Saturday, April 30, 2011

European Commission Investigates Possible Antitrust Violations in Derivatives while US Engages in Watchful Waiting

The European Commission has opened two antitrust investigations concerning the credit default swaps market. In the first case, the Commission will examine whether 16 investment banks and Markit, the leading provider of financial information in the CDS market, have colluded and/or may hold and abuse a dominant position in order to control the financial information on CDS. If proven, such behavior would be a violation of EU antitrust rules. In the second case, the Commission opened proceedings against 9 of the banks and ICE Clear Europe, the leading clearing house for CDS. Here, the Commission will investigate in particular whether the preferential tariffs granted by ICE to the 9 banks have the effect of locking them in the ICE system to the detriment of competitors. In the EU, there is no legal deadline to complete antitrust investigations. The duration depends on a number of substantial and procedural factors.

Credit default swaps are financial products traded between financial institutions or investors. They are derivatives originally created to provide protection against the risk of default. Today, CDS are also used for speculation. Information about CDS is needed to allow market participants to determine the value of their investment portfolios and develop investment strategies. In order to create and sell aggregated CDS information products and services, information service providers need access to a certain amount of CDS transaction and valuation data.

The first case will investigate privileged access to CDS transaction data by Markit. The second will examine the existence of preferential treatment by ICE Clear, a CDS clearing platform, of some well established banks who themselves promote this platform at the expense of others. Lack of transparency in markets can lead to abusive behavior and facilitate violations of competition rules, said Joaquín Almunia Commission Vice President in charge of Competition Policy

The first investigation focuses on the financial information necessary for trading CDS. The Commission has indications that the 16 banks that act as dealers in the CDS market give most of the pricing, indices and other essential daily data only to Markit, the leading financial information company in the market concerned. This could be the consequence of collusion between them or an abuse of a possible collective dominance and may have the effect of foreclosing the access to the valuable raw data by other information service providers. If proven, such behaviour would be in violation of EU antitrust rules. The 16 CDS bank dealers are: JP Morgan, Bank of America Merrill Lynch, Barclays, BNP Paribas, Citigroup, Commerzbank, Crédit Suisse First Boston, Deutsche Bank, Goldman Sachs, HSBC, Morgan Stanley, Royal Bank of Scotland, UBS, Wells Fargo Bank/Wachovia, Crédit Agricole and Société Générale.

The probe will also examine the behavior of Markit, a UK-based company created originally to enhance transparency in the CDS market. The Commission is now concerned certain clauses in Markit's licence and distribution agreements could be abusive and impede the development of competition in the market for the provision of CDS information.

In the second case, the Commission is investigating a number of agreements between nine of the above 16 CDS dealers and ICE Clear Europe. These agreements were concluded at the time of the sale, by the dealers, of a company called The Clearing Corporation to ICE. They contain a number of clauses (preferential fees and profit sharing arrangements) which might create an incentive for the banks to use only ICE as a clearing house. The effects of these agreements could be that other clearing houses have difficulties successfully entering the market and that other CDS players have no real choice where to clear their transactions. The Commission will also investigate whether the fee structures used by ICE give an unfair advantage to the nine banks, by discriminating against other CDS dealers.

In a letter to the SEC late last year, antitrust officials at the Department of Justice, while strongly supporting the SEC's efforts to create meaningful limits on ownership of swap execution facilities and Exchanges, as well as its proposed use of governance restrictions as a separate safeguard against conflicts of interest, expressed concern that the proposed ownership limits for swap execution facilities and Exchanges, which include individual share thresholds but no aggregate cap on ownership by participants or members, will not sufficiently reduce the risk that major dealers may control a swap execution facility or Exchange to restrict competition among dealers and other market participants. In the Department's view, limiting both individual
ownership shares and the aggregate shares held by major dealers would be the most effective structural approach to protecting competition in the derivatives markets.

Friday, April 29, 2011

Treasury Exempts Foreign Exchange Swaps from Dodd-Frank Derivatives Regime

As authorized by Section 721 of the Dodd-Frank Act, Treasury proposes to exempt both foreign exchange swaps and foreign exchange forwards from the definition of swap and invites comment on the proposal for 30 days. Unlike most other derivatives, foreign exchange swaps and forwards have fixed payment obligations, are physically settled, and are predominantly short-term instruments. This results in a risk profile that is different from other derivatives, as it is centered on settlement risk, rather than counterparty credit risk. Settlement risk in foreign exchange swaps and forwards already has been addressed through the extensive use of payment-versus-payment settlement arrangements. Even though central clearing could reduce counterparty credit risk, conceded Treasury, that risk is relatively small in the foreign exchange swaps and forwards market. Imposing central clearing and trading. Treasury also noted that regulating foreign exchange swaps and forwards under Dodd-Frank would introduce risks and operational challenges to the current settlement arrangements that significantly outweigh the marginal benefit.

Private Equity Funds Bid for Representation on Compensation Committees in Wake of Dodd-Frank

As part of the SEC's proposed rules implementing Dodd-Frank provisions requiring fully independent compensation committees, the Private Equity Growth Capital Council requests that the exchanges and the Commission allow representation on the committees of private equity fund shareholders. In a letter to the SEC, the council said that, unlike audit committees, which are concerned with the objective oversight of the company, compensation committees review and adjust compensation.

In the case of audit committees, the Council recognizes the concern that large private equity shareholders may not have the same interest as other shareholders in full disclosure. But with compensation committees, the private equity shareholder is fully aligned with all the other company shareholders. Thus, the Council asks the exchanges and the SEC to show a little more flexibility with the compensation committee independence standards. The per se affiliate bans applied to audit committee independence are neither appropriate nor necessary in the compensation committee context, where flexibility should be the watchword.

Section 952 of the Dodd-Frank Act adds Section 10C to the Securities Exchange Act directing the national securities exchanges to establish listing standards requiring each member of an issuer’s compensation committee to be a member of the board of directors of the issuer and to be independent.

The PEGCC understands that Section 952 of the Dodd-Frank Act was adopted in large part to address perceived abuses and conflicts of interest in the area of executive compensation, including the perception that compensation committees of some public companies were too lax in overseeing executive compensation arrangements, or that those committees, due to a lack of independence, were willing to award excessive management compensation not appropriately linked to performance, at the expense of shareholders and the health of the company in question.

The PEGCC acknowledges the importance of compensation committees that are independent from management and the importance of rigorous oversight of compensation decisions, which they said is a role regularly undertaken by representatives of private equity equity funds serving on portfolio company boards and board committees. The PEGCC also supports the general approach taken in the Proposing Release and the decision by the Commission to leave to the exchanges decisions concerning compensation committee independence.

Thursday, April 28, 2011

Company Director Cannot Delegate Due Diligence to Lawyers on the Board Says Singapore High Court

In an important corporate governance ruling, the Singapore High Court held that a company director abdicated his responsibilities by never asking to see a significant draft corporate announcement before it was released to the public and was quite content to delegate his responsibilities to another director. Moreover, he was either indifferent to his wider responsibilities or failed to appreciate them. The court ordered that the director be disqualified from taking part in the management of any company for a period of two years. It would never be sufficient or acceptable for a director to say that he expected his co-directors to do “right” by the company, said the court. Every director has to ensure that he discharges his responsibilities with due diligence in all pertinent matters. Therefore, any reliance on professionals or any reliance placed on “specialized” directors must be balanced against the responsibility that the law placed upon every individual director to bring to bear their own judgment in evaluating the advice received. Directors cannot adopt a silo approach and invariably seek shelter behind other “specialized” directors on the notion of reliance. How this responsibility ought to be discharged in any particular case would be a question of fact.

The court said that the disqualification regime is predominantly protective in nature. The statutory policy therefore appears to be that disqualification orders ought to be generally imposed to protect the public from individuals who are shown to be unworthy of being privileged with the protective shield of corporate autonomy. In other words, the disqualification regime serves to protect the public from abuses of the limited liability privilege.

The court emphasized that all directors must discharge an obligation of utmost candor to the shareholders and other stakeholders. It would have been imprudent. said the court, to accept the director's contention that he relied on another director’s responsibility of handling the public announcement. The director contended that his breach of statutory duty could be mitigated by the fact that the making of the public announcement was a legal issue to be handled by the lawyers sitting on the Board. While the court accepted that there are of course limits to the extent of knowledge and expertise a director may be expected to have, and that some reliance may be placed on the advice given by professionals, each director of a listed company has a solemn and non-delegable duty of due diligence to ensure compliance with market rules and practices.

Supreme Court Ruling Continues Strong Federal Policy Favoring Arbitration

The US Supreme Court gave a strong endorsement to the primacy of the Federal Arbitration Act in ruling that the Act preempted a California Supreme Court opinion that class action waivers in an arbitration agreement were unconscionable. In a 5-4 opinion, the Court provided a ringing endorsement for federal arbitration of consumer claims and, although, this was not a securities brokerage dispute, reasoning by analogy allows for the thought that the opinion bodes well for the brokerage industry at a time when Congress in Dodd-Frank questioned the continued efficacy of arbitration clauses in brokerage agreements. AT&T Mobility v. Concepcion, Dkt. No. 09-893.

The Court said that the overarching purpose of the FAA is to ensure the enforcement of arbitration agreements according to their terms so as to facilitate streamlined proceedings. Requiring the availability of class wide arbitration interferes with fundamental attributes of arbitration and thus creates a scheme inconsistent with the FAA.

From the Court's Wilko v. Swan ruling in 1953 until a series of rulings by the Court in the 1980s, notably Rodriquez, it was black letter that federal securities claims not arbitrable. Ultimately, through the Court's opinions, the strong federal policy in favor of arbitration took over and now arbitration clauses are the rule in brokerage agreements. The instant opinion reaffirms the strong federal policy favoring arbitration. It involved a cellular telephone contract between respondents (Concepcions) and
petitioner (AT&T) that provided for arbitration of all disputes but did nit permit class wide arbitration.

Massachusetts Proposes Private Adviser Exemption to Coordinate with Dodd-Frank Act

An "exempt reporting adviser" registration exemption was proposed by the Massachusetts Securities Division to coordinate with the SEC's proposed adoption of an exemption for private fund advisers following the July 21, 2011 elimination of the federal de minimis exemption for investment advisers with fewer than 15 clients by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Other proposals would restrict investment advisers' use of the institutional buyer definition exclusion, amend the minimum financial requirements for investment advisers with custody of, or discretionary authority over, their clients' funds, and make retaining consulting services to obtain confidential information about public companies a dishonest practices for investment advisers unless certain conditions are met. Lastly, the registration fees for broker-dealers and agents would increase, nomenclature for stock exchanges would be updated to reflect their current names and, similarly, the name "FINRA" would replace "NASD" as the current name of the organization that regulates broker-dealers and agents.

Public Hearing and comments. A public hearing on the proposals will be held at 10:00 a.m. on June 23, 2011 at One Ashburton Place, 17th Floor, Boston, MA 02108. Comments on the proposals must be submitted by Friday, June 24, 2011. Interested parties will have an opportunity to orally present data, views and arguments relative to the proposed action. Written presentations may be made at the hearing or submitted at any time before the close of business Friday, June 24, 2011 to the Securities Division, One Ashburton Place, Room 1701, Boston, Massachusetts 02108. Copies of the proposed amendments are available on the Division's website at or by calling (617) 727-3548 or (800) 269-5428 (Massachusetts only).

Registration exemption for exempt reporting advisers. To coordinate with the Dodd-Frank Wall Street Reform and Consumer Protection Act that replaced the de minimis exemption for investment advisers with fewer than 15 clients with an SEC proposed exemption for private fund advisers with less than $150 million in assets under management, as well as venture capital funds in whatever amount of assets under management, the Massachusetts Securities Division proposed a new registration exemption for "exempt reporting advisers." Advisers to venture capital funds and funds under section 3(c)(7) of the Investment Company Act of 1940 would be exempt from Massachusetts registration requirements, subject to certain limitations, but be required to file the same reports and amendments with the Division that they are required to file with the SEC. As proposed by the Division, investment advisers that provide advice solely to 3(c)(7) or venture capital funds would be exempt from Massachusetts registration requirements, as long as the advisers are not subject to "bad boy" disqualifications under Rule 262 of federal Regulation A, and electronically file through the IARD the reports and amendments required to be filed with the SEC, together with a $300 fee, at which time the report would be considered "filed."

NOTES: (1) Investment adviser representatives would be exempt from registration if their registration would be required solely because of being employed or associated with an "exempt reporting adviser." (2) The exemption would not apply to federal covered investment advisers; they would be subject to notice filing requirements. (3) The exemption would not apply to any investment adviser whose private funds accept investments from non-natural persons to evade registration or the conditions or limitations of the exemption. (4) A "private fund," "3(c)(7)fund," and "venture capital fund" would be defined.

Institutional buyer definition. Investing entity. The "investing entity" type of institutional buyer is made up exclusively of accredited investors, as defined in Rule 501(a) of federal Regulation D under the Securities Act of 1933, who each invested a minimum of $50,000. As proposed, the definition would be further conditioned by requiring the investing entity to have existed before the date this condition takes effect by the Massachusetts Securities Division, and that, as of the condition's effective date, the investing entity ceased to accept beneficial owners or additional funds for existing investors. Essentially, the proposed condition would phase out this exemption for any new beneficial owners or additional funds for existing investors that investment advisers might accept after the date the condition takes effect, while leaving the exemption intact for beneficial owners or investor funds that existed before the date the condition takes effect.

Currently, the other two types of institutional buyers consist of: (1) an organization described in Section 501(c)(3) of the Internal Revenue Code having a securities portfolio of more than $25 million; and (2) an investing entity whose only investors are financial institutions and institutional buyers as described above and as set forth in the Massachusetts Securities
Act definition of an "investment adviser."

Minimum financial requirements. Massachusetts'current minimum financial requirements allowing investment advisers to maintain a segregated account instead of a bond, having a bonding requirement for custody, and requiring a bond amount of $10,000 would be replaced with the following:

Investment advisers registered or required to register under the Massachusetts Securities Act and having custody of their clients funds or securities would need to comply with the safekeeping requirements of SEC Rule 206(4)-2 of the Investment Advisers Act of 1940, and “custody” would have the meaning as defined in SEC Rule 206(4)-2 of the 1940 Act. Investment advisers registered or required to register under the Massachusetts Securities Act that have discretionary authority over, but not custody of, their clients' funds or securities would need to post a surety bond of not less than $50,000 by a bonding company qualified to do business in Massachusetts.

Dishonest, unethical and fraudulent practices. Retaining consulting services for compensation from a consultant or a matching or expert network service. Added to the list of dishonest, unethical and fraudulent practices for investment advisers or investment adviser representatives would be a prohibition against their retaining consulting services for compensation from a consultant or a matching or expert network service unless the advisers and representatives obtain a written certification signed by consultant describing all
confidentiality restrictions the consultant has (or reasonably expects to have) about the confidential information, and stating affirmatively that the consultant will not provide any confidential information to the adviser. Investment advisers (or investment adviser representatives) who, through a consultation, come into possession of material confidential
information are prohibited from trading any relevant security until the confidential information is made public. "Confidential Information" and "Matching or Expert Network Service" would be defined.

Fee increases. The initial registration fee for broker-dealers would increase to $450, from $300. The initial registration fee for agents would increase to $75, from $50.

Wednesday, April 27, 2011

Fund Directors Forum Says Stripping Credit References from Money Market Fund Rule is Bad Policy

An SEC proposal to eliminate all five remaining references to credit ratings from Investment Company Act Rule 2a-7 would be a mistake that has the potential to harm the money market fund industry and its investors, in the view of the Mutual Fund Directors Forum. In a letter to the SEC, the forum said that the reference to credit ratings in the current rule has served a beneficial purpose by limiting the ability of money market funds to reach for yield by investing in less credit-worthy, higher-yielding securities. While recognizing that Section 939A requires the Commission to remove any reference to or requirement of reliance on credit ratings from its regulations, and that because of the mandate the SEC has lost significant flexibility in determining independently what role, if any, credit ratings should play in delimiting the range of securities that are potentially eligible for inclusion in money market fund portfolios, the forum believes that removing these particular references to credit ratings is bad policy.

The Mutual Fund Directors Forum is an independent organization that serves the independent directors of U.S. mutual funds. The Forum grew out of the Mutual Fund Directors Education Council, a group convened in 1999 in response to the call for improved fund governance by then SEC Chairman Arthur Levitt. Former SEC senior official Susan Wyderko is the Executive Director of the Forum.

The forum of independent directors also advanced the argument that because Section 939A refers to reliance on credit ratings, and Rule 2a-7 does not mandate reliance on credit ratings but rather uses credit ratings to circumscribe the outside boundary of potentially eligible securities, the Commission is not, in fact, required to eliminate this particular reference to credit ratings.
Moreover, since the amended Rule 2a-7 will now necessarily place the responsibility of assessing the credit quality of money market securities on each individual board, the rule will have the effect of introducing more variation into money fund practice rather than establishing the “uniform standards of credit-worthiness” Shat section 939A sets as a goal. But the forum understands that. given the pressure that has been brought to bear on the Commission through the enactment of Section 939A and otherwise, the Commission may well be reluctant to embrace this possibility.

The forum urged the SEC to adopt a final rule allowing boards and advisers to continue to use credit ratings as part of their own processes to the extent that they find those ratings to be credible and useful in their own process. A failure to do so could lead to the implication that the elimination of the reference to credit ratings in the rule itself is somehow intended to ban their use in the portfolio management process entirely. Funds will need to be wary, as they currently are required to be, of relying exclusively on credit ratings in determining whether a particular security presents minimal credit risks. Nonetheless, credit ratings can play a critical role in either supplementing the analytic process or, to the extent that any individual fund’s
board and adviser find appropriate, continuing to serve as a delimiting factor that conclusively eliminates less-highly rated securities from consideration for inclusion in money market fund portfolios. The final rule release should not, even
inadvertently, cast doubt on the appropriateness of this very beneficial use of credit ratings.

Sen. Wicker Concerned that Proposed Risk Retention Regulations May Prevent Return of Private Capital

In a letter to the SEC and the federal banking agencies, Senator Roger Wicker (R-MS), a member of the Banking Committee, expressed concern that the proposed risk retention regulations would prevent private capital from returning to the residential mortgage sector. He noted that the Dodd-Frank Act exempts FHA from the risk retention requirements that are the subject of the regulators' qualified residential mortgage carve out deliberations. He fears doing this may inadvertently set the stage for another bailout.

One of the most important challenges the SEC and the banking agencies have in defining QRMs is what to do about low down payment mortgages. These loans arc critical to first-time home buyers. He is afraid banks may push first-time homebuyers to FHA loans so they will be exempted from retaining five percent of the credit risk. This could drive first-time home owners out of the private secondary market and into taxpayer guaranteed loans. The Senator noted that we are at an unusual time when political leadership agrees that we need to demand prudential credit standards for home ownership.

However, when virtually all first time homeowners have access to government subsidized credit through FHA, he fears some in Congress will unwisely return to enlarging this class of borrowers who have access to taxpayer guaranteed mortgages. The regulations should encourage private sector capital to return to the housing market, and private capital needs to be on a level playing field with the federal government. Prudently underwritten low down payment mortgages in the private sector are critical to a sustainable recovery of the housing finance market. As the Dodd-Frank Act allows, the Senator urged the SEC and the banking agencies to give due consideration to include loans backed with private mortgage insurance in their definition of
Qualified Residential Mortgages.

Tuesday, April 26, 2011

Banking Industry Tells Congress of Concerns over Proposed Risk Retention Regulations

In a statement filed with the House Capital Markets Subcommittee, the American Bankers Association expressed grave concerns over the risk retention regulations proposed by the SEC and banking agencies to implement Section 941 of Dodd-Frank. The group said that the proposed qualified residential mortgage exemption from the risk retention mandate is very narrow and many high-quality loans posing little risk will end up being excluded. This will inevitably mean that fewer borrowers will qualify for loans to purchase or refinance a home.

While endorsing Dodd-Frank's goal of ensuring that participants in a mortgage securitization transaction have skin in the
game sufficient to create incentives for originators to assure proper underwriting and incentives to control default risk for participants beyond the origination stage, the ABA also noted the need for a vibrant and robust qualified residential mortgage exemption to ensure the stability and recovery of the mortgage market. Thus, the ABA strongly believes that creating a narrow definition of QRM is an inappropriate method for achieving the desired underwriting reforms intended by Dodd-Frank.

There have already been dramatic changes to the regulations governing mortgages, observed the ABA, with the result that mortgage loans with lower risk characteristics, which include most mortgage loans being made by community banks today, should be exempted from the risk retention requirements regardless of whether sold to Fannie Mae and Freddie Mac or to
private securitizers.

Under the proposal, for the loan to qualify for the risk retention exemption, borrowers must make at least a 20 percent down
payment and at least 25 percent if the mortgage is to be a refinance (and 30 percent if it is a cash-out refinance). While acknowledging that loans with lower loan-to-value (LTV) ratios are likely to have lower default rates, and that this should be one of a number of characteristics to be considered, the ABA emphasized that it should not be the only characteristic for eligibility as a qualified residential mortgage, and it should not be considered in isolation. Setting the QRM cutoff at a
specific LTV without regard to other loan characteristics or features, including credit enhancements such as private mortgage insurance, will lead to an unnecessary restriction of credit. To illustrate the severity of the proposal, even with private mortgage insurance, loans with less than 20 percent down will not qualify for the QRM.

Sen. Schumer Questions Job Loss Impact of NYSE Takeover

In a letter to Robert Greifeld, CEO of The NASDAQ OMX Group, Inc and Jeffrey Sprecher, CEO of ICE, Senator Charles Schumer (D-NY) expressed concern with the potential impact a NASDAQ/ICE takeover of NYSE Euronext would have on jobs in and around New York City. This would be a major consideration in judging any potential transaction, he said. The NYSE Euronext board of directors has once again reaffirmed its support for the Deutsche Börse transaction, he noted, but NASDAQ and ICE may further revise their proposal or take it directly to NYSE Euronext’s stockholders.

The Senator requested an estimate of expected job losses in the New York City area that would result from a NASDAQ/ICE takeover of NYSE Euronext. The given business rationale for a NASDAQ/ICE transaction appears predicated largely on over $700 million in so-called “cost synergies,'' which to the Senator almost certainly means significant job losses. At his request, NYSE Euronext estimated that the NASDAQ/ICE proposal, if effectuated, would result in the loss of 1,000-1,100 U.S. jobs, including approximately 800 in the New York City area.

Prior to taking additional steps in the acquisition efforts, the Senator wants to know how many jobs would be lost in the New York City area in the event of a NASDAQ/NYSE combination, and an explanation for how the claimed cost synergies would be achieved in light of the estimated level of job losses.

Monday, April 25, 2011

Supreme Court Hears Oral Argument in Role of Loss Causation in Class Certification Case

The US Supreme Court heard oral argument about what elements of a Rule 10b-5 private cause of action must be tested at the class certification stage, such as loss causation and reliance. David Boies, arguing for the petitioner-investor noted that loss causation is currently tested at three stages, pleading, summary judgment and trial. The question before the Court is whether it should be tested at a fourth stage, the class certification stage. He said that in Basic and last month in Matrixx, the Court said that loss causation and reliance are two distinct elements and this is an important distinction because individual reliance issues can predominate over common ones and loss causation issues cannot. The case is on appeal from the Fifth Circuit. Erica P. John Fund Inc. v. Halliburton Co., Dkt. No. 09-1403.

At the invitation of the Court, the SEC had filed an amicus brief asking the Court to resolve a split in the federal circuits over when a plaintiff in a securities fraud action relying on a fraud-on-the-market reliance presumption must demonstrate loss causation to obtain class certification. The brief contends that a Fifth Circuit panel erroneously required the plaintiff to prove loss causation at the class certification stage by a preponderance of the evidence. The petition asks the Court to review the significant threshold issue of the proper procedural standard for loss causation at the class certification stage.

The Fifth Circuit’s approach to class certification in securities fraud cases conflicts with the decisions of two other courts of appeals. The Seventh Circuit has expressly rejected the Fifth Circuit’s approach, said the Commission, and the Second Circuit, while allowing some consideration of the merits at the class certification stage, does not require the putative class representative to prove loss causation. The question presented is a recurring and important one, emphasized the SEC, and the Court was urged to grant review and use the suitable vehicle of the instant action to address it.

Justice Alito noted that there can be instances in which the market does not incorporate certain statements into the price of a
stock; and therefore even when it is demonstrated that the market meets the test for efficiency that the lower courts have settled upon in the wake of Basic, the defendant in a class action where there is reliance on the Basic presumption should be permitted at the class certification stage to prove that the allegedly fraudulent statements had no impact on price, and by doing that destroy the theory that the class relied on the statements, because they relied on the price which incorporated the statements.

Mr. Boies replied that if you have a situation in which the proof is class-wide, it is something that goes only to summary
judgment or trial. It does not go to the class certification stage. With respect to the issue of whether somebody is relying on an efficient market, that is distinct from whether a particular statement was or was not actionable.

Nicole Saharsky, arguing amicus for the Government, said that the Fifth Circuit erred in requiring proof of loss causation at class certification for three reasons: First, it's conducting a merits inquiry that's not tethered to the Rule 23 requirements; second, it's taking a presumption and requiring plaintiffs to prove it; and third, it's confusing the distinct elements of
reliance and loss causation. Investors are entitled to class certification if they have a common issue. And what the Court said in Basic is that if they set out the prerequisites for the fraud on the market, which the court of appeals agreed were met in this case, that they could proceed together. That threshold showing is required.

Justice Kagan noted that the Fifth Circuit said basically prove your whole case. You don't just have to prove that there was a price decrease; you have to prove that there was an initial material misstatement, that it distorted the stock price, that it led to a price decrease and that the price decrease can't be shown by any other superseding cause

Keying on Justice Kagan's remarks, amicus said that the Fifth Circuit took it upon itself to tighten the Rule 23 requirements. It was not satisfied with the rules as they exist, and it took the class certification stage and turned it into a merits inquiry stage. They required plaintiffs to prove almost their entire case at this stage of the litigation, and that just wasn't right, because the class certification stage is about whether plaintiffs can proceed as a group together.

David Sterling, arguing for the respondent, said that Basic is an exception to the long-understood rule about the nonsusceptibility in class actions to class treatment of fraud cases. Basic says it's not just enough to allege the operative facts,
and we will presume reliance. Basic says you have to plead and prove them, and all of those operative facts are subject to common proof.

Saturday, April 23, 2011

Secretary Geithner Due to Respond This Week to Senator Hatch's Regulatory Arbitrage Concerns

Treasury Secretary Tim Geithner is due to respond by April 28 to the call of Senator Orrin Hatch (R-UT) for the delay of further implementation and rulemaking under the Dodd-Frank Act until the Senate is provided assurances that G-20 nations have agreed to adopt similar regulatory reforms. He is concerned that regulations implementing Dodd-Frank are being drafted without adequate consideration of the possibility that they will push financial activity to foreign financial institutions in jurisdictions that fail to adopt similar regulations. The Senator, who is the Ranking Member on the Finance Committee, specifically focused on regulations to implement the Volcker Rule and the implementation of the Consumer Financial Protection Bureau.

Senator Hatch posed a series of questions that he wants Treasury to answer by April 28. He wants to know whether any provisions of the Dodd-Frank Act are unlikely to become part of the international financial regulatory framework, and, if so, the reasons why. He also seeks details on any action the Administration has undertaken in furtherance of the International Policy Coordination section of the Dodd-Frank Act.

More broadly, the Senator wants information on whether the Administration believes that the failure of G-20 nations to adopt similar provisions to Dodd-Frank will place US financial institutions at a competitive disadvantage with their foreign competitors. In that vein, he asks if any formalized consultations have occurred with G-20 nations regarding implementation of provisions and principles included in the Dodd-Frank Act, specifically mentioning the Volcker Rule in that regard. The Senator asks for the dates by which the Administration believes the G-20 nations will formally adopt and implement provisions akin to the Volcker Rule.

Friday, April 22, 2011

SEC Study Finds 404(b) Not Chilling IPOs among Issuers with $75 to $250 Million Float

An SEC study of Section 404(b) of Sarbanes-Oxley and its impact on issuers with a public float of $75 to $250 million concluded that investors view auditor attestation of a company's internal controls with a beneficial eye and that there is no conclusive evidence that 404(b) has chilled IPO activity in the US in the range of issuers studied. Section 404(b) requires the outside auditor to attest to the management's 404(a) statement on the effectiveness of the company's internal controls. The study was mandated by Section 989G of Dodd-Frank.

The study also found that financial reporting is more reliable when auditors are involved with internal controls. The SEC and the PCAOB effected major reforms in the internal controls reporting regime in 2007, and the study found that the costs of 404(b) have declined since the reforms.

Kentucky Proposes Amendments to IA Post-Licensing Requirements

Amendments to the disclosure (brochure), custody, net capital and bonding requirements for investment advisers were proposed by the Kentucky Department of Financial Institutions, together with modifications to the application withdrawal, written examination, multiple registration and unethical practice rules affecting broker-dealers, agents, investment advisers and investment adviser representatives. Small corporate offering and viatical settlement interest registrations, and a sale of business exemption were also proposed for change, along with new rules creating recordkeeping requirements for firms employing issuer-agents and rules setting forth the procedures for distributing and using funds from the Securities Fraud Prosecution and Prevention Fund.

Thursday, April 21, 2011

Chairman Bachus Says Dodd-Frank Rulemaking Going Too Fast

House Financial Services Chair Spencer Bachus has responded to recent remarks by Assistant Treasury Secretary Neil Wolin that the pace of the rulemaking under Dodd-Frank is appropriate. Chairman Bachus said that the pace, with many comment periods open only 30 days, does not give the public adequate time to provide meaningful and substantive input to the SEC, CFTC and the banking regulators charged with adopting regulations to implement Dodd-Frank. Earlier this year, Chairman Bachus wrote to the SEC and CFTC specifically urging the SEC and the CFTC to move more deliberately with regulations implementing the derivatives provisions of Dodd-Frank.

Recently, Chairman Bachus has become increasingly concerned that the Dodd-Frank derivatives regulations may not be globally consistent, particularly with the EU, which is moving forward with derivatives legislation this year. This concern is shared by House Agriculture Committee Chairman Frank Lucas (R-OK). Partly out of this arbitrage fear, the two Chairs introduced legislation delaying the effective date of most of the derivative provisions of Dodd-Frank until the end of 2012.

Wednesday, April 20, 2011

New Democrats Caution SEC and CFTC to Avoid Regulatory Arbitrage in Implementing the Derivatives Provisions of Dodd-Frank

The New Democrat Coalition in Congress, whose 42 members wrote a number of the derivatives provisions of Dodd-Frank, have cautioned the SEC and CFTC that the new derivatives regulatory regime must be set up in such a way that it prevents regulatory arbitrage and limits unintended consequences that could increase systemic risk. In a letter to the Commissions, the New Democrats emphasized that international harmonization of the derivatives regulations should be a major priority during the rulemaking process. The interconnectedness of the markets and the large global role that derivatives play demand a coordinated approach with US global partners in order to provide a seamless flow of information and eliminate systemic problems at the outset.

Regarding the specter of regulatory arbitrage, the Coalition is especially concerned that the requirements for banks to push out their swap desks into separately capitalized entities may make it more challenging for US regulators to monitor swap activity and exposure at these financial institutions on a net basis, which could increase systemic risk and costs and, in turn, drive derivatives trading into less regulated global markets. This scenario would inevitably make it more difficult for US counterparties to manage risks in the swaps market. The New Democrats strongly urge the SEC and CFTC to consider these implications when constructing rules ensuring that the US market can operate on a level playing field.

An important goal of Dodd-Frank is to provide the SEC and CFTC with the detailed real time information they need to monitor swap activity. Dodd-Frank enhances real time information by encouraging as much trading activity as possible to occur on regulated transparent exchanges. However, Congress also recognized that there is not always sufficient liquidity in the exchanges to support all types of swaps. Thus, Congress designed swap execution facilities to act as an alternative mechanism for bringing transparency and disclosure to the derivatives markets. The Coalition said that SEC and CFTC rules implementing these provisions should provide swap execution facilities with the flexibility to operate distinctly from exchanges. The Coalition said that the SEC’s proposed rule on swap execution facilities is consistent with this goal and urged the CFTC to mirror its final rule with the SEC rule.

Real time reporting of swap transactions and block trades will also infuse transparency into the market, noted the Coalition, and provide regulators important data with which to monitor systemic risk. The market relies on data repositories to function without delay to ensure liquidity while allowing market participants to meet the requirements of the law. The Coalition said that the SEC and CFTC, when writing reporting rules, should protect market liquidity for businesses looking to hedge risk and ensure the infrastructure and technology is in place for the derivatives market to function without delay and at minimal cost.

Finally, the Coalition asked the SEC and CFTC to consider appropriately phasing-in the final rules and implementation guidelines to ensure minimal market disruptions. In this context, the sequencing of the rules is an important element to avoid market disruption and provide certainty that market participants can adjust their operations to meet the new requirements.

Dodd-Frank Act Will Dominate House Financial Services Committee Agenda This Year

The agenda of the House Financial Services Committee for the remainder of 2011 will be dominated by the Dodd-Frank Act, Committee staff director Larry Lavender recently told a recent a Council of Institutional Investors seminar. The Committee will be examining all of the provisions in the legislation, he said, and recognizes the need to keep what is good about the Act. He said many lawmakers are skeptical about the new Consumer Financial Protection Bureau because it has unfettered power. Mr. Lavender also noted that the Committee plans to look at reforming credit rating agencies, but no consensus has been reached on what action to take.

The Committee has announced its intention to mark up a bill extending the deadline for implementation of the Dodd-Frank Act’s provisions regarding derivatives on May 12. This legislation, which is sponsored by Committee Chairman Spencer Bachus, would extend for 18 months the deadline for regulatory implementation of the derivative provisions of Dodd-Frank in order to give the SEC and CFTC more time to effectively meet the objectives of the derivatives title, to prioritize deliberation over speed, to consider the costs and benefits, and to understand the cumulative impact of the rules that will be applied to the derivatives marketplace.

In a nod to international comity, HR 5173 would also authorize the SEC and CFTC to exempt non-US persons from the registration and related regulatory requirements of Dodd-Frank to the extent the Commissions determine that the person is subject to a comparable foreign regulatory scheme in its home country and adequate information sharing arrangements are in effect between the SEC or CFTC and the home country regulator.

Also, on May 12, the Committee will mark up a bill, introduced by Chairman Bachus, that would replace the Director of the Bureau of Consumer Financial Protection with a bi-partisan Commission of five members, modeled on the SEC and FTC. According to Chairman Bachus, the Responsible Consumer Financial Protection Regulations Act, HR 1121, is needed because the Dodd-Frank Act currently puts too much power in the hands of one person. Under Dodd-Frank, the Director of the CFPB is given a broad and virtually unlimited mandate to substitute his or her judgment for that of consumers and the free market. In the Chair’s view, empanelling a five-member commission is an important first step in ending predatory financial practices without inappropriately limiting access to credit that small businesses and individuals want and need. Under the legislation, a five-member Commission would carry out all of the duties that would otherwise fall to the Director of the CFPB. The Chairman said that this proposed structure of the CFPB is the same structure that has worked well for many other federal regulators, including the FTC and the SEC.

On May 3, the Capital Markets Subcommittee is scheduled to mark up a number of pieces of legislation. Prominent among them is the United States Covered Bond Act, HR 940, sponsored by Chairman Scott Garrett (R-NJ). This is bi-partisan legislation designed to create a legislative framework for U.S. covered bonds, which are securities issued by banks and backed by pools of loans that enable credit to flow more readily from the capital markets to individuals and small businesses in a way that enhances stability of the broader financial system.

Currently, the US does not have the extensive statutory and oversight regulation designed to protect the interests of covered bond investors that exists in European countries. The legislation would fill this gap by requiring the Secretary of the Treasury to establish an oversight program that would prescribe minimum overcollateralization requirements, identify eligible asset classes for cover pools, and create a registry to enhance the transparency of covered bond programs. The banking agencies would carry out the Treasury-prescribed oversight program. A critical portion of the bill deals with an issuer’s default on its covered bond obligations, and the procedure for dealing with the covered bond program of an issuer in receivership.

The subcommittee is also slated to mark up The Burdensome Data Collection Relief Act, HR 1062, which would repeal a corporate governance provision of Dodd-Frank requiring publicly traded companies to disclose their median annual total compensation of all employees. Under Section 953 of the Dodd-Frank Act, the SEC must adopt rules requiring new disclosures about the relationship between executive compensation and company performance, and the ratio between the median of the annual total compensation of an issuer's employees and the annual total compensation of the issuer's chief executive officer.

The Financial Services Committee received testimony about the enormous burden and complexity this provision poses to public companies, with very little, if any, corresponding benefit to investors. The draft legislation is sponsored by Representative Nan Hayworth (R-NY). At recent hearings, Rep. Hayworth questioned the usefulness of Section 953 and whether there were any reasonable changes Congress could make to the section to make it less burdensome. Corporation Finance Director Meredith Cross replied that the usefulness of the pay ratio is a call for Congress to make.

The Director said that Congress could make the pay ratio disclosure more manageable by changing the median of the annual total compensation of an issuer’s employees to the average annual total compensation. She added that it is the SEC’s job to implement the statute in a workable manner. The SEC has yet to propose rules under Section 953 since Dodd-Frank set no deadline for SEC rulemaking. Director Cross allowed that the statute is fairly prescriptive and leaves no leeway for the SEC in the rulemaking process.

The subcommittee will also mark up the Small Company Capital Formation Act, HR 1070, which encourages small companies to access the capital markets. The legislation increases the offering threshold for companies exempted from SEC registration under SEC Regulation A from $5 million, a threshold set in the early 1990s, to $50 million. The SEC has the authority to raise this threshold but has not done so for almost two decades. The draft legislation is sponsored by Rep. David Schweikert (R-AZ).

Another bill scheduled for mark up on May 3 is The Small Business Capital Access and Job Preservation Act (HR 1082, which would exempt advisers to private equity funds from SEC registration. The Financial Services Committee has received testimony regarding the role private equity firms play in preserving existing jobs and creating new ones by providing capital to struggling and growing companies. The Dodd-Frank Act requires most advisers to private investment funds to register with the SEC, including advisers to private equity funds. The draft legislation is sponsored by Rep. Robert Hurt (R-VA).

Members are concerned with the private equity registration requirement. They do not see private equity firms as a source of systemic risk. Rep. Gary Peters (D-MI) said that private equity firms are not generally liquid and not highly leveraged, and thus do not pose a systemic risk. It makes no sense to treat private equity firms the same as large hedge funds, he posited. Rep. Hurt fears that the over-regulation of private equity firms could lead to less job creation. At recent hearings, he asked if the SEC could postpone the private equity regulations until Congress can take further action.

The subcommittee will also mark up the Asset-Backed Market Stabilization Act, HR 1539, which would provide certainty to the issuers of asset-backed securities by repealing Section 939G of Dodd-Frank, which nullified SEC Rule 436(g), thereby imposing Section 11 liability on rating agencies if their ratings were determined to be inaccurate. In the week preceding the effective date of Section 939G, the major rating agencies issued public statements refusing to allow their ratings to be included in registration statements. SEC Regulation AB, however, requires that a prospectus for an asset-backed offering disclose ratings whenever an issuance or sale is conditioned on the assignment of a rating. Thus, the public asset-backed securitization markets froze on July 22, 2010, forcing the SEC to step in and issue a temporary no-action letter on July 22, 2010. On November 23, 2010, the SEC issued a permanent no-action letter. The Act is sponsored by Rep. Steve Stivers (R-OH).

Finally, the subcommittee will nark up HR 33, which would amend the Securities Act to specify when certain securities issued in connection with church plans are treated as exempted securities. The legislation is sponsored by Rep. Judy Biggert (R-Il).

Tuesday, April 19, 2011

NASAA Requests Comments on Revisions to Proposed Custody Rule

The North American Securities Administrators Association (NASAA) has re-released for member and public comment the organization's proposed changes to NASAA's model rule on investment adviser custody (Proposed Rule). The proposal, if adopted, would modify both Model Rule 102(e)(1)-1 under the Uniform Securities Act of 1956 and Model Rule USA 2002 411(f)-(1) under the Uniform Securities Act of 2002.

On February 17, 2011, NASAA's Investment Adviser Regulatory Policy and Review Project Group (Project Group) had proposed amendments to NASAA's model rules pertaining to investment adviser custody, financial requirements, recordkeeping and brochure delivery. These changes are required in order to address changes by the U.S. Securities and Exchange Commission (SEC) to its custody and brochure rules for investment advisers. With regard to the proposed amendments to NASAA's model on investment adviser custody, the Project Group had especially asked for comments on the advantages and disadvantages of requiring advisers to private funds to provide quarterly statements to investors.

The Project Group noted that several comments submitted by individuals or entities representing various private funds objected to the quarterly statement requirement, contending, among other things, that the disclosure of detailed trading information would be contrary to how private funds are designed to operate. The commenters had pointed out that an investor in a pooled vehicle who is provided with detailed trading information could, in turn, use that information to trade independently of the fund to the detriment of other investors in that fund. The commenters were also concerned that this requirement could lead to the misappropriation of the trading strategies engaged in by a private fund. The Project Group observed that supporters of the provision, however, believe strongly that regulators and investors should have access to detailed information on the investment activities of the fund in order to understand how the fund is being managed and to identify potential problem areas with the fund and fund adviser.

The Project Group is proposing, therefore, a revision to Section (b)(4)(A) of the Proposed Rule. The proposed revision would maintain the requirement for advisers to private funds to send quarterly statements to investors. These statements must disclose the opening and closing cash balances and the closing security positions of the fund as a whole for the quarterly statement period. In addition, the total amount of additions and withdrawals from the fund as a whole and for each investor must also be disclosed.

Instead of a requirement to list all transactions during the quarter with specificity, the Project Group is proposing that an aggregate listing of transactions be included, with a breakdown by category rather than individual trade. The Project Group believes the absence of trade dates, specific securities and execution prices would address industry concern over identification of trading strategies while providing regulators and investors important information about the activities of the fund.

The comment period will remain open for 30 days. Accordingly, all comments should be submitted on or before May 19, 2011. Comments should be submitted by email or in writing and addressed to Kenneth Hojnacki, Director of Professional Registration and Compliance, Wisconsin DFI Division of Securities, at the address provided. Copies of all comments should also be sent to each of the contacts listed in the notice.

Corporate Secretaries Society Suggests to SEC an Alternative to Credit Ratings for Form S-3 Criteria

An SEC proposal to eliminate the use of investment grade credit ratings as a criterion for Form S-3 eligibility and replace it with a requirement that a company have issued at least $1 billion of non-equity, non-convertible securities in transactions registered under the Securities Act for cash during the past three years is a standard that many issuers currently satisfying the investment grade criteria may not be able to meet, emphasized the Society of Corporate Secretaries and Governance Professionals. In a letter to the SEC, the Society said that the proposed standard is well above what is necessary to ensure a wide following in the market place and is substantially in excess of the thresholds in other criteria for Form S-3 eligibility. For example, currently issuers with only $75 million of public equity float are eligible for unlimited use of Form S-3, and even smaller reporting companies with less than $75 million of public equity float can use Form S-3 in certain circumstances.

The proposal was issued in response to the requirement in Section 939A of the Dodd Frank Act that federal agencies modify regulations to remove any reference to, or requirement of reliance on, credit ratings, and to substitute a standard of credit worthiness as the agency determines to be appropriate. The Society believes that the SEC’s proposal does not set forth an appropriate alternative standard for Form S-3 eligibility within the spirit of Section 939A because it would result in the loss of eligibility by issuers of debt securities that are in fact well known and widely followed in the marketplace. The Society requests that the Commission adopt alternate criteria that are designed to replace, as closely as possible, the existing pool of eligible issuers.

The Commission should permit the use of Form S-3 by majority-owned subsidiaries of well known seasoned issuers that have $1 billion in assets or $1 billion in outstanding debt securities so long as they otherwise meet the registrant requirements of General Instruction I.A. of Form S-3. The Society believes that debt issuers meeting these criteria would be widely followed in the market and therefore should continue to be eligible to use Form S-3.

In the Society’s view, these alternate criteria arc consistent with the legislative history of Dodd-Frank, which does not indicate that Congress intended to change the types of issuers and offerings that could rely on the SEC's forms. In addition, neither Congress nor the Commission has found that issuers using investment grade credit ratings as the criterion for eligibility to use Form S-3 pose any particular risk to investors or were associated with abuses in the markets.

While the SEC recognizes that certain issuers may lose eligibility to use Form S-3 under the proposal, noted the Society, the proposing Release underestimates the effect of the change. The loss of eligibility to use Form S-3 would present significant problems for issuers that arc currently eligible. The use of Form S-1 to register debt offerings would significantly increase the cost and time to prepare for the offering and afford issuers less flexibility in the amount of debt to be issued and the timing of the issuance. Moreover, issuing debt in exempt offerings is often an unattractive alternative, said the Society, since such offerings will likely result in additional costs for issuers, such as higher coupon rates and costs associated with registration rights. Companies choosing this option also would be disadvantaged in that securities issued in exempt offerings would not be counted toward their future eligibility to use Form S-3 under the Commission's proposed issuance test.

The Society also urged that a company a majority of whose common equity is held by a well-known seasoned issuer that has either $1 billion in assets or $1 billion in 1933 Act-registered debt outstanding should be eligible to use Form S-3, provided that it otherwise meets the registrant requirements of General Instruction I.A. of Form S-3. The Society posited that subsidiaries with either $1 billion in assets or $1 billion in debt outstanding are large enough to ensure that the issuer would be subject to the level of market coverage and analysis cited in the proposing Release as a proper substitute for an investment grade security rating as a criterion to permit the use of Form S-3. This level of outstanding debt or assets would ensure that the issuer attracts significant analyst and investor attention.

In this regard, the Society urged that the debt securities that would be counted to satisfy the $1 billion threshold under this test include not only debt securities issued in primary registered offerings for cash, but also those issued in exempt offerings such as Rule 144A offerings and those issued in registered exchange offers. It is appropriate to include all such debt securities, said the Society, because a substantial portion of the market for debt securities consists of institutional investors that purchase debt securities in both Rule 144A offerings as well as registered offerings.

A Report of the CFTC Inspector General Finds Perilous Cost-Benefit Analysis of Dodd-Frank Derivatives Rulemaking

A report of the CFTC Inspector General requested by House Agriculture Committee Chair Frank Lucas (R-OK) found that the CFTC used a perilous cost-benefit methodology for the adoption of regulations implementing the derivatives provisions of Dodd-Frank. The study found that the CFTC General Counsel played a dominant role in the cost-benefit analysis to the derogation of the CFTC Chief Economist, which has been a perilous path for other federal rulemakings. The study recommended an enhanced role in cost benefit analysis for the Chief Economist. The Inspector General examined four separate rulemakings as part of the study: confirmation requirements for swap dealers, core principles for designated contract markets, duties of swap dealers, and a jointly proposed rule with the SEC defining a number of terms under Dodd-Frank Title VII.

Although the development of a uniform methodology appeared to be an equal effort
between the Office of General Counsel and the Office of Chief Economist, noted the study, in practice the cost benefit analyses involved less input from the Chief Economist, with the General Counsel taking a dominant role. For the four rules that were reviewed, the cost-benefit analyses were drafted by CFTC staff in divisions other than the Chief Economist. While staff from the Office of Chief Economist did review the drafts, their edits were not always accepted.

For example, staff in the Office of General Counsel created the first draft of the cost-benefit analysis for the proposed rules defining swap dealer and major swap participant. While the Chief Economist favored addressing the operational and compliance costs that would flow from coverage under the definitions, the General Counsel determined only to address the costs and benefits associated with undergoing an examination or other process to determine whether one fell under the definitions.

While offering no opinion on the cost-benefit analyses for the specific four rules that were part of the study, the CFTC IG noted that similar economic analyses in the context of federal rulemaking have proved perilous for financial market regulators. For this proposition, the IG cited two federal appeals court opinions finding SEC rulemaking deficient. In American Equity Investment Life Ins. Co. v. S.E.C., 613 F.3d 166 (D.C. Cir.2010), the court vacated Rule 151A, which was adopted to ensure that purchasers of fixed income annuities would be entitled to the full protection of the federal securities laws, on the ground that the SEC failed to properly consider the effect of the rule upon efficiency, competition, and capital formation. In Chamber of Commerce. v. S.E.C., 412 F.3d 133 (D.C. Cir.2005), the appeals panel found that, while the SEC is authorized to condition the ability of mutual funds to engage in exemptive transactions under the Investment Company Act on having a board composed of at least 75% independent directors and headed by an independent chair, the Commission failed to adequately consider the costs imposed on funds by the two conditions.

In the letter requesting the study, Chairman Lucas said the CFTC does not appear to be conducting adequate cost-benefit analysis of the derivatives rulemaking. The CFTC has taken a vague and minimalist approach to cost-benefit analysis that is directly contrary to a recent Executive Order of the President and fails to achieve the objectives of Section 15(a) of the Commodity Exchange Act. Chairman Lucas said that the CFTC must approach the cost-benefit aspect of rulemaking thoroughly and responsibly to understand the costs and thus the economic impact that any proposed regulation will have on regulated entities and more widely the financial markets.

At the very least, said the Chairman, CFTC staff should conduct a detailed analysis in an effort to quantify the impact of a regulation using an objective, data-driven approach. Such an approach is absent in subjective and unqualified assessments, such as ``could impose significant compliance costs.’’ Without a detailed and diligent approach to cost-benefit analysis, noted the Ag Chair, the CFTC appears to be failing to comply with both the Executive Order, which admittedly does not bind it, and the spirit or principles of that Order.

Leading House Republican Urges SEC to Drop 20% Down Payment Requirement from Proposed Risk Retention Rules

Conditioning the qualified residential mortgage (QRM) carve out from the risk retention rules under Dodd-Frank with a 20 percent down payment requirement contravenes legislative intent and would knock 20 to 25 percent of borrowers out of QRM eligibility, according to House Deputy Whip Tom Price (R-GA). In a letter to the SEC, he emphasized that Congress intended for a properly crafted QRM definition to provide incentives for the strongest underwriting, discourage bad lending practices, and restore investor confidence by bringing private capital back to the housing finance market. Rep. Price said that the mortgage asset risk retention regulations and the qualified residential mortgage exclusion from risk retention are particularly important for the stability of the United States housing market.

On a separate point, the House leader said that, because Dodd-Frank exempts government-guaranteed FHA lending from the five percent credit risk retention, it is essential to track the legislative language and include private mortgage insurance for any low-down payment lending as an element within the QRM standard. This provision was included in QRM to ensure that comparable treatment is afforded for prudent QRM loans backed by private mortgage insurance, he explained, just as it is for loans insured by FHA.

Rep. Price, a member of the Financial Services Committee, said that the proposed risk retention rules do not follow the clear intent of the Senators who introduced the QRM provision into Section 941 of Dodd-Frank. The 20 percent down payment was not an element of the QRM provision that passed Congress as part of Dodd-Frank. Rep. Price cited a letter from the sponsors, Senator Johnny Isakson (R-GA), Mary Landrieu (D-LA) and Kay Hagan (D-NC) expressing concern that efforts to impose a high down payment requirement for any mortgage to meet the QRM exemption standard would be inconsistent with legislative intent. The Senators said that the issue of whether the QRM should have a minimum down payment was discussed in negotiations during the drafting of Section 941 and it was decided to intentionally omit such a requirement.

According to Rep. Price, the omission of the 20 percent down payment requirement is particularly important because a low down payment is a critical element to stabilizing the housing market and can be done without inappropriately expanding risk. According to a new analysis of 33 million home loans originated between 2002 and 2008, boosting down payments in five percent increments has had only a negligible impact on default rates.

For example, moving from a five to 10 percent down payment on loans that already meet all of the other QRM standards reduces defaults by an average of only two or three-tenths of one percent, but eliminates anywhere from seven to15 percent of borrowers from qualifying for a lower-rate QRM loan. Increasing the minimum down payment to 20 percent would knock 20 to 25 percent of borrowers out of QRM eligibility, with only a small improvement in default performance of about eight-tenths of one percent. In the Deputy Whip’s view, it is hard to envision the recovery of the housing market with unnecessarily high down payment requirements under QRM. Moreover, this was never the intent of Congress.

Monday, April 18, 2011

UK Authorities Propose Major Legislative Changes to UK Covered Bond Regime

With Congress seriously considering legislation establishing a US covered bond market, the UK Treasury and Financial Services Authority have proposed significant changes to the UK covered bonds legislative regime to enhance transparency, introduce consistent standards, exclude securitizations as eligible assets, allow issuers the option of single asset type investment pool, and create a formal asset pool monitor. Covered bonds are a category of secured bonds issued by banks and typically backed by mortgages or public sector loans that provide long-term, stable funding from a diverse investor base. They are often used in place of securitization.

Regulation plays a very important role in the covered bond market. Most covered bond markets across the world are underpinned by dedicated legislation setting out criteria for the assets that can back a covered bond, a process for managing investors’ recourse to those assets if the issuer of the covered bond fails, and a system of regulatory oversight. The UK’s covered bond legislation is set out in the Regulated Covered Bonds Regulations of 2008.

As the designated supervisor of UK regulated covered bonds, the FSA assesses all applications by financial institutions to be issuers of covered bonds, and assesses applications to register individual bonds or programs. Only deposit taking institutions with their registered office in the UK can register as regulated covered bond issuers.

A key requirement of the UK’s regulated covered bond regime is that issuers must provide the FSA with regular, comprehensive information about their covered bond programs. After the initial introduction of the UK regime in 2008, the FSA placed additional requirements on issuers in relation to the information they must provide to the FSA on an ongoing basis.

The Regulations set out which assets are eligible for inclusion in covered bond asset pools. They currently allow securitizations of residential and commercial mortgages to be included in covered bond asset pools. This is in line with the relevant provisions of the European Banking Consolidation Directive. However, many other jurisdictions, such as Germany, take a stricter approach than the Directive and do not allow securitizations to be included.

The rationale for excluding securitizations is that the complex structure of securitizations can make it more difficult to analyze the likely performance of a covered bond. However, since covered bonds are typically low-yielding products, noted the authorities, it is not cost-effective for most investors in them to conduct the detailed analysis needed to fully understand this additional complexity. Instead, investors may choose to uniformly mark down their assessment of a covered bond that contains securitizations. Thus, the government proposes to amend the legislation to exclude securitizations as eligible assets.

UK covered bonds benefit from high levels of transparency, such as detailed reporting about the quality of covered bond asset pools and disclosure of legal documentation. This transparency, however, is not driven by any feature of the Regulations and is instead a result of market practice. The lack of regulation in this area means the format of disclosure is not consistent across all issuers, increasing the barriers to comparing and evaluating the relevant data for investors. A lack of regulation also means investors may not have as much confidence in the quality of this disclosure or recognize it as a key feature of UK covered bonds as if the disclosure was enforced by regulatory requirements.

The Government proposes to authorize the FSA to direct publication of information in order to ensure consistent reporting and disclosure for UK covered bonds, in
line with guidance provided by the FSA. This will reduce the costs for investors of using the information issuers provide and increase its reliability. A better informed market will benefit from more efficient pricing, which will benefit issuers with high quality covered bonds.

In the UK, the regulatory component of overcollateralization levels is determined by FSA stress testing assessing the performance of the covered bond program against a range of possible adverse scenarios to determine how much overcollateralization is needed to ensure that the program can continue to meet its liabilities under these stresses. Some other jurisdictions take a different approach and impose a statutory fixed minimum level of overcollateralization that issuers must meet.

The Government would legislatively require that issuers maintain a fixed minimum level of overcollateralization in covered bond asset pools. Treasury and the FSA envisage setting the fixed level in line with the fixed minimums in other jurisdictions, which would be well below the current levels of overcollateralization in the UK. This means the new requirement will have no material impact on issuers, but will reduce investor uncertainty.

In practice, overcollateralization in these countries is, like in the UK, far higher than the typical fixed minimum levels used, and is driven by rating agency requirements and investor preferences. A fixed minimum level is, however, more transparent and readily understood by investors than a variable level. It also provides a floor to the possible levels of overcollateralization on which investors can rely. The absence of a minimum in the UK introduces a degree of uncertainty and makes the UK regime harder to compare with other jurisdictions

UK covered bonds benefit from a high degree of external scrutiny, including an annual external audit of the program. But the external audit is not currently a statutory requirement. Some jurisdictions include a formal requirement in their regulation for an asset pool monitor, which performs a similar function to an external auditor.

The Government proposes to require issuers to appoint a formal Asset Pool Monitor, with duties similar to that of existing auditors. This is intended to make the presence of external scrutiny of UK covered bond programs more apparent to investors without imposing major changes on issuers. The lack of such a requirement in UK Regulation may be putting UK issuers at a disadvantage compared with competitors

The Regulations currently allow a range of asset types to be included in a covered bond asset pool, including residential mortgages and commercial mortgages. Some jurisdictions require issuers to maintain asset pools with only a single type of asset in them.

The Government proposes to give UK covered bond issuers the option to formally declare their covered bond program as a single asset type program. Such programs would only be allowed to include assets of a single type. Issuers would still be able to retain the current flexibility in the Regulations to mix and change asset types by declaring their program a mixed asset type program.

Treasury and the FSA considered removing the option for mixing asset types altogether, which would bring the UK fully into line with some other jurisdictions. But they rejected this option because it is unnecessary to go this far to address the problem identified. Since mixing asset types may in future meet the needs of some issuers and investors, reasoned the authorities, removing this option from the Regulations may constrain the potential for innovation and growth in the covered bond market.

European Accountants Federation Comments on Proposals to Improve Audit and Quality of Financial Reporting

The responsibility of the outside auditor of financial statements is secondary to that of the client’s company’s management, said the European Federation of Accountants, but the current model for auditor’s communication could lead to an expectation gap to how the auditor discharges the responsibilities for the work being done. These comments were made in a letter to the UK Financial Reporting Council on the FRC’s recent discussion draft on the quality of outside audit and enhanced corporate reporting.

A company’s management is responsible for the preparation of financial statements and other financial information in accordance with national or international accounting standards, said the federation, while the auditor’s responsibility is to express an opinion on such financial statements. But this model is not written in stone. To benefit investors and other users of financial statements, more transparency and communication could be considered. For example, management could, in a proportionate way, report on the assumptions on which the company’s ability to continue as a going concern is based by disclosing additional information on key risks to the company’s business model and its longer term sustainability as well as how the audit committee discharges its duties.

The federation believes that the role of the independent auditor can be expanded in the future. In this context, it is important to note that audit is only one part of the financial reporting system, and therefore auditors should only assume responsibility for their own role and actions without
excessive and disproportionate liability attaching to them.

Considering communication in the broadest sense, the federation urged regulators and oversight bodies to carefully consider whether investors in fact would like information on the company’s performance from the company itself in the form of extended public reporting from the audit committee, or whether the auditor should be involved in providing information on such matters. It may well be that the audit committee is best placed to provide the information potentially requested by investors, and not the auditor. However, if so requested and if suitable criteria exist, auditors could provide a certain level of assurance on the information provided by the audit committee.

Further, when considering how to improve communication, noted the federation, regulators must strike a proper balance and avoid both information overload that would reduce the relevance of key information and self-fulfilling prophecies that would have counterproductive effects threatening the company’s existence.

The federation said that auditor professional skepticism should continue to be reinforced. This could be done by further training, said the group, and by application of international auditing standards since the application of these standards clearly underlines this concept. This was essentially an endorsement of ISA 200.13, which 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. At least two global audit firms, KPMG and Baker Tilly, have found that the ISA definition is 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).

The FRC wants to ensure that the right environment is created for increased auditor skepticism when assessing material assumptions and estimates. Audit committees have an important role to play here by creating the appropriate environment for the audit team to challenge material assumptions and estimates in an effective way and to communicate their views in a forthright and constructive manner.

The federation supports shareholder involvement in the process of appointing the outside auditor since this would contribute to safeguarding the independence of auditors which is an essential part of the trust and integrity of the audit profession. Such additional safeguarding of auditor independence could be done through initiatives such as increased independence of the auditors’ selection process, enhanced shareholders’ engagement and increased transparency of the auditors’ selection, appointment and compensation process.

While reaffirming the appropriateness of having the audit committee appoint the outside auditor, the FRC proposed requiring the audit committee to either report to investors on the process by which the committee reached its recommendation to appoint the company's external auditor and the reasons for their recommendation or discuss with a number of principal investors the approach to be taken to the appointment of the auditors, including the merits of putting its audit out to tender and then report on that consultation to shareholders generally.

In the federation’s view, there are significant potential benefits to the use of technology for the accessibility of the annual report and financial statements. In this context, the group supports the use of electronic applications in financial reporting such as XBRL. However, there are challenges to using XBRL, in relation to financial reporting as well as auditing, such as in relation to the inclusion of extensions and the responsibility for such extensions and with regard to the audit of XBRL generated financial statements.

SEC Likely to Delay until 1Q 2012 Registration of Hedge Fund and Private Equity Fund Advisers, and Mid-Size Advisers Switching to State Regulation

An SEC senior official indicated that, while the Commission will issue final rules under Dodd-Frank mandating hedge fund and private equity fund registration in advance of July 21, the SEC will consider extending the date by which these advisers must register and come into compliance with the obligations of a registered adviser until the first quarter of 2012. In a letter to David Massey, Deputy Securities Administrator of the North Carolina Securities Division, and President of the North American Securities Administrators Association, Robert Plaze, Associate Director in the Division of Investment Management said that the delay, if it occurs, will be intended to give hedge fund and private equity fund advisers the time they need to register and come fully into compliance with the obligations applicable to them once they are registered with the Commission.

Section 403 of the Dodd-Frank Act repeals, as of July 21,2011, the private adviser exemption in section 203(b)(3) of the Investment Advisers Act and will require advisers relying on that exemption, including advisers to many hedge funds and other private funds, to register with the SEC. In addition, Dodd-Frank provides some new exemptions, such as for advisers to venture capital funds and advisers to private funds with less than $150 million in assets under management in the United States.

In the letter to the NASAA president, Mr. Plaze said the Commission will also consider extending the date by which many mid-sized advisers must transition to state regulation such that all SEC-registered advisers would be required to report their eligibility for registration with the Commission in the first quarter of 2012.Those no longer eligible for Commission registration, such as mid-sized advisers, would have a grace period providing them time to register with the appropriate state regulators and come into compliance with state law before withdrawing their SEC registration.

Under Section 410 of Dodd-Frank, mid-sized advisers with up to $100 million of assets under management will have to withdraw from registration with the Commission and register with one or more states pursuant to state law. Once the Commission adopts the implementing rulemaking, noted the SEC official, the Investment Adviser Registration Depository system (lARD) will require re-programming to accept advisers' transition filings. The expected grace period for mid-sized advisers is based on the SEC’s understanding that the re-programming process will take until the end of the year to complete.

Section 410 raised the assets under management trigger from $25 million to $100 million for investment adviser state registration. The $25 million trigger for state regulation was set by the National Securities Markets Improvement Act of 1996. In NSMIA, Congress employed the principle that the SEC should regulate larger investment advisers, while the states should oversee smaller advisers.

Canadian Supreme Court Hears Arguments on a Federal Securities Code for Canada

Against the backdrop of rulings by the Alberta and Quebec Courts of Appeals that the Government of Canada does not have the constitutional authority to enact a federal securities code for the entire country, the Supreme Court of Canada recently heard arguments for and against a federal securities code. A single national securities regulator for Canada was supported by Ontario, FAIR Canada and the Canadian Coalition for Good Governance, while New Brunswick, Manitoba, British Columbia, and Saskatchewan opposed the proposed federal securities code. The Supreme Court reserved the issue. In the Matter of a Reference by Governor in Council concerning the proposed Canadian Securities Act, as set out in Order in Council P.C. 2010-667.

The Attorney General of Ontario argued that the proposed Canadian Securities Act is within the legislative authority of Parliament to make laws in relation to the regulation of trade and commerce pursuant to s. 91(2) of the Constitution Act of 1867. The proposed Act is authorized by the federal power over general trade and commerce affecting Canada as a whole.

Ontario pointed out that a key benefit of a federal securities regulator would be the resulting ability of the federal government to use both banking and securities regulation to better address regulatory challenges, including systemic risks. Banks are both significant traders as well as significant end-users of derivatives and have a dominant share of Canadian trading in OTC derivatives. Moreover, a single securities regulator is in the best interest of market participants.

In Ontario’s view, efforts at provincial harmonization of securities laws to date have been incomplete. Substantial differences in provincial securities law persist even after years of attempted coordination through the Canadian Securities Administrators. These differences exist even among provinces who are participants in the passport system, where different views about, for instance, the appropriate balance between investor protection and facilitating capital raising by business have resulted in different regulatory responses.

Further, the capacity to assess and react swiftly to unexpected developments in capital markets is a necessary feature of a modern securities regulatory system. Ontario’s preference for a single national regulator is based in part on its belief that improvement is needed in the ability of the current provincial system to deliver a timely response to market innovations and emerging issues.

Ultimately, the issue for the Supreme Court to determine is whether Parliament has a rational basis for concluding that regulation of the capital markets raises an economic concern of genuine national interest. The rational basis test has been adopted by the Court in federalism cases in recognition of the fact that governments are best situated to assess competing economic and social science evidence and to make decisions based on complex policy considerations.

Citing the complex, international and highly integrated nature of contemporary capital markets, Ontario submitted that there is a rational basis for concluding that regulation of the capital markets raises an economic concern of genuine national interest. The need for effective federal regulation is further supported by national and international concern regarding the effective management of systemic risk, the considered analysis undertaken in the many studies and reports that have consistently recommended the creation of a single national regulator, and the international community’s continuing criticism of Canada’s fragmented regulatory approach to securities regulation.

FAIR Canada, which represents retail investors, pointed out in its submission that Canada, alone among advanced industrialized economies, does not have a national securities regulator. In an age when capital markets are national or international, when capital flows freely across borders, and when public companies operate in multiple jurisdictions, this anomaly can present hardships for retail investors. FAIR Canada's position is that the proposed Canadian Securities Act is within the legislative authority of Parliament.

The fact that securities regulation has been largely local to date, noted FAIR Canada, does not preclude the federal government from enacting laws to regulate the national economy when what were once local economic concerns develop into national and international ones. Local regulation of securities is a matter of historic, economic and political happenstance, noted FAIR Canada, not constitutional doctrine. The Court has acknowledged many times that the Canadian Constitution must be read in light of changing contemporary realities, which include the development of Canada's capital markets into an important national economic concern, and not merely a collection of local ones. The current patchwork model of securities regulation is inadequate and demonstrates the inability of the provinces and territories, alone or together, to regulate Canada's capital markets in as comprehensive a manner as the proposed code.

While British Columbia supports a national regulatory scheme in principal, the BC submission noted that there is clearly a provincial aspect to securities market regulation. Thus, British Columbia will support the concept of a single federal securities regulator so long as the federal legislation establishing that the single regulator respects the division of powers under ss. 91 and 92 of the Constitution Act.

British Columbia argued that the proposed Canadian Securities Act entrenches upon provincial constitutional jurisdiction under ss. 92(13), property and civil rights in the province, and 92(16), matters of a merely local and private nature in the province, and so is not constitutionally under the legislative authority of the• Parliament of Canada under the general branch of the trade and commerce power.

Fundamentally, regulating trading in securities constitutes regulating contracts made within the province for the purchase and sale of securities, whether or not that contract is made on or through the facilities of an exchange, whether or not that contract is arranged through or by an agent or other intermediary and whether or not the ultimate performance of that contract is carried out within the province or outside the province.

It follows, said British Columbia, that the general regulation of contracts of a particular business or trade, such as the business of trading in securities, is a matter prima facie within exclusive provincial jurisdiction and not within the federal trade and commerce power.

Similarly, in its submission to the Court, Manitoba argued that the proposed federal securities code is not a constitutionally valid exercise of the general branch of the trade and commerce power. Manitoba’s position is that the proposed code would regulate the securities industry or business, as do the securities statutes currently in force in all ten provinces, and is not concerned with trade as a whole.

Manitoba also contended that the existing securities regime in Canada consists of a decentralized, but sophisticated and interlocking, national scheme involving all ten provinces. Far from being constitutionally incapable of regulating the securities industry, emphasized Manitoba, the provinces have successfully engaged in regulation for several decades and are fully capable of continuing to exercise their jurisdiction into the indefinite future.

Saskatchewan submitted that the comprehensive regulatory regime set out in the proposed federal securities act represents an unprecedented extension of the general branch of the trade and commerce power. Were the Court to endorse such an unrestrained exercise by Parliament of its powers, said the submission, it would seriously erode the scope of various heads of provincial jurisdiction and alter the balance between the two orders of government.

Sunday, April 17, 2011

Key Senators Urge SEC to Prohibit Executive Hedging as Part of Dodd-Frank Incentive Compensation Regulations

In a letter to the SEC, three US Senators urged the Commission to prohibit highly-paid corporate executives from hedging in any way on their own incentive-based compensation arrangements as part of the regulations implementing Dodd-Frank provisions. Senators Robert Menendez (D-NJ), Frank Lautenberg (D-NJ) and Jeff Merkley (D-OR) reasoned that the use of hedging by corporate executives of their own compensation arrangements takes the "incentive" out of incentive-based compensation, thereby undermining the accountability of the executives who engage in these tactics and significantly undermining the legislative intent of Dodd-Frank to deal with incentive-based compensation. Executives should benefit when their company does well said the Senators, and, if they are allowed to hedge, it takes their company out of the equation, permitting them to profit regardless and encouraging excessive risk-taking.

Section 956(b) of Dodd-Frank requires the SEC and other federal regulators to adopt regulations prohibiting any types of incentive-based payment arrangement that they determine encourages inappropriate risks by covered financial institutions, which includes SEC-registered broker-dealers and investment advisers.

During debate of the Dodd-Frank Act, the Senators offered Amendment No. 3818 to prohibit executives and other highly-compensated employees, those making more than $1 million, from engaging in trades that would bet against their own company's stock. While the amendment was never voted on, they noted, it was supported by the Americans for Financial Reform, the Council of Institutional Investors, and former SEC Chief Accountant Lynn Turner.

When offering the amendment, Senator Menendez said that executives and highly-compensated employees should never have financial incentives to act against the best interests of their companies. Citing a study indicating that in 2,000 cases at over 900 firms executives tried to profit by betting against their own company, Senator Menendez said that if the executives can hedge their stock it does not matter how well the company does because either way the executive makes money. Not only is this fundamentally wrong, he emphasized, it may in some cases give executives an incentive to use their status to take a position that may not be in the company’s best interest and then make a profit by selling the company stock short. Cong. Record, May 5, 2010, S3153.

In their letter to the SEC, the Senators observed that the SEC and the other regulators on the joint proposal recognized in the proposing release that the use of personal hedging strategies, such as financial derivatives, on incentive-based compensation arrangements for highly-paid executives would make many of the provisions prescribed by the agencies less effective.

In their letter to the Commission, the Senators said there is ample evidence suggesting that this type of hedging is a widespread problem that has serious implications for investors and for the health of their companies.

The Senators cited other federal officials who have taken exception with the hedging tactic. For example, the Treasury Special Master for TARP Executive Compensation, who was responsible for overseeing the distribution of compensation to top executives at companies that received federal bailout assistance, banned executives under his jurisdiction from this practice because he wanted to ensure that they could not undercut the links Treasury created between compensation and long-term performance.

SEC Senior Staff Assure Foreign Private Issuers using IFRS that XBRL Can Await SEC Posting of IFRS Taxonomy

In a letter signed by SEC Chief Accountant James Kroeker, foreign private issuers that prepare their financial statements in accordance with IFRS as issued by the IASB were assured that they would not be required to submit to the Commission and post on their corporate websites Interactive Data Files until the Commission specifies a taxonomy for their use in preparing their Interactive Data Files. The SEC’s eventual posting of a taxonomy for foreign private issuers using IFRS to prepare their financial statements will allow such issuers to comply with Rule 405 of Regulation S-T, which requires issuers to prepare Interactive Data Files in accordance with the EDGAR filer manual, which in turn requires use of a taxonomy specified on the SEC's website. The letter was also signed by Meredith Cross, Director of the Division of Corporation Finance.

The SEC no-action letter, which was in response to a request from the Center for Audit Quality, is a recognition by the SEC staff that it is not possible for foreign private issuers preparing financial statements in accordance with IFRS to comply with Rule 405 until the Commission sets out an IFRS taxonomy for them. There were 970 foreign private issuers registered with the SEC at the end of 2010.

In its request letter, CAQ was concerned that IFRS Taxonomy 2011 may require further development to make it more useful to investors. Specifically, users of the IFRS Taxonomy 2011 still may need to create numerous extensions for their interactive data exhibits, which may limit the usefulness of such interactive data to users of financial statements. Such extensions may be needed because IFRS Taxonomy 2011 does not fully address common reporting practice or industry specific disclosures and, in addition, does not include standard definitions.

Moreover, absent significant development of the IFRS taxonomy for footnote disclosures, observed CAQ, the need to create a significant number of extensions may continue in year two of the phase-in period, when detailed tagging is required. Until these issues are addressed in future taxonomy enhancements, CAQ believes that the benefits achieved by requiring foreign private issuers to submit interactive data based on IFRS Taxonomy 2011 may not outweigh the cost and effort to be expended and that additional time is necessary to further develop the IFRS taxonomy.

In 2009, the SEC adopted final rules requiring companies to submit their financial statements to the Commission in interactive data format using XBRL. Commencing with fiscal periods on or after June 15, 2011, foreign private issuers that prepare their financial statements in accordance with IFRS as issued by the IASB were slated to comply with these rules.

In a letter to the IASB oversight foundation, written before the no-action relief was granted, the AICPA said that it remains unclear at this point whether the IFRS taxonomy will be able to meet the needs of foreign private issuers in complying with the SEC‘s rules. Citing a pilot program, the AICPA noted that participants who tagged their Form 20-F filings found that they needed to create additional taxonomy items, IFRS taxonomy extensions, to reflect common-practice concepts. Further, participants tagged their filings at Level 1 only, which entailed tagging the elements on the face of the financial statements and block tagging each note.

Echoing the concerns CAQ expressed to the SEC, the AICPA noted that the second year of tagging under the SEC rules requires detail tagging of the financial statement notes and schedules, which not only increases the amount of elements tagged in the XBRL files, but also adds more complexity. Without an expanded taxonomy, including a robust set of tags for common-practice concepts as well as footnote disclosures, foreign private issuers will need to create even more extensions for their second year submissions. In the AICPA’s view, the use of significant extensions may impact the usability of the data for consumers of these files.

The need to create extensions may be further increased for foreign private issuers because the IFRS Taxonomy does not yet fully cover industry specific elements or commonly reported concepts, and because it lacks standard definitions. Although the creation of some extensions is important in enabling companies to customize their disclosures where necessary in order to effectively communicate with investors and other stakeholders, acknowledged the AICPA, extensions should only be utilized to differentiate information rather than to communicate commonly reported items. More broadly, the AICPA fears that the overuse of extensions in the absence of standard definitions and taxonomy elements for industry-specific and commonly reported concepts will make it more difficult for investors to analyze and compare disclosures among companies, thereby limiting the usefulness of the XBRL data.