Thursday, December 31, 2009

House Legislation Change to Nationally Registered Statistical Rating Organizations Could Engender Future Legislative Fix

Nationally Recognized Statistical Rating Organizations are currently those credit rating agencies that are registered with the SEC and, therefore, regulated. Most often, the phrase is shortened to its initials, NRSRO. However, in formal contracts and statutes, the words are spelled out and each word matters. The Wall Street Reform and Consumer Protection Act, HR 4173, changes the term to Nationally Registered Statistical Rating Organization every place it appears in the Securities Act and the Exchange Act (Section 6005). This was done to indicate that these rating agencies are merely registered and have no nationally recognized seal of approval.

Rep. Kanjorski attempted to change the language back to ``nationally recognized’’ with a floor amendment, noting that the change would put thousands of contracts in default and upset numerous federal and state regulations. The amendment was defeated. Chairman Frank supports the change to ``nationally registered’’ because the purpose of the name change is to tell investors to use their own judgment rather than completely relying on the rating agencies. Chairman Frank acknowledged that a number of states and private institutions have imbedded in their statutes the old language. He pledged to meet with various State agencies and pension funds to see if there is some legislative fix.


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Draft Legislation in Hong Kong Would Improve Corporate Governance

Draft legislation in Hong Kong would significantly enhance corporate governance by enlarging shareholders remedies and access, codifying the directors’ duty of care, strengthening the rights of independent auditors of financial statements. A statutory statement on a director’s duty of care, skill and diligence would enhance corporate governance in Hong Kong by replacing the corresponding common law rules and equitable principles that created uncertainty as to how the courts would apply them.

Fiduciary duties that apply to directors of Hong Kong listed companies include a duty to act in good faith in the interests of the company, a duty to exercise powers for proper purpose, a duty to refrain from fettering their own discretion, a duty to avoid conflicts of interest, and a duty not to compete with the company.

The draft would also require the preparation of a separate directors’ remuneration report by all listed companies incorporated in Hong Kong. The directors’ remuneration report would cover various types of benefits given to the individual directors by name, including the basic salary, fees, housing and other allowances, benefits in kind, pension contributions, bonuses, payment for loss of office and long-term incentive schemes including share options. It would be approved by the board of directors and signed on behalf of the board by a director. With the exception of service contracts, the information in the report would be subject to audit.

In view of the increasing importance of auditors on the corporate governance front, the draft would provide auditors with a qualified privilege for statements made in the course of their duties as auditors. Auditors would not, in the absence of malice on their part, be liable to any action for defamation at the suit of any person in respect of any oral or written statement which they make in the course of their duties as auditors.

Currently, the right of auditors to request information under the Companies Ordinance is quite restrictive. For example, the auditors can request information only from the officers of the company, not company employees. The draft would empower auditors to require information in the performance of their duties from a wider range of persons, including the employees of the company and the officers and employees of its Hong Kong subsidiaries, and any person holding or accountable for any of the company’s or subsidiaries’ accounting records. When a holding company has a subsidiary which is not a company incorporated in Hong Kong, the auditor may require the holding company to obtain from the relevant parties at the subsidiary such information, explanations or other assistance as the auditor may reasonably require for the performance of their duties.

In recognition of the key role that shareholders play in driving company performance, the legislation would promote wider participation of shareholders and ensure that they are informed and involved. For example, the draft would introduce a number of measures to enhance shareholders’ rights in the decision-making process, including providing members with a right to propose a resolution to be moved at a meeting which they have requested to be convened and requiring companies to circulate at corporate expense shareholders’ statements relating to the business of general meetings and proposed resolutions, so long as they are received in time for sending together with the notice of the meeting.

In addition, companies, subject to shareholder approval, would be able to use electronic communications as a default position, permitting companies to use email and websites to communicate with their shareholders. Individual shareholders would be able to request communication in paper form if they wish. Shareholders would also be given the right to inspect voting records and documents, including proxies, after a general meeting so as to improve the transparency of the voting process.


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Wednesday, December 30, 2009

FINRA Investment Adviser Oversight Provision Stripped from House Reform Legislation

A floor amendment to the Wall Street Reform and Consumer Protection Act, HR 4173, offered by Rep. Cohen of Tennessee stripped a provision out of the legislation that would have authorized the SEC to delegate the regulation of investment advisers to FINRA. The provision had been inserted during the mark up of the bill by the Financial Services Committee. Offered during the mark up by Committee Ranking Member Spencer Bachus of Alabama, the amendment would have allowed the SEC to permit or require FINRA to enforce compliance by its members and associated persons with the provisions of the Act. The Bachus Amendment would have empowered FINRA to enforce the fiduciary duty provisions in the Investment Advisers Act against not only broker-dealer members but also against any affiliated investment advisory firm or any associated person. Additionally, the amendment would have given FINRA sweeping rulemaking authority. The provision would have extended FINRA’s jurisdiction to SEC registered investment advisers that manage almost 80 percent of all advisory firms’ assets under management.

The House ultimately declined to outsource a core mission of the SEC to an SRO out of concern that the high level of investor protection provided under the Advisers Act fiduciary duty would be diminished if FINRA were to obtain the additional authority. The SEC must remain the proper, independent regulator of investment advisers since the Commission is in the best position to oversee investment advisers under the Investment Advisers Act.

SEC Commissioner Luis Aquilar had earlier rejected the main argument in favor of putting oversight in the hands of an industry self-regulator, which is that the SEC lacks resources. The issue of resources masks the real situation, he said, since no private organization has the existing resources to expand investment adviser oversight. No one can suggest that FINRA will oversee advisers using the current budget and staff it has in place. Instead, the investment advisers will need to be assessed a bill for this additional oversight. And if advisers have to write a check to someone, he noted, it makes much more sense for that check to go to the SEC since the SEC already has the team and expertise in place. This issue really boils down to whether Congress is going to enhance the SEC by expanding its authority and fortifying its resources, including user fees from advisers, or weaken the SEC, by taking away its direct oversight in order to transfer it to an industry organization.


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Sunday, December 27, 2009

Peterson-Frank Exchange Reveals that Securities and Derivatives Exchanges Are Not Subject to Systemic Risk Regulation

Title I of the House Wall Street Reform and Consumer Protection Act, HR 4173, creates a systemic risk oversight and regulatory structure that enables regulators to raise capital requirements and impose heightened prudential standards on large, interconnected firms that could pose a threat to financial stability. The legislation also empowers the Federal Reserve Board to impose a host of additional requirements on institutions and activities deemed systemically important.

A colloquy on the House floor between Agriculture Committee Chair Peterson and Financial Services Committee Chair Frank indiates that this new regulatory structure for systemic risk is not intended to replace or duplicate the regulation of securities or derivative exchanges that are already subject to regulations by the SEC or the CFTC. In looking at the statutory criteria for determining whether a financial company should be subjected to stricter prudential standards, it is hard to visualize the application of these criteria to derivatives and securities exchanges. Exchanges are not the players who perform the trading, but the administrators of the marketplace where such trading occurs.

Thus, while derivatives and security exchanges would technically qualify for the definition of a financial company in Title I, the intent of the legislation is targeted more at the players in the marketplace as opposed to the administration of the marketplace. (Peterson-Frank colloquy, Cong. Record, Dec. 9, 2009, H14425).


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Saturday, December 26, 2009

Alberta Challenges Move to Create National Securities Regulator

The provincial government of Alberta has announced that it will launch a court challenge to the Canadian federal government's move to create a national securities regulator. In a news release on December 18, 2009, the Alberta government stated that it would file suit in the Alberta Court of Appeal to challenge the constitutionality of comprehensive federal legislation regulating securities. Alberta will also intervene in support of a similar challenge by the Québec government in the Québec Court of Appeal.

According to the release, Alberta authorities will argue that the federal move to enact federal securities legislation and establish a single national securities regulator represents an unwarranted expansion of the federal trade and commerce constitutional power. Minister of Finance and Enterprise Iris Evans said that the interests of Albertans and the Alberta capital market are best served by the existing regulatory structure. An acknowledgment of federal authority in this area would have implications in other areas of financial regulation that have historically been provincial responsibility, Evans said.

Although noting that federal authorities have announced their intention to ask the Supreme Court of Canada to confirm the federal government's power to enact a comprehensive regulatory scheme, the Alberta government said that is moving forward now with its challenge because it may be many months before a federal action is initiated. Joining in the Québec suit will allow the two provinces to share resources and send a stronger message of opposition to the federal plans, the release stated.


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Thursday, December 24, 2009

Securities Regulation is Part of Larger Societal Matrix

Let us for this one day, December 25, reflect on the larger issues of social responsibility and social justice rooted in the age-old belief that we all have value. And securities regulation, like the financial system itself, is part of the broader society it seeks to serve. It does not exist in a vacuum. Let us not forget that the financial disaster that has occurred also has a moral and social dimension, as well as a regulatory failure. The financial reform legislation seeks, in part, to shift the short-term culture that helped fuel the crisis into a culture of long-term value creation. The moral dimension to this was brought home by Pope Benedict’s recent encyclical, Caritas In Veritate, in which he said that the human consequences of current tendencies towards a short-term economy need to be carefully evaluated. The encyclical asks us to remember that the reduction of cultures to the technological dimension, even if it favors short-term profits, in the long term impedes reciprocal enrichment and the dynamics of cooperation. The dignity of the individual and the demands of justice require, particularly today, that economic choices do not cause disparities in wealth to increase in an excessive and morally unacceptable manner.

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Fund Industry Concerned that House Reform Legislation Could Sweep Mutual Funds into Strict Systemic Risk Regulation

The mutual fund industry has criticized provisions of the Wall Street Reform and Consumer Protection Act, HR 4173, that could sweep large funds into strict prudential systemic risk regulation. The Investment Company Institute said that the legislation could subject mutual funds to wholly inappropriate forms of bank-like regulation were regulators, however improbably, to deem mutual funds to be a source of systemic risk. The ICI believes that mutual funds do not create broad systemic risks for the financial system since even the largest funds lack the interconnected web of relationships that is so crucial in spreading risks throughout the financial system.

In addition, the ICI said that provisions in the legislation allowing the FDIC to assess fees on financial companies with at least $50 billion in assets could unfairly require mutual funds and their shareholders to contribute to a dissolution fund for failing financial institutions. Mutual funds do not and cannot fail in a manner that would require payments to funds or their shareholders out of any such dissolution fund, emphasized the ICI.

Specifically, Section 1105 of the Act authorizes the new systemic risk regulator, the Financial Services Oversight Council, to impose strict standards on financial holding companies that pose a grave threat to financial stability or the US economy. The Council is authorized to impose conditions on fund activities or even terminate fund activities, or restrict the ability of a fund to offer a financial product. If all else fails to address the systemic risk, the Council may order the divestiture of business units, assets or branches.

If a financial holding company subject to stricter standards fails to implement a plan for mitigating systemic risk within a reasonable timeframe, the Council must direct the Federal Reserve Board to take such actions as necessary to ensure compliance with the plan.

There are safeguards built into the Act. For example, the Council can act only after notice and a hearing. In addition, the Council must consider a number of factors when determining if the financial holding company poses a grave systemic risk, including the amount and nature of the company's financial assets, liabilities, and off-balance sheet exposures, reliance on leverage, the company's interconnectedness with other financial and non-financial companies; the company's importance as a source of credit and liquidity for the financial system, and the extent to which prudential regulations mitigate the risk posed.

A financial holding company also has the right to ask a federal judge to rescind the strict prudential standards imposed on it. Rescission must be based on a judicial finding that the standards were imposed in an arbitrary and capricious manner.

In addition, in deciding what mitigating actions to impose on a financial holding company, the Council must consider the need to maintain the international competitiveness of the US financial services industry and the extent to which other countries with a significant financial services industry have established corresponding regimes to mitigate threats to financial stability posed by financial companies

The dissolution fund that has triggered concern in the mutual fund industry is set up under Section 1603 of the Act to fund the orderly dissolution of failed financial firms. The fund is administered by the FDIC, which has the exclusive authority to impose assessments on financial companies with $50 billion in assets to build and maintain the fund

In consultation with the Financial Services Oversight Council, the FDIC must use a risk matrix in setting the fee assessments that takes into account, among other things, the risks presented by the financial company to the financial system, including the extent to which the financial company is leveraged; the potential exposure to sudden calls on liquidity precipitated by economic distress; and the amount, maturity, volatility, and stability of the company's financial obligations to, and relationship with, other financial companies.

Wednesday, December 23, 2009

House Legislation Hedging Exemption from Derivatives Regulation Subject to Floor Amendments

The House reform legislation would require over-the-counter derivatives trading to be conducted through clearinghouses, which are set up to police derivatives trading. Under HR 4173, if a clearing mandate applies to a swap or class of swaps, then the swap dealers and major swap participants not only have to clear such trades but also haveto execute them on or through a futures or securities exchange or a swap execution facility. This provision provides greater price transparency and will narrow spreads, all to the benefit of the end user. For the end users, the bill provide an exemption from the clearing mandate and, consequently, from the execution mandate. The House defeated an amendment that would have imposed an execution mandate on end users.

So clearly, the legislation differentiates between larger brokers and banks who do present a systemic threat to the market and smaller companies who use derivatives to hedge and manage the risk associated with running an effective business. The Murphy Amendment clarifies that end users who do not pose a systemic risk to the financial markets should not be designated as major swap participants or major security-based swap participants and incur the unintended costs.

Legitimate end users were given an exemption from derivatives regulation. But to justify the exemption there has to be integrity in the administration of the process. While the House bill exempts end users, there is an exemption to the exemption. If an end user is engaged in an activity that can cause financial stability problems, then they will lose the exemption. The question is what should trigger the lose of the end user exemption. The legislation says systemic risk.

Pursuant to the Murphy Amendment, major swap participant and major security-based swap participant are defined more restrictively in terms of allowing financial companies to be exempt from being classified as a major swap participant. So more financial companies would be held to a higher regulatory standard. And it is a little bit less restrictive with respect to manufacturing companies being classified as a major swap participant or major security-based swap participant. Congress wants people who are systemically risky to be held to a higher standard of accountability, but it does not want to capture manufacturing companies and other end users in that regulation. They will be permitted to do their business and use derivatives to hedge their actual risk.

Defining the terms major swap participant and major security-based swap participant was one of the most significant challenges in the bill. The definitions generally exempts end users while ensuring that regulation captures the financial players to whom the new regulations should apply. The House rejected an absolute, guaranteed exemption for end users from the definition so that they never would be considered a major swap participant. The House would not do that because it did not know what the future will bring and because one of these end users could, one day, get so large with regard to their swap activity so as to have an impact on the financial system.

The House defeated an amendment that would have authorized the SEC and CFTC to set margin or collateral requirements for swaps and securities-based swaps involving end users. With regard to swap dealers and major swap participants and their security-based swap counterparties, the legislation authorizes the SEC and CFTC to set margin requirements appropriate for the uncleared swaps that they hold.

Because swap dealers and major swap participants are so heavily involved in the swap market and are interconnected with potentially hundreds of different counterparties, Congress believes it is important to regulate their margins for the protection of their end user customers and the financial system as a whole. However, there is no need for the SEC and CFTC to put margin requirements on end users in order to protect the swap dealers and major swap participants. They can look out for themselves. The end user community of energy companies, manufacturers and others did not cause the problem.

Tuesday, December 22, 2009

Michigan Issues Third Transition Order Following Adoption of New Act

A third transition order affecting three securities transaction exemptions, as well as broker-dealers, agents, investment advisers and investment adviser representatives, was issued by the Michigan Office of Financial and Insurance Regulation in connection with adoption of the new Michigan Uniform Securities Act on October 1, 2009.

Exemptions for capital stock issued by professional service corporations, sales of membership interests in professional limited liability companies, and for persons engaged in the oil, gas and mineral business were re-adopted in this transition order, as were examination requirements for broker-dealer proprietorships and agents. Also set forth in the order were minimum net capital and recordkeeping requirements for broker-dealers and investment advisers, brochure disclosure requirements for investment advisers, and administrator authorization to withdraw incomplete broker-dealer, agent, investment adviser and investment adviser representative applications.

For more information, please see here.


Walker Report Calls for Asset Managers to Adopt Institutional Investors Code of Best Practices

The Walker Report on corporate governance in the United Kingdom has called on fund managers and institutional investors to adopt a code of best practices on a comply or explain basis. The report was the result of an independent review of corporate governance in the UK banking and financial services industries led by Sir David Walker.

The Code was developed by the Institutional Shareholders’ Committee. Fund managers will be asked to confirm their commitment to the Code or, alternatively, to explain their investment approach in clear terms if they are unwilling to assume such a commitment. The Code for Institutional Investors embodies the principle that some form of governance or engagement activity may offer a means of increasing absolute returns by addressing issues in the company in a timely and influential manner and thus improving long-run performance. The report envisions engagement by fund managers as monitoring investee companies, meeting their senior management, and having a policy on voting and voting disclosure

The report recommends that the jurisdiction of the Financial Reporting Council should be expanded to cover the development and encouragement of adherence to best practices by institutional investors and fund managers. The code of best practices for institutional investors should be ratified by the FRC, and be akin to the Combined Code on Corporate Governance. The FRC should regularly review the Code in consultation with fund managers and institutional investors and make proposals for change.

All fund managers that indicate commitment to engagement should participate in a survey to monitor adherence to the Code. Arrangements should be put in place under the guidance of the FRC for the independent oversight of this monitoring process which should publish an engagement survey on an annual basis.

Fund managers and other institutions authorized by the FSA to undertake investment business should signify on their websites whether they commit to the Code. Disclosure of such commitment should be accompanied by an indication whether their mandates from pension fund and other major clients normally include provisions in support of engagement activity and of their engagement policies on discharge of the responsibilities set out in the Code. Where a fund manager or institutional investor is not ready to commit and to report in this sense, it should provide on its website a clear explanation of its alternative business model and the reasons for the position it is taking.

The Walker Report also urges fund managers and institutional shareholders to take collective efforts to influence senior management at the companies they invest in. The possibility of such collective initiative on the part of a group of major shareholders to influence a board has given rise to some concern that it could create a possible concert party situation. Fortunately, the Takeover Panel and the Financial Services Authority have respectively issued a practice statement and a letter that are seen as going substantially in the direction of creating safe harbor protection. The Code requires institutional investors to disclose their policy on collective engagement.

As part of best practices, the report urged fund managers and other institutional investors to disclose their voting record, and their policies in respect of voting should be described in statements on their websites. Disclosure of voting policies and outcomes should be seen as part of good governance, and even fund managers that decline to subscribe to the Code should disclose how they vote.

Finally, those that agree to adhere to the Code should consider obtaining an independent audit opinion on their engagement and voting processes having regard to the standards SAS 70. The existence of such assurance certification should be publicly disclosed.


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Commission Proposes Rule 163 Changes Concerning Underwriters and Dealers

The SEC proposed amendments to Securities Act Rule 163(c) (Release No. 33-9098). This rule currently allows well-known seasoned issuers, or "WKSIs," to engage in unrestricted oral and written offers filing a registration statement. The exemption does not currently apply, however, to communications by an offering participant who is an underwriter or dealer. The proposed amendments would extend the Rule 163 exemption to allow a well-known seasoned issuer to authorize an underwriter or dealer to act as its agent or representative in communicating about offerings of the issuer’s securities prior to the filing of a registration statement.

The Commission noted that WKSIs may want to assess the level of investor interest in their securities before filing a registration statement, but lack sufficient knowledge about potential investors to contact them directly, or may prefer not to contact investors directly for other reasons. The amended rule would enable WKSIs to better gauge the level of interest in the market for an offering and explore possible terms for such an offering before filing a registration statement or including the securities in the registration statement through a post-effective amendment. According to the SEC, allowing authorized underwriters or dealers to be agents or representatives of a WKSI would provide these issuers with access to the underwriters’ or dealers’ existing networks of investors to assess market interest in the issuer’s securities.

Comments must be received within 30 days from the date of publication in the Federal Register.

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Monday, December 21, 2009

Hawaii 2009 Reduced Fees to Stay Reduced in 2010

Hawaii's 2009 reduced fees for dealer, salesperson, investment adviser, and investment adviser representative registration applications, and for investment company initial and renewal notice filings, will remain at the 2009 reduced amounts throughout 2010, subject to regulatory approval.

For questions, please call the Hawaii Securities Division at (800) 586-2722.

Also see here.


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Saturday, December 19, 2009

Class Members' Claims Did Not Require Proof of Reliance or Causation Under South Carolina Law

A federal district court (D.S.C.) has ruled that potential class members' claims under the South Carolina Securities Act (Act) did not require proof of causation or reliance in order for the plaintiffs to establish that the defendant's conduct predominantly involved questions of law or fact common to the class. In Brown v. Charles Schwab & Co., the plaintiffs sought class certification for their claims that the broker-dealer and custodian for the plaintiffs' Individual Retirement Accounts violated the Act by facilitating a Ponzi scheme operated by an investment adviser. Specifically, the plaintiffs alleged that the potential class members had the same claims against the defendant for materially aiding the adviser's fraudulent sales of unregistered securities and for directly or indirectly controlling a seller of such securities.

The court ruled that claims that the defendant materially aided and controlled the adviser's violations of Sec. 501 of the Act did not require proof of reliance or causation because the language of the statute does not contain the words "reliance" or "causation." Moreover, a prior decision by the South Carolina Supreme Court involving a predecessor statute had reached the same result, as did a Fourth Circuit decision that had addressed a similar provision in the Virginia securities laws. The court found unavailing the defendant's contention that the plaintiffs must prove reliance or causation because claims brought under federal Rule 10b-5, on which the South Carolina statute is modeled, require proof of reliance. The court rejected this argument, reasoning that federal court rulings involving private rights of action under Rule 10b-5 were distinguishable because the federal cause of action is judicially created. Accordingly, the court found that issues common to the potential class members predominated over individual questions of law and fact. As the plaintiffs established the other requirements for class certification under Federal Rule of Civil Procedure 23(a), the court granted the plaintiffs' motion and certified the class.

Friday, December 18, 2009

SEC Charges Auditors, Former Executives for Roles in Accounting Violations at Bally Total Fitness

The SEC charged former chief financial officer John W. Dwyer and former controller Theodore P. Noncek for their roles in an accounting fraud at Bally Total Fitness Holding Corp. Without admitting or denying the allegations, Dwyer and Noncek agreed to settle the SEC’s charges, subject to court approval.

As alleged, Dwyer and Noncek were responsible for Bally’s materially false and misleading statements about its financial condition in filings with the Commission and in other public statements. These false and misleading statements exaggerated both the health of Bally's financial condition and its performance during the relevant period, according to the Commission charges. Dwyer settled the Commission case against him by consenting to several permanent injunctions, a penalty of $250,000, a permanent officer-director bar and a permanent bar from practice before the SEC. Noncek also consented to injunctive relief, and received a two-year bar from practice before the SEC.

In separate proceedings, the Commission charged Ernst & Young LLP and six of its current and former partners. In the settled order, the Commission found that E&Y knew or should have known about Bally’s fraudulent financial accounting and disclosures, and that the firm improperly unqualified audit opinions on Bally’s financial statements. The individual defendants charged were Randy G. Fletchall (partner in charge of E&Y’s national office), Mark V. Sever (national director of professional practice) Kenneth W. Peterson (professional practice director for the Chicago office), Thomas D. Vogelsinger (former Lake Michigan area managing partner), and William J. Carpenter and John M. Kiss (former engagement partners.)

E&Y and each of the E&Y partners also has settled with the SEC without admitting or denying the charges. E&Y agreed to pay $8.5 million to settle the SEC's charges. The SEC barred Sever, Peterson, Carpenter, Kiss and Vogelsinger from practicing before the SEC for varying periods, and censured Fletchall.

"It is deeply disconcerting that partners, even at the highest levels of E&Y, failed to fulfill their basic obligations to the investing public by not conducting proper audits. This case is a sharp reminder to outside auditors that they must carry out their duties with due diligence. The $8.5 million settlement, one of the highest ever paid by an accounting firm, reflects the seriousness of their misconduct," said Robert Khuzami, director of the SEC's Division of Enforcement.

"Ernst & Young and its partners on the Bally engagement violated their fundamental duty to function as public watchdogs, even after E&Y personnel identified Bally as one of the firm's riskiest audit clients," added Fredric D. Firestone, associate director in the Division of Enforcement.

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Initial CDS Insider Trading Case Survives Challenge

The first insider trading action filed by the SEC alleging misconduct in the credit default swaps market (SEC v. Rorech) survived a motion for judgment on the pleadings. The complaint, filed in the U.S. District Court for the Southern District of New York, alleged Renato Negrin, a former portfolio manager at hedge fund investment adviser Millennium Partners, L.P., and Jon-Paul Rorech, a salesman at Deutsche Bank Securities Inc., engaged in insider trading in the credit default swaps of VNU N.V., an international holding company.

According to the Commission's complaint, Rorech learned information from Deutsche Bank investment bankers about a change to the proposed VNU bond offering that was expected to increase the price of the CDS on VNU bonds. Deutsche Bank was the lead underwriter for a proposed bond offering by VNU. According to the complaint, Rorech illegally tipped Negrin about the contemplated change to the bond structure, and Negrin then purchased CDS on VNU for a Millennium hedge fund. When news of the restructured bond offering became public in late July 2006, the price of VNU CDS substantially increased, and Negrin closed Millennium's VNU CDS position at a profit of approximately $1.2 million.

The defendants argued that they could not be liable for insider trading under Section 10(b) because the credit default swaps in this case were not securities-based swap agreements. In addition, the court rejected arguments by both defendants that the SEC lacked jurisdiction as a matter of law because the credit default swaps at issue were based on foreign bonds, and by Rorech that he had no duty to keep information about the VNU bonds confidential. The court did not reach the merits of the Commission's charges.

As amended by the Commodity Futures Modernization Act, the Exchange Act antifraud provisions apply to security-based swap agreements. The definition includes swap agreements in "which a material term is based on the price, yield, value, or volatility of any security or any group or index of securities, or any interest therein." The swap agreements in this case did not specifically state whether a material term of the instruments was based on a security. However, Judge Koeltl wrote that "it cannot be that traders can escape the ambit of Section 10(b) and Rule 10b-5 by basing a CDS’s material term on a security, but simply omitting reference to the security from the text of the CDS contract." He also noted that there is a secondary market for the instruments, and concluded that there was an issue of fact concerning whether the market price would be based on the value of the underlying bond.

The foreign domicile of the bond issuer was not dispositive, because the unlawful conduct, the tipping and the trading, took place in this country. The court also found that it could not dispose of Rorech's claim that he had no duty of confidentiality on the pleadings. The SEC alleged that he acquired the information about the bonds through his relationship of trust and confidence with his employer. "The question of the scope of his duty to DBSI and whether the information he shared was in fact confidential is a fact-based inquiry that cannot be decided in the defendant's favor on a motion for judgment on the pleadings," concluded Judge Koeltl. The SEC allegations supported a reasonable inference that Rorech breached a duty of confidentiality, and Rorech's responses "do not show that the SEC's claim is implausible on its face."


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House Passes Legislation Bringing Auditors of Brokerage Firms within Purview of PCAOB; Enhancing Foreign Regulatory Information Sharing

Closing a statutory loophole revealed by the Madoff scandal, the House has passed legislation authorizes the PCAOB to flexibly examine the auditors of broker-dealers. Thus, the Wall Street Reform and Consumer Protection Act, HR 4173, would bring auditors of broker-dealers under the PCAOB oversight regime. The Board can inspect the auditors of broker-dealer financial statements; and will have investigatory, examination and enforcement authority over the auditors of broker-dealers. In addition, brokers and dealers would be brought into the Board’s funding scheme by paying a fee allocation
in proportion to their net capital compared to the total net capital of all brokers and dealers that are not issuers, in accordance with the rules of the Board. The Act also authorizes the Board to refer an investigation concerning a broker or dealer’s audit report to the relevant self-regulatory organization. Moreover, the Board is authorized to share with the SRO all information and documents received in connection with an investigation or inspection without breaching its confidential status.

In addition, the House legislation would change the name of the Public Company Accounting Oversight Board to Auditor Oversight Board. The Act would also create an ombudsman within the Auditor Oversight Board to act as a liaison between the Board and registered accounting firms and issuers with regard to the issuance of audit reports.

The Act would also allow the PCAOB to share information with foreign regulatory and law enforcement agencies engaged in the investigation and prosecution of violations of applicable accounting and auditing laws without waiving any privileges the SEC may have with respect to such information. The information sharing is conditioned on the foreign auditor oversight authority providing such assurances of confidentiality as the Board determines appropriate.

In addition, the legislation would enhance the PCAOB’s ability to access the audit work papers and audit documentation of foreign public accounting firms when they perform audit work or other material services upon which a registered public accounting firm relies in the conduct of an audit. This statutory change will resolve international conflicts that have impaired the Board’s ability to fulfill its statutory obligation to inspect non-US registered public accounting firms.

The Act provides that the foreign public accounting firm must be subject to the jurisdiction of the US federal courts for purposes of enforcing a Board request for audit documentation. Any foreign accounting firm that issues an audit report, performs audit work, or other material services upon which a registered accounting firm relies in the conduct of an audit must designate to the SEC or the Board a US agent upon whom may be served any papers in any action brought to enforce this section or any request by the SEC or Board under this section.

In addition, any registered accounting firm that relies on the work of a foreign accounting firm in issuing an audit report or performing audit work must produce the foreign firms audit work papers and all other audit documents related to any such work in response to a request for production by the Board. The accounting firm must also obtain the agreement of the foreign accounting firm to production of the documentation at Board request as a condition of its reliance on the work of the foreign firm.

In an effort to reduce the complexity of financial reporting in order to provide more accurate and clear financial information to investors, the legislation requires the Chairs of the PCAOB, the SEC, and the FASB to testify annually before Congress on accounting and auditing issues. The testimony must discuss the reassessment of complex and outdated accounting standards. The agency chairs must additionally discuss how to improve the understandability, consistency, and overall usability of the existing accounting and auditing literature. Congress also wants information on how the development of principles-based accounting standards is progressing. In addition, there must be a discussion of how to encourage the use and acceptance of interactive data, as well as efforts to promote disclosures in plain English

The legislation also establishes a Financial Reporting Forum composed of, among others, the Chairs of the SEC, FASB and the PCAOB, to meet at least quarterly and discuss issues critical to financial reporting. The Forum must report annually to Congress detailing any determinations or findings, including any legislative recommendations related to financial reporting. Other members of the Forum must include representatives of the auditor, investor and financial institution communities, as appointed by the SEC.


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Thursday, December 17, 2009

Commission Enhances Proxy Disclosure, Adviser Custody Rules

The SEC adopted rule and form changes intended to enhance the information provided in proxy solicitations and in other forms filed with the SEC. Beginning in the upcoming annual reporting and proxy season, the new rules will improve corporate disclosure regarding risk, compensation and corporate governance matters when voting decisions are made. In addition, the SEC adopted rule changes designed to substantially increase the protections for investors who turn their money and securities over to investment advisers.

Proxy Disclosures

The rulemaking requires disclosures in proxy and information statements about:

  1. The relationship of a company's compensation policies and practices to risk management. Smaller reporting companies will not be required to provide the new disclosure;
  2. The background and qualifications of directors and nominees;
  3. Legal actions involving a company's executive officers, directors and nominees;
  4. The consideration of diversity in the process by which candidates for director are considered for nomination;
  5. Board leadership structure and the board's role in risk oversight;.
  6. Stock and option awards to company executives and directors. The amended rule requires companies to report the value of options when they are awarded to executives (the aggregate grant date fair value), instead of the current requirement to report the annual accounting charge; and
  7. Potential conflicts of interests of compensation consultants.
The new rules, which will be effective February 28, 2010, also require quicker reporting of shareholder voting results. Amendments to Form 8-K will require companies to disclose the results of a shareholder vote within four business days after the end of the meeting at which the vote was held. This replaces the requirement to disclose voting results in Forms 10-K and 10-Q, which often were filed months after the relevant meeting.

Adviser Custody Rule

The amended custody rule is intended to promote independent custody and require the use of independent public accountants as third-party monitors. Depending on the investment adviser’s custody arrangement, the rules would require the adviser to be subject to a surprise exam and custody controls review that are generally not required under existing rules. Advisers will be required to engage an independent public accountant to conduct an annual “surprise exam” to verify that client assets exist. In addition, when the adviser or an affiliate serves as custodian of client assets, the adviser will be required to obtain a written report from a PCAOB-registered accountant that, among other things, describes the controls in place at the custodian, tests the operating effectiveness of those controls and provides the results of those tests.

The rule changes also will impose a new control on advisers to hedge funds and other private funds that comply with the custody rule by obtaining an audit of the fund and delivering the fund's financial statements to fund investors. The rule will require that the auditor of such a private fund be registered with and subject to regular inspection by the PCAOB.

The amended rules also will require that the adviser reasonably believe that the client’s custodian delivers the account statements directly to the client, to provide greater assurance of the integrity of these account statements. It also will enable clients to compare the account statement they receive from their adviser to determine that the account transactions are proper.

The rule amendments are effective 60 days after publication in the Federal Register. We will provide a link to the adopting release in this space when it becomes available.

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House and Senate Legislation Combined Would Benefit States

The House and Senate versions of the bill to restructure the financial services industry contain a number of provisions requested by the states at the past two fall conferences of North American Securities Administrators Association (NASAA), namely: (1) providing states with regulatory authority over a larger percentage of investment advisers; (2) striking mandatory arbitration clauses from contracts, thereby allowing defrauded investors to adjudicate their claims in court for a better judgment; (3) removing Rule 506 offerings from the class of “federal covered securities” under the NSMIA Act of 1996, thus permitting the states to once again regulate the merits of these offerings; (4) having a harmonized fiduciary duty standard for broker-dealers and investment advisers; (5) establishing a Consumer Financial Protection Agency that would preserve the current balance of power between state and federal law; and (6) adopting provisions to protect senior investors.

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Wednesday, December 16, 2009

House Legislation Requires FASB to Study Securitization Standards

The House has passed legislation requiring the Federal Reserve Board, in consultation with the SEC, to conduct a study and report to Congress on the impact on individual classes of asset-backed securities of FASB’s new securitization accounting standards, FAS 166 and 167, and the Act’s new credit risk retention requirements.

The Wall Street Reform and Consumer Protection Act, HR 4173, says that the report must make statutory and regulatory recommendations for eliminating any negative impacts on the continued viability of the asset-backed securitization markets and on the availability of credit for new lending. The study would be required to be completed in 90 days.
Taking effect at the end of 2009, FAS 166 and 167 will eliminate qualified special purpose entities, which are the primary securitization accounting vehicle for asset-backed securities.

They will also change the criteria for the sales treatment and consolidation of financial assets and apply all of these changes retroactively.
The new securitization requirements in the legislation and the changes by FASB to the securitization accounting rules will impact both the U.S. financial sector and securitization. Federal Reserve Board Member Elizabeth Duke has noted that, if the risk retention requirements in the legislation, combined with accounting standards governing the treatment of off-balance-sheet entities, make it impossible for firms to reduce the balance sheet through securitization and if, at the same time, leverage ratios limit balance sheet growth, there could be substantially less credit available.

Thus, as policymakers and others work to create a new framework for securitization, cautioned Gov. Duke, they must avoid falling into the trap of letting either the accounting or regulatory capital drive the US to the wrong model.

The legislation also authorizes the new systemic regulator, the Financial Services Oversight Council, to review and make recommendations to the SEC and FASB on any adjustments to accounting standards impacting financial institutions when the Council determines that these accounting standards pose a significant risk to financial stability. For example, this provision allows the Council to make recommendations when there is no functional market for derivatives and other financial instruments.

The provision also directs the Council to monitor international accounting developments and identify any developments that may conflict with the policies of the US or place US financial services firms or US financial markets at a competitive disadvantage. The Council must also advise Congress on financial domestic and international regulatory developments, including accounting developments.

The legislation in this area is intended to provide the accountability and transparency necessary for investors to assess their investments in financial institutions, while at the same time providing regulators with the flexibility they need to work with financial institutions to keep credit flowing. These provisions do not place accounting rulemaking with the Financial Services Oversight Council. The setting of accounting standards remains with FASB, subject to SEC oversight. The Council will have no authority to oversee the FASB since the legislation only allows the Council to become involved on accounting issues with systemic risks. Presumably, only if an accounting standard poses systemic risks would the Council make recommendations, and those recommendations would be with the SEC. But Congress believes that the Council must be permitted to address systemic risks, one of which includes accounting standards.

While mark to market accounting and loan loss accounting rules did exacerbate the financial crisis, these provisions are not about mark to market. Rather, they are about ensuring that policymakers and regulators have a way to examine systemic risks going forward, while working together to ensure that financial statements remain fairly presented for investors and other users of financial statements.


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District Judge Criticizes SEC, CFTC Policy on Recovery of Principal from Ponzi Scheme "Winners"

Paul S. Diamond, a U.S. district judge for the Eastern District of Pennsylvania, "reluctantly" approved a receiver's settlement with two "winning" investors in a multi-million dollar Ponzi scheme. The agreement called for the investors to return their false profits to the receivership estate, but allowed them to retain the amount of principal returned to them before the scheme collapsed (SEC v. Forte).

The receiver initially planned to seek recovery of the entire transfer, including the principal, under Pennsylvania state law. According to Judge Diamond, the state fraudulent transfer statute could allow for recovery of the principal if the investor had sufficient knowledge to place him on inquiry notice of the voidability of the transfer.

However, both the SEC and the CFTC advised the receiver that they would object to any attempt to recover the principal amounts, and would strenuously litigate the issue. As described by the judge, the agencies effectively limited the receiver’s recovery of principal to those winning investors who shared the defendant's "criminal intent." He concluded that because "the winning investors’ returned principal is actually the losing investors’ money, those losing investors could well view the position of the SEC and the CFTC as extraordinarily unfair."

Judge Diamond also criticized the SEC's position, as set forth in a recent amicus brief in a similar case. The Commission wrote that "the receiver’s claims to recover principal lack statutory and case law support, and it would be inequitable to require the innocent investors in these cases to repay these amounts." The district judge rejected the SEC's legal reasoning, and emphasized that the receiver in this case would only seek recovery of principal from those investors who did not meet the good faith standard of the state fraudulent transfer law.

The judge stated that "in other circumstances, I would be inclined to disapprove the proposed consent decrees." However, in response to advice from the attorney for the receiver that the costs of litigating against the SEC, the CFTC and the investors could well exceed the principal that could be recovered, Judge Diamond "reluctantly" approved the orders.

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Tuesday, December 15, 2009

Briefing Paper Examines House Legislation


The CCH Editorial Staff of banking and securities law analysts has authored a detailed overview titled, "House Passes Wall Street Reform Act." Here is a passage from the introduction:

On December 11, 2009, the U.S. House of Representatives passed legislation to restructure the financial services regulatory system, the Wall Street Reform and Consumer Protection Act of 2009 (HR 4173), by a vote of 223-202. As discussed below, the sweeping array of reforms includes the Financial Stability Improvement Act, which would create a systemic risk regulator, strengthen regulation of depository institutions and bank holding companies, improve the asset-backed securitization process, and provide for an enhanced dissolution authority. The legislation also would create a Consumer Financial Protection Agency, reform the over-the-counter derivatives market, subject hedge funds to stricter scrutiny, impose new corporate governance mandates, adopt heightened requirements for credit rating agencies and expand regulatory enforcement powers. Among other measures, the legislation features expansive consumer mortgage protections and creates a Federal Insurance Office.

Download the briefing paper here.



Monday, December 14, 2009

Supreme Court Oral Argument in PCAOB Case Centers on SEC Control of the Board and Presidential Removal Powers

Supreme Court oral arguments in the case deciding the PCAOB’s constitutionality focused on the SEC’s pervasive control over the Board and the President’s control over the SEC. The case, brought by an audit firm, is before the 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 because, under the Appointments Clause of the Constitution, Board Members are inferior officers of the United States who do not have to be appointed by the President and can be appointed by the SEC, as is currently required by Sarbanes-Oxley. (Free Enterprise Fund and Beckstead & Watts v. PCAOB, Dkt. No. 08-861).

The arguments centered on the President’s control over the SEC, the SEC’s control over the Board, and the conclusion that the President had sufficient control over the Board to satisfy the Constitution. Jeffrey Lamken, arguing for the Board, went through a litany of powers that the SEC has over the Board that amount to pervasive authority over every aspect of the Board's operations. For example, Board rules and sanctions have no effect except as the SEC allows, and can be changed by the SEC at any time. In addition, Board inspections and investigations are subject to plenary SEC control. Not only are they conducted under rules that the SEC must approve, he said, but the SEC can threaten or actually rescind the Board's enforcement authority any time it thinks that's appropriate in the public interest. Then there is also the fact that the SEC controls the Board's budget.

To this litany, Chief Justice Roberts noted that the Board can act and the SEC can retroactively veto their actions, but the SEC doesn't propose what actions the Board takes, actions that can have significant, devastating consequences for a regulated firm. Mr. Lamken responded that the SEC has broad authority, in the public interest, to rescind the Board's authority to enforce any devastating action, adding that this is precisely the type of control that powerful executives regularly exercise. If they don't like the way an inferior is doing something, he reasoned, they can take away that authority.

The Chief Justice also questioned Solicitor General Elena Kagan about the for cause removal issue. He noted that the President can remove SEC Commissioners for cause and the SEC can remove Board Members for cause, which the Chief called "for cause squared.’’ You have to have two violations of the for-cause provision, he observed, you have to meet the requirement in two places. When the SEC wants to remove the Board member, they can only do that for cause. And if they decide, well, there isn't cause; I'm not going to do it, then the President, under the Government’s argument, has to remove the SEC commissioners, all of them, not just the chair, and he can only do that for cause.

Justice Alito added the proposition that the more layers of for-cause removal there is the less control the President actually has. Solicitor General Kagan replied that it all depends. The Government is not saying that a double for-cause provision is always constitutional, just as it is not saying that a single for-cause provision is always constitutional. Rather, the question is in what context does that for-cause provision operate. Where it operates in a context like the relationship between the SEC and the Board, being surrounded by a panoply of alternative and equally effective control mechanisms, it simply should not matter that there is another for-cause provision. Removal is just a tool, said the Solicitor General, the ultimate constitutional question is the level of presidential control, and the presidential control here is exactly the same with respect to the Board's activities as it is with respect to the SEC staff's activities.

Arguing for the audit firm, Michael Carvin addressed the Solicitor General's syllogism that because the President can control the SEC somehow he can control those whom the SEC regulates. The New York Stock Exchange has exactly the same relationship with the SEC as does the board, he noted, and no one would argue that the President has the power to direct and supervise the NYSE.

Chief Justice Roberts asked if the SEC could direct the Board not to demand documents from a particular company. The Solicitor General replied that the SEC has full control over the investigative and inspection function of the Board. The Board's investigations and inspections are all done according to rule, she observed, and the SEC can change those rules. The SEC can reach out and abrogate any Board rules, including rules relating to inspections and investigations. The SEC also has power to promulgate its own rules.

The Chief Justice asked if that kind of SEC power over the Board is consistent with the intent of Congress in establishing the PCAOB. The Solictor General said that it is because the intent of Congress was to place the Board under the extremely close and comprehensive supervision of the SEC. The references to independence that one finds throughout the legislative record are almost all references to independence from the accounting industry, not from the SEC.


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House Reform Legislation Provides International Reach to Federal Securities Laws

The rapid globalization of financial markets in recent years has cast into stark relief issues surrounding the international reach of US securities laws. Since the federal securities laws are silent on their international reach, federal courts have developed tests, including the conduct test, which focuses on the nature of the conduct within the US as it relates to carrying out the alleged fraudulent scheme

As part of a sweeping overhaul of US financial regulation, the House has passed legislation authorizing the SEC and the United States to bring civil and criminal law enforcement proceedings involving transnational securities frauds, which are securities frauds in which not all of the fraudulent conduct occurs within the United States and not all of the wrongdoers are located domestically. Specifically, the Wall Street Reform and Consumer Protection Act, HR 4173, would amend the Securities Act and the Exchange Act to provide that US district courts have jurisdiction over violations of the antifraud provisions that involve a transnational fraud if there is conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors.

Heeding the G-20’s advice to prevent regulatory arbitrage, the part of legislation providing for the federal regulation of derivatives calls for international harmonization by requiring foreign boards of trade to share trading data and adopt speculative position limits on contracts that trade U.S. commodities similar to U.S.-regulated exchanges. The SEC and CFTC are also directed to consult and coordinate with foreign regulators to create consistent international standards with respect to the regulation of derivatives.

The SEC and CFTC are authorized to engage in information sharing arrangements with foreign regulators consistent with the public interest and the protection of investors and counterparties. In addition, the SEC and CFTC are authorized to prohibit a foreign entity from participating in the US in any swap or security-based swap activities upon determining that the regulation of derivatives in the entity’s foreign jurisdiction undermines the stability of the US financial system.

In the part of the Act creating a new systemic risk regulator, the Financial Services Oversight Council, the legislation directs the Council to monitor international accounting developments and identify any developments that may conflict with the policies of the US or place US financial services firms or US financial markets at a competitive disadvantage. The Council must also advise Congress on financial domestic and international regulatory developments, including accounting developments.


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Friday, December 11, 2009

House Passes Historic Financial Overhaul Legislation

The House of Representatives passed historic legislation today overhauling the US financial regulatory system. The legislation creates a systemic risk regulator, the Federal Stability Oversight Council, whose members include the Fed, the SEC and the CFTC, to monitor the marketplace to identify potential threats to the stability of the financial system (Title I).

The Council will be chaired by the Treasury Secretary. The Council will subject financial companies and financial activities posing a threat to financial stability to much stricter standards and regulation, including higher capital requirements, leverage limits, and limits on concentrations of risk (Section 1106). The Senate draft legislation would establish an Agency for Financial Stability composed of the SEC, Fed and CFTC, with an independent Chair appointed by the President.

The legislation removes outmoded Gramm-Leach-Bliley Act restraints on the consolidated supervision of large financial companies by the Federal Reserve, and provides specific authority to the Fed and other federal financial agencies to regulate for financial stability purposes and quickly address potential problems.

The Federal Reserve will serve as the agent of the Council in regulating systemically risky firms on a consolidated basis and systemically risky activities wherever they occur, ensuring broad accountability for such regulation. The legislation also substantially enhances the authority of the Government Accountability Office (GAO) to examine the Board of Governors of the Federal Reserve and the Federal Reserve Banks to provide greater transparency to Fed facilities and actions.

Among its other duties, the Council must monitor the financial services markets to identify potential threats to the stability of the US financial system and identify financial companies and activities that should be subject to heightened prudential standards in order to promote financial stability and mitigate systemic risk. The Council must also issue formal recommendations to the SEC and other Council members to adopt heightened prudential standards for the firms they regulate in order to mitigate system risk.

Regulators’ inability to see developments outside their narrow “silos” allowed the current crisis to grow unchecked. The legislation’s information gathering and sharing requirements for the Council and all of the financial regulators, including the SEC and CFTC, will ensure constant communication and the ability to look across markets for potential risks. The Council will facilitate information sharing and co-ordination among its members regarding financial services policy development, rulemakings, examinations, reporting requirements and enforcement actions. Also, the Council must provide a forum for discussion and analysis of emerging market developments and financial regulatory issues among its members.

An important duty of the Council is to advise Congress on financial regulation and make recommendations that will enhance the integrity, efficiency, orderliness, competitiveness, and stability of the US financial markets. The Council must meet at least quarterly .

The Council is empowered to require the submission of periodic and other reports from any financial company solely for the purpose of assessing the extent to which a financial activity or market in which the financial company participates, or the company itself, poses a threat to financial stability. In an effort to mitigate this reporting burden, the Council is directed to rely, whenever possible, on information already being collected by the SEC and other financial regulators.

The Council is authorized to issue formal recommendations, publicly or privately, that the SEC and other federal financial regulators adopt heightened prudential standards for firms they regulate in order to mitigate systemic risk. Within 60 days of receiving a Council recommendation, the SEC or other federal financial regulators must notify the Council of any actions taken in response to the recommendation or why the regulator failed to respond.

The Council may subject a financial company to heightened prudential standards upon determining that material financial distress at the company could pose a threat to financial stability; or the nature of the company activities could pose a threat to financial stability. In making this determination, the Council must consider a number of factors, including the amount and nature of the firm’s financial assets and liabilities and its off-balance sheet exposures, as well as its transactions with other financial companies. The company’s importance as a source of credit for households, businesses, and state and local governments must also be considered, as well as its source of liquidity for the financial system. Once a company becomes an identified financial company, heightened prudential standards can be imposed on it in order to mitigate risks to the financial system, including capital, liquidity and risk management requirements.

Securitization

The legislation reforms the process of securitization by, primarily, requiring companies that sell products like mortgage-backed securities to retain a portion of the risk to ensure that they will not sell garbage to investors, because they have to keep some of it for themselves. The legislation would require companies that sell products like mortgage-backed securities to keep some "skin in the game" by retaining at least five percent of the credit risk so that, if the investment doesn’t pan out, the company that made, packaged and sold the investment would lose out right along with the people they sold it to. (Section 1502) In addition, the legislation would require issuers to disclose more information about the assets underlying asset-backed securities (Section 1503).

The SEC is directed to adopt regulations requiring issuers of asset-backed securities to disclose for each tranche or class of security information regarding the assets backing that security. In adopting these regulations, the SEC must set standards for the format of the data provided by issuers of an asset-backed security, which must, to the extent feasible, facilitate comparison of such data across securities in similar types of asset classes.

In order to facilitate investors in performing independent due diligence, the SEC regulations must require issuers of asset-backed securities, at a minimum, to disclose asset-level or loan-level data, including data having unique identifiers relating to loan brokers or originators. The issuer must also disclose the nature and extent of the compensation of the broker or originator of the assets backing the security; and the amount of risk retained by the originator or the securitizer of such assets.

The SEC must also adopt regulations on the use of representations and warranties in the market for asset-backed securities that require each credit rating agency to include in any report accompanying a credit rating a description of the representations, warranties, and enforcement mechanisms available to investors how they differ from the representations, warranties, and enforcement mechanisms in issuances of similar securities. The regulations must also require any originator to disclose fulfilled repurchase requests across all trusts aggregated by the originator, so that investors may identify asset originators with clear underwriting deficiencies (Section 1504).

Dissolution Authority

The legislation provides, for the first time, a resolution authority to wind down large interconnected failed financial companies in an orderly manner. Currently, there is no system in place to responsibly shut down a failing financial company like AIG or Lehman Brothers. According to Treasury, the lack of a federal regulatory regime and resolution authority for large systemic non-bank financial institutions contributed to the financial crisis and, unless addressed with legislation, will constrain a federal response to future crises (Title I, Subtitle G).

Regulators would be able to dissolve large, highly complex financial companies in an orderly and controlled manner, ensuring that shareholders and unsecured creditors, not taxpayers, would bear the losses. When a financial firm enters the dissolution process, management responsible for the failure would be dismissed, parties that should bear losses, particularly shareholders and unsecured creditors, would do so, and the firm would cease as a going concern. Thus, the legislation establishes an orderly process for the dismantling any large failing financial company in a way that protects taxpayers and minimizes the impact to the financial system.


If a large financial company fails, the legislation holds the financial industry and shareholders responsible for the cost of the company’s orderly wind down, not taxpayers; and protects the stability of the overall financial system. Any costs for dismantling a failed financial company will be repaid first from the assets of the failed firm at the expense of shareholders and creditors. Any shortfall would then be covered by a dissolution fund pre-funded by large financial companies with assets of more than $50 billion and hedge funds with assets of more than $10 billion.

The FDIC will be able to unwind a failing firm so that existing contracts can be dealt with and creditors’ claims can be addressed. Unlike traditional bankruptcy, which does not account for complex interrelationships of such large firms and may endanger financial stability, this more flexible process will help prevent contagion and disruption to the entire system and the overall economy.

Costs to resolve a failing firm will be repaid first from the assets of the failed firm at the expense of shareholders and creditors, and to the extent of any shortfall, from assessments on all large financial firms. In this instance the legislation follows the “polluter pays” model where the financial industry has to pay for its mistakes, not taxpayers.

Fed Audits

In an effort to make the Fed more transparent and accountable, the legislation removes the blanket restrictions on GAO audits of the Fed and allows the audit of every item on the Fed's balance sheet, all credit facilities, and all securities purchase programs. The Act retains a limited audit exemption on unreleased transcripts and minutes. Nothing in the Act shall be construed as interference in or dictation of monetary policy by Congress or the GAO. Also, the Act calls for an180-day time lag on publication of records related to specific market interventions to avoid destabilizing markets or stigmatizing individual firms.

Corporate Governance and Compensation

The legislation requires a non-binding annual shareholder advisory vote on executive compensation. Similarly, there must also be a shareholder advisory vote on golden parachutes. The SEC is allowed to exempt categories of public companies and, in determining the exemptions, the SEC must take into account the potential impact on smaller companies. The legislation also requires at least annual reporting of annual say-on-pay and golden parachutes votes by all institutional investors, unless such votes are otherwise required to be reported publicly by SEC rule The measure also provides that compensation approved by a majority say-on-pay vote is not subject to clawback, except as provided by contract or due to fraud to the extent provided by law (Title II).

The measure would not set any limits on pay, but will ensure that shareholders have an advisory vote on their company's executive pay practices without micromanaging the company. Knowing that they will be subject to some collective shareholder action should give boards pause before approving a questionable compensation plan

In a major governance reform, public companies must have a compensation committee composed of independent directors. Similarly, compensation consultants must satisfy independence criteria established by the SEC. The SEC is allowed to exempt categories of public companies, taking into account the potential impact on smaller companies (Section 2003).

In order to be considered independent, a compensation committee member may not accept any consulting, advisory, or other compensatory fee from the company and cannot be an affiliated person of the company or any of its subsidiaries. The SEC would be authorized to exempt a particular relationship with a compensation committee member from these independence standards.

The legislation gives the compensation committee sole discretion to retain compensation consultants meeting independence standards to be promulgated by the SEC. The compensation committee would be directly responsible for the appointment, compensation, and oversight of the compensation consultant. However, there is no requirement that the compensation committee implement or act consistently with the recommendations of the compensation consultant. In addition, the hiring of a compensation consultant would not affect the committee’s ability or obligation to exercise its own judgment in carrying out its duties.

The compensation committee would also be authorized to retain independent counsel and other advisers meeting SEC independence standards. As with compensation consultants, the compensation committee would be directly responsible for the appointment, compensation, and oversight of such independent counsel and other advisers. But the compensation committee would not be required to implement or act consistently with the advice or recommendations of such independent counsel and other advisers, and the retention would in no way affect the committee’s ability or obligation to exercise its own judgment.

Financial institutions with more than $1 billion in assets must disclose compensation structures that include any incentive based elements. Federal financial regulators, including the Fed, SEC, and FDIC, will jointly determine the disclosure requirements and incentive-based compensation standards. Also, federal regulators must proscribe inappropriate or imprudently risky compensation practices as part of solvency regulation (Section 2004).

The legislation authorizes the SEC to issue proxy access regulations regarding the nomination of directors by shareholders to serve on a company’s board of directors, thereby further democratizing corporate governance. This provision is needed because, without it, the SEC could have faced a lawsuit from corporations and industry groups alleging that the Commission lacked the authority to grant shareholders this right. Congress believes that proxy access is necessary for shareholders to have a meaningful choice in exercising their right to vote for board members, and thus to hold boards accountable. Regulation of proxy access and disclosure is a core function of the SEC and is one of the original responsibilities that Congress assigned to the Commission when it was created in 1934. The legislation would create a new federal right to proxy, but would also ensure that existing laws on the right to proxy are upheld (Section 7222).

Derivatives Regulation

For the first time, credit default swap markets and all other OTC derivative markets will be subject to comprehensive federal regulation under an SEC-CFTC regime in order to guard against activities in those markets posing excessive risk to the financial system and to promote the transparency and efficiency of those markets (Title III). The Senate draft would also authorize the federal regulation of derivatives under a dual SEC-CFTC regime.

The legislation divides jurisdiction over swaps between the SEC and the CFTC. The SEC oversees activity in swaps that are based on securities like equity and credit-default swaps. The CFTC is responsible for all other swaps, including those based on interest rates and currencies.

In setting out the first comprehensive system of regulation of the OTC derivatives market, the House legislation would establish a central clearing requirement for swaps transactions between dealers and large market participants that are accepted by a clearinghouse. Non-cleared swaps must be reported, with major participants and dealers adhering to strengthened capital and margin requirements. OTC derivatives include swaps, which are financial contracts that call for an exchange of cash flows between two counterparties based on an underlying rate, index or credit event or the performance of an asset.

Title III divides jurisdiction over swaps between the SEC and the CFTC. The SEC oversees activity in swaps that are based on securities such as equity and credit-default swaps. The CFTC is responsible for all other swaps.

The legislation would exempt commercial end users from the clearing requirement. These firms, such as airlines, manufacturers, and other small- to medium-sized businesses, often use derivatives markets to hedge their price risk. Regulators would be required to define the types of risk a company may hedge and remain eligible for the limited exception to clearing. The legislation will hold swap dealers like big banks accountable to new standards for capital, margin, and business conduct requirements and will benefit end users’ ability to continue to effectively hedge their price risk by not submitting them to onerous cash collateral requirements.

The legislation will resolve jurisdictional issues between regulators that have compromised past efforts at financial regulation. The House measure will also strengthen confidence in trader position limits on physically deliverable commodities as a way to prevent excessive speculative trading.

Heeding the G-20’s advice to prevent regulatory arbitrage, the legislation calls for international harmonization by requiring foreign boards of trade to share trading data and adopt speculative position limits on contracts that trade U.S. commodities similar to U.S.-regulated exchanges. The SEC and CFTC are also directed to consult and coordinate with foreign regulators to create consistent international standards with respect to the regulation of derivatives. The SEC and CFTC are authorized to engage in information sharing arrangements with foreign regulators consistent with the public interest and the protection of investors and counterparties. In addition, the SEC and CFTC are authorized to prohibit a foreign entity from participating in the US in any swap or security-based swap activities upon determining that the regulation of derivatives in the entity’s foreign jurisdiction undermines the stability of the US financial system.

The legislation specifically forbids federal assistance to support derivatives clearing operations or the liquidation of a derivatives clearing organization set up under the Commodity Exchange Act or a clearing agency described in the Exchange Act unless Congress expressly authorizes such assistance.

The legislation ensures that the expansion of the CFTC’s authority over derivatives will not in any way limit the Federal Energy Regulatory Commission's authority to regulate energy markets. In any area where FERC and the CFTC have overlapping authority, the legislation requires the two agencies to conclude a memorandum of understanding delineating their respective areas so as to avoid conflicting or duplicative regulation. Where FERC has regulatory authority, the CFTC is permitted to step back and let FERC do its job.

The legislation implements important corporate governance reforms in the derivatives markets. In addition to complying with a number of core principles listed in the Act, such as having adequate financial resources and effective risk management, derivatives clearing organizations registered with the SEC must designate a compliance officer to review compliance with the core principles and establish procedures for the remediation of non-compliance. The compliance officer must also prepare an annual report, certifying its accuracy, on the compliance efforts of the derivatives clearing organization. The compliance report will accompany the financial reports that the clearing organization must furnish to the SEC.

Hedge Funds and Private Equity Funds

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. This exemption 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.

The legislation requires investment 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 hedge fund and other private fund advisers to register with any federal financial regulator (Title V, Subtitle A).

The legislation accomplishes the registration of hedge fund advisers by eliminating the Investment Adviser Act’s private adviser exemption, which exempts from registration investment advisers that have fewer than 15 clients, do not hold themselves out to the public as investment advisers, and do not act as investment advisers to registered investment companies or business development companies. (Section 5003) The legislation creates a limited exemption for foreign private fund advisers.

The legislation mandates 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 fund advisers will give regulators the information needed to evaluate both individual firms and entire market segments that have until now have largely escaped any meaningful regulation, without posing undue burdens on those industries (Section 5004). Under the legislation, advisers to hedge funds, private equity firms, and other private pools of capital will have to obey some basic ground rules in order to continue to play in the capital markets. Regulators will have authority to examine the records of these previously secretive investment advisers.

The legislation authorizes the SEC to require registered investment advisers to maintain records of, and submit reports about, the private funds they advise in two instances. First, as the SEC determines is necessary or appropriate in the public interest and for the protection of investors; and second, as the SEC determines in consultation with the Federal Reserve Board, and to any other entity that the SEC identifies as having systemic risk responsibility, is necessary for the assessment of systemic risk. The records and reports of any private fund are further deemed to be the records and reports of the registered investment adviser.

The SEC is authorized, after considering the public interest and potential to contribute to systemic risk, to set different reporting requirements for different classes of private fund advisers, based on the particular types or sizes of private funds they advise. The information that hedge funds and private funds disclose to the SEC is confidential, except that the Commission may not withhold information from Congress. Also, the SEC is authorized to provide the information to the Fed and the new systemic risk regulator, which in turn must keep the information confidential in a manner consistent with the confidentiality regime established by the SEC.

The legislation requires hedge fund advisers covered by the asset threshold exemption to maintain the required records and gives the SEC the discretion to require reports in the public interest or for investor protection. In adopting regulations for investment advisers to mid-sized private funds, the SEC must take into account the size, governance and investment strategy of the funds in order to ascertain if they pose a systemic risk to the financial markets (Section 5007).

The House legislation contains a registration exemption for advisers to venture capital funds. The SEC is directed to identify and define the term venture capital fund and provide an adviser to such a fund an exemption from the registration requirements. But the Commission must require advisers to venture capital funds to maintain records and provide annual or other reports as the Commission determines necessary or appropriate in the public interest or for the protection of investors (Section 5006).

The legislation 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 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 new systemic risk regulator, 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 overall financial stability and should therefore be under the broad oversight of the new federal systemic risk regulator.

The Act would require the SEC to provide guidance to hedge funds, private equity firms, and other private pools as they adjust to the legislation’s new registration requirements.
The Comptroller General would be required to conduct a study and report to Congress within two years on the costs to the hedge fund industry of the legislation’s registration and reporting requirements. The Act would delay the effective date for one year, although advisers would have the discretion to register earlier with the SEC.

Senate legislation would require the SEC registration of hedge fund and other private fund advisers and disclosure of information to the Commission under a confidentiality regime.

Credit Rating Agencies

The credit rating agencies, nationally recognized statistical ratings organizations or NRSROs, have assumed a central role in the global capital markets. They faced growing criticism over the past years which reached a crescendo in the recent financial crisis. In response, the Act enhances the SEC’s oversight and regulation of NRSROs.(Title V, Subtitle B).

The Commission must establish an office that administers the SEC rules with respect to the practices of credit rating agencies in determining ratings, in the public interest and for the protection of investors, including rules designed to ensure that credit ratings are accurate and are not unduly influenced by conflicts of interest. The new Office must be sufficiently staffed to carry out the mission (Section 6002).

The SEC is directed to revise Regulation FD to remove from FD the exemption for entities whose primary business is the issuance of credit ratings (Section 6007). The legislation enhances the accountability of NRSROs by clarifying the ability of individuals to sue NRSROs. The Exchange Act is amended to provide that, in an action for money damages against a rating agency, it is enough for pleading any required state of mind that the complaint state with particularity facts giving rise to a strong inference that the rating agency knowingly or recklessly violated the securities laws. In addition, statements made by rating agencies will not be deemed forward looking statements for purposes of the Exchange Act’s safe harbor (Section 6003).

In any private action against a rating agency, the same pleading standards with respect to knowledge and recklessness must apply to the rating agency as would apply to any other person in the same or similar private right of action against such person. The Act also amends Rule 436(g) of the Securities Act to remove the “expert” exemption for credit ratings included in a registration statement. Thus, NRSROs will now have greater liability under the securities laws if a rating is included in a registration statement. Rating agencies would be liable for omitting information from a registration statement, putting them on the same level as other experts like accountants, auditors, and lawyers. The provision is intended to make credit rating agencies more accountable for their work by making them liable for misstatements or omissions of fact from a statement (Section 6012).

Transparency is a hallmark of the legislation. Investors will gain access to more information about the internal operations and procedures of NRSROs, methodologies, ratings performance and short-comings in ratings assessment. In addition, the public will now learn more about how NRSROs get paid.

The issuer-pay model has long created inherent conflicts of interest for which NRSROs have been criticized. The legislation contains new requirements designed to mitigate these conflicts of interest. The Act requires each NRSRO to have a board with at least one-third independent directors. The independent directors will oversee policies and procedures aimed at preventing conflicts of interest and improving internal controls, among other things. Moreover, the compensation of the directors cannot be linked to the business performance of the rating agency; and must be arranged to ensure the independence of their judgment

The Act adds a new duty to supervise an NRSRO's employees and authorizes the SEC to sanction supervisors for failing to do so. It also includes revolving-door protections when certain NRSRO employees go to work for an issuer

Additionally, the bill significantly enhances the responsibilities of NRSRO compliance officers to address conflicts of interest. The compliance officer would report directly to the board and would review all of the agency’s policies to manage conflicts of interest and, in consultation with the board, resolve any conflicts of interest that arise. The compliance officer must also asses the risk that compliance or lack of such may compromise the integrity of the rating process. Similarly, the compliance officer must review compliance with internal controls with respect to the procedures and methodologies for determining credit ratings, including quantitative models and qualitative inputs used in the rating process, and assess the risk that such compliance with the internal controls or lack thereof may compromise the integrity and quality of the credit rating process (Section 6002).

The measure also requires the compliance officer to be responsible for administering the policies and procedures required to be established by the legislation and, more broadly, ensure compliance with securities laws and SEC regulations. The compliance officer must annually prepare and sign a report on the compliance of the rating agency with the securities laws and its own internal policies and procedures, including its code of ethics and conflict of interest policies, in accordance with SEC rules. This compliance report must accompany the financial reports of the rating agency that are required to be filed with the Commission and must include a certification that the report is accurate and complete.

The legislation removes all references to credit ratings in federal statutes under the jurisdiction of the Committee on Financial Services. The bill directs the agencies to devise a standard of creditworthiness to serve as a substitute for ratings in rules and regulations (Section 6009).

Fiduciary Standard for Brokers and Investment Advisers

The current regulatory regime treats brokers and advisers differently and subjects them to different standards of care even though the services they provide investors are very similar and investors view their roles as essentially the same. This regime was erected during the New Deal and, while amended many times over the years, is still organically rooted in the last century. The legislation brings regulation into today’s reality and mandates a harmonized federal fiduciary standard for brokers and investment advisers in their dealings with retail customers. In the future, every financial intermediary, such as brokers and investment advisers, that provides personalized investment advice to retail customers will have a fiduciary duty to the investor (Section 7103).

The SEC must adopt rules providing that the standard of conduct for all brokers and investment advisers is to act in the best interest of their customers without regard to their financial or other interest. Any material conflicts of interest must be disclosed to the customer, who must consent.

Under this harmonized standard, broker-dealers and investment advisers will have to put customers’ interests first. The receipt of compensation based on commission or fees will not, in and of itself, be considered a violation of the standard applied to a broker or dealer or investment adviser. The legislation defines retail customers as those receiving personalized investment advice from a broker, dealer, or investment adviser for use primarily for personal, family, or household purposes.

The legislation clarifies that the SEC must not define customer to include investors in a private fund managed by an investment adviser when that private fund has also entered into an advisory contract with the same adviser. This is designed to prevent advisers from being subjected to an irresolvable conflict of interest when they manage a pooled investment with the interest of each individual investor in mind.

Additionally, the SEC must, to the extent practicable, harmonize its enforcement and remedy regulations across brokers, dealers and investment advisers with respect to the provision of investment advice.

Arbitration

The SEC will be enabled to restrict or even prohibit the use of mandatory arbitration clauses in contracts with broker-dealers. For too long, pre-dispute mandatory arbitration clauses inserted into brokerage firm contracts have restricted the ability of defrauded investors to seek redress in the courts for wrongdoing (Section 7201).

SEC Funding and Authority

SEC funding will double over the next five years from $1.115 billion in FY-2010 to $2.25 billion in FY 2015. This will provide the SEC with the ability to hire additional staff with industry expertise. In total, nearly $10 billion over the next 6 years will help the SEC better oversee the multi-trillion dollar securities markets. The Senate legislation would make the SEC a self-funded agency through the transaction and registration fees it collects (Section 7301).

In addition, the SEC will obtain additional funding via assessments on investment advisers. The legislation authorizes the SEC to create a new user fee paid by investment advisers to support the Commission’s work related to the inspection and examination of investment advisers. Broker-dealers presently pay fees to FINRA to cover the costs of their primary regulator, but investment advisers do not pay such fees to the SEC, which serves as their front-line regulator (Section 7302).

In addition, the examination statistics of investment advisers and broker-dealers reveal disparities and further vulnerabilities in the present regulatory framework. Last year, the SEC examined only 9 percent of investment advisers, while FINRA examined more than 50 percent of broker-dealers. This new user fee for the investment adviser community would help to increase the resources available at the SEC to inspect investment advisers and better protect investors.

In assessing the fee, the Commission must consider a number of factors, including the size of the adviser and the number and types of its client. The SEC may retain any excess fees imposed in one year for application in future years. Fee increases are not subject to judicial review.

The legislation also provides and clarifies several important rule-making authorities. The SEC will now regulate and establish formal rules for municipal financial advisors.

There is currently no requirement that mutual funds hold liquid securities. The legislation allows the SEC to impose limits on illiquid investments by mutual funds.

The securities lending program of AIG greatly contributed to its downfall. Thus, the legislation authorizes the SEC to regulate stock loans and borrowing in order to enhance market transparency, reduce collateral risk exposures, and limit conflicts of interest in the securities lending process. The SEC would have broader authority to collect information from and coordinate with foreign regulatory bodies, as well as to pursue legal cases across national borders (Section 7401).

The legislation would also expand the scope of securities that must be reported to the SEC or its designee under the Lost and Stolen Securities Program, to include cancelled, missing or counterfeit securities certificates (Section 7402).

For many years the SEC has relied on Section 20(a) of the Exchange Act, which imposes joint and several liability on control persons unless they can establish an affirmative defense. Recent court decisions, however, have concluded that the provision is available only to private parties. The legislation clarifies that the SEC may once again impose joint and several liability on control persons unless they can establish an affirmative defense (Section 7220).

Several of the Exchange Act’s antifraud provisions apply only to those transactions that involve securities registered on an exchange. Congress believes that, in today’s trading environment, the same standards should apply to transactions whether they involve securities registered on an exchange or not registered on an exchange. Thus, the legislation broadens the SEC’s authority under several sections of the Exchange Act to also apply the antifraud provision to securities transactions not conducted on exchanges. The SEC’s existing antifraud rulemaking powers would be expanded to cover short sales in the over-the-counter markets and of non-equity securities, as well as all options on securities. Government securities are excluded in order to avoid any possible impact of SEC rules on that market. The general antifraud provisions for these transactions would continue to apply (Section 7221).

Since 1975, the SEC has had the authority to examine all the records of broker-dealers and other persons registered under the Exchange Act, as well as all records of advisers registered under the Investment Advisers Act. The SEC’s authority to examine registered investment companies, however, has remained limited to required records. The legislation would change the authority under the Investment Company Act to apply to all records and, by fixing this anomaly, allow the SEC to gain a better understanding of the operations of investment companies (Section 7219).

The legislation also amends the Exchange Act, the Investment Company Act, and the Investment Advisers Act to subject registered individuals and firms at any time, or from time to time, to such reasonable periodic, special, or other information and document requests as the SEC by rule or order deems necessary or appropriate to conduct surveillance or risk assessments of the securities markets (Section 7218).

The legislation authorizes the SEC to require that registered management investment companies provide and maintain a bond against losses caused by any officer or employee of the company or any officer or employee of the company’s investment adviser (Section 7217).

Aiding and Abetting

The current law for determining aiding and abetting violations and the scope of primary liability remains unsettled, resulting in challenges for the SEC in charging people who play substantial roles in fraud cases. Specifically, the Exchange Act provides that the SEC can prosecute people for knowingly aiding and abetting securities fraud. A growing number of courts, however, have held that knowingly means actual knowledge, rather than recklessness, resulting in a standard that is higher for aiding and abetting violations than for the primary fraud violation, which would include recklessness. The legislation clarifies that recklessness is sufficient for bringing an aiding and abetting action, thus harmonizing the standard for aiding and abetting and the primary violation. Thus, the SEC would not be at a disadvantage charging someone as an aider and abettor rather than a primary violator (Section 7215).

The Exchange Act and the Investment Advisers Act presently permit the SEC to bring actions for aiding and abetting violations of those statutes in civil enforcement actions. The legislation would authorize the SEC to bring similar actions for aiding and abetting violations of the Securities Act and the Investment Company Act. In addition, the legislation would clarify that the knowledge requirement to bring an aiding and abetting claim can be satisfied by recklessness. The Act also clarifies that the Investment Advisers Act expressly permits imposition of penalties on aiders and abettors.

SEC Use of Grand Jury Information

Under existing law, the SEC may access grand jury information only in the rare case in which it can demonstrate that it has a particularized need for the information and that the information is sought preliminarily to or in connection with a judicial proceeding. As a practical matter, the particularized need standard and the required nexus with an ongoing or imminent judicial proceeding severely limit the situations in which the Department of Justice can share with the SEC even the most critical information relevant to parallel investigations.

In most cases, the SEC must therefore conduct a separate, duplicative investigation to obtain the same information. This both entails an inefficient use of government resources and frequently burdens private parties and financial institutions with the need to provide essentially the same documents and testimony in multiple investigations. The need for the SEC to conduct a separate investigation also can result in substantial delays. The legislation works a narrow modification of the grand jury secrecy rule to aid the SEC in its investigations and greatly enhance the efficient use of the law enforcement resources devoted to those investigations (Section 7214).

This modification is modeled on Section 964 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 providing banking and thrift regulators with access to grand jury information. The legislation authorizes government attorneys to seek court authorization to release certain limited grand jury information to SEC personnel for use in matters within the SEC’s jurisdiction.

The legislation permits the sharing of information only with regard to conduct that may constitute violations of the federal securities laws. With regard to that information, however, the measure lessens the burden in obtaining court approval. The court could approve the sharing of the information upon a showing of a substantial need in the public interest rather than the higher particularized need standard. In addition, the judicial proceeding requirement would not apply to the SEC, permitting information to be shared at an earlier stage in an investigation and in connection with an SEC administrative proceeding.

Information Sharing

The legislation would allow the SEC to share information with domestic regulators, foreign securities regulators, the PCAOB, and state securities agencies engaged in the investigation and prosecution of violations of applicable securities laws without waiving any privileges the SEC may have with respect to such information (Section 7213). The language is modeled on a provision in the Federal Deposit Insurance Act that enables the federal bank regulatory agencies to share information with other regulators without waiving their privileges with respect to such information. Also, the SEC cannot be compelled to disclose privileged information obtained from any foreign securities regulator or law enforcement authority if such authority has in good faith determined that the information is privileged.

Reporting Timeframes

With regard to beneficial ownership reporting and short-swing profit reporting, the legislation authorizes the SEC to adopt rules shortening current reporting timeframes and help the markets receive more timely information concerning substantial ownership interests in issuers that may be important for purposes of obtaining the accurate pricing of listed securities (Section 7105).

The legislation would expand the scope of records to be maintained and subject to examination by the SEC under both the Investment Company Act and the Investment Advisers Act to custodians or others who have custody or use of the investment company’s or the investment adviser’s clients’ securities, deposits, or credits (Section 7419).

PCAOB Reforms

Closing a statutory loophole revealed by the Madoff scandal, the Public Company Accounting Oversight Board will gain the power needed to flexibly examine the auditors of broker-dealers. Thus, the legislation would bring auditors of broker-dealers under the PCAOB oversight regime. The Board will inspect the audit reports on broker-dealer financial statements; and will have investigatory, examination and enforcement authority over the auditors of broker-dealers. In addition, brokers and dealers would be brought into the Board’s funding scheme by paying a fee allocation
in proportion to their net capital compared to the total net capital of all brokers and dealers that are not issuers, in accordance with the rules of the Board. The Act also authorizes the Board to refer an investigation concerning a broker or dealer’s audit report to the relevant self-regulatory organization. Moreover, the Board is authorized to share with the SRO all information and documents received in connection with an investigation or inspection without breaching its confidential status (Section 7601).

The House legislation would also change the name of the Public Company Accounting Oversight Board to Auditor Oversight Board. (Section 7610) In addition, the Act would create an ombudsman within the Auditor Oversight Board to act as a liaison between the Board and registered accounting firms and issuers with regard to the issuance of audit reports (Section 7609).

Securities Investor Protection Act Reforms

The $65 billion Madoff fraud also exposed faults in the Securities Investor Protection Act (SIPA), the law that returns money to the customers of insolvent fraudulent broker-dealers. The legislation attempts to fix these shortcomings. The legislation increases the Securities Investor Protection Corporation (SIPC) cash advance limits to levels of coverage that are similar to those provided by the FDIC. Currently, under SIPA, any amount advanced in satisfaction of customer claims may not exceed $500,000 per customer. If part of the claim is for cash, the total amount advanced for cash payment must not exceed $100,000. The legislation increases the maximum cash advance amount to $250,000 and authorizes SIPC, subject to the approval of the SEC, to make inflationary adjustments every 5 years to that amount starting in 2010.(Section 7503).

The Act also updates SIPA to increase the minimum assessments paid by members of the Securities Investor Protection Corporation to the SIPC Fund. Currently, SIPA provides that the minimum assessment of a SIPC member must not exceed $150 per year, regardless of the size of the SIPC member. The Act strikes this current minimum assessment level and sets a new minimum assessment at 2 basis points of a SIPC member’s gross revenues (Section 7501).

The Act would extend SIPC insurance to futures positions held in a customer portfolio margining account under a program approved by the SEC. This provision is intended to address the possibility that current law would treat a portfolio margining customer as a general creditor with respect to the proceeds from such customer’s futures positions, while the same portfolio margining customer would have priority for their securities holdings in the case of insolvency of their broker-dealer (Section 7509).

Whistleblower Protections

The legislation authorizes the SEC to establish a fund to pay whistleblowers for information that leads to enforcement actions resulting in significant financial awards using funds collected in enforcement actions not otherwise distributed to investors. The SEC currently has such authority to compensate sources in insider trading cases, and this provision would extend the Commission’s power to compensate whistleblowers that bring substantial evidence of other securities law violations. SEC determinations on whistleblower awards are final and not subject to judicial review (Section 7203).

The legislation also closes a loophole in Sarbanes-Oxley Act whistleblower protection by including any subsidiary or affiliate of company whose financial information is included in the consolidated financial statements of the company. Sarbanes-Oxley created federal whistleblower protections for employees when they disclose information about fraudulent activities within their companies. The Act would eliminate a defense now raised in a substantial number of actions brought by whistleblowers and apply the Sarbanes-Oxley whistleblower protections to both companies and their subsidiaries and affiliates (Section 7607). A letter from Senator Patrick Leahy, author of the Sarbanes-Oxley whistleblower statute, to the Department of Labor emphasized that federal whistleblower protection extends to employees of subsidiaries of companies and that the DOL should not interpret the statute to exclude employees working for company subsidiaries.

Investment Advisory Committee

The Act codifies the Investment Advisory Committee that the SEC recently administratively established to advise the Commission on regulatory priorities, including issues concerning new products, trading strategies, fee structures, and the effectiveness of disclosure; initiatives to protect investor interest; and initiatives to promote investor confidence in the integrity of the marketplace. The membership on the Investor Advisory Committee consists of individuals representing the interests of individual and institutional investors who use a wide range of investment approaches. The advisory panel must meet at least twice a year, and its members will receive compensation for participation in meetings and travel expenses. Funding, as is necessary, is authorized to support the work of the Committee (Section 7101).

Consumer Testing

In a congressional endorsement of the benefits that can accrue from field testing, consumer outreach, and testing of disclosures to individual investors, the legislation clarifies the SEC’s authority to gather information, such as through focus groups, communicate with investors or other members of the public through telephonic or written surveys, and engage in temporary experimental programs, such as pilot programs to field test disclosures, in order to inform the Commission’s rulemaking and other policy functions (Section 7102).

International Reach of Federal Securities Laws


The rapid globalization of financial markets in recent years has cast into stark relief issues surrounding the international reach of U.S. securities laws. Since the federal securities laws are silent on their international reach, federal courts have developed tests, including the conduct test, which focuses on the nature of the conduct within the U.S. as it relates to carrying out the alleged fraudulent scheme

The legislation authorizes the SEC and the United States to bring civil and criminal law enforcement proceedings involving transnational securities frauds, which are securities frauds in which not all of the fraudulent conduct occurs within the United States and not all of the wrongdoers are located domestically. Specifically, the legislation would amend the Securities Act and the Exchange Act to provide that US district courts have jurisdiction over violations of the antifraud provisions that involve a transnational fraud if there is conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors (Section 7216).


The "Revolving Door"

In an effort to address the revolving door problem, the legislation directs the US Comptroller General to conduct a study to review the number of SEC employees who leave the Commission to work for financial institutions regulated by the SEC and file a report within one year with Congress. The report must review the length of time these employees work for the SEC before they leave to work for regulated financial institutions (Section 7414).

Importantly, the Comptroller General must determine if greater post-employment restrictions are needed in order to prevent SEC employees from being employed by regulated firms when they leave the SEC, as well as whether the number of former SEC employees going to the industry has led to SEC enforcement inefficiencies. The report must also identify any information sharing engaged in by the SEC employees while they worked for the Commission.

SEC Enforcement Actions

To expedite cases against violators of securities laws, the SEC will generally need to complete enforcement investigations, compliance inspections and exams, within 180 days. (Section 7209) Also, the legislation would allow subpoenas to be served nationwide in SEC enforcement actions in federal court. Currently, the Commission can issue a subpoena only within the federal district where a trial takes place or within 100 miles of the courthouse. Witnesses in civil cases brought by the Commission are, however, often located outside of a trial court's subpoena range. The SEC has nationwide service of process of subpoenas in administrative proceedings (Section 7210).

The SEC would also be authorized to impose collateral bars against regulated persons. The Commission would have the authority to bar a regulated person who violates the securities laws in one part of the industry, such as a broker-dealer who misappropriates customer funds, from access to customer funds in another part of the securities industry, for example, an investment adviser. By expressly empowering the SEC to impose broad prophylactic relief in one action in the first instance, this provision would enable the SEC to more effectively protect investors and the markets while more efficiently using SEC resources (Section 7206).

The legislation expressly authorizes the SEC to bring actions against persons formerly associated with a regulated or supervised entity, such as an investment company or an SRO, for misconduct that occurred during that association. This provision closes a loophole in the securities laws that had allowed those who engage in misconduct while working for an entity regulated by the SEC, like a stock exchange, to resign and avoid being held accountable for their wrongdoing (Section 7212).


Many provisions of the federal securities laws that authorize the sanctioning of a person who engages in misconduct while associated with a regulated or supervised firm explicitly provide that such authority exists even if the person is no longer associated with that firm. Several provisions, however, do not explicitly address this issue. The legislation amends those provisions that do not explicitly address this issue to make it clear that the SEC, or in applicable cases the PCAOB, may sanction or discipline persons who engage in misconduct while associated with a regulated or supervised firm even if they are no longer associated with that firm.

The legislation streamlines the SEC’s existing enforcement authorities by permitting the SEC to seek civil money penalties in cease-and-desist proceedings under federal securities laws. The measure would ensure appropriate due process protections by making the SEC’s authority in administrative penalty proceedings coextensive with its authority to seek penalties in federal court. As is the case when a federal district court imposes a civil penalty in a SEC action, administrative civil money penalties would be subject to review by a federal appeals court (Section 7208).

The Fair Fund provisions of the Sarbanes-Oxley Act take the civil penalties levied by the SEC as a result of an enforcement action and direct them to a disgorgement fund for harmed investors. The legislation would increase the money available to compensate defrauded investors by revising the Fair Fund provisions to permit the SEC to use penalties obtained from a securities fraudster to recompense victims of the fraud even if the SEC does not obtain an order requiring the fraudster to disgorge ill-gotten gains. Currently, in some cases, a defendant may engage in a securities law violation that harms investors, but the SEC cannot obtain disgorgement from the defendant because the defendant did not personally benefit from the violation (Section 7605).

Post-Madoff Report

Within six months, the SEC must report to Congress describing the implementation of reforms in the wake of the Madoff fraud. The report must include an analysis of how many post-Madoff reforms have been implemented and how extensively. The SEC must publish the report on its website (Section 7306).

State Regulation of Investment Advisers

The legislation could move the regulation of thousands of investment advisers from the SEC to the states by raising the assets under management trigger for federal regulation from $25 million to $100 million and authorizing the SEC to move it even higher. The Act sets up state oversight of investment advisers with up to $100 million in assets under management. The $25 million trigger for state regulation was set in the National Securities Markets Improvement Act of 1996 (Section 7418).

As part of the 1996 Act, Congress determined that the SEC should regulate larger investment advisers while States should oversee smaller investment advisers. The legislation would eliminate any remaining application of federal law to investment adviser firms that the states now solely regulate.

Equal Treatment of SRO Rules

Section 29(a) of the Exchange Act voids any condition, stipulation, or provision binding any person to waive compliance with any provision of the Exchange Act, any rule or regulation under it or any rule of an exchange. The legislation would extend this safeguard to the rules of FINRA and registered clearing agencies (Section 7404). This change is consistent with provisions of the Exchange Act that encourage allocation of self-regulatory responsibilities among SROs to avoid overlapping and duplicative regulation. The change is particularly important now that FINRA has taken over the regulation of NYSE members’ conduct in relation to customers.


The legislation also amends the Exchange Act to require fingerprinting for the personnel of registered securities information processors, national securities exchanges, and national securities associations. This change would bring these entities in line with the entities already listed in the statute, and would aid in ensuring that the entities are aware of whether their personnel have criminal backgrounds (Section 7403).

SEC, FASB, PCAOB Testimony on Financial Accounting

The legislation would require the SEC, FASB and the PCAOB to provide oral testimony to Congress by their respective chairs beginning in 2010, and annually for 5 years, their efforts to reduce the complexity in financial reporting to provide more accurate and clearer financial information to investors. The testimony must discuss how the complexity of accounting and auditing standards has added to the costs of financial reporting, as well as the development of principles-based accounting standards (Section 7407).


Senior Investor Protection

The legislation would create a new grant program to provide states with the tools they need to prosecute securities fraud against seniors. (Title V, Subtitle C, Part 5). The legislation recognizes the harm to seniors posed by the use of misleading professional designations by salespersons and advisers and establishes a mechanism for providing grants to states designed to give them the flexibility to use funds for a wide variety of senior investor protection efforts, such as hiring additional staff to investigate and prosecute cases; funding new technology, equipment and training for regulators, prosecutors, and law enforcement; and providing educational materials to increase awareness and understanding of designations.


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