Sunday, February 28, 2010
In a brief filed with the Fifth Circuit Court of Appeals in a PIPE-related insider trading case, the SEC argued that the federal district court (ND TX) failed to give proper deference to Commission Rule 10b5-2(b)(1), which provides that an agreement to maintain information in confidence gives rise to a duty that makes trading on the confidential information without disclosure deceptive. Because the text of Exchange Act Section 10(b) allows the interpretation of deception embodied in Rule 10b5-2(b)(1), said the SEC, and because that interpretation of Section 10(b) is reasonable, the Rule is entitled to Chevron deference. More broadly, public policy also supports viewing an agreement to keep inside information confidential as including an agreement not to trade, the SEC emphasized, lest we undermine the purposes of the Exchange Act and Rule 10b-5 to insure honest securities markets. SEC v. Cuban, CA-5, No. 09-10996.
In the SEC enforcement action, the district judge ruled that the agreement required to invoke the misappropriation theory of insider trading liability must include both an obligation to maintain the confidentiality of the inside information and not to trade on or otherwise use the information. Thus, the court held that the SEC did not state a duty arising by agreement since the Commission failed to allege that the defendant, the company’s largest shareholder, undertook a duty to refrain from trading on information about an impending PIPE offering.
The court also ruled that, because SEC Rule 10b5-2(b)(1) attempts to predicate misappropriation theory liability on a mere confidentiality agreement lacking a non-use component, the SEC could not rely on it to establish the shareholder’s liability under the theory.
In this action, the SEC alleged that, after the shareholder agreed to maintain the confidentiality of inside information concerning the offering, he sold his stock in the company without first disclosing to the company that he intended to trade on this information, thereby avoiding substantial losses when the stock price declined after the PIPE was publicly announced. As the PIPE offering progressed toward closing, the company decided to inform the shareholder of the offering and to invite him to participate.
The CEO prefaced the call by informing the shareholder that he had confidential information to convey to him, and the shareholder agreed that he would keep whatever information the CEO intended to share with him confidential. The CEO, in reliance on this agreement, told the shareholder about the PIPE offering. The shareholder reacted angrily to this news, stating that he did not like PIPE offerings because they dilute the existing shareholders.
Several hours after they spoke by telephone, the CEO sent the shareholder a follow-up email in which he provided contact information for the investment bank conducting the offering. The shareholder then contacted the sales representative, who supplied him with additional confidential details about the PIPE. One minute after ending this call, the shareholder telephoned his broker and directed the broker to sell all 600,000 of his shares, thereby avoiding losses in excess of $750,000 by selling prior to the public announcement of the PIPE.
In its brief, the Commission maintained that in adopting Rule 10b5-2(b)(1) it reasonably viewed an agreement to keep information in confidence as giving rise to a duty of trust or confidence, such that undisclosed trading on the information provided in reliance on that agreement involves deception within the meaning of Section 10(b). The district court disagreed, asserting, without citation to any authority, that in the context of information, agreeing not to disclose information and agreeing not to use information are logically distinct.
The court held that an undertaking to maintain information in confidence meant only non-disclosure, and therefore trading without disclosure would not be deceptive. The SEC pointed out that any difference between an agreement not to disclose and an agreement not to trade does not, however, respond to the Commission’s determination, reached after public notice and comment and on the basis of its expertise in regulating the securities markets, that an agreement to maintain information “in confidence” gives rise to a duty of “trust or confidence.”
The Commission said that its determination hews closely to the literal meaning of “confidence, ” which by definition is information entrusted by one person to another in confidence. Thus, the SEC reasoned that fiduciaries using information for personal trading purposes are misappropriating the principal’s property in breach of their duties of loyalty and confidentiality to the principal.
Similarly, a company that entrusts its inside information to another is giving them the use of a corporate asset with value in the securities markets. The promise to maintain the information in confidence is in essence to preserve the economic value of the information, which becomes worth less, or worthless, upon publication. The company entrusts the information to the third party, not to give away trading profits, but to further corporate purposes, said the Commission.
The provider trusts the recipients of the information not to destroy the value of the information by making it public and not to convert the information to their own use by trading upon it. One cannot reconcile an undertaking to keep information confidential and preserve its value, reasoned the SEC, and trading by the recipient that appropriates the value of the information to the trade.
In this case, the company entrusted confidential business information to its shareholder to solicit his interest in participating in its securities offering. That information was corporate property, said the SEC, a business or economic asset to which the company had a right of exclusive use. The company did not disclose the information to give the shareholder a trading advantage over other market participants. Rather, argued the SEC, it disclosed the information for the limited business purpose of inviting the shareholder to participate in the offering only after securing his commitment to maintain the information in confidence. Having secured his agreement to maintain the confidentiality of the information he received for the purpose of considering participating in the offering, company officials were duped by the shareholder’s undisclosed trading.
According to the SEC, numerous insider trading cases support the view that an agreement to maintain information in confidence necessarily includes an agreement not to trade. Because an undertaking of a duty of confidentiality by agreement is typically easily determined, the published cases primarily grapple with the more difficult issue of when, in the absence of an agreement, a sufficient duty can be implied from the relationship between the information provider and recipient.
While this more involved analysis is not necessary where, as here, a duty is undertaken by agreement, the analytical framework employed in these cases shows that a confidentiality agreement establishes a sufficient duty. In addition, various common law doctrines also support the view that agreeing to maintain information in confidence includes agreeing not to trade
More broadly, the SEC noted that public policy supports viewing an agreement to keep inside information confidential as including an agreement not to trade. The district court’s approach would undermine the purposes of the Exchange Act and Rule 10b-5 to insure honest securities markets and thereby promote investor confidence. The shareholder’s informational advantage over other investors was not based on research or skill. Rather, he secretly used corporate property to avoid losses virtually risk-free through securities transactions. His informational advantage stemmed no less from contrivance and deception simply because he undertook a duty of confidence by agreement with the firm rather than one implied from a relationship between the two parties.
Finally, the SEC said that the district court’s approach would cause anomalies with respect to other federal securities law requirements. For example, it would result in the prohibitions on tipping and trading becoming disjointed. Under this approach, one in this shareholder’s situation could not tip another person who then trades because the tip would breach a confidentiality agreement, but would be free to trade himself.
In addition, the district court’s approach would conflict with SEC Regulation FD, which incorporates the principle that a person who agrees to keep information confidential cannot lawfully use that information for trading. Regulation FD was adopted simultaneously with Rule 10b5-2 as part of a broad rulemaking initiative.
A UK appeals court has ruled that the Financial Services Authority can satisfy an SEC request to obtain documents from a London-based accounting firm to aid an SEC enforcement action in federal court. A three-judge panel said that the Financial Services and Markets Act allows the FSA to accord full faith and credit to a foreign regulator, particularly one as important as and of the reputation of the SEC. The Act did not require the FSA to second-guess the SEC as to its own laws and procedures, or as to the genuineness or validity of its requirement for information or documents. Similarly, it is not proper for English courts to examine the SEC’s request critically and determine if the documents the SEC requested from the UK accounting firm will be useful to the Commission in its enforcement action, said Lord Burnton, writing for the panel. FSA v. AMRO International, Court of Appeal, No. C1/2009/2024, Feb. 24, 2010.
The SEC told the FSA the documents it sought from the accounting firm would be helpful in its enforcement action in SDNY, noted the panel, and gave sensible reasons for that statement, including explaining why similar fact evidence would be helpful. The SEC action alleged fraudulent trading in the shares of a US company. In seeking the FSA’s help, the SEC said that it had ascertained through discovery that the accounting firm possessed records relating to entities and transactions relevant to the Commission’s enforcement action. The SEC statement should be sufficient for both the FSA and an English judge, emphasized the panel, adding that it is not for English courts to consider if the scope of an SEC enforcement action may or may not be enlarged following disclosure of the documents sought from the accounting firm.
Basing its opinion firmly on the Act, the court said it was immaterial whether the SEC’s request complied with Memorandums of Understanding entered into by US and UK regulators. The FMSA imposes a statutory duty on the FSA to take appropriate steps to cooperate with foreign regulators, like the SEC, that have similar functions to the FSA.
In support of its ruling, the appeals court broadly observed that financial enterprises and financial transactions are increasingly international, as the financial crisis has only too clearly demonstrated. Thus, it is extremely important that national financial regulators cooperate, particularly where there are suspicions or allegations of financial fraud. The desirability of such cooperation is reflected by the FSMA, not only in specific sections requiring cooperation with the SEC and other similarly situated foreign regulators, but in a section requiring the FSA to have regard to the international character of financial services and markets.
Saturday, February 27, 2010
With Congress poised to pass legislation creating a federal systemic risk regulator for the financial markets, former NY Fed President Gerald Corrigan emphasized the critically important difference between risk management and risk monitoring. In testimony before the UK Treasury Committee, he noted that risk monitoring has to do with getting the right information to the right people at the right time, while risk management has to do with what you do with the information once you have it.
Mr. Corrigan, currently a Goldman Sachs Managing Director, was also Chair of the Counterparty Risk Management Policy Group, a creation of the President’s Working Group on Financial Markets, which filed a seminal report on containing systemic risk.
A central recommendation of the group is that a risk management function, with a Chief Risk Officer, must be positioned within all large integrated financial intermediaries in a way that ensures that their actions are independent of the firm’s income producing business units.
The former NY Fed chief said that leading to the financial crisis there were important failures in risk monitoring that by their nature suggested that risk management would suffer accordingly. If a financial firm does not do risk monitoring well, he reasoned, the firm will have a problem with risk management. They are interconnected and co-dependent. He also noted that a firm dealing in derivatives should have some idea about the effectiveness of risk management at its counterparties.
With regard to measuring risk using the Value at Risk measurement, Mr. Corrigan first stated that the framework within which his firm works, through a whole family of stress tests, has changed in a very material way over the past two years. While his firm was always among the most progressive firms in the industry in terms of the design and rigor of the stress test it employed before the crisis, he noted, over the past two years that effort has been taken ``many steps up the ladder.’’
For example, the firm developed sophisticated procedures through which it can obtain rigorous scenario and stress test results and take them on a thoroughly integrated basis through the P&L on a global basis within a matter of time. The firm has also substantially upgraded the speed with which it can compile counterparty exposures to any counterparty just about any place in the world across all legal entities and all product groups. The firm has also introduced the use of reverse stress tests as kind of overlay to the more aggressive stress tests that are used in the first place.
The primary use of reverse stress-testing is as a risk management tool to improve business planning and risk management rather than to inform decisions on appropriate levels of capital or liquidity specifically.
In reverse stress-testing, a firm identifies and assesses the scenarios most likely to render its business model unviable. Generally a firm’s business model would be unviable at the point when crystallizing risks cause the market to lose confidence in the firm. A consequence of this would be that counterparties would be unwilling to transact with or provide capital to the firm and, where relevant, that existing counterparties may seek to terminate their contracts. Such a point could be reached well before a firm’s regulatory capital is exhausted.
Using reverse stress testing, firms identify what could cause their business to fail and use this information to ensure that the relevant risks are sufficiently well-understood and appropriately managed to secure consumer protection and market confidence.
The Financial Services Authority views reverse stress testing as an important complement to the suite of stress tests that firms are required to carry out. The FSA’s new reverse stress testing mandate is designed to encourage firms to explore more fully the vulnerabilities of their current business plan, including milder adverse scenarios, and make decisions that better integrate business and capital planning, as well as to improve their contingency planning.
The design and results of a firm’s reverse stress test must be documented, reviewed and approved at least annually by the firm’s senior management or governing body. A firm is required to update its reverse stress test more frequently in light of substantial changes in the market or in macroeconomic conditions.
Friday, February 26, 2010
According to a PCAOB staff Q&A, the new standard on engagement quality review, AS No. 7, does not require the documentation of all of the interactions between the engagement quality reviewer and the engagement team, including all of the interactions before a matter is identified as a significant engagement deficiency. The example in the adopting release illustrates how the documentation requirements of AS No. 7 should be applied once a reviewer concludes that a significant engagement deficiency exists.
The example indicates that engagement quality review documentation should contain sufficient information to enable an experienced auditor, having no previous connection with the engagement, to understand 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.
AS No. 7 requires an engagement quality review and concurring approval of issuance of each audit engagement and for each engagement to review financial information conducted pursuant to PCAOB standards.
In its order approving AS No. 7, the SEC encouraged the PCAOB to provide
further implementation guidance on the documentation requirements of the standard in light of comments the SEC received during its comment period.
Senators Ted Kaufman and Johnny Isakson said that the partial action taken by the SEC will neither provide investors with the same protections as the uptick rule nor address the enforcement issues surrounding the current naked short selling rule. The SEC voted 3-2 to require short sellers, if a company’s shares fall 10 percent in one day, to exceed the prevailing bid for the remainder of the trading day and the following day in short sales of that security.
While encouraged that the SEC took some action to protect investors from manipulative short selling, adding that the circuit-breaker/bid test rule is a step forward, the senators said it will be of limited use, helping only in the worst-case scenarios that could occur during a terrorist attack or financial crisis. The uptick rule worked for 70 years as a systemic check on predatory bear raids; they emphasized, and this approach will not provide investors with the same protections as an always-on bid test.
Moreover, they continued, the real problem is that the SEC does not have an enforceable rule to punish those who undertake market manipulation through abusive naked short selling and rumor-mongering. To this point, they noted that the SEC has not yet brought a single enforcement case in the 2008 naked short selling incidents that helped take down Bear Stearns and Lehman Brothers, said the senators, and the new rule does not address that glaring problem.
The senators were also dismayed that the Commission has never sought comments on a hard locate requirement for short sellers, even after eight senators pointedly made this suggestion last July and seven senators have co-sponsored a bill calling for this. The Commission still failed to seek comments even after the SEC acknowledged in a September roundtable that the naked short selling rule did indeed pose enforcement difficulties.
The senators pointedly ask what would have been the downside to proposing a firm requirement that before stocks can be sold short, the short-seller must have a legally enforceable right and obligation to deliver the stock at the time of settlement. Just by proposing that type of rule, they noted, the Commission would have been in a position to adopt a pre-trade hard-locate requirement, or a circuit-breaker approach combined with a hard-locate requirement, instead of a bid test, for example.
Earlier this year the senators introduced a bill, S. 605, calling for the SEC to adopt regulations prohibiting any person from selling securities short, unless that person demonstrates, at the time of the sale, that such person possesses, at the time of the sale, a demonstrable, legally enforceable right to deliver the securities at the required delivery date.
Specifically, S. 605 orders the SEC to reinstate the uptick rule, which was repealed in July 2007. The uptick rule, Rule 10a-1, required all short sale stock transactions to be conducted at a price that was higher than the price of the previous trade. The legislation directs the SEC to reinstate the substance of the uptick rule prohibiting short sales that are not made on an increase in the price of the stock. This is designed to prevent short sellers from piling on a declining stock, driving prices down. Second, the SEC must require exchanges and other trading venues to execute the trades of long sellers ahead of short sellers, all other things being equal.
In a June 25 letter to SEC Chair Mary Schapiro, the senators said that focusing on the uptick rule alone puts too narrow a frame on the problems associated with naked short selling. The problem at its root may be that the current rules against naked short selling are both inadequate and impossible to enforce.
In a July 22 letter to the SEC Chair, Senators Kaufman and Isakson, and five other senators, suggested a pilot program as proposed by the Depository Trust & Clearing Corporation (DTCC) to prohibit short sales that do not first acquire a hard locate. They said that this centralized hard locate system seems to offer a viable way to eliminate over selling of stock inventories, in that there would no longer be multiple locates on the same shares of a security.
According to the senators, the DTCC proposal could standardize requirements across the industry, can be configured in a way that will not disrupt markets, would streamline locate documentation requirements, and can be overseen directly by the SEC to ensure regulatory compliance.
Wednesday, February 24, 2010
Divided Commission Adopted Alternative Uptick Rule for Short Sales
The below excellent analysis of the SEC's action today was filed by my colleague John Filar Atwood, who attended the SEC's open meeting at which this action was taken.
In a 3-to-2 vote, the SEC adopted amendments to Rules 200(g) and 201 of Regulation SHO that will restrict short selling in instances where a company’s shares drop 10% or more in value in one day. The Commission originally proposed the alternative uptick rule last April, held a roundtable discussion on it in May and then issued an additional call for comments in August. The agency received more than 4,300 comment letters on the controversial issue.
Under the newly-adopted rule, a circuit breaker will be triggered any time a stock declines 10% in one day and short selling will be permitted in that security only if the price is above the current national best bid. Once the circuit breaker has been triggered, the rule would apply to short sale orders in that security for the remainder of the day and the following day.
The alternative uptick rule will apply to equity securities that are listed on a national securities exchange, whether traded on an exchange or in the over-the-counter market. Under the rule, trading centers will be required to establish, maintain and enforce written policies and procedures that are reasonably designed to prevent the execution or display of a prohibited short sale.
Once the circuit breaker is triggered, long sellers will have preferred access to the bid price and will be permitted to sell their shares ahead of any short sellers. Robert Cook, Director of the Division of Trading and Markets, said that this part of the rule is intended to boost investor confidence by assuring them that sales are being made by investors taking a long view of a company’s fundamentals.
SEC Chair Mary Schapiro acknowledged that short selling can have a beneficial impact on the market. However, the Commission is concerned that excessive downward price pressure on individual securities, accompanied by the fear of unconstrained short selling, can destabilize markets and undermine investor confidence. She believes the rule addresses these concerns by preventing short selling, including potentially manipulative short selling, from further driving down the price of a security that has experienced a 10% price decline. Limiting the potential for abuse is an important goal of the new rules, she said.
Commissioner Kathleen Casey opposed the rule amendments, stating that there is no evidence to support the claim that a circuit breaker can stop price declines, or that it would boost investor confidence. She referred to the amendments as “regulation by placebo,” where the agency is putting a rule in place and hoping that it will convince investors that everything will be alright.
Compliance costs for the rule will be in the billions of dollars, she said, and she has no confidence that the new rules will have a positive effect. In her view, the rules will not have their intended impact in the short term and will expose the Commission to considerable criticism in the long term. She believes that enhanced surveillance and enforcement on abusive short selling is the appropriate course of action.
Commissioner Elisse Walter supported the rule changes, but acknowledged that it was a difficult decision. Since becoming a commissioner, she has received more calls on short selling than any other topic, she said. Much of the feedback she has gotten is that investors feel less confident putting their money into the market because of short selling. We must listen to investors, she said, even if the effect of short selling is difficult to quantify.
She supported the amendments to Rule 201 because they take a measured, targeted approach and the short selling restrictions will not apply to the majority of traded securities at any one time. During periods of low volatility, the staff expects the circuit breaker to apply only to about 1.3% of covered securities, Walter noted. Based on the comments the SEC received, she expects many people to be disappointed that the circuit breaker restricts short selling, while others will claim that the rule does not go far enough.
Among the objections of Commissioner Troy Paredes to the rule changes was that he feels a 10% threshold is indiscriminate and not narrowly tailored as suggested by the staff. He believes there is no evidence to suggest that a 10% price decline is not just an effective and appropriate revaluing of a publicly traded security. He also feels that the central rationale that the rule amendments will boost investor confidence is speculative and unsubstantiated.
Cook responded that the staff’s recommendation was based on many factors, including that two-thirds of the comments it received expressed the view that the rule would boost investor confidence. Ultimately, the staff must make a judgment on data that will never be perfect, he said. Henry Hu, Director of the Division of Risk, Strategy and Financial Innovation, concurred, noting that investor confidence is extremely hard to quantify. Existing data is insufficient in either direction, he said.
While noting that incorporating IFRS into the US financial reporting system would involve a significant undertaking, SEC Chair Mary Schapiro reaffirmed the Commission’s support for a single set of global accounting standards. She added that the SEC will carefully consider and deliberate whether such a change is in the best interest of U.S. investors and markets. And, if the Commission decides that such a change best serves these interests, it will provide for a sufficient transition time for those who prepare financial statements and those who use them.
Before the adoption of a global accounting standard, she noted, the convergence projects currently underway between the FASB and the IASB must be successfully completed. Moreover, SEC staff must gather information to aid the Commission as it evaluates the impact that the use of IFRS by U.S. companies would have on our securities market. To this end, the staff has been asked to develop and execute a work plan.
In 2011, upon the conclusion of the fact-gathering and analysis set forth in the work plan, and assuming completion of the convergence projects, the Commission will then be in a position to determine whether to incorporate IFRS into the financial reporting system for U.S. public companies. Until that time, the SEC expects the staff to provide periodic written public reports to the Commission on the progress of its efforts
The Center for Audit Quality praised the SEC for reiterating its support for a single set of high-quality global accounting standards, consistent with comments from the vast majority of investors and other stakeholders who reacted to the Commission’s earlier Roadmap. The Center is similarly pleased that the SEC has expressed its support for IFRS as that single set of high-quality standards.
According to CAQ, the SEC’s action, in conjunction with the staff’s forthcoming work plan, should provide a path forward to the incorporation of IFRS into the financial reporting system for U.S. issuers. CAQ encouraged the Commission to execute its action plan so it is in a position next year to make a positive decision to adopt IFRS.
IFRS is quickly becoming the international standard, with 110 countries having already adopted, or in the process of adopting, IFRS. A few years ago, in an effort to promote the global consistency of financial accounting standards, the SEC e liminated the requirement that foreign private issuers reconcile their IFRS-driven finnacial statements to US GAAP.
In a recent letter to the G-20, a joint FASB-IASB expert group said that it remains critically important to produce a single set of high quality, globally converged financial reporting standards that provide consistent, unbiased, transparent and relevant information across geographical boundaries. The Financial Crisis Advisory Group expects the standard setting process to continue in a spirit of independence and accountability. The G-20 has consistently called for convergence towards a single set of high-quality, global, independent accounting standards. The Financial Crisis Advisory Group is co-chaired by former SEC Commissioner Harvey Goldschmid and Hans Hoogervorst, Chairman of the Netherlands Authority for the Financial Markets.
Tuesday, February 23, 2010
As the US and EU try to pass legislation to regulate hedge fund operators and advisers, a report by an IOSCO working group concluded that hedge funds can have a systemic impact on financial stability and hence the lack of a prudential regime for monitoring hedge funds is a critical gap in the regulatory framework. The failure of a large, highly leveraged hedge fund could systemically impact its investors, other financial institutions and the markets. Further, the G-20 identified hedge funds as one of the most significant group of institutions in the “shadow” banking system.
Exposures to hedge funds are important sources of counterparty risk, noted IOSCO, especially if a hedge fund borrows from multiple brokers or is engaged in multiple trading relationships and individual counterparties do not have a full picture of the hedge fund’s leverage or of its other risk exposures. The current lack of transparency constitutes a major obstacle to risk mitigation.
The report recommends that hedge fund operators be required to develop and maintain proportionate and documented risk management policies to identify and monitor all risks stemming from the activity of each managed hedge fund, consistent with its intended risk profile. Appropriate reporting lines should be established to ensure frequent and timely reporting to senior management about the actual level of risk. The risk management function should be hierarchically and independent from the hedge fund management function.
The hedge fund operator should be required, for each hedge fund it manages, to deploy liquidity risk management systems in order to ensure that the liquidity profile of the fund’s investments complies with its obligations and the redemption policy that has been disclosed to its investors, including possible suspensions. The hedge fund operator should also be required to conduct stress tests to assess the liquidity risk under normal and exceptional circumstances for consistency with the fund liquidity profiles.
Hedge fund managers delegating the performance of risk management to a third party must remain fully responsible for the selection of the third party and for the proper performance of the risk management activity.
Legislation should be passed imposing reporting requirements on hedge fund operators to disclose current or potential sources of systemic risk and to enable cross-sectoral monitoring of systemically important hedge funds. Regulators should be authorized to collect meaningful information from hedge funds to enable them to monitor, evaluate, and exchange information on systemic risks on a cross-sectoral basis.
There should be initial and ongoing capital requirements for relevant hedge fund operators as a condition of registration and ongoing supervision. Such requirements could be designed to absorb losses arising from operational failures and may allow for orderly winding down of a fund operator in the event of bankruptcy. The level of minimum capital standards should be enough to allow an orderly liquidation of or transfer of funds managed by a failing hedge fund operator and take account of the obligations of the operator.
To mitigate counterparty credit risk, IOSCO would require hedge funds to provide collateral in excess of the value of the funds borrowed. This option would limit leverage only if generally imposed by all counterparties, since otherwise the collateral for one counterparty could be financed by borrowing from the other. To limit excessive funding liquidity risks, hedge funds that significantly invest in illiquid assets should be set up as closed-end funds. To avoid excessive risk-taking, said the report, regulators should impose direct and simple caps on leverage, including from exposures arising from derivatives.
Leverage may also be constrained through several other regulatory tools, said IOSCO. For example, the European Commission’s proposed Directive on Alternative Investment Fund Managers would impose leverage limits on alternative fund operators where this is required to ensure stability and integrity of the financial system. The proposal also would grant emergency powers to national authorities to restrict the use of leverage by alternative fund operators in exceptional circumstances.
However, imposing leverage limits is controversial, with some arguing that sophisticated investors invest in a hedge fund to follow a certain strategy and the fund’s strategy should be restricted only if leverage could cause systemic risk. In addition, setting leverage caps could be extremely difficult and complex, particulary because the true extent of leverage cannot easily be figured without analyzing the embedded leverage in each underlying investment.
As a compromise, IOSCO recommended imposing flexible leverage limits. In order to avoid procyclicality in financial markets, leverage could be tightened during market upturns and relaxed during downturns. This would help prevent funds from having to sell assets, reasoned IOSCO, and thus amplify downward pressures during market declines. For example, regulation could result in building risk buffers in the system procyclically and relying on these buffers anti-cyclically.
Amendments to the SEC's e-proxy rules highlighted a series of measures announced by the Commission to educate investors about proxy voting and to support greater investor participation in corporate elections. The agency also issued an investor alert that provides information related to the recent changes to broker voting rules and the impact of those new rules on proxy voting, and created new internet resources that explain the proxy voting process in plain language.
The changes to the proxy rules are intended to clarify and provide additional flexibility regarding the format of the notice of internet availability sent to shareholders and to permit issuers and other soliciting persons to better communicate with shareholders by including explanatory materials regarding the use of the notice and access proxy rules and the voting process. The amendments also revise the timeframe for delivering a notice to shareholders when a soliciting person other than the issuer relies on the notice and access proxy rules, and permit mutual funds to accompany the notice with a summary prospectus.
The amended rules require the information appearing in the notice to address certain topics, without specifying the exact language to be used. Issuers and other soliciting persons must also indicate that the notice is not a form for voting. All soliciting persons may also provide an explanation of 1) the process of receiving and reviewing the proxy materials and voting under the notice and access proxy rules and 2) the reasons for the use of notice and access. However, materials designed to persuade shareholders to vote in a particular manner or change the method of the delivery of proxy materials are not permitted under the revised exception.
The Commission stated in the adopting release that it did not address any broader concerns with the proxy system or the notice and access model raised by commenters that went beyond the scope of the proposals. However, Chairman Mary Schapiro has directed the staff to conduct a comprehensive review of the mechanics by which proxies are voted and the way in which information is conveyed to shareholders, and to prepare a concept release to seek public comment on these issues.
With regard to soliciting persons other than the issuer, the amended rules require the filing of a preliminary proxy statement within 10 calendar days after the issuer files its definitive proxy statement. The soliciting person must also send its notice to shareholders no later than the date on which it files its definitive proxy statement.
The SEC revised the current rule, which requires soliciting persons to send the notice to shareholders 10 calendar days after the date that the issuer first sends its proxy materials to shareholders, because its operation could create potential compliance issues for the soliciting persons. The staff review of filings could result in outstanding comments on a soliciting person’s preliminary proxy statement more than 10 calendar days after the soliciting person has initially filed. The practical effect of this requirement was to limit that soliciting person’s ability to use the notice-only option if the soliciting person was unable to file its definitive proxy statement with the Commission by that time. According to the SEC, the revised rule provides sufficient time for a soliciting person to prepare its proxy statement and respond to any staff comments, while still permitting the soliciting person to use the notice and access model.
The amended rule does not provide for a specific period of time before the meeting by which a soliciting person is required to mail the notice. The SEC advised, however, that the soliciting person should make the notice and proxy materials available to shareholders with sufficient time for shareholders to review the materials and make an informed voting decision.
Monday, February 22, 2010
A study commissioned by the UK Financial Services Authority found that up to 40% of hedge funds and 35% of private equity funds would no longer be available to EU investors because of the equivalence requirements imposed on third countries by the proposed EU Alternative Investment Fund Management Directive. This Directive was proposed by the European Commission last April to strengthen the regulation of the non-UCITS fund-management industry across Europe.
The proposed Directive, centered on enhanced disclosure and effective risk management, is designed to create a comprehensive and effective regulatory framework for hedge and private equity fund managers at the European level. It would impose regulatory standards for all alternative investment funds within its scope and enhance the transparency of the activities of the funds towards investors and public authorities. The draft proposes regulations that will affect, among others, the entire European hedge fund, private equity, and venture capital industries.
In recent remarks, Dan Waters, Director of Asset Management, said that the FSA supports the creation of a marketing passport for fund managers to sell across Europe under a single authorization that would replace the current patchwork of national private placement regimes. The FSA similarly backs the proposal to empower regulators to collect systemically important information from fund managers.
However, he noted that the benefits of the Directive come at a significant cost to those funds and fund managers based outside of the EU because of the so-called third country aspects, which could adversely affect business models and increase costs and reduce choice for investors. These third country proposals include equivalence tests for the tax and legislative standards of non-EU countries to determine whether EU investors should be permitted to invest wherever a fund or fund managers, depositaries, custodians, or other service providers were based outside the EU.
In his view, the practical implications of the proposed Directive would be significant. For example, if major fund managers domiciled in the United States were deemed not to meet the equivalence tests, then EU pension funds and other institutional investors would be prevented from investing in those funds, even if they decided to do so entirely on their own.
In a low interest rate environment characterized by increasing longevity, a maturing population and a growing savings gap, he continued, it is more important than ever for investors to have access to a range of investment opportunities that best match their liabilities. Imposing the restrictions in the proposed Directive would make these issues even more difficult to manage.
While investors may be able to access substitute products if a significant number of existing funds were no longer available, he conceded, they may not have the access to the best in class funds from across the globe that they currently enjoy. In turn, this could force them to hold sub-optimal portfolios with resulting implications for investment returns and risk management. The FSA study estimated substantial damage to portfolio returns resulting from some of the particularly draconian provisions of the initial draft of the Directive.
Of course, the FSA understands the case for setting minimum standards of investor protection as part of creating a single market. But neither the outcome of the Council negotiations nor the Parliamentary negotiations over the proposed Directive envisage that such a single market will exist for non-European domiciled funds, regardless of where they are managed.
The FSA believes that imposing requirements relating to investor protection or equivalence on non-European domiciled funds is unjustified. For one thing, it would drive legitimate business models offshore. But more importantly from a regulatory perspective, while these fund managers would still be operating in Europe through subsidiaries or delegation arrangements, the powers of European regulators to collect systemic information from these managers and deal with emerging financial stability risks would be severely narrowed.
Regarding the Directive’s outcomes, said the senior official, investor protection should not be delivered at the expense of the protection of financial stability. He urged the EU’s key policymakers to ensure that the final framework of the Directive proportionately reflects the fundamental differences between the single EU market and non-EU national domestic regimes.
The IRS is developing a schedule requiring corporate filers to provide information about their FIN 48 and other uncertain tax positions that affect their federal income tax liability. The schedule would require a company to annually disclose a concise description of each uncertain tax position for which the company or a related entity has recorded a reserve in its financial statements and the maximum amount of potential federal tax exposure if the company’s position is not sustained. Announcement 2010-9.
In recent remarks, IRS Commissioner Douglas Schulman explained that concise description means a few sentences on the nature of the issue, and not pages of factual description or legal analysis. The sufficiency of a description will depend on the taxpayer’s particular facts and the nature of the underlying transaction. As currently contemplated, this concise description will include the rationale for the position and a concise general statement of the reasons for determining that the position is an uncertain tax position.
Reporting uncertain tax positions would be required at the time a return is filed by companies that have a financial statement prepared under FIN 48 or other similar accounting standards reflecting uncertain tax positions and assets over $10 million. The schedule would be filed with the Form 1120, U.S. Corporation Income Tax Return, or other business tax returns.
In addition to those positions for which a tax reserve must be established under FIN 48 or other accounting standards, uncertain tax positions will include any position related to the determination of any federal income tax liability for which a taxpayer or a related entity has not recorded a tax reserve because it expects to litigate the position and has determined that the IRS has a general administrative practice not to examine the position.
The IRS is evaluating additional options for penalties or sanctions to be imposed when a taxpayer fails to make adequate disclosure of the required information regarding its uncertain tax positions. One option being considered is to seek legislation imposing a penalty for failure to file the schedule or to make adequate disclosure.
In his remarks, Commissioner Shulman assured that the proposal would not require taxpayers to disclose how strong or weak they regard their tax positions or report the amounts they reserved on the books regarding those positions. And, with the Textron petition before the US Supreme Court, he said that the IRS would otherwise retain its longstanding policy of restraint as it applies to tax accrual work papers
The IRS is looking only for a brief description of the issue and the maximum amount of US income tax exposure, he noted, and there is no requirement that the taxpayer disclose its risk assessment or tax reserve amounts. He also pointed out that the IRS is asking for a list of issues that the company has already prepared for financial reporting purposes.
Invited by a federal appeals court to give its view on the scope of the PSLRA’s safe harbor for forward-looking statements, the SEC said that statements in the MD&A section of a Form 10-Q were within the scope of the safe harbor since the MD&A is separate and distinct from the financial statements in the 10-Q. In its amicus brief, the Commission also opined that it is not a meaningful cautionary statement to warn of a potential deterioration in yields when you are aware that such a deterioration is actually occurring. In addition, a forward-looking statement need not be included in a section marked “Forward-Looking Statements” or specifically labeled as a “forward-looking statement” to be “identified as a forward-looking statement” under the safe harbor. Finally, the SEC said that, under the safe harbor, a person has actual knowledge that a statement of projection is misleading if the person knows that he or she has no reasonable basis upon which to make the statement. The Second Circuit Court of Appeals invited the SEC’s views of the safe harbor for forward-looking statements in the case of Slayton v. American Express Co., which is on appeal from a district court’s dismissal of allegations regarding a company’s statement in its Form 10-Q that losses on high-yield investments for the remainder of 2001 are expected to be substantially lower than in the first quarter.
Section 21E(b)(2)(A) of the Exchange Act excludes from the safe harbor forward-looking statements that are included in a financial statement prepared in accordance with GAAP. Since the forward-looking statement here was included in the MD&A, the court asked the SEC if it came within the exclusion. In the SEC’s view, the challenged statement is not excluded from the statutory safe harbor, since the MD&A section is separate and distinct from the financial statements of a Form 10-Q. The SEC has consistently believed that the MD&A section should provide a discussion and analysis of a company’s business as seen through the eyes its managers, and should not be a recitation of financial statements in narrative form.
Section 21E(c)(1)(A)(i) requires that in order to receive safe-harbor protection a statement must be identified as a forward-looking statement. There is no bright line rule on this element, said the SEC, rather, the facts and circumstances of the language used in a particular registration statement or report will determine whether or not a forward-looking statement is sufficiently identified to receive safe-harbor protection.
But generally, the SEC does not believe that to sufficiently identify forward-looking statements a company must include all forward-looking statements in a separate section or label each forward-looking statement as such. According to the SEC, a forward-looking statement can be adequately identified, as the company did here in its Form 10-Q, by including an explanatory note indicating that the use of certain forward-looking words is intended to identify a forward-looking statement. The use of linguistic cues like “we expect” or “we believe,” when combined with an explanatory description of the company’s intention to thereby designate a statement as forward-looking, generally should be sufficient to put the reader on notice that the company is making a forward-looking statement.
Section 21E(c)(1)(A)(i) also provides that a forward-looking statement that is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement is protected under the safe harbor. In the SEC’s view, the company’s statement that potential deterioration in the high-yield sector could result in further losses in the investment portfolio was not meaningful under the safe harbor provision because, according to the allegations, it misleadingly warned of a potential deterioration in the high yield sector when management was aware that such was actually occurring at the time. The safe harbor provides no protection to someone who warns his hiking companion to walk slowly because there might be a ditch ahead when he knows with near certainty that the Grand Canyon lies one foot away.
The SEC cautioned that safe harbor coverage does not apply when the cautionary statement is itself misleading. In adopting the safe harbor in the Private Securities Litigation Reform Act of 1995, reasoned the Commission, Congress did not intend to deviate from the well-established proposition that misleading cautionary language does not render inactionable a misleading forward-looking statement. The Conference Committee expressly recognized that a company could not rely upon a cautionary statement that misstates historical facts.
Finally, Section 21E(c)(1)(B) states that a person is not liable with respect to a forward-looking statement if the plaintiff fails to prove that the statement was made with actual knowledge that the statement was false or misleading. In the Commission’s view, a forward-looking statement is made with actual knowledge that it is misleading if the speaker makes the statement with the knowledge that he or she had no reasonable basis, or no basis at all, upon which to make it.
A statement of prediction or expectation, like the company’s statement here that losses are expected to be substantially lower, contains at least the implicit factual assertion that the statement is reasonably genuinely believed and the speaker is not aware of any undisclosed facts undermining its accuracy. A speaker has actual knowledge that a forward-looking statement is misleading if the speaker actually knows that these implicit factual representations are not true.
This standard is distinct from, and requires more than, a showing that a speaker acted recklessly in making a misleading forward-looking statement. Although the PSLRA’s legislative history is not illuminating on the matter, noted the SEC, the plain language of the provision requiring actual knowledge indicates that, to avoid the safe harbor, a plaintiff needs to show more than that a defendant acted recklessly.
Thud, to remove a forward-looking statement from the protection of the safe harbor, it must be shown that the company actually knew that the statement was misleading. In other words, to survive a motion to dismiss, an investor must plead facts sufficient to establish that company management was subjectively aware that one of the implicit factual assertions underlying its forward-looking statement was false when the statement was made.
A recent panel decision involving fraud claims against Halliburton again demonstrates the difficulties class action plaintiffs face in the 5th Circuit (Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Company). While all fraud plaintiffs must plead loss causation under the Supreme Court's Dura decision, they must prove loss causation in the 5th Circuit at the class certification stage. As Senior Circuit Judge Reavley wrote in his Halliburton opinion, in order to obtain certification, potential class action plaintiffs must prove "that the corrected truth of the former falsehoods actually caused the stock price to fall and resulted in the losses." This requires a showing by a preponderance of the evidence that "a loss occurred from the decline in stock price because the truth made its way into the marketplace, rather than for some other reason, such as a result of changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other factors independent of the fraud."
The 5th Circuit panel initially rejected the plaintiffs' argument that its 2007 Oscar Private Equity Investments v. Allegiance Telecom, Inc. decision was wrongly decided because a panel of the court could not overrule a precedential decision by a previous panel absent an intervening contrary or superseding decision by the court en banc or the Supreme Court. The court then concluded that the plaintiffs failed to show a specific stock price drop that was necessarily related to the alleged misstatements and any corrective disclosures. As described by the court, the negative information available in the marketplace involved "non-culpable changes in market conditions and the competitive environment that Halliburton faced," and the plaintiffs failed to differentiate this information from any allegedly culpable statements.
Sunday, February 21, 2010
The stripped down Reid jobs bill contains the Foreign Account Tax Compliance Act as a revenue offset to the tax credits contained elsewhere in the bill. The Reid bill, the Hiring Incentives to Restore Employment Act (HIRE) is included as Senate Amendment 3310 to HR 2847. This is the same Foreign Account Tax Compiance Act that the House included in its jobs bill.
The legislation creates a new reporting and taxing regime for foreign financial institutions with US account holders, whether they are participants in the existing Treasury Qualified Intermediary program or not. It casts a wide net in search of undisclosed accounts and hidden income. The legislation adds a new Chapter 4 to the Internal Revenue Code, which would essentially require foreign financial institutions to identify from among all of their customers any US persons and any US-owned foreign entities and then report to the IRS on all payments to, or activity in the accounts of, such persons.
The major focus of the legislation is tax compliance by U.S. persons that have accounts with foreign financial institutions. The legislation imposes substantial new reporting and tax withholding obligations on a very broad range of foreign financial institutions that could potentially hold accounts of U.S. persons. The reporting and withholding obligations imposed on the foreign financial institutions would serve as a backstop to the existing obligations of the U.S. persons themselves, who have a duty to report and pay U.S. tax on the income they earn through any financial account, foreign or domestic. These new reporting and withholding obligations for financial institutions would be enforced through the imposition of a 30 percent U.S. withholding tax on a very broad range of U.S. payments to foreign financial institutions that do not satisfy the reporting obligations.
The legislation provides substantial flexibility to Treasury and the IRS to issue regulations to fill in the numerous details on how the new reporting and withholding tax regime will work. It also provides Treasury with broad authority to establish verification and due diligence procedures with respect to a foreign financial institution’s identification of any U.S. accounts.
It is anticipated that thousands of foreign investment entities, including hedge funds, private equity funds, mutual funds, securitization vehicles and other investment funds, would be required to enter into agreements with the IRS pursuant to new Chapter 4. It is anticipated that implementation of new Chapter 4 will present many operational challenges and expenses for foreign financial institutions.
New Chapter 4 also provides for withholding taxes to enforce new reporting requirements on specified foreign accounts owned by specified US persons or by US-owned foreign entities. The provision establishes rules for withholdable payments to foreign financial institutions and for withholdable payments to other foreign entities.
The Foreign Account Tax Compliance Act would essentially present foreign financial institutions, foreign trusts, and foreign corporations with the choice of entering into agreements with the IRS to provide information about their U.S. accountholders, grantors, and owners or being subjected to 30 percent withholding.
The legislation would increase the disclosure of beneficial ownership. As a tax enforcement tool, U.S. financial institutions must file annual information returns disclosing and reporting on the activities of bank accounts held by U.S. individuals. Congress believes that many U.S. individuals looking to evade their tax obligations in the United States have sought to hide income and assets from the IRS by opening secret foreign bank accounts with foreign financial institutions. Some foreign financial institutions have voluntarily agreed to provide information on the U.S.-source income of U.S. accountholders as part of the Treasury’s Qualified Intermediary program since 2000.
The legislation would create a broad new definition of foreign financial institution and require that they enter into agreements with the IRS and provide annual information reporting in order to avoid a new U.S. withholding tax on U.S. source dividends, interest, and other income, as well as U.S.-related gross proceeds. It would also impose related information reporting and withholding requirements in respect of payments made to non-financial foreign entities.
The scope of application of the new regime would go beyond traditional financial institutions and cover virtually every type of foreign investment entity. The legislation broadly defines foreign financial institutions to comprise, not only foreign banks, but also any foreign entity engaged primarily in the business of investing or trading in securities, partnership interests, commodities or any derivative interests therein. According to the Joint Committee on Taxation, investment vehicles such as hedge funds and private equity funds will also fall within the scope of this regime. The new regime also brings within its scope fund entities, and fund managers, who are not currently within the scope of the Qualified Intermediary regime.
Also affected by the legislation are typical offshore securitization vehicles that hold U.S assets and issue their own equity and debt securities, such as a collateralized debt obligation (CDO) issuer. They would presumably be considered foreign financial institutions under the legislation. As a result, such a securitization vehicle would be required to enter into an information reporting agreement with the IRS and report on U.S. holders of non-publicly traded debt and equity that it had issued, or otherwise be subject to the withholding tax on its U.S. investments. Foreign securitization vehicles currently in existence have invested billions of dollars in the United States, particularly in loans and other debt instruments issued by U.S. companies.
A typical CDO is structured as an offshore corporation that invests in loans and other debt instruments issued by U.S. companies. Such CDOs in turn issue several classes of non-publicly traded debt and equity securities themselves, which divide up the cash flows on the underlying U.S. investments. Another example of a typical securitization vehicle is a grantor trust that invests in U.S. debt or equity investments and in turn issues pass-through certificates representing the cash flows on those investments. Pass-through interests in U.S. investments could also be structured as shares of an offshore cell company.
The principal goal of the legislation is to collect tax from U.S. taxpayers who have been evading their responsibilities by investing through foreign financial institutions and foreign entities that have thus far been generally free of reporting obligations to the IRS. To achieve this goal, the legislation would impose the risk of a withholding tax on a very broad class of U.S.-related payments (including gross proceeds) to a broad class of foreign investors, unless the foreign financial institutions and foreign entities agree to provide information to the IRS regarding their U.S. account holders and owners.
Noting that 13 provincial securities regulators for Canada is a regulatory anomaly, Finance Minister Jim Flaherty said that the government will move forward quickly to establish a Canadian securities regulator. In recent remarks in Toronto, he said the lack of a national securities regulator is a source of awkwardness if not embarrassment internationally, when you look at the Canadian financial system, the strength of its financial institutions, and the overall integrity of the financial system, and then realize that that there are 13 securities regulators. There is even a Financial Consumer Agency of Canada, a type of agency the U.S. is trying to implement in financial reform legislation.
The government will have the draft Securities Act ready by spring, noted the Minister, and will then refer the bill to the Supreme Court of Canada for an opinion on the constitutional jurisdiction of the federal government on this issue. Subject to the direction of the Court, the government will move forward with the Canadian securities regulator. A lot of work is being done on this, he noted, and most of the provinces and territories are working with the government to accomplish the design and goal of a Canadian securities regulator. A transition team has been formed, which is headed by Doug Hyndman, the past Chair of the British Columbia Securities Commission.
Canada is the only industrialized country without a common securities regulator. And the present system of thirteen provincial regulators is seen by many as cumbersome, fragmented, and lacking the proper tools of enforcement. In earlier remarks, the Minister has emphasized that one great advantage of a common regulator would be the establishment of a national enforcement strategy. Currently, some provinces lack sufficient expertise to investigate and prosecute complex cases.
The Minister also believes that moving to a common securities regulator with a new common securities act would provide a unique opportunity to introduce more principles-based, proportionate regulation. This would help establish a regulatory regime that is more flexible and more responsive.
The current passport system is viewed as inadequate in allowing Canada to compete successfully at the international level. For example, with the passport system, investors deal with 13 securities regulators, with 13 sets of laws, however harmonized, and with 13 sets of fees. Further, the passport system does not have a national coordination of enforcement activities, nor does it address the need to improve policy making. It is still necessary to obtain agreement from 13 regulators to make changes to the rules.
Saturday, February 20, 2010
The Japanese Financial Services Agency has proposed enhanced corporate governance disclosure in a company’s securities report. Listed companies in Japan are currently required to disclose basic information of their corporate governance systems in their securities reports. Given the increasing importance of sound corporate governance to the investment community, the FSA would require additional disclosure, mainly centered on executive compensation.
As a threshold matter, companies would have to outline their governance system and the reason for selecting a particular system. They would also have to disclose the state of coordination between outside directors and the corporate departments in charge of internal control and internal auditing, as well as describe the functions and roles of the outside directors in the governance of the company.
The long-term soundness of a company’s executive compensation scheme has become a critical component of corporate governance. Information on compensation in all its forms is important for shareholders and investors, said the FSA, since it allows them to examine whether incentive structures for the management of the company and remuneration amounts are appropriate. Thus, the FSA would require the disclosure of detailed information regarding the remuneration for directors in the company’s securities report.
Specifically, for each director or statutory auditor whose remuneration for the relevant fiscal year is JPY 100 million or more, the company would have to disclose the total amount of remuneration, the name of the executive, and a breakdown by the type of payments, such as salary, bonus, stock option, and retirement payment. The company must also explain its remuneration policies for its directors and statutory auditors, and the way they are decided.
Finally, regarding the results of resolutions at shareholders’ meetings, the current rule requires listed companies to disclose whether each resolution was accepted or rejected, but not the number of votes for support or objection. The FSA believes that requiring the disclosure of votes cast for or against a resolution will give a clearer picture of the decisions made by shareholders, which, in turn, will entail a better functioning of market pressure over management. Therefore, the FSA would require disclosure without delay after the shareholders meeting of the number of votes cast for, against or withheld, including a separate tabulation with respect to each nominee for director or statutory auditor.
Friday, February 19, 2010
Reforming the tax code to move it away from favoring debt and leverage towards favoring equity is a component of controlling systemic risk to the financial markets, in the view of Jaime Caruana, General Manager of the Bank for International Settlements. In recent remarks, the GM also said that a resolution regime to wind down a failed financial firm is a critical component of reform. The cross-border nature of many financial institutions calls for harmonized resolution regimes.
Recently, there has been an increasing consensus that tax code reform needs to be part of financial reform. Taxing bigness or interconnectedness in the financial system deserves study. The idea of a financial transactions tax is under consideration, and the Obama Administration has proposed a .
Regarding these tax proposals, one question to be considered is whether the tax would end up being paid by customers, or even by shareholders. Another question is whether higher capital and liquidity requirements for systemic institutions would be as effective as tax incentives.
More broadly, tax policy could be also used to address sectoral developments with potential financial stability implications. For example, tax policy could be used as a tool to limit excessive credit growth in specific areas, such as housing. A key way to ensure that the tax code worked for rather than against financial stability would be to reduce or to eliminate its bias towards debt and against equity. The recent crisis has shown the unfortunate results this bias can have on asset prices and leverage, especially in housing markets. The BIS official reasoned that getting rid of the tax incentive to leverage could make a significant contribution to financial stability.
Another key way to lessen the systemic risk is establishing adequate resolution regimes to hold down the system-wide loss that arises when a large financial firm fails. One key element of such a regime is to ensure that the counterparties of an important firm are not sheltered from loss in the event of failure, noted the official, so that market discipline is strengthened ex ante. This can further help to limit the probability of default.
However, the BIS official cautioned that setting up an adequate resolution regime is no easy matter. One reason for the difficulty is that the legal problems are complex, with the ongoing Lehman Brothers liquidation being an example. The international nature of the :Lehman dissolution also highlights the need for cross-border resolution frameworks.
There is currently no framework for the resolution of cross-border financial groups or financial conglomerates. At the national level, few jurisdictions have a framework for the resolution of domestic financial groups or financial conglomerates. The global financial crisis illustrates the importance of effective cross-border crisis resolution authority. For example, Lehman Brothers group consisted of 2,985 legal entities that operated in 50 countries, with many of these entities subject to host country national regulation as well as supervision by the SEC.
Financial reform legislation passed last year by he US House would provide for the orderly resolution of cross-border financial institutions, which former SEC Chair Arthur Levitt and former Fed Chair Paul Volcker recently testified is the key to eliminating the moral hazard of too big to fail. In testimony before the House Financial Services Committee, Mr. Levitt said that, in order to address the too big to fail challenge, Congress must provide a legislative process to manage the failure of systemically important financial institutions. The problem is not that financial institutions are too big, he reasoned, but that there is no uniform orderly process to let then fail without causing a market meltdown.
Similarly, Mr. Volcker advocated a new resolution regime for insolvent or failing non-bank institutions, such as hedge funds, of potential systemic importance. He envisions the appointment of a federal conservator to take control of a financial institution defaulting, or in clear danger of defaulting, on its obligations. Authority should be provided to negotiate the exchange of debt for new stock if necessary to maintain the continuity of operations, to arrange a merger, or to arrange an orderly liquidation. In his view, such an authority, preempting established bankruptcy proceedings, would be justified only by the exceptional circumstance of a systemic breakdown.
The senior officials join the growing consensus, shared by the Obama Administration, that the lack of a federal resolution authority for large systemic non-bank financial institutions contributed to the financial crisis and, unless addressed with legislation, will constrain a federal response to future crises. As demonstrated by AIG, severe distress at global financial institutions can pose systemic risks to the financial markets. Former SEC Chair Levitt warned that allowing market participants to assume that large financial institutions will not be permitted to fail is a dangerous course that will only encourage more recklessness.
The Administration asked Congress to pass legislation establishing a new resolution regime for the orderly resolution of failing systemically risky financial institutions, including securities and commodities firms. Instead of subjecting a firm to bankruptcy or simply injecting taxpayers' funds, the legislation would allow for a federal conservatorship leading to orderly reorganization or wind-down.
The Basel Committee recently set forth recommendations on the cross-border resolution of financial institutions. Basel recommends a middle ground approach that recognizes the strong possibility of ring fencing in a crisis and helps ensure that home and host countries as well as financial institutions focus on needed resiliency within national borders. Such an approach may require discrete changes to national laws and resolution frameworks to create a more complementary legal framework that facilitates financial stability and continuity of key financial functions across borders.
This approach aims at improving the ability of different national authorities to facilitate continuity in critical cross-border operations that, absent such efforts, may contribute to contagion effects in multiple countries, while minimizing moral hazard. This middle approach protects systemically significant functions, performed by the failing financial institution, but not the financial institution itself, at least in its current ownership and corporate structure. It would limit moral hazard and promote market discipline by imposing losses on shareholders and other creditors wherever appropriate.
Encouraging greater cross-border cooperation within such a middle ground approach requires improved understanding of the parameters for action by different authorities and greater convergence in national laws.
An alternative approach, which is not as likely to happen, would be to establish by international treaty a comprehensive, universal framework for the resolution of cross-border financial groups. This would require major changes to national legal frameworks and a harmonization of national rules governing cross-border crisis resolution, including rules on core issues such as a avoidance powers, netting of derivative contracts
At the very least, said Basel, the global nature of many financial institutions requires close cooperation among national authorities. Having similar tools and similar early intervention thresholds may facilitate coordinated solutions across borders. Basel urges national authorities and international groups to monitor developments toward the convergence in these legal frameworks.
Thursday, February 18, 2010
A shareholder’s effort to shrink the board of directors by amending the corporate bylaws failed because the attempt conflicted with the Delaware Corporation Code. In a case of first impression, the Chancery Court held that the notion that the terms of the extra surplus directors would end conflicts with Section 141(b)’s mandate that directors hold office until their successor is elected and qualified or until their earlier resignation or removal. Delaware corporate law does not contemplate the continued board presence of seatless directors. Kurz v. Holbrook, Del Chan. Ct,, CA No. 5019, Feb 9, 2010.
Up to now, Delaware law has not addressed what happens when a bylaw amendment would shrink the number of board seats below the number of sitting directors. The Delaware Corporation Code does not address the issue, nor has any Delaware court considered it, and none of the leading treatises on Delaware law mentions it. Indeed, noted Vice Chancellor Laster, no one seems to have contemplated it.
The proposed bylaw amendment would shrink the board to three directorships at a time when five directors are in office. There are two possible consequences for the suddenly surplus directors. One is that their terms would end. The other is that they would continue to serve, albeit without official seats, until their terms were ended by a statutorily recognized means. The court found that both possibilities conflict with the Delaware Corporation Code.
Section 141(b) recognizes three procedural means by which the term of a sitting director can be brought to a close: (1) when the director’s successor is elected and qualified, (2) if the director resigns, or (3) if the director is removed. Section 141(b) does not contemplate that a director’s term could end through board shrinkage. A bylaw that seeks to achieve this result conflicts with Section 141(b) and is void.
In light of the three procedural means for ending a director’s term in Section 141(b), said the Vice Chancellor, a bylaw could not impose a requirement that would disqualify a director and terminate his or her service. Section 141(b)’s recognition of the bylaws as a locus for director qualifications instead contemplates reasonable qualifications to be applied at the front end, before a director’s term commences, when the director is elected and qualified. The concept of a bylaw that would end a director’s service through disqualification thus lends no support to a bylaw that would accomplish the same thing through board shrinkage. Neither is valid under Section 141(b).
If a bylaw amendment reducing the size of a board could eliminate sitting directors, reasoned the court, then directors suddenly would have the power to remove other directors. For 89 years, he noted, Delaware law has barred directors from removing other directors.
Further, The Delaware Corporation Code says nothing about directors continuing in office in the absence of an underlying board seat. Delaware law simply does not contemplate a liminal state in which suddenly surplus directors might continue to exist, untethered from the statute or any constitutive corporate document. Moreover, the lingering presence of directors without board seats would create a direct conflict between the number of directors in office and the number of directors provided for in the bylaws.
The Securities Litigation Uniform Standards Act did not preempt state claims against the directors and administrators of two defunct hedge funds (Pension Committee of the University of Montreal Pension Plan v. Banc of America Securities, LLC, SD NY 05 Civ. 9016). The shares issued by the British Virgin Island-based funds were clearly not "covered securities" under the Uniform Standards Act. According to the fund defendants, however, the Uniform Standards Act preempted the state claims because a portion of the funds' portfolios included, or purported to include, covered securities.
Judge Shira Scheindlin of the Southern District of New York wrote that only the alleged misrepresentations by the defendants were relevant to SLUSA preemption analysis. She concluded that the alleged misstatements concerned only the valuation of the funds and were not made in connection with the purchase or sale of covered securities.
Judge Scheindlin recognized that the Supreme Court interpreted the "in connection with" requirement rather broadly in the 2006 Merrill Lynch v. Dabit case (SLUSA preempted "holder" claims as well as those by buyers and sellers if the fraud "coincided" with a scheme involving covered securities). However, she concluded that such an application of SLUSA to this case "stretches the statute beyond its plain meaning." Congress, and not the courts, should decide whether the statute applied to statements made in connection with the purchase or sale of shares of unregistered hedge funds.
The new Commissioner for the Internal Market, Michel Barnier, wants to act quickly on the comprehensive overhaul of EU financial regulation and harmonize it internationally. In remarks to the EcoFin Council, he said that one immediate priority is to equip the EU with an effective system for regulating hedge funds and other alternative investment funds.
The Commission has proposed the Directive on Alternative Investment Managers, which is now before the European Parliament. Commissioner Barnier urged swift approval of the Directive, noting the G-20’s commitment to the regulation of hedge funds and other alternative investment vehicles.
The proposed Directive on Alternative Investment Fund Managers, centered on enhanced disclosure and effective risk management, is designed to create a comprehensive and effective regulatory framework for hedge and private equity fund managers at the European level. The proposed Directive would impose regulatory standards for all alternative investment funds within its scope and enhance the transparency of the activities of the funds towards investors and public authorities.
The Commissioner also urged quick action on the regulation and standardization of derivatives and the development of central clearing parties for derivatives products. This type of regulation is essential for financial stability, he said. At his confirmation hearings before the European Parliament, Mr. Barnier said that he would propose a coherent legislative framework to the Commission for the regulation of OTC derivatives, as well as for post-trade activities and infrastructure, including a legislative proposal on indirectly held securities.
He wants to revise the Markets in Financial Instruments Directive (MiFID), with the aim of strengthening transparency on financial markets, in particular for alternative platforms. Commissioner Barnier also wants to improve risk management and internal controls at financial institutions
Another strong priority in the coming months will be to execute the G-20’s vision of ensuring the convergence of accounting standards at an international level. To this end, regulators must find the right balance between a faithful representation of a company’s financial situation and wider financial stability. The Commissioner also said that rules on dynamic provisioning must be adopted. Dynamic provisioning permits more mechanical increases to loan loss reserves based on loan growth rather than measures of projected loss.
More broadly and importantly, the EU’s reform effort must be harmonized with the reform legislation of the US and other jurisdictions in order to prevent regulatory arbitrage. In his view, it is imperative to establish common rules at an international level that guaranty the solidity of the financial sector and do not worsen pro-cyclicality. No jurisdiction can go it alone, he emphasized, rather there must be a shared commitment to regulatory reform. Pro-cyclicality is the term given to the exacerbation of fluctuations on volatile markets by, among other factors, bank capital requirements, accounting standards, and remuneration schemes.
With the G-20 emphasizing the need for a global regulatory response to the financial crisis, Mr. Barnier is aware of the challenges of globalization and the need to craft a harmonized cross-border response. In earlier remarks, he has noted that not long ago financial exchanges were nation-centric and, in all countries, capital exchanges were forbidden or restricted and the approval of the Ministry of Finance was needed before any capital could leave or enter a country. Noting that change now happens very quickly and abruptly, he recognizes the need for new paradigms and thus a need for a new governance.
Commissioner Barnier will implement stronger rules on corporate governance, especially measures to move executive compensation to long-term value creation and less risk taking. He also supports targeted measures to strengthen the responsibility and the independence of management boards. The new Commissioner intends to issue a report on corporate governance, containing proposals for remedying the weaknesses revealed by the crisis, particularly involving the eradication of abusive executive remuneration practices and policies. Also, a report on the application of the Transparency Directive will be published shortly, possibly followed by proposed amendments.
The Commissioner also intends to submit a proposal creating a legal framework for crisis management and resolution, including a resolution fund, that would reinforce and harmonize the regulation of financial groups in terms of equity and liquidity and the financial stability of each Member State and of the Union as a whole. Recently, in an effort to end too big to fail, the US House passed legislation creating a resolution authority and a resolution fund paid for by assessments on systemically risky financial firms.
Wednesday, February 17, 2010
Senator Jack Reed has introduced a bill creating an executive agency to collect and standardize data on financial firms and their activities to aid and support the work of the federal financial regulators. The National Institute of Finance Act of 2010, S 3005, would provide the financial regulators with the data and analytic tools needed to prevent and contain future financial crises by developing tools for measuring and monitoring systemic risk. The logic behind the legislation is that it makes no sense to pass legislation creating a systemic risk regulator when there are no standardized tools for measuring systemic risk.
A key member of the Banking Committee, Senator Reed is also Chair of the Securities Subcommittee. He is working with Senator Gregg on the derivatives piece of the financial reform bill.
The Institute would not only develop the metrics and tools financial regulators need to monitor systemic risk, it would also help policymakers by conducting studies and providing advice on the impact of government policies on systemic risk. Thus, the Institute would be required to provide independent periodic reports to Congress on the state of the financial system. This will ensure that Congress is kept apprised of the overall picture of the financial markets.
The Institute would be headed by a Director appointed by the President for a 15-year term and a board of directors composed of the Treasury Secretary and the Chairs of the SEC, CFTC and other federal financial regulators. The Director could not concomitantly serve as Chair of the SEC or any other financial regulator. The Institute would be funded through assessments on the financial firms required to report data to the Institute.
The Institute is broadly authorized to require financial firms to report all data and information necessary to fulfill the responsibilities of the Institute. It can require reporting on a global basis from the financial firms organized in the United States. The Institute can also require reporting of US-based activities by foreign financial firms. The legislation empowers the Institute to enforce and apply sanctions on all financial firms that fail to report the requested data.
According to Senator Reed, the crisis revealed that federal financial regulators do not have the appropriate tools or knowledge to address risks that cut across different markets and sectors of the financial system. While the financial regulatory reform legislation moving through Congress is an important step in filling this huge regulatory gap by establishing centralized systemic risk oversight, he reasoned, any new regulatory structure will be ineffective unless also equipped with a strong, independent, and well-funded data, research, and analytic capacity to fulfill its mission.
At the behest of Senator Reed, the National Academy of Sciences conducted a study and found that the U.S. currently lacks the technical tools to monitor and manage systemic financial risk with sufficient comprehensiveness and precision. The Academy also found that market efficiency, in addition to regulatory capacity, would be enhanced by improved intelligence about what is going on in the system as a whole. Existing capabilities are not a sufficient foundation for systemic risk management.
The legislation would provide for the new Institute to house a data center that would collect, validate and maintain key data to perform its mission, including a central database to map the interconnections between financial institutions, along with details on their transactions and positions, and their valuation of their assets and liabilities. By working with banks and other firms to standardize the format of such data and by providing standard reference data, such as databases of legal entities andfinancial products, the Institute would reduce the costs to regulators and financial institutions from the currently fragmented and disorganized systems used to collect and store such information.
The Institute would also contain a research and analysis center to develop the needed metrics and then measure and monitor systemic risk posed by individual firms and markets. The Institute would house some of the country's most-well-respected researchers to collect and analyze the data needed to understand what is happening in the financial markets, to conduct investigations of market disruptions, and to work with regulators to identify new and dangerous trends. It would conduct and help coordinate applied research on financial markets and systemic risk, a field that is not well-represented right now at the Federal Reserve or within other regulatory agencies.
The legislation is also an effort to implement a recommendation of the Counterparty Risk Management Policy Group, which called on the financial industry to move rapidly toward real-time reconciliation and confirmation of financial transactions. Industry experts believe that this change would yield substantial benefits to firms individually, to the financial services industry, and to the economy as a whole. Achieving this goal would not be possible, however, without industry-wide adoption of common standards for coding and handling financial transaction data. Despite the clear benefits of data standardization and despite years of effort, the financial services industry has not been able to make meaningful progress towards the goal of universal adoption of uniform, consistent standards for data handling.