Thursday, April 30, 2009

Senate Passes Measure Strengthening Securities Fraud and Financial Fraud Enforcement; Creating Financial Markets Commission

A
bill to improve enforcement of securities fraud and financial institution fraud involving asset-backed securities and fraud related to federal assistance and relief programs has passed the US Senate. The bill was introduced by Senator Patrick Leahy, chair of the Judiciary Committee, and Senator Charles Grassley. Fraud contributed to an unprecedented collapse in the mortgage-backed securities market, he noted, and as Congress passes legislation to make sure this kind of collapse cannot happen again, a component of reform must be the reinvigoration of federal anti-fraud measures. The Senate also adopted an amendment sponsored by Senator Johnny Isakson creating a federal Financial Markets Commission to investigate the causes of the current financial crisis. The amendment was applauded by Senate Banking Committee Chair Christopher Dodd.

The Fraud Enforcement and Recovery Act, S 386, makes a number of important improvements to fraud and money laundering statutes to strengthen prosecutors' ability to combat this growing wave of fraud. Specifically, the legislation would amend the federal securities fraud statute to cover fraudulent schemes involving commodities futures and options, including derivatives involving the mortgage-backed securities that caused such damage to the banking system.

A week after the measure cleared the Committee, Senators Leahy and Grassley wrote a letter to the Senate leadership urging prompt action. They noted that the draft legislation includes important improvements to federal fraud and money laundering statutes to strengthen prosecutors' ability to confront fraud in mortgage lending practices, to protect TARP funds, and to cover fraudulent schemes involving commodities futures, options and derivatives, as well as making sure the government can recover ill-gotten proceeds from crime.

The bill also amends the definition of financial institution to extend federal fraud laws to mortgage lending businesses that are not directly regulated or insured by the federal government. These companies were responsible for nearly half the residential mortgage market before the economic collapse, yet they remain largely unregulated and outside the scope of traditional federal fraud statutes. This change will apply the federal fraud laws to private mortgage businesses just as they apply to federally insured and regulated banks.

Expanding the term financial institution to include mortgage lending businesses will also strengthen penalties for mortgage frauds and the civil forfeiture in mortgage fraud cases. It would also extend the statute of limitations in investigations of mortgage fraud cases to be consistent with bank fraud investigations. The new definition would also provide for enhanced penalties for mail and wire fraud affecting a financial institution, including a mortgage lending business.

The bill would also amend the major fraud statute to protect funds expended under the Troubled Asset Relief Program (TARP) and the economic stimulus package, including any government purchases of preferred stock in financial institutions. This change will give federal prosecutors and investigators the explicit authority they need to protect taxpayer funds.

This amendment will make sure that federal prosecutors have jurisdiction to use one of their most potent fraud statutes to protect the government assistance provided during this most recent economic crisis, including money from the TARP and circumstances where the government purchased preferred stock in companies to provide economic relief.

This bill will also strengthen one of the core offenses in so many fraud cases, money laundering, which was significantly weakened by a recent Supreme Court case. The bill would amend the federal criminal money laundering statute to make clear that the proceeds of specified unlawful activity include the gross receipts of the illegal activity, not just the profits of the activity. The money laundering statutes make it an offense to conduct financial transactions involving the proceeds of a crime, called specified unlawful activity in the statutes. These statutes, however, do not define the term “proceeds” and the term has been left to be defined by the courts. For 22 years, since the money laundering statutes enactment in 1986, courts have construed “proceeds” to mean gross receipts and not net profits of illegal activity consistent with the original intent of Congress.

But in United States v. Santos, 128 S.Ct. 2020 (2008), the Supreme Court suggested that the term “proceeds” was ambiguous and gave the term a narrower meaning. In this decision, according to Senator Leahy, the Court mistakenly limited the term “proceeds” to the profits of a crime, not its receipts, and as a result, the decision limited the money laundering statute to only profitable crimes, and permits criminal defendants to reduce their culpability for money laundering by deducting the costs of their criminal conduct.

For example, under the decision, an executive who committed securities fraud could not be charged with money laundering if the fraud were unsuccessful in making a profit, even though there was a fully completed financial transaction. This decision is contrary to the intent of Congress in passing the money laundering statutes, said the chair, and weakens one of the primary federal tools used to recover the proceeds of illegal activity, including mortgage and securities frauds.
European Commission Proposes Broad Regulation of Hedge Fund and Private Equity Fund Managers

In a move that is the first of its kind in the world, and anticipates similar legislation in the US, the European Commission has proposed the broad regulation of managers of heddde funds and all private equity funds with 100 millon euros of assets under management. The Directive on Alternative Investment Fund Managers is designed to create a comprehensive and effective regulatory framework for hedge and orivate equity fund managers at the European level. The proposed Directive will provide robust and harmonised regulatory standards for all alternative investment funds within its scope and enhance the transparency of the activities of the funds towards investors and public authorities. This will enable Member States to improve the macro-prudential oversight of the sector and to take coordinated action as necessary to ensure the proper functioning of financial markets. The proposed regulations would require extensive disclosure of valuations, risk management, and other aspects of fund governance.

There had been some confusion over whether just hedge funds would be included in the proposed regulations. Members of the European Parliament reecently expressed concern to the Commission that earlier remarks by Commissioner McCreevy indicated that only hedge funds would be covered by new regulations. In the end, the Commission opted for the broad regulation of all alternartive investment funds over a certain minimum asset management level. The Commission said that it was loath to attempt to define hedge funds, fearing that many systemically relevant funds may fall through a regulartory gap.

The proposed Directive parallels a proposal presented by the Obama Administration to Congress, which would federally regulate both hedge funds and other private equity funds. Fully acknowledging the need for harmonized fund regulation, the Commission anticipates similar US legislation later this year.

Tuesday, April 28, 2009

Utah To Increase Mutual Fund and Rule 506 Fees

The mutual fund/unit investment trust notice filing fee will increase to $600, from $500, and the Rule 506 notice filing fee will increase to $100, from $60, for filings received by the Utah Securities Division on or after July 1, 2009.

For more information, please contact Benjamin Johnson, Director of Corporation Finance at (801) 530-6134.

Thursday, April 23, 2009

Fraud Claim Could Not Rest on Omissions from Martin Act Disclosures

The New York Court of Appeals has held that the purchaser of a condominium could not bring a claim for common law fraud based solely on alleged material omissions from disclosures mandated by the New York Blue Sky Law (Martin Act). Reversing the decision below, the state high court emphasized that the Martin Act authorizes only the Attorney General to enforce its provisions and permits no private right of action. Although the plaintiff alleged that the defendants fraudulently represented that there were no material changes in the offering by not disclosing various construction and design defects, the court reasoned that the disclosures would not have been required but for the Martin Act and its implementing regulations. Accordingly, to accept the plaintiff's pleading as valid would impermissibly expand the statute's detailed disclosure requirements by transforming every claim concerning latent construction defects into a claim for common law fraud.

The state high court also rejected the plaintiff's claim that the defendants actively concealed fraud by repeatedly representing in plan amendments that there were no material changes of facts or circumstances. Nothing in the complaint supported claims of active concealment that were unrelated to the defendants' alleged omissions from Martin Act disclosures, the court held. At most, the court stated, the plaintiff's proposed second amended complaint alleged only that the defendants tolerated shoddy construction.

The court distinguished its holding from that in CPC International, Inc. v. McKesson Corp., where the court concluded that a purchaser of securities sufficiently pleaded a claim for common law fraud when it alleged that the seller and its investment bankers falsely prepared projections of revenues, operating expenses, and profits, while intentionally withholding other accurate projections. Unlike the instant case, the court stated, CPC International did not turn on the alleged non-disclosure of information required by the Attorney General's Martin Act regulations. Rather, the plaintiff in CPC International sufficiently pleaded common law fraud because, given its most favorable treatment, the complaint described a scheme to defraud.

Wednesday, April 22, 2009

PCAOB Staff Alert Advises Auditors on Impact of FASB Guidance on Fair Value Accounting

A recent PCAOB staff practice alert instructs auditors to evaluate whether a firm’s financial statement disclosures are in conformity with recent FASB guidance on mark-to-market fair value accounting. Also, depending upon the circumstances, the implementation of the guidance may present matters that the auditor should communicate to the audit committee. (Staff Audit Practice Alert No. 4).

New FAS 157-e affirmed that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction, not a forced liquidation or distressed sale, between market participants at the measurement date under current inactive market conditions. FASB also adopted guidance providing a clearer benchmark for when an other-than-temporary impairment exists and needs to be recorded on securities held outside of a firm’s trading book, and to transparently disclose the amount of the impairment directly associated with probable cash flow declines.

The practice alert advised auditors to evaluate whether disclosures in the financial statements being audited are in conformity with the disclosures required by the FASB guidance. FAS 157-4 requires the disclosure of changes in valuation techniques and related inputs for fair value measurements in interim and annual periods. FAS 115-2 requires disclosure enabling users to understand the reasons that a portion of other than temporary impairment was not recognized in earnings and the methodology and significant inputs used to calculate the portion recognized in earnings.

In addition, the Board staff advised auditors to read the MD&A accompanying the interim financial statements filed with the SEC since the MD&A and other filings might include discussions regarding fair value measurements and other than temporary impairment. Auditors should consider whether that information or the manner of its presentation is materially inconsistent with the financial statements. If the auditors conclude that there is a material inconsistency, or become aware of information they believe is a material misstatement of fact, the auditors should determine if the financial statements, the audit report, or both require revision.

Under FAS 157-4, revisions resulting from a change in the valuation technique are to be accounted for as a change in accounting estimate in the period of adoption. Firms are required to disclose a change, if any, in valuation technique and related inputs and quantify the total effect, if practicable, by major category. In addition, FAS 115-2 requires the company to recognize the cumulative effect of initially applying the guidance as an adjustment to the opening balance of retained earnings, as of the beginning of the period in which FAS 115-2 is adopted, with a corresponding adjustment to accumulated other comprehensive income.

The PCAOB staff advised auditors to evaluate whether the company's accounting for and disclosure of the changes are in accordance with the FASB guidance. To identify consistency matters that might affect the audit report, continued the alert, auditors should evaluate whether the comparability of the financial statements between periods has been materially affected by changes in accounting principles. The staff indicated that a change in accounting principle that has a material effect on the financial statements should be recognized in the audit report through the addition of an explanatory paragraph following the opinion paragraph.

More broadly, the staff alert advised that, in considering the effects of the FASB guidance on their audits and reviews, auditors should be aware that some PCAOB standards include descriptions of accounting requirements that are no longer current. The accounting standards set by the FASB are recognized by the SEC as generally accepted, continued the Board staff, and auditors should look to those standards and to the requirements of the SEC, rather than the standards of the PCAOB, for current accounting requirements and disregard descriptions of accounting requirements in PCAOB standards that are inconsistent with the recent FASB guidance.

It is axiomatic that the PCAOB has no authority to prescribe the form or content of an issuer's financial statements. Thus, while the staff audit practice alert describes applicable GAAP, it neither establishes nor interprets GAAP. The staff also noted that the PCAOB has a project on its standards-setting agenda to address the auditing standards related to auditing accounting estimates and auditing fair value measurements. In connection with this project, the PCAOB is planning to remove descriptions of accounting requirements from these standards.
US Supreme Court Will Conference on PCAOB Case in May

The US Supreme Court will hold a conference on May 14, 2009 to decide if the Court wants to hear a case challenging the constitutionality of the PCAOB. Four Justices have to vote in conference to hear the case in order for the Court to take the PCAOB case and ultimately decide the Board’s constitutionality.. If the Court decides to grant certiorari in the action, the case will almost certainly be set for oral argument and decision in the 2009-2010 Court term, which begins this October. The petitioner, a small audit firm, and the Government have filed their briefs in the case. Given that the conference is being held in May, it is likely that the Court will issue an order either granting or denying certiorari by the end of this term.

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

Upholding a district court ruling, a split federal appeals court panel decided that the PCAOB is constitutional and rejected claims that SEC rather than presidential selection of Board members violates the Constitution. The panel concluded that Board members are inferior officers of the United States within the meaning of the Appointments Clause; and thus properly appointed by the SEC. The fact that the Sarbanes-Oxley Act limited the SEC’s authority by providing that Board members can only removed for cause did not elevate Board members to the status of principal officers of the US worthy of presidential appointment. Despite the for-cause removal, said the panel, the fact remained that the Act gave the SEC comprehensive and pervasive control of the PCAOB, including the approval of the Board’s budget.

The US Court of Appeals for the DC Circuit, by a 5-4 vote, denied full or en banc review of the split panel decision. Given the fact that four circuit judges wanted a full review of the constitutional issues surrounding the Board’s creation made it almost certain that Supreme Court review would be sought. The full circuit court denied the rehearing en banc in a one page order, with no written opinions. Judge Kavanaugh, who dissented in the panel opinion, would have granted review. He was joined by Circuit Judges Ginsburg and Griffith, and Chief Judge Sentelle. Voting to deny full court review were Judges Brown and Rogers, who were the majority on the panel decision, and Judges Henderson, Tatel, and Garland.

In the federal district court, seven
former SEC chairs, including William Donaldson, Arthur Levitt, Harvey Pitt, David Ruder, and Roderick Hills, filed an amicus brief defending the PCAOB as constitutional. The former chairs described the PCAOB as being squarely within the historical structure of federal regulation of the capital markets, which has relied for decades on a unique combination of public-private institutional relationships under SEC oversight. The Board exists, maintained the former SEC heads, because of a Congressional conclusion that the system of profession-dependent self-regulation of auditing contributed to the corporate financial scandals of the recent past. And nothing in the federal Constitution denies Congress the power to make the policy judgments reflected in the legislative design of the PCAOB-SEC relationship, according to the brief.

For its part, the SEC has consistently and vigorously defended the PCAOB against this constitutional attack on the appointment process of Board members and the manner in which the Board conducts its operations. In a joint brief in the district court with the Justice Department, the SEC contended that the method detailed in Sarbanes-Oxley for appointing Board members satisfies the Appointments Clause. In addition, the brief said that the pervasive authority of the SEC to supervise and control the PCAOB’s activities refutes the depiction of the Board as a rogue agency running unchecked over the separation of powers. Also, the Commission said that the Board’s performance of diverse functions pursuant to a variety of intelligible principles defeats the argument that Sarbanes-Oxley unconstitutionally delegated legislative power to the Board.

Tuesday, April 21, 2009

Basel Guidance Links Sound Corporate Governance to Proper Fair Value Accounting

In the wake of FASB’s recent guidance on fair value accounting, the Basel Committee for Banking Supervision has issued guidance to financial institutions and their regulators designed to strengthen their valuation processes for financial instruments. The principles promote strong governance and risk management around valuations and the allocation of sufficient resources to create an independent valuation process.

The application of fair value accounting to a wider range of financial instruments, together with experiences from the recent market turmoil, have emphasized the critical importance of robust risk management and governance control processes around fair value measurements. Moreover, given the significance of fair value measurements for regulatory capital adequacy and internal risk management it is equally important that regulators assess the soundness of valuation practices through the Pillar 2 process under the Basel II Accord.

The guidance is intended for both two-tier and one-tier governance structures. Some countries, such as the Netherlands, use a two-tier structure, where the supervisory function of the board of directors is performed by a separate entity known as a supervisory board, which has no executive functions. Other countries, by contrast, such as the US, use a one-tier structure in which the board has a broader role. Basel refers to both approaches as corporate governance structures, which indeed they are.

A broad theme of the Basel guidance is that regulators should factor in governance and risk management when evaluating a firm’s valuation practices. In addition to communicating their concerns to firms about governance deficiencies, regulators can take informal or formal actions requiring management and the board to remedy the deficiencies in a specified timeframe and provide periodic written progress reports.

Stronger action may be needed if a firm exhibits significant weaknesses in its risk management policies, systems and controls related to valuations. For example, the regulator could determine that the firm needs to hold more capital in relation to its overall risk exposure under Pillar 2 of the Basel II Accord. Further, if such weaknesses call into question the reliability of the fair values, it is appropriate in certain circumstances to exclude from or make adjustments to Tier 1 capital for the associated unrealized gains or require other prudential adjustments for capital purposes such as for potential overstatement of fair value based on a third party valuation.

As part of sound governance, senior management should ensure that appropriate control policies are in place regarding the classification and any subsequent reclassification of financial instruments. Moreover, senior management should ensure that internal policies related to classification and reclassification of financial instruments are applied consistently over time and within a group. There must also be proper documentation supporting the initial classification and any subsequent transfers between asset categories.

Senior management and the board must also ensure that an independent, adequately funded fair valuation process is implemented and subjected to periodic review. As a corollary, there must also be an ongoing review of valuation models.

For inactive markets, a firm needs to put more work into the valuation process to gain assurance that the transaction price provides evidence of fair value or to determine the adjustments to transaction prices that are necessary to measure the fair value of the instrument. When a market is not active, a firm will measure fair value using a valuation model reflecting current market conditions.

Basel said it is fundamental that final approval of valuations should not be the responsibility of the risk taking units. There should be clear and independent reporting lines to ensure that valuations are independently determined. Financial institutions should maintain functional separation between the risk taking units that typically provide the initial fair valuation estimates and the measurement unit providing independent price verification.

Sound internal and external auditor procedures play an important role in the bank’s validation process. Auditors should devote considerable resources to reviewing the control environment, the availability and reliability of information or evidence used in the valuation process, and the reliability of estimated fair values. This includes the price verification processes and testing valuations of significant transactions. Auditors should also evaluate whether the disclosures about fair values made by the bank are in accordance with applicable accounting standards.

The use of a third-party pricing service for fair valuations for financial instruments does not relieve the board of its oversight responsibility or senior management of its responsibility to ensure appropriate fair valuations and provide appropriate supervision, monitoring and management of risks. Management should have a due diligence process by which it assesses third party pricing services that it uses for fair valuations so that it has a sufficient basis upon which to determine the appropriateness of the techniques used, the underlying assumptions and selection of inputs and the consistency of application.

Monday, April 20, 2009

SEC Defends Adoption of Rule 151A on Indexed Annuities against Federal Appeals Court Challenge

The SEC vigorously defended its adoption of Rule 151A defining indexed annuities as not being exempt annuity contracts under Section 3(a)(8) of the Securities Act against a federal court challenge to the rule. Relying on a series of US Supreme Court rulings, the SEC reasoned that, given the unpredictability of the securities markets, index annuities contain substantial risk that must be addressed by the disclosure regime established by the Securities Act so that investors can accurately evaluate their investment risk.

Earlier this year, the SEC adopted new rule 151A under the Securities Act in order to clarify the status under the federal securities laws of indexed annuities, under which payments to the purchaser are dependent on the performance of a securities index. Section 3(a)(8) of the Securities Act provides an exemption for certain annuity contracts. The new rule prospectively defines indexed annuities as not being “annuity contracts” under this exemption if the amounts payable by the insurer under the contract are more likely than not to exceed the amounts guaranteed under the contract. The effective date of Rule 151A is January 12, 2011, two years after its adoption. Rule 151A was challenged in the US Court of Appeals for the District of Columbia Circuit in American Equity Investment Life Insurance Company v. SEC, No. 09-1021. Oral argument is set for May 8, 2009.

In its
brief filed with the federal court of appeals, the SEC contended that its adoption of Rule 151A was based on a permissible construction of the term “annuity contract” in Section 3(a)(8). The Commission explained that purchasers of indexed annuities are exposed to a significant investment risk, namely the volatility of the underlying securities index, that the securities laws were enacted to address through disclosure to investors.

Applying the Chevron framework, the Commission said that it adopted Rule 151A pursuant to its express statutory authority to adopt binding rules and regulations that define terms. Further, the interpretation of “annuity contract” in Rule 151A is not unambiguously precluded by the statute. The Securities Act does not define “annuity contract,” continued the SEC, and the US Supreme Court in a series of rulings has made clear that the only contracts unambiguously covered by that term are the traditional fixed annuities that existed when Section 3(a)(8) was enacted in 1933. Because indexed annuities did not exist in 1933 and confront purchasers with investment risks that traditional fixed annuities do not, said the SEC, they are not unambiguously covered by Section 3(a)(8).

Moreover, the Commission said that it reasonably concluded that indexed annuities described by Rule 151A expose purchasers to investment risk that the Securities Act was intended to address through disclosure to investors and, therefore, are not the sort of annuity that Congress intended to leave exclusively to state insurance regulation through the Section 3(a)(8) exemption. The Commission reasoned that an indexed annuity in which the payout is more likely than not to be derived from the future performance of a securities index exposes an annuity purchaser to a significant investment risk, because his or her securities-linked return is not known in advance. This determination is consistent with case law, longstanding Commission interpretations, and common understanding of investment risk.

The SEC also said that it correctly concluded that none of the asserted burdens of Rule 151A on efficiency, competition and capital formation is a basis for altering the conclusion that an indexed annuity described by the Rule is not an exempt “annuity contract” under Section 3(a)(8). In any event, because the Commission adopted Rule 151A under its Section 19(a) authority to define terms, it was not required by the statute to analyze Rule 151A’s potential impact on efficiency, competition and capital formation.

The arguments that the Commission did not adequately address Rule 151A’s impact on small entities and that indexed annuities are not securities because they are not “investment contracts” are not properly before the Court, noted the SEC, because they address issues not raised by any party to the proceeding. In any event, neither has merit since the Commission asserted that it adequately addressed Rule 151A’s impact on small entities; and, under settled precedent, indexed annuities are investment contracts.

The critical question addressed in the US Supreme Court opinions construing Section 3(a)(8)’s exemption is whether the contract presents investment risks that the Securities Act was enacted to address. If so, the contract is not an exempt “annuity contract.” Rule 151A describes indexed annuities that do not qualify for the Section 3(a)(8) exemption.

Rule 151A is limited to indexed annuities that are “more likely than not” to pay a return based on the uncertain future performance of a fluctuating index of securities such as the Standard & Poor’s 500 Index. The Commission reasonably determined that these products expose purchasers to substantial investment risk. Such risk exists for the simple reason that purchasers cannot know in advance how much money they will make in light of the inherent unpredictability of the securities market.

Friday, April 17, 2009

Government Urges US Supreme Court to Reject Constitutional Challenge to PCAOB

The US Government has asked the Supreme Court to reject an audit firm’s petition to rule on the constitutionality of the PCAOB. The main government argument is that the audit firm failed to exhaust its administrative remedies before the SEC; and thus the federal district court lacked jurisdiction to entertain the claim that the creation of the Board was unconstitutional. Congress modeled the Board on the SROs, noted the brief, and the same judicial-review procedures for the SROs are applicable to the Board. Because the district court lacked jurisdiction, the Supreme Court could not reach the merits of the questions presented in the petition, argued the brief, even if review of those questions was otherwise warranted.

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

Upholding a district court ruling, a split federal appeals court panel decided that the PCAOB is constitutional and rejected claims that SEC rather than presidential selection of Board members violates the Constitution. The panel concluded that Board members are inferior officers of the United States within the meaning of the Appointments Clause; and thus properly appointed by the SEC. The fact that the Sarbanes-Oxley Act limited the SEC’s authority by providing that Board members can only removed for cause did not elevate Board members to the status of principal officers of the US worthy of presidential appointment. Despite the for-cause removal, said the panel, the fact remained that the Act gave the SEC comprehensive and pervasive control of the PCAOB, including the approval of the Board’s budget.

In its
brief, the Government noted that, since the enactment of the Exchange Act, the federal securities laws have provided the exclusive mechanism for parties aggrieved by self-regulatory organizations to obtain judicial review. That procedure guarantees the SEC an opportunity to address the questions presented in an authoritative order or ruling, subject to direct review in a federal appeals court.

According to the Government, the audit firm was not free to disregard the statutory review process established by Congress and, instead, assert facial challenges in district court untethered to particular claims of injury. These jurisdictional defects are underscored by the firm’s implicit invitation to the lower courts to create a new cause of action on its behalf. The federal courts should not entertain requests to create implied remedies against quasi-governmental agencies when Congress has expressly provided a mechanism for judicial review.


If the firm had presented its constitutional challenges to the Commission, the federal courts would then have the benefit of the Commission’s authoritative construction of the Act. But by bringing their claims directly in federal district court, said the brief, the firm deprived the Commission of the opportunity to consider those arguments and, if necessary, to construe its own powers under the Act in light of the asserted constitutional defects.

Thus, the Court’s review of the questions that petitioners seek to pose is premature. If, in an appropriate future case in which a regulated person invokes the Act’s review procedures, the SEC interprets its statutory authority over the Board in such a way as to call the constitutionality of the Act into question, there would be time enough for the Court to review the relevant constitutional questions.

The government also addressed the substantive claims. The audit firm contended that members of the PCAOB are principal officers under the Constitution who can only be appointed by the President with the advice and consent of the Senate. In the government’s view, the court of appeals correctly rejected that claim, holding that Board members are inferior officers since they are in every respect subordinate to the SEC.

Further, the Commission’s authority over the Board is explicit and comprehensive. Indeed, it is extraordinary. Every auditing standard, ethics rule, or other rule or modification of a rule promulgated by the Board must be approved by the Commission. And no rule of the Board can become effective without prior approval of the Commission. If the Commission becomes dissatisfied with the operation of a Board rule in practice, it is empowered at any time to abrogate, add to, or delete from the rule as the Commission deems necessary.

The government also said that the creation of the Board did not violate the more general separation-of-powers principles. The court of appeals correctly explained that, given the constitutionality of independent agencies and the Commission’s
comprehensive control over the Board, the audit firm could not show that the statutory scheme so restricts the President’s control over the Board as to violate the separation of powers.

Thursday, April 16, 2009

IOSCO Recommends Hedge Fund Regulation as Part of Systemic Risk Oversight

The IOSCO technical committee has set forth recommendations for hedge fund regulation embodying a consistent global approach to addressing hedge fund risk. SEC Commissioner Kathleen Casey, Chair of the committee, noted that the financial crisis is not a hedge fund crisis, and that hedge funds contribute to market liquidity, price efficiency, risk distribution and global market integration. But, she said that regulators are beginning to consider what role hedge funds played in amplifying the financial crises through trading strategy, reliance on leverage and the need to liquidate positions.

Dovetailing with recent G-20 recommendations, IOSCO urges risk-based regulatory oversight of hedge funds, focused particularly on systemically important and higher risk hedge fund managers, with a de-minimus cut-off. As part of this regulation, hedge fund managers should provide information to help regulators protect investors and monitor systemic risk and risks to hedge fund counterparties. Broadly, the information supplied through the registration process would provide adequate transparency into the business of the hedge fund manager and should also be made available to all prospective clients prior to the execution of the investment management agreement. More specifically, the disclosure should include assets under management, fees charged, investment strategies, risk tools employed, and conflicts of interest.

IOSCO also recommends that regulations require hedge fund managers to have comprehensive and independent risk management functions that measures risks across the whole of the business, including market, liquidity, credit and operational risks. Risk management should also inckude stringent stress testing of portfolios for market and liquidity risk. Appropriate disclosure regarding risk should also be made to investors.

Hedge funds should also implement a strong independent compliance function supported by sound and controlled operations and infrastructure, adequate resources and checks and balances in operations.

Valuation is also very important, said IOSCO, with valuation procedures embracing adequate segregation of responsibilities and thorough written policies. For example, the procedures must ensure that valuation principles are standardized, including disclosure about fair value measurements determined based on common market participant assumptions. In addition, robust verification of fund valuations can be achieved through independent third party providers or strong independent overview from the hedge fund‘s governing body.

Regulators must also ensure that hedge funds manage conflicts of interest and provide full disclosure and transparency about such conflicts of interest. IOSCO identified two categories of hedge fund conflicts of interest. The first category includes conflicts that affect the hedge fund manager as an institution, such as investment and brokerage allocation practices and undisclosed compensation arrangements with affiliates and counterparties. The second category includes individual conflicts, such as personal trading; personal investing; and personal or business relationships with issuers.

Regulatory concerns have been voiced about the role of off-shore financial centers where, for tax reasons, many of the underlying hedge funds are registered. First, IOSCO believes that all securities regulators, including those in the offshore financial centers, should ensure that appropriate information about the funds and its activities is maintained and properly audited for each fund registered in their jurisdiction. Regulatory cooperation, which IOSCO also calls for, would be further enhanced if all jurisdictions were able to collect key information items which could then be efficiently shared. But irrespective of where the underlying funds are established, hedge fund managers and prime brokers remain subject to regulatory jurisdiction, such as in the UK and US.

Given that circumstance, IOSCO believes that hedge fund managers should be able to obtain all the necessary information from their underlying funds irrespective of the location of those funds. Then, armed with this information, hedge fund managers will be able to evaluate the risks they are taking in their portfolio. If they cannot get the necessary information, said IOSCO, they should consider limiting the risks they are taking.

NASAA Conference to Spotlight Regulatory Restructuring and Systemic Risk Regulation


The North American Securities Administrators Association (NASAA) will feature panel discussions on financial regulatory restructuring and systemic risk regulation as part of its upcoming Public Policy Conference in Washington, D.C. on April 28.

Duke University law professor James Cox will moderate the first roundtable discussion, "Answering an Angry Public: Restructuring Our Regulatory System and Restoring Investor Confidence." The panel of experts will include Mark Cooper, Director of Research, Consumer Federation of America; Matt Kitzi, Missouri Commissioner of Securities; and Donald Langevoort, Georgetown University School of Law.

The second panel discussion, "Risky Business: Rebuilding Market Integrity through Systemic Risk Regulation," will be moderated by Alabama Secuurities Commissioner Joseph Borg and will feature Monica Lindeen, Montana State Auditor; Sarah Bloom Raskin, Maryland Commissioner of Financial Regulation; and Dean Shahinian, Senior Counsel, U.S. Senate Banking Committee.

The conference opens with a keynote address by Rep. Paul Kanjorski (D-PA), who chairs the Senate Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises.

Conference registration forms and a full schedule of events may be downloaded from the NASAA website. Advance registration for the conference ends on April 20.

Wednesday, April 15, 2009

Hong Kong Court Approves PCCW Going Private Scheme Despite SFC Concerns over Share Splitting

A Hong Kong court approved the takeover and privatization of a major telecommunications company despite serious allegations of impropriety by the Securities and Futures Commission involving share splitting and the coercion of minority shareholders. Justice Kwan concluded that the statutory majority who voted for the scheme were acting bona fide and were not coercing the minority in order to promote interests adverse to those of the class whom they represented. (In re PCCW Limited, Court of First Instance, Hong Kong Special Administrative Region, April 6, 2009).

The privatization proposal was to provide shareholders an opportunity to realize their investment in the company for cash during sustained poor market conditions. The independent financial adviser was of the view that the cancellation price offered a reasonable premium and that the terms of the proposal were fair and reasonable to the shareholders. On the advice of the independent financial adviser, noted the court, an independent board committee recommended that shareholders vote in favor of the scheme.


In the court’s view, the fact that a large majority in value of the shareholders approved the scheme was a major factor in considering whether an intelligent and honest person might reasonably approve. The function of the court is not to decide how it would have voted on the scheme, but to consider whether an intelligent and honest member of the class could reasonably approve it.

The Court of Appeal stayed the decision and granted the Securities and Futures Commission leave to appeal the order of the Court of First Instance approving PCCW’s scheme of arrangement to privatize the company. On appeal, the SFC will seek clarifications in relation to the splitting of shares. The Commission is concerned that important points of law regarding the splitting of shares, which are of significant public concern, have not been fully clarified. the SFC’s Chief Executive Officer, Martin Wheatley, said that these are important points of principle for the Hong Kong market and the protection of minority shareholders.

Share splitting involves one or more members transferring small parcels of shares to a large number of other persons who are willing to attend the meeting and vote in accordance with the wishes of the transferor. At common law, a shareholder is entitled to transfer some of his or her shares to nominees to increase voting power at a meeting, noted the court, and there is no legal provision or regulatory rule in Hong Kong prohibiting share splitting for that purpose.

In addition, the court found no discernible public policy in Hong Kong regarding share splitting in the context of a scheme for privatization of a company. Further, no mention of any abuse in the practice of share splitting was made in the Takeovers Code, which represents a consensus of opinion of those who participate in Hong Kong’s financial markets, and of the SFC, regarding standards of commercial conduct and behavior considered acceptable for takeovers, mergers and share repurchases. If Hong Kong is to introduce a policy on share splitting, reasoned the court, there should be a publicly available statement by the regulatory authority, after proper and informed consultation

It would be unfair and wrong for the SFC to ask the court to lay down, for the first time, a policy on what should or should not be followed with regard to share splitting in a scheme, and to apply the policy to the scheme on a retrospective basis. This would only lead to chaos, said the court. Thus, the court rejected the idea of excluding all votes in favor of the scheme as a result of share splitting.
Virginia Proposes Securities Rule Revisions

Rule revisions anticipated to become effective July 1, 2009 were proposed by the Virginia Corporation Commission. Among the proposals would be one to eliminate the Form U-2 filing requirement for Rule 505 and 506 offerings but mandate issuers to send the Corporation Commission the same Form D filed with the SEC (for Rule 505) and submit the SEC's most recently effective Form D as the appropriate notice (for Rule 506). Other proposals would adopt NASAA's Model Custody Rule 102(e)(1)-1 and the NASAA policy statement on corporate securities definitions, require additional information on investment adviser and federal covered investment adviser registration applications, amend the examination and termination requirements for agents and investment adviser representatives, and allow agents terminating employment with registered broker-dealers because of retirement or disability to continue to receive compensation after termination if certain conditions are met.

A copy of the proposed rules may be found
here.

Interested persons may submit written comments to Joel H. Peck, Clerk, State Corporation Commission, c/o Document Control Center, P.O. Box 2118, Richmond, Virginia 23218, by May 15, 2009. A hearing may be held on June 3, 2009 if requested.

Monday, April 13, 2009

Public Comments Support European Commission Proposal on Hedge Fund Regulation

There is a general consensus that hedge funds should be regulated as part of systemic risk regulation, according to public comments on the European Commission’s proposal to regulate hedge funds, but there is also a fear of regulatory arbitrage if such regulation is not global. There were 104 comments from a wide range of public authorities, financial organizations and investors. Although some prudential reporting to regulators is currently required, a large majority of commenters believe that regulators do not have enough information to monitor hedge fund trading activities. To that extent, transparency and disclosure by hedge funds to regulators should be improved and harmonized.

The European Commission recently endorsed a High Level Group report setting forth a broad blueprint for a complete overhaul of financial regulation in the European Union, including the regulation of hedge funds. Similarly, the G-20 recommends systemic risk regulation that includes hedge funds.

The comment letters revealed a general acceptance of the fact that hedge funds may constitute a source of counterparty risk to core financial institutions and the broader financial system as a consequence of sudden and large scale liquidation of hedge fund positions. In deciding the important question of the criteria for judging the systemic importance of a fund, most commenters said that the systemic risks of hedge funds should focus more on leverage. In assessing possible stability impacts, this perspective should take into account assets under management, number of counterparties, level of leverage, and volume of trading.

Many comments favored a single, global registration procedure for hedge funds and their managers as a starting point for improved transparency. Hedge funds could also be required to deliver periodic regulatory reports of appropriate information on, for example, size, investment style, exposures, leverage and performance. It was suggested that the information collection process could involve hedge fund managers as well as prime brokers, the valuator, the clearing broker or other central counterparties.

Importantly, a majority of commenters are not convinced that a purely EU response is likely to be successful. They feel that it may even have adverse effects on the European asset management industry, exposing it to regulatory arbitrage. A heavy-handed EU response not matched by action elsewhere could drive business away and reduce the competitiveness of the EU asset management industry. Given the interconnectedness of global financial markets and the international dimension of hedge funds, said many comments, any effective answer must be taken at a global level.

Other commenters said that the superiority of international action must not be an excuse for European passivity. Europe is home to a major alternative investment management industry and represents a substantial client base for this industry. Further, an EU framework could serve as a reference for global regulation of alternative investment management activity. It would also help to enhance the attractiveness of the European asset management industry and to foster the spread of standards of best practices. Some commenters even perceived an EU initiative as a first step towards an international consensus on hedge fund regulation.

While there was broad support for short selling as a legitimate investment technique under normal market conditions, a large number of commenters said that there are a range of circumstances in which short selling restrictions could be justified. Almost half the comments acknowledged that short selling could potentially be used as a part of an abusive strategy.

There was broad support for enhancing risk management standards employed by hedge funds. There was a split over whether effective risk management could best be achieved through self-regulatory codes of conduct or mandated regulation. Those favoring regulation argued that the experience with self-regulatory codes has raised questions relating to compliance and enforcement which undermine their effectiveness. The existence of these codes has not been sufficient to prevent the emergence of concerns relating to the hedge fund industry.

It was agreed that indirect supervision through prime brokers could not fully substitute for the required direct regulation of some aspects of hedge fund risk management. There were many suggestions as to how hedge fund risk management could be improved. For example, there has been excessive reliance on theoretical models for assessing risk. Also, internal governance should be improved so that managers have the appropriate risk management systems and reporting mechanisms.

Separation of functions was seen as a way to reduce operational risk and the possibility of fraud, and misappropriation of assets. Thus valuator, administrator, auditors and custodial functions should be separated in order to avoid possible conflicts of interest. In addition, some respondents insisted that the assets of the fund should be segregated from those of the prime broker. If not, the interests of the former are exposed to the risk of the bankruptcy of the latter.

Some commenters, however, contested the perception of hedge funds as unregulated. Even at the EU level, aspects of hedge fund business and hedge funds themselves are subject to MiFID, the Transparency Obligations Directive and the Market Abuse
Directive. When they become members of trading systems, they are also subject to the rules of that platform including all relevant transaction reporting rules.

Saturday, April 11, 2009

German Regulator (BaFin) Extends Ban on Naked Short Selling

The German Federal Financial Supervisory Authority (BaFin) has extended its ban on naked short selling in the shares of eleven financial companies to May 31, 2009. This is BaFin’s second extension of the prohibition, which was adopted in September of 2008. The companies affected by the ban include Allianz SE, Commerzbank AG, and Deutsche Bank AG.

Bafin defines naked short selling as when sellers sell shares which they do not own or for which they do not have a plea-proof claim to transfer of title in shares of the same class at the time of the transaction. By influencing the prices of the stocks specified, transactions resulting in a short position or in the increase of a short position (referred to as short selling transactions) in shares within the meaning of the ban would, by reason of the importance of the companies for the aggregate economy, reinforce this development and result in further excessive price movements, thereby jeopardizing the stability of the financial system.

BaFin noted that short share positions created by the exercise of option transactions are not subject to the ban. Although the sale of a short call option is a transaction, it does not yet result in a short position in shares. The short position arises only when the call option is exercised, explained BaFin, since it is only at this point of time that a delivery obligation arises with the option writer. Similarly, BaFin said that the ban does not extend to the sale of futures since the d decree only refers to naked short transactions in shares.


Regarding the ban’s application to trading in short warrants or short certificates, BaFin said that restrictions may arise for trading in short positions if the risk positions created thereby are hedged by a short sale of shares. If, however, hedging is performed by the sale of a future or a similar instrument, this is not subject to the restriction on short selling.

The ban does not apply to short sales backed by securities lending. The decree only prohibits naked transactions in the specified shares that are not backed by securities lending. According to BaFin, the securities lending transactions have to have been concluded prior to, or at least simultaneous with, the respective transaction. It is sufficient that at the time of the conclusion of the transaction an absolutely enforceable legal claim on the borrowed shares already exists. It is not necessary that the shares have already been booked into the account of the borrower.

Thursday, April 09, 2009

SEC Chair Schapiro Details Bold Corporate Governance Initiatives

By James Hamilton, J.D., LL.M.

SEC Chair Mary Schapiro outlined a bold corporate governance initiative to ensure that shareholders fully understand how compensation structures and practices drive an executive's risk-taking. This is in keeping with the Financial Stability Board’s principles for executive compensation reform, which were endorsed by the G-20 leaders in their final communiquĂ©. In remarks to the Council of Institutional Investors, the Chair also discussed additional corporate governance disclosure initiatives.

The SEC Chair said that the Commission will consider whether its compensation disclosure rules accomplish the objective of providing shareholders with the most relevant information. Noting that compensation drives behavior, she mentioned that the Counterparty Risk Management Policy Group identified compensation schemes as one of five primary driving forces of the turmoil.

She observed that the Financial Stability Board (formerly Forum) issued a report agreeing with this assessment, and suggesting principles for sound compensation practices, including an effective alignment of compensation with prudent risk taking; and effective supervisory oversight and engagement by stakeholders.

The Commission will be considering whether greater disclosure is needed about how a company manages risks, both generally and in the context of setting compensation. The SEC will not mandate any particular form of oversight, noted the Chair, because that, not only would be beyond the Commission's traditional disclosure role, but would also suggest that there is a one-size-fits-all approach to risk management. Instead, the SEC will seek to provide investors, and the market, with better insight into how each company and each board addresses what the Chair described as ``these vital tasks.’’

The Commission will also consider whether greater disclosure is needed about a company's overall compensation approach, beyond decisions with respect only to the highest paid officers, as well as compensation consultant conflicts of interests

On other corporate governance matters, the SEC, in June, will consider whether to enhance disclosure around director nominee experience, qualifications and skills. The current rules only require a very brief description of a candidate's business experience over the past five years. In Ms. Schapiro’s view, that may not be sufficient in today's complex business environment. She wants to make sure that shareholders have the information needed to make sound proxy voting decisions.

The SEC will also consider whether boards should disclose to shareholders their reasons for choosing their particular leadership structure, whether that structure includes an independent chair, a non-independent chair, or a combined CEO/chair.

Next month, the Commission will consider a proposal to ensure that a company's owners have a meaningful opportunity to nominate directors. The SEC will look at what the Commission considered in both 2003 and 2007; and will also consider the potential impact of proposed changes to Delaware's corporate law. But the SEC Chair pledged that the Commission would view these issues with "fresh eyes."

Wednesday, April 08, 2009

SEC Set to Propose Modified Uptick and Circuit Breaker Rules

With Congress readying legislation directing the SEC to reinstate the uptick rule, Rule 10a-1, the Commission will consider proposing two approaches to restrictions on short selling. One would apply a modified uptick rule on a market wide and permanent basis, while the other would apply a circuit breaker to a particular security during severe market declines in that security

The proposed modified uptick rule would be based on the national best bid, similar to the former Nasdaq “bid” test. This proposal would require trading centers to establish and enforce policies and procedures reasonably designed to prevent the execution or display of a short sale order of an National Market System stock, absent an exception, at a down-bid price. Trading centers, which include broker-dealers and exchanges that execute short sales, must regularly surveil for effectiveness of policies and procedures and take action to remedy deficiencies.

The proposed uptick rule is similar to former Rule 10a-1, and based on the last sale price. This proposal would prohibit any person from effecting a short sale below the last sale price or at the last sale price, unless such price is above the next preceding different price.

Both the proposed modified uptick rule and the proposed uptick rule include exceptions that are based on exceptions to, or exemptions granted under, former Rule 10a-1. These exceptions would be limited to activities that promote liquidity and foster the workability of the proposed rules without undermining the effectiveness of the proposals. The Commission will seek specific comment regarding how each proposed short sale price test would work in the context of today’s markets.

The proposed circuit breaker rules would be triggered by a specified ten percent decline (as reported in the consolidated system) in a particular NMS stock. Each proposed rule, however, would impose different short sale restrictions when triggered. The proposed circuit breaker halt rule, when triggered, would prohibit any person from selling short in that security for the remainder of the day.

The proposed circuit breaker modified uptick rule, when triggered, would require trading centers to enforce established policies and procedures designed to prevent the execution or display of a short sale order at a down-bid price for the remainder of the day. The proposed circuit breaker uptick rule, when triggered, would prohibit any person from effecting a short sale below the last sale price or at the last sale price, unless such price is above the next preceding different price, for the remainder of the day. To avoid potential market disruption, the proposed rules would not be triggered if the price of a covered security reaches the specified ten percent decline threshold within thirty minutes of the end of regular trading hours.

The proposed circuit breaker rules would include several exceptions. As with the short sale price test proposals, these exceptions would be limited to activities that promote liquidity and foster the workability of the proposed rules without undermining the effectiveness of the proposals. The Commission will seek specific comment regarding how each proposed circuit breaker rule would work in the context of today’s markets.

Recently, six US Senators have written to SEC Chair Mary Schapiro urging the Commission to adopt and enforce regulations putting an end to naked short selling. At a minimum, those regulations should address the need for an uptick rule, as well as a pre-borrow requirement to prevent naked short sellers from artificially depressing or diluting stock values. If the SEC fails to signal clear action at its April 8 meeting, at least to reinstate some form of the uptick rule and impose a pre-borrow requirement on short sellers, said the Senators, Congress will consider legislation directing the Commission to do so. The six Senators are Ted Kaufman (D-DE), Johnny Isakson (R-GA), John Tester (D-MT), Arlen Specter (R-PA), Carl Levin D-MI, and Saxby Chambliss (R-GA).

Tuesday, April 07, 2009

Executive Compensation Reform Legislation Should Be Guided by Financial Stability Board Principles

Based on the final communiqué of the G-20 leaders and their pledge to pass legislation reforming compensation regimes as part of financial regulatory reform, it is very probable that US legislation reforming executive compensation will be based on principles concomitantly set forth by the Financial Stability Board. That is because the G-20 endorsed the compensation principles of the new Financial Stability Board, formerly the Financial Stability Forum. The Board, with a strengthened mandate, now includes all G-20 countries, and the European Commission.

It is almost certain that the legislative overhaul of US financial regulation will include significant reform of executive compensation. 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 as part of financial reform they will draft legislation comprehensively reforming corporate governance and executive compensation. 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.

According to the G-20, the legislation must ensure that compensation structures are consistent with firms’ long-term goals and prudent risk taking. Specifically, firms' boards of directors must play an active role in the design, operation, and evaluation of compensation schemes. Compensation, particularly bonuses, must properly reflect risk; and the timing and composition of payments must be sensitive to the time horizon of risks.

Payments should not be finalized over short periods where risks are realized over long periods, said the communiqué, and firms must disclose comprehensive and timely information about compensation. Stakeholders, including shareholders, should be adequately informed on a timely basis on compensation policies in order to exercise effective monitoring. The inclusion of stakeholders in the communiqué portends a role for shareholder advisory votes on executive compensation.

For their part, regulators will assess firms’ compensation policies as part of their overall assessment of their soundness. When necessary, regulators should intervene with responses that can include increased capital requirements.

Compensation regimes must be viewed in the broader context of sound corporate governance and effective risk management. Governance is more likely to be effective if the firm’s stakeholders, particularly shareholders, are engaged with compensation. In order for them to be engaged, they must be informed. Disclosure must go well beyond the compensation details of a few senior officers.

The Financial Stability Board said that relevant disclosure should include the general design philosophy of the compensation system and the manner of its implementation, as well as a sufficiently detailed description of the manner of risk adjustment and of how compensation is related to actual performance over time. There should also be disclosure of compensation outcomes for employees at different levels or in different units sufficient to allow stakeholders to evaluate whether the system operates as designed, and summaries of results of internal and external audits.

In addition, the Board recommends an annual non-binding shareholder advisory vote on executive compensation. In cases where the shareholders do not approve the compensation, the firm would be expected to consult, make material changes, and provide explanations why proposed compensation is aligned with shareholders’ interests.

The Board views golden parachute arrangements that generate large payouts to terminated staff and that are not sensitive to performance or risk as prudentially unsound. Such arrangements create a “heads I win, tails I still win” approach to risk, said the Board, which encourages more risk taking than would likely be preferred by the firm’s shareholders or creditors. Similarly, golden handshakes that reimburse unvested compensation foregone at the employee’s former firm are a difficult problem. If employees are routinely compensated by a new employer for accumulated unvested bonuses, or for vested bonuses still subject to clawback, in a manner that removes the employee’s exposure to risks imposed on the old employer, the incentive effects of the principles will be reduced. Also, multi-year guaranteed bonuses are not in line with the principles.

With regard to risk management, three principles focus on making compensation sensitive to risk outcomes: First, compensation must be symmetric with risk. This means that compensation systems should link the size of the bonus pool to the overall performance of the firm. Employees’ incentive payments should be linked to the contribution of the individual and business to such performance. Bonuses should diminish or disappear in the event of poor firm, divisional or business unit performance.

Second, compensation payout schedules must be sensitive to the time horizon of risks. Payments should not be finalized over short periods where risks are realized over long periods.

Third, the mix of cash, equity and other forms of compensation should be consistent with risk alignment. It is not obvious that more equity and less cash always increases the employee’s incentive to align risk with the firm’s appetite. The mix is likely to differ across employees and to involve a smaller cash component the more senior the employee.

Monday, April 06, 2009

Investor and Consumer Groups Question FASB's Independence over Mark-to-Market Guidance

In a letter to Rep. Paul Kanjorski, a wide-ranging group of participants in the Corporate Reporting Users Forum (CRUF) expressed concern that FASB’s independence and due process was undermined by its recent adoption of guidance on mark-to-market accounting. Rep. Kanjorski is Chair of the House Capital Markets subcommittee. The letter was also sent to Financial Services Committee Chair Barney Frank and Ranking Member Spencer Bachus, as well as to SEC Chair Mary Schapiro.

On March 12, the subcommittee held hearings on mark-to-market accounting. The letter expresses the CRUF members’ agreement with Rep. Kanjorski’s opening remarks at the hearings that Congress should not interfere through legislation in the area of establishing specific accounting rules. However, the subcommittee then proceeded to demand that FASB alter its mark-to-market accounting rules or face imminent legislation. The following Monday, the FASB complied with a proposal to provide guidance on mark-to-market accounting, which it adopted on April 2.

In addition to concerns over FASB’s independence, the investment professionals are also worried that, having seen Congress act in this case, special interests will pursue this avenue in the future to advance narrow agendas at the expense of the broader market. If investor confidence is to be restored, they reasoned, it is critical that investors have access to transparent information truly useful to investment decisions. They urged Congress to recognize the independence of FASB and the importance of preventing lawmakers from rewriting accounting principles during times of economic stress. More broadly, the forum participants believe that political interference will only serve to further destabilize confidence in the financial system.

Echoing these concerns in its comment
letter to FASB, the Consumer Federation of America said that, in rolling out these proposals in obvious direct response to congressional pressure, FASB abandoned all pretence that it is an independent standard-setting body. By offering this radical change in policy with only a two-week comment period and with a vote scheduled for the following day, stressed the Federation, FASB also abandoned any pretence that it is a body guided by expert analysis and a respect for due process. Similarly, the Securities Industry and Financial Markets Association said in its comment letter to FASB that it was concerned about the lack of due process and the limited comment period. Rushed projects increase the probability of unintended consequences, noted SIFMA.

Under pressure from Congress to ameliorate the application of mark-to-market accounting in asset-backed securities in illiquid markets, FASB adopted guidance on whether a market is not active and a transaction is not distressed. New FAS 157-e affirmed that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction, not a forced liquidation or distressed sale, between market participants at the measurement date under current inactive market conditions.

At a press conference announcing the guidance, FASB officials said that the Board’s independence remains intact; and that due process was faithfully observed in the adoption of the guidance, with all public comments carefully considered. The officials emphasized that the Board reached out to many investors, institutional and otherwise, and the majority supported what the Board was doing.

Six US Senators Ask SEC to Adopt Regulations Ending Abusive Naked Short Selling

By James Hamilton, J.D., LL.M.

Six US Senators have written a letter to SEC Chair Mary Schapiro urging the Commission to adopt and enforce regulations putting an end to naked short selling. At a minimum, those regulations should address the need for an uptick rule, as well as a pre-borrow requirement to prevent naked short sellers from artificially depressing or diluting stock values. If the SEC fails to signal clear action at its April 8 meeting, at least to reinstate some form of the uptick rule and impose a pre-borrow requirement on short sellers, said the Senators, Congress will consider legislation directing the Commission to do so. The six Senators are Ted Kaufman (D-DE), Johnny Isakson (R-GA), John Tester (D-MT), Arlen Specter (R-PA), Carl Levin D-MI, and Saxby Chambliss (R-GA).

Naked short selling has been a controversial practice for several years and, while not illegal per se, abusive or manipulative naked short selling, such as intentionally failing to borrow and deliver shares sold short in order to drive down the stock price, violates the federal securities laws.

The letter focused on a recent SEC Inspector General report detailing the results if an audit of the Division of Enforcement policies and procedures for processing complaints about naked short selling. The report noted that, despite receiving more than 5,000 complaints about abusive short selling, not one enforcement action resulted. Further, said the senators, the Division of Enforcement only agreed with one of eleven of the Inspector General’s recommendations to improve processing and analyzing abusive short sale claims. Equally troubling to the Senators is the Division’s reluctance to agree with the Inspector General and the SEC itself that naked short selling is harmful. When it adopted a naked short selling antifraud rule, rule 10b-21, in 2008, noted the Senators, the SEC expressed its concern about abusive naked short selling. However, in response to the Inspector General’s report, the Division said that there is hardly unanimity in the investment community or the financial media on either the prevalence or the dangers of naked short selling.

More broadly, the Senators emphasized that investors and the financial markets are waiting to know if the SEC will restore an uptick rule, and whether it will take additional steps to address abusive short selling practices. There is a widespread belief that the abuse of naked short-selling, which is the selling of stock that the trader does not own, has added fuel to the fire of distressed stocks and markets. The letter emphasized that investors need to know that the market fairly values the actual shares issued by a company and that their transactions will not be distorted by manipulative naked short sellers creating phantom shares. The senators clarified that they do not oppose short selling per se, which they said can enhance both market efficiency and price discovery. But naked or abusive short selling has gone unaddressed for far too long, they said, and the practice must end.

Sens. Kaufman and Isakson have been pushing the SEC to make progress for a month. Senator Kaufman initially proposed the reinstatement of the uptick rule in a March 3 letter to Chair Schapiro. On March 16, Sens. Kaufman and Isakson introduced bipartisan legislation, S. 605, directing the SEC to write regulations within 60 days to end abusive short selling. Each has spoken on the floor, and after Chair Schapiro's testimony before the Senate Banking Committee last week, they said they were "cautiously optimistic" that the SEC may take action on April 8, but remain concerned over whether it will go far enough.

S. 605 orders the SEC to reinstate the uptick rule, which was repealed in July 2007. The uptick rule, Rule 10a-1, required all short sale stock transactions to be conducted at a price that was higher than the price of the previous trade.

The legislation directs the SEC to write regulations within 60 days accomplishing five things to end abusive short selling. First, the SEC must reinstate the substance of the uptick rule prohibiting short sales that are not made on an increase in the price of the stock. This is designed to prevent short sellers from piling on a declining stock, driving prices down. Second, the SEC must require exchanges and other trading venues to execute the trades of long sellers ahead of short sellers, all other things being equal.

Third, with the concurrence of Treasury and the Federal Reserve Board, the SEC must prohibit short sales of the securities of any financial institution unless that trade is affected at a price (in minimum lots specified by the Commission) at least 5 cents higher than the immediately preceding transaction in such securities. Since the financial sector is in such a fragile state, if the Treasury and Fed believe they it needs additional protection, the legislation permits it.

Fourth, SEC rules must prohibit any person from selling securities short unless that person has at the time of the short sale a demonstrable legally enforceable right to deliver the securities at the required delivery date. Under current law, many short sellers fail to deliver. Fifth, the SEC will require that all short sales settle on the same time frame employed for long sales of the same securities. There is no reason, said the senators, that short sellers should have 13 days to deliver shares when long sellers have only three days.

Sunday, April 05, 2009

G-20 Endoses Consistent Systemic Financial Regulatory Reform; Financial Stability Board Given Crucial Role

In their final communiquĂ©, the G-20 leaders pledged to pass legislation reforming the financial regulatory system that is consistent across borders and based on high international standards. Yes, it is a global financial crisis, but the G-20 rejected the French President’s desire to have a global regulator that could reach into a country and direct its securities regulation. The United States will pass its own massive financial regulation legislation and the European Parliament will do the same for the EU. Will the legislation be similar, yes, because the broad themes are the same: a systemic risk regulator; regulation of hedge funds, OTC derivatives, and credit rating agencies, and reform of executive compensation to base pay on performance not excessive risk taking. Also, a new Financial Stability Board is charged with monitoring the national reform legislation for consistency.

As reported in the Financial Times, German Chancellor Angela Merkel said that each leader was determined to defend his or her own national interest. And we are all captives of our past. For Germany, it is the hyperinflation of the Weimer Republic and what that produced. For the US, is the Great Depression and how President Roosevelt fought it. So, let us take what we can get, consistent regulation, and realize that global securities regulation remains an elusive dream. As William Faulkner said, the past is never dead, it is not even past.

The communiquĂ© announced the establishment of the Financial Stability Board (FSB) with a strengthened mandate, as a successor to the Financial Stability Forum (FSF), including all G-20 countries, and the European Commission. The Board will monitor the cross-border consistency of the national financial regulatory reform legislation. The G-20 pledged to endorse and implement the FSB’s tough new principles on pay and compensation and to support sustainable compensation schemes and the corporate social responsibility of all firms.

The G-20 will extend regulation to all systemically important financial institutions, instruments and markets. This will include, for the first time, systemically important hedge funds. There will be a systemic risk regulator with macro-prudential risks across the financial system with authority over financial firms, the shadow banking universe, and private pools of capital. In order to prevent regulatory arbitrage, the IMF and the FSB will produce guidelines for national authorities to assess whether a financial institution, market, or an instrument is systemically important.

Hedge funds or their managers will be registered and mandated to disclose information on an ongoing basis to regulators for the assessment of the systemic risks that the funds pose individually or collectively. Registration should be subject to a minimum size. Hedge funds will also be subject to oversight to ensure that they have adequate risk management. Similarly, regulators must require that institutions which have hedge funds as their counterparties have effective risk management, including mechanisms to monitor the funds’ leverage and set limits for single counterparty exposures.

The Financial Stability Board will develop mechanisms for cooperation and information sharing between relevant authorities in order to ensure that effective oversight is maintained where a hedge fund is located in a different jurisdiction from the manager.

The leaders also called on the accounting standard setters to work urgently with regulators to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards. Specifically, the standard setters should improve standards for the valuation of financial instruments based on their liquidity and investors’ holding horizons, while reaffirming the framework of fair value accounting. In addition, the standard setters should reduce the complexity of accounting standards for financial instruments and strengthen accounting recognition of loan-loss provisions by incorporating a broader range of credit information. They must also improve accounting standards for provisioning, off-balance sheet exposures and valuation uncertainty.

The standards setters should achieve clarity and consistency in the application of valuation standards internationally, working with regulators. Within the framework of the independent accounting standard setting process, they must also improve the involvement of stakeholders, including prudential regulators and emerging markets, through the IASB’s constitutional review.

The communiquĂ© also said that robust regulation would extend to credit rating agencies to ensure that they meet the international code of good practice, particularly to prevent unacceptable conflicts of interest. Under the new regime envisioned by the G-20, all credit rating agencies whose ratings are used for regulatory purposes should be subject to regulation, including registration. The regulatory oversight regime should be consistent with the IOSCO Code of Conduct, with IOSCO coordinating full compliance. National authorities will enforce compliance and require changes to a rating agency’s practices and procedures for managing conflicts of interest and assuring the transparency and quality of the rating process.

In particular, rating agencies should differentiate ratings for structured products and provide full disclosure of their ratings track record and the information and assumptions that underpin the ratings process. The oversight framework should be consistent across jurisdictions with appropriate sharing of information between national authorities, including through IOSCO. The Basel Committee should take forward its review on the role of external ratings in prudential regulation and determine whether there are any adverse incentives that need to be addressed.

The G-20 endorsed major changes in executive compensation based on just announced Financial Stability Board principles. Regulation must ensure that compensation structures are consistent with firms’ long-term goals and prudent risk taking. Specifically, firms' boards of directors must play an active role in the design, operation, and evaluation of compensation schemes. Compensation, particularly bonuses, must properly reflect risk; and the timing and composition of payments must be sensitive to the time horizon of risks. Payments should not be finalized over short periods where risks are realized over long periods, said the communiquĂ©, and firms must disclose comprehensive and timely information about compensation. Stakeholders, including shareholders, should be adequately informed on a timely basis on compensation policies in order to exercise effective monitoring. The inclusion of stakeholders in the communiquĂ© portends a role for shareholder advisory votes on executive compensation.

For their part, regulators will assess firms’ compensation policies as part of their overall assessment of their soundness. When necessary, regulators should intervene with responses that can include increased capital requirements. The G-20 also wants the Basle Committee to integrate these principles into its risk management guidance.

Oral Histories Aim to Preserve State Securities History


In an effort to preserve the history of blue sky regulation, the website of the SEC Historical Society now includes a series of recorded interviews with persons significant to state securities work. As announced by the Society last fall when it published the first of the oral histories, a working group of current and former state securities administrators has volunteered to assist the Society in preserving state securities history in its virtual museum and archive. Hugh Makens, former Director of the Michigan Corporation and Securities Bureau and a past President of the North American Securities Administrators Association (NASAA), chairs the group.

The first group of interviews provides some interesting material for those unfamiliar with the history and development of the NASAA organization. For example, NASAA's first Executive Director, Bruce Burditt, and former NASAA President Jeffrey Bartell (Wisconsin) discuss how NASAA began to emerge as a potent force in the area of state securities regulation near the end of the 1970s. According to Bartell and Burditt, this was due in large measure to NASAA's development, with the NASD, of a uniform examination for the licensing of securities agents. Not only did the uniform examination eliminate a patchwork of individual state tests and procedures, but NASAA's share of the fees from the administration of the examination allowed the organization to hire an executive director and staff and ultimately take a much more active role in the area of merit regulation.

Other state securities materials currently posted to the Society's website include interviews with former NASAA Presidents Christine Bruenn (Maine) and Lewis Brothers (Virginia). The interviews may be accessed in either audio or written format. The Society has also announced that the working group is preparing a timeline of important state securities events over the last century with an eye to adding these developments to the Society's Timeline in the future.

Thursday, April 02, 2009

FASB Adopts Mark-to-Market Guidance in Reaction to Congress' Desire

Under intense pressure from Congress to ameliorate the application of mark-to-market accounting in asset-backed securities in illiquid markets, the FASB adopted guidance on whether a market is not active and a transaction is not distressed. New FAS 157-e affirmed that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction, not a forced liquidation or distressed sale, between market participants at the measurement date under current inactive market conditions. The guidance includes additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is inactive. Board officials said they expect to issue the text of 157-e next week.

In reaction to comment letters, FASB eliminated the proposed presumption that all transactions are distressed unless proven otherwise. Instead, the guidance requires a firm to base its conclusion about whether a transaction was not orderly on the weight of the evidence. The guidance will also require an entity to disclose a change in valuation technique, and the related inputs, resulting from the application of 157-e and to quantify its effects, if practicable. During the Q&A, Floyd Norris of the New York Times wondered how many firms will find that it is not practicable to quantify the effects of the change.

Responding to a question on how 157-3 would impact mortgage-backed securities, Board officials said that the valuation of mortgage-backed securities could change depending on market liquidity. Also, there will be significantly more disclosure around credit losses. There will also be quarterly disclosure of the value of these securities.

The Board also emphasized that the guidance would be applied prospectively and that retrospective application would not be permitted. The Board decided that 157-e would be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009.

The FASB also adopted guidance providing a clearer benchmark for when an other-than-temporary impairment exists and needs to be recorded on securities held outside of a firm’s trading book, and to transparently disclose the amount of the impairment directly associated with probable cash flow declines. The changes would provide greater clarity than exists today about the nature of losses. The Board decided that the change to existing guidance for determining whether impairment is other than temporary should be limited to debt securities.

The Board replaced the existing requirement that the firm’s management assert it has both the intent and the ability to hold an impaired security until recovery with a requirement that management assert that it does not have the intent to sell the security; and it is more likely than not it will not have to sell the security before recovery of its costs basis. When a firm does not intend to sell the security and it is more likely than not that the firm will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income.

A firm will be required to recognize noncredit losses on held-to-maturity debt securities in other comprehensive income and amortize that amount over the remaining life of the security in a prospective manner by offsetting the recorded value of the asset unless the security is subsequently sold or there are additional credit losses. The guidance also stipulates that credit losses should be measured on the basis of an entity’s estimate of the decrease in expected cash flows, including those that result from an increase in expected prepayments. A firm will be required to present the total other-than-temporary impairment in the statement of earnings with an offset for the amount recognized in other comprehensive income.

The guidance significantly enhances disclosure by requiring the disclosure of the cost basis of available-for-sale and held-to-maturity debt securities by major security type. The firm must also disclose the methodology and key inputs, such as performance indicators of the underlying assets in the security, and loan to collateral value ratios, used to measure the portion of an other-than-temporary impairment related to credit losses by major security type.

This guidance will also be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009.

Wednesday, April 01, 2009

G-20 Working Group Proposes Systemic Risk Regulation, Including Hedge Funds, and Reform of Executive Compensation

A G-20 working group has issued a report proposing a massive overhaul of financial regulation involving the creation of a systemic risk regulator and the regulation of all systemically important financial institutions, markets and instruments, including hedge funds, derivatives, and structured securitization vehicles. Effective macro-prudential regulation requires enhancements to a range of supporting policies and infrastructure, including compensation practices that promote prudent risk taking, greater standardization of derivatives contracts and the use of risk-proofed central counterparties; and improved accounting standards that better recognize loan-loss provisions and dampen adverse dynamics associated with fair-value accounting. The full title is the G-20 Working Group on Sound Regulation and Strengthening Transparency.

Defining what is systemically important will be crucial, said the report. The importance of how broadly systemically important institutions are defined was also noted by SEC Chair Mary Schapiro in recent testimony before the Senate Banking Committee. The report said that assessments of systemic significance should take into account a wide range of factors, including size, leverage, interconnectedness, and funding mismatches. In addition, the increased integration of markets globally should be taken into account when assessing the systemic importance of any given financial institution, market or instrument given the potential for cross-border contagion.

More specifically, the G-20 report listed three key sets of data that regulators should consider in analyzing the potential risks posed. First, data on the nature of a financial institution’s activities should be collected, including, in the example of a hedge fund manager, data on the size, investment style, and linkages to systemically important markets of the funds it manages. Second, regulators should develop common metrics to assess the significant exposures of counterparties on a group-wide basis, including prime brokers for hedge funds, to identify systemic effects.

Third, data on the condition of markets such as measures on the volatility, liquidity and size of markets which are deemed to be systemically important should also be collected. It is envisaged that regulators would use a combination of existing information sources, including data collected from key institutions and vehicles. Consideration of what regulatory, registration or oversight framework would best enable this information collection and subsequent action would be determined by financial regulators at the home and host country level.

The data collected would likely include the size, investment style, leverage and performance of the hedge fund along with its participation in certain systemically important markets. In addition, since one mechanism through which the failure of a systemically important hedge fund or cluster of hedge funds would be transmitted to the broader financial system is through its counterparties, regulators must develop and monitor common metrics to assess the significant exposures of counterparties, including prime brokers for hedge funds.

Particular consideration should be given to the potential for the shadow banking system and for leveraged institutions such as hedge funds to contribute to systemic risk. The G-20 said that hedge funds or their managers will need to register and provide authorities with the relevant information they require. Oversight and regulation will then be enhanced as appropriate, depending on risks revealed by the analysis of the information obtained.

Regulation could be enhanced either by restricting some of their activities that may present particularly high risks or conflicts of interest, or by assigning appropriate capital charges to reflect non-core activities. Measures for restricting activities of financial institutions could include disallowing the sponsorship or the management of private pools of capital in which the bank’s own funds are commingled with that of clients, and imposing strict capital rules.
The G-20 endorses the sound regulation of credit rating agencies since self-regulation is no longer appropriate. Regulations should prevent conflicts of interest and adequately manage conflicts that do arise. There must also be transparency about the quality of ratings, the ratings methodology, and the rating process, both in general and with respect to a specific issuer or financial instrument.

Moreover, there should be a dual rating scale or an identifier distinguishing between corporate and sovereign debt, on the one hand, and structured financial products on the other. The G-20 also recommend an enforcement component to the registration of credit rating agencies so that regulators can require changes to a rating agencies’ procedures for managing conflicts of interest and assure the transparency and quality of the rating process. Given the global scope of credit rating agencies, the new oversight framework must be consistent across jurisdictions in order to avoid regulatory arbitrage.

The report noted that a key lesson from the current crisis is that accounting standards have not accurately represented the financial situation of entities, as they did not take into account available information on risks. Thus, accounting standards need to be strengthened to better reflect risks through the cycle. Accounting standard setters must mitigate procyclicality by identifying solutions that are compatible with their complementary objectives of enhancing the stability of the financial sector and promoting transparency of economic results in financial reports.

Specifically, the G-20 recommend that accounting standard setters strengthen the accounting recognition of loan loss provisions by considering alternative approaches for recognizing and measuring loan losses that incorporate a broader range of available credit information They should also change the standards to dampen adverse dynamics associated with fair value accounting, including improvements to valuations when data or modeling is weak.

The G-20 also endorsed the Basel Committee on Banking Supervision package of measures to strengthen the Basel II capital framework in order to address weaknesses revealed by the crisis. These measures form part of a comprehensive strategy to strengthen the regulation and risk management of internationally active banks. Basel II will establish stronger capital requirements for banks’ structured credit and securitization activities. Recognizing the need to also mitigate procyclicality, high quality capital should serve as a buffer which would be built up during periods of rapid earnings growth and be drawn down in a downturn.

The increasing complexity of financial instruments also creates challenges for managing liquidity. The inclusion of options in financial instruments and the fact that some instruments have short track records or do not trade actively, increases the difficulty in assessing the behavior of these instruments during periods of stress. The G-20 recommends that financial institutions establish a robust framework for managing liquidity risk, and that they maintain sufficient liquidity, including a cushion of unencumbered, high quality liquid assets.

Enhancing liquidity supervision includes an evaluation of tools, metrics and benchmarks that regulators can use to assess the resilience of liquidity cushions and constrain any weakening in liquidity maturity profiles, diversity of funding sources, and stress testing practices. An effective global liquidity framework for managing liquidity in large, cross-border financial institutions should include internationally agreed levels of liquidity buffers, and should encourage an increase in the quality of their composition

The G-20 endorsed the position of the President’s Working Group on Financial Markets that transactions in credit default swaps not cleared through a central counterparty be registered, with risk management standards for these instruments developed by regulators. There should also be public reporting of prices and trading volume.

The G-20 report also urged the creation of a central counterparty for OTC credit derivatives as an important step towards reducing systemic risk. Clearing and settling credit default swap contracts through a central counterparty means that the two counterparties to the swap are no longer exposed to each other’s credit risk. Hence, well-managed, and properly regulated, central counterparties will contain the failure of a major market participant.

Central counterparties also contribute to enhancing market efficiency by helping ensure that eligible trades are cleared and settled in a timely manner, thereby reducing the operational risks associated with significant volumes of unconfirmed and failed trades. Furthermore, the development of a central counterparty facilitates greater market transparency, including the reporting of prices for credit default swaps and trading volumes.

The G-20 also support central counterparty clearing for other types of derivatives trading over-the-counter. Moreover, in order to foster transparency and to promote the use of a central counterparty and of exchange trading for credit derivatives, regulators should also encourage the financial industry to standardize contracts and to use data repository for the remaining non-standardized contracts. The G-20 also said that central counterparties should be subject to oversight by regulators, including central banks, and satisfy high standards in terms of risk management.

A general consensus has emerged that compensation practices have contributed to the financial crisis by focusing on bonuses linked to short-term profits without adequate regard to the longer-term risks they imposed on their firms. This misalignment of incentives amplified the risk-taking that severely threatened the global financial system. Going forward, compensation systems must be related to risk management. Noting that compensation reform must be mandated industry-wide and not be voluntary and ad hoc, the G-20 views regulation as the proper vehicle for promoting compliance with sound compensation.

The board of directors should be required to set clear firm-wide lines of responsibility and accountability to ensure that the compensation regime promotes prudent risk taking. Shareholders may also have a role in this process. The compensation scheme must also be monitored through a formal mechanism. For their part, regulators should enhance their oversight of compensation schemes by taking their design into account when assessing risk management.