Friday, September 30, 2011

SEC Report on Credit Rating Agencies Finds Them Trending Even More to Issuer Pay Model

An SEC report on credit rating agencies found that the NRSROs appear to be trending even more toward employing the issuer-pay business model. Of the ten registered NRSROs, seven—including the three larger NRSROs—operate predominantly under the issuer-pay model. The remaining three have historically operated predominantly under the subscriber-pay model. However, the SEC found that two of the subscriber-pay NRSROs have recently taken steps to focus more on issuer-pay business. Even more, this new focus on the issuer-pay model appears to be occurring with respect to ratings of asset-backed securities.

There are two business models used by the NRSROs. Under the issuer-pay model, the NRSRO receives compensation from obligors for rating the obligor or securities issued by the obligor. Under the subscriber-pay model, subscribers pay the NRSRO for access to the NRSRO’s ratings.

The report notes that despite changes by some of the examined credit rating agencies to improve their operations, Commission staff identified concerns at each of the NRSROs. These concerns included apparent failures in some instances to follow ratings methodologies and procedures, to make timely and accurate disclosures, to establish effective internal control structures for the rating process and to adequately manage conflicts of interest. The report notes that the staff made various recommendations to the NRSROs to address the staff’s concerns and that in some cases the NRSROs have already taken steps to address such concerns.

“This report demonstrates the SEC’s enhanced oversight of credit rating agencies,” said Carlo V. di Florio, Director of the SEC’s Office of Compliance Inspections and Examinations (OCIE). “We have recruited experts and strengthened the overall monitoring and examination process to better protect investors, ensure market integrity, and facilitate capital formation.”

The Commission staff conducted the examinations as required by the Dodd-Frank Act, which imposed new reporting, disclosure and examination requirements to enhance the regulation and oversight of NRSROs. Among other things, the Dodd-Frank Act requires the Commission staff to examine each NRSRO at least annually and issue an annual report summarizing the essential findings of the examinations.

SEC Staff Gives Assurances to Advisers Keeping Alternate Records under Pay to Play Advisers Act Recordkeeping Rule

The staff of the Division of Investment Management has given no-action assurances under the government plan recordkeeping rule, adopted in conjunction with the pay to play rule, to investment advisers to Covered Investment Pools who keep an alternative set of records that is in some ways a broader set of records than required by the government plan recordkeeping rule, and in other ways a more narrow set of records than those required under the rule. For purposes of the letter, the term “Covered Investment Pool” means any investment company registered under the Investment Company Act that is an investment option of a plan or program of a government entity. Investment Company Institute, Sept 12, 2011.

Specifically, a letter from the Investment Company Institute states that an investment adviser seeking to rely on this relief will make and keep a list or other record that includes each government entity that invests in a Covered Investment Pool, where the account of such government entity can reasonably be identified as being held in the name of or for the benefit of the government entity on the records of the Covered Investment Pool or its transfer agent; Each government entity, the account of which was identified as that of a government entity at or around the time of the initial investment to the adviser or one of its client servicing employees, regulated persons or covered associates; Each government entity that sponsors or establishes a 529 Plan and has selected a specific Covered Investment Pool as an option to be offered by such 529 Plan; and Each government entity that has been solicited to invest in a Covered Investment Pool either by a covered associate or regulated person of the adviser; or by an intermediary or affiliate of the Covered Investment Pool if a covered associate, regulated person, or client servicing employee of the adviser participated in or was involved in such solicitation, regardless of whether such government entity invested in the Covered Investment Pool.

The letter asserts that by maintaining these records, including a list of those government entities to which an adviser markets (whether successfully or not), the adviser’s records will likely capture most of the larger government entities and most other government entities whose investments are likely to create an incentive for the adviser to engage in pay to play conduct. The letter further asserts that maintenance of such a list, in conjunction with compliance with the other requirements of Advisers Act Rule 204-2(a)(18) and Rule 206(4)-5, will allow the Commission to achieve the purposes of the pay to play regime under the Act.

Thursday, September 29, 2011

CAQ and the CII Oppose Pending House Legislation Raising the Public Float Exemption for Compliance with Sarbanes-Oxley 404(b)

The Center for Audit Quality and the Council of Institutional Investors oppose pending legislation that would expand the exemption from Sarbanes-Oxley Section 404(b), which requires an independent audit of a company’s assessment of its internal controls as a component of its financial statement audit, beyond the $75 million public float provided by the Dodd-Frank Act. In a joint letter to House Financial Services Chair Spencer Bachus (R-ALA), the groups said that effective internal controls have become more central to the financial statement audit, a fact that has contributed to an increase in overall audit quality in the years since the passage of the Sarbanes-Oxley Act. CAQ and the CII believe that all investors should receive equal protections with respect to the effectiveness of internal control over financial reporting by publicly traded companies.

U.S. Representative Stephen Fincher (R-TN) has introduced draft legislation, The Small Company Job Growth and Regulatory Relief Act, expanding the exemptions available to small companies from the Section 404(b) auditor attestation reporting requirements of the Sarbanes-Oxley Act. The Act would expand the Sarbanes-Oxley 404(b) exemptions for small and mid-size companies with a market capitalization of less than $500 million. The exemption is currently at the $75 million cap set by the Dodd-Frank Ac

CAG and the CII emphasized that the processes associated with attesting to a company's internal control effectiveness have become more integrated into the financial statement audit and, as a result, are more cost-efficient than in the early days of Sarbanes-Oxley Act implementation. Additionally, the original PCAOB standard that implemented auditor attestation of effective internal controls (AS2) was revised in 2007 to allow for greater efficiencies, and the SEC also issued guidance to management on the implementation of Section 404, both of which contributed significant cost savings after the first few years of SOX implementation.

While recognizing efforts to address redundant and unnecessary regulation that provides little value, the groups believe effective internal controls to be a critical component of the financial statement audit. The financial statement audit, in turn, continues to be important to well-functioning capital markets by improving the quality of, and confidence in, the financial reports provided to investors and other stakeholder.

They noted that Section 989G(b) of the Dodd-Frank Act required the SEC to conduct a study to determine how the SEC could reduce the burden of complying with Section 404(b) for companies whose market capitalization is between $75 and $250 million, while at the same time maintaining investor protection. In the resulting study, the SEC concluded that the existing requirements for issuers with a $75-$250 million public float to comply with the auditor attestation provisions of Section 404(b) should be maintained and that no new exemptions should be granted. Specifically, the SEC found strong evidence that the auditor‘s role in auditing the effectiveness of Internal Control for Financial Reporting] improves the reliability of internal control disclosures and financial reporting overall and is useful to investors.

Senior Fed Official Would Require Money Market Funds to Have Capital-Like Buffer

A senior Federal Reserve Board official would require money market funds to have a meaningful capital-like buffer that exceeds their single-issuer concentration exposure limit, perhaps on the order of 2 to 3 percent, that, if violated, would automatically lead to a fund’s conversion to a floating net asset value. Boston Fed President Eric Rosengren said that examples of how to structure such a buffer include having the sponsor of the money market fund directly fund the creation of the buffer, or creating a separate class of loss-absorbing shares that could be marketed to investors willing to bear some risk in exchange for a higher return than that provided by the stable value shares. If in some appropriate period of time a satisfactory plan for such a capital buffer is not produced and accepted, then those prime funds would be required to float their net asset value.

In remarks at a seminar on the capital markets in Stockholm, the Fed official said that, given the systemic importance of the money market fund industry, it is critical that one way or another regulators make the industry less susceptible to credit shocks and liquidity runs. While many in the industry have been reducing their exposure to troubled financial institutions, some continue to take what some observers might consider outsized credit risks. The experience of 2008 showed the potential for a money market fund's problems to precipitate redemptions that are ultimately destabilizing to short-term credit markets, and contribute to economic difficulties.

Like other mutual funds of which they are a subset, money market funds are not required to hold any capital as protection against adverse movements in the value of the assets they hold. This absence of capital, noted the Fed senior officer, together with the stable net asset value, results in a structure that despite its appeal in other ways is prone to shareholder “runs” during times of financial stresses.

The Boston Fed President urges a more pro-active regulatory approach with regard to money market funds. Currently, money market funds are required to provide a monthly report of holdings and, while monthly reporting has been helpful, noted the Fed official, given the very short maturity of many of the assets the reporting should be more frequent to avoid the possibility of “window dressing” at the end of the month. Also, reducing a fund’s maximum permissible exposure to any one firm could reduce the potential loss that would occur from a credit event involving only one counterparty. Consideration might also be given to whether the assets of riskier firms (for example those with very high market credit default swaps prices are appropriate investments for money market funds, which are expected to maintain a low risk profile.

Money market funds have purchased a large amount of foreign-bank securities, he observed, but most funds have been reducing their exposure to European banks posing more significant credit risks. Some of the reductions have been quite dramatic, and money funds are no longer holding short-term credit instruments issued by institutions headquartered in the most financially strained countries. They have greatly reduced the size of their overall exposure, and have also significantly reduced the maturity they are willing to hold. But the Fed official cautioned, just as in the fall of 2008, a very few aggressive money market funds could encounter trouble that ends up ratcheting up redemption requests across the industry.

Money market funds have also substantially increased their liquidity over the last year, noted the Fed official. In part this reflects a tightening of liquidity requirements by the SEC, but it also reflects the realization among fund managers that during times of significant liquidity risk, they need to maintain a more defensive posture.

Shelby Legislation Would Create Council of Agency Chief Economists and Change Standard of Judicial Review of Federal Financial Regulations

Two of the more interesting provisions of Senator Richard Shelby's proposed legislation reforming the federal financial regulatory process are the creation of a council of economists composed of the Chief Economists of the SEC and CFTC and other federal financial regulators and a new standard under which federal courts will review agency regulations.

Senator Richard Shelby (R-AL), Ranking Member on the Banking Committee has introduced the Financial Regulatory Responsibility Act of 2011, which holds federal financial regulators such as the SEC and CFTC accountable for rigorous, consistent economic analysis on every new regulation they propose. The legislation would require the SEC and CFTC to provide clear justification for the regulations and determine the economic impacts of proposed rulemakings, including their effects on growth and net job creation. In addition, the legislation mandates that if a regulation’s costs outweigh its benefits, regulators are barred from promulgating it.

Under the measure, during the period beginning on the date on which a notice of final rulemaking for a regulation is published in the Federal Register and ending one year later, a person that is adversely affected or aggrieved by the regulation is entitled to bring an action in the United States Court of Appeals for the District of Columbia Circuit for judicial review of agency compliance with the requirements of section 3 of the Shelby legislation. The court may stay the effective date of the regulation or any provision thereof.

If the court finds that an agency has not complied with the requirements of section 3, the court must vacate the subject regulation, unless the agency can show by clear and convincing evidence that vacating the regulation would result in irreparable harm.

The legislation would establish the Chief Economists Council to meet at least quarterly and be composed of the Chief Economist of each federal financial regulator. The members of the Council will select the first chairperson of the Council. Thereafter the position of Chairperson must rotate annually among the members of the Council.

The Council must submit an annual report to Congress on the benefits and costs of regulations adopted by the agencies during the past year, the regulatory actions planned by the agencies for the upcoming year, and the cumulative effect of the existing regulations of the agencies on economic activity, innovation, international competitiveness of entities regulated by the agencies, and net job creation. The Council must also report on the training and qualifications of the persons who prepared the cost-benefit analyses of each agency during the past year and the sufficiency of the resources available to the Chief Economists during the past year for the conduct of the activities required by the Act. Finally, the Council must make recommendations for legislative or regulatory action to enhance the efficiency and effectiveness of financial regulation in the United States.

This Term, Supreme Court Will Decide Scope of Equitable Tolling under Exchange Act Short-Swing Trading Provision Two-Year Limitations Period

The Supreme Court will decide in the upcoming 2011-2012 term whether and under what circumstances the two-year time limit for bringing an action to recover insider short-swing trading profits pursuant to Section 16(b) of the Securities Exchange Act may be tolled for equitable reasons. In an amicus brief, the Solicitor General and the SEC said that Section 16(b)’s two-year limitations period should be equitably tolled until a reasonably diligent security holder would have discovered the transaction that is alleged to trigger a disgorgement obligation. The filing of a Section 16(a) report that accurately discloses the transaction will preclude further tolling, whether or not a particular plaintiff had actual knowledge that the report was submitted. But even without a Section 16(a) disclosure, said the government, circumstances may arise in which a reasonably diligent security holder would be aware of the relevant transaction. Credit Suisse Securities v. Simmonds, Dkt. No. 10-1261.

At that point, the security holder is charged with knowing the facts that would form the basis for his or her action and has two years to bring an action to recover any short-swing profits. That approach balances the need for effective enforcement of the disgorgement obligation for short-swing profits with the need for finality on long-settled transactions, reasoned amicus, in a manner that comports with the background rules that have historically governed the application of statutory limitations periods. Because security holders have the ultimate authority to sue for enforcement of Section 16(b), said amicus, it is their knowledge of facts, and not the issuer’s knowledge, that determines the running of the limitations period. Security holders have the right to bring suit under Section 16(b) precisely to prevent concerted action between the issuer and the insiders whose profits are sought to be recovered.

A panel of the Ninth Circuit Court of Appeals held that the two-year limitations period in Section 16(b) is tolled until the insider discloses his or her transactions in a Section 16(a) filing, regardless of whether the plaintiff knew or should have known of the conduct at issue. That approach is inconsistent with the background rules described above, contended amicus. Section 16(b)’s limitations period should be tolled until a reasonably diligent security holder knows or should know the facts that would form the basis of a short-swing claim, said amicus. Although a Section 16(a) report will usually provide the first public notice that a short-swing transaction has occurred, continued the government's brief, that information may come to light in other ways as well. Amicus therefore contended that the court of appeals erred in holding that, as a matter of equity, the statute is invariably tolled until a Section 16(a) report is filed.

Sections 16(a) and (b) are designed to operate together: The two provisions cover the same class of insiders, and Section 16(a)’s disclosure requirement serves in large part to bring to light the short-swing transactions covered by Section 16(b). But allowing Section 16(b)’s limitations period to be triggered by public disclosures other than Section 16(a) statements would not sever the connection between the two provisions. The two provisions may thus be read as a coherent whole without taking the further and unwarranted step of treating Section 16(a) statements as the only means by which shareholders may be placed on notice of insiders’ short-swing transactions.

Wednesday, September 28, 2011

European Commission Proposes Financial Transactions Tax for the EU

The European Commission has proposed an EU-wide financial transactions tax similar to the financial transactions tax recently set forth in the Obama Administration's deficit reduction program. The tax would be levied on all transactions on financial instruments between financial institutions when at least one party to the transaction is located in the EU. The financial instruments in question would be products such as shares, bonds, derivatives and structured financial products. Whether transactions were carried out on organized markets or over the counter would not make any difference since in both cases they would be taxed.

The exchange of shares and bonds would be taxed at a rate of 0.1% and derivative contracts at a rate of 0.01%. The is estimated to raise approximately €57 billion every year.

The financial transaction tax is being imposed to ensure that the financial sector makes a fair contribution at a time of fiscal consolidation in the Member States. The financial sector played a role in the origins of the economic crisis, noted the Commission, and Governments and European citizens at large have borne the cost of massive taxpayer-funded bailouts to support the financial sector. Furthermore, the sector is currently under-taxed by comparison to other sectors. Financial services are, in the majority of cases, exempt from paying VAT, due to difficulties in measuring the taxable base, leading to the under-taxation of financial services.

The proposal would introduce new minimum tax rates and harmonize different existing taxes on financial transactions in the EU.. This will help to reduce competitive distortions in the single market, discourage risky trading activities and complement regulatory measures aimed at avoiding future crises. More broadly, the financial transaction tax at EU level would strengthen the EU's position to promote common rules for the introduction of such a tax at global level, notably through the G20.

Only transactions related to financial instruments would be covered by the financial transactions tax. This means that all transactions in which private households or SMEs were involved would fall out of the scope of the tax. For instance, house mortgages, bank borrowing by SMEs, or contributions to insurance contracts would not be included. Spot currency exchange transactions and the raising of capital by enterprises or public bodies, including e.g. public development banks through the issuance of bonds and shares on the primary market, would not be taxed either.

SEC Enforcement Director Responds to Senator Grassley's Inquiry on Document Retention for Matters Under Inquiry

Senator Charles Grassley (R-Iowa) is engaged in a discussion with the SEC over whether the agency for years destroyed investigative documents inappropriately or illegally. Prompted by an agency whistleblower, Senator Grassley, Ranking Member on the Judiciary Committee, is communicating with the agency as new information and questions emerge. He received a response to his latest letter from the SEC’s enforcement director, Robert Khuzami.

The Director said that the SEC does not classify any of its activities as matters under investigation. Rather, the enforcement division has two general categories of matters: 1) Matters Under Inquiry (MUI) and 2) Investigations. An MUI is a pre-investigative inquiry to evaluate whether opening an investigation would be an appropriate use of Commission resources, said the Director, and as such is designed to be a quick look at readily available information in order to determine if an investigation should be opened. The threshold for opening an MUI is low, he explained, and hence an MUI can be opened on very limited information. Because of an MUI's limited purpose, its duration is also limited. By contrast, an Enforcement investigation is designed to determine if there have been violations of the federal securities laws and, if so, whether the staff should recommend that the SEC take enforcement action.

Enforcement staff is under orders to close an MUI or convert it to an investigation within the earlier of 60 days or 80 hours of work. Starting in 2003, enforcement policy automatically converted any MUI that exceeds 60 days. Also, during a pre-investigative inquiry, staff is not authorized to issue subpoenas to compel testimony or produce documents. The threshold for closing an MUI is low, noted Director Khuzami, and the closing procedures are abbreviated.

The Director said that guidance on document retention regarding MUIs was changed in July 2010 after questions were raised. Since that time, MUI documents have been handled under the Enforcement Division's document retention policy for investigative files, which are covered by a records control schedule approved by the National Archives and Record Administration (NARA). After discussions with NARA and because the proper disposition of records involves issues of interpretations and judgments in the application of technical provisions of federal law, said the Director, the Division recently decided to retain all documents created, received or maintained for all enforcement matters, including MUIs, investigations and litigation, until the Division is certain that its document retention policies satisfy NARA standard.

Under the old guidance, MUI files were not stored as official files of the SEC and documents obtained in connection with an MUI were discarded. However, the SEC does not believe that current or future investigations have been harmed by the Division's previous guidance. The electronic MUI information that has been retained allows SEC staff to connect the dots between closed and current matters. The SEC retained significant information on all MUIs even under the old guidance. As part of the Division's case tracking systems, the SEC maintains electronic information concerning all MUIs opened during the past 20 years, including key information such as the title and source of the matter and the general subject matter of the inquiry. The MUI information is searchable and available to staff of the Division of Enforcement. Indeed, noted the Director, the electronic MUI information was designed to be and in practice has proven to be a useful resource for Enforcement Division staff.

Tuesday, September 27, 2011

Citing Executive Order, House Chairman Asks IRS to Justify Proposed Regulation Requiring Banks to Disclose Interest Paid to Non-Resident Aliens

In a letter to Treasury Secretary Tim Geithner and the IRS, Rep. Charles Boustany (R-LA) asked that the IRS suspend a proposed regulation requiring banks to disclose interest paid to non-resident aliens. IRS Notice of Proposed Rulemaking REG-146097-09 (“proposed regulation”). If the regulation were to take effect, said the Chairman of the Ways and Means Oversight Committee, it would not only run counter to the will of the Congress, but would potentially drive foreign investments out of the US economy, hurting individuals and small businesses by reducing access to capital.

The proposed regulation requires U.S. banks to collect and report information on interest paid to nonresident aliens who deposit funds in U.S. financial institutions, he noted. As the Internal Revenue Code imposes no taxation or reporting requirements on this deposit interest, reasoned Chairman Boustany, the proposed regulation serves no compelling tax collection purpose. Instead, it is his understanding that the IRS seeks this new authority to help foreign governments collect their own taxes abroad.

The Chairman asks that this regulation be suspended until his Subcommittee has a better understanding of IRS’s authority, policy objectives, and intentions with regard to this matter. To assist in that effort, the Chairman asks the IRS to provide certain information by no later than October 11, 2011. He asks if the IRS has considered the administrative burden of this proposed regulation on U.S. banks and, if so, how is this burden outweighed by the IRS’s policy goals. The Oversight Chair notes that the proposed regulation states that neither Executive Order 12866 nor section 553(b) of the Administrative Procedure Act applies to it. In that light, he asks that the IRS provide all correspondence and other documents relating to the formation of this opinion.

The Chairman noted that federal agencies must conduct a cost-benefit analysis of all “significant regulatory action” under
Executive Order 12866, which include regulations that have “an annual effect on the economy of $100 million or more or adversely affect in a material way... a sector of the economy.” He asks for all correspondence and other documents relating to the proposed regulation and its “significant regulatory action” status. He also wants a thorough cost-benefit analysis of the proposed regulation. Finally, he wants to know, how the IRS plans to share information collected under this regulation with
foreign countries.

Int'l Securities Associations Seek Changes in FATCA to Alleviate Compliance Burdens

The International Council of Securities Associations, the global forum for the trade associations and SROs that represent and regulate the securities industry, seek a delay in the implementation of the Foreign Account Tax Compliance Act and a cross border framework. In a letter to the IRS and Treasury, the Council said that, while fully supporting FATCA's overarching goals of preventing tax evasion and promoting financial transparency, its fears that the Act would impose significant compliance costs on all foreign financial institutions and, in a number of jurisdictions, cause financial institutions to violate data privacy laws if they were to comply with FATCA. In addition, FATCA sets new, unilateral standards for beneficial ownership, thereby undercutting the multilateral negotiations carried out under the leadership of the Financial Action Task Force.

Rather than the unilateral approach taken by FATCA, the Council suggested the development of a global framework allowing the US and other governments to obtain information regarding income paid to citizens of their countries by foreign financial institutions which is in harmony with each jurisdiction’s existing laws and does not create an excessive compliance burden for financial institutions. The Council believes that an approach developed through negotiations between governments and not through the agreements between the IRS and private entities mandated by FATCA, would be consistent with the G20’s emphasis
on building a coherent global framework for financial markets.

FATCA will effectively compel foreign financial institutions, broadly defined to include banks, hedge funds, investment companies and securities and commodities firms, to enter into an agreement with the IRS requiring them to report annually certain customer information and to withhold and pay to the IRS a 30% withholding tax on customers of those institutions who are US companies or US citizens that have not supplied certain information to the foreign financial institution. Thus, FATCA will compel foreign financial institutions to screen their existing customer database to identify clients that are US companies or individuals who are US persons.

But according to the Council, FATCA goes further than just requiring financial institutions to identify US companies and citizens. Financial institutions must be able to prove that their non-US clients are in fact not US companies or citizens or people born in the US. This requirement would apply not just to new accounts, but to many existing accounts as well, especially where clients may have US indicia on file, such as a U.S. mailing address (with some proposed exceptions). However, querying the nationality of customers is not part of the identification and verification of identity of customers under current anti-money laundering requirements in most jurisdictions.

The Council also noted that the definition of specified U.S. persons contained in the FATCA legislation encompasses foreign visitors who satisfy the substantial presence test. The test of whether an individual has a “substantial US tax presence” is based on whether or not a person has spent a weighted average of more than 183 days in the US over the past three calendar years, including at least 31 days in the past year. However, financial institutions generally do not collect such information as part of their initial or ongoing customer due diligence assessment.

In order to obtain this information, firms would have to explain the definition of a “substantial US tax presence” to their customers and then rely on the individual in question being able to both understand the definition and answer the question honestly. And the firm would not be able to verify the answer since it would not have access to the necessary documentation. In addition, given that the answer to the question may change from year to year, firms will need to identify such persons on an annual basis although they will not have access to the information that would allow them to actually verify if the customer were telling the truth or not.

Similarly, the definition of specified U.S. persons in FATCA legislation also includes green card holders. However, financial institutions are generally not required to request the details of a person’s green card status as part of their initial or ongoing due diligence. Therefore, to comply fully with the legislation, firms will have to attempt to indentify those existing and new customers who are green card holders without being able to independently verify the information that is given to them by the customers.

Even more troubling is the likelihood that all major non-US financial institutions will be captured by the requirement to be FATCA compliant due to their US exposures. As a result they will need to report all their US client dealings to the IRS and withhold 30% of US based income including gross proceeds of sales, from clients and counterparties that decline or for any reason do not cooperate with their US client identification regime. However, in a large number of countries, the legal basis on which they will be able to report their US client dealings and/or withhold 30% of US based income is not clear at this time. Indeed, there are a number of jurisdictions where financial institutions are expressly prohibited from undertaking these actions by data privacy and and other national laws.

For example, in Japan disclosure of personal information to a third party without the consent of the customer is prohibited by the Act on the Protection of Personal Information. If a customer did not consent to the disclosure, it would be difficult if not impossible for a financial institution based in Japan to withhold funds from the customer’s accounts based on an agreement with the US government, since that agreement would not have any legal basis in Japan. Similarly, under the Australian Privacy Act, every identified US person would need to consent to the disclosure of their personal information by the financial institution to the US government.

Financial institutions based in the EU would also face criminal prosecution as well as civil claims over breaches of data protection laws if those firms were to comply with FATCA. Absent direct EU legislative action, the FATCA obligations placed on the firms would mean that those financial institutions face a significant risk of customer claims of non-compliance with data protection and banking confidentiality obligations.

Monday, September 26, 2011

House Democrats Urge SEC to Quickly Finish Dodd-Frank Conflict Minerals Regulations and Use OECD Due Diligence Guidelines

In a letter to SEC Chair Mary Schapiro, four prominent House Democrats, including Rep. Barney Frank (D-MASS) urged the SEC to quickly complete the conflict minerals regulations implementing Section 1502 of the Dodd-Frank Act. The letter also said that the SEC should incorporate the OECD due diligence guidance in the regulations. Section 1502 of the Act requires companies that report to the SEC to disclose the measures they use to certify that their products do not contain conflict minerals from the Congo. Companies also have to track their supply chains back to a mineral's origin.

Earlier this year, the SEC announced that the issuance of final rules for Section 1502 would be delayed beyond the April 17 date established in law. Noting that we are now almost five months past that April deadline, the House Democrats said that, unless the regulations are promulgated soon, an entire year of implementation could be missed, since the law requires companies to begin reporting in the first fiscal year after regulations are finalized. For many companies, the fiscal year begins in January. The lawmakers also said that delays in implementation will seriously undermine the aim of the provision to reduce violence on the ground as quickly as possible and will send the wrong message to companies about the importance of this provision.

The lawmakers also advised the SEC that companies should not be allowed to report that the minerals in their products are of
"indeterminate origin". Rather, if companies fail to determine the origin ofthe minerals in their products, they must describe them as "Not DRC conflict free" in their Conflict Minerals report. Otherwise, reasoned the Representatives, a perverse incentive is created for companies not to exercise full due diligence, which could result in "indeterminate" mineral characterizations that would render the determinations meaningless . In addition, they noted that Section 1502(b) intended for all manufacturing companies that use minerals in their products, regardless of how small the percentage or what label they manufacture under, to be required to trace and disclose information on their supply chains. This intention should be reflected in the final regulations, said the House Members.

The House Democrats encouraged the SEC to build upon the OECD by adopting the five step due diligence framework set out in the OECD's "Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High Risk Areas". The OECD guidance was developed in coordination with a broad range of companies, non-governmental organizations, processing facilities, and regional governments. It represents an international consensus on how to approach the minerals trade without contributing to violence and human rights violations. In July, the Department of State endorsed this framework.

The OECD Due Diligence Guidance for responsible supply chains of conflict minerals is a five step risk-based due diligence regime for use by any company potentially sourcing minerals or metals from conflict-affected areas. The final version of the Guidance was approved by the OECD Investment and Development Assistance committees n December 2010.

Broadly, the Guidance recognizes that, while specific due diligence requirements and processes will differ depending on the mineral and the position of the company in the supply chain, companies should review their choice of suppliers and sourcing decisions and integrate into their management systems a five-step framework for risk-based due diligence for responsible supply chains of minerals from conflict areas.

The first step is to establish strong management systems under which companies can adopt and communicate to suppliers a policy for the supply chain of minerals originating from conflict areas, a policy incorporating the standards against which due diligence is to be conducted. The company must also structure internal management to support supply chain due diligence and establish a system of controls over the mineral supply chain, including a chain if custody. The supply chain policy should also be incorporated into contracts with suppliers. The company should establish a company-level, or industry-wide, grievance mechanism as an early-warning risk-awareness system.

The second and third steps are to identify and assess risk in the supply chain of adverse impacts in light of the standards of the company’s supply chain policy and implement a strategy to respond to identified risks. A risk management plan should be implemented and monitored and the performance of risk mitigation efforts tracked.

The fourth step is to carry out an independent third-party audit of due diligence at identified points in the supply chain. The fifth step is to publicly report on the company’s supply chain due diligence policies and practices.

Collins Legislation Would Mandate One-Year Moratorium on Significant Federal Regulations

Legislation introduced by Senator Susan Collins (R-ME) would provide a one-year moratorium for significant regulations of federal executive and independent agencies. The Regulatory Time-Out Act, S 1538, would impose a one year moratorium on significant new regulations from going into effect if they would have an adverse impact on jobs, the economy, or US international competitiveness. Significant regulations include those costing more than $100 million per year. This definition is similar to definitions used by Presidents Clinton and G.W. Bush in Executive Orders, said Senator Collins. The time-out applies to regulations issued by Executive Branch agencies and independent regulatory agencies.

The legislation would exempt regulations that address imminent threats to human health or safety or other emergencies, or that apply to the criminal justice system, military or foreign affairs. Under the legislation, a regulation cannot go into effect unless the issuing agency publishes, in the Federal Register, an explanation of why the rule is exempt from the moratorium. Regulations which foster private sector job creation and the enhancement of the competitiveness of the American worker, or which otherwise reduce the regulatory burden, are also exempt from the time-out.

Within 10 days of the effective date of the Regulatory Time-Out Act, agencies must submit to OMB and to Congress a list of rules which they believe are exempt.

Sunday, September 25, 2011

Federal Legislation Would Curb Excessive Energy Derivatives Position Limits and Define Excessive Speculation

Concerned with proposed CFTC regulations on energy derivatives position limits, Senator Bill Nelson (D-FL) has introduced legislation under which no single investor could hold more than 5 percent of the oil futures market thereby greatly reducing speculators ability to manipulate prices. And because more speculators have jumped into the oil flipping business, said the Senator, the bill caps the overall level of speculation in the market at its average over the most recent 25 years. Rep. Peter Welch (D-VT) has introduced a companion bill in the House. The lawmakers say that the legislation could reduce present day levels of speculation by more than half.

The Anti-Excessive Speculation Act of 201, S 1598, would also clarify for the first time that one of the fundamental objectives of the Commodity Exchange Act is to ensure that the commodity markets accurately reflect the fundamental supply and demand for commodities, and establish the deterrence and prevention of excessive speculation as an express purpose of the Act. In order to end decades of legal uncertainty and ambiguity that has thwarted enforcement efforts, the Act defines “excessive speculation” and creates legal presumptions that would give rise to a determination that excessive speculation exists.

Under the draft, excessive speculaiton in a commodity market exists if speculative traders have a substantial impact on price discovery. For purposes of the Act, speculative traders must be presumed to have a substantial impact on price discovery if the CFTC determines that gross positions, long or short, attributable to speculative trading in a contract for future delivery, an option on such a contract, a swaps contract listed for trading on a designated contract market, or a swaps contract listed for trading on a swaps execution facility exceed the gross positions, long or short, attributable to bona fide hedging transactions traded in such a contract or option; or the average percentage of open interest, long or short, held by persons primarily engaged in speculative trading during the most recent 12-month period for which data are available exceeds by more than 10 percent the average annual percentage of open interest, long or short, held by persons primarily engaged in speculative trading during gthe preceding 25 years.

The draft also establishes individual statutory speculative position limits for energy futures, options, and economically similar contracts, whether they are traded on an exchange or over-the-counter. The position limits would be set at 5 percent of deliverable supply in the spot month and 5 percent of open interest in the out-months. The speculative position limits would not apply to bona fide hedging transactions. No single trader could hold more than 5 percent of the oil futures market, thereby greatly reducing the risk that any trader will be able to corner, squeeze, or otherwise manipulate oil and gas prices.

The legislation would also establish aggregate speculative position limits in energy contracts that would apply to speculators as a class of traders. The aggregate position limits would cap the overall level of speculation in the market at its historic, 25-year average. The effect would be to reduce oil speculation from about 45 percent of the total market to 20 percent of the market. The aggregate speculative position limits would not apply to bona fide hedging transactions

The Act also closes a loophole by requiring foreign exchanges seeking access to U.S. traders to adopt rules prohibiting excessive speculation that are comparable to the U.S. rules. It also broadly authorizeso the Commodity Futures Trading Commission to issue rules necessary to prevent persons from circumventing or evading the speculative position limits and to carry out the purpose of the Act.

Saturday, September 24, 2011

Federal Court Rules that Plaintiff Stated a Claim for Breach of Duty of Loyalty in Wake of Shareholder Negative Say-on-Pay Vote

In the wake of a negative shareholder advisory vote on a company's executive compensation package, a federal judge ruled that company shareholders adequately stated a claim for breach of the duty of loyalty against the company's board of directors for granting $4 million in bonuses on top of $4.5 millon in salary and other compensation in the same year the company incurred a $61.3 million decline in net income, a drop in earnings per share from $.037 to $.09, a reduction in share price from $3.45 to $2.80, and a negative 18.8 percent shareholder return. Normally a board is protected by the business judgment rule when making decisions about executive pay, said the judge, and a court will not inquire into the wisdom of actions taken by a director in the absence of fraud, bad faith, or abuse of discretion. But the business judgment rule is a presumption that can be rebutted by a plaintiff with factual evidence that board members acted disloyally. NECA-IBEW Pension Fund v. Cox, et al, SD Ohio, No. 1:11-civ-451, Sept 20, 2011.

The court also ruled that pre-suit demand on the directors was futile and hence not necessary. The plaintiff alleged specific facts raising a doubt the the directors could make an unbiased independent business judgment about whether to sue. The directors devised the challenged compensation, approved the compensation, recommeded that the shareholders approve the compensation in the Dodd-Frank mandated vote, and then suffered a negative shareholder vote on the compensation.

Dodd-Frank requires public companies to include a shareholder advisory vote on executive pay in their proxies at least every three years. Pursuant to this provision, the company included a say on pay provision in the proxy seeking shareholder approval of the 2010 compensation package. The board recommend that shareholders support the executove compensation. But 66 percemt of the company's voting shareholders voted against the 2010 executive compensation. Citing the shareholder rejection of the executive compensation, plaintiff alleged that the board breached its fiduciary duty of loyalty when it approved large pay raises and bonuses for senior officers in a year when the company performed dismally.

The court ruled that the plaintiffs adequately pled that the board is not entitled to business judgment protection for its 2010 executive pay hikes. The factual allegations raised a plausible claim that the multi-million dollar bonuses approved by the board at a time of declining corporate performance violated the company's pay for performance compensation policy and were not in the best interests of the shareholders and thus constituted an abuse of discretion and/or bad faith.

The court noted that the directors may offer the business judgment rule defense at trial, where the plaintiff may well not be able to prove by clear and convincing evidence that the directors acted with a deliberate intent to cause injury to the company or reckless disregard for the best interest of the company.

SEC Official Discusses 404(b) as Draft Legislation Would Exempt Companies with up to $500 million Market Cap from 404(b)

As the SEC staff works with the PCAOB to monitor auditor inspection results on 404(b) internal controls, U.S. Representative Stephen Fincher (R-TN) introduced draft legislation, The Small Company Job Growth and Regulatory Relief Act, expanding the exemptions available to small companies from the Section 404(b) auditor attestation reporting requirements of the Sarbanes-Oxley Act. The Act would expand the Sarbanes-Oxley 404(b) exemptions for small and mid-size companies with a market capitalization of less than $500 million. The exemption is currently at the $75 million cap set by the Dodd-Frank Act.

Supporters of increasing the $75 million cap believe that duplicative audit requirements hinder many companies from going public, noted Rep. Fincher, and going public provides opportunities for companies to raise desperately needed capital in order to expand, reinvest, and create jobs. Opponents argue that changing the auditing requirements would lead to corporate fraud and shift us back to the days of Enron and World Com. Congressman believes ``we can have our cake and eat it too on this issue.'' He assured that the legislation would not eliminate corporate audits or internal controls; just auditing of the internal controls of companies that could use their scarce resources to expand their business, while at the same time preserving the goal of Sarbanes-Oxley, which is to ensure that large and complex companies, which brought us Sarbanes-Oxley in the first place, continue to be subject to these additional audits.

SEC Corporation Finance Director Meredith Cross testified before the Capital Markets subcommittee that Dodd-Frank amends the Section 404 requirements to provide that smaller companies (specifically those that are not “accelerated filers” or “large accelerated filers” are exempt from the requirement in Section 404(b) that an independent auditor attest to, and report on, the issuer’s assessment of its internal controls. As a result, more than 60% of companies filing reports with the Commission, those with the smallest public float, are now exempt from the internal controls audit requirement.

The Director also noted that the staff encourages activities that have the potential to further improve both the effectiveness and the efficiency of the evaluation of internal controls, while maintaining important investor protection safeguards. For example, with this objective in mind, the staff continues to work with the PCAOB to monitor inspection results and assess the extent to
which publishing observations can be useful. The staff is also observing COSO’s project to review and update its internal control framework, which is the most common framework used by management and auditors alike in performing assessments of internal control over financial reporting.

Chamber of Commerce Urges SEC Modernization Act Changes to Set Specific Objectives for SEC

The US Chamber of Chamber agrees with the goal of the SEC Modernization Act of 2011, introduced by Financial Services Committee Chair Spencer Bachus (R-ALA) to bring about transformative change to establish even handed and effective regulation to ensure that U.S. capital markets are competitive in a global economy. However, in a letter to Chairman Bachus, the Chamber said that the legislation could be improved to promote the nimbleness of the SEC in an ever changing financial market.

The Chamber urged the Chairman and the Committee to change the legislation to outline in the measure a series of principles and objectives for the SEC to achieve, such as a defined chain of command, elimination of regulatory silos and improved coordination and communications amongst divisions, and a defined regulatory plan to promote market efficiency and capital formation. The SEC should also be statutorily directed, within a specified period of time, to present a reorganization plan for Congressional review, consistent with Congressional oversight responsibilities and the long-established process for review of agency reprogramming requests. In the Chamber's view, these changes would put the onus on the SEC to reorganize itself with Congressional oversight, and overcome an organization resistant to change. A holistic reorganization could also be mandated to reoccur over specified time horizons.

Friday, September 23, 2011

Citing Hocking Opinion, SEC Contends in Ninth Circuit Amicus Brief that Sale and Rental of Hotel Rooms Were Investment Contracts

In an amicus brief filed in the Ninth Circuit, the SEC contends that a series of related contracts involving the sale and rental management of hotel rooms in a hotel that the promoters were constructing constituted investment contracts under the federal securities laws when from the time the sales commenced the purchasers had so little use or control of the rooms that they had no practical alternative but to rely on the promoters to rent the rooms and obtain profits, which were shared between the purchasers and the promoters. Allowing to stand the district court's holding that there was not the sale of a federal security would impermissibly allow a promoter to avoid the coverage of the federal securities laws by artificially dividing a single investment transaction into ostensibly separate parts, and including written disclaimers falsely stating that there is no investment expectation. Salameh v. Tarsadia Hotel, CA-9, No. 11-55479.

Language in the sales agreements disclaiming any investment expectation should not be given any weight, argued the SEC, because the economic and practical reality demonstrates that the transactions were investments. The existence of an investment contract turns on the economic and practical realities of the transaction, said the SEC and not the legal formulations or contract terminology the parties may use.

According to SEC as amicus, the district court misapplied the Howey test by treating the room sales and the rental program as separate transactions. Parties cannot escape the federal securities laws by artificially dividing a securities investment into a series of ostensibly discrete transactions. The SEC said that courts must ascertain the general scheme of profit seeking activities that was explicitly or implicitly offered to induce the purchase, citing the seminal Ninth Circuit ruling in Hocking v. Dubois, 885 F.2d 1449, 1457-58 (9th Cir. 1989) (en banc) where the full Ninth Circuit, applying the Howey test, recognized that condominium sales offered in conjunction with rent pooling or rental management agreements can constitute an
investment contract.

If the economic and practical realities indicate that multiple agreements in fact comprise a single transaction or package, reasoned the SEC, they must be analyzed together to determine if they constitute an investment contract. The room sales and rental management program plainly constituted a single transaction, said the SEC. an investment in a hotel enterprise. Further, there is no dispute that each purchase required an investment of money that exposed the purchaser to a risk of financial loss. The SEC also said that a common enterprise exists because the Rental Management Agreement establishes a revenue-sharing
arrangement for each participating room between the promoter and the unit owner. It is also apparent, said the SEC, that the plaintiffs were led to expect profits from the promoters efforts.

From the time of the room sales, said the SEC, the plaintiffs were precluded for all practical purposes from exercising any meaningful control over their rooms. The promoters had reserved such authority for themselves. Moreover, the Rental Management Agreement expressly provided the promoters with exclusive authority to manage, operate, market and rent the owner’s room. Hocking teaches that the essential showing of an expectation of profit from the essential efforts of others is established where the purchaser demonstrates a practical “inability to exercise meaningful powers of control or to find others to manage his investment,” notwithstanding any appearance of legal control that the parties’ written agreements may suggest.

UK Minister Urges Institutional Investors to Help Enhance Corporate Governance

UK Financial Secretary Mark Hoban urged pension funds and other institutional investors to become more involved with corporate governance at the companies they invest in. In remarks to the National Association of Pension Funds, he pledged that the Government will work with investors and companies to strengthen the corporate governance framework and provide greater opportunities for stewardship over a sustained period.

In his view, institutional shareholders, such as pension funds, are responsible for holding directors to account for corporate performance and pay, and the Government will help them strengthen their ability to discharge this role. But as well as strengthening corporate governance, the Government has also looked at a more fundamental question around that debate around stewardship and trading. For example Vince Cable the Secretary of State for Business has commissioned Professor John Kay to conduct an independent review of UK equity markets, examining the question of how equity investment can better support the long term interests of companies, as well as in this case, pension fund members themselves.

On a broader front, the Walker Review of corporate governance of led to a thorough revision of the UK Corporate Governance Code to promote better informed, more focused and effectively led boards, and to a Stewardship Code to encourage institutional investors to exercise their governance responsibilities more effectively and transparently.

These improvements have been complemented by the FSA’s strengthening of its Significant Influence Function reviews of prospective board members, and its introduction of the FSA Remuneration Code, which establishes a firm link between executive pay and effective risk management.

Finally, the Minister noted the publication of a BIS consultation on measures to improve the transparency of pay, and of a discussion paper on executive pay, which takes this further. These will promote informed debate on the incentivisation and accountability of company managers for long-term performance.

Singapore Exchange Listing Standards Enhanced for Corporate Governance, Outside Auditor Must Be Registered with Oversight Body

The Singapore Stock Exchange has amended its listing standards to enhance the corporate governance of listed companies. Among other things, effective Sept. 29, 2011, the Exchange will require a listed company's outside auditor to be registered with and regulated by the Accounting and Corporate Regulatory Authority (“ACRA”) or an independent audit oversight body acceptable to the Exchange [Rule 712]. Existing issuers who are unable to comply with this rule will be given one year from the date of implementation to fulfill this requirement. The Exchange will also require listed companies to have a robust and effective system of internal controls that addresses financial, operational and compliance risks [Rule 719].

Under specific circumstances, such as where the issuer is the subject of an investigation of irregularities or other wrongdoing, the Exchange’s approval may be required for appointments of directors, chief executive officers and chief financial officers. The Exchange’s right to take action against directors or key executive officers, such as public censure or objecting to their appointments to the boards of other issuers is also codified in this rule. [Rule 720]. There are also disclosure enhancements.

The listing standards will require the disclosure of a company's loan agreements that make reference to control or controlling shareholder interest. Issuers with such loan agreements are to require an undertaking from their controlling shareholders to provide notification when share pledging arrangements are entered into such that details of the pledge can be disclosed by the issuer [Rule 704(31) and Rule 728]. Also, companies must disclose whether any of their independent directors have been appointed to the board of the issuer’s principal subsidiaries based in jurisdictions other than Singapore. On an ongoing basis, announcement is required for the appointment and cessation of such independent directors to the board of these principal subsidiaries [Rule 610(8) and Rule 704(12)].

In Letter to Treasury, Securities and Fund Industries Oppose Financial Transactions Tax as Part of Deficit Reduction Legislation

Against the backdrop of the Administration's proposed fiscal responsibility fee, SIFMA and the Investment Company Institute have voiced their strong opposition to the imposition of a financial transactions tax as part of any budget deficit reduction legislation or G-20 mechanism. In a joint letter to Treasury Secretary Tim Geithner, the SIFMA and the ICI, joined by the Chamber of Commerce, the Financial Services Forum, and the Business Roundtable, urged the Treasury Secretary to continue to encourage other members of the G-20 to resist pressures to adopt such proposals on a global basis.

The industry groups are concerned with the French and German effort to seek endorsement of such a tax through the G-20 mechanism. The G-20 members have committed to work together to support policies that will lead to strong, sustainable and balanced growth, said the industry groups, and the imposition of a financial transaction tax would run counter to achieving these objectives.

The case against the imposition of such a tax is strong, said the groups, since a financial transactions tax will cycle through the entire U.S. economy, harming both investors and businesses. The financial transactions tax, which generally includes derivatives transactions, would impede the efficiency of markets, noted SIFMA and the ICI, impair depth and liquidity, raise costs to issuers, investors, and pensioners, and distort capital flows by discriminating against asset classes. Major economies that have adopted a FTT and FTT-like initiatives have had overwhelmingly negative results, said the groups, including reduced asset prices, trading moving to other venues, market dislocation, and a decrease in liquidity.

Thursday, September 22, 2011

Senator Shelby Introduces Legislation Reforming Federal Financial Regulatory Process

Senator Richard Shelby (R-AL), Ranking Member on the Banking Committee has introduced the Financial Regulatory Responsibility Act of 2011, which holds federal financial regulators such as the SEC and CFTC accountable for rigorous, consistent economic analysis on every new regulation they propose. The legislation would require the SEC and CFTC to provide clear justification for the regulations and determine the economic impacts of proposed rulemakings, including their effects on growth and net job creation. In addition, the legislation mandates that if a regulation’s costs outweigh its benefits, regulators are barred from promulgating it. The Financial Regulatory Responsibility Act of 2011 is cosponsored by all Republican members of the Banking Committee and is supported by former SEC and CFTC Chief Economists. Senator Shelby has written a letter to Banking Committee Chairman Tim Johnson (D-SD) requesting a hearing on the Financial Regulatory Responsibility Act.

The Financial Regulatory Responsibility Act is the culmination of a series of actions taken by Banking Committee Republicans over the past several months. In February, committee Republicans wrote to financial regulators urging them to take more seriously public comments and cost-benefit analyses of proposed rules. In May, committee members wrote to the Inspectors General (IG) of the financial regulators requesting that they evaluate the economic analysis performed by their respective agencies. Upon receipt of the IG reports, Senators Shelby and Crapo (R-ID), ranking Republican on the Subcommittee on Securities, issued a statement regarding their serious concern with many of the issues raised. In July, Senator Shelby called for Congressional action when a panel of the DC Circuit struck down the SEC’s proxy access rule because the court found that the SEC failed to adequately consider the economic effects of the rule.

Many of the proposed Dodd-Frank rules contain cursory, boilerplate cost-benefit analyses that do little to quantify the rules’ costs and benefits and their effect on the economy, said Senator Crapo, who added that the panel's unanimous decision to invalidate the SEC proxy access rule for failing to adequately analyze its economic costs reaffirms that economic analysis matters and that a check-the-box mentality will not suffice. By requiring federal financial regulators to conduct meaningful economic analysis, he said, there will be better regulations that can withstand scrutiny of whether the benefits of the proposed rule outweigh its cost.

The Financial Regulatory Responsibility Act ensure that all financial regulators conduct comprehensive and transparent economic analysis in advance of adopting new regulations. It sets forth the factors that agencies must consider in their analysis, allows the public to comment, and requires the agency to revisit the effectiveness of the rule five years after it takes effect. The bill would also establish a Council of Chief Economists from the federal financial regulators to bolster the quality of economic analysis being conducted and to ensure that the financial regulators work together to understand the aggregate effects that financial regulations are having on the economy. Through a judicial review mechanism, the legislation would ensure that the agencies take their new economic analysis requirements seriously. Finally, the bill would mandate that a rule does not take effect if its costs outweigh its benefits.

Former SEC Chief Economist Chester Spatt said that the legislation would heighten the regulatory emphasis on the underlying economics and on undertaking after-the-fact assessments of regulatory impacts. Former CFTC Chief Economist Jeff Harris said that the recommended Chief Economist Council is particularly innovative, and holds the promise to improve interagency cooperation and to give economists more visibility beyond the walls of an individual agency.

Bi-Partisan Legislation Would Completely Revamp the Federal Regulatory and Rulemaking Process

Groundbreaking bi-partisan legislation reforming the federal regulatory process has been introduced by Senators Rob Portman (R-OH), David Pryor (D_AK), House Judiciary Committee Chair Lamar Smith (R-TX) and House Agriculture Committee Ranking Member Colin Peterson (D-MN). Informed by a recent Presidential Executive Order, the Regulatory Accountability Act would embed cost-benefit principles at every step of the regulatory rulemaking process, enhance the transparency of the process, and change the judicial standard of review of major regulations.

The legislation heeds President Obama’s recent call for public participation and open exchange before a rule is proposed in Executive Order No. 13563 by requiring, prior to proposing any major rule, the agency to issue an advance public notice explaining the problem it intends to address and call for public comment on the need for a new rule and potential options the agencies should consider. Similarly, federal agencies would be required to use scientific and technical evidence that meets the standards of the Information Quality Ac, consistent with the President’s call for regulating based on the best available science. (Executive Order 13563)

The legislation would cut back on what its congressional sponsors call the misuse of guidance document, which are agency directives written outside the normal public process, while allowing their legitimate use to continue. Specifically, it would adopt the good-guidance practices issued by OMB in 2007 (under then-Director Portman) and ensure that agencies do not use
guidance to skirt the public input required to write new regulations.

The OMB good guidance practices state that, among other things, given their non-binding nature, federal agency guidance documents should not include mandatory language such as ‘‘shall,’’ ‘‘must,’’ ‘‘required’’ or ‘‘requirement,’’ unless the agency is using these words to describe a statutory or regulatory requirement, or the language is addressed to agency staff and will not foreclose consideration by the agency of positions advanced by affected private parties.

The measure would builds basic cost-benefit analysis principles into each step of the rulemaking process, the proposed rule, final rule, and (for major rules) judicial review. These principles are drawn from the longstanding, bipartisan Executive Order framework created by the Reagan and Clinton Administrations and reaffirmed by President Obama in January 2011. Those principles would be made permanent, enforceable and applicable to independent federal agencies. In the Smith-Peterson bill,
compliance with these new requirements would be subject to judicial review for all rules.

The legislation also requires federal agencies to adopt the least costly regulatory alternative that would achieve the policy goals set out by Congress. It permits agencies to adopt a more costly approach only if the agency demonstrates that it is more cost-effective and serves interests clearly within the scope of the statute. This is consistent with the White House’s recent instruction to federal agencies to minimize regulatory cost and the President’s directive to tailor regulations to impose the least burden on society. (Executive Order No. 13563)

The measure has a special and more rigorous process for high-impact regulations, defined as those with an impact of 1 Billion dollars or more. Parties affected by billion-dollar rules will have access to a fair and open forum to question the accuracy of
the views, evidence, and assumptions underlying the agency’s proposal. The hearing would focus on (1) whether there is a lower-cost alternative that would achieve the policy goals set out by Congress (or a need that justifies an higher cost than otherwise necessary); (2) whether the agency’s evidence is backed by sound scientific, technical and economic data, consistent with the Information Quality Act; (3) any issues that the agency believes would advance the process. Parties affected by major
rules, defined as having an impact of $100M or more, would also have access to hearings, unless the agency concludes that the hearing would not advance the process or would unreasonably delay the rulemaking.

As a consequence of the formal hearing, high-impact rules would be reviewed under the slightly higher judicial standard of a substantial evidence review. While this standard would still be highly deferential to agency expertise, it would allow a court reviewing the regulation to ensure that an agency’s justifications are supported by evidence that a reasonable mind could accept as adequate to support a conclusion based on the record as a whole. This standard would also apply to major rules
that undergo the formal hearing procedure.

State Securitiies Officials Concerned with Legislation Lifting General Solicitation Ban in Rule 506 of Regulation D

State securities commissioners have urged Congress to carefully consider the impact of legislation that would lift the general solicitation ban in Rule 506 of Regulation D. In testimony before the House Capital Markets subcommittee, Arkansas Securities Commissioner Heath Abshure, speaking for the North American Securities Administrators Association said that there are significant concerns with the The Access to Capital for Job Creators Act (H.R. 2940), which would will allow general solicitation in Rule 506 offerings. Rule 506 is a safe harbor under Section 4(2) of the Securities Act, noted NASAA, and these securities are meant to be private offerings. With this expansion, emphasized Mr. Abshure, we are getting further and further away from the ideas of a private offering under Section 4(2).

NASAA noted that when there is no limit on the number of offerees, the size of the offerings, or the manner of offering, it is a public offering. The fact that sales may only be to accredited investors does not change the public nature of the offering. Further, NASAA believes that it is going to be impossible to limit the sale to only accredited investors when they advertise to everyone. Indeed, there will be no reason to believe that any investor, seduced by the public advertising, will hesitate to be dishonest when completing the investor suitability questionnaire.

Companies using the Rule 506 exemption can raise an unlimited amount of money without registering the offering with the SEC as long as they meet certain standards. Although the SEC has performed limited reviews of private offerings since 1982, they had been subject to regulatory review by state securities regulators who routinely screened bad actors from raising money through private securities offerings. This regulatory authority was stripped from the states in 1996 when Congress passed the National Securities Markets Improvement Act (NSMIA). As a result, said the NASAA official, today private offerings receive virtually no regulatory scrutiny.

Since NSMIA became law, the use of the securities exemption found in Rule 506 has increased significantly. Although properly used by many legitimate issuers, noted NASAA, the exemption has become an attractive option for individuals who would otherwise be prohibited from engaging in the securities business. Indeed, the state official said that the exemption is being misused to steal millions of dollars from investors through false and misleading representations in offerings that provide the appearance of legitimacy without any meaningful scrutiny of regulators. Private placement offerings have been identified by NASAA as a top trap facing investors in three out of the past five years.

NASAA believes that there is a more reasonable way to balance the reasonable needs of businesses with reasonable protection of investors. One option is for Congress to consider is the Model Accredited Investor Exemption (“MAIE”), which was adopted by NASAA in 1997. This exemption, subsequently adopted by 32 states, maintains appropriate investor protections while giving small businesses the ability to conduct general solicitation and a cost-effective means to raise capital.

The MAIE allows the issuer to use a general advertisement to “test the waters.” There is no limit on the number of investors under the MAIE, and there is no limit on the amount an issuer may raise in an offering under the MAIE. Although only accredited investors may purchase securities offered through the MAIE, dissemination of the general announcement of the proposed offering to non-accredited investors will not disqualify the issuer from claiming the exemption.

The MAIE also contains a number of important provisions that reflect the speculative nature of the offerings and the need for reasonable investor protections, such as limiting sales to accredited investors. Moreover, the MAIE is not available to issuers in the development stage that either have no specific business plan or purpose, or have indicated its business plan is to engage in a merger with an unidentified company. Small businesses, typically with no operational history, untested technologies, and limited resources, are extremely speculative. It is absolutely vital that any efforts to lessen the requirements of the capital-raising process for these companies maintain appropriate, necessary investor protections. The MAIE, or a provision containing similar protections, is a reasonable middle ground that was adopted by NASAA.

Rather than passing H.R. 2940 in its current state and further limiting states’ ability to protect investors, NASAA urged Congress to instruct the SEC to adopt an exemption to coordinate with this model exemption.

Wednesday, September 21, 2011

Federal Court Rules Dodd-Frank Did Not Alter Federal Preemption Standard

A federal judge (SD Iowa) has ruled that the Dodd-Frank Act did not raise the standard for National Bank Act preemption of state law. The Dodd-Frank Act adopts the same standard curently applied by the federal courts that state consumer financial laws are preempted, only if in accordance with the legal standard for preemption in the decision of the Supreme Court in Barnet Bank that the State consumer financial law prevents or significantly interferes with the exercise by the national bank of its powers. Thus, the Dodd-Frank Act did not materially alter the standard for preemption the court must apply in a case involving federal preemption of the Iowa Electronic Transfer of Funds Act. US Bank National Assoc. v. Schipper US District Court, Southern District of Iowa.

EU Commissioner Barnier Says Independence, Audit Concentration and the Efficacy of the Audit Report Will Inform EU Audit Reform Proposals

The proposed EU regulations or legislation on financial audit will focus on independence, audit concentration, and providing a more informative audit report, said EU Commissioner for the Internal Market Michel Barnier. In remarks to the European Parliament, he said that the Commission plans to build a more integrated single market and transparent auditing. The proposals are slated to be set forth in November. The Commissioner prasied a repprt to Parliament on audit reform by Mr. Antonio Masip Hidalgo, which will inform the Commission's proposals.

The Commission's first concern is the quality and credibility of the audit. Regulators must restore the confidence in company financial statements, he said, and this requires that auditors be independent of the entities they audit. Yet too often companies keep the same audit firm for decade, he noted, in some cases for more than a century. The consequence of this is less confidence in company accounts. The Commissiom is considering mandatory rotation of audit firm after an appropriate period of time. In addition, the Commission is considering limitimg or in some cases prohibiting the non-audit services the financial auditor can provide to the audit client.

While he assured that he is not on a crusade against the Big Four, Commissioner Barnier is concerned with audit concentration and wants to see more players in the outside financial audit market. He noted that the Big Four audit firms control about 80% market share of listed companies. In Germany only two firms hold 90% of the mandates of the DAX 30, he said, and in Spain one can even speak of a Big One, as only one firm certifies the accounts of the largest banks and holds 58% market share
of major listed companies. In his view, the audit market of large companies should not be so dominated by four audit networks when there are at least as many firms wishing to enter this market in Europe. For one thing. Comm. Barnier favors a ban on contractual restrictions in favor of the Big Four, which are unacceptable in a European market where competition should be free and authentic.

Finally, the proposals will be designed to achieve an audit report that is more detailed and informative and gives investors and other users of the financial statements a thorough knowledge of the audited company and its organization and risks.

Legislation Would Allow General Solicitations under Rule 506 of Reg D, SEC Official Tells House of Possible Concept Release

House legislation would remove the general solicitation prohibition in SEC Rule 506 under Regulation D and allow small businesses to attract capital from accredited investors nationwide, or even globally, in order to grow their company. The Access to Capital for Job Creators Act, HR 2940, introduced by Rep. Kevin McCarthy (R-CA), is primarily designed to eliminate the cost burden associated with SEC registration that small businesses face. HR 2940 would require the Commission to revise its rules to permit general solicitation in offerings under Rule 506 of Regulation D

Any company looking to sell securities must register with the SEC or meet qualifications under Regulation D in order to be exempt from SEC registration. Regulation D exemptions are designed so that small companies can access capital markets without bearing the costs of SEC registration. Under Rule 506 of Regulation D, certain companies may be exempt from SEC registration if they meet specific conditions, including a prohibition on general solicitation.

The general solicitation prohibition has been interpreted to mean that potential investors must have a pre-existing relationship with an issuer or intermediary before the potential investor can be notified that unregistered securities are available for sale. According to Rep. McCarthy, this ban severely hampers the ability for small companies to obtain needed capital from investors, and as a result, many companies are limited to only to the universe of investors with which they clearly have pre-existing relationships. This legislation would remove the solicitation prohibition and allow small businesses to attract capital from accredited investors nationwide, or even globally, in order to grow their company.

SEC Chairman Schapiro has asked the staff to review the restrictions that SEC rules impose on communications in private offerings, in particular the restrictions on general solicitation, noted Corporation Finance Director Meredith Cross in testimony to be delivered to House hearings on the legislation. Recognizing the increased use of the Internet and other modern communication technologies in private offerings, said the Director, the SEC staff has issued no-action letters providing issuers with flexibility to use modern communication technologies without the staff recommending enforcement action regarding the general solicitation restriction.Notwithstanding these efforts, she observed, the restriction on general solicitation is cited by some as a significant impediment to capital raising.

The SEC understands that some believe that the restriction may be unnecessary because offerees who might be located through a general solicitation but who do not purchase the security, either because they do not qualify under the terms of the exemption or because they choose not to purchase, would not be harmed by the solicitation. In addition, some have questioned the continued practical viability of the restriction in its current form given the presence of the Internet and widespread use of electronic communications. At the same time, others support the restriction on general solicitation on the grounds that it helps prevent securities fraud by, for example, making it more difficult for fraudsters to find potential victims or unscrupulous issuers to condition the market.

Director Cross said that it is important to consider both of these views about the need for the restriction on general solicitation in private offerings when considering possible revisions to SEC rules. In analyzing whether to recommend changes to the restriction, the staff is considering next steps, including a possible concept release for the Commission to seek the public’s input on the advisability and the costs and benefits of retaining or relaxing the restrictions on general solicitation.

The Commission could seek views from all interested parties on a number of issues related to the restriction on general solicitation, including specific protections that could be considered if the restriction is relaxed and the types of investors who would be most vulnerable if it is relaxed. The staff also will seek input from the Advisory Committee on Small and Emerging Companies. The Director emphasized that, in considering whether to recommend that the Commission make changes to the rules restricting general solicitation, the SEC staff will remain cognizant of the investor protection mandate.

SEC Corp Fin Director Cross to Tell House that Staff Conducting Study of 12(g) 500-Shareholder Trigger Akin to Special Study

Against the backdrop of pending legislation that would raise the 500-shareholder threshold for public reporting, the SEC is conductng a review of the 500-sharegholder regulations under Section 12(g) of the Exchange Act that is at least as robust as the 1963 special study of the securities markets that generated the enactment of Section 12(g). This is the message SEC Director of Corporation Finance Meredith Cross will deliver to House Capital Markets subcommitee hearings on capital formation and job creation. The special study included a survey of over 2,000 issuers that sought data from these issuers on, among other things, asset levels, their securities offerings, shares outstanding, stockholders of record, and the number of shares held by large shareholders. The data derived from the study was critical in developing the most appropriate metrics upon which to base the triggers for public reporting given the nature of the companies and the shareholders that would be impacted.

Section 12(g) requires a company to register its securities with the Commission, within 120 days after the last day of its fiscal year, if, at the end of the fiscal year, the securities are “held of record” by 500 or more persons and the company has “total assets” exceeding $10 million. Shortly after Congress adopted Section 12(g), the Commission adopted rules defining the terms “held of record” and “total assets.” The definition of “held of record” counts as holders of record only persons identified as owners on records of security holders maintained by the company, or on its behalf, in accordance with accepted practice.

Securities markets have changed significantly since the enactment of Section 12(g) and the Commission’s adoption of the definition of “held of record.” Today, the vast majority of securities of publicly-traded companies are held in nominee or “street name” rather than directly by the owner. This means that the brokers that purchase securities on behalf of investors typically are listed as the holders of record.

Director Cross will tell Congress that the SEC staff is conducting a robust study seeking to determine whether the current thresholds and standards effectively implement the Exchange Act registration and reporting requirements and what it means to be a public company such that an issuer should be required to register its securities and file with the Commission. The staff has begun a detailed analysis of public company information, including numbers of record and beneficial owners, total assets, and public float, to assess the characteristics of public companies.

The study also will seek to obtain and consider private company information to assess current reporting thresholds. To the extent that the staff develops recommendations or proposals regarding changes to the reporting thresholds for the Commission’s consideration, the consequences of any such proposed change will be subject to careful assessment as to the impact on investor protection and capital formation and the other costs and benefits of any proposed change.

Tuesday, September 20, 2011

Securities Industry Applauds DOL Decision to Repropose Fiduciary Standard Rule Changes

The Securities Industry and Financial Markets Associaiton praised the Labor Department's decision to repropose the chnages to the fiduciary standard under ERISA to, among other things, coordinate the rulemaking more closely with the SEC and CFTC. Since the beginning, SIFMA has raised significant concerns about the proposal and lack of cost-benefit analysis on a rule that would affect millions of IRA holders and plan participants. The new proposed rule is expected to be issued in early 2012.

DOL said that, consistent with the President's January executive order on regulation, the re-proposal will be designed to inform judgments, ensure an open exchange of views and protect consumers while avoiding unjustified costs and burdens. DOL also pledged tp coordinate closely with the SEC and CFTC to ensure that this effort is harmonized with other ongoing rulemakings. Specifically, DOL anticipates revising provisions of the rule including, but not restricted to, clarifying that fiduciary advice is limited to individualized advice directed to specific parties, responding to concerns about the application of the regulation to routine appraisals and clarifying the limits of the rule's application to arm's length commercial transactions, such as swap transactions.

Also anticipated are exemptions addressing concerns about the impact of the new regulation on the current fee practices of brokers and advisers, and clarifying the continued applicability of exemptions that have long been in existence that allow brokers to receive commissions in connection with mutual funds, stocks and insurance products. The agency will carefully craft new or amended exemptions that can best preserve beneficial fee practices, while at the same time protecting plan participants and individual retirement account owners from abusive practices and conflicted advice.

In testimony earlier this year before the House Education & Workforce Committee, SIFMA asserted that the proposed rule is in conflict with Section 913 of the Dodd-Frank Act, which authorizes the SEC to establish a uniform fiduciary standard of care for brokers and advisors providing personalized investment advice. While current exemptions to the prohibited transaction rules of ERISA permit fiduciaries to select themselves or an affiliate to effect agency trades for a commission, there is no exemption that permits a fiduciary to sell a fixed income security or any other asset on a principal basis to a fiduciary account.

Lack of exemptive relief in this area is contrary to what Congress explicitly stated in authorizing the SEC to promulgate a uniform fiduciary standard of care for brokers and advisers providing personalized investment advice under Section 913 of Dodd-Frank. In SIFMA’s view, the result of that conflicting prohibition is that the broker would not be able to execute a customer’s order from his or her own inventory, but rather must purchase the order from another dealer, adding on a mark-up charged by the selling dealer.

At the hearings, SIFMA also noted that, during consideration of the Dodd-Frank Act, Congress considered the question of a counterparty providing a fiduciary duty to plans engaging in swaps and it rejected such an approach because it wanted to be sure that plans could continue to engage in such activities principally for hedging purposes. However, as currently drafted, the Department’s proposed rule would result in a counterparty being deemed a fiduciary, which would eliminate the ability for plans to enter into swap transactions.

The SEC and CFTC were directed by Congress to establish business conduct rules for dealers engaging in swaps with plans, and the Department’s rule would conflict with those rules. SIFMA noted that DOL has not fully considered the costs of this proposal on small plans and IRAs and the manner in which their investment choices will be curtailed, or the costs on large plans that may be unable to engage in swaps, prime broker their assets, invest in alternatives, obtain futures execution and otherwise have their investment choices limited by the proposal.

Monday, September 19, 2011

Obama Administration Says Deficit Reduction Should Include Financial Crisis Responsibility Fee and End LIFO Accounting

The Obama Administration wants the deficit reduction legislation produced by the Joint Select Committee on Deficit Reduction created by the Budget Control Act to include a Financial Crisis Responsibility Fee on the largest financial institutions to fully compensate taxpayers for the extraordinary support they provided to the financial sector through the Troubled Asset Relief Program (TARP). The Administration also seeks the repeal of the LIFO accounting system used by public reporting companies.

The assistance given to the largest financial firms represented an extraordinary step that no one wanted to take, said the White House, but one that was necessary in order to stem a deeper financial crisis and set the economy on a path to recovery. The cost associated with the excessive risk-taking by the largest financial institutions continues to ripple through the economy, said the Administration, although many of the largest financial firms have repaid the Treasury for their TARP assistance, they continue to implicitly benefit from the TARP funds that bolstered their balance sheets during a period of great economic upheaval.

The fee will be restricted to financial firms with assets over $50 billion and will be imposed until all TARP costs have been recouped. The Administration’s Financial Crisis Responsibility Fee is designed to align with the congressional intent of the TARP legislation that requires the President to propose a way for the financial sector to pay back taxpayers. The structure of this fee would also be consistent with principles agreed to by the G-20 Leaders and similar to fees proposed by other countries. This fee will reduce the deficit by $30 billion over 10 years.

As first proposed by the Administration last year, the fee would be levied on the debts of financial firms with more than $50 billion in consolidated assets, providing a deterrent against excessive leverage for the largest financial firms. By levying a fee on the liabilities of the largest firms , excluding FDIC-assessed deposits and insurance policy reserves, the Financial Crisis Responsibility Fee will place its heaviest burden on the largest firms that have taken on the most debt.

Covered liabilities would be reported by regulators, but the fee would be collected by the IRS and revenues would be contributed to the general fund to reduce the deficit. The Administration will also work with Congress and regulatory agencies in order to design protections against avoidance by covered firms.

The Administration also ask for the repeal of the last-in, first-out (LIFO) method of accounting for inventories. Under the LIFO
method of accounting for inventories, the cost of the items of inventory that are sold is equal to the cost of the items of inventory that were most recently purchased or produced. For many businesses where the price of goods in inventory rise over time, like oil and gas companies, the LIFO approach allows firms to artificially lower their tax liability, The President’s proposal would repeal the use of the LIFO accounting method for Federal tax purposes, effective for taxable years beginning after December 31, 2012. Assuming inventory costs rise over time, taxpayers required to change from the LIFO method under the proposal generally would experience a permanent reduction in their deductions for cost of goods sold and a corresponding increase in their annual taxable income as older, cheaper inventory is taken into account in computing taxable income.

Taxpayers required to change from the LIFO method also would be required to report their beginning-of-year inventory at
its first-in, first-out (FIFO) value in the year of change, causing a one-time increase in taxable income that would be recognized ratably over 10 years. This would reduce the deficit by $52 billion over 10 years.

SIFMA Supports Uniform Fiduciary Standard for Brokers and Advisers in House Testimony

The securities industry supports a uniform fiduciary standard for brokers and advisers as being consistent with current best practices and serving the best interest of retail customers. However, in testimony before the House Capital Markets subcommittee, SIFMA conditioned its support on the uniform standard of care being achieved it in a manner that protects investors, preserves investor choice, is cost-effective and business model neutral, and avoids regulatory duplication or

SIFMA believes that Congress explicitly intended for the SEC to craft a uniform fiduciary standard that not only protects investors, but also preserves investor choice and access to cost-effective financial products and services and is adaptable to the substantially different operating models of broker-dealers and investment advisers. Congress expressly provided the SEC with the statutory tools necessary to achieve these inextricably linked goals.

Specifically, Section 913 of Dodd-Frank requires that the uniform fiduciary standard be “no less stringent than” the general fiduciary duty implied under the Advisers Act, noted SIFMA, thus granting the SEC the latitude and ability to establish a separate, unique uniform fiduciary standard that is appropriately tailored to the business models of broker-dealers. The plain language of Section 913, together with the legislative history of Dodd-Frank, makes clear that the “no less stringent” language does not require the SEC to impose the Advisers Act standard on broker-dealers.

In support of this position, SIFMA cited a recent letter from Rep. Barney Frank to SEC Chairman Mary Schapiro, in which he said that if Congress intended the SEC to simply copy the Advisers Act and apply it to broker-dealers, it would have simply repealed the broker-dealer exemption, an approach Congress considered but rejected. The new standard contemplated by Congress is intended to recognize and adapt the differences between broker-dealers and investment advisers. emphasized the Representative.

In SIFMA's view, a mere overlay of the Investment Advisers Act onto broker-dealers would negatively affect client choice, product access, and affordability of customer services and, thus, by definition, would not be in the best interest of retail
customers. Imposing the Advisers Act standard would also be problematic for broker-dealers from a commercial, legal, compliance, and supervisory perspective, thereby undercutting the SEC’s stated intent to take a “business model neutral” approach.

On July 14, 2011, SIFMA filed a detailed letter with the SEC that offers a framework and principles for rulemaking under Section 913 of Dodd-Frank. The Framework Letter says that SEC should have five key components, including enunciating the core principles of the uniform fiduciary standard, articulating the scope of obligations under the uniform fiduciary standard. defining “personalized investment advice, ''providing clear guidance regarding disclosure that would satisfy the uniform fiduciary standard, and preserving principal transactions and proprietary products. SIFMA envisions that the principles would be articulated through comprehensive SEC rulemaking as a uniform standard of conduct that is “no less stringent than” the
general fiduciary duty implied under the Advisers Act.

The SIFMA Framework Letter also explains in detail why a wholesale extension to broker-dealers of the case law, regulatory guidance, and other legal precedent under the Advisers Act would result in a host of adverse consequences for retail customers.

NASAA Continues Waiver of IARD System Fees

In a recent news release, the North American Securities Administrators Association (NASAA) announced that it will waive the initial set-up and annual system fees paid by investment adviser firms and investment representatives to maintain the Investment Adviser Registration Depository (IARD) system. NASAA President Jack Herstein said that NASAA's Board of Directors this week approved the system fee waiver and will continue to monitor the system’s revenues and make future adjustments, including waiving the system fees, if warranted.

As described by NASAA in the release, the IARD provides a single source for filing state and federal registration and notice filings and serves state and federal regulators as a nationwide database for the collection and dissemination of information about individuals and firms in the investment advisory field. IARD system fees are used for user and system support and for enhancements to the system.