Sunday, August 31, 2008

SEC and Federal Reserve Board Issue Regulation R Guidance for Small Entities

Guidance prepared by the staffs of the SEC and Federal Reserve Board has been issued for small entities. The guidance was prepared as a “small entity compliance guide” under Section 212 of the Small Business Regulatory Enforcement Fairness Act of 1996.

Regulation R was jointly adopted last year by the Fed and the SEC to implement the bank broker provisions of the Gramm-Leach-Bliley Act. Regulation R provides a flexible framework for banks to continue to serve the demands of their customers for banking services that include securities products while ensuring consumer protection.

The Gramm-Leach-Bliley Act repealed the blanket exemption banks had historically enjoyed from the Exchange Act definition of broker and replaced it with a set of limited exemptions that allow the continuation of traditional activities performed by banks. Thus, a bank will be considered a broker under the Exchange Act and subject to the full panoply of SEC regulation if it engages in the business of effecting transactions in securities for the accounts of others. However, at the same time, the Act carves out a number of exemptions from the definition of broker. Regulation R implements those exemptions.

The exemptions embrace a number of activities and transactions traditionally performed by banks and those involving identified excepted banking products. If a bank limits its brokerage activities to those described in the exceptions, the bank will not be subject to broker-dealer registration.

In the guidance, the staffs noted that, if more than one broker exemption is available to a bank under the statute or Regulation R, the bank may choose the exemption on which it relies to effect the transaction without registering as a broker-dealer. For example, if a bank effects no more than 500 securities transactions as agent for its customer in a calendar year, the bank may rely on the de minimis exception in lieu of any other available exception for such transactions. The bank, of course, must comply with all of the requirements contained in the exception on which it relies. More broadly, the staffs advise that any bank that wants to rely on one of these exemptions to the definition of broker should review and understand the terms, limits and conditions to the particular exemption.

The safekeeping and custody exception allows banks to engage in a variety of securities activities in connection with their customary custody and safekeeping activities, such as, for example, clearing and settling securities transactions and holding pledged securities on behalf of a customer. The staffs noted that a bank does not need to rely on this exception if it does not accept orders from or on behalf of custody accounts.

The networking exception permits bank employees that are not registered representatives of a brokerage firm to refer customers to the firm subject to several conditions, including a prohibition on the a bank employee referring a customer to a securities broker from receiving incentive compensation for a securities transaction other than a nominal one-time cash fee for making the referral. The staffs pointed out that the definition of incentive compensation in Regulation R includes exclusions from that definition for certain types of bank bonus plans.

There is also an exemption for securities transactions effected by a bank in a trustee or fiduciary capacity so long as the bank is chiefly compensated for effecting such transactions with certain types of fees called relationship compensation. Regulation R provides examples of the type of fees that qualify as relationship compensation and also specifies the conditions a bank must comply with in order to rely on the trust and fiduciary exception, such as restrictions on the bank’s advertisement of its securities activities for its trust and fiduciary accounts.

Saturday, August 30, 2008

Hedge Fund Industry Concerned with Working Group FAS 157 Valuation Recommendations for Fund Managers

The hedge fund industry has significant concerns with recent best practices recommended by the President's Working Group on Financial Markets regarding the disclosure of the valuation of managed assets centered on FAS 157 fair value accounting. In a letter to the Working Group, the Managed Funds Association said that the ambiguities of fair value accounting work against achieving a consensus on proper valuation of a hedge fund’s portfolio assets. The MFA also noted that the recommended disclosure goes beyond the requirements of FAS 157.

The Working Group issued complementary sets of best practices for hedge fund mangers and investors in the most comprehensive effort yet to increase accountability for participants in the industry. The Working Group called on hedge fund manegers to adopt comprehensive best practices in the critical areas of disclosure, valuation of assets, risk management, and conflicts of interest. Specifically, the Working Group said that fund managers should provide financial information supplementing FASB Standard No. 157 to help investors assess the risks in the valuation of the fund's investment positions.

Depending upon the extent to which the fund manager invests in illiquid and difficult-to-value investments, noted the Working Group, the disclosures should occur at least quarterly and include the percentage of the fund's portfolio value that is comprised of each level of the FAS 157 tripartite valuation hierarchy. Level 1 is comprised of assets with highly liquid market prices, while Level 2 assets have no quoted prices but there are similar assets with quoted prices. Level 3 is for illiquid assets that have to be priced using models.

The group also said a best practice would be to set up a Valuation Committee with ultimate responsibility for reviewing compliance with the fund manager's valuation policies. Further, the group said that independent personnel should be in charge of the valuation of the fund's investment positions. While broadly agreeing that investors would benefit from disclosure of hedge fund valuation policies, the MFA noted that there is much ambiguity and a lack of consensus among managers, counterparties and accounting professionals as to the appropriate treatment of a number of products under FAS 157 such that the Working Group’s recommendations may not be achievable. Further, the lack of consensus is likely to result in inconsistent disclosure across the industry, which could be both confusing and potentially mislead investors.

Thus, until a greater consensus exists with respect to implementation of FAS 157, the MFA asks that this recommendation be deleted. The MFA noted that fund managers will still be required by their independent auditors to follow the procedures specified in FAS 157, as the industry continues to develop consensus on the implementation of those procedures.

The committee also recommended that hedge fund managers disclose the percentages of a fund’s portfolio value for which a manager relied on one dealer quote and multiple dealer quotes. The MFA believes that this disclosure could also be misleading to investors since there are certain types of products for which one dealer quote is used in valuing the asset, even though there is a liquid and deep market for the product, such as certain types of OTC products. There may also be products for which multiple quotes are available, but for which there is not a particularly liquid, active and deep market. While the availability of multiple dealer quotes may be an indication of the level of market activity for an asset, said the MFA, it may be misleading in certain instances. As such, the group was urged to delete this recommendation.

While agreeing that the valuation function should be independent of the portfolio management function in order to reduce conflicts of interest, the MFA believes that the recommendations are confusing when read in conjunction with the make-up of the proposed Valuation Committee. The Working Group said that the Valuation Committee may include members of senior management who have portfolio management responsibilities. However, the recommendations also discuss segregation of valuation personnel from portfolio management personnel. To the extent that a Valuation Committee is partially comprised of senior portfolio managers, reasoned the MFA, then the desired segregation of personnel does not seem possible.
UK Accounting Regulator Proposes Changes to Directors Going Concern Report to Reflect IFRS

The UK Financial Reporting Council has proposed revisions to its guidance for directors going concern and financial reporting in light of the adoption of international financial reporting standards and the ongoing financial crises. The listing rules of the Financial Services Authority require the annual reports of listed companies to include a statement by the directors on the going concern status of the company. In making their statement, directors are required to consider the going concern guidance. In addition to the listing standards, the UK corporate governance Combined Code states that directors should report on the business as a going concern, with supporting assumptions or qualifications as necessary. Comments on the proposals are invited until Nov 24, 2008.

Since the guidance was adopted in 1994, there have been substantial changes to accounting standards. In particular, noted the FRC, substantial additional disclosures are required about how liquidity risks are managed, the maturity profile of liabilities, and details of any defaults on borrowing covenants. The FRC also observed that current economic conditions are creating particular challenges for companies. Recent developments in global debt markets have led banks to be cautious of lending to one another, which has severely restricted liquidity and created unexpected financial difficulties for banks and entities that depend on the availability of loans as a key source of capital.

First off, the FRC reaffirmed that the use of the going concern basis of accounting is so fundamental to the preparation of financial statements that directors should make an explicit written statement in their annual report that they are satisfied that the going concern assumption remains appropriate. The going concern concept is a fundamental accounting concept that underlies the preparation of financial statements. The Companies Act of 2006 requires that the company be presumed to be carrying on business as a going concern.

In assessing going concern, said the FRC, directors should take account of all information of which they are aware at the time. It is not possible to specify a minimum period to which they should pay particular attention in assessing going concern. The FRC recognizes that any such period is artificial and arbitrary. When the period considered by the directors has been limited, for example, to a period of less than one year from the date of approval of the financial statements, the directors should determine whether, in their opinion, the financial statements require any additional disclosure to explain adequately the assumptions that underlie the adoption of the going concern

Consistent with IFRS, budgets and forecasts for the entity as a whole should be prepared to cover the period to the next balance sheet. The onus is on the directors to be satisfied that there are committed financing arrangements in place. IFRS 7 requires disclosure of defaults on borrowings and certain breaches of covenants. Directors should also consider the company’s exposure to contingent liabilities such as legal proceedings and environmental clean up.

There are many types of financial risk facing a company, sad the FRC, and directors should identify which risks are most significant to their company. IFRS 7 requires directors to disclose what financial risks they face and their objectives and polices for managing these risks.

Directors should include their statement on going concern in the Business Review section of the directors’ report. Directors should also consider whether there needs to be a specific cross reference between the going concern statement in the Business Review section and the accounting policy note in the financial statements.

After directors have conducted the going concern analysis, they are four conclusions they can reach, with the fourth one newly proposed. First, that they have a reasonable expectation that the company will continue in operatio and have therefore used the going concern basis in preparing the financial statements. Second, that they have identified factors which cast doubt on the ability of the company to continue in operation but they consider it appropriate to use the going concern basis in preparing the financial statements.

Third, that they consider that the company is unlikely to continue in operation and therefore the going concern basis is not appropriate. Fourth, added by the proposal, that they have identified material uncertainties that may cast significant doubt on the ability of the company to continue as a going concern; and so additional disclosures are required by IFRS.

Thursday, August 28, 2008

Hedge Funds and Private Equity Funds Ask FASB for Exemptions from FIN 48

A growing chorus of hedge fund and private equity groups has asked FASB for an exemption from FIN 48, a FASB interpretation of a standard on accounting for income taxes. In a letter to FASB, the Managed Funds Association said that the sophisticated investors that invest in hedge funds do not need the enhanced disclosures that FIN 48 was designed to provide. In its letter, the Private Company Financial Reporting Committee stated that private company financial statement users find the accounting matters and disclosures encompassed by FIN 48 to be largely irrelevant to their decision making. The committee’s also noted that FASB and the IASB are working on a convergence project on accounting for income taxes and that this may significantly affect FIN 48. Thus, if FASB is unwilling to grant hedge funds an exemption from FIN 48, the private fund groups ask that the Board at least postpone the effective date of FIN 48 pending completion of the convergence project.

FIN 48 was adopted to provide for increased relevance and comparability in financial reporting of income taxes and to provide enhanced disclosures of information about the uncertainty in income tax assets and liabilities. The genesis of FIN 48 is FASB Statement No. 109, which established financial accounting and reporting standards for the effects of income taxes that result from an enterprise’s activities during the current and preceding years. It requires an asset and liability approach to financial accounting and reporting for income taxes

While acknowledging the need for FIN 48-type disclosures in the case of companies offering securities to the investing public, the MFA pointed out that the institutions and individuals that invest in private investment funds do not fall within this category. Hedge fund investors typically conduct extensive due diligence assisted by their own lawyers, accountants and other advisers, noted the MFA, and they often request, and receive, additional information, including tax information, if they believe that such information is material to their investment decision.

Moreover, private investment funds with U.S. investors are treated as partnerships for Federal income tax purposes. As a result, a private investment fund is not itself a taxpayer. It files an annual information return with the IRS, said the MFA, and each investor in the fund pays tax on its pro-rata share of the income of the fund. Thus, while fund personnel have historically focused substantive attention on issues surrounding the proper allocation of taxable items in a partnership environment, explained the MFA, it has been unnecessary for them to devote substantial time to traditional FAS 109 accruals.

For this reason, private investment funds are incurring significant costs in preparing to comply with, and complying with, FIN 48. Even more, many private investment funds make investments outside the United States, said the MFA, and FIN 48 will require them to make an additional layer of judgments concerning uncertainties in the tax laws of other countries.

Finally, the MFA noted that hedge funds need to determine NAV with reasonable frequency, both to establish a price for investments and redemptions, and also for other purposes. As a result of the fiduciary nature of the NAV calculation, and economic fairness to investors that subscribe and redeem at that amount, the MFA believes there are substantial questions whether FIN 48 analyses should be reflected in the NAV of a private investment fund.

The MFA is aware that SEC has concluded that FIN 48 analyses should be reflected in NAV in order to give investors more disclosure. Significantly, however, the SEC said its guidance was limited to assessing tax positions reflected in NAV calculations subject to the Investment Company Act and should not be applied by analogy in other cases.

The MFA believes that there are differences between public and private investment companies that warrant a different conclusion with respect to private investment funds. The MFA stands ready to make a more comprehensive submission on this point if the FASB believes that it would be of assistance.

Wednesday, August 27, 2008

Global Accounting and Auditing Firms Raise Auditor Attestation Issues with SEC XBRL Proposal

While expressing overall support for the SEC‘s proposed move towards requiring interactive XBRL filings of financial statements, global accounting and auditing firms have concerns about auditor attestation and internal controls. The firms are concerned about the extent of the independent auditor’s involvement with the XBRL information. The SEC proposal would require the submission of interactive data-formatted financial statements according to a phase-in schedule beginning with domestic and foreign large accelerated filers with a worldwide public common equity float above $5 billion. The comment period on Release No. 33-8924 ended on August 1, 2008.

The firms agree with the proposing release’s provision that during the three-year phase-in period no form of auditor assurance should be required for the interactive data exhibit furnished with a company’s filing. But, the firms generally believe that, in order to prevent investor confusion, filings should clearly specify the extent of auditor involvement with the interactive data exhibit. Deloitte & Touche specifically urged the SEC and PCAOB to work with the auditing profession to revise the standard report of the independent auditor to expressly refer to the financial statements filed in Item 8 of the Form 10-K and perhaps to include a statement that assurance has not been provided on the interactive data.

Moreover, until the issuance of amended auditing standards, the firm recommends that the final SEC rules prohibit tagging the auditor’s report when no assurance has been provided on the interactive data exhibit. Otherwise, reasoned the firm, an investor viewing the report in the rendered XBRL document could incorrectly conclude that the auditor’s report covers the interactive data.

Unless an auditor’s report on the interactive data exhibit is included in the filing, said the firm, the SEC also should require separate disclosure in the interactive data exhibit explicitly stating that the interactive data has not been subject to any assurance procedures either at the individual tag level or taken as a whole. The firm also suggested that the SEC could avoid the potential for confusion by requesting the PCAOB to issue guidance consistent with this interpretation.

PricewaterhouseCoopers urged the SEC to consider cautionary language in the XBRL Exhibit and on the SEC Viewer to make clear to investors that there will be neither auditor assurance on the Exhibit nor any consideration by the auditor of the information. Eventually, predicted PwC, users relying on XBRL-formatted financial statement information will seek the same level of confidence in the reliability and accuracy that they currently have on audited financial statements used in traditional format.

The firm fundamentally believes that independent assurance on XBRL documents adds value by increasing reliability and enhancing public confidence in financial reporting. In this spirit, the firm wants to engage in a collaborative process with the SEC, the PCAOB and other market participants to help define an appropriate assurance framework that provides meaningful value to investors.

The firms expect that a number of issuers will voluntarily seek assurance-related or other permitted services on their XBRL submissions. As a result, PwC, BDO, and Grant Thornton said it would be appropriate for the SEC to request that the PCAOB update the May 2005 PCAOB Staff Questions and Answers, Attest Engagements Regarding XBRL Financial Information Furnished Under the XBRL Voluntary Financial Reporting Program, for use beyond the voluntary program, which would be discontinued under the SEC proposal.

In addition, PwC believes that it would be beneficial for the SEC to include in the final rules guidance around the appropriate protocol for submitting general use auditor XBRL attestation reports when a company obtains such voluntary assurance. Ernst & Young asked the PCAOB and SEC to seek input from companies and investors on the type, timing and extent of assurance, if any, that should be provided during the phase-in period.

Further, BDO suggested that the PCAOB consider the feasibility of services other than an examination, such as a review or agreed upon procedures, and provide appropriate guidance. In any event, the Commission should clarify in the final rule the type of reports that would be appropriate in filings as well as the legal liability, if any, associated with any attestation reports issued by auditors and voluntarily provided by companies. The Commission also should develop specific guidance on how the auditor reports that are issued on interactive data are to be filed in conjunction with the interactive data exhibit.

The SEC noted in the proposal that the preparation of financial statements may eventually become interdependent with the interactive data tagging process. As this occurs, a company and its auditor should evaluate these changes in the context of their Sarbanes-Oxley mandated reporting on the effectiveness of internal controls. However, the evaluation would not require an auditor to separately report on a company’s interactive data provided as an exhibit to a reports or registration statement

With this in mind, commenters asked that the final rules clarify that the auditor’s report on a company’s internal controls provides no assurance on the interactive data exhibit. Under PCAOB standards, an auditor is not permitted to perform an audit of the effectiveness of internal controls unless it has audited the underlying financial statements to which the internal controls relate. Thus, for internal controls to be extended to include controls over the creation of the XBRL submission, reasoned the firms, the auditor also would have to perform an audit of the
XBRL submission.

The SEC proposal indicates that the interactive data is excluded from the officer certification requirements under the Exchange Act, but it is unclear whether the basis for this exclusion is that the exhibit does not constitute disclosure controls and procedures as defined by the Exchange Act or whether the exclusion is simply an exception to the general rule that has been granted by the Commission at this time. In the view of KPMG, the exemption of the Interactive Data Exhibit from the officer certification requirements implies that the Exhibit need not be subjected to the issuer’s disclosure controls and procedures.

Tuesday, August 26, 2008

Vermont Adopts New Fees for Notice Filings, Securities Registrations, and Agents

The Vermont Division of Securities and Retail Franchising changed the following fees, effective July 1, 2008:

1. Notice filings. For offerings by investment companies under Section 18(b)(2) of the Securities Act of 1933 and for registrations of securities, the fee is now a flat $600. The old fee was $1.00 for each $1,000 of the aggregate amount of the offering of the securities to be sold in Vermont for which the issuer is seeking to perfect a notice filing under this section, with minimum and maximum fees of $400 and $1,250, respectively.

2. For offerings under Section 18(b)(4)(D) of the Securities Act of 1933--Rule 506 offerings--the fee is now a flat $600. The old fee was $1.00 for each $1,000 of the aggregate amount of the offering of the securities to be sold in Vermont for which the issuer is seeking to perfect a notice filing under this section, with minimum and maximum fees of $400 and $1,250, respectively.

IMPORTANT NOTE ON RULE 506: Even with the 7/1/2008 effectiveness of the $600 fee, Vermont still DOES NOT require a notice filing for Rule 506 offerings. HOWEVER, Securities Examiner John Reese in Vermont at jreese@bishca.state.vt.us has informed me 8/26/2008 that the Vermont Securities Staff is presently working on a 506 Rule to be adopted in a few months that will reinstate the notice filing on Form D, the Consent to Service of Process on Form U-2 and implement the $600 fee.

3. Agent registration fees. The registration fee for agents is $60, up from $55. However, the registration fee for investment adviser representatives remains at $55.

Monday, August 25, 2008

Fed Chair Seeks Legislation on Macro Prudential Regulation of Systemic Risk to Financial System

Citing the Bear Stearns experience, Federal Reserve Board Chair Ben Bernanke asked Congress to adopt a regulatory macro-prudential regime capable of dealing with systemic risk to the financial markets. In remarks at the Fed’s annual economic symposium, he also asked Congress to give the Treasury the duty and resources to intervene in cases in which an impending default by a major investment firm is judged to carry significant systemic risks. These remarks were similar to the chair’s recent testimony before the House Financial Services Committee in which he said that legislation is needed to authorize strong holding company oversight of large investment banks currently regulated under the SEC’s consolidated supervised entity regime. He also urged Congress to provide new tools for ensuring the orderly liquidation of a systemically important investment firm that is on the verge of bankruptcy.

In his view, the critical question for regulators and policy makers is what the Fed official called "the appropriate field of vision." Under current safety-and-soundness regulation, the focus is on the financial conditions of individual institutions in isolation. The system-wide or macro-prudential oversight envisioned by the Fed Chair would broaden the mandate of regulators to encompass consideration of potential systemic risks and weaknesses. Under macro-prudential regulation, federal agencies would determine the risks imposed on the system as a whole if common exposures significantly increase the correlation of returns across institutions. But the Fed chief assured that, in warning against excessive concentrations or common exposures across the system, regulators would not make a judgment about whether a particular asset class is mispriced, although he admitted that rapid changes in asset prices or risk premiums could increase the level of regulatory concern.

A system-wide focus for financial regulation would also increase attention on how the incentives and constraints created by regulations affect behavior, especially risk-taking. For example, risk concentrations that might be acceptable at a single institution in a period of economic expansion could be dangerous if they existed at a large number of institutions simultaneously.

More ambitiously, macro-prudential regulation would involve the development of a more fully integrated overview of the entire financial system. This approach is well justified, he said, since the financial system has become less bank-centered and because activities or risk-taking not permitted to regulated institutions have a way of migrating to other financial firms or markets. But he also cautioned that this approach would be technically demanding and possibly very costly both for the regulators and the firms they supervise.

It would likely require at least periodic surveillance and information-gathering from a wide range of nonbank institutions, such as securities industry participants. For example, increased coordination would be required among the private and public sector supervisors of exchanges and other financial markets to keep up to date with evolving practices and products and to try to identify those which pose risks outside the purview of each individual regulator. International regulatory coordination, already quite extensive, would also need to be expanded.

Another aspect of macro-prudential regulation would be stress testing across a range of firms and markets simultaneously. In his view, wide-ranging stress testing might reveal important interactions that are missed by stress tests at the level of the individual firm. For example, such an exercise might suggest that a sharp change in asset prices would not only affect the value of a particular firm's holdings but also impair liquidity in key markets, with adverse consequences for the ability of the firm to adjust its risk positions or obtain funding.

System-wide stress tests might also highlight common exposures that would not be visible in tests confined to one firm. Again, however, the technical and information requirements of conducting such exercises effectively must not be underestimated. Financial markets move swiftly, he noted, firms' holdings and exposures change every day; and financial transactions do not respect national boundaries. Thus, the information requirements for conducting comprehensive macro-prudential surveillance could be daunting.

The senior official also cautioned that macro-prudential regulation presents communication issues. For example, the expectations of the public and of financial market participants would have to be managed carefully, he reasoned, since such an approach would never eliminate financial crises entirely. Indeed, an expectation by financial market participants that crises will never occur would create its own form of moral hazard and encourage behavior that would make financial crises more likely.
Securities Regulators Must Scrutinize Mortgage Brokers

Securities regulators need to provide more oversight over the licensing of mortgage brokers says some industry attorneys following the resignation of Don Saxon, the Florida Commissioner of Securities, amid reports published in the Miami Herald that his agency let many convicted criminals work in the mortgage business, including bank robbers and racketeers. Florida, however, is not the only state that has seen the resignation of it's securities commissioner: G. Brent Bishop was fired as Ohio's Securities Commissioner in August, 2007. Mr. Saxon and Mr. Bishop both faced pressure after local newspapers analyzed records of mortgage brokers, although Florida is the only state that places the licensing of mortgage brokers directly into the hands of its securities division.

Joseph Borg, the Director of Alabama's Securities Division and former president of the North American Securities Administrators Association (NASAA), said the biggest problem is resources. A state's legislature is the body required to fund licensing agencies but it often does not have the money to do detailed background checks, and without funding the job can't get done.

With compliments to Bruce Kelly.
Email: bkelly@investmentnews.com
9th Circuit: State Claims Against Clearing Agencies Preempted

A 9th Circuit panel found that the federal securities laws preempted state law fraud claims against Depository Trust and Clearing Corp., Depository Trust Co. and the National Securities Clearing Corp. The claims arose from the stock borrow program created by NSCC to deal electronically with temporary short term fails-to-deliver. As alleged by an issuer, the stock borrow program facilitated naked short selling and artificially depressed the price of its stock by creating more electronic shares in the marketplace than were reflected in paper stock certificates.

Under the stock borrow program approved by the SEC, NSCC settles fail-to-deliver transactions by electronically “borrowing” the requisite number of shares of the undelivered stock from one of its members who is willing to lend the shares, and then delivering the “borrowed” shares to the purchaser. NSCC guarantees the transactions it processes by assuming the obligation of sellers to deliver shares to buyers. The buyer is credited with the shares and generally unaware that there has been a fail-to-deliver.

The appeals court found that Congress did not intend to preempt the entire field of regulating the clearing and settlement of securities transactions. So-called "field preemption" was inapplicable because "an examination of the statutory framework of the Exchange Act does not reveal the comprehensiveness necessary to infer that Congress intended" for federal regulation to completely occupy the field. However, the court concluded that "conflict preemption" applied because the state claims to either the existence or the operation of the program "would conflict with Congressional directive, as set forth under Section 17A."

The SEC previously expressed its support for such a conclusion in an amicus brief filed in similar litigation. In 2006, the SEC asserted that the
plaintiffs’ theory of liability would open up any Commission-approved SRO rule to challenges under similar theories, namely that the Commission erred in approving the rule because it misapprehended the rule’s consequences, and that the SRO then committed state-law fraud by failing to disclose the facts that establish the Commission’s error. Of course, any state law that created this result would make uniform regulation impossible, and would impermissibly stand as an obstacle to the accomplishment and execution of the full purpose and objectives of Congress in creating the Exchange Act’s self-regulatory regime, including the portion of that regime applicable to registered clearing agencies under Section 17A.

Whistler Investments, Inc. v. The Depository Trust and Clearing Corp. (9th Circuit) (opinion in full text)

Friday, August 22, 2008

Federal Appeals Court Upholds Constitutionality of PCAOB

A split federal appeals court panel has ruled that the PCAOB is constitutional and rejected the claims of an audit firm inspected by the Board that SEC rather than presidential selection of Board members ran afoul of the Appointments Clause of the US Constitution. The appeals court concluded that Board members are inferior officers of the United States within the meaning of the Appointments Clause; and thus properly appointed by the SEC. The fact that the Sarbanes-Oxley Act limited the SEC’s authority by providing that Board members can only removed for cause did not elevate Board members to the status of principal officers of the US worthy of presidential appointment. Despite the for-cause removal, said the panel, the fact remained that the Act gave the SEC comprehensive and pervasive control of the PCAOB, including the approval of the Board’s budget. Free Enterprise Fund v. PCAOB, No. 07-5127, DC Circuit Court of Appeals, Aug. 22, 2008).

The Appointments Clause empowers the President to appoint officers of the U.S., while allowing Congress to vest the appointment of inferior officers in Heads of Departments. The audit firm argued that PCAOB members are not inferior officers since they are neither appointed nor supervised on a daily basis by principal officers directly accountable to the President. Rejecting this argument, the appeals court held that the SEC is a Department; that the commissioners are Heads of a Department under the Appointments Clause; and that PCAOB members are inferior officers subject to appointment and removal by the SEC. Thus, the Sarbanes-Oxley Act provisions creating the PCAOB did not violate the Appointments Clause.

The SEC’s power over the PCAOB is broad and complete, noted the court, since no Board rule or standard is promulgated and no Board sanction is imposed without the Commission’s stamp of approval. Further, all Board adjudications are subject to Commission review. Indeed, any policy decision of the Board is subject to SEC oversight.

The SEC can also relieve the Board of any enforcement authority. Audit firms inspected by the Board can seek SEC review of their inspection report. The SEC can modify the Board’s investigative authority as it sees fit and may mandate that all decisions regarding enforcement actions be approved by the Commission.

The audit firm’s argument that the SEC is not a constitutional Department of the federal government capable of appointing Board members was also rejected. The court said that the Commission is “Cabinet-like” because it exercises executive authority over a major aspect of government policy, and its principal officers are appointed by the President with the advice and consent of the Senate. The SEC is not a subordinate body attached to an executive departments, noted the court, but is in itself an independent division of the Executive Branch with certain independent duties and functions.

Moreover, the commissioners are heads of a Department under the Appointments Clause because they, as a group, exercise the same final authority as is vested in a single head of an executive department. Congress gave the SEC rulemaking, investigative, and adjudicatory authority. And, emphasized the court, Congress can authorize multi-member commissions to appoint inferior officers.

Finally, the appeals panel rejected the argument that the legislative creation of the PCAOB violated the separation of powers doctrine by directly encroaching on the Executive Branch’s appointment, removal, or decision making authority. The court said that the double for-cause limitation on removal of Board members did not constitute an excessive attenuation of Presidential control of the Board.

The President is not completely stripped of his ability to remove Board members. Like-minded SEC Commissioners can be appointed by the President, noted the panel, and they can be removed by the President for cause; and Board members can be appointed and removed for cause by the commissioners. Although the level of Presidential control over the Board reflects Congress’s intention to insulate the Board from partisan forces, acknowledged the court, this statutory scheme preserves sufficient executive influence over the Board through the Commission so as not to render the President unable to perform his or her constitutional duties.

Further, there is no thought that the Board’s creation represents an unprecedented congressional innovation. The SEC’s wide-ranging oversight over the Board was modeled after the rules regarding Commission authority over self-regulatory organizations in the securities industry, which has existed for over seventy years.

Thursday, August 21, 2008

Society of Corporate Secretaries and Governance Professionals Comment on SEC XBRL Proposal

With the SEC moving towards interactive XBRL filings of financial statements, the Society of Corporate Secretaries and Governance Professionals has voiced concerns with liability and the presentation of executive compensation information. The SEC proposal would require the submission of interactive data-formatted financial statements according to a phase-in schedule beginning with domestic and foreign large accelerated filers with a worldwide public common equity float above $5 billion. The comment period on Release No. 33-8924 ended on August 1, 2008.

The Society believe that addressing liability issues separately for the Interactive Data in Viewable Form will encourage users to rely on individual pieces of financial data without referring to the disclosures that accompany financial information in the filing. Thus, when the Interactive Data in Viewable Form complies with or is deemed to comply with the requirements of proposed Rule 405 of Regulation S-T, said the Society, there should be no additional exposure to, or standard of liability for, that data. Rather, any liability should arise only with respect to the disclosures in the related official filing.

Moreover, the Society opined that the proposed requirement to post a data file on the issuer’s website isolates the financial statement disclosures from the context and disclosures that normally accompany that information when set forth in a complete annual report on Form 10-K. The Society suggested that this separate posting requirement should either not be adopted or the posting should be insulated from all liability, with any liability instead resting solely on the corresponding disclosures made in the underlying document from which the financial statements have been extracted. If the SEC retains an obligation for issuers to post an interactive data file on their websites, continued the Society, the Commission should clarify that this applies only to the file submitted with the issuer’s most recently filed Form 10-K and files submitted with any subsequent interim reports.

More broadly, the Society said that creating new standards of liability for interactive data files, whether it is a good faith or reasonably practicable standard, is neither necessary nor appropriate. While the SEC may retain authority to impose consequences for a filing that fails to satisfy the XBRL requirements, the group observed, liability attached to interactive data should be limited to cases involving fraud for deliberately manipulating or misusing the tags. Further, compliance with Rule 405 should be enforced solely by the SEC.

The distinction of liability between Interactive Data in Viewable Form and the substantive content of the financial and other disclosures is unclear. Because the Interactive Data in Viewable Form is intended to be displayed identically in all material respects to the corresponding information in the related official filing, reasoned the Society, only the related official filing should be subject to liability.

With regard to the disclosure of executive compensation, the Society’s main concern relating to interactive data submissions stems from the fact that currently executive compensation data does not have the same degree of comparability among companies as does financial data. Items, such as bonuses, non-equity incentive plan compensation, and non-qualified deferred compensation earnings, are comprised of different elements at different companies. At many companies, the compensation awards that are commonly known to employees as bonuses end up being included in the non-equity incentive plan compensation column in the Summary Compensation Table, while at other companies they end up reported in the bonus column.

In addition, under the SEC’s current method of calculating the value of options for purposes of disclosure in the Summary Compensation Table, two executives at different companies who were granted options equal in worth based on total fair value at grant could have drastically different values under the options column in the Summary Compensation Table, and in an interactive data comparison table, because one executive was age 54 and the other was age 55.

In order for an investor to have an understanding and appreciation of why those numbers are different, they would have to read the accompanying footnotes and narrative to the Summary Compensation Table, which likely would not be included in a comparison table created using interactive data.

The Society is also concerned that interactive disclosure of executive compensation data would encourage users to decouple the numerical data from the narrative explanations of that data, which would antithetical to the SEC’s new executive compensation regime. In the Society’s view, a core principle of the new regime is providing narrative disclosure needed to understand the information presented in the individual tables. To allow the investor to easily compare companies’ numerical data, while omitting a similar comparison of the narrative, would heighten the possibilities for materially misleading comparisons.

In order to preserve the concept that the narrative and numerical disclosures are inextricably linked, the Society suggested that, if tagging were to be required, the requirement should be such that any comparison of numerical data must require the accompanying narrative disclosure to travel with the numbers and appear in close proximity in the resulting comparison.

Wednesday, August 20, 2008

NYSE and Nasdaq Conform Director Independence Standards to SEC Regulation S-K

The NYSE and Nasdaq have both amended their listing standards to conform their director independence requirements to the related party transaction requirements of Item 404 of Regulation S-K. Specifically, the SROs have raised the compensation bar from $100,000 to $120,000 for purposes of deeming a director independent. Separately, the NYSE also amended the independence requirement on relationship with the company’s auditor to allow an immediate family member of a director to be employed by the auditor so long as the relation is not a partner of the audit firm or working on the company’s audit. The SEC approved the Nasdaq rule changes in Release No. 34- 58335; and the changes to the NYSE’s Listed Company Manual in Release No. 34-58367.

The changes to Nasdaq Rule 4200(a)(15)(B) provide that a director of a listed company who accepted, or has a family member who accepted, any compensation from the company in excess of $120,000 (up from $120,000) during any period of twelve months within the preceding three years cannot be deemed an independent director. Item 404 of Regulation S-K requires public companies to disclose certain material information regarding the independence of directors, among other related persons associated with the company, and establishes $120,000 as the amount above which financial transactions and relationships.

The Commission believes that it is appropriate for Nasdaq to use this same threshold amount with regard to its definition of independent director as a bright line test to determine whether a director of a listed company would be precluded from being considered independent. The SEC noted that even if a director or a family member received less than $120,000 in compensation from the listed company, the company’s board still would still have to make an affirmative determination that the director has no relationship with the listed company that, in the board’s opinion, would interfere with the exercise of his or her independent judgment in carrying out the responsibilities of a director.

NYSE

Similarly, the NYSE amended Section 303A.02(b)(ii) of its Listed Company Manual to provide that directors may not be deemed independent for purposes of Section 303A if they, or an immediate family member has received more than $120,000 (up from $100,000) in direct compensation from the listed company during a 12-month period within the last three years. The change reflects the SEC’s August 2006 amendment to the dollar threshold applicable to related party transactions that must be disclosed under Item 404 of Regulation S-K. Prior to the SEC’s amendment to Item 404, the applicable threshold for disclosures was $60,000.

The NYSE believes that the monetary threshold in its independence definition should be consistent with the amount in Item 404. Using a consistent standard would enhance the NYSE’s ability to assess compliance with the independent director requirements because companies are required to disclose compensation in excess of $120,000, but are not necessarily required to disclose compensation between $100,000 and $120,000.


Auditors and Relationship With Directors and Families

Separately, the NYSE amended the bright line test set out in Section 303A.02(b)(iii) of the Manual relating to a listed company’s internal or external auditor. The test currently precludes a director from being deemed independent if the director or an immediate family member is a current partner of a firm that is the company’s internal or external auditor; the director is a current employee of such a firm; the director has an immediate family member who is a current employee of such a firm and who participates in the firm’s audit, assurance or tax compliance (but not tax planning) practice; or the director or an immediate family member was within the last three years (but is a partner or employee of such a firm and personally worked on the listed company’s audit within that time).

The NYSE’s experience demonstrates that the current standard with respect to immediate family members has precluded a director from being deemed independent in cases even when an immediate family member had no relationship to the listed company’s audit. For example, the current test requires a listed company’s board to conclude that a director may no longer be deemed independent when the director’s child took an entry-level job in the audit practice of the listed company’s external auditor upon graduation from college, notwithstanding the fact that the child was a low-level employee in a different region and had no involvement with the listed company’s audit.

Thus, the test was modified with respect to a director’s immediate family member to cover only an immediate family member who is a current partner of the company’s internal or external auditor; is a current employee of such a firm and personally works on the listed company’s audit; or was within the last three years a partner or employee of such a firm and personally worked on the listed company’s audit within that time.

Tuesday, August 19, 2008

SEC Approves BATS Exchange Conditioned on FINRA Performing Regulatory Duties

The SEC has approved the registration of a new national securities exchange, BATS Exchange, conditioned on the further approval of the exchange’s contract with FINRA to perform examination, enforcement, and disciplinary functions. FINRA will also provide dispute resolution services, including the operation of the exchange’s arbitration program. In addition, FINRA will provide the exchange with access to FINRA’s WebCRD system. Release No. 34-58375.

The SEC believes that FINRA has the expertise and experience needed to perform these functions on behalf of the new exchange. The Exchange Act requires SROs to examine their members and associated persons and enforce compliance with the federal securities laws and their own rules. But the Act also permits an exchange to allocate regulatory duties. The exchange has indicated that it will submit an agreement with FINRA for SEC approval.

The SEC emphasized that the exchange bears the ultimate responsibility for self-regulatory conduct and primary liability for self-regulatory failures, not the SRO retained to perform regulatory functions on the exchange’s behalf. In performing these regulatory functions, however, FINRA may nonetheless bear liability for causing or aiding and abetting the failure of BATS Exchange to perform its regulatory functions. For example, if failings by FINRA have the effect of leaving the exchange in violation of any aspect of its self-regulatory obligations, BATS Exchange would bear direct liability for the violation, while FINRA may bear liability for causing or aiding and abetting the violation.

Thus, although FINRA will not act on its own behalf under its SRO responsibilities in carrying out these regulatory services for BATS Exchange, FINRA may have secondary liability if, for example, the SEC finds that the contracted functions are being performed so inadequately as to cause a violation of the federal securities laws by BATS Exchange.

Under the pact, FINRA will examine and investigate common members of BATS Exchange and FINRA for compliance with federal securities laws and regulations; and exchange rules that have been certified by BATS Exchange as identical or substantially similar to FINRA rules. FINRA will also enforce compliance by common members with federal securities laws and regulations; and exchange rules certified as identical or substantially similar to FINRA rules.

In performing many of the initial disciplinary processes on behalf of BATS Exchange, FINRA will investigate potential securities laws violations, issue complaints, and conduct hearings pursuant to exchange rules. FINRA will also assist exchange staff on registration issues on an as-needed basis, investigate potential violations of BATS Exchange’s rules or federal securities laws related to activity on the exchange, conduct examinations related to market conduct on the exchange by members, assist the exchange with disciplinary proceedings, and conduct hearings.
Montana Proposes Rules on Senior Specific Certifications and Requesting a Transactional Exemption

Rules making the use of senior specific certifications by securities industry persons an unethical practice, together with a rule setting forth the procedure for requesting a transactional exemption, were proposed by the Montana Securities Department. "FINRA" would replace "NASD" in a sales material, limited offering exemption and examination rule. Investment adviser representatives would be included with investment advisers and federal covered investment advisers as persons having a fiduciary duty to act for their clients' benefit.

Public comments and hearing. A hearing on the proposals will take place September 5, 2008 at 10:30 a.m. in the 2nd floor conference room of the State Auditor's Office in Helena, Montana. Persons may present their views of the proposed new rules & rule changes either orally or in writing at the hearing. Persons may also submit comments to Roberta Cross Guns, State Auditor's Office, 840 Helena Avenue, Helena, Montana 59601 -- Phone: (406) 444-5234; fax (406) 444-5558; email: rcrossguns@mt.gov. Comments must be received by no later than 5 p.m. on September 12, 2008.

Monday, August 18, 2008

Cox Details SEC's Conditions for Mutual Recognition of Foreign Exchanges and Brokers

As at a time when US investors are demanding foreign investment opportunities and technological innovations have eliminated physical barriers to market access, SEC Chairman Christopher Cox believes that adopting a mutual recognition regime is absolutely urgent. Reaffirming the SEC’s longstanding commitment to investor protection, the chair said that such mutual recognition is conditioned on developing proper metrics for judging the comparable investor protections of different national regulatory regimes. His remarks were delivered at a recent roundtable on mutual recognition.

At the same time that an ever increasing share of investors’ capital is allocated outside of their home countries, he noted, the markets themselves are responding through alliances and mergers of securities exchanges, including the creation of NYSE Euronext and the stake that NASDAQ has acquired in the LSE. For its part, the SEC is working as never before with its counterpart regulators around the world to develop a regulatory approach that captures all of the potential benefits of greater cross-border access to investment opportunities while providing the highest level of investor protection.

Where the SEC shares common concerns about investor protection and market efficiency, the Commission has been able to move quickly to execute new information sharing arrangements on both the regulatory and the enforcement sides. And, promised the SEC chair, this is just the beginning.

Currently a foreign exchange conducting business in the United States has to register the exchange and the securities trading on it with the SEC. And foreign broker-dealers that induce or attempt to induce trades by investors in the U.S. generally must also register with the SEC as well as with at least one SRO.

By contrast, selective mutual recognition would permit foreign exchanges that are subject to comparable home country registration and regulation to place trading screens with U.S. brokers in the United States without need of compliance with effectively duplicative regulations.

Selective mutual recognition would similarly permit foreign broker-dealers subject to comparable regulatory standards in their home countries to have increased access to U.S. institutional investors without the U.S. investors having to pay double for both a foreign and a U.S. broker-dealer.

The SEC and the regulators of every nation need to deal with the reality of global markets, emphasized the chair, and the Commission needs to ensure that the great potential benefits for U.S. investors and not the new array of risks and dangers are what manifest themselves in the months and the years ahead. According to Mr. Cox, the SEC wants U.S. investors to have choices, to enjoy lower transaction costs, and to have greater opportunity for diversification. The SEC also wants them to have more access to better information about foreign investments, emphasized the chair, all within the context of the accustomed high standards of investor protection.

Chairman Cox went on to spell out how selective mutual recognition would work. It begins with an analysis of a foreign jurisdiction's regulatory regime to determine if, in its overall effects and results, it is substantially comparable to the SEC’s. If it is, the Commission would then consider whether investment services already provided in the foreign jurisdiction might be offered to domestic investors without U.S. investors having to pay the full costs of both regulatory regimes.

Always guided by the principle of investor protection, the SEC would have to become comfortable with its ability to fairly evaluate the regulatory regimes of different countries in comparison with its own and to determine whether they produce results that are substantially comparable to the SEC’ approach.

At a minimum, continued Chairman Cox, this sort of undertaking would include a comprehensive review of the jurisdiction's commitment to investor protection by looking at, among other things, the regulatory mandate of the foreign jurisdiction and how it is implemented and enforced. For foreign exchanges and foreign broker dealers, the SEC would be interested in seeing how the home country addresses such things as fraud and manipulation and insider trading; and how they deal with such issues as registration qualifications, trading surveillance, sales practice standards, financial responsibility standards and dispute resolutions. And, the SEC would expect that the foreign jurisdiction would provide reciprocal treatment to U.S. exchanges and broker-dealers seeking to conduct business in that country.

Sunday, August 17, 2008

Japan Financial Services Agency Firmly Responds to Subprime and Securitization Crisis

Japan’s Financial Services Agency has firmly responded to the global subprime and securitization crisis with a series of initiatives on many fronts, including increased transparency, better risk management, and improved early warning systems. The FSA has also established an Office for Supervisory Policy, Financial Market and Risk Analysis that will filter information from the financial markets for regulatory purposes. The FSA also emphasized that regulatory responses must be global and all-inclusive in order to meet 21st century market crises.

The FSA cited the recent bailout of Bear Stearns as an object lesson for the need to improve early warning systems. As business conditions deteriorate, the FSA noted, the liquidity conditions and financial soundness of a securities firm or an investment bank may deteriorate rapidly when the market environment is undergoing drastic changes.

Thus, the Japanese early warning system, which takes into consideration liquidity conditions and financial soundness with regard to banks, has been expanded to financial instruments firms. An alarm is set regarding any sharp decline in the capital adequacy ratio or a drastic change in prices of stocks and bonds held by a financial services firm, and a detailed hearing will be conducted when the situation falls below standard, thereby leading to adequate regulation.

On another front, voluntary rules and best practices have been adopted by self-regulatory organizations with regard to disclosure related to securitized products. In this connection, the Japan Securities Dealers Association has held working groups and discussed issues such as disclosure and risk measurement. In addition, fourteen Principles in the Financial Services Industry have been announced as part of the FSA’s efforts toward better regulation. Among other things, these principles embody the importance of risk management and information provision. Specifically, Principle No. 12 is to conduct proper risk management in accordance with the size and features of a business operation and inherent risk profile.

In the view of the FSA, risk proliferation uncertainty also contributed significantly to the spreading of the subprime mortgage problem. As securitization became widespread, explained the FSA, it became difficult to identify the location and magnitude of risks because the risks pertaining to the underlying assets were widely dispersed. In addition, there were problems with the arrangers and distributors of securitized products in their information collection and analysis, and their framework for communication and sales.

In an effort to enhance the transparency of the firms involved in the securitization process, the FSA revised its guidelines for financial instruments firms to encourage companies selling securitized products to acquire and provide information on the risks of original assets, and thereby improve transparency in the securitized markets.

On the separate issue of the impact of fair value accounting on the crisis, it was noted that a recent IMF report suggested that some latitude be given in the strict application of fair value accounting during stressful events. But the FSA believes that suspending the application of fair value accounting would not help stabilize the market since it would only postpone the booking of losses. The FSA cautioned that any measure that would lessen the impact of the application of fair value accounting to asset-backed securities must be given careful consideration.

Saturday, August 16, 2008

SEC Supports Monitoring Group for IASB as Debate Rages on Role and Composition

In an effort to deflect the criticism that the IFRS standard setter is not answerable to securities regulators, the oversight trustees of the International Accounting Standards Board have proposed a Monitoring Group composed of the SEC and other securities authorities. The SEC welcomes the creation of the Monitoring Group as a way of providing organized interaction between the IASB and national securities regulators responsible for the adoption or recognition of accounting standards for listed companies.

The Monitoring Group will be composed of the SEC Chair, the European Commissioner for Internal Market, the IMF managing director, two IOSCO senior officials, the Commissioner of the Japanese Financial Services Agency, and the President of the World Bank. At the same time, CESR’s bid for a seat on the Monitoring Group appears to have failed and banking regulators have been excluded.

At a recent IASB roundtable, SEC Deputy Chief Accountant Julie Erhardt said that there was a need to create a mechanism for the interaction between securities authorities and the oversight trustees that approximates the historical relationship between securities authorities and accounting standards setters, such as the relationship between the SEC and FASB. In turn, she continued, this will enable securities authorities that allow or require the use of IFRS to effectively discharge their own mandates relating to investor protection, market integrity and capital formation. The SEC has been assured that the Monitoring Group will not affect the independence of the standard setting process.

According to Oversight Chair Gerrit Zalm, the Monitoring Group provides the IASB with a link to securities regulators. The group will have the ultimate say in appointments of oversight trustees. The SEC agrees with Mr. Zalm that the Monitoring Group should be transparent and keep in touch with and inform other stakeholders.

Currently, IASB oversight trustees are self-appointed. There is no reporting or influence from the SEC or other public authorities even though IFRS have a great influence on national economies. The Monitoring Group ends the self appointment of trustees by getting a veto power on new trustee appointments. And the group will judge whether the trustees are doing their work properly since the trustees will now report to them. Moreover, there will be regular meetings between the trustees and the Monitoring Group.

Chairman Zalm noted however that, while the Board voluntarily agreed to give power to the Monitoring Group and be publicly accountable to it, there will be no transfer of the power to organize the IASB or control its agenda. The chair also emphasized that the Monitoring Group will not have the ability to appoint trustees; but will be able to veto new trustees recommended by the oversight trustee group.

At a recent IASB roundtable, all the participants supported establishing the Monitoring Group. It was seen as an essential safeguard because, when a jurisdiction adopts IFRSs, it surrenders its sovereignty over accounting standards. While agreeing that it is essential that securities regulators be represented on the monitoring group, however, some commentators expressed concern about the absence of other market regulators such as banking agencies. In addition, some participants noted that the proposed monitoring group does not include a regulator directly involved with small and medium-sized companies, for which the IASB is developing a separate IFRS.

Also, many participants in the roundtable said that it must be made crystal clear that the oversight trustees are responsible for the governance of the IASB. The participants want to ensure that the Monitoring Group does not, in any way, compromise or impair the IASB's independence, especially its ability to set the technical agenda. Some suggested that the Monitoring Group should be viewed as equivalent to an independent audit committee.

The Monitoring Group must also avoid getting involved in operational aspects of the IASB and avoid conflicts of interest. In their view, the Monitoring Group should monitor the trustee appointment process and approve actual appointments, but it should be precluded from nominating trustees directly. A key question, which has not been addressed, is whether the Monitoring Group will have the power to remove trustees who, in their opinion, were performing unsatisfactorily.

A CESR senior official made a spirited bid to give CESR a seat on the Monitoring Group because CESR represents the securities regulators of Europe and has a keen interest in ensuring the right strategy, as well as the operational effectiveness, of the IASB. Javier Ruiz also noted that CESR members have enforcement authority over 2,500 IFRS companies.

Chairman Zalm appeared to reject CESR’s request when he noted that that the Monitoring Group is already at a correct size. Further, if CESR gets a seat, he said, there might be demands from other parts of the world because if Europe is represented by the Commission and by CESR, for example, the US or Japan may demand two members.
Form D Surveys Will Not Be Submitted to SEC

The ABA State and Federal Securities Regulation Committees Survey on Electronic Form D will not be submitted to the SEC. Some of the survey's results will be used in their letter to the SEC seeking interpretive guidance on the electronic Form D release. The survey is designed to gleen information about a firm's use of Form D for Regulation D securities offerings so that the Committees can obtain interpretive guidance on Electronic Filing and Revision of Form D.

Thursday, August 14, 2008

Congress Wants the SEC to Reinstate the Uptick Rule

In the wake of the SEC’s emergency short sale order, there is growing congressional sentiment for the SEC to reinstate the uptick rule, which was rescinded in 2007. The uptick rule, Rule 10a-1, required all short sale stock transactions to be conducted at a price that was higher than the price of the previous trade. The SEC claims that they fully researched the regulation before it was repealed, but some commenters have noted that the research took place during one of the biggest bull markets in history.

The most demonstrative signal of congressional intent is a bill introduced by Rep. Gary Ackerman that would order the SEC to reinstate the uptick rule within 90 days. HR 6517. In the wake of the elimination of the uptick rule, noted Mr. Ackerman, many volatile stocks that the regulation was designed to protect are being driven down as a result of manipulative short sale practices. He believes that the reinstatement of the uptick rule would help curb these abuses and ensure greater stability and confidence in the market. Under a reinstated uptick rule, he continued, fewer companies would fail, less investors would be driven out of the market, and more capital would remain in the stock markets.

In a short sale, an investor borrows shares of a stock from a broker, sells it to others, and then hopes to buy it back at a lower price before returning it to the lender. The difference, if any, is kept as a profit. The uptick rule was designed to prevent short sellers from being the only investors to cause a stock price to decline. Under the rule, a short sale could only be entered after a trade that caused the last price to increase. The uptick rule had been in place since 1938, and Rep. Ackerman does not fully understand why the SEC rescinded it.

The core provisions of Rule 10a-1 had remained virtually unchanged since its adoption 70 years ago. Over the years, however, in response to changes in the securities markets, including changes in trading strategies and systems used in the marketplace, the SEC had added exceptions to Rule 10a-1 and granted numerous requests for relief from the rule’s restrictions In addition, in rescinding the rule, the SEC noted that decimal pricing increments had substantially reduced the difficulty of short selling on an uptick.

In another signal of Congress’ concern, Rep. Mike Castle sent a letter to Chairman Cox noting that, since the rescission of the uptick rule, there has been a dramatic increase in short selling and substantial market volatility. He suggested that the volatility might, in some measure, be attributable to the withdrawal of the uptick rule. This rule had been in place since 1938, he said, and was responsible for limiting short selling in the securities markets.

Rep. Castle emphasized that it has been a long standing goal of the SEC to maintain an orderly market process that offers reasonable risks and rewards for those willing to invest in it. While speculation is an integral part of a vibrant market, he observed, today's market is vastly different than the market of 70 years ago and given that current market conditions are more volatile than those that previously prevailed, it is important that regulators monitor closely any impact of unrestricted short selling.

Wednesday, August 13, 2008

Senate Readying Legislation on Offshore Entities and Unrealized Business Income Tax, Energy Commodities Speculation

Legislation ending the tax breaks that speculators in energy and other commodities enjoy is being readied in the Senate Finance Committee. The legislation would also prevent tax-exempt organizations such as pension funds from avoiding tax on unrelated business taxable income by holding commodities through an offshore foreign blocker company.

Under current tax law, commercial buyers, such as airlines, who need to buy energy futures contracts in order to run their businesses pay ordinary income tax on any profits from such trading. By contrast, for-profit speculators pay lower capital gains rates on their profits and tax-exempt investors, such as pension funds and university endowments, pay no taxes on these investments. Under a bipartisan bill being drafted by Senators Ron Wyden and Charles Grassley, everyone directly purchasing oil and natural gas, or indirectly through futures contracts, commodity index funds or other investment strategies, would be taxed as if they were commercial commodity traders.

Foreign Blocker Companies

The Senate Finance Committee has long been concerned that non-profit entities such a pension funds, which represent some of the largest investors in hedge funds, are using offshore structures to avoid the unrealized business income tax. Federal tax law requires non-profit investors that invest directly in hedge fund partnerships to pay the unrealized business income tax.

Specifically, Internal Revenue Code section 511 imposes tax on the unrelated business taxable income (UBTI) of organizations that otherwise are exempt from tax, such as charities and pension funds. UBTI generally is taxed at the rates applicable to business corporations. A primary reason for imposing the unrelated business income tax was to end a source of unfair competition by placing the unrelated business activities of exempt organizations on the same tax basis as the nonexempt business endeavors with which they compete.

To avoid UBTI, non-profit investors sometimes invest in hedge funds through offshore entities incorporated in low or no tax jurisdictions. These offshore entities are known as foreign blocker companies. The tax-exempt organization invests in the blocker company, which in turn invests in a hedge fund or other similar debt-financed investment. Income from the hedge fund is distributed to the blocker corporation, which pays little or no tax on the income as a result of the jurisdiction in which it is established. The corporation in turn pays the income to the tax-exempt investor as a dividend. Because dividends are not subject to UBTI, the income from the hedge fund is not taxable to the tax-exempt investor and the debt-financed income rules are avoided.

Commenters have observed that most hedge funds are partnerships and, absent the blocker entity, debt-financed income would be passed through to the tax-exempt investor as debt-financed income and would be subject to tax. Thus, there is reliance currently being placed on the IRS private letter rulings upholding the treatment of income received from a foreign corporation used as a blocker entity as a dividend that is not subject to UBTI.

The IRS has concluded in a series of private letter rulings that when UBTI-producing assets are owned by a corporation and an exempt organization invests directly or indirectly in such corporation the exempt organization will not recognize UBTI as a result of the investment. Thus, blocker companies are interposed between an exempt organization investor and assets that would give rise to UBTI if owned by the exempt organization directly.

The legislation would amends the Code to require tax exempt organizations to take income, gain, or loss with respect to applicable commodities into account as income, gain, or loss as unrelated business taxable income, which is taxable at the rates applicable to corporations or trusts. In order to prevent a tax-exempt organization from avoiding tax on UBTI by holding commodities through a foreign blocker corporation, the bill imposes a look-through rule requiring a tax-exempt organization that directly or indirectly owns stock in a foreign corporation to treat as UBTI its pro rata share any income, gain, or loss of such corporation with respect to any applicable commodity. Where a tax-exempt organization sells stock of a foreign corporation that holds applicable commodities, the portion of the tax exempt organization’s gain or loss that is attributable to unrecognized gain or loss of the foreign corporation with respect to applicable commodities is treated as UBTI.
Demutualization Did Not Render Policyholder's Ownership Interest Zero for Purposes of Federal Tax Code; No Capital Gains Due on Cash for Stock

In an opinion that may have enormous consequences for the demutualization of insurance companies, a federal court of claims ruled that a policyholder of a mutual insurance company that was transforming into a public stock company did not have to pay capital gains on an exchange of its interest in the mutual company for shares in the new company that the policyholder then sold in a cash election. The policyholder’s ownership rights did have value, said the court, and, that being the case, the amount it received being less than its cost basis in the insurance policy as a whole, the policyholder did not realize any income on the sale of the stock in question and, therefore, was entitled to a refund. Fisher, Trustee for Seymour P. Nagan Irrevocable Trust v. United States, US Court of Federal Claims, Aug. 6, 2008).

Since its infancy, federal income tax law has provided that gross income includes gains derived from dealings in property and that such gains generally equal the amount realized less the seller’s cost basis in the property sold. For generations, courts faced with this scenario have grappled with two possibilities: to treat the property sold as having little or no cost basis, so that the sale proceeds are taxable, or, the course taken here, to treat the property as sharing the cost basis of the entire bundle, such that no gain is realized until all the capital represented by that basis is recovered.

A mutual insurance company has no shareholders, but instead is owned by policyholders possessing both ownership rights and contractual insurance rights. The insurance company converted into a publicly-traded stock company through a process known as demutualization. Under the plan, the policyholders received shares of stock in a new company in exchange for their ownership rights. They could elect to sell their shares in a cash election.

When the demutualization took effect, the policyholder received 3,892 shares, opted for the cash election, received $31,759.00 and paid a tax of $5,725. Later, the policyholder requested a refund of that amount.

The court rejected the contention that the ownership rights had no value.
Reg. § 1.61-6(a) provides that when property is acquired for a lump sum and interests therein are subsequently disposed of separately, in order to compute the gain or loss from each disposition an allocation or apportionment of the cost or other basis to the several units must be made. Of course, for this formula to work, one must be able to derive the fair market values of the component parts of the larger property. The regulations presume these values are obtainable, stating that only in ``rare and extraordinary’’ cases will property be considered to have no fair market value.

This was a such a ``rare and extraordinary’’ case, said the court, adding that irreducible values could exist, with the effect of postponing the recognition of income. The court applied the judicially-created open transaction doctrine, which coexists with the regulation and endures as a viable, albeit limited, exception to the general rule enunciated in Reg. § 1.61-6.

The ownership rights were, at the outset, inextricably tied to the underlying insurance policy and were not separately sellable. This fact is an important indication that the ownership rights lacked a determinable fair market value at the time the policy in question was first acquired. But this limitation did not mean that the value of the ownership rights was zero. Unless the Internal Revenue Code specifies otherwise, noted the court, appraisers must take an asset as they finds it.

One of the critical features that could not be ignored was the fact the ownership rights were indivisible from the insurance policy. The fact that future financial benefits associated with the ownership rights were speculative did not mean they should be valued at zero.

Tuesday, August 12, 2008

Corrigan Counterparty Risk Management Policy Group Issues Report on Reforming Global Markets; Examines Role of SEC Reg. AB

The Counterparty Risk Management Policy Group has issued
report detailing a forward-looking integrated framework designed to advance the global reform of securitization in light of the recent market turmoil. While the report centers on sound corporate governance and enhanced risk management, it also granularly examines FASB standards for off-balance sheet vehicles and comes up with a sophisticated investor model for investing in high risk asset-backed securities based on SEC rules. The report also examines the efficacy of due diligence practices mandated by SEC Regulation AB in light of the subprime crisis. The co-chair of the policy group is Gerald Corrigan, former President of the New York Federal Reserve Bank. This is the third report by the policy group.

The policy group strongly recommends that high-risk complex securitized financial instruments be sold only to sophisticated investors. In establishing standards of sophistication for investors and counterparties in high-risk complex financial instruments, said the group, the overriding principle should be they should be capable of assessing and managing the risk of their positions in a manner consistent with their needs and objectives.

Specifically, it will be important to develop a workable definition of sophisticated investor. In this regard, the policy group looked to the approach followed by the SEC in Rule 144A, which defines and lists various types of entities which the SEC calls qualified institutional buyers. These QIBs are entities that own or invest in at least $100 million in securities that are not affiliated with the QIB. Similar regulatory definitions are employed in other jurisdictions, noted the policy group, including under the European Union’s Markets in Financial Instruments Directive (MiFID).

For its part, the Corrigan group has listed the minimum qualifications a sophisticated investor should possess, including the capability of understanding the risk and return of the complex securitized product and the financial resources to withstand potential losses. The report also states that financial intermediaries should adopt policies to identify when it would be appropriate to seek written confirmation that a counterparty possesses these characteristics.

The policy group also questioned why the due diligence procedures for asset-backed securities mandated by SEC Regulation AB did not work better during the subprime crisis. All publicly registered asset-backed securities are subject to Regulation AB, which dictates registration, disclosure and reporting requirements.

In the asset-backed markets, due diligence involves the issuer or underwriter hiring an accounting firm to check data integrity. Regulation AB mandates a formal agreed upon procedures (AUP) letter from the accountant reporting the findings of this confirmatory analysis. The AUP letter has two parts: (1) verification of the accuracy of historical data; and (2) comparison of the data tape to the actual loan files through tape-to-file procedures. The issuer provides the accountants with sample documents and data related to the transaction pool of receivables, including a prospectus supplement and the composition of receivables. To verify historical data, the accountants recalculate a selection of key data and performance metrics and compare their findings with those of the issuer to ensure accuracy.

Regulation AB also specifies disclosure in four key categories: static pool data, credit enhancement, transaction parties, and pool assets. Regulation AB also contains extensive disclosure guidelines regarding the securitized asset pool. For example, the credit underwriting process description must include details of any internal credit grading scales and a description of any economic or other factors that may affect the pool assets.

While the policy group has some recommendations concerning due diligence, it is left with the question of what went wrong in the process and how diligence practices might have contributed to the unexpected nature of the losses associated with a number of asset-backed securitizations. In the group’s view, this problem appears to have arisen more from a general reliance by all market participants, including the rating agencies, on historical information in assessing the potential for losses, rather than systemic shortcomings in due diligence.

In any event, the group strongly urges underwriters and placement agents to redouble their efforts to adhere fully to the letter and spirit of existing diligence standards, and seek opportunities to standardize and enhance such standards. Enhancements suggested by the group include requiring all firms to follow statistically valid sampling techniques in assessing the quality of assets in a securitization and encouraging disclosure to investors of due diligence results, including making the AUP letter publicly available.

Sunday, August 10, 2008

IASB to Adopt Global Standard for Fair Value Accounting Converged with FASB SFAS 157

The IASB plans to propose a single fair value standard for IFRS by mid-2009 and adopt an IFRS for fair value accounting in 2010 that will be converged with FASB SFAS 157. The IASB has already begun formulating the standard based on an earlier discussion paper and plans to hold roundtables in the fourth quarter of this year. This is an important development in light of the fact that the issue of valuing asset-backed securities in illiquid markets is one of the factors contributing to the current market crisis. In fact, the IASB’s push toward a single fair value standard is partially driven by the Financial Stability Forum’s recommendations on the reform of fair value accounting. The Forum has called for guidance on the valuation of complex securities in inactive markets as part of a broad reform of the securitization process.

Since guidance on measuring fair value has been added to IFRS piecemeal over many years, current guidance on measuring fair value is dispersed across many IFRSs and is not always consistent. Further, the current guidance is incomplete in that it provides neither a clear measurement objective nor a robust measurement framework. The Board believes that this adds unnecessary complexity to IFRSs and contributes to diversity in practice. The Board’s overarching goal is to establish a single source of guidance for all fair value measurements required or permitted by existing IFRSs and at the same time enhance disclosure about fair value to enable users of financial statements to assess the extent to which fair value is used to measure assets and liabilities and to provide them with information about the inputs used to derive those fair values.

While cautioning that its proposal may differ from SFAS 157, the Board assured that the project is part of the roadmap to convergence with FASB and US GAAP. In that spirit, the Board said that SFAS 157 will be the starting point on the road to the issuance of a common standard.

The IASB’s definition of fair value for financial instruments in IAS 32 is similar to that in SFAS 157. However, there are differences that must be resolved if the two boards are to issue a common standard requiring the fair value measurement of financial instruments. As part of the process, the Board has formed an expert advisory panel comprised of preparers and users of financial statements, as well as regulators and auditors, to assist it in developing an IFRS fair value standard.

One of the more significant differences between SFAS 157 and IFRS is that SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in a transaction between market participants at the measurement date. By comparison, fair value is generally defined in IFRSs as the amount for which an asset could be exchanged, or a liability settled, between willing parties in an arm’s length transaction.

While there is a growing consensus that the goal of one consistent global standard on fair value accounting is desirable, some commenters to the IASB discussion paper had concerns. For example, PricewaterhouseCoopers is concerned about the reliability of market based exit prices in some circumstances, particularly where any determination of fair value is dependent on an assessment of a transaction in a hypothetical market.

While applauding the use of SFAS 157 as a starting point, PwC asked the Board to recognize that the circumstances in which fair value is used as a measurement basis differ between IFRS and US GAAP. For example, IFRSs require or permit the use of fair values in situations which have no parallel in current US GAAP. In addition, SFAS 157 defines how to measure fair value more narrowly than US GAAP. PwC believes that the exit price concept underlying SFAS 157 is not relevant in many circumstances where the term fair value is used under IFRS. Thus, the firm recommends the elimination of the term fair value in each individual IFRS standard and the use of more precise terminology such as exit price, entry price etc.

Expressing similar concerns, KPMG advised the IASB not to pursue a solution based on a single definition of fair value using the exit price approach that is the basis of SFAS 157. KPMG also suggested replacing fair value with more specific descriptions, such as current exit price or current entry price

Saturday, August 09, 2008

Final Report of SEC Advisory Committee on Improvements to Financial Reporting Impacts PCAOB

The SEC Advisory Committee on Improvements to Financial Reporting has issued its final
report recommending major changes to regulation and standard-setting involving financial statements and the independent audit of them. Formed by the SEC in July 2007 with a mandate to examine how to increase the usefulness of financial reports to investors and reduce their complexity to investors, preparers and auditors, the committee is chaired by Robert Pozen.

From the outset, the committee focused its recommendations on areas where the SEC, FASB, and the PCAOB could act in a reasonable time. The committee avoided recommendations that would require legislation. The overarching principle guiding the committee’s recommendations is that the primary purpose of financial statements must be to help investors make well-informed decisions.

The committee also limited its scope on international matters. While broadly supporting the move towards international accounting standards, the committee did not focus on the ongoing convergence of US GAAP and IFRS. The committee believes that the principles underlying its recommendations are relevant no matter how convergence ends up.

Professional Judgment

In recognition of the increasing exercise of accounting and audit judgments in an era of principles-based standards, the committee urged the SEC and PCAOB to adopt policy statements on this subject. These policy statements would provide more transparency into how the SEC and the Board evaluate the reasonableness of a judgment made by an accountant or auditor of financial statements. This transparency is needed, the committee reasoned, in order to assuage the concern of auditors in a principles-based environment that their judgments will not be second-guessed after the fact

In the committee’s view, the statements should also encourage preparers and auditors to follow a disciplined process in making judgments. In addition, as a result of the policy statements, investors should have more confidence in how accounting and auditing judgments are exercised.

The committee set forth a number of factors it considers important in evaluating professional judgment, including the available alternatives a company identified and the robustness of a company’s analysis of the relevant literature and review of the pertinent facts. The evaluation by the oversight bodies should also consider the degree to which a company’s approach is consistent with current accounting practice and how a company’s conclusions meet the information needs of investors. Further, the policy statements should emphasize the contemporaneous documentations of professional judgments in order to ensure that the evaluation is based on the same facts that were reasonably available at the time the judgment was made.

More specifically, the committee believes that the PCAOB’s statement of policy should acknowledge that the Board will look to the SEC’s statement of policy to the extent that the Board would be evaluating the appropriateness of accounting judgments as part of an auditor’s compliance with PCAOB auditing standards.

Financial Reporting Forum

The committee also suggested the creation of a Financial Reporting Forum that would include key constituents from the preparer, auditor, and investor communities. Forum members would meet with representatives from the SEC, the FASB, and the PCAOB to discuss pressures in the financial reporting system overall, both immediate and long-term, and how individual constituents are meeting these challenges. This may require the FASB and PCAOB to re-evaluate the roles and composition of their advisory groups. For example, the involvement of preparers, auditors, and investors could be effectuated by leveraging members or executive committees from existing FASB or PCAOB advisory groups and agenda committees. It is envisioned that one or more key decision-makers from the SEC, the FASB, and the PCAOB will participate in the FRF.

Internal Controls

The committee praised the efforts of the SEC and PCAOB to effectively implement the internal control mandates of section 404 of the Sarbanes-Oxley Act. But, while internal control over financial reporting has been strengthened in recent years, there is evidence indicating that material weaknesses in internal control are often identified after a financial reporting problem has arisen, and perhaps only as a result of the event itself.

In the committee’s view, financial reporting would be improved if there was more timely identification of material weaknesses, and remediation of those weaknesses to prevent errors from occurring in the first place. Thus, the committee encouraged the SEC and the PCAOB to continue to stress the timely identification and correction of weaknesses, with appropriate emphasis on tone at the top and corporate governance as key factors that will lead to early identification and timely action, particularly as they relate to the potential for fraudulent financial reporting.