Wednesday, February 29, 2012

US Senator Concerned about Impact of Volcker Regulations on Market Making and Venture Capital Funds

Senator Michael Bennet (D-CO) is concerned that the proposed regulations implementing the Volcker Rule provisions of Dodd-Frank could unintentionally chill basic market making activities, which are explicitly permitted under the Volcker Rule. In a letter to the SEC and banking agencies, he also noted that Congress never intended for venture capital funds to be swept into the embrace of the Volcker regulations.

The Senator pointed out that the proposed regulations highlight seventeen measurements that a financial institution must calculate regarding its market making activities. It also contains a list of qualitative criteria that an institution must satisfy. He pointed out that some aspects of the proposed regulations could potentially work to place an institution at risk of an enforcement action for undertaking proprietary trading even if it satisfies both the metrics and the qualitative criteria.

He urged that the final regulations provide a greater degree of certainty as to what constitutes permissible market making activities. This is particularly important for institutions that are making a good faith attempt to comply with the Volcker Rule. The Senator fears that, without greater clarity on questions of compliance, a final rule may unintentionally disrupt traditional hedging and market making activities.

Similarly, he asked the SEC and other regulators to implement consistent supervisory procedures when enforcing the Volcker Rule. If one regulator determines that a set of transactions constitutes permissible market making, he emphasized, another regulator should not be able to characterize the same set of transactions as improper proprietary trading. The Senator views this kind of coordination as critical for the proper functioning of the financial markets.

On a separate point, he asked the regulators to refine the breadth of the covered fund definition as it pertains to joint ventures and other acquisition vehicles that occur commonly in commercial transactions. The proposal notes that the definition of a covered fund could potentially include within its scope many entities and corporate structures that would not usually be thought of as a hedge fund or private equity fund. The proposal goes on to acknowledge that joint ventures, acquisition vehicles and other widely-utilized corporate structures are generally not used to engage in investment or trading activities.

If the final regulations prohibit companies that are somehow affiliated with insured depository institutions from forming joint ventures or other acquisition vehicles, reasoned the Senator, it may become substantially more expensive and complicated to engage in an otherwise common merger or acquisition. All the while, such a prohibition would have little, if any, bearing on Congress' intended goals of the Volcker Rule.

In his view, the final regulations should also permit financial institutions to invest in venture capital funds. He emphasized that venture capital funds lack the size and interconnectedness of the type of investment vehicles that Congress contemplated in crafting the Volcker Rule. They also play an important role in the economy at a time when it has become increasingly difficult for smaller and mid-size companies to obtain access to capital.

Finally, Senator Bennet said that final regulations should permit insurance companies to obtain ownership interests in certain covered funds for their general accounts. Under various state laws, insurance companies are already required to diversify their investments and are restricted in the categories of investments that they may hold. These various state laws are aimed at minimizing excessive risk taking, which overlap with the goals of the Volcker Rule.

Without such an ability to invest in certain covered funds, noted the Senator, insurance companies may have difficulty finding alternative investment vehicles to fund their products. Such a prohibition may also run counter to the intent of Congress, which sought to exempt insurance companies from the restrictions set forth in the Volcker Rule.

SEC Issues Wells Notices Involving Sub-Prime Mortgage-Backed Securities

A leading global investment banking, securities and investment management firm revealed in its SEC-filed 10-K that it received a Wells Notice from the SEC staff with respect to the disclosures contained in the offering documents used in connection with a late 2006 offering of approximately $1.3 billion of subprime residential mortgage-backed securities underwritten by the firm. In the filing, the firm, Goldman Sachs Group, Inc., said that it will be making a submission to, and intends to engage in a dialogue with, the SEC staff seeking to address their concerns.

The firm has also received, and continues to receive, requests for information and/or subpoenas from federal, state and local regulators and law enforcement authorities, relating to the mortgage-related securitization process, subprime mortgages, CDOs, synthetic mortgage-related products, particular transactions involving these products, and servicing and foreclosure activities, and is cooperating with these regulators and other authorities.

The SEC uses an informal procedure to allow persons under investigation to present their views to the Commission before an enforcement proceeding is authorized. These presentations are referred to as Wells Submissions, named for John A. Wells who headed the SEC’s 1972 Advisory Committee on Enforcement Policies and Practices.

In its annual report to shareholders, another financial institution noted that government agencies continue investigations or examinations of mortgage related practices relating to whether the firm properly disclosed in offering documents for its residential mortgage-backed securities the facts and risks associated with those securities. Wells Fargo also noted that it has received a Wells Notice from SEC staff relating to its disclosures in mortgage-backed securities offering documents. Wells Fargo said that it continues to provide information requested by the various agencies in connection with certain investigations.

Tuesday, February 28, 2012

House Leaders Bundle Crowdfunding, On Ramp and Other Legislative Pieces Together to Create Omnibus JOBS Act

House leaders have bundled together the crowdfunding, on ramp, Regulation D, Regulation A, raising 500-shareholder threshold pieces legislation to create an omnibus Jumpstart Our Business Startups (JOBS) Act that they could bring to the House floor as early as next week. All of the constituent measures composing the JOBS Act have either passed out of committee or passed the House with broad bi-partisan support. Meanwhile, Senate Majority Leader Harry Reid (D-NV) said that the Senate will move forward with its own package of legislation to create jobs and streamline how companies sell stock through IPOs.

A central component of the JOBS Act is the Reopening American Capital Markets to Emerging Growth Companies Act, HR 3606, approved by the House Financial Services Committee by a 54-1 vote. HR 3606 would reduce the costs of going public by providing companies with a temporary reprieve from SEC regulations by phasing in certain regulations over a five-year period. This would allow smaller companies to go public sooner, which directly leads to more job creation within the company. HR 3606 would create a new category of issuers called emerging growth companies, which would retain its status for five years or until it exceeds $1 billion in annual gross revenue or becomes a large accelerated filer.

H.R. 3606 ensures that investors are protected by requiring the emerging growth companies to provide audited financial statements as well as establishing and maintaining internal controls Over financial reporting. The measure also amends Section 404(b) of Sarbanes-Oxley to delay hiring an additional outside auditor to verify the company's internal controls for the five year on ramp period. In addition, the bill would only require emerging growth companies to provide audited financial statements for the two years prior to registration rather than three years, saving the companies millions.

Emerging growth companies would also be exempt from the requirement to hold a shareholder vote at least once every three years on executive compensation packages and golden parachutes. They are also exempt from the requirement to disclose the relationship between executive compensation and financial performance and the ratio of the CEO compensation to the median total compensation of all employees.
Another key component of the JOBS Act is H.R.2940, the Access to Capital for Jobs Creators Act, which would allow small companies offering securities under Regulation D to utilize advertisements or solicitations to reach investors and obtain capital. The SEC’s ban on solicitation, first adopted in 1982, limits the pool of potential investors and hampers the ability of small companies to raise capital, said the House leaders. HR 2940 passed the House by a vote of 413 to 11 last November.

H.R. 2930, the Entrepreneur Access to Capital Act, HR 2930, would remove SEC restrictions Preventing crowdfunding so that entrepreneurs can raise equity capital from a large pool of small investors who may or may not be considered accredited investors by the SEC. H.R 2930 allows companies to pool up to $1 million from investors without registering with the SEC, or up to $2 million if the company provides investors with audited financial statements. Individual contributions are limited to $10,000 or 10 percent of the investor’s annual income,whichever is less. HR 2930 passed the House by a bipartisan vote of 407‐17 last November.

Another piece of the JOBS Act is H.R.1070, the Small Company Capital Formation Act, which would make it easier for small businesses to go public by increasing the offering threshold for companies exempted from SEC registration from $5 million to $50 million. The SEC has the authority to raise this threshold but has not done so for almost two decades. H.R. 1070 passed the House by a bipartisan vote of 421-1 last November. The Act amends Regulation A to make it a viable channel for small companies to access capital and will permit Greater investment in these companies.

Another bill approved by voice vote in the Financial Services Committee has been added to the JOBS Act. The Private Company Flexibility and Growth Act, HR 2167, removes barriers to capital Formation for small companies by raising the shareholder registration requirement threshold from 500 to 1,000 shareholders. Many small businesses are forced to file as a public company because of an SEC regulation requiring companies with 499 shareholders and $10 million in assets to file with the SEC. This current shareholder threshold rule was originally adopted in 1964 and has not been modernized since that time. In the view of the House leaders, this regulation causes undue pressure on the markets because it restricts the number of shareholders and assets these companies can have, which in turn limits the growth stages for companies that need time and flexibility to develop.

HR 4088, The Capital Expansion Act, the House version of S. 1941, would increase the number of shareholders permitted to invest in a community bank from 500 to 2,000.
The measure would enable banks to better deploy their capital to make loans and create jobs.

PCAOB and IAASB Members Disagree at DC Bar Event on Benefits of Int'l Auditing Standards to US Investors

A panel that included SEC and PCAOB officials, as well as an IAASB Member, examined issues surrounding the adoption of international accounting and auditing standards at a recent DC Bar event. Jeff Mahoney, General Counsel, Council of Institutional Investors, moderated the panel discussion. He began by stating that the CII generally supports single sets of high quality global accounting and auditing standards, but does not support replacing US accounting and auditing standards until there are assurances that international accounting and auditing standards and standard setters would be comparable.

PCAOB Member Dan Goelzer noted the Sarbanes-Oxley Act authorized the Board to set auditing standards for public companies. While Sarbanes-Oxley gave the Board to ability to delegate that authority to a private body, he continued, a fundamental and bedrock principle of the Board is that the Board itself would set the auditing standards. The SEC must approve the standards. The PCAOB is accountable to the SEC and, through the SEC, ultimately accountable to investors.

The PCAOB interacts with the IAASB, said Member Goelzer, and seeks to avoid needless inconsistency between IAASB standards and PCAOB standards. But there are times when PCAOB standards and international auditing standards adopted by the IAASB need to be different.

PCAOB staff meets regularly with IAASB staff to discuss standard setting agendas. When adopting standards, the PCAOB staff examines international auditing standards and the Board publishes an appendix in the adopting release comparing the PCAOB standards with IAASB standards.

Member Goelzer said that for the foreseeable future US investors would not benefit from a single set of international auditing standards. While acknowledging that conceptually it would be beneficial if audit meant the same thing cross-border, he noted that the US has a much different legal and securities regulatory system with a higher rate of retail investor participation in the capital markets than other jurisdictions, along with a sophisticated investors protection regime that is supported by PCAOB auditing standards.

Global standards would not necessarily be focused on US securities and regulatory regimes. He noted that international auditing standards are divided into requirements and application material, including non-mandatory guidance. The PCAOB does not draft its standards in that way, he noted, adding that Board standards are drafted in light of internal controls and an integrated audit. In addition, PCAOB audits must be performed with due professional care, said the Member, while international auditing standards do not have a comparable standard of due professional care. Moreover, auditor interaction with audit committees is a key component of the US regime, but is not as important in some jurisdictions using international auditing standards.

Not surprisingly, IAASB Member John ``Arch’’ Archambault said that the adoption of international auditing standards would benefit US investors, adding that the globalization of capital markets means global auditing standards. Investors rely on audited financial information, he noted, and need relevant and comparable information to measure performance. The need for consistent and comparable standards dictates the need for international auditing standards. The quality and rigor of the audit of financial statements should be the same no matter where the audit is conducted.

Mr. Archambault, who is also a member of the PCAOB’s Standing Advisory Group, said that the IAASB is an independent standard setting body that serves the public interest and facilitates the global convergence of auditing standards. It has 18 members and a full time Chair. Each member must annually sign a document that they will act in the public interest. The IAASB standard setting process involves extensive consultation efforts. The Board’s Consultative Advisory Group has a key role in setting auditing standards, providing significant input. The CAG is composed of, among others, the European Commission, IOSCO, and the Basel Committee. The PCAOB is an observer at CAG meetings.

The IAASB’s oversight body, the Public Interest Oversight Board, provides independent oversight of the IAASB to ensure transparency and accountability. The IAASB engages in a rigorous standard setting process, said the Member, with significant input from the CAG. The PIOB reviews the entire process to ensure that due process was followed.

It takes a 2/3 vote of the IAASB to adopt a standard. The IAASB has high credibility with both investors and regulators, he noted, and works closely with the PCAOB.

With regard to the adoption of global accounting standards, Teresa Polley, President and CEO of the Financial Accounting Foundation, FASB’s oversight body, said that the Foundation has had a longstanding joint relationship with the IASB’s oversight body. The end goal of both the FASB and IASB is comparable financial information for investors to facilitate the capital markets and ensure investor protection. She mentioned that some main areas to still be dealt with are revenue recognition, financial instruments, and lease accounting.

Ms. Polley referenced a letter that the Foundation sent to the SEC last year that set forth the appropriate criteria for the good faith evaluation of international standards and the IASB’s standard-setting process in determining whether to incorporate an international standard into U.S. GAAP. The criteria include investor primacy, independent standard setting, a robust and participatory due process, and the clarity and adequacy of guidance. In addition, critical to evaluating whether to issue a new standard is determining that the expected benefit of effecting the proposed changes are cost beneficial and will enhance the body of standards already in place.

SEC Chief Accountant James Kroeker said that the SEC staff is developing a draft proposal for the SEC on US adoption of IFRS. While the staff found strong support for uniformity of accounting standards, the staff also found concern that US interests must be protected. More specifically, the US should have a strong voice in the process of adopting global standards. The Chief Accountant mentioned that the Financial Accounting Foundation and others have raised concerns around the US having a voice up front. The SEC official also said that any framework must deal with existing differences in IFRS and US GAAP, some of which are ingrained, like LIFO accounting. US GAAP allows LIFO accounting, primarily due to US tax code considerations, but the IASB does not.

The Chief Accountant also noted that the IASB and FASB share common objectives of what financial reporting should be about. He added that most jurisdictions adopting IFRS are doing so through an endorsement process. With regard to IASB funding, he observed that the IASB has no ability to levy fees or taxes for its funding. The IASB makes allocations based on the economies largely involved in IFRS and suggests a contribution based on the allocation, but with no enforcement capability. He noted that of the more than 100 countries using IFRS, 30 provide funding to the IASB.

Monday, February 27, 2012

SEC Investor Protection Culture Embedded at PCAOB Says Member Goelzer

Outgoing PCAOB Member Dan Goelzer said that he and other Board Members have tried to instill at the PCAOB the same culture of single-minded focus on the best interests of investors and the same pride in excellence through open and robust debate that have been hallmarks of the SEC. In remarks at the Annual William O. Douglas Award Dinner, Mr. Goelzer, a former SEC General Counsel,noted that the PCAOB is under the SEC's oversight and works hand-in-hand with the Commission to further the interests of the investing public in fair and accurate audited financial reporting.

At a time when confidence in auditing was severely shaken, he continued, the first Board Members were able to tap into the same sense of mission and excitement that the early Commissioners must have felt in the wake of the 1929 crash. But the PCAOB had an advantage that the founders of the SEC did not, he observed, the example and support of the SEC itself. As he prepares to leave the Board, he emphasized the strong commitment of both the PCAOB and SEC to investor protection and full disclosure.

Mr. Goelzer was appointed by the SEC as a founding member of the PCAOB in October 2002. In 2007, the SEC unanimously reappointed him to serve an additional term of five years. He served as Acting Chairman of the PCAOB from August 2009 through January 2011. Throughout his tenure, Member Goelzer has consistently exhibited a strong commitment to the Board's mission to protect the interests of investors and further the public interest in the preparation of informative audit reports.

Mr. Goelzer is Vice-Chair of the International Forum of Independent Audit Regulators (IFIAR), of which the PCAOB is a member. 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 has suggested that these mechanisms could be used to discuss those issues with the large firms.

Wisconsin Issues Private Fund Adviser Exemption

A private fund adviser exemption was adopted, effective February 17, 2012, by administrative order of the Wisconsin securities Division.

COSO Says Updated Internal Control Framework Should Not Change Section 404(b) Attestation

The Committee of Sponsoring Organizations of the Treadway Commission (COSO) has indicated that its updated Internal Controls Framework is not expected to change the underlying assessment and attestation process of Sections 404(a) and 404(b) of Sarbanes Oxley. While the original Internal Controls Framework has proven to be one of the most widely accepted frameworks for designing and evaluating systems of internal control, the COSO Board recently proposed to update the Framework to make it more relevant to stakeholders in the current business environment.

Section 404(a) of Sarbanes-Oxley requires that annual reports filed with the SEC must be accompanied by a statement by company management that management is responsible for maintaining adequate internal controls. In the report, management must also present its assessment of the effectiveness of those controls. In addition, Section 404(b) requires the company's auditor to report on and attest to management's assessment of the company's internal controls.

To capture views of a broad range of professionals in the market place, COSO has formed an Advisory Council representing industry practitioners as well as representatives and observers from government agencies and non-profit organizations to capture views of a broad range of professionals in the market place. The PCAOB and SEC have been invited as observers to attend the Advisory Council meetings and provide input to the project.

The updated Framework should enable more effective application in practice of internal control over operations, compliance and reporting. Certain concepts and discussions are expected to be refined to reflect certain changes in the business environment and in expectations in the market place. However, COSO believes that the principles embedded within the original Framework are timeless.

Thus, the updated Framework is consistent in many respects with the original Framework and includes the same definition of internal control and five components of internal control: control environment, risk assessment, control activities, information and communication, and monitoring activities. Also, the updated Framework continues to apply judgment in developing, implementing and assessing effective internal control. Similarly, the updated Framework retains the three categories of objective: the effectiveness and efficiency of operations, reliability of reporting, and compliance with applicable laws and regulations;

To have an effective system of internal control, each of the five components must be present and operate together in a manner that reduces, to an acceptable level, the risk of not achieving an objective. In addition, the existence of any material weakness or major non-conformity would preclude an organization from concluding that the entity's system of internal control is effective.

While PCAOB auditing standards are neutral regarding the internal control framework that auditors use for testing and evaluating controls, Board standards require auditors to use the same internal control framework that management uses and the overwhelming majority of U.S. public reporting companies use the COSO framework. Changes to the COSO framework would thus have significant implications for audits conducted in accordance with PCAOB standards.

COSO officials told the PCAOB’s Standing Advisory Group that the enhancements to the framework are not intended to alter the core principles of the framework, but to facilitate a more robust discussion of internal controls. Concepts and guidance in the framework will be refined to reflect the evolution of the operating environment and the changed expectations of regulators and other stakeholders. In addition, the enhancements are expected to cover more than financial reporting by considering ways to enrich the guidance on operations and compliance objectives.

Saturday, February 25, 2012

In Letter to Senate Leaders, ABA Urges Legislation Preserving Confidentiality of Privileged Information Provided to CFPB

The American Bar Association supports legislation expressly extending protection for privileged materials submitted to the Consumer Financial Protection Bureau. In a letter to Senator Tim Johnson (D-SD), Chair of the Banking Committee, and Senator Richard Shelby (R-Ala), the Committee’s Ranking Member, the ABA urged swift passage of S 2099 or similar legislation to create a single and consistent standard for the treatment of privileged information submitted to all federal agencies that supervise banks, including the CFPB. S 2099 is co-sponsored by Senators Johnson and Shelby.

Recently, the House Financial Services Committee unanimously approved bi-partisan legislation fixing the omission in the Dodd-Frank Act that opens the door for third parties to obtain privileged information provided by financial institutions to the Consumer Financial Protection Bureau. The legislation, HR 4014, would require the CFPB to preserve the confidentiality of privileged information it receives from financial institutions, as other banking regulators do.

The ABA, working through its Task Force on Financial Markets Regulatory Reform, has developed key principles for financial regulatory reform. S 2099 advances three of those principles: 1) the regulation of financial intermediaries, products, and services should be integrated and comprehensive to protect investors and consumers; 2) functionally similar products and services should be subject to the same or essentially equivalent regulation; and 3) the regulation of the financial services industry should operate in a complementary and coordinated manner.

Currently, privileged materials shared with federal banking agencies remain privileged as to all other parties. Under 12 U.S.C. § 1828(x), the submission by any person of any information to any federal banking agency must not be construed as waiving, destroying, or otherwise affecting any privilege such person may claim with respect to such information under federal or state law as to any person or entity other than such agency.

The creation of the Bureau requires that this statute be updated, said the ABA letter. The term federal banking agency is defined in the Federal Deposit Insurance Act, and that definition does not include the CFPB. Although the CFPB issued guidance asserting that 12 USC 1828(x) applies to its receipt of privileged materials, Bureau Director Richard Cordray has acknowledged that there is real concern over the issue. He expressed support for legislation to resolve any doubt. See testimony of Richard Cordray before the House Subcommittee on TARP, Financial Services and Bailouts, Jan. 24, 2012 and the Senate Banking Committee, Jan 31, 2012.

By explicitly applying the same privilege standards to information submitted to the CFPB that currently apply to any submissions to a federal banking agency, said the ABA, S. 2099 fosters a more integrated, consistent and coordinated approach to the regulation of financial services providers. In particular, the legislation would align current law with past practices by promoting uniform treatment of privileged materials by the Federal banking regulators and the CFPB.

Prior to the creation of the Bureau, noted the ABA, the Federal banking agencies examined depository institutions for compliance with consumer protection laws and such examinations could include the review of privileged materials without causing a waiver of the privilege. See 12 U.S.C. § 1828. Unfortunately, when the Bureau examines the same institutions today for compliance with the same consumer protection laws, there is uncertainty over whether the examination may include the review of privileged materials without causing a waiver of the privilege. S. 2099 would place CFPB examinations on the same footing as prior consumer protection examinations conducted by Federal bank regulators with regard to privilege.

S. 2099 also takes the important step of adding the Bureau to the list of agencies that may share privileged information without causing a waiver. Under 12 U.S.C 1821(t), a covered agency, in any capacity, must not be deemed to have waived any privilege applicable to any information by transferring that information to, or permitting that information to be used by, any other covered agency or any other federal agency.

However, unlike the Federal banking agencies, the Bureau is not yet included in the definition of a covered agency. S. 2099 would make the Bureau a “covered agency” and thereby place it on the same footing as the prudential regulators when it shares privileged information with other covered agencies or other federal agencies referenced in the statute.

According to the ABA, this change makes particular sense in light of the existing statutory requirement that the Bureau and prudential regulators share draft reports of examination with each other. Absent legislation, privileged information within a draft CFPB report could lose its privileged status when shared with the prudential regulators, while privileged information in the draft report of a prudential regulator would remain privileged even after being received by the CFPB. The ABA said that S. 2099 would eliminate this inconsistency.

SEC Chair Says Cross-Border Issues of Dodd-Frank Derivatives Regulation Will Be Addressed in Single Proposal

In the near term, said SEC Chair Mary Schapiro at the PLI SEC Speaks seminar, the Commission will address the most salient international issues of Dodd-Frank OTC derivatives regulation in a single proposal. This will give interested parties an opportunity to consider, as an integrated whole, the SEC’s approach to cross-border transactions and the registration and regulation of foreign entities engaged in derivatives transactions with U.S. parties. Overall regarding implementation of Title VII of Dodd-Frank, the SEC staff is continuing to develop a plan for how the derivatuves regulations will be put into effect. The plan should establish an appropriate timeline and sequence for implementation and avoid a disruptive and costly “big bang” approach.

While some international regulation issues are stand-alone concerns, said the SEC Chair, certain issues cut across the entirety of the implementation of Title VII. Among the most important, given the global nature of the derivatives market, is the international impact of the SEC regulations. Chairman Schapiro said that the SEC is working to coordinate with its foreign counterparts to help achieve consistency among approaches to derivatives regulation. There has been significant progress on the international level. This cross-border approach must strike a balance between sufficient domestic regulatory oversight and the realities of the global market. In that context, she emphasized that a one-size-fits-all approach is neither feasible nor desirable.

On the overall implementation of Title VII, the Chair said that, in the near term, the SEC will complete the last remaining proposals regarding capital, margin, segregation and recordkeeping requirements. And, the agency is already beginning to transition to the adoption phase. As a first step, Commission will soon finalize rules that further define who will be covered by the new derivatives regulatory regime and, next, what will constitute a security-based swap. Finalizing these definitions will be a foundational step, she noted, defining the scope of the new regulatory regime and letting market participants know whether their current activities will subject them to the substantive requirements being adopted. Chairman Schapiro assured that at all stages of implementation those subject to the new regulatory requirements will be given adequate time to comply.

CFTC Commissioner Strongly Criticizes Agency Cost-Benefit Analysis

In a blistering dissent, CFTC Commissioner Scott O’Malia criticized a final rule imposing certain reporting and recordkeeping requirements for swap dealers and major swap participants. In the commissioner’s view, the agency committed “regulatory malpractice” by implementing a major rule without adequate discussion of anticipated costs.

“I have reached a tipping point and can no longer tolerate the application of such weak standards to analyzing the costs and benefits of our rulemakings,” said the commissioner in a prepared dissent. “I believe it is time for professional help.”

According to Commissioner O’Malia, the CFTC must go out of its way to undertake thorough cost-benefit analyses, both qualitative and quantitative, to ensure that new rules do not impose unreasonable costs. This is required, he said, by two Executive Orders (13,563 and 13,579) issued by President Obama in 2011 with the aim of improving regulatory review. Taken together, the orders exhort independent regulatory agencies – a category that includes the CFTC – to comply with the same provisions required of executive agencies.

The commissioner noted that the staff’s own guidance on cost-benefit analysis stated that rulemaking teams should incorporate the principles of the executive orders to the extent they are consistent with the cost-benefit provisions of the CFTC’s authorizing statute, and to the extent “reasonably feasible.” By accepting the low bar of “reasonably feasible,” said the commissioner, the rulemaking was “nothing but unreasonably feeble.”

Commissioner O’Malia singled out two provisions of the final rules for criticism. The new rules require swap dealers and major swap participants to maintain certain audio recordings, and to tag each taped conversation and make it searchable by transaction and counterparty. According to the commissioner, the technological challenges posed are “enormous”, and the agency did not determine whether such technology exists or the cost or feasibility of developing it in the required timetable.

Further, the commissioner objected to the agency’s decision not to allow substituted compliance for recordkeeping requirements. Specifically, the Commission declined some commenters’ request that firms be allowed to rely on swap data repositories (SDRs) for recordkeeping requirements. The reason for this, according to the Commission, is that SDRs are new entities under the Dodd-Frank Act with no track record of operations. However, said O’Malia, if the Commission had doubts as to the reliability of SDR data, it ought not to have relied on it in a previous rulemaking requiring real-time public reporting of swap data. Moreover, the commissioner has concerns about the Commission’s ability to monitor and reconcile two sets of records.

The commissioner’s statement comes in the context of the recent approval by the House Financial Services Committee of legislation directing the SEC to conduct thorough cost-benefit analyses of its regulations and proposed regulations. Under the SEC Regulatory Accountability Act, HR 2038, the SEC would have to ensure the benefits of its regulations outweigh the costs. The legislation was introduced by Rep. Scott Garrett (R-NJ), Chair of the Subcommittee on Capital Markets and Government-Sponsored Enterprises, with 15 original cosponsors.

A similar bill was introduced last year in the Senate by Sen. Richard Shelby (R-AL), Ranking Member on the Banking Committee. The Financial Regulatory Responsibility Act (S. 1615) would require the SEC and CFTC to provide clear justification for the regulations and determine the economic impacts of proposed rulemakings, including their effects on growth and net job creation. In addition, the legislation mandates that if a regulation’s costs outweigh its benefits, regulators are barred from promulgating it.

In addition to legislative action, several recent court cases have challenged SEC and CFTC rulemakings on the basis of cost-benefit analysis. Last July, the United States Court of Appeals for the District of Columbia Circuit struck down an SEC rule on proxy access, finding that the regulator had conducted inadequate cost-benefit analysis.

More recently, a CFTC rule on position limits has been challenged in the District Court for the District of Columbia. Two derivatives industry associations asserted that the CFTC failed to give serious consideration to the costs that the position limits rule will impose on commodity markets and the broader economy. In particular, the bona fide hedging exemption is “unnecessarily narrow”, limiting the ability of market participants to hedge their risks, and infrastructure costs will be substantial. In the view of the associations, the CFTC did not make a genuine effort to estimate these costs, instead citing its failure to obtain empirical data that would enable to assess the economic impact of the rule.

Also last year, the CFTC Inspector General found that the CFTC used a perilous cost-benefit methodology for the adoption of regulations implementing the derivatives provisions of Dodd-Frank. The study found that the CFTC General Counsel played a dominant role in the cost-benefit analysis to the derogation of the CFTC Chief Economist, which has been a perilous path for other federal rulemakings. The study recommended an enhanced role in cost benefit analysis for the Chief Economist.
In the rulemaking dissent, Commissioner O’Malia indicated that he would follow up his statement with a letter to the Director of the OMB seeking an independent review of the new rules to determine wither the rulemaking fully complies with the President’s Executive Orders and OMB guidance found in OMB Circular A-4.

This post was contributed by my colleague Lene Powell

Friday, February 24, 2012

European Federation of Accountants Supports PCAOB’s Reproposed Standard on Communications with Audit Committee

The PCAOB’s reproposed standard on communications with the audit committee introduces enhancements that better enable the audit committee to carry out its monitoring role based on the information received from the auditor, noted the European Federation of Accountants. In a letter to the Board, the Federation emphasized that a fruitful two-way dialogue with the company’s audit committee is an important part of the work of an outside auditor of financial statements, and any initiative to strengthen this cooperation is beneficial to both parties.

The Federation believes that the global alignment of auditing standards to the maximum degree possible is beneficial for capital market participants with cross-border interests. The reproposed standard introduces a closer alignment with the equivalent international audit standards issued by the IAASB, for instance in relation to the emphasis on two-way communication. However, an even closer alignment could further enhance the communication between the two parties.

The use of professional judgment in audits is indispensable, said the federation, enabling the auditor to make informed decisions about the appropriate course of action during the audit. The requirements related to the communication with audit committees in the reproposed standard continue to appear prescriptive and rules-based, although some flexibility has been introduced. Therefore, the risk of limiting the auditor’s ability to exercise professional judgment in deciding on the most appropriate and efficient way of communicating with the audit committee remains.

Although the reproposed standard remains essentially rules-based rather than principles-based, noted the group, quite a lot of guidance and explanation relating to the application of particular requirements is provided in material accompanying the draft standard. The FEE urged the Board to put some of the guidance in the standard itself in order to ensure consistent application of the standard, such as the timing, form, and documentation of communications.

The original proposal included the evaluation of the adequacy of the two-way communication. This particular point is not taken forward in the reproposed standard as the PCAOB considers it duplicative of requirements in other PCAOB standards. Although this may be the case, the Federation believes that the requirement to carry out such evaluation of the adequacy of the communication is an essential part of the quality review of the two-way communication from the viewpoint of the auditor. Thus, the group does not support the proposed deletion, since the auditor should make an assessment of whether improvements to the communication can be introduced to enhance the effectiveness of the audit.

The requirement to disclose details of the composition of the engagement team and others participating in the audit has been expanded compared to the original proposal. While such information could be relevant to disclose to the audit committee, the Federation said that the appropriate balance between useful information and boilerplate disclosure must be found. The Federation supports the proposal, but recommended that the scope of the disclosure be reduced to only significant work performed by another external auditor or a person involved in the audit, and that it not be supplemented by details, such as the percentage of hours. Further, clarification of how the requirement relates to the definition of engagement team is needed to ensure that the disclosures are consistent from one company to another.

The PCAOB is proposing to use the term ``could be substantial doubt’ in relation to going concern evaluations. In contrast, Section 10A of the Securities Exchange Act requires the auditor to perform `` an evaluation of whether there is substantial doubt about the ability of the issuer to continue as a going concern" In the view of the Federation, the proposed PCAOB wording might set too low a threshold. In this context, the PCAOB was urged to use the SEC term of “substantial doubt" or alternatively, include further clarification of what "could" is intended to mean in this context.

Massachusetts Adopts Private Fund Adviser Exemption

A new private fund adviser exemption was adopted by the Massachusetts Securities Division, along with amendments to the "qualified institutional buyer" definition and IA custody requirements. Please note that while the amendments took effect February 3, 2012 they will be not be enforced until August 3, 2012, giving investment advisers six months to comply.

ECOFIN Approves Regulation on Short Selling and Credit Default Swaps

The EU Economic and Financial Affairs Council adopted a Regulation on short selling and credit default swaps that contains common EU disclosure requirements and harmonizes the powers that regulators may use in exceptional situations where there is a serious threat to financial stability. The Regulation covers all types of financial instrument, but given the potential risks posed by short selling, this form of trading is a central element to be governed by the new rules. The Regulation also provides for notification of significant positions in credit default swaps that relate to EU sovereign debt issuers.Having been approved by ECOFIN and the EU Parliament, after publication in the Official Journal, the new Regulation can enter into force before the end of the year.

For significant net short positions in shares of EU listed companies, the Regulation creates a two-tier reporting model. At a lower threshold, positions must be reported privately to regulators so that they can detect and investigate short sales that might constitute abuse or create systemic risks. At a higher threshold, positions must be disclosed to the market in order to provide useful information to other market participants. For sovereign debt, significant net short positions relating to issuers in the EU will always require private disclosure to regulators.

Short selling is a practice whereby investors sell a security that they do not own but whose delivery is promised, with the intention of buying it back later. If the security price drops, the short sellers, after having bought back the securities in question, profit from the price difference. Short selling could roughly be divided into two types: covered short selling, where the seller has borrowed the security, or made arrangements to ensure they can be borrowed before the short sale is done; and uncovered (or naked) short selling, where at the time of the short sale the seller has not borrowed the securities or ensured they can be borrowed.

To mitigate the greater risks created by uncovered short sales, the Regulation provides that anyone entering into a short sale must at the time of the sale have borrowed the instruments, entered into an agreement to borrow them or made other arrangements to ensure they can be borrowed in time to settle the deal. These restrictions do not apply to the short selling of sovereign debt if the transaction serves to hedge a long position in debt instruments of an issuer. Furthermore, if the liquidity of sovereign debt falls below a specified threshold, the restrictions on uncovered short selling may be temporarily suspended by the regulator.

In exceptional situations regulators may temporarily require further transparency or restrict short selling and credit default swap transactions. In such a situation the European Securities and Markets Authority (ESMA) would coordinate action between regulators to ensure that measures are truly necessary and proportionate.

The Regulation will contain highly speculative financial market transactions in government bonds and credit-default swaps. The Parliament fought for very strict conditions for short selling to contain destructive speculation. The new transparency rules will help stabilize financial markets, said Markus Ferber MEP who is responsible for the Regulation on short selling and CDS for the EPP Group.

Short selling of uncovered credit-default swaps for government bonds will be subject to the strictest cirteria. Only if the liquidity in the market for government bonds comes to a standstill will exemptions be possible. Respective applications will have to be endorsed by ESMA. According to Mr. Ferber, this means a de-facto ban on the short selling of uncovered credit default swaps on government bonds. This is crucial as the speculative potential currently possible can lead and has lead to the artificial decrease of the value of certain government bonds, said MEP Ferber.

Credit default swaps can be used as an insurance against the default of government bonds. However, they can also be used to speculate against the value of government bonds. With uncovered credit default swaps, market participants do not possess the financial instruments, they have only borrowed them. Mr. Ferber emphasized that it is logical that CDS on government bonds are meant for investors who actually have the respective government bonds. All else is pure market speculation that can have incalculable effects, he said, and should therefore be contained.

Thursday, February 23, 2012

SEC Charges China-Based Executives with Securities Fraud and Internal Control Violations Involving Company Created by Reverse Merger

In an enforcement action, the SEC charged two China-based executives with defrauding investors into believing they were investing in a Chinese coal business when in fact they were investing in an empty shell company created through a reverse merger. Among other things, the SEC alleged that the company’s former CEO falsely certified in financial statements filed with the SEC that he had disclosed to the company’s auditors and audit committee all significant deficiencies and material weaknesses in the design or operation of the company’s internal controls and. any fraud, whether or not material, that involved management or other employees who had a significant role in the company’s internal controls. According to the SEC’s complaint, the company entered the U.S. capital markets through a reverse merger, with the company’s common stock listed and traded on the NYSE Amex from September 2009 to August 2011. (SEC v. Ming Zhao and Liping Zhu, SD NY, Feb 22, 2012, Civ. No. 12-CV-1316, Litigation Release No. 22264)

The SEC alleged that the company’s board chair schemed with the former CEO to steal and sell the company’s sole revenue-producing asset, a coal mining company. The chair secretly transferred the company’s controlling interest in the mining company to himself and then sold a substantial portion to a fund controlled by what is reported to be China’s largest state-owned financial firm. The scheme enabled the executive rather than the company’s shareholders to profit from a lucrative business opportunity and left the company a shell company with no ongoing business operations. The SEC also alleged that the two senior executives failed to disclose these transactions in periodic reports to the SEC, and continued to raise funds from U.S. investors by conducting two public offerings.

The SEC charged the board chair and the former CEO with violations of the antifraud provisions, as well as violating the proxy solicitation rules and various corporate reporting, recordkeeping and internal controls provisions of the Exchange Act. The SEC’s complaint seeks a final judgment ordering the senior officers to disgorge their ill-gotten gains plus prejudgment interest, imposing financial penalties, barring them from acting as officers or directors of a public company, and permanently enjoining them from committing future violations of these provisions.

The SEC also said that the company’s outside auditor during the time of the events sent the company a letter resigning from the engagement and stating that further reliance should no longer be placed on its previously issued audit reports for the company’s fiscal years ended December 31, 2009 and 2010. In its resignation letter, the audit firm stated that the company had made representations to it that were materially inconsistent with the share transfers made by the board chairman.

The SEC’s Cross Border Working Group, which has representatives from each of the SEC’s major divisions and offices and focuses on U.S. companies with substantial foreign operations, has assisted the New York Regional Office enforcement staff in the investigation. Over the past year, the SEC has moved to protect U.S. investors in U.S. companies with substantial foreign operations through trading suspensions of at least 20 U.S. issuers based abroad; stop orders against two U.S. issuers based abroad to prevent further stock sales under materially misleading and deficient offering documents; and filing a subpoena enforcement action against a foreign-based audit firm to obtain documents.

Wednesday, February 22, 2012

In Letter to SEC, House Members Reaffirm that Volcker Rule Restrictions Were Not Intended for Venture Capital Funds

Congress did not intend for the Volcker Rule restrictions in the Dodd-Frank Act to apply to venture capital funds, according to fifteen House Members. In a letter to the SEC and banking agencies, the House Members noted that Congress treated venture capital funds different than hedge and private equity funds in the legislation because of the unique characteristics of their investment model. Consistent with this intent, the House Members urged the SEC and other regulators to use the flexibility in the Dodd-Frank Volcker Rule provisions to avoid restricting access to venture capital funds and other types of illiquid funds.

Venture capital funds are uniquely different from hedge funds and private equity funds. They are not highly leveraged, have set fund terms, said the House Members, and are usually invested in private companies. These characteristics mean that investment in venture capital funds do not pose a danger to safety and soundness or create systemic risk.

Section 619 of Dodd-Frank, the codified Volcker Rule, limits financial institutions from investing in or sponsoring hedge funds and private equity funds. But Congress clarified that these statutory restrictions were not intended for venture capital funds. The text of the statute refers solely to hedge funds and private equity funds, specifically leaving out venture capital funds. The House Members reminded that the fact that Section 619 was not intended to apply to venture capital funds was affirmed by a colloquy between Senator Chris Dodd (D-CT) and Senator Barbara Boxer (D-CA) that took place as the Senate was debating the Dodd-Frank Act conference committee report.

According to then Senate Banking Chair Chris Dodd, the purpose of the Volcker Rule is to eliminate excessive risk taking activities by banks and their affiliates while at the same time preserving safe, sound investment activities that serve the public interest. It prohibits proprietary trading and limits bank investment in hedge funds and private equity for that reason. The colloquy between Chairman Dodd and Senator Boxer revealed that properly conducted venture capital investment will not cause the harms at which the Volcker rule is directed. (Cong. Record, July 15, 2010, S 5904-5905).

Section 619 explicitly exempts small business investment companies from the rule, and because these companies often provide venture capital investment, the intent of the rule is not to harm venture capital investment. In the event that properly conducted venture capital investment is excessively restricted by the provisions of Section 619, Chairman Dodd expects the appropriate federal regulators to exempt it using their authority under Section 619 (d)(1)(J).

Senator Boxer noted the crucial and unique role that venture capital plays in spurring innovation, creating jobs and growing companies. She said that it is not the intent of Congress that the Volcker rule should cut off sources of capital for technology startups, particularly in this difficult economy.

Tuesday, February 21, 2012

UK FSA Will Move to Twin Peaks Regulation Ahead of New Regulatory Regime

Starting April 2, the UK Financial Services Authority will realign into a twin peaks model of regulation paralleling the new financial regulatory system that will take effect next year. In remarks to the British Bankers Association, FSA CEO Hector Sants said that for the rest of the year the FSA will move as close as possible to the new style of regulation outlined in the government’s White Paper. Namely, that firm- specific supervision for banks, insurers and major investment firms will be carried out by two separate entities, one for prudential and one for conduct regulation.

The White Paper announced a plan to transfer prudential supervision for banks, insurers and major investment firms to a new Prudential Regulation Authority, and rename the FSA the Financial Conduct Authority, which will focus on consumer protection and market regulation. These actions will create a twin peaks style regulatory model in the UK. The current expectation is that the move to the new structure will occur early in 2013, noted the official, but this timetable is dependent on the successful passage of proposed new legislation, the Financial Services Bill, which was introduced in late January and is currently moving through the legislative process.

Meanwhile, the FSA must operate within the current legal framework of the Financial Services and Markets Act and thus cannot entirely replicate the approach set out in the White Paper. However, Mr. Sants emphasized that the FSA will move as close as possible to that model in order to ensure that the cutover to the actual oversight by the PRA and FCA is as smooth as possible.
Under the new model, there will be two independent groups of supervisors for banks, insurers and major investment firms covering prudential and conduct. All other firms, such as those not dual regulated, will be solely supervised by the conduct regulators. The supervisors will make their own, separate, set of regulatory judgments against different objectives.

In addition, under the doctrine of independent but coordinated regulation, the conduct and prudential regulators will coordinate internally to maximize the exchange of information which is relevant to their individual objectives. But they will act separately when engaging with firms.
The FSA will retain the principle of seeking to ensure that regulatory data is only collected once. In that regard, the common, current data infrastructure will be retained.

More broadly, the FSA official said that the move to twin peaks is an opportunity to drive home and further embed the move to forward-looking, proactive, judgment-based regulation. The regulator will move from the old style reactive approach to the new style proactive approach. The essence of a judgment-based approach is a willingness to intervene when the regulator decides that the outcomes will, in the future, be at variance to its mandate, even if the firm does not agree. This type of proactive intervention needs to be proportionate and justified.

The objective of the prudential group will be closely aligned with that of the coming Prudential Regulatory Authority. The overarching objective is to seek to ensure the safety and soundness of firms and to avoid disorderly failure with systemic consequences.

Similarly, the conduct group’s objective will be aligned as closely as possible with that of the Financial Conduct Authority. The overarching aim here is to ensure that markets work well by protecting consumers and protecting and enhancing the integrity of markets. Essentially, this can be distilled into three objectives, said Mr. Sants, a fair deal for consumers, fair and resilient markets, and minimizing the possibility that firms may be used for financial crime. The new conduct group within the FSA will not, however, be required to take into account the new responsibilities and powers that the pending legislation is proposing for the FCA. .

Finally, the senior official said that the new regulatory approach will abolish box ticking regulation, which was rooted in the old FSA’s conduct agenda and the days of better regulation and light touch regulation, which essentially meant that regulators were seeking to avoid second guessing management. The FSA believed that it would be sufficient to give consumers risk information at the point of sale and to seek to ensure that firms could demonstrate that they had the right systems and controls in place to ensure consumers were treated fairly.
This focus on ensuring firms had the right systems and controls and right management information led to a proliferation of requests and to the regulator being swamped by data and information. The focus was not on the outcomes experienced by consumers but on the firm’s controls. The official emphasized that in future the focus will be on whether the firms’ judgments and in particular their business models deliver good outcomes for consumers.

Illinois Replaces References to NASD with FINRA

References to the Financial Industry Regulatory Authority (FINRA) replace existing references to the National Association of Securities Dealers (NASD) throughout the Illinois securities rules, to reflect the official name of the organization that now regulates broker-dealers and investment advisers, effective February 8, 2012. Other adopted changes by the Securities Department include restating that the CRD, not the IARD, is the electronic database for receiving investment adviser representative filings and fees; specifying that new and re-registration applications for investment advisers or IA branch offices, along with re-registrations for investment adviser representatives and re-notifications for federal covered investment advisers, annually expire at the end of the day on December 31; amending the language of the grandfathering provision of the exam requirement for investment adviser principals and representatives, from “on the effective date of this section” to “on May 1, 2000,” replacing legalese, e.g., “hereunder,” “such,” and “which,” with plain English, e.g., “the” or “that,” and substituting current terms or dates for outdated references.

Monday, February 20, 2012

Amsterdam Appeals Panel Approves Settlement of Securities Action for non-US Exchange Purchasers

The Amsterdam Court of Appeal approved settlement agreements of a securities fraud action for non-US exchange purchasers because the settlements are reasonable in all aspects, are in the best interests of all non-US shareholders, and fully satisfy the requirements under Dutch law for approval. A US federal judge had earlier approved a settlement agreement with US exchange purchasers. (SCOR Holding (Switzerland) AG Securities Litigation, Amsterdam Court of Appeal, Jan. 17, 2012)

During the period of 7 January 2002 through and including 2 September 2004, Converium Holding AG, which is now known as SCOR Holding (Switzerland) AG) announced reserve increases in its North American business of approximately USD 526 million, including a 20 July 2004 announcement that it would take a charge of up to USD 400 million to increase reserves in its North American business. The price of the company’s common stock declined after the 20 July 2004 announcement. The action alleged that the company and certain of its officers allegedly disseminated false and misleading statements during this period of time regarding the company’s financial condition, including the adequacy of loss reserves in its North American business, which alleged misstatements and omissions purportedly had the effect of artificially inflating the price of the company’s securities.

The total amount that is available under the agreements for the non-US exchange purchasers is (before deduction of costs and fees) USD 58,400,000. That sum is proportionally considerably lower than the settlement payment for the smaller group of US exchange purchasers (USD 84,600,000), who found themselves in a comparable position to the non-US exchange purchasers insofar as it concerns their alleged loss. According to petitioners, the justification for this difference may be found in the fact that the US federal district court (SDNY) excluded the non-US exchange purchasers from participation in the class, so that they have no effective course of justice for validating their potential legal claims.

The Amsterdam panel noted that the events to which the compensation pertains took place in the period 2002-2004 and, since then, outside of the United States no litigation has been brought to obtain compensation. Petitioners, submitting reports by experts, have pointed to the various factual and legal circumstances that impede obtaining such compensation in court proceedings outside of the United States. Leaving aside whether and to what extent those circumstances render the acquiring of compensation impossible, the appeals court found it plausible that they will form a real obstacle for many non-US exchange purchasers to
have their potential claims awarded in court outside of the United States.

In view of their being excluded from participation in the US class, continued the panel,it is not plausible that they would still have effective remedies to this end in the United States. It may thus be assumed that the legal position of the non-US exchange purchasers is essentially different to that of the US exchange purchasers. This also means that there is no unacceptable difference in the treatment of equal cases.

The appeals court also pointed out that non-US exchange purchasers who still want to bring their claims to court have the possibility of opting out of the binding nature of the agreements by issuing an opt-out statement, so that they are at liberty to bring individual litigation. However, it is more plausible that in view of the time and the costs and the risks that are associated with conducting individual litigation many of the non-US exchange purchasers will not bring litigation and therefore would not receive any compensation at all if the settlement agreements are not approved. Moreover, the non-US exchange purchasers will in relative terms, certainly in comparison with conducting individual litigation, receive the awarded compensation with ease and speed and against no or very mincosts.

In letter to SEC, Bill Gates Emphasizes Need for Strong Regulations on Dodd-Frank Resource Extraction Provisions

It is critical to ensure that the final regulations implementing the Dodd-Frank provisions on the disclosure of payments by resource extraction issuers are strong and robust and in keeping with Congressional intent, said Bill Gates in a letter to the SEC. Mr. Gates is particularly interested in these regulations in light of the report on financing for development that he presented to G20 leaders last year in which he referred to the U.S. government's important lead role in enacting legislation requiring exchange-listed mining and oil companies to disclose payments to governments and recommended that other G20 countries follow the U.S. government's lead and endorse legally binding transparency requirements. In his view, transparency of financial flows is critical to ensuring that valuable natural resources in Africa and elsewhere are transformed into public benefits.

Section 1504 requires companies to report the type and total amount of payments made for each project as well as the type and total amount of such payments made to each government.

The legislative intent of Section 1504 is clear, posited Mr. Gates, to make publicly available and easily accessible the detailed information on the payments companies engaged in the commercial extraction of oil, gas, and mining resources made to governments around the world, country by country, project by project, and payment type by payment type.

These provisions are consistent with and should reinforce the U.S government's long-standing policy against corruption, such as the Foreign Corrupt Practices Act, which details the obligations of corporations doing business in the U.S. to refrain from the bribery and corruption of overseas officials.

According to Mr. Gates, a primary goal for the disclosure of payments by resource extraction issuers is to make this information available to citizens when their own government denies them access. It is in the most secretive jurisdictions that corruption, poverty, and instability flourish, he noted, and the risk to investors is greatest. He stressed that any exemption from reporting payments to governments that object to such disclosure would defeat a primary purpose of the Dodd-Frank provision.

It is also important to seek disclosure below the country level. In his view, project level reporting will give both citizens and investors valuable information. Defining the term "project" in the regulations as activities in a particular geologic basin or province would be of limited use to both citizens and investors. This concept also has no relation to how companies actually make payments to governments. Royalty rates, tax payments, cost recovery, tax holidays, and the like are defined in laws, leases, and licenses, not by geologic basin. Defining projects in an artificial manner would increase compliance costs while greatly reducing the benefits to users, he noted, and would require companies to create new databases
unrelated to how they currently pay most taxes.

Finally, and more broadly, Mr. Gates said that the SEC has a mandate to implement final regulations reflecting the intent and reporting requirements established by. Congress, adding that such regulations would be consistent with emerging international practice, and reinforce a competitive and level playing field for U.S. corporations and foreign companies.

Hedge Fund Industry Comments on ESMA Proposed Standards under EU Short Selling Directive

In a letter to the European Securities and Markets Authority, the Managed Funds Association urged ESMA to provide additional flexibility in the technical standards implementing the EU Regulation restricting transactions in short sales and credit default swaps. The Regulation, (2010) 0482, was approved recently and will be immediately and directly applicable in all Member States from November 1, 2012, with no possibility for Member State regulators to interpret or implement the Regulation in a way which fits local circumstances. With that in mind, the MFA asked that ESMA be given time to consult with market participants on the issues and seek additional relevant data, such as the frequency of settlement fails for short sales. The letter was signed by former US Rep. and House Capital Markets Subcommittee Chair Richard Baker, who is currently MFA President.

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

In its comments, the MFA accepted that, in the case of shares, information on the exact percentage of holding and equivalent number of shares would provide competent authorities with useful information as well as an opportunity to conduct checks on the accuracy of calculations. In this regard, MFA broadly agrees with the format of the net short position fields in the Notification Form for Net Short Positions annexed to the draft technical standards.

However, the MFA believes that, for the purposes of public disclosure, the net short position size should be rounded down to one decimal place rather than two, as suggested in the draft. This approach would follow the language and the legislative intent of Article 6 of the Regulation more closely. The thresholds contained in Article 6 are expressed in one decimal point format, said the hedge fund association, which indicates that the legislative intent was to monitor the variations of 0.1% and not positions in between. ESMA did not identify any public policy reasons as to why disclosure of position in two decimal point format would be preferable. Thus, the MFA believes that it would be disproportionate for ESMA to require public disclosure in that format.

The MFA agreed that there should be one standard form for public disclosure of information on significant net short position in shares. Similarly, the association agreed that there should be one standard format for notifying relevant competent authority for each type of instrument.

The MFA is concerned with the binary nature of the assessment of whether a share is a “liquid share” and thus whether it falls within the Standard Same Day Locate Confirmation and Measures or the Liquid Shares Locate Confirmation and Measures. In the MFA’s view, these should be collapsed into what is currently proposed to be the Liquid Shares Locate Confirmation and Measures, but with a different name to remove the reference to Liquid Shares.

In addition, the MFA believes that the proposed definition of a “liquid share” from the Market in Financial Instruments Directive (MiFID) would not be appropriate in the context of locate arrangements. The liquid shares concept in MiFID was introduced for the purposes of pre- and post-trade transparency, such as provisions relating to disclosure of firm quotes in liquid shares and publication of share turnover statistics. In the context of short sale transactions and the trading of securities in general, however, what may be considered to be liquid can change from day to day. For example, a share that may be liquid under the MiFID definition may in fact be extremely illiquid at the time of the short sale transaction due to a merger announcement or other corporate event.

As a practical matter, reasoned the MFA, the approach that a locate provider uses, such as a prime broker in relation to a hedge fund, is fundamentally the same regardless of liquidity of the relevant shares. There is no simple line that can be drawn between liquid shares and illiquid shares; instead, there is a spectrum with liquid shares at one end, then hard to borrow shares and finally extremely hard to borrow shares at the other end.

A useful indicator of where the share falls in that spectrum is the cost that the locate provider charges the investor for the locate, which reflects the cost of borrowing such shares from other parties in order for the locate provider to satisfy its obligation to the investor. The MFA believes that the locate provider should make the assessment of the relative liquidity or illiquidity of shares available to it, to settle an investor’s sale, whenever it provides a locate to an investor. In doing so, the locate provider should have regard to the relevant criteria, including the cost that the locate provider is charging the investor and the daily sources of supply of such shares available.

Sunday, February 19, 2012

Senators Urge SEC to Quickly Finalize Conflict Minerals Regulations and Require Companies to File Not Furnish Reports

Urging the SEC to quickly implement the conflict minerals disclosure provisions of the Dodd-Frank Act, Senators Patrick Leahy (D-VT) and Christopher Coons (D-DE) emphasized that the final regulations must require company conflict minerals reports to be filed with the Commission not furnished. In a letter to the SEC, the Senators also advised that the filed reports should contain enough substantive information so that investors can understand what actions a company has taken to make a reasonable country of origin inquiry. Reports that do not clearly list a company's activities, they said, and SEC regulations allowing a category of ``indeterminate’’ would undermine the congressional intent of Section 1502 of Dodd-Frank. The letter was also signed by House Members Jim McDermott (D-WA) (a co-author of Section 1502), Harold Berman (D-CA), Gregory Meeks D-NY), Donald Payne (D-NJ) and Karen Bass (D-CA).

Section 1502 of the Act requires companies that report to the SEC to disclose the measures they use to certify that their products do not contain conflict minerals. Companies also have to track their supply chains back to a mineral's origin.

The Senators and House Members have become very concerned about the outlines of the final regulations under Section 1502, in particular that the Commission will approve a rule that contravenes Congress's legislative intent and does not require the conflict mineral reports to be filed with the SEC, but instead allows them to be furnished. The Commission's misreading of legislative history and congressional intent, they said, were made clear in meetings with the SEC and what they described as the ``alarming’’ report of June 13, 2011 by the SEC Inspector General stating that SEC staff had determined the transparency provisions of Section 1502 did not protect investors.

According to the lawmakers, it was clarified during the legislative process, meetings with the SEC, and in written comments to the Commission that Section 1502 was designed as a transparency measure to provide investors with the information they needed to make informed choices. Accountability in the reporting of conflict minerals is critical to both investors and to capital formation, they posited, and this is well documented in comments on Section 1502 by investment companies, investment advisors, and thousands of individual investors.

Even beyond the submissions, they continued, it is of deep material interests to investors when a public company relies on an unstable black market for inputs essential to manufacturing its products. Protecting investor interests by making companies liable for fraudulent or false reporting of conflict minerals is critical. Thus, the reports must be "filed," not "furnished."

The Senators pointed out that the need to adhere to congressional intent was further emphasized in the recently passed FY 2012 Omnibus Appropriations measure's Financial Services Explanatory Statement (based on Senate Report 112•79), which stated that the Committee expects the clear congressional intent of Section 1502 to be implemented in a timely manner.

In addition to the issues of divergence from congressional intent, the Senators are also concerned about the economic cost estimate contained in the final regulations. They advised that the SEC’s cost estimate should only rely on those submitted estimates that use credible and publicly cited data, methodologies that rely on practices of companies in the field, and comparisons to costs of truly similar regulations.

Finally, they are heartened that Section 1502 has started to have its intended effects. The black market is being curtailed, there is now transparent mining at considerable scale, militia disengagement has accelerated, overall violence has abated, and investors and consumers arc getting better informed. They noted that proactive companies have found that understanding their supply chains is manageable and considerably less complex and less expensive than they had first projected.

Despite positive change on the ground, however, the lack of final SEC regulations is having negative consequences. The SEC's inaction is undermining the policy goals of Section 1502. Further, it has slowed the establishment of transparent supply chains as good actors hesitate. Thus, in addition to the need to follow congressional intent, it is critically important that the SEC quickly finalize the regulations implementing Section 1502.

With strong final regulations in place, reasoned the Senators, companies will become more comfortable engaging, investors will have the accountability essential to sound capital formation, the smuggling that has emerged will become less economically viable, and the people of Central Africa will benefit from further reduced violence and increased economic opportunities.

UK FRC Report Examines Adequate Explanation for Comply or Explain Corporate Governance Code

As a debate rages in the EU over what constitutes an adequate explanation for a company’s deviation from a provision in a comply or explain corporate governance code, the UK Financial Reporting Council issued a report setting forth the attributes of an adequate explanation. The consensus is that a meaningful and adequate explanation should set the context and historical background, should give a convincing rationale for the action the company is taking, and should describe mitigating action to address any additional risk and to maintain conformity with the relevant Code principle. Also, the explanation should indicate whether the deviation from the Code’s provisions was limited in time and when the company intended to return to conformity with the Code’s provisions. Ideally, explanations should be sufficiently full to meet the needs shareholders who cannot not simply call up the company and ask for information, said the FRC, and also serve as the foundation for further dialogue with large shareholders.

It was also noted that the comply or explain concept is more about mindset and culture than box ticking. There is no absolutely right answer. But there is a general recognition that explanations and corporate governance reporting generally should be specific to the company’s position, not generic boilerplate or off the shelf. The report emphasized that a company was still in compliance with the corporate governance code if it chose to deviate from one or more of its provisions and made a full and ample explanation. Explanations should also apply to deviations from the provisions of the Code, not to deviations from its main principles, which companies are expected to apply. Companies have to deliver on the main principles, which are not negotiable. However, the principles are expressed in general terms which allowed some latitude in their implementation.

The FRC rejected the European Commission proposal in a recent Green Paper for making corporate governance statements regulated information within the meaning of the Transparency Directive. This would mean that regulators rather than shareholders would have the task of deciding whether an explanation was sufficiently complete. The FRC believes strongly that explanations are directed to shareholders and it is up to them to decide whether to accept or reject explanations. For this to work, the market needs to develop and maintain a clear understanding of what constitutes an explanation. If regulators have a role it should be in support of shareholders rather than as a substitute for them.

The Green Paper itself goes some way to offering a definition by stating that companies should state clearly which corporate governance code rules they have not complied with, explain the reasons for each case of non-compliance and describe the solution they adopted instead. In the FRC’s view, a critical question is what exactly is meant by the word reason. It might, for example, be possible for a company to argue that the reason why it has combined the role of chairman and chief executive was simply that the board considered that this was the right thing for the company. That would be a reason in a technical sense, acknowledged the FRC, but the UK Governance Code demands that companies in this position explain how they have applied the principle that there should be a clear division of responsibilities at the head of the company and that no individual has unfettered powers of decision.

The FRC also posited that companies which offer a coherent explanation of their corporate governance approach are more likely to find that their explanation in a comply or explain situation is readily acceptable when they do choose to deviate from a particular provision of the Code. Thus, companies were urged to clearly articulate how their governance arrangements support their business model.

The report contribute to a growing consensus in the EU that the comply or explain approach can deliver greater transparency than formal regulation. For example, German officials have been skeptical of regulatory oversight of explanations. The German Corporate Governance Code Commission expressed concern with regard to the proposal for public monitoring of the quality of a company’s explanation when it does not comply with a corporate governance code recommendation. The Commission has fundamental reservations regarding a review by public authorities under a voluntary comply-or-explain code. German officials believe that monitoring by the authorities runs counter to a best practices Code. Either the markets and shareholders will react to deviations from the Code or they will not, they reason, and monitoring by the authorities will not change that dynamic.

Friday, February 17, 2012

House Members Urge SEC to Promptly Adopt Strong Regulations Implementing the Extractive Industry Revenue Transparency Provisions of Dodd-Frank

Rep. Barney Frank (D-Mass) and thirteen other House Members have urged the SEC to promptly adopt strong and effective regulations implementing the extractive industry revenue transparency mandate in Section 1504 of the Dodd-Frank Act. In a letter to the SEC, the Members said that the Commission should resist industry pressure to start the rulemaking process anew or release a watered down rule that does not reflect the legislative intent of Section 1504. They emphasized that public disclosure of extractive industry revenues and how they flow from industry to governments is fundamental to improving governance, curbing corruption, improving revenue management, and allowing greater accountability from governments for spending that serves the public interest. While sympathetic to the challenges the SEC faces due to capacity constraints, the Members are concerned that the Commission is far behind in meeting the statutory deadline of April 17, 2011 to adopt final regulations on Section 1504.

Section 1504 requires companies to report the type and total amount of payments made for each project as well as the type and total amount of such payments made to each government. This language clearly intends for project and government to represent different levels of payment reporting, said the Members, which means "payment" cannot be considered synonymous with "government" or "country." Thus, payments should not be allowed to be reported only at an aggregate, country level. The House Members rejected the suggestion by some commenters that a project could be defined in the same way as country for payment reporting purposes. While Congress entrusted the SEC to find the best fitting technical definition of project, the lawmakers clarified that a project is not equivalent to a country, and not an aggregate of all activities in a country or a geologic basin.

Indeed, the House Members viewed as ``deeply misguided’’ the idea that "project" could be defined by the SEC as all activities in a geologic basin. Multiple companies often conduct activities in a single geologic basin, they acknowledged, but Section 1504 requires disclosure by each resource extraction issuer and does not allow aggregation of payments by multiple companies. In addition, geologic basins may span more than one country, and in such cases, reporting at a geologic basin level would violate both the clear and separate company-by-company and the country-by-country requirements of Section 1504.

Further, any project definition should require the disclosure of payments on the level at which rights and fiscal obligations are assigned, which the Members understand to be the lease or license in the case of many payment streams. They endorsed the Department of Interior's request in its letter of August 4, 2011, which asks the SEC to support a project definition that is tied to a specific lease, which is the norm in the United States.

The final regulations should also define the terms "project" and "payment" in ways that do not create reporting loopholes, emphasized the House Members, particularly with regard to the threshold amount for reporting. Section 1504 requires any payment to be disclosed as part of country and project-level disclosures, except if it is de minimis.

Section 1504 does not reference materiality in regards to which payments or projects are to be disclosed. Congress knows how to impose a materiality requirement when it wants to, said the Members, noting that the Exchange Act contains numerous instances where Congress chose to qualify an otherwise required disclosure by the term material. Since Congress did not do so here, the Members believe that any inclusion of materiality to limit payments or projects to be disclosed would be in violation of Section 1504.

On the definition of de minimis, if the SEC were to provide a specific monetary threshold below which payments are not required to be reported, it would be very important not to set this threshold too high, posited the Members, as that would leave important payment streams undisclosed as well as encourage companies and governments to structure payments in future contracts in a way that would avoid the disclosure requirement.

The Members urged the SEC to make Section 1504 requirements applicable to all companies that raise capital in U.S. markets and report to the SEC, with no exemptions. In particular, companies should not be exempted from the reporting requirements by virtue of their status as foreign companies, nor should contractual provisions or foreign legal prohibitions be allowed to preempt US law.

More broadly, the Members said that extractive industry revenue transparency will be of great value to investors as they assess the commercial, political and reputational risk faced by companies in often volatile locations. In addition, this kind of mandatory disclosure can help diminish the political instability caused by opaque governments, which is a clear threat to investment. Since extractive industries are capital-intensive and dependent on long-term stability to generate returns, transparency of payments made to a government can help mitigate political and reputational risks and also allow shareholders to make informed assessments of opportunity costs, threats to corporate reputation, and a company's dependence on such ventures.

House Panel Approves Legislation Managing SEC Rulemaking Process and Directing Regulatory Review

The House Financial Services Committee approved legislation directing the SEC to conduct thorough cost-benefit analyses of its regulations and proposed regulations. Under the SEC Regulatory Accountability Act, HR 2038, the SEC must ensure the benefits of its regulations outweigh the costs. The legislation was introduced by Rep. Scott Garrett (R-NJ), Chair of the Subcommittee on Capital Markets and Government-Sponsored Enterprises, with 15 original cosponsors.

The SEC Regulatory Accountability Act would require the SEC to abide by President Obama’s executive order that government agencies conduct robust cost-benefit analysis to ensure that the benefits of any rulemaking outweigh the costs, and that both new and existing regulations are accessible, consistent, written in plain language, and easy to understand. As an independent agency, the SEC is not required to follow the executive order. While Chairman Mary Schapiro has indicated that she intends for the SEC to abide by the order, the legislation is designed to codify that executive order and require her and future SEC Chairmen to abide by it.

Specifically, the SEC Regulatory Accountability Act requires the SEC to clearly identify the nature of the problem that a proposed regulation is designed to address, as well as assess the significance of that problem, before issuing a new rule. Additionally, the bill requires the SEC to utilize the Office of the Chief Economist to conduct the cost-benefit analysis of potential rules to ensure that the regulatory consequences on economic growth and job-creation are properly accounted for. The legislation also directs the SEC to review its regulations and orders periodically to determine their efficacy and whether to modify or repeal them.

An amendment offered by Rep. Gary Miller (R-CA), and approved by the Committee, would require the SEC to explain in its final rule the nature of comments received, including those from industry or consumer groups on the potential costs or benefits of the proposed rule and provide a response to those comments and the reasons that the SEC did not incorporate those industry or group concerns on costs or benefits into the final rule.

An amendment offered by Chairman Garrett and Rep. David Schweikert (R-AZ), and approved by the Committee, would require an assessment of any unintended or negative consequences the SEC foresees may result from the regulation.

Maine Releases Private Adviser Interim Order

An interim order exempting private fund advisers was issued by Maine's Office of Securities, effective February 16, 2012, until a private fund adviser rule can be proposed. Persons employed by or associated with exempt private advisers are, themselves, exempt from investment adviser and investment adviser representative registration.

To qualify for the exemption, investment advisers providing advice only to qualified private funds defined in SEC Rule 203(M)-1 must: (1) maintain a place of business in Maine; (2) not hold themselves out generally to the public as investment advisers; (3) not be subject to "bad boy" disqualification provisions under Rule 262 of federal Regulation A; and (4) send the Office of Securities SEC-filed reports and amendments required for exempt reporting advisers under SEC Rule 204-4. Other requirements are specified in the Order.

Thursday, February 16, 2012

House Panel Approves Bi-Partisan Legislation Creating On Ramp for Emerging Growth Companies

The House Financial Services Committee approved legislation seeking to promote job creation and further economic growth by making it easier for more companies to access capital markets by reducing the cost of going public for small and medium size companies. The Reopening American Capital Markets to Emerging Growth Companies Act, H.R. 3606, which passed by an overwhelming bi-partisan vote of 54-1 is sponsored by Rep. Stephen Fincher (R-TN) and John Carvey (D-DE). HR 3606 would create a new category of issuers, called emerging growth companies.

Under the Act, SEC regulations for emerging growth companies will be phased in over a period of five years or until the company becomes large enough to afford the regulatory costs traditionally associated with going public. This temporary reprieve from costly regulations will allow smaller companies to go public sooner in their life cycle. According to its sponsors, the legislation would apply scaled regulations for emerging growth companies without compromising core investor protections or disclosures.

The legislation creates a new category of issuers, called emerging growth companies, with annual revenues of less than $1 billion and following the initial public offering, less than $700 million in publicly traded shares. Exemptions for these on ramp status companies would end either after five years, or when the company reached $1 billion in revenue or $700 million in public float. The bill mirrors legislation introduced by a bipartisan group of U.S. Senators.

The measure also amends Section 404(b) of Sarbanes-Oxley to delay hiring an additional outside auditor to verify the company's internal controls for the five year on ramp period. In addition, the bill would only require emerging growth companies to provide audited financial statements for the two years prior to registration rather than three years, saving the companies millions.

The legislation would also make it easier for potential investors to get access to research and company information in advance of an IPO. This is critical for small and medium-sized companies trying to raise capital that have less visibility in the marketplace, said Rep. Fincher. Currently, there are regulations in place that make it difficult for investors to find the detailed research reports they need to make an informed decision about new companies.

Emerging growth companies would also be exempt from the requirement to hold a shareholder vote at least once every three years on executive compensation packages and golden parachutes. They are also exempt from the requirement to disclose the relationship between executive compensation and financial performance and the ratio of the CEO compensation to the median total compensation of all employees.

The Committee unanimously approved a Fincher-Carney Manager’s Amendment that made technical changes to the legislation and, in part, reflects discussions with the SEC and the FASB oversight body. Among other things, the amendment clarifies the definition of emerging growth company, makes the legislation prospective only, and makes accounting corrections.

An amendment offered by Rep. David Schweikert (R-AZ), and approved by the Committee, would direct the SEC to conduct a study examining the transition to trading and quoting securities in one penny increments, also known as decimalization. The study must examine the impact that decimalization has had on the number of initial public offerings since its implementation relative to the period before its implementation. The study must also examine the impact that this change has had on liquidity for small
and middle capitalization company securities and whether there is sufficient economic incentive to support trading operations in these securities in penny increments. Within 90 of enactment, the SEC must submit a report to Congress on the findings of the study.

The Schweikert Amendment also provides that if the Commission determines that the securities of emerging growth companies should be quoted and traded using a minimum increment of greater than $0.01, the Commission may by rule, not later than 180 days after the date of enactment, designate a minimum increment for the securities of emerging growth companies that is greater than $0.01 but less than $0.10 for use in all quoting and trading of securities in any exchange or other execution venue.

An amendment offered by Chairman Garrett, and approved by the Committee, directs the SEC to analyze the registration requirements of Regulation S-K and determine how they can be updated to modernize and simplify the registration process and reduce the costs for emerging growth companies. Within 180 days, the SEC must report on this review of Regulation S-K and recommend how the registration process can be streamlined to make it more efficient and less burdensome for emerging growth companies.

An amendment offered by Rep. Edward Royce (R-CA) raising the Section 404(b) exemption to companies with less than $1 billion market cap was withdrawn based on assurances from Committee leaders that there would be an opportunity to place the expanded exemption in another piece of legislation. Committee Vice Chairman Jeb Hensarling (R-TX) said that it is proper to reexamine the correct threshold for Section 404(b) compliance, but that this may not be the moment.

An amendment offered by Rep. Jim Himes (D-CT) that would have amended the definition of emerging growth company from a company with less than $1 billion in sales to one with $750 million or less was rejected. Another Himes amendment that would have directed the SEC to require disclosure of a symbol or some other kind of identifier so that investors could identify an emerging growth company was also rejected. Rep. Fincher said that such an identifier could serve to stigmatize an emerging growth company.

An amendment offered by Rep. Keith Ellison (D-MN) that would have deleted the emerging growth company exemption for shareholder advisory votes on executive compensation was also rejected. However, the Committee approved an Ellison Amendment that requires an emerging growth company that terminates its status as such to conduct a shareholder advisory vote on executive pay at the one year period beginning on the date the issuer is no longer an emerging growth company. In the case of an emerging growth company that had that status for less than two years after the first sale of common equity securities pursuant to a Securities Act registration statement, the shareholder advisory vote must be held on the three-year period beginning on such date. The Amendment deals with Rep. Ellison’s concern that, under the original bill, an emerging growth company could go eight years before conducting its first shareholder advisory vote on executive compensation.