Monday, August 31, 2009

Chairman Schapiro Issues Open Letter to Broker-Dealer CEOs

SEC Chairman Mary L. Schapiro issued an open letter to remind broker-dealer chief executive officers of their supervisory responsibilities following reports that special recruitment programs at some firms are premised on enhanced compensation arrangements.

The letter to broker-dealer CEOs states that some enhanced compensation arrangements could induce brokers to engage in conduct that is not in investors' best interest and reminds CEOs that they have an obligation to police for such conflicts. In addition, the letter reminds CEOs that, as their firms grow, their supervisory and compliance infrastructures should retain sufficient size and capacity.

The letter is available here.


Sunday, August 30, 2009

Corporate Counsel Group Assails First Circuit Tax Audit Work Papers Ruling as Deletorious to Attorney-Auditor Relationship

The Association of Corporate Counsel has decried the First Circuit’s en banc ruling that audit work papers were discoverable by the IRS since they were done with SEC-required financial statements not litigation in mind. The group said that the decision hamstrings public companies’ in-house lawyers from advising auditors in a manner that promotes accuracy and transparency in financial reporting and the certification of financial statements filed with the SEC. It eviscerates the notion that the in-house lawyer can share legal assessments with company auditors without risking waiving the client’s privilege.

In US v. Textron, the full First Circuit Court of Appeals ruled that the attorney work product doctrine does not shield from an IRS summons tax accrual work papers prepared by a company’s lawyers to support the calculation of tax reserves for audited financial statements filed with the SEC. In a 3-2 opinion, the court held that the purpose of the tax audit work papers was not to prepare for litigation, but rather to make book entries, prepare financial statements and obtain a clean audit. This was the testimony of IRS expert and former PCAOB Chief Auditor Douglas Carmichael, who said that tax accrual work papers include all the support for the tax assets and liabilities shown in the financial statements.

In adopting this standard, said the corporate counsel association, the appeals court seeks to promote greater convenience for government investigators at the expense of the public interest in promoting the accurate and complete preparation of corporate financial documents and audits by independent outside auditors. Further, the decision serves as an impediment to accurately gauging corporate liability, averred the association, which is a requirement of disclosure and necessary to transparency in the marketplace. Similarly; it diminishes the value of the important preventive and strategic roles that in house counsel play in complex, publicly companies.

Challenge to Gartenberg Ruling on Fund Advisory Fees Set for November Oral Argument before US Supreme Court

A case challenging the 1982 Gartenberg ruling involving the fiduciary duty imposed on mutual fund advisers under Section 36(b) of the Investment Company Act is set for oral argument before the US Supreme Court on November 2. 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. In an amicus brief filed with the Court, 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.


Thursday, August 27, 2009

French Central Bank Official Views Fair Value Accounting as Tool to Fight Procyclicality

Noting that there is no reasonable or practical alternative to fair value accounting for tradable securities, the Deputy Governor of the Bank of France believes that accounting standards, including fair value standards, may yet be used as a tool to address procyclicality and pre-empt the build up of imbalances in the financial system. In recent remarks, Governor Jean-Pierre Landau said that regulatory concern on fair value accounting’s impact should focus on procyclicality that originates and amplifies inside the financial system and not the type caused by cyclical evolutions in the real economy.

In its proposed reforms of the US financial regulatory system, the Obama Administration noted that the interpretation and application of fair value accounting standards raised significant procyclical concerns.; and that earlier loss recognition could have reduced procyclicality. The Administration called for a review of the fair value accounting rules.

Procyclicality refers to the tendency of financial variables to fluctuate around a trend during the economic cycle. Procyclicality of capital occurs when financial institutions are profitable and their strong capital base allows them to take larger positions in the markets. This mechanism has been amplified by mark-to-market accounting. In a mark- to-market environment, an increase in asset prices quickly translates into stronger capital for financial institutions. In turn, this triggers additional demand for assets and a further increase in their prices. Procyclicality in leverage is more subtle. It has been shown that financial institutions' balance sheets expand and contract with the economic cycle. Risk management practices hardwired to valuations strongly amplify fluctuations in leverage and may lead to fire sales and one sided markets.

There is currently no consensus on whether accounting standards, particularly mark-to-market rules, contributed procyclicality to the financial crisis. According to one view, the application of fair value accounting to financial instruments is neutral; and any procyclicality in financial variables faithfully reflects reality. An opposite view holds that accounting creates incentives, influences behavior and, therefore, fair accounting rules have a significant impact on the dynamics of financial systems.

While not officially taking sides in the debate, the central banker did note that accounting methodologies played a central role in the crisis. The instant recognition of profits led to a disconnection in time between measuring the return on an asset and recognizing the risk; he said, which in turn created a powerful incentive to take risk and strongly amplified the credit cycle.

While it will always be difficult, when looking at revenues drawn from a financial investment to distinguish excess return from additional risk taking, said the central banker, financial reporting could be conceived in such a way that this distinction is prudently introduced. For example, he noted that the application of fair value accounting to a security does not mean that any single valuation gain or loss should instantly be recognized as a profit or loss and financially treated as such.

It is possible to delink valuation from income and profit recognition. Some disconnection between the valuation process, which should remain anchored on market prices, and income and profit recognition would have to be introduced, he reasoned, if only to account for risks which are out there but have not yet materialized.

Dynamic provisioning is one technique for doing so, he said, especially when risks are closely related to the economic cycle. Valuation reserves may also be used when complexity or illiquidity creates additional risk linked to valuation. If these adjustments are rule based and made in a fully transparent process, he added, they would not reduce either the quantity or quality of information available to investors as to the real health of financial institutions.

Another method would be for the regulatory system to force the pricing of risk in all its dimensions. There is a clear analogy with tax theory, he said, in which internalizing the risk eliminates market failures. This approach would be best implemented to liquidity risk linked to maturity transformation. He noted that a number of jurisdictions are considering the imposition of quantitative liquidity ratios on financial institutions. However, he believes that mandatory liquidity ratios may not protect the system against an aggregate liquidity shock, when the demand for liquidity becomes infinite and any buffer proves insufficient.

More broadly, Governor Landau emphasized that procycality forces were at work over a longer time frame than accounting valuations of illiquid securities. During the first phase of the crisis, the short term view of procyclicality may have looked as if mark-to-market accounting, together with highly illiquid markets, generated downward spirals in asset prices and created excessive losses, with no relation to real underlying economic reality. However, it now seems that the disproportion between losses at financial institutions and movements in underlying asset prices can almost fully be accounted for by the extraordinary degree of leverage which accumulated in the financial system over the last decade. Procylicality was at work, he acknowledged, but on a much longer time horizon, and during the upward phase of the credit cycle.

UK Reaffirms Comply or Explain Model for Corporate Governance as Financial Crisis Roils

Despite concerns that the comply or explain principle of corporate governance may not be robust enough in light of the financial crisis, the principle recently received a strong endorsement from the Walker Report on corporate governance, as well as from UK senior officials. There is no indication that the UK and other EU member corporate governance codes will abandon comply or explain in favor of a US-type Sarbanes-Oxley model, which they view as prescriptive and rules-based. Their main bow to the financial crisis is a call for increased shareholder vigilance and a closer inspection of company explanations.

The Walker Report said that, combined with tougher capital and liquidity requirements and a tougher regulatory stance on the part of the FSA, the comply or explain approach to guidance and provisions under the Combined Code provides the surest route to better corporate governance. The relevant guidance and provisions require amplification and better observance, conceded the report, but there are no proposals for new primary legislation. There is, however, widespread criticism that fund managers and other institutional investors give inadequate weight to explanations of non-compliance with code provisions.

Comply or explain was never intended to be a check-the-box exercise. Rather, the explanation for not complying with a code provision must be reasonable and avoid boilerplate. Boards that provide inadequate explanation for non-compliance, and investors who appear to disregard reasonable explanations, should expect to come under increasing pressure to explain their positions.

Regulators recognize that non-compliance may be justified in particular circumstances if good governance can be achieved by other means. A condition of non-compliance is that the reasons for it should be explained to shareholders, who may wish to discuss the position with the company and whose voting intentions may be influenced as a result. A clear and well-founded explanations which support actions to enhance the long term value of the firm should be acceptable to shareholders

The comply or explain approach has been in operation since the Code’s beginnings in 1992 with the seminal Cadbury Report, noted the Walker Report, and the flexibility it offers is valued by company boards and by investors in pursuing better corporate governance. The Cadbury Report notes that a voluntary corporate governance code, coupled with disclosure, will prove more effective than a statutory code.

The Walker Report concludes that conformity has overall been good in the sense that where boards do not comply, they generally explain. But research by Grant Thornton UK LLP revealed that the quality of explanations appears to have been variable. In this respect, the report emphasized the need for greater shareholder attentiveness to such disclosures in their engagement with the companies.

Echoing the Walker Report, FRC Chief Executive Paul Boyle recently said that the comply or explain UK corporate governance code would not be replaced by a mandatory code. He said that mandatory requirements will not necessarily improve the decision making or behavior of company management. Corporate governance is one of the FRC’s broad range of responsibilities, which also includes the oversight of financial accounting and independent auditing of financial statements. The rationale for having all of these issues under one regulatory roof, he explained, is that there are strong connections between corporate governance, corporate reporting, and auditing and assurance.

The UK places a great responsibility on institutional shareholders to monitor compliance with the corporate governance code These responsibilities of institutional shareholders are set out in Section 2 of the Code, he noted, which contains two main principles relating to the need for institutional shareholders to enter into a dialogue with companies and to make considered use of their votes. If the UK system of corporate governance is to be sustained, he emphasized, it is essential that a sufficient number and weight of institutional shareholders demonstrate a willingness and a capability to live up to those responsibilities.

The FRC chief acknowledged that some commentators have suggested that the UK system of comply or explain coupled with monitoring by institutional investorsis unsatisfactory and should be replaced by regulatory monitoring and enforcement. Noting that the FRC has considered and rejected this option, the chief executive explained that the oversight board was not able identify a more effective alternative in improving the practice of corporate governance in a manner that would be consistent with the principles that regulatory actions must be targeted and proportionate.


Tuesday, August 25, 2009

SEC Corp Fin Staff Examines Loan Loss MD&A Disclosure Issues

The SEC's Division of Corporation Finance has released a sample of a
letter sent to public companies' chief financial officers about the issues they may wish to disclose in Management's Discussion and Analysis given the current economic environment. The generally accepted accounting principles relating to allowances for loan losses have not changed, but given the current economic environment, the staff suggested that companies reassess whether the information on which they base their accounting decisions remains accurate given its critical importance to investors' understanding of their financial statements.

One area that may require enhanced disclosure is higher-risk loans, according to the staff. The letter mentions certain types of loans, such as option ARM products, junior lien mortgages, high loan-to-value ratio mortgages, interest-only loans, subprime loans and loans with initial teaser rates, as among those posing higher risk of non-collection. Additional information about these loans may help investors understand the risks associated with companies' loan portfolio and whether known trends could have a material impact on their results of operations.

Companies may wish to consider disclosing the carrying value of their higher-risk loans by loan type and, to the extent feasible, include allowance data. Current loan-to-value ratios could be segregated by geographic location if there are concentrations in certain areas. Companies may want to include the amount and percentage of refinanced or modified loans by loan type. The staff also recommended disclosure of asset quality information and measurements, such as delinquency statistics and charge-off rates by loan type.

Companies should consider whether to disclose their policy for placing loans on non-accrual status when a loan's terms allow for a minimum monthly payment that is less than interest accrued on the loan. This disclosure should include a discussion of how the policy affects the companies' non-performing loan statistics.

Companies may wish to disclose the expected timing of adjustments to option ARM loans and the effect of the adjustments on future cash flows and liquidity. Companies should take into consideration the current trends of increased delinquency rates on ARM loans and the reduced collateral values due to declining home prices. Companies could also disclose the amount and percentage of customers that are making the minimum payments on their option ARM loans.

The staff advised companies to discuss the reasons for any changes in their practices for determining allowances for loan losses. If they change their practices, they should also discuss the historical loss data used as a starting point for estimating current losses and how economic factors affecting loan quality were factored into the allowance estimates. Additional disclosure could include the level of specificity used to group loans for estimating losses, non-accrual and charge-off policies, the application of loss factors to graded loans and any other estimation methods and assumptions that were used.

The staff noted that a decline in the value of assets serving as collateral for companies' loans may affect their ability to collect on those loans. Accordingly, they should consider disclosing the approximate amount or percentage of residential mortgage loans as of the end of the reporting period with loan-to-value ratios above 100%. Companies may also wish to disclose their consideration of housing price depreciation and the homeowners' loss of equity in the collateral in their allowance for loan losses for residential mortgages. The staff suggested that companies include a discussion about the basis for the assumptions on the housing price depreciation.

The staff also urged companies to consider whether investors would benefit from MD&A disclosure about any risk mitigation transactions they used to reduce credit risk exposure, such as insurance arrangements, participation in the U.S. Treasury Home Affordable Modification Program, credit default agreements or credit derivatives.


Monday, August 24, 2009

US Senator Asks SEC for Broad Review of Structure of Market Regulation

Senator Ted Kaufman (D-DE) has urged the SEC to conduct a broad comprehensive review of the structure of the financial markers in order to ensure a level playing field for all investors. In a letter to SEC Chair Mary Schapiro, the senator suggested that conflicts of interests may be leading to failures to protect retail order flow from being taken advantage of by high frequency traders, that dark pools are undermining public price discovery and are not being adequately surveilled, and that disparities in execution speed may have made the national best bid or offer (NBBO) "questionable as a benchmark of execution fairness." Sen. Kaufman noted in his proposal that the study should include independent outside experts from across the United States, including representatives of the retail investor community and small business.

The senator is concerned that questionable practices threaten to further erode investor confidence in the financial markets and that regulatory capacity has not kept pace with those changes. In his view, actions taken by the SEC over recent decades have, perhaps unintentionally, encouraged the development of markets which seem to favor the most technologically sophisticated traders. The current market structure appears to be the natural consequence of regulatory structures designed to increase efficiency and thereby provide the greatest benefits to the highest volume traders. The implications of the current system for buy-and-hold investors have not been the subject of a thorough analysis. He believes that SEC rules have effectively placed increased liquidity as a value above fair execution of trades for all investors

He asks the SEC to undertake a comprehensive, independent "zero-based regulatory review" of a broad range of market structure issues, analyzing the current market structure from the ground-up before piecemeal changes built on the current structure exacerbate potential execution unfairness.

Sen. Kaufman further suggested that flash orders should be banned and high frequency trading strategies that take advantage of market structure latencies should be subjected to a searching examination and in some cases possibly prohibited. Further, liquidity rebates should be reconsidered. Importantly, the co-location of servers at execution venues should be regulated by the SEC to ensure fair access, he emphasized, and auditing of execution at all market centers should be uniform and improved.

Markets have become so fragmented, he averred, and the rise of high-frequency trading that can execute trades in milliseconds has been so rapid, that the SEC should review and quantify the costs and benefits of these market structure developments to all investors. Specifically, he noted that Regulation NMS appears to have had many unintended consequences, driving order flow into dark pools when it was intended to strengthen public order display. Moreover, Regulation ATS has permitted execution venues to flourish, and competition generally has been beneficial. More than 50 execution platforms now exist. While this has led to increased competition for market share, he acknowledged, this also includes questionable practices such as liquidity rebates, flash order offerings, co-location of servers and other inducement arrangements with broker-dealers and other market participants.

Moreover, market structure developments have taken place so quickly, that the SEC rule-making process is applying principles and precedents based on floor-based trading to electronic environments. For example, he noted that, in May 2009, the SEC staff permitted two exchanges to introduce flash-order offerings, even though both admitted that the practice was of dubious value and that they simply were being driven to adopt it by the loss of market share to competitors. Instead of simply applying precedent from an obsolete business practice to a particular electronic order type or technological development, he said, there needs to be a comprehensive evaluation of each proposal's direct and indirect costs to the average investor.

The senator asked the SEC to improve the reporting of execution quality for all trading venues in Rule 605. The SEC should also make brokerage firms produce better and usable execution quality statistics in Rule 606. He also asks if the national best bid and offer (NBBO) truly reflects the quotes consolidated from the various venues at current execution speeds. Otherwise, NBBO is questionable as a benchmark measure of execution fairness.

Liquidity, speed and the role of arbitrage functions cannot be the end of the discussion, he said, adding that this conversation is only now beginning to take place, as recent questionable market practices, which few previously understood, are only now coming to light.

He urged the SEC to ban selectively displayed orders and indications of interest that are the functional equivalent of orders. In addition, he said that the SEC needs to ensure fair access by pro-actively determining a method of allocation of co-located capacity. The Commission must also insure that such closeness is consistent with its plans for protection against terrorist attacks in the various business continuity directives.

Further, the senator said that fees for co-locating servers should be approved by the SEC. Agreements should offer the same terms and conditions and be transparent to regulators. Also retail investors should have adequate choice of co-located execution by wholesalers. Finally Sen. Kaufman said that the use of liquidity rebates (payment for order flow) to attract market share should be reconsidered. In this context, he noted that the London Stock Exchange has decided to end liquidity rebates by replacing them with a flat fee beginning September 1.

D.C. Circuit: Partnership Interests in "Family Feud" Were Securities

In a complex case involving various affiliated business entities, a D.C. Circuit panel found over a dissent that certain limited partnership interests were "securities" under the Howey test. The thorny issue in this case is that the same individuals were associated with both the plaintiff and defendant entities. In assessing the panel's findings, the concern may be not whether they reached the right answer but rather if they asked the correct questions (Liberty Property Trust v. Republic Properties Corp.).

Richard Kramer and Steven Grigg were real estate developers who owned and controlled Republic Properties Corp. The two, along with a third (non-party) developer, formed a public REIT, Republic Property Trust. The trust subsequently established a limited partnership, owning approximately 88 percent of the partnership and serving as its sole general partner.

The transaction that spawned the litigation amidst this intertwined family tree involved a development contract between the corporation and the city of West Palm Beach, Florida. The corporation also subsequently hired Raymond Liberti, a city official as a "consultant," paying him up to $8,000 a month. The corporation then assigned the contract to the limited partnership in exchange for $1.2 million worth of partnership interests.

The deal imploded when the federal government charged Mr. Liberti with official corruption. The city notified the corporation that it intended to terminate the agreement, and the limited partnership ended all involvement with the developers. The trust and the partnership then sued the developers and the corporation.

The district court found that the complaint adequately alleged fraud but that the interests involved were not "securities." According to the lower court, "one can extract a general principal from these various results: when the same parties stand on both sides of the transaction-no matter how many nominally distinct legal entities lie in between, and no matter how convoluted their interrelationships-the transaction is not an investment contract under Howey because the buyers necessarily have power to control their investment's outcome."

The majority of the appellate panel disagreed. Initially, the majority criticized the district court for disregarding the separate legal entities of the parties to the transaction. In addition, the court ruled that Kramer and Grigg did not exercise sufficient control of the limited partnership to disqualify their units as securities under a Howey analysis.

It appears that both the district court and the appellate majority failed to ask some very significant questions. While the district court emphasized that the same parties stood on both sides of the transaction in its Howey discussion, the trial judge did not address that issue in a rather formulaic finding of reliance and causation. The appellate majority did not address the issue at all, as it adopted the district court's reasoning. Both courts wrote at length on the debate over whether these instruments were investment contracts while largely ignoring the question of whether the securities laws should apply to the statements in question given the relationship between the parties.

Senior Circuit Judge Randolph dissented, primarily on the majority's Howey conclusion. He stated that to hold "that Kramer and Grigg had a legal obligation to provide information to themselves is to render the securities laws senseless." While he seems to suggest that there may be no underlying fraud given the parties' interrelationship, he does not address this specifically in terms of disclosures, reliance or loss causation.


Friday, August 21, 2009

Revised French Corporate Governance Code Emphasizes Independent Audit Committees

A revised French corporate governance code places the independent audit committee at the heart of effective governance and provides for the appointment of employee-shareholder directors. In accordance with French law, the code also offers companies the choice between a unitary board of directors, such as in the US, and a two-tier supervisory board-executive board structure, as used in Germany and the Netherlands. The code does not favor either formula, leaving it up to each corporation to decide on the basis of its own specific constraints.

The code provides that at least one-half of the board members must be independent. A director is independent when he or she has no relationship of any kind whatsoever with the company, its group or the management of either that is such as to color his or her judgment. Thus, an independent director is to be understood not only as a non executive director, that is one not performing management duties, but also as one devoid of any particular bonds of interest with them.

The board should appoint an audit committee composed of members competent in finance and accounting; two-thirds of whom are independent. The committee must be permitted to hire experts as needed. The annual report should include a statement on the audit committee's activity during the financial year.

The main tasks of the audit committee are to review the financial accounts and ensure the relevance and consistency of accounting methods used in drawing up the company’s financial statements. The committee should also monitor the process for the preparation of financial information; and also monitor the effectiveness of the internal control and risk management systems.

The review of accounts by the audit committee should be accompanied by a presentation from the outside independent auditors stressing the essential points not only of the results, but also of the accounting methods chosen; and a presentation from the chief financial officer describing the company’s risk exposures and its material off-balance-sheet commitments.

The code provides that the audit committee will steer the procedure for selection of the outside auditors and submit the outcome of that selection to the board of directors. The audit committee must also monitor the rules ensuring the independence of the outside audit firm. The committee will also conduct regular interviews with the outside auditors without the presence of company management.

The code essentially charges the audit committee with ensuring the independence of the company’s outside auditor. The committee must review with the auditors the risks weighing on their independence and the protective measures taken in order to attenuate those risks. In particular, the committee must ensure that the amount of the fees paid by the company and its group, or the share of such fees in the turnover of the firms and audit networks, are not likely to impair auditor independence.

The statutory auditing assignment should be exclusive of any other assignment not related to statutory audit. Thus, the selected audit firm should give up, for itself and the audit network to which it belongs, any consulting activity, such as legal, tax, or IT, performed for the company. However, subject to prior approval from the audit committee, services that are accessory or directly complementary to auditing may be performed, such as acquisition audits, but exclusive of valuation or advisory services.

As regards internal audit and risk review, the committee should review the material risks and off balance-sheet commitments, interview the person in charge of internal audit, issue an opinion regarding that department's organization, and be informed of its work program. It should receive internal audit reports or a regular summary of those reports.


Thursday, August 20, 2009

CFTC Chair Gensler Asks Congress for Changes to Administration's Draft Legislation Regulating Derivatives

In a letter to Congress, CFTC Chair Gary Gensler has asked for specific changes in the Obama Administration’s draft legislation to regulate the OTC derivatives markets. While praising the legislation as an important step toward comprehensive regulation of both derivatives dealers and derivatives markets, the CFTC Chair said that the legislation must cover the entire marketplace without exception and also remain true to its vision of parallel SEC-CFTC swap regulatory regimes.

Thus, he urged the Administration to drop the exclusion for foreign exchange swaps currently contained in the draft. He fears that these broad exclusions could enable swap dealers and participants to structure swap transactions to come within these foreign exchange exclusions and thereby avoid regulation. He also asked that dual SEC-CFTC regulation of mixed swaps be deleted. The letter was sent to Senate Ag Committee Chair Tom Harkin (D-IA) and Ranking Member Saxby Chambliss (R-GA). The letter was copied to Senate Banking Committee Chair Chris Dodd (D-CT) and Ranking Member Richard Shelby, as well as to House Ag Committee Chair Collin Peterson (D-MN) and Financial Services Chair Barney Frank (D-MA)

Chairman Gensler fears that currency and interest rate swaps could be broken down into their component parts and then restructured to resemble a series of foreign exchange forwards or a foreign exchange swap to come within the scope of the proposed foreign exchange exclusions. There is also a risk that these exclusions may have the unintended consequence of undermining the CFTC’s enforcement authority over retail foreign currency fraud enacted by Congress as part of last year’s Farm Bill.

Moreover, Mr. Gensler said that the proposed exception from the mandatory clearing and exchange trading of standardized swaps when one of the counterparties is not a swap dealer or major swap participant excludes a significant class of end users and may undermine the policy objective of lowering risk through bringing all standardized OTC derivatives into centralized clearing. It may also undermine the policy objective of increasing transparency and market efficiency through bringing standardized OTC derivatives onto exchanges.

While the proposed legislation includes important protections with respect to insolvency risk involving OTC swaps, Mr. Gensler asked Congress to include several additional measures to protect customers and counterparties in the event of a bankruptcy of a swap dealer. Specifically, the legislation should impose a mandatory set-aside requirement with respect to collateral received by swap dealers. As envisioned by the Chair, this set-aside requirement would be equivalent to the CEA’s segregation requirement for futures, which has effectively protected customer funds from loss ever since the CFTC was created in 1974.

As important, the legislation should amend the Bankruptcy Code to afford, in the event of a swap dealer bankruptcy, swap counterparties and customers of swap dealers similar protections as those currently available to futures customers of commodity brokers, including the transfer of customer funds to other solvent commodity brokers in the event of a bankruptcy without violating the automatic stay or being subject to the bankruptcy trustee’s avoidance powers.

Mr. Gensler also asked Congress to strike out the mixed swap provisions of the proposed draft, which provide for the dual SEC-CFTC regulation of swaps that derive their value from both a security and a commodity. The mixed swap provisions are a departure from the legislation’s vision of allowing the CFTC and SEC to separately administer parallel regulatory regimes with respect to swaps and security-based swaps. Mr. Gensler suggested that the legislation should subject such swaps to SEC regulation if their value is based primarily on a security or narrow-based security index, or to CFTC regulation if their value is based primarily on something else.

Wednesday, August 19, 2009

Major Law Firms Oppose SEC Proposed Shareholder Access Rule

A consortium of major law firms has asked the SEC not to adopt proposed Rule 14a-11, the shareholder access rule, and instead amend the shareholder proposal rule to permit stockholders to utilize Rule 14a-8 for proxy access proposals. Further, any prescriptive proxy access regime the SEC may adopt should permit private ordering under state law so as to allow stockholders to modify the SEC’s proxy access regime as they see fit, including by opting out of the that regime in its entirety. The laws firms that signed the comment letter are Skadden, Arps, Wachtell, Lipton, Cravath Swaine & Moore, Davis Polk & Wardwell, Latham & Watkins, Sullivan & Cromwell, and Simpson, Thacher & Bartlett.

In addition, to ensure workability and avoid the need for a special meeting of stockholders, averred the firms, boards should explicitly be permitted to adopt or amend proxy access bylaws in the period between annual meetings, subject to stockholder ratification at the next annual meeting. The firms also urged the SEC to adjust upwards the ownership thresholds to determine eligibility to use Rule 14a-11 to 5% for individual stockholders and higher thresholds for groups of stockholders.

In the view of the law firms, the SEC can achieve its goal of removing impediments in the proxy rules to proxy access by amending Rule 14a-8 to permit stockholder proposals relating to the election of directors with far less complexity and disruption than a prescriptive one-size-fits-all rule. SEC reliance on Rule 14a-8 would also show far greater deference to the value of private ordering under state law which, say the firms, has been the hallmark of the federal system of corporate regulation for decades.

Further, proposed Rule 14a-11 would have the practical effect of foreclosing much of the potential scope and utility of private ordering in an area of great complexity and factual variation. The proposal would preclude companies and their stockholders from adopting any form of proxy access that is more restrictive, thereby eliminating the flexibility and experimentation necessary to deal with the complex issues that inevitably will arise.

Moreover, the workability issues do not have one obvious solution, noted the firms, but rather can rationally be resolved in a number of different ways, illustrating that a one-size-fits-all approach is inherently flawed as a regulatory model for proxy access. There are over 7,000 public companies that would be subject to proposed Rule 14a-11, observed the firms, and the appropriate form of proxy access will depend upon a number of factors, including a company’s state of incorporation, capital structure, board composition, stockholder base, and governance practices.

According to the firms, a single, national prescriptive rule is neither adequate to address all of the issues and ambiguities that will arise nor readily adaptable to unique circumstances. Private ordering, on the other hand, not only allows flexibility of design but also provides an inherent capability of dealing with error, ambiguity and change of circumstance as companies and their stockholders gain experience with proxy access, without requiring the SEC continually to interpret and amend its access rules.

Private ordering under enabling state corporate statutes has proven responsive to changing stockholder views concerning other governance matters, noted the firms, with meaningful changes such as the widespread adoption of majority voting and the elimination of classified boards. Delaware amended its corporate statute explicitly to enable adoption of a bylaw establishing a proxy access regime by board or stockholder action.

The firms also recommend that the SEC exempt controlled companies that are majority-owned by one or more stockholders from proposed Rule 14a-11. Since voting at these companies is pre-determined through the sizeable voting block held by the controlling stockholders, reasoned the firms, subjecting those companies and their stockholders to the proxy access process would impose costs without any possibility of the stockholder nominee’s election.

Ninth Circuit Panel Overturns Criminal Conviction for Stock Options Backdating

A Ninth Circuit panel has overturned the first criminal conviction for backdating stock options because the prosecutor made a false assertion of material fact to the jury in closing argument. But the prosecutor’s conduct was not so egregious as to require dismissal of the prosecution against the company CEO. Rather, the case was remanded for a new trial. (US v. Reyes, CA-9, No. 08-10047).

The issue that was dispositive of the appeal concerns the government attorney’s misconduct in falsely telling the jury that the company’s Finance Department did not know about the backdating, when the prosecutor knew that statements by department employees revealed that they did. Moreover, the prosecutor was charged with knowledge of a parallel SEC investigation in which parallel evidence was produced about the knowledge of Finance Department executives. For example, the SEC complaint charged that the company’s CFO acted with knowledge of the backdating.

The appeals court found that senior Finance Department employees had given statements to the FBI describing their knowledge of the backdating scheme. Both prosecution and defense counsel were familiar with these statements. Those employees, who were themselves subject to possible criminal prosecution and had been targets of SEC civil suits, did not testify.

There was also no question that the CEO signed off on stock option grants that were priced retrospectively, and that the backdating allowed the company to understate its compensation expenses. That was indeed the way that the alleged scheme was supposed to operate, by providing a valuable option to employees at no apparent expense to the company.

During trial, the CEO’s position was that he relied on the Finance Department to make sure that the corporate books were accurate, and that he was not responsible for the false records. Thus, the CEO’s defense to the charges was that he thought the transactions were properly accounted for, in reliance on the Finance Department’s expertise to comply with the relevant accounting principles and SEC regulations. His counsel, in closing argument, therefore told the jury that the Finance Department knew about the backdating, thus supporting the defense position

The prosecutor, however, told the jury that the employees in the Finance Department “don’t have any idea” that the backdating was occurring. The prosecutor thereby asserted to the jury facts that he knew were belied by the statements to the FBI from responsible Finance Department officers, and by SEC complaints that had been filed against some of the Finance Department employees alleging they knew about the scheme.

But the appeals panel also ruled that the government satisfied its burden of proving that the false records would have affected the judgment of a reasonable investor. If the government had failed to establish the materiality of the falsification, then the prosecution would have had to be dismissed and no new trial would be possible.

Expert government testimony established that improper accounting of backdated options presents investors with an incorrect picture of a company’s finances. Thus, a rational trier of fact could find beyond a reasonable doubt that the omissions and misstatements were material to a reasonable investor. And the Ninth Circuit has recognized that information regarding a company’s financial condition is material to investment.


Tuesday, August 18, 2009

Corporate Secretaries Society Opposes Proposed SEC Shareholder Access Rule 14a-11; Suggests Opt Out Alternative

The Society of Corporate Secretaries and Governance Professionals does not support the adoption of the SEC’s proposed shareholder access rule as currently proposed. In a letter to the SEC, the Society said that, if Rule 14a-11 is adopted, it should be modified to permit companies and their shareholders to opt out of Rule 14a-11 and adopt their own form of proxy access. In addition, the Society believes that proposed Rule 14a-11’s eligibility thresholds should be raised and its disclosure requirements enhanced. The Society does support amending the shareholder proposal rule, Rule 14a-8, to permit shareholders to propose proxy access bylaws for their respective companies.

Under the Society’s suggested approach, a company could propose a proxy access procedure to its shareholders, or shareholders could propose a proxy access procedure pursuant to the proposed amendment to Rule 14a-8. In either case, if such proxy access proposal receives the affirmative vote of a majority of the shares of stock present in person or by proxy and entitled to vote on the proposal, the proxy access proposal would apply in place of proposed Rule 14a-11.

Under the Society’s plan, shareholders could vote affirmatively that they do not want proxy access, or they could vote on procedures that would provide a level of proxy access that is more or less restrictive than Rule 14a-11. The Society believes that requiring shareholder approval of a board’s proposed proxy access procedures should alleviate concerns that boards might attempt to overreach in proposing such procedures, as shareholders would refuse to ratify such board proposed proxy access procedures.

Boards should be given the right to adopt or amend existing proxy access procedures, subject in every case to ratification by shareholders at the next annual meeting. In this way, boards could address issues and problems arising between annual meetings to preserve and enhance effective corporate governance, reasoned the Society, but would always be subject to the requirement of shareholder approval for their actions. The Society feels that this approach appropriately balances the SEC’s concern of ensuring proxy access is available to shareholders of public companies who desire it, while encouraging private ordering and enabling companies and their shareholders to make appropriate choices as to the form of proxy access best suited to their individual company.

The Society also asked that proposed Rule 14a-11 be amended to provide an exception for controlled companies. For this purpose, the Society asked the SEC to consider the definition of controlled company adopted by the NYSE in its Section 303A Corporate Governance Rules, under which a controlled company is a company where more than 50% of the voting power is held by an individual, a group or another company. NASDAQ has a similar rule. The Society said that this will minimize costs to the company for shareholder nominations that have little chance of success.

Proposed Rule 14a-11 provides that shareholders who beneficially own 1% of large accelerated filers or 3% of accelerated filers securities for one year may nominate a director and have their nominee included in the company’s proxy materials. Noting that these thresholds are too low, the Society suggested ownership thresholds of 5% of the company’s securities that are entitled to be voted on the election of directors at a meeting of shareholders for single nominating shareholders and 10% where a group of shareholders are nominating the director. In the Society’s opinion, the 5% and 10% thresholds are not so high as to impose undue impediments to proxy access, while being sensitive to the real costs that such proposals impose on a company and its shareholders. The Society pointed out that in the United Kingdom shareholders must own at least 5% of the company’s securities or be part of a group of at least 100 shareholders in order to submit a nominee for inclusion in the company’s proxy materials.

The Society also believes that it is very important that proposed Rule 14a-11 provide that the director nominee be independent of the nominating shareholder. Specifically, the Society recommends that the rule provide that the director nominee cannot be a nominating shareholder or a member of the immediate family of any nominating shareholder, or a partner, officer, director or employee of a nominating shareholder.

In the Society’s view, ensuring the nominee’s independence makes it less likely that proposed Rule 14a-11 will be used by shareholders seeking to control the company. In addition, independence will make it more likely that the shareholder nominee will discharge his or her fiduciary duties to all shareholders and not be unduly obligated to represent the interests of the
nominating shareholder.

Under proposed Rule 14a-11, the nominating shareholder that first provides notice to the company will be permitted to include its nominee in the proxy materials. However, the rule does not specify the earliest date that a nominating shareholder can file a notice on Schedule 14N. The Society believes that the proposal could have the unintended consequence of resulting in a race by shareholders to be the first to provide their notice to the company. This dynamic could discourage potential nominating shareholders from engaging in constructive dialogue with the board in an effort to achieve its objectives without a proxy access election contest.
The Society urges that the final rule provide for a specific window within which nominating shareholders can make a nomination pursuant to proposed Rule 14a-11, suggesting no earlier than 150 calendar days and no later than 120 calendar days before the date that the company mailed its proxy materials for the prior year’s annual meeting. In addition, the Society believes that, when there is more than one eligible nominating shareholder, the nominating shareholder with the largest holdings should be entitled to include its nominee in the company’s proxy materials.

The Society has asked for enhanced disclosure under proposed Schedule 14N, which is designed to provide information about the nominee and the nominating shareholder. Schedule 14N should require disclosure describing any material transactions between the nominating shareholder and the company within the past 12 months, as well as any discussion on the nomination between the shareholder and a proxy advisory firm. The Society would also like to see the disclosure of contacts with the management or directors of the company that occurred during the 12-month period that had nothing to do with the proposed nomination. Moreover, any holdings of more than 5% of the securities of any competitor of the company should be disclosed.

The Society also urged the SEC to require Schedule 14N disclosure of the items required by Item 4 of Schedule 13D regarding the purpose or plans of the nominating shareholder. This information would include any acquisition, merger or sale plans.Nominating shareholders that beneficially own 5% or more of a subject class of securities should have the option of disclosing this information on their Schedule 13D.

In the Society’s view, the time constraints of proposed Rule 14a-11 mean that the nominating committee will be unable to properly vet a shareholder nominee for inclusion in the company’s proxy materials. Yet, the proposal indicates that the company would have liability if it knows or has reason to know that the information is false or misleading. The company does not have sufficient time to investigate the statements made by the nominating shareholder and the nominee, said the Society, nor will it have the means to determine whether the statements are false or misleading. Thus, the Society urged the SEC to allow a company to explicitly state in the proxy statement that it takes no responsibility for the accuracy or completeness of the information supplied to it by the nominating shareholder or group or the nominee for director.

Constitutional Law Professors Contend that PCAOB's Creation Violated the Appointments Clause

PCAOB members are superior officers of the United States who must be constitutionally appointed by the President and confirmed by the Senate, argued a consortium of constitutional law professors in an amicus brief filed with the Supreme Court in a case challenging the PCAOB’s constitutionality. The mode of appointment specified in the Sarbanes-Oxley Act under which Board members are appointed by the SEC would be permissible only if the members are inferior officers within the meaning of the Appointments Clause, noted the brief, which they are not. The case is before the Supreme Court on a grant of certiorari of a split panel ruling of the DC Circuit Court of Appeals that the PCAOB’s creation was constitutional. The Supreme Court will hear oral arguments this Autumn and a decision is expected during this term. (Free Enterprise Fund and Beckstead & Watts v. PCAOB, Dkt. No. 08-861).

The brief observed that many functions of the PCAOB are not subject to appropriate control and direction by other principal officers. In addition, apart from the lack of control and supervision by superiors, the sheer scope of the responsibilities of the PCAOB mandates that its members be considered principal officers.’

While the SEC has the power to review the PCAOB’s rules and sanctions, conceded the professors, it has no specific statutory power to direct, supervise, or review the PCAOB’s investigative and enforcement decisions, which are precisely the decisions to which the audit firm petitioner here has been subjected. The ability to review subsequent actions, such as reports, sanctions, or rules, that result from investigative and enforcement actions simply is not the power to supervise and direct the investigative and enforcement actions themselves. Citing an example used by Judge Kavanaugh in the panel’s dissent, the brief noted that a federal court’s ability to review the results of a U.S. Attorney’s investigative and prosecutorial efforts is not the power to supervise the investigative and prosecutorial activities themselves.

If the SEC had the plenary power to remove at will the members of the PCAOB, said the brief, that power might suffice to give the SEC adequate supervisory power over all aspects of the PCAOB’s work. But the SEC may only remove a PCAOB member for good cause. Thus, in the absence of at will removal power, the SEC’s supervisory authority must come from more specific statutory provisions, and with respect to the investigative and enforcement decisions illustrated by this case, there are none.

More broadly, the professors argued that the PCAOB is important enough to be a department within the meaning of the Constitution. The PCAOB has authority to regulate virtually every aspect of the public auditing process. The PCAOB is further empowered to inspect, investigate, and discipline all registered public accounting firms. The power to discipline includes the power to impose substantial civil fines. These powers extend to the entirety of the public auditing process, throughout the country and across all businesses.

The Appointments Clause permits appointment of inferior officers by the President, the courts of law, or the heads of departments. According to the professors, the natural inference from this enumeration is that all courts of law and heads of departments must be principal officers in the constitutional sense. Thus, if someone is the head of a department, he or she must be appointed by the President with the advice and consent of the Senate. It followed that the head of the PCAOB, whether that be the Chairperson or the entire PCAOB, is the department head and necessarily a principal officer.


Monday, August 17, 2009

Rhode Island Increases BD, Agent, IA and IA Rep. Fees

The following fees were increased in Rhode Island, effective July 1, 2009:

Broker-dealers, $300, from $250
Agents, $60, from $50
Investment Advisers, $300, from $250
Investment Adviser Representatives, $60, from $50

Please see

BaFin Adopts New Risk Management and Executive Compensation Regulations

In light of the financial crisis, and in reaction to the G-20 mandate, The German Federal Financial Supervisory Authority (BaFin) has adopted new regulations for risk management and executive compensation at banks and other financial institutions. The new risk management regualtions enhance stress testing, liquidity risk and oversight of risk concentrations. The executive compensation regulations are modelled on principles enunciated by the Financial Stability Board and endorsed by the G-20. The regulations apply to German financial institutions, including branches of German institutions abroad. BaFin Executive Director Sabine Lautenschlager said that the financial crisis has pointed to the utmost importance of financial institutions implementing effective operational risk management systems.

The firms must develop and document a strategy for group-wide risk management. BaFin also emphasized that risk management provides a basis for the proper exercise of the oversight functions of the supervisory board and demands the board’s appropriate involvement.

Firms will have the flexibity to develop risk management strategies appropriate for their business model. Management cannot delegate the implementation of effective risk management systems. Management should review the risk management strategy at least annually. More granularly, the adequay of the stress tests and their underlying assumptions should be reviwed at regular intervals, at least annually. The stress tests should focus on significant risks, including risk concentrations, and risks from off-balance sheet vehicles.

According to the BaFin regulations, adequate and effective risk management involves taking into account the risk-bearing capacity, in particular the definition of strategies and the establishment of internal control procedures consisting of internal control and internal audit. The internal control system includes rules on operational and organizational structure and procedures to identify, assess, monitor and communicate risks.

Risks are to be managed organizationally regardless of which unit caused the risks. Measuring the following risks is considered essential to an effective risk management system: default ris, market risk, liquidity risk, and operational risk. Risks associated with significant risk concentrations should also be considered. Firms should also consider risks arising from off-balance sheet vehicles, such as special purpose entities.

Noting that agressive compensation schemes with perverse short-term incentives contributed to the taking of excessive risks financial crisis. BaFin said that compensation must be designed so as to avoid incentives to enter into harmful disproportinately high risk positions. Financial institutions will now have to link variable compensation with the long-term success of the organization. If the variable compensation, such as a bonus, is not risk-based acceptable, there should be claw back.

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

SEC Seeks Comment on Alternative Uptick Rule

The comment period on proposed changes to the SEC's short sale rules has been extended for 30 days so that the public may comment on an alternative approach to short selling price test restrictions. The alternative would allow short selling only at an increment above the national best bid. This alternative uptick rule would not require monitoring of the sequence of bids to determine whether the current national best bid is above or below the previous national best bid. According to the SEC, this approach may be more effective and easier to implement than previously proposed price test restrictions currently under consideration.

See Release No. 34-60509.


Friday, August 14, 2009

Audit Work Papers Were Discoverable by IRS Since They Were Done for SEC-Required Financial Statements Not Litigation

The full First Circuit Court of Appeals has ruled that the attorney work product doctrine does not shield from an IRS summons tax accrual work papers prepared by a company’s lawyers to support the calculation of tax reserves for audited financial statements filed with the SEC. In a 3-2 opinion, the court held that the purpose of the tax audit work papers was not to prepare for litigation, but rather to make book entries, prepare financial statements and obtain a clean audit. This was the testimony of IRS expert and former PCAOB Chief Auditor Douglas Carmichael, who said that tax accrual work papers include all the support for the tax assets and liabilities shown in the financial statements.

From the company's perspective, said the former Chief Auditor, they are created because the key officers of the company sign a certification saying that the financial statements are fairly presented; and they need support for that. From the auditor's perspective, the auditors need to record in the workpapers what they did to comply with GAAP. So the workpapers are the principal support for the auditor's opinion, testified the former PCAOB official.

The court emphasized that the tax work papers were independently required by statutory and audit requirements and that the work product privilege does not apply. It is not enough to trigger work product protection that the subject matter of a document relates to a subject that might conceivably be litigated. A set of tax reserve figures, calculated for purposes of accurately stating a company's financial figures, has in ordinary parlance only that purpose, said the en banc court, which is to support a financial statement and the independent audit of it.

Moreover, the tax work papers have to be prepared by exchange-listed companies to comply with federal securities regulations and accounting principles for certified financial statements. The compulsion of the federal securities laws and auditing requirements assure that they will be carefully prepared, in their present form, even though not protected, noted the court, and IRS access serves the legitimate and important function of detecting and disallowing abusive tax shelters.

The Supreme Court has not squarely ruled on the issue. The Fifth Circuit, the only other federal circuit to rule, denied protection for the work papers because the court recognized that the company in question was conducting the relevant analysis because of a need to bring its financial books into conformity with generally accepted auditing principles. The Fifth Circuit, which employs a primary purpose test, found that the work papers' sole function was to back up financial statements. Here, too, said the First Circuit, the only purpose of Textron's papers was to prepare financial statements.

5th Circuit Remains Hostile Terrain for Class Actions

In Fener v. Belo Corp., a 5th Circuit panel continued that circuit's narrow view of securities class action pleading. Initially, the court rejected claims that the Supreme Court's Stoneridge decision effectively overruled the 5th Circuit's 2007 decision in
Oscar Private Equity Investments v. Allegiance Telecom, Inc. In the 2007 case, the appeals panel, in an interlocutory appeal, vacated a class certification that was based on a presumption of reliance under the fraud on the market theory. According to the majority opinion in Oscar, "[e]ssentially, we require plaintiffs to establish loss causation in order to trigger the fraud-on-the-market presumption." The panel rejected the district court's conclusion that the class certification stage was not the proper time for the defendants to rebut the lead plaintiffs' fraud on the market presumption.

In effect, the 5th Circuit in Oscar reversed the burden of proof involved with the fraud on the market presumption. Rather than requiring the defendant to rebut the presumption, plaintiffs were required to prove by a preponderance of the evidence the existence of a sufficient and specific causal link. The panel in Fener found nothing in Stoneridge that invalidated its Oscar holding, noting that "when the Supreme Court discusses a general legal standard and cites its earlier caselaw on point, it does not necessarily overrule intervening decisions of the lower courts."

The case involved alleged misstatements by the officers of the publisher of the Dallas Morning News concerning the paper's circulation numbers. The company issued a press release stating that an internal investigation had revealed irregularities in the circulation numbers. The press release also stated that the circulation declines were “coupled with” losses previously announced and with circulation declines anticipated due to overall industry weakness.

The 5th Circuit noted that when there are several negative statements absorbed by the markets that fraud plaintiffs must show at this initial state of the litigation that "it is more probable than not that it was this negative statement, and not other unrelated negative statements, that caused a significant amount of the decline." The court found that the plaintiffs' expert witness and other evidence did not establish a sufficient connection between the disclosure of the alleged fraud and the stock price drop.

9th Circuit Allows SOX Whistleblower Claim to Go Forward

A Sarbanes-Oxley whistleblower suit brought by two former in-house attorneys may proceed, ruled a unanimous 9th Circuit panel (Van Asdale v. International Game Technology). The case arose from the merger of companies that made gaming equipment and involved the alleged failure to disclose information concerning the viability of certain key patents. Circuit Judge Jay Bybee wrote that the fired lawyers need not prove that the company actually committed fraud to maintain their action. Judge Bybee stressed that "we wish to make absolutely clear that we are not suggesting" that there was actual wrongdoing. The plaintiffs only needed to show that they reasonably believed that there might have been fraud and were fired for suggesting further inquiry.

The panel disagreed with the lower court holding that no reasonable jury could find that one of the dismissed lawyers subjectively believed that shareholder fraud had occurred. The trial judge based this conclusion on her response of "no" to a deposition question concerning whether she had "reached a conclusion one way or another as to fraud." Judge Bybee reasoned that to require "an employee to essentially prove the existence of fraud before suggesting the need for an investigation would hardly be consistent with Congress’s goal of encouraging disclosure."

The court also rejected the employer's state law arguments. Illinois law did not preclude former in-house counsel from bringing this federal action, and the trial judge could effectively manage the litigation to avoid any conflicts with conversations protected by the attorney-client privilege.


Thursday, August 13, 2009

Hedge Fund Industry Seeks IRS Guidance on FBAR's Application to Private Funds

The hedge fund industry has asked the Internal Revenue Service for official guidance on the application of the duty to file the Report of Foreign Bank and Financial Accounts (FBAR) for investments in hedge funds and other private investment funds. The industry has been seeking such guidance since 2006, but events in the weeks immediately prior to the most recent June 30 deadline for filing FBAR forms make it manifestly evident that prompt action by the IRS is necessary. In a letter to the IRS, the Managed Funds Association also requested a one-year moratorium on FBAR filings not related to a traditional financial account.

Earlier, the MFA asked for guidance concerning whether a hedge fund organized outside of the United States constituted a “financial account” for purposes of FBAR and, if such a fund was treated as a “financial account”, how the IRS should resolve a variety of collateral issues arising under FBAR. The MFA said that there is widespread confusion concerning these basic questions and urged the IRS to issue an announcement clarifying that, until the IRS issues further guidance, it should not treat a hedge fund organized outside of the United States as a “financial account” for purposes of FBAR compliance.

Since there was no such official guidance in advance of the June 30, 2009 filing deadline, noted the MFA, fund managers were forced to make filing decisions based on unofficial statements delivered by IRS personnel at an industry forum and through a series of press reports. According to the MFA, the absence of official statements from senior Treasury or IRS officials or official guidance has caused great consternation and confusion among practitioners and other affected parties in light of the significant penalties for non-compliance.

Senior IRS officials have advised the MFA that no official guidance would be
forthcoming until the IRS has had an opportunity to fully examine all of the issues and determine an appropriate process to provide guidance. In lieu of the requested official guidance, the IRS announced an extension to September 23, 2009 for filings by persons who had only recently learned that they may have an FBAR filing requirement, where certain conditions were satisfied. However, ISDA noted that, in the absence of prompt official guidance, persons who took advantage of the extension will have no better information than those who made timely June 30, 2009 filings.

North Dakota Updates Form D Rule 506 Policy

*The updated parts are underlined:

Issuers intending to make an offering under Rule 506 of federal Regulation D must file Temporary Form D (including the state appendix), a Form U-2, Uniform Consent to Service of Process, and fee within 15 days after the first sale of the securities in North Dakota. A late fee is required if the filing is not made within the 15-day period. An original signature is not required for Parts D and E of Form D. A copy of Form D is permitted. Neither a Form U-2 nor the appendix is required if filing the newly adopted Form D. Make a check payable to the NORTH DAKOTA SECURITIES DEPARTMENT.

Renewal, commission and amendment . There is no renewal provision. The documents and fee for the original filing must be resubmitted if the offering extends beyond the one year period, except for the Form U-2 that may be incorporated by reference. No commission or remuneration may be paid for soliciting any prospective buyer in North Dakota except for a commission paid to a North Dakota-registered broker-dealer or agent. An amendment must be filed to reflect an issuer's name change if the change occurs while the filing is in active status.

See bottom of this webpage.


Wednesday, August 12, 2009

FSA Adopts Remuneration Code for Financial Institutions

The UK Financial Services Authority has adopted a remuneration code for financial institutions, including broker dealers. The code takes effect on January 1, 2010; but by the end of October the firms must submit a remuneration policy statement providing the FSA with the information that it needs to verify that the firm’s remuneration policies and practices will be compliant with new code.

The FSA will be asking firms to explain in some detail how they are ensuring that their remuneration policies are consistent with effective risk management in their remuneration policy statements. The remuneration policy statement will have to be signed off by the remuneration committee. Non-compliant firms could face enforcement action or ultimately, be forced to hold additional capital should they pursue risky processes.

This is a principles-based code designed to ensure that remuneration policies and practices promote effective risk management.

There is now a consensus among regulators that inappropriate remuneration practices contributed to significant losses at major firms and therefore to the severity and duration of the current market turmoil. Cash bonuses paid out immediately without any deferral or claw back mechanism, and based on a formula that links bonuses to current year revenues rather than risk-adjusted profit, created strong incentives for managers to avoid conservative valuation policies and ignore concentration risks, thereby undermining effective risk management. In addition, market discipline has not been effective in limiting the adverse impact of poor remuneration practices on risk management, particularly at large systemically relevant institutions.

Firms must identify the incentives created by the firm’s remuneration policies and consider what risks might be created by resulting behavior and actions, including credit risks, market risks, and operational risks, and also whether these risks fall within the firm’s overall tolerance level. If the remuneration policies contribute to the firm exceeding its risk tolerance level, the policies must revised. The firm must also set up procedures and controls to ensure that the agreed remuneration policies are implemented in practice. Further, management information systems must be set up to ensure that there is effective monitoring of outcomes.

Another key element of effective risk management is the communication of the firm’s values and objectives to employees, and a high degree of transparency about what is required of them. Effective risk management would link honuses to individual objectives, including non-financial objectives, ahead of the period during which performance will be assessed.

Under the code, firms should not enter into contracts with individuals which provide guaranteed bonuses for more than one year. It is also expected that for senior employees two-thirds of bonuses will be spread over three years

The FSA plans to ask most firms to prepare an annual remuneration policy statement. However, if the FSA believes that a firm is not meeting the requirements set out in the Code, the agency may ask it to undertake a risk mitigation program and provide a remuneration policy statement on a more frequent cycle so that the FSA can monitor progress with the program. Generally, the statement should set forth the principles of the remuneration policy, and how it is applied to employees according to seniority, business line, and function. It should also discuss the intended impact on employee behavior and on the risk profile of the firm, as well as how remuneration policies are communicated to staff.

If a firm does not intend to comply with one or more of the principles, the remuneration statement should state what the firm intends to do in lieu of compliance and why this alternative course of action will promote effective risk management.

For its part, the remuneration committee should exercise independent judgment and be able to demonstrate that its decisions are consistent with a reasonable assessment of the firm’s financial situation. The committee must also have the skills and experience to reach an independent judgment on the suitability of the policy, including its implications for risk and risk management. The committee is also responsible for approving and periodically reviewing the remuneration policy and its effectiveness.

Emphasizing the need for international consistency in compensation reform, the FSA said that the new Code is aligned with the proposed compensation principles of the Financial Stability Board, which were endorsed by the G-20. For example, both the Code and the principles have the broad goal of aligning compensation with prudent risk taking and call for the establishment of a link between compensation and risk management. There is also alignment on the need for remuneration committees to be independent, to have risk expertise, and to monitor and review the compensation systems to ensure that they operate as intended. On the need for flexible bonus policies, the Board says that bonuses should diminish or disappear in the event of poor firm, divisional or business unit performance.

In early June, the US Treasury announced its intention to introduce reforms to compensation practices along the lines of the Financial Stability Board principles. The Federal Reserve Board is working on rules and/or guidance for the implementation of the reforms.


Tuesday, August 11, 2009

Obama Administration Unveils Legislation to Regulate Derivatives, Including Credit Default Swaps

The Administration has proposed detailed legislation regulating the OTC derivatives markets. As part of the first-time federal regulation, credit default swap markets and all other OTC derivative markets would be subject to comprehensive regulation in order to guard against activities in those markets posing excessive risk to the financial system and promote the transparency and efficiency of those markets. The legislation would also empower the SEC and CFTC to prevent market manipulation, fraud, insider trading, and other market abuses. In addition, it would block OTC derivatives from being marketed inappropriately to unsophisticated parties.

The Obama Administration proposes, for the first time, the federal regulation of credit default swaps as part of the regulation of OTC derivatives. Credit default swaps are contracts which insure a party to the contract against the risk that an entity may experience a loss of value as a result of an event specified in the contract, such as a default or credit downgrade. Naked credit default swaps are those swaps that are merely a wager on the viability of an institution or financial instrument without requiring the corresponding underlying risk from the failure of those institutions or instruments.

The comprehensive regulation would include the regulation of OTC derivative markets and all OTC derivative dealers and other market participants. To reduce risks to financial stability that arise from the web of bilateral connections among major financial institutions, the legislation would require standardized OTC derivatives to be centrally cleared by a derivatives clearing organization regulated by the CFTC or a securities clearing agency regulated by the SEC. To improve transparency and price discovery, standardized OTC derivatives would be required to be traded on a CFTC- or SEC-regulated exchange or a CFTC- or SEC-regulated alternative swap execution facility.

Through higher capital requirements and higher margin requirements for non-standardized derivatives, the legislation would encourage substantially greater use of standardized derivatives and thereby facilitate the substantial migration of OTC derivatives onto central clearinghouses and exchanges. Further, the legislation proposes a broad definition of a standardized OTC derivative that will be capable of evolving with the markets.

The measure creates a presumption that an OTC derivative that is accepted for clearing by any regulated central clearinghouse is standardized. The CFTC and SEC would be authorized to prevent attempts by market participants to use spurious customization to avoid central clearing and exchange trading.

Transparency is a hallmark of the legislation. To that end, all relevant federal financial regulators would have access on a confidential basis to the OTC derivative transactions and related open positions of individual market participants. In addition, the public would have access to aggregated data on open positions and trading volumes.

The legislation would require, for the first time, the federal supervision and regulation of any firm that deals in OTC derivatives and any other firm that takes large positions in OTC derivatives. Under the legislation, OTC derivative dealers and major market participants that are banks will be regulated by the federal banking agencies, while OTC derivative dealers and major market participants that are not banks will be regulated by the CFTC or SEC.

The federal banking agencies, CFTC, and SEC would be required to provide comprehensive prudential regulation, including strict capital and margin requirements, for all OTC derivative dealers and major market participants. The legislation authorizes the CFTC and SEC to deter market manipulation, fraud, insider trading, and other abuses in the OTC derivative markets.

The CFTC and SEC would be able to set position limits and large trader reporting requirements for OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets. The full regulatory transparency that the legislation would bring to the OTC derivative markets will assist regulators in detecting and deterring manipulation, fraud, insider trading, and other abuses. The CFTC and SEC would be required to issue and enforce strong business conduct, reporting, and recordkeeping (including audit trail) rules for all OTC derivative dealers and major market participants.

The financial crisis revealed that massive risks in derivatives markets went undetected by both regulators and market participants. In 2000, the Commodity Futures Modernization Act (CFMA) explicitly exempted OTC derivatives, to a large extent, from regulation by the CFTC. Similarly, the CFMA limited the SEC's authority to regulate certain types of OTC derivatives. As a result, the market for OTC derivatives has largely gone unregulated.

This lack of regulation led to disastrous consequences. Many institutions and investors had substantial positions in credit default swaps, swaps tied to asset backed securities, complex instruments whose risk characteristics proved to be poorly understood even by the most sophisticated of market participants. At the same time, excessive risk taking and poor counterparty credit risk management by many banks saddled the financial system with an enormous unrecognized level of risk.

When the value of the asset-backed securities collapsed, the danger became clear. Individual institutions believed that these derivatives would protect their investments and provide return, even if the market went down. But, during the crisis, the sheer volume of these contracts overwhelmed some firms that had promised to provide payment on the swaps and left institutions with losses that they believed they had been protected against. Lacking authority to regulate the OTC derivatives market, regulators were unable to identify or mitigate the enormous systemic threat that had developed.
Financial Crisis Advisory Group Urges Convergence and Voices Concern over Pressure to Make Rapid Changes in Accounting Standards

A joint FASB-IASB expert group has urged the standard setters to develop a single set of high quality, globally converged financial reporting standards providing consistent information, regardless of the geographical location of the reporting entity. In a seminal report, the Financial Crisis Advisory Group simultaneously encouraged all national governments that have not already done so to set a firm timetable for adopting or converging with IFRS. The expert group also said that it is critical that the accounting standard setters themselves enjoy a high degree of independence from undue commercial and political pressures, and employ appropriate due process, including wide engagement with stakeholders. In particular, to protect its independence from undue influence, the IASB must have a permanent funding structure that can generate sufficient funds on an equitable and mandatory basis.

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

The report strongly emphasized that the Boards must make substantial progress on converged and improved standards on consolidation and derecognition and the other areas within their Memorandum of Understanding. In the meantime, FASB’s new off-balance sheet standards should be implemented without revision or delay. In the consolidation/derecognition projects, improvements should be made with an eye toward a more transparent depiction of the risks involved, especially with complex financial instruments.

Although accounting standards were not a root cause of the financial crisis, noted FCAG, the crisis exposed weaknesses in accounting standards that reduced the credibility of financial reporting. The weaknesses primarily involved the difficulty of applying fair value accounting in illiquid markets, the delayed recognition of losses associated with structured financial products, off-balance sheet financing structures, and the extraordinary complexity of accounting standards for financial instruments.

The FCAG has become increasingly concerned about the excessive pressure placed on the two Boards to make rapid, piecemeal, and uncoordinated changes to standards, particularly fair value standards, outside of their normal due process procedures. While it is appropriate for public authorities to voice their concerns and give input to standard setters, said the FCAG, in doing so they should not seek to prescribe specific standard setting outcomes. Such restraint is important in maintaining public confidence in the independence of the standard setting process, said FCAG, and, thus in financial reporting and the financial system as a whole.

As a specific example of its concern, the FCAG noted that in October 2008 the IASB’s oversight body, under EU pressure, allowed the Board to waive its due process procedures to amend IAS 39 to exclude with limited retroactive effect certain financial instruments from asset classifications subject to fair value accounting. Similarly, in April 2009, under pressure that Congress would change accounting standards by legislation, the FASB accelerated its normal due process before issuing guidance in several fair value areas.

The expert group believes that the truncating of due process, whether in fact or appearance, undermines public confidence in the integrity of the standard setting process and therefore hinders broad acceptance of the standards themselves. Also, threats of potential carve-outs might eventually lead to a renewed fragmentation of the standard setting process and reverse the momentum toward convergence.

At the same time, FCAG understands that at a time of acute crisis an expedited due process may be needed for a timely response by the standard setters. For this reason, FCAG urged the Boards to define in advance the circumstances under which it is appropriate to act on the basis of expedited due process; and also define the contours of such expedited due process in a way that ensures maximum consultation practicable under the circumstances.