Thursday, May 29, 2008

5th Circuit: No Private Money Damages Available for
13(d) Violations


A 5th Circuit panel followed the lead of earlier decisions from the 2nd and 11th Circuits and
found that no private cause of action for money damages existed for violations of Exchange Act Section 13(d). The case arose from a failed attempt by Highland Capital Management, an investment fund, and its affiliates, to take over Motient Corp., an Illinois-based wireless communications company. The litigation in federal court on the 13(d) violations was one of several actions involving Motient and James Dondero, the principal of the investment fund group and a Motient director.

As alleged, the investment group filed Schedule 13D amendments "containing false, incomplete, and misleading information about the company, its management, and its board." Motient sought a declaratory judgment, an order that the investment group immediately amend the Schedule 13D amendments, injunctive relief preventing the buyers from taking further actions to purchase or sell Motient securities or solicit shareholder votes, and compensatory damages.

The appellate panel agreed with the district court's finding that the claims for money damages were not actionable. The court observed that "[t]he Williams Act was enacted to protect shareholders who are forced to make decisions between bidders and management. Since any material misstatement or omission to an investor who purchases or sells the security and actually relies on that information gives rise to a private cause of action under Section 18(a) of the Exchange Act, 15 U.S.C. § 78r(a)." This section, concluded the court, "provides the sole basis for a private right of action for damages resulting from a violation of Section 13(d)" and "Motient provides no compelling reason for recognizing a private right of action in favor of issuers for money damages."

The court also concluded that the requests for equitable relief were moot because the proxy fight was over and the investment fund had sold its Motient securities. "We decline to issue an advisory opinion forbidding Highland from soliciting shareholder votes for a tender offer or engaging in a contest for control, on the assumption that such activity might take place in the future," concluded the court.



Motient Corp. v. Dondero, May 27, 2008.

Tuesday, May 20, 2008

States Propose Adding Senior Provisions to List of Unethical Practices for Broker-Dealers, Agents, IAs and IA Reps.

Missouri, Virginia and Washington are among the first states to propose rules prohibiting state-registered broker-dealers, agents, investment advisers and investment adviser representatives from using certain professional designations that state or imply specialized knowledge of the financial needs of senior investors. These rules are being promulgated to combat the abuse the North American Securities Administrators Association (NASAA) is documenting in the senior community now starting to be comprised of the first wave of Post WWII baby boomer retirees. Broker-dealers, agents, investment advisers and investment adviser representatives are holding free lunch seminars with seniors at which they proclaim themselves to have specialized knowledge and credentials for handling the financial needs of senior citizens. Under the proposed rules, the use of "senior designations" by a broker-dealer, agent, investment adviser or investment adviser representative would be a fraudulent, unethical practice. Only those professional designations attained through prescribed training offered by a nationally recognized accredited institution would be approved professional designations by the states' securities regulators.

Friday, May 16, 2008

Fed Chair Details Regulatory Response to Risk Management Failures

Federal Reserve Board Chair Ben Bernanke has concluded that a failure of effective enterprise-wide risk management was a major cause of the recent subprime market turmoil. A regulatory response is demanded, he noted, and the Fed is planning one involving additional guidance and joint international efforts. In remarks at a recent Chicago Fed seminar, the chair also discussed individual core components of risk management, including risk identification and liquidity risk.

Given the central role of effective, firmwide risk management in maintaining strong financial institutions, emphasized the Fed chair, regulators must redouble their efforts to help organizations improve their risk management practices. Thus, the Fed is giving increased attention to financial institutions that are in most need of improvement, but will also continue to remind the stronger institutions of the need to remain vigilant, particularly in light of the ongoing fragility of market conditions.
The Fed is considering the issuance of revised guidance regarding various aspects of risk management, including further emphasis on the need for an enterprise-wide perspective when assessing risk. The Fed is also working through the Basel Committee on Banking Supervision to develop enhanced guidance on the management of liquidity risks. At the same tine, the Fed is promoting better disclosures by financial institutions with the goal of increasing transparency.
Implementation of the Basel II Accord will also be of help, said the chair, since Basel II enhances the quality of risk management by tying regulatory capital more closely to institutions' underlying risks and by requiring strong internal systems for evaluating credit and other risks. Although Basel II will by no means eliminate future episodes of financial turbulence, reminded the chair, it should help to make financial institutions more resilient to shocks and thus enhance overall financial stability.
At the same time, the Fed will ensure that the Basel II framework reflects the lessons of recent events. The Basel Committee has been evaluating how the framework might be strengthened in areas such as the capital treatment of off-balance-sheet vehicles and the use of credit ratings. The relatively lengthy transition to Basel II will allow more opportunity to absorb the lessons of the financial turmoil and make necessary adjustments to the framework.
For risks to be successfully managed, reasoned the Fed chair, they must first be identified and measured. Unfortunately, recent events revealed significant deficiencies in these areas, with a notable example being the underestimation of the credit risk of subprime mortgages and tranches of securitized products. Other firms did not fully consider the linkages between credit risk and market risk, leading to mismeasurement of their overall exposure.
Stress tests can provide a valuable perspective on risks falling outside those typically captured by statistical models, noted the official, such as risks associated with extreme price movements. Stress testing forces practitioners to step back from daily concerns to think through the implications of scenarios that may seem relatively unlikely but could pose serious risks to the firm if they materialized. For stress tests to be useful, they should be relevant to the business at hand, change with market and risk positions, and, have an impact on management's decisionmaking. Applying stress tests to several business lines at the same time is operationally challenging, he acknowledged, but exercises of this type can reveal previously undetected firmwide risk concentrations that cut across the banking book, the securities portfolio, and counterparty exposures.
In his view, another crucial lesson from recent events is that financial institutions must understand their liquidity needs at an enterprise-wide level and be prepared for the possibility that market liquidity may erode quickly and unexpectedly. Weak liquidity risk controls were a common source of the problems many firms faced. He urged financial institutions to develop firmwide strategies for liquidity risk management that incorporate information from all business lines. A best practice is to develop firmwide strategies that include consideration of the liquidity risks associated with structured investment vehicles.
With Enron Loophole Closed; Senate Looks to International Markets

With the Enron Loophole closed by recent passage of the Farm Bill, key senators now want to ensure adequate market protections for the trading of U.S. energy future contracts on international markets. In a letter to CFTC Acting Chair Walter Lukken, Senators Diane Feinstein and Olympia Snowe expressed concern that, when the Enron Loophole is finally closed, there will be a lack of comparable protections in place for trading of U.S. energy futures on international markets. Allowing the trading of US commodities in a foreign jurisdiction presents the potential for a significant loophole in oversight that must be closed, they emphasized.

The senators noted that the CFTC has allowed US energy traders to trade energy commodity futures contracts on European exchanges, even for United States based energy products. The CFTC allows this because it has recognized the UK regulations enforced by the Financial Services Authority as comparable to US regulation, and because it receives data from the FSA on trading activity in U.S. based contracts.

The senators are concerned that the CFTC has declared FSA regulation comparable even though they do not reflect some of the core principles of the Commodity Exchange Act. Specifically, exchanges in London are not required to monitor daily trading to prevent manipulation, publish daily trading information, or impose and enforce position limits that prevent excessive speculation.

The senators are aware that the CFTC and FSA signed a Memorandum of Understanding (MOU) in 2006 establishing a framework for the agencies to share information that the respective authorities need to detect potential abusive or manipulative trading practices involving trading in related contracts on U.K. and U.S. derivatives exchanges. They now request an update on the nature of the oversight currently preventing manipulation in US energy contracts traded abroad. Specifically, they want to know if the CFTC has asked the FSA to impose speculation limits when U.S. commodities are traded under the FSA’s jurisdiction.

They also want to know which system is more likely to prevent manipulation if the CFTC imposes speculation limits and the FSA does not. More broadly, the senators request the CFTC to explain what steps it is taking to monitor US energy commodities traded abroad. For example, how many times has the CFTC referred a suspected manipulation case to the FSA.
Volcker Says Regulate Investment Banks Like Commercial Banks in Light of Subprime Crisis

Former Federal Reserve Board Chair Paul Volcker told Congress that the natural corollary of the Fed’s Bear Stearns action is that systemically important investment banks should be regulated along the same basic lines as the commercial banks that they closely resemble. Further, if the Fed is to be given an increased role as a market stability regulator, he called for legislation clearly designating a senior Fed official with direct responsibility for prudential market regulation.

In testimony before the Joint Committee on Economics, the former chair reasoned that, however unique was the Fed’s action in extending the safety net to an investment bank experiencing a devastating run, it is inevitable that the nature of the Fed’s response will be taken into account and be anticipated by officials and market participants alike in similar future circumstances.

Given that, he continued, several issues must be resolved by legislation or otherwise. For example, he asks if regulation should be extended to all investment banks and, if so, what is an accepted definition of an investment bank. The next question is what to do about hedge funds. While few hedge funds could reasonably meet the test of systemic importance, he noted, a few years ago a large heavily engineered hedge fund suddenly came under market pressure and was judged to require assistance by the Fed in the form of moral suasion among its creditors.

More broadly, he said that public policy questions are raised by the Fed’s direct intervention into the financial markets, a departure from its time-honored practice of limiting the direct purchase of securities to government obligations. One questions is whether the Fed’s intervention in a broad range of credit market instruments may imply official support for a particular sector of the market.

Mr. Volcker also emphasized that marker reforms cannot proceed independently without a high degree of cooperation with other leading financial powers, especially the European Union and Japan. In a world of globalized finance, he observed, idiosyncratic national approaches cannot be fully effective and may even be counter-productive. Echoing these sentiments, Senator Charles Schumer, chair of the committee, noted that national regulations can only achieve so much in a global financial market. New regulation will do us no good, he proclaimed, if other countries remain lax in their regulations or their enforcement. He also emphasized that the global financial regulatory system should not be the arithmetical equivalent of the lowest common denominator.

The senator also noted that there are no longer any clear distinctions between commercial banks, investment banks and, for that matter, broker-dealers. As large investment banks have come to act more and more like commercial banks, especially now that they can borrow from the Fed’s discount window , then they need to be supervised more strictly The current market is characterized by a large number of financial institutions surrounded by many smaller institutions, such as hedge funds, with their own specialties, a situation the senator characterized as a handful of ``large financial Jupiter encircled by numerous small asteroids.’’ The regulatory structure has to recognize that change. .

Finally, the chair said it is imperative to regulate the currently unregulated parts of financial markets. For example, credit default swaps are a multi-trillion dollar industry almost completely outside the purview of regulators. He advocates the creation of a clearinghouse for
credit default swaps. He would also consider a unique exchange for these swaps as an even more effective way to bring about greater transparency and limit systemic risk.

Thursday, May 15, 2008

Veto-Proof Farm Bill Terminates Enron Loophole and Reforms Electronic Energy Markets

Congress has passed a veto-proof measure reauthorizing the CFTC and closing the Enron loophole as part of a massive Farm Bill. Provisions in the Food, Conservation and Energy Act (HR 2419) would end the Enron-inspired exemption from federal oversight now provided to electronic energy trading markets set up for large traders. It will ensure the ability of the CFTC to police all US energy exchanges to prevent price manipulation and excessive speculation. These bipartisan provisions would give the CFTC the ability to scrutinize these transactions in energy commodities and prosecute traders that are manipulating energy prices. The House passed the bill 318-106; the Senate vote was 81-15

The Enron loophole was codified in Section 2(h)(3) of the Commodity Exchange Act. It exempts from oversight the electronic trading of energy commodities by large traders. In closing the Enron Loophole, the measure would increase federal oversight to detect and prevent manipulation and to limit speculation in U.S. electronic energy markets. It would increase transparency, and create an audit trail, impose firm speculation limits, and significantly increase financial penalties for cases of market manipulation and excessive speculation. The measure was approved as part of the CFTC Reauthorization Act of 2008, which is Title XIII of the Farm Bill.

The Enron loophole has allowed large volumes of energy derivatives contracts to be traded over-the-counter and on electronic platforms without the federal oversight necessary to protect both the integrity of the market and energy consumers

The Act puts all significant energy trades on electronic platforms within the regulatory confines of the CFTC and imposes limits on the size of trader’s positions to prevent excessive speculation. It also ensures that there is an audit trail, imposes recordkeeping requirements, and forces electronic exchanges to monitor trading behavior and prevent manipulation.

For contracts that are significant in determining commodity market prices, the CFTC will require the electronic exchange to provide strict oversight, similar to what takes place on regulated markets like the New York and Chicago Mercantile Exchanges. The exchanges will be required to monitor trading to prevent manipulation and price distortion; ensuring that contracts are not susceptible to manipulation; limiting the size of positions to prevent excessive speculation, and; reducing holdings of traders in violation of position limits. The exchanges will also have to establish an audit trail by collecting information on trading activity and supplying large trader reports to the CFTC. They will also have to enhance transparency by publishing price, trading volume, and other trading data on a daily basis.

The Act directs the CFTC to review all electronic contracts to identify those that are significant in determining market prices and thus must be regulated under the measure. The CFTC will consider the following factors in making that determination: 1) If the contract is traded in significant volumes; 2) If the contract is used by traders to help determine the price of subsequent contracts. This is like using “comps” in the real estate market or “Blue Book” for auto sales; 3) If the contract is equivalent to a regulated contract and used the same way by traders. The CFTC refers to these contracts as “look-alikes.”

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

One prime genesis of the measure was the fact that, when the Amaranth hedge fund was directed to reduce its position in regulated natural gas contracts, it simply moved its position to an unregulated exchange. The bill would essentially say that similar contracts on ICE and NYMEX will be regulated the same way.

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

The CFTC is directed to adopt rules implementing the authorities provided by this Act regarding significant price discovery contracts. The conference report indicates that the Commission can consider the potential for arbitrage between a potential significant price discovery contract and an existing such contract in making a determination whether a contract has that status.

The conference report clarifies that, in determining appropriate position limits or position accountability limits under the Act, an electronic trading facility must consider cleared swaps transactions that are treated by a derivatives clearing organization as fungible with significant price discovery contracts.

Portfolio Margining

Following enactment of the CFMA, the CFTC and the SEC jointly promulgated rules relating to the margining of security futures products. Under those rules, security futures products have been subject to the same fixed-rate strategy-based margining scheme applicable to security options customer accounts, rather than the risk-based portfolio margining system typical in the futures industry. Many have argued that this has contributed to the low volume of trading in such products which, by contrast, have been successful in Europe.

The Act directs the CFTC and SEC to use their existing authorities to allow customers to
benefit from the use of a risk-based portfolio margining system for both security options
and security futures products. The detailed statutory test of a narrow-based security index was tailored to fit the U.S. equity markets, which are by far the largest, deepest and most liquid securities markets in the world. The Act provides clarity in this area by requiring the CFTC and the SEC to adopt rules providing criteria that will exclude broad-based indexes on foreign equities from the definition of narrow-based security index as appropriate.

Thus, the measure requires the President’s Working Group on Financial Markets to work with the SEC and the CFTC to allow risk-based portfolio margining for security options and security futures products by September 30, 2009; and the trading of futures on security indexes by June 30, 2009, by resolving issues related to foreign security indexes.

Wednesday, May 14, 2008

Three Former SEC Chairs Endorse Obama Presidential Bid

Three former SEC chairs have endorse Democratic Sen. Barack Obama's bid for the presidency William Donaldson, Arthur Levitt and David Ruder, will join former Fed Chair Paul Volcker in endorsing Sen. Obama, his campaign said. Mr. Volcker endorsed Sen. Obama in January. In a statement released by the campaign, the former chairs said they believed that Sen. Obama would take a "reasoned approach" to "balanced regulatory reform."

Among other things, the senator has called for improved transparency in the market by investigating potential conflict of interest between credit rating agencies and financial institutions. Credit agencies are paid by the issuers of securities, not by the buyers of securities, which creates a potential conflict of interest in favor of issuing strong securities ratings. This problem was illustrated in the subprime market crisis in which credit rating agencies strongly rated subprime mortgage securities even as there weresignificant indications of large numbers of foreclosures and a weakening housing market. Sen. Obama supports an immediate investigation into the ratings agencies and their relationships to securities’ issuers, similar to the investigation the EU has recently announced.
FASB Chair Emphasizes Role of Disclosure in Fair Value Accounting

In the aftermath of the role of fair value accounting in the market crisis, FASB Chair Robert Herz noted that fair value is not a new concept and is not required in many instances. Similarly, in a recent FASB issues fact sheet, the chair reminded that the use of fair value in determining writedowns in periods of down markets is not new.

While conditions in the credit markets pose significant challenges in valuing a number of asset classes, he said, the concepts and practices employed in valuing illiquid and non-marketable assets are not new. They have been used for many years in valuing a wide range of items for financial reporting purposes, including intangibles, illiquid securities, and complex derivatives. In such situations, the FASB chair emphasized that clear and ample disclosures are critical in helping investors make informed decisions.

SFAS 157 establishes a fair value hierarchy that prioritizes the inputs that should be used to develop the fair value estimate. The fair value hierarchy prioritizes quoted prices in active markets for identical assets or liabilities (Level 1). In the absence of quoted prices in active markets for identical assets or liabilities, the fair value hierarchy allows for the use of valuation techniques, such as pricing models that incorporate a combination of other inputs. Those other inputs consist of observable inputs that are reasonably available in the circumstances, including quoted prices in markets for comparable assets or liabilities (Level 2), and unobservable inputs in illiquid markets (Level 3).

While Level 3 estimates can be difficult and require the use of significant judgments, acknowledged Mr. Herz, investors have indicated that such estimates provide more relevant and useful information than alternatives that ignore current economic conditions and that can introduce management bias into the estimation process, such as those that involve smoothing techniques.

SFAS 157 requires expanded disclosures about the Level 3 estimates used for financial assets and liabilities that are reported at fair value on an ongoing basis. Those disclosures focus on the effect of the estimates on reported earnings and financial position. Recently, the SEC staff issued a letter encouraging public companies to provide additional disclosures about the Level 3 estimates used for financial assets, including asset-backed securities and derivatives, in their Management Discussion & Analysis. According to Chairman Herz, the letter does not, as some have asserted, interpret, amend, or otherwise change the application of SFAS 157.
Clinton Bill Would Require Shareholder Advisory Vote on Executive Pay

A bill (S 2866) recently introduced by Senator Hillary Clinton would require a voluntary shareholder advisory vote on a company’s executive compensation package. The bill is similar to a measure that passed the House last year requiring that companies include in their annual proxy to investors the opportunity cast a non-binding vote on the company’s executive pay packages. In 2006, the SEC took a major step forward by requiring that companies significantly improve their executive compensation disclosures to shareholders. Financial Services Committee Chair Barney Frank believes that these measures are needed because the SEC-mandated disclosure, while important, is incomplete. On the day the House bill passed, April 20, 2007, Sen. Barack Obama introduced a companion bill in the Senate (S 1181) requiring a shareholder advisory vote on executive compensation.

The bills also contain a separate advisory vote if a company gives a new, not yet disclosed, golden parachute to executives while simultaneously negotiating to buy or sell a company. This rare second vote is designed to empower shareholders to protect themselves from senior management's natural conflict of interest when negotiating an agreement to buy or sell a company while simultaneously negotiating a personal compensation package.

These measures are designed to ensure that shareholders have an opportunity to give their approval or disapproval on the company’s executive pay practices. As such, they represent a market-based approach empowering shareholders to review and approve their company's comprehensive executive compensation plan. In that spirit, the bills do not establish any artificial restrictions on executive compensation, nor do they seek to set any form or measure of executive compensation. The shareholder vote is advisory in nature, which means that the board and the CEO of a company can ignore the will of the shareholders if they so choose.

According to Rep. Frank, the bills in no way intrude Congress or the SEC into the process of setting management compensation. That said, the House financial services chair does believe that boards of directors are not likely to disregard an advisory opinion from the shareholders. As a matter of sound corporate governance, observed Rep. Frank, Congress feels that the advisory vote is important input that the board should have.

The Clinton bill would go further than the Frank and Obama bills and amend Section 304 of Sarbanes-Oxley, which requires forfeiture of incentive-based executive compensation when misconduct leads to an accounting restatement, to increase the look back period to 36 months from 12 months. The bill would also direct the SEC to adopt regulations defining misconduct to include the backdating of stock options to conceal losses or any other negative financial information from investors. Misconduct must also include accounting irregularities designed to conceal losses, liabilities, or other negative financial information or to artificially achieve profit or other financial targets that would not have reasonably been met under GAAP.

The Clinton measure also directs the SEC to adopt regulations prohibiting any work by a compensation consultant on behalf of the company that compromises the independence of the consultant. Companies would have to certify if a compensation consultant is independent.

Tuesday, May 13, 2008

Provisions in Farm Bill Would Close Enron Loophole

A measure reauthorizing the CFTC and closing the Enron loophole is included in the massive Farm Bill that has been reported out of a House-Senate conference and awaits congressional action, and a possible presidential veto. Provisions in the Food, Conservation and Energy Act (HR 2419) would end the Enron-inspired exemption from federal oversight now provided to electronic energy trading markets set up for large traders. It will ensure the ability of the CFTC to police all US energy exchanges to prevent price manipulation and excessive speculation. These bipartisan provisions, championed by Senators Carl Levin (D-MI), Dianne Feinstein (D-CA), and Olympia Snowe (R-Me) would give the CFTC the ability to scrutinize these transactions in energy commodities and prosecute traders that are manipulating these energy prices.

The bill also requires the President’s Working Group on Financial Markets to work with the SEC and the CFTC to allow risk-based portfolio margining for security options and security futures products by September 30, 2009; and the trading of futures on security indexes by June 30, 2009, by resolving issues related to foreign security indexes.

In closing the Enron Loophole, the measure would increase federal oversight authority to detect and prevent manipulation and to limit speculation in U.S. electronic energy markets. It would increase transparency, and create an audit trail, impose firm speculation limits, and significantly increase financial penalties for cases of market manipulation and excessive speculation. The measure was approved as part of the CFTC Reauthorization Act of 2008, which is Title XIII of the act..

According to Senator Feinstein, the bill puts all significant energy trades on electronic platforms within the regulatory confines of the CFTC and imposes limits on the size of trader’s positions to prevent excessive speculation. It also ensures that there is an audit trail, imposes recording keeping requirements, and forces electronic exchanges to monitor trading behavior and prevent manipulation.

For contracts that are significant in determining commodity market prices, the CFTC will require the electronic exchange to provide strict oversight, similar to what takes place today on regulated markets like the New York and Chicago Mercantile Exchanges. The exchanges will be required to prevent manipulation and price distortion by monitoring trading to prevent manipulation and price distortion; ensuring contracts are not susceptible to manipulation; limiting the size of positions to prevent excessive speculation, and; reducing holdings of traders in violation of position limits. The exchanges will also have to establish an audit trail by collecting information on trading activity and supplying large trader reports to the CFTC. They will also have to enhance transparency by publishing price, trading volume, and other trading data on a daily basis.

Regarding electronic contract oversight, the bill directs the CFTC to review all electronic contracts to identify those that are significant in determining market prices and thus must be regulated under the bill. The CFTC will consider the following factors in making that determination: 1) If the contract is traded in significant volumes; 2) If the contract is used by traders to help determine the price of subsequent contracts. This is like using “comps” in the real estate market or “Blue Book” for auto sales; 3) If the contract is equivalent to a regulated contract and used the same way by traders. The CFTC refers to these contracts as “look-alikes.”

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

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

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

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

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

The legislation would do more than require CFTC oversight; it would also require electronic exchanges, for the first time, to begin policing their own trading operations and become self-regulatory organizations in the same manner as futures exchanges like NYMEX. Specifically, the legislation would establish five core principles to which electronic exchanges must adhere, each of which parallels core principles already applicable to other CFTC-regulated exchanges and clearing facilities.

Monday, May 12, 2008

SEC Proposes Major Revision to Cross-Border Exemption Rules

Taking notice of the increasing globalization of the securities markets, the SEC proposes to enhance and expand its cross-border exemptions to facilitation the participation of US shareholders in cross-border business transactions. Many of the rule changes proposed would codify existing interpretive positions and exemptive orders in the cross-border area. The proposed revisions represent a balancing between the need to protect U.S. investors and the desirability of enabling transactions that may benefit all shareholders, including those in the U.S. Expanding the availability of the cross-border exemptions should encourage bidders to include U.S. shareholders in cross-border business combination transactions from which they otherwise might be excluded.

Cross-border in this context refers to business combinations in which the target company is a foreign private issuer and rights offerings where the issuer is a foreign private issuer.

In addition, the SEC believes that the proposed changes will reduce the overall cost for issuers engaged in cross-border business combination transactions. Currently, when there are conflicts between U.S. and foreign law or practice, acquirors in cross-border business combination transactions frequently seek no-action or exemptive letters from the SEC staff. Upon adoption of the changes, much of the relief sought in the past would be available without the need for no-action or exemptive letters, with concomitant cost reduction. In addition, the changes will provide regulatory certainty about U.S. rules governing cross-border business combination transactions.
The cross-border exemptions are structured as a two-tier system based broadly on the level of U.S. interest in a transaction, measured by the percentage of target securities of a foreign private issuer held by U.S. investors. A Tier I exemption applies when no more than ten percent of the subject securities are held in the U.S. A qualifying cross-border transaction will be exempt from most U.S. tender offer rules and from the registration requirements of Section 5 of the Securities Act. Tier I also provides a broad exemption from the filing, dissemination and procedural requirements of U.S. tender offer rules and the heightened disclosure requirements applicable to going private transactions as defined in Rule 13e-3.

Tier II exemptions apply when U.S. holders own more than ten percent but no more than 40 percent of the target securities. The Tier II exemptions encompass narrowly-tailored relief from certain U.S. tender offer rules, such as the prompt payment, extension and notice of extension requirements in Regulation 14E. The Tier II exemptions do not provide relief from the registration requirements of Securities Act Section 5, nor do they include an exemption from the additional disclosure requirements applicable to going private transactions by issuers or affiliates.

The SEC proposes a refinement of the tests for calculating U.S. ownership of the target company for purposes of determining eligibility to rely on the cross-border exemptions in both negotiated and hostile transactions. The SEC also proposes to expand relief under Tier I for affiliated transactions subject to Rule 13e-3 for transaction structures not covered under the current cross-border exemptions, such as cash mergers or compulsory acquisitions for cash.

The SEC also proposes to expand the relief afforded under Tier II in several ways to eliminate recurring conflicts between U.S. and foreign law and practice, including allowing more than one offer to be made abroad in conjunction with a U.S. offer. The changes would also permit bidders to include foreign shareholders in the U.S. offer and U.S. holders in the foreign offers. The Commission also would allow subsequent offering periods to extend beyond 20 U.S. business days and permit securities tendered during the subsequent offering period to be purchased within 14 business days from the date of tender.

In addition, the Commission proposes guidance on the ability of bidders to terminate an initial offering period or any voluntary extension of that period before a scheduled expiration date. Guidance is also also proposed on the ability of bidders in tender offers to waive or reduce the minimum tender condition without providing withdrawal rights.
SEC Chair Cox and IASB Oversight Chair Herald Global XBRL Standard for Financial Statements

At a recent XBRL conference in the Netherlands, SEC Chair Christopher Cox and IASB oversight Chair Gerrit Zalm proclaimed a strong commitment to global use of XBRL in preparing and filing financial statements. Currently, markets representing two-thirds of the world’s total market capitalization have mandatory or voluntary XBRL filing programs in place.

Chairman Zalm said that, as IFRS becomes the global accounting standard for financial statements, the availability of a high quality IFRS taxonomy, based on XBRL standards, goes hand in hand. In this context, the IASB will provide, free of cost to users, an XBRL taxonomy based upon the IFRS bound volume of standards in a timeframe consistent with the bound volume’s publication.

While maintaining the free availability of the IFRS taxonomy, the IASB promised to use its intellectual property rights to ensure the consistency of the global implementation of the IFRS taxonomy. The Board will also ensure the quality of the taxonomy by providing additional staff resources, where appropriate, and by utilizing the recently created XBRL Quality Review Team and XBRL Advisory Council.

The IASB is also pledged to work with any regulator wishing to use the IFRS taxonomy. For example, the Board is co-operating with the European Commission, the Committee of European Securities Regulators (CESR), and regulators in Australia, Canada, Japan, the Netherlands and the United States, among others.

For his part, Chairman Cox said that, just as IFRS and U.S. GAAP are moving toward convergence, so too is the XBRL community working to align the structures of the data tags for both IFRS and U.S. GAAP. At the same time, the software development community is developing tools that will allow investors to mash up and creatively analyze all of this newly liberated financial data.

Once XBRL unleashes interactive data for thousands of public companies around the world, the SEC chair emphasized, millions of users will find new ways to look at financial statements that even the people who are writing the software cannot yet imagine. There will be exciting opportunities to evaluate financial information in new ways and to derive even greater insights into its meaning, which will change the face of investing forever.

Saturday, May 10, 2008

Canadian Banking Regulator Examines Fair Value Accounting from Investor Angle

Fair value accounting has been much in the news lately and, in my view, rightly so given the difficulty of valuing illiquid securities during the market turmoil. There is a need to get more clarity around the issue of fair value accounting in light of the ongoing market crisis, in the view of Julie Dickson, Canadian Superintendent of Financial Institutions. Her remarks were delivered at a recent Ontario financial services forum. Her office is the primary federal regulator of Canadian financial institutions.

While there are many reasons to support the concept of fair value, noted the official, there are enough concerns being expressed with fair value when markets are illiquid that the IASB should not just push ahead to adopt full fair value accounting to create so called simplicity, as the Board suggested in a March 2008 discussion paper. In clarifying the issues surrounding fair value, the expert panel being set up by the IASB will be very important before considering a move to full fair value, said the official, who also urged people to comment on the IASB discussion paper by the September 19, 2008 deadline.

According to the senior official, there is general agreement that more disclosure of fair value methodologies is needed when assets are illiquid, the so-called level 3 assets. There is also some understanding that accounting standard setters are not trying to disrupt business, but are instead representing the interests of investors, which is why they are currently not focusing on the unintended consequences of fair value accounting but on its strengths. The fact that the IASB is focused on investors is key to how this issue will evolve.

While the senior banking official is confident that the IASB will likely be more driven by investor interests than by the interests of financial institutions and regulators, she has called for more discussion of what is in the interest of investors. Against this background, Ms. Dickson recognizes the view that, while fair value of a securitized asset represents a point-in-time measure and does not reflect the eventual realizability of the income or loss attributed to the asset, investors, not aware of that, may react in ways that amplify distortions. Financial statements work to give investors confidence in the results that are reported and, when confusion and uncertainty occur, investors may not react rationally.

Friday, May 09, 2008

IASB Chair Defends Fair Value Accounting; Says IFRS Global by 2011

Fair value accounting standards are not the cause of the current market crisis, declared IASB Chair David Tweedie in remarks to the Empire Club of Canada. While conceding the difficulty of valuing complex, illiquid securities and derivatives, he believes that showing the changes in values of these securities, even imperfectly, provides critical transparency and enables markets to adjust in a necessary albeit painful manner. More broadly, he noted that IFRS will essentially be the global accounting standards by 2011, with adoption by nearly 150 countries and the convergence project with FASB completed. He said that IFRS are principles-based standards whose implementation relies largely on the judgments of auditors and preparers.

With regard to the crisis and fair value accounting, the chair observed that financial reporting entered the picture by way of the requirement to value illiquid and complex securities reflecting bad lending practices and alert the market to the risks associated with their existence. When recoverability of a loan is doubtful, he noted, the loan has to be marked down to the present value of the cash flows expected from the loan, which value would be fair value. He pointed out that no entity is ever allowed to disclose assets valued at more than their recoverable amount in its financial statements. He discerns a growing consensus that fair value requirements for financial institutions will improve transparency and contribute to investor understanding of the risk profiles of these institutions.

Acknowledging that the existing IFRSs are not perfect, the chair said that the IASB is examining how to improve its standards in light of recent market developments. In endorsing a plan drafted under the auspices of the Financial Stability Forum and Central Banks, the IASB will improve the accounting and disclosure standards for off-balance sheet entities and enhance its guidance on fair value accounting, particularly on valuing financial instruments in periods of stress.

Indeed, there are IASB projects underway on financial instruments, fair value measurement, consolidations and derecognition. Chairman Tweedie pledged that, for the consolidations and derecognition projects, which directly address off-balance sheet issues, the IASB will move expeditiously. The IASB will also form an advisory group to help address the issue of valuing financial instruments in illiquid markets.

On the broader theme of global accounting standards, the chair sees clear momentum towards accepting IFRSs as a common financial reporting language throughout the world. This works on a number of levels. Multinational companies will benefit from reduced compliance costs associated with the removal of the need for the consolidation of different national accounts into a single statement to meet their home country’s requirements. Investors will be able to make comparisons of companies operating in different jurisdictions more easily. Whether an investor is looking at a financial statement in Toronto, Tokyo, or Tampa, he said, the accounting standard should be the same for the same economic transaction. Further, IFRS will allow regulators to develop more consistent approaches to supervision across the world.

The FASB-IASB convergence project is moving steadily along, he said, and there is reason to believe that IFRS will be used by US companies in the near future since the SEC is giving serious consideration to a proposal to allow such use.

Convergence is running on two tracks. First, the goal by 2008 is to reach a conclusion about whether existing major differences in a few focused areas should be eliminated through one or more short-term standard-setting projects and, if so, complete or substantially complete work in those areas. For the IASB, this would mean considering changes in six targeted areas, including joint ventures, segment reporting, impairment, and income tax. The FASB would also need to consider changes to six of its standards. At the same time, convergence would not need to exact replication of standards, but achieve agreement on major principles.

Second, the MoU established the target of 2008 to have made significant progress on a number of areas identified by both Boards where current accounting practices of US GAAP and IFRSs are considered outdated. The Boards have completed virtually identical business combinations standards already, eliminating an area that produced significant difference in financial results between IFRSs and US GAAP. They also decided not to tackle intangible assets as part of the MoU. This leaves nine other projects to complete with FASB. At the end of the process, the intention is to have identical standards, which should make US transition to IFRSs easier. He estimates completion of these MoU projects by 2008.

Finally, he pointed out the benefits of IFRS being principles-based. The idea is that the core principles are clearly stated, with sub-principles related to them in a tree-like structure. Principles should be tied to a sound conceptual framework, with any departure explained. It may be necessary to depart from the framework if emerging transactions indicate that the framework is out of date. Any exception to the framework, however, should provide a basis for elimination of the exception by later changes to the framework itself.

In his view, the use of principles should eliminate the need for anti-abuse provisions. It is harder to defeat a well-crafted principle than a specific rule which financial engineers can by-pass, he reasoned. A principle followed by an example can defeat the ``tell me where it says I can’t do this’’ mentality.

Since principle-based standards rely on judgments by auditors and others, he posited, disclosure of the choices made and the rationale for these choices is essential. If in doubt about how to deal with a particular issue, he instructed, preparers and auditors should relate back to the core principles.

The basis for conclusions should also include the question of whether there is only a single view to tackle the economics of the situation. Often there are competing views, with one deemed more relevant. If so, reasons for choosing that particular view should be explained in the basis for conclusions and reasons for rejecting the others clearly outlined.

Thursday, May 08, 2008

Volcker Examines Fair Value Accounting, Hedge Funds, and Fed's Role

Former Federal Reserve Board Chair Paul Volcker said that the market crisis has raised questions about the usefulness of mark-to-market accounting, particularly its extension in uncertain and illiquid markets to what is euphemistically known as fair value accounting. In recent remarks at the Economic Club of New York, he noted that, while mark-to-market is an essential discipline for hedge funds and other thinly capitalized financial firms, it may not be as suitable for regulated, more highly capitalized intermediaries, such as commercial banks.

Ongoing bank-customer relationships, the value of which is not automatically correlated with reversible swings in market interest rates, cannot be easily reduced to a market price or a mathematical model. He is satisfied that competent independent standard setters are reviewing the highly complex world of fair value accounting with open minds as to the appropriateness of mark-to-market under particular circumstances.

The former chair is also highly concerned about the practice of important commercial and investment banks of moving sponsored and related operations off balance sheet, which he found particularly surprising in light of the well-publicized problems of Enron and other industrial companies. Experience has again demonstrated that off balance sheet cannot be the same as out of mind or out of responsibility, he emphasized, since too much is at risk both financially and reputationally.

Separately, Mr. Volcker said that hedge funds, which managed carefully add to market efficiency, also have the potential for trouble when sponsored by banks. In his view, consideration needs to be given to ways and means of damping excessive leverage, possibly through the influence of the hedge funds’ prime brokers. Similarly, banks in their lending need to resist the dangerous and excessive.

More broadly, the former Fed chair examined the role of the Federal Reserve Board in what many see as its new role of market stability regulator. He observed that US financial regulation is afflicted by fragmented responsibilities, competing and overlapping institutional objectives, and ingrained resistance to change. Established agencies have not been able to keep up with all the complexities. At the same time, the drumbeat of lobbying pressure has not been for more effective regulation, he noted, but, to the contrary, it has been to highlight a fear of allegedly heavy handed and intrusive official intervention damaging to the competitive position of institutions operating in international markets.

The issue now is extending and clarifying the Fed’s oversight duties to investment banks and beyond or, conversely, changing direction toward a new and consolidated regulator. In Mr. Volcker’s view, the Fed’s role should be clarified as a lender of last resort and as a regulator since these functions are inextricably linked to the extent particular institutions are protected by borrowing privileges. The plain implication of recent actions is that in times of stress investment banks deemed of systemic importance are to be so privileged. Since the Fed’s initiative can not be confined to a single aberrant incident, reasoned the former chair, the Board should have direct responsibility for oversight and regulation.

Further, if the Fed is given umbrella oversight of the financial system, internal reorganization will be essential. According to Mr. Volcker, fostering the safety and stability of the financial system would be a heavy responsibility paralleling that of monetary policy itself. Providing direction and continuity will require clear lines of accountability, he added, backed by a stronger, larger, and highly experienced professional staff.

Wednesday, May 07, 2008

Basel Chair and ECB Chief Say Basel II Key to Securitization Reform

The Basel II Accord will be a crucial element in controlling off-balance sheet entities and other risk exposures as the securitization process is reformed, in the view of Basel Committee Chair Nout Wellink and European Central Bank President Jean-Claude Trichet. In separate remarks, they noted that under Basel II all exposures will be subject to regulatory capital charges, whether on or off the balance sheet. Basel II will also create more neutral incentives between retaining exposures on the balance sheet and transferring them to the capital markets through securitization. It will reinforce capital requirements for banks’ trading books and enhance disclosure of banks’ risk profiles, notably with regard to structured credit and securitization. Mr. Wellink, who is also President of the Netherlands Bank, delivered his remarks at an Amsterdam economics seminar.

In an interview with the European press, Mr. Trichet said that Basel I was very complacent regarding structured investment vehicles, conduits or other off-balance-sheet entities. Noting that the Basel II rules are fortunately much more stringent, the ECH head speculated that an earlier implementation would likely have curtailed off-balance sheet operations and limited damages.

More broadly, Chairman Wellink noted that, even though Basel II has only been fully implemented in Europe since the beginning of the year and the US is rolling it out more slowly, there is a consensus that the new accord will improve incentives for risk management and market disclosure and enhance capital regulation. For example, under Basel II, banks are required to perform forward-looking stress tests to make sure that they hold enough cushions above the minimum. Basel II will also require much stronger management of risk exposures; and, banks that take on more risk will be required to hold more capital in the first place, helping to prevent the build-up and under pricing of risk.

Although Basel II represents a major improvement, said the chair, the committee is not resting. Rather, Basel has begun to act on pressure points and weak spots in the regulatory regime revealed by the market crisis, including those involving the securitization of complex products, reputational risk and disclosure. Sound risk management and robust liquidity cushions are critical, he said, and the Basel Committee will strengthen practice in these areas.

It is also in the process of finalizing global sound practice standards for liquidity risk management and supervision, which will address many of the lessons learned from the market turmoil. The Committee will also work on stress testing, off-balance sheet management, and valuation practices. Furthermore it is enhancing market discipline through better disclosure. The chair promised that Basel will conduct an ongoing review of the framework over time and make any necessary adjustments based on its findings.

Monday, May 05, 2008

Failure to Disclose Receipt of Wells Notice Does Not Support Demand Futility

Applying Delaware law, a federal judge ruled that a shareholder derivative action alleging proxy fraud in the company’s failure to disclose its receipt of a Wells Notice from the SEC could not proceed because of a failure to show demand futility. Demand on the directors was not futile, said the court, since there was no questioning of their disinterestedness or independence. (In re Morgan Stanley Derivative Litigation, SD NY, 05 Civ. 6516, Mar27, 2008).

When shareholders brings a derivative action on behalf of the companyagainst the directors, there is a threshold question of whether they made a demand on the board of directors. The federal judge identified two Delaware tests for assessing demand futility, both enunciated by the state Supreme Court. The Aronson test requires shareholders seeking to establish demand futility to create a reasonable doubt that the directors are disinterested and independent, or that the challenged transaction was a valid exercise of business judgment. The Rales test essentially eliminates the business judgment rule prong of the Aronson test and focuses solely on whether the pleadings create a reasonable doubt that a majority of directors are disinterested and independent.

In this case, the federal court applied the Rales standard because that is the test to use when the subject of the derivative suit is not a business decision of the board, thus not implicating the business judgment rule.

In attempting to explain why a demand would be futile, the shareholders made insufficient generalized allegations to the effect that most of the directors desired to maintain their offices and would never vote to sue themselves. The court concluded that the allegations failed to create a reasonable doubt as to whether a majority of the board would have been sufficiently disinterested and independent in deciding whether the company should pursue the claim.

Disinterested in this context means that directors can neither appear on both sides of a transaction nor expect to derive any personal financial benefit from the transaction. There was no showing that the board members’ prospects of remaining in office would have been in serious doubt if the Wells Notice had been revealed to shareholders.

Similarly, the allegations did not create a reasonable doubt as to the board members’ independence in deciding whether to approve the pursuit of a proxy fraud claim. In the demand futility context, independent means that a director’s decision is based on the corporate merits of the subject before the board rather than extraneous considerations. The shareholder failed to allege any improper benefit that might accrue to a director-defendant for voting against a demand to sue a former or current director or officer. Thus, the proxy claim was dismissed for failure to plead demand futility under the Rales test.

Saturday, May 03, 2008

Directors Owe No Fiduciary Duty to Warrant Holders, But They Deserve Truthful Answers

Directors did not have a fiduciary duty to holders of warrants in the company’s stock, ruled the Delaware Chancery court, and thus had no duty to give the warrant holders advance notice of dividend declarations. Analogizing warrant holders to holders of convertible debentures, Vice Chancellor Strine said that the Delaware courts have consistently held that directors owe no fiduciary duty to future stockholders. But the court also held that the warrant holders deserved a truthful answer from the company when they inquired about a second dividend. (Corporate Property Associates v. CHR Holding Corp., Delaware Chan Ct. No 3231-VCS).

A few weeks before the second dividend was issued, the warrant holders asked the company to discuss any significant developments related to the business over the course of the past six months. Rather than remaining silent, which it could have, the company provided an answer that omitted any reference to the second dividend or related refinancing. The warrant holders contended that, had the company given a complete answer to their question, they would have chosen to exercise their warrants before the second dividend was issued.

In holding that the directors did not have a fiduciary duty to the warrant holders, the Vice Chancellor cited a 1988 Delaware Supreme Court ruling that a convertible debenture represents a contractual entitlement to the repayment of a debt and does not represent an equitable interest in the issuing company necessary for the imposition of a trust relationship with concomitant fiduciary duties. The same analysis applies to warrants, said the chancery court, in that the convertibility of the warrants does not result in the imposition of fiduciary duties. Just like with convertible debentures, the court reasoned, the convertibility feature of warrants does not bestow stockholder status until the warrant is in fact converted. Any rights that warrant holders may have are based, not on any fiduciary duty, but are contractual.

However, regarding fraud and negligent misrepresentations claims, the court reasonably inferred that the company was in the final throes of implementing a large dividend and knew that the warrant holders would exercise their warrants promptly if told of that development, and consciously decided to omit that development from its response to the questions. Importantly, by the time the company answered, it knew that the warrant holders were interested in the question of dividends from their prior demand to participate in the first dividend, said the court, raising an inference that the company did not want to tip the warrant holders that another dividend was coming, especially one that was three times the amount of the first.

The company had a duty to provide materially complete information once it voluntarily chose to speak in a situation when it could have remained silent. Thus, these circumstances stated a claim for fraud in the face of a duty to speak.