Wednesday, August 31, 2011

Chairman Bachus to SEC: It is Premature to Implement Dodd-Frank Sec. 913 on a Uniform Fiduciary Standard for Brokers and Advisers

In a letter to SEC Chair Mary Schapiro, House Financial Services Committee Chair Spencer Bachus (R-ALA) said that any SEC action to implement Section 913 of Dodd-Frank on a uniform fiduciary duty for brokers and advisers is premature until the Commission can demonstrate that investors are being harmed by the current regulatory standard of care and that harmonization would enhance investor protection. Should the SEC decide to issue a proposal implementing Section 913, despite no statutory deadline to do so, cautioned Chairman Bachus, the Commission must act carefully and comprehensively to avoid disrupting an investors’s chosen relationship with his or her investment professional. Moreover, he expects that if the SEC acts to implement Section 913 the agency should not impose in any formulation the Investment Advisers Act standard of care on brokers.

More broadly, the oversight chair said that the SEC’s primary focus should be the completion of the mandatory Dodd-Frank rulemakings. He noted that the SEC apparently plans to push forward by recalling examiners and reassigning them to write optional rules at a time when the Commission has yet to provide Congress with empirical data and economic analysis to justify these rulemakings. The Dodd-Frank Act authorizes, but does not require, the SEC to adopt rules applying the same standard of care to brokers as to investment advisers.

Section 913 of the Dodd-Frank Act, in addition to requiring the SEC to study the effectiveness of existing regulatory standards of care for brokers and investment advisers when providing personalized investment advice about securities to retail customers, also authorized the SEC to adopt rules providing for a uniform standard of care for all brokers and investment advisers. Based on the study, the SEC staff recommended the adoption of a uniform federal fiduciary standard for brokers and advisers that would be no less stringent than the standard currently applied to investment advisers under Advisers Act Sections 206(1) and (2).

While the study recommended the adoption of a uniform fiduciary duty standard, noted Chairman Bachus, the SEC has failed to answer the fundamental question of whether it is necessary or even appropriate to change the standard of care for brokers. He fully supports the comments of Commissioners Casey and Paredes that the SEC staff study does not identify whether retail investors are systematically being harmed or disadvantaged under one regulatory regime as compared to the other and that, therefore, the study lacks a basis to reasonably conclude that a uniform standard or harmonization would enhance investor protection. Parenthetically, Chairman Bachus noted that the lack of a harmonized standard of care neither caused nor contributed to the financial crisis.

SEC Issues Concept Release on 1940 Act Real Estate Structured Finance Exclusion

Concerned that mortgage-related pools are making judgments about their status under the Investment Company Act without sufficient SEC guidance, the Commission has issued a concept release on interpretive issues relating to mortgage-related pools that rely on the Section 3(c)(5)(C) exclusion from the Investment Company Act. The SEC is also concerned that some mortgage-related pools appear to resemble investment companies such as closed-end funds and may not be the kinds of companies that were intended to be excluded.

Companies that are engaged in the business of acquiring mortgages and mortgage-related instruments have been relying on Section 3(c)(5)(C) to be excluded from the definition of investment company and consequently from the requirements of the Investment Company Act. Section 3(c)(5)(C) was enacted to exclude from the definition of investment company those companies that were engaged in the mortgage banking business and were not considered to be in the investment company business.

Since Section 3(c)(5)(C) was enacted in 1940, the mortgage markets have evolved and expanded, and the provision has been used by a wide variety of types of pooled vehicles and other companies unforeseen at the time of enactment. These issuers include certain mortgage-backed securities issuers and certain REITs

The Concept Release provides an overview of mortgage-related pools and requests data and comment on their management styles, corporate governance, and similarities to traditional investment companies. It also discusses the legislative, administrative and interpretive background of Section 3(c)(5)(C). The Concept Release asks, for example, whether a test could be devised to differentiate companies that are primarily engaged in the real estate and mortgage banking business from those companies that look like traditional investment companies, and what factors the SEC should consider in such a test.

In the seminal study of the 1940 Act, Protecting Investors: A Half-Century of Investment Company Regulation, the SEC staff noted that many issuers of mortgage-backed securities and similar products have relied on Section 3(c)(5)(C), noting that an issuer seeking to rely on this exception must invest at least 55 percent of its assets in mortgages and other liens on and interests in real estate. Another 25 percent of the issuer’s assets must be in real estate related assets, although this percent may be reduced to the extent that more than 55 percent of the issuer’s assets are invested in qualifying interests.

SEC Questions Use of Credit Ratings in Rule Excluding Issuers of Asset-Backed Securities from 1940 Act

The SEC plans to issue an Advance Notice of Proposed Rulemaking on possible amendments to regulations excluding issuers of asset-backed securities from having to comply with the requirements of the Investment Company Act. While issuers of asset-backed securities typically meet the 1940 Act definition of investment company, SEC Rule 3a-7 excludes some asset-backed issuers from the definition of investment company provided they meet specified conditions, one of which is that the asset-backed securities be rated by a nationally recognized statistical ratings organization, but the SEC says that condition was not primarily intended as a measure of credit-worthiness of the issuer.

Rather, the Commission included the credit rating condition because it believed that as part of the ratings process, the rating agencies assessed the issuer’s investor protection measures. In the aftermath of the recent financial crisis, the Commission has engaged in various regulatory initiatives to address concerns raised by credit rating procedures and methodologies.

The Advance Notice of Proposed Rulemaking would solicit public comment on possible amendments to Rule 3a-7 including the role, if any, that credit ratings should continue to play in the rule. In order to use Rule 3a-7, an issuer must meet the rule’s conditions including the existing rating condition.

The ANPR posits removing the rating condition and replacing it with new conditions. Rather than rely on rating agencies to assess the issuer’s structure and operations, such new conditions could address the structure and operations of asset-backed issuers. Possible new conditions also could require the issuer to undergo an independent review to protect investors in the asset-backed securities from self-dealing and overreaching by insiders. Additional possible conditions could help ensure that the issuer preserves and safeguards its assets and cash flow.

The ANPR also asks whether Rule 3a-7 issuers should still be considered investment companies for the limited purpose of determining whether an entity investing in Rule 3a-7 issuers is itself an investment company that should comply with the requirements of the 1940 Act.

SEC Will Use Concept Release as Part of Broad Review of Derivatives Use by Investment Companies

The SEC will issue a Concept Release to solicit public comment on the use of derivatives by investment companies and on the current regulatory regime under the Investment Company Act as it applies to the use of derivatives by investment companies.. The Commission will use the comments to help determine whether regulatory initiatives or guidance is needed that would continue to protect investors and fulfill the purposes underlying the 1940 Act.

Subject to the various safeguards contained in the Investment Company Act as well as SEC rules and guidance, funds are permitted to invest in derivatives . A common characteristic of most derivatives, which are among a panoply of investments that a fund may make in managing its portfolio, is that they involve leverage. When the Investment Company Act was enacted in 1940, it did not contemplate funds investing in derivatives as they may do today.

The Concept Release asks for information on how different types of funds use various types of derivatives as well as the benefits, risks and costs of using derivatives. It also asks for comment on several specific issues under the Investment Company Act implicated by funds’ use of derivatives.

The Investment Company Act restricts the manner and extent to which funds may incur indebtedness and leverage their portfolios. The Concept Release discusses the treatment of derivatives under these restrictions. The Concept Release asks, among other things, how to measure the amount of leverage that a fund incurs when it invests in a derivative. While the 1940 Act does not require the portfolios of funds to be diversified, it does require them to disclose in their registration statements whether they are diversified or not. The Act also prohibits a fund from changing its classification from diversified to non-diversified without shareholder approval. The Concept Release asks how a fund should value a derivative to determine the percentage of the fund's assets that' are invested in a particular company for diversification purposes.

While the 1940 Act prohibits funds from acquiring any security issued by, or any other interest in, the business of a broker, dealer, underwriter or investment adviser, funds that meet certain conditions may acquire some securities issued by companies engaged in such business. The Concept Release asks how investing in a derivative issued by a broker-dealer may be different from, or similar to, investing in the broker-dealer's stock or bond.

Similarly, although the 1940 Act does not prohibit funds from concentrating their investments in a particular industry, it does require funds to disclose their industry concentration policies in their registration statements. It also prohibits funds from deviating from those policies without shareholder approval. The Concept Release queries how funds determine the industry or industries to which they may be exposed through a derivative investment.

Also, the Investment Company Act specifies how funds must determine the value of their assets. The Concept Release asks whether the SEC should issue guidance on how funds should value derivatives in their portfolios.

Tuesday, August 30, 2011

Global Audit Firms Ask SEC for Guidance on Outside Audit of Dodd-Frank Mandated Conflict Minerals Report

Global audit firms have a number of concerns around proposed SEC regulations implementing Dodd-Frank’s requirement of an independent outside audit of a company’s Conflict Minerals Report included in the annual report. In letters to the SEC, the audit firms ask the SEC to clarify and provide guidance on issues affecting the nature and form of the independent private sector audit, suitable criteria, and the sufficiency of evidence to support the assertion. Broadly, the independent auditors want the final SEC regulations implementing Section 1502 to provide guidance that would form a framework to aid both the company in preparing the Conflicts Minerals Report and the audit firm in conducting an independent audit of the report.

The proposed regulations would require a company, including a foreign private issuer, to undergo a reasonable due diligence process to ascertain whether conflict minerals are used in the manufacture or production of its products and, if they are, disclose in the body of its annual report on Form 10-K, or Form 20-F for foreign private issuers, whether its conflict minerals originated in the Democratic Republic of the Congo or an adjoining country. In addition to disclosure in its annual report, a company must also furnish a separate conflict minerals report as an exhibit to its annual report when it concludes that conflict minerals are used in, or are necessary for the manufacture or functionality of, its products or the company is unable to conclude whether any of the named minerals originate from the DRC or adjoining countries.

The Conflict Minerals Report should include a description of the measures taken to exercise due diligence on identifying the source and chain of custody of the conflict minerals, including an independent private sector audit of the issuer’s Conflict Minerals Report conducted in accordance with standards established by the Comptroller General. Further, any company furnishing a Conflict Minerals Report as an exhibit to its annual report would be required to certify that it obtained an independent audit of the report, furnish the auditor’s report as an exhibit to its annual report, and make the report and the auditor’s report publically available on the company’s internet Web site.

In its comment letter, Grant Thornton recommend that the Commission establish a working group to support the Comptroller General in the development of the appropriate form of engagement, including the criteria to be used to evaluate the subject matter and the opinion to be expressed thereon. Although recognizing the time constraints imposed by the effective dates mandated by the Dodd-Frank Act, GT believes that the expedited formation of a working group would assist the Commission in making appropriate decisions as it relates to the final rule and, along with the Comptroller General, in developing appropriate criteria and a practicable reporting framework.

In its letter, Deloitte asked for SEC guidance on the nature, objectives, criteria, and evidence of the company’s Conflict Minerals Reports so that the independent auditor would have better clarity on the type of audit procedures and reporting for its report. Similarly, Deloitte asked that the final regulations clarify the nature and objective of the independent audit because the nature and objectives would directly impact the complexity, practicability, and level of effort involved for the outside auditor. For example, it is unclear whether the objective is for the independent auditor to opine on the accuracy and completeness of information within an the Conflict Minerals Report or on the design and effectiveness of a company’s process used to identify the origin of conflict minerals.

Deloitte supports the SEC proposal to allow the audits to be performed either as examination attestation engagements or performance audits. However with regard to both of these audit types, there is insufficient guidance regarding suitable objectives and benchmarks and consequently there is not a consistent framework for companies to prepare their Conflict Minerals Reports and against which independent auditors need to perform the audit. Deloitte also asked that the final rule provide additional guidance on defining what would constitute sufficient audit evidence.

Deloitte also supports the proposal to furnish to the SEC, rather than file, the Conflict Minerals Report and the audit report and that such reports would not be automatically incorporated by reference into filings under the Securities Act.

It is unclear if the independent auditor would be required to issue an opinion on the content of the Conflict Minerals Report or the procedures that the company had in place to support assertions in the report. Thus, Deloitte urged the SEC to clarify whether the independent auditor should opine on the information contained in the Conflict Minerals Report or on the design and effectiveness of the corporate process to identify the origin of conflict minerals

In its comment letter, Ernst & Young noted that the SEC proposal states that a certified audit would constitute a critical component of the company’s due diligence in establishing the source and chain of custody of the conflict minerals. This language in the proposing release could cause confusion as to the nature of the engagement and the role of the independent auditor if it is perceived to be a component of management’s procedures, said E&Y.

The proposed rule does not dictate the standard for, or otherwise provide guidance concerning, the due diligence that a company must use related to the evaluation of its supply chain. Instead, the proposal would require the company to disclose the due diligence it used in making its determinations, including for example, whether it used any nationally or internationally recognized standards or guidance of supply chain due diligence.

For calendar-year issuers, these new processes and procedures would need to be in effect for the year ending 31 December 2012, noted E&Y, which provides limited time to develop and implement appropriate due diligence procedures to comply with this new reporting obligation. Many companies would be conducting supply chain due diligence procedures for the first time and would not have the benefit of the experiences of others in applying the new standards or guidance.

Thus, the SEC was urged to consider identifying a comprehensive framework to satisfy the criteria necessary to perform either an attestation engagement or performance audit. The proposing release cites the Organization for Economic Cooperation and Development’s (OECD) effort to develop due diligence guidance for conflict mineral supply chains. The SEC should consider whether the due diligence guidance issued by the OECD would provide a sufficient framework and, if so, reference to that guidance could be provided in the final rule.

Deloitte urged the SEC to clarify the independence standards applicable to the audit of the report and specifically clarify that the independence of the external auditor of the company’s financial statements would not be impaired if the same auditor performed an audit of the Conflict Minerals Report

Grant Thornton noted that the proposal, consistent with the Dodd-Frank Act, indicates that the independent audit is a critical component of due diligence. Noting that this statement is contradictory to the concept of an independent opinion, GT urged the SEC to clarify the intent of this statement, including the effect on the independence of the auditor.

Bi-Partisan Group of House Members Urges SEC to Include Credit Scores in Dodd-Frank Risk Retention Regulations

In a letter to the SEC and federal banking agencies, a bi-partisan group of seven House members urged that credit scores be part of the qualified residential mortgage equation in the Dodd-Frank risk retention regulations. Credit risk retention is intended to help foster a strong and healthy securitization market, said the Representatives, and, it is important that elements of the regulation are done right. Thus, if the qualified residential mortgage equation is to include credit history standards, credit scores should be incorporated in the final rule. Section 941 of Dodd-Frank exempts qualified residential mortgages from the new risk retention requirement. The letter was signed by Representatives John Campbell (R-CA), Erik Paulsen (R-MN), Robert Dold (R-IL) Ed Royce (R-CA), John Carney (D-DE) Gregory Meeks (D-NY) and Keith Ellison (D-MN)

While congressional commenters have raised issues related to the proposed definition of qualified residential mortgage, the Members believe that attention also must also be focused on the proposed qualified residential mortgage credit history standards that, in their view, will not serve as a strong predictor of default risk. They want the reasonable use of credit scores that reflect the need for strong credit risk standards without posing an unreasonable barrier to accessing qualified residential mortgages to be incorporated into the standards.

The proposed credit history standards are limited to a set of derogatory factors that appear on the borrower's credit report. While the proposal fails to include any specific data that demonstrates the effectiveness of using these derogatory factors to measure credit risk, concerns exist that the proposed credit history standards would actually result in some of the riskiest borrowers being included under the qualified residential mortgage, while excluding other low-risk borrowers. These distorted outcomes are neither desirable nor appropriate, said the Members, and do not support the Congressional intent of creating a pool of high quality, accessible, low risk loans that warrant exemption from risk retention requirements.

However, these same low risk and high risk consumers are easily identified by the empirically derived, credit scoring models that have been used in the market for decades to effectively manage credit risk and avoid unfair or illegal discrimination. Here, the Members cited a Federal Reserve Board 2007 Report to Congress on "Credit Scoring and Its Effects on the Availability and Affordability a/Credit," which concluded that credit scoring promotes a more efficient marketplace and provides valuable benefits to consumers.

Further, the Members noted that, while not all borrowers have high credit scores, most can improve their scores over time and actively reduce their risk profile. Also, by building credit scores into the criteria for determining qualified residential mortgage eligibility, costs and risks associated with manual underwriting can be reduced. A manual review of derogatory factors in the credit file can be accompanied by added costs, delays, errors and transparency concerns.

The House members also noted several implementation challenges to the proposed credit history standards. Some of the data relied upon in the proposed standards, such as the timing of short sales and repossessions, is not readily available to lenders at the time of underwriting. The proposed standards also permit lenders to determine qualified residential mortgage status on data that is up to 90 days old, which could lead to many of these important decisions being made based on stale information. The Members are also concerned that small and medium size financial institutions with scarce compliance resources will be forced to comply with an ineffective, check-the-box regulatory requirement that could result in some institutions taking the disastrous step of substituting the proposed standards for sound underwriting practices.

Finally, they observed that Regulation B sets standards for lenders to use approved credit scoring models that are empirically derived, demonstrably and statistically sound. As a result, guidance and oversight exist to try and make certain these scoring models operate effectively and provide an objective assessment of a borrower's credit risk. The members pledged that Congress will continue to work to ensure that the current system further benefits consumers and all other participants in the residential mortgage market.

Hedge Fund Manager Owed Fiduciary Duty to Fund’s Seed Investor Says Delaware Chancellor

A hedge fund manager’s refusal to honor a withdrawal request and return the capital of the hedge fund’s seed investor at the end of a three-year lock-up period was a violation of the seeder agreement and a breach of contract, ruled the Delaware Chancery Court and, alternatively, a breach of the fund manager’s fiduciary duty. Thus, Chancellor Strine ordered a remedy requiring the immediate return to the seed investor of all of its capital and of an award of interest to compensate it for the delay.

When the seed investor sought to withdraw its entire investment in the fund, the hedge fund manager invoked a gate provision in the contract enabling the fund manager to restrict a withdrawal of capital if it would result in more than 20 percent of the total assets of the hedge fund being withdrawn in any six-month period. Because the hedge fund manager had never secured any other outside investor in the fund, the seed investor’s $40 million investment comprised over 99.9 percent of the fund’s invested capital. Rather, the gate was erected solely for the self-interested benefit of the hedge fund manager as manager, and not for the benefit of the fund’s investors.

The court found that the hedge fund manager was not contractually entitled to raise the gate provision. The partnership agreement is a general agreement that specifically contemplates agreements like the seeder agreement between the hedge fund manager and the seed investor. When pertinent principles of contract law are considered, the terms of the seeder agreement setting forth the conditions and time frame under which the seed investor could withdraw must be read as exclusive and as excluding any application of the gate provision, which would undercut the specifically negotiated withdrawal arrangements in the seeder agreement.

Alternatively, said the court, even if the gate provision was potentially applicable, it was a breach of fiduciary duty for the hedge fund manager to use the gate solely for a selfish reason. The only rational reason for the failure to take down the gate was to enable the manager to continue to receive management fees for as long as possible. The discretion granted to the hedge fund manager to determine whether to waive the gate provision is a fiduciary authority that must be used for the benefit of those whom the hedge fund is intended to benefit, reasoned the court, and not for the selfish interest of the manager. Because the decision to use the gate was a selfish one, inimical to the interests of the fund’s 99.9 percent investor, it was a breach of the duty of loyalty.

The Chancellor invoked a line of Delaware precedent establishing that a director, member, or officer of a corporate entity serving as the general partner of a limited partnership, like the hedge fund manager, who exercises control over the partnership’s property owes fiduciary duties directly to the partnership and its limited partners, the fund investors.

Monday, August 29, 2011

Majority Leader Says House Will Move Regulatory Reform Legislation This Year

The regulatory relief agenda in the House of Representatives will include repeal of specific regulations, as well as fundamental and structural reform of the federal rulemaking system through legislation like the REINS Act and the Regulatory Flexibility Improvements Act, said Majority Leader Eric Cantor (R-VA). He expects that both bills will be on the House floor in late November and early December.

Regulations from the Executive in Need of Scrutiny Act (REINS), HR 10, would require Congress to take an up-or-down, stand-alone vote on all new major regulations before they can be enforced. Major regulations are defined as those that have resulted in or are likely to result in an annual effect on the economy of $100 million or more; a major increase in costs or prices, or significant adverse effects on competition, employment, investment, productivity, innovation, or U.S. competitiveness.

The Act provides that if a joint resolution of approval of a major rule is not enacted by the end of 70 session days or legislative days after the agency proposing the rule submits its report on such rule to Congress, the rule must be deemed not approved and must not take effect. However, HR 10 allows a major rule to take effect for 90 calendar days without such approval if the President determines that the rule is necessary because of an imminent threat to health or safety or other emergency, for the enforcement of criminal laws, for national security, or to implement an international trade agreement.

Responding to concerns that the legislation would set up the filibustering of federal agency regulations, New York Law School Professor David Schoenbrod testified before the Judiciary Committee that REINS limits debate on the vote approving the regulation and all related motions to two hours in the House and Senate and that there is no realistic way around this time limit. The Judiciary Committee has jurisdiction over H.R. 10. House Judiciary Committee Chairman Lamar Smith (R-TX)has signed on as the bill’s lead co-sponsor.

HR 10 has the bipartisan support of 149 co-sponsors. Senator Rand Paul (R-KY) has introduced a companion bill in the Senate as S. 299, which currently has the bipartisan support of 27 co-sponsors

The Regulatory Flexibility Improvements Act (HR 527) has already been reported out of the Judiciary Committee and is designed to expand and enhance the Regulatory Flexibility Act (RFA) of 1980, which require federal agencies to prepare a regulatory flexibility analysis so the agencies will know how a proposed regulation will affect small businesses before it is adopted. Currently, the law allows an agency to avoid preparing a regulatory flexibility analysis if the agency head certifies that the new regulation will not have a significant economic impact on a substantial number of small businesses. But none of these terms is defined in the law, noted Judiciary Committee Chair Lamar Smith, who added that agencies routinely take advantage of this by issuing boilerplate certifications.

According to Chairman Smith, the sponsor of HR 527, the legislation would fix this problem by requiring the SBA to define these terms uniformly for all agencies, and by requiring agencies to justify a certification in detail and to give the legal and factual grounds for the certification. The legislation would also require agencies to document all economic impacts, direct and indirect, that a new regulation could have on small businesses. It restricts agencies’ ability to waive Regulatory Flexibility Act requirements.

Importantly, HR 527 would also require each federal agency to publish in the Federal Register a plan for the periodic review of existing and new rules that have a significant impact on a substantial number of small entities to determine whether such rules should be continued, changed, or rescinded.
Current law requires only three agencies, OSHA, the EPA, and the Consumer Financial Protection Bureau, to consider the input of small business advocacy review panels before issuing new major regulations. The legislation would require all federal agencies to use advocacy review panels. According to Chairman Smith, this gives small businesses more opportunity to be heard before major new regulatory burdens are imposed.

HR 527 would require the SBA Chief Counsel for Advocacy to issue rules governing federal agency compliance with RFA requirements; and authorize the Chief Counsel to modify or amend such rules, to intervene in agency adjudication relating to such rules, and to inform an agency of the impact of its rulemaking on small entities.
The legislation would revise requirements for agency notification of the SBA Chief Counsel for Advocacy prior to the publication of any proposed rule. Federal agencies would be required to provide the Chief Counsel with all materials prepared or utilized in making the proposed rule, and information on the potential adverse and beneficial economic impacts of the proposed rule on small entities.

The Regulatory Flexibility Improvements Act would define "economic impact" with respect to a proposed or final regulation as any direct economic effect on small entities from such regulation and any indirect economic effect on small entities that is reasonably foreseeable and that results from such. HR 527 would also require initial and final regulatory flexibility analyses to describe alternatives to a proposed rule that minimize any adverse significant economic impact or maximize the beneficial significant economic impact on small entities.

It would also expand elements of initial and final regulatory flexibility analyses under the RFA to include estimates and descriptions of the cumulative economic impact of a proposed rule on a small entity. HR 527 would repeal provisions allowing a waiver or delay of the completion of an initial regulatory flexibility analysis.

Council of Institutional Investors Urges Legislation Providing for Director Majority Voting to Complete what Dodd-Frank Began

In letters to the American Bar Association and the Delaware State Bar Association, the Council of Institutional Investors made a strong case for finishing the job begun by Dodd-Frank and enact legislation providing for majority voting in all director elections. The letters request that the associations support amendments to the Model Business Corporation Act and the Delaware General Corporation Law to replace the current default standard of plurality voting in uncontested elections with a majority vote standard. Specifically, the CII recommends that Section 216(3) of the Delaware corporation code be amended to provide for majority voting as the default standard in director elections. Currently, Section 216(3) provides that directors must be elected by a plurality of the votes of the shares present in person or represented by proxy.

A provision in the base text of the Dodd-Frank Wall Street Reform and Consumer Protection Act, as approved by the Senate, would have required the SEC to direct national securities exchanges and associations to prohibit the listing of any security of an issuer who has on its board any members that did not receive a majority vote in uncontested board elections

While this provision was ultimately dropped from Dodd-Frank during the Conference Committee negotiations, the desire of investors for majority voting in uncontested elections of directors continues, noted the CII, and it is not inconceivable that such legislation could once again arise at the federal level.

The Senate provision, which was not in the House bill, would have required the SEC to adopt rules providing that in an uncontested election a director receiving a majority of the votes cast must be deemed to be elected. If a director failed to win a majority of the vote in an uncontested election, the director must tender his or her resignation to the board. Upon accepting the director’s resignation, the board must set a date on which the resignation will take effect in a reasonable period of time and publish such date within a reasonable period of time as established by SEC rule.

Under the Senate base text, dropped in conference, if the board declines to accept the resignation, the board must disclose the specific reasons why it decided not to accept the resignation and why that decision was in the best interest of the company and its shareholders. The SEC would have been authorized to exempt a company from any or all of these requirements based on the company’s size, its market capitalization, the number of shareholders of record, or any other criteria, as the Commission deemed necessary and appropriate in the public interest or for the protection of investors

In its letters, the Council said that its director election policy is based on the view, long accepted in the United Kingdom, Germany, and other European nations, that a plurality standard for the uncontested election of directors, under which a director may be elected even though a majority of shares are withheld from the nominee, is inherently unfair and undemocratic. The benefits of a majority vote standard are many, said the CII, including democratizing the corporate electoral process, enhancing investor voting power with minimal disruption to corporate affairs; and making boards more representative of, and accountable to, shareowners.

While a common criticism of majority voting is that it would result in frequent changes disruptive to corporate boards, said the Council, the data suggests a different reality. On average less than one percent of corporate directors are rejected by shareowner voting each year. The CII also believes that Dodd-Frank’s introduction of mandatory advisory votes on executive compensation beginning this proxy season appears to provide an alternate avenue for shareowners to express their discontent with directors.

More specifically, so far in the 2011 proxy season, only one company has had both a say-on-pay proposal and a director candidate fail to receive majority support, said the CII. Thus, the data appears to indicate that shareowners are discerning in how they voice disapproval of a corporation’s actions, noted the CII, thus making it highly unlikely that a binding majority vote standard would be disruptive to boards.

Federal Appeals Panel Says Company Statements on Goodwill Were Subjective Opinion and Could Not Support 1933 Act Claims

An investor alleging that a company failed to write down goodwill in connection with an acquisition, and that its outside auditor falsely certified that the company financials were GAAP-compliant, did not state a claim under Sections 11 and 12 of the Securities Act since the statements regarding goodwill were subjective opinions rather than objective factual matters. Applying the US Supreme Court’s reasoning in the 1991 Virginia Bankshares v. Sandberg opinion, a Second Circuit panel ruled that the Section 11 and 12 claims failed because the investor failed to allege that the opinions on goodwill were both false and not honestly believed when they were made. (Fait v. Regions Financial Corp., CA-2, 10-2311, Aug. 23, 2011).

Although Virginia Bankshares involved claims under the Exchange Act proxy provisions, the Court addressed whether statements of opinions or beliefs could be considered factual statements under the securities laws, and the Second Circuit has applied the Court’s approach in Virginia Bankshares to claims under the 1933 Act. The panel assured that the standard being applied here does not amount to a requirement of scienter since a requirement that a plaintiff plausibly allege that a company misstated its truly held belief and an allegation that it did so with fraudulent intent are not one and the same.

In particular, the complaint asserted that the company overstated goodwill and falsely stated that it was not impaired, and vastly underestimated loan loss reserves and failed to disclose that they were inadequate. Relying on these allegations, the complaint further contended that the outside auditor falsely certified that the company’s financial results were presented in accordance with GAAP.

Under FASB standards, after an acquisition, goodwill is measured as any excess of the purchase price over the value of the assets acquired and liabilities assumed. US GAAP requires that goodwill be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. Goodwill is an intangible asset that is recorded similarly to any other asset, and any subsequent decline in its value is recorded as a loss. Loan loss reserves refer to the amount set aside to cover expected defaults or losses on loans.

According to the appeals panel, the allegations regarding goodwill did not involve misstatements or omissions of material fact, but rather a misstatement regarding the company’s opinion. Estimates of goodwill depend on management’s determination of the fair value of the assets acquired and liabilities assumed, which are not matters of objective fact. The investor did not point to any objective standard such as market price that the company should have used, but failed to use, in determining the value of the acquired company’s assets Absent such a standard, an estimate of the fair value of those assets will vary depending on the particular methodology and assumptions used. In other words, the statements regarding goodwill at issue here were subjective ones rather than objective factual matters.

Applying the US Supreme Court’s opinion in Virginia Bankshares, the panel said that the investor had to allege the company’s disbelief in, and the falsity of, the opinions or beliefs regarding goodwill. This requirement ensures that the allegations concern the factual components of the statements. Applying these principles, the appeals panel concluded that the investor did not adequately allege actionable misstatements or omissions regarding goodwill.

The investor relied mainly on allegations about adverse market conditions to support the contention that the company and its auditor should have reached different conclusions about the amount of, and the need to test for, goodwill. The complaint does not, however, plausibly allege that the company did not believe the statements regarding goodwill at the time they made them. Under Virginia Bankshares such an omission was fatal to the Section 11 and 12 claims.

Massachusetts Adds Performance-Based Fees and Investment Consulting Services to IA Unethical Practices and Increases BD/Agent Fees

Performance-based fee and investment consulting service provisions were added to the list of unethical practices for investment advisers; registration fees for broker-dealers and agents were increased, along with the name "FINRA" replacing NASD as the current name of the organization that regulates broker-dealers and agents; and, similarly, the nomenclature for stock exchanges was updated to reflect the exchanges' current names, as rule changes adopted by the Massachusetts Securities Division. The initial and renewal registration fee for broker-dealers was increased to $450, from $300. The initial, renewal and transfer registration fee for agents was increased to $75, from $50.

NOTE: The previously proposed exemption for exempt reporting advisers, and both the amended "institutional buyer" definition and minimum financial requirements for investment advisers remain proposed.

Sunday, August 28, 2011

Corporate Tax Professionals Support SEC Staff Plan for IFRS Incorporation into US Financial Reporting

In-house company accountants and lawyers responsible for implementing the accounting rules for income taxes that form a part of the company’s financial statements support the SEC staff’s plan to incorporate IFRS into the US financial reporting system. In a letter to the SEC, the Tax Executives Institute said that the staff outlined a pragmatic approach, based on both endorsement and convergence, which is consistent with the broad goal of using a single set of high quality accounting standards for financial reporting purposes, which will allow a comparison of financial statements of U.S. companies with that of non-U.S. companies. In the view of the tax executives, consistency in global financial reporting standards is critical to creating a single set of financial statements, and all efforts should be undertaken to achieve that objective.

Tax professionals deal with accounting principles in two significant ways. First, FASB accounting standards undergird the books and records that serve as the starting point for US tax compliance. Second, tax executives are responsible for the implementation of the specific rules for accounting for income taxes that form a part of the financial statements and required disclosures.

The Institute supports the SEC staff framework for three main reasons. First, U.S. GAAP is retained as the statutory basis for financial reporting and is the vehicle for incorporating IFRS. By retaining U.S. GAAP as the framework within which IFRS will be integrated, reasoned the tax executives, the need to modify numerous tax regulations and agreements with tax authorities referencing U.S. GAAP will be reduced.

Second, the FASB is retained as the U.S. standard setter to facilitate the incorporation of IFRS into U.S. GAAP. Third, implementation is to be effected on a gradual basis, which will temper the significant resource, education, and implementation challenges attending a wide-ranging regulatory shift.

Given the FASB’s participation in the IASB’s standard-setting process, the FASB should be in a position to readily endorse, and integrate into U.S. GAAP the vast majority of the IASB’s modifications to IFRS. There may be instances, however, in which the FASB decides to modify or not follow IFRS. TEI concurs with the Staff Paper that those situations should be rare, and that any variations from IFRS should be carefully and deliberately scrutinized through a transparent and comprehensive process

Incorporating standards that are not currently the subject of existing projects or other IASB agenda items, so-called Category 3 standards, should be accorded particular attention. Whether these standards are incorporated simultaneously or more gradually into U.S. GAAP, TEI urged the use of a clear timeline for adopting Category 3 standards in order to allow companies to plan ahead for the implementation. Allowing adequate lead time becomes especially critical if a determination is made that Category 3 IFRSs would be incorporated into U.S. GAAP simultaneously rather than gradually. Although the Work Plan does not provide an extensive discussion of a potential timeline for incorporation, TEI says that a five-to seven-year timeline is realistic

In an earlier letter on the SEC’s roadmap to IFRS, the Institute said that, given the historical linkage between financial information prepared in accordance with U.S. GAAP and the calculation of U.S. federal tax income, it is also essential that the taxing authorities charged with developing and implementing transitions from U.S. GAAP to IFRS be central players in this process

The move toward a single set of accounting rules implicates the rights and responsibilities of many stakeholders beyond investors and issuers, including tax authorities and regulators, emphasized the Institute, and their views should be considered as the process moves forward. This would include Treasury and the Internal Revenue Service as stakeholders because the U.S. corporate tax base is currently inextricably linked to the calculation of income under U.S. GAAP.

State tax systems will similarly be affected because the calculation of state taxable income generally begins with federal taxable income. Thus, unless the views of federal and state tax authorities are appropriately considered, U.S. GAAP may remain important for U.S. tax purposes, thereby diminishing benefits promised from the adoption of global standards.

When calculating taxable income for U.S. federal tax purposes, companies are bound by the methods of accounting that they have chosen. If taxpayers wish to change those methods of accounting, they must first request permission from the IRS. For example, if a corporation elects to use the LIFO method of accounting for inventory on its corporate income tax return but later desires to change to FIFO, that corporation must continue to use LIFO until it requests and receives permission from the IRS to make the change.

Most U.S. corporations have historically begun their calculations of U.S. federal taxable income using financial information prepared in accordance with U.S. GAAP. Consequently, in the view of the Institute, those companies have established methods of accounting for tax purposes that align in most instances with U.S. GAAP.

According to the tax executives, a change from U.S. GAAP to IFRS would constitute a change to those methods of accounting for each item of income or expense whose treatment differs between the two financial reporting systems. Corporate taxpayers would need to file a separate request with the IRS to make each change. Without IRS permission, existing law would require taxpayers to continue calculating taxable income for U.S. purposes under U.S. GAAP, which is the method of accounting" currently used, while simultaneously keeping their books according to IFRS for purposes of financial reporting.

Saturday, August 27, 2011

Senate Legislation Would Expand Unfunded Mandates Reform Act to Bring SEC and CFTC Within Its Embrace

Legislation introduced by Senator Rob Portman (R-OH) would strengthen the Unfunded Mandates Reform Act of 1995 by bringing the SEC, CFTC and other independent federal agencies within its mandate. UMRA was a bipartisan effort to prevent Congress and federal regulators from blindly imposing major economic burdens on the private sector and on state, local and tribal governments without weighing the costs and benefits, said Senator Portman. Signed by President Bill Clinton in 1995, the Unfunded Mandates Reform Act was bipartisan legislation that basically says that regulators have to evaluate a regulation’s cost and find less costly alternatives before adopting a major rule.

In 1995, noted Senator Portman, UMRA was imposed upon the executive agencies but not on independent federal agencies. Those independent agencies have grown, and so have their regulations. Based on information from the GAO, observed Sen. Portman, between 1996 and this year independent agencies issued nearly 200 regulations that had an impact of $100 million or more on the economy. Over 200 regulations were not subject to review under UMRA, he emphasized, because they were from independent agencies. He sees a need to extend UMRA to these independent agencies in order to close this loophole. Cong. Record, June 9, 2011, pps. S S3657-3658

As introduced by Sen. Portman, the Unfunded Mandates Accountabilty Act would require federal agencies to specifically assess the potential effects of new regulation on job creation or job loss; consider market-based and non-government alternatives to regulation; require agencies to choose the least burdensome regulatory option that achieves the policy goal set out by Congress; extend UMRA to independent agencies; and permit courts to review an agency’s economic impact analysis under UMRA.
Federal agencies would, for the first time, be required specifically to assess the potential impact of any new major regulation with an annual effect of $100M or more on job creation or job loss and quantify that impact to the extent feasible. It would also require the consideration of market‐based, flexible, and nongovernmental alternatives.

UMRA requires agencies to consider a reasonable number of regulatory alternatives. This legislation would go further by specifically requiring agencies to consider reasonable alternatives that require no action by the federal government, use incentives and market‐based solutions, and/or permit the greatest flexibility in achieving the goals of the statute authorizing the regulation.

UMRA now states that agencies must select the least costly, most cost effective or least burdensome alternative that achieves the objectives of the rule unless the agency head simply provides an explanation. The Portman bill eliminates that excessively broad exception to require an agency to follow the least onerous regulatory course to achieve the policy goals set out by Congress. Agencies will, however, continue to have latitude to interpret statutory objectives.

This bill would apply the cost-benefit framework of UMRA to independent agencies. There is no basis for distinguishing between executive and independent agencies with respect to cost‐benefit analysis of new regulations. Given that rules issued by independent agencies are not reviewed by OMB’s Office of Information and Regulatory Affairs, there is an even more compelling need to bring independent agencies within the basic cost‐benefit framework created by Congress for executive agencies.

Currently, UMRA’s cost‐benefit framework is triggered only by rules that require direct expenditures of $100 million or more, indexed for inflation. This focus on expenditures makes sense for intergovernmental mandates, reasoned the Senator, but it excludes a host of compliance costs borne by the private sector. The legislation would revise the economic threshold to include any rule that imposes an annual effect on the economy of $100 million or more. According to Senator Portman, the broader scope would capture rules that impose less direct, but no less tangible, costs on employers. It would also better align UMRA with the definition of a “significant regulatory action” contained in President Clinton’s Executive Order 12,866 (1993).

UMRA currently applies only to general notices of proposed rulemaking, which excludes rules hastily adopted without general notice. The Portman measure would expand UMRA to apply to any proposed or final rule.

Courts have interpreted a handful of regulatory statutes to prohibit agencies from even considering costs when crafting certain rules. That approach does not accord with economic reality in a world of scarce resources, noted Senator Portman, and it often results in agencies considering cost in an undisclosed, back‐of‐the‐envelope manner. The bill would extend the cost‐benefit analysis to any new rule, while still recognizing that an agency can consider only regulatory alternatives within its discretion under the statute authorizing the rule.

Finally, the legislation would permit judicial review of an agency’s compliance with UMRA as part of any challenge to the rule brought under the Administrative Procedure Act. Each agency’s cost‐benefit analysis, as well as its approach to less onerous regulatory alternatives, would be reviewed under the arbitrary and capricious standard. Review would be deferential, but it would require an agency to provide a reasoned explanation of how its adoption of a particular regulatory means is consistent with UMRA. An agency that relies on an irrational or otherwise deficient cost‐benefit analysis, or adopts a needlessly burdensome option, would risk remand or vacatur of its regulation.

Friday, August 26, 2011

Speaker Asks President for List of Regulations as House Prepares to Take Up Legislation Requiring Congressional Approval of Major Regulations

In a letter to President Obama, House Speaker John Boehner (R-OH) asked the Administration to provide a list of all pending and planned federal regulations with a projected impact on the US economy in excess of $1 billion. The Speaker asked that the list be provided by the time Congress reconvenes in September so that the information will be available as the House considers legislation requiring congressional approval of any proposed federal regulation that will have a significant impact on the economy.

The Speaker is referring to the Regulations from the Executive in Need of Scrutiny Act (REINS), HR 10, which would require Congress to take an up-or-down, stand-alone vote on all new major regulations before they can be enforced. Major regulations are defined as those that have resulted in or is likely to result in an annual effect on the economy of $100 million or more; a major increase in costs or prices, or significant adverse effects on competition, employment, investment, productivity, innovation, or U.S. competitiveness.

The Act provides that if a joint resolution of approval of a major rule is not enacted by the end of 70 session days or legislative days after the agency proposing the rule submits its report on such rule to Congress, the rule must be deemed not approved and must not take effect. However, HR 10 allows a major rule to take effect for 90 calendar days without such approval if the President determines that the rule is necessary because of an imminent threat to health or safety or other emergency, for the enforcement of criminal laws, for national security, or to implement an international trade agreement.

Responding to concerns that the legislation would set up the filibustering of federal agency regulations, New York Law School Professor David Schoenbrod testified before the Judiciary Committee that REINS limits debate on the vote approving the regulation and all related motions to two hours in the House and Senate and that there is no realistic way around this time limit.
The Judiciary Committee has jurisdiction over H.R. 10. House Judiciary Committee Chairman Lamar Smith has signed on as the bill’s lead co-sponsor.

HR 10 has the bipartisan support of 149 co-sponsors. Senator Rand Paul (R-KY) has introduced a companion bill in the Senate as S. 299, which currently has the bipartisan support of 27 co-sponsors.

Hedge Fund Industry Supports SEC Proposal Raising Qualified Client Test

The hedge fund industry generally supports the SEC’s proposal raising the assets under management and net worth tests to become a qualified client under the performance compensation provisions of the Investment Advisers Act. As directed by Section 418 of the Dodd-Frank Act, the SEC would raise the assets under management amount to $1 million from the current $750,000 and the investor net worth test to $2 million from the current $1.5 million. Although not required by Dodd-Frank, the SEC proposes to exclude the value of a natural person’s primary residence from the net worth test.

These proposed changes would be to Advisers Act Rule 205-3, which currently exempts an investment adviser from the prohibition against charging a client performance fees, thereby allowing the adviser to charge performance fees if the client has at least $750,000 under management with the adviser immediately after entering into the advisory contract or if the adviser reasonably believed the client had a net worth of more than $1.5 million at the time the contract was entered into. These standards are designed to limit the availability of the exemption to clients who are financially experienced and able to bear the risks of performance fee arrangements.

In a letter to the SEC, the Managed Funds Association said that Section 418 of Dodd-Frank is a proper mechanism to ensure that the qualified client standard does not become diluted over time as a result of inflation by requiring the SEC to adjust the dollar amount tests under Section 205 of the Advisers Act for the effects of inflation within one year of the enactment of Dodd-Frank, and every five years thereafter.

Thus, the MFA supports the SEC’s proposal to implement Section 418 by increasing the assets under management threshold in Rule 205-3 to $1 million and the net worth threshold to $2 million, and by issuing an order every five years to adjust the thresholds to account for inflation. The hedge fund association also supports the proposal to exclude the value of a natural person’s primary residence from the determination of a person’s net worth since this would more closely align the calculation with the definition of accredited investor in Rule 501 under the Securities Act and qualified purchaser in Section 2(a)(51) of the Investment Company Act, and ensure that only sophisticated investors are able to purchase interests in private funds.

The SEC proposes to replace the current transition rules with two new subsections of Rule 205-3 maintaining existing performance fee arrangements that were permissible when the advisory contract was entered into, even if performance fees would not be permissible under the contract if it were entered into at a later date. These transition provisions are designed so that restrictions on the charging of performance fees apply to new contractual arrangements and do not apply retroactively to existing arrangements, including investments in companies that are excluded from the definition of an investment company by reason of section 3(c)(1) the Investment Company Act, which exempts a fund whose securities are owned by 100 or fewer persons and is not making a public offering.

The MFA generally supports the proposed transitional relief and appreciates that it would provide relief to advisers that are currently exempt from SEC registration and will be required to register as a result of Title IV of the Dodd-Frank Act. This transitional relief, which is similar to the relief that the SEC provided in connection with the hedge fund manager registration rule in 2004, is necessary to allow advisers to continue to operate their businesses without significant disruption.

However, the MFA cautioned that the proposed transitional relief could affect the operations of a 3(c)(1) fund that invests in another 3(c)(1) fund. In complying with the qualified client rule, a 3(c)(1) fund must look through another 3(c)(1) fund that is an equity owner of the fund to its individual investors. Under this look through analysis, the SEC proposal could be interpreted to lead to the anomalous result that a 3(c)(1) fund in compliance with Rule 205-3 and relying on the transitional relief for one or more of its investors would be effectively precluded from purchasing interests in another 3(c)(1) fund.

Such a result would be significantly disruptive to the investment strategies and operations of many 3(c)(1) funds, noted the MFA, and inconsistent with the goal of the transitional relief to apply the new thresholds prospectively. The MFA urged the SEC to clarify in the final rule that a 3(c)(1) fund will be deemed to have satisfied Rule 205-3 if an equity owner of the fund that itself is a 3(c)(1) fund is in compliance with Rule 205-3.

Thursday, August 25, 2011

Massachusetts Increases BD and Agent Fees

The fee to initially register or annually renew a broker-dealer registration was increased to $450, from $300. The fee to initially register, annually renew or transfer an agent registration was increased to $75, from $50.

Council of Institutional Investors Urges SEC to Seek En Banc Review of DC Circuit Panel Proxy Access Ruling

Noting that proxy access remains its number one priority, the Council of Institutional Investors has urged the SEC to seek a rehearing en banc of a DC Circuit panel’s recent ruling vacating the proxy access rule, Exchange Act Rule 14a-11, because it was adopted in an arbitrary and capricious manner. In a letter to the SEC, the Council said that the panel’s failure to follow established precedent provides a strong basis for the Commission to pursue a petition for rehearing before the full DC Circuit in the proxy access case. The panel’s decision does not merely delay the implementation of a critically important rule designed to benefit long-term investors and the markets, said the Council, it also imposes unnecessary costs on the Commission by requiring it to consider anew issues it already fully and reasonably examined.

More broadly, the Council emphasizede that the panel’s decision could have long-term negative consequences on the ability of the SEC and other agencies to effectively and efficiently promulgate rules that improve the regulation of the markets. This is particularly troubling given the extraordinarily high demands that are being placed on the SEC staff at this time.

The panel explicitly rejected the Commission’s conclusions about the benefits to shareowners of Rule 14a-11 because, in the court’s view, the empirical evidence was mixed. But, said the Council, it is precisely the role of expert agencies like the SEC, and not the courts, to reach reasoned conclusions based on such mixed evidence. So long as the agency considers the relevant factors and articulates a reasoned basis for its decision, noted the CII, a standard plainly met by the final proxy access rule, the agency’s determination should not be disturbed.

According to the Council, the panel’s decision reflects a failure to abide by the standards applicable to judicial review of agency determinations and, in particular, agency cost-benefit analysis. It is well-settled that a court is not to substitute its judgment for that of the agency, especially when the agency is called upon to weigh the costs and benefits of alternative polices. Cost-benefit analyses epitomize the types of decisions that are most appropriately entrusted to the expertise of an agency. The panel ignored these well-established principles, said the CII.

IRS Finalizes Schedule UTP Requiring Companies to Report Uncertain Tax Positions; Expands Policy of Restraint

The IRS has finalized Schedule UTP requiring companies to report uncertain tax positions on their tax returns starting with 2010 tax returns. The schedule will require the annual disclosure of uncertain tax positions in the form of a concise description of those positions and information about their magnitude. The company does not have to disclose the risk assessment or tax reserve amounts, even though the IRS can compel the production of this information through a summons.

Schedule UTP requires companies to provide a concise description of each uncertain tax position for which they have recorded a reserve in their financial statements, or for which no reserve has been recorded because of an expectation of litigation. These uncertain tax positions are identified by corporations during the process of preparing financial statements for SEC filing under applicable FASB accounting standards, such as FIN 48. In reviewing and verifying financial statements for compliance with FIN 48, independent auditors may ask for copies of legal opinions and other documents in order to understand transactions, to understand the legal bases for the treatment of transactions, and to determine the adequacy of reserves for contingent tax liabilities. Under the codification of accounting standards, the relevant portions of FIN 48 are now contained in Accounting Standards Codification subtopic 740-10, Income Taxes. FASB ASC 740-10.

In Announcement 2010-76, the IRS expanded its policy of restraint in connection with its decision to require corporations to file Schedule UTP and will forgo seeking particular documents that relate to uncertain tax positions and the work papers that document the completion of Schedule UTP. In reviewing and verifying financial statements for compliance with FIN 48, independent auditors may ask for copies of legal opinions and other documents in order to understand transactions, to understand the legal bases for the treatment of transactions, and to determine the adequacy of reserves for contingent tax liabilities.

If a document is otherwise privileged under the attorney-client privilege, the tax advice privilege in section 7525 of the Internal Revenue Code, or the work product doctrine and the document was provided to an independent auditor as part of an audit of the taxpayer’s financial statements, the IRS will not assert during an examination that privilege has been waived by such disclosure.

Under current procedures, examiners request tax reconciliation work papers as a matter of course. Announcement 20100-76 states that the company-taxpayer may redact the following information from any copies of tax reconciliation work papers relating to the preparation of Schedule UTP it is asked to produce during an examination: working drafts, revisions, or comments concerning the concise description of tax positions reported on Schedule UTP; the amount of any reserve related to a tax position reported on Schedule UTP; and computations determining the ranking of tax positions to be reported on Schedule UTP or the designation of a tax position as a Major Tax Position.

In a recent FAQ on Schedule UTP, the IRS clarified that the changes to the policy of restraint announced in Announcement 2010-76 apply to documents requested by Appeals. While it would be very unusual for Appeals to conduct any substantive fact-finding during its case consideration, said the IRS, the changes to the policy of restraint apply to any request for documents during the administrative process of determining the correct tax liability, which includes Appeals’ consideration of proposed audit adjustments. Regarding whether the changes to the policy of restraint applies to documents requested by Counsel after the filing of a Tax Court petition, the IRS said that generally counsel attorneys will not issue discovery requests for documents or information that the IRS would not seek under its policy of restraint.

The IRS also clarified that the changes announced in Announcement 2010-76 apply to any request for documents outstanding on or made after September 24, 2010, in any open examination

The instructions to Schedule UTP state that corporations need not report tax positions for which no reserve is recorded because it was sufficiently certain so that no reserve was required. For a corporation subject to FIN 48, noted the FAQ, a tax position is considered sufficiently certain so that no reserve was required, and therefore need not be reported on Schedule UTP, if the position is highly certain within the meaning of FIN 48.

The issue of whether the IRS can discover tax accrual work papers remains extremely contentious and has now divided the federal courts. A panel of the DC Circuit Court of Appeals ruled that a memo prepared by a company's outside audit firm recounting the thoughts of corporate counsel on the prospect of tax litigation over company partnerships could be protected attorney work product. Similarly, the panel said that a company's disclosure to the independent auditor of a tax opinion on company partnerships by outside counsel did not constitute a waiver of the work product privilege. Disclosure to an adversary or a conduit to an adversary could waive the privilege, noted the panel, but a company's independent outside auditor of its financial statements is neither an adversary of the company nor a conduit to its adversaries. The government sought production of the documents in connection with ongoing tax litigation with the company. (US v. Deloitte LLP, US Court of Appeals for the DC Circuit, No. 09-5171, June 29, 2010).

Earlier, the full First Circuit Court of Appeals, in a 3-2 opinion, ruled that the attorney work product doctrine does not shield from an IRS summons tax accrual work papers prepared by a company’s lawyers to support the calculation of tax reserves for audited financial statements filed with the SEC. In Textron Inc. v. United States, CA-1, No. 07-2631, 200, In a 3-2 opinion, the full appeals court held that the purpose of the tax audit work papers was not to prepare for litigation, but rather to make book entries, prepare financial statements and obtain a clean audit.

Wednesday, August 24, 2011

Corporate Secretaries Society Urges Gradual Phase-In of SEC Conflict Minerals Disclosure Regulations

In a letter to the SEC, the Society of Corporate Secretaries and Governance Professionals asked that the due diligence, disclosures and reporting required under the conflict minerals provisions of Dodd-Frank be phased-in similar to the approach taken by the SEC with respect to the introduction of required reporting on internal controls mandated by the Sarbanes-Oxley Act. A transitory phase-in would recognize the fact that the infrastructure necessary to comply with the SEC proposed regulations implementing Section 1502 of Dodd-Frank does not currently exist, said the Society, and thus would minimize the undue burden and cost imposed on companies in the near future. The Society also said that the cost of compliance with the regulations will be significantly greater than the SEC’s estimate.

In order to comply with the regulations, said the letter, companies must have a reliable basis for determining the origin of conflict minerals used at the processing facilities in its supply chain. A phase-in would provide the necessary time for companies to develop mechanisms to trace conflict minerals from the mine of origin to the processing facility. The Society urged the SEC to adopt a transition rule requiring reporting only with respect to conflict minerals that are derived from metal smelted on or after January 1, 2012. This would relieve companies of the undue burden of tracing minerals potentially sourced many years prior to the effective date of the Dodd-Frank Act.

More specifically, the Society suggested that for the period from January 2012 through January 2014, the SEC should require only disclosure of the following information for companies unable to determine the country of origin after a reasonable inquiry: (1) the conflict minerals that are necessary to the functionality or production of a product manufactured or contracted to be manufactured by that company and (2) the fact that the company is unable to determine the country of origin after due inquiry. During this period, such companies should not be required to submit a Conflict Minerals Report. After January 2014, company obligations would be phased-in by conflict mineral type based on when industry verification programs are put in place.

By recognizing the reality that it will take time for conflict mineral tracing mechanisms to develop and for downstream companies to implement practices affecting supplier sourcing behavior, reasoned the Society, this phase-in period would advance the goals of Section 1502 in the most effective manner and result in more meaningful disclosure

Corporate Secretaries Int’l Assoc. Sets Forth Twenty Principles for Better Corporate Governance

The Corporate Secretaries International Association has issued 20 principles to foster better corporate governance. The principles center on the role of independent directors, the broader duty of the entire board to achieve sound corporate governance and the crucial role of the board chair, and the roles of the outside auditor and the audit committee. The principles also deal with the role of the corporate secretary and the company’s relationship with its regulators, its shareholders, and its stakeholders.

The first two principles center on the important role of the board and the board chair. Corporate governance needs to be distinguished from management, said the Association, management runs the enterprise, while the governing body ensures that it is being well run and is heading in the right direction. Also, the company must confirm the leadership role of the board chair. In his seminal work on board chairmanship, Sir Adrian Cadbury, who drafted the first UK corporate governance code and helped to develop these principles, said that board chairs should be open to ideas and open in explaining the company’s actions and intentions. Balance is also important since the chair has the duty to weigh the consequences of decisions on all those who will be affected by them, and to hold the scales between the demands of today and the needs of tomorrow.

Principles 3, 4 and 5 deal with non-executive directors. Companies must ensure that the independent outside directors have sufficient intelligence, integrity, personality, and knowledge to stand against an over-powerful CEO and other directors from the executive suite. In addition, companies must review the role and contribution of non-executive directors. Sir Adrian Cadbury said that the role of independent directors is the most significant general issue to arise from the financial crisis. Outside directors were criticized for not restraining headstrong CEOs and failing to question the risks their companies were taking.

Principles 6 through 11 deal with the key role of the board of directors in achieving sound corporate governance. The company must ensure that all directors have a sound understanding of the company and confirm that the board’s relationship with executive management is sound. Companies must also ensure that directors can access all the information they need.

The directors must agree on the strategic direction of the business, said the Association, and every director needs to understand, accept, and be committed to the company’s strategic direction. Board chairs need to ensure that every director understands the company’s strategic profile, fully appreciates the strategic risks to which the company is exposed, and is committed to the companies’ strategies.

Boards need to accept that the governance of risk is a board responsibility. Board-level policies for enterprise risk management are needed, with appropriate systems in place. The board may delegate the main effort to a risk management standing committee of the main board or to a subcommittee of the audit committee.

Principles 12 ad 13 deal with shareholder relations. They posit that the crucial element of corporate governance is the responsibility of the governing body to be accountable to its shareholders, regulators and other legitimate stakeholders. Company law, supplemented by listing rules and corporate governance codes, determines the nature and extent of that accountability. Companies belong to their shareholders for whom the directors act as stewards.

Boards need to assess their performance critically, and those assessments need to be taken seriously by shareholders, particularly institutional shareholders who can take action when necessary. Companies’ corporate governance policies should confirm the board’s commitment to be accountable to shareholders, balancing what the Associaiton called the ``siren song’’ of short-term profits with longer-term corporate growth, while ensuring compliance with regulatory and stock exchange requirements.

Principle 14 seeks to ensure that directors’ remuneration packages are justifiable and justified. This is a corporate governance issue that will have to be addressed in many regulatory jurisdictions. Some corporate governance codes call for performance-related pay to be aligned to the company’s long-term interests and its policy on risk. Expectations are running high in many countries for greater transparency and confirmation that top-level remuneration packages are justified.

Principles 15 through 18 deal with the company’s relationships with outside auditors, regulators and stakeholders. The outside auditor needs to be, and be seen to be, independent of the audited company. It is vital that external auditors provide a genuinely objective judgment on the report of the directors.

Modern corporate governance codes place a major responsibility on the audit committee. The audit committee’s original function was to provide a link between the board and external auditor to ensure that the inevitable close relationship between the finance function and the auditor did not mean that issues of valuation, reporting, and control were resolved without the directors being aware. More recently, the role of the audit committee has been expanded to make audit committees a dominant feature in the corporate governance process. Some companies have given the responsibility for enterprise risk management to the audit committee.

Since audit committees are comprised of independent outside directors, it has been suggested that they have become more like a European supervisory board. However, a contrary view suggests that, provided all directors have access to the minutes of audit committee meetings and can raise questions in full board meetings, the board is fulfilling its responsibilities.

Nevertheless, a best governance practice is for all the directors to see the routine auditors’ management letter, which reports on their audit in detail. The board also needs to confirm that directors have sufficient knowledge about the relations between the finance function and the internal auditors to meet their duties to shareholders. The external auditors should
meet with the main board periodically and be available at meetings of shareholders.

Society allows companies to be incorporated and operate with limited liability. In response, all companies are regulated by the state. Public companies, in addition, have to ensure that they fulfill the demands of the securities regulators and the listing requirements of the stock exchanges on which their stock is listed.

In the past, relationships with company registrars and stock exchange listing committees tended to be left to specialist functions, such as the company secretary, the finance department or the lawyers. Following the global financial crisis, boards need to recognize that these relationships can have strategic importance. Directors need to be aware of the thinking of their regulators and ensure that their own corporate processes and reporting practices are evolving appropriately. The board also needs to be aware of changing expectations of their stock exchange authorities, ensure that they are able to respond to new demands and, perhaps, develop a closer relationship.

Corporate social responsibility and sustainability have been added to the corporate governance portfolio. Companies should develop written board-level policies covering relations between the company and the societies it affects. Some jurisdictions now require companies to recognize their social responsibilities. The UK Companies Act
2006, for the first time, specifically included corporate social responsibilities within the formal duties of company directors.

As a practical step towards better corporate governance, boards might review their social responsibility policies covering relations between the company and the stakeholders affected by its activities. Written board-level policies can help to promulgate these polices throughout the organization and among the stakeholder groups As another step towards better corporate governance, directors might review their company’s attitude towards ethical behavior and consider whether any changes are needed in the light of recent developments.

Finally, Principles 19 and 20 deal with the role of the corporate secretary. The original Cadbury Report suggested that the corporate secretary has a key role to play in ensuring that board procedures are both followed and regularly reviewed. The chairman and the board will look to the company secretary for guidance on what their responsibilities are under the regulations to which they are subject and on how those responsibilities should be discharged. All directors should have access to the advice and services of the company secretary and should recognize that the chairman is entitled to the strong support of the company secretary in ensuring the effective functioning of the board

Boards should consider the role currently played by their corporate secretary and whether it should be expanded. Similarly, boards should consider how the corporate secretary’s function might be developed.

The demands and opportunities for better corporate governance, following the global financial crisis, reinforce the important contribution that the company secretary can make to the company and the board.

Tuesday, August 23, 2011

Int’l Institute Emphasizes Need for Consistent High-Quality Global Accounting Standards in Letter to SEC

By bringing the U.S. market into the international accounting system, noted the Institute of International Finance, the SEC has the opportunity to take a significant step toward the development of integrated, efficient and well-informed global markets. Achieving this will certainly be in the public interest and further the protection of investors, said the Institute in a letter to the SEC, and also contribute to the broad interest of U.S and non-U.S. investors alike in enhancing financial stability and creating efficient markets. A single, consistent, global set of high-quality standards will also facilitate capital formation and allocation across the global economy.

The Institute emphasized that nothing could contribute more importantly toward these goals than adoption of IFRS as the single language of accounting in all the increasingly interlinked major financial centers. The Institute believes that there is a high level of support among internationally active firms for the adoption of IFRS in the U.S.

The Institute is convinced that IFRS generally constitute high-quality international standards developed through proper due process and public consultation procedures, while at the same time recognizing that work on important projects is in process. Moreover, the governance of the IASB has been substantially improved, said the Institute, with an important dimension of this being the oversight provided by the IFRS Foundation's Monitoring Board, of which the SEC is a member.

The Commission can have confidence that IFRS will generally continue to constitute high-quality standards as they develop and evolve, said the Institute, citing the keen interest of international issuers as well as the support of IOSCO and the international regulatory community.

Hong Kong Court Upholds Insider Trading Conviction

Noting that insider dealing is a serious crime, the Hong Kong Court of First Instance upheld the insider trading conviction of a person who used inside information about takeover negotiations to buy target company shares acting as a representative of the controlling shareholder and later sold the shares at a 40 percent higher price once the negotiations were announced. Securities and Futures Commission Director of Enforcement Mark Steward said that the SFC will continue to prosecute insider dealing as a criminal offence wherever possible since insider dealing is a serious crime that causes direct damage to the investing public and undermines confidence in the markets.

In this case, the actor’s offense involved obviously price sensitive information at the heart of a proposed major transaction and a serious breach of trust which allowed him to take an unfair advantage over the investing public, said the Director, who pledged that the Commission will continue the fight against market misconduct to ensure that ordinary investors can be confident in dealing in Hong Kong’s markets. The case is a further demonstration of the active commitment of the Commission to fight insider dealing with both criminal and civil remedies.

The SFC found that as a representative of the controlling shareholder the actor took part in the negotiation of a proposed acquisition of shares from the controlling shareholder. The actor purchased a total of 3,880,000 target company shares while in possession of confidential, price-sensitive information about the takeover offer; The company announced that its controlling shareholder was negotiating with an independent third party regarding the disposal of its entire holding of shares and trading in company shares was suspended. Trading resumed the following day and the share price soared by about 40 percent and the actor promptly disposed of all his shares, making a profit of approximately $120,000 from the trades.

UK Tribunal Upholds FSA Decision to Ban Hedge Fund Managers for Deceiving Investors and Market Abuse

A UK court, reviewing a Financial Services Authority decision, said that a hedge fund management company’s officers deliberately concealed the deterioration in the fund’s performance from the investors, so that existing investors did not withdraw their investments, and new investors put in money. The Upper Tribunal found that both the CEO and CFO of the hedge fund manager embarked on a deliberate and calculated course of concealing facts from investors and of misleading them. They have, albeit with differing degrees of culpability, engaged in a prolonged deceit of the hedge fund’s investors.

Tracey McDermott, Acting Director of Enforcement and Financial crime said that the conduct fell woefully short of the standards required of approved persons. They showed a flagrant disregard for the interests of their investors and over a considerable period engaged in a sustained and deliberate course of deception to present a picture of the fund’s performance that was entirely false

Where disagreements arise between the FSA and firms or individuals about the FSA’s regulatory decisions, the matter can be referred to the Upper Tribunal, which is an independent judicial body established by the Tribunals, Courts and Enforcement Act of 2007.

The Tribunal emphasized that there is a considerable public interest in its being clearly and widely understood that those who apply for FSA approval to carry on controlled activities take on a serious responsibility, and cannot shelter behind claims of ignorance or inexperience, when they fail to meet the obligations and standards which approval carries with it. There can be no possible room for doubt that the two did not act with an appropriate degree of integrity, said the Tribunal.

The Tribunal agreed with the FSA that those who fail, as in this case persistently and in several different ways, to comply with the obligations they have voluntarily assumed as approved persons, who engage in market manipulation, who breach the trust reposed in them by investors, and who systematically deceive those same investors, deserve to forfeit their right to carry on controlled activities and to suffer severe punishment.

Those are not, and are not intended to be, alternatives, said the Tribunal, the first is designed to protect the public, the second to mark disapproval of the person’s conduct and to deter others from similar actions.

It follows from the conclusions reached about their conduct that the actors both failed, persistently and repeatedly, to respect not only the requirements of the Prospectus, but also the requirements of the Authority’s Handbook. The Tribunal concluded that neither of them is fit to work in any capacity within the financial services industry.

SEC Staff Comment Letter Required Bank to Discuss Whether Foreign Currency Trading is Proprietary Trading under Volcker Rule

In what may be the first published SEC staff comments to a company regarding the Volcker rule, the staff asked Northern Trust Corporation to provide additional explanation of foreign currency trading on behalf of its clients. The Volcker rule is contained in Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The rule amends Section 13 of the Bank Holding Company Act of 1956 to prohibit most forms of proprietary trading by banks and nonbank financial institutions supervised by the Board.

The Volcker rule generally prohibits a banking entity from engaging in proprietary trading, or from acquiring or retaining any equity, partnership, or other ownership interest in, or sponsoring a hedge fund or a private equity fund. (Bank Holding Company Act of 1956 Sec. 13(a)(1) as amended by Sec. 619 of the Dodd-Frank Act). "Proprietary trading" means engaging as principal for the trading account of a banking entity or nonbank financial company supervised by the Board in any transaction to buy or sell any security, derivative, contract of sale of a commodity for future delivery, any option on any such security, derivative, or contract, or any other security or financial instrument identified by federal regulators (Bank Holding Company Act of 1956 Sec. 13(h)(4) as amended by Sec. 619 of the Dodd-Frank Act).

A "banking entity" is an insured depository institution, a company that controls an insured depository institution, or a company that is treated as a bank holding company, including any affiliates or subsidiaries. "Insured depository institution" does not include trust and fiduciary activities that meet specified criteria. (Bank Holding Company Act of 1956 Sec. 13(h)(1) as amended by Sec. 619 of the Dodd-Frank Act).

The Volcker rule, however, permits some activities, including the buying and selling of securities for purposes of market-making-related activities, if the permitted activity is designed not to exceed reasonably expected near term demands of clients, customers, and counterparties (Bank Holding Company Act of 1956 Sec. 13(d)(1)(B) as amended by Sec. 619 of the Dodd-Frank Act). Even permitted activities, however, are subject to limits due to material conflicts of interest, material exposure to high-risk assets or trading strategies, safety and soundness concerns, and threats to U.S. financial stability (Bank Holding Company Act of 1956 Sec. 13(d)(2)(A) as amended by Sec. 619 of the Dodd-Frank Act).

Permitted activities must satisfy any capital and quantitative limits established by rules (Bank Holding Company Act of 1956 Sec. 13(d)(3) as amended by Sec. 619 of the Dodd-Frank Act). Permitted activities also must not violate the anti-evasion provisions established by federal regulators (Bank Holding Company Act of 1956 Sec. 13(e) as amended by Sec. 619 of the Dodd-Frank Act).

The SEC staff, upon reviewing the Form 10-K filed by Northern Trust Corporation, inquired whether foreign currency trading services provided by the bank to customers amounted to proprietary trading under the Volcker rule. Specifically, the staff observed that it was unclear how much of Northern Trust's foreign currency trades were for its own account and how much trading was conducted on behalf of clients. Thus, the staff asked the bank to separately quantify proprietary trading revenues (if material) to better inform investors of the significance of proprietary trading to the bank's overall results of operations. The staff requested that the bank explain the future impact of any proprietary trading limits imposed by the Volcker rule on its proprietary trading activities. The staff also asked Northern Trust to explain in its future filings how it intends to comply with the Volcker rule.

Northern Trust replied that it does not engage in proprietary trading as defined in the Dodd-Frank Act. The bank noted that it acts as a foreign exchange market maker and principal in order to provide foreign exchange services to customers in the normal course of its business. The bank stated that it acts as market maker and as principal in transactions with third parties, investment managers of clients, and with some clients directly. As a result, Northern Trust trades currencies in the interbank market and may hold inventory positions in currencies to promote efficient trading.

The bank described these interbank transactions in aid of its market making services as "trading for its own account" in its Form 10-K. The bank records aggregate revenues from such trades as foreign exchange trading income in its consolidated income statement. In addition, the bank observed that it had already disclosed in its Form 10-K regulatory section that it did not expect the Volcker rule to impact its foreign currency trading activities. [Editor's Note: Northern Trust did not discuss in its reply whether its activities may fall within in any of the permitted activities, including permitted market-making-related activities.

However, the bank did discuss these permitted activities in Page 5 of its Form 10-K for the year ended December 31, 2010, filed February 25, 2011.] The bank further noted that it could not assess the full impact of the Volcker rule since multiple federal regulators must adopt rules and regulations over several years in order to fully implement the restrictions on proprietary trading. The staff subsequently indicated that it had completed its review.

This post was provided by Mark S. Nelson, CCH Federal Securities Writer Analyst, Wolters Kluwer Incorporated.

Securities and Exchange Board of India Proposes Regulation of Hedge Funds and Other Alternative Investment Funds

The Securities and Exchange Board of India has issued a concept paper proposing the regulation of hedge funds and other alternative investment funds. SEBI proposes to create a regulatory framework embracing all shades of private pools of capital or investment vehicles so that such funds are channeled into the desired space in a regulated manner without posing systemic risk. For example, private pools of capital of institutions or sophisticated investors who entrust pooled funds to managers who themselves need to have their own funds forming part of the corpus could potentially employ leverage. Also, at that end of the spectrum, the regulations would not try to regulate the business risks but would provide minimum ground rules for disclosures and governance practices to minimize conflict. Up the middle of the regulatory spectrum would be various specialized funds where risks are graded and investment portfolios designed to suit specific regulatory incentives.

SEBI intends to regulate private pools of capital where institutions or high
net worth investors invest in alternative investment funds. While institutions and high net worth investors are expected to be savvy investors and need not be protected
from market and credit risk, noted SEBI, there is a need for a regulatory framework to deter from fraud and unfair trade practices and minimize conflicts of interest. Mitigation of potential conflicts and the deterrence to fraud will be addressed through disclosure,incentive structures, and reporting requirements.

Making clear distinctions among the various types of private pooled investment
vehicles of institutional or sophisticated investors will allow the regulator to tailor concessions that may be desirable for individual kinds of funds, like venture capital funds. These concessions will be tied to investment restrictions for special kinds of funds, said SEBI, and may not be available to private equity, PIPE or hedge funds.

Under the proposal, it would be mandatory for all types of private pools of capital or investment funds to register with SEBI. The regulations would require that the fund manager or asset management company or trustees of the fund be specified, and that a change of such entities be reported to the regulator. At the time of application, the fund would specify the category under which it is seeking registration, the targeted size of the proposed fund, and its life cycle and target investors.

The investment restrictions on different types of alternative investment funds would be specified separately for each category of fund, as these would be the main differentiating criteria between the different types of funds.

For strategy funds, the fund would be guided by the strategy it specifies at the time of registration with no other restrictions. Any fund operating as a hedge fund will be required to be registered as a strategy fund under the alternative investment fund regulations.

Any alteration to the fund strategy must be made with the consent of at least 75 percent of unit holders. Compensation arrangement must be on the basis of performance related remuneration, plus a cost of fund management. The responsibilities of the fund manager or asset management company must be clearly defined. There must also be identification of conflicts of interest and the establishment of a mechanism for managing these conflicts of interest.