Friday, November 30, 2012

Mark Carney, Canadian Central Bank Chair, Named to Head Bank of England as Twin Peaks Regulatory Regime Nears

Mark Carney, currently Governor of the Bank of Canada, has been named Governor of the Bank of England as the UK central bank is set to assume regulation of the financial system and financial institutions under thw new twin peaks regulatory regime being adopted in tghe UK in gthe wake of the financial crisis. The Prudential Regulatory Authority (financial system and financial institutions) and the Financial Conduct Authority (securities markets and financial intermediaries, such as brokers) will replace the unitary regulatory, the Financial Services Authority. Chancellor of the Exchequer George Osborne said that Mr. Carney did a brilliant job for the Canadian economy as its central bank Governor, avoiding big bail outs and securing growth. He also chairs the Financial Stability Board, charged with strengthening global financial regulation after the financial crisis.

Along with its central role in monetary policy, said the Chancellor, the Government has put the Bank of England back in charge of regulating our financial system so the UK does not repeat the mistakes of the last decade. Mark Carney is the perfect candidate to take charge of the UK central bank as it takes on these vital new responsibilities, said the Chancellor.

The Financial Stability Board, chaired by Gov. Carney, has been ther job of aiding in the harmonization of financial regulations by the G-20 leaders and G-20 Finance Ministers. In that capacity, the Board has issued principles of executive compensation,  among other areas.

Mr. Carney will take over as UK legislation enacting a UK version of the Volcker Rule looms next year. Based on the Vickers Commission recommendations, the legislation will ring-fence a retail bank inside a holding company and prohibit the bank from engaging in proprietary trading and sponsoring hedge funds.

Rep. Jeb Hensarling Named new Chair of House Financial Services Committee for 113th Congress

House Speaker John Boehner (R-OH) has announnced that Rep. Jeb Hensarling (R-TX) will be the Chair of the Financial Services Committee in the upcomong 113th Congress, succeeding Rep. Spencer Bachus (R-AL). The Committee has oversight of the securities markets and the securties industry, we well as the banking industry and financial institutions. Rep. Hensarling is currently the Vice-Chairman of the Committee.

Rep. Hensarling has been a strong advocate for the reform of goevrnment-sponsored enterprises and the creation of a private secondary mortgage market in the US and a revival of securitization. In the 112th Congress. Vice Chairman Hensarling inroduced legislation that would either place Fannie Mae and Freddie Mac into receivership or reform the GSEs under new regulations. Chairman-designate Hensarling could be expected to reintroduce a version of this legislation in the 113th Congress andtry to  pass it out of the Committee to the House floor.

The GSE Bailout Elimination and Taxpayer Protection Act (HR 1182) would establishe a finite end to the GSEs’ conservatorship 2 years from the date of enactment and imopose a prohibition on any reduction to the senior preferred stock dividends the GSEs contractually agreed to pay taxpayers under their conservatorship. Upon the end of the conservatorship, the Federal Housing Finance Agency (FHFA) must evaluate the financial viability of each GSE. If it is determined not to be viable, the FHFA would follow the procedure laid out by the Housing and Economic Recovery Act of 2008 (P.L. 110-289) for placing that GSE into receivership. If determined to be viable, the GSE would be allowed to resume limited market operations under its own control for a maximum of three years under new regulations that would enhance the authority for FHFA to adjust the minimum capital requirements for the GSEs as appropriate, mirroring the existing capital adequacy requirements other regulators already have in place for banks. The legislation would also repeal the exemption allowing GSE securities to avoid full SEC registration.

Rep. Hensarling co-sponsored the GSE Credit Risk Equitable Treatment Act HR 2223), which would amends the Securities Exchange Act to require that credit risk retention regulations ensure that there is no difference in the treatment of asset-backed securities securitized by Fannie Mae or Freddie Mac solely because of securitization by the GSE, from the treament of other asset-backed securities securitized by any other entity.

Rep. Hensarling also introduced a bill (HR 2225) to amend the Investment Advisers Act to define "family office" (exempt from coverage by the Act) as a company (including any director, partner, trustee, or employee of such company, when acting in their respective capacities as such) that has no clients other than family clients and is owned, controlled, or operated primarily for the benefit of family clients and does not hold itself out to the public as an investment adviser.

The incoming Chair is also a proponent of reforming the federal regulatory process. He co-sponsored the
SEC Regulatory Accountability Act, HR 2308, which would amend the Securities Exchange Act to direct the SEC, before issuing a regulation, to: (1) identify and evaluate the significance of the problem that the proposed regulation is designed to address in order to assess whether any new regulation is warranted; (2) use the SEC Chief Economist to assess the costs and benefits of the intended regulation and adopt it only upon a reasoned determination that its benefits justify the costs; (3) identify and assess available alternatives that were considered; and (4) ensure that any regulation is accessible, consistent, written in plain language, and easy to understand.

The legislation would also require the SEC to: (1) consider whether the rulemaking will promote efficiency, competition, and capital formation; (2) consider the impact of the regulation upon investor choice, market liquidity and small business; (3) explain in its final rule the nature of comments received concerning the proposed rule or rule change; and (4) respond to those comments, explaining any changes made in response, and the reasons that it did not incorporate industry group concerns regarding potential costs or benefits.

The bill would further directs the SEC to: (1) review its regulations and orders periodically to determine if they are outmoded, ineffective, insufficient, or excessively burdensome; and (2) modify, streamline, expand, or repeal them.

Monday, November 26, 2012

US Government Responds to Federal Court Constitutional Challenge to the Dodd-Frank Act

The US government has responded to a federal court action challenging the constitutionality of the Dodd-Frank Act by arguing that the action is not ripe since the claims of injury by the community bank, three states and various advocacy groups fall far short of the imminent non-conjectural injury needed to confer Article III standing.  Despite the roving allegations of unconstitutionality, said the response, not one of the Dodd-Frank authorized actions that plaintiffs speculate might cause them harm has yet occurred. The government asks the court to dismiss the claims as unripe for judicial resolution. The 52-page response motion and accompanying memorandum was filed by the US Attorney, with Treasury of counsel (Big Springs National Bank of Texas v. Geithner, DC DofC, No 1L12-1032).

The plaintiffs are complaining that the Consumer Financial Protection Bureau and the Financial Stability Oversight Council have been given powers by Dodd-Frank that are not restrained by reasonable checks and balances and thus violate separation of powers provisions of the US Constitution In addition, the orderly liquidation authority set up by Title II of Dodd-Frank is also challenged as violating due process, separation of powers and uniformity of bankruptcy provisions of the Constitution.

The response states that the community bank has not been designated a systemically important financial institution by the FSOC and may never be designated as such. A systemically important financial institution, so designated by FSOC, would be subject to more stringent federal regulation, said the response, but the community bank in this action has not been so designated and is not likely to be and thus any asserted injury is speculative. The bank's argument that SIFI designation is a benefit also falls short since such a contention directly contravenes the intent of Congress in creating the FSOC and conferring it with the power to designate a a financial institution as systemically important. It also falls far short of a concrete injury that would confer federal court standing.

As for the claim that the orderly liquidation authority in Title II, the bank has not even attempted to an injury flowing from the authority and lacks standing to pursue this claim.

The claims of the advocacy organizations are even more attenuated than those of the banks, said the government response. They have alleged only an abstract interest in maintaining the separation of powers, a type of generalized grievance that does not confer standing to challenge federal legislation.

The claim of the states that the Dodd-Frank orderly liquidation authority, which has never been invoked,  may be applied to a financial institution of which their pension funds are creditors is pure conjecture. The states have failed to allege that the liquidation authority has been invoked as to any financial company or is imminently to be invoked, much less to one of which a state pension fund is a creditor.

Corporate Secretaries Society Opposes Investor Metric Standards

In a letter to the Society for Human Resource Management , the Society of Corporate Secretaries and Governance Professionals, and members of the corporate community urged that the “Guidelines for Reporting on Human Capital to Investors,” (the “Investor Metrics standard”), be withdrawn and any further work on it be terminated. The letter said that the standard is not being sought by institutional investors and is strongly opposed by the HR and business communities. 

According to the Society, the metrics contemplated by the standard are not material to investors, nor are investors 
requesting the information. In addition, the cost of publicly disclosing these metrics would be excessive. Gathering, aggregating, standardizing and certifying the data is time intensive 
and costly. 

Moreover, substantial explanation is required to provide the context necessary to understand the meaning of most metrics (e.g., engagement survey results), adding to already long corporate disclosures without substantially improving understanding of a company’s operations. Disclosure of metrics does not benefit employees and could be used by competitors and others to the detriment of the company. 

Sunday, November 25, 2012

Securities Industry Urges the Supreme Court to Apply Bright Line Limitations Period to SEC Enforcement Action

In a case involving an SEC enforcement action for market timing, the securities industry urges the US Supreme Court to apply the five-year statute of limitations in 28 US Code Sec. 2462 as written without implying the discovery rule requested by the SEC and erroneously applied by the Second Circuit Court of Appeals. In an amicus brief, SIFMA said that the Court has repeatedly stressed that the financial markets need predictability and that the Second Circuit violated that principle by engrafting a discovery rule on to a five-year statute of limitations, thereby transforming it from a bright line into a shifting and uncertain inquiry. SIFMA was joined on the brief by the US Chamber of Commerce. The case is set for oral argument on January 8, 2013. (Gabelli v. SEC, Dkt. No.  11-1274 )

Judicially applying a discovery rule is particularly inappropriate in the securities law context, said SIFMA, because it invades the legislative province and creates an uncertainty in the markets that Congress deems unwise. The plain text of Section 2462 does not contain a discovery rule, noted amicus, and Congress knows how to insert a discovery rule into a statute when it wants to. It has incorporated a discovery rule into other statutes of limitations. In addition, SIFMA argued that engrafting a discovery rule onto Section 2462 would degrade, not enhance, enforcement of the securities laws. Indefinite extension of the statute of limitations for SEC enforcement actions would lead to perverse incentives, diminish the SEC's enforcement capabilities and injure innocent businesses.

The SEC alleged that the market timing conduct violated the Investment Advisers Act and sought monetary penalties for those violations. The Advisers Act, like many federal statutes, does not set forth a specific time period within which the government must institute an enforcement action. In such instances, the five-year limitations period in Section 2462 is applied. Despite this five-year limitations period, the SEC instituted the enforcement action eight years after the alleged misconduct began and six years after it ended, excusing the delay by asserting that the claim did not accrue until the SEC first discovered the alleged wrongdoing.

The plain text of Section 2462 precludes the SEC's interpretation, argued SIFMA. The term accrue means the occurrence of the event giving rise to the cause of action, said the brief, and does not support application of a discovery rule. Thus, contended SIFMA, the SEC's enforcement action is untimely.

ABA Federal Securities Committee Supports SEC Proposals Implementing JOBS Act Ending of General Solicitation Ban

The Federal Securities Regulation Committee of the American Bar Association strongly support the SEC’s view that the reasonable steps to verify an investor’s accredited investor status should be an objective determination, based on the particular facts and circumstances of each transaction. In a letter to the SEC, the Committee said that the Commission appropriately notes in the proposing Release that a number of factors should be considered when determining the reasonableness of the steps taken to verify that a purchaser is an accredited investor. The Release identifies certain of these factors, such as the nature of the purchaser, the category of accredited investor the purchaser claims to be, the amount and type of information that the issuer has about the purchaser, and the nature of the offering. By acknowledging that the verification process for each offering and each particular investor may differ from the process applicable to other offerings or other investors, the Commission appropriately creates flexibility while discharging its statutory mandate.

In the view of the bar group, a prescriptive standard may not only be unduly burdensome but may also be inappropriate to the circumstances. The Committee believe that the approach taken by the Commission will help assure that the verification process reflects the facts and circumstances of the particular issuer, the particular investment, and the particular offering, which will encourage compliance and aid the enforceability of the rule. The group commended the Commission for taking this flexible approach, and also appreciate the guidance in this regard set forth in the Release. The Committee recommended that the Commission consolidate this guidance in the adopting release. Similarly, the Committee encouraged the Division of Corporation Finance to continue its practice of publishing useful, pragmatic guidance under the JOBS Act, in this case Title II and the Commission’s implementing rules and interpretations thereunder  

The Committee also supports the SEC’s determination not to provide a non-exclusive list of the specified methods for satisfying the verification requirement. As the Commission correctly notes, said the group, a non-exclusive list of specified verification methods could be viewed by market participants as the required verification methods, thus undermining the flexibility the Commission views as appropriate in connection with the verification process. 

Saturday, November 24, 2012

In Letter to SEC, Rep. Waters Concerned witb Verification Process under Proposed Regulations Implementing JOBS Act Ending of Reg. D General Solicitation Ban

In a letter to the SEC, Rep. Maxine Waters (D-CA) expressed concern that proposed regulations implementing the JOBS Act termination of the Regulation D ban on general solicitation does not adequately define the reasonable steps issuers must take to verify that purchasers of securities under the new offering exemption are accredited investors, consistent with the mandate in Section  201 of the Act. While the proposal suggests that self-certification would be an inadequate form of verification in instances where an issuer solicits new investors through a website accessible to through a website accessible to the general public or through a widely disseminated email or social media solicitation, said the prospective Ranking Member on the Financial Services Committee in the 113th Congress, the Commission fails to set forward what steps would be required in these circumstances and leaves open the possibility that self-certification may be acceptable in other circumstances.

As a Member of Congress deeply involved in the legislative drafting of Section 201, Rep. Waters emphasized that self-certification was never contemplated to be an adequate form of verification. She urged the SEC to consider defining specific, additional verification requirements, particularly relating to the protection available to natural persons claiming accredited investor status. The senior member also asked the SEC to consider requiring some form of third-party verification, such as letters from attorneys, accountants, or broker-dealers.

In addition,  and related to the issue of protection of natural persons, Redp. Waters believes that the Commission should consider amending the definition of accredited investor in light of the expansion to Rule 506 provided in the JOBS Act. Despite Section 413 of the Dodd-Frank Act, which precludes changes in the net worth threshold in the accredited investor definition before 2014, the Representative believes that the SEC has the authority to adjust this definition.

Rep. Waters also urged the SEC to set standards for the reporting of performance and fees by hedge funds and other private funds using the offering exemption proposed under Rule 506(c). Given that the SEC has acknowledged that hedge funds in  particular pose heightened risks to investors, reasoned Rep. Waters, it would be appropriate to establish clear reporting standards before allowing such funds to advertise or solicit the public.

Friday, November 23, 2012

Chancellor Osborne Says UK Vickers-Based Legislation Should Allow Ring-Fenced Banks to Trade Plain Vanilla Derivatives

Chancellor of the Exchequer George Osborne told the UK Parliamentary Commission on Independent Banking Standards that a ring-fenced retail bank should be able to trade plain vanilla derivatives under the proposed legislation implementing the UK's version of the Volcker Rule. Whie derivatives are very complicated and exotic instruments hould not be in a ring-fenced bank, he said, some derivatives are absolutely plain vanilla parts of operating a global economy. In this, the Chancellor disagrees with the Vickers Commission proposals on whikch the    legislation is based.
If you are a farmer who wants to hedge your income or protect yourself against fluctuations in the euro-sterling exchange rate, noted the Chancellor in his testimony, you go to your local branch and buy yourself a derivative. Equally, a small exporter that wants to hedge against the currency risk, will again buy a derivative. He wants to allow these simple derivatives in the ring-fenced bank because the farmer and the exporter will have to pay more for a derivative product if it is not originated by the ring-fenced retail bank.
The legislation  can draw a distinction between simple derivative products and more complex derivative products and trust that judgment to the regulators, The alternative is to say that all derivative products should not be in the ring-fenced bank, which would carry a price. The products are probably more expensive and a small business would not be able to get that product through their retail bank; they would have to start to interact with an investment bank or some other business. Committee members pointed out that it is difficult to define a simple derivative and it might better to keep all derivatives out of the ring-fenced bank. 
While understanding that the Commission is trying to make this all as simple as possible to and does not want any derivative instruments in the ring fence, the Chancellor urged the Commission to look at carefully at the issue, bearing in mind that not all derivatives are the most exotic things that the traders in the City of London and Wall Street are operating with. It is worth exploring if UK legislation an regulation can separate out the more exotic and complex derivatives from the very plain vanilla ones that are used by hundreds of millions of people across the world every day, observed the Chancellor.

German Finance Minister Calls for Globally Harmonized Financial Regulations to Prevent Regulatory Arbitrage

The financial regulatory monopoly of the old-fashioned nation state is over, declared the German Federal Finance Minister in recent remarks, and a new model for global governance must be forged. Dr. Wolfgang Schäuble said that regional cooperation can and must make a contribution to this new form of global governance. We will have to find our way there through a process of trial and error, he noted, because there is not one specified model.

However, make no mistake, globally coordinated and harmonized financial regulation is an imperative to prevent regulatory arbitrage. National financial markets in particular are so tightly interlinked globally that without global solutions there will always be the risk of regulatory arbitrage and thus the massive imbalances that follow from it. There is no turning back, he warned.

Germany does not see regulation as an end in itself, said the Minister. One of the key lessons from the past financial crises is that high cyclical, credit- and profit-fueled growth driven by financial markets does more harm than good. Instead, regulators need to create the conditions for sustained and sustainable growth on the basis of solid structural frameworks. By sustainable growth, the Minister means steady growth that is compatible with environmental and social priorities, without massive distortions and erratic volatility in the financial sector. 

Chancellor Osborne Tells Parliamentary Commission that Return to Glass-Steagall Fails Cost-Benefit Test and Would Erect a Maginot Line

UK Chancellor of the Exchequer George Osborne told the joint Parliamentary Commission on Independent Banking Standards that there is a strong consensus behind the proposed legislation to ring-fence retail banking in a holding company away from proprietary trading and sponsoring hedge funds. The UK legislation neither completely follows the Volcker Rule nor erects Glass-Steagall like separation. He urged Parliament not to unpick the work that John Vickers and his commissioners did that has been accepted by all the major political parties and is now on the verge of enactment.

The legislation would enable the regulator to establish a ring-fenced entity, to ensure its independence and to impose certain duties and directors and the like. The Government is absolutely clear that it will have separate governance; an independent board; separate risk management; separate balance sheets; separate remuneration committees and-as John Vickers added to the list when he gave evidence-capital and liquidity requirements. 

Calling for regulatory flexibility, the Chancellor warned against creating a kind of Maginot line in primary legislation that is absolutely right for 2012 and then find out in 2022 that the banks and the industry have completely bypassed it. The legislation must ensure that UK regulators are still fully armed and equipped to do what they need to do. He noted that by the early 1990s, the financial institutions had found ways around Glass-Steagall, and that was one of the reasons why it was repealed by Bill Clinton’s Administration. There is no guarantee that, if you go for some other approach, that will not happen.

Equally, he said of Paul Volcker that his definition of proprietary trading might look really good in 2012, but it might not look so good in 2022. Whichever approach you take, he emphasized, you have to have flexibility to address changing practices in the industry. 
The legislation does not simply follow the Volcker Rule. It is very clear that market making, investment banking and hedging is in the non-ring-fenced bank. That would not be the case with the Volcker Rule. 
While there is consensus that some form of separation is required, the Vickers process specifically looked at what form of separation and specifically rejected Glass-Steagall complete separation. One reason for this rejection was a cost-benefit analysis, revealed the Chancellor.
There is a very considerable cost to the industry in what this legislation is doing. There are going to be several billion pounds of set-up costs and several billion pounds of ongoing costs of implementing the ring-fencing. Full separation would be an even greater cost that could not be justified.

In addition, there are no additional benefits that full separation would bring so long as the you can make the ring fence high and impermeable. That is absolutely the intention of the legislation, he emphasized.

Thursday, November 22, 2012

Senator Levin Urges IRS and Treasury to Make FATCA Disclosure Non-Tax Return Information to Aid Financial Fraud Fight

Senator Carl Levin (D-MI) has urged Treasury and the IRS to issue guidance on the Foreign Account Tax Compliance Act (FATCA), that would assist foreign financial institutions in meeting their legal obligations, while facilitating law enforcement's use of foreign account information to combat tax evasion, financial fraud, and money laundering. In a letter to the IRS and Treasury, the SEnator said that treating FATCA offshore account information as non-tax return would ensure that the information is accessible to law enforcement and securities authorities to combat financial fraud and crimes other than tax evasion. 

Although FATCA is structured to address offshore tax abuse, he noted, offshore account information has significance far beyond the tax context, affecting cases involving money laundering and financial fraud. Given the importance of offshore account disclosures, FATCA guidance and implementing regulations should create account FATCA forms that are not designated as tax return information but, like FBARs, may be provided to law enforcement and regulators upon request. 

Foreign financial institutions are not U.S. taxpayers, he said, and will not be supplying tax information on behalf of their U.S. clients; they will instead be providing information about accounts opened by U.S. persons. According to the Senator, the U.S. Supreme Court has long held that bank account information is not inherently confidential but is subject to inspection by law enforcement and others in appropriate circumstances. Foreign account information is too important to a wide range of civil and criminal law enforcement and financial regulators efforts to be designated as tax return information bound by IRC Section 6103's severe restrictions on access.

Similarly, he urged that FFI Agreements, auditor verification forms, copies of actual account documentation be treated as non-tax return information available to the larger law enforcement and regulatory communities. 

In addition to giving FFI forms the same status as FBAR forms, the implementing rules should construct those forms to ensure that they collect and produce account information in a standardized electronic format that will enable efficient analysis of data. Treasury and the IRS should consult with IRS analysts and revenue agents as well as the Tax Division of the Justice Department to determine how the collected information should be structured to provide timely and usable data in tax enforcement efforts. Treasury and the IRS should also consider making the FFI data compatible with the existing FBAR database so that the two sets of forms can be easily analyzed in an integrated fashion. 

Wednesday, November 21, 2012

ESMA Issues IFRS Enforcement Priorities for the EU, Urges Auditors to Play Important Role

The consistent and coordinated enforcement of IFRS is a condition precedent to market discipline, said ESMA Chair Steven Maijoor, which in turn contributes to investor protection and financial stability. Further, The worldwide adoption of IFRS is a necessary but, on its own, an insufficient condition for global comparability.  In order to achieve true global comparability, emphasized the ESMA Chair in his London remarks, the standards have to be enforced. 

 Thus, ESMA has issued a set of common IFRS enforcement priorities in the EU, which is the first time EU enforcers have agreed on common enforcement priorities highlighting the areas on which all EU enforcers will focus when reviewing 2012’s financial statements.  These areas are: financial instruments; impairment of non-financial assets; defined benefit obligations; and provisions that fall within the scope of IAS 37 – Provisions, Contingent Liabilities and Contingent Assets

ESMA issued the EU common enforcement priorities before the year-end so that companies and their outside independent auditors could and should take due consideration of them when preparing and auditing the IFRS financial statements for the year ending December 2012.  Chairman Maijoor urged outside auditors to play an important role in assuring investors about a company’s financial position and performance, which is more important than ever for all companies, and especially financial institutions. 

Since the beginning of the financial crisis, noted the Chair, transparency related to financial instruments is a top priority.  Issuers should provide disaggregated and expanded disclosures on material exposures to all financial instruments that are exposed to risk. ESMA expects relevant quantitative and qualitative disclosures reflecting the nature of the risk exposure, elements related to the valuation of the instruments as well as an analysis of the concentration of exposure to relevant risks. In addition,  there should be due assessment at the end of the reporting period as to whether there is evidence that a financial asset is impaired.  ESMA believes that issuers should be more transparent on how they assess the event or events triggering impairment.

With regard to impairment of non-financial assets, ESMA believes that the current economic situation increases the likelihood that the carrying amounts of assets might be higher than their recoverable amounts.  The market value of many listed companies has fallen below their book value, a situation potentially indicating impairment and thus the need for an impairment test.

ESMA considers that particular attention has to be paid to the valuation of goodwill and intangible assets with indefinite life spans, whenever significant amounts are recognised in the financial statements.  ESMA emphasized the need to use assumptions that represent realistic future expectations and would expect issuers to provide entity specific information related to assumptions used, when preparing discounting cash flows (such as growth rates, discount rate and consistency of such rates with past experience) and sensitivity analyses. 

Tuesday, November 20, 2012

US Chamber of Commerce Urges SEC to Ensure that Volcker Rule is Global to Prevent Regulatory Arbitrage

To prevent regulatory arbitrage and provide for a level international playing field, yje US Chamber of Commercde urged that the the enforcement of the Volcker Rule should be suspended pending certification by the Treasury Secretary that other international jurisdictions have adopted similar statutory schemes and are abiding by similar restrictions. 

In a letter to the SEC, CFTC and Fed, the Chamber said that the Volcker Rule was originally meant to include all of the major global capital market participants. However, this international call to action was swiftly and universally rebuffed by other nations, said the Chamber. Thus, the United States has unilaterally placed itself at a disadvantage in an increasingly competitive global capital marketplace. 

Monday, November 19, 2012

Treasury Official Endorses Substituted Compliance Principle for Cross-Border Derivatives Transactions

Since the derivatives market is global and highly mobile, said Mary Miller, Treasury Under Secretary for Domestic Finance in recent remarks, one regulator or one jurisdiction cannot effectively enact reforms alone of the derivatives market. Thus, Treasury strongly support efforts by U.S. market regulators to align their rules on transactions that are subject to regulation under the Dodd-Frank Act with global regulators. To provide certainty to global market participants, many of whom are hedging risks that are integral to their core operations, the U.S. market regulators should strive to establish consistent standards that apply to cross-border derivatives transactions of similar types.

Treasury also supports SEC, CFTC and other US regulators as they work with their international counterparts to develop robust frameworks for effective substituted compliance wherever appropriate, while always keeping in mind the risks of regulatory arbitrage and the need for transparency.  U.S. market regulators should also continue to work with their foreign peers to develop consistent frameworks to avoid unnecessary and unproductive conflicts that inhibit the development of coordinated global rules. Ms. Miller emphasized that this will help increase confidence in markets. 

As the SEC and CFTC  focus on completing derivatives regulations that work domestically and internationally, noted the Treasury official, the reforms should be guided by the key pillars of derivatives market reform: (i) trades should be cleared where appropriate and subject to a strong margin regime, (ii) the most standard derivatives should move to trade execution platforms, and (iii)  prudential regulations of large dealers and large market participants should provide enhanced disclosure to the public and regulators.

Sunday, November 18, 2012

Senate Banking Chair Johnson Urges Calibration of Basel III Capital Standards with Dodd-Frank Regulations

Senate Banking Committee Chair Tim Johnson (D-SD) is concened about the impact of Basel III on US community banks. At recent committee hearings, he urged federal banking agencies to calibrate Basel IIL regulations in coordination with regulations being adopted under the Dodd-Frank Act. While recognizing that the banking agencies have undertaken a number of efforts to explain the proposed rules to community banks, including issuing a capital estimation tool for banks to evaluate how the proposed rules will impact them, the Chairman remains concerned that the proposed risk weights could have an adverse impact on small banks’ ability and willingness to offer mortgages, especially in rural areas. He is particularly interested in how the risk weights were determined for mortgages and securitizations.

 He noted that a strong capital base is a key component of a resilient financial system. This was a major lesson of the financial crisis in 2008, he added, and commended the bank regulators for their efforts to steadily recapitalize the U.S. banking system and establish new standards. But while capital can serve as an important loss-absorbing buffer, he said, capital alone will not prevent financial firms from failing and potentially threatening the broader financial stability.

As Part of Shadow Banking Oversight, Financial Stability Board Urges Floating NAV for Money Market Funds

As part of its recommendations to strengthen the shadow banking system, the Financial Stability Board endosred the reform that stable NAV money market funds should be converted into floating NAV where workable. The FSB believes that the safeguards required to be introduced to reinforce stable NAV money market funds’ resilience to runs where such conversion is not workable should be functionally equivalent in effect to the capital, liquidity, and other prudential requirements on banks that protect against runs on their deposits.

In the view of the Board, money market funds form a large element within the shadow banking system by providing short-term non-deposit funds to the regular banking system, and also funding separate non-bank chains of credit intermediation. During the crisis, moreover, certain types of money market funds experienced investor runs, some of which necessitated large scale support from sponsors or the official sector to maintain stability in the money fund sector. Also, the money market funds that faced runs typically offered stable or constant net asset value (NAV) to their investors, fostering an expectation that their claims were similar to bank deposits.

The Board also recommended that money market funds comply with the general principle of fair value when valuing their assets. Amortised cost method should only be used in limited circumstances. Such money market fund valuation practices should be reviewed by a third party as part of their periodic reviews of the funds accounts.
Further, the FSB said that money market fund documentation should include the absence of a capital guarantee and the possibility of principal loss. The funds should disclose to investors all necessary information regarding their practices in relation to valuation and the applicable procedures in time of stress.


Saturday, November 17, 2012

Treasury Exempts FX Forwards and Swaps from Dodd-Frank Clearing and Exchange-Trading Rules

The US Treasury has issued a final determination to exempt foreign exchange forwards and swaps transactions from the clearing and exchange trading requirements of the Dodd-Frank Act. This final determination is narrowly tailored. FX swaps and forwards will remain subject to the Dodd-Frank Acr's new requirement to report trades to repositories and remain subject to the Act's rigorous business conduct stndards. Also, Dodd-Framk makes it illegal to use these instruments to evade other derivatives reforms. Importantly, the final determination does not extend to other FX derivatives, such as options and currency swaps, which will be subject to mandatory clearing and exchange-traded requirements.

The FX swaps and forwards market is different from other derivatives markets, explained Treasury, in that existing practices mitigate risk and ensure stability. For example, FX swaps and forwards always require both parties to physically exchange the full amount of currency on fixed terms and market participants know the full extent of their own payment obligations to the other party to a trade throughout the life of the contract.

The Treasury exemption is a critical step in ensuring the safe functioning of a well performing market and in promoting clarity in the international regulatory regime, according to the Global Financial Markets Association, whicch added that subjecting FX transactions to mandatory clearing would have introduced new risks into a stable market that performed well during the crisis with serious negative consequences for corporate and asset manager end-users.

The Treasury decision also recognizes the FX industry’s efforts along with DTCC to develop a global trade repository to store FX trade information, thereby providing additional oversight for regulators and transparency for users. The global build out of this repository, already in testing, will increase its effectiveness for regulators and efficiency for participants.

According to James Kemp, managing director of GFMA’s Global FX Division, said that the final decision from the US Treasury provides the clarity the industry needs to now further develop the infrastructure of the future. Treasury has identified that the key risk in FX is settlement risk and that it is already effectively managed. He urged regulators in other jurisdictions to acknowledge the US Treasury’s key points and follow suit in exempting FX from mandatory clearing and execution requirements in order to ensure that the global FX market is not fragmented into different regimes and remains cost effect

Friday, November 16, 2012

European Commission Proposes Directive on Gender Equality for Company Non-Executive Boards

The European Commission has proposed legislation, a Directive, with the aim of attaining a 40 percent objective of the under-represented gender in non-executive board-member positions in publicly listed companies by 2020, with the exception of small and medium enterprises. Despite an intense public debate and some voluntary initiatives at national and European level, the situation has not changed significantly in recent years. At present, 91.1 percent of executive board members, 85 percent of non-executive board members and 96.8 percent of the boardroom chairs are men. Thus, legislation is needed. The Directive leaves it to the Member States to adopt appropriate sanctions for companies in breach of the Directive.

The proposal's objective of 40 percent only applies to non-executive directors, such as supervisory board members in the two-tier structure, who, while important actors in relation to corporate governance, are not involved in the day-to-day running of a company. This is so as not to interfere with the freedom to conduct a business and property rights, noted the Commission, two fundamental rights guaranteed by the EU's Charter of Fundamental Rights.But the proposal also includes an obligation for listed companies to set themselves individual, self-regulatory targets regarding the representation of both genders among executive board directors to be met by 2020. Companies will have to report annually on the progress made.

The Directive establishes a minimum harmonization of corporate governance requirements, as appointment decisions will have to be based on objective qualifications criteria. Inbuilt safeguards will ensure that there is no unconditional, automatic promotion of the under-represented gender. In line with the European Court of Justice's case law on positive action, preference must be given to the equally qualified under-represented gender, unless an objective assessment taking into account all criteria specific to the individual candidates tilts the balance in favor of the candidate of the other sex. Member States that already have an effective system in place will be able to keep it provided it is equally efficient as the proposed system in attaining the objective of a presence of 40 percent of the under-represented sex among non-executive directors by 2020. And Member States remain free to introduce measures that go beyond the proposed system.

House Panel Report on MF Global Recommends Legislation, Enhanced SEC and CFTC Regulations and Inter-Agency Cooperation

The House Financial Services Committee released a report on MF Global recommending that the SEC investigate whether the firm, a futures commission merchant and a securities broker-dealer, violated federal securities laws and regulations in connection with its disclosures about its European repurchase-to-maturity (RTM) trades and the firm’s overall financial health. The report was prepared under the auspices of Rep. Randy Neugebauer (R-TX), Chair of the Oversight and Investigations Subcommittee, who has been leading the congressional investigation.  In order to restore investor confidence in the futures markets, the Subcommittee also recommends that Congress enact legislation imposing civil liability on the officers and directors that sign the financial statements of a futures commission merchant or authorize specific transfers from customer segregated accounts for regulatory shortfalls of segregated customer funds.

Noting the lack of meaningful cooperation between the SEC and the CFTC regarding MF Global, the Subcommittee recommends that Congress explore whether customers and investors would be better served if the SEC and the CFTC streamline their operations or merge into a single financial regulatory agency that would have oversight of capital markets as a whole. Referencing MF Global, the House panel discerned an apparent inability of the SEC and CFTC to coordinate their regulatory oversight efforts or to share vital information with one another, coupled with the reality that futures products, markets and market participants have converged. Had the SEC and the CFTC coordinated their supervision and shared critical information about MF Global, said the report, they might have gained a more complete understanding of the company’s deteriorating financial health, and they might taken action to better protect the company’s customers and investors before it collapsed.

On October 31, 2011, MF Global filed for bankruptcy under Chapter 11 of the U.S. Bankruptcy Code.  On the same day, the Securities Investor Protection Corporation began liquidation proceedings for MF Global’s U.S.-based subsidiary, MF Global, Inc.and the U.S District Court appointed a trustee to handle the company’s liquidation. Although initial reports estimated that $700 million in customer funds required to be housed in separate accounts for safekeeping were missing, said the House report, it is now known that  MF Global’s collapse resulted in a $1.6 billion shortfall in customer funds.

MF Global’s ability to amass more than $6.3 billion in European sovereign debt without fully disclosing the size and nature of its European portfolio also raises congressional concerns about the sufficiency of off-balance sheet reporting requirements under US GAAP and SEC regulations, said the report, which noted that FINRA has proposed a rule requiring member companies to disclose the gross contract value of  European RTM trades that are derecognized from their balance sheets in a supplementary schedule for quarterly FOCUS reports. In addition, FASB has tentatively voted to amend its accounting guidance to require RTM transactions to be accounted for as secured borrowings.

An RTM differs from a traditional repurchase agreement in one important respect.  In a traditional repurchase agreement, the securities held by a counterparty are returned to the borrowing company before the securities collateralizing the borrowing reach maturity. By contrast, in an RTM transaction, the counterparty keeps the pledged securities as collateral until they mature, whereupon the counterparty may either return the securities to the borrowing company or redeem them from their issuer at par value. According to the House report, MF Global learned that by entering into RTM transactions collateralized with European sovereign bonds (the European RTM trades) it could realize an immediate profit on the difference between the interest the issuer of the bonds paid to MF Global and the rate the company paid to its counterparty to repurchase the bonds, and that it could derecognize the bonds from its balance sheet.

Regarding credit rating agencies, the report noted that, while Moody’s and S&P acknowledged that MF Global’s transformation into an investment bank would increase the company’s risk profile as it took  on greater proprietary trading positions, the credit rating agencies did not sufficiently review MF Global’s public filings to identify these risks when they did emerge. Indeed, the Subcommittee found that, despite the information that was available to them for a period of five months, Moody’s and S&P did not factor MF Global’s European sovereign debt exposure into its public credit assessments until one week before the firm filed for bankruptcy. 

In order to address the problems raised by sudden downgrades, the Subcommittee called for a congressional review of whether the SEC should require each NRSRO to establish and enforce written policies and procedures reasonably designed to provide for periodic monitoring of credit ratings and periodic communications to the market about the NRSRO’s monitoring practices. The Subcommittee believes that some form of periodic review could instill a greater level of scrutiny and diligence in the ratings process and give investors more confidence that the ratings they receive are current.

The report found that MF Global customers who traded abroad faced the risk that the funds set aside in secured accounts would not readily be available to satisfy their claims upon the firm’s bankruptcy and subsequent liquidation.  Customers who traded foreign futures and options executed and cleared trades on foreign exchanges, which were beyond the jurisdiction of U.S. authorities.  In light of this, the Subcommittee recommends that the House Committee on Agriculture consider whether to direct the CFTC to study whether it can better mitigate the risks that customers of futures commission merchant face when customer funds are placed in secured accounts subject to the law of a foreign jurisdiction.

In conducting any such study, said the Subcommittee, the CFTC should consider whether the rules that govern trading on foreign exchanges should be amended to establish protections comparable to those that govern domestic transactions. In particular, the CFTC should consider whether any potential rule change could impose costs on futures commission merchants and their customers that would place foreign futures and options trading at a competitive disadvantage to similar products and services.

Under its primary dealer program, the New York Fed grants financial companies the privilege of acting as counterparties to open market operations executed by the New York Fed. In the view of the Subcommittee,  MF Global’s risk management failures, chronic net losses, and untested business strategy, combined with the New York Fed’s internal concerns that MF Global posed reputational risks, should have given the New York Fed pause before conferring primary dealer status on MF Global. Even though the subsidiary met the basic requirements to become a primary dealer, the New York Fed should have, at a minimum, placed the firm’s application on hold until MF Global’s new business strategy had been successfully implemented.  

Thus, in order to discourage companies from utilizing a primary dealer designation beyond its intended purpose, the Subcommittee recommends that the New York Fed strengthen its application guidelines to expressly forbid companies from speaking publicly about their application status during the pendency of the application unless required for regulatory disclosure purposes.  If an applicant company ignores the disclosure prohibition, emphasized the House panel, the New York Fed should consider instituting a cooling-off period, similar to the one-year delay for material regulatory actions. The Subcommittee further recommends that the New York Fed consider re-examining its primary dealer selection process to provide for greater scrutiny of companies with questionable financial health, risk management histories, and ambitious business strategies.

Senators Put Hold on Office of Financial Research Director over Treasury’s Failure to Respond to LIBOR Concerns

Senators Charles Grassley (R-Iowa) and Mark Kirk (R-IL) have put a hold on the nomination of Richard Berner to be the head of  the new Dodd-Frank created Office of Financial Research due to Treasury’s failure to respond to issues surrounding LIBOR. The OFR is designed to assist the Financial Stability Oversight Council by conducting studies and accumulating financial data.

Specifically, the Senators are concerned that Treasury failed to respond to their October 2 letter to Sescribed as a rigged interest rate that affects interest rates on mortgages, student loans, credit cards and other loans. In the letter to the Secretary, the Senators asked Mr. Geithner to answer a series of questions including whether the Treasury Department has calculated the increased debt burden that  U.S. borrowers, including state, municipal, and local governments, will face as a result of the LIBOR scandal.

The Senators also ask if U.S. officials considered the litigation risks to U.S. borrowers in deciding to bring the LIBOR scandal only to the attention of British central banks rather than U.S. lenders and borrowers and whether the Treasury Department’s continued reliance on LIBOR is affecting borrower access to Small Business Administration loans. The Secretary’s response to the questions was requested by October 16.

The London interbank offered rate, or LIBOR, is the average interest rate that banks use to borrow from each other.  Set in London, the rate is one of the main rates that determine the cost of interest for trillions of dollars of loans on a variety of everyday consumer loans such as mortgages and more complicated financial instruments such as derivatives.

Senators Grassley and Kirk emphasized that, in the wake of the LIBOR scandal, it is essential to undertake steps to consider the creation of a US-based interest rate index. If U.S. investors and borrowers have suffered financial harm from dependence on an index set in London, they have the right to expect the country’s leaders to support better alternatives. Complacency in the wake of losses and lawsuits will diminish both investor and borrower confidence regarding debt securities issued in U.S. financial markets, said the Senators.

Taxpayers need to know that the Treasury Department is making sure that the interest rates they pay on everything from home loans to retirement investments are not rigged, said Senator Grassley. Treasury must take swift action to inform consumers, homeowners, students and other borrowers about potential impacts of faulty interest rates, added Senator Kirk, a member of the Senate Banking Committee. The financial system depends on this crucial information, he posited, and Treasury should consider alternative solutions to boost confidence in the marketplace.”

In the letter, the Senators noted that, in recent testimony before Congress, Secretary Geithner said that when, as president of the Federal Reserve Bank of New York, he became aware of concerns that the LIBOR rate was being rigged, he deferred to the British central bankers to fix the problem.  Despite those concerns, continued the Senators, Mr. Geithner appears not to have taken action to diminish use of this flawed index in U.S. financial markets; to the contrary, Treasury’s use of LIBOR has increased.

Recently, a Task Force headed by Martin Wheatley, UK Financial Services Authority Managing Director, recommended three specific regulatory reforms to restore credibility to LIBOR. First, regulation of LIBOR by the FSA. Second, the key persons in the LIBOR process should be approved by the FSA. Third, amending the Financial Services and Markets Act to allow the FSA to prosecute the manipulation of LIBOR.

Wednesday, November 14, 2012

Senator Shelby Questions Cost-Benefit Analysis of Basel III Implementation at Banking Committee Hearing

Senator Richard Shelby (R-AL) questioned how the  Basel III capital accord will impact US financial institutions and the unique and diverse US banking system at a Banking Committee hearing on Basel III. In a statement at the hearing, Senator Shelby, the Committee’s Ranking Member, said the public has the right to know the consequences of adopting Basel III, including how it will impact the stability of the U.S. banking system, US economic growth, and the ability of consumers to obtain loans. The public’s right to know is even more pronounced, he said, given the failure to properly set capital requirements before the crisis. Moreover, there are growing doubts about Basel III’s model-based approach to setting capital requirements.  Many commentators and even some regulators are concerned that the Basel III models are too complex and inaccurate to be relied upon.  If the agencies want the public to have confidence in Basel III, said the Senator, they need to make their case publicly.  

Senator Shelby called on the Banking Committee to conduct a rigorous review of the banking agencies’ proposals to ensure that the goal of Basel III is actually achieved. The Committee cannot simply rely on agency assurances that their proposed rules will leave US banks properly capitalized. Instead, banking regulators must demonstrate to the Committee  that their proposed rules are supported by proper data and rigorous economic analysis. Regrettably, he said,  the agencies have so far not provided sufficient data and analysis of their proposals.

In October, Senator Shelby sent a letter to the banking agencies asking them to publicly release detailed estimates on how capital levels will change for US financial institutions under Basel III, how the agencies determined that those levels will leave the US banking system well-capitalized, and what will be the compliance costs. These are basic questions that should be publicly answered before this rulemaking proceeds, he said.

But, the response of the banking agencies to the Shelby letter relied largely on studies by the Basel Committee, which used data only from the very largest banks.  For example, one key study included data from only 13 U.S. banks. In addition, the Basel Committee’s quantitative impact study aggregates country results, noted the Ranking Member, and does not specifically show how Basel III will impact the U.S.  Even more troubling to the Senator was the agencies’ belief that Basel III is appropriate based on the losses experienced by US financial institutions, but they do not provide data to support this conclusion.

Senator Shelby admonished the banking regulators to stop outsourcing their economic analysis to the Basel Committee and determine how Basel III will impact the diverse and unique US banking system and the overall economy.

Texas Adopts Accredited Investor, Finder and Successor Registration Changes

Amendments to the exemption for individual accredited investor sales, and to the application procedures for finders and for successor entity securities dealers and investment advisers were adopted by the Texas Securities Board, effective November 8, 2012.

In Letter to SEC, Fund Industry Applauds NYSE Proposal to Exempt Open-End and Closed End Funds from Compensation Committee Standards

In a letter to the SEC, the Investment Company Institute supported the NYSE’s proposal to exempt both closed-end and open-end investment companies from listing standard compensation committee requirements because of the fundamental structural differences between investment companies and operating companies. Primarily, most investment companies enter into a contract with an investment adviser that manages the fund’s securities portfolio in conformance with the fund’s stated investment objectives and policies. As a result, said the Institute, these investment companies do not have compensated executives and thus have no need for compensation committees to oversee executive compensation.

Section 952 of the Dodd-Frank Act requires the SEC to adopt rules directing the national securities exchanges to prohibit the listing of any equity security of an issuer that is not in compliance with compensation committee and compensation adviser requirements. Pursuant to Section 952, the SEC adopted Rule 10C-1 directing the establishment of listing standards that require each member of a listed issuer’s compensation committee to be a member of the board of directors and to be independent as defined in the listing standards. Rule 10C-1(b)(1)(iii)(A) exempts registered open-end investment companies from the compensation committee member independence listing standards. The SEC rule does not explicitly exempt other types of investment companies registered under the Investment Company Act of 1940, including closed-end investment companies. The SEC did, however, expressly confirm the authority of each exchange to exempt any additional categories of issuers as such exchange determines is appropriate. The NYSE proposes to exempt both open-end and closed-end funds registered under the Investment Company Act from the proposed compensation committee independence requirements.

The ICI fully supports the NYSE’s proposal to exempt both open-end and closed-end funds registered under the 1940 Act from the new compensation committee requirements. These issuers typically are externally managed and do not employ executives or by their nature have employees. The NYSE recognizes that both closed-end and open-end funds registered under the 1940 Act do not generally have compensation committees because of their unique structure and that it would be a significant and unnecessarily burdensome alteration in their governance structure to require them to comply with the proposed new requirements. Moreover, noted the ICI, any potential conflicts of interest that are raised with respect to compensation paid to investment advisers are adequately governed by the corporate governance standards provided in the Investment Company Act.

Tuesday, November 13, 2012

FSOC Recommends Money Market Fund Reforms for Public Comment While Urging SEC to Act

The Financial Stability Oversight Council voted unanimously to seek public comment on a set of alternative structural reforms of money market funds. FSOC is proposing three alternative reforms: 1) a floating NAV under which money market funds would be required to use mark-to-market valuation to set share prices, like other mutual funds; 2) a capital buffer of up to one percent combined with a requirement that a small percentage of shareholder funds could be redeemed on a delayed basis; and 3) a capital buffer of 3 percent combined with other measures that together could reduce the size of the requited buffer. FSOC Chair, Treasury Secretary Tim Geithner, recognized that, in addition to these three options, there is a range of proposals by the industry and by academics and FSOC wants to hear comments on those options as well. The comment period is 60 days.

Secretary Geithner said that the basic vulnerabilities and design of money market funds tended to exacerbate the financial crisis of 2008. Currently, regulators do not have a sufficient degree of comfort that regulations are in place to guard against these vulnerabilities. While acknowledging the efficacy of the SEC’s 2010 reform of money market fund regulations, the FSOC Chair said that the 2010 reforms did not go far enough,

FSOC has proposed a set of recommendations, he noted, in order to provide public comment on which the SEC can move forward to further money market fund reform. If at any point the SEC has a majority to go forward, said the Secretary, FSOC would suspend its work and let the SEC go forward. Indeed, FSOC would prefer for the SEC to take this back and move forward.

SEC Chair Mary Schapiro said that she asked FSOC to address the structural weaknesses of money market funds and is very pleased that FSOC is acting to protect investors and the financial system. The FSOC recommendations represent meaningful structural reform options, she noted.

The SEC Chair noted that FSOC is committed, along with the SEC, to take the necessary action and make the tough calls. Of the three proposed recommendations, she said that the floating NAV is the simplest option and the option most consistent with the SEC’s approach to investment products. But, at the same time, she said that the SEC was also open to a stable NAV with added protections against panicked redemptions. In 2008, she said, a broad-based run on prime money market funds panicked investors and reduced short-term funding for municipalities.

Public input will be very important, emphasized the SEC Chair, and the Commission looks forward to it. The SEC is best positioned to implement money market reforms, emphasized Chairman Schapiro, and so it is her understanding that if the  SEC moves forward with meaningful reform, FSOC would not issue a final recommendation to the SEC.

Echoing these comments, Fed Chair Ben Bernanke said that the SEC should make the ultimate regulations on money market reform. He noted that a run on prime money market funds added significantly to the distress of the financial crisis. Extraordinary federal intervention was needed, he said, with powers that are no longer available. The SEC’s 2010 reforms were useful but only as first step, he noted, since they did not address the fixed NAV issue, which maintains the incentive for first movers to propagate a run. Thus, the basic run issue has not been solved and money market funds remain a systemic risk to the financial markets.

CFTC Chair Gary Gensler views FSOC’ s role as advisory and supports the proposal to seek broad public input on the reform alternatives. He said that the key to money market fund reform is finding the appropriate balance. On the one hand, there is a run risk, but on the other is the fear that the proposed alternative reforms may change the product that so many US investors rely upon.  The CFTC Chair has a keen appreciation of the importance of money market funds to municipal governments and to the markets; and he does not want the reforms to diminish money market funds as an investment product.

But first movers exacerbate market forces in bear markets. Chairman Gensler said that the SEC’s 2010 reforms were an important step in enhancing portfolio quality, liquidity and transparency, but that there is still an invective to run first.

IASB Chair Calls for Transparency in Lease Accounting

IASB Chair Hans Hoogervorst called on securities regulators and national accounting standard-setters to support the IASB’s joint efforts with FASB to bring transparency to lease accounting. In remarks at the London School of Economics, Mr. Hoogervorst highlighted the extent to which lease arrangements have become one of the greatest sources of off balance sheet financing for many companies. Companies favor off-balance sheet financing since it masks the true extent of their leverage

Specifically mentioning the earlier battles over stock option expensing and bringing pension liabilities on balance sheet, he explained how efforts to bring greater transparency in financial reporting often met strong resistance and lobbying from vested interests, but that in time those enhancements became accepted as normal business practice. He emphasized that the efforts of the IASB and FASB to shed light on hidden leverage should be warmly welcomed around the world. This is an ongoing and uphill battle for accounting standard setters, he added.

The vast majority of lease contracts are not recorded on the balance sheet, noted the IASB Chair, even though they usually contain a heavy element of financing.  For many companies, such as airlines and railway companies, the off-balance sheet financing numbers can be quite substantial. In addition, the companies providing the financing are more often than not banks or subsidiaries of banks.  If this financing were in the form of a loan to purchase an asset then it would be recorded, he noted, but calling it a lease means that it miraculously does not show up on the books. 

Currently, most analysts take an educated guess on what the real but hidden leverage of
leasing is by using the basic information that is disclosed and by applying a rule-of-thumb multiple. In the view of the IASB Chair, it seems odd to expect an analyst to guess the liabilities associated with leases when management already has this information at its fingertips. This is one reason why it is urgent that the IASB create a new standard on leasing, in close cooperation with the FASB.

In June 2005, the SEC submitted a prescient report to Congress regarding the use of off-balance sheet arrangements. Arguing for a change in lease accounting, the report said that the fact that lease structuring based on the accounting guidance has become so prevalent will likely mean that there will be strong resistance to significant changes to the leasing guidance, both from preparers who have become accustomed to designing leases that achieve various reporting goals, and from other parties that assist those preparers.

The SEC turned out to be quite prophetic, said the IASB Chair. As the financial crisis was caused by excessive leverage, he continued, the IASB-FASB efforts to shed light on hidden leverage should be warmly welcomed globally. National accounting standard-setters, regulators such as the SEC, and investors must stand by their beliefs and help bring much-needed transparency to this important area. Their vocal support will be needed to counter what is a well-funded lobbying campaign.