Wednesday, September 30, 2009

NYSE Proposes Significant Changes to Its Corporate Governance Listing Standards

In a filing with the SEC, the NYSE has proposed significant changes to its corporate governance listing standards, in part to conform the standards to the requirements of Item 407 of Regulation S-K, which consolidates director independence and related corporate governance disclosure requirements under a single item. Essentially, the NYSE would eliminate each disclosure requirement currently included in the listing standards that is also required by Item 407 and incorporate directly into the standards the applicable disclosure requirement of Item 407. Upon SEC approval, the changes would take effect on January 1, 2010. Release No. 34-60653.

The NYSE also proposes to move the audit, compensation and nominating committee charter, corporate governance guidelines and code of business conduct and ethics website posting requirements to a new Website Posting Requirement section in the listing standards manual. The NYSE would change the disclosure regarding website postings to just require a listed company to disclose in its annual proxy statement or Form 10-K that the applicable charters, corporate governance guidelines and code of business conduct and ethics are available on the company’s website, and provide the website address.

This is designed to conform the Exchange’s disclosure requirements with respect to committee charters to the disclosure required by Instruction 2 to Item 407. At the same time, the NYSE would eliminate the requirement that the company disclose that hard copies of the charters, guidelines and code are available in print upon request. The exchange believes that it is unnecessary to require companies to provide physical copies of these documents upon request when they are readily accessible on the company’s website.

Under current NYSE rules, companies listing in conjunction with an IPO can phase in their independent audit, nominating and compensation committees, but are required to have one independent director on each committee as of the date of listing. Market practice, however, is that a company does not normally appoint independent directors to its board in advance of the date it lists on the NYSE. In light of this, the NYSE would require companies listing in conjunction with an IPO, spin-off or carve-out to be in compliance with the applicable provisions of the SEC’s audit committee requirements set forth in Rule 10A-3 as of the listing date, defined as the date the company’s securities first trade on the exchange.

The exchange also would require that a company listing in conjunction with its IPO, spin-off or carve-out have a majority of independent members on its audit committee within 90 days of the effective date of its registration statement; and a fully independent committee within one year of the effective date of its registration statement.

Similarly, the NYSE would require companies listing in conjunction with an IPO to have at least one independent member on its nominating and compensation committees by the earlier of the date the IPO closes or five business days from the listing date, at least a majority of independent members on each committee within 90 days, and fully independent committees within one year.

The current standards require that, if an audit committee member simultaneously serves on the audit committees of more than three public companies, and the listed company does not limit the number of audit committees on which its audit committee members serve to three or less, then in each case the board must determine that such simultaneous service would not impair the ability of the member to effectively serve on the audit committee and disclose such determination. The current language has led to confusion that disclosure is only required to the extent that the listed company does not limit the number of audit committees on which its audit committee members serve to three or less. The NYSE would clarify that the mandated disclosure is required to the extent that an audit committee member simultaneously serves on the audit committees of more than three public companies.

Currently, companies must disclose any waiver of the code of business conduct and ethics granted to executive officers and directors. The NYSE proposes to require that the waiver be disclosed to shareholders within four business days by distributing a press release, providing website disclosure, or by filing a current report on Form 8-K with the SEC. The new four-day period would be uniform with the requirements of Item 5.05 of Form 8-K regarding disclosure of waivers from codes of ethics.

Companies are currently required to disclose that they filed the CEO certification required by the NYSE and any certifications required by the SEC in the following year’s annual report. This requirement has caused significant confusion due to the fact that it relates to filings that were made in the previous year. Thus, the NYSE proposes to eliminate this disclosure requirement in light of amendments to the exhibit requirements of Form 10-K to require that the SEC certification be included as an exhibit to the company’s annual report.

In addition, investors now have timely notification of all material non-compliance with the NYSE’s listing standards due to the SEC’s amended requirements relating to Form 8-K. Item 3.01 of Form 8-K requires the filing of an 8-K disclosing any noncompliance with NYSE rules and any action or response that, at the time of filing, the company has determined to take regarding its noncompliance.


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Oral Argument Set for Supreme Court Case Challenging PCAOB's Constitutionality

The US Supreme Court has set December 7, 2009 as the date for oral argument in the action challenging the constitutionality of the PCAOB. At the same time, the Court extended to October 13, 2009 the deadline for the government’s merits brief in the action.

An audit firm contends that, in creating the Board, the Sarbanes-Oxley Act violated two basic tents of the Constitution: separation of powers and the Appointments Clause. 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. (Free Enterprise Fund and Beckstead & Watts v. PCAOB, Dkt. No. 08-861).

By vesting the power to appoint, remove and review the work of Board members in the SEC, argued the firm, the Act completely and impermissibly burdened the President’s power to control or supervise executive officials. The audit firm contends that, under the Appointments Clause, Board members exercising widespread governmental power are principal officers of the US who must be appointed by the President with the advice and consent of the Senate. Rejecting this claim, the appeals panel concluded that Board members are inferior officers of the United States within the meaning of the Appointments Clause; and thus properly appointed by the SEC.


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IMF Praises Obama Administration Proposal to Restart US Securitization Markets

Restarting the US private securitization markets is critical to limiting the fallout from the credit crisis, says the IMF in a report on financial stability. But, in restarting securitization, regulation must strike the right balance between allowing financial intermediaries to benefit from securitization and protecting the financial system from the instability that may arise if the origination and monitoring of securitized assets is not based on sound principles. At the end of the day, the value of securitized products relies on the quality of the underlying assets.

The IMF’s vision is a restarted securitization market that reliably permits lenders to redistribute risk to others without the undue use of leverage and complexity. The new securitization will require improving accounting, disclosure, and transparency rules all along the intermediation chain, and reducing investors’ blind reliance on credit rating agencies. In addition, securitizer compensation should be better linked to the longer-term performance of the securitized assets. Securitization products should be simplified and standardized to the extent possible to improve liquidity and reduce valuation challenges.

Securitization is a process that involves repackaging portfolios of cash-flow-producing financial instruments, such as mortgages, into securities for transfer to third parties. Structured finance techniques entail dividing the cash flows into tranches or slices. Tranche holders are paid in a specific order, starting with the senior tranches (least risky) working down to the most risky equity slice.

Securitization product issuers were poorly incentivized to conduct the appropriate due diligence on loan originators, including the review of financial statements and underwriting guidelines. In an effort to incentivize stronger issuer due diligence, the Obama Administration is proposing to amend securitization-related regulations to incentivize issuers to retain an economic interest in the securities-backed products they issue, the so called skin in the game.

The Administration’s legislative proposal contains several risk retention options, including retaining the equity tranche and equal amounts of all tranches. Regulations would require loan originators or sponsors to retain five percent of the credit risk of securitized exposures. The regulations would prohibit the originator from directly or indirectly hedging or otherwise transferring the risk it is required to retain. This is critical to prevent gaming of the system to undermine the economic tie between the originator and the issued asset-backed securities.

Anticipating the Administration’s proposals, the House has passed legislation that would begin the reform of the securitization process by introducing extensive new requirements for residential mortgage products and lending practices. The Mortgage Reform and Anti-Predatory Lending Act of 2009, HR
1728, would encourage a return to sound underwriting practices by prohibiting mortgage lenders from relinquishing all responsibility for the bad loans they make and sell to Wall Street.

Under the measure, lenders will now be required to keep skin in the game and retain a 5 percent stake in any home loan they make and sell. The House action mirrors the European Union, which amended the Capital Requirements Directive, which sets out the rules for Basel II implementation in Europe, to provide incentives for securitizers to retain at least 5 percent of the nominal value of originations.

The House legislation would also push assignee liability that ensures that some entity in the securitization chain remains legally liable for securitized loans that do not meet certain ability-to-pay and “net tangible benefit” standards. While supporting the House legislation, the IMF said it is important that the legal liability be quantifiable at origination and capped at some reasonable level. Otherwise, loan origination would be curtailed, due to a withdrawal of mortgage-backed security market financing for loans that carry assignee liability.

The IMF generally applauded the Obama Administration’s legislative proposal to force securitizers to retain some of their credit risk exposures so that they have more skin in the game to better align their interests with investors.

However, the IMF is concerned that the these proposals may be so blunt that they will either be ineffective at providing incentives for better securitizer behavior, or alternatively, may slow the market recovery.

More broadly, the IMF said that regulations mandating skin in the game retention requirements should not be imposed uniformly, but instead tailored to the type of securitization and underlying assets to ensure that those forms of securitization that already benefit from skin in the game and operate well are not weakened. Also, the effects induced by interaction with other regulations will require careful consideration.


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Tuesday, September 29, 2009

Securities Industry Concerned About Consumer Financial Protection Draft, Supports Draft Creating Federal Fiduciary Standard for Brokers and Advisers

The securities industry fears that draft legislation creating a Consumer Financial Protection Agency with broad new powers could inadvertently encroach on the jurisdiction of the SEC and CFTC. In testimony before the House Small Business Committee, SIFMA also said it favors draft legislation creating a new uniform federal fiduciary standard for brokers and advisers. However, SIFMA opposes the piece of the draft authorizing the SEC to prohibit pre-dispute arbitration clauses in broker-dealer and investment advisory agreements with retail customers.

While Treasury officials have reiterated that the Consumer Financial Protection Act is not intended to supersede the broad investor protection mandate of the SEC and CFTC, SIFMA believes that the Act’s broad jurisdictional grant to the new agency could potentially overlap with SEC and CFTC jurisdiction. SIFMA urged Congress to provide a full exclusion for investment products and services regulated by the SEC or the CFTC. As currently drafted, the legislation excludes only a narrow list of activities of some of the persons regulated by the SEC, such as broker-dealers and investment advisers.

Arguably, continued SIFMA, the SEC’s authority over transparency and disclosure, including its exclusive ability to mandate issuer disclosure in proxy statements and annual reports, also would be called into question. To avoid overlapping jurisdiction, said SIFMA, Congress should exclude from the jurisdiction of the CFPA any securities activity and any person, product or other activity that is regulated by the SEC or the CFTC.

SIFMA applauded Congress for recognizing that, when broker-dealers and investment advisers engage in the identical service of providing personalized investment advice about securities to individual investors, they should be held to the same standard of care. Conversely, when broker-dealers are not providing personalized securities investment advice to individual investors, such as when they are executing orders for customers, or engaging in market-making, there is no cause for modifying the existing, extensive regulatory regime that governs broker-dealers. The proposed Investor Protection Act acknowledges these important
distinctions, noted SIFMA, and would authorize the SEC to adopt rules creating a new, uniform, federal standard.

Individual investors deserve, and SIFMA strongly supports, a new federal fiduciary standard of care that supersedes the existing fiduciary standards, which have been unevenly developed and applied over the years, and which are susceptible to multiple and differing definitions and interpretations under existing federal and state law. The legislation must ensure that the new standard functions as a unitary and exclusive standard that is uniformly and even-handedly applied at the federal level to both investment advisers and broker-dealers when they provide personalized investment advice about securities to individual investors. Congress successfully followed a similar approach when it restructured federal-state securities regulation through the National Securities Markets Improvement Act of 1996.

The new federal standard must be sufficiently flexible to be adapted to the products, services and advice chosen by the investor, emphasized SIFMA, and applied only in the context of providing personalized investment advice about securities to individual investors.

In SIFMA’s view, the legislation must make clear that subjecting a financial professional to the new federal standard does not create any presumption that the financial professional is providing investment advice or is a fiduciary for purposes of any other federal or state laws. This clarification will enable broker-dealers to continue to provide investors choice of investment products, particularly in IRAs.

Congress favors, and the Supreme Court has expressly approved, the use of pre-dispute arbitration clauses in broker agreements. Further, a SIFMA study found that securities arbitration is faster and less expensive than litigation and benefits small investors. In SIFMA’s view, prohibiting such clauses would essentially be tantamount to doing away with securities arbitration. SIFMA suggested further study on this issue.


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SEC Amicus Says Attribution of False or Misleading Statement Not Sole Way of ``Making'' Statement under Central Bank Paradigm

In an amicus brief filed in the Second Circuit Court of Appeals, the SEC said that attribution of a false or misleading statement to a person is only one means by which that person can create the statement and thus be a primary violator under the Central Bank rubric. A person who, acting with the requisite scienter, creates a misstatement is a primary violator regardless of whether the victim knows the person’s identity. Thus, the SEC disagreed with the district court’s holding that, in order for a person to be a primary violator with respect to a publicly disseminated false or misleading statement, the person must have been identified to potential investors as the maker of the statement or, in other words, the statement must have been attributed to the person at the time it was made. Pacific Management Company LLC v. Mayer Brown LLP, CA-2, on appeal from SD NY, 09-1619-cv.

This is a Rule 10b-5 private damages action. While the SEC, unlike a private party, has express statutory authority to bring aiding and abetting claims, there are instances where the Commission might need to assert a claim for primary liability. The SEC is concerned that the district court appeared to recognize language in the Second Circuit’s 2008 ruling in US v. Finnerty suggesting in dictum that attribution is required even in a government law enforcement action.

In Central Bank v. First Interstate Bank, the Supreme Court drew a distinction between persons who aid and abet securities fraud violations and primary violators of Rule 10b-5, ruling that private parties cannot bring actions against aiders and abettors, only against primary violators. The Court said that secondary actors, such as lawyers and accountants, could be primary violators if they made a false or misleading statement.

In the SEC’s view, a person makes a false and misleading statement and can thus be liable as a primary violator of Rule 10b-5 when he or she creates the statement. In this context, a person creates the statement if they write or speak the statement or if they provide the false or misleading information that another person puts into the statement or if they allow the statement to be attributed to them. For example, a person who actually drafted an offering document containing false or misleading statements can be a primary violator, as can a person who supplied the writer with the false or misleading information in the document, as can a person who signed the offering document or otherwise acknowledged to investors that the statements were his or her own.

The SEC argued that its position is consistent with the Court’s Central Bank ruling. The Court did two things in Central Bank, said the SEC, first the Court held that there is no private right of action for aiding and abetting under Rule 10-5 but only for primary violations and, secondly, it stated that a plaintiff would have a private cause of action against a secondary actor for primarily violating Rule 10b-5 when the secondary actor was a primary violator, that is, had, among other things, made a false or misleading statement. According to amicus, the Court thus excluded liability when a person’s responsibility for a false or misleading statement did not rise to the level of a primary violation and made clear that if a person’s liability did rise to that level, then the person would be liable even though he or she might not have been the principal actor in the alleged fraudulent activity.

The word "make," as used in Central Bank, noted the SEC, does not give rise to a requirement that only a person who has been identified to investors can be deemed to have made a statement. A person can "make" a false or misleading statement anonymously or indirectly through someone else.

A test imposing primary liability when a person creates a false or misleading statement reflects both of the Central Bank concerns, said the SEC. Such a person is, with regard to the statement, not just an aider and abettor, he or she is responsible for the statement coming into being. As such, the person should be held primarily liable. And, continued amicus, a person creating a false or misleading statement would be primarily liable without regard to whether he or she acted alone or with others. They would also be primarily liable regardless of whether they initiated the false or misleading statement.

The SEC also contended that an attribution requirement would shield significant misconduct from liability by allowing a person who created a false or misleading statement to escape primary liability by acting anonymously or in another’s name. Thus, the SEC reasoned that an attribution requirement could provide a defense for the person having the greatest culpability for a deception.


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Monday, September 28, 2009

Senior Senate Democrat Sponsors Legislation Regulating OTC Derivatives

Draft legislation establishing a comprehensive regulatory framework for derivatives has been introduced by Jack Reed, Chair of the Senate Securities Subcommittee. The Comprehensive Derivatives Regulation Act, S. 1691, would require standardized credit default swaps and other unregulated derivatives to be cleared through a clearinghouse in order to protect the companies and the financial system from the risks posed by these instruments. Importantly, the draft would also authorize regulators to oversee any new derivative product in the future, so dealers can no longer create products that fall into holes in the law. Moreover, S. 1691 would set up strong capital and margin requirements for derivatives dealers and other major market participants and subject them to higher standards for products that are not traded on clearinghouses.

The draft repeals provisions of the Gramm-Leach-Bliley Act and the federal securities laws added to the US Code by the Commodity Futures Modernization Act of 2000. These provisions said that security-based swap agreements are not securities and prohibited the SEC from regulating them as such.

The draft legislation embodies a congressional finding that customized derivative products provide key benefits to some market participants and should be permitted under comprehensive regulation; but that all derivatives activities should be accompanied by appropriate risk management and prudential standards. The legislation seeks to rectify the situation under which OTC derivatives market have grown rapidly while regulators have lacked key information and adequate authority to address systemic and other risks posed by unregulated derivatives trading.

Parties to a standardized security-based swap or security derivative must submit the instrument for clearing to a registered clearing agency. The draft directs the SEC to adopt a rule defining the term ``standardized.’’ The draft mandates the factors the SEC must consider in defining what a standardized derivative is. For example, the SEC must define standardized consistent with the public interest, the protection of investors, the safeguarding of securities and funds, and the maintenance of fair competition among market participants and clearing agencies.

The SEC must also consult with the CFTC and the Fed in defining standardized and maintain comparability, to the maximum extent practicable, with the definition of the CFTC of the term standardized for purposes of section 4r of the Commodity Exchange Act. The SEC must further consider is a clearing agency prepared to clear the security-based swap or security derivative, has effective risk management systems in place.

The Reed draft would subject firms to new conduct requirements to protect investors from abusive practices in the market. It also includes new recordkeeping and reporting requirements to ensure that regulators and investors have broad information about derivatives transactions and positions throughout the financial sector.

In an effort to curtail fraud and manipulation in derivatives markets, the draft would authorize regulators to set position limits and oversee the marketing of products to certain investors. The bill strengthens thresholds in place to ensure that only sophisticated investors are engaging in certain types of trading.

Specifically, the draft bill provides the SEC with jurisdiction over all derivatives that are securities or can be used as synthetic substitutes for securities. This was done, explained Sen. Reed, because without such authority over products that can affect securities markets, the SEC cannot accomplish its mission to protect investors and ensure the integrity and fairness of markets. The draft gives the CFTC jurisdiction over all other derivatives.

The draft would require significant security-based derivatives market participants to register with the SEC and be subject to SEC regulation. The legislation defines a significant security-based derivatives market participants as any person, other than a registered investment company, that is engaged in the business of purchasing or selling security-based swaps or security derivatives for their own account or for others, or making a market in security-based swaps or security derivatives.

As part of rationalizing the sharing of jurisdiction between the SEC and CFTC, the legislation would establish a process for quickly assigning responsibility for new products to the SEC or CFTC so they new instruments do not fall through the cracks. The measure also creates an efficient process for the US Court of Appeals for the District of Columbia Circuit to resolve any differences in views between the agencies that might arise.

The legislation mandates that the SEC and CFTC to jointly issue rules establishing a 90-day process for resolving any disagreement regarding the status of a derivative as security-based. In the determination process, the SEC and CFTC must consider the nature of the derivative, the extent to which the derivative is economically similar to instruments that are subject to regulation by the agencies, and the appropriateness of regulation of the derivative under either the securities laws or the Commodity Exchange Act.

If the SEC and CFTC are unable to agree on the status of a derivative as security-based or commodity-based, either agency may petition the US Court of Appeals for the District of Columbia Circuit for a determination of the status of the derivative under a system of expedited review giving the appeals court 60-days to reach a determination. In making such determination, the legislation specifically instructs the court not to give deference to the views of either the SEC or the CFTC. The draft further mandates that any certiorari petition for Supreme Court review of the appeals court determination of the derivative products jurisdictional status must be filed as soon as practicable after such determination is made.


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EU Central Banker Details Key Elements for Successful Systemic Risk Regulation

With the US moving towards the creation of a systemic risk regulator, be it the Fed or a Council of Regulators, and the EU creating a Systemic Risk Board, a member of the executive board of the European Central Bank detailed the elements of successful systemic risk regulation. In remarks at the European Banking Center, Lorenzo Bini Smaghi said that the four components of a successful systemic risk regulator are: 1) creating a clear legislative framework to underpin the Board’s work; 2) preparing risk assessments and potential risk warnings based on pervasive analysis; 3) backing up risk warnings with granular information about hedge funds and other non-regulated entities; 4) translating risk warnings and related policy recommendations made by the systemic risk regulator into concrete action by regulators.

He analogized the European Systemic Risk Board to a doctor who examines a patient, makes a diagnosis and recommends medicine. It is up to the patient to abide by the doctor’s recommendation. The doctor is not in a position to take direct action. The treatment will only be as good as the patient’s willingness to take the medicine prescribed.

The senior official also outlined a workable definition of systemic risk as the risk that an event will trigger a loss of economic value or confidence in a substantial portion of the financial system that is serious enough to have significant adverse effects on the real economy. See 2001 G-10 Report on Consolidation in the Financial Sector.

Risk detection conducted by the Board involves monitoring risk to identify sources of risks from within the financial system, stemming from financial institutions, or market infrastructure. Risk monitoring involves processing large and often disparate amounts of information. In addition, continuous market intelligence efforts are essential for effective risk monitoring and the early detection of new financial instruments, practices or business strategies which could create risks in financial markets.

In the case of the Systemic Risk Board, market intelligence will be complemented by institutional and policy intelligence available to central banks and regulators represented on the Board. The official said that risk monitoring should be facilitated by tools, including contemporaneous financial stability indicators and forward-looking early warning indicators and models. These tools need to be regularly updated in order to capture innovation in financial markets, fueled by new products and new business models.

He noted that macro-prudential indicators comprise a vast set of indicators, including asset valuations, risk appetite, market liquidity, funding liquidity, and credit risk. Some of these indicators may contain information relevant to early warnings as they may draw attention to rapidly increasing exposures to specific asset classes and broad-based increases in financial leverage.

Risk assessment relates to the evaluation of the relevance and potential severity of each risk identified as material in the surveillance phase. It should therefore include a quantitative evaluation of the likelihood that the potential risk scenarios will materialize. It should also include cost estimates in terms of the failure of institutions, costs deriving from the malfunctioning of financial markets or impairment of the real economy.

The product of these factors forms the basis for the ranking of risks, he said. Quantitative methods and analytical tools such as stress testing models should support, together with expert judgment, the prioritizing or ranking of risks.

Stress testing models have become the workhorse of macro-prudential stability analysis in the last decade, he observed, including quantitative impact studies for specific scenarios. Their main purpose is to assess the resilience of the financial systems against extreme but still plausible events.

The risk assessment task is currently much less developed than the risk detection one. This is not only because it involves considerable analytical sophistication, he said, but also because there are significant gaps in the information on hedge funds and other financial intermediaries and their linkages with other parts of the financial system.

In his view, systemic risk analysis needs to be supported by a suite of state-of-the-art analytical models and tools, and a conceptual framework for using them. The complex and intertwined financial linkages call for a constant cross-checking of several indicators or measures. In addition, the pace of innovation requires that the set of tools for systemic risk detection and assessment be constantly revised.

While the risk assessment exercise should become increasingly quantitative, he said, it must never become mechanistic or fully model-based. Expert judgment and qualitative assessments will always be crucial to understand the messages coming from various analytical tools.

A comprehensive information base is also key in the risk detection phase that precedes the actual risk assessment. This is because the establishment of a wide radar screen supporting rigorous monitoring is only possible if the critical information is available.

The current crisis demonstrated that a significant part of credit intermediation was channeled outside the regulated financial sector and off the radar screen into hedge funds and other entities comprising the non-regulated shadow banking system. Moreover, little was known about the exposures between this shadow system and the regulated one, which turned out to be substantial.

Information on non-banking institutions, potentially of systemic importance, such as hedge funds, was scattered, not quality-checked and provided on a voluntary basis. A tendency to create a bias towards the best performers was the result.

In addition to risk detection and assessment, the systemic risk regulator will also issue risk warnings and policy recommendations. This is new, said the central banker, and will differ substantially from other types of analysis. The Systemic Risk Board must translate systemic risk assessments into proposals for concrete policy actions.


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Sunday, September 27, 2009

G-20 Calls for Broad Financial Regulatory Reform; Exec Comp Overhaul and Regulation of OTC Derivatives

In the final communiqué from their Pittsburgh summit, the G-20 leaders called for the sweeping reform of global financial regulation, including strengthening prudential oversight, improving risk management, enhancing transparency, promoting market integrity, establishing supervisory colleges, and reinforcing international cooperation. The G-20 endorsed tougher regulation of over-the-counter derivatives, securitization markets, credit rating agencies, and hedge funds. The G-20 also endorsed the institutional strengthening of the Financial Stability Board as it assumes its role of coordinating the international consistency of financial regulation. The G-20 said that the FSB’s ongoing efforts to monitor progress will be essential to the full and consistent implementation of needed reforms.

Noting that excessive compensation has encouraged excessive risk taking, the G-20 called for the reform of compensation policies as an essential part of increasing financial stability. They endorsed the FSB standards aimed at aligning compensation with long-term value creation, not excessive risk-taking, by avoiding multi-year guaranteed bonuses and by requiring a significant portion of variable compensation to be deferred, tied to performance and subject to appropriate clawback. Variable compensation could be in the form of stock or stock-like instruments, said the G-20, so long as equity compensation creates incentives aligned with long-term value creation and the time horizon of risk.

It is also important to assure that compensation for senior executives and other employees having a material impact on the firm’s risk exposure is aligned with performance and risk. This should be done by making firms’ compensation policies and structures transparent through disclosure requirements and limiting variable compensation as a percentage of total net revenues when it is inconsistent with the maintenance of a sound capital base. Corporate governance reforms are also critical, emphasized the G-20, especially the need to ensure the independent oversight of board compensation committees.

For their part, regulators should review compensation policies with institutional and systemic risk in mind and, if necessary in order to offset additional risks, apply corrective measures, such as higher capital requirements, to those firms that fail to implement sound compensation policies. Regulators should be authorized to modify compensation structures in the case of firms that fail or require extraordinary public intervention. The FSB is tasked with monitoring the implementation of compensation standards.

The G-20 supports legislation requiring all standardized OTC derivative to be traded on exchanges or electronic trading platforms and cleared through central counterparties. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements. Again, the FSB should assess implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.

Systemically important financial firms should develop internationally-consistent firm-specific contingency and resolution plans. There should be legislation creating a legal cross-border framework for crisis intervention as well as improving information sharing in times of stress; and developing a framework for the effective resolution of financial groups to help mitigate the disruption of financial institution failures and reduce moral hazard in the future. The FSB should propose measures, including more intensive supervision and specific additional capital, liquidity, and other prudential requirements.


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Friday, September 25, 2009

Frank Circulates Draft Legislation on Consumer Financial Protection

House Financial Services Chair Barney Frank is circulating draft legislation establishing a new independent federal consumer financial protection agency with power to prohibit unfair and deceptive practices in connection with a consumer financial transaction for a product or service and to mandate disclosure to consumers of the costs, benefits, and risks associated with any financial product or service. Broadly, the Director of the new agency would have a legislative mandate to promote transparency, simplicity, fairness, accountability, and equal access in the market for consumer financial products or services.

The Consumer Financial Protection Agency Act (HR 3126) would establish the independent Consumer Financial Protection Agency, with a Director appointed by the President and subject to Senate confirmation. The Act also creates a Consumer Financial Protection Oversight Board composed of federal financial regulators to advise the Director on overall strategy and the consistency of regulation. The intent of the new CFPA is to give consumer protection an independent seat at the table in the federal financial regulatory system. The Act also creates a Consumer Advisory Board to advise the Director and provide information on emerging practices in the consumer financial products or services industry.

The draft is in line with the Obama Administration’s call for a single regulatory agency with the authority and accountability to make sure that consumer protection regulations are written fairly and enforced vigorously. The CFPA should reduce gaps in federal supervision and enforcement; improve coordination with the states; set higher standards for financial intermediaries; and promote consistent regulation of similar products.

The Act covers persons engaged in a financial activity in connection with the provision of a consumer financial product or service and service providers to such persons. The legislation grants the CFPA consolidated authority over the closely related functions of writing rules, supervising and examining institutions’ compliance, and administratively enforcing violations.

The legislation orders the creation of an CFPA unit to analyze and report on market developments for consumer financial products or services, including market areas of alternative products or services with high growth rates and risk. This unit must also examine consumer awareness and understanding of disclosures and communications regarding consumer financial products or services. Even if disclosures are fully tested and all communications are properly balanced, product complexity itself can lead consumers to make costly errors. The Administration believes that a careful regulatory approach can tilt the scales in favor of simpler, less risky products while preserving choice and innovation.

The Director must also establish a central database for collecting and tracking information on consumer complaints about financial products or services and the resolution of those complaints. In performing these functions, the Director must coordinate with the federal financial regulators and share data relating to the complaints.

The legislation specifically orders the Director to coordinate with the SEC and CFTC to promote consistent regulatory treatment of, and enforcement related to, consumer and investment products, services, and laws.

The Act imposes extensive reporting duties on the Director. For example, the Director must submit a report to the President and the appropriate congressional oversight committees at the beginning of each regular session of Congress. The report must list the significant regulations and orders adopted by the Director, as well as other significant initiatives he or she conducted; and any plans for future regulations or initiatives. The report must also contain an analysis of complaints about consumer financial products or services that the Agency collected in its complaints database during the preceding year.

The Act does not alter or affect the authority of the SEC to adopt rules, initiate enforcement proceedings, or take any other action with respect to a person regulated by the Commission. Moreover, the Director has enforcement powers with respect to a person regulated by the SEC. But the draft directs the SEC to consult and coordinate with the Director regarding any rulemaking, including any advance notice of proposed rulemaking, with respect to 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 CFPA’s jurisdiction. There are similar limitations and coordination provisions in place for the CFTC.

In adopting disclosure regulations on the risks, costs, and benefits of financial products or services, the Director must take into account disclosure requirements under other laws in order to enhance consumer compliance and reduce regulatory burden. The draft allows the Agency, in its discretion, to provide model disclosures to facilitate compliance. If the CFPA does set out model disclosures, the legislation provides that any person complying with the model disclosures will per se be in compliance with the disclosure requirements.

The CFPA must also establish standards and procedures for approval of pilot disclosures to be provided to consumers in connection with the provision of a financial product or service.


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Global Audit Firms Oppose Requiring Engagement Partner to Sign Audit Report

Global audit firms believe that requiring an engagement partner to sign the audit report would not enhance either transparency or accountability; and may even damage the carefully constructed corporate governance structure that gives a key role to audit committees. In comments on the PCAOB’s concept release on engagement partners signing the public company audit report, the audit networks were not impressed by an EU requirement for engagement partner sign off, citing vast differences in the EU-US litigation environment. The comment period closed on September 11, 2009. The Board’s current standard requires the firm itself to be the signatory on the audit report.

In 2006, the European Union's Audit Directive required the signature of a natural person on company audit reports, compelling a public discussion in the US on partner sign-off. This issue has been discussed by the Board’s own Standing Advisory Group; and the Treasury’s Advisory Committee on the Auditing Profession has recommended that the PCAOB undertake a standard setting initiative mandating that the engagement partner sign the audit report.

While acknowledging that the EU Directive does require the engagement partner to sign the audit report, PricewaterhouseCoopers noted that the EU does not have the uniquely US litigation environment that allows shareholder class actions to be brought against auditors based on a drop in share price. Deloitte & Touche pointed out that liability reform is proceeding in Europe in respects not present in the United States. For example, last year the European Commission called for adoption of one of three approaches to limit the liability risks for auditors: by contract with the client, liability caps, or adoption of proportionate liability. Noting that the engagement partner signature initiative is still in the embryonic stage in the EU, Deloitte asked the PCAOB to wait until it can more thoroughly assess the impact on audit quality, if any, of the signature requirement in the EU.

In its comments, Grant Thornton said that requiring engagement partner sign off could disrupt the intricate corporate governance structure set up by Sarbanes-Oxley, with the audit committee in a key role. In the wake of a signature requirement, posited GT, shareholders may believe it is appropriate to contact the engagement partner directly to ask questions about the audit or the company’s financial statements. This would put both auditors and shareholders in a frustrating position, said GT, because the auditor cannot answer such questions due to confidentiality and other legal requirements.

Auditors are accountable to the shareholders through the audit committee and the board of directors. This governance structure allows decisions to be made by people with an appropriate level of understanding of the company. GT believes that shareholders, operating outside this governance structure, could add confusion, cost, and frustration
to a process that already contains mechanisms in place to hold auditors appropriately accountable.

Similarly on this theme, McGladrey & Pullen noted that the audit committee is responsible for engaging the audit firm. If the audit committee has concerns about the independence or competency of the engagement partner, they would address those concerns with the firm. If the committee was not satisfied with the firm’s response, they would likely consider engaging another audit firm. McGladrey emphasized that these types of decisions are appropriately left with the audit committee and not with the individual shareholders.

In its comment letter, Ernst & Young said that requiring the engagement partner to sign the audit report would not provide appreciable benefit in audit quality. On the issue of accountability, E&Y noted that sufficient mechanisms are already in place to heighten the engagement partner's sense of personal accountability to financial statement users. Indeed, E&Y believes that the engagement partner's signature would dilute if not
put at risk the benefits gained from the collective, firm signature. E&Y feels that the engagement partner's strong sense of personal accountability is already well in place and supported by a firm's system of quality control and PCAOB oversight.

Similarly, PwC said that the signature requirement is premised on the unsupported assumption that engagement partners, as a class, need to have an increased sense of accountability in order to achieve improved audit quality. An audit opinion reflects the cumulative effort of myriad individuals rather than the competence of the engagement partner alone. The current practice of signing the audit report in the firm’s name reflects the reality that the quality of an audit depends on the competence of many people at the firm, as well as the firm’s quality controls. In addition to the auditor’s sense of personal accountability, the SEC can enforce the securities laws against auditors, thus reinforcing that accountability.

The concept release indicates that the signature requirement would increase transparency about who is responsible for performing the audit, which could provide useful information to investors. E&Y is of the view that the benefits of transparency that might be afforded by requiring the engagement partner to sign the audit report are significantly overstated. The identity of the engagement partner is readily known to members of the board of directors and in particular to the audit committee that, on behalf of the shareholders, is vested with the responsibility of evaluating the audit firm, including the engagement partner, and proposing the firm for ratification by the shareholders. Given the limited nature of information that would be afforded by a signature requirement, E&Y believes that the public would be at risk of reaching unjust and inappropriate conclusions regarding the quality of work of an individual engagement partner.

Similarly, KPMG said that the identity of the engagement partner is fully transparent to company management and audit committee members, by way of the direct and frequent interactions that occur with both groups throughout the audit process. In addition, although there is no requirement to do so, the engagement partner usually attends the annual shareholders’ meeting, and typically is available to respond to appropriate questions. Therefore, shareholders attending the annual meeting have a chance to pose questions directly to the engagement partner.

Grant Thornton opined that the engagement partner signature requirement would actually reduce transparency in that it obfuscates how an audit is performed. To imply that an individual is solely responsible for performing the audit is misleading. Furthermore, this requirement may signal to the markets that there has been a fundamental shift in the responsibilities of the audit firm and the engagement partner, which is not the case

The engagement partner is responsible for oversight of the audit, noted GT, but often specialists and national office partners assume significant responsibilities related to some technical matters or complex areas. The confidence in the audit opinion is based on the quality of the firm’s policies and procedures, not just the abilities of the individual partner.

Deloitte wrote that the suggested beneficial effects on accountability and transparency are speculative. The notion that signing the audit report will increase partner accountability does not recognize that audit partners are already held fully accountable through a variety of mechanisms. Audit partners are subject to multiple layers of internal quality control mechanisms and multiple sources of external oversight, such as audit committees, federal and state regulators, and the threat of civil liability.

Moreover, under current PCAOB standards, registered firms are required to establish a system of quality control that provides the firm with reasonable assurance that the engagement partners have a professional responsibility to adhere to PCAOB professional standards. Their work is subject to review by the PCAOB through regular inspections and through PCAOB investigations and enforcement proceedings.

Importantly, the Sarbanes-Oxley Act requires audit committees to be directly responsible for the appointment, compensation, and oversight of the work of the independent auditor. As a result, the engagement partner is accountable to and reports to the audit committee. Further, on a regular basis the engagement partner meets with the audit committee and is required to provide certain communications at the completion of the audit. Throughout the audit process the engagement partner is evaluated by the audit committee.

Auditors, including engagement partners, are also subject to SEC oversight and enforcement. Determinations of improper professional conduct can lead to the suspension or bar of an engagement partner’s ability to practice before the Commission.

The PCAOB indicated that it does not intend for the signature requirement to increase the liability of engagement partners. But, according to Deloitte, the possibility of this increased exposure is real. The Second Circuit, where a large number of securities lawsuits are litigated, holds that a misstatement is actionable under Exchange Act antifraud provisions only if it is attributed to the specific actor alleged to have made it, which in the audit context would typically include the firm.

Thus, in some jurisdictions, depending on the circumstances of the case, engagement partners who do not sign audit reports, as opposed to the firms that sign the audit reports, may be able to argue that they are not subject to fraud claims because they are not the “specific actor” to which a disputed audit report was attributed. The signature requirement could make it more challenging to assert that argument successfully.

The possibility of requiring the disclosure of engagement partners’ names as an alternative to requiring their signatures, as suggested by the Board, would not cure the problem. According to Deloitte, there is no basis to conclude that this alternative would generate less risk of liability or less litigation. For example, the jurisdictions that hold that misstatements are actionable only if attributed to a specific actor do not address a distinction between attribution by signature or by other means. In any event, a disclosure rule would have all the same undesired consequences of making individual audit partners more visible targets in litigation.

BDO Seidman noted that the analogy to the certification of corporate financial statements by the CEO and CFO required by Sec. 302 of Sarbanes-Oxley is not a valid analogy to requiring engagement partner sign off. The purpose of the senior officer’s signature in a filing is to clarify management’s long-standing responsibility for the information included therein. In that regard, Sec. 302 was adopted because some management was attempting to disavow responsibility for the financial statements.

In contrast, reasoned BDO, the engagement partner’s responsibilities for the performance of the audit are set out extensively in professional standards. The effectiveness with which these professional standards have been implemented is routinely monitored as part of a firm’s system of quality control, in addition to periodic inspections by professional and regulatory bodies. There is no similar monitoring by regulators of management’s exercise of its duties.


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Thursday, September 24, 2009

Levitt, Volcker Stress Need for Resolution Authority for Large Financial Institutions; Basel Urges Cross-Border Framework

With the US contemplating legislation establishing the orderly resolution of cross-border financial institutions, and the issue of global coordination of national resolution regimes looming, former SEC Chair Arthur Levitt and former Fed Chair Paul Volcker told Congress that the creation of such a resolution authority is the key to eliminating the moral hazard of too big to fail. In testimony before the House Financial Services Committee, Mr. Levitt said that, in order to address the too big to fail challenge, Congress must provide a legislative process to manage the failure of systemically important financial institutions. The problem is not that financial institutions are too big, he reasoned, but that there is no uniform orderly process to let then fail without causing a market meltdown.

Similarly, Mr. Volcker
advocated a new resolution regime for insolvent or failing non-bank institutions, such as hedge funds, of potential systemic importance. He envisions the appointment of a federal conservator to take control of a financial institution defaulting, or in clear danger of defaulting, on its obligations. Authority should be provided to negotiate the exchange of debt for new stock if necessary to maintain the continuity of operations, to arrange a merger, or to arrange an orderly liquidation. In his view, such an authority, preempting established bankruptcy proceedings, would be justified only by the exceptional circumstance of a systemic breakdown.

The senior officials join the growing consensus, shared by the Obama Administration, that the lack of a federal resolution authority for large systemic non-bank financial institutions contributed to the financial crisis and, unless addressed with legislation, will constrain a federal response to future crises. As demonstrated by AIG, severe distress at global financial institutions can pose systemic risks to the financial markets. Former SEC Chair Levitt warned that allowing market participants to assume that large financial institutions will not be permitted to fail is a dangerous course that will only encourage more recklessness.

Thus, the Administration has asked Congress to pass legislation establishing a new resolution regime for the orderly resolution of failing systemically risky financial institutions, including securities and commodities firms. A federal regulator would manage the resolution of such firms in a manner that limits systemic risk with the least cost to the taxpayer, in conjunction with the primary regulator of the affected institution. The draft authorizes federal regulators to use the same set of tools for addressing distress at non-bank financial institutions as they currently posses to deal with distressed banks. Institutions covered by the proposed legislation would include holding companies that control broker-dealers and futures commission merchants.

Before any of the emergency measures specified in the proposed legislation may be taken, Treasury, upon the positive recommendations of both the Fed and the appropriate primary federal regulator of the firm, and in consultation with the President, must make a triggering determination that the financial institution is in danger of becoming insolvent and that such insolvency would have serious adverse effects on financial stability.Instead of subjecting a firm to bankruptcy or simply injecting taxpayers' funds, the draft legislation would allow for a federal conservatorship leading to orderly reorganization or wind-down. As part of this process, the draft would enable the federal conservator to sell or transfer the assets or liabilities of the firm, renegotiate or repudiate contracts, and address the firm’s derivatives portfolio

There is currently no framework for the resolution of cross-border financial groups or financial conglomerates. At the national level, few jurisdictions have a framework for the resolution of domestic financial groups or financial conglomerates. The global financial crisis illustrates the importance of effective cross-border crisis resolution authority. For example, Lehman Brothers group consisted of 2,985 legal entities that operated in 50 countries, with many of these entities subject to host country national regulation as well as supervision by the SEC.

The Basel Committee recently set forth
recommendations on the cross-border resolution of financial institutions. Basel recommends a middle ground approach that recognizes the strong possibility of ring fencing in a crisis and helps ensure that home and host countries as well as financial institutions focus on needed resiliency within national borders. Such an approach may require discrete changes to national laws and resolution frameworks to create a more complementary legal framework that facilitates financial stability and continuity of key financial functions across borders.

This approach aims at improving the ability of different national authorities to facilitate continuity in critical cross-border operations that, absent such efforts, may contribute to contagion effects in multiple countries, while minimizing moral hazard. This middle approach protects systemically significant functions, performed by the failing financial institution, but not the financial institution itself, at least in its current ownership and corporate structure. It would limit moral hazard and promote market discipline by imposing losses on shareholders and other creditors wherever appropriate.

Encouraging greater cross-border cooperation within such a middle ground approach requires improved understanding of the parameters for action by different authorities and greater convergence in national laws.

An alternative approach, which is not as likely to happen, would be to establish by international treaty a comprehensive, universal framework for the resolution of cross-border financial groups. This would require major changes to national legal frameworks and a harmonization of national rules governing cross-border crisis resolution, including rules on core issues such as a avoidance powers, netting of derivative contracts

At the very least, said Basel, the global nature of many financial institutions requires close cooperation among national authorities. Having similar tools and similar early intervention thresholds may facilitate coordinated solutions across borders. Basel urges national authorities and international groups to monitor developments toward the convergence in these legal frameworks.


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Global Exchanges Ask G-20 to Address Dark Pools and Absence of Level Playing Field

The world’s major financial exchanges have asked the G-20 to examine two interconnected problems that could compromise the ability to extend exchange best practices to OTC markets as part of regulatory reform. The first concern is the absence of a level playing field between exchanges and other entities performing some of the same or similar functions. The second concern is an erosion of price discovery and dark pools, arising from recent trends. The concerns were voiced in a letter to the Financial Stability Board, which the G-20 has designated as a key player in assuring the cross-border consistency of financial regulation legislation. The letter was signed by William Brodsky, CEO of the CBOE, in his role as Chair of the World Federation of Exchanges. It was endorsed by, among others, NASDAQ, NYSE Euronext, the London Stock Exchange, and the Tokyo Stock Exchange.

The exchanges urge the G-20 to assure a level playing field for the responsibilities assumed by all securities order execution venues. In many jurisdictions, said the exchanges, the introduction of alternative order execution platforms has led to significant internalization of order flow and related practices.

These practices limit the visibility of orders, hampering investors' ability to respond to them and diluting the price discovery process. These practices also reduce the ability of both market participants and regulators to see overall market activity and may impact the conduct of proper market surveillance. The letter quoted a former director of the SEC's Division of Trading and Markets as pointing out, "we want the benefits of competition, but without the adverse effects of fragmentation."

The exchanges support the benefits of competition, but acknowledge that fragmentation, if not properly managed, may have harmful effects on market efficiency, financial stability and investor protection. In their view, a central and transparent price discovery process is at the heart of every sound market whereas fragmentation, when its design facilitates a lower level of transparency, hinders this process.

At the end of the day, all investors need to have confidence in the reliability of information reflected in the prices at which securities transactions occur. The exchanges fear that the heightened opacity of certain trading venues inhibits price discovery and may lead to negative outcomes, inc1uding increased market volatility.

The global exchanges believe that the current environment is creating an unequal distribution of the costs of providing a capital markets infrastructure at the expense of regulated markets and to the advantage of alternative trading venues. While welcoming competition, the exchanges say that it should not be structured in ways that can affect the quality of market operations and the soundness of the price discovery process.

The letter also examined the impact of dark pools on market transparency; and asks the G-20 to consider this issue. The SEC has also become increasingly concerned about the post-trade transparency of dark pools, which are electronic trading systems that do not display public quotes. According to James Brigagliano, Co-Acting Director of the Division of Trading and Markets, this lack of post-trade transparency can make it difficult for the public to assess dark pool trading volume and evaluate which ones may have liquidity in particular stocks.

According to the exchange, a question has arisen over the right of markets participants to trade without providing visibility on prices and quantities to other market participants, in order that their orders are executed without moving the market against them. Recently, some exchanges have accommodated these demands by creating order types or opening segments allowing trading that is not immediately visible to the rest of the market. In the case of exchanges, this trading is nonetheless tied into the visible market's surveillance and position-monitoring in order to assure the oversight of total market operations.

Other execution venues also offering dark trading in so-called "dark pools," but their trading and clients' positions are not visible for surveillance purposes. Regulators have no way to evaluate the risks which may be inherent in the combined on-exchange/off-exchange dark pool activities, nor what effects they might have on the visible markets.

Taken together, the combination of the absence of a level playing field between execution venues and decreased market transparency is an unsettling development. The policies and practices that exchanges have developed to ensure fair, orderly markets are at risk of becoming less meaningful and less available to investors and listed companies.


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Wednesday, September 23, 2009

Maine Adopts Electronic Form D Requirements and Caution for Third Party Brokers at Banks

Electronic Form D Requirements.


Issuers intending to make a Rule 506 offering of federal covered securities in Maine under Section 18(b)(4)(D) of the Securities Act of 1933 must file with the Maine Securities Division a hard copy of the SEC-filed electronic Form D, following the SEC's adoption of electronic filing of Form D on March 16, 2009. Issuers are no longer required to include the Appendix to Form D or a Consent to Service of Process.

Broker-dealers providing third-party brokerage services on financial institution premises.


Broker-dealers providing third party brokerage services on financial institution premises are prohibited under the Maine Banking Code and Uniform Securities Act from marketing themselves as "a division" of the financial institution. The broker-dealers and financial institutions are separate entities providing separate services on a financial institution's premises and, therefore, broker-dealers marketing themselves as part of the financial institution is considered to misleads customers.

Please see
here for more information.

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SEC Chair Outlines Efforts Promoting Sound Corporate Governance in Line with Global Principles

Noting that poor corporate governance contributed to the current financial crisis, SEC Chair Mary Schapiro detailed steps the Commission is taking to enhance transparency and accountability in the governance of public companies. In her keynote address at the Transatlantic Corporate Governance conference, the SEC official said that the Commission is working to improve the accountability of corporate managers to the owners of the company. She emphasized that the SEC is operating with an invigorating sense of urgency.

The financial crisis cast into stark relief the problems associated with corporate governance. In particular, boards of directors did not thoroughly question the decisions of senior management to take on risks. Of equal concern, boards often appeared to misunderstand the gravity of risks taken. Senior management took higher returns at face value, noted Ms. Schapiro, without questioning why such higher returns were possible for supposedly safe investments and strategies. In addition, too many boards failed in their primary function of diligently overseeing management. As a result, too many managers took on too much risk and made decisions that were too focused on the short-term.

The SEC Chair set forth a good workable definition of corporate governance as being about maintaining an appropriate balance of accountability between three key players: the corporation's owners, the directors whom the owners elect, and the managers whom the directors select. Accountability requires not only good transparency, she averred, but also an effective means to take action for poor performance or bad decisions.

This definition leads into a discussion of the efficacy of the SEC’s shareholder access proposal which, in this context, is part of good corporate governance. The SEC Chair believes that the most effective means of ensuring that corporations are accountable is to ensure that the shareholders' vote is both meaningful and freely exercised, which is why the SEC proposed rules removing obstacles to shareholders' ability to nominate candidates for the boards of directors of their companies.

Under the proposal, shareholders who otherwise are provided the opportunity to nominate directors at a shareholder meeting would, subject to certain eligibility and procedural requirements, be able to have their nominees included in the company proxy that is sent to all voters. Shareholders would also have the ability to use the shareholder proposal process to modify the company's nomination procedures or disclosure about elections, so long as those proposals do not conflict with state law or SEC rules. The SEC has received over 500 comment letters on the shareholder access proposal, she noted, and is currently reviewing them.

The Commission has also proposed a series of additional measures seeking to improve proxy disclosure and the process by which shareholders exercise their vote. These new disclosures would include expanded information about the relationship between a company's overall compensation policies and the company's risk profile; the qualifications of directors, executive officers and nominees; the board's leadership structure; and potential conflicts of interests of compensation consultants.

The SEC’s proposals are in keeping with high level principles on the effective governance of compensation, emphasized the official, which is a key component of sound corporate governance. The Commission endorses the Financial Stability Board report calling for the effective alignment of compensation with prudent risk taking and the effective supervisory oversight and engagement by stakeholders. In turn, the Financial Stability Board’s principles have been endorsed by the G-20 Finance Ministers, who recently issued a communiqué calling for a framework on corporate governance and executive compensation practices designed to prevent short-term risk taking and mitigate systemic risk. The new executive compensation regime should be globally consistent and build on and strengthen the application of the Financial Stability Board principles.


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Tuesday, September 22, 2009

IASB Assures Obama and G-20 on Fair Value Accounting Reforms

Ahead of the G-20 Pittsburgh summit, the oversight body of the IASB has assured the G-20 that the reform of the international standard for fair value accounting in proceeding along the lines of principles outlined by the Basel Committee. Complimentary reform of loan loss provisioning is also on target. In a letter to President Barack Obama, host of the G-20, Gerrit Zalm, chair of the IASB oversight committee, stressed the urgency in completing the first component of the comprehensive revision of IAS 39, the IASB’s financial instrument standard, by year end. In this work, the IASB is guided by principles of transparency and the avoidance of undue complexity enunciated by Basel and recently endorsed by the G-20 Finance Ministers, including Treasury Secretary Tim Geithner. In addition, Basel urges that the standards reflect the need for earlier recognition of loan losses.

The IASB has proposed significant changes to its fair value accounting standard that would essentially require all financial instruments that do not have basic loan features to be measured at fair value. The proposal would also eliminate the requirement to identify and account for embedded derivatives separately. The IASB’s proposed approach would reduce the complexity that results from the many categories and related impairment methods in the current standard.

The draft proposes two primary measurement categories for financial instruments: amortized cost and fair value. A financial asset or financial liability would be measured at amortized cost if the instrument has loan features and is managed on a contractual yield basis. All other financial assets or would be measured at fair value. Therefore, the draft proposes that all investments in equity instruments, as well as derivatives on those equity instruments, should be measured at fair value.

Mr. Zalm noted that the proposals are consistent with the view of the Basel Committee, that cost-based accounting is appropriate for some categories of financial instruments. In order to provide transparency and reflect economic reality, the IASB’s emphasis has been to define in a balanced and transparent way the appropriate criteria for classifying instruments to be measured at cost and fair value, he noted, and not to increase or decrease arbitrarily the use of fair value. Whether there is a decrease or an increase of fair value will depend on a particular institution’s business model and holdings. Importantly, Chairman Zalm emphasized that the IASB is not proposing that the loan book of banks will be held at fair value.

Similarly, the IASB is improving the accounting for loan-loss provisions, another area cited by the G-20. The IASB is working closely with regulators, financial institutions, and investors to develop more forward-looking measures, such as an expected loss model
rather than the incurred loss model currently in place in IFRS and US GAAP. The IASB has already issued a discussion document on provisions and will release a final proposal in the fourth quarter.


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Monday, September 21, 2009

FSA Official Seeks Revision of Draft Directive on Hedge Fund Regulation

A senior official of UK Financial Services Authority urged the European Commission to recast the proposed Directive on Alternative Investment Fund Management to recognize of the global nature of the hedge fund industry and not impose unjustifiable geographical restrictions on firms' business models that would significantly restrict investor choice. At a recent seminar on asset management, Sally Dewar, Director of Wholesale Markets, emphasized that proposed restrictions on non-European management firms are misplaced; as are blanket prohibitions on the marketing of non-European funds to professional investors.

The Director also urged the Commission to differentiate between types of alternative investment fund management. Given the diversity of the alternative investment fund sectors, she noted, a single, standardized approach will not work. The issues around a hedge fund prime brokerage business model, for example, are quite different from those around the management of a private equity fund.

In addition, some fundamental concepts that are relevant to one type of fund may not be equally applicable to others. For example, leverage and liquidity issues, and capital risks, are different for closed-ended funds, she observed, and the additional investor protection afforded by requiring independent custody is quite different for private equity investments than for funds which invest in financial securities or derivative contracts.

The Director also called for a more risk-based approach to hedge fund regulation. The draft Directive’s scope and thresholds are too low to adequately focus on those alternative funds and managers posing significant risks to financial stability and market efficiency, she averred. The draft does not strike the correct balance between imposing additional costs and enabling regulators to identify and therefore mitigate systemic risks.

Further, the official cautioned against leading regulators into prescriptive product regulation of alternative investment funds. Thus, the FSA believes that the hard limits on leverage proposed in the Directive are both inappropriate and unworkable; and could result in considerable unintended consequences for European hedge funds.


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IOSCO Issues Risk Liquidity and Due Diligence Standards for Funds of Hedge Funds

With the US and EU readying legislation to regulate hedge funds, IOSCO has set forth regulatory standards for funds of hedge funds, focusing primarily on liquidity risk and due diligence. Generally, the standards reflect a common approach and a practical guide currently acknowledged by regulators. Implementation of the standards may vary from jurisdiction to jurisdiction, depending on the circumstances.

In dealing with liquidity risk, the fund of hedge funds’ manager should make inquiries in order to be in a position to consider if the fund’s liquidity is consistent with that of the underlying hedge funds, particularly in order to meet redemptions. Prior to investing, and during the investments’ lifetime, the fund manager should consider the liquidity of the types of the financial instruments held by the underlying hedge funds. The manager should also consider whether conflicts of interest may arise between any underlying hedge fund and any other relevant parties.

If the fund introduces limited redemption arrangements for dealing with a potential liquidity issue, said IOSCO, the fund manager should consider whether these are consistent with the fund of hedge funds’ objectives. Moreover, the conditions relating to the activation of the limited redemption arrangements should be clearly specified in the fund of hedge funds’ prospectus. Further, the redemption arrangements should only be activated for a limited period of time and for the purpose of dealing with exceptional situations in the interest of shareholders as clearly stated in the prospectus.

More generally, before and during any investment, a fund of hedge funds’ manager should consider whether conflicts of interest may arise between any underlying hedge fund and any relevant other parties. In particular, the fund manager should consider the nature of the agreements entered into between any underlying hedge fund and any investors, which provide for preferential rights to some investors through side-letters or other similar arrangements. The fund should disclose the existence of any material side-letters or similar arrangements.

The hedge fund manager should also implement appropriate due diligence procedures for the purpose of investment into hedge funds; and review them regularly. Fund managers should additionally conduct due diligence on the underlying hedge fund whenever it is considered necessary.

IOSCO sets forth a laundry list of due diligence factors that the manager of the fund of hedge funds should consider, many of which deal with the underlying hedge fund’s valuation techniques, risk management, and corporate governance. Specifically, the fund manager must consider whether the underlying hedge fund complies with established valuation principles and whether the methodology used for calculating the hedge fund’s value is appropriate. Similarly, the fund manager should consider the adequacy of the method used for the purpose of calculating the underlying hedge fund’s performance history and whether the hedge fund’s reported performance is consistent with its stated strategy.

The fund of hedge fund’s manager should also consider the adequacy of the experience and qualifications of the underlying fund’s portfolio managers and the extent to which they adhere to industry professional codes. If the underlying portfolio managers have personally invested in the fund, the fund of funds manager must consider whether the underlying hedge fund has adequate systems to identify any potential conflicts of interest related to such investments.

Proper due diligence will also require adequate technical and human resources, procedures and organizational structures. More granularly, there must be documented and traceable procedures for selecting hedge funds. Relatedly, there must be in place resources and procedures to deal with any anomalies identified by the due diligence system, to take the necessary corrective action, and to confirm that all procedures are traceable and have been catalogued.

Fund of hedge funds managers authorizing the outsourcing of any aspect of due diligence it should determine that any conflicts of interest are adequately addressed; and consider the extent that the outsourcing of due diligence is consistent with IOSCO principles.


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Sunday, September 20, 2009

Law and Business Professors, Including former SEC Officials, Urge Supreme Court to Clarify Gartenberg Ruling on Advisory Fees

In a case challenging the 1982 Gartenberg ruling involving the fiduciary duty imposed on mutual fund advisers under Section 36(b) of the Investment Company, law and finance professors have urged the Supreme Court to clarify the Gartenberg factors in recognition of the significant changes that have occurred in the mutual fund industry. In their amicus brief, they ask the Court to allow lower courts to consider the fees charged by advisers of similar funds and whether competition among similarly situated funds affected the advisory fees. Fees charged by competing advisors to similar funds will generally be more probative of advisory fees’ fairness than other measures, they aver. The amicus brief was submitted by, among others, former SEC Commissioner Joseph Grundfest and former SEC General Counsel Simon Lorne.

The case is on appeal from a Seventh Circuit panel ruling that expressly disapproved the Gartenberg approach based on the panel’s view that a fidu­ciary duty differs from rate regulation. The 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. The court of appeals denied rehearing en banc, with five judges dissenting. The Supreme Court granted certiorari. Oral argument is set for November 2, 2009. (Jones v. Harris Associates L.P., Dkt. No. 08-586).

A core argument of the brief is that competition for mutual fund investors generally constrains advisory fees. The assertion that fund boards rarely dismiss an adviser does not mean that fees are immune from fee competition, argued amici. Rather, the structure of mutual funds allows investors to react easily to fee disparities by investing elsewhere.

Robust fee competition in the fund industry results from a number of factors, said the brief, including investor mobility and choices, low barriers to entry, numerous distribution models, widespread advisory fee reductions, and, most importantly, strong and consistent correlations between lower advisory fees and higher returns.

The brief recognizes that Gartenberg appropriately recognized that courts should consider all pertinent facts when evaluating mutual fund advisory fees under Section 36(b). However, the professor argued that, in dicta the Gartenberg court expressed skepticism regarding the existence of competition among funds and its impact on advisory fees. Gartenberg focused primarily on competition for a fund’s advisory contract and noted that funds rarely fire their advisers. In fact, contended amici, courts should focus at the investor level. Economic evidence demonstrates that investors are fee sensitive, asserted the brief, and advisers are aware of investor preferences and competition for investors constrains fees.

Amici thus urged the Supreme Court to clarify that the dicta in Gartenberg concerning the lack of competitive forces affecting advisory fees in the mutual fund industry are outdated and not binding. In particular, the Court should specify that lower courts should be permitted to consider two sets of facts relating to competition and advisory fees under Section 36(b): (1) evidence of competition for investors by funds similar to the type of fund at issue; and (2) evidence of the extent to which such competition constrains the fees charged by the adviser and approved by the fund’s directors, and whether that competition is likely to produce fees similar to those generated by arm’s-length bargaining.

According to the brief, Gartenberg relies on a 1966 SEC report concluding that cost reductions in the form of lower advisory fees do not figure significantly in the battle for investor favor. Amici argued that the observations in the 1966 report do not accurately characterize today’s fund industry, where competitiveness constrains the amount of advisory fees that a fund adviser can charge. Thus, said amici, the statutory scheme and the evidence about competition in the mutual fund industry demonstrate that consideration of competitive fees is relevant to the evaluation performed by independent directors, in the first instance, and by a court, in the event of a fee challenge.


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Friday, September 18, 2009

Hong Kong Investment Banker Found Guilty of Insider Dealing as SFC Assert Its Powers

As part of its ongoing vigorous initiative to combat insider dealing, the Hong Kong Securities and Futures Commission successfully concluded an enforcement against an investment banker for insider dealing during an acquisition deal. Judge Andrew Chan found the investment banker, a former managing director at Morgan Stanley Asia, guilty of all ten charges of insider dealing after a 38-day trial following an investigation by the Commission.

This is the tenth successful case of insider dealing that the SFC has secured since the first conviction of its kind in July 2008. The maximum penalty for insider dealing is a jail term of ten years and a fine of $10 million. According to Enforcement Director Mark Steward, the verdict underscores the Commission’s commitment to protect ordinary investors from this type of misconduct. The action also demonstrates, as Mr. Steward earlier said, that the Commission will use all available legal powers to achieve significant results in enforcement actions.

During the course of the investigation, the SFC obtained an injunction order from the court freezing $46.5 million of the banker’s liquid assets. This order marked the first time the SFC was granted an injunction order under section 213 of the Securities and Futures Ordinance to freeze the assets of a suspect during an insider dealing investigation. The Commission also successfully defeated a challenge to its power to execute search warrants and to audio record interviews.

The court concluded that the power to record an interview by audio means is reasonably incidental and necessary to the power under section 183(1)(c) of the SFO to compel a person under investigation to attend an interview and answer questions. In insisting upon an audio recording of an interview, said the court, the Commission and its investigators did not act ultra vires. The court agreed with the SFC’s submission that audio recording is an important way of ensuring the integrity of the interview process and that this does not interfere illegally with any privacy right.

The court also rejected claims that a search warrant obtained by the Commission in the ongoing insider dealing investigation was overly broad. The SFC executed the search warrant and seized a number of documents.


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Thursday, September 17, 2009

German Legislation Increases Liability of Supervisory Board for Inappropriate Management Remuneration; Mandates Say on Pay

The German Federal Parliament, the Bundestag, has adopted legislation increasing the liability of a company’s supervisory board for management remuneration and mandating a shareholder advisory vote on management remuneration. The Act on Appropriateness of Management Board Remuneration (Gesetz zur Angemessenheit der Vorstandsvergütung) ensures that, when executive remuneration is determined by the supervisory board, there will be a greater focus on incentives concerning the company's long-term development. The hallmarks of the Act are transparency, accountability, and a focus on long-term sustainability. The Act must still pass through the Bundesrat. However, it does not require the consent of the Bundesrat, the federal council of states, and will enter into force on the day following its promulgation.

The legislation is based primarily on the belief by the Federal Republic that a factor contributing to the financial crisis is that the incentives in management remuneration promoted the wrong kind of conduct. Many companies were too focused on the attainment of short-term parameters, such as turnover figures or stock market prices on certain dates. As a result, management lost sight of the long-term state of well-being of the company. Moreover, providing the wrong incentives created the temptation to take irresponsible risks.
In order to achieve long-term incentives, variable components of the remuneration package will be based on assessment criteria covering a number of years, and longer periods will apply concerning the exercise of stock options. However, the legislation does not to establish a specific level of remuneration by law. This is not a matter for the State to decide, said Federal Justice Minister Brigitte Zypries, but should be up to the contracting parties.

If the supervisory board determines a level of remuneration that is inappropriate, it thereby makes itself liable to compensation vis-à-vis the company. This provision clarifies that determining an appropriate level of remuneration is one of the most important duties of the supervisory board; and that the board is personally liable for any violations of its obligations. Further, there must be an appropriate relationship between the remuneration of the company’s management board and the management board's performance. Management remuneration may not exceed the usual sector or country-specific level of remuneration in the absence of special reasons.

More broadly, the remuneration structure of listed companies must be oriented towards sustainable corporate development. Components of the remuneration package that are variable, such as bonuses, should be based on assessment criteria covering a number of years. The supervisory board should provide the possibility of introducing caps in the event of unusual developments.

Stock options may be exercised at the earliest four years after the option was granted. This provision is intended to give managers who benefit from such schemes a greater incentive to act with sustainable goals in mind and in the interests of the company.

Under the Act, the general meeting of shareholders of a listed company will be able to give a non-binding vote on management board remuneration. In this way, an instrument for controlling the existing executive remuneration system is put at shareholders' disposal, which enables them to express their approval or disapproval. Thus, pressure will be exerted on those responsible to act particularly conscientiously when determining management board remuneration.

The Act empowers the supervisory board to subsequently make cuts in the level of remuneration in the event that the company's situation worsens. Express statutory regulation was necessary in this respect since this constitutes an interference with existing contracts. An example of worsening in this sense would be where a company is forced to make redundancies and is unable to distribute profits. In such a case, continuing to pay the agreed remuneration to the management board members would be inequitable for the company in question. There is no requirement of insolvency to trigger this new power. The possibility of reducing pensions is restricted to the first three years following the board member's departure.

In order to enhance the transparency of compensation, a decision concerning remuneration of a board member may no longer be delegated to a committee of the supervisory board; but must be made by the supervisory board in a plenary meeting.

Also, companies are required to disclose more extensive information regarding remuneration and pension payments made to management board members when they discontinue their board activity, be it premature or under normal circumstances. This will enable shareholders to gain a better insight into the extent of agreements entered into with members of the management board.

If the company takes out directors and officers liability insurance, a mandatory deductible amount must be agreed upon. This amount must not be lower than one and a half times the amount of annual fixed remuneration. This is intended to promote business conduct that is focused on greater sustainability.

Finally, former management board members may not become a member of the supervisory board within a two-year period following their departure from the management board, in order to prevent any conflict of interest arising. However, in a bow to family-run companies, which are prevalent in Germany, this restriction does not apply if election to the supervisory board takes place at the instigation of shareholders who hold more than 25% of voting rights in the company.

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