Wednesday, October 31, 2012

Corporate Secretaries Society Has Concerns with ISS Policy on Board Response to Majority-Approved Shareholder Proposals

The Society of Corporate Secretaries and Governance Professionals has major concerns with a proposed revision to the Institutional Shareholder Services (ISS) voting policies on a board’s response to a majority-supported shareholder proposal. In a letter to the ISS Global Policy Board, the Society said that the proposed change would undermine the exercise of directors’ fiduciary duties on matters that under state law are firmly within the board’s purview. The Society urged the Global Policy Board to reject this proposed change.

Currently, ISS policy provides for opposition to all incumbent directors if the board does not act on a shareholder proposal that was supported by a majority of outstanding shares the previous year, or a majority of shares cast the previous year and at least once in the two years before that. The revised policy would accelerate this process, with against or withhold recommendations on all but new directors if the board does not act on a shareholder proposal between the annual meeting and the publication of the proxy statement for the next annual meeting, whether the shareholder proposal received a majority of votes outstanding or a majority of votes cast.

In the Society’s view, this shortened time frame for a board to take action in instances where a proposal is supported by a majority of the votes cast, rather than a majority of the outstanding shares, raises significant concerns about the coercive nature of the director vote and its impact on the ability of directors to perform their fiduciary obligations.

The Society noted that fiduciary duties do not disappear or become less significant when a majority of the votes cast at a meeting support a particular non-binding shareholder proposal.  A fundamental principle of state corporation law is that directors are not mere agents of shareholders but must exercise their independent judgment to act in the best interest of the corporation.  Thus, boards of directors cannot implement a proposal presented to shareholders that they do not believe would be in the best interests of a company. Rather, they must determine the most appropriate response to the proposal, which may be to consider other actions they believe address the shareholder concerns in a manner consistent with the best interests of the corporation. 

The Society believes that in these circumstances the appropriate policy approach would be to consider disclosure of board action with respect to alternatives considered, any action taken and the board’s rationale for its decision.  An automatic recommendation against all directors is inappropriate and inadvisable. The group also said that the importance of the shareholder proposal in question, and the importance of other factors in the election of directors, is not being given due consideration in the proposed policy change. 

There is a risk that an entire board under a majority vote framework will be removed for failure to set special meeting rights at a 10 percent threshold rather than 15 percent.  If the director vote matters, reasoned the Society, making it contingent entirely on one, possibly minor, difference does not serve the interests of the company or the shareholders.

Moreover, in view of the number of companies that have adopted majority voting for directors and eliminated staggered board elections, an ISS negative vote recommendation could result in the failure to elect a board.  According to the Society, a strict one-size-fits-all policy that leads to this result without any consideration of the broader circumstances, including the positive value that a board brings on other matters and the level of importance of the particular subject matter of the proposal, cannot be in the interest of the shareholders.

The Society is also concerned that the policy is based on a majority of shares voted, not on a majority of shares outstanding, and does not take into account whether the proposal was approved under the company’s own rules. The expression of substantial opposition to the ISS view, by for example 49 percent of shares voted, apparently is seen as meriting no consideration by a board, where a compromise on an issue may make more sense.  This is in stark contrast to the ISS policy on say-on-pay, in which substantial opposition by a minority of shares voted is said by ISS to require a response from the board.  A board should have some flexibility to take into consideration substantial minority views.

In addition, the revised policy is silent on the circumstances under which ISS would view a board as having failed to act on a majority-supported shareholder proposal.  It would thus appear that, under this policy change, ISS would be second-guessing board decisions to implement a proposal in an alternative manner, even where the alternative approach is submitted for shareholder approval.  The Society believes that this is fundamentally at odds with a board’s fiduciary duties under state corporate law.

For example, a board may respond to a proposal to permit shareholders to act by written
consent by reducing the ownership threshold at which shareholders can call a special meeting. In this instance, the Society queries if ISS would call for a vote against all directors. While ISS previously has not recommended against directors in some cases like this, the change in policy would appear to yield a different result.

Tuesday, October 30, 2012

UK Central Banker Says Faithful Implementation of Volcker Rule and Vickers Proposals Can Enhance Resolution Authorities

Legislation providing for the orderly resolution of failed financial institutions is an important practical step towards preventing systemic risk and ending too-big-to-fail, as well as lowering the societal costs of the failure of a large interconnected financial firm, noted Andrew Haldane, Executive Director of Stability for the Bank of England. While it is striking how much progress has been made in so short a space of time on so complex an issue, he noted, the practical question is how far this takes us towards removing the too-big-to-fail externality. In recent remarks, he posited that the faithful implementation of both the letter and the spirit of the Volcker Rule in the US and the Vickers Commission ring-fence proposals in the UK will enhance the ability of resolution authorities to succeed in the goal of ending too-big-to-fail.

He mentioned that Title II of the Dodd-Frank Act creates a new regime for the resolution and liquidation of financial companies, banks and non-banks, which pose a systemic financial stability risk.  It enables losses to be imposed on creditors in resolution, while also prohibiting state bail-outs. Internationally, in November 2011 the G20 endorsed the Financial Stability Board’s Key Attributes of Effective Resolution Regimes, developed by an international working group. Efforts are underway to align national resolution regimes with these principles.  As part of that, in Europe a draft Directive on recovery and resolution of financial institutions was published in June 2012.  

During the resolution of a financial firm, noted the Executive Director, one way of ensuring continuity of services is by transferring assets and/or liabilities of a failing firm to a third party.  But he noted that the only entity with sufficient financial and managerial resource to absorb a large asset or liability portfolio, without ``suffering chronic indigestion,’’ is another large financial institution, citing examples during the crisis of Bear Stearns being swallowed by JP Morgan Chase, Merrill Lynch by Bank of America and Washington Mutual by Citigroup.  

According to the senior official, this makes for an uncomfortable evolutionary trajectory, with rising levels of banking concentration and ever-larger too-big-to-fail banks.  Levels of banking concentration have risen in many countries since 2007, he noted, precisely because of such ``shot-gun marriages by over-sized partners.’’  In other words, resolving big banks may have helped yesterday’s too-big-to-fail problem, but at the expense of worsening tomorrow’s problems.

One way of lessening that dilemma, he reasoned, and at the same making resolution more credible, is to act on the scale and structure of financial firms directly. Recent regulatory reforms have sought to do just that. In the United States, the Volcker Rule prohibits US-operating banks from undertaking proprietary trading and sponsoring hedge funds and engaging in other types of private equity activity. 

In the United Kingdom, the proposals of the Vickers Commission include placing a ring-fence around retail banking activities, supported by higher levels of capital, and thus fencing them off from commercial banking. The government’s plan is to enact the ring-fence through legislation. The EU announced the Liikanen plan in October 2012, which proposes that the investment banking activities of universal banks be placed in a separate entity from the remainder of the banking group.

Volcker, Vickers and Liikanen seek legal, financial and operational separation of activities, noted the Executive Director, and thus in principle should prevent cross-contamination of retail and investment banking at crisis time.  Whether they do so in practice, said the official, depends on loopholes in, or omissions from, the ring-fence. 

And each of the existing proposals has open questions on this front. For example, the Volcker Rule separates only a fairly limited range of potentially risky investment bank
activities, in the form of proprietary trading.  The Vickers proposals mandate only a limited range of basic banking activities to lie within the ring-fence, namely deposit-taking and overdrafts.  And the Liikanen plan allows a wide range of derivative activity to lie outside of the investment banking ring-fence.

US Hedge Fund Industry Urges Basel-IOSCO Working Group to Consider Risk Management in Margin for Non-Centrally Cleared Derivatives

While generally supporting the efforts of a Basel-IOSCO Working Group to provide an international framework for the bilateral exchange of initial and variation margin for non-centrally cleared derivatives, the US hedge fund industry urged the Working Group to consider the cumulative effect of the proposals on the liquidity of the non-cleared derivatives markets.  In a letter to the Working Group, the Managed Funds Association said that the proposals should not unduly impinge on the ability of market participants to transact on the non-cleared derivatives markets, given their critical role in allowing market participants to meet their risk management needs. Unless carefully managed and monitored, cautioned the MFA, the aggregate impact of the proposals could place unwarranted burdens on market participants, particularly in the period before the market has transitioned to mandatory clearing.

Thus, the Working Group, in its final recommendations, should take into consideration the risk management needs of participants in the non-cleared derivatives markets and to avoid compromising their ability to manage risk effectively. More broadly, the MFA strongly urged regulators across jurisdictions to coordinate with each other in order to ensure a uniform set of margin requirements in non-cleared derivatives markets.

The MFA believes that the derivatives markets operate most efficiently where the margin requirements are harmonized cross-border and applied uniformly with respect to all non-cleared derivatives. A uniform set of margin requirements will facilitate orderly collateral management practices. Without cross-border uniformity, warned the MFA, market participants will have to monitor and comply with multiple margin regimes, which would be a costly and burdensome task that could increase the likelihood for errors and instances of non-compliance. Further, margin requirements that differ according to the jurisdiction would encourage regulatory arbitrage and create advantages for market participants established in certain jurisdictions over other market participants.

The MFA looks forward to the results of the quantitative impact study to assess the effect of the proposed margining requirements on the orderly functioning and liquidity of the non-cleared derivatives markets, and urged the Working Group to consider the results of the study when finalizing the proposals. The final recommendations should take into consideration the importance and continued viability of non-cleared derivatives as customized risk management tools.

Specifically, the MFA supports the bilateral exchange of initial margin, provided that the initial margin requirements appropriately reflect and address the risks to the financial system presented by the non-cleared derivative transaction. However, the association is concerned that buy-side market participants will bear their sell-side counterparties’ costs associated with establishing and maintaining segregated custodian accounts for counterparties. The MFA is also concerned that the increased cost of trading non-cleared derivatives could reduce liquidity and adversely impact market participants’ ability to properly hedge their portfolios. Thus, the group said that the final recommendations should consider the overall cost and liquidity impact of the proposed margining requirements.

Similarly, the MFA supports the proposal to allow portfolio margining. But for portfolio margining to achieve the intended risk offset benefits, said the association, initial margin models should account for risk offsets across suitably correlated cleared and non-cleared derivative and non-derivative products. The MFA believes that such portfolio margining within a single cross-product master netting agreement is instrumental in mitigating the potential shortfall in eligible collateral while ensuring sufficient reserves to preserve systemic safety. Portfolio margining arrangements should account adequately for the risks of a portfolio, continued the hedge fund group, while avoiding the capital inefficiencies of over-collateralization. In addition, portfolio margining arrangements encourage market participants to enter into mutually offsetting transactions and maintain balanced and hedged portfolios.

The MFA does not believe that thresholds are an appropriate tool for managing the liquidity impact of the proposed initial margin requirements. The introduction of thresholds would result in counterparties being treated unequally, said the association, with some counterparties being required to post no initial margin, or a significantly reduced amount after application of a high threshold.

Monday, October 29, 2012

In Letter to SEC, US Senators Say Proposed Regulations Implementing Sec. 201 of JOBS Act Are Fatally Flawed and Should be Re-Proposed

In a letter to the SEC, seven US Senators, including Securities Subcommittee Chair Jack Reed (D-RI), said that the proposed regulations implementing JOBS Act provisions eliminating the ban on general solicitation in Regulation D are fatally flawed because they fail to establish methods sufficient to ensure that only accredited investors participate in the offerings. The SEC proposal fails to implement the directive of Section 201 of the Act that requires issuers to take ''reasonable steps" to ensure that only accredited investors participate in the private offerings and further directs the Commission to establish the methods issuers must use in order to qualify as taking such "reasonable steps." The Senators also urged the SEC to distinguish between issuers that engage in operational businesses and those that are merely investment vehicles.

Because of the significance of the changes the Senators are requesting to the proposed regulations, and because effectively implementing Section 201 is essential to protecting investors and ensuring market integrity, the Senators ask the SEC to re-propose a new regulatory framework for implementation of Section 201 of the JOBS Act. The letter was also signed by Senators Carl Levin (D-MI), Richard Durbin (D-IL), Tom Harkin (D-Iowa), Frank Lautenberg (D-NJ), Al Franken (D-MN) and Daniel Akaka (D-Hawaii).

The proposal emphasizes the need to provide sufficient flexibility to accommodate the different types of issuers that would conduct offerings under the new Rule 506(c).  The proposal further states that requiring issuers to use specified methods of verification would be impractical and potentially ineffective in light of the numerous ways in which a purchaser can qualify as an accredited investor, and the potentially wide range of verification issues that could arise. But in its effort to accommodate all types of issuers, noted the Senators, the SEC proposal provides no certainty to issuers and fails to ensure that only accredited investors participate in the offerings.

According to the Senators, the "reasonable steps" language used in the JOBS Act was specifically intended to ensure that only accredited investors participated in private offerings, and the provision’s author, Rep. Maxine Waters (D-CA), made it clear that self-certification was inadequate. The Senators said that the proposed regulations must require common-sense documentation and/or verification practices and procedures, thus allowing the SEC to fulfill its mission to protect investors, while providing needed, bright-line certainty for issuers and investors. In addition, the proposal appears to misconstrue Section 201 as a mandate to remove any and all regulation of general solicitation.  However, the statute and legislative history reflect the intent to only remove the prohibition on general solicitation.

Congress could have removed from the SEC any authority to condition, limit, or otherwise regulate the manner or substance of general solicitation, reasoned the Senators, but instead Congress elected to allow the Commission to retain its authority to regulate this new allowance for general solicitation in offerings exempt from registration pursuant to Rule 506 or Rule 144A.  As such, the Senators urged that the proposal be significantly revised to provide clear, objective, and meaningful regulation of the manner and substance of general solicitations that may be allowed in private offerings.

Also, the Commission should take into account the nature of the securities being offered.  In providing a solid regulatory framework within which to permit general solicitation regarding certain private offerings, they noted, the Commission should distinguish between issuers that engage in operational businesses and those that are merely investment vehicles.

Congress did not contemplate removing the general solicitation ban-without retaining any limitations on forms of solicitation for private investment vehicles.  Indeed, continued the Senators, no argument was made during the debate of the bill that the objective was to ease the capital aggregation process for private investment vehicles.  The words "hedge fund," ''private fund," or "investment vehicle" were not used either during the committee or floor debate in the House of Representatives, they emphasized, nor did the Senate engage in any debate relating to removing these advertising and marketing restrictions completely from private investment vehicles.

Division of Trading and Markets Issues FAQ on Hurricane Sandy

The SEC’s Division of Trading and Markets has issued a FAQ dealing with the close out of fail to deliver positions under Regulation SHO due to financial markets being closed for Hurricane Sandy. The FAQ said generally that registered clearing agency participants, or broker-dealers allocated fail to deliver positions by a participant, “may delay closing out fail to deliver positions that have become due on a day major U.S. equity exchanges are closed as a result of Hurricane Sandy until no later than the beginning of trading on the day that major U.S. equity exchanges re-open.” The FAQ noted that Regulation SHO Rule 204 allows the result because of the “unique circumstances” presented by the storm. The FAQ also clarifies several other points and offers an example of how Regulation SHO may apply to hypothetical facts.

Federal Court Rules Audit Firm Internal Documents Developed in Response to PCAOB Comments Are Privileged in Securities Fraud Action

A federal judge has ruled that the Sarbanes-Oxley Act privilege for PCAOB information protects materials that are specifically for the Board as well as internal audit firm communications that discuss confidential questions or comments made by the Board or reflect the firm’s development of responses to Board inquiries. Because the final version of PCAOB comments and audit firm responses to those comments are all privileged, reasoned the court, then it follows that any internal auditor communications that reveal those comments, or the work to develop the responses to the comments, are also privileged. All of these communications are specifically for the Board because, absent the Board’s audit inspection, these documents and communications would not exist. Thus, the court rejected a discovery request for these documents from plaintiffs in a securities fraud action alleging that the audited company filed false financial statements that failed to timely write off impaired goodwill in connection with a merger. (Bennett v. Sprint Nextel Corp., KPMG, Interested Party, WD Mo., No. 11-9014, Oct 10, 2012)

While the plaintiffs demonstrated that the information they sought was reasonably calculated to lead to the discovery of admissible evidence regarding whether goodwill was properly stated by the company, said the court, the documents were privileged pursuant to Section 105(b)(5)(A) of Sarbanes-Oxley. This privilege provision addresses two circumstances. The first, which was not at issue in this case, involves discovery requests directed to the Board itself. The second circumstance involves discovery requests directed to targets of the Board's investigations. The second aspect of the privilege protects those who are under investigation from being required to divulge their responses to that investigation. 

Specifically, the court found the following documents to be privileged under Section 105(b)(5)(A) because they were prepared by the Board, received by the Board, or specifically for the Board: direct communications between the Board inspectors and KPMG; forms labeled as "Public Company Accounting Oversight Board Inspection Comment Form," including the Board's comments, KPMG's responses, and drafts thereof; spreadsheets including data prepared specifically for the Board; any information revealing specific questions or inquiries from Board members and drafts and final versions of KPMG responses to those questions or inquiries; drafts and final versions of the Engagement Profile; and the kick-off meeting presentation file.

The court found, however, that any substantive information, documents, spreadsheets, or forms that were compiled specifically for the company, but nevertheless used to respond to the Board's inquiries, are not privileged.

The court rejected the argument that the privilege only covers documents in the hands of the Board and does not protect documents in the hands of third parties, namely the audit firm, KPMG. This argument is not supported by the plain language of the statute, which extends the privilege to both materials "prepared . . . for" and "received by" the Board. If only materials in the possession of the Board (i.e. "received by") were protected, then the phrase "prepared . . . for" would be rendered superfluous. Further, the privilege not only protects the Board, but also those who are under investigation from being required to reveal their responses to the Board's inquiries. Thus, the privilege outlined in Section 105(b(5)(A) may be asserted by KPMG.

Similarly rejected was the contention that the "Board" as used in the statute only includes the five appointed Governing Members of the Board, thus excluding the Board’s inspection staff. Sarbanes-Oxley defines "Board" as the "Public Company Accounting Oversight Board," noted the court, and the Board's duties include registering and inspecting audit firms, as well as conducting investigations and disciplinary hearings. The five appointed Board members must necessarily rely on other PCAOB officials to conduct investigations and prepare documents that relate to the investigation, reasoned the court, as well as receive documents relating to the investigation. Thus, the Court found that the "Board" as mentioned in Section 105(b)(5)A) includes the PCAOB's inspectors who actually conduct the investigations.

Martin Wheatley Tells UK Parl. Commission that Proper Outcomes for Investors is Key to New Twin Peaks Financial Regulation

Martin Wheatley, UK Financial Services Authority Managing Director, and Chief Executive-designate of the new Financial Conduct Authority, told a Joint Select Parliamentary Commission on Banking Standards that the FCA will be guided by achieving the proper outcomes for investors and consumers of financial products. The FCA will have the ability to look closely at the financial products being designed and provided and, in extreme cases, use new regulatory powers to ban products

Andrew Tyrie MP, Commission Chair, asked how the FCA will know if a financial product is the right financial product for investors. Mr. Wheatley said that the FCA will not have a product pre-approval regime, adding that the Authority will not stand in the way of people innovating and taking new products to market. When something goes wrong, he noted, the FCA will step in and ask of the product is the wrong product for the investor class it is being sold to. It is all about outcomes, he said, getting the right outcomes for investors and consumers of financial products. He noted that good financial products sold badly become poor outcomes for investors. It is question of whether investors are getting good or bad outcomes. For example, some complex products could be appropriate for some investors, he noted, but not for others. The FCA will not say that a financial product is unsuitable in all circumstances. It will often be an individual facts and circumstances decision. The FCA will look at a firm’s governance, its target market and how it is selling to that market.

Asked if there should be a benchmark of plain vanilla financial products, the Director said that it would be difficult for the FCA to bless plain vanilla products because even those products could have bad outcomes for investors and consumers if sold in the wrong way and to the wrong market.

Asked by Chairman Tyrie if the FCA would create a safe harbor for a product, the Director said that the FCA could do that but it would be at a high cost since the agency would have to go through a great amount of detail and bring a great amount of expertise to bear in order to give such assurance. It would not be possible to develop this expertise on every financial product before it is launched, he said, nor would the FCA do it randomly. The FCA would do it if the agency perceived a financial product was causing bad outcomes for investors.

Lord Lawson emphasized the need the for reform of incentive-based compensation regimes, such as bonuses, at financial firms.  The Director noted that a compensation regime of incentives focused on short-term profits led to excessive risk-taking at financial firms. A change in accounting standards could help by discouraging the booking of profits up front on long-term trades and linking bonuses to that. Accounting standards could require amortization over a longer term. He also said that legislation capping bonuses that can be paid would be helpful in changing the current culture, as well as requiring that bonuses be paid over a longer period and that there be clawback of bonuses under certain circumstances. In addition, as a best practice, the FSA is asking financial firms to design their incentive compensation regimes  to produce good outcomes for investors. This would be outside of statutory intervention.

Andrew Love MP, noted that insider trading is widespread but extremely difficult to prosecute, adding that the UK does not bring as many enforcement actions for insider trading as the US. Mr. Wheatley noted that the FSA is taking a robust approach to insider trading and taking on complex and difficult cases. He noted that, under the UK sentencing structure, UK courts do not give as high a sentence for insider trading as US courts. There are two main differences between the US and the UK in this area, he said. First, in the UK, wiretaps are not available to the authorities in insider trading cases and, second, because of high sentences in the US, often someone will turn state’s witness.

Baroness Kramer noted that whistleblowers seem to have more incentives in the US and asked if the FSA has looked at enhancing the use of whistleblowers. The Director said that the FSA has not looked at the incentive structure, but added that the FSA does have whistleblowers come forward and does provide protection, but it is not at the same scale as in the US. Chairman Tyrie noted that the Commission is looking into legislation to enhance whistleblowing, adding that the central question is what incentives can be provided without creating a moral hazard.

Saturday, October 27, 2012

Senator Specter Championed Cause of Private Investor Actions for Aiding and Abetting Securities Fraud

It was with regret that we note the recent passing of Senator Arlen Specter. Senator Specter was very active in the area of securities regulation. One cause that Senator Specter championed over the years was the enactment of legislation providing for a private right of action for aiding and abetting securities fraud. During the deliberations that led up to the passage of the Dodd-Frank Act, the Specter Amendment to the Senate bill  would have overturned two US Supreme Court opinions and provided a private right of action for aiding and abetting securities fraud.  An amendment offered by Rep. Maxine Waters in the House-Senate conference on the financial reform legislation mirrored the Specter Amendment.

In turn, the Waters and Specter Amendments essentially mirrored the Liability for Aiding and Abetting Securities Violations Act, S. 1551, introduced by Sen. Spector in 2009. The Amendments would have legislatively overruled what Senator Specter has called ``two errant decisions of the Supreme Court’’, namely the 1994 Central Bank of Denver v. First Interstate Bank ruling and the 2008 ruling in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. The immunity from suit that Central Bank confers on secondary actors, said the Senator, has removed much-needed incentives for them to avoid complicity in and even help prevent securities fraud; and all too often left the victims of fraud uncompensated for their losses.

House conferees voted to adopt the Waters Amendment, but the Senate rejected the idea of creating a private Rule 10b-5 cause of action against secondary actors in a securities fraud. The Senate countered with the offer of a mandated GAO study on the costs and benefits of creating a private right of action against aiders and abettors of securities fraud, which ultimately passed.

The Specter Amendment would have taken the limited, but important, step of amending the Exchange Act to authorize a private right of action under §10(b), the antifraud provision, and other, less commonly invoked, provisions of the Act, against a secondary actor who provides substantial assistance to a person who violates the securities antifraud rule. Any suit brought under the proposed Specter Amendment would be subject to the heightened pleading standards, discovery-stay procedures, and other defendant-protective features of the Private Securities Litigation Reform Act of 1995.

Until the Central Bank ruling, noted the Senator, every Federal Court of Appeals had concluded that §10(b)'s private right of action allowed recovery not only against the person who directly undertook a fraudulent act, the primary violator, but also anyone who aided and abetted the actor. A five-Justice majority in Central Bank narrowed §10(b)'s scope by holding that its private right of action extended only to primary violators. When Congress debated the legislation that became the Private Securities Litigation Reform Act of 1995, then-SEC Chair Arthur Levitt and others urged Congress to overturn Central Bank, said Sen. Specter, but Congress declined to do so. Cong. Record, July 30, 2009, S8564.

The PSLRA authorized only the SEC to bring aiding and abetting enforcement litigation. But in the Senator’s view, SEC enforcement actions have proved to be no substitute for suits by private plaintiffs. 

Friday, October 26, 2012

Hedge Funds Enhance Risk Management to Attract Institutional Investors Says Singapore Trade Minister

While the macro economic environment has left hedge funds grappling with volatile financial markets and an environment that has grown averse to risk taking, noted a Singapore senior financial regulator, the  long term prospects for the alternative investment industry remain positive. In recent remarks , Trade Minister Lim Hng Kiang, who is also Deputy Chair of the Singapore Monetary Authority, said that to meet the demands of institutional investors and global regulatory standards, hedge funds have enhanced their risk management and compliance functions. He cited a recent study by the Managed Funds Association, BNY Mellon and Hedgemark finding that 79 percent of global hedge funds now separate the roles of the risk manager and the fund manager, with 60 percent of the larger hedge funds having a dedicated risk management function. He believes that all this augurs well for the hedge fund industry, since it allows the industry to grow in a more sustainable manner with strong internal control systems and risk management oversight.

The Minister also noted that institutional investors have increased allocations to hedge funds significantly over the last decade, from only US$125 billion in 2002 to approximately US$1.5 trillion as of the end 2011. Looking forward, he also noted that institutional investors in the major markets have indicated their intent to increase allocations to almost all alternative classes, including hedge funds. In the Minister’s view, increased institutional participation will drive growth as hedge funds become an important part of the investment landscape.

Senate Authors of Volcker Rule Say SEC, CFTC and Banking Agencies Must Adopt Final Regulations Implementing the Rule by Year End

Senators Jeff Merkley (D-OR) and Carl Levin (D-MI) called on federal financial regulators to end the delay in issuing a final version of the Volcker Rule. In a letter to the SEC, CFTC and the federal banking regulators, the Senators expressed frustration that months after the deadline for finalizing the Volcker Rule has past staff-level differences at the various agencies may be obstructing progress on removing the loopholes from earlier proposals and finalizing the rule. Senators Levin and Merkley are the co-authors of Section 619 of the Dodd-Frank Act, which directs federal regulators to implement the Volcker Rule. The regulations implementing the Volcker Rule were due two years after the law was passed, on July 21, 2012. Until a strong Volcker Rule is firmly in place and meaningfully enforced, cautioned the Senators, businesses and investors will continue to doubt the U.S. commitment to Wall Street reform, and taxpayers will remain exposed to the dangers of high-risk trading and conflicts of interest by Wall Street’s largest firms.

As with any rulemaking, conceded the Senators, different agencies may have their own perspectives on various provisions.  While cautiously pleased to see reports that a consensus is emerging, they are concerned that some ongoing staff-level differences may be obstructing progress.  Noting that the time for resolving those differences is long overdue, the Senators urged the regulators to move quickly, make the final adjustments needed to simplify and strengthen the October 2011 proposal, and bring the process to a conclusion.  The final regulations needed to implement the ban on high-risk trading and conflicts of interest should be issued without delay, they emphasized, and no later than the end of the year, so that financial institutions can speed the process of eliminating the risks and conflicts of interest that continue to endanger the U.S. financial system.

If because of differing agency procedures or timelines, not all of the regulators can finalize the rule simultaneously, they noted, so be it, adding that the statute was constructed with that possibility in mind.  The Senators are confident that if the majority of regulators act, any remaining agency or agencies will soon follow suit. 

Thursday, October 25, 2012

In Brief to Second Circuit, Former Federal Judges Fault Wiretap Application in Insider Trading Case for Failure to Disclose SEC Investigation

In an insider trading case, eight former federal district and circuit court judges argued in an amicus brief to the Second Circuit Court of Appeals that the federal government recklessly failed to disclose an ongoing SEC investigation in its wiretap application even though that investigation was the most important part of the criminal investigation into the insider trading at the time of the wiretap application and the SEC investigation employed entirely conventional investigative techniques. The trial court found that these omissions made it impossible for the authorizing judge to fulfill his function of determining whether conventional investigative techniques were likely to prove inadequate, contended amici, a necessary finding before a wiretap can be authorized under Title III.  Nevertheless, the district court held that the government’s omissions were not material and refused to suppress the resulting wiretap evidence, relying upon evidence that was presented by the government at  the suppression hearing, but never made available to the authorizing judge, that the SEC investigation had  failed to fully uncover the scope of Rajaratnam’s alleged insider trader ring and was reasonably unlikely to do so because evidence suggested that Rajaratnam and others conducted their scheme by telephone. (US v. Chiesi, CA-2, No. 11-4416).

According to former federal judges John W. Bissell, Robert J. Cindrich, John J. Gibbons, Nathaniel R. Jones, Timothy K. Lewis, Stephen M. Orlofsky, H. Lee Sarokin, and  Alfred M. Wolin, the district court’s decision in this regard is not only inconsistent with the case law regarding suppression, but also dangerously undermines judges’ ability to provide meaningful oversight of wiretaps and other electronic surveillance.  By allowing the government to retroactively rewrite a wiretap application, said amici, the district court transformed the prior approval process into little more than an empty gesture, creating  incentives for the government to mislead authorizing judges and undermining the ability of these judges to provide the prior approval and oversight that the Constitution and laws of the United States demand.  The former federal judges asked the Second Circuit to correct this serious error and clarify that a motion to suppress a wiretap does not offer the government an opportunity to introduce facts that it failed to include in its wiretap application.

Citing Supreme Court precedent, the amicus brief noted that by its very nature electronic eavesdropping involves an intrusion on privacy that is broad in scope. Berger v. New York, 388 U.S. 41, 56 (1967).  With this intrusion in mind, the Fourth Amendment and Title III demand close judicial oversight of wiretaps, they said, including prior judicial approval, in order to ensure that the appropriate balance between the interests of law enforcement and the privacy  interests of individuals is maintained.  But judges can only perform this crucial role if the government is forthright during the wiretap application process, particularly because the proceedings are ex parte, and judges are therefore entirely dependent upon government representations in determining whether a wiretap is appropriately authorized.

It also undermines the central role that judges play in the wiretap authorization process and, more generally, their capacity to perform their constitutional and statutory function of acting as a vital check on executive branch actions which may intrude into personal privacy.  Even more troubling, perhaps, it writes a dangerous new chapter in the history of the relationship between the executive and judicial branches, so essential to the scheme of government.  For these reasons, amici said that the district court’s decision should not be permitted to stand. The former federal judges urged the Second Circuit to clarify that, in finding that government misrepresentations or omissions in a wiretap application were not material, the district court can rely only upon those facts that were presented to the authorizing judge in the government’s wiretap application.

Wednesday, October 24, 2012

FINRA Arbitration Panel Award Upheld by Fifth Circuit

A Fifth Circuit panel upheld a FINRA arbitration award against claims that the panel exceeded its authority. The case involved investor claims that a fund manager engaged in a fraudulent scheme that induced them to invest substantially in four highly risky mutual funds. The appeals panel said that the parties expressly agreed to abide by FINRA Rules, which provide at Rule 12409 that the arbitration panel has the authority to interpret and determine the applicability of all provisions under the  Code and that such  interpretations  are  final  and  binding  upon  the  parties. Thus, because  the  parties  agreed  to  submit  the issue to arbitration, a federal court may  only  set  aside the  arbitration  panel’s  decision  in very unusual  circumstances under which the arbitration panel exceeded its powers” under the Federal Arbitration Act. (Morgan Keegan & Co. v. Garrett, CA-5, Oct 23, 2012, No. 11-20736).

The appeals panel said that the district  court erroneously held that the arbitrators exceeded their authority by arbitrating derivative claims and non-customer claims.  In doing so, the district court impermissibly premised its decision to vacate upon finding error in the arbitration panel’s conclusion that the claims were not derivative and that the claims were customer claims.  The high standard for the district court to vacate the arbitration panel’s award on the merits was not satisfied.

The appeals panel noted that federal courts are not authorized to reconsider the merits of an award even though the parties may allege that the award rests on errors of fact or on misinterpretation of the contract. Federal courts do not sit to hear claims of factual or legal error by an arbitrator as an appellate court does in reviewing decisions of lower courts.

Under FINRA Rule 12409, it was clearly within the arbitration panel’s scope of authority to decide whether, under the FINRA Rules, the claims were derivative and were customers’ claims for purposes of  arbitration. The arbitration panel determined that the claims were not derivative and that they  were customer claims, thereby subjecting the claims to FINRA arbitration. Because the appeals court concluded that the arbitration panel did not exceed its powers in reaching these conclusions, it declined to reach the merits of investor assertions that their claims were derivative or not the claims of customers. 

Treasury Responds to US Senators on FATCA Implementation Concerns

In response to a letter of concern from four US Senators, Treasury officials said that Treasury and the IRS are committed to implementing FATCA in a way that eases burdens on financial institutions while still achieving FATCA’s compliance objectives. The letter was sent by Senators Rand Paul (R-KY), Saxby Chambliss (R-GA), Mike Lee (R-UT) and Jim DeMint (R-SC). The Treasury response was signed by Mark Mazur, Assistant Secretary for Tax Policy. In their letter, the Senators questioned the scope and authority of an intergovernmental framework for FATCA compliance featuring an arrangement under which the US is willing to reciprocate in collecting and exchanging information on accounts held in US financial institutions by residents in five EU countries. Treasury assured the Senators that neither the OECD nor the European Union would be a party to any bilateral agreement for FATCA implementation and neither organization would have any say about whether the US concludes a bilateral agreement with a particular country.

Passed as part of the Hiring Incentives to Restore Employment Act (HIRE), FATCA creates a new reporting and taxing regime for foreign financial institutions with U.S. accountholders. FATCA adds a new Chapter 4 to the Internal Revenue Code, essentially requiring foreign financial institutions to identify their customers who are U.S. persons or U.S.-owned foreign entities and then report to the IRS on all payments to, or activity in the accounts of, those persons. The Act broadly defines foreign financial institution to comprise not only foreign banks but also any foreign entity engaged primarily in the business of investing or trading in securities, partnership interests, commodities or any derivative interests therein. According to the Joint Committee on Taxation, investment vehicles such as hedge funds and private equity funds will fall within this definition. Firms meeting the definition must enter into agreements with the IRS and report information annually in order to avoid a new U.S. withholding tax.

The response letter noted that, on February 8, 2012, Treasury and the IRS issued comprehensive proposed regulations, which addressed many of the concerns that had been expressed regarding potential administrative burdens in implementing FATCA. In finalizing the proposed regulations, Treasury and the IRS continue to engage with U.S. and foreign financial institutions in order to implement the statute in a way that appropriately balances its compliance objectives with the burdens imposed.

The Treasury response letter also noted that the law in many jurisdictions would prevent foreign financial institutions from directly reporting to the IRS the information required by FATCA. Thus, under the statute, absent the cooperation of foreign governments, U.S. financial institutions would be required to withhold on payments to foreign financial institutions, and FATCA would fail to achieve its objective of fighting offshore tax evasion through increased information reporting.

The Joint Statement reflects a shared commitment with France, Germany, Italy, Spain, and the United Kingdom to cooperate to address the legal conflicts that might otherwise interfere with the implementation of FATCA. Since issuing the Joint Statement the Treasury Department has worked closely with representatives of those countries to develop a model intergovernmental agreement for the implementation of FATCA, which was released on July 26.

The Model Agreement is intended to be used as the basis for concluding bilateral agreements for the implementation of FATCA on a government-to-government basis, building on a longstanding history of bilateral information exchange. The first bilateral agreement was signed with the United Kingdom on September 12, 2012.

Like the United States, noted Treasury, many foreign governments are trying to address offshore tax evasion by their residents and need information from other jurisdictions to support their efforts. Existing regulations already require U.S. financial institutions to report to the IRS certain information with respect to amounts paid to nonresidents. Treasury reasoned that the US cannot expect foreign governments with shared policy goals and practices regarding transparency and fairness to facilitate the reporting of the information required under FATCA by their financial institutions if the US is unwilling to help address tax evasion under their tax systems.

In Treasury’s view, the most straightforward approach would be to share information, in appropriate circumstances, that pursuant to existing law already must be reported to the IRS about accounts held by their residents in the United States. Accordingly, the Model Agreement includes a reciprocal version, which contemplates information sharing by the US with appropriate jurisdictions.

Section 6103(k)(4) of the Internal Revenue Code authorizes the IRS to share information it collects with a foreign government, but only if the United States has in effect an income tax treaty or tax information exchange agreement with the foreign jurisdiction. Therefore, the Treasury Department assured the Senators that it would only enter into the reciprocal version of the Model Agreement with jurisdictions with which the United States has in effect such an agreement.

Moreover, among those jurisdictions, the reciprocal version will be used only with foreign governments that the Treasury Department and the IRS have determined have robust protections and practices in place to ensure that exchanged information will remain confidential and will be used solely for tax purposes. The information that the United States would agree to exchange under the reciprocal version of the Model Agreement differs in scope from the information that foreign governments would agree to provide to the IRS.

In fact, noted the Treasury official, the information specified to be exchanged by the IRS under the reciprocal version of the Model Agreement is limited to the information that U.S. financial institutions will be required under existing regulations to report to the IRS about nonresident accounts for 2013. While the reciprocal version of the Model Agreement includes a policy commitment to pursue equivalent levels of reciprocal automatic exchange in the future, no additional obligations will be imposed on U.S. financial institutions unless and until additional laws or regulations are adopted in the United States.

Treasury and the IRS pledged to continue to work closely with businesses and foreign governments to implement FATCA in a manner that reasonably balances the administrative burdens with the compliance goals. Entering into bilateral intergovernmental agreements based on the Model Agreement will be an important part of achieving that end.

By allowing foreign financial institutions to participate in FATCA by reporting information to their own government (followed by the automatic exchange of the reported information from the foreign government to the IRS), Treasury believes that bilateral  intergovernmental agreements will substantially reduce the potential burdens imposed by FATCA on financial institutions, avoid foreign legal impediments to reporting, and build on existing exchange practices and common international norms for transparency.

Tuesday, October 23, 2012

European Commission Adopts Regulation Allowing ESMA to Fine Credit Rating Agencies

The European Commission has adopted a regulation enabling the European Securities and Markets Authority (ESMA) to impose fines on credit rating agencies. The Delegated Regulation establishes the rules within which ESMA will operate when imposing fines on credit rating agencies when they breach EU legislation. In order to respond to the deficiencies in the credit rating sector which contributed to the financial crisis, a regulatory framework for credit rating agencies operating in the EU was established by legislation and ESMA was entrusted with oversight of the rating agencies. The Credit Rating Agency Regulation includes a full list of infringements that, if committed by a rating agency, may trigger fines, including conflicts of interest, obstacles to supervisory activities or non-disclosure of certain information.

ESMA is exclusively responsible for the registration and oversight of credit rating agencies in the European Union. In executing its oversight responsibilities, ESMA conducted two on-site inspections at the three largest registered create rating agencies. The first inspections were carried out in December 2011 and the findings were published last March, while a second on-site inspection was completed in September of 2012. The March report identified several shortcomings and areas for improvement which ESMA is now  following-up through risk mitigation plans for each individual rating agency. ESMA is examining evidence from the second round of  inspections.

In a significant decision that paves the way for cross-border harmonization and cooperation, the European Commission recently found that the US regulatory regime for credit rating agencies is equivalent to the US regime. The Commission said that the US framework for regulating credit rating agencies provides for equivalent protection in terms of integrity, transparency, good governance of credit rating agencies and reliability of the credit rating activities. Similarly, the Commission found that the Canadian and Australian regimes for credit rating agencies are also equivalent

Former COSO Chair Details Enhancements of Auditor Professional Skepticism at PCAOB Roundtable

Independent audit committees can enhance auditor independence and professional skepticism, former COSO Chair Larry Rittenberg told a PCAOB roundtable recently. He detailed a number of things the audit committee can do to enhance auditor independence and professional skepticism, including requiring audit expertise on the committee and ensuring that the outside audit team has a knowledge of the company’s business. COSO is the Committee of Sponsoring Organizations of the Treadway Commission, and provides guidance on internal controls, risk management and fraud deterrence.

Every business, its strategies and its processes are unique, he noted, and reminding outside auditors of the uniqueness of each audit finding has been shown to help maintain skepticism.  He maintained that most of the larger financial reporting problems could have been identified earlier if the auditor had better known the client company’s business, its strategies, operations, and the successes and challenges of its competitors. He envisions that the audit committee would evaluate the auditor’s knowledge of the business, its strategies, its risks, pressures on managers, and audit risks through discussion with the audit partner and audit manager. Audit committee members are first and foremost board members, he emphasized, and thus have a working knowledge of business issues and can decipher whether the audit is properly adjusted to fit the organization’s strategies, its risk and related accounting and auditing issues.

The audit committees should also review the overall audit plan built on the auditor’s risk assessment. The audit committee should be proactive in discussing accounting issues with both the financial management of the enterprise and with the audit team. The outside auditor should have a documented, systematic process in reviewing such transactions, including understanding the economics of the proposed transaction, identifying the relevant facts, and developing alternatives and recommending a preferred approach, along with the rationale as to why such an approach is best.  In this approach, the former COSO official would like to see a best solution and the rationale for such by both management and the audit team, not just an acceptable approach.

He supports a recommendation by the Commission On Auditors’ Responsibilities, chaired by former SEC Chairman Manuel Cohen, that the auditors look at the cumulative effect of transactions to determine if they adequately portray the economic substance of what is taking place in the company and communicate that assessment to the audit committee. Requiring discussion of the cumulative effect of accounting choices on the overall presentation of the financial statements would be a positive contributor to the dialogue with the audit committee, he said, and thus benefit investors.

Finally, he believes that the audit committee should be supportive of the need for the audit partner to consult with the national office on important issues.  At the same time, the chair of the audit committee, the local audit partner, and management need to be involved in the conversations.

Business Groups Challenge SEC Conflict Minerals Regulation in DC Circuit

A consortium of corporate and business groups has asked the DC Circuit to review the SEC regulation implementing the conflict minerals disclosure provisions of the Dodd-Frank Act. In a petition filed with the federal appeals court, the US Chamber of Commerce, the Business Roundtable and the National Association of Manufacturers asked that the DC Circuit modify or set aside the regulation in whole or in part. The vote to adopt the regulations was 3-2, with Commissioners Paredes and Gallagher dissenting. While the business community understands the need to end the strife in the Democratic Republic of Congo, the SEC regulation is not an effective approach. Rather, the final conflict minerals regulation imposes an unworkable and overly broad and burdensome system that will undermine jobs and may not achieve the overall congressional objective. (National Association of Manufacturers, et al. v. SEC, CA DofC, No. 12-1422, Oct. 22, 2012).

Section 1502 directs the Commission to issue rules requiring companies to disclose their use of conflict minerals if those minerals are necessary to the functionality or production of a product manufactured by those companies. Under the Act, those minerals include tantalum, tin, gold or tungsten. In their petition, the business groups also asked the DC Circuit to review Section 1502.

The SEC rule would apply to a company that uses any of the four designated minerals if the company files reports with the SEC under the Exchange Act and the minerals are necessary to the functionality or production of a product manufactured or contracted to be manufactured by the company. 

A company would be considered to be contracting to manufacture a product if it has some actual influence over the manufacturing of that product.  This determination would be based on the facts and circumstances, taking into account the degree of influence the company exercises over the product’s manufacturing.  A company would not be deemed to have influence over the manufacturing if it merely affixes its brand or logo to a generic product manufactured by a third party, services, maintains, or repairs a product manufactured by a third party, or specifies or negotiates contractual terms with a manufacturer that do not directly relate to the manufacturing of the product.

Under the final rule, a company that uses any of the designated minerals would be required to conduct a reasonable good faith country of origin inquiry reasonably designed to determine whether any of its minerals originated in the covered countries or are from scrap or recycled sources.  If the inquiry determines that the company knows that the minerals did not originate in the covered countries or are from scrap or recycled sources or the company has no reason to believe that the minerals may have originated in the covered countries and may not be from scrap or recycled sources, then the company must disclose its determination, provide a brief description of the inquiry it undertook and the results of the inquiry on new Form SD filed with the Commission.

The company also would be required to make its description publicly available on its Internet website and provide the Internet address of that site in the Form SD.

Under the final regulation, companies that are required to file a Conflict Minerals Report would have to exercise due diligence on the source and chain of custody of their conflict minerals.  The due diligence measures must conform to a nationally or internationally recognized due diligence framework, such as the due diligence guidance approved by the Organization for Economic Co-operation and Development (OECD).

If a company determines that its products are DRC conflict free, that is the minerals may originate from the covered countries but did not finance or benefit armed groups, then the company would have to obtain an independent private sector audit of its Conflict Minerals Report, certify that it obtained such an audit, include the audit report as part of the Conflict Minerals Report, and identify the auditor. 

The independent audit would verify that the company’s due diligence was conducted in conformity with an internationally recognized due diligence guideline, which essentially means the OECD Due Diligence Guidance, which the staff noted is the only internationally recognized due diligence guideline.

The OECD Due Diligence Guidance for responsible supply chains of conflict minerals is a five-step due diligence regime for use by any company potentially sourcing minerals or metals from conflict-affected areas. Broadly, the guidance recognizes that, while specific due diligence requirements will differ depending on the mineral and the position of the company in the supply chain, companies should review their choice of suppliers and sourcing decisions and integrate into their management systems a five-step framework for risk-based diligence for responsible supply chains of minerals from conflict areas.

In Letter to Fed, House Oversight Chairs Urge US-Tailored Application of Basel III Capital Standards

In a letter to the Federal Reserve Board, House Financial Services Committee Chair Spencer Bachus (R-Ala.) and Vice-Chair Jeb Hensarling (R-TX) urged federal banking regulators to carefully consider the potential consequences of applying Basel  III capital requirements across the board without tailoring them to the unique characteristics of community and regional banks. They asked regulators to ensure that the US financial system remains a diverse mix of community, regional and global financial institutions by structuring regulations to promote that diversity rather than moving towards a system of fewer, larger financial institutions. The letter was also signed by Oversight Subcommittee Chair Randy Neugebauer (R-TX) and Financial Institutions Subcommittee Chair Shelley Moore Capito (R-WV).

While the higher capital requirements contained in Basel III are entirely appropriate for internationally active financial institutions that may pose a systemic risk to the economy, the Chairs noted, the application of these requirements to community and regional banks raises serious concerns. Higher capital requirements will force community and regional banks to hold resources internally instead of providing much-needed credit for small businesses and consumers. The impact of Basel III will be especially problematic for small rural areas served by community banks. They also noted that the U.S. financial system’s strength lies in its diverse mix of community, regional and multinational banks. It is important to ensure that regulations are structured in a manner that promotes and strengthens this diversity rather than moving towards a system of fewer, larger institutions. While acknowledging that the Basel Committee adopted the Basel III Accord in an effort to harmonize capital requirements cross-border, the House leaders believe that the one-size-fits-all approach may make sense in jurisdictions served by a few large and complex financial institutions competing globally, it may prove problematic when applied to the diverse US banking system.

Senator Warner Says 113th Congress Will Take Up Major Bi-Partisan Dodd-Frank Corrections Legislation

Senator Mark Warner, a key member of the Banking Committee, told the Bipartisan Policy Center that the 113th Congress should consider major and bipartisan Dodd-Frank corrections legislation. While Dodd-Frank broadly got things directionally right, said Senator Warner, there are at least 50 sections of Dodd-Frank he would like to change. The Senator added that, regardless of the outcome of the November election, the Dodd-Frank Act would not be repealed.  The repeal of Dodd-Frank would be extremely disruptive to the market, he warned, and would chill financial stability in the US and globally. The Banking Committee will revisit Dodd-Frank in a rational way, he promised. 

While Dodd-Frank only got the 60 votes needed to clear the Senate hurdle, he noted, many parts of the legislation received a much broader bi-partisan consensus. For example, he observed that Titles I and II setting up the Financial Stability Oversight Council (FSOC) and an Orderly Resolution Authority were embraced by 85 Senators.

That said, he added that there are lots of places in Dodd-Frank where Congress got it wrong. Historically, with any major piece of federal legislation, Congress never gets it entirely right the first time. But as imperfect as Dodd-Frank may be, he continued, the US acted in a comprehensive way and, as a result, financial markets are safer and banking institutions are stronger.

Specifically, when Congress revisits Dodd-Frank, he noted, more work must be done on transparency, derivatives, and the Volcker Rule. He called for a more principles-based Volcker Rule that is not as rules-based. He also said that many of the problems arising around swaps are due to regulatory overlap. The reality is that regulators protect their own turf, he observed. Congress and the regulators must also recognize the diversity of US financial institutions and not impose the same level of stringent regulations and capital standards on mid-size and smaller financial institutions that are applied to large global financial institutions.

Another concern is that FSOC is an imperfect creation with no independent entity or person in charge. FSOC has not become the arbiter of conflicting regulations that he envisioned it would be. It has not played the role of adjudicator of conflicting regulations. Perhaps it is because the Office of Financial Research created by Dodd-Frank has not functioned as a quasi-independent backstop to get data to the FSOC as he had hoped it would. There is still no permanent  OFR Director.

There are also continuing issues around FSOC designation of financial firms as systemically important, thereby subjecting then to stricter regulation. The Banking Committee knew that the designation process would be problematic, said Senator Warner.

He explained that Congress was confronted with two choices: 1) break up the largest financial institutions or put a cap on them (which Congress may revisit), or 2) designate systemically important financial institutions for more stringent regulation. Congress rejected the first choice because of a global trend toward larger financial firms; and Congress did not see the size of US firms as putting many of them in the global top 50. In addition, it would be difficult to impose and administer an arbitrary asset cap.

So, Congress decided to put a price on being large, in the form of higher capital standards, stricter leverage ratios, and convertible contingent capital. The capital standards component is working, he said, while the jury is out on contingent capital.

Finally, Senator Warner disagreed that Dodd-Frank institutionalized the too big to fail doctrine. Bankruptcy simply will not work in every circumstance for large, complex and sophisticated financial institutions. Thus, Title II sets up a process to make resolution so bad that no rational management team would prefer that route. The resolution authority should be the default of last choice, he emphasized, because under it the shareholders are wiped out, management is removed and there are clawbacks, and creditors and bondholders face haircuts.

Monday, October 22, 2012

European Commission Official Tells PCAOB Roundtable that EU Moving Forward with Legislation Mandating Audit Firm Rotation

The European Commission’s proposed legislation mandating audit firm rotation is currently before the European Parliament and the Council of Member States and some action is expected by year end, Nathalie Berger, Director of Audit at the European Commission, told a PCAOB roundtable on auditor independence. After audit inspections in the UK, France and Germany revealed weakness in internal control procedures, insufficient auditor professional skepticism, too much reliance on management representations, and a lack of sufficient evidence to support audit opinions, the Commission drafted reform legislation that included mandatory audit firm rotation every six years for solo audits and nine years for joint audits. . According to Commissioner for the Internal Market Michel Barnier, the proposals are intended to restore confidence in the independent audit of a company’s financial statements.

The Commission rejected the alternative of voluntary audit firm rotation, said Ms. Berger, who noted that it does not mean much and is no solution to the problem. She said that the status quo, which includes key audit partner rotation every seven years, is not an option.

In her view, mandatory audit firm rotation would element threats to independence, reinforce professional skepticism and enhance competition. It will have positive impact on audit quality and lead to better audit processes and planning. The Commission acknowledges that costs would increase with the introduction of mandatory audit firm rotation, but believes that costs would diminish over time. Importantly, she emphasized that the benefit of improving the quality of the outside audit would far outweigh any increase in costs. The Commission official emphasized that investor protection comes first, adding that the investor is the principal client of the outside auditor.

Mandatory audit firm rotation also presents advantages in terms of meeting potential conflicts of interest and thereby improving audit quality. In a long term audit relationship, reasoned the EC official, the auditor will tend to identify too closely with the management. Proper professional skepticism will be diluted and auditors will be more likely to smooth over areas of difficulty in order to preserve the relationship. Auditors may become stale and view the audit as a simple repetition of earlier engagements. This staleness fosters a tendency to anticipate results rather than keeping alert to subtle changes in circumstances which could be significant.

Mandatory auditor rotation is based on the rationale that a long professional relationship undermines auditor independence and negatively impacts on auditor professional skepticism. The Commission rejected the idea of simply rotating the key audit partner as insufficient because the main focus would still be client retention. A new partner would be under pressure to retain a long standing client of the firm, reasoned the Commission, and it would be unlikely that he or she would criticize the work of the previous audit partner.

Director Berger noted that the Commission sees support for mandatory audit firm rotation in the Council and in Parliament and will soon be entering into negotiations with those bodies with an eye towards passing final legislation. The six year term is subject to negotiation, said the official, with some Members of Parliament wanting it to be ten years. The report of the UK Competition Commission, due in November, may inform the negotiations.

The draft would also create an EU Audit Quality Certification to confer on mid-tier audit firms, which would be a label of good quality. There would be no legal value to the certificate that would allow a firm to claim access to a certain market, noted the official, but it would empower mid-tier audit firms to tender to a big firm market and help expand the pool of audit firms serving this market. The European Securities and Markets Authority would draft the certificate and administer it.

This voluntary pan-European Audit Quality Certification is introduced to increase the visibility, recognition and reputation of all audit firms having capacities to conduct high quality audits. ESMA will publish the requirements for obtaining the certificate along with any administrative and fee implications.

Sunday, October 21, 2012

Former Fed Chair Volcker Tells UK Parl. Commission that Vickers Proposed Separation of Commercial and Investment Banking within Holding Company Would Break Down

Former Fed Chair Paul Volcker told the UK joint Parliamentary Commission on Banking Standards that the ring-fencing of retail from commercial banking within the same bank holding company would inevitably break down. The exceptions to ring-fencing is where the problems will begin as financial institutions begin to expand the exceptions. Mr. Volcker called for institutional separation of retail banking and proprietary trading and sponsoring hedge funds.

While ring-fencing would be effective to a considerable extent, he allowed, there are holes in the fence, and leakages which are likely to get bigger. That is what happened to the Glass-Steagall Act, he noted. The chipping away at the Glass-Steagall wall of separation between commercial and investment banking began with the creation of subsidiaries and adding more of what was possible for a subsidiary to do in the securities area.

The UK Government has submitted to Parliament landmark legislation to ring-fence retail commercial, deposit-taking banking from investment banking. The bill has been referred for review to the Parliamentary Commission on Banking Standards, which will report on the legislation by December 18, 2012. In the main, the legislation is intended to implement the recommendations of the UK Independent Commission on Banking, the Vickers Commission, which proposed a sweeping structural change under which, within a single organization, the range of ordinary banking operations, such as deposit taking, and lending, would be segregated in a retail bank, which would be overseen by its own independent board of directors and ring-fenced to greatly reduce relations with the rest of the organization.

Mr. Volcker tempered his remarks by noting that ring-fencing will not be totally ineffective and is certainly worth a try. But he believes that the better approach would be to put retail and commercial banking in two separate organizations. In addition, he found common ground among the Volcker Rule, the Vickers Commission and the Dodd-Frank Act in that they all want to create a separation between retail and commercial banking, and between traditional retail banking activities and proprietary trading and sponsoring hedge funds. Put more simply, the common ground is that both the US and the UK are worried about proprietary trading in a financial institution. He also noted that proprietary trading in US commercial banks is diminishing as they approach the implementation of the Volcker Rule.

Mr. Volcker testified that there is a significant difference between traditional bank functions that carry a fiduciary duty to customers and proprietary trading, which does not. Proprietary trading is generally episodic and does not envision a continuing relationship. Mr. Volcker said that proprietary trading should be taken out of the banking organization and be allowed to fail and the protected ring-fenced bank should not engage in proprietary trading. In other words, the government should not protect proprietary trading.

Some members of the committee voiced the belief that a separate and independent board of directors in the proprietary trading subsidiary, as proposed by the Vickers Commission, would ameliorate the problem of blurring the lines between proprietary trading and the ring-fenced retail bank. In Chairman Volcker’s view, a separate independent board of the subsidiary doing proprietary trading may not be enough since the board of the bank holding company will have to take account of what is going on in the subsidiary since that board is responsible for the entire organization. In addition, the ultimate stockholder in the holding company has a stake in both the retail and commercial sides, reasoned the former Fed Chair, and the board has a fiduciary duty to them.
More broadly, trading and retail banking have different cultures and putting two different  cultures into one organization was wrong and created some of the problems leading up to the financial crisis. Moreover, proprietary trading and sponsoring hedge funds have inherent conflicts of interest with other parts of the bank.

Mr. Volcker noted that there is a difference between proprietary trading and market making. In determining the difference, management must control the traders and have metrics to look at, such as volatility and the volume of trading. He said that it would be a ``fool’s errand’’ to look at every transaction, it is better to look at metrics and trends.


Saturday, October 20, 2012

Former SEC Commissioners Urge Supreme Court to Require Materiality Showing at Class Certification Stage in Private Securities Fraud Action

Six former SEC Commissioners have urged the US Supreme Court to require investors in a private fraud-on-the-market securities action seeking to obtain class certification to establish by a preponderance of the evidence that the alleged misrepresentations were material in that they affected the stock price. In their amicus brief, the former Commissioners asked the Court to reverse a Ninth Circuit panel ruling that investor need not prove materiality at the class certification stage in order to use the fraud-on-the-market presumption of reliance. The former SEC Commissioners are Aulana Peters, Charles Cox., Philip Lochner, Stephen Friedman, Joseph Grundfest, and Paul Atkins. The case is set for oral argument on November 5. Amgen, Inc. v. Connecticut Retirement Plans and Trust Funds, Dkt. No. 11-1085.

According to the former Commissioners, the Ninth Circuit decision strikes at the heart of the Court’s 1988 ruling in Basic, Inc. v. Levinson, which recognized that in order to benefit from a presumption of class-wide reliance, a private securities fraud plaintiff seeking money damages must show at the class certification stage that the essential predicates to a fraud-on-the-market theory are met. The crux of the theory is that an efficient market reflects all public information in the price of a security. Thus, investors purchasing a stock relying on the integrity of the market price rely on any material misstatements made to the market because the effect of the misstatement is incorporated in the stock price.

It follows that materiality in the form of information that is incorporated into securities prices is a necessary condition precedent to the very theory that makes class certification possible. In Basic, the Court recognized that whenever the link between an alleged misrepresentation and the market price is severed the presumption of reliance in not applicable and class certification is improper. In the view of amici, the Ninth Circuit did not follow these important principles.

The Ninth Circuit’s misreading the Supreme Court’s Basic decision, and the role of materiality in the class certification inquiry, has significant implications. Because securities are almost always settled when a class is certified, reasoned amici, the materiality and stock price impact of an alleged misstatement will never be tested unless examined as part of a Rule 23 inquiry. It follows that the investor’s allegation of reliance will never be tested.

Thus, in the view of the former SEC Commissioners, the Ninth Circuit ruling unleashes the in terrorem power of class certification to compel settlement of even questionable claims without any meaningful inquiry into materiality or price impact or the properness of  presuming reliance. The Basic decision teaches that these are critical issues that must be tested at the class certification stage.

Further, the Ninth Circuit’s expansive interpretation of the fraud-on-the-market doctrine untethers the class certification determination from even the most cursory consideration of  materiality. The panel’s decision is therefore contrary to recent Supreme Court admonitions that the Rule 10b-5 implied right of action is to be narrowly interpreted.

Amici assured that the position they are advocating would not impair the SEC’s ability to enforce the federal securities laws. In civil enforcement actions, the SEC is not required to establish reliance or causation. Thus, the SEC need not depend on the fraud-on-the-market theory and need not prove materiality by way of price impact.