Thursday, January 29, 2009

Senior Senators Introduce Hedge Fund SEC Registration Bill

A bill requiring hedge funds to register with the SEC has been introduced by Senators Carl Levin and Charles Grassley. The Hedge Fund Transparency Act would make hedge funds subject to SEC regulation and oversight by requiring them to register with the SEC, to file an annual public disclosure form with basic information, to maintain books and records required by the SEC, and to cooperate with any SEC information request or examination. The measure also requires hedge funds to establish anti-money laundering programs and report suspicious transactions, thereby clarifying that hedge funds have the same obligations under US money laundering statutes as other financial institutions.

The information to be made available to the public under the Act must include, at a minimum, the names of the companies and natural individuals who are the beneficial owners of the hedge fund and an explanation of the ownership structure; the names of any financial institutions with which the hedge fund is affiliated; the minimum investment commitment required from an investor; the total number of investors in the fund; the name of the fund’s primary accountant and broker; and the current value of the fund’s assets and assets under management. The bill also authorizes the SEC to require additional information it deems appropriate.

The bill imposes a set of basic disclosure obligations on hedge funds and makes it clear they are subject to full SEC oversight while, at the same time, exempting them from many of the obligations that the Investment Company Act imposes on other types of investment companies, such as mutual funds that are open for investment by all members of the public. The bill imposes a more limited set of obligations on hedge funds in recognition of the fact that they are generally confined to wealthy investors. The bill also, however, gives the SEC the authority it needs to impose additional regulatory obligations and exercise the level of oversight it sees fit over hedge funds to protect investors, other financial institutions, and the U.S. financial system as a whole.

Hedge funds generally rely on Sections 3 (c)(1) and (7) of the Investment Company Act for exemptions. The bill applies to all entities that rely on Sections 3(c)(1) or (7) to avoid compliance with the full set of the Investment Company Act requirements. A wide variety of entities invoke those sections to avoid those requirements and SEC oversight, and they refer to themselves by a wide variety of terms, hedge funds, private equity funds, venture capitalists, small investment banks, and so forth.

Rather than attempting a futile exercise of trying to define the specific set of companies covered by the bill and thereby invite future claims by parties that they are outside the definitions and thus outside the SEC’s authority, the bill applies to any investment company that has at least $50 million in assets or assets under its management and relies on Sections 3(c)(1) or (7) to avoid compliance with the full set of Investment Company Act requirements.

The bill also moves paragraphs (c)(1) and (7) from the part of the 1940 Act that defines “investment company” to the part that exempts certain investment companies from the Investment Company Act’s full set of requirements. This was done to clarify that hedge funds really are investment companies, and that they are not excluded from the coverage of the Investment Company Act.

Instead, they are being given an exemption from many of that law’s requirements, because they are investment companies which have voluntarily limited themselves to one hundred or fewer beneficial owners and to accepting funds only from investors of means. Under placement in current law, the two paragraphs allow hedge funds to claim they are excluded from the Investment Company Act and that they are not investment companies at all and are outside the SEC’s reach. Under the bill, the hedge funds would qualify as investment companies, which Congress believes they plainly are, but would qualify for exemptions from many of the Act’s requirements by meeting certain criteria.

Wednesday, January 28, 2009

House Passes Stimulus Bill Repealing IRS Ruling 2008-83 Favoring Bank Acquisitions; Excludes TARP Recipients from 5-Year Loss Carryback

The House has passed an economic stimulus bill, HR 1, prospectively repealing IRS Notice 2008-83 that interprets Section 382 of the Internal Revenue Code to allow banks and other financial institutions pursuing acquisitions to write-off acquired losses stemming from takeovers of other banks to offset future income. The bill would also exclude companies receiving TARP benefits, and Fannie Mae, Freddie Mac, from a 5-year carryback of net operating losses for companies. A companion bill reported out of the Senate Finance Committee would also repeal 2008-83 and exclude TARP recipients, now estimated to be about 300 companies, from the 5-year carryback provisions. Notice 2008-83 came under intense criticism by many in Congress and is now almost certain to be repealed in any version of economic stimulus legislation presented for President Obama’s signature.

Section 382 was enacted by Congress to prevent tax-motivated acquisitions of loss corporations. On September 30, 2008, Notice 2008-83 effectively removed the limit on how much taxable income a purchasing bank, thrift, industrial loan company, and trust company could deduct post-acquisition. The Notice was designed to help the struggling banking sector recover by allowing acquiring banks the ability to deduct the built-in tax losses of any banks they acquire that possesses a portfolio of loans that have deteriorated in value.

The provision states that Congress finds that the delegation of authority to the Treasury under section 382(m) does not authorize the Secretary to provide exemptions or special rules that are restricted to particular industries or classes of taxpayers. Also, the statute says that IRS Notice 2008-83 is inconsistent with the congressional intent in enacting such 382(m); and that the legal authority to prescribe 2008-83 is doubtful.

With two exceptions, the provision states that Notice 2008-83 will not have any effect for any ownership changes after January 16, 2009. One exception is for ownership changes pursuant to a binding contract entered in to on or before such date, The second exception is for changes pursuant to an agreement entered into on or before such date and such agreement was described in a public announcement or in a filing with the SEC.

At his Senate confirmation hearings, Treasury Secretary Tim Geithner acknowledged that IRS Ruling 2008-83 favoring bank acquisitions raised complex issues about Treasury’s authority and differential treatment of the financial services industry. Under strong questioning from Finance Committee Member Charles Grassley, the Secretary promised to more closely examine the issue and work with the committee to resolve the issues raised by 2008-83.
UK FSA Chair Outlines Proposal for Broad Regulatory Reform

UK Financial Services Chair Adair Turner laid out a sweeping financial regulatory reform plan centered on a macro-prudential systemic risk regulator and a safer and more transparent securitization process. While rejecting a reimposition of the Glass-Steagall complete separation of commercial and investment banking, he said that a way must be found to restrict the systemic risk taking activities of global complex financial institutions.

A key principle of the reforms is to ensure that financial activities are always regulated according to their economic substance not their legal form. Thus, money market funds which want to continue to offer bank-like services and assurances should be reorganized as special purpose banks and regulated as such. Hedge funds posing systemic risks should also be regulated. The chair also said that the value-at-risk standard for valuing financial instruments held by banks and other firms was a flawed model that contributed to the crisis. The management of liquidity risk will be very important, he added.

Other areas of reform that the Chair did not discuss, but which will be in the FSA’s formal proposal slated for March, include executive compensation, rating agencies, and counterparty risk in derivatives. The reforms will also involve finding the appropriate balance between mark to market and accrual accounting principles. Importantly, the FSA must solve the regulation of cross-border financial institutions and the scope for global coordination, and strike the appropriate balance of responsibility between home and host regulators.

The biggest regulatory failure, he said, was the failure to identify that the whole financial system was fraught with market-wide, systemic risk. Regulators were too focused on the institution-by-institution supervision of idiosyncratic risk. Thus, there is a crucial need to create a systemic risk regulator.

His plan envisions the retention of the originate and distribute securitized model, albeit made safer. The new system should be a combination of traditional on balance sheet credit intermediation and securitized intermediation. The FSA plans to formally propose a safer, simpler, and more transparent version of securitization, with less exclusive reliance on credit ratings and more independent judgment, and with less packaging and trading of securitized credit through multiple balance sheets. While changed significantly, the new securitization regime will still play an important role in national and global credit intermediation.

Measuring and managing liquidity risk is also crucial, he noted, and regulation needs to include both far more effective ways for assessing and limiting the liquidity risks which individual institutions face and a better understanding of market-wide liquidity risks. Thus, the FSA proposes a major reform of liquidity regulation, including significantly enhanced reporting requirements and regulations requiring all financial institutions to focus on the combined liquidity effect of their holdings of liquid assets, the maturity of their assets and liabilities, and the term, diversity and reliability of funding sources.

At the core of the risk assessment will be stress testing, rather than models which seek to infer the probability distribution of risks from the observation of past fluctuations. This reflects the fact that liquidity risk assessment is inherently concerned with low probability but extreme events. And crucially the stress tests will need to cover potential market-wide stresses as well as idiosyncratic stresses, reflecting the lesson of the financial crisis that market-wide collapses in the liquidity of specific asset or funding markets can have huge impacts which analysis of individual specific risks will not capture.

The FSA Chair said that the new regime, along with the related reporting requirements, will greatly enhance the FSA’s ability to understand emerging liquidity risks in individual institutions and system wide. Further, the new regime will result in major changes in the extent and nature of maturity transformation in the overall financial system, with banks holding more liquid assets and a greater proportion of those assets held in government securities, an incentive for banks to encourage more retail time deposits and less instant access, less reliance on short-term wholesale funding, and, as a result, a check on rapid and unsustainable expansion of bank lending during a favorable economy.

One of the striking features of the years running up to the crisis was that core banking functions were being performed by institutions which were not legally banks, such as structured investment vehicles and other off balance sheet vehicles, investment banks and mutual funds. These vehicles escaped the capital, leverage and liquidity regulation which would apply to banks and, in the case of SIVs, they also escaped the degree of disclosure and accounting treatment which would have applied if the activities were performed on balance sheet.

Chairman Turner emphasized that it is essential that if an economic activity is bank-like and poses a significant risk to financial stability, regulators be able to extend banking-style regulation. It is also essential that accounting treatment reflect the economic reality of risks being taken.

In line with the recent Volcker report, the FSA will regulate bank-like mutual funds as banks. These are funds that have made assurances that they will maintain a stable net asset value, that they will not “break the buck”, and may in a liquidity crisis act in a fashion which exacerbates that crisis, selling rapidly to meet redemptions and fuelling the deflationary cycle. That is why the Volcker report recommends that money market funds which want to continue to offer bank-like services and assurances should be reorganized as special purpose banks and regulated as such.

With regard to hedge funds, the FSA proposes what the Chair called a ``halfway house’’ regulation under which funds with the potential to pose a systemic risk would be subject to prudential regulation. Currently, while hedge fund managers in the UK are regulated, the fund is usually registered offshore and not subject to prudential regulation.

While acknowledging that hedge funds are not bank-like, and have neither the scale nor the characteristics requiring that individual funds be treated as systemically important, the FSA Chair said that in the aggregate they may nevertheless play a role with systemic effects which regulators and central banks need to understand, but which they currently lack the data to analyze effectively.

Rapid deleveraging by hedge funds has played a role in exacerbating financial instability. It is for these reasons that the Volcker report suggested that regulators should have the power to gather detailed information from hedge funds, so that they can judge their evolving systemic importance. Thus, for funds judged to be potentially systemically significant, the prudential regulator should have the authority to establish standards for capital, liquidity and risk management. This ``halfway house’’ regulation of hedge funds should provide the information and the power to respond to future developments in size, concentration, leverage levels, and practices in line with the principle of focusing on economic substance not legal form.

Tuesday, January 27, 2009

Proposed FINRA Rule 5122 to Impose Requirements Regarding Member Private Offerings

Financial Industry Regulatory Authority, Inc. (“FINRA”) filed with the Securities and Exchange Commission (“SEC” or “Commission”) a proposed rule change to adopt new FINRA Rule 5122. As proposed, the rule would require a member that engages in a private placement of unregistered securities issued by the member or a control entity to: (1) make certain disclosures to investors in a private placement memorandum (“PPM”): (2) file the PPM with FINRA: and (3) commit that at least 85 percent of the offering proceeds will be used for the business purposes identified in the PPM.

For more information, please click here.
Geithner Promises Congress to Review IRS Ruling 2008-83 Favoring Bank Acquisitions

At his Senate confirmation hearings, Treasury Secretary Tim Geithner acknowledged that IRS Ruling 2008-83 favoring bank acquisitions raised complex issues about Treasury’s authority and differential treatment of the financial services industry. Under strong questioning from Finance Committee Member Charles Grassley, the Secretary promised to more closely examine the issue and work with the committee to resolve the issues raised by 2008-83.

Notice 2008-83 interpreted Section 382 of the Internal Revenue Code to allow banks and other financial institutions pursuing acquisitions to write-off acquired losses stemming from takeovers of other banks to offset future income. Section 382 was enacted by Congress to prevent tax-motivated acquisitions of loss corporations. On September 30, 2008, Notice 2008-83 effectively removed the limit on how much taxable income a purchasing bank, thrift, industrial loan company, and trust company could deduct post-acquisition. The Notice was designed to help the struggling banking sector recover by allowing acquiring banks the ability to deduct the built-in tax losses of any banks they acquire that possesses a portfolio of loans that have deteriorated in value

Senator Grassley noted that Section 382 was not enacted lightly by Congress, but rather after extensive scholarly reflection by the staffs of the Senate and House tax-writing committees and the Joint Committee on Taxation. It has been an established part of the law ever since 1986. In the senator’s view, this law was changed when Treasury issued Notice 2008-83. He observed that many tax law scholars have opined that Treasury simply did not have authority to make this change. One of the country’s largest law firms at one point estimated that this IRS waiver could cost the US Treasury $140 billion dollars in taxes that would have otherwise been paid.

Further, the senator was troubled that this Notice was issued on September 30, 2008, meaning that Treasury virtually waived section 382 the day after the House said no to the first bail-out bill and two days before Wells Fargo acquired Wachovia on October 2, 2008.

Noting the high level of congressional concern over this issue, the Secretary pledged to respect the constitutional limits on Treasury’s authority. He also mentioned the House stimulus bill provision repealing 2008-83, as well as the fact that Senator Grassley has called for an Inspector General’s report on this issue. The Secretary looks forward to reviewing that report when it is completed.

Notice 2008-83 came under intense criticism by many in Congress and is now very likely to be repealed in any version of economic stimulus legislation presented for President Obama’s signature. For example, in a letter to Treasury and the IRS, Senator Charles Schumer demanded to know why the IRS issued a notice allowing financial institutions pursuing acquisitions to write-off acquired losses stemming from takeovers of other banks to offset future income. He questioned the need for the tax change after the implementation of the Treasury’s capital injection program and expressed concern that the change would result in tens of billions of lost tax dollars for the federal government, which has already committed $700 billion in resources to many of these same financial institutions under the rescue plan approved by Congress.

Monday, January 26, 2009

European Commission Proposes Public Funding for Accounting and Auditing Standard Setters

In an effort to address the independent funding issue hanging over the IASB with the global acceptance of IFRS, the European Commission has proposed public funding for the Board in an effort to enhance its independence. For similar reasons, the Commission has proposed independent funding for the oversight body of the IAASB, the standard setter for international audit standards. The independence of the oversight process without any undue influence is crucial for both standard setters, said the Commission.

Since IFRS is mandated for EU listed companies, reasoned the Commission, the standards play a major role in the operation of the Single Market and of the EU's economy. Thus, the EU has a direct interest in ensuring that the process through which these standards are developed and approved delivers standards that are consistent with the public interest and enhance financial stability.

A main concern in this respect is to avoid the reliance of the standard-setter on voluntary funding from interested parties, such as auditors or listed companies. The establishment of appropriate funding arrangements is important to put an end to such reliance.

Independent funding should contribute to ensuring the independence of its standard setting and limit concerns about possible conflicts of interest. Thus, the Commission proposes a public financial contribution to the IASB budget proportionate to the EU weight in the global economy and capital market.

The financial statements of EU companies must be audited by independent auditors. According to Directive 2006/43/EC, international standards for auditing can be adopted in the EU provided a number of conditions are met, in particular that the standards have been developed with proper due process, public oversight and transparency. International standards for auditing are developed and approved by the International Auditing and Assurance Standards Boards, whose overseer is the Public Interest Oversight Board.

The key concern in this respect is to avoid the reliance of the PIOB for its funding over from interested parties which have a direct interest in auditing standards. The establishment of appropriate funding arrangements of the PIOB is important to put an end to such reliance. This should, in turn, contribute to guarantee the independence of its oversight activity and limit concerns about possible conflicts of interest. To achieve this objective, it is therefore necessary for the EU contribute fairly to the funding of the PIOB.
European Commission Seeks Public Comment on Prospectus Directive

We are indebted to my colleague John Filar Atwood for the below post.

The European Commission has issued a consultation paper on proposals to improve and simplify the prospectus directive. The directive tries to ensure that investors receive clear and complete disclosure when making investment decisions. Proposals to change the directive are part of the EC’s action plan to reduce administrative burdens on EU companies. Comments are due to the Commission by March 10.

The prospectus directive introduced a single passport for issuers, making securities available to investors either through a public offer procedure or by admitting their shares to trading. Under the directive, once a prospectus is approved by the regulatory authority in one member state, it then has to be accepted everywhere else in the EU. In order to ensure investor protection, approval is granted only if the prospectus meets common EU disclosure standards.

After consulting with, among others, the Committee of European Securities Regulators and the European Securities Markets Expert Group, the EC concluded that some elements of the prospectus directive should be reviewed.

The consultation paper starts with a general assessment of the overall effectiveness and efficiency of the prospectus directive. The Commission concluded that the application of the directive is broadly positive. In general, most market participants appear satisfied with the disclosure regime established by the directive, according to the Commission, and they consider it an important step towards the establishment of a single European securities market.

However, the Commission identified some elements in the directive that may create in practice unnecessary burdens and unjustified costs for companies and intermediaries. The issues include the definition of qualified investors, the revision of exempt offers, the revision of the annual disclosure obligation, a time limit for exercise of right of withdrawal and certain thresholds of the directive.

In addition to offering proposals to address each of these areas, the consultation paper discusses issues that have been brought to the Commission's attention but are not included in the draft proposals. The EC said that it is anxious to receive feedback on these issues, including the effectiveness of the prospectus summary, disclosure requirements for offers with government guarantee schemes and disclosure requirements for small quoted companies and for rights issues.

The EC noted that it wants to fully understand and assess the financial and other impacts of the proposal as well as any alternative approaches. As a result, commenters are invited to offer their views on compliance costs, the impact on competition and other impacts, costs and benefits.

John Filar Atwood
SEC Chair Schapiro Cautions on IFRS Roadmap

SEC Chair Mary Schapiro said the Commission would proceed to implement IFRS with great caution in order to avoid a race to the standard setting bottom. At her confirmation hearing before the Senate Banking Committee, the new SEC Chair said that she does not feel bound by the existing roadmap that the Commission put out for comment last year. She intends to ``take a big deep breath’’ and carefully examine this entire area again.

While she applauds a single set of global accounting standards as a very beneficial thing, allowing investors to compare companies around the world, she has concerns with the roadmap that has been published by the SEC. A main concern is about the IFRS standards generally. They are not as detailed as US GAAP standards, she noted, with a lot left to interpretation. Moreover, even if they are adopted, there will still be a lack of consistency around the world in how they are implemented and how they are enforced.

In addition, the cost to switch from US GAAP to IFRS is going to be extraordinary, she noted, with some estimates ranging as high as $30 million for each US company. This is a time, she said, when regulators must think carefully about whether it makes sense to impose those sorts of costs on US industry.

But perhaps her greatest concern is the independence of the International Accounting Standards Board and the ability to have oversight of the Board’s process for setting standards and the amount of rigor that exists in that process today.

Sensitive to such criticism, the oversight trustees of the International Accounting Standards Board has proposed a Monitoring Group composed of the SEC and other securities authorities. The SEC welcomed the creation of the Monitoring Group as a way of providing organized interaction between the IASB and national securities regulators responsible for the adoption or recognition of accounting standards for listed companies.

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

Saturday, January 24, 2009

Geithner Will Direct IRS to Examine Legislation Repealing IRC 162(m) Exemption for Performance-Based Executive Compensation

At his confirmation hearings, Treasury Secretary Tim Geithner agreed to consider legislation to amend section 162(m) of the Internal Revenue Code to eliminate the deduction of commissions and performance-based pay for a company’s most highly paid exexutives.The Emergency Economic Stabilization Act limited executive compensation for executives of companies that are participating in the Troubled Asset Relief Program (TARP). These restrictions include a limitation of $500,000 (instead of 162(m)’s $1 million cap) on the amount of compensation that can be deducted as an ordinary and necessary business expense. Also, the definition of compensation for TARP recipientas was expanded to include performance pay and stock options. Senator John Kerry has introduced legislation that would amend 162(m) to repeal the exemption for performance based pay and bonuses for all companies, not just TARP recipients.

Responding to a question from Senator Kerry, Mr. Geithner said that excessive executive compensation that provides inappropriate incentives has played a role in exacerbating the financial crisis. The SEC and Treasury are closely examining the issue. First, the Secretary will charge the Internal Revenue Service with ensuring that the regulations implementing the executive compensation provisions of the Economic Emergency Stabilization Act are fully complied. Second, he pledged that Treasury and IRS staff will study the Kerry legislative proposal to permanently limit the deductibility of performance-based executive compensation.

Under current law, the allowable deduction for the compensation of the top five highly paid individuals, including the CEO and the chief financial officer, CFO, is limited to $1 million per year. This limitation does not include commissions and performance-based pay. Congress is concerned that these exceptions have weakened the effectiveness of the limitation and encourage performance-based pay arrangements which could cause executives to manipulate earnings

The Compensation Fairness Act would make several changes to the limitation on deduction for compensation. It would repeal the exceptions for commission and performance-based pay. Under current law, an employee that is covered by the limitation has to be an employee the last day of the year. The legislation would change this to make a covered employee one who is employed at any time during the year. This legislation would retain the $1 million limitation and index it for inflation.

The Compensation Fairness Act would not limit the amount of salary an executive can receive, it would just limit the tax subsidy.

Friday, January 23, 2009

Appeals Court Finds Protection for Tax Accrual Work Papers Produced for Dual Purpose of Possible IRS Litigation and SEC-Filed Financial Statements

A split First Circuit panel ruled that the work-product doctrine protects tax accrual work papers prepared by a company for the purpose of calculating tax reserve liability from an IRS subpoena even though the work papers were also prepared in conjunction with the independent audit of the company’s SEC-filed financial statements. The question of whether showing these tax accrual workpapers to the company’s independent auditor was remanded for consideration by the trial court. In a ringing dissent, Judge Boudin found that the IRS offered compelling evidence that the sole reason for creating the estimates of risks with respect to the tax positions was to prepare the reserve figures for the company’s financial statements and satisfy the outside auditor that the reserves were adequate. (US v. Textron, CA-1, No. 07-2631, January 21, 2009)

The federal securities laws require public companies to have their financial statements certified by an independent auditor, noted the dissent, and a key element of the audit is evaluating the adequacy and reasonableness of the company’s reserve account for contingent tax liabilities. Judge Boudin interpreted the Supreme Court’s Arthur Young opinion as rejecting privilege for the preparation of tax accrual work papers since companies have to comply with SEC financial statement obligations and accounting rules and would do so with or without a privilege.

In finding that the tax accrual work papers were protected from the IRS, the appeals panel first found that, while not all dealing with the IRS during an audit is litigation, the resolution of disputes through adversary administrative processes, including proceedings before the IRS Appeals Board, meets the definition of litigation.

The panel then found that one of the purposes behind the creation of the documents was anticipation of litigation by analyzing litigation for the purpose of creating and auditing a reserve fund. Even more, it could fairly be said that the driving force behind the preparation of the documents was the need to reserve money in anticipation of disputes with the IRS. The mere concurrent presence of complying with SEC regulations as a purpose for producing the tax accrual papers did not defeat the work product protection, said the panel. Protection of dual purpose documents is consistent with the purpose of the work product doctrine.
Michigan Adopts Uniform Securities Act of 2002

Michigan adopted Act 551, which can be cited as the "Michigan Uniform Securities Act (2002)." This Act replaces the existing Michigan Securities Act, and is effective October 1, 2009. Although differences occur, this new Act adopts a large part of the Uniform Securities Act of 2002 (USA 2002) verbatim.

The enacted version of House Bill 5008, Act 551, can be found here.

Thursday, January 22, 2009

Frank Reorganizes Financial Services Committee for 111th Congress

Facing the need for major financial regulation reform legislation this year, House Financial Services Committee Chair Barney Frank has named crucial subcommittee chairs for the 111th Congress. Rep. Paul Kanjorski will continue to chair the important subcommittee on capital markets. Rep. Luis Gutierrez has been named chair of the equally important subcommittee on financial institutions, replacing Rep. Carolyn Maloney. In addition, Rep. Dennis Moore will be the new chair of the subcommittee on oversight and investigations, replacing Rep. Melvin Watt.
Senate Reform Bill Would Enhance SEC Enforcement Capabilities

In the wake of the Madoff scandal and as the financial crisis deepens, Senators Charles Schumer and Richard Shelby introduced bipartisan legislation to enhance SEC enforcement capabilities, as well as overall federal enforcement ability. The Supplemental Anti-Fraud Enforcement (“SAFE”) Markets Act would dedicate an additional $110 million annually for these new hires. The senators, who are members of the Banking Committee, said they would seek to pass the additional funding at the earliest possible opportunity. Senator Shelby is the committee’s Ranking Member.

The measure would add hundreds of new investigators and prosecutors to the financial fraud units at the nation’s top law enforcement agencies in order to expose and punish white-collar crimes that have contributed to the ongoing fiscal crisis. The SEC would receive funds to hire 100 new enforcement division employees, while the Justice Department would be able to hire 50 new Assistant United States Attorneys. Congress expects that an increase in fines levied by the SEC and the collection of orders of restitution in criminal cases could be far greater than the cost of increasing enforcement personnel.

Since Congress views the current economic crisis as one of confidence, which underpins the entire financial system, the legislation should restore confidence in the markets by helping bring those who perpetrate fraudulent acts to justice. The legislation will help ensure that federal enforcement agencies have the resources they need to investigate and prosecute these crimes.

In recent months, amid the financial crisis, a rising number of securities and accounting fraud cases have surfaced, accounting for billions of dollars in losses for investors. But the agencies on the front lines of policing the financial institutions and investment managers have been hamstrung by a lack of resources. For example, from 2000-2007 the number of prosecutions of frauds against financial institutions plummeted by 48 percent. This measure aims to provide extra resources to meet the added strain put on these enforcement agencies.

In comments at the confirmation hearings of new SEC Chair-designate Mary Schapiro, Sen. Schumer said that the SEC needs a stronger emphasis on finding and preventing fraud by bolstering its inspection and examination process. He also advised the Commission to adopt former Chair Donaldson's proposal to have an office of risk assessment.
House Passes TARP Reform Bill Emphasizing Oversight and Executive Compensation Reform

The House passed a bill to reform the Troubled Assets Relief Program (TARP) provisions of the Emergency Economic Stabilization Act of 2008. The vote was 260-166. The TARP Reform and Accountability Act, HR 384, would strengthen accountability, close loopholes, increase transparency, and require Treasury to take significant steps on foreclosure mitigation. The measure requires detailed reports from recipients of TARP funds and ensures that those funds un-thaw credit. It provides even stronger limits on executive compensation. It further requires that Treasury act promptly to permit the smaller community financial institutions that have been shut out so far to participate on the same terms as the large institutions that have already received funds.

The Act also requires the Treasury to incorporate within the TARP assistance agreement how the funds are to be used and the benchmarks an institution must meet in using such funds. It also requires federal banking regulators to examine annually the use of TARP funds made by the deposit institutions. Also, the measure prohibits the use of TARP funds by a TARP-assisted institution for mergers or acquisitions unless such a transaction will reduce risk to the taxpayer or could have been consummated without such funds.

With regard to corporate governance and executive compensation provisions, all types of funding would get the same treatment. For any new receipt of TARP funds, the bill applies the most stringent non-tax executive compensation restrictions from EESA across the board. For example, the measure requires Treasury to prohibit incentives that encourage excessive risks and provides for claw-back of compensation received based on materially inaccurate statements.

It also prohibits all golden parachute payments for the duration of the investment. The bill also removes the de minimus exception under which institutions smaller than $300 million in assets had not been subject to the golden parachute limitations in auction purchases of troubled assets.
The Act also authorizes Treasury to apply these expanded executive compensation provisions retroactively to existing recipients of direct assistance. Existing tax-related executive compensation provisions under EESA Section 302 are not modified in the draft bill

A broader corporate governance provision would allow Treasury to have an observer at board or board committee meetings of recipient institutions.

The measure also clarifies Treasury’s authority to provide support to issuers of municipal securities, including through the direct purchase of municipal securities or the provision of credit enhancements in connection with any Federal Reserve facility to finance the purchase of municipal securities.

A floor amendment to the bill requires the Federal Reserve Board to disclose the details of its program to purchase illiquid mortgage-backed securities from troubled financial institution. The Fed hired four investment firms to manage the program. According Rep. Patrick Murphy, sponsor of the amendment, the Fed has refused to release details about how they chose the four firms and who will manage the purchases. They have refused to share how much those firms are getting paid. And it is still unclear what steps have been taken to ensure strict conflict of interest provisions are put in place so that these four firms are not given an unfair market advantage because of their role in the mortgage backed securities program.

Thus, the Murphy amendment would require the Fed to disclose the process by which it selected the investment managers and the details of the contracts reached with these four investment managers, including price. The bill would also force the Fed to disclose the steps that each investment manager has taken to ensure that the program is free of conflicts of interest or an unfair advantage.

A Manager's Amendment added Section 107 to the Act creating an Office of Minority and Women Inclusion, which will be responsible for ensuring the inclusion and utilization of minority and women-owned businesses. These businesses will include financial institutions, investment banking firms, mortgage banking firms, broker-dealers, and accountants. This office will also be responsible for diversity in the management, employment, and business activities of the TARP, including the management of mortgage and securities portfolios, making of equity investments, and the sale and servicing of mortgage loans.

Section 107 also calls for the Secretary of the Treasury to report to Congress in 180 days detailed information describing the actions taken by the Office of Minority and Women Inclusion, which will include a statement of the total amounts provided under TARP to small, minority, and women-owned businesses. The Manager's Amendment in Section 404 also has clarifying language ensuring that the Secretary has authority to support the availability of small business loans and loans to minority and disadvantaged businesses. This will be critical to ensuring that small and minority businesses have access to loans, financing, and purchase of asset-backed securities directly through the Treasury Department or the Federal Reserve.
Dismissal of Enron SPE Action Against JPMorgan Chase & Co. Affirmed

A class action suit against JPMorgan Chase & Co. arising from an affiliated special purpose entity involved with Enron Corp. were properly dismissed, concluded the 2nd Circuit. As alleged, the company created special purpose entities, including Mahonia Ltd., to facilitate disguised loan transactions with Enron Corp. According to the plaintiffs, JPMorgan Chase made false and misleading statements or omissions that were material by 1) failing to report the Mahonia transactions as related-party transactions and 2) reporting the Mahonia transactions as trading assets rather than loans.

Initially, the appellate panel found that while the Mahonia transactions should have been identified as involving a related party, the complaint failed to show that that JPMorgan chase acted with scienter in failing to disclose the relationship. In addition, the failure to report the transactions as loans was not actionable because from both a quantitative and qualitative standpoint, the transactions were not material.

ECA v. JPMorgan Chase Co.

Wednesday, January 21, 2009

SEC Commissioner Calls for Legislation to Register Hedge Fund Advisers

SEC Commissioner Luis Aguilar has called on Congress to pass legislation mandating the registration of hedge funds so that the Commission can obtain at least basic information about the funds and their advisers. Because neither hedge funds nor hedge fund advisers are required to be registered, he explained, the Commission lacks meaningful information about these entities, such as how many hedge funds operate in the United States, the size of their assets, and who controls them.

In remarks at a recent NASAA seminar, he also emphasized that, because hedge fund advisers are not subject to periodic examinations like registered investment advisers, the staff does not have the opportunity to identify misconduct prior to significant losses occurring. And, importantly, the argument for regulation is reinforced by the fact that retirement assets have been increasingly invested in hedge funds and that hedge funds are such significant players in our capital markets.

In June of 2006, a federal appeals court vacated an SEC rule requiring hedge fund managers to register under the Investment Advisers Act and comply with adviser regulations, including filing disclosures, adopting a compliance program and a code of ethics, and being subject to SEC examinations. As a result of the court’s ruling, the Commission currently lacks tools to provide effective oversight and supervision of the hedge fund industry. Thus, the commissioner asked Congress to amend the Investment Advisers Act to clearly provide the SEC with authority over hedge fund advisers.
Ohio Adopts Electronic Filing Procedures for Investment Company and Rule 506 Issuers

Federally-registered investment companies (or those investment companies having filed a registration statement under the Investment Company Act of 1940), and issuers intending to make a securities offering under Rule 506 of federal Regulation D, may file electronically a Form NF, Uniform Investment Company Notice Filing, or Form D, Notice of Sale of Securities Pursuant to Regulation D, respectively. A Form U-2, Uniform Consent to Service of Process, must be filed if required by Ohio statutory section 1707.11. A typed signature is accepted in place of a manual signature. Fee payments must be transferred through the automated clearing housenetwork in cash concentration or disbursement entry format by fedwire transfer. Electronic filings may be submitted Monday through Friday from 8:00 a.m. through 5:00 p.m. eastern standard time and are considered upon receipt of the required forms and fees. Amendments to a previously submitted electronic filing must include the file number assigned by the Securities Division, and additional fees to amend a previously submitted electronic filing must be transferred through the automated clearing house network in cash concentration or disbursement entry format by fedwire transfer.
Minnesota Proposes Securities Rules to Coordinate with New Act

New securities rules to coordinate with the Minnesota Uniform Securities Act adopted in 2007 were proposed by the State's Department of Commerce.

The proposed rules can be found here.

Interested persons have until February 19, 2009 to submit written comments about the proposed rules and to request a public hearing on them. Please submit these comments to Brett Bordelon, Minnesota Department of Commerce, 85 7th Place East, Suite 500Saint Paul, MN 55101 FAX: (651) 284-4106;TTY (651) 296-2860.

Tuesday, January 20, 2009

President's Working Group on Financial Markets Issues Best Practices for Hedge Fund Managers

Against the backdrop of market turmoil, two committees established by the President's Working Group on Financial Markets have issued complementary sets of best practices for hedge fund investors and asset managers in the most comprehensive effort yet to increase accountability for participants in this industry. Given the global nature of financial markets, the best practices were designed to be consistent with the work that was recently done in the United Kingdom to improve hedge fund oversight

The best practices
issued for hedge fund managers embody principles of enhanced disclosure, proper valuation, risk management, sound infrastructure, and compliance. All these elements are intertwined, said the committee, since trade documentation and settlement procedures are critical to accurate valuation and disclosure to investors. In addition, adequate procedures to control the creation of counterparty relationships are a critical part of counterparty risk management.

While recognizing that no set of best practices can resolve the complex issues facing the financial industry, the committee believes that these events underscore the need for hedge funds to implement strong practices to manage their businesses. The committee also emphasized that, even with the dramatic changes talking place, hedge funds will continue to be an important source of capital and liquidity in global markets by providing financing to new companies and committing capital in times of both market stress and market stability.


Drawing from key elements of the public company disclosure regime, the committee urged hedge funds managers to disclose periodic performance information and provide a quarterly investor letter or similar communication and risk report. Managers should also provide both a qualitative and quantitative discussion of performance information so that investors can better understand fund performance. This discussion is intended to provide context to the manager’s performance and can be in any form the manager feels is most useful, such as part of the investor letter.

A fund manager’s disclosure framework should also address disclosure to counterparties, such as banks and broker-dealers. The relationship between hedge funds and counterparties is mutual and both sides must understand their respective credit exposures. Thus, both parties should agree on the types of information that will be made available. Information provided should be appropriate to the type of relationship between the fund and the counterparty, and be subject to protection of confidentiality.


The committee urges hedge fund managers to adopt a valuation framework that provides for consistent and documented policies and the segregation of responsibilities between portfolio managers and those responsible for valuations. Funds should also establish a Valuation Committee with responsibility for monitoring compliance with the manager’s valuation policies.

FASB Standard No. 157 on valuation establishes a hierarchy of assets based on the reliability of available pricing information: Level 1 assets have observable market prices like NYSE stock quotes, while Level 2 assets have some observable market price information other than quoted market prices. Level 3 assets are illiquid and have no observable market price information. Believing that investors need to understand what portion of the fund is comprised of hard-to-value assets, the committee urges fund managers to go beyond the requirements of GAAP and provide a quarterly report on the percentage of their assets that are in each FAS 157 level.

Risk Management

The working group recommends that hedge funds adopt a comprehensive framework to measure, monitor, and manage risk consistently with the fund’s risk profile. Managers should identify risks to the portfolio, measure the principal categories of risk, such as liquidity risk, market risk, and counterparty credit risk, and adopt policies to monitor and measure criteria, and maintain a regular and rigorous process of risk monitoring by knowledgeable personnel.

Hedge fund managers should also regularly disclose risk information, including a qualitative discussion that will help investors understand how they view the fund’s risk profile. Recognizing that confidentiality is important to the manager’s business, the working group does not expect that investors will be provided with all information used to monitor risk.

Depending on the extent of the fund’s exposure, the failure of a counterparty could have serious consequences for a fund’s access to liquidity and overall success. Thus, asset managers should assess the creditworthiness of counterparties and understand the complex legal relationships they may have with prime brokers or lending or derivative counterparties and their affiliates.


In recent years, strong trading and business operations have become more critical than ever to the sound and effective operation of hedge funds. Thus, the committee recommends a comprehensive framework for a manager’s trading and business operations, including naming a senior officer responsible for operations and backing up that officer with adequate resources.

In addition, there must be segregated functions, a process for documenting relationships with counterparties and infrastructure to accommodate the types of investments traded by the fund and adequate management of the fund’s internal operations. Managers must continuously assess the effectiveness of their operational and internal controls.

Hedge funds should also employ qualified, independent auditors, and should thoroughly investigate the qualifications of all service providers to the fund, including custodians, prime brokers, and third party administrators.

Compliance and Conflicts of Interest

Finally, hedge funds must make a strong commitment to compliance and controlling conflicts of interest. In this regard, hedge funds should have a written code of ethics and a written compliance manual, including a process for handling conflicts of interest. Since it is impossible to anticipate every potential conflict, funds should establish a Conflicts Committee as the focal point for reviewing potential conflicts and addressing them as they arise.

Most importantly, hedge funds should also name a Chief Compliance Officer supported by a culture of compliance in which every person in the firm feels empowered to raise concerns. The duties of the Chief Compliance Officer should include identifying compliance risks; monitoring compliance with the fund’s policies; and conducting an annual review and assessment of the compliance framework.

Monday, January 19, 2009

President Obama Brings Winds of Securities Regulatory Change

It is fitting that President Obama will take the oath of office today on the bible used by President Lincoln because, like Lincoln, he comes into office with a full blown crisis well underway. On the regulatory front, he must restore the shattered confidence in federal financial regulators and, more broadly, in the financial markets. He must also craft a securities regulatory model for the 21st Century, with full global consistency. But today I will not speak of global securities regulation, I will simply say God Bless President Obama and the United States of America as we continue to pursue President Lincoln’s vision of whether a nation in which we all have value can long endure.

For my white paper on the financial regulatory reforms likely to be effected by the Obama Administration and the 111th Congress please click here.

Sunday, January 18, 2009

Treasury Amends TARP Executive Compensation Rules to Drop CD&A Disclosure and Clarify Duties of SEC Smaller Reporting Companies

The Treasury regulations for financial institutions participating in the troubled asset relief program (TARP) under the Emergency Economic Stabilization Act have been amended to require that the compensation committee’s certification be included in the committee’s report rather than in the Compensation Discussion & Analysis portion of SEC filings. Treasury also clarified that smaller reporting companies participating in the TARP must cover the five executive officers named in Item 402 (a) of Regulation S-K even though 402 (m) allows them to report the compensation of only three senior officers. In addition, Treasury mandated a new reporting requirement for the principal financial officer of a participating financial institution.

Treasury regs require the compensation committee to meet, within 90 days after a purchase under the program, with senior risk officers of the financial institution to ensure that the firm’s incentive compensation arrangements do not encourage senior executive officers to take unnecessary and excessive risks that might threaten the firm’s value. After that, the compensation committee must meet annually with senior risk officers to review the relationship between the financial institution’s risk management policies and the compensation arrangements. Also, the compensation committee must certify that they have done so in order to assure investors and taxpayers that the institutions are complying with the requirements.

The Treasury believes that it is more appropriate to require that the certification be included in the compensation committee report because the compensation committee prepares the report and is also making the required certifications. Management of the financial institution prepares the Compensation Discussion & Analysis, which does not directly address the operations and functions of the compensation committee.

The Treasury also clarified that the rules requiring clawback of any bonuses or incentive compensation paid during the period Treasury holds an interest in the financial institution apply to such compensation earned, but not paid, during the holding period. The Treasury believes that any bonus or incentive compensation earned during he Treasury holding period should be subject to clawback; and will consider any such compensation paid during the holding period when the senior officer obtains a legally binding right to that payment during the holding period.

Generally, the SEC requires disclosure of the executive compensation of the principal executive officer, principal financial officer and the other three most highly compensated senior officers. But for smaller reporting companies, the SEC requires disclosure of the compensation of the principal financial officer and the other two most highly compensated officers.

Treasury has clarified that, for purposes of participating in the TARP, a financial institution that is a smaller reporting company under SEC rules must identify five senior executive officers as subject to the TARP rules even though only three senior officers are provided in the disclosure pursuant to section 402 of Regulation S-K under the federal securities laws. Also, a financial institution that is a smaller reporting company should provide the certifications of the compensation committee in the same way a larger financial institution would do.

Treasury has also added a new compliance reporting regime relating to the executive compensation requirements earlier set forth under which the principal executive officer of the financial institution must provide certifications to the Chief Compliance Officer of the TARP. Specifically, within 120 days of the closing date of the securities purchase agreement between the financial institution and the Treasury, the principal executive officer must certify that the compensation committee has reviewed the incentive compensation arrangements with the firm’s senior risk officers to ensure that the arrangements do not encourage the taking of unnecessary and excessive risks that could threaten the value of the financial institution.

Also, within 135 days of the completion of each fiscal year during which the financial institution participated in the program, the principal executive officer must certify the following to the CCO: that the compensation committee has met at least once during the year with the senior risk officers to review the relationship between the risk management policies and the incentive compensation arrangements; that the compensation committee has certified to this review; that the financial institution has required that bonuses be subject to clawback; that golden parachutes are prohibited; and that the financial institution has limited the deduction for remuneration for federal income tax purposes to $500,000 for each senior executive officer as if section 162(m)(5) of the Internal Revenue Code applied to the financial institution.

The principal executive officer must either timely provide these certifications or explain to the TARP CCO why they have not been provided.

Financial institutions must preserve documentation and records to substantiate each certification for at least six years, the first two years in an easily accessible place. The financial institution must promptly furnish such documentation to the CCO on request.

Saturday, January 17, 2009

Senate Bill Would Regulate OTC Derivatives and Credit Default Swaps

A bill introduced by Senator Tom Harkin would bring all OTC financial transactions and credit default swaps currently traded without federal oversight onto regulated exchanges. The Derivatives Trading Integrity Act, S. 272, would establish stronger standards of transparency and integrity in the trading of swaps and other over-the-counter financial derivatives as a critical step toward restoring confidence in the financial system. Senator Harkin is Chair of the Agriculture Committee.

The broad goal of the legislation is to establish the standard that all futures contracts trade on regulated exchanges. According to the chair, it will bring these transactions out into the sunlight where they can be monitored and appropriately regulated. Senator Harkin envisions that the regulated exchanges will work with the CFTC to ensure that trading on the exchange is fair and equitable and not subject to abuses. In calling for thee regulation of credit default swaps, SEC Chair Christopher Cox recently told the Senate Banking Committee that the credit derivatives market is a regulatory hole that must be closed by Congress.

Senator Harkin has noted that, while swaps contracts function much like futures contracts, they are not regulated as futures contracts because of a statutory exclusion from CFTC authority. Since they do not have to be traded on open, transparent exchanges, it is impossible to know whether credit default and other swaps are being traded at fair value or whether institutions trading them are becoming overly leveraged or dangerously overextended. Financial derivatives like credit-default swaps must be traded on a regulated exchange, said the senator, so that regulators can know the value of the contracts, who is trading them, and if they have enough assets to back the contract.

The SEC’s current authority with respect to these instruments, which are generally security-based swap agreements under the Commodity Futures Modernization Act, is limited to enforcing antifraud prohibitions under the federal securities laws. The SEC is prohibited under current law from promulgating any rules regarding credit default swaps in the over-the-counter market. Thus, the tools necessary to oversee this market effectively do not exist.Over the years, the CFTC and laws enacted by Congress have allowed instruments that are essentially futures contracts to be privately negotiated without the safeguards provided through exchange trading. In this economic downturn, said Senator Harkin, Congress does not have the luxury to sit back and let the markets work.

The Derivatives Trading Integrity Act will bring more transparency and accountability into the marketplace. Specifically, the bill amends the Commodity Exchange Act to eliminate the distinction between “excluded” and “exempt” commodities and transactions versus commodities and transactions traded or conducted on regulated exchanges. All commodities and transactions of the same nature would be treated the same.

In addition, the bill eliminates the statutory exclusion of swap transactions, and ends the CFTC’s authority to exempt such transactions from the general requirement that a contract for the purchase or sale of a commodity for future delivery can only trade on a regulated board of trade. In effect, this means that all futures contracts must trade on a designated contract market or a derivatives transaction execution facility. Virtually all contracts now commonly referred to as swaps fall under the definition of futures contracts and function basically in the same manner as futures contracts

The bill seeks to eliminate the negative consequences from the lack of price transparency and the failure to properly measure and collateralize the risk in trading over-the-counter derivatives. Similar problems have not been seen in the trading of financial futures on regulated futures markets, subject to CFTC oversight.

OTC credit derivatives emerged in the mid-1990s as a means for financial institutions to buy insurance against defaults on corporate obligations. Credit default swaps are executed bilaterally with derivatives dealers in the OTC market, which means that they are privately negotiated between two sophisticated, institutional parties.

They are not traded on an exchange and there is no required recordkeeping of who traded, how much and when. Although credit default swaps are frequently described as buying protection against the risk of default on, for example, corporate bonds, they are also used by investors for purposes other than hedging. Institutions can and do buy and sell credit default swap protection without any ownership in the entity or obligations underlying the swap. In this way, credit default swaps can be used to create synthetic long or short positions in the referenced entity.
Using SEC Data, GAO Finds that TARP Recipients Have Subsidiaries in Offshore Tax Havens; Legislation Likely

A new GAO study reveals that an overwhelming majority of the 100 largest U.S. corporations in terms of 2007 revenue reported to the SEC have multiple subsidiaries in offshore tax havens. A number of the companies have received funds under the Emergency Economic Stabilization Act. The report was done at the request of Senators Carl Levin and Byron Dorgan, who have vowed to introduce legislation this year to stop tax haven abuse by companies, financial institutions and hedge funds. Legislation is likely to pass this year given President-elect Obama’s strong pledge to give Treasury the tools it needs to stop the abuse of tax shelters and offshore tax havens.

In the 110th Congress, Senator Levin and then Senator Barack Obama introduced a bill to stop offshore tax haven abuse. The Stop Tax Haven Abuse Act would have allowed U.S. tax and securities law enforcement officials to presume against the validity of transactions involving foreign tax havens identified in the Act. The bill would also have authorized Treasury to take special measures against foreign jurisdictions and financial institutions that impede U.S. tax enforcement.

The bill would also have required hedge funds to know their offshore clients by requiring them to establish anti-money laundering programs under Treasury regulations. The measure would have amended the Securities Exchange Act to impose a penalty for failure to disclose holdings or transactions involving a foreign entity. A companion bill was introduced in the House.

In conducting the study, the GAO used information filed with the SEC to determine where subsidiaries were located. Since the SEC only requires public corporations to report significant subsidiaries, the companies listed in the study could have additional subsidiaries under the SEC radar screen and thus underreported in the study.

While the existence of a subsidiary in a jurisdiction listed as a tax haven does not signify that a corporation established that subsidiary for the purpose of reducing its tax burden, noted the GAO, Treasury takes offshore tax evasion very seriously and has taken strong administrative and regulatory steps to address the problem.

GAO was unable to find a universal definition for a tax haven or an agreed-upon list of jurisdictions that should be considered tax havens. However, there is a consensus on the characteristics used to define and identify tax havens, including: no or nominal taxes; lack of effective exchange of tax information with US and other tax authorities; lack of transparency in the operation of legislative, legal, or administrative provisions; no requirement for a substantive local presence; and self-promotion as an offshore financial center.

The GAO used Form 10-K and Exhibit 21, which are included in the SEC’s EDGAR database to determine the locations of corporate subsidiaries based on the latest filings with the SEC. Since the principal executive officers, the principal financial officers, and a majority of the board of directors must sign the form filed with the SEC that includes the subsidiaries, GAO did not take additional steps to verify the accuracy of information found in EDGAR. Also, since the SEC only requires public corporations to report their significant subsidiaries, GAO was only able to identify the subset of corporate subsidiaries meeting the definition of significant subsidiary. The SEC considers a subsidiary to be significant if, among other things, the parent corporation’s and its other subsidiaries’ investments in the subsidiary exceed 10 percent of the consolidated total assets of the parent corporation and its subsidiaries.

Thursday, January 15, 2009

Former Fed Chief Volcker Unveils Plan for Reforming Financial Regulation

Former Federal Reserve Board head Paul Volcker has unveiled a plan for the reform of the regulation of the financial markets that envisions a macro prudential regulator and more robust regulation of credit rating agencies. Also, the plan states that fair value accounting principles and standards should be reevaluated with a view to developing more realistic guidelines for dealing with less liquid instruments and distressed markets. Mr. Volcker is a top adviser to President-elect Barack Obama.

The plan recommends a framework for national-level consolidated prudential regulation and over large internationally active brokerage firms, investment banks, and financial institutions. In addition, money market mutual funds wishing to continue to offer bank-like services, such as transaction account services, withdrawals on demand at par, and assurances of maintaining a stable net asset value (NAV) at par should be required to reorganize as special-purpose banks, with appropriate prudential regulation, government insurance, and access to central bank lender-of-last-resort facilities.

Those institutions remaining as money market mutual funds should only offer a conservative investment option with modest upside potential at relatively low risk. The vehicles should be clearly differentiated from federally insured instruments offered by banks, such as money market deposit funds, with no explicit or implicit assurances to investors that funds can be withdrawn on demand at a stable NAV. Money market mutual funds should not be permitted to use amortized cost pricing, with the implication that they carry a fluctuating NAV rather than one that is pegged at US$1.00 per share.

Managers of private pools of capital that employ substantial borrowed funds should be required to register with the SEC or other appropriate regulator, with provisions for some minimum size and venture capital exemptions from such registration requirement. The prudential regulator of such managers should have authority to require periodic reports and public disclosures of appropriate information regarding the size, investment style, borrowing, and performance of the funds under management. Since introduction of even a modest system of registration and regulation can create a false impression of lower investment risk, disclosure, and suitability standards will have to be reevaluated. Moreover, for funds above a size judged to be potentially systemically significant, the prudential regulator should have authority to establish appropriate standards for capital, liquidity, and risk management.

Regulatory standards for governance and risk management should be raised, with particular emphasis on enhancing boards of directors with greater engagement of independent members having financial industry and risk management expertise. Also, it is imperative to coordinate board oversight of compensation and risk management policies, with the aim of balancing risk taking with prudence and the long-run interests of and returns to shareholders;

The reforms must also ensure that risk management and auditing functions are fully independent and adequately resourced areas of the firm. The risk management function should report directly to the chief executive officer rather than through the head of another functional area.
House Stimulus Bill Would Repeal IRS Ruling 2008-83 Favoring Bank Acquisitions; Exclude TARP Recipients from 5-Year Loss Carryback

The economic stimulus bill unveiled by the House today would prospectively repeal IRS Notice 2008-83 that interprets Section 382 of the Internal Revenue Code to allow banks and other financial institutions pursuing acquisitions to write-off acquired losses stemming from takeovers of other banks to offset future income. Section 382 was enacted by Congress to prevent tax-motivated acquisitions of loss corporations. On September 30, 2008, Notice 2008-83 effectively removed the limit on how much taxable income a purchasing bank, thrift, industrial loan company, and trust company could deduct post-acquisition. The Notice was designed to help the struggling banking sector recover by allowing acquiring banks the ability to deduct the built-in tax losses of any banks they acquire that possesses a portfolio of loans that have deteriorated in value.

The bill would also exclude companies receiving TARP benefits, and Fannie Mae, Freddie Mac, from a 5-year carryback of net operating losses for companies.

Notice 2008-83 came under intense criticism by many in Congress and is now very likely to be repealed in any version of economic stimulus legislation presented for President Obama’s signature. For example, in a letter to Treasury and the IRS, Senator Charles Schumer demanded to know why the IRS issued a notice allowing financial institutions pursuing acquisitions to write-off acquired losses stemming from takeovers of other banks to offset future income.

He questioned the need for the tax change after the implementation of the Treasury’s capital injection program and expressed concern that the change would result in tens of billions of lost tax dollars for the federal government, which has already committed $700 billion in resources to many of these same financial institutions under the rescue plan approved by Congress.

Senator Schumer also questioned whether the tax change created an unnecessary incentive for acquisition-minded banks to pursue takeovers that provide no benefit to the stability of the larger financial system, but simply represent an opportunity for firms seeking future tax deductions to shelter their earnings. Since the Notice was issued, he continued, at least three banks stand to gain sizeable tax benefits from acquisitions. For example, the new ruling will allow Wells Fargo to save $19.4 billion in taxes from their acquisition of Wachovia, according to published reports.

The senator and others were concerned that the Notice, which was never debated by Congress, could end up costing taxpayers tens of billions of more dollars on top of the hundreds of billions of dollars already approved by Congress in the financial rescue plan. He also feared that the Notice could have the unintended consequence of motivating more financial firms wanting future tax deductions to shelter their earnings to buy competitors, leading to more consolidation in the financial industry than would be necessary to restore stability in the financial sector.

Given that the Notice does not have an expiration date, leaving its future uncertain, he is concerned that this change in federal tax law may lead to takeovers motivated solely by the opportunity to take advantage of tax savings.

Senator Schumer and others more broadly questioned the rationale for making this change and why was there no consultation with Congress. The Section 382 change was made prior to the Treasury’s rollout of its capital infusion program; and there was a question whether Treasury still thought the change to Section 382 was necessary as part of its financial rescue efforts. Another fear was that this change could create an incentive for consolidation beyond what is necessary for stability in the financial sector.

Even more broadly, the prospective repeal of Notice 2008-83 reveals Congress’ belief that allowing the Notice to stand would thwart a main goal of the financial rescue program to permit taxpayers to share in the upside as the financial industry recovers. The repeals signals congressional belief that it would be against taxpayer interests to allow these tax deductions to be carried forward, since it would reduce the taxable profits of the banks making the purchases and reduces taxpayers’ potential.
Class Action Removable to Federal Court Under CAFA

Securities class actions covered by the Class Action Fairness Act of 2005 were removable to federal court, concluded a 7th Circuit panel. The case, which arose from a real estate investment trust merger,conflicts with a July 2008 9th Circuit case on the interplay between the non-removal provisions of the 1933 Act and CAFA.

In the earlier decision, Luther v. Countrywide Home Loans Servicing, LP, the 9th Circuit held that the class action was not removable because the CAFA did not supersede the specific bar against removal contained in Securities Act Section 22(a). The court explained that Section 22(a) bars the removal of cases brought in state court asserting only claims arising under the Securities Act. The 9th Circuit panel found that the specific bar to removal in Section 22(a) was not trumped by the CAFA's more general grant of removal.

The 7th Circuit, however, rejected this interpretation,finding that CAFA prevailed. Initially, the 7th Circuit panel rejected the plaintiff's claim that he was a "buyer" of securities after he converted his existing holdings into cash. Judge Easterbrook wrote for the panel that "the `fundamental change doctrine' that turns a sale into a purchase is word play designed to overcome the actual text of the securities law." He added that the 9th Circuit in Luther "failed to recognize" the proper relationship between the statutes and that the court in Luther "did not appear to understand" the impact of CAFA.

The appellate panel remanded the case to the federal district court to determine if any exemption from CAFA was available. "The best approach is to have the district court hold a hearing at which the parties can elaborate on their positions,for the characterization of an ambiguous claim is closer to a question of fact than to one of law," explained the court.

Katz v. Gerardi
9th Circuit: SOX Whistleblower Claim Properly Denied

The Department of Labor properly affirmed an administrative review board's dismissal of a whistleblower claim under Sarbanes-Oxley Act Section 1514A, concluded a 9th Circuit panel. The employee, who reported alleged accounting improprieties by his employer, Intel Corp., to the SEC did establish a prima facie case of retaliatory behavior. However, the review board found, and the Labor Department properly affirmed, that Intel rebutted the presumption of improper conduct by presenting sufficient evidence of performance-related causes for the termination.

The appellate panel's decision was unpublished.

Halloum v. Dept. of Labor

Wednesday, January 14, 2009

Auditors Advised on Going Concern Issues Spawned by Financial Crisis

In light of the impact of the current crisis on financial statements, the European Federation of Accountants has advised auditors on issues ranging from fairly valuing securities to going concern considerations. The advice given by the group is so specific that it rises to the level of best practices for auditors in these difficult financial times. The going concern advice is particularly detailed and relevant.

Auditors will need to ensure that they fully consider the going concern assessments and only refer to going concern in their audit reports when appropriate. For their part, companies’ directors and management need to ensure that they prepare thoroughly for their assessment of going concern and make appropriate disclosure.

In the federation’s view, the current economic situation does not necessarily mean that a material uncertainty exists about a company’s ability to continue as a going concern or justify auditors modifying their reports to draw attention to going concern. Similarly, extensive disclosures, of themselves, are not indicative of the existence of a significant doubt on the company’s ability to continue as a going concern.

The current pressure on corporate cash flows means that liquidity risk is likely to be a material risk for many more companies, said the group, resulting in an increased need for companies to present relevant disclosures concerning liquidity risk. Auditors will need to examine the directors’ processes underlying the preparation of these disclosures which provides useful evidence for auditors with respect to the validity of the going concern assumption.

Auditors’ consideration of the directors’ assessment of going concern will encompass evaluating the means by which the directors have satisfied themselves it is appropriate to prepare the financial statements on a going concern basis, focusing on the future availability of finance, the reliability of the company’s information systems, the adequacy of underlying assumptions, and written representations. Auditors must also conclude whether or not they concur with the directors’ view. They must also assess whether the financial statements contain adequate and readily understandable disclosures relating to going concern.

Following this analysis, the auditors will determine the implications for their reports on the financial statements. If auditors conclude that the disclosures regarding going concern are not adequate, a qualified or adverse opinion will need to be issued by referring to the existing material uncertainty. If a material uncertainty exists that leads to significant doubt about the ability of the company to continue as a going concern and these uncertainties have been adequately disclosed in the company’s financial statements, auditors are required to modify their reports by including an emphasis of matter paragraph.

In this respect, it should be noted that what constitutes a material uncertainty that may cast significant doubt on the company’s ability to continue as a going concern is a judgment involving not only the nature and materiality of the events or conditions giving rise to uncertainty; but also the ability of the company to mitigate the uncertainty by adopting alternative strategies that are reasonably expected to resolve the foreseen problems.

According to the federation, determining what constitutes a material uncertainty involves assessing both the likelihood of an event or condition occurring and the impact it will have if it occurs. For example, the lack of a positive confirmation from a bank does not of
itself provide evidence of a material uncertainty that casts significant doubt on the entity’s ability to continue as a going concern, reasoned the federation, since it could also be increased caution on the part of the bankers. Investors and lenders must read all of the relevant information in annual reports and other financial statements before making decisions. Users should also realize that proper and solvent entities may become rapidly affected when liquidity starts to fall short.

Under such conditions, the going concern assumption that is normally underlying any audit opinion may need to be considered in a different perspective. It would be advisable when the financial statements of entities that are within the boundaries of such expectations disclose these elements at such place that it will attract the attention of the user immediately.

Tuesday, January 13, 2009

House Bill Would Require SEC to Reinstate the Uptick Rule

Acting on a growing congressional sentiment for the SEC to reinstate the uptick rule, which was rescinded in 2007, Rep. Gary Ackerman has introduced a bill, HR 302, in the 111th Congress that would order the SEC to reinstate the uptick rule within 90 days.The uptick rule, Rule 10a-1, required all short sale stock transactions to be conducted at a price that was higher than the price of the previous trade. The SEC claims that they fully researched the regulation before it was repealed, but some commenters have noted that the research took place during one of the biggest bull markets in history.

In the wake of the elimination of the uptick rule, noted Mr. Ackerman, many volatile stocks that the regulation was designed to protect are being driven down as a result of manipulative short sale practices. He believes that the reinstatement of the uptick rule would help curb these abuses and ensure greater stability and confidence in the market. Under a reinstated uptick rule, he continued, fewer companies would fail, less investors would be driven out of the market, and more capital would remain in the stock markets

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

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

A small audit firm has asked the US Supreme Court to declare the PCAOB unconstitutional because Sarbanes-Oxley Act provisions creating the Board violated the separations of powers and Appointments Clause by stripping the President of all powers to appoint or remove or otherwise supervise Board members. In its petition, the firm said that the Board is a congressional attempt to create a ``Fifth Branch’’ of the federal government over which the President has less control than over ``Fourth Branch’’ agencies like the SEC which currently reflect the outermost constitutional limits of congressional restrictions on the executive. (Free Enterprise Fund v. PCAOB, Dkt No 08-861).

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

The US Court of Appeals for the DC Circuit, by a 5-4 vote, denied full or en banc review of the split panel decision. Given the fact that four circuit judges wanted a full review of the constitutional issues surrounding the Board’s creation made it almost certain that Supreme Court review would be sought.

The full circuit court denied the rehearing en banc in a one page order, with no written opinions. Judge Kavanaugh, who dissented in the panel opinion, would have granted review. He was joined by Circuit Judges Ginsburg and Griffith, and Chief Judge Sentelle. Voting to deny full court review were Judges Brown and Rogers, who were the majority on the panel decision, and Judges Henderson, Tatel, and Garland.

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

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

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

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

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

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

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

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

But the audit firm argued that allowing the panel opinion to stand would permit Congress to dramatically alter the rules governing the organization of the federal government by reducing the President to the symbolic role of appointing bipartisan independent commissioners with defined tenure who, in turn, would appoint independent Boards that do the actual governing, but cannot be removed by the President in any circumstance or even by the independent agency absent offenses which would justify impeachment.

While the panel found that the President had influence over the SEC, said the audit firm, it did not suggest that such influence could coerce the SEC to exercise its discretion to remove Board members. Thus, since the President cannot order the SEC to remove a Board member, the Act strips the President of any power to remove and violates constitutional separation of powers.

A President facing an SEC reluctant to remove a Board member would have only the avenue of removing all the recalcitrant commissioners and nominating new ones that he or she hoped would effectuate the removal; and then the Senate would have to confirm the new commissioners. The audit firm concluded that this unrealistic removal scenario, itself hostage to Senate concurrence, violates separation of powers. The firm said that earlier Supreme Court decisions recognized that the President’s removal authority is a necessary element of executive power and cannot be subject to plenary congressional control.

Monday, January 12, 2009

Financial Crisis Advisory Group Members Named; First Meeting Scheduled

The first meeting of the joint IASB-FASB advisory group created to consider financial reporting issues arising from the global financial crisis will occur this month. The group is co-chaired by Hans Hoogervorst, Chairman of the Netherlands Authority for the Financial Markets and former SEC Commissioner Harvey Goldschmid. Mr. Hoogervorst also serves as Vice-Chairman of the IOSCO Technical and is a former Dutch Finance Minister. The SEC and the Basel Committee have been named as observers.

The advisory group is comprised of auditors, investors, regulators, and preparers of financial statements and will help ensure that financial reporting issues arising from the crisis are considered in an internationally coordinated manner. It is expected that the work of the advisory group will be completed within a four to six month period.

Recently named members of the advisory group are Jerry Corrigan, former President of the NY Federal Reserve Bank and chair of the Counterparty Risk Management Policy Group, and Gene Ludwig, former US Comptroller of the Currency. Other members are Lucas Papademos, Vice President of the European Central Bank; and Don Nicolaisen, former SEC Chief Accountant. Recommendations from the advisory group will be jointly considered by the two boards. Any decisions to act upon the recommendations will be subject to appropriate due process. In the interest of transparency, the advisory group will meet in public session with webcasting facilities available to all interested parties.

In recent remarks at a UK seminar on restoring confidence in the financial markets, Chairman Hoogervorst said that a global response to the financial crisis is critical in order to prevent regulatory arbitrage and a regulatory race to the bottom. He also believes 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.