Tuesday, December 30, 2008

Illinois Sets Forth Electronic Form D Filing Procedures

Illinois' electronic Form D filing procedures apply to Rules 504, 505 and 506 of federal Regulation D. Between September 15, 2008 and March 15, 2009, the Illinois Securities Department will accept either a copy of the electronic version of new Form D or the SEC-filed existing ("Temporary") Form D. Beginning March 16, 2009, the Department will accept only a copy of the SEC-filed electronic version of Form D.

For more information, see http://www.cyberdriveillinois.com/departments/securities/regd.html

Saturday, December 27, 2008


Alabama Administrator Advocates Steps to Close "Gap" in Regulatory Information Sharing

In remarks delivered at NASAA's Regulatory Reform Roundtable, Alabama Securities Director and former NASAA President Joseph Borg stated that we must close the vacuum, or "gap," in financial regulation that led to the current financial crisis. According to Borg, the crisis has revealed that an enormous amount of unregulated capital is traded through esoteric instruments on opaque markets. Borg believes that these products, which were created through consolidation and creative expansion in the financial services industry, must be subjected to effective information analysis and regulation in order to detect and manage risk in the financial markets.

Borg acknowledged that the current form of ad hoc information sharing among regulatory agencies suffers from inefficiencies and a lack of coordination. Regulators, who historically have been siloed and compartmentalized, have had difficulty in coordinating and cooperating on forward-looking analyses of certain instruments, such as structured products. The inability or unwillingness of agencies to break down barriers has allowed for gaps in the monitoring and detection of systemic market risk by preventing regulators from seeing what was "around the curve," Borg said.

Borg argued, however, that the solution does not lie in the centralization of interagency coordination at the highest levels of government. Rather, he believes, the goal must be truly horizontal interagency planning performed virtually simultaneously. In Borg's view, we must mandate robust information exchange by establishing and enforcing minimum standards of information sharing at the appropriate agency level, while still protecting the sources of that information.

In order to facilitate an increase in communication and cooperation, Borg suggests the establishment of a council of experts that would monitor financial activity in all sectors and recommend any necessary corrective action. As envisioned by Borg, the council would be comprised of both state and federal regulators, academics, and others with expertise in securities, banking, and insurance. This new "financial products commission" would have no regulatory authority other than carefully defined powers to collect data from market participants and regulators. The council would examine the totality of the data in order to identify systemic risks or the emergence of new products not subject to adequate regulation. The council would then pass on its recommendations for corrective action to the various regulatory agencies with the ultimate policy making decisions, Borg said.

Borg believes that the proposed council could also be used to improve risk understanding and accounting. Borg noted that accounting measures are the primary data used for corporate decisions and regulatory requirements, even though current GAAP accounting methods are backward-looking by definition and not well suited for providing risk transparency. Borg stated that the use of cross sector financial expertise may result in a new branch of accounting, risk accounting, which captures the linkages and vulnerabilities of the entire financial system, and not just those of the banking system.

Wednesday, December 24, 2008

SEC Action Allows Central Counterparty for Credit Default Swaps

The SEC approved temporary exemptions allowing LCH.Clearnet Ltd. to operate as a central counterparty for credit default swaps. The Commission acted to reduce counterparty risk and promote efficiency in the credit default swap market.

Credit default swaps are derivative contracts between two counterparties. Under these agreements, the buyer makes periodic payments to the seller, and will be paid by the seller if the underlying financial instrument goes into default. These instruments trade in a largely unregulated environment worth several trillion dollars. The use of credit default swaps was a key part of the collapse of Lehman Brothers and the turmoil at AIG.

The implementation of central counterparty services for credit default swaps was a top priority of the President's Working Group on Financial Markets. The temporary exemptions will facilitate central counterparties such as LCH.Clearnet and certain of their participants to implement centralized clearing quickly, while providing the Commission time to review their operations and evaluate whether registrations or permanent exemptions should be granted in the future. The conditions to the exemptions are designed to provide that key investor protections and important elements of Commission oversight apply, while taking into account that applying all the particulars of the securities laws could have the unintended consequence of deterring the prompt establishment and use of a central counterparty.

The SEC is seeking public comment on this issue, and did not specify how long the temporary exemptions would remain in force.


Tuesday, December 23, 2008

Massachusetts White Paper Argues Against Erosion of State Authority

Investors and other consumers of financial services would be severely damaged by any further preemption of state enforcement authority, argues Massachusetts Secretary of the Commonwealth William F. Galvin. Galvin, who also serves as Co-Chair of the Standing Committee on Securities of the National Association of Secretaries of State, set forth his views in a white paper that seeks to remind policymakers of the effectiveness of state securities regulators over the last ten years. In particular, Galvin highlighted how the states taken the lead in a number of important investor protection issues and contends that any federal regulatory consolidation should be balanced by an affirmation of the valuable role that the states play in securities regulation.

The Secretary stated that the presence of both state and federal securities regulators, a complementary regime that has endured for more than 75 years, has been largely responsible for the competitiveness of U.S. capital markets. In the words of one commentator, state securities regulation serves as a "fail safe mechanism," providing the public with an additional source of protection in the event of regulatory failure at another level of government. Galvin noted that state regulators have often been the crucial "first responders" to the major abuses that have occurred in the securities markets over the past ten years, including issues involving auction rate securities, fraud against senior investors, market timing, tainted stock ratings, and day trading. Although the SEC has also been at the forefront on several issues, such as insider trading, the states have consistently been in the vanguard of investor protection on the retail, consumer-facing, business conduct issues, Galvin said.

Galvin expressed concern that any federal regulatory consolidation carried out in response to consolidation in the financial services industry will likely be deregulatory in nature. As such, the Secretary believes, any regulatory consolidation at the federal level should be counterbalanced by an affirmation of the states' securities enforcement powers. The consolidation of the banking, securities, and insurance industries in the wake of the Gramm Leach Bliley Act has intensified many conflicts of interest in those industries, the Secretary observed, resulting in effects on the consumer that have not been adequately addressed at the federal level. For example, Galvin cited how federal regulators were slow to move to correct problems involving the sales of auction rate securities to depository clients by the same financial conglomerates who had underwritten the securities. In Galvin's view, federal regulatory efforts have not kept pace with financial innovation and consolidation over the past ten years. Rather, it has been the states who have fielded calls from investors and provided a strong regulatory response.

Galvin believes that whatever form regulatory consolidation may take at the federal level, it will likely result in fewer cops on the beat, less regulatory competition among regulatory entities, and greater possibilities for "regulatory capture." Additionally, a large, centralized bureaucracy may be unable to respond rapidly and effectively to consumer concerns. Galvin also expressed skepticism that the implementation of a principles-based regime would be anything but deregulatory in nature, given that one of the tenets of a principles-based approach is industry self-policing and two of its central goals involve limiting the number of rules and limiting the number of enforcement actions.

Accordingly, any such deregulatory moves at the federal level must be accompanied by an express recognition and affirmation of the states' central role in securities enforcement, Galvin wrote, in order to ensure adequate protection of both investors and savers. Although acknowledging the benefits of increased cooperation and information sharing between federal and state enforcement authorities, Galvin said that any such cooperation must be promoted in a manner that does not compromise the independence and authority of state securities regulators.

Friday, December 19, 2008


Connecticut Sets Forth Electronic Form D Filing Procedures

Electronic Form D filing procedures in Connecticut apply to securities offerings made in reliance on Rules 504, 505 or 506 of federal Regulation D, as well in reliance on Section 4(6) of the Securities Act of 1933. These procedures cover the transition period of September 15, 2008 through March 15, 2009 during which the SEC allows issuers to paper-file old (or "Temporary") Form D, or paper or electronically file new Form D. Beginning March 16, 2009, issuers will only be permitted to file new Form D and must file it electronically.

Issuers filing either Form D version in Connecticut during the transition period for a Rule 506 offering must include $150 and submit the filing to the Securities Division within 15 days after the securities are first sold in the State.

Issuers paper-filing Temporary Form D must sign the Form and include: (1) the Form D Appendix; (2) Form U-2, Uniform Consent to Service of Process; (3) Form D amendments for material changes; and (4) a Sales Agent/Broker-Dealer Questionnaire (or Equivalent).

Issuers paper-filing new Form D must sign the Form and include Form D amendments for material changes. The other requirements for Temporary Form D are not required when paper-filing new Form D.

Issuers electronically filing new Form D may type their signature. The other requirements for Temporary Form D and paper-filing new Form D are not required when electronically filing new Form D.

NOTE: The Connecticut Commissioner of Banking may request sales reports in certain circumstances from issuers making any type of Form D filing.

For more information, see http://www.ct.gov/dob/cwp/view.asp?=2255&q=299280

New SEC Rule Would Regulate Most Indexed Annuities

The SEC adopted a new rule, despite substantial opposition from the insurance industry and over a dissent from Commissioner Troy Paredes, that defines the terms "annuity contract" and "optional annuity contract" under the Securities Act. New Rule 151A is intended to clarify the federal securities law status of indexed annuities, under which payments to the purchaser are dependent on the performance of a securities index. Under the rule, certain indexed annuities would be defined as not being "annuity contracts" or "optional annuity contracts" if the amounts payable by the insurer under the contract are more likely than not to exceed the amounts guaranteed under the contract. Under this definition, these securities would not fall within the statutory insurance exemption set forth in Section 3(a)(8) of the Securities Act.

According to the SEC, these instruments are not the kind of investment vehicles that Congress intended to be regulated exclusively by state insurance commissioners. Purchasers of these instruments, noted the SEC, assume the risk of an uncertain and fluctuating financial instrument, in exchange for exposure to future, securities-linked returns. The SEC determined that this assumption of risk merited the application of the registration and provisions of the federal securities laws to these contracts.

The Commission proposed the rule in June 2008 to curb abusive sales practices of equity-indexed annuities that have particularly harmed senior investors. Chairman Christopher Cox said that one reason the abusive sales practices have gone unchecked is that the question of whether the annuity contracts are securities has been left unanswered.

In remarks made at the open meeting, Commissioner Paredes explained why he voted against the adoption of the rule. He stated that the Commission's action was based on good intentions and founded on a desire to protect investors from unscrupulous practices. Despite these laudable objectives, however, the commissioner stated that the rulemaking exceeded the SEC's authority. According to Commissioner Paredes, "by defining indexed annuities in the manner done in Rule 151A, I believe the SEC will be entering into a realm that Congress prohibited us from entering."

The rule, in Mr. Paredes' opinion, could result in blanket SEC regulation of the indexed annuity market. He also criticized the majority for not exploring less burdensome alternatives. Compliance would be costly, he asserted, and could force smaller issuers out of the market, according to the commissioner. Finally, he expressed disappointment that the Commission apparently dismissed as inadequate the oversight of these instruments by state regulators.

Thursday, December 18, 2008

Obama Choice of Schapiro for SEC Chair Should Facilitate SEC-CFTC Merger

President-Elect Obama's choice of Mary Schapiro for the ncxt SEC Chair is almost certain to increase the chances for the merger of the SEC and CFTC that so many heavyweights, including former SEC Chair Arthur Levitt, are calling for. In addition to the fact the she is uniquely a former SEC Acting Chair and a former CFTC Chair, Ms. Schapiro was calling for a merger of the two agencies as far back as 1990.

In a speech to the Economists Club, then SEC Commissioner Schapiro listed a number of reasons for the merger. She prefers merger to the piecemeal transfer of products from the CFTC to the SEC. Merger, as opposed to the transfer of only one product, can result in economies for brokerage firms and should not increase costs for exchanges. Merger enables the expeditious resolution of intermarket issues. Merger enables the new agency to speak with one voice internationally, and to bring the maximum amount of leverage to bear in international negotiations. Merger would release both the futures and securities industry from the current
climate of uncertainty that dominates and hampers the development and introduction of new products. Merger more nearly ensures that the scheme of regulation that recognizes futures as unique instruments will survive. Merger leaves no agency overburdened or stripped of the resources necessary to do the job.

Tuesday, December 16, 2008

Citing Madoff Firm, SEC Chair Cox Orders Broad Review of SEC Internal Policies; SIPC Begins Liquidation

Noting that the SEC was informed of the Madoff investigation last week despite the fact that credible allegations of wrongdoing were brought to the staff’s attention as early as 1999, Chairman Christopher Cox ordered a broad review of the Commission’s internal investigative policies. The chair said that he was gravely concerned by the apparent multiple failures over at least a decade to thoroughly investigate these allegations or at any point to seek formal authority to pursue them. At the same time, the SIPC said that it was liquidating the Madoff investment firm under the Securities Investor Protection Act. At SIPC’s request, a federal judge has already appointed a trustee for the liquidation of the brokerage firm. Mr. Cox said that SEC investigators are currently working with the trustee to review vast amounts of records and information involving Mr. Madoff and his firm.

The SEC chair also pledged that every necessary resource at the SEC has been dedicated to pursuing the investigation, protecting customer assets and holding both Mr. Madoff and others who may have been involved accountable. Firm records are increasingly exposing the complicated steps that Mr. Madoff took to deceive both investors and regulators. The investigation has already found that the firm kept several sets of books and false documents, and provided false information involving advisory activities to investors and to regulators. Moreover, as a consequence of the staff’s failure to seek a formal order of investigation from the Commission, subpoena power was not used to obtain information. Rather, the staff relied upon information voluntarily produced by Mr. Madoff and his firm.

In response, after consultation with the Commission, the chair directed the SEC’s Inspector General to conduct a full and immediate review of the past allegations regarding Mr. Madoff and his firm and the reasons that they were not found credible. The review will also cover the internal policies at the SEC governing when allegations such as those in this case should be raised to the Commission level, whether those policies were followed, and whether improvements to those policies are necessary. The investigation should also include all staff contact and relationships with the Madoff family and firm, and their impact, if any, on decisions by staff regarding the firm.

While it is clear that customers of the Madoff firm need the protections available under federal law, SIPC President Stephen Harbeck cautioned that the scope of the misappropriation and the state of the defunct firm's records will make this more difficult than in most prior brokerage firm insolvencies. It is unlikely that SIPC and the federal liquidation trustee will be able to transfer the customer accounts of the firm to a solvent brokerage firm, said the SIPC chief.

The state of the firm's records may preclude a transfer of customer accounts. Also, because the size of the misappropriation has not yet been established, it is impossible to determine each customer's pro rata share of customer property. The trustee is charged with giving notice of the proceeding and mailing claim forms to the customers and other creditors of the firm.
Revival of Mortgage Securitization Depends on Greater Transparency Says Fed Governor Kroszner

A recovery in the market for mortgage-backed securities will require greater transparency and less complexity, as well as comprehensive and standardized loan-level data that will allow more independent credit analysis, in the view of Federal Reserve Board Governor Randall Kroszner. In remarks at a Fed seminar on the mortgage markets, he sketched a scenario under which investors may gradually regain confidence in mortgage securitization.

However, the Fed official does not expect a revival for some of the most complex structures that were created in recent years to finance a portion of sub prime mortgages, specifically collateralized debt obligations that were themselves backed by other structured credit products, including the lower-rated tranches of mortgage-backed securities. These two-layer securitizations were far more complex and much more exposed to systematic losses than were the mortgage-backed securities themselves. Indeed, investors in, and more importantly, financial institutions that retained, the super senior tranches of CDO-squared securities took substantial losses. Given the magnitude of those losses and the recognition that rigorous credit analyses are extremely information intensive, he expects investors to remain skeptical of two-layer securitized financial products for the foreseeable future.

But he does envision the recovery of securitization with much less complex structures of cash flows from mortgage payments in the pool to the various tranches of mortgage-backed securities. In addition, securitization contracts will need to be made more homogeneous so as to allow greater comparability of risk profiles across deals and promote more robust liquidity. Also, securitizations should involve fewer and larger tranches of mortgage-backed securities which, in addition to further promoting liquidity, could also reduce the exposure of some securities to certain tail risks and model uncertainty

This change would make the situation closer to what occurs in the corporate bond market, he noted, in which standardized disclosures about relatively homogeneous and straightforward securities of publicly traded companies allow many analysts and potential purchasers to come up with their own evaluations, in addition to those of the credit rating agencies. Moreover, such changes might also lead to the creation of structures whose credit analyses are less sensitive to certain tail risks and types of model uncertainty and more likely to be liquid even in times of market stress. Thus, this new infrastructure might allow investors gradually to regain confidence in their ability to assess the risk-return tradeoffs inherent in mortgage-backed securities, allowing them to reconsider how those securities may best fit into their overall portfolios.

A new infrastructure for mortgage-backed securities built upon these foundations might also reasonably be expected to lower the costs of information production and processing in the marketplace. The reduction of these costs will facilitate broader independent credit analyses, greater due diligence by potential purchasers, and, hence, greater ability to provide a double check on credit rating agencies' evaluation of the riskiness of the securities. In other words, market participants would be more likely to acquire the expertise to evaluate securities issues that were more homogeneous and less complex.

The Fed official also noted that the American Securitization Forum is in the midst of a large-scale project called RESTART, or Residential Securitization Transparency and Reporting. This project seeks to develop a standardized format for mortgage data that would be available to all investors and other market participants, with the goal of substantially improving disclosure and transparency related to mortgage-backed securities. RESTART has wide support in the industry, he said, and the project is receiving input from a wide range of market participants, including investors, mortgage originators, and credit rating agencies.

Monday, December 15, 2008

"Core Operations" Inference Works Against Plaintiffs: 4th Circuit

I have discussed in earlier posts how courts have reacted to pleadings that attempt to raise the requisite scienter inference by associating alleged misstatements with the "core operations" of the issuer. The 4th Circuit, however, turned the "core operations" influence around in an action against a drug maker in holding that a complaint failed to show scienter under the Tellabs guidelines. The court concluded that because the product involved in the alleged misstatements was so essential to the company's success that "[i]t is improbable that Inspire would stake its existence on a drug and a clinical trial that the company thought was doomed to failure."

As alleged, the maker of an experimental drug to treat dry eyes fraudulently misstated the results of its clinical trials. The appellate panel found after balancing the competing inferences as required by Tellabs that the innocent inferences that the company made limited disclosures about the "endpoints" of the studies for competitive purposes more compelling than suggestions of fraudulent reasons for the statements.

Securities Act claims also were insufficient, concluded the court. The plaintiffs failed to show why the statements in the prospectus and registration statement concerning the clinical trials were false or misleading.

Cozzarelli v. Inspire Pharmaceuticals Inc. (Link)
CCH Publishes White Paper on Fraud Pleading

CCH has published a white paper on fraud litigation after the Supreme Court decisions in the Dura, Stoneridge and Tellabs cases. The paper examines the challenges plaintiffs face to plead scienter and loss causation in light of Tellabs and Dura, including conflicts between the various circuits, and to recover against third-party defendants in light of Stoneridge.
Chair of Dutch Financial Markets Authority Says Reform Must be Global; Demands Regulation of Credit Default Swaps

A global response to the financial crisis is critical in order to prevent regulatory arbitrage and a regulatory race to the bottom, in the view of Hans Hoogervorst, Chair of the Netherlands Authority for the Financial Markets and Vice Chair of the IOSCOI Technical Committee. In remarks at a UK seminar on restoring confidence in global markets, he also said that the moral hazard created by a public safety net of central bank lending and government bailouts, which he concedes was needed, must be counterbalanced by strong regulation.

Thus, while providing a safety net is inevitable to contain systemic risk, more regulation will also be needed in the opaque over-the-counter market for derivatives. In addition, the credit default swap market is in obvious need of enhanced transparency and a sound clearing and settlement system. For the longer term, the entire institutional regulatory structure will have to be reformed, he said, since the crisis makes clear that this review needs to include not only prudential regulation, but also conduct-of-business regulation.

More broadly, he noted a need to make sure that regulatory reform is structured nationally, regionally and globally. For this, regulators should look to the recommendations of the Financial Stability Forum, the European Union and the International Monetary Fund. The chair pointed to what he called the outdated, fragmented and hole-ridden US regulatory framework, which he said has contributed to serious lapses in oversight and created incentives for regulatory arbitrage. The need for far-reaching consolidation of the US regulatory system is now widely recognized.

But at the same time, he noted that Europe’s regulatory system does not seem to be in much better shape. Many European banks were allowed to fill up on mortgage-based structured products, he noted, and increased their leverage to levels higher than their American counterparts.

Europe’s regulatory system is burdened by a history of fragmentation. Although it rests on European law, he observed, considerable divergence remain in national legislation. Licensing and regulation are executed nationally through the principle of home country control by national regulators. While the home country control system was a very practical way to make progress in creating the European capital market, he conceded, the system is vulnerable to regulatory arbitrage, just as in the US.

The obvious regulatory shortcomings in recent years have shown that it is very difficult to prevent a regulatory race to the bottom. This is especially the case when competition between financial markets is fostered by government policies. In order to prevent this scenario, Chairman Hoogervorst called for the creation of a centralized European financial regulator. While we will continue to need national financial regulators, assured the Dutch official, there is also a need for an independent European regulator that could identify weaknesses in national regulation and ensure a harmonized application of EU law. This agency should have the authority to inspect and guide national regulators if deemed necessary. In his view, a European regulatory agency could help prevent arbitrage and shore up the passport system.

Having a centralized regulator would have the additional advantage of making it easier for the European Central Bank to fulfill its role in addressing systemic risks. The costs of the regulatory race to the bottom and subsequent failure have been colossal, he emphasized, and it is thus time to start building a 21st century regulatory framework.
Bailouts Raise Moral Hazard Issue to New Levels as Deficits Grow

Just as the mantra of the dot.com era was profits don’t matter, at least until the bubble burst, the mantra of the federal bailout era is deficits don’t matter. This mantra has even been taken up by supposedly fiscal conservatives in Congress who have abandoned the pay-as-you-go principle that they so recently embraced. Can there now be any doubt that the tax cuts in the 2009 economic stimulus legislation will not be offset by revenue raisers and enhancers in direct contradiction of pay-go.

For the first time in history, waging a very expensive war was accompanied by a huge tax cut instead of austerity. With the budget thus thrown off balance, it will be very difficult to try and spend our way out of the current crisis. The G-20 countries have called for fiscal stimulation measures, while at the same time maintaining fiscal sustainability. But we cannot have it both ways. The unpleasant truth is that the room for another monetary stimulus is extremely limited. There is no way of knowing what the ultimate budgetary consequences of the unpaid for bailouts will be.

Should we abandon central bank and government support of the financial sector? Obviously not, since interventions by public authorities around the world is necessary to avert a systemic meltdown. But we must admit that free market advocates grossly underestimated the moral hazard, said Hans Hoogervorst, Chair of the Netherlands Authority for the Financial Markets and Vice Chairof the IOSCOI Technical Committee. When a financial or even industrial sector knows it will be bailed out when things go wrong, he reasoned, it has a huge incentive to privatize gains and socialize losses.

Sunday, December 14, 2008

SEC Corp Fin Official Details Best Practices for Fair Value Accounting

At a recent AICPA seminar on SEC and PCAOB developments, Stephanie Hunsaker, Associate Chief Accountant in the SEC’s Division of Corporation Finance, listed a number of best practices that would help investors understand the how and why fair value accounting was applied. The best practices build on two Dear CFO letters issued by the division earlier this year. The key principle driving the Dear CFO letters and the best practices is transparency, said Ms. Hunsaker. The staff noted that the SEC’s Dear CFO letters, and now these best practices, are good examples of the types of additional disclosures that investors may find useful in the area of fair value accounting. In March 2008, the SEC staff sent 30 letters to CFOs addressing disclosures in MD&A about fair value measurements in increasingly illiquid markets. Similar follow-up letters were sent in September 2008.

In Ms. Hunsaker’s view, an important best practice is to develop a disclosure policy for when instruments are transferred into and out of Level 3 measurements, which is the FAS 157 level for inactive securities in illiquid markets. The disclosure should use a tabular presentation to separately quantity gains and losses for instruments transferred into Level 3. When the transfer of an instrument into Level 3 occurs, she continued, the company should discuss the specific inputs that become unobservable.

Another best practice is to disclose the key drivers of value for each significant Level 3 valuation. Further, the company should discuss in detail how liquidity was taken into consideration in the valuation. In addition, separate quantitative disclosure should be provided on the effects of the company’s own credit risk and counterparty credit risk on net income. The company should also discuss events that impacted the adjustment for credit and any material change during the period.

Also, the collateral underlying mortgage-backed securities and collateralized debt obligations should be disclosed. Charts should be used to give investors a quick snapshot of losses. A further best practice is to separately disclose the extent that brokers and pricing services were used. Validation procedures employed should also be discussed, including the key judgments used in arriving at the fair value.

It is a best practice to disclose any alternative valuation techniques, said the SEC official, and whether they would have resulted in materially different fair values. Finally, issuers should provide a sensitivity analysis with reference to Section 5 of Financial Reporting Release No. 72 dealing with critical accounting estimates and IFRS No. 7. Section 5 states that, since critical accounting estimates and assumptions are based on matters that are highly uncertain, a company should analyze their specific sensitivity to change, based on other outcomes that are reasonably likely to occur and would have a material effect.

Friday, December 12, 2008

EU Internal Market Commissioner McCreevy Says Self Regulation Still Open to Private Equity Firms under Codes of Conduct.

Fearing that private equity firms could get swept up in a wide-ranging and indiscriminate regulatory rethink, European Commissioner for the Internal Market Charlie McCreevy said that private equity may still be a candidate for self regulation under codes of conduct like the UK Walker Guidelines. Private equity does not give rise to the macro-prudential systemic concerns driving the regulatory agenda, he told a group of British venture capitalists.

The Walker Guidelines, issued by a working group headed by Sir David Walker, recommend that private equity firms disclose on their website a commitment to conform to the guidelines on a comply or explain basis and to promote conformity on the part of the portfolio companies owned by its fund or funds. The firms should also disclose the most senior members of their management or advisory team and confirm that arrangements are in place to deal with conflicts of interest. The guidelines also call for a description of UK portfolio companies in the private equity firm's portfolio.

The failure of some private equity funds will lead to painful losses for investors, the commissioner acknowledged, but there should be no knock-on consequences for the wider financial system. Banks and other financial institutions have lent money to finance private equity portfolio companies, he noted, but these exposures are relatively limited. Thus, he will neither lump private equity funds with other categories of leveraged financial institutions nor shackle them with unnecessary regulatory constraint.

This does not mean, however, that private equity is entirely off the hook. The private equity industry needs to be attentive to the impact of buy-out activity on the social economy and must better manage its relationships with key stakeholders. Perceived failure to manage these relationships in the context of buy-outs has fuelled pressure to regulate private equity activities.

There are also concerns relating particularly to corporate governance, transparency and reporting that warrant further attention. And, some private equity deals have been over-leveraged.

Thus, the Commission will review the Transparency Directive in order to examine issues such as notification thresholds, investment policy disclosure and identification of shareholders. In addition, the Commission will address the issue of remuneration in the financial sector; and in particular the need for reward structures to be more closely aligned to the real medium term benefits accruing.

In general though, the types of policy issue raised by private equity do not lend themselves to a regulatory solution. The concerns relate to the way in which private equity funds manage their relationships with investors and stakeholders in portfolio companies. Regulation cannot prescriptively define the type of conduct or behavior that private equity managers should follow when initiating, implementing and managing deals.

In his view that self-regulation represents the most promising avenue for promoting the desired behavior by private equity managers, the commissioner is comforted by the recent G20 declaration calling on regulators to first look to the industry codes of best practices before considering the need for any regulatory intervention. This is the approach that the European Commission will follow, he announced.

Thus, the commissioner promised a thorough and critical review of the codes of conduct for private equity firms, focusing primarily on the Walker guidelines. Already there is a concern since only 32 out of a possible 200 members are current signatories to the guidelines. The limited reach of the Walker guidelines is also apparent when you look at the number of portfolio companies covered by them.

Only 56, out of about 1,300 portfolio companies in the UK that are targeted by private equity investments, are reported to comply with the disclosure and transparency rules. These kinds of statistics are not going to impress ``trigger-happy regulators,’’ said the commissioner. Since the guidelines are voluntary, there will have to be monitoring, as well as mechanisms for promoting compliance.

There must also be cross-border consistency of codes of conduct. Currently, the European private equity market is characterized by a proliferation of significantly different industry codes. At a certain stage, said the commissioner, it may be possible to codify the common elements of inconsistent national codes into a set of widely understood and widely upheld guidelines.

Thursday, December 11, 2008

IASB Members Say Fair Value Not to Blame for Financial Crisis; Will not Include FIN 48 in IFRS Tax Standard Proposal

IASB Chair David Tweedie and Board Member James Leisenring both said at a recent AICPA seminar that fair value accounting was not the cause of the current financial crisis and should not be suspended. Fair value means transparency, said Chairman Tweedie, and a return to the relative inaccuracy of historical cost is not an option. To emphasize his point, the chair asked if anyone would be willing to pay the historical value of Bear Stearns securities.

While recognizing that the fair value standard is difficult to apply in illiquid markets, Member Leisenring said that we need fair value even more in an environment of declining asset values. He believes that any attempt to weaken the fair value standard would concomitantly weaken financial reporting. That said, the Member acknowledged that the fair value standard is complex and has too many exceptions. Moreover, any mixed measurement models would cause more complexity. Financial instruments must all be measured at fair value, he emphasized, in order for it to be a true principles-based standard.

Mr. Leisenring also noted that the coming exposure draft on IAS 12 dealing with accounting for income taxes will not include FASB’s FIN 48. He said that the IASB does not agree with FIN 48 and will expose a different approach. FIN 48 was adopted to provide for increased relevance and comparability in financial reporting of income taxes and to provide enhanced disclosures of information about the uncertainty in income tax assets and liabilities. The genesis of FIN 48 is FASB Statement No. 109, which established financial accounting and reporting standards for the effects of income taxes that result from an enterprise’s activities during the current and preceding years. It requires an asset and liability approach to financial accounting and reporting for income taxes

Member Leisenring also noted that the standards on revenue recognition present a difficult convergence problem. Differences between the IASB and FASB, and even within both Boards, have made it difficult to find common ground. He described the present standards as hopeless.

But both IASB officials said that FASB is committed to achieving a single global set of high quality financial accounting standards. This is not a rivalry between the two Boards, said Member Leisenring, they both have the same ultimate goal of one set of uniform converged accounting standards. He cautioned, however, that the process of interpreting the global accounting standards must be carefully watched lest we allow differing interpretations of the standards to destroy uniform international standards. He noted that the SEC favors IFRS as adopted by the IASB, unmodified by any other entity.

Wednesday, December 10, 2008

PCAOB Issues Audit Practice Alert on Economic Crisis Highlighting Fair Value and Derivatives

The PCAOB staff has issued an audit practice alert dealing with a number of issues spawned by the ongoing financial crisis, including the adequacy of disclosures, auditing accounting estimates, going concern considerations, and fair value accounting and derivatives. Recent events in the financial markets may have implications for audits of financial statements and internal control over financial reporting, said the Board. Audit risks identified previously may have become more significant or new risks may exist due to current events affecting credit and liquidity. Among other things, the current uncertainties in the market may create questions about the valuation, impairment, or recoverability of assets and the completeness or valuation of liabilities reflected in financial statements. This is the third in a series of staff audit practice alerts.

The practice alert builds on an earlier alert dealing with the important and controversial area of fair value accounting. The new PCAOB guidance comes in light of recent amelioration of fair value accounting standards due to the ongoing financial crisis. According to PCAOB staff, it will be particularly important to auditors considering fair value estimates of financial instruments to consider the extent to which fair value accounting applies, the choice and complexity of valuation techniques and models, judgments on significant assumptions, and the extent of disclosure in the financials about measurement models.

Derivatives, especially credit derivatives, pose a special problem for fair value accounting. The staff advised that the downturn in the credit markets can have a significant effect on the fair value of a company's credit derivatives. Credit derivatives are valued through the use of internally developed models or by pricing services, noted the staff, and the assumptions used in models can be highly subjective, sensitive, and complex.

The staff cautioned auditors that a slight difference in assumptions could result in a significant change in the valuation of the derivative. Auditors should obtain evidence supporting management's assertions about the fair value of derivatives measured or disclosed at fair value. In addition, they should evaluate whether the presentation and disclosure of derivatives are in conformity with GAAP.

The current crisis may also entail more auditor attention to the effective operation of internal controls over financial reporting, including the company's entity-level controls, such as controls related to the control environment, and the company's risk assessment process. Additional attention also may be warranted on the controls related to significant accounts and disclosures and their relevant assertions, such as controls over the development of inputs and assumptions for the valuation of significant assets and liabilities; controls over the identification and review of assets for recoverability or impairment; and controls over the company's use of external valuation specialists.

In addition, some companies are responding to the current economic conditions by eliminating jobs. The Board cautioned that the loss of employees integral to the operation of internal controls may increase the risk of deficiencies in internal control over financial reporting because of, for example, lack of segregation of duties or lack of effective monitoring controls.

Given that the auditor has a responsibility to communicate to the audit committee, said the staff, some of the required communications that may be affected by current economic conditions include discussions about accounting estimates as well as the company's accounting principles. With respect to accounting estimates, auditors should determine that the audit committee is informed about the process used by management in formulating particularly sensitive accounting estimates and about the basis for their conclusions regarding the reasonableness of those estimates.

Moreover, auditors should discuss with the audit committee their judgments about the quality, not just the acceptability, of the company's accounting principles as applied in its financial reporting. The discussion should include such matters as the consistency of the company’s accounting policies and their application, as well as the clarity and completeness of the company’s financial statements, which include related disclosures. The discussion also should include items that have a significant impact on the representational faithfulness, verifiability, and neutrality of the accounting information included in the financial statements, such as the selection of new or changes to accounting policies, and estimates, judgments, and uncertainties, as well as unusual transactions.

Going concern issues have emerged in both the US and the EU. In the current economic environment, said the staff, some companies may face challenges in their ability to continue operating as a going concern. For instance, sources of liquidity may be strained because of reduced availability of lines of credit from financial institutions. Also, companies may encounter limited access to the commercial paper markets, a decrease in valuation of collateral, difficulty restructuring loans, and delays in payment from customers.

The staff reminded auditors that they have a duty to evaluate whether there is a substantial doubt about the company's ability to continue as a going concern for a reasonable period of time. The auditor's evaluation is based on knowledge of relevant conditions and events, including negative trends and other indications of possible financial difficulties.

If auditors believe that there is substantial doubt about the company's ability to continue as a going concern, said the staff, they should obtain information about management's plans to mitigate the effect of such conditions or events and assess the efficacy of such plans. If, after considering management's plans, the auditors conclude that there is substantial doubt about the company’s ability to continue as a going concern, they must consider the effects on the financial statements and the adequacy of disclosure and include an explanation in the audit report.
Fed Gov Kroszner Views Enhanced Counterparty Credit Risk Management as Key to Securitization Reform

In the coming reform of securitization, noted Federal Reserve Board Governor Randall S. Kroszner, financial institutions must strengthen their counterparty credit risk management, mainly through more extensive stress testing. In remarks at a seminar in Geneva, he said that in the current crisis risk managers did not fully contemplate the possibility that many participants would need to unwind their positions at the same time, that such actions might present substantial losses for several key counterparties, and that collateral posted as protection for positions would fall in value at the same time.

This goes back to a failure to do adequate stress testing. Also, even when risk managers at financial institutions had some understanding of these issues, they found it difficult to demand more collateral or guarantees during good times because no risk manager wanted to be the first to do so.

Financial markets have developed mechanisms that are specific to the control of counterparty risk. The simplest of these is the posting of collateral against counterparty exposures. Ensuring the efficacy of collateral is challenging even under ordinary circumstances, said the official, and may leave counterparties especially vulnerable to large sudden changes in market prices, also called gap risk

The Fed governor observed that a central counterparty or clearinghouse is a sophisticated convention for mitigating counterparty credit risk. The NY Fed is currently vetting a process to create a central counterparty in the credit derivatives market. In markets with a clearinghouse, all trades are intermediated through a central counterparty. This arrangement can vastly reduce counterparty risk, enthused the governor. The central counterparty runs a balanced book, he pointed out, so generally has no direct market exposure. In the case of a member's default, the central counterparty can draw upon the proprietary margin of the defaulting member, its own reserve fund, and the assessment of members for share purchase.

According to Gov. Kroszner, counterparty credit risk management should be focused on its effectiveness in different market situations and its implications for financial stability, which in turn underscore the importance of stress testing and scenario analysis focused on market-wide events. Such stress tests would include the potential for key counterparties to fail or suffer difficulty at the same time, he noted, or market liquidity to erode and remain low for some time, and for market participants to view the financial institution itself as an impaired counterparty.

In his view, properly designed stress tests can provide information that typical statistical models may leave out, such as abnormally large jumps or market moves, evaporation of liquidity, prolonged periods of market distress, or structural changes in markets. Stress tests are most useful when they aim to include potential secondary or knock-on effects, he emphasized, which are often difficult to model with standard techniques. In these ways, stress tests can serve as a complementary tool to other risk measures. It is also important for banks to conduct stress tests across several markets, Mr. Kroszner said, since some counterparties are key players across many financial markets and their inability to repay could cascade across those markets.

Many good events flow from effective stress testing. For example, based on the results of their stress tests, banks may reassess their participation in certain markets and exercise greater caution to account for potential tail risks and better protect themselves in times of market wide stress. One of the first things they may do is increase their internal assessments of capital needs for these activities, given the added risks that stress tests reveal. They may wish to restructure contracts or alter terms.

Financial institutions also might ask for higher initial margin, given that subsequent calls may not provide as much risk mitigation during distress. They may wish to ask for more collateral, or ensure that the collateral is less linked to the counterparty's condition or broader market distress. Or they might look for other ways to enhance their assessment of counterparties, and, perhaps more importantly, the potential for counterparties to encounter difficulties during market wide stresses. Moreover, they may wish to conduct more of their trading and hedging on more organized exchanges or with clearinghouses, to benefit from their safeguards.

In addition, banks acting collectively may decide to take action to improve the quality assurance performance of markets during future times of stress. For their part, trade associations in the banking industry may consider additional safeguards to reduce the impact of systematic risks among counterparties. For example, banks may collectively act to remove uncertainty associated with back-office inefficiencies and related risks in the credit default swaps market. Another example is an attempt to enhance mortgage markets so that there is greater standardization of data and simpler, more homogeneous provisions in the securitizations, and less reliance on third-party monitoring.

Tuesday, December 09, 2008

Former NY Fed Chief Tells Congress Credit Default Swap Debacle Was Risk Management Failure

The implosion of the credit default swaps market was due to a massive failure of risk management, said former NY Fed President Gerald Corrigan, rather than any inherent flaw in the instruments themselves. In testimony before the House Agriculture Committee, he also said that, from the viewpoint of financial stability, whether or to what extent credit default swap trades occur on organized exchanges is not a matter of overriding concern so long as the details of all such trades are made available on trade date to a central counterparty clearing system. Mr. Corrigan is also chair of the Counterparty Risk Management Policy Group.

It is now clear, said the chair, that a number of sophisticated financial institutions experienced shortcomings in their risk management before and during the crisis. The presence of a small number of highly concentrated credit default swap risk exposures across the financial landscape unmistakably reveals that some market participants were quite slow in recognizing that these exposures risked material write-downs and very sizeable collateral calls.

With regard to counterparty risk, said the group chair, it is widely recognized that highly concentrated positions at a relatively small number of institutions resulted in massive collateral calls which caused large write-downs and impaired the liquidity position of the institutions in question. Even worse, there were situations in which basis risk, counterparty risk, and the embedded leverage in certain classes of structured credit products interacted with each other in ways that amplified contagion and volatility, and multiplied the size of margin calls and write-downs.

Reforms will now be needed to mitigate systemic risk, probably though enhanced federal oversight. Regardless of which central counterparty process emerges as the industry standard, noted the former Fed official, the authorities must satisfy themselves that its risk mitigation features have virtually failsafe operational and financial integrity, including the capacity to absorb the default of two of its largest members. Consistent with this philosophy, he believes that there should be a single dedicated global central counterparty platform and that any approach that co-mingles credit default swap settlement funds with settlement funds for other financial instruments is unwise.

Moreover, regulators should, as a part of their regular inspections and examinations, ensure that individual institutions are doing their part to ensure that such institutions’ policies and practices regarding the needed infrastructure improvements are in line with industry best practices.

The former Fed official also said that regulators should, on a case by case basis, make inquiries regarding highly concentrated positions and crowded trades and, where necessary, encourage or require individual institution to moderate the risks of such positions. On a voluntary basis, hedge funds and other unregulated financial institutions should be willing to respond to similar inquiries or face the prospects of greater direct regulation.

In addition, major market participants and their regulators must ensure that risk monitoring, risk management and, of special importance, corporate governance practices are in line with best practices with particular emphasis on monitoring exposures and the application of rigorous valuation and price verification practices to complex transactions. Among other things, he noted, such best practices will play a constructive role in quickly resolving collateral disputes.
Vermont 506 Offering Rule Adopted to Accommodate Electronic Form D

Vermont's 506 offering rule was adopted, effective January 1, 2009, to accommodate electronic Form D that issuers have the option of filing electronically through March 15, 2009 but will be required to file electronically with EDGAR starting March 16, 2009.

NOTE: The notice filing requirements do not apply to 506 offerings sold between July 1, 2006 and December 31, 2008 UNLESS additional sales of a 506 offering take place on or after January 1, 2009. Any 506 offerings sold on or after January 1, 2009 are subject to all of the 506 notice filing requirements.

See here for more details.

Monday, December 08, 2008

SEC Adopts Credit Rating Agency Reform; Differentiation for Future Action

The SEC approved a series of measures to increase transparency and accountability at credit rating agencies, and ensure that firms provide more meaningful ratings and greater disclosure to investors. The new rules are designed to deal with conflict of interest issues that came into stark relief as a result of the securitization crisis. The rules reflect a growing skepticism that a rating agency can give an objective rating to a security product if it has advised the issuer or underwriter on how to structure that same product. In an effort to restore trust in the rating process, the SEC has established a framework for rating agencies under which conflicts of interest are properly and more effectively managed. The SEC’s actions were informed by an extensive 10-month examination of three major credit rating agencies that found significant weaknesses in ratings practices. But, the SEC deferred action on the issue of differentiation of structured products.

These comprehensive rules touch every aspect of the credit rating process, said Chairman Cox, from conflicts of interest, to publication of ratings methodologies, to disclosure of ratings track records.

Addressing conflict of interest charges, the SEC added three new prohibited conflicts to its rules. The first would prohibit a rating agency from issuing a credit rating with respect to a security where the agency made recommendations to the issuer or underwriter of the security about the corporate or legal structure, assets, liabilities, or activities of the issuer of the security. The second change would prohibit a person within a rating agency who has responsibility for participating in determining credit ratings or for developing or approving procedures or methodologies used for determining credit ratings from participating in any fee discussions or arrangements. The third change would prohibit a rating agency from allowing a credit analyst who participated in determining or monitoring the credit rating to receive gifts, including entertainment, from the obligor being rated or from the issuer or underwriter of the securities being rated, other than items provided in the context of normal business activities, such as meetings, that have an aggregate value of no more than $25.

The new rules also require rating agencies to provide the Commission with an annual report of the number of credit rating actions that occurred during the fiscal year for each class of security for which they are registered.

The SEC added three new recordkeeping requirements to its rules. First, rating agencies would have to make and retain records of all rating actions related to a current rating from the initial rating to the current rating. Second, if a quantitative model is a substantial component of the credit rating process for a structured finance product, a rating agency must keep a record of the rationale for any material difference between the credit rating implied by the model and the final credit rating issued. Third, rating agencies would be required to retain records of any complaints regarding the performance of a credit analyst in determining, maintaining, monitoring, changing, or withdrawing a credit rating.

The SEC rules will also require rating agencies to make publicly available a random sample of 10% of their issuer-paid credit ratings and their histories documented for each class of issuer-paid credit rating for which they are registered and have issued 500 or more ratings. This information would be required to be made public on the rating agency’s corporate Internet website in XBRL format no later than six months after the rating is made.

At the same time it adopted these reform rules, the SEC also reproposed rules that would prohibit rating agencies from issuing a rating for a structured finance product paid for by the product’s issuer or underwriter unless the information about the product provided to the agency to determine the rating and, thereafter, monitor the rating is made available to other rating agencies.

Specifically, the SEC would require rating agencies that are hired by arrangers to perform credit ratings for structured finance products to disclose to other agencies, and only other agencies, the deals for which they were in the process of determining such credit ratings. The arrangers would need to provide the rating agencies they hire to rate structured finance products with a representation that they will provide information given to the hired agency to other rating agencies. In addition, rating agencies seeking to access information maintained by the agencies and the arrangers would need to furnish the Commission an annual certification that they are accessing the information solely to determine credit ratings and will determine a minimum number of credit ratings using the information.

The European Commission proposed reforms embody the principle of differentiation under which rating agencies must either differentiate rating categories for structured finance instruments so that they are not confused with rating categories for other types of financial instruments or produce a comprehensive report attached to each structured finance rating. It is envisioned that such a report would provide a detailed description of the rating methodology used to determine the credit rating and an explanation of how it differs from the determination of ratings for any other type of rated entity or financial instrument, and how the credit risk characteristics associated with a structured finance instrument differ from the risks related to any other type of rated instrument.

Sunday, December 07, 2008

German Central Bank Chief Outlines Vision of Financial Regulation Reform

The coming reform of financial regulation must enhance transparency concerning unregulated business areas and markets, including hedge funds, OTC traded derivatives and off-balance-sheet vehicles, emphasized Axel Weber, President of the Deutsche Bundesbank. In remarks at the Euro Banking Congress in Frankfurt am Main, he said that effective reform must also address fair value accounting which, in his view, amplifies the cyclicality of leverage. Just as war is too important to leave to generals, he noted that financial accounting has become too important to leave to accountants. While recent changes in accounting rules have been useful in protecting banks’ current results from further crisis-driven exaggerations, he cautioned that the one-sided easing of accounting rules entails the risk of sowing the seeds of a growing risk appetite in the future.

According to the German central bank head, executive compensation is also in need of urgent reform in order to free the financial system from procyclicality, which he described as the reinforcement of the natural cycle of the system. In his view, executive compensation schemes that reward quick success with annual bonuses without penalizing the long-term consequences of decisions that were taken enhances procyclicality and contributes to boom and bust cycles.

Mr. Weber joins the growing consensus that the originate and distribute system of securitization is here to stay, but must be reformed. Recently, remarks by the two most senior officials of the European Central Bank reflected a growing consensus that the originate and distribute securitization model will be retained in the wake of the subprime crisis. Both ECB President Jean-Claude Trichet and Vice President Lucas Papademos believe that the benefits of securitization argue for its retention so long as major reforms are effected. The ongoing reform of securitization must center on the principles of transparency, liquidity risk management, and cross-border cooperation, in the view of President Trichet

Finally, Mr. Weber noted that Germany has set up an emergency rescue regime, with the core instrument being the German Market Stabilization Fund. In order to eliminate liquidity shortages and to support refinancing in the capital markets, the Fund is authorized to guarantee, for a suitable fee, newly issued refinancing instruments with maturities of up to 36 months. The Fund may also purchase shares or dormant equity holdings of financial institutions in order to recapitalize them. Finally, with the option of acquiring problematic assets, it can improve capital ratios. After initial reluctance, a growing number of banks, both from the private and the public sector, have asked the Fund for help. An important feature of the Fund is that it is voluntary. He cautioned that the use of public funds for these purposes should be as temporary as possible.
Corp Fin Director White Defends SEC's Disclosure Regime

Corporation Finance Director John White said that the SEC's disclosure regime was one process that did not fail during the credit crisis. In remarks at the American Bar Association Section of Business Law's fall meeting, he said that the disclosure rules work and, while they can be improved upon, should be largelly preserved. Mr. White will end his tenure as Corp Fin Director at the end of the year and return to Cravath Swaine & Moore.

Further, while it may be necessary to create a new regulatory system for complex financial instruments and for financial institutions, noted the director, there is only one agency and one group within that agency that focuses on disclosure. He agreed that regulatory overlaps and gaps should be addressed, but said that prudential regulators have a different focus and different goals than transparency and disclosure for investors. Regarding policy makers who are thinking about what to do with the SEC, he urged them not to "throw the baby out with the bath water."

One of his initiatives during his three years as head of the Division was to update the staff interpretations. He hopes the project will be done by the end of the year, including updates to the mergers and acquisitions interpretations. White reported that Wayne Carnall, the Division's chief accountant, plans to roll out accounting interpretations this month to coincide with the AICPA's annual meeting on SEC and PCAOB developments. The accounting interpretations will also be posted on the SEC's website. Next year, shareholder proposals will be posted on the SEC's website in real time.

The staff is trying to approach the comment and review process in a more forward-looking way, rather than as an after-the-fact process. The idea is to give advice to everyone at the same time in advance of filings. The result is better disclosure for investors a whole reporting cycle earlier, he said. An example of this approach is the three "Dear CFO" letters that have been released by the staff. Mr. White said that two more letters are on the way.

While his predecessor Alan Beller implemented the Sarbanes-Oxley Act rules and securities offering reform measures, Director White faced issues dealing with executive compensation, Sarbanes-Oxley Section 404 internal controls reporting and interactive data. New executive compensation disclosure rules were adopted, but the issue is back as a major topic because of the Troubled Asset Relief Program. White believes the legislation will also affect companies that are not in TARP.

Since Chairman Christopher Cox's number one priority is technology, the director expects that the interactive data proposal will be finalized by the end of the year. The electronic delivery of proxy materials has saved companies millions of dollars, he noted, but also has resulted in a decrease in the direct retail vote. The SEC staff plans to recommend technical changes to improve the electronic proxy process.

Looking forward, Mr. White said that the five major areas under consideration are international financial reporting standards, the recommendations by the Advisory Committee on Improvements to Financial Reporting, proxy matters, technology and beneficial owners. IFRS is also critically important. The SEC will decide in 2011 whether to make mandatory the use of IFRS. For those who are skeptical that IFRS will be adopted in the U.S., Mr. White said that they are mistaken. The case for a single set of standards is compelling. He believes it is a matter of when, not if, but said it will be a challenge and will take leadership and vision.

He referred to proxy matters as "the elephant in the room." He grappled with it, Mr. Beller grappled with, and the next Corp Fin direcror will have to grapple with it. There is little, if any, common ground.

The SEC's 21st Century Disclosure Initiative should produce a blueprint for reform in the near future. Mr. White had two warnings. First, he said technology is not content, it's a delivery vehicle. Second, he said not to lose track of the periodic disclosure system. There is a temptation to rely on technology to disclose information more quickly, but it is important to take the time to get it right. The periodic disclosure system benefits from disclosure controls, internal controls, an independent auditor regime and CEO/CFO certifications, he said.

In closing remarks, the outgoing official spoke about Corp Fin's important role. The SEC is being closely scrutinized because of the market crisis, he said. Calls have been made to restructure the oversight regime for the financial markets, to merge the SEC and the CFTC, or to create a super regulator. These discussions have focused on the appropriate form of regulation for financial institutions of all types and for complex financial instruments.

People are focusing on how to address the failures, said the official, but we must also look at the successes and support the regulatory elements that worked. The U.S. system of providing full, fair and timely disclosure is "head and shoulders above other markets," he said, adding that the Division's review of company filings is a great success and the envy of foreign regulators. Rules are only as good as the extent to which companies comply with them, he said, and the review process is part of that success.

Wednesday, December 03, 2008

Indenture Did Not Require Timely SEC Filing

By Rodney Tonkovic
Associate Writer-Analyst
CCH Federal Securities Law Reporter

In a case of first impression, an Eighth Circuit panel affirmed a district court judgment that a company had no obligation under an indenture to file timely reports with the SEC. The indenture provided that the company file with the indenture trustee copies of periodic reports within fifteen days after they were filed with the SEC. The company, however, had come under scrutiny for its involvement in backdating employee stock options and filed a notice with the SEC stating that it would delay filing reports for certain quarters.


When the company eventually filed its reports, it then delivered copies to the trustee within the required fifteen days. The company had asked for a declaratory judgment that it was not in default, while the trustee claimed that the failure to timely file with the SEC breached the indenture agreement. The district court (District of Minnesota) granted summary judgment in favor of the company, finding that the agreement only required that the trustee be provided with copies of the reports required by the Exchange Act, and that there was no obligation to timely file.

On appeal, the trustee argued that the district court erroneously construed the contractual and statutory duties imposed by the indenture agreement, specifically that the language of the indenture imposed an independent obligation to file timely SEC reports. The panel found that the language of the agreement imposed no independent obligation to timely file. According to the plain language of the agreement, stated the panel, it was the Exchange Act, and not the terms of the indenture that compelled the company to produce a particular report. The agreement only established when the reports should have been forwarded to the trustee, and references to the Exchange Act merely identified which reports were to have been forwarded. The panel pointed out that the parties or their attorneys could have specified a timetable, but they did not do so.

The panel similarly disagreed with the trustee's argument that the Trust Indenture Act requires an issuer to make timely SEC filings. According to the panel, Section 314 of the Act requires only that a trustee be provided with copies of SEC filings and does not provide an independent obligation for an indenture obligor to timely file reports. Since the required reports were eventually filed and promptly forwarded to the trustee, the panel found no violation of the TIA.

The panel affirmed the district court and summed up by stating that the company was "indisputably delinquent," but "whatever duties [the company] might have neglected were imposed by the SEC and the Exchange Act and not by the indenture or the TIA." The company was only obliged to forward copies of SEC reports within fifteen days of filings, and it "met all of its contractual and statutory duties."

UnitedHealth Group Inc. v. Wilmington Trust Co.
[Note: The link takes you to the general opinions page]
Union Pension Fund to Head Freddie Mac Class Suit

Judge John Keenan named the Teamsters' Central States, Southeast and Southwest Areas Pension Fund as lead plaintiff in a class action by holders of common stock of the Federal Home Loan Mortgage Company brought in the Southern District of New York. The fund's choice of counsel, Coughlin, Stoia, Geller, Rudman & Robins, LLP, will represent the class. The court named Central States to lead the action even though a rival applicant, the state treasurer of North Carolina, acting as trustee of the North Carolina state retirement funds, was presumptively the most adequate plaintiff.

Initially, the court laid out its methodology for selecting the presumptive plaintiff. The factors involved are 1) the number of shares purchased during the class period, 2) the number of net shares purchased during the class period, 3) the total net funds expended during the class period and 4) the approximate losses suffered during the class period. Of these, Judge Keenan observed that the "fourth factor—amount of losses suffered—is by far the most significant." The court also determined that losses should be computed using a LIFO calculation. "The main advantage of LIFO is that, unlike FIFO, it takes into account gains that might have accrued to plaintiffs during the class period due to the inflation of the stock price," wrote Judge Keenan.

Under these measures, the North Carolina treasurer was presumptively the most adequate plaintiff. The first three factors strongly favored the state funds, and the state had slightly larger LIFO losses. However, Judge Keenan found that the opposing claimants sufficiently rebutted the statutory presumption. The state attorney general objected to the treasurer's appointment on the ground that the treasurer did not have legal authority to seek NCRS’s appointment as lead plaintiff or to retain counsel to represent NCRS in the litigation. The treasurer disputed the attorney general’s interpretation of North Carolina law. According to lawyers for the treasurer, the two officials were involved in a "political shoving match.” The court found that because of the uncertainty surrounding the treasurer’s legal authority, it could not conclude that the treasurer was "willing and able" to serve as lead plaintiff.

The court rejected attempts to rebut the presumption of adequacy with regard to Central States. One challenge was based on the fact that the pension fund had been operating since 1982 under a consent decree with the Department of Labor arising from allegations of corruption and mismanagement in the 1960s and 1970s. The court noted that opposing counsel even conceded "with commendable candor" that "he could not think of any way that the consent decree realistically might affect Central States’ ability to represent the class."

Challenges based on potential conflicts involving the Coughlin Stoia firm also failed. The firm had been proposed to represent a class of preferred shareholders, but the court concluded that the actions involved different claims and a different defendant pool. The actions also would not require the firm to advance conflicting arguments sufficient to disqualify them.

Finally, the court rejected the request to appoint co-lead plaintiffs and counsel. Judge Keenan concluded that there was " no need for two lead plaintiffs and two lead law firms to represent the common shareholders, as this would result in unnecessary disagreement, motion practice, delay, and increased attorney’s fees."
Maryland Sets Forth Electronic Form D Filing Procedures

Between September 15, 2008 to March 15, 2009, issuers making securities offerings under either Rule 505 or 506 of federal Regulation D must file the version(s) of Form D accepted by the SEC at the time of filing, along with a manually executed Form U-2, Uniform Consent to Service of Process, when the version of Form D filed in connection with the offering does not contain a consent to service of process, and any other information required by the Maryland rules pertaining to Rule 505 or 506, including the applicable fee.

Click here for more information.

Monday, December 01, 2008

9th Circuit Rejects Collective Scienter

Must a fraud plaintiff plead facts showing that the particular individual who made allegedly actionable misstatements acted with scienter in order to recover against a corporate defendant? The 9th Circuit, in
Glazer Capital Management LP v. Magistri (In re Invision Technologies Inc. Securities Litigation), joined the list of circuit courts that have answered "yes" to that question (for a discussion of other cases, click here).

The 9th Circuit did not quite rule out any situation in which there could be a finding of corporate scienter absent actionable individual intent, but it certainly indicated that this would require highly unusual circumstances, in which "a company’s public statements were so important and
so dramatically false that they would create a strong inference that at least some corporate officials knew of the falsity upon publication.

The case arose from a merger between Invision, a maker of explosive detection systems, and General Electric. In the merger agreement, attached as an exhibit to Invision's Form 10-K, the company warranted to GE that it was "in compliance in all material respects with all laws" in general, and with the books and records and anti-bribery provisions of the Exchange Act in particular. Subsequently, the company disclosed violations of the Foreign Corrupt Practices Act.

The court expressed skepticism about collective scienter in this factual situation, stating that if "the doctrine of collective scienter excuses Glazer from pleading individual scienter with respect to these legal warranties, then it is difficult to imagine what statements would not qualify for an exception to individualized scienter pleadings."

The panel then found that the CEO, who signed the merger agreement, lacked the requisite intent because the pleadings did not indicate any knowledge of the FCPA violations at the time of the merger agreement. The payments in question were not "the type of transaction of which it would be `hard to believe' senior officials were unaware," stated the court (for a discussion of the "core operations" inference, click
here). Absent other particularized indications of fraud, the fact that the officers signed Sarbanes-Oxley certifications and could profit from the merger were insufficient to show individual scienter.