Wednesday, April 30, 2008
The Treasury Blueprint’s role for the Federal Reserve Board as market stability regulator envisions macro-prudential regulation that may encompass the risk exposures of hedge funds and other financial firms, according to David Nason, Assistant Secretary for Financial Institutions. In remarks at a London seminar on new financial frontiers, he said that the market stability regulator should have the ability to require financial firms to undertake corrective actions to address financial stability problems, such as counterparty risk exposures and concentrations of asset exposures.
Similarly, the market stability regulator must have access to detailed information from all types of financial institutions, including data submissions and the ability to join in or initiate examinations. Treasury also envisions the market stability regulator having the authority to require additional disclosure by financial institutions so that market participants can better evaluate their risk profiles.
As the market stability regulator collects and analyzes this type of information, continued the official, it could publish aggregate information to highlight issues associated with potential risk exposure. Such actions, combined with enforcement authority, would provide a clear signal to market participants that the market stability regulator has identified some potential problems that should be addressed. Treasury expects that this action alone could have an impact on overall behavior.
Mr. Nason referred to this process as "leaning against the wind" in an attempt to prevent broad economic dislocations caused by potential excesses. It will not be an easy job. In addition to the difficulty of determining just where and when to lean against the wind, he reasoned, there could be a tendency of the market stability regulator to lean too heavily simply to avoid blame for any ensuing financial instability. Moreover, regulated entities could push back, alleging regulatory over-reach. But, at the end of the day, it is a process worth trying for anyone who wants to preserve innovative financial markets.
The Blueprint advocates a separation of responsibilities between a regulator looking at the system as a whole and another regulator focused on the health of individual institutions. A macro-stability regulator should not be concerned with the failure of an individual institution, he emphasized, while a micro-prudential regulator should be very concerned with individual institution failures, especially when the government safety net is involved.
In remarks at a London seminar on new financial frontiers, David Nason, Treasury official for financial institutions, said that the recasting of the Fed into a market stability regulator is in the future. For the near term, there is the question of the proper regulatory oversight of investment banks, especially the largest firms regulated under the SEC's consolidated supervised entities regime. The Fed and the SEC are currently working constructively together while the primary dealers have access to the Federal Reserve's liquidity facilities.
This is appropriate, said the Treasury official, since the Fed needs to have information about institutions to which it is lending. What happens next after that facility eventually closes, however, is a more difficult policy question. ``We are in the first act of what is a multi-act play,’’ observed the Assistant Secretary.
As the process unfolds, some principles seem clear. For example, financial firms with permanent access to a government backstop must be regulated in the same way as all other institutions that have access to this backstop. Similarly, as markets have become inter-connected, it is necessary to have some type of oversight to ensure that broader issues of market stability are considered adequately.
If bank-like regulation is expanded to a wider range of firms, he reasoned, two outcomes are possible. First, innovation and risk-taking could decline to levels below what the market would normally allow. Second, a false sense of security could be provided to market participants, potentially leading to less market discipline and even greater financial instability. Both of these outcomes are unattractive, he noted, but so is the status quo. Thus, change, in one form or another, is likely.
In the wake of the Gramm-Leach-Bliley Act, noted Fed Vice Chairman Donald Kohn, large commercial and investment banks have become indispensable to the efficiency and stability of the securities markets. For example, the $2 trillion hedge fund sector is critically dependent on a relatively small number of commercial and investment banks that serve as secured creditors and derivatives counterparties. And, as the financial market turmoil has revealed, banks provide liquidity support to various short-term financial markets, including the commercial paper market.
In remarks at a Fed credit symposium in Charlotte, the senior official also emphasized that the creation of innovative and complex securitized products has outstripped banks' risk-management capabilities. While securitization can transform illiquid assets into more-liquid securities, he noted, risk managers must be more aware of the ways that securitization can become a drain on a bank's liquidity position in times of stress.
The Fed official also pointed out that large banking organizations, freed from the constraints of Glass-Steagall, have significantly increased their capital markets businesses, including underwriting securitizations, securities custody, prime brokerage, and both over-the-counter and exchange-traded derivatives. They have also made significant inroads into both traditional asset management and the management of hedge funds. Indeed, he observed that the largest commercial banks are now major competitors in many of the business lines historically viewed as the province of investment banks.
For its part, the Fed is reexamining a host of things ranging from Basel II to liquidity to transparency. The Fed wants the Basel II capital requirements raised on specific exposures, such as super senior CDOs of asset-backed securities and off-balance-sheet commitments. The central bank also wants to see better disclosures of off-balance-sheet commitments and of valuations of complex structured products.
According to Mr. Kohn, the entry of large banks into securitization raises a new threat to financial stability. In part, this threat stems from the complexity of banks' capital markets activity, and from the services that banks provide to the asset-management industry, including hedge funds. Traditional risks, such as liquidity risk and concentration risk, have appeared in new forms.
He also emphasized the need for increased due diligence, for both banks and investors. They must devote more effort to due diligence when investing in complex securitized products, and also avoid relying so heavily on credit rating agencies to do all their homework for them. As institutional investors fueled securitization by demanding fixed-income securities, said the vice chair, they should have done better due diligence on the subprime risks they were taking on, but they largely failed to do so. The Fed official speculated that these investors relied on inadequate credit rating agency analyses or simply misunderstood the risk of very complex securities.
Another change affecting financial stability is the growth of services that banks provide, including running their own asset-management businesses and providing prime brokerage services to hedge funds. He urged banks to manage the reputational risks of their asset-management businesses.
Because institutional investors are naturally sensitive to the reputation of their asset managers, he reasoned, losses elsewhere in the bank can be compounded if they leave the bank's asset-management business exposed to a flight of business and a sharp reduction in fee income. Moreover, an increase in the business that banks do with hedge funds leads to an increase in the attention that banks must pay to counterparty risk management.
A major cause of the market turmoil is that a good part of the risk associated with the securitization of subprime mortgages was not distributed into the market but instead was retained by banks. The most glaring example is their exposures to super senior tranches of collateralized debt obligations (CDOs) that had invested in subprime mortgage-backed securities.
One reason for this was the decision of underwriters to retain some of the super senior exposure, in some cases reportedly because they met some resistance when they attempted to sell them at very slim spreads. The underwriters evidently misjudged the risk of those positions, he posited, often because they relied too heavily on external triple-A ratings
Further, while the originate-to-distribute model aims to move exposures off of banks' balance sheets, noted the Fed vice-chair, there is the liquidity risk that a sudden closing of securitization markets can force a bank to hold and fund exposures that it had originated with the intent to distribute. And even when banks did distribute exposures, they did so to various off-balance-sheet financing vehicles in which they retained contractual and reputational liquidity exposures.
As part of reforming securitization, the Fed official called on financial institutions to enhance risk management comprehensively across business lines and fully integrate risk management into the decision making of senior management. Self-interest provides a strong incentive to improve risk management, he said, but better risk management at the largest banks would also benefit the broader financial system. Banks must also improve their management of counterparty risks.
Tuesday, April 29, 2008
A Conference Board working group has issued proposed recommendations for companies and institutional investors facing hedge fund activism. The Hedge Fund Activism working group suggested a number of practices that could be employed by public companies and institutional investors that find themselves involved in activism campaigns mounted by hedge funds. After comments, the working group plans to issue a final report by June 2008.
As they proliferate, hedge funds have been exploring new investment policies. Among others, a number of hedge fund managers have undertaken an activist role within their portfolio companies, attempting to influence financial and strategic decisions and effect corporate governance changes. Hedge fund activism has focused on a few very different courses of action. Hedge funds may, for example, leverage a company’s balance sheet so as to return cash to shareowners; or they may assume an operating role, blurring the lines between themselves and private equity. At other times, they may advocate for a quick sale of the company or seek a change in top management.
As such activism grows, the working group recommends that companies be aware of their strategic, financial and governance vulnerabilities. To facilitate such awareness, they should designate a corporate governance officer reporting to the board on emerging best practices. Similarly, senior internal auditors should apprise the board of financial conditions that could make the company attractive to hedge fund activists, such as a substantial cash balance. When there is excess cash, management should disclose what it is going to do with it, such as share repurchases, returning it to shareholders through a special dividend, or reinvesting it.
The working group also suggests that boards should understand the rationale behind emerging governance standards and practices arising from recent proxy seasons or supported by proxy advisors or major shareholder interest groups. Directors should also encourage voluntary changes necessary to avoid being a target.
Boards should be open-minded, advised the report, and not assume that requests for change from a hedge fund always reflects hostility or short-term investment goals. The board should review any hedge fund demands in light of the company’s current strategy and financial condition, as well as the activist’s profile and the long-term interests of shareholders. While management should meet with hedge funds, said the working group, they must also consult with counsel on the impact of shareholder communication rules and Regulation FD.. It may sometimes be appropriate to request the hedge fund to execute a confidentiality agreement.
The company should also formulate a consistent response strategy to hedge fund requests and fully equip management to carry it out. In this pursuit, boards could form a special execution team composed of, for example, finance and governance officers and outside and inside counsel.
As for institutional investors, the working group urges them to consider the suitability of capital allocations in an activist hedge fund in the context of their overall portfolio and in light of their financial objectives. They should also seek regular communication with portfolio hedge funds on any activism agenda. Importantly, fiduciaries of pension plans, as well as other institutional investors should ensure that the decision to invest in an activist hedge fund relies on a thorough due diligence process.
Monday, April 28, 2008
Noting that the convergence of US GAAP and IFRS is proceeding at an appropriate pace, a European Commission working group found that US GAAP is equivalent to IFRS for use in EU markets. In its report, the working group also praised the SEC for its recent elimination of the need for foreign private issuers to reconcile IFRS-driven financial statements to US GAAP.
In reaching the conclusion that US GAAP is equivalent to IFRS, which was in concurrence with a CESR recommendation, the working group observed that the IASB and FASB have publicly committed to convergence between IFRS and US GAAP under a mechanism ensuring that new standards or interpretations do not create new differences between the two sets of standards. In addition, the report emphasized that the two boards plan to issue joint standards in future and are generally working together in a proactive manner.
The SEC abolished the reconciliation to US GAAP for foreign companies using IFRS as published by the IASB, not IFRS as published by the EU. There is concern over the carve out for hedge fund accounting in IAS 39, which makes IFRS as published by the EU different from IFRS as published by the IASB. While recognizing that such an exercise would be far less onerous than reconciling to US GAAP, the report notes that the overall EU objective is to eliminate all reconciliation.
The European Commission will continue to pursue this goal during the two-year transition period. Efforts will continue to resolve the issue of the carve-out of IAS 39. In this context, the working group calls on the IASB to play a full role. The European Commission adopted IAS 39 with two carve outs. One of those carve outs, the fair value option, has been removed. However, the other, on hedge accounting, remains.
Under the SEC’s rule, the reconciliation can be dispensed with only for issuers who use IFRS as published by the IASB. For the European Commission, the problem with this requirement is that no jurisdiction, including the European Union, has adopted the identical set of IFRS as published by the IASB.
The German Accounting Standards Board has noted that there is only one issue, which is the carve-out in IAS 39 of hedge accounting, in which the IFRS as adopted by the EU differ from the IFRS as published by the IASB. Since this difference relates to an accounting policy option, GASB reasoned, it does not result in an unavoidable difference in the financial statements.
The working group report also considered countries which are already successfully applying IFRS, including Australia; Hong Kong; and Singapore. Israel has made IFRS mandatory for all listed companies except for banks and dual listed companies as from January 2008. In these cases, the working group calls for an explicit and unreserved statement of such a compliance with IFRS to be included in the audited financial statements.
Saturday, April 26, 2008
Enhanced investor due diligence and strengthened risk management are the keys to the future of originate and distribute securitization, in the view of a senior UK FSA official. In remarks to the Euro 50 in London, Banking Director Thomas Huertas also said that banks and financial institutions that held senior super tranches and did not distribute them quickly enough took on massive amounts of unmanaged liquidity risk.
The director joined the growing consensus that originate and distribute securitization is here to stay; but must be completely overhauled. There is simply no turning back to the world of originate and hold. Analogizing securitization to nuclear energy, he said that its future depends on whether it is effectively managed and regulated.
The first thing that must be done, he continued, is to rebuild credibility with investors, which requires enhanced disclosure about the risks of securitization structures as well as information about the performance of the assets underlying the securitization. Although reformed credit rating agencies may endeavor to resurrect their crucial role as validators and evaluators of such information, the director believes that investors will move to a do-it-yourself model of robust due diligence. As part of that effort, they will demand ongoing information from the investment banks that underwrite new securitization issues. And, for their part, investment banks will need to think about how they warrant what they sell.
In addition, it is crucial for banks and other financial institutions to reform their own risk management practices. The most significant problems over the past year have been associated with banks that originated but did not distribute. For example, some banks thought that it paid to keep vast quantities of super senior tranches of securitized deals on their own books, he noted, quantities that amounted to several decades of daily trading volume in such securities.
In the banking director’s view, these super senior tranches become the financial equivalent of ``hula hoops piled up in the warehouse of a defunct retailer.’’ At the same time, banks were warehousing extensive amounts of mortgages, pending securitization, so that they could save on underwriting fees, thereby taking on massive amounts of liquidity risk. They simply did not distribute quickly enough, said the official, thus effectively taking on inventory risk. Ultimately, the financial institutions either ran out of funding or found that investors did not share their assumptions about the value of the merchandise that they had stockpiled.
In reforming their risk management practices, banks and other financial institutions must above all get two things right. First, they must build in the risk that really adverse events can occur and; second, take measures to protect themselves against these realistic disaster scenarios. He advised financial institutions to recognize that their own actions, including their policies with respect to remuneration, can have a material influence on whether they will or will not be subject to really adverse events.
In the near term, the FSA official called for action on three fronts. First, regulators must assure that banks keep adequate capital and better quality capital. They are already engaged in discussions with banks on this, and international forums such as the EU and the Basel Committee are reviewing the rules with respect to own funds. Second. regulators must assure that banks have adequate liquidity. Again, they are already engaged in discussions with banks on this, and the Basel Committee is reviewing the rules with respect to liquidity. Third, regulators must commit to intervene promptly when banks veer toward failing to meet these threshold conditions. If need be, governments should pass reform legislation to strengthen the ability of the authorities to make such interventions.
Thursday, April 24, 2008
Seeking to allay the fears of Senate Banking Chair Christopher Dodd, an SEC senior official outlined the Commission’s enforcement capabilities with regard to sovereign wealth funds. Ethiopis Tafara, Director of the International Affairs Office, told the committee that an effective enforcement mechanism takes on heightened importance when sovereign wealth funds are involved since, while cross-border enforcement assistance involving private actors is readily honored, help may not as forthcoming when the subject is the government itself.
But the SEC is not without tools, he assured, even when it comes to enforcement against a sovereign wealth fund. He emphasized that the SEC’s response would be firm if it was pursuing wrongdoing by a sovereign wealth fund and the jurisdiction in which it was based did not cooperate in the investigation. And even in the face of a lack of cooperation from the country in which the foreign actor is based, he continued, experience teaches that market manipulation, insider trading, and other illegal activities that take place in the market often leave sufficient evidence that the SEC can proceed with an enforcement action against the offender.
Moreover, being owned by a foreign government does not shield a sovereign wealth fund from liability under U.S. federal securities laws. It is a well-established principle that sovereign immunity does not extend to a state's commercial activities in another jurisdiction. While SEC enforcement cases involving a foreign entity are more complicated than those with no cross-border nexus, noted the director, the SEC staff has a strong track record of investigating such cases and working closely with its foreign counterparts in collecting evidence abroad. In 2007, the SEC sent more than 550 requests for assistance to foreign regulators, and received more than 450 in return. The SEC expects this number to grow as cross-border securities activity grows.
Importantly, he noted, cross-border regulator-to-regulator cooperation in enforcement investigations is now an international expectation. In 2002, IOSCO created a multilateral arrangement through which signatories to memorandums of understanding agree to share enforcement-related information. Currently, this arrangement has 47 signatories, with another 15 publicly committed to obtaining the legislation they need to provide this information. Further, in 2010, the ability to sign on to this MOU will become a criterion for continued IOSCO membership. Most of the governments that have sovereign wealth funds that invest in the United States are members of IOSCO, and many have already signed on to the MOU.
The director praised the international effort to develop best practices for sovereign wealth funds. He cited the IMF’s ongoing campaign to develop a set of voluntary best practices for sovereign wealth funds, as well as the European Commission’s proposed code of conduct for sovereign wealth funds. There is a growing consensus that sovereign wealth funds should disclose their investment positions and asset allocations and their governing home country regulations.
Here is a summary of the proposals from Washington, the only state so far to have them:
I. Issuers would file with the Administrator or his or her designee an initial notice on Form D consisting of either: (1) a copy of the notice of sales on Form D filed electronically with the SEC through EDGAR in accordance with Regulation S-T in effect on September 15, 2008; or (2) a temporary Form D in effect from September 15, 2008 through March 15, 2009. Form D would be manually signed by the issuer's duly authorized person or contain a photocopy of a manually signed copy. Form D would be filed in the above manner until a system allowing electronic filing of Form D with the Administrator or his or her designee is implemented and approved by the Administrator.
II. Issuers making an offering under either Rule 505 or 506 of federal Regulation D would file Form D and a $300 fee no later than 15 days after the first sale of the securities in Washington, or on the first business day following that date if the end of the period falls on a Saturday, Sunday or holiday. Issuers would include with the notice a statement indicating either the date of first sale of securities in Washington or that sales have yet to occur in Washington.
III. Issuers could file an amendment to a previously filed Form D at any time. Issuers would have to file an amendment to a previously filed Form D to correct a material mistake on the Form or to reflect a change in the information provided. No amendment would be required for changes that occur after the offering terminates or for changes to specified information.
IV. The prohibition against general solicitation or advertising in Regulation D offerings would not apply to an issuer's publication of a notice made in accordance with SEC Rule 230.135c or a notice of sales on Form D made with a good faith and reasonable attempt to comply with the requirements of Form D. The prohibition against general solicitation or advertising would also not apply to either press conferences or meetings conducted by journalists with representatives of the issuer or selling security holder outside the United States, or to written press release materials distributed outside the United States, in which a proposed or present securities offering is discussed, provided the requirements of SEC Rule 230.135e are complied with.
Blue Sky No-Action Letter: Fin. Mgmt. Advisory Co. Permits Retired Advisers to Participate in Fee-Based Program to Consult with Former Clients
In this situation from 2007, Merrill Lynch requested no enforcement action for permitting its financial advisers to participate, after retirement, in a fee-based program to consult with former clients without maintaining their agent and investment adviser representative registrations. Merrill Lynch probably made the no-action letter request to a number of state securities commissions, but we have published in the CCH Blue Sky Law Reporter the responses from Arizona and Kansas, that granted the firm's request.
Merrill Lynch contended its client transition program complied with NASD Rule IM 2420-2 and benefited both the participating financial advisers and their former clients by allowing the advisers, after retirement, to receive a declining fee for continuing to consult with the clients until a new adviser could be transitioned on to serve them. The Company's program, however, required the participating financial advisers to maintain their agent and investment adviser representative licenses after retirement. The no-action letter requested that registration after retirement not be required because of concern the financial advisers would switch, before retirement, to other firms that provided compensation for consulting but without the obligation of an "after retirement" registration requirement. The Company said that if the no-action letter request were granted, participating advisers would be prohibited from performing the functions of licensed agents and investment adviser representatives.
Tuesday, April 22, 2008
The private sector Code of Conduct on clearing and settlement has been very positive, said EU Commissioner for the Internal Market Charlie McCreevy, but at the same time he called on all infrastructures to fully respect and apply the Code in order to show that it can deliver competition. He reminded the industry that the Code is the last chance they have to prove that they are capable and mature enough to provide adequate solutions to the current issues. His remarks were delivered at a European Commission-European Central Bank seminar in Frankfurt.
The commissioner noted that the Code has significantly increased price transparency. There is now universal publication of fees, as well as much more clarity on discount and rebate schemes. Moreover, since the beginning of this year, services have also been unbundled and accounts will be provided on a separated basis.
But, he said that the main purpose of the Code is to facilitate greater competition in the post-trading sphere. He believes that there has been movement in the right direction on this front. The Code has injected momentum into the market. The appetite of post-trading infrastructures to go to other markets and to compete with incumbents has increased.
He pointed out that there are problems in the area of access and interoperability. While this is not a particular surprise because establishing links between infrastructures is a complex and time-consuming process, the issues do need to be sorted out in coming months.
Interoperability between central counterparties involves challenges for providers, users and regulators alike. Thus, he noted that all involved entities have a legitimate interest to study these issues in depth.
But he warned that endless foot-dragging is not going to be acceptable, either by incumbent infrastructures or their regulators. The Commission is monitoring the situation very closely to ensure that all actors involved respect the commitments of the Code, as well as broader obligations of, for example, a competitive nature.
In his first major address to the European Parliament, Gerrit Zalm, oversight chair of the IASB praised the SEC’s recent actions advancing the use of IFRS by foreign private issuers and US public companies. He also pledged that the IASB would avoid future carve-outs of IFRS. Moreover, with the global acceptance of IFRS accelerating, he proposed a new monitoring group for the IASB, which would include the SEC chair, and an increase in the size of the Board as an avenue to geographical diversity.
Chairman Zalm’s desire to avoid carve outs from international accounting standards comes against the backdrop of the problematic carve out of hedge fund accounting from IAS 39. The European Commission adopted IAS 39 with a carve out for hedge accounting. The carve out reflected criticisms by European banks that the application of IAS 39 would produce unwarranted volatility. A team of IASB members and staff have had extensive technical discussions with the European Banking Federation aimed at resolving this issue.
The global acceptance of IFRS is proceeding apace. The chair noted that more than 100 countries have agreed to require or permit the adoption of IFRS or have established timelines towards adoption. In the last year, Brazil, Canada, China, and India have all committed to formal timelines to adopt IFRS, and Japan established 2011 as its target for convergence to IFRS.
The chair is greatly encouraged that the SEC has eliminated the requirement that foreign private issuers reconcile IFRS-prepared financial statements to US GAAP. He is also buoyed by the fact that the SEC is giving serious consideration to a proposal to permit US public companies to use IFRSs. While the SEC is still in the process of considering this proposal, Chairman Zalm believes that it is reasonable to expect that US companies will be permitted to use IFRSs in the near future. In what the chair considers a major shift, even FASB is calling for the adoption of IFRS, not on the basis that it will be US GAAP under another name, but on the basis that it will remain a principles-based set of standards instead of a more rules-based system.
As the global acceptance of IFRS deepens, the IASB oversight foundation is moving towards more transparency and diversity. The foundation has improved its due process by broadcasting over the Internet all of its meetings and the meetings of its working groups; and posting on its website enhanced observer notes to enable interested parties to follow the IASB’s deliberations. The foundation is also providing a minimum of one year between the approval and the required application of new IFRS or major amendments to IFRS. The IASB overseer has also introduced feedback statements, impact assessments, and two-year post-implementation reviews.
In an effort to increase diversity, the foundation proposes to expand the IASB to 16 members. There will also be geographic minimums. Four IASB members must come from the Asia/Oceania region, with four to come from Europe. Four IASB members must come from North America, with the remaining four IASB members to be appointed from any area, subject to maintaining overall geographical balance.
Finally, the foundation will establish a Monitoring Group to end the practice of self-appointment and create a formal link to public authorities. Among other things, the Monitoring Group will review procedures for appointing IASB members, ensure adequate financing for the Board, and review the IASB’s compliance with its operating procedures. The group will be composed of the SEC chair, a European Commissioner, the chair of the Japanese Financial Services Agency, the IMF Managing Director, the chairs of the IOSCO technical and emerging markets committees, and the president of the World Bank.
Friday, April 18, 2008
As the European Commission initiative to reform the Lamfalussy process rolls on, Internal Market Commissioner Charlie McCreevy urgently called for the strengthening of the Level 3 committees in order to clarify their duties and properly equip them. In remarks to the EU Parliament Economic Committee, the commissioner said that four reform options are being explored.
The Lamfalussy process of EU financial regulation contains four levels. Level 1 is the adoption of the core Directive, followed by the Level 2 adoption of the implementing Directive. Level 3 involves interpretation by committees like CESR, while Level 4 deals with enforcement.
The first Commission option for reforming Level 3 would be to simply give the Level 3 committees a set of minimum, general responsibilities in the area of regulatory cooperation and convergence. This would be achieved by aligning the Commission decisions which created the Level 3 committees. The second option would be to modify the Commission decisions in order to include a non-exhaustive and flexible list of activities that the Level 3 committees should perform to foster greater regulatory cooperation and convergence. The third option, which the European Commission favors, would be to combine option 2, where necessary, with some targeted modifications to the relevant Level 1 Directives. The fourth option, which perhaps is the most radical, envisions the creation of European regulatory agencies to replace the Level 3 committees. Under this scenario, these agencies could adopt individual technical decisions applicable to market participants.
With regard to option four, noted the commissioner, seeking to transform the Level 3 committees into a single or separate agencies would be highly controversial and divisive. It would risk paralyzing the quick and practical progress that is so urgently needed. Furthermore, in his view, the real added value of this option remains to be demonstrated.
A securities fraud plaintiff pleaded "enough to give rise to inferences that are at least as strong as any competing inferences regarding scienter," wrote a 1st Circuit panel, as the court re-instituted one of four dismissed claims under a Tellabs analysis. The remand permitted the district court, to allow a limited discovery period on the issues raised.
A plaintiff class sued Boston Scientific, a medical device manufacturer, for securities fraud under four distinct allegations of securities fraud. The investor class claimed inadequate and misleading disclosures regarding 1) a civil fraud and contract lawsuit with another manufacturer, 2) a Department of Justice investigation into a 1998 product recall, 3) the company's introduction of TAXUS stents to the market, and 4) FDA investigations and warnings regarding Boston Scientific's plants. Only the TAXUS stent issue was before the court on appeal following the dismissal of all claims.
The class made several allegations concerning problems with the company's stent device. As alleged, the company knew of and did not reveal problems with the device from its use in Europe prior to its U.S. introduction, and the company's failure to disclose an FDA deficiency letter. The company also did not disclose a change in its manufacturing process, and according to the class complaint, the defendants misleadingly attributed any risks or problems to the unfamiliarity of doctors with the new device rather than to any functionality issues. This delay in addressing functionality evidenced scienter, according to the complaint, because of the desire of the defendants to build up inventory before announcing product recalls.
The district court dismissed all claims, finding in a pre-Tellabs decision that the allegations represented at most fraud by hindsight. "[N]o liability exists where a plaintiff's claim rests on the assumption that the defendants must have known of the severity of their problems earlier because conditions became so bad later on," wrote the trial court.
The 1st Circuit rejected this conclusion, however, because the district court failed to consider other allegations that the lead plaintiff made in its supporting documents. The panel found, in applying a Tellabs analysis, that "while there is support for defendants' inferences, we think, at this stage, that plaintiff's inferences are at least equally strong." Initially, the court found that it could draw a very reasonable inference that "defendants initiated the manufacturing change as a result of the complaints" it had received from Europe. Similar inferences could also be drawn from statements by the company's chief operating officer. These remarks to investors omitted any references to product problems, and were followed within a week by a recall announcement. While "[t]emporal proximity alone is insufficient to establish a claim for fraud," in this instance the COO was a "point person" on this product and "would presumably have been aware of the status of the company's `ongoing monitoring' of `old' TAXUS stents."
The appeals panel also noted that the trial court failed to consider insider trading claims as evidence of scienter. While noting that the fact of several insider transactions made outside the class period "undermines the inference that the timing of the trading was suspicious," and conceding that the insider trading claims "as alleged are on the weaker end of the spectrum" in terms of indicators of fraud, the court concluded, quoting a previous decision, that "we think that the
plaintiffs' allegations of insider trading, inasmuch as they are at least consistent with their theory of fraud, provide some support against the defendants' motion to dismiss."
The court declined to address the validity of claimed group pleadings, given that the trial court had not decided this issue. The panel also re-instated Section 20(a) controlling person claims.
Two private-sector committees established by the President's Working Group on Financial Markets have issued complementary sets of best practices for hedge fund investors and asset managers in the most comprehensive effort yet to increase accountability for participants in this industry. Given the global nature of financial markets, the best practices were designed to be consistent with the work that was recently done in the United Kingdom to improve hedge fund oversight The recommendations are open for public comment for 60 days. Based on the comment, the committees may revise the best practices and standards.
The committee on asset managers called on hedge funds to adopt comprehensive best practices in the critical areas of disclosure, valuation of assets, risk management, business operations, compliance and conflicts of interest. The investors’ committee recommended best practices that include two guides. A Fiduciary's Guide provides recommendations to individuals charged with evaluating the appropriateness of hedge funds as a component of an investment portfolio. An Investor's Guide provides recommendations to those charged with executing and administering a hedge fund program once a hedge fund has been added to the investment portfolio.
Both sets of best practices recommend broad innovative practices that exceed existing industry standards. The recommendations complement each other by encouraging asset managers and investors to hold each other accountable.
Analogizing from the key principles of public company disclosure, the asset managers committee urged hedge funds to provide investors with a comprehensive summary of their performance, including a qualitative discussion of hedge fund performance and annual and quarterly reports. The funds should also timely disclose material events.
Another crucial practice is to produce independently audited, GAAP-compliant financial statements so investors can get accurate financial information. Specifically, fund managers should provide financial information supplementing FASB Standard No. 157 to help investors assess the risks in the valuation of the fund’s investment positions. Although FAS 157 is not required to be fully implemented until the end of audit year 2008, fund managers should work closely with their auditors throughout the year for purposes of implementing it and the related practices.
Depending upon the extent to which the fund manager invests in illiquid and difficult-to-value investments, the disclosures should occur at least quarterly and include the percentage of the fund’s portfolio value that is comprised of each level of the FAS 157 valuation hierarchy. Level 1 is comprised of assets with highly liquid market prices, while Level 2 assets have no quoted prices but there are similar assets with quoted prices. Level 3 is for illiquid assets that have to be priced using models.
Because it is impossible to anticipate every potential conflict of interest relevant to the hedge fund industry, the report urges fund managers to establish a Conflicts Committee
to review potential conflicts and address them as they arise. For example, funds should segregate the functions between portfolio managers and non-trading personnel who are responsible for implementing the valuation process.
Fund managers should also establish a comprehensive valuation framework to
provide for clear and consistent valuations of all the investment positions in the fund’s portfolio, while minimizing potential conflicts that may arise in the valuation process. A best practice would be to set up a Valuation Committee with ultimate responsibility for reviewing compliance with the fund manager’s valuation policies and providing objective oversight of those policies. Further, independent personnel should be in charge of the valuation of the fund’s investment positions.
The report also urges fund managers to establish a comprehensive risk management framework that is suited to the size, portfolio, and investment strategies of the funds. Managers should identify the risks inherent in their investment strategies, and measure and monitor exposure to these risks. The risk management framework should be communicated to investors to enable them to assess whether the fund’s risk profile is appropriate for them and how the investment is performing against that profile.
As part of risk management, hedge funds should assess the creditworthiness of counterparties and understand the complex legal relationships they may have with them. The fund manager should monitor the exposure to counterparty credit
risk, including prime brokers and derivatives dealers, and understand the impact of potential counterparty loss of liquidity or failure.
The investors committee strongly urges hedge fund investors to conduct due diligence tailored to their individual circumstances and objectives and to the particular risk
and reward character of each hedge fund investment. They should also evaluate the risk management framework employed by a hedge fund manager.
Similarly, investors should obtain a full understanding of valuation since this can be the key to deciding whether to make an investment. Each investor should also develop a comprehensive philosophy regarding the payment of fees and expenses for all investment management services, relative to the returns sought and risk taken by an investment strategy.
Tuesday, April 15, 2008
A federal bankruptcy court has ruled that corporate officers, as well as directors, have fiduciary duties to the company under Delaware’s Caremark line of cases. While Delaware law does not impose fiduciary duty on employees generally, noted the court, it does impose failure of oversight fiduciary duty as to officers. In this action, the individual in question was not just an employee, but wore the twin hats of vice president of operations and general counsel. (Miller v. McDonald, B.C. District of Delaware, Apr. 9, 2008, No. 06-10166-PJW).
The trustee had alleged that the officer failed to implement any internal monitoring system and failed to utilize such system as is required by Caremark. The trustee further said that material misrepresentations contained in the company’s SEC filings were examples of such failure.
In support of its holding that corporate officers are fiduciaries, the court noted that in Walt Disney Co. Derivative Litigation, the Delaware Chancery Court said that the fiduciary duties of officers have been assumed to be identical to those of directors. Thus, an individual who was first named an officer and later became a director owed fiduciary duties to the company and its shareholders upon becoming a director.
The court also cited federal court rulings to the effect that, with respect to the obligation of officers to their corporation and its stockholders, there is nothing in any Delaware case suggesting that the fiduciary duty owed is different in the slightest from that owed by directors.
A 9th Circuit panel found that a district court improperly dismissed criminal securities fraud charges against two former corporate officers. The district court concluded that the government had engaged in quotedeceitful conduct quote in violation of due process by simultaneously pursuing civil and criminal investigations. In the alternative, the trial court ruled that if there was a criminal trial, all evidence provided by the individual defendants in response to SEC subpoenas should be suppressed. Additionally, the district court found that the government improperly interfered with or intruded into the attorney-client relationship of one of the defendants by accepting incriminating evidence about the entry from a defense attorney. The attorney had an apparent conflict of interest because she represented the corporation as well as an individual defendant.
The 9th Circuit panel vacated the dismissal of the indictments, however. According to the appellate court, a "standard form" letter sent to the defendants "fully disclosed the possibility that information received in the course of the civil investigation could be used for criminal proceedings." The panel reasoned that there was "no deceit," and that the government did not act wrongfully in its decision not to conduct the criminal investigation openly. "There is nothing improper about the government undertaking simultaneous criminal and civil investigations, and nothing in the government's actual conduct of those investigations amounted to deceit or an affirmative misrepresentation justifying the rare sanction of dismissal of criminal charges or suppression of evidence received in the course of the investigations," stated the court.
The court found the government had no duty to disclose the criminal investigation beyond what was stated in the form letter sent to the defendants. The civil investigation was also not a sham or pretext to produce information for the criminal prosecution. Claims that the conduct of SEC staff attorneys who instructed court reporters to refrain from mentioning the U.S. Attorney's involvement in the case and gave "evasive" answers to questions about the dual investigations were rejected.
According to the court,
in this case, the SEC made no affirmative misrepresentations. The SEC did advise defendants of the possibility of criminal prosecution. The SEC engaged in no tricks to deceive defendants into believing that the investigation was exclusively civil in nature. The SEC's Form 1662 explicitly warned defendants that the civil investigation could lead to criminal charges against them: "Information you give may be used against you in any federal . . . civil or criminal proceeding brought by the Commission or any other agency. " Defendants were represented by counsel, and the government provided counsel, so far as this record reflects, with accurate information.Finally, the court agreed with the government that it did not deliberately intrude into one of the defendants' attorney-client relationship because it received information that the attorney offered the government, wholly independent of any government conduct. According to the court, the defendant was fully aware of the attorney's potential conflicts of interest and had been advised of the risks of employing an attorney who also represented the corporation.
U.S. v. Stringer (9thCir)
A 2nd Circuit panel held that the Exchange Act Rule 16b-3(d) exemption applies to so-called "directors by deputization." (Roth v. Perseus, L.L.C.) In reaching this result, the appellate panel found persuasive the SEC's interpretation of Rule 16b-3(d) that such directors, even if they were also 10 percent holders, were protected by the rule. The court also found that the adoption of Rule 16b-3(d) was within the agency's exemptive authority under Section 16(b).
Rule 16b-3(d) exempts directors and officers, but not 10 percent holders, from Section 16(b) liability with regard to certain transactions with the issuer. As in effect at the time of the transactions in question, the rule applied to a grant, award or other acquisition from the issuer that 1) was approved by the board, or a board committee composed solely of at least two non-employee directors, 2) was approved or ratified by a majority vote of the shareholders or 3) involved the acquisition of securities held by the officer or director for a period of six months following the date of such acquisition.
In this case, Perseus, a private equity fund management firm (and its affiliates) acquired more than 10 percent of the common stock of Beacon Power Corp. Subsequently, two senior officers of Perseus were named to serve as Beacon directors. Perseus distributed 7.5 million Beacon shares to its members, pursuant to an investment agreement with Beacon which Beacon’s board approved. The members, in turn, sold the shares. A Beacon shareholder filed a derivative action claiming that the acquisition of the Beacon shares by Perseus, allegedly a director by deputization, could be matched with the member sales for Section 16(b) purposes.
The U.S. Supreme Court recognized the doctrine of directors by deputization in the 1962 decision, Blau v. Lehman. The high court found that a shareholder, such as a partnership or corporation, could be a director for Section 16 purposes "if the investor actually functioned as a director" and "had been deputized to perform a director's duties not for himself" but for the firm. In subsequent rulemaking, the SEC did not include deputization in its definition of a director. According to the Commission in 1988, it did not
propose to codify case law relating to deputization. Under that theory, a corporation, partnership, trust or other person can be deemed a director for purposes of Section 16 where it has expressly or impliedly "deputized" an individual to serve as its representative on a company's board of directors. In determining whether a person has been deputized for purposes of Section 16, the courts have looked at a variety of factors, focusing primarily on the alleged deputy's position of control within the deputizing entity and the deputy's independent qualifications to serve on the board of the issuing corporation. This fact-intensive analysis appears best left to a case-by-case determination.However, in its amicus brief, the Commission argued that "the rationale underlying Rule 16b-3(d), as set forth in the 1996 adopting release, applies not just to named directors but also to directors by deputization. Like named directors, in transactions exempted by the rule the director by deputization deals with the issuer and not in the market, and thus there generally is no informational disadvantage as there might be in market transactions."
The court also rejected the plaintiff's contention that the Rule 16b-3(d) exemption is inapplicable to a director by deputization that is also a 10 percent holder. The court noted that "the Commission’s adopting release, however, specifically addresses the rule’s application to ten percent holders who are directors, and it does so without drawing a distinction between named directors and directors by deputization." In that release, the SEC stated that Rule 16b-3 does not provide an exemption for persons who are subject to section 16 solely because they beneficially own greater than ten percent of a class of an issuer’s equity securities. Officers and directors owe certain fiduciary duties to a corporation. Such duties, according to the SEC, act as an independent constraint on self-dealing, and may not extend to 10 percent holders. The Commission emphasized that Rule 16b-3 is available "to such a person who is also subject to Section 16 by virtue of being an officer or director with respect to transactions with the issuer."
The court reasoned that the rule’s gatekeeping procedures...are no less effective simply because an officer or director also happens to be a ten percent holder, and that the fact that a person is both a ten percent holder and a director by deputization does not undermine the basis for the exemption. The same policies underlying Rule 16b-3(d) that support application of the rule to a 10 percent holder who is a named director apply to a 10 percent holder who is a director by deputization.
Finally, the panel deferred to the SEC’s opinion on whether the transactions exempted by Rule 16b-3(d) were comprehended within the purpose of Section 16(b). According to the court, a focus on preventing insiders from taking advantage of “information not available to others” supports the SEC’s contention that issuer-insider transactions, where both parties have the benefit of `insider' information, are not comprehended within the purpose of Section 16(b)."
Monday, April 14, 2008
As part of its ongoing project to revise and redraft auditing standards, the International Auditing and Assurance Standards Board revised the standard governing written statements that management provides to auditors to confirm certain matters or to support other audit evidence. These statements, referred to as written representations, are necessary information that the auditor requires in connection with the audit of the company’s financial statements. According to IAASB Chair John Kellas, the revised standard focuses on what is really necessary and, in particular, deals with concerns that auditors may over rely on representations at the expense of other evidence.
The revision is part of the Board’s Clarity Project, which involves the complete reengineering of the structure and format for writing international audit standards. As a precursor to converged international audit standards, the IAASB is presently redrafting and sometimes revising its entire body of audit standards.
The revised standard, ISA 560, requires management to provide written representations on two fundamental matters:
· That it has fulfilled its responsibility for the preparation and presentation of the financial statements; and
· That it has provided the auditor with all relevant information and that all transactions have been recorded and are reflected in the financial statements.
The auditor is also free to request other written representations during the course of the audit. The revised standard includes requirements for appropriate action by the auditor when written representations are not provided by management or are considered to be unreliable.
If management does not provide requested written representations, the auditor must discuss the matter with management and reevaluate management’s integrity and the effect this may generally have on the reliability of representations and audit evidence. Further, the standard requires the auditor to disclaim an opinion on the financial statements if it concludes that there is either sufficient doubt about the integrity of management such that the requisite written representations are not reliable or management does not provide the written representations.
ISA 560 also clarifies that, although written representations provide necessary audit evidence, they do not provide sufficient appropriate audit evidence on their own about any matters. Further, the fact that management has provided written representations does not affect the nature or extent of other audit evidence that the auditor obtains about the fulfillment of management's duties, or about specific assertions.
The revised standard allows management to include in the written representations qualifying language to the effect that the representations are made to the best of its knowledge and belief. It is reasonable for auditors to accept such wording if they are satisfied that the representations are being made by those with appropriate duties and knowledge of the matters included in the representations.
Sunday, April 13, 2008
A new Treasury-sponsored study on financial restatements found that there was a significant increase in restatements by 2005 accelerated filers during the 2003-2005 implementation period for internal controls reporting under section 404 of the Sarbanes-Oxley Act. The study also found that restatements associated with fraud and revenue declined after 2001. Fraud was a factor in 29 percent of all 1997 restatements, the study found, but only 2 percent of 2006 restatements. The proportion of revenue-related restatements also decreased from 41percent in 1997 to 11 percent in 2006. Not surprisingly, market reaction to financial restatements tended to be more negative when the restatement involved fraud or revenue errors.
The study, conducted by University of Kansas Professor Susan Scholz, provides one of the most in-depth looks at the soaring number of financial restatements in the years before and after the Sarbanes-Oxley Act. Treasury did not ask the study's author to develop policy recommendations. Rather, the study was intended to inform federal regulators and advisory committees, such as the SEC's Advisory Committee on Improvements to Financial Reporting.
Broadly, the study found that the enactment of Sarbanes-Oxley affected restatement activity in several ways. For example, section 302 required senior executive and financial officers to provide formal assurance that internal controls were adequate and that the financial statements were fairly presented. Combined with section 404 reporting on the effectiveness of internal controls, the focus on internal control attestation and reporting appears to have increased restatements announced during the 2003-2005 section 404 implementation period.
Beginning with financial statements for fiscal years ending on or after November 15, 2004, section 404 regulations required U.S. accelerated filers to document, test and report on internal controls over financial reporting (ICFR). Auditors were also required to attest to management’s internal controls assertions. Efforts to implement these requirements began as early as 2003, intensifying in 2004 and culminating in the first ICFR reports in early 2005. Implementation of ICFR processes sometimes identified ongoing misstatements.
The study also found that another factor increasing the attention on financial reporting quality was the establishment of the PCAOB as the public company auditor regulator with an inspection process and enforcement authority.
The study drilled down into restatements by companies that were accelerated filers mandated to report on the effectiveness of internal controls under section 404. There was a significant increase in restatements by 2005 accelerated filers during the 2003-2005 ICFR implementation period. During this time, accelerated filers announced 47 percent of restatements. In contrast, in the pre-2003 period, companies destined to be classified as accelerated filers for 2005 were responsible for 33 per cent of all restatements. The percentage drops to 40 per cent in 2006
Although some accelerated filers would have announced restatements absent ICFR implementation, said the report, nearly a quarter of all 4,923 restatements (1997-2006) wee made by 2005 accelerated filers during ICFR implementation (2003- 2005).
Data indicated that about 3,700 companies issued ICFR reports in the first year of required reporting. This suggests that approximately 31 per cent (1,156 of 3,700) of accelerated filers restated their financial reports over the three-year period.
But not all restating accelerated filers reported ineffective controls. Of the 349 accelerated filers restating in 2004, only 137 reported ineffective controls in their initial report for fiscal year end 2004, typically filed in early 2005. Of the 527 companies announcing restatements in 2005, 263 initially reported ineffective controls. This count was later revised upward, presumably because companies later discovered misstatements.
PCAOB Member Bill Gradison has added his voice to the growing call for convergence of US and international audit standards. In fact, in remarks to the American Accounting Association, he said that this year the PCAOB may move the issue of multiple auditing standards ``to the front burner.’’ Specifically, he mentioned that the Board’s own Strategic Plan, under the general goal of playing a leadership role in international efforts to improve auditor oversight and auditing practices and reduce duplication of effort, commits the Board to examine the implications for the PCAOB’s mission of multiple auditing standards and varying audit environments across global capital markets and consider how the Board should respond.
In the past six months, PCAOB senior officials have agreed in principle that there is a strong movement towards international auditing standards, but at the same time recognizing that significant differences remain, including the internal control standard mandated by the Sarbanes-Oxley Act. And Member Gradison mentioned that there has been no global groundswell of support for the Section 404(b) requirement that audits of US issuers include an integrated audit to determine the effectiveness of internal controls.
In his view, there are two separate but related issues on the road to convergence. First, there is the appropriateness of the objectives and requirements of the standards themselves. Second, there is the operational issue of the formatting of the standards, which involves the clarity of the wording, organization, and presentation, all of which may impact the auditors’ ability to understand and follow the standards. As a corollary, there is also the ability of inspectors to monitor compliance.
The Member noted that the Board is already taking some concrete steps in the area of international audit standards. For example, in considering proposed PCAOB standards, a current priority for the Chief Accountant is how PCAOB standards relate to those of the IAASB.
Working towards convergence of auditing standards globally is likewise a theme that has emerged from discussions of the PCAOB’s Standing Advisory Group.
Further, it is a perspective receiving prominence in the recommendations of other groups. For example, the Bloomberg/Schumer Report suggested that the PCAOB take a leadership role in establishing the standardization of world-wide auditing standards as a priority for the relevant national bodies.
Member Gradison noted that the Board’s recent proposed guidance on achieving full reliance on the inspections of foreign audit firms by non-US audit regulators also opened a window into how people think about international audit standards. For example, in its comment letter on the proposed guidance, the Swiss Federal Audit Oversight Authority welcomed convergence so that the differences between the auditing of financial statements pursuant to US law and Swiss law will be minimal. Similarly, the global audit firm Mazars noted that the problems of implementing a full reliance regime demonstrate the importance of accelerating convergence towards international audit standards. And another global firm, KPMG, urged the Board to achieve full international convergence of inspection and registration regimes, like in the area of accounting standards and auditing standards.
Wednesday, April 09, 2008
The International Banking Federation has urged standard setters to implement a mixed measurement model in place of full fair value accounting. The FASB and IASB were advised that a mixed measurement model provides investors with better information for evaluating financial instruments. The mixed model requires fair value measurement for assets and liabilities managed on a fair value basis. But at the same time it recognizes that not all financial instruments are managed on a fair value basis, or are even capable of reliable fair value measurement.
The Federation represents the view of the international banking community on the relative merits of fair value and mixed measurement when used as the primary measurement basis for the preparation of annual reports and other financial statements. In a conceptual paper, the Federation evaluated both fair value and mixed measurement against the qualitative characteristics that make information useful. On that basis, the banking group concluded that a fair value measurement is appropriate for financial instruments held for trading purposes or otherwise managed on a fair value basis.
A full fair value measurement model would, however, overstate the extent to which instruments are held for trading or managed on a fair value basis within the business. It would also exaggerate the extent to which deep and liquid markets exist. In addition, the Federation noted that the reality of a fair value model is extremely complex and intricate. Performance reporting cannot be achieved if the framework for financial reporting remains rigid and sticks to either an amortized cost model or a fair value one.
The Federation’s report comes against the backdrop of a recent IASB discussion paper on reducing complexity in financial statements. In that paper, 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 of the Board’s initiative is to reduce the current complexity by using a single measurement method for all financial instruments.
In the view of the Federation, the IASB has predetermined the outcome of the debate by offering a choice between full fair value today and full fair value tomorrow. This is at odds with the banking industry’s view that a mixed measurement model is essential for the faithful representation of an entity’s business model and how it generates earnings. Rather than concentrating on taking steps to implement a full fair value model, the IASB was urged to reduce complexity by simplifying the existing measurement requirements for financial instruments. The support of the international banking community is conditioned on the development of a measurement principle reflecting the reality of how business operates.
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.
Tuesday, April 08, 2008
Senate Securities Subcommittee Chair Jack Reed has asked the SEC to conduct an analysis of the issues before embarking on a system of mutual recognition, which he called a radical departure from current policy. At the same time, the European Commissioner for the Internal Market, Charlie McCreevy, recently reaffirmed his commitment to mutual recognition.
In remarks at the NASAA public policy seminar, Sen. Reed said that 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.
The senator is particularly concerned by the timing of the SEC’s mutual recognition announcement, which comes in the midst of a major market crisis that has raised questions about the adequacy of U.S. regulatory oversight. He emphasized how critical it is that the SEC ensure that U.S. investors do not suffer any diminished protections under a system of mutual recognition. This is especially crucial given that no other market enjoys comparable participation by retail investors, he noted, or the benefits and responsibilities that such participation brings.
Senator Reed also emphasized that no other regulator is likely to share the SEC’s commitment to protecting U.S. investors, particularly if that protection comes at the expense of its domestic firms. Thus, he will send the Commission a letter requesting an analysis of issues before undertaking such a radical departure; and follow up with hearings on the topic.
In remarks to the European Parliament, Commissioner McCreevy said that if the regulators calibrate the conditions correctly it could lead to ``immense’’ rewards. Mutual recognition would also be a much needed show of confidence, he added, and would help to restore trust in the markets. In this spirit, the Commissioner praised as a very positive development the substantial progress made in the recent months on the US side, particularly, the SEC’s confirmation that it will work with the European Commission and CESR to develop a framework for mutual recognition.
Thursday, April 03, 2008
Noting an almost 50% decrease in disgorgements in 2007, Senate Banking Committee Chair Christopher Dodd and Securities Subcommittee Chair Jack Reed have asked the GAO to review whether the SEC’s Division of Enforcement has sufficient staff and funds to perform its mission and whether there have been fundamental changes in operation to the way they handle cases. The senators wonder if changes have taken place in the Commission’s enforcement philosophy or scope of activity. Separately, Sen. Reed asked the SEC to conduct an analysis of the issues before embarking on a system of mutual recognition, which he called a radical departure from current policy. In remarks at the NASAA public policy seminar, he also called for the reform of the credit rating agencies.
With U.S. markets in disarray, he noted, the SEC and PCAOB have stepped up their efforts to converge and harmonize with international standards. The subcommittee chair is particularly concerned by the timing of the SEC’s mutual recognition announcement, which comes in the midst of a major market crisis that has raised questions about the adequacy of U.S. regulatory oversight.
The senator emphasized how critical it is that the SEC ensure that U.S. investors do not suffer any diminished protections under a system of mutual recognition. This is especially crucial given that no other market enjoys comparable participation by retail investors, or the benefits and responsibilities that such participation brings, he added, and no other regulator is likely to share the SEC’s commitment to protecting U.S. investors, particularly if that protection comes at the expense of its domestic firms.
Thus, he will send the Commission a letter requesting an analysis of issues before undertaking such a radical departure; and follow up with hearings on the topic.
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.
Also disconcerting to the senator is that the SEC requested less than a 1% increase in its operating budget for 2009. This is a significant concern given that increased demands are being placed on staff and the agency during this critical time. Further, it was recently reported that, with the naming of a director of risk assessment at the SEC, the total number of individuals working in that office had doubled to two. The oversight chair was astounded that this office, which is charged with maintaining the overall process for risk assessment through the SEC and serves as a resource for other offices in their risk assessment efforts, up until last month had only one person working in it.
That said, the senator understands that Chairman Cox has committed to hiring additional staff this year. But one is still left to wonder, he said, why there was such barebones staffing in an office with a critical mission to identify systemic risks.
There must be reform of the credit rating agencies, he posited, as the evidence builds on the shortcomings of the rating agencies and their role in the recent market troubles. As part of the reform, the oversight of credit rating agencies needs to be strengthened. The rating agencies failed to understand the securities they were rating and failed to proactively monitor these securities resulting in stale and inaccurate ratings.
The system was also beset by an incentive structure driven by fees, he said, and a process geared towards fueling the demand for poorly written loans in which each part of the chain delinked as soon as the fees were collected.
In his view, it was a glaring omission on the part of the Treasury’s blueprint not to include a recommendation on how and where credit rating agencies can be better regulated. The SEC either needs to have more authority to ensure that the conflicts are managed appropriately and that the ratings are credible or a new agency needs to be established. Fundamentally, he reasoned, credit rating agencies, like auditing firms, are gatekeepers and, as such, play a critical role in the capital markets.
But, in the end, financial regulators are the ultimate gatekeepers, he observed, and a regulatory structure that limits risk in one area but is unable to contain it in others will ultimately leave all investors exposed to volatility in the financial system. Overall, the SEC and other financial regulators have to more rigorously examine financial institutions and require better disclosures of products sold to investors so that they are aware of the true risks.
Wednesday, April 02, 2008
Company directors who approved spring loaded and bullet dodged stock option grants may have breached their fiduciary duty and forfeited the protection of the business judgment rule, held the Delaware Chancery Court, since the spring-loading and bullet-dodging practices constituted material information that should have been disclosed. Vice Chancellor Lamb also ruled that the alleged stock manipulation supported a claim of corporate waste. While recognizing that a claim of waste must satisfy a difficult test, the court noted that the allegations were not so much that the grants were excessive, but that the directors and officers should not have received any of the timed options at all, and that the grants were approved without any valid corporate purpose. (Weiss v. Swanson, Del Chan Ct, Mar 7, 2008, No. 2828-VCL).
In its earlier Tyson ruling, the Chancery Court ruled only that the practice of spring-loading options was material. This appears to be the first ruling that bullet dodging is also material information that should have been disclosed.
The challenged options were granted pursuant to stockholder-approved option plans. But the shareholder alleged that the directors bullet-dodged the options by delaying their grant until after the release of adverse information and, conversely, when the quarterly earnings release contained positive information expected to drive up the market price of shares, they spring-loaded the options by granting them just prior to the earnings release, without ever disclosing to stockholders that they timed option grants in this manner.
It was reasonable to infer that stockholders would consider the practice of timing options to be important in deciding whether to approve the option plans or to reelect board members. Under Tyson, because the allegations support an inference that the directors never disclosed this practice in the plans themselves, subsequent proxy statements, or SEC filings describing the option grants, the allegations also give rise to an inference that the directors violated their fiduciary duties. Echoing Tyson, the Vice Chancellor said that shareholders have a right to the full, unvarnished truth in the area of executive compensation, and therefore directors, as fiduciaries, have a duty to disclose all material information when seeking stockholder approval of an option plan, or when disclosing an option grant.
The court noted that, unlike the disclosures in Tyson, the company’s disclosures did not
affirmatively state that all options were granted with a fair market value strike price. Rather, the disclosures appear to be much more ambiguous about the options’ strike prices. For example, the compensation committee reports accompanying annual proxy statements stated that the corporation retained the right to grant options that did not qualify for treatment under IRC section 162(m), indicating grants may have been issued in the money, i.e., with a below fair market value strike price. These grants would not be considered performance based under 162(m) and thus not outside the $1 million cap on executive pay.
Therefore, the inference of impropriety is somewhat weaker in this case than it was in Tyson. Nonetheless, the shareholder alleged facts creating a reasonable doubt that the option grants resulted from a valid exercise of business judgment.
The court rejected the directors’ argument that this case is distinguishable from Tyson because the SEC had ceased its investigation of the company. The allegations in this case involve whether the directors violated their fiduciary duties, not federal securities law, noted the court. Therefore, it is immaterial to this case that the SEC ceased its investigation.