Thursday, January 28, 2010

2nd Circuit Affirms Fund Conflicts Dismissal

The 2nd Circuit upheld the dismissal of actions brought by shareholders of two mutual funds affiliated with Morgan Stanley. According to the complaints, the Morgan Stanley broker-dealers affiliated with the funds suffered from internal conflicts of interest. Because the fund managers relied on these broker-dealers’ stock research, the broker-dealer conflicts allegedly increased the risk to investors in the funds. In re Morgan Stanley Information Fund Securities Litigation

The district court (SD NY) found that the shareholders failed to plead the existence of any material omissions or misstatements, and the 2nd Circuit agreed. The appeals panel, relying in part on an amicus brief filed by the SEC, held that the funds were not required to disclose on Form N-1A that they invested in companies which might have an investment banking relationship with fund affiliates. The instructions to the form were not independent sources of disclosure, advised the SEC. Rather, they were intended to provide funds with general guidance as to the nature of the information they should provide in responding to specific disclosure items.

The SEC also advised the court that it considered the breakdown of the "Chinese Wall," or "information barrier," between Morgan Stanley and the funds to be a "generic" risk rather than a specific risk that the funds' investment objectives included enhancing an affiliated entity’s investment banking business. While funds would be required to disclose such particular intentions, the Commission advised that "the danger that analyst reports (whether from affiliated or unaffiliated analysts) will be tainted by undisclosed conflicts of interest or actual corruption is but one of an indefinitely large number of factors that could cause a fund (or any other investor) to purchase overpriced securities, and it would not be useful to investors to require an attempt to set all of those forth in the prospectus."

In addition to rejecting the investor claims based specifically on Form N-1A, the court also dismissed the allegations based on the general Securities Act disclosure requirements. According to the court,

plaintiffs have not alleged that the Funds’ managers pursued an undisclosed objective or investment strategy when making investment decisions for the Funds. Therefore, the Funds’ disclosures about these topics were not misleading. Similarly, in light of our holding that plaintiffs have not identified any undisclosed “principal risks” relating to the Funds, it cannot be said that the Offering Documents’ risk disclosures were misleading because they omitted the generic risks relied on by plaintiffs.

Commission Strengthens Money Market Regulations

The SEC adopted new rules designed to significantly strengthen the regulatory requirements governing money market funds. The new rules are intended to increase the resilience of money market funds to economic stresses and reduce the risks of runs on the funds by tightening the maturity and credit quality standards and imposing new liquidity requirements. The Commission acted after a review of the money market regulatory scheme prompted by the Reserve Primary Fund's "breaking the buck" in September 2008. A money market fund "breaks the buck" when its net asset value falls below $1.00 per share, meaning investors in that fund will lose money.

The new rules require money market funds to have a minimum percentage of their assets in highly liquid securities so that those assets can be readily converted to cash to pay redeeming shareholders. There are currently no minimum liquidity mandates. For all taxable money market funds, at least 10 percent of assets must be in cash, U.S. Treasury securities, or securities that convert into cash within one day. For all money market funds, at least 30 percent of assets must be in cash, U.S. Treasury securities, certain other government securities with remaining maturities of 60 days or less, or securities that convert into cash within one week.


The rules would further restrict the ability of money market funds to purchase illiquid securities by 1) restricting money market funds from purchasing illiquid securities if, after the purchase, more than 5 percent of the fund's portfolio will be illiquid securities (the current limit is 10 percent); and 2) redefining as "illiquid" any security that cannot be sold or disposed of within seven days at carrying value.

The new rules also place new limits on a money market fund's ability to acquire lower quality, or "Second Tier," securities. Under the new rules, funds may not 1) invest more than three percent of their assets in Second Tier securities (the current limit is five percent); 2 ) invest more than one-half of one percent of their assets in Second Tier securities issued by any single issuer (the current limit is the greater of one percent or $1 million) or 3) buy Second Tier securities that mature in more than 45 days (the current limit is 397 days).

Money market funds will also face shorter maturity limits, in order to limit the exposure of funds to certain risks such as sudden interest rate movements. The maximum "weighted average life" maturity of a fund's portfolio will be 120 days. Currently, there is no such limit. The effect of the restriction is to limit the ability of the fund to invest in long-term floating rate securities. In addition, the rules shorten the maximum weighted average maturity of a fund's portfolio to 60 days. The current limit is 90 days.

Measures described as "know your investor" procedures rules require funds to hold sufficiently liquid securities to meet foreseeable redemptions. Currently, there are no such requirements. In order to meet this new requirement, funds would need to develop procedures to identify investors whose redemption requests may pose risks for funds. As part of these procedures, funds would need to anticipate the likelihood of large redemptions. The rules also will require fund managers to examine the fund's ability to maintain a stable net asset value per share in the event of shocks, such as interest rate changes, higher redemptions, and changes in credit quality of the portfolio. Previously, there were no such stress test requirements.

The new rules continue to limit a money market fund's investment in rated securities to those securities rated in the top two rating categories, or to unrated securities of comparable quality. At the same time, the new rules also continue to require money market funds to perform an independent credit analysis of every security purchased. As such, the credit rating serves as a screen on credit quality, but can never be the sole factor in determining whether a security is appropriate for a money market fund. In addition, the new rules improve the way that funds evaluate securities ratings provided by NRSROs. Funds must designate at least four NRSROs each year whose ratings the fund's board considers to be reliable. This permits a fund to disregard ratings by NRSROs that the fund has not designated, for purposes of satisfying the minimum rating requirements, while promoting competition among NRSROs. The rules also will eliminate the current requirement that funds invest only in those asset backed securities that have been rated by an NRSRO.

With regard to repurchase agreements, the new rules strengthen the requirements for allowing a money market fund to "look through" the repurchase issuer to the underlying collateral securities for diversification purposes. Collateral must be cash items or government securities, as opposed to the current requirement of highly rated securities. The fund must also evaluate the creditworthiness of the repurchase counterparty.

Each month, money market funds must post on their Web sites their portfolio holdings. Currently, there is no Web site posting requirement. Portfolio information must be maintained on the fund's Web site for no less than six months after posting. The new rules also require money market funds each month to report to the Commission detailed portfolio schedules in a format that can be used to create an interactive database through which the Commission can better oversee the activities of money market funds. The information reported to the Commission would be available to the public 60 days later. This information would include a money market fund's "shadow" NAV, or the mark-to-market value of the fund's net assets, rather than the stable $1.00 NAV at which shareholder transactions occur. Currently a money market fund's "shadow" NAV is reported twice a year with a 60-day lag.

Funds and their administrators must be able to process purchases and redemptions electronically at a price other than $1.00 per share. This requirement facilitates share redemptions if a fund were to "break the buck." Fund boards may also to suspend redemptions if the fund is about to break the buck and the board decides to liquidate the fund. Ccurrently the board must request an order from the SEC to suspend redemptions. In the event of a threatened run on the fund, this allows for an orderly liquidation of the portfolio. The fund is now required to notify the Commission prior to relying on this rule.

The Commission also expanded the ability of affiliates of money market funds to purchase distressed assets from funds in order to limit losses. Currently, an affiliate cannot purchase securities from the fund before a ratings downgrade or a default of the securities unless it receives individual approval. The rule change permits such purchases without the need for approval under conditions that protect the fund from transactions that disadvantage the fund. The fund must notify the Commission when it relies on this rule.

The adopted are effective 60 days after publication in the Federal Register. We will provide a link to the release when it becomes available.


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Wednesday, January 27, 2010

SEC Staff Updates Interpretations under Reg. S-K and Enhanced Proxy Dislcosure Transition

The SEC Division of Corporation Finance has updated its compliance and disclosure
interpretations to add new questions and answers under Regulation S-K and the proxy disclosure enhancements transition. The guidance was updated on January 20, 2010.

In disclosing the experience, qualifications, attributes or skills for directors and nominees, a company may not provide the information on a group basis, even if the individuals share similar characteristics, such as qualifications as audit committee financial experts or former CEOs of major companies. The information must be provided on an individual basis.

The company must disclose why a person's particular and specific experience, qualifications, attributes or skills led the board to nominate that person to serve as a director in light of the company's business and structure at the time the filing is made.

The composition of the entire board is important for shareholder decision making, even where a person serves on a classified board and is not up for re-election at the upcoming shareholders' meeting. For each person who is not up for re-election, the evaluation of the director's particular and specific experience, qualifications, attributes and skills and the reason why the director should continue serving on the board, should reflect the time that the filing containing the disclosure is made.

The staff noted that for some boards, particularly those that do not conduct annual self-evaluations, this may require additional disclosure controls and procedures to ensure that the information about directors who are not up for re-election at the upcoming meeting is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms.

If a company granted an equity award to an executive officer in 2009 and the same award is forfeited in 2009 because the officer left the company, the grant date fair value of the award should be included for purposes of determining the 2009 total compensation and identifying the 2009 named executive officers.

The grant date fair value reported for awards that are subject to time-based vesting excludes the effect of estimated forfeitures. Service conditions that affect vesting are not reflected in estimating the fair value of an award at the grant date because those conditions are not restrictions that stem from the forfeitability of instruments to which employees have not yet earned the right.

The SEC's new rules do not specify where the Item 402(s) narrative about compensation policies and practices as they relate to risk management should be presented. However, the staff recommends that the disclosure be presented together with the registrant's other Item 402 disclosure. The staff said it would have concerns if the Item 402(s) disclosure is difficult to locate or is presented in a manner that obscures the information.

The additional services provided by executive compensation consultants that are subject to the disclosure requirements of Item 407(e)(iii)(A) and (B) are not limited to services for non-executives.

Whether compensation consultants' fees with respect to broad-based and non-customized plans are considered to be for determining or recommending the amount or form of executive and director compensation or are considered to be for additional services depends on the facts and circumstances of each service.

Fees for consulting on broad-based, non-discriminatory plans in which executive officers or directors participate, and for providing information relating to executive and director compensation such as survey data (in each case, that would otherwise qualify for the exclusion from disclosure if they are the only services provided), are considered to be fees for determining or recommending the amount or form of executive and director compensation for purposes of reporting fees under Item 407(e)(3)(iii).

Consulting on broad-based non-discriminatory plans does not include any related services such as benefits administration, human resources services, actuarial services and merger integration services, all of which are additional services that are subject to the disclosure requirements of Item 407(e)(3)(iii)(A) and (B). If the non-customized information relates to matters other than executive and director compensation, the fees would be for additional services.

If a company's Form 10-K or 10-Q is due on or after February 28, 2010, the results of the meeting should be reported in the "other information" item of each form, rather than in the "submission of matters to a vote of security holders" item, which will be rescinded from Forms 10-K and 10-Q on February 28, 2010.

Compliance with the Regulation S-K amendments would be required for reporting issuers with fiscal years ending on or after December 20, 2009 that file a 1933 or 1934 Act registration statement on or after that date in order for it be to declared effective on or after February 28, 2010. If the registration statement is on Form S-3, it will incorporate by reference the issuer's 2009 Form 10-K.

If the issuer's fiscal year ends on or after December 20, 2009, its Form 10-K and proxy statement must be in compliance with the new proxy disclosure requirements if filed on or after February 28, 2010. If the issuer's fiscal year ends before December 20, 2009, its 2009 Form 10-K and related proxy statement are not required to be in compliance with the new proxy disclosure requirements, even if filed on or after February 28, 2010.


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Monday, January 25, 2010





Oral Argument Set and Merits Brief Filed in Supreme Court Case Involving Extraterritorial Reach of US Securities Laws

The U.S. Supreme Court has scheduled oral argument for March 29, 2010 on the extraterritorial reach of the US federal securities laws in what appears to be the first foreign cubed case to ever reach the Court. The investors recently filed their merits brief. The Court agreed to review a Second Circuit panel ruing that the US federal securities laws did not apply to foreign investors alleging fraudulent statements by a foreign issuer when the conduct in the US was merely preparatory to the fraud and the acts directly causing loss to investors occurred outside the US. The panel described itself as an American court, not the world’s court, which cannot expend resources resolving cases that do not affect Americans or involve fraud emanating from America. Morrison v. National Australian Bank, Ltd., Dkt. No. 08-1191.

This is the so-called foreign-cubed securities fraud action, said the appeals panel, and it is judged by the same standard of any extraterritorial application of the federal securities laws, which is whether actions in the U.S. directly caused the loss to investors. The panel described itself as an American court, not the world’s court, which cannot expend resources resolving cases that do not affect Americans or involve fraud emanating from America.

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 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

A three-way split has developed among the federal Circuit Courts of Appeal as to the proper scope of jurisdiction when conduct within the US results in fraud in connection with a transaction outside the U.S. The predominant difference among the Circuits is the degree to which the U.S.-based conduct must be related causally to the fraud and the resulting harm to justify the application of the federal securities laws.The Third, Eighth and Ninth Circuits have held that jurisdiction may be exercised when conduct within the U.S. furthered the alleged fraud The Second, Fifth and Seventh Circuits have established a more restrictive test, holding that jurisdiction may be exercised only when conduct occurring within the U.S. directly caused the alleged losses. Finally, the District of Columbia Circuit has adopted the most stringent test, holding that jurisdiction is proper only when the fraudulent statements or misrepresentations originate in the United States, are made with scienter and in connection with the purchase or sale of securities, and directly cause the harm to those who claim to be defrauded, even if reliance and damages occur elsewhere.

In their merits brief, the investors said that the Second Circuit ruling diminishes the effectiveness of the Exchange Act and divests the SEC of critical enforcement powers. There is no jurisdictional safe harbor in the Exchange Act, said the brief, yet that is what the Second Circuit created, thereby allowing an unregulated launching point for fraud generated in the U.S. so long as the ultimate transaction was elsewhere.

According to the brief, the information that rendered the statements in Australia false was fabricated in the U.S. by a wholly-owned subsidiary of the Australian entity with the expectation that it would be distributed to foreign and domestic investors. The activity in the U.S. was, at the very least, part of a single fraudulent scheme to inflate the bank’s stock price.


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Financial Stability Board Welcomes Obama Proposal on Bank Proprietary Trading As It Readies Similar Proposal for G-20

The Financial Stability Board welcomes the Obama Administration’s proposals for reducing the risk of moral hazard by prohibiting banks and financial institution that contain a bank from owning, investing in or sponsoring a hedge fund or a private equity fund, or engaging in proprietary trading operations unrelated to serving customers for their own profit. The President also announced a new proposal to limit the consolidation of the financial sector by placing broader limits on the excessive growth of the market share of liabilities at the largest financial firms.

The proposals are among a range of options and approaches that the Board has also been considering as it works to address the moral hazard risks posed by systemically important, too-big-too-fail financial institutions. The Board said that it plans to publish an interim report on this effort shortly after the June G-20 summit, and will make recommendations to the G-20 leaders in October.

The range of options being examined by the Board include targeted capital and leverage requirements, simplification of firm structures, enhanced national and cross-border resolution frameworks, and infrastructure changes at financial institutions that reduce contagion risks. The Board believes that a mix of approaches will be needed to address the problem, given the different types of institutions and national and cross-border issues. At the same time, these approaches must preserve an integrated financial services market and not create regulatory arbitrage through an uneven playing field.

The Board is armed with a mandate from the G-20 to promote globally consistent financial regulation as the US and the EU prepare major reform legislation. There are standing Board committees designed to ensure consistent cross-border high quality financial regulation and avoid regulatory arbitrage. The Obama Administration’s plan for regulatory reform also endorsed the Financial Stability Board’s role as coordinator of consistent cross-border financial regulation and arrangements for international cooperation on supervision of global financial firms through establishment of supervisory colleges.


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FSA Chair Says Bank Fair Value and Loan Loss Accounting Can Add to Systemic Risk; Notes Tension Between Banking and Securities Regulators

Fair value mark-to-market accounting and accounting for loan losses as applied to banks can increase pro-cyclicality and pose a systemic risk, said UK Financial Services Authority Chair Adair Turner, and thus is linked to macro-prudential risk regulation. In remarks at a London conference hosted by the Institute of Chartered Accountants of England and Wales, he noted that no other sector of the economy is remotely comparable to banking in its capacity to be a driver of economic volatility. As a result, accounting standards relevant to banks need to reflect these differences.

On a broader level, the FSA Chair acknowledged the rising tension over fair value accounting between banking and securities regulators, which has spilled over into the accounting standard setters. The banking regulators are convinced that banks are different and that the IASB and FASB must consider this difference. The pure securities regulators, conversely, tend to be more sympathetic to the idea that accounts are for investors and must reflect fair value at all times.

In the Chair’s view, the tension within the accounting standards setters is complicating progress towards the convergence of international accounting standards. The IASB has been sympathetic to the idea that it must be involved in close dialogue with the banking regulators, he noted, while FASB has been wedded to the ``accounts are for investors only’’ philosophy, and to the accompanying belief that banks, in their accounting, should be treated the same as everyone else.

Fair Value Accounting

Chairman Turner recognizes that there is no alternative to mark-to-market accounting for some instruments, that there is information shareholders value in mark-to-market accounts, and that there is danger in allowing the freedom to switch accounting approaches to hide problems. In addition, he knows that there are many instruments for which there is no feasible alternative to a fair value approach. For example, it is almost impossible for derivatives to be dealt with in any other fashion since concepts of historic cost, nominal value or incurred loss cannot help gauge the economic substance of the risks inherent in a derivative.

However, he also believes that too widespread an application of mark-to-market accounting can exacerbate system volatility. The mark-to-market approach recognizes unrealized gains or losses, which, when applied to illiquid securities, can drive harmful volatility in both upswings and downswings. The fundamental problem is that there are no definitive facts about value. Rather, value in financial markets is contingent on specific circumstances and on the action of all other participants.

For an individual bank selling slices of its individual portfolio in conditions where the actions of other banks can be considered independent, mark-to-market accounting provides meaningful facts and a useful management discipline. But if all banks simultaneously try to sell all or a significant proportion of their assets, the facts become quite different. And a fully transparent system of across the board mark-to-market accounting could simply increase the speed with which self-reinforcing assumptions about appropriate value generate herd effects.

The FSA recommends limiting the use of fair value accounting in the income statement to the areas of the trading book where it is most appropriate and, in particular, to trading activities in markets likely to remain highly liquid in nearly all circumstances. The way forward also requires a parallel look at the appropriate coverage of fair value approaches to the definition of profit or loss, ensuring that fair value gains or losses affect profit and loss only where instruments are liquidly traded, and are likely to be liquidly tradable in almost all circumstances.

Loan Losses

The Chair pointed out that current accounting standards base loan loss provisions on evidence of already current credit impairment and do not allow for reasonable judgments on future potential losses. He welcomes the increasing dialogue between the IASB and regulators, particularly the IASB’s consultation on a new version of IAS 39, which would require loans on balance sheet to bear an economic loss provision, rather than recognizing losses solely according to the existing incurred loss approach. In principle this approach has merit, he said, but the devil is very much in the details and, in particular, in the detail of how economic loss will be calculated.

If it is calculated by reference to current market expectations of future losses, there is a danger that the new approach could actually be more pro-cyclical than the past. In extremis, if expected losses are calculated by reference to the market prices and spreads of traded credit securities, then an expected loss approach to the banking books becomes a form of mark-to-market by another name, potentially increasing rather than reducing pro-cyclicality.

Conversely, if, as regulators would generally prefer, expected loss is calculated by reference to judgments about future possible losses informed by past experience or by formulae which link provisions to broad indicators of likely future credit problems, some investors might have concerns about whether these judgments, whether made by the management or by the regulator, are based on fact and are transparently understandable.

The FSA recommends allowing the banking book to reflect a more forward looking approach to loan losses. Ideally, the FSA would like to see two separate lines of account information on loan loss provisions. The first line is the existing line, as now.

The second line is a separate line based either on a formula that uses a dynamic provisioning model permitting more mechanical increases to loan loss reserves based on loan growth rather than measures of projected loss, or on the judgments of management, challenged by regulators, and with the details, basis and rationale for that judgment extensively disclosed. If this ideal approach is not followed, careful disclosure of the judgments made in the development of the single economic loss line will be essential.

Two separate lines and extensive disclosure would, the FSA believes, provide better information to investors than either the current incurred loss line or any one expected loss based line could ever provide.

The current IASB accounting treatment requires banks to recognize the implications for potential loan losses of events which have already occurred, such as failures to make interest or principal payments; but also requires them only to recognize such known events, not to anticipate possible or probable future events. This necessarily implies that loan loss provisions will vary dramatically through the economic cycle, and means that in good years income will be declared which does not reflect the average future loan losses likely to arise from loans being put on the books. As a result, this accounting treatment can contribute to a cycle of self-reinforcing responses which tends to exacerbate the volatility of credit extension and of the economic cycle, both on the way up and the way down.


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Sunday, January 24, 2010

Financial Crisis Inquiry Commission Hearings Reveal Broad Support for Legislation to Regulate OTC Derivatives

Recent hearings of the Financial Crisis Inquiry Commission revealed deep and broad support among regulators and financial industry leaders for federal legislation regulating OTC derivatives. The Commission was created by Section 5 of the Fraud Enforcement and Recovery Act of 2009 to examine the causes of the current financial and economic crisis in the United States and report its conclusions to the President and Congress by December 15, 2009. Late last year, the House passed legislation placing the OTC derivatives market under joint SEC-CFTC regulation. Similar legislation is currently under consideration in the Senate.

Commission Member, and FDIC Chair, Shelia Bair
said Congress should require that all standardized OTC derivatives clear through appropriately designed and central counterparty systems (CCPs) and, where possible, trade on regulated exchanges. To ensure necessary risk management, the CCPs and exchanges must be subject to comprehensive settlement systems supervision and oversight by federal regulators.

Recognizing that not all OTC derivatives are standardized, Member Bair said that, in those limited circumstances where customized OTC derivatives are necessary, the contracts should be reported to trade repositories and be subject to robust standards for documentation and confirmation of trades, netting, collateral and margin practices, and close-out practices. She emphasized that this is an essential reform to reduce the opacity in the OTC market that contributed to market uncertainty and greatly increased the difficulties of crisis management.

Currently, trade repository information is not yet complete or available to all regulators who need it. For example, the FDIC as deposit insurer and receiver, does not currently have access to end-user data from the CDS trade repository. This gap must be closed, she insisted. In addition, improved transparency is vital for a more efficient market and for more effective regulation.

In her view, the clearance of standardized trades through CCPs and the reporting of information about customized derivatives will greatly improve transparency. To achieve greater transparency, she continued, it is essential that CCPs and trade repositories be required to make aggregate data on trading volumes and positions available to the public and to make individual counterparty trade and position data available on a confidential basis to federal regulators, including those with responsibilities for market integrity.

Commission Member Brooksley Born urged Congress to act quickly to regulate the OTC derivatives markets. The former CFTC Chair said that exempting OTC derivatives from federal regulation in the Commodity Futures Modernization Act of 2000 was a ``profound shortcoming’’ of government regulation. Through rampant speculation and excessive leverage, she noted, opaque OTC derivatives spread and multiplied risk and contributed to the financial crisis

Commission Member, and Goldman Sachs CEO, Lloyd Blankfein
supports a broad move to central clearinghouses and exchange trading of standardized derivatives. He advocates a central clearing house with strong operational and financial integrity will reduce bi-lateral credit risk, increase liquidity, and enhance the level of transparency through enforced margin requirements and verified and recorded trades. In his view, this will go a long way to enhance price discovery and reduce systemic risk.

Importantly, the Goldman chief said that financial institutions have a duty to the financial system not to favor customized products when a client’s objective and the market’s interest can be met through an exchange-traded standardized product. Further, when customized derivatives are used they should entail more rigorous capital requirements.

He also said that liquid OTC derivatives should be centrally cleared. Where trading volumes are high enough and price discovery mechanisms can be set up, regulators should encourage exchange trading. In less liquid markets, prompt reporting of aggregated pricing and clearing is necessary to improve transparency.


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Audit Firm Governance Code Adopted in UK

A working group sponsored by the UK Financial Reporting Council has adopted a governance code for the auditors of listed company financial statements. The Audit Firm Governance Code will cover global audit firms that audit the accounts of 95 per cent of the companies listed on the London Stock Exchange. The code will be applicable to those firms that audit more than 20 listed companies, which essentially restricts it to the Big Four and other global audit networks. For these firms, the code sets a benchmark for good governance which other audit firms may wish to voluntarily adopt in full or in part. As with almost all European corporate governance codes, the Audit Firm Governance Code will operate on a comply or explain basis.

Drawing on aspects of the UK Corporate Governance Code, the audit firm code establishes a core principle that audit firms should appoint independent non-executives within their governance structure and deeply involve them in the governance of the audit firm. These independent non-executives will have a duty of care to the overall firm.

The code also embodies the idea that management at the audit firms should set a tone at the top that fosters quality audits, sound professional judgments, and the public interest. The firm should have a code of conduct and disclose the code on its website. Similarly, audit firms should publicly commit themselves to follow the governance code.

The code requires audit firms to maintain a sound system of internal control and risk management. Firms should annually evaluate the effectiveness of risk management and internal controls using a recognized internal control framework, such as the Turnbull Guidance.

The code sees the management of reputational risk as being quite important. The ability of a firm to continue to operate in the listed company audit market largely depends on its reputation of conducting high quality audits. The firm’s independent non-executives can be particularly useful in addressing reputational risks.

Another code principle is that firms should establish confidential whistleblower procedures enabling people to report concerns about the firm’s commitment to quality work and professional judgment. In addition, the code envisions that audit firms will publish audited financial statements in accordance with ISFR or GAAP. And, management should annually publish commentary on the firm’s financial performance and prospects.

Audit firms should also commit to a dialogue about the code with shareholders and audit committees at the companies whose financial statements they audit. This principle is based on the belief that an audit firm’s continued ability to maintain confidence in its audits depends on good two-way communication between the firm and shareholders and audit committees. Independent communication channels are likely to be most important when events occur posing a major threat to a firm’s reputation.

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Saturday, January 23, 2010

UK FSA Dear CEO Letter to Investment Firms Faults Compliance with Principle on Protecting Client Assets

The UK Financial Services Authority has sent a Dear CEO letter and report to the chief executive officers of major insurance brokers and investment firms which hold money or assets on behalf of clients, drawing their attention to the FSA’s concerns over the handling of client money and assets. In the letter, the CEOs were asked to confirm that their firms are in compliance with their obligation to protect client money and assets.

The letter and report were sent to the CEOs of all insurance brokers and investment firms which are supervised by the FSA on a relationship managed basis and which are able to hold client money or assets. Other firms which have the ability to hold or control client money and assets will be provided with a link to the letter and report via a regulatory update sent to small firms.

Under FSA Principle No. 10, a firm is required to arrange adequate protection for client assets when it is responsible for them. In the FSA’s view, there is still a significant amount of work to be done in order for firms to ensure that the assets and money of their clients is adequately protected. According to Sally Dewar, FSA Managing Director for Risk, the client asset rules are a key protection for consumers, and firms must ensure that consumers get the appropriate protection. The FSA said that the protection of client assets will continue to be a top regulatory priority in 2010.

The letter follows up on a Dear Compliance Officer letter sent to firms in March 2009, which explained the obligations a firm has to protect client money and assets and set out the FSA’s intention to conduct further firm visits during 2009.

Subsequently, the FSA visited a range of firms and found a number of failings. As a result, the FSA decided to write to chief executives with an accompanying report containing details of visit findings, and highlighting some of the weaknesses discovered, including inadequate management oversight and control, unclear arrangements for the segregation and diversification of clients’ money; and incomplete or inaccurate recordkeeping. The FSA has already taken measures against a number of the firms that it visited, including referring two firms to enforcement, freezing a firm’s assets and commissioning skilled persons reports.

With regard to investment firms, the FSA found limited due diligence of banks and money market funds that were used to hold client money, with the firms typically relying on the credit rating of the institution used. In addition, firms failed to adequately explain the rationale for using a particular bank or fund. The FSA emphasized that simply looking at the credit rating of a bank or fund is not proper due diligence. The FSA said that adequate due diligence would involve assessing a bank or fund’s market reputation and market practices, as well as risk diversification.


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Leading German Companies Implement Shareholder Advisory Vote on Management Compensation

Pursuant to federal legislation adopted last year, leading German companies are providing for a shareholder advisory vote on management compensation at the annual meeting of shareholders. For example, Siemens AG has proposed a resolution on shareholder say-on-pay, which refers to the company’s present compensation system that was used to determine the compensation of management board members in 2009. A similar proposal was made at ThyssenKrupp AG. At both companies, the supervisory board and the management board advised the shareholders to approve the compensation packages.

Germany companies operates under a two-tier system of corporate governance with a supervisory board with oversight power and a management board that daily runs the company. Generally, the compensation system for members of the management or executive board is presented in detail in the compensation report that forms part of the corporate governance report in the company’s annual report.

The Act on Appropriateness of Management Board Remuneration (Gesetz zur Angemessenheit der Vorstandsvergütung), which took effect last year, enables the annual shareholders meeting to resolve on the approval of the system of management board compensation. The German Federal Parliament, the Bundestag, adopted the legislation based primarily on the belief by the Federal Republic that a factor contributing to the financial crisis is that the incentives in management remuneration promoted the wrong kind of conduct. Many companies were too focused on the attainment of short-term parameters, such as turnover figures or stock market prices on certain dates. As a result, management lost sight of the long-term state of well-being of the company. Moreover, providing the wrong incentives created the temptation to take irresponsible risks.

However, the legislation does not establish a specific level of remuneration by law. This is not a matter for the State to decide, said Federal Justice Minister Brigitte Zypries, but should be up to the contracting parties.

The Federal Republic believes that allowing a general meeting of shareholders of a listed company to deliver a non-binding vote on management compensation will be an instrument for controlling the existing executive pay system and enable shareholders to express their approval or disapproval. In turn, pressure will be exerted on those responsible to act particularly conscientiously when determining management pay packages.

In other compensation reform, the Act provides that a decision concerning the compensation of a management board member may no longer be delegated to a committee of the supervisory board; but instead must be made by the supervisory board in a plenary meeting. Also, companies are required to disclose more extensive information regarding compensation and pension payments made to management board members when they discontinue their board activity, be it premature or under normal circumstances. This will enable shareholders to gain a better insight into the extent of agreements entered into with members of the management board.

The legislation also provides that, if the supervisory board determines a level of remuneration that is inappropriate, it thereby makes itself liable to compensation vis-à-vis the company. This provision clarifies that determining an appropriate level of remuneration is one of the most important duties of the supervisory board; and that the board is personally liable for any violations of its obligations.

Further, there must be an appropriate relationship between the remuneration of the company’s management board and the management board's performance. Management compensation may not exceed the usual sector or country-specific level of remuneration in the absence of special reasons.


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Claim that Hedge Funds Filed False 13Ds with SEC as Part of Creeping Takeover Goes Forward in Delaware Court

An acquiring company stated a claim for common law fraud against hedge funds that engaged in a creeping takeover of a target company under the cover of allegedly false Section 13 beneficial ownership filings. In so ruling, the Delaware Chancery Court first decided that it had jurisdiction to provide a common law fraud remedy for claims arising out of statements made in SEC-mandated filings. Although the federal government has an obvious interest in enforcing the disclosure scheme established by the Exchange Act, said Vice Chancellor Laster, Delaware has a powerful interest of its own in preventing the entities that it charters from being used as vehicles for fraud. Nacco Industries, Inc. v. Applica, Inc., Del Chan Ct, No. 2541, Dec. 22, 2009.

The court rejected the assertion that it is widely believed in the hedge fund community that one need not disclose any intent in a 13D other than an investment intent until one actually makes a bid. The hedge funds could offer no legal support for this view, said the court, and there has been a recent and persuasive rejection of what the Vice Chancellor called a ``similarly self-serving, formalistic, and bright-line interpretation’’ advanced by frequent Schedule 13D filers. CSX Corp. v. Children’s Inv. Fund Mgmt. (UK) LLP, (S.D.N.Y. 2008), aff’d, (2d Cir. 2008).

On the same day that that it announced a merger with the acquiring company, noted the Vice Chancellor, target company management contacted the hedge funds and signaled that an all-cash offer would likely be successful. The hedge funds had acquired a nearly 40% stake in the target while the acquiring company was under a standstill agreement. The hedge funds continued to maintain that they were holding the shares for investment purposes.

The hedge funds then topped the merger by offering to acquire all of the outstanding shares of the target company for $6.00 per share. In conjunction with their bid, the hedge funds filed a Schedule 13D/A amending the disclosure in its prior Schedule 13 forms. The amended disclosure stated that rather than acquiring its shares for investment purposes, the hedge funds purchased the shares in order to acquire control of the company. The target company terminated the merger, paid a $4 million termination fee, and entered into a merger agreement with the hedge funds.

Section 27 of the Exchange Act provides that federal courts have exclusive jurisdiction of violations of the Act. At the same time, Section 28(a) of the Exchange Act provides that the rights and remedies provided by the Act are in addition to any and all other rights and remedies that may exist at law or in equity .

The Chancery Court held that the federal statutory remedies of the Act over which the federal courts have exclusive jurisdiction are intended to coexist with claims based on state law and not preempt them. Thus, the state law claim for common law fraud could proceed, ruled the Vice Chancellor, even though the statements giving rise to the claim appeared in filings made pursuant to the Exchange Act.

The company’s real beef, said the court, is that the information in the hedge funds’ Schedule 13G and 13D filings was false and misleading, regardless of whether the information was required to be included under federal law. This issue can be adjudicated by a state court as a question of fact, separate and independent from what the line items of Schedule 13G and Schedule 13D require.

It is alleged that the Schedule 13D filings made affirmative statements of fact that were false or materially misleading because they were incomplete. The court felt that it did not have to consider federal law to evaluate the truth, falsity, or misleading nature of the factual statements.

In the court’s view, the company adequately claimed that the hedge funds falsely disclosed in Section 13 that they were acquiring shares for investment purposes when in fact they were purchasing shares to control or influence at a time when it had plans for a merger involving the target and at a time when it had plans to defeat the acquisition.

Delaware’s common law fraud remedy does not provide investors with expansive, market-wide relief. That is a domain appropriately left to the federal securities laws, the SEC, and the federal courts. But Delaware law does requires that a plaintiff show reliance, said chancery, and the state Supreme Court has declined to permit the fraud-on-the-market theory to be used as a substitute. In this regard, the company was entitled to treat the disclosures as true and accurate, as the law required them to be, and reasonably rely on the disclosures.

The court was sympathetic to the view that at some point it became unreasonably naïve for the company to trust that hedge funds engaging in conduct resembling a creeping takeover wanted only to receive their ratable share of the benefits of the existing deal. However, the line when the company’s reliance became unreasonable is difficult to draw, said the court, and not something to be addressed on a motion to dismiss

The court reasonably concluded that the company relied on the disclosures in deciding what to do and what not to do, and that the false disclosures were material to the company. Critical to the court’s ruling was the fact that the company alleged a reasonable basis to allow an inference that the hedge funds intentionally made false disclosures about their investment intent in a context where they expected the company to review and rely on them and where the company reasonably did so.


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Thursday, January 21, 2010

Sarbanes-Oxley Whistleblower Entitled to Federal Court De Novo Review if No Timely DOL Final Decision

Under Section 806 of Sarbanes-Oxley, a corporate whistleblower had the right to a de novo proceeding in federal district court during his appeal of an Administrative Law Judge’s opinion within the Department of Labor since the DOL had not issued a final decision within the statutory 180-day time period. A Fourth Circuit panel ruled that Congress plainly has the authority, in balancing speed against resources, to rationally weigh timeliness as a more compelling concern and provide that proceedings begin anew in district court if the DOL is unable to reach a final decision within 180 days. If this aggressive statutory timetable is unworkable in practice, the remedy must be provided by Congress, not the courts. Stone v. Instrumentation Laboratory Company, CA-4, No. 08-1970, Dec. 31, 2009.

The panel also pointed out that the benefit of the aggressive timetable established by Congress does not inure solely to the benefit of whistleblowers, since Section 806 presents a whistleblower with an extremely limited window to file a retaliation claim, providing that a whistleblower action must be commenced not later than 90 days after the date on which the violation occurs. The fact that the statute requires both the DOL and the whistleblower to act swiftly further evidences the weight Congress placed on the timely resolution of whistleblower claims.

After repeatedly voicing concerns about company internal controls, the employee was terminated. He filed a retaliation claim under Section 806 of Sarbanes-Oxley with the Department of Labor. Despite the DOL’s concern that Congress created a framework allowing for duplication of efforts, said the appeals court, such a framework is precisely what Congress reasonably and unambiguously provided for in Section 806. Thus, even if the 180-day statutory period is arguably both overly aggressive and not the most efficient use of administrative and judicial resources, said the panel, the whistleblower was entitled to a fresh federal court review.

Congress unquestionably has the right to create a complainant-friendly whistleblower statutory scheme that affords no deference to non-final agency findings. Congress chose an aggressive timetable for resolving whistleblower claims and reasonably created a cause of action in an alternative forum should the DOL fail to comply with such schedule. A natural result of this aggressive timeframe is that efforts will be duplicated when the DOL engages in a thorough, yet non-final process that fails to resolve the administrative case within the prescribed timeframe. But neither DOL nor the courts have the authority to engage in creative interpretation of the statute to avoid duplication of efforts, even if the goal for doing so is laudable.


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President Obama Proposes Legislation Prohibiting Financial Institutions Involvement with Hedge Funds

The Obama Administration has proposed new restrictions on the size and scope of banks and other financial institutions in order to rein in excessive risk taking and to protect taxpayers. President Obama joined former Fed Paul Volcker, former SEC Chair Bill Donaldson, House Financial Services Chair Barney Frank; and Senate Banking Committee Chair Chris Dodd in announcing the proposal, which would strengthen the comprehensive financial reform package that is already moving through Congress.

Under the proposal, no bank or financial institution that contains a bank would be able to own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit. The President also announced a new proposal to limit the consolidation of the financial sector. The proposal would place broader limits on the excessive growth of the market share of liabilities at the largest financial firms.

The proposal embraces an idea earlier set forth by Mr. Volcker that banking organizations should be prohibited from sponsoring and capitalizing hedge funds or private equity funds, and there should be strict regulation, with strong capital and collateral requirements, on proprietary securities and derivatives trading. In remarks last year at the Association for Corporate Growth, he noted that extensive participation in the impersonal, transaction-oriented capital market is not an intrinsic part of commercial banking.In his view, substantial involvement in heavily leveraged finance and heavy proprietary trading almost inevitably entails substantial risk. It also adds a layer of complexity that is challenging for management and poses insidious, unmanageable conflicts of interest with customer relationships in a banking organization.

While acknowledging that hedge funds and other non-banking institutions have played an essential and increasing role in the financial markets, he observed that given the lessons of the recent past the federal oversight and regulation of hedge funds is inevitable and appropriate. The registration of hedge funds and equity funds is a minimal step, he said, and the reporting to authorities of their business models and large positions is appropriate. Collateral requirements and leverage restrictions, with accompanying official oversight, of the largest and systemically significant individual institutions are also needed.


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Tuesday, January 19, 2010

SEC Approves PCAOB Standard on Engagement Quality Review

The SEC has approved PCAOB Auditing Standard No. 7, which requires an engagement quality reviewer to evaluate the significant judgments made and related conclusions reached by the audit engagement team in forming the overall conclusion on the engagement and in preparing the engagement report. AS 7 also requires the engagement quality reviewer to perform procedures designed to focus the reviewer on those judgments and conclusions. In its approval order, the SEC encouraged the PCAOB to issue guidance on the standard’s documentation requirements. In response, the PCAOB said that it would publish a staff Q&A on implementation of the standard in the near future.
Release No. 34-61363

The standard is effective for engagement quality reviews of audits and interim reviews for fiscal years that began on or after Dec. 15, 2009. Thus, for interim reviews of public companies that file financial reports on a calendar-year basis, AS 7 is applicable beginning with the quarter ending March 31, 2010.

According to PCAOB Acting Chairman Dan Goelzer, the standard should improve the reliability of audited financial statements by increasing the likelihood that reviewers will identify significant engagement deficiencies before audit reports are issued to the investors. Martin F. Baumann, Chief Auditor and Director of Professional Standards, emphasized that a well-performed engagement quality review can serve as an important safeguard against erroneous or insufficiently supported audit opinions and, in this way, contribute to audit quality.

The procedures required of an engagement quality reviewer are different in nature from the procedures required of the engagement team. Unlike the engagement team, a reviewer does not perform substantive procedures or obtain sufficient evidence to support an opinion on the financial statements or internal control over financial reporting. If more audit work is necessary before the reviewer may provide concurring approval of issuance, the engagement team, not the reviewer, is responsible under PCAOB standards for performing the work. In contrast, the reviewer fulfills the obligation to perform an a quality review by holding discussions with the engagement team, reviewing documentation, and determining whether to provide concurring approval of issuance.

A number of commenters were concerned about an example in the PCAOB’s adopting release describing the documentation requirement for significant engagement deficiencies identified by the engagement quality reviewer. The release states that the documentation should contain sufficient information to enable an experienced auditor, having no previous connection with the engagement, to understand, for example, the significant deficiency identified, how the reviewer communicated the deficiency to the engagement team, why such matter was important, and how the reviewer evaluated the engagement team’s response.

Commenters were concerned that the example in the release could be read to be inconsistent with the requirement in the standard and could result in unintended consequences in terms of performance. The primary concern was that the engagement quality reviewer may be compelled to document every interaction with the engagement team, not knowing whether a matter will ultimately be identified as a significant engagement deficiency. This was viewed as a documentation requirement incremental to the requirements of Auditing Standard No. 3 on audit documentation, which does not require the auditor to document each discussion and preliminary conclusion.

But the SEC does not believe that there is any inconsistency between the example in the adopting release and the requirements of AS 7. The SEC said that the documentation suggested in the example from the adopting release is appropriate after the engagement quality reviewer has concluded that he or she has identified a significant engagement deficiency. However, in light of commenter concern, the SEC asked the PCAOB to provide further implementation guidance on the documentation requirement.

Some global audit firms expressed concern with language in the adopting release indicating that a qualified reviewer who has performed the required review with due professional care will, necessarily, have discovered any significant engagement deficiencies that could reasonably have been discovered under the circumstances. The firms said that this language could be read as requiring absolute assurance or a flawless review.

But the SEC did not find any inconsistency between the PCAOB’s adopting release and the requirement to conduct the review with due professional care. The SEC emphasized that the adopting release specifies that the Board is not redefining due professional care in the context AS 7.


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Monday, January 18, 2010

SEC Delays Effective Date of Rule 151A on Fixed Index Annuities as It Works to Cure Analysis on DC Circuit Remand

As part of its request to the court of appeals to not vacate Securities Act Rule 151A while it is being cured on remand, the SEC agreed to a two-year stay of the rule’s effective date to run from the date of publication of a reissued or retained rule in the Federal Register. Rule 151A was to have taken effect January 12, 2011. Last year, a panel of the US Court of Appeals for the District of Columbia ruled that the rulemaking process was flawed by the fact that the SEC’s consideration of the effect of Rule 151A on efficiency, competition, and capital formation, as required by Securities Act Section 2(b), was arbitrary and capricious. American Equity Investment Life Insurance Co. v. SEC, No. 09-1021, CA DofC Circuit.

Rule 151A defines indexed annuities as not being exempt annuity contracts under Section 3(a)(8) of the Securities Act. Relying on a series of US Supreme Court rulings, the SEC reasoned that, given the unpredictability of the securities markets, index annuities contain substantial risk that must be addressed by the disclosure regime established by the Securities Act. A fixed index annuity is a hybrid financial product that combines some of the benefits of fixed annuities with the added earning potential of a security. Like traditional fixed annuities, fixed index annuities are subject to state insurance laws, under which insurance companies must guarantee the same 87.5 percent of purchase payments. Unlike traditional fixed annuities, however, the purchaser’s rate of return is not based upon a guaranteed interest rate.

In its supplemental brief, the SEC assured the court that it can readily address judicial concerns with the Commission’s analysis of the effect of Rule 151A on efficiency, competition, and capital formation. Indeed, SEC staff have taken significant steps in this regard even before the court issued its mandate. Thus, the Commission believes that remand without vacatur is the most equitable and appropriate remedy in this case.

Refuting the petitioning company’s assertion that vacatur is required in all instances in which a rule violates the APA, the SEC pointed out that the practice in the DC Circuit has been to remand without vacating an agency regulation found to have been deficient for a failure to engage in reasoned decisionmaking or because the agency failed to follow the appropriate rulemaking procedures. Underlying the court’s decisions in this regard is a recognition that countervailing considerations often may justify allowing a rule to remain in place by remanding without vacatur to permit an agency to address a deficiency in the rule’s adoption that can be readily remedied.

In order to guide this determination, the court has used a two-prong test which the SEC believes that it passes, especially given the equitable circumstances. The first prong considers the seriousness of the deficiencies of the action, that is, how likely it is the SEC will be able to justify its decision on remand, while the second prong weighs the disruptive consequences of vacatur.

Vacatur will serve no equitable purpose, said the SEC, because concerns over when firms would have to comply with reissued Rule 151A are alleviated by the Commission’s consent to delay the effective date for two years. In addition, the Commission is working in good faith to promptly address the defect in its rule. To date, SEC staff have conducted a comprehensive survey of state insurance regulation of indexed annuities. Based on that state-law baseline, the staff is currently analyzing the impact Rule 151A would have on efficiency, competition, and capital formation.

The staff intends to complete this process and to bring a recommendation before the Commission in the Spring of 2010. If the staff recommends retaining Rule 151A, the staff also expects to recommend that the Commission seek public notice and comment on the efficiency, competition, and capital formation analysis.

Addressing specifically the first prong of the court’s test, the SEC noted that there is, at a minimum, a substantial likelihood that the Commission will be able to address on remand the court’s concerns regarding the Section 2(b) analysis. In initially remanding without vacatur, the court identified two alternative ways in which the Commission could remedy its deficient Section 2(b) analysis. First, the Commission could determine that it is not required to conduct the analysis here because it was proceeding under Section 19(a), a provision of the Securities Act to which Section 2(b), by a plain reading of its text, does not apply. Or, second, the SEC could undertake the analysis after first conducting a baseline analysis of efficiency, competition, and capital formation under the existing state-law regime. Either approach, or both, could be followed on remand and, the Commission staff already has taken significant steps towards addressing the court’s concerns.

The Commission did not conduct a baseline study of state insurance regulation of indexed annuities in adopting Rule 151A because it believed that prior Supreme Court’s holdings obviated any need to assess the current level of state-law regulation. Although the appeals court agreed with the Commission’s reading of the Supreme Court rulings, the panel held that the SEC’s obligations under § 2(b) are distinct from the questions posed before the Supreme Court, and that the Commission was therefore required to consider the state-law baseline in a Section 2(b) analysis in this case.

The court remanded Rule 151A to allow the Commission the opportunity to conduct a more thorough review of the existing state law regime, which could lead the Commission to decide ultimately that Rule 151A will promote competition, efficiency, and capital formation.

Bi-partisan legislation introduced by in the Senate would nullify the Commission’s adoption of Rule 151A before it has a chance to take effect. The Fixed Indexed Annuities and Insurance Products Classification Act, S. 1389, provides that Rule 151A will have no force or effect. There is a companion bill in the House, HR 2733. The draft legislation expresses a congressional sense that the SEC’s adoption of Rule 151A interferes with state insurance regulation, harms the insurance industry, reduces competition, and creates unnecessary and excessive regulatory burdens. The measure also embodies a congressional finding that indexed insurance and annuity products offered by insurance companies are subject to a wide array of state laws and regulations, including non-forfeiture requirements that provide for minimum guaranteed values, thereby protecting consumers against market swings.


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Public Policy May Compel Supreme Court to Review Ruling that Audit Work Papers Discoverable by IRS Since Done for SEC-Filed Financial Statements

The U.S. Supreme Court has been asked to review an en banc First Circuit Court of Appeals ruling that the attorney work product doctrine does not shield from an IRS summons tax accrual work papers prepared by a company’s lawyers to support the calculation of tax reserves for audited financial statements filed with the SEC. Textron Inc. v. United States, Dkt. No. 09-750.

In a 3-2 opinion, the full appeals court held that the purpose of the tax audit work papers was not to prepare for litigation, but rather to make book entries, prepare financial statements and obtain a clean audit

It is always difficult to hazard an opinion on whether the Court will take a given case. In this case, there is no split among the federal circuits since the only two federal appeals courts to decide the issue, the First and Fifth, have ruled in favor of IRS discovery of the tax accrual work papers. However, the issues involved have enormous importance for the corporate and independent auditor communities. In addition, there is an argument to be made on public policy grounds, pitting the need to fairly enforce the federal tax code and the need to have accurate SEC-filed financial statements.

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

There is also the public polocy issue created by the intersection of federal tax and federal securities regulation. This was discussed in the Fifth Circuit panel opinion in U.S. v. El Paso Company, CA-5 1982, 682 F2d 530.

The federal tax code is a sprawling tapestry of almost infinite complexity. Its details and intricate provisions have fostered a wealth of interpretations. The Code is a finite system of rules designed to apply flexibility to an infinite variety of situations. There are many "gray areas" in the tax world, twilight zones in which one may only dimly perceive how properly to treat a given accretion to wealth or given expenditure of funds.

When a large corporation completes its return, the number of decisions in the gray areas is enormous. To characterize a sale as ordinary income or capital gain, to depreciate equipment over ten years or twenty, to attribute a transaction to this year or to the next: these decisions recur over and over in a course of preparing a return and guarantee that a large corporation has many opportunities to choose in good faith an interpretation of the tax code that leans toward lessening its taxes. The return is filed with the understanding, however, that the IRS may challenge some of these questionable positions and, through settlement or litigation, the corporation may end up owing more taxes than it initially acknowledged.

Federal securities regulation intrudes because business reality compels corporations to recognize on their financial sheets that the return as filed is not the last word in determining the taxes owed. Public companies must file financial statements with the SEC, and SEC regulations require that independent accountants verify these financial statements. To demonstrate to the accountant that a balance sheet does not portray an overly-rosy view of a corporation's financial health, the balance sheet must provide for contingent future tax liabilities. In short, the corporation must set aside an account to cover additional taxes that it may become liable to pay above and beyond the amount indicated on the initial return.

To comply with the securities laws, therefore, companies must prepare in-house or have prepared by outside auditors an analysis of their contingent tax liabilities. The analysis pinpoints the soft spots on the corporation's tax returns and indicates those areas in which the taxpayer has taken a position that may, upon challenge, negotiation, or litigation, require the payment of more taxes. The analysis is known in the trade as the tax pool analysis, the noncurrent tax account, or tax accrual work papers.

In El Paso, the appeals court rejected the company’s plea to refuse to enforce the IRS tax pool analysis summons, even though it sought otherwise relevant and non-privileged documents, on grounds of the public policy underlying the securities laws. To permit routine summoning of tax pool analyses from companies, argued El Paso, would have a chilling effect on the companies' willingness to prepare such analyses searchingly and critically. Moreover, companies would conceal tax pool analyses from their auditors and thereby thwart the accountants' attempts to measure the adequacy of the contingent tax accounts. These consequences obstruct the full and frank disclosure of financial information that the securities laws envision. The public policy of protecting investors, therefore, demands the denial of IRS access to a company's tax pool analysis.

The appeals court squarely rejected the argument that the public policy of the securities laws implicitly overrides the clear grant of summons power to the IRS. While the IRS does not enjoy untrammeled authority to direct the production of documents, noted the panel, Congress has endowed the IRS with broad authority to conduct tax investigations.


The Supreme Court has consistently construed congressional intent to require that if the summons authority claimed is necessary for the effective performance of congressionally imposed responsibilities to enforce the tax code, that authority should be upheld absent express statutory prohibition or substantial countervailing policies. The appeals court was unwilling to make inroads in the plainly-announced congressional policy to allow the IRS broad access to relevant, nonprivileged documents on the basis of the company’s claim of a conflict with the policies underlying the securities laws.

The court rejected as speculative the theory that the accuracy of financial reports would suffer if companies had to divulge their tax pool analyses to the IRS. The court similarly rejected a picture of corporations evading their responsibilities under the securities laws to prepare their financial books properly and to lay open their books and records to independent auditors. The court refused to assume that corporations would dishonor their legal obligations by discontinuing the preparation of tax accrual work papers. If a company blocked the efforts of the outside auditors to ascertain the true state of the company's contingent tax liabilities, the auditor would be obligated to decline to certify the financial statements. The powers of the SEC suffice to ensure that companies will comply with the securities regulation.


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Dr. King's Universal Appeal Will Never Fade

In our age of sometimes bitter legislative partisanship, let us pause to remember the lessons of Dr. Martin Luther King, who we honor today. Dr. King appealed to our common humanity and a shared sense of social justice. I am fairly certain that, if he had seen our recent financial disaster, Dr. King would have decried the short-term risk taking and excessive bonuses. In his letter from a Birmingham jail, Dr. King wrote that, lamentably, it is an historical fact that privileged groups seldom give up their privileges voluntarily. Individuals may see the moral light and voluntarily give up their unjust posture; but, groups tend to be more immoral than individuals. Amen to that, Dr. King, and thank you for liberating the South from itself. I recently read that no international company, be it Toyota, BMW, Mercedes, or Siemens, would have ever come to and had a large presence in the segregated South. I believe that is a true statement.

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Saturday, January 16, 2010

NY Fed Study Says Derivatives Clearing Houses May Themselves Pose a Systemic Risk to the Financial Markets

As Congress moves toward the passage of legislation that would create a federal systemic risk regulator, a NY Fed study questions whether the central derivatives clearing organizations also envisioned by the legislation would themselves pose a systemic risk. If this is true, it raises the issue of whether very active derivatives clearing organizations should come under the purview the new Financial Services Oversight Council, which includes the Fed, SEC and the CFTC.

In the wake of the recent financial crisis, over-the-counter (OTC) derivatives have been blamed for increasing systemic risk. OTC derivatives markets are complex, opaque, and prone to abuse by market participants who take irresponsibly large amounts of risks. Although OTC derivatives were not a central cause of the crisis, weaknesses in the infrastructure of derivatives markets did exacerbate the crisis. As a result of failures of risk management, corporate governance, and management supervision, some market participants took excessive risks using these instruments. The complexity and limited transparency of the market reinforced the potential for excessive risk-taking, as regulators did not have a clear view into how OTC derivatives were being traded.

Counterparty credit risk rises to the level of systemic risk when the failure of a market participant with an extremely large derivatives portfolio could trigger large unexpected losses on its derivatives trades, which could seriously impair the financial condition of one or more of its counterparties. The antidote to counterparty credit risk is clearing, which means obtaining the effect of a guarantee by a central counterparty (CCP), sometimes called a clearing house. The CCP stands between the two original counterparties, acting as the seller to the original buyer, and as the buyer to the original seller.

The NY Fed study posits that, if a CCP is successful in clearing a large quantity of derivatives trades, the CCP itself becomes a systemically important financial institution. The failure of a CCP could suddenly expose many major market participants to losses. Any such failure, moreover, is likely to have been triggered by the failure of one or more large clearing members, and therefore to occur during a period of extreme market fragility. Thus, while robust operational and financial controls are paramount in reducing the likelihood of a CCP failure, emphasized the study, a CCP must also have methods in place for quickly recapitalizing, or for quickly unwinding its derivatives positions with minimal impact on counterparty risks and on the underlying markets.

The NY Fed study urges regulators to ensure that a CCP’s risk management design and financial resources are robust enough to allow the CCP to withstand extreme but plausible loss scenarios. Regulatory standards should ensure that CCPs remain resilient to a broader set of risks, including multiple participant failures, sudden fire sales of financial resources and rapid reductions in market liquidity. “Extreme but plausible” loss scenarios should encompass, at a minimum, the largest historical observed price movements in that market.

The Wall Street Reform and Consumer Protection Act, HR 4173, passed by the House late last year, would require OTC derivatives trading to be conducted through clearinghouses, which are set up to police derivatives trading.

The legislation addresses the concerns of the NY Fed study by implementing important corporate governance reforms in the derivatives markets. In addition to complying with several core principles listed in the Act, such as having adequate financial resources and effective risk management, registered derivatives clearing organizations 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.


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Friday, January 15, 2010

Key Senate Banking Committee Member Questions Treasury on Fannie and Freddie

Senator Bob Corker, a key member of the Banking Committee, has asked Treasury to explain its recent decision to remove the $200 billion per enterprise cap on government-sponsored enterprises Fannie Mae and Freddie Mac, which, in effect, provides a blank check for the amount of credit that will be made available to the two mortgage giants. In a letter to Treasury, Sen. Corker expressed concern about the lack of transparency around this arrangement and asked Treasury to respond to a series of questions about the action. In particular, Sen. Corker asked Treasury to cite the legal authority for these actions. He also queried if Treasury’s action effectively nationalized the two GSEs. Senator Corker is working with Senator Mark Warner to craft the systemic risk and resolution authority provisions of the Senate’s financial regulatory reform legislation.

On December 24, 2009, Treasury announced amendments to the Preferred Stock Purchase Agreements it has with Fannie Mae and Freddie Mac. The amendments removed the $200 billion per enterprise cap. Since the 2008 decision to place the entities into conservatorship and take a 79.9% preferred stock position in the companies in lieu of 80%, noted the Senator, a move he said was purposefully intended to not have to show the liabilities of these two companies on the balance sheet of the U.S. Treasury, the implied guarantee has been made effectively explicit.
The dollar amounts, when looked at in total that are guaranteed in some form or fashion by Treasury, are in the trillions of dollars, he said, yet this liability will not appear on the balance sheet of the US government. He strongly believes that the liabilities of these two firms should be reflected on the Treasury’s balance sheet.

The Senator requested an explanation of the steps taken prior to the December 24 action to guarantee that shareholders and other debt holders are not unfairly benefiting from this largesse. He asked for details on what has been done to guarantee that Treasury will recoup all of its investment prior to any shareholder or other debt holder returns

Senator Corker also asked for the delinquency rates on the loans Fannie and Freddie have guaranteed or hold in portfolio. In addition, he would like to receive copies of any written reports and summaries of oral reports that Treasury has received from Fannie or Freddie as to anticipated losses in the future. The Banking Committee Member asks to what degree have Fannie and Freddie been directed to make subprime or other nonprime loans in order to stabilize housing prices.

Finally, in its financial regulatory reform proposal, the Administration said that Treasury would be engaging in an initiative to determine the future role of the government-sponsored enterprises and recommendations would be forthcoming in the President’s February FY 2011 Budget release. In light of Treasury’s determination to provide continued capital support to Fannie Mae and Freddie Mac, the Senator asked Treasury to reaffirm its commitment to releasing those recommendations along with the FY 2011 Budget release.

The Housing and Economic Recovery Act of 2008 created an independent and unified regulator of Fannie and Freddie, the Federal Housing Finance Agency (FHFA), with broad powers analogous to federal banking regulators, and with a free hand to set appropriate capital standards, and a clear and credible process sanctioned by Congress for placing a GSE in receivership.

When FHFA placed Fannie Mae and Freddie Mac into conservatorship in September of 2008, Treasury established Preferred Stock Purchase Agreements to ensure that each firm maintained a positive net worth. The Treasury amendments allows the cap on the funding commitment under these agreements to increase as necessary to accommodate any cumulative reduction in net worth over the next three years. At the conclusion of the three year period, explained Treasury in its
announcement, the remaining commitment will be fully available to be drawn per the terms of the agreements.

According to Treasury, neither firm is near the $200 billion per institution limit established under the agreements. Total funding provided under these agreements through the third quarter has been $51 billion to Freddie Mac and $60 billion to Fannie Mae. Treasury emphasized that the amendments demonstrate its commitment to support these firms as they continue to play a vital role in the housing market during the crisis.

The Preferred Stock Purchase Agreements also cap the size of the retained mortgage portfolios and require that the portfolios are reduced over time. Treasury is also amending the agreements to provide Fannie Mae and Freddie Mac with some additional flexibility to meet the requirement to reduce their portfolios. The portfolio reduction requirement for 2010 and after will be applied to the maximum allowable size of the portfolios, or $900 billion per institution, rather than the actual size of the portfolio at the end of 2009.

Treasury remains committed to the principle of reducing the retained portfolios. To meet this goal, Treasury does not expect Fannie Mae and Freddie Mac to be active buyers to increase the size of their retained mortgage portfolios, but neither is it expected that active selling will be necessary to meet the required targets. FHFA will continue to monitor and oversee the retained portfolio activities in a manner consistent with the FHFA's responsibility as conservator and the requirements of the Preferred Stock Purchase Agreements.

Treasury made two additional changes to the agreements. Treasury will delay setting the Periodic Commitment Fee by one year to December 31, 2010. Treasury will also make technical changes to the definitions of mortgage assets and indebtedness to make compliance with the covenants of the agreements less burdensome and more transparent in light of impending accounting changes.


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House-Senate Oversight Chairs Support Obama Proposed Fee on Large Banks and Securities Firms

Senate Banking Committee Chairman Chris Dodd and House Financial Services Chair Barney Frank strongly support the Obama Administration’s proposed Financial Crisis Responsibility Fee that would require the largest and most highly leveraged Wall Street firms to pay back taxpayers for the extraordinary assistance provided so that the TARP program does not add to the deficit. Senator Dodd also said that the committee may also consider additional means to limit executive compensation as part of the financial reform legislation it is working on.

Chairman Frank said that President Obama’s action fully complies with taxpayer protection language of the Economic Emergency Stabilization Act, which requires the President to put forward a plan that recoups from the financial industry an amount equal to the shortfall in order to ensure that the TARP does not add to the deficit or national debt. Mr. Frank said that he is confident that the House will act on the measure soon,

Covered institutions on which the fee would be assessed include firms that were insured depository institutions, bank holding companies, and securities broker-dealers as of January 14, 2010, or that become one of these types of firms after January 14, 2010, and who were recipients and/or indirect beneficiaries of aid provided through the TARP, the Temporary Liquidity Guarantee Program, and other programs that provided emergency assistance to limit the impact of the financial crisis.

The fee, which would take effect on June 30, 2010, would last at least 10 years. If the costs have not been recouped after 10 years, the fee would remain in place until they are paid back in full. In addition, the Treasury Department would report after five years on the effectiveness of the fee as well as its progress in repaying projected TARP losses.

The fee would be levied on the debts of financial firms with more than $50 billion in consolidated assets, providing a deterrent against excessive leverage for the largest financial firms. By levying a fee on the liabilities of the largest firms , excluding FDIC-assessed deposits and insurance policy reserves, the Financial Crisis Responsibility Fee will place its heaviest burden on the largest firms that have taken on the most debt.


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Thursday, January 14, 2010

Obama Proposes Financial Crisis Responsibility Fee on Wall Street Firms as House Bill Would Tax Financial Transactions

Financial transaction taxes have been talked about recently as a way of increasing revenue from the financial sector to make it pay for its rescue. In addition, the Obama Administration has proposed a fee on the liabilities of banks and securities broker-dealers that received TARP and other bailout funds. At the same time, Rep. Peter Welch has introduced the Wall Street Bonus Tax Act, HR 4426, that would tax bonuses at financial firms that have received assistance through the TARP program at a rate of 50 percent for all bonus compensation in excess of $50,000, both cash and stock awards. Revenues generated through the tax would fund a new direct lending program administered by the Small Business Administration.

Other legislation introduced in the House, with a companion bill in the Senate, would impose a tax on securities and futures transactions, including derivatives transactions, in an effort to curb speculation and short-term trading. HR 4191, Let Wall Street Pay for the Restoration of Main Street Act, was introduced by Rep. Ed Perlmutter and Rep. Peter DeFazio. Senator Tom Harkin introduced the companion bill, S 2927, Wall Street Fair Share Act.

The Obama plan would assess a Financial Crisis Responsibility Fee on the largest and most highly leveraged Wall Street firms in an effort to recover for taxpayers the extraordinary assistance provided so that the TARP and other bailout programs do not add to the deficit.

The fee, which would take effect on June 30, 2010, would last at least 10 years. If the costs have not been recouped after 10 years, the fee would remain in place until they are paid back in full. In addition, the Treasury Department would report after five years on the effectiveness of the fee as well as its progress in repaying projected TARP losses.

Covered institutions on which the fee would be assessed include firms that were insured depository institutions, bank holding companies, and securities broker-dealers as of January 14, 2010, or that become one of these types of firms after January 14, 2010, and who were recipients and/or indirect beneficiaries of aid provided through the TARP, the Temporary Liquidity Guarantee Program, and other programs that provided emergency assistance to limit the impact of the financial crisis.

The fee would be assessed pursuant to a mandate of the Emergency Economic Stabilization Act, which requires the President to put forward a plan that recoups from the financial industry an amount equal to the shortfall in order to ensure that the TARP does not add to the deficit or national debt.

The fee would be levied on the debts of financial firms with more than $50 billion in consolidated assets, providing a deterrent against excessive leverage for the largest financial firms. By levying a fee on the liabilities of the largest firms , excluding FDIC-assessed deposits and insurance policy reserves, the Financial Crisis Responsibility Fee will place its heaviest burden on the largest firms that have taken on the most debt.

Covered liabilities would be reported by regulators, but the fee would be collected by the IRS and revenues would be contributed to the general fund to reduce the deficit. The Administration will also work with Congress and regulatory agencies in order to design protections against avoidance by covered firms.

Under the House financial transactions tax bill, one half of the revenue generated by the transaction tax would be used to directly reduce the deficit, while the second half of the revenue generated by the tax will be deposited in a Job Creation Reserve Fund. HR 4191 would tax stock transactions at a rate of 0.25%. Futures contracts to buy or sell a specified commodity of standardized quality at a certain date in the future, at a market determined price would be taxed at 0.02%.Similarly, swaps between two firms on certain benefits of one party's financial instrument for those of the other party's financial instrument would be taxed at 0.02%. Credit default swaps where a contract is swapped through a series of payments in exchange for a payoff if a credit instrument, typically a bond or loan, goes into default would be taxed at 0.02%.

In order to ensure that the tax is appropriately targeted to speculators and has no impact on the average investor and pension funds, the tax will be refunded for tax favored retirement accounts, education savings accounts, health savings accounts, mutual funds and, the first $100,000 of transactions annually that are not already exempted.

The European Union is considering a financial transactions tax. UK FSA Chair Adair Turner recently expressed qualified support for a tax on financial transactions, but cautioned against thinking that such a tax could be designed to tune the liquidity of markets to precisely its optimal level, neither too liquid nor insufficiently liquid.

Last March, EU Commissioner for Taxation Laszlo Kovacs said that the Commission did not view a financial transactions tax that favorably since the positive effects of a such a tax have not been clearly documented. The described relationship between liquidity, price fluctuations, and speculation cannot be proven either empirically or theoretically. It is even possible that a tax on financial transactions, and hence on liquidity, could lead to higher volatility.

The tax could also increase the capital costs for companies, noted the Commissioner, as well as increasing the price of urgently needed investments. Also, the relocation of transactions to other markets or countries could result in sustained damage to securities trading in the European financial centers. The effect of the tax could be very different depending on the traded products and the organization of the market.

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