Friday, December 31, 2010

Thirteen Senators Tell Fed of Concerns with Implementation of Dodd-Frank Interchange Fee Provisions

Thirteen US Senators, including leading members of the Banking Committee have expressed concern with the consequences of replacing a market-based system for debit card acceptances with a government-controlled system pursuant to Section 1075 of the Dodd-Frank Act. In a bi-partisan letter to Fed Chair Ben Bernanke, the senators said that having the government fix prices in any venue is a bad idea. As the Fed implements Section 1075, the senators want to ensure that all costs to the issuers and economic value to the merchants are considered in the regulations. The senators urged the Fed to take the time to consider all the implications of implementing Section 1075 and exercise the discretion granted by Dodd-Frank to minimize negative consequences. The letter was signed by Senator Richard Shelby (R-AL), the Banking Committee’s Ranking Member, and two influential members of the committee, Senators Mark Warner (D-VA) and Bob Corker (R-TN).

Section 1075 requires that the Fed issue by April 21, 2011 three final rules on interchange fees regarding a reasonable and proportional debit fee structure, fees for fraud prevention on debit transactions, and debit transaction network fees. There is a statutory exemption for small issuers under $10 billion in assets from the new debit fee rules.

During what the senators described as a ``very limited debate’’ on the Senate floor, the debt interchange fee amendment was presented as a pro-consumer provision that would lower costs for customers who use debit cards. However, since passage of Dodd-Frank Section 1075, analyst reports for retailers likely to be affected by the provision make no mention of any benefits to consumers. Indeed, many predict that consumers will be faced with additional bank fees as the rule is implemented.

In addition, the senators said that there is a misconception that the small bank exemption will level the playing field for financial institutions under $10 billion. They are concerned that the statute will make small bank and credit union debit cards more expensive for merchants to accept that those issued by larger financial institutions and would likely put them at a disadvantage compared to large issuers

Thursday, December 30, 2010

President Signs Legislation Amending Dodd-Frank to Provide Full FDIC Protection for Lawyer Trust Accounts

The President signed legislation yesterday amending Section 343 of the Dodd Frank Act to assure continued full FDIC protection for lawyer trust accounts. The current Term Asset Guarantee program under which the FDIC guarantees the total amount of client funds maintained in lawyer trust accounts expires December 31, 2010. The Dodd-Frank Act creates an equivalent program, running for 2 years beginning January 1, 2011, but makes several changes, including a more narrow definition of a covered account. In what appears to have been a drafting error, lawyer trust accounts were not covered under the new program established by the Dodd-Frank Act. The legislation, HR 6398, corrects that inadvertent omission so that the accounts are fully insured. The President is expected to sign the legislation.

A Senate amendment to HR 6398 that would have clarified that derivatives trades by commercial end-users are not subject to margin requirements did not make it into the final legislation. The amendment was sponsored by Senator Saxby Chambliss (R-GA), Ranking Member on the Agriculture Committee, and Senator Bob Corker R-TN), a leading member of the Banking Committee, and supported by, among others, the Business Roundtable, the National Association of Manufacturers, and the U.S. Chamber of Commerce.

The Senate passed the legislation by unanimous consent on December 22, 2010. Senator Jeff Merkley (D-Ore) explained that in all fifty states lawyers have to put clients’ funds into trust accounts. Under the law, they are not allowed to earn interest on these accounts. Over time, however, an arrangement has been worked out whereby the banks pay interest, but it does not go to the clients; it goes to fund civil legal services for those who cannot afford those services. The Dodd-Frank Act as passed put this arrangement in great jeopardy and the legislation is designed to fix the problem.

Without the legislation, explained Sen. Merkley, lawyers applying their fiduciary duty would have had to withdraw their funds from these interest bearing accounts and put them in non-interest bearing accounts. Similarly, Senator Johnny Isakson (R-GA) noted that an unintended consequence of the Dodd-Frank legislation with regard to interest on lawyer trust accounts is that, without the HR 6398 fix, we would have had thousands of escrow accounts held by law firms and attorneys, real estate transactions, dispute resolution transactions, and beneficial programs that would have had to be spread among many more banks because the insurance level drops. It would have forced the transfer of escrow account money out of a number of banks. At a time when capital is critical in small community banks, the unintended consequence might have been to take them below tier one capital requirements and put them in a stress situation. (Cong. Record, Dec. 22, 2010, pS10964).

Rep. Lloyd Doggett, (D-TX), the House sponsor of HR 6398, noted that at a time when interest rates are at an all-time low, it is particularly important that there be a complete government-backed guarantee against any loss on these trust accounts. He also said that such protection also ensures that small, independent banks are on a level playing field with their larger competitors in securing these trust fund deposits. (Cong. Record, The legislation is supported by a broad range of groups, including the Independent Community Bankers of America and the American Bar Association.

Rep. Bachus Urges Fed to Go Slow on Regulations Implementing Dodd-Frank Interchange Fee Provision

The incoming Chair of the House Financial Services Committee has voiced concern over pace of the Fed’s efforts to implement the derivatives regulatory regime mandated by the Dodd-Frank Act. In a letter to Fed Chair Ben Bernanke, Rep. Spencer Bachus (R-AL) questioned the feasibility of the required nine-month deadline under Section 1075 of Dodd-Frank to adopt rules on debit card interchange fees and routing. Given the broad scope of this required rulemaking and the enormity of its potential impact, Rep. Bachus doubted that the extremely short timeframe would be sufficient to produce thorough and thoughtful final rules that consider the myriad perspectives of all affected parties. He cautioned that hastily written rules may end up doing more harm than good to consumers and have negative effects on competition in the marketplace. He added that proceeding cautiously with the regulations will also allow Congress the opportunity to conduct its own review of the intent and impact of the changes enacted in Section 1075 as part of its vigorous oversight of the Dodd- Frank Act. The letter was signed by Rep. Jeb Hensarling (R-TX), the incoming Vice-Chair of the oversight committee.

Section 1075 requires that the Fed issue by April 21, 2011 three final rules on interchange fees regarding a reasonable and proportional debit fee structure, fees for fraud prevention on debit transactions, and debit transaction network fees. There is a statutory exemption for small issuers under $10 billion in assets from the new debit fee rules.Section 1075 also requires the Fed to produce new rules regarding the routing of transactions on payment card networks by July 21, 2011.

These rules pose important public policy questions, said the new Chair, and there are concerns regarding whether the Fed has had the time and input it needs to best address the intent of the statute. He noted that Congress devoted little if any time to considering the impact of these changes before Section 1075 was enacted into law, with the House Financial Services Committee holding only one hearing on the general subject of interchange over the last two years and none on the subject of routing. Additionally, some concerns have been raised that, despite its intent, the small issuers' exemption may end up creating an unlevel playing field in the industry that hurts small issuers like community banks and credit unions by making their cards more expensive for merchants to accept. In the Chair’s view, such an outcome would run contrary to the general goal of benefiting consumers and promoting competition that we all share.

Former SEC Commissioners Urge Supreme Court to End Circuit Split and Apply Efficient Market Theory to Loss Causation Element of Rule 10b-5

Three former SEC Commissioners and a former General Counsel have asked the US Supreme Court to resolve the split among the federal courts of appeal and rule that the efficient market theory that underlies the fraud-on-the-market reliance element of Rule 10b-5 must be equally applied to the antifraud rule’s loss causation and materiality elements. In an amicus brief, the former Commissioners said that this means applying the fundamental premise of the efficient market theory that the company’s stock price immediately reacts to new information. The former SEC officials also contended that the instant ruling by the Ninth Circuit panel represents an unwarranted expansion of the Rule 10b-5 implied cause of action that threatens the careful balance Congress has struck in securities fraud actions. Amici are former Commissioners Charles Cox, Joseph Grundfest, and Roberta Karmel and former SEC General Counsel Simon Lorne. . Apollo Group, Inc. v. Policemen’s Annuity and Benefit Fund of Chicago, Dkt. No. 10-649.

Unlike traditional fraud actions, noted amici, modern securities fraud class actions depend on a series of presumptions and methods of proof that substitute for the traditional forms of evidence such as investor testimony. In almost every Rule 10b-5 class action investor reliance on the alleged misrepresentations is presumed on the theory that the impersonal market swiftly assimilates all new material information and incorporates it in securities prices. This presumption was enshrined in Rule 10b-5 by the Supreme Court in its 1988 opinion in Basic Inc. v. Levinson, which formally adopted the fraud-on-the-market theory of investor reliance.

Judicial acceptance of the efficient market theory of swift market incorporation of new, material information gave plaintiffs a powerful weapon since by pleading and proving that a market is efficient they can recover damages without proof that anyone actually relied on an alleged misrepresentation, based on the theory that the unsleeping eye of the market took notice and incorporated the misrepresentation into its prices.

But the circuit courts of appeal have split over how to apply the efficient market theory to market responses to true information for purposes of proving the elements of loss causation and materiality under Rule 10b-5. Some Circuits hold that if the market fails to react to an initial corrective disclosure of facts, the plaintiffs cannot prove that such disclosures were the cause of their losses, even if those losses followed some later disclosure repackaging and commenting on the same facts.

The Ninth Circuit, in this case, took the opposite view. The market for the company’s stock, whose efficiency was presumed for purposes of reliance, did not show a statistically significant response to initial reports of an adverse report by the Department of Education that undermined the company’s prior statements, nor to subsequent extensive press reports detailing the troublesome findings of that report. Yet, noted the former Commissioners, the Ninth Circuit found it legally permissible for plaintiffs to establish loss causation. from the market’s delayed reaction to the analyst reports and to recover damages from the days when the original facts were disclosed. It is the view of amici that, under the efficient capital market theory as it is applied to the reliance inquiry, and as it is applied in other Circuits to materiality and loss causation, this is not a permissible result.

Further, in amici’s view, the split among the Circuits creates an unpredictable landscape for securities class actions and encourages forum shopping in search of courts that will judicially expand the boundaries of recoverable losses. The Ninth Circuit’s rule leaves the determination of recoverable losses under Rule 10b-5 uncertain from case to case and Circuit to Circuit, and untethered from the efficient market theory that gives the claim life in the first instance.

The former SEC Commissioners urged the Court to put an end to the confusion by granting certiorari and clarifying that any lawsuit using the efficient capital market theory to establish the reliance element of the claim must apply the same theory to establish the materiality and loss causation elements as well. If the efficient market theory is to form the basis of a lawsuit, they reasoned, it must be applied consistently to all elements of the claim.

Amici also argued that the Ninth Circuit’s loss causation amounts to a judicial expansion of the implied Rule 10b-5 cause of action, enabling plaintiffs to selectively use the efficient capital market theory to sustain a presumption of reliance while disregarding precisely the same theory for purposes of proving loss causation and materiality. Noting that the Supreme Court has consistently rejected such expansions, the former Commissioners invited the Court to take this opportunity to rein in unreasonable extensions of the efficient markets theory.

Moreover, judicial expansion of Rule 10b-5 upsets the careful balance the securities laws strike between compensating fraud victims and protecting capital markets from the damaging effects of frivolous litigation. Congress has not been silent in striking this balance, noted the former SEC officials, but has actively and repeatedly legislated in this area. For example, the loss causation provisions applicable to Rule 10b-5 claims were enacted in the Private Securities Litigation Reform Act of 1995 against the backdrop of the efficient-market presumption in Basic. If Congress had wanted to provide a more expansive method of proving damages, reasoned the former SEC Commissioners, it could have done so.

Wednesday, December 29, 2010

Hedge Fund Industry Asks SEC to Require Fund Managers to Disclose Information on Say on Pay Only When They Instructed the Share Voting

Hedge fund managers and other institutional managers should be required to report information to the SEC on say-on-pay voting only when they have instructed an intermediary to vote their shares, according to the hedge fund industry. In a letter to the SEC on the Commission’s proposal requiring institutional investment manager with voting power over a vote on executive compensation to report voting information on Form N-PX, the Managed Funds Association said that reporting information with respect to such non-votes is not required by the Dodd-Frank Act, would be of minimal use to investors, and would be burdensome for managers. Many hedge fund managers would fall within the definition of “institutional investment manager” as proposed in the Release, and thus would be subject to the new reporting requirements.

As fiduciaries, hedge fund and other institutional managers act in the best interests of their clients. Informed by their fiduciary duty to their clients, hedge fund managers determine whether it is in the best interests of their clients for them to participate in shareholder votes. For a variety of reasons, noted the MFA, hedge fund managers may elect to refrain from exercising their voting power. For example, a manager implementing an investment strategy that is designed to achieve returns through short-term trading may determine that the substantial costs associated with tracking votes and identifying matters to be voted outweigh the benefit of participation in the shareholder vote, particularly if the manager is unlikely to continue to hold the shares at the time of the shareholder meeting and beyond.

Moreover, requiring managers that determine not to exercise their voting power to report information about the shareholder vote would not serve any clear policy objective. In the case of a private fund manager, said the MFA, investors in funds it manages are sophisticated individuals and institutions that are aware of the manager’s proxy voting policies. There would seem to be little benefit to such investors or the public generally in requiring reporting and disclosure of voting information if a manager has declined to vote.

Thus, the MFA urged the SEC to require hedge fund managers to report information only when they have instructed an intermediary to vote their shares. In the industry’s view, such a requirement would elicit more useful information from institutional investment managers and avoid imposing an unnecessary cost on investors when managers do not vote their securities, such as those that use investment strategies that are not related to the voting of proxies. This approach would also be consistent with Section 951 of Dodd-Frank, which does not appear to require reporting when a manager has not voted. The statute says that every institutional investment manager subject to Section 13(f) must report how it voted.

The MFA also asked the SEC to modify the proposal to take into account the complex mechanics of proxy voting for institutional managers. While appreciating the goal of requiring managers to report how they have voted, the MFA noted that current portfolio management and custody practices in many cases do not allow an institutional manager to confirm whether its instructions to its broker were followed. In maintaining securities for institutional managers, prime brokers often have authority to lend the securities on behalf of the manager, and may also have authority to re-hypothecate the securities under the terms of their arrangements with the manager. Both securities lending and re-hypothecation have the effect of transferring voting power from the manager to another firm, and may not include a procedure for notifying the manager. For example, a prime broker may loan securities it holds on behalf of institutional managers without identifying which managers’ securities were loaned. As a result, managers may not know over which securities they have voting power at the applicable record date.

Moreover, managers that submit instructions for shares to be voted often are unable to verify that the shares were actually voted according to the instructions due to the number of intermediaries involved in the proxy voting process. The involvement of such intermediaries in the submission of a manager’s shareholder proxies, including proxy voting service providers, custodians, and others, create significant operational challenges to confirming that votes were submitted and recorded by an issuer. A requirement that an institutional manager report on Form N-PX how the shares were actually voted would attach liability to the manager, which would likely be passed through the chain of intermediaries in some manner, further raising the costs and creating additional complications to any confirmation process.

With this in mind, the MFA suggested the proposed rule require instead that each institutional investment manager report on Form N-PX how it instructed the shares to be voted. Such a requirement would continue to provide important information about a manager’s voting on the Section 14A executive compensation matters, and would avoid mandating that managers undertake a new, costly vote confirmation process.

Tuesday, December 28, 2010

US Manufacturers Ask Supreme Court to Apply Efficient Market Theory to Loss Causation Element of Rule 10b-5

The federal courts should apply the efficient market theory underlying the fraud-on-the-market presumption equally to both the reliance and loss causation elements of Rule 10b-5, said the National Association of Manufacturers in an amicus brief filed with the US Supreme Court. The association asked the Court to review a Ninth Circuit panel ruling that embraced the efficient market theory in order to certify a class, but effectively rejected it on the issue of loss causation. Assessing loss causation with reference to events that occur long after corrective public disclosure of the relevant facts in a theoretically efficient market improperly expands the potential exposure of defendants in securities class action cases, argued the association, and decreases the certainty with which companies can assess this exposure. Apollo Group, Inc. v. Policemen’s Annuity and Benefit Fund of Chicago, Dkt. No. 10-649.

The question before the Court, which awaits a grant or denial of certiorari, is whether a plaintiff, invoking the efficient market theory to avoid having to prove reliance on a misrepresented stock price that caused him loss, is barred from trying to prove loss causation based on a decline in price that happened weeks or months after a corrective disclosure, rather than immediately after the disclosure.


Amicus points out that the ability to bring a securities fraud class action is grounded in the presumption of reliance under the fraud on the market theory, without which each investor would have to prove actual reliance on the allegedly false statement. The presumption of reliance is based on the efficient market theory, which holds that in an efficient securities market all information available to the market is always rapidly reflected in the price at which securities trade in the market. Thus, the fact that an investor was not aware of a particular statement is irrelevant under the theory because the stock price, of which the investor was aware, already incorporates the statement. In turn, the efficient market theory is based on the premise that competition among investors and traders forces stock prices to rapidly reflect all publicly available information.

By beginning class certification periods immediately after the allegedly false statement is made, said the brief, federal courts embrace the concept that efficient markets act quickly in assimilating new facts into the price of securities for purposes of applying the presumption of reliance.

If the securities markets are presumed for purposes of class certification and reliance to be efficient in their ability to rapidly assimilate any false statements made by a company into the price of securities, reasoned the association, they should likewise be presumed for purposes of assessing loss causation to be efficient in their ability to rapidly assimilate any corrective statements made by that company into the price of securities.

There is no rational basis for applying different standards of market efficiency for false statements and true statements, contended amicus, thus if an investor gets the benefit of a reliance presumption based on the efficient market theory, a compamy should get the benefit of the same market efficiency reacting to all available corrective disclosures.

Due to the split in the circuit courts on the issue, continued the brief, U.S. manufacturers whose shares trade on efficient markets run the risk of being whipsawed. On the front end, courts assume that their stock price immediately reflects all available information, while in some jurisdictions courts do not permit manufacturers to rely on the same presumption to establish that the immediate market reaction to an appropriate corrective disclosure effectively caps their damages.

Monday, December 27, 2010

Congress Amends Dodd-Frank to Provide Fix for Full FDIC Protection for Lawyer Trust Accounts

Congress has passed legislation, HR 6398, amending Section 343 of the Dodd Frank Act to assure continued full FDIC protection for lawyer trust accounts. The current Term Asset Guarantee program under which the FDIC guarantees the total amount of client funds maintained in lawyer trust accounts expires December 31, 2010. The Dodd-Frank Act creates an equivalent program, running for 2 years beginning January 1, 2011, but makes several changes, including a more narrow definition of a covered account. In what appears to have been a drafting error, lawyer trust accounts were not covered under the new program established by the Dodd-Frank Act. The legislation corrects that inadvertent omission so that the accounts are fully insured. The President is expected to sign the legislation.

A Senate amendment to HR 6398 that would have clarified that derivatives trades by commercial end-users are not subject to margin requirements did not make it into the final legislation. The amendment was sponsored by Senator Saxby Chambliss (R-GA), Ranking Member on the Agriculture Committee, and Senator Bob Corker R-TN), a leading member of the Banking Committee, and supported by, among others, the Business Roundtable, the National Association of Manufacturers, and the U.S. Chamber of Commerce.

The Senate passed the legislation by unanimous consent on December 22, 2010. Senator Jeff Merkley (D-Ore) explained that in all fifty states lawyers have to put clients’ funds into trust accounts. Under the law, they are not allowed to earn interest on these accounts. Over time, however, an arrangement has been worked out whereby the banks pay interest, but it does not go to the clients; it goes to fund civil legal services for those who cannot afford those services. The Dodd-Frank Act as passed put this arrangement in great jeopardy and the legislation is designed to fix the problem.

Without the legislation, explained Sen. Merkley, lawyers applying their fiduciary duty would have had to withdraw their funds from these interest bearing accounts and put them in non-interest bearing accounts. Similarly, Senator Johnny Isakson (R-GA) noted that an unintended consequence of the Dodd-Frank legislation with regard to interest on lawyer trust accounts is that, without the HR 6398 fix, we would have had thousands of escrow accounts held by law firms and attorneys, real estate transactions, dispute resolution transactions, and beneficial programs that would have had to be spread among many more banks because the insurance level drops. It would have forced the transfer of escrow account money out of a number of banks. At a time when capital is critical in small community banks, the unintended consequence might have been to take them below tier one capital requirements and put them in a stress situation. (Cong. Record, Dec. 22, 2010, pS10964).

Rep. Lloyd Doggett, (D-TX), the House sponsor of HR 6398, noted that at a time when interest rates are at an all-time low, it is particularly important that there be a complete government-backed guarantee against any loss on these trust accounts. He also said that such protection also ensures that small, independent banks are on a level playing field with their larger competitors in securing these trust fund deposits. (Cong. Record, The legislation is supported by a broad range of groups, including the Independent Community Bankers of America and the American Bar Association.

Sunday, December 26, 2010

In letter to SEC and Fed, Rep. Brad Miller Warns that Qualified Residential Mortgage Exception Could Swallow Dodd-Frank’s 5% Skin in the Game Mandate

A leading member of the House Financial Services Committee has asked the SEC to carefully craft rules for the qualified residential mortgage exception to the Dodd-Frank risk retention requirements for securitized mortgages lest the exception swallow the five percent skin in the game provision. In a letter to SEC Chair Mary Schapiro, Rep. Brad Miller (D-NC) also urged that any exception to the risk retention requirements of Section 941 of Dodd-Frank include rigorous requirements for servicing securitized residential mortgages.

Rep. Miller noted that Section 941 requires that securitizers retain five percent of the credit risk on mortgage-backed securities, which according to a recent study published by the Federal Reserve Bank of San Francisco by Christopher M. James dated December 13, 2010, and entitled “Mortgage-Backed Securities: How Important Is ‘Skin in the Game’?”, which finds that the requirement will have the intended effect of reducing “moral hazard” and significantly reducing the loss ratios on mortgage-backed securities.

The Dodd-Frank Act provides for an exception for qualified residential mortgages and for other exemptions and adjustments to the risk-retention requirement. Sponsored by Senators Mary Landrieu (D-LA) and Johnny Isakson (R-GA), the bi-partisan carve out for qualified residential mortgages is designed to ensure that originators of mortgages with a high FICO rating will not have to retain the five percent amount required of other securitized assets. (Cong. Record, May 12, 2010, S3576).

Rep. Miller strongly urged the SEC to use great care in allowing any exception to the risk retention requirement, and to be vigilant in assuring that any exception not defeat the purpose of the requirement. In his view, recent experience in financial regulation has been that seemingly modest, reasonable exceptions have swallowed the rules and allowed abusive practices to continue unabated. Thus, in considering any requested exception under Section 941, the SEC should remember that the advocates for rule-swallowing exceptions to other financial regulation have not been entirely candid with regulators or legislators on the likely effect of those exceptions.

While the rules adopted pursuant to section 941 must require rigorous underwriting standards for qualified residential mortgages or any other mortgages excepted from the risk retention requirement, he added that underwriting requirements are not enough. The rules must also address the servicing of securitized mortgages. In his view, much of the turmoil in the housing market is the result, not just of poorly underwritten mortgages, but of conduct by mortgage servicers. Rep. Miller emphasized that Dodd-Frank authorizes the SEC and other federal financial regulators to reform servicing practices

He urged that any rule for securitized mortgages require that servicers not be affiliated with the securitizer since there are potential conflicts of interest and no apparent countervailing justification. He said that at a recent hearing of the Financial Services Committee witnesses from major servicers were unable to offer any advantage in being affiliated with securitizers, other than to offer full service to customers, a justification he viewed as entirely unpersuasive. Homeowners may select the bank with which they have a credit card or a checking account, he noted, but they have no say in who services their mortgage.

In fact, community banks and credit unions have been reluctant to sell the mortgages that they originate to “private-label securitizers” for fear that the mortgages will be serviced by an affiliate of a bank, and the servicer will use that relationship to cross market other banking services to the homeowner. Requiring that servicers be independent of banks, therefore, would advance the goal of increasing the availability of credit on reasonable terms to consumers.

Friday, December 24, 2010

Congress Passes Legislation Mandating Accountability and Performance at Federal Agencies

Congress has passed landmark, bipartisan legislation requiring federal agencies to set clear goals that can be measured and reported to Congress and the American people in a more transparent way. The Government Performance and Results Modernization Act (HR 2142) calls on federal agencies to identify overlapping federal programs and requires more focused efforts to identify potential taxpayer savings. This legislation is the first significant update of the Government Performance and Results Act (GPRA) of 1993 in nearly two decades. The bill now goes to the President's desk for his signature, which is expected.

At a time of budget deficits and crippling national debt, the Government Performance and Results Modernization Act takes several significant steps to make the federal government work smarter and look for ways to save taxpayer money, said Senator Mark Warner, Chair of the Senate Budget Committee's Task Force on Government Performance. The legislation also takes a first step in supporting a key recommendation from the President's Commission on Fiscal Responsibility and Reform (Bowles Commission) to increase reporting on government-wide cross-cutting priorities, require agencies to identify low priorities and provide new data to identify duplicative federal programs.

The legislation requires the federal government to set government-wide goals and to align programs from different federal agencies to work together to reduce overlap and duplication. Each agency will be required to designate a Chief Operating Officer and a Performance Improvement Officer, with the primary responsibility for pursuing cost-savings through the improved coordination of duplicative programs. These officials also would be held responsible for considering taxpayer savings through better coordination of administrative functions common to every agency, including purchasing.

The legislation also requires federal agencies to post performance data on a single public website on a quarterly, rather than a yearly, schedule. It also sets an ambitious first-year goal of an overall 10-percent reduction in the total number of little-used or outdated reports mandated by previous Administrations and Congresses.

Federal agencies are also directed to make their annual performance plans available on its public website and notify the President and Congress by the first Monday in February. The performance plan must describe how performance goals contribute to objectives of the agency's strategic plan and goals of the federal government performance plan; identify agency priority goals, as well as low-priority program activities; and identify clearly defined milestones, the activities, entities, and policies contributing to each goal, how the agency is working with other agencies to achieve performance goals, and the agency officials responsible for the achievement of each goal. The plan must also describe how the agency will ensure the accuracy and reliability of the data used to measure progress towards its performance goals, as well as the major management challenges and plans to address such challenges.

Under the legislation, OMB must determine whether each agency's programs or activities meet performance goals and objectives outlined in the agency performance plans and submit an annual report on unmet goals to the agency head, specified congressional committees, and the GAO. A federal agency which OMB determines has not met performance goals for one fiscal year must submit a performance improvement plan for each unmet goal with measurable milestones and designate a senior official to oversee the performance improvement strategies for each unmet goal.

The federal agency's Chief Operating Officer must annually to compile and submit to OMB a list of all plans and reports the agency produces for Congress and a list that identifies a specified percentage of those (at least 10% in the first year) as outdated or duplicative. In turn, the OMB Director must include the list of outdated or duplicative agency plans and reports in the annual federal budget submitted by the President and is also authorized to concurrently submit legislation to eliminate or consolidate such plans and reports.

Thursday, December 23, 2010

Senior Global Regulators Report that Sound Corporate Governance Is Key to Effective Risk Appetite Framework for Firms

A consortium of global senior regulators, including the SEC, the Fed, BaFin, and the UK and Japanese FSAs, have concluded that financial firms that most effectively implement a risk appetite framework are those that create a strong corporate governance culture involving the engagement of the board and senior management and distinctive mandates and duties at each stage of governance. A risk appetite framework is an explicit effort to describe the boundaries within which management is expected to operate when pursuing a firm’s strategy. It codifies which types of risk the firm is willing to bear and under what conditions, as well as which risks the firm is unwilling to assume. In turn, the group defined risk appetite as the level and type of risk a firm is able and willing to assume in its exposures and business activities, given its business objectives and obligations to stakeholders.

Risk appetite is generally expressed through both quantitative and qualitative means and should consider extreme conditions, events, and outcomes. In addition, risk appetite should reflect potential impact on earnings, capital, and liquidity. The report was issued by the Senior Supervisory Group, which also includes the Canadian Superintendent of Financial Institutions, the Netherlands Bank, and the Swiss Financial Markets Supervisory Authority.

The report also found that, while most firms have made progress in developing risk appetite frameworks, considerably more work to do in order to strengthen these practices. In particular, the group said that the aggregation of risk data remains a challenge for institutions despite its critical importance to risk management.

The most effective risk appetite frameworks were found in firms with highly engaged boards working closely with senior officers, including the CFO and the chief risk officer. Active engagement by directors and senior management was observed to be critical in securing the financial and human capital necessary to implement IT infrastructure projects. In particular, this level of management support was seen as critical for IT projects aimed at improving the aggregation of risk data.

In addition, the role of the chief risk officer and its relationships with others is particularly notable, because the chief risk officer leads risk discussions among the board, the senior management team, and the business line leaders. Strong communication among these individuals allows the management team to effectively translate the board’s expectations of risk appetite into the firm’s day-to-day operations.

While risk limits set boundaries, noted the regulators, they do not by themselves offer enough accountability for operating within the risk appetite framework. Thus, the SEC and other regulators suggested that creating a risk culture consistent with a risk appetite framework would require positive incentives, such as career advancement and compensation, for individuals demonstrating strong risk management abilities.

A threshold element of a risk appetite framework is a risk appetite statement, which should be driven by the board and supported and implemented by senior management. The risk appetite statement is essentially a risk philosophy or a mission statement for risk that gives senior managers both guidance and constraints as they pursue the firm’s strategy. Risk appetite statements should contain the acceptable trade-off between risk and reward, the tolerances for volatility, and capital thresholds (including regulatory capital and leverage ratios). A useful risk appetite statement is relatively simple,easily communicated, and resonates with multiple stakeholders.

While the board or its risk committee cannot be expected to monitor every facet of a firm’s risk profile, said the report, boards that invest a significant amount effort in articulating a firm’s risk appetite statement will have a greater stake in ensuring that the framework is implemented and guides decision making throughout the firm. Directors should challenge management until they are comfortable that management both understands the risk profile and is running the business in a manner consistent with the risk appetite framework.

The global regulators describe risk profile as a point-in-time assessment of actual aggregate risks associated with a firm’s exposures and business activities, through the use of several tools and measures. Generally, a firm should aim to have its risk profile remain within its stated risk appetite and should ensure that its risk profile does not exceed its risk capacity, which is the full level and type of risk at which a firm can operate and remain within constraints implied by capital and funding needs. Risk capacity is a maximum measure, emphasized the regulators, and is not necessarily intended to be reached, meaning that a firm might set a buffer between risk capacity and risk appetite and manage that on an ongoing basis.

Corporate Secretaries Society Says SEC Proposed Whistleblower Rules Could Undermine Corporate Compliance Programs

The rules proposed by the SEC to implement the Dodd-Frank whistleblower provisions could undermine corporate compliance programs, in the view of the Society of Corporate Secretaries and Governance Professionals. In a letter to the SEC, the Society suggested modifications in the proposal that are intended to strike the proper balance in preserving the purposes of effective corporate compliance programs while also fulfilling the legislative mandate to maximize the submission of high-quality tips and enhance the utility of the information reported to the Commission.

Integral to compliance programs, noted the Society, corporate tip lines are valuable mechanisms for revealing and remedying securities law violations. The Society urged the SEC not to undermine these federally mandated programs which already exist at most public companies. Rather, these corporate compliance programs should be the first line for reporting violations, said the Society, and persons seeking a whistleblower bounty should be required to first report the information to the company so long as the company has an effective corporate compliance program.

Section 301 of the Sarbanes-Oxley Act, adopted as Exchange Act Rule 10A-3, required companies to establish tip line procedures for anonymous reporting relating to accounting, internal accounting controls, and auditing matters. The Society believes that these in-place procedures can be readily modified to include the anonymous reporting of potential securities law violations.

These hot line programs generally require employees to internally report any potential violations of law. In the Society’s view, it is thus important that the SEC whistleblower rules work in tandem with these existing procedures. The Society asks that the SEC rules expressly require an employee to report first through the company’s compliance and tip reporting programs, with a futility exception, or risk totally undermining existing programs. Specifically, the Society suggested that initial reporting to the company could be implemented by including a section in proposed Form TCR inquiring whether the whistleblower reported first to the company’s internal compliance program, and if not, why not.

At the same time, the Society recognized that for companies with no effective compliance programs it may be appropriate for an individual to report first to the SEC. For example, initial SEC reporting would be mandated when a company does not have any reporting process in place that protects anonymous or confidential reporting or when the audit committee has not adopted procedures for the handling of reports relating to securities violations. These exceptional circumstances should be expressly defined in the rules, said the Society, and the employee submitting Form TRC to the Commission should provide an explanation with evidence of these specified circumstances.

The Society also suggested that a company should have 120-days after being notified of a securities law violation by a whistleblower to investigate, remediate and report back to the tipper. If the tipper is not satisfied with the report from the company, the tipper may begin the SEC process. Having the employee report first to the company and giving the company an opportunity to investigate the matter and take appropriate remedial action quickly can save limited and valuable SEC resources, emphasized the Society. Also, when the Commission first receives the tip, as currently contemplated under the proposal, and then notifies the company of such fact, there could be unnecessary delay in the company learning of the violation, and therefore delay in its ability to initiate any remediation actions.

Further, the proposal to allow awards to be granted to persons who participated in the violation would reward wrong-doers. The Society believes that individuals who actively participated or facilitated the violation, even if such person did not substantially direct, plan or initiate the misconduct, should not be awarded a whistleblower’s bounty.

The Society also asked the Commission to confirm that it intends to assert the FOIA exception for records of an ongoing investigation by law enforcement agencies for any tips received by it prior to its determination to open an investigation as well as with respect to any information regarding a closed investigation where no enforcement action was recommended.

Under the proposed rules, the SEC does not have to obtain permission from a company’s counsel in order to speak with a whistleblower. While the SEC does not need permission to speak directly with a whistleblower, the Society asked the SEC to revise the proposal to require that the SEC notify the company that it intends to speak with a whistleblower. Anonymous whistleblowing to the Commission puts companies at undue risk, said the Society, if they determine to take a disciplinary action against an employee who may then claim the protections of the anti-retaliation provisions. Companies should be aware that an employee made a whistleblower claim to ensure that any actions taken by the company does not appear to be retaliatory.

Wednesday, December 22, 2010

President Signs Legislation Modernizing Federal Tax Code Treatment of SEC-Regulated Investment Companies

President Obama signed today bi-partisan legislation modifying and updating federal tax code provisions pertaining to SEC-regulated investment companies in order to make them better conform to, and interact with, other aspects of the tax code and applicable federal 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. Click here for a detailed white paper on the legislation,

Specifically, the legislation:
—Sets forth a special rule allowing unlimited carryovers of the net capital losses of regulated investment companies

—Exempts regulated investment companies from loss of tax-preferred status and additional tax for failure to satisfy the gross income and assets tests if such failure is due to reasonable cause and not due to willful neglect and is de minimis.

—Revises the definitions of "capital gain dividend" and "exempt-interest dividend" for purposes of the taxation of funds and their shareholders to require such dividends to be reported to shareholders in written statements

—Excludes net capital losses of funds from earnings and profits. Prohibits earnings and profits from being reduced by any amount which is not allowable as a deduction in computing taxable income, except with respect to such a net capital loss.

—Allows a regulated investment company, in the case of a qualified fund of funds, to pay exempt-interest dividends and allow its shareholders the foreign tax credit without regard to certain investment requirements in state and local bonds and foreign securities.

—Modifies rules for dividends paid by funds after the close of a taxable year, so called, spillover dividends.

—Revises the method for allocating fund earnings and profits to require such earnings and profits to be allocated first to distributions made prior to December 31 of a calendar year

—Allows funds with shares that are redeemable upon demand to treat distributions in redemption of stock as an exchange for income tax purposes.

—Repeals preferential dividend rules for funds that are publicly offered.

—Allows funds to elect to treat a post-October capital loss and any late-year ordinary loss as arising on the first day of the following taxable year.

—Exempts from holding period requirements applicable to fund stock regular dividends paid by a fund which declares exempt-interest dividends on a daily basis in an amount equal to at least 90% of its net tax-exempt interest and distributes such dividends on a monthly or more frequent basis

—Extends the exemption from excise tax for failure to distribute taxable income of a fund to other tax-exempt entities with an ownership interest in a fund.

—Allows specified gain and loss of a fund derived after October 31 of a calendar year to be deferred, for excise tax purposes, until January 1 of the following calendar year.

—Sets forth a special rule for estimated excise tax payments of funds.
—Increases from 98% to 98.2% the amount of capital gain net income funds are required to distribute.

—Repeals the additional penalty on funds for tax deficiencies for which a deficiency dividend has been distributed

The House passed the legislation by a voice vote on September 28, 2010. The Senate passed the legislation by unanimous consent on December 8, 2010. Because the Senate passed the legislation with an amendment (the Bingaman Amendment stripping out Sec. 201 on fund commodities investments), HR 4337 returned to the House and, on December 15, 2010, the House agreed to the Senate Amendment and sent the legislation to the President.

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 corporations
that either meet or 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 incoming Chair of the House Ways and Means Committee, Rep. Dave Camp (R-Michigan) strongly supports the complete legislative overhaul of federal tax code provisions affecting investment companies. Specifically, Rep. Camp, who was a manager of the Regulated Investment Company Modernization Act, HR 4337, said that 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. Noting that he is not aware of any controversy or opposition to the legislation, Rep. Camp broadly emphasized that it is entirely appropriate for Ways and Means to periodically review the tax law to ensure that targeted provisions of importance to particular segments of the economy, including the mutual fund industry and their investors, are kept up to date. (Cong. Record, Sept. 28, 2010, H7069-7070).

Incoming Chair of House Oversight Subcommittee Might Introduce Legislation Delaying Dodd-Frank Regulations

Congressman Randy Neugebauer (R-TX), the incoming Chair of the House Financial Services Subcommittee on Oversight and Investigations, might introduce legislation to delay for one year the implementation of some provisions of the Dodd-Frank Act, presumably including derivatives rulemaking mandates. This was reported on theHill.com blog. The possible legislative delay of Dodd-Frank regulations was heralded by an earlier letter from Financial Services Committee Chair Spencer Bachus (Rp-AL) to SEC Chair Mary Schapiro and CFTC Chair Gary Gensler stating that Congress will consider legislation to delay the statutory deadlines in Dodd-Frank if that will allow the SEC and CFTC to move deliberately and carefully to ensure that the derivatives regulatory regime is correctly implemented. Rep. Bachus voiced concern over the direction and pace of the SEC-CFTC efforts to implement the derivatives regulatory regime mandated by the Dodd-Frank Act; and warned that derivatives regulations adopted hastily and without due care could damage the economy.

At the time the Dodd-Frank Act was passed by the House, Reps. Bachus and Neugebauer favored an alternative derivatives regulatory regime whose centerpiece would have been a comprehensive OTC derivatives trade repository that would provide transparency to the market, give regulators the ability to analyze appropriate data to detect and prevent fraud. It would also help regulators understand and analyze counterparty exposures in order to prevent excessive risks from building up within the system.

The Bachus-Neugebauer alternative would also have required regulators to review market data and report back to Congress if they identify an entity not already regulated by a prudential regulator that should be more heavily regulated based on its size or activities in the OTC derivatives markets.

Tuesday, December 21, 2010

Law Professors Join SEC in Urging Supreme Court to Reject Bright Line Test for Rule 10b-5 Materiality

A group of law and business professors have filed an amicus brief urging the US Supreme Court to reject a bright line test for Rule 10b-5 materiality and retain the current fact specific test that federal courts and the SEC have used for years to determine materiality. The traditional fact intensive approach set out in the Supreme Court’s Northway ruling and reiterated in its Basic opinion provides an appropriate framework for resolving the materiality issue, argued amici, and the imposition of a bright line test would be fundamentally inconsistent with the reasoning in of those opinions. Similarly, the SEC has filed an amicus brief urging the Court to reject a bright-line rule both because it is too under inclusive and because the materiality inquiry requires delicate assessments better suited to the trier of fact.

The amicus briefs were filed in a private securities fraud action posing the question of whether an investor can state a claim under Rule 10b-5 based on a pharmaceutical company’s nondisclosure of adverse event reports about a drug even though the reports are not alleged to be statistically significant. The Court will hear oral argument in the case on Jan. 10, 2011. Matrixx Initiatives Inc. v. Siracusano, Dkt. No. 09-1156.

It cannot be established that investors will only find reports important upon a showing of a statistical significance, said the brief, and such an approach is inconsistent with assumptions underlying the Court’s use of a total mix analysis. Moreover, statistical significance assumes away, at least in the first instance, any contextual examination of the available information and presupposes that the market singularly relies on the presence or absence of a mathematically validated association between the drug and the adverse events at issue. This approach treats investors as nitwits, remarked the professors, who are unable to appreciate the importance of any other information that could affect their investment decisions.

Even if investors can be said to require evidence of an association between a drug and adverse health effect, reasoned the professors, statistical significance is not the only method of establishing the requisite relationship. For example, there are scientifically valid studies that, while not statistically significant, nonetheless provide evidence of biological significance.

Northway created the analytical template for addressing the materiality of factual misstatements or omissions under the antifraud provisions of the federal securities laws. Information is material if there is a substantial likelihood it would be important to a reasonable investor in making an investment decision or if there is a substantial likelihood that the information would, if disclosed, significantly impact the total mix of available information. The test is fact specific and eschews reliance on bright-line tests.

In the view of the professors, the materiality standard first set forth in Northway has proved sufficiently robust to allow courts to resolve the materiality of quantitative thresholds such as misstatements in earnings or the number of adverse event reports. The SEC has likewise rejected numerical cut offs and bright-line tests and instructed that the analysis take into consideration all the relevant circumstances. See SEC Staff Accounting Bulletin No. 99. While SAB 99 represents the views of the staff, said the brief, the Commission has recognized the need to consider qualitative factors when determining the materiality of quantitative elements. See In re AIG, Exchange Act Release No. 48477 (admin. proc. Sept. 11, 2003), where the SEC said that materiality judgments involve both quantitative and qualitative considerations. Amicus also noted remarks by former SEC Chair Arthur Levitt that materiality is not a bright line cutoff of three or five percent, but rather requires consideration of all relevant factors that could impact an investor’s decision. See Speech by Arthur Levitt, SEC Chairman, The Numbers Game (Sept. 28, 1998).

SEC Censures Outside Auditor of NASDAQ Shell Company that Owned Mainland China Manufacturer

The SEC censured the outside auditor of a NASDAQ-listed shell company with ownership of a Mainland China manufacturer of energy savings products for failing to exercise professional skepticism and take due professional care with regard to revenue recognition and failing to consider the reasonableness and consistency of management’s response to inquiries concerning significant sales transactions. The SEC also suspended the engagement partner on the audit from Commission practice for at least two years and entered a cease and desist order against the audit firm and the engagement partner. The audit firm and its partner settled the proceeding without either admitting or denying the SEC’s findings.

As part of the settlement, the audit firm agreed not to accept any new issuer audit clients with operations located in the People's Republic of China, the Hong Kong Special Administrative Region, and Taiwan, between the date of the SEC order and the issuance of a certification that the firm has complied with the recommendations of an independent consultant that it has agreed to hire to ensure that its procedures will produce audits in compliance with SEC regulations and PCAOB standards and rules. In the Matter of Moore Stephens Wurth Frazer & Torbett LLP, AAER No. 3221.

Although the audit firm and its engagement partner determined that the audit engagement involved high risks, noted the SEC, they did not exercise professional skepticism and due professional care, and otherwise violated professional standards. The audit firm issued unqualified audit opinions, which were included in the company’s FY 2004 and 2005 annual reports.

During the engagement, the auditors learned information that contradicted disclosures in the company’s annual reports. The company claimed in its filings that the Mainland operations were located on a single floor of a building. But when the audit team arrived at that location to begin their audit field work, none of the industrial’s inventory was at the site.

The SEC found that the company materially overstated earnings per share (EPS) in its annual report for FY 2004. At the time, the company lacked accounting personnel trained in U.S. GAAP and was unable to complete a calculation. At the company’s request, the audit firm prepared the initial EPS calculation. In making the calculation, however, a firm accountant used the wrong number of shares, which had the effect of overstating EPS. The engagement partner reviewed the draft calculation but did not identify the error. The company adopted the calculation without change and included the overstated EPS in its annual report. The Commission also found that the engagement partner acquiesced in the company’s improper revenue recognition and accepted company that were inconsistent with the company’s prior representations and with contracts and other company records.

As part of the settlement, the audit firm agreed to hire an independent consultant to evaluate whether its policies and procedures are were adequate to ensure compliance with SEC regulations and PCAOB standards and rules. Within 60 days, the consultant must report to the SEC and Board with recommendations designed to ensure that the firm’s outside audits of a client company’s financial statements so conform. The audit firm agreed to implement the recommendations as soon as practicable unless it can negotiate an alternative with the consultant.

Within sixty days of issuance of the report, the audit firm must certify to the SEC and the PCAOB in writing that it has implemented or will implement all the consultant’s recommendations. Finally, six months after issuance of the certification the consultant will undertake a follow-up evaluation of the firm’s compliance with the matters certified. Within thirty days after the completion of this evaluation, the consultant will issue a supplemental written report to the SEC and PCAOB certifying the firm’s compliance, describing any matters on which it was unable to certify compliance, and making recommendations designed to ensure that the firm’s audits comply with SEC regulations and PCAOB standards and rules

Sunday, December 19, 2010

Business Coalition Supports Chambliss-Corker Amendment to Nail Down Commercial End-User Exemption from Dodd-Frank Derivatives Mandate

In a letter to the US Senate, the Coalition of Derivatives End Users urged support for the Chambliss-Corker Amendment to legislation amending the Dodd-Frank Act, which would clarify that derivatives trades by commercial end-users are not subject to margin requirements. It is expected that the amendment, sponsored by Senator Saxby Chambliss (R-GA), Ranking Member on the Agriculture Committee, and Senator Bob Corker R-TN), a leading member of the Banking Committee, will be offered by unanimous consent. The coalition is composed of, among others, the Business Roundtable, the National Association of Manufacturers, and the U.S. Chamber of Commerce.

The amendment is to HR 6398, which passed the House on November 30, 2010 by voice vote. HR 6398 would amend Dodd-Frank to assure continued full FDIC protection for lawyer trust accounts. The current Term Asset Guarantee program under which the FDIC guarantees the total amount of client funds maintained in lawyer trust accounts expires December 31, 2010. The Dodd-Frank Act creates an equivalent program, running for 2 years beginning January 1, 2011, but makes several changes, including a more narrow definition of a covered account. In what appears to have been a drafting error, lawyer trust accounts were not covered under the new program established by the Dodd-Frank Act. The legislation corrects that inadvertent omission so that the accounts are fully insured.

It is unclear if there is sufficient time left in the lame duck session of the 112th Congress to amend and pass the legislation in the Senate and send it back for House approval of the Chambliss-Corker Amendment.
According to the coalition, the amendment does no more than make the margin provisions of the Dodd-Frank Act consistent with the way they have been described by their sponsors. A letter written by Senators Dodd and Lincoln and a colloquy engaged in by Representatives Frank and Peterson stated that margin is not intended to be imposed on end-users. The amendment would begin to fulfill the promise made at the time of passage of the Dodd-Frank Act for legislation to address several issues known at the time, said the coalition, including this one.

The letter also noted that the amendment is consistent with Chairman Gensler’s recent statement on margin requirements. At a meeting of the Commodity Futures Trading Commission on December 1, 2010, Chairman Gensler said that the proposed rules on margin requirements should focus only on transactions between financial entities rather than those transactions that involve non-financial end-users. The Chambliss-Corker Amendment would achieve the focusing that Chairman Gensler supports, emphasized the coalition, by removing the authority of regulators to impose margin on trades with non-financial end-users. This is an extremely positive step, said the letter, and one that the business coalition hopes will lead to a margin exemption for all end-user trades.

Saturday, December 18, 2010

Rep. Bachus Hints at Legislation to Delay SEC-CFTC Implementation of Dodd-Frank Derivatives Regime as Concerns Grow

The incoming Chair of the House Financial Services Committee has voiced concern over the direction and pace of the SEC-CFTC efforts to implement the derivatives regulatory regime mandated by the Dodd-Frank Act. In a letter to SEC Chair Mary Schapiro and CFTC Chair Gary Gensler, Rep. Spencer Bachus (R-Ala)warned that derivatives regulations adopted hastily and without due care could damage the economy. He said that Congress will consider legislation to delay the statutory deadlines in Dodd-Frank if that will allow the SEC and CFTC to move deliberately and carefully to ensure that the derivatives regulatory regime is correctly implemented. More broadly, Rep. Bachus warned that creating a prohibitively expensive and rigid market for using and trading derivatives in the US could shift the market overseas.The letter was co-signed by Rep. Frank Lucas (R-Okla), the incoming Chair of the House Agriculture Committee.

Alluding to the earlier Dodd-Lincoln letter and a House colloquy between Rep. Frank and Rep. Peterson, the new Chair said that is critically important that the SEC and CFTC implement the commercial end user exemption consistent with legislative intent and allow companies to engage in the hedging of legitimate business risks. For example, end users must not be required to post margin, he said, and must be able to rely on their exemption from clearing and trading rules without having to overcome ``unnecessary bureaucratic obstacles.’’ He also cautioned the SEC and CFTC not to apply margin to existing derivatives contracts since doing so would retroactively upset the rational expectations of thousands of end users.

Rep. Bachus also urged the Commissions to consider carefully the scope of who is defined as a swap and security-based swap dealer and a major swap and security-based swap participant. Creating an overly broad net in defining these terms, he said, could force smaller participants to leave the market and eliminate some types of hedging contracts, thereby exposing businesses to market volatility.

Noting that they are unlike other derivatives regulated by Dodd-Frank, Rep. Bachus said it is vital that foreign exchange swaps and forwards be exempted from Dodd-Frank’s clearing and exchange trading rules. He predicted that an already stable foreign exchange swap market would become more transparent with the imposition of Dodd-Frank reporting rules.

He also warned that implementing real-time reporting and trade execution requirements without adequate safeguards could increase the price of a derivatives contract to hedge risk by facilitating speculative front running. While recognizing that the SEC and CFTC must have real time access to derivatives data, Rep. Bachus said that mandating real time reporting of thinly-traded products and illiquid markets in an effort to force derivatives to trade similarly to exchange traded products is a fundamentally flawed approach.

Finally, Rep. Bachus urged the SEC and CFTC to use the exemptive authority given to them in Dodd-Frank to avoid establishing position limits that would force widely-held funds or firms to divest their current holdings in highly-regulated products. He warned that overly prescriptive position limits would drain existing liquidity from the capital markets, impair price discovery, and harm the futures markets.

Incoming Chair of House Capital Markets Subcommittee Wants to Reform GSEs and Create US Covered Bond Market

Rep. Spencer Bachus (R-AL), incoming Chair of the House Financial Services Committee, has named Rep. Scott Garrett (R-NJ) to chair the subcommittee with jurisdiction over the financial markets, the SEC, the NYSE, NASD, the SROs, and the government -sponsored enterprises, such as Fannie Mae and Freddie Mac. The Capital Markets subcommittee also has oversight of all matters related to capital markets activities such as business capital formation and venture capital, and derivative instruments.

While there will be a number of very important issues on the subcommittee’s plate during the 112th Congress, said Rep. Garrett, reforming the GSEs and the securitized secondary mortgage market will be priority number one. He also wants to reform the Securities Investor Protection Act to better protect customers of brokerage firms. The incoming Chair is also a sponsor of legislation to create a US covered bond market as part of the effort to reform the secondary market.

On December 16, 2010, Rep. Garrett introduced legislation amending the Securities Investor Protection Act to determine a customer's net equity based on the customer's last statement, to prohibit certain recoveries, and to change how trustees are appointed. The Equitable Treatment of Investors Act, HR 6531, is designed to protect ordinary investors who have already been defrauded and financially devastated from further clawbacks by the Securities Investor Protection Corporation trustee.

Upon introducing the bill in the House, Rep. Garrett said that when investors see the SIPC seal of approval they should have confidence in the account statements they receive. These ordinary investors who knew nothing about the fraud should not be held to a higher standard than the federal government, he emphasized, which in the case of the SEC missed the Madoff fraud in the first place, and in the case of the Internal Revenue Service was happy to rely on these same statements to collect taxes from the reported profits. He noted that customers of registered brokers regulated by the SEC are legally entitled to rely on their customer statements as evidence of what their broker owes them; this does not change when a broker engages in fraud. Indeed, it is there to protect customers in the event of fraud. Since customers dealing with brokers do not hold physical securities, he reasoned, there is no other way for customers to verify their holdings.

Rep. Garrett is concerned that the trustee in the Madoff case is ignoring this law and failing to provide prompt assistance to those who have been thrust into financial chaos. According to the incoming Chair, the trustee is taking positions on a wide range of issues that are contrary to the Securities Investor Protection Act, the Bankruptcy Code, and federal and state laws that are intended to protect investors against bad acts on the part of their brokers. Rep. Garrett said that the legislation is intended to clarify for the trustee and the federal bankruptcy court that Congress wants these laws to be followed. If the current law is not followed, he emphasized, no customer can ever have confidence in his or her dealings with a broker.

Reform of the GSE’s has been a special concern of Rep. Bachus (R-AL), who has vowed to make this a top priority of the 112th Congress. As part of GSE reform, and as a replacement for the mortgage securitization function that GSEs currently perform, there is growing bi-partisan effort to pass legislation creating a US covered bond market under SEC supervision. In late July, the House Financial Services Committee reported out by voice vote the US Covered Bond Act, HR 5823, which was authored by Rep. Garrett

A centerpiece of the Bachus GSE reform legislation is the establishment of a regulatory framework for a U.S. covered bond market. Covered bonds are an innovative source of private mortgage market financing which have worked well in many European countries. They are also a private market solution to the need for market participants to have "skin in the game."

A covered bond is a form of debt issued by a financial institution where a specific set of high quality assets, typically loans, are set aside into a pool for the benefit of the bondholders. The issuers of covered bonds are responsible to their bond holders for the risk posed by the underlying loan pool. For example, if the underlying loans default, bond holders can make claims against the issuer. And if the issuer becomes insolvent, bondholders retain full claim on the loan pool. Additionally, issuers of covered bonds are required to account for the risk posed by their bonds on their balance sheets.

Rep. Bachus has historically supported this type of legislation. In a letter to Senate Banking Committee Chair Chris Dodd, that he co-signed with Rep. Garrett, principal author of the covered bond legislation, the incoming House leaders said that Congress must consider creative means to enable the private sector to provide funding for additional consumer credit and alternative options for financial institutions to finance their operations. Establishing a U.S. covered bond market would further each of these shared policy goals. The letter also noted that a robust U.S. covered bond market would provide a significant source of much-needed liquidity for home mortgages, commercial real estate (including multi-family), student loans, and public sector financing.

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

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

The covered bond provisions narrowly missed being included in the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Garrett provisions were supported in conference by Senate Banking Committee Chair Chris Dodd, who recently held scheduled hearings on the covered bond legislation.

At the hearings, Senator Dodd said that covered bonds can provide an additional option to the two dominant funding mechanisms in the US marketplace, which are securitization and the traditional portfolio lender model where a bank holds mortgages on its balance sheet and funds them with deposits, said Chairman Dodd. He added that the proponents of covered bonds point to their greater transparency, because these assets remain on a bank’s balance sheet so investors can analyze their value more easily than in the case of some other asset-backed securities. Proponents also note that issuers of covered bonds have a long term interest in the underlying loans because they keep them on the balance sheet, which increases investor confidence.

Senator Dodd said that legislation and agency rulemaking on cocered bonds are needed to provide clarity about how covered bonds would be regulated. Any legislation would define the rights and responsibilities of investors, issuers, and regulators. Among other things, the legislation would spell out the treatment of covered bonds if the issuer goes into conservatorship or receivership.

Friday, December 17, 2010

State of Delaware Amicus Brief Says SEC Proxy Access Rule Runs Afoul of Principles of Stockholder Choice and Private Ordering

The SEC’s proxy access rule is completely contradictory to Delaware law governing proxy access and denies stockholders their state law right to freely amend proxy access bylaws, according to the State of Delaware. In an amicus brief filed in an action in the DC Circuit Court of Appeals seeking to have the proxy access rule vacated, the State of Delaware contended that the SEC’s attempt to facilitate shareholders’ effective exercise of their traditional state law rights to nominate directors and cast their votes for nominees fails because it ignores Delaware’s policy of allowing stockholders, through their ability to amend bylaws, to determine how any particular corporation will protect the rights of stockholders in the election process. (Business Roundtable and US Chamber of Commerce v. SEC, US District Court for the District of Columbia Circuit, No. 10-1305, Dec. 9, 2010).

The SEC adopted shareholder proxy access, Rule 14a-11, which is shorthand for a regulatory framework under which a shareholder may require the company to include in its proxy statement and proxy card a person nominated by the shareholder, and not by the board, for election to the board. The proxy access rule would apply to all Exchange Act reporting companies, including investment companies, other than companies whose only public securities are debt securities. The SEC also amended Rule 14a-8, which is not being challenged in the DC Circuit, requiring companies to include in their proxy materials shareholder proposals seeking to establish a procedure in the company’s governing documents for the inclusion of shareholder director nominees in company proxy materials.

The Delaware corporate code provides that a company’s bylaws can establish a right of proxy access, which gives stockholders the ability to decide whether and when stockholders would be granted such a right of access. According to the brief, this provision, together with the amendments to SEC Rule 14a-8, would allow stockholders increased flexibility in shaping the process by which directors are elected. This company-by-company flexibility is said to be consistent with longstanding Delaware corporate law principles.

Delaware corporate law, composed of a code and the common law, is enabling, said amicus, and grants corporations and their stockholders broad latitude to privately order their corporate governance structure. This body of law protects the ability of stockholders to choose and replace the directors. The Delaware principles of stockholder choice and private ordering give stockholders a clear right to adopt a wide variety of proxy access models.

Amicus argues that mandating proxy access would fundamentally alter the policy of stockholder choice embodied in Delaware corporate law. SEC Rule 14a-11 prevents stockholders from exercising their right to adopt a variety of terms for proxy access that would differ from the strictures of Rule 14a-11 if they would prevent any nomination permitted under the rule. Thus, even where a majority of stockholders want to exercise their state law rights to adopt a more stringent bylaw, noted the State of Delaware, they are prevented from doing so by the mandatory provisions of Rule 14a-11. Moreover, stockholders are prevented from exercising their Delaware law right to adopt an alternative to proxy access.

In the State’s view, Delaware law working in tandem with amended Rule 14a-8 would allow stockholders to make efficacious decisions for their particular corporations and to learn from each other’s innovations and mistakes. Such flexibility and diversity are hallmark virtues of a system based on stockholder freedom of choice. On the other hand, a government-mandated system that makes all corporate electorates bear the cost of a rigid approach eliminates those virtues.

Thursday, December 16, 2010

Mutual Fund Industry Opposes Applying SEC Proxy Access Rule to Funds

The Investment Company Institute has joined the effort to vacate the proxy access rule adopted by the SEC. In an amicus brief filed in the U.S. Court of Appeals for the District of Columbia, the ICI, joined by the Independent Directors Council, focused exclusively on the application of the rule to registered investment companies and urged a panel of the court to vacate the proxy access rule as it applies to funds. (Business Roundtable and US Chamber of Commerce v. SEC, US District Court for the District of Columbia Circuit, No. 10-1305, Dec. 9, 2010)

The proxy access rule would permit shareholders to place their director nominees on a company’s proxy statement. The ICI does not oppose the proxy access rule per se and, in fact, supports in principle the SEC’s efforts to further enfranchise shareholders. The ICI believes, however, that the SEC rule in its present form is unsuited to the unique corporate governance structure of fund companies and boards and could increase costs for investors if implemented.

The brief argues that the SEC failed to consider the very different context presented by funds. As a result, the SEC adopted a one-size-fits-all standard that fails to take into account the extensive regulatory requirements and governance structure that are unique to investment companies. In the ICI’s view, the SEC’s regulatory statement provides no logical explanation for why the Commission deemed the material differences between funds and operating companies to be wholly irrelevant to Rule 14a-11.

The brief noted that the federal regulation of funds sets independence requirements for fund boards; imposes specific responsibilities on independent directors; requires shareholder approval for key fund decisions; and provides an avenue for shareholder lawsuits against an investment adviser for receipt of excessive compensation. There are no comparable provisions with respect to public operating companies

In view of the comprehensive protection of fund shareholders afforded by the Investment Company Act of 1940, the ICI found it ``hard to fathom’’ the SEC’s summary conclusion that the regulatory protections of the 1940 Act do not decrease the importance of shareholders’ state law rights. The question, said the ICI, is not whether in a vacuum state rights are important, but whether the 1940 Act’s robust federal protections reduce the need for the new federal right embodied in Rule 14a-11, or, at a minimum, call for special tailoring. Although urging the SEC to exclude funds from Rule 14a-11, the ICI did not take the position that funds should not be subject to any proxy access rules, but rather that such rules should reflect consideration of, and tailoring to, the unique circumstances of funds.

The ICI contended that the ill-conceived regulation of the $11.5 trillion fund industry was arbitrary and capricious. The ICI urged the court to grant the Chamber of Commerce and Business Roundtable petition for review and vacate the proxy access rule as to the extent that it applies to funds.
The ICI also noted that fund complexes generally have adopted specific board structures, sometimes known as unitary boards, designed to efficiently oversee multiple funds, increase board knowledge of fund operations across the complex, and strengthen oversight of the investment adviser. But the ICI fears that the benefits of a unitary board are threatened by the proxy access rule’s invitation to elect different directors for particular funds within the complex.

The brief also contended that the SEC relied on empirical studies that expressly excluded funds. Given the unique features of funds, as well as the size of the fund industry, argued the ICI, the SEC cannot rationally rely on those studies without considering whether there are meaningful differences between funds and operating companies that require a different analysis. Amici further contended that the SEC failed to consider whether current federal law provides sufficient protections for shareholders so as to outweigh the obvious efficiency costs of the rule, and then compounded its error by failing to consider the extent of existing competition in its analysis.

The brief also argued that the SEC’s state law rationale cannot be squared with the position that the Commission adopted as recently as July 2009 when it approved an exemption for funds from a NYSE rule concerning director elections. Like Rule 14a-11, the NYSE rule was intended to protect shareholder voting rights by preventing brokers from voting shares in their custody, absent express instructions from their customers. In approving the fund exemption from this restriction, the SEC concluded that such protections were less necessary because, among other reasons, the Investment Company Act requires a fund to obtain the approval of a majority of its voting securities before taking key actions, and this different regulatory regime supports the exemption.

Mutual Fund Industry Strongly Supports Legislation Modernizing Federal Tax Code Treatment of Funds

The mutual fund industry strongly supports the legislation passed by Congress modernizing the tax treatment of mutual funds and other investment companies regulated by the SEC. In a statement, the Investment Company Institute said that the Regulated Investment Company Modernization Act (HR 4337) will make funds more efficient and reduce the need for investors to file amended tax returns related to their investments. The legislation streamlines and updates technical tax rules, allowing fund companies to focus on innovating and serving shareholders, said the Institute. HR 4337 has passed the Senate and House and now goes to the White House for the President’s signature into law.

The Regulated Investment Company Modernization Act modifies and updates federal tax code provisions pertaining to SEC-regulated investment companies in order to make them better conform to, and interact with, other aspects of the tax code and applicable federal securities laws. The Regulated Investment Company Modernization Act will 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.

Specifically, the legislation:

Sets forth a special rule allowing unlimited carryovers of the net capital losses of regulated investment companies
Exempts regulated investment companies from loss of tax-preferred status and additional tax for failure to satisfy the gross income and assets tests if such failure is due to reasonable cause and not due to willful neglect and is de minimis.
Revises the definitions of "capital gain dividend" and "exempt-interest dividend" for purposes of the taxation of funds and their shareholders to require such dividends to be reported to shareholders in written statements
Excludes net capital losses of funds from earnings and profits. Prohibits earnings and profits from being reduced by any amount which is not allowable as a deduction in computing taxable income, except with respect to such a net capital loss.
Allows a regulated investment company, in the case of a qualified fund of funds, to pay exempt-interest dividends and allow its shareholders the foreign tax credit without regard to certain investment requirements in state and local bonds and foreign securities.
Modifies rules for dividends paid by funds after the close of a taxable year, so called, spillover dividends.
Revises the method for allocating fund earnings and profits to require such earnings and profits to be allocated first to distributions made prior to December 31 of a calendar year
Allows funds with shares that are redeemable upon demand to treat distributions in redemption of stock as an exchange for income tax purposes.
Repeals preferential dividend rules for funds that are publicly offered.
Allows funds to elect to treat a post-October capital loss and any late-year ordinary loss as arising on the first day of the following taxable year.
Exempts from holding period requirements applicable to fund stock regular dividends paid by a fund which declares exempt-interest dividends on a daily basis in an amount equal to at least 90% of its net tax-exempt interest and distributes such dividends on a monthly or more frequent basis

Extends the exemption from excise tax for failure to distribute taxable income of a fund to other tax-exempt entities with an ownership interest in a fund.
Allows specified gain and loss of a fund derived after October 31 of a calendar year to be deferred, for excise tax purposes, until January 1 of the following calendar year.
Sets forth a special rule for estimated excise tax payments of funds.
Increases from 98% to 98.2% the amount of capital gain net income funds are required to distribute.
Repeals the additional penalty on funds for tax deficiencies for which a deficiency dividend has been distributed

Nebraska No-Action Letter Interprets "Institutional Buyer" Definition

Legal counsel for the Nebraska Department of Banking and Finance, responding to a no-action letter request, interpreted the definition of an "institutional buyer" specified by statutory exemption at Section 8-1111(8) of the Nebraska Securities Act and elaborated upon in a 1985 interpretative opinion (No. 10), by agreeing with the requesting limited liability partnership (LLP) that entities other than those expressly stated in the exemption and interpretative opinion may be institutional buyers for purposes of exempting from registration the securities they buy but only if the entities have the prescribed characteristics of an institutional buyer as listed in Joseph Long's Blue Sky Law treatise.

The LLP inquired whether, and contended that, large manufacturers, commodity trading firms, utilities, government agencies and municipalities would fall within the statutory exemption's "other financial institutions or institutional buyers" category because of the entities' large securities portfolios and sophisticated investment activities, further advocating that restricting institutional buyers to the statutory exemption's banks, savings institutions, trusts, pensions, profit sharing plans and insurance or 1940-Act investment companies, and to the interpretative opinion's business development and small business investment companies would be a strained and, therefore, unintended reading of those provisions by the Department of Banking and Insurance.

Legal counsel concluded, however, that while the LLP mentioned entities could be institutional buyers for purposes of exempting from registration in Nebraska the securities offered and sold to them, the determining factors from Joe' Long's treatise for a particular entity's meeting the definition would include not only whether the investors are sophisticated about securities and understand the appropriate questions to ask regarding particular transactions, but whether the investors have sufficient economic leverage to refuse a securities offering to insure their questions are sufficiently answered; overall, the determination focuses on the investment part of the entity's business rather than on the amount of cash it can generate.

For more information, please click on http://www.ndbf.org and/or email Sheila Cahill, Legal Counsel for the Nebraska Department of Banking and Finance at sheila.cahill@bkg.ne.gov.

Congress Passes Legislation Modernizing Federal Tax Code Treatment of SEC-Regulated Investment Companies

Congress has passed bi-partisan legislation modifying and updating federal tax code provisions pertaining to SEC-regulated investment companies in order to make them better conform to, and interact with, other aspects of the tax code and applicable federal 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 applies to taxable years beginning after the date of enactment.

Specifically, the legislation:
—Sets forth a special rule allowing unlimited carryovers of the net capital losses of regulated investment companies
—Exempts regulated investment companies from loss of tax-preferred status and additional tax for failure to satisfy the gross income and assets tests if such failure is due to reasonable cause and not due to willful neglect and is de minimis.
—Revises the definitions of "capital gain dividend" and "exempt-interest dividend" for purposes of the taxation of funds and their shareholders to require such dividends to be reported to shareholders in written statements
—Excludes net capital losses of funds from earnings and profits. Prohibits earnings and profits from being reduced by any amount which is not allowable as a deduction in computing taxable income, except with respect to such a net capital loss.
—Allows a regulated investment company, in the case of a qualified fund of funds, to pay exempt-interest dividends and allow its shareholders the foreign tax credit without regard to certain investment requirements in state and local bonds and foreign securities.
—Modifies rules for dividends paid by funds after the close of a taxable year, so called, spillover dividends.
—Revises the method for allocating fund earnings and profits to require such earnings and profits to be allocated first to distributions made prior to December 31 of a calendar year
—Allows funds with shares that are redeemable upon demand to treat distributions in redemption of stock as an exchange for income tax purposes.
—Repeals preferential dividend rules for funds that are publicly offered.
—Allows funds to elect to treat a post-October capital loss and any late-year ordinary loss as arising on the first day of the following taxable year.
—Exempts from holding period requirements applicable to fund stock regular dividends paid by a fund which declares exempt-interest dividends on a daily basis in an amount equal to at least 90% of its net tax-exempt interest and distributes such dividends on a monthly or more frequent basis

—Extends the exemption from excise tax for failure to distribute taxable income of a fund to other tax-exempt entities with an ownership interest in a fund.
—Allows specified gain and loss of a fund derived after October 31 of a calendar year to be deferred, for excise tax purposes, until January 1 of the following calendar year.
—Sets forth a special rule for estimated excise tax payments of funds.
—Increases from 98% to 98.2% the amount of capital gain net income funds are required to distribute.
—Repeals the additional penalty on funds for tax deficiencies for which a deficiency dividend has been distributed


An SEC-regulated investment company must derive 90 percent of its gross income for a taxable year from certain types of income, called qualifying income, which includes gains from the sale or other disposition of stock or securities as defined in Section 2(a)(36) of the Investment Company Act or foreign currencies, or other income derived with respect to the business of investing in such stock, securities, or currencies. In general, because direct investments in commodities are not securities under Section 2(a)(36)they do not generate qualifying income for purposes of the 90 percent gross income test. Similarly, the IRS has ruled that derivative contracts with respect to commodity indexes are not securities for the purposes of the gross income tests.

The original House version of HR 4337 would have changed the qualifying income test to provide that gains from the sale or other disposition of commodities are qualifying income for purposes of the gross income test. As a result, income earned by an investment company from derivative contracts with respect to commodity indices would have been qualifying income. However an amendment offered by Senator Jeff Bingaman (D-NM), and approved by the Senate, stripped out this provision. The HOuse agreed to the Bingaman Amendment and sent the bill to the President, who is expected to sign it.


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 corporations
that either meet or 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 incoming Chair of the House Ways and Means Committee, Rep. Dave Camp (R-Michigan) strongly supports the complete legislative overhaul of federal tax code provisions affecting investment companies. Specifically, Rep. Camp, who was a manager of the Regulated Investment Company Modernization Act, HR 4337, said that 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. Noting that he is not aware of any controversy or opposition to the legislation, Rep. Camp broadly emphasized that it is entirely appropriate for Ways and Means to periodically review the tax law to ensure that targeted provisions of importance to particular segments of the economy, including the mutual fund industry and their investors, are kept up to date. (Cong. Record, Sept. 28, 2010, H7069-7070).

The legislation provides capital loss carryover treatment for investment companies similar to the current Code treatment of net capital loss carryovers applicable to individuals. Under the Act, if a fund has a net capital loss for a taxable year, the excess of the net short-term capital loss over the net long-term capital gain is treated as a short-term capital loss arising on the first day of the next taxable year, and the excess of the net long-term capital loss over the net short-term capital gain is treated as a long-term capital loss arising on the first day of the next taxable year. The number of taxable years that a net capital loss of an investment company may be carried over under the provision is not limited.

The legislation provides for the treatment of net capital loss carryovers under the present Code rules to taxable years of a fund beginning after the date of enactment. These rules apply to capital loss carryovers from taxable years beginning on or before the date of enactment of the provision and capital loss carryovers from other taxable years prior to the taxable year the corporation becoming an SEC-regulated investment company.

Amounts treated as a long-term or short-term capital loss arising on the first day of the next taxable year under the provision are determined without regard to amounts treated as a short-term capital loss under the present-law carryover rule. In determining the amount by which a present-law carryover is reduced by capital gain net income for a prior taxable year, any capital loss treated as arising on the first day of the prior taxable year under the provision is taken into account in determining capital gain net income for the prior year.

The legislation, in Section 301, replaces the present-law designation requirement for a capital gain dividend with a requirement that a capital gain dividend be reported by the fund in written statements furnished to its shareholders. A written statement furnishing this information to a shareholder may be a Form 1099.

The legislation provides a special rule allocating the excess reported amount for taxable year funds in order to reduce the need to amend Form 1099s and shareholders to file amended income tax returns. This special allocation rule applies to a taxable year of a fund which includes more than one calendar year if the fund’s post-December reported amount exceeds the excess reported amount for the taxable year.

Section 303 says that a qualified fund of funds may pay exempt-interest dividends without regard to the requirement that at least 50 percent of the value of its total assets consist of tax-exempt state and local bonds and elect to allow its shareholders the foreign tax credit without regard to the requirement that more than 50 percent of the value of its total assets consist of stock or securities in foreign corporations. For this purpose, the Act defines a qualified fund of funds to mean a fund at least 50 percent of the value of the total assets of which, at the close of each quarter of the taxable year, is represented by interests in other funds.

The legislation provides that, in the case of a non-calendar year fund which makes distributions of property with respect to the taxable year in an amount in excess of the current and accumulated and earnings and profits, the current earnings and profits are allocated first to distributions made on or before December 31 of the taxable year. Thus, under Section 305 of the Act, in the above example, all $3 million of the distribution made on September 15 is out of current earnings and profits and thus treated as dividend income.

Section 306, provides that, except to the extent provided in regulations, the redemption of stock of a publicly offered fund is treated as an exchange if the redemption is upon the demand of the shareholder and the company issues only stock which is redeemable upon the demand of the shareholder. A publicly offered fund is a fund the shares of which are continuously offered pursuant to a public offering, regularly traded on an established securities market, or held by no fewer than 500 persons at all times during the taxable year.