Tuesday, March 31, 2009


NASAA Launches ARS Arbitration Information Center


The North American Securities Administrators Association (NASAA) announced today that it has launched a new website to assist auction rate securities (ARS) investors with the arbitration of their claims.

According to NASAA, the settlements reached by state securities regulators with several major brokerage firms have resulted in the return of more than $60 billion to ARS investors. The settlements further provide, however, that ARS investors who are also seeking consequential damages may elect to pursue their claims using a "special arbitration procedure." Under the special procedure, all settling firms have agreed to pay forum costs, while most have agreed to pay filing fees. Moreover, the claims are brought before a single public arbitrator, rather than the mixed public-private panels found in the standard arbitration process governed by FINRA.

The website is intended to guide investors step-by-step through the arbitration process. Investors first identify the brokerage firm, then identify the state (if applicable) and download the documents they need. Currently, the website provides information pertaining to the arbitration of claims against Citigroup and Wachovia. Investors are instructed to "stay tuned" for more information.
Target Company Directors Satisfied Their Duty of Loyalty in Merger Approval

Directors of a target company satisfied their duty of loyalty and discharged their Revlon duties to maximize shareholder value in a merger situation, ruled the full Delaware Supreme Court. While it was a quick sale done within a week with no market check, the directors valued the company, they knew the market for that kind of company, they tried to get better terms, and ended up with a premium offer that received overwhelming shareholder approval. ( Lyondell Chemical Co. v. Ryan, Del. Supreme Court, No. 401, March 25, 2009).

When a Schedule 13D was filed, the target directors believed that the company was in play, but took a wait and see approach. While the trial court criticized the directors for slothful indifference for languidly awaited overtures from potential suitors reacting to the acquirer’s SEC Schedule 13D filing, the Supreme Court said that the wait and see approach after the 13D filing was an entirely appropriate exercise of the directors’ business judgment.

Revlon duties do not arise simply because a company is in play, said the Court. The duty to seek the best available price applies only when a company embarks on a transaction on its own initiative or in response to an unsolicited offer that will result in a change of control. The time for action under Revlon did not begin until the day the directors began negotiating the company’s sale. The Chancery Court wrongly focused on the directors two months of inaction, said the en banc Court, when it should have focused on the one week during which they considered the offer.

During that crucial week, the directors met several times to consider a premium offer. They knew the company’s value and followed the advice of legal and financial advisers. They tried to negotiate a higher offer, evaluated the price offered and the likelihood of obtaining a better price, and then approved the merger at a premium price. While they did not conduct a market check before agreeing to the merger, they did not breach their duty of loyalty by failing to act in good faith.

There is only one Revlon duty, said the Supreme Court, to get the best price for the shareholders in a sale of the company. No court can tell directors exactly how to accomplish that goal because they will be facing a unique combination of circumstances, many of which will be outside their control. There is no single blueprint that a board must follow to fulfill its Revlon duties

They did not act in bad faith, said the Court. Bad faith is when fiduciaries intentionally fail to act in the face of a known duty to act, demonstrating a conscious disregard for their duties. According to the Court, there is a vast difference between an inadequate or flawed effort to carry out fiduciary duties and a conscious disregard for those duties.

Directors must be reasonable not perfect, continued the Court. In a merger situation, an extreme set of facts is required to sustain a disloyalty claim premised on directors intentionally disregarding their duty. If directors fail to do all that they should have done, said the court, they breach their duty of care. But only if they knowingly and completely fail to undertake their duties would they breach their duty of loyalty. Instead of questioning whether the independent directors did everything they arguably should have done to obtain the best sale price, explained the Court, the inquiry should have been whether those directors utterly failed to attempt to obtain the best sale price.

There may have been a triable issue of due care, intimated the Court, but the duty of due care was not on the table because the company’s charter had a clause protecting directors for liability for breaches of due care, but not for breaches of loyalty.

Monday, March 30, 2009

Financial Oversight Chairs Pledge to Work Together to Produce Reform Legislation by Year End

In a letter to President Obama, Senator Christopher Dodd and Rep. Barney Frank pledged to work together in a bicameral and bipartisan effort to pass legislation reforming the regulation of the nation’s financial markets by the end of the year. Senator Dodd is Chair of the Banking Committee, and Rep. Frank is Chair of the Financial Services Committee. The oversight Chairs said that they would work expeditiously, carefully and deliberately to create a framework for 21st century regulation that will enhance financial stability and protect consumers and investors.

The legislators said that they agree with the Administration’s core principles for modernizing financial regulation as recently articulated by Treasury Secretary Tim Geithner, including providing for systemic risk regulation, strengthening consumer and investor protection, streamlining prudential supervision, and addressing regulatory gaps, such as with hedge funds and other private pools of capital. In drafting legislation, the leaders will also be guided by the principles of openness, transparency, and plain language.

As part of the reform, the Chairs will draft legislation comprehensively reforming corporate governance and executive compensation at financial institutions. They promised to work with the Administration to ensure a new corporate governance framework focused on strict accountability and the promotion of long-term value. One of the most consistent criticisms of current executive compensation is that it favors short-term performance and contributes to excessive risk taking.

While recognizing that the adoption of regulatory rules is a sovereign decision, the chairs want to prevent regulatory arbitrage; and so they will consult closely with other major cross-border financial centers in an effort to coordinate legislation.
Companion House-Senate Bills Designate Council of Regulators as Systemic Risk Regulator

Rep. Mike Castle, a senior member of the House Financial Services Committee, has introduced legislation, H 1754, to create a systemic risk regulator. The measure is a companion bill to S 644, a measure introduced by Senator Susan Collins that would create a new federal systemic risk regulator to monitor the financial markets and oversee financial regulatory activities. Eschewing the Federal Reserve Board for such a role, the companion bills, both named the Financial System Stabilization and Reform Act, would create an independent Financial Stability Council to serve as systemic risk regulator. The Financial Stability Council would be composed of representatives from the Fed, the SEC, the CFTC, the FDIC and the National Credit Union Administration. The council would maintain comprehensive oversight of all potential risks to the financial system, and would have the power to act to prevent or mitigate those risks.

Recently, SEC Chair Mary Schapiro told the Senate Banking Committee that the Commission favors a college of regulators for systemic risk rather than a single systemic risk regulator. Banking Committee Chair Christopher Dodd also endorsed a council of regulators for systemic risk. Ms. Schapiro specifically made favorable mention of S 664.

Given the regulatory failures leading up to this crisis, Senator Dodd has concerns about systemic risk authority residing exclusively with any one body. For example, there have been problems with regulated bank holding companies where they have not been well-regulated at the holding company level. That is why the Banking Committee Chair is intrigued by the idea of a council approach to addressing systemic risk.
The new Financial Stability Council would be led by a chair nominated by the President and confirmed by the Senate, with the responsibility for the day-to-day operations of the council.

The chair would be required to appear before Congress twice a year to report on the state of the country's financial system, areas in which systemic risk are anticipated, and whether any legislation is needed for the Council to carry out its mission of preventing systemic risks
As financial institutions speculated in increasingly risky products and practices leading to the current crisis, not one federal financial regulator was responsible for detecting and assessing the risk to the system as a whole. The financial sector was gambling on the rise of the housing market, yet no single regulator could see that everyone, from mortgage brokers to credit default swap traders, was betting on a bubble that was about to burst. Instead, each agency viewed its regulated market through a narrow lens, missing the total risk that permeated the financial markets.

In order to prevent this problem from recurring, Senator Collins envisions a single financial regulator tasked with understanding the full range of risks faced by the final system. This regulator will also be authorized to take proactive steps to prevent or minimize systemic risk. The legislation guarantees holistic regulation of the financial system as a whole, not just its individual components. The bills reject the idea of a single regulator, such as the Fed, being given systemic powers in favor of a body made up of the key federal financial regulators in favor of collaborative systemic risk oversight.

Under the bills, whenever the Financial Stability Council believes that a risk to the financial system is present due to a lack of proper regulation, or by the appearance of new and unregulated financial products or services, it would have the power to propose changes to regulatory policy, using the statutory authority provided to existing federal financial regulators.

The Council would also have the power to obtain information directly from any regulated provider of financial products and, in limited form, from state regulators regarding the solvency of state-regulated insurers.

The Council will also be able to propose regulations of financial instruments which are designed to look like insurance products, but that in reality are financial products which could present a systemic risk. But Senator Collins assured that the bill does not preempt state law governing traditional insurance products.

The measure empowers the Council to address the `too big to fail'' problem by adopting rules designed to discourage financial institutions from becoming ``too big to fail'' or to regulate them appropriately if they become systemically important financial institutions.

Under the legislation the Council would help make sure financial institutions do not become ``too big to fail'' by imposing different capital requirements on them as they grow in size, raising their risk premiums, or requiring them to hold a larger percentage of their debt as long-term debt. Senator Collins clarified that the Council’s power is not meant to restrict financial institutions from growing in size, but rather from becoming risks to the system as a whole.
State Securities Officials Bid to Readjust State-Federal Regulation as Part of Legislative Reform Effort

State securities regulators have asked for increased authority over investment advisers and the general ability to address fraud in its earlier stages as part of financial regulatory reform legislation, effectively asking Congress to revisit the SEC-state model established by the National Securities Markets Improvements Act of 1996. In testimony before the Senate Banking Committee, Fred Joseph, President of the North American Securities Administrators Association, noted that the Markets Improvement Act preempted much of the states’ regulatory apparatus for securities traded in national markets, and although it left state antifraud enforcement largely intact, it limited the states’ ability to address fraud in its earliest stages before massive losses have been inflicted on investors. Mr. Joseph is also the Colorado Securities Commissioner.

NASAA is asking for nothing less than a reordering of the state-federal regulatory regime set up for investment advisers by the Markets Improvement Act. More specifically, the NASAA chief asked Congress to give state regulators authority over investment advisers with up to $100 million in assets under management. Currently, as provided by the Markets Improvement Act, state securities regulators have authority over investment advisers managing up to $25 million in assets, while all advisers managing assets over that amount must register with the SEC.

According to Mr. Joseph, Congress intended that the SEC would periodically review this allocation of authority and adjust it appropriately. Indeed, the Markets Improvement Act specifically authorizes the SEC to set an amount higher than $25 million, as the Commission deems appropriate. Urging legislation to increase the assets under management test for state regulation purposes to $100 million, he said that such an adjustment is appropriate in light of changes in the economic context. He pointed out that even small investment advisers typically have more that $25 million under management. In addition, this increase will reduce the number of federally registered investment advisers, thereby permitting the SEC to better focus its examination and enforcement resources on the largest advisers. The term ``assets under management’’ is one of art; and is defined in the Act as securities portfolios over which the adviser provides continuous and regular supervision or management services.

The NASAA head also asked Congress to increase the states’ enforcement authority over large investment advisers. Currently, a state can only take enforcement action against an SEC-registered investment adviser if it finds evidence of fraud. He urged that this authority be broadened to encompass any violations under state law, including dishonest and unethical practices. This enhancement of state authority will deter all forms of abuse by the large investment advisers, he emphasized, without interfering with the SEC’s exclusive authority to register and oversee the activities of the large investment advisers.

Until 1996, both federal and state regulations governed securities offerings. The Markets Improvement Act eliminated the dual system of regulations for certain securities offerings, and prohibited states from requiring the registration of such securities. NASAA is now asking Congress to reinstate state regulatory oversight of all Regulation D Rule 506 offerings by repealing Section 18(b)(4)(D) of the Securities Act. Even though these securities do not share the essential characteristics of the other national securities offerings addressed in the Markets Improvement Act, Congress precluded the states from subjecting them to regulatory review. These offerings also enjoy an exemption from registration under federal securities law, he noted, so they receive virtually no regulatory scrutiny. The Markets Improvement Act preempted the states from prohibiting Regulation D offerings even where the promoters or broker-dealers have a criminal or disciplinary history.

Moreover, Mr. Joseph said that some courts have held that offerings made under the guise of Rule 506 are immune from scrutiny under state law, regardless of whether they actually comply with the requirements of the rule, citing Temple v. Gorman (SD Fla 2002), CCH Fed. Sec. L. Rep. No. 2019, ¶91,733. In Temple, a federal judge ruled that claims for violations of state registration requirements were preempted by the National Securities Markets Improvement Act. Securities offered pursuant to the registration exemption of Regulation D's Rule 506 were covered securities and exempted from state registration requirements, held the court, even if the private placement did not comply with the substantive requirements for the exemption.

Since the passage of the Markets Improvement Act, NASAA has observed a steady and significant rise in the number of offerings made pursuant to Rule 506 that are later discovered to be fraudulent. Further, most hedge funds are offered pursuant to Rule 506, so state securities regulators are prevented from examining the offering documents of these investments, which represent a huge dollar volume. Although Congress preserved the states’ authority to take enforcement actions for fraud in the offer and sale of all covered securities, including Rule 506 offerings, he stressed that this power is no substitute for a state’s ability to scrutinize offerings for signs of potential abuse and to ensure that disclosure is adequate before harm is done to investors.

Sunday, March 29, 2009

UK FSA Says that We have Crossed the Financial Regulatory Rubicon

As the legislative overhaul of the regulation of the financial markers looms, there is a growing consensus that the global financial system has crossed the Rubicon and there will be no return to the world of Glass-Steagall separation of securities and banking activities and the days of originate and hold before securitization.

While acknowledging the theoretical clarity of this model, the FSA Turner report on reform said that it would be difficult for any one country to pursue a clear separation while other countries did not, and there is unlikely to be an agreement on an appropriate division, given the very different historic traditions in the US and Europe. Moreover, it is not clear that in its extreme and simple form, it is practical in today’s complex global economy. Thus, large complex financial institutions spanning a wide range of activities are likely to remain a feature of the world’s financial system.

In the US, the Glass Steagall Act drew a clear regulatory distinction between commercial and investment banking, which survived until dismantled through legislative changes in the 1990s. But in most of continental Europe, there was no such distinction, and universal banks were involved in securities related activities. Moreover, the era of almost complete separation between banking and securities activities was also an era of fixed exchange rates and exchange controls, with far more limited capital flows and trade flows as a percentage of GDP, and a much smaller role played by cross-border corporations.

Serving the financial needs of today’s complex globally interconnected economy, which let us not forget has, over the long term, delivered rising prosperity, said the FSA, requires the existence of large complex financial institutions providing financial risk management products which can only be delivered off the platform of extensive market making activities, which inevitably involve at least some position taking.

Moreover, said the report, if more effectively regulated and supervised, securitization can provide the advantages of lower cost and lower risk. Thus, the optimal financial
system for the future probably will include a significant role for securitized credit.

The FSA said that this approach is broadly in line with that put forward in the Group of 30 Report authored by a committee chaired by Paul Volcker, which seeks to constrain risk taking within large integrated financial institutions, rather than require a disintegration into separate institutions.
UK FSA Regulatory Reform Charts Way Forward on Mark-to-Market Accounting

UK Financial Services Authority Chair Adair Turner has set out a broad plan for overhauling financial regulation that envisions a systemic risk macro prudential regulator and increased reporting requirements for unregulated financial institutions such as hedge funds. The Turner plan also wrestles with the conundrum of fair value mark-to-market accounting. It is a conundrum because, in normal times, there are significant merits to this accounting approach when viewed from the perspective of an investor seeking accurate information on the value of a security. But in a financial crisis, the application of mark-to-market can feed procyclicality

If a security has a clearly defined market value, noted the Turner report, this is indeed the best indicator of what the shareholders indirectly own at the balance sheet date. And the evidence of the crisis suggests that the financial institutions which most rigorously applied mark-to-market approaches, identifying rapidly the impact of falling prices, performed best since they exited problem asset areas faster and at lower eventual cost.

But from the point of view of regulators, and of systemic financial risk, mark-to-market has serious disadvantages because it can fuel systemic procyclicality. The report observed that the mark-to-market approach means that irrational exuberance in asset prices can feed through to high published profits and perhaps bonuses, encouraging more irrational exuberance in a self-reinforcing fashion. When markets turn down, it can equally drive irrational despair. And, at the systemic level, the idea that values are realizable because they are observable in the market at a point in time is illusory.

If all market participants attempt simultaneously to liquidate positions, reasoned the UK report, markets which were previously liquid will become in illiquid, and realizable values may be significantly lower than the published accounts suggest. Thus, the application of fair value mark-to-market accounting played a significant role in driving the unsustainable upswing in credit security values in the years running up to 2007; and exacerbated the downswing.

This then is the essential challenge of the fair value accounting regime: it makes sense in stable conditions; but is not optimal when viewed from a regulatory, systemic and macro-prudential viewpoint.

The report states, however, that it is possible to devise an approach which can meet both requirements. The key features of this new regime would be using existing accounting rules to determine specific profit and loss, including derivative positions, which would continue to reflect fair value mark-to-market approaches, while augmenting these rules with the creation of a non-distributable Economic Cycle Reserve, which would set aside profit in good years to anticipate losses likely to arise in future. As with a regulatory capital buffer, there are two ways by which the size of this reserve could be determined. It could either be proposed by management, after extensive consultation with boards and risk committees, and approved by regulators or by a pre-determined formula.

In a discussion paper accompanying the report, the FSA emphasized that, at the current time, for both conceptual and practical reasons, fair value accounting should continue to be used for derivatives and for instruments held for trading purposes. In both cases, a mark-to-market approach is the correct one. For those assets held for the longer term the cost less impairment approach should be applied.

Friday, March 27, 2009

SEC Must Have Role in Systemic Risk Regulation Says SEC Chair Schapiro

As Congress considers legislation to create a systemic risk regulator with consolidated power over large financial institutions, SEC Chair Mary Schapiro emphasized that the SEC must have a role in the areas of systemic risk that are part of its investor protection mandate. In testimony before the Senate Banking Committee, Ms. Schapiro also said that she supports the Administration’s proposal to regulate hedge funds, credit default swaps, and OTC derivatives as part of the systemic risk regulation legislation

The SEC Chair said the Commission favors a college of regulators for systemic risk rather than a single systemic risk regulator. Banking Committee Chair Christopher Dodd also endorsed a council of regulators for systemic risk. Ms. Schapiro specifically made favorable mention of a bill, S 664, sponsored by Senator Susan Collins, that would create an independent Financial Stability Council to serve as the systemic risk regulator. The Financial Stability Council would be composed of representatives from the Federal Reserve Board, the SEC, the CFTC, the FDIC and the National Credit Union Administration.

Given the regulatory failures leading up to this crisis, Senator Dodd has concerns about systemic risk authority residing exclusively with any one body. For example, there have been problems with regulated bank holding companies where they have not been well-regulated at the holding company level. That is why the Banking Committee Chair is intrigued by the idea of a council approach to addressing systemic risk.

The SEC Chair said that how Congress defines a systemically important financial institution will be very critical to the scope of the systemic risk regulator’s authority. If the definition is too broad, she fears that the systemic risk regulator could usurp the authority of multiple regulators, including the SEC. The systemic risk regulator should not diminish the role of the SEC, noted Ms. Schapiro, adding that systemic risk cannot trump investor protection.

The SEC Chair assured Congress that the Commission can perform its critical capital markets and investor protection functions without compromising the oversight of systemic risk. Indeed, she believes that investor protection enhances the mission of controlling systemic risk. As the primary regulator of important market functions, she reasoned, the SEC would be a critical party in contributing to any systemic risk regulator's evaluation of risks.

Senator Dodd said that the SEC should have a role in systemic risk regulation; and advised the Chair to ``kick down the door’’ to make sure the Commission has input. There are many types of risk, said the senator. Just as there are many aspects of the financial system, he explained, systemic risk itself has many parts as well. One is the regulation of practices and products which pose systemic risks, from subprime mortgages to credit default swaps

Regarding the Administration’s request for legislation authorizing the government to take control and unwind non-bank financial institutions such as securities and commodities firms, the SEC Chair generally supports such resolution authority; but again, wants the SEC to be part of actions involving broker-dealers and other market players that it regulates. It is unclear if SIPC proceedings on brokerage firm liquidation would be rolled into the new scheme or whether the resolution authority would coordinate with SIPC. Senator Dodd, who supports the resolution authority in principle, said that he wants the SEC to have an appropriate role in the proceedings. He said that the Committee will be deeply involved in how the resolution authority interacts with the SEC and other functional regulators.

Thursday, March 26, 2009

FINRA Proposes Amendments to Form U4, U5 and FINRA Rule 8312

The Financial Industry Regulatory Authority ("FINRA") proposed rule changes to Form U4 , Uniform Application for Securities Industry Registration or Transfer, Form U5, Uniform Termination Notice for Securities Industry Registration, and FINRA Rule 8312 ("Broker-Dealer Disclosure).

The
proposed rule changes address regulatory concerns, ease, clarify or facilitate industry reporting requirements, and make technical and conforming amendments.
Administration Proposes Systemic Risk Legislation Covering Regulation of Hedge Funds, Credit Default Swaps, and OTC Derivatives

In testimony before the House Financial Services Committee, Treasury Secretary Tim Geithner outlined a broad legislative overhaul of the parallel unregulated universe of hedge funds, credit default swaps and OTC derivatives as part of creating a systemic risk regulator for the financial markets. The centerpiece of the legislative proposal is the creation of a federal systemic risk regulator with consolidated power over all systemically important firms that can impact the financial markets. The legislation should define the characteristics of covered firms, set objectives and principles for their oversight, and assigns responsibility for regulating these firms.

The Treasury Secretary suggested that, in identifying systemically important firms, the following characteristics should be considered: the financial system’s interdependence with the firm, the firm’s size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding, and the firm’s importance as a source of credit for households, businesses, and governments, and as a source of liquidity for the financial system.

The single systemic regulator must also be empowered to impose liquidity, counterparty, and credit risk management requirements that are more stringent than for other financial firms. For example, regulations must require more demanding liquidity constraints; and also mandate that these firms be able to aggregate counterparty risk exposures on an enterprise basis within a matter of hours.

In conjunction with the creation of a macro-prudential regulator for the markets, the Administration proposes federal regulation of systemically important financial institutions and entities that can impact the broader financial markets. The legislation should require SEC registration of all advisers to hedge funds and other private pools of capital, including private equity funds and venture capital funds, with assets under management over a certain threshold.

All such funds advised by an SEC-registered investment adviser should be subject to investor and counterparty disclosure requirements and regulatory reporting requirements. The regulatory reporting requirements should require reporting, on a confidential basis, information necessary to assess whether the fund or fund family is so large or highly leveraged that it poses a threat to financial stability. The SEC should share the reports that it receives from the funds with the entity responsible for oversight of systemically important firms, which would then determine whether any hedge funds could pose a systemic threat and should be subjected to the prudential standards administered by the systemic risk regulator.

The financial crisis has been amplified by excessive risk-taking by insurance companies and poor counterparty credit risk management by many banks trading credit default swaps on asset-backed securities. These complex instruments were poorly understood by counterparties, noted Mr. Geithner, and the implication that they could threaten the entire financial system or bring down a company of the size and scope of AIG was not identified by regulators, in part because the credit default swap markets lacked transparency.

Thus, the Administration proposes, for the first time, the federal regulation of the markets for credit default swaps and over-the-counter derivatives. Under the proposal, all dealers in OTC derivative markets and any other firms whose activities in those markets pose a systemic threat will be placed under a strong federal regulatory regime as systemically important firms. In addition, the legislation will mandate that all standardized OTC derivative contracts be cleared through appropriately designed central counterparties subject to comprehensive settlement systems supervision and oversight.

At the same time, all non-standardized customized derivatives contracts must be reported to trade repositories and will be subjected to robust standards for documentation and confirmation of trades, netting, collateral and margin practices, and close-out practices.

Further, in an effort to bring unparalleled transparency to the OTC derivatives markets, the legislation would require the central counterparties and trade repositories to make aggregate data on trading volumes and positions available to the public and make individual counterparty trade and position data available on a confidential basis to federal regulators, including those with responsibilities for market integrity. The draft will also strengthen participant eligibility requirements and, where appropriate, introduce disclosure or suitability requirements. Further, all market participants will be required to meet recordkeeping and reporting requirements.

There are currently bills in the Senate and House dealing with the regulation of credit default swaps. Recently, in testimony before the Committee, SEC Commissioner Elisse Walter said that credit default swaps are analogous to insurance arrangements with respect to the risk of default on a corporation's debt. In exchange for one party's payment of a specific sum of money to a counterparty (similar to an insurance premium), the counterparty guarantees payment of predetermined amount ("face value") of a corporation's debt in the event of default. The amount paid as a "premium" for default protection is directly correlated with the perceived risk of default by the corporation.

Turning to money market funds, the Secretary noted that the Lehman Brothers’ bankruptcy taught the lesson that even one of the most stable and least risky investment vehicles, money market mutual funds, is not safe from the failure of a systemically important institution. These funds are subject to strict regulation by the SEC and are billed as having a stable asset value, a dollar invested will always return the same amount. But when a major prime money fund broke the buck, the event sparked sharp withdrawals across the entire industry. Those withdrawals resulted in severe liquidity pressures, not only on prime money market funds, but also on financial and non-financial companies that relied significantly on money funds for funding. The vulnerability of money market funds to breaking the buck and the susceptibility of the entire industry to sharp withdrawals in such circumstances remains a significant source of systemic risk.

Thus, the Administration believes that the SEC should strengthen the regulatory framework around money market funds in order to reduce the credit and liquidity risk profile of individual funds and to make the money market fund industry as a whole is less susceptible to runs.

Weaknesses in the settlement systems for key funding and risk transfer markets, notably overnight and short-term lending markets and OTC derivatives, have been highlighted as a key mechanism that could spread financial distress between institutions and across borders. Authority over such arrangements is incomplete and fragmented.

Thus, legislation should give a single entity broad and clear authority over systemically important payment and settlement systems and activities. Where such systems or their participants are already federally regulated, the authority of those federal regulators should be preserved and the single entity should consult and coordinate with those regulators.
California Clarifies Form D Filing Procedures After SEC's 3/16/2009 Electronic Form D Filing Mandate

Procedures for filing Form D to claim California's Rule 506 or Section 25102(f) exemptions were clarified by the Department of Corporations in light of the SEC's requirement, effective March 16, 2009, that Form D be filed electronically at the federal level.

Section 25102.1(d) [Rule 506]. Issuers claiming federal preemption under Rule 506 of federal Regulation D at California statutory section 25102.1(d) must file a copy of the SEC-filed and -accepted version of Form D, accompanied by a $300 fee. The filing must include a consent to service of process at Rule 260.165 or Form U-2, Uniform Consent to Service of Process, if Temporary Form D was filed with the SEC before March 16, 2009 but does not require a consent to service of process or Form U-2 if Form D was filed electronicallywith the SEC. The filing must be submitted to the Department of Corporationsno later than 15 days after the first sale in California.

Section 25102(f). Issuers claiming an exemption at statutory section 25102(f) from California qualification requirements, if filing a copy of Form D rather than electronically filing a notice with the Department of Corporations, must file a copy of the SEC-filed and -accepted version of Form D, accompanied by the appropriate fee based on the value of securities proposed to be sold at Section 25608(c) and a cover letter stating that Form D is filed in reliance on Section 25102(f). The filing must include a consent to service of process at Rule 260.165 or Form U-2, Uniform Consent to Service of Process, if Temporary Form D was filed with the SEC before March 16, 2009 but does not require a consent to service of process or Form U-2 if Form D was filed electronically with the SEC. The filing must be submitted to the Department of Corporations no later than 15 days after the first sale in California.


The failure to file the notice or the failure to file the notice within the time specified by the rule of the commissioner shall not affect the availability of this exemption. An issuer who fails to file the notice as provided by rule of the commissioner shall, within 15 business days after discovery of the failure to file the notice or after demand by the commissioner, whichever occurs first, file the notice and pay to the commissioner a fee equal to the fee payable had the transaction been qualified under Section 25110.

NOTES for either filing above: (1) An electronic signature on a copy of electronic Form D is accepted in California; (2) California does not require amendments or annual renewals; and (3) Issuers filing electronically with the SEC are advised to allow adequate time to obtain an EDGAR access code before filing with the SEC, to meet the California 15-day filing requirement.

Mail all filings to: California Department of Corporations, 1515 K. Street, Suite 200, Sacramento, California 95814.

Questions regarding Form D filing requirements may be called in to 1 (866) ASK-CORP [(1) 866-275-2677].

For the full text of this Release, No. 120-C, please see here.

IAASB Values Relationship with PCAOB

In its annual report, the International Auditing and Assurance Standards Board named the PCAOB as one of its key stakeholders as the goal of global auditing standards comes into sharper focus. Recently, the IAASB completed its Clarity Project to revise and redraft all of its 36 international auditing standards as a precursor to a global set of accepted auditing standards.

The IAASB said that its observer status at meetings of the PCAOB’s Standing Advisory Group allows it to keep in touch with PCAOB develop­ments and provide the PCAOB with an international view on a number of its auditing standards projects. The advisory group meets two or three times a year and, at these meetings, the IAASB is often represented by its Chair. This activity complements the PCAOB’s observer membership on the IAASB’s Consultative Advisory Group.

The IAASB pledged to find ways to work together more closely with the PCAOB. Both Boards agree that it is desirable to avoid unnecessary differences between their respective standards. To that end, the IAASB noted that the PCAOB recently issued a proposed new auditing standard related to the auditor’s assessment of and response to risk in an audit. The Board was pleased to note that the PCAOB began by consider­ing international auditing standards with the aim of achieving a degree of commonal­ity, while at the same time recognizing that certain changes were necessary. The IAASB said that it would continue to monitor the PCAOB as it continues its work on these important standards. The IAASB views the use of its international standards as a basis for the PCAOB’s proposed new standard as a testament to the value placed on the IAASB’s standard-setting pro­cesses and output.

Wednesday, March 25, 2009

Administration Unveils Draft Legislation Authorizing Federal Takeover of Systemically Risky Securities and Commodities Firms

Presaged by testimony before the House Financial Services Committee in which Treasury Secretary Tim Geithner and Fed Chair Ben Bernanke asked Congress to pass legislation allowing the government to take control and unwind non-bank financial institutions such as securities and commodities firms, the Obama Administration unveiled draft legislation empowering a federal regulator to manage the resolution of such firms efficiently and effectively in a manner that limits systemic risk with the least cost to the taxpayer, in conjunction with the primary regulator of the affected institution.

According to Treasury, the lack of a federal regulatory regime and resolution authority for large systemic non-bank financial institutions contributed to the financial crisis and, unless addressed with legislation, will constrain a federal response to future crises. As demonstrated by AIG, severe distress at large global non-depository financial institutions can pose systemic risks to the financial markets just as distress at banks can. The Administration asks for legislation authorizing federal regulators to use the same set of tools for addressing distress at non-bank financial institutions as they currently posses to deal with distressed banks. Institutions covered by the proposed legislation would include holding companies that control broker-dealers, insurance companies, and futures commission merchants.

Before any of the emergency measures specified in the proposed legislation may be taken, Treasury, upon the positive recommendations of both the Fed and the appropriate primary federal regulator of the firm, and in consultation with the President, must make a triggering determination that the financial institution is in danger of becoming insolvent and that such insolvency would have serious adverse effects on financial stability.

Instead of subjecting a firm to bankruptcy or simply injecting taxpayers' funds, the draft legislation would allow for a federal conservatorship or receivership leading to orderly reorganization or wind-down. As part of this process, the draft would enable the federal conservator or receiver to sell or transfer the assets or liabilities of the firm, renegotiate or repudiate contracts, and address the firm’s derivatives portfolio.

The proposed legislation permits many forms of federal assistance in order to stabilize the institution in question, including making loans, purchasing obligations or assets, assuming or guaranteeing liabilities, and purchasing an equity interest in the institution. The federal conservator would also have the power to fundamentally restructure the institution by, for example, replacing its directors and senior officers without seeking the approval of the institution's creditors or other stakeholders.

The draft proposes a funding mechanism that could take the form of a mandatory appropriation out of the general fund of the Treasury or through a scheme of assessments on the financial institutions covered by the legislation. The government would also receive repayment from the redemption of any loans made to the financial institution in question, and from the ultimate sale of any equity interest taken by the government in the institution.

NASAA Rebuts SIFMA Testimony on Legal Standards of Care


The North American Securities Administrators Association (NASAA), the Consumer Federation of America, and the Investment Adviser Association have called upon Congress to apply a fiduciary duty to all financial professionals who give investment advice regarding securities. Writing in a joint comment letter to Chairman Christopher Dodd and Ranking Member Richard Shelby of the Senate Banking Committee, the commenters sought to rebut recent testimony from the Securities Industry and Financial Markets Association (SIFMA) concerning the legal standards of care owed to investors by broker-dealers and investment advisers. Although agreeing that investor protection would be strengthened if a consistent legal standard governed the provision of investment advisory services, they strongly disagreed with SIFMA that the standard should be anything less than a fiduciary duty. Accordingly, the commenters urged Congress to extend fiduciary standards to all entities providing investment advice, regardless of their licensing status.

The commenters rejected SIFMA's recommendation of a "universal standard of care" that expresses, in plain English, principles of "fair dealing." They acknowledged the superficial appeal of such a standard, one apparently based on the good faith and fair dealing requirements in arm's length transactions between commercial parties under the Uniform Commercial Code. The commenters strongly believe, however, that the application of this commercial standard to the relationship of financial service providers and their clients would greatly diminish investor protection. Rather, they asserted that the investor protection benefits of investment adviser fiduciary standards, under which advisers have an affirmative duty to act in the best interests of their clients and to make full and fair disclosure regarding conflicts of interest, should be extended to anyone who offers investment advice, including broker-dealers.
US Securities Exchanges Urge SEC to Adopt Modernized Uptick Rule

With Congress readying legislation directing the SEC to reinstate rule 10a-1, the uptick rule, a consortium of US securities exchanges sent a letter to SEC Chair Mary Schapiro urging the Commission to adopt a modified and modernized version of the uptick rule. The exchanges also urged the Commission to adopt a Circuit Breaker that would trigger the application of the modified uptick rule only after the price of a stock has experienced a precipitous decline by a certain percentage, perhaps ten percent. The letter was signed by the CEOs of NYSE Euronext, NASDAQ, BATS Exchange, and the National Stock Exchange.

The original uptick rule, rescinded by the SEC in 2007, provided that short selling could occur only when the last sale was at or above the previous sale. This longstanding rule was understood by the trading community and supported by issuers. But the exchanges said that the original uptick rule, which had remained virtually unchanged since its adoption over 70 years ago, would be difficult to implement and enforce in the current penny increment market structure. Moreover, the exchanges reasoned that the original rule would not be as prohibitive in markets where transaction prices change multiple times in a single second and message traffic has exploded to billions of messages storming down on the markets every day.

Instead, the exchanges proposed a modernized version of the uptick rule under which short selling could only be initiated at a price above the highest prevailing national bid by posting a quote for a short sale order priced above the national bid. As such, the execution of a short sale would occur only at a higher price than the prevailing market at the time of initiation, and only on a passive basis. This restriction would greatly assist the prevention of manipulative short selling, said the letter, which so harms the markets.

In the exchanges’ view, the modified rule is superior to the original uptick rule in several ways. For one thing, it is conceptually simple. Also, it is likely to be more effective in dampening downward price pressure, and easier to program into trading and surveillance systems than the original rule. While there is no perfect solution, the exchanges believe that the modified rule is the most effective answer to deal with the faster-moving, post-Regulation NMS trading environment and to reduce downward pressure on stocks created by abusive short selling.

In addition, the most practical and effective way to structure adherence to the modernized rule would be similar to oversight of the trade-through rule under Regulation NMS. In this vein, the modified rule would be a policies and procedures requirement, and brokers would have responsibility for ensuring compliance with the rule before sending a short sale order into the marketplace. Exchanges could offer order types to assist brokers in performing their compliance duties, but would rely on a broker’s indication that they had performed the required due diligence on the order when so indicated.

In combination with the adoption of the modified uptick rule, the exchanges urged the SEC to adopt a Circuit Breaker that would trigger the application of the modified rule only after the price of a stock has experienced a precipitous decline by a certain percentage, perhaps ten percent. Noting that markets have successfully used circuit breakers on both broad indexes and individual securities for many years, the exchanges emphasized that a Circuit Breaker permits normal market activity while a stock is trading in a natural range and short selling is more likely to benefit the market by, for example, increasing price discovery and liquidity.

Conversely, a Circuit Breaker will restrict short selling when prices begin to decline substantially and short selling is more likely to become abusive and harmful. The Circuit Breaker is particularly efficient in stable and rising markets because it avoids imposing continuous monitoring and compliance costs where there is little or no corresponding risk of abusive short selling

With respect to the Circuit Breaker, the exchanges recognize that the SEC will have to determine the proper reference price for calculating it, as well as the duration of the Circuit Breaker once triggered. Also, the network processors must determine how to disseminate an indication that a Circuit Breaker has been triggered and, later, lifted. For their part, the exchanges and their member firms must provide estimates of programming and testing requirements for both the Circuit Breaker and the modified uptick rule.
Draft Legislation Designates CESR as Single EU Regulator for Credit Rating Agencies

A committee of the European Parliament has reported out legislation providing for the regulation of credit rating agencies under a single EU-wide regulator, the Committee of European Securities Regulators (CESR). Rejecting the European Commission’s proposal for national regulation, the Economic and Monetary Affairs Committee designated CESR as the sole registration and
supervisory body over EU rating agencies. Parliament will now take up the legislation.

Under the draft legislation, CESR would be in charge of registering credit rating agencies, checking their compliance with the rules and ultimately withdrawing an agency's registration should the rules be breached. CESR would inform Member State authorities once all registration steps are accomplished. On an ongoing basis, CESR would also be in charge of monitoring the past performance of rating agencies and publishing statistical data on the reliability of ratings issued. To that end, credit rating agencies must make available in a public central repository, to be established by CESR, information on their historical performance data and information about past credit rating activities.

The committee referred to credit rating agencies as a de facto oligopoly that clearly underestimated the credit risk inherent particularly in structured credit products and did not adapt their ratings when the markets fell. Given this background, the committee concluded that ratings agencies should be subject to strict regulation. The legislative effort signals the failure of voluntary regulation through codes of conduct for rating agencies

A major issue dealt with in the draft is how to let European investors use non-EU ratings while maintaining the same criteria as for EU ratings. Embracing an equivalence regime, the legislation provides that non-EU ratings would have to be endorsed by an EU credit rating agency and comply with equivalent criteria to those in the EU legislation. A list of third country legislation and regulation considered equivalent to the EU credit rating agency regulatory regime will be prepared by the European Commission and regularly updated by the Commission.

Pending harmonized global rules, stated the committee report, ratings issued by credit
agencies not subject to European regulation could be used as long as these ratings are confirmed
and endorsed by an agency based within the European Union, in the sense of its assuming
responsibility and certifying that the agency that issued the rating is bound by regulation
equivalent to that which exists in the EU. The report emphasized that this is an opportune moment to promote healthy competition in the field of credit rating agencies by favoring the establishment of credit rating agencies with a head office in Europe. To this end, Member States will encourage entities to be rated to use agencies which have their head office located in the EU for a proportion of the ratings to be obtained.

The European Commission proposed the strict regulation of credit rating agencies in an effort to restore confidence in the markets. The legislation is designed to ensure that the ratings issued by the agencies are independent, objective, and of the highest quality. The new regime is based on concepts of transparency and independence. According to Commissioner for the Internal Market Charlie McCreevy, the proposed regime for credit rating agencies will ensure that regulators with responsibility for oversight will have at their disposal sufficient resources and expertise to keep up with financial innovation and to challenge the rating agencies in the right areas, on the right issues, and at the right time.

The legislation provides for a rotation mechanism to avoid conflicts of interest. A key goal of the reforms is to avoid conflicts of interest between the agency issuing the rating and the rated organization. The draft requires that a rotation mechanism be implemented to ensure that rating agency analysts who are in direct contact with the rated entity be rotated out after five years. In order to avoid negative effects on rating agency performance, the draft stresses that rotation should be on an individual basis rather than changing the entire team.

Other reforms would require rating agencies to disclose the compensation arrangements with their clients. In addition, compensation and performance evaluation of analysts providing the credit ratings cannot be contingent on the amount of revenue that the credit rating agency derives from the rated entities. Further, analysts and other employees who are directly involved in the credit rating process must not be allowed to participate in negotiations regarding fees or payments with any rated entity.

Incorporating the concept of differentiation, the legislation provides that credit rating agencies should use different rating categories when rating structured finance instruments and provide additional information on the different risk characteristics of these products. They should also indicate when rating a product for the first time and when rating a newly-created product.

Tuesday, March 24, 2009

SEC Commissioner Walter Details Hedge Fund Enforcement and Extraordinary Efforts Being Made in Madoff Case

As the financial crisis deepens, SEC enforcement activities have focused intensely on a number of institutional players in the financial market, including hedge funds. According to Commissioner Elisse Walter, the huge number of liquidations and suspensions of redemptions by hedge funds in the past year have created particular concern at the Commission over whether hedge fund advisers may be favoring their own interests above others and whether principals, employees or favored investors of the advisers may have received preferential redemptions from the fund at issue. I

In
testimony before the House Financial Services Committee, the official said that, in an effort to better detect any insider trading before material corporate events, the SEC’s Hedge Fund Working Group is developing technological tools that will enable staff to more readily capture patterns of unlawful trading by hedge funds and institutional traders. Separately, the commissioner described the extraordinary efforts the SEC is making in the SIPA liquidation of the Bernard Madoff Investment Fund, LLC, particularly the international initiative to uncover the Madoff feeder funds.

The SEC is focusing on a number of issues involving hedge funds and other institutional traders, including manipulation, insider trading, valuation of illiquid securities, abusive short selling and collusion. Working under the auspices of the Enforcement Division, the Hedge Fund Working Group is addressing these and other issues arising in investigations relating to hedge funds. The Hedge Fund Working Group works closely with SEC examiners, while at the same time coordinating with outside agencies and foreign regulators.

The commissioner said that the SEC has dozens of active investigations involving individuals associated with hedge funds. During the current crisis, the SEC has become particularly concerned about possible hedge fund offering frauds, where fraudsters use the non-transparent and largely unregulated status of hedge funds to conceal large Ponzi schemes. The SEC is also concerned with possible misconduct by funds of funds and feeder funds, which invested their own investors' funds with other hedge fund managers, but may have failed to exercise the due diligence and compliance oversight touted to investors regarding such investments.

The Commission has brought a broad range of enforcement actions involving hedge funds and institutional traders. While hedge funds are not required to register with the SEC, she noted, the Commission retains limited authority over hedge funds under the antifraud provisions of the federal securities laws. Despite the relative lack of regulation in this area, the Commission has brought over 100 cases involving hedge funds in the last five years, primarily under its antifraud authority.

In these actions, the SEC obtains asset freezes and other emergency relief to halt the alleged frauds. In addition, the Commission can seek permanent antifraud injunctions, disgorgement and civil penalties. In some cases, the SEC coordinates its actions with parallel criminal proceedings filed by the U.S. Attorney. The Commission also coordinates with other regulators that have filed related charges.

The Commission has also pursued numerous cases involving information leakage within the financial markets, particularly with respect to large financial institutions that may possess inside information about numerous clients, including hedge funds and other institutional traders. These include cases in which the SEC has charged large broker-dealers with having inadequate information barriers or other internal controls that prevent misuse of confidential inside information, such as allowing the firm's proprietary traders to have access to confidential information about upcoming research reports or about clients' upcoming mergers and acquisitions, as well as cases involving alleged misuse of such information about clients' trading activities.

Commissioner Walter also outlined the extraordinary efforts being made by the SEC to recover funds for investors in the massive Bernard Madoff Ponzi scheme. While the SIPA liquidation of the Madoff investment firm proceeds apace, the SEC has been probing all facets of the scheme to secure assets for investors. The SEC has committed considerable enforcement and examination resources to this effort, including 18 enforcement attorneys and investigators in the New York Regional Office, 30 examiners from New York and three other regional offices around the country.

In addition, emphasized the commissioner, the SEC is coordinating its investigations with numerous domestic and international agencies, such as the Justice Department, the FBI, the SIPC, the UK Financial Services Authority and a court-appointed receiver in the UK, as well as various other European securities regulators. One aspect of this international coordination is identifying Madoff feeder funds.

The Commission is also working with the Department of Labor with respect to ERISA plans that invested pension funds with the Madoff firm, as well as with FINRA and Attorneys General and regulators from various states that are also interested in investigating the Madoff fraudulent scheme.
Sirri Outlines SEC's Systemic Risk Role and Lessons from CSE Program

As Congress considers creating a systemic risk regulator as part of a new financial services regulation structure, noted SEC Director of Trading and Markets Erik Sirri, the Commission is focusing on how best to deploy its broker-dealer expertise in the new regulatory paradigm. In testimony before the Senate Securities Subcommittee, he asked that the SEC’s regulatory expertise be recognized and deployed efficiently. He also listed some important lessons learned from the SEC’s supervision of investment banks under the Consolidated Supervised Entity (CSE) program.

For a set of large broker-dealer holding companies that are not affiliated with banks, he noted, the SEC supports a program that would permit the Commission to also set capital standards at the holding company level, perhaps, in consultation with a holding company regulator, if any. In addition, the director envisions that the SEC will obtain financial information about and examine the holding company and material affiliates.

These broker-dealer holding companies may also have an emergency liquidity provider, which would not be the SEC. But the SEC would determine the universe of broker-dealer holding companies that would be subject to parent company capital standards. The remaining broker-dealer holding companies not affiliated with banks would be subject to material affiliate reporting requirements, similar to the reporting regime under Section 17(h) of the Exchange Act.

Given the recent dialogue about systemic regulation, the director noted that the SEC’s experience with the bankruptcy filing of a foreign affiliate of Lehman Brothers demonstrated the innate difficulties of any multi jurisdictional approach to regulation. While cross border coordination is important, he said, jurisdictions nonetheless have unique bankruptcy and financial regulatory regimes. In addition, creditors wherever they are located will always act in their own interest during a crisis. Thus, a U.S. liquidity provider might be faced with the difficult choice of guaranteeing the assets of the holding company globally, or else risk creditors exercising their rights against foreign affiliates or foreign supervisors acting to protect the regulated subsidiaries in their jurisdictions, either of which could trigger bankruptcy of the holding company. The official described these as ``thorny issues’’ that Congress should consider carefully

He also testified that the Bear Stearns and Lehman Brothers' experience challenged a number of assumptions held by the SEC. Long before the CSE program existed, the SEC's supervision of investment banks recognized that capital is not synonymous with liquidity. A firm could be highly capitalized, that is, it can have far more assets than liabilities, while also having liquidity problems. While the ability of a securities firm to withstand market, credit, and other types of stress events is linked to the amount of its capital, he reasoned, the firm also needs sufficient liquid assets, such as cash and U.S. Treasury securities, that can be used as collateral to meet its financial obligations as they arise.

The CSE program built on this concept and required stress testing and substantial liquidity pools at the holding company to allow firms to continue to operate normally in stressed market environments. But what neither the CSE regulatory approach nor most existing regulatory models have taken into account was the possibility that secured funding, even that backed by U.S. Treasury securities, could become unavailable. The existing models for both commercial and investment banks are premised on the expectation that secured funding would be available in any market environment, albeit perhaps on less favorable terms than normal.

Thus, he pointed out that one lesson from the SEC's oversight of CSEs is that no parent company liquidity pool can withstand a run on the bank. Supervisors simply did not anticipate that a run-on-the-bank was indeed a real possibility for a well-capitalized securities firm with high quality assets to fund. Given that the liquidity pool was sized for the loss of unsecured funding for a year, such a liquidity pool would not suffice in an extended financial crisis of the magnitude now being experienced, he emphasized, where firms are taking significant write downs on what have become illiquid assets over several quarters while the economy contracts.

These liquidity constraints are exacerbated when clearing agencies seize sizable amounts of collateral or clearing deposits to protect themselves against intraday exposures to the firm. Thus, he said that, for financial institutions that rely on secured and unsecured funding for their business model, some modification, such as government backstop emergency liquidity support, may well be necessary to plug a liquidity gap on an interim basis, to guarantee assets over the longer term, or to provide a capital infusion.

Another lesson relates to the need for supervisory focus on the concentration of illiquid assets held by financial firms, particularly in entities other than a U.S. registered broker-dealer. Such monitoring is relatively straightforward with U.S. registered broker-dealers, which must disclose illiquid assets on a monthly basis in financial reports filed with their regulators. Also, registered U.S. broker-dealers must take capital charges on illiquid assets when computing net capital. As a result, illiquid assets often are held outside the registered U.S. broker-dealer in other legal entities within the consolidated entity. So, for the consolidated entity, supervisors must be well acquainted with the quality of assets on a group wide basis, monitor the amount of illiquid assets, and drill down on the relative quality of such illiquid assets.
SEC Would Be Part of Systemic Risk Regulator in Senate Reform Bill

A bill introduced by Senator Susan Collins would create a new federal systemic risk regulator to monitor the financial markets and oversee financial regulatory activities. Eschewing the Federal Reserve Board for such a role, the Financial System Stabilization and Reform Act, S 664, would create an independent Financial Stability Council to serve as systemic-risk regulator. The Financial Stability Council would be composed of representatives from the Fed, the SEC, the CFTC, the FDIC and the National Credit Union Administration. The council would maintain comprehensive oversight of all potential risks to the financial system, and would have the power to act to prevent or mitigate those risks. The draft legislation would also regulate investment banks for safety and soundness and close the gap that has allowed credit default swaps and other financial instruments to escape federal regulation.

The new Financial Stability Council would be led by a chair nominated by the President and confirmed by the Senate, with the responsibility for the day-to-day operations of the council. The chair would be required to appear before Congress twice a year to report on the state of the country's financial system, areas in which systemic risk are anticipated, and whether any legislation is needed for the Council to carry out its mission of preventing systemic risks
As financial institutions speculated in increasingly risky products and practices leading to the current crisis, not one federal financial regulator was responsible for detecting and assessing the risk to the system as a whole. The financial sector was gambling on the rise of the housing market, yet no single regulator could see that everyone, from mortgage brokers to credit default swap traders, was betting on a bubble that was about to burst. Instead, each agency viewed its regulated market through a narrow lens, missing the total risk that permeated the financial markets.

In order to prevent this problem from recurring, Senator Collins envisions a single financial regulator tasked with understanding the full range of risks faced by the final system. This regulator will also be authorized to take proactive steps to prevent or minimize systemic risk. The legislation guarantees holistic regulation of the financial system as a whole, not just its individual components.

The bill rejects the idea of a single regulator, such as the Fed, being given systemic powers in favor of a body made up of the key federal financial regulators. This type of collaborative systemic risk oversight is gaining a following in Congress. Senate Banking Committee Chair Christopher Dodd recently expressed skepticism that the Fed would be the appropriate systemic risk regulator. Senator Collins said that the Federal Reserve already has enough on its plate, and does not need additional, heavy responsibilities. She added that nothing in the bill alters the Fed’s role with respect to monetary policy in any way. Former Senator John Sununu has reasoned that, since systemic risk can materialize in a broad range of areas within the financial system, it would be impractical, and perhaps a dangerous concentration of power, to give one single regulator the power to set or modify all standards relating to such risk.

Under the bill, whenever the Financial Stability Council believes that a risk to the financial system is present due to a lack of proper regulation, or by the appearance of new and unregulated financial products or services, it would have the power to propose changes to regulatory policy, using the statutory authority provided to existing federal financial regulators. The Council would also have the power to obtain information directly from any regulated provider of financial products and, in limited form, from state regulators regarding the solvency of state-regulated insurers.

The Council will also be able to propose regulations of financial instruments which are designed to look like insurance products, but that in reality are financial products which could present a systemic risk. But Senator Collins assured that the bill does not preempt state law governing traditional insurance products.

The measure empowers the Council to address the `too big to fail'' problem by adopting rules designed to discourage financial institutions from becoming ``too big to fail'' or to regulate them appropriately if they become systemically important financial institutions.

Under the legislation the Council would help make sure financial institutions do not become ``too big to fail'' by imposing different capital requirements on them as they grow in size, raising their risk premiums, or requiring them to hold a larger percentage of their debt as long-term debt. Senator Collins clarified that the Council’s power is not meant to restrict financial institutions from growing in size, but rather from becoming risks to the system as a whole.

The bill also authorizes the Council to address so-called regulatory ``black holes,'' created by new and imaginative financial instruments that do not fall within the jurisdiction of any federal financial regulator. Credit default swaps are an example of this problem. Prior to 2000, credit default swaps existed in a regulatory limbo. Neither the SEC nor the CFTC were willing to exert authority over the credit default swap market. As a result, they fell through the jurisdictional cracks. Congress then compounded the problem by explicitly exempting credit default swaps from regulation under the Commodity Futures Modernization Act of 2000

The draft legislation specifically addresses the credit default swap problem by repealing the exemption from regulation that Congress created for these instruments in 2000, and by setting up a government-regulated clearinghouse.

But beyond credit default swaps, risky new financial instruments could still avoid the reach of the regulatory system. For that reason, the draft provides the Council with the power to propose regulations governing the sale or marketing of any financial instrument which would fall into a ``black hole,'' and would otherwise present a systemic risk to the financial system if left unmonitored.

Finally, the bill would apply safety and soundness regulation to investment bank holding companies by assigning the Federal Reserve this responsibility. The SEC would be able to regulate the broker-dealer operations. Under the draft legislation, the Council's role as the systemic-risk regulator would support the critical importance of the Federal Reserve's safety and soundness duties.
Kanjorski to Keynote NASAA Public Policy Conference

The North American Securities Administrators Association (NASAA) has announced that Rep. Paul E. Kanjorski (D-PA) will deliver the keynote address at NASAA's 24th Public Policy Conference in Washington, D.C. on April 28. Congressman Kanjorski chairs the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, which has jurisdiction over securities, exchanges, and most insurance matters. Among his legislative initiatives, Kanjorski introduced H.R. 6513, the Securities Act of 2008, which NASAA has supported as an effort to strengthen securities regulation.

NASAA also announced that this year’s conference will feature two panel discussions focusing on regulatory reform. The first panel will examine the challenges of restructuring our regulatory system and restoring investor confidence in the wake of the Madoff fraud and other financial scandals. The second panel will focus on systemic risk regulation and the need for greater transparency and regulation of hedge funds and derivatives.

Registration materials and a full conference agenda may be downloaded from the NASAA website.

Monday, March 23, 2009

Commissioner Paredes Suggests Four Ways to Make SEC Enforcement More Effective

SEC Commissioner Troy Paredes has suggested four ways to make SEC enforcement more efficient and effective: involving case selection, case tracking, cooperation credit, and self assessment. In remarks at the Southeastern Securities Conference in Atlanta, he said that he would be exploring these areas with the other commissioners and with the new Enforcement Director Robert Khuzami. (We were honored to have Commissioner Paredes as a guest blogger before he assumed his commissionership).

Case selection is critical, he maintained, since an effective enforcement program must have a strategy for selecting the investigations and enforcement actions to pursue and then determining how aggressively to pursue them. Given the SEC’s finite resources, he continued, the decision to pursue a particular matter can compromise the agency’s ability to investigate and bring other cases that can better serve investors and markets.

In constructing the right blend of cases, the SEC must ask itself a number of questions. The first question is how and to what extent did the misconduct harm investors. Similarly, it must be determined if the misconduct was intentional or the result of negligence. While the SEC should not abstain from bringing cases for negligence-based violations, he said, at the same time there must be adequate resources available to aggressively pursue those who intentionally violate the federal securities laws.

Another important question associated with case selection is whether there are alternative ways to address the violation short of an enforcement action. Some technical violations, for example, may be better addressed through remedial steps that parties have already undertaken or agree to undertake without an enforcement action.

The SEC should also ask what the impact of bringing one more case of a particular type will be. Specifically, it should be determined if there is an important deterrent effect from bringing another case of this type or have diminishing returns already set in. Similarly, there is the question of the marginal benefit of bringing a particular charge or advancing a particular legal theory. In this regard, the commissioner reasoned that a case built on untested legal theories may evoke a more strenuous defense that prolongs the matter at the expense of valuable Commission time.

A further consideration is whether the alleged wrongdoer will be meaningfully sanctioned through other sources. For example, if an individual is being pursued by federal criminal authorities, it may be more productive for the SEC to dedicate its efforts to matters that others may not pursue. Further, active private enforcement through litigation may counsel against an SEC action.

Secondly, with regard to case tracking, the commissioner recommended that the SEC’s system be enhanced so that the Enforcement Division can more effectively track the status of ongoing investigations and cases. In his view, a robust centralized tracking system would serve investors well. By affording senior Enforcement Division officials a comprehensive look at the range of ongoing and potential investigations and cases, the system would empower the Commission to allocate resources more strategically and make proper adjustments over time regarding how resources are expended. It is impossible to choose the best blend of cases without an at-the-ready panoramic look at all the options, he reasoned, and a complete understanding of what resources are being dedicated to what matters. An enforcement strategy without the information needed to implement it will fall short of its potential, he warned.

More robust centralized tracking would also better position the agency to achieve important synergies out of complementary enforcement efforts. For example, on an ongoing basis, senior Division officials would be better able to see interconnections among investigations and cases that, once identified, would allow the staff to work the matters more effectively. State-of-the-art centralized tracking would help the agency get the most out of the staff’s expertise. Such tracking also may enable the Commission to spot trends in fraud and manipulation cases sooner rather than later, thus allowing the SEC to take appropriate enforcement or regulatory steps expeditiously.

On the third point, the commissioner espoused giving defendants a credit for cooperation. Encouraging parties to self-report violations and otherwise cooperate with SEC investigations is an important enforcement tool, he averred, since it helps the Commission conserve resources and provides an opportunity to get helpful information concerning the perpetration of fraud and manipulation.

The Commission's 2001 Statement Concerning Cooperation, the Seaboard Report, guides the Commission in measuring the extent of a party's cooperation and assessing whether to bring an enforcement action. Cooperation credit is an asset that the Commission has at its disposal to grant.

Fourth and finally, Commissioner Paredes urged the SEC to periodically undertake a frank self-assessment that audits the agency’s progress as part of a rigorous evaluation of whether the enforcement program is accomplishing its goals. While conceding that this will not be easy to measure, the official said that the SEC cannot measure the actual impact of its enforcement program by overemphasizing the number of cases brought or the monetary sanctions imposed. The analysis he is suggesting, if done right, will be more nuanced and refined than focusing on such metrics to the exclusion of other considerations.

However, he cautioned that the SEC’s self-audit should not be taken as an opportunity to second-guess the staff, which often must make decisions under enormous time pressure and without perfect information. To be constructive and fair, he emphasized, the review must account for the actual environment in which decisions were made.
SEC Investment Management Director Calls for New Money Market Fund Model

As the financial crisis continues and money market funds face the most challenging period of their history, Andrew Donohue, the SEC’s Director of Investment Management has called for a review of rule 2a-7 and the money market fund model. Reform of the rule 2a-7 model is a high priority going forward for the Division of Investment Management. With almost $4 trillion in assets, money market funds are of fundamental importance to the financial system as they serve to meet the liquidity and capital preservation needs of all types of investors, both individual and institutional. In remarks at the Investment Management Conference in Palm Desert, the SEC official endorsed the recent Investment Company Institute recommendations for strengthening money market funds as a good first step in developing changes to rule 2a-7.

The ICI recommends, for the first time, imposing daily and weekly minimum liquidity requirements for money market funds; and requiring regular stress testing of a money market fund’s portfolio. The Institute also urges a tightening of the portfolio maturity limit currently applicable to money market funds. Client risk would be addressed by requiring money market fund advisers to adopt know your client procedures; for the first time, disclosing client concentrations by type of client and the potential risks posed by a fund with a client base that is strongly concentrated. In addition, monthly website disclosure of a money market fund’s portfolio holdings would be required.

The director recognizes that the stable net asset value of $1.00 has been an integral part of the money market fund model, but is also aware of the challenges that it presents. He wants to quickly develop recommendations to the Commission for changes to rule 2a-7 to protect money market investors.

Reform has become urgent. In addition to experiencing the first breaking of the buck by a widely-held money market fund, he observed, over 120 money market funds face their own credit or liquidity challenges. To allow the asset purchase or credit support arrangements for funds facing these challenges, he noted, over 30 firms have sought and promptly received no-action relief from Division staff.

The Division has actively worked with the managers of money market funds as they cope with events during the crisis. In addition, the official listed a number of important actions taken to assist various liquidity facilities to assist money market funds, including consulting with Treasury on the implementation of the Temporary Guarantee Program.

The staff issued a no-action letter stating that it would not object under the senior security provisions of the Investment Company Act if money market funds participate in the Temporary Guarantee Program. In addition, the Commission issued a temporary rule enabling a money market fund participating in the program to immediately suspend redemptions, as contemplated by the program, if it breaks the buck. This rule allows for an orderly wind down of a fund under the program.

Further, the staff issued a no-action letter permitting money market funds to access the Federal Reserve's Asset Backed Commercial Paper Facility through affiliated banks; and issued a subsequent letter clarifying diversification analysis and other operational impacts of the Federal Reserve's Money Market Investor Funding Facility. The Division staff also issued a no-action letter providing temporary relief for money market funds to shadow price securities at amortized cost, if they have a final maturity of 60 days or less.

According to the director, this temporary relief was granted based on the assertion that the markets for short-term securities, including commercial paper, were not functioning as intended or were not resulting in the discovery of prices that properly reflected the fair value of securities that were fully expected to pay off upon maturity. That relief has now expired. As required by rule 2a-7, emphasized Mr. Donohue, all money market funds should have resumed shadow pricing their portfolio securities based on their market price.
SEC Approves FINRA Rule 5122 re Private Placements of Securities Issued by Members

The SEC approved FINRA's proposal to adopt new FINRA Rule 5122, that will require a member offering or selling any security in a private placement issued by the member or a "control entity" to:

(1) disclose to investors in a private placement memorandum, term sheet or other offering document the intended use of offering proceeds and the offering expenses;

(2) file the offering document with FINRA; and

(3) commit that at least 85% of the offering proceeds will be used for business purposes, that will not include offering costs, discounts, commissions and any other cash or non-cash sales incentives.

FINRA Rule 5122 will take effect 30 days following publication of a FINRA Regulatory Notice announcing the date, with the notice to be published no later than 60 days following SEC approval.

For the text of FINRA Rule 5122, please see here.

Sunday, March 22, 2009

UK FSA Sets Out Blueprint for Massive Financial Regulatory Reform

UK Financial Services Authority Chair Adair Turner has set out a broad plan for overhauling financial regulation that envisions increased reporting requirements for unregulated financial institutions such as hedge funds as part of a pan-European systemic risk regulator. The plan envisions the retention of securitization under a reformed model, with no return to a Glass-Steagall like separation of banking and securities activities. The Turner plan also proposes the regulation of credit rating agencies to limit conflicts of interest and inappropriate application of rating techniques. The plan also calls for national and international action to ensure that executive compensation policies are designed to discourage excessive risk-taking.

A central theme of the FSA blueprint is that regulation must have a more macro-prudential focus. Thus, the FSA recommends the creation of a new European Union regulator, which would replace the Lamfalussy committees. This new body would be an independent authority with regulatory powers, a standard setter and overseer in the area of macro-prudential analysis, while leaving the primary responsibility for supervision at member state level.

While hedge funds are able to apply redemption gates in the event of significant investor withdrawals, the activity of hedge funds in the aggregate can have an important procyclical systemic impact on financial markets. The simultaneous attempt by many hedge funds to deleverage and meet investor redemptions may well have played an important role over the last six months in depressing securities prices in a self fulfilling cycle. And it is possible that hedge funds could evolve in future years, in their scale, their leverage, and their customer promises, in a way which make them more bank-like and more systemically important.

Thus, the report recommends that regulators be authorized to gather much more extensive information on hedge fund activities; and then consider the implications of this information for overall macro-prudential risks. Regulators must also be empowered to apply prudential regulation, such as capital and liquidity rules, to hedge funds or any other category of investment intermediary judged to have become of systemic importance.

Extension of prudential regulation to hedge funds raises the issue of the geographic coverage of regulation, noted the report, since many hedge funds are legally domiciled, principally for tax purposes, in offshore financial centers, even if the fund managers are legally domiciled and located in the UK, the US, or Switzerland. The report recommends a global agreement on regulatory priorities to include the principle that offshore centers must be brought within the ambit of internationally agreed upon financial regulation. Tighter effective controls in offshore centers will, however, become more important over time as regulation is improved in the major onshore locations and as the incentives for regulatory arbitrage through movement offshore therefore increase.

The report also takes aim at flawed valuation methods that contributed to the crisis. The development of complex securitized products necessitated the development of sophisticated mathematical techniques for the measurement and management of position-taking risks. The financial crisis revealed severe problems with these techniques. Thus, the report recommends significant changes in the way that VAR-based methodologies have been applied. Even more, there is the fundamental question of the ability in principle to infer future risk from past observed patterns.

At the very least, the report urges that VAR models be buttressed by the application of stress tests that consider the impact of extreme movements beyond those which the model suggests are at all probable. Deciding just how stressed the stress test should be, is however inherently difficult, and not clearly susceptible to any mathematical determination approaches.

An underlying assumption of financial regulation in the US and the UK has been that financial innovation is by definition beneficial, since market discipline will winnow out any value destructive innovations. As a result, the SEC and FSA have historically not considered it their role to judge the value of different financial products, and thus have avoided direct product regulation, certainly in wholesale markets with sophisticated investors.

But the report considers the possibility of the direct regulation of financial products identified as having potentially adverse financial stability effects, using credit default swaps as an example. Regulators should not treat it is as given that direct product regulation is by definition inappropriate, said Mr. Turner, but should be willing to consider over time whether particular markets have characteristics sufficiently harmful, and benefits sufficiently slight, as to justify intervention.

The FSA believes that regulatory reform must address issues relating to the proper governance and conduct of credit rating agencies and the management of conflict of interest. Legislation to achieve this aim is now being formulated by the European Union with regulation likely to enter into force in late summer 2009.

The FSA supports the aims of this legislation. As the draft legislation currently stands, credit rating agencies will be registered and financial regulators such as the FSA will play a supervisory role, coordinated at European level via colleges of supervisors, which will ensure that appropriate structures and procedures are in place to manage conflicts of interest and to reinforce analyst independence. This supervisory oversight should extend to requiring that rating agencies only accept rating assignments where there is a reasonable case based on historical record and adequate transparency for believing that a consistent rating could be produce. It is also important that the European legislation be matched to compatible global standards; and the FSA is working through IOSCO to achieve this goal.

Compensation policies created incentives for some executives and traders to take excessive risks that resulted in large payments in reward for activities which seemed profit making at the time but subsequently proved harmful to the institution, and in some cases to the entire financial system. In future the FSA will therefore include a strong focus on the risk consequences of compensation policies within its overall risk assessment of firms, and will enforce a set of principles which will better align compensation policies with appropriate risk management.

An initial draft of the Code which sets out these principles has already been published. Key principles within the Code include firms ensuring that their compensation policies are consistent with effective risk management and compensation committees reaching independent judgments on the implications of remuneration for risk and risk management. Another principle is that compensation should reflect an individual’s record of compliance with risk management rules, as well as financial measures of performance.

The effectiveness of the Code will depend on gaining widespread international agreement to publish and enforce similar principles in all major financial markets. Acting alone, the FSA cannot influence the policies of foreign firms operating in the London market, nor the practices followed in other financial centers where UK firms operate. Thus, the FSA has engaged with the Financial Stability Forum to forge that international agreement, and the FSF will shortly publish principles closely aligned with the FSA’s approach. Achieving international mechanisms to ensure application of the principles by all major financial authorities will be a crucial subsequent step
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