Wednesday, January 30, 2013

IOSCO Secretary General Envisions Global Financial Regulation Enforced by Treaty

Given the cross-border interconnectedness of financial markets, IOSCO Secretary General David Wright called for a global institutional framework for financial regulation, established by International Treaty, and with some enforcement authority and sanctioning possibilities. In his view, the alternative to enforceable global regulation is the law of the jungle or keeping the status quo of loose forms of cooperation. In remarks at the Atlantic Council in Washington, the Secretary General said that the current situation is not sustainable because the tools at hand can best be described as soft: peer review; transparency; and monitoring plus. There are no binding tools whatsoever at the global regulatory level, he noted, and no legally binding enforcement mechanisms.

The global institutional framework should encompass at least the Financial Stability Board and the main global sectoral standard setters. Its role would not be to try to enforce a one-size-fits-all harmonized set of regulations, he assured, but rather to ensure and, if necessary legally require, that basic globally agreed policy principles are properly implemented by all jurisdictions who are signatories to the Treaty arrangements. 
Mutual recognition, substitute compliance and equivalence regimes could be first steps on the path but they will not, in the end, suffice because they are subjective and contestable. A TransAtlantic Treaty between the U.S. and the E.U. would also be a good start, but again, it would insufficient in the long run given the massive growth of financial markets elsewhere in the world.

Tuesday, January 29, 2013

Ways and Means Committee Sets Out Draft Legislation Reforming Taxation of Derivatives and Other Financial Products as Part of Tax Code Overhaul

As part of a comprehensive overhaul of the federal tax code, the House Ways and Means Committee set out draft legislation reforming the taxation of derivatives and other financial products.
The current tax treatment of gains and losses from entering into derivative transactions, such as swaps and futures, is highly dependent upon the type of derivative, the profile of the taxpayer, and other factors, which can result in very different tax consequences for economically similar transactions. In order to bring uniformity to the tax treatment of derivatives and more appropriately measure income and loss, the draft would require all derivative positions to be marked to market at the end of each tax year so that changes in the value of the derivative result in taxable gain or loss.

Any gains or losses from marking a derivative to market would be treated as ordinary income or loss. For straddles, offsetting financial positions, that include at least one derivative position, all positions in the straddle would be marked to market with ordinary income or loss treatment, including stock, debt and other financial
products that otherwise would not be subject to mark-to-market treatment under this proposal.

For purposes of determining the amount of mark-to-market gain or loss on a derivative, the draft would provide regulatory authority to rely upon the fair market value of the derivative that the taxpayer reports for financial or credit purposes.

The legislation would not apply to common transactions involving derivatives, such as hedges used by companies to mitigate the risk of price, currency and interest rate changes in their business operations and real estate transaction, such as options to acquire real estate. The draft would repeal several tax law provisions that would be superseded by general mark-to-market tax treatment of derivatives, such as provisions that attempt to police the inconsistent tax treatment of derivatives under current law.

The draft would also simplify business hedging tax rules. Currently, taxpayers are permitted to match the timing and character of taxable gains and losses on certain hedging transactions with the gains and losses associated with the price, currency or interest rate risk being hedged.  However, taxpayers can only accomplish such matching tax treatment if they properly identify the transaction as a hedge on the day they enter into the transaction.  Often, taxpayers inadvertently fail to satisfy this identification requirement, even though they have properly identified the transaction as a hedge for financial accounting purposes. The draft would permit taxpayers to rely upon an identification of a transaction as a hedge that they have made for financial accounting purposes. 

The draft would eliminate phantom tax resulting from debt restructurings. Currently, when the terms of an outstanding debt instrument are significantly modified, the issue price of the modified debt instrument does not necessarily equal the issue price of the debt instrument prior to modification.  In particular, the issue price of the modified debt instrument can be substantially lower than the issue price of the debt instrument prior to
modification if the debt instrument has lost significant value since the loan was originally made.

The reduction in the issue price resulting from the modification of the debt instrument constitutes taxable cancellation of indebtedness income to the borrower, although the borrower still owes the same actual principal amount as was owed prior to the modification. The draft would eliminate the phantom taxable income problem associated with many debt restructurings by generally providing that the issue price of the modified debt instrument cannot be less then the issue price of the debt instrument prior to modification.  This floor on the issue price of the modified debt instrument would be reduced by any amount of actual principal that is forgiven.

The draft would prevent the harvesting of tax losses on securities. For decades, the wash sale tax rules have prevented taxpayers from artificially creating tax losses on securities that have declined in value by selling the securities at a loss and, within a short time before or after the sale, acquiring the same securities.  When these rules apply, the loss is deferred until the replacement securities are later sold.  However, many taxpayers can avoid the wash sale rules by directing a closely related party, such as a spouse or dependent child, to acquire the replacement securities.

The draft would close this loophole by expanding the scope of the wash sale rules to include acquisitions of replacement securities by certain closely related parties, including spouses, dependents, controlled or controlling entities (such as corporations, partnerships, trusts or estates), and certain qualified compensation, retirement, health and education plans or accounts.  

Saturday, January 26, 2013

ESMA Calls for Improved Reporting of Goodwill Impairment

Based on a seminal review of IFRS-driven financial statements on the impairment of goodwill at 235 EU issuers, the European Securities and Markets Authority (ESMA) called for improved disclosure of goodwill impairment. ESMA questioned if the level of goodwill impairment disclosed in 2011 corporate financial statements properly reflected the difficult economic operating environment for most companies. While the major disclosures related to goodwill impairment testing were generally provided, conceded ESMA, in many cases these were  boilerplate and not entity-specific. ESMA expects issuers and their auditors to consider the findings of this review when preparing and auditing their IFRS financial statements. 

ESMA Chair  Steven Maijoor said that good quality financial information is key for investors in understanding the financial health of an issuer and, in turn, goodwill, and its impairment, are key components in making a realistic evaluation of firms.  In that respect ESMA’s review will help in providing a more harmonized approach to the disclosure of goodwill impairment under IFRS throughout the European Union

IFRS require recognition of goodwill in the consolidated financial statements of the acquiring company when the company pays a premium over the fair value of the identified assets and liabilities of the target company in a business combination.  After initial recognition, goodwill and intangible assets with indefinite useful lives are subject to annual impairment testing, but not to amortization.

According to IAS 36, when the carrying amount of an asset exceeds the recoverable amount, the asset is considered to be impaired and the company should reduce the carrying amount, and recognize an impairment loss.  Goodwill acquired in a business combination or intangible assets with indefinite useful lives have to be tested for impairment at least on an annual basis.  Goodwill impairment loss cannot be reverse

In order to improve the overall disclosure provided in this area, ESMA urged issuers to specify the key assumptions used in the impairment test and include sensitivity analyses with sufficient detail and transparency, especially in situations when indicators are present that impairment might have occurred. Companies should also determine the growth rates used to extrapolate cash flows projections based on budgets and forecasts; and disclose specific discount rates for each material cash-generating unit rather than average discount rates.

Disclosure on the sensitivity of key assumptions is an area where different practices were observed. ESMA noted that a considerable number of issuers provided very vague sensitivity analysis disclosures. Including a negative confirmation of impairment is wide-spread among issuers.  Disclosing such a confirmation might be helpful for the readers of the financial statements, said ESMA, but it can also cause some confusion, as an investor cannot determine either the amount of headroom or what management considers to be not a reasonably possible change.  As a result of these different practices, users of financial information do not always know why the sensitivity analysis was not provided. ESMA expects issuers to be more transparent and disclose the sensitivity of the impairment calculation to changes in key assumptions.

In addition, ESMA and national competent authorities responsible for IFRS enforcement will use the review’s findings as areas to focus their assessments on when reviewing 2012 IFRS-driven financial statements. These reviews will aim at improving the rigor applied by issuers in the impairment test of goodwill. Also important is monitoring the application and compliance with IAS 36 requirements on goodwill impairment, in particular with regard to the reasonableness of cash flows forecasts, the key assumptions used in the impairment test, and the sensitivity analyses provided.

Former Chairman Bachus Named to Key Subcommittees of Financial Services Committee

Former House Financial Services Committee Chairman Spencer Bachus (R-AL) was named Chairman Emeritus of the Committee and assigned as a voting member of two important subcommittees, Capital Markets and Financial Institutions. This was announced at the Committee’s organizational meeting for the 113th Congress. Chairman Emeritus Bachus was praised by current Chairman Jeb Hensarling (R-TX) and Ranking Member Maxine Waters (D-CA).

Noting that members on both sides of the aisle have tremendous respect and admiration for Chairman Bachus, Chairman Hensarling said that conferring the status of Chairman Emeritus is a recognition of his many contributions and the fact that he has so much more to contribute to the Committee. Members of the Financial Services Committee will continue to benefit from the wisdom, counsel and leadership of the Chairman Emeritus, added Chairman Hensarling.

At the organizational meeting, Rep. Waters named Rep. Carolyn Maloney (D-NY) as the Ranking Member on the Capital Markets Subcommittee, which is chaired by Rep. Scott Garrett (R-NJ). The full Committee Ranking Member also named Rep. Al Green (D-TX) as the Ranking Member on the Oversight and Investigations Subcommittee, which is chaired by Rep. Patrick McHenry (R-NC). For the Financial Institutions Subcommittee, chaired by Rep. Shelley Moore Capito (R-WV), Rep. Gregory Meeks (D-NY) was named Ranking Member,
Given the state of the struggling economy, noted Chairman Hensarling, the work of the committee and subcommittees has perhaps never been more important. He also added that Congress enshrined a too big to fail bailout scheme into law with the Dodd-Frank Act. While praising the bi-partisan nature of the organizational meeting, the Ranking Member said that, far from enshrining too-big-to-fail, Dodd-Frank specifically ends too-big-to-fail by prohibiting the bailout of a failing financial institution.  In fact, it mandates the orderly liquidation of such an institution, in which its executives are dismissed and its shareholders are wiped out.  

Thursday, January 24, 2013

In Letter to SEC, Rep. Markey Says Use Market Reform Act of 1990 to Limit High Frequency Trading

In a letter to SEC Chair Elisse Walter, Rep. Edward Markey pointed out that a section of the Market Reform Act of 1990 gives the SEC broad powers to limit or ban high frequency trading. He believes that high frequency trading is a clear and present danger to the stability and safety of the financial markets and that its use should be curtailed immediately.  Rep. Markey expects a response from Chairman Walter by February 7, 2013.

Section 9(i) of the Exchange Act, added by the Market Reform Act, authorized the SEC to limit or prohibit practices which result in extraordinary levels of volatility. While  originally designed to give the Commission the ability to curtail program trading, reasoned Rep. Markey, Section 9(i) could also be used to restrict or ban high frequency trading. If the SEC makes a finding that the financial markets are currently in a period of extraordinary volatility and that high frequency trading is reasonably certain to engender such levels of volatility, emphasized Rep. Markey, the Commission could immediately promulgate rules restricting or eliminating the practice.

Further, given that numerous commenters have already pointed out that the level of market volatility is at historically high levels and that high frequency trading augments that volatility, both of these findings could be made very easily. In his capacity as Chair of the House Telecommunications and Finance Subcommittee, Rep. Markey authored the provisions of the Market Reform Act that authorized the Commission to crack down on program trading.

More broadly, Rep. Markey said that high frequency trading has established bifurcation in the markets in that well-financed and sophisticated trading firms make full use of light-speed high frequency trading algorithms while ordinary investors remain at more terrestrial speeds. Ordinary investors are increasingly citing high frequency trading as evidence that markets are a rigged game where large firms with a high-speed  supercomputing terminal can always outperform ordinary investors.

Wednesday, January 23, 2013

NASAA Opens Registration for 28th Public Policy Conference

NASAA has now opened registration for the organization's 28th Public Policy Conference, which will take place on Tuesday, April 16 at the Mayflower Renaissance Hotel in Washington, D.C. The half-day program will provide an opportunity to join securities regulators, financial services industry representatives, legal professionals, academics, investor advocates and legislative and regulatory policymakers for an in-depth look at the key public policy issues facing investors, securities regulators and the investment industry.

Respected Washington observer James Thurber will keynote the conference with a luncheon address examining the current fiscal and political battleground in the 113th Congress. Thurber is University Distinguished Professor of Government and Founder and Director of the Center for Congressional and Presidential Studies at American University in Washington, D.C. He is an expert on campaigns and elections, presidential-congressional relations, and author of "Obama in Office" (2011). Thurber was previously legislative assistant to Senators Hubert H. Humphrey, William Brock, Adlai Stevenson III, and Representative David Obey.

Conference attendees may register on the NASAA website. Registration fees are $150.00 for federal government employees and $495.00 for representatives from the financial services industry and self regulatory organizations. Participants desiring hotel accommodations may book their reservations with the Mayflower Renaissance Hotel either online or by calling 1-800-HOTELS-1. Participants should provide the conference code "NASAA Spring Conference" in order to take advantage of the special discounted rate of $249 per night plus tax. The deadline for booking hotel accommodations is March 22.

Tuesday, January 22, 2013

Final FATCA Regulations Amplify Broad Sweep of Legislation for Securities and Banking Industry and Confirm Inter-Governmental Agreements

The Treasury and IRS have adopted final regulations implementing the Foreign Account Tax Compliance Act (FATCA). The regulations provide additional certainty for financial institutions and government counterparts by finalizing the step-by-step process for U.S. account identification, information reporting, and withholding requirements for foreign financial institutions, other foreign entities, and U.S. withholding agents.

The final regulations also build on intergovernmental agreements the U.S.Treasury has entered into with foreign governments to facilitate the effective and efficient implementation of FATCA by eliminating legal barriers to participation, reducing administrative burdens, and ensuring the participation of all non-exempt financial institutions in a partner jurisdiction. In order to reduce administrative burdens for financial institutions with operations in multiple jurisdictions, the final regulations coordinate the obligations for financial institutions under the regulations and the intergovernmental agreements. 

Passed in 2010 as part of the Hiring Incentives to Restore Employment Act (HIRE), FATCA creates a new reporting and taxing regime for foreign financial institutions with U.S. accountholders. FATCA adds a new Chapter 4 to the Internal Revenue Code, essentially requiring foreign financial institutions to identify their customers who are U.S. persons or U.S.-owned foreign entities and then report to the IRS on all payments to, or activity in the accounts of, those persons.

The Act broadly defines foreign financial institution to comprise not only foreign banks but also any foreign entity engaged primarily in the business of investing or trading in securities, partnership interests, commodities or any derivative interests therein. According to the Joint Committee on Taxation, investment vehicles such as hedge funds and private equity funds fall within this definition. Firms meeting the definition must enter into agreements with the IRS and report information annually in order to avoid a new U.S. withholding tax.

The final regulations broadly define financial institution and investment entities to effectuate the purposes of the Act to effectively and efficiently combat offshore tax evasion.  The regulations define a financial institution as, among other things, an investment entity which, in turn, is defined as an entity that primarily conducts as a business one or more of the following activities or operations for or on behalf of a customer: (1) Trading in money market instruments (checks, bills, certificates of  deposit, derivatives, etc.); foreign currency; foreign exchange, interest rate, and index instruments; transferable securities; or commodity futures; (2) Individual or collective portfolio management; or (3) Otherwise investing, administering, or managing funds, money, or financial assets on behalf of other persons. Moreover, the entity functions or holds itself out as a collective investment vehicle, mutual fund, exchange traded fund, private equity fund, hedge fund, venture capital fund, leveraged buyout fund, or any similar investment vehicle established with an investment strategy of investing, reinvesting, or trading in financial assets. Reg. § 1.1471-5(d).

The legislation’s principal focus is tax compliance by U.S. persons that have accounts with foreign financial institutions. The Act imposes substantial new reporting and tax-withholding obligations on a broad range of foreign financial institutions that could potentially hold accounts of U.S. persons. The reporting and withholding obligations imposed on the foreign financial institutions will serve as a backstop to the existing obligations of the U.S. persons themselves, who have a duty to report and pay U.S. tax on
the income they earn through any financial account, foreign or domestic. These new reporting obligations for financial institutions will be enforced through the imposition of a 30-percent U.S. withholding tax on a wide range of U.S. payments to foreign financial institutions that do not satisfy the reporting obligations. The legislation provides substantial flexibility to Treasury and the IRS to issue regulations detailing how the new reporting and withholding tax regime will work. It also gives Treasury broad authority to establish verification and due-diligence procedures with respect to a foreign financial institution’s identification of any U.S. accounts.

Chapter 4 also provides for withholding taxes as a means to enforce new reporting requirements on specified foreign accounts owned by specified U.S. persons or by U.S.-owned foreign entities. The provision establishes rules for withholdable payments to foreign financial institutions and for withholdable payments to other foreign entities. The Act essentially presents foreign financial institutions, foreign trusts and foreign corporations with the choice of entering into agreements with the IRS to provide information about their U.S. accountholders, grantors and owners or becoming subject to 30-percent withholding.

The legislation’s principal goal is to collect tax from .S. taxpayers who have evaded their responsibilities by investing through foreign financial institutions and foreign entities not subject to IRS reporting obligations. To achieve this goal, the legislation imposes the risk of a withholding tax on a broad class of U.S.-related payments (including gross proceeds) to a broad class of foreign investors, unless the foreign financial institutions and foreign entities agree to provide information to the IRS regarding their U.S. account holders and owners. Essentially, the withholding tax will function as a “hammer” to induce reporting.

Many of the foreign financial institutions that hold accounts on behalf of U.S. persons fall outside the reach of U.S. law. As a result, the current ability of the United States to require foreign financial institutions to disclose and report on U.S. account holders is significantly limited. Although these foreign financial institutions are outside the direct reach of U.S. law, many of them have substantial investments in U.S. financial assets or hold substantial U.S. financial assets for the account of others.

The federal government imposes a tax on the beneficial owner of income, not its formal recipient. For example, if a U.S. citizen owns securities that are held in street name at a brokerage firm, that U.S. citizen (and not the brokerage-firm nominee) is treated as the beneficial owner of the securities. A corporation (and not its shareholders) ordinarily is treated as the beneficial owner of the corporation’s income. Similarly, a foreign complex trust ordinarily is treated as the beneficial owner of income that it receives, and a U.S. beneficiary or grantor is not subject to tax on that income unless and until he or
she receives a distribution.

Under FATCA, the financial world is essentially divided into foreign financial institutions and US financial institutions. US financial institutions have the first compliance obligations under FATCA as the primary withholding agents for withholdable payments made to foreign financial institutions. IRS Notices 2010-60 and 2011-34 provide details regarding how participating foreign financial institutions must identify, report, and withhold on their accounts, and how US financial institutions must identify and withhold on some payments to foreign financial institutions, many details regarding US financial institutions have not yet been provided.

The Act imposes a 30-percent withholding tax on certain income from U.S. financial assets held by a foreign financial institution unless the foreign financial institution agrees to: (1) disclose the identity of any U.S. individual that has an account with the institution or its affiliates; and (2) annually report on the account balance, gross receipts and gross withdrawals and payments from the account foreign financial institutions also must agree to disclose and report on foreign entities that have substantial U.S. owners. These disclosure and reporting requirements are in addition to any requirements imposed under the Qualified Intermediary program. It is expected that foreign financial institutions will comply with these disclosure and reporting requirements in order to avoid paying this withholding tax.

In addition to requiring 30-percent withholding on the expanded category of withholdable payments for financial institutions that do not enter into an agreement with the IRS, new Internal Revenue Code Section 1474(b)(2) will deny a credit or refund to a foreign financial institution that is the beneficial owner of a payment except to the extent that the firm is eligible for a reduced treaty rate of withholding. The section will also deny interest on refunds.

The agreement between the IRS and the foreign financial institution must contain several provisions. Specifically, the foreign financial institution must obtain information regarding each holder of each account maintained by the firm as is necessary to determine which accounts are U.S. accounts, to comply with verification and due-diligence procedures with respect to the identification of U.S.accounts, and to report annually information with respect to any U.S. account maintained by the firm. The foreign financial institution must also deduct and withhold 30 percent from any pass-through payment that is made to a recalcitrant account holder or another financial institution that does not enter into an agreement. A pass-through payment is any withholdable payment or payment that is attributable to a withholdable payment.

A “recalcitrant account holder” is defined as any account holder that fails to comply with reasonable requests for information necessary to determine if the account is a U.S. account; fails to provide the name, address, and TIN of each specified U.S. person and each substantial U.S. owner of a U.S. owned foreign entity; or fails to provide a waiver of any foreign law that would prevent the foreign financial institution from reporting
any information required under this provision.

The Act adds a new Section 1472 to the Internal Revenue Code to deal with withholdable payments to non-financial foreign entities, which it defines as any foreign entities that are not financial institutions. Specifically, the legislation requires a withholding agent to deduct and withhold a tax equal to 30 percent of any   withholdable payment made to a non-financial foreign entity if the beneficial owner of the payment is a non-financial foreign entity that does not meet specified requirements.

A non-financial foreign entity meets the requirements of the provision, and payments made to it will not be subject to the imposition of 30-percent withholding tax, if the payee or the beneficial owner of the payment provides the withholding agent with either: (1) a certification that the foreign entity does not have a substantial U.S. owner; or (2) the name, address and TIN of each substantial U.S. owner.

The Act defines a “substantial U.S. owner” as a person who owns more than ten percent of the company’s stock or is entitled to more than ten percent of the profits in a partnership. In the case of an investment firm, however, that limit is reduced from ten percent to zero. Additionally, the withholding agent cannot know or have reason to know that the certification or information provided regarding substantial U.S. owners is incorrect, and the withholding agent must report the name, address and TIN of each substantial U.S. owner to the Secretary.

The legislation provides a carve-out for corporations whose stock is regularly traded on an established securities market. The carve-out is presumably based on a congressional belief that the risk of tax evasion in connection with a publicly-traded corporation is low. Similarly, the legislation provides a carve-out for charitable and other organizations that are exempt from tax under IRC Section 501(a), again presumably because these entities pose a low risk of being used to facilitate U.S. tax evasion. A further carve-out is provided for SEC-regulated investment companies.      

Due Diligence

The final regulations phase in over an extended transition period to provide sufficient time for financial institutions to develop necessary systems. In addition, to avoid confusion and unnecessary duplicative procedures, the final regulations align the regulatory timelines with the timelines prescribed in the intergovernmental agreements. The final regulations allow reasonable timeframes to review existing accounts and implement FATCA’s obligations in stages to minimize burdens and costs consistent with achieving the statute’s compliance objectives.

To limit market disruption, reduce administrative burdens, and establish certainty, the final regulations provide relief from withholding with respect to certain grandfathered obligations and certain payments made by non-financial entities.

To better align the obligations under FATCA with the risks posed by certain entities, the final regulations expand and clarify the treatment of certain categories of low-risk institutions, such as governmental entities and retirement funds. They also provide that certain investment entities may be subject to being reported on by the FFIs with which they hold accounts rather than being required to register as FFIs and report to the IRS. The regulations also clarify the types of passive investment entities that must be identified and reported by financial institutions.

The final regulations provide more streamlined registration and compliance procedures for groups of financial institutions, including commonly managed investment funds, and provide additional detail regarding the obligations of foreign financial institutions to verify their compliance under FATCA.

Sunday, January 20, 2013

Two Bibles Inform Themes of Continuity and National Unity for Second Inaugural

It is reported that at his public inaugural today President Barack Obama will use the Bible Abraham Lincoln used at his first inaugural and a Bible used by Dr. Martin Luther King, Jr. (see Wall Street Journal, Jan. 18, 2013, p. A13). This is entirely appropriate since it evokes themes of national commonality and continuity, which will almost certainly inform the second inaugural address. In an era of gridlock, these are important reminders of national unity.

With malice toward none, with charity for all, with firmness in the right as God gives us to see the right, let us strive on to finish the work we are in. Abraham Lincoln, Mar 4, 1865.

Let us move on in these powerful days, these days of challenge to make America what it ought to be. We have an opportunity to make America a better nation. Dr. Martin Luther King, Jr., April 3, 1968.

Let us create together a new national spirit of unity and trust. Jimmy Carter, Jan. 20, 1977.

Alongside our famous individualism, there is another ingredient in the American saga, a belief that we're all connected as one people. Do we participate in the politics of cynicism or do we participate in the politics if hope. Barack Obama, July 27, 2004.

German Legislation Creates Financial Stability Commission

German legislation that took effect on January 1, 2013 created the Financial Stability Commission to issue warnings and recommend corrective action if threats to Germany’s financial stability arise. The Financial Stability Act also created the Consumer Advisory Council to ensure, for the first time, that consumer issues will play a larger role in the regulation of German securities markets by the German Federal Financial Supervisory Authority (BaFin)

The Financial Stability Commisison will consist of representatives from the Bundesbank, the Federal Ministry of Finance and BaFin. It will also include one representative of the Financial Market Stabilization Agency, who will not have any voting rights. The Bundesbank is tasked with analyzing all relevant factors in order to identify threats to financial stability, suggest respective warnings or recommendations for corrective measures and submit such warnings or recommendations to the Financial Stability Commission. Under the new regime, the Commission thus ensures that a transparent dialogue takes place between the financial institutions relevant to the regulation of the German financial market and system. 

As regards cooperation between BaFin and the Bundesbank, the legislation stipulates a duty to keep each other informed of any observations, findings and assessments that BaFin and the Bundesbank require to perform their respective functions. In addition, the Bundesbank now has the right to obtain information from financial corporations if the information required to perform its functions cannot be obtained from BaFin or other authorities.

Saturday, January 19, 2013

FASB Proposes Guidance on Repurchase Agreements

The Financial Accounting Standards Board (FASB) has proposed guidance to improve financial reporting about repurchase agreements and other transfers with forward agreements to repurchase transferred assets. The guidance would clarify how to distinguish these transactions as either sales or secured borrowings and improve disclosures about them. The comment period ends on March 29, 2013.

In general, a repo or repurchase agreement is the sale of a portfolio of securities with an agreement to repurchase that portfolio at a later date. Investors have raised concerns that current accounting and disclosures for repurchase agreements do not appropriately reflect the transferor’s obligations and risks resulting from those transactions in certain circumstances, noted FASB Chair Leslie Seidman. FASB is seeking stakeholder input on changes intended to ensure that investors are getting useful information about these and similar arrangements, said Chairman Seidman.

Determining whether a transfer of financial assets in a repurchase agreement is a sale or an on-balance-sheet secured borrowing often rests on an evaluation of whether the transferor maintains effective control over the transferred asset. Under U.S. GAAP, effective control is maintained by a transferor, and therefore secured borrowing accounting is required, if there is a contemporaneous forward agreement to repurchase the same or substantially-the-same financial asset at a fixed price from the transferee before its maturity.

However, effective control is not maintained if a transferor will not recover the transferred asset at the conclusion of the agreement because the asset has matured, resulting in sale accounting if other criteria are met. Stakeholders have said that such an accounting distinction is unwarranted because, during the term of both types of transactions, the transferor retains exposure to the credit risk related to the transferred asset and obtains certain benefits from the asset. 

The proposed guidance would eliminate the distinction between agreements that settle before the maturity of the transferred asset and those that settle at the same time as the transferred asset matures. As a result, both types of transfers with forward agreements to repurchase the transferred assets or substantially-the-same assets at a fixed price would maintain the transferor’s effective control during the term of the agreement and would be accounted for as secured borrowings. For these types of arrangements, noted FASB, the proposed guidance would result in financial reporting that is more comparable with International Financial Reporting Standards (IFRS). When the transferor does not maintain effective control over a transferred financial asset, the transaction would be required to be assessed under the remaining derecognition conditions in U.S. GAAP to determine whether it should be accounted for as a secured borrowing or sale with a forward repurchase agreement. 

Stakeholders also cited the need for more guidance on assessing whether financial assets to be repurchased are substantially the same as those initially transferred, as well as the need for improved disclosures regarding the effect of repurchase agreements and other transfers with forward agreements to repurchase transferred assets on the transferor’s risk profile. The proposed guidance would clarify the characteristics of assets that may be considered substantially the same and would require new disclosures for certain transfers with forward agreements to repurchase the transferred assets. 

In addition, the proposed guidance would change the accounting for a transfer of a financial asset and contemporaneous repurchase agreement financing that asset between the same counterparties (repurchase financings). The proposed guidance would eliminate the current requirement to account for the initial transfer and related repurchase agreement on a combined basis in some circumstances, and would instead require separate accounting for the initial transfer and the repurchase financing.

Canadian Court Finds that Nortel Senior Officers Did Not Misrepresent Financial Results

A Canadian Superior Court judge was not satisfied beyond a reasonable doubt that a company’s CEO, CFO and Controller misrepresented the quarterly financial results of the company, a Canadian manufacturer of telecommunications equipment, by releasing to income $361 million and $372 million respectively in accrued liability balances. Thus, the court found the three senior officers not guilty of fraudulently misrepresenting the company’s financial results. R. v. Dunn, et al., 10-00145, Jan. 14, 2013.

While conceding that, in the abstract, the fact that accrued liability balances in Nortel’s balance sheet were restated is capable of supporting an inference that, in their original form, the financial statements misrepresented the company’s financial results, the court, based on the evidence , could not draw such an inference in this case..

Nortel reported its financial results in accordance with US GAAP and Canadian Generally Accepted Accounting Principles (“Canadian GAAP”). The primary financial statements were prepared in accordance with US GAAP.

In the opinion, the court applied the definition of  materiality such that misrepresented financial results are material if, in light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable member of the investing public would have been changed or influenced by the correction of the item.  The omission of a financial result is material if, in light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable member of the investing public would have been changed or influenced by the disclosure of the item. 

The court also found that Nortel was a significant Deloitte & Touche client and that Deloitte was embedded in one form or another in all aspects of Nortel’s operations. The evidence is replete with communications between Nortel staff and Deloitte staff. Many of the witnesses testified that, when Deloitte asked for information, it was provided. This assertion is amply borne out by the documentary record, said the court.

In 2007, the company settled an SEC enforcement action alleging that it had engaged in accounting fraud to close gaps between its true performance, its internal targets and Wall Street expectations. Without admitting or denying the Commission's charges, the company agreed to pay a $35 million civil penalty, which the Commission placed in a Fair Fund for distribution to affected shareholders. The company also agreed to report periodically to the SEC staff on its progress in implementing remedial measures and resolving an outstanding material weakness over its revenue recognition procedures. SEC v. Nortel Networks Corp., SD NY, Oct. 15, 2007, Civil Action No. 07-CV-8851 (S.D.N.Y.), Oct 15, 2007.

Wednesday, January 16, 2013

Ohio Securities Division Offers SEC Detailed Comments on Regulations Implementing the Crowdfunding Provisions of the JOBS Act

In a detailed and substantive comment letter to the SEC, the Ohio Securities Division set forth a number of recommendations for the Commission to consider at it drafts regulations implementing the crowdfunding provisions (Title III) of the Jumpstart Out Business Startups (JOBS) Act. Broadly, the Division urged the Commission not to rely on the "wisdom of the crowd" theory because it is effective at exposing only the simplest form of fraud, and not those forms of fraud that pose the greatest risk to investors. Claiming that  the  crowd  is  immune from  fraud  because  of its internet  research  savvy  takes  a  far  too  simplistic  view  of the  ways  fraudulent  and  abusive practices occur in the securities context, said the Division in a letter signed by Ohio Securities Commissioner Andrea Seidt.

Authored by Senator Jeff Merkley (D-OR), Title III of the JOBS Act adds a new crowdfunding exemption from the Securities Act allowing companies to accept and pool donations of up to $1 million over the Internet. Generally, the term crowdfunding describes a new form of raising capital whereby groups of people pool money, typically comprised of small individual contributions, to support an entrepreneurial effort.

Title III imposes  disclosure  obligations  on both  crowdfunding intermediaries  and  crowdfunding  issuers. For their part, issuers  are required to  provide to investors  a number of typical offering disclosures including, among others, the business's name and legal status, the names of directors  and officers,  a description of the business of the issuer, and a report of financial condition. The Ohio Securities Division encourages the Commission to mandate a single-offering-circular standard, incorporating disclosures  prepared  by  both  the  intermediary  and  the  issuer.

One  disclosure document  is  simpler, reasoned the Division, and  may  encourage  investors  to  more  fully  review  and  consider  the document.  Moreover,  a  single  offering  document  would  be  consistent  with  other  types  of offerings  where  two  parties  are  responsible  for  preparing  disclosure, for  example,  in  an underwritten public offering,  underwriters  and issuers  generally work together to  craft a single  disclosure document.

Each offering should clearly disclose that the  issuer is seeking  an  exemption from  both state  and  federal  securities  registration  and  therefore  no  regulatory  agency  has  reviewed  the offering.  The offering should clearly state that an investor must make his or her own investment decision.  The offering should  also  clearly state that regulatory  agencies  do  not recommend or endorse the investment for  any offeree and that any representation to the contrary is  a violation of state and federal securities laws.  This disclosure is similar to that required by Rule 253(d) under the  Securities  Act. 

The Division also asked the SEC to consider restricting  if not prohibiting  outright, the  use  of any forecasts or projections of the issuer's future financial performance, whether by the  issuer,  the  intermediary,  or  any  officer,  director,  employee  or  agent  of either.  In  the Division's  experience,  forecasts  and  projections  are  often rife  with fraud,  bear  no  reasonable basis in reality,  and fail to  identify the assumptions made  and the sources  of information relied upon.

The Division explained that it is widely accepted that Title III was intended to be used by very young issuers,  and even true start-ups.  An issuer with little or no  operating history has no  historical  basis  on  which  to  reasonably  predict  future  operating  results.  The  factual  or historical  basis  on  which  to  reasonably  predict  future  financial  returns  becomes  even  more tenuous  where  a  business  is  led  by  inexperienced  management,  employs  new  or  unproven processes,  offers  new  or  untested  products  or services,  or  enters  new  markets  with  unknown levels of demand and competition.  In the Division’s view, it is difficult to see how any young entity or start-up can, in good  faith  and  with  a sound  factual  or  historical  basis, predict  its  future  financial performance..

Title III requires that each crowdfunding issuer provide a description of the  business  of the  issuer  and the  anticipated business plan  of the  issuer. Traditionally, a business plan was a planning document prepared by management for internal use only,  and  not  intended to  be  disseminated  outside  the  company.  Among start-up  companies, however, the word business plan has taken on the meaning of a marketing document used to pitch investors,  not  to  disclose  the  materials  terms  and  risks  of a securities offering.  They are neither tailored for prospective investors nor drafted with the securities laws  in mind.  Thus, the Division said the Commission should clarify the meaning  of the term "business plan," as  used in Title III so that issuers do  not inadvertently provide to investors a document that opens the issuer to potential civil and criminal liability.

Title III conditions the exemption on at least an annual SEC filing of reports  of the  results  of operations  and  financial statements. In the Division’s view, the most appropriate interpretation of this provision is to require the annual filing of updated financial statements for  the fiscal  year  end in the  form  as  referenced  in  Section  4A(b)(l) which were  provided to investors.  Smaller issuers should not be required to obtain an audit.  However, the Commission should require  audited financial statements for  the  larger size  offerings  over $500,000  and for smaller issuers if during the course of their business they obtain an audit for other purposes.

Under Title III,  the  crowdfunding exemption is only available to  offerings transacted  through  a  broker  or  funding  portal.  Because  crowd funding  offerings  are  exempt from registration and review by the Commission, and preempted from review by state securities regulators,  Congress  placed  upon  intermediaries  the  responsibility  of serving  as  the  primary gatekeepers to the  crowdfunding marketplace.  As such, the intermediaries must play a  critical role in ensuring the integrity of the market and maintaining meaningful investor protections.  It is crucial that the Commission's rulemaking recognizes the significance of this role,  and requires crowdfunding intermediaries to uphold their obligation.
Unlike broker-dealers, the activities of funding  portals are significantly restricted under Title  III  of the  JOBS  Act.  Funding  portals  may  not  offer  investment  advice or  make recommendations. The Division hinted that strong guidance from the Commission may be needed to inform this new breed  of industry professional  about the  broad scope  of both recommendation  and  investment advice activities.  This guidance may prevent them from creeping into practices prohibited by the statute down the road and would also inform the public of the extent of the lawful capabilities of funding portals.

Crowdfunding  intermediaries  will  have  extensive  due  diligence  obligations  under existing securities  law  and  under the  Title III, noted the Division. As   an  initial  matter,  new  Section 4A(a)(5)  of the  Securities Act provides,  in part,  that crowdfunding intermediaries  are to  take such measures to reduce the risk of fraud with respect to such transactions,  as  established by the Commission, by rule. According to the Division, this section establishes a due diligence requirement by noting that the measures to reduce the risk of fraud include conducting a criminal and securities enforcement background check of officers, directors,  and 20 percent shareholders of an issuer.

 Moreover, given the balance of power in these transactions, the Division believes that crowdfunding intermediaries may be the only securities professionals with the bargaining power necessary to require  access to  the issuer's information, given that the issuers cannot conduct a crowdfunding offering without the intermediary.  Investors will view  crowdfunding  intermediaries  not  merely  as  passive  "bulletin  boards,"  noted the Division, but  as  active gatekeepers  that  make  representations  regarding  licensing  and  their  affiliation  with  a  self­-regulatory agency, and offer various securities with different pricing.

Tuesday, January 15, 2013

European Commission Adopts Regulation Supplementing Alternative Investment Managers Directive

The European Commission adopted a Regulation supplementing  the Alternative Investment Fund Managers Directive. With the AIFMD, all investment funds in the EU fall into one of the following two categories: They are either UCITS (undertakings for collective investment in transferable securities) or hedge funds and other types of alternative investment funds. UCITS funds are governed by the UCITS Directive (2009/65/EC) and are authorized for sale to the retail market.

Following its implementation, the AIFMD will introduce authorization and regulation requirements for hedge funds and private equity funds and regulatory standards for depositaries and administrators; minimum capital requirements related to portfolio size, governance and risk management requirements for fund managers. The Directive will also allow EU-wide marketing of hedge funds through a passport scheme, initially for EU fund managers only, and then to be extended to non-EU based fund managers two years later. EU Member States must transcribe the AIFMD into their respective national laws by July 22, 2013. 

The Regulation clarifies the general duty of hedge fund managers and other alternative investment fund managers to act in the best interests of the fund and fund investors and the integrity of the market. It clarifies the scope of due diligence in general and the scope of due diligence which should be applied if investments are made in assets of limited liquidity and where fund managers are selecting and appointing counterparties and prime brokers. The Regulation sets out rules on inducements and handling of orders, including reporting obligations in respect of execution of subscription and redemption orders, and rules on placing orders to deal on behalf of hedge and private equity funds with other entities for execution and aggregation and allocation of orders.

The Regulation specifies the types of conflicts of interest that may arise and sets out a conflict of interests policy which includes procedures and arrangements that fund managers are expected to implement and apply in order to identify, prevent, manage, monitor and disclose conflicts of interest.

The Regulation lays down rules concerning the risk management system that should be established and applied by fund managers. The system comprises the organizational structure, policies and procedures for managing the risks relevant to each fund’s investment strategy and the processes and techniques used to measure and manage those risks. The Regulation requires a permanent risk management function to be established and entrusts it with specific tasks, including the implementation of the risk management policy, risk monitoring and measuring the risk level and ensuring that it complies with the fund’s risk profile. The Regulation also requires the functional and hierarchical separation of the risk management function from operating units and specifies safeguards against conflicts of interest which should ensure that the risk management activities are carried out independently.

The fund manager must ensure that, for each fund it manages, appropriate and consistent procedures are established so that an independent valuation of the fund’s assets can be performed in accordance with Article 19 of the AIFMD and the applicable national rules. The Regulation requires the fund manager to establish and implement for each fund policies and procedures for the valuation of assets, and lays down the main features of such valuation policies and procedures. Specific rules are adopted for the use of models for valuing asset. There must be periodic review of valuation policies and procedures, as well as a review of individual values of assets, the calculation of the net asset value per unit or share, and the professional guarantees to be provided.

Under the Regulation, in calculating total assets under management, the preference is to use the value of all assets managed by the fund manager without deducting liabilities and valuing financial derivative instruments at the value of an equivalent position in the underlying assets. Valuing financial derivative instruments as if the underlying assets were acquired by the fund reflects the fund’s exposure to these assets.

With regard to the calculation of leverage, the preferred option is to combine the so-called gross and the commitment methods, The leverage ratios that result from applying the gross method are consistent with the objective to monitor macro-prudential risks. The commitment method is well established and recognized in the asset management sector. Its results can be easily compared with those for UCITS funds. It provides, in particular when combined with the gross method, a good insight into the investment strategies and exposure of hedge funds and private equity funds relevant for both investors and supervisors.

In case of proven necessity for an additional method to better apprehend systemic risk, the precise parameters of such an advanced method should be established by EMSA. This method would then be adopted by modifying the delegated act. Recourse to an advanced method must not obviate the calculation of leverage according to the gross and commitment method, noted the Commission, both remain obligatory for all hedge fund and other alternative fund managers.

All financial instruments which can be registered in a financial instruments account, essentially, transferable securities, money market instruments units in collective investment undertakings, and which belong to a hedge fund or private equity fund must be held in custody. Alternative investment funds may not be excluded from the scope of custody simply because they are the subject of a security interest collateral arrangement. Therefore, should a hedge fund provide its assets as collateral to a collateral taker, the AIFMD requires that these assets remain in custody, except if the fund transfers ownership of the collateralized assets to the collateral taker.

Custody of the collateralized fund assets can be ensured in three ways: (1) the collateral taker is appointed custodian over the collateralized fund’s assets; (2) the fund’s depositary appoints a sub-custodian that acts for the collateral taker or (3) the collateralized assets remain with the fund’s depositary and are earmarked in favor of the collateral taker. All of the above custody arrangements reflect industry practice to ensure that the depositary is not liable for the return of assets that are beyond its control. In addition, the proposed approach, in line with the AIFMD, does not require that a central counterparty become a sub-custodian.

OCC Chief Sees Dodd-Frank Corrections Legislation in 2013

It is likely that Congress will pass Dodd-Frank technical corrections legislation this year, said OCC Thomas Curry, adding that some corrections will be a bit more substantive than technical. But, he assured that the basic legislative framework will not undergo significant change. Thus, the Volcker Rule and the risk retention rules currently being finalized by the SEC, CFTC and the banking regulators are not likely to change much as a result of anything Congress might do. He said that the Volcker Rule and the risk retention regulations will be finalized in ``relatively short order.’’ He noted that regulators are continuing to work on the Basel III capital regulation.

Regarding Basel III, regulators are closely reviewing the comment letters and are especially focused on the provisions that might have an outsized impact on smaller banks and thrifts.

Some of the standards set out in the proposed rulemaking are clearly appropriate for banking institutions of all sizes, and they belong in the rulemaking. For example, I think most of us would agree that we should exclude from regulatory capital those instruments that can’t be trusted to be there when they are most needed to absorb losses. Likewise, the idea of restricting bonuses and dividend distributions for institutions that are nearing minimum capital ratios also seems sound.

But other elements are clearly not appropriate for smaller banks and thrifts, and our proposed rulemaking reflects that. For example, the counter-cyclical buffer as proposed applies only to large banks, and, of course, the parts of the proposal related to the advanced approaches don’t apply to community institutions either. I can assure you that we are giving very close attention to all of the issues that have been raised in the comment process, and we are doing our best to craft rules that will maintain strong capital standards without unduly increasing burden.

Sunday, January 13, 2013

FSC Chair Hensarling Urged Reform of Fair Value Accounting in 2009 TARP Oversight Panel Report

In additional views to the TARP oversight panel’s 2009 report on regulatory reform, Financial Services Committee Chair Jeb Hensarling (R-TX) called for the reform of fair value market-to-market accounting. Noting that the application of these accounting rules magnified the stress of the financial crisis with serious procyclical effects, he said that when markets turn sour or panic the assets in a mark-to-market accounting system must be repeatedly written down, causing financial institutions to appear weaker than they might otherwise be.

In his view, a superior accounting system would not require financial institutions to write down their assets at a time when prices have fallen precipitously during a rapid downturn, as in the collapse of a bubble. Chairman Hensarling was a member of the Congressional Oversight Panel created to oversee the expenditure of the TARP funds authorized by Congress in the Emergency Economic Stabilization Act. The Panel was also required by law to review the state of the federal regulatory system and report to Congress.

In the report on regulatory reform provided by the TARP oversight panel, Chairman Hensarling suggested that an alternative asset valuation procedures, such as discounted cash flow, should be used instead of mark-to-market. This would make it easier for financial institutions to declare assets as held-to-maturity during periods of financial stress. In normal markets, he noted, prices will fluctuate within a limited range, and will rise slowly if at all. But in times of crisis, write-downs beget fire sales, which beget further write-downs. The accounting rules must be improved, he emphasized, taking into account the lessons learned from the financial crisis. Ultimately, greater transparency and accuracy in accounting standards are necessary to restore investor confidence.

Chairman Hensarling also observed that, in late September 2008, the SEC released encouraging changes in guidance allowing companies greater flexibility in valuing assets in a nonfunctioning market. Moving forward, he continued, accounting rules have to provide transparency and the most accurate depiction of economic reality as possible. More broadly, he said that the development of accounting rules should not be conducted in the political arena. 

Saturday, January 12, 2013

Chairman Hensarling Says Financial Services Committee Will Examine Impact of CFPB Qualified Mortgage Regulations

House Financial Services Committee Chair Jeb Hensarling (R-TX) said that the Committee will examine the CFPB’s qualified mortgage regulations and other mortgage regulations for their impact on the ability of community financial institutions to compete and offer sustainable and affordable mortgages or whether they will cause a further consolidation toward perceived too big to fail banks. The Committee will also examine the extent to which these regulations impact a qualified consumer’s ability to access credit. A consolidation in this market is already underway, noted the Chairman, including banks and other mortgage loan originators pull back from offering their products and services.

The CFPB adopted regulations implementing Dodd-Frank Act requirements that mortgage lenders consider consumers’ ability to repay home loans before extending them credit. The Dodd-Frank Act provides that qualified mortgages are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. However, the Act did not specify whether the presumption of compliance is conclusive, thereby creating a safe harbor, or is rebuttable. The regulations provide a safe harbor for loans that satisfy the definition of a qualified mortgage. The regulations take effect on January 10,  2014.

Securities Industry Applauds CFBP for Including Safe Harbor in Definition of Qualified Mortgage

The securities industry is pleased that the Consumer Financial Protection Bureau regulations implementing Dodd-Frank Act requirements that mortgage lenders consider consumers’ ability to repay home loans before extending them credit contains a true legal safe harbor for mortgages that fall within the scope of the qualified mortgage definition. The Dodd-Frank Act provides that qualified mortgages are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. However, the Act did not specify whether the presumption of compliance is conclusive, thereby creating a safe harbor, or is rebuttable. The regulations provide a safe harbor for loans that satisfy the definition of a qualified mortgage

In a statement, SIFMA said it believes that few rebuttable presumption loans are likely to be made and that safe harbor loans will define the market. Therefore it is critical that appropriate, balanced parameters be chosen. SIFMA urged the CFPB to show similar flexibility, inclusiveness, and responsiveness to feedback and be willing to calibrate various parameters of the rules prior to the implementation date.

SIFMA notes that the qualified mortgage definition is a key first step of housing finance reform, which is essential to revitalizing the flow of capital to the private securitization markets and increasing the availability of credit to U.S. consumers. As regulators continue to finalize new rules, including risk retention rules and the associated qualified residential mortgage definition and the capital rules that apply to mortgage lending and securitization, it is vital that they coordinate to ensure that all the rules work together seamlessly. SIFMA cautioned that a failure to coordinate these new rules could lead to conflicting and restrictive regulation that would slow the flow of credit to consumers and hamper the housing market recovery and economic growth. SIFMA said that the qualified mortgage definition is very important since it will set the
parameters for the vast majority of mortgage lending in the United States.

On July 11, 2012, in Congressional testimony, the securities industry urged the Consumer Financial Protection Board to adopt a safe harbor in the qualified mortgage regulations under the Dodd-Frank Act and reject the alternative of a rebuttable presumption which, according to SIFMA, carries the risk of assignee liability. In testimony before the House Financial Institutions Subcommittee. SIFMA senior official Ken Bentsen, cautioned that a rebuttable presumption in the qualified mortgage regulations would have transferred liability to securitizers and investor, SIFMA urged a safe harbor. Given the impact of assignee liability, SIFMA believes it critical that the final rules provide for certainty of compliance with ability to repay requirements.

CFPB Adopts Dodd-Frank Act Qualified Mortgage Regulations with Safe Harbor

The Consumer Financial Protection Bureau adopted regulations implementing Dodd-Frank Act requirements that mortgage lenders consider consumers’ ability to repay home loans before extending them credit. The Dodd-Frank Act provides that qualified mortgages are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. However, the Act did not specify whether the presumption of compliance is conclusive, thereby creating a safe harbor, or is rebuttable. The regulations provide a safe harbor for loans that satisfy the definition of a qualified mortgage. The regulations take effect on January 10,  2014.

The Dodd-Frank Act sets certain product-feature prerequisites and affordability underwriting requirements for qualified mortgages and vests discretion in the Bureau to decide whether additional underwriting or other requirements should apply. The regulations implement the statutory criteria, which generally prohibit loans with negative amortization, interest-only payments, balloon payments, or terms exceeding 30 years from being qualified mortgages.

So-called “no-doc” loans where the creditor does not verify income or assets also cannot be qualified mortgages. Also, a loan generally cannot be a qualified mortgage if the points and fees paid by the consumer exceed three percent of the total loan amount, although certain bona fide discount points are excluded for prime loans. The rules provide guidance on the calculation of points and fees and thresholds for smaller loans.

On July 11, 2012, in Congressional testimony, the securities industry urged the Consumer Financial Protection Board to adopt a safe harbor in the qualified mortgage regulations under the Dodd-Frank Act and reject the alternative of a rebuttable presumption which, according to SIFMA, carries the risk of assignee liability. In testimony before the House Financial Institutions Subcommittee. SIFMA senior official Ken Bentsen, cautioned that a rebuttable presumption in the qualified mortgage regulations would have transferred liability to securitizers and investor, SIFMA urged a safe harbor. Given the impact of assignee liability, SIFMA believes it critical that the final rules provide for certainty of compliance with ability to repay requirements.

Wednesday, January 09, 2013

US Supreme Court Hears Oral Arguments in Case Involving Discovery Rule and Statute of Limitations for SEC Enforcement Actions

Oral argument in a case involving the question of whether a discovery rule should be engrafted on the applicable limitations period for SEC enforcement actions seeking civil penalties revealed concern among Supreme Court Justices as to the broad scope of such a rule and the difficulty of showing whether a federal regulatory agency acted with due diligence in discovering alleged misconduct. The Court is reviewing a decision by a Second Circuit panel 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. Gabelli v. SEC, Dkt. No. 11-1274.

In the enforcement action, the SEC alleged that 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.

Justice Stephen Breyer was concerned that Section 2462 is not an SEC statute, it is not a securities statute. Rather, it is a statute that applies to all Government actions, he noted, which is a huge category across the board and it is about 200 years old. Until 2004, the Justice was unable to find a single case in which the Government ever tried to assert the discovery rule where what it was seeking was a civil penalty, not to try to make themselves whole where they are a victim, with one exception, a case in the 19th century where they did make that assertion and were struck down by the district court. Mentioning Social Security, Veterans Affairs, and Medicare, Justice Breyer noted that this has enormous consequences for the Government suddenly to try to assert a quasi-criminal penalty and abolish the statute of limitations in a vast set of cases.

Arguing for the SEC, U.S. Assistant Solicitor General Jeffrey Wall noted that it was not until 1990 that Congress gave the Commission the right to seek civil penalties, so it could only have brought these actions for the last 20 years. 

Justice Sonia Sotomayor questioned how a party could defeat the Government's claim of discovery by showing that the Government wasn't reasonably diligent. How does a party ever accomplish that, she queried.

Mr. Wall said that discovery is playing itself out in cases like these in district courts and privilege has not been a very major issue for the reason that defendants are by and large pointing to things in the public domain, such as private lawsuits, public filings with the Commission, and public statements, to say that those put the Commission on constructive notice. The way it plays out is that the Commission says that it didn't know and a defendant points to something in the public domain, such as public filings with the Commission or public statements to say that those put the Commission on constructive notice.

Chief Justice John Roberts said that it really depends on how many enforcement officers the SEC has if it is reasonable for them to have been aware of the particular item in some publication.  To the Chief Justice, it seems that it is going to be almost impossible for somebody to prove that the Government should have known about something. It does not provide a lot of repose because you have to establish that this particular federal agency should have known about this.

Justice Ruth Bader Ginsburg described the five-year limitations period in Section 2462 as a generous period. She asked Mr. Wall to explain the SEC's pursuit of this case. The alleged fraud went on from 1999 to 2002, noted the Justice, and it was discovered in 2003.  The SEC waited from 2003 to 2008 to commence suit.  What is the reason for the delay from the time of discovery till the time suit is instituted, asked the Justice. Mr. Wall noted that there was a lot of back and forth between the parties, document exchanges and such, and they wanted to make additional submissions. The Government hoped that there would be a settlement that would encompass all the defendants.  Ultimately, there was a settlement that only went to the fund and petitioners did not settle and then the Government put together and brought its case.

Justice Elena Kagan described the situation as one involving a decision about enforcement priorities.  The Government had decided not to go after market timers, but changed its decision when a State attorney general decided to do it. She questioned if that was the kind of situation that the discovery rule was intended to operate on. Mr. Wall noted that  it wasn't market timing that the Government discovered.  What the State attorney general announced was that there were advisors permitting market timing, but misleading investors about it and they were doing it in return for investments in other funds that they managed, and then the Government started doing market sweeps for those agreements.

Arguing for the petitioner, Lewis Liman noted that in this case the government is seeking a penalty, and is not acting on behalf of underlying investors, and the  recovery is not one that is brought by way of damages or disgorgement. You are talking about a penalty, he emphasized, you are not talking about recovery to victims. 

On a question from Justice Ginsburg, Mr. Liman clarified that Section 2462 applies exclusively with  respect to penalties, fines and forfeitures.  It does not apply with respect to equitable remedies, such as disgorgement.