Saturday, May 29, 2010

Senator Feingold Explains Genesis of Congolese Conflict Minerals Disclosure Requirement in Senate Reform Bill

A provision in the Senate financial reform legislation requiring public companies to disclose in SEC filings their use of Congolese conflict minerals was authored by Senator Sam Brownback. A co-sponsor of the provision, Senator Russ Feingold explained that the provision specifically responds to the continued crisis in the eastern region of the Democratic Republic of Congo. Despite efforts to curb the violence, mass atrocities and widespread sexual violence and rape continue at an alarming rate. One of the underlying reasons this crisis persists is the exploitation and illicit trade in natural resources, specifically cassiterite, columbite-tantalite, wolframite and gold. The United Nations Group of Experts has reported for years how parties to the conflict in eastern Congo continue to benefit and finance themselves by controlling mines or taxing trading routes for these minerals. In response to these reports, the UN Security Council adopted Resolution 1857 (2008), encouraging Member States to ensure that companies handling minerals from the DRC exercise due diligence on their suppliers. Cong. Record, May 19, 2010, S3976.

The provision is intended to do just that by requiring public companies for which these minerals constitute a necessary part of a product they manufacture to disclose annually to the SEC if the minerals in their products originated or may have originated in Congo or a neighboring country. Furthermore, it will require those companies to provide information on measures they have taken to exercise due diligence on the source and chain of custody to ensure activities involving such minerals did not finance armed groups. The amendment was narrowly crafted in consideration of local economies and thus includes waivers and a sunset clause after five years. Cong. Record, May 19, 2010, S3976.

Friday, May 28, 2010

Supreme Court Cert. Denial in Textron Leaves Intact IRS Discovery of Tax Accrual Work Papers

The US Supreme Court declined to review the First Circuit’s en banc opinion in the Textron case, thereby leaving intact a 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.

This was the testimony of IRS expert and former PCAOB Chief Auditor Douglas Carmichael, who said that tax accrual work papers include all the support for the tax assets and liabilities shown in the financial statements. From the company's perspective, said the former Chief Auditor, they are created because the key officers of the company sign a certification saying that the financial statements are fairly presented; and they need support for that. From the auditor's perspective, the auditors need to record in the workpapers what they did to comply with GAAP. So the workpapers are the principal support for the auditor's opinion, testified the former PCAOB official.

The court emphasized that the tax work papers were independently required by statutory and audit requirements and that the work product privilege does not apply. It is not enough to trigger work product protection that the subject matter of a document relates to a subject that might conceivably be litigated. A set of tax reserve figures, calculated for purposes of accurately stating a company's financial figures, has in ordinary parlance only that purpose, said the en banc court, which is to support a financial statement and the independent audit of it.Moreover, the tax work papers have to be prepared by exchange-listed companies to comply with federal securities regulations and accounting principles for certified financial statements. The compulsion of the federal securities laws and auditing requirements assure that they will be carefully prepared, in their present form, even though not protected, noted the court, and IRS access serves the legitimate and important function of detecting and disallowing abusive tax shelters.

The Association of Corporate Counsel called the Supreme Court’s refusal to hear the case an egregious blow to the well-established precedent on application of work product doctrine. In the ACC’s view, this refusal undermines important efforts by in-house and outside counsel to contribute to greater accuracy and better-considered financial accounting and disclosure decisions necessary to assure corporate accountability, and transparency. In earlier comments, the ACC criticized the appeals court ruling as eviscerating the notion that the in-house lawyer can share legal assessments with company auditors without risking waiving the client’s privilege.

A number of amici urged the Supreme Court to take the case. In its brief, Financial Executives International said that company management has a powerful incentive to provide an independent auditor with all information the auditor deems necessary to evaluate the adequacy of the corporate financial statements. Moreover, the interests of investors in having access to accurate financial statements requires that the tax work papers be protected. More broadly, the integrity of the securities markets requires that published financial statements filed with the SEC fairly reflect a public company’s financial position. It follows that, in providing assurance that a company’s financial statements fairly reflect its financial position, an independent auditor serves the public interest.

The importance of Textron was borne out by recent remarks by SEC Enforcement Division chief Robert Khuzami that, in light of the First Circuit ruling, the Commission is skeptical of an auditor’s assertion of privilege for tax accrual work papers on behalf of an audit client. What the Director described as the First Circuit’s ``common sense analysis’’ is how the SEC staff evaluates these types of assertions of privilege. The staff does not see how the audit documentation prepared by or relied on by an auditor in connection with an audit report can be privileged, or how any claimed privilege hasn’t been waived. Audit documentation is collected or prepared for the purpose of issuing an audit opinion, he emphasized, not for the purpose of litigation. And sharing the work product with auditors, who are supposed to be public watchdogs, strongly undermines any such claim.

Thursday, May 27, 2010

Wisconsin Announces Annual Rules Revision

Wisconsin's 2010 annual rules revision primarily addresses investment adviser solicitation activities using language developed by the NASAA Investment Adviser Regulatory Policy and Review Project Group. The proposed rules are contained in two lengthy provisions.

Public hearing and comments. A copy of the Notice of Rule-Making Hearing, together with a Proposed Rule-Making Order containing the Public Comment Draft of the proposed rules in line-and strike form, may be reviewed and downloaded from the Division's Web page at and written comments regarding the proposed rules, or questions about the Division's internal processing of the proposed rules, should be submitted to the Department of Financial Institutions' Deputy General Mark Schlei at the Department of Financial Institutions, Office of the Secretary, P.O. Box 8861, Madison, WI 53708-8861, tel. (608) 267-1705, email

Substantive questions on the rule proposals should be directed to Randall Schumann, Attorney, Department of Financial Institutions, Division of Securities, P.O. Box 1768, Madison, WI 53701-1768, tel. (608) 266-3414, email

Comments must received by the June 28, 2010 hearing date, or alternatively, public hearing testimony may be provided at the rulemaking hearing.


In Colloquy with Alaska's Senators on Sec. 412, Chairman Dodd Agrees SEC Should Include State and Local Governments in Definition of Accredited Invest

Section 412 of the legislation requires the SRC conduct a rulemaking to implement changes to the definition of accredited investor in Regulation D. Senators Begich and Murkowski engaged in a colloquy with Senator Dodd over whether the SEC has authority under existing law to amend the definitions of accredited investor in Regulation D and related SEC rules and qualified institutional buyer in rule 144A under the Securities Act to expressly include state and local government bodies within those definitions and whether the SEC should take the opportunity presented by Section 412 to include governmental entities within those definitions. Cong. Record, May 20, 2010, S4063-4064.

Senator Murkowski said that it is in the interests of state and local governments for the SEC to add governmental entities to the definitions of accredited investor and qualified institutional buyer when it promulgates rules pursuant to the legislation. The reasons for including governmental entities in these definitions are that governments are large and sophisticated investors with professional treasury management staffs that manage large amounts of the government’s own money and seek to invest in securities in order to prudently diversify their investment portfolios and obtain a favorable return. Many of the most attractive investments are offered only in private placements to institutional investors conducted under Regulation D or Rule 144A. Without access to these investments, the government earns a lower return and has less diversification in its investments than would be optimal. The Senators asked Chairman Dodd if he agreed that when the SEC promulgates its rules under the legislation, it should address, while taking care to ensure appropriate minimum asset protections are in place, the inclusion of state and local governments in the definitions of accredited investor and qualified institutional buyer.

In response, Senator Dodd said that the SEC certainly has existing authority to add state and local governments to the definitions of accredited investor and qualified institutional buyer under its Securities Act rules, adding that it would be appropriate for the SEC to take the opportunity presented by the rulemakings under Section 412 of the legislation to consider whether to include state and local government bodies within those definitions.

Senator Akaka Envisions SEC Investor Advocate Office as Ombudsman for Retail Investors

Authored by Senator Daniel Akaka, Section 914 of the Senate-passed financial reform legislation enhances the ability of the SEC to better represent the interests of retail investors by creating an Investor Advocate within the SEC. The Investor Advocate is tasked with assisting retail investors to resolve significant problems with the SEC or the self-regulatory organizations. The Investor Advocate’s mission includes identifying areas where investors would benefit from changes in Commission or SRO policies, noted Senator Akaka, and problems that investors have with financial service providers and investment products. The Investor Advocate will recommend policy changes to the Commission and Congress on behalf of investors. Cong. Record, May 20, 2010, S4068.

Senator Akaka envisions the Office of Investor Advocate as being very different from the SEC’s existing Office of Investor Education and Advocacy, which provides a variety of services and tools to address the problems and questions that confront investors. Senator Akaka wants the Investor Advocate to act as the chief ombudsman for retail investors and increase transparency and accountability at the SEC. The Investor Advocate will be best equipped to act in response to feedback from investors and potentially avoid situations such as the mishandling of information that could have exposed Ponzi schemes much earlier. Cong. Record, May 20, S4069.

The Office of Investor Education and Advocacy posts information to warn people about scams, compiles complaints, and provides help for people seeking to recover funds. The Office of the Investor Advocate will be a very different office, said Senator Akaka. The Investor Advocate is precisely the kind of external check, with independent reporting lines and independently determined compensation, that cannot be provided within the current structure of the SEC. It is not that the SEC does not advocate on behalf of investors, noted Senator Akaka, it is that it does not have a structure by which any meaningful self-evaluation can be conducted. This would be an entirely new function, he added, and the Investor Advocate would help to ensure that the interests of retail investors are built into rulemaking proposals from the outset and that agency priorities reflect the issues confronting investors. Cong. Record, May 20, S4069.

Monday, May 24, 2010

Briefing Paper Examines Senate Legislation

The CCH Editorial Staff of banking and securities law analysts has authored a detailed overview titled, "Senate Passes Sweeping Financial Reform Bill" available here and excerpted below.

On May 20, 2010, the U.S. Senate passed legislation to restructure the financial services regulatory system by a vote of 59 to 39. As discussed in this briefing paper, the Restoring American Financial Stability Act of 2010 (S 3217, the Senate version of H.R. 4173) would institute far-reaching reforms, including the creation of an independent Consumer Financial Protection Bureau housed within the Federal Reserve Board and new federal government power to wind down large, failing financial institutions.

The bill would establish a nine-member Financial Services Oversight Council to oversee systemic risk, strengthen regulation of financial holding companies and abolish the Office of Thrift Supervision, transferring its functions to the Fed, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. Other provisions of the bill would establish strict oversight of the derivatives market, including mandatory clearing and trading and real-time reporting of derivatives trades. It further calls for banks to spin off their derivatives activities. The legislation would also allow the Government Accountability Office to conduct a one-time audit of the Fed’s emergency lending activities during the financial crisis and would establish the Office of National Insurance to supervise insurance products, other than health insurance, at the federal level.

Among other measures, the bill would also institute numerous investor protections, including stricter oversight of credit rating agencies, shareholder “say on pay,” and expanded SEC enforcement powers.


Friday, May 21, 2010

Senate Passes Historic and Sweeping Overhaul of US Financial Regulation

for an exemption that is consistent with the SEC‘s previous exemptive policy and that takes into account the range of organizational and employment structures employed by family offices. Section 409

The legislation raises the asset threshold above which investment advisers must register with the SEC from the $25,000,000 set in 1996 by the National Securities Markets Improvement Act to $100,000,000. States will have responsibility for regulating advisers with less than $100,000,000 in assets under management. A primary reason for raising the asset under management threshold is to allow the SEC to focus its examination and enforcement resources on the largest investment advisers and thus improve its record in uncovering major cases of investment fraud. Section 410.

Accredited Investors

Accredited investor status, defined in SEC regulations, is required to invest in hedge funds and other private securities offerings. Accredited investors are presumed to be sophisticated, and not in need of the investor protections afforded by the registration and disclosure requirements of the federal securities laws. For individuals, the accredited investor thresholds are dollar amounts for annual income ($200,000 or $300,000 for an individual and spouse) and net worth of $1 million, including the value of a person‘s primary residence). These amounts have not been adjusted since 1982. Thus, the Senate legislation directs the SEC to adjust the net worth needed to attain accredited investor status to $1,000,000, excluding the value of the person’s primary residence. Within the period of four years after enactment, however, the net worth standard must be $1,000,000, excluding the value of the primary residence. Section 412. The legislation also directs the SEC, four years after enactment, and once every 4 years thereafter, to review the definition of accredited investor to determine whether the requirements of the definition should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy. Upon completion of the review, the SEC may adjust the term accredited investor.

Clearing and Settlement

In order to mitigate systemic risk in the financial system and promote financial stability, the legislation provides the Financial Stability Oversight Council with a role in identifying systemically important financial market utilities and the Federal Reserve Board with an enhanced role in supervising risk management standards for systemically important financial market utilities and for systemically important payment, clearing, and settlement activities conducted by financial institutions. Section 805.

The Fed is authorized, in consultation with the Council and the SEC or other appropriate regulator, to prescribe risk management standards governing the operations of designated financial market utilities and the conduct of designated payment, clearing, and settlement activities by financial institutions. The statute sets out the objectives, principles, and scope of such standards.

The Fed is also authorized to maintain an account for a designated financial market utility and to modify or provide an exemption from reserve requirements that would otherwise be applicable to such utility. A designated financial market utility must provide advance notice of and obtain approval of material changes to its rules, procedures, or operations. Section 806.

The supervisory agency must conduct safety and soundness examinations of a designated financial market utility at least annually and can take enforcement actions against the utility. The Fed can participate in the examinations and is also authorized to take enforcement actions against a designated financial market utility if there is an imminent risk of substantial harm to financial institutions or the broader financial system. Section 807.

The SEC or other primary financial regulator is authorized to examine a financial institution engaged in designated payment, clearing, or settlement activities and to enforce the provisions of the Act and the rules prescribed by the Fed against such an institution. The Fed is required to collaborate with the primary financial regulator to ensure consistent application of the rules. The Fed is granted back-up authority to conduct examinations and take enforcement actions if it has reasonable cause to believe a violation of its rules or of the Act has occurred. Section 808.

SEC Self Funding

The legislation would also realize a goal of SEC self-funding. The legislation would allow the SEC to fund its own operations by using the transaction and registration fees it collects in place of a Congressionally-mandated budget. Self-funding will give the SEC access to millions more than is allocated through the Congressional appropriations process.
The SEC is one of only two federal financial regulators that must go through the annual Congressional appropriations process. Federal banking regulators such as the Federal Reserve and the FDIC, on the other hand, can use what they collect in fees, deposit insurance and interest income to fund their operations.

SEC Collateral Bars

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. Section 925.

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.

SEC Fair Fund

The Fair Fund provisions of the Sarbanes-Oxley Act take the civil penalties levied by the SEC as a result of an enforcement action and direct them to a disgorgement fund for harmed investors. The legislation would increase the money available to compensate defrauded investors by revising the Fair Fund provisions to permit the SEC to use penalties to recompense victims of the fraud even if the SEC does not obtain an order requiring the defendant to disgorge ill-gotten gains. Currently, in some cases, a defendant may engage in a securities law violation that harms investors, but the SEC cannot obtain disgorgement from the defendant because the defendant did not personally benefit from the violation. Section 929B.

Updating SIPA

The legislation updates the Securities Investor Protection Act, including provisions on increasing the borrowing limit, the distinction between securities and cash insurance, portfolio margin, and liquidation. The line of credit has not been increased since SIPA was enacted in 1970, and an increase is necessary to provide the Securities Investor Protection Corporation with sufficient resources in the event of the failure of a large broker-dealer. This line of credit is used in the event that SIPC asks for a loan from the SEC and the SEC determines that such a loan is necessary for the protection of customers of brokers or dealers and the maintenance of confidence in the US securities markets. Section 929C.


The Madoff fraud revealed that the Public Company Accounting Oversight Board lacked the powers it needed to examine the auditors of broker-dealers. Thus, the legislation brings broker-dealers under the PCAOB oversight regime. The PCAOB is given authority over audits of registered brokers and dealers that is generally comparable to its existing authority over audits of issuers. This authority permits the Board to write standards for, inspect, investigate, and bring disciplinary actions arising out of, any audit of a registered broker or dealer. It enables the PCAOB to use its inspection and disciplinary processes to identify auditors that lack expertise or fail to exercise care in broker and dealer audits, identify and address deficiencies in their practices, and, where appropriate, suspend or bar them from conducting such audits. Section 982.

The PCAOB must allocate, assess and collect its support fees among brokers and dealers as well as issuers. The PCAOB is expected to reasonably estimate the amounts required to fund the portions of its programs devoted to the oversight of audits of brokers and dealers, as contrasted to the oversight of audits of issuers, in deciding the total amounts to be allocated to, assessed, and collected from all brokers and dealers. The implementation of a program for PCAOB inspections of auditors of brokers and dealers is not intended to and should not affect the PCAOB‘s program for the inspections of auditors of issuers. Cost accounting for each program is not required. See Senate Banking Committee Report, Apr 30, 2010.

The legislation also authorizes the PCAOB to share confidential inspection and investigative information with foreign audit oversight authorities under specified circumstances. Information sharing may occur if the PCAOB makes a finding that it is necessary to accomplish the purposes of the Sarbanes-Oxley Act or to protect investors in U.S. issuers and the foreign authority has provided the assurances of confidentiality requested by the PCAOB, described its information systems and controls; described its jurisdiction‘s laws and regulation that are relevant to information access. The Board must also determine it is appropriate to share such information. Section 981.

The information about information controls and relevant law is to assist the PCAOB in making an independent determination that the foreign authority has the capability and authority to keep the information confidential in its jurisdiction. The PCAOB may rely on additional information in making the determining that the information will be kept confidential and used no more extensively than the same manner that the federal and state entities may use the information, which is an important consideration of determining the appropriateness of such sharing

Investor Protection for Seniors

Similar to the House legislation, the Senate legislation contains specific provisions dealing with senior investor protection. The NASAA has long been concerned with the use of misleading professional designations that convey an expertise in advising seniors on financial matters. Many of these designations in reality reflect no such expertise but rather are conveyed to individuals who pay to attend weekend seminars and take open book, multiple choice tests. NASAA has adopted a model rule designed to curb abuses in this area. Section 989A.

The legislation recognize the harm to seniors posed by the use of such misleading activity and establishes a mechanism for providing grants to states as an incentive to adopting the NASAA model rule. The grants are designed to give states the flexibility to use funds for a wide variety of senior investor protection efforts, such as hiring additional staff to investigate and prosecute cases; funding new technology, equipment and training for regulators, prosecutors, and law enforcement; and providing educational materials to increase awareness and understanding of designations.

Financial Literacy and Underserved Investors

The three vital components of financial literacy are education, consumer protection, and economic empowerment, and the legislation includes essential provisions in all three of these areas for consumers and investors. See remarks of Sen. Daniel Akaka, Cong. Record, Apr 30, 2010, p. S2996. With regard to education, the legislation requires a the SEC to conduct a financial literacy study and develop an investor financial literacy strategy intended to bring about positive behavioral change among investors. Section 916. In addition, an Office of Financial Literacy is created within the new Consumer Financial Protection Bureau and is tasked with implementing initiatives to educate and empower consumers. Section 1013.

A strategy to improve the financial literacy among consumers, that includes measurable goals and benchmarks, must be developed. With regard to the second key component of financial literacy, consumer protection, the Act strengthens the ability of the SEC to better represent the interests of retail investors by creating an Investor Advocate within the SEC. Section 911. The Investor Advocate is tasked with assisting retail investors to resolve significant problems with the SEC or the self-regulatory organizations. The Investor Advocate’s mission includes identifying areas where investors would benefit from changes in Commission or SRO policies and problems that investors have with financial service providers and investment products. The Investor Advocate will recommend policy changes to the Commission and Congress in the interests of investors.

The legislation also authorizes the SEC to effectively require disclosures to retail investors prior to the sale of financial products and services. Section 918. This provision will ensure that investors have the relevant and useful information they need when making decisions that determine their future financial condition. The information to be disclosed by SEC rule must be in summary format and contain concise information about investment objectives, strategies, costs, and risks, as well as any compensation or financial incentive received by the financial intermediary in connection with the purchase of the retail investment product.

The measure authorizes the SEC to gather information from and communicate with investors and engage in such temporary programs as the Commission determines are in the public interest for the purpose of evaluating any rule or program of the SEC. Section 912. In the past, the SEC has carried out consumer testing programs, but there have been questions of the legality of this practice. This legislation gives clear authority to the SEC for these activities.

The legislation modifies the Electronic Fund Transfer Act to establish remittance consumer protections. It would require simple disclosures about the costs of sending remittances to be provided to the consumer prior to and after the transaction. A complaint and error resolution process for remittance transactions would also be established. Section 1076.

On the third component, economic empowerment, the legislation intends to increase access to mainstream financial institutions for the unbanked and the underbanked. The legislation authorizes programs intended to assist low- and moderate-income individuals establish bank or credit union accounts and encourage greater use of mainstream financial services. Title XII would also encourage the development of small, affordable loans as an alternative to more costly payday loans.

Credit Rating Agencies

Credit rating agencies market themselves as providers of independent research and in-depth credit analysis. But in the financial crisis, instead of helping people better understand risk, they failed to warn people about risks hidden throughout layers of complex securitized structures.

Flawed methodology, weak oversight by regulators, conflicts of interest, and a total lack of transparency contributed to a system in which AAA ratings were awarded to complex, unsafe asset-backed securities and other derivatives, adding to the housing bubble and magnifying the financial shock caused when the bubble burst. When investors no longer trusted these ratings during the credit crunch, they pulled back from lending money to municipalities and other borrowers.

The legislation establishes an independent office within the SEC dedicated to improving the quality of regulation of credit rating agencies. The Office of Credit Ratings, headed by a direct report to the SEC Chair, will promote accuracy in credit ratings and keep conflicts of interest from unduly influencing ratings. Section 932.

The Office of Credit Ratings must also conduct annual examinations of each credit rating agency, including a review of its policies, procedures, and rating methodologies and whether it follows these policies, the management of conflicts of interest, the implementation of ethics policies; the internal supervisory controls of the agency, the governance of the agency; the activities of its compliance officer; the processing of complaints, and the policies of the agency governing the post-employment activities of former staff.

The SEC will annually publish the essential findings of all examinations, including the responses of rating agencies to material regulatory deficiencies identified by the SEC and to recommendations made by the SEC.

The legislation mandates that each nationally recognized statistical rating organization must establish, enforce, and document an effective internal control structure governing the implementation of policies and methodologies they use to determine credit ratings. Further, the SEC must adopt rules requiring credit rating agencies to submit to the Commission an annual internal controls report, containing a description of the responsibility of the management of the rating agency in establishing and maintaining effective internal controls. In addition, the rating agency must assess the effectiveness of the internal controls and the CEO must attest to it. Section 932.

The legislation authorizes the SEC to fine a rating agency for violations of law or regulations. The Act eliminates the effect of the inherent conflict of interest in the much criticized issuer pays model in the credit rating industry. The conflict of interest arises because rating agencies want to provide the highest rating to keep the issuer‘s business and are less willing to publish a lower rating. The Act addresses this conflict by directing the SEC to write rules preventing sales and marketing considerations from influencing the production of ratings. Violation of these rules will lead to suspension or revocation of rating agency status if the violation affects a rating.

The legislation promotes sound corporate governance by prohibiting compliance officers at rating agencies from participating in the production of ratings, the development of ratings methodologies, or the setting of compensation for agency employees.

The legislation eliminates the effect of the inherent conflict of interest in the issuer-pays model of the credit rating industry under which issuers of structured securities have the incentive to use the rating agency that provides the highest rating. A conflict of interest thus arises because rating agencies want to provide the highest rating to keep the issuer‘s business and are less willing to publish a lower rating. The Act addresses this conflict by directing the SEC to adopt rules preventing sales and marketing considerations from influencing the production of ratings. Violation of these rules will lead to suspension or revocation of NRSRO status if the violation affects a rating. Section 932. Also, rating agencies must consider information about an issuer that they receive from a source other than the issuer, that the agency finds credible and potentially significant to a rating decision. But the measure does not require a rating agency to initiate a search for such information.

The Franken Amendment further attacks the conflict of interest problem by creating a board overseen by the SEC that will assign credit rating agencies to provide initial ratings on a rotating basis. The SEC will create a credit rating agency board, a self-regulatory organization, tasked with developing a system in which the board assigns a rating agency to provide a product’s initial rating. Requiring an initial credit rating by an agency not of the issuer’s choosing will put a check on the accuracy of ratings, in the Senator’s view. The amendment does not prohibit an issuer from then seeking a second or third or fourth rating from an agency of their choosing. The amendment leaves flexibility to the Board to determine the assignment process. Thus, the new board gets to design the assignment process it sees fit, which can be random or based on a formula, just as long as the issuer doesn’t get to choose its rating agency. Cong. Record, May 10, 2010, S3465.

The SEC must also adopt rules separating the ratings from sales and marketing. Specifically, the rules must prevent the sales and marketing considerations of a rating agency from influencing the production of ratings. The SEC rules must provide for exceptions for small rating agencies when the Commission determines that the separation of the production of ratings and sales and marketing activities is not appropriate.

Reform of Securitization

In many ways, the financial crisis was at root a crisis of securitization. While traditional securitization was a successful tool for bundling loans into asset-backed securities, in the last decade it morphed into the short-term financing of complex illiquid securities whose value had to be determined by theoretical models. The inherent fragility of this new securitization model was masked by the actions of market intermediaries, particularly credit rating agencies. Predatory mortgages and securitization of those mortgages on Wall Street built a house-of-cards economy. The predatory subprime mortgages were done at the retail level, but the securitization and selling of those packages occurred on Wall Street. Remarks of Senator Jeff Merkley, Cong. Record May 6, 2010, S3319.

The collapse of structured securitization revealed the ugly reality that, far from managing and dispersing risk, it had increased leverage and concentrated risk in the hands of specific financial institutions. The Obama Administration proposed the reform securitization by changing the incentive structure of market participants; increasing transparency to allow for better due diligence; strengthening credit rating agency performance; and reducing the incentives for over-reliance on credit ratings. Provisions of the draft legislation would implement these goals.

One of the most significant problems in the securitization markets was the lack of sufficient incentives for lenders and securitizers to consider the performance of the underlying loans after asset-backed securities were issued. Lenders and securitizers had weak incentives to conduct due diligence regarding the quality of the underlying assets being securitized. This problem was exacerbated as the structure of those securities became more complex and opaque. Inadequate disclosure regimes also exacerbated the gap in incentives between lenders, securitizers and investors.

There is a growing consensus that we have ``crossed the Rubicon’’ into originate and distribute securitization and there is no turning back to originate and hold. Indeed, restarting private-label securitization markets, especially in the United States, is critical to limiting the fallout from the credit crisis and to the withdrawal of central bank and government interventions. However, no one wants policies that would take markets back to their high octane levels of 2005–07. Thus, the legislation aims to put securitization on a solid and sustainable footing.

The legislation reforms the process of securitization by, primarily, requiring companies that sell products like mortgage-backed securities to retain a portion of the risk to ensure that they will not sell toxic securities to investors, because they have to keep some of it for themselves. The Senate legislation would require companies that sell products like mortgage-backed securities to keep some ``skin in the game’’ by retaining at least five percent of the credit risk so that, if the investment doesn’t pan out, the company that made, packaged and sold the investment would lose out right along with the people they sold it to. Section 941. In addition, the legislation would require issuers to disclose more information about the assets underlying asset-backed securities and to analyze the quality of the underlying assets. Section 942.

Specifically, the legislation directs the federal banking agencies and the SEC to jointly prescribe regulations to require any securitizer to retain a material portion of the credit risk of any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells, or conveys to a third party. When securitizers retain a material amount of risk, they have skin in the game, thereby aligning their economic interests with those of investors in asset-backed securities. Securitizers who retain risk have a strong incentive to monitor the quality of the assets they purchase from originators, package into securities, and sell.

While the legislation provides a baseline risk retention amount of five percent of the credit risk in any securitized asset, that figure may be set higher at the regulators‘ discretion, or it may be reduced below 5 percent when the assets securitized meet standards of low credit risk to be established by rule for the various asset classes. The legislation gives the SEC and the banking regulators flexibility in setting risk retention levels in order to encourage the recovery of the securitization markets and to accommodate future market developments and innovations. But it must be remembered that in all cases the amount of risk retained should be material so that it creates meaningful incentives for sound and sustainable securitization practices

Whistleblower Protections

Section 922 of the Act allows the SEC to reward whistleblowers who provide the Commission with information on securities law violations. The provision, found in new Exchange Act Section 21F, applies to any judicial or administrative action brought by the SEC under the securities laws that result in monetary sanctions exceeding $1,000,000. Whistleblowers will also enjoy more protections from retaliation under the Act.

Currently, the SEC may reward individuals for providing information leading to the recovery of civil penalties for insider trading. New Section 21F will allow the payment of rewards for information that leads to the successful enforcement of any judicial or administrative action brought by the SEC under all provisions of the securities laws. For example, whistleblowers in financial fraud and Foreign Corrupt Practices Act cases, which often generate substantial civil penalties, would be eligible for awards.

The Senate measure, unlike the House bill, provides a minimum award of 10 percent of the funds collected as sanctions. Both bills cap awards at 30 percent of collected funds. Whistleblowers may appeal the SEC's award decision to the appropriate circuit court for review under an abuse of discretion standard. The statute prohibits payments to specified administrative and law enforcement personnel, auditors and individuals convicted of a crime connected to the judicial or administrative action in question.

The Act expands the whistleblower protections in the Sarbanes-Oxley Act. While the two statutes prohibit similar conduct, there are significant differences in both the scope of the measures and in the available relief.

Section 929A of the t amends Sarbanes-Oxley Act Section 806(a) to clarify that the whistleblower protections apply to both parent companies and their subsidiaries and affiliates if their financial information is included in the consolidated financial statements of the parent company. Victims of retaliatory discrimination may also immediately and directly file suit against the employer in federal district court. Under Section 806, claimants had to file a complaint with the Department of Labor, and could only seek district court review if the Secretary of Labor failed to reach a determination within 180 days. Both statutes provide for reinstatement and for the recovery of lost wages and costs. Under the Senate bill, however, injured persons may recover twice their lost wages, while the Sarbanes-Oxley Act allowed only the recovery of actual wages lost.

The Cardin-Grassley Amendment extended whistleblower protection to employees of credit rating agencies, which are the nationally recognized statistical rating organizations, NRSROs, which issue credit ratings that the SEC permits other financial firms to use for certain regulatory purposes.

Securities Lending

The legislation directs the SEC to adopt rules that are designed to increase the transparency of information available to brokers, dealers, and investors with respect to loaned or borrowed securities. Section 984 also makes it unlawful for any person to effect, accept, or facilitate a transaction involving the loan or borrowing of securities in contravention of the SEC rules.

Resolution Authority

According to Treasury, the lack of a federal regulatory regime and resolution authority for large systemic financial institutions contributed to the financial crisis and, unless addressed with legislation, will constrain a federal response to future crises. As demonstrated by AIG, severe distress at large global non-depository financial institutions can pose systemic risks to the financial markets just as distress at banks can.

Thus, the legislation establishes an orderly liquidation authority to give the U.S. government a viable alternative to the undesirable choice it faced during the financial crisis between bankruptcy of a large, complex financial company that would disrupt markets and damage the economy, and bailout of such financial company that would expose taxpayers to losses and undermine market discipline. The new orderly liquidation authority would allow the FDIC to safely unwind a failing nonbank financial firms or bank holding companies, an option that was not available during the financial crisis. The process includes several steps intended to make the use of this authority very rare. There is a strong presumption that the Bankruptcy Code will continue to apply to most failing financial companies. Section 203.

Once a failing financial company is placed under this authority, liquidation is the only option; since the failing financial company may not be kept open or rehabilitated. The financial company‘s business operations and assets will be sold off or liquidated, the culpable management of the company will be discharged, shareholders will have their investments wiped out, and unsecured creditors and counterparties will bear losses.

The Dodd-Shelby Amendment, in conjunction with the Boxer Amendment, ends the idea that any firm can be too big to fail. Pursuant to the Dodd-Shelby Amendment, the legislation creates an orderly liquidation mechanism for the FDIC to unwind failing systemically significant financial companies. This mechanism represents a fundamental change in federal law that will protect taxpayers from the economic fallout of the collapse of a large interconnected systemically significant financial firm. Senator Chris Dodd, Cong Record, May 5, 2010, S3131.

Shareholders and unsecured creditors will still bear losses and management at the failed firm will be removed. In fact, the Dodd-Shelby Amendment empowers regulators to bar culpable management and directors of failed firms form working in the financial sector. According to Senator Dodd, it makes sense that if someone has been involved in the mismanagement of a company and caused such disruption in the economy they should be banned from engaging in further economic activities. Senator Chris Dodd, Cong Record, May 5, 2010, S3131.

Subject to due process protections, regulators can ban from the financial industry senior executives and directors at failed financial firms upon determining that they violated a law or regulation, a cease and desist order, or an agreement with a federal financial regulator; or breached their fiduciary duty; or engaged in an unsafe or unsound practices. In addition, the executive must have benefitted from the violation or breach, which must also involve personal dishonesty or a willful or continuing disregard for the firm’s safety or soundness. The length of the industry ban is in the regulator’s discretion, but must be at least two years. Section 212.

There will also be clawbacks of excess payments to creditors, such that creditors will be required to pay back the government any amounts they received above what they would have received in liquidation. Those who directly benefitted from the orderly liquidation will be the first to pay back the government at a premium rate.

Congress must approve the use of debt guarantees by the Fed or Treasury. The Fed can only use its Section 13(3) emergency lending authority to help solvent companies.

The Dodd-Shelby Amendment also requires post-resolution reviews to determine if regulators did all they were supposed to do to prevent the failure of a systemically significant institution. According to Senator Shelby, this post-resolution review is essential to hold regulators accountable for their actions or inactions as the case may be. Cong. Record, May 5, 2010, S3140.

The Boxer Amendment puts to rest any doubt that the legislation ends federal bailouts of financial firms. The amendment means that no financial company is going to be kept alive with taxpayer money. Remarks of Senator Boxer, Cong. Record, May 4, 2010, S3063.

Specifically, the Boxer Amendment states that all financial companies put into receivership under the legislation must be liquidated and no taxpayer funds can be used to prevent the liquidation of any financial company. Further, all funds expended in the liquidation of a financial company must be recovered from the disposition of assets of such financial company, or must be the responsibility of the financial sector, through assessments. According to Senator Warner, the Boxer Amendment reaffirms that entry into the resolution regime will mean that the financial firm will go out of business, that equity will be toast, management will be toast, the unsecured creditors will be toast. This will be an effective death panel for a financial institution. Cong. Record, May 3, 2010, S3027.

Municipal Securities

The legislation establishes an Office of Municipal Securities in the SEC to administer the Commission‘s rules with respect to municipal securities dealers, advisors, investors, and issuers. The Director of the Office will report to the SEC Chair. The Office must coordinate with the MSRB for rulemaking and enforcement actions, and must be sufficiently staffed to carry out its duties, including individuals with knowledge and expertise in municipal finance. Section 979.

SEC Inspector General

The Grassley-McCaskill Amendment also requires the SEC and CFTC inspector generals to report to the full Commission rather than only to the SEC or CFTC Chair. It will additionally require that two-thirds of the Commission must vote for cause to fire the inspector general. Section 989D. According to Senator Grassley, the two-thirds for cause vote ensures the possibility that any political attempt to remove an agency inspector general will be met by dissent from some some Commissioners.


    Thursday, May 20, 2010

    Grassley-McCaskill Amendment Enhances SEC, CFTC Inspector Generals, Sets Up Council of Inspector Generals

    The Senate approved an amendment to the financial reform legislation creating a council of federal financial agency inspector generals, including the IGs at the SEC, CFTC, FDIC and the Fed. The council will meet quarterly and compare notes and talk about their investigations in order to ensure that they are not duplicating each other’s work. They will also discuss collective approaches to systemic risk. The council must also submit an annual report to Congress recommending improvements to financial oversight. Section 989E.

    The Grassley-McCaskill Amendment also requires the SEC and CFTC inspector generals to report to the full Commission rather than only to the SEC or CFTC Chair. It will additionally require that two-thirds of the Commission must vote for cause to fire the inspector general. Section 989D. According to Senator Grassley, the two-thirds for cause vote ensures the possibility that any political attempt to remove an agency inspector general will be met by dissent from some Commission members. Cong Record, May 18, 2010, S3877.

    The amendment also requires the SEC and other inspector generals to disclose the results of all their peer reviews to Congress, thereby making them public. Also, the SEC and other financial regulators would have to respond when inspector generals identify deficiencies in their agencies, either by taking corrective action or by explaining to Congress why they did not take effective action. Section 989C.

    There are two types of federal inspector generals created by the Inspector General Act, those appointed by the President and those designated by the agency, such as the SEC and CFTC inspector generals. The original Section 989B in the Senate bill would have replaced agency designated inspector generals with IGs appointed by the President. The amendment strips out the original Section 989B and replaces with a new 989B, ending the effort to make the SEC and CFTC IGs presidentially appointed. According to Senator Grassley, there is no evidence that presidentially-appointed IGs will be more independent than agency-designated IGs. In fact, citing the SEC’s inspector general as an example, Senator Grassley said that agency-designated IGs can be fiercely independent despite the fact they could be removed by the agency. Cong. Record, May 18, 2010, S3876.

    Wednesday, May 19, 2010

    Bond Amendment Adjusts Accredited Investor and Reg. D Provisions in Senate Reform Bill

    The Senate approved a bi-partisan amendment, SA 4056, that would raise the accredited investor amounts in the federal securities laws and eliminate the language in the underlying bill that required a 120 day SEC review period for private placements. Sponsored by Senator Christopher Bond, the amendment promotes integrity in Regulation D private placements and protects investors from fraud by prohibiting felons and other known bad-actors from seeking to raise investment and capital in private placements.

    Accredited investor status, defined in SEC regulations, is required to invest in private securities offerings. An investor must have a net worth of $1 million, including the primary residence. Originally, Section 412 of The Restoring American Financial Stability Act required the SEC to increase the dollar threshold for accredited investors to account for inflation and to adjust those figures every five years for inflation. The amendment directs the SEC to adjust the net worth needed to attain accredited investor status to more than $1,000,000, as amount is adjusted periodically by SEC rule, excluding the value of the primary residence. Within the period of four years after enactment, however, the net worth standard must be $1,000,000, excluding the value of the primary residence.

    The amendment also directs the SEC, four years after enactment, and once every 4 years thereafter, to review the definition of accredited investor to determine whether the requirements of the definition should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy. Upon completion of the review, the SEC may adjust the term accredited investor.

    The amendment also provides that a GAO study on accredited investor status ordered by Section 413 can be completed within three years of enactment, extending the time from the original one year.

    Originally, Section 926 restored certain authority to the states over Regulation D offerings. In addition, it provided a 120-day period for the SEC to determine whether it will review a filing before it would then go to the state regulator. The amendments eliminates the 120-day period and strips out the state authority provisions. The amendment lifts bad actor provisions into the private placement arena by directing the SEC, within one year of enactment, to adopt rules disqualifying any securities offerings under Rule 506 of Regulation D by a person convicted of any felony or misdemeanor in connection with the purchase or sale of any security or involving the making of any false filing with the SEC or subject to a final order of a State securities commission, or state or federal banking authority barring the person from the financial industry.

    SEC, CFTC Have Few Answers in Preliminary Report on Market Upheaval

    The SEC and CFTC staffs may have concluded what did NOT cause the dramatic market turmoil on May 6, but their preliminary report offers few answers as to what did cause the upheaval. According to the report, the staff review is in its preliminary stages and is ongoing.

    Initially, the staffers indicated that they had found no evidence that these events were triggered by “fat finger” errors, computer hacking, or terrorist activity, although they could not completely rule out these possibilities. While not identifying any particular cause, the report focuses on six major themes:

    1) a possible linkage between the price decline in index products coupled with simultaneous and subsequent waves of selling in individual securities;
    2) a severe mismatch in liquidity that may have been exacerbated by the withdrawal of liquidity by electronic market makers and the use of market orders, including automated stop-loss market orders designed to protect gains in recent market advances;
    3) the impact on the liquidity mismatch of disparate trading conventions among various exchanges, with trading slowed in one venue while continuing normally in another;
    4) the impact of the use of “stub quotes”, which technically provide a “two sided quote” but are at such low or high prices that they are not intended to be executed;
    5) the use of market orders, stop loss market orders and stop loss limit orders that, when coupled with sharp declines in prices, for both equity and futures markets, may have contributed to market instability and a temporary breakdown in orderly trading; and
    6) the impact on ETFs, which suffered a disproportionate number of broken trades relative to other securities.


    The SEC staff stated that they will continue the ongoing investigation into the nature of the overall market liquidity dislocation and the impact on individual stocks. The staff anticipates that SROs will propose circuit breakers for individual stocks that are designed to address temporary liquidity dislocation. The procedures for breaking trades that occur at off-market prices should also be improved to provide investors greater consistency, transparency and predictability. The report stated that the staff will review a range of other policy options, including addressing the use of stub quotes, reviewing the obligations of professional liquidity providers and evaluating the use of various order types.


    The CFTC staff will continue its review of the activity of the largest traders in stock index futures, and will analyze liquidity provision in futures markets, with a particular focus on electronic trading. Subjects under review include high frequency and algorithmic trading, automatic execution innovations on trading platforms, market access issues and co-location. The staff is also considering rulemaking with respect to exchange colocation and proximity hosting services. The rule would ensure that all otherwise qualified and eligible market participants that seek co-location or proximity hosting services offered by futures exchanges have equal access to such services without barriers that exclude access, or that bar otherwise qualified third-party vendors from providing co-location and/or proximity hosting services. Another purpose of the proposal would be to ensure that futures exchanges that offer co-location or proximity hosting services disclose publically the latencies for each available connectivity option, so that participants can make informed decisions.

    The staff is also examining the CFTC’s surveillance capabilities. They will consider automation of the statement of reporting traders in the large trader reporting system, and access to account ownership and control information in the exchange trade registers. According to the staff, these initiatives would increase the timeliness and efficiency of account identification.


    The agency staffs are planning a joint study to examine the linkages between correlated assets in the equities (single stocks, mutual funds and ETFs), options and futures markets. The study could partly focus on examining cross-market linkages by analyzing trading in stock index products such as equity index futures, ETFs, equity index options, and equity index OTC derivatives using, to the extent practicable, market data, special call information, and order book data. The report noted that existing cross-market circuit breaker provisions should be re-examined to ensure they continue to be effective in a high-speed electronic trading environment.


    Tuesday, May 18, 2010

    Key Committee of European Parliament Approves Hedge Fund Legislation

    A key committee of the European Parliament has approved draft legislation regulating hedge funds and private equity funds. The Economic and Monetary Affairs Committee approved the Alternative Investment Fund Managers Directive with improvements in transparency and risk reduction. The draft also embraces a proportionality system that regulates less risky funds more lightly, which means that private equity funds and investments trusts would be more lightly regulated than hedge funds and some types of alternative investment funds would be completely exempted from regulation.

    Hedge fund managers in non-EU countries (third countries) would have to voluntarily comply with the Directive in order to have access to the EU. In such cases, the third country regulators of fund managers would act as agents to supervise the fund managers. Third country hedge funds could market their funds in the EU if their home country has high enough standards to combat money laundering and terrorist financing and grants reciprocal access to the marketing of EU funds on its territory and has agreements in place with the Member States on the exchange of information related to taxation and monitoring matters. The home country of the non-EU hedge fund must also recognize and enforce judgments given in the EU on issues connected to the Directive.

    The committee-approved legislation contains a proportionality model for regulation of alternative investment funds under which different levels of regulation will be applied according to the type of fund rather than the asset thresholds proposed by the European Commission. National regulators will establish who qualifies for lighter regulation on the basis of the Directive’s rules. Private equity funds and non-systemically important alternative investment funds will avoid the full force of the Directive, while banks and pension funds investing only their own money will be completely exempted.

    While the Commission proposed that it would set the maximum levels of borrowing that a hedge fund manager could use to increase the returns of a fund, the draft legislation approved by the committee would allow fund managers to set their own leverage limits for each fund they manage. National regulators would then monitor the suitability of these limits.
    While the Commission-proposed Directive prohibited hedge fund managers from doing their own valuations, the committee draft would allow this so long as safeguards are in place that provide for independent valuations. However, the delegation of valuation to an outside valuator will not shift liability from the fund manager to the outside valuator. If there is no external valuator, regulators can request that the internal fund system guaranteeing independent valuations be checked by an outside audit firm.

    The main innovation on fund depositaries in the committee draft is that the depositary will be able to delegate its tasks to a certain extent, provided that it keeps a watchful eye on the actions of the sub-depositary it has delegated these tasks to. A depositary will also be able to delegate some of its tasks to a sub-depositary outside the EU provided it remains liable for the sub-depositary's actions, retains control over it, and the third country fulfils similar conditions required from non-EU countries wishing to have their funds marketed in the EU.

    A depositary will be able to avoid liability for any loss of financial instruments if this is a result of force majeure or it can be proven that the cause of the loss was an unforeseeable external event. In the event of delegation, the main depositary remains liable for the actions of the sub-depositaries unless the depositary is legally prevented from exercising its role in the country where its fund manager is investing or could not due to unforeseeable external events. Finally, in the event of the sub-depositary being contractually able to reuse or transfer the assets, the depositary can then relieve itself of liability.

    With regard to capital requirements, the draft proposes to align the Directive with the UCITS Directive. The Commission’s proposals on capital requirements for external hedge fund managers managing a fund are maintained. In the case of large value portfolios (over EUR 250 million) the text caps the extra capital needed at EUR 10 million. The Commission had not proposed any such cap. Moreover the committee draft provides that funds can be exempt from up to 50% of the extra capital required if they have guarantees by a bank or an insurance company matching the amount of which they are to be exempt.

    According to the committee draft Directive, when a hedge fund has more than 10, 20, 30, and 50% of the voting rights of a non-listed company it must notify the relevant authorities and the investors in the fund in question. The manager must provide information on the communication policy with employees, plans for conflict-resolution and indicate which persons are responsible for deciding on business strategy and employment policy. Finally, hedge funds must give notice of any planned divestment of assets.

    The draft Directive also deals with asset-stripping practices by requiring that the company owned by private equity must have capital which is in line with the requirements on capital adequacy established in already existing legislation on EU company law.

    However, the private equity provisions will not apply to companies employing less than 50 persons. In this sense investment by private equity in micro-companies will be excluded from the Directive's scope. Moreover, the Directive calls on the Commission to review existing company law legislation to ensure that companies owned by private equity are not at a disadvantage in comparison to companies owned by other means, especially regarding reporting requirements and information which needs to be divulged to employees.

    The committee draft enhances hedge fund disclosure. Most notably, new rules would require funds to inform investors about maximum levels of leverage (borrowing) and the total amount of leverage used by the fund, and to provide information on the domicile of underlying funds in case of fund of funds hedge funds and the domicile of any master fund. Managers would also be required to provide a description of the past performance of the fund, changes in liability if there is a contractual agreement between the fund manager and the depositary, and information about the role of sub-depositaries if these are being used.

    Regulators would need to be informed about the overall leverage used for each fund, the ways fees are paid and the amounts paid to the fund manager, and performance data of the fund, including the valuation of assets. Regulators may also ask for additional information from fund managers which they consider may pose important risks. The European Securities and Markets Authority (ESMA) may also require additional reporting in exceptional circumstances or in order to protect the stability of the financial system.

    The committee draft includes new features designed to reduce risk in the financial system, including new rules on remuneration, short-selling and marketing to retail investors. On remuneration, the draft requires fund managers to adopt sound policies and practices that do not encourage excessive risk. More specifically, it demands that remuneration policies be closely similar to those to be applied to banks.

    The draft bans naked short-selling, a process of selling a security which is neither owned nor borrowed. It also requires fund managers regularly to disclose information on important short positions to regulators. It also provides that ESMA may decide to restrict short-selling activities in exceptional circumstances or to protect the financial system's stability.

    On marketing to retail investors, Member States would have to ban the marketing of a hedge fund to retail investors on their territory if the fund invests more than 30% of its funds in other funds which are prohibited from being marketed within the EU.

    The access by third-country hedge funds to the EU remains one of the most controversial issues in the proposed Alternative Investment Funds Management Directive. Recently, global hedge fund groups sent a letter to the European Parliament urging a reasonable and workable compromise on the third-party fund issue involving the access to non-EU funds and fund managers.

    As the legislative process continues, a number of compromises are being considered. One such deal preserving the required choice of investment solutions for professional investors could be that Member States have the possibility of allowing private placement of non-EU hedge funds to professional investors within their own jurisdiction, and professional investors would be able to continue investing in non-EU hedge funds at their own initiative. Other voices have called for a reasonably conditioned equivalence coupled with a passport as the only long term solution able to conciliate internal market principles with free movement of capital and ensure a level playing field both within Member States and within EU based and third country based funds.


    Monday, May 17, 2010

    Landrieu-Isakson Amendment Carves Out Exemption from 5 Percent "Skin in the Game" Requirement

    An amendment carving out qualified residential mortgages from the requirement in the Senate financial reform bill that originators retain a 5 percent interest in mortgages underlying mortgage-backed securities has been approved. Sponsored by Senators Mary Landrieu (D-LA) and Johnny Isakson (R-GA), the amendment ensures that originators of mortgages that have 20 percent down and a high FICO rating will not have to retain the 5 percent skin in the game required of other securitized assets. According to Senator Isakson, the only risk retention that will be required is when someone is making a bad loan. The amendment embodies the principle that underwriting, not risk retention, is the cure all to good lending. Cong. Rec. May 12, 2010, S3576. While skin in the game is important, echoed Senator Mark Warner, more important is the underlying quality of the mortgage. Senator Warner added that the amendment remains true to the intent of the legislation to ensure that the mortgage securitization process requires the originators of the mortgages to have some skin in the game. Cong. Rec. May 12, 2010, S3576.

    The amendment to Section 941 of S3217, which effectively amends new Section 15G of the Exchange Act, requires the SEC and the federal banking and housing authorities to jointly issues regulations exempting qualified residential mortgages from the risk retention requirements of S3217. In defining the term qualified residential mortgage, the amendment directs the SEC and the other authorities to consider underwriting and product features that historically have indicated a low risk of default, such as, in addition to 20 percent down, the mortgagor’s residual income and ratio of the mortgage payment to total monthly income. The SEC must also consider whether the mortgage prohibits or restricts the use of ballon payments, prepayment penalties, interest only payments, and other features that have historically demonstrated a higher risk of borrower default.

    The regulations must provide that an asset-backed security that is collateralized by tranches of other asset-backed securities must not be exempted from the risk retention requirements.

    An important part of the amendment directs the SEC to require an issuer to certify, for issuances of asset-backed securities exclusively collateralized by qualified residential mortgages, that the issuer has evaluated the effectiveness of its internal controls with regard to the process for ensuring that all the assets collateralizing the asset-backed security are qualified residential mortgages.

    There is broad agreement that a key element of the reform of the securitization process is that originators of mortgage-backed securities must retain a portion of the risk, discouraging them from selling junk because they would have to keep some of it for themselves. The House financial reform legislation, HR 4173, would require companies that sell products like mortgage-backed securities to keep some “skin in the game” by retaining at least five percent of the credit risk. Section 1502. However, the House legislation does not have an analog to the Landrieu-Isakson Amendment carving out securitized qualified residential mortgages form the risk retention requirement.


    Saturday, May 15, 2010

    Geithner and Barnier Affirm Goal of Non-Protectionist Hedge Fund Legislation
    With a vote on proposed hedge fund legislation looming in a committee of the European Parliament, and the U.S. Congress soon expected to legislate the regulation of hedge funds, Treasury Secretary Tim Geithner and European Commissioner for the Internal Market Michel Barnier affirmed their strong determination to avoid regulatory arbitrage in strengthening the global financial system and in putting in place the G-20 financial reform agenda.

    In reviewing a range of U.S. and EU priority issues, including the proposed EU Alternative Investment Fund Management Directive, they supported the principle of non-discrimination and the importance of maintaining a level playing field. They agreed that the United States and the European Union, as the world's two largest economies and financial systems, have a special responsibility to implement stronger global financial standards, reduce the scope for regulatory arbitrage and work toward greater regulatory convergence.

    In separate remarks at the European Institute in Washington, Commissioner Barnier said that final EU legislation on the regulation of hedge funds and private equity funds is possible soon. He reiterated his opposition to any protectionist or discriminatory outcome with regard to the proposed Directive.

    In an earlier letter to EU finance ministers, Secretary Geithner called on the European Union to participate in a globally coordinated approach toward financial regulatory reform and resist protectionist-driven initiatives in the proposed Alternative Investment Fund Manager Directive. Specifically, he asked that EU legislation regulating hedge funds not discriminate against U.S. and other third country hedge funds not based in the EU.

    He urged EU legislators not to include a provision that would discriminate against U.S. and other foreign funds and fund managers by denying them the opportunity to access the EU single market through a passport approach, which would be an avenue open solely to EU funds and fund managers. Mr. Geithner urged that this provision be revised to provide U.S. and other non-EU funds, fund managers and global fund custodians the same access as their EU counterparts.

    He noted that the U.S. is actively implementing its G-20 commitment to enhance the regulation of hedge funds. The House has passed legislation requiring all advisers to hedge funds and private equity funds whose assets under management exceed a modest threshold to register with the SEC under the Investment Advisers Act. The Senate is set to pass similar legislation. The Secretary told the Finance Ministers that the U.S. hedge fund regulatory regime will give equal treatment to all funds and advisers operating in the U.S. regardless of their country of origin.

    Concerns about the proposed EU Directive have also been voiced in Europe, particularly in the UK. At a recent seminar, Dan Waters, FSA Director of Asset Management, said that the proposed Alternative Investment Fund Managers Directive would restrict the access of EU institutional investors to valid investment opportunities in U.S. and other third-country hedge funds while delivering little real benefit to European market stability or investor protection. He said that the draft could be seen as an attempt to protect European funds from competition from legitimate U.S. and other third-country funds.


    LeMieux-Cantwell Amendment Ends Federal Endorsement of Credit Ratings, Orders SEC Study

    The approved LeMieux-Cantwell Amendment (SA 3774) to the Senate financial reform bill eliminates statutory protections and references to national credit ratings agencies in a number of federal acts, including the Exchange Act and Investment Company Act, thereby essentially removing the federal government's seal of approval from investment rating agencies. The effect of this action will be to force federal regulators to develop more diverse and accurate measures of credit worthiness. According to Senator Cantwell, it is critical that federal regulators use their discretion to come up with appropriate standards of creditworthiness and not rely on the monopoly of the rating agencies. Press release of May 13, 2010.

    The Amendment also requires the SEC to evaluate and make recommendations to Congress within one year regarding how credit ratings can be standardized and better utilized as one of many tools for evaluating general investment risk. The study will be very granular. For example, the SEC must determine the feasibility of standardizing the market stress conditions under which ratings are evaluated, and requiring a quantitative correspondence between credit ratings and a range of default probabilities and loss expectations under standardized conditions of economic stress. The study must also examine the feasibility of standardizing credit rating terminology across asset classes so that named ratings correspond to a standard range of default probabilities and expected losses independent of asset class and issuing entity.

    Section 6009 of the House financial reform legislaiton is virtually the same in its provisions removing federal statutory references to credit ratings as the Senate bill, with the difference that the House provisions would become effective six months after enactment, while the Senate provisions would take effect one year after enactment. Also, the House version does not direct the SEC study ordered by the LeMieux-Cantwell Amendment.


    Friday, May 14, 2010

    NASAA Joins State Banking and Insurance Regulators in Calling for Non-Voting FSOC Membership

    The North American Securities Administrators Association (NASAA) has joined the National Association of Insurance Commissioners and the Conference of State Bank Supervisors in calling for non-voting membership for state banking, insurance, and securities regulators on the proposed Financial Stability Oversight Council (FSOC). In a joint letter yesterday to Senators Patty Murray (D-WA) and Susan Collins (R-ME), the organizations thanked the lawmakers for their efforts in sponsoring amendments that would provide representation for state regulators on the FSOC that would be established under Section 111 of the Restoring American Financial Stability Act of 2010 (S. 3217).

    The organizations said that including state regulators on the FSOC is both necessary and appropriate because "[s]tate banking, insurance, and securities regulators are on the front lines of financial regulation and bring information and perspectives that are necessary components of an effective regulatory structure." "By including state regulators in the FSOC, your amendments create a more comprehensive and efficient approach that will benefit from access to all relevant information regarding the accumulation of risk in our financial system," the organizations stated.


    Thursday, May 13, 2010

    Franken Amendment Approved Directing SEC to Set Up SRO to Assign Credit Ratings on Rotating Basis

    The Senate approved an amendment to the financial reform bill that seeks to end the conflicts of interest in the prevalent issuer pays model of credit rating agencies. Sponsored by Senator Al Franken, the amendment creates a board overseen by the SEC that will assign credit rating agencies to provide initial ratings on a rotating basis in order to eliminate inherent conflicts of interest. Currently, firms choose which credit rating agencies will rate the quality of their securities and other financial products.

    The SEC will create a Credit Rating Agency Board, a self-regulatory organization, tasked with developing a system in which the Board assigns a rating agency to provide a product’s initial rating. Requiring an initial credit rating by an agency not of the issuer’s choosing will put a check on the accuracy of ratings, in the Senator’s view. The amendment does not prohibit an issuer from then seeking a second or third or fourth rating from an agency of their choosing

    The amendment leaves flexibility to the Board to determine the assignment process. Thus, the Board gets to design the assignment process it sees fit, which can be random or based on a formula, just as long as the issuer doesn’t get to choose.The Board will select a subset of credit rating agencies to be eligible for the assignment pool. The Board will be required to monitor the performance of the agencies in the pool. If the Board so chooses, it can reward good performance with more rating assignments. It can recognize poor performance with fewer rating assignments. If the rater is bad enough, that might even be zero assignments.

    The rotating system of assigning credit ratings is designed to reduce forum shopping and, in the Senator’s opinion, gets to the root of the conflict of interest problem with rating agencies. By allowing an SRO to assign more work to rating agencies that produce accurate ratings, he reasoned, will allow the market to reward accuracy and increase true competition and enhance faith in the rating process. Cong. Record, May 10, 2010, S3465.


    Wednesday, May 12, 2010

    President Urges No Carve Out for Auto Dealer Lenders as Senate Approves Snowe-Landrieu Amendment

    President Obama said that there should be no carve out for auto dealers-lenders from the consumer financial protection provisions of the Senate reform bill. Auto dealer-lenders make nearly 80 percent of the automobile loans and should be subject to the same standards as any local or community bank that provides loans. Michael Barr, Treasury Assistant Secretary for Financial Institutions, said that many of these auto loans were originated and then securitized. Mr. Barr noted that companies that originate loans for the purpose of selling them off to Wall Street, such as auto dealer-lenders, often have skewed incentives. For example, Wall Street pays dealer-lenders more to bring in loans with higher interest rates than the borrower qualifies for. This encourages dealer-lenders to inflate rates and pack loans with expensive and unnecessary add-ons, while using deceptive tactics to make customers think they’re getting a good deal.

    At the same time, the Treasury official endorsed the Snowe-Landrieu amendment, which he said makes clear once and for all that the Senate bill does not apply to small businesses, such as florists, that simply extend credit to facilitate sales of nonfinancial goods or services to their customers and keep the credit on their own accounts. These types of companies are not significantly engaged in providing financial goods and services within the meaning of the legislation, said Mr. Barr.

    The Senate approved the Snowe-Landrieu amendment by a voice vote. The amendment clarifies that the new Consumer Financial Protection Bureau cannot regulate small businesses if they meet a three prong test. Specifically, the amendment exempts a business from CFPB regulation if it sells non-financial products, does not securitize its consumer debt, and falls within the North American Industry Classification System (NAICS) code’s definition of a small business. NAICS codes are used by the Small Business Administration to determine whether or not a business is considered a small business and are commonly used by small businesses when filling out their tax forms.

    New businesses would also be exempt from the CFPB so long as a reasonable determination could be made that the business would fall within the NAICS code guidelines during its first year in existence and comply with the first two prongs of the test discussed above. In addition, businesses that fall under this safe harbor are specifically exempted from Section 1042(a) which allows state Attorneys General to bring lawsuits to enforce the provisions in this bill.

    Oregon Proposes Fee Increases for UITs, BDs and Salespersons

    The following fee increases were proposed by the Oregon Division of Finance and Corporate Securities:

    * Unit Investment Trusts: Initial and Renewal Notice Filing Fee Per Portfolio, $500 (from $350)

    * Broker-Dealers: Renewal License Fee, $250 (from $200)

    * Broker-Dealer Salespersons: Initial License Fee, $55 (from $50)

    In addition, state investment advisers would apply for licensing through the Investment Adviser Registration Depository (IARD).

    For more information about the proposed rules, please contact the rules coordinator, Shelley Greiner at (503) 947-7484.

    Tuesday, May 11, 2010

    Cardin-Grassley Amendment Extends Whistleblower Protections to NRSRO Employees

    The Senate has approved an amendment to the financial reform package extending whistleblower protection to employees of credit rating agencies. The Cardin-Grassley Amendment adds whistleblower protections to employees of nationally recognized statistical rating organizations, NRSROs, which issue credit ratings that the SEC permits other financial firms to use for certain regulatory purposes. There are 10 NRSROs at present, including some privately held firms. The NRSROs played a large role in the financial crisis by o verestimating the safety of residential mortgage-backed securities and collateralized debt obligations and then by marking tardy but massive simultaneous downgrades of these securities, thereby contributing to the collapse of the subprime secondary market and the fire sale of assets, exacerbating the financial crisis. Remarks of Senator Cardin, Cong. Record, May 6, 2010, S3349.

    According to Senator Dodd, extending whistleblower protection to employees at rating agencies complements provisions in the bill that make rating agencies more transparent, accountable, and accurate. It will also help increase the SEC’s regulatory performance, and reduce investors’ reliance on ratings issued by nationally recognized statistical rating organizations. Cong. Record, May 6, 2010, S3349.

    Reed Amendment Would Impose SEC Registration on Advisers to Private Equity and Venture Capital Funds, in Addition to Hedge Fund Advisers

    An amendment to the Senate financial reform legislation would extend mandatory SEC registration to advisers to private equity funds and venture capital funds. Currently, S3217 requires hedge fund advisers to register with the SEC, and exempts adviser to private equity and venture capital firms. The House financial reform legislation requires registration of hedge fund and private equity fund advisers, while exempting advisers to venture capital funds.

    The amendment is sponsored by Senator Jack Reed, Chair of the Senate Securities Subcommittee. In order to ensure that the new adviser registration threshold does not weaken existing oversight, the Reed Amendment would require advisers that fall below the new $100 million adviser registration threshold set by S3217 to either be registered and examined by a state regulator, or registered with the SEC.

    Senior members of the Senate Banking Committee co-sponsored the Reed Amendment out of a concern that advisers who today are managing hedge funds could tomorrow be operating a private equity or venture capital fund in order to avoid registration. The members believe that it is important to require registration by hedge funds, private equity and venture capital to collect the best data on these firms, fill regulatory gaps and prevent regulatory arbitrage.

    Senate Approves Amendment to Financial Reform Bill to Combat Manipulation in Derivatives Markets

    On May 6, 2010, the Senate approved an amendment to the financial reform bill, S3217, authored by Senator Maria Cantwell (D-WA) designed to strengthen enforcement powers over commodity and derivatives trading. The amendment authorizes the CFTC to go after manipulation and attempted manipulation in the swaps and commodities markets. It makes it unlawful to manipulate or attempt to manipulate the price of a swap or commodity using any manipulative device or contrivance. According to Sen. Cantwell, current law makes it very difficult for the CFTC to prove that someone had specific intent to manipulate, and that is a very difficult standard to prove. Most individuals don’t write an e-mail, for example, saying they intend to manipulated prices, but that is currently what the law requires the CFTC to prove, specific intent to manipulate. As a result of this, the federal courts have recognized that with the CFTC’s weaker anti-manipulation standard, market manipulation cases generally have not fared so well. In fact, the law is so weak that in the CFTC’s 35-year history, it has only had one successfully prosecuted case of market manipulation. Cong, Record, May 6, 2010, S3348.

    The language in the Cantwell Amendment is patterned after the law that the SEC uses to go after fraud and manipulation; that there can be no manipulative devices or contrivances. It is a strong and clear legal standard that allows regulators to successfully go after reckless and manipulative behavior. The amendment tracks the Securities Act in part because federal case law is clear that when the Congress uses language identical to that used in another statute, Congress intended for the courts and the Commission to interpret the new authority in a similar manner, and Congress has made sure that its intention is clear.

    In the 75 years since the enactment of the Securities and Exchange Act, a substantial body of case law has developed around the words manipulative or deceptive devices or contrivances. Speaking in support of the Cantwell Amendment, Senator Blanche Lincoln, Chair of the Agriculture Committee, noted that market manipulation is an ever present danger in derivatives trading. Derivatives are leveraged transactions, she said, and there are numerous opportunities for traders to abuse their positions in order to game the market to their advantage.

    The Dodd-Lincoln derivative title to S3217 strengthens existing law to target specific market abuses that have arisen in recent years. These abuses are outlawed as disruptive practices in section 747 of the legislation. The Cantwell Amendment takes the significant step of adding a new and versatile standard for deceptive and manipulative practices under the Commodity Exchange Act. It addresses false reporting and authorizes private rights of action that will aid the CFTC in its enforcement effort. Cong, Record, May 6, 2010, S3349.
    New Mexico Proposes Late Fees for Rule 506 Issuers

    Issuers intending to offer and sell securities under Rule 506 of federal Regulation D that file their notice on Form D within 10 days after the due date must pay a late fee of $700. Issuers filing their notice more than 10 days after the due date must pay a late fee of $1,050.

    Written Comments. Interested persons may submit written comments about the proposed rule amendment to Marianne Woodard, Attorney, Securities Division, New Mexico Regulation and Licensing Department, 2550 Cerillos Rd., Toney Anaya Bldg, Third Floor, Santa Fe, New Mexico 87505. Alternatively, comments may be faxed to (505) 984-0617. Comments must be received by the Securities Division by 5 p.m. on June 14, 2010.

    Please see


    Monday, May 10, 2010

    Investor Groups Oppose Legislative Accounting Standards in Senate Reform Bill

    In a letter to Senate leadership, investors groups opposed any effort to legislate accounting standards in the financial reform bill, S 3217, that is moving through the Senate. . 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 said that the accounting standards underlying company financial statements filed with the SEC derive their legitimacy from the confidence that they are set based on independent, objective
    considerations focusing on the needs of investors, who are the primary users of financial statements.

    In order for investors and other users of company financials to maintain this confidence, continued the investor advocates, the process by which accounting standards are developed must be free, both in fact and appearance, of outside influences that inappropriately benefit any particular participant in the financial reporting system to the detriment of investors. In the view of the groups, which included the AICPA., political influences that dictate one particular outcome for an accounting standard without the benefit of a procedure that considers the views of investors and other stakeholders would have adverse impacts on investor confidence and the quality of financial reporting.

    In the letter, the groups expressed particular concern with an amendment to S 3217 that would require the SEC or a standard setter selected by the SEC (presumably FASB) to adopt a standard mandating that SEC reporting companies record all assets and liabilities on their balance sheets. The amendment, SA 3853, sponsored by Senator Sherrod Brown, would require the adopted accounting standard to include that the recorded amount of assets reflects the company’s reasonable assessment of the most likely outcomes of the amount of assets and liabilities and also any financing of assets above a minimal level.

    The standard would allow a company to exclude a liability from its balance sheet if it can not determine its amount. But the use of the exclusion is conditioned on the company disclosing the nature of the liability and why it was incurred and the most likely loss, as well as the maximum loss, which could be incurred from the liability. The standard must also condition the exclusion on the disclosure of persons who have recourse against the company with regard to the liability and whether the company has any continuing involvement with an asset financed by the liability or any beneficial interest in the liability.