Tuesday, July 31, 2012

SEC Report Calls for Legislation to Enhance Oversight of Municipal Securities Market

An SEC report on the municipal securities market has suggested legislation for Congress to consider to provide the Commission with authority to establish improved disclosures and practices in the municipal securities market. The legislation would authorize the Commission to require that municipal issuers prepare and disseminate official statements and disclosure during the outstanding term of the securities, including timeframes, frequency for such dissemination and minimum disclosure requirements, including financial statements and other financial and operating information, and provide enforcement tools.

The SEC assured that this legislative approach would not entail any repeal or modification to the existing proscriptions on the SEC or the MSRB requiring any presale filing of disclosure documents, known as the Tower Amendment. Nor would this approach involve elimination of the exemptions for municipal securities under Section 3(a)(2) of the Securities Act or the exemptions under the Exchange Act. This legislative approach, however, would meaningfully enhance disclosure practices by municipal issuers and could be accomplished in a short period of time.

Conduit Borrowers

The report also proposes legislation to amend the municipal securities exemptions in the 1933 and 1934 Acts to eliminate the availability of such exemptions to conduit borrowers who are not municipal entities under Section 3(a)(2) of the Securities Act. Currently, conduit borrowers, those non-municipal entities receiving proceeds from municipal securities offerings, may be subject to the Securities Act or Exchange Act registration or disclosure requirements because they may not be considered to be offering their own securities at the time of the municipal securities offering.

According to the SEC, it is important that investors have information about the entities that are responsible for the monies necessary to make payments on municipal securities in order to be able to assess their investments. This is especially true in light of the relatively high default rate of conduit bonds. This approach would not eliminate other available exemptions, such as those for nonprofit entities under Section 3(a)(4) of the Securities Act and other exemptions that are available to corporate issuers, such as the private offering exemption under Section 4(a)(2) of the Securities Act, without differentiation based on the size of the financing due to the continuing availability of other exemptions, including those available for small businesses, private offerings, and non-profit entities that take into account different types of offerings and issuers.

Financial Statements of Municipal Issuers

The proposed  legislation would also authorize the Commission to establish the form and content of financial statements for municipal issuers who issue municipal securities, including the authority to designate and oversee a private-sector body as the GAAP standard setter for municipal issuer financial statements. The Commission currently does not have authority to establish the form and content of financial statements of municipal securities issuers that are used in connection with primary offerings of municipal securities or provided on an ongoing basis in connection with outstanding municipal securities. Moreover, the Commission does not have direct authority over the standard setter for those financial statements. This legislative authorization would be for purposes of the federal securities laws only, thereby allowing municipal issuers to continue to comply with applicable state accounting principles in the preparation of their financial statements.

Safe Harbor—Forward-Looking Statements

Congress is also asked to authorize the Commission as it deems appropriate, to require municipal securities issuers to have their financial statements audited by an independent auditor or a state auditor. The legislation should also provide a safe harbor from private liability for forward-looking statements of repeat municipal issuers who are subject to and current in their ongoing disclosure obligations that satisfy certain conditions, including appropriate risk disclosure relating to such forward-looking statements, and if projections are provided disclosure of significant assumptions underlying such projections.

Currently, municipal issuers, as any other issuer of securities, can rely on the judicially established bespeaks caution doctrine when providing forward-looking information. Despite the existence of this doctrine, some municipal issuers have expressed continuing concerns with respect to the provision of forward-looking information in the municipal securities market. In the SEC’s view, this safe harbor would encourage municipal issuers to provide forward-looking information and would be available only to those municipal issuers that provide ongoing public disclosures and provide such information on a current and timely basis. The proposed safe harbor would be similar to the Private Securities Litigation Reform Act safe harbor for reporting public companies and would apply only to private rights of action for antifraud violations.

IRS-SEC Information Sharing

The proposed legislation should permit the Internal Revenue Service to share with the SEC information that it obtains from returns, audits, and examinations related to municipal securities offerings in appropriate instances and with the necessary associated safeguards, particularly in instances of suspected securities fraud. Section 6103 of the Code does not permit the IRS to disclose return information to the SEC and Commission staff in connection with civil enforcement of the securities laws.

If Congress were to allow the IRS to share with the SEC in appropriate instances information it obtains from returns, audits, and examinations, noted the report, enforcement actions relating to municipal securities would be more consistent, comprehensive, and timely. Furthermore, it would promote the efficient use of limited resources and improve compliance by participants in the municipal securities market.

In the past, IRS officials have publicly acknowledged the value of such increased information sharing, should Congress choose to pass the necessary legislation. Moreover, this change would be consistent with the recent guidelines prepared by the GAO to assist Congress in evaluating proposed exceptions to Section 6103.


Finally, legislation should also provide a mechanism to enforce compliance with continuing disclosure agreements and other obligations of municipal issuers to protect municipal securities bondholders and authorize the SEC to require trustees or other entities to enforce the terms of continuing disclosure agreements. The Commission does not currently have authority to enforce issuer compliance with continuing disclosure agreements that are provided as a condition to an underwriting of municipal securities subject to Rule 15c2-12, and no entity is required to enforce the terms of continuing disclosure agreements.

Monday, July 30, 2012

On SOX Tenth Anniversary, Senator Sarbanes and Rep. Oxley Note that Act Restored Investor Confidence in the Financial Markets

On the tenth anniversary of the enactment of the Sarbanes-Oxley Act, the sponsors of the legislation said that the Act has been successful in preventing large-scale accounting fraud at public companies. At a seminar sponsored by the Center for Audit Quality and the SEC Historical Society, Senator Paul Sarbanes (D-MD) said that the Act was designed to aid investor protection and restore public confidence in the integrity of the financial markets, adding that the processes mandated by the Act have become part and parcel of the process for public companies and, in the words of former SEC Chair William Donaldson, become part of the DNA of public companies. The integrity of the U.S. financial markets is an important economic asset for the U.S. and undermining the Act would be detrimental to the U.S. economy.

Rep. Michael Oxley (R-OH) noted that the Act restored investor confidence in financial markets that had been badly shaken. The legislation enhanced transparency and accountability. Rep. Oxley mentioned that at the time the back dating of stock options was perceived by investors as a game for insiders.  Sarbanes-Oxley stopped this process by requiring two-day Form 4 electronic filing.

Senator Sarbanes noted that a significant part of the Act was the establishment of the PCAOB to oversee outside auditors of company financial statements, shifting the oversight process from self-review to an outside, independent, and objective body. The PCAOB has significantly enhanced auditing standards and practices, he noted, establishing very good procedures for establishing their auditing standards. Rep. Oxley added that the PCAOB is tackling difficult issues under a process has been a plus, much better and fairer than self-regulation

Senator Sarbanes and Rep. Oxley lauded the establishment of disclosure of the effectiveness of, and attestation of, internal controls over financial reporting mandated by Section 404. Internal controls build safeguards and set up a system of checks and balances, said Senator Sarbanes, so that policing would be done within the organization. Rep. Oxley said that Section 404 helped restore investor confidence, adding that the concepts in Section 404 are now ingrained in corporate structures and it would be folly to go the other way. Senator Sarbanes emphasized that internal financial controls are a very important part of the process, and is another way to screen out the bad actors early on before it gets to a regulator.

Senator Sarbanes noted that the Act enhanced the role of audit committees and how audit firms relate to audit committees. But we need to do more to enhance the role of audit committees, he said, specifically mentioning communications between the outside auditors and the audit committee.

Rep. Oxley mentioned that the Powers Report said gatekeepers had fallen down on the job and failed investors. Senator Sarbanes noted that the Act was designed to enhance the status of the gatekeepers by making the outside auditors more independent, and placing limitations on what services audit firms could provide to the company.

U.S. Senators Ask Treasury to Respond to Concerns around Reciprocal FATCA Compliance Agreements with EU Countries

In a letter to Treasury Secretary Tim Geithner, four U.S. Senators question the scope and authority of an intergovernmental framework for FATCA compliance that features a reciprocal arrangement under which the U.S. is willing to reciprocate in collecting and exchanging information on accounts held in U.S. financial institutions by residents of five EU countries. The Senators ask Treasury to respond to a series of questions on the framework, including whether legislation will be needed to implement, within thirty days of receipt of the letter, which is dated July 25, 2012. The letter was signed by Senators Saxby Chambliss (R-GA), Ranking Member on the Intelligence Committee, Jim DeMint (R-SC), Mike Lee (R-Utah) and Rand Paul (R-KY).
FATCA was enacted in 2010 by Congress as part of the Hiring Incentives to Restore Employment (HIRE) Act. FATCA requires foreign financial institutions (FFIs) to report to the IRS information about financial accounts held by U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial ownership interest. FATCA is an important part of the U.S. government’s effort to improve tax compliance.
Under the framework, FATCA partner countries would agree to pursue the necessary implementing legislation to require foreign financial institutions in its jurisdiction to collect and report to authorities of the FATCA partner country the required information for later transfer to the United States on an automatic basis. However, observed the Senators, the model makes no reference to the legislative authority by which the U.S. would require domestic financial institutions to collect and report information to the U.S. government for transfer to FATCA partner countries. The Senators ask if Treasury anticipates that legislation will be needed to require U.S. financial institutions to collect and report information on the accounts of residents of FATCA partner countries, or amendments to existing tax treaties or does Treasury have authority to issue regulations to that end. If legislation is needed, when will it be proposed and, if regulations can be adopted in this area, cite the statutory authority for such adoptions.
The joint statement does not specify the types of institutions that would be considered U.S. financial institutions for purposes of information exchange with FATCA partner countries. The agreement commits the US to reciprocity on collecting and reporting information. The Senators said it was thus reasonable to infer that the definition of U.S. financial institution would the same or similar to the broad definition of a foreign financial institution in FATCA, codified as IRC Section 1471(d)(5), which is a broad definition embracing banks, investment funds, and securities and commodities trading firms.
The Senators ask Treasury to describe the types of U.S. financial institutions comparable to the foreign financial institutions defined in Code Section 1471(d)(5), that would be subject to legislation or regulations establishing the reciprocal information exchange with FATCA partner countries.
While the anticipated cost of FATCA compliance for foreign financial institutions is estimated to be substantial, noted the Senators, they are not aware of any estimated costs of domestic U.S. financial institutions to comply with collecting and reporting the information on the five initial FATCA partners pursuant to the commitment in the agreement. The Senators ask if Treasury has conducted or is aware of a study of the potential costs and benefits of FATCA from a revenue standpoint, either with or without the reciprocal arrangement. More broadly, the Senators ask if Treasury conducted a study of the costs and benefits of FATCA from a broader economic standpoint, such as the refusal of foreign firms to do business with U.S. citizens or withdrawal of foreign investment from the U.S.
The Senators are also concerned about the compromising of personal financial information. They ask what types of assets, such as bank account interest, hedge fund and private equity fund accounts, and trusts, would be subject to collection and reporting by U.S. financial institutions under the commitments made in the joint statement. Similarly, what types of personal data and categories of persons would be required to be part of the collection and reporting.  Importantly, the Senators ask what safeguards Treasury would apply to protect asset and personal information in the course of collecting and reporting by U.S. financial firms and later transfer to partner governments.
Citing media reports that the Treasury Office of Tax Policy is working on a single model agreement under FATCA in consultation with partner countries, the Senators ask Treasury to provide immediately the text and explanations of any model agreement to which any foreign government has access.
Noting that under the joint statement, the U.S. would commit to work with other FATCA partner countries, the OECD and the EU on adapting FATCA to a common model for the automatic exchange of information, the Senators ask what Treasury anticipates would be the role of the OECD or the EU pursuant to U.S. FATCA reciprocal commitments. Further, Treasury must respond on whether it anticipates that financial information and personal data collected and reported by domestic U.S. financial institutions pursuant to the commitments made by the U.S. for transfer to partner governments would also be transferred to the OECD and EU, or any other international organization.

Senator Corker Says FSOC Can Act if SEC Fails to Move Forward on Money Market Fund Reform

In a colloquy with Treasury Secretary Tim Geithner during the Secretary’s recent appearance before the Senate Banking Committee, Senator Robert Corker (R-TN) said that the Financial Stability Oversight Council (FSOC) can act if the SEC fails to move forward with money market fund reforms beyond the 2010 reforms the SEC has already effected.  Senator Corker is concerned that a run on money market funds could create systemic risk. Secretary Geithner replied that, while money market funds are in a stronger position since the 2010 reforms, they are still susceptible to runs that could hurt investors and the financial system as a whole. He noted that the Fed and SEC Chairs, two members of FSOC, also believe that money market fund reforms must go further because of the concerns around systemic risk. In its annual report, FSOC endorsed additional money market fund reform and urged the SEC to publish structural reform options for public comment and ultimately adopt reforms addressing money market funds susceptibility to runs.

The Secretary said it is important for the SEC to propose a range of options on money market reform so that the market can assess them and comment on them and the SEC can reflect on them. The SEC can and must go further than it has gone. Various options are available, he noted, such as a free floating NAV. Senator Corker observed that a free floating NAV would require a change in the federal tax code. A free floating NAV should not create tax consequences, he said, adding that a de minimus floating NAV should not create tax consequences.

Finding Scienter Sufficiently Alleged, Second Circuit Panel Reinstates Securities Fraud Claim against Audit Firm

The independent auditor of a company’s financial statements may have acted with scienter with regard to revenue recognition involving some transactions, ruled a Second Circuit panel. While at the time the audit firm considered these transactions to be red flags warranting heightened scrutiny, noted the panel, the firm ultimately approved the company’s recognition of revenue in connection with each of these transactions. There was evidence that in the course of its audit Grant Thornton learned of and advised against the use of indisputably deceptive accounting schemes, said the appeals court, but eventually acquiesced in the schemes by issuing an unqualified audit opinion. Thus, the panel held that the securities fraud claims could go forward since the investors set out enough facts constituting evidence of conscious misbehavior or recklessness to survive a motion fir summary judgment. Gould v.Winstar Communications, CA-2 July 19, 2012.

GT requested that the company’s counterparties provide additional documentary evidence of the relevant sales underlying each questionable transaction. By doing so, consistent with SEC Staff Accounting Bulletin 101, in which the SEC states four conditions that must be satisfied before revenue can be recognized, GT sought to obtain independent support for the company’s recognition of revenue for each transaction, in other words, support from documents that were not generated by the company itself. As of February 10, 2000, GT still had not received responsive documents from four of these customers. Nonetheless, it issued an audit opinion letter opining that the company’s 1999 financial statements accurately reflected its financial condition and complied with GAAP.

The appeals court found evidence supporting the contention that GT consciously ignored the company’s fraud when it approved the company’s recognition of revenue for the suspicious 1999 transactions. This evidence goes beyond a mere failure to uncover the accounting fraud and, in general, relates to the company’s recognition of revenue for the sale of equipment or services without sufficient indicia of delivery, its recognition of all revenue associated with the incomplete sale of telecommunications systems, and its recognition of revenue for sales of indefeasible rights of use, equipment, and services to financially unstable companies to whom the company paid back large sums under separate contractual obligations. There was also evidence that GT failed to confirm the company’s representations regarding these transactions or to retain and review documents evidencing each transaction.

Saturday, July 28, 2012

NASAA Applauds Bill Authorizing SEC User Fees for Advisers

The North American Securities Administrators Association (NASAA) has applauded Rep. Maxine Waters (D-CA) for introducing legislation that would authorize the SEC to impose "user fees" on federally registered investment advisers. In a comment letter supporting the legislation, NASAA stated that the Investment Adviser Examination Improvement Act of 2012 (H.R. 6204) would significantly increase the resources available to the SEC to oversee large investment advisers, thus improving the frequency and overall effectiveness of examinations at no additional expense to taxpayers. More importantly, the legislation would not impose additional costs and added regulation on the thousands of small and mid-size investment adviser firms that are regulated by the states.

NASAA reaffirmed its position that investment adviser regulation is, and should remain, a governmental responsibility where oversight is both transparent and accountable. Unlike a private, third-party organization that does not have the expertise or experience with investment adviser regulation and that is accountable to a board of directors and not the investing public, government regulators bring to the table decades of unmatched experience. As a matter of policy and principle, NASAA believes that the most appropriate way to improve the oversight of federally registered investment advisers is to provide the SEC with the resources needed to do the job, either through increased appropriations, or by authorizing the SEC’s Office of Compliance Inspections and Examinations to collect user fees from the investment advisers it examines.

NASAA contended that authorizing the SEC to fund enhanced oversight of federally registered investment advisers through the imposition of user fees is also more efficient and cost-effective than establishing a self-regulatory organization (SRO) for advisers. NASAA cited a recent economic analysis performed by the Boston Consulting Group which found that establishing an SRO to examine investment advisers would likely cost twice as much as funding an enhanced SEC examination program. The analysis also found that investment advisers would likely pay twice as much in membership fees to an SRO as they would pay in user fees to the SEC. Further, imposing user fees would be a less expensive option because it eliminates the need for the SEC to spend significant resources in overseeing an SRO. According to the Boston Consulting Group, the start-up costs alone of an SRO could fund an enhanced SEC examination program for an entire year.

NASAA also believes that the existing division of federal and state regulatory responsibility over investment advisers should be preserved. For over 70 years, NASAA wrote, the SEC and state securities regulators have had concurrent regulatory authority over the investment adviser industry. The SEC has an experienced examination staff with industry expertise and established enforcement mechanisms, while state securities regulators have been effectively overseeing and regulating small and mid-sized investment advisers. NASAA observed that Section 914 of the Dodd-Frank Act mandated only that the SEC review and analyze its challenges in examining federally registered advisers. The 914 Study did not consider, or make recommendations regarding, state regulated investment advisers. The Investment Adviser Examination Improvement Act recognizes this important distinction and seeks to address the problem of SEC oversight by covering only federally registered investment advisers in the scope of the bill, NASAA wrote.

CAQ Tells House Panel PCAOB Has Improved Audit Quality since Enactment of Sarbanes-Oxley

The activities of the PCAOB, particularly its inspections and standard-setting roles, have been a significant factor in the improvement of audit and financial reporting quality in the decade after the enactment of the Sarbanes-Oxley Act, the Center for Audit Quality told the House Capital Markets Subcommittee. Testifying for CAQ, Michael Gallagher, Chair of CAQ’s Professional Practice Executive Committee, and managing Partner of PwC’s audit quality functions, said that PCAOB inspections promote audit quality in a number of ways. For example, they reinforce accountability for audit quality at all levels of an audit firm, including leadership. The inspections also highlight opportunities for audit firms to improve, including identifying areas on an engagement where more or different audit procedures should be performed. The inspections also help identify areas in which additional training, audit guidance, skills, or communications may be needed.

The CAQ official, who is also a member of the PCAOB’s Standing Advisory Group, noted that the Board's inspection activities are not limited to the U.S. The PCAOB has made significant progress over the past several years reaching inspection agreements with audit regulators in other jurisdictions. These efforts are ongoing, he observed, and US regulators are seeking to obtain better alignment in those cases where US and local laws conflict. International inspections promote investor protection, he emphasized, particularly in light of the ever increasing complexity and global scale of business. Many jurisdictions have adopted similar independent auditor oversight models.

In CAQ’s view, standard-setting can also have a significant impact on audit quality. The PCAOB publishes its standard setting agenda, and solicits feedback, in part, through its Standing Advisory Group, which comprises investors, public company executives, audit committee members, auditors, and other stakeholders. Also, CAQ works closely with the PCAOB and its staff on new and emerging auditing issues, with a focus on promoting standards that enhance financial reporting and audit quality.

More specifically, the collective impact of PCAOB and SEC actions, and other factors, has led to a general decline in compliance costs associated with the internal control provisions of Sarbanes-Oxley.       The PCAOB’s original auditing standard on internal control, issued in 2004, was widely viewed as being too rules-based and costly, as audit hours, audit fees, and companies' associated internal costs increased significantly. The PCAOB recognized these concerns and responded by issuing a revised standard in 2007 that was intended to promote a more risk-based audit and was less prescriptive, thereby allowing the use of more auditor judgment. While focused on maintaining audit quality, noted CAQ, that standard generally resulted in reductions to the nature and extent of audit procedures, and a corresponding reduction in audit hours and fees.

The PCAOB also published staff guidance on its revised standard for audits of smaller public companies to facilitate more efficient and effective audits of internal control over financial reporting for smaller, less complex public companies. In addition, the PCAOB conducted nation-wide forums for auditors of smaller audit firms to help address implementation issues associated with its revised standard. Similarly, the SEC issued guidance for companies to use in their assessment of internal controls that improved management assessments, which has contributed to an increase in auditor efficiency.

Other factors driving down costs are that auditors have made continued progress in integrating their audits of internal control over financial reporting with their financial statement audits. Similarly, management’s processes and activities that support a public company's required assertion about internal control over financial reporting have become more integrated with their day-to-day activities and related financial reporting, in part due to investments to update information technology systems.

Friday, July 27, 2012

Treasury and EU Countries Develop Compliance Framework for FATCA Compliance

The  U.S. Treasury has developed  a model intergovernmental agreement with EU partners  to implement the information reporting and withholding tax provisions of the Foreign Account Tax Compliance Act  (FATCA). The model agreement was developed in consultation with France, Germany, Italy, Spain, and the United Kingdom and marks an important step in establishing a common approach to combating tax evasion based on the automatic exchange of information.  These five countries, along with the United States, will, in close cooperation with other partner countries, the OECD, and, when appropriate, the European Commission, work towards common reporting and due diligence standards in support of a more global approach to comply with FATCA.
There are two versions of the model agreement, a reciprocal version and a nonreciprocal version, which both versions establish a framework for reporting by financial institutions of certain financial account information to their respective tax authorities, followed by automatic exchange of such information under existing bilateral tax treaties or tax information exchange agreements.  Both versions of the model agreement also address the legal issues that had been raised in connection with FATCA, and simplify its implementation for financial institutions.
The reciprocal version of the model also provides for the United States to exchange information currently collected on accounts held in U.S. financial institutions by residents of partner countries, and includes a policy commitment to pursue regulations and support legislation that would provide for equivalent levels of exchange by the United States.  This version of the model agreement will be available only to jurisdictions with whom the United States has in effect an income tax treaty or tax information exchange agreement and with respect to whom the Treasury Department and the Internal Revenue Service (IRS) have determined that the recipient government has in place robust protections and practices to ensure that the information remains confidential and that it is used solely for tax purposes.  The United States will make this determination on a case by case basis.
FATCA was enacted in 2010 by Congress as part of the Hiring Incentives to Restore Employment (HIRE) Act. FATCA requires foreign financial institutions (FFIs) to report to the IRS information about financial accounts held by U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial ownership interest. FATCA is an important part of the U.S. government’s effort to improve tax compliance.

Obama Administration Asks for Public Comment in Aid of Federal Regulatory Reform

As part of its reform of the federal regulatory process, the Obama Administration has asked for public comment on which regulations are outdated, which ones are imposing unjustified costs, and which regulations can be improved or made more effective. In issuing the call for public comment, Cass Sunstein, Administrator of the White House Office of Information and Regulatory Affairs, noted that In January of 2011, the President issued an Executive Order directing all executive agencies to undertake an unprecedented government-wide review of regulations on the books, in order to figure out what is working and what is not, and where appropriate, to streamline or eliminate ineffective, overly burdensome, and outdated rules. Over two dozen agencies have responded with regulatory reform plans, listing more than 800 initiatives. In May of 2012, the President issued an Executive Order making regulatory reform a continuing responsibility of all federal executive agencies.

President Obama Issues Veto Message on House-Passed Regulatory Freeze Legislation

The Obama Administration has issued a veto message on the Red Tape Reduction and Small Business Job Creation Act , HR 4078, which would prohibit any federal agency from taking any significant regulatory action until the Secretary of Labor reports that the Bureau of Labor Statistics average of monthly unemployment rates for any quarter after the enactment of the Act is 6 percent or less. HR 4078, which passed the House by a vote of 245-172, would also require the SEC to conduct a more thorough cost-benefit analysis of proposed regulations.

According to the Administration Statement of Policy, HR 4078 would undermine critical public health and safety protections, introduce needless complexity and uncertainty in agency decision-making, and interfere with agency performance of statutory mandates. The Administration is committed to ensuring that regulations are smart and effective, that they are tailored to advance statutory goals in the most cost-effective and efficient manner, and that they minimize uncertainty. But HR 4078  would impede the ability of federal agencies to protect public health, welfare, safety, and our environment, as well as to promote economic growth, innovation, competitiveness, and job creation.         

In the Administration’s view, the passage of HR 4078 would seriously undermine the existing regulatory framework. The Act would also add layers of procedural burdens that would interfere with agency performance of statutory mandates, unnecessarily delay important public health and safety protections, and undermine and potentially delay important environmental reviews. For example, HR 4078 would create excessively complex permitting processes that would hamper economic growth. It would also spawn excessive regulatory litigation, and introduce redundant processes for litigation settlements. It also addresses numerous problems that do not exist, such as a moratorium on "midnight" rules.

When a Federal agency promulgates a regulation, noted the Statement of Policy, the agency must adhere to the strong and well understood procedural requirements of federal law, including the Administrative Procedure Act, the Regulatory Flexibility Act, the Unfunded Mandates Reform Act, the Paperwork Reduction Act, and the Congressional Review Act. In addition, for decades, agency rulemaking has been governed by Executive Orders issued and followed by administrations of both political parties. These require regulatory agencies to promulgate regulations upon a reasoned determination that the benefits justify the costs, to consider regulatory alternatives, and to promote regulatory flexibility.

Through Executive Orders and the direction of the President, agencies must also ensure that they take into account the consequences of rulemaking on small businesses. Executive Order 13563 requires careful cost-benefit analysis, increased public participation, harmonization of rulemaking across agencies, flexible regulatory approaches, and a regulatory retrospective review. Through Executive Orders 13579 and 13610, the Administration also has taken important steps to promote systematic retrospective review of regulations by all agencies. Collectively, these requirements promote flexible, commonsense, cost-effective regulation. 

Thursday, July 26, 2012

House Passes Regulatory Freeze Legislation that Also Imposes Added Rulemaking Duties on SEC, Including 404(b) Impact

The House passed with a bi-partisan vote of 245-172 the Red Tape Reduction and Small Business Job Creation Act , HR 4078, to prohibit any federal agency from taking any significant regulatory action until the Secretary of Labor reports that the Bureau of Labor Statistics average of monthly unemployment rates for any quarter after the enactment of the Act is 6 percent or less. HR 4078 would also require the SEC to conduct a more thorough cost-benefit analysis of proposed regulations.

HR 4078 permits an agency to take a significant regulatory action notwithstanding such prohibition if the President determines by executive order that such action is necessary because of an imminent threat to health or safety or other emergency, necessary for the enforcement of criminal laws, necessary for U.S. national security, or issued to implement an international trade agreement.
Under Title VI of HR 4078, the SEC must clearly identify the nature and source of the problem that the proposed regulation is designed to address, as well as assess the significance of that problem, to enable assessment of whether any new regulation is warranted. The SEC must also use the Chief Economist to assess the costs and benefits, both qualitative and quantitative, of the intended regulation and propose or adopt a regulation only on a reasoned determination that the benefits of the intended regulation justify the costs of the regulation.

The Commission must also identify and assess available alternatives to the regulation that were considered, including modification of an existing regulation, together with an explanation of why the regulation meets the regulatory objectives more effectively than the alternatives. The SEC must ensure that any regulation is accessible, consistent, written in plain language, and easy to understand and must measure, and seek to improve, the actual results of regulatory requirements.

In deciding whether and how to regulate, the Commission must assess the costs and benefits of available regulatory alternatives, including the alternative of not regulating, and choose the approach that maximizes net benefits. In addition, in making a reasoned determination of the costs and benefits of a potential regulation, the Commission must, to the extent that each is relevant to the particular proposed regulation, take into consideration the impact of the regulation on investor choice; market liquidity in the securities markets;  and small businesses.

The Commission must explain in its final rule the nature of comments that it received, including those from the industry or consumer groups concerning the potential costs or benefits of the proposed rule or proposed rule change, and must provide a response to those comments in its final rule, including an explanation of any changes that were made in response to those comments and the reasons that the Commission did not incorporate those industry group concerns related to the potential costs or benefits in the final rule.

Within one year after enactment, and every  five years thereafter, the Commission must review its regulations to determine whether any are outmoded, ineffective, insufficient, or excessively burdensome, and must modify, streamline, expand, or repeal them in accordance with such review. The SEC must also conduct a post-adoption impact assessment.

The House approved, by a bi-partisan 251-166 vote, a floor  amendment offered by Rep. Mike Fitzpatrick (R-PA) that would require the SEC, when reviewing regulations, to consider the burden of applying Section 404(b) of Sarbanes Oxley to companies with a public float of less than $250 million. Section 404(b) requires outside auditor attestation of management’s assessment of the company’s internal controls. According to Rep. Fitzpatrick, the amendment would merely require the SEC to consider the burden of Section 404(b) when reviewing its regulations and would not change current law. The amendment would apply to all companies and would not discriminate based on when a company issued their IPO (Cong Record, July 25, 2012, H 5278).

The House also approved, by a bi-partisan 245-171 vote, an amendment offered by Rep. Bill Posey (R-FL) prohibiting the SEC from issuing any interpretive guidance with respect to disclosures related to climate change. In 2010, the SEC issued an interpretative guidance for companies to disclose the impact global climate change might have on their businesses. The Posey Amendment, according to its author, does not stop companies from mentioning bona fide weather and environmental risks in disclosures. And if a company really wants to weigh in climate change for some reason, they are free to volunteer that information.

UK FSA Chair Sees Benefits from Ring-Fencing Commercial and Investment Banking Similar to Volcker Rule

Structural reforms of the regulation of financial institutions, such as those recommended in the UK by the Vickers Commission, or to be implemented in the US via the Volcker Rule, will play an important role in robust regulatory reform, according to Adair Turner, Chair of the UK Financial Services Authority. He said that the implementation of the Vickers Commission recommendations will deliver three important benefits. First, they will increase the array of resolution options available to the authorities in the event of a crisis, creating at least the possibility that regulators may choose to rescue the ring-fenced entity while allowing non ring-fenced entities to fail.  That possibility will in itself reintroduce market discipline into a system characterized by too-big-to-fail assumptions, he emphasized, which in turn will help constrain the unnecessary proliferation of complex structuring and trading activities, reinforcing the impact of higher capital requirements
Second, the implementation of the Vickers recommendations will give regulators the option, provided the vast majority of SME lending is conducted within the ring-fence, of applying macro-prudential policy levers at the ring-fenced level instead of at group level.  This will create a tighter link between macro-prudential levers and the dynamics of credit supply in the real economy, said the FSA Chair, and increase the likelihood that regulators could limit the impact of booms and busts in commercial  bank lending. Third, the Vickers recommendations will give banking groups the opportunity to build institutions very explicitly focused on the excellent provision of essential banking services to households and SMEs, which  could play a major role in rebuilding customer trust.
The UK government endorses the recommendations of the Independent Banking Commission, chaired by Sir John Vickers, that a ring fence be placed around better capitalized banks to make them safer, and to protect their vital services to the economy if things go wrong. The Commission is driven by the belief that large scale proprietary trading and large scale internal hedge funds do not sit easily alongside retail banking. While the UK government has not implemented the Volcker Rule per se, in a bow to the Volcker Rule the Commission recommended ring-fencing a financial institution’s retail banking activities from investment banking.

The ring-fencing proposal shares a common motivation and underlying philosophy with the Volcker Rule being implemented under the Dodd-Frank Act. Similar to a retail ring-fence, the Volcker Rule aims to curtail government guarantees and the instability they can create by subsidizing risk taking. Under the Volcker Rule, because deposit-taking banks benefit from some explicit and implicit government guarantees, they should not be able to conduct trades or invest in funds purely for the purpose of making money on their own account. A rubric of both the Volcker Rule and the Vickers Commission rink fencing proposal is that socializing part of the risk of these activities while privatizing their benefits encourages excessive risk taking that may damage the stability of the financial institution.
The Commission’s ring-fencing proposal is different from the Volcker Rule in that, while proprietary trading and investments in hedge funds would not be prohibited, these activities would be outside the ring-fence and so isolated from retail banking where implicit government guarantees appear strongest.
Chairman Turner cautioned that the implementation of the Vickers Commission recommendations will not be, standing alone, sufficient to ensure stability.  While complex investment bank trading activity played a role in the origins of the financial crisis, with the failure of Lehman’s was a crucial event; so too did over-rapid expansion of plain lending to commercial real estate companies. Chairman Turner further cautioned that the isolation of retail and commercial banking within a ring-fence, as recommended by the Vickers Commission, does not mean that regulators can be indifferent to the development of risks outside the ring fence. Such a view would be both wrong and dangerous. But he emphasized that structural reforms which create either entire banks or units within wider banking groups more exclusively focused on classic retail and commercial banking activity will play a vital role.

ESMA Executive Director Endorses Globally Coordinated Financial Regulations through Equivalence and Mutual Recognition

The most effective and efficient way to achieve the global harmonization of financial and derivatives regulation is through a system based on equivalence and mutual recognition, said Verena Ross, Executive Director of the European Securities and Markets Authority (ESMA). In remarks at the International Council of Securities Associations, she emphasized that cross-border coordination of regulation is very important given the interconnectedness of the financial markets and the need to avoid regulatory arbitrage.

Without mutual recognition, reasoned the ESMA official, entities operating on a cross-border basis would be subject to different requirements and to the jurisdiction of different authorities, which exposes them to potentially conflicting requirements and to higher compliance costs.  However, the robustness of a foreign regulatory system must be assessed before it can be relied upon. Thus, equivalence needs to be assessed of the home country’s regulation of the foreign market player.  When the home country regulation achieves similar outcomes, one needs to rely on mutual recognition and co-operation with the home country regulator.  This cooperation with the home country regulator is essential to ensure that when needed and in response to specific risks the third-country market participant can be supervised in the same way as domestic market participants.

A specific example of where ESMA has applied this model of mutual recognition concerns the endorsement assessment of third countries for credit rating agencies. The essence of the assessment is whether ratings from third countries used in the EU meet EU requirements.  While the banking industry in particular was understandably concerned about sufficient third countries being endorsed before the deadline, the senior official noted, it can now be seen that the most important third countries have been endorsed.   

Looking back at the whole assessment process, the ESMA Executive Director was quite positive about the current third-country regime for credit rating agencies.  It ensures a level playing field between the EU and other regions, she enthused, and investors can expect the same quality of endorsed non-EU ratings as EU-rating.

When regulating national or, in the case of the EU, regional financial markets, the issue
needs to be addressed of how international market players are regulated.  For example, there is the issue of how to regulate market players like credit rating agencies, hedge funds, private equity firms, and central counterparties from third countries outside the EU that are doing business in the EU. To provide EU investors with the same level of protection, and to create a level playing field with EU market players, these third-country market players need to meet the same EU requirements, noted the ESMA official, which raises the potential problem of market players becoming subject to multiple regulatory regimes.

These potential problems can be controlled under two conditions.  The first one is that the regulatory requirements of the third country and the EU are broadly similar. More common regulations between home and host countries obviously limit the potential problems facing cross-border entities and activities. Second, authorities  must avoid circumstances where market players are subject to two, or even more, sets of daily regulatory demands.

Currently, while there is a G-20 commitment to harmonized financial regulation and a role for the Financial Stability Board, noted the official, there is no global governance mechanism which ensures that governments take coordinated decisions regarding the regulation of financial markets.  The EU has developed such a mechanism after many decades: the European Commission, Council, and EU Parliament can decide on Directives and Regulations, and ESMA now has the powers to write technical standards.

While sovereign governments can obviously deviate locally, she observed, such deviations come at a high price. Not achieving broadly common financial regulation will inevitably lead to different levels of investor protection, as well as an uneven playing field and the potential to spread risks, along with the overall specter of regulatory arbitrage.

Not to minimize the G-20’s actions, the ESMA official pointed out that as a result of these G-20 commitments the regulatory developments in the main global financial centers are broadly similar on such issues as credit rating agencies, hedge funds
and OTC derivatives. ESMA supports a strong international community of securities regulators driving the international policy debate on financial market regulation. This is needed so regulators can ``be ahead of the curve” and identify future areas of regulation and offer possible regulatory frameworks.  For example, an area where this has worked well is credit rating agencies where IOSCO published its first principles in 2003. The actual IOSCO Code of Conduct Fundamentals for Credit Rating Agencies has been largely incorporated in legislation in many countries in response to the financial crisis.

In addition, the  initiatives related to OTC derivatives are a good example of the need for global convergence and cooperation.   In Europe, the result from the G-20 commitments has been EMIR,  and to a degree the provisions on derivatives transparency in MiFID II.  But the same issues are occupying ESMA’s counterparts in the US, Asia and other parts of the world. Regulators have also set up a number of international groups aiming at achieving  international consistency of the different regimes, and ESMA plays a full role in this global dialogue.

House Panel Hearings Reveal Support for Legislation Making PCAOB Proceedings Public

At House Capital Markets Subcommittee hearings on the tenth anniversary of th enactment of the Sarbanes-Oxley Act, Mercer Bullard, CEO of Fund Democracy, urged Congress to amend Sarbanes-Oxley to require that PCAOB proceedings be public except by order of the Board. Section 105 of  Sarbanes-Oxley permits PCAOB proceedings to be public only if the PCAOB finds good cause and    both sides consent which, in the view of Professor Bullard, as a practical matter, ensures that these proceedings will never be made public. He noted that secret proceedings improperly deny the public, including issuers’ audit committees, material information regarding auditors, and increase auditors’ incentives to litigate actions. PCAOB enforcement proceedings should be public, he emphasized, just as SEC proceedings have been for 25 years.
Senators Jack Reed (D-RI) and Charles Grassley (R-Iowa) have introduced legislation making PCAOB disciplinary proceedings public to bring auditing deficiencies at the audit firms or the companies they audit to light in a timely manner and help deter violations. The PCAOB Enforcement Transparency Act,  S 1907, would make hearings by the PCAOB, and all related notices, orders, and motions, open and available to the public unless otherwise ordered by the Board. The Board procedure would then be similar to the SEC's Rules of Practice for similar matters, where hearings and related notices, orders, and motions are open and available to the public. There is a companion bill in the House, HR 1503.

Wednesday, July 25, 2012

NASAA Proposes Revisions to Form ADV Part 1B

The North American Securities Administrators Association (NASAA) has released for public comment a proposal to revise Form ADV Part 1B. Form ADV is used by investment advisers to register and report with the appropriate state securities regulators and the SEC. Investment advisers registering with one or more states must complete Form ADV and also Part 1B.

Form ADV had been significantly revised by the SEC in 2011, largely to carry out the provisions of Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act. NASAA's proposed revisions to Part 1B of the Form ADV are designed to: (1) eliminate information that is now captured in other questions within the Form ADV; (2) capture limited additional information, and (3) make technical updates.

Among the proposed changes, Item 2A, which requests information on the person responsible for supervision and compliance, would be amended from a mandatory item to an item required when applicable. NASAA observed that information on the adviser's Chief Compliance Officer (CCO) is now captured in the Form ADV. Despite this addition, however, the person responsible for supervision in the state of registration may not be the CCO of the adviser.  Accordingly, Item 2.A is now designed to capture such information.

Item 2G, concerning the investment adviser's other business activities, is being amended to delete information collected in other places on the ADV and to add categories to collect information about the adviser, its affiliates, and management persons. As amended, Item 2G would require the adviser to disclose whether the adviser, any advisory affiliate, or any management person is actively engaged in business as: an issuer of securities; sponsor or syndicator of limited partnerships; sponsor, general partner, managing member of pooled investment vehicles; real estate adviser; bookkeeper; or bill payment service provider.

The disclosures concerning custody in Item 2I would be amended to include additional information not currently captured in Part 1B, including information on “independent party” as used in the NASAA Custody Requirements for Investment Advisers (Model Rule 102(e)(1)-1)).  Item 2I would also be amended to ask whether the adviser or a related person acts as trustee for any trust in which the firm's advisory clients are beneficiaries of the trust.

New Item 2.K will collect information on advisers organized other than as a sole proprietorship, including the adviser's date of formation and IRS Employer Identification Number. The Disclosure Reporting Pages are being amended to require additional disclosures of advisory affiliates and management persons.

The public comment period will remain open until August 13, 2012.  Comments should be submitted to the individuals listed in the proposal as well as to the NASAA Legal Department. NASAA also welcomes any general comments on any other provisions in Part 1B.

House Oversight Panel Questions CFTC Chair Gensler on Use of Guidance on Cross-Border Derivatives Regulation and Coordination with SEC

There is a growing congressional concern in both the House and Senate Agriculture Committees over the CFTC’s use of interpretative guidance on the cross-border application of the derivatives provisions of the Dodd-Frank Act, while the SEC has indicated that it will issue regulations on the extraterritorial reach of Title VII after a rigorous economic and cost-benefit analysis. The CFTC guidance introduces the concept of substituted compliance under which, as recently explained by CFTC Chair Gary Gensler at the Senate Ag Committee hearing, the CFTC would defer to comparable and comprehensive foreign regulations. The CFTC proposes to permit a non-U.S. swap dealer or non-U.S. major swap participant, once registered with the Commission, to comply with a substituted compliance regime under certain circumstances. Substituted compliance means that a non-U.S. swap dealer or non-U.S. major swap participant is permitted to conduct business by complying with its home regulations, without additional requirements under the Commodity Exchange Act.

During today’s House Ag Committee hearing, Rep. Mike Conaway (R-TX), Chair of the Commodities and Risk Management Subcommittee, was concerned that the use of guidance by the CFTC obviated the conducting of a cost-benefit analysis and a also presaged a lack of coordination with the SEC, which intends to adopt regulations on the cross-border application of Dodd-Frank. Rep. Conaway said that Congress wants regulations that work for everyone. He asked CFTC Chair Gensler if the SEC will come to similar conclusions as the CFTC guidance when the SEC adopts its regulations on cross-border application of Title VII. The SEC regulations will be similar, but not identical to the guidance, said Chairman Gensler, adding that the guidance was issued under Section 722(d) of Dodd-Frank and there is no analogous provision on the SEC side. 

Chairman Gensler noted that Section 722(d) states that swaps reforms must not apply to activities outside the US unless those activities have a direct and significant connection with activities in, of effect on, commerce of the United States. He noted that, in Dodd-Frank, Congress included Section 722(d) for swaps regulated by the CFTC, but included a different provision with regard to the SEC’s oversight of the security-based swap market. In addition, he noted that the CFTC was reacting to a request from market participants for guidance and interpretation.  Chairman Gensler emphasized that the CFTC had counsel from the SEC and the Fed when it drafted the proposed guidance and will be working closely with the SEC as the process moves forward.

Chairman Conaway said that Congress believes that other provisions in Section 722 of Dodd-Frank give the SEC analogous authority to the CFTC authority in Section 722(d). He asked Chairman Gensler if that is the CFTC’s understanding, and the CFTC Chair noted that Section 722 is housed in the regulation of swaps markets part of Title VII, and that the CFTC would look into the issue.

Rep. Larry Kissell (D-NC) said that people want certainty with regard to the cross-border application of the derivatives provisions of Dodd-Frank and urged coordination with the SEC so that the CFTC does not get too far ahead of the SEC. Chairman Gensler noted that any timing gap with the SEC would raise concerns in the clearing of credit default swaps.

Chairman Gensler referenced a comment letter on the guidance from the Swiss Financial Market Supervisory Authority (FINMA) expressing concern about the potential extraterritorial effects of registration rules for swap dealers. Despite the issuance of the proposed guidance, FINMA was not in a position to fully assess the consequences of CFTC registration and whether these can be reconciled with Swiss law and regulations. Indeed, FINMA seriously doubts if CFTC registration as a swaps dealer by a Swiss bank can be reconciled with Swiss practice.

In particular, proposed reporting requirements on trade data and end-customer data, as well as access requirements, may raise Swiss privacy and data protection issues, along with enforcement difficulties. Due to these concerns, FINMA cautioned that it may have to deny financial institutions permission to supply certain information or grant direct access to US regulators. However, FINMA ended in a hopeful note that viable alternatives can be found to allow compliance with both CFTC and FINMA prudential mandates, one possible alternative being the provisional registration of foreign branches of Swiss banks in which swap transactions with US persons are booked until a separate entity is set up or the registration of a US incorporated entity acting as information transfer agent for the bank.

Chairman Gensler said that he has been in discussion with FINMA officials on the concerns raised in the letter. He noted that the impact of the proposed guidance on Swiss secrecy laws is a main concern of FINMA.

Former CFTC Acting Chair Walter Lukken, currently CEO of the Futures Industry Association, noted that the proposed CFTC guidance is not a regulation under the Administrative Procedure Act and thus does not require the CFTC to conduct a cost-benefit analysis before finalizing the guidance.

Moreover, in the view of the former official, the CFTC has proposed a broad interpretation of the definition of a US person and of the activities that would, under Section 722(d) of Dodd-Frank, be deemed to have a direct and significant connection with activities in, or effect on, US commerce. The result would be a complex and confusing regulatory scheme exposing US futures commission merchants and swaps dealers to considerable regulatory risk and effectively expand the CFTC’s reach into many jurisdictions around the world. The former CFTC official urged the Commission to clarify the guidance before registration and other Dodd-Frank requirements go take effect so that firms can plan for the scope of Dodd-Frank’s impact on their global businesses.

Tuesday, July 24, 2012

Securities, Banking and Hedge Fund Industries Urged CFTC to Extend Comment Period on Proposed Cross-Border Guidance

The securities, banking and hedge fund industries have asked the CFTC to extend the public comment period on proposed guidance on the cross-border application of the Dodd-Frank derivatives provisions from August 27 until September 10. According to SIFMA, the American Bankers Association and the Managed Funds Association, the proposed guidance will have a significant impact on how the global derivatives markets will be regulated and will have broad repercussions on how banks, securities firms and hedge funds conduct their swaps business. The associations are working together to provide thoughtful and constructive comments to the Commission.
In addition, since the proposed guidance will have implications for a substantial number of other regulations, it will take time for interested parties to analyze the various regulatory inter-relationships and dependencies to provide comments that are as informed and well-considered as possible. Moreover, the guidance is likely attract substantial interest from constituencies outside the United States, noted the industry associations, and they should be afforded the opportunity to develop their comments in a thorough manner.  
The proposed guidance also contains fundamental information concerning which entities will need to register as swap dealers or major swap participants under Title VII of Dodd-Frank. Thus, the industry groups urged the CFTC to delay the compliance date for registration as a swap dealer or major swap participant until a period of time after the Commission publishes its final cross-border interpretative guidance.

The CFTC guidance introduces the concept of substituted compliance under which, as recently explained by CFTC Chair Gary Gensler at a congressional hearing, the CFTC would defer to comparable and comprehensive foreign regulations. The CFTC proposes to permit a non-U.S. swap dealer or non-U.S. major swap participant, once registered with the Commission, to comply with a substituted compliance regime under certain circumstances. Substituted compliance means that a non-U.S. swap dealer or non-U.S. major swap participant is permitted to conduct business by complying with its home regulations, without additional requirements under the Commodity Exchange Act.

The Commission believes that a cross border policy that allows for flexibility in the application of the Commodity Exchange Act, while ensuring the high level of regulation contemplated by the Dodd-Frank Act and avoiding potentially conflicting regulations, is consistent with principles of international comity. It would also advance the congressional directive in Section 752 of the Dodd-Frank Act that the Commission act in order to promote effective and consistent global regulation of swaps and coordinate with foreign regulators on the establishment of consistent international standards with respect to the regulation of swaps.

In addition, practical considerations underlie the substituted compliance doctrine. Namely, the limitations in the Commission’s supervisory resources and its ability to effectively oversee and enforce application of the Commodity Exchange Act to cross-border transactions and activities support the CFTC in applying its regulations in a manner that is focused on the primary objectives of the Act.

Whistleblower Protection for Employees of Subsidiaries Applies Retroactively

This post was authored by our colleague, Rodney Tonkovic.

Resolving what it described as a novel question, a district court (SD NY) concluded that a Dodd-Frank Act amendment to the Sarbanes-Oxley whistleblowing provisions applies retroactively. The plaintiff alleged that his employment was wrongfully terminated in 2008 in violation of the SOX whistleblower provisions. The employee claimed that his employment was terminated as a consequence of his objecting to a proposal to use fraudulent information to obtain a contract.

Prior to 2010, SOX protected employees of publicly traded companies against retaliation for whistleblowing, and, in this case the plaintiff was employed by non-public subsidiaries of the publicly-traded defendant. The Dodd-Frank Act amended SOX to clarify that Section 806 protects employees of subsidiaries of public companies as well as those employed directly by public companies. Since the plaintiff's claims arose before the 2010 amendment, the court was required to determine whether the amendment applied retroactively. If so, the court would have subject matter jurisdiction over the case under Sarbanes-Oxley.

The employee argued that he had established subject matter jurisdiction because the amended statute explicitly addresses the liability of non-public subsidiaries. According to the employee, the amended provisions clarify the earlier version of the statute and should be applied retroactively. The defendants argued that Section 806 did not apply to this case because the employee was never directly employed by the publicly-traded company. The court did not address the employee's claim and held only that it had subject matter jurisdiction under Section 806.

Few courts have considered whether the earlier version of the statute applied to employees of subsidiaries, the court observed, and those held that the statute did not apply to employees of non-public subsidiaries. In 2011, the Department of Labor's Administrative Review Board held that the amendment to the provision should apply retroactively because it was a clarification of the intent of the previous version of the statute. The court noted that both the SEC and OSHA submitted amicus briefs to the ARB supporting the retroactive application of the amendment.

The court also cited precedent from appellate courts holding that an amendment clarifying an existing law is not considered to retroactive legislation. In this case, the Senate report accompanying Dodd-Frank Section 929A stated that the intent of the amendment was to clarify Section 806. Next, the court concluded that there was conflict and ambiguity regarding the meaning of Section 806 prior to the amendment. The Department of Labor's administrative law judges, for example, reached widely divergent conclusions on the issue. The district courts that addressed the issue generally reasoned that, since there was no specific reference to subsidiaries in Section 806, Congress appeared to have intended that the statute protect only employees of public companies. Several district court decisions, however, implicitly acknowledged the possibility that the statute covered employees of subsidiaries, the court remarked.

The court then concluded that the amendment is consistent with a reasonable interpretation of the pre-amendment text. The court based its conclusion on the policy and legislative history of Sarbanes-Oxley, noting in particular the importance with which Congress viewed whistleblowers and their role in exposing corporate fraud. The court stated that since corporate malfeasance can occur within subsidiaries, it is reasonable to infer that Congress intended to protect the employees of subsidiaries in addition to employees of the parent corporation. Support for the court's conclusion was also found in other securities laws and SOX provisions. Under the reporting provisions of the securities laws, for example, a public company includes its subsidiaries. The court also found nothing contrary to its conclusion in labor law cases or in the interpretation of other Dodd-Frank provisions.

Concluding, the court found that Dodd-Frank Section 929A's amendment is a clarification of SOX Section 806 that applies retroactively. As an employee of a subsidiary of a public company, the plaintiff's whistleblowing activities were covered under Section 806. The court therefore had subject matter jurisdiction and accordingly denied the defendants' motion to dismiss.

Leshinsky v. Telvent GIT, S.A.

Responding to Request from SEC Chair Schapiro, Senate Legislation Would Raise SEC Limits on Securities Fines, Tie Penalties to Scope of Harm and Crack Down on Recidivists

Senators Jack Reed (D-RI) and Charles Grassley (R-IA) have introduced bipartisan legislation strengthening the SEC’s ability to crack down on securities laws violations. The Stronger Enforcement of Civil Penalties Act (SEC Penalties Act) of 2012 would increase the statutory limits on civil monetary penalties, directly link the size of these penalties to the scope of harm and associated investor losses, and substantially raise the financial stakes for repeat offenders of the securities laws.

The legislation responds, in part, to an earlier letter sent to Senator Reed, and Securities Subcommittee Ranking Member Larry Crapo (R-ID), by SEC Chair Mary Schapiro requesting statutory changes substantially enhancing the effectiveness of the SEC’s enforcement program by addressing existing limitations. In the letter, Chairman Schapiro sought five specific statutory enhancements to Commission enforcement authority that collectively would allow the SEC to impose appropriate monetary penalties for serious violations and authorize greater penalties for recidivists.

Under existing law, the SEC can only penalize individual violators a maximum of $150,000 per offense and institutions $725,000.  In some cases, the SEC may calculate penalties to equal the gross amount of ill-gotten gain, but only if the matter goes to federal court, not when the SEC handles a case administratively.  The SEC Penalties Act increases the per violation cap applicable to the most serious securities laws violations to $1 million per violation for individuals, and $10 million per violation for entities.

In cases where the penalty is tied to the amount of money gained by the bad action, the SEC would be able to triple the penalty.  The legislation would also triple the penalty cap for recidivists who have been convicted of securities fraud or subject to SEC administrative relief within the past five years.  The agency would be able to assess these types of penalties in-house, and not just in federal court.

Specifically, the measure would modernize and update the maximum money penalties that may be obtained from individuals and entities charged with securities law violations in administrative and civil actions. The maximum penalty for an individual charged with the most serious violations, such as third tier violations involving fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement that resulted in substantial losses to victims or substantial pecuniary gain to the violator, could not exceed, for each violation, the greater of $1 million, three times the gross pecuniary gain, or the losses incurred by victims as a result of the violation.  The maximum amount that could be obtained from entities charged with the most serious violations could not exceed, for each violation, the greater of $10 million, three times the gross pecuniary gain, or the losses incurred by victims as a result of the violation.

The maximum penalties for individuals and entities charged with other violations would be revised by the legislation so that the maximum penalty for an individual charged with less serious violations involving fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement could not exceed, for each violation, $100,000 or the gross pecuniary gain as a result of the violation.  The maximum penalty that could be obtained from entities charged with these violations could not exceed, for each violation, $500,000 or the gross pecuniary gain as a result of the violation.

The maximum penalty for an individual charged with violations not involving fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement could not exceed, for each violation, $10,000 or the gross pecuniary gain as a result of the violation.  The maximum penalty that could be obtained from entities charged with these violations could not exceed, for each violation, $100,000 or the gross pecuniary gain as a result of the violation.

The Act would also deal with the p
enalties for recidivists. Thus, the maximum amount of the penalty for repeated misconduct must be three times the applicable cap when the person or entity within the five years preceding the act or omission is criminally convicted of securities fraud or is subject to a judgment or order concerning securities fraud.

In addition, the measure would provide authority to seek civil penalties for violations of previously imposed injunctions or bars obtained or entered under the securities laws.  It also provides that each violation of an injunction or order must be considered a separate offense.  In the event of an ongoing failure to comply with an injunction or order, each day of the continued failure to comply with the injunction or order will be considered a separate offense.

Senator Reed, the Chair of the Subcommittee on Securities, said that tougher antifraud laws are needed to protect taxpayers and investors. With a number of financial firms, he noted, if they look at the bottom line and see they can break the law, get caught, pay a nominal fine, and still profit, the cycle of misconduct will continue. Noting that the law needs to change to ensure the punishment fits the crime, Senator Reed emphasized that the legislation would give the SEC more tools to demand meaningful accountability from Wall Street and enhance the Commission’s ability to protect investors and crack down on fraud.

The SEC is responsible for overseeing approximately 35,000 entities, as well as the Financial Industry Regulatory Authority (FINRA), which itself oversees 4,500 brokers; the Public Company Accounting Oversight Board (PCAOB), which oversees auditors of public companies; and the Municipal Securities Rulemaking Board (MSRB), which regulates municipal securities firms and municipal advisors.

Last year, the SEC successfully brought 735 enforcement actions which resulted in the transfer of $2.8 billion in penalties and returned funds to harmed investors. However, the Senators noted that in a recent case between the SEC and two former Bear Stearns hedge fund managers who were indicted on charges of wire and securities fraud for misrepresenting the health of their funds that cost investors $1.6 billion, the SEC was forced to settle for civil penalties of $800,000 and $250,000, respectively. 

SEC Staff Publishes JOBS Act Decimals Study

The SEC staff published a report in response to a JOBS Act requirement that the SEC must study the effects of the transition from fractional trading to penny trading for securities, including the effect of the transition on initial public offerings. The statute required the Commission to study the impact that this change has had on liquidity for small and middle capitalization company securities and whether there was sufficient economic incentive to support trading operations in these securities in penny increments. The statute provided that if the SEC determined that the securities of emerging growth companies should be quoted and traded using a minimum increment of greater than $0.01, the Commission could 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.

In its report, the staff concluded that the Commission should not proceed with specific rulemaking to increase tick size but should consider additional steps that may be needed to determine whether rulemaking should be undertaken in the future. According to the staff, the SEC should solicit the views of investors, companies, market professionals, academics, and other interested parties on the broad topic of decimalization, how to best study its effects on IPOs, trading, and liquidity for small and middle capitalization companies, and what, if any, changes should be considered. According to the staff, there are several ways for the Commission to gather additional views and data, such as a roundtable with opportunity for public comment. Participants could examine (1) the economic consequences that might accompany alternative methods for analysis, (2) the types of data that should be collected and used to assess the effects of an increase in or variation of tick size for companies of different capitalizations, including how best to gather the data, and (3) whether other policy alternatives might better address congressional concerns.

In its study, the staff undertook a three-pronged approach, including (a) a review of empirical studies regarding tick size and decimalization, (b) participation in, and a review of the materials prepared in connection with, discussions concerning the impact of market structure on small and middle capitalization companies and on IPOs held as part of a meeting of the SEC Advisory Committee on Small and Emerging Companies, and (c) a survey of tick-size conventions in non-U.S. markets.

While the published literature is useful, the staff cautioned that there are few studies focus on differing effects related to market capitalization. The effect of decimalization on capital formation has also not been explored in the literature, which may make it difficult to quantify the mechanism by which, if at all, decimalization may have hindered capital formation. Finally, many of the studies examine only the time period surrounding the implementation of decimalization and do not examine its longer term effects.

The staff also recognized that unlike many other countries, the United States employs a “one size fits all” approach to tick size. According to the report, “such an approach may not necessarily be optimal for smaller capitalization securities in all contexts.” The staff noted that decimalization may be just one factor attributable to the recent decline of smaller public company IPOs. Recent studies on the IPO market have attributed the decline in U.S. IPOs to greater globalization of financial markets and to the increase in the use of global IPOs. According to the staff, further study to assess the impact of tick size as distinct from other potential factors.


Monday, July 23, 2012

Second Circuit Panel Affirms FINRA Arbitration Award against Hedge Fund Prime Broker

A FINRA arbitration award against the sole clearing broker and prime broker for a hedge fund that turned out to be a massive Ponzi scheme was affirmed by a Second Circuit panel. The court found that the prime broker failed to satisfy the difficult standard for demonstrating that the arbitrators manifestly disregarded the law. (Goldman Sachs Execution & Clearing, L.P. v. The Official Unsecured Creditors’ Committee of Bayou Group, LLC, CA-2, July 3, 2012)

When the fund filed for bankruptcy, the bankruptcy trustee authorized a committee of unsecured creditors of the fund to pursue claims against the prime broker. Pursuant to an arbitration agreement between the fund and the prime broker, the committee pursued a FINRA arbitration proceeding against the prime broker, which resulted in an award in favor of the committee by a FINRA arbitration panel in the amount of $20.5 million.

The arbitration award was judicially reviewed under the manifest disregard standard, which the appeals panel called a standard that is highly deferential to arbitrators. In applying the manifest disregard standard, courts in the Second Circuit consider first whether the governing law alleged to have been ignored by the arbitrators was well defined, explicit, and clearly applicable, and, second, whether the arbitration panel knew about the existence of a clearly governing legal principle but decided to ignore it. The manifest disregard standard is designed to be exceedingly difficult to satisfy, noted the appeals court, and the prime broker did not satisfy it in this case. 

The committee alleged in the arbitration that deposits transferred into four new hedge funds in the fund group were fraudulent transfers under the Bankruptcy Code and were recoverable from the prime broker because it was an initial transferee under the Code. The prime broker did not contest that the transfers were fraudulent, said the court, or even that it was on inquiry notice of the fraud, but it argued that it is not an initial transferee and that the arbitration panel manifestly disregarded the law in concluding that it was. The argument failed because the most recent case on point in the Southern District of New York, where the arbitration was held, cuts in favor of the committee. Bear Stearns Securities Corp. v. Gredd, 397 BR 1 (SD NY 2007).

Much like Bear Stearns in the Gredd case, the prime broker here possessed considerable control with respect to the fund’s deposits under the relevant account agreements. Not only did the prime broker possess a security interest for payment of all of the hedge fund’s obligations and liabilities, but it also had the rights to require the fund to deposit cash or collateral with to assure due performance of open contractual commitments; to require the hedge fund to maintain such positions and margins as the prime broker deemed necessary or advisable, to lend either to itself or to others any of the fund’s securities held by the prime broker in a margin account and to liquidate securities and/or other property in the account without notice to ensure that minimum maintenance requirements are satisfied.

The appeals panel emphasized that these provisions gave the prime broker broad discretion over the funds in the hedge fund accounts and allowed it to use the funds to protect itself. While the Second Circuit has not previously endorsed the district court's decision in Gredd, and did not do so here, neither has the appeals court rejected it. It is enough, said the Second Circuit panel, under the manifest disregard standard, that the Gredd opinion reveals considerable uncertainty as to whether cases like this one come within an exception to the mere conduit principle on which the prime broker relies. Under these circumstances, the appeals court could not conclude that the arbitrators manifestly disregarded the law in applying the legal principles set forth in Gredd to impose transferee liability on the prime broker.