Monday, December 31, 2012

House Financial Services Committee Likely to Examine High Frequency Trading in 2013

Given that the new Chair of the House Financial Services Committee, Rep. Jeb Hensarling (R-TX) is a longtime leader on the issue of high frequency trading, it is highly likely that the Committee will pursue this issue with hearings and other activities in 2013. In earlier remarks, Rep. Hensarling has noted that a shoot the computers first and ask questions later approach will not restore investor confidence or promote capital formation.

Chairman Hensarling believes that the high frequency trading debate is not a debate about who has access to what technology. Rather, it is a debate about the health, efficiency, and competitiveness of the financial markets. Any action taken by Congress or the SEC should be based on economic and empirical data, not political pressure.

In 2010, then Senator Edward Kaufman (D-DE) informed the high frequency trading debate with some specific proposalssubmitted to the SEC. The Senator said that high frequency traders who exceed a certain volume threshold should be required to register with the SEC, and then subjected to automatic risk compliance and anti-gaming checks. He also urged the SEC to impose some liquidity provision obligations on high frequency traders. Enhanced requirements should be crafted to encourage high frequency traders to post two-sided markets and supply investors with a consistent source of deep liquidity. In addition to affirmative liquidity provision obligations, the Commission should consider instituting negative obligations as well.

Sunday, December 30, 2012

Former SEC Chair Harold Williams Warned of Expanded Judicial Review of Federal Regulations

As the 113th Congress considers legislation to reform the federal regulatory process, a look back at remarks by former SEC Chair Harold Williams may prove instructive with regard to providing an expanded role for federal judicial review of SEC and other agency regulations. In remarks at the National Press Club on Nov. 7, 1979, Chairman Williams said that federal courts should not be encouraged to substitute their general knowledge for the specific expertise of an administrative agency, adding that the judicial process is not well-suited to decide matters of economic regulation and social policy on a routine basis.

Indeed, he continued, the very essence of effective rulemaking, which is a non-adversarial balancing of many different and often competing interests, is inconsistent with the case-by-case focus imposed upon federal courts by Article III of the Constitution.

Remarking on a proposal from then Senator Dale Bumpers (D-ARK) that would have, as part of judicial review, shifted the burden to the agency whose regulation is challenged to demonstrate its legitimacy, Chairman Williams reasoned that subjecting challenged regulation to this kind of judicial review would undercut the very rationale for having administrative agencies in the first place. He noted tha, traditionally, courts have been required to defer to agency expertise in reviewing challenged regulations, to resume a regulation to be legal and to place the burden on those challenging the regulation to establish its invalidity.

The SEC Chair, appointed by President Jimmy Carter, observed that then Chief Judge J. Skelly Wright of the D.C. Circuit Court of Appeals, the court that handles much of the judicial review of the regulatory process, is reported to have said that the federal courts ought to stop telling the regulatory agencies what to do.

Friday, December 28, 2012

Chairman Hensarling Names Leadership Team for Financial Services Committee, Rep. McHenry Will Chair Oversight and Investigations Subcommittee

Rep. Jeb Hensarling (R-TX), the new Chair of the Financial Services Committee in the 113th Congress has named the Chairs of the various Subcommittees, including Rep. Patrick McHenry (R-NC) to Chair the Oversight and Investigations Subcommittee with oversight of the Fed, the SEC, the FDIC and the OCC. Rep. Randy Neugebauer, Chair of the Oversight Subcommittee in the 112th Congress will Chair the Insurance and Housing Subcommittee in the new Congress. Rep. Scott Garrett (R-NJ) returns as Chair of the pivotal Capital Markets Subcommittee and Rep. Shelly Moore Capito (R-WV) returns as Chair of the Financial Institutions and Consumer Credit Subcommittee. The Vice Chairman of the Committee will be Rep. Gary Miller (R-CA) and, the newly created position of Committee Whip will be filled by Rep. Lynn Westmoreland (R-GA).

In naming Rep. McHenry, Chairman Hensarling said that his exemplary efforts overseeing the SEC and CFPB in his former role as Chair of the TARP and Financial Services Subcommittee of the House Oversight and Government Reform Committee have been critical for small businesses and entrepreneurs. In his new role on the Financial Services Committee, Chairman Hensarling expects him to continue the fight for efficient markets that support the free flow of capital to every aspect of the economy.
On his appointment, Chairman McHenry noted that federal regulators need proper oversight in order to avoid bureaucratic overreach. He pledged to ensure that small businesses have access to the capital they need to grow and expand.

In letters to SEC Chair Schapiro during the 112th Congress, Chairman McHenry urged the Commission to complete the final regulations implementing Section 201 of the JOBS Act. In a November 30, 2012 letter to Chairman Schapiro, Chairman McHenry said that the SEC’s delay in implementing Section 201 is a significant obstacle to capital formation and economic recovery. The House oversight Chair also said that documents provided by the SEC to the Committee implied that Chairman Schapiro intervened to delay implementation of Section 201 in an effort to appease special interest groups and out of concern for her legacy as SEC Chairman

Thursday, December 27, 2012

SEC Urges Supreme Court to Apply Discovery Rule to Limitations Period for Enforcement Actions

With oral argument in the case set for January 8, 2013, the SEC has asked the US Supreme Court to uphold a Second Circuit panel ruling that the five-year limitations period in 28 USC 2462 did not begin to run until the SEC discovered, or reasonably could have discovered, a fraudulent scheme alleged as part of an SEC enforcement action involving market timing of mutual funds. In its brief, the SEC argued that the discovery rule is a background principle that presumptively governs the application of a federal limitations statute unless Congress specifies otherwise. Gabelli v. SEC, Dkt. No. 11-1274.

In the enforcement action, the SEC alleged that the market timing 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 28 USC 2462 is applied.

Section 2462 provides that an action for the enforcement of any civil penalty must not be entertained unless begun within five years from the date when the claim first accrued. The appeals court rejected the petitioners’ argument that the SEC claims against them for civil penalties first accrued when they engaged in the fraud at issue regardless of the time at which the SEC discovered or reasonably could have discovered the scheme.

A discovery applies to Section 2462 when the government seeks civil penalties based on fraud, said the SEC, citing opinions by the Fifth and Seventh Circuits that the five-year limitations period in Section 2462 does not begin to run until the SEC knew or should have known the relevant facts. The application of a discovery rule in cases of fraud or concealment dates to the earliest days of the Republic, added the Commission.

Application of the discovery rule does not depend on its express incorporation in a federal limitations period, said the SEC. Rather, the crucial question is whether Congress has clearly displaced the usual rule that limitations periods in fraud cases are triggered by actual or constructive discovery. It has not, emphasized the SEC, since nothing in Section 2462 clearly displaced the fraud discovery rule.

The SEC noted that the Supreme Court has repeatedly recognized that, unless Congress specifies a different rule, the limitations period in an action for fraud does not begin to run until the plaintiff discovers, or in the exercise of reasonable diligence could have discovered, the facts underlying the claim. That rule, said the SEC, derives from the equitable maxim that a party should not be permitted to benefit from its own misconduct.

The Court has long held as a matter of equity that defendants cannot use their own conduct as a defense, including by unfairly relying on a statute of limitations. The Court’s approach, said the SEC, follows naturally from equity’s primary justification for the fraud discovery rule, which is to prevent defendants from unfairly relying on a statute of limitations when their own acts have kept potential plaintiffs in the dark.

Wednesday, December 26, 2012

House Passes Bi-Partisan Legislation Raising Leverage for Small Business Investment Companies

The US House of Representatives passed the Small Business Investment Company Modernization Act, H.R. 6504, by an overwhelming bi-partisan vote of 359 to 36 to amend the Small Business Investment Act of 1958 by increasing from $225 million to $350 million the maximum amount of outstanding leverage to be made available by the Small Business Administration to two or more commonly controlled small business investment companies not under capital impairment.

Rep. David Cicilline (D-RI), a co-sponsor of the legislation, observed that H.R. 6504 is a common sense, bipartisan measure that raises the amount of leverage that a group of community-held and successful small business investment companies, referred to as a family of funds, can access. The Small Business Investor Alliance estimates that increasing the leverage from $225 million to $350 million in the legislation would facilitate approx. $500 million a year in new small business investment. Cong. Record, Dec. 19, 2012, H6839.

The sponsor of the legislation, Rep. Steve Chabot (R-OH), noted that the Small Business Investment Company program was created in 1958 and provides leverage to highly regulated private investors. These private investment funds are called small business investment companies, which raise private capital from institutions like banks and pension funds, and also borrow Federal capital to invest in promising small businesses. As required by law, 100 percent of the money is invested in US companies. He also said that the legislation will assist proven fund managers by allowing them to assess additional funds that they can use to assist small businesses. Cong. Record, Dec. 19, 2012, H6838-6839.

In addition to having bipartisan congressional support, the legislation has the support of the Small Business Investor Alliance, the association that represents small business investment companies, as well as the support of the U.S. Chamber of Commerce Additionally, the Obama Administration recommended this provision as a part of the President's Startup America initiative.  

Monday, December 24, 2012

Business Groups Urge Third Circuit to Allow Arbitration by Sitting Delaware Chancery Court Judges

In an amicus brief filed with the Third Circuit Court of Appeals, business groups asked for judicial approval of a valuable alternative to civil litigation offered to companies through arbitration by Delaware Court of Chancery judges. This arbitration allows companies to resolve their disputes before experts in corporate law, said the groups, but without the trammels and expense of drawn out litigation. A federal district court (DC Del) held that such arbitration must be conducted in public because it is tantamount to civil litigation, noted the brief, even though Delaware intended the arbitration as an alternative to and a substitute for, such litigation. The district court’s decision denies businesses a promising alternative to cumbersome litigation, argued the business groups, while not advancing any interest of openness, and should be reversed. The brief was submitted by the Business Roundtable and the US Chamber of Commerce. (Delaware Coalition for Open Government v. Strine, CA-3, No. 12-3859).

The district court held that a secret Delaware Chancery Court arbitration proceeding set up to decide corporate governance and other business disputes submitted by private entities was essentially a civil trial and thus the First Amendment qualified right of access mandates that the proceeding must be open to the public. The Delaware proceeding functions as a non-jury trial before a Chancery Court judge, said the federal district court.

In the Delaware proceeding, the parties submit their business dispute to a sitting judge acting pursuant to state authority, using state personnel and facilities. The judge finds facts, applies the relevant law and issue an enforceable order dictating the obligations of the parties. A judge bears a special responsibility to serve the public interest, said the federal court, an obligation that is undermined when a judge acts as an arbitrator bound only by the parties’ interest. The parties’ consent could not alter the judge’s public role as a judicial officer.

To determine whether arbitration by Court of Chancery judges is subject to a limited public right of access, noted the brief, the Third Circuit applies the experience and logic test. A key question arising under the logic prong of the test is what public benefit, if any, is served by requiring such arbitration to be conducted in the open. The answer is none, said the business groups.

Indeed, since confidentiality is essential to arbitration, if arbitration by Court of Chancery judges were made public businesses that would otherwise avail themselves of it would turn instead to other non-public fora to resolve their disputes. Thus, whatever public benefit might accrue in theory from open arbitration proceedings in the Court of Chancery, emphasized the business groups, none will be realized in practice.

The district court wrongly conflated arbitration with a civil trial based on the single fact that the arbitrator is a Chancery Court judge, said the business groups. Court of Chancery arbitration is consensual, they pointed out, while litigation is not. That the Court of Chancery arbitrator is a judge who also resolves other disputes between other parties in judicial proceedings governed by other rules and resulting in precedential decisions does not somehow transform consensual arbitration into non-consensual litigation.

In the view of amici, the district court’s reasoning amounts to a per se rule that any proceeding conducted with public funds by a state judicial officer is necessarily “civil litigation” and therefore subject to a qualified First Amendment right of access. But that conclusion is clearly overbroad, contended the business groups, and contrary to settled practice in courts throughout the country. For example, it would invalidate the numerous state programs authorizing judges to act as arbitrators in court-annexed or similar arbitration programs.

Sunday, December 23, 2012

Securities Industry Urges US Supreme Court to Reverse Second Circuit Expansion of Class Action Status for Purchasers of Mortgage-Backed Securities

In an amicus brief filed with the US Supreme Court, the securities industry asked the Court to review and reverse a ruling by a Second Circuit panel that class standing permits purchasers of mortgage-backed securities to assert claims under the Securities Act on behalf of absent class members that purchased mortgage-backed securities that the named plaintiff did not itself purchase so long as the claims implicate the same or a similar set of concerns. The Court was urged to clarify that merely adding class allegations does not permit plaintiffs to assert claims they lack standing to assert on their own. The US Chamber of Commerce was also on the brief. The Court is slated to consider the certiorari petition in this case at its January 4, 2013 conference. Goldman Sachs & Co., et al. v. NECA-IBEW Health & Welfare Fund, Dkt. No. 12-528.

The Second Circuit’s analysis has a basic flaw, said SIFMA, in that there is no such thing as “class standing.” To the contrary, that a suit may be a class action adds nothing to the question of standing. The standing analysis is the same regardless of whether a plaintiff purports to act on behalf of a class. Here, the plaintiff’s standing is limited by the Securities Act, which expressly permits a plaintiff to sue only with respect to the particular security it purchased.

The more specific question is whether purchasers of mortage-backed securities from one tranche of an offering have standing to represent a class that includes purchasers of different tranches of the same offering, or other mortgage-backed securities offerings, based on the same shelf registration. Mortgage-backed securities are divided into tranches with different rights, risk profiles and rates of return, noted amici, and each tranche is a separate and unique security with its own CUSIP.

The differences among such offerings are particularly acute, explained SIFMA, because each offering is backed by a unique securitization pool that typically does not exist until the specific mortgage-backed security is structured. To SIFMA’s knowledge, the Second Circuit ruling is the only decision in which a court concluded that such plaintiffs have standing to pursue a claim on behalf of purchasers of different mortgage-backed securities.

The Second Circuit’s “similar” or “same” set of concerns standard is also vague and indeterminate, argued amici, in contrast to the statutory test. It rewards a plaintiff that pleads its claim broadly and would unjustifiably multiply defendants’ potential liability under the Securities Act, further burdening already busy courts and resulting in increased vexatious litigation and coercive settlements to the detriment of the nation’s

Amici also predicted that the Second Circuit’s decision, if left intact, would not be limited in application to litigation involving mortgage-backed securities. Rather, the Second Circuit established a broad standard for determining class standing in any putative class action, whether the putative class claims concern violations of the federal securities laws related to mortgage-backed securities, other types of securities, or any other statutory or common law violation. The Second Circuit’s new standard will magnify the existing confusion among the lower courts regarding standing, creating uncertainty and inconsistent outcomes, as well as cumbersome litigation regarding the “same” or “similar” concerns standard.

In determining that the plaintiff below had standing to pursue claims on behalf of purchasers of securities it did not itself purchase, continued SIFMA, the Second Circuit ignored the limits on standing imposed by the Securities Act itself. Although Sections 11 and 12(a)(2) impose near strict liability for material misrepresentations in a registration statement or prospectus, they authorize only an actual purchaser of the particular security described in the offering materials to sue. 

Friday, December 21, 2012

Senate Panel Reviews Alternative Trading Systems with View Towards Reform of Market Regulation

Senate Securities Subcommittee hearings examined alternative trading systems and dark pools amidst a growing consensus that holistic market regulatory reforms are needed to address increasingly electronic and complex securities markets. Chairman Jack Reed (D-RI) questioned if current market regulations reflect the reality of the current market structure. He said it could be necessary to change the rules of the road. The Senator is also concerned about the complexity of the markets and the cost of that complexity. Senator Reed also fears that off-exchange trading may be hurting price discovery

Senator Reed noted that SEC Regulations ATS and NMS dramatically accelerated changes in the structure of financial markets. Regulation ATS encouraged the development of new market centers by exempting alternative trading systems from having to register as exchanges. Taken together, said Senator Reed, Regulations NMS and ATS led to a proliferation of new trading platforms and put a premium on speed, giving an advantage to firms that could place their order first.

The motivating idea behind the adoption of Regulation  NMS, in Senator Reed’s view, is to ensure that orders are sent to the trading platform with the best price regardless of where the orders originated and, he added, that does not seem to be happening with dark pool, whichs are computerized trading systems organized under Regulation ATS that do not show publicly displayed bids and offers. The order sits inside the computer waiting  for a sell order to intersect. After the trade is executed, it is publicly displayed.

Senator Kay Hagen (D-NC) also expressed concern with the dramatic increase in dark pool trading, which now accounts for 14 percent of trades. Senator Hagen perceives a lack of transparency in dark pool trading.

The Committee’s Ranking Member, Senator Mike Crapo (R-ID), was concerned about how markets perform in times of stress and what tools can be used to minimize any deleterious impact.  He noted that the use of automated switches, which the Senator called kill switches,  to turn off trading at securities firms when their volume exceeds pre-set maximums appear to be the first choice of many market participants.

Senator Crapo asked the exchanges what progress they are making in implementing kill switches. Joe Mecane Executive Vice President, NYSE Euronext, said that NYX is having an active dialogue around kill switches and is developing a framework for kill switches and should have something to report in 1Q 2013. Eric Noll, NASDAQ OMX Executive Vice President, said that the exchange is: working with the SEC to implement kill switches.

Mr. Mecane noted that there are around 63 execution venues in the US markets, including 13 exchanges and 50 dark pools.  Exchanges find themselves competing more directly with alternative trading systems, which are able to employ different practices than exchanges with far less oversight and disclosure.

In 2007, just as the technology among the trading community was becoming more sophisticated, the SEC adopted Regulation. NMS, he noted, which gave brokers the freedom to trade around markets such as the NYSE when the NYSE was in slow mode, and at the same time forced participants to access the national best bid or offer (NBBO) in the market.  Because exchanges competed by establishing the NBBO, speed among markets became the competitive differentiator based on one exchange’s ability to set the NBBO faster than a competing market.  While Reg. NMS also established the Order Protection Rule to protect visible orders and encourage displaying quotes, today more than 3000 securities have over 40%  of their volume occurring off exchange in dark markets. 

The NYX senior officer noted that technology and the rules that govern the U.S. equity markets have resulted in the creation of a trading infrastructure primarily focused on speed and a resulting complexity through which professional traders can identify and access liquidity, too often at the expense of retail investors and market integrity.  To accomplish this, exchanges, brokers, and vendors have had to build expensive networks with the capacity to keep up with the growth of messages delivered each day to market participants seeking liquidity, as well as learn how to interact in a very complex ecosystem.  

The NYX believes that the SEC is best suited to propose meaningful market structure changes. Global regulators in other markets, including Canada, Australia and Europe, are already taking action.  With Congressional oversight, the SEC should continue with the holistic review it began in 2010 with the Concept Release on Equity Market Structure
by proposing changes promoting additional transparency, fairness and long term capital formation.  This unfinished initiative needs to be completed and made a 2013 priority, emphasized Mr. Mecane.

European Parliament Approves Financial Transaction Tax for Eleven EU Member States

By a vote of 533-91, the European Parliament approved a financial transaction tax for eleven EU countries, including France and Germany, which account for about 90 percent of Eurozone GDP. EU Tax Commissioner Algeria Semeta has noted that, in addition to being a new source of revenue from a currently under-taxed sector, the financial transaction tax will encourage more responsible trading. Thus, aside from its revenue raising potential, a financial transactions tax could reduce harmful and speculative short-term and high speed trading and thereby link a trade more closely to the underlying fundamental economic market conditions and make financial markets less volatile.

The financial transaction tax will be applied to all financial transactions, in particular those carried out on organized markets such as the trading of equity, bonds, derivatives, and currencies. The tax would be levied at a relatively low statutory rate and would apply each time the underlying asset was traded. The tax collection or the legal tax incidence should be, as far as possible, via the trading system which executes the transfer.

The proposed EU Directive on which the tax is based defines a financial transaction as the purchase and sale of a financial instrument before netting and settlement, including repurchase and reverse repurchase and securities lending and borrowing agreements; the transfer between entities of a group of the right to dispose of a financial instrument as owner and any equivalent operation implying the transfer of the risk associated with the financial instrument; and the conclusion or modification of derivatives agreements.
For stocks and bonds the value of the transaction would constitute the tax base. For example, if an investor buys 20 shares of a corporation worth EUR 100 per share the tax base would be EUR 2,000. In this sense, it is easy to define tax bases for transactions where the asset price is determined by the market at the time when the transaction is executed.

For derivatives, the determination of the transaction value is more complex. In principle, one could argue that the value of the notional or underlying value could be the tax base. Given the sometimes high leverage of certain derivatives this would have two effects. On the one hand, taxing the notional value creates a very large tax base. On the other hand, the tax payment is large compared to the actual price paid for the contract. While this could reduce leverage taken by means of these contracts, noted EC staff, it would also increase the costs for companies when hedging risk. Also, taxing the notional might lead to double taxation in the case where the underlying is traded and taxed at the spot market if for example an option is executed. Instead of taxing the notional, an alternative way of taxing derivatives could be to tax the actual price only.

Wednesday, December 19, 2012

BaFin Authorized to Regulate High Frequency Trading under Draft German Legislation

Draft legislation would authorize the German Federal Financial Supervisory Authority (BaFin) to oversee high frequency trading with a special right to information that would enable better surveillance of firms engaged in algorithmic trading and the systems used for the trading. In particular, under the draft          High Frequency Trading Act, BaFin could require from the firms a description of their algorithmic trading strategies and the specifics of the trade parameters or trade limits. In addition, the legislation would authorize exchanges to ban the use of a specific algorithmic trading strategy if it violates exchange regulations or to remedy undesirable situations that could have an adverse impact on the orderly conduct of exchange trading. In order to aid in regulatory surveillance efforts, the draft would require electronic identification for orders generated algorithmically. The German federal government is committed to the Act, which is designed to curb the risks associated with algorithmic high frequency trading. The legislation must be considered by the Bundestag and the Bundesrat.

High frequency traders must be authorized by BaFin, including traders admitted to a trading venue as trading participants, as well as firms to which trading participants grant electronic access to the trading venue. However, pursuant to the EU passport under the Markets in Financial Instruments Directive (MiFID), securities firms domiciled in another EU state with state approval for trading on their own accounts would not need additional authorization in Germany.

Under the draft, asset management companies, investment services enterprises and investment stock companies engaged in algorithmic trading must structure their trading systems so that they do not disrupt the market. Specifically, firms engaged in algorithmic trading must ensure that their trading systems are resilient, have sufficient capacity and are subject to appropriate trading limits. Algorithmic trading is defined as trading in financial instruments for which a computer algorithm automatically determines the specific order parameters, such as a decision to initiate an order, its timing, price and quality.

House Oversight Panel Report Finds CFPB Cost-Benefit Analysis Deficient, While Praising SEC and CFTC Efforts

Citing improved cost-benefit analysis by the SEC and CFTC, a House Oversight Committee report found that the Consumer Financial Protection Bureau (CFPB) does not perform adequate cost-benefit analyses in its rulemakings. The report was released by Oversight Committee Chair Darrell Issa (R-CA) and Rep. Patrick McHenry (R-NC), Chair of the Financial Services Subcommittee. The funding was part of a broader Committee concern around the CFPB's lack of accountability. The report noted that, fortunately, other independent financial regulators have relevant experience in improving their cost-benefit analyses.  The CFTC signed a memorandum of understanding with the White House Office of Information and Regulatory Affairs (OIRA) to review its cost-benefit analyses. The SEC likewise recently implemented improved cost-benefit analysis practices after receiving criticism about its approach to rulemaking from many observers, including the Committee. The SEC’s new guidance ensures that decisions are informed by the best available information about a rule’s likely economic consequences; involves economists at the earliest stages of developing rules; and requires economists to concur in the economic analyses.

The CFPB, however, remains unconvinced.  Despite calls for action to ensure the Bureau’s cost  benefit analyses are rigorous and complete, noted the report, the CFPB has given no indication that it would consider enhancing its own cost-benefit procedures.

The report also noted that the CFPB’s unnecessarily aggressive processes prevent the Bureau from adequately considering how its enforcement and regulatory actions could restrict access to and increase the cost of credit.  Unlike other prudential regulators, the CFPB has assigned lawyers to its examination teams, which in turn has caused financial institutions to retain additional lawyers as well.

While it has vast powers, observed the report, the CFPB lacks some of the most basic institutional and external  controls that would provide much needed oversight to the agency.  Unlike other independent financial regulators, including the SEC and the FDIC, the CFPB is run by a single director instead of a bipartisan or nonpartisan commission. The CFPB Director serves a five-year term and can only be removed for inefficiency, neglect of duty, or malfeasance in office. Unlike some other agencies, the CFPB is not subject to annual congressional appropriations, and its regulations are not subject to stringent interagency review by the OIRA, within the Office of Management and Budget (OMB). According to the Committee, these structural deficiencies allow the CFPB to be a rogue financial regulator with the unmatched potential to create uncertainty for providers of consumer financial products and services

With these concerns in mind, Chairman McHenry wrote to Mr. Cordray in July 2012 withquestions about the CFPB’s commitment to regulatory independence.  In response to this oversight, the CFPB produced to the Subcommittee an email in which the White House overtly sought to use the CFPB to further the Obama Administration’s policy objectives. 

The Dodd-Frank Act empowers the CFPB to prevent “unfair, deceptive, or abusive” financial services or products. Because the statutory definition in the Dodd-Frank Act is ambiguous and the CFPB has repeatedly declined to interpret it, said the report, there is tremendous uncertainty about how the CFPB will apply the “abusive” standard in practice. During his testimony before the Subcommittee in January 2012, Mr. Cordray refused to offer a clear definition of  “abusive,’’ declaring that it will be a fact and circumstances determination.

Tuesday, December 18, 2012

European Commission Proposes Action Plan for Corporate Governance Reform

The European Commission has launched an Action Plan to improve corporate governance throughout the EU by means of enhanced transparency, increased shareholder engagement, and greater board diversity. While endorsing the comply-or-explain approach of EU corporate governance codes, the Commission urged an improvement in the quality of explanations to be provided by companies departing from the corporate governance codes. Currently, the explanations provided by companies are often insufficient. They either simply state that the company departed from a provision in code without any further explanation or provide only a general or limited explanation for such departure. These types of explanations for failure to implement a corporate governance code recommendation are not useful to investors faced with making investment decisions and assessing the value of a company.

The Commission also endorsed the two-tier board system extant in many EU member states, while at the same time urging non-executive supervisory boards to give broader consideration to the entire range of  risks faced by their  company. In the Commission’s view, the effective oversight of the executive directors or the management board by the non-executive directors or supervisory board leads to successful governance of the company. It follows that diversity of gender, competences and views among the board’s members is very important because it facilitates an understanding of corporate operations and thus enables the board to challenge the management decisions objectively and constructively. Thus, in 2013, the Commission will propose strengthening disclosure requirements with regard to board diversity policies and risk management through an amendment of the Accounting Directive

The 2011 Green Paper identified the need for an EU mechanism to help companies identify their shareholders in order to facilitate dialogue between the company and its shareholders on corporate governance issues. Thus, the Commission will propose, in 2013, an initiative to improve the visibility of shareholdings in the EU as part of its legislative work program in the field of securities law. The Commission will also consider an initiative in 2013, possibly in the context of the revision of the Shareholder Rights Directive, with a view to improving the transparency and conflict of interest frameworks applicable to proxy advisory services, which have become de facto corporate governance standards setters.

In 2013, the Commission will also begin an initiative, possibly through modification of the Shareholders Rights Directive, on the disclosure of voting and engagement policies as well as voting records by institutional investors. The Commission believes that the disclosure of such information could have a positive impact on investor awareness, optimize investment decisions, facilitate dialogue between investors and companies, encourage shareholder engagement and strengthen companies’ accountability to civil society. The Commission noted that, currently, the UK Stewardship Code and the Dutch Eumedion best practices for engaged share ownership recommend that institutional investors be transparent about the way they exercise their ownership responsibilities, which includes in particular information about voting and engagement.

Another 2013 initiative through a modification of the Shareholders Rights Directive would be to improve transparency on remuneration policies and individual remuneration of directors, as well as to grant shareholders the right to vote on remuneration policy and the remuneration report. In the Commission’s view, shareholders should be able to express their views on the matter through a mandatory shareholder vote on the company’s remuneration policy and the remuneration report, providing an overview of the manner in which the remuneration policy has been implemented. Currently, not all EU member states give shareholders the right to vote on remuneration policy and/or the report, and information disclosed by companies in different states is not easily comparable.

The Commission will also propose in 2013 an initiative aimed at improving shareholder control over related party transactions, possibly through an amendment to the Shareholder Rights Directive. Related party transactions may cause prejudice to the company and its minority shareholders, noted the Commission, since they give the related party the opportunity to appropriate value belonging to the company. Thus, adequate safeguards for the protection of shareholder interests are of great importance.

Current EU regulations require companies to include in their annual reports a note on transactions entered into with related parties, stating the amount and the nature of the transaction and other necessary information. However, since this requirement tends to be regarded as insufficient, the European Corporate Governance Forum issued a statement on related party transactions recommending the introduction of common principles across Europe. The Forum proposed in particular that transactions above a certain threshold should be subject to evaluation by an independent advisor and that the most substantial transactions should be approved by shareholders.

Monday, December 17, 2012

House FSC Member Urges Mandated Stand-Alone Subsidiaries for Systemically Important Financial Firms

Noting that too big to fail is an unacceptable regime, Rep. Brad Miller (D-NC), a senior member of the Financial Services Committee, urged that Federal Reserve and the FDIC to consider the proposal by former FDIC Chair Sheila Bair to require that systemically important financial institutions be simplified and subsidiarized into discrete, separately managed legal entities based on business lines. In a letter to the Fed and FDIC Chairs, Rep. Miller said that he favors the direct approach of breaking up the most systemically important firms into smaller or simpler pieces as a way to end too big to fail, but is willing to consider nuanced approaches.

He noted that stand-alone subsidiaries would be easier to manage and regulate and far less messy to resolve. The failure of one or more subsidiaries would result in an investment loss for the parent corporation, he noted, but would not necessarily result in the disorderly collapse of the financial institution. If the financial institution became insolvent, many subsidiaries could still operate relatively normally. Stand-alone subsidiaries could be sold or spun off without significant disruption to the financial firm or the financial system, even in a crisis, without damaging the franchise value of the subsidiaries.
According to Rep. Miller, stand-alone subsidiaries would also provide prudential regulators with an important ally, the financial market, in the oversight of systemically significant institutions: Each of the systemically significant institutions has hundreds if not thousands of subsidiaries. The financial institutions create subsidiaries for regulatory or tax purposes, noted Rep. Miller, but operate the firm as a single enterprise with consolidated management and a common pool of capital and liquidity. While the financial institution presents the subsidiaries to taxing authorities and regulators as separate entities, said Rep. Miller, the firm assures counterparties that all of the assets of the financial institution stand behind each subsidiary.
Practically speaking, the prudential regulators have no realistic way to assess the risk posed in thousands of subsidiaries engaged in all manner of businesses and neither do counterparties, warned Rep. Miller. Counterparties assume that the financial institutions are still too big to fail, so they will get paid one way or another. But if counterparties knew that they could only be paid from the assets of the specific subsidiary with which they did business, he reasoned, they would consider that subsidiary's assets and potential liabilities. The adequacy of capital would be far easier to judge if the capital was devoted to a specific subsidiary.
In his view, this restoration of market discipline would go a long way to solving the too big to fail problem. If subsidiaries engaged in other business lines were small enough to fail, prudential regulators could pay closer attention to the activities that create the greatest risk of economic disruption.
The congressman also urged the Fed and FDIC to exercise their authority under the living wills provision of the Dodd Frank Act with more energy, ambition and urgency. In the letter to the Fed and FDIC Chairs, he referenced recent concerns voiced by William Dudley, the president of the Federal Reserve Bank of New York, that the living wills submitted by systemically significant financial institutions this summer confirmed that we are a long way from the desired situation in which large complex firms could be allowed to go bankrupt without major disruptions to the financial system. Significant changes in structure and organization will ultimately be required for this to happen.

Rep. Miller agreed with Mr. Dudley that "ultimately" is an unacceptable deadline for structural changes required for credible resolution plans. The legislator warned that the uncertainties in the financial system may not allow for year after year of polite suggestions by regulators and modest tweaks by financial institutions.

Saturday, December 15, 2012

House Panel Troubled by Differing Versions of Volcker Rule Among SEC, CFTC and Banking Agencies, Hears Suggested Legislative Corrections

The House Financial Services Committee examined the efforts of the SEC, CFTC and banking agencies to implement the Dodd-Frank Act Volcker Rule provisions in Section 619 amidst reports that the financial regulators are struggling to adopt a consistent and coordinated final Volcker Rule for the US financial industry. The Committee also entertained industry and investor suggestions for changes to Section 619 as part of any Dodd-Frank corrections legislation in the 113th Congress.

Committee Chairman Spencer Bachus (R-AL) is extremely troubled that the SEC, CFTC and the banking agencies have been unable to agree on a final single version of the Volcker Rule. He said that competing versions of the Volcker Rule will make it difficult for market participants to know what their obligations are and how to comply with them, especially if they find themselves subject to conflicting obligations enforced by different regulators. More broadly, Chairman Bachus called for the repeal of the Volcker Rule in the 113th Congress, adding that the rule does not make the financial system any safer. The oversight Chair said that the Volcker Rule will impose significant costs on consumers, savers and businesses, and may even hamper the ability of asset managers and pension funds to grow the value of their portfolios.

Rep. Carolyn Maloney (D-NY), a key member of the Committee, cautioned that a conflicting set of Volcker regulations could leave the financial industry in total disarray. She advised the SEC, CFTC and the banking agencies to act in a coordinated fashion, resolve their differences, and put forth a consistent set of regulations. Rep. Maloney also said that the complexity of the proposed regulations implementing the Volcker Rule should not be carried into the final regulations.

The Chair-designate of the Committee in the 113th Congress, Rep. Jeb Hensarling (R-TX), said that his approach to the Volcker Rule, and any other financial regulation, is to try to separate the purported benefit of the regulation from its actual benefit and weigh the actual benefit against the actual cost of the regulation. He noted that former Fed Chair Volcker said that he would have written a simpler rule than the one proposed by the financial regulators. He is also concerned about the impact of the Volcker Rule, not so much on large complex financial institutions, but on entities like public utilities.

Rep. Barney Frank (D-MA), the Committee’s Ranking Member, said that the Volcker Rule can help with ending too big to fail because it offers a logical and functional way to diminish the size of financial institutions. He also noted that it is important that the financial regulators finalize the Volcker regulations this year. He predicted that the regulators will adopt a uniform Volcker Rule.

Rep. Shelley Moore Capito (R-WV), Chair of the Financial Institutions Subcommittee, is concerned about the impact of the Volcker Rule on community banks and the businesses they serve. Rep. Capito also expressed concern that market making activities could be construed as proprietary trading under the proposed regulations and that the Volcker Rule could impact liquidity. She called on the SEC and the banking agencies to ensure that community banks and liquidity are not adversely affected by the final Volcker regulations.

Tom Quaadman of the US Chamber of Commerce testified that the Volcker Rule must be viewed in conjunction with international regulatory initiatives such as the Basel III accord on capital and liquidity. Rep. Steve Stivers (R-OH) asked if this conjunction of the Volcker Rule with other international initiative makes the US more or less competitive. Less competitive, responded Mr. Quaadman, because at this point the Volcker Rule is a unilateral US effort.

Rep. Maxine Waters (D-CA), Committee Ranking Member-designate for the 113th Congress, asked about the efficacy of legislation introduced by Rep. Peter King, (R-NY), H.R. 6524, the U.S. Financial Services Global Viability Act, which would stay the enforcement of the Volcker Rule pending a certification that other nations are also abiding by a similar regulatory framework. Rather than quickly passing H.R. 6524, Dennis Kelleher, CEU of Better Markets, advised a watchful waiting period that would allow the financial regulators to do their job and then observe how the Volcker Rule works in practice, and then revisit the Volcker regulations with actual knowledge of how they are working.

Panelists also set forth recommendations to change the Volcker Rule as part of any Dodd-Frank Corrections legislation considered in the 113th Congress. On behalf of the Association of Institutional Investors, Jeff Plunkett asked Congress to clarify the exemption for proprietary trading in State or municipal agency obligations by adopting the definition of “municipal securities” already included in Section 3(a)(29) of the Securities Exchange Act.

He also asked Congress to clarify that regulators should focus on trading activities that are conducted solely for the purpose of executing trading strategies that are expected to produce short-term profits without any connection to customer facilitation or intermediation. This would limit proprietary trading to situations that are not difficult to identify and would be consistent with former Federal Reserve Chairman Paul Volcker’s statements that it should be easy to recognize proprietary trading.

Similarly, Congress should clarify that market making activities taken on behalf of customers fall within the market making exemption. The meaning of the phrase “reasonably expected near term demands of clients, customers, or counterparties” in Section 619(d)(1)(B) should also be clarified to state that “near term” does not limit the market making trading activity in markets that are illiquid or have episodic liquidity.

Congress should also clarify that regulators must allow coordinated aggregate risk-mitigating hedging activities that are implemented across trading units. Additionally, Congress should define the term ‘trading unit’ and the correlation to risk-mitigating hedging activities in the corrections legislation to ensure that banking entities may continue to hedge adequately their trades with institutional clients.

The institutional investors group also urged Congress to narrow the definition of “hedge fund” or “private equity fund” to exclude all registered investment companies and specifically identify the factors that must exist in other pooled vehicles before the regulators may designate them as “similar funds.” Also, foreign funds that are not actively marketed to U.S .investors and non-U.S. regulated funds, such as UCITS funds and other European regulated funds, which are subject to a degree of regulation in foreign jurisdictions, such as the Alternative Investment Fund Managers Directive, should also be excluded from the definition.

Similarly, Investment Company Institute CEO Paul Schott Stevens asked Congress to provide an express exclusion in Section 619 of Dodd-Frank for mutual funds from the definition of hedge fund and private equity fund, as well as an express exclusion for non-US retail funds. Further, since these funds are neither managed nor structured like hedge funds or private equity funds, they should never be categorized as ``similar funs’’ under the Volcker Rule.

FASB-CAQ Forums Examine Notes to Financial Statements as Part of Disclosure Reform

FASB and the Center for Audit Quality issued a summary of observations from two forums on the effectiveness of disclosure. The forums keyed on FASB's Invitation of Comment, Disclosure Framework, which outlines possible approaches to improving the effectiveness of disclosure in the notes to financial statements. Forum participants provided insight and feedback on a number of topics, including the role of the notes, streamlined disclosure in the current environment, the prescriptive nature of current accounting guidance, and the overlap of notes and Management’s Discussion and Analysis (MD&A). PCAOB Chief Auditor Marty Baumann was a forum participant, as well as former SEC Chief Accountant Don Nicolaisen, and former FASB Chair Robert Herz.

Many participants voiced general support for the FASB’s ITC as a good starting point for discussing disclosure effectiveness. Many also noted that it would be difficult to maximize financial statement disclosure effectiveness without also considering SEC disclosure requirements
and presentation of information in the primary financial statements. Many participants also thought that providing flexibility in future disclosure requirements could significantly improve disclosures, although there was diversity in views on how to achieve such flexibility.

Regardless of the manner in which the preparer would carry out its decision making, many participants gravitated toward the idea of always providing a minimum set of disclosures that would allow users to compare entities on some uniform basis.

While some participants generally supported relevance as an appropriate criterion for determining which disclosures to provide, others indicated that, because relevance has not been used as a basis for reporting entities’ decisions, it might be more confusing to use relevance instead of the term materiality, which is already familiar to preparers. The language in the ITC that a disclosure would be relevant if it “could be useful to investors’’ was considered too broad and too low a threshold.

Participants generally favored using “would be useful” instead of “could be useful.” Moreover, while many participants did not favor using a new term in describing how to identify appropriate
disclosures, some stated that a clear explanation of how relevance differs from materiality is necessary if that term is used.

There was some discussion on the overlap of disclosures relating to future returns and other forward-looking information in the notes and in MD&A. Participants also discussed the differences between disclosures in MD&A and financial statements, noting that the former may be subject to forward-looking statement safe harbors and the latter are audited. Some participants at both forums encouraged the SEC and the FASB to agree on where a particular disclosure should be presented and only require it once. However, a minority of participants felt that MD&A and the notes should each stand on their own, and opposed cross-referencing.

Thursday, December 13, 2012

House Panel Examines SEC-CFTC Harmonization of Dodd-Frank Derivatives Regulations Both Globally and Domestically

 A House panel pressed CFTC Chair Gary Gensler and SEC Director of Trading and Markets Robert Cook on the harmonization of regulations implementing the derivatives provisions of the Dodd-Frank Act both domestically and globally. Members of the House Capital Markets Subcommittee expressed concern that, with regard to cross-border derivatives transactions, the CFTC issued guidance centered on the doctrine of substituted compliance, while the SEC will conduct formal rulemaking

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

Chairman Gensler said that the CFTC is committed to the doctrine of substituted compliance and will engage with foreign regulators to make the concept work. Director Cook noted that the SEC has not yet issued proposed derivatives cross-border regulations, but such is at the top of the Commission’s agenda. He pledged that the SEC will do a formal rulemaking with an attendant full cost-benefit analysis on cross-border derivatives transactions. Given the global nature of the derivatives market, the SEC will take a holistic approach on cross-border regulations.

The regulations will strike a balance between domestic priorities and the reality of the global nature of the derivatives market. In any event,  the new Title VII regime will present challenges in its implementation phase, and in overseeing and enforcing the new regime because of the wide range of new market participants and transactions

The SEC expects that the scope of the cross-border regulations will be broad. They will address the application of Title VII in the cross-border context with respect to each of the major registration categories covered by Title VII for security-based swaps and swap dealers; major security-based swap participants; security-based swap clearing agencies; and security-based swap data repositories and swap execution facilities. The regulations will address the application of Title VII in connection with reporting and dissemination, clearing, and trade execution, as well as the sharing of information with regulators and related preservation of confidentiality with respect to data collected and maintained by security-based swap data repositories.

Rep. David Schweikert (R-AZ) asked if the SEC and CFTC have harmonized their regulations implementing Title VII. Chairman Gensler replied that the SEC and CFTC issued jointly harmonized definitions and that the Commissions are coordinating on other regulations. Mr. Cook testified that the SEC is committed to consulting with the CFTC and other regulators at home and abroad in an effort to foster the development of common frameworks and to help ensure a level playing field for market participants consistent with the requirements of the Dodd-Frank Act. He also said that SEC has engaged in extensive interagency discussions concerning rules to implement Title VII that are not required to be adopted jointly. Although the timing and sequencing of the CFTC’s and SEC’s proposal and adoption of these rules have varied, he assured Congress that the objective of consistent and comparable requirements continues to guide the Commission’s efforts

Rep. Schweikert said that he was comfortable with the SEC conducting a formal rulemaking with regard to cross-border derivatives, but was concerned about the CFTC issuing guidance instead of regulations.

Noting that the CFTC is committed to substituted compliance, Rep. Spencer Bachus (R-AL), Chair of the full Financial Services Committee, said that market participants have grave concerns about substituted compliance and foreign regulators do not seem to agree with substituted compliance. He queried if any foreign regulators have endorsed the CFTC’s approach. Chairman Gensler responded that market participants requested substitute compliance and the Commission embraced what the  market participants wanted. Further, he noted that the CFTC engaged in extensive consultation with international regulators and continues to work with them on cross-border issues.

Chairman Bachus observed that the CFTC guidance may be in conflict with foreign regulations. Chairman Gensler acknowledged that there is a conflict with Japanese regulators over clearing. The CFTC is working with the Japanese regulators to provide relief so that US firms can use Japanese clearinghouses even if they are not registered in the US. He emphasized that the CFTC is committed to sorting out conflicts with foreign regulators in a practical way.

He also noted that the CFTC has received excellent cooperation from EU regulators on substituted compliance. The EU authorities have concerns around substituted compliance, but the CFTC and the EU regulators are working through these concerns, said Chairman Gensler.  Mr. Cook noted that the SEC is engaged with the CFTC and with foreign regulators, adding that many jurisdictions are at the cusp of implementing their G-20 commitment to erect a derivatives regulatory regime. The EU talks of mutual recognition and the CFTC speaks of  substituted compliance, he noted

Senate Passes and Clears for President Legislation Preserving Confidentiality of Privileged Information Provided to the CFPB

The Senate passed by unanimous consent bi-partisan legislation fixing an omission in the Dodd-Frank Act that opens the door for third parties to obtain privileged information provided by financial institutions to the Consumer Financial Protection Bureau. The legislation, HR 4014, would require the CFPB to preserve the confidentiality of privileged information it receives from financial institutions, as other banking regulators do. The legislation also clarifies that the CFPB can share such information with the SEC and other federal agencies without impacting a financial institution's attorney-client privilege or work product immunity as it applies to third parties. 

The House passed HR 4014 earlier this year. Since the Senate passage is without amendment, the legislation is cleared for the President, who is expected to sign it.

Richard Cordray, Director of the CFPB, told a House panel earlier this year that this was an oversight and that he supports a legislative solution to ensure that privileged information is not leaked to third parties through the CFPB.

Financial Services Committee Chairman Spencer Bachus (R-ALA) noted that the legislation protects both attorney-client and work product privilege. Rep. Bill Huizenga (R-MI), the author of the legislation, noted that the Dodd-Frank Act specifically failed to safeguard the proprietary information that HR 4014 protects. Currently, the Bureau could have access to confidential information and the legislation would close this loophole and protect data provided during an examination. He described the legislation as a common sense measure that applies to both depository and non-depository institutions.

Banks currently have express legal protection that gives them the confidence and legal certainty to turn over confidential privileged documents at the request of the federal banking agencies. Current law provides that a bank does not waive confidentiality and risk disclosure of the information to an outside party, potentially involved in litigation with the bank, by providing the information to its regulator.

But uncertainty has arisen related to privilege and the Consumer Financial Protection Bureau. In creating the CFPB, Congress did not provide the same express statutory protections relating to privilege that the other banking agencies are given. This was clearly an unintended oversight, in the view of Congress and the banking industry, and while the CFPB has made commendable efforts to address this issue through the regulatory process, there is broad bipartisan support for removing any uncertainty.

Wednesday, December 12, 2012

Former SEC Commissioners Urge US Supreme Court to Apply Bright Line Limitations Period to SEC Enforcement Action

Five former SEC Commissioners have asked the US Supreme Court to disallow the institution of an SEC enforcement action more than five years after the alleged market timing violation occurred since allowing the penalty action would undermine efficient law enforcement. In an amicus brief, the former SEC officials expressed concern that the discovery rule enunciated by the Second Circuit Court of Appeals could subject the Commission and other federal agencies to inappropriate and damaging judicial inquiry intro the process of bringing enforcement actions. The former SEC officials urged the Court to reverse the judgment of the Second Circuit that the five-year limitations period in 28 USC 2462 did not begin to run until the SEC discovered, or reasonably could have discovered, the alleged fraudulent scheme. The Court has set January 8, 2013 for oral argument in the case. Gabelli v. SEC, Dkt. No. 11-1274.

The former SEC Commissioners are Laura Unger, Roberta Karmel, Joseph Grundfest, Richard Roberts and Paul Atkins. Also on the brief were former SEC General Counsels Simon Lorne and Brian Cartwright.

In the enforcement action, the SEC alleged that the market timing 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 28 USC 2462 is applied.

Section 2462 provides that an action for the enforcement of any civil penalty must not be entertained unless begun within five years from the date when the claim first accrued. The appeals court rejected the petitioners’ argument that the SEC claims against them for civil penalties first accrued when they engaged in the alleged fraud at issue regardless of the time at which the SEC discovered or reasonably could have discovered the scheme.

The former SEC officials said that statutes of limitation in penalty cases are crucial to the public’s confidence in the fairness of the system and provide salutary limits on the ability of the government to punish old behavior, in turn promoting the timely investigation of potential violations. In addition, amici argued that the discovery rule endorsed by the Second Circuit could undermine the purpose of repose and certainty underlying Section 2462 and damage the public perception that the federal securities laws are being fairly and timely enforced. Any need of the SEC for more time to bring such enforcement actions should be addressed through tolling agreements in individual cases, said the former officials, and more broadly through requests to Congress for additional resources or an extension of the limitations period.

A discovery rule would involve the federal courts in intrusive discovery of the SEC’s investigative and decision making process, said amici, including particular information received by SEC investigators, including information from confidential sources. This type of inquiry would harm sound principles and encroach on separation of powers. It would also needlessly focus the courts on the actions of federal agencies rather than on defendants in securities fraud cases.

Amici noted that the doctrine of equitable tolling based on fraudulent concealment by a defendant is not at issue here, The Second Circuit properly distinguished the concept of a defendant’s fraudulent concealment, they said, which focuses on the defendant’s conduct from a discovery rule that focuses on the knowledge and diligence of federal agencies, and grounded its ruling in the discovery rule.

In an earlier amicus brief, the securities industry and the US Chamber of Commerce said that the Supreme Court has repeatedly emphasized that the financial markets need predictability and that the Second Circuit opinion violated that principle by engrafting a discovery rule on to the five-year limitations in Section 2462, thereby transforming it from a bright line to a shifting and uncertain inquiry. 

Tuesday, December 11, 2012

UK Government Drafts Legislation to Implement LIBOR Reforms Based on Wheatley Report

The UK Government has drafted legislation to implement the Wheatley report and reform of the London Inter-Bank Offered Rate (LIBOR) by bringing LIBOR within the scope of regulation and making the manipulation of LIBOR a criminal offense. The Government endorses every one of Martin Wheatley’s recommendations and is committed to implementing the necessary changes to legislation without delay. Indeed, in order to fast track the reform of LIBOR, the Government proposes to effect the reform through amendments to the Financial Services Bill, which is currently before Parliament. The Financial Services Bill creates a new twin peaks regulatory regime based on separate prudential and conduct of business regulators; the Prudential Regulatory Authority (PRA) and the Financial Conduct Authority (FCA). LIBOR is a benchmark used to gauge the cost of unsecured borrowing in the London interbank market and sets the price for hundreds of trillions of dollars worth of derivatives and other financial contracts worldwide.

The Wheatley report recommended that the new Financial Conduct Authority should regulate the submission to, and administration of, LIBOR and there should be criminal sanctions for any attempted manipulation. The British Bankers’ Association should make an orderly transfer of responsibility for LIBOR to a new administrator, selected by an independent committee. The new administrator should scrutinize submissions and regularly review the effectiveness of LIBOR. There should be a new code of conduct for submitters, approved by the Financial Conduct Authority. To improve this ability to corroborate submissions, the number of currencies and maturities for which submissions are made should be cut substantially to achieve a sharper focus on the more heavily-used benchmarks.

Under the draft legislation, the regulation of LIBOR-related activities will enhance the ability of the FCA to oversee firms’ conduct in respect of those activities. In particular, it will enhance the ability of the FCA to adopt specific rules in relation to the LIBOR process, which would, among other things, set out the systems and controls requirements that firms will need to have in place. The FCA will also supervise the conduct of both firms and individuals involved in the LIBOR process, including regular reviews of firms’ procedures as well as an assessment of performance of the activities. The FCA will be empowered to take appropriate regulatory action for any misconduct if a firm or approved person does not conduct itself or themselves with the standards set out in the applicable regulatory requirements.

The Government believes that, collectively, these changes will result in a clear and robust regulatory regime, which should in turn lead to the restoration of credibility and confidence in LIBOR, as outlined in the Wheatley review.

The draft would implement the Wheatley recommendation that there should be sufficient criminal sanctions for misconduct in relation to benchmarks, in order that the FCA can investigate and prosecute such behavior. The FCA will have statutory powers of investigation with respect to various offences under the Financial Services and Markets Act, including the making of misleading statements and practices under section 397 of the FSMA and other offenses such as insider dealing. However, the FCA will have no powers to investigate the suspected commission of an offense under the Fraud Act of 2006.

While LIBOR misconduct may fall within the scope of other criminal offenses, it is important that the FCA, as the body responsible for the supervision of conduct in the financial services sector, is able to conduct effective criminal investigations and prosecutions in this area. Indeed, there are also merits in the creation of a specific criminal offence that relates specifically to misconduct in relation to the setting of financial benchmarks.

ISS Issues FAQ on Peer Groups and Executive Compensation Issues

A proxy advisory firm has issued FAQs on selecting a company’s peer group for purposes of analyzing executive compensation. The Institutional Shareholder Services (ISS) said that its new peer group methodology focuses on identifying companies that are reasonably similar to the subject company in terms of size, industry profile, and market capitalization. The peer group will contain a minimum of 14 and maximum of 24 companies based on such factors as the GICS industry classification of the subject company. Proxy advisory services have become de facto corporate governance standard setters in recent years.

The basic principles of the new methodology are that peers should come from similar industries and be of similar size. If the standard methodology fails to yield the minimum number of acceptable peers, ISS will supplement the peer group to reach the minimum. For super mega-cap companies, ISS will use the standard methodology to identify as many peers as possible for these very large companies rather than create supermega peer groups, as was done in 2012. When the standard methodology appears to have produced inappropriate peers, ISS will apply manual judgments to build a peer group.

Sunday, December 09, 2012

EU Council and Parliament Reach Agreement on Legislation to Enhance Regulation of Credit Rating Agencies, Including Mandatory Rotation

The Council of EU Member States and the European Parliament have reached an agreement on legislation to broadly overhaul the regulation of credit rating agencies. The draft Directive and draft Regulation are aimed at reducing investors' over-reliance on credit rating agencies, mitigating conflicts of interest and increasing transparency and competition. The texts will be submitted to the Parliament and the Council for approval and adoption.

Specifically, the draft Directive amends current Directives on undertakings of collective investment in transferable securities (UCITS) Directive 2009/65/EC and on alternative investment funds managers (AIFM) Directive 2011/61/EU in order to reduce these funds' reliance on external credit ratings when assessing the creditworthiness of their assets. The draft regulation introduces a mandatory rotation rule forcing issuers of structured finance products with underlying re-securitized assets who pay credit rating agencies for their ratings under the issuer pays model to switch to a different agency every four years. An outgoing rating agency would not be allowed to rate re-securitized products of the same issuer for a period equal to the duration of the expired contract, though not exceeding four years.

But the legislation would not impose mandatory rotation on small credit rating agencies , or on issuers employing at least four rating agencies each rating more than 10 percent of the total number of outstanding rated structured finance instruments.

A review clause in the legislation provides the possibility for mandatory rotation to be extended to other instruments in the future. Mandatory rotation would not be a requirement for the endorsement and equivalence assessment of third country rating agencies. Due to the complexity of structured finance instruments and their role in contributing to the financial crisis, the draft Regulation also requires issuers to engage at least two different credit rating agencies for the rating of structured finance instruments.

In an effort to mitigate the risk of conflicts of interest, the legislation would require rating agencies to disclose if a shareholder with 5 percent or more of the capital or voting rights holds 5 percent or more of a rated entity, and would prohibit a shareholder of a rating agency with 10 percent or more of the capital or voting rights from holding 10 percent or more of a rated entity.

And to ensure the diversity and independence of credit ratings and opinions, the proposal would prohibit ownership of 5 percent  or more of the capital or the voting rights in more than one rating agency, unless the agencies concerned belong to the same group.

Investors or issuers would be able to claim damages from a rating agency if they suffered a loss due to an infringement committed by the agency intentionally or with gross negligence.

Moreover, sovereign debt ratings would have to be reviewed at least every six months rather than the 12 months that is currently required and investors and Member States would be informed of the underlying facts and assumptions on each rating. Rating agencies would also have to provide more information on the reasons behind sovereign ratings, explaining why it took a specific rating action.

Legislation to Exempt Financial Firms from Providing G-L-B Act Privacy Notifications if No Change Is Debated in the House

A bill to amend the privacy provisions of the Gramm-Leach-Bliley Act to exempt financial institutions from providing an annual privacy notice if they have not changed their privacy policies in the last year was debated in the House, but a vote on the measure was postponed. Introduced by Rep. Blaine Luetkemeyer (R-MO), the Eliminate Privacy Notice Confusion Act, H.R. 5817, is designed to reduce an unnecessary burden facing consumers and financial institutions alike. The bill also would eliminate the annual privacy disclosure for state licensed financial institutions that are subject to state privacy protection laws or regulation, or that become subject to such regulation in the future. The amendments are to Section 503 of Gramm-Leach-Bliley, dealing with disclosure of a financial institution's privacy policy. Section 509 defines financial institution to include firms engaged in securities underwriting, dealing and market making, as well as those providing financial or investment advisory services and advising an investment company.

The bill has strong bi-partisan support. For example, Rep. Brad Sherman (D-CA) called the measure common sense legislation that makes a minor change to federal law to revise a very costly and unnecessary requirement that financial institutions send each of their customers a copy of their privacy policy every year, even when that policy hasn't changed from the prior year when they got the same exact privacy notification. (Cong. Record, Dec. 3 2012, H6581)

Under current law, financial institutions of all sizes are required to provide annual privacy notices explaining information sharing practices to all customers. Financial firms are required to give these notices each year even if their privacy policies have not changed in the slightest. According to Rep. Luetkemeyer, this creates not only waste for financial institutions, but confusion among consumers, as well as increased indirect cost to consumers. (Cong. Record, Dec. 3 2012, H6581)

Rep.Shelley Moore Capito (R-WV), Chair of the Financial Institutions Subcommittee, noted that these annual mailings cost millions of dollars each year and do not provide consumers with new information if the financial institutions have not changed their practice. The legislation will require a financial institution to provide annual privacy notices only if they have changed privacy policies that affect the customer. This is an important, commonsense bill, said the Chair, that will provide further clarity to customers and consumers and eliminate an unnecessary regulatory burden for financial institutions. (Cong. Record, Dec. 3 2012, H6581)

Rep. Sherman noted that the changes will help consumers because, by sending out less, the financial firms will attract attention to those situations where there's been a change in the privacy policy. As a result of the legislation, consumers will know that the privacy notices that arrive in their mailbox actually require their attention. And financial institutions that have been spending millions of dollars to mail out duplicative notices and redundant notifications each year can redirect those savings back to providing for the consumer, to their community, or to loans to help the economy grow.  (Cong. Record, Dec. 3 2012, H6581)

Similarly, Rep. Luetkemeyer said that H.R. 5817 would eliminate millions of costly, confusing, and often ignored mailings that cost millions of dollars to produce each year. And with passage of this bill, information included in these mailings would likely be more significant to the consumer because they would only come after a change in the privacy policy. (Cong. Record, Dec. 3 2012, H6581)
The sponsor assured that the legislation specifically ensures that a financial institution cannot be exempted from annual privacy notices if that institution changes in any way its policies or practices related to the disclosure of nonpublic personal information.

The legislation is supported by Independent Community Bankers of America, the Credit Union National Association, the American Bankers Association, and the National Association of Federal Credit Unions, among others.

But the measure is opposed by the House Privacy Caucus, co-chaired by Rep. Joe Barton (R-TX) and Rep. Ed Markey (R-MA). Rep Barton said that existing privacy protections should not be given up. The bill would eliminate a requirement of notification, which is not the same as reducing the privacy that is in the law, conceded Rep. Barton, but ``when you start down that slippery slope where you know that you don't have to notify of privacy protection,’’ he emphasized, the next step is to not even have privacy at all. (Cong. Record, Dec. 3 2012, H6582)

Rep. Sherman noted that consumers are going to get notification of what the privacy rules are when they start with the financial institution and they are going to get notified every time the firm makes a change, and they are going to be notified any time of the night or day when they simply go onto the website of the firm and look at the required privacy notification. (Cong. Record, Dec. 3 2012, H6582)

When Gramm-Leach-Bliley was passed, he said, not everybody had access to the Internet. Today, a much larger percentage of people are familiar with the Internet, have access to the Internet, and know that if they want to see the privacy notification, the privacy rules of their financial institution, it's there on the Internet in a way that most people are going to have easy access to.

Rep. Sherman said that he would be happy to co-sponsor legislation to require an email notification once a year to every customer willing to provide their email address to the financial institution.