Monday, June 30, 2008

Big Four Object to Importing Legal Rule into PCAOB Standard for Audit Engagement Review

The Big Four audit firms have serious concerns about the PCAOB’s proposed standard addressing the responsibility of the audit firm partner that reviews the work of the engagement partner on a public company audit. The proposed standard of performance for engagement quality reviewers requires them to consider not merely what they know, but also what they should know. The Big Four are united in their opposition to injecting this legal standard into a review of the audit engagement. They believe it is an unworkable standard that will force audit engagement reviewers to significantly increase the scope and extent of their work in order to protect themselves from SEC or PCAOB sanctions. It would also conflict with international audit standards at a time when the Board should be aligning with international standards.

Under the proposed standard, the engagement reviewer cannot provide concurring approval of the engagement report if he or she knows or should know that any of four enumerated conditions exist. The four conditions are: 1) the engagement team failed to obtain sufficient competent evidence; 2) the engagement team reached an inappropriate overall conclusion; (3) the firm's report is not appropriate in the circumstances; or (4) the firm is not independent of its client.

In the view of the Big Four, the proposed PCAOB standard departs significantly from current international practice since the engagement reviewer is directed to consider not only what is known, but also those matters the reviewer should have known, possibly to levels approaching those currently applied by the engagement team, in order to avoid being second-guessed after the fact by those who have the benefit of hindsight, including PCAOB inspectors. In its comment to the Board, PricewaterhouseCoopers pointed out that the proposal goes well beyond international audit standards when it should be aligned with them.

Further, it imposes legal standards of conduct on the reviewing partner. By creating new standards of performance for the reviewer and a ``knows or should know’’ level of assurance, the standard is too focused on the adequacy of the engagement review itself and not on assessing the work of the engagement team.

PricewaterhouseCoopers said that the standard works a fundamental change in audit review by importing a legal formulation into an auditing standard. Audit and legal standards are different, reasoned the firm, in that legal standards are rules to assess the legal significance of behavior, often in hindsight, while audit standards guide auditors in carrying out their duties. Auditors are unfamiliar with this legal term in an auditing context.

Engagement reviewers will be overly focused on being second guessed on what they should have known if a problem is identified. Moreover, the phrase creates the potential for post hoc questioning of whether a reviewer should have identified a condition that would have precluded him or her from concurring with the engagement report.

KMPG believes that the standard would impose substantial new burdens on the engagement quality reviewer without a commensurate benefit to audit quality. The objective of the review should be to enhance audit quality by providing an independent, objective review of the significant accounting and auditing judgments and the conclusions reached. The proposed standard, however, would redirect the focus of the engagement quality reviewer away from the work of the engagement team to the work performed to carry out the reviewer’s duties.

In the firm’s view, this will lead engagement quality reviewers to engage in substantial procedures to conclude that they do not know that any of the specified conditions are present. The term ``should know’’ is even more troubling. It inherently creates a potential for post-hoc questioning of whether quality reviewers should have identified a condition that would have precluded them from concurring in the issuance of the engagement report. Thus, KPMG believes that engagement quality reviewers will be overly focused on being second-guessed as to what they should have known if a problem with the audit is later identified, rather than on assisting the engagement team by reviewing significant judgments and conclusions.

The Deloitte firm commented that requiring assurance on what reviewers know or should know represents a significant recasting of their role, which heightens the level of responsibility for reviewers and profoundly affects their conduct. The significance of the shift is illustrated by the fact that this standard is not currently used in PCAOB auditing and professional standards even for the engagement partner.

Deloitte also believes that the “should know” standard is illogical, and thus unworkable, because reviewers cannot reasonably be asked to make a representation and provide a concurring approval based on what they should know as opposed to what they actually know.

In the view of Ernst &Young, the proposed standard would significantly change the nature and scope of the engagement quality review. Since its inception the engagement quality review has been a “fatal flaw” review, said the firm, with the stated objective of identifying potential matters that, if not addressed prior to issuance of the audit report, potentially would require recalling and reissuing the audit report when subsequently discovered. Adoption of the “knows or should know’’ standard would expose engagement quality reviewers to substantial risk of sanctions by the SEC or PCAOB in nearly every occasion where an audit is later found to be deficient.

Sunday, June 29, 2008

SEC Commissioner Troy Paredes on Shareholder Access and Business Judgment Rule

New SEC Commissioner Troy Paredes has mentioned shareholder access to directly nominating directors in the context of exploring whether CEO overconfidence is the product of corporate governance. In a 2004 paper, he noted that, whatever its other merits or demerits, the SEC’s shareholder access rule, if adopted, will make it easier for shareholders to nominate directors and it is reasonable to expect that shareholder-nominees, if elected, will be more responsive to shareholders than to management or other directors.

In seeking other antidotes to CEO overconfidence, the future commissioner said that a lead director could be a counterweight to the CEO. He posits that governance can cause CEO overconfidence in two ways: large executive compensation packages and deference to managerial decisions largely dictated by the business judgment rule. He examines the possibility of extending the law of fiduciary duty to cover mismanagement rooted in overconfidence, even while acknowledging that this could undermine the business judgment rule.

Courts could also decide to assert greater say over the size and structure of executive pay by revitalizing the waste doctrine. He also noted that a controversial accounting change, the expensing of stock options, may also curb excessive compensation since companies may limit the number of options granted to mitigate the earnings hit of the expense.

In an interesting theory, the commissioner suggests that courts could adjust what it means to be reasonably informed under the business judgment rule to better ensure that corporate decision makers account for the cognizable risk of CEO overconfidence and the risk that directors and subordinate officers will too easily go along with the chief executive. Under a business judgment rule more sensitive to CEO overconfidence, inquiry and deliberation would become a central component of the duty of care.
House Passes Bill Directing CFTC to End Speculation in Energy Futures Markets

The House has passed a bi-partisan measure directing the CFTC to immediately curb the role of excessive speculation in the energy and swaps futures market within its jurisdiction and eliminate unlawful activity preventing the markets from accurately reflecting the forces of supply and demand of energy commodities. Passed by a vote of 402-19, the Energy Markets Emergency Act (HR 6377) directs the CFTC to use all of its authority, including its emergency authority, to eliminate excessive speculation, price distortion, sudden or unreasonable fluctuations or unwarranted changes in prices in the energy futures markets.

House Agriculture Committee Chair Colin Peterson, the sponsor of HR 6377, promised that in July the committee will examine legislative proposals that would affect the CFTC’s authority over energy futures and swaps markets. The committee will produce a bipartisan bill strengthening the CFTC’s ability to identify fraud and manipulation in the energy futures markets.

Under current law, U.S. traders can execute energy transactions on NYMEX, a CFTC-regulated exchange, and on London's ICE exchange that is regulated by the United Kingdom's FSA. The CFTC, however, has information on the positions of traders on the NYMEX that they don't have on the traders on ICE, and this is part of the issue that has caused Congress to be concerned because US regulators do not have complete information on exactly what is going on in all of these markets.

Against the backdrop of the legislation, the CFTC is taking steps to gain more information. They have executed an agreement with the FSA to expand trader data and obtain more transparency. The House believes that more should be done. Thus, the bill orders the CFTC to immediately take these steps to utilize their authority to make sure that there is not excessive speculation in these markets.

Friday, June 27, 2008

Hedge Fund Standards Board Charts Path to Int'l Best Practices

The Hedge Fund Standards Board has named Antonio Borges as its first permanent chairman, with a goal to harmonize international standards for hedge funds. He is a former Vice Governor of the central bank of Portugal. A permanent board of trustees for the standards board was also named, including major hedge fund investors, sovereign wealth fund executives, a UK pension fund manager and the former Calpers chief investment officer.

The board was formed in January 2008 to take forward the work started by the Hedge Fund Working Group, whose report on best practices for hedge fund managers was published that month. One of the board’s major goals is to harmonize its best practice standards with those being developed in the US by the President’s Working Group on the Financial Markets so that a set of international best practices for hedge funds can become a reality.

Because of their size and their innovation, noted Chairman Borges, hedge funds have become a critical part of the financial system. Thus, it is very important that managers adhere to standards that give confidence to investors and financial regulators. Earlier, the board had praised the best practices set forth in April by the President’s Working Group, stating that they share much common ground with the board’s best practices for hedge fund managers.

In addition, the board welcomed the working group’s best practices for hedge fund investors. Similarly, the board has praised the decision by the Bundesverband Alternative Investments (BAI) to recommend that institutional investors take account of the board’s best practices when investing in hedge funds.

The BAI, the German hedge fund trade association, issued revised guidelines to investors on the due diligence they should conduct into hedge funds and fund of hedge funds. The guidelines take the form of standardized questionnaires to help investors systematically assess hedge funds. Among other things, the BAI recommends that institutional investors ask hedge fund managers if they are conforming to the board’s standards.
European Central Bank Official Predicts Single Securities Settlement Regime

The best route to a single cross-border transparent securities settlement system in which real time settlement in central bank money is provided across accounts is the Target2 Securities Initiative. This was the view espoused recently by European Central Bank member Gertrude Tumpel-Gugerell. T2S is a proposal to overcome the fragmentation in the EU market for securities settlement by providing a harmonized cross-border settlement platform. T2S is designed to reinforce other EU initiatives, such as the Code of Conduct for clearing and settlement, in driving forward the single market objectives.

Noting that there is little benefit in preserving a multiplicity of competing platforms, the official emphasized that integration and harmonization have become core objectives of the European Union. She added that the European financial industry must have access to an efficient, state of the art financial infrastructure supporting a true single market.

In this respect, said the official, T2S will deliver a significant amount of settlement harmonization in important areas such as common interfaces, a common set of rules for intra-day settlement finality, and a common daily timetable. T2S combines cash and securities settlements in a single shared platform in real time to provide a single settlement platform for securities in central bank money, irrespective of the location of the issuer, the security or the settlement counterparty. This will create a single pool of securities available to market users and service providers. In her view, T2S will also lead to more transparent and efficient pricing and facilitate competition to provide cross-border trading venues.

As noted by the ECB member, T2S is designed to build on the Code of Conduct adopted by the clearing and settlement industry. The EU Commissioner for the Internal Market Charlie McCreevy has praised the new code as an important step in the creation of an efficient EU financial market. He also said that the Commission will closely monitor the code’s implementation, which became key once the EC decided to go the more risky self-regulation route.
Claim Fails, But Court Says Individual Scienter Not Necessary

The 2nd Circuit agreed with a district court finding that a plaintiff need show actionable scienter by individual defendants in order to show corporate scienter. The panel concluded, however, that while even though the lack of individual scienter did not preclude a similar finding against the corporate entity, the plaintiffs in this instance failed to show the requisite fraudulent intent by other means. As the court stated, "Although there are circumstances in which a plaintiff may plead the requisite scienter against a corporate defendant without successfully pleading scienter against a specifically named individual defendant, the plaintiff here has failed to do so."

The district court held that the allegations that the corporation systematically disregarded various indicia of borrowers' creditworthiness in order to quickly consummate large volumes of loans and ignored signs that the bond collateral was defective after the loans were originated were sufficient to infer scienter on the part of the corporation itself. However, the 2nd Circuit panel stated that the complaint "lacks even an allegation that these data had been collected into reports that demonstrated that loan origination practices were undermining the collateral’s performance. Accordingly, they have not raised an inference of scienter based on knowledge of or access to information."

The court also found that claims of a duty to monitor or a motive and opportunity to commit fraud failed to show corporate scienter. The court cited that "they have not specifically identified any reports or statements that would have come to light in a reasonable investigation and that would have demonstrated the falsity of the allegedly misleading statements." Additionally, the "proffered motive is the same desire to maintain the appearance of profitability that we have consistently rejected as insufficient in securities fraud pleading."

The appeals panel stated that the complaint "fails to allege the existence of information that would demonstrate that the statements made to investors were misleading" and did not allow the court to "infer that someone whose scienter is imputable to the corporate defendants and who was responsible for the statements made was at least reckless toward the alleged falsity of those statements. "

The court found that the inferences raised in the complaint were not "at least as compelling as the competing inference" and that "the statements either were not misleading or were the result of merely careless mistakes at the management level based on false information fed it from below."


Thursday, June 26, 2008

FSA Requires Enhanced Disclosure of Short Positions

In a significant move, particularly for hedge funds, the UK Financial Services Authority adopted rules requiring the disclosure of significant short positions in stocks admitted to trading on markets which are undertaking rights issues. For this purpose, the authority defined a significant short position as 0.25% of the issued shares achieved via short selling or by any instruments giving rise to an equivalent economic interest. The obligation will be to disclose positions exceeding this threshold to the market by means of a Regulatory Information Service by 3.30pm the following business day. The new rules took effect on June 20, 2008.

The FSA still views short selling as a legitimate technique which assists liquidity and is not in itself abusive. But it is also the case that the rights issue process provides greater scope for what might amount to market abuse, particularly in current conditions. The FSA believes that improving transparency of significant short selling in such shares would be a good means of preventing the potential for abuse. In these circumstances, non-disclosure of significant short positions gives the market a false and misleading impression of supply and demand in the securities concerned.

A disclosable short position is one representing an economic interest of one quarter of one per cent of the issued capital of a company. Holders calculating whether they have a disclosable short position must take into account any form of economic interest they have in the shares of the issuer, excluding any interest held as a market maker. Failure to give adequate disclosure of a disclosable short position will constitute market abuse.

The FSA promised that these provisions and, in particular, the threshold triggering a disclosure of a short position, will be kept under review and may be subject to change in the light of experience. Further, the overall effectiveness of the measure will be considered as part of the wider review.

In addition to the new disclosure regime, the FSA is also considering whether it might be necessary to take further measures in this area. A number of options are being looked at, including restricting the lending of stock of securities in rights issues for the purposes of enabling short selling.

Tuesday, June 24, 2008

House Bill Closes London and Swaps Loopholes and Empowers CFTC

A bill to firmly and finally close both the London and Swaps Dealers loopholes left open by the recently enacted Farm Bill has been introduced by Rep. Bart Stupak, chair of the a House energy subcommittee. The Prevent Unfair Manipulation of Prices (PUMP) Act (HR 6330) requires all U.S-delivered futures energy transactions executed in any manner within the U.S. to be traded on U.S. contract markets subject to direct regulation by the CFTC. The bill also clarifies that energy swaps are futures and requires transparency for energy index funds. Moreover, the measure provides strong congressional oversight of CFTC exemptive authority.

In the view of former CFTC Director of Trading and Markets Michael Greenberger, the PUMP Act comprehensively closes completely and firmly all of the troublesome loopholes that have been created by the Enron Loophole or by CFTC letter, policy statements, and exemption rules. In testimony before the subcommittee, he said that these deregulatory measures have allowed the U.S. energy futures markets to be overrun by unpoliced speculation. In turn, this uncontrolled speculation has unhinged those markets and the price of the underlying commodities from economic fundamentals.

The Farm Bill did not return to the status quo prior to the passage of the Enron Loophole by bringing all energy futures contracts within the full U.S. regulatory regime. Instead, the Farm Bill amendment requires the CFTC and the public to prove on a case-by-case basis through administrative proceedings that an individual energy contract should be regulated if the CFTC can prove that the contract serves a significant price discovery function.

According to the former official, the CFTC has also made it clear that the Farm Bill amendment will not cover any U.S. delivered futures contracts traded on the U.S. terminals of foreign exchanges operating pursuant to staff no action letters. The former director said that legislation is needed to assure rapid oversight of any foreign board of trade trading U.S. delivered energy futures products on U.S. terminals.

The PUMP Act expressly bars over-the-counter energy futures swaps involving transactions of futures energy contracts to be delivered in the U.S. or conducted using computer terminals in the U.S. The combination of statutorily eliminating over-the- counter energy swaps transactions and requiring that all energy futures contracts delivered or traded in the U.S. be on exchange makes doubly clear that energy futures index funds can only be traded on a U.S. regulated and CFTC overseen U.S. contract market.

The Act also would require the CFTC to make monthly website postings about aggregate numbers and positions of anyone using index funds to trade U.S-delivered futures energy contracts or trade on U.S. computer terminals. The Act would nullify all CFTC no action letters previously granted to exchanges trading futures energy contracts to be delivered in the U.S. or using computer terminals in the U.S. A foreign exchange desiring to trade energy futures on U.S. terminals would have to register as a U.S. regulated contract market, with a six-month grace period for compliance.

The PUMP Act would require that U.S. energy futures or energy futures traded on U.S. terminals be subject to the essential core principles of regulation of U.S. contract markets; which principles are designed to prevent fraud, manipulation and excessive speculation. These regulatory requirements include the imposition of mandatory speculation limits, regular and reliable large trader reporting to detect immediately excessive speculation, manipulation or fraud, strong contract market self-regulation surveillance systems, and authority for strong CFTC emergency intervention to resolve dysfunctions within the energy futures markets.

According to the former director, most of those protections are either not provided for or are not emphasized in the foreign regulatory regimes to which the CFTC has deferred in the no action process. The PUMP Act would eliminate in the case of ICE, for example, the need to rely on a regulator in London, using less rigorous oversight of the markets, for activity directly and significantly impacting U.S. energy markets.

More importantly, the PUMP Act strengthens those regulatory requirements that now apply to CFTC-regulated contract markets engaged in energy futures trading. For example, the measure requires the CFTC to establish uniform speculation limits for transactions involving U.S-delivered energy contracts futures or those traded on computer terminals in the U.S.

The Commission is required to fix limits on the aggregate number of positions which may be held by any person for each month and in all markets under CFTC jurisdiction. Under the exiting regulatory regime, speculation limits are only applied by each contract market, and aggregate positions are never imposed. In the former CFTC official’s view, this position limit would prevent a trader from spreading speculation over a host of markets, thereby accumulating a disproportionately large share of an energy market while satisfying each exchange‘s separate limits.

On the other hand, the PUMP Act would exempt bona fide hedging transaction involving U.S-delivered futures energy contracts or those traded on computer terminals in the U.S. In short, speculation limits would only apply to speculators and not to those using the markets to hedge risks involved in selling or buying the energy commodity at issue in the wholesale or retail markets.

The PUMP Act also would provide special rules for bilateral included energy transactions, or transactions involving U.S-delivered futures energy contracts not made through a trading facility. Such bilateral included energy transactions would consist of transactions between two principals, which do not involve communication or negotiation about any of the material economic terms of an energy futures contract.

While a source of great concern by industrial users of the energy futures markets for their abusive speculative impact on the markets, these bilateral transactions were not regulated by the Farm Bill amendment. The Stupak legislation would require eligible contract participants to provide the CFTC with market data about large trading positions involving principal to principal standardized contracts relating to an energy commodity. Additionally, the CFTC and Department of Justice are authorized to examine the trading records of an eligible contract participant that enters into or executes a bilateral included energy transaction.

Finally, the Act recognizes that the CFTC has, through section 4(c) of the Commodity Exchange Act, the power to tailor U.S. futures regulations from one size fits all rules by granting exemptions from statutory requirements so long as the exempted trading comes with assurances that there will be no fraud, manipulation, or excessive speculation and that it otherwise serves the public interest. However, in order to avoid abusive use of that exemption authority, the Act requires the CFTC to provide Congress with two months notice and to otherwise solicit public comment before promulgating a rule that exempts energy futures transactions governed by the Act from the requirements of that statute or the CEA in general.

ABA Securities Committees Comment on SEC Form ADV Amendments

On June 18, 2008 the ABA Committees on Federal and State Securities Regulation submitted comments to the SEC about the SEC’s proposed amendments to Form ADV and about rules under the Investment Advisers Act of 1940. Comments concerned electronic filing of Part 2 of Form ADV through the Investment Adviser Registration Depository (IARD) ["brochure delivery requirement"], as well as the brochure delivery requirements for investment advisers to their private fund clients, custodial fees, custody of client funds in Rule 206(4)-2 of the Investment Advisers Act of 1940 and disciplinary information requirements in Rule 206(4)-4.

The Committees thanked the SEC for working with the North American Securities Administrators Association (NASAA), the umbrella organization representing Blue Sky interests, to create a single form with standard definitions and reporting requirements so that federal covered and state investment advisers can more easily progress from federal to state investment adviser status and visa versa. The Committees were also encouraged about the SEC's adoption of a more uniform brochure format to better provide actual and prospective advisory clients, and the SEC, with more meaningful disclosures.


Brochure delivery requirement. Regarding completion of Part 2 of Form ADV [the "brochure delivery requirement"], the Committees request that the Form ADV instructions specify that in those instances when an investment adviser is not required to deliver the brochure because the clients are in the "no delivery required" category, the investment adviser can simply complete Part 2 by stating that preparation and delivery of a brochure is not required.

Private funds. The Committees also believe that as a result of Goldstein v. SEC, 451 F.3d 873, 877 (D.C. Cir. 2006) that deemed a fund rather than the fund's investors to be the client of an investment adviser, an exemption from the Part 2 brochure preparation and delivery requirement should apply to private funds that are the only client of a registered investment adviser acting as promoter, as well as to funds in which a registered investment adviser or one of its affiliates is the general partner or limited partner of a limited partnership or managing member of a limited liability company; and also that the investment adviser be identified as a "promoter." The Committees also believe the exemption should extend to investment advisers of private funds that are exempt from registration as investment companies under Sections 3(c)(1), 3(c)(5), 3(c)(7) and 3(c)(9) of the Investment Company Act of 1940.

Annual update. The Committees request that instead of the SEC's proposal to require an adviser to provide each client with an annual update of the adviser's brochure's material changes, the SEC adopts the "access equals delivery" approach used for 1933 Act prospectuses, whereby the SEC would allow an adviser to place the updated brochure on its website and then send an email notification of the material changes to the clients telling them where on the website they can navigate to the updated brochure.

Custodial fees. The Committees request that a proposal requiring investment advisers to disclose their custodial fees to clients take into account those cases where a client enters into an agreement with a custodian unaffiliated with the client's investment adviser, in which case the investment adviser would be unaware of the fee. The Committees recommend that investment advisers only be required to disclose custodial fees when they, themselves, have entered into a custodial agreement with their clients and/or have discretionary authority to hire the custodian.

Custody of client funds. The Committees believe that Item 15A in the Form ADV instructions is unnecessary in its requiring an investment adviser to disclose certain additional risks as defined in rule 206(4)-2 of the Investment Advisers Act of 1940 if the adviser has custody of it's clients' funds and the adviser, rather than the custodian, sends the clients the required account statements. The Committees emphasize the already existing safeguards contained in rule 206(4)-2, including a mandate that an adviser must arrange its own surprise audit with an independent public accountant if it, rather than the custodian, sends the quarterly account statements to the clients.

Disciplinary information and Rule 206(4)-4. The Committees ask that the term "currently material" be eliminated from proposed Item 9 of the Form ADV instructions pertaining to disclosure of disciplinary events, to avoid having to distinguish between an event that is "within the 10-year cut-off but not material" from one that is "after the 10-year cut-off but not currently material." The Committees believe the test should be whether an event is material to a client's or prospective client's evaluation of the investment adviser, regardless of whether the event is on the list or whether or not it occurred within the past 10 years. Also, proposed Item 9 states that the 10-year period for disclosing disciplinary violations begins at the time a final order, judgment or decree is issued against the investment adviser or at the time an appeal of a preliminary order, judgment or decree has lapsed. The Committees request that proposed Item 9 also contain the much more unlikely situation, that if a final order, judgment or decree is not issued, the 10-year period for disclosing the disciplinary violation begins at the time proceedings are instituted against the investment adviser. Lastly, the Committees believe Rule 206(4)-4 should be amended to continue to require only the delivery of disciplinary information to clients for whom the brochure delivery requirements do not apply.

Monday, June 23, 2008

Congress Moving to Close the London Loophole Left Open by Farm Bill

Companion bills have been introduced in the House and Senate to close a loophole allowing speculative energy trades by US traders on the London Exchange. The bills are designed to ensure that energy commodities traded on foreign exchanges using trading terminals located within the United States are subject to the same speculative trading limits and reporting requirements as energy commodities traded on U.S. exchanges. Importantly, Senator Barack Obama recently called for legislation to accomplish essentially what these bills would do. Meanwhile, at the behest of Senators Levin and Reed, the President created a federal interagency task force composed of the SEC, CFTC and Treasury to examine how energy commodities markets are being manipulated.

In the Senate, the Close the London Loophole Act (S. 3129 ) would ensure that the Commodity Futures Trading Commission has the same authority to detect, prevent, and punish manipulation and excessive speculation for traders in the United States who trade U.S. energy commodities on foreign commodity exchanges as the CFTC has for traders who trade on U.S. exchanges. The bill was introduced by Senators Carl Levin and Diane Feinstein, who were instrumental in closing the Enron loophole in the recently enacted Farm Bill. The Farm Bill did not close the foreign board of trade exemption, which allows speculative energy trades by US traders on the London Exchange

According to Sen. Levin, closing the London loophole will ensure that the CFTC has the tools to protect U.S. markets from manipulation and excessive speculation no matter where U.S. energy commodities are traded. Domestic traders would no longer be able to avoid the ``cop on the beat’’ by routing their trades through a foreign exchange.

Currently, the CFTC can obtain the information it needs to detect price manipulation and excessive speculation involving U.S. energy trades on foreign exchanges only through voluntary data-sharing agreements with relevant foreign regulators. Moreover, the CFTC can take action against a U.S. trader on a foreign exchange to prevent manipulation or excessive speculation only with the cooperation and consent of the foreign regulator.

The Act would authorize and order the CFTC to obtain trading data from foreign exchanges operating in the United States through direct trading terminals. The bill would also enable the CFTC to act on its own initiative to prevent manipulation or excessive speculation by U.S. traders directing trades through foreign exchanges.

In addition, Section 3 of the bill, which subsumes a separate bill, S. 2995, earlier introduced by Sen. Levin, would increase U.S. access to foreign exchange trading data and strengthen oversight of the trading of U.S. energy commodities no matter where that trading occurs. This provision would require the CFTC, prior to allowing a foreign exchange to establish US-located direct trading terminals, to obtain an agreement from that foreign exchange to impose speculative limits and reporting requirements on traders of U.S. energy commodities comparable to the requirements imposed by the CFTC on domestic exchanges.

There are currently two key energy commodity markets for U.S. crude oil, gasoline, and heating oil trading. The first is the New York Mercantile Exchange or NYMEX. The second is the ICE Futures Europe exchange, located in London and regulated by theUK Financial Services Authority.

In overseeing their energy markets, UK regulators do not place limits on speculation like US regulators do, nor do they monitor trader positions in the same way. Also, they do not require the same type of data to be reported to regulators. All this means that traders can avoid U.S. speculation limits on the New York exchange by trading on the London exchange, thereby making the London exchange less transparent.

Recently, the CFTC moved to address some of the gaps in its ability to oversee foreign exchanges operating in the United States. Specifically, the CFTC, working with the FSA and the ICE Futures Europe exchange, announced that it will now obtain information about the trading of U.S. crude oil contracts on the London exchange, including information on large trader positions for all futures contracts, not just a limited set of contracts due to expire in the near future, and enhanced trader information to permit more detailed identification of end users; improved data formatting to facilitate integration of the data with other CFTC data systems; and notification to the CFTC of when a trader on ICE Futures Europe exceeds the position accountability levels established by NYMEX.

While these new steps will strengthen the CFTC's ability to detect and prevent manipulation and excessive speculation by ensuring that the it has the same type of information it receives from U.S. exchanges, Congress believes this in not enough to fully close the London loophole. The CFTC must also have clear authority to act upon this information to stop manipulation and excessive speculation.

Thus, the bill authorizes the CFTC to prosecute and punish manipulation of the price of a commodity, regardless of whether the trader within the United States is trading on a U.S. or on a foreign exchange. It also authorizes the CFTC to require traders in the United States to reduce their positions, no matter where the trading occurs to prevent price manipulation or excessive speculation in U.S. commodities. Finally, it clarifies that the CFTC has the authority to require all U.S. traders to keep records of their trades, regardless of which exchange they are using.

Sunday, June 22, 2008

Obama Calls for Closing Part of Enron Loophole Left Open by Farm Bill

In a major development, Senator Barack Obama has endorsed efforts to fully close the Enron Loophole that many believe was partially left open by the recent fix embodied in the Farm Bill. The Enron loophole was inserted at the last minute into the Commodity Futures Modernization Act of 2000 and passed in the waning hours of the 106th Congress. This loophole, which exempted from federal oversight the electronic trading of energy commodities by large traders, helped foster the explosive growth of trading on unregulated electronic energy exchanges.

A measure reauthorizing the CFTC and closing the Enron loophole was included in the massive Farm Bill. Provisions in the Food, Conservation and Energy Act (HR 2419) ended the Enron-inspired exemption from federal oversight provided to electronic energy trading markets set up for large traders. It ensures the ability of the CFTC to police all US energy exchanges to prevent price manipulation and excessive speculation.

But The Farm Bill did not close the foreign board of trade exemption, which allowed speculative energy trades by US traders on the London Exchange. A bill to cure this oversight and ensure that energy commodities traded on foreign exchanges using trading terminals located within the US are subject to the same speculative trading limits and reporting requirements as energy commodities traded on U.S. exchanges has been introduced by Senators Carl Levin and Dianne Feinstein. The Oil Trading Transparency Act (S 2995) would close a loophole allowing speculative energy trades by US traders on the London Exchange by requiring that foreign boards of trade operating US trading terminals comply with US trading limits and reporting requirements.

Senator Obama appears to have put his full weight behind the Levin-Feinstein bill or at least the idea the measure embodies. The senator fears that not completely closing the Enron loophole would render the CFTC unable to fully oversee the oil futures market and investigate cases where excessive speculation may be driving up oil prices. More broadly, he described the regulatory gap as dangerous because the absence of oversight has the potential to facilitate abusive trading or price manipulation; and the failure of a large derivatives dealer could trigger disruptions of supplies and prices in energy markets.

As President, Senator Obama vowed to go beyond the changes in the Farm Bill and fully close the Enron loophole by requiring that U.S. energy futures trade on regulated exchanges. Moreover, the senator also called for new, disaggregated data on index fund and other passive investments to increase transparency and oversight of the growing number of institutional investors participating in commodities futures markets. More generally, he pledged to support legislation directing the CFTC to investigate whether additional regulation is necessary to eliminate excessive speculation in U.S. commodities markets, including higher margin requirements and position limits for institutional

Noting the cross-border nature of today’s markets, the senator also urged US financial regulators to work globally to establish uniform approaches to avoiding excessive speculation in commodities futures markets. As President, he vowed to work through the International Organization of Securities Commissioners (IOSCO) to harmonize regulations in order to ensure that U.S. efforts to enhance oversight and transparency in U.S. exchanges are not undermined.
SEC Plans Historic and Profound Changes to Form ADV

Form ADV is the primary disclosure document that investment advisers provide to clients and prospective clients. It contains information about the adviser's business, backgrounds of advisory personnel, disciplinary information and conflicts of interest.

The SEC has proposed amendments to Part 2 of Form ADV not once but twice. The comment period on the reproposal ended on May 16th, 2008 and the SEC staff is considered the many weighty comments from the usual heavyweights. According to SEC Director of Investment Management Andrew Donohue, the revision of Part 2 of Form ADV is a major event in the regulation of the advisory industry. The proposed changes to Form ADV are designed to give clients disclosure that is more meaningful, more effective, and easier to understand. Part 2 plays such an important role in the regulation and compliance programs of advisers, and the proposal is intended to result in more client-friendly disclosures.

The proposed amendments would substantially improve advisers' disclosure to clients in Part 2 of Form ADV. As you know, Part 2 is the primary disclosure document that investment advisers provide to clients and prospective clients. It contains information about the adviser's business, backgrounds of advisory personnel, disciplinary information and conflicts of interest. The goal of Part 2 is to allow investors to make an informed choice in selecting an investment adviser and to evaluate any conflicts an adviser may have.

Unlike other countries that regulate investment advisers by imposing qualification and other requirements on advisers, the US allows clients to make their own determinations when selecting advisers and evaluating any conflicts an adviser may have. However, in the view of the SEC, this process only works if clients and prospective clients have the information necessary to allow them to make informed decisions regarding the advisers they choose to hire. This is where Form ADV comes in.

Thus, Form ADV is especially important because the federal securities laws do not prescribe minimum experience or qualification requirements for persons providing investment advice. They do not establish maximum fees that advisers may charge. They generally do not prohibit advisers from having substantial conflicts of interest that might adversely affect the objectivity of the advice they provide.

Instead, investors have the responsibility in selecting their adviser to negotiate their own fee arrangements and evaluate their adviser's conflicts. As a result, it is critical that investors receive sufficient information about the adviser and its personnel to permit them to make an informed decision about whether to engage an adviser, and having engaged the adviser, how to manage that relationship.

The Commission's substantial amendments to Part 1 of Form ADV in 2000, along with the institution of the IARD electronic registration system and the establishment of the Investment Adviser Public Disclosure website, was the first step in revolutionizing, not only the content of advisers' disclosures, but also the process by which investors could access information about investment advisers. There have been major benefits from these amendments in terms of enhanced disclosure and transparency and ease of access to information.

In the reproposal, the SEC responds to comments on the original proposal. The goal is to provide advisory clients and prospective clients clear, current, and more meaningful disclosure of the adviser's business practices, conflicts of interest, and background of advisory personnel. The SEC rejects the current check-the-box approach in favor of more meaningful disclosure. In addition, following the success of Part 1 and the public disclosure website, the SEC wants advisers to be able to electronically file their brochures with the Commission; and they would be available to the public through the Commission's website, which would greatly enhance access to this important information.
Canadian Supreme Court Reverses Extending Revlon Doctrine to Bondholders

On an expedited appeal, the Supreme Court of Canada set aside a court of appeals ruling that the Delaware doctrine requiring directors to maximize shareholder value through an auction process when a company is in play also applies to bondholders. In a unanimous decision, the Quebec Court of Appeals had said that Canadian directors have a more extensive duty than that of directors of Delaware companies. The duty of care in Canada requires consideration of the impact of a takeover or leveraged buyout on bondholders as well as shareholders. Specifically, sad the appeals court, the directors must have regard for the reasonable expectations of bondholders. Because the board considered only the interests of the shareholders, ruled the appeals court, its decision to accept a buyout offer was not protected by the business judgment rule. In the Matter of BCE, Inc., No. 500-09-018525-089, May 21, 2008).

The Supreme Court issued no opinion, only a two paragraph judgment, which promised the Court’s reasoning at a later time. The effect of the Supreme Court’s set aside was to reinstate the trial court’s approval of the transaction. The trial court had faithfully applied the Revlon doctrine mandating the maximization of only shareholder value.

In 1986, the Delaware Supreme Court ruled that, when the sale of a target company becomes inevitable, the role of the company’s directors changes from that of defenders of the corporate bastion to that of auctioneers charged with getting the best for the stockholders at a sale of the company. Revlon v. MacAndrews & Forbes Holding, Inc. These enhanced Revlon duties are triggered when a company initiates an active bidding process seeking to sell itself.

When the Canadian company went into play, the board applied Delaware’s Revlon doctrine and conducted an auction process to maximize shareholder value. The offer and plan finally accepted would have had a significant negative impact on the bondholders, while at the same time giving a substantial premium to shareholders. The appeals court emphasized that the board’s efforts to obtain the best value reasonably available to the shareholders cannot be considered in isolation from the interests of the bondholders.

Friday, June 20, 2008

SEC Official Defends Regulation of Investment Banks; But Says Legislation Needed

In the wake of the collapse of Bear Stearns and in the face of calls for a market stability regulator, the SEC Director of Market Regulation Erik Sirri noted changes that the Commission has made to its consolidated supervised entity (CSE) regime for investment banks. In testimony before the Senate Securities Subcommittee, he said it was imperative that Congress legislate how and by whom large investment banks should be regulated and supervised. The testimony comes in a week in which Treasury Secretary Henry Paulson called on Congress to empower the Fed as the broad market stability regulator for investment banks.

Under the CSE program, the Commission supervises global securities firms on a group-wide basis. For such firms, the Commission oversees not only the U.S-registered broker-dealer, but also the consolidated entity, which may include foreign-registered broker-dealers and banks, as well as unregulated entities, such as derivatives dealers and the holding company itself. All of the CSEs are of potentially systemic importance since they trade a wide range of financial products, connected through counterparty relationships to other large institutions.

For example, the primary concern of the CSE program with regard to hedge funds revolves around the risks they potentially pose to the firms specifically and, through the CSEs, to the financial system. In his testimony, Mr. Sirri said that, in light of the Bear Stearns affair, the SEC has revised its analysis of the adequacy of capital and liquidity and is currently directing investment banks to do more stress testing at the holding company level. The SEC has also engaged both international and domestic regulators in a cooperative manner to provide information and to discuss the broader policy implications of these events.

The SEC has also enhanced liquidity requirements for CSE firms. In particular, the Commission is closely scrutinizing the secured funding activities of each CSE firm, with a view to encouraging the establishment of additional term funding arrangements and a reduction of dependency on open transactions, which must be renewed as often as daily.

The Commission is also focusing on the so-called matched book, a significant locus of secured funding activities within investment banks. The agency is closely monitoring potential mismatches between the asset side, where positions are financed for customers, and the liability side of the matched book, where positions are financed by other financial institutions and investors. Moreover, funding and liquidity information for all CSEs is being obtained on a daily basis.

Further, together with the Fed, the SEC has developed stress scenarios focused on shorter duration but more extreme events that entail a substantial loss of secured funding, which will be layered on top of the existing scenarios as a basis for sizing liquidity pool requirements. The Commission has also discussed with CSE senior management their longer-term funding plans, including plans for raising new capital by accessing the equity and long-term debt markets.
The senior official also pledged to continue to improve the SEC’s prudential oversight of capital, liquidity, and risk management at all CSEs in response to what was learned during the subprime crisis. The SEC staff will focus on practices related to valuation, stress testing, and accumulation of concentrated positions.

The director acknowledged that the Bear Stearns' experience has challenged a number of the SEC’s assumptions relating to the supervision of large and complex securities firms. The SEC is working with other regulators to ensure that the proper lessons are derived from these experiences, he said, and that changes are made to the relevant regulatory processes to reflect those lessons.

For example, the Fed is now a very key player since, after Bear Stearns, the investment banks have temporary access to the primary dealer's credit facility as a back-stop liquidity provider should circumstances require. Thus, the SEC is in frequent discussions with the Federal Reserve Bank of New York about the financial and liquidity positions of the investment banks and issues related to the use and potential use of the credit facility.

Moreover, the director noted that the SEC and the Fed are nearing completion of a formal Memorandum of Understanding providing an agreed-upon scope and mechanism for information sharing related to the credit facility, as well as other areas of overlapping regulation. Under the current statutory framework, he observed, no agency is charged with the stability of the financial system broadly. The MOU will provide one mechanism for two of the critical agencies with responsibilities in this area to gain a broader and continuous perspective on key financial institutions and markets that could impact the stability of the financial system.

The MOU will also provide a framework for bridging the period of time until Congress can address through legislation fundamental questions about the future of investment bank supervision, including which agency should have supervisory responsibility, what standards should apply to investment banks compared to other financial institutions, and whether investment banks should have access to an external liquidity provider under exigent conditions.

Thursday, June 19, 2008

Fed Must Be Given Powers as Market Stability Regulator Says Treasury Chief

With the Bear Stearns episode and current market turmoil placing in stark relief the outdated nature of the financial regulatory system, Treasury Secretary Henry Paulson said it is imperative to quickly consider how to give the Federal Reserve Board the authority it needs as the primary market stability regulator to access necessary information from complex financial institutions and the power to mitigate systemic risk in advance of a crisis. In remarks at a markets seminar in Washington, he also saw the need to strengthen practices and financial infrastructure in the OTC derivatives market and provide greater certainty around the mechanics of winding down the derivatives positions of a failed institution.

In recent years, credit default swaps and OTC derivatives have become integral for hedging credit, default and price risk. Due to innovation and demand, there has been a tremendous expansion in the scale, diversity and impact of these instruments and markets. As price volatility has surged, so have trading volumes. Market infrastructure needs to more sufficiently evolve to support this expansion. In response to this pressing need, Treasury recommends the establishment of a functional industry cooperative that can meet the needs of the OTC derivatives markets in the years ahead. Treasury is working with the Fed, SEC and other members of the President’s Working Group to get this done.

In its earlier blueprint for reform of financial regulation, Treasury suggested a regulatory structure in which the Federal Reserve would take on the role of market stability regulator. In response to the Bear Stearns collapse, the Fed acted to address market liquidity issues by giving primary dealers temporary access to the discount window. In light of this extraordinary action, Treasury is working with the Fed and SEC to decide what role the Fed should play now that it is a lender to investment banks.

The parties are working to formalize this role in a Memorandum of Understanding. The Fed must have information and access so that it can assess its potential borrowers and counterparties. A more difficult issue is how this newly formalized relationship evolves when these temporary facilities eventually close and how the MOU will be perceived by the marketplace. In this context, Treasury will consider how the SEC and the Fed should coordinate regarding capital and liquidity requirements for these firms.

While the Fed is essentially currently playing the role of market stability regulator, noted Paulson, it has neither the clear statutory authority nor the mandate to anticipate and deal with risks across the entire financial system. The current crisis shows that a wide range of financial institutions can potentially threaten the stability of the financial system.

Thus, the Fed might need to make liquidity available to a broader range of financial institutions under certain extraordinary circumstances. However, at the same time, the circumstances under which that liquidity is provided must be limited and focused on systemic risk that can impact the overall economy. In addition, it is imperative that market participants not have the expectation that lending from the Fed is readily available.

To act as market stability regulator, the Fed needs authority to proactively address systemic risks posed by a commercial bank, an investment bank, or a hedge fund. To perform this function, it is vital that the Fed have information and access across all types of financial institutions. But information gathering alone is not enough. The Fed must also be able to identify and constrain risk-taking that can detrimentally affect the financial system. This will require authority to intervene to prevent the build up of conditions that create significant risk to the stability of the financial system. It will be a regulatory balancing act of providing additional stability to the financial system on the one hand, while limiting moral hazard on the other.

In addition, the perception that some institutions are either too big or too interconnected to fail must be disabused. One way to do that is to strengthen market infrastructure and operating practices in the OTC derivatives market and clarify the resolution, or wind down, procedures for non-depository institutions. Creating a more stable environment will mitigate the likelihood that a failing institution can spur a systemic event.

Given the massive scale of the OTC derivatives market, he said, trade processing must be enhanced with more automation. He praised the NY Fed’s efforts to bring together institutions that account for a significant percentage of OTC derivatives trading into a cooperative to create the necessary protocols to bring more transparency and efficiency and reduce counterparty credit risk. It is imperative that this cooperative bring standardization not only to dealer transactions but to the broader community of counterparties, including hedge funds.

Finally, despite longstanding efforts to address the treatment of derivatives in the case of a failed financial institution, there still seems to be uncertainty surrounding the process by which a large complex institution is wound down and what impact that would have on the overall financial system. U.S. bankruptcy law was updated significantly in 2005 to address many issues associated with OTC derivatives contracts. The Working Group should evaluate whether the resolution, or winding down, process for large complex institutions should be modified to help mitigate disruption to the financial system and improve market discipline. This requires addressing a number of difficult questions, including whether a particular regulatory agency should be assigned to oversee resolutions and how any potential intervention is justified.

Wednesday, June 18, 2008

SEC Staff Legal Bulletin Clarifies Registration Exemption for Securities Issued in Reorganizations

In the first staff legal bulletin in almost three years, the SEC staff has clarified the registration exemption for securities issued in reorganizations. The exemption, found in Section 3(a)(10) of the Securities Act, is available when the securities are issued in exchange for other securities, not for cash, and the fairness of the exchange is approved by a court of governmental entity. The fairness hearing must be open to everyone to whom securities would be issued in the proposed exchange.

The Section 3(a)(10) exemption is available without any action by the staff or the Commission. But issuers unsure of whether the exemption is available for a specific transaction they are contemplating may request a no-action position. The bulletin discusses issues that commonly arise in those no-action requests.

The SEC staff said that it will not issue a no-action response concerning a transaction after the fairness hearing has been held. Thus, an issuer must submit its no-action request before the fairness hearing. Also, the staff cautioned issuers not to submit a no-action request very close to the fairness hearing date since that may not give the staff adequate time to consider the issues presented and respond before the hearing.

Statutes governing fairness hearings often require a shareholder vote before the hearing, which could be at a time when the issuer is not certain it will be able to rely on the Section 3(a)(10) exemption. In these situations, the SEC staff has not objected to a vote before the fairness hearing, even though this means an investment decision is made before the fairness hearing, since the transaction is not effected unless the court or other authority approves it. In the staff’s view, the issuer should submit to the court or approving authority the disclosure materials offering the securities before it mails them to the offerees.

In addition, the staff believes that the court or authority making the fairness determination must have sufficient information before it to determine the value of both the securities, any claims or interests to be surrendered, and the securities to be issued in the proposed transaction. The staff will allow a foreign court to approve the transaction if all requirements that apply to exchanges approved by U.S. courts are satisfied and the issuer provides an opinion from counsel in the foreign jurisdiction stating that, before the foreign court can give its approval, it must approve the fairness of the proposed exchange to persons receiving securities in the exchange.

While the issuer must provide appropriate and timely notice of the fairness hearing, the statute does not specify the information that must be included in the required notice. And the SEC staff does not address the adequacy or appropriateness of the information provided to persons who have a right to appear at the hearing, except to broadly require that the notice adequately advise those who are to be issued securities in the exchange of their right to attend the hearing and give them the information necessary to exercise that right. The staff also cautions issuers rely on the Section 3(a)(10) exemption to consider whether, as a practical matter, imposing prerequisites to appearance will prevent those persons from having a meaningful opportunity to appear at that hearing.

The staff also clarified the status of fairness hearings conducted under state securities laws. The National Securities Markets Improvements Act of 1996 amended Section 18 of the Securities Act to preclude any state from requiring registration or qualification of covered securities, which are nationally listed securities. One effect of this was that an issuer could not use a state fairness hearing as a basis for relying on the Section 3(a)(10) exemption.

The SEC staff said that Congress’ prohibiting reliance on state fairness hearings was inadvertent. The staff noted that Congress corrected this situation in the Securities Litigation Uniform Standards Act of 1998, which amended Section 18 to add securities issued under Section 3(a)(10) as a category exempt from the definition of covered securities. Thus, the staff believes that an issuer may rely upon a fairness hearing conducted under state securities law to perfect an exemption under Section 3(a)(10) for securities that otherwise would be covered securities.
Basel Committee Proposes Updated Guidance on Managing Liquidity Risk

With the ongoing crisis caused by the securitization of subprime assets, the Basel Committee for Banking Supervision has proposed updated guidance for managing liquidity risk. While the guidance issued in 2000 remains generally relevant, a Basel working group identified areas that need updating and strengthening. The proposed guidance focuses on liquidity risk management at medium and large complex banks, but the sound principles have broad applicability to all types of banks. That said, Basel wants banks to tailor the principles of liquidity risk to the nature and complexity of their business. The primary objective of the new guidance is to raise banks’ resilience to liquidity stress

More broadly, since 2000 and leading up to the current market turmoil, there has been a loss of investor confidence in a wide range of structured securities markets that, in turn, has led to risks flowing on to banks’ balance sheets. The initial shock in credit markets was transmitted through a fall in asset market liquidity, which led to an increase in funding risk.

There is also now an international component to liquidity risk. Cross-border coordination becomes critical when an entire global banking group comes under pressure as a single entity. In such a scenario, the host regulator may require the host entity to increase its level of insurance against liquidity risk across the group. Increased cooperation and understanding between national regulators may reduce uncertainties as to the level of resilience provided by other regimes.

The market turmoil that began in mid-2007 has highlighted the crucial importance of market liquidity to the banking sector. The contraction of liquidity in certain structured securities product, as well as an increased probability of off-balance sheet commitments
coming onto banks’ balance sheets, led to severe funding liquidity strains for some banks, which required central bank intervention in some cases.

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

Securitization can be used by banks to expand sources of funding and create revenue
through buying and distributing third-party assets they did not originate, such as asset-backed securities. But the Basel Committee cautioned that securitization also presents liquidity risks that need to be managed carefully.

For example, the process of pooling assets, selling to a special purpose vehicle, obtaining credit ratings and issuing securities is time consuming, and market difficulties during this timeframe could result in a bank having to warehouse assets for longer than planned. In addition, some forms of securitization give rise to contingent liquidity risk, i.e. the likelihood that a firm will be called upon to provide liquidity unexpectedly, potentially at a time when it is already under stress.

Moreover, the increasing complexity of financial instruments creates new challenges for banks’ management of liquidity risk. For example, the inclusion of credit rating downgrade clauses and call features complicates the assessment of an instrument’s liquidity profile. Also, complex financial instruments are often not actively traded, which can make assessing their price and secondary market liquidity highly challenging.

Compounding all of this for global financial institutions is the fact that strong cross-border flows raise the prospect that liquidity disruptions could pass quickly across different markets and settlement systems. Banks operating a centralized liquidity risk model may plan to meet a shortfall in one currency with funds in another currency.

The enhanced liquidity risk management principles seek to improve governance and the articulation of a firm-wide liquidity risk tolerance. Banks must also improve liquidity risk measurement, including the capture of off-balance sheet exposures, securitization activities, and other contingent liquidity risks that were not well managed during the financial market turmoil. They should also aligning the risk-taking incentives of individual business units with the liquidity risk exposures their activities create for the bank.

Importantly, banks should conduct stress tests covering a variety of institution-specific and market-wide scenarios, with a link to the development of effective contingency funding plans. In addition, there must be strong management of intraday liquidity risks and collateral positions, as well as regular public disclosure of the financial institution’s liquidity risk profile.
The Basel Committee also emphasized that the principles strengthen expectations about the role of bank regulators, including the need to intervene in a timely manner to address deficiencies and the importance of communication with other regulators and authorities, both domestically and cross-border.

But liquidity may not be fully transferable across borders, Basel has warned, particularly in times of market stress, since regulators require sufficient liquidity to be held for local operations to protect national interests. Thus, an important element of conducting cross-border operations is the need to understand fully the regulatory practices within each jurisdiction.

Liquidity risk management regimes have been developed along national lines to support the preservation of the safety and soundness of each country’s financial system. The regimes are nationally based according to the principle of host country responsibility, although in some cases, the task, though not the responsibility, of supervision of branches is delegated to the home supervisor.

While the high level cross-border objectives for liquidity regulation are similar, there is much diversity in how these objectives translate into rules and guidelines. Broadly speaking, high-level approaches to supervising liquidity risk are common across regimes. For example, most firms are expected to have specific policies to address liquidity risk and the use of stress tests is commonplace.

Tuesday, June 17, 2008

COSO Proposes Guidance on Monitoring Internal Controls Over Financial Reporting

COSO has proposed guidance on monitoring internal controls over financial reporting that relies heavily on tone at the top and risk assessment. According to COSO, monitoring is an integral part of internal control over financial reporting. Further, it is important that internal control be viewed as a continuous process and that effective monitoring be implemented as a component of that process. In COSO’s view, the core of effective monitoring lies in designing and executing monitoring procedures that evaluate important controls over meaningful risks to the company’s objectives

The COSO guidance comes against the backdrop of a new SEC-PCAOB initiative to significantly revise the internal control reporting mandates of Section 404 of Sarbanes-Oxley. COSO, the sponsoring organizations of the Treadway Commission, supports the PCAOB’s new risk-based internal control audit standard, AS5 and finds that its focus on a top down risk-based approach is consistent with COSO’s own internal control framework. However, COSO is concerned that many companies have not fully integrated the monitoring component of its internal control framework into their overall control structures.

The organizations comprising COSO are the American Accounting Association, the AICPA, Financial Executives International, the Institute of Internal Auditors, and the National Association of Accountants (now the Institute of Management Accountants).

The guidance builds on two fundamental principles. The first is that ongoing evaluations enable management to determine whether the other components of internal control4 continue to function over time. The second principle is that internal control deficiencies should be identified and communicated in a timely manner to those parties responsible for taking corrective action and to management and the board as appropriate.

COSO recognizes that risks change over time and that there is a need for management to determine whether the internal control system continues to be relevant and able to address new risks. Thus, monitoring should assess whether management reconsiders the design of controls when risks change, and verifies the continued operation of existing controls that have been designed to reduce risks to an acceptable level.

Thus, the guidance emphasizes COSO’s belief that monitoring should be based on a fundamental analysis of risks and an understanding of how controls may or may not manage or mitigate those risks. More specifically, monitoring involves establishing a foundation for monitoring, designing and executing monitoring procedures that are prioritized based on risk, and assessing and reporting the results, including following up on corrective action where necessary

Management has the primary responsibility for the effectiveness of a company’s internal control system. Management establishes the system and makes sure that it continues to operate effectively. Controls performed below the senior-management level can be
monitored by management personnel or their objective designees

However, controls performed directly by members of senior management cannot be monitored objectively by those individuals or their designees. In such circumstances, other members of senior management may be able to monitor the controls. For example, the chief legal officer might monitor controls over new corporate contracts entered into by the chief operating officer. The board may also need to monitor such controls, which it frequently accomplishes through an audit committee and an internal audit function.

Board-level monitoring becomes increasingly important regarding controls that are at risk of senior management override. In most cases, the board is ultimately responsible for determining whether management has implemented effective internal controls. It makes this assessment by understanding the risks the organization faces and gaining an understanding of how senior management manages or mitigates those risks that are meaningful to the company’s objectives. Obtaining this understanding includes determining how management supports its beliefs about the effectiveness of the internal control system in those important areas.

Previously effective internal control systems become ineffective for one of
two reasons, reasoned COSO, the risk environment changes without corresponding controls adjustments or the operation of the internal control system changes such that it no longer adequately manages existing risks.

When ongoing-monitoring identifies a change in the environment, the organization determines whether a corresponding change is needed in the internal control system. When monitoring identifies a change in the internal control system, the organization needs to verify whether that change was designed and implemented properly.

The monitoring process is complete when the results are compiled and reported to appropriate personnel. This final stage enables the results of monitoring to either confirm previously established expectations about the effectiveness of internal control or highlight identified deficiencies for possible corrective action.
Company Breached Registration Rights Agreement

By Rodney Tonkovic
Associate Writer-Analyst
Wolters Kluwer Law and Business

A district court (SD NY) held that a company was obliged under the terms of an agreement to redeem an investor's shares. The action arose out of an alleged breach of a provision in the agreement that the company would redeem its convertible preferred stock for cash or an equivalent value of common stock. The provision granted preferred holders a qualified right of redemption upon the occurrence of certain "triggering events. The shareholders claimed that the suspension of the convertible stock's registration statement for sixty days due to the company's failure to timely file its annual report constituted a "triggering event" and demanded that their shares be redeemed. The company refused to tender any stock or the equivalent value of cash.

The court first determined that the suspension of the convertible stock's registration statement for sixty days constituted a triggering event under the structure and language of the agreement. Next, the right to redeem was only triggered if the registration statement lapsed during the Effectiveness Period, which was defined in the agreement as the period during which all registrable securities could be sold without volume restrictions pursuant to Rule 144(k). The company argued that the investors holdings were subject to Rule 144(e), meaning that the effectiveness period would have ended before the suspension. The court disagreed, finding that it was indisputable that, at the time the investor requested redemption of its preferred shares, some registrable securities were subject to the volume restrictions of Rule 144(e).

The court read the agreement as plainly and unambiguously requiring a uniform effectiveness period of two years under Rule 144(k). The court, however, found that, given the posture of the summary judgment motion and the complex nature of the damages calculation, the factual record was inadequate to support an immediate reward of damages and other equitable relief.

Portside Growth and Opportunity Fund v. Gigabeam Corp., Inc. (SD NY)

Monday, June 16, 2008

European Commission Will Regulate Credit Rating Agencies

In the wake of the SEC’s proposed reform of the regulation of credit rating agencies, the European Commission said that credit rating agencies must be subjected to regulation since, in the words of Internal Market Commissioner Charlie McCreevy, the IOSCO code of conduct for rating agencies has been revealed as a ``toothless wonder.’’ In remarks at a Dublin seminar, he said that no regulator appears to have ``got as much as a sniff of the rot at the heart’’ of the securitized asset rating process before it blew up. He is deeply skeptical that the appropriate response lies in building on and strengthening the IOSCO code. Discounting recent IOSCO task force recommendations as not being enforceable in a meaningful way, the commissioner is now convinced that limited but mandatory, well targeted internal governance reforms are imperative to complement stronger external oversight of rating agencies

European Union political leaders have already called for reform of the credit rating agency process in light of the market turbulence triggered by the sub-prime crisis. While supporting a market-driven solution, the leaders have said that regulation and legislation will be on the table if an appropriate market response is not forthcoming. Regulation is now on the table.
The commissioner is skeptical that a rating agency can give an objective rating to a bank’s structured securitized product if it has advised that same bank on how to structure that same product. He believes that, in order to effectively restore trust in the process, a framework for rating agencies must be implemented under which conflicts of interest are properly and more effectively managed.

The commissioner is not concerned that regulation of the rating agencies could be seen as some sort of official endorsement of the ratings they disseminate. The rating agencies have already been given recognition, legitimacy, and implicit trust in key pieces of European financial services regulation, he reasoned. Indeed, when so many of the rating agencies have standards of governance that fall so far short of best practice, he continued, the question to ask is whether their ratings should be so embedded and implicitly endorsed in EU legislation without best practice in corporate governance.

In his view, it is absolutely essential to ensure that there are sufficiently strong firewalls between those who are charged with the primary responsibility to shareholders of driving forward earnings and those who must have the primary responsibility for managing the quality and integrity of the rating process. Remuneration and incentive packages for analysts must also be geared to underpinning long term confidence in the ratings they disseminate. Management must be challenged to effectively manage the conflicts of interest arising from the trade off between quality standards and profitability, especially in structured finance, because of the exceptional and disproportionate impact on earnings of the flow of new structured finance ratings issued.

While oversight of policies and procedures of rating agencies is essential, the commissioner assured that the Commission will not pass on the substance of ratings and the design of models. Regulators should not be in the business of opining on individual rating content, he added. However, the Commission will mandate the ring-fenced internal governance of rating content, including statistical modeling and the quality and remuneration structures of analysts and the promulgation of appropriate corporate culture.

Action must be taken to address the potential conflicts of interest for rating agencies. In earlier remarks, Commissioner McCreevy has specifically recommended a governance structure involving a direct reporting line from fully ring-fenced rating assessment functions to a supervisory rating sub-committee of independent directors of the rating agency boards.

Sunday, June 15, 2008

Levitt Committee Proposes Major Changes to PCAOB-SEC Auditor Oversight

A blue-ribbon Treasury advisory committee has proposed significant and far reaching changes in SEC-PCAOB oversight of the outside auditors of public company financial statements. The Advisory Committee on the Auditing Profession, co-chaired by former SEC Chair Arthur Levitt, focused on improving audit quality and oversight, enhancing the ability of auditors to detect fraud, strengthening corporate governance at audit firms, and expanding the number of global audit firms.

In a major step, the committee urges the SEC to mandate annual shareholder ratification of the company’s outside auditor. Under Sarbanes-Oxley, the audit committee hires, pays and oversees the work of the outside auditor. The committee believes that shareholder ratification of the audit firm will enhance the audit committee’s oversight to ensure that the auditor is suitable for the issuer’s size and financial reporting needs. At the same time, shareholders will be given a voice on the reasonableness of audit fees and any apparent conflicts of interest.

The committee reasoned that shareholder ratification of the outside auditor would be more meaningful if accompanied by the disclosure of key indicators of audit quality, Thus, the panel asks the PCAOB to develop key indicators of audit quality and require audit firms to publicly disclose them. The Board could monitor the audit quality indicators through its inspection process. Audit quality indicators could be the average experience level of auditing firm staff on individual engagements, the average ratio of auditing firm staff to auditing firm partners on individual engagements, and annual staff retention.

More granularly, the committee urges the PCAOB and SEC to clarify in the auditor’s report the auditor’s role in detecting fraud; and the limitations on that role imposed by current auditing standards. An expectations gap has arisen between the public’s perception of the ability of outside auditors to detect and prevent fraud, noted the panel, and the actual capability of auditors to do so under current regulation. In light of this continuing expectations gap, the committee asks the PCAOB to review the auditing standards governing fraud detection and fraud reporting and update these standards as needed..

The panel believes that a collective sharing of fraud prevention and detection experiences among auditors and other market participants will provide a broad view of auditor practices and ultimately improve fraud prevention and detection capabilities. With that in mind, the committee urges auditors, in consultation with the SEC and PCAOB, to develop best practices for fraud prevention and detection.

In an effort to help investors determine the quality of financial reporting and make investment decisions, the committee asks the SEC to amend Form 8-K to characterize appropriately and report on every public company auditor change. The SEC should also require audit firms to notify the PCAOB of any premature engagement partner changes on audit clients if made before the normal rotation period and, expect in cases of retirement, the reason for the premature change.

The committee tackles the salient and seemingly intractable problem of auditor concentration and the need to expand the number of global audit firms. Noting that underwriters and lenders often insist that the company employ a Big Four audit firm and thereby limit auditor choice, the panel urges the SEC to require disclosure in the annual report and proxy statement any agreements with third parties that limit auditor choice. The UK auditor overseer has also suggested similar disclosure of contractual obligations limiting auditor choice. In addition, the panel asks the SEC and PCAOB to include smaller audit firms in their public forums.

It is also important to auditor choice that the Big Four not become the Big Three. To this end, the PCAOB should monitor potential sources and situations of catastrophic risk at he audit firms that it oversees. The Board could conduct this monitoring through its existing inspections, registration, and reporting regimes.

At the same time, the panel proposes a two prong governance mechanism for larger audit firms to assist in the preservation and rehabilitation of a troubled firm. The first step would be for the SEC and PCAOB to encourage larger audit firms to adopt a voluntary internal governance mechanism that could be triggered in the event of threatening circumstances.

If the governance mechanism failed to stabilize the firm, a second step would permit the SEC to appoint a court-approved trustee to preserve and rehabilitate the firm by addressing the threatening situation, including through a reorganization, or if such a step were unsuccessful, to pursue an orderly transition. If this second mechanism includes addressing claims of creditors, the panel recognizes that legislation to integrate this mechanism with the judicial bankruptcy process may be necessary.

Friday, June 13, 2008

IAASB Nears Completion of Redrafting Project as Acceptance of Int'l Standards Grows

The International Auditing and Assurance Standards Board is on target to complete the redrafting of all its 35 international auditing standards by the end of 2008, noted IFAC President Fermin del Valle at a recent IOSCO seminar, and these standards will be effective for financial periods beginning on or after December 15, 2009. Under its Clarity Project, which is a precursor to converged international audit standards, the IAASB is presently redrafting its entire body of audit standards using new drafting conventions. The Clarity Project is crucial to removing barriers to convergence to international auditing standards, said the official, who called the effort one of the most significant milestones in the history of auditing

The Clarity Project has been a major focus of the international regulators' attention over the past two years, with IOSCO and SEC officials coordinating the Board’s activities and discussing proposed standards. PCAOB Chair Mark Olson has said that global auditing standards are inevitable, but that they will be 10 years behind global accounting standards. The PCAOB is currently tailoring its auditing standards to minimize the differences with the standards adopted by the IAASB.

A significant number of countries are currently using international audit standards or are adopting such as national standards or are converging by comparing national standards with international standards to eliminate differences. Even more significant, said the IFAC official, is the fact that this year seventeen international networks of accounting firms, whose member firms perform transnational audits, have implemented a globally coordinated quality assurance program committed to the use of international audit standards.

Broader global organizations are also embracing international audit standards at some levels. For example, The World Federation of Exchanges endorsed the IAASB’s processes for standard setting and recognized the importance of international audit standards. The Financial Stability Forum identified international audit standards as a key standard for sound financial systems and deserving of implementation depending on country circumstances. Finally, he noted that the World Bank uses international audit standards as the benchmark for assessing the quality of national auditing and accounting standards.

As the financial world moves towards international audit standards, the IFAC chief praised the IAASB governance and the Board’s transparent standard-setting process. All proposals and final standards are debated and approved at an open and public IAASB meeting. In advance of each meeting, the IAASB posts the agenda and background materials publicly on its web page. In addition, the IAASB makes all its exposure drafts, final standards, project histories, and audio recordings of its meetings freely available. Proposed auditing standards are normally given a 120-day comment period.

Also, throughout the entire standard-setting process, the IAASB is subject to public interest oversight from the independent Public Interest Oversight Board.
With regard to governance, the IFAC official noted that the PIOB oversees the process of nominating IAASB members. The PIOB is involved throughout this process, including having a representative attend all meetings of the nominating committee where candidates for membership on the IAASB are discussed. The PIOB also has final approval of candidates for these groups. This year, IFAC achieved its goal of creating a balance of 50 percent practitioners and 50 percent non-practitioners on the IAASB.

Thursday, June 12, 2008

New Developments in SEC's Comment Letter Process Reviewed

This post is courtesy of my colleague Mark Nelson, who intensely follows the SEC's comment letter process.

This month, the Division of Corporation Finance posted a document titled "Filing Review Process" on its website The new document is the most concise explanation of the disclosure review and comment letter process to date and ties together many important ideas. This blog entry will review the new document and several other press releases, staff speeches, and commission reports describing the comment letter process. The bibliography following the blog contains links to the original documents.

The SEC announced its plans to publicly release staff comment letters and issuer responses in a press release on June 24, 2004. One year later, after overcoming technical issues, the staff began to release comments via EDGAR starting with the May 12, 2005 upload. Initially the volume of comment letters was very low, but by mid-year 2006, the volume began to increase as the staff cleared the backlog. The public comment letters program covers filings made after August 1, 2004 to the present, although earlier comments must be obtained via FOIA request. Staff comment letters regarding disclosure review are distinguishable from the comments submitted by interested persons regarding proposed rulemaking. Currently, there are approximately 70,000 comment letters and issuer responses available on EDGAR plus a significant number of issuer responses that have been attached as exhibits to filings.

The staff have also published comment letters that were subject to two special reviews pertaining to International Financial Reporting Standards (IFRS) and the new executive compensation rules. The list of companies subject to the IFRS review is available on the SEC's website. Executive compensation comments are not well disclosed on the SEC's website, but can be identified by reviewing the initial staff letter for a paragraph stating that the review is limited to the issuer's executive compensation disclsoure. The CCH division of Wolters Kluwer reproduces all publicly released staff comment letters posted on EDGAR in a topically organized and searchable database. Abstracts of significant comments are published in a related newsletter.

According to the division's "Filing Review Process" document, the division staff begins the disclosure review process by conducting reviews required by the Sarbanes-Oxley Act of 2002. Under SOX Section 408, the staff must review each public company's disclosure once every three years. The staff also conducts selective reviews of public offerings, mergers, proxies and other transactional filings based upon the results of preliminary reviews. The staff, however, has not publicly disclosed the criteria used in preliminary reviews. Once the decision to conduct a review has been made, the staff may undertake a full review of the entire filing, perform a review of financial statements only, or engage in a targeted issue review focused on specific items of disclosure. The eleven offices within the disclosure review organization are dedicated to specific industries and comprise 80 percent of the division's employees, with 25 to 35 attorneys and accountants assigned to each office. The cover letter preceding each staff comment letter indicates which office conducted a particular review.

The staff do not always issue comments as part of the disclosure review process, but when comments are issued to a company, the staff and the issuer engage in a back-and-forth dialog regarding the items noted by the staff. Communications are often times in written form, but the dialog also can occur telephonically or by facsimile. Rule 83 accords an issuer the opportunity to assert confidentiality over portions of its response dealing with competitively sensitive information. Confidential materials are not reproduced when the comments are posted on EDGAR. Many of the staff's comments require an issuer to address an item in its future filings, although the staff will occasionally ask a company to amend or formally restate its filings. An issuer also must file a so-called "Tandy letter" stating that the staff's comments may not be raised as a defense to any proceeding. At the conclusion of the comment letter process, the staff typically will issue a "No Further Comments" letter or , at an issuer's request, the staff may declare a registration statement to be effective. Staff comments and issuer responses are then published on EDGAR no earlier than 45 days after the disclosure review period has ended.

At any time during the comment letter process, an issuer may request that the staff reconsider any comments it has provided to the issuer. The reconsideration process is informal and may be written or oral. In general, an issuer should first contact the examiner for clarification before it responds. Next, the issuer may speak to the reviewer who approved the comments. Reconsideration by more senior staff depends on the type of issue to be reconsidered. Legal and textual matters should be addressed, in order, to the legal branch chief in the assistant director office, the assistant director, the associate director, the deputy director, and the director of the Corporation Finance division. Similarly, accounting issues should be directed to the accounting branch chief in the assistant director office, the senior assistant chief accountant of the relevant office, the associate chief accountant in the division's office of the chief accountant, and the division's chief accountant.

For additional insight into the disclosure review and comment letter process, the following bibliography should be consulted:

Press Release (June 24, 2004): SEC Staff to Publicly Release Comment Letters and Responses


Speech by John White (September 25, 2006):An Expansive View of Teamwork: Directors, Management and the SEC

Speech by John White (June 5, 2008): IFRS and U.S. Companies: A Look Ahead