Saturday, December 31, 2011

SEC Issues Revised Dodd-Frank Implementation Schedule at Year End

On December 30, 2011, the SEC revised its Dodd-Frank implementation timetable, moving a number of items planned for December 2011 into 2012 time frames. All of the regulatory activity around the Title VII derivatives regulatory regime is now planned for the July-December 2012 time frame. Similarly, the adoption of regulations setting up a registration regime for municipal securities advisors has been moved to July-December 2012.

Regulations regarding disclosure related to conflict minerals under Section 1502 of Dodd-Frank and disclosure by resource extraction issuers under Section 1504 are slated to be adopted in the January-June 2012 time period. The SEC also plans to virtually complete Title IV implementation in the first half of 2012, adopting regulations adjusting the threshold for qualified client as directed by Section 418 and reporting to Congress on the study of the costs and benefits of real time reporting on short sale positions as directed by Section 417. However, a report to Congress on a study on the state of short selling on exchanges and in the over-the-counter markets under Section 417 will wait until the second half of 2012.

The adoption of regulations implementing the Volcker Rule prohibitions on proprietary trading and certain relationships with hedge funds and private equity funds is scheduled for the July-December 2012 time frame.

The adoption of risk retention rules for securitizers of asset-backed securities is set for the first half of 2012. The SEC is also slated to complete the implementation of Title VIII in the first half of 2012 by adopting rules regarding standards for clearing agencies designated as systemically important under Section 805 and adopting rules regarding the process to be used by designated clearing agencies to provide notice of proposed changes under Section 806.

Friday, December 30, 2011

Federal District Court that Rejected SEC-Citigroup Settlement Now Orders SEC to Promptly Notify It of Any Filings in Second Circuit Court of Appeals

A federal court that had refused to approve a settlement in an SEC enforcement action against Citigroup declined to grant a request by the parties to stay all proceedings in the case pending determination of an appeal to the Second Circuit Court of Appeals. SEC v. Citigroup Global Markets, Inc., 11 Civ. 7387, Dec. 27, 2012, (memorandum order). Further, in a December 29th order supplementing the memorandum order, the district court ordered the parties to promptly notify it of any filings in the court of appeals by faxing copies of the filings to the district court immediately after they are filed in the court of appeals.

Virtually simultaneously with the district court’s opinion denying the stay, the appeals court granted the SEC’s request for a temporary stay until Jan. 17, 2012 when a Second Circuit motions panel will consider the motion for a stay. According to the district court, the appeals court issued its decision without the benefit of the memorandum order denying the stay in which the district judge concluded that the purported statutory basis for the instant appeal is patently defective, and, given the absence of any obligation to consider a stay on the basis of the SEC's putative intention to seek mandamus, there is no occasion for the court to address the merits of the parties' request for a stay.

According to the district court, the alleged error that the SEC, joined by Citigroup, seeks to correct by their appeal is the court's insistence that it be provided with proven or acknowledged facts in order to evaluate whether the proposed consent judgment, in any of its aspects, is fair, reasonable, adequate, and in the public interest. Thus, said the district judge, the gravamen of the parties’appeal has nothing to do with the denial of injunctive relief per se.

Moreover, the court said that failure to grant the injunctive relief sought in the proposed consent decree does not relate in any material way to the primary irreparable harm that the parties assert they will suffer if the decree is not immediately approved, namely that they will be required to allocate substantial resources to the litigation of this matter. This alleged harm is a product of the rejection of the settlement overall, reasoned the district court, and would not be cured by the granting of the proposed injunctive relief.

Furthermore, the alleged harm is largely illusory because the SEC has filed a parallel action against a Citigroup employee that repeats every allegation that is made in the Citigroup complaint, and more. Given that the employee intends to litigate these charges to the fullest, noted the court, the SEC will have to undertake virtually the same discovery, motion practice, and trial preparation with respect to him as it will have to
undertake with respect to Citigroup.

In the view of the district judge, a more fundamental problem with all these arguments is that if these kinds of harms were sufficient to justify interlocutory appeals the final judgment rule would be rendered a nullity. The court cited a 1994 US Supreme Court ruling involving a refusal by a district court to enforce a settlement agreement. In Digital Equip. Corp. V. Desktop Direct, Inc., 511 U.S. 863 (1994), the Court held that such harms cannot support an interlocutory appeal. The Supreme Court noted that there are innumerable situations, including rejections of settlement agreements, where the effect is to force the parties to go to trial even though they had expressly bargained not to. But if immediate appellate review were available every such time, reasoned the Court, Congress’ final decision rule would end up a pretty puny one.

In its supplemental order, the district court noted that as a reason for proceeding on an emergency basis, the SEC stated that Citigroup had only until January 3, 2012 to answer or move to dismiss the underlying complaint, and that if Citigroup files its answer denying some or all of the allegations, or if Citigroup moves to dismiss, challenging the complaint’s legal sufficiency, it will disrupt a central negotiated provision of the consent judgment pursuant to which the financial institution agreed not to deny the allegations. According to the district judge, this statement would seem to have been materially misleading in at least four respects.

First, a motion to dismiss does not constitute either an admission or denial but is rather a challenge to the face of the complaint. Second, the SEC was either already aware that Citigroup was planning to move to dismiss rather than to answer or could have readily found this out by calling counsel for the bank. Third, nowhere in the underlying papers of the parties to the district court seeking a stay had they argued that January 3 was a critical or even material date. Fourth, in light of the fact that the court’s position was not before the appeals court, the SEC was under a professional obligation to bring to the attention of the appeals court the fact that the US Supreme Court had previously ruled that the denial of the fruits of a settlement does not, without more, provide a basis for interlocutory appeal, let alone a stay, citing the Court’s ruling in Digital Equip. Corp. V. Desktop Direct, Inc.

PCAOB Member Goelzer Outlines Auditor Reporting Model Projects at IFIAR Roundtable

Auditor responsibilities for the completeness and accuracy of financial institution risk disclosures affect the inspection programs of the members of the International Forum of Independent Audit Regulators (IFIAR), noted PCAOB Member Dan Goelzer in a paper submitted at the IFIAR Roundtable on Financial Institution Risk Disclosure. He also said that through inspection workshop and plenary meeting discussions IFIAR members share inspections insights and identify challenges. In his view, this process could be a vehicle for gathering information about how auditors are performing in this area. Mr. Goelzer is Vice-Chair of the IFIAR.

IFIAR engages in dialogue with the major multi-national firms, both at the plenary meeting and working group level. In particular, IFIAR's Global Public Policy Committee Working Group provides a central forum for regular dialogue between audit regulators and the six largest audit firms regarding audit challenges and quality control system improvements. To the extent specific issues emerge regarding risk disclosure auditing, Member Goelzer suggested that these mechanisms could be used to discuss those issues with the large firms.

IFIAR members have a strong interest in the responsibilities of auditors with respect to financial institution risk disclosures and in any changes in those responsibilities. Member Goelzer reviewed the three major reporting model projects affecting risk disclosures put forth by key regulatory and standard-setting bodies that are considering ways of expanding the scope of the auditor's reporting responsibilities. These initiatives arise from dissatisfaction expressed by users of financial statements concerning the lack of information that auditors were required to provide about the risks and uncertainties faced by major financial institutions in the run-up to the 2008 economic crisis. The various auditor reporting proposals and alternatives under discussion extend beyond financial institution risk
disclosure.

The IAASB issued a consultation paper setting out options to close a perceived information gap and states that some investors and analysts believe that the auditor could report on key business, operational and audit risks the auditor believes exist as well as on the quality and effectiveness of the governance structure and risk management. The paper seeks views about types of additional information that could be included in the auditor's report and on the prospect of the auditor providing insight about the quality of entity financial reporting. Through IFIAR's Standards Working Group, members discuss and may comment on the implications of IAASB proposals, including any that address risk disclosure.

Issued on June 21, 2011, the PCAOB concept release discusses alternative ways of expanding the auditor's reporting model. Three of those alternatives could result in expanded information or assurance regarding risk, said Member Goelzer. The first alternative would require the auditor to provide an auditor's discussion and analysis (AD&A), similar to MD&A, which would be a supplemental narrative report discussing the auditor’s views regarding significant matters, such as audit risks.

The AD&A might also include a discussion of the auditor's views regarding the company's financial statements, such as management's judgments and estimates, accounting policies and practices, and difficult reporting issues.
The second alternative would require one or more emphasis paragraphs in all audit reports. The Board member noted that emphasis paragraphs could be used to highlight the most significant matters in the financial statements and identify where these matters are disclosed. The auditor might also be required to comment on key audit procedures performed pertaining to such matters. The third alternative would require auditors to provide assurance on information outside the financial statements, such as MD&A or earnings releases. Such a requirement could have the effect of requiring that risk discussion in MD&A be audited.

Finally, On November 30, 2011, the European Commission proposed a series of new requirements regarding statutory audits of public interest entities. Under the proposal, the content of the audit report disclosed to the public would be expanded to include an explanation of key areas of risk of material misstatements in the financial statements, a going concern assessment, and whether the audit was designed to detect fraud. In addition, the auditor would be required to prepare a more detailed report for the audit committee. This report would explain judgments about material uncertainty that may cast doubt about the entity's ability to continue as a going concern and on the findings of the audit with the necessary explanations.

Wednesday, December 28, 2011

California to Extend Emergency Effectiveness of Private Fund Adviser Exemption

On January 5, 2012, the Commissioner of Corporations will file with the Office of Administrative Law (OAL) the readoption of emergency Rule 260.204.9 of Title 10 of the California Code of Regulation (10 C.C.R. §260.204.9) for a period of no longer than 90 days. The changes to the rule will extend the current exemption from registration for investment advisers who are “private advisers” for an additional 90 days. The changes to the rule will extend the current exemption from registration for investment advisers who are “private advisers” for an additional six months. The anticipated operative date of the emergency regulation is January 18, 2012.

EU Tax Commissioner Says Financial Transactions Tax Will Advance in 2012

A consensus is growing in the European Union on the efficacy of a financial transactions tax that should presage quick progress towards enactment of legislation in 2012, said EU Tax Commissioner Algirdas Semeta. In remarks before a European Parliament group, the Commissioner noted that a financial transactions tax is the only policy instrument that can ensure that financial institutions make a fair and substantial contribution to public finances, can discourage high frequency trading, and can reduce competitive distortions. Neither a financial activity tax, nor a bank levy, nor a levy on bonuses, nor exposing financial services to VAT would deliver on all these goals, he remarked.

The European Commission has recommended that a financial transaction tax be applied to all financial transactions, in particular those carried out on organized markets such as the trade of equity, bonds, derivatives, and currencies. The tax would be levied at a relatively low statutory rate and would apply each time the underlying asset was traded.

After a first debate on the Commission’s proposal for a financial transactions tax in the ECOFIN in November, the Tax Commissioner has detected the start of a convergence of views among the Euro zone members. The proposal must now be analyzed in detail by the Member States.

It is important to be clear on the scope of this tax, emphasized the Commissioner. The financial transactions tax will tax the trading typically carried out by financial institutions. The day-to-day financial activities of ordinary citizens or companies will not to be taxed, he pointed out, and neither would be the primary markets where companies and governments issue securities necessary to finance their activities. Therefore, financing of the real economy such as industrial projects will not be directly affected, he added, thereby mitigating the risk of adverse economic effects.

Moreover, the tax rate proposed is very low in order not to penalize medium and long term investing strategies. Only aggressive and very active investment strategies, such as high frequency trading or very actively-managed pension and hedge funds, will be affected.

In addition, the proposal contains measures to fight tax avoidance effects. In this respect,together with low tax rates differentiated per product group, the Commission proposes taxation at the place of establishment of the financial institution. In combination with other administrative tax cooperation instruments and regulatory reforms aiming at more financial market transparency, it will adequately target tax avoidance. As a result, reasoned the Commissioner, delocalization would not be an option for avoiding the tax, unless the operator wants to completely abandon European markets and clients in the European markets.

PCAOB Answers Questions About Broker-Dealer Accounting Support Fee

In the wake of the Dodd-Frank Act authorizing PCAOB oversight of the audits of broker-dealers, all brokers and dealers registered with the SEC as of the date on which the allocation of the annual accounting support fee is set are subject to the accounting support fee. The Board's funding rules require that the allocation of the broker-dealer accounting support fee be based on tentative net capital, as that term is defined in SEC regulations.

The funding rules are based on Section 109(h)(3) of the Sarbanes-Oxley Act of 2002, which states that the amount due from a broker or dealer shall be in proportion to the net capital of the broker or dealer. The Board uses tentative net capital reported by brokers and dealers on their quarterly FOCUS reports to determine the allocation of the broker-dealer accounting support fee. In the Board’s view, this data provides a common basis among the broker and dealer population for determining the combined average, quarterly tentative net capital amount. In a FAQ, the Board noted that it would not recalculate a firm’s share of the broker-dealer accounting support fee using tentative net capital amounts reflected on the monthly FOCUS reports, instead of the quarterly FOCUS reports, even if a firm provided such data to the Board.

A firm ceasing to be a broker or dealer after the 2011 Calculation Date, which was October 31, 2011, will still have to pay the accounting support fee. The Board noted that the fact that a firm ceases to be a broker or dealer after that date does not relieve the firm of its responsibility for a share of the broker-dealer accounting support fee. However, a firm ceasing to be a broker or dealer before the 2011 Calculation Date would not have to pay the accounting support fee.

PCAOB Rule 7104(b)(1) provides that an auditor may not sign an unqualified audit opinion with respect to a broker-dealer’s financial statements unless the auditor has ascertained that the firm has no outstanding past-due share of the accounting support fee. There are three exceptions to this rule. First, PCAOB Rule 7103(c) allows a broker or dealer, under certain circumstances, to petition for correction of its share of the accounting support fee. Second, PCAOB Rule 7104(b)(2) creates a one-time exception to take account of a situation in which a broker or dealer may have a past-due share of the accounting support fee at a time when the broker or dealer needs the audit report to submit a report to, or make a filing with, the SEC.

Third, the Board will not enforce PCAOB Rule 7104(b) against an auditor that signs an unqualified audit opinion with respect to the financial statements of a broker or dealer with an outstanding past-due share of the accounting support fee of less than $50.

If a broker or dealer has paid its original share of the broker-dealer accounting support fee but not interest due under the PCAOB's rules, the auditor cannot sign an unqualified opinion unless one of the three exceptions is applicable.

PCAOB rules allow an auditor to ascertain that a broker or dealer has no outstanding past-due share of the accounting support fee by obtaining a representation from the broker or dealer. In addition, the PCAOB posts a list of brokers and dealers that have no outstanding past-due share of the accounting support fee.

Further, the Board said that a management representation that the brokerage firm has no outstanding past due share is sufficient to not preclude the auditor from signing an unqualified report. In such situations, the auditor does not have to also obtain a confirmation from the Board that no past-due share of the broker-dealer accounting support fee is outstanding. Further, the PCAOB noted that the fact that a broker or dealer is not on the Board's Web site confirmation list is not, in and of itself, a reason for an auditor to believe that a broker's or dealer's representation is inaccurate.

Tuesday, December 27, 2011

SEC Extends to Feb. 13, 2012 the Comment Period on Proposed Regulations Implementing Dodd-Frank Securitization Conflict of Interest Provisions

The SEC has extended until February 13, 2012 the comment period on proposed regulations implementing Section 621 of the Dodd-Frank Act, which deals with material conflicts of interest in connection with the securitization of asset-backed securities. Release No. 34-66058. The original comment period for the ABS Conflicts Proposal was scheduled to end on December 19, 2011. On December 13, 2011, the comment period was extended until January 13, 2012. The Commission is again extending the time period in which to provide comments on the ABS Conflicts Proposal until February 13, 2012 to allow interested persons additional time to analyze the issues and prepare their comments. A main reason for the extension is to provide the public with a better opportunity to consider the potential interplay between the ABS Conflicts Proposal and the and proposed regulations implementing the Volcker Rule provisions of Dodd-Frank, whose comment period lasts until February 13, 2012.

Proposed Securities Act Rule 127B would prohibit persons who create and distribute an asset-backed security, including a synthetic asset-backed security, from engaging in transactions, within one year after the date of the first closing of the sale of the asset-backed security, that would involve or result in a material conflict of interest with respect to any investor in the asset-backed security. The proposed rule also would provide exceptions from this prohibition for certain risk-mitigating hedging activities, liquidity commitments, and bona fide market-making.

In an earlier letter to the SEC and other federal financial regulators, Senators Jeff Merkley (D-ORE) and Carl Levin (D-MICH), the co-authors of Section 621, noted that, like the Volcker Rule, the statute also addresses conflicts of interest, but only in the context of asset-backed securities. Section 621 prohibits firms from packaging and selling asset-backed securities to their clients and then engaging in transactions that create conflicts of interest between them and their clients.

Monday, December 26, 2011

PCAOB Settles Two Disciplinary Proceedings involving Audit Firms

An audit firm and engagement partner that failed to plan, perform or supervise the audit of a company’s financial statement in accordance with PCAOB auditing standards had its registration revoked for at least two years and the engagement partner was barred from the industry for at least two years. The audit firm and engagement partner settled the disciplinary proceeding without either admitting or denying the Board’s findings. In the Matter of Bentleys Brisbane Partnership, PCAOB Release No. 105-2011-007 (Dec. 20, 2011)

The PCAOB said that a network member firm that was not registered with the Board purportedly performed the audit and the audit firm performed a limited review of the work papers. Yet, the audit firm still expessed an unqualified opinion in its audit report on the company’s financial statements filed with the SEC.

The firm also violated PCAOB rules and quality control standards by failing to develop policies and procedures to provide it with reasonable assurance that the work performed by its engagement personnel met applicable PCAOB auditing standards and to provide reasonable assurance that the firm undertook only those engagements that the firm could reasonably expect to complete with professional competence. The PCAOB found that the engagement partner substantially contributed to those quality control violations.

Thus, the Board found that the audit firm neither performed the audit nor ensured that the audit by the network firm was performed in accordance with PCAOB standards. The firm performed no audit procedures, and collected no evidential matter. They never visited the company, nor did they perform any fieldwork in the audit; noted the Board, and they prepared no work papers relating to the audit. Their audit procedures were limited to the engagement partner’s review of work papers provided by the network firm.

PCAOB Censures Audit Firm for Failing to Timely File Annual Report and Pay Fee

In another proceeding, the PCAOB censured and imposed a fine on a public accounting firm that failed to timely file an annual report and timely pay an annual fee in both 2010 and 2011. Without either admitting or denying the Board’s findings, the firm settled the disciplinary proceeding. The PCAOB noted that Section 102(d) of the Sarbanes-Oxley Act and PCAOB Rule 2200 require that each registered public accounting firm must file with the Board an annual report on Form 2 by June 30 of each year. In addition, pursuant to Section 102(f) of the Act and PCAOB Rule 2202, each registered public accounting firm must pay an annual fee to the Board on or before July 31. On November 18, 2011, the audit firm filed its annual reports for 2010 and 2011, noted the Board, and on December 2, 2011, the audit firm paid its annual fees for 2010 and 2011. In the Matter of Reuben E. Price & CO., PCAOB Release No. 105-2011-008, December 20, 2011.

Sunday, December 25, 2011

Pontifical Council Calls for Global Financial Authority on Bretton Woods Level

As the G-20 and national policymakers and regulators wrestle with the specter of financial regulatory arbitrage, the Pontifical Council for Justice and Peace has set forth a vision for reforming the international financial and monetary systems in the context of a global public authority. Essentially, the Council is calling for a Bretton Woods type agreement on sustained and coordinated and consistent global financial regulation in order to avoid a race to the bottom. Regulations, imperfect though they may be, already often exist at the national and regional levels, noted the Council, but on the international level it is hard to apply and consolidate such regulations.

The purpose of the public authority, as John XXIII recalled in Pacem in Terris, is first and foremost to serve the common good. Therefore, it should be endowed with effective mechanisms equal to its mission and the expectations placed on it. This is especially true in a global financial system that makes individuals and peoples increasingly interconnected and interdependent, reasoned the Council, but which also reveals the existence of speculative monetary and financial markets that are harmful to the real economy

A supranational Authority should be set up gradually. It should be favorable to the existence of efficient and effective financial systems and promote free and stable markets overseen by a suitable legal framework, well-functioning in support of sustainable development and social progress of all, and inspired by the values of charity and truth. A person is not made to serve authority unconditionally, instructed the Council, rather it is the task of authority to be at the service of the person, consistent with the pre-eminent value of human dignity.

According to the Council, the underlying logic of coordination and common vision which led to the Bretton Woods Agreements needs to be dusted off in order to provide adequate answers to the current questions. The process could begin by strengthening existing institutions, such as the European Central Bank. However, this would require not only a reflection on the economic and financial level, but also and first of all on the political level, so as to create the set of public institutions that will guarantee the unity and consistency of the common decisions. These measures ought to be conceived of as some of the first steps in view of a public Authority with universal jurisdiction.

More specifically, the Council urged consideration of a coordinated financial transactions tax through fair but modulated rates with charges proportionate to the complexity of the operations, especially those made on the secondary market. Such taxation would be very useful in promoting global development and sustainability according to the principles of social justice and solidarity. It could also contribute to the creation of a world reserve fund to support the economies of the countries hit by crisis as well as the recovery of their monetary and financial system. The Council also called for the recapitalization of banks with public funds, making the support conditional on virtuous behavior aimed at developing the real economy. Moreover, the Council recommended defining distinct domains of ordinary credit and investment banking in a way allowing for a more effective management of the shadow markets which have no controls and limits.

Finally, and more broadly, the Council states that the economic and financial crisis which the world is going through calls everyone, individuals and peoples, to examine in depth the principles and the cultural and moral values at the basis of social coexistence. In his social encyclical, Benedict XVI precisely identified the roots of a crisis that is not only economic and financial but above all moral in nature. In fact, as the Pontiff notes, to function correctly the economy needs ethics; and not just of any kind but one that is people-centered.

Friday, December 23, 2011

SEC and Banking Regulators Extend Comment Period on Proposed Regulations Implementing Volcker Rule

The SEC and federal banking regulators have extended the comment period on the proposed regulations implementing the Volcker Rule provisions of the Dodd-Frank Act from January 13, 2012 to February 13, 2012. The comment period was extended as part of a coordinated interagency effort to allow interested persons more time to analyze the issues and prepare their comments. The Dodd-Frank Act requires the regulators to implement prohibitions and restrictions on the ability of bank and non-bank financial companies to engage in proprietary trading and have certain interests in, or relationships with, a hedge fund or private equity fund.

In Release No. 34-66057, the SEC noted that the extension of the comment period is appropriate due to the complexity of the issues involved and the variety of considerations involved in its impact and implementation. The Agencies believe that the additional period for comment will facilitate public comment on the provisions of the proposed rule and the questions posed by the proposal.

The Agencies have received a number of requests for an extension of the comment period to allow for additional time for comments related to the provisions of the proposed rule. The SEC Release cites comment letters from the Center for Capital Markets Competitiveness of the U.S. Chamber of Commerce (November 17, 2011); American Bankers Association et al. (November 30, 2011); and House Members led by Oversight Subcommittee Chair Randy Neugebauer (R-TX) (December 20, 2011).

President Signs Legislation Funding SEC for FY 2012 and Authorizing CFTC Fund Transfer

President Obama signed the Consolidated Appropriations Act, which provides $1,321,000,000 for the SEC for FY 2012 instead of $1,185,000,000 as proposed by the House and $1,407,483,130 as proposed by the Senate. The conference agreement provided that $1,321,000,000 be derived from offsetting collections resulting in no net appropriation. The conference agreement also provided that the SEC Office of Inspector General must receive no less than $6,795,000 as proposed by the Senate, instead of$6,790,000 as proposed by the House. The legislation contains a provision allowing the CFTC to transfer $10 million in funding between the agency’s Information Technology account and its Salaries and Expenses account.

The Act also makes available $100,000 for expenses for consultations and meetings hosted by the SEC with foreign regulatory officials to exchange views concerning securities matters. It also rescinds $25 million from the unobligated balances available in the SEC Reserve Fund established by Section 991 of the Dodd-Frank Act, which created a Reserve Fund that the SEC could use as it deems necessary to carry out its functions.

While the Consolidated Appropriations Act generally withholds funding for interagency commissions, councils, or committees, the legislation specifically states that funds made available to the CFTC and SEC may be used for the interagency funding and sponsorship of a joint advisory committee to advise on emerging regulatory issues.

The conferees did not adopt the Senate designation of $483, 130 specifically for the strengthening of the acquisition workforce. However, while not designating funding, the Conference Committee remains concerned about the SEC's acquisition processes and expects the SEC to dedicate sufficient resources to strengthening the agency's capacity and capabilities of the acquisition workforce.

The conferees remain concerned with the SEC's lack of judgment in its past
leasing practices. (H 112-131) The conferees are aware of the SEC's arrangement with the General Services Administration, which the conferees believe is a good first step. The conferees intend to closely monitor how the SEC exercises its leasing authority to ensure that the Commission has adequately reformed its leasing practices. The conferees are also concerned about the unauthorized destruction of documents by the SEC.

Due to the above concerns, the conferees direct the SEC to provide the House and Senate Appropriations Committees with corrective action reports, submitted to the SEC Inspector General, related to lease agreements and document destruction no later than 30 days after enactment.

NASAA Supports Transparency in PCAOB Disciplinary Proceedings

The North American Securities Administrators Association (NASAA) has supported provisions in the proposed PCAOB Enforcement Transparency Act of 2011 (S. 1907) that would amend the Sarbanes-Oxley Act of 2002 to make disciplinary proceedings of the Public Company Accounting Oversight Board (PCAOB) open to the public. In a comment letter to leaders of the Senate Banking Committee, NASAA wrote that the non-public nature of PCAOB disciplinary proceedings has serious adverse consequences for the investing public, audit committees, the auditing profession, the PCAOB and other interested parties.

NASAA observed that Congress established the PCAOB in order to protect investors and further the public interest in the preparation of informative, fair and independent audit reports on the financial statements of public companies. NASAA believes that adjudicatory proceedings to determine whether an auditor or audit firm should be sanctioned for violating applicable rules form an important part of the PCAOB's oversight authority. Unlike disciplinary proceedings of other, comparable regulators, however, current law provides that PCAOB cases may not be made public until they are appealed to the SEC.

NASAA reminded the lawmakers that making the PCAOB's disciplinary proceedings "open to the public" was among the goals that NASAA had articulated in its Pro-Investor Legislative Agenda for the 112th Congress. Accordingly, NASAA believes that the enactment of S. 1907 will achieve this objective.

Rep. Schweikert Urges SEC and Bank Regulators to Exclude Venture Capital Funds from Volcker Rule or Classify Them as Dodd-Frank Permitted Activity

A leading member of the House Financial Services Committee urges that the final regulations implementing the Volcker Rule provisions of Dodd-Frank exclude venture capital funds or classify them as a permitted activity under Section 619 (d)(l )(J), which is a catch all allowing the regulators to permit an activity promoting safety and soundness and financial stability. In a letter to the SEC and banking regulators, Rep. David Schweikert said that Congress did not intend for the Volcker Rule, as codified by Dodd-Frank, to cover venture capital investing because it does not promote excessive risk and is critical to job creation and continued economic growth. Properly conducted venture capital investing does not carry the types of risk that threaten the safety and soundness of the U.S. financial system, said the Congressman, and is limited in scale, does not use leverage and is long term in nature.

He noted that the Financial Stability Oversight Council underscored these points in a report released in January. The Council identified concerns that noted venture capital funds are fundamentally different from other funds as significant, and recommended that the implementing agencies carefully consider whether it is appropriate to narrow the statutory definition by rule in some cases, including to exclude venture capital funds.

Rep. Schweikert is disappointed that the proposed regulations do not take a position on the question of how to treat venture capital funds. The draft acknowledges that the agencies have the discretion to refine the definition of covered funds, as proposed in some limited cases for bank owned life Insurance vehicles, asset-backed securitization vehicles, and corporate organizational vehicles, and that an exemption for venture capital funds under Section 619 (d)(l )(J) might be warranted. But the draft did not contain any definitive clarification on the treatment of venture capital funds.

Over 100 House Members Urge SEC and Bank Regulators to Extend Comment Period on Volcker Rule Proposal

In a letter to the SEC and banking regulators, a bipartisan group of over 100 House Members, including oversight Chairs, urged that the comment period on the proposed regulations implementing the Dodd-Frank Volcker Rule be extended for at least 30 days past the current January 13,2012 deadline. The Members also asked the financial regulators to consider producing an interim proposed rule reflecting the comments from affected stakeholders and the CFTC, and to extend the implementation deadline.

Given the short timeline for comment and the rapidly approaching July 2012 implementation deadline, noted the House Members, concerns have been raised that affected stakeholders will not have a sufficient opportunity to examine the proposal, which is approximately 300 pages and includes a request for comment on more than 1,300 questions, and provide meaningful comment, and that regulators will not have adequate time to digest these comments.

According to the Members, the complexity of these issues necessitates a deliberative and thoughtful process that considers an appropriately tailored proposal to improve safety and soundness without disrupting market liquidity for investors and the flow of capital to businesses.

Ultimately, the significance of any final Volcker Rule for US businesses cannot be overstated given the direct impact on the U.S. capital markets, which today are the deepest and most liquid in the world. Initial reports from asset managers, mutual funds, pension plans and other stakeholders suggest that the draft would result in higher borrowing costs for US businesses, thereby impacting economic growth and job creation.

For example, noted the Members, given the nearly $8 trillion corporate bond market, if the cost of borrowing increases by just one-quarter of a percent for investment-grade bonds, and one-and-a-quarter percent for high-yield bonds, the impact on the economy will be greater than $45 billion for corporate bonds alone. This estimate does not consider the costs associated with consumer lending (e.g. student loans, auto loans), commodities, or other impacted markets. The effects are expected to be most pronounced for small and medium-sized companies.

President Signs Legislation Extending Payroll Tax Holiday and Increasing Fee Charged by GSEs on Mortgage-Backed Securities

President Obama has signed the Temporary Payroll Tax Cut Continuation Act, HR 3675, extending the payroll tax holiday for two months and increasing the guarantee fees charged by Fannie Mae and Freddie Mac for assuming the risk of mortgage-backed securities.

The legislation increases the guarantee fees that are charged to mortgage lenders with respect mortgage-backed securities by Fannie Mae and Freddie Mac by 10 basis points. An enterprise cannot offset the cost of the fee to mortgage originators, borrowers, and investors by decreasing other charges, fees, or premiums, or in any other manner. Revenue generated by the increase is deposited directly into the United States Treasury.

Thursday, December 22, 2011

Implementing Vickers Commission Recommendations, UK Will Ring Fence Retail Banking from Proprietary Trading and Sponsoring Hedge Funds

The UK government will draft legislation implementing the Vickers Commission recommendation to ring-fence retail traditional banking activities from investment banking activities. Ring-fencing vital banking services on which households and small and medium-sized businesses depend from investment banking activities will effectively insulate them from problems elsewhere in the financial system, reduce risk taking, and curtail implicit government guarantees. While proprietary trading and investments in hedge funds would not be prohibited, these activities would be outside the ring-fence and thus isolated from retail banking where implicit government guarantees appear strongest.

In addition, the ring-fenced bank should be legally and operationally independent from the rest of its corporate group. Ring-fenced banks should be regulated for capital and liquidity purposes on a solo basis; should not be over-reliant on the rest of the corporate group for funding, and should undertake transactions with the rest of the group on a third-party basis.

According to the Vickers Commission, effective ring-fencing also requires measures for independent governance to enforce the arm’s length relationship. The Commission’s view is that the board of the ring-fenced retail subsidiary should normally have a majority of independent directors, one of whom is the chair. For the sake of transparency, the ring-fenced subsidiary should make disclosures and reports as if it were an independently listed company. While corporate culture cannot directly be regulated, noted the Commission, proper structural and governance arrangements should consolidate the foundations for long-term customer-oriented UK retail banking.

The Commission set forth five ring-fence principles identifying the features of financial services that should determine their treatment and thus provide a guide for the operation of the ring-fence when new products arise. Notably, the Commission pointed out that the Glass-Steagall Act, which prevented deposit-taking banks from underwriting or dealing in securities, was undermined in part by the development of derivatives.

Principle 1 is that only ring-fenced banks should be granted permission by the UK regulator to provide mandated services. Conversely, Principle 2 states that ring-fenced banks should be prohibited from providing services that make resolution significantly more costly, increase exposure to global financial markets, and involve risks not integral to the provision of traditional banking services to customers. Under, Principle 3, the ring-fenced bank should be allowed to conduct ancillary activities to support the provision of its core functions.

The height of the fence is specified in Principles 4 and 5, which describe the legal, operational and economic links which should be permitted between a ring-fenced bank and any wider corporate group of which it is part. Ring-fenced banks should be separate legal entities. Where a ring-fenced bank is part of a wider corporate group, its relationships with entities in that group should be conducted on a third-party basis and it should not be dependent for its solvency or liquidity on the continued financial health of the rest of the corporate group.

The Commission said that, under the Volcker Rule, banks are not allowed to engage in proprietary trading, and investments in hedge funds and private equity firms are restricted. In part the Volcker Rule aims to remove from certain activities the benefit of implicit and explicit government support for the banking system.

According to the Vickers Commission, those activities prohibited by the Volcker Rule should be prohibited from ring-fenced banks. Proprietary trading is not a necessary part of intermediation in the real economy and so should not be conducted in the same entity as the mandated services.

However, the Commission emphasized that prohibiting only those activities caught by the Volcker Rule would not achieve all of the objectives of ring-fencing. As a result, most of the efforts to improve the resolvability of universal banks involve requiring that all investment banking activities must be separable from the rest of the bank.

Also, in order to reduce the ring-fenced bank’s interconnectedness with the financial system and the correlation of its performance with that of financial markets, it should not conduct trading or other activities which give rise primarily to market risk or counterparty credit risk. The Commission reasoned that removing the complexity of some investment banking would make it easier for ring-fenced banks to be managed, monitored and supervised.

House Oversight Chairs Urge the SEC to Scale Back Scope of Municipal Securities Advisor Regulations

In a bi-partisan letter to the SEC, two House oversight chairs urged the Commission to scale back the scope of the proposed regulations defining municipal securities advisors as part of implementing Section 975 of the Dodd-Frank Act, which directs the SEC to set up an effective registration and examination program for municipal financial advisors. Capital Markets Subcommittee Chair Scott Garrett (R-NJ) and Oversight Subcommittee Chair Randy Neugebauer (R-TX) said that the SEC regulations should exempt from the definition of municipal advisor broker-dealers, investment advisers and banks that are already regulated by the Commission and the federal banking agencies. The letter was signed by 30 other House Members.

In the view of the Members, the SEC’s proposal goes far beyond the legislative intent of Section 975 and embraces parties and activities neither anticipated by Congress nor authorized by the statute and imposes duplicative regulation on parties that are already heavily regulated. The proposal may even harm state and local government, said the Members, by driving some parties out of the municipal market or limiting the services they provide.

The intentionally narrow focus of Section 975 is to bring under the regulatory umbrella of the SEC and the MSRB parties who provide advice to municipal entities on securities issuances and the investment of the proceeds of municipal securities and who are not already regulated. Specifically, Congress intends Section 975 to apply to parties known in the municipal securities markets as independent financial advisors, swap advisors, and other parties who are not already regulated by the SEC, the MSRB or the federal and state bank regulators. Congress did not intend to impose additional layers of regulation on parties and entities that are already well regulated.

In an earlier letter to the SEC, Financial Services Committee Chair Spencer Bachus (R-AL) said that the proposed regulations are overly broad and would reach significantly more people than Congress intended. For example, he said that the broad definition of municipal financial products combined with the failure to define ``advice’’ would result in thousands of bank employees conducting routine business with municipal entities having to register with the SEC Chairman Bachus urged the Commission in developing rules under Sec. 975 to strike a balance ensuring that non-broker-dealer financial advisors register with the SEC, while not forcing thousands of unsuspecting individuals to comply with yet another regulatory burden that he feels would be detrimental to the very municipal entities Congress is trying to protect.

Supreme Court of Canada Says Federal Securities Regulatory Regime Not Valid under Constitutional Trade and Commerce Clause

The proposed Canadian Securities Act creating a single national federal securities regulator and regime is not valid under the general branch of the federal power to regulate trade and commerce under s. 91(2) of the Constitution Act, 1867, ruled the Supreme Court of Canada. In an advisory opinion, the Court said that, while the trade and commerce power is broad its face broad, it cannot be used in a way that denies the provincial legislatures the power to regulate local matters and industries within their boundaries. Allowing an interpretation of the general trade and commerce power supporting an exclusively federal securities regulatory regime, said the Court, would disrupt the careful balance of federal and provincial powers.

Parliament cannot regulate the whole of the securities system simply because aspects of it have a national dimension, held the Court. The Court did say, however, that a cooperative approach involving a regime recognizing the essentially provincial nature of securities regulation while allowing Parliament to deal with genuinely national concerns, such as systemic risk, remains available and is supported by Canadian constitutional principles. But the Court cautioned that the need to prevent and respond to systemic risk may support federal legislation pertaining to the national problem raised by this phenomenon, but it does not alter the basic nature of securities regulation which remains primarily focused on local concerns of protecting investors and ensuring the fairness of the markets through regulation of participants.

Taken as a whole, the proposed Act overreaches genuine national concerns. While acknowledging that the economic importance and pervasive character of the securities market may, in principle, support federal intervention, the Court said that this does not justify a wholesale takeover of the regulation of the securities industry, which is the ultimate consequence of the proposed federal legislation. Indeed, in order to be included in the comprehensive regulatory scheme created by the Act, provinces and territories must suspend their own securities laws. The follow-through effects of the proposed Act will therefore be to subsume the existing provincial and territorial legislative schemes governing securities under the federal regulatory scheme.

The main thrust of the Canadian Securities Act is to exclusively regulate all aspects of securities trading in Canada, including the trades and occupations related to securities in each of the provinces. The purpose of the Act is to implement a comprehensive Canadian regime to regulate securities with a view to protect investors, to promote fair, efficient and competitive capital markets and to ensure the integrity and stability of the financial system. It would effectively duplicate and displace the existing provincial and territorial securities regimes.

Viewed in its entirety, noted the Court, the Act cannot be classified as falling within the general trade and commerce power. The main thrust of the legislation does not address a matter of genuine national importance and scope going to trade as a whole in a way that is distinct and different from provincial concerns.
Canada has not established that the area of securities has been so transformed that it now falls to be regulated under the federal head of power. The preservation of capital markets to fuel Canada’s economy and maintain Canada’s financial stability is a matter that goes beyond a specific industry and engages trade as a whole.

However, the Act is chiefly concerned with the day to day regulation of all aspects of contracts for securities within the provinces, including all aspects of public protection and professional competences. In the Court’s view, these matters remain essentially provincial concerns falling within property and civil rights in the provinces and are not related to trade as a whole.

Specific aspects of the Act aimed at addressing matters of genuine national importance and scope going to trade as a whole in a way that is distinct from provincial concerns, including management of systemic risk and national data collection, appear to be related to the general trade and commerce power. With respect to these aspects of the Act, the provinces, acting alone or in concert, lack the constitutional capacity to sustain a viable national scheme. Viewed as a whole, however, the Act is not chiefly aimed at genuine federal concerns. It is principally directed at the day to day regulation of all aspects of securities and, in this respect, it would not founder if a particular province failed to participate in the federal scheme.

Wednesday, December 21, 2011

SEC Implements Dodd-Frank Changes to Accredited Investor Definition

The SEC adopted amendments to the accredited investor standards in the Securities Act regulations to implement the requirements of Section 413(a) of the Dodd-Frank Act, which requires the definition of accredited investor to exclude the value of a person’s primary residence for purposes of determining whether the person qualifies as an accredited investor on the basis of having a net worth in excess of $1 million. Under the previous standard, individuals qualified as accredited investors if they had a net worth of more than $1 million, including the value of their primary residence. The definition of accredited investor was adjusted in Rule 501(a)(5) of Regulation D and Securities Act Rule 215(e).

Under the new regulations, the value of an individual’s primary residence will not count as an asset when calculating net worth to determine accredited investor status. Thus, an individuals’ net worth will be calculated excluding any positive equity that they may have in their primary residence.

Thus, for example, if an investor with a net worth of $2 million (calculated in the conventional manner before the enactment of Section 413(a), that is, by subtracting from the investor’s total assets, including primary residence, the investor’s total liabilities, including indebtedness secured by the residence, has a primary residence with an estimated fair market value of $1.2 million and a mortgage loan of $800,000, the investor’s net worth for purposes of the new accredited investor standard is $1.6 million. Before enactment of Section 413(a), the primary residence would have contributed a net amount of $400,000 to the investor’s net worth for purposes of the accredited investor net worth standard, the value of the primary residence ($1.2 million) less the mortgage loan ($800,000). Under the changes, exclusion of the value of the primary residence would reduce the investor’s net worth by the same $400,000 amount.

Also, under the amended net worth calculation, indebtedness secured by the person’s primary residence, up to the estimated fair market value of the primary residence, is not treated as a liability, unless the borrowing occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence. In such cases, the debt secured by the primary residence must be treated as a liability in the net worth calculation. This is intended to prevent manipulation of the net worth standard, by eliminating the ability of individuals to artificially inflate net worth under the new definition by borrowing against home equity shortly before participating in an exempt securities offering.

In addition, any indebtedness secured by a person’s primary residence in excess of the property’s estimated fair market value is treated as a liability under the new definition. Thus, the fair market value of the residence and the amount of the mortgage up to that fair market value are excluded from the calculation, and the excess of the amount of the mortgage over the fair market value of the primary residence is included as a liability. In both cases, the overall impact on net worth is a reduction equal to the underwater amount (i.e., the excess of the amount of the mortgage over the fair market value of the esidence). For example, if you have an investor whose primary residence has an estimated fair market value of $1.2 million, with a mortgage of $1.4 million, the excess of mortgage loan over the fair market value of the primary residence (in this case, $200,000) would be taken into account as a liability and serve to reduce net worth both under a conventional net worth calculation and under the accredited investor definition adopted by the SEC. If, on the other hand, all debt secured by the primary residence were excluded, including debt in excess of the estimated fair market value of the residence, the investor’s net worth would be $200,000 higher than under a conventional calculation because the mortgage debt in excess of the value of the primary residence would not be treated as a liability.

German Finance Minister Calls for Financial Transactions Tax and Market Transparency

The German Federal Finance Minister, Dr. Wolfgang Schäuble, called for EU-wide implementation of a financial transactions tax. In recent remarks, he also endorsed more transparency for the financial markets. More broadly, he said that one lesson of the financial crises is that a self-regulating financial market is an elusive dream. The financial markets need regulations and boundaries in order to act responsibly. The goal of federal regulators is to find a new balance between financial markets and the state. Financial markets need a regulatory framework that above all increases transparency, reduces extreme leverage, and limits excessive volatility. Only the state can provide such a framework, said the Minister, and with global markets, only the community of states.

At the same time, he fears the increasing danger of what the Minister called “regulatory parochialism”. One example of this is the proposed Financial Transaction Tax. It is short-sighted parochialism which is currently keeping the EU from implementing a European Financial Transaction Tax. If a Financial Transactions Tax were introduced in all of Europe it could help reduce volatility further, he reasoned, not least because it could make leveraged trading less profitable. He is also in favor of an FTT because financial market participants need to convincingly demonstrate to taxpayers and their fellow citizens that they are willing to contribute to clean up the mess they helped to create. One way of doing that is through the FTT. More broadly, the Minister believes that the current demonstrations against financial market participants show that the FTT can play an essential in peace-making between different parts of the society.

The European Commission has recommended that a Financial Transaction Tax be applied to all financial transactions, in particular those carried out on organized markets such as the trade of equity, bonds, derivatives, and currencies. The tax would be levied at a relatively low statutory rate and would apply each time the underlying asset was traded. A Financial Transaction Tax could narrowly apply only to stocks and bonds or could be broadly extended to all financial instruments, including derivatives and structured instruments.

To stabilize the international financial system, continued the Minister, regulators need to overcome such parochial behavior, increase transparency and reduce volatility. Dark pools and over-the-counter-trades must be made more transparent, the shadow banking system, including hedge funds, must be regulated, and the risks posed by the extensive leverage of some modern financial instruments, including credit default swaps, must be contained. Similarly, the assumptions of credit rating agencies must be more transparent and the financial markets must be weaned away from their influence. States empowered rating agencies so that they could point to policy errors earlier than financial markets and thereby blunt market reactions, he noted, but the opposite has happened.

Former IASB Member and Auditor Becomes Head of German Financial Authority

Dr. Elke König has been named the new President of the German Federal Financial Supervisory Authority (BaFin). Dr. Wolfgang Schäuble, Federal Minister of Finance, presented her with her certificate of official appointment. Dr. König's term will commence in early January 2012. Previously, Dr. König was a member of the International Accounting Standards Board (IASB). From 2002 to March 2009, she served as CFO of Hannover Rückversicherung AG and E+S Rückversicherung AG, Hanover. From 1990 to 2002, Dr. König was a member of the senior management and head of accounting and financial control of the Munich Re Group. Before entering the reinsurance industry, she was a partner in KPMG’s German audit practice.

California Proposes Private Fund Adviser Exemption

Interested persons may, in writing, comment on the California Department of Corporations' proposed private fund adviser exemption until 5 pm on February 20, 2012. Send comments by regular mail to Department of Corporations, Attn: Karen Fong, Office of Legislation and Policy, 1515 K. Street, Suite 200, Sacramento, CA 95814, and by electronic mail to regulations@corp.ca.gov. Private fund advisers are exempt from investment adviser registration if they satisfy specified requirements.

Martin Act Does Not Preempt Common Law Claims, New York High Court Rules

The New York Court of Appeals held yesterday that the New York Blue Sky Law (Martin Act) does not preempt common law claims involving securities. In Assured Guaranty (UK) Ltd. v. J. P. Morgan Investment Management Inc., the state high court ruled that the statute did not preempt the plaintiff's causes of action for breach of fiduciary duty and gross negligence arising from the defendant's management of an investment portfolio. The decision appears to have settled a long-standing question concerning the viability of common law securities claims by private litigants under New York law.

Although the defendant contended that the Martin Act vests the Attorney General with exclusive authority over fraudulent securities and investment practices, the state high court reasoned that the plain text of the statute, while granting the Attorney General investigatory and enforcement powers and prescribing various penalties, does not expressly mention or otherwise contemplate the elimination of common law claims. Moreover, nothing in either the original conception of the Martin Act in 1921 or any of the subsequent amendments demonstrates a "clear and specific" legislative mandate to abolish preexisting common law claims that private parties would otherwise possess in the securities field.

The state high court rejected the defendant's argument that the court's previous decisions in CPC International, Inc. v. McKesson Corp. (N.Y. 1987) and Kerusa Co. v. W10Z/515 Real Estate L.P. (N.Y. 2009) settled the issue in favor of preemption. Rather, these decisions stand for the proposition that a private litigant may not pursue a common law cause of action where the claim is predicated solely on a violation of the Martin Act or its implementing regulations and would not exist but for the statute. But, the state high court noted, an injured investor may bring a common law claim, either for fraud or otherwise, that is not entirely dependent on the Martin Act for its viability. Mere overlap between the common law and the Martin Act is not enough to extinguish common law remedies.

Tuesday, December 20, 2011

Fed Proposes Enhanced Standards for Systemically Important Financial Companies, Including Counterparty Credit Limits

As directed by the Dodd-Frank Act, the Federal Reserve Board has proposed enhanced prudential standards for systemically important backs and non-bank financial companies that pose a grave threat to financial stability. The Dodd-Frank Act tags banks and bank holding companies with $50 billion in assets as subject to enhanced oversight. For hedge funds, private equity funds and other non-bank financial firms, the Act entrusts the Financial Stability Oversight Council with the task of designating the firms for enhanced regulation based on a set of factors.

The prudential standards for covered companies must include enhanced risk-based capital and leverage requirements, enhanced liquidity requirements, enhanced risk management and risk committee requirements, a requirement to submit a resolution plan, single-counterparty credit limits, stress tests, and a debt-to-equity limit for covered financial companies that the Council has determined pose a grave threat to financial stability. Dodd-Frank also requires the Fed to establish a regulatory framework for the early remediation of financial weaknesses of covered financial companies in order to minimize the probability that they will become insolvent and the potential harm of such insolvencies to US financial stability.

In addition to the required standards, the Act authorizes but does not require the Board to establish additional enhanced standards for covered financial firms relating to contingent capital; disclosure; short-term debt limits; and such other prudential standards as the Board determines appropriate. But the Fed decided not to propose any of these supplemental standards at this time.

The single-counterparty credit requirements would limit credit exposure of a covered financial firm to a single counterparty as a percentage of the firm's regulatory capital. Credit exposure between the largest financial companies would be subject to a tighter limit. Credit exposures to sovereign entities would be subject to the credit exposure limits in the same manner as credit exposures to financial companies.

Interconnectivity among major financial companies poses risks to financial stability. The effects of one large financial company’s failure or near collapse may be transmitted and amplified by the bilateral credit exposures between large, systemically important financial companies. Thus, Dodd-Frank directs the Board to establish single-counterparty credit limits for covered financial companies in order to limit the risks that the failure of any individual company could pose to a financial company.

The Fed proposes a two-tier single counterparty credit limit, with a more stringent limit applied to the largest financial companies. The general limit would be 25 percent of capital stock and surplus and the more stringent limit between major covered financial companies and major counterparties would be 10 percent of capital stock and surplus. They both apply to the aggregate net credit exposure between the covered company and the counterparty.

Credit exposure to a company is defined broadly in Section 165(e) of Dodd-Frank to cover all extensions of credit to the company; all repurchase and reverse repurchase agreements, and securities borrowing and lending transactions, with the company as well as all investments in securities issued by the company and counterparty credit exposure to the company in connection with derivative transactions.

The Fed would allow covered financial companies to reduce their credit exposure to a counterparty for purposes of the limit by obtaining credit risk mitigants such as collateral and credit derivative hedges. The proposal describes the types of eligible collateral and derivative hedges and provides valuation rules for reflecting such credit risk mitigants.

The Fed proposed risk-based capital and leverage requirements that would be implemented in two phases. In the first phase, the financial firms and institutions would be subject to the Board's capital plan rule, which was issued in November 2011, requiring them to develop annual capital plans, conduct stress tests, and maintain adequate capital, including a tier one common risk-based capital ratio greater than 5 percent, under both expected and stressed conditions. In the second phase, the Board would issue a proposal to implement a risk-based capital surcharge based on the framework and methodology developed by the Basel Committee on Banking Supervision.

The Fed also proposed liquidity requirements that would be implemented in multiple phases. First, financial firms and institutions would be subject to qualitative liquidity risk-management standards generally based on the interagency liquidity risk-management guidance issued in March 2010. These standards would require companies to conduct internal liquidity stress tests and set internal quantitative limits to manage liquidity risk. In the second phase, the Board would issue one or more proposals to implement quantitative liquidity requirements based on the Basel III liquidity rules.

Sound, enterprise-wide risk management by financial companies reduces the likelihood of their material distress or failure and thus promotes financial stability. Thus, the Fed would require all covered financial companies to implement robust enterprise-wide risk management practices that are overseen by a risk committee of the board of directors and chief risk officer with appropriate levels of independence, expertise and stature.

Stress tests of the financial companies would be conducted annually by the Board using three economic and financial market scenarios. The stress tests would be under baseline, adverse, and severely adverse scenarios and financial firms subject to company-run stress test requirements would conduct their own capital adequacy stress tests on an annual or semiannual basis. A summary of the results, including company-specific information, would be made public. In addition, the proposal requires financial companies to conduct one or more company-run stress tests each year and make a summary of their results public.

Dodd-Frank says the Board must require a covered financial firm to maintain a debt-to-equity ratio of no more than 15-to-1, upon a determination by the Council that the firm poses a grave threat to US financial stability and the imposition of such a requirement is necessary to mitigate the risk that the firm poses to financial stability. The Fed proposes to notify a financial company that the Council has made a determination that the company must comply with the 15-to-1 debt-to-equity ratio requirement. The proposal defines the terms “debt” and “equity” for purposes of calculating compliance with the ratio, and provides an affected financial firm with a transition period to come into compliance with the ratio.

The early remediation requirements would be put in place for all financial firms subject to the proposal so that financial weaknesses are addressed at an early stage. The Board is proposing a number of triggers for remediation, such as capital levels, stress test results, and risk-management weaknesses. In some cases, the triggers would be calibrated to be forward-looking. Required actions would vary based on the severity of the situation, noted the Fed, but could include restrictions on growth, capital distributions, and executive compensation, as well as capital raising or asset sales.

Chamber of Commerce Urges SEC Not to Recommend Legislation Altering Supreme Court Ruling on Transnational Securities Fraud

In a letter to the SEC, the US Chamber of Commerce said there is no basis for the Commission to recommend congressional action to alter the US Supreme Court’s ruling in Morrison setting a transactional test for the extraterritorial application of the federal securities laws. In its 2010 ruling in Morrison v. National Australia Bank, the Court found that securities antifraud provisions applied to transactions in securities listed on domestic exchanges, and domestic transactions in other securities. The Chamber noted that the United States should not create a new, extraterritorial private cause of action for securities fraud to overturn the Supreme Court’s decision. The letter references Section 929Y of the Dodd-Frank Act, which directs the SEC to conduct a study to determine the extent to which private rights of action under the antifraud provisions of the Exchange Act should be extended to cover transnational securities fraud.

The Chamber’s review of post-Morrison decisions revealed that the federal courts have been consistently and appropriately applying Morrison. When a transaction occurs in the United States, courts have been permitting claims under the antifraud rule. Conversely, when a transaction occurs abroad, courts have been deferring to the judgment of foreign nations on the appropriate security enforcement mechanisms. Moreover, there is no indication that the application of the principles set forth in Morrison is leaving unsophisticated U.S. investors without a remedy that they believed to have been available or leaving any U.S. investors without protection. To the contrary, said the Chamber, the off-exchange transactions to which Morrison is being applied are highly complex transactions entered into by extremely sophisticated investors able to ascertain the governing remedial laws, which in virtually all cases have been the well-developed laws of key U.S. allies and trading partners.

Following Morrison, courts have concluded that the purchase of securities by foreigners on a foreign market cannot be the basis for a Section 10(b) claim. Similarly, courts have universally extended Morrison’s transactional test to reject also claims where U.S. individuals purchase securities of a foreign issuer on a foreign exchange. In both of these situations, reasoned the Chamber, the investor is purchasing shares on a non-U.S. exchange, and, there is little chance that the investor could mistakenly believe that U.S. laws apply. Moreover, because the foreign exchanges are supervised by sophisticated regulators there is little chance that the investor will be left unprotected.

Although the Supreme Court in Morrison did not explicitly define the phrase domestic transactions, courts have found that the phrase was intended to be a reference to the location of the transaction, not to the location of the purchaser and that the Supreme Court clearly sought to bar claims based on purchases and sales of foreign securities on foreign exchanges, even though the purchasers were American. See In re Vivendi Universal Securities Litigation, (SDNY 2011).

The Chamber also observed that courts have correctly concluded that when a plaintiff purchases the securities issued by a defendant on a U.S. exchange, a Section 10(b) remedy is available against the issuer for fraudulent conduct. This principle applies even when the fraudulent conduct occurs abroad. But when a foreign issuer lists securities on both foreign and domestic exchanges, Section 10(b) extends only to parties to transactions that occur on a U.S. exchange

Swap agreements can replicate other securities transactions, such as purchasing or shorting company stock. These transactions are synthetic in the sense that gains and losses are the product of contracts and the parties need not actually own the underlying security instrument at issue. The economic reality of such swap agreements determines whether it is foreign or domestic for Morrison purposes. Thus, when a swap agreement is functionally indistinguishable from purchasing or shorting stock on a foreign market, it must he treated as a foreign transaction and thus outside the scope of the federal antifraud rule.

Similarly, contracts for difference are another type of synthetic security pegged to an underlying since they are derivative instruments allowing a trader to take a long or short position on an underlying financial instrument without actually owning it.

A federal district court recently concluded that foreign purchases of contracts for difference nonetheless fell within Section 10(b) when the underlying referent is a stock traded on a U.S. exchange. See SEC v. Compania Internacional Financeria SA (SDNY 2011). As with swap-based agreements, the Court looked to the economic reality of the transaction. As the transaction was indistinguishable from the purchase of a U.S. security, and indeed likely caused the provider to purchase U.S. securities, it properly fell within the scope of U.S. regulation.

PCAOB Re-Proposes Expanded Standard on Auditor Communications with the Audit Committee

The PCAOB has unanimously re-proposed a standard on the outside auditor’s communications with the audit committee. The re-proposed standard will supersede AU sec. 380, the existing PCAOB auditing standard governing communications with audit committees and will apply to auditor communications with issuer and broker and dealer audit committees. The new proposed standard does not impose new performance requirements on auditors but does expand and clarify the nature of communications that the auditor needs to have with the audit committee. It also aligns the auditor's communications more closely with other PCAOB standards governing the auditor's performance requirements. The comment period on the re-proposed standard will end on Feb 29, 2012. According to PCAOB Chief Auditor Marty Baumann, the goal is for the standard to take effect for audits beginning after Dec 15, 2012.

While the re-proposed standard is not fundamentally different from than the original proposal, there have been some significant changes. For example, the requirement in the original proposal that auditors evaluate the two-way communications process between the auditor and the audit committee has been deleted. Further, the requirements concerning auditor communications regarding management's critical accounting estimates have been streamlined. Also, there is a new requirement that the auditor communicate with the audit committee regarding significant transactions not in the ordinary course of business, including any transactions that appear to be unusual due to their timing, size, or nature. The auditor also would be required to explain his or her understanding of the business rationale for such transactions.

PCAOB Chair James Doty said that the new proposed standard is designed to benefit investors by enhancing the relevance and quality of the communications between the auditor and the audit committee. It should also help auditors perform their job by fostering thoughtful and engaged discussions between the auditor and the audit committee that, over time, arm the audit committee with the information it will need when a tough issue arises and the time comes to champion investor interests. The standard should also avoid burdening the audit committee with minutia. He cautioned auditors and audit committees to avoid turning the standard into a mere compliance exercise. The Chair believes that the re-proposed standard moves the auditor's communication with the audit committee away from compliance checklists, and decisively in the direction of meaningful, effective interchange.

Board Member Lewis Ferguson noted that the re-proposed standard now includes a number of specific matters that must be discussed with the audit committee, including the structure and timing of the audit, the auditor's assessment of risk areas including fraud risks, the auditor's use of outside experts and other auditors, difficult or contentious issues that arise in the course of the audit, significant accounting policies, judgments and estimates, going concern issues and other matters. Importantly, the enumerated items in the standard are not exclusive and any other matter that the auditor deems important should also be brought to the audit committee's attention.

For highly experienced and knowledgeable audit committees some of these required communications may seem unnecessary, noted Member Ferguson, but experience levels among audit committees of public companies vary widely and robust communications between an auditor and an audit committee can both educate the audit committee members and assist them in performing their oversight functions.

Board Member Jay Hanson noted that some commenters responding to the original proposed standard were hoping that the Board would require auditors to discuss their assessment of the company's tone at the top. The Board was careful to tie its communications requirements in the proposed standard to existing requirements for audit procedures in order to avoid increasing the substantive audit work that must be performed through the communication standard. As a result, the standard addresses tone at the top only insofar as AS 5 includes audit performance requirements to evaluate management in connection with the control environment.

According to Member Hanson, audit committees are free, however, to expand on these discussions with their auditors by asking for additional information about management's philosophies and priorities, in order to develop a more comprehensive picture of the company's tone at the top.

During Q&A with the staff, Member Hanson, noting that the communications should involve consultations with other accountants not involved with the audit, asked who are these other accountants. Chief Auditor Marty Baumann said that they could be accountants consulted by management with regard to complex accounting issues, or they could also be accountants consulted for opinion shopping purposes. The re-proposed standard clarifies that the auditor should communicate to the audit committee consultations by management with other accountants when the auditor has concerns about the subject matter of those consultations.

Member Ferguson, noting that the re-proposed standard requires documentation of the auditor communications with the audit committee, asked about the level of detail of the documentation. The Chief Auditor said that the general rule is that the documentation must be such that an experienced auditor not having been involved with the audit can look at the documentation and understand the nature of the communications.

Member Steven Harris noted that some have called the standard overly prescriptive: The Chief Auditor observed that the re-proposed standard embodies important requirements for communication between the auditor and the audit committee. He added that the standard does not prescribe the nature of how these communications are to take place. Communications can be in the form of bringing attention to critical matters to the audit, for example. Similarly, Member Dan Goelzer noted that the original proposal had been criticized for being one-size-fits-all. The Chief Auditor responded that the re-proposal provides great flexibility on how the audit committee and the auditor carry out their dialogue.

Member Harris posed a question concerning the difference between the terms must or should as used in the standard and the legal implications of such. The staff replied that the term ``must’’ connotes an unconditional responsibility, such as the auditor must be independent. The term ``should’’ carries the presumption of unconditional responsibility, that the auditor can rebut by showing that an alternative approach would otherwise satisfy the objective of the standard. This would be a rare occurrence, said the staff, since the term ``should’’ leaves little flexibility, is tantamount to a requirement, and is enforceable.

Member Goelzer is concerned about how the re-proposed standard will apply, and indeed be efficacious, to smaller broker-dealers where the same people both manage and oversee the financial reporting process. The staff shares these concerns. The Chief Auditor noted that the re-proposal questions if the standard should apply to all broker-dealers in an effort to elicit feedback from which the staff can learn more about whether the standard should be applicable in all cases.

Monday, December 19, 2011

SEC May Provide Guidance on Proxy Advisory Firms, Says Chairman Schapiro, and Will Review Beneficial Ownership Rules

The SEC is considering providing guidance on how the federal securities laws should regulate the activities of proxy advisory firms as a result of comments received on a Concept Release on the US proxy system, said SEC Chair Mary Schapiro. In remarks at the Transatlantic Corporate Governance Dialogue, she also noted that the beneficial ownership reporting rules will be reviewed next year with an eye to modernizing them in light of modern investment strategies and innovative financial products. Chairman Schapiro also examined say-on-pay, proxy access, and beneficial ownership issues.

More broadly, the SEC Chair set a goal of breaking down barriers that may prevent effective engagement, impact investor confidence and, ultimately, diminish financial performance to the detriment of shareholders. Effective corporate governance is an imperfect art, she said, with case-specific rules of engagement that can vary dramatically from company to company, while yielding satisfactory results. Given the diversity of approaches, the focus of the SEC is on variables through which the Commission can have a beneficial impact on engagement, and where it can increase the quality of communication in the board-shareholder dialogue.

Many commenters suggested that proxy advisory firms may interfere with, rather than enhance, the communication at the heart of effective engagement. Companies are frustrated by the influence these firms have, noted Chairman Schapiro, and worry that they may not be accountable for, or even concerned with, the quality of the information on which they make voting recommendations.

And, when boards believe that a recommendation has been based on incorrect information, she reasoned, those recommendations can act as a barrier to boards’ efforts to persuade investors to change their minds. A related fear is that proxy firms’ conflicts of interest may be insufficiently disclosed, preventing shareholders from considering possible conflicts when analyzing those recommendations.

The SEC is also examining uncertainty surrounding vote confirmation. Currently, investors are often not able to receive confirmation that their votes have been cast and accurately counted. This inability to confirm voting information is caused in part because no one individual participant in the voting process, neither issuers, transfer agents, vote tabulators, securities intermediaries, nor third party proxy service providers, possesses all of the information necessary to confirm whether a particular shareholder’s vote has been timely received and accurately recorded.

Thus, the SEC is considering how to require participants in the voting process to share information with each other in order to allow for vote confirmations.
The review of beneficial ownership reporting will consider whether the 10-day initial filing requirement for Schedule 13D filings should be shortened and whether beneficial ownership reporting should be changed with respect to the use of cash-settled equity swaps and other types of derivative instruments. According to Chairman Schapiro, the first step will likely be a concept release given the controversy surrounding some of the issues

The Dodd-Frank Act has provided the Commission with new statutory authority to shorten the 10-day filing deadline for 13D, as well as to regulate beneficial ownership reporting based on the use of security-based swaps. And, earlier this year, the SEC received a petition for rulemaking recommending amendments to Regulation 13D-G.

The petition asks the SEC to broaden the definition of beneficial ownership to include interests held by persons who use derivative instruments. The petition also specifically requests that the time period within which initial beneficial ownership reports must be filed be shortened to one calendar day because technological advances have rendered the 10-day window obsolete.

The SEC Chair noted that many feel that the 10-day window results in secret accumulation of securities and material information being reported to the marketplace in an untimely fashion. They also say that it allows 13D filers to trade ahead of market-moving information and maximize profit, perhaps at the expense of uninformed security holders and derivative counterparties. In response, some argue that tightening the timeframe may reduce the rate of returns to large shareholders, thereby resulting in decreased investments and monitoring of and engagement with management. They also maintain that state law developments, such as the validity of poison pills and staggered boards, have tilted the regulatory balance towards issuers.

While disappointed by the DC Circuit decision striking down the proxy access regulation, Chairman Schapiro believes that, as a matter of fairness and accountability, long-term significant shareholders should have a means of nominating candidates to the boards of the companies that they own. She has great faith in the collective wisdom of shareholders to determine which competing candidates will best fulfill the responsibilities of serving as a director. The critical point is that shareholders have the ability to identify alternatives and for all shareholders to make an informed choice.

She noted that, while the appeals court vacated the proxy access rule, it did not impact Rule 14a-8, which will increase shareholder access to the proxy ballot in key circumstances. Shareholders will be able to submit proposals for proxy access at their individual companies, she emphasized, a process known as private ordering.
Rule 14a-8 provides an opportunity for shareholders owning a relatively small amount of a company’s securities to have their proposal placed alongside management’s proposals in the proxy materials.

There are several procedural requirements that a shareholder must satisfy to have a proposal included in the company’s proxy materials, including ownership of at least $2,000 or 1 percent of the company’s securities entitled to be voted for at least one year. Within the parameters of Rule 14a-8, said the Chair, shareholders will now have the chance to ask their fellow shareholders to support a proxy access system at their companies.

Finally, Chairman Schapiro reported that it appears that say-on-pay regulations put in place through Dodd-Frank are leading to improvements in communication in both directions. It has given shareholders a clear channel to communicate to the boards their satisfaction or lack of satisfaction with executive compensation practices. And it is giving boards a powerful incentive to clarify disclosure to shareholders, and to make a coherent case for the compensation plans they have approved.

The regulations require companies to provide shareholders with an advisory vote on executive compensation at least once every three years and an advisory vote on the frequency of say-on-pay votes at least once every six years. In addition, companies must provide a separate advisory vote regarding certain golden parachute arrangements in connection with a merger, acquisition, or other disposition of all or substantially all, assets.

While the outcomes of these votes are not binding on the company, noted the SEC Chair, the advisory vote does let boards know what shareholders think of compensation arrangements. Also, companies are required to quickly report on Form 8-K the results of these votes, she emphasized, and there is tremendous interest in the outcome of these votes.

In addition, companies have to report the decision on the frequency of say-on-pay votes. And, going forward, companies will have to disclose in proxy statements, in the year following the vote, how they have responded to the most recent say-on-pay vote. Chairman Schapiro is heartened that the SEC is beginning to see companies filing proxy statements following say-on-pay votes that are, in fact, responding to these issues.

Corporate Secretaries Society Says Costs of Mandatory Auditor Rotation Outweigh Benefits, Urges PCAOB to Use ``Bully Pulpit''

In a letter to the PCAOB, the Society of Corporate Secretaries and Governance Professionals said that the cost of mandatory audit firm rotation outweighs the benefits. Moreover, the Society believes that mandatory auditor rotation will introduce significant issues that would likely contribute to an actual decrease in audit quality. In the Society’s view, existing Sarbanes-Oxley regulations, including the rotation of the lead audit partner every five years and other audit firm employees with significant involvement in the audit every seven years, adequately addresses the concerns of professional skepticism and ongoing objectivity. Essentially, reasoned the Society, the rotation of audit firm personnel gives the audit a fresh look without disrupting the continuity of audit firm service. The Society was responding to a PCAOB Concept Release on enhancing auditor independence and audit quality.

The Society noted that there would be considerable costs underlying an auditor rotation requirement for both audit firms and public companies at the various stages of the process, including the selection of the new audit firm, the costs of changing firms and finally the costs of rotating the audit firms after a certain amount of time. Each time an audit firm rotation occurs, noted the Society, the company’s audit committee, management and employees in its finance, legal, tax, accounting, and internal audit organizations, across all the jurisdictions in which the company operates, will have to invest significant amounts of time and money to ensure selection of an appropriate new audit firm.

The complex process of evaluating a potential new audit firm includes consideration of numerous factors, including the firm’s reputation; the firm’s knowledge and experience in the company’s lines of business; potential conflicts of interest or independence issues; and the scope of the audit firm’s international network in the countries and regions in which the company operates. According to the Society, the thoughtful consideration of each of these factors in support of the important decision on the best audit firm for a company at a given time would likely necessitate thousands of hours of work and analysis and concomitant expenditures. More broadly, the Society said it would be inefficient to require thousands of company hours every five or ten years to assess an audit firm change, especially when such a change may not be needed or be in the best interests of the company or its shareholders.

Further, once a new audit firm has been retained, observed the Society, a significant amount of company management time is required to provide the successor firm with the information needed to plan its audits and gain familiarity with the company and its accounting policies and methodologies, and its internal controls. The company’s audit committee must maintain an appropriate level of oversight throughout the entire process.

Contrary to the Concept Release’s position that mandatory auditor firm rotation would enhance auditor quality, the Society believes that it will actually harm audit quality. Evidence in the Concept Release indicates that audit quality in the first years of an engagement tends to be lower, and therefore could lead to a greater risk of audit failure. Because the start-up requirements for a new audit, such as gaining familiarity with the client’s particular practices, are significant for an incoming auditor, the ability to conduct the audit with the degree of diligence and thoroughness possible in later years is lessened.

With a mandatory rotation rule in place, reasoned the Society, companies will spend more time in a short-tenure audit situation, and overall audit quality will be negatively impacted. Also, incoming auditors, unfamiliar with the details of a new client’s business, will be less likely to identify fraud or deception. The accumulated experience of a longer audit tenure helps a firm better spot and account for these issues.

The Society also posited that mandatory rotation of external auditors would be an ineffective means of addressing the risk of inadequate professional skepticism, primarily because it fails to consider that professional skepticism is a skill the auditor employs, and instead confuses it with the normal questioning that takes place as a new auditor tries to understand a new client. Professional skepticism is most effectively used by an auditor with a full understanding of the facts and circumstances related to the clients’ businesses, emphasized the governance group, and mandatory rotation of external auditors will not cure this purported problem.

Indeed, continued the Society, there is no foolproof method for ensuring that professional skepticism is maintained throughout the life of an audit firm’s tenure. However, the Society believes that the inspection and enforcement tools that the PCAOB already possesses are sufficient to ensure professional skepticism. These tools provide an effective arsenal to address issues with the firms through monetary penalties, professional penalties and by publicity of failures that would adversely impact their customer base and, ultimately, an audit firm’s ability to retain clients. In this regard, the Society urged the PCAOB to use its “bully pulpit” to speak out on the need for auditor skepticism and thereby heighten sensitivity to the topic.

House Panel Will Conduct Hearings on Use of SEC Consent Judgments in Wake of Citigroup Ruling

House Financial Services Committee Chair Spencer Bachus (R-ALA) and Ranking Member Barney Frank (D-MASS) jointly announced that the Committee will hold a hearing next year to examine the practice by the SEC of settling enforcement actions with defendants that neither admit nor deny complaints made by the SEC. The SEC has proposed to settle a string of recent cases by levying fines without requiring the defendants to admit wrongdoing.

In the most recent case, a federal judge (SD NY) rejected a $285 million settlement between Citigroup and the SEC in November because, the judge said, he could not determine whether the settlement was fair, adequate or in the public interest since the SEC had alleged, but had not proven, that Citigroup committed fraud. Such settlements require approval by a federal judge.

The SEC’s practice of using no-contest settlements has raised concerns about accountability and transparency, noted Chairman Bachus, adding that he is pleased the Committee will examine these concerns in a bipartisan manner. The policy of signing agreements without forcing firms to admit or deny wrongdoing raises serious issues, said Rep. Frank, who expressed his appreciation that Chairman Bachus is moving to address this issue in a bipartisan, cooperative manner.

The timing of the hearing will be announced at a later date, as will the list of witnesses the Committee will call to testify

The court said that the consent judgment 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. SEC v. Citigroup Global Markets, Inc., SD NY, 11 Civ. 7387, Nov. 28, 2011.

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.

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.

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 enforcement action 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.

The SEC will appeal the federal district court’s rejection of the proposed settlement to the US Court of Appeals for the Second Circuit.

In an earlier memorandum to the federal district court, the SEC noted that use and entry of consent judgments has long been endorsed by the US Supreme Court. Lower federal courts have recognized the importance of consent judgments to the SEC’s effective and efficient enforcement of the federal securities laws. In its 1983 ruling in SEC v. Clifton, the DC Circuit noted that, because of its limited resources, the SEC has traditionally entered into consent decrees to settle most of its injunctive actions.

The SEC said that there is nothing unusual or untoward about a consent decree entered into without an admission of wrongdoing by the defendant, and that criticism of consent decrees for not including such an admission is unjustified. Consistent with this standard practice, the SEC has long used consent decrees in which defendants admit no wrongdoing.

Courts have repeatedly recognized the balance of advantages and disadvantages in settlements entered in no admit/deny enforcement actions and have been reluctant to upset that balance, said the SEC. While the defendant is not subject to collateral estoppel with regard to the claims asserted, acknowledged the SEC, investors are able to pursue any available private remedies, in addition to the relief obtained by the SEC. Moreover, the SEC was able to bring the matter to a speedy conclusion, obtain compensation for victims in a timely manner, and allocate limited resources to bring additional enforcement actions for the protection of more investors.