Sunday, May 31, 2009

Convergence of US GAAP and IFRS May Be 10-15 Years Away Says FASB Chair as Boards Vow Int'l Fair Value Accounting Standard

FASB Chair Robert Herz told a meeting of the Financial Crisis Advisory Group that full convergence of US GAAP and IFRS could take as long as 10–15 years. While substantial convergence of the two sets of financial accounting standards will result from completion of
the Norwalk Agreement , he said, there will still be numerous areas of difference between IFRS and U.S. GAAP. IASB Chair David Tweedie mentioned that if the international and US accounting standard do not converge, constituents will be interested why it will have taken seven years for the US to realize it will not converge when the IASB and the Japanese Accounting Standards Board may adopt IFRS in less time. Mr. Tweedie also noted that some constituents have said that FASB should be cut out of the discussion. The meeting also revealed a consensus that FASB acted properly in adopting short-term guidance on fair value accounting in illiquid securities markets, while the two Boards plan a converged long-term standard for mark-to-market accounting.

The Financial Crisis Advisory Group is co-chaired by former SEC Commissioner Harvey Goldschmid and Hans Hoogervorst, Chairman of the Netherlands Authority for the Financial Markets. Other members of the group include: Jerry Corrigan, former President of the NY Fed, Gene Ludwig, former Comptroller of the Currency, Don Nicolaisen, former SEC Chief Accountant, and Lucas Papademos, Vice President of the European Central Bank. Acting SEC Chief Accountant James Kroeker was an observer at the meeting.

While reaffirming FASB’s commitment to a set of global accounting standards, Mr. Herz said that convergence is not the primary statutory responsibility of FASB. When emergency actions are required for the US financial market, he added, efforts may be taken without a thrust toward convergence. That said, Mr. Herz was quick to point out that convergence of US GAAP and IFRS is important to other US statutory bodies. For example, the Sarbanes-Oxley Act and the SEC 2003 policy statement state that FASB should look toward convergence where it is helpful to do so.

With regard to fair value accounting, Chairman Herz said that FASB’s recent guidance was a responsible and appropriate response, but that the Board does not view it as a long-term solution. Mr Herz explained that the long-term solution is the joint financial instruments project with the IASB, which is aimed at developing a single, high-quality standard on fair value accounting. Mr Herz said that if FASB and the IASB expose a joint draft on improving financial accounting and reporting for financial instruments by the end of the current year, a final standard might not be issued until 2010.

He noted that impairment will be a difficult issue because the Boards may have different perspectives. But the FASB Chair emphasized that impairment accounting would not need to exist if financial instruments were measured at fair value or current value.

The IASB Chair said that, while it took the IASB and its predecessors12 years to produce IAS 39, the two Boards have accepted the challenge of the G-20 to complete a comprehensive, high-quality, single standard to account for financial instruments within a shorter time frame.

Chairman Tweedie said that the Boards envision two classifications for financial instruments; one being full fair value and the other possibly current value. The determination of which classification a security is in will be based on either an entity’s business model, management’s intent, or the variability on cash flows. If the Boards agree on a single impairment model, it may be a modified incurred loss model, a dynamic provisioning model, or an expected loss model.

Mr Tweedie noted that tentatively the IASB believes that FASB’s fair value guidance is consistent with the principles of IAS 39. As for impairments, he said that the concept of other-than-temporary impairment does not exist in international standards. Although the IASB considered changing the fair value impairment model, it was deemed to be too large a change. Additionally, the FASB’s
impairment model is very different than the IASB’s impairment approach.

FCAG co-chair Harvey Goldschmid understands the arguments made to move away from a snapshot measurement of fair value, and agreed that stock exchange pricing is not always accurate in terms of valuation. However, the co-chair stated that active stock market valuations are the best valuation approach, as well as the most practicable and verifiable approach, now available in an imperfect world. Other FCAG members agreed that mark-to-market accounting is the best valuation model in well-functioning markets and, while markets may not be the best valuation mechanism in illiquid markets, it is still better than having management make an estimate of the value. FCAG member Tommaso Padoa-Schioppa, a former chair of the IASB’s oversight body, noted that a financial instrument may be more observable than another instrument at one instant; however, financial statements are used over a period of time, something that is not currently reflected in fair value measurements.
UK Corporate Secretaries Suggest Revision of Combined Code to Make Risk Management a Board Duty

The UK corporate secretaries have recommended that the Combined Code, the UK’s corporate governance code, be amended to ensure that risk management is a collective board responsibility at the core of effective corporate governance. In a comment letter to the Financial Reporting Council, the Institute of Chartered Secretaries and Administrators said that setting risk management policy is a matter for the collective board and should not be delegated to a board committee. Even more, to ensure that risk management is given a higher profile by boards, the ICSA urged that the very definition of corporate governance in the Code be amended to provide that good governance should facilitate effective management that can deliver shareholder value within appropriate risk parameters established by the board. The ICSA also reaffirmed its commitment to a comply or explain model of corporate governance, specifically rejecting the prescriptive approach to corporate governance embodied in the Sarbanes-Oxley Act.

The financial crisis has shown that a company’s risk appetite must be considered a primary function of the full board. Thus, the Code should encourage the embedding of the consideration of risk within business objectives and strategy and the board should, after consultation with the company’s risk manager, be responsible for setting the risk parameters within which the company should operate.

While the oversight of risk management could be delegated to a board committee, the board should review risk on a regular basis, perhaps at least quarterly, and set out a clear policy that can be implemented by management on a day-to-day basis. Also, good governance requires disclosure of the risk policy and any delegated authorities for the oversight and management of risk within the parameters of that policy.

More specifically, the full board should categorize the types of risk which are acceptable for the company to bear in pursuit of its business objectives. Those which should not be tolerated, either at all or subject only to specified restrictions, should be identified. Upon becoming aware of any violations of the risk policy, executive management or the risk manager should report them to the relevant oversight committee chair, or company chair, who should arrange for a full report to be made to the board at its next meeting on the violation and any corrective action taken.

Further, the glass ceiling that often discourages or even stops risk managers from talking directly to the board has to be broken. The Code should encourage directors, particularly independent directors, to make visits within the business, which are not stage-managed, in order to facilitate interaction by the independent directors with the business managers below board level and to enable direct relationships to be fostered.

Management’s compliance with the board’s policy on risk, as distinct from internal control, should be subject to an annual review as part of any review by the audit committee or other appropriate board committee of the effectiveness of the company’s system of internal control.

The Code should also be amended to provide a greater link between reward policies and risk policies. As part of that effort, the remuneration committee should review all remuneration policies that could influence the firm’s risk profile. Models of performance-related pay that facilitate a culture of pursuing growth contrary to the board’s risk policy should be prohibited. The board should be required to state the effectiveness of the remuneration policy in achieving the appropriate balance between reward and risk and that the meeting of any targets would not in fact lead to a position where the risk appetite of the company has been exceeded.

The corporate secretaries group cautioned that the Code should in no way discourage risk taking per se, and perhaps should positively assert that fact. Rather, the extent of the material risks taken should be agreed by the board. At that point, the company secretary, internal audit, or the audit committee can set the framework for the review of the effectiveness of the internal control system, including the implementation of and compliance with the risk policy and report on it to the board or a board committee.

Thursday, May 28, 2009

Committee on Capital Markets Regulation Issues Broad Reform Framework Centered on Unitary Regulator

The blue ribbon Committee on Capital Markets Regulation has recommended a consolidated unitary regulator approach for the US, modeled on the UK Financial Services Authority, plus naming the Federal Reserve Board as systemic risk regulator. The Committee urged the creation of the US Financial Services Authority (USFSA) with jurisdiction over market structure and activities, safety and soundness of financial institutions, and possibly consumer and investor protection with respect to financial products. The USFSA would be comprised of the OCC, FDIC, SEC CFTC, and the OTS.

The Committee noted that the vast majority of other leading financial center countries have moved toward more consolidated financial oversight. A rapidly dwindling share of the world’s financial markets are supervised under the fragmented, sectoral model still employed by the United States.

The Committee also proposed that the Fed be given the role of systemic risk regulator, in addition to keeping jurisdiction over monetary policy. The committee offered the alternative recommendation of a third independent agency to separately regulate investor protection, which has the advantage of ensuring a sole mission focus on investor protection. The disadvantage of such an agency would be that it would not effectively weigh competing policy interests. In addition, it would be difficult to coordinate the inevitable conflicts between prudential regulation and consumer and investor protection.

The Committee on Capital Markets Regulation is co-chaired by Glenn Hubbard and John Thornton. Other members of the Committee are former SEC Commissioner Roel Campos, former NASD CEO Robert Glauber, CBOE CEO William Brodsky, and PricewaterhouseCoopers CEO Samuel DiPiazza.

The Treasury Department would coordinate the work of the Fed and USFSA. The Treasury would also be responsible for the expenditure of public funds used to provide support to the financial sector, as in the TARP. In addition, to preserve the independence and credibility of the Fed, existing Fed lending against no or inadequate collateral would be transferred to the Treasury, and future lending of this type would be done only by the Treasury Department.

The Committee believes that one regulator needs the authority and accountability to regulate matters pertaining to systemic risk. As such, the Committee rejected current proposals in Congress and elsewhere to vest systemic risk regulation in an interagency council comprising several existing regulatory agencies. As the systemic risk regulator, the Fed would set capital requirements for all financial institutions. Other types of regulation that directly bear on systemic risk, like margin requirements, would also be entrusted to the Fed.

The Committee presented three options for regulating financial institutions: 1) The Fed regulates systemically important financial institutions, and the USFSA regulates all the others; 2) the Fed regulates all financial institutions; 3) the USFSA regulates all financial institutions. Whatever framework is chosen, the committee does not believe that the regulation of holding companies should be split from the regulation of their financial institution subsidiaries. The same agency that supervises the holding company should also supervise the subsidiaries. Also, the determination of whether an entity is systemically important should be made on the basis of the fully consolidated holding company.

Hedge funds would be subject to federal regulation under the proposed scheme, but private equity firms would not. Hedge funds should keep regulators informed on an ongoing basis of their activities and leverage. Private equity, however, in the view of the Committee, poses no more risk to the financial system than do other investors. But private equity firms, if large enough, should be subject to some regulatory oversight and periodically share information with regulators to confirm they are engaged only in the private equity business.

Under existing SEC regulation AB addressing disclosure in connection with asset-backed securities dealers issuing mortgage-backed securities may, but are not required to, provide granular loan-level data regarding the underlying mortgages. Based on empirical research, the Committee concluded that Regulation AB should be amended to require issuers of mortgage-backed securities to provide loan-level data. The SEC should set forth in its regulation the particular field of loan-level data that must be disclosed. This should be largely based on investor demand and inputs. The SEC should also immediately initiate a study to refine the standardized list of residential mortgage-backed securities pool data required at inception and on an ongoing basis. This additional information would not only benefit investors in such securities, but also investors in collateralized debt obligations predicated on mortgage-backed securities.

Because the enhanced disclosures would be useful only to the extent they are actually made, the Committee encouraged the SEC to consider whether the less-than-300-holder exemption from the periodic reporting requirements of Section 15(d) of the Exchange Act was meant to apply to the typical residential mortgage-backed securities issuance otherwise covered by Regulation AB. If so, the Commission should seek a statutory change to remedy this problem.

Regarding hedge fund regulation, at least one proposal presently before Congress, The Hedge Fund Transparency Act of 2009, would eliminate current statutory exemptions and impose SEC registration and periodic disclosure requirements on hedge funds. The committee seriously doubts that the passage of this legislation would help reduce systemic risk, noting that the enormity of daily trading activity alone makes periodic disclosure a futile method for gauging the risks posed by individual hedge funds at any given moment At best, such historical information would be useless; at worst it would be misleading. The Committee believes that strengthening SEC resources for greater investigatory and enforcement work is a better-tailored solution.

Instead, the Committee proposes requiring hedge funds to confidentially report to regulators information such as fund’s total assets under management, relative measures of leverage, portfolio holdings, and list of credit counterparties. The Treasury recently recommended that newly-regulated hedge funds be required to report to the SEC on a confidential basis information necessary to assess whether a particular fund or fund family is so large or highly-levered that it poses a threat to financial stability. This information would be shared with a systemic risk regulator, which would then determine whether a given hedge fund should be subject to certain prudential standards. At this time, Treasury has not offered any specifics as to what information would be required to be disclosed confidentially.

The Committee also recommends supplementing fair value accounting with a dual presentation of market and credit values. The Committee believes that FASB should supplement the fair value standard outlined in FAS 157-4 by requiring preparers to disclose two additional balance sheet presentations that would enable investors to distinguish the influence of market and credit value inputs more explicitly.

Wednesday, May 27, 2009

SEC Rule 151A Challenged in Federal Appeals Court

SEC Rule 151A defining indexed annuities as not being exempt annuity contracts under Section 3(a)(8) of the Securities Act is being challenged in federal court by issuers of fixed indexed annuities that will be subject to SEC regulation as a consequence of the rule. Fixed indexed annuities as described by the SEC are annuities, argued the issuers, not regulated securities. They are uniformly recognized as such by the states and are subject without exception to the state laws that exist to assure that insurance products provide protections against risk commensurate with the name. Unlike variable annuities and mutual funds, noted the issuers, fixed indexed annuities are not marketed or valued according to the investment management of the issuer. The petitioners asked the federal appeals court to vacate Rule 151A.

Earlier this year, the SEC adopted Rule 151A 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 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 was held on May 8, 2009.

In its brief defending its adoption of Rule 151A, the SEC, relying on a series of US Supreme Court rulings, said 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.

The petitioner contended that fixed indexed annuities are exempt from regulation as securities according to the plain terms of Section 3(a)(8), which exempts “any” annuity contract from SEC regulation, and there was no need to deploy the analysis used in the Supreme Court opinions. Picking and choosing which annuities to regulate as securities was outside the Commission’s authority, argued the brief.

But even if the Supreme Court analysis is deployed, continued the issuers, fixed indexed annuities plainly satisfy that analysis, while the terms of Rule 151A conflict with the Supreme Court’s decisions and the statutory text. Further, the issuers said that the rule’s invalid terms result from the SEC’s use of a definition of investment risk that conflicts with the governing case law and common parlance. In its haste to finalize the rule only a month after the comment deadline, contended the petitioners, the Commission ignored record evidence about the meaning of investment risk and the marketing of indexed products.

The petitioners also said that the SEC incorrectly characterized indexed annuities as similar in many ways to mutual funds, variable annuities, and other securities in that purchasers of indexed annuities assume many of the same risks as investors in mutual funds and variable annuities. The petitioner noted that, in contrast to mutual funds and variable annuities, fixed indexed annuities are subject to the full panoply of state insurance laws whose function is to protect against risk of loss, guaranteeing that a contract owner receives no less than 87.5 percent of premiums even if the contract is surrendered in the first year, and assuring that the minimum contract value will increase at a rate of at least 1 to 3 percent annually for the life of the contract.

These are identical to the guarantees for traditional fixed annuities. Moreover, fixed indexed annuity premiums are invested in insurers’ general account subject to special state investment requirements, and contract values are not based on insurers’ investment management.
Supreme Court Takes Inquiry Notice Case

The high court seems to have a renewed interest in securities cases. The court had already agreed to hear Jones v. Harris Associates L.P., a case involving excessive fee claims under Section 36(b) of the Investment Company Act, and the Free Enterprise Fund case on the constitutionality of the PCAOB. This week the court agreed to review a 3rd Circuit ruling on the statute of limitations and inquiry notice in In re Merck & Co. arising from the drug maker's Vioxx litigation. The appeals panel decision is discussed here.

Tuesday, May 26, 2009

President Signs Legislation Imposing Disclosure and Fiduciary Duties on Treasury Program to Remove Toxic Securities from Financial Institutions

President Obama has signed legislation providing for additional oversight of the Treasury’s Public-Private Investment Program (PPIP), which is designed to remove toxic securities from the balance sheets of financial institutions. The Helping Families Save Their Homes Act, Public Law No.111-22., is bi-partisan legislation crafted to prevent foreclosures and strengthen the housing market. The measure would also provide the Government Accountability Office (GAO) with the authority to investigate the books of companies receiving TARP dollars.

The legislation requires that any program to create a private-public investment fund must have conflict of interest rules, and requires funds to report on 10 largest positions in the fund and investors with greater than 10 percent interest in fund, to retain records by fund, to acknowledge fiduciary duty, and to develop ethics rules and screening. It also allows the Special Inspector General access to books and records of a fund. The legislation requires Treasury to consult with Special Inspector General on the interaction between the Private-Public Investor Program, the Term-asset Backed Securities Loan Facility, and similar programs and to issue conflicts of interest rules, including concerning the potential for excessive leverage as a result of interactions of program. Also makes additional funds of $15 million available to the Special Inspector General.

A House Manager’s Amendment inserted into the legislation near the end of the process clarified that Treasury must write the conflict of interest rules required by the provision. The amendment also clarified that fund managers are to provide Treasury information on any investor that holds an equity interest in a fund of at least 10 percent. It also highlighted that the Special Inspector General must prioritize audits or inspections of any program funded by the Emergency Economic Stabilization Act of 2008.

The oversight provisions were added to the legislation by Senator Barbara Boxer. The provisions would require Treasury to write tough rules to guard against collision and conflicts of interest in the PPIP, require funds to disclose their ten largest positions, and impose a fiduciary duty on fund managers. It would also give the Special Inspector General for TARP additional funding to conduct audits to enforce these rules.

The Boxer amendment requires federal programs creating a public-private investment fund to impose strict conflict of interest rules on managers of public-private investment funds specifically describing the extent to which the managers may conduct transactions involving funds that affect the value of assets that are not part of such funds; and in which managers or significant investors in such funds have a direct or indirect financial interest. Rules must also require each public-private investment fund to make a quarterly report to Treasury disclosing the ten largest positions of such fund. Fund managers must also identify for Treasury each investor whose interest in the fund totals at least ten percent, in the aggregate

In addition, managers of public-private investment funds must report to Treasury any holding or transaction by the manager or a client of the manager in the same type of asset that is held by the fund.

Funds must also allow the Special TARP Inspector General access to all of their books and records, including all records of financial transactions in machine readable form. Similarly, fund managers must retain all books, documents, and records relating to the public-private investment fund, including electronic messages.

Importantly, the legislation requires each manager of a public-private investment fund to acknowledge a fiduciary duty to both the public and private investors in such fund. Similarly, funds must develop a robust ethics policy that includes methods to ensure compliance with the policy. The funds must also implement investor screening procedures, including know your customer requirements that are at least as rigorous as those of a commercial bank or a retail brokerage operation.

According to Senator Boxer, the legislation is saying that the new investment program to take toxic securities off the books of financial institution should have the private sector come in and give a value to those assets so the federal government does not have to do it.
Hypothetically, a bank trying to unload toxic securities wants the most they can get for it. They can go to a private party and say: between us, bid a little bit more for this toxic asset and we will give you a kickback later. Under the Boxer Amendment, that would not be allowed. The Treasury must adopt regulations to make sure it is not allowed, emphasized the senator. The TARP Inspector General would be given $15 million to perform audits of selected recipients so that Congress can follow up and make sure there is no collusion.

The legislation guarantees that there will be access to financial data from the public-private Investment fund that is necessary to perform these audits, noted Senator Boxer, and requires regulations that are very clear so that the private sector cannot use money they have borrowed from other federal programs to pump into the system. They might be able to use some loans, said the senator, but Congress does not want 100 percent of that money being recycled again.
Senate Leader Introduces Legislation to Curb Excessive Compensation

Senator Richard Durbin, Assistant Majority Leader, has introduced two pieces of legislation to curb excessive executive compensation by requiring a super majority shareholder vote approving excessive compensation and denying companies a tax deduction under IRC ¶162 with regard to excessive compensation. The Excessive Pay Shareholder Approval Act, S. 1006, would amend the Exchange Act to require a 60 percent shareholder vote to approve a compensation structure in which any employee receives more than 100 times more than the average employee of that company. The SEC would be directed to adopt rules requiring proxy materials for the supermajority shareholder vote to include the amount of compensation paid to the company’s lowest and highest paid employee, the average amount of compensation paid to all employees, the number of employees who are paid more than 100 times the average amount of compensation for all employees, and the total amount of compensation paid to employees who are paid more than 100 times the average amount of compensation for all employees.

Similarly, the Excessive Pay Capped Deduction Act, S 1007, would limit the normal tax deduction for compensation for executives to 100 times the compensation of the average worker at that company. Both bills would broadly define compensation to include wages, salary, fees, commissions, fringe benefits, deferred compensation, retirement contributions, options, bonuses, property, and any other form of remuneration that the SEC determines is appropriate, in consultation with the Secretary of the Treasury.

S. 1007 would require, under the IRC, that employers providing excessive compensation to any employee during a taxable year must file a report with Treasury with respect to such taxable year. The report must include the amount of compensation of the company employees that received the lowest and highest amount of compensation during such taxable year, the average compensation of all employees, the number of employees who are receiving compensation that is more than 100 times the average compensation of all employees, and the amounts of that compensation.

Congress Passes Legislation Imposing Disclosure and Fiduciary Duties on Treasury Program to Remove Toxic Securities from Financial Institutions
Congress has passed and cleared for the President legislation providing for additional oversight of the Treasury’s Public-Private Investment Program (PPIP), which is designed to remove toxic securities from the balance sheets of financial institutions. The Helping Families

Monday, May 25, 2009

ECB Official Says Systemic Risk Regulation Must be Cross-Border

Noting that the financial crisis has shaken markets to their foundations and revealed gaps in risk management and the geographical reach of regulation, an Austrian Member of the European Central Bank called for cross-border systemic risk regulation in order to prevent regulatory arbitrage. In remarks to a panel at the German Office of the European Commission, Executive Board Member Gertrude Tumpel-Gugerell also reaffirmed the ECB’s belief that legislation implementing systemic risk regulation must include all systemically important institutions and markets, including hedge funds, credit rating agencies and OTC derivatives markets. Recently, ECB President Jean-Claude Trichet called for the regulation of hedge funds, OTC derivatives, and credit rating agencies since they can pose a systemic risk to the markets.

Recently the G-20 called for international cooperation and consistency as part of the reform of financial regulation, she noted, and the recommendation of the De Larosière Report for a globally coordinated legislative response to the financial crisis was endorsed by the European Commission. In the area of macro-prudential systemic risk regulation, the De Larosière Report urged the creation of a European Systemic Risk Council to be established under the auspices of the ECB.

The financial markets are inexorably globally integrated, reminded the central banker, and financial stability must be cross-border in order to ameliorate systemic risk and prevent regulatory arbitrage. Thus, reform legislation must provide for the global monitoring of system stability and the regulation of cross-border systemically important institutions. For the proper regulation of cross-border institutions that can impact systemic risk, she continued, there must be strong international cooperation and clear rules. For the global monitoring of systemic risks, the ECB official envisions close cooperation between the International Monetary Fund and the Financial Stability Board in the conduct of early warning exercises.

At a minimum, she emphasized that a coordinated EU solution must be found for the supervision of cross-border financial institutions and the monitoring of systemic risks. In order to augment this effort, she strongly urged the creation of the European Systemic Risk Council recommended by the De Larosière Report.

The Rick Council could improve the identification and assessment of systemic risks affecting the EU financial system by analyzing the interconnections among financial institutions and markets on the basis of both macro and micro-prudential regulatory information. The provision of the logistical and analytical support to the Council by the ECB would allow existing knowledge and skills in financial stability analysis to be exploited. The views of the regulators could be integrated in the process by ensuring their adequate representation on the Risk Council.

In her view, the success of the Risk Council would be conditioned on a number of factors. For example, the body’s effectiveness would crucially depend on the access of the central bank to relevant information for risk assessment and the monitoring of vulnerabilities in the financial system. Similarly, the Risk Council would need to rely on effective institutional mechanisms ensuring adequate information-sharing with micro-prudential regulators.

Also, risk warnings would have to be effectively translated into concrete recommendations on macro-prudential policies requiring follow-up actions by competent authorities. This would, in turn, require adequate mechanisms for monitoring and enforcement. Any recommendations from the Risk Council should concern mainly financial regulatory action and should not address either monetary or fiscal policy. Finally, the global dimension of the financial system calls for swift and comprehensive coordination between the Risk Council and the Financial Stability Board.

Friday, May 22, 2009

President Signs Legislation Strengthening Securities and Financial Fraud Enforcement and Creating Commission to Examine Causes of Crisis

President Obama has signed the Fraud Enforcement and Recovery Act (FERA) improving the enforcement of securities and commodities fraud and financial institution fraud involving asset-backed securities and fraud related to federal assistance and relief programs. The legislation expands the scope of securities fraud provisions to include commodities and derivatives fraud and extends the prohibition against defrauding the federal government to the TARP program and to the stimulus bill. The legislation also provides the Department of Justice with the tools it needs to fight fraud in the use of funds under TARP and the American Recovery and Reinvestment Act. The legislation creates the Financial Crisis Inquiry Commission to examine and report on the causes of the financial crisis.

The measure also authorizes additional appropriations for the SEC and other federal agencies to investigate and prosecute fraud, and creates a Select Commission to examine the causes of the current financial crisis. This legislation also makes a number of important improvements to fraud and money laundering statutes to strengthen prosecutors' ability to combat this growing wave of fraud.

In a signing statement, the President said that the legislation was needed because the federal government's ability to investigate and prosecute securities and other financial frauds is severely hindered by outdated laws and a lack of resources. The legislation provides the resources necessary for federal agencies, from the Department of Justice to the SEC to pursue financial fraud cases. FERA also expands DOJ's authority to prosecute fraud that takes place in many of the private institutions not covered under current federal bank fraud criminal statutes, noted the President, institutions where more than half of all subprime mortgages came from as recently as four years ago.

FERA, S 386, was introduced by Senator Patrick Leahy, chair of the Judiciary Committee, and Senator Charles Grassley, Ranking Member on the Finance Committee. It is based on a sense of Congress that fraud contributed to an unprecedented collapse in the mortgage-backed securities market. The legislation is designed to ensure that this kind of collapse cannot happen again. A main component of the reform is the reinvigoration of federal antifraud measures. FERA is a major step toward holding accountable those who have caused so much damage to the US economy, while at the same time protecting economic recovery efforts from the scourge of fraud.

FERA makes a number of important improvements to antifraud 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.

The federal securities antifraud statute was added to the U.S. criminal code by Section 807 of the Sarbanes-Oxley Act, which created a new federal felony for securities fraud with a 25-year penalty. Section 807, codified as 18 U.S.C. §1348, made it easier to prove securities fraud while at the same time increasing the penalty. Before Sarbanes-Oxley, federal prosecutors were forced to resort to a patchwork of technical offenses and regulations that criminalized particular violations of the securities laws, or to treat the cases as generic wire or mail fraud. Sarbanes-Oxley criminalized any scheme to defraud persons in connection with securities or public companies to obtain their money or property. Importantly, FERA extends the strong provisions of Section 807 to frauds involving commodities, including derivatives, such as options and mortgage-backed securities.

The Act authorizes additional appropriations for the SEC to fight financial fraud of $20 million for fiscal years 2010 and 2011. The legislation specifically states that the additional funds are to be used for investigations and enforcement proceedings involving financial institutions. The Act also adds $1 million a year for two years for the salaries and expenses of the SEC’s Inspector General.
SEC Concerned About Post-Trade Transparency of Dark Pools

The SEC has become increasingly concerned about the post-trade transparency of dark pools, which are electronic trading systems that do not display public quotes. According to James Brigagliano, Co-Acting Director of the Division of Trading and Markets, this lack of post-trade transparency can make it difficult for the public to assess dark pool trading volume and evaluate which ones may have liquidity in particular stocks. In keynote remarks at a recent SIFMA seminar on market structure, he also examined the potential effect of dark pools on the public price discovery function.

Public quote streams are distributed by central processors that act on behalf of all the SROs in making market information widely available to the public. Over the last year, dark pools, which do not display public quotes, appear to have increased their percentage share of total trading volume in US-listed stocks. But the SEC official noted that there is very little reliable public information on dark pool trading activity. He said that this lack of public information illustrates a transparency concern that warrants attention. Dark pools report their trades to the consolidated public trade streams, but their trades are identified merely as non-exchange, or OTC, trades. The public trade reports do not identify whether an OTC trade was reported by a dark pool and, if so, the identity of the dark pool.

Although many dark pools publicize volume statistics on their web sites, he noted, they do not use a uniform methodology and may effectively overstate their true executed volume because of double counting of both the buy and sell side of a single trade or by including touched volume of orders routed elsewhere for execution with the matched volume that they actually execute. The official is concerned that this state of affairs may not promote public confidence in the equity markets.

There does not appear to be a particularly compelling reason for dark pools to object to improved post-trade transparency. While full pre-trade darkness is an important element of the business model of some dark pools, he said, it does not appear that some form of improved post-trade transparency would interfere with their business models. Indeed, uniform and reliable trade reporting practices could help establish a fairer playing field because those dark pools that report their volume accurately would not be disadvantaged in comparison with any that might inflate their volume.

The SEC will consider whether the post-trade transparency of dark pools should be enhanced. A key question is whether this type of information would be useful to investors and, if so, what is the best vehicle for disseminating the information. For example, Mr. Brigagliano queried whether trade-by-trade disclosure by dark pools would be most helpful, or would the public availability of more uniform, reliable summary statistics on trading volume be sufficient.

Another regulatory concern with respect to many dark pools relates to their transmittal of pre-trade messages about their available liquidity. Although dark pools do not publicly display quotes, he observed, many nevertheless are not entirely dark on a pre-trade basis. In an effort to attract order flow, many dark pools transmit messages to selected market participants notifying the recipient that the dark pool currently has an actionable order in a particular stock, that is, an order that currently is available for automated execution. One of the regulatory issues that former Director Erik Sirri earlier noted was the potential for such messages to fall within the regulatory definition of a "quote." Most dark pools label their pre-trade messages as indications of interest, or "IOIs."

Focusing on the policy implications of actionable order messages and whether they raise any market structure concerns, Mr. Brigagliano said that, given the speed and sophistication of order routing and trading systems, private actionable order messages are functionally and economically similar to public quotes. The systems are incredibly fast, he added, and both actionable order messages and quotes can be transmitted and responded to within a few milliseconds. Although a public quote always will have an explicit price, an actionable order message is implicitly executable at the national best bid and offer or better.

Dark pools that use actionable order messages typically transmit them to networks of selected market participants. As a result, said the official, the widespread use of actionable order messages could create the potential for significant private markets to develop that exclude public investors. In particular, these private markets could wind up representing a significant volume of trading based on valuable information on actionable orders to which the public does not have fair access.

Another aspect of actionable order messages the SEC will consider is their potential effect on competition among trading centers and market fragmentation. Erik Sirri suggested last year that competitive forces seemed particularly apt to address the problem of fragmented dark pools. He noted that the users of dark pools seemed likely to pressure their operators to consolidate the pools to enable users to check liquidity more efficiently. Mr. Brigagliano noted, however, that actionable order messages are used by the operators of dark pools to alert users when they have liquidity and thereby may weaken this competitive force for consolidation. If actionable order messages enable many small pools to survive separately, he added, market fragmentation could worsen.

Finally, the co-director discussed the potential effect of dark pools on the public price discovery function. It is possible that a substantial increase in dark pool volume could impair the public price discovery function by diverting valuable marketable order flow away from the exchanges that contribute to the public quote stream.

The official distinguished between two major types of dark pool trading mechanisms: block crossing systems and small order systems. Block crossing systems focus on arranging large trades between institutional investors. With an average trade size as high as 50,000 shares, block crossing systems offer significant size discovery benefits to their participants, though they currently appear to execute a small percentage of dark pool trading volume.

Small order systems, in contrast, appear to execute the great majority of dark pool volume and to be the fastest growing type of dark pool. They also may have the greatest effect on price discovery in the public markets. In particular, they may attract a significant volume of very desirable small marketable order flow away from the public markets.

This type of marketable order flow is desirable for those who supply liquidity through resting, non-marketable orders. To the extent desirable order flow is diverted from the public markets, reasoned the SEC official, it potentially could adversely affect the execution quality of those market participants who display their orders in the public markets. The Commission is concerned that any practice that significantly detracts from the incentives to display liquidity in the public markets could decrease that liquidity and, in turn, harm price discovery and worsen short-term volatility.

Thursday, May 21, 2009

Financial Industry Groups Ask Congress to Redefine and Improve Fair Value Accounting

Noting that when there is no market, market value does not provide relevant, useful information about a securitized asset, the financial industry told Congress that the fair value accounting mark-to-market standard still needs additional improvement even in the wake of FASB’s recent guidance. In a letter to the leaders of the House Financial Services Committee, groups ranging from the American Bankers Association to the Financial Services Roundtable said that FASB’s emphasis on mark-to-market not only results in misleading information in a distressed market, but can also result in misleading information in a typical market. The current volatility of exit prices for many financial instruments in uncertain economic times has demonstrated how unreliable fair values can be, which can have severe adverse implications when determining total reported capital and undermine public confidence. The groups stopped short of asking Congress to suspend the fair value accounting standard, but they do want it improved.

In the industry’s view, accounting rules should follow the business model. If the cash flows to be received are based on an expectation the asset will be sold, then mark-to-market is appropriate. If the cash flows to be received are not based on buying and selling in the market, then it is not appropriate. Accounting rules should provide information about an entity’s financial condition and should not cause management to make decisions based solely on accounting outcomes.

According to the groups, the most important improvement would be to change the definition of fair value. The current definition, which was reaffirmed by FASB in its recent guidance, continues to mislead users of financial statements. In practice, the application of FASB’s rule defining fair value as “exit price” gives no consideration to what price a seller is willing to accept, and therefore, results in a downward bias in reported values. It is precisely what the associations called an ``immense difference’’ between the economic value of the underlying assets in the security and the prices brokers are offering that has frozen the markets. They urged that fair value be defined as a willing buyer and willing seller in an arm’s length transaction that is not a forced sale.

On a longer term basis, FASB has publicly stated its view that mark-to-market accounting should be required for all financial instruments, including loans. But, the groups told the committee that the result of such a requirement would be that many financial institutions would need to curtail their lending activities due to the risk of volatility from recording immediate mark-to-market gains and losses. Such a risk would also drive up the cost of loans to consumers for the increased financial reporting risk assumed. Thus, the industry groups urged that the current efforts to require that all financial instruments be marked to market be abandoned.

The groups acknowledged that the recent FASB changes to the accounting for other than temporary impairment (OTTI) represent a major improvement in financial reporting. But while FASB acted expeditiously at the Committee’s request, noted the groups, the changes only scratched the surface. For example, OTTI continues to result in higher losses for U.S. companies versus companies that follow international accounting standards (IFRS) and may unintentionally increase the number of bonds that become subject to an OTTI charge. Additionally, while the other changes made by the FASB on mark-to-market provide more specific guidance, which is useful for more consistent application of the rules, they do not focus on the heart of the problem, which is that mark-to-market does not provide the most relevant measurement basis for many types of transactions.

Finally, the industry groups cited recent remarks by former Fed Chair Paul Volcker that pushing mark-to-market accounting to an extreme during the crisis is a mistake since it can lead to a cascading decline in valuations. It certainly has led to inconsistencies among institutions, noted the former chair, but beyond that is the more fundamental problem that mark-to-market accounting may not really be consistent with the traditional financial system.

All regulated institutions that perform the vital function of transferring maturity and credit differences into a practical, money-making operation are intermediaries, reasoned the former Fed chief, and you can't intermediate if you can't take any maturity differentials or any credit risk.

The recent FASB guidance provided additional guidance on determining whether a market for a financial asset is not active and a transaction is not distressed for fair value measurements. Generally, if the market is not active, then a valuation technique other than one that uses the quoted price must be used. FASB also provided a clearer benchmark for when an other-than-temporary impairment exists and needs to be recorded on securities held outside of a company's trading book.
White Paper on Finacial Regulatory Reform Available

On May 18th, Congress passed and cleared for the President’s signature its first piece of legislation reforming the oversight of the financial industry following the recent economic upheavals. The Fraud Enforcement and Recovery Act (FERA), S.386, strengthens enforcement of securities and commodities fraud, financial institution fraud involving asset-backed securities, and fraud related to federal assistance and relief programs.

Jim Hamilton has written a white paper that outlines and analyzes this legislation. The paper is available here.

Wednesday, May 20, 2009

SEC Proposes Shareholder Access Rule Based on Minimum Time and Ownership Requirements

Against the backdrop of impending changes to the Delaware corporation code making it easier for shareholders to nominate directors to corporate boards, the SEC has proposed rules facilitating the rights of shareholders to nominate directors. Proposed rule 14a-11 would allow shareholders to include their nominees for director in the company's proxy materials if they have been shareholders of the company for at least one year and satisfy a minimum holdings test based on the company’s market value. The proposed rule would apply to all Exchange Act reporting companies, including investment companies.

Shareholders would be eligible to have their nominee included in the proxy materials if they own at least 1 percent of the voting securities of a large accelerated filer, which is a company with a worldwide market value of $700 million or more or of a registered investment company with net assets of $700 million or more. Shareholders of an accelerated filer with market value of $75 million to $700 million would need to own at least 3 percent of the voting securities in order to be eligible. For a non-accelerated filer with less than $75 million, the ownership requirement is 5 percent. Shareholders would be able to aggregate holdings to meet the thresholds.

Under the proposal, shareholders would be required to sign a statement declaring their intent to continue to own their shares through the annual meeting at which directors are elected. They would also have to certify that they are not holding their stock for the purpose of changing control of the company, or to gain more than minority representation on the board of directors.

The nominating shareholder would be required to file with the Commission and submit to the company a new Schedule 14N disclosing the amount and percentage of securities owned, the length of ownership, and intent to continue to hold the securities through the date of the meeting. The Schedule 14N would require a certification that the nominating shareholder is not seeking to change the control of the company or to gain more than minority representation on the board of directors. For its part, the company would include in its proxy materials disclosure concerning the nominating shareholder, as well as the shareholder nominee or nominees, that is similar to the disclosure currently required in a contested election

The nominating shareholder would be liable for any false or misleading statements in information provided to the company that is then included in the company's proxy materials. The proposed rule would provide that the company will not be responsible for information provided by the shareholder, unless the company knows or has reason to know the information is false.

Under the proposal, shareholders could nominate no more than one shareholder nominee, or a number of nominees that represents up to 25 percent of the company's board of directors, whichever is greater. For example, if the board is comprised of three members, one shareholder nominee could be included in the proxy materials. If the board is comprised of eight members, up to two shareholder nominees could be included in the proxy materials. The nominee must satisfy objective independence standards of the applicable national securities exchange. Further, the nominating shareholder may have no direct or indirect agreement with the company regarding the nomination of the nominee.

Changes to the Delaware corporation code that take effect August 1, 2009 will make it easier for shareholders to nominate directors to corporate boards. A new Section 112 of the Delaware General Corporation Law clarifies that company bylaws may require, that if the company solicits proxies on an election of directors, the company may be required to include in its proxy materials one or more nominees submitted by shareholders in addition to individuals nominated by the board. Section 112 also identifies a non-exclusive list of conditions that the bylaws may impose on shareholder access to the proxy materials, including a minimum level of stock ownership and the duration of shareholder ownership
Pension Funds Urge Congress to Give SEC Crucial Role in New Financial Regulatory Regime

As Congress develops legislation to reform the regulation of financial markets, a group of large public pension funds has urged congressional oversight leaders to give the SEC a crucial role in the overall reform legislation. In letters to House Financial Services Chair Barney Frank and Senate Banking Committee Chair Christopher Dodd, the pension funds emphasized that the SEC must have the independence, robust regulatory authority, staffing, and budgetary resources necessary to effectively fulfill its unique mission of investor protection. The pension funds writing to the oversight committees included the California Public Employees Retirement System and the New York State Common Retirement Fund.

The funds said that they depend on the SEC to help protect the pension fund community’s interest in the integrity of the financial markets. Congress established the SEC to serve as the investor’s advocate, they pointed out, and in the wake of recent market events it is hard to imagine a more compelling need for a strong, independent regulator with a proven record of expertise to oversee and advocate the interests of investor protection. They similarly strongly support SEC Chair Mary Schapiro’s commitment to vigorously carry out this mission.

As the oversight committees develop legislation to revamp the current financial regulatory system, the pension funds request that a number of principles be given careful consideration with respect to the future role of the SEC. For example, the SEC’s independence must continue under a revamped financial regulatory regime. Congress established the SEC as an independent agency, noted the pension funds, and such independence has been critical to the SEC’s historical success as regulator.

Also, the SEC must maintain robust regulatory and enforcement authority over securities market transactions and trading practices, the policing of market professionals, and the disclosure and accounting standards which provide investors with the tools and market information necessary to make sound investment decisions and to participate in meaningful corporate governance dialogue.

The pension funds believe that the SEC has historically demonstrated the expertise to most effectively carry out these critical regulatory functions. While recognizing the difficulty in drawing precise boundaries between systemic risk regulation on the one hand and oversight of market integrity and conduct and investor protection on the other, the funds urged that regulatory boundaries be drawn with the utmost care so that the SEC retains the full panoply of authority and tools necessary to deter market misbehavior and enforce the law where violations do occur, in order to discharge its unique and fundamental mission of investor protection. At the same, the SEC’s oversight and protection of the integrity of capital markets would make an important contribution to effective systemic risk regulation.

Within the reality of the current overall Federal budget constraint, continued the funds, the SEC must be given the staffing and budgetary resources necessary to be a vigorous regulator. An emerging market problem that is addressed promptly by strong regulatory action avoids a much more costly government intervention later.

In earlier Banking Committee hearings, SEC Chair Schapiro emphasized that the SEC must have a role in the areas of systemic risk that are part of its investor protection mandate. The systemic risk regulator should not diminish the role of the SEC, noted Ms. Schapiro, adding that systemic risk cannot trump investor protection. Senator Dodd said that the SEC should have a role in systemic risk regulation; and advised the Chair to ``kick down the door’’ to make sure the Commission has input.

In a letter to President Obama earlier this year, Senator Dodd and Rep. 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. The legislators said that they agree with the Administration’s core principles for modernizing financial regulation as recently articulated by Treasury Secretary Tim Geithner, including providing for systemic risk regulation, strengthening consumer and investor protection, streamlining prudential supervision, and addressing regulatory gaps, such as with hedge funds and other private pools of capital.
FINRA Adopts Member Private Offering Rule

The Financial Industry Regulatory Authority's (FINRA) Rule 5122 regulating private offerings of securities issued by a FINRA member on the member's "control entity" ( a "Member Private Offering") takes effect June 17, 2009.

Rule 5122 prohibits any FINRA member and its associated persons from participating in a Member Private Offering unless the member issuing the Member Private Offering:

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

(2) files the offering document with FINRA; and

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

The full text of the adopted rule is

Tuesday, May 19, 2009

Congress Passes Legislation Strengthening Securities Fraud and Financial Fraud Enforcement

Congress has passed and cleared for the President legislation improving enforcement of securities fraud and financial institution fraud involving asset-backed securities and fraud related to federal assistance and relief programs. The legislation expands the scope of securities fraud provisions and extends the prohibition against defrauding the federal government to the TARP program and to the stimulus bill. The measure also authorizes additional appropriations for the SEC to investigate and prosecute fraud, and creates a Senate Select Committee to examine the causes of the current financial crisis.

The Fraud Enforcement and Recovery Act, S 386, was introduced by Senator Patrick Leahy, chair of the Judiciary Committee, and Senator Charles Grassley, Ranking Member on the Finance Committee. It is based on a sense of Congress that fraud contributed to an unprecedented collapse in the mortgage-backed securities market. The legislation is designed to ensure that this kind of collapse cannot happen again. A main component of the reform is the reinvigoration of federal anti-fraud measures. The original Senate bill was passed with amendments by the House, creating a blended compromise measure that combines the original S. 386 with HR 1748, the Fight Fraud Act, sponsored by House Judiciary Chair John Conyers. The Senate agreed to the amendments, with a minor amendment of its own; and the House agreed to the Senate amendment and cleared the legislation for the President, who is expected to sign it.

The differences between the Senate and House measurs do not appear to be terribly significant, one of which is the composition of the commission, which the House measure calls the Financial Crisis Inquiry Commission and the Senate calls the Federal Markets Commission. The final legisaltion calls the tribunal to Financial Crisis Inquiry Commission. Also, a section in the Senate bill amending the international money laundering provision in the federal money laundering statute to make it a crime for individuals to transport or transfer money in and out of the United States to evade taxes was dropped by the House.

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.
The Act authorizes additional appropriations for the SEC to fight financial fraud of $20 million for fiscal years 2010 and 2011. The legislation specifically states that the additional funds are to be used for investigations and enforcement proceedings involving financial institutions. The Act also adds $1 million a year for two years for the salaries and expenses of the SEC’s Inspector General.

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.

The legislation 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.

Monday, May 18, 2009

Supreme Court Will Decide Constitutionality of PCAOB

The US Supreme Court has agreed to hear an audit firm’s challenge to the constitutionality of the PCAOB. 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. The case will be briefed over the summer and argued in the fall when the Court convenes for the 2009-2010 term. (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.The main government argument before the Court 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 government’s 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.

Taking square aim at the Government’s argument that an audit firm challenging the PCAOB’s constitutionality in federal court failed to exhaust its SEC administrative remedies, the firm told the Supreme Court that it would not invent a fictional controversy with the SEC solely to create a vehicle to challenge the Board’s constitutionality. In its reply brief to the Government, the audit firm said that no case has ever hinted that a standard provision for appellate review of agency rulemaking is the exclusive vehicle for challenging the agency’s, much less another agency’s, constitutionality, thus displacing a federal district court proceeding for injunctive relief. The firm urged the Supreme Court not to allow the Board to convert the most important separation-of-powers case in the last 20 years into a narrow dispute.

In its reply, the audit firm described as disingenuous the Government’s suggestion that it should have challenged a Board sanction because the Board’s investigation of the firm did not result in sanctions. Even more disingenuous, said the firm, is the assertion that it could have brought the challenge by seeking SEC review of the Board’s inspection report on the firm or petitioning the SEC to modify or revoke the Board’s authority, because appellate courts have no jurisdiction over SEC inspection report rulings or refusals to initiate rulemaking.

Moreover, the firm argued that the SEC’s views on the constitutional issues before the Court are not entitled to deference, adding that the Commission lacks institutional competence and authority to opine on separation of powers or invalidate the Board. And, pointed out the firm, the Commission in the lower courts and before the Court, has provided, in the United States briefs it joined, its construction of the Act, just as it would have done in a statutory review case.
Supreme Court Takes PCAOB Case

The Supreme Court today granted the petition for certiorari in Free Enterprise Fund v. PCAOB.

Sunday, May 17, 2009

Chinese Central Bank Chief Identifies Ratings Agencies and Fair Value Accounting as Driving Pro-Cylicality in Crisis

The Governor of the People’s Bank of China has identified two pro-cylical factors that worked to exacerbate the financial crisis: credit rating agencies and fair value accounting. At a meeting of G-20 central bankers, Zhou Xiaochuan said that the problems of fair value accounting have been exposed by the current crisis. Compared with the historical cost approach, he noted, fair value accounting intensifies market fluctuations. While acknowledging that the fair value approach can better reflect the real time value of assets and liabilities, he said that it also magnifies the changes in their values and increases the volatility of returns through the profit and loss account as a consequence.

As a result of the massive collateralized securities they held, financial institutions registered mounting unrealized losses which actually involved no cash flow under the fair value rule. Though these losses were only meaningful in accounting, he said, such astronomical book losses distorted investors' expectations and formed a vicious cycle of tumbling prices and asset write-downs.

GAAP and IFRS define fair value in a similar way, which is a price at which an asset and liability can be traded with a willing counterparty in an orderly manner. Both accounting frameworks also provide measurement approaches at differentiated levels. Level 1: prices can be observed on active market, which are used to measure the value of assets and liabilities, a practice called mark-to-market. Level 2: when there is no active market, prices are assessed by using models with observable parameters as inputs, a process called mark-to-model. The measurement approach used on level 3 is similar to the mark-to-model approach, but it involves unobservable parameters and model assumptions as inputs. Both IFRS and GAAP require disclosure of the adoption of fair value approaches and specific assumptions as well as risk exposures and sensitivities.

In the view of Governor Zhou, the poorly guided adoption of fair value in non-active markets exacerbated market volatility. As defined, the using of fair value approaches must be based on the prerequisite of orderly trading. At times of crisis, as a large number of institutions were forced to liquidate their assets, prices developed under this situation did not meet the prerequisite for fair value measurement. However, due to the lack of specific guidelines on dealing with such circumstances, reporting entities had to conduct fair value measurement on the basis of unreasonable market prices, which magnified book losses and exacerbated the vicious cycle. The governor recommended implementation of circuit-breakers to stem the pro-cyclicality caused by mark-to-market and fair value accounting in specific situations.

The global financial system relies heavily on external credit ratings for investment decisions and risk management, he observed, giving rise to a prominent feature of pro-cyclicality. The rating industry is dominated by a few large players, which provide practically all important rating services. Specific ratings from these players tend to be highly correlated and they are combined to form a strong cyclical force. Many market players adopting ratings from these agencies and using them as the yardstick for operations and internal performance assessments results in a massive "herd behavior" at the institutional level.

Moreover, the central banker emphasized that the rating process is filled with conflicts of interest by virtue of the issuer-paying business model in which issuers also pay for the rating agencies' advisory services on structuring their products, which leads to more problems. He added that the rating models for mortgage-related structured products are fundamentally flawed.

Many financial institutions outsourced the development of their internal control systems and the technical models used by their traders in internal assessment and risk control, including the program trading models that had been widely adopted at an earlier time. Outsourcing of system technologies at such a prevalent scale contributed to high degree of homogeneity in the financial system, he noted, which strongly added to pro-cyclicality. For complex financial products, most institutions used models built by a handful of quantitative analysts that got widely adopted throughout the industry.

The governor urged regulators to require systemically important financial institutions to complement external pricing models with internally developed pricing capabilities. In addition, issuers of complex asset-backed securities should be given incentives to better assess their risks. Regulators should also require them to retain a meaningful share of the underlying assets on their balance sheets in order to alleviate the myriad of problems associated with the originate-to-distribute business model, including moral hazards and fraudulent loan underwritings.

On the users' side of ratings, he continued, there is the long-standing moral hazard issue. Various rules have required investment management decisions and risk management practices to be benchmarked on financial instruments attaining certain ratings from Nationally Recognized Statistical Rating Organizations (NRSRO). According to the central banker, this practice has enabled industry practitioners to piggyback on the external ratings and not to worry about the inherent risks once the instruments have achieved the threshold ratings. Over time, the financial industry has become accustomed to the practice and become complacent of the ratings they rely on so heavily

According to Gov. Zhou, institutional users of credit ratings, such as money managers and financial firms, should be ultimately accountable to their customers and shareholders and should exercise their own judgment of risk, not just outsource risk assessment duties to the rating agencies. To the extent they have to use external expertise, internal and independent judgment has to be deployed as a complement. The problem has become so serious that regulators must encourage financial institutions to enhance internal rating capability to rely less on external ratings. Further, regulators should impose requirements whereby use of external ratings should not exceed 50 percent of business activities for systemically important financial institutions. Internal capabilities should be developed to exercise independent judgment on credit risks at such organizations.

Friday, May 15, 2009

German Government Proposes Legislation to Take Toxic Securities Off Bank Balance Sheets

The German government has proposed legislation to transfer toxic securities from the balance sheets of financial instructions to specific purpose vehicles, colloquially called ``bad banks,’’ which will not have to be licensed. The transfer of the toxic securities will be at a 10 percent discount to book value. The plan is designed to avoid continuing massive write downs connected to the declining value of the toxic securities held by financial institutions on their books; and so free up funds for lending.

In return for the transfer, the special purpose vehicle will issue a bond guaranteed by the German bailout fund, the Special Institute for Financial Stability (called SoFFin) in the amount of the transfer value of the toxic securities. The financial institution will pay the SPV over the term of 20 years, a compensation amount of the difference between 90 percent of book value and the estimated value at maturity of the securities. Shareholders will benefit from any surplus in the liquidation of the SPV.

Thursday, May 14, 2009

FASB and IASB Working Together to Satisfy G-20 Goals Says Advisory Group

The FASB and IASB are working together to meet the G-20 goals of improved valuation standards and achieving a single set of high-quality global accounting standards. In a letter to the G-20, the Financial Crisis Advisory Group said that the two Boards are working jointly to improve and converge standards and have given priority to areas highlighted by the financial crisis.

The IASB decided to adopt approaches consistent with the recent FASB guidance on fair value for illiquid markets and fair value disclosure. While the IASB decided not to implement the FASB staff’s approach to credit loss impairment for available-for-sale debt securities, it did decide to work with FASB to issue this year a converged proposal to dramatically simplify their standards for financial instruments, which is expected to include a common credit loss impairment approach for loans and debt securities.

The Financial Crisis Advisory Group called on both standard setters to work with the Financial Stability Board and the Basel Committee to address the provisioning and valuation recommendations of the FSB and the G-20. A working group to be run by the Basel Committee is being established to develop positions.

In the G-20 letter, FCAG said that the Boards are working together, and in consultation with key regulators, will issue a comprehensive proposal later this year to improve and streamline the reporting of financial instruments. The FCAG also believes that valuation and off-balance sheet standards particularly need improvement. The group is convinced that improved standards in these areas, and also in the provisioning area, which is of particular importance to regulators, can increase transparency and preserve financial statement integrity.

The IASB issued proposed improvements in the area of off-balance sheet items earlier this year and is working jointly with FASB in this area. The FASB is expected to soon issue improvements to the current US standards in this area. These projects follow a number of other improvements the Boards individually and together have been making over the past several months. In the view of FCAG, the two Boards have provided globally consistent fair value measurement guidance for inactive markets and enhanced fair value disclosure requirements. In May, the IASB is expected to publish a proposal to enhance disclosures related to fair value measurements.
Panelists at ICI Conference Focus on Market Crisis and Regulatory Reform

The below post is courtesy of my colleague Amy Leisinger, who attended the below conference.

As the fund industry has evolved to meet the demands of recent economic events and to attempt to calm increasing investor anxiety, perspectives have been forced to change, Director of the SEC's Division of Investment Management Andrew Donohue explained in his keynote address at the Investment Company Institute's ("ICI") annual mutual funds conference. Market uncertainty has resulted in increased pressure on funds from all fronts, he continued, and reevaluation of current regulations, including Investment Company Act Rule 2a-7 governing money market funds, will be necessary in the coming months. Unprecedented market changes have cast doubt on even the most "basic tenets" of sound investment management, he explained.As such, the conference began with a panel focused on pinpointing the causes of the credit crisis and the lessons learned from recent events.

Robert Plaze of the SEC's Division of Investment Management explained that the most crucial fact that the Division learned from the onset of the economic crisis is that money market funds, while generally considered among the safe investment vehicles, could be subject to investor runs and numerous concurrent redemption requests. Robert Deutsch, managing director of JPMorgan Asset Management, pointed out that not all money market funds are the same; some funds focus on asset quality while others focus primarily on growing yield. More and more funds were engaging in the latter, he explained, and clients should have been informed as to the kind of investments in which their funds were involved.

Mr. Plaze also stated that after all of the turmoil in the money market fund industry, the SEC staff realized that Rule 2a-7 may have some flaws, including a lack of guidance concerning a fund's ability to take substantial risks and a lack of clear boundaries designed to address liquidity risks. There are competing interests between institutional investors and individual retail investors, and the rule needs to take that into account, he concluded.

At present, the main consideration in regulatory reform is the possible creation of a systemic-risk regulator, which would closely monitor the very large players in the financial services industry. According to Peter Wallison of the American Enterprise Institute, certain issues may arise under the systemic-risk approach. If we start looking at large institutions as special in some way, as "too big to fail," he explained, these entities may appear "safer" to the public because the government would be obliged to step in to save them. He expressed concern that this structure would result in the government basically selecting dominant financial players. Thus, the panel also considered a functional system with multiple regulators and an overarching systemic regulator broadly monitoring the industry.
Key Senator Urges Passage of Legislation Authorizing Regulation of Swaps as First Step in Broad OTC Derivatives Regulation

Praising the Obama Administration’s proposal to regulate OTC derivatives, Senator Levin urged quick action on his legislation repealing existing statutory provisions prohibiting federal regulators from exercising authority over swaps. In his view, the Levin-Collins bill, S. 961, would be the first step in constructing the comprehensive federal oversight regime envisioned by the Administration. The Levin-Collins measure would restore to federal regulators the authority to police the swaps market that Congress took away in the Commodity Futures Modernization Act of 2000.

The Authorizing the Regulation of Swaps Act authorize SEC and CFTC oversight and regulation of all types of swap agreements, including credit default, commodity, equity, interest rate, and foreign currency swaps. Those regulators could no longer use as an excuse for not regulating swaps the prohibitions which exist in current law. The bill uses the same definition of swaps that is used in current law to prohibit swaps regulation, and would authorize federal oversight and regulation of all exchange-traded and over-the-counter swap agreements, without exception. While S 961 does not take the next step of specifying how swaps should be regulated, noted Sen. Levin, it would clear the decks for more comprehensive reform.

Wednesday, May 13, 2009

Obama Administration Proposes Broad Federal Regulation of OTC Derivatives

The Obama Administration has proposed legislation to provide for a comprehensive and detailed regulatory regime for all OTC derivatives. The legislation would be designed to achieve the four broad goals of preventing systemic risk to the financial system, promoting transparency, preventing market manipulation, and protecting unsophisticated parties. To achieve these goals, it is critical that similar products and activities be subject to similar regulations and oversight.

The legislation would amend the Commodity Exchange Act and the federal securities laws to require the clearing of all standardized OTC derivatives through regulated central counterparties (CCP). For their part, the central counterparties would be required to maintain robust margin requirements and other necessary risk controls and ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP. The legislation would provide that the acceptance of an OTC derivative for clearing by a fully regulated CCP should create a presumption that it is a standardized contract and thus required to be cleared.

Further, all OTC derivatives dealers and all other firms who create large exposures to counterparties would be subject to a robust regime of prudential supervision and regulation, which will include conservative capital requirements, business conduct standards, reporting rules, and initial margin requirements with respect to bilateral credit exposures on both standardized and customized contracts.

In order to promote transparency, the legislation must ensure that regulators have comprehensive and timely information about the positions of each and every participant in all OTC derivatives markets. This goal would be accomplished by authorizing the CFTC and the SEC to impose recordkeeping and reporting requirements, including audit trails. Trades not cleared by a CCP will have to be reported to a regulated trade repository.

In addition, CCPs and trade repositories must make aggregate data on open positions and trading volumes available to the public; and make data on individual counterparty's trades and positions available to federal regulators. The legislation should also mandate the development of a system for the timely reporting of trades and the prompt dissemination of prices and other trade information. It would also encourage regulated institutions to make greater use of regulated exchange-traded derivatives. The Administration believes that competition between regulated OTC derivatives markets and regulated exchanges will make both sets of markets more efficient and thereby better serve end-users of derivatives.

In order to effectively police fraud and market manipulation, the CFTC and SEC must be authorized to to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to futures markets. The regulators must also have a complete picture of market information from CCPs, trade repositories, and market participants so that the SEC and CFTC can detect and deter market abuses.

The legislation must also set stringent limits to protect unsophisticated parties from entering into inappropriate derivatives transactions by limiting the types of counterparties that could participate in those markets. To that end, the CEA and the federal securities laws must be amended to tighten the limits or to impose additional disclosure requirements or standards of care with respect to the marketing of derivatives to less sophisticated counterparties, such as small municipalities.

Two bills regulating OTC derivatives were reported out of the House and Senate Agriculture Committees earlier this year. The House Derivatives Markets Transparency and Accountability Act of 2009 was sponsored by Ag Committee Chair Collin Peterson. The bill was referred to the House Financial Services Committee. There is a companion bill in the Senate introduced by Senator Tom Harkin, Chair of the Agriculture Committee. The Harkin bill, S 272, would bring all OTC financial transactions and credit default swaps currently traded without federal oversight onto regulated exchanges.

In the wake of the Administration’s proposal, Chairman Peterson and House Financial Services Chair Barney Frank said that they would work closely together to pass legislation providing for the strong, comprehensive and consistent regulation of OTC derivatives.

The Administration’s proposal comes against the backdrop of a growing global consensus favoring a central counterparty for OTC derivatives, including credit default swaps. Earlier this year, Elizabeth King, SEC Associate Director for Trading and Markets, said that a well-regulated and prudently managed central counterparty for credit default swaps has the potential to significantly reduce counterparty credit risks to market participants.

In remarks at the Security Traders Association mid-winter meeting, the SEC official also emphasized that a CCP can also reduce systemic risks by preventing the failure of a single market participant from having a disproportionate effect on the overall market.

A global CCP is becoming more likely as a consensus builds that this is an important aspect of market reform. Recently, French central bank chief Christian Noyer endorsed the initiative to create a central counterparty for credit default swaps, calling the initiative crucial to financial stability. Similarly, the European Central Bank welcomes the initiatives to create central counterparties and expects to see concrete results. Former NY Fed President Gerald Corrigan told the House Agriculture Committee that there should be a single dedicated global CCP for credit default swaps.