Thursday, March 31, 2011

Companion Legislation to Reform GSEs Introduced in the Senate

Senators Orrin Hatch (R-Utah) and John McCain (R-Ariz.) have introduced a companion bill to the House bill to reform the government-sponsored enterprises. Based on the House bill introduced by Rep. Jeb Hensarling (R-Texas), and other House GSE reform bills, the legislation would permanently end government support for Fannie Mae and Freddie Mac, the two heavily-indebted government-sponsored enterprises that were a major cause of the financial crisis over two years ago. The GSE Bailout Elimination and Taxpayer Protection Act, would put an end to Fannie Mae and Freddie Mac’s conservatorship in two years, while enacting several fundamental reforms to protect taxpayers. The House bill is co-sponsored by Financial Services Committee Chair Spencer Bachus (R-Ala).

The legislation would repeal of the exemption allowing GSE securities to avoid full SEC registration. There would also be a repeal of the GSEs’ exemption from having to pay state and local taxes, to remove one of the distinct advantages of being a GSE.

The bill would repeal the GSEs’ affordable housing goals mandate and the Affordable Housing Trust Fund. The legislation would start shrinking the size of the GSEs by capping their maximum portfolio size at $700 billion and gradually reducing that cap to $250 billion over five years. The Senate bill would reduces the GSEs’ market share by returning the conforming loan limit to its pre-housing crisis standard limit of $417,000. The guarantee fees would be increased to eliminate the GSEs’ competitive advantage and bring more private capital into the market.

The legislation includes a prohibition on any reduction to the senior preferred stock dividends the GSEs contractually agreed to pay taxpayers under their conservatorship. Upon the end of the conservatorship, the Federal Housing Finance Agency (FHFA) must evaluate the financial viability of each GSE. If it is determined not to be viable, the FHFA would follow the procedure laid out by the Housing and Economic Recovery Act of 2008 (P.L. 110-289) for placing that GSE into receivership.

If determined to be viable, the GSE would be allowed to resume limited market operations under its own control for a maximum of three years, with the following new rules: The enhanced authority for FHFA to adjust the minimum capital requirements for the GSEs as appropriate, mirroring the existing capital adequacy requirements other regulators already have in place for banks (12 U.S.C. 3907);

At the end of that 3 year period, each GSE’s charter expires. At that point, Fannie and Freddie must conduct all new operations as fully private sector companies competing on a level playing field without any government advantages. It would also provide for the orderly wind down of any legacy business commitments post-charter expiration over a 10 year period following the model successfully used in the Sallie Mae transition from GSE to a private company (P.L. 104-208)

SEC Proposals Would Implement Dodd-Frank Mandates on Independent Compensation Committees and Compensation Consultants

Pursuant to Dodd-Frank mandates, the SEC has proposed rules directing exchanges to adopt listing standards requiring issuers to have independent compensation committees. In developing a definition of independence, the exchanges would be required to consider such factors as the sources of compensation of a director, including any consulting, advisory or compensatory fee paid by the company to the director and whether a director is affiliated with the company, a subsidiary of the company, or an affiliate of a subsidiary of the company. As with all listing standards, exchanges would need to seek the approval of the SEC before adopting them.

While the proposed independence rules for compensation committees are similar to the independence rules for audit committees adopted under the Sarbanes-Oxley Act, with one significant difference. Dodd-Frank requires only that the exchanges consider the relevant factors of the source of compensation and any affiliate relationship in developing independence standards for compensation committee members, while Sarbanes-Oxley expressly states that certain relationships preclude independence of an audit committee member. Thus, the exchanges will have the flexibility to establish their own minimum independence criteria for compensation committee members after considering the relevant factors.

In doing so, the SEC believes that the exchanges would likely consider whether the prohibitions imposed on audit committee members should also be applicable to compensation committee members. But, again, there is discretion, and the Commission recognizes that the exchanges may determine that, even though affiliated directors are not allowed to serve on audit committees, such a blanket prohibition would be inappropriate for compensation committees, and certain affiliates, such as representatives of significant shareholders, should be permitted to serve.

The listing standards would also have to provide that the compensation committee must be fully funded and have the sole discretion to retain the advice of a compensation consultants and be directly responsible for the appointment, payment and oversight of the such consultants.

As directed by Dodd-Frank, the SEC would require the exchanges to exempt the following five categories of entities from the compensation committee independence requirements: controlled companies, limited partnerships. companies in bankruptcy proceedings, mutual funds, and foreign private issuers that disclose in their annual report the reasons that they do not have an independent compensation committee.

In addition, the SEC proposes that, in selecting a compensation consultant, legal counsel or other adviser, the compensation committee must follow a number of independence factors, including whether the compensation consultant’s employer is providing any other services to the company and what percentage of the employer’s total revenue comes from fees charged the company for the consultant. The compensation committee must also consider what conflict of interest policies have been adopted by the employer of the compensation consultant and whether the consultant has any business or personal relationship with a member of the compensation committee or owns any stock in the company. The proposals would allow the exchanges themselves to impose additional considerations.

SEC proxy rules currently require disclosure of information about the use of compensation consultants, including specific information about fees paid to consultants. The proposal would modify existing rules to require disclosure about whether the compensation committee has obtained the advice of a compensation consultant and whether the work of the compensation consultant has raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed.

The proposed rules also would eliminate the current disclosure exception for services that are limited to consulting on broad-based plans and the provision of non-customized benchmark data, but would retain the fee disclosure requirements, including the exemptions from those requirements.
The Act requires the issuance of the Section 952 rules by July 16, 2011. But the Act did not establish a specific deadline by which the listing standards promulgated by the exchanges must be in effect. To facilitate timely implementation of the proposals, the SEC proposes that each exchange must provide to the Commission, no later than 90 days after publication of the final rules in the Federal Register, proposed rules or rule amendments that comply with the SEC final rules. Further, each exchange would need to have final rule or rule amendments compliant with the SEC final rule approved by the Commission no later than one year after publication of the final rule.

SIGTARP Tells Congress that Dodd-Frank Did Not End Market Perception that Systemically Risky Financial Institutions Are Too Big to Fail

Despite Dodd-Frank’s enactment of a liquidation authority for failing systemically risky financial institutions, TARP Special Inspector General Neil Barofsky said that there is still a public perception, reinforced by global credit rating agencies, that these institutions are still too big to fail. Dodd-Frank was intended to end too big to fail, acknowledged Mr. Barofsky, and the Title II liquidation authority does wind down a failed financial institution, but there is still a market perception that these large firms will simply not be permitted to fail. As long as the executives, rating agencies, creditors and counterparties believe that there will be a bailout, he noted, too big to fail will persist.

In testimony before the House TARP oversught subcommittee, he said that the largest financial institutions continue to enjoy cheaper credit based on the existence of the implicit government guarantee against failure. Two globally influential rating agencies recently reinforced this advantage. For example, Moody’s said that the resolution regime would not wok as planned, posing a risk of contagion and most likely forcing the government to provide support to avert a systemic crisis. The rating agencies are telling the market that they do not believe that the Dodd-Frank Act ended too big to fail, said SIGTARP, and the markets seem to be listening given the discounts that large firms continue to receive.

Until financial institutions viewed by the market as too big to fail are either broken up or some structure is put in place to assure the market that they will be left to suffer the full consequences of what SIGTARP called ``their wanton risk taking’’, the prospect of more bailouts will potentially fuel more bad behavior with potentially disastrous consequences.

But SIGTARP held out the hope that regulatory action is still possible to avert this scenario. He pointed to FDIC Chair Shelia Bair’s position that regulators must take a more proactive role and use the Dodd-Frank living will provisions as a tool to force systemically important financial institutions to simplify their operations and shrink their size, if necessary to ensure that orderly liquidation is possible.

Under Dodd-Frank, the FDIC and the Federal Reserve wield considerable authority to shape the content of the liquidation plans. If the plans are not found to be credible, the FDIC and the Fed can even compel the divestiture of activities that would unduly interfere with the orderly liquidation of these companies. The success or failure of the new regulatory regime will hinge in large part on how credible these resolution plans are as guides to resolving these companies.

Chairman Bair has pledged that the FDIC will require these institutions to make substantial changes to their structure and activities if necessary to ensure orderly resolution. If regulators do not ensure that these institutions can be unwound in an orderly fashion during a crisis, she emphasized, they will have fallen short of the Dodd-Frank goal of ending too big to fail. Mr. Barofsky said that if the FDIC prevails in ensuring that Dodd-Frank is used to simplify and shrink large institutions as necessary then perhaps in the long run Dodd-Frank will have a chance to end too big to fail.

In his testimony, Mr. Barofsky also favorably noted that Senators Sherrod Brown (D-OH) and Ted Kaufman (D-DE) had offered an amendment to Dodd-Frank that would changed the size, leveraging, and capital requirement standards of large financial institutions in order to prevent them from becoming too big to fail. The amendment, which was essentially the SAFE Banking Act (S3241) the Senators had introduced earlier in the year, would have limited the size of these firms by imposing a strict 10 percent cap on any bank-holding-company's share of the United States' total insured deposits and limiting the size of non-deposit liabilities at financial institutions to 2 percent of GDP for banks, and 3 percent of GDP for non-bank institutions. It would also have set into law a 6 percent leverage limit for bank holding companies and selected nonbank financial institutions.

The Brown-Kaufman Amendment was defeated 61-33, but Banking Committee Ranking Member Richard Shelby (R-AL) and Majority Leader Harry Reid (D-NV) voted for the amendment. While the amendment failed to become part of Dodd-Frank, Mr. Barofsky seemed to be suggesting that this could be a legislative avenue to take the ``big’’ out of too big to fail,

House Ag Chair Says CFTC Interpretations of Dodd-Frank Derivatives Exemptions Are Too Narrow

In implementing Title VII of Dodd-Frank, the CFTC has proposed regulations with very broad and far-reaching definitions, but very narrow interpretations of the derivatives exemptions Congress authorized. This was the message delivered by House Agriculture Committee Chair Frank Lucas (R-OK) ahead of hearings on the derivatives title of Dodd-Frank. Chairman Lucas also said that, under the current timeframe, the CFTC cannot possibly comprehend the cumulative impact over 40 proposed regulations will have on the markets and the economy, or adequately evaluate and weigh the costs and the benefits for each rule.

While Congress gave the CFTC broad discretion in defining key terms, acknowledged Chairman Lucas, it also directed the Commission to provide exemptions where appropriate to avoid imposing unjustified and unnecessary costs on market participants. The result of this approach will be a spectrum of market participants subject to a new and sweeping regulatory regime that far exceeds the risks those entities pose to the financial system or their counterparties.

The Chair noted that Dodd-Frank requires several new regulatory designations that will define the market, and very importantly shape the ability for end-users across the country to affordably hedge their risks. One of Congress’ principal objectives in Title VII was to mitigate risks to the financial system and to prevent another financial crisis. Yet under the regulatory proposals entities that do not come close to threatening financial stability, and who had no role in the financial crisis, may be regulated in the same way as those that do. That simply doesn’t make sense, emphasized the Chair, and is not what Congress intended.

Chairman Lucas urged caution with the derivatives regulations. The derivatives markets serve an important risk mitigation role across the economy, he noted, and the regulations cannot be allowed to create significant economic disincentives to using these markets, especially for end-users and smaller entities that can least afford the costs of new regulation. Congress will ensure that the regulations do not eliminate these tools for commercial hedgers, which he believes would shift more of the trading volume to the largest financial players or send activity to our competitors overseas

Wednesday, March 30, 2011

IOSCO Issues Key Principles on Point of Sale Disclosure

As securities regulators consider point of sale disclosure requirements for retail investors, IOSCO has issued a number of principles designed to provide key information quickly to the investors. As a threshold matter, IOSCO defines point of sale as the moment at which a customer requests that a product be purchased.

While setting forth general principles for point of sale disclosure, IOSCO is not recommending a one-size-fits-all approach. IOSCO recognizes that key information will necessarily vary depending on the type of financial product being offered. For some complex financial products with a multitude of risks, the amount of key information that a regulator might mandate for immediate disclosure to the investor under a layered approach may be greater than for less complicated products

The first principle of point of sale disclosure is that key information should include disclosures informing the investor of the fundamental benefits, risks, terms and costs of the product and the remuneration and conflicts associated with the intermediary through which the product is sold. Regarding disclosures about the financial instrument, IOSCO suggested that key information could include the name of investment and type of product, the investment objectives and strategy of product, and its risk and reward profile. Risk disclosures should include the material risks for the product, including performance risk, credit risk, liquidity risks and operational risks.

Key information will also include fees and costs, including information on any breakpoint discounts and expense reimbursements or fee waivers. Also key is disclosure on the nature of any guarantees being offered, including any restrictions or conditions that the guarantees are based on. It is also important to disclose potential conflicts of interest inherent in the terms of the product. For example, these may include when payments to the investor are dependent on certain criteria such as product performance as measured against a benchmark.

Finally, IOSCO said that past performance presented in a way that enables easy comparison between products is key data. Past performance disclosures should include a warning that historical performance is not an indicator of future performance. Where no past performance is available, potential return scenarios should be provided.

Concomitant with point of sale disclosure, IOSCO recommended that securities regulators consider measures to improve retail investor education in order to enhance their financial literacy and ability to read investment documentation. There should do this, said IOSCO, because it is axiomatic that no matter what disclosures are mandated they will not have the intended effect of having retail investors engage in an informed investment process if the investor either does not read or understand the information provided.

Section 919 of the Dodd-Frank Act provides that SEC may issue rules designating documents or information that must be provided by a broker to a retail investor before the purchase of an investment product or service by the investor. Dodd-Frank provides that any documents or information required to be provided to investors must be in summary format; and contain clear and concise information about investment objectives, strategies, costs, and risks; and any compensation or other financial incentive received by a broker, dealer, or other intermediary in connection with the purchase of retail investment products.

In Germany, a draft law is expected to be approved in a few months, which provides that where investment advice is provided to a customer an information form is to be made available to the customer promptly and prior to any sale for each financial instrument being recommended. The form must be short and easy to understand.

In Japan, the Financial Instruments and Exchange Act requires a document before concluding a contract containing a statement that the company is a financial instruments firm; and the registration number; an outline of the contract and any fees; a warning concerning potential losses; and information concerning applicable taxes, cooling off periods, and the name of the SRO of which the firm is a member.

In Letter to SEC, House Oversight Chair Questions Efficacy of Capital Formation Regulation

In a letter to SEC Chair Mary Schapiro, House Oversight Committee Chair Darrell Issa asked that the Commission consider whether its current regulations and actions contribute to the decline of capital formation. The letter was send in light of Facebook's recent attempt to raise additional equity capital while avoiding the burdens of SEC registration, and the SEC's subsequent examination into the strategy employed by Facebook

The letter highlights outdated laws that place an arbitrary cap on the number of shareholders permitted to own private entities. It questions whether quiet period restrictions are appropriate given modern communications, the trend toward improved disclosure and the need for transparency. In addition, it poses constitutional questions regarding the legality of restricting communications to investors under the quiet period. The letter also asks the SEC to answer whether the risk of diminished regulatory reach poses a conflict of interest that prevents the SEC from acting in the best interest of markets and investors.

The letter states that the SEC should take all possible steps to arrest the decline of capital formation, both public and private, and expand opportunities for domestic entities to raise capital within the U.S. It should investigate the causes of the decline in the competitiveness of the public markets. It should likewise consider whether the complex rules and restrictions that govern private capital formation are appropriate

Senator Shelby Outlines Process for Drafting GSE Reform Legislation in Banking Committee

As the House Financial Services Committee prepares to mark up legislation reforming government-sponsored enterprises and the secondary market form mortgage-backed securities, Senator Richard Shelby outlined a two-tier hearings process in the Banking Committee before drafting legislation. While committed to passing legislation to reform the GSEs, the Ranking Member said that the Banking Committee must first clearly identify the problems the legislation will be intended to solve. Without that examination, said the Senator, the Committee will again yield to the temptation of picking a solution before it has accurately described the problem. Legislation should be driven by facts, he emphasized, not by pre-determined outcomes.

Sen. Shelby proposed that the Committee establish a formal process for considering reform, including a series of hearings that are preceded by comprehensive staff work. First, the Committee should hold a series of investigative hearings to examine Federal housing policy and the housing finance system. These hearings would seek to determine what aspects of the system have worked well and should be retained, as well as which aspects should be reformed. As part of these hearings, the Committee would also examine what caused the failures of Fannie Mae and Freddie Mac.
The Committee would next gather proposals for reforming the housing finance system from a wide array of interested parties across industry, academia and the public. The Committee should then commence a second series of hearings examining the costs and benefits of these proposals, directly applying the lessons learned from our first round of hearings.

Once the Committee has identified the problems and researched the potential solutions, the final phase will be the drafting of legislation. Not only is this the proper way to produce legislation on a subject as complex and important as housing finance, said the Senator, it also offers the best chance of forging a bipartisan consensus on legislation.

Construing Delaware Law, Federal Appeals Court Rules Disclosure of Conflict of Interest Does Not Excuse Breach of Duty of Loyalty

A federal appeals court has ruled that a director’s disclosure of a conflict of interest does not excuse an alleged breach of fiduciary duty involving a duty of loyalty. It just excuses the conflict. To have a conflict and to be motivated by it to breach a duty of loyalty are two different things, reasoned a Seventh Circuit panel, the first a factor increasing the likelihood of a wrong, the second the wrong itself. Thus, a disloyal act is actionable even when a conflict of interest is not, said Judge Posner, one difference being that the conflict is disclosed and the disloyal act is not. CDX Liquidating Trust v. Venrock Associates, CA-7, No. 10-1953, Mar 29, 2011).

The case involved bridge loans made to the company that may have disadvantaged it in later attempts to sell the company. The director was also a director of one of the firms that made the bridge loans to the company.

Under Delaware law, when directors are sued for breach of their duty of loyalty or care to the shareholders, said the panel, their first line of defense is the business-judgment rule, which creates a presumption that a business decision, including a recommendation or vote by a corporate director, was made in good faith and with due care. But the presumption can be overcome by proof that the director breached fiduciary duties to the corporation, duties of loyalty and due care. If the business judgment rule is rebutted, the burden shifts to the defendant directors, the proponents of the challenged transaction, to prove to the trier of fact the entire fairness of the transaction to the shareholders. The shift to entire fairness makes sense in cases governed by the business judgment rule, reasoned the panel, since the rule creates such a commodious safe harbor for directors that overcoming it requires a very strong showing of misconduct.

Delaware law permits the shareholders to adopt a charter provision exculpating directors from liability in damages for failure to exercise due care, but does not enforce a provision exculpating them from liability for disloyalty. Thus, the compay’s articles of incorporation were not effective in waiving the director’s duty of loyalty, and so proof of their disloyal acts (had the jury been permitted to find that they’d indeed committed those acts) would have placed on them the burden of proving the entire fairness of the bridge loans.

There was enough proof that the alleged misconduct caused loss to company shareholders to make the issue of causation one for the jury no matter which side has the burden of proof. It was after the dot-com bubble burst, and only a few months before the company was sold for $55 million, that a similar company was sold for $300 million. The company could not hold out for a comparable deal because of the terms of the bridge loans. Thus, there was some evidence that company shareholders were hurt by director misconduct, over and above the hurt inflicted by events over which the defendants had no control.

North Carolina Clarifies Financial Reporting Requirements for IAs with Custody

North Carolina-registered investment advisers with custody of their clients’ funds or securities or who require prepayment of advisory fees of at least $500 per client six months or more in advance must send the North Carolina Securities Division a copy of an audited balance sheet within 90 days of the advisers’ fiscal year-end, effective March 11, 2011 by policy statement bulletin. The balance sheet must conform to generally accepted accounting principles and be audited by an independent public accountant or CPA in accordance with generally accepted auditing standards accompanied by an opinion as to the advisers’ financial position with a note about the principles used to prepare it, the basis of included securities, and other any explanations needed to clarify the opinion. North Carolina-registered investment advisers with discretionary authority over their clients’ funds or securities must send the North Carolina Securities Division a copy of a balance sheet (that may be unaudited) within 90 days of the advisers’ fiscal year-end. The balance sheet must conform to generally accepted accounting principles and include a representation by the preparer that the balance sheet as true and accurate as of the investment advisers’ fiscal year-end.

Tuesday, March 29, 2011

House Committee Unveils Eight Pieces of Legislation to Reform GSEs

As part of its plan to reform the secondary market for mortgage-backed securities, the House Financial Services Committee unveiled eight pieces of legislation reforming government-sponsored enterprises such as Fannie Mae and Freddie Mac. This legislation is in addition to the main reform vehicle introduced earlier by Committee Vice-Chair Jeb Hensarling (R-TX), the GSE Bailout Elimination and Taxpayer Protection Act (HR 4889), that applies only to Fannie Mae and Freddie Mac and establishes a finite end to the GSEs’ conservatorship 2 years from the date of enactment. Upon the end of the conservatorship, FHFA must evaluate the financial viability of each GSE. If it is determined not to be viable, FHFA would follow the procedure laid out by the Housing and Economic Recovery Act of 2008 (P.L. 110-289) for placing that GSE into receivership.

Rep. Scott Garrett (R-NJ), Chair of the Capital Markets Subcommittee. is the lead sponsor of legislation to prohibit the exemption of GSE securities from the risk-retention requirements of Dodd-Frank. The GSE Credit Risk Equitable Treatment Act would clarify that Fannie Mae and Freddie Mac will be held to the same standards as any other secondary mortgage market participants. Under Dodd-Frank, Fannie and Freddie would still be able to purchase a mortgage from a financial institution that falls outside of the Qualified Residential Mortgage (QRM) definition and issue asset-backed securities backed by non-QRM assets.
The Garrett legislation would clarify that a GSE loan purchase or asset-backed security issuance would not affect the status of the underlying assets. If the GSEs purchase a non-QRM loan, all lender risk-retention requirements will still apply, and if the GSEs issue a non-QRM security, all securitization risk retention rules will still apply.

Regulations proposed by the SEC and the banking agencies would provide that Fannie Mae and Freddie Mac will be able to satisfy the risk retention requirement through their guarantees (which cover 100% of principal and interest) as long as they continue to operate under the conservatorship or receivership of the FHFA and with direct government support through the Treasury Department’s Senior Preferred Stock Purchase Agreement.

Introduced by Committee Chair Spencer Bachus (R-AL), the Equity in Government Compensation Act would establish a compensation system for employees of Fannie Mae and Freddie Mac that is consistent with other federal government employees. The legislation would suspend the current compensation packages for all employees at Fannie Mae and Freddie Mac and establishes a compensation system that is consistent with that of the Executive Schedule and the Senior Executive Service of the Federal Government. Now that Fannie and Freddie are owned by the government, reasoned the Committee, there is no reason that employees of Fannie and Freddie should not be paid like government employees. In addition, the bill expresses the sense of the Congress that the 2010 pay packages for Fannie and Freddie senior executives were excessive and that the money should be returned to taxpayers.

Rep. Ed Royce (R-CA) is the lead sponsor of legislation to permanently abolish the affordable housing goals of Fannie Mae and Freddie Mac. The GSE Mission Improvement Act permanently abolishes the GSEs’ affordable housing goals, which the Committee believes were a central cause behind the collapse of the GSEs. The ongoing goal of the GSEs should be to reduce risk to taxpayers, not expose them to further losses. By eliminating these requirements and ending the mandate that Fannie and Freddie buy riskier loans in the name of affordable housing in the United States, the bill is designed to protect American taxpayers going forward.
According to Rep. Royce, the passage of legislation in the early nineties required the government-sponsored enterprises to devote a significant portion of their business to specific affordable housing goals. To meet these goals, the GSEs purchased more than $1 trillion in ‘junk loans, which ccounted for a large portion of the mortgage giants’ losses.

Legislation sponsored by Rep. Judy Biggert (R-IL), Chair of the Housing Subcommittee, would ramp up oversight of Fannie Mae and Freddie Mac by establishing in statute an Inspector General within FHFA and providing the IG with additional law enforcement and personnel-hiring authority. The Fannie Mae and Freddie Mac Accountability and Transparency for Taxpayers Act would also require the GSE Inspector General to submit regular reports to Congress outlining taxpayer liabilities, investment decisions, and management details of Fannie and Freddie. Finally, the bill requires that these reports, along with a system to report waste, fraud, or abuse, be made publically available.

Rep. Randy Neugebauer (R-TX), Chair of the Oversight Subcommittee is the lead sponsor of legislation to direct the Federal Housing Finance Agency (FHFA) to increase the guarantee fees. The GSE Subsidy Elimination Act directs the FHFA to phase in an increase of the guarantee fees over two years so Fannie Mae and Freddie Mac price their guarantees as if they were held to the same capital standards as private banks or financial institutions. By gradually increasing their guarantee fees, the Committee believers that the playing field will be leveled so that private capital can re-emerge and thus decrease the government’s exposure to the housing market.

Vice Chairman Hensarling is the lead sponsor of legislation to cap the current portfolios of Fannie Mae and Freddie Mac and increase their annual attrition rate. The GSE Portfolio Reduction Act accelerates and formalizes the reductions in the size of the GSEs’ portfolios by setting annual limits on the maximum size of each GSE’s retained portfolio and ratcheting the limits down over five years until they have reached a sustainable level. In the first year, the GSEs would have their portfolios capped at no more than $700 billion, declining to $600 billion for year two, $475 billion for year three, $350 billion for year four, and finally $250 billion in year five.

Rep. David Schweikert (R-AZ) is the lead sponsor of legislation to prohibit Fannie Mae and Freddie Mac from engaging in any new activities or businesses. The GSE Risk and Activities Limitation Act bill prohibits Fannie and Freddie from engaging in any new activities or businesses. Currently, FHFA is preventing the entities from engaging in new activities, and Congress wants to ensure that stays that way by codifying that current practice. The legislation is intended to prevent taxpayers from taking on additional risk and allowing the GSEs to spread into other areas.

Rep. Steve Pearce (R-NM) is the lead sponsor of legislation to require formal approval by the Department of Treasury for any new debt issuance by the GSEs. The GSE Debt Issuance Approval Act requires the Department of Treasury to formally sign off on any new debt issuance by the GSEs. The legislation would require the formal legal authority of U.S. debt issuance to approve the issuing of agency debt, which is roughly the same as U.S. debt.

The Committee intends to conduct a markup of the legislation on April 5.

SEC and Banking Agencies Set to Propose Dodd-Frank Risk Retention Regulations with 5 Percent Benchmark and Conservative QRM Exemption

Consistent with the securitization and ``skin in the game’’ risk retention provisions of Dodd-Frank, the SEC and the Federal banking agencies will propose regulations this week requiring securitization sponsors to retain an economic interest equal to at least 5 percent of the aggregate credit risk of the assets collateralizing an issuance of asset-backed securities. The agencies will structure the risk retention requirements in a flexible manner that will allow the securitization markets for non-qualified assets to function in a manner that facilitates the flow of credit to on economically viable terms and is consistent with investor protection.

The proposed regulations will include disclosure requirements specifically tailored to each of the permissible forms of risk retention. The disclosure requirements are designed to provide investors with material information concerning the securitizer’s retained interests, such as the amount and form of the interest retained, and the assumptions used in determining the aggregate value of asset-backed securities to be issued.

The proposal will provides several options for the form in which a securitization sponsor may retain risk. For example, the securitizer can retain a 5 percent vertical slice of the asset-backed security interests, whereby the sponsor retains a specified pro rata piece of each class of interests issued in the transaction, that is, the sponsor must hold 5 percent of each tranche. Another option will be to hold a 5 percent horizontal first-loss position, whereby the sponsor retains a subordinate interest in the issuing entity that bears losses on the assets before any other classes of interests.

In addition to the base credit risk retention requirement, the proposed regulations would prohibit sponsors from receiving compensation in advance for excess spread income to be generated by securitized assets over time. This is accomplished by imposing a premium capture mechanism designed to prevent a securitizer from structuring an asset-backed security transaction in a manner that would allow the securitizer to take an up-front profit on a securitization before any unexpected losses on the securitized assets appeared that would pay the sponsor more up front than the cost of the risk retention interest it is required to retain.

The proposed regulations would also establish the conditions under which a residential mortgage would have the status of a qualified residential mortgage exempted from risk retention mandates. As required by the statute, the agencies developed these underwriting criteria through evaluation of historical loan performance data. Generally, qualified residential mortgages would be prohibited from having product features that add complexity and risk to mortgage loans, such as terms permitting negative amortization, interest-only payments, or significant interest rate increases.

The proposed definition of qualified residential mortgage would establish conservative underwriting standards designed to ensure that QRM loans are of very high credit quality.These standards would include a maximum front-end and back-end borrower debt-to-income ratios of 28 percent and 36 percent, respectively and a maximum loan-to-value (LTV) ratio of 80 percent in the case of a purchase transaction, as well as a 20 percent down payment requirement in the case of a purchase transaction.

With regard to other quailed asset classes, the proposed rules also would not require a securitizer to retain any portion of the credit risk associated with a securitization transaction if the asset-backed securities issued are exclusively collateralized by auto loans, commercial loans, or commercial real estate loans that meet robust underwriting standards designed to ensure that the loans backing the asset-backed securities are of very low credit risk. They were developed by the Federal banking agencies based on supervisory expertise.

Rather than providing an outright exemption, Dodd-Frank provides that a sponsor of an asset-backed securities issuance collateralized exclusively by loans that meet the underwriting standards must be required to retain less than five percent of the credit risk of the securitized loans. The proposal would set that number at zero percent.

The agencies were concerned that establishing a risk retention requirement between zero and five percent for qualifying assets within these asset classes may not provide sufficient incentives for securitizers to allocate the resources necessary to ensure that the collateral backing an asset-backed securities issuance satisfies the proposed underwriting standards, as there may be significant compliance costs to structure and maintain the retention piece of a securitization structure, irrespective of how it is calibrated, and provide required
disclosures to investors. The underwriting standards the agencies have proposed are conservative, as is appropriate for a zero percent risk retention requirement.

The regulations would prohibit a securitizer from hedging its required retained interest or transferring it, unless to a consolidated affiliate. However, hedging of interest rate or foreign exchange risk would be permitted, as well as pledging the required retained interest on a full recourse basis. Hedging based on an index of instruments that includes the asset-backed securities would also be allowed, subject to limitations on the portion of the index represented by the specific securitization transaction or applicable issuing entities.

Since the sponsor is the true decision maker behind the securitization transaction and determines what assets will be securitized, the regulations would provide that a sponsor of an asset-backed security transaction is the party required to retain the risk. The proposed rules define the term “sponsor” in a manner consistent with the definition of that term in the SEC’s Regulation AB, which defines ``sponsor’’ as the person who organizes and initiates an asset-backed securities transaction by selling or transferring assets to the issuing entity.

However, a securitization sponsor could allocate a proportional share of the risk retention obligation to the originator of the securitized assets, subject to certain conditions. This would have to be voluntary on the originator’s part, however, through a contractual agreement with the sponsor.

In order to ensure that the originator has skin in the game, the regulations would require the originator to be the originator for at least 20 percent of the loans in the securitization, take on at least 20 percent of the risk retention, and pay up front for its share of retention, either in cash or a discount on the price of the loans the originator sells to the pool.

Illinois Adopts by Emergency Written Exam for Salespersons Dealing Exclusively in Investment Banking

Salespersons intending to deal exclusively in investment banking must take and pass the Investment Banking Representative Examination (Series 79), as well as either the Series 63 or 66 Exam. FINRA is added to a definitions rule and replaces the NASD in the salesperson exam rule. These rule changes are adopted by emergency of the Illinois Securities Department, effective March 10, 2011 for a maximum 150 days.

Monday, March 28, 2011

Sen. Crapo Asks Regulators to Refrain from Uniform Risk Retention Rules for Commercial Mortgage-Backed Securities

In a letter to Treasury copied to the SEC, Senator Mike Crapo (R-ID) explained the intent behind the commercial mortgage-backed securities alternatives of the risk retention requirements of Section 941 of Dodd-Frank, which he authored. The Senator said that the legislative intent is for the regulations to offer alternative options with regard to commercial mortgage-backed securities as provided in Dodd-Frank and avoid the creation of a one-size-fits-all retention rule that could stifle a commercial real estate recovery before it can occur. He is concerned because, while the SEC and federal bank regulators must jointly adopt retention rules, there already have been several ad hoc rules from individual regulators that simply blanket a single retention framework broadly across all asset classes.

In order to support credit availability, Sen. Crapo urged the SEC and the other regulators to deliberately follow the statutory mandate to structure reforms for each unique asset class, including commercial real estate, home loans, automobile and student loans, and credit cards. Further, with a phased-in implementation, including two years for commercial mortgage-backed securities and consumer asset-backed securities after final rules, regulators should use the time to consider rules carefully and to better understand their impact on access to credit. Any review should also include an extensive examination of how the market is evolving and consideration of other developments such as the creation of market standards and other safeguards in the commercial real estate finance market that could assist regulators in their rulemaking.

With respect to commercial mortgage-backed securities, the provision in Section 941 mandates that there are several specific options for, as well as alternatives to, a percentage risk retention, including adequate underwriting standards, adequate representations and warranties and related enforcement mechanisms, and a percent of the total credit risk of the asset held by either the securitizer, originator or a third party investor. It follows, reasoned Sen. Crapo, that regulators should construct a joint rule effectuating these options in order to strengthen the commercial real estate market and support its recovery.

The Senator pointed to two reports mandated by Dodd-Frank that have reinforced the commercial mandate for risk retention. First, the Federal Reserve's October 2010 study cautioned that retention is not a panacea, and that if rules are not implemented carefully by asset class, credit availability could be disrupted at a time when it is desperately needed. The Federal Reserve report also suggested that regulators consider alternative ways other than retention to align interests. Second, the Financial Stability Oversight Council study on risk retention noted that there are several ways to accomplish retention for commercial mortgage-backed securities, including retention by a third-party investor, which the commercial provision recognizes as a viable option.

Community Bankers Endorse Bachus Legislation Replacing CFPB Director with Five Member Commission

The Independent Community Bankers of America support legislation to replace the Director of the Consumer Financial Protection Bureau with a five-member Commission modeled on the SEC and FTC. Commissioners would be appointed by the President and confirmed by the Senate to staggered, five-year terms, and no more than three commissioners would be affiliated with any one political party. Responsible Consumer Financial Protection Regulations Act of 201 (HR 1121) would requite that all Commissioners have strong competencies and experiences related to consumer financial protection. Presidential removal powers would be confined to inefficiency, neglect of duty, or malfeasance in office. HR 1121 has picked up 28 co-sponsors.

In a letter to House Financial Services Committee Chair Spencer Bachus (R-ALA), the sponsor of the legislation, the industry group said that the legislation is appropriate, given that the new CFPB will have far-reaching discretion in writing rules for all banks, including those exempt from primary CFPB examination, as well as non-bank financial services providers. A commission form of governance would allow for a variety of views on issues before the Bureau and thus build in a system of checks and balances that a single director form of governance simply cannot do. The commission model, which has worked well for the SEC and FTC would help ensure that the actions of the CFPB are measured, non-partisan and result in balanced, high quality rules and effective consumerprotection.

Senate Authors of Qualified Residential Mortgage Carve Out from Dodd-Frank Risk Retention Provisions Clarify Legislative Intent

With the SEC and the federal banking agencies set to consider risk retention rules under Dodd-Frank, the Senate authors of the qualified residential mortgage carve out have written to the Commission to clarify the legislative intent of the carve out, which is codified in Section 941. The Senators said that, under Section 941, the SEC and the federal banking agencies are directed to define qualified residential mortgage by taking into consideration underwriting and product features that historical loan performance data indicate result in a lower risk of default. Dodd-Frank provides a baseline risk retention amount of five percent of credit risk for securitized assets, but carves out qualified residential mortgages.

In their letter to the SEC, Senators Mary Landrieu (D-LA), Johnny Isakson (R-GA) and Kay Hagan (D-NC) said that any effort to impose a high down payment requirement for any mortgage to meet the qualified residential mortgage exemption standard would be inconsistent with legislative intent. The Senators assured the SEC that, while there was discussion on whether the qualified residential mortgage should have a minimum down payment in negotiations during the drafting of the provision, they intentionally omitted such a requirement.

According to the Senators, the purpose of the qualified residential mortgage exemption is to support a housing recovery by creating a robust underwriting framework that will attract private capital to support responsible lending and borrowing. In developing the QRM framework, the Senators recognized the importance of establishing a framework that would allow creditworthy first-time homebuyers to have access to the benefits of loans meeting the QRM standard. They also recognized that homeowners in the hardest hit housing markets have lost extraordinary amounts of equity and that a high down payment is out of reach for many of them.

A qualified residential mortgage with a high down payment requirement would force them to postpone buying or refinancing a home for years, or to take on mortgages at much higher interest rates. Consequently, the QRM framework set forth in Dodd-Frank specifically contemplates the inclusion of low-down payment loans, provided they have mortgage insurance or other forms of credit enhancement, to the extent such insurance or credit enhancement reduces the risk of default.

The Senators strongly urged the SEC and the banking agencies to adopt a QRM framework that follows the statutory framework and supports a housing recovery by ensuring that all financially responsible families will have access to the lower interest rates and borrower protections afforded by the qualified residential mortgage carve out.

The risk retention rules are challenging enough to write without the inclusion of extraneous issues, emphasized the Senators, and the qualified residential mortgage provisions of Section 941 are clear in their intent and provide regulators with an explicit framework to follow. The Senators also envision lenders, investors, housing groups and consumers having ample time to provide extensive comment on the proposals. The Senators intend to review the proposed regulations for risk retention and qualified residential mortgages.

Global Audit Firms and Corporate Groups Reject Presumptive Doubt as Part of Professional Skepticism in Financial Statement Audit

The auditing industry and their corporate clients have strongly rejected any suggestion of replacing the enquiring mind approach to the professional skepticism brought to an audit of financial statements with a presumptive doubt approach. Comment letters to UK Auditing Practices Board proposals to reinforce skepticism in the audit culture indicated a broad consensus that a presumptive doubt standard would increase the cost of the audit without a concomitant benefit and contradict international audit standards, which have essentially codified the enquiring mind standard enunciated by Lord Denning in a famous 1958 opinion. The ISAs took effect in the UK and Ireland for reporting periods ending on or after 15 December 2010.

ISA 200.13 defines professional skepticism in auditing standards as an attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence. Two global audit firms, KPMG and Baker Tilly, find the ISA definition consistent with professional skepticism as described by Lord Denning, who said that auditors must come to their task with an enquiring mind, not suspicious of dishonesty, but suspecting that someone may have made a mistake somewhere and a check must be made to ensure that there has been none. Fomento (Sterling Area) Ltd. v Selsdon Fountain Pen Co. Ltd. (1958). In an earlier opinion, Lord Lopes noted that the auditor is not bound to be a detective and does not have to approach the audit with suspicion or with a foregone conclusion that there is something wrong. In re Kingston Cotton Mill Company (1896).

In its comment letter, Baker Tilly said that presumptive doubt is contrary to the risk-based approach in the clarified ISAs. Audits planned on the basis of presumptive doubt would greatly increase the work needed to issue an opinion because auditors would have to plan their audits assuming that all the evidence they had been provided with by management was, at best, wrong or, at worst, a lie. The concomitant increase in audit cost for companies would be unjustified because it would not add to the quality of the audit.

Baker Tilly also noted that the key phrase in the ISA 200.13 definition of professional skepticism is the auditor being alert to conditions that ``may’’ indicate possible misstatement, which is very different from the presumptive doubt approach suggested by the Board under which an auditor assumes that there is possible misstatement. This is reinforced by ISA 200.15 which requires the auditor to plan and perform an audit with professional skepticism recognizing that circumstances may exist that cause the financial statements to be materially misstated. Again, the use of ``may’’ indicates that the auditor does not assume that such circumstances do exist, reasoned the audit firm, but nevertheless plans the audit recognizing the possibility that they may.

In its comments, the Confederation of British Industry noted that auditors are required to exercise an enquiring mind. The proposed new test of presumptive doubt seems to require auditors to dig much deeper, said the CBI, and such a change would result in significantly more work for the audit firm and significantly more cost for the audit client company. It is not clear to the CBI that auditor skepticism through the exercise of an enquiring mind has failed. Thus, a move to presumptive doubt is not consistent with the risk-based approach to audit regulation and the requirement for auditors to carry out additional work only where significant risks are identified.

According to conmments by the Institute of Chartered Accountants in England and Wales, auditor skepticism is a fundamental requirement of any audit conducted under international auditing standards and therefore a mindset of professional skepticism should pervade all aspects of ISA audits. The ICAEW questioned whether there should be a presumptive doubt approach. The ICAEW believes that audits conducted with a skeptical mindset in accordance with the clarified ISAs should be sufficient to demonstrate high audit quality to relevant stakeholders and the level of work will be appropriate given the risks identified by auditors in accordance with the ISAs. The ICAEW is not convinced of the need to require or expect anything beyond what is envisaged in the clarified ISAs.

Noting that the term presumptive doubt is not used in the international auditing standards, PwC believes that having an initial mindset of presumptive doubt reflects an approach that assumes management is dishonest. Starting with a presumptive doubt mindset would result in procedures far beyond a questioning mind and the established concept of an enquiring mind. More broadly, it would go against the grain of risk-based standards for an auditor to take a presumptive doubt approach in all circumstances

According to PwC, the auditor starts from a neutral mindset and, based on a robust understanding of the company and its environment, performs a risk assessment to the level of evidence needed to respond to the assessed risk of material misstatement. For significant risks of material misstatement the international auditing standards require the auditor to perform additional procedures.

In its comments, Deloitte also challenged the use of the term presumptive doubt, which the firm believes goes much further than the established concept of an enquiring mind. A change to presumptive doubt would significantly increase business costs and runs contrary to a risk-based approach, which emphasizes the need for the application of further procedures only where significant risks are identified.

In its feedback statement, the Board said that the reaction to what was meant by presumptive doubt was a misunderstanding. The Board said that it had used the term as it had been used in academic research, as meaning the auditor exhibiting a heightened awareness of the risk that the figures could be affected by error or dishonesty rather than making the assumption that there was a misstatement.

Sunday, March 27, 2011

IAASB Examines Implications of Evolving Financial Statement Disclosures for the Outside Auditor

An International Auditing and Assurance Standards Board discussion paper on the evolving nature of financial statement disclosure and its implications for the independent audit has been praised by PCAOB Standing Advisory Group members as containing a complete discussion of these highly important and sometimes contentious issues which arise against the backdrop of the efficacy of company financial statements for investors and other users. The study also arises as disclosures, which were once related directly to further explanations of line items on the face of the financial statements, have grown more complex and include items such as significant accounting policies, judgments made in the process of applying such policies, assumptions and models relevant to the calculation of items in the financial statements, and descriptions of risk management policies. Adding to the complexity is the use of fair value estimates for items measured at historical or amortized cost, or even by computer models, in order to disclose the fair value of reclassified financial assets.

At the same time, there has been some blurring of the boundaries of the traditional financial statements. For example, under IFRS 7, certain mandated disclosures can be presented outside of the financial statements in a document that is made available on the same terms as the financial statements and at the same time, using cross references from the financial statements.

A threshold issue identified by the Board is the materiality of disclosure, which is a pervasive concept in auditing, as well as in all federal securities law disclosures. One view is that accounting standard setters have applied a materiality filter in setting accounting standards and have judged disclosures to be material if the related line item is material. Since both preparers and auditors desire to have the financial statements include all required disclosures, some companies may believe that it is easier to include the requested disclosure rather than try to prove to the auditor that the disclosure is immaterial.

In the Board’s view, this could lead to voluminous disclosures that obscure important information from investors. IFRS 7 notes the need to strike a balance between overburdening financial statements with excessive detail that may not assist users and obscuring important information as a result of too much aggregation. This requires companies and auditors to exercise judgment in determining how much disclosure to provide and how it should be presented. That said, the Board noted that lengthy and complex disclosures may be necessary in many instances to fully inform users of financial statements of the key aspects of the company‘s financial position, performance and cash flows.

Another materiality issue concerns how to apply materiality to quantitative disclosures of financial instruments, such as disclosure of the nominal contract amounts of derivatives. In contrast, applying materiality to qualitative disclosures poses very different challenges. A key consideration is likely to be finding a balance between competing demands such as understandability of disclosures and excessively lengthy financial statements. Auditors need to consider whether the assertion of understandability has been met in respect of these disclosures, which is a subjective judgment, leading to disagreements with management that may be difficult to resolve.

Fair Presentation

The issue of materiality must be considered in the broader fair presentation context. Many financial reporting frameworks require financial statements to be true and fair (UK) or present fairly (US), which implies a need for the financial statements to do more than just comply with a checklist of accounting requirements and disclosures, but rather aim for overall transparency of the company’s financial position, performance and cash flows.

The concept of fair presentation has broken into two camps: those that believe that presents fairly means compliance with the financial reporting framework and those that believe that fair presentation is an overarching concept that goes beyond compliance with the financial reporting framework.

UK regulators have noted that, when the accounting standards do not specify disclosures, in such circumstances, the auditor needs to evaluate whether additional disclosures may be necessary to give a true and fair view, which means challenging management‘s accounting estimates and the appropriateness of their disclosures.

According to the IAASB, a key question to be explored is whether expectations in this regard can be reasonably met, recognizing that the adequacy of the disclosures is likely to be judged in hindsight once events have unfolded

A further aspect of presents fairly concerns the understandability, prominence and presentation of key disclosures in the context of the financial statements as a whole. Some would like auditors to give greater focus to the understandability of the financial statements, which may include the extent to which they tell the story of the company’s financial position, performance and cash flows. One factor in assessing presents fairly is the prominence of key disclosures. It may be argued by some that key disclosures should be easy to find and early in the notes to the financial statements, rather than towards the back of the financial statements.

Audit Evidence

Audit evidence is another important issue in the auditor‘s consideration of financial statement disclosures, that is, what constitutes sufficient appropriate audit evidence in relation to different categories of financial statement disclosures. It is important to recognize that the objective of the auditor is not to form an opinion on each individual disclosure in the financial statements.

International auditing standards require the auditor to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement. Auditors are looking for sufficient appropriate audit evidence to enable them to draw reasonable conclusions on which to base an opinion on whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework.

Different issues about audit evidence arise with different types of disclosures. The evidence regarding the amounts included in the related note disclosures, such as categories of property, plant and equipment and related amortization, will often be obtained in the course of auditing the assertions for the related line item rather than as a separate evidence gathering exercise. The auditor obtains some of the evidence regarding the information in operating segment disclosures in the process of obtaining evidence on the full financial statements.

A note disclosure supporting a line item recorded at fair value extends to describing the judgments, assumptions and model, if any, used. Therefore, the auditor seeks audit evidence about whether the disclosure is an accurate portrayal of the basis for the calculation of the fair value.

Another disclosure that helps illustrate the different issues is a risk disclosure required under IFRS 9, which includes a description of an internal control. For such a disclosure, questions arise as to whether the focus of the auditor‘s work is on whether the description of the control is accurate or whether the auditor is expected to test that the internal control is also operating effectively.

The ISAs are premised on management assuming responsibility for the preparation and fair presentation of the financial statements and, while not explicitly stated in the ISAs, having a sufficient basis, read evidence, to support their disclosures. This leads to the question of what is adequate support for management‘s disclosures, particularly for the newer and more subjective categories of disclosures.

Professional Skepticism

Closely related to the topic of sufficient appropriate audit evidence are calls for an examination of the use of professional skepticism. UK regulators have emphasized the importance of auditors applying a high degree of professional skepticism when examining key areas of financial accounting and disclosure which depend critically on management judgment. Both the FSA and the FRC believe auditors need to challenge management more. The Board recognizes the perception that auditors may not be exercising sufficient judgment regarding disclosures in the financial statements, that they may not be sufficiently challenging management.

Saturday, March 26, 2011

IOSCO Begins Initiatives to Involve Securities Regulators in Mitigating Systemic Risk

IOSCO has issued a discussion paper on the enhanced role that securities regulators can play in mitigating systemic risk through better surveillance, transparency, and the imposition of position limits. Traditionally, securities regulators have focused on transparency and disclosure. But IOSCO wants to push the envelope further out by having securities regulators monitor and manage systemic risk to the financial system. IOSCO believes that securities regulators can and should play a key role in addressing systemic risk. To do this, they need to incorporate the goal of reducing systemic risk into their everyday tasks and processes

This new role will require the development of a methodology for identifying, analyzing, monitoring and mitigating systemic risk, and promoting financial system stability. In turn, thus will require securities regulators to expand their role to enhance market transparency and disclosure, gain a better understanding of financial innovation that appreciates its potential risks and finds a balance between unrestrained innovation and overregulation, devote more internal resources to monitoring market developments and identifying emerging risks; and engage with other national and international regulators, and central banks and self-regulatory organizations, to produce a more robust, coordinated framework for promoting financial system stability.

The tools that IOSCO suggests securities regulators consider using to do this job include measures to improve transparency, business conduct rules, organizational, prudential and governance requirements, and emergency powers. Disclosure and transparency are critical for identifying emerging systemic risk. These are also what arm regulators for addressing it. Also necessary is robust regulatory supervision of business conduct essential for managing conflicts of interest and the build-up of undesirable incentive structures within the financial system.

Concretely, monitoring and tacking excessive leverage and concentration in the market will be very important in mitigating systemic risk. Securities regulators traditionally monitor firms and customers controlling or owning large positions in particular securities or derivatives. The goal is to prevent market manipulation but also to identify any risks relating to significant concentrations in the market, such as through counterparty risks.

The financial crisis has given impetus and a legislative imprimatur to these efforts. In Hong Kong for example, statutory position limits have been imposed on most of the derivatives products traded on the exchange. In the United States, the Dodd-Frank Act allows the CFTC to impose position limits across different markets, including the energy and agricultural markets, and with respect to trading in certain OTC derivatives. In March 2009 the IOSCO Task Force on Commodity Futures Markets called on all futures market regulators and other relevant authorities to have access to information that permits them to identify concentrations of positions and the overall composition of the market, comparable to the authority which the CFTC already has. Reforms of the commodities markets are also expected in the European Union in 2011.

Dodd-Frank also enhanced the regulation of hedge funds to allow the tracking of the potential for a hedge fund or group of funds to have systemic implications because of relative size or presence in a market. IOSCO has developed a template to enable the collection and exchange of consistent and comparable data amongst regulators and other competent authorities for the purpose of facilitating international regulatory cooperation in identifying possible systemic risk in the hedge funs area.

The new framework for hedge funds will allow regulators to better monitor their leverage through borrowing or from positions held in derivatives, as well as some other information such as the extent and nature of funding counterparty exposure. Regulators will then have the information necessary to take actions to impose limits on leverage when the stability and integrity of financial markets may be weakened.

In recent remaks, Jane Diplock, IOSCO Chair and Chair of the New Zealand Securities Commission, each IOSCO member will determine its response to this imperative based on its own mandate and domestic regulatory structure, as well as the size and characteristics of its securities market. Individual regulators will need to judge the scale of their response. They will need to develop their own risk indicators in the form of both qualitative information gained by general market surveillance, review of products and securities offerings, and business conduct oversight and quantitative data such as micro and macro-level indicators.

They will also need to judge the extent to which they can leverage, rather than duplicate, the work of other regulators, particularly by sharing information, combining expertise and coordinating action through such bodies as the Financial Stability Board and the Basel Committee, as well as IOSCO itself.

Friday, March 25, 2011

Global Hedge Fund Assoc. Opposes SRO for US Investment Advisers

Against the backdrop of Dodd-Frank mandated studies on the efficacy of an SRO to oversee investment advisers, the global hedge fund industry has raised the specter that delegating oversight to a SRO could impact the ability of US investment advisers to access European markets and use the management passport provided to third-country managers under the EU’s Alternative Investment Fund Managers Directive. In a letter to the SEC, the Alternative Investment Management Association also said that it is not clear if an SRO could inspect registered investment advisers outside the US who have US investors since SROs are not currently subject to memoranda of understanding with foreign market regulators. Moreover, there is no certainty that non-US regulators would agree to an include an SRO in the MOUs, leaving the SRO with no authority to operate outside the US. For these and other reasons, the association supports full oversight and regulation of investment advisers by the SEC

In addition, SROs for investment advisers do not exist in any other major financial jurisdictions, noted the association, and have been abandoned as a concept in a number of important hedge fund jurisdictions, including the United Kingdom. Indeed, the current trend globally in implementing new regulatory regimes appears to be moving away from reliance on third parties such as SROs and away from delegating important responsibilities to non-governmental bodies. For example, the Financial Stability Board, which has been tasked by the G-20 with helping to globally harmonize financial regulation, is skeptical of any reliance on or use of the work of third parties.

Further, the association said that the use of an SRO for investment advisers may give rise to a public impression that the industry is not properly regulated or overseen, leading to a lack of confidence in investors as to availability of proper protection. An SRO may also lead to duplicative regulatory requirements, which in turn may lead to confusion over which body has regulatory responsibility. An SRO would also place a disproportionate and unjustifiable cost on the advisory industry by membership fees and additional compliance costs, which may ultimately be borne by investors.

PCAOB Advisory Group Members Praise IAASB Paper during Discussion on Financial Statement Disclosure

Against the backdrop of a growing global concern with the efficacy of financial statement disclosures, the PCAOB’s Standing Advisory Group examined issues around financial statement disclosures during their March meeting. PCAOB Member Dan Goelzer began the meeting by noting that financial statement disclosures have evolved and are still evolving significantly in their extent and nature. The increasing complexity of business transactions, including off-balance sheet transactions and non-recognition of assets and liabilities, as well as the increased use of fair value and other accounting estimates, have all augmented the importance of financial statement disclosures. PCAOB Chairman James Doty said that a major challenge in the post-Enron, post-financial crisis world is how can the auditing of the financial statement come to grips with non-quantitative disclosure in the financial reporting model.

SAG members especially and favorably noted the IAASB policy paper on financial statement disclosure. The discussion paper, entitled The Evolving Nature of Financial Reporting: Disclosure and Its Audit Implications, was released for public comment earlier this year and explores key issues relating to disclosures in financial statements. The paper highlights recent trends in the range, volume, and complexity of financial statement disclosures, and explores issues and practical challenges in preparing, auditing, and using them.

In the view of SAG member, and Grant Thornton senior partner, John Archambault, the IAASB paper lays out the complete issues on the evolving nature of financial reporting disclosure. Mr. Archambault, who also serves on the IAASB, said that the Board is looking for robust responses on its discussion paper from a wide variety of stakeholders. He said that the IAASB would provide input to the PCAOB as it gets responses. He noted that risk standards point auditors to what they should consider for disclosures, adding that risk based standards are conceptually going in the right direction. Echoing these comments, SAG member, and KPMG national managing partner, Sam Ranzilla said that the IAASB discussion paper was excellent and asks all the right questions. He urged the PCAOB to get involved with the IAASB effort.

SAG member, and former FASB chairman, Dennis Beresford outlined three approaches to financial statement disclosure. The first is the overall conceptual approach that aims to provide all the information users need to understand the financial statement. The second way is the specific topic approach that FASB generally uses under which FASB will focus on a specific topic, such as pensions or leases, and place the disclosure around the topic. Under this approach, disclosure is not looked at holistically.

The third approach is a subset of the other two and is what the Mr. Beresford calls the `trees approach, ’’ which envisions a long GAAP checklist of items of individual disclosure requirements, some which are freestanding and some of which are linked to specific topics. The problem for companies is that there is no basis or guidance for deciding what to put in. He urged the PCAOB to begin a project aimed at a standard that looks for specific auditing requirements to ferret out the ``trees approach.’’.

SAG member Gaylen Hansen, and Director of Accounting and Auditing Quality Assurance, Ehrhardt Keefe Steiner & Hottman, said that a holistic approach to financial statement disclosure is laudable but that it would be a challenge to apply such an approach to disclosure decisions made under time pressure by preparers of financial statements. He added that a holistic approach to financial statement disclosure applied in hindsight would not be very helpful.

Financial Services Companies Fear that Proposed SEC Whistleblower Rules Could Breach Customer Information Walls

In a letter to the SEC, banking and financial services associations cautioned that the Commission’s proposed whistleblower rules would create powerful financial incentives for unscrupulous persons to download, copy, and steal confidential corporate and customer information in order to substantiate their claims and receive monetary rewards. Financial services companies are particularly concerned about data breaches, said the letter, because so much of their corporate information consists of non-public customer information. Whistleblowers who download information to support their claims may, deliberately or inadvertently, come into possession of such customer information.

In the joint letter, the Financial Services Roundtable and the American Bankers Association said that the costs to the banking and financial services industry of preventing and detecting data breaches, and notifying customers when their information is at risk of misuse, is already huge. Moreover, once corporate and customer information leaves its corporate data environment, especially if it leaves in electronic form, further distribution is virtually guaranteed. The associations believe that there is no good reason to create new incentives for such breaches.

Proposed Rule 21F-4(b)(4)(vi) provides that the SEC will not consider information to be derived from the whistleblower’s independent knowledge if the knowledge upon which the analysis is based is obtained in violation of federal or state criminal law. The Proposing Release says that a whistleblower should not be rewarded for violating a federal or state criminal law, doubting whether Congress intended to encourage whistleblower assistance to a law enforcement authority where the assistance itself is undertaken in violation of law. The Proposing Release asks whether the exclusion is appropriate, whether it should extend to other types of criminal violations, and whether it should exclude persons who provide information in violation of judicial or administrative orders.

In the letter, the associations said that bounties should not be paid for reports based on information obtained in violation of any civil law prohibition, including any legal or regulatory privacy requirement, any foreign civil or criminal law or regulation, any other legal proscription, or any company policy designed to facilitate compliance with such. Quite simply, they said, violations of such laws, court orders, legal proscriptions or company policies should not be rewarded.

The industry urged the SEC to ensure that the whistleblower program includes provisions clarifying that whistleblowers responsible for obtaining information in violation of any of the above prohibitions will not be protected by the anti-retaliation provisions, and will be subject to criminal prosecution and/or civil actions under applicable state and federal law.

Thursday, March 24, 2011

Pending COSO Updated Internal Controls Framework Discussed by PCAOB’s Standing Advisory Group

The March meeting of the PCAOB's Standing Advisory Group included an examination of the pending revised internal controls framework being developed by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). Describing the update as a welcome development, PCAOB Member Lewis Ferguson said that the update will make the COSO internal control framework more relevant to the complex global business environment.

Section 404(a) of Sarbanes-Oxley requires that annual reports filed with the SEC must be accompanied by a statement by company management that management is responsible for maintaining adequate internal controls. In the report, management must also present its assessment of the effectiveness of those controls. In addition, Section 404(b) requires the company's auditor to report on and attest to management's assessment of the company's internal controls

SEC rules require that management's evaluation of a company's internal controls pursuant to Section 404 must be based on a suitable, recognized control framework established by a body that follows notice and comment procedures. The Commission has identified the COSO internal controls framework as such a framework.

While PCAOB auditing standards are neutral regarding the internal control framework that auditors use for testing and evaluating controls, Board standards require auditors to use the same internal control framework that management uses and the overwhelming majority of U.S. public reporting companies use the COSO framework. Changes to the COSO framework would thus have significant implications for audits conducted in accordance with PCAOB standards. Changes to the COSO framework could lead companies to make changes to their controls, their control documentation or management's process for assessing the effectiveness of internal controls which, in turn, could affect the auditor's procedures regarding internal controls.

COSO officials told the SAG that the enhancements to the framework are not intended to alter the core principles of the framework, but to facilitate a more robust discussion of internal controls. Concepts and guidance in the framework will be refined to reflect the evolution of the operating environment and the changed expectations of regulators and other stakeholders. In addition, the enhancements are expected to cover more than financial reporting by considering ways to enrich the guidance on operations and compliance objectives.

COSO has engaged PricewaterhouseCoopers to support its update of the framework. PwC will work under COSO's direction in developing the updated framework. COSO will conduct the update pursuant to rigorous due process. In order to ensure a broad representation of perspectives, COSO is forming an advisory council comprised of representatives from industry, academia, government agencies and nonprofits to provide input as the project progresses. In addition, the updated framework will be exposed for public comment. COSO intends to issue an exposure draft this year, with final adoption of a revised framework planned for next year.

COSO envisions two documents emerging from the revision process. The first document will be the updated overall internal controls framework, which will supersede the original 1992 framework. COSO’s 2006 small business guidance will also be superseded and folded into the revised framework.

A second document will deal with applying the framework in the financial reporting arena, such as in Section 404 areas. The COSO officials hastened to add that the internal controls framework is not being bifurcated. The first document is the updated framework, while the second document is guidance in specific areas.

COSO believes that the impact of the revised framework on governance will be positive. The framework will also provide a better understanding of programs supporting fraud deterrence.

SAG member, and Duke University Law Professor, James Cox asked if COSO has considered the carve out from the Section 404(b) auditor attestation requirement in the Dodd-Frank Act for small companies in light of the fact that most abuses are disproportionately found in smaller issuers. He asked if the framework would bifurcate companies exempt from 404(b) from those that are non-exempt. The COSO officials said that they have not considered this, noting that COSO is not the regulator. They said that the core internal controls framework is important and relevant for all companies, exempt or not. Former PCAOB Chief Auditor, and SAG member, Douglas Carmichael noted that, while COSO may not be a regulator, COSO is effectively the center of internal controls standards and as such plays a vital public interest role through the Section 404 mandates.

With regard to the carved out small companies, SAG member, and Director of Accounting and Auditing Quality Assurance at Ehrhardt Keefe Steiner & Hottman, Gaylen Hansen suggested that COSO do something in the risk assessment area to ascertain if company management did what 404(a) commands it to do, not to audit management’s conclusions of the effectiveness of the internal controls, but to tie it in to risk assessment, without conducting an audit.

Regarding the Dodd-Frank carve out, PCAOB Chairman James Doty asked COSO to help enable the Board to direct auditors to look for fraud in smaller companies. COSO officials replied that they could make guidance more robust in this area. Chairman Doty also said that there should be a consideration of whether risk assessment standards should require a determination that company management has taken into account the COSO guidelines outside of a 404(b) attestation requirement.

Given the fact of global financial markets, SAG member, and CalPERS official, Mary Hartman Morris questioned whether COSO could make the updated framework less US centric. COSO officials responded that are obtaining the views of the International Federation of Accountants in preparing the revised framework. While noting that they are not obligated to fully harmonize the COSO framework with non-US guidance, COSO officials said that the revised internal controls framework must be globally meaningful and relevant.

They are also aware that non-US users and jurisdictions would discount the framework if it was too US-centric. Furthermore, they noted that the sponsoring organizations of the Treadway Commission, which include the AICPA and the Financial Executives International, have many members outside the US, and COSO has a duty to these non-US stakeholders.

SAG member, and former SEC Chief Accountant Lynn Turner noted that the original COSO framework was missing a principle that the SEC staff had wanted to include, which was the need for companies to identify changes and trends. In light of the financial crisis, said Mr. Turner, that pillar should have been in the framework. He asked COSO to consider including it in the updated framework.

Noting the Sarbanes-Oxley Sec. 407 requirement that companies disclose if they have a financial expert on the audit committee, SAG member, and Eli Lilly & Company Chief Accounting Officer, Arnold Hanish said that there is a need to beef up financial experts on boards. He said that there is no firm definition of what a financial expert is, and that there is a wide variety of people calling themselves financial experts. Given the complexity of FASB standards, audit committees must have true financial expertise, he emphasized, so that the right questions get asked of auditors. This should be baked into governance. COSO officials agreed that there is a wide difference among financial experts and offered that guidance could be drafted to help determine what good governance is in this regard.

House Financial Services Committee to Mark Up GSE Reform Legislation

After a hearing on GSE reform on March 31, the House Financial Services Committee will mark up a bill reforming Fannie Mae and Freddie Mac on April 5. The GSE Bailout Elimination and Taxpayer Protection Act, HR 1182, was introduced by Committee Vice Chairman Jeb Hensarling (R-TX) and is co-sponsored by Committee Chairman Spencer Bachus (R-ALA). The legislation sets a deadline for the Director of the Federal Housing Finance Agency (FHFA) to terminate the conservatorship of Fannie or Freddie upon a determination that it is financially viable to do so. The Director would be required to appoint the FHFA immediately as receiver of either enterprise if it is found not to be financially viable. Moreover, the legislation prescribes a deadline and procedures for the winding down of operations and dissolution of an enterprise. The legislation is very similar to the GSE Bailout Elimination and Taxpayer Protection Act (HR 4889) that Rep. Hensarling introduced in the 111th Congress.

The legislation applies only to Fannie Mae and Freddie Mac and establishes a finite end to the GSEs’ conservatorship 2 years from the date of enactment. Upon the end of the conservatorship, FHFA must evaluate the financial viability of each GSE. If it is determined not to be viable, FHFA would follow the procedure laid out by the Housing and Economic Recovery Act of 2008 (P.L. 110-289) for placing that GSE into receivership.

If determined to be viable, the GSE would be allowed to resume limited market operations under its own control for a maximum of three years under strict new rules. There will be enhanced authority for FHFA to adjust the minimum capital requirements for the GSEs as appropriate, mirroring the existing capital adequacy requirements other regulators already have in place for banks. The legislation repeals the exemption allowing GSE securities to avoid full SEC registration. At the end of that 3 year period, Fannie and Freddie must conduct all new operations as fully private sector companies competing on a level playing field without any government advantages.

Wednesday, March 23, 2011

House Legislation Raising the Regulation A Exemption Threshold Gains Favor Conditioned on Audited Financial Statements

Support is growing for House legislation designed to encourage small companies to access the capital markets by increasing the offering threshold for companies exempted from SEC registration under Regulation A from $5 million to $50 million. The SEC has the authority to raise this threshold but has not done so for almost two decades. The Small Company Capital Formation Act, sponsored by Rep. David Schweikert (R-AZ), would also require the SEC to re-examine the threshold every two years and report to Congress on decisions regarding the adjustment to the threshold.

Financial Services Committee Chairman Spencer Bachus (R-ALA) said that amending Regulation A to make it a viable channel for small business to access capital will result in economic growth and more jobs. Small business creates most of the new jobs in the country, he added, and also new and better products that are so necessary to keep a mature economy vibrant and competitive. Rep. Schweikert emphasized that taking a small company public is an important, but expensive process that requires millions in underwriting costs. Raising the Regulation A threshold to $50 million is one way to lower those costs and promote economic growth and job creation.

In testimony before the Committee, Grant Thornton applauded the Small Company Capital Formation Act as the beginning of a campaign to bring back the small IPO market. The bill does three things that are enormously beneficial for small companies, said GT. First, it will drive down costs for issuers by permitting the use of a simpler Offering Circular for the SEC’s review. Second, it opens up the Regulation A exemption to a size that will allow companies to list on the NYSE and NASDAQ and to avail themselves of the so-called Blue Sky exemption, thus avoiding very costly state-by-state filings. The current Reg A limit of $5 million is below NYSE and NASDAQ listing minimums.

Third, the legislation will allow issuers to gauge the viability of an offering by meeting with investors before incurring the significant costs of an offering. This testing-the-waters provision is important, said GT, because there has been a steady increase in IPOs that are postponed, withdrawn, priced below the low end of the IPO filing range or that have broken the IPO price within 30 days of the completion of the offering. These busted deals can be ruinous to small companies:

Currently, companies relying on the Regulation A exemption do not have to submit audited financial statements. GT endorsed enactment of the legislation conditioned on issuers filing audited financial statements with the SEC and distributing such statements to prospective investors and submitting their offering statements to the SEC electronically. GT’s support was also conditioned on periodic disclosures determined by the SEC mimicing those required of registered companies and the inclusion of so called “bad boy” provisions to disqualify from participation in this market those individuals or entities with a disciplinary or criminal history.

GT also suggested that Regulation A financings be done through a FINRA-registered firm out of a concern that a minority of unscrupulous investors will pitch adverse deal structures and that issuers may not understand the implications to the company or its shareholders. While this may be controlled for at the listed-company level by exchange rulemaking, it would not be controlled for in the over-the-counter market and requiring the use of a FINRA-registered firm might minimize abuse.

The draft legislation would permit, but not require, the SEC to impose additional conditions on such Regulation A offerings, including authorizing the Commission to: require the issuer to file audited financial statements, to require the issuer to submit the offering statement and related filings electronically, and to establish disqualification provisions based on the disciplinary history of the issuer or related parties. The legislation would also permit the SEC to impose additional unspecified periodic reporting requirements on companies which make use of the exemption.

While noting that the bill’s sponsor has attempted to include provisions designed to enhance investor protections associated with Regulation A offerings, Damon Silvers, Policy Director of the AFL-CIO, was concerned that the bill does not guarantee that these added protections would be imposed even as it requires that the exemption be expanded. Moreover, he does not believe that the advocates of this approach have provided sufficient evidence that the change is warranted or given adequate thought to the potential harm to investors that could result.

German High Court Rules that Bank Had Duty to Advise on Risks of Complex Derivatives Contract

The German Federal Court of Justice has ruled that a global German bank violated its advisory duties with regard to a derivatives interest rate swap contract and was liable for damages. A bank must determine investment advice with regard to derivatives contracts before making recommendations, noted the court, taking into account the risk appetite of the investor, unless the bank has had a long business relationship with the investor or already knows the recent investment behavior of the customer. Further, the professional qualifications of a customer cannot in itself allow the bank to conclude or infer that the investor has knowledge of the specific risks of a CMS Spread Ladder swap contract, said the court.

With such a highly complex and risky structured derivatives product such as the CMS Spread Ladder swap contract, there was a high demand on the bank to provide advisory services to the investor. Similarly, the customer needs to be enlightened as to the risk of such highly complex derivatives products with substantially the same information and knowledge as his or her advisory bank because it is only then that a responsible investment decision can be made as to whether he or she will accept the offered interest rate be. Special circumstances existed with the recommendation of the CMS Spread Ladder swap, said court, because the advisory bank knew that the product had been structured to the detriment of the investor.

The Federal Court of Justice is Germany's highest court of general civil and criminal jurisdiction and is the court of last instance in matters of general jurisdiction, with the Federal Constitutional Court hearing only constitutional complaints. The Federal Court of Justice has issued a summary of its opinion, with the full text of the opinion expected in several weeks.

In Letter to Sen. McConnell, Senate Democrats Urge Adequate Funding for CFTC

In a letter to Senate Minority Leader Mitch McConnell (R-KY), 48 Senate Democrats, including Majority Leader Harry Reid (D-NV) and Agriculture Committee Chair Debbie Stabenow (D-MI), urged the abandonment of the reckless proposal in the House-passed Continuing Resolution (H.R 1) that would reduce funding for the CFTC by one-third. The CFTC serves as an important cop on the beat, said the Senators, working to protect American consumers by cracking down on manipulation and other market abuses that can drive up oil prices. HR 1 would shrink the CFTC budget back to 2008 levels, when Americans were blindsided by both record high gas prices and a financial crisis that cost us millions of jobs. The letter noted that CFTC Chairman Gary Gensler has warned that these cuts would cause significant curtailment of CFTC staff and resources. The Senate has a responsibility to provide the financial watchdog the resources they need to fulfill their important oversight and regulatory responsibilities. The Democrats pledged to work towards a responsible budget compromise on CFTC funding.

Tuesday, March 22, 2011

Supreme Court Reaffirms Historic Total Mix Test for Rule 10b-5 Materiality, Rejects Bright-Line Rule as SEC Urged

Rejecting a bright line test for Rule 10b-5 materiality, the US Supreme Court ruled unanimously that an investor can state a claim under Rule 10b-5 based on a pharmaceutical company’s nondisclosure of adverse event reports about a drug even though the reports are not alleged to be statistically significant. Matrixx Initiatives Inc. v. Siracusano, Dkt. No. 09-1156. The Court noted that its conclusion accords with views of the SEC, as expressed in an amicus brief, that the proper balance between the need to insure adequate disclosure and the need to avoid the adverse consequences of setting too low a threshold for civil liability is entitled to consideration.

Writing for the Court, Justice Sotomayor said that the materiality of adverse event reports cannot be reduced to a bright-line rule. Although in many cases reasonable investors would not consider reports of adverse events to be material information, the investors alleged facts plausibly suggesting that reasonable investors would have viewed these particular reports as material.

The Court reaffirmed the traditional test of Basic, Inc and Northway that the Rule 10b-5 materiality requirement is satisfied when there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.

The categorical rule urged by the company here would artificially exclude information that would otherwise be considered significant to the trading decision of a reasonable investor. The company’s argument rests on the flawed premise that statistical significance is the only reliable indication of causation. As the SEC pointed out in its amicus brief, noted the Court, medical researchers consider multiple factors in assessing causation. Statistically significant data are not always available. For example, when an adverse event is subtle or rare, an inability to obtain a data set of appropriate quality or quantity may preclude a finding of statistical significance.

Applying Basic’s “total mix” standard in this case, the Court concluded that the investors adequately pleaded materiality. This is not a case about a handful of anecdotal reports, noted the Court. Assuming the complaint’s allegations to be true, as it had to, the Court noted that the company received information that plausibly indicated a reliable causal link between the drug and and anosmia. That information included reports from three medical professionals and researchers about more than 10 patients who had lost their sense of smell after using the drug.

In this case, the SEC urged the Court to hold that information that a drug causes adverse effects may be material to investors even absent statistical significance. Information suggesting a causal link between use of a drug and a serious adverse effect may significantly alter the behavior of consumers and regulators, contended the SEC, even when there is no allegation of a statistically significant association. In turn, because those reactions can affect a company’s share price reasonable investors would consider such information to be highly relevant to their investment decisions. The SEC urged the Court to reject a bright-line rule both because it is too under inclusive and because the materiality inquiry requires delicate assessments better suited to the trier of fact.

Similarly, an amicus brief of a group of law professors said that the materiality standard set forth in Northway-Basic has proved sufficiently robust to allow courts to resolve the materiality of quantitative thresholds such as misstatements in earnings or the number of adverse event reports.