Tuesday, June 30, 2009

IOSCO Issues Principles for Hedge Fund Regulation as Legislation Looms

With the US and EU readying legislation to regulate hedge funds, IOSCO has set forth six high level principles for hedge fund regulation driven by disclosure and international coordination. IOSCO calls for the mandatory registration of hedge fund advisers under a prudential regulatory regime emphasizing disclosure and the elimination of conflicts of interest. In addition, prime brokers and banks which provide funding to hedge funds should be subject to mandatory registration and should have to implement risk management systems to monitor their counterparty credit risk exposures to hedge funds.

SEC Commissioner Kathleen Casey, Chair of the IOSCO Technical Committee, said that the collective application of the principles can provide regulators with the tools to obtain relevant information in order to address the systemic risks posed by hedge funds. While securities regulators recognize that the current crisis is not a hedge fund driven event, she noted, the crisis did reveal the systemic role hedge funds may play and the way in which regulators deal with the risks they may pose to the oversight of markets and protection of investors.

Anticipating the passage of systemic risk legislation, IOSCO recommends that hedge fund advisers and prime brokers be required to give their relevant regulators information for systemic risk purposes, including the identification, analysis and mitigation of systemic risks.

Also, regulators should have the authority to co-operate and share information with each other in order to facilitate effective oversight of globally active hedge fund advisers and funds and to help identify systemic risks, market integrity and other risks arising from the activities or exposures of hedge funds with a view to mitigating cross-border risks.

Disclosure is a key element of the regulation. Hedge fund managers, like other fund managers, are subject to significant conflicts of interest. IOSCO urges them to provide full disclosure and transparency about such conflicts of interest and how they manage them.

Hedge fund managers should ensure that there is proper disclosure to investors on the risks incurred, the conditions for redemption, the existence and conditions of any side letters and gating structures, the fund‘s strategy and performance, including audited financial statements. As part of these ongoing requirements, regulators should have the power to inspect the fund managers and their records.

In addition, hedge fund managers should provide to regulators information on their prime brokers, custodian, and background information on the persons managing the assets, as well as information on the hedge fund manager‘s larger funds including, the net asset value, predominant strategy, and performance. The disclosure should also include data on leverage and risk, including concentration risk of the hedge fund manager‘s larger funds. Importantly, regulators should be told counterparty risk; and assets and liability information for the hedge fund manager‘s larger funds. Moreover, there should be disclosure of product exposure for all of the hedge fund manager assets, such as structured and securitized credit.

Under the IOSCO principles, prime brokers should provide on-going information on hedge funds to their regulators so as to gauge risk appetite and identify the emergence of large and highly leveraged funds. The data will also help assess banks’ ability to aggregate counterparty exposure across business lines and build a prime brokerage network.

IOSCO also urges regulatory standards on the operational conduct of hedge fund managers, including the valuation techniques they employ. As part of operations, there should be an independent risk management function appropriate to the size, complexity and risk profile of the hedge fund manager. There should be a similar independent compliance function. The nine previously announced IOSCO principles on valuation remain valid and should be incorporated into operations.

First, documented policies and procedures should be established for the valuation of financial instruments held by a hedge fund. Second, the policies should identify the methodologies used for valuing all of the financial instruments held by the hedge fund. The third and fourth principles are that the financial instruments held by hedge funds should be consistently valued according to the policies and the policies should be reviewed periodically. The fifth principle is that independence should be embedded into the valuation processes by using third-party pricing services.

The sixth principle is that the valuation policies should ensure that an appropriate level of independent review is undertaken of the individual values that are generated by the policies. The seventh principle is that a hedge fund’s policies should describe the process for handling and documenting price overrides, including the review by an independent party. The eighth principle is that initial and periodic due diligence should be conducted on third parties appointed to perform valuation services. The ninth principle is that the valuation arrangements must be transparent to investors.
Draft Legislation Creating Consumer Financial Protection Agency Mandates Coordination with SEC but Excepts SEC-Registered Brokers and Advisers

The Obama Administration has sent draft legislation to Congress that would create a new federal Consumer Financial Protection Agency to protect consumers across the financial sector from unfair, deceptive, and abusive practices. The 152-page draft is entitled the Consumer Financial Protection Agency Act of 2009.

The new independent agency would be housed in the Executive Branch, with its members appointed by the President. The agency would have broad jurisdiction to protect consumers of credit, savings, payment, and other consumer financial products and services, and regulate providers of such products and services. The legislation envisions that the agency will coordinate with the SEC and CFTC to promote consistent regulatory treatment of consumer and investment products and services.

In fact, the draft provides that the SEC must consult and coordinate with the agency with respect to any rule, including any advance notice of proposed rulemaking, regarding an investment product or service that is the same type of product as, or that competes directly with, a consumer financial product or service that is subject to the jurisdiction of the CFPA. But the draft also provides that the Act should not be construed as altering, amending, or affecting the authority of the SEC to adopt rules, initiate enforcement proceedings, or take any other action with respect to a person regulated by the SEC. Thus, the new agency will have no authority to exercise any power to enforce the Act with respect to a person regulated by the SEC.

There are similar provisions in the draft with regard to the CFTC and persons regulated by the CFTC.

The draft define a person regulated by the SEC to mean a broker or dealer that is required to be registered under the Exchange Act, an investment adviser that is required to be registered under the Investment Advisers Act, or an investment company that is required to be registered under the Investment Company Act, but only to the extent that the person acts in a registered capacity.

Similarly, the draft defines a person regulated by the CFTC as a futures commission merchant, commodity trading adviser, commodity pool operator, or introducing broker that is subject to the jurisdiction of the CFTC under the Commodity Exchange Act, but only to the extent that the person acts in such capacity.

The draft embodies a new proactive approach to disclosure. The CFPA will be authorized to require that all disclosures and other communications with consumers be reasonable: balanced in their presentation of benefits, and clear and conspicuous in their identification of costs, penalties, and risks.

The legislation envisions that the agency’s rules would serve as a floor, not a ceiling. The states would have the ability to adopt and enforce stricter laws for institutions of all types, regardless of charter.

The Board of the agency would be composed of five members, four of whom would be appointed by the President and the fifth would be the Director of the National Bank Supervisor. The Presidential appointments must be US citizens with strong competencies and experiences related to consumer financial products or services. From among the appointed Board members, the President will designate one member of the Board to serve as the Director.

The agency has a broad mandate to promote transparency, simplicity, fairness, accountability, and access in the market for consumer financial products or services. Specifically, the draft would authorize the agency to exercise its authorities to ensure that consumers have, understand, and can use the information they need to make responsible decisions about consumer financial products or services; that consumers are protected from abuse, unfairness, deception, and discrimination; that markets for consumer financial products or services operate fairly and efficiently with ample room for sustainable growth and innovation; and that traditionally underserved consumers and communities have access to financial services.

Covered persons under the draft are persons engaging in a financial activity, in connection with the provision of a consumer financial product or service; or any person who, in connection with the provision of a consumer financial product or service, provides a material service to, or processes a transaction on behalf of, the person engaging in the financial activity.

The legislation defines financial activity to mean, among other things, acting as an investment adviser to any person and not subject to regulation by the SEC or CFTC and acting as financial adviser to any person, including providing financial and related advisory services; providing educational courses, and instructional materials to consumers on individual financial management matters; or providing credit counseling, tax-planning or tax-preparation services to any person. Financial activity is also acting as a custodian of money or any financial instrument.

As a catch all, the draft also deems a financial activity to be other activity that the agency defines, by rule, as a financial activity, except that the agency cannot define engaging in the business of insurance as a financial activity.

The term “financial product or service” means any product or service that, directly or indirectly, results from or is related to engaging in one or more financial activities.
Wisconsin Legislature Adopts Fee Increases

Effective June 30, 2009, the Wisconsin Legislature adopts the following fee increases:

1. Securities Agents/Investment Adviser Representatives:

$80 per person (up from $30)

2. Branch office maintenance: $80 (up from $30)

3. Securities Registration by Coordination or Qualification and initial filing fee for investment companies/federal covered securities under Section 18(b)(2) of NSMIA:

$1,500 (up from $750)

4. Annual sales report-related fees for investment companies:

minimum $750 (up from $150)
maximum $15,000 (up from $1,500)

NOTE: Same "formula" of 0.05% of sales in Wisconsin remains unchanged to calculate the fee between the minimum and maximum amounts.

Click here and see pgs. 1561-1563 under sections 2997 through 3002 for all the securities fee changes.
Financial Stability Board Charts Role Ensuring Globally Consistent Financial Regulation

Armed with a mandate from the G-20 to promote globally consistent financial regulation, the Financial Stability Board has reorganized to better carry out is critical mission as the US and the EU prepare major reform legislation. There will be three standing committees designed to ensure consistent cross-border high quality financial regulation and avoid regulatory arbitrage. The Obama Administration’s plan for regulatory reform also endorsed the Financial Stability Board’s role as coordinator of consistent cross-border financial regulation and arrangements for international cooperation on supervision of global financial firms through establishment of supervisory colleges. The Administration also urged the Board to restructure, as it is now doing.

The Board’s Standing Committee for Regulatory Cooperation will address coordination issues that arise among regulators, and will raise any need for policy development that arises in this regard. It will set guidelines and oversee the effective functioning of supervisory colleges and advise on best practice in meeting regulatory standards with a view to ensure consistency, cooperation and a level playing field across jurisdictions. It will work on contingency planning for cross-border crisis management at major financial institutions. Current UK FSA Chair Adair Turner will chair the committee. A cross-border crisis management working group has been set up under this committee. The working group will establish a framework to implement the Board’s principles for cross-border cooperation on crisis management.

The Standing Committee for Standards Implementation will report on members’ commitments and progress in implementing international financial standards and other initiatives. More broadly, the Committee will propose a framework to strengthen adherence to prudential regulatory standards by relevant jurisdictions. Tiff Macklem, Associate Deputy Minister of the Department of Finance of Canada, will chair this Committee.

The Standing Committee for Vulnerabilities Assessment will assess and monitor vulnerabilities in the financial system and propose to the FSB actions needed to address them. It will be chaired by Jaime Caruana, General Manager of the Bank for International Settlements.

The FSB also noted significant progress in implementing the G20 recommendations, including strengthening international accounting standards; developing a macro prudential systemic risk approach to financial regulation; oversight for hedge funds and credit rating agencies ; and sound compensation practices.

The IASB plans to improve and simplify accounting for financial instruments, loan loss provisioning and hedge accounting. The IASB also indicated that the changes to simplify and address impairment in certain financial assets would be decided in time to be implemented for the 2009 annual accounts. The FSB stressed the need to achieve convergence of accounting standards and take into account their procyclicality effects, and encouraged the IASB to enhance its dialogue with regulators.

The FSB welcomed the publication by IOSCO of Principles for Hedge Funds Regulation, and work by the Joint Forum on hedge funds oversight from a prudential and financial stability perspective. The FSB stressed the need for coherent national implementation. The FSB also praised IOSCO’s work on developing recommendations on regulatory approaches to securitization and credit default swap markets. It looks forward to publication of the final IOSCO report in September 2009.

Monday, June 29, 2009

SEC Defends Gartenberg Ruling in Amicus Brief Filed with Supreme Court

The SEC defended the venerable 1982 Gartenberg ruling in an amicus brief filed with the US Supreme Court in a case involving the fiduciary duty imposed on mutual fund advisers under Section 36(b) of the Investment Company Act. The case is on appeal from a Seventh Circuit panel ruling that expressly disapproved the Gartenberg approach based on its view that a fidu­ciary duty differs from rate regulation. The SEC said that the panel’s focus on whether an adviser has made full disclosure and played no tricks on the investment company’s board is inconsis­tent with the plain text of Section 36(b), the structure of the 1940 Act, and the purposes and legislative history of the statute. The court of appeals denied rehearing en banc, with five judges dissenting. The Supreme Court granted certiorari. (Jones v. Harris Associates L.P., Dkt. No. 08-586).

Section 36(b) gives mutual fund shareholders and the SEC an inde­pendent check on excessive fees by imposing a fiduciary duty on investment advisers with respect to the receipt of compensation for services. In Gartenberg v. Merrill Lynch Asset Management, Inc. (CA-2 1982), the court ruled that, in order to violate Section 36(b), the adviser must charge a fee that is so disproportionately large that it bears no relationship to the services rendered and could not have been the product of arms-length bargaining.

In this action, the Seventh Circuit panel held that an investment ad­viser’s fiduciary duty to a mutual fund is satisfied when­ever the adviser has made full disclosure and played no tricks on the board. The panel indi­cated that, so long as such disclosure occurs, the board’s approval is conclusive and Section 36(b) imposes no cap on the amount of compensation that the adviser may receive.

According to the government’s brief, the panel committed two fundamental errors in applying Section 36(b) to the record in this case. First, the court viewed the investment ad­viser’s fiduciary duty under the statute as limited to the provision of full and accurate information to the mu­tual fund’s board. Second, the court indicated that, as­suming Section 36(b) contemplates an inquiry into the substantive reasonableness of an adviser’s fee in ex­treme cases, the fees paid by comparable mutual funds provide the only suitable benchmark for evaluating the fee. Because both of those propositions are wrong, said the SEC, the judgment of the court of appeals should be vacated, and the case should be remanded for further proceedings under the appropriate legal standards.

The SEC also contended that the disclosure only stance taken by the appeals panel reflects an unduly limited view of the fiduciary duty created by Section 36(b). According to the brief, the text of Section 36(b) and complementary statutory provisions strongly indicates that a fully informed board’s approval of compensation does not guarantee against a fiduciary breach. The statute’s trust-law background, purposes, and legislative history reinforce that conclusion.

For purposes of any suit enforce the fiduciary duty, Section 36(b)(2) specifies that approval by the fund’s board of directors of such compensation must be given such consideration by the court as is deemed appropriate under all the circum­stances. Thus, the SEC reasoned that, when invest­ment advisers are alleged to have breached their fiduciary duty to the fund by receiving a particular fee, the court should consider all the circum­stances in determining whether a fiduciary breach has occurred. The panel’s approach here contradicts the statute, said the Commission, by making conclusive the presence of a single circumstance, namely that the board was apprised of all relevant information before it ap­proved the adviser’s fee. The text of Section 36(b) makes clear that Congress intended courts to engage in a fuller inquiry.

The court of appeals remarked that a lot has happened in the mutual-fund market since Section 36(b) was enacted in 1970. But, said the SEC, one thing that has not happened is any change in Section 36(b)’s statement of fiduciary duty. Congress’s imposition of that duty was largely predicated on the assumption that disclosure and the pressures of the marketplace were not fully adequate to protect investors from the potential for abuse inherent in the structure of investment companies.

Another amicus brief filed by a consortium of law professors said that, in discarding Gartenberg, the Seventh Circuit panel discarded more than a quarter-century of jurisprudence and substituted in its place an imaginative economic reinterpretation of Section 36(b) that undercuts a critical provision of the statute and at the same time creates a harmful split among the circuits. In addition, the law professors said that the Seventh Circuit’s reasoning overlooks the substantial value of the Gartenberg factors, which are: rates charged by other advisers of similar funds; the adviser’s cost in providing the service; the nature and quality of the service; the extent to which the adviser realizes economies of scale as the fund grows larger; and the volume of orders which must be processed.

In the view of the law professors, the Gartenberg factors have a healthy impact on the behavior of the fund’s trustees in their mandated annual review of the advisory contract. Gartenberg has positively stimulated procedural protection for shareholders during the renewal of investment advisory contracts. The board, with its independent counsel, systematically reviews the advisory contract through the lens of the Gartenberg factors, noted the professors.

Sunday, June 28, 2009

Japan FSA Endorses Obama Administration Call for Systemic Risk Regulation, Including Hedge Funds and Derivatives

A senior official of the Japanese Financial Services Agency has endorsed the Obama Administration’s call for systemic risk regulation and international consistency in the regulatory reform through the offices of the Financial Stability Board. In setting out the key principles for financial reform efforts at the International Bankers Association, Commissioner Takafumi Sato also agreed that the scope of regulation should be broadened to cover all systemically important institutions, products, and markets, including the regulation of hedge funds and OTC derivatives.

A key concept of reform is broadening the regulatory scope with a view to systemic risk. In his view, systemic risk regulation is imperative because the behavior of investment and other non-bank financial firms had a significant impact on overall financial stability. Traditionally, the regulatory framework to deal with systemic risk has been mainly focused on the commercial banking sector. However, the current turmoil was triggered and deepened by troubles at large investment banks, while the bailout of a global insurance group exposed the significant gap in the US regulatory framework.

Large commercial banks had also expanded the scope of their business, for example, by using structured investment vehicles and asset-based conduits and by providing them with liquidity support. Furthermore, previously unregulated firms and markets are exerting increasing influence over the global financial system. Thus, the FSA believes that the scope of regulation should be broadened to cover all systemically important institutions, products, and markets, including strengthening regulation on hedge funds and OTC derivatives.

An intertwined but no less important concept is the need for macro-prudential regulation. The current crisis has demonstrated that macro market developments are as important as idiosyncratic risk at individual firms, he said. Risk factors at an individual firm can spread to the entire financial system through increased counterparty risk and behavioral changes at financial firms, he noted, with market liquidity dried up and the pricing function of the markets impaired.

It is therefore essential that regulators identify common risk factors and make use of the analysis. To this end, he emphasized that traditional micro prudential supervision focusing on the soundness of individual financial firms will not be sufficient. Regulators will need to analyze more thoroughly the effect of macro market developments on the soundness of the financial system and the behavior of financial firms.

In Commissioner Sato’s view, addressing procyclicality of the capital adequacy requirements can be seen as one of these macro prudential approaches in this broader sense. Arguments have been raised that the capital regime has a procyclical effect. That is, when the economic situation gets worse, more capital is required but raising it is made more difficult. In such a situation, banks are tempted to squeeze lending, which in turn further worsen the real economy. On the other hand, when the economy is in good shape and their asset quality is improved, the banks may need less capital but capital increases without much effort.

Another key concept is the need for international cooperation among regulators. The international impact of the recent collapse of large, complex financial institutions demonstrated that global systemic risk posed by such institutions needs to be dealt with by close cooperation among regulators. To this end, the world’s major regulators must establish supervisory colleges for each of the global financial firms. As did the G-20 and the Obama Administration, the FSA official endorsed the Financial Stability Board as a key vehicle for monitoring national regulations so that agreement can be reached on the fundamental principles for cross-border cooperation on crisis management.

Another key concept is enhancing risk management. He recommended that risk management at financial firms be upgraded and given higher priority. Firms should strengthen risk capture and build a sufficient level of capital that is proportionate to the risks their business models entail. For their part, regulators should revise the regulatory framework in a way that promotes the efforts made by the industry to this end. The internal presence of risk management sections at financial firms has been low, and their views were often suppressed by the drives for maximization of short-term profits.

A related key concept is to align compensation incentives so that they do not favor the maximization of short-term profits. Compensation schemes must recognize explicitly the huge risks that materialize later. Legislation and regulation must put in place incentive structures that encourage originators, arrangers, distributors and investors to carry out due diligence and transmit accurate information of underlying assets at each stage; in addition to new regulation on credit rating agencies.

A final concept is enhancing integrity and transparency of the market. Complex, opaque financial products were widely traded among market participants, including off-balance-sheet entities, without adequate appreciation of risks, without transmission of accurate information, and without sufficient disclosure of assets held by financial institutions. As a result, tremendous uncertainty was built up in the market as to toxic exposures and future losses which, in turn, increased the level of counterparty risk. To prevent the recurrence of such a situation, the commissioner recommended improving the transparency of securitized products, strengthening disclosure by financial institutions, enhancing the quality of accounting standards, and more rigorous due diligence.

Thursday, June 25, 2009

Nebraska Issues Electronic Form D Policy for Rule 506 Issuers

Issuers offering securities under Rule 506 of federal Regulation D must file with the Nebraska Department of Banking and Finance an authenticated paper copy of the Form D filed electronically with the SEC, beginning March 16, 2009. The Nebraska-filed Form D must include the State Appendix Pages and a $200 fee but Form U-2, Uniform Consent to Service of Process, is not required. The notice must be filed with the Department no later than 15 days after the first sale of securities in Nebraska, but if the 15th day falls on a Saturday, Sunday or holiday, then the following business day. Note that a Form D filed after the due date will void the exemption. Regarding amendments, they must be filed to correct mistakes of fact or errors within a practicable time after discovering them. Amendments to a previously filed paper copy of SEC-filed electronic Form D must contain the most current information to all responses no matter why the Form was filed.

For more information, please see here.
North Carolina Provides Requirements for Issuers Claiming Rule 506 Exemption Following Mandate that Form D be Filed Electronically with the SEC

Issuers relying on the exemption under Rule 506 of federal Regulation D must submit to the North Carolina Securities Division an authenticated paper copy of the Form D filed electronically with the SEC and a $350 fee, beginning March 16, 2009. The filing must be made no later than 15 calendar days after the first sale of securities in North Carolina unless the 15th day falls on a Saturday, Sunday or holiday in which case the filing date will be the following business day. Issuers may file a Form D amendment at any time but must file an amended Form D to correct material mistakes of fact or error on a previously filed Form D within a reasonable time after discovering the mistake or error. Issuers must provide current information on an amended Form D no matter the reason why the amendment is filed.

For more information, please see here.

Wednesday, June 24, 2009

Tennessee Sets Forth Electronic Form D Filing Requirements for Rule 505 and 506 Offerings

Rule 505. Beginning March 16, 2009, issuers intending to make a securities offering in Tennessee under Rule 505 of federal Regulation D must file with the Securities Division a printed copy of the Form D electronically filed with the SEC, manually signed by the issuer's authorized person. Issuers must include a copy of all written material furnished to offerees, a Form U-2, Uniform Consent to Service of Process, a Form U-2A, Uniform Corporate Resolution, if a corporate issuer, a $300 fee, and a statement identifying the date the security is first sold in Tennessee (if a sale takes place). The filing must be made no later than 15 days after the either the date consideration is first paidor the date a subscription agreement signed by an investor in Tennessee that results from an offer being made under the exemption, whichever date first occurs. Issuers must file amendments correcting material misstatements or omissions on Form D. Written offering materials not prepared in time for the initial offering or that materially differ from materials included in the offering must be delivered (or mailed) to the Securities Division at the time the materials are first used in Tennessee.

Rule 506. Issuers intending to make a securities offering in Tennessee under Rule 506 must file with the Securities Division a printed copy of the Form D electronically filed with the SEC, manually signed by the issuer's authorized person, together with a Form U-2, Uniform Consent to Service of Process, and a $500 fee. The filing must be made no later than 15 days after the first sale of the federal covered security in Tennessee. Issuers must file amendments correcting material misstatements or omissions on Form D.

For more information please see here.
Broad Shareholder Democracy Legislation Introduced in Congress

Comprehensive corporate governance legislation has been introduced in the House that would require a shareholder advisory vote on executive pay, allow shareholders to nominate a candidate for director on management’s proxy card, and eliminate uninstructed discretionary broker votes in uncontested elections that allows fund managers to vote on investors’ behalf. The Shareholder Empowerment Act of 2009, HR 2861, would also require that a board chair be completely independent from executive management, thereby prohibiting the CEO from concomitantly serving as chair of the board.

The Act would stop golden parachutes to executives terminated for poor performance. It would also curb excessive risk taking of the sort that led to the financial crisis by requiring shareholders to be informed of the performance targets being used to determine bonuses and other incentives. The Act even includes clawback provisions allowing the recovery of executive bonuses or other payments awarded on the basis of fraudulent or faulty earnings statements. The company must have a policy on reviewing this type of variable incentive compensation; and the policy should require recovery or cancellation of any unearned payments to the extent that it is feasible and practical to do so.

Under the plurality voting standard that is the default standard in most corporation codes, the candidate receiving the most votes for director is elected. In uncontested elections, shareholders can protest a candidate for director by withholding their vote, but there is no mechanism for opposing a candidate, even one vote is enough to win.

The legislation would require a candidate for the board in an uncontested election to receive votes from a majority of shareholders; and would also require a candidate running unopposed for election to resign if he or she failed to obtain majority shareholder approval.

Currently, companies can keep shareholder nominees for director off the proxy ballots. The measure would give shareholders that have held at least one percent of a company’s shares for one year access to the proxy to nominate director candidates.

Under the legislation, any compensation adviser hired by the company must be independent and must also report solely to the full board of directors or the compensation committee. Moreover, companies are prohibited from agreeing to indemnify or limit the liability of compensation advisers. The SEC is directed to implement this provision within one year.

In doing so, the SEC must consider a number of factors pertaining to the compensation adviser’s independence. The legislation states that the SEC must consider the extent, as measured by annual fees and other metrics, to which the adviser or advisory firm provides services in conjunction with negotiating compensation agreements with the company’s executives, as compared to other services that the adviser provides to the company or executives. The SEC must also consider whether individual advisers are permitted to hold equity in the company; and whether an advisory firm’s incentive compensation plan links the compensation of individual advisers to the firm’s provision of other services to the company.

The legislation also directs the SEC to adopt rules requiring additional disclosure of specific performance targets that companies use to determine a senior executive officer’s eligibility for bonuses, equity and incentive compensation. The Commission must consider methods to improve disclosure in situations where it is claimed that disclosure would result in competitive harm; including requirements that the company describe its past experience with similar target levels, disclose any inconsistencies between compensation targets and targets set in other contexts, submit a request for confidential treatment of the performance targets under SEC rules, or disclose the data after disclosure would no longer be considered competitively harmful.

Under the legislation, the chair of the board of directors must be an independent director who has not previously served as an executive officer of the company. The legislation defines an independent director as one who during the preceding 5 years has not been employed by the company in an executive capacity; has not been an employee, director or owner of greater than 20 percent of the beneficial shares of a firm that is a paid adviser or consultant to the company; has not been employed by a significant customer or supplier; has not had a personal services contract with the company, or with the chair, the CEO, or other senior executive officer; has not been an employee, officer or director of a foundation, university or other non-profit organization that receives the greater of $100,000 or 1 percent of total annual donations from the company; has not a relative of a company executive; has not part of an interlocking directorate in which the company’s CEO or another executive serves on the board of another company employing that director; and has not been engaged in any other relationship with the issuer or senior executives that the Commission determines would not render that director an independent director.
Leading Senator Introduces Legislation Regulating Hedge Fund Advisers

A leading Democratic Senator has introduced legislation requiring advisers to hedge funds, private equity funds, and venture capital funds with $30 million under management to register as investment advisers with the SEC. The Private Fund Transparency Act, S 1276, sponsored by Securities Subcommittee Chair Jack Reed, would also authorize the SEC to collect information from the hedge fund industry and other investment pools, including the risks they may pose to the financial system. The legislation incorporates a confidentiality requirement. The SEC would also be authorized to require hedge funds and other investment pools to maintain and share with other federal agencies any information necessary for the calculation of systemic risk.

Hedge funds and other private funds are not currently subject to the same set of standards and regulations as banks and mutual funds, reflecting the traditional view that their investors are more sophisticated and therefore require less protection. According to Sen. Reed, this has enabled private funds to operate largely outside the framework of the financial regulatory system even as they have become increasingly interwoven with the financial markets. As a result, there is no data on the number and nature of these firms or ability to calculate the risks they pose to the broader markets and the economy.

Tuesday, June 23, 2009

Illinois Updates Electronic Form D Policy for Rule 504, 505 and 506 Offerings

Beginning March 16, 2009 issuers intending to make an offering under Rule 504 in Illnois may use Section 4.G of the Illinois Securites Law to file SEC Form D or Illinois Form 4.G, along with $100 made payable to the Secretary of State.

Rule 505 issuers may use Section 4.D to file a paper copy of the Form D electronically filed with the SEC, along with $200 made payable to the Secretary of State.

Rule 506 issuers may use Section 2a of the Illinois Securities Law and Rule 130.293 to file a paper copy of the Form D electronically filed with the SEC, along with $100 made payable to the Secretary of State.

Rule 504 issuers must submit their notice no later than 12 months after the date of first sale to an Illinois resident. Rule 505 issuers must submit their notice no later than 15 days after the receipt of consideration or delivery of a subscription agreement. Rule 506 issuers must file their notice no later than 15 days after the first sale of securities to an Illinois resident.

NOTE: Form D must be filed with the SEC as well as the Illinois Department of Securities to qualify for the Rule 505 or 506 exemptions.

For more information please see here.
Settlement Bar Order Proper Under PSLRA

The 11th Circuit rejected challenges to a bar order in the HealthSouth fraud litigation by former HealthSouth CEO Richard Scrushy. Mr. Scrushy, a non-settling defendant, objected to the portions of the bar order that extinguished his contractual claims against HealthSouth for indemnification of settlement payments to the underlying plaintiffs and for advancement of legal defense costs.

With regard to the indemnification question, the court rejected Mr. Scrushy's assertion that the mandatory contribution bar set forth in the Private Securities Litigation Reform Act was exclusive and prohibited the district court from barring claims other than contribution claims. Initially, the court noted that there is no provision in the statute expressly limiting or prohibiting a bar of indemnity claims, and concluded that there is no language in the statute suggesting that the contribution bar is exclusive. "The statute merely mandates a contribution bar, but is silent with respect to barring similar indemnification claims," stated the court. Finally, the court found that such a reading of the act would be improper because "the PSLRA was enacted against a background of established case law which had approved bar orders precluding such indemnification claims."

The 11th Circuit panel also rejected the former CEO's assertion that his contractual claim against HealthSouth for advancement of his attorney fees was a truly independent claim. Despite the fact that his injury was not measured by any liability to the underlying plaintiffs, and resulted from his payments to his attorneys, the court held that "the attorneys' fees are nonetheless paid on account of liability to the underlying plaintiffs or the risk thereof."

In re HealthSouth Corp. Securities Litigation
District of Columbia Issues Bulletin on Electronic Form D for Rule 504, 505 and 506 Issuers

Beginning March 16, 2009, issuers intending to make a Rule 504, 505 or Rule 506 offering in the District of Columbia must file an authenticated paper copy of the SEC-electronically filed Form D, and a fee of $100 (Rule 504); 1/10 of 1% of the maximum aggregate offering price, with minimum and maximums of $250 and $1,500 respectively (Rule 505); and $250 (Rule 506). Rule 504 issuers may submit a paper copy of Form D with their filing; Rule 505 and 506 issuers must provide via cover letter submitting a paper copy of Form D, a representation of the date of first sale; the number of accredited and nonaccredited investors; and the aggregate dollar amount of securities offered or sold in the District of Columbia. The notice must be filed no later than 15 calendar days after the first sale of securities in the District of Columbia, unless the 15th day is a Saturday, Sunday or holiday, in which casethe due date is the first following business day. NOTE: A consent to service of process is not required.

Amendments. SEC-filed amendments including annual renewals may be voluntarily filed in the District of Columbia at any time, except that amendments increasing the number of investors and aggregate dollar amount of securities offered or sold that were originally reported must be promptly submitted to the D.C. Department of Insurance, Securities and Banking. Amendments to correct material mistakes of fact or errors on a previously filed Form D must be filed as soon as discovering the mistake or error.

For more information please see here. Questions about the Bulletin can be answered by J. Mike McManus, Assistant Director, Division of Corporation Finance, at (202)-442-7826 or here.
Washington State Releases Checklist on Electronic Form D Filings for Rule 504, 505 and 506 Offerings

A checklist on the notice filing and fee requirements for making Rule 504, 505 and 506 offerings following the SEC's mandate that Form D be filed electronically beginning March 16, 2009 was issued by the Washington Department of Financial Institutions. The checklist provides a capsule summary of the notice filing requirements of Washington's Regulation D Rules for 504, 505 and 506 offerings that were amended effective September 15, 2008 to conform to federal electronic Form D filing requirements.

Beginning March 16, 2009, issuers making a Rule 504, 505 or 506 offering must file with the Department of Financial Institutions a paper copy of the Form D electronically filed with the SEC. The Department also requires a report of the date of first sale to a Washington resident or an indication that sales have not yet occurred in Washington (that may be included in a cover letter). The fee for Rule 505 or 506 is $300; the fee for Rule 504 is $50. The Rule 505 or 506 notice must be filed no later than 15 days after the first sale in Washington; the Rule 504 notice must be filed no later than 10 business days before receipt of consideration or the delivery of a signed subscription agreement. An amendment updating Form D information must be filed, as well as annual amendments for ongoing offerings.

Please click here for additional information.

Monday, June 22, 2009

SEC Chair Presents Plan for Regulation of OTC Derivatives to Congress

Against the backdrop of the Obama Administration’s call for federal regulation of the OTC derivatives markets, SEC Chair Mary Schapiro has asked Congress to pass legislation subjecting securities-related OTC derivatives to the federal securities laws and Commission regulation. In her view, this could be achieved by clarifying the definition of “security” in the federal securities laws to expressly include securities-related OTC derivatives and removing the current express exclusion of swaps from that definition. Thus, securities-related OTC derivatives could be brought under the same umbrella of oversight as the related, underlying securities markets in a relatively straightforward manner with little need to reinvent the wheel. The SEC then would have authority to regulate securities-related OTC derivatives regardless of how the products are traded, whether on an exchange or over-the-counter; and regardless of how the products are cleared.

Regarding the nettlesome issue of how to deal with customized OTC derivative contracts that may be ineligible for central clearing, the SEC Chair suggested imposing appropriate margin and capital requirements on the participants in customized transactions to reflect the risks they pose to market systems generally. While acknowledging that there are legitimate economic reasons to engage in customized derivatives transactions, the SEC official emphasized that participants in individual transactions should not be permitted to externalize the costs of their decisions, such as by creating additional systemic risk.

In testimony before the Senate Subcommittee on Securities, the SEC Chair explained that OTC derivatives can be categorized as securities-related or non-securities-related based on the different types of their underlying assets. Securities-related OTC derivatives would include equity derivatives and credit and other fixed income derivatives. Non-securities-related derivatives would include interest rate derivatives, foreign currency derivatives, and all non-financial derivatives.

Securities-related OTC derivatives can be used to establish either a synthetic long exposure to an underlying security or group of securities, or a synthetic short exposure to an underlying security or group of securities In this way, market participants can replicate the economics of either a purchase or sale of securities without purchasing or selling the securities themselves Similarly, credit default swaps can be used as synthetic substitutes for the debt securities of one or more companies. Indeed, any exchange of cash for a security can be structured as an OTC derivatives contract.

By including securities-related OTC derivatives under the umbrella of the federal securities laws, noted the official, the SEC would oversee the portion of the OTC derivatives market that is vital to promote its mission of investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation. In addition, the SEC would continue to regulate those types of OTC derivatives that always have been considered securities, such as OTC security options, certain OTC notes, including equity-linked notes, and forward contracts on securities. These particular types of OTC derivatives always have been included in the definition of security and current law recognizes this fact by excluding these derivatives from the definition of “swap agreement” in Section 206A of the Gramm-Leach-Bliley Act

The SEC also recommended subjecting major participants in the OTC derivatives markets to oversight in order to ensure that there are no regulatory gaps. OTC derivatives dealers that are banks would be subject to regulation by the federal banking agencies, she said, while all other OTC derivatives dealers in securities-related OTC derivatives would be subject to SEC regulation. The Commission would also be authorized to set appropriate capital requirements for these OTC derivatives dealers.

The SEC Chair said that this approach would permit existing OTC derivatives dealers that are banks to continue to engage in derivatives activities without being subject to the full panoply of broker-dealer regulation; while at the same time ensuring that all currently unregulated dealers in securities-related OTC derivatives are subject to regulation. Moreover, if Congress establishes a new systemic risk regulator as proposed by the Obama Administration, that entity, be it a single regulator or a council of regulators, could help monitor institutions that might present systemic risk

The SEC should also be authorized to establish business conduct standards and recordkeeping and reporting requirements, including an audit trail, for all securities-related OTC derivatives dealers and major market participants with large counterparty exposures in securities-related OTC derivatives. According to the SEC official, this umbrella authority would help ensure that the Commission has the tools it needs to oversee the entire market for securities-related OTC derivatives. Major OTC participants also would be required to meet standards for the segregation of customer funds and securities.

Trading markets and clearing organizations for securities-related OTC derivatives would also be subject to registration requirements as exchanges and clearing agencies. Importantly, however, Ms. Schapiro assured that the conditional exemption from exchange registration that the SEC provided under Regulation ATS would be available to trading systems for securities-related OTC derivatives. Among other things, Regulation ATS lowers barriers to entry for trading systems in securities because the systems need not assume the full self-regulatory responsibilities associated with being a national securities exchange.

Both registered exchanges and ATSs are subject to important transparency requirements. Thus, the official believes that expanding the SEC’s authority over securities-related OTC derivatives would promote improved efficiency and transparency in the markets for securities-related OTC derivatives.

Similarly, the regulatory regime for securities clearing agencies would ensure that central counterparties for securities-related OTC derivatives impose appropriate margin requirements and other necessary risk controls. The SEC’s historic and efficient regulation of clearing agencies under the Exchange Act would support both the goal of having the greatest number of OTC derivatives centrally cleared, while retaining flexibility to allow variation in trading venues to meet the trading needs of different instruments and participants.

The SEC is currently considering whether reporting under the Exchange Act should apply to security-based OTC derivatives so that the ownership of and transactions in these derivatives would be considered ownership of and transactions in the underlying equity security. The Commission is further evaluating whether persons using equity derivatives, such as an equity swap, should be subject to the beneficial ownership reporting provisions of the Exchange Act when accumulating substantial share positions in connection with change of control transactions.

CFTC Chair

In his testimony before the subcommittee, CFTC Chair Gary Gensler said that a comprehensive regulatory framework governing OTC derivative dealers and OTC derivative markets should apply to all dealers and all derivatives, no matter what type of derivative is traded or marketed. It should include interest rate swaps, currency swaps, commodity swaps, credit default swaps, and equity swaps. Further, the regulatory framework should apply to dealers and derivatives, no matter what type of swaps or other derivatives may be invented in the future.

This framework should also apply regardless of whether the derivatives are standardized or customized. Anticipating the Obama Administration's plan, Chair Gensler testified that a new regulatory framework for OTC derivatives markets should be designed to achieve four key objectives: (1) Lower systemic risks; (2) Promote the transparency and efficiency of markets; (3) Promote market integrity by preventing fraud, manipulation, and other market abuses, and by setting position limits; and; (4) Protect the public from improper marketing practices. In order to achieve these objectives, said Mr. Gensler, regulators must regulate both derivatives dealers and derivatives markets.

According to Mr. Gensler, all derivatives that can be moved into central clearing should be required to be cleared through regulated central clearing houses, and traded on regulated exchanges or regulated transparent electronic trading systems.
Colorado Provides Guidance on Electronic Form D Filing Procedures for Rule 504, 505 and 506 Offerings

Beginning March 16, 2009, issuers intending to make a Rule 504, 505 or Rule 506 offering in Colorado must file a paper copy of the Form D electronically filed with the SEC, with an original signature. The copy of the electronic Form D with the electronic signature, with an original signature on the cover letter is accepted by the Colorado Securities Division as is the electronic Form D's consent to service of process. A filing fee of $75 made payable to the Colorado State Treasurer is required. The filing must be submitted to the Division no later than 15 days after the date of the first sale to a Colorado resident.

NOTE: Form D must be filed with the SEC and the Colorado Securities Division to qualify for exemption.

See here for more information.
Obama Administration Plan Would Reform Executive Compensation as Part of Vast Overhaul of US Financial Regulatory System

The Obama Administration has proposed to Congress the most sweeping and fundamental regulatory reform of the US financial and securities markets since President Franklin D. Roosevelt’s New Deal. As part of the overhaul of the US financial system, the Administration proposes vast corporate governance reform to regulate systemic risk, enhance transparency and disclosure, and delink executive compensation from excessive risk. A centerpiece of the Administration’s plan, which is in line with the G-20 principles, is to reform compensation schemes to eliminate short-term thinking and excessive risk taking.

Please click here for a white paper on the Obama Administration's Proposal to Reform the US Financial Regulatory System

Acting on a broad and growing consensus, the Administration wants legislation and regulation to align executive compensation incentives, particularly variable compensation such as bonuses, with shareholder interests and long-term, firm-wide profitability. Moreover, compensation schemes must become fully transparent. Also, the assessment of bonuses should be set in a multi-year framework in order to spread out the actual payment of the bonus pool through the cycle. Further, bonuses should reflect actual performance and, therefore, should not be guaranteed in advance.

Specifically, boards of directors must play an active role in the design, operation, and evaluation of compensation schemes. Compensation, particularly bonuses, must properly reflect risk; and the timing and composition of payments must be sensitive to the time horizon of risks.

More concretely, the Administration asked Congress to pass legislation mandating a non-binding shareholder advisory vote on executive compensation. The Administration also seeks legislation ensuring the independence of board of directors compensation committees similar to the manner in which the Sarbanes-Oxley Act provided for independent audit committees.

The G-20 principles, to which the US is a signatory, demand that payments not be finalized over short periods where risks are realized over long periods. Also, firms must disclose comprehensive and timely information about compensation. Stakeholders, including shareholders, should be adequately informed on a timely basis on compensation policies in order to exercise effective monitoring. The inclusion of stakeholders portends a role for shareholder advisory votes on executive compensation, what is popularly known as say-on-pay.

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

Congressional oversight chairs quickly expressed support for the Administration’s legislative proposal. Senate Banking Committee Chair Christopher Dodd said that he strongly supports say-on-pay legislation. More broadly, the senator said that executive compensation has gone completely out of control by rewarding short-term gain and encouraging excessive risk-taking. House Financial Services Committee Chair Barney Frank also supports say-on-pay legislation, but does not think simply mandating independent compensation committees goes far enough. He believes that the legislation should also direct the SEC to set principles preventing companies from providing compensation systems that lead to excessive risk taking.
Alaska Issues Electronic Form D Filing Procedures

Beginning March 16, 2009, issuers intending to make a Rule 506 offering in Alaska must file a paper copy of the Form D electronically filed with the SEC, together with a copy of Form U-2, Uniform Consent to Service of Process, a cover letter stating the first sale in Alaska, and a fee of $600 for one year or $1,100 for an automatic extension of one year (if desired by the issuer atthe time of the notice filing). The notice must be filed within 15 days of the first sale in Alaska.

For more information please contact Roger W. Prince at (907) 269-8144 or visit the Alaska Division of Banking and Securities website.

Sunday, June 21, 2009

Senator Shelby Skeptical of Fed as Systemic Risk Regulator

As the Senate Banking Committee begins to craft legislation overhauling the US financial regulatory system, Senator Richard Shelby (R-Alabama), the Committee’s Ranking Member, has cast doubt on whether the Fed can fill the macro prudential role envisioned for it by the Obama Administration. He also set forth the principles that should guide the financial reform legislation. One key principle laid down by the Senator is that the reform legislation must reduce expectations that some firms are too big to fail.

In his view, the many conflicting duties the Fed currently has, in addition to the quasi-public nature of the Federal Reserve banks, make the Fed ill-suited to be the systemic risk regulator. The Fed already handles monetary policy, bank regulation, holding company regulation, payment systems oversight, international banking regulation, consumer protection, and the lender of last resort function. According to Senator Shelby, these responsibilities conflict at times and some receive more attention than others. He cautioned that we cannot reasonably expect the Fed or any agency to effectively play so many roles.

Moreover, the structure of the Federal Reserve involves quasi-public Reserve Banks that are under the control of boards with members selected by banks regulated by the Fed. By design, the Board and the Reserve Banks are not directly accountable to Congress and are not easily subject to Congressional oversight. In his view, recent events have clearly demonstrated that this structure is not appropriate for a federal banking regulator, let alone a systemic regulator.

More broadly, the Senator said that the legislation must establish regulatory mandates that are achievable, especially with respect to the regulation of systemic risk. While conceding there is wide agreement that the crisis was a system-wide event, Sen. Shelby noted that Congress has spent very little time discussing the concept of systemic risk, determining how best to regulate it, or even establishing whether it can be regulated at all. Further, while risk management should, be improved, risk taking must remain an essential ingredient in the financial markets.

In addition, financial regulators should have clear and manageable responsibilities and be subject to oversight and proper accountability. The Ranking Member is concerned that we already have a number of regulators that do not currently meet these criteria and the Administration is contemplating giving them additional responsibilities.

Friday, June 19, 2009

EU Endorses Systemic Risk Board as Part of Regulatory Reform

While Congress debates the Obama’s Administration’s proposal that the Fed be the systemic risk regulator, the European Union Council has endorsed the creation of a European Systemic Risk Board to monitor and assess potential threats to financial stability and, where necessary, issue risk warnings and recommendations for action and monitor their implementation. The members of European Central Bank will elect the chair of the Systemic Risk Board The creation of the Board would address one of the fundamental weaknesses highlighted by the financial crisis, which is the exposure of the financial system to interconnected, complex, and cross-sectoral systemic risks

The Council also endorsed the European Commission’s proposal to create a European System of Financial Supervisors for individual financial institutions, consisting of a network of national financial regulators working in tandem with new European Supervisory Authorities, created by the transformation of existing Committees for the banking, securities, and insurance sectors. The ESFS is to be built on shared and mutually-reinforcing responsibilities, combining nationally-based regulation of firms with specific tasks at the European level.

Recognizing the potential or contingent liabilities that may be involved for Member States, the European Council stresses that decisions taken by the European Supervisory Authorities should not impinge in any way on the fiscal responsibilities of Member States.

The ESFS will foster harmonized rules and coherent regulatory practice and enforcement. This network should be based on the principles of partnership and flexibility and aim to enhance trust between national regulators by ensuring that host regulators have an appropriate say in setting financial stability and investor protection policies so that cross-border risks can be addressed more effectively.

The Commission envisions that the European Central Bank will have a prominent role on the Risk Council. Also the governors of the central banks of the members will be on the Council, as well as national financial regulators.

Thursday, June 18, 2009

Obama Administration Seeks Federal Regulation of Hedge Funds

The Obama Administration has asked Congress to pass legislation requiring SEC registration of advisers to hedge funds and other private pools of capital, including private equity funds and venture capital funds, with assets under management over a certain threshold. All such funds advised by an SEC-registered investment adviser should be subject to investor and counterparty disclosure requirements and regulatory reporting requirements.

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

The legislation should require the SEC to share the reports it receives from hedge funds with the Fed so that the Fed can determine if the funds or fund families pose a systemic risk and thus become subject to Tier 1 financial holding company regulation.

The Administration’s proposal is broadly in line with proposals advanced by the G-20 and the Scott Report, which recommended the adoption of a confidential reporting requirement pursuant to which each hedge fund would be required to register and provide a regulator with information relevant to the assessment of systemic risk. Confidential reporting would involve information addressing, among other things, a fund’s liquidity needs, leverage, return correlations, risk concentrations, connectedness, and other relevant sensitivities.

However, the regulator would bear the burden of demonstrating its need for the required information as well as its ability to use that information effectively. The regulator also would have limited authority to take prompt action in extreme situations where a hedge fund poses a clear and direct threat to market stability.

Because many hedge funds fall within certain exemptions of the Investment Company Act of 1940 and the Investment Advisers Act of 1940, those hedge fund are required neither to register with the SEC nor to disclose publicly all their investment positions.

The Administration’s proposal was not written on a blank slate. The SEC took the first step in this direction with the issuance of a rule requiring hedge fund managers to register with the Commission as investment advisers pursuant to the Investment Advisers Act. But a federal appeals court later vacated the rule.

In a 2006 case, a panel of the District of Columbia Circuit Court of Appeals declared arbitrary an SEC rule requiring hedge fund managers to register with the SEC if they had more than fourteen clients and managed a specific amount of assets. The Investment Advisers Act exempts from registration those investment advisers with fewer than fifteen clients. The court rejected the SEC’s suggestion of counting the investors in the hedge fund as clients of the fund’s adviser in order to get over the fourteen client limit.That decision effectively ended all registration of hedge funds with the SEC, unless and until Congress acts. Goldstein v. SEC (CA DofC 2006), 451 F3d 873.

Currently, there is pending legislation in Congress designed to close the loophole created by the Investment Advisers Act of 1940, which exempts hedge fund advisers from registering with the SEC if they have less than 15 clients. The Hedge Fund Adviser Registration Act, HR 711, would require anyone who manages hedge funds to register with the SEC. A companion bill in the Senate, the Hedge Fund Transparency Act, S 344,
would impose registration and periodic disclosure requirements on hedge funds essentially the same as the regulation of traditional investment companies.

The Hedge Fund Transparency Act would require hedge funds to register with the SEC, file an annual public disclosure form with basic information, and cooperate with any SEC information request or examination. Public disclosures pursuant to the Act would include a listing of beneficial owners, a detailed explanation of the fund’s structure, an identification of affiliated financial institutions, as well as the number of investors and the fund’s value and assets under management.

European Union

In Europe, the European Commission favors the identification of hedge funds that are of systemic importance, and imposing on them reporting requirements that provide a clear ongoing view of the strategies, risk structure and leverage of these systemically-important funds. In the UK, the Turner report, by the Financial Services Authority Chair Adair Turner, similarly highlights the need to gather much more extensive information on hedge fund activities in order to understand overall macro prudential risks.

Anticipating similar legislation in the US, and in a move that could prevent regulatory arbitrage, the European Commission proposed the broad regulation of managers of hedge funds and all private equity funds with 100 million euros of assets under management. The Directive on Alternative Investment Fund Managers is designed to create a comprehensive and effective regulatory framework for hedge and private equity fund managers at the European level.

The proposed Directive will provide robust and harmonized regulatory standards for all alternative investment funds within its scope and enhance the transparency of the activities of the funds towards investors and public authorities. This will enable Member States to improve the macro-prudential oversight of the sector and to take coordinated action as necessary to ensure the proper functioning of financial markets. The proposed regulations would require extensive disclosure of risk management procedures and other aspects of fund governance.

There had been some confusion over whether just hedge funds, and not private equity funds, would be included in the proposed Directive. In the end, the Commission opted for the broad regulation of all alternative investment funds over a certain minimum asset management level. The Commission was loath to attempt to define hedge funds, fearing that many systemically relevant funds may fall through a regulatory gap. The proposed Directive parallels the proposal presented by the Obama Administration to Congress, which would federally regulate both hedge funds and other private equity funds.

Fully acknowledging the need for harmonized fund regulation, the Commission anticipates similar US legislation later this year.In order to operate in the European Union, all hedge funds and private equity funds will have to be authorized by their home state regulator. They will have to demonstrate that they are suitably qualified to provide fund management services and will be required to provide detailed information on the planned activity of the fund, the identity and characteristics of the assets managed, the governance of the fund, including arrangements for the delegation of management services, arrangements for the valuation and safe-keeping of assets.

The alternative investment funds would also be required to hold and retain a minimum level of capital.To ensure effective risk management of hedge fund activities, the funds will be required to satisfy their regulators of the robustness of their internal risk management procedures, in particular liquidity risks and additional operational and counterparty risks associated with short selling. They will also have to set forth procedures for the management and disclosure of conflicts of interest and the fair valuation of assets.Disclosure is a centerpiece of the proposed regime.

Hedge and private equity funds would have to disclose to investors their investment policy, including descriptions of the type of assets and their use of leverage. They would also have to disclose their redemption policy in both normal and exceptional circumstances, as well as their fees and expenses. The funds would also have to disclose their risk management and valuation procedures. The funds would be required to disclose to regulators the principal markets and instruments in which they trade, as well as their principal exposures, performance data and concentrations of risk.
Geithner Defends Administration's Reform Plan

In prepared testimony released ahead of a pending appearamce before the Senate Banking Committee, Treasury Secretary Tim Geithner defended the Administtration’s proposal to name the Federal Reserve Board the primary systemic risk regulator in the reformed financial regulatory regime. The Fed is best positioned to play that role, he said, since it already supervises and regulates bank holding companies, including all major U.S. commercial and investment banks. The Secretary also pointed out that the Fed will be aided in that role by a new Financial Services Oversight Council composed of the heads of all of the major federal financial regulatory agencies, including the SEC and CFTC. The Council will fill gaps in the regulatory structure where they exist. It will improve coordination of policy and resolution of disputes. And, most importantly, it will have the power to gather information from any firm or market to help identify emerging risks.

The Fed will regulate systemically significant financial firms, what the Administration plan calls Tier 1 financial holding companies, including the parent company and all its subsidiaries, foreign or domestic. The Council will be authorized to facilitate information sharing and coordination, identify emerging risks, resolve jurisdictional disputes among regulators, and, advise the Fed on identifying firms whose failure could pose a threat to market stability and would qualify as Tier 1 financial holding companies and be subjected to systemic risk regulation.

The Secretary noted that the Council does not have the responsibility for supervising the largest, most complex and interconnected institutions. The reason for that is that systemic risk regulation is a specialized task, which requires tremendous institutional capacity and organizational accountability. The Council would not be an appropriate first responder in a financial emergency, he noted, adding that ``You don't convene a committee to put out a fire.’’

Wednesday, June 17, 2009

Obama Administration Urges Harmonization of Securities and Futures Regulation

The Administration decided not to propose a merger of the SEC and CFTC. Instead, the SEC and CFTC should make recommendations to Congress for changes to their statutes and regulations that would harmonize the regulation of futures and securities. The SEC and CFTC should also blend their rules-based and principles-based approaches to regulation respectively into a blended regulatory approach more precise than the principles-based approach while still allowing flexible innovation.

The Administration pointed out that the broad public policy objectives of futures regulation and securities regulation are the same: protecting investors, ensuring market integrity, and promoting price transparency. While differences exist between securities and futures markets, many differences in regulation between the markets are no longer justified. In particular, the growth of derivatives markets and the introduction of new derivative instruments have highlighted the need for addressing gaps and inconsistencies in the regulation of these products by the CFTC and SEC.

Many of the instruments traded on the commodity and securities exchanges and in the OTC markets have attributes that may place the instrument within the purview of both regulatory agencies. One result of this jurisdictional overlap has been that economically equivalent instruments may be regulated by two agencies operating under different and sometimes conflicting regulatory philosophies and statutes.

For example, many financial options and futures products are similar. Under the current federal regulatory structure, however, options on a security are regulated by the SEC, whereas futures contracts on the same underlying security are regulated jointly by the CFTC and SEC.

In many instances the result of these overlapping yet different regulatory authorities has been numerous and protracted legal disputes about whether particular products should be regulated as futures or securities. These disputes have consumed significant agency resources that otherwise could have been devoted to the furtherance of the agency's mission.

Uncertainty regarding how an instrument will be regulated has impeded and delayed the launch of exchange-traded equity, equity index, and credit event products, as litigation sorted out whether a particular product should be regulated as a futures contract or as a security. Eliminating jurisdictional uncertainties and ensuring that economically equivalent instruments are regulated in the same manner, regardless of which agency has jurisdiction, would remove impediments to product innovation.

Arbitrary jurisdictional distinctions also have unnecessarily limited competition between markets and exchanges. Under existing law, financial instruments with similar characteristics may be forced to trade on different exchanges that are subject to different regulatory regimes. Harmonizing the regulatory regimes would remove such distinctions and permit a broader range of instruments to trade on any regulated exchange.

In the Administration’s view, permitting direct competition between exchanges also would ensure that plans to bring OTC derivatives trading onto regulated exchanges or regulated transparent electronic trading systems would promote rather than retard competition. Greater competition would make these markets more efficient, which would benefit users of the markets, including investors and risk managers.

The bottom line is that there must be greater coordination and harmonization between the SEC and CFTC going forward. The Commodity Exchange Act currently provides that funds trading in the futures markets register as commodity pool operators (CPO) and file annual financials with the CFTC. Over 1300 CPOs, including many of the largest hedge funds, are currently registered with and make annual filings with the CFTC. It will be important that the CFTC be able to maintain its enforcement authority over these entities as the SEC takes on important new responsibilities in this area.

The CFTC currently employs a principles-based approach to regulation, while the SEC employs a rules-based approach. The Administration said that efforts at harmonization should seek to build a common foundation for market regulation through agreement by the two agencies on principles of regulation that are significantly more precise than the CEA's current core principles. The new principles need to be sufficiently precise so that market practices that violate those principles can be readily identified and subjected to enforcement actions by regulators.

At the same time, they should be sufficiently flexible to allow for innovations by market participants that are consistent with the principles. For example, the CFTC has indicated that it is willing to recommend adopting as core principles for clearing organizations key elements of international standards for central counterparty clearing organizations which are considerably more precise than the current CEA core principles for CFTC regulated clearing organizations.

Harmonization of substantive futures and securities regulation for economically equivalent instruments also should require the development of consistent procedures for reviewing and approving proposals for new products and rulemakings by self-regulatory organizations. Here again, the agencies should strike a balance between their existing approaches. The SEC should recommend requirements to respond more expeditiously to proposals for new products and SRO rule changes and should recommend expansion of the types of filings that should be deemed effective upon filing, while the CFTC should recommend requiring prior approval for more types of rules and allowing it appropriate and reasonable time for approving rules that require prior approval.

The harmonization of futures and securities laws for economically equivalent instruments would not require eliminating or modifying provisions relating to futures and options contracts on agricultural, energy, and other physical commodity products. There are important protections related to these markets which must be maintained and in certain circumstances enhanced in applicable law and regulation.

The Administration directs the CFTC and the SEC to file a report with Congress by September 30, 2009 identifying all existing conflicts in statutes and regulations with respect to similar types of financial instruments and either explain why those differences are essential to achieving underlying policy objectives with respect to investor protection, market integrity, and price transparency or make recommendations for changes to statutes and regulations that would eliminate the differences. If the two agencies cannot reach agreement on such explanations and recommendations by September 30, 2009, their differences should be referred to the new Financial Services Oversight Council. The Council should be required to address such differences and report its recommendations to Congress within six months of its formation.
Obama Reform Proposal Would Enhance SEC Investor Protection Role

In its draft plan to overhaul US financial regulation, the Obama Administration endorses the SEC as an experienced federal regulator with comprehensive responsibilities for protecting investors against fraud and abuse. To further the SEC’s mission, the Administration proposes legislation modernizing the financial regulatory structure and improving the SEC's ability to protect investors, focusing on principles of transparency, fairness, and accountability.

The SEC should require that certain disclosures (including a summary prospectus) be provided to investors at or before the point of sale, if the Commission finds that such disclosures would improve investor understanding of the particular financial products, and their costs and risks. Currently, most prospectuses (including the mutual fund summary prospectus) are delivered with the confirmation of sale, after the sale has taken place. Without slowing the pace of transactions in modem capital markets, the SEC should require that adequate information is given to investor to make informed investment decisions.

The SEC can better evaluate the effectiveness of investor disclosures if it can meaningfully engage in consumer testing of those disclosures. The SEC should be better enabled to engage in field testing, consumer outreach and testing of disclosures to individual investors, including by providing budgetary support for those activities.

New legislation should also bolster investor protections and bring important consistency to the regulation of two types of financial professionals, brokers and advisers, by: requiring that broker-dealers who provide investment advice about securities to investors have the same fiduciary obligations as registered investment advisers; providing simple and clear disclosure to investors regarding the scope of the terms of their relationships with investment professionals; and prohibiting conflict of interests and sales practices that are contrary to the interests of investors.

Currently, investment advisers and broker-dealers are regulated under different statutory and regulatory frameworks, even though the services they provide often are virtually identical from a retail investor's perspective.

Retail investors are often confused about the differences between investment advisers and broker-dealers. Meanwhile, the distinction is no longer meaningful between a disinterested investment advisor and a broker who acts as an agent for an investor. Current regulations are based on antiquated distinctions between the two types of financial professionals that date back to the early 20th century. Brokers are allowed to give incidental advice in the course of their business pursuant to an exemption in the Investment Advisers Act, and yet retail investors rely on a trusted relationship that is often not matched by the legal responsibility of the securities broker. In general, a broker-dealer's relationship with a customer is not legally a fiduciary relationship, while an investment adviser is legally its customer's fiduciary.

From the vantage point of the retail customer, however, an investment adviser and a broker-dealer providing incidental advice appear in all respects identical. In the retail context, the legal distinction between the two is no longer meaningful. Retail customers repose the same degree of trust in their brokers as they do in investment advisers, but the legal responsibilities of the intermediaries may not be the same.

Thus, the Administration proposes legislation allowing the SEC to align duties for intermediaries across financial products. Standards of care for all broker-dealers when providing investment advice about securities to retail investors should be raised to the fiduciary standard to align the legal framework with investment advisers. In addition, the SEC should be empowered to examine and ban forms of compensation that encourage intermediaries to put investors into products that are profitable to the intermediary, but are not in the investors' best interest.

Mandatory Arbitration

Broker-dealers generally require their customers to contract at account opening to arbitrate all disputes. Although arbitration may be a reasonable option for many consumers to accept after a dispute arises, the Administration believes that mandating a particular venue and up-front method of adjudicating disputes, and thereby eliminating access to courts, may unjustifiably undermine investor interests.

Thus, legislation should authorize the SEC to prohibit mandatory arbitration clauses in broker-dealer and investment advisory accounts with retail customers. The legislation should also provide that, before using such authority, the SEC would need to conduct a study on the use of mandatory arbitration clauses in these contracts. The study must consider whether investors are harmed by being unable to obtain effective redress of legitimate grievances, as well as whether changes to arbitration are appropriate.

Historically, claims for violations of the federal securities laws were considered to be non-arbitrable based on the doctrine enunciated by the US Supreme Court in Wilko v. Swan (US Sup Ct 1953), 1952-1956 CCH Dec.¶90,640. In Wilko, the Court held that an agreement to arbitrate claims under Section 12(2) of the Securities Act was not enforceable. However, as arbitration gained increasing judicial favor, the Court began to chip away at the Wilko doctrine and in 1989 expressly overruled it. The Court ruled that a pre-dispute agreement to arbitrate an investor’s securities claims against a brokerage firm was enforceable in view of the strong federal policy favoring arbitration. Rodriguez v. Shearson/American Express, Inc. (US Sup Ct 1989), 1989 CCH Dec. ¶94.407.

Whistleblower Protection

Legislation should authorize the SEC to establish a fund to pay whistleblowers for information that leads to enforcement actions resulting in significant financial awards. Currently, the SEC has the authority to compensate sources in insider trading cases; but that authority should be extended to compensate whistleblowers that bring well-documented evidence of fraudulent activity. The Administration supports the creation of this fund using monies that the SEC collects from enforcement actions that are not otherwise distributed to investors.

Sanctions

Noting that improved sanctions would better enable the SEC to enforce the federal securities laws, the Administration proposes legislation authorizing the SEC in pursuing enforcement to impose collateral bars against regulated persons across all aspects of the industry rather than in a specific segment of the industry. The interrelationship among the securities activities under the SEC's jurisdiction, the similar grounds for exclusion from each, and the SEC's overarching responsibility to regulate these activities all argue in favor of the imposition of such collateral bars.

Improved sanctions would better enable the SEC to enforce the federal securities laws. The Administration supports the SEC in pursuing authority to impose collateral bars against regulated persons across all aspects of the industry rather than in a specific segment of the industry. The interrelationship among the securities activities under the SEC's jurisdiction, the similar grounds for exclusion from each, and the SEC's overarching responsibility to regulate these activities support the imposition of collateral bars.

Liability Standards

The legislation should also amend the federal securities laws to provide a single explicit standard for primary liability to replace various federal circuit courts of appeal formulations of different tests for primary liability.

Investment Advisory Committee

The SEC recently established an Investor Advisory Committee, made up of a diverse group of well-respected investors, to advise on the SEC's regulatory priorities, including issues concerning new products, trading strategies, fee structures, and the effectiveness of disclosure. The administration proposes legislation making the Investor Advisory Committee permanent.

Financial Consumer Coordinating Council

Similarly, in order to address potential gaps in investor protection and to promote best practices across different markets, the Administration proposes the creation of coordinating council composed of the heads of the SEC, the FTC, the Department of Justice, and the new Consumer Financial Protection Agency. The Coordinating Council should meet at least quarterly to identify gaps in consumer and investor protection across financial products and facilitate coordination of consumer protection efforts.

Congress should help ensure the effectiveness of the Coordinating Council for the benefit of consumers by empowering the Council to establish mechanisms for state attorneys general, consumer advocates, and others to make recommendations to the Council on issues to be considered or gaps to be filled. Legislation should also require the Council to report to Congress and the SEC and other member agencies semi-annually with recommendations for legislative and regulatory changes to improve consumer and investor protection, and with updates on progress made on prior recommendations. The Council should also be authorized to sponsor studies or engage in consumer testing to identify gaps, share information and find solutions for improving consumer protection across a range of financial products.
Obama Administration Proposes Vast Overhaul of US Financial Regulation

The Obama Administration has proposed to Congress the most sweeping and fundamental regulatory reform of the US financial and securities markets since President Franklin D. Roosevelt’s New Deal. The overhaul of the US financial system is based on the themes of regulating systemic risk, enhancing transparency and disclosure, delinking executive compensation from excessive risk, expanding investor protection, and preventing regulatory arbitrage.

The Administration has set forth detailed recommendations on the regulation of hedge funds, private equity funds, and OTC derivatives, including credit default swaps, as well as draft legislation on a new resolution authority to unwind failing securities and commodities firms. The Administration also recommends major corporate governance reforms, such as shareholder advisory votes on compensation and enhanced compensation committees. The Administration also envisions a completely reformed securitization process playing an important role in the financial markets. The plan also proposes new authority for the SEC to protect investors, improve disclosure, raise standards and increase enforcement. The SEC would be directed to establish a fiduciary duty for broker-dealers offering investment advice and also harmonize the regulation of investment advisers and broker-dealers.

A new independent regulator, the Consumer Financial Protection Agency, with authority to make sure that consumer protection regulations are written and enforced. The Administration also proposes a new resolution authority to unwind failing securities and commodities firms and bank holding companies.

In a bow to international financial regulatory coordination, the Administration recommends that the Financial Stability Board and national regulators implement the G-20’s commitment to enhance arrangements for international cooperation on the regulation of global financial firms through the establishment of a college of regulators, a concept favored in the European Union.

Guiding Principles

There are a number of key principles that will guide the effort to overhaul the oversight of financial markets. A broad principle is that the nation must devise a financial regulatory regime for the 21st century to replace one that is still essentially a 1930s regulatory apparatus. A guiding principle is that the Fed must have authority over any financial institution to which it may make credit available as a lender of last resort. The Federal Reserve does not exist to bail out financial institutions, but rather to ensure stability in the financial markets. There must be prudential oversight commensurate with the degree of exposure of specific financial institutions.

In light of the widespread valuation problems of complex financial instruments such as mortgage-backed securities, another principle of the Obama reforms is enhancing capital requirements and the development and rigorous application of new standards for managing liquidity risk. A further principle is to regulate financial institutions for what they do rather than who they are. The current oversight structure is rooted in the legal status of financial firms. This must end, since this fragmented structure is incapable of providing the oversight necessary to prevent bubbles and curb abuses.

An important principle of financial markets reform is to establish a mechanism that can identify systemic threats to the financial system and effectively address them. Financial regulation should identify, disclose, and oversee risky behavior regardless of what kind of financial institution engages in them. This is essentially a regulation by objective approach. Another core principle is that the SEC should aggressively investigate reports of market manipulation and crack down on trading activity that crosses the line to fraudulent manipulation. In the last eight years, the SEC has been sapped of the funding, manpower and technology to provide effective oversight. The SEC’s budget was left flat or declining for three years.

As a result, during a period of increasing market uncertainty and opacity, the SEC enforcement division has not effectively policed potentially manipulative behavior. The SEC’s FY2009 budget request itself shows that the percentage of first enforcement actions filed within two years of opening an investigation or inquiry fell from 69 percent in 2004 to 54 percent last year. The Administration believes that there must be an effective, functioning cop on the beat to identify market manipulation, protect investors and avoid excessive speculation in financial markets. The President took a step towards enhancing the SEC’s enforcement powers when he recently 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 measure also authorizes additional appropriations for the SEC and other federal agencies to investigate and prosecute fraud. See related white paper on the Fraud Enforcement and Recovery Act.

Another element of reform is the need to remove negative incentives for regulators to compete against each other for clients by weakening regulation. The new financial regulatory system cannot encourage regulatory arbitrage, charter-shopping or a regulatory race to the bottom in an attempt to win over institutions. Regulators should not have to fear losing institutions, and thus the source of their funding, by being good cops on the beat.

Reform legislation must also ensure that regulators are aware of risks that the institutions they supervise are taking and effectively control them, so that they do not imperil the financial system. All institutions that pose a risk to the financial system must be carefully and sensibly supervised. This responsibility could reside with a single regulator or multiple agencies, but in either case communication and information-sharing among agencies must be streamlined and improved.

Another key principle is the need for more transparency in the financial system. Market participants need information about the risks they are taking. And, it is not acceptable to have regulators in the dark about the risks posed to and by the institutions under their watch.

Another important principle is that investor protection must be placed on an equal footing with regulations ensuring the safety and soundness of the financial system. It is now clear that investor protection and economic growth are not in conflict but, on the contrary, are inextricably linked. The crisis teaches that a failure to protect investors can wreak havoc on the financial system.

Systemic Risk Regulator

The Administration proposes the creation of a regulator to police all systemically important firms and markets as a broad consensus develops on the need for Congress to create a systemic risk regulator. This regulator would be authorized to take proactive steps to prevent or minimize systemic risk. Legislation will seek to guarantee holistic regulation of the financial system as a whole, not just its individual components.

Any financial institution that is big enough, interconnected enough, or risky enough that its distress necessitates government intervention is an institution that necessitates oversight by a federal agency responsible for managing the overall risk to the financial system. In a world where financial innovation is pervasive and where market conditions constantly change, regulators must be authorized to take a holistic view of the playing field, identifying gaps, pointing to unsustainable trends, and raising questions about new kinds of interactions. See remarks of White House economic adviser Lawrence H. Summers at the Council on Foreign Relations.

The financial crisis has demonstrated that large, interconnected financial firms and markets need to be under a more consistent, and more conservative regulatory regime. These standards cannot simply address the soundness of individual institutions, but must also ensure the stability of the system itself.

As financial institutions speculated in increasingly risky products and practices leading to the current crisis, not one federal financial regulator was responsible for detecting and assessing the risk to the system as a whole. The financial sector was gambling on the rise of the housing market, yet no single regulator could see that everyone, from mortgage brokers to credit default swap traders, was betting on a bubble that was about to burst. Instead, each agency viewed its regulated market through a narrow lens, missing the total risk that permeated the financial markets. See . Report of the Committee on Capital Markets Regulation (hereinafter Scott Report).

Thus, the Administration seeks to strengthen the system of prudential regulation across the financial sector. The Administration proposes a single regulator with responsibility for systemic stability over the major institutions and critical payment and settlement systems and activities. Major financial institutions cannot be allowed to choose among consolidated regulatory regimes and regulators or avoid consolidated regulation entirely. The plan would create higher standards for all systemically important financial firms, regardless of whether they own a depository institution, to account for the risk that the distress or failure of such a firm could impose on the financial system and the economy.

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

The systemic regulator will also need to impose liquidity, counterparty, and credit risk management requirements that are more stringent than for other financial firms. For instance, the regulator should apply more demanding liquidity constraints; and require that these firms be able to aggregate counterparty risk exposures on an enterprise basis within a matter of hours. The regulator of these entities will also need a prompt, corrective action regime that would allow the regulator to force protective actions as regulatory capital levels decline.

There was a fierce debate over whether the systemic risk regulator should be a single regulator, new or existing, or a council of regulators. The Administration proposes that the Federal Reserve Board should be the macro prudential systemic risk regulator, advised by a Financial Services Oversight Council (FSOC), whose members will include Treasury, the Fed, the SEC, the CFTC, the FDIC, and the Federal Housing Finance Authority.

The Fed will regulate systemically significant financial firms, what the plan calls Tier 1 financial holding companies, including the parent company and all its subsidiaries, foreign or domestic. The FSOC will be authorized to facilitate information sharing and coordination, identify emerging risks, resolve jurisdictional disputes among regulators, and, advise the Fed on identifying firms whose failure could pose a threat to market stability and would qualify as Tier 1 financial holding companies and be subjected to systemic risk regulation.

The FSOC would be authorized to recommend financial firms that would be subject to Tier 1 regulation, but it would be up to the Fed to accept the recommendation. The Fed would be required to consult with the FSOC in developing rules to be used to identify Tier 1 firms and in setting standards for Tier 1 firms. The Fed would also have to consult with the FSOC in setting risk management standards for systemically important activities. Also, a subset of the FSOC would be responsible for determining whether to invoke resolution authority for large, interconnected firms.

In order to identify emerging threats to market stability, the FSOC would also be authorized to require periodic and other reports from any US financial firms solely for the purpose of assessing the extent to which the firm’s activities threaten market stability.

The Fed will be the macro prudential systemic risk regulator for firms whose size, leverage, and interconnectedness could pose a threat to financial stability. In order to do this job properly, the Fed must expend beyond being a safety and soundness regulator to include regulation of the activities of the firm as a whole and the risks the firm poses to the entire market. Obviously, the Fed would have to develop new regulatory approaches to do the job of systemic risk regulator.

Definition of Systemically Significant Financial Firm

Obviously, how Congress defines a systemically important financial institution will be very critical to the scope of the systemic risk regulator’s authority. If the definition is too broad, the systemic risk regulator could usurp the authority of multiple regulators, including the SEC. The systemic risk regulator should not diminish the role of the SEC, since systemic risk should not trump investor protection.

The G-20 noted that, in determining the systemic importance of a financial institution or hedge fund or other entity, the assessment should take into account a wide range of factors, including size, leverage, interconnectedness, and funding mismatches. In addition, the increased integration of markets globally should be taken into account when assessing the systemic importance of any given financial institution, market or instrument given the potential for cross-border contagion.More specifically, the G-20 report listed three key sets of data that regulators should consider in analyzing the potential risks posed. First, data on the nature of a financial institution’s activities should be collected, including, in the example of a hedge fund manager, data on the size, investment style, and linkages to systemically important markets of the funds it manages.

Second, regulators should develop common metrics to assess the significant exposures of counterparties on a group-wide basis, including prime brokers for hedge funds, to identify systemic effects.Third, data on the condition of markets such as measures on the volatility, liquidity and size of markets which are deemed to be systemically important should also be collected. It is envisaged that regulators would use a combination of existing information sources, including data collected from key institutions and vehicles. Consideration of what regulatory, registration or oversight framework would best enable this information collection and subsequent action would be determined by financial regulators.

The Administration wants legislation specifying the factors that must be considered in determining if a financial firm poses a threat to market stability. The factors must include the impact of the firm’s failure on the entire financial system, the firm’s combination of size, leverage, including off-balance sheet exposures, and degree of reliance on short-term funding, and whether the firm is a critical source of credit for households, businesses, and state and local government, as well as a liquidity source for the financial system. This is a non-exclusive list of factors since the Fed would be authorized to consider other relevant factors in identifying a systemically risky firm. Balance sheets should be a factor, but not a determinative factor, else firms would have an incentive to conduct off-balance sheet transactions through off-balance sheet vehicles and we would be right back to firms growing outside the regulatory system.

The Fed, in consult with Treasury, will adopt rules identifying the Tier 1 firms, But Treasury would have no role in applying the rules to individual firms. In order to help the Fed identify firms in need of systemic risk regulation, Congress must authorize the Fed to collect reports from all US financial firms meeting minimum size thresholds.

The Fed should also be given access to reports submitted to the SEC and other financial regulators. The Fed’s authority to require reports and gain access to reports must be limited to those reports that aid in determining if a firm poses systemic risks. The legislation should also authorize the Fed to examine any US financial firm meeting minimum size thresholds if the Fed is unable to determine if the firm poses systemic market risks based on regulatory reports and discussions with the firm’s management. The scope of the Fed’s examination authority would be strictly limited to examinations reasonably necessary to enable the Fed to determine if the firm needs systemic oversight.

The legislation should remove the constraints that the Gramm-Leach Bliley Act imposed on the Fed’s ability to require reports from, examine, or impose higher regulatory standards or more stringent activity restrictions on the functionally regulated subsidiaries of financial holding companies.