Friday, July 30, 2010

SEC Staff Clarifies Dodd-Frank Change to Accredited Investor Test

Under Section 413(a) of the Dodd-Frank Act, the net worth standard for an accredited investor, as set forth in Securities Act Rules 215 and 501(a)(5), is adjusted to delete from the calculation of net worth the value of the primary residence” of the investor. Section 413(a) of the Dodd-Frank Act does not define the term value, nor does it address the treatment of mortgage and other indebtedness secured by the residence for purposes of the net worth calculation. As required by Section 413(a), the SEC will issue amendments to its rules to conform them to the adjustment to the accredited investor net worth standard made by the Act.

However, Section 413(a) provides that the adjustment is effective upon enactment of the Act. The SEC staff advised that, when determining net worth for purposes of Securities Act Rules 215 and 501(a)(5), the value of the person’s primary residence must be excluded. Pending implementation of the changes to the SEC’s rules, the staff advised that the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth. Division of Corporation Finance, Compliance and Disclosure Interpretations, Question 179.01.

IMF Praises Dodd-Frank But Laments Failure to Streamline Regulation

While praising the overall financial reforms achieved by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the IMF lamented the Act’s failure to consolidate US financial regulation. Although the Act did eliminate the Office of Thrift Supervision, it left intact the OCC, FDIC, and the Fed with significant and overlapping oversight responsibilities. In a first report on the Dodd-Frank legislation, the IMF also noted that, since the SEC and CFTC have similar and converging market oversight and conduct-of-business missions, a merger of the two agencies would have properly addressed the seeming artificiality of the present separation between securities and futures oversight, as well as end the complexities of reporting to two separate Congressional oversight committees which, in the IMF’s view, has led to inefficiencies and jurisdictional disputes.

Several systemic financial intermediaries are classified as both SEC-registered securities broker-dealers and CFTC-registered futures commission merchants, subject to overlapping rules. The Dodd–Frank Act introduces yet another designation, the major swaps participant, with securities swaps and commodities swaps to fall under SEC and CFTC jurisdiction, respectively.

In the IMF’s view, there remains a good case for defining one banking agency with safety-and-soundness responsibility for national banks, federal thrifts, state member banks, state nonmember banks, and state thrifts, in the latter cases serving as joint primary supervisor along with the applicable state regulators. This would free the Fed to focus on monetary policy, macro financial oversight, and consolidated regulation
and supervision, and the FDIC on insurance and resolution.

The recommendation was contingent upon the Fed gaining separate oversight authorities over systemically important payment, clearing, and settlement systems, including those chartered as state member banks. The team also felt, on balance, that the Fed should retain some responsibility for the consolidated supervision of non-systemic BHCs, even as broad back-up supervisory authorities spanning all insured banks and thrifts would
suffice for the FDIC’s resolution planning and deposit insurance responsibilities. Several systemic financial intermediaries are classed as both SEC-registered securities

The IMF praised Congress for creating a new framework for macro prudential oversight by the new Financial Stability Oversight Council, which will identify and address systemic risks, with powers and duties to gather information, designate systemically
important nonbank financial firms for consolidated regulation and supervision by the Fed,
make broad recommendations to its member agencies, and report to Congress.

The Council will bring together the Treasury, the Fed, the SEC and essentially all financial regulators, backed by a dedicated Office of Financial Research. Bearing the financial stability mandate, the Council is authorized to demand information from any member agency or regulated or unregulated financial firm, deem any nonbank financial firm potentially systemic for enhanced regulation, deem financial market utilities and payment, clearing, or settlement activities potentially systemic, and approve the break-up of systemic financial firms deemed by the Fed to pose a grave threat to financial stability.

According to the IMF, a pre-eminent, hands-on role for the Fed backed by binding enforcement authorities is wholly appropriate given its existing expertise, broad understanding of the financial sector, and role as lender of last resort. In the IMF’s view, successful systemic risk regulation will require a more muscular approach to consolidated regulation and supervision, quite likely involving less deference to functional regulators of nonbank subsidiaries, in order to effectively identify and act upon emerging systemic risks. The FSOC will also need to define systemically risk-sensitive prudential norms for capital, leverage, and liquidity.

The new Act also vests the FSOC with responsibility to designate as systemic any payment, clearing, or settlement activity or financial market utility to be subject to heightened and uniform risk management standards, including on margin, collateral, capital, and default policies, to mitigate systemic risk.

Since the FSOC will be composed of ten voting members, noted the IMF, it is imperative that the Council achieve consensus and coordinate timely responses to emerging risks. It is also critical that data and information be timely available, which will require investment in systems and commitment to inter-agency information sharing. Council members must develop or adjust a range of regulations to focus more on systemic risk mitigation, combining automatic triggers with room for discretionary action. The IMF also emphasized that there must be accountability and a will to act on the part of all
Agencies, which should be underpinned by transparency and communication, ideally to include policies governing the release of minutes of FSOC proceedings

Actions taken by the Council, many of which are enumerated in the Dodd–Frank Act, could include penalizing size, complexity, and interconnectedness through measures such as liquidity and capital surcharges, anti-cyclical provisioning, leverage ratios, contingent capital, resolution fees, or insurance schemes; encouraging financial firms to build capital buffers in good times; tightening risk exposure limits on rapidly expanding asset classes; and limiting the impact of corporate governance and compensation policies on risk-taking.

The IMF also urged the Council to address the risks posed by the shadow banking system along the regulatory perimeter. The Council could require money market funds to make real-time disclosures of their actual, as opposed to stabilized, net asset values and subject conduits and asset-backed securities issuers to stringent disclosure, as well as restructuring the tri-party repo system to make it more resilient to stress.

The reform legislation will formalize most crisis management arrangements under the FSOC. The IMF said that this should build on the regular process for macro-prudential surveillance already envisaged for the FSOC, but will require enhanced arrangements for coordination, information sharing, and decision making in crisis. Such arrangements should be tested periodically in simulation exercises similar to those currently employed by the agencies to check the resilience of business continuity arrangements.

The IMF said that the new orderly liquidation authority for systemic financial firms created by the Dodd–Frank Act should substantially fortify the U.S. resolution toolkit, although it deemed unfortunate the decision to drop a pre-funded special resolution fund. But application of the new authority swill not be easy, cautioned the IMF, since the crisis illustrated the speed with which large firms can lose access to wholesale funding and the pace at which difficult rescue operations need to be formulated. Moreover, contagion risks may require that short-term funding in repo and securities lending would need to be honored and the close-out of foreign exchange and derivative contracts avoided.

Under the new systemic resolution authority, repos, forwards, swaps and other similar transactions are defined as qualified financial contracts. The FDIC must decide within a day of intervening whether to transfer these contracts to another solvent entity, such as a bridge bank, or to leave them in the failed firm subject to termination and close out.

Moreover, although the special resolution mechanism breaks new ground, cross-border issues in the event of the future failure of a systemic international group will remain a challenge.

Thursday, July 29, 2010

Indiana Adopts Rules Coordinating with Indiana Securities Act

Proposed rule amendments, repeals and new rules coordinating with the Indiana Securities Act that took effect July 1, 2008 were adopted by the Indiana Securities Division, effective July 28, 2010. The new rules and existing rule changes pertain to federal covered securities, exemptions, registrations of securities, broker-dealers, agents, investment advisers, investment adviser representatives and administrative hearings but a substantial portion of the existing rule text remains unchanged. Instead, most of the amendments are nonsubstantive, updating numerical section references to conform to the Indiana Securities Act, providing the official citations to federal securities acts such as the Securities Exchange Act of 1934 and the Investment Company Act of 1940, changing NASD references to FINRA, removing or replacing the word "said" and "such" with "the" and "these" as appropriate, and making certain provisions applicable to both "he" and "she" or "his" and "her."

For additional information please see The contact person for the rules is Jeff Bush, Chief Deputy Commissioner at (317) 232-6681 or

Wednesday, July 28, 2010

UK Financial Services Secretary Wants Non-Protectionist EU Hedge Fund Legislation

The new Financial Services Secretary reaffirmed the UK position that the pending EU legislation on hedge funds and private equity funds must be proportionate, workable and non-discriminatory. In remarks at a London private equity event, Mark Hoban said that the final legislation must ensure that European and international measures support the government’s private equity initiatives and encourage capital to flow into the UK. He emphasized London’s pivotal role as the leading center for private equity in Europe.

The activities of hedge funds and other private equity funds are currently regulated by a combination of national regulations and general provisions of EU law, supplemented in some areas by industry standards. The global financial crisis showed that uncoordinated national responses to the risks to which the funds were exposed made the efficient management of these risks difficult.

Thus, there is now pending a proposed Directive on Alternative Investment Fund Managers in order to produce harmonized EU hedge fund legislation. The most controversial issues still to be resolved under the Directive center on the rules for non-EU hedge funds and hedge fund managers, the third country rules. The Minister said that it is important to attain a workable third country passport without closing the EU to managers who cannot attain this passport. It is also important that the legislation not limit investor choice and access, and maintain national regimes that operate in parallel alongside any passporting regime. Mr. Hoban said that EU private equity should not be at a competitive disadvantage to funds from other jurisdictions and that requirements should apply proportionately to the size of the business.

The UK has supported the concept of the marketing passport since it was originally proposed by the European Commission last year. UK officials have opposed an outright ban on non-EU funds and managers who can not obtain the passport, however, since this would restrict the access of European investors to valuable, open and successful markets.

The hedge fund legislation will be a priority in September, said the Minister, who noted that he has raised the UK’s concerns with EU Commissioner for the Internal Market Michel Barnier and Members of the European Parliament. Commissioner Barnier has acknowledged the G-20’s call to build a globally consistent regulatory framework for financial services. Commissioner Barnier has also reaffirmed in a letter to Treasury Secretary Tim Geithner that he would oppose any discriminatory outcome arising from the proposed Directive.

In an earlier letter to Commissioner Barnier, Secretary Geithner expressed concern over provisions in the proposed Alternative Investment Funds Management Directive that would discriminate against US hedge funds and deny them the access to the EU market that they currently enjoy. He urged the EU to ensure that non-EU fund managers have the same access to their EU counterparts. More broadly, he said that it was essential to fulfill the G-20’s commitment to avoid discrimination and maintain a level playing field in regulating the alternative investment fund management industry. The Secretary said that the US hedge fund regulatory regime embodied in the financial reform legislation signed by the President will give equal treatment to all funds and advisers operating in the US regardless of their country of origin. He thus urged that the AIFM Directive allow US and other third country funds and fund managers the opportunity to access the EU single market through a passport approach.

German Legislation Bans Naked Short Selling and Naked Credit Derivatives

German legislation that took effect July 27, 2010 prohibits naked short-selling transactions in shares and certain debt securities as well as naked credit derivatives. The Act on the Prevention of Improper Securities and Derivatives Transactions (Gesetz zur Vorbeugung gegen missbräuchliche Wertpapier und Derivategeschäfte) would exempt from the ban investment services enterprises engaging in such transactions as market makers, lead brokers, or designated sponsors. But, while exempt from the legislative prohibition, the investment services enterprises would still be are required to report these short selling and derivatives activities to BaFin, providing details of all financial instruments concerned. BaFin will soon adopt regulations detailing this reporting requirement. Until then, notifications pursuant to section 30h (2) and section 30j (3) of the Securities Trading Act (Wertpapierhandelsgesetz - WpHG) must be submitted and signed, dated and sent to BaFin by fax.

In addition to information regarding the notifying party, the contact person the position, and the financial instruments concerned must be specified. Further, the financial instruments must be specified in category, such as shares, debt securities and credit derivatives. In the case of shares and debt securities, the date on which the activity in a certain financial instrument is taken up must be stated. In the case of credit derivatives, the respective reference liability must also be specified in addition to the type of the credit derivative and the date on which the activity in a certain financial instrument is taken up. In addition, an electronic version of the list of the financial instruments concerned must be sent to BaFin.

Any changes in the disclosed information must be reported to BaFin at the end of each quarter. Any changes that might occur during the quarter do not need to be reported to BaFin in detail at the time of their occurrence, with a notification of change at the end of the quarter being deemed sufficient. The notification of change must specify on which date the activity has been taken up for a further financial instrument. If no changes have occurred from the previous quarter, a notification of holdings must be submitted.

The recently passed Dodd-Frank Wall Street Reform and Consumer Protection Act, while it placed OTC derivatives under federal regulation, stopped short of an outright ban on naked credit default swaps. A Senate floor amendment to the bill sponsored by Senator Byron Dorgan that would have banned the use of synthetic asset-backed securities and naked credit default swaps in which no one had an insurable interest was tabled and effectively killed.

In light of the prohibitions in the Act on the Prevention of Improper Securities and Derivatives Transactions, BaFin revoked its earlier decrees banning short-selling transactions in certain shares, naked short-selling transactions in debt securities issued by EU Member States whose legal currency is the euro, as well as credit default swaps to the extent that at least one reference liability is a liability of a euro zone country and to the extent that they do not serve as hedging instruments against credit default risks.

However, BaFin noted that earlier FAQs regarding the prohibitory regulations contained in the revoked General Decrees may be used to a large extent when interpreting the provisions of the Act on the Prevention of Improper Securities and Derivatives Transactions. For example, the FAQs define a naked credit default swap as one in which, based on an economic view, a no more than insignificant reduction of the credit risk is achieved for the protection buyer. Also, the ban also applies if such credit default swaps are embedded in other instruments, such as credit-linked notes or total return swaps.

Importantly, the FAQs also indicate that the ban relates only to transactions that have actually been concluded in Germany. The place where the transactions are recorded, however, does not matter. Also, follow-up activities of the concluded transaction, such as the exchange of confirmations, as a rule are not covered. The FAQs also explain that the decree only prohibited transactions in the specified shares that are not backed by securities lending. In other words, only naked short selling transactions are affected. Apparently dovetailing with the legislation, the FAQs state that market makers are not concerned by the ban within the scope of their activities undertaken by contract to perform binding buy and sell orders; and this applies both to stock exchanges and to futures exchanges.

Tuesday, July 27, 2010

Government Proposes Historic Overhaul of UK Financial Regulation Architecture

The new UK Government has unveiled a legislative proposal to end the current financial regulatory regime centered on the unitary Financial Services Authority and erect a new regulatory architecture of macro and prudential regulation revolving around the central bank alongside a new market regulation authority. A new Financial Policy Committee would be established in the Bank of England with the duty to consider the macro-economic and financial issues that may threaten financial stability. The Bank of England will have responsibility for the regulation of settlement systems and central counterparty clearing houses to sit alongside its existing responsibilities for payment system oversight. A new Prudential Regulation Authority would be established as a subsidiary of the Bank of England with the Deputy Governor for prudential regulation serving as chief executive of the Authority, which will oversee deposit-taking institutions, insurers, broker-dealers, and investment banks.

A new Consumer Protection and Markets Authority (CPMA) would have responsibility for consumer protection in financial services and for regulating conduct in financial services. A CPMA markets division will lead on market conduct regulation. The CPMA will also be responsible for the regulation of all firms not regulated by the Authority, including most investment firms, investment exchanges and providers of trading facilities.

The Government is also considering whether the UK Listing Authority (UKLA) should be merged with the Financial Reporting Council or whether it should remain within the CPMA markets division.

In the Government’s view, the current system failed in a number of ways during the financial crisis because it places responsibility for all financial regulation in the hands of a single, monolithic financial regulator, the Financial Services Authority, which is expected to deal with issues ranging from the safety and soundness of the largest global investment banks to the customer practices of the smallest financial adviser. Perhaps the most obvious failing of the UK system, however, is the fact that no single institution has the authority to monitor the system as a whole, identify potentially destabilizing trends, and respond to them with concerted action.

The Financial Policy Committee will have primary statutory responsibility for maintaining financial stability and will be given the tools to ensure that systemic risks to financial stability are dealt with. The Committee will monitor the financial stability of the UK’s financial system, identifying emerging risks and vulnerabilities, and cyclical imbalances. The Committee will receive such tools as leverage limits and capital requirements, as well as a loss provisioning tool. The FPC will be chaired by the Governor of the Bank of England and will include the existing Deputy Governors for monetary policy and financial stability and the newly created Deputy Governor for prudential regulation, as well as external members.

The Prudential Regulation Authority will have rulemaking and enforcement authority over the firms it regulates. It will also be authorized to exercise judgments about the safety and soundness of financial firms and take appropriate action. The core regulatory function of the Authority will be to adopt rules governing the performance of regulated activities by financial firms.

The regulatory architecture must ensure that macro-prudential regulation of the financial system is coordinated effectively with the prudential regulation of individual firms. To this end, the legislation will create two prudential regulators, the Prudential Regulation Authority will be responsible for the regulation of all deposit-taking institutions, insurers and investment banks, and will be housed in the central bank, while the Consumer Protection and Markets Authority (CPMA) will have primary responsibility for financial services and markets.

In its consumer-focused role, the CPMA will take on all the FSA’s responsibilities for conduct of business regulation and supervision of all firms. A markets division within the CPMA will regulate all aspects of the conduct of participants in wholesale markets, as well as various elements of market infrastructure such as investment exchanges. The CPMA will be governed by a board with a majority of non-executives, appointed by the Treasury.

Louisiana Sets Forth Schedule for Inspecting BD and IA Firms

Broker-dealers and state-registered investment advisers doing business in Louisiana will be subject to inspections by the Office of Financial Institutions. Broker-dealers and state-registered investment advisers domiciled in Louisiana will receive their initial visit from the Office no later than one month after the firm’s registration effective date to review policies and procedures and ensure proper commencement of the firm’s business. Subsequent inspection dates are specified. Broker-dealers and state-registered investment advisers not domiciled in Louisiana may be inspected at any time if consumer complaints are filed with the Office or other information indicates potential problems. The findings of these inspections will be shared with the firm’s home state securities administrator.

For further information, please see

Hong Kong Legislation Provides for Electronic Company Filings and Expanded Derivative Actions

Legislation recently passed by the Hong Kong Legislative Council allows for the electronic filing of company registration statements and other corporate documents. Similarly, the legislation authorizes Hong Kong companies to make use of electronic means, including company websites, to communicate with their shareholders.

Professor KC Chan, the Financial Services Secretary, said that the new system should come on stream in phases early next year. Hong Kong will amend its Companies Ordinance to facilitate on-line applications for company registration, for example, to allow the signing of the incorporation forms using passwords, streamline the attestation requirements for signatures by founder members, and facilitate the issuance of certificates of incorporation through electronic means. The Secretary said that the new electronic filing regime will put Hong Kong on a par with comparable jurisdictions like the UK and Singapore.

The legislation also expands the statutory derivative action to cover multiple derivative actions. Under the legislation, a member of a related company of a specified corporation can commence or intervene in proceedings on behalf of the corporation. The changes will further enhance the protection of the interests of minority shareholders in a group of companies.

The legislation also strengthens Hong Kong's company name registration system to enhance enforcement against possible abuses by shadow companies, which are
companies incorporated in Hong Kong with names very similar to existing and
established trademarks or trade names and often pose as representatives of the
owners of such trademarks or trade names to produce counterfeit products. The Act empowers the authorities to act pursuant to court order to direct a shadow company to change its name.

Monday, July 26, 2010

SEC Responds Quickly to Concerns Over Dodd-Frank Nullification of Securities Act Rule 436(g)

Effective July 22, 2010, Section 939G of the Dodd-Frank Act provides that Securities Act Rule 436(g) will have no force or effect, which effectively removes the ``expert’’ exemption for credit ratings included in a registration statement, As a result, disclosure of a rating in a registration statement requires inclusion of the consent by the rating agency to be named as an expert. Issuers must now obtain credit rating agency's experts consent for use in filings, as is the case with other experts. The NRSROs have indicated that they are not willing to provide their consent at this time.

In order to facilitate a transition for issuers of asset-backed securities, an SEC no-action letter provides that the Division of Corporation Finance will not object if an asset-backed securities issuer as defined in Item 1101 of Regulation AB omits the ratings disclosure required by Item 1103(a)(9) and 1120 of Regulation AB from a prospectus that is part of a registration statement relating to an offering of asset-backed securities. This no-action position will expire with respect to any registered offerings of asset-backed securities commencing with an initial bona fide offer on or after January 24, 2011. (Ford Motor Credit Company LLC, July 22, 2010).

Items 1103(a)(9) and 1120 of Regulation AB require disclosure of whether an issuance or sale of any class of offered asset-backed securities is conditioned on the assignment of a rating by one or more rating agencies. If so conditioned, those items require disclosure about the minimum credit rating that must be assigned and the identity of each rating agency. Item 1120 also requires a description of any arrangements to have such ratings monitored while the asset-backed securities are outstanding.

According to Meredith Cross, Director of the Division of Corporation Finance, this no action letter allows issuers for a period of six months to omit credit ratings from registration statements filed under Regulation AB. Although there are currently few issuers in the registered asset-backed securities market, she noted, some issuers cannot currently obtain credit rating agency consent to include the credit ratings in these Regulation AB filings. This action will provide issuers, rating agencies and other market participants with a transition period in order to implement changes to comply with the new statutory requirement while still conducting registered ABS offerings.

The Securities Industry and Financial Markets Association (SIFMA) applauded the SEC for its timely recognition of the unintended effect that the interaction of Section 939G with Regulation AB has had on the public asset-backed securities markets. SIFMA said that the no-action letter will allow issuers, credit rating agencies and other market participants to conduct registered ABS offerings, avoiding the potential for negative impact on the availability of financing.
SIFMA has expressed deep concern that this provision of Dodd-Frank has created a roadblock to the issuance of any deals in these markets due to the interaction of provisions of Regulation AB and the refusal of the major rating agencies to consent to the inclusion of their ratings in transaction documents. The alternative for issuers would be to only place deals into the private market, which decreases transparency to both market participants and regulators.

The Division of Corporation Finance staff has also responded with a series of Compliance and Disclosure Interpretations. Presaging these interpretations, The Corp Fin Director assured that the current rules for corporate debt issuances differ in this respect and that the Commission believes that the corporate debt market has not been, and should not under current rules be, meaningfully affected by the statutory change that nullified Rule 436(g).

The Corp Fin staff said that, for companies not subject to Regulation AB disclosure rules, a consent by a credit rating agency would be required if the company includes the credit rating in its registration statement or Section 10(a) prospectus either directly or through incorporation by reference. However, if the disclosure of a credit rating in an SEC filing relates only to changes to a credit rating, the liquidity of the registrant, the cost of funds for a registrant or the terms of agreements that refer to credit ratings (issuer disclosure-related ratings information), then a consent by the credit rating agency would not be required. For example, some companies note their ratings in the context of a risk factor discussion regarding the risk of failure to maintain a certain rating and the potential impact a change in credit rating would have on the company. A company also may refer to, or describe, its ratings in the context of its liquidity discussion in the MD&A Companies may also need to discuss ratings when they describe debt covenants, interest or dividends that are tied to credit ratings or potential support to variable entities. (Division of Corporation Finance, Compliance and Disclosure Interpretations, Q. 233.04)

For a company not subject to Regulation AB disclosure, consent by a credit rating agency would also be required if ratings information, other than issuer disclosure-related ratings information, is included in, or incorporated by reference into, a prospectus or prospectus supplement first filed on or after July 22, 2010. (Division of Corporation Finance, Compliance and Disclosure Interpretations, Q. 233.05).

But, consent from a credit rating agency would not be required if ratings information is included in a free writing prospectus that complies with Securities Act Rule 433 or in a term sheet or press release that complies with Securities Act Rule 134. Rule 436, which requires the filing of written consents by experts, applies only to registration statements and to prospectuses. A Rule 433 free writing prospectus is not part of a registration statement, nor, as a Section 10(b) prospectus, is it included in the definition of prospectus in Securities Act Rule 405. Communications that are in compliance with Rule 134 are not prospectuses. If any of these documents are also filed as prospectuses under Rule 424, a consent would be required. (Division of Corporation Finance, Compliance and Disclosure Interpretations, Q. 233.06)

A company not subject to Regulation AB disclosure can continue to use its registration statement without filing a consent by the credit rating agency if it has a registration statement on Form S-3 or Form F-3 that was declared effective before July 22, 2010 and includes or incorporates by reference ratings information that is not limited to issuer disclosure-related ratings information. Under this scenario, the SEC staff would not object to reliance upon Rule 401(a) under the Securities Act to allow continued use of the registration statement for the limited period permitted under Rule 401(a). This would be applicable only until the next post-effective amendment to such registration statement and only if no subsequently incorporated periodic or current report contains ratings information that is not limited to issuer disclosure-related ratings information. It should be noted that the filing of the issuer’s next annual report on Forms 10-K, 20-F or 40-F is deemed to be the post-effective amendment of such registration statement for purposes of Securities Act Section 10(a)(3), so that in accordance with Rule 401(a), the registration statement could no longer be used after the annual report is filed without the filing of the consent. (Division of Corporation Finance, Compliance and Disclosure Interpretations, Q. 233.07).

A consent by a credit rating agency is required to be filed with a registration statement or post-effective amendment that becomes effective on or after July 22, 2010 and includes or incorporates by reference ratings information that is not limited to issuer disclosure-related ratings information. (Division of Corporation Finance, Compliance and Disclosure Interpretations, Q. 233.08).

Dodd-Frank Volcker Provisions Wisely Leave Details to Regulators Says UK FSA Chair

The Volcker Rule clauses of the Dodd-Frank Wall Street Reform and Consumer Protection Act wisely leave it to regulators to apply the rules in practice, noted Financial Services Authority Chair Adair Turner, because drawing a legislative distinction between proprietary trading and customer facilitation is close to impossible in a world where securitized credit will still play a significant role. In remarks at a recent London seminar on the future of finance, the FSA He said that a key lever regulators should use in applying the Volcker provisions is appropriate capital requirements for trading activity in order to prevent banks holding credit securities in trading books with the inadequate capital support allowed before the crisis. The Volcker provisions of Dodd-Frank prohibit high risk proprietary trading at banks, limit the systemic risk of such activities at non-bank financial companies, and prohibit material conflicts of interest in asset-backed securitizations.

The FSA Chair cautioned that, even if proprietary trading of credit securities was largely conducted by institutions separate from commercial banks, important and potentially destabilizing interactions could still exist between maturity transforming banks and credit securities trading. A credit supply and real estate price boom could be driven by the combination of commercial banks originating and distributing credit and non-banks buying and trading it, he said, with the two together generating a self-referential cycle of optimistic credit assessment and loan pricing, even if the functions were performed by separate institutions.

The essential challenge, which remains unchanged post-Dodd-Frank, is that the tranching and maturity transformation functions which banks perform do deliver economic benefit, and that if they are not delivered by banks customer demand for these functions will seek fulfillment in other forms. Regulators must find safer ways of meeting these demands and constraining the satisfaction of the demands to safe levels, he emphasized, but cannot abolish these demands entirely.

Securitization may never return to pre-crisis levels, said the Chair, but the benefits of securitization virtually assure its continuance post-reform. Ideally, securitization should result in assets being held by end investors rather than by leveraged bank intermediaries. It should also remove the contractual maturity transformation of bank balance sheets, substituting instead liquidity through marketability.

These benefits of securitization were never actually delivered, said Chairman Turner, because, when the music stopped in 2008, a large share of credit securities turned out to be held on the trading books of banks that had originated and distributed credit with one hand then bought back other banks’ credit securities with the other hand. In his view, they were encouraged to so by utterly inadequate capital requirements against trading assets. Moreover, the shadow bank maturity transformation process, with conduits and mutual funds holding long-term assets against short-term liabilities and relying on market liquidity to allow sales to meet redemptions, turned out to be as risky as the contractual on balance sheet variety.

In the Chair’s view, these specific faults in the system can be addressed by better regulation. Higher capital and liquidity standards, applicable throughout the cycle, will themselves create a financial system less vulnerable to shocks. Moreover, the risk tranching and maturity transformation functions which banks perform do deliver value, he noted, even if the scale on which they perform them needs to be constrained.

In addition to higher capital and liquidity requirements, therefore, the regulatory response needs to involve the deployment of counter cyclical macro-prudential tools, which directly address aggregate credit supply. These could include automatic or discretionary variation of capital or liquidity requirements across the cycle, or constraints which directly address borrowers rather than lenders. Such policy levers may moreover need to be varied by broad category of credit, such as distinguishing between commercial real estate and other corporate lending, given the very different elasticity of response of different categories of credit to both interest rate and regulatory levers.

He also noted that the UK is committed to creating a new Financial Policy Committee, chaired by the Governor of the Bank of England, drawing on the analyses and insights of both central bankers and prudential regulators, and responsible for considering the overall evolution of credit supply, and for taking appropriate action against excessive credit creation. He called the creation of the committee a vital response to the previous gap in the regulatory system between a central bank focused on monetary policy alone, and a regulator focused on micro rather than macro issues.

Thursday, July 22, 2010

Dodd-Boxer Colloquy Says Volcker Rule Exempts Venture Capital Investments

According to Senate Banking Chair Christopher Dodd, the purpose of the Volcker rule, which is in Section 619 of the Dodd-Frank Act, is to eliminate excessive risk taking activities by banks and their affiliates while at the same time preserving safe, sound investment activities that serve the public interest. It prohibits proprietary trading and limits bank investment in hedge funds and private equity for that reason. A colloquy between Chairman Dodd and Senator Barbara Boxer revealed that properly conducted venture capital investment will not cause the harms at which the Volcker rule is directed. (Cong. Record, July 15, 2010, S 5904-5905).

Section 619 explicitly exempts small business investment companies from the rule, and because these companies often provide venture capital investment, the intent of the rule is not to harm venture capital investment. In the event that properly conducted venture capital investment is excessively restricted by the provisions of Section 619, Chairman Dodd expects the appropriate federal regulators to exempt it using their authority under section 619(J).

Senator Box noted the crucial and unique role that venture capital plays in spurring innovation, creating jobs and growing companies. She said that it is not the intent of Congress that the Volcker rule should cut off sources of capital for technology startups, particularly in this difficult economy.

Dodd-Lincoln Colloquy Clarifies Scope of Family Office Exemption from Advisers Act

Section 409 of the Dodd-Frank Act excludes family offices from the definition of investment adviser under the Investment Advisers Act. The SEC is directed to define the term family offices and provide exemptions that recognize the range of organizational, management, and employment structures and arrangement employed by family offices. For many decades, family offices have managed money for members of individual families, and they do not pose systemic risk or any other regulatory issues. The SEC has provided exemptive relief to some family offices in the past, but many family offices have simply relied on the under15 clients exception to the Investment Advisers Act. In a colloquy with Senator Blanche Lincoln, Senate Banking Committee Chair Christopher Dodd confirmed that when Dodd-Frank eliminated the 15 clients exception, it was not the intent of Congress to include family offices in the legislation. (Cong.
Record, July 15, 2010, p. S5904).

Further, it is the desire of Chairman Dodd that the SEC write rules to exempt certain family offices already in operation from the definition of investment adviser, regardless of whether they had previously received an SEC exemptive order. Congress intends that the rule would exempt family offices, provided that they operated in a manner consistent with the previous exemptive policy of the Commission as reflected in exemptive orders for family offices in effect on the date of enactment of the Dodd-Frank Act; reflect a recognition of the range of organizational, management and employment structures and arrangements employed by family offices; and not exclude any person who was not registered or required to be registered under the Advisers Act from the definition of the term family office solely because such person provides investment advice to natural persons who, at the time of their applicable investment, are officers, directors or employees of the family office who have previously invested with the family office and are accredited investors, any company owned exclusively by such officers, directors or employees or their successors-in-interest and controlled by the family office, or any other natural persons who identify investment opportunities to the family office and invest in such transactions on substantially the same terms as the family office invests, but do not invest in other funds advised by the family office, and whose assets to which the family office provides investment advice represent, in the aggregate, not more than 5 percent of the total assets as to which the family office provides investment advice.

Senators Dodd and Lincoln both agreed to make this point in a future technical corrections bill.

Lincoln-Feinstein Colloquy Reveals that CFTC Should Prohibit Event Derivatives Contracts as Against the Public Interest

In a colloquy with Senator Diane Feinstein on Section 745 of Dodd-Frank, which authorizes the CFTC to prevent the trading of derivatives contracts that are contrary to the public interest, Senator Blanche Lincoln agreed that Section 745 should be broadly construed to prevent derivatives that exist predominantly to enable gaming through event contracts, such as the Super Bowl, and serve no commercial or hedging purpose. These types of event contracts would not serve any real commercial purpose and would be contrary to the public interest.
Similarly, continued Sen. Lincoln, national security threats, such as a terrorist attack, war, or hijacking pose a real commercial risk to many businesses in America, but a futures contract that allowed people to hedge that risk would also involve betting on the likelihood of events that threaten US national security, and would be contrary to the public interest.

Firms facing financial risk posed by threats to national security may take out insurance, added Senator Feinstein, but they should not buy a derivative. A futures market is for hedging, she reasoned, it is not an insurance market.

From 1974 to 2000, the Commodity Exchange Act required the CFTC to prevent trading in futures contracts that were contrary to the public interest. But the Commodity Futures Modernization Act of 2000 stripped the CFTC of this authority. It is the intent of Congress in Dodd-Frank that the term ``public interest’’ in Section 745 should be broadly construed so that the CFTC may consider the extent to which a proposed derivative contract would be used predominantly by speculators or participants not having a commercial or hedging interest. Thus, the CFTC will have the power to determine that a contract is a gaming contract if the predominant use of the contract is speculative as opposed to a hedging or economic use. (Cong. Record, July 15, 2010).

Wednesday, July 21, 2010

President Signs Legislation Overhauling US Financial Regulation

President Obama today signed the Dodd-Frank Wall Street Reform and Consumer Protection Act, calling it the strongest consumer financial protection legislation in history. Transparency is a hallmark of the Act, he said, with ordinary investors, like seniors, being able to receive more information about the costs and risks of mutual funds and other investment products, so that they can better make financial decisions that work for them. The Act will also bring transparency to the kinds of complex, risky transactions that helped trigger the financial crisis. And shareholders will also have a greater say on the pay of CEOs and other executives, so that they can reward success instead of failure.

We all win when shareholders have more power and information, emphasized the President, and we all win when folks are rewarded based on how well they perform, not how well they evade accountability.

The Act also ensures that the American people will never again be asked to foot the bill for Wall Street’s mistakes. There will be no more taxpayer-funded bailouts. If a large financial institution should ever fail, Dodd-Frank provides for a winding down without endangering the broader economy. And there will be new rules to make clear that no firm is somehow protected because it is “too big to fail.”

Tuesday, July 20, 2010

Legislation Would Align Financial Accounting for Stock Options with Federal Tax Code

Bi-partisan legislation would align the GAAP treatment of stock options under FASB financial accounting standards with how options are treated under the Internal Revenue Code. FASB rules value stock options on their grant date, while and the Code values stock options on their exercise date, two numbers that rarely match. Bolstering the need for the legislation, data recently compiled by the IRS shows that corporations who issued stock options to their executives claimed 2008 stock option tax deductions that were collectively $52 billion larger than the expenses shown on the company books for options granted during the tax year covered by the returns.

Sponsored by Senators Carl Levin and John McCain, the Ending Excessive Corporate Deductions for Stock Options Act, S 1491, would curb excessive corporate tax deductions for stock options by requiring that the corporate tax deduction for stock option compensation be no greater than the expense shown on SEC-filed corporate financial reports. The IRS data shows that current stock option accounting and tax rules are misaligned, said Sen. Levin, leading to corporations reporting inconsistent stock option expenses on their financial books versus their tax returns, and often producing huge tax windfalls for companies that pay their executives with large stock option grants.

The legislation would require the corporate tax deduction for stock option compensation to be no greater than the stock option book expense shown on a corporation’s financial statement. It would also allow companies to deduct stock option compensation in the same year it is recorded on the company books, without waiting for the options to be exercised. It would ensure that research tax credits use the same stock option deduction when computing the wages eligible for this tax credit. At the same time, the bill would make no changes to incentive stock options under Section 422 of the federal tax code, which are often used by start-up companies and other small businesses.

Importantly, S 1491 would also eliminate the favored treatment of corporate executive stock options under section 162(m) of the Code by making executive stock option deductions part of the existing $1 million cap on corporate deductions that applies to other types of compensation paid to the top executives of public companies. In 1993, Congress enacted a $1 million cap on the compensation that a corporation can deduct from its taxes so taxpayers would not be forced to subsidize excessive executive pay. However, the cap was not applied to stock options, allowing companies to deduct any amount of stock option compensation, without limit. By not applying the $1 million cap to stock option compensation, the Code created a significant incentive for corporations to pay their executives with stock options. Indeed, it is very common for executives to have salaries of $1 million, while simultaneously receiving millions of dollars more in stock options. The sponsors of S 1491 believe that it is effectively meaningless to cap deductions for executive salary compensation but not also for stock options.

Currently, stock options are the only type of compensation where the federal tax code permits companies to claim a bigger deduction on their tax returns than the corresponding expense on their books. For all other types of compensation, such as cash and bonuses, the tax return deduction equals the book expense. The sole exception to this rule is stock options. In the case of stock options, the tax code allows companies to claim a tax deduction that can be two, three, ten or one hundred times larger than the expense shown on their books.

Public companies are required by law to follow Generally Accepted Accounting Principles, GAAP, issued by FASB, which is overseen by the SEC. For many years, GAAP allowed companies to issue stock options to employees and, unlike any other type of compensation, report a zero compensation expense on their books, so long as, on the grant date, the stock option’s exercise price equaled the market price at which the stock could be sold. Assigning a zero value to stock options that routinely produced huge amounts of executive pay provoked deep disagreements within the financial accounting community. In 1993, FASB proposed assigning a fair value to stock options on the date they are granted, using mathematical valuation tools. FASB proposed
further that companies include that amount as a compensation expense on their financial statements.

A battle over stock option expensing followed, involving the accounting profession, the
corporate community, FASB, the SEC, and Congress. In the end, after years of negotiation, FASB issued Financial Accounting Standard 123R, which was endorsed by the SEC and became mandatory for all publicly traded corporations in 2005. In essence, FAS 123R requires all companies to record a compensation expense equal to the fair value on grant date of all stock options provided to an employee in exchange for the employee’s services. The details of this accounting standard are complex, because they reflect an effort to accommodate varying viewpoints on the true cost of stock options. Companies are allowed to use a variety of mathematical models to calculate a stock option’s fair value. Option grants that vest over time are expensed over the specified period so that, for example, a stock option which vests over four years results in 25 percent of the cost being expensed each year. If a stock option grant never vests, the rule allows any previously booked expense to be recovered. On the other hand, stock options that do vest are required to be fully expensed, even if never exercised, because the compensation was actually awarded. These and other provisions of this accounting standard reflect painstaking judgments on how to show a stock option’s value.

During the years the battle raged over stock option accounting, relatively little attention was paid to the taxation of stock options. Enacted in 1969, Section 83 of Code is the key statutory provision. It essentially provides that, when an employee exercises compensatory stock options, the employee must report as income the difference between what the employee paid to exercise the options and the market value of the stock received. The corporation can then take a mirror deduction for whatever amount of income the employee realized.

Stock option accounting and federal tax regulations have evolved separately over the years and are now at odds with each other. Accounting rules require companies to expense stock options on their books on the grant date. Tax rules provide that companies deduct stock option expenses on the exercise date. Companies have to report the grant date expense to investors on their financial statements, and the exercise date expense on their tax returns. The financial statements report on all stock options granted during the year, while the tax returns report on all stock options exercised during the year. Thus, company financial statements and tax returns identify expenses for different groups of stock options, using different valuation methods, and resulting in widely divergent stock option expenses for the same year.

The legislation would bring stock option accounting and the Code into alignment so that the two would apply in a consistent manner. It would accomplish that goal by requiring the corporate stock option tax deduction to be no greater than the stock option expenses shown on the corporate books each year. The legislation would end the use of the current stock option deduction under Section 83 of the Code, which allows corporations to deduct stock option expenses when exercised in an amount equal to the income declared by the individual exercising the option and replace it with a new Section 162(q), which would require companies to deduct the stock option expenses shown on their books each year.

Finally, the legislation contains a transition rule for applying the new Section 162(q)
stock option tax deduction to existing and future stock option grants. This transition rule would make it clear that the new tax deduction would not apply to any stock option exercised prior to the date of enactment. The bill would also allow the old Section 83 deduction rules to apply to any option which was vested prior to the effective date of FAS, 123R, June 15, 2005 for most companies and exercised after the date of enactment.

For stock options that vested after the effective date of FAS 123R and were exercised after the date of enactment, the bill employs another rule. Under FAS 123R, these corporations would have had to show the appropriate stock option expense on their books, but would have been unable to take a tax deduction until the executive actually exercised the option. For these options, the bill would allow corporations to take an immediate tax deduction in the first year that the bill is in effect for all of the expenses shown on their books with respect to these options.

This catch-up deduction in the first year after enactment would enable corporations, in the following years, to begin with a clean slate so that their tax returns the next year would reflect their actual stock option book expenses for that same year. After that catch-up year, all stock option expenses incurred by a company each year would be reflected in their annual tax deductions under the new Section 162(q).

Federal Appeals Court Vacates SEC Rule on Fixed Index Annuities; Dodd-Frank Has Impact

Against the backdrop of a Dodd-Frank Act provision exempting indexed annuity products from SEC regulation, a federal appeals court has ruled that an SEC regulation on fixed index annuities, while reasonably adopted, did not take into account its effect on efficiency, competition and capital formation. In Rule 151A, the SEC took fixed indexed annuities out of the exemption for annuity contracts bestowed by Section 3(a)(8) of the Securities Act and placed them under Commission regulation. In vacating Rule 151A, a panel of the DC Circuit Court of Appeals held that the SEC’s consideration of the effect of the rule on efficiency, competition and capital formation, as required by the 1933 Act, was arbitrary and capricious. But the SEC’s decision to regulate fixed indexed annuities, and not allow them to use the Section 3(a)(8) exemption, was a reasonable interpretation of an ambiguous statute, said the panel. (American Equity Investment Life Insurance Co. v. SEC, DC Circuit Court of Appeals, No. 09-1021, July 12, 2010).

Section 929J of Dodd-Frank would essentially preempt federal securities regulation of equity indexed annuities. Senator Dan Akaka has noted that preempting fixed index annuities from SEC regulation would set a dangerous precedent that promotes the development of financial products not subject to regulation and investor protection standards. Senator Akaka said that there will be Senate hearings on the consequences of this provision. (Cong. Record, July 15, 2010, p. S5917).

A fixed index annuity is a hybrid financial product. Unlike traditional fixed annuities, the purchaser’s rate of return is not based upon a guaranteed interest rate. In fixed index annuities the insurance company credits the purchaser with a return that is based on the performance of a securities index, such as the Dow Jones Industrial Average. Depending on the performance of the securities index to which a particular annuity is tied, the return on a fixed index annuity might be much higher or lower than the guaranteed rate of return offered by a traditional fixed annuity. The SEC adopted Rule 151A in order to clarify the status under the federal securities laws of indexed annuities, under which payments to the purchaser are dependent on the performance of a securities index. The rule defines indexed annuities as not being annuity contracts under the 3(a)(8) exemption if the amounts payable by the insurer under the contract are more likely than not to exceed the amounts guaranteed under the contract.

Finding the rulemaking process defective, the appeals panel rejected as flawed the SEC’s reasoning that adopting Rule 151A would enhance competition by resolving the current uncertainty over the legal status of fixed index annuities. The panel said that the lack of clarity resulting from the uncertain legal status of a financial product is only another way of saying that there was not a regulation in place before the adoption of Rule 151a.

In the court’s view, the SEC cannot justify the adoption of a particular rule based solely on the assertion that the existence of a rule provides greater clarity to an area that remained unclear in the absence of any rule. Whatever rule the SEC chose to adopt could equally be said to make the previously unregulated market clearer than it would be without that adoption. Moreover, the fact that federal regulation of fixed index annuities would bring clarity to this area of the law is not helpful in assessing the effect that Rule 151A has on competition.

While creating a rule that resolves the uncertain legal status of fixed index annuities might be said to improve competition, said the panel, that conclusion could be asserted regardless of whether the rule deems such instruments to fall within the SEC’s regulatory reach or outside of it. Indeed, continued, the panel, the SEC would achieve a similar clarity if it declined outright to regulate fixed index annuities. The 1933 Act test does not ask for an analysis of whether any rule would have an effect on competition. Rather, it asks for an analysis of whether the specific rule the SEC adopted will promote efficiency, competition, and capital formation.. The SEC’s reasoning with respect to competition supports at most the conclusion that any SEC action in this area could promote competition, noted the court, but does not establish Rule 151A’s effect on competition.

Moreover, the SEC’s competition analysis also failed because the SEC did not make any finding on the existing level of competition in the marketplace under the state law regime. The SEC asserted that competition would increase based upon its expectation that Rule 151A would require fuller public disclosure of the terms of fixed index annuities and thereby increase price transparency. The SEC could not accurately assess any potential increase or decrease in competition, however, because it did not assess the baseline level of price transparency and information disclosure under state law.

The SEC’s analysis of the efficiency of Rule 151A was similarly arbitrary and capricious. The SEC concluded that Rule 151A would promote efficiency because the required disclosures under the rule would enable investors to make more informed investment decisions about purchasing indexed annuities. But the panel found that the SEC’s analysis was incomplete because it failed to determine whether, under the
existing regime, sufficient protections existed to enable investors to make informed investment decisions and sellers to make suitable recommendations to investors.

The SEC’s failure to analyze the efficiency of the existing state law regime rendersed arbitrary and capricious the SEC’s judgment that applying federal securities law would increase efficiency. This flawed efficiency analysis also rendered the capital formation analysis arbitrary and capricious. The SEC’s conclusion that Rule 151A would promote capital formation was based significantly on the flawed presumption that the enhanced investor protections under Rule 151A would increase market efficiency, said the court, and this analysis fell with the failure of its underlying premise.

But the court also held that the SEC’s interpretation of an ambiguous statute was based in reason. By their nature, fixed index annuities appeal to the purchaser not on the usual insurance basis of stability and security but on the prospect of growth through sound investment management. While a fixed index annuity is akin to an annuity contract with respect to its pay-in and guaranteed minimum value of purchase payment features, it is more like a security in that the index-based return of a fixed index annuity is not known until the end of a crediting cycle, as the rate is based on the actual performance of a specified securities index during that period. In fixed index annuities, as in securities, there is a variability in the potential return that results in a risk to the purchaser. By contrast, an exempt annuity contract avoids this variability by guaranteeing the interest rate ahead of time.

In the court’s view, Rule 151A is the SEC’s means of ensuring greater protection for consumers exposed to greater risk when insurers are exposed to less risk than normal. Indeed, the rule sets forth a test to distinguish between those contracts where the insurer bears more risk by paying a fixed amount, and those in which purchasers bear more risk because they will receive a variable amount that is dependent upon fluctuating stock market prices. The panel concluded that such an approach in light of this risk assessment was reasonable.

Monday, July 19, 2010

Senator Reed Will Fight to Place Gustafson Fix in Future Legislation

Senator Jack Reed has vowed to continue to try in future legislation to correct the investor protection problem associated with the US Supreme Court ruling in Gustafson v. Alloyd, 513 US 561 (1995), where the Court held that Section 12(2) of the Securities Act does not extend to a private sale contract, since a contract, and its recitations, that are not held out to the public are not a "prospectus" as the term is used in the 1933 Act.

A Senate counteroffer in the House-Senate conference reconciling the two versions of financial reform legislation would have amended the Securities Act to address the effects of the Gustafson ruling that has left investors in private securities offerings without protection from material misstatements or omissions in the security’s prospectus. This was the Levin Amendment in the Senate , SA 3969. Ultimately, however, the Gustafson provision was stripped out of the final legislation.

According to Senator Levin, the Gustafson ruling interpreted the securities laws as depriving purchasers in private offerings of the same protections against material misstatements or omissions that apply to public offerings. The amendment would have restored Congressional intent and closed that loophole. Cong. Record, May 11, 2010, S3530. The amendment would have brought investors in private securities offerings under within the scope of Section 12(2) of the Securities Act by amending the definition of prospectus in the 1933 Act.

On the day the Senate passed Dodd-Frank, Senator Reed vowed to continue to work on a bipartisan basis to add the Gustafson fix to a future legislative vehicle so that investors in private offerings are placed on the same level as investors in public offerings, thereby restoring congressional intent and a standard that was in place for 60 years before the Supreme Court decided Gustafson. Before the Supreme Court's decision in this case, noted the Chair of the Senate Securities Subcommittee, the simple yet clear rule was to be careful not to mislead when selling securities in both public and private offerings. After Gustafson, this simple rule was needlessly complicated and limited just to public offerings, in his view(Cong. Record July 15, 2010, p. S5916).

Lincoln-Stabenow Colloquy Clarifies Captive Finance Affiliate Derivatives Risk Hedging Exemption in Dodd-Frank

In a colloquy with Senator Stabenow on the day the Senate passed the Dodd-Frank Act, Senator Blanche Lincoln confirmed that the legislation ensures that clearing and margin requirements would not be applied to captive finance or affiliate company transactions that are used for legitimate, non-speculative hedging of commercial risk arising from supporting their parent company's operations. But the Chair of the Agriculture Committee also noted that all swap trades, even those which are not cleared, would still be reported to regulators, a swap data repository, and subject to the public reporting requirements under the legislation. Senator Stabenow noted, and Senator Lincoln agreed, that the legislation recognizes the unique role that captive finance companies play in supporting manufacturers by exempting transactions entered into by such companies and their affiliate entities from clearing and margin so long as they are engaged in financing that facilitates the purchase or lease of their commercial end user parents products and these swaps contracts are used for non-speculative hedging. (Cong. Record, July 15, 2010, p. S5905).

According to Senator Lincoln, the two captive finance provisions in the legislation work together in the following way. The first captive finance provision, codified in section 2(h)(7) of the Commodity Exchange Act, deals with the treatment of affiliates provision in the end-user clearing exemption and is entitled transition rule for affiliates. This provision is available to captive finance entities which are predominantly engaged in financing the purchase of products made by its parent or an affiliate. The provision permits the captive finance entity to use the clearing exemption for not less than two years after the date of enactment. The exact transition period for this provision will be subject to rulemaking. The second captive finance provision differs in important ways from the first provision.

The second captive finance provision does not expire after 2 years. The second provision is a permanent exclusion from the definition of financial entity for those captive finance entities who use derivatives to hedge commercial risks 90 percent or more of which arise from financing that facilitates the purchase or lease of products, 90 percent or more of which are manufactured by the parent company or another subsidiary of the parent company. It is also limited to the captive finance entity's use of interest rate swaps and foreign exchange swaps. The second captive finance provision is also found in Section 2(h)(7) of the CEA at the end of the definition of financial entity. Together, these two provisions provide the captive finance entities of manufacturing companies with significant relief which will assist in job creation and investment by manufacturing companies. (Cong. Record, July 15, 2010, p. S5905).

Sunday, July 18, 2010

Senator Johnson Clarifies Compromise on Broker Duty of Care

The current regulatory regime treats brokers and advisers differently and subjects them to different standards of care even though the services they provide investors are very similar and investors view their roles as essentially the same. This regime was established during the New Deal and, although amended many times since, remains rooted in the last century. An ultimate goal of financial regulatory reform has been to allow the SEC to align duties for financial intermediaries across financial products. A corollary of this goal is that standards of care for all brokers when providing investment advice about securities to retail investors should be raised to the fiduciary standard to align the legal framework with investment advisers.

The House bill would have imposed a uniform federal fiduciary duty on brokers and advisers, while the Senate bill directed the SEC to conduct a study on the matter. The House-Senate conference committee struck a compromise, vetted by Senator Tim Johnson, a senior member of the Banking Committee, under which the SEC will conduct a study under what Senator Johnson called strict parameters and the SEC is also authorized to impose a uniform federal fiduciary standard on brokers and investment advisers.

On the day the Senate passed Dodd-Frank, Senator Johnson said that Section 913 reflects a compromise between the House and Senate provisions on the standard of care for brokers, dealers, and investment advisers. It includes the original study provisions passed by the Senate, together with additional areas of study requested by the House--a total of 13 separate considerations and a number of subparts, where we expect the SEC to thoroughly, objectively and without bias evaluate legal and regulatory standards, gaps, shortcomings and overlaps. We expect the SEC to conduct the study without prejudging its findings, conclusions, and recommendations and to solicit and consider public comment, as the statute requires. As Chairman Frank described the compromise when he presented it to the committee, section 913 does not immediately impose any new duties on brokers, dealers and investment advisers nor does it mandate any particular duty or outcome, but it gives the SEC, subsequent to the conclusion of the study, the authority to conduct a rulemaking on the standard of care, including the authority to impose a fiduciary duty. I think this is a strong compromise between the House and Senate positions. (Cong. Record, July 15, 2010, p. S5889).

Thursday, July 15, 2010

Congress Approves Historic and Sweeping Overhaul of US Financial Regulation

After nearly two years of extensive hearings and intense legislative negotiations, Congress has passed and sent to the President a sweeping overhaul of the regulation of US financial services and markets. The Dodd-Frank Wall Street Reform and Consumer Protection Act overhaul of the US financial regulatory system is based on the themes of regulating systemic risk, enhancing transparency and disclosure, sound corporate governance and executive compensation linked to long-term value creation, expanding consumer protection, and preventing regulatory arbitrage. The Act restructures the foundations of the U.S. financial regulatory system, enhances regulation over more products and actors, creates additional investor protections and consumer safeguards, and promotes greater accountability in capital markets.

The legislation ends the era of too-big-to-fail financial institutions by establishing new regulatory authorities to dissolve and liquidate failing financial institutions in an orderly manner and vesting regulators with the power to limit the activities of financial services firms. Specifically, the Act permits regulators to preemptively break up and take other actions against financial institutions whose size, scope, nature, scale, concentration, interconnectedness, or mix of activities pose a grave threat to the financial stability or economy of the United States.

The legislation provides for the regulation of hedge funds, and OTC derivatives, as well as a new resolution authority to unwind failing financial firms. The legislation ends taxpayer bailouts of financial institutions and by creating a way to liquidate failed firms without taxpayer money.
The Dodd-Frank Act establishes a strong set of consumer protections, including a a new Bureau of Consumer Financial Protection that will be led by an independent director appointed by the President and confirmed by the Senate, with a dedicated budget in the Federal Reserve. The Bureau will write rules for consumer protections governing financial institutions, banks and non-banks, offering consumer financial services or products and oversee the enforcement of federal laws intended to ensure the fair, equitable and nondiscriminatory access to credit for individuals and communities. The Bureau will roll together responsibilities that are now spread across seven different government entities, providing consumers with a single, accountable, and powerful advocate.

The legislation also establishes strong mortgage protections, requiring that lenders ensure that their borrowers can repay their loans by establishing a simple federal standard for all home loans. Lenders also are required to make greater disclosures to consumers about their loans and will be prohibited from unfair lending practices, such as steering consumers to higher cost loans. Lenders and mortgage brokers who fail to comply with new standards can be held accountable by consumers.

The Dodd-Frank Act also creates a process to shut down large failing financial firms whose collapse would put the entire economy at risk. The dissolution of a failing firm will be paid for first by shareholders and creditors, followed by the sale of any remaining assets of the failed company. Any shortfall that results is paid for by the financial industry. Financial institutions will pay assessments based on a company’s potential risk to the whole financial system if they were to fail. Before regulators can dissolve a failing company, a repayment plan must be in place to recoup any cost associated with the shutdown.

The Act introduces a new Volcker Rule that will limit the amount of money a bank can invest in hedge funds. The legislation also discourages financial institutions from taking too many risks by imposing tough new capital and leverage requirements. The legislation effectively ends new lending under the Troubled Asset Relief Program.

This measure will also increase investor protections by strengthening the SEC and boosting its funding level. For the first time ever, the over-the- counter derivatives marketplace will be regulated and hedge funds will have to register with the SEC. The legislation addresses the utter lack of regulation in the enormous derivatives market by mandating the clearing of most derivative contracts on exchanges in order to increase transparency. For those derivatives that are not cleared, new reporting and disclosure requirements ensure that information on the transaction is maintained. At the same time, under an end user exemption, non-financial firms can still use derivatives to hedge and manage the commercial risks associated with their businesses.

The Act modifies, enhances and streamlines the powers and authorities of the SEC to
hold securities fraudsters accountable and better protect investors. For example, the SEC
will have the authority to impose collateral bars on individuals in order to prevent wrongdoers in one sector of the securities industry from entering another sector. The SEC will also gain the ability to make nationwide service of process available in civil actions filed in federal courts, consistent with its powers in administrative proceedings. Dodd-Frank further facilitates the ability of the SEC to bring actions against those individuals who aid and abet securities fraud.

The Securities Exchange Act and the Investment Advisers Act presently permit the SEC to bring actions for aiding and abetting violations of those statutes in civil enforcement cases. The Act provides the SEC with the power to bring similar actions for aiding and abetting violations of the Securities Act of 1933 and the Investment Company Act. In addition, the measure not only clarifies that the knowledge requirement to bring a civil aiding and abetting claim can be satisfied by recklessness, but it also makes clear that the Investment Advisers Act of 1940 expressly permits the imposition of penalties on those individuals who aid and abet securities fraud. The Act also provides new authority of the SEC and the Justice Department to bring civil or criminal law enforcement proceedings involving transnational securities frauds.

The SEC, after it conducts a study, may issue new rules establishing that every financial intermediary who provides personalized investment advice to retail customers will have a fiduciary duty to the investor. The SEC is also authorized to set up an investor protection fund to pay whistleblowers whose tips lead to successful enforcement actions. The House bill would have imposed a uniform federal fiduciary duty on brokers and advisers, while the Senate bill directed the SEC to conduct a study on the matter. The House-Senate conference committee struck a compromise, vetted by Senator Tim Johnson, a senior member of the Banking Committee, under which the SEC will conduct a study under what Senator Johnson called strict parameters and the SEC is also authorized to impose a uniform federal fiduciary standard on brokers and investment advisers.

Thus the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the SEC to conduct a study to evaluate the effectiveness and efficacy of the existing standards of care for brokers and investment advisers and whether there are regulatory gaps in the protection of retail customers with regard to the standards

The legislation modifies the SEC’s structure by creating a number of new units and positions, like an Office of the Investor Advocate, an office to administer the new whistleblower bounty program, and an Office of Credit Ratings. Dodd-Frank mandates an expeditious, independent, comprehensive study of the securities regulatory regime by a high caliber body with expertise in organizational restructuring to identify deficiencies and reforms, and ensure that the SEC and other regulatory entities put in place further improvements designed to provide superior investor protection. The Act also includes deadlines generally forcing the SEC to complete enforcement, compliance examinations, and inspections within 180 days, with some limited exemptions for complex cases.

Responding to problems laid bare by the Madoff fraud, Congress authorized the PCAOB to examine the auditors of broker-dealers. In addition, the Act increase the credit line at the U.S. Treasury from $1 billion to $2.5 billion to support the work of the Securities Investor Protection Corporation and raises SIPC’s maximum cash advance amount to $250,000 in order to bring the program in line with the protection provided by the Federal Deposit Insurance Corporation. This bill additionally increases the minimum assessments paid by SIPC members from $150 per year, regardless of the size of the SIPC member, to 2 basis points of a SIPC member’s gross revenues in order to ensure that SIPC has the reserves it needs in the future to meet its obligations.

The Act greatly increases the accountability of credit rating agencies. By imposing structural, regulatory, and liability reforms on rating agencies, the Act will change the way nationally recognized statistical rating organizations behave and ensure that they effectively perform their functions as market gatekeepers. The Act also takes steps to reduce market reliance on the credit rating agencies and impose a liability standard on the agencies.

The legislation also permanently exempts small public companies from the Sarbanes- Oxley Act’s requirement to obtain an external audit on the effectiveness of internal financial reporting controls.

According to Senator Warner, systemic regulation sanctioned by the Act will mean that regulatory arbitrage can no longer take place. The silo-approach to risk regulation was ended and a new Financial Stability Oversight Council is authorized to regulate systemic risk wherever it occurs across the financial system. The legislation recognizes that systemic risk is not about size alone, but about leverage, risk management, and interconnectedness. Contingent capital is an important risk management tool, he said. (Senate debate on HR 4173 conference report, July 15, 2010).

The Dodd-Frank Act sets up a new office in the SEC to oversee and examine the work of the credit rating agencies. It requires the agencies to disclose their methodology and their track records. It allows investors to file private causes of action against agencies that fail to thoroughly investigate products they rate. The Act also tasks the SEC with examining the clear conflict of interest involved in Wall Street firms shopping for the highest rating among the various rating agencies. Senator Carl Levin hopes that, at the end of this study, the SEC will adopt the approach taken in the Franken Amendment that won bipartisan support in the Senate, and establish an intermediary that will separate the credit rating firms from the investment banks that press them for high ratings in return for lucrative compensation.

The Bureau of Consumer Financial Protection will bring new scrutiny to the practices of financial companies, providing important oversight that can end the kinds of abusive and even fraudulent practices used by some mortgage lenders. Other provisions will require those who create mortgage backed securities to retain a portion of the risk of securities backed by high risk loans, such as subprime mortgages, so that securitizers will no longer be able to offload all that risk onto the market and walk away from losses that occur down the road. Still another set of provisions bans so-called “liar loans,” which allowed firms to sell loans without any documentation of a borrower’s income or ability to repay.

The legislation gives the SEC and CFTC the authority to regulate over-the- counter derivatives to stop irresponsible practices and excessive risk taking. It requires central clearing and exchange trading for derivatives that can be cleared. It requires margin for uncleared trades in order to offset the greater risk they pose to the financial system and encourage more trading to take place in transparent, regulated markets. It increases data collection and publication through clearing houses or swap repositories to improve market transparency and provide regulators important tools for monitoring and responding.

OTC derivatives will now have to be cleared, said Senator Maria Cantwell, and thus a third party will have to validate that there is real money behind the transaction. Senator Cantwell said that she received written assurance from CFTC Chair Gary Gensler, that the bill explicitly requires that swap dealers, major swap participants and financial entities use a clearinghouse for standardized or clearable derivatives transactions. Dodd-Frank also includes a narrowly-crafted exemption that will allow legitimate commercial end-users, such as farmers and manufacturers, to continue to hedge business risks without being subject to the clearing and exchange trading requirements.

The Act mandates aggregate position limits across all exchanges, foreign and domestic, for commodity contracts and all economically equivalent contracts that could be used to speculate in a particular commodity, so speculator can’t evade the rules by trading like contracts on different exchanges. The CFTC is directed to use position limits to diminish, eliminate, or prevent excessive speculation, disrupt market manipulation, and ensure price discovery is not disrupted. According to Senator Cantwell, these key improvements will stop speculators from driving up the price of oil and other commodities, creating a more stable price environment for US businesses. The Act also closes the London loophole by giving the CFTC authority to require registration of Foreign Boards of Trade that provide direct access to U.S. customers.

Dodd-Frank also authorizes the SEC and the Justice Department to bring civil or criminal law enforcement proceedings involving transnational securities frauds. These are securities frauds in
which not all of the fraudulent conduct occurs within the United States or not all of the
wrongdoers are located domestically. The Act creates a single national standard for protecting
investors affected by transnational frauds by codifying the authority to bring proceedings
under both the conduct and the effects tests developed by the courts regardless of the jurisdiction of the proceedings.

Wednesday, July 14, 2010

Historic Reform of US Financial Regulation Nearing Legislative Finish Line

When the Senate passes the Dodd-Frank Wall Street Reform and Consumer Protection Act later this week and sends this historic overhaul of US financial regulation to President Obama for his signature, it will represent the culmination of an 18-month struggle to enact reform the regulation of US markets in the wake of the greatest financial crisis since the Great Depression.

The Dodd-Frank Wall Street Reform and Consumer Protection Act is based on the themes of regulating systemic risk and OTC derivatives, enhancing transparency and disclosure, moving executive compensation regimes away from a culture of short-term risk taking towards long-term value creation, expanding consumer and investor protection, and preventing regulatory arbitrage. The Act restructures the foundations of the U.S. financial regulatory system, enhances regulation over more products and actors and promotes greater accountability in capital markets.

The road to reform began when President Obama signed the American Recovery and Reinvestment Act of 2009 on February 17, 2009. In provisions authored by Senator Dodd, the recovery legislation mandated important corporate governance safeguards and imposed various executive compensation limits on companies participating in the troubled assets relief program (TARP), including a requirement for a nonbinding shareholder advisory vote on executive compensation and for independent compensation committees, presaging requirements that would be placed on all listed companies by the Dodd-Frank Act.

On February 25, 2009, President Obama outlined seven broad principles involving transparency, systemic risk management, and investor protection to guide Congress in passing this historic legislation to reform the nation’s outdated financial regulatory regime.

On March 30, 2009, Senate Banking Committee Chair Christopher Dodd and House Financial Services Committee Chair Barney Frank sent a letter to President Obama pledged to work together to pass legislation creating a framework for 21st century regulation that will enhance financial stability and protect consumers and investors.

On May 20, 2009, President Obama signed the Fraud Enforcement and Recovery Act (FERA) improving the enforcement of securities and commodities fraud and financial institution fraud involving asset-backed securities and fraud related to federal assistance and relief programs. The legislation expands the scope of securities fraud provisions to include commodities and derivatives fraud.

In June of 2009, the Obama Administration proposed to Congress the most sweeping and fundamental regulatory reform of the US financial and securities markets since President Franklin D. Roosevelt’s New Deal. Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Regulation, Treasury Department (June 17, 2009).

December 11, 2009: The U.S. House of Representatives passes the Wall Street Reform and Consumer Protection Act (HR 4173) to restructure the financial services regulatory system.

May 20, 2010: The U.S. Senate passes Restoring American Financial Stability Act (S. 3217, the Senate version of H.R. 4173) to bring about far-reaching reforms.

June 26, 2010: The House-Senate Conference Report is issued reconciling the House and Senate versions of the financial services regulatory reform bills.

June 30, 2010: The U.S. House of Representatives passes the Dodd-Frank Wall Street Reform and Consumer Protection Act.

After nearly two years of congressional hearings and extremely intense legislative negotiations, we are on the verge of historic and comprehensive reform of US financial regulation. This is landmark legislation that touches many aspects of banking and securities regulation, regulates the OTC derivatives markets for the first time and enhances the powers and resources of the SEC.

Tuesday, July 13, 2010

EU Groups Find Proposed PCAOB Standard on Auditor-Audit Committee Communications Overly Prescriptive

While applauding the PCAOB’s efforts to align its proposed standard on auditor-audit committee communications with international standards, the Institute of German Chartered Accountants (IDW) said that the standard was overly prescriptive and evinced a check-the-box mentality when compared to IAASB standards. Also, in comments to the Board, the IDW said that the proposed standard did not involve a two-way exchange of information since most of it involves the auditor imparting information to the audit committee. Similarly, in its letter to the Board, the European Federation of Accountants said that the proposed standard appeared to be quite prescriptive and rules-based and, therefore, may limit the auditor’s ability to exercise professional judgment in deciding on the most appropriate and efficient means and content of the communication with the audit committee. Further, this level of detail may serve to detract from the aim of communications, as both parties seek to comply with the letter of the requirements.

In the view of the German Institute, it is counterproductive to construe the role of the audit committee in overseeing the auditor’s work as necessitating a list of specific information designed to provide evidence that the auditor has performed routine quality control measures and routine procedures. Yet the matters identified in the Board’s proposed standard seem to imply a move towards this checklist mentality. The Institute is concerned that this approach will encourage auditors to produce copious reports in an attempt to “cover their backs”.

In contrast, the IDW believes that it is significant matters and audit findings that need to be communicated. There is a danger that auditors and audit committees may become overly focused on adhering to the required informational exchange as set forth in the proposed standard and fail to see the larger picture. As a result, important information may be overshadowed such that its significance is not readily apparent to the recipient.

The proposed standard’s over prescription may also be detrimental to an effective two-way exchange of information since if a matter is not listed in the requirements of the standard it may not be communicated at all. Further, over prescription discourages auditors from properly exercising their professional judgment, which in turn may not be conducive to enhancing audit quality.

The IAASB recently revised ISA 260 “Communication with Those Charged with Governance” and developed a new auditing standard, ISA 265 “Communicating Deficiencies in Internal Control to Those Charged with Governance and Management”, both of which cover communications between the auditor and those charged with governance of the entity subject to audit.

It is reasonable, said the IDW, to expect that the audit committee would posses a detailed knowledge of the company. The PCAOB, however, does not appear to view the propensity for the audit committee to provide information to the auditor as particularly significant in the proposed standard, since other than requiring the auditor to inquire of the audit committee whether it is aware of matters that may be related to the audit and about the risks of material misstatement, this aspect is less prevalent in the standard than is the case of ISA 260.

Other than the two instances mentioned above, the proposed standard concentrates primarily on the auditor imparting specified information to the audit committee, which does not promote a two-way exchange of information. Indeed, the standard would require the auditor to discuss the significant risks identified by the auditor during risk assessment procedures, without suggesting that two-way discussions could be useful, particularly if further information has become available to the audit committee or the committee believes the auditor’s assessment may be incomplete or incorrect.

In addition, the requirement as to the adequacy of the two-way communication appears to revolve around matters communicated to the audit committee and their reactions thereto, rather than any additional information the audit committee may impart to the auditor. This seems incongruent with the requirement that the auditor evaluate the effects of inadequate two-way communication on its assessment of risk and ability to obtain appropriate audit evidence. The Institute questions how an auditor may reach a determination that the two way communication was so inadequate as to warrant the measures such as a modification of the auditor’s opinion on the basis of a scope limitation and withdrawal from the engagement.

Monday, July 12, 2010

Audit Firm Memo on Counsel's Tax Opinion on Company Partnerships Could Be Protected Work Product; Govt's Reliance on Arthur Young Misplaced

A memo prepared by a company’s outside audit firm recounting the thoughts of corporate counsel on the prospect of tax litigation over company partnerships could be protected attorney work product. Similarly, the company’s disclosure to the independent auditor of a tax opinion on company partnerships by outside counsel did not constitute a waiver of the work product privilege. Disclosure to an adversary or a conduit to an adversary could waive the privilege, noted a DC Circuit appeals court panel, but a company’s independent outside auditor of its financial statements is neither an adversary of the company nor a conduit to its adversaries. The government sought production of the documents in connection with ongoing tax litigation with the company. (US v. Deloitte LLP, US Court of Appeals for the DC Circuit, No. 09-5171, June 29, 2010).

The Supreme Court did rule in US v. Arthur Young that there is no auditor-client work product privilege. But the fact that it was the audit firm that prepared the memo on counsel thoughts did not turn this into an auditor-client case. The memo, while put out by the auditor, contained the thoughts of counsel on the prospects of litigation over the tax treatment of the company’s partnerships. Under the Supreme Court Hickman v. Taylor doctrine creating the attorney work product privilege, the question to ask is not who created the document but whether the document contained the thoughts of counsel developed in anticipation of litigation. Further, the fact that the document was generated during the firm’s annual audit of the company’s financial statements did not defeat the privilege since a document can be protected work product even when it serves multiple purposes so long as it was prepared because of the prospect of litigation.

Even more, the panel said that the government’s reliance on the Arthur Young ruling was misplaced. The Supreme Court refused to grant accountant work product the same protection as attorney work product because the attorney’s duty is to present the client’s tax position in the best possibly light while an independent auditor’s ultimate allegiance is to the investing public. In this case, however, the government is attempting to
discover not an independent auditor’s interpretations of the client’s financial statements, which Arthur Young would permit, but an attorney’s thoughts developed in anticipation of tax litigation, which the work product doctrine forbids.

With regard to the company’s disclosure to the audit firm of outside counsel’s tax opinion, the panel found that such disclosure did not waive the work product privilege. The outside auditor’s power to issue an adverse opinion on the company’s financials, noted the court, does not make it the sort of litigation adversary contemplated by the waiver standard. Similarly, the court said that any tension between an auditor and a company arising from the auditor’s need to scrutinize corporate books and records is not the equivalent of an adversarial relationship contemplated by the work product doctrine. In preparing the documents, the company anticipated a dispute with the IRS, not a dispute with its outside auditor. Further, the panel reasoned that documents concerning the tax implications of partnerships would not likely be relevant in any dispute the company might have with Deloitte.

The court also concluded that Deloitte’s independent auditor obligations do not make it a conduit to the company’s adversaries. The government asserted that there are a myriad of ways an independent auditor might disclose attorney tax opinion information obtained from a company whose finances it audits. For example, the auditor could make the company disclose its confidential tax analysis in footnotes to its public financial statements. Likewise, the auditor could testify about confidential information obtained from the company in proceedings brought by the SEC or private parties. Or the auditor might report illegal acts it detects during its audit in accordance with § 10A of the Exchange Act.

Rejecting these contentions, the appeals panel noted that the government has neither pointed to any regulation nor posited any specific circumstance under which the auditor would be required to disclose attorney work product on tax treatment of company partnerships. The panel reasoned that an independent auditor can fulfill its duties and render an opinion on a company’s SEC-filed financial statements without revealing every piece of information it reviews during the audit process. In short, the independent auditor obligations do not make it a conduit to the company’s adversaries.

Finally, while recognizing that independent auditors have significant leverage since they can essentially compel an audited company’s disclosure by refusing to provide an unqualified opinion otherwise, the panel said that a waiver of the work product privilege based on such disclosures could encourage the unfairness and sharp practices that the Supreme Court sought to avoid when it created the privilege in Hickman v Taylor. For example, it might discourage companies from seeking legal advice and candidly disclosing that information to independent auditors.