Tuesday, September 30, 2008

Bailout Bill Mandates Report to Congress on Reforming Financial Regulation

One of the more forward looking and possibly mementous provisions in the Emergency Economic Stabilization Act is one mandating a report to Congress on modernizing financial regulation. The report is be delivered by the Treasury Secretary, who earlier this year published a comprehensive blueprint for reform. The report must be submitted by April 30, 2009, after the Secretary conducts an exhaustive review of the financial markets and the regulation of them.

The Secretary is specifically ordered to analysis the over the counter swaps market and the government sponsored enterprises. In addition, the Secretary must recommend whether any currently unregulated market participants, such as hedge funds, should become subject to federal regulation. The Secretary must also submit recommendations on how to enhance the clearing and settlement of over-the-counter swaps.

Monday, September 29, 2008

Bailout Bill Gives SEC Oversight Role Amidst Extraordinary Power for Treasury

The Emergency Economic Stabilization Act that failed to pass the House today, but which I expect to pass Congress by the end of the week, gives the SEC a crucial role in overseeing the Secretary of the Treasury as that cabinet member exercises extraordinary, but judicially reviewable power in purchasing illiquid mortgage-backed securities from financial institutions. The bill sets up an oversight body called the Financial Stability Oversight Board composed of the chairs of the SEC and the Fed, the HUD Secretary and the Director of the Federal Home Finance Agency and the Secretary of the Treasury. The Board will select its own chair, but it cannot be the Secretary. So, the new SEC Chair could be the Board chair.

The Board will meet two weeks after the Secretary's first purchase of distressed assets and monthly thereafter. The Board must report to Congress semiannually. It may also set up a credit review committee to review how the purchase of troubled assets program is being conducted.
CAFA Trumps 33 Act's Non-Removal Position

Judge Harold Baer of the Southern District of New York held that the removal provisions of the Class Action Fairness Act of 2005 trumped the non-removal provisions of Section 22(a) of the Securities Act.

In an action arising from the sub-prime mortgage crisis, Judge Baer found that Congress intended "to include within the reach of CAFA all securities class actions except for those set forth" in the specified exceptions. The exceptions, noted the court, are to be construed narrowly and were not applicable in this instance.

New Jersey Carpenters Vacation Fund v. Harborview Mortgage Loan Trust 2006-4


Link to CourtWeb site.
Bailout Bill Falters in House

With "no" votes from approximately 90 Democrats and 130 Republicans, the controversial financial bailout bill was defeated in the House today.
The Bailout Plan: Will it Work?

By Katalina M. Bianco, Law Analyst, Wolters Kluwer Banking and Finance Group

Congressional leaders and the White House announced on September 28 that they had reached a tentative agreement on the $700 billion rescue program dubbed the “bailout plan” by the popular media. The plan is expected to go to the House for a vote on Monday, September 29.

As Congressional leaders prepare to sell their colleagues on the plan, questions as to the plan’s viability remain. Few experts doubt that decisive action by the government is necessary to restoring confidence in the credit markets, but economists and analysts are split on whether the plan will have the desired effect of righting the economy.

The extraordinary decline in the housing market has increasingly devalued financial institutions’ trillions in mortgage-related securities. As the value of those assets drops, losses have decreased the capital available to cover them, making it difficult for banks to lend.


Critics of the plan have identified what they see as problems with the plan. One of these problems is that if the government pays current prices for the securities in the current depressed market, selling firms may experience sever losses, leaving them vulnerable to the fate of such financial giants as Lehman Brothers and Goldman Sachs. However, critics reason that should the government pay too high a price for the securities, any benefits that taxpayers may expect would be lessened.

Allowing companies to get rid of their portfolios of failing mortgage securities under the plan would halt the current decline and make them more attractive to investors, providing them with the capital necessary to go about the business of lending. The problem, critics argue, is that the complexity of the mortgage securities market could work against this capital transfer.

The typical mortgage-backed security is a trust containing a portfolio of thousands of individual mortgages merged to create a specific risk profile. It offers investors a stream of payments (based on the underlying mortgage payments) at a given yield.

A single trust might be further blended to construct different derivative securities, each one subordinated to the next in terms of the claim on cash flow. Should a default occur, the highest-rated, and lowest-yielding, security has the priority claim to the remaining mortgage payments. The next-highest-rated security has the next claim and so on. As the market grew, underwriters got more creative in their construction. Risk went up and in many cases loan quality went down. When the real-estate market disintegrated, defaults rose, undermining values, and trading slowed until determining actual value, always difficult with mortgage-backed paper, became almost impossible.
Draft Bill Would Authorize SEC to Suspend FAS 157

Section 132 of the draft bailout bill would authorize the SEC to suspend the operation of FAS 157 by rule, regulation or order for any issuer as required by the public interest and the protection of investors. Section 133 of the bill would also require the SEC to conduct a study of mark-to-market accounting and the fair value measurement standard with regard to financial institutions. The study, to be conducted in consultation with Treasury and the Federal Reserve, would examine:

1) the effects of FAS 157 on financial institution balance sheets;
2) the impacts of such accounting on the current crisis;
3) the relationship between the standard and quality financial reporting;
4) the FASB standard-setting process;
5) the advisability and feasibility of modernizing the standard and
6) available alternatives to FAS 157.

The SEC would report to Congress concerning the study within 90 days.

Section 132 also contains a "savings provision" which specifies that the bill does not restrict or limit any current authority of the SEC.
Bailout Draft Calls for Studies of Regulatory Roles

Section 105 of the draft bailout bill currently before the House requires the Secretary of the Treasury to "review the current state of the financial markets and the regulatory system" and to report to Congress by April 2009 on "the current state of the regulatory system and its effectiveness at overseeing the participants in the financial markets, including the over-the-counter swaps market and government-sponsored enterprises." The required report is to provide recommendations on whether any participants in the financial markets that are currently outside the regulatory system should become subject to the regulatory system and how to enhance the clearing and settlement of over-the-counter swaps.

In Section 117, the Comptroller is charged with studying the role of leverage in the markets. The purpose of the study would be to determine the extent to which leverage and sudden deleveraging of financial institutions precipitated the current financial crisis. The study is to examine the proper regulatory role of the Federal Reserve, the SEC, the Secretary of the Treasury and the banking regulators with respect to monitoring leverage and curtailing excessive leveraging. The study would be due to Congress in June 2009.

Sunday, September 28, 2008

SEC's Consolidated Supervised Entities Program Ended

SEC Chair Christopher Cox has ended the Consolidated Supervised Entities (CSE) program, created in 2004 as a way for global investment bank conglomerates that lack a supervisor under law to voluntarily submit to regulation. Chairman Cox also described the agency's plans for enhancing SEC oversight of the broker-dealer subsidiaries of bank holding companies regulated by the Federal Reserve, based on the recent Memorandum of Understanding (MOU) between the SEC and the Fed.

With the federalization or bank holding company status of the investment banks regulated under the CSE program, that regime simply lost its reason for being.

When Congress passed the Gramm-Leach-Bliley Act, it created a significant regulatory gap by failing to give to the SEC or any agency the authority to regulate large investment bank holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns. Because of the lack of explicit statutory authority for the Commission to require these investment bank holding companies to report their capital, maintain liquidity, or submit to leverage requirements, the Commission in 2004 created a voluntary program, the Consolidated Supervised Entities program, in an effort to fill this regulatory gap. The chair acknowledged that voluntary regulation has failed.

As he reported to the Congress multiple times in recent months, the CSE program was fundamentally flawed from the beginning, because investment banks could opt in or out of supervision voluntarily. The fact that investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate of the CSE program, and weakened its effectiveness.

At the same time, the Inspector General of the SEC released a report on the CSE program's supervision of Bear Stearns, and that report validates and echoes the concerns Cox expressed to Congress. The report's major findings are ultimately derivative of the lack of specific legal authority for the SEC or any other agency to act as the regulator of these large investment bank holding companies.

With each of the major investment banks that had been part of the CSE program being reconstituted within a bank holding company, they will all be subject to statutory supervision by the Federal Reserve. Under the Bank Holding Company Act, the Federal Reserve has robust statutory authority to impose and enforce supervisory requirements on those entities. Thus, there is not currently a regulatory gap in this area.

Under the Memorandum of Understanding between the SEC and the Federal Reserve that was executed in July of this year, said the chair, the SEC will continue to work closely with the Fed, but focused even more clearly on its statutory obligation to regulate the broker-dealer subsidiaries of the banking conglomerates. The information from the bank holding company level that the SEC will continue to receive under the MOU will strengthen its ability to protect the customers of the broker-dealers and the integrity of the broker-dealer firms.

The Inspector General's office also made 26 specific recommendations to improve the CSE program, said the SEC chair, which are comprehensive and worthy of support. Although the CSE program is ending, he vowed that the SECwill look closely at the applicability of those recommendations to other areas of the Commission's work and move to aggressively implement them.

Saturday, September 27, 2008

Regime Change?

As a probable bailout bill moves through Congress, it may be a good time to assess some matters that impact federal securities regulation. It is too early to assees whether the financial regulatory regime we have labored under since the New Deal is broken beyond repair. But it is almost certain that the 111th Congresss will pass major securities and financial regulatory structure next year in what may be the equivalent of FDR's first hundred days legislation. I believe that our oversight chairs are up to the task, Barney Frank Chair of the House Financial Services Committee and Chris Dodd, chair of the Senate Banking Committee.

It is also too early to determine if we will see the equivalent of the Pecora hearings in an effort to determine what happened and possibly assess blame. But that scenario is very possible. Reform of securitizaton is essential since many still believe that we cannot return to the originate and hold model. Fair value accounting, FAS 157, will be examined for its role, as well as the credit rating agencies. Te continued efficacy of the principle of functional regulation, enshrined in the Gramm Leach Bliley Act, must be studied.

Wednesday, September 24, 2008

SEC Staff Issues Guidance on New Short Positions Disclosure Form SH

The SEC has adopted a new disclosure rule requiring hedge funds and other large institutional investors to disclose their short positions. The new rule, designed to ensure transparency in short selling, applies to asset managers with more than $100 million invested in securities, who are required to promptly begin public reporting of their daily short positions on new Form SH. The order is effective September 22, 2008.

New Form SH requires disclosure of the number and value of securities sold short for each section 13(f) security, except for short sales in options, and the opening short position, closing short position, largest intraday short position, and the time of the largest intraday short position, for that security during each calendar day of the prior week.

According to the staff guidance, the disclosure requirement applies only to short sales effected after the effective date of the order. If a manager has a short position reflecting short sales effected prior to the effective date of the order, that pre-existing short position is not required to be reported on Form SH or for any days throughout the calendar week-long period that must be reported in the Form SH filing.

Thus, the manager is not required to add that pre-existing short-position to any new short positions created after the effective date. Transactions effected after the effective date to close out that pre-existing short position should also not be reported. Pre-existing short positions should not be included for purposes of determining whether the de minimis exclusion applies.

If the short position in the Form SH security constitutes less than one-quarter of one per cent of that class of the issuer's Form SH securities issued and outstanding and the fair market value of the short position in the Form SH security is less than $1,000,000 on every day of the reporting period, the manager need not file Form SH. If the manager fails to satisfy either prong of the de minimis exclusion on any day of a reporting period for any Form SH security, the manager must file Form SH for that period with respect to that Form SH security. Pre-existing short positions should not be included for purposes of determining whether the de minimis exclusion applies

The institutional investment manager may apply the de minimis exclusion on a day-by-day and column-by-column basis. For example, if the amount of securities sold short on a given day is de minimis for purposes of Form SH, said the staff, then disclosure of the amount is not required. However, the amount of securities sold short should still be taken into account in determining what type of disclosure is required under Column 6 (short positions at the end of the day) and Column 7 (largest intra-day short position). In the event the institutional investment manager excludes information using the de minimis exclusion, it should enter "N/A" in the appropriate columns.

Managers should use fair market value when valuing securities for purposes of Form SH. Managers should not use execution prices for valuing such securities. For purposes of determining the fair market value of securities sold short, a manager must use the market price of the security on the primary or listing market for the Form SH security as of the close of floor trading on the New York Stock Exchange for the day in question. This market closing time should be used to determine the price of all Form SH securities irrespective of the U.S. market on which such security trades. If the securities are sold short on a non-business day, a manager must use the market price of the Form SH securities as of the close of the NYSE for the most recent business day.

Options on section 13(f) securities and short sales of options on section 13(f) securities are not Form SH Securities, and therefore, should not be reported on Form SH. However, certain transactions that involve options are required to be reported on Form SH. For example, if an institutional investment manager exercises a put and is net short pursuant to Rule 200(c) of Regulation SHO, the resulting transaction is a short sale and must be reflected in Form SH. Similarly, if the institutional investment manager effects a short sale as a result of assignment to it as a call writer, upon exercise, the resulting transaction is a short sale and must be reflected in Form SH. Any short sales of Form SH securities resulting from exercise of options contracts are reportable as of the date of exercise.

Tuesday, September 23, 2008

IRS Notice 2008-81 Says Treasury Program to Support Money Market Funds Does Not Run Afoul of Federal Guarantee of Tax Exempt Bonds under IRC

The IRS has found that the Treasury program to support tax-exempt money market funds during this period of market turmoil does not violate restrictions against federal guarantees of tax-exempt bonds under Section 149(b) of the Internal Revenue Code. All money market mutual funds that are regulated under Rule 2a-7 of the Investment Company Act and are publicly offered and registered with the SEC are eligible to participate in the program. But the IRS guidance applies specifically to tax-exempt money market funds.

The Treasury Department has offered temporary, unlimited deposit insurance for money market funds. The support program is available to both money market funds holding assets subject to federal income taxation and to tax-exempt money market funds. In Notice 2008-81, the IRS said that the program will not result in any violation of the restrictions against federal guarantees of tax-exempt bonds with respect to the tax-exempt bond assets of tax-exempt money market funds which would impair the tax-exempt status of dividends received by their shareholders.

Section 103 of the Code provides that the interest on state and local government bonds is excludable from gross income, except that under Section 149(b) the interest is not excludable if the bonds are federally guaranteed.

The notice provides comfort that the IRS will not assert that the Treasury’s support program for money market funds causes any violation of the restrictions against federal guarantees of tax-exempt bonds under Section 149(b) with regard to any tax-exempt bond assets held by participating tax exempt money market funds. Similarly, the IRS will not assert that the program impairs the ability either of a participating money market fund to designate exempt interest dividends under § 852(b)(5) or of the shareholders of such a fund to claim the benefits of tax exemption with respect to such exempt interest dividends under § 852(b)(5)(B).
Global Securities Regulators Follow SEC Lead and Ban Short Selling to Prevent Regulatory Arbitrage

Following the lead of the SEC and the UK Financial Services Authority, and in an effort to prevent regulatory arbitrage, securities regulators around the world have acted to ban forms of short selling as the crisis in the financial markets spreads globally. Countries which have now followed in banning or limiting short selling are Australia, France, Germany, Switzerland, Ireland and Canada (Ontario), and other regulators are assessing their responses.

The Australian Securities and Investments Commission has banned naked short selling and covered short selling subject to a limited authorized market-maker exemption. The Commission said that it would reassess and advise the market in 30 days whether or not it will at that time, or at a later date, reopen covered short sales for non-financial stocks. Because of the relatively small size and the structure of the Australian market, the Commission felt that it was necessary to extend the prohibition to all stocks. To limit the prohibition to financial stocks, as has been done in the UK, could subject other stocks to unwarranted attack given the unknown amount of global money which may be looking for short sell plays.

While emphasizing that it sees a legitimate place for short selling in markets, the Commission believed that in the current climate and, in light of the actions taken by other regulators, the market needed a circuit breaker to assist in maintaining and restoring confidence. These measures will operate for a limited time and in the case of non-financial stocks, will be reviewed in 30 days. In the case of financial stocks, the review will be in line with the time limits imposed by other international regulators such as the SEC and the FSA.

The Netherlands Financial Markets Authority took measures concerning the naked short selling of shares issued by financial companies. The measures concern shares issued by financial companies which are traded on the Euronext Amsterdam stock exchange; these shares concern transactions performed on own account or on behalf of third parties, with the exception of transactions performed by intermediaries acting as cash market maker or counter party in block trade transactions. All selling orders resulting in postponed settlement/delivery concerning one of the shares involved must be covered for 100% by the financial instruments that are the subject of the selling orders.

Thus, the AFM’s prohibition only applies to uncovered short positions as a result of selling orders in shares issued by financial companies. It does not apply to covered short positions resulting from selling orders in shares issued by financial companies. Market makers on the derivatives market and liquidity providers on the cash market, as defined by the Rulebook of Euronext, are exempt, as well as block trade counterparties. Market makers and liquidity providers designated by Euronext are only exempt in this capacity with regard to the relevant financial institutions.
The German Federal Financial Supervisory Authority (BaFin) prohibited short selling of the shares of a number of financial institutions, including Deutsche Bank, Commerzbank, and Allianz SE. The ban expires at the end of the year, but BaFin vowed to review it on an ongoing basis. BaFin justified this move by the recent developments in the global capital markets.The legal basis for its decision was section 4 of the Securities Trading Act. Based on this, the regulator had to counteract undesirable developments that might result in serious disadvantages for the financial markets. The statute provides that BaFin may issue orders which are appropriate and necessary to eliminate or to prevent such undesirable developments.

Noting that SEC and the UK FSA prohibitions on short sales, the BaFin said that, given the close interdependence of the financial markets, it is likely that without this order there would be serious adverse effects for the conduct of orderly trading on German markets. Particularly given the current state of the capital markets, an influencing of the market prices of shares of certain credit institutions, stock exchange operators, insurance companies and other companies from the financial sector is resulting in excessive price movements that could jeopardize the stability of the financial system and thus lead to serious disadvantages for the financial market.

The Ontario Securities Commission issued a temporary order prohibiting short selling of securities of certain financial sector issuers that are listed on the Toronto Stock Exchange and are also interlisted in the United States. This order was issued as a precautionary matter with respect to short selling of the securities of financial sector issuers subject to the U.S. SEC short selling order and to ensure that Canadian markets are not used for purposes of regulatory arbitrage The Commission vowed to monitor trading in securities of other Canadian financial issuers and take action if necessary.

Monday, September 22, 2008

Dodd Bill Gives SEC Oversight Role in Federal Purchases of Mortgage-Backed Securities; Addresses Executive Compensation

Going beyond the Treasury bill authorizing the federal purchase of up to $700 billion in distressed mortgage-backed securities, Senate Banking Chair Christopher Dodd has proposed legislation that would also set up an oversight board, require more transparency, and establish executive compensation standards for financial institutions selling asset-backed securities to the Treasury. The Dodd measure also includes a number of provisions to assist homeowners.

Similar to the Treasury bill, the Dodd bill allows the purchase of up $700 billion in distressed assets, but that number includes any expenditures made to the Exchange Stabilization Fund for any funds used for the temporary guaranty program for the US money market mutual fund industry.

Like the Paulson bill, the Dodd bill would authorize Treasury to set up the purchase program under the Secretary’s terms and conditions. However, unlike the Paulson bill, the Dodd measure would require the Secretary to implement the program through an Office of Financial Stability to be set up within the Treasury Department.

Similar to the Treasury bill, the Secretary is authorized to appoint employees and enter into contracts to help carry out the transactions and designate financial institutions as federal financial agents to perform reasonable duties related to the purchase of the asset-backed securities. Similarly, the Secretary could establish vehicles to purchase mortgage-related assets and issue obligations. The Treasury is also empowered to issue guidance and regulations to carry out the purposes of the legislation.

But the Dodd bill would also require the Treasury to lay out its program, policies and procedures to ensure that the new authority is not used on a completely ad hoc basis. The bill also strengthens reporting provision by requiring monthly, rather than the Paulson bill’s semi-annual, reports to Congress regarding the exercise of authority under the Act. In order to ensure proper use of funds, and prevent waste and fraud, the Dodd bill adds a new provision requiring the Secretary to annually submit to Congress, and make publicly available, audited financial statements prepared in accordance with GAAP.

Importantly, unlike the Treasury bill, the Dodd bill would establish a five-member Emergency Oversight Board to review the purchase regime set up by Treasury. The Board would be composed of the Chairs of the Federal Reserve Board, the FDIC, and the SEC, as well as two private sector members appointed by bi-partisan congressional leadership. The Act requires that the private sector members have financial expertise in both the public and private sectors. The Board will have broad authority to review all actions taken by the Secretary, including the appointment of financial agents and the designation of asset classes to be purchased.

Also, replacing the Treasury bill provision providing that the Secretary’s determination are not subject to judicial or administrative review, the Dodd bill would allow review of determinations found to be arbitrary, capricious, an abuse of discretion, or not in accordance with the law.

The Dodd bill would also require that all financial institutions seeking to sell assets through a program established under this Act must satisfy appropriate standards for executive compensation in order to be eligible. One standard is that executive compensation must exclude incentives for executives to take risks that the Secretary deems inappropriate or excessive. There must also be a claw-back provision for incentive compensation paid to a senior executive based on earnings, gains, or other criteria that are later proven to be inaccurate. More broadly, there must be limitations on the entity paying severance compensation to its senior executives as are determined to be appropriate in the public interest in light of the assistance being given to it

The Treasury bill allows the Secretary to hire large asset management firms to organize the purchases of the asset-backed securities as well as their sale. However, Senator Dodd noted that Treasury ignores the fact that many of these firms have large positions in the same assets; and that those positions could be affected by the way they manage the federal government’s portfolio.

Thus, the Dodd bill would add a provision requiring the Secretary to issue rules on conflicts of interest that may arise in connection with the administration of the authorities provided in the Act. The conflicts include, but are not limited to, hiring contractors or advisors, management of assets, bidding or purchasing of assets, and employees leaving to work for an institution that has benefited from the program.

Similar to the Treasury bill, the Dodd bill requires the Secretary to ensure that any repurchase program will provide stability or prevent disruption to the financial markets and the banking system, as well protect the taxpayer.

Unlike the Treasury bill, the Dodd bill requires the Secretary to receive contingent shares in the financial institution from which the assets are to be purchased equal in value to the purchase price of the assets. In the Secretary’s discretion, the contingent shares may include shares of the financial institution, its parent company, its holding company, or any of its subsidiaries. If the purchased securities are not publicly traded, the Secretary must acquire a senior contingent debt instrument in lieu of contingent shares.

The Treasury Department has offered temporary, unlimited deposit insurance for money market funds. This has caused considerable concern in the banking industry that this will precipitate a run on the banks by large depositors, who can now access unlimited deposit insurance in money markets. To allay this concern, the Dodd measure would create parity between banks and money market funds in terms of insured deposits during the period in which Treasury offers the insurance. Also, in exchange for the guarantee being provided to the money market funds, Treasury must charge them a premium equivalent to the rate the FDIC charges banks providing deposit insurance. Finally, in providing guarantees to money market funds, the Treasury is ordered to consult with the FDIC and the SEC.

In an effort to assist homeowners, the Dodd bill would require the Treasury to shift the whole mortgages and residential mortgage-backed securities it purchases to the FDIC to manage; and add the requirement that the FDIC modify those loans where possible. The bill similarly requires other federal agencies that hold or control mortgages or residential mortgage-backed securities to modify whenever possible. In addition to FDIC, this includes FHFA, which controls Fannie Mae and Freddie Mac’s portfolios, and the Federal Reserve Bank of New York, which owns a portfolio of mortgages acquired from Bear Stearns.

The Dodd bill orders the Comptroller General to determine the extent to which leverage and sudden deleveraging of financial institutions was a factor behind the current financial crisis and report back to Congress by June 1, 2009. The report must include an analysis of the roles and responsibilities of the SEC and the banking regulators with respect to monitoring leverage and acting to curtail excessive leveraging.

A mortgage-backed security is generally one that represents an undivided interest in a group of mortgages. Investors in mortgage-backed securities receive pro rata shares of principal and interest payments on the loans backing the securities. There are different types of mortgage-backed securities. Residential or private label mortgage-backed securities are those issued by a private entity, other than Fannie Mae or Freddie Mac. A mortgage-backed security representing an undivided interest in mortgages made to finance retail, office, industrial, hotel and resort, or multi-family properties is a commercial mortgage-backed security. See OFHEO, Mortgage Market Note 07-1,Portfolio Caps and Conforming Loan Limits, 9-06-07. According to Senator Olympia Snowe, in hindsight, it appears that it was the inability to gauge risk in mortgage-backed securities that caused much of this financial turmoil.
Form D Amendments--When to File Them

Effective September 15, 2008, issuers must file amendments to a notice on Form D:

1. Within 12 months of: (a) the initial Form D filing; or (b) within 12 months of the most recent Form D amendment filing, if the offering is continuing;

2. Upon discovering a material mistake of fact or error in the previously filed Form D; and

3. To reflect changes in the information contained in a Form D, other than a change that occurs after the offering terminates or a change that occurs solely in the following information:
the address or relationship to the issuer of a related person identified in response to Item 3 of Form D;

an issuer's revenues or aggregate net asset value;

the minimum investment amount, if (A) the change is an increase or (B) the change, together with all other changes in that amount since the previously filed Form D, does not result in a decrease of more than 10%;

any address or state(s) of solicitation shown in response to Item 12 of Form D;

the total offering amount, if (A) the change is a decrease or (B) the change, together with all other changes in that amount since the previously filed Form D, does not result in an increase of more than 10%;

the amount of securities sold or the amount remaining to be sold in the offering;

the number of non-accredited investors who have invested in the offering, so long as the change does not increase the number to more than 35;

the total number of investors who have invested in the offering; or

the amount of sales commissions, finders' fees or use of proceeds for payments to executive officers, directors or promoters, if (A) the change is a decrease or (B) the change, together with all other changes in that amount since the previously filed Form D, does not result in an increase of more than 10%.

Attributed to Ann McGovern, Senior Paralegal, Goodwin Proctor, LLP, at Paralegal Roundtable, Annual Fall 2008 Conference of the North American Securities Administrators Association (NASAA).


SEC Amends Orders Halting Short Selling in Stocks of Financial Institutions and Requiring Hedge Funds to Report Short Positions

The SEC has amended its emergency orders prohibiting short selling in 799 financial companies and requiring institutional money managers to report their new short sales of certain publicly traded securities.

The SEC issued a new disclosure rule requiring hedge funds and other large investors to disclose their short positions in order to ensure transparency in short selling. Hedge fund managers with more than $100 million invested in securities would be required to promptly begin public reporting of their daily short positions. Specifically, under the order, institutional investment manager who have to file a Form 13F for the calendar quarter ended June 30, 2008 will be required to file a report on new Form SH with the SEC on the first business day of every calendar week immediately following a week in which it effected short sales. Form SH must be filed electronically, but under the amended order, will not be publicly available on EDGAR for two weeks.

In the amending release, Release No. 34-58591A, the SEC said that Forms SH will be filed on a non-public basis. The Commission is permitting the non-public filing of Form SH in order to maintain fair and orderly securities markets and prevent substantial disruption in the securities markets. The Commission believes that the non-public submission of Form SH may help prevent artificial volatility in securities as well as further downward swings that are caused by short selling, while at the same time providing the Commission with useful information to combat market manipulation that threatens investors and capital markets. Two weeks after the due date for the Forms SH, the Commission will make the Forms available to the public. The SEC believes that by two weeks after the due date the reasons to maintain the information as non-public will have diminished.

Short Selling Order Amended.

The SEC banned short selling in the stocks of almost 800 financial institutions out of a concern that short selling in the securities of a wider range of financial institutions may be causing sudden and excessive fluctuations of the prices of such securities in such a manner so as to threaten fair and orderly markets.

In the later technical amendments to the order banning short selling in financial stocks, Release No. 58611, the SEC kept on place the exception contained in the original order for short selling related directly to bona fide market making in derivatives in the securities of any included financial firm. However, this exception now requires that, for new positions, a market maker may not sell short if the market maker knows a customer or counterparty is increasing an economic net short position in the shares of the included financial firm. The technical amendments thus incorporate concepts included in the limitations on increasing net short positions imposed by the U.K. Financial Services Authority in its response to short selling. The provisions are not identical because unlike the FSA, the Commission does not have statutory authority over swap contracts and other non-security over-the-counter derivatives.
Federal Securities Act of 2008 Would Impact Blue Sky Law

The proposed federal Securities Act of 2008 would impact Blue Sky law in the following ways if adopted:

Secs. 4 and 5(a) of the Act (pp. 10-12) amend 1933 Act Sec. 18(b)(1) to: (1) delete the reference in Sec. 18(b)(1)(A) to the National Market System of the Nasdaq Stock Market (so that securities listed or authorized for listing on any of the Nasdaq tiers will be "covered securities" without need for SEC rulemaking under Sec. 18(b)(1)(B)); (2) add a qualifier to Sec. 18(b)(1)(A) that the NYSE, AMEX or Nasdaq may designate a tier or segment of securities which will not be "covered securities"; and (3) add a new Sec. 18(b)(1)(D) making any warrant or right to subscribe to or purchase any of the securities specified in
18(b)(1)(A) - (C) "covered securities."

Sec. 5(b) of the Act (p. 12) amends 1933 Act Sec. 18(b)(4)(D) to add language confirming that states may require that notice filings for Rule 506 offerings include "information corresponding to that in all the parts and the appendix to Form D," thereby ending the controversy over whether states could insist that pp. 6-8 of Form D (the paper version) be filed with them when those pages don't have to be filed with the SEC.

Sec. 13 of the Act (pp. 20-21) amends Advisers Act Sec. 205(a) to clarify that Advisers Act Sec. 205 [imposing certain limitations on advisory contracts] applies only to advisers registered or required to be registered with the SEC, not state-registered advisers.

Sec. 16 of the Act (pp. 25-27) amends Exchange Act Sec. 24 to authorize the SEC to share privileged information with, among others, "State securities or law enforcement authorities" (as defined in new Sec. 24(d)(4)(C)).

Above summary attributed to Michele Kulerman, Vice Chair of ABA Committee of State Regulation and Counsel for Hogan & Hartson in the District of Columbia.
Vermont Proposes Long-Awaited 506 Offering Rule

The Vermont Department of Banking, Insurance, Securities and Healthcare proposed a long awaited Rule for 506 offerings. Following the 2006 adoption of Vermont's version of the 2002 Model Uniform Securities Act, a notice filing and fee to make a Rule 506 offering could not be required until a Vermont rule mandating the notice filing was adopted. But now a rule is proposed.

The full text of the rule proposal is here.


The fee for the notice filing will be a flat $600.

A public hearing on the rule proposal will be held October 16, 2008 at 10 a.m. at BISCHCA, 89 Main Street, Montpelier, VT in the 3rd floor large conference room. The deadline for public comment is October 30, 2008.

Saturday, September 20, 2008

Bill Would Give Treasury Unparalled Authority to Purchase up to $700 Billion in Mortgage-Backed Securities

A bill being readied by the Bush Administration would give the Treasury Secretary extraordinary and unreviewable discretion to purchase up to $700 billion of mortgage-backed securities and other mortgage-related assets from any US financial institution. The purchasing authorization would be on the Secretary’s terms and conditions. Also, the Secretary would have unlimited authority to appoint employees and enter into contracts to help carry out the transactions. The bill also provides that decisions by the Secretary taken pursuant to the Act could not be reviewed by any court or any administrative agency.

The measure also authorizes the Secretary to designate financial institutions as federal financial agents to perform reasonable duties related to the purchase of the asset-backed securities. Similarly, the Secretary could establish vehicles to purchase mortgage-related assets and issue obligations. The Treasury is also empowered to issues guidance and regulations to carry out the purposes of the legislation.

One legislative check on the Secretary’s broad authority is the mandate that the Secretary must consider how to provide stability or prevent disruption to the financial markets and the banking system, as well protect the taxpayer, when exercising the powers given by the Act. Also, within three months of first exercising these new powers, and semiannually thereafter, the Secretary must report to Congress with respect to the authorities exercised under the Act and the considerations required by it.

Once the mortgage-backed securities are purchased with the funds authorized by the Act, the Secretary may exercise any rights received in connection with the securities. The Secretary must also manage the purchased mortgage-related assets. Also, at prices that he or she determines, the Secretary may sell the mortgage-backed securities, or enter into securities loans, or repurchase transactions.

A mortgage-backed security is generally one that represents an undivided interest in a group of mortgages. Investors in mortgage-backed securities receive pro rata shares of principal and interest payments on the loans backing the securities. There are different types of mortgage-backed securities. Residential or private label mortgage-backed securities are those issued by a private entity, other than Fannie Mae or Freddie Mac. A mortgage-backed security representing an undivided interest in mortgages made to finance retail, office, industrial, hotel and resort, or multi-family properties is a commercial mortgage-backed security. See OFHEO, Mortgage Market Note 07-1,Portfolio Caps and Conforming Loan Limits, 9-06-07. According to Senator Olympia Snowe, in hindsight, it appears that it was the inability to gauge risk in mortgage-backed securities that caused much of this financial turmoil.

Friday, September 19, 2008

SEC Issues Emergency Order to Halt Short Selling in Stocks of Financial Institutions and Require Hedge Fund Managers to Report Short Positions

On top of its actions earlier this week to curb abusive naked short selling, the SEC has temporarily prohibited short selling in financial companies to protect the integrity and quality of the securities market and strengthen investor confidence. The Commission acted in concert with the UK Financial Services Authority, which took similar action.

The Commission’s action, which is effective immediately, applies to the securities of 799 financial companies. The action effectively calls a time-out to aggressive short selling in financial institution stocks because of the essential link between their stock price and confidence in the institution. Release No. 34-58592. The emergency order will terminate at 11:59 p.m. ET on October 2, 2008; but the SEC may extend it beyond 10 days if it deems an extension necessary in the public interest and for the protection of investors, but will not extend the order for more than 30 calendar days in total duration.The Commission also will temporarily require that institutional money managers report their new short sales of certain publicly traded securities.
These money managers are already required to report their long positions in these securities.

Separately, the SEC also temporarily eased restrictions on the ability of securities issuers to repurchase their securities. This change will give issuers more flexibility to buy back their securities, and help restore liquidity during this period of unusual and extraordinary market volatility.The SEC banned short selling in the stocks of almost 800 financial institutions out of a concern that short selling in the securities of a wider range of financial institutions may be causing sudden and excessive fluctuations of the prices of such securities in such a manner so as to threaten fair and orderly markets.

The Commission exercised its powers under Section 12(k)(2) of the Exchange Act, which allow the SEC to issue orders with respect to matters based on a determination that such an order is necessary to maintain or restore fair and orderly securities markets. The SEC believes that this emergency action will prevent short selling from being used to drive down the share prices of issuers even where there is no fundamental basis for a price decline other than general market conditions.

The SEC also issued a new disclosure rule requiring hedge funds and other large investors to disclose their short positions. Release No. 34-58591. Prepared by the staffs of the Divisions of Investment Management and Corporation Finance, the new rule is designed to ensure transparency in short selling. Hedge fund managers with more than $100 million invested in securities would be required to promptly begin public reporting of their daily short positions. The managers currently report their long positions to the SEC. The emergency order will terminate at 11:59 p.m. on October 2, 2008 unless further extended by the Commission.

Specifically, under the order, institutional investment manager who have to file a Form 13F for the calendar quarter ended June 30, 2008 will be required to file a report on new Form SH with the SEC on the first business day of every calendar week immediately following a week in which it effected short sales. Form SH must be filed electronically and will be publicly available on EDGAR.

New Form SH requires disclosure of the number and value of securities sold short for each section 13(f) security, except for short sales in options, and the opening short position, closing short position, largest intraday short position, and the time of the largest intraday short position, for that security during each calendar day of the prior week.No filing, however, will be required when no short sales of a section 13(f) securityhave been effected since the previous filing of a Form SH.

In addition, this disclosure requirement will only apply to short sales effected after the effective date of the order.In addition, the money managers do not have to report short positions otherwise reportable if the short position in the section 13(f) securities constitutes less than one quarter of one per cent of the class of the issuer’s outstanding section 13(f) securities and the fair market value of the short position in the section 13(f) securities is less than $1,000,000.In another emergency order, the SEC temporarily eased restrictions on the ability of securities issuers to repurchase their securities based on its determination that issuer repurchases can represent an important source of liquidity during times of market volatility. This emergency order will also terminate at 11:59 p.m. on October 2, 2008 unless further extended by the Commission. Release No. 34-58588.Exchange Act Rule 10b-18 provides issuers with a safe harbor to effect repurchases within certain conditions. Historically, issuers have been reluctant to undertake repurchases without the certainty that their repurchases come within the safe harbor.

In the SEC’s view, temporarily altering the timing and volume conditions in the safe harbor will provide additional flexibility and certainty to issuers considering the execution of repurchases during the current market conditions. In these unusual and extraordinary circumstances, the SEC believes that altering the timing and volume conditions in Exchange Act Rule 10b-18 is necessary in the public interest and for the protection of investors to maintain fair and orderly securities markets and to prevent substantial disruption in the securities markets.

UK Financial Services Authority


Acting in concert with the SEC, the UK Financial Services Authority adopted a rule requiring both the disclosure of short positions on a daily basis in respect of financial institutions; and a prohibition in any active increase in a net short position in a financial stock by whatever instrument. There will be an exception for market makers to enable them to meet client demand. The prohibition will remain in force until January 16, 2009, during which time the FSA will review both its effectiveness and the general policy the authority wishes to adopt in respect of short selling. Also, The FSA stands ready to extend this approach to other sectors if it judges it to be necessary.

According to FSA Chair Callum McCarthy, the FSA acted out of a concern over the volatility and incoherence in the trading of equities, particularly for financial institutions. There is a danger in a trading system which allows financial institutions to be targeted and subject to extreme short selling pressures, said the chair, because movements in equity prices can be translated into uncertainty in the minds of those who place deposits with those institutions with consequent financial stability issues.
Texas Provides Guidance on Filing Electronic Form D

The Texas Securities Board issued the following bulletin on electronic filing of Form D in the State:

On February 6, 2008, the Securities and Exchange Commission (SEC) mandated the electronic filing of Form D. See Securities Act Release No. 33-8891 (Feb. 6, 2008), available from the SEC in pdf format. The SEC also adopted revisions to Form D designed to simplify and restructure information requirements. The new online filing system will be accessible from any computer with Internet access. The newly revised Form D may be filed electronically with the SEC on a voluntary basis from September 15, 2008, through March 15, 2009. Beginning March 16, 2009, electronic filing is mandatory for all Forms D filed with the SEC.

The intent of this bulletin is to advise you of revisions to the filing requirements for an issuer offering or selling securities in Texas in reliance on a limited offering exemption under state law and federal Regulation D.

What to file

On or after September 15, 2008, but before March 16, 2009, an issuer offering or selling securities in reliance on Rule 505 or Rule 506 of SEC Regulation D shall file with the Texas Securities Commissioner:

a Temporary Form D (17 CFR 239.500T)
available in pdf format, together with a consent to service of process on Form U-2 , available from NASAA; or

a copy of the notice of sale on Form D filed electronically with the SEC, until such time that the requisite Form D notice is no longer accepted as paper-only and an electronic filing system acceptable to the Texas Securities Commissioner is implemented.

The filing must also be accompanied by the requisite fee. The fee is one-tenth (1/10) of one percent (1%) of the aggregate amount of securities described as being offered for sale, but in no case more than $500. Payment is to be made by check, payable to "State of Texas".

How to file

A paper filing shall be submitted to the Texas Securities Commissioner at: 208 E. 10th Street, 5th Floor, Austin, Texas 78701 or POB 13167, Austin, Texas 78711-3167.

In order to make an electronic filing with the SEC on Form D, an issuer will need to obtain an EDGAR access code. EDGAR access codes may be obtained by following the instructions on the
SEC EDGAR website. For an inexperienced issuer the authentication process should be reviewed in advance of an anticipated filing of Form D because the authorization process could be time consuming. For additional information on how to file with the SEC, go to the SEC Form D.

When to File

The filings made with the Texas Securities Commissioner shall be filed no later than 15 calendar days after the first sale of securities in Texas, unless the 15th day falls on a Saturday, Sunday or holiday, in which case the due date is the first business day following.

When to file amendment

Issuers must file an amendment for excess sales with the Texas Securities Commissioner in accordance with requirements set forth in
Rule 114.4(d)(2), but may voluntarily file an amendment to a Form D at any time.

An amendment to a Temporary Form D filing need only report the issuer's name and any material change in the facts from those set forth initially in Parts A and B of the form.
An amendment to a previously filed paper copy of an electronic Form D filed with the SEC must provide current information in response to all requirements of the notice of sale on Form D regardless of why the amendment is filed.

How to get help with questions regarding filing requirements

Requests for additional information or questions regarding this bulletin may be directed to: David Weaver, General Counsel here,
or by calling (512) 305-8300.
Six-Month Period Period Begins for Electronic Filing of Form D

Beginning September 15, 2008 through March 16, 2009, you can opt to file Temporary Form D in paper format or electronically through EDGAR. This is the old Form D revised slightly and now called “Temporary Form D.” Until March 16, 2009, the SEC will continue to accept paper filings of this Form at U.S. Securities and Exchange Commission, 100 F. Street, N.E., Washington, D.C., 20549, or electronic filings through EDGAR. On March 16, 2009, however, all persons will be required to file New Form D electronically through EDGAR.

Beginning September 15, 2008 through March 16, 2009, you can opt to file New Form D in paper format or electronically through EDGAR. This Form D contains the SEC’s recent changes to information requirements. Until March 16, 2009, the SEC will accept paper filing of this Form at U.S. Securities and Exchange Commission, 100 F. Street, N.E., Washington, D.C., 20549, or electronic filings through EDGAR. On March 16, 2009, however, all persons will be required to file New Form D electronically through EDGAR.

See here for more information including the steps to obtaining an EDGAR access code [Central Index Key (CIK)].

Thursday, September 18, 2008

SEC Will Require Disclosure of Hedge Fund Short Positions

SEC Chair Christopher Cox will ask the Commission to consider on an emergency basis a new disclosure rule requiring hedge funds and other large investors to disclose their short positions. Prepared by the staffs of the Divisions of Investment Management and Corporation Finance, the new rule will be designed to ensure transparency in short selling. Hedge fund managers with more than $100 million invested in securities would be required to promptly begin public reporting of their daily short positions. The managers currently report their long positions to the SEC.
At the same time, the Division of Enforcement will expand its ongoing investigations by undertaking a series of additional enforcement measures against market manipulation. The Enforcement Division will obtain disclosure from significant hedge funds and other institutional traders of their past trading positions in specific securities. Those institutions will also be required immediately to secure all of their communication records in anticipation of subpoenas for these records. Director of Enforcement Linda Chatman Thomsen emphasized that the SEC has been investigating and will continue to investigate any suggestion of manipulative trading; and will use every weapon in its arsenal to combat market manipulation that threatens investors and capital markets.

Chairman Cox has consistently emphasized that hedge funds are subject to SEC regulations and enforcement under the antifraud, civil liability, and other provisions of the federal securities laws. The SEC will continue to vigorously enforce the federal securities laws against hedge funds and hedge fund advisers who violate those laws.
SEC Chair Cox Rejects Senator McCain's Call to Resign

In response to a call from the Republican presidential candidate for his resignation, SEC Chair Christopher Cox defended the Commission’s actions in the ongoing financial crisis. While expressing great respect for Senator McCain, Mr. Cox rejected the call for his resignation, noting that a change in leadership at this moment would inevitably disrupt the work of the SEC at just the wrong time. History will judge the quality of the SEC response’s to this economic crisis, he observed, but now is not the time for the Commission and its dedicated men and women to be distracted by the ebb and flow of the current election campaign. He reiterated his intention to leave the SEC at the end of the Bush Administration.

The chair went on to detail the decisive actions that the SEC has taken to address the extraordinary challenges facing the financial markets. He also emphasized the Commission’s zero tolerance for naked short selling.

This week the SEC adopted a package of measures to strengthen investor protections against naked short selling, including rules requiring a hard T+3 close-out, eliminating the options market maker exception of Regulation SHO, and expressly targeting fraud in short selling transactions. Earlier, the SEC issued an emergency order enhancing protections against naked short selling in the securities of primary dealers, Fannie Mae, and Freddie Mac. Also, the SEC announced emergency plans for a rule to ensure public disclosure of short selling positions of hedge funds and other institutional money managers.

On the enforcement front, he noted the sweeping measures the SEC has undertaken against market manipulation. He also mentioned a landmark enforcement action against a trader who spread false rumors designed to drive down the price of stock.
SEC Issues Emergency Orders to Halt Short Selling in Stocks of Financial Institutions and Require Hedge Fund Managers to Report Short Positions

On top of its actions earlier this week to curb abusive naked short selling, the SEC has temporarily prohibited short selling in financial companies to protect the integrity and quality of the securities market and strengthen investor confidence. The Commission acted in concert with the UK Financial Services Authority, which took similar action.

The Commission’s action, which is effective immediately, applies to the securities of 799 financial companies. The action effectively calls a time-out to aggressive short selling in financial institution stocks because of the essential link between their stock price and confidence in the institution. Release No.
34-58592. The emergency order will terminate at 11:59 p.m. ET on October 2, 2008; but the SEC may extend it beyond 10 days if it deems an extension necessary in the public interest and for the protection of investors, but will not extend the order for more than 30 calendar days in total duration.

The Commission also will temporarily require that institutional money managers report their new short sales of certain publicly traded securities. These money managers are already required to report their long positions in these securities. Separately, the SEC also temporarily eased restrictions on the ability of securities issuers to repurchase their securities. This change will give issuers more flexibility to buy back their securities, and help restore liquidity during this period of unusual and extraordinary market volatility.

The SEC banned short selling in the stocks of almost 800 financial institutions out of a concern that short selling in the securities of a wider range of financial institutions may be causing sudden and excessive fluctuations of the prices of such securities in such a manner so as to threaten fair and orderly markets. The Commission exercised its powers under Section 12(k)(2) of the Exchange Act, which allow the SEC to issue orders with respect to matters based on a determination that such an order is necessary to maintain or restore fair and orderly securities markets. The SEC believes that this emergency action will prevent short selling from being used to drive down the share prices of issuers even where there is no fundamental basis for a price decline other than general market conditions.

The SEC also issued a new disclosure rule requiring hedge funds and other large investors to disclose their short positions. Release No.
34-58591. Prepared by the staffs of the Divisions of Investment Management and Corporation Finance, the new rule is designed to ensure transparency in short selling. Hedge fund managers with more than $100 million invested in securities would be required to promptly begin public reporting of their daily short positions. The managers currently report their long positions to the SEC. The emergency order will terminate at 11:59 p.m. on October 2, 2008 unless further extended by the Commission.

Specifically, under the order, institutional investment manager who have to file a Form 13F for the calendar quarter ended June 30, 2008 will be required to file a report on new Form SH with the SEC on the first business day of every calendar week immediately following a week in which it effected short sales. Form SH must be filed electronically and will be publicly available on EDGAR.

New Form SH requires disclosure of the number and value of securities sold short for each section 13(f) security, except for short sales in options, and the opening short position, closing short position, largest intraday short position, and the time of the largest intraday short position, for that security during each calendar day of the prior week.

No filing, however, will be required when no short sales of a section 13(f) security have been effected since the previous filing of a Form SH. In addition, this disclosure requirement will only apply to short sales effected after the effective date of the order.

In addition, the money managers do not have to report short positions otherwise reportable if the short position in the section 13(f) securities constitutes less than one quarter of one per cent of the class of the issuer’s outstanding section 13(f) securities and the fair market value of the short position in the section 13(f) securities is less than $1,000,000.


In another emergency order, the SEC temporarily eased restrictions on the ability of securities issuers to repurchase their securities based on its determination that issuer repurchases can represent an important source of liquidity during times of market volatility. This emergency order will also terminate at 11:59 p.m. on October 2, 2008 unless further extended by the Commission. Release No.
34-58588.

Exchange Act Rule 10b-18 provides issuers with a safe harbor to effect repurchases within certain conditions. Historically, issuers have been reluctant to undertake repurchases without the certainty that their repurchases come within the safe harbor.

In the SEC’s view, temporarily altering the timing and volume conditions in the safe harbor will provide additional flexibility and certainty to issuers considering the execution of repurchases during the current market conditions. In these unusual and extraordinary circumstances, the SEC believes that altering the timing and volume conditions in Exchange Act Rule 10b-18 is necessary in the public interest and for the protection of investors to maintain fair and orderly securities markets and to prevent substantial disruption in the securities markets.

UK Financial Services Authority

Acting in concert with the SEC, the UK Financial Services Authority adopted a rule requiring both the disclosure of short positions on a daily basis in respect of financial institutions; and a prohibition in any active increase in a net short position in a financial stock by whatever instrument. There will be an exception for market makers to enable them to meet client demand. The prohibition will remain in force until January 16, 2009, during which time the FSA will review both its effectiveness and the general policy the authority wishes to adopt in respect of short selling. Also, The FSA stands ready to extend this approach to other sectors if it judges it to be necessary.

According to FSA Chair Callum McCarthy, the FSA acted out of a concern over the volatility and incoherence in the trading of equities, particularly for financial institutions. There is a danger in a trading system which allows financial institutions to be targeted and subject to extreme short selling pressures, said the chair, because movements in equity prices can be translated into uncertainty in the minds of those who place deposits with those institutions with consequent financial stability issues.

Wednesday, September 17, 2008

SEC Adopts Rules to Curb Abusive Short Selling

Against the backdrop of roiling markets, the SEC adopted rules to curb abusive naked short selling that go beyond its previously issued emergency order, which was limited to the securities of financial firms with access to the Federal Reserve's Primary Dealer Credit Facility. These rules, effective on September 18, will apply to the securities of all public companies, including all companies in the financial sector. They signal the SEC’s zero tolerance for abusive naked short selling, said Chairman Christopher Cox.

The Commission adopted, on an interim final basis, a new rule requiring that short sellers and their brokers deliver securities by the close of business on the settlement date (three days after the sale transaction date, or T+3) and imposing penalties for failure to do so.
If a short sale violates this close-out requirement, then any broker-dealer acting on the short seller's behalf will be prohibited from further short sales in the same security unless the shares are not only located but also pre-borrowed. The prohibition on the broker’s activity applies not only to short sales for the particular naked short seller, but to all short sales for any customer.
Although the rule will be effective immediately, there will be a 30 day comment period on all aspects of the rule. The Commission expects to follow further rulemaking procedures at the expiration of the comment period.

Also, effective on September 18, the SEC adopted Rule 10b-21, which expressly targets fraudulent short selling transactions. The new rule covers short sellers who deceive broker-dealers or any other market participants. Specifically, the new rule makes clear that those who lie about their intention or ability to deliver securities in time for settlement are violating the law when they fail to deliver.

Finally, the SEC approved a final rule eliminating the options market maker exception from the close-out requirement of Rule 203(b)(3) in Regulation SHO. This rule change also becomes effective on Sept. 18, 2008. As a result of the rule, options market makers will be treated in the same way as all other market participants, and required to abide by the hard T+3 closeout requirements that effectively ban naked short selling. Regulation SHO was adopted to update short sale regulation in light of numerous market developments since short sale regulation was first adopted in 1938.

A short sale is the sale of a stock that the seller does not own or that the seller will borrow for delivery. Short sellers believe the price of the stock will fall, or are seeking to hedge against potential price volatility in securities that they own. If the price of the stock drops, short sellers buy the stock at the lower price and make a profit. If the price of the stock rises, short sellers will incur a loss. In a naked short sale, the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer within the standard three-day settlement period.


SEC Explains Need for Emergency Naked Short Selling Rules

Against the backdrop of roiling markets, the SEC adopted rules to curb abusive naked short selling that go beyond its previously issued emergency order, which was limited to the securities of financial firms with access to the Federal Reserve's Primary Dealer Credit Facility. These rules, effective on September 18, will apply to the securities of all public companies, including all companies in the financial sector. They signal the SEC’s zero tolerance for abusive naked short selling, said Chairman Christopher Cox.

These rules were adopted to preserve fair and orderly markets pursuant to the SEC’s powers under Section 12(k)(2) of the Exchange Act. The Commission explained that its finding of an emergency is solely for purposes of Section 12(k)(2) and is not intended to have any other effect or meaning or to confer any right or impose any obligation other than set forth in this order.

Pursuant to Section 12(k)(2), in appropriate circumstances the Commission may issue summarily an order to alter, supplement, suspend, or impose requirements or restrictions with respect to matters or actions subject to regulation by the Commission.

As explained in Release No. 34-58572, the SEC acted out of a concern that there is a substantial threat of sudden and excessive fluctuations of securities prices and disruption in the functioning of the securities markets that could threaten fair and orderly markets. There is the possibility of unnecessary or artificial price movements based on unfounded rumors regarding the stability of financial institutions and other issuers exacerbated by naked short selling. The Commission’s concerns have gone beyond that limited amount of financial institutions that were the subject of its earlier emergency order.

There is also concern that some persons may take advantage of issuers that have become temporarily weakened by current market conditions to engage in inappropriate Moreover, sudden and unexplained declines in the prices of securities have raised questions about the underlying financial condition of an issuer, which in turn can create a crisis of confidence without a fundamental underlying basis. In turn, this crisis of confidence can impair the liquidity and ultimate viability of an issuer, with potentially broad market consequences.
Short Selling Is One Aspect of Market Crisis

With the SEC’s adoption of regulations to curb abusive naked short selling, the practice of short selling has come front and center into the regulatory consciousness.

A short sale is the sale of a stock that the seller does not own or that the seller will borrow for delivery. Short sellers believe the price of the stock will fall, or are seeking to hedge against potential price volatility in securities that they own. If the price of the stock drops, short sellers buy the stock at the lower price and make a profit. If the price of the stock rises, short sellers will incur a loss.

Short selling is used for many purposes, including to profit from an expected downward price movement, to provide liquidity in response to unanticipated buyer demand, or to hedge the risk of a long position in the same security or a related security. The vast majority of short sales are legal.

However, abusive short sale practices are illegal. For example, it is prohibited for any person to engage in a series of transactions in order to create actual or apparent active trading in a security or to depress the price of a security for the purpose of inducing the purchase or sale of the security by others. Thus, short sales effected to manipulate the price of a stock are prohibited.
In a naked short sale, the seller does not borrow or arrange securities in time to make delivery to the buyer within the standard three-day settlement period. As a result, the seller fails to deliver securities to the buyer when delivery is due, which is known as a failure to deliver or fail.

Failures to deliver may result from either a short or a long sale. There may be legitimate reasons for a failure to deliver. For example, human or mechanical errors or processing delays can result from transferring securities in physical certificate rather than book-entry form, thus causing a failure to deliver on a long sale within the normal three-day settlement period. A fail may also result from naked short selling. For example, market makers who sell short thinly traded, illiquid stock in response to customer demand may encounter difficulty in obtaining securities when the time for delivery arrives.

Naked short selling is not necessarily a violation of the federal securities laws or SEC rules. Indeed, in certain circumstances, naked short selling contributes to market liquidity. For example, broker-dealers that make a market in a security generally stand ready to buy and sell the security on a regular and continuous basis at a publicly quoted price, even when there are no other buyers or sellers.

Thus, market makers must sell a security to a buyer even when there are temporary shortages of that security available in the market. This may occur, for example, if there is a sudden surge in buying interest in that security, or if few investors are selling the security at that time. Because it may take a market maker considerable time to purchase or arrange to borrow the security, a market maker engaged in bona fide market making, particularly in a fast-moving market, may need to sell the security short without having arranged to borrow shares. This is especially true for market makers in thinly traded, illiquid stocks such as securities quoted on the OTC Bulletin Board as there may be few shares available to purchase or borrow at a given time.

Naked short selling, however, can have negative effects on the market. Fraudsters may use naked short selling as a tool to manipulate the market. Market manipulation is illegal. The SEC has toughened its rules and is vigilant about taking actions against wrongdoers.

Fails to deliver that persist for an extended period of time may result in a significantly large unfulfilled delivery obligation at the clearing agency where trades are settled. The SEC’s Regulation SHO is intended to address these effects by reducing the number of potential failures to deliver, and by limiting the time in which a broker can permit a fail to deliver to persist. Regulation SHO requires brokers and dealers to close-out the open fail-to-deliver positions in threshold securities, for example, securities that have experienced a substantial number of extended delivery failures, that have persisted for 13 consecutive settlement days.

When considering naked short selling, it is important to know which activity is the focus of discussion.

Selling stock short without having located stock for delivery at settlement. This activity would violate Regulation SHO, except for short sales by market makers engaged in bona fide market making.

Selling stock short and failing to deliver shares at the time of settlement. This activity doesn't necessarily violate any rules. There are legitimate reasons why a seller may fail to deliver on the scheduled settlement date.

Selling stock short and failing to deliver shares at the time of settlement with the purpose of driving down the security's price. This manipulative activity, in general, would violate various securities laws, including Rule 10b-5 under the Exchange Act. Regulation SHO does not address this issue.

Tuesday, September 16, 2008

Center for Audit Quality Pushes Treasury's Levitt Committee on Audit Profession to Limit Auditor Liability

In a comment letter to the Levitt Committee on the Auditing Profession, the Center for Audit Quality said that the committee’s second draft report still did not address the catastrophic litigation threat that, in CAQ’s view, is the single greatest threat to the auditing profession’s sustainability. While agreeing with the committee’s recommendation that the PCAOB should monitor potential sources of catastrophic risk that would threaten audit quality, CAQ believes that the committee’s implication that auditing firm conduct is the sole cause of increased catastrophic risk is misleading. The threat of catastrophic loss primarily comes from factors other than audit firm conduct, posited CAQ, and it is those other factors, largely found in the litigation environment, that the PCAOB should monitor.

Treasury established the advisory committee to examine the sustainability of a strong and vibrant auditing profession. It is co-chaired by former SEC Chair Arthur Levitt and former SEC Chief Accountant Donald Nicolaisen. Other members of the committee include former SEC Corporation Finance Director Alan Beller and former Fed Chair Paul Volcker.

The center supports the committee’s recommendation that the PCAOB require that, beginning in 2011, the larger auditing firms file with the Board on a confidential basis audited financial statements. The center agreed with the conclusion that public dissemination of the firms’ financial statements should not be required. The PCAOB should determine the nature and form of audit firm financial and risk information that would be important for them to assess audit firm stability and sustainability, and that information should be treated as confidential under Section 105 of the Sarbanes-Oxley Act.

While the report characterized the serious litigation risk facing audit firms as real and discussed past catastrophic litigation, noted the center, it did not contain even limited litigation reforms such as exclusive federal jurisdiction and a uniform standard of care. Even more, the committee did not consider any of the measures proposed by the CAQ in a June letter, including a revised Rule 10b-5 and caps on liability for audit firms.

The center urged the committee not to be lulled into inaction by arguments that link high audit quality to auditor liability. To suggest that auditors will not perform well unless faced with unlimited liability is a totally unsupported assertion, emphasized CAQ, which does a disservice to the audit profession and investors. In CAQ’s view, appropriately measured liability and robust regulation, combined with clear professional standards, are strong motivators of audit quality. Indeed, continued CAQ, extreme disproportionate liability threats can lead to over-auditing and inefficiently cautious behavior, as well as hurting the profession’s ability to attract new talent.

While acknowledging that independent auditors should be exposed to both the legal and economic consequences of failure and that potential liability can provide incentives for more careful audits, the center said that the extraordinary growth in auditor liability reflects audit client capitalization, not auditor misconduct. In this regard, the center cited a written submission of Kathryn A. Oberly, Americas Vice Chair and General Counsel, Ernst & Young LLP, on June 3, 2008, which noted that the size of the damages being claimed has grown substantially, in tandem with the growth in market capitalization of the firms’ audit clients.

Sunday, September 14, 2008

FASB and IASB Update Agreement to Converge Accounting Standards

As the world moves inexorably to IFRS as the global accounting standard, the FASB and IASB have updated their 2006 agreement to converge US GAAP and IFRS. The Norwalk Agreement committed the Boards to develop high quality compatible accounting standards for use in both domestic and cross border financial statements. Based on the progress achieved by the Boards through 2007, the SEC removed the requirement for foreign private issuers to reconcile their IFRS-driven financial statements to US GAAP. Noting that a number of jurisdictions, including Canada and Japan, will adopt IFRS from 2011 on, IASB Chair David Tweedie emphasized the need to complete the project beforehand so as to avoid the necessity for them to make major changes shortly after the project is completed.

A number of short-term projects on the road to convergence have been completed. For example, bringing U.S. GAAP into line with IFRSs, FASB issued new or amended standards that introduced a fair value option (SFAS 159) and adopted the IFRS approach to accounting for research and development assets acquired in a business combination (SFAS 141R). In addition, converging IFRSs with U.S. GAAP, the IASB published new standards on borrowing costs (IAS 23 revised) and segment reporting (IFRS 8).

In the near term, the IASB plans to publish a proposed standard on income taxes that would improve IAS 12 and eliminate certain differences between IFRSs and U.S. GAAP. For its part, the FASB plans to publish proposed standards on accounting and reporting for
subsequent events in the second half of 2008.

Also, in the second half of 2008, the FASB will review its strategy for short-term convergence projects in light of the possibility that some or all U.S. public companies might be permitted or required to adopt IFRS at some future date. As part of that review, the Board will solicit input from U.S. constituents by issuing an Invitation to Comment containing the IASB’s proposed replacement of IAS 12. At the conclusion of that review, it will decide whether to undertake projects that would eliminate differences in the accounting for taxes, investment properties, and research and development by adopting the relevant IFRS.

The Boards also issued a status report on long-term projects. The convergence on business combinations was completed with the issuance of FAS 141R and revisions to IFRS 3. Regarding financial instrument presentation, the IASB revised IAS 1 and joint Board deliberations are ongoing, with a discussion paper to be issued in 3Q 2008. On the issue of revenue recognition, joint Board deliberations are ongoing, with a discussion paper to be issued in 4Q 2008. Finally, on the important and controversial issue of fair value accounting, FASB issued FAS 157 and the IASB issued a discussion paper. The IASB plans to issue a proposal draft in 2009, after which FASB will review FAS 157 in light of the draft.

Friday, September 12, 2008

Colorado Proposes to Adopt Electronic Form D

Colorado Proposes to amend its Securities Act of 1933 Rule at Section 11-51-3.7 to add the SEC requirement to file Form D electronically. Additionally, Rule 51-3-5 coordinating with the Colorado statutory investment company exemption at 11-51-307(1)(k) would be amended to change the filing requirements. Lastly, the NASAA Model Rule on the use of senior specific certifications and professional designations would be proposed.

A public hearing on the above proposals will take place at the Colorado Department of Regulatory Agencies, Conference Room 900, 1560 Broadway, 9th Floor, Denver, Colorado 80202, on Friday October 3, 2008 at 9:00 a.m. Information on the proposed rules are available at the Division of Securities, 1560 Broadway, Suite 900, Denver, Colorado 80202, and the Division's website http://www.dora.state.co.us/securities at least five days before the public hearing.
Eighth Circuit Affirms Dismissal After Tellabs Review

A fraud complaint did not meet the Tellabs standard for pleading scienter, concluded an 8th Circuit panel. In affirming a district court's pre-Tellabs dismissal of claims based on several accounting errors and resulting restatements by Ceridian Corp., an information services and human resources outsourcing firm, the court found that the non-culpable inferences of negligence and mistake raised by the allegations were more compelling than the inferences of fraud.

The class alleged that Ceridian's senior officers participated in a scheme to artificially inflate the company's financial results by exploiting a weak or corrupt system of internal controls to commit numerous violations of Generally Accepted Accounting Principles. Initially, the appellate panel agreed with the lower court finding that the sheer number and magnitude of the financial restatements, "an amalgam of unrelated GAAP violations," without more, did not raise a sufficient inference of scienter. "Without something more, the opposing inference of nonfraudulent intent-that these were mistakes by accounting personnel undetected because of faulty accounting controls-is simply more compelling," stated the court.

When viewed as a whole, the court found that the various obligations failed to meet the Tellabs standard. Of particular note was the court's holding on allegations that the officers must have known that their Sarbanes-Oxley certifications concerning the effectiveness of the company's internal controls were false, in light of the subsequent revelations of accounting errors and control deficiencies. "Allegations that accounting errors were discovered months and years later do not give rise to a strong inference that the certifications were knowingly false when made," stated the court, as the panel concluded that the complaint did not identify any specific factual basis for inferring that the officers knew their certifications were false. The court in effect observed that the plaintiffs' interpretation of the certification requirement would turn the provision into a strict liability measure, because scienter would be established in every case where there was an accounting error or auditing mistake.

Other allegations of insider trading and bonus awards were also not sufficiently suspicious. An ongoing SEC investigation which produced no adverse findings also did not show scienter, and a compelling inference that the senior officers knew of the series of GAAP violations could not be drawn from the dismissal of several mid-level accounting personnel. "The flaw in this argument," observed the court, "is that the opposing inferences-that the SEC investigation uncovered no evidence of fraud, and that accounting personnel and corporate officers responsible for the accounting function were fired or forced to depart for incompetence, not fraud-are more compelling in the absence of particular facts giving rise to a strong inference of fraud."


In re Ceridian Corp. Securities Litigation

Thursday, September 11, 2008

House Passes Securities Act of 2008 Enhancing SEC Enforcement Powers

A bipartisan bill increasing the SEC’s enforcement powers and requiring increased attention to accounting and auditing matters has passed the House under a suspension of the rules. The Securities Act of 2008 (HR 6513) authorizes the SEC to impose monetary penalties in cease and desist proceedings. In 1990, the Securities Enforcement Remedies Act authorized the SEC to issue cease and desist orders through administrative action, which allows the Commission to act quickly when ongoing conduct places investors in continuing jeopardy. A cease and desist order is an administrative remedy directing a person to refrain from engaging in further violative conduct.

Moreover, SEC enforcement efforts will benefit from provisions authorizing the nationwide service of subpoenas and the imposition of collateral bars. These provisions respectively will allow the Commission to allocate its funds more efficiently and prevent bad actors from re-entering other parts of the industry. The bill is endorsed by the SEC and the North American Securities Administrators Association. In fact, the bill’s sponsor, Rep. Paul Kanjorski, noted that a majority of the provisions in the bill were recommended to Congress by the Commission.

Other provisions in the bill help investors by extending the insurance provided by the Securities Investor Protection Corporation to securities futures held within their portfolio. As a result, the bill enhances the competitiveness of the U.S. markets by advancing portfolio-based margining for the customers of broker-dealers.

The bill also provides that the SEC can impose a tiered monetary penalty if it finds that a person is violating or caused a violation of the securities laws or regulations; and the penalty is in the public interest. The first tier maximum penalty is $6500 for a natural person and $65,000 for any other person. The penalty increases to $65,000 for a natural person and $325,000 for others if the act involved fraud or the reckless disregard of a regulation. Finally, for fraudulent or reckless acts resulting in substantial losses to victims or substantial pecuniary gain to the actor, the SEC may impose penalties of up to $130,000 for a natural person and $650,000 for others.The measure provides that actors subject to these monetary penalties may present evidence of their ability to pay such penalty, which the Commission has discretion to consider in determining whether such penalty is in the public interest. The evidence may relate to the extent of such person’s ability to continue in business and the collectability of a penalty, taking into account any other claims of the United States or third parties upon the person’s assets.

Many provisions of the Federal securities laws authorizing the sanctioning of a person who engages in misconduct while associated with a regulated or supervised entity explicitly provide that such authority exists even if the person is no longer associated with that entity. Several provisions, however, do not explicitly address this issue, although, according to Rep. Kanjorski, the intent of earlier Congresses appears to have been that the SEC had such authority, and no contrary statutory language or legislative history exists.

In fact, Congress has amended several statutory provisions to ratify and confirm the authority of the Commission to discipline a person formerly associated with a regulated entity for conduct while an associated person, but it did not express intent to provide such authority only for those provisions being amended

To build on these previous efforts, section 3 of the Act amends additional provisions of the securities laws that do not explicitly address this issue. These changes confirm that the Commission may sanction or discipline persons who engage in misconduct while associated with a regulated or supervised entity, even if they are no longer associated with that entity.

Thus, the amendments would not alter or expand the Commission's current authority, noted Rep. Kanjorski, they would only ratify and confirm it. As a general rule, it is the intent of the Congress that the securities laws, including but not limited to those provisions amended by section 3, apply to and provide meaningful remedies for sanctioning persons who engage in misconduct while associated with a regulated or supervised entity, even if the person is no longer associated with that entity.

The bill also conforms the language of the law to existing interpretations about when unlawful margin lending occurs. The Capital Markets Efficiency Act of 1996 exempted from federal margin requirements, adopted under section 7 of the Exchange Act, credit extended, maintained, or arranged to or for a member of a national securities exchange or registered broker-dealer under certain circumstances. In the portion of section 7 that was not substantively amended by the Capital Markets Efficiency Act, the word ``and'' was inserted, which could be read to mean that margin lending would be unlawful only if both elements of the pre-existing prohibitions were violated, when prior to the Capital Markets Efficiency Act violation of either prong was sufficient to make such margin lending unlawful.

Specifically, the first prong, section 7(c)(1)(A), states that margin lending is unlawful if done in contravention of the Federal Reserve Board's rules, and the second prong, section 7(c)(1)(B), states that margin lending is unlawful without collateral or on any collateral other than securities, except in accordance with the Federal Reserve Board's rules. The bill would clarify that a violation of either prong remains sufficient to establish a cause of action for improper margin lending.

The Act also finds that the complexity of accounting and auditing standards in the United States has added to the costs and effort involved in financial reporting. In this regard, the bill mandates the SEC, FASB and the PCAOB to annual provide oral testimony to Congress on their efforts to reduce the complexity of financial reporting in order to provide more accurate and clear financial information to investors.The testimony must discuss the reassessment of complex and outdated accounting standards. The agency chairs must also discuss how to improve the understandability, consistency, and overall usability of the existing accounting and auditing literature. Congress also wants information on how the development of principles-based accounting standards is progressing. In addition, there must be a discussion of how to encourage the use and acceptance of interactive data, as well as efforts to promote disclosures in plain English.