Thursday, June 30, 2011

Senate Leader and Industry Oppose Administration Effort to Repeal LIFO Accounting

Senator Orrin Hatch (R-Utah), Ranking Member of the Finance Committee, opposes the Obama Administration’s proposal to repeal the last-in first-out (LIFO) inventory accounting method. The Senator said that repeal of LIFO would raise taxes on US manufacturers by roughly $69 billion, threatening firms’ ability to hire new workers and make new capital investments. The Chamber of Commerce has cautioned that LIFO repeal could force many companies out of business who lack the ability to obtain the debt financing needed to pay the taxes resulting from repeal of LIFO, which is an accounting method that has been expressly permitted by the Internal Revenue Code since the 1930’s. According to the Chamber, businesses that use LIFO assume for accounting purposes that they sell first the inventory most recently acquired or manufactured. Industries that often experience rising inventory costs typically account for inventory using the LIFO method. This is because LIFO accounting allows them to match current sales income with the current higher cost of that inventory. In short, said the Chamber, the LIFO method enables businesses to avoid phantom profits caused by inflation.

In general, for Federal income tax purposes, taxpayers must account for inventories if the production, purchase, or sale of merchandise is a material income-producing factor to them Under the LIFO method, it is assumed that the last items entered into the inventory are the first items sold. Because the most recently acquired or produced units are deemed to be sold first, cost of goods sold is valued at the most recent costs; the effect of cost fluctuations is reflected in the ending inventory, which is valued at the historical costs rather than the most recent costs.

Unlike U.S. GAAP, IFRS do not treat LIFO as a permitted method of accounting. The SEC recently indicated its support for global accounting standards and it continues to work toward making a determination by 2011 as to whether to incorporate IFRS into the U.S. financial reporting system. SEC staff has also noted that if the SEC were to decide to move to IFRS, the transition date for U.S. issuers would be no earlier than 2015. The Joint Committee on Taxation noted that the seemingly inevitable shift from GAAP to IFRS raises the issue of whether companies will be able to continue using LIFO for tax purposes in light of the conformity requirement.

If LIFO is repealed, said the Joint Committee on Taxation, taxpayers that currently use LIFO would be required to write up their beginning LIFO inventory to its first in, first out (FIFO) value in the first taxable year beginning after December 31, 2012. The resulting increase in income is taken into account ratably over 10 taxable years beginning with the first taxable year beginning after December 31, 2012.

The Committee noted that proponents of the FIFO method argue that LIFO permits deferral of inflationary gains in a taxpayer’s inventory even when those gains arguably have been realized by the business. They note that outside of the inventory context, inflationary gains are generally taxed when the gain is realized, i.e., upon sale of the appreciated asset, and LIFO offers self-help against inflation that is not available in other contexts.

Independent Auditor Provides 10A Report and Resigns

An outside auditor has provided a Section 10A report to an SEC registrant and resigned as the company’s independent auditor. In a letter to the audit committee of China-Biotics, Inc., which was an exhibit to the company’s Form 8-K disclosing the resignation of the independent auditor, the resigning outside auditor said that certain irregularities constituted illegal acts that could have a material effect on the company’s financial statements for purposes of Section 10A of the Exchange Act.

The audit firm, BDO Limited, concluded that the board and audit committee have not taken timely and appropriate remedial action in respect of the illegal acts, a failure that rendered it impossible for BDO to gather evidence to assess whether the company’s accounting records have been falsified and whether there are other issues that could have a material effect on the company’s financial statements, which warranted BDO’s resignation.

The board and audit committee were informed of the irregularities, including those related to the performance of audit procedures reviewing the company’s on-line bank accounts through the e-banking system of the bank, in that the auditor was directed by company staff to access a suspected fake website of the bank. Another irregularity was in bank advice pertaining to bank income, which contained mathematical errors, which company management dismissed as clerical mistakes made by the bank. A further irregularity was that deposit interest recorded as earned by the company differed from an undated deposit agreement with the bank presented to the auditor and which the company represented as having been entered into between a company subsidiary and the bank.

The auditor asked the audit committee to take steps as part of its oversight duties to deal with the irregularities. The audit committee’s response failed to provide the auditor with sufficient details about the work the committee should have performed to discharge its oversight duties with regard to the irregularities, such as preparing a specific plan for investigating and remediating the irregularities.
Further, the auditor was not provided with the results and findings of an investigation into the irregularities by a special committee of the audit committee. The auditor was not authorized to communicate directly with those conducting the investigation. Nor has the auditor been able to meet with bank personnel to confirm the company’s bank balances and transactions directly with the bank.

Wednesday, June 29, 2011

House Legislation Would Codify and Apply to SEC Presidential Executive Order on Agency Rulemaking

Legislation introduced in the House would codify and apply to the SEC the Executive Order on agency rulemaking issued recently by President Obama. Sponsored by Rep. Scott Garrett (R-NJ), Chairman of the Financial Services Subcommittee on Capital Markets, H.R. 2308, the SEC Regulatory Accountability Act, with 15 original cosponsors, would require the SEC to abide by President Obama’s executive order that government agencies conduct robust cost-benefit analysis to ensure that the benefits of any rulemaking outweigh the costs, and that both new and existing regulations are accessible, consistent, written in plain language, and easy to understand.

As an independent agency, the SEC is not currently required to follow the Executive Order. While SEC Chairman Mary Schapiro has indicated that she intends for the SEC to abide by the order, noted Chairman Garrett, the legislation would codify that Executive Order and require her and future SEC Chairs to abide by it.

Specifically, the SEC Regulatory Accountability Act requires the SEC to clearly identify the nature of the problem that a proposed regulation is designed to address, as well as assess the significance of that problem, before issuing a new rule. Additionally, the bill requires the SEC to utilize the Office of the Chief Economist to conduct the cost-benefit analysis of potential rules to ensure that the regulatory consequences on economic growth and job-creation are properly accounted for.

Chairman Garrett said that, in the wake of the financial crisis, Congress reexamined how Wall Street operates and is regulated, which resulted in the unprecedented Dodd-Frank Act and its 300 new rules. While certain regulation is necessary, he conceded, it is… important to ensure that the cumulative amount of this rulemaking does not turn into a massive and unnecessary drag on economic growth.

The legislation would require the SEC to abide by President Obama’s executive order that government agencies conduct a thorough analysis of the economic effects of both new and existing regulations to avoid creating unnecessary, burdensome rules that affect economic growth and job-creation. It is based on the principle that sound data and economic analysis should underpin regulations. The legislation requires that the SEC utilize the Office of the Chief Economist to identify the nature and significance of the problem that the proposed rule seeks to address.

Landmark Australian Ruling Calls Directors Essential Component of Corporate Governance

In a landmark corporate governance opinion, the Federal Court of Australia ruled that company directors failed to take all reasonable steps required of them, and acted in the performance of their duties as directors without exercising the degree of care and diligence the law requires of them. Far from a mere technical oversight, said Justice Middleton, the information not disclosed was a matter of significance to the assessment of the risks facing the company. Giving that information to shareholders and, for a listed company, the market, is one of the fundamental purposes of the requirement that financial statements must be prepared and published. The importance of the financial statements is one of the fundamental reasons why the directors are required to approve them and resolve that they give a true and fair view. A director, while not an auditor, should still have a questioning mind, said the Court. More than a mere going through the paces is required for directors, since a director is not an ornament, but an essential component of corporate governance. Australian Securities and Investments Commission v. Healy, [2011] FCA 717, June 27, 2011.

Justice Middleton said that each director is placed at the apex of the structure of direction and management of the company. The Court said that the higher the office that is held by a person, the greater the responsibility that falls upon him or her. The role of a director is significant as their actions may have a profound effect on the community, noted the court, and not just shareholders, employees and creditors.

Australian Securities and Investment Commission Chair Greg Medcraft said that the case highlighted the danger of boards uncritically relying on management, or the auditors. Each member of the board must bring and apply their own skills and knowledge when declaring financial statements are true and fair, he said. This is not a responsibility company boards can delegate or merely rubber stamp. It’s not good enough for directors to just be present. Chairman Medcraft also said that there was a minimum standard of boardroom participation that directors must meet. This means the key elements of a company’s financial position are something directors should understand and be able to communicate accurately to the market.

The Commission alleged that the directors failed to discharge their duties with due care and diligence in approving the financial reports and that the directors, and the former chief financial officer, knew that the entities had very significant short-term interest bearing liabilities, and should have known that these liabilities were incorrectly classified in the 2007 financial reports.

The central question in the proceeding was whether the directors were required to apply their own minds to, and carry out a careful review of, the proposed financial statements and the proposed directors report, to determine that the information they contained was consistent with the director's knowledge of the company's affairs, and that they did not omit material matters known to them or material matters that should have been known to them.

The Court noted that the significant matters not disclosed were well known to the directors, or if not well known to them, were matters that should have been well known to them. In the light of the significance of the matters that they knew, they could not have, nor should they have, certified the truth and fairness of the financial statements, and published the annual reports in the absence of the disclosure of those significant matters. If they had understood and applied their minds to the financial statements and recognized the importance of their task, posited the Court, each director would have questioned each of the matters not disclosed. Each director, in reviewing financial statements, needed to inquire further into the matters revealed by those statements.

All directors must carefully read and understand financial statements before they form their opinions, said Justice Middleton, and such a reading and understanding would require the director to consider whether the financial statements were consistent with his or her own knowledge of the company’s financial position. This accumulated knowledge arises from a number of responsibilities a director has in carrying out the role and function of a director, noted the Court, including acquiring at least a rudimentary understanding of the business of the corporation and becoming familiar with the fundamentals of the business in which the corporation is engaged.

A director should keep informed about the activities of the corporation. While not required to have a detailed awareness of day-to-day activities, said the Court, a director should monitor the corporate affairs and policies, as well as maintaining familiarity with the financial status of the corporation by a regular review and understanding of financial statements.

Tuesday, June 28, 2011

European Commission Proposes Regulatory Regime for Venture Capital Funds

The European Commission has launched a consultation on new regulations for venture capital funds. Venture capital is an important source of financing and support for innovative small and medium-sized enterprises that encounter difficulties in accessing bank loans or listing on stock exchanges. The proposal outlines the broad contours of a European passport for venture capital funds so that they could raise capital freely throughout the EU from professional investors and invest in innovative companies. Once the passport had been obtained upon registration in one Member State, the fund manager could then operate throughout the EU without having to register in each Member State where it wanted to raise capital, as is often the case today.

The Commission emphasized that the fragmentation of markets for venture capital is an issue that requires immediate action. The immediate priority is to enlarge the geographical base in which venture capital funds can raise and invest capital. The Commission's goal is to achieve a real internal market for venture capital funds in the EU and reduce tax barriers to the greatest extent possible.

In this way venture capital funds would benefit from economies of scale and specialized sectoral expertise would emerge. This situation would have a number of positive consequences, said the Commission, such as more and bigger venture capital funds able to provide capital to a greater number of small and medium-sized enterprises.

Managers of venture capital funds are covered by the Directive on Alternative Investment Fund Managers, noted the Commission, since venture capital falls under the generic category of alternative investment. Therefore, managers of venture capital funds with assets under management above EUR 500 million can benefit from the European passport provided by the Directive. Managers under that threshold do not benefit from the Directive passport unless they decide to make use of the opt-in procedure envisaged in the Directive, in which case they have to comply with the full set of obligations and requirements of the Directive.

In order to provide legal certainty, the interaction of the new regime on venture capital with the AIFMD would be clarified. There are two options to do this. The first one is to exempt from the AIFMD only those managers that are below the threshold of the Directive. The second option is to exempt from the scope of the AIFMD the managers that fall under the new venture capital regime even if they trespass the thresholds of the Directive. In any event, the managers falling within the scope of the new venture capital initiative should exclusively manage venture capital funds investing in small and medium-sized enterprises.

Since investment in venture capital implies a certain level of risk, said the Commission, it is generally not considered a suitable investment vehicle for retail investors. Therefore, venture capital funds covered by the proposed European passport system would only be offered to professional investors as defined by MiFID. As a consequence, venture capital funds that would operate under the proposed passport system would not be obliged to face the traditional disclosure obligations and requirements linked to investor protection, which would imply an offer to retail clients.

Thus, the Commission envisions that venture capital investors would be professional and would apply high standards of due diligence, while undertaking a thorough examination of any fund before they decide to make an investment. These investors are expected to closely monitor the activity of the manager of the venture capital fund and the evolution of their investments.

Under the proposal, venture capital managers would only be required to produce an annual report including the annual financial accounts and a report of the activities of the financial year for each fund, and this report would be made available to investors and competent authorities. The financial information would be audited. The proposal would not include any other specific information requirements to investors, since the information for investors will follow industry standards and will be specified in the fund rules or instrument of incorporation of the venture capital fund.

It will be difficult but essential to get the definition of venture capital fund right, said the Commission. The proposed European passport will be conditioned on the definition, noted the Commission, as well as possible tax benefits that Member States might design for this type of investment. The Commission will approach the definition from a number of inclusionary and exclusionary paths involving fund activities and investment strategies. For example, the Commission envisions defining a venture capital fund as an entity that invests in small and medium-sized enterprises with growth potential that are in the first or very early stages of development or expansion. More precisely, it seems appropriate to concentrate the legislative initiative on venture capital funds that invest in either seed, start-up or expansion stages.

Definition by exclusion is based on the rationale that there are some types of investments which per se do not fit into the notion of venture capital helping to develop small and medium-sized businesses. In particular, it is not appropriate to allow venture capital funds who wish to benefit from the EU regime to invest in companies that are traded on a secondary market, in financial entities, other funds or financial instruments.

Nebraska Adopts Amendments to Limited "Private Placement" Offering Exemption Rule

The rule setting forth the notice filing requirement for Nebraska's limited offering exemption at Section 8-1111(9) of the State's Securities Act was amended, effective June 25, 2011. Here is a summary of the adopted changes:

1. The mailing address for filing the notice with the Nebraska Department of Banking and Finance is now P.O. Box 95006, Lincoln, Nebraska 68509.

2. Contents of notice. The information provided in the notice must include, among other things:

--Currently, the name and address of the broker-dealer representing the seller in promoting the offering. As amended, the name and address of any officer, director, manager, member or other person representing the seller in promoting the offering if there is no broker-dealer representing the seller.

--Currently, the total dollar amount of the securities, but as amended, that are sold as of the date of the filing whether or not [sold] in Nebraska.

--As added, the dollar amount of securities to be offered during the 12-month period following the filing, whether or not [offered] in Nebraska.

3. NEW: Additional filings. Audited financial statement and sales report requirement for issuers either: (1) having made sales under the limited offering exemption for five consecutive 12-month periods; OR (2) having total sales of $1 million from one or more offerings under the limited offering exemption.

The required information must be filed no later than 90 days after the date the issuer files the fifth consecutive annual notice claiming the limited offering exemption OR the date the issuer's total sales of the securities exceed $1 million.

The financial statements must include a balance sheet, an income statement, a cash flow statement and a net worth computation, as of the end of the issuer's most recent fiscal year. The financial statements must be examined according to generally accepted auditing standards and prepared to comform to GAAP; and audited by an independent CPA containing the CPA's opinion of the issuer's financial position.

The sales report must include the name and address of all purchasers and holders of the issuer's securities, the amount of securities held, the dates the purchases were made and a statement whether each purchaser or holder is an "accredited investor" and, if so, whether their accredited investor status is based on net worth or net income.

Issuers must file audited financial statements and sales reports with the Nebraska Director of the Department of Banking and Finance each time the issuer sells an additional $1 million in securities or after the lapse of each additional 60-month period when sales are made.

NOTE WELL: This additional filing is a necessary precursor to attaining the exemption for issuers who fall within one of the two abovementioned categories, by either having made sales under the limited offering exemption for five consecutive 12-month periods or by having total sales of $1 million from one or more offerings under the limited offering exemption. Issuers in one of these categories who do not make the filing will lose the exemption. Moreover, they will be in violation of the registration provision of the Nebraska Securities Act if they effect sales without first making the additional filing.

Effectiveness. A notice filed to claim the limited offering exemption remains effective until, as amended, the first of the following two events occur: Either sales are made to 15 persons (excluding persons designated in Nebraska's financial institutions/institutional investor, existing security holder or employee benefit plan exemptions), OR one year from the date of the first sale.

With questions about the amendments please contact Sheila Cahill, Legal Counsel at the Securities Bureau, by emailing or by phoning (402) 471-3445.

In Light of Financial Crisis, Singapore Proposes Revisions to Corporate Governance Code

The Singapore Corporate Governance Council has proposed significant changes to the Corporate Governance Code that would enhance the areas of executive compensation, the role of independent directors, and risk management. One revision to the Code would include a provision that the compensation committee should ensure that existing key relationships between the company and its appointed compensation consultants will not affect the independence and objectivity of the consultants. The Code would also include additional guidance that companies should disclose more information on the link between compensation and the performance of directors, CEOs and key management personnel.

Also, companies should fully disclose the compensation of each individual director and the CEO on a named basis. Companies should disclose in aggregate the total remuneration paid to the top five key management personnel who are not directors or the CEO.

Global events over the past two years have underscored the importance of companies taking an integrated, firm-wide perspective of their risk exposure, and increased the focus on the governance of risk management. Thus, the Council proposes a new Code principle on risk management under which the Board would be responsible for the risk governance of the company and would determine the nature and extent of risks which the company may undertake. The Board would also ensure the maintenance of a sound system of risk management and internal controls.

The Council also recommends a separate Board risk committee. Further, to enhance management’s accountability for the company’s risk management, the Council also proposes that the Board comment on whether it received assurance from the CEO or the CFO regarding the company’s risk management system.

There is growing recognition that a company’s corporate governance framework should involve shareholders and other stakeholders. International corporate governance practices have evolved to provide for shareholder rights to be recognized and facilitated, and for company boards to engage with their shareholders. In Singapore, the legal rights of shareholders are set out in legislation or embodied in common law principles. The Council recommends a new Code principle, and accompanying guidelines on Shareholder Rights to guide companies in their engagement with shareholders.

Internationally, the proportion of independent directors on the board of a listed company ranges from one-third in Hong Kong to half or majority in Australia, the UK and the US. The current Code requires independent directors to make up at least one-third of the board of a listed company. The Council proposes that independent directors should make up at least half of the Board when the Chair and the CEO is the same person, immediate family members or part of the same management team, or the Chair is not independent.

Monday, June 27, 2011

Hong Kong Court Has No Jurisdiction Over SFC Action Against Hedge Fund for Insider Trading

The Hong Kong High Court of First Instance has ruled that it had no jurisdiction to entertain an action by the Securities and Futures Commission alleging that a hedge fund engaged in insider dealing and false trading in securities since the Securities and Futures Ordinance created a dual regime of civil actions before the Market Misconduct Tribunal or criminal proceedings. Justice Harris noted that the legislation does not contemplate a tripartite regime with, in addition to criminal prosecution or an inquiry by the Market Misconduct Tribunal, a third procedure by which the Commission could go to the court and ask it to determine whether there had been a violation of the insider dealing provisions. The hedge fund, a New York-based asset management company, specializes in equity investments in China, Japan and Korea. Securities and Futures Commission v. Tiger Asia Management LLC, High Court of the Hong Kong Special Administrative Region, Court of First Instance, June 21, 2011.

The effect of the ruling is that a court exercising criminal jurisdiction or the Market Misconduct Tribunal has jurisdiction to determine whether a violation of Hong Kong’s insider dealing laws and market manipulation laws has occurred, with the result that the Commission cannot seek final orders under section 213 without such a prior determination. The Commission said that it would appeal the court’s ruling. The Commission noted that the hedge fund is not within the jurisdiction of Hong Kong’s criminal courts nor, in the SFC’s view, should it be entitled to receive immunity from prosecution which would be the result if proceedings were commenced before the Tribunal.

In cases in which the evidence is thought sufficiently strong to satisfy the criminal standard of proof, noted the court, an alleged violation can be prosecuted. If there is doubt about the strength of the evidence the violation can be referred to the Financial Secretary, who can instigate an inquiry by the Market Misconduct Tribunal before whom the less onerous civil standard of proof applies. The court emphasized that proceedings before the Market Misconduct Tribunal and criminal prosecution are mutually exclusive. The effect of the Financial Secretary instituting proceedings before the Market Misconduct Tribunal is to prevent further criminal proceedings.

If proceedings are instituted before the Market Misconduct Tribunal the inquiry is conducted with the assistance of an officer who presents to the Tribunal such available evidence as will enable it to make an informed decision as to whether market misconduct has taken place. The Commission is not in any sense a party to the proceedings, said the court. Rather, the Commission’s role is to provide such evidence as it is able to the Presenting Officer, who decides whether or not it should be adduced before the Tribunal.

Citing Basel Committee Action, Members of House Financial Services Committee Caution on Raising Bank Capital Requirements

Noting that the Basel Committee is contemplating raising the capital level for global systemically important financial firms, three members of the House Financial Services Committee urged US regulators to carefully consider the impact of any Basel actions on the US economy. In a letter to Treasury and the Fed, Rep. Nan Hayworth (R-NY), Rep. John Carney (D-DE), and Rep. James Renacci (R-OH) said that it is crucial that US policymakers carefully examine and weigh the cumulative impact on credit availability and overall recovery efforts before considering additional surcharges for US financial institutions.

On June 25, 2011, the oversight body of the Basel Committee agreed on a consultative document setting out measures for global systemically important banks, including required capital ranging from 1 percent to 2.5 percent, depending on a bank's systemic importance. This builds on the Basel III requirements of holding a capital conservation buffer of 2.5 percent to withstand future periods of stress bringing the total common equity requirements to 7 percent.

The Representatives noted that the Basel proposal is on the heels of the December 2010 proposal to triple capital levels, which is an action that would require banks to add more than $600 billion in capital to their balance sheets. While recognizing that prudent capital standards can increase safety and soundness, the Representatives said that unnecessarily high capital surcharges on top of Basel III and other reforms could place an untimely drag on the recovery. Also, they said that the new capital requirements must be implemented consistently cross-border to provide a level playing field for US firms and international counterparties.

Finally, noting the Dodd-Frank reforms addressing systemic risk and interconnectedness of firms, the Representatives said that the Basel Committee has not yet demonstrated that revised capital levels are necessary in the wake of all the other reforms implemented since the crisis.

UK Official Launches Corporate Governance Initiative on Executive Compensation and Shareholder Involvement

The UK will launch a consultation on executive compensation and conduct a review of the UK equity investment regime, said Secretary of State for Business Vince Cable. In remarks to the Association of British Insurers, the Minister noted positive UK developments promoting investor involvement in corporate governance, such as the Stewardship Code, which sets out the role of shareholders in holding directors to account and the new Advisory Council of the Institutional Investor Committee, which is a promising sign that investors are starting to work together. But, he noted that the financial crisis has intensified long-standing concerns about whether there are systemic flaws in the way companies are owned and managed in the UK.

The Minister said that he will soon be launching a consultation on changes to company reporting that will propose tougher provisions on disclosure of executive pay and its link to company performance. This is the culmination of a body of work on narrative reporting that will make company reports clearer, shorter and more relevant. Transparency only gets us so far, noted the Minister, and may have the perverse effect of encouraging a race to the top. The Minister intends to explore other ways to intervene sensibly and, in particular, to put an end to the culture of rewards for failure.

As a first step, he will be holding talks with interested parties including remuneration committee chairs in the next few weeks to explore various policy options, with a view to announcing further action in this area in the autumn. In a complex, globalized world, he continued, heavy handed controls aren’t going to work and will do damage. He will require creative thinking on this problem to match, for example, the corporate governance provisions of the Dodd Frank Act.

But ultimately there is no substitute for leadership from companies themselves and their owners. The Minister called on remuneration committees and institutional investors to take a much stronger line and uphold the Corporate Governance Code, which makes it clear that executive remuneration should be tied to performance and a company’s long-term success.

Secretary Cable also stressed the urgency of recalibrating the equity investment regime to support the long-term interests of companies as well as underlying beneficiaries, such as pension fund members. Serious commentators from the business community have suggested expanding a board’s fiduciary duties to make directors give higher priority to the long-term and boosting shareholders rights for long term investors to give them greater voting power than short-term traders. In addition, there have been suggestions that the Government use the tax system to penalize short-term share trading and encourage long-term investment.

The Minister has launched an independent review of investment in UK equity markets. The review will examine behavior right along the investment chain, from company boards, through pension funds, advisers and fund managers, to ultimate beneficiaries. He expects the review to produce recommendations on how best to ensure that the timescales over which companies and fund managers operate match the interests of clients and beneficiaries and ways to strengthen engagement between institutional investors and quoted companies. The review will also examine the most effective means of boosting transparency for clients, underlying beneficiaries and companies themselves and the legal duties and responsibilities of asset owners and managers.

Sunday, June 26, 2011

Legislation Repealing Pay Ratio Provision of Dodd-Frank Passed Out of House Financial Services Committee

Legislation repealing a provision of Dodd-Frank that would require public companies to disclose their median annual total compensation of all employees was reported favorably out of the House Financial Services Committee to the full House. The Burdensome Data Collection Relief Act, HR 1062, would remove Section 953(b) of Dodd-Frank, which directs the SEC to adopt rules requiring disclosure of the median of the compensation of the company’s employees and the ratio between the median of the annual total compensation of the employees and the annual total compensation of the issuer's chief executive officer. The vote was 33-21. The legislation has the support of the Society of Corporate Secretaries and Governance Professionals.

The Committee received testimony about the 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(b) 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 SEC has yet to propose rules under Section 953(b) 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 Society of Corporate Secretaries and Governance Professionals supports the legislation. Testifying in favor of the legislation, Society President Ken Bertsch said that it will be virtually impossible for large global companies to comply with Section 953(b) and that its implementation will impose a substantial burden even on smaller issuers. While acknowledging a public policy concern on pay gaps in the United States, the Society believes that the required ratio will be neither material or nor meaningful to investors. At the hearing, Rep. Hayworth also said that the Section 953(b) mandates disclosure of information that is essentially immaterial.

According to the Society, the pay ratio under Section 953(b) will not provide useful information to investors because it is not comparable in any way across industries, companies, geographies, or employees. For example, companies located in certain areas of the country pay employees and executives more than others, given the cost of living in those areas. Moreover, some businesses have a large number of low-paid workers and some have a higher percentage of part-time employees or seasonal employees. These companies will likely have worse pay ratios.

In addition, companies with franchisees rather than company-staffed stores will also likely have a better pay ratio. Thus, the Society said that the pay ratio will not be a meaningful measure to compare to the CEO’s compensation, or to compare the pay practices compared within a single industry.

Given the definition of “annual total compensation” as set forth in Section 953(b)(2), said the Society, many companies would not be able to calculate the median of the annual total compensation of all employees of the issuer with the degree of precision required for information filed under the federal securities laws. Payroll systems are not set up to gather the kind of information required under this provision. This is especially the case for companies organized into multiple operating business units.

Those business units keep records and have internal controls over what each employee is paid, but they report aggregated figures to the parent company for inclusion in consolidated financial reports for public filings. Thus, the parent company that files SEC reports does not have direct access to the employee-by-employee data necessary to identify the median employee. This is complicated even further when operating business units are based outside the United States or employ people in multiple countries.

Moreover, the Society noted that Section 953(b) requires the issuer to disclose the median of all employees, using the same calculations as are used to determine total pay for named executive officers under the proxy rules. In other words, a company would have to convert the pay of each employee globally into the pay formula applicable to the named executive officers in the Summary Compensation Table. To the Society’s knowledge, no public company now calculates each employee’s total compensation in the way it is required to calculate total pay on the Summary Compensation Table for named executive officers (usually five individuals). Disclosure of executive pay has a different purpose than internal accounting.

Supreme Court This Term Strongly Reaffirms Deference to Agency Interpretation of Regulations

With the SEC and CFTC in the process of adopting a host of regulations to implement the Dodd-Frank Act, the US Supreme Court this term delivered a strong endorsement to the doctrine of judicial deference to an agency’s interpretation of its own regulations, even when the interpretation is delivered in an amicus brief. Three unanimous opinions by the Court strongly reaffirmed the Chevron standard of review for agency regulations and the Auer doctrine for deference to agency amicus briefs. At a time when federal regulators are filling in the gaps of Dodd-Frank and piecing together the interstices to create a mosaic of the complete financial regulatory picture, the Supreme Court appears to have given its strongest endorsement of agency interpretation of regulations since the Administrative State was created by the New Deal.

The first and broadest opinion involved the correct judicial standard of review for a federal tax regulation. In an opinion strongly reaffirming the Chevron standard of review of regulations, and rejecting a special standard for reviewing tax regulations, Chief Justice Roberts said that regulation, like legislation, often requires drawing lines.

If Congress has not directly addressed the precise question at issue, he said, the Court will not disturb a regulation unless it is arbitrary or capricious in substance, or manifestly contrary to the statute. Chevron U. S. A. Inc. v. Natural Resources Defense Council, Inc., 467 U. S. 837 (1984). Noting that the Chevron standard applies with full force in the tax context, the Court refused to apply the additional factors, such as how long the regulation has been in effect, used in National Muffler Dealers Assn., Inc. v. United States, 440 U. S. 472 (1979). Mayo Foundation v. US 09-837.

The Court recognized that filling gaps in the Internal Revenue Code plainly requires regulations at least as complex as the ones other agencies, such as the SEC and CFTC, must make in administering their statutes. The question presented, whether doctors who serve as medical residents are properly viewed as students whose service Congress has exempted from FICA taxes under 26 U. S. C. §3121(b)(10), was one of ambiguity that could be left to regulatory interpretation.

In Chase Bank v. McCoy, Dkt. No. 9-329, the Court, citing Auer v. Robbins, 519 U. S. 452 (1997), said that it would defer to an agency’s interpretation of its own regulation, advanced in a legal brief, unless that interpretation is plainly erroneous or inconsistent with the regulation. Finding Regulation Z to be ambiguous as to the question presented, the Court therefore looked to the Federal Reserve Board’s own interpretation of the regulation for guidance in deciding this case. Justice Sotomayor, writing for the Court, emphasized that just because the Fed’s interpretation of Regulation Z came in a legal brief did not make it unworthy of deference.

In Talk America v. Michigan Bell Telephone, Dkt. No. 10-313, the Court, in the absence of any unambiguous statute or regulation, turned to the FCC’s interpretation of its regulations in its amicus brief. Justice Thomas, writing for the Court, said that the Court will defer to an agency’s interpretation of its regulations, even in a legal brief, unless the interpretation is plainly erroneous or inconsistent with the regulations or there is any other reason to suspect that the interpretation does not reflect the agency’s fair and considered judgment on the matter in question. The Court held that the FCC as amicus curiae has advanced a reasonable interpretation of its regulations, and deferred to its views.

But note that judicial deference to agency amicus briefs is not unlimited. Justice Sotomayor noted that the Court will not apply Auer deference if the regulation in question was unambiguous, and adopting the agency’s contrary interpretation would permit the agency, under the guise of interpreting a regulation, to create de facto a new regulation. In light of Regulation Z’s ambiguity, there was no such danger in the Chase Bank case. But, said the Justice, if the text of a regulation is unambiguous a conflicting agency interpretation advanced in an amicus brief will necessarily be plainly erroneous or inconsistent with the regulation.

Thursday, June 23, 2011

House Leaders Ask for Audit of Financial Stability Oversight Council

House Financial Services Chair Spencer Bachus (R-AL) and Oversight and Investigations Subcommittee Chair Randy Neugebauer (R-TX) have asked the GAO to conduct an audit and report to Congress on the Financial Stability Oversight Council specifically, among other things, examining the Council’s use of quantitative and qualitative data to develop metrics for determining which investment funds and other non-bank financial institutions will be designated systemically important financial institutions and subjected to heightened regulation. In a letter to the Comptroller General, the Chairs said that, given the Council’s sweeping mission to monitor financial market stability and mitigate risks, Congress must fully understand its structure and decision making process in order to ensure the Council’s accountability. They noted that Section 122 of Dodd-Frank authorizes the GAO to audit the activities of the FSOC.

The study should also report on the Council’s staffing, operations and budget, including the ability of the SEC, CFTC and other FSOC members to consult with staff from their respective agencies on FSOC matters. In addition, the report should deal with FSOC procedures for dealing with comments to studies and proposed regulations. Chairman Bachus noted that in two Dodd-Frank mandated FSOC studies international competitiveness was given only a cursory assessment despite concerns expressed by Congress and regulated entities.

In addition, the study should examine the operation and plans for the Office of Financial Research, including an account of information requests made by FSOC of the Office to date and any plans to collect data from regulated entities. The House oversight chairmen also want the study to examine FSOC and Office of Financial Research plans for safeguarding proprietary information and consumer data, including data security infrastructure and post-employment policies. The Office of Financial Research was created by Dodd-Frank to develop the metrics and tools the Council and financial regulators need to monitor systemic risk.

Finally, and more broadly, with regard to each FSOC-proposed rule,the Chairmen want GAO to compile all documents and cost analyses used by FSOC to determine if the rule should be designated an ``economically significant regulatory action’’ or ``significant regulatory action under Executive Order 12866, which, among other things, requires that a regulation be proposed or adopted only upon a reasoned determination that its benefits justify its costs.

Comment Period Extended on Proposed Regulations on Margin and Capital for Swap Dealers

Federal regulators have extended until July 11, 2011 the comment period on proposed regulations establishing margin and capital requirements for swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants as required by the Dodd-Frank Act. The comment period was extended to allow interested persons more time to analyze the issues and prepare their comments. Originally, comments were due by June 24, 2011.

House Committee Gives Bi-Partisan Approval to Legislation Creating US Covered Bond Market

The House Financial Services Committee has approved H.R. 940, the U.S. Covered Bond Act of 2011, by a bi-partisan vote of 45-7, to facilitate a covered bond market in the U.S. and add liquidity and certainty to the capital markets. Introduced by Rep. Scott Garrett (R-NJ), Chairman of the Financial Services Subcommittee on Capital Markets, and Rep. Carolyn Maloney (D-NY), Ranking Member of the Financial Services Subcommittee on Financial Institutions, the Act would create a covered bond market with appropriate protections that would level the playing field for U.S. financial institutions to better compete with their foreign counterparts. Since S 940 would amend the Internal Revenue Code and has other federal tax code implications, the measure was referred to the House Ways and Means Committee. The Obama Administration backs, in principle, efforts to create a market for covered bonds for financing mortgages that would help wean the mortgage market from government support.

The bi-partisan legislation would create a 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. The Act declares any covered bond issued or guaranteed by a bank to be a security issued or guaranteed under specified securities laws, including the Securities Act and the Investment Company Act.

A critical portion of the legislation 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. If an uncured default occurs on a covered bond before the issuer enters receivership, liquidation, or bankruptcy, the legislation creates an estate automatically by operation of law to be administered separately from the issuer or any later receivership or estate in bankruptcy. A separate estate must be created for each affected covered bond program. Any estate so created will generally be exempt from all securities laws, except that it would be subject to the reporting requirements established by the applicable covered bond regulator and must succeed to any requirement of the issuer to file periodic reports in respect of the covered bonds as specified in section 13(a) of the Exchange Act.

Similarly, the estate would not be treated as an entity subject to taxation separate from the owner of the residual interest for purposes of the Internal Revenue Code, including by reason of the taxable mortgage pool provisions of section 7701(i) of the Code, but instead must be treated as a disregarded entity that is owned by the owner of the residual interest for such purposes as described in applicable regulations, as in effect on the date of enactment. No transfer or assumption of any asset or liability to or by an estate or an eligible issuer would constitute an event in which gain or loss must be recognized under section 1001 of the Code.

Covered bonds have been used in Europe for centuries to help provide additional funding options for the issuing institutions and are a major source of liquidity for many European nations’ mortgage markets. The purpose of the U.S. Covered Bond Act is to create a legislative framework for the development of a covered bond market in the U.S. This framework will enable credit to flow more readily from the capital markets to households, small businesses, and state and local governments in a way that enhances stability of the broader financial system. The core elements of the legislative framework are legal certainty for covered bond programs and supervision by federal regulators.

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 establishing 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.

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

Speaking in support of the legislation, Financial Services Committee Chairman Spencer Bachus (R-Ala) said that covered bonds are an innovative source of financing that has worked well in many European countries, particularly in the aftermath of the financial crisis when many other traditional credit channels were badly disrupted. In his view, covered bonds would provide much needed liquidity in capital markets while at the same time representing a private market solution to the need for market participants to have skin in the game.

Senator Corker Has Concerns about Proposed Dodd-Frank Risk Retention Regulations

Senator Bob Corker (R-TN) an influential member of the Banking Committee, asked regulators to improve the qualified residential mortgage rules under the proposed regulations implementing the risk retention requirements of Dodd-Frank. In a letter to Treasury, with copies to the SEC and banking regulators, the Senator said that a rule allowing for a more sophisticated trade-off between down payment and other risk mitigating factors, such as documentation type or credit score, would still materially improve underwriting quality but would not represent such a blunt change to market conditions. More broadly, he urged the regulators to use the ``incredibly’’ broad discretion that Dodd-Frank give them when crafting the risk retention regulations to weigh the impact of this pro-cyclical regulation on the housing market’s ability to recover. For example, regulators could use this discretion to gradually phase-in rules limiting negative amortization of payments or strictures that include significant interest rate shocks.

Wednesday, June 22, 2011

SEC Adopts Regulations Requiring Registration of Hedge Funds and Private Equity Funds; Defines Venture Capital Fund

The SEC has adopted regulations facilitating the registration of advisers to hedge funds and other private funds as required by the Dodd-Frank Act, which ended the statutory exemption for advisers with fewer than 15 clients. As a result, many of these private fund advisers will now, not only register with the Commission, but be subject to its rules, its regulatory oversight and its examination program. In order to facilitate an orderly transition and enable private fund advisers to come into compliance with the new regime, advisers will not be required to comply with these registration requirements until the first quarter of 2012. To provide these advisers with a window to meet their new obligations, the transition provisions the Commission adopted require these advisers to be registered with the Commission by March 30, 2012.

The new registration regime will provide the SEC and the public with information about the business operations of these advisers, as well as information about their conflicts of interest, disciplinary history and investment strategies. The regulations will also require these advisers to detail the size and strategy of their hedge funds and other private funds, as well as the identities of critical gatekeepers such as auditors and prime brokers that provide services to these funds. According to SEC Chair Mary Schapiro, the registration and reporting requirements are designed to obtain a meaningful collection of data that would aid investors and assist SEC regulatory and examination efforts, without requiring any disclosure that could inadvertently harm the interests of private fund investors.
While imposing new registration responsibilities upon advisers to hedge funds and many other private funds, Dodd-Frank exempted from registration advisers solely to venture capital funds and advisers solely to private funds with less than $150 million in assets in the United States. But Congress mandated that these advisers be subject to certain reporting requirements.

The SEC followed a balancing approach in developing a reporting regime for want Chairman Schapiro called “exempt but reporting advisers.” The Commission seeks information on key census data about the firm, its private funds and any disciplinary information, noted the Chair, but decided not to require the full panoply of information, including the ADV, Part 2 client-oriented narrative disclosure that would be required of a registered investment adviser.
Since this is the SEC’s first time developing a reporting a regime for advisers that are exempt from registration, noted Chairman Schapiro, it is important that the Commission assess the reporting requirements for these advisers once it has experience receiving the information and can fine-tune the information collected at that point. Thus, Chairman Schapiro directed the staff to reconsider the information collected from “exempt but reporting advisers” after assessing the first year’s filings. In her view, this will enable the Commission to make necessary adjustments if it is not receiving sufficient information from these advisers.

Although the law enables the Commission to examine these “exempt but reporting advisers,” observed the Chair, the SEC does not intend to conduct routine examinations of them. The Commission will use its scarce resources to the advisers that are actually registered which, sad the Chair, is where the investing public expects the agency to be focused.
With regard to the $150 million assets under management threshold, the SEC said that, while many advisers will calculate fair value in accordance with GAAP or another international accounting standard, other advisers acting consistently and in good faith may utilize another fair valuation standard. While these other standards may not provide the quality of information in financial reporting, the SEC expects that these calculations will provide sufficient consistency for purposes of regulatory assets under management.

However, the SEC expects, consistent with the good faith requirement, that an adviser calculating fair value in accordance with GAAP or another basis of accounting for financial reporting purposes will also use that same basis for purposes of determining the fair value of its regulatory assets under management. In addition, the fair valuation process need not be the result of a particular mandated procedure and the procedure need not involve the use of a third-party pricing service, appraiser or similar outside expert. An adviser could rely on the procedure for calculating fair value that is specified in a private fund‘s governing documents.

The SEC defined venture capital funds in a way that distinguishes them from hedge funds and private equity funds by focusing on the lack of leverage of venture capital funds and the non-public, start-up nature of the companies in which they invest.

The regulation focuses on the provision of capital for the operating and expansion of start-up businesses, rather than buying out prior investors. In crafting the definition of venture capital fund, the goal was to develop an accurate and legitimate definition without including loopholes that could be inappropriately exploited down the road.

The definition flexibly provides a 20 percent basket that would be outside the strict venture capital-oriented investment parameters imposed on the remaining 80 percent of the fund. This 20 percent basket would enable legitimate one-off investments and flexibility while maintaining a fund’s core venture capital nature.

The SEC regulations do not define a venture capital fund as a fund advised by an adviser with a principal office and place of business in the United States. Thus, a non-U.S. adviser, as well as a U.S. adviser, may rely on the venture capital exemption provided that they solely advise venture capital funds that satisfy all of the elements of the rule. A non-U.S. adviser may rely on the venture capital exemption if all of its clients, whether U.S. or non-U.S., are venture capital funds.

Chairman Schapiro added that the Commission will supplement the new regulations with consideration of adoption of new Form PF. As proposed earlier this year, Form PF would provide additional information from private fund advisers that would be reported on a non-public basis pursuant to the Dodd-Frank Act. The information would be used to inform the SEC and the Financial Stability Oversight Council about the systemic risk profile of private fund advisers and the private funds they manage.

The Dodd-Frank Act provided an exemption from registration for foreign private advisers that do not have a place of business in the United States, have less than $25 million in aggregate assets under management from U.S. clients and private fund investors and fewer than 15 clients in the US. The SEC defined certain terms included in the statutory definition of “foreign private adviser” in order to clarify the application of the exemption and reduce the potential burdens for advisers that seek to rely on it.

Under the SEC regulations, a foreign adviser can treat as a single client a corporation or partnership to which the adviser provides investment advice. Moreover, if an adviser reasonably believes that an investor is not in the United States, the adviser may treat the investor as not being in the United States. Also, a person who is in the United States may be treated as not being in the United States if the person was not in the United States at the time of becoming a client or, in the case of an investor in a private fund, each time the investor acquires securities issued by the fund. This regulation is designed to reduce the burden on the foreign adviser of having to monitor the location of clients and investors on an ongoing basis

Under the regulations, any office from which an adviser regularly communicates with its clients, whether U.S. or non-U.S., would be a place of business. In addition, an office or other location where an adviser regularly conducts research would be a place of business because research is intrinsic to the provision of investment advisory services. But a place of business would not include an office where an adviser solely performs administrative services and back-office activities if they are not activities intrinsic to providing investment advisory services and do not involve communicating with clients.

The SEC indicated that there is no presumption that a non-U.S. adviser has a place of business in the United States solely because it is affiliated with a U.S. adviser. A non-U.S. adviser might be deemed to have a place of business in the United States, however, if the non-U.S. adviser‘s personnel regularly conduct activities at an affiliate‘s place of business in the United States.

Funds’ Distributor and Adviser Settle Fraud Charges Related to Subprime Mortgage-Backed Securities in Coordinated Federal-State Action

The SEC, state regulators, and FINRA have settled proceedings against an investment adviser to investment companies and a broker-dealer that underwrote and distributed the funds’ shares. Without admitting or denying the charges, the broker and adviser agreed to pay $200 million to settle fraud charges related to subprime mortgage-backed securities and a former senior portfolio manager agreed to pay penalties for his alleged misconduct, and was barred from the securities industry. The SEC brought its enforcement action in coordination with FINRA and a task force of state regulators from Alabama, Kentucky, Mississippi, Tennessee and South Carolina.
Alabama Securities Commissioner Joe Borg said that, while the SEC and the state regulators proceeded on parallel tracks, there was some overlap and also a tremendous amount of cooperation.

Commissioner Borg noted that the state regulators focused on sales practices, the SEC focused on pricing, and FINRA focused on advertising. Of the $200 million settlement fund, Commissioner Borg noted that $100 million is going into an SEC Fair Fund for the benefit of investors and $100 million into a state fund that also will be distributed to investors. He also emphasized that investors are not giving up any arbitration claims that they may have in connection with the activities of the firms. Shonita Bossier of the Kentucky Department of Financial Institutions emphasized that the proceedings put firms on notice that these types of practices will not be tolerated.

William Hicks, Associate Director for the SEC’s Atlanta Regional Office, added that this enforcement action clarifies that the SEC will deal firmly with those who abuse their responsibility to assign accurate values to securities or other assets held by funds. Robert Khuzami, Director of the SEC’s Division of Enforcement emphasized that the falsification of fund values misrepresented critical information exactly when investors needed it most, that is, when the subprime mortgage meltdown was impacting the funds.

Specifically, the SEC found that the portfolio manager instructed the fund’s accounting department to make arbitrary price adjustments to the fair values of certain portfolio securities. The price adjustments ignored lower values for those same securities provided by outside broker-dealers as part of the pricing process, and often lacked a reasonable basis. In some instances, when price information was received that was substantially lower than current portfolio values, fund accounting personnel acted at the direction of the manager and lowered values of bonds over a period of days in a series of pre-planned reductions to values at or closer to the price confirmations. As a result, during the interim days, the fund did not price those bonds at their current fair value.

The SEC also found that the portfolio manager screened and influenced the price confirmations obtained from at least one broker-dealer. Among other things, the broker-dealer was induced to provide interim price confirmations that were lower than the values at which the funds were valuing certain bonds, but higher than the initial confirmations that the broker-dealer had intended to provide. The interim price confirmations enabled the funds to avoid marking down the value of securities to reflect current fair value. According to the SEC’s order, through his actions the portfolio manager fraudulently prevented a reduction in the NAVs of the funds that should otherwise have occurred as a result of the deterioration in the subprime securities market in 2007. This misconduct, said the SEC, occurred in the context of a nearly complete failure to employ the fair valuation policies and procedures adopted by the funds’ boards of directors to fair value the funds’ portfolio securities

Many of the securities held by the funds and backed by subprime mortgages lacked readily available market quotations and, as a result, were required by the Investment Company Act to be priced by the funds’ boards of directors, using fair value methods. Under Section 2(a)(41)(B) of the Investment Company Act, the funds were required to use market values for portfolio securities with readily available market quotations and use fair value for all other portfolio assets, as determined in good faith by the board of directors. The fair value of securities for which market quotations are not readily available is the price the funds would reasonably expect to receive on a current sale of the securities

Under the state consent orders, the firms were prohibited from creating, offering or selling any proprietary funds for a period of two years. Further, if the firms form and sell any proprietary investment products before January 1, 2016, for three years the firms are required to retain an independent auditor acceptable to the SEC and state securities regulators from Alabama, Kentucky, Mississippi, South Carolina and Tennessee.

Also, for the next three years, the firms must provide special mandatory training to all of their registered agents and investment adviser representatives, which is required to be comprehensive for each of the products and offerings sold or recommended to clients. The firms must also conduct training on suitability and risks of investments. They are also prohibited from having one person simultaneously hold the positions of general counsel and chief compliance officer.

Tuesday, June 21, 2011

NASAA Questions Registration Exemption for Private Equity Fund Advisers

The North American Securities Administrators Association (NASAA) has questioned provisions of the proposed Small Business Capital Access and Job Preservation Act (H.R. 1082) that would exempt private equity fund advisers from registration under the Investment Advisers Act of 1940. In the organization's recent comment letter to leaders of the House Financial Services Committee, NASAA observed that the bill would exempt advisers to private equity funds from registration or reporting requirements, while at the same time requiring these advisers to maintain records and provide reports as the SEC deems necessary and appropriate. Although acknowledging the congressional desire to facilitate job creation, NASAA believes that fundamental components of the bill are so vague as to undermine any purported benefits to small businesses.

First, NASAA noted that the legislation does not define the term "private equity fund" but rather delegates this task to the SEC, an undertaking which the SEC is required to complete within six months after the legislation's enactment. Although the bill appears to provide treat "private equity funds" similar to venture capital funds for exemptive purposes, without more specificity and a clear definition it is unknown what types of entities are covered by the exemption, NASAA stated. Accordingly, any assessment of risk to financial stability posed by these investments would be invalid absent clarification of what constitutes the universe of "private equity." In any event, NASAA wrote, it would be unwise to establish an exemption before defining what is covered by the exemption.

Second, NASAA stated that the bill is unclear as to what, if any, reporting requirements would be required for private equity fund advisers. NASAA referenced the language in the title of Section 2, "Registration and Reporting Exemptions Relating to Private Equity Fund Advisers," which appears to suggest that an adviser to a "private equity fund" would be exempt from both registration and reporting requirements, regardless of the adviser's assets under management. NASAA also believes that the proposed exemption contained in Section 203(o)(1) would likely have the unintended consequence of depriving the SEC of regulatory information critical for assessing risk and protecting investors.

Finally, NASAA observed that the bill's scope appears to cover all investment advisers who advise undefined "private equity funds." The exemption, therefore, would differ from exemptions established in the Dodd-Frank Act for advisers to private funds, which are limited to advisers who solely advise one type of fund. Accordingly, as drafted, the exemptions contained in the bill for advisers to private equity funds would exceed the limitations of the exemptions available to private funds and venture capital funds, NASAA wrote.

NASAA Opposes Efforts to Strip Protections from Regulation A Offerings

The North American Securities Administrators Association (NASAA) has expressed concern that provisions of the proposed Small Company Capital Formation Act (H.R. 1070) would strip exempt offerings conducted under federal Regulation A of all investor protections, thereby resulting in the broad marketing and sale of riskiest and most speculative securities to the least sophisticated investors. Writing on June 15 to the leadership of the House Financial Services Committee and the Capital Markets Subcommittee, NASAA supported the bill's premise of reducing burdensome regulation on small business. NASAA believes, however, that the current disclosure requirements and investor protections contained in the registration and exemption provisions of the federal securities laws are not unnecessarily burdensome. Rather, NASAA argued, these provisions are absolutely necessary for fair and efficient capital formation, given the speculative nature of the businesses that would benefit from the changes proposed by H.R. 1070.

NASAA noted that Regulation A under the Securities Act of 1933 currently blends elements of a registered offering and an exempt offering, essentially permitting issuers to conduct a mini-public offering on a private offering scale. Although Regulation A offerings do not have all of the investor protections of a typical registered offering, NASAA noted, these offerings do benefit from the investor protections contemplated by Section 3(b) of the Securities Act because of the small dollar amount involved. In NASAA's view, the changes proposed by H.R. 1070 would strip Regulation A offerings of all investor protections by opening up a quasi-public market without the market integrity and protections for investors that currently exist in both the public offering and exempt offering setting.

NASAA also expressed concern that an amendment to H.R. 1070 introduced by Rep. David Schweikert (R-AZ) would limit the authority of the states to regulate Regulation A offerings that are sold through broker-dealers. The Schweikert amendment ostensibly seeks to clarify that any securities exempted under Section 3(b) of the Securities Act that are offered by any means other than through a broker or dealer will not be federal covered securities within the meaning of Section 18(b) of the Securities Act or exempt from state regulation under Section 18(a). NASAA fears that, by stating that non-broker-sold offerings will not be covered securities, the amendment leaves open, by implication, the argument that broker-sold Regulation A offerings could be construed to be federal covered securities. Accordingly, NASAA strongly urged the Committee to remove or clarify this language to avoid any unintended limitations on the states’ ability to protect investors.

Expressing NASAA's support for SEC Chair Mary Schapiro's plan to establish an Advisory Committee on Small and Emerging Companies, the state regulators suggested that NASAA's Model Accredited Investor Exemption (MAIE) could serve as an option for the Advisory Committee to consider as it develops ideas on reducing the regulatory burdens on small business capital formation. Adopted by the NASAA membership in 1997, and subsequently adopted by 32 states, the MAIE provides small businesses with the ability to conduct a general solicitation while also containing a number of investor protection provisions that reflect the speculative nature of the offerings, such as limiting sales to accredited investors.

NASAA observed that small businesses are extremely speculative and typically have untested technologies, limited resources, and no operational history. As a result, NASAA believes that any efforts to lessen the capital raising requirements of these companies must maintain appropriate, necessary investor protections. As currently drafted, however, H.R. 1070 focuses entirely on the desire of the small business issuer and ignores the need for reasonable investor protections contained in existing law, NASAA wrote. Accordingly, NASAA offered the MAIE, or a provision containing similar protections, as a reasonable middle ground that should be considered before final action is taken on H.R. 1070.

Senate and House Oversight Chairs Urge Regulators Not to Undermine Derivatives End-User Exemption and Limit Title VII’s Extraterritorial Scope

The Chairs of the Senate and House Agriculture Committees are concerned that recent proposed regulations may undermine the exemptions Congress provided from mandatory clearing, exchange trading, and margin for end users using derivatives to hedge commercial risks. In a letter to the SEC, CFTC and banking regulators, House Agriculture Committee Chair Frank Lucas (R-OK) and Senate Ag Chair Debbie Stabenow (D-MI) said that undermining these exemptions would substantially increase the cost of hedging for end users and needlessly tie up capital that would otherwise be used to create jobs. The Chairs are also concerned about the extraterritorial scope of rule proposals that could put US firms and markets at a competitive disadvantage. The Chairs urged the regulators implementing Dodd-Frank to be mindful of recognized international law principles and provide additional guidance and clarity on the extraterritorial scope of the proposed regulations.

The letter states that there is a continuing lack of clarity regarding the territorial scope of Dodd-Frank. Section 722(d) directed the regulators not to apply new requirements to activities outside the US unless those activities have a direct and significant connection with activities in, or effect on, US commerce. The Chairs said that this provision is consistent with the historical practice of US regulators to recognize and defer to foreign regulators when registered entities engage in activities outside the US and are subject to comparable foreign regulation.

Despite Section 722(d) and historical practice, noted the oversight Chairs, the CFTC has proposed the possibility of treating foreign subsidiaries of US persons as a US person for purposes of swap dealer registration. If the Commission does that, the proposal would apply margin requirements to all of a US financial institution’s transactions, even those between a foreign subsidiary of a US financial institution and non-US customers that are conducted wholly outside the US. In the view of the Chairs, this proposal could put US firms at a significant competitive disadvantage to their foreign competitors when dealing with non-US counterparties outside the US. In addition, the extraterritorial application of Dodd-Frank to non-US activities, particularly if it engenders reciprocal foreign regulatory treatment, could deter cross-border participation in markets, fragmenting them and making them less liquid and efficient.

Regarding margin for end-users, the letter said that, despite clear congressional intent to the contrary, the prudential regulators proposals could require swap dealers and major swap participants to collect margin from non-financial end-users. Further, despite a statutory objective to allow the use of non-cash collateral, the proposals are overly restrictive when it comes to requiring and valuing highly liquid assets such as cash, treasuries and GSE securities, and does not provide sufficient clarity that the use of other forms of non-cash collateral is permitted.

In addition, there is uncertainty over which entities will be deemed financial end users. Captive finance affiliates of manufacturing companies that exist to facilitate the sale of parent company’s goods should not be deemed high risk financial end users, said Sen. Stabenow and Rep. Lucas. Such a designation would subject these affiliates to significant and substantial cash burdens that would reduce their ability to provide financing to businesses and consumers. The definition of financial entity in Title VII expressly excludes captive finance affiliates of manufacturers and grants them a full exemption from clearing requirements.

The Ag Committee Chairs asked the regulators to clarify that transactions involving non-financial end users meeting the statutory requirement are exempt from margin, consistent with congressional intent. It should also be clarified that captive finance affiliates of manufacturing companies are non-financial end users. The regulators were also urged to ensure that any new capital requirements are carefully linked to the risk associated with the uncleared transactions and not used as a means to deter OTC derivatives trading.

Congress specifically clarified that captive finance affiliates should be exempt from the clearing requirement when their primary business is providing financing and they use derivatives to hedge underlying commercial risks related to interest rate and foreign currency exposures, 90 percent or more of which arise from financing facilitating the purchase or lease of products, 90 percent or more of which are manufactured by the parent company or another subsidiary of the parent company.

The CFTC’s proposed rule on the end user exception to mandatory clearing did not clarify the calculation of this exemption, said the Chairs, creating uncertainty regarding the eligibility of many captive finance affiliates. In order to facilitate the sale of the parent company’s manufactured goods, captive finance affiliates often finance the sale or lease of products that are connected to the underlying product, such as financing an implement for farming equipment or financing a marine vessel to facilitate the sale of the vessel’s engine. Essentially, financing offered by the captive affiliate facilitates the sale of the parent’s manufactured goods.

If the CFTC were to require 90 percent or more of a particular package of equipment be manufactured by the parent company, reasoned the Chairs, the test itself would be an enormous burden to calculate and impractical to apply. They thus urged the CFTC to provide further guidance regarding the calculation of this exemption and its application, and do so in a way that is flexible and responsive to the general practices and operational realities of captive finance affiliates. This clarification should be provided for the identical provisions providing an exemption for captive finance affiliates from designation as major swap participants.

Texas Adopts Form D Electronic Filing and Accredited Investor Definitions

The Electronic Form D (EFD) System being developed by the North American Securities Administrators Association (NASAA) for multi-state electronic filing of 2008-adopted Form D was adopted for use in Texas by the State Securities Board, along with new definitions for accredited investors, individual accredited investors and institutional accredited investors, effective June 21, 2011.

Please note: Proposed rule amendments pertaining to investment advisers--(1) initial application using new Part 2 of Form ADV, (2) post-registration reporting on new Part 2, (3) disclosure "brochure rule" requirements, and (4) specified language for use in investment advisory contracts--were part of the January, 2011 proposed rules package that included the June 21, 2011 adopted rules. The investment advisers rule changes, however, were already adopted on March 9, 2011. There is a previous blog posting on the IA rule changes.

I. Regulation D and Intrastate Limited Offering Exemptions

Exemption under Rule 505 and 506 of federal Regulation D. Electronic Form D. Issuers making an offering under either Rule 505 or 506 of federal Regulation D are required to electronically submit Form D and the applicable fee through the EFD System when that system becomes available. Form D, Notice of Exempt Offerings of Securities, is the Form D that took effect on September 15, 2008. The "EFD System" is the Electronic Form D system provided by the North American Securities Administrators Association (NASAA) to be used for electronic filing of Form D with the Texas Securities Commissioner when that system becomes available.

Rule 506--Consent to Service of Process eliminated. The consent to service of process requirement is eliminated for Rule 506 offerings, leaving issuers to file a notice on Form D and the applicable fee [1/10 of 1% of the aggregate amount of securities to be offered for sale in Texas, with a maximum fee of $500]. NOTE: The notice and fee payment, as well as any applicable notice and fee payment for excess sales, must be electronically submitted through the EFD system when that system becomes available.

Intrastate limited offering exemption. Issuers not registered as securities dealers who do not sell securities by or through a registered securities dealer need to file a sworn notice on Texas Form 133.29, Intrastate Exemption Notice for Sales Under Regulation 109.13(l), not less than 10 business days before any sale exempt under this exemption is consummated in whole or in part to individual accredited investors. The definition of an "individual accredited investor" for this intrastate limited offering exemption is a natural person described in Rule 501(a)(5) and (6) as promulgated by the SEC under the Securities Act of 1933.

No notice is required for sales made exclusively to institutional accredited investors. The definition of an "institutional accredited investor" for this intrastate limited offering exemption is an entity described in Rule 501(a)(1) - (4), (7) and (8) as promulgated by the SEC under the Securities Act of 1933.

An accredited investor includes any person who the issuer reasonably believes comes within the definition of an accredited investor at the time of the sale of the securities to that person. The definition of an "accredited investor" for this intrastate limited offering exemption is a person who is either an individual accredited investor or an institutional accredited investor.

II. Accredited Investor Exemptions and Definitions

Exemption for sales to financial institutions and certain institutional investors. The definition of an "institutional accredited investor" in the exemption for securities and for dealers in connection with sales to financial institutions and certain institutional investors is an entity described in Rule 501(a)(1) - (4), (7) and (8) as promulgated by the SEC under the Securities Act of 1933.

Sales to individual accredited investor exemption. The definition of an "individual accredited investor" in the exemption for sales to individual accredited investors is a natural person described in Rule 501(a)(5) and (6) as promulgated by the SEC under the Securities Act of 1933.

Accredited investor exemption. The definition of an “accredited investor” in the accredited investor exemption is a person who is either an individual accredited investor or an institutional accredited investor.

III. Administration

Charge for certified copies of public records. The charge for certified copies of public records is $1.00 per page plus a $15.00 certification fee, increased from $10.00.

Historically underutilized business program. The State Securities Board adopts by reference the rules of the Comptroller of Public Accounts for the Historically Underutilized Business Program in the Texas Administrative Code.

Louisiana Incorporates SEC Recordkeeping Requirements for Broker-Dealers and Investment Advisers

Broker-dealers and investment advisers are required to make, maintain and preserve books and records that comply with SEC recordkeeping requirements, effective June 20, 2011. Dealers must comply with SEC Rules 17a-3, 17a-4 and 15c-211; investment advisers must comply with Rule 204-2 of the Investment Advisers Act of 1940. Investment advisers whose principal place of business is located in another state are exempt from Louisiana recordkeeping requirements if the investment advisers are licensed or registered in the other state and comply with that state’s books and records requirements.

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

Monday, June 20, 2011

Delaware Chancery Court Interprets Airgas to Allow Nominal Truncation of Director’s Term

The Delaware Chancery Court ruled that holding an annual meeting within six months of the last annual meeting did not run afoul of the Supreme Court’s 2010 Airgas ruling invalidating a bylaw advancing an annual meeting with the effect of so truncating the directors’ term as to constitute a de facto removal, since directors seeking election at the 2011 meeting were last considered at a 2008 vote of the shareholders and their terms will only be nominally shortened if they are not elected at the upcoming meeting. In declining to decide the parameters of an approximate term of three years, the Delaware Supreme Court observed in Airgas, Inc. v. Air Products and Chemicals, Inc. that a director’s term may properly end at an annual meeting even though that director only served approximately three years rather than exactly three years. Thus, Vice Chancellor Noble concluded that truncating a director’s three-year term by a few days appears to be permitted under the Airgas ruling. Goggin v. Vermillion, Inc., Del. Chan. Ct, June 3, 2011, CA No. 6465-VCN.

The court also rejected the contention that the company used a poison pill to chill intra-shareholder dialogue and bully its shareholders. Noting that Delaware courts have repeatedly approved of the adoption of a rights plan, the Vice Chancellor said that the poison pill dates back to 2002 and was authorized seemingly without a threat to the Company. It is triggered by an acquiring person who, along with affiliates and associates, as those terms are defined by SEC Rule 12b-2, becomes a beneficial owner of 15% or more of the company’s common stock.

Rather than seek rescission of the pill, the shareholder took issue with its use, specifically pointing to a letter from the company’s outside counsel inquiring as to interactions with other company shareholders. The court said that the letter appears to be a valid investigation on behalf of the board into activities it believed could implicate the pill. Had it not conducted any inquiry, noted the court, the board may have faced accusations that it had breached its fiduciary duties.

More broadly, the court said found no indication of any improper action undertaken or contemplated by the board or the company related to the pill. There was little evidence of the board using the pill as a defensive device against the company’s shareholders. This independent board’s use of the pill would likely fall within the range of reasonableness based on what appears to be the directors’ good faith effort to use the pill to promote stockholder value. Importantly, the poison pill did not disenfranchise stockholders in the sense of preventing them from freely voting and does not prevent a stockholder from soliciting revocable proxies.

House Passes Appropriations Bill Requiring CFTC to Finalize Swap Data Reporting Rules before Block Trade and Real-Time Reporting Rules

The House passed the Fiscal Year 2012 Agriculture Appropriations Bill (HR 2112) with an amendment requiring that commodity swap data reporting rules be finalized and in effect for 12 months before the CFTC can lock in final trade blocks or real-time reporting rules. The amendment, introduced by House Capital Markets Subcommittee Chair Scott Garrett (R-NJ), is designed to allow industry time to comply with any new rules. The amendment passed on a vote of 231-189.

Thus, the CFTC would be required to finalize important data reporting rules prior to finalizing block trade and real-time reporting rules. According to Chairman Garrett, the amendment would give the CFTC the ability to collect transaction data it needs to determine reasonable standards for block trade levels and real-time reporting without disrupting the marketplace. Without rulemaking informed by data, said the Chairman, liquidity and pricing in the swaps market could be severely impacted. He reasoned that finalizing any numerical determination of block trade sizes or setting real-time reporting time frames prior to having the necessary data is arbitrary, encourages litigation, and will likely have unintended consequences on the ability of pension funds to protect their

Senate Legislation Would Direct CFTC to Impose Position Limits and Margin Requirements on Oil Speculation

Senate legislation would require the CFTC to impose unilaterally position limits and margin requirements to eliminate excessive oil speculation, which would remain in effect until the date on which the Commission establishes position limits to diminish, eliminate, or prevent excessive speculation as required by title VII of the Dodd-Frank Act. Introduced by Senator Bernie Sanders (I-VT) the End Excessive Oil Speculation Now Act, S 1200, would direct the CFTC to establish strong position limits to eliminate excessive oil speculation and impose margin requirements so investors would have to back their bets with real capital.

The measure states that it is the sense of Congress that, if finalized, the proposed position limits for derivatives that the CFTC included in the notice of proposed rulemaking entitled `Position Limits for Derivatives' (76 Fed. Reg. 4752 (January 26, 2011)) are not sufficient to fulfill the statutory requirements of title VII of Dodd-Frankto diminish, eliminate, or prevent excessive speculation.

The legislation has a number of co-sponsors, including Senator Bill Nelson (D-FL). According to Senator Sanders, Rep.Maurice Hinchey (D-NY) will be introducing this legislation in the House. Senator Sanders also noted that the legislation already has the support of a very diverse group of organizations representing small businesses, fuel dealers, consumers, workers, airlines, and farmers.(Cong. Record, June 15, 2011, p. S3

Senator Sanders noted that the measure would classify as speculators bank holding companies, investment banks or hedge funds that engage in proprietary oil trading. The CFTC Chair would also be given broad power to take any other actions needed to ensure that the price of crude oil, gasoline, diesel fuel, jet fuel, and heating oil accurately reflects the fundamentals of supply and demand.

Senator Sanders said that the legislation would require the CFTC to establish speculative oil position limits equal to the position accountability levels that have been in place at the New York Mercantile Exchange since 2001. The measure would also require the CFTC to double the margin requirements on speculative oil trading so that investment banks back their bets with real capital. (Cong. Record, June 15, 2011, p. S3822).

However, S 1200 provides that position limits and margin requirements established pursuant to the legislation would not apply to bona-fide hedge trading. The Act would define bona-fide hedge trading and bona-fide hedge transaction to mean a transaction or position that represents a substitute for a transaction made or a position taken at a later time in a physical marketing channel that is economically appropriate for the reduction of risks in the conduct and management of a commercial enterprise and arises from the potential change in the value of assets that a person owns, or, reduces risks attendant to a position resulting from a swap that was executed opposite a counterparty for which the transaction would qualify as a bona-fide hedging transaction.

Securities and Banking Groups Ask Banking Agencies to Coordinate with SEC on Margin and Capital Rules for Swap Entities

Securities and banking associations have asked the banking agencies to extend the comment period for their proposed rulemaking on the capital and margin requirements for covered swap entities so that the comment period coincides with the anticipated SEC rules on capital and margin. In a letter to the prudential regulators, the American Banking Association, the Investment Company Institute and the ABA Securities Association cited a recent speech to the International Monetary Conference by Treasury Secretary Tim Geithner calling for a more coordinated and integrated approach to rulemaking by U.S. agencies responsible for financial regulation and emphasizing the critical need for U.S. regulators to adopt rules that are as consistent as possible.

In his speech, the Secretary urged a global margin standard that would set minimum requirements applicable to uncleared derivatives trades. Closer coordination and consistent standards among the U.S. financial regulators on margin requirements would be key to any process for developing an international agreement on a global margin standard. Consistent with these principles, the trade associations asked that the public have the opportunity to review all of the capital and margin standards for uncleared swaps required by the Dodd-Frank Act before being required to submit comments on the Prudential Regulator proposal.

To date, both the prudential regulators and the CFTC have proposed rules that would establish minimum capital and margin requirements applicable to non-cleared swaps and security-based swaps. The deadline for comments on the prudential regulator proposal is June 24, and the deadline for the CFTC proposals is July 11. However, the SEC has not yet issued its proposed margin and capital rules.
Dodd-Frank Sections 731 and 764 require the prudential regulators, the CFTC, and the SEC to establish and maintain comparable requirements for capital as well as initial and variation margin for swaps to the maximum extent practicable. The statute also stipulates that all of the regulators consult at least annually on these requirements.

In the view of the trade associations, these provisions clearly manifest Congressional intent that the regulators work in concert to establish capital and margin requirements. Yet the public is being asked to comment on the proposed prudential regulator and CFTC rules without the benefit of a key component, namely the SEC’s proposed capital and margin rules. Given the language in the statutory mandate for promulgating these rules, the banking and securities groups believe that extension of the comment period so that it coincides with the comment period on the anticipated SEC rule proposal is not only appropriate but also essential.

Sunday, June 19, 2011

Consensus Growing for Allowing Exchanges Flexibility in Setting Independence Standards for Compensation Committees

There appears to be strong support for the SEC’s proposal, in implementing Dodd-Frank’s requirement for independent compensation committees, to allow the exchanges to establish their own independence standards based on factors set forth in Section 952 of Dodd-Frank. While CalPers thought that applying a consistent definition of independent director for all exchanges to follow was preferable, a number of other comment letters to the SEC favored exchange flexibility in this area.

For example, the Center on Executive Compensation believes that the SEC’s proposed approach provides exchanges with the flexibility to tailor independence standards appropriately for their member companies based on a listed set of principles. The Center said that this flexibility has allowed different approaches on independence to develop which reflect the differences in the size and types of companies that are traded on those exchanges.

The Society of Corporate Secretaries and Governance Professionals also supports permitting each exchange to establish its own independence criteria. Exchanges possess the necessary experience and expertise to define independence for the purpose of compensation committee membership, according to the Society
The Sullivan & Cromwell firm supports the Commission’s proposal to permit stock exchanges to establish their own independence criteria. The stock exchanges have spent considerable time and resources over the past ten years to develop, interpret and apply listing standards relating to compensation committee independence, noted the firm, which added that they possess a deep and practical understanding of the considerations that should be taken into account in setting broadly applicable rules in this regard.

The Davis Polk firm also supports the Commission’s approach in permitting the exchanges to establish their own independence criteria. As the Commission notes as a point of reference, Section 301 of the Sarbanes-Oxley Act included bright-line prohibitions mandated for members of a board audit committee. However, the Dodd-Frank Act is less prescriptive with respect to the determination of compensation committee independence, stating instead that SEC rules must require that the national securities exchanges consider relevant factors, including certain fees and affiliations with the issuer. The firm agrees with the Commission that this is an important distinction that merits taking a different approach in rulemaking implementation, including permitting the exchanges significant flexibility in developing standards that recognize the differences between audit committees and compensation committees.

The CFA Institute agrees with allowing each exchange to establish its own independence criteria. Exchanges already have their own definitions of director independence which are understood by investors and issuers alike, said the Institute. The definitions of independence required by each exchange may differ slightly, but these definitions of independence are similar enough that the Institute did not feel the need for the Commission to offer one overarching definition of director independence for all board members of listed companies.