Monday, March 31, 2008

Treasury Proposes Massive Overhaul of US Financial Services Regulation Affecting Fed, SEC, CFTC

The US Treasury has proposed the most complete overhaul of federal financial regulation since the current regulatory structure was erected in the 1930s. The proposal would create new federal regulators for market stability, business conduct, corporate finance and prudential finance. In the short term, Treasury recommends legislation merging the SEC and CFTC under a principles-based regime.

Under the proposed reform, the new Market Stability Regulator would be the Federal Reserve Board, while the Prudential Financial Regulator would assume the role of the current federal prudential regulators, the OCC and OTS. The SEC’s current regulatory and enforcement duties over financial institutions would be assumed by the Business Conduct Regulator, while the Commission’s responsibilities over corporate disclosures, corporate governance, and accounting oversight would be assumed by the Corporate Finance Regulator.

The Treasury model represents an objectives-based regulatory approach currently used by Australia and the Netherlands; and a rejection of the unitary regulator model used by the UK Financial Services Authority. Treasury also rejected the functional regulation model enshrined in the Gramm-Leach-Bliley Act of 1999

The current system of functional regulation with separate regulators maintained across segregated lines of banking and securities and futures is not compatible with the evolving markets. The most damaging part of functional regulation is that no single regulator has either enough information or sufficient authority to monitor systemic risk or broad dislocations across the financial system.

As the Market Stability Regulator, the Fed would be given broad powers to focus on the overall financial system. The Fed could gather and disclose information, collaborate with other regulators on rulemaking, and take corrective action to preserve market stability. The Fed would have access to detailed information about SEC-regulated financial institutions and their holding companies in order to assess their impact on market stability. The Fed would also be authorized to mandate additional disclosure for federally chartered financial institutions. Similarly, the Fed would be empowered to require financial institutions to limit their risk exposures to certain asset classes or certain types of counterparties.

Payment and settlement systems are the mechanisms used to transfer funds and financial instruments between financial institutions and between financial institutions and their customers. Currently, there is no uniform payment and settlement system, resulting in an idiosyncratic system. The plan recommends a single federal payment and settlements regime under Fed supervision.

The Prudential Financial Regulator would focus on financial institutions with express government guarantees, such as federal deposit insurance. It is also envisioned that the GSEs would eventually come under prudential regulation since the federal government has charged them with a specific mission.

The Business Conduct Regulator (CBRA) would be responsible for all financial products in order to bring consistency where overlapping requirements currently exist. The CBRA would also charter and license a wide range of financial services providers, such as broker-dealers, hedge funds, private equity funds, venture capital funds, and mutual funds. The establishment of a federal charter would result in the creation of national standards for financial capacity, expertise, and other requirements that must be satisfied to enter the business of providing financial services. These firms would also have to remain in compliance with the standards and provide regular updates on financial conditions to CBRA and the Federal Reserve Board.

CBRA would have broad authority over securities and futures firms and their markets, including operational ability, professional conduct, testing and training, fraud and manipulation, and duties to customers, such as best execution and suitability. Given the scope of CBRA’s duties, the Treasury plan envisions an important role for SROs, particularly in the areas of rulemaking, compliance, and enforcement.

Since the original reason for bifurcating the regulation of securities and futures no longer exists, Treasury recommends an SEC-CFTC merger to provide unified oversight and regulation of the futures and securities industries. Recognizing the need to preserve the principles-based regulation embraced by the CFTC, Treasury recommends that the SEC prepare for the merger by taking a number of specific steps.

The SEC should use its exemptive authority to adopt core principles to apply to securities clearing agencies and exchanges. These core principles should be modeled after the core principles adopted for futures exchanges and clearing organizations under the Commodity Futures Modernization Act.

The SEC should also issue rules updating and streamlining the SRO rulemaking process to recognize the market and product innovations of the past two decades. The rules should include a firm time limit for the SEC to publish SRO rule filings and expand the type of rules deemed effective upon filing, including trading rules and administrative rules.

Importantly, the SEC should also streamline the approval process for any securities products common to the marketplace, similar to what the Commission has done for certain derivatives securities products. An updated, streamlined, and expedited approval process will allow U.S. securities firms to remain competitive with the over-the-counter markets and international institutions.

Also on a global competitive note, the SEC should use its exemptive power under the Investment Company Act to allow the trading of products already being actively traded in non-US jurisdictions. Similarly, Congress should expand the Investment Company Act to allow the registration of a new global investment company.

Legislation merging the SEC and CFTC would need to include many items. For example, Treasury believes the legislation should, consistent with the CFMA, statutorily permit all clearing agency and market SROs to self-certify all rulemakings, except that involving corporate listing and market conduct standards, which would then become effective upon filing. The SEC would retain its right to abrogate the rulemakings at any time. By limiting self-certified SRO rule changes to non-retail investor related rules, investor protection will be preserved.

In addition, merger legislation would have to harmonize differences between futures regulation and federal securities regulation, including margin and segregation rules, insider trading, broker-dealer insolvency, customer suitability, short sales, SRO mergers, implied private rights of action, the SRO rulemaking approval process, and the agency funding mechanisms.

Due to the complexities and nuances of the differences in futures and securities regulation, legislation should establish a joint CFTC-SEC staff task force with equal agency representation with the mandate to harmonize these differences. In addition, the task force should be charged with recommending the structure of the merged agency, including its offices and divisions.

Finally, the legislation would have to deal with the continuing convergence of the services provided by broker-dealers and investment advisers within the securities industry. These entities operate under a statutory regime reflecting the brokerage and investment advisory industries as they existed decades ago.

Thus, Treasury recommends statutory changes to harmonize the regulation and oversight of broker-dealers and investment advisers offering similar services to retail investors. In that vein, the establishment of an SRO for the investment advisory industry would enhance investor protection and be more cost-effective than direct SEC regulation. Thus, to effectuate this statutory harmonization, Treasury recommends that investment advisers be subject to a self-regulatory regime similar to that of broker-dealers

Saturday, March 29, 2008

SEC Allows Range of Values in Fair Value Accounting Measurements

In a significant move given current market conditions, the SEC will allow issuers to provide in their MD&A a range of values for hard-to-value illiquid securities. In a letter to chief financial officers, the SEC staff also urged issuers to describe in the MD&A the technique or model they use to value the illiquid securities, as well as any changes to the model made during the reporting period. To the extent a range of values is provided, issuers should discuss why they believe the range is appropriate, identify the key drivers of variability, and discuss how they developed the inputs used in determining the range.

FASB Statement of Financial Accounting Standards No. 157 requires that assets be measured at fair value and provides for three levels of fair value measurement. Level 1 measurements are the quoted price of the instrument in active markets. If quoted prices are not available, Level 2 allows for measurement of similar securities in less active or active markets. For illiquid instruments, Level 3 allows the use of models for measurement.

Regardless of how issuers classify their assets and liabilities within the SFAS 157 hierarchy, the SEC staff urges them to provide in their MD&A a general description of the valuation models they used and any material changes they may have made to them, as well as the extent to which they used relevant market indices in applying the models. Issuers should discuss how they validate the models, including how often they calibrate and test them. Importantly, the MD&A should also discuss how sensitive the fair value estimates are to the significant inputs the model uses, including how the fair value estimate could potentially change as the significant inputs vary.
In the letter, the SEC staff reminded that SFAS 157 allows an issuer to consider actual market prices, or observable inputs even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs are not available, said the staff, is it appropriate to use unobservable inputs reflecting assumptions of what market participants would use in pricing the asset or liability. Current market conditions may require the use of valuation models for some assets. Thus, as of January 1, 2008, those assets should be classified as Level 3 measurements under SFAS 157.

If an issuer concludes that its use of unobservable inputs is material, its MD&A should disclose, in a manner most useful to its particular circumstances, how the issuer determined them and how the resulting fair value of assets could impact the results of operations, liquidity, and capital resources. In addition, the amount of Level 3 assets and liabilities measured as a percentage of the total assets and liabilities measured at fair value could be relevant.

If a material amount of assets or liabilities were transferred into Level 3 during the period, continued the staff, there should be a discussion of the significant inputs no longer considered observable; and any material gain or loss recognized on those assets or liabilities during the period. With regard to Level 3 assets or liabilities, there should be a discussion of whether realized and unrealized gains (losses) affected the results of operations, liquidity or capital resources during the period, and if so, how.

There should be disclosure of the reason for any material decline or increase in the fair values and whether the issuer believes the fair values diverge materially from the amounts the issuer currently anticipate realizing on settlement or maturity. Moreover, the nature and type of assets underlying any asset-backed securities may be relevant to the MD&A, such as the types of loans, as well as the years of issuance and information about the credit ratings of the securities, including changes or potential changes to those ratings.

Friday, March 28, 2008

Federal Examiner Finds Internal Control and Audit Committee Failures at Mortgage Company

A federal bankruptcy court examiner has found that a failure to establish and monitor internal controls over financial reporting substantially contributed to a company’s accounting errors and allowed those errors to go undetected. Many of the control failures related to the lack of written and effective policies for calculating accounting estimates. The examiner also found that the company’s audit committee had been deficient in a number of areas. The examiner was appointed by the US Trustee at the court’s direction to investigate accounting and financial statement errors or misstatements. (In re New Century TRS Holdings, Inc., US Bankruptcy Court for the District of Delaware, No. 07-10416).

The company, which filed for bankruptcy protection, was at one time the second largest originator of subprime residential mortgage loans. Company management had conducted its assessment of the internal controls as required by section 404 of the Sarbanes-Oxley Act and a Big Four audit firm had assessed the internal controls using PCAOB Auditing Standard No. 2.

The examiner found that the company failed to develop effective policies for performing accounting estimates requiring the exercise of considerable judgment. It did not remediate internal control deficiencies that existed at year-end despite representing to the outside auditor that it would. Overall, the company did not devote sufficient internal resources to the Sarbanes-Oxley assessment process.

In its 2004 management letter, the audit firm reported that management neglected to create adequate documentation evidencing the appropriate application of GAAP in certain areas. The same findings were not made in 2005 even though the auditor found in the 2005 Sarbanes-Oxley audit that the company continued to lack written policies in several key accounting areas, including loan losses and repurchase reserve. The examiner said that there was no sufficient explanation for why the auditor reached a different conclusion in 2005.

Despite the company’s failure to adopt adequate repurchase reserve policies for the second year in a row, the outside auditor concluded that this deficiency was inconsequential and did not report it to the audit committee. Moreover, in the examiner’s opinion, the audit engagement team failed to appreciate the impact of material, improper changes in the methodology for calculating the repurchase reserve.

According to the examiner, the company’s failure to develop policies for calculating the repurchase reserve was at least a significant deficiency, if not a material weakness, in its internal control environment that contributed to a material misstatement in its financial reports. The examiner also concluded that management did not sufficiently test and evaluate the severity of, and the auditor did not sufficiently review, the allowance of loan losses controls during the 2005 Sarbanes-Oxley audit.

Separately, the examiner found that the audit committee was deficient in a number of areas. The audit committee did not ensure that management conducted an adequate analysis of entity-wide risk, nor did it ensure that key operational risks were addressed. Further, the audit committee did not adequately supervise or make effective use of internal audit.

Sound corporate governance dictates that the audit committee guide an entity-wide risk management process, said the examiner. Moreover, under the audit committee’s supervision, internal audit should provide assurance to the audit committee on the effectiveness of a company’s entity-wide risk management program.

While neither section 404 nor the regulations adopted under it specifically assign any role to the audit committee in connection with management’s internal control assessment or the auditor’s attestation, noted the examiner, the auditor should take a significant interest in reviewing the annual 404 internal control assessment, the auditor’s attestation, and the process by which both were arrived at. In the examiner’s opinion, this review should include presentations by management and the external auditor at audit committee meetings regarding the 404 internal control report and attestation.

Thursday, March 27, 2008

Treasury Official Sees Reform of Credit Rating Process and Enhanced Disclosure

Echoing a recent UK Treasury Committee finding that securitization is here to stay, a US Treasury senior official called for broad reform of the securitization process, including reliable ratings of complex securities, better disclosure, and improved risk management Assistant Secretary Anthony Ryan told the Exchequer Club that securitization is a financial innovation that has expanded the availability of credit and reduced the cost of capital. After diagnosing the weaknesses of the securitization process, the Treasury, the SEC and the Fed have embarked on reform.

As part of that reform, the President’s Working Group on Financial Markets recently proposed broad and substantial changes to US financial regulation. The comprehensive reforms are nothing less than a complete overhaul of the securitization process and the concomitant mortgage origination process that relied on the sale of asset-backed securities.

The working group recommendations, when implemented, will strengthen markets through risk awareness, enhance disclosure and risk management, reform credit rating agencies processes, and promote transparency. The PWG put forth a series of recommendations regarding ratings practices that focused on improving the quality and integrity of underlying data and models, independence of the ratings process, and limits in utilizing ratings.

The weaknesses of the rating agencies were compounded by investor over reliance on the rating agencies' assessments and by the practices of other market participants, including originators and securitizers. He emphasized, as others have, that investors have a responsibility to conduct independent analysis and not simply rely solely on ratings.
It is axiomatic, said the official, that rating assessments are dependent on the quality and integrity of the underlying data received from both the originator of credit and the packager of securitized products. As a result, the PWG has called for rating agencies to disclose what qualitative reviews they perform on originators. Rating agencies should also require securitizers to represent the level and scope of due diligence performed on the underlying assets

In addition, the use of the same rating categories for both securitized products and corporate bonds must end, noted the official; since this facilitated investor complacency. Investors acted as if they did not appreciate that risk characteristics differed. But they most certainly do differ, declared the official, and there needs to be a clearer distinction made by the rating agencies, investors, and regulators. The Treasury official suggested the use of a separate nomenclature or identifying suffix highlighting the unique risk characteristics of structured credit products.

Noting that many securitized products are opaque, the official called for additional disclosure by originators, underwriters, and credit rating agencies so that investors have information available to better assess risk. Securitizers need to enhance disclosure regarding the originators of assets, including, for example, assessing the originator's experience, quality of management, underwriting standards, process by which loans are sourced, and track record of providing accurate information on originated assets. They should also publicly disclose whether they engage in ratings shopping, and if they do, disclose the reason for not publishing preliminary ratings.

The PWG also called on financial institutions to make more detailed and comprehensive disclosure of off-balance sheet commitments, including commitments to support conduits and other off-balance sheet vehicles. To facilitate better disclosure, the PWG will ask a private sector committee made up of investors, rating agencies, and issuers to develop best practices.

Much of this comes back to risk management, said the Treasury official. Market participants and regulators must both be part of curing weaknesses in risk management. He related that U.S. banking regulators and the SEC are developing common guidance to address risk management weaknesses, including improving stress testing, the governance of the risk management and control framework, and internal risk reporting and measurement.
New Broker and Investment Adviser Regulation White
Paper Now Available

A new white paper addressing the future of broker and investment adviser regulation and the recent Rand report to the SEC may be found here.

Wednesday, March 26, 2008

Fed Gov. Kroszner Gleans Lessons
from Risk Management Report

In the view of Federal Reserve Board Governor Randall S. Kroszner, the recent report on risk management by global regulators, including the Fed and the SEC, contains many valuable lessons for all levels of risk management. Although the analysis of the Senior Supervisors Group (SSG) report covered the largest banking and securities firms, he noted, the lessons learned actually have relevance for financial institutions of all sizes and scope, even those that have thus far not suffered from recent financial turbulence. Other regulators involved in the report were the UK Financial Services Authority and the German Federal Financial Supervisory Authority.

The report highlights the critical role that sound corporate governance plays in effective risk management. The report states that solid senior management oversight and engagement is a key factor that differentiated performance during recent events. Senior management must take on a very active and involved role in risk management. Senior managers must also ensure that they have proper understanding of the risks assumed by their firm.

Disturbingly, there is evidence that information was kept in silos within some firms and not adequately distributed, he noted, which prevented senior managers from developing enterprise-wide risk management. In turn, this meant that managers were not fully aware of the extent to which the risks of the different activities undertaken by the firm could become correlated in times of stress and result in high concentrations of risk exposures. Specifically, in particular cases, senior management was not fully aware of the firm's latent concentrations in U.S. sub prime mortgages, because they did not realize that in addition to the sub prime mortgages on their books, they had exposure to the claims on counterparties exposed to sub prime and complex securities.

According to the Fed official, effective risk management remains sturdy and durable only if supported by strong and independent risk functions that produce unbiased information. Since timely and accurate information is the lifeblood of sound risk management, he observed, a good risk-management structure must encompass risks across the entire firm, gathering and processing information on an enterprise-wide basis in real time.

The report noted that some firms could not easily integrate market and counterparty risk positions across risks types, making it difficult for their executives to identify concentrations across the entire firm. Understanding a firm's true risk exposures requires examining not just risks on the balance sheet, but also off-balance-sheet risks that are sometimes more difficult to identify and often not so easy to quantify. Latent risks from complex products and risky activities should be properly recognized, he pointed out, because they can manifest themselves when market turbulence sets in.

As the SSG report indicates, some firms had a poor understanding of the risks inherent in complex products or failed to recognize that certain activities contained latent risks that could be manifest in unexpected concentrations of risk exposures when market turbulence arose. For example, there were lapses in credit risk identification and measurement when certain institutions underestimated the actual credit risk of sub prime mortgages and the secondary effects brought on by disruptions in sub prime markets for their broader set of activities.

He also emphasized that the proper valuation of securitized products is part of sound risk management, particularly with regard to new products. The core of these practices is the ability to make appropriate judgments about the quality of information being used for valuations. The process usually starts with an initial experimentation phase in which market participants learn a great deal about the product's expected performance and risk characteristics, preferably under different market conditions.

Due diligence in the valuation process is very important, he noted, especially with regard to new and complex products. Unfortunately, in some recent cases new products were developed very quickly and not properly road-tested. He urged market participants to ensure that valuation decisions are not based solely on excessive reliance of external ratings or evaluations, but also reflects their own assessment.

Gov. Kroszner’s advice echoes the finding of the SSG report that firms that fared better in the crisis had in place rigorous internal processes requiring critical judgment and discipline in the valuation of holdings of complex or potentially illiquid securities. Skeptical of rating agencies’ assessments of complex structured credit securities, these firms developed in-house expertise to conduct independent assessments of the credit quality of assets underlying the complex securities to help value their exposures appropriately.

Stress testing and scenario analysis are of paramount importance, the Fed official emphasized, since they can reveal potential concentrations of risk that may not be apparent from using information gleaned from normal times. The SSG report stressed this point, but the federal banking agencies have also highlighted its importance for smaller- and medium-sized institutions.

The governor urged financial institutions to re-check the robustness of their stress testing in light of recent events. For example, banking organizations might benefit from expanding tests to include a wider set of variables to stress and to consider shocks they might have considered much less probable one or two years ago. He reminded that past experience is not always predictive of future events, meaning that firms should be creative in designing potential shocks.

Tuesday, March 25, 2008

ICI Mutual Funds Seminar Raises issue of
International Regulation

The Investment Company Institute held its annual Mutual Funds and Investment Management Conference this month in Phoenix. Fortunately, the CCH Mutual Funds Guide editor, Amy Leisinger, attended this very substantive seminar and filed a report.

In part, she reports that, in his keynote address, SEC Commissioner Paul Atkins advocated balance in the industry and the development of consistent regulation at the state, federal, and international level. He emphasized the need to focus on long-term national and international regulatory effects and global competition, especially while regulation attempts to catch up with market innovation.

International regulatory convergence was further discussed by a panel of industry leaders who considered the key differences between rules pertaining to US mutual funds and European Union mutual funds. According to the panelists, these investment vehicles are quite similar and, as a result, should be treated equally under a global regulatory approach, and regulators should do away with current discrepancies.

Jean-Marc Goy, counsel to the director general of the Luxembourg Supervisory Authority of the Financial Sector, discussed the key differences between US and EU fund regulation. He explained that the focus of UCITS regulation is more preventive than critical; no authorization to operate would be given to an entity unless the regulatory authority is satisfied with the ``whole picture,’’ meaning the entire structure of a financial organization. This approach results in fewer regulatory actions and less private litigation than the US reactive system of governance.

Andrew Donohue, Director of the Division of Investment Management, responded that enforcement is a tool that the SEC uses to get necessary information and to ensure industry compliance. If the SEC was put in the position to approve firm structure and choice of directors, he reasoned, conflicts would arise. Balance between the two approaches, however, would be something to consider, he noted. ``We should never say we have the best model,’’ he stated.

Monday, March 24, 2008

SEC Moves Forward with Mutual
Recognition Framework

Against the backdrop of continuing cross-border exchange mergers, the SEC will accelerate its implementation of the concept of mutual recognition for high-quality non-US regulatory regimes. The Commission will explore initial agreements with foreign regulatory counterparts based on a comparability assessment by the SEC and by the foreign authority of one another's regulatory regimes. The SEC will also consider adopting a formal process for engaging other national regulators on mutual recognition through rulemaking or other appropriate mechanisms. More broadly, the SEC plans to develop a framework for mutual recognition discussions with jurisdictions comprising multiple securities regulators tied together by a common legal framework, including Canada and the European Union. The SEC also plans to propose reforms to Rule 15a-6 in order to improve the process by which U.S. investors have access to foreign broker-dealers.

The mutual recognition concept would permit foreign exchanges and foreign broker-dealers to provide services and access to U.S. investors under an abbreviated registration system. This approach would depend on these entities being supervised in a foreign jurisdiction providing ``substantially comparable oversight’’ to that in the U.S. In addition, this approach could require that the home jurisdiction of the foreign exchange and the foreign broker-dealer provide reciprocal treatment to U.S. exchanges and broker-dealers seeking to conduct business in that country.

Currently, a foreign exchange conducting business in the U.S. for example must register the exchange and the securities trading on the exchange with the SEC. In addition, foreign broker-dealers inducing trades by investors in the U.S. generally must register with the SEC and at least one SRO. The SEC has, however, provided exemptions to foreign broker-dealers engaging in a limited U.S. business, such as effecting transactions with U.S. institutional investors with the participation of a U.S.-registered broker or dealer.

In reaffirming its commitment to mutual recognition, the SEC reasoned that globalized markets and increased cross-border access offer many potential benefits for U.S. investors, including broader investment choices, lower transaction costs, improved integration of cross-border trading, diversification, and more access to information about foreign investment opportunities. At the same time, taking advantage of these developments requires greater international cooperation to ensure consistent and strengthened investor protection.

Moreover, regulatory overlap from different national securities regimes can pose impediments to cross-border trading. This overlap can result in additional costs for U.S. investors and regulatory compliance burdens on market participants without consideration of whether such costs afford any additional meaningful investor protections.

The mutual recognition regime contemplated by the SEC would consider under what circumstances foreign exchanges could be permitted to place trading screens with U.S. brokers in the U.S. without full registration. Mutual recognition would also consider under what circumstances foreign broker-dealers subject to an applicable foreign jurisdiction's regulatory standards could be permitted to have increased access to U.S. investors without the need for intermediation by an U.S.-registered broker-dealer.

The exemptions from registration would depend on whether the foreign exchange and the foreign broker-dealer are subject to comprehensive and effective regulation in their home jurisdiction. To make this determination, the Commission would need to undertake a detailed examination of the foreign jurisdiction's regulatory regime, considering whether it adequately addresses such things as: investor protection, fair markets, fraud, insider trading, registration qualifications, trading surveillance, sales practice standards, financial responsibility standards, and dispute resolution

Sunday, March 23, 2008

Cox Praises Basel Committee Plan to Update
Guidance on Liquidity Risk Management

SEC Chair Christopher Cox has praised the decision by the Basel Committee on Banking Supervision to update its guidance on liquidity risk management at financial institutions. In a letter to Basel Chair Nout Wellink, he also described how the SEC staff evaluates liquidity risk management at the financial institutions the Commission regulates under its consolidated supervised entity regime. Mr. Cox further assured the Basel chief that, when broker-dealer holding companies and their affiliates elect to be subject to group-wide SEC supervision, they must compute on a monthly basis their group-wide capital in accordance with the Basel standards. Specifically regarding Bear Stearns, the SEC chair assured Basel that Bear Stearns' registered broker-dealers were comfortably in compliance with the SEC's net capital requirements, and, in addition, that the firm’s capital exceeded relevant supervisory standards at the holding company level.

The job of liquidity risk management is to ensure a financial institution’s ability to fund increases in assets and meet obligations as they come due. The market turmoil that began in mid-2007 highlighted the crucial importance of market liquidity to the banking sector. The contraction of liquidity in certain structured securities product, as well as an increased probability of off-balance sheet commitments coming onto banks’ balance sheets, led to severe funding liquidity strains for some bank, which required central bank intervention in some cases.

With the increasing securitization of assets and the explosive growth of complex derivatives, the Basel Committee decided to update its guidance for managing liquidity risk, with proposed new standards expected in July. Mr. Wellink recently emphasized the need to enhance the overall governance of liquidity risk management, integrating it more closely with other risk management disciplines. Also, liquidity stress testing practices must be enhanced, including the capture of off-balance sheet contingent exposures. And Basel is focused on the importance of firms having in place rigorous contingency funding plans that reflect the possibility of major funding sources drying up for long periods of time.

In his letter to the committee, Chairman Cox explained how liquidity risk management functions under the SEC’s consolidated supervised entity regime. The holding company must periodically provide the Commission with extensive information regarding its capital and risk exposures, including market and credit risk exposures, as well as an analysis of its liquidity risk.
With respect to computing capital at the holding company level, CSEs are expected to maintain an overall Basel capital ratio at the consolidated holding company level of not less than the Federal Reserve Bank's 10 per cent well-capitalized standard for bank holding companies. CSEs provide monthly Basel capital computations to the SEC. The CSE rules also provide that an early warning notice must be filed with the SEC in the event that certain minimum thresholds, including the 10 per cent capital ratio, are breached or are likely to be breached.

The SEC considers liquidity risk management to be of critical importance to broker-dealer holding companies, said Chairman Cox. Due to the importance of liquidity to the firms, CSEs have adopted funding procedures designed to ensure that the holding company has sufficient stand-alone liquidity and sufficient financial resources to meet its expected cash outflows in a stressed liquidity environment where access to unsecured funding is not available for a period of at least one year.

In evaluating the liquidity risk management processes at a CSE, the SEC staff considers not only capital but also the assets supported by the capital. Applying such a liquidity standard alongside a capital standard is critical to the effective supervision of a CSE. To assess the adequacy of liquid assets, the SEC staff takes a scenario-based approach. The CSEs have developed a set of scenarios for use internally in assessing liquidity. A key assumption underlying the scenario analysis is that during a liquidity stress event, the holding company would not receive additional unsecured funding but would need to retire maturing unsecured obligations.

Further, firms generally assume that during a liquidity crisis, assets would not be sold to generate cash. Another premise of this liquidity planning is that any assets held in a regulated entity are unavailable for use outside of the entity to deal with weakness elsewhere in the holding company structure, based on the assumption that during the stress event, including a tightening of market liquidity, regulators in the US and relevant foreign jurisdictions would not permit a withdrawal of capital. There are also considerations as to the degree a firm relies on overnight and other short-term funding versus long-term funding.
Japanese Securities Regulator to Allow
More English Language Filings

As part of a broad reform initiative, the Japanese Financial Services Agency will significantly expand the use of English language filings permitted for the Japanese markets. Currently, disclosure in English is allowed only for foreign exchange-traded funds. But, according to Commissioner Takafumi Sato, the FSA will soon permit English disclosure for all types of securities issued by foreign issuers, including foreign governments and foreign funds. In remarks at a recent CFO roundtable in Tokyo, he said that this action is expected to greatly reduce the administrative burden on foreign issuers raising funds in Japanese markets. At the same time, the FSA will accelerate its efforts in translate into English financial laws and rules and relevant policy documents. The FSA expects to complete the translation of major laws by June.

In an effort to create a more vibrant market for alternative investment vehicles, the FSA will expand private offerings to sophisticated investors. Noting the growing success of SEC Rule 144A offerings, the FSA is contemplating a highly flexible market designed for professional investors based on the principle of self-responsibility. Commissioner Sato believes that alternative investments will broaden opportunities for both Japanese and non-Japanese issuers to raise funds in Japan’s markets, and will also promote financial innovation through competition among professional players.

Under current securities regulations, private offerings limited to qualified institutional investors are exempt from public disclosure requirements. Taking advantage of this existing exemption, noted the commissioner, the FSA plans to put in place a framework for transactions among professionals by the end of this year. Simultaneously, the agency is working on a new framework for an exchange market, whose participants will be expanded to include specified investors with better competence than ordinary retail investors.

As part of the reforms, the FSA also plans to lift the ban on interlocking officers and employees among banking, securities, and insurance businesses in a financial group. In addition, restrictions on the sharing of undisclosed corporate customer information between banking and securities businesses will be relaxed. According to Commissioner Sato, these steps should enable financial groups to better serve their customers by allowing them to propose a wide range of alternatives; and also facilitate integrated risk management within a financial group. But he cautioned that, concomitant with this relief, the FSA will require financial firms to implement internal systems for controlling conflicts of interest.

Thursday, March 20, 2008

Rep. Frank Calls for Financial Services
Risk Regulator

With markets in turmoil primarily because of a failure to manage the risk of complex securitized financial instruments, House Financial Services Chair Barney Frank has called for the creation of a federal Financial Services Risk Regulator to assess risk across financial markets regardless of corporate form. The new regulator would be expected to act when necessary to limit risky practices or protect the integrity of the financial system. More broadly, Rep. Frank called for reform of financial regulation to consolidate the current duplicative regulatory structure. In remarks to the Boston Chamber of Commerce, the chair said that the risk regulator could either be a brand new entity or an adjunct of the Federal Reserve Board.

In exchange for potential access to the discount window for non-depository institutions, noted Mr. Frank, the new financial risk regulator would have enhanced tools to receive timely market information from market players, and inspect institutions. The risk regulator would also report to Congress on the health of the entire financial sector. The risk regulator must focus on the substantive regulation of market behavior, and not the form of it. Since the repeal of Glass-Steagall, observed Rep. Frank, a host of new players have emerged and old ones are doing new things. To the extent that anybody is creating credit, he believes that they should be subject to the same type of prudential supervision that now applies only to banks.

In the chair’s view, the current market crisis has revealed that consumer protection and systemic risk are intertwined. The crisis has also shown that seemingly well-capitalized institutions can be frozen when liquidity runs dry and particular assets lose favor, leaving many policymakers calling for enhanced liquidity risk management.

Recently, due to the increasing securitization of assets, the Basel Committee on Banking Supervision said it intends to update its guidance for managing liquidity risk. While the guidance issued in 2000 remains generally relevant, a Basel working group has identified areas in need of updating and strengthening. Enhanced best practices for managing liquidity risk will be issued later this year. Also, UK FSA Chair Callum McCarthy has called for a uniform international policy on liquidity risk management to provide clarity to global financial institutions and other market participants.

Liquidity risk management is designed to ensure a financial institution’s ability to fund increases in assets and meet obligations as they come due. The increasing complexity of financial instruments has led to a heightened demand for collateral and to uncertainty on prospective liquidity pressures from margin calls, as well as a lack of transparency that can contribute to asset market contraction in times of stress.

Wednesday, March 19, 2008

IASB Reaffirms Fair Value in Proposing Revision
of Standard for Measuring Financial Instruments

While acknowledging concerns about volatility, the IASB said that fair value is the only measure appropriate for all types of financial instruments as it embarks on a major revision of IAS 39, the standard for measuring the value of financial instruments. The overall goal is to reduce the current complexity by using a single measurement method for all types of financial instruments. In the view of IASB Chair Sir David Tweedie, IAS 39 is far too complex; and the Board is determined to simplify and improve it by creating a principle-based standard. In addition, the Board is coordinating its initiative with FASB as part of the overall framework to converge accounting standards. In this spirit, the Board’s proposal will be considered for publication by FASB for comment by its constituents

IASB and FASB standards for fair value measurement are different. The FASB has issued SFAS 157, which establishes general principles for determining the fair value of all types of assets and liabilities. It defines fair value as an exit price and addresses many but not all measurement issues specific to financial instruments. The IASB’s requirements for the fair value measurement of financial instruments are in IAS 39. The IASB published SFAS 157 as a discussion paper in November 2006 and has begun deliberating on the comments received. The boards will need to make decisions about some measurement issues related specifically to financial instruments as part of the broader convergence process.

While the long-term standard will be a general fair value measurement, the Board set forth some intermediate approaches that can help improve and simplify measurement requirements in the short run. One suggestion is to reduce the number of categories of financial assets and financial
liabilities. Another option is to replace the existing requirements with a fair value measurement principle with some optional exceptions and/or simplify hedge accounting.

Regarding hedge accounting, two alternatives are suggested. The first is to eliminate all hedge accounting; and the second is to maintain but simplify the existing fair value and cash flow
hedge accounting requirements, particularly those relating to partial hedges and effectiveness testing.

Obviously, the definition of fair value is crucial. The IASB has an ongoing project to establish general principles in determining fair value. For present purposes, fair value will be deemed to represent a current value that is, in many situations, an exit value.

The proposal divides financial instruments into two categories. The first is financial instruments with highly variable future cash flows, which are most derivatives. Fair value is the only measurement for derivatives, the Board explained, since an accreted cost measurement is not possible because it requires a fixed amount and date to accrete to and derivatives do not have fixed payment amounts or dates.

The second category contains financial instruments with fixed or slightly variable future cash flows. Compared with cost-based measures, the fair value of these financial assets better reflects the price of the asset that would be received at the measurement date. Such information is generally useful. There are often events and circumstances beyond management’s control that create a need to sell. Therefore, even if management has no plans to sell an asset, it is useful for users of financial statements to know the potential effects of such events and transactions.

In addition, fair value is a better measure for use in assessing the effect on cash flow prospects of credit risk for financial assets because it provides both information about anticipated future losses and about improvements in credit risk since origination or acquisition.

The IASB’s definition of fair value for financial instruments in IAS 32 is similar to that in SFAS 157. However, there are some differences. Those differences must be resolved if the two boards are to issue a common standard requiring the fair value measurement of financial instruments.
To that end, in November 2006 the IASB published a discussion paper on fair value measurements that used SFAS 157 as the starting point for its deliberations. The IASB has recently started its redeliberations.

In the IASB’s view, both IFRSs and US GAAP could be simplified if a principle or definition could describe items in a standard on financial instruments in a simple and understandable way.
The tentative decision of the IASB and FASB is to use a definition of a financial instrument to set the initial scope.

Tuesday, March 18, 2008

Canada Moving Towards One
Securities Regulator

Canada is the only industrialized country without a common securities regulator. And the present system of thirteen provincial regulators is seen by many as cumbersome, fragmented, and lacking the proper tools of enforcement. But a bill moving through the Canadian Parliament may change all that. Largely modeled on the Ontario Securities Act, the bill, S-211, calls for the replacement of provincial securities regulators with a single federal regulator administering a new federal securities law.

In testimony before the Senate Banking Committee last December, David Dodge, former governor of the Bank of Canada, said it was difficult to determine the penalty that Canada is now paying for retaining the current multi-level securities regulatory system. A good securities framework, he noted, would enable the markets to function efficiently and with sufficient flexibility to ensure that the system is not overburdened with regulation.

The current passport system is viewed as inadequate in allowing Canada to compete successfully at the international level. For example, with the passport system, investors deal with 13 securities regulators, with 13 sets of laws, however harmonized, and with 13 sets of fees. Further, the passport system does not have a national coordination of enforcement activities, nor does it address the need to improve policy making. It is still necessary to obtain agreement from 13 regulators to make changes to the rules.

Moving on a separate track from the bill is a government plan for a common securities regulator. While the difference between a common and a single regulator may seem semantical, Senator Michael Meighen explained that a single regulator is generally understood to mean one regulator administering one securities act, with responsibility for the regulation of securities throughout the country. Indeed, in 2003, the Wise Persons Committee recommended the establishment of a single regulator under a federal statute.

A common regulator implies the participation of willing governments in establishing a joint organization responsible for the regulation of securities in their respective jurisdictions. In 2006, the Crawford panel recommended just this model. A common regulator emphasizes and, indeed requires, cooperation among all levels of government, rather than the federal government simply going it alone.

The government’s plan is designed to make Canada more competitive in the global market. A common securities regulator would improve market efficiency and ensure the best use of money. A common regulator would also improve enforcement and better protect investors with a common set of sanctions and remedies. And a common regulator would allow Canada to move towards a simpler, more principles-based regulation.

For Finance Minister James Flaherty, the great advantage of a common regulator would be the establishment of a national enforcement strategy. Currently, some provinces lack sufficient expertise to investigate and prosecute complex cases. The Minister also believes that moving to a common securities regulator with a new common securities act would provide a unique opportunity to introduce more principles-based, proportionate regulation. This would help establish a regulatory regime that is more flexible and more responsive.

Moving to a common securities regulator is supported by the Investment Industry Association of Canada, representing investment banks and broker-dealers. The idea of a common regulator is also endorsed formally by the Canadian Coalition for Good Governance, whose members include pension funds and other institutional investors.
SEC Details Staff's Involvement in Bear Stearns Transaction

During discussions of the Bear Stearns/JPMorgan Chase transaction, SEC officials were in close contact with Federal Reserve Board officials, as well as with representatives of the firms involved. To assist in advancing a possible transaction, the SEC staff able provided several letters clarifying the staff’s position on certain matters connected with the merger.

The SEC also assured that, despite the loss in market value in Bear Stearns’ stock, and independent of the transaction, many protections remain in place for customers of Bear Stearns’ broker-dealers. According to Bear Stearns’ reports to the SEC, the firm’s broker-dealers were in compliance with the SEC’s capital and customer protection rules

The Division of Trading and Markets wrote a letter addressing the timing of JPMorgan’s filing of a Form BD with the SEC. Form BD is required to be filed promptly after a registered broker-dealer is acquired by another firm. The staff’s letter states that it would be acceptable if JPMorgan filed a completed Form BD a reasonable period after the merger closes.

The Division of Investment Management wrote two letters concerning issues under the Investment Company Act and Investment Advisers Act arising out of the change in control of investment advisers affiliated with Bear Stearns. One letter addresses approvals by the mutual funds advised by the Bear Stearns advisers of new advisory contracts between the funds and the advisers. The other letter provides temporary, conditional relief from restrictions on principal transactions between the Bear Stearns advisers and clients of investment advisers affiliated with JP Morgan and transactions between the JP Morgan advisers and clients of the Bear Stearns advisers.

The Division of Enforcement wrote a letter declining to provide assurances about possible future enforcement actions. The letter stated that reaching conclusions about those inquiries would be premature. In the letter, the Division confirmed that, consistent with prior statements and guidance by the SEC, the staff would favorably take into account the circumstances of the JPMorgan acquisition of Bear Stearns when considering whether to recommend enforcement action against JPMorgan arising out of statements made by Bear Stearns in the 60 days before the public announcement of the merger.

The Division of Corporation Finance wrote a letter addressing sales by client accounts managed by JPMorgan and Bear Stearns of the other firm’s securities, in view of the control relationship created by the merger agreement. The letter states that these sales may occur temporarily without registration under the Securities Act or compliance with Securities Act Rule 144 in certain limited circumstances.

Finally, the SEC emphasized that capital is not synonymous with liquidity. A firm can be highly capitalized, that is, can have more assets than liabilities, but can have liquidity problems if the assets cannot quickly be sold for cash or alternative sources of liquidity, including credit, obtained to meet other demands. While the ability of a securities firm to withstand market, credit, and other types of stress events is linked to the amount of capital the firm possesses, the firm also needs sufficient liquid assets, such as cash and U.S. Treasury securities, to meet its financial obligations as they arise.

Accordingly, large securities firms must maintain a minimum level of liquidity in the holding company. This liquidity is intended to address pressing needs for funds across the firm. This liquidity consists of cash and highly liquid securities for the parent company to use without restriction.

Monday, March 17, 2008

Basel Committee Revisiting Basel II Accord in Light of Financial Crisis

As the market turmoil associated with securitization deepens, the Basel Committee is looking at making improvements to certain aspects of the Basel II Accord. In remarks, at a recent Basel II Implementation Summit in Singapore, Basel Committee Chair Nout Wellink said there are no simple measures that will capture the complex risks now facing global financial institutions. Multiple perspectives on risk are an imperative, he noted, as provided under the three pillars of Basel II.

Concomitant with the Basel chair’s remarks, FSA Chair Callum McCarthy told the International Institute of Bankers that any failings in Basel II revealed by the ongoing financial market crisis must be identified and corrected. There are both specific issues, like the capital charge for trading book credit loss, and the more general issue of how ratings are used, which are central to Basel II, noted the FSA chair, and where the problems in ratings of structured securities instruments should ``make us thoughtful.’’

The Basel II Accord has three mutual reinforcing pillars. The first pillar is the minimum regulatory capital charge. The second pillar deals with risk management, while the third pillar enhances disclosure.

Under the first pillar of Basel II, noted Chairman Wellink, the committee is examining the treatment of highly rated securitization exposures, especially asset-backed securities and collateralized debt obligations. These securities have recently been the source of the greatest losses across the banking sector and they have an unusual feature in that losses can build very rapidly. This feature explains the unprecedented downgrades of triple-A super senior tranches, which exceed anything yet seen in traditional corporate bonds. These structured securities are highly correlated with systematic risk, said the Basel chair, and the Basel Committee will look at whether the capital charges for these types of exposures are calibrated appropriately in relation to their risks and complexity.

The committee has decided to introduce a credit default risk charge for the trading book. There has been a rapid growth of less liquid, credit sensitive products in banks’ trading books, he said, including structured credit assets and leveraged lending. The VAR-based approach is insufficient for these types of exposures, he posited, and needs to be supplemented with a default risk charge.

In addition, Mr. Wellink said that it is critical that banks conduct rigorous Pillar 2 stress testing of their trading book exposures. They must factor in liquidity horizons and reflect these results in their risk limits, economic capital and concentration management strategies. Many structured credit products are tailored for individual investors and have a limited or no secondary market. The Basel II framework has guidelines for what should and should not go into the trading book, he emphasized, and these need to be reviewed by banks.

Under the second pillar of the Basel framework, regulators will be reinforcing the importance of banks’ stress testing practices. Basel II already requires banks to conduct stress tests of their credit portfolios to validate the adequacy of their capital cushions at all points of the credit cycle. However, it is important that banks also conduct scenario analyses and stress tests of their contingent credit exposures, both contractual and non-contractual. These contingencies have implications for balance sheet growth and capital. Banks have taken significant exposures back on the balance sheet for reputation reasons. Being better prepared for such scenarios going forward can help make banks more resilient to stressful conditions.

Turning to Pillar 3, the chair said that there are opportunities to further leverage off the types of disclosure required under Basel II. In particular, regulators need to monitor the type of information that banks make available for structured credit products. The committee will determine whether improvements are needed, particularly related to securitizations, conduits and the sponsorship of off-balance sheet vehicles.
SEC Staff Acts to Thaw Frozen Auction-Rate Securities Market

In an effort to thaw the essentially frozen auction-rate securities market, the SEC staff said it would not object if municipal issuers, conduit borrowers, dealers and auction agents participated in bids for municipal auction rate securities. In a letter to SIFMA signed by the directors of the Divisions of Market Regulation and Corporation Finance, the staff conditioned the no-action relief on the prompt disclosure following the auction of detailed information concerning the bidding that occurred, including the amount of securities for sale in the auction; the number and aggregate dollar amount of bids made; the number of bidders, and the high, low and median bids received.

There should also be disclosure of any steps to avoid an auction leading to a below market clearing interest rate, such as whether the rates bid would not be less
than an appropriate benchmark, such as the relevant SIFMA municipal swap index. Further, there must be timely dissemination of the disclosures to the public, including
provision of the disclosures to nationally recognized municipal securities information repositories and the financial press, coupled with posting on publicly accessible portions of the websites of the participating dealers, the municipal issuer's and the conduit borrower.

Municipal auction rate securities are municipal bonds with interest rates that are
periodically re-set through auctions, typically every 7, 14,28, or 35 days. Municipal auction-rate securities are auctioned at par so the return on the investment to the investor and the cost of financing to the issuer between auction dates is determined by the interest rate set through the auctions. The interest rate is set through a process in which bids with successively higher rates are accepted until all of the securities in the auction are sold. The final rate at which all of the securities are sold is the clearing rate that applies to all of the securities of an offering until the next auction occurs. If there are not enough bids to cover the securities. Hundreds of auctions for municipal auction-rate securities recently have failed to obtain sufficient bids to establish a clearing rate.

The no-action letter was issued because the SEC staff learned that a contributing
factor may be the reluctance of participating dealers to purchase in the auctions due to
uncertainty regarding the staff’s views on the circumstances under which participating
dealers may accept bids from issuers desiring to participate in auctions.

Regarding disclosure, the SEC recognizes that appropriate disclosure in any particular case will depend on all the relevant facts and circumstances. Among other things, the staff believes that municipal issuers, conduit borrowers, participating dealers and auction agents should consider whether an offer to purchase subsequent to an auction is permissible under the contractual arrangements governing the particular municipal auction rate securities. Also to be considered is whether the submission of a bid by the municipal issuer or conduit borrower, or by participating dealers acting on its behalf, and the acceptance or processing of such a bid by participating dealers or auction agents, is consistent with the issuer's or borrower's disclosure documents.

Sunday, March 16, 2008

PCAOB Chair Examines Double-Edged Sword of Fair Value Accounting

Fair value accounting presents the promise of making financial statements more relevant, said PCAOB Chair Mark Olson, but at the same time poses heightened audit risk, especially in illiquid markets. In remarks at the Institute for International Bankers, he pledged that the PCAOB will continue to monitor fair value accounting in order to understand how audit firms are addressing this potential risk.

Fair value accounting was adopted by the FASB in Standard No. 157, which defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Last December, the Board issued a practice alert on auditing the fair value measurements of financial instruments.

Fair value accounting for certain securities is being implemented in the US and elsewhere based on a belief that this standard more rationally reflects management's intent for the use of those assets and thereby offer investors more relevant information. Chairman Olson observed that current market conditions have cast into stark relief the challenges that determining fair value measurements can pose. As companies make the transition to fair value accounting, he continued, the auditors of their financial statements face three basic challenges.

First, many auditors may not have the extensive training in the valuation techniques needed to measure fair value. Second, since financial statement preparers can be biased in their assessments of fair values, auditors have to be sure that preparers have considered alternative valuation scenarios. Third, the internal controls surrounding fair value measurements may be different from controls over typical business transactions.

As the growing market turmoil engulfed asset-backed securities and collateralized debt obligations, he noted, the PCAOB reached out to auditors to discuss the emerging potential audit risks. This dialogue continues as credit risks deepen and spread to a number of other complex instruments. Questions have emerged as preparers and their auditors struggle over the need to measure the fair value of complex securities in an increasingly thin market. Throughout this dialogue, the PCAOB has communicated to auditors the need to ``stay the course,’’ reminding them to adhere to existing requirements. To that end, the Board has discussed the approaches to determining fair value provided for in accounting standards and the relevant requirements for auditors.

The chair emphasized that the Board’s message to auditors throughout this rapidly changing economic environment has consistently been to obey existing requirements. Specifically, auditors should get behind the prices or estimates provided by brokers and other specialists. Also, auditors and preparers must understand where the quoted value of the financial instrument is coming from; that is, whether it is a quote based on an active market, a price based on observable inputs, or an estimate based on a model. If the value is produced from a model, he said, preparers and auditors must understand the model and assess the reasonableness of its significant assumptions. More broadly, he emphasized that the nature of how the fair value measurement was derived will drive the work that preparers and auditors must undertake.
Key Senator Says PCAOB Reliance on Foreign
Audit Regulators Thwarts Sarbanes-Oxley

In the view of Senator Carl Levin, the PCAOB’s proposed guidance to rely on non-US audit oversight bodies to conduct inspections of foreign audit firms registered with the Board is antithetical to its mandate under Sarbanes-Oxley. In a letter to the Board, the chair of the Senate Investigations Subcommittee said that moving to full reliance on foreign inspections is ill-advised because it would weaken Sarbanes-Oxley oversight requirements, consume significant Board resources without improving audit oversight, and potentially place US firms at a disadvantage.

The Board’s proposal would undermine the Sarbanes-Oxley requirement that foreign firms auditing US companies receive the same oversight as US audit firms. Section 106 of the Act states that foreign audit firms must be subject to the Act and to PCAOB and SEC rules issued under the Act to the same extent as US audit firms. According to Sen. Levin, this means that Congress wants US and foreign audit firms to receive equal treatment from the PCAOB, subject to the same inspections and reports.

By plain statutory language, said the senator, the Board is not authorized to delegate its inspection duties to a foreign body, no matter how trustworthy that body may be. While acknowledging that working with foreign audit regulators to conduct joint inspections is useful, Sen. Levin said that actually delegating the Board’s inspection duties to a foreign regulator would be a bridge too far under Sarbanes-Oxley. He urged the Board to continue its current policy of partially relying on foreign audit regulators, which he said is working well.

The proposal would also weaken Sarbanes-Oxley by allowing foreign audit regulators to decide how to apply US rules to non-US audit firms. Similarly, the proposal would reduce the oversight role of the SEC, which has no authority over foreign regulators. In the chair’s opinion, the result would be inconsistent legal interpretations and divergent oversight practices in multiple countries.

The senator cited a letter from the German Auditor Oversight Commission (AOC) as evidence that the Board’s adoption of full reliance would open a ``Pandora’s Box of problems.’’ The German audit overseer said that, while the Federal Republic would allow joint PCAOB-AOC inspections of German audit firms for a limited period of time, it would forbid joint inspections once a decision on full reliance had been made.

At that point, the PCAOB would have to fully rely on German oversight. In the senator’s view, the German regulator is saying that, once accorded full reliance from the Board, it would object to any independent inspection of a German audit firm by the PCAOB even if that firm were to consent and even if concerns about the firm’s operations or the quality of German oversight were raised by investors, the Board or the SEC.

Even more, German law does not allow the German audit authority to publish individual inspection reports, as required by Sarbanes-Oxley, unless the audit firm agrees to publication. While the PCAOB might be able to execute a bilateral agreement with German authorities over constraints on the Board’s reporting duties, noted the senator, the PCAOB is not authorized to bargain away its statutory obligation to inspect foreign audit firms under the same oversight rules as those imposed on US audit firms.

Friday, March 14, 2008

Senate Finance Committee Will Study the Taxation of Sovereign Wealth Funds

As the assets controlled by sovereign wealth funds increase dramatically, leaders of the Senate Finance Committee have asked the Joint Committee on Taxation to analyze the current federal tax rules, and underlying policy, applicable to U.S. investment by sovereign wealth funds. The report must be provided by June 16, 2008. A letter requesting the report was signed by committee chair Max Baucus and ranking member Charles Grassley.

The federal tax code has long exempted from taxation passive income from U.S. investments made by foreign governments. The dual reasons for the exemption in Section 892 are sovereign immunity and to keep the U.S. economy open to foreign investment. The United States does not exempt a foreign government’s income earned from commercial activities in the U.S. market because to do so would give them a competitive advantage over non-governmental market participants. There are also issues related to the transparency of sovereign wealth funds and the political concerns that might develop without such transparency.

Specifically, the senators asked the joint committee to provide information on trends in the level and types of U.S. investment by foreign governments, in absolute terms and relative to non-governmental pools of capital, and factors contributing to these trends. Similarly, the committee wants to know about trends in the level and types of investments (U.S. and foreign) by domestic public funds, such as state pension funds and other investment funds controlled by federal or state governments. The joint committee should also report on the techniques used by sovereign wealth funds to invest in U.S. corporations, referencing Revenue Ruling 2003-97.

More broadly, the joint committee will detail the present law and background regarding the federal taxation of U.S. income derived by sovereign wealth funds, including the history of the federal income taxation of U.S. income derived by foreign governments. Also to be examined is the scope of the Section 892 exemption; as well as the application of Section 892 to recent SWF investments in U.S. financial institutions and how income from those investments would be taxed in the absence of Section 892;

The joint committee will also compare the federal tax treatment of US income derived by foreign governments with the tax treatment of U.S. investment by non-governmental
foreign residents and tax-exempt entities. The committee wants information on any filing, third party tax reporting and withholding requirements associated with U.S. income derived by foreign governments.

Finally, the joint committee will provide information on the applicability of income tax treaties or other international agreements to U.S. income derived by foreign governments, as well as any policy considerations regarding the current tax treatment of U.S. investment by foreign governments. Finally, the tax treatment in other major OECD countries of investment by foreign governments will be examined.

Thursday, March 13, 2008

President's Working Group Proposes
Major Reforms to US Financial Regulation

In the wake of recent market turbulence, the President’s Working Group on Financial Markets has proposed broad and substantial changes to US financial regulation. The comprehensive reforms are nothing less than a complete overhaul of the securitization process and the concomitant mortgage origination process that relied on the sale of asset-backed securities. The working group recommendations would enhance disclosure, reform credit rating agencies processes, strengthen risk management, promote transparency, and converge accounting standards.

The PWG calls upon the SEC and the federal banking regulators to implement a number of reforms across a wide range of areas. The Basel Committee is also urged to quickly update its guidance on liquidity risk management. The President’s Working Group on Financial Markets is comprised of the Treasury Secretary and the chairs of the SEC, the CFTC, and the Federal Reserve Board.

The working group said that the SEC should require investors and their asset managers to obtain from sponsors and underwriters of securitized credits access to better information about the risk characteristics of such credits, including information about the underlying asset pools, on an initial and ongoing basis. Similarly, the SEC should ensure that investors and their asset managers develop an independent view of the risk characteristics of the instruments in their portfolios, rather than relying solely on credit ratings. For its part, the PWG will engage the private sector to develop best practices regarding disclosure to investors in securitized credits, including asset-backed securities and collateral debt obligations.

The report also calls for structural reform of the process of rating securitized assets. Credit rating agencies would have to disclose what qualitative reviews they perform on originators of assets that collateralize asset-backed securities rated by the agencies. Underwriters of asset-backed securities would have to represent the level and scope of due diligence performed on the underlying assets. The rating agencies should also reform their ratings processes for structured credit products to ensure integrity and transparency.

More specifically, credit ratings agencies should implement changes suggested by the SEC’s broad review of conflict of interest issues. They must also disclose sufficient information about the assumptions underlying their credit rating methodologies so that users of the ratings can understand how a particular credit rating was determined. They should clearly differentiate ratings for structured products from ratings for corporate and municipal securities.

Ratings performance measures for structured securities credit products and asset-backed securities should be made readily available to the public in a manner that facilitates comparisons across products and credit ratings. More broadly, the ratings agencies must work with investors to provide the information they need to make informed decisions about risk including measures of the uncertainty associated with ratings and of potential ratings volatility

Turning to risk management, the PWG said that global financial institutions must promptly identify and address any weaknesses in risk management that the turmoil has revealed. For their part, the SEC and the federal banking regulators should promptly develop common guidance to address the risk management weaknesses revealed by the market turmoil, including improvements to concentration and liquidity risk management, and stress testing, as well as the governance of the risk management and control framework.

For its part, the PWG will form a private-sector group to reassess implementation of the Counterparty Risk Management Policy Group II’s existing guiding principles regarding risk management, risk monitoring, and transparency. The idea would be to modify or develop new principles and recommendations as necessary to incorporate lessons from the recent turmoil, including lessons regarding valuation practices.

The PWG also wants regulators to require financial institutions to make more detailed disclosures of off-balance sheet commitments, including commitments to support conduits and other off-balance sheet vehicles. Similarly, regulators should encourage financial institutions to improve the quality of disclosures about fair value estimates for complex and other illiquid instruments, including descriptions of valuation methodologies regarding the degree of uncertainty associated with such estimates.

The working group wants the SEC to encourage FASB to evaluate the role of accounting standards in the current market turmoil. This evaluation should include an assessment of the need for further modifications to accounting standards related to consolidation
and securitization, with the goal of improving transparency. Additionally, the SEC should encourage FASB and the IASB to achieve more rapid convergence of accounting standards for consolidation of conduits and other off-balance sheet vehicles.

Regarding derivatives, regulators of OTC derivatives dealers should enhance the infrastructure for the rapidly growing OTC derivatives markets. Regulators should urge the industry to develop a longer-term plan for an integrated operational infrastructure supporting OTC derivatives that, among other things, enhances participants’ ability to manage counterparty risk through netting and collateral agreements by promoting portfolio reconciliation and accurate valuation of trades.

Finally, the working group calls on the Basel Committee on Banking Supervision to promptly complete its update of Basel’s 2000 guidance on liquidity risk management, including best practice guidelines to be followed by financial institutions, as well as the oversight principles for regulators. The Basel Committee is also urged to review capital requirements for asset-backed securities and other re-securitizations and for off-balance sheet commitments, with a view towards increasing requirements on exposures that have been the source of recent losses to firms.

Canada Overhauls Its Dealer and Adviser Registration/Exemption Rules

The Canada Securities Administrators (CSA) have proposed amendments to a rule adopted February, 2007 that overhauled registration and exemption provisions for Canadian dealers, investment advisers and investment fund managers. The new round of proposals published February 29, 2008 will continue to pertain directly to Canadian dealers, investment advisers and investment fund managers but will also impact non-Canadian dealers, investment advisers and investment fund managers doing business in Canada on a registered or exempt basis, by affecting a number of capital market activities that include private placements, public and private fund offerings, and advisory activities.

Please see the following website for how the 2007 rule affects limited market dealers, investment fund managers, dealers registered in Ontario and non-Canadian investment funds, and for summaries of the proposals affecting non-Canadian dealers and investment advisers: (Stikeman Elliot law firm)

Public comments on the proposals will be accepted until May 29, 2008.

Wednesday, March 12, 2008

Chevron Deference May Be Due
Sarbanes-Oxley Whistleblower Ruling

A Fifth Circuit panel has ruled that a securities analyst did not engage in protected activity under the Sarbanes-Oxley Act whistleblower provision when she refused to upgrade a company’s rating in her report since she never said that changing the rating would violate any securities laws and the employer did not express an intent to change the rating, but merely questioned her decision. Getman v. US Dept. of Labor, Administrative Review Board, CA-5, Feb. 13, 2008, No. 07-60509.

In a per curiam unpublished
opinion, the appeals court said that it appears that Chevron deference is due to the Department of Labor in interpreting the Sarbanes-Oxley whistleblower provision, Section 806. This was dicta since the court said that, either with or without Chevron deference, the decision of the Department of Labor that the activity was not protected under Section 806 would be upheld. But it was an important statement because the issue of Chevron deference under Section 806 has not been addressed before, at least in the Fifth Circuit.

The Chevron doctrine was promulgated by the US Supreme Court and is a powerful principle of administrative law. The doctrine means that, when Congress has explicitly left a gap for an agency to fill, there is an express delegation of authority to the agency to elucidate a specific provision of the statute by regulation, and any ensuing regulation is binding in the courts unless procedurally defective, arbitrary or capricious in substance, or manifestly contrary to the statute. In Section 806, Congress specifically authorized the Department of Labor to enforce the whistleblower provision.
3rd Circuit: SLUSA No Bar to Aiding and Abetting,
Foreign Claims by Trust

The Securities Litigation Uniform Standards Act did not preclude a trust from bringing state law claims for aiding and abetting breaches of fiduciary duties, concluded a 3rd Circuit panel. In addition, the trustees could bring, as assignees of individual investors in the bankrupt enterprise, claims against foreign entities that arose under foreign law for aiding and abetting money laundering.

The case arose from the failure of a software company after some of its officers and directors allegedly ran a "pump and dump" scheme, and then attempted to conceal their actions by channeling funds through sham entities and accounts with the assistance and knowledge of foreign banks.

After the issuer filed for bankruptcy, the reorganization plan assigned the corporation's claims to a state law trust, as did individual purchasers of the company's securities. The trustees filed suit in federal court alleging that the foreign banks aided and abetting breaches of fiduciary duties and violated Swiss money-laundering laws.

The district court (DC NJ) dismissed the claims under the Uniform Standards Act. First, the court rejected the trustees' claims that the trust should be considered one "person" under the Uniform Standards Act because the trust was formed for the primary purpose of pursuing causes of action and recovering damages for shareholders. The trust was actually acting as a shareholder representative, pursuing the litigation on behalf of a class of 6,000 people, held the district court.

The court also held that the aiding and abetting action itself was preempted by the Uniform Standards Act because that statute prohibits claims in state court that plaintiffs are prohibited from pursuing under federal law. Recognizing that the U.S. Supreme Court's decision in Central Bank of Denver v. First Interstate Bank prohibited private plaintiffs from bringing aiding and abetting claims, under Section 10(b), the district court broadly interpreted the Uniform Standards Act to preempt state law claims where a plaintiff is unable to bring a federal securities claim (LaSala v. Bordier et Cie, CCH Federal Securities Law Reporter ¶93,975).

On appeal, the 3rd Circuit initially held that the damages resulting from the pump and dump scheme accrued to the corporation. The panel noted that

The fact that AremisSoft no longer exists does not convert its corporate claims into direct shareholder claims; rather, the corporate nature of the claims endures, and ownership of the claims passes to AremisSoft’s successor.
The court then disagreed with the trial court's finding that the trust entity should be disregarded and the stock purchasers should be counted for Uniform Standards Act purchases.

SLUSA preemption would prevent the estate from assigning certain legal claims to any class of creditors or equity holders containing more than 50 persons, but it would allow assignment to classes with fewer constituents. This result would make little sense, as we see no indication that Congress’s aim in fashioning the “covered class action” definition was to control the number of constituents to whom a bankruptcy estate’s claim is assigned. Rather, the statutory text and legislative history signal that the definition was designed to prevent securities-claims owners from bringing what are, in effect, class actions by assigning claims to a single entity. Put simply, Congress’s goal was to prevent a class of securities plaintiffs from running their claims through a single entity, not to prevent a single bankruptcy estate from assigning its claims to an entity capable of acting to protect the common interests of a class of people.

Moreover, it is difficult to see what purpose would be served by holding otherwise. If we held that the key issue is to whom a claim is assigned, then we would likely see two results. First, we might see parties to bankruptcies engage in some rather creative class construction to keep numbers below 51. Parties’ ability to do this would not turn on any factor related to preventing frivolous securities litigation, but on the creativity of the parties’ lawyers and the particulars of a debtor’s pre-petition liabilities.
With regard to the Swiss banking law claims, the panel concluded that the Uniform Standards Act, which applies to claims “based upon the statutory or common law of any State," did not preclude actions for foreign law violations. Initially, the court rejected the banks' claim that Congress intended to preempt such foreign law claims. The court cited language that "[i]t is not our job to speculate upon congressional motives; our job is to hew as closely as possible to the meaning of the words
Congress enacted." Because Congress could have defined a state to include foreign jurisdictions, and had done so in other legislation, the court declined to extend the definition in this case.

The claims also did not arise from or incorporate state law claims, and were not dependent on state law, including New Jersey's choice of law provisions. To conclude that, within the intendment of SLUSA, those claims are “based upon the . . . law of New Jersey would require attributing to Congress a subtlety of such exquisite reach as to have no place in the legislative process," stated the court.

LaSala v. Bordier et Cie, CCH Federal Securities Law Reporter ¶94,597 (Dkt. No. 06-4323)

Tuesday, March 11, 2008

House Bill Would Make Securities
Litigation More Transparent

A bill fostering transparency and accountability of attorneys in private securities litigation has been introduced in the House. The Securities Litigation Attorney Accountability and Transparency Act (HR 5463) would provide that, in any private securities action in which the court enters a final judgment against plaintiff, the court must determine whether the position of the plaintiff was not substantially justified; whether the imposition of fees and expenses on the plaintiff's attorney would be just; and whether the cost of such fees and expenses to the defendant is substantially burdensome or unjust. Further, the court must award the defendant reasonable fees and other expenses if the court makes positive determinations in such a case. The bill places the burden of persuasion upon the defendant as to whether or not the position of the plaintiff was substantially justified.

Under the Act, plaintiffs and their attorney must provide sworn, signed certifications identifying any actual or promised payment by the attorney to the plaintiff, beyond the plaintiff's pro rata share of any recovery. Similarly, similar certifications are required regarding legal representations; contributions; and conflicts of interest. Moreover, in exercising discretion over the approval of lead counsel, courts would be directed to employ, if feasible, a competitive bidding process as one of the criteria.

Finally, the bill instructs the Comptroller General to study and report to Congress on average hourly fees in securities class actions.

Sunday, March 09, 2008

Vice-Chancellor Strine Distinguishes Rulings
Involving Delay of Shareholder Vote

Recently, I blogged about a decision by Vice Chancellor Strine that 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)

Some people may have been wondering if and how the Vice Chancellor distinguished the Portnoy ruling on delay with his earlier
ruling in Mercier v. Inter-Tel Inc., Del. Chancery Court, Aug 14, 2007, CA No. 2226, that a special committee of independent directors could reschedule an imminent meeting of stockholders to consider an all cash, all shares offer from a third-party acquirer when they believed that the merger was in the best interests of the stockholders and knew that if the meeting proceeds the stockholders wouldl vote down the merger and the acquiror would irrevocably walk away from the deal and the company’s stock price will plummet.

Please allow me to note that, in footnote 188 of his Portnoy opinion, Vice Chancellor Strine did distinguish the two rulings. He said that the situation in Inter-tel, where the directors advocated an affirmative vote on a transaction because they believed in good faith that the transaction would benefit the stockholders, was importantly distinct from an actual election of directors, like in Portnoy, in which the insiders delay because they believe the stockholders are making a mistake in choosing new leadership. In the Inter-tel situation, directors who faced no risk of removal were asking for more time to make their case that a non-self dealing transaction should receive approval.

By contrast, in the Portnoy situation, reasoned the Vice-Chancellor, the directors were trying to insulate themselves from ouster by forcing the insurgents to continue the fight beyond when the election was supposed to be held. In Portnoy, unlike in Inter-Tel, management gave the assembled stockholders false reasons for delay and was not acting in good faith to ensure that stockholders had more time to consider an arms-length transaction that was at danger in a time of economic tumult