Tuesday, April 30, 2013

Former SEC Commissioners File Amicus Brief with DC Circuit in Stanford Ponzi Scheme Action

Former SEC Commissioners Paul Atkins and Joseph Grundfest, and former SEC General Counsel Simon Lorne, filed an amicus brief in the DC Circuit in a case involving an SEC request to compel the Securities Investor Protection Corporation to file an application for a protective decree and commence a liquidation proceeding in relation to the fraudulent activities of Robert Allen Stanford. A federal court jury convicted Stanford of conspiracy, wire fraud, mail fraud, obstruction of justice and money laundering in connection with the sale of fraudulent certificates of deposits issued by a foreign bank that was not a SIPC member and marketed by a broker-dealer that was a SIPC member. A federal district court found that the bank CD purchasers were not customers of the broker-dealer within the meaning of the Securities Investor Protection Act. The former Commissioners asked the DC Circuit to reject the SEC’s unprecedented interpretation of the term “customer” and affirm the district court’s judgment. SEC v. SIPC, CA of DC, Civil Action No. 12-5286, April 19, 2013.

In their amicus brief filed with the DC Circuit, the former SEC officials contended that the SEC’s efforts to so dramatically expand the scope of persons covered through SIPC should be rejected for at least three distinct reasons. First, the SEC’s proposal to deem purchasers of CDs issued by a foreign bank to be customers of a domestic broker-dealer contravenes the plain language of the statute, conflicts with the relevant statutory history, and is at odds with more than forty years of judicial precedent. Second, the SEC’s unwarranted expansion of the definition of the term “customer” would substantially increase the financial exposure of the SIPC Fund. Third, the SEC’s proposed redefinition of the term “customer” does not warrant Chevron deference.

Where a statute is administered by more than one entity, noted the former SEC Commissioners, no single entity can claim Chevron deference. Here, the relevant statute is also administered by SIPC, a body governed by a seven-member board composed of presidential and executive branch appointees. SIPC’s views are diametrically opposed to the SEC’s, said the former officials, and should be accorded more deference.

According to amici, the SEC has presented no economic analysis considering the financial implications of this expanded coverage for the industry that must pay fees in order to support the SIPC Fund and the U.S. Treasury, which is statutorily required to provide a line of credit to help support the SIPC Fund, which line of credit is more likely to be drawn down if the scope of coverage is expanded as the SEC requests. The SEC’s proposed expansion of SIPC protection, absent even the most rudimentary consideration of any financial consequences, would radically transform SIPA and threaten SIPC’s ability to function as Congress intended. Under the SEC’s interpretation, noted the brief, SIPC would become another version of the FDIC, with SIPC obligated to provide blanket protection against investment fraud.

The critical aspect of the “customer” definition under SIPA is the entrustment of cash or securities to the broker-dealer for the purposes of trading securities. The investors in the CDs had no cash or securities on deposit with the broker-dealer at the time it failed. Thus, said amici, the SEC does not seek the return of any cash on deposit with the broker-dealer for the purpose purchasing CDs because there is none. It is undisputed that the investors had purchased and received those CDs at the time the broker failed. Instead, said the brief, the SEC is essentially seeking to force SIPC to generate rescission damages for CDs already purchased and received. But SIPC has no such authority, emphasized the former Commissioners.

Sunday, April 28, 2013

Senate Legislation Would Require Impact Study on Regulations Implementing Basel III Accord


Bi-partisan Senate legislation would require the Federal Reserve Board, the FDIC and the OCC to conduct an empirical impact study on proposed regulations relating to the Basel III agreement on general risk-based capital requirements, particularly as they apply to community banks. The Basel III Commonsense Approach for Small Entities Act (Basel III CASE Act), S. 731, was introduced by Senators Joe Manchin (D-WV) and Dean Heller (R-NV). The bill has the support of the banking industry.

In a letter to Senators Manchin and Heller, the American Bankers Association noted that, although the new capital standards were originally intended to set appropriate levels of high quality bank capital for internationally active financial institutions, the regulations proposed by the federal banking agencies go far beyond the Basel III framework and would impact financial institutions of all sizes and business models and have adverse consequences for the communities they serve and the overall U.S. economy.

The proposals are complex and would have a multitude of unintended consequences. In fact, posited the ABA, notwithstanding the fundamental changes and the broad scope of the proposed rules, the federal banking agencies did not present a thorough quantitative analysis of the proposals. Although there were quantitative impact studies of the potential impact on the largest financial institutions, there was no empirical study of the impact of the proposals on all segments of the U.S. banking sector, customers, and the broader U.S. economy.

In the view of the ABA, S. 731 corrects this flaw by requiring the federal banking agencies to perform an empirical impact study of the proposed rules on the entire financial services sector before any final rules are issued, and this is specifically to include community, mid-size, and regional financial institutions. In addition, the study must be made public and subject to comment, and any new rules issued must be based upon the results of the study and comments.

Thursday, April 25, 2013

E.U. Moving Closer to Single Platform for Clearing and Settlement of Securities Transactions

As the E.U. moves towards a single platform for the clearing and settlement of securities transactions, there is a growing consensus that the proposed Central Securities Depository Regulation must be harmonized with Target2 Securities (T2S), an initiative on the operation of securities settlements. The President of the European Central Bank, Mario Draghi, emphasized that T2S is the necessary platform for setting up a single European market for securities. In recent remarks in Frankfurt Am Main, he said that T2S will make the post-trade environment safer and more efficient. It will reduce the cost of settling securities transactions and bring about significant collateral savings for market participants.

These collateral savings are particularly valuable at a time when demand for high-quality collateral continues to increase, as a result of both the crisis and new regulatory developments. But reaping the full benefits from the launch of T2S, noted the ECB chief, requires that it is complemented by the provisions laid out in the CSD Regulation proposed by the European Commission. The CSD Regulation is critical to post-trade harmonization efforts in Europe. The ECB’s Governing Council has stated its strong support for the proposed Regulation, which will enhance the legal and operational conditions for cross-border settlement in the EU in general and in T2S in particular. In this respect, the ECB has recommended that the proposed Regulation and the corresponding implementing acts be adopted prior to the launch of T2S.

Clearing and Settlement. The European Commission proposed a European common regulatory framework for the institutions responsible for securities settlement, called Central Securities Depositories. The proposal is intended to bring more safety and efficiency to securities settlement in Europe. It also seeks to shorten the time it takes for securities settlement and to minimize settlement fails.

The settlement period will be harmonized and set at a maximum of two days after the trading day for the securities traded on stock exchanges or other regulated markets. Market participants that fail to deliver their securities on the agreed settlement date will be subject to penalties, and will have to buy those securities in the market and deliver them to their counterparties. Issuers and investors will be required to keep an electronic record for virtually all securities, and to record them in CSDs if they are traded on stock exchanges or other regulated markets.

Target2 Securities. The Commission believes that the objectives of the proposed Regulation are consistent with those of Target2 Securities, a project launched to create a common technical platform to support CSDs in providing borderless securities settlement services in Europe. The two initiatives are complementary in that the proposed Regulation harmonizes legal aspects of securities settlement and the rules for CSDs at European level and T2S harmonizes operational aspects of securities settlement.

In a recent interview, European Securities and Markets Chair Stephen Maijoor said that ESMA stands ready to implement the CSD Regulation through proposed standards and guidance once political agreement is reached by the legislative bodies. ESMA is establishing working groups to start quickly when the Regulation is enacted. ESMA will need about one year to do its work, he noted, since the standards will necessarily be highly technical. Chairman Maijoor noted that because the CSD is a Regulation, not a Directive, it will be uniform throughout the European Union.

U.K. Parliamentary Committee Questions Extraterritorial Reach of E.U. Financial Transaction Tax

In a letter to Treasury Financial Secretary Greg Clark, the U.K. Parliament’s European Union Committee warned that the financial transaction tax being implemented by eleven E.U. member states, including Germany and France, under the principle of enhanced cooperation could have a significant impact on non-participating states through the residency and issuance principles embedded in the tax.

The European Parliament has approved the European Commission’s proposal for a financial transaction tax, which would impose a 0.1% tax for shares and bonds and a 0.01% tax for derivatives. The adopted text includes an issuance principle under which financial institutions located outside the E.U. would be obligated to pay the financial transaction tax if they traded securities originally issued within the E.U.

The issuance principle means that financial instruments issued in a participating state will be taxed when traded even if those conducting the trade are outside the financial transaction tax zone. For example, the tax would apply when a U.K. pension fund purchased German shares from a U.S. bank. Manfred Bergmann, Director of Indirect Taxation and Tax Administration for the European Commission, told the Committee that the issuance principle was a key element of the financial transaction tax and an important anti-avoidance measure. Director Bergmann estimated that the issuance principle would bring another 4 percent of trades within the scope of the tax, with the other 95 percent already covered by other criteria. The Committee remains concerned about the scope of the issuance principle.

More broadly, the Committee believes that the proposal for a financial transaction tax does not satisfy the criteria for enhanced cooperation, in particular the requirement to respect the rights and obligations of non-participants. The Committee finds it particularly unacceptable that a full analysis of the impact of the tax on non-participating member states was not made available before the vote on enhanced cooperation was taken. The Committee urged Treasury to consider challenging the tax in the European Court of Justice.

Director Bergmann also assured the Committee that there would be no legal obligation on U.K. tax authorities to collect the financial transaction tax. He said that U.K. and U.S tax authorities might be invited to collect the tax, but it would be entirely voluntary. In theory, the financial institution in the participating member state could be requited to pay the tax.

 Despite this assurance, the Committee was concerned with possible adverse consequences for U.K. financial institutions. For example, in the case of a financial transaction involving German shares between a U.S. and a U.K. financial institution, application of the issuance principle would mean that a financial transaction tax would be imposed on both parties payable to the German tax authorities. Given that collecting the tax from the U.S. financial institution may prove difficult, the German tax authorities could impose joint and several liability for both instances of the tax on the U.K. entity and recover the entire amount using the E.U. mutual assistance regime.

 The Committee also took a skeptical view of the European Commission’s belief that the E.U. financial transaction tax would pave the way for a global financial transaction tax. While it is true, as pointed out by Director Bergmann, that the eleven E.U. members implementing the tax represent 90 percent of the eurozone economy, it does not follow that it will be difficult for other world financial centers to resist the tax. The Committee stated that it is almost certain that the U.S. will never enact a financial transaction tax and, indeed, may even view such a tax with hostility as an extraterritorial tax.

Tuesday, April 23, 2013

In Letter to Fed, Senator Shelby Calls for More Transparency in Rulemaking Implementing Basel III Accord

Senator Richard Shelby (R-AL) has asked the Federal Reserve Board to provide the analysis used to determine that the proposed regulations implementing the Basel III Accord would leave the banking system adequately capitalized. In a letter to the Fed, he also asked the Board to provide a quantitative analysis of how the proposal will affect the capitalization levels of US banks by size and asset class. The Ranking Member of the Senate Banking Committee also requested that the Fed provide a cost-benefit analysis of the impact these rules would have on both the US banking system and the overall economy.

By omitting key data from this important rulemaking, he noted, the Fed is preventing public understanding of the impact of the rules and undermining the ability of Congress to hold federal agencies accountable for the regulations they promulgate. Senator Shelby emphasized that it is imperative that Congress and the public have the information they need to independently assess the proposed regulations before they are adopted.

While reaffirming his belief that strong capital requirements are essential to safety and soundness, Senator Shelby said that the proposal fails to explain how the Basel III Accord is appropriate for the US banking system and how the agencies calibrated Basel III for domestic financial institutions. Although he agrees with the Fed’s assertion that the financial crisis showed that the amount of high-quality capital held by banks globally was insufficient to absorb losses during the financial crisis, the Senator said that the proposed regulations do not explain why Basel III will ensure the adequate capitalization of the US banking system.

The Senator also strongly believes in transparent cost-benefit analysis in the federal rulemaking process to ensure full disclosure of the impact of new regulations. In that regard, the proposal implementing Basel III fails to explain with the requisite specificity the impact of the proposed regulations on the banking system and the overall economy. He asked the Fed to provide Congress with a cost-benefit analysis estimating how existing capitalization levels will change, the cost of complying with the rules and their aggregate impact on the economy.

While the banking agencies said that they conducted an impact analysis using bank regulatory input data, and made assumptions when such data was unavailable, noted the Senator, such assumptions and the underlying data were not disclosed. Essentially, the banking agencies have proposed regulations based in large part on a global quantitative impact study using non-public data and relying on non-public assumptions. More transparency is needed in this process, concluded the Senator, adding that such a cloistered approach to rulemaking is inconsistent with US democracy.

Sunday, April 21, 2013

Senator Warner Would be Worthy Senate Banking Committee Chair

With the announcement of the fact that Senator Tim Johnson, Chairman of the Senate Banking Committee, will not seek re-election in 2014, speculation began on who would be the Chair of the Senate Banking Committee in 2014. The name of Senator Jack Reed was mentioned. Senator Reed has seniority and has chaired the Securities Subcommittee and has shown a great deal of interest in issues around securities regulation.

I would also put the name of Senator Mark Warner into the mix as the next Banking Committee Chair. Senator Warner operates in a bi-partisan manner and is well-versed in the issues around financial regulation. he was a key player in drafting Titles I and II of the Dodd-Frank Act.

Saturday, April 20, 2013

House Panel Examines SEC Failure to Meet JOBS Act Rulemaking Deadline, Comm. Walter Says Accredited Investor Definition Is Outdated


At a hearing of the Subcommittee on Oversight and Investigations of the House Financial Services Committee examining the failure of the SEC to meet the statutorily imposed deadline for implementing Title II of the Jumpstart Our Business Startups Act (JOBS) Act, SEC Commissioner Elisse Walter testified that the Commission will move ahead to adopt final regulations implementing Title II as expeditiously as possible. This is a top priority for the SEC, she emphasized. During the hearing, Commissioner Walter said that she favors a revision to the definition of accredited investor to focus more on the amount of money a person already has invested.

Title II of the JOBS Act allows private issuers to market their securities through general solicitations and advertising under exemptions to the registration requirements of the Securities Act. The JOBS Act required the SEC to revise its rules to remove the prohibition against general solicitations and advertising in these exemptions within 90 days of its enactment. The deadline for the SEC to revise Rules 506 and 144A was July 4, 2012. The SEC proposed regulations on August 29, 2012, but has not yet adopted the regulations.

Lifting Ban on General Solicitation. Subcommittee Chair Patrick McHenry (R-NC) noted that Title II lifts the ban on general solicitation and Title II is now the law. Thus, in the Chairman’s view, the SEC has lost its authority to enforce the ban on general solicitation for issuers who abide by Title II, adding that at the very least the enforceability of the ban is now questionable.

Commissioner Walter noted that the SEC received approximately 220 ``quite substantive’’ comment letters on the proposed regulations, which generated a meaningful discussion of the issues. She added that the comments were very beneficial in this rulemaking. Moreover, the Commissioner noted that the comment letters were sharply divided, with some commenters saying that the proposal would facilitate capital formation, while others were concerned that the proposed rules would result in an increase in fraudulent offerings.

A Subcommittee staff memorandum related that, on June 28, 2012, then SEC Chairman Mary Schapiro testified at a hearing before the Committee on Oversight and Government Reform’s Subcommittee on TARP and Financial Services, chaired by Rep. McHenry, that the SEC would miss the July 4, 2012 deadline for implementing Title II, but that the Commissioners would vote on a draft rule during the summer of 2012. Within the SEC, an interim final rule was distributed that would have implemented Title II and permitted companies to use its provisions to raise capital. Rather than holding a vote on the interim final rule, Chairman Schapiro instead recommended that the Commissioners vote on a proposed rule, which was approved on August 29, 2012.

Rep. Stephen Fincher (R-TN), a lead sponsor of the JOBS Act, cautioned that, if all the sections of the Act are not implemented together, the full effect of the Act to create jobs and foster economic growth will not be realized. Rep. Dennis Ross (R-FL) said that the SEC has deviated from clear and unambiguous statutory language. Rep. Ann Wagner (R-MO) noted that the mood of investors and entrepreneurs has gone from excitement to frustration over the delay in implementing the JOBS Act.

Commissioner Walter noted, while the 90-day statutory deadline was clear, the SEC needs good cause to dispense with notice and comment and use an interim final rule process. The SEC must also comply with the Administrative Procedure Act. While noting that it is not inevitable that lifting the ban on general solicitation will lead to fraud, Commissioner Walter emphasized that the SEC has an obligation to address the investor protection issues. She also said that the Commission should also put in place a review program and ascertain if there has been an increase in fraud after the lifting of the general solicitation ban and come back and tell Congress the results of the review program.

Definition of Accredited Investor. Shifting the emphasis of the hearing, Rep. Maxine Waters (D-CA), Ranking Member of the full Financial Services Committee, asked if the SEC intends to redefine the definition of accredited investor. Commissioner Walter said that the definition of accredited investor is outdated and should be redefined. Not only should the numerical standards be changed, testified the Commissioner, the SEC should change the criteria entirely on how to measure sophistication. In her view, the current definition of accredited investor does a poor job of screening out people who are unsophisticated. The definition currently covers people who lack the sophistication to evaluate the investment.

Currently,  the definition of “accredited investor” includes natural persons with an individual net worth, or joint net worth, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person; natural persons with incomes exceeding $200,000 in each of the two most recent years or joint incomes with spouses exceeding $300,000 for those years; or businesses in which all the equity owners are accredited investors.

Rep. Denny Heck (D-WA) asked if a review of the accredited investor definition is currently underway. The Commissioner said that the SEC has started to look at the issues.

In reply to a query from Rep. Heck on how she would change the definition, Commissioner Walter said that, in addition to, or in lieu of, raising the numbers in the definition, a new and different criteria should be employed that would look at the amount a person has already invested, since prior experience in investing would be an good objective indicator of financial sophistication. Borrowing from the Title III crowdfunding provisions of the JOBS Act, the Commissioner said that it might be beneficial to require investors to demonstrate an understanding of basic concepts, showing a degree of financial  knowledge. That element could be imported into the accredited investor definition.

Responding to Rep. Heck’s question on how much of an investment would indicate sophistication, Commissioner Walter said that the amount would have to be relatively high, mentioning, for example, $500,000.


Tuesday, April 16, 2013

ESMA Provides Guidance on E.U. Short Selling Regulation Exemption for Market Making

In order to ensure a level playing field, consistency of market practices and convergence of regulatory practices, the European Securities and Markets Authority has issued guidance under the provisions of the E.U. Short Selling Regulation providing an exemption for market making activities and primary market operations. The Regulation prescribe the notification of intent to make use of the exemption to be made to the home Member State for the market making exemption and the relevant competent authority of the concerned sovereign debt for the authorized primary dealer exemption, while the exempted activities might also take place in other jurisdictions outside the supervisory remit of that authority. In the case of third country entities not authorized in the E.U., the notification has to be sent to the competent authority of the main trading venue in the Union in which the third country entity trades.

ESMA noted that the exemption only covers activities when, in the particular circumstances of each transaction, they are genuinely undertaken in the capacity of market making as defined in the Regulation. Thus, persons notifying of the intent to make use of the exemption are not expected to hold significant short positions, in relation to market making activities, other than for brief periods. Arbitrage activities, particularly those executed between different financial instruments but with the same underlying security, are not considered market making activities under the scope of the Regulation and therefore cannot be exempted.

The over-riding principle for all asset classes is that an entity notifying its intention to make use of the exemption for its market making activities must provide liquidity to the market on a regular and ongoing basis by posting firm, simultaneous two-way quotes of comparable size and at competitive prices. Market making activities that are exempted under the Short Selling Regulation will be those where a person is offering prices that are competitive and in comparable sizes, in line with the specified qualifying criteria for at least the stated mandatory time presence where relevant.

When carrying out hedging activities under the Regulation, said ESMA, the size of the position acquired for the purpose of hedging should be proportionate to the size of the exposure hedged in order for these activities to qualify for exemption. The person should be able to justify upon request from the competent authority why an exact match in size was not possible. The discrepancy should, in all cases, be insignificant.

The Regulation defines market making activities, in part, as dealing as principal in a financial instrument. Consequently, the exemption applies to activities in a financial instrument, emphasized ESMA, on an instrument per instrument basis, and should not be considered as a global exemption for market making activities in general. The notification submitted when notifying of the intent to use the exemption, and further use of this exemption should, therefore, concern a financial instrument issued by a particular issuer subject to the Regulation, such as shares of an issuer falling under the regime and a sovereign issuer as defined by the Regulation.

Further, any such notification of the exemption should identify, with regard to shares, the individual instrument for which market making activities are notified for the purpose of exemption and, for sovereign debt and credit default swaps in sovereign debt if applicable, the sovereign issuer in the debt of which market making activities are notified for the purpose of the exemption.

Senate Legislation Would Exempt Financial Firms from Providing G-L-B Act Privacy Notifications if No Change

Bi-partisan legislation has been introduced in the Senate 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 and the firm otherwise provides customers access to such most recent disclosure in electronic or other form permitted by regulation. The Privacy Notice Modernization Act, S. 635, was introduced by Rep. Sherrod Brown (D-OH) and co-sponsored by Senators Pat Toomey (R-PA). Mike Johanns (R-NE), and Mark Warner (D-VA).

A companion bill, Eliminate Privacy Notice Confusion Act, H.R. 749, passed the House by voice vote in March. The Senate bill differs from the House bill in that H.R. 749 does not condition the exemption on the firm otherwise providing customers access to the most recent privacy disclosure in electronic form.

The amendments effected by the legislation are to Section 503 of Gramm-Leach-Bliley, dealing with the disclosure of a financial institution’s privacy policy. Section 509 defines a financial institution to mean any institution the business of which is engaging in financial activities as described in Section 4(k) of the Bank Holding Company Act, which includes securities underwriting, dealing and market making, as well as providing financial, investment or economic advisory services and advising an investment company.

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.

Saturday, April 13, 2013

E.U. Legislation Would Require Disclosure of Resource Extraction Payments Similar to Dodd-Frank Act Mandate

The European Parliament and the E.U. Council have reached agreement on legislation requiring resource extraction companies to disclose payments to governments on a country and project basis. The vehicle to require disclosure of such payments was legislation amending the Accounting Directive. According to Commissioner for the Internal Market Michel Barnier, this change to the Directive puts the E.U. on a level playing field with the U.S., which mandated such disclosure in Section 1504 of the Dodd-Frank Act.

While the E.U. legislation is broadly similar to the Dodd-Frank Act requirements, they go further in two respects. First, the E.U.logging industry is within the scope of the reporting requirement in addition to the oil, gas and mining industries. Section 1504 of Dodd-Frank targets only the oil, gas and mining sectors. Second, the E.U. regulations would apply to large unlisted companies, as well as to listed companies, while the Dodd-Frank Act requirements are restricted to listed extractive companies. The legislation defines a large company as one that exceeds two of the following three criteria: Total assets of €20 million, turnover of €40 million and 250 employees.

Friday, April 12, 2013

FSC Chair Hensarling Says the Committee Will Consider Legislation to Repeal Dodd-Frank Orderly Liquidation Authority as Part of Ending Too Big to Fail


In remarks at the Center for Capital Markets Competitiveness, Rep. Jeb Hensarling (R-TX), Chair of the House Financial Services Committee, emphasized that too big to fail must be ended. He noted that the Dodd-Frank Act codified too big to fail with two provisions. The first is Title II, providing for an orderly liquidation authority; and the second is allowing FSOC to designate financial firms as systemically important financial institutions.  Becoming a SIFI is a double-edged sword, he observed, since, while the firm is subjected to enhanced regulation, the designation implies a federal bail out . The Chairman said that the Committee will take up legislation to repeal Title II and repeal the provisions authorizing FSOC to designate SIFIS.

He said that there was regulatory timidity and confusion before the financial crisis. But there was no lack of regulatory authority among prudential regulators before the crisis. Dodd-Frank has bestowed an enormous level of discretionary power on regulators.

Chairman Hensarling also noted that the weight, volume, and complexity of federal financial regulations must be alleviated. In addition, he said that, in adopting regulations, the SEC must carry out a thorough cost-benefit analysis. The Chairman said that Congress should pass the Regulations In Need of Scrutiny (REINS) Act so that Congress would get to approve significant federal regulations and thus enforce regulatory accountability. The Act would require Congress to take an up or down vote on all new significant regulations before they could be enforced.

Thursday, April 11, 2013

Oral Argument in DC Circuit on Resource Extraction Provisions of Dodd-Frank Centers on SEC Cost-Benefit Analysis When Regulations Are Mandated

Oral argument in the DC Circuit involving the challenge to SEC regulations implementing the resource extraction provisions of the Dodd-Frank Act centered on the type of cost-benefit analysis needed to be done when Congress has mandated the SEC to adopt regulations. The oral argument, before Circuit Judges Tatel and Brown and Senior Circuit Judge Sentelle, occurred against the backdrop of an earlier DC Circuit opinion, Business Roundtable v. SEC. which held that the SEC was arbitrary and capricious in promulgating the proxy access rule and vacating the rule. American Petroleum Institute, et al. v. SEC, No. 12-1398, U.S. Court of Appeals for the District of Columbia.

Resource Extraction Provision. Section 1504 of the Dodd-Frank Act directs the SEC to adopt regulations requiring resource extraction issuers to include in their annual reports information on any payments made to foreign governments or to the federal government for the purpose of the commercial development of oil, natural gas or minerals. The SEC adopted regulations requiring a resource extraction company to disclose payments made to governments if it is required to file an annual report with the SEC and engages in the commercial development of oil, natural gas, or minerals. The company would be required to disclose payments made by a subsidiary or another entity it controls. A resource extraction company would need to make a factual determination as to whether it has control of an entity based on a consideration of all relevant facts and circumstances.

Cost-Benefit Analysis. On the cost-benefit issue, William Shirey, SEC Senior Litigation Counsel, said that at the end of the day Section 1504 is congressionally mandated rule-making. Congress spoke to the main issues, such as the publication of the information that comes in to the Commission that ultimately should be going out to the public in the same format, which forecloses the possibility of some kind of anonymized aggregation that neither the legislative history nor the statute speaks to.

The SEC senior counsel distinguished this case from the court’s proxy access decision in the Business Roundtable case, because this case involves a statutory provision that Congress has mandated in virtually an unprecedented fashion within the securities laws. Ultimately, the benefit is to provide payment transparency, he said, and also to provide information to investors. Senior Circuit Judge Sentelle noted that the payment transparency part of the SEC’s argument sounds ``kind of circular.’’ in that payment transparency is being compelled because it promotes payment transparency.

Given the congressional mandate, Judge Tatel asked what the role of the cost benefit analysis should be. While cost benefit is a nice formulation to use, replied SEC counsel, the Commission's obligation here is slightly more specific in that it has to consider the rule's impact on efficiency, competition, and capital formation. And as the court has instructed, that requires the Commission to consider as best it can what the economic implications of the rule are, and here the Commission did that, said counsel, ultimately deferring to Congress' determination about the benefits because the benefits were difficult to quantify or determine with any precision. But ultimately the Commission did use the cost analysis, he continued, and the competitive effects throughout the rule-making to tailor provisions, such as not expanding beyond the statute's contours the definition of commercial development, taking a very reasonable approach to the definition of de minmus, and not requiring an accounting or any kind of auditing of the disclosures. Thus, argued SEC senior counsel, the cost-benefit analysis did play a role in the discretionary components of this rulemaking.

Eugene Scalia of Gibson, Dunn & Crurcher, representing the petitioners, noted that, with respect to cost-benefit analysis, an agency assigned to protect shareholders has adopted a rule with a minimum of $14 billion cost on U.S. shareholders and to the competitive advantage of foreign countries. He argued that there were numerous ways beyond the small ministerial changes identified by the SEC counsel by which the Commission could have vastly reduced the costs, including, for example, grandfathering countries that currently prohibited these kinds of disclosures. For all of these reasons, the petitioners ask the court to vacate the rule.

Judge Tatel noted that, on the cost benefit analysis generally that the SEC states that the court’s opinion in the proxy access case was different because here there is a command by Congress to issue these regulations. In a sense, reasoned Judge Tatel, the SEC is arguing that Congress has already made the determination, at least on the benefit side of the analysis.

Rejecting the Commission’s contention, Mr. Scalia countered that any reasonably informed rulemaking where there's a statutory duty to do a cost-benefit analysis looks at where their costs fall and where the benefits fall.

On the publication issue, Mr. Shirey noted that there is issuer specific information that is coming in and projects that have to come in that have to be identified. The only use for that information is for it to be provided to the public. Thus, SEC counsel rejected the idea that somehow Congress left on the table the possibility of anonymized aggregation when the entire purpose of the statute is to provide transparency.

Judge Tatel asked what role the statutory language ``to the extent practical’’ plays. While the SEC counsel acknowledged that the statute requires compilation subject to a practicability determination and it may actually prove impracticable to do the compilation for some reason or another, he noted that Section 13(q) was added to the Exchange Act by Section 1504 and the Exchange Act is all about the public disclosure of corporate annual reports, current reports, and quarterly reports.

Statutory Language. Pressed by Judge Tatel on what in the statutory language makes Section 1504 unambiguous, Mr. Shirey said that in determining whether a statute is unambiguous you look at the structure and the design of the statute, and here you have a statutory provision that provides no use for the information that comes in other than providing that information to the public. There is no independent use that the Commission has identified to do with this information.

Section 13(q) stands on two legs, noted the SEC counsel, there is the project level disclosures, and the government level disclosures. The statute is designed to provide transparency on both ends, what resources are generating the funds, and where those funds are ultimately going to the government. Accepting petitioners' argument about an anonymized aggregation only gives the second piece of that, argued the SEC, because their whole view is that you can just anonymize the payments that are paid to the government. But if you just do that, contended the SEC, you lose that first critical piece of the transparency, the project level disclosures, and projects by definition cannot be aggregated. For example, argued the SEC senior counsel, you can't aggregate an Exxon/Mobil project with a Shell project that may sit, for example, on the other side of Turkmenistan. There is no meaningful way to determine what resource extraction activity the payments are coming from. There is no way to anonymize or aggregate that information to provide the transparency benefits.

Arguing for the petitioners, Mr. Scalia cited the SEC’s exemptive authority, which he described as a long-standing authority the Commission has to carve out what Congress has required. He noted that the Dodd-Frank Act prohibited use of the exemptive authority as to some things, but not as to Section 1504. Congress is not just presumed to have been aware, he noted, it was aware and left the authority open to the Commission.

Mr. Scalia observed that the reasons the Commission gave for not using the exemptive authority are the essence of arbitrary explanations. The Commission said an exemption would not be consistent with the language of the statute, and that it would not be consistent with the structure. He argued that exemptions by definition are exemptions that change what Congress provided.

He said that the SEC rejected a ``very sensible definition’’ of project proposed by the petitioner which, he said, was in and of itself a reason to vacate the regulation. The definition of project goes very directly to the competitive harm industry members fear, continued Mr. Scalia, which is that 90 percent of this market is dominated by state owned oil companies that will not be subjected to this requirement, and the more granular the information published the better the competitive advantage that they will receive.

With respect to requiring public disclosure, petitioner believes that there was room for discretion since the statute was ambiguous. Congress gave the SEC utmost flexibility to avoid burdening companies, emphasized Mr. Scalia, and the Commission declined to exercise that discretion.

Wednesday, April 10, 2013

Rosa Parks Honored and Judge Frank Johnson Remembered

This year we honor the memory of Rosa Parks on the 100th anniversary of her birth . A statue of Rosa Parks now stands in the U.S. Capitol’s Statuary Hall. The U.S. Post Office has also issued a commemorative stamp honoring Rosa Parks, the catalyst of the Montgomery, Alabama bus boycott. This seminal event in U.S. history also brought to national prominence Dr. Martin Luther King, Jr. At the Capitol event, President Obama noted that ``Rosa Parks tells us there is always something we can do. We all have responsibilities to ourselves and others.”

It was federal Judge Frank Johnson, Jr. of the Middle District of Alabama who was part of a three-judge panel that ordered the integration of the public transportation system of Montgomery in Browder v. Gayle, 142 F.Supp 707, a ruling later upheld by the United States Supreme Court.

I once heard Judge Johnson say that the overwhelming work of a federal judge is interpreting sometimes arcane provisions of the U.S. Code and regulations; and rarely does a major civil rights case appear before the court. But, that said, Judge Johnson went on to issue other major rulings of the civil rights era, including Williams v. Wallace, 240 F.Supp 100, which cleared the way for the historic march from Selma to Montgomery.

President Jimmy Carter named Judge Johnson to the U.S. Court of Appeals for the Fifth Circuit and, when Florida, Alabama and Georgia were spun off to create the Eleventh Circuit, Judge Johnson served on that federal appeals court.

In Letter to SEC, Corporate Secretaries Society Says Nasdaq Internal Audit Rule Should Be Confined to Financial Reporting Risk

In a letter to the SEC, the Society of Corporate Secretaries and Governance Professionals urged the Commission to ensure that the proposed Nasdaq internal audit rule applies only to financial reporting risk.

The Society is concerned that the proposed rule could be interpreted to have no limit on the scope of risks that an internal audit function would be required to assess. There are many types of risks facing listed companies, noted the Society, such as liquidity, credit, currency, and interest rate risk, as well as strategic risk, operational risk, cyber risk, legal and compliance risk, and brand risk. The nature of these unique industry risks is such that technical expertise, other than financial literacy/expertise, is critical in order to provide comprehensive board oversight

The proposed rule would require the internal audit function to report solely to the audit committee. The Society believes that audit committees should not be required to oversee all types of risk and internal controls. The Society is concerned that the implication is that the audit committee would, therefore, not be responsible for merely financial risks and financial reporting, but would also be responsible for all facets of risk and internal controls.

Similarly, there seems to be no limit on the types of internal controls that the internal audit function would be required to assess. The rulemaking notice refers both to a system of internal control and to internal control over financial reporting. The implication is that a system of internal control is broader than internal controls over financial reporting. For example, the proposed rule could be interpreted to require assessments of information technology controls, operational risk controls, disclosure controls, and compliance controls. Thus, the Society urged that the rule be narrowed to confine its scope to internal controls over financial reporting only.

Tuesday, April 09, 2013

Australian Securities Commission Proposes Regulation of Dark Pools

The Australian Securities and Investments Commission proposed regulations for dark pools, which are electronic trading systems that do not display public quotes. A key component of the regulatory regime is the adoption of minimum size threshold for dark orders for a security or group of securities. This would involve monitoring the relevant trigger on a quarterly basis to determine when to increase the minimum size threshold; not permitting the aggregation of orders to meet the threshold; and periodically reviewing the categories and thresholds in consultation with industry. Market participants would not be permitted to aggregate orders to meet the minimum size threshold since this would undermine its purpose.

The Commission proposes two alternative triggers for the minimum size threshold. The first trigger would apply when dark liquidity, excluding block size trades, for a security exceeds 10 percent, there is a 4 percent increase in the pre-trade transparent quoted spreads for that security, and there is a 15 percent decrease in the depth at the top five price points for that security. Alternatively, the minimum size threshold would apply when dark liquidity, excluding block size trades, for a security exceeds 10 percent; there is a 20 percent increase in the pre-trade transparent quoted spread for that security; and there is a 20 percent decrease in the depth at the top five price points for that security.

A crossing system is currently defined in the ASIC Market Integrity Rules as any automated service provided by a participant to its clients which matches or executes client orders with orders of the participant or other clients of the participant, otherwise than on an Order Book. As part of the proposed dark pool regulations, crossing system operators would be required to make information about their crossing system publicly available, disclose to users information about user obligations, execution risk and the operation of the crossing system, and have a common set of procedures which appropriately balance the interests of all users and do not unfairly discriminate between users. Also, the regulations would allow users to opt out of a crossing system at no additional cost, and with no additional operational or administrative requirements. Crossing systems would also have to maintain records of all orders that enter a crossing system.

In the U.S., the SEC has become increasingly concerned about the post-trade transparency of dark pools. SEC officials have noted that this lack of post-trade transparency can make it difficult for the public to assess dark pool trading volume and evaluate which ones may have liquidity in particular stocks. Last year, the Senate Securities Subcommittee 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. 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.

Hong Kong SFC Chair Discusses Cross-Border Regulation and Auditor Relationships

Chairman Carlson Tong of the Hong Kong Securities and Futures Commission recently examined cross-border financial regulation, particularly in the area of outside audit relationships. While noting the appropriateness of overhauling financial regulation with a focus on global co-operation and global convergence, he warned of the risk of a one-size-fits-all solution without adequate regard to the different sophistication of local regulatory systems and the maturity of economic and financial development. He pointed out that some of the legislation and regulations that have already been formulated will have far-reaching extraterritorial effect on foreign jurisdictions.

Noting that some Mainland privately-owned enterprises listing in Hong Kong have reported deteriorating results not too long after their listing, Chairman Tong, a former auditor and Chair of KPMG China, said that this situation presents an issue of cross-border regulation around access to information, especially access to auditor working papers, which he said has recently ``become a burning issue.’’

While observing that it is not appropriate to comment in detail on the ongoing proceedings against Ernst & Young over access to auditor working papers, the SFC Chair generally stated that it is important for the SFC and auditors to be able to discuss issues that may arise from the audits of listed companies in Hong Kong, especially if there are issues that may affect the integrity of the market for shares in a listed company.

While the auditor is often likened to a watchdog rather than a bloodhound, he noted, the SFC can properly be described as a bloodhound and the regulatory framework presumes that the watchdog auditor will be able to put the bloodhound regulator on the scent. To do this, auditors must be able to discuss matters they come across and issues that the regulator comes across, and sometimes that must involve disclosing matters contained within the audit working papers.

He said this is a little different from the issue that has arisen in the U.S. where the spotlight has recently focused on non-US audit firms located on the Mainland. This raises a significant cross-jurisdictional issue because it involves Mainland firms and a foreign regulator. In contrast, the question in Hong Kong concerns Hong Kong firms and the application of Hong Kong law.

For its part, the Securities and Futures Commission will continue to implement and adopt global financial regulatory reforms but at the same time make adaptations to suit the uniqueness of Hong Kong’s securities markets through involvement in the International Organization of Securities Commissions and other global regulatory bodies. Chairman Tong emphasized that the profile of the players in Hong Kong’s securities and futures industry is quite unique with a combination of international, local and an increasing number of Mainland players.

Friday, April 05, 2013

Securities and Business Groups Warn on Global Reach of E.U. Financial Transaction Tax

In a letter to E.U. Tax Commissioner Algirdas Semeta and Commissioner for the Internal Market Michel Barnier, securities and business groups warned on the extraterritorial impact in the United States and other countries of the European Commission’s draft Council Directive implementing enhanced cooperation in the area of a financial transaction tax. SIFMA, the Investment Company Institute, the Chamber of Commerce and the Financial Services Roundtable noted that the proposed Directive has substantial extraterritorial impact and introduces both a residency and issuance test for the taxation of financial transactions. The groups described these tests as ``novel and unilateral theories’’ of tax jurisdiction that are both unprecedented and inconsistent with existing norms of international tax law and long-standing treaty commitments. Indeed, the signatories emphasized, there is a high risk that their adoption could lead to double and multiple taxation, a deterioration of international tax cooperation, and trade protectionism and a further impeding of global capital flows.

Based on the process by which the financial transaction tax is coming together, the securities and business groups concluded that the tax is specifically designed to be global in its reach, and, as such, it would collect revenue from financial markets and investors around the world to which the minority of E.U. countries that support the tax have little or no connection. Of particular concern is the extremely broad concept of residency embedded in the EC proposal which, coupled with the issuance principle, would extend the financial transaction tax to many transactions occurring within the United States that have no direct connection to Europe.



U.K. Parliamentary Committee Questions Extraterritorial Reach of E.U. Financial Transaction Tax

In a letter to Treasury Financial Secretary Greg Clark, the U.K. Parliament’s European Union Committee warned that the financial transaction tax being implemented by eleven E.U. member states, including Germany and France, under the principle of enhanced cooperation could have a significant impact on non-participating states through the residency and issuance principles embedded in the tax.

The European Parliament has approved the European Commission’s proposal for a financial transaction tax, which would impose a 0.1% tax for shares and bonds and a 0.01% tax for derivatives. The adopted text includes an issuance principle under which financial institutions located outside the E.U. would be obligated to pay the financial transaction tax if they traded securities originally issued within the E.U.

The issuance principle means that financial instruments issued in a participating state will be taxed when traded even if those conducting the trade are outside the financial transaction tax zone. For example, the tax would apply when a U.K. pension fund purchased German shares from a U.S. bank. Manfred Bergmann, Director of Indirect Taxation and Tax Administration for the European Commission, told the Committee that the issuance principle was a key element of the financial transaction tax and an important anti-avoidance measure. Director Bergmann estimated that the issuance principle would bring another 4 percent of trades within the scope of the tax, with the other 95 percent already covered by other criteria. The Committee remains concerned about the scope of the issuance principle.

More broadly, the Committee believes that the proposal for a financial transaction tax does not satisfy the criteria for enhanced cooperation, in particular the requirement to respect the rights and obligations of non-participants. The Committee finds it particularly unacceptable that a full analysis of the impact of the tax on non-participating member states was not made available before the vote on enhanced cooperation was taken. The Committee urged Treasury to consider challenging the tax in the European Court of Justice.

Director Bergmann also assured the Committee that there would be no legal obligation on U.K. tax authorities to collect the financial transaction tax. He said that U.K. and U.S tax authorities might be invited to collect the tax, but it would be entirely voluntary. In theory, the financial institution in the participating member state could be requited to pay the tax.

Despite this assurance, the Committee was concerned with possible adverse consequences for U.K. financial institutions. For example, in the case of a financial transaction involving German shares between a U.S. and a U.K. financial institution, application of the issuance principle would mean that a financial transaction tax would be imposed on both parties payable to the German tax authorities. Given that collecting the tax from the U.S. financial institution may prove difficult, the German tax authorities could impose joint and several liability for both instances of the tax on the U.K. entity and recover the entire amount using the E.U. mutual assistance regime.

The Committee also took a skeptical view of the European Commission’s belief that the E.U. financial transaction tax would pave the way for a global financial transaction tax. While it is true, as pointed out by Director Bergmann, that the eleven E.U. members implementing the tax represent 90 percent of the eurozone economy, it does not follow that it will be difficult for other world financial centers to resist the tax. The Committee stated that it is almost certain that the U.S. will never enact a financial transaction tax and, indeed, may even view such a tax with hostility as an extraterritorial tax.

Wednesday, April 03, 2013

Senator Sanders to Introduce Legislation Ending Too Big to Fail

Senator Bernie Sanders (I-VT) has indicated that he will introduce legislation to break up large financial institutions and firms and end too big to fail. The legislation would give the Treasury Secretary 90 days to compile a list of commercial banks, investment banks, hedge funds and insurance companies that he deems too big to fail. The affected financial institutions and financial firms have grown so large that their failure would have a catastrophic effect on the stability of either the financial system or the United States economy without substantial government assistance. Within one year of enactment, the Treasury Department would be required to break up those financial institutions and firms identified by the Secretary. The Sanders legislation comes against the backdrop of indications from Senators Sherrod Brown (D-OH) and David Vitter (R-LA) that they will soon introduce legislation ending too big to fail.

Noting that if a financial institution is too big to fail, it is too big to exist, Senator Sanders expects that the legislation will garner support from a number of federal officials, such as Richard Fisher, President of the Dallas Federal Reserve Bank, who recently offered a tripartite approach to reform. First, roll back the safety net to apply only to commercial banks and not to non-bank affiliates. Second, require non-commercial bank customers and counterparties to sign a disclosure acknowledging that there is no implied government backstop. Third, downsize and restructure too big to fail firms, using as little public policy intervention as possible, to realign incentives and reestablish a competitive, level playing field.

ICI Senior Counsel Says Financial Transaction Tax Would Harm Individual Fund Investors

The Investment Company Institute senior tax counsel said that the financial transaction tax being implemented in the European Union under an enhanced cooperation framework and proposed in Senate and House Legislation would harm individual investors despite assurances from proponents that the tax would be imposed only on financial institutions. Keith Lawson noted that, while mutual funds would ostensibly pay the tax, it would be borne solely by fund shareholders. A mutual fund is merely a vehicle through which investors pool their resources, he pointed out, and a mutual fund’s investors are the only owners of the fund.

Further, any financial transaction tax incurred by a fund reduces dollar-for-dollar (or euro-for-euro) the value of the fund’s assets. Thus, each investor incurs directly, in the form of a smaller account balance, his or her proportionate share of the tax, based upon his or her proportionate interest in the fund.

The European Parliament has approved the European Commission’s proposal for a financial transaction tax, which would impose a 0.1% tax for shares and bonds and a 0.01% tax for derivatives. Parliament set forth the possibility of using the enhanced cooperation provision to enable a subgroup of at least nine EU Member States to adopt the financial transaction tax if there is no agreement among all EU Member States. However, the legislative body also recognizes that introducing the tax in a very limited number of Member States could lead to the single market being undermined and that measures should therefore be taken to prevent this.

At the end of last year, eleven EU members, Germany and France plus Austria, Belgium, Estonia, Greece, Italy, Portugal, Slovakia, Slovenia and Spain, applied to the European Commission to enter into enhanced cooperation on the introduction of a financial transaction tax. In the view of German Federal Finance Minister Wolfgang Schäuble, enhanced cooperation will ensure that the participating countries introduce a European financial transaction tax through a joint European process and under European rules.

The ICI senior counsel noted that a fund is expressly identified as a financial institution under the E.U. proposal. As such, a fund would be taxed each time it bought or sold securities issued by a company with a participating member state connection. The fund also would be taxed each time one of its individual investors with a permanent address in a participating member state redeemed shares in the fund.

Under the Wall Street Trading and Speculators Tax Act, S. 410, introduced by Senator Tom Harkin (D-Iowa), a fund would be taxed each time a fund investor redeemed shares, as the fund is purchasing its shares from the redeeming shareholder. The fund also would be taxed each time it bought securities for its portfolio, including with new cash invested by individuals in the fund. A companion bill, H.R. 880, was introduced in the House by Rep. Peter DeFazio, (D-OR).

Counsel also observed that the extent of a mutual fund’s liability would depend, in part, on whether a financial transaction tax has extraterritorial or only national application. In his view, the European Commission proposal has unprecedented extraterritorial scope. Specifically, the FTT would be imposed in all cases without regard to where a fund is organized. A Hong Kong fund, for example, would owe the financial transaction tax to Germany if a German investor residing outside of Germany, but with a permanent address in Germany, redeemed shares of the Hong Kong fund. Likewise, a Canadian fund would owe tax to France if it bought shares of a French company on a stock exchange, even if the exchange were located outside of France. Under the Harkin-DeFazio legislation, the financial transaction tax would be only national in scope. Specifically, the tax would be imposed only on transactions occurring in the United States and involving U.S. persons. Thus, a U.S. fund buying shares of a U.S. company would be a taxable transaction.

Former Fed Chair Volcker Calls on SEC to Adopt IFRS in a Financially Integrated World

Former Fed Chair Paul Volcker, and Chair of the President’s Economic Recovery Advisory Board, urged the SEC to adopt IFRS since it is important to have a global set of strong and common accounting standards. In remarks at the Economy Summit, he noted that a financially integrated world means that the use of different accounting standards impairs investment analysis, prevents informed investment decisions and impairs consistent and disciplined auditing practices. While acknowledging that there are important technical issues to be resolved, the former Fed Chair said that they will never be resolved without a clear impetus from the SEC setting a time certain for IFRS adoption.

Mr. Volcker also called on Congress to strengthen the mandate of the Financial Stability Oversight Council so that the Council can effectively harmonize the regulations of the SEC, CFTC, the Fed and its other constituent members. He emphasized the importance of the simultaneous and uniform regulatory implementation of Section 619 of the Dodd-Frank Act, popularly known as the Volcker Rule, prohibiting retail FDIC-insured banks from proprietary trading and the sponsoring hedge funds. The FSOC, while a step in right direction, needs a much stronger mandate from Congress to be effective. He added that much of the regulatory implementation of the Dodd-Frank Act is in limbo. A major reason for this situation, he believes, is the involvement of too many regulators with overlapping responsibilities, differing priorities, differing governance, and a zealous maintaining of their turf.

The former Fed Chair emphasized that the final Volcker Rule regulations should be uniform for all covered financial institutions. However, the relevant regulating agencies have overlapping responsibilities, idiosyncratic ideas of their own, and differing approaches. Thus, there is a stalemate or a retreat to an unsatisfactory common denominator.

The Chairman said that the Volcker Rule, when fully implemented, will move speculative capital out of banks to hedge funds and private equity funds, which is where it should be. He was somewhat skeptical of the U.K. legislative approach of ring-fencing retail banks to create a pure and simple commercial bank and pushing out proprietary trading and the sponsoring of hedge funds to an investment bank within the same holding company, noting that this approach will be ``hard to pull off.’’

Chairman Volcker also emphasized the importance of enhancing the regulation of money market funds, which have operated as an invasive exotic hybrid, somewhere between a mutual fund and a deposit taking commercial bank. They flourish outside of banking and mutual fund regulations, he said.

Given their vulnerability to runs during the financial crisis, he added, it is widely recognized that money market funds present a structural weakness in the financial system. There are a number of plausible reform alternatives being offered for money market funds. In the Chairman’s view, The most direct option is to say that they are mutual funds and that their assets should be marked to market every day, which could be done without the need to enact legislation. Mr. Volcker expressed his frustration that the relevant regulators seem unable to act, even at the urging of the FSOC.

E.U Securities Authority Is Coordinating Cross-Border Derivatives Regulations under EMIR with SEC and CFTC Says Chairman Maijoor

In proposing regulations on cross-border derivatives transactions and assessing the equivalence of the U.S. and other non-E.U. regulatory regimes, the European Securities and Markets Authority must drill down past internationally agreed-upon principles to detailed regulations. Otherwise, noted ESMA Chair Steven Maijoor in recent remarks, ESMA would not tackle the potential regulatory arbitrage that can arise because many detailed differences will exist between the European Market Infrastructure Regulation (EMIR) and, for example, the Dodd-Frank Act, even when the same high level principles are met by different countries. Many of these detailed differences can be economically significant, he added, and might affect in which part of the world OTC derivatives transactions are conducted.

ESMA has not yet proposed regulations on cross-border derivatives transactions. This is because, given the international reach of EMIR, ESMA wants to take into account the on-going discussions with regulators of other jurisdictions on the cross-border application of their provisions. More specifically, said Chairman Maijoor, the reason for the postponement of the delivery of ESMA’s proposed regulations on equivalence for the U.S. and Japan is to allow sufficient time to identify, together with ESMA’s U.S. and Japanese counterparts, the appropriate solutions to avoid potential market disruptions.

In order to assess whether another country is equivalent to the E.U. derivatives regulatory regime, emphasized the Chair, ESMA must use the EMIR requirements as the yardstick. However, he noted that ESMA performs analyses that are outcome based, rather than rules based. This means that, although the starting point is the comparison of each respective set of rules, when advising the European Commission on the equivalence decision, ESMA will analyze whether different regulations can achieve a similar outcome and whether solutions can be found to prevent, on the one hand, possible market disruptions that a non-equivalent decision may bring and, on the other hand, regulatory arbitrage and risks to the European financial markets as a result of third country entities subject to less stringent requirements.

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

The SEC has indicated that it 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, said former Director of Trading and Markets Robert Cook, the SEC will take a holistic approach on cross-border regulations.

Congress is watching these developments very carefully. Last year, a House panel pressed CFTC Chair Gary Gensler and SEC Director 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.

At the hearing, Rep. Spencer Bachus (R-AL), then Chair of the full Financial Services Committee, now Chairman Emeritus, 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.

Director Cook testified that the Dodd-Frank Act specifically requires the SEC and CFTC to consult and coordinate with foreign regulators on the establishment of consistent international standards with respect to the regulation of OTC derivatives. Thus, the SEC is actively working on a bilateral and multilateral basis with its global regulatory counterparts to address the regulation of OTC derivatives.