Friday, April 30, 2010

Senator Webb Would Amend Financial Reform Bill to Add Measure Taxing Bonuses

An amendment to the Senate funancial reform bill (S 3217) would tax excessive Wall Street bonuses. The measure is co-sponsored by Senator James Webb (D-Va) and Senator Barbara Boxer D-CA) . The Webb-Boxer measure, which is essentially their earlier introduced Taxpayer Fairness Act, S. 2994, would impose a 50 percent excise tax on the bonuses of employees at banks, financial firms, and Fannie Mae and Freddie Mac, that exceeded $400,000 in 2009. Any employee who received a bonus larger than $400,000, the salary of the President of the United States, would have to pay a 50 percent tax on the portion of the bonus over $400,000. This is a one-time tax on firms that received more than $5 million in TARP and other federal emergency assistance funds. It affects only bonuses received this year that are based on performance in 2009. The revenues generated would be used for deficit reduction.

CBO conservatively estimates that this amendment will raise at least $3.5 billion. The amendment is supported by Senators Durbin and Lincoln, among others.

The Taxpayer Fairness Act, codified as Title XIII of the Dodd bill would add a new Section 4999A to the Internal Revenue Code imposing the tax on any covered employee who receives a covered excessive 2009 bonus, which includes a retention bonus. Covered employees are defined as both as employees of the company and non-employee directors of a major federal emergency economic assistance recipient.The Act defines major federal emergency economic assistance recipients as financial institutions of which the federal government acquired an equity interest of more than $5 million pursuant to a program authorized by the Emergency Economic Stabilization Act of 2008, as well as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac)

The Act authorizes Treasury to adopt regulations to prevent the recharacterization of a bonus payment as a payment which is not a bonus payment in order to avoid the tax or to prevent the avoidance of the tax through the use of partnerships or other pass-thru entities.

The senators attempted to add the Taxpayer Fairness Act to the recently passed HIRE Act, but their amendment never came up for a vote.


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Sen. Bill Nelson Aims to Enhance Credit Rating Agency Oversight in Dodd Reform Bill

Amendments offered by Senator Bill Nelson (D-Fla) would significantly strengthen the oversight of credit rating agencies embodied in the Senate financial reform bill, S 3217, by randomly assigning credit ratings and providing for SEC enforcment of a mandated ongoing monitotring of ratings by the rating agencies that issued them.

Senator Nelson praised the Dodd bill for requiring rating agencies to consider information in their ratings that comes from outside sources. But when it comes to addressing the fundamental
conflict of interest in the credit rating agency business model, he said, the bill falls short. It would require the rating agencies to separate ratings activities from their sales and marketing activities. But the Senator said that he would offer an amendment establishing a clearinghouse to randomly assign rating assignments with rating issuers. In his view, the conflict of interest in the credit rating industry would end if, randomly, it is going to be assigned among companies that rate issuers of financial instruments. Cong Record, Apr 28, 2010, S2742.

Second, the Senator offered an amendment (SA 3739) to require the rating agencies to monitor, to review, and to update their credit ratings after the initial issuance of their credit rating so it does not become stale. They are going to have to continue to look at it to review it, to update it, and to publish it. In the Senator's view, the rating agency should not be able to walk away from a rating after it has been issued. It is going to be fresh. The rating agencies ought to conduct continued surveillance of these securities and update them along the line.

The amendment would amend Sec. 15E of the Exchange Act to require the SEC to issue rules requiring each nationally recognized statistical rating organization to regularly monitor, review, and update the credit ratings they issued to ensure that the ratings remain current and reliable. The SEC would be authorized to enforce the rules with the power to censure, fine or place limitations on the activities of agencies that do not comply with the rule, and also to suspend or revoke the registration of agencies not compliant with the rules. Cong. Record, Apr 29, 2010, p. S 3751.


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Thursday, April 29, 2010

Menendez Amendment Would Require SEC to Adopt Uniform Fiduciary Standard for Brokers and Advisers, Conforming to House Bill

Senator Robert Menendez plans to introduce an amendment to the Senate financial reform bill, S. 3217, that would mandate a harmonized federal fiduciary standard for brokers and investment advisers in their dealings with retail customers. Thus, every financial intermediary, such as brokers and investment advisers, that provides personalized investment advice to retail customers would have a fiduciary duty to the investor. The Menendez Amendment essentially mirrors Section 7103 of the House-passed reform measure, HR 4173, in directing the SEC to adopt rules providing that the standard of conduct for all brokers and investment advisers is to act in the best interest of their customers without regard to their own financial or other interest.

Any material conflicts of interest must be disclosed to the customer, who must consent. However, brokers or dealers are not subject to a continuing duty of care or loyalty to the customer after providing personalized investment advice about securities. Under this harmonized standard, broker-dealers and investment advisers will have to put customers’ interests first. The receipt of compensation based on commissions or fees will not, in and of itself, be considered a violation of the standard applied to a broker or dealer or investment adviser. The legislation defines retail customers as those receiving personalized investment advice from a broker, dealer, or investment adviser for use primarily for personal, family, or household purposes.

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

Instead of mandating a new uniform federal fiduciary standard for brokers and investment advisers, the Senate bill currently directs the SEC to conduct an exhaustive study of the effectiveness of existing legal and regulatory standards of care for brokers and investment advisers and whether there are any legal or regulatory gaps or overlap in the protection of retail customers, defined as individual customers, of the broker or adviser relating to the standards of care. If such gaps are found, the SEC must commence rulemaking within two years to address them and protect the interests of the retail customers of brokers and investment advisers.

The SEC supports a harmonized standard requiring broker-dealers and investment advisers to act solely in the interests of their customers when providing investment advice. The SEC believes that all financial service providers that provide personalized investment advice about securities should owe a fiduciary duty to their customers or clients and be subject to equivalent regulation.

Many investors do not recognize the differences in standards of conduct or the regulatory protections applicable to broker-dealers and investment advisers. Thus, the SEC believes it essential that when investors receive similar services from similar financial service providers, the service providers should be subject to the same standard of conduct and regulatory requirements, regardless of the label attached to the providers.

Currently, the fiduciary duty imposed by the Investment Advisers Act requires advisers to act solely with the client’s investment goals and interests in mind, free from any conflicts of interest that would tempt them to make recommendations that would also benefit them. Unlike investment advisers, brokers are not categorically bound by statute, regulation, or precedent to a per se rule imposing fiduciary obligations toward clients.


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Wyden Amendment to Senate Financial Reform Bill Would Require Ful Disclosure to Customers of Financial Firm's Positions

In an effort to promote greater transparency between buyers of securities and the firms that sell them, Senator Ron Wyden (D-Ore.) has filed an amendment to the financial reform legislation that would force financial firms to clearly state, among other things, any financial stake they have in seeing their product lose value. The Wyden Amendment is based on a belief that transparency and accountability are essential to a functioning market and that the amendment would bring those attributes to an area of finance that has notoriously operated in secret.

The Wyden Amendment would require the new Financial Stability Oversight Council to put forward rules requiring any seller of a financial product to disclose to the purchaser whether the seller would benefit financially if the product lost value. While Sen. Wyden identified disclosure of short positions made against clients as the immediate priority for the Council, he said that a case can be made for disclosing all of a firm’s financial positions related to products that they are marketing.

Financial firms have been selling more and more complex financial products and instruments and in some cases hedging their bets against the failure of those complex products. Wyden’s legislation intends simply to require sellers of these products to be honest and forthright with customers. The new Financial Stability Oversight Council is given broad authority to push forward a wide array of rules to promote transparency. The Wyden Amendment would require the Council to prioritize rules that require disclosure when firms bet against their clients.

According to Senator Wyden, the financial services industry has used the sin of omission and the sheer complexity of their products to hide their hedging and their real views about the value of their products.


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Financial Reform Legislation Should Give SEC Collateral Bar Power

Both the House (HR 4173) and Senate (S 3217) versions of financial reform legislation contain provisions authorizing the SEC to impose collateral bars. Thus, it appears highly likely that the bill that emerges from the House-Senate conference on the legislation will contain this enhanced power for the Commission.

Currently, a securities professional barred from being an investment adviser for serious misconduct could still participate in the industry as a broker-dealer. Noting that improved sanctions would better enable the SEC to enforce the federal securities laws, the Obama Administration sought authority for the SEC to impose collateral bars against regulated persons across all aspects of the industry rather than in a specific segment of the industry. The interrelationship among the securities activities under the SEC’s jurisdiction, the similar grounds for exclusion from each, and the SEC’s overarching responsibility to regulate these activities support the imposition of collateral bars.

Thus, the legislation authorizes the SEC to impose collateral bars against regulated persons. The Commission would have the authority to bar a regulated person who violates the securities laws in one part of the industry, such as a broker-dealer who misappropriates customer funds, from access to customer funds in another part of the securities industry, for example, an investment adviser. By expressly empowering the SEC to impose broad prophylactic relief in one action in the first instance, this provision would enable the SEC to more effectively protect investors and the markets while more efficiently using SEC resources. Collateral bars will be available under the Exchange Act and the Investment Advisers Act.

Thus, the SEC would be authorized to bar a regulated person who violates the securities laws in one part of the industry, for example a broker-dealer who misappropriates customer funds, from access to customer funds in another part of the securities industry such as an investment adviser. By expressly empowering the SEC to impose broad prophylactic relief in one action in the first instance, the legislation enables the SEC to more effectively protect investors and the markets while more efficiently using SEC resources.


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Tuesday, April 27, 2010

Reed Measure Would Add SEC Investor Protections to Senate Financial Reform Bill

Legislation just introduced by Senator Jack Reed, a senior member of the Senate Banking Committee, would add a number of SEC investor protections to the Restoring American Financial Stability Act, S. 3217, including nationwide service of process and authority to impose civil penalties in cease and desist proceedings. Senator Reed plans to introduce these investor protection provisions as an amendment to S. 3217 when it reaches the Senate floor. Essentially, the effort is to fill investor protection gaps in the Senate financial reform legislation by reference to the House reform legislation passed last year, HR 4173, which contains enhanced authority for the SEC in a number of areas pursuant to provisions championed by Rep. Paul Kanjorski, a senior member of the House Financial Services Committee.

The Modernizing and Strengthening Investor Protection Act, S 3258. would improve the ability of the SEC to protect investors by strengthening its ability to bring enforcement actions, addressing issues revealed by the recent Madoff fraud, and modernizing its ability to obtain critical information. In particular, it would enhance the ability of the SEC to hire market experts, strengthen oversight of fund custodians, modernize the SEC's ability to obtain information from the firms it oversees, and clarify and enhance SEC penalties and other authorities. According to Senator Reed, his legislation is intended to mirror a bill that Rep. Kanjorski introduced and worked to include in the House version of Wall Street reform. (Cong. Record, April 26, 2010, S 2644)

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

Also, the legislation would allow subpoenas to be served nationwide in SEC enforcement actions in federal court. Currently, the Commission can issue a subpoena only within the federal district where a trial takes place or within 100 miles of the courthouse. Witnesses in civil cases brought by the Commission are, however, often located outside of a trial court's subpoena range. The SEC has nationwide service of process of subpoenas in administrative proceedings.


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

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

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


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NASAA Supports Reed-Specter Amendment to Restore Investors' Rights

The North American Securities Administrators Association (NASAA) has sent a letter today to each member of the U.S. Senate, urging the lawmakers to support the Reed-Specter Amendment to the Restoring American Financial Stability Act of 2010 (S. 3217). Writing on behalf of NASAA, Texas Securities Administrator and NASAA President Denise Voigt Crawford described the amendment, which would reimpose private civil liability on aiders and abettors of securities fraud, as a "positive step" for investors. According to Crawford, the amendment would foster greater accountability and integrity in the nation's capital markets by restoring to investors the ability to seek damages from all entities that knowingly and substantially participate in securities fraud.

Among its other recommendations, NASAA continued to urge the Senate to support the Akaka-Menendez "Honest Broker" amendment to Section 913 of the bill. The amendment would replace the study in Section 913 with House-passed language that directs the U.S. Securities and Exchange Commission to conduct rulemaking that would require stockbrokers giving investment advice to act in their clients' best interest. NASAA also reiterated its call for the adoption of disqualification provisions to prevent violators of the securities laws from conducting private offerings of securities under Rule 506 of Regulation D, while recommending that the Senate increase the monetary standards required for the "accredited investors" who may participate in such offerings.

Finally, NASAA called for state banking, insurance and securities regulators to have seats at the table as members of the Financial Stability Oversight Council that would be established under Section 111 of the bill. Crawford stated that the presence of state regulators would foster federal-state regulatory cooperation and communication. NASAA also believes that the inclusion of state regulators would result in more effective oversight of systemic risk by creating a body with access to all the critical information regarding the accumulation of risks in the financial system.
Unanimous Supreme Court Allows Vioxx Suit to Proceed

A unanimous Supreme Court held that the limitations period for securities fraud cases begins to run on the earlier of 1) the date on which the plaintiff actually discovered the facts constituting the violation or 2) the date on which a reasonably diligent plaintiff would have made that discovery. In securities fraud cases, held the Court, facts showing scienter are among those that constitute the violation (Merck & Co., Inc. v. Reynolds).


In this case, an investor class sued Merck & Co., alleging that the drug maker knowingly misrepresented the risks associated with Vioxx, an arthritis medication. A study showed adverse cardiovascular results for Vioxx when compared to naproxen, another pain reliever. Merck suggested that this might be due to the absence of a benefit conferred by naproxen rather than a harm caused by Vioxx. The investors alleged that Merck committed fraud by promoting the so-called "naproxen hypothesis," even though it knew the hypothesis was false.

Writing for the Court, Justice Breyer noted that securities fraud plaintiffs must show that it is more likely than not that the defendant acted with the relevant knowledge or intent to state a claim. In these cases, stated Justice Breyer, it would "frustrate the very purpose of the discovery rule" in the Sarbanes-Oxley Act limitations provision if the limitations period began to run regardless of whether a plaintiff had discovered any facts suggesting scienter. "So long as a defendant concealed for two years that he made a misstatement with an intent to deceive," wrote the Court, "the limitations period would expire before the plaintiff had actually `discover[ed]' the fraud."

In applying this standard, the Court concluded that an FDA warning letter to Merck which stated that the company had “minimized” a study's “potentially serious cardiovascular findings,” and the pleadings filed in products-liability actions alleging that Merck had “omitted, suppressed, or concealed material facts" concerning Vioxx, were insufficient to initiate the limitations period. The FDA letter and the complaints did not contain any specific information concerning the alleged deceptive promotion of the naproxen hypothesis, concluded the Court.

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Monday, April 26, 2010

Key Senator Backs Strong Derivatives Legislation Along Ag Committee Bill Lines

Senator Olympia Snowe (R-Maine) has come out for strong federal regulation of derivatives along the lines of the bill reported out of the Senate Agriculture Committee last week. In a letter to Senate Majority Leader Harry Reid, Sen. Snowe said that the final derivatives title in the massive financial reform legislation must include mandatory clearing and execution requirements, real time reporting to the SEC or CFTC, a prohibition on abusive derivatives contracts and a narrow end user exemption confined to non-financial commercial firms. The letter was co-signed by Senators Dianne Feinstein (D-Calif.) and Maria Cantwell (D-Wash.),

The legislation should also require that trades that the CFTC or the SEC require to be cleared must also be traded on an exchange or on a swap execution facility. Trading on exchanges or execution facilities provides for pre-trade transparency, said the letter, which is necessary to fully understand and manage the risks being taken by market participants, to provide more efficient and accurate pricing, and to facilitate more cost-effective risk management. Along with an execution requirement, a robust mandatory clearing requirement for derivative contracts is needed in order to assess, manage, and collateralize risks, to ensure post-trade accountability, to ensure market stability, and to reduce systemic risk. Mandatory clearing provides an essential safety net in the market by requiring market participants to post margin and hold capital to support their positions in the market, and to prevent the default of any one party from putting the entire market at risk.

Further, the senator emphasized that all trades, including those that are not required to be cleared or traded on an exchange or execution facility, need to be reported to the SEC or CFTC in real time so regulators will for the first time have a full understanding of the aggregate positions held by each entity. To serve as large a share of the transparency objectives that would otherwise be served by the trading requirement, regulators should be required to disclose those trades to the public as soon as technologically feasible and in a manner that protects market integrity.

The legislation must also require the SEC and CFTC to set and enforce position limits, noted the letter, since position limits provide an important restriction on market manipulation and the amount of risk that can build up in any one market participant. Swaps dealers should have a fiduciary duty of care to pension funds, endowments, retirement funds, and state and local governments to protect vulnerable market participants from being taken advantage of by dealers.

The CFTC and SEC should be authorized to prohibit trading of derivative contracts, whether traded on an exchange, execution facility, or OTC, if they are created with the purpose of defrauding a third party, are otherwise abusive, or if their trading is against the public interest. More general protections that may presently exist in federal, state, or common law against fraud, for example, are not sufficient.

Swaps that are not cleared are likely to be some of the non-standard and risky contracts. Thus, to mitigate the risks that these contracts pose to financial stability, the CFTC and SEC must be authorized to set margin requirements for swaps that are not required to be cleared in addition to any capital requirements that may be set by a prudential regulator. Similarly, the CFTC and SEC should be authorized to require market participants to hold substantially higher levels of capital to support any swaps that they determine should be required to be cleared but that are not cleared. In Senator Snowe’s view, the substantially higher capital standard is essential to ensure that firms can adequately cover the risk of non-cleared swaps in times of market distress.

Senator Snowe emphasized that any exemption to the clearing requirements for commercial end-users must be narrowly constructed. If an end-user provision is included in the legislation it must apply only to commercial entities that use swaps to hedge their commercial risk. Financial entities of any type should not be allowed to qualify as end users. Also, counter-parties to end-users must be required to hold adequate capital to protect against risk, including systemic risk, associated with swaps eligible for the end-user exemption, and end-users must be given the option to clear standard transactions at their discretion.

Moreover, foreign exchange swaps should not have a statutory exemption from the clearing and execution requirements or any other requirements in the bill. Foreign boards of trade must be prohibited from allowing members or participants located in the United States to have access to the foreign board of trade for contracts that settle against prices for contracts traded on CFTC or SEC registered entities unless the foreign board of trade adheres to minimum standards comparable to those in the United States and reports all trading activity in these contracts to U.S. regulators on a timely basis.


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Sunday, April 25, 2010

Senate and House Financial Reform Bills Differ on Mandatory Arbitration

Historically, claims for violations of the federal securities laws were considered to be non-arbitrable based on the doctrine enunciated by the U.S. Supreme Court in Wilko v. Swan (U.S. Sup. Ct. 1953), 1952-1956 CCH Dec. ¶90,640. In Wilko, the Court held that an agreement to arbitrate claims under Section 12(a)(2) of the Securities Act was not enforceable. However, as arbitration gained increasing judicial favor, the Court began to chip away at the Wilko doctrine and in 1989 expressly overruled it. The Court ruled that a pre-dispute agreement to arbitrate an investor’s securities claims against a brokerage firm was enforceable in view of the strong federal policy favoring arbitration. Rodriguez v. Shearson/American Express, Inc. (U.S. Sup. Ct. 1989), 1989 CCH Dec. ¶94.407.

Broker-dealers generally require their customers to contract at account opening to arbitrate all disputes. Although arbitration may be a reasonable option for many consumers to accept after a dispute arises, mandating a particular venue and up-front method of adjudicating disputes, and thereby eliminating access to courts, may unjustifiably undermine investor interests. Thus, the Obama Administration recommend legislation that would give the SEC clear authority to prohibit mandatory arbitration clauses in broker-dealer and investment advisory accounts with retail customers. The legislation should also provide that, before using such authority, the SEC would need to conduct a study on the use of mandatory arbitration clauses in these contracts. The study shall consider whether investors are harmed by being unable to obtain effective redress of legitimate grievances, as well as whether changes to arbitration are appropriate. Financial Regulatory Reform, A New Foundation, Treasury Department, June 2009

The House financial reform legislation, HR 4173, would enable the SEC to restrict or even prohibit the use of mandatory arbitration clauses in contracts with broker-dealers and investment advisers. . Mandatory arbitration clauses inserted into brokerage firm contracts will no longer restrict the ability of defrauded investors to seek redress in the courts for wrongdoing.

The House legislation also directs the GAO to report to Congress within one year of enactment on the costs to parties of an arbitration proceeding using the arbitration system operated by FINRA and overseen by the SEC as compared to litigation and the percentage of recovery of the total amount of a claim in an arbitration proceeding using the FINRA arbitration system.

The Senate reform bill, S 3217m would authorize the SEC to reaffirm, or prohibit, or impose conditions on the use of mandatory arbitration in brokerage or advisory agreements. Thus, the Senate bill authorizes the SEC to reaffirm and essentially sanction the staus quo of mandatory arbitration. The House bill does not authorize the SEC to reaffirm the status quo.


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Friday, April 23, 2010

Investor Groups Want No Legislative Exemption from SOX 404(b) Auditor Internal Control Attestation

In a letter to Senate leaders, investor groups opposed exempting smaller public companies from compliance with Section 404(b) of the Sarbanes-Oxley Act in the financial legislation moving through Congress. Section 404(b) requires an independent audit of a public company’s assessment of its internal controls. In the letter to Senate Banking Committee Chair Chris Dodd and Senator Richard Shelby, the committee’s Ranking Member, the Center for Audit Quality and the Council of Institutional Investors warned that a permanent legislative 404(b) exemption for smaller companies would create a dual class system of investor protection in the United States with no compelling reason to do so. If Congress agrees to a permanent 404(b) waiver for smaller companies, said the groups, there may be little independent scrutiny of financial reporting safeguards at half of all listed companies nationwide.

Reporting under Section 404 provides investors with meaningful information regarding a public company’s internal control over financial reporting, emphasized the organizations, adding that the required independent audit of management’s assessment of the effectiveness of internal controls has been integral to the achievement of the intended objectives of internal control reporting under the overall Section 404 framework.

Moreover, the groups noted that a congressionally-mandated study by the SEC found that Section 404 provides benefits that are valuable regardless of a public company’s size. In their view, reporting requirement reforms, including the PCAOB’s adoption of Audit Standard No. 5 and the SEC’s management guidance, are reflective of the real-world lessons learned since the law’s enactment. The result has been a decline in compliance costs of approximately 30 percent. SEC Office of Economic Analysis, Study of the Sarbanes-Oxley Act of 2002 Section 404 Internal Control Over Financial Reporting Requirements (September 2009).

The SEC’s study also determined that investors and other financial statement users regard internal controls disclosures to be beneficial and indicated that both 404(a) and 404(b) compliance has had a positive impact on their confidence in the companies’ financial reports. The users generally indicate that Section 404 compliance leads management to better understand financial reporting risks, put in place appropriate controls to address financial reporting risks, and address internal control deficiencies in a more timely fashion than in the absence of the disclosure requirement.

Since investor confidence in public companies’ financial reports is imperative to the successful operation of the capital markets, reasoned the groups, it makes sense to apply the benefits of Section 404(b) to investors to public companies of all sizes, even those that have not yet had to comply. This is especially meaningful in view of the fact small companies are more likely to issue earnings restatements.

In fact, noted the groups, a November 2009 study by Audit Analytics suggests that companies that have not yet had auditors review their internal control reports have a restatement rate that is 46 percent higher than larger public companies, despite claiming they have effective controls. Moreover, a 2009 analysis of restatements of small companies by Glass Lewis for the Ohio Public Employees Retirement System found a correlation between internal control problems and poor stock performance. The analysis revealed the large costs incurred by investors in the form of continued stock underperformance of small companies with deficient internal controls.

Currently, the House reform legislation, HR 4137, would permanently exempt non-accelerated issuers with a market capitalization of $75 million or less from Section 404 (b) of Sarbanes Oxley. The Senate bill, S 3217, does not contain a similar exemption.


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NASAA Backs Akaka-Menendez Fiduciary Duty Amendment

The North American Securities Administrators Association (NASAA) has joined AARP, the Consumer Federation of America, and the National Association of Secretaries of State in urging members of the U.S. Senate to co-sponsor an amendment to the Restoring American Financial Stability Act of 2010 (S. 3217) that would place a fiduciary duty on brokers who provide investment advice to their clients. In a letter today to the full Senate, the organizations asked lawmakers to support the amendment proposed by Senators Daniel Akaka (D-HI) and Robert Menendez (D-NJ) which would replace language in the bill calling for a study of investment adviser regulation with a stronger measure approved by the House of Representatives. Under the House provision, the U.S. Securities and Exchange Commission (SEC) would be required to adopt rules under the Securities Exchange Act of 1934 to require brokers to act in the best interests of their customers when giving personalized advice to retail customers. The organizations noted that the approach approved by the House has won broad support not only from a variety of groups but also from SEC Chairman Mary Schapiro.

The organizations stressed to the lawmakers that brokers and insurance agents frequently market themselves to investors as trusted advisers, yet they are not currently subject to the same legal responsibilities placed on investment advisers to act in the best interests of their clients. The organizations believe that reform in this area is critical because research has shown that investors do not understand the difference between brokers and advisers. Moreover, retail investors rely heavily on the recommendations they receive. As a result, middle income Americans who can ill afford in even the best of times the high costs of deceptive sales pitches find themselves even more vulnerable in the aftermath of the recent financial crisis.

The organizations sharply criticized the approach favored by certain industry members which would maintain the status quo in which brokers and insurance agents portray themselves to their clients as advisers without having to meet the standards appropriate to that role. In the organizations' view, the current language in the Senate bill will not serve to protect investors from biased investment advice. Rather, the organizations believe, the current provision would waste the SEC's time and resources in a needless and duplicative study while denying to the agency the authority to address a known and pressing disparity in the levels of investor protection.


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Senate Reform Bill Section 926 Hotly Contested at State Level

Section 926 of the Senate reform bill, added March 15 by Senator Dodd, has become the most hotly contested provision, to date, to affect the states, with both the state securities regulators under the North American Securities Administrators Association (NASAA) and private industry opposing it, but for different reasons.

Section 926 concerns Rule 506 of federal Regulation D, currently the most widely used exemption that became federally preempted from state regulation when the NSMIA Act was adopted in 1996. A belief held by current NASAA President Denny Crawford that a large number of Rule 506 offerings, because they were unregulated at the federal and state level, ultimately led Senator Dodd to draft Section 926.

Section 926 requires the SEC to: (1) conduct a rulemaking within 120 days after the Act’s enactment to determine if the covered securities status of certain Rule 506 offerings should be removed based on the offering size, number of offering states and the nature of the offerees, thereby giving those offerings back to the states to regulate; (2) review any Rule 506 filing within 120 days and remove its covered security status if the SEC fails to review the filing in the 120-day period, unless the issuer made a good faith effort to comply with the terms of the offering, and the terms not complied with are insignificant as compared to the whole offering; and (3) implement procedures not later than 180 days after the Act is passed and after consulting with the states to promptly notify them after completing its review of Rule 506 offerings.

NASAA opposes Section 926 because it doesn’t give exclusive regulation of Rule 506 offerings back to the states by outright repealing Section 18(b)(4)(D) of the NSMIA Act. Blue Sky attorneys oppose Section 926 because it’s premised on an unrealistic expectation that the SEC will review particular Rule 506 offerings to determine their covered securities status.

For Section 926, please see pages 816-819 here.


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Wednesday, April 21, 2010

Senate Agriculture Committee Reports Out Strong Derivatives Legislation

The Senate Agriculture Committee has reported out a strong measure that would regulate derivatives under a transparent regime that contains narrow user exemption for non-financial firms so that they can hedge risk. Sponsored by Committee Chair Blanche Lincoln, the Wall Street Transparency and Accountability Act would set up derivatives clearing organizations under a sound corporate governance regime.

Under the bill, the CFTC must consult with the SEC on the development of certain rules and orders. The CFTC will not have jurisdiction over security-based swaps, while the SEC will not have jurisdiction over other swaps. Similarly, no futures association registered under the Commodity Exchange Act has authority over any security-based swap and no national securities association registered under the SEC has jurisdiction over any swap.

The SEC and the CFTC may appeal to the DC Circuit Court if either determines that the other has issued a rule or order that conflicts with their authority. The CFTC and SEC must consult with each other and adopt rules regarding the maintenance of records of all activities pertaining to uncleared swaps and sharing with each other information regarding swaps or security-based swaps under their respective jurisdictions. The CFTC or the SEC must separately promulgate regulations required due to enactment of this Act within 180 days. The CFTC and SEC may use emergency and expedited procedures to carry out this title if, in its discretion, it deems it necessary to do so.

The SEC and CFTC are directed to make recommendations to Congress on laws intended to facilitate portfolio margining of securities and commodity futures and options, commodity options, swaps, and other financial instruments within 180 days after the date of enactment.

The CFTC and SEC are authorized to investigate and report on any swap or security-based swap that is found to be detrimental to the stability of financial markets or their participants. The CFTC and SEC may by rule or order collect any information they find necessary to conduct these investigations.

The CFTC and SEC can ban foreign entities from participating in US derivatives markets if it is determined that the regulation in the foreign entity’s country undermines the US financial system.

The legislation would prohibits federal assistance, including federal deposit insurance, and access to the Fed’s discount window, to swaps entities in connection with their trading in swaps or securities-based swaps.

The CFTC has exclusive jurisdiction over swaps. Swaps cannot be regulated as insurance under state law. Swaps, other than security-based swaps, cannot be considered securities at the state or federal level, and cannot be regulated as securities under state or federal law. The only time this derivatives legislation applies to activities outside the United States is when those activities have a direct and significant connection with the commercial activities of the United States, or CFTC rules promulgated by the Commission to prevent evasion of the requirements of the Act.

The measure dramatically changes the treatment of transactions in excluded and exempt commodities. Swap transactions in these commodities will be regulated and the facilities which traded them will be required to be registered. Only Eligible Contract Participants may enter into an off-exchange swap. The bill also requires derivatives clearing organizations to allow for offset among economically equivalent contracts, and provide for nondiscriminatory clearing of
swaps executed bilaterally or through unaffiliated DCMs or SEFs. The CFTC has expedited rulemaking authority to define criteria for determining what swaps or class of swaps are required to clear, which may include certain factors including volume, open interest, impact on systemic risk mitigation, material differences with other cleared swaps, or such other factors as the CFTC determines to be appropriate.

The CFTC must review any swap a derivatives clearing organization lists for clearing and then make a determination by order within 90 days from when the clearing organization certifies or receives approval from the CFTC to list the swap as to whether the swap or class of swaps is required to clear. It may review any swap not listed for clearing. Nothing in the mandatory clearing requirement affects the ability of a derivatives clearing organization to list for permissive clearing any swap or class of swaps.

If a swap meets the criteria of the rules adopted by the CFTC, the CFTC determines by order that such swap is required to be cleared, and the swap is listed for clearing by a registered derivatives clearing organization, it must be submitted for clearing unless one of the counterparties qualifies for an end user clearing exemption. The CFTC can write rules to prevent evasion of the clearing requirements.

If the CFTC finds that a swap otherwise would be subject to mandatory clearing but no clearing organization has listed the swap for clearing, it must investigate, report, and take action as necessary and in the public interest. Swaps entered into before the date of enactment are exempt from the clearing requirement. The CFTC may stay the clearing requirement on its own initiative to review a mandatory clearing determination or if there is an application of a counterparty from a swap that has been determined to be required to clear.

Commercial end users are exempted from mandatory swap clearing. Such end users are defined by nature of their primary business activity. Financial entities may not claim this exemption. These end users can opt out of the clearing requirement for the swaps only if they are hedging commercial risk. If they opt to clear, they can choose which derivatives clearing organization at which the swap is cleared. Affiliates of commercial end users may opt out of the clearing requirement for swaps if the affiliate is using the swap to hedge risk of the parent or affiliates of the parent. Affiliates cannot use the parent’s exemption if they are themselves swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, issues that would be investment companies but for certain exemptions in the Investment Company Act, a commodity pool, a bank holding company with over $50 billion in consolidated assets, or affiliates of certain of these
entities.

The House legislation, HR 4173, exempts commercial end users from the clearing requirement. These firms, such as airlines, manufacturers, and other small- to medium-sized businesses, often use derivatives markets to hedge their price risk. Regulators would have to define the types of risk a company may hedge and still remain eligible for the limited exception to clearing. But if an end user is engaged in an activity that can cause financial stability problems, they will lose the exemption.

Under the Senate Ag bill, the CFTC is authorized to write rules to prevent abuses of the clearing exemption.

Commercial end users which are public companies that issue securities registered under the federal securities laws would be required to have their audit committee review and approve their of use of the end user clearing and trading exemptions for their swaps which would be subject to the mandatory clearing and trading requirement.

Security-based swap dealers must register with the SEC, as well as major security-based swap participant. The security-based swap dealers and major security-based swap participants must satisfy minimum capital and margin requirements. They must report on their financial condition and keep records under rules to be adopted by the SEC. They must also maintain daily trading records of their security-based swaps and related records of cash or forward transactions and recorded communications, including electronic mail, instant messages, and recordings of telephone calls, for such period as may be required by SEC regulation. They must also maintain daily trading records for each customer or counterparty in a manner and form that is identifiable with each security-based swap transaction, as well as a complete audit trail for conducting comprehensive and accurate trade reconstructions.


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Confidentiality Agreement on Inside Information Also Includes Duty Not to Trade Says SEC Brief

A shareholder who agreed to keep confidential the inside information given to him by the company also accepted the duty not to trade on the information and his trading without advance disclosure to the company constituted deception, argued the SEC in a reply brief filed with the Fifth Circuit. No company providing inside information in reliance upon an agreement to keep the information confidential would believe that it was authorizing the recipient to trade on the information, said the SEC, nor could any recipient of such information reasonably believe that he was authorized to trade. These common-sense notions are incorporated into SEC Rule 10b5-2(b)(1), which sets forth a duty to disclose before trading on a person who agrees to maintain the information in confidence. SEC v. Cuban, CA-5, No. 09-10996.

The case is on appeal from a district court ruling in an SEC enforcement action 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.

Refuting the shareholder’s argument that a sufficient duty of disclosure only arises from a full-fledged, traditional fiduciary relationship, the SEC pointed out that the Supreme Court in United States v. O’Hagan, 521 U.S. 642 (1997), recognized that a fiduciary or similar obligation is sufficient. Although O’Hagan involved a traditional fiduciary relationship (attorney-client), conceded the SEC, that does not mean such a relationship is required. In the SEC’s view, all that is needed for potential liability under the misappropriation theory is a duty to the provider not to use the information for personal benefit, such that a duty of disclosure arises and makes undisclosed trading deceptive.

The Commission also noted the Supreme Court’s declaration in Carpenter v. United States, 484 U.S. 19 (1987) that a person who acquires special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that information for their own personal benefit.

The SEC similarly refuted the argument that the legal basis for determining what facts and circumstances give rise to the requisite duty of disclosure must come exclusively from state law. Rather, Rule10b5-2(b)(1) validly sets forth a sufficient duty binding on the shareholder, said the Commission, and therefore controls based on the Supremacy Clause of the U.S. Constitution. Moreover, Section 10(b) is not coextensive with common law doctrines of fraud given the antifraud statute’s important purpose to rectify perceived deficiencies in the available common law protections. The SEC emphasized that the meaning of deception under the antifraud provisions of the federal securities laws is a federal question extending beyond the common law.

The SEC also noted that the Supreme Court’s concern in dicta in the 1977 Santa Fe Industries case that to allow a Rule 10b-5 action sans allegations of manipulation or deception would create a federal fiduciary principle absent an indication of congressional intent was inapposite. The Court did not suggest that conduct that does involve deception, as in this case, should not be measured against federal standards under Section 10(b), a statute which clearly indicates congressional intent to create federal standards for deceptive conduct in connection with securities transactions. Indeed, because the misappropriation theory requires deception, the Court concluded in O’Hagan that the theory is consistent with Santa Fe.

Finally, the SEC turned to an amicus brief filed by a group of law professors that the Commission said was based on a fundamental disagreement with the controlling Supreme Court decisions adopting the misappropriation theory and reflected a misunderstanding of how that theory applies to facts alleged in the SEC’s complaint.

Amici asserted that the misappropriation theory of insider trading relied on by the SEC is tangential to the primary purpose of the antifraud provisions of the Exchange Act to prevent the deception of investors and to facilitate disclosure of information to the market. To the contrary, said the SEC, the Supreme Court has stated that the misappropriation theory is well tuned to an animating purpose of the Exchange Act to insure honest securities markets and thereby promote investor confidence. Amici further incorrectly asserted, continued the SEC, that under the misappropriation theory, theft rather than fraud or deceit, seems the gravamen of the prohibition. The Supreme Court has made clear, countered the SEC, that deception through nondisclosure is central to the misappropriation theory.


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Tuesday, April 20, 2010

NASAA Calls for State Authority to Disqualify "Bad Boys" from Rule 506 Offerings

In a statement issued yesterday, the North American Securities Administrators Association (NASAA) called upon the Senate to amend its proposed financial reform legislation to reinstitute the authority of the states to use their so-called "bad boy" provisions to disqualify recidivist securities violators from conducting private securities offerings under Rule 506 of federal Regulation D. Commenting on the most recent version of the Restoring American Financial Stability Act of 2010, NASAA President Denise Voigt Crawford expressed NASAA's belief that barring recidivists from conducting private placements would provide important investor protections against fraud, while not being detrimental to those legitimate issuers who use Rule 506 offerings almost exclusively to raise capital.

“The bill's current language offers an unworkable regulatory review process, which, contrary to those who have mischaracterized our position on Reg D Rule 506 offerings, has not been called for by NASAA," Crawford said. "Such a process would impede capital formation in the United States, especially in the small business community and would add little to protect investors."

NASAA also called upon the Senate to restore to the states the ability to request and obtain a copy of an issuer's private placement memorandum when there is reason to believe that investors might be defrauded. As with the states' bad boy provisions, state laws which required issuers to furnish these documents were preempted by the passage of the National Securities Markets Improvement Act of 1996 (NSMIA).


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Special Litigation Committee Not Independent and Misapplied Delaware Corporation Code

A two-member special litigation committee of a company board that recommended dismissal of a derivative action was not independent and did not have a reasonable basis for its conclusion, ruled the Delaware Chancery Court. One committee member had a familial relationship with the company’s CFO, while the other member had a professional relationship with the CFO. Applying the Delaware Supreme Court’s test for demand-excused derivative cases, Chancellor Chandler concluded that there were material questions on whether the special litigation committee was independent and whether it conducted a good faith investigation of reasonable scope that yielded a reasonable basis for its decisions.

The chancery action was governed by the 1981 Delaware Supreme Court opinion in Zapata Corp v. Maldonado, which established a two-part analysis that must be applied when a special litigation committee recommends dismissal of a derivative action. The first analysis, which is mandatory, is a judicial review of the committee’s independence and whether it conducted a good faith investigation of the claims and reached a reasonable conclusion. The second analysis, which is discretionary, is whether the company’s best interests would be served by dismissing the suit. Since he decided the case based on the mandatory analysis, the Chancellor declined to conduct the discretionary analysis.

More broadly, the court emphasized that the independence inquiry under Zapata is critically important if the special litigation committee process is to remain a legitimate mechanism in Delaware corporate law. Committee members should be selected with the utmost care to ensure that they can, in both fact and appearance, carry out the extraordinary responsibility placed on them to determine the merits of the derivative suit and the best interests of the corporation, acting as proxy for a disabled board. In this case, the independence prong of the Zapata standard was not satisfied.

A member of a special litigation committee does not have to be unacquainted or uninvolved with fellow directors to be regarded as independent, noted the court, but a member is not independent if he or she is incapable of making a decision with only the best interests of the corporation in mind. Essentially, this means that the independence inquiry goes beyond determining whether members are under the domination and control of an interested director. Independence can be impaired by lesser affiliations, said the court, so long as those affiliations are substantial enough to present a material question of fact as to whether the committee member can make a totally unbiased decision. For example, independence could be impaired if members sense that they owe something to the interested director based on prior events. This sense of obligation need not be of a financial nature.

Further, special litigation committee members are not given the benefit of the doubt as to their impartiality and objectivity. They bear the burden of proving that there is no material question of fact about their independence. The composition of a committee must be such that it fully convinces the court that the committee can act with integrity and objectivity, because the situation is typically one in which the board as a whole is incapable of impartially considering the merits of the suit.

Here, said the Chancellor, it is undisputed that neither committee member had a personal stake in the challenged transactions centered on an equity incentive plan. Yet, there was a material question as to their independence based on their relationships with the CFO.

The spouse of one committee member was the CFO’s cousin. This association could influence the member’s objectivity, said the Chancellor, who cited an earlier holding of Vice Chancellor Strine that familial relationships between directors can create a reasonable doubt as to impartiality.

The other committee member had a professional association with the CFO in that he had hired the CFO as an internal auditor for a six-year stint in 1993 for a company he co-founded. Their professional relationship was reinstated when the CFO asked the founder to serve on the board.

Under Delaware law, the independence of a special litigation committee member may be impaired if that member feels he or she owes something to an interested director. Noting that this sense of obligation does not have to be financial in nature, the court found a material question of fact as to the committee member’s independence because his earlier associations with the CFO may have given rise to a sense of obligation or loyalty to him.

The court also questioned the reasonableness of the committee’s conclusion regarding the duty of care claims. The committee found that the action should not be pursued on the basis of duty of care claims because Section 102(b)(7) of the Delaware Corporation Code protects directors from personal liability, in the form of money damages, for gross negligence. The court found this to be an unreasonable conclusion because the committee failed to consider that the requested relief in plaintiffs’ complaint is not limited to money damages since it specifically requests that the equity incentive plan be rescinded.

Under Delaware law, noted the court, exculpatory provisions do not bar duty of care claims in remedial contexts such as in injunction or rescission cases. It thus was unreasonable, said the court, for the committee to conclude that the duty of care claims should not go forward solely on the basis of § 102(b)(7). Indeed, the court emphasized that the committee simply failed to understand that Delaware law permits a suit seeking rescission to go forward despite a § 102(b)(7) provision protecting directors against monetary judgments.

Monday, April 19, 2010

Industry Groups Oppose Senate Reform Bill's Corporate Governance Provisions

In a letter to the US Senate, industry groups including the Chamber of Commerce and the Business Roundtable said that provisions in the Restoring American Financial Stability Act such as mandating a shareholder right to proxy access and an advisory vote on executive compensation and requiring majority voting in uncontested director elections would federalize corporate law, thereby creating a “one-size-fits all” approach to the resolution of these issues. The measure’s corporate governance provisions would also impose an unwarranted burden on mid-sized and smaller companies, marginalize the state corporate law expertise that has been developed over decades and is better suited to address these issues, and undermine ongoing reforms undertaken by the State of Delaware and the “Model Business Corporation Act,” which impacts 30 states.

Further, the industry groups maintain that the corporate governance provisions would, if enacted, unleash an onslaught of activists trying to manipulate the proxy process to force corporate decisions that adversely impact shareholders as a whole in order to further their parochial social or political agenda. The letter also said that the measures would saddle the SEC with significant additional responsibilities at a time when it is struggling to perform its existing mission critical goal of protecting investors.

The Senate legislation would gives shareholders a say on pay with the right to a non-binding vote on executive compensation. The bill also authorizes, but does not require, the SEC to grant shareholders proxy access to nominate directors. It does require directors to win by a majority vote in uncontested elections, which should help shift management’s focus from short-term profits to long-term growth and stability

Most public companies currently elect directors using the plurality standard, by which shareowners may vote for, but not against, a nominee. If shareowners oppose a particular nominee, they may only withhold their votes. As a consequence, a nominee only needs one “for” vote to be elected and unseating a director is virtually impossible. Plurality voting in uncontested situations results in "rubber stamp" elections. Majority voting ensures that shareowners’ votes count and makes directors more accountable to shareowners.

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UK Takeover Code Amended to Enhance Disclosures

Effective April 19, 2010, the UK Takeover Code has been amended to require any person who is interested in 1 per cent or more of any class of relevant securities of an offeree company to make an Opening Position Disclosure following the commencement of the offer period detailing the person’s interests and short positions in, and rights to subscribe for, any relevant securities of the company. The Opening Position Disclosure must be made within ten business day following the commencement of the offer.

In addition, any person who is, or becomes, interested in 1 per cent or more of any class of relevant securities of the offeree company must make a Dealing Disclosure if the person deals in any relevant securities of the company. A Dealing Disclosure must contain details of the dealing concerned and of the person’s interests and short positions in, and rights to subscribe for, any relevant securities of the offeree company save to the extent that these details have previously been disclosed.

The Dealing Disclosure must be made by no later than the business day following the date of the relevant dealing. If two or more persons act together pursuant to an agreement or understanding, whether formal or informal, to acquire or control an interest in relevant securities of an offeree company, they will be deemed to be a single person for purposes of the rule.

The UK Takeover Code implements the EU Takeovers Directive (2004/25/EC) and complies with the relevant requirements of the Directive. The Code is based upon a number of General Principles, which are essentially statements of standards of commercial behavior. These General Principles are the same as the general principles set out in Article 3 of the Directive. In addition to the General Principles, the Code contains a series of rules.




UK Legislation Contains Strong Short Selling Provisions

The recently enacted UK Financial Services Act of 2010 authorizes the Financial Services Authority to adopt rules prohibiting persons from engaging in short selling and requiring persons who have engaged in short selling to provide detailed information about the short selling, including how and when such disclosure must be made. The FSA rules may apply to short selling engaged in before the rules are adopted when the resulting short position is still open when the rules are adopted. When the short selling relates to UK financial instruments, the FSA rules will apply to short selling wholly outside the UK by persons outside the UK. But the FSA must, when making short selling rules, have regard to any international agreement as to measures to be taken in respect of short selling.

The Act defines short selling as when a person enters into a transaction which creates, or relates to, another financial instrument; and the effect of the transaction is to confer a financial advantage on the person in the event of a decrease in the price or value of the shorted instrument.

Upon a breach of the short selling rules, the FSA may impose a penalty in an amount it considers appropriate or impose censure. When imposing a penalty, the FSA must consider the seriousness of the contravention and whether it was deliberate or reckless; and whether the person on whom the penalty is to be imposed is an individual.

Even before the passage of the Financial Services Act, the Financial Services Authority was active in regulating short-selling. On September 18, 2008, the FSA introduced short selling measures in relation to stocks in UK financial sector companies on an emergency basis. This was done because of concerns about the potential for market abuse resulting from short selling and the consequent destabilizing effects in the extreme conditions prevailing. The measures effectively banned the active creation or increase of net short positions in the stocks of UK financial sector companies and required disclosure to the market of significant short positions in those stocks. They were set to expire on January 16, 2009. Following a short consultation in January 2009, the FSA allowed the ban to expire but extended the disclosure obligation until June 30, 2009.

The FSA then extended the short selling disclosure obligation without time limit. The FSA believes that maintaining the disclosure obligation will help continue to minimize the potential for market abuse and disorderly markets in financial sector stocks. It will also enhance transparency in that sector. As is the case at present, disclosures will need to be made if a net short position exceeds 0.25% of a company’s issued shared capital or increases by 0.1% bands above that, for example, net short position reaches 0.35%. 0.45% and so on.
While the FSA did not set an expiration date, the regulator emphasized that if does not intend for it to apply permanently in its current form. The FSA pledged to also continue to engage in the international dialogue on short selling.

Friday, April 16, 2010

Senate Ag Chair Introduces Strong Derivatives Legislation

The Chair of the Senate Agriculture Committee has introduced a strong measure that would regulate swaps and security-based swaps under a transparent regime bifurcating CFTC jurisdiction over swaps and SEC jurisdiction over security-based swaps. Sponsored by Senator Blanche Lincoln, the Wall Street Transparency and Accountability Act would set up derivatives clearing organizations under a sound corporate governance regime. Similar to the financial reform measure that passed the House last year, HR 4173, the bill contains a user exemption for non-financial firms allowing them to hedge risk.

Under the bill, the CFTC must consult with the SEC on the development of certain rules and orders. The CFTC will not have jurisdiction over security-based swaps, while the SEC will not have jurisdiction over other swaps. Similarly, no futures association registered under the Commodity Exchange Act has authority over any security-based swap and no national securities association registered under the SEC has jurisdiction over any swap.

The SEC and the CFTC may appeal to the DC Circuit Court if either determines that the other has issued a rule or order that conflicts with their authority. The CFTC and SEC must consult with each other and adopt rules regarding the maintenance of records of all activities pertaining to uncleared swaps and sharing with each other information regarding swaps or security-based swaps under their respective jurisdictions. The CFTC or the SEC must separately promulgate regulations required due to enactment of this Act within 180 days. The CFTC and SEC may use emergency and expedited procedures to carry out this title if, in its discretion, it deems it necessary to do so.

The SEC and CFTC are directed to make recommendations to Congress on laws intended to facilitate portfolio margining of securities and commodity futures and options, commodity options, swaps, and other financial instruments within 180 days after the date of enactment.

The CFTC and SEC are authorized to investigate and report on any swap or security-based swap that is found to be detrimental to the stability of financial markets or their participants. The CFTC and SEC may by rule or order collect any information they find necessary to conduct these investigations.

The CFTC and SEC can ban foreign entities from participating in US derivatives markets if it is determined that the regulation in the foreign entity’s country undermines the US financial system.

The legislation would prohibits federal assistance, including federal deposit insurance, and access to the Fed’s discount window, to swaps entities in connection with their trading in swaps or securities-based swaps.

The CFTC has exclusive jurisdiction over swaps. Swaps cannot be regulated as insurance under state law. Swaps, other than security-based swaps, cannot be considered securities at the state or federal level, and cannot be regulated as securities under state or federal law. The only time this derivatives legislation applies to activities outside the United States is when those activities have a direct and significant connection with the commercial activities of the United States, or CFTC rules promulgated by the Commission to prevent evasion of the requirements of the Act.


The measure dramatically changes the treatment of transactions in excluded and exempt commodities. Swap transactions in these commodities will be regulated and the facilities which traded them will be required to be registered. Only Eligible Contract Participants may enter into an off-exchange swap. The bill also requires derivatives clearing organizations to allow for offset among economically equivalent contracts, and provide for nondiscriminatory clearing of
swaps executed bilaterally or through unaffiliated DCMs or SEFs. The CFTC has expedited rulemaking authority to define criteria for determining what swaps or class of swaps are required to clear, which may include certain factors including volume, open interest, impact on systemic risk mitigation, material differences with other cleared swaps, or such other factors as the CFTC determines to be appropriate.

The CFTC must review any swap a derivatives clearing organization lists for clearing and then make a determination by order within 90 days from when the clearing organization certifies or receives approval from the CFTC to list the swap as to whether the swap or class of swaps is required to clear. It may review any swap not listed for clearing. Nothing in the mandatory clearing requirement affects the ability of a derivatives clearing organization to list for permissive clearing any swap or class of swaps.

If a swap meets the criteria of the rules adopted by the CFTC, the CFTC determines by order that such swap is required to be cleared, and the swap is listed for clearing by a registered derivatives clearing organization, it must be submitted for clearing unless one of the counterparties qualifies for an end user clearing exemption. The CFTC can write rules to prevent evasion of the clearing requirements.

If the CFTC finds that a swap otherwise would be subject to mandatory clearing but no clearing organization has listed the swap for clearing, it must investigate, report, and take action as necessary and in the public interest. Swaps entered into before the date of enactment are exempt from the clearing requirement. The CFTC may stay the clearing requirement on its own initiative to review a mandatory clearing determination or if there is an application of a counterparty from a swap that has been determined to be required to clear.

Commercial end users are exempted from mandatory swap clearing. Such end users are defined by nature of their primary business activity. Financial entities may not claim this exemption. These end users can opt out of the clearing requirement for the swaps only if they are hedging commercial risk. If they opt to clear, they can choose which derivatives clearing organization at which the swap is cleared. Affiliates of commercial end users may opt out of the clearing requirement for swaps if the affiliate is using the swap to hedge risk of the parent or affiliates of the parent. Affiliates cannot use the parent’s exemption if they are themselves swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, issues that would be investment companies but for certain exemptions in the Investment Company Act, a commodity pool, a bank holding company with over $50 billion in consolidated assets, or affiliates of certain of these entities.

The House legislation, HR 4173, exempts commercial end users from the clearing requirement. These firms, such as airlines, manufacturers, and other small- to medium-sized businesses, often use derivatives markets to hedge their price risk. Regulators would have to define the types of risk a company may hedge and still remain eligible for the limited exception to clearing. But if an end user is engaged in an activity that can cause financial stability problems, they will lose the exemption.

Under the Senate Ag bill, the CFTC is authorized to write rules to prevent abuses of the clearing exemption. Commercial end users which are public companies that issue securities registered under the federal securities laws would be required to have their audit committee review and approve their of use of the end user clearing and trading exemptions for their swaps which would be subject to the mandatory clearing and trading requirement.

Users of uncleared, bilateral swaps and security-based swaps that are registered issuers under the federal securities laws will be required to have the audit committee review and approve their uncleared, bilateral positions.

A swap that is subject to mandatory clearing must be traded through a designated contract market that makes the swap available for trading.

Any clearinghouse that clears non security-based swaps must register as a derivatives clearing organization with the CFTC even if they are a bank or SEC-registered clearing agency. However, existing banks and clearing agencies are deemed registered to the extent that before enactment the banks cleared swaps as multilateral clearing organizations or the clearing agencies cleared swaps. Any clearinghouse that clears swaps not required to clear by the CFTC voluntarily may register as a derivatives clearing organization. The CFTC may exempt conditionally or unconditionally a clearing agency from registration as if it finds that the clearing agency is subject to comparable, comprehensive supervision and regulation and is registered as a clearing agency with the SEC.

Every derivatives clearing organization must have a Chief Compliance Officer who among other things must prepare and sign an annual report on compliance in accordance with CFTC rules. Every derivatives clearing organization must comply with a series of core principles addressing compliance, financial resources, participant and product eligibility, risk management, settlement procedures, treatment of funds and assets, default rules and procedures, rule enforcement, system safeguards, reporting, recordkeeping, public disclosure of information, information-sharing, antitrust considerations, governance fitness standards, conflicts of interest, composition of governing boards, and legal risk. A derivatives clearing organization must have objective, publicly disclosed participation requirements for membership that permit fair and open access.

Derivatives clearing organizations must keep records and provide information to the CFTC as determined by the CFTC, which must share this information with other regulators. Those regulators must keep the information confidential.

The measure excludes identified banking products from the definition of security-based swaps and bars the CFTC from regulating such products unless an appropriate federal banking agency, in consultation with the CFTC and the SEC, determines otherwise, or in instances where the product qualifies as a swap or security-based swap, is not under the regulation of an appropriate federal banking agency, and has been structured for the purpose of evading the commodity or securities laws.

The CFTC is authorized to adopt rules for the public release of swap transaction and pricing data in as close to real-time as is technologically possible after execution for swaps subject to the mandatory clearing requirement and for swaps that are not subject to the mandatory clearing requirement but are cleared by a clearing organization. The CFTC must include provisions in the rule to ensure that participants are not identified and specify criteria for determining what constitutes a large notional swap transaction for particular markets, with appropriate time delays of the reporting of such large notional swap transactions.

Additionally, the CFTC must take into account when promulgating the rule whether the public disclosure would materially reduce market liquidity. For swaps that are not cleared but are reported to a swap data repository or the CFTC, the CFTC must make available to the public aggregate data on the trading volumes and positions but not disclose the business transactions and market positions of any person. The CFTC may require registered entities to publicly disseminate swap transaction and pricing data information required by this section.

The CFTC is required to issue semiannual and annual reports on the trading and clearing of major swap categories and the market participants and development of new products.

Swap Data Repositories must register with the CFTC and are subject to inspection and examination. The Commission will set standards for data identification, collection, and maintenance.

All uncleared swaps must be reported to a swap data repository or the CFTC if a swap data repository is unavailable. Swaps entered into before enactment, the terms of which have not expired as of the date of enactment, must be reported to a swap data repository or the CFTC no later than 30 days after issuance of an interim final rule or such other period as the CFTC determines is appropriate.

Traders that enter into swaps that perform a significant price discovery function to file reports as required or directed by the CFTC for positions in excess of amounts determined by the CFTC. If the traders meet certain recordkeeping and filing requirements, they may be exempted from the restrictions.


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Wednesday, April 14, 2010





Government Brief in Textron Case Asserts that Work Papers Used to Assess Uncertain Tax Positions in SEC Filings Subject to IRS Discovery

Tax accrual work papers used by a company’s accountants and lawyers in assessing uncertain tax positions for SEC filings are prepared for a business purpose rather than for litigation and can be discovered by the IRS, argued the US Solicitor General in the Textron case before the Supreme Court. The government’s brief urging denial of review cited the testimony of a former Chief Auditor of the PCAOB that accounting standards compel public companies to create tax accrual work papers in substantially the same form whether or not litigation is anticipated.

Moreover, the company itself admitted that its work papers included items that it intended to concede, and therefore never litigate, if the IRS were able to discover them during the audit, and that in each audit cycle, the company typically agrees to hundreds of IRS adjustments without any dispute. Indeed, said the Solicitor General, the company has never claimed that any of the uncertain items listed in the tax accrual work papers related to existing or expected litigation. Tax accrual work papers assess uncertain tax positions and not actual or expected litigation, contended the brief, which distinguishes them from litigation reserve documents

Further, even if the Court were to grant certiorari and hold that the tax accrual work papers were prepared “in anticipation of litigation” within the meaning of Rule 26(b)(3)(A) of the Federal Rules of Civil Procedure, the company would still be required to turn over the work papers if the courts below found that the work-product protection had been waived by disclosure to Ernst &Young for use in the preparation of E&Y’s own work papers.

The brief was filed in a case where the 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.


The federal securities laws require public companies to file annually with the SEC financial statements that have been audited by a public accounting firm. The companies must obtain from the auditor an unqualified opinion that the financial statements conform with GAAP. To prepare GAAP-compliant financial statements, companies must calculate reserves to account for deferred and contingent tax liabilities, including estimates of the liability facing the company if the IRS were to challenge uncertain positions on the company’s income tax return. Independent auditors must review the financial statements under standards requiring them to obtain evidence supporting the accuracy of the financial statements, including evidence regarding the company’s reserve account for deferred and contingent tax liabilities.

To demonstrate that the amount it has reserved is consistent with GAAP, a company creates tax-accrual work papers which list and analyze uncertain tax positions and estimate the likelihood that the position will not withstand scrutiny and calculate the additional tax liability that would result from a successful challenge by the IRS. Independent auditors require access to those work papers in order to provide the clean opinion that the client needs to meet SEC filing requirements. In performing the audit, the independent auditor generates its own tax accrual work papers. The auditor’s work papers must contain an item-by-item analysis of the company’s tax accrual analysis and the auditor’s judgment on the correctness of the client’s tax position

According to the brief, Textron’s tax accrual work papers were created annually by accountants and attorneys in its Tax Department, and then reviewed by its independent auditor, Ernst & Young. Because the tax-accrual work papers were created in the ordinary course of business for a SEC regulatory rather than a litigation purpose, said the government, the company could not prevail under any formulation of the work-product doctrine.

The fact that tax accrual work papers could in some instances describe potential litigation does not mean that they are generated because of litigation, said the government. They are created
because statutory and audit requirements mandate that they be created.

Moreover, the brief contended that providing the IRS access to a company’s tax accrual work papers would not have a chilling effect on the creation of those documents. A public company
seeking an attestation that its financial statements comply with GAAP must permit its independent auditor to verify that those financial statements adequately reserve against tax contingencies. The auditor, in turn, is required by auditing standards now incorporated
into federal law to review sufficient documentation to understand the basis for the amount reserved and to verify that the reserve is adequate.

There is no reason to suppose that the possibility of compelled disclosure to the IRS will induce companies to breach their obligation to prepare tax accrual work papers that are both accurate and sufficiently detailed to enable auditors to verify the adequacy of company reserves.

The government also asserted that the company and its amici ignore the critical fact that tax assessment does not begin on a level playing field. On the contrary, the taxpayer has all the information relevant to its actual tax liability, and it may self report its liability in a manner that minimizes its tax obligations. The IRS must then determine whether the taxpayer’s self-assessment is accurate or whether some of the many items contained in a potentially voluminous tax return should be adjusted.

The corporate taxpayer, by contrast, already knows which issues may merit adjustment and records that analysis in its tax accrual work papers. By requesting those work papers under some circumstances where the corporation has already demonstrated a willingness to engage in listed tax shelter transactions the IRS seeks to perform its obligation to verify the self-assessment despite the information disadvantage inherent in the self-reporting tax system.

Monday, April 12, 2010

House and Senate Reform Bills Take Different Approach to Volcker Rules

The House and Senate financial reform bills both have provisions banning financial institutions from proprietary trading. Proprietary trading is generally trading on behalf of the financial firm, rather than on behalf of a client. It is often considered high risk activity that contributed to the financial crisis. In fact, there is a growing consensus that proprietary trading is a riskier activity than other types of activities that financial institutions undertake, and therefore may require closer control.

The Senate bill prohibits proprietary trading by financial institutions and their subsidiaries. The bill exempts from the prohibition, State obligations, US obligations and federal agency obligations fully guaranteed by US, as well as obligations of government sponsored enterprises like Fannie Mae and Freddie Mac. Trading in foreign company activities is also exempt from the prohibition so long as the foreign company is not controlled by a US company.

The Senate bill defines proprietary trading to mean purchasing or selling, or otherwise acquiring and disposing of, stocks, bonds, options, commodities, derivatives, or other financial instruments by a financial institution for its trading book.

But proprietary trading does not include purchasing or selling, or otherwise acquiring and disposing of, stocks, bonds, options, commodities, derivatives, or other financial instruments on behalf of a customer, as part of market making activities, or otherwise in connection with or in facilitation of customer relationships, including hedging activities related to such a purchase, sale, acquisition, or disposal.

The Senate definition of proprietary trading is almost identical to the Treasury’s draft legislative language, which defines the term to mean purchasing or selling, or otherwise acquiring and disposing of, stocks, bonds, options, commodities, derivatives, or other financial instruments for the institution’s or company’s own trading book, and not on behalf of a customer, as part of market making activities, or otherwise in connection with or in facilitation of customer relationships, including related hedging activities.

The House bill defines proprietary trading to mean the trading of stocks, bonds, options, commodities, derivatives, or other financial instruments with the company's own money and for the company's own account. Unlike the Senate’s definition, the House bill does not specifically exempt proprietary trading in connection with market making and hedging.

However, the House bill allows the Fed to exempt proprietary trading ancillary to other corporate operations and that does not pose a threat to the safety and soundness of the company or to US financial stability, including making a market in securities issued by the company, hedging or managing risk, determining the market value of assets, and propriety trading for such other purposes allowed by the Board by rule. The House bill does not specifically exempt federal and state government and GSE obligations.


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3rd Circuit Rejects Government Liability Theories in Bristol-Myers CFO's Criminal Trial

In a pre-trial interlocutory appeal, a 3rd Circuit panel rejected the legal theories underlying several fraud charges against the former CFO of Bristol-Myers Squibb. The court also found that the trial judge properly excluded testimony from a government expert witness. U.S. v. Schiff.

The charges arose from statements made by Frederick Schiff, the former CEO, concerning Bristol-Myers inventory backlog. As alleged, Schiff and others offered incentives to their wholesalers to carry larger than normal inventories to conceal the negative impact that the backlog would have on future sales. The officers then allegedly made material misstatements and omitted material facts concerning the inventory situation in analyst calls.

With regard to the claimed omissions, the 3rd Circuit initially held that Schiff had no fiduciary duty to rectify the allegedly material misstatements made by another executive during the analyst calls. The panel referred to the 3rd Circuit's 2000 decision in Oran v. Stafford, where the court determined that a duty to disclose existed when there is 1) insider trading, 2) a statute requiring disclosure or 3) an inaccurate, incomplete or misleading prior disclosure. The government argued that Schiff’s duty to disclose arose from a general fiduciary obligation of “high corporate executives” to the company’s shareholders. The court rejected the government's argument that the Oran factors were not exclusive, and that this fiduciary duty qualified as a fourth circumstance. Stating that "such a generalized corporate fiduciary duty has few logical boundaries," the court found the government's position too broad and vague to support an extension of the Oran factors.

The 3rd Circuit also rejected the government's claim that Schiff should have made corrective disclosures in the company's Form 10-Q filing concerning his statements in the analyst calls. However, because the government stipulated that Schiff was not charged with affirmative misstatements in the company's SEC filings, the alleged omissions were not tied to any purported misleading statements in those filings.

Finally, the court held that the trial judge properly excluded proffered expert testimony from a government witness. The government sought to present an expert to testify on materiality and the company's stock price drop following the disclosures, but the appeals panel found that the expert's evidence was not sufficiently tied to the facts of the case and would not aid the jury in resolving factual disputes. The appellate court noted, however, that the trial judge stated that if the government properly laid the foundation for the expert's testimony at trial, then it could make a renewed application to the court to present the stock price drop through the expert as evidence of materiality.

The case will, however, go forward on the government's legal theories related to the alleged conspiracy, other misstatements and omissions, aiding and abetting and other charges.