Sunday, October 31, 2010

Presidential Assistant Warren Pledges Transparency and Tough Enforcement for new Bureau of Consumer Financial Protection

Assistant to the President Elizabeth Warren said that the new Bureau of Consumer Financial Protection created by the Dodd-Frank Act will operate with transparency and will strictly enforce its regulations. In remarks at the Mario Savio Memorial Lecture, the official committed to making public the advocates, lobbyists, and other stakeholders she meets with in creating the new Bureau. A key to transparency will be the annual report the Bureau will produce, which Ms. Warren called a State of the Union for Consumer Financial Issues. But remaining focused on the mission requires more than just transparency, she said, it requires engagement. Thus, the Bureau will interact with financial consumers and investors. Ms. Warren was also named Treasury Special Advisor on the Consumer Financial Protection Bureau and will play a lead role in setting up the new Bureau.

According to the Special Advisor, the Bureau will be driven by data collected from a myriad of diverse sources, including from financial institutions, from academic studies and from the Bureau’s own independent research. Importantly, the Bureau will seek data from the consumers of financial products, with appropriate privacy protections in place. Ms. Warren said that the Bureau will have an open platform that invites consumers to share their experiences with credit and financial products. Ms. Warren envisions consumers telling the Bureau what has happened to them as they have used credit cards, tried to pay off student loans, or worked to correct errors in a credit report. From consumers and investors, the Bureau can learn about good practices, bad practices and downright dangerous practices.

The Bureau will use vigorous enforcement tools to become the cop on the beat watching huge credit card companies, local payday lenders, and others in between. Technology will ensure that the Bureau’s enforcement priorities are tightly connected to the financial market realities as experienced by customers every day. In the official’s view, new technology can help the Bureau supplement the cop on the beat by building a neighborhood watch. The agency can empower a well-informed population to help expose, early on, consumer financial tricks. If rules are being broken, the Bureau will not have to wait for an expert in Washington to wake up. Ms. Warren envisions an agency that can collect and analyze data faster and get on top of problems as they occur, not years later.

Friday, October 29, 2010

EU Commissioner Barnier Sees No Point in Converged Capital Requirements If Accounting Standards Not Converged

It is essential for global financial reform that the SEC take the necessary steps to transpose IFRS in the United States since if accounting standards are different then capital requirements become different too, in the view of EU Internal Market Commissioner Michel Barnier, who asked what is the point of agreeing on capital requirements if their application leads to different results because of different accounting rules. In remarks at SIFMA, the Commissioner, while acknowledging that the US and EU have harmonized derivatives legislation, chided US authorities for not reining in bonuses as part of executive compensation reform.

The Commissioner said that the US could do more to control excessive risk taking by getting the incentives right. Excessive risk is at the expense of shareholders who have to provide additional capital, he said, and excessive risk is at the expense of society as a whole, as evidenced by the financial crisis. It is in everybody's interest that these risks are kept under control, he noted. While acknowledging that competent people should be rewarded, the Commissioner posited that the way compensation is structured can give wrong incentives and lead to excessive risk taking. While conceding that payment of bonuses is a very sensitive issue in the US, Commissioner Barnier noted that the EU has taken determined steps to reduce bonuses at financial institutions. Based on Financial Stability Board principles, one of which says that bonuses should diminish or disappear in the event of poor business unit performance, the EU has adopted binding rules that will apply to bonuses paid in 2010.

Regarding derivatives, Commission Barnier said that he has worked closely with CFTC Chair Gary Gensler to ensure that the final EU derivatives legislation is consistent with the approach taken by the Dodd-Frank Act. Consistent cross-border regulation is crucial, he observed, since 80 per cent of derivatives trading takes place in the United States and Europe. The Commissioner rejected US voices saying that the OTC derivatives provisions of the Dodd-Frank Act should be given a light implementation because the EU is being less ambitious.

Similar to Dodd-Frank, he said, the EU draft deals with requirements on central clearing parties and trade repositories. Other key aspects of the EU approach are additional capital requirements for contracts not centrally cleared, pre- and post- market transparency and the trading of OTC-derivatives on exchanges or electronic platforms, which will be addressed in upcoming proposals on reviewing the Capital Requirements Directive and the MiFID Directive.

Also, like Dodd-Frank, the EU adopted regulations for credit rating agencies involving, among other things, supervision and conflicts of interest. However, similar to the discussions going on in the US, the European Commission wants more reflection on the role of ratings, including a detailed look at the impact of ratings on some markets, such as sovereign bonds, where announcements have widespread consequences for markets and countries. Also, the EU wants to enhance competition by lowering barriers to entry in the market and reducing the market power of the existing agencies. More broadly, the Commission will examine the issuer-pays model. The Commission will start consulting stakeholders very soon on these issues.

Corporate Counsel Say That Proposed Changes to FASB Standard on Loss Contingencies Could Harm Auditor Relationship

The tension over waivers of privilege or work product protection for accrual work papers arising from proposed changes to the FASB standard for disclosing loss contingencies would complicate the relationship between companies and their independent auditors. In a letter to FASB, which was signed by over 150 General Counsel from a variety of companies, the Association of Corporate Counsel noted that, if the auditors needed to evaluate the legal analysis underlying a given disclosure, even if such analysis itself is not disclosed, this could increase the likelihood of a court determining that a waiver of privilege has occurred. In support of its contention, the group cited the full First Circuit’s 2009 ruling in U.S. v. Textron, Inc. that tax accrual materials prepared by in-house lawyers primarily to obtain a final audit opinion would not be afforded work product protection. In the group’s view, the Ninth Circuit ruling presents in stark relief the serious dangers raised by the accrual-related disclosures in the FASB draft. The changes are proposed for former FAS 5, loss contingencies, which is Topic 450 in the Codification.

Although corporate counsel understands that FASB does not want to jeopardize these fundamental protections, the association still has significant concerns that the accrual-related disclosures, if adopted as proposed, could lead to an outcome where plaintiffs’ lawyers eventually are able to arm themselves with the thoughts and impressions of company counsel, which the group believes would be an unacceptable outcome injurious to the company and its shareholders. Thus, the association urged FASB to modify the proposal to require disclosure of accrual amounts only if necessary for the financial statements not to be misleading, as under the current standard, and to remove the requirement for disclosure of accrual amounts in the tabular reconciliation.

A tension arises because, if companies adhere to the FASB guidance in the draft and refrain from disclosing any information that is privileged or subject to attorney work-product protection, then disclosures about accruals likely would be based on very limited information, without the benefit of in-house and outside counsels’ analyses of the risks and exposure. Disclosures based on such limited information not only would be laden with necessary disclaimers but also would disservice the users of financial statements. On the other hand, the accrual disclosures and related information that the outside auditors may seek as part of the audit process in order to audit the accrual amounts or range of loss for each individual contingency could raise the risk that a court later will deem that these disclosures constitute a waiver of privilege or work-product protection. Thus, the disclosure of accrual amounts for each litigation contingency that is probable, and the related tabular reconciliations of such amounts, present a real risk that privilege and work product protections that form the bases for such information could be lost.

In any event, the association asked FASB to delay the effective date of the new standard in order to give audit committees, company management and outside auditors time to evaluate the final guidance and discuss implementation issues that are particular to the company. And, once developed, audit committees and the outside auditor will need to spend adequate time assessing and, in the case of the auditor, auditing the information relevant to the disclosures. FASB originally proposed that companies would begin providing enhanced loss contingency disclosures in financial statements for fiscal years ending after December 15, 2010. But at an October 27 meeting, FASB decided that a final standard would not be effective for the 2010 calendar year-end reporting period.

Alaska Sets Schedule for IAs Filing Form ADV Part 2

State investment advisers applicants. Persons applying to register as investment advisers for the first time in any state may between October 12, 2010 and December 31, 2010 electronically file with the IARD an old Part II or new Part 2 of Form ADV. Beginning January 1, 2011 persons applying to register as investment advisers for the first time in any state or for initial registration in a new state must electronically file new Part 2 with the IARD.

State investment adviser registrants.
Alaska-registered investment advisers may between October 12, 2010 and December 31, 2010 electronically file with the IARD their Form ADV amendments on either old Part II or new Part 2. Alaska-registered investment advisers will, however, need to incorporate new Part 2 with either their next filing of a Form ADV amendment or filing of the annual updating amendment, whichever filing occurs first, so that investment advisers with a December 31, 2010 fiscal year-end who have not already filed an updated Part 2 must electronically file with the IARD an annual updating amendment that includes new Part 2 brochures no later than March 31, 2011.

SEC-registered investment advisers.
SEC-registered investment advisers must within 60 days of filing an amendment deliver a new Part 2 brochure and brochure supplement to their existing clients that meets amended Form ADV requirements. SEC-registered investment advisers must immediately after filing the amendment begin delivering their new Part 2 brochure and brochure supplements to new and prospective clients.

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Eighteen Senators Urge SEC to Adopt Strong Dodd-Frank Volcker Regulations

In a letter to the SEC and the broader Financial Stability Oversight Council, eighteen Senators provided detailed guidance to regulators to help them effectively implement and enforce the statutory language of the Volcker provisions of the Dodd-Frank Act. Senators Carl Levin and Jeff Merkley, who co-authored the Volcker provisions, were signatories of the letter. Section 619 of Dodd-Frank establishes the basic principle that a bank must not engage in proprietary trading or acquire or retain ownership interests in or sponsor a hedge fund or private equity fund. Section 621 prohibits financial firms from engaging in transactions involving or resulting in material conflicts of interest. According to the Senators, the broad intent of the Volcker provisions is to protect investors and the financial system from the distortion caused by proprietary trading practices and from conflicts of interest that place a firm’s own interests ahead of the interests of its clients

The Senators envision implementing the Volcker provisions by establishing a regulatory structure capable of meaningful enforcement. The Council and the SEC were urged to establish a two-tier, cooperative regulatory structure. At the first tier, regulators should conduct real-time monitoring and enforcement. In the Senators’ view, the SEC and the CFTC are in the best position to take a leadership role in monitoring trading and positions, much like they do for insider trading, position limits, and other trading provisions. The newly-created Office of Financial Research may assist in standardizing the data collection and review efforts. At the second tier, regulators should review firms’ policies and procedures and conduct in-depth portfolio-level examinations. Banking regulators, such as the FDIC and the Federal Reserve Board, are best positioned to conduct these broader reviews of firms. This type of two-tier, cooperative approach would enable regulators to share the implementation burdens and also play to their traditional strengths, reasoned the Senators.

More specifically, the Senators believe that the term “trading account” should cover all types of accounts that may be used to conduct proprietary trading. Also, the extent of permitted activities, particularly market making and risk mitigating hedging, should be strictly and clearly delineated to ensure that high-risk proprietary trading stops, while economically beneficial and risk-reducing activities continue. Capital charges governing these permitted activities should also be vigorous enough to protect the economy and U.S. taxpayers from risks arising from them. In addition, the relationships between covered financial firms and the private funds they manage or sponsor should be carefully circumscribed to prevent those private funds from being used to circumvent the law’s limits.

The SEC and other regulators are urged to meaningfully define the terms “material conflicts of interest” and “high risk” assets and trading strategies so as to safeguard U.S. taxpayers from unfair practices and systemic risk. Moreover, capital charges and quantitative limits for systemically significant hedge funds and other nonbank financial companies should be vigorous so as both to discourage and to reduce the risks and conflicts of interest from proprietary trading at these entities. Importantly, Dodd-Frank’s anti-evasion provisions should be implemented to ensure that the SEC and other regulators have clear authority to prevent abusive and evasive tactics from undermining the Volcker-Merkley-Levin provisions.

The Financial Stability Oversight Council is a collaborative body established as part of the Dodd-Frank Act to monitor and address risks to financial stability. The FSOC, chaired by the Secretary of the Treasury, and including the SEC and CFTC, is authorized to facilitate regulatory coordination, recommend stricter standards, and break up firms that pose a grave threat to financial stability, among other responsibilities. The FSOC is currently requesting comments to inform a study of the implementation of the Volcker-Merkley-Levin provisions of Dodd-Frank, to be completed by January 2011 as required by the Dodd-Frank Act. The SEC is also seeking public comment in aid of its adoption of regulations implementing these provisions.

Thursday, October 28, 2010

American Securitization Forum Urges SEC Not to Take Broad Reading of Material Conflict of Interest When Crafting Dodd-Frank Volcker Regulations

With regard to the conflict of interest provision in Dodd-Frank co-authored by Senators Carl Levin and Jeff Merkley, the American Securitization Forum urged the SEC to, consistent with legislative intent, adopt regulations specifically tailored to prohibit transactions that create a material incentive for firms to intentionally design asset-backed securities to fail or default. Section 621, one of the Volcker provisions of Dodd-Frank, prohibits firms from packaging and selling asset-backed securities to their clients and then engaging in transactions that create conflicts of interest between them and their clients. In the Forum’s view, a broad reading of Section 621 could effectively lead to a contraction of available credit for consumer finance and small business, where securitization has provided a significant source of funding, including mortgage loans and auto loans.

In its letter to the SEC, the Forum cited as legislative history an earlier letter to the SEC from Senators Levin and Merkley clarifying that the intent of Section 621 is to end the conflicts of interest that arise when a financial firm designs an asset-backed security, sells it to customers, and then bets on its failure. Thus, the Forum said that SEC regulations implementing Section 621 should be crafted to prohibit the situations that result in the material conflicts of interest identified by the Senators without causing unnecessary adverse impacts on the markets for asset-backed securities.

In the view of the Forum, a broad interpretation of the phrase material conflicts of interest prohibiting any transaction relating to an asset-backed security by which a party might receive a potential profit upon failure or default of the security would inhibit many activities currently undertaken by market participants and be against legislative intent. For example, many underwriters of asset-backed securities provide transaction sponsors with short-term funding facilities such as variable funding notes and asset-backed commercial paper, whereby the underwriter provides financing to the sponsor to fund asset originations or purchases of assets.

These facilities provide essential liquidity until the assets can be packaged through a term securitization and sold into the debt capital markets. As the proceeds from the securitization are used to repay the financing, noted the Forum, a broad reading of material conflicts of interest as used in Section 621 could prohibit this funding tool, essentially cutting off one of the only available sources of credit in today’s constrained market. Similarly, a broad interpretation of material conflicts of interest could prohibit servicers of mortgage loans, auto loans, and other assets who are affiliated with the sponsor of a transaction from pursuing customary servicing activities

Moreover, an overly broad reading of Section 621 could effectively prohibit the issuance of subordinated classes of securities and interest-only and principal-only classes of securities, especially given the requirement contained in Dodd-Frank that a securitizer retain a portion of the securities issued in a transaction. A risk retention requirement is also contained in the FDIC’s safe harbor and the SEC’s proposed revisions to Regulation AB.

Further, the Forum noted that many investors in asset-backed securities seek interest rates or currencies that differ from the underlying assets, which require that the structures employ interest rate or currency swaps. These swaps are standardized and bid out to various market participants, including affiliates of the underwriter of the asset-backed transaction. An expansive interpretation of material conflicts of interest could prohibit an affiliate of the underwriter from providing such a swap, potentially depriving investors of the best possible execution.

This outcome would be outside the Congressional intent of Section 621, maintained the Forum, which sought to eliminate the improper incentives to issue asset-backed securities designed to fail, but not to prohibit the creation of asset-backed securities that allocate disclosed risks between or among separate parties. While noting that Senator Levin believes that disclosure alone may not cure material conflicts of interest in all cases, the Forum feels that disclosure would remedy perceived conflicts in situations that are clearly not instances of an asset-backed security being designed to fail.

The Forum proposed that the SEC define a material conflict of interest as being when, other than for hedging purposes, a Restricted Party participates in the issuance of an asset-backed security created primarily to enable it to profit from a related or subsequent transaction as a direct consequence of the adverse credit performance of the asset-backed security and within one year following the issuance of the asset-backed security the Restricted Party enters into such related or subsequent transaction.

By clearly identifying principles upon which market participants can determine what activities would constitute a material conflict of interest under Section 621 and which parties are subject to such restriction, the Commission can effectively eliminate the practices identified by Senators Merkley and Levin without risking unintended consequences to the efficient functioning of the capital markets. Finally, the Forum noted that Section 621 includes exceptions for risk-mitigating hedging activities, bona fide market making, and commitments to provide liquidity. The Forum agrees with Senators Merkley and Levin that appropriate hedging, market-making and liquidity commitments are necessary and proper for the development of a healthy asset-backed securities market.

EU Commissioner Barnier Links More Board Involvement to Sound Corporate Governance

Effective corporate governance requires that company directors limit the number of boards that they serve on so that they can dedicate more time to their governance duties, emphasized EU Commissioner for the Internal Market Michel Barnier at a Brussels seminar. In a major address on corporate governance, Commissioner Barnier also noted that the ability and willingness of a company’s directors, particularly non-executive directors, to exercise effective control over senior management must be improved.

In his view, during the financial crisis, directors too often failed to act as the principal decision-making body of the company and failed to challenge the decisions and practices of senior management. That must change in future, he said. The Commissioner also called for more diverse boardrooms since diversity in all forms creates the right conditions for a real exchange of views.

Commissioner Barnier also called for the reassessment of the role of board risk committees as part of an overall enhancement of risk management. Risk managers must be given more authority, he added, with the company’s Chief Risk Officer being given equal standing with the Chief Financial Officer.

On the issue of executive compensation, the Commissioner said that compensation must always be oriented towards mid and long-term achievements. It is imperative to move the corporate culture away from the short-term, hit-and-run culture that has caused so much damage. In particular, financial companies were obsessed by immediate and maximum profits, he noted, which led to irresponsible behavior as longer term interests were forgotten. The EU is leading the way on compensation reform, he said, with the Capital Requirements Directive 3, which will apply to 2010 bonuses.

Finally, the EU official said that regulatory enforcement must be enhanced to ensure that reforms actually happen. In this regard, Commissioner Barnier will soon propose enhancing the EU sanctions regime for market abuse and making it consistent across borders. Regulators can only make sure the financial markets work properly if they have at their disposal appropriate sanctioning powers that are applied consistently across the EU. Currently, sanctions differ significantly across the EU. They can be quite tough in some countries and virtually absent in others. The same is true for investigative tools. This leaves too much scope for regulatory arbitrage, noted the Commissioner, and puts financial stability at risk, with consumers suffering the consequences.

Wednesday, October 27, 2010

UK Audit Overseer Says Market Forces Alone Will Not Move Auditor Choice Beyond the Big Four

The UK regulator of financial statement audit told a parliamentary committee that market forces alone will not expand global audit choice beyond the Big Four and that regulation will be needed on auditor concentration. In a prepared submission to the Economic Affairs Committee, the Financial Reporting Council expressed concern that the highly concentrated market for audit services in the Big Four and a litigious market, especially in the US, poses a risk that one of the Big Four could fail, resulting in severe disruption to global capital markets as investors lose confidence in the financial statements of the firm’s audit clients. The FRC also said that there is an expectation gap between the actual scope of an audit and public perception of the information an audit should reveal. This gap was particularly evident in much of the commentary following the financial crisis, with many people querying how a financial institution could have received an unqualified audit report only to collapse a few months later.

The market for the audits of the largest companies is highly concentrated, noted the FRC, with the Big Four auditing 99 percent of the FTSE 100, and with similar levels of concentration in the US and most other developed countries. The FRC believes that market perception is the main barrier to the expansion of non-Big Four firms into the audit market for large public companies. While mid-tier firms may not have the resources to audit the very largest companies, noted the FRC, they are quite capable of auditing a far broader range of companies than is currently the case.

One negative result of audit concentration is the potential for moral hazard as the largest firms consider they are too big to fail and judge that regulators will be reluctant to take enforcement action against them if that action has the potential to result in the firm leaving the market. Also, there is a lack of auditor choice for large companies, particularly those in certain industries where only two or three firms are judged to have the appropriate expertise to act as auditor. If the company uses another large firm for other services, such as corporate finance, it may find itself without an effective choice of auditor in the short term due to independence restrictions. In the FRC’s view, there is also a lack of innovation in audit, with all large firms offering a virtually identical product. Regulatory restrictions on the scope of audit, independence rules and the format of the audit report offer only a partial explanation for this lack of innovation. Similarly, the FRC found little indication that the large audit firms attempt to compete on quality.

The FRC does not believe that the Big Four should be preserved at all costs, and regulators and legislators should not be afraid to take action against a Big Four firm if it is warranted. The FRC would not wish to preserve a firm from commercial failures, but would prefer to see action after failure to prevent the market becoming dominated by just three firms.

With regard to audit expectations, the FRC observed that there have been suggestions from various market participants, including some audit firms, that there would be value in widening the scope of audit and in extending reporting requirements beyond shareholders to include bodies such as regulators. Recently, the European Commission issued a Green Paper on audit suggesting this type of auditor scope. Early feedback suggests that auditors could validate a wider range of risk-related information on financial institutions and engage more closely with regulators.

Corporate governance also plays a significant role, emphasized the FRC. Boards must ensure that the corporate culture and environment encourages open dialogue with the auditors at all levels. Auditors and individual partners should not fear removal if they challenge management assumptions. Audit committees have primary responsibility for the appointment, reappointment and removal of external auditors, noted the FRC, and should also review annually the effectiveness of their audit arrangements, including the experience, expertise, resources and independence of the audit firm. Audit firms have told the FRC that effective audit committees are a powerful driver of audit quality and that there has been an improvement in the overall effectiveness of audit committees in recent years

Finally, the FRC urged audit firms to do more to promote auditor skepticism, Application of appropriate professional skepticism is vital, reasoned the FRC, since auditors must be prepared to challenge management’s assertions or they will not be able to confirm, with confidence, that a company’s financial statement gives a true and fair view. The audit oversight body therefore looks closely at the evidence of skepticism during its inspections and, if concerned, will seek an improved approach by the firm. The regulator also pays attention to whether recruitment, appraisal and promotion policies reward personnel for delivering high quality audits, including displaying appropriate skepticism in their audit work.

SEC Seeks Comments in Aid of Dodd-Frank Mandated Study on Extraterritorial Reach of Federal Securities Laws

The SEC has requested, Release No. 34-63174, public comments to help it conduct a Dodd-Frank Act mandated study to determine the extent to which private rights of action under the antifraud provisions of the Securities Exchange Act should be extended to cover transnational securities fraud. Congress ordered the study in the wake of this year’s US Supreme Court ruling that Rule 10b-5 does not provides a cause of action to foreign plaintiffs suing foreign and American defendants for misconduct in connection with securities traded on foreign exchanges. The antifraud rule reaches the use of a manipulative or deceptive device only in connection with the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States. When a statute gives no clear indication of an extraterritorial application, it has none. Since there is no affirmative indication in the Exchange Act that §10(b) applies extraterritorially, the Court concluded that it does not. The Court adopted a transactional test of whether the purchase or sale is made in the United States, or involves a security listed on a domestic exchange. (Morrison v. National Australia Bank, Ltd, US Sup. Ct., Fed. Sec. L. Rep. ¶95,776).

In what is perhaps the first foreign-cubed case to ever reach the US Supreme Court, the Court said that the fact that many difficult to apply judge-made tests on the extraterritorial aspects of the federal securities laws have developed over the years demonstrates the wisdom of the presumption against extraterritorial application of Rule 10b-5. Rather than guess anew in each case, the Court said that it would apply the presumption in all cases, preserving a stable background against which Congress can legislate with predictable effects.

In the Dodd-Frank Act, Congress addresses the extraterritorial reach of the federal securities laws in two sections. Section 929P, sponsored by Rep. Paul Kanjorski, authorizes the SEC and the Justice Department to bring civil or criminal enforcement actions involving transnational securities fraud and Section 929Y directing an SEC study of private securities fraud actions in transnational situations.

The legislative history of Dodd-Frank reveals that 92P is intended to rebut the recently announced US Supreme Court presumption against extraterritorial application of the federal securities laws enunciated by the Supreme Court in Morrison.

In floor comments on the day the House passed the Dodd-Frank Act, Rep. Kanjorski, said that the Act’s provisions concerning extraterritoriality of the federal securities laws are intended to rebut that presumption by clearly indicating that Congress intends extraterritorial application in cases brought by the SEC or the Justice Department. More specifically, the Chair of the Capital Markets Subcommittee explained that the purpose of the language of section 929P, which he authored, is to clarify that in actions and proceedings brought by the SEC or the Justice Department, the specified provisions of the Securities Act, the Exchange Act and the Investment Advisers Act may have extraterritorial application, and that extraterritorial application is appropriate, irrespective of whether the securities are traded on a domestic exchange or the transactions occur in the U.S., when the conduct within the United States is significant or when conduct outside the U.S. has a foreseeable substantial effect within the United States. Cong Record, June 30, 2010, p. H5237

Section 929Y provides that the SEC must study the scope of such a private right of action, including whether it should extend to all private actors or be limited to institutional investors, the implications a private right of action would have on international comity; and the economic costs and benefits of extending a private right of action for transnational securities frauds.

In addition to these mandated statutory topics, the SEC also asks comment on whether it should matter if the security was issued by a U.S. company or by a foreign company or whether the security was purchased or sold on a foreign stock exchange. Commenters are also asked to identify any cases that have been dismissed as a result of Morrison or pending cases in which a challenge based on Morrison has been filed, as well as any cases brought prior to Morrison that likely could not have been brought or maintained after Morrison.

More subjectively, the SEC wants input on the degree to which investors buying securities know whether the order will take place on a foreign stock exchange or on a non-exchange trading platform or other alternative trading system outside the US. And, more broadly, the SEC will analyze the implications on international comity and international relations of allowing private investors to pursue Rule 10b-5 securities fraud claims in cases of transnational securities fraud. Concomitantly, the Commission wants to know what remedies outside of the United States would be available to U.S. investors who purchase or sell shares on a foreign stock exchange if their securities fraud claims cannot be brought in U.S. courts.

Connecticut Adopts New Form ADV Part 2 for IAs in 2011

Investment adviser applicants filing an initial Form ADV, Uniform Application
for Investment Adviser Registration,
may between October 12, 2010 and January 1, 2011 submit electronically through the IARD or file in paper format directly with the Securities and Business Investments Division of the Connecticut Department of Banking either current Part II or new Part 2 of Form ADV. Beginning January 1, 2010 investment adviser applicants must electronically file new Part 2 with the IARD as part of their Form ADV application.

Connecticut-registered investment advisers between October 12, 2010 and January 1, 2011 may submit Form ADV amendments electronically through the IARD or in paper format directly to the Securities and Business Investments Division using either current Part II or new Part 2 or Form ADV. Investment advisers registered in Connecticut on or before December 31, 2010 should update their information on current Part II by filing new Part 2 between January 1 and June 1 of 2011 (no later than June 1, 2011). All Connecticut-registered investment advisers starting January 1, 2011 must electronically file with the IARD any Form ADV amendments using new Part 2. CAUTION: Connecticut does not require investment advisers to file an annual updating amendment but mandates that Form ADV be amended to reflect material information changes [see Rule 36b-31-14e(a)] and specifies annual delivery of the brochure or an offer to deliver it to their clients [see Rule 36b-31-5c(d)(1)].

PDF format required. Form ADV Part 2 must be electronically filed with the IARD as a searchable text, portable document format (PDF) file.

Note on federal covered investment advisers. Federal covered investment advisers filing a notice in Connecticut need only submit Part 2 of Form ADV if requested by the Securities and Business Investments Division, according to the instructions for filing new Part 2, as stated by Cynthia Antanaitis, the Assistant Director for the Division.

Please see for more information.

Tuesday, October 26, 2010

Hawaii Nonsubstantively Amends Dealer Waiver of Annual Report of Condition

The following interpretive order from 2003 was amended only nonsubstantively to replace the name of the “NASD” organization with its current “FINRA” name and to substitute the outdated section numbers with the new numbers for the Hawaii Uniform Securities Act of 2008.

Hawaii-registered dealers also registered with the SEC and members of FINRA may waive the Business Registration Division’s annual report of condition, provided the dealers: (1) submit their most current annual audit financial reports to FINRA; (2) notify the Hawaii Commissioner in writing within 24 hours of the dealers' net capital falling below the State's required minimum amount; (3) send financial information, in writing, to the Commissioner within 24 hours of its request; and (4) execute the prescribed "Waiver Eligibility Certificate."

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EU Reaches Compromise on Legislation Regulating Hedge Funds, Final Vote in Parliament Set for Early November

EU authorities reached a final compromise on draft legislation regulating hedge funds and alternative investment funds. The European Parliament is expected to vote on the legislation in early November. Commissioner for the Internal Market Michel Barnier hailed the breakthrough agreement as a victory for transparency and risk management in the alternative investment fund area. He said that the legislation will require regulators to authorize hedge fund managers and give regulators the tools to control risk-taking, including the level of leverage. Information on leverage and other systemically important information must be shared with the new European Systemic Risk Board. On the very sensitive question of access of US and other non-EU funds to the EU market, the issue of an EU passport, the draft foresees a passport for US and other third-country funds and managers. According to Commissioner Barnier, it will be a passport on merit, founded on a solid basis and providing strong controls in terms of risk management. It will also reinforce the internal market.

The European Council noted the compromise legislation established a harmonized framework for monitoring and supervising the risks that hedge fund and other alternative investment fund managers pose to their investors, to counterparties, to other market participants and to the stability of the financial system. The draft also allows fund managers to provide services and to market funds throughout the EU single market, subject to compliance with strict requirements.

Generally, the vehicle for the legislation, the proposed Directive on Alternative Investment Fund Managers, centered on enhanced disclosure and effective risk management, is designed to create a comprehensive and effective regulatory framework for hedge and private equity fund managers at the European level. The proposed Directive would impose regulatory standards for all alternative investment funds within its scope and enhance the transparency of the activities of the funds towards investors and public authorities

Article 35 of the new draft legislation sets forth conditions for an EU hedge fund manager with an EU passport to market shares in a US hedge fund to professional investors in the European Union. Note that EU Member States must require that the US funds managed and marketed by the fund manager are only marketed to professional investors. Article 36 provides for a transitional regime allowing EU fund managers to market US hedge funds in the EU without a passport. This transitional regime may or may not be extended depending on the results of a study by the European Securities and Markets Authority.

In order to market a US fund in the EU with a passport, the draft requires that appropriate cooperative arrangements be in place between the authorities of the fund manager’s country, those member states hosting the fund manager, and the supervisory authorities of the US or other third country where the non-EU hedge fund is established in order to ensure an efficient exchange of information allowing the authorities to carry out their duties according to the Directive

In addition, the US or other the third country where the fund is established must sign an agreement with the home Member State of the authorized fund managers and with each Member State in which the shares of the fund are proposed to be marketed, which fully complies with the standards laid down in Article 26 of the OECD Model Tax Convention and ensures an effective exchange of information in tax matters, including multilateral tax agreements. Also, the third country where the non-EU hedge fund is established must not be listed as a Non-Cooperative Country and Territory by the Financial Action Task Force on anti-money laundering and terrorist financing.

Under Article 36, EU Members may, without a passport, allow authorized EU fund managers to market to professional investors shares of US and other non-EU funds that they manage. The marketing of the US fund in the EU is conditioned on the existence of cooperative arrangements for the purpose of systemic risk oversight between the authorities of the fund manager’s home jurisdiction and US authorities in order to ensure an efficient exchange of information that allows the authorities of the fund manager’s jurisdiction to carry out their duties according to the Alternative Investment Management Directive. Another condition is that the fund manager cannot perform depositary functions. Rather, the fund manager must ensure that another entity is appointed to carry out the depositary functions and inform its regulator of the identity of the appointed entity.

The legislation commands ESMA to conduct a review three years after the legislation’s enactment of the managing and marketing of US and other non-EU hedge funds under the passport regime with an eye to seeing if the transitional non-passport regime can be terminated. The ESMA will consider investor protection, market disruption, competition and the supervision of systemic risk issues.

The conditions under which US hedge funds could be marketed in the EU has been the one of the most hotly contested issues as the EU attempts to pass legislation regulating hedge funds in 2010. In an earlier letter to EU Commissioner for the Internal Market Michel Barnier, Treasury Secretary Tim 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. More broadly, he said that it was essential to fulfill the G-20 commitment to avoid discrimination and maintain a level playing field in regulating the alternative investment fund management industry.

The UK’s position has consistently been that the legislation should not restrict EU institutional investors from taking advantage of valid investment opportunities in US and other third-country hedge funds. Earlier, Dan Waters, FSA Director of Asset Management, emphasized that the legislation should not be seen as an attempt to protect European funds from competition from legitimate US and other third-country funds. In today’s fragile international economic environment, he noted, introducing damaging constraints on international investment flows is not a sensible policy

Maine Adopts New Form ADV Part 2 for IAs in 2011

Investment adviser applicants filing an initial Form ADV, Uniform Application for Investment Adviser Registration, and investment adviser licensees filing amendments to Form ADV Part II may, between October 12, 2010 and January 1, 2011, use either current Part II or new Part 2, although Maine's Office of Securities encourages using new Part 2 as soon as possible.

Applicants and licensees will be required, starting January 1, 2011, to electronically file their initial applications, amendments and annual updating amendments, respectively, using new Part 2. The annual updating amendment to Form ADV (Parts 1 and 2) must be submitted within 90 days of the investment advisers’ fiscal year-end but investment advisers with a December 31 fiscal year-end have until March 31, 2011 to submit this filing.

Licensed investment advisers must annually either: (1) deliver to each client within 120 days of the advisers' fiscal year-end a free updated brochure that includes a summary of material changes or is accompanied by a summary of material changes; or (2) deliver to each client a summary of material changes including an offer to provide a copy of the advisers’ updated brochure and information on how a client may obtain it. The Office of Securities encourages investment advisers to follow the new Form ADV Part 2 instructions on the distribution and delivery schedule of the new brochure and brochure supplement.

For more information on Maine's 2011 renewal procedures for investment advisers please see

Monday, October 25, 2010

KPMG Survey Finds that New IRS Uncertain Tax Position Disclosure Regime Could Create Tension with Outside Auditor

Almost half of senior corporate executives surveyed by KPMG believe that the IRS’s new reporting regime for uncertain tax positions will create tensions among or between their outside audit firm, tax advisors and tax department. The survey also revealed that an enhanced policy of restraint in discovering tax accrual work papers used to prepare corporate financial statements, announced by the IRS concomitant with the new Schedule UTP, left corporate executives divided over their comfort level. The survey, conducted by KPMG’s Tax Governance Institute, found that 45 percent of the senior officers remain uncertain about how uncertain tax positions might impact privilege but are confident in their ability to resolve the issue with appropriate IRS personnel, while 42 percent said the expanded policy of restraint in IRS Announcement No. 2010-76. does not remove their concern that IRS agents will demand information which may impinge on privilege.

Schedule UTP requires companies to provide a concise description of each uncertain tax position for which they have recorded a reserve in their financial statements, or for which no reserve has been recorded because of an expectation of litigation. These uncertain tax positions are identified by corporations during the process of preparing financial statements for SEC filing under applicable FASB accounting standards, such as FIN 48. In reviewing and verifying financial statements for compliance with FIN 48, independent auditors may ask for copies of legal opinions and other documents in order to understand transactions, to understand the legal bases for the treatment of transactions, and to determine the adequacy of reserves for contingent tax liabilities.

Concomitant with requiring companies to file an uncertain tax position statement on Schedule UTP, and addressing an issue that has roiled the federal courts, the IRS expanded its policy of restraint and will forgo seeking particular documents that relate to uncertain tax positions and the work papers that document the completion of Schedule UTP. IRS Announcement No. 2010-76. Thus, if a document is otherwise privileged under the attorney-client privilege, the tax advice privilege in section 7525 of the Code, or the judicially-created work product doctrine, and the document was provided to an independent auditor as part of an audit of the company’s financial statements, the Service will not assert during an examination that privilege has been waived by such disclosure.

The KPMG survey also found that almost half of senior executives polled are most concerned about the prospect of providing a concise description of their uncertain tax positions in order to comply with the new disclosure requirement. Their biggest concern was providing the concise description for a disclosed UTP. Other major concerns cited centered on the IRS’s ability to effectively administer the UTP program and on the scope of taxpayers required to file UTPs under the new rule.

Commenting on the survey results, Hank Gutman, director of the Tax Governance Institute, and former chief of staff of the U.S. Congressional Joint Committee on Taxation, said that, while the IRS went to considerable lengths to ease corporate taxpayer concerns about specific elements of the original Schedule UTP proposal, and incorporated many of the suggestions offered during the public comment period, the implementation of the new disclosure regime will invariably produce practical questions and issues. Mr. Gutman noted that it is not too early to begin an analysis of the potential impact of the Schedule.

The issue of whether the IRS can discover tax accrual work papers is extremely contentious and has divided the federal courts. Recently, a panel of the DC Circuit Court of Appeals ruled that 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 panel said that a 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. 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).

Earlier, the US Supreme Court declined to review the First Circuit’s en banc opinion in the Textron case, thereby leaving intact a ruling that the attorney work product doctrine does not shield from an IRS summons tax accrual work papers prepared by a company’s lawyers to support the calculation of tax reserves for audited financial statements filed with the SEC. Textron Inc. v. United States, Dkt. No. 09-750. In a 3-2 opinion, the full appeals court held that the purpose of the tax audit work papers was not to prepare for litigation, but rather to make book entries, prepare financial statements and obtain a clean audit.

Sunday, October 24, 2010

Comments on SEC Proxy Voting Concept Release Explore Regulation of Proxy Advisory Firms, New Dodd-Frank Mandates Heighten Concern

Comments received by the SEC on its proxy voting concept release, 34-62495, reveal a growing consensus in the corporate community that proxy advisory firms should be subject to federal regulation requiring greater transparency and accountability with respect to the formulation of voting recommendations and potential conflicts of interest. For example, in its comment letter to the SEC, General Mills said that proxy advisory firms should be subject to proxy rules and regulated as investment advisers, including mandated disclosure of specific conflicts of interest, and duties to adopt procedures ensuring the accuracy of their reports and voting recommendations. But Nell Minow of the Corporate Library objected in the strongest possible terms to the federal regulation of proxy advisory services, noting the absence of evidence that the proxy advisory firms have been anything but transparent about their approaches and the way they deal with conflicts of interest.

And, according to the Council of Institutional Investors, proxy advisory firms play an important role in helping pension fund managers fulfill their fiduciary duties with respect to proxy voting by providing an analysis of issues on the ballot, executing votes and maintaining voting records. Without proxy advisers, maintained the Council, many smaller pension plans would have difficulty managing their highly seasonal proxy voting responsibilities for the thousands of companies in their portfolios. While the Council supports the registration of proxy advisory firms, it opposes regulatory involvement in methodologies used by proxy advisers to determine vote recommendations.

Ever since the Department of Labor’s 1988 “Avon Letter,” which asserted that proxy voting rights are plan assets subject to the same fiduciary standards as other plan assets, pension fund managers have been on high alert to vote their proxies in the best interest of beneficiaries. Subsequently, over the two decades, institutional investors, including pension plans, and employee benefit plans, have substantially increased their use of proxy advisory firms, reflecting the tremendous growth in institutional investment as well as the fact that institutional investors have fiduciary obligations to vote the shares they hold on behalf of their beneficiaries.

In its concept release, the SEC raised a number of concerns about the increasing use of proxy advisory firms, paramount among these being possible conflicts of interest. For example, to the extent that conflicts of interest on the part of proxy advisory firms are insufficiently disclosed and managed, shareholders could be misled and informed shareholder voting could be impaired. Similarly, said the Commission, to the extent that proxy advisory firms develop, disseminate, and implement their voting recommendations without adequate accountability for informational accuracy in the development and application of voting standards, informed shareholder voting may be likewise impaired.

Over the last two decades, noted the Wachtell Lipton firm in comments to the SEC, this small ``hegemony of for-profit firms’’ have proclaimed themselves the arbiters of corporate governance practices and become de facto corporate governance regulators without accountability or regulation to the detriment of both issuers and shareholders. This problem is compounded each year, said Wachtell, as additional matters become subject to shareholder votes. When fully implemented, the Dodd-Frank Act will require shareholder votes on a host of compensation-related issues for which broker discretionary voting is prohibited. In Wachtell Lipton’s view, all of these changes will further empower the proxy advisors due both to the higher frequency of votes, such as say-on-pay, and the fact that the demands imposed by an increased number of votes each season are likely to cause institutional investors to outsource even more voting responsibility to the proxy advisory firms. In addition to requiring proxy advisory firms to register with the SEC, said the Wachtell comment letter, these firms should also be brought more squarely within the regulatory constraints of the proxy rules through a requirement to file recommendations as soliciting material.

In its comment letter to the SEC, General Mills said that greater transparency about how voting policies are developed and the clients that support those policies will help identify the influence of special interests and ensure that all clients are properly represented. Similarly, where executive compensation analysis or recommendations depend on specific data and financial formulas, such information is not fully available to investors or issuers. Full public disclosure of this supporting information would allow issuers and investors to better understand and evaluate the related voting recommendation.

To the extent that the recommendations of the proxy advisory firms are based on a factual analysis, noted the General Mills letter, issuers do not have an adequate opportunity to review the information, engage in discussion about possible changes, or inform investors about concerns or objections to the report.

In its letter to the SEC, Dupont urged that proxy advisers be subjected to additional disclosures aimed at improving the quality of ratings and recommendations, including disclosures of the depth of its research on recommendations, the effectiveness of its controls over accuracy of issuer data, and the procedures for communications with issuers. Dupont also asked that Form N-PX, the annual report of proxy voting of management investment companies, be amended to require disclosure of whether a proxy advisory firm was used by the investor, and if so, which one, and whether the investor voted in accordance with that firm's recommendation. The company believes that this would encourage institutional investors to give adequate consideration to the facts and circumstances of a given shareholder proposal.

While recognizing that proxy advisory firms play an important role within the proxy system, the Sidley & Austin firm has significant concerns regarding the manner in which they play that role. In particular, there is concern about the one-size-fits-all approach that some proxy advisory firms take in their articulation of voting guidelines and the influence that those guidelines carry. In addition, the firm cited numerous occasions in which voting recommendations issued by a proxy advisory firm appear to have been based on an apparent misapprehension of the underlying facts.

Sidley supports the views of the NYSE Commission on Corporate Governance report, which recommended that the SEC engage in a study of the role of proxy advisory firms to determine their potential impact on corporate governance and consider whether or not further regulation of these firms is appropriate. The report also said that proxy advisory firms should be required to disclose their methodologies for formulating voting recommendations, as well as material conflicts of interest, and to hold themselves to a high degree of care, accuracy and fairness in dealing with both shareholders and companies by adhering to strict codes of conduct.

In comments to the SEC, CalPERS also generally supports the recommendations of the NYSE report. Specifically, CalPERS backs complete disclosure of all conflicts of interest on the part of proxy advisory firms, especially as such conflicts relate to consulting services in conjunction with providing proxy vote recommendations, as well as disclosure of procedures for interacting with both issuers and shareowners, informing issuers and shareowners of recommendations, and handling appeals of proxy advisory firm vote recommendations.

In an effort to increase transparency, the Sullivan & Cromwell firm suggested the direct regulation of these firms to require enhanced disclosure, or the imposition of disclosure requirements on institutional investors that utilize a proxy advisory firm in making voting decisions or casting votes. For example, the investor could be required to disclose the firm on which it relies, and whether the firm makes disclosures about its policies for making recommendations with respect to the particular matter voted on.

For its part, the Council of Institutional Investors said that the contention that proxy advisory firms’ recommendations have too much influence on the outcome of voting at public companies is ``greatly exaggerated.’’ The notion that proxy advisory firms control the institutional vote wrongly assumes that institutions are a unified bloc of voters. In fact, asserted the CII, many institutional investors are passive voters that defer routinely to the recommendations of management.

Also, the CII noted that institutional investors’ use of proxy advisers’ services, whether research or vote execution, does not equate to the outsourcing of voting decisions. The Council emphasized that proxy advisers’ clients retain the ability to vote however they wish, and regularly diverge from their proxy advisers’ recommendations. Indeed, the CII believes many clients of proxy advisers use the firms’ research and recommendations solely as a supplement to their own evaluation of agenda items.

While the Council does not have a formal policy on proxy advisory firms, it acknowledges the importance of their role in providing pension funds with informative and accurate information about matters that are put before shareowners for a vote. It is reasonable to expect proxy advisory firms to provide clients with substantive rationales for vote recommendations; minimize conflicts of interest and disclose the details of such conflicts; and correct material errors promptly and notify affected clients as soon as practicable.

Friday, October 22, 2010

IRS Expands Policy of Restraint in Discovering Tax Accrual Work Papers Used In Preparing Financial Statements

Concomitant with requiring companies to file an uncertain tax position statement on Schedule UTP, and addressing an issue that has roiled the federal courts, the IRS expanded its policy of restraint and will forgo seeking particular documents that relate to uncertain tax positions and the work papers that document the completion of Schedule UTP. IRS Announcement No. 2010-76. Thus, if a document is otherwise privileged under the attorney-client privilege, the tax advice privilege in section 7525 of the Code, or the judicially-created work product doctrine, and the document was provided to an independent auditor as part of an audit of the company’s financial statements, the Service will not assert during an examination that privilege has been waived by such disclosure.

However, the IRS’ exercise of restraint will not apply if the company has engaged in any activity or taken any action that would waive the attorney-client privilege, the tax advice privilege in section 7525 of the Code, or the work product doctrine; or a request for tax accrual work papers is made under IRM because unusual circumstances exist or the taxpayer has claimed the benefits of one or more listed transactions.

Schedule UTP requires companies to provide a concise description of each uncertain tax position for which they have recorded a reserve in their financial statements, or for which no reserve has been recorded because of an expectation of litigation. These uncertain tax positions are identified by corporations during the process of preparing financial statements for SEC filing under applicable FASB accounting standards, such as FIN 48. In reviewing and verifying financial statements for compliance with FIN 48, independent auditors may ask for copies of legal opinions and other documents in order to understand transactions, to understand the legal bases for the treatment of transactions, and to determine the adequacy of reserves for contingent tax liabilities.

The issue of whether the IRS can discover tax accrual work papers is extremely contentious and has divided the federal courts. Recently, a panel of the DC Circuit Court of Appeals ruled that 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 panel said that a 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 the 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).

Earlier, the US Supreme Court declined to review the First Circuit’s en banc opinion in the Textron case, thereby leaving intact a ruling that the attorney work product doctrine does not shield from an IRS summons tax accrual work papers prepared by a company’s lawyers to support the calculation of tax reserves for audited financial statements filed with the SEC. Textron Inc. v. United States, Dkt. No. 09-750. In a 3-2 opinion, the full appeals court held that the purpose of the tax audit work papers was not to prepare for litigation, but rather to make book entries, prepare financial statements and obtain a clean audit. This was the testimony of IRS expert and former PCAOB Chief Auditor Douglas Carmichael, who said that tax accrual work papers include all the support for the tax assets and liabilities shown in the financial statements.

From the company's perspective, said the former Chief Auditor, they are created because the key officers of the company sign a certification saying that the financial statements are fairly presented; and they need support for that. From the auditor's perspective, the auditors need to record in the workpapers what they did to comply with GAAP. So the workpapers are the principal support for the auditor's opinion, testified the former PCAOB official.

The court emphasized that the tax work papers were independently required by statutory and audit requirements and that the work product privilege does not apply. It is not enough to trigger work product protection that the subject matter of a document relates to a subject that might conceivably be litigated. A set of tax reserve figures, calculated for purposes of accurately stating a company's financial figures, has in ordinary parlance only that purpose, said the en banc court, which is to support a financial statement and the independent audit of it.

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

In earlier remarks, IRS Commissioner Douglas Shulman assured that the new regulations would not require companies to disclose how strong or weak they regard their tax positions or report the amounts they reserved on the books regarding those positions. He said that the IRS would otherwise retain its longstanding policy of restraint as it applies to tax accrual work papers. The IRS is looking only for a brief description of the issue and the maximum amount of US income tax exposure, he noted, and there is no requirement that the taxpayer disclose its risk assessment or tax reserve amounts. He also pointed out that the IRS is asking for a list of issues that the company has already prepared for financial reporting purposes.

President’s Working Group Proposed Reform of Money Market Fund Regulation Would Require SEC Rulemaking and Legislation

A report by the President’s Working Group on Financial Markets detailing reforms for money market funds will be considered by the Financial Stability Oversight Council, with the assistance of the SEC. The Commission, which would lay an integral role in implementing the reforms, will soon solicit public comment on the proposed reforms. Some of the proposed reforms could be adopted by the SEC under its existing authorities, while others would require legislation. The reform options address the vulnerabilities of money market funds that contributed to the financial crisis in 2008. Following the crisis, the Treasury Department directed the PWG to report on options for mitigating the systemic risk associated with money market funds and reducing their susceptibility to runs.

Several key events during the financial crisis underscored the vulnerability of the financial system to systemic risk. One such event was the September 2008 run on money market funds, which began after the failure of Lehman Brothers Holdings, Inc. caused significant capital losses at a large money market fund. Amid broad concerns about the safety of money market funds and other financial institutions, investors rapidly redeemed fund shares, and the cash needs of the funds exacerbated strains in short-term funding markets. These strains, in turn, threatened the broader economy, as firms and institutions dependent upon those markets for short-term financing found credit increasingly difficult to obtain. Thus, reducing the susceptibility of money market funds to runs and mitigating the effects of possible runs are important components of the overall policy goals of decreasing and containing systemic risks.

One reform proposed by the PWG would be to move from the current stable NAV, which has been a key element of the appeal of money funds investors but has also heightened their vulnerability to runs, to a floating NAV. The Working Group conceded that the elimination of the stable NAV for money market funds would be a dramatic change for a nearly $3 trillion asset-management sector that has been built around the stable share price. Such a change may have several unintended consequences, including the reductions in money funds’ capacity to provide short-term credit due to lower investor demand.

Another proposed reform is to provide emergency liquidity facilities for money market funds since their liquidity risk contributes to their vulnerability to runs. The PWG believes that an external liquidity backstop augmenting the SEC’s new liquidity requirements for money market funds would help mitigate this risk by buttressing their ability to withstand outflows, internalizing much of the liquidity protection costs for the industry, offering efficiency gains from risk pooling, and reducing contagion effects. A liquidity facility would also preserve fund advisers’ incentives for not taking excessive risks because it would not protect funds from capital losses.

When investors make large redemptions they may impose liquidity costs on other shareholders in the fund by forcing the fund to sell assets in an untimely manner. The PWG would require money market funds to distribute large redemptions in kind, rather than in cash, thereby forcing these redeeming shareholders to bear their own liquidity costs and thus reducing the incentive to redeem. But the PWG acknowledged that mandating redemptions in kind could present policy challenges to the SEC, which would have to make key judgments regarding when a fund must redeem in kind and how funds would fairly distribute portfolio securities. Funds should not, for example, be able to distribute only their most liquid assets to redeeming shareholders, since doing so would undermine the purpose of an in-kind redemptions requirement.

More broadly, the PWG proposed a two-tier system of money market funds with enhanced protection for stable NAV funds. The susceptibility of money market funds may be effectively reduced if investors are permitted to select the types of funds that best balance their appetite for risk and their preference for yield. Policymakers could allow two types of money market funds, said the PWG, stable NAV funds, which would be subject to enhanced regulatory protections, and floating NAV funds, which would have to comply with certain, but not all, Rule 2a-7 restrictions and which would presumably offer higher yields.

Because this two-tier system would permit stable NAV funds to continue to be available, reasoned the PWG, it would reduce the likelihood of a substantial decline in demand for money market funds and large-scale shifts of assets toward unregulated vehicles. At the same time, the forms of protection encompassed by such a system would mitigate the risks associated with stable NAV funds. It would also avoid problems that might be encountered in transitioning the entire MMF industry to a floating NAV. Moreover, during a crisis, a two-tier system might prevent large shifts of assets out of money market funds, and a reduction in credit supplied by the funds, if investors simply shift assets from riskier floating NAV funds toward safer stable NAV funds.

Another approach to the two-tier system would distinguish funds by investor type: Stable NAV money market funds could be made available only to retail investors, who could choose between stable NAV and floating NAV funds. This approach would require the SEC to define who would qualify as retail and institutional investors.

Finally, another policy option laid on the table by the PWG would be to regulate stable NAV money market funds as special purpose banks based on the many functional similarities between money market fund shares and bank deposits. While the conceptual basis for this option is fairly straightforward, noted the PWG, its implementation might take a broad range of forms and would probably require legislation together with interagency coordination.

One important hurdle for successful conversion of a money market fund to a special purpose bank may be the very large amounts of equity necessary to capitalize the new banks. In addition, to the extent that deposits in the new special purpose banks would be insured, the potential government liabilities through deposit insurance would be increased substantially, and the development of an appropriate pricing scheme for such insurance would be challenging.

Basel Committee Issues Corporate Governance Principles, Strong Role Seen for Internal and External Audit

The Basel Committee has issued corporate governance principles emphasizing transparency, aligning executive compensation with prudent risk taking, and making more and better use of internal and external auditors. A central principle envisions the board and senior management making very broad use of internal audit and effectively engaging the independent outside auditor. Independent and qualified internal and external auditors, as well as other internal control functions, are vital to the corporate governance process, said the committee.

The board and senior management can enhance the ability of the internal audit function to identify problems with the firm’s governance, risk management and internal control systems by encouraging internal auditors to adhere to national and international professional standards, requiring that audit staff have skills that are commensurate with the business activities and risks of the firm, promoting the independence of the internal auditor by ensuring that internal audit reports are provided to the board and that the internal auditor has direct access to the board or the board's audit committee. Importantly, the board should also engage the internal auditors to judge the effectiveness of the risk management and compliance functions, including the quality of risk reporting to the board and senior management.

The board and senior management can also contribute to the effectiveness of external auditors by including in engagement letters the expectation that the external auditor will be in compliance with applicable domestic and international codes and standards of professional practice. Also, non-executive board members should have the right to meet regularly, in the absence of senior management, with the external auditor and the heads of the internal audit and compliance functions. This can strengthen the ability of the board to oversee senior management’s implementation of the board’s policies and ensure that business strategies and risk exposures are consistent with risk parameters established by the board.

Another principle demands active board oversight of compensation so that it is aligned with risk management and prudent risk taking. Sound governance means that compensation is sensitive to the time horizon of risks and that the mix of cash, equity and other forms of compensation is consistent with risk alignment. Since employees can generate equivalent short-term revenues while taking on vastly different amounts of risk in the longer term, a firm should adjust variable compensation to take into account the risks an employee takes. This should consider all types of risk over a timeframe sufficient for risk outcomes to be revealed. It is appropriate to use both quantitative risk measures and human judgment in determining risk adjustments. Where firms make such adjustments, all material risks should be taken into account, including difficult-to-measure risks such as reputational risk and potentially severe risk outcomes.

In addition, compensation should be sensitive to risk outcomes over a multi-year horizon. This is typically achieved through arrangements that defer compensation until risk outcomes have been realized, and may include clawback provisions under which compensation is reduced or reversed if employees generate exposures that cause the firm to perform poorly in subsequent years or if the employee has failed to comply with internal policies or legal requirements.
The principles flatly state that golden parachute arrangements under which terminated executives receive large payouts irrespective of performance are generally not consistent with sound compensation practice.

A broad principle holds that transparency is essential for sound and effective corporate governance. It is difficult for shareholders and relevant stakeholders and market participants to effectively monitor and properly hold accountable the board and senior management when there is insufficient transparency. The objective of transparency in the area of corporate governance is therefore to provide these parties key information necessary to enable them to assess the effectiveness of the board and senior management.

As part of transparency, the company should disclose material information on its objectives, organizational and governance structures and policies, in particular the content of any corporate governance code or policy and the process by which it is implemented, major share ownership, and related parties transactions, as well as its incentive and compensation policy. The firm should also disclose key points concerning its risk tolerance appetite, along with a description of the process for defining it and information concerning the board’s involvement in such process.

Adoption of Poison Pill to Protect Net Operating Loss Carryforwards Protected by Business Judgment Rule

In a case involving a profitless company’s fight to preserve valuable net operating loss carryforwards, the board of director’s adoption of a poison pill to protect the NOLs bestowed on the company by the federal tax code was protected by the business judgment rule even under the heightened Unocal test. While the value of net operating loss carryforwards is inherently unknowable before they are used, ruled the full Delaware Supreme Court, a board may properly conclude that NOLs are worth protecting when it does so reasonably and in reliance on expert advice. The board here had ample reason to conclude that the NOLs were an asset worth protecting and that their preservation was an important corporate objective. Versata Enterprises, Inc. v. Selectica, Inc., Del Supreme Court, No. 193, Oct 4, 2010.

By consistently failing to achieve positive net income, the company generated $160 million in NOLs for federal tax purposes. NOLs are tax losses realized by a company that can be used to shelter future, 20 years, or immediate past, 2 years, income from taxation. But NOLs are a contingent asset and, if a company fails to realize a profit, they can expire worthless. In order to prevent corporate taxpayers from benefiting from NOLs
generated by other entities, Section 382 of the Internal Revenue Code establishes limitations on the use of NOLs in periods following an ownership change. If Section 382 is triggered, the law restricts the amount of prior NOLs that can be used in subsequent years to reduce the firm’s tax obligations. Once NOLs are so impaired, a substantial portion of their value is lost. The company’s NOL poison pill was designed to prevent that from happening.

Applying the Unocal test to the pill, the en banc Supreme Court concluded that the protection of company NOLs may be an appropriate corporate policy that merits a defensive response when they are threatened. Unocal is a two-part test under which a board’s defensive response must be reasonable in relation to a reasonably identified threat to the company.

The Unocal is usually employed when a poison pill is adopted as an antitakeover Device. The main intent of a NOL poison pill is to prevent the inadvertent forfeiture of potentially valuable assets, not to protect against hostile takeover attempts. In fact, companies with large NOLs are not at risk of takeover since the change of control would impair the asset. Even so, said the Court, any poison pill, by its nature, operates as an antitakeover device. Thus, despite its primary purpose, a NOL poison pill must also be analyzed under Unocal because of its effect and its direct implications for hostile takeovers.

The Unocal test was met here because the board reasonably concluded that the NOLs were worth preserving and the acquirer’s actions posed a serious threat to their impairment. The Court ruled that the directors satisfied the first part of the Unocal test by showing that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed because of another person’s stock ownership. The en banc Court then ruled that the second part of the test was satisfied in that defensive response was reasonable relative to the threat of a longtime competitor seeking to increase the percentage of its stock ownership to intentionally impair corporate assets, the NOLs, or else coerce the company into meeting its business demands under the threat of such impairment.

Thursday, October 21, 2010

House Passes Investment Company Taxation Reform Legislation

The House has passed by voice vote bi-partisan legislation modifying and updating federal tax code provisions pertaining to investment companies in order to make them better conform to, and interact with, other aspects of the tax code and applicable securities laws. The Regulated Investment Company Modernization Act, HR 4337, would reduce the burden arising from amended year-end tax information statements, improve a mutual fund's ability to meet its distribution requirements, create remedies for inadvertent mutual find qualification failures, improve the tax treatment of investing in a fund-of-funds structure, and update the tax treatment of fund capital losses.

The legislation would modernize federal tax code provisions governing mutual funds that have not been updated in any meaningful or comprehensive way since the adoption of the Internal Revenue Code of 1986, and some of the provisions date back more than 60 years. Numerous developments during the past two decades, including the development of new fund structures and distribution channels, have placed considerable stress on the current tax code sections.

In general, regulated investment companies under the Code are domestic corporation
that either meet are excepted from SEC registration requirements under the Investment
Company Act, that derive at least 90 percent of their ordinary income from passive investment income, and that have a portfolio of investments that meet certain diversification requirements. Regulated investment companies under the Code can be either open-end companies (mutual funds) or closed-end companies.

The legislation would update the capital loss carryforward rules for regulated investment companies so that they match the capital loss carryforward rules for individuals. As a result, an investment company would be permitted unlimited carryforwards of their net capital losses under the HR 4337 and a net long term capital loss will retain its character when carried forward instead of being treated as a short term capital loss as under present law. The legislation would also include commodities as a source of good income. Currently, an investment company must derive at least ninety percent of its income from sources of good income, such as dividends, interest, and gains from the sale or other disposition of stock; and commodities are not one of these enumerated sources.

Further, it a fund currently fails to comply with the ninety percent ``good income’’ requirement by even one dollar it is subject to tax as a corporation at a thirty-five percent rate. The legislation would permit an investment company to cure inadvertent failures to comply with the gross income test by paying a tax equal to the amount by which the company failed the gross income test.

An investment company must also satisfy asset diversification tests under the tax code. . Similar requirements apply to real estate investment trusts (REITs). Unlike investment companies, however, REITs have statutory means to remedy inadvertent failures of such tests. For example, if a REIT fails the asset tests by a de minimis amount and the REIT comes into compliance within six months after it identifies the failure, then the REIT is treated as satisfying the asset tests. For non-de minimis asset test failures, a REIT can avoid disqualification under subchapter M if the failure is due to reasonable cause and not willful neglect and the REIT notifies the IRS, disposes of the assets, and pays an excise tax equal to the greater of $50,000 or the highest corporate tax rate times the net income from the bad assets during the period of failure. The legislation would extend these REIT remedies to investment companies.

Under current law, investment companies are required to send a written designation notice to shareholders within sixty days of the end of their taxable year notifying the shareholders of the tax treatment of various distributions made during the course of the year. Since, this requirement predates the comprehensive Form 1099 information reporting requirements that are also imposed on investment companies, HR 4337 would eliminate the now-obsolete 60-day shareholder notification requirement.

Investment companies may distribute their net capital gain income, determined at the end of their taxable year, through specially-designated capital gain dividends. Investment companies with a taxable year other than the calendar year have to determine whether a dividend made prior to December 31 is a capital gain dividend when it sends information returns (Form 1099) to its shareholders. However, the amount that a RIC expects to be a capital gain dividend at the end of the calendar year may be different from the amount that ultimately is allowed to be treated as a capital gain dividend at the end of the taxable year.

If this occurs, the RIC must send out amended Form 1099s and shareholders must file amended returns clarifying that the dividend was not, in fact, a capital gain dividend. This can be both confusing and burdensome for taxpayers. Rather than force funds and taxpayers to file amended returns for the prior calendar year, the bill would allow the fund to first reduce capital gain dividends in the subsequent calendar year by the amount of the excess capital gain dividends reported in the prior calendar year. Similar rules would apply to other types of specially-designated dividends (e.g., exempt-interest dividends, short-term capital gain dividends and interest-related dividends).

The Code mandate that the current earnings and profits of a regulated investment company are not reduced by any amount which is not allowable as a deduction in computing its taxable income works an inappropriate result for tax-exempt bond funds, which results in shareholders being overtaxed. In particular, if a company that invests exclusively in tax exempt obligations distributes an amount greater than its net tax-exempt interest income for the year, that excess is economically a return of capital to shareholders. However, because deductions associated with tax-exempt income are disallowed, the excess is treated as a dividend out of current earnings and profits. The legislation would fix this by allowing certain disallowed deductions associated with tax-exempt income to be taken into account in calculating earnings and profits.

A regulated investment company is allowed to pass-through tax-exempt interest and foreign tax credits if more than fifty percent of its assets are comprised of municipal bonds or stock and securities issued by foreign corporations. However, if a RIC invests exclusively in shares of other RICs in a fund-of-funds structure that pass through tax-exempt interest or foreign tax credits, the top-tier RIC is limited in its ability to separately pass these tax attributes on to its shareholders because it does not technically meet this fifty percent requirement. As the mutual fund industry has evolved, this aspect of current law has become problematic for the many fund-of-funds structures. Thus, HR 4337 would allow a fund of funds that invests fifty percent of its assets in interests in other regulated investment companies to pass-through tax-exempt interest and foreign tax credits without regard to the fifty percent requirement.

Currently dividends paid by a RIC after the end of its taxable year may be taken into account in computing its dividends paid deduction for such taxable year. In order for a dividend to qualify for this spillover treatment, the RIC must declare the dividend by the due date for filing its tax return and pay the dividend to shareholders within the twelve months following the end of the taxable year and not later than the date of the first regular dividend paid by the RIC after such declaration. The requirement that a spillover dividend be paid no later than the next regular dividend paid after the spillover dividend is declared may unnecessarily restrict a RIC’s flexibility in determining when to make distributions. For example, a fund may wish to make a capital gain distribution before making its spillover dividend. The legislation would allow a RIC to make a spillover dividend with the first dividend payment of the same type of dividend and limit the time period for making a spillover dividend to the 15th day of the ninth month following the close of the taxable year.

If a regulated investment company makes a return of capital distribution it must allocate it pro rata over all distributions made during the taxable year. RICs are also required to distribute essentially all of their calendar-year income by December 3 in order to avoid the annual RIC excise tax. The interaction between these two rules can be problematic. If a RIC makes a computational error over the course of the taxable year, distributions that the RIC treats as dividends in the pre-January 1 period of the taxable year could turn out to be, in part, return of capital distributions. This can be particularly problematic for funds because they are required to track the cost basis of each share and also notify their shareholders of the amount of dividends that each shareholder receives during the calendar year. Substantial confusion can arise if shareholders receive amended information returns and cost basis statements. In order to remedy this situation, HR 4337 would provide that a RIC’s earnings and profits shall be allocated first to distributions made prior to December 31 and then to distributions occurring after December 31 instead of requiring earnings and profits be allocated pro rata over all distributions during the taxable year.

Massachusetts Set Time-Table for Mandating New Part 2 of Form ADV

Massachusetts-registered investment advisers may continue to use old Part II of Form ADV to electronically file material amendments with the IARD until their next annual updating amendment is required, within 90 days of a registrant's fiscal year-end. At the time of the next annual updating amendment, investment advisers must: (1) electronically file with the IARD a new Form ADV that includes new Part 2; and (2) deliver or offer to deliver new Form ADV Part 2 to their existing, new and prospective advisory clients. Investment advisers need to also consider the new SEC custody rule incorporated by reference in Massachusetts Rule 950 CMR 12.205 (5).

For more information please see

Wednesday, October 20, 2010

Montana Mandates Investment Company Filings at the Class Level

Investment company and similar issuers must, starting January 1, 2011, register or notice file their securities in Montana at the class rather than at the previously-required portfolio level. Beginning January 1, 2011, new and renewing issuers must submit a new application for each class previously incorporated in a portfolio filing of multiple classes. NOTES: (1) Notification of registration of each class included in a prospectus containing more than one class is required by the Montana Securities Department unless the issuer undertakes to “sticker” the prospectus indicating the classes not available to Montana investors; and (2) Issuers are encouraged to file their Consent to Service of Process with the Department at the trust level.

For more information please see

New Mexico Proposes Eliminating Form U-2 from Rule 506 Notice Filing Requirement

Form U-2, Uniform Consent to Service of Process, would be eliminated from the Rule 506 notice filing requirement, as proposed by the New Mexico Securities Division. With this requirement eliminated, issuers would file Form D and a $350 fee.

Written comments. Interested person may submit written comments about the proposed rule amendment to Marianne Woodard, Attorney, Securities Division, New Mexico Regulation and Licensing Department, 2550 Cerillos Rd., Toney Anaya Bldg 3rd Floor, Santa Fe, New Mexico 87505, or by fax to Ms. Woodard at (505) 984-0617. Written comment must be submitted by 5:00 p.m. on November 15, 2010.

For more information, please see

Tuesday, October 19, 2010

Congress, Not IRS, Must Provide Tax Relief from Flash Crash

Absent the enactment of a relief provision by Congress, the IRS is not authorized to provide for the non-recognition of gain for stop-loss orders executed on the day of the flash crash in the markets, May 6, 2010. An SEC-CFTC report said that the flash crash was triggered by large trader automated sell algorithms triggered during a an unusually turbulent day for the markets. According to an IRS Information Letter, 2010-0188, various non-recognition provisions in the Code are not applicable to the situation. Section 1031 provides for deferral of recognition of gain on like-kind exchanges of property held for productive use in a trade or business or held for investment, but specifically excludes stocks, bonds, and notes from its scope. Section 1033, which provides for deferral of gain if property is compulsorily or involuntarily converted into property similar or related in service or use to the property so converted, or to money, applies only to dispositions resulting from destruction, theft, seizure, or requisition or condemnation.

On the day of the flash crash, many investors had their holdings sold because of stop-loss orders and that, in some cases, they realized gains subject to tax. Some securities industry professionals have asked the IRS if these investors could be allowed to reinvest in the stock sold and that the replacement stock be given the same basis as the stock originally held, and that the investors be excused from recognizing gain.

Stop-loss orders direct a broker to sell a stock at the best price currently available if the stock reaches a specified price. As the flash crash progressed, many stop-loss orders were triggered and the paucity of bids for many stocks resulted in sales at prices significantly below those of prior trades. Many investors incurred losses as the result of such sales, although stock prices
rebounded significantly thereafter. The dramatic recovery in stock prices was a source of frustration to investors whose stock holdings were liquidated as the result of the execution of stop-loss orders. The closing price for many stocks was higher than either the price at which investors’ stop-loss orders were triggered or the price realized on the sale of stock as a result of the triggering of a stop
loss order.

Reinvestment in securities sold at a loss in some circumstances requires application of the wash sale rules set forth in section 1091 of the Internal Revenue Code, so that the loss cannot be recognized fully for federal income tax purposes. An example is if an investor bought 1,000 shares of X Co. stock at $70.00 at the opening of the market on May 6, 2010, and placed a stop-loss order at $66.50 (5% below the cost of the stock). When the stock declined to $66.50, the investor’s stop-loss order became a market order. As a market order, the order was executed at $61.00, the best available price. The sale resulted in a loss of $9.00 per share to the investor. If the investor, within 30 days before or after the sale of the X Co. stock, purchased X Co. stock, the wash sale rules would apply to limit or deny deduction of the loss. The amount of the disallowed loss would be reflected in the investor’s basis in the X Co. stock purchased within 30 daysbefore or after the sale under the stop-loss order.

But, explained IRS staff, there is no similar rule allowing non-recognition of gain on the sale of stock if an investor purchases replacement stock within a prescribed period. For example, an investor who had purchased X Co. stock on July 20, 2009, at a cost of $40.00 per share had placed a stop-loss order at $66.50 (5% below the closing market price of the stock on May 5, 2010). During the flash crash, the investor’s stop-loss order was triggered, and the investor’s X Co. stock was sold at $66.50 per share. The investor realized a gain of $26.50 per share on the stock and would be required to recognize the realized gains, i.e., include the gains in gross income, irrespective of whether the investor acquired X Co. stock within a prescribed period, e.g., 30 days, before or after
the sale at a loss.