Monday, April 30, 2012

NASAA Opposes "Watered Down" Private Placement Disclosures

The North American Securities Administrators Association (NASAA) has expressed disappointment at FINRA's partial amendment to a proposed rule that would require FINRA members and associated persons that offer or sell certain private placements to provide relevant disclosure to each investor prior to sale. Although generally supporting FINRA’s efforts to increase disclosures of information to investors in private offerings through proposed Rule 5123, NASAA believes that the amendments to the rule do not provide material gains in the area of protecting investors and are insufficient to promote confidence in the markets. In a comment letter to the U.S. Securities and Exchange Commission on April 23, 2012, NASAA wrote that state securities regulators view the partial amendment as "highly watered down" and a step in the wrong direction towards dealing with fraud in Regulation D and other private placements.

NASAA reminded the SEC that improving investor protections and preventing fraud promotes confidence in the market, which in turn creates the foundation for improving capital formation. NASAA expressed disappointment, therefore, that the proposed amendment does not take a strong stand to improve investor protections. In particular, FINRA's partial amendment does not address concerns raised by state regulators in NASAA's comment letter of November 17, 2011 regarding the initial proposal.

NASAA stated that the proposal lacks substantive review of private placements by any regulator, while the exemptions to the proposed rule are too extensive.  NASAA also questioned FINRA's retreat from efforts to expand the "85 Percent Rule" currently found in FINRA Rule 5122 (Private Placements of Securities Issued by Members), which requires that at least 85 percent of a "Member Private Offering" may not be used to pay for offering costs and compensation, and must be used for business purposes disclosed in the offering document.

Additionally, Rule 5123 does not require firms to disclose the risks associated with private placements, and fails to address the fact that persons acting as finders may still be subject to state registration requirements. Finally, NASAA believes that the confidentiality provisions in the proposal should not outweigh investor protection and should not be used to prohibit information sharing with the states.

NASAA observed that FINRA itself has acknowledged that there are significant concerns about private placements. In a letter to the SEC that responded to public comments on the initial proposal, FINRA had stated that it received over 1100 complaints in 2011 concerning private placements, and that it had over 250 open investigations of these matters. FINRA also noted that in 2010, state regulators brought over 250 actions involving Rule 506 or Regulation D offerings.

Statements in Alleged Ponzi Scheme Satisfied “In Connection With” Requirement

The 10th Circuit affirmed a multi-million judgment for the SEC against the operator of an alleged Ponzi scheme. As alleged, the defendant and his firm defrauded multiple investors by representing that their money would be placed in low-risk financial instruments. Rather than making these investments, the defendant allegedly used the funds to cover personal expenses, pay prior investors and engage in high-risk real estate lending. In the process, the defendant allegedly commingled investor funds, fabricated account statements, refused investors’ inquiries about their money, misled investors about his affiliation with a financial-planning firm, gave promissory notes as collateral for investment funds and gave investors bogus financial product-information sheets.

The court rejected defense claims that there were no statements made in connection with a purchase or sale of securities. The “in connection with” requirement should be broadly interpreted to cover any fraud that coincides with a securities transaction, stated the court. The fact that the defendant did not actually sell or buy any securities was not dispositive. The fact that the defendant took investor funds under the pretense that it would be invested in safe securities such as mutual funds was sufficient.

In addition, the court noted that the defendant gave investors promissory notes to finance investments. Under these circumstances, the notes constituted securities and the transactions were subject to the antifraud provisions of the securities laws.

The 10th Circuit panel also found no error in the refusal of the district court to allow the defendant to withdraw his Fifth Amendment privilege claim. Generally, courts will often allow withdrawal when the claimant was unaware of the consequences, including adverse inferences, of taking the Fifth, and the opposing party has other sufficient sources of evidence. However, in this case, the circumstances of the “invocation of the Fifth Amendment reveal that he was using the privilege to manipulate the litigation process.”

The court affirmed the judgment for the SEC, finding that the defendant was liable for disgorgement of $2,059,077 in investor funds, a civil penalty in that amount, and $597,426 in prejudgment interest, for a total judgment of $4,715,580.


SEC v. Smart (No. 11-4134)


.

Sunday, April 29, 2012

Senators Harkin and Brown (OH) Urge Regulators to Exempt Insurance Company Investments in Hedge Funds from Volcker Rule


Senators Sherrod Brown (D-OH) and Tom Harkin (D-Iowa) have urged the SEC and banking regulators to exempt from the Dodd-Frank Volcker Rule regulations insurance companies directly engaged in the business of insurance when making purchases consistent with State insurance laws in hedge funds and private equity funds. In a letter to the regulators, the Senators noted that the Dodd-Frank Act exempts from the proprietary trading prohibition insurance companies that are: (1) subject to state insurance regulation; (2) making investments from their general account; and (3) complying with home-state insurance investment laws, regulations and guidance. But the exemption in the proposed regulations do not extend to state-regulated insurance companies' general account investments in hedge funds or private equity funds. 


The Senators said that the final regulations should treat certain insurance company investments in these funds using money from their general accounts in a manner consistent with Congress' intent. These investments, when conducted by state-regulated companies, can be an appropriate and important part ofan insurer's investment strategy. 

The Senate Committee Report on Dodd-Frank stated that one goal of the Volcker Rule provision is appropriately accommodating the business of insurance within insurance companies subject to State insurance company investment laws. In light ofthis statement, the key test should be whether an investment is permitted by State insurance company investment law. Provided that investments in hedge and private equity funds are permissible under state law, said the Senators, they should be permitted under the Volcker Rule. 

Friday, April 27, 2012

SEC Posts Final Rules Defining Key Security-Based Swaps Terms

The SEC has posted the 644 page text of a rulemaking release adding Exchange Act definitions of key terms for security-based swaps. These rules were adopted unanimously at the Commission’s open meeting on April 18, 2012. The swaps and security-based swaps definitions were jointly issued with the Commodity Futures Trading Commission, following consultation with the Fed. The Commission also has issued a FactSheet describing key provisions. The rules are effective 60 days following publication in the Federal Register, although some CFTC final and interim rules have separate compliance dates and comment periods.

NASAA Urges FINRA to Expand BrokerCheck Disclosures

The North American Securities Administrators Association (NASAA) has urged FINRA to expand the scope of information provided on BrokerCheck, FINRA's online tool to help investors check the professional background of securities firms and brokers. In a comment letter today regarding FINRA Regulatory Notice 12-10, NASAA noted that a gap exists between the information that is provided in BrokerCheck reports and the snapshot reports from the Central Registration Depository (CRD) that are provided to the investing public by state securities regulators.

NASAA believes that reports generated from the BrokerCheck system should include all of the information that a CRD snapshot would provide, absent a compelling reason to do otherwise. For example, NASAA believes that BrokerCheck reports should include such information concerning a broker’s educational background, continuing education history, and CRD/IARD filing history, as well as the reason for and comments related to a broker’s termination. Additionally, NASAA believes that FINRA should discontinue the practice of placing time limits on disclosure, such as the 10-year limit on the inclusion of bankruptcies in BrokerCheck reports.

NASAA also recommended that, where an associated person or firm has been involved in an arbitration involving an allegation of a sales practice violation, BrokerCheck include a link to statements of claim, answers, and the final decision, regardless of whether a complainant has received a favorable ruling. NASAA observed that similar information involving civil litigation is publicly available in courthouses across the country. Although BrokerCheck does currently provide a link to arbitration awards, access is limited to final awards against associated persons.

Missouri Proposes Private Fund Adviser Exemption

proposed private fund adviser exemption to replace Missouri's current de minimis exemption in light of the Dodd-Frank Act's elimination of the federal exemption at Section 203(b)(3) was announced by the Securities Division in it's latest advisory release.  

Broker-Dealers Temporarily Exempted from Recordkeeping, Reporting and Monitoring Requirements of Rule 13h-1

The SEC temporarily exempted registered broker-dealers from the requirements of new Exchange Act Rule 13h-1 dealing with large traders by extending the end of April 2012 compliance date to provide broker-dealers with additional time to comply with the recordkeeping, reporting and monitoring requirements. The compliance date has been extended to May 1, 2013, except for certain broker-dealers that: (1) are large traders or (2) have large trader customers that are either broker-dealers or that trade through a “sponsored access” arrangement, for which the Commission is extending the compliance date to November 30, 2012.

In addition, the Commission is exempting certain transactions from the definition of the term “transaction” provided in Rule 13h-1(a)(6), but for the sole purpose of determining whether a person is a large trader.

Rule 13h-1 requires certain broker-dealers to, among other things, maintain specified records of transactions that they effect, directly or indirectly, for large traders, and to provide these records to the SEC on request. Registered broker-dealers who are themselves large traders or carry accounts for a large trader or an unidentified large trader must also report to the SEC, upon request, certain required transaction information on these persons whose activity is equal to or greater than the specified reporting activity level.

The Financial Information Forum, an industry group representing a variety of broker-dealers and other market participants, and the Securities Industry and Financial Markets Association had approached Commission staff seeking an extension of the compliance date and substantive relief. The SEC concluded that an extension of the compliance date would provide it with an opportunity to work with market participants to more fully examine the implementation issues raised by FIF, assess the appropriateness of any exemptive relief and allow broker-dealers time to develop, test and implement the necessary systems changes once the examination of implementation issues was complete.

The SEC also exempted from the definition of a “transaction,” for the sole purpose of determining whether a person is a large trader: (1) any transaction that is part of an offering of securities by or on behalf of an issuer, or by an underwriter on behalf of an issuer, or an agent for an issuer, whether or not such offering is subject to registration under the Securities Act, regardless of whether such transaction is effected through the facilities of a national securities exchange; and (2) sales of securities by a selling shareholder in connection with an initial public offering or in a registered secondary offering if such selling shareholder is a current or former employee of the issuer and the securities being sold were acquired as part of the person’s compensation as an employee of the issuer.

According to the SEC, this limited exemption will continue to ensure that Rule 13h-1 provides a mechanism for the Commission to gather data on persons that conduct a significant amount of secondary market trading in NMS securities, while providing limited relief to issuers and selling shareholders who would not otherwise meet the definition of large trader in the absence of these capital market transactions. Because such transactions typically are infrequent in nature and are distinguishable in character from the secondary market activity that is the focus of Rule 13h-1, the SEC believes that it will be able to identify large traders while reducing burdens on issuers and selling shareholders and thereby assist in the promotion of capital formation.

FSA Official Urges SEC and Other Regulators to Clarify Impact of Volcker Rule Proposed Regulations on UK Covered Bond Market


UK Financial Services Authority officials are concerned that, in the absence of clarification, the proposed regulations implementing the Dodd-Frank Volcker Rule provisions may unintentionally interfere with U.K. covered bond structures and as a result have potential negative implications for U.K. banks and possibly the U.K. economy more widely. In a letter to the SEC, CFTC and the banking agencies, David Lawton, Acting Director of Markets, said that the proposed regulation prohibiting banking entities from sponsoring or retaining as principal an ownership interest in a covered fund, and/or entering into a transaction with a related covered fund for which it serves as sponsor, investment manager or investment advisor could apply to U.K. covered bond structures given the wide definition of "covered fund" which, in the absence of further clarification, could potentially include the asset pool owners in UK covered bond structures; and the points of connection between U.K. banking entities and U.K. asset pool owners.

Moreover, some of the transactions entered into by the issuing bank may be interpreted as a "covered transaction" with a covered fund for the purposes of section 23A of the US Federal Reserve Act. The UK official also noted that asset pool owners could also fall under the definition of " banking entity" since the issuing bank is typically one of the asset pool owner's members. The UK FSA does not believe it is the intention of the regulations to interfere with UK covered bond structures or indeed covered bond structures in other jurisdictions, but these uncertainties, if not appropriately addressed, could adversely impact the ability of U.K. banks to finance thcmselves through covered bond transactions.

The FSA official urged the SEC, CFTC and banking agencies to clarify the scope of U.K. covered bonds under the proposed regulations. A lack of such clarification will serve to create uncertainty for market participants, he reasoned, which would be detrimental for these institutions. In particular, special focus should be given to the definitions of "covered fund" and "banking entity" to ensure that these derinitions do not inadvertently capture the asset pool owners in covered bond structures. 

Covered bonds are a type of secured bond that is usually backed by mortgages or public sector loans. In the U.K., regulated covered bond structures involve a separate special purpose vehicle which holds the collateral pool and guarantees payments under the covered bonds pursuant to a guarantee which is secured over such pool (the asset pool owner). In order for such covered bonds to achieve the intended economic effect of holding dual recourse, to both the bank issuing the instrument and the collateral pool, the issuing bank (which would fall under the definition o["banking entity" under the proposed Volcker regulations, enters into a number of transactions with the asset pool owner. This includes transactions where the bank takes on credit exposure to the asset pool owner (e.g. through derivatives and securities lending transactions, provision of loans and/or investment in securities of the asset pool owner). 

Thursday, April 26, 2012

House Passes Legislation Extending Dodd-Frank Swap Exemption


The House passed by an overwhelming bi-partisan vote legislation to ensure that smaller financial institutions can continue to provide and use risk management tools that facilitate the flow of credit throughout the economy. The Small Business Credit Availability Act, HR 3336, would amend the Commodity Exchange Act to clarify that insured depository institutions and Farm Credit institutions will not be swap dealers to the extent the institution enter into swaps with customers seeking to manage risk in connection with an extension of credit by the institution.

The Act would amend the Commodity Exchange Act to exclude from the definition of financial entity small banks, savings associations, farm credit system institutions, non-profit cooperative lender controlled by electric cooperatives and credit unions with aggregate uncollateralized outward exposure plus potential outward swap exposure less than $1 billion.

Section 1a(49)(A)(iv) of the Dodd-Frank Act provides that in no event shall an insured depository institution be considered to be a swap dealer to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer. It is common for banks, for example, to lend at variable rates to commercial customers, and in connection with that loan, provide an interest rate swap so that the customer is able to achieve a fixed rate on the loan. The swaps in connection with loans' exemption included in the swap dealer definition was intended to permit banks to continue providing this service to their customers without being designated as swap dealers. Congress recognized that the efficiency created by pairing these transactions facilitates the flow of credit.

H.R. 3336 extends the exemption to farm credit institutions that provide similar services to their customers but that do not fall within the definition of insured depository institution. In addition, the bill clarifies that the exemption is to be applied when the institutions enter into swaps in connection with an extension of credit, and that it is not limited to a swap that is provided exactly at the point of origination and only when the credit extended to the customer is a loan. This clarification is intended to accommodate common transactions between small and mid-size banks and farm credit institutions and their customers whereby the swap may be provided before or after the credit is originated, and when the credit may be in the form of a guarantee, or letter of credit, for example, rather than just a traditional loan.

In the CFTC's proposed rule `End-User Exception to Mandatory Clearing of Swaps,' the CFTC did not propose to provide an exemption as authorized by Congress. In order to ensure that small financial institutions are afforded the relief that Congress intended, H.R. 3336 requires the CFTC to exempt small financial institutions that have exposure that is less than $1 billion in current uncollateralized exposure plus potential future exposure. Collectively, small banks engage in only a fraction of the swaps activity in the U.S. banking system. In fact, 25 of the largest bank holding companies hold 99.86% of the total notional held by all banks in the U.S., leaving only .14% of the total notional spread across the remaining 1,046 banks. House Committee Report No. 112-390.

The legislation is necessary to ensure that small and mid-size financial institutions can continue to provide important hedging tools to small businesses, and that the banks themselves can continue to use swaps to hedge their own interest rate risk. The bill acknowledges and upholds the important relationship between risk management tools and the flow of credit in the economy. At the same time, there are important safeguards in place to prevent any small financial institution from engaging in speculative or highly risky activity, or to engaging in swaps to a level that their positions could pose a threat to the financial system. House Committee Report No. 112-390.

US Senators Say Regulations Implementing Dodd-Frank Volcker Rule Must Be Finalized This Summer

Stating that the Volcker Rule is a critical protection to help ensure that a financial crisis of such magnitude does not happen again, 22 US Senators said that the regulations implementing the Dodd-Frank Volcker Rule provisions must be finalized this summer. In a letter to the SEC and the banking agencies, the Senators, led by the co-authors of the Volcker Rule provisions Senators Calr Levin (D-MI) and Jeff Merkley (D-OR), said that, while the proposed regulations ate not perfect, they should not be delayed or scrapped.  Rather, the Senators urged the regulators to adopt the best elements from the proposed regulations; eliminate loopholes; draw clear lines based on objective data and observable markets; strengthen CEO and board-level accountability and public disclosure; and provide coordinated and consistent enforcement, including data sharing by regulators.

The financial institutions that will be directly impacted by the Volcker Rule have already had nearly two years to realign their businesses to comply with the broad contours of the rule, noted the Senators, and many have already taken steps to do so.  The statute itself provides for an additional two years,  extendable up to five years, for financial firms to come into compliance with the Volcker Rule.  During the period, additional guidance may be offered as new data becomes available or with with respect to particular provisions that may require deeper analysis, for example, prohibited conflicts of interest or high-risk trading strategies.  Setting out this guidance now is the path to providing industry, investors, and taxpayers the certainty they want regarding how this important firewall will be applied, emphasized the Senators.

US capital markets will be the stronger under the Volcker Rule, they noted. With fewer conflicts of interest and more reliable market-makers, said the Senators, US financial markets will be healthy and vibrant, just as they were when the Glass-Steagall Act protected the financial system. But the SEC and the banking regulators need to fulfill the statutory mandate, concluded the Senators.

House Leaders Introduce Legislation Creating SRO for Investment Advisers


House Financial Services Committee Chairman Spencer Bachus (R-AL) and Rep. Carolyn McCarthy (D-NY), a leading member of the Committee, introduced bipartisan legislation to create a self-regulatory organization for the more efficient and effective oversight of the retail investment advisory industry. Chairman Bachus and Rep. McCarthy introduced their proposal in response to an SEC study that revealed the agency lacks resources to adequately examine the nation’s nearly 12,000 registered investment advisers.  As part of its study, which was a requirement of the Dodd-Frank Act, the SEC recommended a self-regulatory organization as one option for Congress to consider as it looks for ways to help the agency monitor the industry. The Bachus-McCarthy bill would authorize one or more self-regulatory organizations (SROs) for investment advisers funded by membership fees.
Investment advisers and broker-dealers often provide indistinguishable services to retail customers, noted the Chairman, yet only 8 percent of investment advisers were examined by the SEC in 2011 compared to 58 percent of broker-dealers. Noting that the average SEC-registered investment adviser can expect to be examined less than once every 11 years, Chairman Bachus said this level of oversight is not acceptable.
The Investment Advisers Oversight Act of 2012 would amend the Investment Advisers Act to provide for the creation of National Investment Adviser Associations (NIAAs), registered with and overseen by the SEC.  Investment advisers that conduct business with retail customers would have to become members of a registered NIAA.  The SEC would have the authority to approve the registration of any NIAA. The legislation also permits the SEC to suspend or revoke an NIAA’s registration, or censure or impose limits on an NIAA’s activities and operations, if the SEC finds that the NIAA has violated the Advisers Act, SEC rules or its own rules.  The SEC would also be able to suspend or revoke an NIAA’s registration if the association has failed to enforce compliance with any provision by an NIAA member firm or associated person. 
The legislation would require the SEC to determine whether an NIAA has the capacity to carry out the purposes of the Advisers Act and to enforce compliance by its members and their employees with the Advisers Act, the SEC’s rules, and the NIAA’s rules before the association can register as an NIAA. 
The measure also recognizes the authority given to the states over small investment advisers in Title IV of the Dodd-Frank Act by preserving state authority over investment advisers with fewer than $100 million in assets under management, so long as the state conducts periodic on-site examinations. 
Under the measure, the SEC must determine that the NIAA’s rules are designed to prevent fraud and protect investors; are consistent with the Advisers Act and fiduciary duties under the Act and state law; and do not impose any burden on advisers that is not in the public interest or for investor protection. The Commission must also determine that the SRO provides for periodic examinations of members and their related persons, and for coordination of those examinations with the SEC and state securities authorities. The SRO must also assure a fair representation of the public interest and the investment adviser industry in its selection of directors and administration of its affairs, and provide that a majority of its directors do not come from the securities industry. Finally, the SEC must assure itself that the SRO rules provide for equitable allocation of dues and fees and establish appropriate disciplinary procedures for members and their associated persons.

Wednesday, April 25, 2012

SEC Chair Tells House Panel that SEC Rulemaking Teams Working on Complex JOBS Act Implementing Regulations

SEC rulemaking teams have been working on the proposed regulations to implement the Jumpstart Our Business Startups Act (JOBS Act), enacted on April 5, 2012, which makes significant changes to the federal securities laws, SEC Chair Mary Schapiro told the House Financial Services Committee. The teams include staff from across the SEC, including economists from the Division of Risk, Strategy and Financial Innovation. These teams are beginning to prepare proposed rules with economic analyses to recommend to the Commission to implement the various provisions of the JOBS Act. Some of the JOBS Act’s provisions became effective immediately upon enactment, while others require extensive Commission rulemaking, in some cases under what Chairman Schapiro described as very tight deadlines.

Among other things, the JOBS Act alters the initial public offering process for securities of a new category of issuer, called an emerging growth company, and provides exemptions for such companies from various disclosure and other requirements generally for up to five years following their initial public offerings. The ACT also requires the Commission to modify the prohibition against general solicitation and general advertising in Rule 506 of Regulation D and Rule 144A under the Securities Act. It also requires the Commission to provide exemptions under the Securities Act for crowdfunding offerings and unregistered public offerings up to $50 million. The Act increases the number of shareholders a company can have before it must register under the Securities Exchange Act, and changes the Exchange Act thresholds for registration and deregistration for banks and bank holding companies.

The SEC Chair also told the House panel that the rulemaking required for implementation of many new JOBS Act provisions will be complex. Additionally, the JOBS Act requires the Commission to undertake a number of studies and complete several reports. Because many of the rulemakings, studies, and reports are subject to near-term deadlines, she noted, resources will need to be shifted to these projects. Longer term, certain of the changes in the federal securities laws caused by the JOBS Act will require ongoing staff resources, including for the review of confidential draft registration statements submitted by emerging growth companies and supervision of intermediaries in crowdfunding transactions.

H&R Block Subsidiary Enters Into Multi-Million Dollar Subprime Settlement

The SEC charged Option One Mortgage Corporation, a subsidiary of H&R Block Inc., with misleading investors in several offerings of subprime residential mortgage backed securities (“RMBS”). To settle the SEC’s fraud charges, Option One, now known as Sand Canyon Corporation, agreed to pay over $28.2 million.

Option One originated, sold and serviced subprime mortgage loans. In 2006 and 2007, Option One was a leading subprime originator with originations of nearly $40 billion in its fiscal 2006. The SEC alleged that between January and March 2007, Option One offered and sold more than $4.3 billion of RMBS in seven separate offerings.

According to the SEC’s complaint, Option One misled investors in its RMBS by promising to repurchase or replace mortgages in its RMBS that breached representations and warranties. These promises were rendered misleading by Option One’s failure to disclose that its financial condition was significantly deteriorating and it could not meet its repurchase obligations on its own.

The SEC further alleged that at the time Option One offered and sold the RMBS, it needed to rely on voluntary financial support from Block to meet its financial obligations but that Block was under no obligation to continue providing that financing. Option One never disclosed this information to investors.

Option One, without admitting or denying the SEC’s allegations, consented to the entry of an order permanently enjoining it from violating Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933 and requiring it to pay disgorgement of $14,250,558, prejudgment interest of $3,982,027, and a $10,000,000 civil penalty. The proposed settlement is subject to approval by the court.

Tuesday, April 24, 2012

SEC Warns Issuers on Premature Use of Crowdfunding Exemption


The SEC has issued a notice reminding issuers that the crowdfunding exemption created under the recently enacted Jumpstart Our Business Startups (JOBS) Act is unavailable to them until the Commission adopts implementing rules. Said the SEC: “The Act requires the Commission to adopt rules to implement a new exemption that will allow crowdfunding. Until then, we are reminding issuers that any offers or sales of securities purporting to rely on the crowdfunding exemption would be unlawful under the federal securities laws.” The JOBS Act was enacted on April 5, 2012.
Title III of the JOBS Act contains the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012 (CROWDFUND Act). Section 302(c) of the CROWDFUND Act requires the Commission to adopt rules to implement the crowdfunding exemption set forth in Securities Act Sections 4(6) and 4A. The Commission must consult with state securities commissions and national securities associations in crafting the rules. The SEC also must adopt rules under CROWDFUND Act Section 302(d) to provide for the disqualification of persons and entities from invoking the crowdfunding exemption.

CROWDFUND Act Section 303(a) amended Exchange Act Section 12(g) to exclude crowdfunding investors from the shareholder cap; the Commission must adopt implementing rules per CROWDFUIND Act Section 303(b). Exchange Act Section 3(h), added by CROWDFUND Act Section 304(a)(1), details the criteria by which a registered funding portal has a limited exemption from registration as a broker-dealer; CROWDFUND Act Section 304(a)(2) requires the SEC to issue implementing rules.


Each of the above provisions requires the SEC to adopt rules or regulations within 270 days of enactment.

Advocacy Group Files Amicus Brief Supporting CFTC Position Limits Regulations

In an amicus brief filed with the US District Court for the District of Columbia, the Better Markets group argued that the Commodity Futures Trading Commission has no legal obligation to study the costs of its position limits rule and requiring it to do could imperil financial reform effort. Better Markets is a non-profit, financial reform advocacy group that promotes the public interest in financial reform in the domestic and global capital and commodity markets.

The group said it was inconceivable that Congress would pass financial reform legislation following 2008's financial crisis only to have the reforms hinge on a rule-by-rule study of the costs to industry. Better Markets contended that such a stance would ignore the overriding purpose of the new regulatory framework and give controlling weight to cost concerns from the very industry that precipitated the crisis.

Recently, nineteen U.S. senators filed an amicus brief in federal court supporting action en by the Commodity Futures Trading Commission to impose trading limits on speculators in U.S. commodity markets to combat excessive speculation and combat high prices for gasoline, crude oil, food, and other commodities. Senator Carl Levin (D-MI), who spearheaded the effort on the brief, said that an ongoing contributing factor in high energy prices is excessive speculation in U.S. commodity markets.

The amicus brief concentrates on a single issue: demonstrating that the Dodd-Frank Act made imposing position limits on speculators mandatory, not discretionary. It discusses the plain language of the law, its legislative history, and seven years of Senate investigations and legislative efforts to combat excessive speculation, in part, by imposing mandatory trading limits on speculators. Senator Levin noted that position limits, which have been part of U.S. commodities law since 1936, are a recognized tool to reduce and prevent excessive speculation and price manipulation in commodity markets. ISDA and SIFMA v. CFTC, Civil Action No. 1:11-CV-2146-RLW, DC of D.C,. April 13, 2012.

Two years ago, the Dodd-Frank Act directed the CFTC to clamp down on excessive speculation by imposing trading limits on speculators, he noted, and the CFTC issued a new regulation to do just that. The financial industry challenged the CFTC regulation in federal court, claiming that Congress never meant for the trading limits to prevent excessive speculation to be mandatory. The amicus brief contends that is exactly what Congress meant. The derivatives and securities industry lawsuit asks the court to impose a preliminary injunction to suspend the regulation immediately and summary judgment to invalidate it permanently.

Monday, April 23, 2012

Missouri Offers Guidance on Crowdfunding Exemption

Following President Obama's signing the Jumpstart Our Business Startups Act ("JOBS Act")  into law on April 5, 2012, Missouri has taken the lead among the states to guide small businesses on the use of the crowdfunding exemption, a crucial part of the JOBS Act. The crowdfunding exemption as applied under the new Act allows small businesses and start up companies to raise capital by making securities offerings to the public on the Internet without having to register the offerings at the federal or state level. The following caveats, however, are provided by the Missouri Securities Division:

1. Enterpreneurs and issuers may not claim the crowdfunding exemption until the SEC adopts rules regulating use of the exemption. As rules may not be in place until 2013, entrepreneurs and issuers making interim Internet offerings to the public risk liability for fraud, as well as subjecting themselves to state administrative enforcement actions.

2. Even after SEC crowdfunding rules are adopted:

a. the amount of securities an investor may purchase from an issuer is limited to the amount of the     investor's annual income or net worth, e.g, an investor with less than $100,000 in annual income or net worth may only purchase securities in an amount not exceeding either $2,000 or 5% of the investor's annual income or net worth, whichever amount is greater.

b. issuers must offer their securities through an SEC-registered broker or funding portal. 

c. while the crowdfunding exemption exempts issuers from federal and state registration requirements, the broker or funding portal must comply with disclosure requirements, by making certain disclosures to the SEC and investors.

Sunday, April 22, 2012

Community Banking Group Urges Inclusion of Thrifts in JOBS Act Raising of Shareholder Threshold

The Independent Community Bankers of America have urged the SEC to issue guidance indicating that thrifts and thrift holding companies will be considered banks and bank holding companies for purposes of Section 601 of the JOBS Act, which raises the shareholder threshold for SEC reporting from 500 shareholders to 2000. In a letter to the SEC, the industry group said that it was an oversight that community thrifts and thrift holding companies with less than 2,000 shareholders were not included in the legislation, particularly since there is no compelling reason to treat them differently from banks and bank holding companies under the law.

Thrifts and thrift holding companies are really banking institutions, reasoned the industry group, since they make loans, gather deposits, and are considered insured depository institutions under the Federal Deposit Insurance Act. Further, thrifts are subject to the same oversight as banks and are overseen by bank regulators. The group emphasized that there is no compelling reason to treat thrifts differently from banks under Section 601. 

A second issue deals with the timing of future SEC rulemaking.  The Commission’s guidance earlier in April indicated that even though a bank holding company can immediately terminate its Section 12(g) registration of a class of equity securities, its duties to file periodic reports won’t be suspended until 90 days after the holding company files its Form 15.  Until that date of termination, the bank holding company is required to file all reports required by Exchange Act Sections 13(a), 14, and 16.  Alternatively, a bank holding company could rely on Exchange Act Rule 12g-4, which permits the immediate suspension of Section 13(a) reporting obligations upon a filing of a Form 15, but since that rule has not been amended to incorporate the new 1200 shareholder deregistration threshold, bank holding companies cannot take advantage of that rule. Thus, the industry group urged the Commission to adopt changes to Rule 12g-4 as soon as possible so that bank holding companies that have a class of equity securities held of record by less than 1,200 persons can terminate their Section 13(a) responsibilities immediately upon the filing of a Form 15.   

  

Friday, April 20, 2012

IASB Advisory Group Examines Issues Around Materiality

The Capital Markets Advisory Committee of the IASB reached a general consensus that improving the quality of disclosures may not be achieved by simply reducing the disclosure requirements.  Some CMAC members indicated that today’s problem with disclosures may not be the accounting standard’s disclosure requirements but the behavior and judgment relating to the concept of materiality.  There is a concern that preparers are not exercising enough judgement when determining what information to disclose.  The work of the auditor and regulator plays an important factor. 

There were different views about whether a disclosure project could have short-term vs. long-term objectives.  Some CMAC members talked about whether there should be only a framework project, or an individual IFRS with disclosures. Some CMAC members highlighted that the IASB has already received information from users of financial statements about which current IFRS disclosures could be improved as ‘quick wins’.  They also discussed the need to address the issue of what should be on the face of the financial statements and what should be in the notes.  Furthermore, CMAC members discussed whether the IASB could explore new approaches to disclosures; for example, layering of information.  CMAC members concluded by stating the importance of involving users of financial statements in all future disclosure project efforts to make sure that the disclosures provided are relevant to their work.  

European Securities and Markets Authority (ESMA) representatives gave a presentation about their November 2011 consultation 
paper considerations of materiality in financial reporting (which was available for public comment until 29 February 2012).  They
suggested that there should not be a focus on a quantitative assessment of materiality, but rather on the usefulness of the information being provided.  Materiality would often be based on a percentage figure of the balance sheet or the profit and loss account.
  
ESMA observed that preparers, auditors and regulators have different understandings of materiality.  He explained that the rationale behind ESMA’s project is to be helpful in implementing a principle-based standard by preventing misconceptions in different jurisdictions throughout Europe.  Although the CMAC was sympathetic to having consistent and comparable information, members expressed their concerns about the danger of materiality guidance being a means to challenge existing accounting requirements.  They suggested that the IASB and the International Auditing and Assurance Standards Board (IAASB) should work together on this topic.  

New CF Guidance for Smaller Financial Institutions


The SEC's Division of Corporation Finance has issued CF Disclosure Guidance: Topic 5. This CF Guidance contains staff observations on the MD&A and accounting policy disclosures of smaller financial institutions. The guidance cautions these companies that while staff observations may help them to draft better disclosure, the guidance is not a substitute for the Commission's rules or the Accounting Standards Codification.
Topics addressed in the guidance are separated into three categories. The section covering asset quality and loan accounting issues discusses the following: allowance for loan losses, charge-off and nonaccrual policies, commercial real estate, loans measured for impairment based on collateral value, credit risk concentrations, troubled debt restructurings and modifications, and other real estate owned. The guidance also addresses deferred taxes and FDIC-assisted transactions.
Previously issued CF Guidance addresses:
Topic No. 1: Staff Observations in the Review of Forms 8-K Filed to Report Reverse Mergers and Similar Transactions.
Topic No. 2: Cybersecurity.
Topic No. 3: Staff Observations in the Review of Promotional and Sales Material Submitted Pursuant to Securities Act Industry Guide 5.
Topic No. 4: European Sovereign Debt Exposures.

ESMA Standards and Guidance Aim for Consistent Application of EU Hedge Fund Directive


With regard to the EU Alternative Investment Fund Managers Directive, the European Securities and Markets Authority has submitted technical standards  to the European Commission. The AIFMD requires hedge fund managers and private equity fund managers  to report significant amounts of information to their home competent authorities on such matters as the main instruments in which they trade, their principal exposures and the risk profiles of the funds they manage. ESMA  developed a template to be used by fund managers in order to have as much consistency in the disclosures as possible. The interesting  point from the ESMA perspective is that all of the information provided by fund managers to their home authorities must also be made available to ESMA and the European Systemic Risk Board. While aware of the challenges involved in gathering such vast amounts of data and analyzing it in a way that adds value from a regulatory perspective, ESMA is confident that this additional transparency will be a key tool in helping both the EU and national authorities better understand the functioning of the hedge fund sector, as well as in identifying possible systemic impacts. 

But ESMA’s work on the AIFMD does not stop there. ESMA is also working on guidelines on remuneration under Article 13 of the Directive and plan to publish a consultation paper with its proposals in the second quarter of this year. There is already a broad set of material from which ESMA can draw inspiration when developing these guidelines, such as the Commission Recommendation of 2009 and the CEBS guidelines of 2010, while bearing in mind the need to adapt that material to the alternative investment fund sector.  

ESMA recently published a discussion paper on key concepts of  the hedge fund Directive and types of alternative investment fund AIFM. This is the first stage of ESMA's  work on the regulatory technical standards required under Article 4(4) of the Directive. ESMA will  clarify some areas of potential uncertainty arising from the Directive and ensure that there is a common understanding of the text across the EU. The discussion paper addresses such issues as the delegation of portfolio and risk management functions, the definition of the term ‘alternative investment fund’ and the interaction of the  AIFMD with other pieces of EU legislation such as UCITS and MiFID. These latter points are unlikely to be included in the technical standards themselves and will probably take the form of ESMA guidelines or a Q&A at a later stage. To some extent the precise legal form here is less important than the overall  objective, reasoned ESMA, namely the consistent application of the Directive throughout Europe.  

G-30 Report Says Understanding Risk Is the Essence of Corporate Governance


The essence of sound governance at financial services firms is understanding risk. posited a new G-30 report.  If a risk is too complicated to understand, said the G-30, it is too complicated to accept. Effectively balancing risk, return, and resilience takes judgment.  The report also concluded that values and culture are the ultimate “software” that determines the behaviors of people throughout the financial firm and the effectiveness of its governance arrangements. The report stresses that values influence the behavior of those with governance responsibilities and the key to reform is to promote changes in the ways in which these individuals think about their responsibilities.

Roger W. Ferguson Jr., Chairman of the G30 Steering Committee on Corporate Governance, and former Vice Chairman, Board of Governors of the Federal Reserve System, said that effective governance greatly depends on the tone set at the top. The corporate culture dictates the values and the behaviors of the people in the firm and how they interact, he emphasized, and firms can tailor and optimize governance processes and procedures. But if they have the wrong people, or if those people do not behave with integrity and transparency, said the former Fed official, the arrangements will not save them. Leadership makes a huge difference, he concluded.

G-30 Chairman Jean-Claude Trichet, former President of the European Central Bank, noted that ineffective governance of systemically important financial institutions contributed to the massive failure of financial-sector decision making that led to the financial crisis. The paramount aim of the new report is to promote changes in governance behavior, he said, which demands changing the ways in which people think so that they can successfully induce the specific, tailored reforms that will enhance governance in their institutions.

Thursday, April 19, 2012

SEC Chair Tells House Oversight Panel of Enhanced Role for Economists in SEC Rulemaking

SEC Chair Mary Schapiro told a House oversight panel of the strengthened role of economists in SEC rulemakings. In testimony before the House TARP and Financial Services Oversight Subcommittee, the SEC Char emphasized that economists must play a central role in rulemaking, whether in identifying concerns or issues that may justify regulatory action or analyzing the likely economic consequences of competing approaches. Further, agency economists should be involved at the earliest stages of the rulemaking process, even before the specific preferred regulatory course is determined, and throughout the course of writing proposed and final rules. Close collaboration with the Division of Risk, Strategy, and Financial Innovation will help to integrate economic analysis as key policy choices are being made, she noted, thereby assisting in the evaluation of different or competing policy options by identifying the major economic effects of those options and influencing the choice, design, and development of policy options.

This approach will also assist in the evaluation of whether and to what extent any proposed policy would promote efficiency, competition, and capital formation, as well as improve the quality of regulation, better support policy choices made by the Commission, and increase confidence in the regulatory process. Chairman Schapiro also said that the SEC expects to have at least 20 additional economists join the Division over the coming months. Moreover, the Commission will continue to pursue additional hiring opportunities, including requesting additional funding from Congress for 20 additional economists in fiscal year 2013.

More broadly, the SEC’s Chief Economist and General Counsel have jointly developed new guidance for conducting economic analysis, taking into account the recommendations made by the GAO, as well as comments from others, including Members of Congress and the courts. The guidance includes earlier and more comprehensive involvement economists to provide economic analysis of different policy options before a proposed course is chosen and throughout the course of the development of the rule. The guidance also assures that rule releases clearly identify the justification for the proposed rule, such as a market failure or a statutory mandate. When a statute directs rulemaking, the SEC staff should consider the overall economic impacts of the rule, including those attributable to Congressional mandates and those resulting from the Commission’s exercise of discretion;
where feasible, quantifying the costs and benefits and, where not reasonable to do so, transparently explaining why not, and then qualitatively explaining the remaining costs and benefits.

Moreover, an integrated analysis of economic issues, including efficiency, competition, and capital formation, will be contained in the Commission’s rule releases, as well as more explicit encouragement to commenters to provide quantitative, verifiable estimates of costs and benefits. The guidelines call for a fuller analysis and discussion in Commission rule releases of the cost-benefit information received from commenters; and a grter discussion of reasonable alternatives not chosen.

Volcker Rule Conformance Period Clarified

The Federal Reserve Board announced its approval of a statement clarifying that an entity covered by section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, or the so-called "Volcker Rule," has the full two-year period provided by the statute to fully conform its activities and investments, unless the Board extends the conformance period.

Section 619 generally requires banking entities to conform their activities and investments to the prohibitions and restrictions included in the statute on proprietary trading activities and on hedge fund and private equity fund activities and investments. Section 619 required the Board to adopt rules governing the conformance periods for activities and investments restricted by that section, which the Board did on February 9, 2011.

Subsequently, the Board received a number of requests for clarification of the manner in which this conformance period would apply and how the prohibitions will be enforced. The Board issued this statement to address this question.

The Board’s conformance rule provides entities covered by Section 619 of the Dodd-Frank Act a period of two years after the statutory effective date, which would be until July 21, 2014, to fully conform their activities and investments to the requirements of section 619 of the Dodd-Frank Act and any implementing rules adopted in final under that section, unless that period is extended by the Board.

The Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, and the Commodity Futures Trading Commission (the agencies) plan to administer their oversight of banking entities under their respective jurisdictions in accordance with the Board’s conformance rule and statement. The agencies have invited public comment on a proposal to implement the Volcker rule, but have not adopted a final rule.

Wednesday, April 18, 2012

House Panel Approves Budget Reconciliation Legislation Repealing Dodd-Frank Office of Financial Research

An amendment adopted during the House Financial Services Committee mark up of the budget reconciliation legislation would repeal provisions in the Dodd-Frank Act creating the Office of Financial Research. The amendment, offered by Rep. Francisco Canseco (R-TX) was approved by voice vote.

The Dodd-Frank Act established the OFR as an executive agency to collect and standardize data on financial firms and their activities to aid and support the work of the federal financial regulators. The Office of Financial Research, headed by a Director appointed by the President for a six-year term, provides the Council and financial regulators with the data and analytic tools needed to prevent and contain future financial crises by developing tools for measuring and monitoring systemic risk. The logic behind the Office is that it makes no sense to pass legislation creating a systemic risk regulator when there are no standardized tools for measuring systemic risk. The Office is patterned on an executive agency envisioned by the National Institute of Finance Act of 2010, S 3005, sponsored by Senator Jack Reed (D-RI), Chair of the Securities Subcommittee.

The OFR not only develop the metrics and tools financial regulators need to monitor systemic risk, it also help policymakers by conducting studies and providing advice on the impact of government policies on systemic risk. Thus, the Office provides independent periodic reports to Congress on the state of the financial system. This will ensure that Congress is kept apprised of the overall picture of the financial markets. The legislation provides for the Office to house a data center that would collect, validate and maintain key data to perform its mission.

Secretary Geithner Urges House Panel Not to Repeal Dodd-Frank Orderly Liquidation Title as Part of Budget Legislation

In a letter to House Financial Services Committee Chair Spencer Bachus (R-AL), Treasury Secretary Tim Geithner asked the Committee not to move forward with Budget Reconciliation legislation that would repeal Title II of the Dodd-Frank Act, which provides for the orderly liquidation of failed financial firms. The Secretary said that the legislation would undermine the government's ability to limit the damage that failed firms could cause in a future crisis by eliminating the authority to break up or unwind failing financial firms. Title II was designed to have no cost to the taxpayer over the long run, but rather ensure that the failed financial institution bears the cost.

On a separate point, the Secretary said that the derivatives legislation building in the House amending Title VII is at best premature as the SEC and CFTC continue adopting regulations. Since the House bills deal with issues under active regulatory consideration, reasoned the Secretary, enactment of the legislative changes would undermine the integrity of the rulemaking process, further complicate the work of the regulators and create uncertainty. The Secretary urged the Committee to allow the regulators to work their way through the rulemaking process.

ICI AND Chamber Challenge CFTC Rule on Registration of Mutual Funds

The Investment Company Institute and the U.S. Chamber of Commerce today filed a legal challenge to the Commodity Futures Trading Commission’s final rule imposing redundant regulations on registered investment companies, such as mutual funds and exchange traded funds, without satisfying the agency’s obligation to weigh the costs or benefits of the rule. Eugene Scalia and Daniel J. Davis of Gibson, Dunn, and Crutcher LLP will be counsel to ICI and the Chamber on this litigation, which was filed in the federal district court for the District of Columbia.

In their complaint, the ICI and the Chamber charge that the CFTC’s Rule 4.5 amendment, which requires advisers to registered investment companies already regulated by SEC, to be dually regulated by the CFTC as commodity pool operators, violates the Commodity Exchange Act and the Administrative Procedure Act on multiple counts. The complaint states the rule is arbitrary and capricious and requests injunctive relief to prevent the CFTC from implementing the Rule.

The rule layers the CFTC’s regulatory regime atop that already applied to funds by the SEC under all the major federal securities laws. The CFTC in its rulemaking process did not remotely justify such regulatory excess, said ICI president and CEO Paul Schott Stevens, adding that the rule will impose significant compliance costs on mutual fund advisers and, ultimately, these costs will come out of shareholders’ pockets.

The ICI and Chamber allege that investment companies and their advisers already are among the most highly regulated entities in the financial industry. In clear disregard for the most basic requirements of reasoned agency action, posited the complaint, the CFTC simply ignored and declined to mention key elements of the reasoning it had previously followed in lowering barriers to participation in the commodities markets by investment companies that it has now raised again. The CFTC nowhere explained or determined in any manner that SEC regulation was proving to be insufficient, they said. In addition, at critical junctions in its decision-making leading to adoption of the Rule, the [CFTC failed to perform the most basic tasks of an appropriate cost-benefit analysis.”

SEC Adopts Key Definitions for Security-Based Swaps

The SEC today unanimously adopted a rule defining key terms for security-based swaps. The Commission has issued a Fact Sheet on the new rule, but the final rule itself has not yet been posted to the SEC’s website. The rule was adopted under provisions contained in the Dodd-Frank Act. Said Chairman Mary L. Schapiro: “Adopting the entity definitions is a foundational step in the establishment of the new regime to regulate trading in this significant market. These rules clarify for market participants whether their current activities will subject them to comprehensive oversight in the coming months.”

“Security-Based Swap Dealer” is defined to include a de minimis exception. The discussion at today's Commission meeting highlighted the usefulness of analytical data in fixing the de minimis exception level. In general, the de minimis rule exempts entities with dealing activity in security-based swaps based on a notional dollar amount: $3 billion over the prior 12 months for credit default swaps (CDS) dealing transactions in CDS that are security-based swaps; $150 million for other security-based swaps.

The de minimis exception is to be phased in over time: for credit default swaps, those entities with $8 billion or more in CDS dealing transactions over the prior 12 months must register; for other security-based swaps, the phase-in amount is $400 million. The phase-in period will end on a date after the SEC finalizes a report on the security-based swap market, unless the Commission modifies the de minimis thresholds or specifies a time period by rule. The term “Security-Based Swap Dealer” does not include persons who enter security-based swaps for their own account “not as part of a regular business.”

Other key terms defined in the rule include “Major Security-Based Swap Participant,” “Substantial Position,” “Hedging or Mitigating Commercial Risk,” “Substantial Counterparty Exposure,” “Financial Entity,” and “Highly Leveraged.” Also, exemptive relief from Exchange Act Section 6(l) will expire when the term “eligible contract participant” becomes effective.

The final rule is effective 60 days after publication in the Federal Register. Dealers and major participants must register on the dates to be fixed in final rules for the registration of these entities.

Corp Fin to Republish Certain Exchange Act and Securities Act Orders in EDGAR

The SEC’s Division of Corporation Finance has announced that it will publish Exchange Act revocation of registration orders and Securities Act stop orders on EDGAR beginning April 19, 2012. Revocations are made pursuant to Exchange Act Section 12(j), whereas stop orders are made under Securities Act Section 8. The notice observed that by publishing these orders on EDGAR, investors can view the orders in the context of a company’s filing history.

In EDGAR, the company information at the top of an EDGAR search will state “This company’s Exchange Act registration has been revoked.” Exchange Act revocations will be tagged as document type “REVOKED” and Securities Act stop orders will be labeled document type “STOP ORDER.”

NASAA Re-Proposes Model Franchise Exemptions

NASAA’s Franchise and Business Opportunity Project Group (Project Group) has re-released for public comment proposed changes to NASAA’s Model Franchise Exemptions (Model Exemptions). In the original proposal released on July 1, 2011, the Project Group had sought public comment on the establishment of four types of franchise exemptions: (1) a fractional franchise exemption; (2) an experienced franchisor exemption; (3) a set of three sophisticated purchaser exemptions; and (4) a discretionary exemption. The original proposal contained elements of existing exemptions adopted by several franchise registration states, but updated some requirements in order to reflect current conditions in franchising and the U.S. economy.

After considering comments regarding the various provisions, the Project Group has concluded that, in general, the Model Exemptions strike the right balance between the desirability to reduce compliance burdens on franchisors and the need for prospective franchisees to review a franchise disclosure document in order to make an informed investment decision. The Franchise Project Group has determined, however, to propose revisions to specific Model Exemptions in light of several comments. Although some of the proposed revisions are technical corrections or changes to form only, other revisions are more substantive.

In light of several comments, the Project Group has determined that the language of the model Fractional Franchise Exemption should be revised to clarify that the exemption anticipates an annual filing, as opposed to a separate filing for each proposed exempt transaction. The Project Group has, therefore, revised the language of this exemption to state specifically that the exemption requires an annual notice filing that, once made, expires after a period of one year from the date of the notice of exemption, and that the exemption may be claimed for additional one year periods.

Additionally, the Project Group concluded that it is impractical under the model Fractional Franchise Exemption to require state administrators to determine from a notice filing whether a “reasonable basis” exists for the parties to anticipate sales volume sufficient to qualify for the exemption. Therefore, the Franchise Project Group has revised the exemption to clarify that the administrator does not evaluate, in advance, anticipated sales volume of a proposed transaction, but that, in order to qualify for the exemption, both parties to the transaction must be capable of demonstrating that the franchisee can derive 80% of its total dollar volume in sales during the first year of operation independent of the franchise relationship.

The Project Group has clarified the Experienced Franchisor Exemption with respect to how a subsidiary franchisor can establish net equity when separate financial statements do not exist because the parent prepares consolidated financial statements. The Project Group has now revised the exemption to allow a franchisor to submit a statement by an officer confirming a franchisor’s net equity if the franchisor does not prepare its own audited financial statements because its parent prepares consolidated statements.

The Project Group has also added a subsection to the Experienced Franchisor Exemption which provides that audited financial statements required under the exemption cannot contain a going concern explanatory paragraph. This revision was based on the comments of several state examiners, who had expressed concern that the language of the model Experienced Franchisor Exemption may not describe accurately the financial condition a franchisor must demonstrate in order to qualify for the exemption.

Several commenters suggested that NASAA revise the model Sophisticated Franchisee Exemption to delete a requirement that prospective sophisticated franchisees be represented by legal counsel. In response, the Project Group has revised the exemption to include an optional provision to allow each state adopting the exemption to decide whether or not to require sophisticated franchisees to have legal counsel as a condition of granting the exemption. The Project Group determined that if different states made different policy determinations on this isolated requirement, that distinction would not be a significant detraction from the goals of uniformity.

The Project Group also agreed with several commenters who stated that it is unduly burdensome to require that sophisticated franchisees have financial statements prepared under U.S. GAAP. These commenters states that franchisors should be able to rely on facially valid financial statements of a sophisticated franchisee without having to assume the risk that the statements do not comply with U.S. GAAP. Accordingly, the Project Group has deleted the requirement from the Sophisticated Franchisee Exemption.

Finally, the Project Group has deleted from the Model Discretionary Exemption a requirement that applicants must submit a proposed order in order to claim the exemption. As one commenter observed, the requirement might prove problematic for applicants and state administrators because most applicants are not able to prepare proposed orders in the form acceptable to the administrator.

The comment period will remain open for 30 days. Accordingly, all comments should be submitted on or before May 16, 2012. Comments should be submitted, by email or in writing, to Dale Cantone of the Maryland Division of Securities and Joseph Opron of the NASAA Legal Department.

Monday, April 16, 2012

Commissioner Walter Tells Senate Panel that SEC is Coordinating Cross-Border on OTC Derivatives Regulation

Given the global nature of the OTC derivatives market, the SEC intends to address the international implications of its regulations under Sub B, Title VII of Dodd-Frank in a single proposal in order to give interested parties, including investors, market participants, and foreign regulators, an opportunity to consider as an integrated whole the Commission's approach to the registration and regulation of foreign entities engaged in cross-border security-based swap transactions involving U.S. parties. This was the message that SEC Commissioner Elisse Walter delivered to the Senate Banking Committee.

In her testimony, Commissioner Walter said that the SEC understands that its approach to the cross-border application of Title VII must both achieve effective effective domestic regulatory oversight and reflect the realities of the global derivatives market. The SEC is continuing to actively coordinate with its counterparts in other jurisdictions to help achieve consistency and compatibility among approaches to derivatives regulation.

The Commissioner also noted that the SEC and CFTC staff have been working on a bilateral basis with counterparts from Canada, the European Union, Hong Kong, Japan, and Singapore to coordinate technical issues that are in the interest of leveling the playing field for the regulation of derivatives transactions. In December, leaders and senior representatives of the authorities responsible for the regulation of the OTC derivatives markets in these jurisdictions met in Paris to discuss significant cross-border issues related to the implementation of new legislation and rules governing the OTC derivatives markets, including concerns about possible regulatory gaps, conflicts, arbitrage, and duplication. In addition to agreeing to continue staff-level bilateral technical dialogues, the leaders are planning to meet again as a group this spring.

NASAA Suggests Improvements to Valuation of Unlisted REITs and DPPs

The North American Securities Administrators Association (NASAA) has offered support for recent efforts by FINRA to improve the valuation of unlisted direct participation plan (DPP) and real estate investment trust (REIT) offerings. In a comment letter to FINRA on April 11, NASAA said that FINRA's efforts in Regulatory Notice 12-14 and the proposed amendments to NASD Rule 2340 should help customers to comprehend the value of unlisted DPPs and REITs held in their accounts. Noting the concern of state regulators regarding inaccurate valuation methods presently used by issuers and broker-dealers to present investment values on customer statements, NASAA believes that a more uniform and accurate valuation method will benefit not only investors but issuers and FINRA member firms.

NASAA observed that Regulatory Notice 12-14 extends and modifies Regulatory Notice 11-44, which NASAA had supported in a previous comment letter. NASAA wrote that it continues to support Regulatory Notice 11-44’s proposed limit on the period during which a per share estimated value based on the net offering price may be included on a customer account statement. Under Regulatory Notice 11-44, the use of estimated valuations based on the net offering price is limited to the Initial Offering Period provided under Securities Act Rule 415(a)(5).

NASAA also continues to support the proposal in Regulatory Notice 11-44 that following the Initial Offering Period, a per share estimated value included on a customer account statement must be based on an appraisal of a DPP’s or REIT’s assets, liabilities and operations. NASAA suggested, however, that FINRA add a requirement that such appraisals must be conducted by qualified independent appraisers, using Rule 2-01 of Regulation S-X, or a similar rule, as guidance. NASAA also suggested that the selection criteria for those portfolio assets to be appraised be set by rule in order to help alleviate any conflicts of interest the appraiser and the issuer may have in manipulating its net offering price or NAV in future periods.

NASAA disagreed, however, with FINRA's modifications to the definition of "net offering price" contained in Regulatory Notice 12-14. Regulatory Notice 11-44 had defined “net offering price” as the gross offering price less all organization and offering expenses, including issuer expenses reimbursed or paid for with offering proceeds, underwriting compensation, and due diligence expenses. Regulatory Notice 12-14, however, redefines “net offering price” as “gross offering price less any front-end underwriting compensation expenses.”

NASAA acknowledged that subtracting fees and expenses from an already arbitrary price simply yields a different arbitrary price. NASAA nevertheless believes that, since front-end fees and expenses are not made available for investment by DPP and REIT programs, deducting them from the gross offering price results in a more accurate, estimated per share value. Accordingly, NASAA suggests that other standard costs incurred during the Initial Offering Period should also be deducted, such as acquisition fees and expenses, incurred advisory fees, and other incurred fees and expenses, as such costs continue to erode the value of a customer’s initial investment.

NASAA supported Regulatory Notice 12-14's proposal that a FINRA member firm may present a modified version of net offering price or list the securities as "not priced" during the period in which the issuer has not provided an appraised value. This period, however, may extend no longer than the second quarterly filing after the initial offering period. As no ready market exists for shares of non-traded DPP and REIT offerings, NASAA reasoned, the price a customer would receive if it were able to find buyers for its shares would likely represent a significant discount to even the “net offering price.” Therefore, “net offering price” may still be misleading to investors. NASAA believes that presenting such shares as “not priced” on customer account statements, while not providing much information to customers about the current value of their investments, is less likely to confuse them as to the liquidation value of their accounts.

NASAA strongly urged FINRA to reinstate a requirement proposed in Regulatory Notice 11-44 that would prohibit a member firm from using a per share estimated value “if it knows or has reason to know that the value is unreliable.” Member firms have a role to play as gatekeepers, NASAA argued, and prohibiting member firms from reporting valuations that they have reason to know are unreliable is central to maintaining customer and market confidence in the integrity of reported valuations of securities. Removing the proposed requirement tacitly permits member firms to report unreliable information that could undermine such customer and market confidence. If the proposed rule is reinstated, NASAA also encouraged FINRA to provide additional guidance to help member firms comply with this provision. This would include a review of the financial statements and a U.S. GAAP or IFRS (as allowed by law) analysis in assessing the appropriate valuation.

Finally, NASAA suggested that unlisted DPPs and REITs using daily net asset value (NAV) pricing should required to calculate daily NAV using fair value pricing under acceptable methods detailed under the FASB Accounting Standards Codification Topic 820. Additionally, NASAA noted that it is important for NAV to not be presented as an on-the-market price unless liquidity and risk adjustments are made to NAV since, if the issuer were to sell its real estate assets, it would incur exit and carrying costs and face potential liquidity issues. Using gross on-the-market pricing for NAV, especially if used in determining compensation elements and various other expenses, will likely cause such elements and expenses to be unnecessarily higher than if determined on a fair value GAAP pricing, liquidation pricing, or Investment Company pricing model, NASAA believes.