Saturday, October 31, 2009

Seven Former SEC Chairs Urge Supreme Court to Uphold Constitutionality of the PCAOB

Seven former SEC Chairs appointed by Presidents of both parties, and representing four decades of SEC leadership, have asked the US Supreme Court to uphold the constitutionality of the PCAOB in an action alleging that the Board’s existence runs afoul of the Appointments Clause. Given the SEC’s pervasive power over the PCAOB, said the amicus brief filed by the Chairs, the Board is not an independent federal agency whose members must be appointed by the President. Congress designed the Board to be independent of the accounting profession, noted the brief, but completely subordinate to the SEC. The SEC’s comprehensive power over the Board enables the SEC to direct the Board’s every action and effectively precludes any Board member from defying the Commission’s policy choices. The former SEC Chairs signing on to the brief include Arthur Levitt, Rod Hills, William Donaldson, Harvey Pitt, and David Ruder.

The case, brought by an audit firm, is before the Supreme Court on a grant of certiorari of a split panel ruling of the DC Circuit Court of Appeals that the PCAOB’s creation was constitutional. The Supreme Court will hear oral arguments on December 7, 2009 and a decision is expected during this term. (Free Enterprise Fund and Beckstead & Watts v. PCAOB, Dkt. No. 08-861).

According to the former SEC leaders, the Board’s design is a logical outgrowth of decades of public-private regulatory partnerships that uniquely characterizes US regulation of the financial markets. Industry SROs have long been subject to SEC plenary control, they noted, and provide the regulatory framework within which Congress designed the PCAOB. Congress built upon decades of experience with these structures in an effort to maintain the distinct advantages that flow from the SROs’ public-private nature while providing needed independence from the regulated profession.

The SEC exercise profound power over the PCAOB. For example, the SEC’s is authorized to disapprove PCAOB rules or budget proposals, reverse the Board’s enforcement decisions, remove Board members and censure the Board, or even rescind its duties altogether The SEC’s complete control over the Board’s budget provides the Commission with one of its most potent tools to control all of the Board’s actions. The SEC must approve the PCAOB’s annual budgets, as well as the user fees established each year to fund the Board The SEC has used this budgeting authority as a means to influence and supervise the Board’s rulemaking and inspection activity. Moreover, the Commission’s actual exercise of its authority in practice confirms that the Board is subject to the Commission’s constant control and oversight in every facet of its operations, noted the brief, just as Congress intended.

In the view of the former Chairs, the profound and pervasive power that the SEC exercises over the Board compels the conclusion that PCAOB Members are not principal officers of the United States who wield power comparable to SEC Commissioners; and therefore the Appointments Clause does not require that they be appointed by the President. Rather, they are inferior officers who can be appointed by Heads of Departments. And, the Appointments Clause contemplates that Heads of Departments can be collective bodies like the SEC.

The former Chairs then specifically refuted the audit firm’s argument that the SEC Chair rather than the Commission as a whole is the “Head” of the SEC within the meaning of the Appointments Clause. They noted that, contrary to the firm’s assertion, the Chair alone does not appoint the SEC’s Division Heads and General Counsel. Indeed, no appointment of major SEC personnel can be made unless the Commission approves the appointment, even when the Chair has the power to initiate the process.

Thus, they maintained that, even when the Chair may initiate an appointment, that action casts no doubt on the fact that the Commissioners collectively are the “Head” of the SEC for Appointments Clause purposes. Moreover, citing their decades of experience, the former officials said that even when an SEC Chair is authorized to initiate an appointment, the Chair routinely solicits input on possible candidates from the other Commissioners. Thus, no meaningful distinction exists, in practice, between
whether the Chair or the Commission has the formal power to initiate an appointment.

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Hong Kong SFC Launches Massive Investor Protection Initiative; Starting with Proposed Code for Derivatives Investing

In light of the global financial crisis, the Hong Kong Securities and Futures Commission has launched a multi-pronged offensive to enhance investor protection and provide increased market transparency. The first prong of the offensive is a rulemaking proposal to enhance disclosure to investors about derivatives and other unlisted structured financial products. Later, there will be rulemaking and legislation authorizing the formation of an Investor Education Council and a Financial Ombudsman for dispute resolution. There will also be legislation governing the authorization of products sold to the public.

The proposals are nothing less than a Code intended to cover all unlisted structured products commonly offered to the public in Hong Kong, including equity, credit, and commodity-linked notes, equity-linked investments and equity-linked deposits. In future, where issuers seek authorization in respect of types of unlisted structured products that are new to the market, the Commission will consider these on a case-by-case basis and, where appropriate, consult the new Products Advisory Committee, which would comprise representatives of industry participants and other stakeholders with diverse knowledge and expertise. The Code would also introduce the concept of investors ``with derivative knowledge’’ as determined under criteria listed in the Code. The comment period ends December 31, 2009.

Where necessary, the Commission will engage in further public consultation and publish further guidance on requirements for these types of structured products. The common types of currency-linked and interest rate-linked products issued by banks would fall outside the scope of the Code. Also listed structured products would continue to be subject to the Listing Rules. They are not, and will not be, required to seek the Commission’s authorization.

A broad principle behind the proposed Code is that the investment life-cycle involves multiple parties, such as the product issuer, the selling intermediary and the investor, each of whom must bear some responsibility for the investment that is ultimately made. Issuers would be required to prepare concise and easily understandable summaries of their financial products, what the Commission calls "Key Facts Statements", which would form part of the offering documents. Designed to help investors better understand the products being considered, these would be only a few pages long, which is much shorter than an offering document

The ``Key Facts Statement’’ is a concept akin to the proposal by the Committee of European Securities Regulators (CESR) with respect to the key information document. Both CESR and the Commission intend for these documents to be concise, user friendly and standardized to facilitate comparison between securities products. In principle, noted SFC Chief Executive Martin Wheatly, the Key Facts Statement will comprise part of the offering documents of the product and have equal force and standing as the prospectus, yet it will be limited to only a few pages in length so as to highlight and facilitate investors’ appreciation of the key features and risks of the product.

At the same time, the Commission is aware that some UCITS schemes may already be using a specific form of key factsheet that satisfies their home regulator’s requirement. Since a large proportion of Hong Kong funds are UCITS funds, noted Mr. Wheatly, the SCF would accept these European key factsheet counterparts provided that they provide substantially the same information as required under the Key Facts Statements, and their format and presentation are user friendly and easy to understand.

Selling intermediaries often get incentives from issuers who want their products sold. While there is nothing wrong with salespeople being rewarded for their work, this commercial arrangement poses a potential conflict of interest between the seller and the buyer. The SFC therefore proposes that intermediaries disclose at the pre-sale stage any commissions, fees or other benefits they would earn from the sale of a product. Knowing the rewards or benefits to be received by the selling intermediaries provides greater transparency and provides the investor with relevant information in making investment decision.

The Commission is considering a cooling-off period for some derivative products. This would be a short period, immediately after committing to make an investment, during which investors could change their minds and exit the arrangement. However, to prevent any abuse of the process, investors would have to bear some costs attached to this exit option, such as administrative fees, applicable unwinding costs and any decline in underlying market value of the product during the cooling-off period. The SFC has suggested that the cooling-off period apply only to longer-term products with no ready secondary market. This is because these are the types of products where a cooling-off period might be of most benefit as an investor protection measure. Where products already have an active and liquid secondary market, such as mutual funds, investors could exit the investment if they subsequently change their minds.

Another proposal relates to investor profiling. As part of the know-your-client procedures, intermediaries would be required to seek each client's knowledge of derivatives and characterize those with such knowledge as clients with derivative knowledge. Additionally, the professional investors regime will be reviewed to consider whether or not the assessment criteria for qualifying as a professional investor should be revised.

The proposed Code provides three alternative avenues by which investors may be regarded as having knowledge of derivatives. First, they may have undergone training or attended courses on derivative products. Second, they may have prior trading experience in derivative products, or, third, they may have work experience related to derivative products.

Under the proposed Code, if an investor is not characterized as a client with derivative knowledge, the intermediary could not promote any unlisted derivative products to such a client under any circumstances. When clients who do not have derivative knowledge wish to purchase an unlisted derivative product on their own initiative, the intermediary should warn them about the proposed transaction and provide appropriate advice to them, including assessment of suitability of the transaction, taking into account the client’s personal circumstances such as total portfolio, asset concentration and exposure to a particular market or asset class. The warning and communications with the client should be recorded. However, intermediaries would not be required to seek information about a client’s knowledge of derivatives if no services with respect to unlisted derivative products are envisaged to be provided to that client.

Regarding valuation, the Commission believes that it would be helpful for investors assessing the performance of a structured product if they were provided with regular information about the prevailing market value of their investments. Thus, the Code would require that issuers or their agents make available indicative valuations of structured products on a daily basis throughout their terms. Such indicative valuations would be determined in good faith, on an independent basis, and must be fair and reasonable.

The Commission similarly proposes that, except for structured products with a short term of one month or less, issuers should provide liquidity by way of making firm price quotations for the structured product available to investors at least weekly. Such quotations should be fair and reasonable.

The Commission ensured that the enhanced proposed Code does not represent product or merit regulation, where the regulator judges the merits of an investment product before it is marketed. Similar to the SEC and the FSA, the SFC does not believe that the regulator should become the final judge of the soundness or suitability of a product. In an extreme case, product regulation could be obstructive to market innovation because the regulator may substitute its own preferences for those of investors. Limiting approvals of products to those judged suitable for all types of investors would result in a narrower selection of products available to investors and militate against Hong Kong’s reputation and status as an international financial center.


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Friday, October 30, 2009

New Mexico Proposes Rules to Coordinate with Adoption of New Securities Act

New rules and amendments to existing rules were proposed by the Securities Division of the New Mexico Regulation and Licensing Department to coordinate with the State's new Securities Act that takes effect January 1, 2010. The proposals are anticipated to also become effective on January 1, 2010.

The proposed rules and amendments would affect federal covered securities, exemptions for securities and transactions, registration of securities and licensing of broker-dealers, sales representatives, investment advisers and investment adviser representatives.

For more information, please see here.
Does the "Subject" "Matter?" SEC, Solicitor General Urge Supreme Court to Deny Review of Cross-Border Claims

Senior SEC counsel and the U.S. Solicitor General filed an amicus brief urging the U.S. Supreme Court to let the dismissal of a fraud action against an Australian bank stand. While the government lawyers stated that the 2nd Circuit erred in characterizing the issue as one of subject matter jurisdiction, they believed that the court was correct in holding that the suit should not proceed (In re National Australia Bank Securities Litigation).

The investors filed suit against the largest bank of Australia in federal court in New York. The bank had acquired a mortgage service provider based in the United States that had, according to the complaint, used faulty accounting methods that resulted in the dissemination by the bank of public filings and statements containing materially false and misleading statements. The trial court dismissed the action on jurisdictional grounds, and the 2nd Circuit affirmed.

As stated in the brief, both courts improperly read the case as one of subject matter jurisdiction. The nexus between the plaintiffs, the fraudulent scheme, and the United States is not, however, relevant to the court’s subject matter jurisdiction in the view of the government lawyers. They wrote that "if a particular suit is otherwise an appropriate means of enforcing a `liability or duty created by' the Exchange Act or rules promulgated thereunder by the Commission, Section 78aa unambiguously vests the district courts with jurisdiction to resolve it." According to the SEC lawyers and the solicitor general the "geography" of an alleged fraudulent scheme is "irrelevant" to the district court’s subject matter jurisdiction.

Contacts between the parties, the fraud and the country are relevant, according to the brief, to the applicability of Section 10(b)’s substantive prohibition and the implied private right of action. The government lawyers asserted that the determination whether a fraudulent scheme violated Section 10(b) depends in part on the location of the actions taken to effectuate it. The prohibition of the use of a “manipulative or deceptive device or contrivance” in connection with the purchase or sale of a security does not apply if the scheme bears an insufficient connection to the United States.

In addition, the brief stated that the transnational character of the scheme and any resulting harms may bear on the availability of Section 10(b)’s private right of action. The cross-border nature of some claims could hinder the ability of plaintiffs to establish a direct causal link between the violations and their injuries.

The government lawyers conceded that the plaintiffs had adequately alleged a substantive violation of Section 10(b). They criticized the 2nd Circuit's “heart of the alleged fraud” approach which could limit Section 10(b)’s coverage to transnational frauds in which domestic conduct predominates. Such a reading, in their view, would not adequately protect the government’s law enforcement interests.

In this case, however, the brief argued that the link between the Florida subsidiary's alleged false statements and the ultimate harm to petitioners was too indirect to support liability. The U.S. company had no authority to direct or control the reporting of its parent's financial results, and the causal chain of the investor losses included significant intervening events outside this country, including the inflation of the stock price in the Australian trading market. The brief concluded that the "indirectness of the link between the Florida component of the scheme and petitioners’ injuries does not negate the existence of a Section 10(b) violation, but it provides a sound basis for dismissing petitioners’ private suit."

The brief may be found here.

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Key House Committee Passes Legislation Regulating Hedge Fund Advisers

As part of the plan for overhauling US financial regulation, the House Financial Services Committee has reported out legislation requiring advisers to hedge funds and other private investment funds to register with the SEC if they have assets under management of at least $150 million and be subject to significant disclosure and other requirements. Current law generally does not require private fund advisers to register with any federal financial regulator. The $150 million assets under management threshold is significantly higher than the $30 million trigger proposed by the Obama Administration. The higher number also sets up a possible fight with the Senate, where proposed legislation by Securities Subcommittee Chair Jack Reed would set a $30 million assets under management trigger.

However, the Meeks-Peters-Garrett Amendment also requires hedge fund advisers covered by the exemption to maintain the required records and gives the SEC the discretion to require reports in the public interest or for investor protection. The House legislation also contains a registration exemption for advisers to venture capital funds.

The Private Fund Investment Advisers Registration Act, HR 3818, passed with bi-partisan support of 67-1, would mandate the registration of private advisers to private pools of capital so that regulators can better understand exactly how those entities operate and whether their actions pose a threat to the financial system as a whole. In addition, new recordkeeping and disclosure requirements for private advisers will give regulators the information needed to evaluate both individual firms and entire market segments that have until this time largely escaped any meaningful regulation, without posing undue burdens on those industries. Under the legislation, advisers to hedge funds, private equity firms, single-family offices, and other private pools of capital will have to obey some basic ground rules in order to continue to play in our capital markets. Regulators will have authority to examine the records of these previously secretive investment advisers.

The draft mandates the confidential reporting to the SEC of amount of assets under management, borrowings, off-balance sheet exposures, counterparty credit risk exposures, trading and investment positions, and other important information relevant to determining potential systemic risk and potential threats to our overall financial stability. The legislation would require the SEC to conduct regular examinations of such funds to monitor compliance with these requirements and assess potential risk. In addition, the SEC would share the disclosure reports received from funds with the Federal Reserve Board and the Financial Services Oversight Council.

This information would help determine whether systemic risk is building up among hedge funds and other private pools of capital, and could be used if any of the funds or fund families are so large, highly leveraged, and interconnected that they pose a threat to our overall financial stability and should therefore be supervised and regulated as what the Administration calls Tier 1 financial holding companies, which would be subject to oversight by the new federal systemic risk regulator.

An amendment by Rep. Garrett would require the US Comptroller General to conduct a study and report to Congress on the costs to the hedge fund industry of the legislation’s registration and reporting requirements. Another amendment offered by Rep. Kosmas would delay the effective date for one year, although advisers would have the discretion to register earlier with the SEC.

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

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


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Schapiro Calls for Legislation on Asset-Backed Securities

In a recent speech, SEC Chairman Mary Schapiro stated that there may be gaps in the regulation of the asset-backed securities market. She has asked the staff to broadly review the Commission's regulation of ABS including disclosures, offering process, and reporting of asset-backed issuers. The staff is considering a number of proposed changes, which are designed to enhance investor protection in this part of the market.


However, the chairman indicated that not all problems with ABS can be addressed under the agency's current rulemaking authority. Legislative action may be necessary to deal with the issues recently highlighted by the credit crisis. The chairman described how the current disclosure-based regulation regime was designed to deal with issuers in actively-managed businesses. Securitization, however, is a financing technique in which financial assets, in many cases themselves less liquid, are pooled and converted into instruments that may be offered and sold in the capital markets. Asset-backed securities are generally securities that are backed by a discrete pool of self-liquidating financial assets.


The chairman described how most legislative proposals aimed at improving securitization have focused on the disclosure of material information. She believes, however, that substantive protections beyond disclosure requirements are needed for the ABS arena due to the nature of securitization and the role it plays in the national economy.

Creating a new act directed solely at securitizations would allow Congress to "specifically tailor solutions for these investment vehicles—much like the Investment Company Act of 1940, and, it could be done without compromising or changing the fundamental structure and underpinnings of existing statutes," said the chairman. As described by Chairman Schapiro, such a statute could have substantive restrictions or requirements for the trust that issues the securities and for related parties, and set minimum requirements for the pooling and servicing agreements.

These minimums could include strong representations and warranties about the assets being securitized and the procedures for ensuring those representations and warranties are followed. Any substantive changes would apply in addition to the disclosure requirements of the Securities Act, which would continue to apply when ABS securities were offered and sold.

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Thursday, October 29, 2009

9th Circuit Rejects "Statistical Significance" Materiality Argument

A 9th Circuit panel rejected claims by the maker of Zicam Cold Remedy, an over-the-counter product, that the number of users who suffered from a loss of smell (anosmia) was statistically insignificant, and therefore immaterial as a matter of law (Siracusano v. Matrixx Initiatives). The court below concluded that the allegations of a phone conversation between a company vice-president and a University of Colorado researcher discussing one anosmia complaint, as well as studies, including a University of Colorado study citing 11 cases of anosmia in Zicam Cold users were not statistically significant.

The appellate court stated that "in relying on the statistical significance standard to determine materiality, the district court made a decision that should have been left to the trier of fact." The court could not determine as a matter of law whether the links between the harm to consumers and product use were statistically insignificant on the pleadings.

With regard to scienter, the panel found that the claims sufficiently alleged that the issuer failed to disclose known or reasonably suspected risks associated with the use of Zicam nasal products. Significantly, the court noted that the individual defendants may not have engaged in unusual or suspicious stock sales at the same time that they were attempting to downplay the reports of anosmia. While recognizing that motive can be a relevant consideration, the 9th Circuit concluded that "the absence of a motive allegation is not fatal.”

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Minnesota Adopts Securities Rules to Coordinate with 2007 Uniform Securities Act

New rules involving federal covered securities, exemptions from registration and securities registrations, broker-dealers, agents, investment advisers and federal covered investment advisers were adopted by the Minnesota Department of Commerce to coordinate with the State's Uniform Securities Act that took effect on August 1, 2007. The rules take effect November 1, 2009.

For more information on the new rules, please see here.

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Wednesday, October 28, 2009

Fraud by Hindsight Claims Fail to Show Scienter

by Rodney Tonkovic
Associate Writer-Analyst
CCH Federal Securities Law Reporter

In Indiana State District Council of Laborers and Hod Carriers Pension and Welfare Fund v. Omnicare, Inc. (here), a 6th Circuit panel affirmed the dismissal of a fraud complaint that attempted to show "fraud by hindsight." The class action complaint alleged that a provider of pharmaceutical care services and several of its officers and directors made a number of false and misleading statements. The district court (ED Ky) found that the shareholders failed to plead loss causation and scienter and dismissed the action.

The panel agreed that the shareholders were trying "to turn bad corporate news into a securities class action" and generally affirmed the dismissal. The appellate court first found that the complaint failed to allege a material misstatement or omission. A statement by the CEO which the shareholders claimed should have disclosed a contract dispute was protected as a forward-looking statement because it discussed the company's "growth outlook," and general optimistic statements by management predicting positive future results were not material. Next, the shareholders failed to plead loss causation because the complaint failed to allege that a company's operational difficulties or alleged GAAP violations were known to the market or that they caused the company's stock price to fall.

The company's statements regarding legal compliance were also not actionable. The panel found that in this case, while the shareholders claimed that the company's statement on legal compliance was made knowing it was false when made, the allegations did not support this claim. Finally, the panel reversed and remanded the complaint's Securities Act Section 11 claims after finding that they sounded in fraud, leaving it to the court to apply the stricter fraud pleading standards of Rule 9(b).

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Tuesday, October 27, 2009

Florida Proposes to Review Associated Person Applicants' Law Enforcement Record

As proposed, the law enforcement records of associated person applicants who have been found guilty of, or who have pled guilty or nolo contendere to, certain crimes would be reviewed by the Office of Financial Regulation to determine their eligibility to register in Florida. Applicants would be disqualified from registration for certain periods based upon criminal convictions, pleas of nolo contendere, or pleas of guilt, whether or not there was an adjudication. Class A crimes (felonies) involving fraud, dishonesty or any other acts of moral turpitude would disqualify applicants from associated person registration for 15 years while Class B crimes (misdemeanors) would disqualify applicants from registration for five years. Disqualification periods could be extended for applicants having committed multiple Class A or B crimes but could also be reduced with mitigating factors. Applicants would have the burden to prove they're entitled to register when their disqualifying periods expire.

Please see here for more information.

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Monday, October 26, 2009

Arkansas Revises its Securities Rules

Arkansas rule changes pertaining to federal covered securities; exemptions from securities registration; registration of securities; registration and post-registration requirements for broker-dealers, agents, investment advisers and investment adviser representatives, notice filings for federal covered investment advisers; and administrative procedures for conducting investigations and hearings, and reviewing exemption filings were adopted by the Arkansas Securities Department, effective November 1, 2009.

It is unlikely there will be any additional changes to the proposed rule text so consider the text under "proposed rules"
here to be the final version. But for confirmation of this or for any other questions pertaining to the proposals, please contact Deputy Commissioner Ann McDougal at (501) 324-8685 or here.

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Fraud Claims Against Medical Device Maker Die a Procedural Death

The 7th Circuit allowed the dismissal of claims against Guidant Corp to stand. The plaintiffs claimed that Guidant knew that some of its pacemaker devices were defective but failed to disclose that information in periodic reports and in connection with a merger (Fannon v. Guidant Corp.).

The district court dismissed the claim with prejudice on scienter grounds. The court rejected a "core operations" assertion, and found that insider stock sales were not suspicious. In addition, the trial judge found that the plaintiffs did not cite “any internal documents, confidential witnesses, or other sources to support their allegations."

On appeal, the investors limited their arguments to the "with prejudice" element of the dismissal order. As described by Circuit Judge Diane Wood,

Notably, the plaintiffs have not urged us directly to review the district court’s assessment of the legal sufficiency of their complaint,and so we do not have any issue before us that we review de novo and we need not again consider the standards for pleading a securities fraud case. Instead, each of the rulings before us is one that lies within the district court’s discretion, and our review is deferential.

Judge Wood recognized that while many courts freely allow amendments in securities cases due to the demanding PSLRA pleading standards, she observed that "each case must be evaluated on its own merit, in light of its own procedural history." She concluded that the "district court was entitled to view this case as one in which the plaintiffs had, as a practical matter, a number of opportunities to craft a complaint that complied with the standards of the PSLRA...and was therefore entitled to bring this litigation to a close with a dismissal with prejudice."

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Conference Focuses on Litigation Trends

by Rodney Tonkovic
Associate Writer-Analyst
CCH Federal Securities Law Reporter


The Practising Law Institute recently hosted its annual Securities Litigation and Enforcement Institute in San Francisco, California. Several of the panelists described the current litigation environment as a "brave new world" brought on by the global financial crisis. Co-Chair Jerome F. Birn, Jr. of Wilson Sonsini Goodrich & Rosati in Palo Alto noted that it had been "an extraordinary year" and pointed to the "new genre" of market-meltdown cases.

Jonathan C. Dickey of Gibson, Dunn & Crutcher in New York discussed subprime litigation, stating that definitive guidance on the direction of the cases would not be available for "a year or two." He noted that asset management firms have become the largest group of defendants and that "the diversity and sheer heft of the cases has become enormous." Blair A. Nicholas of Bernstein Litowitz Berger & Grossman in San Diego then described the increasing involvement of foreign institutional investors and European courts in investor litigation.

During a morning session discussing current developments in litigation, panelists discussed the re-emergence of the core operations doctrine. However, Co-Chair David Siegel of Irell & Manella in Los Angeles cautioned that "what judge and what panel you draw in the 9th Circuit is a better predictor" of how the inference will be applied than precedent.

While discussing trends in pleading standards, Mr. Dickey expressed hope that the Supreme Court will clarify what will trigger inquiry notice with respect to the distinction between the Securities Act and the Exchange Act when it rules on the Vioxx shareholder litigation. Mr. Dickey also said, in reference to trends in loss causation, that "a lot of the action in loss causation is outside of the 9th Circuit" and noted the 5th Circuit's narrow view of securities class action pleading with the caveat that few circuits agree. Mr. Dickey believes that the best strategy to follow is to work closely with experts and "front-end load" on loss causation.

Sherrie R. Savett of the Philadelphia firm of Berger & Montague described how rating agencies are, for the first time, exposed to liability. She explained that the agencies had previously been protected under the 1st Amendment as issuing opinions, but that changed when subprime issuers began paying for ratings.

In the afternoon session discussing the involvement of and how to deal with the government, Marc J. Fagel, Regional Director of the SEC's San Francisco office and Doug Sprague, Chief of the White Collar Crime Section of the Northern District of California's U.S. Attorney's Office both noted the recent rise in the number of Ponzi schemes. Both Mr. Fagel and Mr. Sprague described changes made in order to speed up the investigative process and reduce bureaucratic roadblocks. Mr. Fagel forecast an increase in the number of subprime and market crisis-related cases in the next year, while Mr. Sprague expects to focus on corporate and securities fraud.

Mr. Fagel also discussed the role of the SEC in investigating insider trading and said that referrals from exchanges are "constantly going up." He noted concerns with respect to misappropriation by friends and family members as well as the need to look closely at the role of gatekeepers.

Co-Chair David Siegel of Irell & Manella in Los Angeles concluded the program by pointing out that the government currently has a "controlling" role and that it is “increasingly a player in its own right.” Government intervention is now routine and, Mr. Siegel predicted, in the form of investigations by the Commission and the initiation of more criminal actions, will increase.


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Sunday, October 25, 2009


Senior Senate Democrat Asks How Treasury Can Support House Derivatives Legislation

In a letter to Treasury Secretary Tim Geithner, Senator Maria Cantwell expressed severe disappointment in Treasury's support for the OTC Derivatives Markets Act reported out of the House Financial Services Committee with what the senator called large loopholes that would allow financial firms to continue unregulated derivatives trading. Specifically, she questioned an exception from the mandatory clearing and exchange trading requirements for standardized swaps when one of the counterparties is not a swap dealer or major swap participant. She also queried the Act's definition of major swap participant, which the senator characterized as so broad as to include a large universe of companies and financial firms and thus also extend to them the exemption from the mandatory clearing and exchange trading requirement. She also decried an exemption in the legislation for foreign exchange trades and dealing on overseas exchanges by US counterparties. Finally, the senator said that empowering clearing organizations rather than their SEC or CFTC regulators to determine which transations should be cleared would essentially allow them to determine which transactions should be executed on regulated exchanges.


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Friday, October 23, 2009

Utah Proposes IA licensing Exemption

An exemption from licensing for investment advisers and investment adviser representatives was proposed by the Utah Securities Division, along with an amendment to the number of working days the disclosure statement for a coordination registration must be filed with the Division to take effect in the State, the elimination of references to notification registration and the repeal of a definitions rule.

For additional information please see
here.

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Wednesday, October 21, 2009

House Derivatives Legislation Represents Compromise with Moderate Democrats; Ag Committee Approves Legislation

The OTC Derivatives Markets Act, HR 3795, that was favorably reported out of the House Financial Services Committee is a consensus-based piece of legislation representing significant input from moderate Democrats. Members of the New Democrat Coalition worked with Chairman Frank to bring this legislation to fruition. The legislation incorporates provisions from the Derivatives Trading Accountability and Disclosure Act HR 3300, which was backed by the New Democrat Coalition.

The House bill would exempt end users that use derivatives to hedge risk or engage in other risk management tools from margin or capital requirements. This is in keeping with the Coalition's goal of protecting end users seeking to hedge their risks. The legislation would also expand the definition of swap dealer to include entities that not only buy and sell derivatives but those that engage in trades. This provision will allow the prudential regulator to identify and address the derivatives trading activities of large financial institutions. The measure would mandate clearing for standardized derivatives products between major swap participants that pose a systemic risk to the financial system. This builds on the Administration's goal of reducing systemic risk to the financial markets, a goal also endorsed by the Coalition.

Rep. Michael McMahon (D-NY), a leader of the New Democrat Coalition, said that the legislation reported out under Chairman Frank's leadership addressing systemic risk in the OTC derivatives markers while preserving the OTC market for specialized products.

The House Agriculture Committee has also approved HR 3795, with multiple changes pursuant to a Manager's Amendment offered by Committee Chairman Collin Peterson. The Ag Committee changed the name of the legislation to the Derivative Market Transparency and Accountability Act of 2009. The Ag version of the legislation also provides an exemption for commercial end users to use derivatives to hedge their risk. It also establishes an SEC-CFTC bifurcated regime for the regulation of the OTC derivatives markets. The SEC would have exclusive jurisdiction over security-based swaps.

The Peterson amendment adds a new section to the legislation essentially prohibiting the federal bailout of a Securities Exchange Act derivatives clearing agency or a Commodity Exchange Act derivatives clearing organization.
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NASAA Issues Reminder About U4 Disclosure Deadline
The North American Securities Administrators Association (NASAA) issued a reminder today that November 14, 2009, is the effective date for completion of the six regulatory action disclosure questions that were added to the Form U4 on May 18, 2009. NASAA reminded investment adviser firms that they must file amended Forms U4s for all of their investment adviser representatives in order to provide answers to these new disclosure questions regarding willful violations (i.e., Questions 14C (6), (7) and (8) and Questions 14E (5), (6) and (7)).

According to the release, firms must file any required amendments via the Investment Adviser Registration Depository (IARD) by 11 p.m. Eastern Time, November 13, 2009. If a firm determines that a registered person must answer “yes” to any of the new regulatory action disclosure questions, it should ensure that the disclosure reporting pages are complete for the amended filings. NASAA stated that the IARD will not be available for form filings on Saturday, November 14, 2009.

NASAA also reminded firms that any provisional “no” answers filed between May 18 and November 14, 2009, that are not amended prior to the deadline will become final, and the firm and investment adviser representative will be deemed to have represented that the person has not been the subject of any finding addressed by the new disclosure questions. Accordingly, firms should be certain that these responses represent the final response for an individual or update any such provisional “no” response by 11 p.m. Eastern Time, November 13, 2009.


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Tuesday, October 20, 2009

Financial Stability Board Becoming International Coordinator of Financial Reform Legislation

All major participants in financial reform, including the Obama Administration, the EU, and the G-20, all agree that the financial crisis was global and that the reform legislation must be globally coordinated. Since there seems little possibility of an international treaty, given sovereignty concerns, there is a strong consensus that the Financial Stability Board must be the entity that coordinates a global legislative and regulatory response.

The Obama Administration’s blueprint for reform and the G-20 have both endorsed the FSB for this international role. It is envisioned that the FSB would operate through the adoption of principles, such as the principles adopted by the Board on executive compensation, and would also monitor the consistency of legislation and regulations. But these goals may be somewhat problematic.

Even given the consensus-based approach involving the relevant national authorities, some subjects will simply be very difficult to handle fully in this fashion. Cross-border resolution may be one such issue, in the view of Fed Governor Daniel Tarullo. The Obama Administration has proposed legislation creating a resolution authority to wind down failed securities and commodities firms. International coordination of this legislation may prove difficult, said the Governor, due to differing bankruptcy laws.

There will likely be a period of working out the relationships among the various international bodies, particularly in light of the increased role of the FSB. Congress and other bodies will need to determine how extensively the FSB and its newly constituted committees should themselves develop standards, particularly where an existing international standards-setting body has the expertise and mandate to address the topic. Similarly, while simultaneous consideration of the same issue in multiple international bodies can sometimes be a useful way to develop alternative proposals, there is also the possibility that differing approaches may develop.

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Thursday, October 15, 2009

House Financial Services Committee Approves Legislation Regulating OTC Derivatives Markets

The House Financial Services Committee has approved legislation that would, for the first time ever, require the comprehensive regulation of the over-the-counter (OTC) derivatives marketplace. The OTC Derivatives Markets Act of 2009 (HR 3795), which was approved by a vote of 43-26, represents a key part of a broader effort by Congress and President Obama to modernize America’s financial regulatory system in response to last year’s financial crisis

Introduced by Rep. Barney Frank, Chair of the Financial Services Committee, the legislation would mandate exchange clearing and trading for the majority of derivatives products, while preserving the over-the-counter market for specialized derivatives. The legislation is designed to implement the broad goals of the Obama Administration to increase transparency and eliminate systemic risk in the OTC derivatives markets while at the same time protecting end users seeking to hedge their risks and preventing much of the U.S. derivatives market from being forced overseas.

Three amendments to HR 3795, sponsored by Ranking Member Spencer Bachus were accepted by the committee. The Bachus amendments would extend the rulemaking implementation period of the legislation from 180 days to 270 days after enactment, provide the SEC and the CFTC with exemptive authority similar to current law; and prevent taxpayer funded bailouts of derivatives clearinghouses. All three amendments were accepted by voice vote.


Under the bill, all standardized swap transactions between dealers and large market participants, referred to as “major swap participants,” would have to be cleared and must be traded on an exchange or electronic platform. A major swap participant is defined as anyone that maintains a substantial net position in swaps, exclusive of hedging for commercial risk, or whose positions creates such significant exposure to others that it requires monitoring. OTC derivatives include swaps, which are contracts that call for an exchange of cash between two counterparties based on an underlying rate, index, credit event or the performance of an asset.

The legislation then sets out parallel SEC-CFTC regulatory frameworks for the regulation of swap markets, dealers, and major swap participants. Rulemaking authority is held jointly by the CFTC, which has jurisdiction over swaps, and the SEC, which has jurisdiction over security-based swaps. The Treasury Department is given the authority to issue final rules if the CFTC and SEC cannot decide on a joint approach within a certain time period. Subsequent interpretations of rules must be agreed to jointly by the Commissions.

The legislation provides a mechanism to determine which swap transactions are sufficiently standardized that they must be submitted to a clearinghouse. For transactions that are clearable, clearing is a requirement when both counterparties are either dealers or major swap participants. Clearing organizations must seek approval from the SEC or CFTC before a swap or class of swaps can be accepted for clearing. Transactions in standardized swaps that involve end-users are not required to be cleared. Such customized transactions must, however, be reported to a trade repository.

A standardized and cleared swap transaction where both counterparties are either dealers or major swap participants must either be executed on a board of trade, a national securities exchange or a swap execution facility, which is defined in the legislation. If none of these venues makes a clearable swap available for trading, the trading requirement would not apply. Counterparties would, however, have to comply with transaction reporting requirements established by the SEC or CFTC. The legislation also directs the regulators to eliminate unnecessary obstacles to trading on a board of trade or a national securities exchange.

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Government Brief Defends SEC Appointment of PCAOB Members Against Constitutional Challenge

The merits brief filed by the Government in the Supreme Court case challenging the constitutionality of the PCAOB contends that the fact that the Sarbanes-Oxley Act empowered the SEC rather than the President to appoint Board members did not violate the Appointments Clause of the US Constitution. PCAOB members are inferior officers not superior officers, argued the government, and the Constitution allows Congress to vest the appointment of inferior officers in Heads of Departments and the SEC qualifies as such. The government also said that the audit firm’s failure to fully exhaust special Exchange Act review procedures barred the district court from exercising jurisdiction over the firm’s challenge to the Board’s constitutionality.

The case, brought by an audit firm, is before the Supreme Court on a grant of certiorari of a split panel ruling of the DC Circuit Court of Appeals that the PCAOB’s creation was constitutional. The Supreme Court will hear oral arguments on December 7, 2009 and a decision is expected during this term. (Free Enterprise Fund and Beckstead & Watts v. PCAOB, Dkt. No. 08-861).

When it passed Sarbanes-Oxley in 2002, noted the brief, Congress set up a regime under which the SEC would have comprehensive overview and control of the Board and its activities. For example, the Board’s rules only become effective upon SEC approval, noted the brief, and the SEC may amend or even abrogate those rules at any time. The SEC can review, reject or modify all disciplinary actions of the Board. Having no subpoena power of it own, the Board must seek an SEC subpoena in aid of its investigations, thereby ensuring SEC control over the investigations. The SEC also has sweeping authority to rescind any aspect of the Board’s enforcement authority at any time. Finally, the SEC is authorized to approve the Board’s budget. Thus, the government reasoned that Board members are not principal officers who wield power comparable to SEC Commissioners; and therefore the Appointments Clause does not require that they be appointed by the President.

They are inferior officers that can be appointed by Heads of Departments. The Appointments Clause contemplates that Heads of Departments can be collective bodies like the SEC

The government also said that the audit firm’s failure to fully exhaust special Exchange Act review procedures barred the district court from exercising jurisdiction over the firm’s challenge to the Board’s constitutionality. These special procedures give the SEC a chance to address relevant legal issues in an order or ruling, which is subject to direct review by a federal appeals court. The audit firm bypassed this procedure and directly challenged the Board in district court. That course, argued the brief, was contrary to the bedrock principles of judicial review of administrative action. The government thus contended that, since the firm’s failed to pursue the express statutory mechanism Congress established for challenges to Board actions, the district court could not properly exercise jurisdiction over their suit.

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McCreevy Sees Transatlantic Consensus Building on Legislation Regulating Derivatives

There is a transatlantic consensus building on the contours of legislation regulating derivatives as the US House Financial Services Committe marks up the OTC Derivatives Markets Act and the European Commission reviews over 100 comments on its derivatives regulation proposal. In remarks at a recent derivatives conference in Brussels, Commissioner for the Internal Market Charlie McCreevy said that there is a broad cross-border consensus that standardized OTC derivative products should be cleared as far as possible by central clearinghouses and that central data repositories should enable regulators to get a complete overview of where the risks are in the system. For those segments of the market that may not fit central counterparty clearing because they are too bespoke, he noted, bilateral clearing should be tightened and made more secure.

Heeding the urgent call of Commissioner McCreevy, the derivatives industry has already begun to implement the clearing of credit default swaps on a European central counterparty, pending a more complete review of the whole derivatives area. Two European central counterparty clearing entities, ICE Europe and Eurex, have began clearing credit default swaps in the EU.

The question now is how to expand the use of central counterparties beyond credit default swaps. Chairman McCreevy suggested that the Commission could provide incentives through regulatory capital, or could simply mandate the use of central counterparty clearing. There is also the issue of how central counterparties should be regulated in the single market, bearing in mind their systemic relevance.

A similar question exists regarding the use of central data repositories. For example, should the use of repositories be incentivized or mandated by law, and how should the Commission ensure data quality and also ensure equal access of regulators to the stored data.

Another area the Commission will examine is bilateral clearing: Central counterparty clearing can only cover a subset of the market. Some derivatives are too bespoke to be centrally cleared. If the Commission incentivizes the use of central counterparty clearing, noted Mr. McCreevy, that will make bilateral clearing more costly. Or put more bluntly, bilateral clearing will reflect better the social cost of counterparty risk, which is now partly borne by the taxpayer. One approach might be stricter collateral requirements, said the commissioner, while another could be raising the regulatory capital cost for bilaterally-cleared products. A final concern, and a very important one, is how to incentivize standardization of derivatives without stifling innovation.

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Wednesday, October 14, 2009

US Supreme Court to Decide Fate of Honest Services Fraud, Linked to Duty of Loyalty

Senior corporate officers have gained Supreme Court review of their convictions that were partially based on a scheme to deprive the company and its shareholder of their right to honest services. The trial court explained that to show guilt under the honest-services theory the government had to prove that the senior officers misused their positions for private gain by knowingly and intentionally breaching their fiduciary duty of loyalty. Black v. US, 08-876. The case is due to be argued before the Supreme Court in December. The Court has also agreed to review another case that questions the constitutional vagueness of the honest services statute. Skilling v. US, 08-1394.

Section 1346 of the US Code prohibits schemes to deprive another of the intangible right of honest services, thereby defining a fraud offense in the deprivation of the right to honest services. The government’s merits brief pointed out that honest services fraud requires a breach of the duty of loyalty, carried out with an intent to deceive, on a material matter. The jury instructions in this case embodied those requirements, said the brief, because they required an intentional breach of the fiduciary duty of loyalty, committed with intent to defraud and involving material omissions or misrepresentations.

Under Delaware law, the duty of loyalty requires that a corporate fiduciary act with undivided and unselfish loyalty, with no conflict between duty and self-interest. The duty of loyalty mandates that the best interest of the company and its shareholders take precedence over any interest of an officer or director.

Properly construed, argued the government, the elements of Section 1346, breach of duty of loyalty, intent to deceive, and materiality, limit its application and provide intelligible bounds. Honest services fraud bleeds into money or property fraud when disclosure of a breach of duty of loyalty would lead the principal to seek a more advantageous financial deal. In this case, noted the brief, had the senior officers disclosed to the company’s audit committee and board of directors that the recharacterization of management fees would net the defendants a higher after tax income, the committee or the board might have decided that this increase in the value of the fees to them warranted a reduction in the size of the fees.

By limiting actionable honest-services schemes to those involving undisclosed breaches of the duty of loyalty, said the government, Congress ensured that Section 1346 does not criminalize all manner of dishonesty. For example, the statute does not cover the employee who phones in sick so he or she can go to a ball game. Instead, the statute criminalizes only schemes in which an employee or public officer secretly takes official action to further their own interests while pretending to act in the interests of those to whom they owe a duty of loyalty.

The petitioning senior officers argued in their brief that the jury was allowed to convict even if it found that they sought a lawful tax benefit in another country, with no contemplated detriment to their employer, but in the process fell short of complying with their Delaware-law duty of loyalty to the company. That anyone could even consider such conduct to be a federal crime, said the brief, is the unfortunate consequence of Congress’ decision some twenty years ago to expand the definition of a scheme to defraud to include the vaguest of terms: encompassing any plan to deprive another of the intangible right of honest services. According to the corporate officers, the government has stretched this malleable phrase, unknown in the common law, far beyond the public corruption context that gave rise to its enactment, treating the statute as an invitation for federal courts to develop a common-law crime of unethical conduct.

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US Hedge Fund Industry Concerned about EU Proposed Hedge Fund Directive

The Managed Funds Association, a US and global hedge-fund industry association, has added its voice to the growing chorus of industry groups and policy makers critical of the European Commission’s proposed Directive on the regulation of hedge fund managers. In a comment letter to the Commission, the MFA expressed concern about the degree to which the Directive would interfere with existing efficient market practices and the unintended consequences it would have on hedge fund managers and European investors.

The proposed Directive on Alternative Investment Fund Managers, centered on enhanced disclosure and effective risk management, is designed to create a comprehensive and effective regulatory framework for hedge and private equity fund managers at the European level. The proposed Directive would provide harmonized regulatory standards for all alternative investment funds within its scope and enhance the transparency of the activities of the funds towards investors and public authorities. The draft proposes regulations that will affect, among others, the European hedge fund, private equity, and venture capital industries.

MFA responded to a call for evidence regarding the Directive with a twelve-page comment letter cautioning, among other things, that the Directive “would interfere with efficient market practices without justification” and would both obstruct hedge-fund managers and limit the choices of EU hedge-fund investors.

The comment letter stressed the significant role hedge funds play in the global financial system, particularly by providing liquidity and price discovery to capital markets, capital to businesses, and diversification to investors to reduce overall investment risk. While acknowledging that the hedge-fund industry as a whole is systemically relevant, the MFA emphasized that hedge funds did not cause the global financial crisis and did not cause systemic risk.

The MFA noted that hedge funds’ borrowings from banks and brokers are collateralized, that hedge funds do not provide banking or similar services to the public, and that, notably, contrary to popular perception that apparently carried over into the text of the Directive, hedge funds are not highly leveraged. The comment letter cites studies finding that hedge funds have had a leverage ratio of, on average, two or three to one and that more than 25 percent of hedge fund managers reported using no leverage.

As such, the comment letter objects to the Directive’s figure of one times capital (a two-to-one leverage ratio) as the threshold for what constitutes a high level of leverage on a systemic basis. More broadly, the MFA objected to any strict limitation on the amount of leverage a hedge fund may employ. Noting that one of the stated purposes of the Directive was to focus on issues inherent to the hedge-fund industry, the MFA protested that there should not be restrictions on the use of leverage outside of more general systemic-risk regulation that would affect all market participants, including banks, in light of the fact that the risks associated with leverage are not specific to hedge funds.

For similar reasons, the MFA opposed the Directive’s requirement that a fund manager make certain disclosures when one of its funds acquires 30 percent or more of the voting rights in a company—a requirement that does not apply to other types of market participants.

The comment letter also objected to the initial capital requirement contained in the Directive, protesting that it may be a barrier to new entrants, is a static approach that does not consider whether the fund manager’s obligations increase along with assets under management, and would not be geared to the fund manager’s risks or expense obligations. Furthermore, the capital requirement fails to allow for the fact that, in practice, many of the management risks in the industry are contractually borne by the fund itself and not by the fund manager.

The comment letter also expressed concerns regarding some of the Directive’s requirements for third parties and its restrictions on non-EU funds and managers. The MFA argued that the Directive’s requirement that a fund manager hire a third-party valuator would bypass managers’ own expertise and may give investors a false sense of security about the resulting valuations. Because European hedge funds typically hire independent third-party administrators, the valuator requirement would increase costs without a corresponding improvement in independence (assuming that there are parties willing and able to act as valuators at all).

Similarly, the restrictions on depositaries under the Directive, particularly the requirement that depositaries be EU-authorized credit institutions and the increased standard of liability that they would be subject to, would limit the number of available custodians and lead to a corresponding cost increase for funds’ investors. The requirement to use an EU-authorized depositary also ignores the “integral” existing practice of maintaining custody of fund assets with the manager’s prime broker.

The MFA also found the disclosure requirements of the Directive problematic. Any sensitive information required to be disclosed to regulators should be kept confidential, it explained. Furthermore, disclosure of side letters should be required only where the side letters would have a material effect on other investors, and the identity of investors subject to the side letters should be kept confidential.

Finally, the MFA echoed recent comments by the Mayor of London expressing concern about the effect of the Directive on competitiveness among hedge funds in the global marketplace. Because the Directive prohibits unauthorized fund managers from managing funds domiciled in the EU and does not permit a non-EU manager to seek authorization, it effectively prohibits a non-EU manager from managing an EU fund. Additionally, the Directive permits only a very limited power of delegation from an EU manager to a non-EU manager.

These limitations, the letter argues, would cause difficulties for many managers with global operations. Furthermore, the Directive restricts non-EU managers from marketing non-EU funds to European investors. The comment letter also expressed some ambivalence about the passporting provisions of the Directive. While passporting would standardize currently disparate offering and compliance processes, it would restrict marketing in some countries that currently have broader laws.

My compliments to my colleague Anne Sherry for this post.

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Tuesday, October 13, 2009

EU Central Banker Applauds Derivatives Regulation as Key to Containing Systemic Risk

As legislation regulating the OTC derivatives markets advances in the EU and the US Congress, a member of the European Central Bank said that it is critical to regulate the market for credit default swaps since it is systemically important. In remarks at an ECB workshop at Frankfurt am Main, Gertrude Tumpel-Gugerell said that the default of one major counterparty can put the whole financial system under severe strain.

Thus, legislation establishing central counterparties for credit default swaps is crucial in order to address the high degree of interconnectivity between credit default swap markets and credit and cash securities markets, as well as the high leverage embedded in these financial instruments and the significant concentration of related risks in a small group of major market players. In her view, the effective implementation of central clearing of derivatives will facilitate a significant reduction in counterparty risk, thereby addressing some of the negative externalities that stem from the over-the-counter network that has formed over the years.

More broadly, the central banker praised the draft legislation in the US and EU creating a systemic risk regulator. A European Systemic Risk Board will be established with the mandate to map financial risks and their concentration at the system level for macro regulation of systemic stability. A similar council of financial regulators, including the SEC and the Fed, seems likely to be created in the US.

The central banker defined systemic risk as the possibility that a triggering event such as the failure of a large financial institution could cause widespread disruption of the financial system, including significant difficulties in otherwise viable institutions or markets. An important aspect of the analysis of systemic risk is that an apparently robust system may in fact be very fragile. This comes from the fact that a high number of interconnections within the network will serve as shock-amplifiers rather than as absorbers.

According to the central banker, critical to the success of the systemic risk regulator will be network analysis that can identify linkages between market participants. Network analysis offers a relevant tool for focusing on interconnectedness and on systemically important market players. For example, network analysis can help the systemic risk regulator understand the systemic connections in many different segments of the financial markets, ranging from money markets to networks of credit default swaps, and from large-value payment systems to cross-sector exposures in the euro area financial system.

Network analysis is also crucial for the identification of systemically important financial institutions and markets which are critical market players in the web of exposures. A particular financial institution might not only be critical to the functioning of financial markets because other institutions are financially exposed to it, she noted, but also because other market participants rely on the continued provision of its services.

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NASAA Announces Waiver of IARD System Fees

The North American Securities Administrators Association (NASAA) has announced that it will waive the initial set-up and annual system fees paid by investment adviser firms and investment representatives to maintain the Investment Adviser Registration Depository (IARD) system.

In a news release today, NASAA President Denise Voigt Crawford said that the IARD system’s continued success will allow NASAA to maintain the system fee waivers put in place in 2005 for investment adviser firms and also to fully waive for a second year the system fees paid by investment adviser representatives.

According to the release, NASAA’s Board of Directors will continue to monitor the system’s revenues to determine whether future fee adjustments are warranted.

Monday, October 12, 2009

SEC Asks for Changes to House Draft Derivatives Legislation to Prevent Regulatory Arbitrage

While praising the House Financial Services Committee’s draft legislation to regulate the OTC derivatives markets, the SEC warned that the draft could present opportunities for significant regulatory arbitrage. In testimony before the committee, Henry T.C. Hu, Director of the Risk, Strategy and Financial Innovation Division said that the draft adopts a distinction that is not meaningful between derivatives referencing a single security or a narrow-based index of securities and derivatives referencing a broad-based index of securities. The SEC cautioned that a market participant could use a broad-based swap as part of a strategy to gain highly targeted exposure to a single company or a narrow group of companies.

In addition, the draft could result in regulatory differences between swaps products and currently regulated securities and futures products. For example, energy swaps would not be regulated in the same way as energy futures, he noted, and securities swaps would not be regulated in the same way as securities. The differences come from the fact that the draft sets up a new regulatory scheme for swaps and securities swaps.

Focused as it is on minimizing differences in the regulation of swaps and security-based swaps, this scheme would be different from the regulations applicable to securities or futures. In the SEC’s view, this is significant because market players evaluating whether to engage in a swap transaction are far more likely to focus on the choice between a swap and a regulated alternative.

These differences could perpetuate regulatory arbitrage that encourages the migration of activities from the traditional regulated markets into the differently regulated swaps markets. The SEC asked Congress to modify the draft so that all securities-related OTC derivatives are regulated more like securities; and commodity and other non-securities related OTC derivatives are regulated more like futures.

The SEC’s concern is compounded by the fact that the draft revises the Securities Act to include security-based swaps in the definition of security but does not make the corresponding change in the Exchange Act. The SEC urged Congress make the change because including security-based swaps in the 1934 Act is necessary to reduce regulatory arbitrage and bestow Rule 10b-5 antifraud protections on these markets.

Provisions in the draft calling for the SEC to adopt business conduct rules do not fill the gap since the rules would relate only to the conduct of security-based swap dealers and major security-based swap participants and would not reach brokers who sell security-based swap to retail investors. Such brokers would not have to register with the SEC or be required to become FINRA members. Including security-based swaps in the 1934 Act would also give the SEC the tools to oversee the exchange trading of such instruments.

Similarly, inter-dealer brokers would remain outside the regulatory framework, said the SEC, and they are important players in the OTC derivatives markets, with most credit default swaps done through such brokers. Adding security-based swaps to the definition of security would ensure that the SEC can oversee these players.

The draft contains an abusive swap provision allowing the SEC and the CFTC to jointly prohibit swap transactions detrimental to market stability or to market participants. This could be a useful regulatory tool, said the SEC, but Congress should consider how regulators would quantify the destabilizing effects of the derivatives and balance the tension between the destabilizing effects on the entire financial system and large individual participants; and make determinations for products that are both useful and potentially destabilizing. There must be a process for the determination since other regulators might not agree with a decision and there could be a conflict between the SEC and CFTC. Congress may want to consider giving this authority to the Financial Stability Oversight Council instead of to the SEC and CFTC.

Since regulation of major swap participants and dealers is vital to the new OTC regulatory regime, Congress must take care not to allow entities using swaps as risk management tools to fall outside the scheme. The Treasury draft defined a major security-based swap participant as any non-dealer maintaining a substantial net position in outstanding swaps other than to create and maintain an effective hedge under GAAP. The House draft is broader and excludes those who hold position for risk management purposes. The SEC said that the term ``risk management’’ is ambiguous and its use could cause many important entities to fall outside the new regulation. The SEC urged Congress to adopt a more narrow and objective standard more consistent with the legislative purpose.

The draft has an overly broad definition of swap that could include products and transactions already subject to federal and state securities regulation, including investment contracts, some stock options, and security forwards. The SEC sees no benefit in including instruments already subject to the full panoply of securities regulation in the definition of swap. Thus, Congress is urged to clarify that such products or transactions do not fall within the Act’s definition of swap.

The draft’s exclusion of identified banking products from OTC derivatives regulation could allow foreign banks not subject to oversight by a federal banking regulator to offer derivatives products in the US in the guise of banking products. Congress was urged to clarify that the exclusion is not available to foreign banks that are not subject to federal banking regulation.

The draft would create a new category of mixed swaps where dual SEC-CFTC regulation would apply to swaps that are both security and non-security based. The SEC is concerned that even quintessentially security-based swaps could be deemed mixed swaps under this rubric. For example, a marker player entering into an equity swap with a synthetic substitute for owning the shares will often have to make either fixed or floating rate interest payments to the derivatives dealer providing the swap. Under the draft’s proposed definition of mixed swap, the mere fact of the interest rate payments being on a floating basis could cause the swap to be a mixed swap subject to joint SEC-CFTC oversight. The SEC urged Congress to clarify that a swap is not considered a mixed swap merely because it has a floating interest rate component or a foreign currency component.

The SEC fears that the draft would establish a joint rulemaking process with the CFTC that would be hard to implement. The draft places important definitions of security-based swaps within the Commodity Exchange Act. This would establish a rulemaking process undercutting the SEC’s ability to interpret terms in response to market and regulatory developments. If Congress insists on using joint rulemaking, said the Director, it should put all definitions in the text of the legislation itself with cross references to the securities and commodities laws.

The financial crisis taught that less sophisticated institutions need protection from abusive practices by their swap intermediaries through improved business conduct standards. The Treasury draft would require the SEC and CFTC to adopt business conduct rules for dealers and major participants in the OTC derivatives markets. Congress should also direct the SEC and CFTC to adopt more protective rules when a swaps dealer is selling OTC derivatives to the less sophisticated.

Also, Congress should revise the qualification standards for participation in the OTC derivatives markets, The standards for being an eligible contract participant under the Treasury draft are important because only such participants may trade OTC derivatives. All other participants must trade on exchanges. Thus, the SEC urged Congress to raise the qualification standards for a governmental entity, such as a municipality, to quality as an eligible contract participant.

Currently, the SEC believes that exchange-traded credit default swaps on securities are securities whether on one security or a basket of securities. In order to reduce the opportunity for regulatory arbitrage, Congress is asked to clarify that the definition of security-based swap includes broad-based index credit default swaps as well as single name and narrow-based index credit default swaps.

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UK FSA Official Criticizes Protectionist Nature of EU Hedge Fund Directive

While generally supporting the European Commission’s proposed Alternative Investment Fund Managers Directive, FSA Asset Management Division Leader Dan Waters said that the Directive must embrace a global approach that recognizes the cross-border nature of the hedge fund industry and does not restrict investor choice with unjustifiable geographic restrictions. At a hedge fund regulation forum, he called ``misplaced’’ the Directive’s restrictions on the delegation of management services, custody and depositary activity. He similarly scored the blanket prohibitions on the marketing of non-European funds to professional investors.

The FSA leader noted that the UK has successfully permitted non-EU funds of various types to be marketed locally for a number of years. At the same time, the FSA has banned the marketing of hedge funds to the retail market, while permitting them to be marketed to institutional and sophisticated investors and sold on an advisory basis. The FSA believes that this approach provides an appropriate level of investor protection without unduly restricting investor choice and access to specific investment management expertise.

He contended that the proposed ban on non-EU funds and managers would restrict the access of European investors to valuable markets without justification. This radical departure from current arrangements would also create real practical problems for investors and limit their ability to benefit from the diversification offered by the alternative investment fund sector. The problems and complexity with these proposals would be exacerbated by the proposed restriction on the marketing of non-EU managed or domiciled funds three years after the date for Directive transposition.

In addition, the scope of hedge fund marketing under the Directive includes the situation where the investment is made at the initiative of the investor. The result of this would place a non-EU investment manager in breach of the Directive as a result of accepting an investment from an EU investor. The proposed Directive is protectionist, emphasized the official, and invites retaliation from other global markets.

Further, the Directive would only allow an EU credit institution to perform the custodian or even sub-custodian function. This would concentrate custody risk in the hands of a small group of institutions, reduce competition, and would not fit with the current legitimate population of prime brokers, few of which are EU credit institutions.

The FSA does not believe that the depositary function needs to be restricted to EU credit institutions. Prime brokers and investment banks should continue to be able to provide this service as long as they are suitably regulated. Requiring the depositary to be an EU credit institution and restricting delegation only to other EU credit institutions would effectively prevent alternative investment funds of all types from investing in non-EU markets with local custody requirements. The use of multiple prime brokers with depositary functions might also be difficult.

While agreeing with the Commission that regulators need to do more to control the risks of excessive leverage, the FSA official said that imposing arbitrary leverage caps on hedge funds is a simplistic approach that would not capture the fact that leverage can take many forms. Instead, the FSA urged the Commission to empower regulators to intervene in a tailored way when they identify particular risks.

The US Congress has not yet finalized draft legislation regulating hedge fund managers, noted the FSA official, but seems likely to incorporate manager authorization and disclosure requirements to the SEC. Both these are already in place in the UK. Congress appears to have no intention of following the more onerous protectionist elements of the proposed Directive with regard depositary requirements, leverage caps, and delegation restrictions.

With regard to the disclosure by hedge funds of systemically important information, said the senior official, the FSA is working with the SEC to identify a common, coherent set of data to be collected from hedge fund advisers and managers. As regulators of the financial centers in which the vast majority of hedge fund assets are managed, said the FSA official, the SEC and FSA will harmonize the collection and sharing of this information in order to reduce the compliance burden on fund managers while allowing the agencies to better identify risks to their regulatory objectives and mandates.

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Friday, October 09, 2009

Hedge Fund Industry Supports House Draft Legislation Regulating OTC Derivatives Markets

The hedge fund industry has expressed qualified support for the House Financial Services Committee draft legislation regulating the OTC derivatives markets. In testimony before the committee, the Managed Funds Association expressed full support for the broad goals of the Over-the-Counter Derivatives Markets Act of 2009 to reduce systemic risk through the use of central clearing houses, the segregation of customer collateral by central clearing houses, and by providing customers with the option of having their collateral for customized swaps segregated. The MFA also endorsed provisions increasing transparency through trade and position reporting and providing the government with additional authority to avert and respond to economic or financial turmoil without disrupting ordinary market operations. The draft is being circulated by Barney Frank, the committee Chair. It is expected to be marked up in October.

The MFA favors the registration and regulation of swap dealers along the lines provided by the draft, with oversight of swap dealers consistent with the oversight of securities dealers. Also, registration and regulation, such as trade and position reporting, will largely close the regulatory gaps that currently exist in the OTC derivative markets since most swaps transactions are effected with a swap dealer. In particular, the reporting requirements imposed on swap dealers will help assure that all material information is available to the SEC and CFTC.

Calling the term “substantial net position” overly broad and subjective, the trade group urged Congress to direct the SEC and CFTC to publish objective standards for purposes of defining a “substantial net position” in order to provide market participants with a clear understanding of the regulatory boundaries for becoming a major swap participant. The SEC and CFTC should be directed to consider the relative net position of swap dealers, the participant’s average net position over a relative period of time, such as a year, whether the participant’s counterparties have a substantial unsecured credit exposure to such participant from outstanding swaps, whether the participant holds assets belonging to retail customers; and whether the participant is an existing registrant with either the CFTC or SEC.

The draft authorizes the SEC and CFTC to ban abusive swaps. The MFA fears that the authorization is overly broad and vague, and lacks clear statutory and public policy goals. The use of a swap to manipulate the market is more appropriately addressed through the current antifraud and anti-manipulation authority of the SEC and CFTC.

The MFA has strong concerns with draft provisions authorizing the SEC and CFTC to impose position limits in the swap markets. The statutory purpose or public policy objective behind position limits is unclear, said the MFA, and the draft does not provide the SEC and CFTC with adequate guidance as to the policy objectives behind position limits. Position limits do not address systemic risk concerns, noted the MFA, which can be addressed through capital and margin charges. More generally, the MFA believes that position limits should only be imposed for physically-delivered commodities and only where the deliverable supply of the commodity is limited and, thus, subject to control and manipulation.

The MFA supports the draft provision requiring swap dealers to offer customers the availability of collateral segregation. The group believes that the benefit that the financial system will derive from the mandatory clearing of standardized products will be substantially multiplied if consistent protections are at least made available with respect to non-cleared products.

According to the MFA, the draft does not go far enough in promoting the use of clearing organizations to clear standardized OTC derivative products. The draft would only make central clearing mandatory after the SEC or CFTC determines clearing is appropriate for a particular swap, and even then only as to swaps involving a limited group of participants. The MFA urged Congress to make the OTC derivatives regulatory framework available to end-users engaging in standardized trades by allowing end-users that post cash collateral to have access to central clearing either through direct participation in a clearing organization or through a swap dealer.

With regard to clearing organizations, the MFA supports draft provisions mandating that governance arrangements be transparent and taking into account the views of all market participants. It is also proper to mandate that membership standards are fair and open, including with respect to access by non-dealers.


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IASB Chair Charts Path to New Fair Value Standard; Rejects Interim Adoption of US Standard

The IASB is on target to replace the fair value accounting standard embodied in IAS 39 with a new standard that will attain broad global acceptance. In remarks before the European Parliament’s Economic and Monetary Affairs Committee, IASB Chair David Tweedie said that the new fair value rules would be adopted after an extensive consultation that will take into account the views of all stakeholders, including the Committee, ECOFIN, central banks and regulators. The comment period on the proposed reform of IAS 39 has ended, said the Chair, and the IASB received letters from more than 200 individuals and organizations. Additional board meetings have already been held, and will continue to be scheduled as required to complete the project in time for the 2009 financial year.

The IASB chief rejected the suggestion that the Board adopt the FASB standard in the interim. He noted that stakeholders in the European Union have warned against blindly adopting US standards. Indeed, he noted that the Committee questioned the adoption of IFRS 8 on operating segments a few years ago on that ground. The IASB does not want to be bound to US standards when the Board believes that there is a better way to secure the confidence of international capital markets and investors.

He also emphasized that the IASB’s adoption of FASB’s position would neither create a level playing field, nor put an end to the level playing field question. The IASB’s impairment rules are very different, he noted, and on many issues EU financial institutions would not want the IASB to adopt the US approach on impairment. For example, the IASB permits reversals of losses in a number of instances, and FASB does not. Moreover, impairments under IFRSs have different triggers from those in US GAAP. It is for this reason that even today, after the change made by the FASB, some in the US are arguing that EU banks have a competitive advantage.

In the view of Chairman Tweedie, the IASB’s proposals on classification and measurement are consistent with the reform principles recently announced by the G-20. For example, the proposals to revise IAS 39 would significantly reduce the complexity of financial instrument accounting. In addition, the proposals are consistent with the view of many stakeholders, including 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 at fair value, noted the Chair, 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.

The IASB is not proposing that the loan book of banks should be held at fair value. As a result, the Board expects that banks primarily engaged in the traditional activities of deposit-taking and making basic loans are likely to make less use of fair value. Those involved in trading, or who make use of derivatives, may see a greater use of market pricing, which most investors feel is appropriate.

The IASB head believes that the Board’s approach is superior to one that would merely adopt the FASB position on impairment. First and foremost, the IASB’s work on impairment directly addresses the specific nature of EU stakeholder and institutional concerns. In addition, the IASB approach would see a much-needed reduction in the number of categories of financial assets and would leave a single impairment method. Also, the proposal anticipates future problems associated with reclassifications by replacing restrictive tainting rules affecting held-to-maturity securities with measures aimed at transparency. Finally, the transition would allow a reclassification out of the fair value option into other categories.


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