Monday, February 28, 2011

Senator Levin Says No Exemptions from SEC Rules Implementing Dodd-Frank Disclosure of Payments on Oil and Gas Extraction

In a letter to the SEC, Senator Carl Levin said that smaller companies should not be exempted from the Commission’s proposed regulations implementing Dodd-Frank provisions requiring the disclosure of payments to governments related to the commercial development of oil or natural gas. In the Senator’s view, creating issuer exemptions that have no statutory foundation would undermine the law and interfere with its objective of creating a level playing field with meaningful disclosures that will enable investors to understand what payments are being made by extractive industries to what governments.

The Senator added that, due to the nature of the extraction business, most U.S. resource extraction issues are large in size and it is therefore unlikely that many small companies would be covered by the rule. But to the extent that they are covered, he believes that disclosure would help provide investors with key information to assess the potential risks associated with those smaller companies. Moreover, if smaller companies are exempted, larger companies might attempt to engage in complex corporate maneuvers to create affiliates that quality for the exemption, creating administrative and compliance issues for SEC personnel charged with enforcing the disclosure requirements.

Section 1504 directs the SEC to issue rules requiring all resource extraction issuers to provide an annual report disclosing payments made to the U.S. or a foreign government related to the commercial development of oil, natural gas, or minerals. It requires those reports to be made available online to the public. Section 1504 also requires the SEC to issue rules that to the extent practicable support the commitment of the federal government to international transparency promotion efforts relating to the commercial development of oil, natural gas, or minerals.

The SEC proposes to require issuers to furnish the report, rather than file it with the Commission. This wording is critical, explained Senator Levin, because furnished reports do not have to meet the same high standards as filed reports, and their disclosure obligations can be enforced only by the SEC rather than by a private right of action. The Senator believes that investors who purchase or sell a security based upon a statement produced under Section 1504 and then find the statement to be false or misleading should have the right to sue.

Without that right, given the SEC's budget constraints, recalcitrant issuers could ignore Section 1504's disclosure obligations and investors would have little or no recourse to ensure compliance with the law. Sen. Levin emphasized that Congress intended for Section 1504 to have a significant impact in line with the US commitment to international transparency in the commercial development of oil, natural gas, and mining resources. To achieve that objective, he urged the Commission to require that Section 1504 reports be filed rather than furnished to the SEC.

The Senator supports the fact that the proposal does not provide any reporting exceptions, including for companies operating in countries that ban disclosure of information related to their work in the jurisdiction. According to Sen. Levin, exemptions for companies where laws in the host country prohibit required reporting would contradict the purpose of the legislation and create an incentive for those countries who want to prevent transparency. Creating reporting exceptions would also risk creating loopholes that could undermine a level playing field for all covered issuers.

The proposal notes that the term "project" is not defined in Dodd-Frank and asks if a definition is needed. If Section 1504 is to create a level playing field among U.S. resource extraction issuers and produce meaningful comparable information, noted the Senator, this term needs to be defined because, without a definition, issuers are likely to define the term differently, produce information that is not comparable, and create many questions about the meaning of their disclosures.

While the term may have clear application in the case of royalty payments tied to a particular extraction effort, it is not clear how a company should report, for example, expenditures to build a road or hospital near a project, payments to lease office space near a project, payments to hire security guards for a project, hiring a vehicle, ship, or airplane to travel to a project, or capital contributions to create a joint business venture with a government official to distribute fuel from a particular project.

In addition, the oil, natural gas, and mining industry may have industry practices that warrant sector-specific rules to identify how particular payments should be treated. Without a definition, said Sen. Levin, these issues would lead to a variety of disclosure practices and produce a patchwork of information that will impede investor and public analysis of company-specific, regional, and sector-wide developments and trends.

In addition, without a definition, noncompliant governments may tell companies to provide payments in ways intended to defeat the statute's requirement for project-specific information. These considerations indicate that at least a general definition of "project," with subsequent work to refine the definition, is needed to produce meaningful and comparable disclosures from covered issuers.

A related issue is the definition of "payment," including payments made for "other material benefits." He noted that foreign governments and their officials have devised a host of creative ways to extract funds from oil, natural gas, and mining companies. It is unclear whether some of these payments will qualify as "part of the commonly recognized revenue stream for the commercial development of oil, natural gas, or minerals," even if they are widespread within a country.

He suggested that the regulations provide examples of payments that should be reported, including payments made to government agencies, corporations, funds, officials, their relatives, and associates, or to corporations, trusts, or other entities set up to conceal such payments. That list should include payments issuers are required to make for rent, security, food and water, use of roads or airports, the purchase of land, or other material benefits essential to operate in the jurisdiction.

The list should also include capital contributions or other funds that companies are required to provide for joint business ventures with government agencies, corporations, funds, officials, relatives, or associates. The proposed rule must clarify that covered issuers have to track and report all payments made to the government, a government entity or official, or a government official's relative or associate, in exchange for doing business in the country.

Section 1504 defines payments as "payments made to further the commercial development of oil, natural gas, or minerals" which "are not de minimis." The Senator suggested that the SEC adopt the de minimis reporting thresholds set by the London Stock Exchange's Alternative Investment Market, which currently sets a $15,000 minimum threshold for reporting.


In Comments to European Commission, Big Four Oppose Mandatory Audit Firm Rotation and Endorse Market-Driven Selection of Outside Auditor

In comments on a broad and historic European Commission proposal to reform the system of outside audit of financial statements, the Big Four audit firms opposed mandatory audit firm rotation and endorsed the current market-driven selection of outside auditors. The firms said that removing the selection of auditors from the shareholders and the audit committee and giving to a third-party would violate sound corporate governance practice. The audit firms favor the current system, enshrined in the Statutory Audit Directive, of auditor selection by the company’s shareholders based on a recommendation from the audit committee, and reject the idea of third-party audit selection by a regulator.

While recognizing the potential conflict of interest in the auditor being appointed and paid by the audited entity, Ernst & Young said it has seen no evidence suggesting a need for change to the existing model. Audit committees and shareholders are best placed to decide which firm is best equipped to perform the annual audit and they should be responsible for that decision, emphasized E&Y, and the appointment of auditors by a regulator or government-appointed panel would undermine the duties of audit committees and shareholders. It could also expose the regulators to a much greater level of risk because they would be held accountable by shareholders for every perceived audit failure. In addition, if the audit function became an inspection function carried out on behalf of the regulator or government authority, it could result in the auditor having less access to information than is currently the case.

Similarly, in its comments, Deloitte said that it could not support the audit function becoming an inspection-type function carried out on behalf of the regulator. The removal of auditor selection from the shareholders and audit committee could disenfranchise both groups. The audit committee in particular has valuable insights into the audit needs of an entity. The appointment of an auditor by a regulator could also create inherent conflicts in the regulator’s relationship with the audited entity.

KPMG noted that the Audit Directive is already designed to ensure an appropriate degree of independence by providing that the auditor is appointed by the general meeting of shareholders based on a recommendation of the audit committee. The alternative suggestion by the Commission that a regulator should appoint the auditor and determine the remuneration and duration of the engagement would, in KPMG’s view, fundamentally undermine the key role that the audit committee should play within the corporate governance framework. It is also difficult to see that in the event of an audit failure it is in the taxpayers’ interests for a government body to be held accountable for the choice of the auditor.

PricewaterhouseCoopers warned that transforming the audit role into one of statutory inspection would represent a fundamental change in the basis of audit. The change in the nature of the relationship with management would affect openness and would be likely to require a more intensive forensic style of audit, which would be more costly and likely to raise questions around the promptness of reporting.

Instead of changing the current auditor selection process, the Big Four recommended that the Commission enhance the existing process. PwC suggested that the current framework could be enhanced by requiring the audit committee to provide an explanation both of the process they went through and the reasons for their recommendation of an auditor. Similarly, E&Y recommended strengthening the existing model by better defining the role of the audit committee in all aspects of the financial reporting and audit process, not just the appointment of outside auditors.

Deloitte recommended that the role of audit committees in recommending auditor appointments and monitoring the work of the auditor could be strengthened by requiring the committee to disclose the determining factors for their recommendations for auditor appointments. Also, consideration could be given to an EU-wide form of audit committee or supervisory board assessment of the auditor.

Audit Firm Rotation

The Big Four do not support mandatory audit firm rotation. Deloitte does not believe that the continuous engagement of audit firms should be limited in time and is not aware of any evidence that such rotation would enhance audit quality. Deloitte feels that the existing requirement under the Statutory Audit Directive for key audit partner rotation adequately addresses the risk of familiarity which this measure seeks to address.

Moreover, a mandatory requirement for a company to change auditors increases costs for business and risks reducing audit quality as the knowledge of the audited entity acquired by the firm in the past is lost. Deloitte and other Big Four comment letters cited a study carried out by Bocconi University in Italy, where audit firm rotation after a period of nine years is imposed by law for public interest entities, indicating that audit quality is lower in the first year of an audit mandate and that there are higher costs after rotation for both the audit clients and the auditors due to the new auditor’s lack of knowledge of the business.

Similarly, a study carried out by the US General Accountability Office concluded against mandatory audit firm rotation. Further, Deloitte noted that mandatory audit firm rotation is very difficult for multi-national companies to implement in practice. E&Y said that companies and their shareholders should be free to appoint the audit firm that best meets their needs at the time they believe appropriate. Audit partner rotation, coupled with independence requirements and effective regulatory oversight, better addresses the concerns raised by the Commission.

In its comments, KPMG emphasized that sound corporate governance demands that the audit committee recommend to the shareholders the best auditor for the job. Setting arbitrary time limits and requiring change when it may not be merited is inconsistent with that objective. While audit partner rotation has been common practice in some countries for a number of years, noted KPMG, it has only recently been adopted by all EU Member States. Audit partner rotation contributes strongly to objectivity and independence. The Commission should assess how partner rotation is working in practice before making further changes.

PwC noted that audit committees approach the auditor appointment decision very seriously each time it is taken. They specifically consider the incumbent firm’s performance and whether it is in the interest of the company to retain the existing firm or make a change. PwC cautioned the Commission not to infer a lack of independence from the fact that many companies decide to retain the incumbent firm. Current standards effectively minimize any threat of familiarity, said PwC, because there is regular rotation of key audit team members and, with the passage of time and circumstances, changes in others involved in the audit, as well as changes in the composition of the board, the audit committee and company management.

Instead of mandatory firm rotation, PwC suggested formalizing the governance practice which many audit committees currently follow whereby they evaluate the effectiveness and competencies of the auditors at intervals with disclosure by the audit committee of the processes employed in the interest of transparency. The auditor is aware of this procedure so it acts as a driver of good quality and innovation without the expense and disruption to the company of formal tendering.

Audit Firm Concentration or "Big Four Bias"

KPMG opposes regulatory intervention to specifically increase the market share of non Big 4 firms since it is not based on increasing the quality or value of the audit and therefore should not be the driver for change. KPMG believes that the high concentration levels in the Big Four reflect market choice in a fiercely competitive market. The market operates through audit committees having the freedom to make the choice of who is the best auditor for the job and recommending that choice to the shareholders. They are in the best position to do this as they see and can assess the quality of the people on the audit team.

According to KPMG, current good governance practice allows audit committees to test the market whenever they believe necessary through competitive tendering and this allows all firms to compete on an equal basis. Some proposals being consulted on by the Commission would prevent companies having that choice and thereby undermine one of the key principles of modern corporate governance, and may also result in incremental cost and administrative burden for companies and may also result in a decline in audit quality without necessarily reducing market concentration.

E&Y said that audit firm concentration or "Big Four bias" could be addressed by providing smaller firms with the incentive to invest in creating greater breadth and global scale to meet the needs of the market they wish to serve. In addition, institutional investors and audit committees should be better informed about the scale, geographical reach and competencies of audit firms outside the largest firms. KPMG would support the elimination of boilerplate terms in lending agreements which require the shareholders to employ a Big 4 firm. Similarly, E&Y backs the prohibition of contractual restrictions that prevent companies from appointing audit firms outside the largest networks, so-called "Big Four-only" clauses.

Ernst & Young, together with the other large audit networks, have tried to tackle the issue of "Big 4 bias" by writing collectively to the OECD in October 2009. They observed that in certain countries, including the US, UK, and Germany, they have encountered clauses in contractual agreements between companies and their banks or underwriters that state that only the Big 4 audit firms may provide audit services to the company. In some cases, higher interest rates will be applied if these clauses are breached.

The six-firm letter stated that these contractual limitations can distort the market for audit services by excluding certain audit firms from competing in this market segment even if these firms have the necessary size, sector-specific skills and geographical coverage to perform the audit in question. Such clauses could also create the perception that only the largest audit firms have the necessary attributes to audit large corporations, thereby potentially limiting competition.


Saturday, February 26, 2011

Big Four Firm Opposes Audit of Exhibit Disclosing Payments Related to Oil and Gas Extraction

The costs of an outside audit of a proposed Exhibit to a company’s annual report disclosing payments to governments related to the commercial development of oil, natural gas, or minerals would outweigh the benefits, in the view of Ernst & Young. In a letter commenting on the SEC’s proposal to implement this disclosure requirement of the Dodd-Frank Act, E&Y said that significant effort would be required to audit the Exhibit, regardless of whether the information is disclosed on a cash or accrual basis since auditors would not be able to rely on the procedures performed in auditing the financial statement. The firm also noted that Dodd-Frank does not require the audit of such information.

Section 1504 of Dodd-Frank directs the SEC to issue rules requiring all resource extraction issuers to provide a report annually disclosing payments made to the U.S. or a foreign government related to the commercial development of oil, natural gas, or minerals. The SEC proposes to require issuers to "furnish" that report, rather than "file" it with the Commission. This wording is critical because furnished reports do not have to meet the same high standards as filed reports, and their disclosure obligations can be enforced only by the SEC rather than by a private right of action.

While E&Y fundamentally believes that independent assurance would add value by increasing reliability and enhancing public confidence in the completeness and accuracy of the information in the Exhibit, the firm is concerned that the cost and time required to obtain such assurance might outweigh the benefits to users

The payment information, which would be furnished in an Exhibit to the annual report, would not be covered by the auditors’ opinion on the issuer’s annual financial statement. The scope of the auditors’ work on the financial statements is designed to express an opinion on those statements taken as a whole, noted the firm, and the scope of the audit is not designed to provide assurance on the fair presentation of any information underlying those financial statements. Moreover, because the information in the Exhibit is not derived directly from a specific account appearing in the financial statements, auditors would not be able to rely on the procedures performed for that audit to provide limited assurance on the Exhibit, such as they now do on financial statement schedules filed with the annual report.

If an audit of the Exhibit were required, said E&Y, auditors would have to develop specific additional procedures to be able to provide assurance over the completeness and accuracy of the information provided. In addition, audit procedures would have to be designed to provide assurance over the accuracy of the categorization of the payments. Given the de minimis disclosure threshold in the proposed rule, an audit of the Exhibit also would require more extensive procedures than those based on the materiality thresholds established for the financial statement audit.

Further, as proposed, the information in the Exhibit would be presented on a cash basis. However, the financial statements are prepared on an accrual basis. Therefore, the procedures performed to provide assurance over the completeness and accuracy of the information in the Exhibit would be different from those performed for the overall financial statement audit.

Large Audit Firms Seek Clarification of PCAOB’s Proposed Temporary Inspection Program for Auditors of Brokers

Large audit firms generally support the PCAOB’s proposal to establish an interim inspection program related to audits of brokers and dealers and believe that the temporary program will allow the Board to achieve its objective of informing the permanent inspection program. However, the firms seek clarification from the Board on how some aspects of the interim inspection program will work in practice. Further, the firms believe that the permanent inspection program should classify brokers by risk. Section 982 of the Dodd-Frank Act expanded the PCAOB’s inspection authority to include audits of securities brokers and dealers. The Board has proposed a temporary inspection program designed to allow the Board to begin inspection work on audits of broker and dealers without waiting to help it in making fully informed judgments about a permanent program.

While the Board should include registered accounting firms and all types of brokers and dealers in the scope of its temporary program, noted KPMG, the Board should consider the costs and benefits of adopting a permanent inspection program that scopes in all types of brokers and dealers. KPMG urged the Board to focus on brokers and dealers that carry customer accounts and maintain customer cash and securities. These clearing brokers are typically considered to represent greater significance to the markets and investors than introducing brokers, emphasized KPMG, whose customer accounts and transactions are cleared and carried on the books and records of a clearing broker. In its comments, Grant Thornton encouraged the Board to develop a risk profile for the various classes of brokers and focus the inspections on those deemed of higher risk. In that regard, GT suggested that the Board get input from industry and professional groups to assist in identifying and weighting the appropriate risk factors.

KPMG supports the Board’s intention of publishing the results of the interim program’s progress no less frequently than every twelve months since the reports will help improve audit quality. But the reports should not only describe the progress of the program and any significant observations that may bear on the Board’s consideration of a permanent program, said KPMG, but should also include sufficient details on the nature and types of brokers and dealers inspected relative to the observations made to allow accounting firms to improve their audits of brokers and dealers by improving their understanding of the specific issues raised in the reports.

Although the Board refers to a draft inspection report, noted KPMG, it has not incorporated Rule 4007 dealing with procedures on draft inspection into Rule 4020T and the proposed interim inspection program. Further, the proposal does not discuss any provisions for the issuance of a draft inspection report or procedures to allow an audit firm to respond to inspection findings during the program period.

KPMG also seeks clarification on how the Board will report inspection deficiencies in such reports. Specifically, during the course of the program it is not clear how findings will be communicated to the firm, what opportunities the firm will have in responding to such findings, or the timing and extent to which interim inspection findings will be communicated in firm-specific public reports. Similarly, McGladrey & Pullen recommend that the Board articulate in Rule 4020T how it intends to communicate identified audit deficiencies throughout the interim inspection period and what the Board’s expectations are for the firm in responding to any deficiencies.

More broadly, KPMG believes that publicly issuing firm-specific reports during the program period would be inconsistent with the Board’s expectation that inspection procedures performed on a firm as part of the program are to constitute a foundational portion of the inspection of the firm’s broker and dealer audit practice, which eventually would be completed and encompassed within a firm-specific inspection report following the establishment of the permanent program if the firm is included in the permanent program.

Both KPMG and McGladrey noted that, given that SEC rules with respect to reports to be made by brokers may be revised, and that the Board may revise standards with respect to the audits of brokers during the interim program period, publicly disclosing firm-specific inspection findings for certain firms during the interim period may not be beneficial to investors since the inspection findings may be based upon regulations that are no longer in effect at the time of issuance of the firm-specific inspection report and would not serve to help improve the quality of future audits.

McGladrey observed that such disclosure would not serve the two principal purposes of the proposed rule of allowing the Board to assess current compliance rules and standards in performing audits with respect to brokers and informing the Board’s decision about significant elements of a permanent inspection program. McGladrey urged the Board to state in the “Reporting” section of Rule 4020T under which circumstances it would incorporate interim inspection findings in firm-specific inspection reports

KPMG also said it is unclear what program observations the Board intends to include in the initial firm-specific report released after a permanent program takes effect. Although KPMG expects that the Board would only publish observations noted during the
program period that would have an impact on an accounting firm going forward, the
Release does not address what specifically the Board intends to include in the initial firm-specific public report. For example, it is not clear as to whether potential deficiencies cited in a firm-specific report will be cumulative over the course of the three years of the program.

Similarly, McGladrey found it unclear whether the initial firm-specific reports issued after the rules for a permanent program take effect will include inspection comments on a cumulative basis over the three years of the interim inspection program. If comments are cumulative, inspection deficiencies related to standards that have been amended and are no longer relevant could be included. Also, cumulative reporting would result in significant reporting time lags, including the potential for reporting of inspection findings that have been satisfactorily addressed subsequent to the interim inspection. Public disclosure of inspection deficiencies related to outdated standards or deficiencies that have already been satisfactorily addressed could be misleading. Thus, the firm urged the Board to clarify its intentions regarding the nature of what will be communicated in the initial firm-specific public report after the permanent program takes effect.

While GT agreed with the proposed mechanisms for providing feedback to the inspected firms and the issuance of a formal report describing the progress of the temporary inspection program and the Board’s significant observations, the firm recommend that the Board keep separate the process for reporting on inspections of a firm’s audits of issuers out of concern that combining the communication of findings may result in report issuance delays and potential confusion in interpreting the PCAOB’s comments.

Friday, February 25, 2011

District of Columbia Sets Time-Table for IAs Filing New Part 2 of Form ADV

Investment adviser applicants and registrants that follow SEC instructions for completing and filing new Part 2 of Form ADV will be in compliance with District of Columbia requirements. Applicants beginning January 1, 2011 must file through the IARD a new Part 2 with their application, and applicants with a pending application for an IA license, as well as licensed investment advisers beginning January 1, 2011 need to include new Part 2 in their next filing of an amendment or annual updating amendment to Form ADV, whichever filing occurs first. NOTE: All investment advisers must no later than March 31, 2011 file a new Part 2 with the DC Department of Insurance, Securities and Banking.

Deliveries of Form ADV Part 2A and 2B to clients. All advisory firms filing an IA licensing application on or after February 18, 2011 must deliver new Part 2A to their clients immediately on being notified through the IARD that the license is effective. Investment advisers licensed as of December 31, 2010 must deliver new Part 2A to their clients within 60 days of filing the firm brochure on IARD. Investment advisers licensed as of December 31, 2010 whose fiscal year ends on December 31, 2010 through April 30, 2011 will have until July 31, 2011 to deliver new Part 2B to their new and prospective clients, and until September 30, 2011 to deliver brochure supplements to their existing clients. Advisory firms filing an IA licensing application from February 18, 2011 through April 30, 2011 will have until May 1, 2011 to deliver new Part 2B to their new and prospective clients, and until July 1, 2011 to deliver brochure supplements to their existing clients.

Please see Click on "securities" under Regulatory Areas and Functions. Then click on "bulletins" under Laws and Regulations.

In Letter to Fed, Senate Banking Committee Democrats Question Dodd-Frank Interchange Fee Provisions

In a letter to the Fed, Senators Kay Hagan (D-NC) and Michael Bennet (D-CO) expressed concern that proposed regulations implementing the interchange fee provisions of Section 1075 of the Dodd-Frank Act might prevent small issuers from benefitting from the exemption set forth in the Act. They also asked the Board to adequately account for fraud prevention costs, which all issuers typically absorb, when determining the final rule. 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.

The Senators noted that in recent congressional testimony both Fed Chair Ben Bernanke and FDIC Chair Shelia Bair similarly expressed concern about the efficacy of the interchange fee exemption. Chairman Bernanke said that it is possible that because merchants will reject more expensive cards from smaller institutions or because networks will not be willing to differentiate the interchange fee for issuers of different sizes the exemption may not be effective in the marketplace, which would mean that, in practice, community banks would not be exempt from the lower interchange fee.

The Senators noted that interchange fees offset the costs associated with debit transactions and enable smaller institutions to provide their customers with lower cost access to their checking accounts. If the Dodd-Frank limits on fees ultimately affects smaller institutions, feared the Senators, consumers may lose access to free checking or other important services that have become common in today’s marketplace.

While the Senators supported the Durbin Amendment to Dodd-Frank (codified as Sec. 1075) that created interchange reform, their support was conditioned on the understanding that the Act specifically exempted smaller institutions from its limits on interchange fees. They urged the Fed to work aggressively to ensure that the small issuer exemption is fully realized in the final rules. The Fed must create a practical and effective small issuer exemption that takes into account the interests of all stakeholders before the rules pertaining to Section 1075 are implemented.

Thursday, February 24, 2011

House Leaders Ask Questions About SEC General Counsel and Madoff Fraud

In a letter to SEC Chair Mary Schapiro, House Financial Services Chair Spencer Bachus (R-AL) asked for a response on a series of questions regarding SEC General Counsel David Becker, who is a defendant in a clawback lawsuit initiated by Irving Picard, the trustee in the Bernard L. Madoff Investment Securities liquidation. The letter was also signed by Committee Vice Chair Jeb Hensarling (R-TX), Oversight Subcommittee Chair Randy Neugebauer (R-TX), and Capital Markets Subcommittee Chair Scott Garrett (R-NJ). The SEC is asked to respond by March 4, 2011.

During Mr. Becker's first term at the SEC, including his tenure as General Counsel from 2000-2002, asked the letter, was he aware of the analysis prepared by and presented multiple times to the SEC by Harry Markopolos, which correctly alleged that Bernard Madoff was operating a multi-billion dollar Ponzi scheme. If he was aware of the Markopolos allegations, did he inform then-Chairmen Arthur Levitt or Harvey Pitt and if not, why not.

The House leaders also ask if, during Mr. Becker's first term at the SEC, he met with or had occasion to speak with Bernard Madoff and, if he did, what was discussed during these meetings or conversations.

Also during Mr. Becker's first term at the SEC, they want to know if he prepared any legal memoranda, or provided counsel to any SEC employees about any matters involving Bernard L. Madoff Investment Securities. Before Mr. Becker returned to the SEC to serve as General Counsel in 2009, said the letter, did he inform anyone at the SEC that he was the co-executor of his parents' estate that profited from the Bernard Madoff Ponzi scheme.

Further, when Mr. Becker returned to the SEC in 2009 as General Counsel, did he formally recuse himself from all aspects of the SEC's involvement with Bernard L. Madoff Investment Securities, including any meetings with the Justice Department or SIPC, Mr. Irving Picard or any Madoff victims. If so, did Mr. Becker formally document the recusal?

Further, the Committee members ask if Mr. Becker notified the SEC’s Office of Ethics Counsel of his role as the co-executor of an estate that profited from the Bernard Madoff Ponzi scheme and seek its guidance. If he did consult with the SEC's Office of Ethics Counsel, did he act in accordance with the Office's advice or recommendations.

Louisiana Proposes Recordkeeping Requirements for Broker-Dealers and Investment Advisers

Broker-dealers and investment advisers would be required to make, maintain and preserve books and records that comply with SEC recordkeeping requirements under new rules proposed by the Louisiana Securities Commission. Dealers would comply with SEC Rules 17a-3, 17a-4 and 15c-211; investment advisers would comply with Rule 204-2 of the Investment Advisers Act of 1940. Investment advisers whose principal place of business is located in another state would be exempt from Louisiana recordkeeping requirements if the investment advisers are licensed or registered in the other state and comply with that state’s books and records requirements.

Broker-dealers and investment advisers who cease doing business would, for the remainder of the specified period, preserve the books and records they’re required to maintain and notify the Louisiana Securities Commissioner of the location of those books and records. Note that a broker-dealer’s filing Form BD-W, Uniform Request for Withdrawal from Broker-Dealer Registration, or an investment adviser’s filing Form ADV, Notice of Withdrawal from Registration as Investment Adviser, would satisfy the notice requirement.

Broker-dealer Registration Applications only Considered "Filed" When Automatic Registration of Agents is Complete

Broker-dealer registration applications are not considered "filed" in Massachusetts until the broker-dealer applicants have, in addition to complying with other conditions, either: (1) automatically registered any agent who is a partner, officer or director, or a person occupying a similar status or performing similar functions; or (2) waived automatic registration for any person not seeking automatic registration by submitting a duly executed affidavit in a form approved by the Securities Division.

The affidavit can be found at Once there, click on Securities Division followed by Licensing and Registration and go to Forms at the bottom of this section. For the policy statement, after clicking on Securities Division go to other topics (the last of the four boldface headings in the list) and click on policy statements.

Banking Industry Urges SEC and CFTC to Include Small Banks within Dodd-Frank Derivatives End-User Exemption

In a joint letter to the SEC and CFTC, the American Bankers Association urged the Commissions to include an exemption for small banks in their final rules on the end-user exception to mandatory swaps clearing. With regard to the notification requirements for end users, the ABA urged the agencies not to require public dissemination of the information since it would reveal proprietary business information and could cause competitive harm.

The Dodd-Frank Act mandates new clearing requirements for swaps but provides an exception for end users if they use these derivatives to hedge or mitigate commercial risk. Dodd-Frank requires both Commissions to consider whether to exempt small banks from the new mandatory swaps clearing requirements. Absent an exemption, noted the ABA, even small banks would be deemed financial entities, which would not be eligible to be considered as end users. Thus, unless the Commissions exercise their exemptive authority, such banks will have to comply with the new clearing requirements even if they use swaps to hedge commercial risk.

The statutory mandate is for the Commissions to consider an exemption for small banks, including depository institutions with total assets of $10 billion or less. But, noted the ABA, Dodd-Frank gives the SEC and CFTC the flexibility to consider exempting institutions with total assets higher than the $10 billion threshold, and they should do so. The ABA urged the SEC and CFTC to raise the threshold to $30 billion in assets, which would still only exempt an extremely small percentage of the total swaps market from clearing requirements.

The SEC is considering a definition of bank that is similar, but not identical, to that in Section 3(a)(6) of the Exchange Act. The SEC release does not explain why it is proposing a different definition. Nor does it appear to the ABA that the Dodd-Frank Act would necessitate the changes. Absent a compelling reason to diverge from the existing Exchange Act definition, the ABA recommend that the end user exemption include the same definition to ensure consistency of interpretation in the definition of bank.

More broadly, but on the same theme, the banking group strongly urged the SEC and CFTC to adopt substantively identical provisions. Otherwise, inconsistent regulation for swaps and security-based swaps could undermine the effectiveness of exempting small banks from the clearing requirements.

A counterparty must use swaps to hedge or mitigate commercial risk in order to qualify for the Dodd-Frank end-user clearing exemption. Both the Commissions appear to agree that the definition of the term ``hedging or mitigating commercial risk’’ should be the same as in their joint rule proposal defining significant terms under the regulation of swaps markets to ensure consistent interpretation as well as fair and equivalent treatment for similarly situated parties. At this time, the ABA agrees with both agencies because there is no reason for a distinct definition of hedging or mitigating commercial risk in the end-user context. The association noted, however, that the CFTC approach of incorporating a parallel definition in the end-user exemption increases the risk of inadvertent inconsistent amendment and interpretation. The ABA recommend instead using a cross reference to the primary definition.

Even if end users are exempt from the new mandatory clearing requirements, noted the ABA, they will still have to satisfy notification requirements. The Dodd-Frank Act requires each end user to notify the SEC or CFTC how it generally meets its financial obligations associated with entering into non-cleared swaps. The SEC and CFTC are authorized to establish the form for such notifications.

The ABA is concerned that the proprietary information in these notifications might be made public and cause competitive harm. The ABA urged both the Commissions to ensure that the information in the end-user notifications is not publicly disseminated, although public disclosure of whether the end user exemption was invoked would be appropriate.

Oregon Requires new Part 2 of Form ADV for Investment Advisers

Investment advisers must file new Part 2 of Form ADV, and investment adviser firms and investment adviser representatives must electronically submit their documents and fees through the IARD, as of January 1, 2011.

Please see the three blue hyperlinks under "What's New" on the following home page:

Wednesday, February 23, 2011

CAQ Seeks Clarification of PCAOB’s Interim Rule for Inspection of Auditors of Brokers and Urges Focus on Brokers Controlling Customers’ Securities

In a comment letter, the Center for Audit Quality (CAQ) asked the PCAOB to clarify the Board’s proposed temporary rule for an interim program of inspection related to audits of brokers and dealers. CAQ also encouraged the Board to focus a significant portion of its efforts on audits of brokers and dealers of greater significance to investors. For example, brokers and dealers that have possession and control of customer securities, or act as clearing or custodial brokers, are typically considered to be of greater significance to investors and other users than introducing brokers that accept customers’ orders for processing.

Section 982 of the Dodd-Frank Act expanded the PCAOB’s inspection authority to include audits of securities brokers and dealers. The Board has proposed a temporary rule to establish an interim inspection program designed to allow the Board to begin inspection work on audits of broker and dealers without waiting. This will also help the Board in making fully informed judgments about the scope of a permanent program.

While fully supporting the Board’s intent to inform its decisions in determining a permanent inspection program, CAQ asked for clarity on how the interim inspection program will be executed. For example, given that there is no description or clear understanding of what constitutes the ``classes’’ of brokers and dealers as used throughout the release and the proposed temporary rule, CAQ recommended that the Board specifically define what is meant by “classes” of brokers and dealers.

In addition, the proposal indicates that one of the purposes of the interim inspection program is to assess the degree of compliance of accounting firms with SEC and PCAOB rules in connection with the performance of audits and related matters involving brokers and dealers. CAQ asked the Board to clarify what it means by “related matters” so that audit firms can fully understand the Board’s expectations.

Similarly, CAQ encourages the Board to elaborate on its expectations related to the voluntary cooperation of certain firms under the interim inspection program prior to the proposed temporary rules taking effect. The Board said that even before the rule takes effect it expects to be able to conduct relevant procedures with the voluntary cooperation of certain firms. The Board should clarify what it means by “relevant procedures” during the voluntary period.

For example, does the Board anticipate that inspection procedures performed during the voluntary period will include actual inspection of audits of brokers and dealers or be limited to scoping procedures. In addition, CAQ urged the Board to elaborate on the timing of such procedures and indicate which firms are expected to voluntarily cooperate.

Noting inconsistencies between the release language and the proposed temporary rule regarding firm-specific inspection reports, CAQ seeks clarification regarding the process by which the Board will report inspection deficiencies in such reports. Specifically, during the course of the interim inspection program it is not sufficiently clear how inspection findings will be communicated to the firm, what response opportunities the firm will have, or the timing and extent to which interim inspection findings will be communicated in firm-specific reports.

Further, it is not clear if the findings will be communicated orally or in writing and what opportunities the firm will have to respond to such findings. It is also unclear whether the Board intends to issue the public portion of a firm-specific report before the permanent rule takes effect and, if so, what opportunities the firm will have to respond to a draft inspection report before it is made public. Moreover, it is not clear what interim inspection observations the Board intends to include in the initial firm-specific reports released after a permanent program takes effect.

CAQ commended the Board on its plan to at least every 12 months publish reports on the interim inspection program’s progress and significant observations that either may bear on the Board’s consideration of a permanent program or otherwise may be appropriate to protect investors. CAQ believe that such transparent reports will be helpful not only in informing the public as to the Board’s progress but also in improving audit quality. These reports will clarify the Board’s expectations for effective audits of brokers and dealers as well as focus audit firms on improving their work in areas where common deficiencies, if any, are identified.

As the Board contemplates the structure of these reports, CAQ encourages the PCAOB to consider reporting its observations by different types of brokers and dealers whose audits were inspected during the interim inspection program. Including this level of detail in the Board’s progress reports will help investors in understand how the Board ultimately determines the scope of the permanent inspection program.

In addition, CAQ believes that this information will be helpful to the registered public accounting firms that perform such audits by enhancing their level of understanding of the Board’s expectations and observations with regard to engagements related to the different types of brokers and dealers. CAQ understands that the level of detail will have to be balanced with making certain that the accounting firm and the broker-dealer are not identified or could potentially be identified, but believes that such balance could be achieved.

Oregon Permanently Adopts Dodd-Frank Accredited Investor Definition Exclusion for Primary Residence

Oregon's temporary effective exclusion of an investor's primary residence from the $1 million net worth calculation in the State's accredited investor definition was permanently adopted on February 15, 2011. This amendment to Oregon's accredited investor definition adopts the Dodd-Frank Act's modification to the federal accredited investor definition.

For more information please see subsection (5) of Rule 441-035-0010 at

CAQ Asks PCAOB Not to Change Funding Rule to Require Audit Firm to File Notice

One method of funding the PCAO provided by Sarbanes-Oxley is an annual accounting support fee paid by issuers and now broker-dealers. If the issuer is past due with its allocated share of the accounting support fee, then no registered firm is permitted to sign an unqualified audit opinion with respect to the issuer's financial statements or to sign a consent to the use of prior audit opinions for that issuer. However, the funding rules contain a limited exception to this prohibition. An issuer may have a past-due share of the accounting support fee, including possibly through mistake, inadvertence, or confusion, at a time when, in order to access or preserve its ability to access the capital markets in a timely manner, the issuer needs to submit a report to, or make a filing with, the SEC. Under these circumstances, the rules allow the issuer to submit an electronic notice to the Board no later than the next business day after the filing is made with the Commission. The Board is proposing an amendment to Rule 7103(b)(2) to require that the notice be filed by the registered public accounting firm instead of the issuer.

In a comment letter, the Center for Audit Quality (CAQ) opposed the proposed change. Noting that it does not have a clear understanding as to the rationale for changing this reporting requirement, CAQ urged the Board not to make the change. CAQ believes that the filing should remain a requirement of the issuer because it is the issuer that is delinquent with its share of the accounting support fee and that is filing its documents with the SEC. Moreover, a process has already been established with issuers under the existing rule. However, if the Board determines to make the change, CAQ asks that the Board explain its rationale for the change in requirements relative to notifying the Board when an issuer is delinquent on its share of the accounting support fee and an audit opinion or consent has been included in a filing with the SEC.

Banking Industry Urges SEC to Clarify that Banking Products Are Not Within Embrace of Registration Regime of Sec. 975 of Dodd-Frank

In a comment letter to the SEC, the banking industry said that the Commission’s proposal to require registration and supervision for municipal advisors unnecessarily goes far beyond the legislative intent of the Dodd-Frank Act. While the industry supports the goal of ensuring that market participants providing investment advice to municipalities are appropriately regulated, the proposal goes beyond legislative intent or public policy need by purporting to regulate already-regulated traditional banking products, such as deposit, cash management and lending activities, and trust and custody products with or on behalf of municipalities. The letter was signed by representatives of the American Bankers Association, the ABA Securities Association, and the Clearing House Association.

Section 975 of Dodd-Frank establishes a system of dual registration with the SEC and the MSRB that will require covered municipal advisors to comply with rules of business conduct, ongoing education requirements, and a fiduciary duty to their municipal entity clients. It appears to have been intended primarily to regulate financial advisors to municipalities that have not been previously regulated. Thus, banking products, already subject to extensive regulation, are wholly outside the ambit of Section 975, in the view of the banking groups.

The associations urged the SEC to clarify in the regulations that traditional banking products and services are not covered by Section 975. The failure to do so, they cautioned, would likely force banks to increase the cost or limit their services to municipal entities as a result of this new mandate to register as municipal advisors, along with the attendant ongoing compliance costs. The groups said that the proposal has already driven community banks to reevaluate the services provided to municipalities.

Section 975 exempts from registration as municipal advisors, firms and individuals that are registered as investment advisers under the Investment Advisers Act. However, banks that are not required to register under the Advisers Act pursuant to a statutory exemption would nevertheless be caught by the planned implementation of Section 975. Thus, the associations urge the Commission to provide a comparable exemption from the requirements of Section 975 for advisory activities that would be exempt were banks required to register as advisers under the Advisers Act.

The associations also pointed out that the recordkeeping and reporting requirements established under the bank regulatory regime, which have long been in place, are tailored to banking activities. The municipal advisor regulatory scheme, by contrast, is a securities-based regime based on traditional investment adviser structures. In the industry’s view, the cost of complying with a markedly different recordkeeping and reporting system would be substantial and would necessarily be passed on to customers. Further, because of the dispersion throughout a bank of business with municipalities, the entirety of a bank’s recordkeeping would become subject to Commission oversight, a result unnecessarily duplicative of the banking agencies’ functions.

In the Gramm-Leach-Bliley Act, noted the associations, Congress determined that banks should be able to continue to engage in traditional bank activities without registering with the SEC as broker-dealers. Congress codified that determination in the Exchange Act by providing an express exemption from broker-dealer registration for a bank that effects transactions in identified banking products or other enumerated activities, including deposit-taking and lending, sweep accounts, trust and fiduciary, investment adviser, safekeeping and custody, municipal securities, and transfer agency activities, as later implemented in Regulation R.

In the associations’ view, neither the statutory language of Section 975 nor its legislative history indicate that Congress intended to upend the determinations concerning traditional bank activities that it made in Gramm-Leach-Bliley. Indeed, Section 975 was primarily directed at establishing a regulatory scheme for persons unregulated with respect to providing advice to municipalities about certain complex transactions, namely, municipal derivatives, guaranteed investment contracts, the issuance of municipal securities, or investment strategies with respect to the proceeds of such issuances. Thus, in any final rule, the Commission should state clearly that neither Section 975 nor its implementing regulations reach traditional bank products and services, including but not limited to those defined in Section 3(a)(4)(B)(i)–(x) of the Exchange Act.


Report Finds Broad Support and High Compliance Rate for Dutch Corporate Governance Code

The new Dutch Corporate Governance Code that came into force for listed companies in January 2009 has broad support and a high rate of compliance, said a report by the Corporate Governance Code Monitoring Committee. Compliance with the Code is on an apply or explain basis under which the principles and best practice provisions of the Code must be applied unconditionally or an explanation must be given for any departure from them.

According to the Monitoring Committee, a best practice provision is said to be applied if it is strictly observed. The term comply includes the application of a best practice provision and the giving of a reasoned explanation where a best practice provision is not applied. The most common explanations given for non-application of a provision was that the costs of implementing the provision was too high or that the company was too small to apply the provision

The report revealed that for the most part the Code is only of interest to and known by large institutional investors. Moreover, the Monitoring Committee noted that proxy advisory services have a major influence on how votes are cast at general meetings of shareholders.

The best practice provision for which an explanation of non-application was most commonly given was the clawback clause, under which the supervisory board may recover from the management board members any variable remuneration awarded on the basis of incorrect financial or other data. The reason usually cited for non-compliance was that the company is awaiting legislation on this point.

The remuneration report of the supervisory board must explain how the company’s remuneration policy contributes to the achievement of the long-term objectives of the company in keeping with the risk profile. The report must be posted on the company’s website. The rate of compliance with this provision varied. It was noteworthy that shareholder value was the objective most frequently mentioned in the context of remuneration policy.

The Code states that shares granted to management board members without financial consideration must be retained for at least five years and depend on the achievement of challenging targets specified beforehand. The Committee noted a high level of non-compliance or explanation of non-application with this provision

A fairness test is a new addition to the Code under which the supervisory board has the power to adjust the value of a variable remuneration component conditionally awarded in a previous financial year if this award would produce an unfair result due to extraordinary circumstances. The most common explanation of why a company did not apply the fairness test was that, although the company endorsed the new code in this respect, it would not apply it until 2010 or 2011

The rate of compliance with the new Code provisions on remuneration is good. However, in explaining why they have not applied the best practice provisions on the maximum term of office and maximum severance pay of management board members, companies often state that they wish to honor existing agreements and/or contracts. This is an explanation that should cease to apply in due course.
Unlike the management board and the supervisory board, shareholders are not, in principle, guided exclusively by the interests of the company and its business. For example, shareholders can give priority to their own interests, provided they act in accordance with the principles of reasonableness and fairness

The Monitoring Committee is aware that the auditor’s role in monitoring compliance with the Code by listed companies is unclear. Nonetheless, the Committee calls upon auditors to hold the management board of the company to account if the Code is not complied with, for example, if it is not applied and no explanation is given.

Tuesday, February 22, 2011

Draft Code of Practice for Auditor-Regulator Interaction Set Out by UK FSA

The UK Financial Services Authority has proposed a draft Code of Practice to enhance the relationship between the outside independent auditor of a firm’s financial statements and the regulator of the firm. The Code is composed of principles focusing on open and regular dialogue, confidentiality, and the fulfillment of statutory duties. In a preamble, the Code sets forth the basic tenet that the external auditor has an important role to play in the regulatory framework, which requires a constructive relationship between the FSA and the auditor so that they can both provide effective input to the regulatory process.

It is important, therefore, that the terms and scope of this relationship are clearly defined and understood by both parties. While the high level goal of the Code is to contribute to quality audits by promoting an effective relationship between the auditor and the FSA, this does not detract from the auditor’s independent role in forming judgments and opinions on the firm’s financial statements for the benefit of investors and other users of the financial statements.

The Code provides that there should be an open and constructive dialogue between the auditor and the regulator through formal meetings and informal channels such as telephone calls. In terms of formal meetings, there should be a bilateral meeting once a year between the auditor and the regulator. There should be an annual trilateral meeting for high impact firms attended ideally by the lead audit partner, the regulatory team leader, and the chair of the firm’s audit committee. Additional bilateral meetings between the regulator and auditor of very high impact firms will be needed around the time the annual report is planned and concluded.

Another principle is that auditors and regulators must share all information relevant to carrying out their respective statutory duties in a timely fashion. The overriding consideration here should be to disclose information that the lead audit partner judges to be of aid to the FSA in performing its functions, and such information should be timely disclosed by the auditor directly to the FSA. The auditor should not rely on the audited firm to notify the FSA.

Conversely, the FSA should disclose information to auditors relevant to the fulfillment of their statutory duties. Subject to restrictions, the presumption should be that the FSA will want to share any information likely to contribute to higher quality audits. The Code provides for the confidential treatment of shared information between the FSA and the auditor, as well as information received from the regulated firm.

Volcker Calls for Global Accounting Standards in Tribute to IFRS Oversight Chair

In a world of global finance, noted former Fed Chair Paul Volcker, common accounting standards are a matter of fundamental importance. In remarks paying tribute to Tommaso Padoa-Schioppa, former Chair of the IFRS Foundation which oversees the IASB in an effort to achieve global accounting standards, Mr. Volcker said that accounting standards by their nature are detailed and complex but, technical as they may be, they are sometimes highly controversial, politically as well as among businesses. Mr. Padoa-Schioppa was also a former board member of the European Central Bank.

Mr. Volcker praised Chairman Padoa-Schioppa for changing the perception of the IASB oversight body as a self-appointed body of “mandarins” setting out accounting standards insensitive to national priorities to a globally diverse body with a whole-hearted commitment to the mission of achieving common accounting standards around the world. The former Fed Chair also applauded remarks given last year by the oversight chief that more broadly called for globally consistent financial regulations.

Since the financial crisis was global in both its origin and its consequences, reasoned Mr. Padoa-Schioppa in his remarks, coherent prevention requires a global policy. The crisis stemmed largely from the inconsistency between the cross-border span of financial markets and the national span of government. Also playing a key role was regulatory arbitrage in which financial centers competed to attract pieces of the global financial industry.

The former EU central banker did not call for the suppression of national sovereignty but rather an admission that it is not absolute. He noted that the financial crisis was partially fueled by the fact that policy and regulation remained almost exclusively concentrated at the nation-state level and left unmanaged the rapid emerging reality of global financial markets. In his view, reform legislation has only partly corrected this problem since the reforms are generally more responsive to national constituencies than to the call for global governance.

In his view, this trend is reinforced by years of declining international cooperation as the financial markets became global and there was a concomitant shift from strong treaty-based agreements to soft voluntary forums without the power to take binding action.

In Letter to House Leader, Prof. Warren Says Consumer Financial Protection Bureau Regulations Will First Seek to End Duplication

In a letter to House Oversight Subcommittee Chair Randy Neugebauer (R-TX), Professor Elizabeth Warren said that the Bureau of Consumer Financial Protection created by the Dodd-Frank Act was preparing regulations that will deal directly with duplication when it begins to operate on July 21, 2011. For example, she said that the Bureau’s first regulations will combine complicated and duplicative mortgage forms separately mandated by the Truth in Lending Act and the Real Estate Settlement Procedures Act. The Bureau will reduce these forms into a single readable document that will be cheaper for lenders to execute and easier for customers to understand. Professor Warren is an Assistant to the President and Special Advisor to the Secretary of the Treasury. She was responding to an earlier letter from Chairman Neugebauer, in which he asked how the Bureau intended to avoid potentially duplicative or conflicting rulemaking with agencies that will ultimately be under the Bureau’s regulatory authority.

While the Bureau is not currently authorized to prescribe substantive regulations, noted Prof. Warren, the implementation team has been laying the groundwork in order to be prepared to receive rulemaking authority on the transfer date. As part of this effort, the Bureau has been has been monitoring regulatory activity by the Fed, the FTC and others concerning areas over which the Bureau will assume oversight on the transfer date.

The Bureau is conducing ongoing discussions with these agencies to understand their pending regulations and avoid conflicting regulations, she noted, with an eye towards a smooth transition to Bureau oversight. Also, the implementation team is working with the new Office of Financial Research created by Dodd-Frank on developing information technology and human capital resources. Prof. Warren pledged to the Chairman that there would be interagency coordination after the transition period in response to his desire that the Bureau have ongoing interaction with the SEC, CFTC, Fed and other agencies.

The CFPB team is also preparing to carry out the Dodd-Frank requirement that it assess the impact of its regulations on small financial service providers. Before proposing rules, the Bureau will convene panels that draw on expertise from small businesses and government agencies with deep knowledge of small business. These panels will be part of an ongoing effort to assess the effectiveness and impact of CFPB regulations. The Special Advisor said that Senator Olympia Snowe (R-ME), who authored the Dodd-Frank provision on small business impact panels, has already been a key source of advice for the Bureau around this issue.

More broadly, the Special Advisor vowed that the Bureau will be a data driven agency that, in adopting regulations, will always concentrate on making prices and risks of financial products clear up front and on making it easy for consumers to compare one financial product with those offered by competitors. The Bureau is focused on ensuring that consumers have the information they need so that the markets will work for them.

Monday, February 21, 2011

Institutional Investors Support SEC’s Proxy Access Rule in Amicus Brief

An amicus brief filed by the Council of Institutional Investors and TIAA-CREF strongly defends the SEC’s proxy access rule against a challenge by business groups in federal court. A number of other significant institutional investors signed on to the brief, including CalPERS, the Wisconsin Investment Board, and the New York State Employees Retirement System. The brief was filed in the DC Circuit Court of Appeals, where the business groups are challenging the rule. Oral argument is set for April 7, 2011. (Business Roundtable and Chamber of Commerce v. SEC, DC Circuit Court of Appeals, No. 10-1305).

The brief first points out that the Dodd-Frank Act specifically sanctions the SEC’s adoption of the proxy access rule. Seeking to restore investor confidence and management accountability in the wake of the recent financial crisis, Congress reaffirmed the SEC’s authority to establish proxy access rules that are in the interests of shareholders and for the protection of investors. Congress’ decision was well founded, said amici, since economists and courts alike have long recognized the costs that investors suffer when corporate officers make decisions based on interests that diverge from those of long-term shareholders.

Because attending shareholder meetings is impractical for most shareholders, noted the brief, state law typically allows shareholders to vote for directors by proxy. For 70 years, the SEC has sought to ensure that the proxy process functions as a reasonable substitute for in-person meetings. The current proxy process, however, does not, concluded amici.

Shareholders generally cannot have their director nominees placed on the company proxy, but must instead circulate competing proxy materials and campaign for support separately. The costs can be prohibitive, noted the brief, and incumbents can impose significant procedural hurdles. Absent a realistic prospect of removal, directors can fail to act in the long-term interests of the corporation, with disastrous results.

Responding to those failures, Rule 14a-11 allows certain shareholders to include director nominees in the company’s proxy materials. In the view of the institutional investors, the SEC carefully circumscribed that right, limiting it to shareholders with a large, long-term stake in the corporation, while deterring shareholders with parochial agendas. Experience
abroad with similar rules strongly supports the SEC’s conclusion that, while proxy access will rarely be invoked, it provides broad benefits. Some benefits are that the rule enhances the possibility of shareholder candidates communicating with management and significant investors, and that it improves management performance.

Arguments that proxy access will force corporations to oppose parochial-interest nominees or make concessions to avoid such contests ignore the experience of foreign systems, the preconditions limiting proxy access to long-term shareholders; and the minimal chance that parochial nominees will be elected. The business groups challenging the rule also asserted that the SEC did not explain why proxy access contests would occur less frequently than traditional proxy contests. But as the SEC observed and overseas proxy access demonstrates, proxy access is rarely exercised precisely because it provides management with incentives to address shareholder concerns before contested elections become necessary.

According to amici, the SEC properly rejected the petitioners’ private-ordering approach under which each corporation would independently decide whether to allow proxy access. The notion that one generation of shareholders could disenfranchise the next is contrary to the purpose of shareholder meetings, posited amici. Moreover, such a company-by-company approach would impose staggering costs.

In addition, in the view of the investors, effective private ordering is not possible because many companies impose impediments such as supermajority requirements, restrictions on shareholders’ ability to amend or propose bylaws, and board repeal of shareholder-adopted bylaws. The proxy access rule, by contrast, provides a baseline that improves corporate accountability for all shareholders.

The brief also said that the SEC properly justified its decision not to exempt investment companies from proxy access. The rule’s core purpose of facilitating the exercise of shareholders’ traditional state-law rights to nominate and elect the directors who are supposed to protect their interests applies with equal force to investment company boards and operating company boards alike.

Corporate Governance Group Applauds IASB Draft on Management Commentary for Financial Statements

The IASB’s proposed framework for the presentation of management commentary to accompany financial statements prepared in accordance with IFRSs received a strong endorsement from the International Corporate Governance Network, which called the draft a significant step forward in promoting best practice in terms of disclosure on risk and business strategy supported by appropriate metrics and key performance indicators. In the group’s view, the main beneficiaries of management commentary would be existing and potential equity investors, who do not have the same degree of access to information about a company as other capital providers such as lenders and creditors.

However, the governance group said that management commentary should be mandatory rather than non-binding as the Board proposes. There is a major risk that preparers will not take a non-mandatory approach as seriously as a mandatory one. The network also cautioned that using the term “forward looking information” to describe information and disclosures having an orientation to the future may be problematic in jurisdictions such as the US and Canada where that term has a statutory definition and is burdened with a considerable body of court opinions. To avoid this potential pitfall, the governance group suggested that some other term be used to capture the meaning, such as “future oriented information”.

The group values bringing together the financial statements with the key non-financial information and hopes that management commentary will gain prompt acceptance globally as an anchor document for any integrated reporting framework. The proposed disclosures about strategy, resources and performance measures need to be enhanced to include additional features. Disclosures about risks and risk management are important enough to be treated as a separate content element, rather than being grouped with resources and relationships.

Further, specific mention should be made of the need for the management commentary to provide explicit disclosures about environmental, social and governance matters that are relevant and material in assessing a company’s future profitability and sustainability Similarly, intellectual and human capital should be given some specific recognition as a content element. While agreeing with the Board’s proposal not to include illustrative examples, the governance network asked that more guidance be provided regarding the nature and extent of disclosures for each content element.

The principle of management’s view has its roots in regulation, specifically in the MD&A requirements of the SEC. The SEC objective for MD&A reporting is to provide a narrative explanation of a company’s financial statements that enables investors to see the company through the eyes of management. In determining the purpose for management commentary, the Board looked to the objectives stated in existing regulations and guidance issued by the SEC, which stated that the purpose of Management’s Discussion and Analysis (MD&A) is to provide readers with information necessary to an understanding of a company’s financial condition, changes in financial condition and results of operations.

In the IASB’s view, the purpose of management commentary is to provide a context within which to interpret the financial position, financial performance and cash flows of an entity. It also provides an opportunity to understand management’s objectives and its strategies for achieving those objectives. Users of financial reports routinely use the type of information provided in management commentary as a tool for evaluating a company’s prospects and its general risks, as well as the success of management’s strategies for achieving its stated objectives.

FSA Dear CEO Letter Updates on New Regulatory Regime as Treasury Committee Says Take Time

The UK FSA has changed its management structure in anticipation of a smooth transition to a new bifurcated system of financial regulation. In a Dear CEO letter, the FSA noted that the Prudential Regulation Authority (the PRA), which will be a subsidiary of the Bank of England, will be responsible for promoting the stable and prudent operation of the financial system through regulation of all deposit-taking institutions, insurers and investment banks. The Consumer Protection and Markets Authority (the CPMA) will be responsible for regulation of conduct in retail, as well as wholesale, financial markets and the infrastructure that supports those markets. The CPMA will also have responsibility for the prudential regulation of firms that do not fall under the PRA’s scope.

Hector Sants, currently FSA Chief Executive, will be the Chief Executive of the PRA, while Martin Wheatley, formerly CEO of the Hong Kong Securities and Futures Commission, will be Chief Executive of the CPMA.

This internal reorganization is the first step on the road to becoming two separate regulators. The FSA assured, however, at this point it will not be moving to twin peaks regulation. Rather, the reorganization begins a gradual process of change to ensure that the regime is ready in 2012 to cut over to the twin peaks approach. Integrated supervision will continue until the design and piloting of new regulatory processes and trained staff. The FSA will be subject to integrated executive and board governance throughout the transition process under Chair Adair Turner.

Meanwhile, a Treasury Committee report told the Government to take the time it needs to get financial regulatory reform right. In any event, the Committee urges the Government to wait for the upcoming report of the Independent Commission on Banking before coming to conclusions. The Commission report is due in September, with an interim report set for April.
The Committee is also concerned that the current reform proposals say little about some key segments of the UK financial sector. The inappropriate regulation of non-banking sectors could cause serious and unintended damage to companies within those sectors. Thus, it is important that the Government clarify the regulatory impact of its proposals on the non-bank sectors. More broadly, the legislation to establish the new regulatory structure should be subject to pre-legislative scrutiny, over a reasonable timescale.

Saturday, February 19, 2011

IOSCO Report on OTC Derivatives Trading Platforms Emphasizes Full Transparency

IOSCO has issued a report analyzing the benefits, costs, and challenges associated with increasing exchange and electronic trading of OTC derivative products, with recommendations to assist the transition of trading in standardized derivatives products from OTC venues onto exchanges and electronic trading platforms, while preserving the efficacy of those transactions for counterparties. The Task Force that produced the report was led by the SEC, the CFTC, and the UK FSA.

The report concludes that it is appropriate to trade standardized derivatives contracts with a suitable degree of liquidity on organized platforms, and that a flexible approach to defining what constitutes an organized platform for derivatives trading would maximize the number of standardized derivative products that can be appropriately traded on these venues. It identifies characteristics that an organized platform should exhibit in order to fulfill the G-20 Leaders’ objectives, as well as the benefits and costs associated with transitioning trading of derivatives from OTC venues onto organized platforms. It also presents a range of actions that regulators may choose to take to increase organized platform trading of OTC derivatives products.

This report provides regulators, regardless of the state of development of their derivatives markets, with an analytical tool that can inform their current and future efforts at addressing the trading of derivatives on organized platforms, and a range of actions which they can take to facilitate this.

Assuming that product standardization has increased, that central clearing is used for OTC derivatives suitable for clearing, and significant data on OTC derivatives is reported to trade repositories, the report identifies a number of benefits that can result from organized platform and mitigate systemic risk and protect against market abuse in the derivatives market. For example, there could be greater pre- and post-trade transparency, increased market competition, deep liquidity, and improved market surveillance.

In the context of trading platform regulation, platform operators are generally expected to operate in the front line to promote clean markets through market monitoring activities. This is reflected in the IOSCO Principles, which specify that there must be mechanisms in place to identify and address disorderly trading conditions and to ensure that contravening conduct when detected will be dealt with.
Under the European Commission’s MiFID proposals, the monitoring of all trading taking place on the facility with a view to identifying conduct involving market abuse would be a minimum characteristic of organized trading facilities. Similarly, a common theme of platform regulation under the Dodd-Frank Act is that the platform is obliged to monitor trading to prevent manipulation.

IOSCO notes that organized platforms can also facilitate post-trade transparency for products traded on such platforms since the same mechanisms used to match trading interest and establish terms of a trade can allow for wide dissemination of information about the trade. However, post-trade transparency may not be dependent on trading on organized platforms. For example, the Dodd-Frank Act requires post-trade transparency for derivatives transactions executed on trading platforms as well as OTC. Similarly, EU draft legislation provides for a post-trade transparency regime by type of derivative, rather than execution venue. This could result in real-time or near real-time post-trade transparency with appropriate deferrals, such as for large trades. Thus, IOSCO concludes that organized platforms would be one source of post-trade transparency.

The G-20 has stated that OTC derivatives contracts should be reported to trade repositories so that such data would be accessible by market regulators in order to review overall OTC derivatives activity, or a portion of it, based on counterparty or otherwise. Some information on OTC derivatives activity would also be made available to the public. The Dodd-Frank Act and EU legislation, and comparable initiatives in other jurisdictions, are expected to obligate market participants to report their derivatives trades to trade repositories and provide for oversight of those repositories.

The report notes that some trade repositories may be able, over time, to provide a post-trade transparency or a surveillance function. However, the IOSCO analysis has not taken into account any resulting benefits and costs from such functions because the repositories are not expected, at least initially, to have functionality beyond their core repository function and issues remain over whether that functionality could or should be extended.

IOSCO emphasized that an organized platform must have good governance and manage conflicts of interest. In many jurisdictions, obligations are placed on platform operators to identify, mitigate and manage potential conflicts of interest. The nature and scale of the potential conflicts of interest that a platform operator might face can differ according to the nature of the platform, including whether the operator is a trading participant, requiring different arrangements to ensure that regulatory standards are met. Specifically, if the platform operator is also a participant more robust conflicts of interest arrangements should be adopted.

FSA Dear CEO Letter Updates on New Regulatory Regime as Treasury Committee Says Take Time

In a Dear CEO letter, the UK FSA said that it has changed its management structure in anticipation of a smooth transiton to a new bifurcated system of financial regulation. The Prudential Regulation Authority (the PRA), which will be a subsidiary of the Bank of England, will be responsible for promoting the stable and prudent operation of the financial system through regulation of all deposit-taking institutions, insurers and investment banks. The Consumer Protection and Markets Authority (the CPMA) will be responsible for regulation of conduct in retail, as well as wholesale, financial markets and the infrastructure that supports those markets. The CPMA will also have responsibility for the prudential regulation of firms that do not fall under the PRA’s scope.

Hector Sants, currently FSA Chief Executive, will be the Chief Executive of the PRA, while Martin Wheatley, formerly CEO of the Hong Kong Securities and Futures Commission, will be Chief Executive of the CPMA.

This internal reorganization is the first step on the road to becoming two separate regulators. The FSA assured, however, at this point it will not be moving to twin peaks regulation. Rather, the reorg begins a gradual process of change to ensure that the regime is ready in 2012 to cut over to the twin peaks approach. Integrated supervision will continue until the design and piloting of new regulatory processes and trained staff. The FSA will be subject to integrated executive and board governance throughout the transition process under Chair Adair Turner.

Meanwhile, the Treasury Committee told the Government to take the time it needs to get financial regulatory reform right. In any event, the Committee urges the Government to wait for the upcoming report of the Independent Commission on Banking before coming to conclusions. The Commission report is due in September, with an interim report set for April.

The Committee is also concerned that the current reform proposals say little about some key segments of the UK financial sector. The inappropriate regulation of non-banking sectors could cause serious and unintended damage to companies within those sectors. Thus, it is important that the Government clarify the regulatory impact of its proposals on the non-bank sectors. More broadly, the legislation to establish the new regulatory structure should be subject to pre-legislative scrutiny, over a reasonable timescale

Proposed German Sustainability Code Linked to Sound Corporate Governance

Comments on the proposed German Sustainability Code designed to foster corporate sustainability through better governance, social responsibility and enviromental concerns were generally favorable and said sustainability is intertwined with sound governance. The aim of the German Sustainability Code is to make sustainability tangible for all stakeholder groups, to tap opportunities and avert risks. The German Sustainability Code, which is on a comply or explain basis, would apply to all listed companies, with unlisted companies at liberty to comply with the Code. The comment period ended on Feb. 14, 2011.

The German Sustainability Code will be implemented through a statutory provision in the German Stock Corporation Act under which the management board and the supervisory board of listed companies would issue an annual statement detailing how well they comply with the Code. A separate sustainability report would be incorporated into the annual report and be subject to external audit. Also, the company must issue a declaration of conformity with the German Corporate Governance Code.

The Sustainability Code requires the company to link executive compensation to the attainment of sustainability goals. For senior management, sustainability performance should form part of the supervisory board’s evaluation of the management board.

The Code requires a company to analyze the opportunities and risks for its core business arising from the sustainability requirements with regard to their long-term implications. The company should establish relevant industry-specific, national and international standards and ensure it operates in keeping with these standards. The significant opportunities and risks arising from sustainable development should be recorded and form an integral part of the risk management system. Moreover, key indicators on sustainability should be integrated into the company’s internal controls.

The Code also requires companies to implement processes ensuring that employee rights are observed at both national and international level. Compliance should be
based on internationally recognized standards; and the company should systematically involve its employees in the sustainability and strategy process

In a comment letter supporting the Code, the International Corporate Governance Network said that sustainability performance is largely determined by how well sustainability is integrated with the corporate governance processes. A discussion of how a company deals with environmental and social issues that can affect its long-term success and how it identifies and prioritizes such issues provides investors with valuable insights into management’s ability to run the company for the long-term.

The Network suggested that the Sustainability Code include an explicit commitment to genuine integrated reporting that goes beyond including a section on sustainability in the annual report but interlinks sustainability and financial performance to allow an assessment of long-term potential for success. In the Network’s view, companies should support integrated disclosures targeted at economic stakeholders by further disclosures for its social stakeholders.

Regarding compensation, the Network expects companies to investigate actively
whether or not it is appropriate to include sustainability or non-financial targets, and to report publicly what the board has concluded, explaining the reasons why or why not sustainability targets have been included

Equally, the Network seeks assurance that companies will build good stakeholder relationships and maintain ongoing dialogue with their stakeholders and implement mechanisms to solicit their views and take those into account. Moreover, the Network is interested in how a company responds to the challenges of demographic change, human capital management and corporate citizenship in all the countries in which it

Ahead of Legislation, Hong Kong Securities and Futures Commission Issues Guidelines on Disclosure of Inside Information

As the Government readies legislation on insider trading, the Hong Kong Securities and Futures Commission set out draft guidelines on the disclosure of inside information, which have been well received by the corporate and investor communities. The Commission will issue final guidelines after the legislation is enacted later this year.

According to the SFC, there are three key elements in the concept of inside information: the information must be specific, must not be generally known, and must be likely to have a material effect on the price of the corporation’s securities.

Specific information is information capable of being identified, defined and unequivocally expressed, said the Commission, and carries with it such particulars as to a transaction or event as to allow that transaction or event to be identified and its nature to be coherently described and understood. It is not necessary that all details of the transaction or event be precisely known. Information may still be specific even though it has a vague quality and may be broad which allows room, even substantial room, for further particulars. For instance, information that a company is having a financial crisis would be regarded as specific, as would contemplation of a forthcoming share placing even if the details are not known

Information on a transaction contemplated or at a preliminary state of negotiation can be specific information, said the Commission, but vague hopes and wishful thinking may not be specific information. The fact that a transaction is only contemplated or under negotiation and has not yet been subjected to any formal final agreement does not necessarily cause the information concerning that contemplated course of action or negotiation to be non-specific. However, vague hope or wishful thinking that a transaction will occur or come to fruition does not amount to sufficient contemplation or preliminary negotiation of that transaction. To constitute specific information, a proposal, whether described as under contemplation or at a preliminary stage of negotiation, should have more substance than merely being at the stage of a vague exchange of ideas or a fishing expedition.

Regarding the ``not generally known’’ element of inside information, the SFC noted that rumors, media speculation or market expectation as to an event or a set of circumstances of a company cannot be equated with information which is generally known to the market. There is a clear distinction between actual knowledge of the market about a hard fact and speculation or expectation of what might have happened about a corporation, which obviously requires proof.

The test of whether the information is likely to materially affect the stock price is a hypothetical one that must be applied at the time the information becomes available. The exercise in determining how the general investor would behave if he or she is in possession of that piece of information has necessarily to be an assessment.

The Commission said that fixed thresholds of price movements or quantitative criteria alone are not a suitable means of determining the materiality of a stock price movement. For example, the volatility of blue-chip securities is typically less than that of small, less liquid stocks. In determining materiality, factors to be considered are the anticipated magnitude of the event, the relevance of the information, the reliability of the source, and market variables that affect the price of the listed securities.

All that said, the Commission advised that companies should take into account that the materiality of the information in question will vary widely from entity to entity, depending on a variety of factors such as the company’s size, its course of business and recent developments, as well as market sentiment about the company and the sector in which it operates. For example, a bank’s cancellation of a credit line which is material to an entity facing liquidity problems may be immaterial to a highly liquid entity.

The guidelines state that a corporation must disclose any inside information to the public as soon as practical, which means that the company should immediately take all necessary steps that are reasonable in the circumstances to disclose the information to the public. Before it is publicly disclosed, the company should ensure that the information is kept strictly confidential. When the company believes that the necessary degree of confidentiality cannot be maintained or that confidentiality may have been breached, it should immediately disclose the information to the public.

If a company needs time to clarify the details of, and the impact arising from, an event or a set of circumstances before it is in a position to issue a full announcement to properly inform the public, said the SFC, the company should consider issuing a holding announcement detailing as much of the subject matter as possible and setting out reasons why a fuller announcement cannot be made. The company should make a full announcement as soon as possible.
The Commission also emphasized that no analyst, investor or journalist should receive a selective release of inside information. The guidelines indicate that a company must ensure that only public information is given when answering an analyst’s questions or reviewing an analyst’s draft report. It is inappropriate for a question to be answered, or draft report corrected, if doing so involves providing inside information. Further, when analysts visit the company, noted the SFC, care should be taken to ensure that they do not obtain inside information.

The Commission recognizes that sometimes analysts may draw out data or misinterpret historical information. In such cases, it is appropriate for the company to clarify historical information and correct any factual errors in analyst assumptions which are significant to the extent that they may mislead the market, so long as any clarification is confined to drawing the analyst’s attention to information that has already been made available to the market. If the company is aware of inside information that would correct a fundamental misconception in the report, it should consider making public disclosure of such information and at the same time correcting the report.

Publications by third parties such as regulators or rating agencies may affect the price of, or market activity in the company’s securities. If such events when they become public knowledge are expected to have significant consequences directly affecting the corporation, said the SFC, this may be inside information that should be disclosed by the company with an assessment of the likely impact of those events. Similarly, while companies are not expected to disclose general external developments, such as foreign currency rates, the market price of commodities or changes in a taxation regime, noted the SFC, if the information has a particular impact on the corporation this may be inside information that should be disclosed with an assessment of the likely impact of those events.

In the view of the SFC, a company should be aware that inside information requiring disclosure may emerge during the preparation of periodically filed financial statements. In this instance, the company cannot defer releasing inside information until the prescribed structured document is issued. Separate immediate disclosure of the information is necessary.