Wednesday, November 30, 2011

House Financial Services Committee Approves Legislation Clarifying End User Exemption from Dodd-Frank Margin Requirements

The House Financial Services Committee has approved bi-partisan legislation clarifying that commercial end users would not be subject to margin requirements for uncleared swaps. The Business Risk Mitigation and Price Stabilization Act, HR 2682, sponsored by Rep. Michael Grimm (R-NY) and Gary Peters (D-MI), passed by voice vote.
The Dodd-Frank Act does not require regulators to impose margin requirements on end users and the legislative history makes it clear that Congress did not intend to impose margin requirements on end users. Nonetheless, the legislation was driven by end user uncertainty about whether they will be subject to margin requirements.

Rep. Grimm said that HR 2682 clarifies the intent of Congress to provide an explicit exemption on the posting of margin by end users. He emphasized that the legislation ensures that federal regulators will not impose margin requirements on true ends users that use swaps to manage their business risks, like to lock in the cost of raw materials.

True end-users are companies that use derivatives to manage an actual business risk, he noted, generally to hedge against fluctuating prices, currency rates, or interest rates, and not to speculate. Forcing true end-users to post margin can have several negative consequences, he noted, such as the costs of hedging could be become so high that they stop hedging, resulting in a detrimental rise in prices for consumers. Also, capital would be restricted that would otherwise be used for job creation or reinvestment to make US companies more competitive in the global economy. Further, the high costs of hedging could drive business overseas to foreign derivatives markets and could also increase regulatory arbitrage.

During the mark-up session, Rep. Shelley Moore Capito (R-WV) engaged in a colloquoy with Rep. Grimm over the status of captive finance companies as exempt from the margin requirements. Captive finance companies use derivatives solely to manage legitimate business risks, said Rep. Capito, and not for speculative purposes. They provide a key source of alternative funding, she emphasized, and should not be subject to margin requirements.

In a colloquy with Senator Debbie Stabenow (D-MI) on the day the Senate passed the Dodd-Frank Act, Senator Blanche Lincoln (D-ARK) confirmed that the legislation ensures that clearing and margin requirements would not be applied to captive finance or affiliate company transactions that are used for legitimate, non-speculative hedging of commercial risk arising from supporting their parent company's operations. Senator Stabenow noted, and Senator Lincoln agreed, that the legislation recognizes the unique role that captive finance companies play in supporting manufacturers by exempting transactions entered into by such companies and their affiliate entities from clearing and margin so long as they are engaged in financing that facilitates the purchase or lease of their commercial end user parents products and these swaps contracts are used for non-speculative hedging. (Cong. Record, July 15, 2010, p. S5905).

House Financial Services Committee Approves Bi-Partisan Legislation Exempting Inter-Affiliate Swaps from Dodd-Frank Derivatives Provisions

Legislation exempting inter-affiliate swaps from derivatives regulation under the Dodd-Frank Act was approved by the House Financial Services Committee in a bi-partisan 53-0 vote. Sponsored by Rep. Steve Stivers (R-OH), HR 2779, would exempt inter-affiliate swaps from the Dodd-Frank definition of swap. Rep. Stivers said that the legislation is designed to ensure that Congress does not penalize companies over the way they choose to do business.

The Congressman noted that inter-affiliate swaps are a type of accounting transaction used to assign risk of swap to the proper entity within the corporate family. The federal government should not be influencing that type of decision by essentially picking winners and losers within a corporate family, said the Representative, who assured the subcommittee that the legislation does not change corporation law. Rep. Stivers also noted that the measure applies only to swaps, not to all derivatives.

An amendment offered by Rep. Stivers and Rep. Gwen Moore (D-WI) designed to prevent entities from using the inter-affiliate swap exemption to evade Dodd-Frank derivatives regulation was agreed to by voice vote. Primarily, the amendment would ensure that financial services companies cannot use the exemption to evade other provisions of Dodd-Frank. Rep. Moore noted that the intent of the amendment is to prevent evasion of clearing and margin requirements. The amendment allows the SEC to adopt regulations to include in the definition of security-based swap any agreement or transaction structured as an affiliate transaction to evade the requirements of Dodd-Frank.

In earlier testimony supporting HR 2779, ISDA noted that the legislation addresses an issue of significant concern to major swaps market participants. Inter-affiliate swaps are transactions between two legally separate subsidiaries, explained ISDA, and are commonly used by financial institution dealers in connection with their roles as market intermediaries and by end-users to hedge capital and manage balance sheet risks. End-users use inter-affiliate swaps transactions to hedge their capital, manage risks inherent in a particular balance sheet asset/liability mix and manage other related risks arising from their general operations.

For example, capital invested in overseas subsidiaries may need to be hedged for foreign exchange fluctuations. A commercial bank whose core lending and deposit taking business causes its balance sheet and earnings to be highly susceptible to interest rate changes will need to hedge for interest rate risks. If a firm issues debt overseas, it will need to use interest rate and foreign currency derivatives to lock in costs.

ISDA noted that inter-affiliate swaps generally do not raise the systemic risk concerns that Title VII regulation is intended to address because they do not create additional counterparty exposure outside of the corporate group and do not increase interconnectedness between third parties.

SEC Chair Schapiro Asks Senators for Statutory Changes Enhancing the Commission’s Enforcement Program

In a letter to Senators Jack Reed (D-RI) and Larry Crapo (R-ID), SEC Chair Mary Schapiro requested statutory changes that would substantially enhance the effectiveness of the SEC enforcement program by addressing existing limitations. The SEC seeks five specific statutory enhancements to its enforcement authority that collectively would allow the Commission to impose appropriate monetary penalties for serious violations and authorize greater penalties for recidivists. Senator Reed is Chair of the Securities Subcommittee and Senator Crapo is the Ranking Member.

The first legislative change suggested by the SEC Chair would increase the per violation cap applicable to the most serious violations of the federal securities laws (tier three violations) to $1 million per violation for individuals and $10 million per violation for entities. Chairman Schapiro said that these increases would ensure that a third tier penalty has an appropriate deterrent on both individual and corporate violators and is not just viewed as a cost of doing business.

The second proposed change would amend the maximum tier three penalty to authorize penalties equal to three times the gross amount of pecuniary gain to the defendant and make a calculation method based on the gross amount of pecuniary gain available in SEC administrative proceedings for all violations. This change would allow the SEC to address situations where the actual pecuniary gain to the violator is relatively small compared to the nature or magnitude of the wrongdoing, noted Chairman Schapiro, and would eliminate the current disparity between the penalty relief available in a federal district court and an SEC administrative proceeding.

The third proposed statutory change would authorize a calculation method for tier three penalties based on the amount of investor losses incurred as a result of a defendant’s violations that would be available in both civil and administrative actions. This would allow the SEC to consider more directly the harm inflicted on investors in seeking appropriate penalties. Chairman Schapiro also noted that implementing this change may require the SEC to expend significant additional resources to determine and prove the amount of investor losses in particular cases, such as conducting event studies or retaining expert witnesses to evaluate and opine on such losses.

These three changes would, in the Chair’s view, provide the SEC with greater flexibility regarding monetary penalties in cases where the misconduct is very serious, repeated or involves substantial losses, but current statutes do not allow for an appropriately significant penalty.

The fourth proposed change would authorize the SEC to seek a penalty enhancement in the current action equal to three times the otherwise applicable penalty cap if within the preceding five years a defendant has been criminally convicted of securities fraud or become subject to a judgment or order imposing monetary, equitable or administrative relief in any SEC action alleging fraud.

The fifth legislative change would be authorizing the SEC to seek a civil penalty for violations of a federal court injunction or an industry bar obtained by the SEC from a federal court or imposed by the Commission, including officer and director bars, penny stock bars, and other court-ordered equitable disqualifications. This approach, said Chairman Schapiro, would be more effective and flexible than the limited and cumbersome civil contempt remedy.

Georgia Adopts Revised Securities Rules

Revisions to the Georgia securities rules were adopted by the Secretary of State's Office but the effective date is slated to be about 20 calendar days from November 15, 2011. The rule changes were made to conform to the Georgia Uniform Securities Act of 2008, and affect federal covered securities, exemptions, securities registrations, broker-dealers/agents, investment advisers/investment adviser representatives and administrative hearings, procedures and investigations. The adopted (final) version of the rules is substantively the same as the proposed version here with some technical changes to be made by the rules revisor in time for the effective date.

Chamber of Commerce Supports Expected Legislation Prohibiting PCAOB from Mandating Auditor Rotation

In a letter to Rep. Spencer Bachus (R-ALA), Chair of the House Financial Services Committee, the US Chamber of Commerce expressed support for an amendment the Chairman is expected to offer to H.R. 3213, the Small Company Job Growth and Regulatory Relief Act, prohibiting the SEC and PCAOB from issuing rules requiring mandatory rotation of a public company’s auditor or accounting firm. Mandatory audit firm rotation could increase costs and the incidence of fraud, said the Chamber, while degrading financial reporting.

Currently, HR 3213 would exempt smaller companies from the auditor attestation provisions of Section 404(b) of the Sarbanes-Oxley Act. The House Capital Markets Subcommittee has approved HR 3213, which expanding the exemption from 404(b) beyond the $75 million public float provided by the Dodd-Frank Act to a $350 million public float. HR 3213 is expected to be marked up in the near future by the full Financial Services Committee.

In an earlier letter to the PCAOB, the Chamber listed a number of reasons that it opposes mandatory audit firm rotation. The Chamber noted that the PCAOB has failed to demonstrate a need for mandatory audit firm rotation, and would deprive the audit committee of discretion and judgment in contravention of the Congressional intent expressed in Sarbanes-Oxley; The Chamber also pointed out that academic studies demonstrate that fraudulent financial reporting is more likely to occur within the first three years of an audit and that audit quality increases with auditor tenure length.

In addition to being costly to companies and markets, mandatory audit rotation is also impracticable, said the Chamber, since size, expertise and complexity may only allow two or three firms to conduct major audits per industry. In the Chamber’s view, the SEC and PCAOB have failed to move forward on 2008 recommendations to reduce restatements through the use of the concept of materiality as a determinative factor to trigger a restatement or further disclosure to investors.

Tuesday, November 29, 2011

IASB Chair Recounts Global Acceptance of IFRS, Says IASB-FASB Convergence Has Served Its Purpose

IASB Chair Hans Hoogervorst believes that the move towards global accounting standards is an essential element of the global financial reform agenda, providing the bedrock on which to build a better, more resilient global financial infrastructure. In remarks at the IFRS Foundation seminar, he noted that successive G-20 communiqués have supported the work of the IASB and called for a rapid move towards global standards. In doing so, the G-20 has emphasized that the IASB must meet the needs of both developed and emerging economies.

The majority of G-20 members now require the use of IFRSs, he said. In particular, China has come a substantial way in a very short period of time. Chinese accounting standards are now very similar to IFRSs. The Chair noted that the IASB has a very good relationship with Chinese authorities, an example of which is China’s agreement to provide the Secretariat for the newly-formed IASB Emerging Economies Group. The IASB also has technical staff seconded from the Chinese Finance Ministry.

Indian authorities are in the process of revising Indian accounting standards substantially. On the way to full adoption, India still has quite a few obstacles to overcome. Nevertheless, the IASB Chair believes that there is a shared desire on both sides to help India become a fully committed member of the IFRS family.

The IASB and the Accounting Standards Board of Japan have worked together for many years to bring about convergence of IFRSs and Japanese GAAP. Earlier this month the Boards met for the 14th time to discuss how to eliminate the remaining differences.
In recognition of this work, Japan now allows certain Japanese companies to report using IFRSs as issued by the IASB. Several Japanese companies have already done so, and many more are planning to follow suit. Furthermore, Japan is expected to decide next year whether to mandate a national transition from J-GAAP to IFRSs, and if so, when.

There has been some debate about the transition period should Japan decide to fully commit to IFRSs, noted the IASB Chair, but this is secondary to the actual decision to switch.

Regarding the United States, Chairman Hoogervorst noted that the pace of events appears to be picking up. The SEC has repeatedly said that it intends to make a determination this year regarding the possible incorporation of IFRSs, he noted, adding that he recognizes the many practical challenges facing the SEC in making that decision.

The US is the single largest and most liquid national capital market in the world, he remarked, and has already developed a sophisticated set of financial reporting standards over many decades. Therefore, transitional concerns have to be carefully considered.

The SEC staff has nearly completed its comprehensive assessment of the issues related to US adoption of IFRSs. Two recent SEC staff papers examine how well the standards are being applied by companies reporting using IFRSs and the remaining differences between IFRSs and US GAAP.

While the first paper concluded that the financial statements analyzed generally complied with IFRSs, there were inconsistencies observed, mainly due to a lack of disclosure of accounting policies and how individual standards had been applied. The Chair pointed out that the problem of inconsistent application exists whether companies use IFRSs or US GAAP.

Moreover, standard-setters and securities regulators know that they have to improve consistency of application. The preliminary conclusions of the IASB strategy review are that the IASB should play a more active role in matters related to application of the standards. The Board will achieve this by working in close cooperation with national and regional standard-setting bodies, securities regulators, and the accounting profession.

The important point is that you can only work towards consistent application if you have one single language, said Chairman Hoogervorst, and IFRS is the only candidate. Moreover, if the SEC is an active enforcer of IFRSs for US companies, as well as foreign private issuers, the Commission will be in a position to drive consistency.

The second paper, which examined the differences between IFRSs and US GAAP, contained no major surprises. The paper recognized the tremendous progress that the IASB and FASB have made in bringing IFRSs and US GAAP into alignment. However, the paper also revealed that quite a few differences remain. Many of these differences are not very important, said the Chair, but getting rid of them through a process of convergence could take many, many years. The SEC staff analysis reinforced the IASB Chair’s conviction that ongoing convergence is not the answer.

Indeed, in 2006, the SEC urged the IASB and the FASB to stop eliminating narrow differences and focus on the big picture. It is not in the best interests of investors in the US or anywhere else to spend another ten years seeking to eliminate ever-smaller differences, reasoned the IASB head, which entail significant costs for change without much incremental benefit.

The convergence process has been extremely useful in getting to a point where IFRSs and US GAAP are much improved. These standards are now much closer together. In the long run, however, a dual decision-making process is a very unstable way to work. In practice, it can lead to diverged solutions or sub-optimal outcomes at the very end.

In the Chair’s view, when you have two independent, highly competent Boards, sometimes they will agree with each other, and other times they will not. It’s not that one is right and the other wrong, he said, they just reach different conclusions. He posited that convergence does not always result in the highest quality outcome. It has served its purpose, but now it is time to move on. International stakeholders have supported the current convergence process between the IASB and the FASB as a way to facilitate improvements in financial reporting and global adoption. At the same time, many have already indicated that they will not support an indefinite continuation.

Whichever way the SEC goes, noted the Chair, what is needed more than anything is clarity. The transition to any new set of accounting standards is a major challenge. Chairman Hoogervorst pledged that, if a commitment is given, the IASB will carefully consider issues associated with transition in the United States, as it has for other jurisdictions throughout the world.

Supreme Court Hears Oral Argument in Case Involving Tolling of Sec. 16(b) Limitations Period

The US Supreme Court has heard oral arguments in a case involving the construct of the two-year statute of limitations in Section 16(b) of the Exchange Act. Section 16(b) provides for the recovery from company insiders of short-swing profits; and also states that no suit for such recovery can be brought more than two years after the date such profit was realized. A Ninth Circuit panel 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. Credit Suisse Securities v. Simmonds, Dkt. No. 10-1261.

The limitations period in Section 16(b) of the Exchange Act is a period of repose and runs from the time of the violation when profit was realized, contended an amicus brief filed by SIFMA and the Chamber of Commerce. But in another 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 shareholder 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.

Christopher Landau, for the petitioner, said that in Section 16(b) Congress created a cause of action allowing securities issuers to recover short-swing profits from certain covered persons, but specified that a lawsuit must be brought 2 years after the date the short-swing profit was realized. The statute doesn't say two years after the date the defendants filed a Section 16(a) report, as the Ninth Circuit and Respondents would like to have it, he noted, nor does the statute say two years after the date the plaintiff discovers the short-swing transaction, as the government would like to rewrite it. Arguing for a period of repose, he said that a Congress that could give repose to intentional fraudsters would not want to deny repose to a defendant in a purely prophylactic section 16(b) action.

Justice Ginsburg noted that Section 16 of the 1934 Act is not simply prophylactic. There is an objective that 16(a) expresses, which is that Congress wanted these trades to be reported and to have a Form 4 filed. This is a disclosure-forcing provision, she observed, and so why would Congress mean for it to operate to immunize a defendant who has not made that filing, and who has concealed what is supposed to be reported under 16(a).

Mr. Landau said that if Congress had wanted the Section 16(a) disclosure to be the trigger under Section 16(b), it could have expressly said so. The Ninth Circuit adopted this absolute black letter rule that says, it is tolled, that it does not even start to run unless and until the Section 16(a) report is filed.

Jeffrey Wall, arguing for the government, said that where you have statutes that say there shall be no jurisdiction after a particular time, the Court has read them to cut off equitable tolling after that time. He added that Congress could have written the statute to say the time limit shall not be tolled. And there are statutes like that. In the government's view, the traditional equitable rule is that the statute is tolled until the plaintiff has actual or constructive notice of the facts underlying her claim.

Justice Breyer commented that, taking that view, a person who really thinks he doesn't have to file and so he doesn't file will be liable forever, there will be no statute of limitations because the plaintiff will never find out, or maybe find out 50 years later. But if you take the opposite position, then you will prevent plaintiffs in borderline cases from bringing suits because they aren't going to find out if somebody thinks it is a borderline case. Justice Breyer sees one harm one way, and one harm the other way.

Arguing for the respondent, Jeffrey Tilden said that Section 16(b) is unique in the securities law in that the plaintiff suffers no injury and recovers no damages. There is no triggering event, unlike a fraud case where their stock drops, to suggest that you have been harmed. Section 16(b) is 99% of the time irrelevant without a 16(a) filing, he emphasized, adding that as a matter of logic it makes no sense to provide the one who violates 16(b) an escape liability because they also violate 16a.

What about as a matter of language, asked Justice Alito, whether or not 16(b) is a statute of repose or a statute of limitations, it tells you exactly when the time is supposed to begin to run, and that is from the realization of the profit. And some want to say no, it doesn't begin to run from that point, it begins to run from the point when some other completely different external event occurs, if it ever does occur, which is the filing of the 16(a) report.

Mr. Tilden noted that the Court has several times recognized that 16(b) and 16(a) were interrelated. Section 16(b) is a statute of limitations for those who file the form demanded by Section 16(a), he posited, adding that there is no statute of limitations in 16(b) for those who do not. Noting that Section 16(a) is the discovery rule, he contended that Congress looked at this and commanded insiders to put the information in a particular location, so that shareholders who have the primary enforcement authority under Section 16(b) can go find it there

Justice Sotomayor observed that a very strong argument on the other side is that Congress, having created a statute of repose for intentional conduct like fraud, why would Congress not create a statute of repose for what is a strict liability statute.

Mr. Tilden noted that fraud cases involve someone who has reason to know that they have been defrauded. It may only be that they bought their stock at X, and now, it's selling for half of X, but they know something has happened. In the Section 16(b) context, the plaintiff has suffered no injury. It is critical to an understanding of what the Congress contemplated at the time.

Justice Scalia noted that, if the 16(b) plaintiff has really suffered no injury, it would be all the more likely that Congress would want a statute of repose.

Mr. Tilden said that legislative history reveals that Congress was extraordinarily concerned about a broad sweep of misconduct in the 1920s. They intended a rule that in this Court's language in the Reliance Electric opinion would be flat, sweeping, and arbitrary. They intended to squeeze every penny of profit out of these transactions, and they did so in 16(b).

In 1934, he noted, the purchase or sale of a stock required the actual knowledge of some other people, whereas today it is an impersonal electronic transaction, often at home in the middle of the night, invisible to everyone. Insider trading was hard enough to uncover then, he said, and it has gotten harder now. He does not believe that Congress envisioned that any additional burden would be placed on shareholders by forcing them to learn of this undetectable conduct within two years. The 16(b) plaintiff does not know insider trading has occurred and won't know unless he or she is told. And no other statute of limitations will serve as an analog here because of the unique nature of Section 16(b), he argued.

The plaintiff has no injury and recovers no damages. The Reliance Electric Court concluded that, if you have a choice, you should select that interpretation that best serves the goal of short-swing trading by insiders. He urged the Court to determine the case based on the wording of 16(b) itself, such that the limitations period in (b) applies to those who file the form in (a).

In rebuttal, Mr. Landau said that if there is any one theme that runs through the Court's 16(b) jurisprudence, it is that precisely because Section 16(b) is prophylactic it should be interpreted in a literal and mechanical way., which argues for repose, because you don't get into a lot of these questions about who knew what when. This certainly would be consistent with that tradition.

Colorado Provides Instructions for Completing IA Switch

The time-line for investment advisers with assets under management of between $25 million and $100 million to switch from federal to state registration in Colorado is provided by release of the Securities Division. The eight important dates comprising Colorado's switch program span from November 21, 2011 (the date of this release) to June 28, 2012 (the date the switch program ends).

The Colorado Securities Division will hold a series of "Switch Seminars" between December 2 and 19, 2011 covering material provided in a November 28 release that advisers may will be notified of by email of but also posted for sign-up at Switching advisers must electronically file their Annual Updating Amendment through the IARD between January 1 and 31, 2012, notifying the SEC that they are no longer eligible for SEC registration and are applying for registration in Colorado. The advisers must send the Division required documents, between February 1 and 29, 2012, as specified in the November 28 release. The Securities Division will approve the advisers on June 14, 2012 and notify them they are approved and eligible to withdraw from SEC registration. The advisers must file a partial Form ADV-W to terminate their SEC registration between June 15 and 28, 2012.

SEC Staff and Senator Grassley React to Federal Court Rejection of Citigroup Settlement

Of a federal court’s (SD NY) rejection of the an SEC-Citigroup settlement of an enforcement action, Senator Charles Grassley (R-Iowa) said that Judge Rakoff was right to ask for information. According to Senator Grassley, Ranking Member on the Judiciary Committee, the SEC needs to provide a clear rationale for the enforcement penalties in this case and in others. Otherwise, the public is in the dark about whether the settlements are adequate and the court’s role is reduced to a rubber stamp. A settle and slap-on-the-wrist approach has not and will not deter the defrauding of investors, emphasized the Senator.

While expressing respect for the court's ruling, SEC Enforcement Director Robert Khuzami emphasized that the proposed $285 million settlement was fair, adequate, reasonable, in the public interest, and reasonably reflects the scope of relief that would be obtained after a successful trial. The Commission is reviewing the court's ruling, he said, and will take steps that best serve the interests of investors.

According to the SEC official, the court's criticism that the settlement does not require an admission to wrongful conduct disregards the fact that obtaining disgorgement, monetary penalties, and mandatory business reforms may significantly outweigh the absence of an admission when that relief is obtained promptly and without the risks, delay, and resources required at trial. It also ignores decades of established practice throughout federal agencies and decisions of the federal courts. Refusing an otherwise advantageous settlement solely because of the absence of an admission, continued the Director, would also divert resources away from the investigation of other frauds and the recovery of losses suffered by other investors not before the court.

The SEC also believe that the complaint fully and accurately sets forth the facts that support the claims in this case as well as the basis for the proposed settlement. These are not mere allegations, emphasized the Director, but the reasoned conclusions of the federal agency responsible for the enforcement of the securities laws after a thorough and careful investigation of the facts.

Although the court questions the amount of relief obtained, he continued, it overlooks the fact that securities law generally limits the disgorgement amount the SEC can recover to Citigroup's ill-gotten gains, plus a penalty in an amount up to a defendant's gain. It was for this reason that the SEC sought to recover close to $300 million, he noted, adding that all of which we intended to deliver to harmed investors. The SEC does not currently have statutory authority to recover investor losses, he pointed out.

Banking Industry Supports House Legislation on Derivatives Involving End Users, Inter-affiliate Swaps and Swap Execution Facilities.

As the House Financial Services Committee prepares to markup and approve three pieces of derivatives legislation, the banking industry announced its strong support for measures relating to inter-affiliate swaps and swap execution facilities. In a letter to Chairman Spencer Bachus (R-ALA) and other members of the Committee, the American Bankers Association endorsed H.R. 2779, which would clarify that inter-affiliate swaps should be exempt from many of the anticipated SEC and CFTC swap regulations.

Inter-affiliate swaps do not create additional counterparty exposure outside of the corporate group, noted the ABA, and do not increase interconnectedness between third parties. In fact, said the banking association, inter-affiliate trades reduce systemic risk by making it possible to increase the use of netting with clients and by bringing together a diversified portfolio in one entity to use more offsets to manage and reduce risk. For some financial institutions, inter-affiliate swaps are an important tool to accommodate customer preferences and manage interest rate, currency exchange, or other balance sheet risks that arise from the normal course of business. Failing to pass HR 2779 would undermine bank internal risk management procedures, posited the ABA.

The ABA also supports HR 2586, the Swap Execution Facility Clarification Act, which would clarify that a swap execution facility cannot be required to have a minimum number of participants, receive or respond to quote requests, or display quotes for a certain period of time. Further, the SEC and CFTC would not be permitted to limit the means of contract execution or require trading systems to interact with each other. Absent HR 2586 and the clarifications it provides, said the ABA, the regulations will limit the availability of swaps and constrain liquidity in a manner inconsistent with Congressional intent.

The Business Risk Mitigation and Price Stabilization Act, HR 2682, would clarify that end users would not be subject to margin requirements for uncleared swaps. The Dodd-Frank Act does not require regulators to impose margin requirements on end users, noted the ABA, and the legislative history makes it clear that Congress did not intend to impose margin requirements on end users. Nonetheless, end users currently face uncertainty about whether they will be subject to margin requirements, said the banking association, and this legislation would provide much-needed clarity.

The ABA supports an end-user exemption from margin requirements for uncleared swaps and believes that all end users, including banks that use swaps to hedge or mitigate risk, should be exempt. However, HR 2682 would limit the margin exemption to end users that are not financial entities. Imposing margin requirements on any end users would discourage the use of swaps to hedge or mitigate risk, reasoned the ABA, so it would both increase risk in the system and vitiate the end-user clearing exemption.

If the Committee wants to make a distinction between the margin requirements for bank end users and other end users, emphasized the ABA, then the Committee should consider imposing only variation margin for end-user banks, rather than both initial and variation margin requirements.

NASAA Announces Coordinated Review for Investment Advisers

The North American Securities Administrators Association (NASAA) announced today that state securities regulators have developed a coordinated review program for investment advisers switching from federal to state registration as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

According to NASAA's news release this morning, the Investment Adviser Coordinated Review Program is open to SEC-registered investment advisers switching their registration to between four and 14 states. NASAA President Jack Herstein said that the program will conclude on March 30, 2012.

To participate in the program, eligible investment advisers must complete and submit the Coordinated Review Form found in the IA Switch Resource Center on the NASAA website in addition to filing all materials required by the states in which the adviser is applying for registration.

The states where the investment adviser has filed a registration application will conduct a coordinated review of the investment adviser’s registration materials. After completion of the review, the adviser will be informed of the deficiencies, if any, that must be resolved before the registration will be approved, NASAA stated.

Herstein said there is no additional cost to use the program. “Advisers will be subject only to the filing fees specified by the states in which the investment adviser is applying for registration,” Herstein said.

House Panel Requests Quarterly Reports on Spending from CFPB

The House Subcommittee on Oversight and Investigations has requested that the Consumer Financial Protection Bureau provide it with ongoing quarterly reports for FY 2012 on Federal Reserve transfers and obligations by class, with the reports to be delivered within two weeks after the end of the quarter. In a letter to the Bureau, Chairman Randy Neugebauer (R-TX) also requested a five-year capital plan from the CFPB, including IT hardware, software and services, vehicles, major equipment, facilities and leases, as well as research and performance measures. In the letter, Chairman Neugebauer also asked for information on FY 2011, including a detailed quarterly accounting of transfers from the Fed and of obligations by kind of service for obligations incurred. He also wants the number of positions filled by quarter and by pay band.

The Chairman also requests information about the salaries of CFPB personnel, including the median 2011 annual salary for employees in each department of the Bureau, as well as a spreadsheet listing each position currently held by an employee or contractor at the CFPB along with a description of the position title. The Bureau should respond by December 16, 2011.
Noting that Congress has heard from the Fed that the Bureau requested $28 million more from the Fed that was estimated for FY 2011 in the budget, Chairman Neugebauer said that this amount was 21 percent more than estimated in the budget. While the Dodd-Frank Act allows for such transfers up to certain limits, the Chairman requested a written account of the why the additional $28 million was requested from the Fed.

More broadly, he said that the oversight committee has a duty to account for money authorized to be spent by legislative action. Congress wants to know what goods and services have been purchased by the CFPB, to what purpose they will be put, and what benefit the American people will derive from the resulting Bureau action. This is an important and relevant inquiry, noted Chairman Neugebauer, because every dollar transferred to the CFPB is a dollar that cannot be put towards deficit reduction.

Chairman Neugebauer is a strong advocate for bringing the CFPB within the congressional appropriations process. Earlier this year, he introduced the Bureau of Consumer Financial Protection Accountability and Transparency Act. HR 1355, designed to move the CFPB from the Federal Reserve to the Treasury where it would not be autonomous, and place the Bureau within the regular appropriations process. The legislation would repeal the requirement of an annual transfer to the Bureau of funds from the Federal Reserve System.

Arkansas Adopts Securities Rule Amendments

Amendments to rules affecting federal covered securities, exempt transactions and broker-dealers, agents, investment advisers and investment adviser representatives were adopted by the Arkansas Securities Department, effective December 1, 2011.

Monday, November 28, 2011

Federal Court Refuses to Approve Settlement of SEC-Citigroup Enforcement Action

After agonizing over the substantial deference to be given to the SEC in approving the settlement of an agency enforcement action, a federal judge ruled that the consent judgment in an action against a large financial institution was neither fair, nor reasonable, nor adequate, nor in the public interest. It is not reasonable, said Judge Rakoff, because how can it ever be reasonable to impose substantial relief on the basis of mere allegations. It is not fair, because, despite Citigroup's nominal consent, there is a potential for abuse in imposing penalties on the basis of facts that are neither proven nor acknowledged patent. It is not adequate, because, in the absence of any facts, the court lacked a framework for determining adequacy. And, the proposed consent judgment does not serve the public interest because it asks the court to employ judicial power and assert judicial authority when it does not know the facts. Refusing to approve the proposed consent judgment, the court instead consolidated the case with an SEC enforcement action against an employee of the financial institution and directed the parties to be ready to try the case next July. SEC v. Citigroup Global Markets, Inc., SD NY, 11 Civ. 7387, Nov. 28, 2011.

An application of judicial power that does not rest on facts is inherently dangerous, emphasized the court, adding that the injunctive power of the judiciary is not a free roving remedy to be invoked at the whim of a regulatory agency, even with the consent of the regulated. If its deployment does not rest on facts, established either by admissions or by trial, it serves no lawful or moral purpose and is simply an engine of oppression.

While giving substantial deference to the views of an administrative body vested with authority over a particular area, federal courts must still exercise a modicum of independent judgment in determining whether the requested deployment of injunctive powers will serve or disserve the public interest. Anything less would not only violate the constitutional doctrine of separation of powers, said the judge, but would undermine the independence of the federal judiciary. Thus, before a federal court may employ its injunctive and contempt powers in support of an administrative settlement, it is required, even after giving substantial deference to the views of the administrative agency, to be satisfied that it is not being used as a tool to enforce an agreement that is unfair, unreasonable, inadequate, or in contravention of the public interest.

More broadly, the court said that in any case like this that touches on the transparency of financial markets whose gyrations have so depressed the economy and debilitated lives, there is an overriding public interest in knowing the truth. While apologists for suppressing or obscuring the truth may always be found, said the court, the SEC has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, a court must not, in the name of deference or convenience, grant judicial enforcement to the agency's contrivances

The court noted that the consent did not provide it with a sufficient evidentiary basis to know whether the requested relief is justified under any of the standards. The succcessful resolution of competing interests cannot be automatically equated with the public interest, noted the court, especially in the absence of a factual base on which to assess whether the resolution was fair, adequate, and reasonable.

When the SEC or any federal administrative agency asks a court to become its partner in enforcement by imposing wide-ranging injunctive remedies on a defendant, enforced by the formidable judicial power of contempt, the court needs some knowledge of what the underlying facts are, reasoned Judge Rakoff, otherwise the court becomes a mere handmaiden to a settlement privately negotiated on the basis of unknown facts, while the public is deprived of ever knowing the truth in a matter of obvious public importance.

The SEC's long-standing policy of allowing defendants to enter into consent judgments without admitting or denying the underlying allegations deprived the court of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact.

The SEC took the position that, because the financial institution did not expressly deny the allegations, the court, and the public, somehow knew the truth of the allegations. This is wrong as a matter of law and unpersuasive as a matter of fact, said the court.. As a matter of law, an allegation that is neither admitted nor denied is simply that, an allegation. It has no evidentiary value and no collateral estoppel effect.

As for common experience, the court observed that a consent judgment that does not involve any admissions and that results in only very modest penalties is just as frequently viewed, particularly in the business community, as a cost of doing business imposed by having to maintain a working relationship with a regulatory agency, rather than as any indication of where the real truth lies.
While the financial institution gets to settle what it states was a broad-ranging four-year investigation by the SEC of its mortgage-backed securities offerings, said the court, it is harder to discern from the limited information before the court what the SEC is getting from the settlement. By the SEC's own account, Citigroup is a recidivist, and yet, in terms of deterrence, the $95 million civil penalty that the consent judgment proposes was described by the court as pocket change to this
large financial institution.

Moreover, the court found that the combination of charging the financial institution only with negligence and then permitting it to settle without either admitting or denying the allegations deals a double blow to any assistance defrauded investors might seek to derive from the SEC litigation in attempting to recoup their losses through private litigation, since private investors not only cannot bring securities claims based on negligence, but also cannot derive any collateral estoppel assistance from Citigroup's non-admission/non-denial of the allegations

Michigan FAQ Addresses Investment Adviser Representative Concerns

A release by the Michigan Office of Financial and Insurance Regulation answers frequently asked questions pertaining to investment adviser representatives.

Topics include whether:

* employees or those associated with an investment adviser firm or a federal covered investment adviser must be registered as investment adviser representatives

* a fingerprint card is required for registration

* the Series 65 Exam must be taken

And what:

* procedure and fee amount are required for registration

* registration deadlines apply

Michigan Provides FAQ on Mid-Size Adviser Switch from Federal to State Registration

A release by the Michigan Office of Financial and Insurance Regulation provides the time-table and procedures for switching from federal to state registration by mid-size advisers having assets under management of between $25 and $100 million.

Michigan FAQ Addresses Investment Adviser Concerns

A release by the Michigan Office of Financial and Insurance Regulation answers frequently asked questions pertaining to investment advisers.

Topics include whether:

* "solicitors" must register as investment adviser representatives and, if so, whether they must also pass written exams

* investment adviser representatives must register in Michigan if they represent SEC registered adviser firms not having a place of business in Michigan

* owners of a registered investment adviser firm must register as an investment adviser representatives

* individuals may dually register as an investment adviser representative and securities agent or as an investment adviser representative for two adviser firms

* Michigan has a custody rule and surety bond requirement

* newly created firms with no clients must file a balance sheet

* the firm must maintain a written code of ethics

And what:

* forms are required for registration

* records and written policies/procedures firms must maintain and preserve

* procedure exists for succession of firm ownership

Senate Legislation Would Provide Small Companies with Exemption from Sarbanes-Oxley Section 404(b)

Bi-partisan Senate legislation would provide relief from Section 404(b) of Sarbanes-Oxley as part of an effort to forge agreement between the President’s American Jobs Act, recommendations from the President’s Council on Jobs and Competitiveness, and proposals put forward by members of both parties in Congress. The American Growth, Recovery, Empowerment and Entrepreneurship (AGREE) Act (S 1866), introduced by Senators Chris Coons (D-DEL) and Marco Rubio (R-FLA), is a mixture of tax relief for small businesses and regulatory relief for small companies. A companion bill, HR 3476, has been introduced in the House.

According to Senator Coons, the auditor attestation requirements of Section 404(b) have placed a high cost of compliance on small public companies. President Obama’s Council on Jobs and Competitiveness recommends amending Sarbanes-Oxley to allow shareholders of public companies with market valuations below $1 billion to opt out of Section 404 compliance.

The Coons-Rubio legislation goes further by providing a five-year exemption from Section 404(b) of Sarbanes-Oxley for the first five years after a company goes public, or for those below $250 million in total gross revenue (whichever comes first). The legislation also directs the SEC to submit a report to Congress within nine months to determine how the SEC could reduce the burden of Section 404(b) for companies with a market capitalization of between $250 million and $1 billion. The Commission must also assess the annual compliance costs posed by Section 404(b) for all companies with a market capitalization of below $1 billion.

The legislation would extend through 2014 the IRC Section 179 expensing levels allowing businesses to immediately expense or deduct investments in capital, reducing the cost of investment and expansion. Unless Congress acts, Sec. 179 expensing will fall sharply to $125,000 on January 1, 2012. The AGREE Act would extend Section 179 expensing levels through 2014, thereby allowing expensing of investments up to $500,000.

The legislation would eliminate taxes on small business stock. The Tax Relief, Unemployment Insurance Reauthorization Act of 2010 extended the 100% exclusion for qualified small business stock acquired before January 1, 2012.The Coons-Rubio bill would extend the 100% exclusion to stock acquired before January 1, 2015 and held for more than five years, boosting investment and encouraging job creation in small businesses. Without an extension, the capital gains exclusion will lapse to 50% on January 1, 2012.

The legislation would also extend a business allowance to depreciate the cost of investments in equipment and property through 2014. Currently, businesses are allowed to depreciate the full cost of qualified investments such as equipment and property, but this provision will lapse to 50% on January 1, 2012 absent Congressional action. The AGREE Act would extend 100% bonus depreciation through 2012 and maintain the $2 million threshold in current law. President Obama’ American Jobs Act proposed extending this provision through 2012, and House Republicans have identified this as an issue of potential common agreement with the President.

Hong Kong Securities Regulator Will Amend Code of Conduct to Help Implement Financial Dispute Resolution Center

The Hong Kong Securities and Futures Commission fully supports the Financial Dispute Resolution Center proposed by the government to provide a mediation and arbitration process for mostly small retail disputes between brokers and other intermediaries and their customers. The Commission is currently consulting on changes to the Code of Conduct obligating all those licensed by or registered with the SFC to participate and comply with the FDRC scheme. The establishment of the FDRC will give rise to a dispute resolution regime that will uphold investors’ rights and interests, said Ashley Alder, the SFC’s Chief Executive Officer.

According to SFC Director of Enforcement Mark Steward, the process of mediation is designed to leverage an agreed outcome and the FDRC will have experienced mediators who will work with banks, brokers and their customers to arrive at an agreed resolution quickly and cheaply. If mediation is unsuccessful, the parties have the option of arbitration which will result in an arbitration award binding on both parties.

In recent remarks at the Hong Kong Securities Institute, the Enforcement Director said that the SFC proposes to add to the Code of Conduct an obligation that banks and brokers act in good faith when engaged with the FDRC process. This is an important obligation, he noted, because the success of mediation and arbitration depends very much on the mediators and arbitrators having access to the relevant documents and, potentially, the staff that explains what happened with the customer. Without access to the right material, he continued. the mediation and arbitration process may result in unfair outcomes which will trigger successive waves of discontent and cynicism. This obligation is mirrored in other jurisdictions with financial services ombudsman or dispute resolution schemes and it is an important feature, he emphasized.

The Director noted that the Commission does not expect the FDRC to be used to handle many complaints. The Commission has an expectation and a strong preference for internal complaint handling, he said, which should be sufficient to deal with most complaints. For this reason, the internal complaint handling process will be supplemented with an obligation upon each financial institution to examine the subject matter of the complaint. This is designed to help ensure that the inarticulate complainant with a genuine grievance is treated fairly and also to oblige financial firms to have a concern for what may be behind or on the horizon. One complaint may raise issues that affect other customers, he reasoned, and the earlier these risks can be identified and managed the better.

There are also new obligations to notify and report certain matters to the SFC when the FRDC is engaged. These obligations are set out in the consultation document; and the Director expects to get strong responses to these new obligations.

The SFC also proposes to amend the Code of Conduct to impose an obligation on firms to report actual or suspected misconduct by clients. The Commission has already warned the industry that firms who execute self-evidently suspicious or manipulative orders will be disciplined. Some people have been the subject of enforcement action because they have allowed their systems to be exploited by manipulators in circumstances where manipulation was obvious. The Commission believes that it is a short but necessary step to require firms who receive a manipulative order which they may decline to execute to report to the SFC. He assured that the reporting would be confidential.

Sunday, November 27, 2011

PCAOB Finds Big Four Audit Firm Deficient in Testing Issuer’s Fair Value Measurement Procedures and Internal Controls

A PCAOB inspection team identified matters that it considered to be deficiencies in the performance of the audit work of a Big Four firm, primarily including failures involving fair valuation of asserts and internal control over financial reporting. In some instances, follow-up between the audit firm and the issuer led to a change in the issuer’s accounting or disclosure practices. In some cases, the conclusion that the firm failed to perform a procedure was based on the absence of documentation and the absence of persuasive other evidence, even if the firm claimed to have performed the procedure.

In its response letter to the PCAOB, the audit firm said that it conducted a thorough evaluation of the matters identified in the Board’s report and addressed the engagement–specific findings in a manner consistent with PCAOB auditing standards and KPMG policies and procedures.

The Board’s inspection report highlighted issues around the testing of fair value measurements and the use of third party pricing services. The PCAOB currently has a Pricing Sources Task Force examining issues pertaining to fair value measurements of financial instruments and the use of third-party pricing sources. Recently, the PCAOB’s Standard Advisory Group discussed the role of fair value pricing services.

In seven of the audits, the Board found deficiencies in testing the fair value measurements of, and the disclosures related to, hard-to-value financial instruments without readily determinable fair values, including collateralized mortgage obligations, and other mortgage-backed securities. The audit firm generally failed to obtain sufficient evidence to support its audit opinions.

In a separate audit, the Board found that the audit firm failed to obtain sufficient evidence to support its opinions on the financial statements and on the effectiveness of internal controls related to control and substantive testing with respect to the valuation of the issuer’s financial instruments. The issuer’s traders determined the fair value of financial instruments, noted the Board, and non-trader personnel performed monthly procedures to verify if the traders’ fair values were reasonable.

The price verifiers and the procedures differed depending on the type of financial instrument and its classification within the fair value hierarchy. The price verification procedures for financial instruments classified as Level 1 and Level 2 included an automated comparison of the trader’s fair value to prices for the same or similar instruments provided by pricing services or other third parties, comparing the inputs that the traders had used in issuer-approved models to value certain Level 2 financial instruments to available market data, or comparing the trader’s fair value to the fair value the price verifier had developed.

For Level 3 financial instruments with little or no market transparency, the price verifiers were required to perform some analysis to determine whether the fair value was within a reasonable range or document why such analysis was not possible. The issuer’s control procedures required a third group to investigate and resolve differences between the price verifier’s and the trader’s prices that were in excess of established thresholds.

For control and substantive testing, the audit firm selected the issuer’s portfolios that it considered to be significant. For control testing, the firm concluded that the issuer’s price verification procedures over all the diverse financial instruments in the portfolios constituted a single control that operated monthly. The Board found that the audit firm’s conclusion was inappropriate since it did not take into account the different price verification procedures the issuer performed, which ranged from straightforward automated procedures for Level 1 instruments to highly complex judgmental procedures for Level 3 instruments, and the different inherent risks and the fraud risk associated with the various financial instruments, especially the hard-to-value Level 2 and Level 3 instruments.

As a result of the audit firm’s inappropriate conclusion, said the Board, the firm’s sample size for control testing of the price verification procedures for Level 3 financial instruments was inadequate. The audit firm’s control testing of the price verification procedures for some Level 3 financial instruments also was insufficient because the firm failed to test whether variances between the price verifier’s and the trader's prices that were in excess of established thresholds were identified for investigation and appropriately resolved.

Further, for some Level 3 financial instruments, the auditor concluded that it did not need to change the nature, timing, and extent of its procedures despite issues that came to the firm’s attention regarding controls related to the valuation of these instruments. Moreover, with regard to model-valued financial instruments, the firm’s testing of the issuer’s controls to assess whether the proper approved models and inputs were used was insufficient to support the conclusion that the controls were operating effectively.

For example the auditor failed to identify and test important controls within the process, and failed to evaluate the implications of the firm’s identification of financial instruments that had been valued using models that the issuer had not approved for those specific financial instruments. The firm also inappropriately selected only one item, what the Board called a ``a test-of-one’’ to test the operating effectiveness of application controls that addressed multiple types of financial instruments, and therefore included multiple models and multiple pricing inputs.

The Board found that the firm’s substantive testing related to significant Level 3 portfolios was also insufficient because testing only one financial instrument for certain portfolios was inappropriate given the level of risk of material misstatement associated with such portfolios.

In addition, for certain hard-to-value Level 2 financial instruments, the auditor failed to obtain an understanding of the specific methods and assumptions underlying the fair value estimates that were obtained from pricing services or other third parties and used in the firm’s testing related to these financial instruments. Further, the firm used the price closest to the issuer’s recorded price in testing the fair value measurements, without evaluating the significance of differences between the other prices obtained and the issuer’s prices.

Saturday, November 26, 2011

European Parliament Approves Regulation Restricting Short-Selling and Use of Credit Default Swaps

Acting to provide uniformity across the EU, the European Parliament approved a Regulation restricting transactions in short sales and credit default swaps. The Regulation, (2010) 0482, notes that at the height of the financial crisis authorities in several EU Member States and other countries such as the United States and Japan adopted emergency measures to restrict or ban short selling in some or all securities. They acted due to concerns that at a time of considerable financial instability, short selling could aggravate the downward spiral in the prices of shares, notably in financial institutions, in a way which could ultimately threaten their viability and create systemic risks.

The measures adopted by Member States were divergent as the Union has lacked a common regulatory framework for dealing with short selling. The Regulation is intended to harmonize the rules on short selling and credit default swaps and thereby ensure that the EU internal financial market functions correctly. Internal Market Commissioner Michel Barnier praised the adoption of the Regulation, especially noting that the work of the rapporteur Pascal Canfin, who strengthened the text.

The Regulation addresses only restrictions on short selling and credit default swaps to prevent a disorderly decline in the price of a financial instrument, and does not address the need for other types of restrictions such as position limits or restrictions on products.

Under the Regulation, a person may only enter into a short sale of a share admitted to trading on a trading venue where one of the following three conditions is met. First, the person has borrowed the share or has made alternative provisions resulting in a similar legal effect. Second, the person has entered into an agreement to borrow the share or has another absolutely enforceable claim to be transferred ownership of a corresponding number of securities of the same class so that settlement can be effected when it is due. Third, the person has an arrangement with a third party under which that third party has confirmed that the share has been located and has taken measures vis-à-vis third parties necessary for the person to have a reasonable expectation that settlement can be effected when it is due.

In order to ensure uniform conditions of application, ESMA is directed to draft regulations determining the types of agreements and measures that adequately ensure that the shares will be available for settlement. In determining what measures are necessary to have a reasonable expectation that settlement can be effected when it is due, ESMA must take into account, among other things,, the intraday trading and the liquidity of the shares. ESMA must submit the draft implementing these standards to the European Commission by March 31, 2012.

The Regulation imposes similar restrictions on uncovered short sales in sovereign debt. However, the restrictions do not apply if the transaction serves to hedge a long position in debt instruments of an issuer, the pricing of which has a high correlation with the pricing of the given sovereign debt.
Similarly, the Regulation imposes restrictions on uncovered credit default swaps in sovereign debt. Thus a person may enter into credit default swap transactions relating to an obligation of a sovereign issuer only where that transaction does not lead to an uncovered position in a credit default swap.

For purposes of the Regulation, a person will be considered to have an uncovered position in a sovereign credit default swap when the swap does not serve to hedge against the risk of default of the issuer when the person has a long position in the sovereign debt of that issuer to which the sovereign credit default swap relates; or the risk of a decline of the value of the sovereign debt where the person holds assets or is subject to liabilities, including but not limited to financial contracts, a portfolio of assets or financial obligations the value of which is correlated to the value of the sovereign debt.

A competent authority may temporarily suspend the restrictions when it believes, on the basis of objective elements, that its sovereign debt market is not functioning properly and that the restrictions might have a negative impact on the sovereign credit default swap market, especially by increasing the cost of borrowing for sovereign issuers or affecting the sovereign issuers' ability to issue new debt.

These objective elements must be based on the following non-exclusive indicators: high or rising interest rate on the sovereign debt, widening of interest rate spreads on the sovereign debt compared to the sovereign debt of other issuers, widening of the sovereign credit default swap spreads compared to other sovereign issuers, timeliness of the return of the price of the sovereign debt to its original equilibrium after a large trade; and amounts of sovereign debt that can be traded.

The Regulation also states that a central counterparty providing clearing services for shares must ensure that, when a person who sells shares is not able to deliver the shares for settlement within four business days after the day on which settlement is due, procedures are automatically triggered for the buy-in of the shares to ensure delivery for settlement. Similarly, when the buy-in of the shares for delivery is not possible, there must be procedures ensuring that an amount is paid to the buyer based on the value of the shares to be delivered at the delivery date, plus an amount for losses incurred by the buyer as a result of the settlement failure.

Also, the Regulation requires the central counterparty to have procedures ensuring that a person who sells shares fails to deliver the shares for settlement by the date on which settlement is due will be subject to the obligation to make daily payments for each day that the failure continues. The daily payments must be sufficiently high to act as a deterrent to failing to settle.

European Commission Proposes Enhanced Regulation of Credit Rating Agencies

The European Commission proposes enhanced credit rating agency regulations around sovereign debt issuances and to reduce conflicts of interest in the ratings process. Less than two years after the adoption of the EU Regulation on Credit Rating Agencies, Regulation (EC) No 1060/2009, recent developments in the context of the euro debt crisis have shown that the existing regulatory framework is not good enough. So, the Commission has set out proposals to toughen that framework further and deal with outstanding weaknesses by increasing the transparency and frequency of the rating of sovereign debt. The proposals now go to the European Parliament and the Council for negotiation and adoption.

Internal Market Commissioner Michel Barnier expressed surprise at the timings of some sovereign ratings, such as ratings announced in the middle of negotiations on an international aid program for a country. The Commission will not allow ratings to increase market volatility further. The Commissioner’s first objective is to reduce the over-reliance on ratings, while at the same time improving the quality of the rating process. Credit rating agencies should follow stricter rules, be more transparent about their ratings and be held accountable for their mistakes, he said.

With regard to sovereign debt, Member States would be rated every six months rather than 12 months and investors and Member States would be informed of the underlying facts and assumptions on each rating. Rating agencies would also have to provide more information on the reasons behind sovereign ratings, explaining why it took a specific rating action. To avoid market disruption, sovereign ratings should only be published after the close of business and at least one hour before the opening of trading venues in the EU. Thus, rating agencies would have to publish those sovereign debt ratings outside the European working hours of the stock exchanges, so that traders have some time to assess them before starting to trade. The possible suspension of sovereign ratings is a complex issue which the Commission will consider further.

In order to reduce conflicts of interest, the Commission would require issuers to rotate every three years between the agencies that rate them. The general rule would be that rating agencies must not rate corporate issuers for a period exceeding three years. However, when an issuer has employed more than one rating agency to rate its creditworthiness or its instrument, only one of the agencies would have to respect the three years' limitation. The Commission cautioned that this exception should not lead to any contractual relationship exceeding a total duration of six years. The rotation rule would not apply in the case of unsolicited ratings, or in the case of sovereign ratings, where the issuer-pays model is less common and therefore conflicts of interests are less relevant.

Noting that many structured finance instruments rated with the highest ratings have become toxic assets, the Commission proposed measures reinforcing the regulations regarding the rating of structured finance. First, two ratings from two different rating agencies would be required for complex structured finance instruments. The two ratings would have to be parallel and independent from each other, and the two rating agencies would have to be independent from each other in terms of ownership and management.

Second, issuers of structured finance products would have to provide more information on the credit quality and performance of the individual underlying assets of the structured finance instrument, the structure of the securitization transaction, the cash flows and any collateral supporting a securitization exposure on their products to the market, so that investors can make their own judgments and not rely mechanically on ratings to assess the creditworthiness of those instruments

Also, cross-shareholdings in rating agencies would be limited in that a shareholder with a sizeable stake, more than 5 percent, in a credit rating agency could not simultaneously be a major shareholder in another credit rating agency unless both rating agencies belong to the same group. Rating agencies would also be prohibited from rating an entity in which its largest shareholders, those holding more than 10 percent of the capital or the voting rights, have a financial interest.

The existing Credit Rating Agency Regulation focuses on registration, conduct of business and supervision. In order to be registered, a credit rating agency must fulfill a number of obligations on the conduct of its business intended to ensure the independence and integrity of the rating process and to enhance the quality of the ratings issued.

The European Securities and Markets Authority (ESMA) is entrusted since July 2011 with the responsibility for registering rating agencies in the EU. ESMA also has comprehensive investigative powers, including the power to demand any document or data, to summon and hear persons, to conduct on-site inspections and to impose administrative sanctions, fines and periodic penalty payments. Credit rating agencies are currently the only financial institutions directly supervised by a European supervisory authority. Further, shareholders with more than 5 percent of the capital or the voting rights in a rating agency or otherwise in a position to exercise significant influence over its business activities would not be allowed to provide consultancy services to the rated entities.

Moreover, the Commission proposes to allow investors to sue a credit rating agency which, intentionally or with gross negligence, fails to respect the obligations set out in the CRA Regulation, thereby causing damage to investors. Given that it would often be difficult for the investor to prove what the reason for the breach of the Regulation was and whether this breach was due to gross negligence of the rating agency, the Commission proposes that it will be for the rating agency to prove that it applied the necessary care. The investor only has to provide facts that suggest that there was an infringement.

The existing Regulation requires rating agencies to avoid conflicts of interests. For example, rating analysts employed by an agency should not rate an entity in which they have an ownership interest. Further, in order to ensure the quality of ratings, the Regulation requires the ongoing monitoring of credit ratings and rating methodologies, which must be rigorous and systematic, and a high level of transparency.

Friday, November 25, 2011

European Commission Refers Germany Back to Court of Justice to Comply with Volkswagen Law Opinion

The European Commission has decided to refer the Federal Republic of Germany back to the EU Court of Justice for failing to fully comply with the Court's previous ruling on the anti-takeover ``Volkswagen law’’. In 2007, the Court of Justice ruled that Germany’s ``Volkswagen Law’’ restricted the free cross-border movement of capital through the intervention of the public sector. The Court found that capping the voting rights of every shareholder at 20 percent regardless of their shareholding violated the requirement that there be a correlation between shareholding and voting rights. The Court also held that provisions in the law conferring two seats each on the company’s supervisory board (equivalent to the board of directors in the US) for the German Federal Republic and the State of Lower Saxony, regardless of their shareholding, also constituted a restriction on the cross-border movement of capital. (European Commission v. Federal Republic of Germany, No. C-112/05).

The Volkswagen law was hammered out in 1960 with the participation of workers and trade unions that, in return for relinquishing their claim of ownership rights in the company, secured protection against any large shareholder gaining control. The legislation allows the federal government and Lower Saxony to each appoint two members of the supervisory board and gave them each a 20 percent stake.

Subsequent to the Court’s opinion, Germany enacted legislation abolishing the provisions providing for the representation of public authorities on the board and the 20 percent voting cap, noted the Commission, but the legislation did not modify the provision establishing a 20 percent blocking minority in favor of Lower Saxony. Further, no changes were foreseen to the VW Articles of Association, which contain majority voting requirements mirroring the VW law and which were considered as a State measure by the Court.

There is no room for piecemeal compliance with the Court’s judgment, said the Commission, since EU Member States are required to take all necessary measures to comply with the entirety of the judgment of the Court of Justice. Despite entreaties from the Commission, German authorities declined to make further changes to the law. The Commission has always taken the view that each of the three provisions in the Volkswagen law individually restricts the free movement of capital and, therefore, all of them, including the 20 percent blocking minority, need to be abolished.

The free movement of capital is at the heart of the EU Single Market, emphasized the Commission, and allows for open, integrated, and efficient markets. For citizens it means the ability to undertake a range of operations abroad, such as buying shares in non-domestic companies. For companies, it means the ability to invest in and own companies in other EU countries, and to play an active role in their management.

The Commission is aware that, in principle, German company law allows a company’s Articles of Association to derogate from the legal majority requirements and fix the blocking minority at 20 percent. But, the Commission emphasized that in this instance the 20 percent blocking minority was imposed on VW’s shareholders by federal legislation in order to procure for government authorities a blocking minority. In effect, the legislation enables the Land of Lower Saxony to block important decisions in VW on the basis of a 20 percent interest.

The Commission said that legislation allowing German public authorities to oppose important resolutions in VW on the basis of a lower level of investment than would be required under general company law is liable to deter direct investors from other Member States. It constitutes, as has been found by the Court to constitute, an unjustified restriction on the free movement of capital enshrined by Article 63 of the Treaty on the Functioning of the European Union..

Thursday, November 24, 2011

UK Commission Urges Employee Membership on Compensation Committees and Forward-Looking Shareholder Vote on Executive Pay

The UK High Pay Commission urges the inclusion of employee representatives on company compensation (remuneration) committees. In its final report, the Commission also recommended that the current shareholder advisory vote on executive compensation be made forward looking. The Commission additionally recommended a standardized form for compensation reports that incorporates but moves beyond current best practices and includes a total executive compensation figure and a methodology for how it has been calculated. The High Pay Commission, a bi-partisan, independent body, is chaired by Deborah Hargreaves, and includes Lord Richard Newby, Co-chair of the Liberal Democrat Parliamentary Treasury Committee.

Currently, shareholders have an advisory vote on the remuneration report, which the Commission described as a backward looking vote on decisions already made and implemented on executive pay, which creates an atmosphere of box ticking. The Commission considered and rejected the idea of making shareholder advisory votes on executive compensation binding, instead urging that the shareholder vote be made forward looking. Thus, shareholder votes should be cast on compensation arrangements for three years following the date of the vote and these arrangements should include future salary increases, bonus packages and all hidden benefits, giving shareholders a genuine say in the remuneration of executives.

The Commission noted that, since the seminal Cadbury report on corporate governance, all the reforms aimed at tackling executive pay have empowered shareholders and given greater authority to non-executive directors. Yet this model has proved deeply problematic, said the Commission, and its effectiveness in tackling issues of executive pay is questionable.

In particular, the Commission found compensation committees to be a closed shop made up largely of current and recently retired executives. This model has failed, said the Commission, leading to spiraling pay. The Commission believes that greater engagement with employees may help restrain executive pay and help mitigate negative impacts on morale as well as encourage a greater engagement with the workforce. Thus, the Commission urged that employees be represented oncompensation committees as a first step to better engagement and accountability.

Compensation consultants advise the compensation committee on executive pay. However, there are widespread concerns over the role they play and potential conflicts of interest. While the UK voluntary guidelines for compensation consultants prohibit cross-selling services, noted the Commission, there is no evidence available to demonstrate whether this is the case or the extent to which it is being flouted. Thus, the Commission recommended that companies disclose the extent and nature of all the services provided by compensation consultants.

Most large shareholders, pension funds or institutional shareholders have a
large portfolio and they often have an investment in hundreds of companies. As a result it is often not feasible for them to engage meaningfully with executive compensation. The Commission called on all investments fund managers to fully disclose how they vote on all issues including those of remuneration.

The Commission believes that it is essential that the pay gap between highest paid and the company median should be open to scrutiny, including how the ratios of highest to median pay has changed over a three-year period. If companies produce a fair pay report it will allow them to state their principles in relation to pay, encouraging pay to be considered across the company when setting executive pay, as is required by the UK Corporate Governance Code. Thus, the Commission recommends that all public companies issue fair pay reports as part of their compensation reports.

UK FSA Fines and Bans Hedge Fund Compliance Officer For Failure to Act with Care and Diligence

The UK Financial Services Authority has fined and banned from the financial services industry a hedge fund compliance officer for breaching Principle 6 of the FSA’s Statements of Principle for Approved Persons. Principle 6 provides that approved persons performing a significant influence function must exercise due skill, care and diligence in managing the business of the firm for which they are responsible in their controlled function. The hedge fund compliance officer agreed to settle the FSA action during the course of the investigation; and therefore qualified for a 30% reduction on her financial penalty.

In the wake of the collapse of Lehman Brothers, found the FSA, the investment strategy adopted by the hedge fund manager for the hedge fund resulted in losses totalling approximately 85% of the fund’s total assets under management. To conceal the losses, a senior employee of the fund manager entered into a number of contracts on behalf of investment funds managed by the fund manager for the purchase and resale of a bond whose legitimacy was questioned by investors. In addition, the hedge fund’s prime broker resigned as a result of its concerns about this bond.

The FSA said that the hedge fund compliance officer failed to consider the reasons for the prime broker’s resignation and, despite being aware of the investors´ concerns about the bond, failed to properly investigate those concerns or act upon the information. The FSA found that the compliance officer did not fulfill her responsibilities and therefore failed to act with due skill and care. She relied wrongly on another employee of the hedge fund manager and on her belief that external lawyers were instructed and would have acted on concerns as appropriate.

The FSA said that the hedge fund compliance officer should have ensured that the concerns raised were urgently considered and investigated. If these investigations had not confirmed that the bond was a legitimate financial instrument, the compliance officer should have notified the FSA that a person may have committed financial crime. The compliance officer did not take any such steps, but instead relied on her mistaken belief that external lawyers had advised on the bond, without having seen this advice and without confirming whether any such advice had been obtained.

Tracey McDermott, acting FSA Director of Enforcement, said that the compliance officer’s failure to challenge a colleague and investigate and act on the information she received resulted in the hedge fund manager and the FSA being unable to take appropriate action. The hedge fund compliance officer took far too narrow a view of her role as a compliance officer, said Director McDermott, and failed to understand the importance of her role and the wider regulatory obligations it brings.

Wednesday, November 23, 2011

SEC Chair Discusses International Implications of Derivatives Regulation at Hedge Fund Seminar

Implementing the derivatives regulatory regime mandated by the Dodd-Frank Act and bringing this wholly unregulated market under a regulatory umbrella has presented the SEC with unique challenges, especially for the Commission as a first mover internationally, said SEC Chair Mary Schapiro in a dialogue at the Managed Funds Association Outlook 2011 seminar. There are challenges coordinating derivatives regulations with the SEC’s global counterparts, said Chairman Schapiro, and also challenges within the United States coordinating between the SEC and CFTC. The two Commissions have different statutory foundations and different approaches to regulation that have grown historically over the years. There is also the fact that the commodities and securities swap markets, while they are all OTC derivatives markets, are not exactly the same, and that calls for some differences as well.

When all of the Dodd-Frank Title VII regulations are out for public comment, the SEC plans to publish for comment a detailed implementation plan so that investors and market participants can see very holistically how the Commission expects to sequence implementation of the regulations in a way that is logical and rationale. The public should be able to see a rational sequencing of all the regulations’ effective dates and be able to comment on those, and give the SEC some guidance; some good information and data about what it will take to put each of these rules into place.

The international questions around derivatives regulation are extraordinary, said the SEC Chair. Recently, the SEC had a session with its global regulatory counterparts in London to discuss the extraterritorial implications of Title VII and the regulations implementing the derivatives regime required by Dodd-Frank, and what this means for foreign institutions facing US customers, facing other US institutions or having affiliates in the US.

International questions permeate every regulation, said Chairman Schapiro, who added that SEC’s approach is going to be a holistic one. The Commission is going to set out a broad international release for comment from investors, market participants, and foreign regulators to ascertain the global reach of US derivatives regulations so as to avoid opportunities for regulatory arbitrage and opportunities for anti-competitive impact on US financial institutions.

Chairman Schapiro said that the SEC has benefited from the fact that the Financial Stability Board and most of the international jurisdictions have a common framework with the Commission. She also noted that the SEC has been having weekly calls with global counterparts to go line by line through its regulations and what is expected out of the Markets in Financial Instruments Directive (MiFID) and EMIR, the European Market Infrastructure Regulation; and how that will translate into real regulatory frameworks in Europe and how those might match up. The SEC and its global regulatory counterparts are concerned about possible regulatory gaps and duplication. These weekly sessions going through this in detail have been enormously helpful for all the regulators, she averred. The SEC Chair believes that the different securities regulators genuinely want to try to land in the same place. They want to have high standards that are achievable around the world so as not to create any distortions or dislocations.

Tuesday, November 22, 2011

Tennessee Issues Policy on Requesting Confidential Treatment for Filings

A policy statement by the Tennessee Securities Division reiterates and elaborates upon Tennessee securities rule 0780-4-1-.04(5)(f) allowing persons to request that specified information received by the Division in connection with the filing of registration statements, applications or reports be kept confidential. The request for confidential treatment must be sent to the Division separate from the other parts of the filing, marked "Confidential Treatment Requested" and signed by the person submitting the registration statement, application or report. Note that the request itself will be available for public inspection so should not contain any information considered confidential. Tennessee securities rule 0780-4-1-.04(5)(f) sets forth the details of a request for confidential treatment including the statements that must be made for the request and the different responses the Assistant Commissioner might take upon receiving it.

Colorado Provides Time-Table for Investment Adviser Switch Program

The time-line for investment advisers with assets under management of between $25 million and $100 million to switch from federal to state registration in Colorado is provided by release of the Securities Division. The eight important dates comprising Colorado's switch program span from November 21, 2011 (the date of this release) to June 28, 2012 (the date the switch program ends).

Senator Schumer Urges PCAOB to Discipline Chinese Audit Firms that Resist Oversight

In a letter to the PCAOB, Senator Charles Schumer called on the PCAOB to discipline Chinese accounting firms that continue to resist independent regulatory inspections. The letter expressed the Senator’s concern about the PCAOB’s ``continued failure’’ to inspect Chinese audit firms. Noting that close to 100 Chinese auditors, or China-based affiliates of U.S. auditors, have registered with the Board to perform audit work for over 300 U.S. public companies with operations in China, Senator Schumer said that the Board’s failure to inspect means that investors have no independent assurance that Chinese accounting firms’ audits on U.S. public companies’ operations in China comply with U.S. law. The Banking Committee member called this a serious problem that threatens to undermine public confidence in the companies’ financial statements, which is critical to confidence in the markets. In a separate letter, Senator Schumer asked the SEC to require upfront disclosure by public companies that use China-based audit firms.

Senator Schumer agreed with PCAOB Chair James Doty that it is not tenable to continue indefinitely to allow Chinese audit firms to remain registered if the PCAOB cannot inspect their U.S.-related audit work. Six years with no resolution on this critical issue is unacceptable, emphasized the Senator, and it is time for the Board to exercise its enforcement authority against Chinese audit firms that have not submitted to independent regulatory review.

Despite six years of Chinese audit firms’ refusals to cooperate in inspections, he noted, the Board has taken no disciplinary actions with respect to any of those firms. While he recognizes that the Chinese government is acting to obstruct the Board’s inspection of registered Chinese audit firms, the Senator said that this standoff has gone on long enough. He urged the Board to take immediate disciplinary actions against Chinese audit firms that continue to refuse to cooperate.
In a two-month span earlier this year, he observed, more than 24 companies doing business in China reported auditor resignations and accounting irregularities.

Moreover, the Board itself has expressed concern about the danger that the lack of inspection of Chinese audit firms poses for U.S. investors. The Board has listed the Chinese auditors that have never been inspected, along with the names of their client companies, and issued an audit alert to remind registered audit firms of their obligations. The alert appears to have been prompted by the increasing numbers of companies based in China and Hong Kong accessing the U.S. markets via reverse mergers. In the Senator’s view, these recent reverse merger scandals are a case-in-point that failure to scrutinize Chinese audits can cost U.S. investors billions.

The Board was not created to merely alert the public to problems, emphasized the Senator, rather the Board was set up as a watchdog to protect investors, to inspect and assess compliance with applicable securities laws to protect the interests of investors, and to further the public interest in the preparation of accurate audit reports.

To ensure corporate financial statements are subject to tough, outside scrutiny, said the Senator, Congress authorized the Board to take disciplinary action if auditors refuse to cooperate in inspections. Those sanctions include suspending or revoking an audit firm’s registration, he said, which would preclude the firm from preparing or issuing any audit reports concerning any issuer. Despite this enforcement authority, and despite six years of Chinese audit firms’ refusals to cooperate in inspections, the Board has taken no disciplinary actions on any Chinese auditors, noted Senator Schumer, who added that he was troubled by the Board’s failure to do what it was created to do, particularly in the face of Chinese corporate accounting scandals that have already cost U.S. investors billions.

Bi-Partisan Senate Legislation Would Enhance Transparency of PCAOB Proceedings

Senators Jack Reed (D-RI) and Charles Grassley (R-Iowa) have introduced legislation making PCAOB disciplinary proceedings public to bring auditing deficiencies at the audit firms or the companies they audit to light in a timely manner and help deter violations. The PCAOB Enforcement Transparency Act, S 1907, would make hearings by the PCAOB, and all related notices, orders, and motions, open and available to the public unless otherwise ordered by the Board. The Board procedure would then be similar to the SEC's Rules of Practice for similar matters, where hearings and related notices, orders, and motions are open and available to the public.

The PCAOB is responsible for setting auditing standards for auditors of public companies, for examining the quality of audits performed by public company auditors, and where necessary, for imposing disciplinary sanctions on registered auditors and auditing firms. The Board's ability to commence proceedings to determine whether there have been violations of its auditing standards or rules of professional practice is an important component of its oversight.

In order to determine whether to institute a proceeding, the Board's enforcement staff conducts a nonpublic investigation and makes a recommendation to the five-member Board. However, unlike other oversight bodies, such as the SEC and the CFTC, the Board's disciplinary proceedings are not allowed to be public.

Unfortunately, noted Senator Reed, over the last several years, bad actors have been taking advantage of this lack of transparency. In April 2011, the Senate Securities Subcommittee, which he chairs, considered the issue of enhancing the PCAOB's effectiveness by permitting the Board to disclose information about its enforcement proceedings. PCAOB Chair James Doty noted that the secrecy has a variety of unfortunate consequences and this state of affairs is not good for investors, for the auditing profession, or for the public at large. Cong. Record, Nov. 18, 2011, pp. S 7831-7832.

In one example cited by Senator Reed, an accounting firm that was subject to a disciplinary proceeding continued to issue no fewer than 29 additional audit reports on public companies without any of those companies knowing about the PCAOB proceedings. Those public companies and their investors were completely in the dark about the board's decision to both institute disciplinary proceedings and about the progress of those proceedings. The auditor knew about the proceedings, but the investors and public companies were denied information that was arguably very relevant to the audit relationship. Cong. Record, Nov. 18, 2011, pp. S 7831-7832.

Senator Reed noted three additional reasons that the proceedings should be open and transparent. First, the closed proceedings run counter to the public proceedings of other oversight bodies. Nearly all administrative proceedings brought by the SEC against public companies, brokers, dealers, investment advisers, and others are open, public proceedings. Cong. Record, Nov. 18, 2011, pp. S 7831-7832.

The PCAOB's secret proceedings are not only shielded from the public, said Senator Reed, but from Congress as well. The public and Congress have a role in ensuring that not just auditors are held to account, he emphasized, but also that the PCAOB is held to account as well for its oversight of the auditors and audit firms.

Second, the incentive to litigate cases in order to continue to shield conduct from the public as long as possible frustrates the process and requires the expenditure of needless resources by both litigants and the PCAOB. In April, Chairman Doty, in testimony before the Securities Subcommittee, noted that the fact that PCAOB disciplinary proceedings are required to be secret creates a considerable incentive to litigate.

Third, a recent academic study noted that the public nature of SEC proceedings against companies creates good results. The study observed that a public SEC enforcement action in its industry against a target firm is likely to increase a peer firm's knowledge about SEC activity and cause it to revise upward its subjective probability of attracting such an action against itself. In effect, the study noted that this may serve as a deterrent to misconduct because of a perceived increase in getting caught. Accordingly, the audit industry would also benefit from timely, public, and non-secret enforcement proceedings.