Thursday, September 30, 2010

Business Groups Challenge SEC Proxy Access Rule in Federal Appeals Court

The US Chamber of Commerce and the Business Roundtable have asked a federal appeals court to invalidate the recently adopted SEC proxy access rule, Exchange Act Rule 14a-11. In a petition to the US Court of Appeals for the District of Columbia, the business groups said that Rule 14a-11 is arbitrary and capricious, violates the Administrative Procedure Act, and was adopted without a proper assessment of its effect on efficiency, competition, and capital formation. The petition also asserts that the rule violates company rights under the First and Fifth Amendments. At the same time, the business groups asked the SEC to stay the rule's effect until the litigative challenge is resolved. While the Dodd-Frank Act specifically authorized the SEC to adopt the proxy access rule in an effort to insulate the SEC from a challenge to its rulemaking authority, the business groups said that the Dodd-Frank provision does not exempt the SEC from following the law when it conducts rulemaking.

In a brief filed with the SEC stay petition. the groups said that the SEC erred in appraising the costs of the rule. The SEC did not dispute evidence that hotly contested elections would be costly, but hypothesized that such elections may not occur since directors may decide not to oppose shareholder nominees. This hypothesis conflicts with the directorial fiduciary duties, said the brief, since such duty may compel company directors to spend significant amounts to defeat shareholder nominees they believe to be unqualified. More broadly, the brief, which was signed by Eugene Scalia of Gibson Dunn, noted that proxy access has been one of the most contentious issues in the history of the SEC because disagreements over a proxy access rule prefigure the disagreements that will emerge when proxy access is actually used. Thus, in the view of the business groups, it was not reasonable for the SEC to premise its cost analysis on the assumption that companies would become passive and acquiescent once access nominees are advanced. 

The brief also contends that the adoption is arbitrary and capricious in its treatment of state law. While claiming to effectuate rights under state law, asserted the brief, the proxy access rules effectively moot them by establishing by fiat a federal proxy access regime regardless of what system a company's shareholders would adopt under the law of Delaware or any state.  Delaware specifically addresses shareholder access to the proxy for director nominations and provides for an access mechanism through a bylaw amendment.

Wednesday, September 29, 2010

Rep. Kanjorski Says Expand SIPA to Customers of Investment Advisers as SIPC Task Force Prepares Legislative Recommendations

Despite the impressive post-Madoff SIPA reforms effected by the Dodd-Frank Act, more reforms of the Securities Investor Protection Act and the entire SIPC regime are needed in order to protect investors. This was the message delivered by House Capital Markets Subcommittee Chair Paul Kanjorski at recent hearings exploring the efficacy of post-Dodd-Frank SIPA legislation. Rep. Kanjorski, who was the principal author of the Dodd-Frank SIPA provisions, also saw a need to expand SIPC protection beyond brokers to the customers of investment advisers.

In order to better protect the customers of failed brokerages going forward, the Dodd-Frank Act increased cash protection limits and bolstered the resources of the reserve fund used to replace customers’ missing cash and securities.  This new law also quintuples penalties for misrepresentations of membership in or protections offered by the Securities Investor Protection Corporation.  Moreover, the statute makes important changes to prevent, rather than simply replace, the loss of customer property, including new custody safeguards for customer assets held by certain financial professionals. 

Despite this array of achievements, Rep. Kanjorski said that more needs to be done to accomplish complete SIPA reform. For example, SIPC has denied the claims of customers based on the seemingly legitimate paperwork provided to them by their brokers, yet SIPC expects customers to use those very same statements to report unauthorized trading in their accounts.  This inconsistency is unacceptable, emphasized the Chair, and Congress must work to resolve it. More difficult will be legislation to address the tone at SIPC. In Rep. Kanjorski's view, investor trust, for which SIPA was designed to preserve, has been seriously eroded by SIPC’s narrow interpretations of its statutory mandate.  While SIPC’s actions may follow the letter of the law, he said, many would argue that SIPC has ignored the spirit of the law.  Thus, Congress must consider the best way to change the tone at SIPC and refocus this body on maintaining confidence in the financial system and promoting investor protection.  To the extent possible, Congress should also explore how SIPC could learn from the success of the Federal Deposit Insurance Corporation in maintaining the public’s trust. 

To address these questions and many others, SIPC has formed a modernization task force to provide Congress a comprehensive reform plan. Chairman Kanjorski expects the task force to complete its work with great transparency, considerable and to view its mission as broadly as possible.

The Chair of the SIPC Modernization Task Force is Orlon Johnson, who is also the current SIPC Chair. Convened on June 17, 2010, the Task Force consists of a wide range of experts and is in the midst of its review and consideration of possible statutory, procedural and other reforms to SIPA and SIPC. The Task Force draws its members from the ranks of state regulators, attorneys who represent investors, academia, the securities industry, a trustee in the largest insolvency in history, the Chairman of SIPC’s Chinese counterpart, and an observer from the SEC.  This diversity of viewpoints is expected to result in a rigorous analysis of the issues that concern investors. According to Chairman Johnson  the task force has begun its work in earnest by examining the extent of SIPA protection, the problem of “indirect” investors, the use of bankruptcy avoidance powers, and other fundamental issues of concern to investors and Congress. The task force expects to make a full set of recommendations to the 112th Congress in the first quarter of 2011. 



Tuesday, September 28, 2010

Federal Judge Allows Claims Against AIG Management and Outside Auditor to Go Forward

A federal judge (SD NY) has ruled that an  investor's securities fraud action against AIG senior management could proceed since the investor adequately pleaded that the  general disclosures cired by the executieves were insufficient to fulfill their disclosure obligations under the federal securities laws in light of the undisclosed “hard facts critical to 

appreciating the magnitude of the risks described, \such as, to name but a few, the known weaknesses of company models; the deliberate weakening of risk controls. the scope of the exposure to mortgage-backed securities, and the securities lending program and the valuation and 0collateral risk presented by the credit default swap portfolio that rendered misleading the company's frequent placement of emphasis on the remote credit risk.  (In re American International Group, Inc. 2008 Securities Litigation, SD NY, No. 08 Civ 4772, Sept. 27, 2010).

The court also allowed the action to go forward against AIG's audit firm under alleged Section 11 of the Securities Act violations. The investors alleged that the audited financial statements of AIG were not prepared in accordance with GAAP and that the firm did not conduct is audit of the financials in accordance with GAAS. The investors alleged that the audit firm had certain obligations to disclose the scope of AIG’s potential collateral obligations pursuant to FIN 45, which sets forth disclosure requirements for guarantees. The auditor's alleged failure to meet these obligations resulted in its signing unqualified opinions that were included in the 

company’s 10-K that did not disclose adequately the risks posed by the credit default swap portfolio, the securities lending program, and the concentration of exposure to the subprime mortgage market, in violation of various accounting standards, including FAS 107 and 133.

The court said that it is inappropriate to dismiss well-pleaded allegations at a motion to dismiss stage that an accountant blessed financial statementgs that violated certain identified GAAP principles and were fundamentally misleading to investorfs. Rather, because eventual evidence on industry practice or expert testimony are likely to shed light on this question, the determinatio  of whether AIG's accounting treatment of its credit default swap portfolio and its exposure to the subprime mortgage market comported with GAAP in the audited financial statements included in its Form 10-K cannot be determined in advance of the development of the record.


European Parliament Approves Legislation Creating New EU-Wide Financial Regulatory Regime

The European Patliament has approved legislation creating a European financial regulatory framework with separate regulators for securities, banking and insurance, as well as a European Systemic Risk Board similar to the Financial Stability Oversight Council created by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The new regulatory framework should be fully operational by January 1, 2011. Praising the new regulatory regime, EU Commissioner for the Internal Market Michel Barnier said that the new regime will give the EU monitoring tools to detect risk which is accumulating across the financial system and provide effective tools to act. The new framework gives the EU the ``control tower and the radar screens’’ needed to identify risks, he said, and the tools to better control financial players, as well as the means to act quickly in a coordinated and timely fashion.

Financial companies and markets operate mostly at a European level, and now the Commission will have four solid authorities to monitor macroeconomic financial risks and supervise financial markets, banks, and insurance companies. These authorities will be able to benefit from the on-the-ground expertise of national regulators and propose any necessary measures at a European level. Commissioner Barnier said that he will soon present legislation to regulate derivatives and short-selling which will build on the powers of the new authorities.

The three new European Supervisory Authorities for securities, banking and insurance are responsible for ensuring that a single set of harmonized regulations are applied by national regulators. The authorities will also ensure a common regulatory culture and consistent practices. They will collect micro-prudential information and ensure a coordinated response in crisis situations. Decisions taken by the ESAs would not impinge in any way on the fiscal responsibilities of the member states. Any binding decision taken by the ESAs would be subject to review by the EU courts.

The new European Securities and Markets Authority will regulate credit rating agencies (CRAs). Since rating services are not linked to a particular territory and the ratings issued by a CRA can be used by financial institutions all around Europe, the Commission has recently proposed a more centralised system for supervision of Credit Rating Agencies at EU level. Under the proposed changes, the European Securities and Markets Authority would be entrusted with exclusive supervision powers over CRAs registered in the EU. It would have powers to request information, to launch investigations, and to perform on-site inspections.

Day-to-day regulation will remain at the national level, close to the ground, where appropriate expertise can be found. There will always be a pivotal role for national regulators like BaFin and the FSA. The new system is a hub and spoke type of network of EU and national bodies. The new authorities will act only where there is clear added value, and the areas where the authorities can act will be strictly defined by Member States and the European Parliament in co-decision. The objective is for European and national bodies to work hand in hand.

The new system has been designed in a way that it can be adapted to future developments in financial services. Every three years the Commission will publish a wide-ranging report on the functioning of the new Authorities and assess whether further steps are needed to ensure the prudential soundness of institutions, the orderly functioning of markets and thereby the protection of investors. This may or may not lead to proposals to change the structures or tasks of the Authorities.

The securities and banking authorities may temporarily prohibit or restrict certain financial activities and toxic securities products that threaten the orderly functioning and integrity of financial markets or the stability of the whole or part of the financial system in Europe in the cases specified in sectoral legislation, such as the proposal on short-selling, or if so required in the case of an emergency.

 It should be clear that we are talking here of emergency powers, which would only apply in exceptional circumstances, defined as a situation which seriously jeopardizes the stability of financial markets. In the great majority of cases, the legislation envisions national and European level authorities to work hand in hand, sharing information, coordinating their work and making decisions together.

Even in emergencies, the first objective of ESMA will be to facilitate and coordinate actions by national securities regulators, without binding decisions. However, if deemed necessary, there is a procedure in place for ESMA and the Board to address binding decisions to national supervisors requiring them to take the necessary action to safeguard the orderly functioning and integrity of financial markets and the stability of the whole or part of the European financial system. So, the new Authorities will have an important co-ordinating role and will be able to adopt decisions requiring regulators to jointly take action. An example of how this power might be used would be to adopt harmonized temporary bans on short selling on EU securities markets, rather than uncoordinated actions in different Member States, as witnessed over the past years.

The new Authorities will also contribute to and participate actively in the development and coordination of effective and consistent recovery and resolution plans similar to Title II of the Dodd-Frank Act, guarantee schemes, procedures in emergency situations and preventative measures to minimize the systemic impact of any failure. The new Authorities should also ensure that they have a specialized and ongoing capacity to respond effectively to the materialization of systemic risks. In doing so, they must identify and measure the systemic risk posed by financial institutions, which must be subject to, inter alia, enhanced regulation.

The Chairpersons of the new Authorities will be appointed by the Boards of the Authorities composed of the Heads of national supervisors, and confirmed by the European Parliament, after a thorough and public selection procedure – based on a short-list prepared by the European Commission. It is envisaged that the Chairpersons will be high-profile individuals with an established reputation in their field.

Monday, September 27, 2010

Fifth Circuit Reinstates SEC Insider Trading PIPE-Related Enforcement Action

In an SEC enforcement action alleging insider trading in a PIPE-related case, a Fifth Circuit panel said that it was plausible that the company's largest shareholder agreed not to trade on inside information about the PIPE offering when he agreed to keep the information confidential. the district judge ruled that the agreement required to invoke the misappropriation theory of insider trading liability must include both an obligation to maintain the confidentiality of the inside information and not to trade on or otherwise use the information. Thus, the appeals court vacated the district court's dismissal of the enforcement action and allowed the SEC to go forward. (SEC v. Cuban, No. 09-10996, Sept 21, 2010).

In this action, the SEC alleged that, after the shareholder agreed to maintain the confidentiality of inside information concerning the offering, he sold his stock in the company without first disclosing to the company that he intended to trade on this information, thereby avoiding substantial losses when the stock price declined after the PIPE was publicly announced. As the PIPE offering progressed toward closing, the company decided to inform the shareholder of the offering and to invite him to participate.

The CEO prefaced the call by informing the shareholder that he had confidential information to convey to him, and the shareholder agreed that he would keep whatever information the CEO intended to share with him confidential. The CEO, in reliance on this agreement, told the shareholder about the PIPE offering. The shareholder reacted angrily to this news, stating that he did not like PIPE offerings because they dilute the existing shareholders.

Several hours after they spoke by telephone, the CEO sent the shareholder a follow-up email in which he provided contact information for the investment bank conducting the offering. The shareholder then contacted the sales representative, who supplied him with additional confidential details about the PIPE. One minute after ending this call, the shareholder telephoned his broker and directed the broker to sell all 600,000 of his shares, thereby avoiding losses in excess of $750,000 by selling prior to the public announcement of the PIPE.

THe district court found that the complaint asserts no facts that reasonably suggest that the CEO intended to obtain from the shareholder an agreement to refrain from trading on the information as opposed to an agreement merely to keep it confidential. But the appeals panel found that the SEC allegations, taken in their entirety, provide more than a plausible basis to find that the understanding between the CEO and the sharfeholder was that he was not to trade, that it was more than a simple confidentiality agreement.  The panel said that it was at least plausible that each of the parties understood, if only implicitly, that the companny would only provide the terms and conditions of the PIPE offering tothe shareholder for the purpose of evaluating whether he would participate in the offering, and that the shareholder could not use the information for his own personal benefit. 

SEC Issues Guidance on Dodd-Frank Authorization of PCAOB Oversight of Auditors of Brokers

In one of its post-Madoff reforms, the Dodd-Frank Act authorized the PCAOB to inspect and examine the auditors of broker-dealers. Section 982 of the Act authorized the Board to 2establish, subject to SEC approval, auditing and related attestation, quality control, ethics, and independence standards to be used by registered public accounting firms with respect to the preparation and issuance of audit reports to be included in broker and dealer filings with the 

Commission pursuant to Rule 17a-53 under the Exchange Act.  The changes directly impact some Commission regulations, releases, and staff bulletins related to brokers and dealers. The changes worked by Dodd-Frank also impact p00rovisions in the federal securities laws for brokers and dealers, which refer to Generally Accepted Auditing Standards (“GAAS”) and to specific standards under GAAS (including 

related professional practice standards. 

The SEC said that there may be confusion on the part of brokers, dealers, auditors, and investors with regard to the professional standards auditors should follow for reports filed and furnished by brokers and dealers pursuant to the federal securities laws and the rules of the 

Commission.  Thus, while the SEC is considering a rulemaking project to update the audit and related attestation requirements under the federal securities laws for brokers and dealers, particularly in light of the Dodd-Frank Act, the SEC has provided transitional guidance with respect to its existing rules regarding non-issuer brokers and dealers. Specifically, references in Commission rules and staff guidance and in the federal securities laws to GAAS or to specific standards under GAAS, as they relate to non-issuer brokers or dealers, should continue to be understood to mean auditing standards generally accepted in the United States of America,7 plus any applicable rules of the Commission.  

The Commission intends, however, to revisit this interpretation in connection with its rulemaking project referenced above. 


Friday, September 24, 2010

PCAOB Asks Congress to Make Disciplinary Proceedings Public

In a letter to House Financial Services Committee Chair Barney Frank and Ranking Member Spencer Bachus, PCAOB Acting Chair Dan Goelzer asked for legislation amending Sarbanes-Oxley so that Board disciplinary hearing against individual auditors and accounting firms will be public. From the initiation of the PCAOB disciplinary proceeding through the SEC decision to let the snactions commence, the entire proceeding takes place behind closed doors. The closed nature of Board disciplinary proceedings is in sharp contrast to similar SEC proceedings against auditors. 

The proposed legislative draft would make Board disciplinary proceedings public when the Board decides that the evidence gathered in an investigation warrants charging a firm or individual with a violation, while at the same time maintaining exisiting confidentiality of Board inspections. The draft would also retain the Board's flexibility to order non-public proceedings in appropriate cases. 

According to Chairman Goelzer, the non-public nature of Board disciplinary proceedings has adverse consequences for investors, audit committees, and auditors. The public is denied important informaton about PCAOB cases and audit committees are kept in the dark about an auditor's alleged misconduct. Even after a hearing officer finds that the alleged violations occurred, the matter may remain non-public until appealed to the SEC. Investors can be left unaware company financials are being audited by audtors charged and even sanctioned by the Board. As an example, Chairman Goelzer cited the recent Gately case in which the firm issued 29 additional audit reports on public companies' financials between commencement of the Board's proceedings and public disclosure of the Board's charges.

Another adverse consequence of non-public PCAOB proceedings is that audit firms and auditors have an  incentive to litigate Board proceedings rather than settle because they can continue to conduct audits without disclosure to clients or investors of the Board's charges. Again, the Gately case is illustrative, where the firm continued its audit practice during the two years between the filing of the Board's case and the disclosure of sanctions. Similarly, the incentive to litigate consumes Board resources better deployed elsewhere.

More broadly, said the PCAOB Chair, the non-public nature of disciplinary proceedings limits the Board's ability to us its enforcement authority to improve audit quality and deter violations of Board rules. When the Board concludes that there has been an audit failure warranting enforcement action, auditors do not learn of that decision for an extended period of time. Thus, other auditors who face similar situations will be unaware of what prompted the Board to take disciplinary action

Thursday, September 23, 2010

Singapore High Court Examines Shareholder Right to Company Accounting Records

The Singapore High Court has noted that apart from the annual audited accounts and accompanying reports, a shareholder normally has no access to the accounting records of the company. The annual audited accounts and accompanying reports are the primary means by which the directors of a company account for their stewardship. Hence, the requirement that the accounts present a true and fair view of the company’s financial affairs. However, the court went on to say that directors do nit have an absolute right to deny financial information to shareholders in all circumstances. There is neither statutory nor common law authority to justify such an absolute position. There there is in principle no absolute bar against granting shareholders, in limited egregious circumstances, access to specified financial information. Additional information for shareholders may be warranted in egregious circumstances  revealing a pattern of behavior that was dismissive of the shareholders’ concerns and that marginalised their participation once they began probing into suspicious transactions. In other words, the denial of information formed a key element in the overall oppression and unfair treatment of the shareholders. Lian Hwee Choo Phebe v. Maxz Universal Development Group, Singapore High Court, Sept 8, 2010.

Congress Clears Legislation on SEC Dodd-Frank FOIA Exemptions for President's Signature

The House has joined the Senate in passing legislation eliminating broad SEC FOIA exemptions contained in the recently passed Dodd-Frank Wall Street Reform and Consumer Protection Act. The Senate passed S 3217 earlier this week by unanimous consent and the House took up the Senate bill and passed it by voice vote. President Obama is expected to sign the legislation.

Congress believes that the blanket FOIA exemption given to the SEC by Dodd-Frank was overbroad. The legislation clarifies that hedge funds and other new entities that the SEC will regulate under Dodd-Frank will be considered financial institutions for purposes of applying the FOIA exemption. The legislation will ensure that the SEC can treat sensitive information that hedge funds and private equity funds provide to the Commission in connection with SEC surveillence and examination activities in the same manner as the SEC treats such information when it is provided by other financial institutions. The legislation broadly defines financial institution as any entity the SEC examines, regulates or supervises. This broad definition is designed to address concerns that neither the text nor the legislative history of FOIA defines financial institutions encompassed by FOIA Exemption 8 and that newly regulated entities such as hedge funds would not be considered financial institutions under the exemption.

Upon introducing the bill, S, 3717, Senator Leahy said that the Dodd-Frank FOIA exemptions were designed to ensure that the SEC had access to information that the Commission needs to carry out its enforcement powers and protect investors. But the Judiciary Chair is troubled by the SEC's attempts in recent weeks to reyroactively apply these exemptions to pending FOIA matters and by the sweeping interpretations the SEC has expressed that these exemptions would shield all information provided to the Commission in connection with its examination and surveillance activities.

House Financial Services Chair Barney Frank  noted that the bipartisan agreement that a legislative remedy was necessary. The Senate acted first with legislation to solve the immediate problem, noted the Chair, and the House decided that the best way to proceed was to concur with the Senate so that the President could sign legislation that solves the immediate problem. 

New NASAA President to Represent States on the Financial Stability Oversight Council

In a news release today, the North American Securities Administrators Association (NASAA) announced that NASAA President-elect David Massey will represent state securities regulators on the new Financial Stability Oversight Council (FSOC). Created by the recently-enacted Dodd-Frank Wall Street Reform and Consumer Protection Act, the FSOC will monitor emerging risks to U.S. financial stability, recommend heightened prudential standards for large, interconnected financial companies, and require nonbank financial companies to be supervised by the Fed if their failure poses a risk to financial stability. The legislation authorizes a state insurance commissioner, a state banking supervisor and a state securities administrator to serve as non-voting members of the FSOC.

Massey, who serves as Deputy Securities Administrator of the North Carolina Securities Division, will take office as NASAA's President next week during the organization's Annual Conference in Baltimore. The first meeting of the FSOC will be held on October 1, 2010.

Wednesday, September 22, 2010

Senate Passes Legislation Eliminating SEC Dodd-Frank FOIA Exemptions and Broadening Definition of Financial Institution

The Senate has passed legislation by unanimous consent eliminating SEC exemptions from FOIA bestowed by Section 929I of the Dodd-Frank Act. The legislation is sponsored by Judiciary Committee Chair Patrick Leahy (D-Vt) and has strong bi-partisan report. The Senate believes that the blanket FOIA exemption given to the SEC by Dodd-Frank was overbroad. The legislation clarifies that hedge funds and other new entities that the SEC will regulate under Dodd-Frank will be considered financial institutions for purposes of applying the FOIA exemption. The legislation will ensure that the SEC can treat sensitive information that hedge funds provide to the Commission in connection with SEC surveillence and examination activities in the same manner as the SEC treats such information when it is provided by other financial institutions. The legislation broadly defines financial institution as any entity the SEC examines, regulates or supervises. This broad definition is designed to address concerns that neither the text nir the legislative history of FOIA defines financial institutions encompassed by FOIA Exemption 8 and that newly regulated entities such as hedge funds would not be considered financial institutions under the exemption.

Upon introducing the bill, S, 3717, Senator Leahy said that the Dodd-Frank FOIA exemptions were designed to ensure that the SEC had access to information that the Commission needs to carry out its enforcement powers and protect investors. But the Judiciary Chair is troubled by the SEC's attempts in recent weeks to reyroactively apply these exemptions to pending FOIA matters and by the sweeping interpretations the SEC has expressed that these exemptions would shield all information provided to the Commission in connection with its examination and surveillance activities.

According to Senator Leahy, in order to ensure that the Freedom of Information Act (FOIA) remains an effective tool to provide public access to information about the stability of US financial markets, the legislation eliminates several broad FOIA exemptions for SEC records that were recently enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The measure will at the same time also help ensure that the SEC has access to the information that the Commission needs to carry out its new enforcement activities under the new reforms.

Senator Leahy said that FOIA is the people's window into their government and care must be taken to ensure that exemptions from FOIA's disclosure mandates are narrowly applied.

There is a companion bill in the House, HR 6086, introduced by Rep. Edolphus Towns, Chair of the House Oversight and Government Reform Committee. In recent testimony before the House Financial Services Committee, Rep. Towns said that the FOIA exmeption in 929I is too broad since it allows the SEC to keep secret virtually any information it obtains under its examination authority.

The securities industry has criticized the Leahy and Tonws measures because they fail to address public disclosure of a firm's information through third-party subpoenas,

FDIC Says US Covered Bond Legislation Falls Short on Key Principles

Legislation creating a US covered bond market is gaining momentum in Congress and may well pass before the 111th Congress adjourns sometime in December after an almost certain lame duck session concludes. Recent hearings before the Senate Banking Committee revealed that Chairman Chris Dodd wants to explore alternatives to securitization, which covered bonds offer. Senator Dodd supported a provision in the Dodd-Frank draft in conference creating a US covered bond market, but the provision did not make it into the final legislation.

In testimony before the Committee, FDIC officials said that, while the FDIC generally supports legislation, but conditions its support on the covered bonds legislation having three key principles. First, it should clarify the right and duties of investors, issuers and regulator, Second, it should ensure that investment risks are not be transferred to the public sector or to the deposit insurance fund, Third, it should remain consistent with long-standing U.S. law and policy for secured creditors Unfortunately, H.R. 5823, the current legislative vehicle for creating a US covered bond market would, in the FDIC's view, muddy the relationship between investors and regulators, transfer some of the investment risks to the public sector and the deposit insurance fund, and provide covered bond investors with rights that no other creditors have in a bank receivership. As a result, cautioned the FDIC, this legislation could lead to increased losses in failed banks that have issued covered bonds.

Tuesday, September 21, 2010

Securities Industry Supports SEC FOIA Exemption in Dodd-Frank Against Legislative Assault

With legislation curtailing the SEC's FOIA exemption in Dodd-Frank being advanced by prominent House and Senate leaders, the securities industry has spoken out in favor of the FOIA exemption in Section 929I of Dodd-Frank. Almost immediately after the passage of Dodd-Frank, a controversy erupted over the scope of the SEC's FOIA exemption in Sec, 929I, The securities industry supports the SEC's position that Sec. 929I addresses serious concerns that had hampered both the regulator and the regulated from openly sharing information that both agree should be accessible to the SEC. Testifying for SIFMA before the House Financial Services Committee, former FINRA enforcement chief Susan Merrill said that Sec, 929I squarely addresses these concerns and fosters a more open and cooperative dialogue between the securities industry and the SEC. With no risk of possible compelled disclosure looming over the production of information, regulated firms will be able to produce information that the SEC should have access to without fear that the SEC will later be compelled to disclose it.

In addition, Sec, 929I resolves concerns about whether information may fall within the embrace of existing FOIA exemptions. For example, the fear that proprietary information may not meet the criteria for a trade secret under FOIA Exemption Four Eis no longer a concern since the SEC may now lawfully withhold such sensitive information if the data was produced in connection with an SEC examination. Even more, Sec. 929I closes the third-party subpoena loophole that had provided a path to compelled disclosure of confidential information even when FOIA exemptions were met.

Indiana Summarizes Each U.S.A. Provision

An administrative order released by the Indiana Securities Division on September 17, 2010 provides a brief synopsis of, and the purpose for, each provision of the Indiana Uniform Securities Act of 2008. Please contact the Securities Division at (317) 232-6681 to receive a copy.

Baucus Extenders Legislation Would Reform Hedge Fund Managers Carried Interest

Senator Max Baucus (D-Montana), Chair of the Senate Finance Committee, has introduced a new iteration of the tax extenders legislation that, like previous iterations, reforms carried interest taxation of hedge fund managers and other asset fund managers. The legislation would prevent hedge fund and investment fund managers from paying taxes entirely at capital gains rates on investment management service income received as carried interest in an investment fund. To the extent that carried interest reflects a return on invested capital, the Baucus legislation would continue to tax carried interest at capital gains rates,

However, to the extent that carried interest does not reflect a return on invested capital, the legislation would require fund managers to treat 75 percent of the remaining carried interest as ordinary income starting Jan 1, 2011. The amount treated as ordinary income is reduced 50 percent for carried interest that does not reflect return on investment capital but which is attributable to a sale of assets held for 5 or more years. The lower recharacterization percentage also applies to a gain or loss to the underlying assets held for 5 years or more when a partnership interest is sold as well as to gain attributable to IRC Sec. 197 intangibles of an entity providing specific investment management services when the partnership interest has been held for 5 or more years.

Monday, September 20, 2010

Current and Former SEC Chairs Defend Commission's FOIA Exemption in Dodd-Frank

With legislation repealing or modifying Section 929I of Dodd-Frank looming, current and former SEC Chairs have spoken of the Commission's need for the FOIA exemptions that thE statute confers. In testimony before the House Financial Services Committee, SEC Chair Mary Schapiro said that Sec. 929I enhances the SEC's ability to examine the firms it regulates by clarifying that the Commission can protect information gathered in the examination process from the regulated firms. Indeed, the Chair believes that 929I is central to the SEC's ability to develop a robust examination program to protect investors. Former SEC Chair Harvey Pitt said that the need for 929I is manifest, adding that 929I traces its origins to years of SEC experience with confidential information and has been supported by SEC Chairs from both political parties.

The SEC has articulated guidance designed to allay the fears of Congress that the FOIA exemption provided by Sec. 929I is overly broad, The guidance says that, in responding to FOIA requests, the staff may rely on 929I only when there is an absence of case law holding that the firm at issue is a financial institution could restrict the application of FOIA Exemption 8 in protecting materials obtained by the SEC pursuant to an examination. FOIA Exemption 8 protects from disclosure information contained in or related to examinatio, operating or condition reports about financial institutions regulated by the SEC. But FOIA Exemption 8 does not define financial institution.

The SEC guidance also states that, in responding to discovery requests, the staff will not rely on 929I in any non-FOIA case in which the SEC is a party and in other cases will use 929I only with respect to information gathered by the SEC pursuant to its examination authority and that would be withheld pursuant to a FOIA request. Section 929I goes beyond FOIA and codifies reasonable limits on the SEC's obligation to disclose information in the context of third party subpoenas.

The fact that FOIA Exemption 8 does not define financial institution has troubled SEC Chairs. The SEC has been given jurisdiction over a number of new entities and there is no presumption that the courts will find that every firm the SEC examines is a financial institution. Hence, Ms. Schapiro praised Sec. 929I for eliminating any uncertainty concerning FOIA Exemption 8 by clarifying that information obtained in examination from any covered regulated entity would be exempt.

Former Chairman Pitt noted that the impact of 929I is greatest in the area of non-FOIA document requests or third=party subpoenas pursuant to litigation. The need for Sec. 929I is grea t because refusing third-party subpoenas for sensitive information belonging to regulated entities has presented the SEC with significant difficulties. When confronted with a subpoena, in order to protect a firm's confidential information, the SEC has had to challenge the subpoenas on common law grounds such as relevance. Chairman Schapiro pointed this out in letters this past July to Chairmen Dodd and Frank.

Friday, September 17, 2010

Leahy Legislation Repealing SEC Dodd-Frank FOIA Exemptions Reported Out of Judiciary Committee

The Senate Judiciary Committee has reported out bi-partisan legislation to repeal SEC exemptions from FOIA bestowed by Section 929I of the Dodd-Frank Act. The legislation is sponsored by Committee Chair Patrick Leahy (D-Vt) and has strong bi-partisan report. The committee believes that the blanket FOIA exemption given to the SEC by Dodd-Frank was overbroad. The legislation clarifies that hedge funds and other new entities that the SEC will regulate under Dodd-Frank will be considered financial institutions for purposes of applying the FOIA exemption. The bill will ensure that the SEC can treat sensitive information that hedge funds provide to the Commission in connection with SEC surveillence and examination activities in the same manner as the SEC treats such information when it is provided by other financial institutions.

Upon introducing the bill, S, 3717, Senator Leahy said that the Dodd-Frank FOIA exemptions were designed to ensure that the SEC had access to information that the Commission needs to carry out its enforcement powers and protect investors. But the Judiciary Chair is troubled by the SEC's attempts in recent weeks to reyroactively apply these exemptions to pending FOIA matters and by the sweeping interpretations the SEC has expressed that these exemptions would shield all information provided to the Commission in connection with its examination and surveillance activities. The Senator has called on the SEC to issue guidelines interpreting the FOIA Sec. 929I exemptions in a manner consistemt with congressional intent and the President's Jan 21,2009 executive memorandum on FOIA. (Cong Record, Aug 5, 2010, S6889).

Senator Leahy said that FOIA is the people's window into their government and care must be taken to ensure that exemptions from FOIA's disclosure mandates are narrowly applied.

There is a companion bill in the House, HR 6086, introduced by Rep. Edolphus Towns, Chair of the House Oversight and Government Reform Committee. In recent testimony before the House Financial Services Committee, Rep. Towns said that the FOIA exmeption in 929I is too broad since it allows the SEC to keep secret virtually any information it obtains under its examination authority.

Wednesday, September 15, 2010

SEC Adopts Rule on SOX 404(c) Exemption for Small Issuers

The Securities and Exchange Commission has adopted a final rule to implement Section 989G of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Release No. 33-9142 Section 989G affords small issuers an exemption from the internal controls auditor attestation requirement of Section 404(b) of the Sarbanes-Oxley Act of 2002. SOX Section 404(b) requires registered public accounting firms that prepare or issue audit reports for an issuer to attest to, and report on, the assessment made by the issuer's management of the company's internal controls. Previous SEC rules required a non-accelerated filer to include an attestation report in its annual report for years ending on or after June 15, 2010.

Section 989G of the Dodd-Frank Act added SOX Section 404(c) to exempt from the attestation requirement smaller issuers that are neither accelerated filers nor large accelerated filers under Rule 12b-2. Under Rule 12b-2, subject to periodic and annual reporting criteria, an "accelerated filer" is an issuer with market value of $75 million, but less than $700 million; a "large accelerated filer" is an issuer with market value of $700 million or greater. As a result, the exemption effectively applies to companies with less than $75 million in market capitalization. The release notes that the rule refers to these issuers as "non-accelerated filers," a term that is not defined in the securities regulations, but which the SEC deems to mean firms that are not accelerated or large accelerated filers.

Release No. 33-9142 removes from the applicable rules, the requirement that a non-accelerated filer include an attestation report from a registered public accounting firm in its annual report. The release amends Section 210.2-02(f) of Regulation S-X to provide that an auditor of a non-accelerated filer need not include an assessment of the issuer's internal control over financial reporting in its audit report. Item 308 of Regulation S-K is amended to provide that the requirement that management disclose an attestation report in its annual report only applies if an attestation report is included. The final rule also makes conforming amendments to Forms 20-F and 40-F. The rule is effective upon being published in the Federal Register.

In addition, the release reminds issuers that all companies (including non-accelerated filers) must still comply with SOX Section 404(a). Accelerated filers and large accelerated filers must similarly continue to comply with SOX Section 404(b).

This blog was provided by Mark S. Nelson, CCH Federal Securities Writer Analyst, Wolters Kluwer Incorporated

European Commission Proposes Derivatives Legislation Broadly Consistent with Dodd-Frank Act

The European Commission has proposed derivatives legislation that is broadly consistent with Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The draft would require that detailed information on OTC derivative contracts entered into by EU financial and non-financial firms be reported to trade repositories and made accessible to regulators and that trade repositories publish aggregate positions by class of derivatives accessible to all market participants. In addition, the proposal introduces stringent rules on prudential organization and conduct of business standards for central counterparties (CCPs), mandatory CCP-clearing for standardized contracts, and risk mitigation standards for contracts not cleared by a CCP. The proposed legislation must now be considered by the Council and the European Parliament.

According to the Commission, since the main elements of the Dodd-Frank Act are broadly consistent with the draft, at this stage it is possible to claim that there are no significant risks of regulatory arbitrage between the EU and the US. Whether this will remain the case after the final EU legislation is passed is very difficult to predict. The Commission promised to maintain a close dialogue with the US to prevent a major divergence in the two derivatives regulatory regimes.

The draft gives the new European Securities and Markets Authority a key role in the derivatives regulatory regime. ESMA will be responsible for the identification of derivatives contracts subject to the clearing obligation, such as those that are standardized and must then go through central counterparties. It will also be responsible for the surveillance of trade repositories and will be a member of the colleges of regulators supporting national authorities supervising CCPs operating in several members states. Finally, ESMAS will be required to draft a large number of specific binding standards for the application of the legislation, for example with respect to the clearing and information thresholds.

Another key to the new regime will be the central counterparties. A CCP is an entity that interposes itself between the two counterparties to a transaction, becoming the buyer to every seller and the seller to every buyer. A CCP's main purpose is to manage the risk that could arise if one counterparty is not able to make the required payments when they are due.

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. The draft would require the use of electronic means for the timely confirmation of the terms of OTC derivatives contracts. This allows counterparties to net the confirmed transaction against other transactions and ensure accurate book keeping.

In order to clear as many OTC derivative as possible, the draft legislation incorporates two distinct approaches to determine which contracts must be cleared. There is a 'bottom-up' approach under which regulators authorize a CCP to clear a class of derivatives and then inform ESMA, which will have the power to decide whether a clearing obligation should apply to that class of derivatives. The ``top-down approach’’ involves ESMA, on its own initiative and in consultation with the European Systemic Risk Board, identifying contracts that should be subject to the clearing obligation but for which no CCP has yet received authorization. In the Commission’s view, the top down approach will ensure that if no CCP clears a product that should be subject to the clearing obligation there are tools available to regulators to get this product cleared through a CCP. It will also ensure that new products will not fall through the net. ESMA will use the following criteria when determining eligibility for the clearing obligation: reduction of systemic risk in the financial system, liquidity of contracts, availability of pricing information, ability of the CCP to handle the volume of contracts, and level of investor protection provided by the CCP.

The obligation to clear OTC derivatives contracts through a CCP and report them to trade repositories will apply to financial firms such as banks, investment banks, and funds, and to non-financial firms such as energy companies, airlines, and manufacturers, that have large positions in OTC derivatives. However, similar to the Dodd-Frank Act, the draft provides for some limited exemptions from clearing and reporting requirements for non-financial firms. Thus, derivative contracts between two non-financial firms where neither firm exceeds an information threshold' will not need to be reported to a trade repository.

All other contracts, including all contracts between non-financial firms and financial firms, will need to be reported to trade repositories. Also, contracts by non-financial firms below a clearing threshold will not have to be cleared through a CCP. Commercial hedging activities using OTC derivatives to hedge risks related to a firm’s activities will be subtracted from the firm's overall position which means that they will not count towards the threshold set for the clearing obligation. These activities do not need to be cleared. For example, commercial hedging could be when airlines using OTC derivatives to secure the price at which they buy fuel, or when exporters who use OTC derivatives to shield themselves from fluctuations of exchange rates.

Since these thresholds are not set out in the draft legislation, it is expected that the new European Securities and Markets Authority along with the new European Systemic Risk Board will draft technical standards on what these thresholds should be. According to the Commission, when setting these thresholds ESMA should take into account the systemic relevance of the sum of net position and exposures by counterparty per class of derivatives, looking at how much overall risk they pose to the system. The Commission envisions that the clearing and information thresholds will be different for different asset classes and even within an asset class. Members of the European System of Central Banks, public bodies charged with or intervening in the management of the public debt, and multilateral development banks will not be subject to the clearing or reporting obligations in order to avoid limiting their powers to intervene to stabilize the market, if and when required.

Hedge Fund Industry Generally Supports SEC Proposals on Single Stock Circuit Breakers

The US hedge fund industry supports the SEC and self-regulatory organizations’ proposals to adopt uniform market-wide single stock circuit breakers and clearly erroneous trade rules. In a letter to the SEC-CFTC Advisory Committee on Emerging Regulatory Issues, the Managed Funds Association said that the proposed reforms will prevent market disruptions during times of market stress, help restore confidence in the markets and limit harm to investors.

The industry would also support refinements to these rules that would address concerns that most trading halts to-date have been triggered by erroneously reported prices, not actual market activity. Allowing such circumstances to halt trading of stocks is inefficient and creates opportunities for market manipulation. The association also generally supports some other ideas that have been discussed, such as banning stub quotes, implementing market-wide circuit breakers, and expanding the bandwidth for market data to ensure timely quotations, all of which may prevent some market events from cascading into a crisis.

More broadly, the MFA urged the SEC and CFTC to proceed cautiously with reforms and introduce changes that are supported by empirical data. The recent global financial crisis and continuing economic weakness are likely larger contributors to the general market uncertainty than any particular trading rule or practice, reasoned the MFA, and regulatory changes not supported by empirical data and directed at preventing rare market dislocations could further harm investors by decreasing daily market liquidity and raising transaction costs.

The MFA is also concerned that proposals to expand the use of speed bumps, delay trading or set maximum execution speeds would cause greater harm to investors by increasing trading and transaction costs. In the group’s view, limiting trading activities and strategies will only harm everyday liquidity and price continuity with no evidence of efficacy in times of severe stress. Thus, the MFA urged the SEC and CFTC to limit regulatory experimentation.

Moreover, the MFA does not believe that more stringent market maker obligations for firms will prevent a future market break. Indeed, imposing market maker-like obligations on non-market makers may perversely lead to less liquidity in the equity markets. Requiring market participants, to register as market makers could decrease liquidity, emphasized the MFA, since many of them may not be able to commit to meeting market maker obligations, such as broker-dealer capital and margin requirements. As a consequence, such participants would be forced to curtail their trading and investing strategies.

It will be important to build on the SEC’s equity market regulations, including implementation of the Order Handling Rules, Regulation ATS, and Regulation NMS which, in the MFA’s view, have greatly improved the equity markets by removing anti-competitive barriers and promoting fair access to markets and market information. In doing so, the SEC’s regulations have fostered innovations in technology that have revolutionized investing in the equity markets, and promoted greater competition among marketplaces. Most notably, the advancements in technology have empowered investors, both institutional and retail, with more sophisticated and efficient methods to access the markets and execute their investment strategies globally. In the process, these equity market developments have led to greater market liquidity and depth and lower transaction costs.

Tuesday, September 14, 2010

Senator Hagan Explains Volcker Provisions of Dodd-Frank Act

Senator Kay Hagan (D-NC) was pleased to see that the Volcker Rule as modified by the Dodd-Frank Act will permit banking entities several years to bring their full range of activities into conformance with the new rule. In particular, Section 619(c)(2) ensures that the new investment restrictions under Section 619(d)(1)(G)(iii) and Section 619(d)(4), including the numerical limitations under section 619(d)(4)(B)(ii), will only apply to a banking entity at the end of the period that is 2 years after the section’s effective date. This date for the regulators to begin applying the new rules can also be extended into the future for up to three one-year periods under section 619(c)(2) and can also separately be extended for illiquid funds with contractual commitments as of May 1, 2010, under Section 619(c)(3), on a one-time basis for up to 5 years. Only after all of these time periods and extensions have run will any of the limitations under Section 619(d)(1)(G) and Section 619(d)(4) be applied by regulators. (Cong. Record, July 15, 2010, S5889).

As an added protection, Section 619(f) applies Sections 23A and 23B of the Federal Reserve Act to transactions between all of a banking entity’s affiliates and hedge or private equity funds where the banking entity organizes, offers, serves as an investment manager, investment adviser, or sponsor of such funds under Section 619(d). These restrictions are also applied to transactions between a banking entity’s affiliates and other funds that are controlled by a hedge or private equity fund permitted for the banking entity under 619(d). Importantly, noted Senator Hagan, these 23A and 23B restrictions do not apply to funds not controlled by funds permitted for the banking entity under Secti on 619(d), and it should also be clear that under Section 619 there are no new restrictions or limitations of any type placed on the portfolio investments of any hedge or private equity fund permitted for a banking entity under Section 619.

Also, as a condition of sponsorship, Section 619(d)(1)(G)(v) requires that a banking entity does not, directly or indirectly, guarantee or assume or otherwise insure the obligations or performance of any sponsored hedge or private equity fund or of any other hedge or private equity fund in which the sponsored fund invests. While this restricts guarantees by the banking entity as well as the insuring of obligation or performance, explained Senator Hagan, it does not limit other normal banking relations with funds merely due to a non-control investment
by a fund sponsored by the banking entity. (Cong. Record, July 15, 2010, S5889).

Section 619(f) limits transactions under 23A and 23B of the Federal Reserve Act with a fund controlled by the banking entity or a fund sponsored by the banking entity. However, Senator Hagan noted that 619(f) does not limit in any manner transactions and normal banking relationships with a fund not controlled by the banking entity or a fund sponsored by the banking entity.

Section 619(d)(4)(I) permits certain banking entities to operate hedge and private equity funds outside of the United States provided that no ownership interest in any hedge or private equity fund is offered for sale or sold to a U.S. resident. For consistency’s sake, Senator Hagan would expect that, apart from the U.S. marketing restrictions, these provisions will be applied by the regulators in conformity with and incorporating the Federal Reserve’s current precedents, rulings, positions, and practices under Sections 4(c)(9) and 4(c)(13) of the Bank Holding Company Act so as to provide greater certainty and utilize the established legal framework for funds operated by bank holding companies outside of the United States. (Cong. Record, July 15, 2010, S5889-5890).

Monday, September 13, 2010

US Hedge Fund Industry Supports EU Legislative Draft for Derivatives Regulation

The US hedge fund industry generally supports draft EU legislation requiring the clearing and reporting of derivatives. In a letter to the European Commission, the Managed Funds Association enthused that the increased clearing of OTC derivatives will lead to greater
market transparency and competition, as well as diminished counterparty and systemic risks. More specifically, the MFA supports the draft’s clearing obligation requiring that all financial counterparties, including counterparties who enter into derivatives contracts with US counterparties, should clear all eligible derivative contracts with registered central counterparties (CCPs), as either a clearing member or a client. The MFA also agrees with the Commission’s view that certain OTC derivatives are not currently acceptable or appropriate for clearing and should continue to be transacted bilaterally, albeit with additional reporting requirements.

The MFA supports the draft’s “bottom-up approach” to central clearing under which each CCP would decide which contracts it would clear and then submit a list of such contracts to its regulator, who would then inform the European Securities and Markets Authority (ESMA), once the regulator approves the CCP’s list of contracts for clearing. Then, ESMA would determine whether a clearing obligation should apply to those contracts based on objective criteria aimed at systemic risk reduction and following public consultation. In the MFA’s view, this approach appropriately takes into account: that minimizing systemic risk should be an important criterion in deciding which classes of derivatives products should be subject to clearing and that CCPs and their risk committees should be responsible for making such a decision.

But the MFA has concerns related to the approval process for central clearing. First, with respect to the timing of the different stages in the bottom-up approval process, it is not clear whether a client may compel a clearing member to clear its counterparties’ derivatives contracts after the CCP’s risk committee and national regulator approve the contracts for clearing, but before ESMA issues a final determination. The MFA believes that the approval of a contract for clearing by both the CCP and national regulator creates a strong presumption that a contract should be cleared, and thus, clearing members should be required to clear any such contract at the request of a counterparty, pending ESMA’s final approval.

If, however, ESMA makes a final determination that, despite the CCP’s and national regulator’s approval, such contracts should not be subject to the mandatory clearing obligation, only then should a clearing member not have to clear such contracts. Additionally, the MFA asked for more detail regarding the timing of the approval process once ESMA has determined that a contract should be cleared.

The MFA is also concerned that cases may arise where a derivative contract might be of
the type that a CCP could clear but the entity’s governance processes might delay the CCP from permitting the clearing. In these instances, the MFA believes that ESMA should, after consulting with market participants and confirming that the contract may be suitably risk-managed by CCPs, be empowered to require that CCPs offer the product for clearing. The industry group also urged the Commission to clarify whether under the bottom-up approach the submission of contacts would apply to a broad class of OTC derivatives, such as credit default swaps generally, or a subset of such class such as index credit default swaps. The MFA believes that CCPs and national regulators should explicitly define and approve the subset or class of OTC derivatives that are eligible for clearing.

Despite concerns with the bottom-up approach, the MFA agreed that in principle access to a CCP should be granted on a non-discriminatory basis regardless of the venue of execution. But the association asked the Commission to clarify whether the mandatory clearing obligation will apply to OTC derivatives contracts with any European nexus, such as where one counterparty is European-based and/or the underlier is a European entity or index. The MFA urged the Commission to coordinate with US and other non-European policy makers and regulators with respect to such obligation in order to avoid jurisdiction-based market segmentation.

The MFA also said that any corporate end-user exemption in the final legislation should be limited to non-financial counterparties’ hedging of risks that occur in the conduct of their ordinary course, non-financial businesses. Indeed, the exemption should be sufficiently narrow to exempt only non-financial counterparties with a demonstrable, non-financial interest for whom clearing would cause a material hardship. Further, in order to prevent abuse of this exemption, and to install safeguards against the build-up of systemically risky exposure, the MFA called for the creation of clearing and information reporting thresholds for non-financial counterparties.

Non-financial counterparties that take positions exceeding the clearing threshold should be subject to the clearing obligation for eligible OTC derivatives contracts. In addition, OTC derivatives contracts qualifying for the clearing exemption must be subject to the same reporting requirements as all other OTC derivatives contracts to provide regulators with a comprehensive view of each participant’s risk to the system.

An important requirement fully supported by the hedge fund group is the rule that CCPs establish categories of admissible clearing members and non-discriminatory and transparent admission criteria. This requirement will ensure that all market participants have fair, objectively risk-based and open access to CCPs. Also, client access must be supervised to allow the clearing of transactions executed both between clients and CCP clearing members, as well as between clients and executing brokers that are not CCP clearing members.

The MFA believes that the legislation should require all CCPs to establish a default fund, thereby ensuring that CCPs have the financial resources to minimize risk of their failure. By definition, CCPs are systemically significant entities, reasoned the MFA, and it is thus essential that the Commission impose rules to ensure the viability and proper functioning of CCPs that operate in Europe. MFA also believes each CCP’s methodology for determining margin and pricing should be transparent and objectively risk-based.

Noting that it is inappropriate to place jurisdictional-based requirements on central clearing, the MDA said it backed draft language allowing US and other third country-based CCPs to provide clearing services to EU entities. Further, in the MFA’s view, the draft legislation’s three criteria for the recognition of non-European CCPs to provide clearing services in the EU are sufficient and will balance the European Commission’s desire to mitigate risks while permitting competition.

Thus, before non-EU CCPs are permitted to provide clearing services in the EU, they should be authorized and subject to stringent supervision by non-European regulators, the Commission should formally decide whether to recognize the OTC derivatives regulatory frameworks of non-European countries, and cooperation agreements must be in place between the relevant competent authorities.

IASB Proposes Change to Standard on Accounting for Income Tax Against Backdrop of Broad IASB-FASB Review of Tax Accounting Standards

As the IASB and FASB conduct an ongoing fundamental review of the financial standard for accounting for income tax, the IASB has proposed a specific significant amendment to its international accounting standard for income tax, IAS12, that would provide an exception to the principle that the measurement of deferred tax liabilities and deferred tax assets should reflect the tax consequences that would follow from the manner in which the entity expects to recover or settle the carrying amount of its assets and liabilities.

The IASB recognizes that, in some jurisdictions, applying this principle can be difficult or subjective in some circumstances. For example, a deferred tax liability or a deferred tax asset may arise from investment property that is measured using the fair value model in IAS 40 and is held by the company both to earn rental income and for capital appreciation. Attempts to apply this principle to this situation often result in difficulty and subjectivity. This is an issue in jurisdictions where the tax law treats gains and losses from the recovery of an asset through sale differently from income earned from using the same asset by applying different tax rates. As a result, in some jurisdictions, there may be no tax consequences arising from the future sale of the asset, but significant tax consequences if the carrying amount of the asset is considered to be recovered through use.

Under the IASB’s proposed changes to IAS 12, the measurement of deferred tax liabilities and deferred tax assets should reflect a rebuttable presumption that the carrying amount of the underlying asset will be recovered entirely by sale. The specified circumstances are that the deferred tax liability or deferred tax asset arises from investment property, when an entity applies the fair value model in IAS 40, or property, plant and equipment or intangible assets, when an entity applies the revaluation model in IAS 16. The presumption is rebutted only when an entity has clear evidence that it will consume the asset’s economic benefits throughout its economic life.

The Board decided that, when a firm uses the fair value model in IAS 40 or the revaluation model in IAS 16 or IAS 38, the tax consequences reflecting presumed recovery of the underlying asset entirely by sale are more relevant than a presumption of recovery by an alternative manner. In making that decision, the Board considered a combination of various views expressed by interested parties, which included the view that presuming a sale is consistent with measurement of the underlying asset on a fair value measurement basis that reflects the price that would be received if the asset is sold. But the Board made the presumption of recovery through sale rebuttable based on its belief that it is not appropriate to assume the recovery of the underlying asset by sale when the firm has clear evidence that it will consume the asset’s economic benefits throughout its economic life.

The IASB explained that the proposal is intended to provide a practical approach for measuring deferred tax liabilities and deferred tax assets when it would be difficult and subjective to determine the expected manner of recovery. The Board said that the amendments would apply retrospectively, including retrospective restatement of all deferred tax liabilities or deferred tax assets within the scope of the proposed amendments, including those that were initially recognized in a business combination

In March 2009 the Board proposed a new IFRS on accounting for income tax to replace IAS 12. But later that year the IASB withdraw that proposal and embarked with FASB on a fundamental and comprehensive review of the accounting for income tax, but at the same time the IASB reserved the right to address specific issues.

There is Growing Int'l Consensus Among Audit Committees on the High Value of Outside Auditors

A report issued by the Accounting and Corporate Regulatory Authority (ACRA) of Singapore found that company audit committees place a very high value on the outside independent audit of the company’s financial statements. The external audit by an independent audit firm is regarded as extremely valuable by the audit committees, noted ACRA, predominantly for the assurance it brings them that the financial statements prepared by management present a true and fair view of the company’s financial position and results to its shareholders. They see audit as an essential part in the financial reporting value chain which provides them with comfort that the company’s own internal accounting staff, processes and systems are generating reliable information. It therefore assists the audit committees in meeting their corporate governance responsibilities and statutory duties. More broadly, ACRA views external audits as an important indispensable niche in the corporate governance eco-system.

The audit committees said that the most important criterion for the selection of the outside auditor was the engagement partner’s expertise and knowledge of the company’s industry and business; and an informed audit team with international reach. The audit committees expect the engagement partner to set the tone for the audit team with regards to the quality of the audit, the level of professional skepticism, and engagement with the client. Further, the audit committees expect to deal with the same engagement partner and team during the entire audit.

The report indicates that audit committees want their auditors to be independent and speak their mind. Outside audits provides an invaluable independent perspective on the numbers generated by management. Challenging questions from auditors and subsequent responses by management give the audit committees confidence that the figures are reliable for financial reporting purposes. The outside auditor is well-placed to bring to the committee’s attention any current or potential problems. Also, given the growing complexity of international financial reporting standards, the outside auditors’ knowledge of new accounting standards and their ability to draw the attention of the audit committee to the impact that financial reporting standards will have on the company’s financial statements was seen as very valuable.

In addition, the management letter, in which auditors outline weaknesses in internal controls, was particularly important to audit committees, who might not otherwise be informed of these weaknesses. The management letter refers to the letter prepared by the auditor and addressed to management, outlining internal control weaknesses and other related issues, together with management’s responses, based on discussions the auditor had with relevant management personnel during the audit.

The report also found important additional intangible benefits generated by the audit, such as auditors’ feedback on the quality of management’s finance team and the competence and co-operation of staff, particularly those in foreign locations. These and other insights would be lost without the external auditors.

That said, the report emphasized that auditor liability is a key problem that must be addressed. The audit committees believe that auditors have become risk-averse to offering professional views that would be useful to the company but are not required within the scope of the statutory audit. Thus, the full potential value of the audit is generally not being realized.

Dovetailing with the growing global consensus on the value of the outside audit, a study conducted by Maasstricht University found that CFOs and audit committees value the communications with the outside auditor in the audit process, and find it useful to work with the auditor on financial reporting issues. The CFOs envision an enhanced role for the auditor as an independent expert to check and challenge their views on critical and complex issues. The CFOs and audit committees urged that close attention be given to the content of management letters since these are a valuable form of communication.

That said, the CFOs and audit committees would like to see the audit model reconsidered to offer a less compliance driven, more comprehensive approach that additionally offers a broader, more holistic view of the business. They also urged auditors in all jurisdictions to strive for a universally consistent interpretation and application of auditing standards. Policy makers and regulators should support common standards and consistent regulatory oversight across jurisdictions.

Saturday, September 11, 2010

Legislation Requiring Proxy Disclosure of Company’s Political Donations Reported Out to House Floor

Legislation requiring a shareholder vote on a company’s proposed political budget has been favorably reported out of the House Financial Services Committee to the House floor. The Shareholder Protection Act, HR 4790, responds to January’s Supreme Court decision in Citizens United v. FEC that corporations cannot be prohibited from spending general treasury funds on political campaigns because it would violate their free speech rights. Sponsored by Rep. Michael Capuano (D-MA), with 49 co-sponsors, the legislation would give shareholders the ability to vote to approve or reject these expenditures. According to Rep. Capuano, the legislation is a simple and direct way to ensure that corporate political expenditures reflect the will of the shareholders, since the money in question belongs to the shareholders.

The Act would amend the Exchange Act to require that any proxy solicitation describe the specific nature and total amount of expenditures proposed for political activities for the forthcoming fiscal year and provide for a separate shareholder vote to authorize such proposed expenditures. The measure would also prohibit a company from making an expenditure for political activities in any fiscal year unless the expenditure is of the nature of those proposed by the company according to the requirements of the Act and authorization for such expenditure has been granted by votes representing a majority of outstanding shares. Also, the SEC must adopt rules requiring companies to include in their annual report to shareholders an annual summary of all expenditures for political activities made during the year in excess of $10,000.

Importantly, the measure would deem a violation of this requirement to be a breach of the fiduciary duty of the officers and directors who authorized the expenditure. The legislation also subjects officers and directors who authorize the expenditure without prior shareholder approval to joint and several liability to any shareholder or class of shareholders for the amount of the expenditure. Further, institutional investment managers would have to disclose annually in mandatory reports how they voted in certain shareholder votes.

The Act would prohibit any person from bringing a civil, criminal, or administrative action against an institutional investment manager, or any of its employees, officers, or directors, based solely upon the investment manager's decision to divest from, or not to invest in, securities of a company because of its expenditures for political activities.

The SEC would be required to direct the national securities exchanges and national securities associations to prohibit the listing of any equity security of a company whose bylaws do not expressly provide for a vote of the directors on any individual expenditure for political activities in excess of $50,000 or any expenditure that makes the total amount spent by the company for the particular election $50,000 or more. Further, a company would be required to disclose, within 48 hours, the individual votes of the directors regarding any such expenditure.

The SEC is further directed to require companies to disclose expenditures for political activities made during the preceding quarter and the individual votes by board members authorizing such expenditures. Companies must disclose the time and amount of the expenditure and the identity of the recipient. The company must also disclose any materials purchased by the company’s political donation on its Internet website within 48 hours of obtaining the material.

Finally, the SEC must annually assess the compliance of public corporations and their
management with the requirements of the Act, and transmit to Congress a report of its findings. In turn, the GAO must periodically evaluate and report to Congress on the effectiveness of the SEC’s oversight of the reporting and disclosure requirements of the Act.

Legislation Moving Through Congress Would Create US Covered Bond Market

Bi-partisan legislation creating a US covered bond market has been reported out to the House floor and has a good chance of being passed during the final months of the 112th Congress. The legislation is designed to enhance liquidity in the secondary markets, reduce financing pressure, and more broadly reform the mortgage-backed securitization process. The United States Covered Bond Act, HR 5823, is sponsored by Rep. Scott Garrett (R-NJ) and co-sponsored by Rep. Paul Kanjorski (D-PA), Chair of the Capital Markets Subcommittee and House Financial Services Committee Ranking Member Spencer Bachus (R-AL). The covered bond provisions narrowly missed being included in the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Garrett provisions were supported by Senate Banking Committee Chair Chris Dodd, who has scheduled hearings in September on the covered bond legislation.

According to Rep. Garrett, covered bonds have been used in Europe to help provide additional funding options for the issuing institutions and are a major source of liquidity for many European nations’ mortgage markets. The legislation is a thorough framework that seeks to provide the same benefits to the U.S. market. The legislation provides for the regulatory oversight of covered bond programs, includes provisions for default and insolvency of covered bond issuers and subjects covered bonds to appropriate federal securities regulation. According to an FDIC policy statement, covered bonds originated in Europe, where they are subject to extensive regulation designed to protect the interests of covered bond investors from the risks of insolvency of the issuer. By contrast, the US does not currently have the extensive statutory and regulatory regimes designed to protect the interests of covered bond investors that exists in European countries.

Covered bonds help to resolve some of the difficulties associated with the originate-to-distribute model of securitization. The on-balance-sheet nature of covered bonds means that issuers are exposed to the credit quality of the underlying assets, a feature that better aligns the incentives of investors and mortgage lenders than does the originate-to-distribute model of mortgage securitization. The cover pool assets are typically actively managed, thereby ensuring that high-quality assets are in the cover pool at all times and providing a mechanism for loan modifications and workouts. Also, the structure used for such bonds tends to be fairly simple and transparent.

Pursuant to an amendment to HR 5823 offered by Rep. Melissa Bean (D-Il), covered bonds would be co-regulated by the SEC and the appropriate federal bank regulator. Before the Bean Amendment, the legislation housed regulation of the covered bond market solely with the OCC. The Bean Amendment also provides that, when acting as a covered bond regulator, the SEC must consult with the appropriate state regulator. The Bean Amendment also provides that, before approving any covered bond program of any eligible issuer who is an insured depository institution, the SEC or any other covered bond regulator must consult with the FDIC and confirm to the FDIC that the covered bond program is not reasonably expected to materially increase the risk of losses or actual losses to the deposit insurance fund. Similarly, before adopting regulations or issuing guidelines as part of any covered bond oversight regime, the SEC and other covered bond regulators must consult with the FDIC and confirm that the regulations or guidelines are not reasonably expected to materially increase the risk of losses or actual losses to the deposit insurance fund.

A covered bond is a secured debt instrument that provides funding to an issuer that retains residential mortgage assets and related credit risk on its balance sheet. These assets are known as the cover pool. Interest on the covered bond is paid to investors from the issuer’s cash flows, while the cover pool serves as secured collateral. Covered bonds provide dual recourse to both the cover pool and the issuer. In the event of an issuer default, covered bond investors first have recourse to the cover pool.

The Act defines a cover pool as a dynamic pool of assets comprised of eligible assets, including secured first-lien mortgage loans, any state or municipal security, and SBA guaranteed small business loans. A Managers Amendment offered during the mark up of the legislation by Rep. Kanjorski deleted student loans, auto loans, and home equity loans from the list of eligible assets, as well as, in the case of the credit or charge card asset class, any extension of credit to a person under an open-end credit plan.

The legislation also provides that any covered bond issued or guaranteed by a bank is a security under Section 3(a)(2) Securities Act, Section 3(c)(3) of the Investment Company Act, and Section 304(a)(4)(A) of the Trust Indenture Act. However, no covered bond issued or guaranteed by a bank is an asset-backed security, as defined in Section 3 of the Exchange Act.

Any estate created under the legislation will be exempt from all securities laws, except that the estate will be subject to reporting requirements established by the SEC and other covered bond regulators. The Kanjorski Managers Amendment directs the SEC and other covered bond regulators to require that such reports cannot contain any untrue statement of a material fact and cannot omit to state a material fact necessary in order to make the statements made, in light
of the circumstances under which they are made, not misleading. The estate will also succeed to any requirement of the issuer to file periodic information, documents, and reports in respect of the covered bonds as specified in Section 13(a) of the Exchange Act. Any residual interest in an estate created under the legislation will also be exempt from all securities laws.

Covered bonds differ from mortgage backed securities in several ways. First, mortgages
securing covered bonds remain on an issuer’s balance sheet, unlike mortgage backed securities.
Second, pools of loans securing covered bonds are dynamic, and non-performing or prepaying
loans must be substituted out of the cover pool. Finally, if a covered bond accelerates and repays
investors at an amount less than the principal and interest owed, investors retain an unsecured
claim on the issuer.

Covered bonds differ from unsecured debt because of the absence of secured collateral
underlying the obligation of the issuer. While unsecured debt investors retain an unsecured
claim on the issuer in the event of issuer default, covered bond investors possess dual recourse to
both the underlying collateral of a covered bond and to the individual issuer. Accordingly,
covered bonds provide investors with additional protection on their investment compared with
unsecured debt.

The Securities Industry and Financial Markets Association (SIFMA) supports HR 5823, noting that covered bonds can provide a substantial and stable source of long term private capital and liquidity to fund mortgage, public-sector, and small business loans. In doing so, covered bonds have the ability to positively impact the financial system by providing an alternative source of funding and, in turn, increase the availability of consumer credit. In SIFMA’s view, HR 5823 provides the legal framework necessary to develop a liquid and efficient covered bond market in the U.S. It also provides investors with the certainty they need to support the market and is consistent with several policy objectives including increased transparency and uniformity, and the desire for issuers to have skin in the game. Covered bonds also represent an untapped and proven resource to provide liquidity to credit markets, an essential benefit in the current constrained environment.

In a comment letter on the SEC’s proposed revisions to Regulation AB, the American Bar Association said that covered bonds have been widely touted as being able to essentially replace asset-backed securities as a key funding source. The ABA is reluctant to see this type of security encumbered by issues from the securitization industry before a United States market even has a chance to develop. A broad reading of the cash flow element of the SEC’s proposed structured finance product definition could, however, include payments received from the covered bonds’ collateral pool after a default or issuer insolvency under the covered bonds. Although the ABA does not believe that payments on covered bonds depend on the cash flow from the assets in the collateral pool, the Association urged the SEC to explicitly exclude covered bonds from the structured finance product definition.

Thursday, September 09, 2010

Wisconsin Adopts Rule Changes for Annual Rules Revision

Rule amendments pertaining primarily to investment adviser solicitation activities were adopted by the Wisconsin Securities Division, effective October 1, 2010, upon the Division completing its annual revision of rules. The text of the solicitation provision, housed within the investment adviser prohibited conduct rule, is based on language developed by the Regulatory Policy and Review Group of the North American Securities Administrators Association (NASAA).

Other rules changes repeal an outdated requirement for delivering a current brochure and supplement to advisory clients; mandate electronic filing of Form ADV, Part II in 2011 for Advisers registered in Wisconsin by December 31, 2010; permit the Securities Division to designate an employee to examine an applicant's books and records; provide an examination waiver for investment adviser or representative applicants registered as broker-dealer agents within two years before their IA or IA rep. application filing dates; redefine a broker-dealer and investment adviser branch office; repeal an exam waiver for broker-dealer agents of the Japanese Stock Exchange; broaden the oil and gas exemption to apply to any entity's offers or sales; and restrict Wisconsin issuers' offers or sales for the "Wisconsin issuer registration exemption by filing" to equity securities.

For more information please see