 20 percent profits interest is referred to as the carried interest. Generally, the management fee of around 2 percent of the capital is taxed as ordinary income, while the domestic component of the 20 percent of the profits is taxed as capital gains income.

SEC, FINRA and NASAA Create Senior Investor Initiative

SEC Chairman Christopher Cox, FINRA Chief Executive Officer Mary Schapiro and NASAA Present Karen Tyler signed onto an initiative to protect senior investors from fraud. The initiative is not an exam, sweep or survey but rather a voluntary opportunity for financial services firms to dialogue with the SEC, FINRA and NASAA about the effectiveness of the firms' current practices to serve seniors in the following areas: marketing and advertising; account opening; product and account review; ongoing review of the appropriateness of products; meeting the changing needs of customers as they age; surveillance and compliance reviews; and training for firm employees.

The input received by the SEC, NASAA and FINRA will not lead to new regulatory requirements but to helping firms better serve their senior investors. This effort is but one part of an overall national initiative to protect seniors from investment fraud and sales of unsuitable securities that was announced by SEC Chairman Cox, FINRA and NASAA in May, 2006. The initiative's components include targeted examinations, enforcement of securities laws in cases of fraud against seniors and investor education and outreach.

Wednesday, February 06, 2008

Cross-Border Insider Trading Action Shows SEC Commitment to Protect Global Markets

Four Hong Kong residents have settled an SEC enforcement action charging them with illegal tipping and insider trading in the securities of a target company in the weeks before the public disclosure of an unsolicited $60 per share acquisition offer for the target. The alleged tip originated with a board member of the target company, who was also a member of Hong Kong's Legislative Counsel and Executive Committee. Without admitting or denying the allegations, the actors consented to the entry of injunction and disgorgement orders. The board member was ordered to pay a $8.1 million civil penalty. (SEC v. Wong, et al., SD NY, Litigation Release No. 20447).

The SEC said that the board member learned of the then-secret offer for the company and illegally tipped a close friend who, in turned, and with the help of relatives, purchased approximately $15 million worth of target company securities in their account at a global brokerage firm. They stood to make approximately $8 million in illicit profits had the SEC not won an emergency court order within days of the offer, freezing the account and stopping the money from moving half a world away.

SEC Chairman Christopher Cox emphasized that the action represented real-time cross border enforcement to protect the integrity of the global markets, as well as illustrating the valuable international partnerships the SEC is developing with other regulators, in this case the Hong Kong Securities and Futures Commission. More specifically, Linda Chatman Thomsen, Director of the Division of Enforcement, noted that the federal court enforcement action sends a forceful reminder to corporate insiders that they need to exercise careful discretion when discussing important business matters outside the boardroom and executive suite.

Tuesday, February 05, 2008

Lagarde Report Emphasizes Enhanced Internal Controls

A report by the French Finance Minister on the operational loss of 4.9 million euros at a global financial institution identified a number of internal control issues that could have been decisive in light of information provided by the company. The report released by Finance Minister Christine Lagarde also emphasized the importance of clarifying the relationship between regulators and governments in this type of situation that could have consequences for the stability of the financial system.

In an effort to enhance internal controls, the report suggested making better identification of internal fraud an integral part of internal controls. The report also urged the strengthening of the constraints on credit institutions in the implementation of operational risk. Importantly, the Lagarde report recommended the full engagement of management in controlling risks through the creation of committees dedicated to the supervision of risk control and internal controls. Finally, the report called for the development of international standards of risk management and internal controls that can be applied to all the players.

The financial institution in question issued a statement indicating that the internal controls that were successfully circumvented by the fraud are being remediated to enable the detection and prevention of fraud. The financial institution also noted that the Lagarde report does not call into question the systems used to manage market risk.

Monday, February 04, 2008

Atkins Supports Legislation to Curb Agency Abuse of Attorney-Client Privilege

In light of pending legislation to stop the SEC and other federal agencies from conditioning a company’s cooperative efforts on waiving the attorney-client and work privileges, Commissioner Paul Atkins noted that the SEC is re-examining its policind procedures with respect to cooperation credit and penalties. In remarks before the Federalist Society in Dallas, he emphasized that combating efforts to characterize waiving companies as cooperative and non-waiving companies as non- cooperative is particularly important after the SEC's January 2006 Statement Concerning Financial Penalties indicating that the extent of cooperation in an investigation is also an element in determining how high civil monetary penalties against companies could be set.

As the SEC and other federal agencies press to have the attorney-client privilege waived, said the commissioner, the entire privilege is weakened. As knowledge of its weakening spreads, he reasoned, corporate employees will be less candid and forthcoming, corporate internal investigations will be less trustworthy, and shareholders and government investigators will be frustrated in their efforts to prevent misdeeds.

The House has already passed H.R. 3013, the Attorney-Client Privilege Protection Act, he noted, and there is a companion bill in the Senate, S. 186, still in committee. These bills prohibit federal agencies from pressuring companies to waive their privileges or take punitive actions against their employees as conditions for receiving cooperation credit during investigations, while at the same time specifically preserving the ability of prosecutors and other federal officials to obtain the important, non-privileged factual material they need to punish wrongdoers.

The legislation is needed because there is a growing sense that the Department of Justice’s McNulty Memo cure to the earlier Thompson and Holder memoranda is not working. Thompson-Holder stated explicitly that a corporation's willingness to waive the attorney-client and work product privileges should be considered in determining whether it has cooperated adequately with the SEC and other governmental investigations.

Issued in late, 2006, the McNulty Memo provides standards to guide federal prosecutors when they request disclosure of privileged information, observed Commissioner Atkins, but it does not remove from consideration a company's willingness to punish employees who assert their constitutional rights or to enter into valid joint defense or information-sharing agreements with the employees. In addition, while McNulty does bars prosecutors from urging companies not to pay their employees' legal fees in cases where payment is statutorily or contractually required, said the SEC official, the bar does not apply when payment is discretionary or when prosecutors believe that the totality of the circumstances show that it was intended to impede a criminal investigation.

In the commissioner’s view, the most important weakness of the current situation is that DOJ still gives entities credit for turning over work product as well as other material that may be privileged. Privileged material is divided into two categories. Category I material includes witness statements, interview memoranda, and reports; and companies may be considered uncooperative for not producing it. Category II material includes other highly sensitive information, including opinion work product, the contemporaneous advice of counsel, lawyer mental impressions, and other legal advice.

According to Atkins, categorizing these materials does not solve the problem. A company refusing to waive its privilege and turn over Category I material risks being labeled as uncooperative, which in turn increases the risk of being indicted. The opportunity to receive credit for Category II material also increases the pressure to turn privileged information over. Who at a corporation, asked the commissioner, wants to be responsible for not striving to receive every bit of credit possible, regardless of the collateral consequences to the corporation in civil litigation and to other parties, such as officers, directors, and employees in both criminal and civil proceedings.

In support of the need for more robust protection of privilege, the commissioner also cited a report by former Delaware Chief Justice Norman Veasey, which found that the McNulty Memorandum has not significantly reduced the incidence of government coerced waiver, and that federal prosecutors continue to routinely demand waiver of the privilege during investigations despite the new policy.

Finally. Commissioner Atkins observed that the SEC’s 2001 Seaboard Report is a guide encouraging companies to cooperate in an investigation. But it is no comfort, said the commissioner, that the SEC's primary guiding document on attorney-client privilege waiver states that obtaining a waiver is not an end in itself, but only a means to extract useful information.

That said, the commissioner emphasized that waiver is not itself listed as one of the Seaboard criteria for determining whether, and how much, to credit self-policing, self-reporting, remediation, and cooperation. Thus, in Atkins’ view, attempts to interpret Seaboard as allowing the SEC to reward companies for waiving privilege must be resisted. Rewarding companies for co-operating by waiving privilege may sound nice, he continued, but its effect is the same as punishing them for not waiving privilege since both effectively strip the attorney-client privilege.